The Need For A New Financial Architecture.

• Author: LITAN, ROBERT E.

As the last crisis recedes from memory, the financial system needs wholesale reconstruction.

As the world's financial and political elite assembled in Prague for their annual meetings this fall, the financial crisis of 1997-98 seemed like a distant memory. Then, all the talk was about "reforming the financial architecture" to prevent a future financial calamity.

Big plans were circulating. Some called for a new global financial regulator. Others called for dropping many of what were perceived to be intrusive conditions attached to the lending packages that the International Monetary Fund (IMF) arranged for troubled countries. Some wanted to abolish the IMF altogether.

Most recently, a commission chaired by Professor Alan Meltzer in the United States took a somewhat less drastic course. It recommended earlier this year that the IMF dramatically tighten the eligibility criteria for its short-term emergency lending, and urged the World Bank to restrict its longer-term lending to the poorest countries that can access the capital markets only at very high interest rates, if at all.

Yet none of these grander ideas has been implemented. This is not surprising. Even crises do not often precipitate wholesale changes in the way things are done. Instead, they usually lead to moderate, incremental reforms that turn out to be more helpful than is often recognized. The 1997-98 financial crisis has been no exception.

For example, the Southeast Asian countries, Russia, and Brazil--the countries at the heart of the last crisis--no longer peg their exchange rates to the dollar. This is perhaps the most welcome policy reform because it has removed the incentive for firms and financial institutions in those countries to borrow in foreign currencies at ostensibly lower interest rates, but with potentially significant currency risks.

In addition, the IMF did not come to the aid of Russia in 1998 or Ecuador in 1999. That lack of action helped reduce the likelihood that the availability of IMF lending would create a "moral hazard" for lenders and borrowers alike. This message was reinforced by the appointment of Horst Kohler as Executive Director, since Mr. Kohler comes from one of the IMF members--Germany--that has long worried about moral hazard.

In fact, the assertion in the joint communique coming out of Prague goes so far as to suggest that, "in extreme cases a temporary standstill may be unavoidable." This should be seen as a clear attempt to put the lending...