Foreign Policy: Capitalism’s Last Chance?

Foreign Policy
Winter 1998–99

Capitalism’s Last Chance?

By George Soros _*

This abstract is adapted from an article appearing in the Winter 1998–99 issue of FOREIGN POLICY. Neither macroeconomic errors nor Asian governments’ policy missteps can explain today’s global financial crisis; rather, the operation of free financial markets is the culprit. Now is the time for a radical reconsideration of the dominant role that deregulated financial markets play in the world. In the absence of urgent reforms, this rethink could produce a powerful backlash against the global capitalists system, particularly in the developing countries.

The global capitalist system is characterized not just by global free trade but more specifically by the free movement of capital. The system can be envisaged as a gigantic circulatory system, sucking capital into the financial markets and institutions at the center and then pumping it out to the periphery, either directly in the form of credits and portfolio investments or indirectly through multinational corporations.

Until the 1997 Thai crisis, financial markets were growing in size and importance, and countries at the periphery were obtaining an ample supply of capital from the center by opening up their capital markets. During this global boom, the emerging markets fared especially well. The Asian crisis reversed the direction of the flow. Capital started fleeing the periphery. At first, the reversal benefited the financial markets at the center. But in the aftermath of the Russian default in August 1998, the global financial markets themselves came dangerously close to a meltdown.

With the growing realization that the underlying cause of this threat is the inherent instability of deregulated financial markets, the ideology of world capitalism faces a historic challenge. The financial markets are playing a role very different from the one assigned to them by economic theory and the prevailing ideology of market fundamentalism, which says that competitive markets are always right—or at least they produce results that cannot be improved on through the intervention of nonmarket institutions and politicians. If left to their own devices, financial markets are supposed to act in the long run like a pendulum, always swinging back toward equilibrium.

The current crisis has shown this ideology to be irredeemably flawed and the very notion of equilibrium to be inapplicable to financial markets. Equilibrium applies to known quantities. But financial markets do not deal with known quantities. They try to discount a future which is contingent on how it is discounted today. Instead of acting like a pendulum, financial markets can act like a wrecking ball, swinging from country to country and destroying everything that stands in their way.

The trouble is that current international mechanisms for crisis management are grossly inadequate. Most policymakers in Europe and the United States today worry whether their countries can be protected from the global financial contagion. But the issue at the global level is much broader and historically more important. Even if the Western economies and banking systems do survive the present crisis without too much harm, those in the periphery have been significantly damaged. Widely proposed solutions such as transparency, regulation, and other mechanisms that simply improve the efficiency of free markets do not get at the heart of the problem. The flow of capital—and most importantly of private capital—from the center to the periphery must be revived and stabilized.

I propose establishing an International Credit Insurance Corporation, managed by the IMF, to explicitly guarantee, up to defined limits, the loans that private lenders make to countries. If a country defaults, the IMF would pay the international creditors and then work out a repayment process with the debtor country. The borrowing countries would be obliged to provide data on all borrowings, public or private, insured or not. This information would enable the authority to set a ceiling on the amounts it was willing to insure. Up to those amounts, the countries concerned would be able to access international capital markets at prime rates plus a modest fee. Beyond these limits, the creditors would be at risk. The new institution would function, in effect, as a kind of international central bank.

The thorniest problem raised by this proposal is how the credit guarantees allocated to an individual country would be distributed among that country’s borrowers. The guarantees should be channeled through closely supervised international banks that would compete with each other. Credit insurance could also correct the moral hazard in IMF operations; instead of bailing out foreign lenders, the fund would guarantee investors up to insured levels and then allow uninsured debt to be converted into long-term bonds and written off.

Constructive reform will require a change of mentality to get governments, parliaments, and market participants to recognize that they have a stake in the survival of the system—and that this stake is far more valuable than any short-term gains they may make from exploiting the flaws in the existing deregulated system.

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