In the wake of financial crises in Mexico (1994-95), Asia (1997-98), Russia (1998) and Brazil (1998-99), respected observers have questioned the benefits of wide-open international capital markets (Bhagwati, 1998; Krugman, 1998; Rodrik, 1998; Eichengreen, 1999). Our purpose is to identify true hazards and suggest appropriate precautions.
THE BENEFITS OF FINANCIAL INNOVATION
International financial magnitudes have expanded far more rapidly over the past twenty years than international merchandise trade (see the comparisons in Table 1). Moreover, financial crises have been frequent (by historical standards) during these two decades.
On the other hand, financial innovation ranks among the foundations of strong economic performance, alongside high savings, disciplined budgets, low inflation, good education, and information technology.
Countries differ enormously in their degree of financial maturity. At one extreme, in countries at a low stage of financial development, banks dominate the financial system and each bank lends most of its funds to related business firms. The stock and bond markets are small, futures and options markets do not exist, private mutual funds and pension funds are tiny, securitized mortgages and equipment leasing are unknown, and concept of a market for corporate control (through hostile mergers and acquisitions) seems alien. In these settings, it is no surprise that scarce capital is poorly allocated, while banks pay low or negative real rates of interest to households. At the other extreme, in countries with mature financial systems, the “missing” financial markets are well established. Capital is allocated more efficiently between competing uses and households earn better returns on their savings.
