SCAN GLOBALLY, REINVENT LOCALLY: INNOVATING FINANCIAL MARKETS Joseph E. Stiglitz Columbia University New York Global Leadership Forum Kuala Lumpur September 6, 2005

INNOVATION AND FINANCE: KEYS TO SUCCESS IN A DYNAMIC MARKET ECONOMY  Need to scan globally –To look for best practices –To look for failures –To see the circumstances in which different policies, institutions have worked well or failed –To assess what has best prospects of working  Reinvent locally –After determining the strengths and problems, challenges and opportunities of the local economy –“One size fits all” policies have failed

ROLE OF FINANCE AND FINANCIAL MARKETS  Allocates scarce capital - Brain of economy - Without access to capital, new enterprises cannot be created and old enterprises cannot grow  Monitors that it is used well  Redistributes risk - All investment is risky, and - Firms, individuals risk averse - Risk discourages investment - Innovative mechanisms for risk sharing can help promote investment, development and growth by lowering risk premium

FINANCIAL DYSFUNCTION AND RISKS OF LIBERALIZATION  Poorly designed, managed financial systems can impede growth –Macro instability –Lack of access to capital –Access only at high cost  While liberalization and innovation are intended to improve the functioning of capital markets –Overall risk is increased –Capital is less well allocated –Certain groups no longer have access to capital –Cost of capital actually increases

EXAMPLE: RISKS OF FINANCIAL INNOVATION  Some of innovations in financial markets, including those for divesting risk also increase opportunity for risk taking –Derivatives  Have been abused, especially in under-regulated markets –To avoid taxes –Led to conflicts of interest Evident in the U.S. during the “Roaring 90s”  Leading to –Misallocated and over investment –More macro instability, huge underperformance of economy –Lower growth

IMPLICATIONS  Signifies the importance of good financial market regulations  Cannot separate out “micro-” and “macro-” regulations –Prudential regulations have important macroeconomic effects

EXAMPLE: CAPITAL MARKET LIBERALIZATION  Was supposed to increase growth and stability -Actually led to more instability -And not to increased growth - Consistent with economic theory based on imperfect (asymmetric) information - Even IMF now recognizes this - IMF models assumed perfect information Failed to understand modern advances in economic theory Their models were internally incoherent— they talked about problems of lack of transparency and bankruptcy, but their models did not incorporate these phenomena

EXAMPLE: PROBLEMS WITH ACCESS TO FINANCE  Long history of concern that unrestricted markets may lead some groups in the society to be underserved –Predicted consequence of the theories of financial markets based on asymmetric information –Explains the historical U.S. policy of limiting inter-state banking –Lending (CRA) and branch requirements in the U.S, India have proven to be effective

SOUTH EAST ASIA IN THE GLOBAL CONTEXT  Peculiarities of global financial market –Risk of exchange rate and interest rate fluctuations born by developing countries Though “theory” predicts it should be borne by those more able to bear risk –The richest country in the world borrowing huge amounts from poorer countries Though “theory” predicts flows of capital should move in the opposite direction –Asia, especially South East Asia, is the major source of global savings And yet the dollar continues to be viewed as the reserve currency And much of Asian savings is “mediated” by Western capital markets

PUZZLES AND PARADOXES: THE GLOBAL ECONOMY  Risk premia very low –Yet high levels of risk, uncertainty—exchange rate volatility, oil prices, global imbalances  Low ‘risk premia’ sometimes attributed to global savings “glut” –Yet huge U.S. deficits, which look like they will be getting larger  Soaring oil prices –Yet investments in alternative energies, conservation have not increased much

PUZZLES AND PARADOXES: THE U.S. ECONOMY  Short term interest rates have continually increased in the last two years –Yet long term interest rates have fallen  Interest rate decreases have failed to stimulate business investment –Though it did lead to real estate boom (bubble)  U.S. Consumption level remains strong –Yet real wages stagnate  Huge turnaround in the U.S. fiscal position - from 2% surplus to 4% deficit –Less stimulation to U.S. economy than one would have expected

CHANGES ARE IN THE WIND: END OF DOLLAR AS A RESERVE CURRENCY  Dollar losing the status of reserve currency  Already evident in changes in private holdings and some Central Bank portfolios  Exchange rate instability means that dollar is no longer good store of value – what matters to countries is a ‘reserve of wealth’ Instability likely to continue As U.S. fiscal and trade deficits continue to increase U.S. fiscal deficits may further increase with –Permanent tax cuts –Social security reforms (probably dead) –Other tax reforms –Costs of war in Iraq –Borrowing not being used to finance investment  What countries need to do is to manage their wealth Which entails risk diversification

INNOVATIVE RESPONSES  Reforms in the global reserve system –Problems are inherent in current system –But reforms will be difficult given the resistance from U.S., even though it would be in best interests of U.S. –Current system not only leads to instability –But there is a huge opportunity cost in holding dollar reserves  Exchange rate and interest rate volatility is likely to remain large –Need to recognize huge costs associated with freely flexible exchange rates Though as Argentine experience showed, there can be huge costs associated with excessively rigid exchange rates as well  Need to have regulatory frameworks that recognize this, mitigate consequences Need to find innovative ways of transferring, absorbing risk better within Asia, managing Asian financial markets Asian Monetary Fund Chang Mai Initiative

MANAGINGS THE RISKS OF HIGH ENERGY PRICES  Why have high energy prices so far failed to elicit supply response? –Long lags –Uncertainty about whether prices will remain high: low costs of production in Saudi Arabia  What is needed is more conservation –But, unfortunately, largest energy consumer (US) just passed energy bill which did little for conservation –‘Drain America First’ policy leaves the U.S. more vulnerable to supply disruptions  And free market economics has left Europe more vulnerable to gas interruptions from Russia  While financial markets themselves provide only limited “insurance” against these risks

MANAGING THE RISKS OF HIGH ENERGY PRICES  The ‘best’ way of managing risk is to own energy-based assets –Global market place makes this possible –Even countries with high energy dependence can thus mitigate risk –But this means a different approach to managing nation’s “reserves”, national asset management –Has consequences both for distribution of income within and among countries and for macro-stability

MANAGING ONE’S OWN WEALTH Lessons of the “Class of ’97”  Control does matter –Decisions about moving money into and out of country can have huge consequences for entire country, not just capital markets  Asia, especially South East Asia, pays huge costs for “cycling” money through the U.S. –Differences between rate paid by US (e.g. Treasury Bill) and rate paid to US (lending rate) –Huge costs of reserves –Lack of control

MANAGING ONE’S OWN WEALTH  Strengthening Asian financial markets would thus increase income, growth and stability  May require development of new financial instruments –Paying in a new unit of account –Based on a weighted average of currencies –Backed by governments –Perhaps through creation of new Asian Monetary Fund

SOUTH EAST ASIA: BETWEEN TWO GIANTS  Fast changing global economy –With correspondingly fast changes in comparative advantages Dynamic and static comparative advantage  Even with globalization, borders do matter –One of the reasons why investors are attracted to China  But lying between two giants – China and India - gives South East Asia some distinct advantages –“Cross Roads” –And entrepreneurial intermediary –Knowledge of both economies –Access to both economies –Dual role, both competitor and complement

SOUTHEAST ASIA: BETWEEN TWO GIANTS  This will require countries of South East Asia to reassess their dynamic comparative advantages –Niche markets –High innovation –Enhancing intermediary roles  Innovative financial markets will play a key role in redeployment of resources  And will enable South East Asian countries to sustain the remarkable growth rates of the last three decades