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«THE (IN)SECURITY OF INTERNATIONAL FINANCE Valpy FitzGerald [Originally delivered as the first of the Wolfson College Lectures 1999 series on the ...»

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In addition, the difficulty of coordinating three asynchronous economic cycles is often given as a reason why nothing further can be done; despite the successful experience of the Bretton Woods system in the 1950s and 1960s.

This stalemate can be characterized in two ways. On the one hand, it can be regarded as a classic problem of collective action, where there is a need for pooled sovereignty in order to increase the welfare of all three participants - and by extension the rest of the world.31 Failure to agree essentially reflects misguided nationalism and a ‘lack of leadership’ in this explanation. On the other hand the stalemate can be seen as a classic problem in international relations, with the declining hegemon - that is, the US driven by strategic objectives and bank lobbyists - unwilling to cede global economic dominance to rising regional powers.32 Meanwhile, international financial crises will probably become more frequent.


The Rationality of Markets Global policymakers share the orthodox doctrine that the liberalization of trade and investment will increase efficiency, raise human productivity and eventually eliminate world poverty.33 In political terms this has been reinforced by the widespread belief that governments are inherently self-seeking and inefficient, or at best hostages to populist pressures from their electorates. In contrast, markets provide a superior and in some sense more equitable rationality upon which social organization can be based. This view of the market as an objective standard is not fully shared by business people even though they naturally prefer as few regulatory restrictions as possible,34 but it is a doctrine which appears to be received wisdom for most senior politicians and civil servants.

This has a number of corollaries. One is the tendency to entrust economic management to ‘independent’ and ‘technical’ bodies such as autonomous central banks,35 independent of the control of the legislature or elected government. The fact that such institutions inevitably derive their autonomy as much from their coalition with leading banks (or in the case of emerging markets, multilateral agencies) as from their constitutional mandates is often overlooked. Another such corollary is the frequent argument that ‘there is no alternative’ (TINA) to conservative economic policies such as welfare restrictions and employment flexibility at the national level because acceptable standards of conduct are set by international capital markets. Any other policy will be ‘punished’ by capital flight.36 In consequence, to admit that international capital markets are inherently unstable - as I have been arguing explicitly and the proposals for a new financial architecture do implicitly - is to undermine a central political doctrine which is not confined to the realm of ideas moreover. The shift away from occupational and state pension funds on the one hand, and away from bank deposits and fixed-rate mortgages on the other, towards greater involvement of ordinary households (and voters) in financial markets also has profound political implications. The exposure of voters’ sense of well-being to financial asset values (the ‘wealth effect’) has obvious benefits when stock markets are booming and interest rates are low; but any reversal (despite the small print) has equivalent political costs.

In the specific context of the security of internal finance, the neo-liberal trend has been reflected in the gradual move of regulatory practice away from the traditional prescriptive approach based on rules and prohibitions towards designing incentives for private financial institutions to behave in socially optimal ways. After determined lobbying from international banks, ‘risk modelling’ has been permitted by regulators in order to determine the capital reserve requirements of banks. As a result of the 1996 modification to the Basle Capital Accord, leading securities authorities announced in May 1998 that IOSCO members could permit the use of statistical models for regulatory purposes.

However, these models have performed so poorly in the recent financial turmoil that it has become clear that the assumptions upon which these models were based were incompatible with extreme market stress.

This has revealed a fundamental problem in the dominant view of market rationality. While it is clear that asset markets are volatile by their nature, banks argued that the volatility involved could be estimated from past performance and certain ‘fundamentals’. The measurable risk involved could be priced (in much the same ways as insurance premiums are calculated from actuarial tables) and compared to the yield on a safe asset (such as US Treasury Bills) in a portfolio constructed so as to offset the risk in one asset against another. However, this was to confuse risk with uncertainty and it is now clear that future outcomes were not effectively priced into asset values - which reflect subjective enthusiasms (and fears) rather than rational expectations of a predictable outcomes.

The problem has been worsened by a lack of clarity as to what ‘fundamentals’ actually are. Once gross fiscal imbalances have been overcome and market deregulation is under way; the main indicators can become confusing signals for investors. Thus large current account deficits are seen by some as a sign of success in attracting foreign investment and by other as a sign of an overvalued currency; while growing corporate foreign debt is seen by some to reflect efficient financial diversification, and by others as dangerous exchange rate exposure by unhedged corporate treasurers.

This means that the notion that markets would be more stable if more information were available is probably misguided. If the way in which probabilities should be constructed from available data is in doubt, then more data will not necessarily help and may even confuse. Unlike risk, uncertainty cannot be insured against and arguably is the main reason why institutions exist in the first place.

Thus, despite the neo-liberal paradigm still being firmly entrenched, it is not surprising that there is a discernable change of mood back towards a desire for stronger international market rules, even in some business circles.37 Global Property Rules Although over the past decade all countries have embarked on an unprecedented liberalization of their financial regimes, international investment agreements - such as bilateral investment treaties, double taxation treaties, regional trade agreements and certain WTO provisions have all multiplied.

These trends reflect a move away from national rights to control foreign investment and norms for corporate conduct; and play key role in building investor confidence by locking in policy commitments over time.38 They are usually based on general standards of treatment; coupled with norms on specific matters such as expropriation, compensation and the transfer of funds, as well as mechanisms for the international settlement of disputes.

In consequence, the twenty-nine OECD members launched negotiations in 1995 on the world’s first multilateral agreement establishing comprehensive and binding rules for investment providing market access, legal security and a ‘level playing field’ for international investment flows.39 Negotiation was between OECD members only although the Multilateral Agreement on Investment was intended to be eventually open to accession by non-member countries who could reach the required regulatory standards.

This non-inclusive negotiating format had a precedent in the early GATT rounds, but it was clearly a fundamental weakness insofar as emerging market interests could not be directly reflected.

Moreover, a number of non-governmental organizations became concerned by the apparent exclusion of strict safeguards on labour standards and environmental protection from the MAI.

None the less, the eventual breakdown of the Paris negotiations in 1998 arose from the nature of the exceptions claimed by OECD members (particularly the USA and France) rather than the development issue as such.

It now appears that negotiations on a ‘Multilateral Framework for Investment’ will be transferred to Geneva this year, not least because of the many investment-related trade issues already built into the WTO framework. France, Canada and the United Kingdom all support this approach, and the European Commission has included investment in its proposed list of agenda items for the comprehensive ‘Millennium Round’ of multilateral trade talks which it wants to see launched in 1999.

Effective multilateral taxation of corporate profits and asset incomes has also become a topic of increasing concern to industrial countries. There are current moves towards tax harmonization and establish withholding taxes in the EU order to reduce the tax loss on the profits generated there. In order to strengthen this process of fiscal capture, it will become necessary to eliminate tax havens or at the very least deny the benefits of international investor protection to firms registered there.

Such an agreement would not only improve the fiscal revenues participating countries40 but would also strengthen the effort to combat money laundering and financial fraud - again, stabilizing financial flows.

If such a multilateral tax treaty were to include developing countries it would confer a number of advantages. First, it would prevent wasteful tax competition between developing countries in order to attract foreign investors. Second, as all tax paid in developing countries is deductable against tax liability in (developed) home countries, increased effectiveness in tax collection by developing countries would be a net transfer between the treasuries of home and host country - far more effective than the present system of development assistance. Third, this would provide a stable source of long-term funding for the public investment in education, health and infrastructure that developing countries require. Fourth, it would permit effective taxation of their own nationals with considerable overseas assets; and reverse the trend towards national tax systems being forced to taxation their main immobile factor of production - labour.

Such an approach would be superior to proposals for a so-called ‘Tobin’ tax on short-term financial transactions.41 Such a turnover tax would have little effect on speculative flows, because at any feasible rate it would imply a penalty of marginal importance compared to the prospective losses from maintaining asset holdings in a currency under attack. In addition the Tobin tax would be impossible to collect in view of the complexity, speed and substitutability of cross border currency transactions - leaving aside the problem of offshore transactions.

In contrast, multilateral corporate taxation can be based on the statutory requirement to present accounts in some jurisdiction, and only requires the effective coordination of the vast web of existing bilateral tax treaties. It would also deliver resources to developing country governments rather than to an international body and not require - in principle - a new international bureaucracy to administer it.

Global Citizenship?

The difficulty in establishing international rules as the basis for global financial security underlines the fact that no system of international commercial law exists. There does exist a system of international public law which regulates - albeit under some strain at times - the relations between states.42 However there is no equivalent in the fields of trade and investment, beyond the treaty obligations of governments under - say - the World Trade Organization.

In consequence, international commercial cases are arbitrated either in the national jurisdiction of the contracting parties’ choice43 or at private tribunals. Indeed the only persons traditionally recognized under international law are pirates, and more recently perpetrators of genocide. The right of foreign investors to make claims against states on their own behalf has, however, been established recently for the first time in a major plurilateral treaty in the North American Free Trade Agreement (NAFTA); a precedent which generated considerable disquiet when it was included in the draft of the MAI.44 The recognition of firms (‘juridical persons’) in international law as the basis for international property rights, would have considerable implications for global citizenship - although what these implications might be is far from clear. Many critics of globalization would argue that the consequences of such a development would be to further strengthen the hand of multinational corporations free to move around the world and hold governments to ransom, as against local labour forces confined to their national territory and forced to reduce wages and work conditions in order to find employment.45 This would seem to me to be an argument for stricter international regulation of investment, rather than attempts at national withdrawal from the global economy. Equitable negotiations of international investment and taxation rules, along the lines discussed above, would seem to be a first step towards this. What is more, the recognition of firms under international law would make the recognition of persons almost inevitable - thus strengthening the subsequent development of international human rights. A historical precedent is the way in which property rights formed the basis for civil law in England, and subsequently for civil and thus human rights.

It is true that the growing mobility of capital contrasts markedly with the increasing immobility of labour46. However, this would reflect a serious challenge to the notion of citizenship even if an equitable financial architecture were in place and multinational corporations all behaved in an irreproachable manner. As modern economic theory has shown, it is not just financial capital, management skills, modern technology and skilled labour - all of which are internationally mobile in principle - which determine productivity growth and living standards at the national level. Rather it is the ‘social overhead capital’ of infrastructure, institutions and even culture which account for the larger part of international income differences.

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