Recent Papers & Speeches

Free Trade was a Blessing-Is Free Finance a Threat?
at AEI World Forum, June 25-28, 1998 Beaver Creek, Colorado, U.S.A.

Let me start my discussion with a comparison between free trade and free finance. In my view, free trade is a blessing because of the principle of comparative advantage. Regardless of international differences in wages, technology and other factors, each country has its own exporting industries with their own international comparative advantage. Thus, the efficiency of that country's economy and the international economy as a whole is maximized. That is a blessing even for a developing country.

@In the case of free finance, however, the financial service industry can prosper internationally only in those countries that have a comparative advantage linked to financial services. These include the U.S., the U.K. and Japan. Other countries, including developing countries, can have only local financial markets and systems. These latter countries depend upon the former countries for international wholesale banking and other large-scale financial transactions, and also for highly technical transactions such as derivatives.

@If you would argue that dependence on the former countries is a problem for the latter countries, then free finance should be viewed as a threat. However, I do not think in that way.

@International division of labor always favors economic efficiency in all the countries involved, insofar as it is based on the principle of comparative advantage. Financial services are no exception. It is efficient for countries with no comparative advantage in financial services to have no international financial center and to depend upon other countries' financial markets or institutions. It is a kind of "Wimbledon Phenomena" in which players are foreigners but British people are enjoying those plays.

@Here I must move on to consider the recent financial crisis in some Asian countries. Is it because they have free finance? No! It is not because of freedom, but because of the regulations that govern foreign exchange transactions. The ailing Asian countries had pegged their currencies to the U.S. dollar and had welcomed capital inflows from the U.S. Japan and Europe to finance their current account deficits and sustain high economic growth. However, with inflation rates above the U.S. rate, the real value of their currencies rose against the U.S. dollar. Against the Japanese yen and the Chinese currency, they even rose in nominal terms, since the yen had fallen against the dollar and the Chinese currency was devalued against the dollar in 1994.

Thus, those Asian economies that had lost competitiveness relative to the U.S., Japan and China saw their current account balance deficits increase, and finally, and suddenly, foreign capital started to flee in anticipation of a subsequent devaluation. This triggered the abandonment of pegging and the sharp free fall of their currencies, followed by domestic financial turmoil and economic crisis.

In this narrative, free finance is not to blame, but the pegging of exchange rates should be held to account for the present economic difficulties. If the affected Asian countries had had a floating exchange rate system, free finance would have been a blessing because it would have sustained high economic growth with continuing capital inflows and the opening of foreign bank branches with efficient financial services.


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