Reforming the World’s Financial Order. Institutional and Theoretical Aspects

Modern financial markets are characterized by rapid innovation and expansion as well as intensive internationalization. The liberalization of capital markets since the 1980s has been accompanied by a shift from structural regulation towards prudential supervision along with endeavors to establish international norms on capital adequacy. During the same period, the markets have been hit by a series of crises, which have caused concern that more strict and direct controls are warranted. This paper argues that although liberalized capital markets do in some way possess an inherent tendency towards instability, almost all cases of severe disturbances in the international capital markets are the result of excessively expansive fiscal and monetary policies, which at some point had to give way to a sharp liquidity contraction. In order to stabilize the system, the monetary and fiscal authorities quite often accelerated expansive measures, exposing investors, lenders and borrowers to misleading interest rate and price signals which resulted in a postponement of the adaptation process and in a number of cases to the prolongation of stagnation. Given the international integration of modern financial markets, misplaced monetary and fiscal policies cause various international spillover effects. Repeated bailouts of borrowers and creditors by central banks, governments and international institutions have led to the persistence of moral hazard, as the assumption of implicit guarantees to stabilize financial markets has lowered the perception of risk and resulted in over-exposure. This analysis leads to the conclusion that while more strict regulations might be applied to off-balance financial innovations and that capital adequacy norms should be more strictly enforced on an international level, further direct control seems to bring more harm than good and deflect the attention from the causes of financial instability, which are the inadequate control of liquidity.