Building Coherence: Development, Financial Systems, and Institutions

Article excerpt

In the 1980s and 1990s, a number of developing countries pursued extensive economic reforms that in many cases succeeded in achieving economic stability, but rarely resulted in high and sustained economic growth. Only since the turn of the millennium have most developing countries, including some of the poorest ones, enjoyed relatively high rates of economic growth associated with rising export earnings. In some countries this growth was due to improved supply capacity, but in most cases it resulted from a favorable external environment. Global demand has risen rapidly since the beginning of the century, driven in part by the large trade deficit of the United States and other developed countries, and in part by rapid growth in some of the large developing economies, particularly those of China and India. While this enabled many developing countries to make considerable progress toward the Millennium Development Goals, for many of the poorest countries average growth rates will have to rise further and be sustained over many years to achieve these ends.

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Moreover, there are substantial downside risks in the world economy that could lead to a halt or even a reversal of the developmental progress achieved in recent years. These risks are related to shortcomings in the system of global economic governance--in particular to a lack of coherence in the codified and regulated international trading system and the unregulated international monetary and financial system. The international economic system would grow more coherent and stable if new efforts create mechanisms that would contain or mitigate negative impacts on commodity-dependent developing countries.

The Risks of Change

At present, there is a general perception that economic prospects worldwide depend on the resolution of the turbulences in financial markets, which started last summer with the subprime mortgage crises in the United States. This assumption is a demonstration of the extent to which the world's economies are interconnected. When individuals in the United States are unable to repay their housing loans, the economic repercussions can reach the other side of the world. The short-term policy reaction by central banks to the subprime crisis--in the form of a massive provision of liquidity to support the normal functioning of the interbank market and thereby avoid a disintegration of the financial system--has so far proven adequate. But the lessons for dealing with the systemic aspects of that crisis still remain to be established.

There are legitimate questions as to whether something needs to be improved in a financial system that seems unable to function for more than three or four years without an unsettling crisis. It is possible that recurrent episodes of financial volatility are driven by the attempt of financial firms to extract double-digit returns by manipulating claims on as-sets that have single-digit returns. A financial alchemy based on massive leverage and opaque instruments is unlikely to have positive effects on the real economy, and instead leads to recurrent crises driven by the need to realign financial value with the intrinsic value of underlying real assets. This has important implications both in advanced financial markets and in emerging markets that are under the pressures of increasing financial openness and deregulation. Only effective regulation can promote sustained and innovative financial development while preventing risky and far-reaching policies of financial engineering.

It is true that the considerable progress in development over the past few years has been driven by the relatively fast growth of global demand. But the overall performance of the world economy has, at the same time, been associated with the widening current account imbalances of lopsided domestic demand. Such lopsided demand has grown quickly in the United States and other deficit economies and less so in developed countries with large surpluses, such as Japan and Germany. …