Mr Ferguson reviews the historical perspective and policy implications of global financial integration  (Central Bank Articles and Speeches, 4 Mar 99)
Central bank: fed | Type: speech | Date: 1999-03-04

## Mr

Ferguson reviews the historical perspective and policy implications of global finan integrationRemarks by Mr Roger W Ferguson Jr, a member of the Board of Governors of the US Feder Reserve System, at the Annual Policy Seminar of the National Association for Business Econ Washington DC, on 4/3/99.

## Global Financial Integration: Historical Perspective and Policy ImplicationsThank you very much for inviting me to speak to this distinguished group of business econom analysts.

As we have discovered over the last eighteen months or so, we live in a rapidly global economic and financial environment.

Today, given the theme of your conference, I wou to put the events of the last few years into a broader historical context, and ask what appropriate policy solutions.

## Yesterday and TodayLet me turn to a previous period of close global linkage in economic and financial markets years or so prior to World War I.

Here I will draw on a recent NBER working paper by Mi Bordo, Barry Eichengreen and Jongwoo Kim. 1 During this time, capital flowed essentially witho restriction, chiefly from developed Western Europe to regions in the then rapidly de countries of the Americas and to Australia.

Just to put this in perspective, these thre report that at its peak, the outflow from the United Kingdom reached 9 percent of GNP a almost as high in France, Germany and the Netherlands.

Much of this capital was invested that financed railroads and other infrastructure investments and in long-term governm instruments, but there was also significant direct foreign investment.Bordo, Eichengreen and Kim find that one element of the pre-1914 episode of global fi integration is the size and persistence of the current account deficits of capital import mainly Australia, Canada, Argentina and the Scandinavian countries.

Similarly, the curren surpluses of some capital exporters, particularly the United Kingdom, showed consid persistence.

These economic historians indicate that it was not unusual for these co experience current account imbalances, deficits for the capital importers or surpluses fo exporters, of between 5 percent and 10 percent of GDP lasting for several years.The size and persistence of these capital account imbalances in the pre-1914 period appear roughly with the size of current account imbalances that have existed in the most recent global financial integration.

Economic historians indicate that during the period from 197 emerging market countries were running, on average, current account deficits of about 4 p their GDPs.

However, according to these historians, capital flows to the emerging market co today have been somewhat more variable - as measured by the standard deviation of the account to GDP ratio - than those provided to the 'emerging market economies' of the late 1 early 1900s.While the pre-1914 period can be characterized as more stable in some respects, economis identified other important differences between that period of global capital flows and our gross flows are far greater today.

A second difference is in the composition of the invest data are not complete, it does appear that the bulk - possibly as much as 85 percent ac1 Bordo, Eichengreen and Kim, Was There Really an Earlier Period of International Financial Integration Comparable to Today?

National Bureau of Economic Research Working Paper 6738, September 1998.estimates reported by Bordo, Eichengreen and Kim - of pre-1914 investments were in government and municipal securities, railways, resource-extraction companies and public utilities.

Today, it to estimate that a larger proportion of investments are in commercial, industrial and fin concerns, whose assets are more intangible and whose operations are less transparent.

Third, pr 1914, the vast majority of portfolio capital flows took the form of bonds.

More recently, por flows have been more evenly split between bonds and stocks.

## Lessons for PolicymakersPolicymakers need to understand this earlier stage of global capital flows and should attempt to any lessons to today's world of absolutely large, very liquid, and fundamentally less transparent border capital flows.The core question, obviously, is what factors allowed the apparent persistence and relative stab the

pre-1914 era of capital flows?

One theory advanced by academics is that capital exports investments went largely to countries linked through shared language, culture, legal systems accounting regimes.

Another hypothesis may be that, in the period leading up to World War I, commitment of policymakers to stable monetary and fiscal policies was highly credible to mark participants, perhaps reflecting a shared belief in and commitment to the gold standard.The policymakers' challenge today is to build strong institutional structures, policy credibil private sector discipline that are at least as strong as might have existed earlier.

However, we so against a background of modern, technologically driven, global finance.

It is clear that we make the adjustments required because, with the absolute scale of global financial markets increa the size of bailout packages needed to fill financing gaps during international crises wi progressively larger and become less feasible to assemble.

In addition, policymakers must always concerned about the moral hazard of appearing to stand ready to help private sector debtors creditors escape from problems of their making.

Finally, I believe that we must achieve these without attempting to step back to policy regimes of prior periods that are clearly unworkable n that undermine the advantages that we know come with a free flow of capital.So what are the policy solutions that meet these criteria?

In overview, I would say that there p are very few grandiose new solutions that need to be implemented as a policy response to toda global financial turmoil.

Rather, I see an emphasis on basic, sound practices.

## The Need for Sound Institutional UnderpinningsOne lesson suggested by the pre-1914 period of relative stability in capital flows is the import broadly understood and accepted institutional arrangements.

Countries that wish to participate modern global financial market need to modernize their institutional underpinnings.

Several act come to mind.

First, the basic underpinnings of private property protection need to be in plac legal system needs to define and support the enforceability of contracts.

For example, w international bankruptcy procedures do not seem feasible, the adoption or improvement of natio bankruptcy systems is essential and should have a high priority.

Debtors and creditors alike n have an understanding of the rules under which private sector defaults are to be resolved confidence that these rules will be consistently applied.

I put the highest priority on ban procedures because they provide the self-adjusting mechanisms that allow the private sector continue to function even in a world in which financial crises are likely to occur.

Various p improve international financial rules will emerge, but they must all, in my judgment, include a on national bankruptcy codes.Similarly, accounting standards and private sector disclosure are important areas for improvem Accounting standards provide the foundation for credible financial statements and other disclos that are key means for communicating a company's operating results and its overall health, as wefor making more transparent various operating activities.

Disclosure of reliable informatio market discipline, strengthens confidence, improves decision making and reduces the chan rumors and misleading information could cause instability in national and global markets. facilitating market discipline, public disclosure helps reinforce supervisory efforts to en and other companies to maintain sound risk management practices and internal controls.

F reasons, the Federal Reserve and the Basle Committee on Banking Supervision have str supported initiatives to improve the quality of national and international accounting st disclosure practices.Finally, bank supervision and regulation must be upgraded.

Banks are an important mechani transmitting funds both domestically and internationally.

However, in societies in which afforded certain benefits and safety nets because banking problems have the potential t financial markets, banks can perform their intermediary role best if they are properly supe supervision, in turn, should start with oversight by depositors and participants in priv equity markets and be reinforced by appropriate supervisory practices and safeguards.Assessing the soundness of banking institutions is difficult, simply because of the na banking business.

Extending credit inherently involves subjective judgments, and stand adequate risk measurement and disclosure must continually evolve along with the natur complexity of banking products and the ability of institutions to assimilate informat authorities and market participants must request and receive sufficiently accurate, timely, information on which to base their decisions.

They must also have sufficient insight and e evaluate it properly.No discussion of institutional arrangements in the global economic and financial system complete without a discussion of the IMF, the international financial institution central balance of payments crises.

If the IMF did not exist we would probably need to create somet it.

In a world of global finance, it is useful to have a multilateral organization t responsibility for providing liquidity assistance to countries when they do not have acces markets and also encouraging countries to undertake prudent fiscal and monetary policies.The IMF has come under some criticism for elements of its policy prescriptions.

I am s economists and policymakers will have opportunities to review and evaluate the performance IMF during this period.

It might be appropriate to define more clearly the functional role the IMF and other international financial institutions in order to improve the efficient international resources.

At the present time, however, the IMF is a critical participant i international financial stability.

## The Need for Credible Economic and Financial PoliciesA second lesson of history and recent experience is that policymakers must follow sound and macroeconomic, microeconomic and financial policies.

In particular, a necessary condition and monetary policies that are, and are perceived to be, responsible.

As we have seen in s crises that have hit in global financial markets, particularly those that have a public heavy short-term borrowing by governments, when coupled with fiscal imbalances, can be a rec financial market crisis.

Credibility comes from monetary policies aimed at achieving price avoiding either general increases or decreases in price levels, and fiscal policies that av and unsustainable public sector debts or deficits.

In short, in the absence of an extern fiscal and monetary policy, policymakers and politicians must act with a great deal of disciHowever, we also know, particularly from Asia, that fiscal and monetary rectitude is not Many of those countries had strong fiscal positions and sound monetary policy, but still su international financial uncertainties.

Microeconomic and financial policies must also be cr policies that are most responsible are those that allow free markets to work withointervention from governmental authorities.

We have learned that governmental influence in priv sector borrowing and investing decisions is to be avoided.

This is all the more true because, research has shown, a larger portion of cross-border investment in the modern era appears to b sectors in which financial performance and the valuation of assets are harder to gauge.

In circumstances any hint of governmental support is certainly to be avoided.Recently some have proposed the creation of 'target zones' for major currencies, presumably in or to create, in part, greater stability in global financial markets.

I think that these proposals to work.

We have seen on several occasions that the scale of resources required for the authori move exchange rates in directions not supported by the fundamentals, or by market perceptions those fundamentals, can be enormous and effects in terms of exchange rate movements relativel small and transitory.

If monetary policy is used to maintain the exchange rate within a target authorities at times may have to choose between maintaining domestic price stability and a curr target.

Most monetary policy authorities recognize the value of maintaining price stability as the requirements for creating sound macroeconomic conditions for sustainable domestic growth.

F the major countries, the benefits of an explicit focus on exchange rate stability, rather th stability and sustainable growth, are not clear.I believe that policymakers should support greater transparency in the reporting of their operations, as well as in private sector activities that I discussed above.

Better and more information promotes better allocation of resources, including the global allocation of capita financial crises of the last several years indicate that greater transparency is needed on l external debt, including short-term foreign currency debt of the central government, and on lev international reserves, including financial derivative positions.

For transparency standards to effective, they require as broad a participation by authorities as possible.

Further, they must the need for comprehensive and timely disclosure with the need for accurate data.

Improvements financial data from the private sector, which I have discussed, are crucial, but public sector d must not await improvements in private sector disclosure.The IMF can contribute to public sector transparency with respect to critical economic varia through implementation of the Special Data Dissemination Standards, or SDDS.

Voluntary compliance with SDDS by all countries will provide some assurance that economic transactions ar not being based on misleading or incomplete information.

## The Need for Capital MobilityA third lesson suggested by the historical analysis is that the ability to attract foreign exc critical element of a stable global financial system.

In the modern context, I believe that thi has two corollaries.

First, we must avoid blocking capital flows, particularly of long-term There have been policymakers who have advocated capital controls.

I do not need to give a group business economists a lesson in basic economics, but there are those outside of this room who ne be reminded of the benefits of free capital flows.

Even though current international financial t indicate that there are risks from the free flow of capital, the benefits are substantial and importantly to rising standards of living.

As you know, an individual country's pool of savings not always equal its pool of investment opportunities.

If borders were closed to the flow of c interest rates would adjust to equilibrate domestic saving and investment, but some investm opportunities, which might be attractive by international standards, might go unfunded while attractive domestic opportunities would be funded.

With the free flow of capital, countries that greater pool of highly productive investment opportunities will benefit from the inflow of capit those that export capital can put their savings to better, more rewarding use.

This presume institutional underpinnings outlined above.Protectionist impulses for measures that impede the flow of goods, services and managerial kno how must also be avoided.

While participation in such free exchange across borders creates indusand individuals that are made better off and some that do not fare so well, we know that, all societies are better off from allowing the free flows of international competition.

G that there are scarce resources globally, it is important that all resources be emplo comparative advantage, thereby increasing the stock of goods and services available to us al

## ConclusionLet me conclude by saying that while the current era of globalization is quite distinct fro prior to World War I, there are important lessons that can be learned from that earlier historians have argued that the pre-1914 era was notable for the size and relative stabil flows.

Thus far our era has been notable for the size of international capital flows, but r the stability.

I do not doubt that there is room for improvement in the regimes that deter flows.

However, I think that most of the solutions to the challenges that the world has f building institutional mechanisms and policy expertise that allow reliance on the strengths market system.

Improvements in policy discipline, information sharing, and institutional should all be evaluated by the litmus test of whether they enhance the flow of informati reduce bureaucratic interference with, markets and thus provide a safer and more stabl financial and economic environment.