Financial Crises:
A Eurocentric Perception[1]

Jorge Braga de Macedo
Faculty of Economics, Nova University at Lisbon
Revised: 31 January 2000

Abstract: Thinking about the financial architecture has been largely determined by the perceptions of financial crises prevailing between 1997 and 1999. Fortunately, there has been reluctance in embarking in grandiose reform plans, but unfortunately rather little has been done so far to enhance the effectiveness of multilateral surveillance on a global scale, in part because of the perception of the crises as involving mostly emerging markets. This perception stresses the rapidity of US response in October 1998, leaves out Japan's difficulties and ignores European indifference to the crisis.

The current international system calls, however, for a more effective regional and global response to threats of contagion of national crises through coordination mechanisms among monetary and fiscal authorities like the ones found in the EU. These mechanisms rely on shared economic and societal values, and institutions like the EU, but also CEFTA, Mercosul, Sadec or ASEAN ought to adapt them. As the EU is the most ambitious among those, this adaptation can be seen as a "Eurocentric perspective". Over and above the parallels between the 97-99 emerging markets crisis and the Mexican devaluation of December 1994, the lessons from the crises in the ERM may thus be helpful in emerging markets. In effect, the crises were overcome by more effective coordination mechanisms among monetary and fiscal authorities, the so-called ERM code of conduct. With the experience gathered during the first year of the euro, a euro code of conduct may be developing. Unlike the previous one, this new code acknowledges the importance of international banking supervision, including better risk management along the lines proposed by the BIS.

Liberalization and globalization must be better managed to prevent protectionist pressures from taking over. Avoiding contagion by reverting into trade and financial protectionism could well prove as ultimately futile a beggar-thy-neighbor policy in 2000 as it was in the early 1930s.

1. Introduction

A major consequence of the end of the cold war is that respect of property rights and open markets for goods, services and assets have become widely accepted principles for the organization of economic activity everywhere, including mature democracies as well as emerging markets. But risk increases with the reward. If a financial crisis destroys a fragile civil society, then the combination of political and financial freedom found in mature democracies may seem unattainable outside the two dozen members of the Organization for Economic Cooperation and Development (OECD).

Most OECD countries are gathered around the seven richest economies, whose leaders have regularly met over the last quarter century, suggesting a response to international interdependence rooted on the US, European and Japanese blocs. The Eurocentric approach stresses that, in this trilateral world, only the European bloc has attempted to deal with its own regional architecture, in ways that include bridges towards the former Soviet bloc, Africa and Latin America.

Can the multilateral surveillance mechanisms developed among nation-states in the European Union (EU) be adapted to build a global financial architecture resilient to financial crises? For the Eurocentric perception taken here the answer is yes. To begin with, its intercontinental domain reflects longstanding cultural and commercial ties. Moreover, such Eurocentric perception of world financial architecture probes into budgetary procedures and corporate governance standards, in ways that would offend national sovereignty if applied to Washington or Tokyo. The Eurocentric perception does not focus on balance of payments adjustment, but rather attempts to bring together principles of good government commonly accepted in Berlin, London, Paris and Rome and indeed jointly transferred to Brussels and elsewhere.

This Eurocentric perception has weaknesses, however. The degrees of commitment to the union and to each one of its main institutions have been changing in various issue-areas, as a partial response to a more turbulent global and regional environment. The euro was created in January 1999 among most of the fifteen member states but the resignation of the European Commission shortly thereafter delayed the accession calendar. The strains introduced in the balance of power between institutions were exacerbated after the parliamentary elections in spring changed the majority from the European socialist to the popular party. Another challenge had come from military actions in Kosovo, which brought the need for reconstruction and stability in the Balkans. Albeit conjunctural, these two developments may have changed the perception of Europe to a greater extent than the euro, whose introduction had been planned for over ten years. Hopefully the EU will now be able to combine internal reform and external visibility.

One weakness of the Eurocentric perception held here is that peer pressure is sometimes used to stall reforms, rather than to promote the nation's capacity to transform.[2] The other weakness, which is even more serious in times of global financial turbulence, is that the four members of the G-7 often forget their eleven "peers" when discussing global affairs. The two weaknesses may be related and they explain the bewildering complexity of the EU institutions at the moment.[3] Nevertheless, it is my contention that the strengths of the model can be put to good use in the global arena, as long as Eurocentric is understood as a partnership open to other nations, in Europe and elsewhere.[4]

As global integration advances, greater prosperity will result – as long as people do not feel excluded from the necessary reforms. Similarly, the new financial architecture should combine global unity with regional and national diversity. As we know from the eurozone experience over the last year, this is easier said than done. But the euro happened, in spite of many pronouncements to the contrary and European economies are coming along nicely. To adapt this case of successful cooperation to Latin America or Asia might still be called Eurocentric.

The rest of the text is divided into five sections and a conclusion. We begin with an overview (section 2), leading into a primer on crises (section 3), where results from recent academic work are presented along with the views of market participants. The pattern of contagion is addressed (section 4), together with its implications for the global economy (section 5) and for policy coordination therein (section 6).

The conclusion suggests that lessons from the first and second stages of Economic and Monetary Union in Europe, especially the crises in the Exchange Rate Mechanism (ERM) of the European Monetary System may be more relevant than grandiose plans for the reform of the international monetary system. That is not to say that European coordination mechanisms are flawless, far from it. The Eurocentric view adopted here is simply that these lessons may be helpful in emerging markets to the extent that they were overcome by more effective coordination mechanisms among monetary and fiscal authorities.

2. Overview

Financial crises featured prominently in the 1990s. During the second half of the decade, financial interdependence was no longer confined to mature democracies, as more and currencies became fully convertible into each other. Across the global economy, national financial policies came under increased scrutiny from international investors and rating agencies. Interest rate spreads of emerging markets over established borrowers fell. But there were also sudden reversals in investor sentiment, which dramatically increased these same spreads.

Similarly, few opportunities at testing the credibility of exchange rate parities were missed by market operators. This made the exchange rate regime as crucial a determinant of macroeconomic stability as fiscal, debt management and banking policy. The market tests of the credibility of exchange rate parities were often successful in triggering a currency devaluation, so there seemed to be fewer and fewer alternatives to a single currency and pure floating. Accordingly the exchange rate regime may have been perceived as being even more crucial than the other determinants of policy credibility. This perception also rationalized direct policy responses such as exchange controls, perhaps along the lines of the so-called Tobin tax on short term capital movements.[5]

The International Monetary Fund (IMF), whose role in backing the financial deliberations of its seven major shareholders (gathered in the G-7) is well established, is also the world authority on exchange rate regimes. Its ability to manage financial crises where the exchange rate surveillance interacted more with banking supervision than with monetary and fiscal policies has of course generated a great deal of dispute.

The role of "news" in generating sudden changes in beliefs is such that crises can hardly be forecast. This is why perceptions of financial crises on the part of investors and opinion makers matter so much. Depending on the perception, a crisis can become self-fulfilling instead of being countered by effective crisis management. Information about future market perceptions can help national and international policy-makers develop and implement appropriate responses, that is to say responses which re-establish confidence. Better information alone does not, however, succeed in predicting, let alone in preventing, financial crises.

Useful inputs into crisis management come from economists and from market participants, with possible regional patterns. Emphasis will be given here to European perceptions, largely because of their greater exposure to multilateral surveillance compared to North American let alone Japanese perceptions.[6] This is not to say that peer pressure mechanisms are absent from, say, G-7 deliberations. It simply reflects the widely acknowledged fact that there are often four or more European voices in the face of the US and Japan. That being said, geography is sometimes cast in a trilateral fashion, which rather suggests the notion of three hegemonic blocs. Similarly, any sample of individual opinions is likely to be an inaccurate reflection of the market itself.

There were three waves of financial crises in the 1990s. The first broke in September 1992 over the ERM and was solved one year later, after the fluctuation bands were widened. The second wave followed from the attack on the Mexican peso in December 1994 and had ripple effects in 1995 in both South America and Central Europe. The third and most serious wave lasted two years. It began in Spring 1997 when a minor attack on the Czech koruna resulted in its devaluation. However, the Thai baht floated in the Summer of 1997, reversing an implicit dollar peg which had been pervasive in the fast growing East Asian economies, and Malaysia, Indonesia and Philippines also experienced attacks on their currencies. Perceptions of financial crisis began to form.

Currency and banking crises spread to other Asian economies in the Fall of 1997, threatening the role of Hong Kong as a financial center (ruled by, but separate from, China). The Republic of Korea, like the Czech Republic a recent member of the OECD, suffered a combined currency, banking and debt crisis. Japan, a mature democracy and a prominent member of the G-7, was seen as part of the problem. China, whose transition to market and to democracy has yet to begin, was seen as capable of keeping financial stability in the region.

The prevailing perception was of an emerging markets crisis which hurt the borrowing capacity of Asian, Latin American and Central European debtors. The continued weakness of the Japanese currency exacerbated the negative impact of the financial turmoil on Asian growth throughout the Spring of 1998. South Africa followed while Russia floated the rouble and defaulted on its domestic debt in late August. Brazil succeeded in keeping its dollar peg in spite of several attacks in September, on the eve of a crucial presidential election.

A hedge fund, Long Term Capital Management (LTCM), which bet aggressively on declining spreads for emerging markets and which was thought to be "too smart to fail" had to be rescued from bankruptcy by some of its clients, the major global players. The operation, arranged by the New York Fed, was followed by the lowering of interest rates in the US in September, on the eve of the meetings of the IMF and the World Bank. Both measures suggested that the emerging markets crisis had spread to the North Atlantic and was hurting growth prospects in the EU and the US. There were also threats of further contagion to Latin America, let alone to Hong-Kong and China. Brazil did devalue the real in January 1999, but the rapid adaptation to float by a new central bank governor and a series of reforms on the fiscal front improved the financial situation. Accordingly, the fear that the emerging markets crisis would become global subsided.

One specific lesson from the Brazilian crisis is the need to involve the private sector in a solution, as the IMF cannot make private portfolio decisions for banks. The attempts of the Brazilian government to keep banks rolling over their credits have been successful, as creditors realize the importance of not moving if others stay in.

Because of these developments and of the continued strength of the US economy, the spring meetings of the IMF and the World Bank signaled the end of the emerging markets crisis. World growth prospects in 1999 were subdued 1argely because of the lasting negative effects of the previous two years of financial turbulence spreading from the Pacific to the Atlantic. Once again the US economy showed resilience and grew at close to 4%. In spite of unfavorable unemployment prospects in Germany and Italy, EU growth also picked up during the course of the year. Japan’s growth also turned positive, leading to forecast an extra .6% growth since the first quarter, to 3% for world output.

3. Primer on Crises

3.1. Definitions and Caveats

Since almost all but a dozen mature democracies qualify as emerging market economies, the notion hides a lot of different national and regional circumstances.[7] If the notion of emerging market encompasses too many varieties, that of financial crisis is often misused. The term applies best to a combination of currency, banking and sovereign debt crisis with strong negative effect on the national economy.[8]

The definitions of emerging markets and financial crisis help understand that the appropriate level of policy response may no longer be national, but instead become regional or global, depending both on contagion mechanism and on the availability of instruments and institutions.

The success rate at predicting crises is less than one third (25-30%). The reason is that two types of errors must be balanced against each other: not to predict crises that do occur and to predict crises that do not occur. All that can be done is to detect vulnerability, but that's very different from predicting the timing of a crisis.

3.2. Fundamentals vs. Financial Panic

The main source of debate among economists hinges on the role given to fundamentals vs. financial panic. Because both are probably at work, interpretations often depend on a balancing of each factor.[9]

If structural problems and policy inconsistencies make it inevitable that a combination of currency, banking and debt crises will lead to a financial crisis with severe real consequences for the national economy, then the root causes must be addressed, at the risk of encouraging moral hazard behavior.[10]

But because crises are cumulative processes, which have a self-fulfilling character, their costs end up being much greater than called for by the fundamentals. Then prevention efforts make sense almost always.

3.3. List of Causes

One way to solve the debate between the two camps is to look for areas of agreement in what are causes of a financial crisis. The list of favourite causes still leaves a great deal of room for interpretation but it helps focus on the disagreement.[11]

That bad shocks and policy mistakes make things worse is uncontroversial but the practical question is rather how the severity and duration of the bad shock and the irreversibility of the policy mistake make a difference to the perception of crisis. The attack on the Czech koruna, for example, was short-lived because devaluation was coupled with a temporary import deposit and measures to deal with the fragility of some of the financial institutions.[12]

There is again consensus on the statement that large and free foreign exchange reserves, and/or a flexible exchange regime reduce the probability of a crisis. Yet it may not be possible to agree on what finite level of free foreign exchange reserves and exchange rate flexibility averts a crisis. The existence of an international lender of last resort would help if it does not exacerbate moral hazard. For fundamentalists this is a bigger "if" than for those who hold that crises are self-fulfilling. Of course, both sides agree that a crisis always has a combination of causes.

On the economic doctrine, keynesianism seems to have made a comeback. The view that fiscal contraction may turn out to be expansionary due to strong positive confidence effects, is no longer held.[13] Budget cuts in Asia involved fiscal expenditures: they worked and led to falling output. In Thailand in particular they were too large.[14]

3.4. Anatomy

A financial crisis comes in many forms - because it combines a currency collapse, with or without resort to exchange controls, a bank run or the threat thereof and a debt default or moratorium. Its anatomy often includes the expected bailout of private debts by the state, or by international institutions. Such expectations are easier to form in the presence of cronyism and with weak corporate governance.[15]

Even in countries with high savings ratios, investment booms brought about by expected bailouts generate large current account deficits and real appreciation. If these deficits are financed by short term foreign currency unhedged liabilities and by the ever greening of bad loans, it is tantamount to making private debt into an implicit public debt.

3.5. Indicators

When crises loom, there is a great deal of interest in advance warning systems. Nevertheless there has been little progress in developing practical crisis indicators.

Foreign exchange reserves, for example, are still compared to imports with reference to the so-called "3 month IMF rule," without taking into account the exchange rate regime.[16] A better candidate for normalization, especially for inconvertible currencies, would be external debt. Under a fixed rate and free capital mobility, reserves should instead be compared to the broad money stock (M2). While reserve adequacy depends on the exchange rate regime, none of these average measures are satisfactory under uncertainty. Reserves should ideally be related to the volatility of the current account or of short term capital flows.

A high ratio of bad loans to total loans is another indicator which has been used in looking for evidence of a lending boom. The increase in real lending to private sector and state owned enterprises is in turn how a lending boom is identified. The usual criterion for internal balance, namely a sustainable fiscal position, was absent in the Asian economies but it remains a serious problem in transition economies and especially in the Russian crisis.[17]

Real appreciation in terms of effective rates is another early warning indicator. There again, care must be taken to net out the equilibrium component of real appreciation which has accompanied any successful development experience.

3.6. Financial Fragility

Financial fragility is seen as decisive in the combination of currency, banking and debt crisis. In that context, the maturity of capital inflows matters more than their size, because financial fragility comes from failures in the maturity transformation of short-term assets into long-term liabilities banks are suppose to provide.

Another uncontroversial point it that financial liberalization and banking deregulation require improved prudential supervision, the question being how to achieve this supervision in global markets. In particular, does this require a new institution? Instead, can the BIS and the IMF substitute for the role of an international lender of last resort?

The converse of the previous point is that capital account liberalization without improved banking supervision is also found in most crises. Over-investment is the mechanism through which the combination of financial liberalization and banking deregulation results in banking and currency crises.[18]

3.7. Responses

Once a crisis erupts, it is difficult to take action. Indeed, if the IMF goes public about an impending crisis, it becomes even more difficult to act. Despite the advantages of multilateralism, moreover, bilateral action can still help a lot. In the cases of Russia and Ukraine, for example, if IMF helps, it is bad; if IMF does not help, it is also bad! Then political reasons could dictate bilateral help not constrained by the charter of the IMF. Even if action is taken on time, results from action may be modest relative to expectations, feeding into the perceptions of recurrent crises. These thoughts are sobering and they caution against grandiose plans.

National policy responses to a large capital outflow may be a combination of allowing reserves to drop, increasing interest rates, and depreciating the currency. These responses include several different measures, with different effects. In particular, the depreciation may be achieved through controls which lead to multiple exchange rates, of which one or several may remain unchanged at the pre-response level. Moreover, they tend to be combined and the relative importance of each one depends on the particular circumstances of each country. May be outright depreciation is ruled out by an exchange rate arrangement, as in a currency board, or is very costly in terms of financial reputation. This was the case in Mexico and Korea, who had just joined the OECD, and in Russia, who had just been accepted into the G-7. Brazil was also in a similar situation. Except for the Mexican peso, none of these currencies was fully convertible.

Moreover, severe exchange controls have been reinstated in the wake of the Russian crisis, even in countries which previously had graduated from the emerging market indices such as Malaysia.[19]

There may be constraints on the rise in interest rates that is politically or socially viable, and the increase in interest rates is more costly the weaker the banking system. Allowing reserves to drop, on the other hand, is less likely the lower the ratio of reserves to liquid liabilities. And if reserves are low, and cannot drop further, one of the two other alternatives, no matter how unpalatable, must be contemplated.

4. Contagion Patterns: Geography and Hegemony

Suppose a financial crisis is going to occur in country X; will it spread and if so how?[20] In the emerging markets crisis, the spread is global, from Singapore to Chile or to Egypt.

But lessons can be learned from cases when the scope is regional, as in the ERM crises of 1992-93. At that time, Portugal and Ireland suffered currency attacks based on what was happening to the Spanish and British currencies, in what was described as "geographic fundamentals". These attacks were short-lived but they nevertheless led Ireland to request a realignment in January 1993 and Portugal had to partly follow several realignments of the peseta. Given that the ERM code of conduct is based on multilateral rules for exchange rate changes, fundamentals should be less of a geographic than of a policy problem.

Yet this peculiar form of neighborhood contagion was pervasive at the time, perhaps because the financial reputation of these countries was not fully established. One possible reason was that their regime change was quite recent: 1987 for Ireland - even though it was a founder of the ERM -, 1989 for Spain and 1992 for Portugal. A related reason is that testing the ERM parity made sense when the real appreciation was perceived as excessive by export oriented firms and the government may have been sensitive to their pressure. The bet proved correct for Spain, who initiated two realignments during the ERM turmoil. The Portuguese response was to follow in part, so as to reinforce its own credibility without suffering the direct consequences of a competitive depreciation.[21]

Contagion patterns are not well understood, but geography and hegemony seem to play a role, with some evidence pointing to the role of trade and to listings of country potentials that owe more to marketing than to fundamentals.[22] A beauty contest among potential locations for international investment may also crowd some markets and desert others, strengthening the element of hegemony.[23]

Both geography and hegemony are at work when it comes to the economic policy autonomy of Hong-Kong relative to China -- neither a market nor a transition economy. The same is true for the role of Japan - not an emerging market and yet it is part of the Asian problem, rather than helping solve it.[24]

The turmoil in Russia had a strong domestic component and can still reverse the transition process. The sequels of a debt moratorium and of currency inconvertibility, let alone a bank run, will remain economically and politically hazardous, especially due to the lack of a North Atlantic economic dialogue. The informal apportionment of responses to financial crises emerging markets to the major mature democracy in the same continent suggests a pattern of contagion reminiscent of "the Monroe doctrine."

While this regional approach is probably inadequate in today's global markets, there have been proposals to revive it so as to facilitate a new financial architecture.[25] Effects in Brazil, or in Latin America, are already seen as primarily calling for a US response. Instead, given Russia's status as former hegemon in Europe and parts of Asia, perceptions of crisis elicit stronger responses by the US and by the EU. Central Europe is seen as a European problem but the current Balkans war is of course led by NATO, rather than the EU or the UN.

The exchange rate option will be more likely to be chosen the greater the real appreciation observed. But devaluation is a beggar-thy neighbor policy to the extent that it attempts to restore competitiveness at the expense of trading partners and may elicit retaliation. It therefore needs to be coordinated.

The same is true of exchange controls, which almost always function as a devaluation in disguise. Even when they seek to prevent excessive inflows, they are often not matched by free outflows, or even by a relaxation of existing controls. This was true in Portugal in the early 1990s but can also be found in the Chilean experience.[26] The issue is then how can devaluations and exchange controls be coordinated at the regional or global level, to lessen their beggar-thy neighbor character?

5. Threat to Globalization?

The financial crises caused hardship in individual countries but they also served as coordination devices and therefore did not threaten globalization. The cases of withdrawal from world financial markets, most notably Malaysia, were isolated and temporary. In Spring 1998 Chile lowered its barriers to short term capital inflows (a tax called encaje) so as to revive the domestic stock market and set the tax rate to zero in the Fall. Even a country endowed with a relatively well functioning administration found it difficult to keep an exchange control geared to a long term objective when the environment became turbulent. The long term objective here was an improvement in the composition of capital inflows towards long term instruments and especially foreign direct investment relative to short term flows which were considered more volatile. In any event, the rationale for the encaje was clear during the boom of the mid 1990s but it ceased to apply afterwards, reinforcing the idea that such measures work temporarily, and only if they are introduced in good times.

The output declines in several countries hit by financial crises were a definite cost against which some of the positive sides can be evaluated. In particular, improvements in banking supervision and even in corporate governance might not have occurred without a crisis. Nevertheless, there are a lot of reforms in that area remaining to be done, and not only in emerging markets but in the OECD area as well.

If carried out by the EU states, for example, these reforms would not only enhance the potential of the euro as a world currency but also the competitiveness of European firms. The advent of the euro as the common currency of 11 EU states is indeed an enabling reform. Most of the former national currencies ("legacy") except for the Denmark which served as the anchor of the system for some 20 years, could neither float nor credibly fix without a well defined institutional framework such as the European System of Central Banks and the Stability Pact.

In effect, the widespread mobility of financial capital has reduced the attractiveness of exchange rates as policy instruments, thereby lowering the costs of a fully credible peg.

It turns out, however, that floating is not necessarily a viable alternative for many of the world's small open economies, unless they chose to keep the currency fully inconvertible and thereby withdraw from globalization. In this regard, there seems to be less scope for adjustable pegs and independent floating. Another way of saying this is that optimum currency areas are endogenous. Alternatively, you need to float in order to fix.[27]

With global financial markets, exchange rate systems involving fixed but adjustable rates or crawl are crisis prone. If South Africa, Turkey or Mexico had some kind of a peg, there would have been more severe crises there. Otherwise, an extreme commitment is called for, like the Hong Kong or Argentine peg to the dollar. In other words, float or peg hard. But floating alone is no good solution as there may be wild swings in bilateral rates, as in the yen moving from 80 to the dollar in 1995 to 147 in 1998. The lesson of widening the ERM bands shows that multilateral surveillance beyond exchange rates is needed.[28]

6. Coordination and Architecture

The exchange rate regime is just one instance of needed improvements in financial architecture. The debate on the so-called global financial architecture features a reform of the system of international relations and its main institutions, which for the most part were established half a century ago.[29] The reflection of regional cooperation arrangements such as the EU is one of the issues in the debate where the geographic/hegemonic pattern of contagion matters. The role of Japan acquires special salience because it was seen as the major player in South-East Asia, where the current crisis originated.

Grandiose reforms of the international system have been resisted by the G-7 and by its members in the EU but concrete steps are now being taken because markets' resistance to change is lower in times of crisis.[30] Both the Financial Stability Forum (FSF), created by the G-7 and currently chaired by the BIS, and the G-20 (including large emerging markets) examine closely the market behaviour of highly leveraged institutions, offshore centres and short-term capital flows.[31] They will make recommendations on how to improve capital-flow statistics and prudential standards in both lending and borrowing countries aimed at stabilising financial markets. In parallel, progress in risk management techniques is required, as many global players have not yet exploited the potential of their own auditing services.[32] If this is true of global players, central banks and regulators might be even less prepared to carry out let alone being prepared to carry out mandatory value at risk reviews as called for by the Basle committee of the BIS.[33]

Following widespread agreement between academics and market organizations such as the group of thirty that some improvements in orderly workouts were desirable and easy to achieve, the IMF has been authorized to lend in arrears.[34] Nevertheless, the traditional difference remains between national action on private debt and international action on sovereign debt. In the absence of international enforcement, the "pre-nuptial agreement problem" makes these improvements less likely to be accepted outside of a broader set of changes in the international system. An IMF Contingent Credit Facility for pre-defined liquidity support has also been implemented and the debt reduction by private creditors that the Paris Club requires to grant public concessions on debt principal and debt service payments has been broadened.

It may be, then, that the crisis served as a coordinating device by allowing responses that would not obtain in calm periods. As mentioned, bank restructuring which took place in crisis may not have happened otherwise, debt structures are now in better shape that if countries had waited

Opinions commonly found among market participants do not allow us to pass judgement on the different aspects of the emerging market crisis, but they help suggest some implications for policy. Some market-informed propositions suggest that the surprise element was genuine.[35]

Other propositions go more towards opinions on the state of the world and may therefore be more influenced by professional opinion. Thus "the crisis was like worldwide deflationary shock" and "confidence on unregulated globalized financial markets was damaged" imply views about what to do and whether or not economists are useful in sorting out the implications for policy. In addressing this question, market participants often reflect a confusion between their opinions as businesspeople (who prefer to keep free markets, perhaps flexible exchange rates) and their views as market professionals. Similarly, they may accept to strengthen regulation and supervision, including risk management techniques, before further liberalization of the capital account.[36]

The current crisis and its aftermath have uncovered an unusual amount of disagreement within the Bretton Woods institutions. And if they do even appear to agree with each other, the IMF and World Bank may not be capable of influencing the architecture of the international economy. While the competitive tension between the two sister institutions may be helpful, apparent coordination failures do not contribute to the credibility of advice on coordination.[37]

The immediate effect of the crisis is to underscore a lesson from the inter-war period, which could well spread from the tariff escalation to non-tariff barriers like exchange controls. Liberalization and globalization must be better managed to prevent protectionist pressures from taking over. Managing the emerging markets crisis means therefore avoiding a relapse of protectionism while fostering reform in the international system to allow for a more effective regional and global response to threats of contagion of national crises.

The issue is then how can devaluations and exchange controls be coordinated at the regional or global level, to lessen their beggar thy neighbor character. Coordination mechanisms among monetary and fiscal authorities like the ones found in the EU come readily to mind. These mechanisms rely on shared economic and societal values, and institutions like the EU, but also CEFTA, Mercosul, Sadec or ASEAN ought to adapt them.

Over and above the parallels between the 97-99 emerging markets crisis and the Mexican devaluation of December 1994, the lessons from the crises in the ERM may thus be helpful in emerging markets.[38] In effect, the crises were overcome by more effective coordination mechanisms among monetary and fiscal authorities, the so-called ERM code of conduct. With the experience gathered during the first year of the euro, a euro code of conduct may be developing. Unlike the previous one, this new code acknowledges the importance of international banking supervision, including better risk management along the lines proposed by the BIS. In any event, liberalization and globalization must be better managed to prevent protectionist pressures from taking over. Avoiding contagion by reverting into trade and financial protectionism could well prove as ultimately futile a beggar-thy-neighbor policy in 2000 as it was in the early 1930s.

7. Conclusion

In recent years, an increasing amount of tax resources has been devoted to crisis resolution, not just through higher transfers to the international financial institutions, but also through loan-loss reserves by banks which lower their taxable profits. Bailing in the private sector into higher burden sharing is thus hoped to reduce the degree of moral hazard in global financial markets implied by public bailouts. On the other hand, the modifications to the global financial architecture might restrain private flows to the emerging markets, hence making these flows less liquid and more volatile.

These factors raise important questions regarding the consequences of the current proposals to reform the functioning of the international financial system for developing countries with regard to the potential costs, stability and magnitude of private capital flows to these countries.

Systems like the euro (and its predecessor the ERM) code of conduct rely on shared economic and societal values. They may be difficult to adapt to the variety of emerging markets in the current world system, but they are certainly useful in both Central Europe and Latin America, where regional arrangements like CEFTA and MERCOSUL are spreading from trade to investment.

In this regard, there have been proposals for regional fora, which could help the IMF improve its performance when exchange rate and banking issues are difficult to disentangle, as is more and more frequently the case. While this is certainly true, institutions of global governance such as the World Trade Organization (WTO) have been essential in preventing the 1997-99 financial crisis in emerging markets from becoming a 1930's style global depression. This is true whatever the outcome of the Millenium Round launched in Seattle. Parallels between free trade in goods and services and free mobility of capital (or labour) are dangerous to make, but surely the stability of the global trade architecture which led to the creation of the WTO should caution us against purely regional solutions to financial globalization.

Suspicions about "fortress Europe", even limited to the continental EU, are no longer so fashionable that they may be confused with the open Eurocentric view advocated here. This is where the role of the IMF, but also of OECD and BIS, become essential to the usefulness of a Eurocentric architecture based on peer pressure for the world economy of the new millenium.

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Jose De Gregorio, Chile Economic Report No. 1, unpublished, Universidad de Chile, July 1998.

Jose De Gregorio, Chile Economic Report, No. unpublished, Universidad de Chile, October 1998b.

Rudi Dornbusch, Capital Controls, an idea whose time has gone, MIT, March 1998a.

Rudi Dornbusch, Is China Next, Financial Times, August 4, 1998b.

Rudi Dornbusch, Russia: Meltdown or stabilization?, MIT, August 1998c.

Rudi Dornbusch and Francesco Giavazzi, Hard Currency and Sound Credit: A financial Agenda for Central Europe, MIT, May 1998.

Zdenek Drabek and Josef Brada, Exchange Rate Regimes and the Stability of Trade Policy in Transition Economies, unpublished, WTO, Geneva, 1998.

Barry Eichengreen Towards a new international financial architecture a practical post Asia agenda, Washington IIE 1999.

Barry Eichengreen and Ricardo Hausmann, Exchange Rates and Financial Fragility, paper presented at the IDB-OECD Forum, November 1999.

Barry Eichengreen and Richard Portes, Crisis? What Crisis? Orderly Workouts for Sovereign Debtors, CEPR, 1995.

Michael Emerson A Template for EU Action' CEPS Conference on "A System for Post-War South-East Europe", Brussels, May 1999.

EBRD, Sound business standards and corporate practices: A set of guidelines; September 1997.

Ricardo Ffrench-Davis, Managing capital flows in Chile. before and after the Asian crisis, Global Financial Turmoil and Reform A United Nations Perspective, edited by Barry Herman, Tokyo: The United Nations University Press, 1999a.

Ricardo Ffrench-Davis, The role of domestic policies in stabilizing capital flows, paper presented at an international seminar on the globalization of financial markets and its effects on the emerging economies, Santiago, March 1999b.

Taisho Ghost, Anne-Marie Gulled, Holler Wolf, How Much Is Enough? Foreign Reserves And Exchange-Rate Crises paper presented at the NBER Summer Institute 1998.

Reuben Glick and Andrew Rose, Contagion and Trade: Why are currency crises regional, CEPR Discussion Paper No. 1947, August 1998-09-04.

Stephanie Griffith Jones A new financial architecture for reducing risks and severity of crises, paper presented at an international seminar on the globalization of financial markets and its effects on the emerging economies, Santiago, March 1999.

Daniel Kaufmann, Corruption: Myths, Biases and Realities, unpublished, World Bank, February 1998.

Charles Kindleberger, Foreign Trade and the National Economy, New Haven: Yale University Press, 1962.

Paul Krugman, Peddling Prosperity, New York: Norton, 1994.

Paul Krugman, Bahtulism. Who poisoned Asia's currency markets?, Slate, August 14, 1997a Paul Krugman, Currency crises, paper prepared for NBER conference, October 1997b.

Paul Krugman, What happened to Asia2, Paper for a conference in Japan, January 1998a Paul Krugman, Japan's Trap, May 1998b.

Paul Krugman, Saving Asia: It's Time to Get Radical, Fortune, September 7, 1998c.

Jose Antonio Ocampo Reforming the international financial architecture: consensus and divergence, CEPAL Santiago, 1999

OECD and UNDP, Workshop on Corruption and Integrity Improvement Initiatives in the Context of Developing Economies, Paris, October 1997.

Richard Portes, The Asian Financial Crisis, presentation at the Trans-Atlantic Economic Dialogue, Brookings Institution and CEPR, Leesburg, Va, June 1998.

Helmut Reisen, After the Great Asian Slump: Towards a Coherent Approach to Global Capital Flows, OECD Development Center Policy Brief n° 16, January 1999.

Helmut Reisen, revisions to the Basel accord and sovereign ratings, paper presented at the IDB-OECD Forum, November 1999.

The 1997-98 East Asian financial crisis: A New York market-informed view, Global Financial Turmoil and Reform A United Nations Perspective, edited by Barry Herman, Tokyo: The United Nations University Press, 1999.

Andrés Velasco, Financial Crises in Emerging Markets: A Canonical Model, paper presented at the NBER Summer Institute 1998

Rene y Rocio Villarreal, La globalizacion financiera y su impacto en las estrategias de desarollo de los paises emergentes: restricciones y opciones - La experiencia de Mexico 1988­1999, paper presented at an international seminar on the globalization of financial markets and its effects on the emerging economies, Santiago, March 1999

Aaron Tornell, Currency Crises Do Not Spread Randomly, paper presented at the NBER Summer Institute 1998.

The World Bank, Helping Countries Combat Corruption, September 1997.