Posted by: Dirk | October 11, 2008

Evaluating financial market liberalization

The Inter American Development Bank (IADB) has not been alone in promoting financial market liberalization. Other international institutions have been pushing for it, most prominently the International Monetary Fund. Barry Eichengreen and Michael Mussa examined Capital account liberalization and the IMF in a 1998 paper. Paul Knapp and Andres Velasco published their recommendations for the Western Hemisphere in 1997 at the IADB. This is their assessment (p. 8):

Allowing cross-border capital flows gives domestic residents access to the world capital market so that they can borrow abroad in bad times and lend abroad in good times. This provides more flexibility in financing and helps to smooth consumption and economic activity in response to macroeconomic shocks. In addition, the ability to invest in the markets of several countries reduces countryspecific risk for investors. This enables domestic borrowers and lenders to diversify risks, making them less susceptible to shocks and reducing the volatility of returns on savings. From a global point of view, free cross-border capital mobility enables resources to flow to those countries where the return on investment is higher, thus improving the allocation of resources and enhancing world economic performance.

These recommendations were standard in the 90s, the authors just repeated what was supposed to be common knowledge. With hindsight, the passage on diversifying risk looks pretty dubious. Financial globalization has not diversified risk, it connected economies to other economies’ risk. This has led to synchronization of stock markets during financial crisis. If everybody holds everybody else’s risks, then if one goes down everybody goes down. In theory this should dampen the shock. However, if the adjustment happens gradually, then instead of one big shock in country A we get many, many small shocks in a row in different countries. This has happened as financial players have sold assets to decrease their leverage in the last week(s). The newest numbers from the Economist (Oct 11th), Markets, % change on Dec 21st 2007 in $ terms:

United States (DJIA) -30.2
Japan (Nikkei 225) -32.8
Euro area (FTSE Euro 100) -44.2

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