Just how serious a catastrophe do we need to get governments interested in tackling the instability of global financial markets? Well, it depends, of course, on who is affected.

The Asian crisis was disastrous for those countries directly involved - unemployment in Indonesia, Thailand and Korea rose from 5 million to 18 million between 1996 and 1998. But the fact that the West seems to have gotten through relatively unscathed may account for finance ministers' limited interest in radical reform.

The G7 group of industrialized countries has set up a Financial Stability Forum to coordinate the efforts of the Bank of International Settlements and other regulators to improve the prudential regulation of financial institutions and reduce unnecessary risk-taking. But little or no attention is being paid to the more basic problems of the instability of financial markets and exchange rates. Do we need a collapse on Wall Street and a run on the dollar before finance ministers start paying attention to these fundamental issues?

The Asian crisis was an extreme example of the way in which bubbles in asset prices, volatile capital flows and unstable exchange rates all feed on one another. At one moment a flood of foreign capital was helping to drive up share and property prices and putting upward pressure on exchange rates; the next moment, investors were panicking, the bubble burst and the outflow of capital led to plummeting exchange rates. It is not only such sensational movements in times of crisis that pose a threat. The instability of the major currencies is a continuing cause for concern, as British manufacturing firms can testify to their cost.

The present overvaluation of the pound has not only led to plant closures and job losses; if, and when, the pound does return to more reasonable levels, firms will not know how long it may last and will hesitate to put in more export capacity.

The international financial system is overdue for an overhaul. The last time this was done was in 1944, when the Bretton Woods Agreement set up the International Monetary Fund and the World Bank as part of an international regime designed to avoid a repetition of the instability and mass unemployment of the inter-war years. It is time for a new Bretton Woods that will take into account the way in which the world has changed since then.

Contrary to the once-fashionable belief, the liberalization of capital movements has not proved of benefit to all concerned. Developing countries, in particular, have suffered severely from herd movements of investors in and out of countries and assets that became the flavor of the month. Should we, or can we, attempt to put the genie back into the bottle? Certainly there is a strong case for allowing developing countries with emerging capital markets to take measures to regulate the inflow of volatile capital. Such measures can range from direct controls to financial penalties, such as were employed, relatively successfully, in Chile.

A further method of damping down speculative activity is the use of taxation. The proposal for a Tobin Tax, a small tax on all foreign currency transactions, has now re-entered public discussion as a means of raising finance for humanitarian and development purposes. The liberalization of capital markets and the growth of international financial markets led to the break-up of the Bretton Woods system of ``fixed'' exchange rates. A major weakness of such arrangements is that adjustments (virtually always devaluations) take place only in conditions of crisis, as was the recent experience of Asian countries with exchange rates pegged to the dollar.

It is neither practical nor desirable to return to such a system. The nearest alternative for countries whose economies are highly integrated and convergent is complete currency union, as in the EMU. For the rest, the problem is to find a more stable alternative to the present floating rate system - one that will be flexible enough to enable the necessary adjustments needed from time to time to be made smoothly. The desirability and practicality of some form of managed exchange rate system (or systems) is the major topic that should now be under public discussion. But so far, such discussion has been almost entirely confined to the limited question of managing the rate between the euro and the dollar. Experience with the ERM suggests that the key to success depends on three main factors. Rates must be agreed between the parties concerned. Changes must be small and relatively frequent (as opposed to large and infrequent in relatively ``fixed' rate systems). Stabilization arrangements must come into play automatically, and not after discussion between central banks.

It follows that there cannot be one all-embracing system. There are just too many countries and currencies involved. There must be a two-tier approach, with regional arrangements of varying kinds, and global arrangements to manage the rates between such groupings and the leading currencies on which they are based. The starting point would be a ``tri-polar'' system of management for the euro (plus sterling), the dollar and the yen, with the IMF responsible for a global stabilization fund.

It may be easier to start with informal arrangements without any stated exchange rate targets. But publicly stated parities and bands with effective automatic stabilization arrangements offer greater stability in the long run, and a firmer basis for industry to plan ahead. The evolution of a global and regional system on this basis should be a key item on the agenda for a new Bretton Woods Agreement.
 
JOHN GRIEVE SMITH
London Observer Service