When real world outcomes differ from the efficient ones predicted by mainstream models in text books, the memories of pro-capitalists are jogged to recall catch all phrases, like “perfect competition,” and “complete markets.” The word “perfect” refers to knowledge and requires complete and accurate information for all participants in the economy about the consequences of all their conceivable choices, as well as accurate knowledge about all present and future prices for all goods and services. When someone points out that there is uncertainty in the real world, mainstream theoreticians only think of things like earth quakes and hurricanes, and redefine “perfect” to include accurate information about the probability distributions of uncertain events. The word “competition” refers not to strategic behavior to best one's market opponents - which is what anyone grounded in the real economy would naturally assume - but instead, to the number of buyers and sellers in markets. A competitive market is one in which there are a sufficient number of buyers that no buyer can influence the price she must pay by deciding to buy more or less, and no seller can influence the price she receives by selling more or less. A “competitive” market is therefore one where all buyers and sellers are “price takers,” and all attempts at collusion are doomed to failure. In other words, the competitive market of mainstream theory is precisely a market in which all “competitive” behavior is pointless, and therefore not to be expected! Markets are “complete” if there is a market for everything of consequence. Completeness refers to coverage, and requires that anything that anyone cares about can be bought or sold in a market - a perfectly competitive market, of course. Once our capitalist visionaries remember that text book predictions of full and efficient use of all productive resources (including labor) depend on the assumption that there are perfectly competitive markets for everything, as explained above, economic policy is straightforward and simple: reform the real world to conform more closely with the assumptions of the text book models. Create new markets, generate more information, and add sellers and buyers to markets by clearing away obstacles to foreign participants. This is the logic behind conventional “new architecture” proposals, which are the standard remedies recommended by those who orchestrated international liberalization in the first place.

Greater transparency and disclosure by both public and private national financial institutions is called for so that depositors and investors are less likely to operate in blissful ignorance of negative developments, only to be jolted by unpleasant revelations when they become impossible to hide. Improved prudential regulation of banks and other financial institutions for developing countries is now recommended as a panacea, ironically by many of the same people who presided over deregulation of the financial sector in the US and in Europe during the past twenty years. It's amazing how many see the wisdom of “prudential regulation” of financial markets after a crisis has hit, but recommend removal of  “regulatory obstacles” to financial market “efficiency” when the credit system is running smoothly. There is a general consensus that reducing moral hazard is called for. But the question is whose moral hazard, and how to reduce it. Some complain that IMF bailouts lead third world countries to borrow more dangerously than they otherwise would dare to, because they believe they can count on the IMF for emergency loans if need be. Others complain that IMF bailouts lead international investors to make riskier loans than they otherwise would, because they count on IMF bailout loans to their creditors which can be used to pay them off when their investments have gone sour. Still others complain that national banking policy traditions such as those in Japan, South Korea, and China encourage private banks in those countries to go further in debt than they otherwise would because they believe they can rely on governments to back them up in case of trouble even if there has been no formal or legal underwriting agreement. And finally, many argue that an unintended side effect of government deposit insurance has been to eliminate monitoring of banking activities by depositors - who if uninsured would have more incentive to discipline risky banking practices by denying those banks their deposits.

But there are sobering short run economic costs to eliminating each of these practices that have, indeed, increased moral hazard. And there are long run costs to consider as well. What will happen to people in the next third world economy that needs emergency international financial help if it is not given? What will prevent financial contagion from spreading to other economies  deemed similar by international investors? What will prevent recessionary contagion from spreading from the economy that was not thrown a life saver to its trading partners? What will happen to the depositors as well as the stockholders in the next group of international banks,  and what will happen to the shareholders in the next group of mutual funds whose international investments fall into default because no international relief effort is launched? What will prevent contagion from spreading to other banks and mutual funds with extensive overseas investments? And what will prevent the ensuing financial crisis in the international investor economies from triggering an economic recession as those who lose their wealth consume less, and as financial institutions swamped with unexpected losses find it impossible to make new loans to perfectly healthy domestic businesses? Does not government deposit insurance reduce the incentive for runs on banks? Does not government deposit insurance keep interest rates lower and thereby stimulate economic growth? Nor is private deposit insurance a panacea. If equally effective, it creates the same moral hazard as public deposit insurance does currently. But it is unlikely to be as effective because the key to effective deposit insurance is that the insurer be perceived as “too big to fail” itself - otherwise we simply have an infinite regress of depositor doubts.  Since nobody bests Uncle Sam in the role of “too big to fail,” private deposit insurance cannot discourage bank runs or lower the cost of borrowing as efficiently as government deposit insurance.

Calls for better IMF surveillance of borrowing countries and making staff reports and minutes of IMF meetings public are now commonplace, as are suggestions for improved supervision in creditor countries. Another suggestion is to encourage private insurance companies to go into the business of selling insurance against international defaults to international investors. The idea is that international investors could invest in Russian government bonds, for example, and then take out an insurance policy on that investment, and the IMF would no longer need to intervene in the event of a Russian default to prevent financial panic in creditor nations' financial markets because investor losses would be covered. Proponents characterize this suggestion as creating a private market to replace a problematic public intervention. But notice, this “solution” does nothing for the Russian economy. It also does nothing for international investors who opt not to buy the (expensive) insurance. If there are enough who do not insure, the practical dilemma of whether or not to intervene remains, even if the moral case for allowing risk takers to suffer loses is made even more compelling than it already is.

I agree with my colleague Professor Robert Blecker's evaluations of all these “conventional new architecture” proposals: “Most of these measures are helpful but they are not sufficient to prevent financial crises or to lessen their impact on real economic performance. They are also not adequate for restoring high growth rates with full employment and broadly shared prosperity. We need different kinds of policies to make capital flows serve these objectives, rather than just to make capital markets work more efficiently and with less disruptions for wealthy investors.” (Policies for Restoring Financial Stability and Global Prosperity, chapter 3, Economic Policy Institute, forthcoming.) However, I would add that if those who suggest these reforms offer them as alternatives to more far reaching reforms -  which they usually do -  then they are not “helpful,” but counterproductive to efforts to combat international inequity and prevent disruptions in the international credit system that cause terrible economic waste. And I would also point out that precious few of the alternative proposals coming out of the “Keynesian” side of the mainstream discussed below address the issues of international inequality and environmental destruction. Not surprisingly they focus almost entirely on restoring financial stability and decreasing global disequilibrium.