"What Exchange Rate Policies Should Developing/Emerging Market Countries Follow?"

October 2, 1998 Washington, D.C.

J. Rauch: Welcome, everybody. Can people hear? Are the mikes on? My name is Jonathan Rauch; I'm a writer in residence at Brookings and a columnist at National Journal magazine; write for many other places. Thank you for coming today and listening to our first, very interesting session. We're hoping in the next session to broaden a bit into questions of exchange-rate regimes, rather than policies merely in the short term. Our topic is, what exchange rate policies should developing and emerging market countries follow?

On September 1, as his economy was melting down, the Malaysian prime minister, Mahatir Mohammed [phonetic], announced strict capital controls to effectively seal off his country from foreign speculators. On state television, he said, "People can no longer stay with the so-called free market system. We feel that we should control foreign exchange to the point where it cannot be traded atall." Predictably, economists were unhappy, and not just at The Economist magazine, I--in full disclosure of a place I happen to work. The Financial Times said, "Capital controls prevent global capital from flowing to where it is more demanded, so impeding economic efficiency." Many others complained, but also, more interestingly to me and, I think, most of the people in this room, there are deep doubts now in the field about whether the orthodoxy is, in fact, right. We've heard Yajis Bagwati [phonetic], staunch free-trader, has said, "The weight of evidence and the force of logic point toward restraints on capital flows." As has been mentioned in the earlier session, Paul Krugman at MIT is now saying, "Capital controls may be necessary and inevitable."

So suddenly, the advice for developing countries, which of course can be swamped literally overnight by currency trading, isn't as clear as it once was. What should they do? What should they not do? We have picked an extraordinarily good day to have this discussion, as you see from this morning's post; unfortunately, presumably as a resultof today's turmoil, we have lost one of our panelists, David Lipton of the U.S. Treasury. We do have Richard Cooper of Harvard, David Hale of Zurich Financial, and from our earlier panel, Bob Litan of Brookings and Jeff Sachs are also going to join us and serve as kind of commentators. Jeff and Bob have already been introduced to you, so I won't do it again, but Richard Cooper is somebody who, if you don't know about in the field, you certainly should. You probably saw his name in last week's Economist magazine, which discussed his idea from a 1984 foreign affairs article about a common currency zone involving Europe, Japan, and America, although he tells me the Economist mischaracterized this as a proposal for a single world currency. "Much has happened lately to make it worth a moment's thought," said the Economist. So this is a man who clearly has thought hard, and not necessarily conventionally, about these issues from long before it was as urgent to do so as it is today.

Professor Cooper is Maurits C. Boas professor of international economics at Harvard since 1981. He was chairman of the National Intelligence Council, 1995 to '97. He has been chairman of the Federal Reserve Bank of Boston, and he's been Undersecretary of State for Economic Affairs in the Carter administration, with, I might add, a longer list of books and articles and collections than I could begin to list in the time we've got.

I've known David Hale for a long time, something I count extremely fortunate for me. He has been one of the most remarkably catholic and creative minds in all of American economics, I think. His regular reports, which many of you no doubt receive, are not only prolific and wide-ranging, but bracing,and the latest are especially relevant. One is on will Malaysia and Hong Kong change the rules of the international financial system, and the other one on Russia you may have picked up on your way through the door. Since 1977, David has been with the Kemper Group based in Chicago, which subsequently became part of the Zurich Group, of which he is the global chief economist. He's winner of the 1990 William F. Butler Award of the New York chapter of the National Association of Business Economists. He consults with the Defense Department, has degrees from Georgetown and the London School of Economics, and also, if you ever need to know anything about his home state of Vermont, he is the guy to ask.

Probably the best thing to do is ask our two main commentators, Professor Cooper and Mr. Hale, to speak for, say, five minutes each on what currency regimes ought to be for developing countries, what we're getting right and wrong, and then get briefreactive comments from Bob Litan and Jeff Sachs, and then turn it over to you. Our session is short; we need to be done by about noon, so we'll all, if you'llbe helpful, I'd appreciate it, try to keep it fairly crisp and controlled. With that, Richard Cooper:

Richard Cooper

R. Cooper: Thank you. Five minutes is a very short period of time to discuss sensibly what is a very complex topic, so I'm just going to be able to touch on the major points. Let me start out by observing that I think the choice of an exchange-rate policy or, some people would say, an exchange-rate regime, is one of the most critical macro-economic choices that any country can make, and particularly a small, open economy. There's a pervasive influence of the exchange rate throughout the economy, and we see the actual choices that countries have made range from completely fixed exchange rates, as we have in Hong Kong andPanama, for example, through [?--tablita? tablida?], that is to say, a pre-announced, crawling exchange rate which has many analytical features of a fixed exchange rate but, in fact, moves on a pre-announced schedule over time, to a discretionary, crawling peg, in which the exchange rate is kept fixed in the short run but changed at regular intervals, to heavily managed floats, to lightly managed floats. We don't, as far as I am aware, have any country that has elected--any developing country--that has elected to have a freely floating exchange rate except under extreme duress; that is to say, when it's run out of reserves: Indonesia, Malaysia, Thailand; we have the examples in mind. But those were not volitional choices in the usual sense.

Are some of these countries making mistakes? Well, unhappily, there is actually, in my view, no universally correct answer to the choice of an exchange-rate regime. It depends on the economic structure of the country in question, and by "economic," I mean both the market for goods and services and the market for financial assets. And it depends very heavily on the expectational environment in the country, which in turn is linked to that country's history, recent history, as it lives in people's memories. And it depends on the--which is related to that--the credibility of the monetary authorities of the country. Their scope for action or inaction depends on their ability to persuade their public and foreigners, as appropriate, that they can stick by their gun.

We have a number of examples in the last year where countries clearly held onto fixed exchange rates for too long. Thailand ran out of reserves; Korea came close to running out of reserves. And that leads--can lead to the observation that holding onto an exchange rate is just a mistake, and countries ought to float. But I think that runs the risk of awarding the prize to the second singer after having heard the first one sing. We could find also examples where countries have floating their exchange rates and run into serious trouble as a result of floating, and if we want to draw on the same body of experience, both Malaysia and Indonesia elected--after having watched what happened in Thailand--elected to float--in the case of Malaysia, to float cleanly last summer, and Malaysia didn't come out much better relative to Thailand than it went in from the crisis as a whole.

So, I don't think there's a right answer. It is true that a fixed exchange rate is an inviting target if things go wrong, but so is a flexible exchange rate. We have the examples I just gave of Malaysia and Indonesia. One can go back to the 1920s, where Belgium was dragged down by expectations about France, even though the fundamentalists of Belgium were completely different, but Belgium's a small, open economy. So each country has to decide on its own, given its own objectives and its own circumstances. What--there's a wide consensus these days, I think, among economists that fixed exchange rates, unless they are--let me say it more exactly. Fixed but adjustable exchange rates are incompatible with a world of open capital mobility, so that if you're going to fix, you have to really fix. The Europeans, of course, are doing that by going to a common currency. I amdrifting around to the view--I won't say it's a conviction yet--that floating exchange rates for any country that does not have a highly developed capital market with all of its articulation--that is to say, for most countries--are also incompatible with free movements of capital, and the reason is a--I'll state it, although it's not transparent, just stating it: the reason is that the exchange rate is a price between two nominal variables; namely, currency A and currency B, neither of which is anchored in anything in the short run. So the price between two currencies, abstractly, is actually completely arbitrary. And because it's arbitrary, it can be moved around by heavy purchases or sales or by even rumors about heavy purchases or sales. And yet, as I said at the outset, the exchange rate has a pervasive influence in most countries, and so serious damage can be done by a radical change in the exchange rate, moved about either by heavy purchases or sales or by rumors of such.

So, as I say, I'm groping toward the view that a world of floating currencies and free capital movements is not on, actually, and we're going to have to make some choices. So just to wind up, the right answer for a particular country depends on several key variables. One is the degree of price flexibility that it has domestically, both goods and services, asset--factory prices, especially, wages. The more flexible, the more comfortable you can be about fixing the exchange rate. The openness to trade, the openness to international financial transactions, to financial transactions, the more open, the more that drives you toward a fixed exchange rate. I ask, as an exam question of my students, should Cambridge--a city inMassachusetts, a city of about 100,000 people, where Harvard and MIT are located, should Cambridge have a floating exchange rate? It's a really thought-provoking question if one goes through the reasons why one should or should not have and exchange rate. So the more open, the more that drives you to fix--to fixity. Credibility of the monetary authorities. The more credible they are in terms of stated objectives and sticking to them, the more comfortable you can be with a floating exchange rate. The ability to influence capital movements in and out effectively.

So these--the answers to these questions are going to differ--and they're going to differ quantitatively--from country to country. And the appropriate choice of an exchange rate depends on the answer to these complex questions.

David Hale

J. Rauch: Thank you. I myself have often wondered if Cambridge, in fact, belongs in NATO. [laughter] David Hale:

D. Hale: Yes, thank you very much.This is obviously, as Dick just indicated, a very open question, full of relativities, that has--it's very difficult to generalize for very long. What I'd like to do first is review the events of the last twelve months to show how mismatch [unclear] exchange-rate policy gave us the current global financial crisis. Secondly, I'd like to focus on four different things here in the next fifteen minutes. The first is how the character of the exchange-rate regimes we had a year ago laid the groundwork for the current financial crisis we're experiencing on a global basis; secondly, how countries should sort of review a matrix of factors to determine their exchange-rate policy; thirdly, the new dimensions in character of the global capital market, which will also be an important background influence to this; and finally, just summarize a few examples, on a country-by-country basis, of how policies have succeeded or failed.

J. Rauch: David, before you begin, just to interject: fifteen minutes would be a bit more than we've got, since we've got to end about noon.

D. Hale: Okay. First point, very simply, is that this crisis began twelve and eighteen months ago with the decision--or with the breakdown of the [unclear] fixed exchange-rate system. This had encouraged, in the 1990s, a significant over-leveraging in dollar liabilities by the corporate sectors of east Asia. It was a policy that worked very well in the 1980s when we didn't have large capital flows, but in the 1990s, in the aftermath of the cold war, we had a tremendous expansion of capital flows to developing countries and it allowed the corporate sectors of east Asia, basically, to over-leverage themselves. Once we had a devaluation in Thailand, that produced a crisis throughout the whole region because the fact is, in every country--Thailand, Indonesia, Korea, Malaysia, and so on--we had this high lever of dollar liabilities that then had to be hedged and covered. The second stage of the crisis came in the first half of this year, when the Asian recession--a recession in a region that accounted for half of world output growth after 1991--led to a big decline in the value of the currencies of commodity-producing countries: the Australian dollar, the New Zealand dollar, the Canadian dollar, the South African rand, later the Mexican peso--any currency linked to the price of oil or gold or copper or nickel came under[unclear] pressure because of the global cyclical consequences of the Asian crisis. But there was not a crisis in Australia, or in South Africa, or in New Zealand, or the other countries, because they didn't have high levels of dollar debt and didn't have over-leveraged banking systems. They've all had to make adjustments, but they've been very modest compared to what's happened in Asia.

The first stage of the crisis came this summer with the heavy selling pressure, then the collapse of the Russian ruble. The ruble was the one commodity-producing currency which had not corrected because it had the support of the IMF as well as hedge-fund demand for Russian treasury bonds, but by summer, they could no longer sustain this because of concerns in the market about the impact of the falling oil price, the inability to collect taxes, the whole impasse in the Duma over implementing the IMF program. So we had a third stage of the crisis in mid-August in which Russia didn't just devalue; it defaulted and suspended international debt payments in [unclear] as well in its private sector. And this has given us, in the last five weeks, the most extraordinary example of not just regional, but global financial contagion we've seen since the early 1930s. Because Russia was $20 billion short of what it needed to maintain the confidence of the markets this summer, we've taken $3 trillion off global stock-market capitalization and have set in motion what will be, by the end of this year, quite a significant global credit crunch, producing a recession in two-thirds of the world economy next year.

Now, how do you determine your exchange-rate policy? I think there are five key factors a country should focus on. First, its macro-condition: how flexible are its prices, what is its output mix? Is its output mix industrial, or is it commodity-driven? I think the Russian ruble was pegged to the wrong currency. It was pegged to the American dollar; it should have been pegged to the Australian dollar. If it had been allowed to fluctuate with the commodity-producing currency basket, we would not have had the trauma of having a large devaluation this summer; we would have had incremental adjustments instead. Some people would laugh at that, but the fact is, the Australian dollar has been, in the last fifteen years, a fantastic proxy for changes in global commodity prices, and their monetary policy has adapted to that. Price flexibility is important because if youdon't have price flexibility at home, you obviously can't adjust to having a fixed exchange rate.

Second important factor is your monetary credibility. Do you have a history of good central banking to maintain the confidence of your own people, let alone foreign investors, in your currency? Countries like Argentina went to currency boards because they had a long history of hyper-inflation that made it possible to impose a very rigid monetary regime. Countries that have had less dramatic experiences will tend to be content with having a pegged exchange rate or even a floating one.

Third very important criteria is the quality of your banking system. Do you have good financial supervision; do you have strong banks? And now in the 1990s, a further important factor is the level of foreign ownership of the banking system. Argentina has now sold half its banking system to foreign investors, making its currency board much stronger. The lender of last resort now for half the Argentine banking system is the Federal Reserve Bank of the United States, the Central Bank of Spain, the Central Bank of Germany, and soon, the European Central Bank. I had meetings last week in Mexico City with the Central Bank, and they told me they're studying very carefully the New Zealand model. New Zealand coped with its recession seven or eight years ago by selling its entire banking system to foreign investors. There is no longer a lender of last resort in Auckland; the lender of last resort for New Zealand is now Her Majesty's governments in London and Canberra and other foreign banks that also have shareholdings in these New Zealand banks. This is quite a dramatic change, and the goal of some Mexican officials is to do the same thing, sell off the Mexican banking system, and once you've done that, go to a currency board, because you won't have to worry about the central bank playing the lender-of-last-resort role. We wouldn't have had a discussion like this ten or fifteen years ago, but in view of the changes here in the 1990s, there is now a very open-minded view on these issues of bank ownership and, with it, the lender-of-last-resort function.

Fourth important criteria for determining your policy is the character of your capital account. Are you funded externally through bank lending, through foreign direct investment, through securities sales?Until ten years ago, the dominant forms of capital transfer in the world, from almost all the decades after the first world war, was foreign direct investmentor bank lending or official [unclear]. The 1990s has brought us back to the end of the nineteenth century and the first decade of this century by having a tremendous expansion of capital flows through securities markets. The Mexican crisis of two years ago is very much tied into this. Mexico had funded, for four years, a current account deficit, 75% by selling stocks and bonds to American investors, listing companies in New York, creating instruments like [unclear] peso bonds for American investors. This capital flow was interrupted in 1994 because Allen Greenspan doubled the U.S. interest rates. Mexico had two assassinations, and there was a sense that Mexico was developing a big imbalance in its current account that could no longer be sustained as easily as it had been in the previous years by these capital flows. This meant we had a new element of vulnerability that required a more flexible exchange-rate policy. Sadly, though, it came instead through a very traumatic devaluation.

In the case of Asia, we had very diverse capital flows, not just securities markets, but we had this problem of dollar leveraging. The dollar leveraging thatwent on for five years in the capital account created an implicit vulnerability, and once the exchange-rate policy was called into question, this, of course, led to the crisis.

The final important element is, does the country have access to a lender of last resort? Does it have international relationships that can support its exchange-rate policy in periods of stress and crisis? And again, good examples of this: Mexico in 1994 got support from the U.S. Treasury for the first half of the year, after the [unclear] assassination. That helped to enhance credibility of the regime. The Hong Kong dollar has been sustained, in part, in the last year by the belief that China will intervene on a large scale to protect the Hong Kong dollar so as to maintain face, to demonstrate that it can in fact be a good steward for the Hong Kong special administrative region in the aftermath of British rule. I can say quite categorically that the Hong Kong dollar would be far more vulnerable today if it were still a British colony. Her Majesty's government in London would never have lent one penny to the Hong Kong monetary authority to support the exchange rate. The Bank of China, I think, would lend billions of dollars; indeed, the rumor is in the market they've alreadydone that. If you go to central Europe and eastern Europe, an important factor in the future, I suspect, will also be the relationship between the new European Central Bank and countries like Poland or Estonia or Hungary that are now developing, through currency boards or exchange-rate pegs, their own link.

So there's a variety of factors here that determine what you should do. Just to summarize, the major emphasis has to be on consistency and compatibility of your objectives. A currency board can work, a free float can work, a narrow target band can work if you understand what you're doing, and I think the experience here in the last five years indicates that you've got to look at these five factors very comprehensively and then make a realistic objective about which ones you can defend. The Hong Kong and Argentine systems have worked because the political will is there. The same is true of Estonia, which now has the most free-market economy in the whole of Europe, not just the former Soviet Union. Lithuania could not defend its currency board because it had a banking crisisthat destroyed one-third of the banking system. That demonstrated a need for a lender of last resort. Their experience was different. I think a very interesting model right now, if I had to reconcile all these conflicting objectives, is Poland. They have got a very wide target band, almost 10%, because their currency has become very attractive for investors. They've got 19% interest rates as part of their policy of crushing inflation. They're very concerned now about their corporate sector borrowing only in dollars at 6% as the Asian companies did two and three years ago, so they've made a much wider target band than Asia had so as to create some exchange-rate risk. This lessens the danger that you'll have this over-leveraging that we had in Asia two or three years ago because of over-confidence in the exchange-rate policy. So, again, the major themes are consistency and compatibility of objectives. The exchange-rate policy cannot be viewed as a separate issue; it's part of a much larger mix of issues which have to basically flow together. Thank you.

Panel Discussion

J. Rauch: Thank you, David. A quick commentary from, first, Jeff Sachs, and then Bob Litan. I emphasize "quick" if you don't mind.

J. Sachs: I think it's mostly true that countries that do have a choice, but I think there's a real distinction among these choices. When you choose a fixed exchange rate or currency board, you are foregoing a major vehicle of adjustment, and that is nominal exchange-rate changes to adjust to things like terms of trade shocks or changes of capital flows, and the result is that countries that suffer adverse shocks under fixed exchange rates tend to find themselves in a position of having to undertake highly contractionary policies to maintain the peg, such as the -7%--the 7% contraction in Argentina in 1995. I say they mostly can choose because when it becomes apparent that the exchange rate is out of line with goals of stability and growth, the relentless attack in open capital markets on a pegged exchange rate can be absolutely overwhelming, so even if the fundamentals are more or less all right, a speculative attack on a currency judged to be overvalued can, by itself, destroy the peg, even if monetary and fiscal policy are in pretty good shape, the reason being that the interest rates can go so high to defend the peg that the damage done to the financial system, the banking sector, leads to a melt-down which causes investors to realize that even those high interest rates aren't safe because the whole system is going into contraction, bankruptcy, and default. We've seen this over and over again. So I'm not quite so agnostic, I think, as the first two speakers;I still would like to be persuaded of the good cases in the developing world of countries that ought to peg their exchange rates. I know of very few cases for which that's appropriate.

J. Rauch: Bob Litan?

R. Litan: Three quick observations. Number one: under either exchange-rate regime, fixed or flexible, rule number one, you don't want your foreign currency borrowing to get out of whack with your reserves. All right? No matter what you do. So that gets back to our morning discussion justifying, perhaps, a tax on short-term foreign currency borrowing. Number two, we know, from past experience, that adopting fixed exchange rates not only has the problems that Jeff has pointed out, but it also creates a moral hazard and leads to arbitrage, which led to this problem, and we know that from experience. Proposition number three--which therefore leads to my bias, and I think Jeff's bias, in favor of flexible rates. But number three, and this is the tough problem: what about the transition? What about a currency that is fixed and is being assaulted? The question is, what do you do? Well, it seems to me that if you can bear the pain, it may be worth bearing the pain because there are real costs to abandoning a peg if you had a history of high inflation, as Brazil had. On the other hand, if you're Thailand and the pain is too exorbitant, you don't have that prior history, there can be easy adjustment; you just abandon the peg. But I think, in the case of Brazil--and this to [unclear] it with Jeff, perhaps on purpose--I think that not only you have to weigh the costs and benefits from the country's own point of view in deciding what to do in the face of an assault, but there are externalities. And I personally believe that the experience in Russia demonstrates that markets are fickle. When one exchange rate goes, you can get rapid contagious effects elsewhere. I personally am very worried that if the Brazilian real is not defended, we are going to see contagion throughout Latin America; we're going to see a major stock-market jolt here in the United States. I think that's a significant risk. Jeff may disagree with me on the probability of that risk, or whether it's one that we shouldn't worry about. But I happen to believe that it's a significant one, and I think, in this particular case, I would counsel at least try to hold the line. If you have to give up, I agree, eventually you have to give up, but that doesn't mean you don't try to begin with.
 
 

Questions and Answers

J. Rauch: Thanks. I'll usurp the first question and ask the first two speakers: what about capital controls in the situation where you've got vulnerability to massive speculative attacks? Both of you briefly.

D. Hale: Capital controls, obviously, can be used, I think, very carefully, but not extensively, because they create so many distortions. The distortions are quite straightforward. First, you create an artificial cost to capital; that could lead to misallocation of investment. That was part of the Asian crisis and now, with the attempts by Malaysia to stimulate your capital controls, it'll be a new element to risk there. Secondly, they encourage corruption. A country like Malaysia has foreign trade at 250% of GNP. Its corporate sector will easily circumvent these controls; indeed, the IMF booklet that came out on the weekend here has a discussion about all the errors in balance of payments in Asia. We've seen in China a big current account surplus, large amounts of FDI, yet reserves have been static for a year. Obviously there's capital flight going on around the controls through foreign trade and phenomena like that. And thirdly, it can obviously lead to an inflationary monetary policy. I don't think it's an accident this age of disinflation has gone with freedom of movement in capital. Investors can escape from a bad currency or a bad central bank through capital mobility. If they lose that privilege, lose that right, that, of course, creates the risk, at least in a single country, of much more inflation. Examples I think we should look at of how capital controls could work would be Chile. Chile has had this 30% surtax, it brought it in four or five years ago when the problem was too much capital coming in. It abolished it in recent weeks because their problem now is not getting enough capital or, indeed, commodity-environment capital flight. Bank of Mexico is trying to bring a policy reflecting what Bob Litan just said; they now want to limit foreign currency borrowing to the level of foreign exchange reserves so as not to have this big imbalance in the assets and liabilities that might--because of the imbalances in maturity, too much short-maturity lending--give you the possibility of an Asian-type crisis. So, careful regulation, good banking supervision, has an element of capital control built into it. To go beyond that to things that are highly arbitrary and highly discretionary creates great risk. You can't rule out the need for it in the short term, depending on the scope of the global shock, but we have to view it as something very temporary and very undesirable because of these three problems--resource allocation, corruption, and monetary policy--that could easily, over time, get out of control.

J. Rauch: Richard Cooper, do you agree?

R. Cooper: I'd just like to say that capital control is not a self-confining term, and in fact, it encompasses a wide range of instruments which countries have used over the years and some are using today. David mentioned in passing, and a very important type of capital control, which my guess is most people in the room don't know that we in the United States have, which is Federal Reserve regulations on the open position that supervised banks can take in foreign currency in this country. Now, that's a form of capital controls that happens to apply to one admittedly very important class of institutions. We don't think of that as capital controls; we think of it as a prudential regulation. The Chilean technically was a--not a capital control, but a prudential regulation, and so there's a whole spectrum of instruments which vary in their impact and in their effectiveness, depending on the structure of each economy. I do not share the general prejudice against capital controls that many economists have, largely because I'm less enthusiastic than I think David and others may be about the positive resource allocation effects of international--freedom of international capital movements. What I observe is a tremendous amount of tax evasion. Luxembourg and Switzerland thrive on tax evasion, and it's not clear that that's--represents an improvement in the world's allocation of resources, so I would take a much more nuanced position. I think there are serious issues in any particular case about the effectiveness of capital control. If one is trying, as Chile did, to lengthen maturity, one is likely to have much more success than if one is trying to limit the outflow of resident capital. It took about two days, from the announcement of Malaysia's regulation, before a black market in Malaysian ringgits started just north of the border in Thailand and an arbitrage with oil products with Malaysia started, so that anyone who's determined to get capital out can. So there are a lot of practical questions involved in running capital controls.

J. Rauch: Thank you. Let's go to the audience. Raise your hand good and high, especially if you're to my left, since I'm a bit blocked by the podium. Anybody? Sir, in the middle.

Norse Laffe [phonetic]: Thank you. Can you hear me?

J. Rauch: Yes. Your name?

Norse Laffe: Norse Laffe, embassy of Sweden. A quick question to the panel. What should Europe do. What would be the priority? Should Germany and France, together with Federal Reserve, try to cope with the crisis by, for example, cut interest rates? Or should one keep stone-faced and stick to the conversion of the currency in order to wait for the implementation of [unclear] January [?-unclear] first. Thank you.

J. Rauch: I heard Bob Litan say Ayes," so cut rates.

R. Litan: Cut rates, do it in a coordinated fashion; you don't have to worry about disrupting the [unclear] if you do it all together. They've got 11%-plus unemployment. That's what the German election was all about. It was "the economy, stupid" in Germany, and I think that's a good lesson that could be applied to the rest of Europe. Other people may have different views.

D. Hale [?]: Europe, I think, has a fundamental problem; I'm thinking ahead to January and beyond, which the Maastricht treaty under which the European monetary union is established is a quite remarkable document for its omissions, and in particular, Europe will not have, formally, a lender of last resort after January 1, and the formal charge to the European cen--the new European Central Bank does not include preserving stability in financial markets. I find it actually mind-boggling that these two omissions will take place in the charter; I assume that they will be rectified by sensible people behaving sensibly because the Maastricht Treaty doesn't formally exclude a lender-of-last-resort function.But the Europeans have a lot of sorting out to do, in terms of the new European Central Bank, and I hope they can do it before a serious crisis emerges; that is to say, think a little bit ahead rather than after a crisis emerges.

J. Sachs [?]: The Federal Reserve has just begun the process of [unclear]; the problem for Allen Greenspan this week is that his board is still catching up with the shocks of the last four weeks. I saw most of the Federal Reserve Board one-on-one a few weeks ago at Jackson Hole and admitted at that point that there's no longer a case to tighten, whereas many of them in May were calling for tightening, but they still didn't fully grasp what the Russian crisis meant for Brazil and all the countries in our hemisphere, let alone for the larger world. They're probably [unclear], in fact, the other day, because they're still absorbing this. But I think that if we don't see a major improvement in market conditions, to signify that capital is once again flowing and we aren't rationing credit severely, we could easily take our interest rates down a hundred basis points. The [unclear] bank has been coy in recent days because Germany's in the middle of an election campaign. They knew that Schroeder and La Fontaine would call for lower interest rates, and indeed, La Fontaine's done that just in the last48 hours, and they didn't want to kind of appear to be political right at the time of the campaign. But now thatwe have the election out of the way, I suspect that we'll have a debate about monetary easing in the New York and Central Bank by the end of this year.

J. Rauch: Sir, holding the pencil there in the far corner.

[Name unclear]: [unclear] of Business and Russia magazine. My question is basically to Mr. Hale and Mr. Sachs. For past two or three weeks, Russian ruble has fluctuated more than 100 points every day. The situation is very interesting because yesterday we had two proposals. One is to introduce United States dollar as the national currency; another was--another one was for one of their local Russian governors to ban completely dollars out of circulation in Russia. I would like to know you opinion: what is the best solution now for Russia to normalize the exchange rate between dollars and rubles?

Unidentified: David will take that one.

D. Hale: The ruble was very volatile the last few weeks, in part, because Russian banks and the Russian government were intervening a few days ago to match the--to push up the ruble to the for the day that the--a lot of the ruble-forward contracts were expiring. They pushed it all the way back to seven, basically, as a way to try and reduce the contingent liabilities of the Russian commercial banks that had written these currency contracts, so it has not been a really, say, true market. It's been very distorted. Clearly, in view of the political changes in the last four weeks, Russian appears to be on course for hyper-inflation. We have a new central bank governor, Mr. Garashenkov [phonetic], whose name in English means "hyper-inflation." [laughter] We have the announcement overnight of a de facto command to [unclear] economic program involving extensive use of capital controls and regulation, centralization, in fact, of control over foreign currency, so there are no simple solutions. What we have to do, I think, if we could get the right ministers in Moscow, is to try and redesign the program we had back in July, a commitment to reducing the fiscal deficit over time, to further improvement in the system of tax collection, administrative reforms that are essential for either a socialist or market economy, but certainly now for a market economy are even more essential, and pick up where we were in July. And the problem is, because of the shock to confidence, the implosion of the Russian financial system, the power struggle in that national system between the oligarchs and various politicians, there is no clear agenda emerging. So we're probably going to have to suffer a period of economic decline and hyper-inflation, and then hope that perhaps in six or nine months' time, as in Bulgaria two or three years ago, the reformers will get a second chance to come back and start over again. I think we could have avoided this crisis if the Russian loan in July had been as big as the Mexican loan of early 1995, $40 billion, not $22 billion. That wouldn't have solved all the problems, but it would have bought time, and I think that if Mr. Federov [phonetic] had survived as a tax commissioner, we could have carried through the IMF program. Russian might have restored credibility next year and not have needed as much help from the IMF. Unfortunately, this is counter-factual history; I can never prove the point, so now we will have to test it through a period of great adversity for Russia and a period of great apprehension and uncertainty about the political consequences of this economic adversity.

J. Sachs: Let me take the step back before July, because again, this comes to the core of what we're discussing. A year ago, the ruble was clearly overvalued. A year ago, the ruble was under attack. A year ago, oil prices started to fall. But, as is always inconvenient whenever you try to move to flexibility, the idea was we're gonna take heroic measures and save it, so the IMF and the Russian government went to work last October to keep a strong ruble, and it was attacked again in February. Another intervention. Then it was attacked again in June and July. It was never convenient to adjust until the reserves had been let completely go. So I think this idea that we're all in favor of flexibility, but not now, is really a typical kind of response. It's never right to take the medicine of adjustment, but the result in this particular area is that the consequences, in the end, are absolutely extreme. Look at the political consequences. Russia had a superb, young prime minister, Mr. Kureyenko [phonetic], and what happened? He was trotted out to announce every day that the ruble will never fall. So naturally, the day that the ruble fell, he was fired by President Yeltsin. This is part of the political consequence of this game of it never being right to recognize that the peg can't be sustained. And I think we're playing the same game with Brazil. To what end will we spend a few more months of steeper Brazilian recession, slower growth, high interest ratescracking the Brazilian banking sector? Well, maybe the argument that, you know, that way we'll save Argentina. But Argentina chose willingly to put itself in a straitjacket and never get out. It made that tough decision. We can't run the rest of the world for the sake of preserving the health of Argentina's overvalued currency, it seems to me. That's a real deep problem. But--and I don't--and I'm not saying, Bob, that I'm not worried about this; I'm saying, when are you going to do it? When Brazilian growth is -5%? It's zero now. Shall we wait 'til the recession is really steep and then have the crack happen?

R. Litan: I guess my short response is, Brazil's not Russia. And at least we ought to--at least get a chance to find out.

J. Rauch: I think actually I see the solution here, which is that Russia should adopt the dollar and Cambridge should adopt the ruble. [laughter] This gentlemanhere in the red tie has been holding up a hand for a long time; if we can get a mike this close. And this, I think, needs to be our last question, doesn't it?

Marcus Freitas: Do you have any general guidelines for dissociating--

J. Rauch: Who are you, sir?

Marcus Freitas: My name is Marcus Freitas and I asked before: do you have any guidelines, any general idea, of how we can separate speculation from investment? Harry Kissinger mentioned that and I was wondering if you have any general guidelines for that.

R. Cooper [?]: I'd like to make a point on speculators versus investors. Of course, the worst situation that any country can go through is when its own citizens lose confidence in its currency, and in the wrong kind of environment, everyone becomes a "speculator"; that is to say, everyone is trying to preserve his wealth. And that's a perfectly natural and human phenomenon. David mentioned very quickly in passing, but I would underline it, that in southeast Asia last fall, most of the pressure on the foreign exchange was residents, not non-residents; residents who were running for cover. This is residents who had unwisely borrowed dollars and not covered themselves, and once the exchange rate to move, then they had to cover themselves, so it was resident capital that was putting the pressure on the foreign exchanges, so that the distinction between an investor and a speculator, actually you can find some pure examples at both ends, but in the middle is a vast grey area in which all of us are potential speculators in the right kind of circumstances, and it's the responsibility of the monetary authorities to ensure that those circumstances don't arise.

D. Hale: [unclear] we have this tremendous expansion of portfolio capital flows and mutual fund money, I can say, because I've come from a company which is active in mutual funds, in a sense, long-term capital. But obviously, we have to constantly adjust to new information and when that happens, you can change your mind and sell the security, so it's fungible money, compared to a foreign direct investment or compared to even a bank loan. In theory, a bank loan's a contract; you can renegotiate. Then we have this new element of hedge funds. They represent a force that has no parallel in previous financial history. According to surveys, there's two or three hundred billion dollars now in hedge funds in this country; there's twelve hundred altogether; there's a few very big ones, like Soros and Julian Robertson and more capital than lot of tiny ones. But if you leverage that as much as they want to leverage it, you might have two or three trillion dollars there. And I don't think this money is the cause of the crisis, but there's no doubt that in some Taiwan, it was a contributing factor. I know of one hedge fund that had a short position a year ago equal to 20% of Taiwan's foreign exchange reserves. When you have that large a short position out of New York, as opposed to local residents and local companies, it does change the trade-offs. One reason I think that Malaysia and Indonesia surrendered and floating their currencies almost immediately after the Thai devaluation was they were afraid of the hedge funds. The hedge fundsdidn't play an active role there, but they were in the background as an influence. And then, of course, it was the hedge funds that funded Russia this year. Only speculative money would have funded Russia, given the nature of its debt market and its fiscal uncertainties, and you could say they did a good job for awhile; they helped. But when the environment changed, that also meant the money was going to leave, because this capital is, by definition, extremely fungible, it's gypsy-like, and it can, from time to time, also be predatory.

J. Rauch: Thank you all. I think Bailey Morris-Eck is ready to tell us about our lunch.

B. Morris-Eck: Yes, it's going to take us just about ten to twelve minutes to set up the room for lunch; you're all invited to stay. Our guest speaker is his excellency, Mr. Subianto, the Indonesian finance minister, who has agreed to answer questions but not political questions, and only those related to his speech and the finances of his country, so I hope you will join us, and we will break for about twelve minutes. Thank you.