In this working paper, E. V. K. FitzGerald, of the Finance and Trade Policy Research Center at the Oxford University, investigates roles that the International Monetary Fund (IMF) might play given its mandate to provide institutional support for a global capital market that can promote trade and investment and given current worldwide economic instabilities, such as highly volatile exchange rates and financial and macroeconomic instabilities experienced in non-industrialized countries. The experience of steady growth and price stability under the Bretton Woods system is often cited in support of a return to a managed fixed-rate system. FitzGerald contends, however, that although exchange rate instability might be related to the major financial crises of the past 20 years, such instability is not the source of financial crises; rather, factors such as the worldwide integration of financial markets and the development of heterogeneous financial instruments have created new sources of instability. In the new worldwide financial system exchange rates function as asset prices (that is, they reflect international capital flows) as well to regulate trade flows. Current account balances are then more likely a function of internal imbalances than of trade imbalances. Moreover, because interest rates reflect the desire to hold a given stock of bonds, their fluctuation does not cause international capital markets to clear (that is, cause saving to equal investment on a global scale). Recent theoretical models have moved away from the standard model of international capital flows to those in which such flows between industrialized countries are divided among portfolio acquisition, foreign direct investment, bank credits, and official development assistance, each of which is largely determined by the quality of a country's bonds. However, such models have not been explicitly extended to the lesser-developed countries (LDCs); capital flows there are still assumed to be exogenously determined. In fact, LDCs rely on international capital flows to sustain investment. As a result, when worldwide volatility rises, LDCs suffer disproportionately from slower growth, a higher cost of debt service, and denied access to private capital. When the IMF was formed, it was assumed that LDCs would be somewhat sheltered from volatility because capital would flow through central banks; this, of course, is no longer the case. The facts that capital does not flow through central banks and that capital markets have become integrated internationally have led to new problems (such as increased systemic risk) for any global financial regulator. Resolution of these problems would require a regulator to function as a lender of last resort (a role that the 1994 Bretton Woods Commission views as central to the future of the IMF) and to establish an orderly financial market via prudential regulation of financial intermediaries. FitzGerald argues that restrictions under Article VI of the IMF's Articles of Agreement that might seem to prevent the IMF from functioning as a lender of last resort are, in practice, no longer applied. However, the need to conduct open market operations to perform this function might prove problematic for the IMF in terms of the necessarily broad scope of a lender of last resort function and the acceptability of potential reserve sources. FitzGerald notes that the other function of global central banking--prudential regulation--is already being performed, the Bank for International Settlements (BIS) in its role, for example, as coordinator of the OECD (Organization for Economic Coordination and Development) central banks. The BIS also performs oversight duties for settlement systems (for example, by acting as agent for the private European Currency Unit clearing and settlement system), thereby working to improve market transparency and strengthen market infrastructure. According to FitzGerald, the creation of an orderly market would require the ability to influence national propensities for net financial saving, long-term expectations on asset yields, and attitudes about liquidity. The first could be influenced through international tax regulation and the other two through prudential supervision of capital markets. An argument also exists for the creation of some system of orderly workouts modeled after U.S. Chapter 11 bankruptcy provisions. Such a system, however, would require a system of private international law, which does not currently exist. In any case, to be effective, a system of intervention and regulation would require close coordination between the IMF and the BIS. An early-warning structure that could respond to emerging crises would also be necessary; however, because such a structure would require substantial enhancement of IMF powers, it is not clear if the IMF would be the best institution to fulfill this responsibility. The conferral of such powers (or close cooperation between those institutions that might have such powers) would depend, in part, on recognition that current nation-based regulations are inadequate. Considering the extreme unlikelihood that supernational authorities will be established and the limited capacities (and interests) of private actors, managing global capital markets will have to be done through intergovernmental arrangements, but with much more management of private actors by existing international institutions. However, given the move toward deregulation by certain national and sectoral interests seemingly unconcerned about threats posed by market disorder, "it is difficult to see what might press them to support reregulation." At best, then, global regulation of finance might have to be constructed "within a hierarchically organized world economy as in effect exists in the trade areas within the GATT/WTO system."
