Both the past praise and the current criticism of the East Asian miracle have brought the question of the role of the financial system to the forefront. While the economies were growing quickly, incomes were rising, literacy rates were increasing, and poverty was dwindling rapidly, many scholars were quick to praise the East Asian governments for creating and regulating institutions which promoted savings and helped allocate resources, including scarce investment.

The recent turmoil in East Asia has, in some circles, cast doubt on the role of the government in the financial sector, and more generally on the public-private partnerships that characterized the region’s development strategy. The accusations of "crony capitalism," overbearing state direction of investments, and lack of transparency have, in some minds, discredited government involvement in development. I would argue that the critics have been too harsh – after all, the past achievements in accumulating savings, promoting investment, and developing human capital cannot simply be erased. In historical perspective, financial crises and economic downturns are not new phenomena in capitalist economies. Furthermore, several countries in the region, most notably China and Taiwan (China) seem to have weathered the storm quite well. Nevertheless, the depth of the crisis in countries such as Korea, Thailand, and Indonesia does provoke questions.

Curiously many of the factors identified as contributors to East Asian economies’ current problems are strikingly similar to the explanations previously put forward for their success. Addressing information problems in an effective way, including through business-government coordination, was considered a hallmark of these economies’ success; but this coordination is now viewed as political cronyism and lack of transparency is viewed as one of the main failings. Openness to international markets was hailed as one of the grounds of their success, yet insistence on eliminating barriers in capital and trade flows is an important ingredient in many of the reform packages. Macro-stability, including low inflation, was agreed to be one of the key ingredients of the East Asian economies’ remarkable performance, yet the Korean program included a provision requiring the establishment of an independent central bank whose sole focus was price stability. Promoting competition, especially through export-oriented policies, was hailed as one of the central pillars of their stellar performance, yet lack of competition in the business conglomerates is seen as one of critical failings. Finally, and central to my talk today, what were previously viewed as strong financial markets, which were able to mobilize huge flows of savings and allocate them remarkably efficiently, have turned into weak financial markets which are blamed for the current crisis.

Like countries throughout the world, East Asia has had its share of banking crises. Most of these were small (at least by comparison to the current crisis) and were resolved quickly. Why has this crisis been so much larger and so much less tractable? Two hypotheses have been advanced to answer this question. One is that the world has changed, most notably due to the vast increase in private capital flows to developing countries. According to this hypothesis, the current crisis would have been similar to the problems experienced by Korea in 1980 or Thailand in 1983, had they not been magnified enormously by large flows of international capital. An alternative, and potentially complementary hypothesis, is that the East Asian countries have departed from the policies that were so successful in the past. Financial liberalization and capital account opening, without commensurate strengthening of regulation and supervision, according to this hypothesis, can explain both the past success and current crisis in East Asia.

The reason we put so much effort into trying to understand the past and present is that it contains important lessons for the future. In my remarks today I will argue that deep, efficient, and robust financial systems are essential for growth and stability. But left to themselves, financial markets will not become deep, efficient, or robust. The government plays an essential role, both in directly overseeing and regulating the financial system and also in establishing the correct incentives to encourage prudential and productive behavior.

THE ROLE OF THE FINANCIAL SYSTEM IN EAST ASIAN GROWTH

Lately, most discussions begin with the East Asian crisis and proceed backward to identify all of the problems with East Asian financial systems. I would like to take the opposite approach and begin by looking at the East Asian miracle in order to see what we can learn about how the East Asian financial system contributed to its success.

No other region in the world has ever had incomes rise so dramatically and seen so many people move out of poverty in such a short time as East Asia. For the last three decades, per capita GDP growth has averaged more than 5 percent annually in a number of economies in the region (Singapore, Hong Kong, Taiwan (China), Korea, Indonesia, Malaysia and Thailand), earning them the nickname "the East Asian miracle." These gains, it is important to remember, have brought with them extended lifespans, increased educational opportunity, and a dramatic reduction in poverty. Today 2 out of 10 East Asians are living on less than $1 per day; in 1975 the number was 6 out of 10. Among the most remarkable successes was Indonesia, which managed to reduce its poverty rate from 64 percent in 1975 to 11 percent in 1995.

One of the most important elements of this growth was the financial system, which was an important factor, both in the high saving rates in the region and also in the allocation of these savings to productive investment.

High Saving

The extent of the capital accumulation that accompanied the rapid growth in East Asia has been remarkable. East Asia saves over one-third of its GDP, more than any other developing region, and more than double the U.S. saving rate. The saving rates of the individual countries have been substantially higher than would be predicted on the basis of standard economic factors, like demography and growth rates. Some have seized on this to argue that cultural factors explain the thriftiness in East Asia. Although this may contain an element of truth, it is very far from the entire story: A shared culture cannot explain the increase in East Asian saving rates over the last decades or the variation in saving rates within the region.

Government policies boosted national savings, both directly by often running budget surpluses and indirectly by maintaining macroeconomic stability. Government policies in the financial sector had an important impact on savings. Measures to enhance the safety and soundness of the banking system, including prudential regulation, increased the security for depositors, and thus encouraged them to save more. Governments in some economies, including Japan, Malaysia, Singapore, and Taiwan (China), created postal saving systems to facilitate saving by smaller depositors and those living in rural areas by providing security, convenient access, and in some cases, favorable tax treatment.

In addition, many East Asian governments used a variety of financial regulations to influence private savings. In most of the successful East Asian economies, governments discouraged consumer borrowing for houses and consumer durables, a step that increases steady-state saving in a growing economy. Also, mild financial restraint – especially in the form of lower interest rates – may have boosted saving in East Asia by transferring income from households (which tend to consume most of their income) to corporations (which save more of it in the form of retained earnings).

The Allocation of Investment and Productivity Growth

Although in traditional neoclassical economic model, investment and saving are determined independently, most empirical research has found that most of an increase to saving gets translated into higher investment. East Asia is no different, and its high saving rates have been essential to maintaining its high rate of capital accumulation, contributing strongly to its growth.

Research by Alwyn Young, Jong Il Kim and Lawrence Lau, and popularized by Paul Krugman, has argued that rapid capital accumulation is actually all there is to the East Asian miracle. According to their estimates, total factor productivity growth, the additional output that cannot be explained by increases in capital or labor, ranged from unremarkable in Korea to virtually nil in Singapore. In interpreting their results, however, it is important to note that even in the extreme, and in my view, unlikely event that East Asia had no total factor productivity growth, the region still would have demonstrated a remarkable ability both to maintain high saving rates and to allocate that capital to productive uses.

This latter point is particularly underappreciated. An aggregate production function is second nature to many of us trained in economics. Greater capital, all else being equal, will shift an economy along its production function, increasing output, albeit with diminishing returns. In reality, however, all else is not equal. In a world of perfect information, additional financing will go to the projects with the highest rates of return. In a world of imperfect information, incomplete risk markets, and transaction costs, however, the translation of saving into the best investment prospect is not automatic. The process of investing a large fraction of GDP can result in large costs of adjustment and misallocated investment. Indeed, we have seen many examples of countries that have had high rates of investment and negative total factor productivity growth. The fact that, even according to the most critical view, East Asia has managed to move along an unchanged production function is an accomplishment.

I do not believe, however, that East Asia has grown through investment alone. Any visitor to the cities and factories in East Asia comes away impressed by the enormous technological progress in the last decades. The Young, Kim, Lau, et al. results are simply not very robust. When a country is accumulating capital rapidly, small changes in the estimate of the capital share can result in a large shift in estimates of the contribution of total factor productivity. Estimating these shares is very problematic, especially in East Asia where the assumption of perfect competition in labor and product markets is inappropriate, at least in some economies. There are also problems in the measurement of human and physical capital. Moreover, we must remember that technology is both the cause and the consequence of investment. Without improving technology, diminishing returns would have set in, and it is hard to believe that investment could have been sustained. These considerations make me reasonably confident that East Asia has seen impressive productivity growth in recent decades.

East Asia’s productivity growth is the result of many factors, including an emphasis on factor accumulation, both of physical and human capital. But other policies have mattered as well, such as the promotion of social inclusion and the transfer of technology. These have been extensively analyzed in the World Bank’s East Asian Miracle study and in a huge literature in recent years. Today, I would like to concentrate on the contribution of the financial system to growth. In the next section I will discuss general theoretical and empirical evidence on the relationship between finance and growth, introducing some concepts that I will return to in later parts of the lecture.

Finance and Growth

I have sometimes likened the financial system to the "brain" of the economy. It plays an important role in collecting and aggregating savings from agents who have excess resources today. These resources are allocated to others – such as entrepreneurs and home builders – who can make productive use of them. Well-functioning financial systems do a very good job of selecting the most productive recipients for these resources. In contrast, poorly functioning financial systems often allocate capital in low-productivity investments. Selecting projects is only the first stage. The financial system must continue to monitor the use of funds, ensuring that they continue to be used productively. In the process it serves a number of other functions, including reducing risk, increasing liquidity, and conveying information. All of these functions are essential to both the growth of capital and the increase in total factor productivity.

There is now a large body of research linking different measures of financial development, including the depth of the banking system and the liquidity of the stock market, to long-run growth. These proxies may be picking up the informational role that financial markets play in allocating resources. The main finding of this research is that the effects of finance on growth come mainly from increases to long-term productivity growth, although some have found a small positive effect on the rate of capital accumulation.

The magnitudes of the results are striking: one study found that between 1976 and 1993, countries in the highest quartile of stock market liquidity in the beginning of the period saw GDP grow 3.2 percent annually, compared to 1.8 annual growth for countries in the lowest quartile of stock market liquidity. The difference in GDP growth between countries with high and low financial depth was even larger, 3.2 percent versus 1.4 percent.

Financial depth and the liquidity of stock markets are, however, only crude gauges of the development and effectiveness of the financial system. They also beg the question, why is the financial system deep or the stock market liquid? Left to themselves, and without substantial government involvement, financial markets are unlikely to become very deep or very liquid, and many markets may not even exist at all.

Financial markets are markedly different from other markets and, consequently, market failures are more pervasive in this sector. The standard theories of the efficiency of competitive markets are based on the premise that there is perfect information. Thus the fundamental theorems of welfare economics, which assert that every competitive equilibrium is Pareto efficient, provide no guidance with respect to the question of whether financial markets, which are essentially concerned with the production, processing, dissemination, and utilization of information, are efficient. On the contrary, economies with imperfect information or incomplete markets are, in general, not Pareto efficient; there are feasible government interventions that can make all individuals better off.

Many of these market failures – and the remedies – are familiar. It is worthwhile, however, to briefly list some important problems that will affect my discussion later on:

Adverse selection problems occur in both equity and debt markets. With equity, those entrepreneurs who are most willing to sell shares in their firms include those who believe, or know, that the market has overvalued their shares. Although there are also risk-averse individuals with good investment projects seeking equity finance, the mixture of the two types can undermine equity markets unless – and even when – there are laws to protect equity holders and require the disclosure of information. These adverse selection problems also occur in debt markets because entrepreneurs with excessively risky projects might be encouraged to apply for loans knowing that they get all of the upside benefits but have limited downside costs.

Monitoring corporations and financial institutions is essential to make sure that their managers are acting in the interests of shareholders and creditors. Selection and monitoring, like other forms of information, are public goods. I can free ride off of your information, information that is often revealed in stock prices and decisions to lend to a firm. If a firm is well-managed as a result of my monitoring, all suppliers of capital benefit. As a result monitoring, like any public good, will tend to be undersupplied by the market. Furthermore, managers and entrepreneurs often have more information about the consequences of their actions and the nature of these entrepreneurs. It is now well known that informational imperfections give rise to market failures which especially impede the working of capital markets. To the degree that monitoring is imperfect – and it is impossible to design fully incentive-compatible contracts – firms will be encouraged both to take excessive risks (in the case of debt finance) and to enrich management at the expense of shareholders (in the case of equity finance).

THE ROLE OF THE FINANCIAL SYSTEM IN THE EAST ASIAN CRISIS

When financial systems are working well, the result can be strong economic growth. But when financial systems are working badly, the result can be crises and prolonged periods of slower growth.

A growing body of economic research has emphasized the importance of financial markets and explains economic downturns through such mechanisms as credit rationing and banking and firm failures. In the nineteenth century most of the major economic downturns in industrial countries resulted from financial panics that were sometimes preceded by and invariably led to precipitous declines in asset prices and widespread banking failures. Financial crises continue to occur, and there is some evidence that they have become more frequent and more severe in recent years. Even after adjusting for inflation, the losses from the notorious savings and loan debacle in the United States were several times larger than the losses experienced in the Great Depression. Yet when measured relative to GDP, this debacle would not make the list of the top 25 international banking crises since the early 1980s.

Banking crises have severe macroeconomic consequences, affecting growth over the five following years. During the period 1975–94 growth edged up slightly in countries that did not experience banking crises; developing countries with banking crises saw growth slow by 1.3 percentage points in the five years following a crisis, more than the loss in growth in developed countries. Clearly, robust financial systems are a critical ingredient of macroeconomic stability.

The Causes of the East Asian Crisis

The fact that so many countries have experienced banking crises in recent years, while distressing for the countries, has been a blessing to researchers. Systematic cross-country studies have identified several predictors of banking crises. One recent study by Asli Demirgüç-Kunt and Enrica Detragiache found that the most important predictors of banking crises are: macroeconomic factors (low GDP growth and high inflation), high real interest rates, vulnerability to capital outflows, domestic financial liberalization, and ineffective law enforcement.

Some of these factors were present in the East Asian countries that experienced a crisis (like high real interest rates, domestic financial liberalization, and vulnerability to capital outflows), but many of them were not (East Asia was growing strongly, had low inflation, and, according to the International Country Risk Guide, high-quality law enforcement). This does not mean that we should ignore warning signals identified from studying previous crises. It should, however, induce a modicum of humility about our ability to predict crises. This should not be surprising. Every crisis is, in some sense, sui generis.

The East Asian crisis, particularly, differs from many previous crises in that many of the macroeconomic fundamentals were so strong in the affected countries. They had high saving rates, government surpluses or small deficits, low inflation, and low levels of external debt relative to other developing regions. Although some countries (Thailand) had relatively large current account deficits, other crisis counties had relatively standard current account deficits (Indonesia), and others were not only moderate but falling (Korea and Malaysia).

Traditional aggregate macroeconomic theory sheds very little light on the East Asian crisis. In the last fifteen years, however, macroeconomic theory has been reconstructed on the basis of sound microeconomic underpinnings, with greater attention to the importance of the financial system and its linkages to the rest of the economy. These models have been used to provide insights into events from the Great Depression to the 1990-91 recession in the United States. These models are also very helpful in understanding the causes of the East Asian crisis and evaluating the possible policy responses. These models show that exogenous shocks to the economy, even when there is good financial market regulation, may be amplified by the economic system and give rise to effects which persist long after the end of the shock itself. Economic fluctuations are thus an inherent feature of capitalist systems, though economic policies may affect their magnitude and persistence.

The roots of the crisis are not in government profligacy, but in private sector decisions that made the economies vulnerable to a sudden withdrawal of confidence. The biggest problems were the misallocation of investment, most notably to speculative real estate, and the risky form of financing, especially borrowing short-term debt on international markets and also, at least in Korea, the very high levels of debt relative to equity.

The misallocation of some investment, however, is not evidence that their system is fundamentally flawed. Earlier I discussed the impressive ability of the economies to allocate large levels of investment. In recent years, however, the already high investment as a share of GDP jumped by as much as ten percentage points in some countries, reaching about 40 percent of GDP in Korea, Malaysia, and Thailand during 1993-96. Still, some of the supposed misallocation is only clear in retrospect, and is due to unforeseen changes (e.g. the falling price of chips). The misallocation of credit did, of course, put into jeopardy particular loans, and a credit crisis even in one sector of the economy can have systemic ramifications.

The buildup of short-term, unhedged debt left East Asia’s economies vulnerable to a sudden collapse of confidence. As a result, capital outflows, and with them depreciating currencies and falling asset prices, exacerbated the strains on private sector balance sheets and thus proved self-fulfilling. The vicious circle has become even more vicious as financial problems have led to restricted credit, undermining the real economy, and almost inevitably leading to a slowing of the economy. Given the region’s financial fragility, the economic downturn may well feed on itself – worsening bankruptcies and weakening confidence.

This is not meant to absolve governments of responsibility. Government policies helped shaped the incentives facing the private sector and thus contributed to the buildup of vulnerability. This partly was the result of the incentives created by the mix of macroeconomic policy and its interaction with the financial system, particularly the pegged or managed exchange rates combined with high domestic interest rates that resulted from sterilizing capital inflows. These policies encouraged people to borrow abroad in search of lower rates and left them less concerned about the need to hedge their debt against large changes in exchange rates.

In addition to these macroeconomic incentives, inadequate financial regulation allowed banks to make excessively risky loans without adequate monitoring. And part of that problem in turn was due to excessively rapid financial liberalization without a commensurate strengthening of regulation and supervision. In the last decade Thailand has reduced reserve requirements, eased the rules governing non-bank financial institutions, expanded the scope of permissible capital market activities (such as allowing banks to finance equity purchases on margin), and increased access to off-shore borrowing. Beginning somewhat earlier, Korea eliminated many interest rate controls, removed restrictions on corporate debt financing and cross-border flows, and permitted intensified competition in financial services. While the advantages of these changes were lauded, the necessary increase in safeguards was not adequately emphasized.

It was not just the quality of regulatory supervision that was at fault, but more broadly the regulatory structure. Risk-based capital requirements might have induced banks to charge customers with greater risk at an appropriately higher interest rate, and this might have served to reduce both banks’ exposure and excessively risky lending. Also, many of the regulations, and interventions more broadly, including tax incentives, actually encouraged the buildup of vulnerability.

In East Asia, one manifestation of the inadequate financial regulation was the overbuilding in commercial real estate that is so evident to any visitor to major cities in East Asia. This is a recent phenomenon. Thailand, for instance, used to restrict bank lending to real estate, both because it realized the danger of such lending, and because it wanted to direct credit to what it viewed as more growth-enhancing investments. But again, partly under pressure from those who claimed that such restrictions interfered with economic efficiency, it liberalized, eliminating the restrictions with the predictable consequences we have seen. Even the overbuilding in East Asia needs to be put in perspective. The commercial vacancy rates in Bangkok and Jakarta have been around 15 percent and are expected to rise to 20 percent – comparable to Dallas and Houston today, and well below the vacancy rates of 30 percent or higher seen in several major American cities in the 1980s. Nevertheless, the exposure of banks and the systemic risk posed by these vacancies, are much greater in East Asia.

Even with better regulation of banks, as long as there were macroeconomic incentives to borrow from abroad, private corporations or non-bank financial institutions would have accessed international markets directly. This is, of course, what happened in Indonesia, where two-thirds of the external bank lending was to the non-bank private sector, among the highest fraction of any country in the world.

We should not forget, however, that every loan, including every "bad" loan, has a borrower and a lender. And since the international lenders were typically marginal – they undertook loans knowing the high indebtedness of the borrowers – and since they presumably should have better risk management systems in place, their culpability is perhaps even greater (though to be sure, in most cases, they faced less institutional risk, the importance of systemic risk from their borrowing is presumably reflected in the subsequent attempts at international bailouts). This is especially true given their lack of concern about the risks in East Asia – as evidenced by the low spreads on loans to East Asia and their growing volume.

Even with the buildup of vulnerability, it is unlikely that the crisis could have occurred without the liberalization of capital accounts. It is worth observing that some of the countries with the weakest financial sectors and the greatest lack of transparency, were hardly touched by the contagion from East Asia. These were countries with closed, or at least more closed, capital accounts.

Finally, the lack of transparency has played an important role in translating the initial shock into a prolonged downturn. As the crisis began, markets realized that many firms in East Asia were much weaker than they had realized. Without reliable information with which to differentiate among firms, banks may have had difficulty differentiating between good and bad firms, leading them to constrict the supply of credit to all firms (or alternatively, to raise risk premiums for all firms).

Self-fulfilling panics and runs on currencies

Even if the East Asian countries had sound financial systems and good policies, the crises could still have occurred because of the runs on the currencies and vicious cycles to which they gave rise. All you need is instability in beliefs. Of course, the shorter the maturity structure of debt, the higher the debt-equity ratio, and the weaker the financial system, the greater the potential instability of beliefs and the greater the induced disturbance to the economy.

Whenever you have a small open economy, it will be vulnerable to sudden changes in sentiment. Writing during the Great Depression, John Maynard Keynes emphasized the volatile, psychological factors that affected investment and caused business cycles. Keynes thought that these factors were beyond rational explanation, and to emphasize this point he dubbed them "animal spirits." More recently, Alan Greenspan has brought the phrase "irrational exuberance" into our vocabulary. Unfortunately, in East Asia recently this irrational exuberance has given way to an irrational pessimism, a withdrawal of confidence, and a run on economies with very open capital markets. Because expectations are volatile even a well-managed economy can sometimes be overcome by changes in sentiment. Small open economies are like rowboats on a wild and open sea. Although we may not be able to predict when the boat will be capsized, the chances of eventually being broadsided by a large wave are significant no matter how well the boat is steered. Though to be sure, bad steering probably increases the chances of a disaster, and a leaky boat makes it inevitable, even on a relatively calm day.

As a result, capital outflows, and with it depreciating currencies and falling asset prices, exacerbated the strains on private sector balance sheets and thus proved self-fulfilling. The vicious circle has become even more vicious as financial problems have led to restricted credit, undermining the real economy, and leading to a slowing of the economy. Given the region’s financial fragility, the economic downturn may well feed on itself – worsening bankruptcies and weakening confidence. It has already spilled over into the political and social realm, and in some countries had led to unrest that may further weaken their economies.

The magnitude of the irrational exuberance / irrational pessimism can be seen in the spread on East Asian debt compared to comparable, risk-free U.S. Treasury securities. These spreads fell dramatically in early 1997, reaching a low of 90 basis points in Thailand and 110 basis points in Indonesia, up until the onset of the crisis in July 1997, when they rose sharply, reaching roughly 500 basis points by the end of the year. Markets simply did not seem to notice, or reflect, what in retrospect many describe as the growing vulnerability of the East Asian economies.

Further evidence comes from the major rating agencies, who did not downgrade their assessments of the East Asian countries until after the onset of the currency crisis. When these downgrades occurred, the result was another round of sell-offs of East Asian securities, driving the crisis still deeper.

I have indicated how many of the more fundamental explanations have done a poor job in explaining the scope or depth of the East Asian crisis. Further evidence for the role of "animal spirits" comes from the timing of the crisis. Although conditions were deteriorating in some countries prior to the crisis, in other countries there was very little "news" that explains the onset of the crisis. The general facts of high debt-equity ratios, lack of transparency, and weak financial systems were well known to investors during the periods when they were lending relatively cheaply to the East Asian countries. Much of the macroeconomic data, the "news," was actually turning more favorable in the run-up to the crisis. This is especially striking in Korea. Korean inflation rose to 5-1/2 percent in mid-1996, but in the months before the crisis had fallen to just over 4 percent. Its trade deficit – one of the "culprits" in many explanations of the crisis because its counterpart was aggregate net borrowing from abroad – had fallen steadily throughout 1997, essentially reaching balance in the months before the crisis and a small surplus in November.

Crises – or at least marked fluctuations in economic activity – have been features of capitalist industrial economies for at least two hundred years. They have occurred in countries with sophisticated financial regulation (e.g. the U.S. savings and loan debacle just 9 years ago) and in places with high levels of transparency (e.g. the Scandinavian crisis in the last decade). The recognition that crises will occur even in well-managed economies should not lead us to abandon policy, but it suggests that we should try to explore ways to reduce the susceptibility of countries to crises, and to minimize the severity when they do occur.

BUILDING ROBUST FINANCIAL SYSTEMS: TRADE-OFFS AND SHARED GOALS

The experience of East Asia highlights two important goals for the financial system: growth and stability. In addition, regulation in successful financial markets seeks to achieve several objectives, including promoting competition, protecting consumers, and ensuring that underserved groups have some access to capital.

The pursuit of these goals can reinforce each other. At the most basic level, stability is good for long-run growth and long-run growth is good for stability. Earlier I discussed the evidence that banking crises have long-lasting effects on growth. In general, anything that increases the volatility of output can reduce research and development and discourage investment, two of the most important determinants of long-run growth.

There are also important complementarities between the goals at a more specific level. Pursuing social objectives – like ensuring that minorities and poor communities receive funds, as the United States’ Community Reinvestment Act does, or ensuring funds for mortgages, the essential mission of the government-created Federal National Mortgage Association – can, if done well, reinforce economic objectives. Similarly, protecting consumers is not only good social policy, it also builds confidence that there is a "level playing field" in economic markets. Without such confidence those markets will remain thin and ineffective.

At times, however, policymakers face trade-offs among conflicting objectives. The financial restraints adopted by some of the East Asian economies, for example, increased the franchise values of banks, discouraging them from taking unwarranted risks that otherwise might have destabilized the banking sector. Although there were undoubtedly some economic costs associated with these restraints, the gains from greater stability almost surely outweighed those losses. As I discussed earlier, the removal of many of these restraints in recent years may have contributed in no small measure to the current instability that these countries are experiencing.

Another example of a trade-off is the high leveraging practiced by Korean firms. Prior to the crisis many people saw the high debt-equity ratios in Korea as one of the important components of its rapid growth. According to this view, it increased the amount of capital flowing to productive firms without diluting the control of the managers that were so essential to their success. These high debt-equity ratios, however, have also made the Korean firms very vulnerable to a sudden increase in interest rates, and have certainly contributed to the worsening of the crisis.

In my remaining time, I would like to discuss the tensions and complementarities between stability and growth in two crucial areas, domestic financial liberalization and international capital flows.

Domestic Financial Liberalization

Recent discussions have stressed liberalization as a strategy to improve the financial systems. They have promoted a variety of forms of liberalization, including liberalizing domestic deposit rates; liberalizing domestic lending rates; liberalizing constraints on domestic banking; liberalizing constraints on foreign banking; and allowing capital account convertibility.

In my view, we have too often pursued liberalization as an end in itself. We have not systematically assessed how it can help achieve our ultimate goals of promoting stability and growth, while also promoting competition, protecting consumers, and ensuring that underserved groups have access to capital. Liberalization is an important part of achieving these goals, but it should not be the guiding principle of our policies. I would like to discuss some considerations that form the basis of an alternative strategy to mindless deregulation.

First, the key issue should not be liberalization or deregulation but construction of the regulatory framework that ensures an effective financial system. In many countries this will require not only changing the regulatory framework by eliminating regulations that serve only to restrict competition, but also complementing these changes with more effective regulations to ensure competition and prudential behavior.

Second, in all countries a primary objective of regulation should be to ensure that participants face the right incentives: government cannot and should not be involved in monitoring every transaction. In the banking system liberalization will not work unless regulations create incentives for bank owners, markets, and supervisors to use their information efficiently and act prudentially. But doing so will not be easy. Even in the best regulated systems, there is plenty of room for improvement in risk-based regulation, e.g. in reflecting not only credit risk, but capital risk.

Incentive issues in securities markets also need to be addressed. It must be more profitable for managers to create economic value than to deprive minority shareholders of their assets: rent seeking can be every bit as much a problem in the private as in the public sector. Without the appropriate legal framework, securities markets can simply fail to perform their vital functions—to the detriment of the country’s long-term economic growth. Laws are required to protect the interests of shareholders, especially minority shareholders.

Finally, even once the design of the desired financial system is in place, care will have to be exercised in the transition. Attempts to initiate overnight deregulation – sometimes known as the "big bang" – ignore the very sensitive issues of sequencing. There are many dimensions to sequencing: I have time to touch upon only three here:

First, all reforms give rise to changes in capital-asset values – indeed one of the purposes of reform is to eliminate distortionary practices which often give rise to rents, which are capitalized in asset values. As beneficial as the basic reforms are, the losses in capital-asset values, and the uncertainty about the impacts on individual firms and financial institutions, can have disruptive effects on the financial system, and on the economy more broadly. In many cases, especially when distortions do not have large systemic effects, it may be better to ensure that the financial system and the economy are in the position to withstand the shocks before undertaking certain reforms.

Second, we know from the theory of the second best that eliminating some distortions, in an environment where there are many others, may actually be welfare decreasing. But in a system with two distortions, A and B, it is possible that eliminating A only would be welfare decreasing, although eliminating B only was welfare enhancing. We have recently seen a case of such second best economics in practice. How we go about restructuring the banking system – the pace and sequencing of actions – can have enormous impacts. We might eventually wish to eliminate guarantees on all banks, but if we begin by eliminating guarantees only for some the result is likely to be a flight of money to the guaranteed banks, destabilizing the entire system.

Finally, we have increasingly become aware of the political economy dimensions to sequencing. Privatization prior to establishing competitive structures creates establishments which have a vested interest and the resources to resist subsequent reforms aimed at creating a more competitive market.

Responding to International Capital Flow Volatility

Questions about domestic financial reform take are even more important in a world of large private capital flows to developing countries. Until recently capital flows to developing countries were more limited and dominated by public and publicly guaranteed flows. Financial intermediation did not play as important a role. Today, private flows to developing countries are huge and are increasingly channeled by domestic banks throughout the economy. This augments both the potential of the financial system, but it also magnifies any inefficiencies or problems.

We cannot expect to eliminate all fluctuations, or even all crises. Even if we could eliminate all of the "problems" and "mistakes" in economic policy, it is unlikely that we could fully insulate ourselves against shocks to the economy, including events like the OPEC oil price increases in the 1970s or changes in market sentiment, like the current East Asian crisis. Furthermore, although there is much more scope for policy reforms in developing countries, we should not delude ourselves into thinking that this can take place overnight. Building robust financial systems is a long and difficult process. In the meantime, we need to be realistic and recognize that developing countries have less capacity for financial regulation and greater vulnerability to shocks. We need to take this into account in policy recommendations in all areas, and especially in the timing and sequencing of opening up capital markets to the outside world and in the liberalization of the financial sector.

We must bear in mind too in designing policy regimes (such as opening up capital markets) that we cannot assume that other aspects of economic policy, such as macroeconomic policy or exchange rates, will be flawlessly carried out. The policy regimes we adopt must be robust against at least a modicum of human fallibility. Airplanes are not designed to be flown just by ace pilots, and nuclear power plants have built into them a huge margin of safety against human error.

One feature of a robust policy regime is that it minimizes the long-term consequences of the inevitable fluctuations in economic activity, including preventing crises and setting up mechanisms for orderly workouts when they do occur. This means designing financial systems that buffer the economy against shocks rather than magnifying the shocks. At the same time, we want to ensure that adequate savings are mobilized and allocated to productive investments. Again, a robust financial system is essential.

Although domestic economic reforms can go a long way toward achieving these goals, some international effort may be required. I think that the time is ripe for an open debate and discussion on the advantages and limitations of a variety of approaches, including some form of taxes, regulations, or restraints on international capital flows.

The importance and limitations of information

Before discussing these measures, I would like to discuss one important part of the strategy: the need for greater transparency and more information. Both the Mexican and East Asian crises were partly triggered and propagated when investors learned that reserves were smaller than they thought and that short-term debt was higher. The result was not just a withdrawal of short-term credit, but also portfolio outflows.

Perhaps even more important than misleading information being disseminated, at least in some countries, was the general lack of information which made it difficult for investors to distinguish between firms and financial institutions that are healthy and those which are not. In response, investors shied away from all. With more credible information systems in the future, firms that remain healthy will be better able to retain access to credit.

As I discussed earlier, the standard macroeconomic data would not have been very helpful in predicting the East Asian crisis, which depended on the composition and allocation of private-to-private capital flows. Unfortunately, getting information about private sector spending and borrowing is much more difficult than comparable information about public finances. This is especially true when transparency is limited. In a world where private-to-private capital flows are increasingly important, we will need to recognize that monitoring and surveillance are going to be especially challenging. The increased use of derivatives is increasingly making the full disclosure of relevant information, or at least the full interpretation of the disclosed information, even more difficult.

We should remember, too, that the great merit of a market economy is that dispersed information is aggregated through prices and the incentives they create for behavior, without the need for any centralized collection of information or planning. There is a certain irony about praising a market economy for this decentralization of information, and at the same time complaining about the lack of aggregate data necessary to assess systemic risks.

Moreover, we should not be under the illusion that improved data is sufficient for financial markets to function well. In East Asia much of the important information was available, but it had not been integrated into the assessment of the market. Furthermore, it is impossible to eliminate all uncertainty and asymmetries of information. Entrepreneurs will always know more about their investments than will the banks that lend to them; and managers will always know more about their actions than shareholders will. Without the correct incentives, even perfect aggregate information would not be sufficient for the efficient, or stable, functioning of markets.

Although our information about private capital flows is imperfect, and although even with vastly improved information I am not sanguine that we – or the market – would be able to predict or forestall all crises, I do think that the returns from improving our statistical bases are significant. My caution is only that we should not be misled into thinking that this will solve our problems. Better information – seemingly the most important improvement in the international financial architecture to come out of the last crisis – should not lull us into complacency.

The economic justification for "intervening" in the market

After the Mexican crisis, many said that this was the last time anything like this would happen again. The East Asian crisis, just two years after the problems in Mexico, should serve to remind us that we will have more crises in the future. The question we need to ask is what actions can be undertaken, either by lending countries, borrowing countries, or the international community, to reduce the frequency or magnitude of these crises.

I do not think that a blanket objection to government intervention in international capital markets would be a very good way to begin this discussion. The roughly $110 billion package for East Asia is clearly a major intervention with the workings of the free market. The international community justifies this support because it is worried about the potential for systemic risk in these types of crises.

In the case of East Asia, there is much less risk to the banks in developed countries than they faced in the Latin American debt crisis in the 1980s: in June 1997 BIS-reporting banks only had 19 percent of their capital in loans to East Asia, compared to 58 percent to the Latin American countries with debt difficulties in 1982. The risk that worried policymakers in the current circumstances was that the crisis would spread to other developing countries.

There is no consensus in the economics profession about the significance of contagion and systemic risk. Neither the theory nor the evidence seems decisive. There is a controversy in part because we simply have not run the "experiment" to see what would have happened to the international financial system without the international bailouts for Latin America in the 1980s or Mexico in 1995. In both of these cases, as with East Asia, policymakers have been understandably reluctant to simply stand by while the dice were being thrown. But what there can be little argument about is that if you believe in systemic risk, or even if you believe that governments are likely to engage ex post in bailouts because they believe in systemic risk, then you must also believe that government interventions ex ante – including prudential regulation – may be warranted.

There are two possible economic justifications for this intervention. The first is that the social risk is not equal to the private risk so that, left to themselves, markets will accumulate more risk than is socially efficient. This is analogous to pollution, which imposes greater costs on society than are borne by the polluter alone. In this case, we typically tax or regulate the pollution. The same logic would suggest some type of tax or regulation on international capital flows. We should recognize that most countries have various forms of taxes or regulation on the domestic financial system, including measures like reserve requirements or deposit insurance. These are justified by the systemic risk to which financial decisions give rise and by the interventions (e.g. bailouts) which so frequently arise. Although these may or may not be feasible or desirable at the international level, I do not think it would be consistent with our other policies to rule these steps out on a priori grounds.

Another possible economic justification for intervening in the market with the rescue package is that the market is not even pricing private risk efficiently, that is, that the market is irrational. One form of irrationality that is sometimes discussed is the claim that market participants can be overly focused on the immediate term, and particularly in figuring out what other market participants are going to do. This is what Keynes referred to as a "beauty contest" in which contestants are trying to guess who the other judges think is most beautiful, not who actually is the most beautiful. As a result, markets can diverge from long-run fundamentals which, according to this view, are more stable than the actual market outcomes.

There is a large economics literature documenting what is called the market’s "excess volatility." If this is correct then some measure like Tobin taxes, a tax on exchanging currency, could increase the cost of short-term speculations by raising the cost of round-tripping, while still allowing markets to respond to changes in the long-run fundamentals. Again, I am just raising the Tobin tax as an illustration; in practice there are serious questions about its feasibility, especially in a world of rapid financial innovation, where it could be easy to circumvent.

(The argument sometimes put forward that the bailouts do not cost anybody anything can, similarly, be looked at in two different ways. If markets are "rational" then the fact that the interest rate charged is below the market interest rate for these loans is evidence that there is, in an ex ante sense, a real subsidy to the borrower (even if ex post we have been repaid for the loans made in previous bailouts). Alternatively, markets may be "irrational," charging an excessively high risk premium – one that cannot be justified by the real risk. Then the intervention in the market may be costless; but this argument certainly undermines confidence that markets by themselves are likely to yield efficient outcomes.)

The "intermediate targets" of international financial regulation

If we accept the argument that some form of intervention – a term that includes prudential financial regulation – is justified to bring the private risks into line with the social risk, the next question is what "intermediate targets" should we focus on to achieve this broad goal. Two objectives come to mind:

One of our objectives should be to try to influence the pattern of capital flows. Procyclicality is another undesirable feature of the international capital flows. Countries seem to get the most private capital when they are growing strongly and need it least, and have a relatively harder time accessing capital in hard times when they need it most. As a result capital flows do relatively little to smooth the business cycle, and may even amplify it. Accomplishing this objective, however, may be very difficult.

Another objective concerns the composition of capital flows. There is now broad agreement about the value of foreign direct investment, which brings not just capital but also technology and training. Preliminary evidence from East Asia also shows that consistent with past experience, foreign direct investment is relatively stable, especially when compared to other forms of capital flows.

Unlike foreign direct investment, short-term borrowing may bring with it more risks than benefits. In the form of trade credits it provides an important, and relatively inexpensive, source of international liquidity without which no economy, especially an export-oriented economy, could run. However using short-term debt to finance long-term investments, and in volatile sectors such as real estate, can be extremely risky as we have seen here in East Asia. Short-term lenders may be less careful in screening and monitoring, so that the risks that money is not well invested is greater. When the saving rate is already high, and when the money is misallocated, the additional capital flows just increase the vulnerability of the economy without adding much to growth. A prudent strategy would require holding a higher level of reserves, so that the net benefit of short-term borrowing would be reduced even further. Hence, short-term capital’s value in increasing GDP is at most limited.

The large benefits of foreign direct investment, and the costs and benefits of short-term capital flows, have led many people to investigate ways to encourage long-term investments while discouraging rapid round trips of short-term money. There are many components of such a strategy. First, we need to eliminate those tax, regulatory, and policy distortions which may, in the past, have served to stimulate short-term capital flows. Examples of such distortions are evident in the case of Thailand; but subtle examples exist almost everywhere. Without risk-based capital requirements for banks, for instance, incentives for holding certain assets and liabilities will be distorted. Such risk-based capital standards would presumably get reflected in interest rates charged to high risk exposures, e.g. to highly indebted firms or to firms with a high foreign exchange exposures, thus providing them with an incentive to cut back on their borrowing. Second, several countries have imposed prudential bank regulations to limit the extent of currency exposure of their institutions. Colombia’s regulations seem to have served it well during the recent crises.

But these measures may not go far enough, especially once it is recalled that corporate exposure may itself give rise to vulnerabilities. And the systemic risks to which such exposure can give rise provides ample justification for taking further measures, as I have already suggested. Among the ideas currently under discussion are inhibitions on capital inflows. In thinking about how to accomplish this, we should look to the lessons of the Chilean experience. Chile has imposed a reserve requirement on all short-term capital inflows – essentially a tax on short-maturity loans. The overall efficacy of these controls is the subject of much discussion, but even most critics of the Chilean system acknowledge that it has significantly lengthened the maturity composition of capital inflows to Chile. This may be part of the reason that Chile was one of the few countries in the region that was relatively unaffected by the Tequila crisis in 1994-95 and the current East Asian crisis.

Still other measures employ tax policies, for example limiting the extent of tax deductibility for interest in debt denominated or linked to foreign currencies. The problems of implementing these policies may in fact be far less than those associated with the Chilean system.

THE ROLE OF THE WORLD BANK IN THE EAST ASIAN CRISIS

East Asia has come a long way since the 1960s. But in many countries, the financial systems are not sufficient to deal with the increased demands posed by greater capital flows. In the last 9 months I have traveled to Korea, Indonesia, Malaysia, and this is my second visit to the Philippines. My meetings with government officials and others in these countries have convinced me that they are up to the task of building more robust financial systems. Many of these plans, and reforms, were already underway before the crisis struck. In the last several months, there has been further progress.

The World Bank is working with our clients in East Asia to help make financial reform work. This involves technical assistance and financial support. In total, the World Bank has pledged roughly $16 billion to the region, the equivalent of almost an entire year’s lending program. In addition to financial reform, this money will help support other structural reforms, including corporate governance.

At the same time, the Bank, together with our partners, has the responsibility for ensuring that the poor and vulnerable suffer as little as possible in the process of adjustment. Financial crises typically bring with them large increases in unemployment, which often linger well after the initial crisis has passed. The devastating consequences for the poor can persist long after capital flows and economic growth resume. Nor can we ignore the link between these political and social consequences of policy and the more narrow economic concerns: it will be virtually impossible to restore confidence in the midst of political turmoil, and the probability of political upheaval is systematically related to underlying economic factors.

CONCLUDING REMARKS

In the last several months, the public discourse about East Asia has been completely transformed. After proclaiming its successes, we now condemn its failures. I have no doubt which of these two is more lasting. Although a significant setback, it is hard to imagine the current turmoil undoing the gains of the past quarter century.

Pundits are inclined to hyperbole and to simple explanations of complex phenomena. The reality of East Asia’s past success and current turmoil is probably somewhere in between the two extremes. One can see this, for example, by examining the strident accusations of "crony capitalism." True, business-government interaction in the region (the so-called Japan, Inc. and Malaysia, Inc.) always included the danger that the fine line between consensus building and collusion, between partnership and political cronyism, would be crossed. Indeed, those concerns were one of the reasons that many of us hesitated in suggesting that other countries follow all aspects of the East Asian model. Nevertheless, on balance, while there may have been some misallocation of resources as a result of abuses of power, the strength of the East Asian system outweighed the risks for many years. Perhaps the gains from improved coordination exceeded the losses from misguided investments. In any case, only an ideologue would claim that but for their system of close government and business cooperation they would have grown even faster.

In my remarks today, I have tried to shed some light one on particularly important area: the financial system. We have come a long way since the time when many viewed the financial system simply as a sideshow, or a passive channel that allocated scarce resources to the most efficient uses. Today, almost everyone agrees that the financial system is essential for development. Improving the financial system can lead to higher growth and reduce the likelihood and severity of crises. In thinking about financial reform, we need to treat liberalization as a means rather than an end. Instead of pushing for immediate deregulation, we should be trying to understand the important role government plays in financial markets. These steps will not only result in the better allocation of domestic capital, but also help countries to manage international capital flows.

At the same time, however, we should not adopt policies toward international capital flows based on the premise that domestic financial regulation is perfect. Developing countries all have a long way to go until their regulatory systems are as sophisticated as those of the United States, and even the United States continues to suffer from periodic financial debacles.

Recently there have been a number of discussions about reforming or renewing the international financial architecture. Some of these discussions are reminiscent of the debates more than a century ago about how national economic institutions could help the new nation-states achieve their full potential. In the United States, in the midst of the Civil War, in 1863, as Congress grappled with the challenge of providing the foundations of a new, stronger, unified country, they established the world’s first financial sector regulatory body, the Office of the Comptroller of the Currency. It has taken more than a century before the country began to feel comfortable with a system of national banking – and even today, there are misgivings in many parts of the country.

Today, we stand on the edge of a new world economy. But we do not have international institutions to play the role that the nation-states did in promoting and regulating trade and finance, competition and bankruptcy, corporate governance and accounting practices, taxation and standards, within their borders. Navigating these uncharted shoals will be a great challenge. But just as much of the prosperity of the past hundred and fifty years can be related to the expansion of markets that those transformations afforded, so too the prosperity of the next century will depend in no small measure on our seizing the opportunities afforded by globalization.

In approaching the challenges of globalization, we must eschew ideology and over-simplified models. We must not let the perfect be the enemy of the good. As one of my friends put it, in a downpour, it is better to have a leaky umbrella than no umbrella at all. I believe that there are reforms to the international economic architecture that can bring the advantages of globalization, including global capital markets, while mitigating their risks. Arriving at a consensus about those reforms will not be easy. But it is time for us to intensify the international dialogue on these issues.

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