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Needed: A New Financial Architecture



Nations live by their polite fictions as much as individuals do, but the current international financial crisis requires a brutal honesty that so far has been lacking. A deflationary spiral, triggered by powerful monetary forces, is threatening to send the world into a severe economic recession. Federal Reserve Board Chairman Alan Greenspan's modest move to cut interest rates is a step toward restoring liquidity to the global economy. But a more fundamental restructuring of the architecture of international finance is needed.

The truth is that a crisis that revealed deep underlying flaws in Asia's financial system is now uncovering similar problems in the U.S. Europe may soon follow. The best and the brightest minds of our day have made serious errors in judgment and policy. The institutions we rely on to facilitate the international flow of capital are deeply flawed. The capital markets themselves have been defective, warped by an unwillingness to properly evaluate and price risk.

The failure of Long-Term Capital Management, one of Wall Street's best-connected hedge funds, reveals the price of miscalculating risk. The Fed has a public obligation to explain how it failed to see that bank loans to LTCM were fueling an unprecedented leveraging of capital that threatened the entire financial system. Why was a market solution to the problem, in the form of an offer to buy LTCM led by Warren Buffett, rejected? How can the outrageous personal and professional conflicts of interest in the LTCM bailout be justified? The Fed-brokered bailout of LTCM shows the sheer hypocrisy of America lecturing Asia about crony capitalism while apparently practicing it at home.


The debate over creating a new financial structure for the world begins and ends with the issue of risk. It is now clear that the global financial crisis began because capital markets didn't price risk correctly. To many Asian bankers, risk wasn't even an issue. Connections to politicians, friends, or family members determined capital flows. But American and European bankers, who are supposed to be trained in the art of evaluating risk, wound up doing a wretched job as well. And not only in Asia. LTCM is based in Greenwich, Conn.

What must be done now? Large-scale reliquefication of global capital markets is critical. The Fed must ease further, but move cautiously. The terrible credit crunch that is strangling growth in Asia is beginning to squeeze out the speculative froth in the U.S. That's good, but credit could quickly dry up, even for solid U.S. borrowers. It would help if the new European Central Bank moved out of its Eurocentric box and began to lower rates as well.

A global workout is the next step. A huge debt overhang is crushing Asia, Russia, and Latin America. Banks that miscalculated the risk in lending must take the lead in returning regions to growth. Securitizing the debt, swapping it for Brady-type bonds and other workout mechanisms, can ease the overhang problem. Asia's debt problem, unlike Latin America's in the 1980's, is a private matter. Excessive bank lending to businesses triggered the crisis. Mistakes were made on both sides. Both should work it out.

Pumping in Export-Import Bank loans would help in a big way. Asia is starved for export financing. Asian companies import most of their parts from the developed world and then re-export assembled products to the U.S. and elsewhere. The U.S., Japanese, and European ExImbanks should extend massive loans to help liquefy Corporate Asia.


Expanding government oversight is critical, too. The idea that free markets exist in a vacuum has been shattered. Without rules and regulations, they can create anarchy. Enforcing accountability and transparency is government's job. This is as true for the U.S. as for Asia. In Asia, far greater disclosure is needed of usable bank reserves, forward liabilities of corporations, and foreign-currency liabilities of commercial banks. In the U.S., data on derivatives and other off-balance-sheet financing must be made available for oversight.

U.S. hedge funds go entirely unregulated. At the very least, they must reveal their positions, indicating leverage, to regulators, as mutual funds already do. Congress made a huge mistake in allowing hedge funds to go unregulated, while passing legislation that allowed exponential growth in their size, financial leverage and power. The failure to supervise the savings and loan industry in the 1980s and the disaster that followed should have cued them to supervise hedge funds.

U.S. Treasury Dept. and IMF policy must change as well. Forcing Asian governments to raise interest rates and cut public spending, when the problem lay in short-term private corporate borrowing, proved immensely destructive. Austerity is not the solution. A debt workout between the banks and corporations is the answer. Imprudent banks and overambitious companies should take the haircut--not those pushed into poverty. Congressional conservatives are right in insisting that the IMF end its obsession with high interest rates, devaluation, and austerity. If it does, it again deserves U.S. funding.

Finally, temporary capital controls should be considered in preventing the excessive build-up of short-term foreign-currency liabilities. Switzerland had a negative interest rate on foreign-currency deposits for years. Chile has used controls on short-term capital effectively. Permanent capital controls can lead to corruption, the misallocation of capital, and the stunting of economic growth. But free-market economists, such as World Bank Chief Economist Joseph E. Stiglitz, believe they can be temporary salves for a deeply wounded global economy.

There is no time left for defensive justifications and retroactive rationalizations. The Asian crisis is at America's and Europe's shores. It has revealed deep flaws in the global capital markets--in risk assessment, leverage, and oversight. It's time to construct a better financial system.

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