A quarterly magazine of the IMF

March 2002, Volume 39, Number 2

The International Financial Architecture
What's New? What's Missing?

Institute for International Economics, Washington, 2001, xiv + 186 pp., $20 (paper).

Since the 1994 Mexican crisis, there has been a rigorous debate about how to reform the international financial system. The reform process itself is dynamic in that it affects the international community's approach to new crises, but it is also reshaped by the problems new crises pose. As an expert in international finance, Peter B. Kenen is ideally suited to assessing recent developments in this process, and he makes a wide-ranging contribution to the debate.

First, he provides an extensive summary of the Mexican and Asian (1997�98) crises, both of which were instrumental in setting the reform agenda. He highlights the basic differences between the two crises and explains how the differences shifted reformers' attention from the problems of the public sector to those of the private sector. Kenen also carefully reviews the leading explanations of why these crises took place.

Discussing some of the fundamental issues associated with crisis prevention and crisis management, Kenen explains in detail how different parties have approached the reform of the international financial architecture. He notes that, although the problems pertaining to the reform are very complex, the issues and alternatives are not presented in a sophisticated framework. The examples he provides to make his point are insightful. During the Asian crisis, for example, some claimed that there was no need to change domestic economic policies because the major source of the crisis was investor panic. Kenen challenges this view and suggests why policies had to be modified. First, he says, creditor panics are responses to adverse changes in economic conditions. Second, to prevent creditor panics from causing damage, countries must send a strong message to international markets in the form of policy changes.

Kenen's other contribution is his extensive account of the evolution of the reform process, which he divides into three periods of about two years each. The first period, which included the Halifax and Lyon summits, started in 1995. The second period, covering the Denver and Birmingham summits, ran from 1997 to 1999. The third period, which included the K�ln and Okinawa summits, started in 1999. As Kenen documents the results of these meetings, he also highlights the major objectives of the reforms. He explains the roles of the international organizations, which have begun changing some of their practices in response to feedback received from the international community.

Finally, Kenen provides an extensive list of suggestions for improving the functioning of international financial markets. His recommendations range from changing some IMF policies to formulating new measures that would improve domestic financial sectors in emerging market countries. He emphasizes the importance of involving the private sector in resolving crises and considers this to be the major challenge facing the reformers.

The debate over the reform of the financial architecture has reached new heights, and it is highly possible that the recent debt crisis in Argentina has brought us to the fourth phase of the reform process. Kenen's book nicely draws the big picture of the debate, carefully analyzes different views on each major issue, and provides valuable insights into the missing components that should be addressed next. It is certainly a useful reference for those interested in the reform of the international financial system.

M. Ayhan Kose
Economist,
IMF Research Department

Corporate Financing and Governance in Japan
The Road to the Future

MIT Press, Cambridge, Massachusetts, 2001, xx + 358 pp., $35.00 (cloth).

Touted as the catalyst of the Japanese "miracle" only a decade ago and now seen as a massive drag on the economy, Japan's financial and corporate sector has had a striking fall from grace. In this exhaustively researched and persuasive book, Takeo Hoshi and Anil Kashyap shed light on the process that has led to the current state of affairs.

The authors identify four distinct phases in Japan's modern financial history. The first phase—from the nineteenth century through the late 1930s—was characterized by high levels of activity in the bond and securities markets and relatively little reliance on banks for firm-level financing. An examination of this era, the authors claim, dispels the notion that Japanese firms are inherently bank-dependent for cultural and historical reasons.

Rather, banks became a dominant force in Japan only after militarism took hold (in the second phase, which ended with the Second World War), when certain banks were made responsible for financing specific militarily important firms. The zaibatsu—economic conglomerates that had been run mostly by family-owned groups and strengthened by bank financing—also grew in importance during this phase.

Although the postwar years (the third phase, which lasted through the early 1970s) saw the dismantling of the zaibatsu, the importance of banks remained intact. In the capital-starved economy, banks were still the key intermediaries for rationing and directing government credit. Companies that were part of the zaibatsu evolved and formed the basis for keiretsu, a corporate system covering a vertical group of suppliers with one dominant company and a horizontal chain of peers. Firms belonging to the keiretsu were more independent than their predecessors, but featured an almost exclusive reliance on bank financing and significant cross-share holding. A "main bank" acted as a leader of a group of institutions, providing them with financing and resolving their financial difficulties.

Banks flourished during the high-growth, "miracle" years, while tight regulation—a characteristic of the third phase—prevented many firms from accessing the bond market. Applying standard corporate finance theory, the authors argue that in the shallow and weak postwar economy, bank-centered financing offered sizable benefits, which declined as firms matured and capital markets deepened. The debt market, in particular, received a boost in the aftermath of the first oil shock (1973-74, the beginning of the fourth and ongoing phase) and soon began to facilitate government deficit financing.

Faced with a new environment, banks needed to push their businesses into other areas, which they did by expanding their loan portfolios, in the late 1980s, into real estate and construction companies. Loans looked promising during the bubble years, but as the value of loan collateral—land and stocks—plummeted, the banking sector accumulated a mountain of bad debt. The authors argue that the ensuing crisis—which continued through the 1990s—and further deregulation have weakened the banks' role in the Japanese financial system to such an extent that the future could resemble the first phase, with flourishing debt and securities markets and a much smaller and more diversified banking sector.

Throughout the book, boxes provide refreshing detours and insights into Japan's rich financial history. Illustrations of the links between political and financial developments are particularly revealing, especially in the context of the prewar rise in militarism and the postwar influences of the U.S. occupation of Japan.

The authors do an excellent job of distilling the salient features of Japan's rather complex financial sector history. Even the nonspecialist reader will find the book readable and informative. Instead of reaching for policy solutions to the ongoing crisis, the book focuses on the developments that have made the Japanese financial system "comprehensible and even predictable." Its value lies in that effort.

Taimur Baig
Economist,
IMF Asia and Pacific Department

Building Capitalism
The Transformation of the Former Soviet Bloc

Cambridge University Press, New York/ Cambridge, England, 2002, xvii + 508 pp., $80/£55 (cloth), $26.95/£19.95 (paper).

More than a decade has passed since the demise of communism in Eastern Europe and the former Soviet Union. Although the destinies of these countries were closely linked under communism, their political and economic paths have since diverged widely. Among recent studies of this unprecedented transition, Building Capitalism stands out as a comprehensive economic history of the postcommunist transformation in 21 countries. Written in a clear and engaging style, the book leads the reader through the main stages of this great drama. The author, who knows many of the main players and has advised the governments of Russia, Ukraine, and the Kyrgyz Republic at various times, is uniquely placed to write such a history.

�slund cogently assesses developments in the region based on empirical data from primary sources and a thorough review of the relevant literature. While emphasizing recent economic history, he also describes critical political and social developments. �slund argues convincingly that the fundamental conflict in postcommunist transformation has been between market reformers and rent seekers (mainly enterprise managers and state officials who benefit excessively from state redistribution and regulation). His main finding is that countries that did not take radical measures to establish a market economy and a democratic political system either got stuck with large output falls, stifling state intervention, and excessive rent seeking, or degenerated into dictatorship. Radical reform is good for growth and for raising living standards of the population as a whole, while democratic competition for political power is good for reform.

�slund argues that the outcome of the struggle between reformers and rent seekers depends on the development of civil society and democracy in the closing years of the communist system. This could perhaps help explain why reforms in, for example, Poland and Estonia were generally successful, but only slow and partial in Russia and Ukraine and virtually absent in Turkmenistan and Uzbekistan.

According to �slund, the general collapse of output during the transition was a statistical aberration. He arrives at this conclusion by taking account of estimates of the size of the unofficial economy, excluding output drops in the former Soviet Union before 1991, and deducting an estimate for production of substandard goods (value detraction) during the last years of communism. However, estimating the unofficial economy is notoriously tricky: pinpointing the start of transition is not as clear-cut as �slund states, and producing goods and services that are substandard does not justify excluding them from measured GDP. While �slund raises valid points, the reader is unlikely to be convinced by his revision of the growth experience. The strong output decline was no myth, although the decline in welfare was probably much smaller than GDP data would indicate.

Another point �slund makes is that it was common during the transition to have too many, as well as excessively high, taxes. This mistake, for which he partly blames the IMF, led to corruption and kept the size of the government from shrinking. However, �slund ignores the IMF's efforts to assist governments in simplifying taxes and broadening their base.

Overall, the book provides a tour through more than a decade of transition history, with one of the most knowledgeable and erudite experts in the field as the guide.

The Tragedy of Russia's Reforms
Market Bolshevism Against Democracy

United States Institute of Peace Press, Washington, 2001, xxiii + 745 pp., $55 (cloth), $29.95 (paper).

The Tragedy of Russia's Reforms is foremost a comprehensive description of Russian political developments starting with Mikhail Gorbachev's perestroika and ending with the ascendancy of Vladimir Putin. Reddaway and Glinski offer a vivid, blow-by-blow account—based mainly on newspaper reports—of the ups and downs of the various political parties, groups, and personalities and their various alliances, animosities, and sordid accusations. Against this backdrop, the authors see the central feature of the most recent period as a struggle between "market bolshevism" and democracy, with democracy losing.

It might help to note that the authors define key terms within what they see as a Russian historical context. They define Bolshevism as reforms imposed from the top (the authors approvingly quote a description of Peter the Great as a Bolshevik). Russian democracy is said to be characterized by a participatory style, stress on collective interests, opposition to modernizing top-down reforms, and a relative lack of concern with materialistic values. Having offered these definitions, the authors conclude that the choice of "an abrupt marketization, privatization and deregulation led very rapidly . . . to the abandonment of the democratic road to reforms."

The choices Boris Yeltsin made in 1991 in launching radical economic reforms, according to the authors, contributed to a variety of ills during the 1990s. Reddaway and Glinski mention, although in a rather scattered fashion, all the major problems that any reforms would have had to address in late 1991: falling output, a distorted production structure, a large fiscal deficit, loose monetary policy, the virtual depletion of official reserves, widespread price controls and shortages, and nominal public ownership of a huge number of enterprises that were already being spontaneously "privatized" by their nomenklatura managers. To their credit, being so critical of Yeltsin and reformers, the authors see a need to spell out an alternative program. Unfortunately, it would be difficult to argue that their alternative—across-the-board gradualism—was feasible at all in late 1991.

Another problem with the authors' approach stems from their attitude toward the government. They recognize that the state had to reduce its role in the economy, but they did not believe that private economic agents could have replaced it without state assistance. Accordingly, they strongly support subsidized credit and tax benefits for those industries (such as military conversion, steel, energy, and infrastructure) that, in their opinion, are important for the development of the economy and for limiting output losses during the transition. Yet the authors also describe Russia's actual industrial policy: Yeltsin, touring provinces during his election campaign, indiscriminately offered cheap credits and tax exemptions. They condemn Yeltsin but fail to see a link between his actions and their own advocacy of similar policies.

Part of the problem might be the authors' uncertain grasp of economics. For example, they blame shortages of commodities under the conditions of price controls on traders' attempts to blackmail the government. They blame the weakening of the Soviet ruble in 1991, which resulted from loose financial policies, on speculation by the Sicilian mafia and Colombian cocaine cartels.

As for the role of the IMF in Russia's reforms, the authors describe it in a uniformly negative light: "The leitmotifs of IMF interventions from 1992 to 1998 were austerity, budget cuts, and deflation, with little regard for the social consequences." They neither discuss the rationale for these policy prescriptions or the extent to which IMF policy advice was actually followed, nor refer to the social safety nets in IMF programs. The authors believe that the IMF, from the beginning, should have recognized that the reforms would be implemented badly (that is, undemocratically) and refrained from offering assistance. The kernel of truth in what they say is that the reformers spent most of their time fighting for reforms to be implemented but little time explaining to the population the need for the reforms and the costs of partial implementation.

For a book with an emphasis on political issues, it is disappointing that the authors devote little space to constitutional issues, such as the hypothesis that the presidential system of government hinders reform. Overall, readers are likely to be impressed with the book's coverage of political events and controversies in Russia and the attempt to place them in their historical perspective. The treatment of economic issues, however, is unlikely to inspire the same respect. In this context, a key weakness is the complete absence of any comparative perspective, which, by contrast, figures so prominently in �slund's book.

Julian Berengaut,
Assistant Director,

and Erik De Vrijer,
Advisor,
IMF European II Department

Europe in the New Century
Visions of an Emerging Superpower

Lynne Rienner Publishers, Boulder, Colorado, 2001, xii + 268 pp., $16.95 (paper).

This lively collection of essays and interviews examines the political and economic future of the European Union over the next 20 years: how it might change with the accession of new members; the evolving power balance with other major actors, including the United States and China; and the challenges of shaping its foreign policy, trade, and development agendas while forging a new and common identity.

Based on the analysis and interpretation of leading journalists working in Europe, this volume also taps the vision of leading politicians, businesspeople, and young people from the 15-member European Union to focus on subjects ranging from the euro and the single market to the creation of jobs and technology for a globalized era.