Economic Report President

CHAPTER 7The Evolution and Reform of theInternational Financial SystemTHE FINANCIAL PROBLEMS THAT BEGAN in Asia in the secondhalf of 1997 have exposed weaknesses both in emerging market countriesand in the international financial system. In response, the United Stateshas taken steps, jointly with the international community, not only tocontain the financial crisis but also to foster reforms of the internationalfinancial system to make it less crisis prone in the future. The recentturmoil followed a robust period of increasing integration of worldproduct and financial markets—a trend well epitomized by the longanticipatedrealization of European Monetary Union in January 1999.The recurrence of currency and financial crises in the world economyposes major challenges to policymakers. What are the causes of theserepeated crises, and of instability and financial market volatility?Are financial integration and globalization partly to blame? Doesintegration into modern global financial markets require the loss ofmacroeconomic policy autonomy? What regime of exchange rates is bestfor emerging market economies and other small countries in this newworld of global capital mobility? Can the Bretton Woods institutions—theInternational Monetary Fund (IMF) and the World Bank—which weredesigned for a world of fixed exchange rates and limited capital mobility,still promote the stability of the international financial system in aradically different environment? What institutional framework bestpromotes the stability of the international financial system? Answers tothese questions will be critical to efforts to strengthen the stability of theinternational financial system and help to ensure that global financialintegration will continue to sustain prosperity and growth in the worldeconomy.A broad international consensus now supports reform of the globalfinancial architecture to achieve several goals: to increase transparency(that is, to improve the availability of information about macroeconomicand financial conditions); to strengthen and reform domestic financialinstitutions so as to prevent crises from occurring; and to improve themechanisms available to resolve those crises that do occur. This chapterstarts by describing proposals that have been advanced in each of thesethree areas. It then analyzes the next steps that are being considered inthe redesign of the international financial system. Finally, it considersEuropean Monetary Union, the prospects for the euro as an internationalcurrency, and the possible implications for the U.S. dollar.267