International Financial Crises: Causes, Prevention, and Cures

Dale Jorgenson has bestowed a great honor and no small challenge by inviting me to give this lecture: a great honor because of the distinguished list of economists who have preceded me; a challenge because of the standard they have set, and because there is no greater challenge for any economist than providing a coherent account of significant events to his scientific peers. I am sometimes asked by friends about the differences between academic life and life as a public official. There are many. Two stand out. First, as an academic, the gravest sin one can commit is to sign one’s name to something one did not write. As a public official it is a mark of effectiveness to do so as often as possible. Second, as an academic, if a problem is too hard and does not admit of a satisfactory solution, there is an obvious response: work on a different problem. That is not a luxury that one has in government. I have been reminded of this often in recent years as we have grappled with financial crises in a number of what had previously been considered emerging markets with unrestrained futures. Anyone who doubts the social importance of what economists do should consider the debates surrounding these crises. Hundreds of millions of people who expected rapidly rising standards of living have seen their living standards fall; hundreds of thousands if not millions of children have been forced to drop out of school and go to work; hundreds of billions of dollars of apparent wealth has been lost; the stability of large nations as nations has been called into question; and the United States has made its largest nonmilitary foreign-policyrelated financial commitments since the Marshall Plan. Almost all the issues involved in understanding, preventing, and mitigating these crises are the stuff of economics courses and research: fixed versus flexible exchange rates, moral hazard and multiple equilibria, speculation and liquidity, fiscal and monetary policies, regulation and competition. What economists think, say, and do has profound implications for the lives of literally billions of their fellow citizens. Whether it is discussing the role of derivatives in signaling exchange-rate commitments with Chinese Premier Zhu Rongji, or discussing an NBER working paper on inflation targeting with the Brazilian central bank governor Arminio Fraga, or discussing alternative approaches to bankruptcy law with Indonesia’s economic team, or optimal debt durations with the Mexican authorities, I am consistently struck by the impact of the kind of research discussed at the AEA meetings. The future well-being of the world’s people in large part will depend on how the ongoing process of global integration works out. This is a strong statement, but one that is supported by the global economy’s post-World War I failure and its post-World War II success. Central to global integration is financial integration: the flow of funds and of capital across international borders. And as the events of the late 1920’s and early 1930’s remind us, central to global disintegration can be international financial breakdowns. Today, I want to reflect on the issue of global financial integration in light of the dramatic and largely unpredicted events of recent years. It is perhaps a good time for reflection: there has been enough repair that priority can shift from * U.S. Department of the Treasury, 1500 Pennsylvania Avenue, Washington, DC 20005. This lecture reflects many things I have learned from experiences I have shared with colleagues in the United States government and governments around the world. I thank Brad DeLong, Marty Feldstein, Stephanie Flanders, Ken Rogoff, Andrei Shleifer, and Ted Truman for useful comments and suggestions. I am especially grateful to Nouriel Roubini and Stephanie Flanders for valuable discussions and assistance in the preparation of this lecture. The usual disclaimer applies.