The world has witnessed more financial crises in the past twenty years than at any comparable time in its history. More than two-thirds of countries in all parts of the world and at all stages of economic development have experienced a financial crisis. The costs of these crises, moreover, have been disportionately high and thus especially burdensome for developing countries. This disturbing development has led to calls for reform in financial systems around the globe to prevent such crises in the future.
The studies presented in this book are the product of a working group of diverse researchers and practitioners in finance and economics grappling with issues of increasingly more frequent and costly financial crises in the wake of the 1997-1998 rolling financial instability that started in Thailand and Indonesia, traversed to Russia and eventually Argentina, with many stops in-between. Punctuating the period in which this work was written and edited were the attacks on the World Trade Organization meetings in Seattle and other anti-global protests, and finally, the terrorist attacks on the World Trade Center in 2001. Though widely disparate events, this collection focuses our attention upon the all too often ignored dimension of how to finance the future. This is especially keen for a majority of countries struggling to overcome centuries of income, wealth and educational polarization and enter a period of growth. Capital access denied is all too often democracy and freedom deferred accompanied by political instability that hobbles global development.
Walter Russell Mead and Sherle Schwenninger provide a frequently underemphasized but nonetheless important approach to financial reform. They seek to focus the attention of any reform effort on the need to promote the development of a large and prosperous middle-class in emerging market economies. This approach to reform is consistent with the view of Aristotle, who long ago affirmed the virtues of the middle-class in an ideal society, remarking that "where the middle class is large, there are least likely to be factions and dissension." Many calls for reform, however, have failed to emphasize the value of the middle class in this regard. Indeed, as Mead and Schwenninger point out, despite numerous blueprints for reform, none recognize the importance of encouraging emerging economies to promote what every developed economy benefits from: a middle class that acts as a moderating influence on governments' bad policies and a supporting influence on governments' good policies.
It is the need to establish a source of legitimacy for reform in emerging market economies that underlines the importance of a middle-class oriented financial architecture. At present, capital flows into emerging markets remain volatile and relatively short term. In some countries, flows have turned negative in recent years. In most emerging markets, capital flows have yet to be restored to pre-Asian crisis (1997) levels. Small and medium businesses, moreover, are denied access to the vast pool of capital that the savings of developed countries represent. This situation persists because the much-needed changes to economic policy and to the governance of firms in these economies still lack sufficient popular support. The authors convincingly argue that for market-oriented reforms to succeed and produce lasting stability, they must hold out the prospect that all citizens will directly benefit from them. Reforms, for example, must be designed to allow ordinary people access to home ownership through the availability of affordable long-term financing or for private entrepreneurs to enter long protected, government directed business markets. Expanding economic participation in home and business ownership is key to the expansion of consumption and production in these economies. Not only will a program of middle-class oriented development create a constituency that will support reform, but it will be the best guarantor of global stability. Fortunately, much of the world, indeed most emerging market economies, is ready for middle-class oriented policies. Mead and Schwenninger provide evidence for this favorable climate by noting that 52 countries with a combined population of some 1.5 billion have already achieved levels of GDP comparable to those at which the U.S. and other countries first enacted middle-class oriented policies.
The key to the development of a large middle-class is the access of ordinary people to affordable, long term credit enabling them to realize the hopes and dreams in their business, professional, and home lives. This, in turn, requires low and stable interest rates and an overall stable macroeconomic environment. The main barriers to achieving these goals are the lack of stable, hard currencies and credible central banks, the existence of illiquid and poorly or inappropriately regulated capital markets, and the lack of well-functioning and adequately capitalized regional and international financial institutions. The importance of many of these factors for successful reform is not unappreciated by others also calling for meaningful change in financial systems.
What tends to be neglected in the debate on financial reform, however, is the authors' emphasis on the need for regional institutions. Much of the work on a new financial architecture has stressed the importance of national or international initiatives. The roles of the Bretton-Woods institutions and of private- and public-sector entities at the national level have been considered in depth. Yet, perhaps for historical or political reasons, much less attention has been paid to the potential value of regional institutions. Mead and Schwenninger use the appealing homily of Goldilocks and the Three Bears to emphasize the importance of regional financial institutions. The international level is too distant and too unaccountable, while the national level is too open to political manipulation and short-term public opinion. The regional level, however, is just right. Regional institutions and markets would be neither too distant and lacking in legitimacy nor too open to short-term pressures and lacking in credibility.
The two regional institutions central to the blueprint for a middle-class oriented financial architecture are regional central banks and regional currencies. Recognizing that the currencies of developing countries often lack the credibility of their more developed country counterparts, the authors urge the creation of currency regions either through what has come to be known as currency substitution (or more popularly, dollarization) or the creation of new currencies (or indeed the creation of new "synthetic" currencies pegged to a trade-weighted basket of hard currencies in a manner not unlike the ECU). The adoption of such hard currencies will go far to lower the interest rates entrepreneurs and other borrowers in developing countries must pay as well as lengthen the average time horizon of investments made in such countries.
Properly capitalized regional central banks similar in structure and function to the European Central Bank (ECB) would be established to conduct monetary policy on behalf of the region as a whole. Additionally, such regional central banks would be granted stewardship of member countries' foreign reserves and engage in the prudential regulation of the regions' capital markets. Unlike national central banks - where the national government is generally the sole shareholder - these regional central banks would be responsible to a diverse pool of shareholders including the Bretton-Woods organizations, member and non-member central banks, member and non-member country based banks, and other institutional and individual investors.
Accession to membership of these regional central banks would follow a similar, but less onerous, path than that for accession to the Euro. Budget deficits would be reduced (although not as ambitiously as in the Stability and Growth Pact of the EU), reforms would be made to legal systems and the central banks would oversee the comprehensive restructuring of member states' regulatory systems along a single, common line. Once in place, the regional central banks would be responsible for building middle-class oriented financial systems.
In summary, the authors provide a novel approach to financial reform so urgently needed to eliminate the wide gap that separates the have-nots from the haves among the roughly 200 countries in the world. The promise they offer with their proposal of middle-class oriented policies is "enhanced social stability and reduced conflict even as economies shift to more market-based rather than influence-based methods of credit allocation." This presents a compelling, achievable and urgent goal that should be pursued at this time.
James Barth Glenn Yago Series Editors