The Need to Regulate Cross-Border Flow of Speculative Funds

Henry C.K. Liu

This article appeared in AToL and NewDeal2.0 on November 24, 2009

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

The root of 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 US 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 cross-border flow of speculative funds, thus forcing the bailout and stimulus money to stay within US border to create jobs locally. It is a simple measure that can be easily implemented by administrative order.  After the 1997 Asian Financial Crisis, Malaysia imposed currency control and was widely criticized at first but later widely acknowledged as the correct and effective measure to adopt. Germany after 1933 also imposed currency control and its economy recovered faster than any other in the world. There is no way to effectively regulate OTC financial derivative trading against global systemic risk without first stopping cross-border financial arbitrage. Anyone who has studied the and understood problem would know that the path of reinforcing capital reserve adequacy leads to a dead-end against astronomical notional values.

Ever since the end of the Cold War, which actually began winding down with President Nixon’s policy of Détente, 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 subsided and development was channeled solely through global trade.  Persistent US fiscal and trade deficits had forced the abandonment in 1971 of the Bretton Woods regime of fixed exchange rates linked to a gold-back 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 other cylinders of domestic development in a state of permanent stagnation.

Drawing lessons from the 1930s Great Depression, economics thinking prevalent immediately after WWII 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 regarded as the inviolable province of national sovereignty.

Recurring global financial crises will continue to occur until cross-border flow of speculative funds is regulated.

November 22, 2009