JOHN EATWELL / LANCE TAYLOR Towards an Effective Regulation of International Capital Markets* T he fundamental objective of all financial policy is to ensure the best possible outcome in the real economy. In this respect the simplistic complaint that the financial sector produces nothing by itself contains an element of truth. But it is only a small element. In a complex economy, with widespread division of labor through products, space and time, a sophisticated financial sector is necessary for the organization of production and distribu­tion. An international financial system is necessary to sustain world trade and investment. An economy without money markets would not work at all. The mobilization of large quan­tities of capital, and the allocation of that capital to profitable investments is the device that has trans­formed standards of living throughout the world in the past 200 years. Financial institutions must therefore be judged by the contribution they make to that process and hence to growth and employ­ment. There is no point in having a financial sector that is in some sense»efficient« in its own terms if the result is a less efficient real economy. Over the past year the persistent economic crisis in Asia has called into question much of the received wisdom that liberalization has enhanced the economic contribution of international capital markets. The Asian crisis is but the most recent example of other similar episodes: the financial crises in Latin America in the early 1980 s, the European exchange rate crises of 1992 , and the Mexican bond crisis of 1994 . The explanations offered for these severe disruptions are various; indeed each crisis has a set of local explanatory factors. But they also have a common element – the impact of highly liquid international capital markets. These recurring episodes, most of which involve severe costs in terms of unemployment, loss of real income, and even stagnation, pose important questions for policy-makers: ̈ Given that every crisis has its own specific characteristics, what do their common factors suggest about particular strategies in inter­national financial policy? ̈ Should the ubiquitous policy stance of the past three decades in favor of international financial liberalization be qualified in the light of expe­rience? If so, how? ̈ Is any consistent policy toward financial mar­kets, other than liberalization, practically pos­sible? Or can the genie never be put back into the bottle? The succession of financial crisis in the past 20 years, the scale of what is happening now in Asia, and the reverberations of the Asian problems throughout the word, suggest that there is an urgent demand for answers to these questions. Increasingly, financial crises are not»local«. They have worldwide systemic implications. Satisfactory answers will require a clear and convincing theore­tical and empirical characterization of the rela­tionship between financial liberalization and eco­nomic performance. For without such a widely shared characterization it will be almost impossible to formulate an internationally acceptable policy stance, even at the most general level. It is the objective of this article to present the skeleton of such a characterization, and to draw from the argument a number of specific policy recommen­dations. These are neccessarily tentative. If there is anything economists should have learned from the experience of the past two years, it is humility! Nonetheless, in distinctly un-humble manner, we believe the arguments presented here do provide an intellectual framework that might guide prac­tical and successful reform. * The analysis in this article draws heavily on papers written by participants in a project on International Capital Markets and the Future of Economic Policy, organized by the Center for Economic Policy Analysis at the New School for Social Research and supported by the Ford Foundation. IPG 3/99 Eatwell/ Taylor, Regulation of International Capital Markets 279