Brazil became a target last summer because investors feared Argentine contagion and the left-wing candidacy of Luiz Inacio (Lula) da Silva, who was elected president on Oct. 27. As of this writing, the jury is still out on how the markets will respond to Lula’s stewardship. Other less-developed countries that have been faithfully following International Monetary Fund prescriptions are also in trouble because of depressed commodity prices, lack of access to developed markets and weak domestic demand. Overall, there has been a reverse flow of capital from the periphery to the center ever since 1997.
The authorities claim these are temporary aberrations that will be corrected by the market. I contend they are symptoms of a deep structural problem. Until recently, the IMF was ready to bail out periphery countries. Taxpayers in debtor countries, such as Mexico, picked up the tab. This may have been unfair, but it kept money flowing to the periphery.
Then came the crisis of 1997-98, which was attributed to the “moral hazard” of IMF bailouts. Before 1997, the IMF would step in to assure private creditors they would be paid in full, perhaps encouraging them to lend too freely. This led to a U-turn from bailouts to “bail-ins.” Since 1997, the IMF has tried to condition its financing on private creditors’ also stepping up to risk real losses, and it has been willing to let countries like Russia and Argentina default on private loans. The moral hazard has thus been eliminated, but the risks of investing in emerging markets have increased.
At the same time, the rewards in emerging markets have declined because of restrictive policies imposed by the IMF. Countries that can borrow from the markets in their own currencies can engage in countercyclical monetary and fiscal policies; countries that are dependent on the IMF cannot. The deterioration in the risk-reward ratio for emerging-market countries explains the reverse flow of capital from the periphery to the center.
During the bull market, the United States’ current-account deficit allowed it to act as the master, and serve as the motor, of the global economy. After 1997, the tech bubble made up for the devastation of the emerging-market crisis. Now that the bubble has burst, the motor is stalling. Japan and Europe are in worse shape than the United States. The American consumer is still holding on, but business investment shows little sign of improvement. With risk premiums widening, cash flows are better used for paying down debt than for making new investments. The global economy is hovering on the brink of deflation and depression. The financial sector is under great strain, and a Brazilian default could push it over the brink.
There is an urgent need for a new motor. I’ve proposed an annual issue of Special Drawing Rights (SDRs), an interest-bearing asset that would be issued by the IMF. Under my proposal, rich countries would donate their allocations of SDRs to finance international assistance to fund development projects in poorer nations. This is an idea whose time has come.
It would activate resources that are currently idle; it would counteract the widening gap between center and periphery, and it would give the world a fighting chance to reach the United Nations’ goals of eradicating extreme poverty, providing universal primary education and greatly improving health care by 2015. I realize that the international financial authorities will not even consider my plan, because they do not accept the premise that the system is broken and in need of repair. Does that mean that it is unrealistic? No, it means that the authorities are asleep at the switch.
