Nov 24, 2009

US should regulate cross-border cash

By Henry CK Liu

In this season of debate on regulatory reform, an obvious area that has been crying out for reform seems to have been overlooked by government officials and market participants.

Much of past and current global financial crises lies in the unrestricted cross-border flow of speculative funds and the ability of market participants to deploy cross-border speculative financial and regulatory arbitrage for risky profit at the expense of central banks and local market fundamentals.

The reason low dollar interest rates do not help the United States economy is because hot money will respond by flowing into China and other high interest rate economies to profit from carry trade and exchange rate arbitrage, leaving the US with a persistent credit crunch.

The only way a low Fed funds rate will help the US economy is if the US regulates the cross-border flow of speculative funds, thus forcing the bailout and stimulus money to stay within US borders to create jobs locally. It is a simple measure that could be easily implemented by administrative order.

After the 1997 Asian financial crisis, Malaysia imposed currency controls and at first was widely criticized; later it was widely acknowledged as the correct and effective measure to adopt. Germany after 1933 also imposed currency controls and its economy recovered faster than any other.

There is no way to effectively regulate over-the-counter financial derivative trading against global systemic risk without first stopping cross-border financial arbitrage. Anyone who has studied and understood the problem would know that the path of reinforcing capital reserve adequacy is a dead-end against astronomical notional values.

Ever since the end of the Cold War, which actually began winding down with president Richard Nixon's policy of detente, international trade has overwhelmed domestic development in the global economy, as superpower competition to win the hearts and minds of the world, in the form of aid, subsidies and development, was channeled solely through global trade.

Persistent US fiscal and trade deficits forced the abandonment in 1971 of the Bretton Woods regime of fixed exchange rates linked to a gold-backed dollar. The flawed international finance architecture that resulted has since limited the global growth engine to operating with only the one cylinder of international trade, leaving all the other cylinders of domestic development in a state of permanent stagnation.

Drawing lessons from the 1930s Great Depression, economic thinking prevalent immediately after World War II had deemed international capital flow undesirable and unnecessary for national development. Trade, a relatively small aspect of most national economies, was to be mediated through fixed exchange rates pegged to a gold-backed dollar.

These fixed exchange rates were to be adjusted only gradually and periodically to reflect the relative strength of the economies participating in international trade, which was expected to augment but not overwhelm the development of national economies. The impact of exchange rates was limited to the financing of international trade.

Exchange rate considerations were not expected to dictate domestic monetary and fiscal policies, the chief function of which was to support domestic development and were regarded as the inviolable province of national sovereignty.

Global financial crises will continue to occur until cross-border flows of speculative funds are regulated.

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.