Something is wrong with the global financial system. One might think the system would shift money from rich countries, where capital is in abundance, to those where it is scarce, while transferring risk from poor countries to rich ones, which are most able to bear it. A well-functioning global financial system would provide money to countries in their times of need, thereby contributing to global economic stability. Through an orderly bankruptcy procedure, a well-functioning global financial system would grant a fresh start to those who cannot meet their debt obligations, giving creditors an incentive to pursue good lending practices, while ensuring that borrowers able to repay loans do so.

The current global financial system does none of these things. As a result, international financial crises or near-crises have become regular events. The question is not whether there will be another crisis, but where it will be. Mexico, Korea, Indonesia, Thailand, Russia, Brazil, Argentina, and Turkey have each endured a major crisis or near-crisis, bringing the global average for the past eight years to about one crisis per year. This list does not even include the smaller countries, such as Ecuador and Uruguay, whose crises devastated their countries but made less of a dent on Wall Street. But this is only the tip of the iceberg. It is becoming rarer for a country not to have a crisis than to have one, and by some reckonings, there have been 100 crises in the past 35 years. This much seems clear: the International Monetary Fund (IMF), whose responsibility it is to ensure the stability of the global financial system, has failed miserably in its mission to stabilize international financial flows, arguably making matters worse.

Meanwhile, instead of channeling funds from rich countries to poor ones, the global financial system has allowed the United States to become the largest borrower in the world, absorbing about US$40 billion per month to finance a consumption binge amidst declining investment and savings and a decades-old trade deficit that is close to five percent of gross domestic product (GDP).

Observers in the early 1990s, however, lauded the huge flows of private capital—at one point exceeding US$300 billion—from developed to developing countries, heralding a new era in which the private sector would supplant the need for public assistance. But this was a hollow boast. Even then, it was clear that most of the money went to a few countries, most notably China, and virtually none to the countries that needed it most, such as those in sub-Saharan Africa. Nor was the money spent in desperately needed sectors like healthcare, education, and the environment. Developing countries could attract firms to extract their natural wealth—provided they gave it away cheaply enough. There was far less success in attracting investments that would create new jobs. Worse still, much of the money was speculative—hot money—coming in while the going was good, but fleeing the moment matters looked less rosy. The countries did grow a little faster while the money was flowing in, but the damage that ensued when it flowed out more than offset the initial gains.

Economists studying capital flows have long recognized that, especially in developing countries, they are pro-cyclical, coming in good times and leaving in bad thus making the booms more intense and the busts worse. Capital flows are among the primary causes of economic fluctuations and have less to do with what is going on in a particular country than with what is happening elsewhere. Bankers and speculators have given new meaning to the old adage that bankers lend to people who do not need money and refuse to lend in times of need.

These bankers should not be vilified; their vocation, after all, is business, not charity. Instead, the blame lies with the IMF and US Treasury for assuring developing countries that opening their markets to these short term speculative flows would lead to greater stability. There is overwhelming evidence that such capital market liberalization exposes developing countries to high levels of risk beyond their economic capacity without enhancing their economic growth. During the administration of US President Bill Clinton, the US Council of Economic Advisers repeatedly argued this point with the US Treasury, but without success.

But even when foreign banks did not yank money out of developing countries during times of need, they forced the developing countries to bear the brunt of interest and exchange rate fluctuations. The volatility in interest and exchange rates has time after time precipitated crises and debt levels beyond the country’s capacity. Countries struggling to meet their obligations cut their already low levels of education and healthcare spending, but often to no avail. Eventually, they are forced into default. This occurred in Latin America during the early 1980s, when the US Federal Reserve Board’s unprecedented high interest rate levels suddenly rendered their debt unsustainable. Latin America’s problems were not caused by a change in their own policy, but by a change in US policy, yet Latin American states were left to bear the costs. Since there is no adequate international bankruptcy procedure, those countries struggled on, losing a decade of growth and gaining poverty and unemployment.

Another telling example is Moldova, a desperately poor country that has seen its income decline 70 percent during its transition from communism to capitalism—a transition that was supposed to bring unprecedented prosperity. In 2002, almost 75 percent of Moldova’s dwindling government budget went to service the foreign debt, which had grown to unmanageable levels because Moldova had to match Russia’s currency devaluation. Forced to bear the risk of these exchange rate changes, Moldova saw its moderately high debt, denominated in hard currencies, soar to astronomical levels.

Global Market Failures

Underlying these systemic market failures are numerous problems, and it was the responsibility of the international economic institutions to address these issues. Unfortunately, the IMF was so busy preaching the wonders of the market and espousing its version of market fundamentalism—in which markets are intended to solve almost all problems—that it had little time to address the market failures that provided the rationale for its creation.