The future of global financial markets

It is tempting to conclude that global capital markets have reached the point of no return. Capital flows across borders have risen to new heights. This is true first and foremost of foreign direct investment, which has been stimulated by enterprise privatization, the development of global production networks, and the ready availability of finance for mergers and acquisitions. It is hard to imagine a return to significantly lower levels of FDI, since many of the facilitating conditions—the advent of the Internet, for example, which facilitates cheap communication with foreign branch plants, and instantaneous data transfer between cash registers at retail outlets and foreign production facilities—are permanent. The same is true of foreign portfolio investment. All of the advanced countries and a number of developing countries have relaxed or removed their most significant capital controls, and in neither world do policy-makers show any interest in going back. At the same time, policy-makers display more awareness of the dangers of excessive reliance on portfolio capital. Prudential supervision and regulation, corporate governance, and macroeconomic policies have been strengthened to accommodate these changes in the financial environment. Countries have accumulated reserves as protection against capital account reversals. They are more successfully resisting the temptation to expand public spending and acquiesce in a significant increase in private spending in periods when a large volume of foreign finance is flowing in. It is hard to imagine that what has been learned, often at considerable cost, will now be forgotten.

            All this makes it important to recall that this is not the first time that financial markets are significantly globalized; this was also true before World War I. What many contemporaries regarded as a permanent condition was, in the end, only a passing phase. Global financial markets shut down in the 1930s and then took two generations to recover. This resulted from an unfortunate confluence of factors: perverse macroeconomic policies, nationalistic trade policies, poorly regulated financial markets, and the absence of a framework for international cooperation, all against the backdrop of escalating diplomatic and political conflicts.42 Optimists will say that there have been significant improvements in the conceptualization and implementation of macroeconomic policies in the interim. The multilateral trading system is more deeply entrenched; it is institutionalized courtesy of the World Trade Organization. Financial markets and institutions are better regulated. We possess a stronger multilateral framework, starting with the IMF, to facilitate cooperation on the regulation of financial markets and the conduct of macroeconomic policies.

            Pessimists will respond that a nationalist backlash is still possible. The United States, seeing its bilateral trade deficit with China explode, continues to threaten unilateral action. In Latin America, where the benefits of globalization have been slow to trickle down to the poor, populism is alive and well. The privatization of public enterprise that has supported foreign direct investment has uncertain prospects in the wake of Bolivia’s re-nationalization of its energy sector in 2006. The disorderly correction of global imbalances, if it involves sharp shifts in exchange rates and significant increases in interest rates, could again place global financial stability at risk.

            Kurt Vonnegut might have had this set of issues in mind when he wrote that “History is merely a list of surprises. It only prepares us to be surprised yet again.” It will be interesting to revisit this chapter in, say, fifteen years in order to see what the surprises turned out to be.