The growing interdependence among the economies in the world has stepped up the need to engage in international economic cooperation. As economies become more interdependent, spillovers become more important and developments in one economy affect the welfare of other economies in the world. The more extensive the trading and investment links between countries, the deeper are the spillovers. Spillovers or externalities can be either positive or negative. For instance, a high economic growth rate in a country implies a healthy demand for imports from trading partners, whereas a recession in one country can have a negative effect on the performance of the export sector of its trading partners. The main objective of economic cooperation is thus to exploit the positive externalities and minimize the negative ones. Cooperative efforts, such as policy coordination, are intended to ensure that the external effects on partner countries are taken into account adequately in the decision-making calculus of a national government.

The public goods aspect of overall economic stability at the international level provides another motive for international economic cooperation. A stable international trading and financial system may be considered a public good in that all countries benefit from it, whether or not they have contributed to it. Public goods may be supplied by a government agency at the domestic level, such as a central bank that oversees the financial and economic stability of a country, but there is no comparable institution at the international level.⁴ Without modalities for coordination, countries may be tempted to seek the benefits of stability without assuming their share of the burden (free rider problem). The public good of stability may thus be undersupplied. International cooperation aims to instil in countries an understanding of their responsibilities in contributing to a stable economic and financial environment in the world. In addition, it would be impossible for the national institutions of a single or a small number of countries, however important, to ensure the stability of the global trading and financial system.

While there exist various reasons to promote the positive externalities, very often the avoidance of negative externalities provides the most compelling motivation for cooperation. For example, an upsurge in protectionist measures may be resisted in a country because of the beggar-thy-neighbour behaviour to which such a move could give rise. Cooperation can help minimize the prospect of competitive devaluations. Another important dimension to negative spillovers occurs when the policy mix pursued by a country is unsustainable and, in all likelihood, will be reversed in the near future. Sharp policy reversals have implications for the domestic allocation of resources and therefore carry domestic costs. Moreover, this introduces instability, imposes reallocation on the rest of the world, especially on trading partners, and generates negative international spillover effects. Cooperation can help avoid both the initial disturbance and the policy reversal.

Today an additional reason for international cooperation arises from the growth of open capital accounts and highly integrated capital markets of various sorts. Financial markets, by nature, are inherently prone to instability, owing to the fractional reserve system on which they are based. Weak financial systems at the national level can have long-lasting and insidious macroeconomic implications that are naturally of concern to central bankers; monetary stability and financial stability are two sides of the same coin. With integrated markets, financial instability is unlikely to remain contained within national borders. All financial disruptions are likely to have an international dimension because the three pillars of a domestic financial system, financial institutions, financial markets and payment and settlement systems, are increasingly international. The fact that financial transactions can be made, as well as market information disseminated, instantaneously and at almost no cost around the globe increases the probability that shocks in individual countries will be propagated elsewhere, even when such contagion might not be warranted by underlying economic fundamentals. The crises are increasingly coming in waves; they tend to be regional in scope and, even though they have more severe effects within the region of origin, no region is spared.

Indeed, the prospect of financial contagion argues for greater consultation and cooperation. The integration of the capital markets across the globe brings efficiency benefits in terms of competitive cost of funds, diversification benefits etc. However, there are also attendant risks associated with notions of contagion and systemic risks. There are at least three important characteristics of today's capital markets that raise different perspectives on risk.

First, a multiplicity of channels characterizes the transmittal of financial strains from one system to another. Traditionally, trade and investment links are considered to be the main transmission mechanism of disturbances across boundaries. It is now apparent that the transmission mechanism is wider and can include a sell-off instigated by a reassessment by the creditors of a country who become exposed to a previously ignored weakness in another country. The herd mentality of investors who pull out of a region composed of both crisis and non-crisis countries in one sweep on the basis of margin calls, internal risk-management guidelines, or plain panic provides another mechanism for contagion. A series of competitive devaluations in response to a similar action initiated by a country that faces an imminent currency crisis constitutes another channel for the propagation of contagion in a region.

Second, today's capital market is marked by the extremely high speed of transmission of information and transactions. Thus, any change in expectations could trigger massive fund transfers from one system to another and the loss in confidence by investors in a country can result in large and rapid capital outflows with very significant changes in asset prices, which could trigger a financial crisis. The implications of the speed of operations for the reaction time of policy makers in responding to a crisis are that they no longer enjoy the luxury of having a long time to analyse or to determine the appropriate policy response to the initial disturbance.

The third characteristic involves asymmetries in size, particularly between the financial resources available to the private capital market participants and the liquid assets of the official financial sector, and between the size of private capital flows and that of the domestic financial system of an emerging market. Private capital markets far exceed official assets, and international capital flows dwarf the size of the stock markets of almost all emerging markets. One implication of these disparities is that the speed and size of private flows, particularly short-term flows, can significantly destabilize the financial markets of emerging markets. Another implication is that speculative pressure arising from the markets can be very powerful and easily destabilize the asset markets and the exchange rate regimes.

The aforementioned realities impose several challenges on the task of promoting global financial stability. Any such strategy must begin by recognizing two facts: the pace of change in modern financial markets is extraordinary, ongoing and irreversible and financial transactions are becoming increasingly complicated and opaque, involving an ever-widening and changing cast of actors. Thus the system which policy makers aim to stabilize is both difficult to define at any moment in time and rapidly mutating. Moreover, new participants such as pension funds, mutual funds and hedge funds are not likely to behave in the same manner as traditional banks, implying new uncertainties about how the international financial system will react during periods of stress.

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Footnotes:

⁴ While there exist multilateral institutions such as IMF tasked with the oversight of elements of the international financial system, the role of IMF at the international level is not analogous to that of a central bank at the domestic level.