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INTERNATIONAL ECONOMIC TURMOIL
TUESDAY, SEPTEMBER 15, 1998
U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.
The committee met, pursuant to call, at 2:10 p.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.
Present: Chairman Leach; Representatives Roukema, Bachus, Castle, Barr, Kelly, Paul, Snowbarger, LaFalce, Frank, Kennedy, Hinchey, Bentsen, J. Maloney of Connecticut, Sherman, Lee and Sanders.
Chairman LEACH. The hearing will come to order.
Today's hearing comes on the heels of yesterday's promise by the world's financial leaders to take certain action to deal with various economic problems facing nearly all continents of the globe. However, based on the testimony before this committee yesterday, the comments of senior financial ministers and central bank governors of the Group of 7 in London and the speech of the President in New York, it is far easier to identify the economic problems facing the world than coming up with solutions which will alleviate the conditions facing dozens of countries and their peoples.
Tomorrow we will hear the proposals of the most senior United States financial sector policymakers, Secretary Rubin and Federal Reserve Chairman Greenspan, but we open today's hearing with a person regarded by many as one of the most resourceful and successful, at least over the years, and certainly one of the most active participants in the international markets.
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Mr. Soros, we welcome you to the committee and await your suggestions for turning around weak economies in many parts of the world and extending the period of growth in this country.
I would like also to note that we have a statement by Anatoly Chubais, and I would like to ask unanimous consent to place it in the record. Without objection, so ordered.
[The prepared statement of Anatoly Chubais can be found on page 321 in the appendix.]
Chairman LEACH. His statement will be on the Banking Committee's web site, and it is a rather remarkable statement defending his stewardship time period in Russia.
Mr. LaFalce, do you have an opening statement?
Mr. LAFALCE. Thank you very much, Mr. Chairman.
The appropriateness of these hearings could not be greater as the events of the past many months have amply demonstrated. My personal congratulations to you, Mr. Chairman, not just for holding these hearings, but on convening such a tremendous array of panelists to share their knowledge and insights with us.
Yesterday, the President's address to the Council on Foreign Relations described the current situation as the ''biggest financial challenge facing the world in a half century.'' Yesterday's witnesses and today's witnesses will clearly corroborate that conclusion. Secretary Rubin and Chairman Greenspan, appearing tomorrow, have already publicly stated their beliefs that the crisis is severe. It now imperils not only Asia, Russia, and Eastern Europe, but runs through our neighbors in Latin America, and we are not immune from its effects.
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We know what Mr. Soros meant in his Wall Street Journal article this morning. ''There is an urgent need to recognize that financial markets, far from tending toward equilibrium, are inherently unstable. A boom/bust sequence can easily spiral out of control, knocking over one economy after another. Thus, in finding a remedy, market discipline may not be enough. There is also a need to maintain stability in financial markets.''
In January of this year, I said this was the most important issue facing the United States of America, the United States Congress and the world. Let me now repeat that a hundred times over. The President knows this. The almost unanimous bipartisan vote of the Senate on the IMF legislation indicates they know this. Secretary Rubin knows it. Chairman Greenspan knows it.
At some point soon, I hope the leadership of the House of Representatives comes to know this reality and acts before we recess. It would be unthinkable for us to depart Washington, DC., without acting on the IMF authorization.
This does not mean that we should be or are unmindful of the many flaws within the IMF, the World Bank, the G–7 apparatus, the development banks. President Clinton yesterday called on all of these and more to meet the crisis, each in its own sphere. And yet so many of the criticisms leveled against these institutions may have validity, and we would have to address those validities at the appropriate time.
But we can't address them before we recess. We can't address them before we approve the authorization for the IMF. It would be foolish to think so. There is no consensus right now amongst the experts as to what changes should be made either architecturally, that is institutionally, or implementation. So at least we need to put in place the resources to deal with this problem and not leave Washington without doing that.
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Of course, there are certain reforms that are essential internationally in every country. Sound accounting throughout the world financial system—we don't have it. We must have it—vastly improved statistical reporting, accurate disclosures, bankruptcy procedures that do not discriminate against foreign investors, independent judiciaries, adherence to the rule of law. These are just a few, and we are not going to get them overnight. The absence of these makes the job all the more difficult, but all the more imperative that we do everything we can now.
The witnesses that we have heard up till now and today have done this in the context, in large part, of appalling examples of disintegration from Russia through Southeast Asia, where the progress of decades is faced with ruin.
Some ask: could not the IMF and all the other various institutions and businesses in the international machinery have been reformed over the years so that the world would have been more orderly and contingencies planned to avoid the present situation?
Maybe so, but I think very unlikely; and, in any event, it wasn't done.
I believe Congressman Frank hit on the reason yesterday. The entire global scene was totally altered by the rapid fall of communism, not only as the ideology controlling vast territory and many governments, but as a way of looking at economics. Not only was communism destroyed and its cousin, socialism, brought low, capitalism and the idea that it was the firmest ally of democracy were very rapidly elevated.
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In short, the mistakes, including how the entire recent situation has been handled with Russia going from this transition from a centrally planned economy to a market-based economy, has been in large part responsible, I think, for these quickly and greatly altered circumstances.
We are seeing another facet of the changes now—the financial crisis itself, largely induced by the ''excessive exuberance'' that did come about. Political exuberance, financial exuberance.
In economics, not only has the strong trend been away from communism, but also from state planning and ownership in general. Around the world, the efficiencies of private enterprise and market pricing have led to the end of innumerable, government-owned businesses and the opening of huge, new trade opportunities such as those in China. Therefore, it is no surprise that mistakes and imbalances have cropped up as the world has felt its way toward an almost entirely new way of looking at itself.
We have appreciated the domino effect risk of failure, and what we have not adequately appreciated is the risk associated with an ''embarrassment of riches.''
I hope we can deal with this problem head-on through a critical analysis that will help the world to move through to the prosperity and ensuing peace which democracy, private enterprise and individual opportunity promise. These hearings, and the reevaluation which has begun in so many quarters, all contribute to that effort, which I hope, given sustained engagement, can and will succeed.
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Again, I thank the Chair.
[The prepared statement of Hon. John J. LaFalce can be found on page 279 in the appendix.]
Chairman LEACH. Thank you, John.
Mrs. Roukema.
Mrs. ROUKEMA. Thank you, Mr. Chairman. I will make a short introductory remark as I greet our first panelist here today. I certainly thank you and express my appreciation for holding these very timely hearings.
As we all know in this room certainly, not a day goes by that we don't read in the newspapers about what appears to be new problems, whether it is Russia, Asia, or South America, but clearly there are unfolding expanded problems in the world financial order. I am certainly heartened to read and encouraged in reading and learning that the Administration has finally seen fit to call for a financial summit of the G–7 plus other developing nations to discuss these international financial problems and what should be done with the IMF, World Bank, and other international financial institutions.
Indeed, earlier today my colleague Mr. Bereuter, suggested that a Blue Ribbon Committee be appointed by Congress and the Administration to report back to the Congress on what types of reforms might be necessary in the IMF. And I want to be clear, that was not a recommendation that would defer or postpone the recapitalization of IMF, but to coordinate with our ongoing effort. I believe this is probably a good idea whose time has come.
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There are other types of reforms, reforms that we already have considered within the committee, that may be necessary and appropriate. I won't go into those reforms. I think the Chairman, and certainly the Ranking Member, have referenced them. But we need at least those types of reforms, and I am certainly looking forward to hearing what our panelists today would have to say on that matter.
Clearly, we live in a global economy. The Chairman of the Federal Reserve Board, Alan Greenspan, testified to that effect recently and that the U.S. economy is starting to feel the effects of the Asian meltdown. The trade deficit has started to balloon. U.S. exporters, notably the farm sector, have experienced significant declines in shipments due to the Asian currency problems. Main Street will start to feel the effects of these meltdowns in the near future.
In other words, and this is I hope a message that can come out of these hearings, this is not foreign aid that we are talking about. It is in our own economic self-interest to deal with the problem.
I am quite pleased to have Mr. George Soros here today. I understand he supports IMF funding, and I agree with him. I look forward with great interest to his testimony. I also look forward to whatever suggestions and recommendations he might make, both he and our other witnesses, who not only believe in the IMF, but also are recommending some reforms.
What is clear, however, and I heard Mr. LaFalce say, is that the Congress must act. If we do not fund the IMF, we would be totally irresponsible, and we must act on IMF funding before this Congress adjourns—ASAP.
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Thank you, Mr. Chairman.
Chairman LEACH. Thank you, Mrs. Roukema.
Anybody else who wants to make an opening statement?
Let me turn to this side. If I can, I'd like to kind of set a little bit of a time limit so that we can turn to our witnesses by, let's say, 25 of the hour. How many more wish to make—three people—four. Can I suggest three minutes each? Is that all right?
Mr. SANDERS. OK with me.
Chairman LEACH. Mr. Sanders.
Mr. SANDERS. Thank you, Mr. Chairman. I want to congratulate you for holding these hearings and welcome Mr. Soros.
Clearly, what John LaFalce said a moment ago is absolutely right. We are dealing with an issue of enormous consequence for this country and for the world. Unfortunately, I end up disagreeing with where Mr. LaFalce is coming from.
In my view, for the past decade, through both Republican and Democratic Administrations, the United States Government has promoted a model of free market global capitalism that it claimed would benefit the great majority of people both at home and abroad. That model has failed. The countries that would showcase this globalization success are now in economic shambles. South Korea's economy has shrunk by 45 percent, Thailand by 50 percent. Indonesia's has shrunk by nearly 80 percent. And gross domestic product per capita has fallen from $3,500 to $750.
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The economic crisis that began in Asia is now ricocheting around the world. Russia is in default, Japan in recession, and Africa and Latin America in financial turmoil. The United States' bubble economy is showing puncture wounds with a decline in manufacturing, a sharp contrast in agriculture, a fall in corporate profits and wild gyrations on Wall Street.
The past decade of globalization has created an incredible concentration of wealth. We don't talk about that too much, but we should. 358 individuals now have a combined wealth greater than the poorest 45 percent of the people on earth, 2.3 billion people. 358 people here, 2.3 billion there. The concentration of wealth in the world has become significantly starker.
In our own country, one man, not Mr. Soros, Mr. Gates, owns more wealth than the bottom 100 million Americans; and that concentration of wealth in disparity between the rich and the poor has grown significantly wider with the explosion of the global economy.
While many Americans are deeply concerned about the speed and direction of the global economy, the Clinton Administration, Republican leadership and corporate America seek to further accelerate the globalization juggernaut and this is unfortunate. In my view, the International Monetary Fund, the IMF, established at the end of World War II to stabilize exchange rates, has become instead the prime architect and enforcer for global capitalism. In exchange for rescue loans, it has imposed ruinous structural adjustment and shock therapy plans that have bled debt-ridden countries virtually to death.
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While the IMF's actual operations have been little known to most Americans, and even to many Members of Congress, the spectacular failures of its recent bailouts in Russia, Asia, and Mexico have finally brought its disastrous policies of imposed austerity, corporate welfare and, indeed, regulation into question.
As the manic boom phase of globalization began to falter with the outbreak of the Asian crisis a year ago, the Clinton Administration, many in the Republican party and all of corporate America decided that expanded funding for IMF bailouts was the best hope for stalling the deflationary contagion and for protecting the speculative loans and investments made by people in the international financial community. It therefore promoted an $18 billion replenishment—actually, a huge expansion of IMF funding.
Bottom line is, in my view, we need to take a very hard look at what the IMF has been doing and whether, in fact, they have been making a dangerous situation even more dangerous. Should we turn our backs on the global economy? Absolutely not. But should we continue down a failed path which has left disaster in so many countries? I think not.
So, Mr. Chairman, I thank you for these hearings, and I look forward to what Mr. Soros and others have to say, but I do not believe that we should blindly continue to put money into the IMF to bail out international speculators, to continue a process which makes the richest people in this country richer and which places at risk billions of taxpayer dollars in this country.
Thank you, Mr. Chairman.
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Chairman LEACH. Thank you, Mr. Sanders.
Mr. Bachus.
Mr. BACHUS. Thank you, Mr. Chairman.
Mr. Soros, you were one of the people who called for the devaluation of the ruble. Last Thursday, the subcommittee which I chair held hearings concerning the Russia crisis, and we heard from the Under Secretary of International Affairs, David Lipton. And he, in fact, said that that devaluation went against their policy and that it actually had precipitated a deepening of the crisis in Russia.
I know you are here today to advocate IMF policies and that you support—from what others have said—the IMF and their efforts, but I do want to inquire into that obvious difference of opinion about devaluation, and I think it would be a very interesting hearing.
Thank you.
Chairman LEACH. Thank you very much, Mr. Bachus.
Mo, did you want to make an opening statement?
Mr. Hinchey.
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Mr. HINCHEY. I would forego it except to say I want to congratulate you and thank you for the focus of attention you brought to this particular subject. It is a dire one indeed. It requires the focus of the Congress. There is even some question as to whether or not we will be capable in dealing with it completely. Nevertheless, it is a very, very serious situation and needs to be addressed.
And the way to address it is not by weakening the IMF, even though they have made some very serious mistakes in the course of their recent actions unquestionably. But our purpose here should be not to weaken the IMF, but to strengthen other international means by which the situation ought to be dealt with.
And I thank you very much, and I look forward to hearing Mr. Soros' testimony.
Chairman LEACH. Thank you.
Before turning to Mrs. Kelly—I would like to end with you—I am told Mr. Paul has an opening statement. Would you like to make—we are trying to hold it to three minutes. We made a prior agreement—prior to you coming, Ron.
Mr. PAUL. Thank you, Mr. Chairman. I will make it brief.
I would like to congratulate the Chairman for holding the hearings. Obviously, this is a very serious problem. I would like to make the point that we should not blame capitalism for this. We should direct our attention to the fiat currencies of the world, the easy credit we have been living with for decades. When we talk about lowering rates and when we talk about having liquidity, we are asking for more inflation and more debasement of the currency.
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So it isn't a lack of capitalism, it isn't a lack of freedom, it isn't a lack of sound money, and it isn't a lack of international agencies that is our problem. We lack sound money. We lack the marketplace. And the sooner we think about that and talk about the real problem, the problems brought about by the currencies of the world being a fiat currency that are created endlessly by all the central banks, we cannot get to the bottom of this problem.
More inflation, although it may help, just like it will help a drug addict, will make the problem that much worse. So, eventually, we will have to talk about the currencies of the world, and some day we should have a sound currency.
Thank you.
Chairman LEACH. I would like to conclude the opening statements with our witness' Congresslady, Mrs. Kelly.
Mrs. KELLY. Thank you very much, Mr. Chairman, Ranking Member LaFalce.
To be brief, I just want to thank you both for holding the three hearings that you are holding this week on this continuing economic turmoil. We have witnessed in vivid detail the ramifications to our markets of a global economy that is in distress, and we know about the effects of the crisis, but what we need to look at now is the future of the crisis, where it may go from here and what we can do to prevent problems like this in the future.
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One issue that this committee, for the most part, stands together on is the need to approve a new quota increase and the New Arrangements to Borrow for the IMF. On March 5, this committee passed H.R. 3114, a bill to do this by a strong 40-to-9 vote.
One point I want to be very clear on is that this Congress continues to be ready and willing to work with this President to address the economic situation.
Today, I really am very pleased to see this impressive group of witnesses who have agreed to join us. I am especially pleased to see that Mr. George Soros is here. He's not only a constituent, but a neighbor of mine.
I am your Congresswoman, Mr. Soros, and I am glad you are here to join us today and give us the insights and considerable breadth of your knowledge. I am very appreciative that you and the rest of the witnesses are willing to take time out of your very busy schedules to discuss the ramifications of this crisis with us.
And again, I thank you very much, Mr. Chairman.
Chairman LEACH. Thank you, Mrs. Kelly.
With that introduction, we will turn to our witness with one observation. Political scientists say Members of Congress are supposed to represent the common man, and so we have Mrs. Kelly's uncommon common man.
Please, Mr. Soros.
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STATEMENT OF GEORGE SOROS, CHAIRMAN, SOROS FUND MANAGEMENT LCC
Mr. SOROS. Thank you, Mr. Chairman, distinguished Members of the committee.
If you will permit me, I will read my written testimony first, and I would be very happy to answer questions afterwards.
I think that this hearing is very timely, because the global capitalist system which has been responsible for the remarkable prosperity of this country in the last decade is coming apart at the seams. The current decline in the U.S. stock market is only a symptom, and a belated symptom at that, of the more profound problems that are afflicting the world economy. Some Asian stock markets have suffered worse declines than the Wall Street crash of 1929 and, in addition, their currencies have also fallen to a fraction of what their value was when they were tied to the U.S. dollar.
The financial collapse in Asia was followed by an economic collapse. In Indonesia, for instance, most of the gains in living standards that accumulated during 30 years of Suharto's regime have disappeared. Modern buildings, factories, and infrastructure remain, but so does a population that has been uprooted from its rural origins.
The Japanese banking system is in deep trouble. The world's second largest economy just reported an annualized 3.3 percent decline in economic activity for the second quarter. Currently, Russia has undergone a total financial meltdown. It is a scary spectacle, and it will have incalculable human and political consequences. The contagion has now also spread to Latin America.
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It would be regrettable if we remained complacent just because most of the trouble is occurring beyond our borders. We are all part of the global capitalist system which is characterized not only by free trade but, more specifically, by the free movement of capital. The system is very favorable to financial capital which is free to pick and choose where to go, and it has led to the rapid growth of global financial markets. It can be envisioned as a gigantic circulatory system, sucking up capital into the financial markets and institutions at the center and then pumping it out to the periphery, either directly in the form of credits and portfolio investments, or indirectly through multinational corporations.
Until the Thai crisis in July, 1997, the center was both sucking in and pumping out money vigorously, financial markets were growing in size and importance, and countries at the periphery could obtain an ample supply of capital from the center by opening up their capital markets. There was a global boom in which emerging markets fared especially well. At one point in 1994, more than half the total inflow into U.S. mutual funds went into emerging market funds.
But the Asian crisis reversed the direction of the flow. Capital started fleeing the periphery. At first, the reversal benefited the financial markets at the center. The U.S. economy was just on the verge of overheating, and the Federal Reserve was contemplating raising the discount rate. The Asian crisis rendered such a move inadvisable, and the stock market took heart. The economy enjoyed the best of all possible worlds with cheap imports keeping domestic inflationary pressures in check, and the stock market made new highs. The buoyancy at the center raised hopes that the periphery may also recover, and between February and April of this year most Asian markets recovered roughly half their previous losses measured in local currencies. That was a classic bear market rally.
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There comes a point when distress at the periphery cannot be good for the center. I believe that we have reached that point with the meltdown in Russia. I have three main reasons for saying so.
One is that the Russian meltdown has revealed certain flaws in the international banking system which had been previously disregarded. In addition to their exposure on their own balance sheets, banks engage in swaps, forward transactions and derivative trades among each other and with their clients. These transactions do not show up in the balance sheets of the banks. They are constantly marked to market, that is to say, they are constantly revalued and any difference between cost and market made up by cash transfers. This is supposed to eliminate the risk of any default.
Swap, forward and derivative markets are very large and the margins razor thin. That is to say, the value of the underlying amounts is a manifold multiple of the capital employed in the business. The transactions form a daisy chain with many intermediaries, and each intermediary has an obligation to his counterparties without knowing who else is involved. The exposure to individual counterparties is limited by setting credit lines.
This sophisticated system received a bad jolt when the Russian banking system collapsed. Russian banks defaulted on their obligations, but the Western banks remained on the hook to their own clients. No way was found to offset the obligations of one bank against those of another. Many hedge funds and other speculative accounts sustained large enough losses that they had to be liquidated. Normal spreads were disrupted, and professionals who arbitrage between various derivatives, that is to say, trade one derivative against another, also sustained large losses.
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A similar situation arose shortly thereafter when Malaysia deliberately shut down its financial markets to foreigners, but the Singapore Monetary Authority, in cooperation with other central banks, took prompt action. Outstanding contracts were netted out, and the losses were shared. A potential systemic failure was avoided.
These events led most market participants to reduce their exposure all round. Banks are frantically trying to limit their exposure, deleverage and reduce risk. Bank stocks have plummeted. A global credit crunch is in the making. It is already restricting the flow of funding to the periphery, but it has also begun to affect the availability of credit in the domestic economy. The junk bond market, for instance, has already shut down.
This brings me to my second point. The pain at the periphery has become so intense that individual countries have begun to opt out of the global capitalist system, or simply fall by the wayside. First Indonesia, then Russia have suffered a pretty complete breakdown, but what has happened in Malaysia and to a lesser extent in Hong Kong is in some ways even more ominous. The collapse in Indonesia and Russia was unintended, but Malaysia opted out deliberately. It managed to inflict considerable damage on foreign investors and speculators, and it managed to obtain some temporary relief, if not for the economy, then at least for the rulers of the country. The relief comes from being able to lower interest rates and to pump up the stock market by isolating the country from the outside world and squeezing short sellers.
The relief is bound to be temporary, because the borders are porous and money will leave the country illegally. The effect on the economy will be disastrous, but the local capitalists who are associated with the regime will be able to salvage their businesses unless the regime itself is toppled.
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The measures taken by Malaysia will hurt the other countries which are trying to keep their financial markets open, because it will encourage the flight of capital. In this respect, Malaysia has embarked on a ''beggar-thy-neighbor'' policy. If this makes Malaysia look good in comparison with its neighbors, the policy may easily find imitators, making it harder for the others to keep their markets open.
The third major factor working for the disintegration of the global capitalist system is the evident inability of the international monitory authorities to hold it together. IMF programs do not seem to be working. In addition, the IMF has run out of money. The response of the G–7 governments to the Russian crisis was woefully inadequate, and the loss of control was quite scary. Financial markets are rather peculiar in this respect: They resent any kind of government interference, but they hold the belief deep down that if conditions get really rough the authorities will step in. This belief has now been shaken.
These three factors are working together to reinforce the reverse flow of capital from the periphery to the center. The initial shock caused by the meltdown in Russia is liable to wear off, but the strain on the periphery is liable to continue.
The flight of capital has now spread to Brazil, and if Brazil goes, Argentina will be endangered. The forecast for global economic growth are being steadily scaled down, and I expect they will end up in negative territory. If and when the decline spreads to our economy, we may become much less willing to accept the imports which are necessary to feed the reverse flow of capital, and the breakdown in the global financial system may be accompanied by a breakdown in international free trade.
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This course of events can be prevented only by the intervention of the international financial authorities. The prospects are dim, because the G–7 governments have just failed to intervene in Russia, but the consequences of that failure may serve as a wake-up call. There is an urgent need to rethink and reform the global capitalist system. As the Russian example has shown, the problems will become progressively more intractable the longer they are allowed to fester.
The rethinking must start with the recognition that financial markets are inherently unstable. The global capitalist system is based on the belief that financial markets, left to their own devices, tend toward equilibrium. They are supposed to move like a pendulum: They may be dislocated by external forces, so-called ''exogenous shocks,'' but they will seek to return to the equilibrium position.
This belief is false. Financial markets are given to excesses, and if a boom/bust sequence progresses beyond a certain point, it will never revert to where it came from. Instead of acting like a pendulum, financial markets have recently acted more like a wrecking ball, knocking over one economy after another.
There is much talk about imposing market discipline, but imposing market discipline means imposing instability and how much instability can society take? Market discipline needs to be supplemented by another discipline: Maintaining stability in financial markets ought to be the objective of public policy. This is the general principle that I should like to propose.
This principle has, in fact, already been accepted and implemented on a national scale. We have the Federal Reserve and other financial authorities whose mandate is to prevent a breakdown in our domestic financial markets and, if necessary, act as lenders of last resort. I am confident that they are capable of carrying out their mandate.
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But we are sadly lacking in the appropriate financial authorities in the international arena. We have the Bretton Woods institutions—the IMF and the World Bank—which have tried valiantly to adapt themselves to rapidly changing circumstances. Admittedly the IMF programs have not been successful in the current global financial crisis. Its mission and its methods of operation need to be reconsidered.
I believe additional institutions may be necessary. At the beginning of this year, I proposed establishing an International Credit Insurance Corporation, but at that time it was not yet clear that the reverse flow of capital would become such a serious problem, and my proposal fell flat. I believe its' time has now come. We shall have to establish some kind of international supervision over the national supervisory authorities. We shall also have to reconsider the workings of the international banking system and the functioning of the swap and derivative markets.
These issues may be beyond the purview of Congress. There is, however, one issue which is very much within its jurisdiction. That is the request to authorize an increase in the capital of the IMF. I am aware that Congress was greatly influenced by the testimony given by George Shultz opposing such an increase. I hope my remarks will serve to contradict that testimony.
George Shultz argued that it is better if markets are allowed to look after themselves than if they are looked after by regulators. There is an element of truth in his argument, because regulators do make mistakes. The IMF approach clearly didn't work. Otherwise, we would not find ourselves in the current situation. But that does not mean that financial markets can look after themselves. Everybody looking out for his or her self-interest does not lead to equilibrium, but to what Alan Greenspan has called ''irrational exuberance'' and afterwards, panic.
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George Shultz inveighed against a moral hazard of bailing out irresponsible investors and speculators. Here he has a valid point. Bailouts did encourage irresponsible behavior, not so much by speculators—because we know that we have to take our lumps when markets decline—but by banks and other lenders who could count on the IMF coming in when a country got into difficulties. The IMF imposed tough conditions on the country concerned, but it did not impose any penalties on the lenders.
This asymmetry in the treatment of lenders and borrowers is a major source of instability in the global capitalist system, and it needs to be corrected. It has to be a central point in the soul searching that the IMF must undergo, but I am glad to say that the IMF is a fast learner. In its $2.2 billion program in Ukraine, it is now imposing a new condition: 80 percent of Ukraine's treasury bills have to be ''voluntarily'' rescheduled into longer-term, lower yielding instruments before the program can go forward. This means that the speculators or investors who bought those bonds have to take a hit, and this is a long way from the Mexican bailout of 1995 where the holders of Mexican treasury bills came out whole and which was a serious case of creating moral hazard.
The moral hazard now operates in the opposite direction, in not enabling the IMF to do its work when it is most needed. Congress bears an awesome responsibility for keeping the IMF alive. I am convinced that the attitude of the Congress was already an important element in the failure to deal with Russia because it did not have sufficient funds. As you probably know, I have foundations in many of the formerly communist countries. Some of these countries are badly hit from the fallout of the Russian collapse. Countries like Moldova and Romania have nowhere else to turn but the IMF. The IMF is perfectly capable of assisting them without any further reforms. It would be tragic if it ran out of resources.
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Replenishing the capital of the IMF, however, will not be sufficient to resolve the global financial crisis. A way has to be found to provide liquidity not only at the center but also at the periphery. I believe there is an urgent need for the creation of Special Drawing Rights which can be used to guarantee the rollover of the already existing debt of countries which receive the IMF's seal of approval. If there is no reward for good behavior, meltdowns and defections will multiply. But such radical ideas can't even be considered until Congress changes its attitude toward international institutions and the IMF in particular.
So far, our stock market has escaped relatively unscathed, and our economy has actually benefited from the global crisis, but make no mistake: unless Congress is willing to support the IMF, the disintegration of the global capitalist system will hurt our financial markets and our economy as well, because we are at the center of that system.
Thank you very much, and I would be happy to answer your questions.
[The prepared statement of George Soros can be found on page 287 in the appendix.]
Chairman LEACH. Thank you very much, Mr. Soros.
In the latter part of our hearings, we are going to hear from three academic experts on the subject of corruption and crony capitalism. One of the concerns of Congress that relates to anything that involves underpinning world economic situations based on U.S. taxpayer funds is the status of corruption. That is, what can we do to assure that any resources that we provide to help are not simply transferred into the pockets of few for the benefit of even fewer? Do you have any advice in that regard?
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Mr. SOROS. Well, I very much support that position, that, in fact, corruption has been perhaps the main factor in the two cases where there has been a total collapse, in Indonesia and Russia. And I hope that in the future the IMF and the World Bank will have learned from that experience and will be much more concerned with imposing conditions that deal with corruption.
Unfortunately, the IMF comes in very late in the process, and private capital has been really quite intensive to the dangers of corruption. Indonesia has been a country that was very much favored by investors because there was a receptive local partner which usually included a member of the family—Suharto's family. And this was very much part of the scene in Indonesia, and I hope not only the IMF, but also private investors will remember that lesson.
Chairman LEACH. In terms of Russia, Anatoly Chubais, in his statement given to us today, makes the point of the problems of protectionism, particularly in the banking sector. It strikes us as a Banking Committee, because banking is our principal jurisdiction, that unless a society has an intermediary financial system to serve as a bulwark for savings and investment, the country is in pretty dire straits. How do you look at the Russian banking system and what can be done there?
Mr. SOROS. Well, basically, Russia's banking system has been wiped out by what has happened. I didn't talk about the corruption in Russia, but, of course, it was a very important element in the Russia situation as well. The banks—most of the banks, with one exception, Asbada Bank—were basically vehicles of the rapid capitalists or the oligarchs. And some of them had some public accounts—in fact, my foundation's employees had lost all of their money in one of these banks, but these banks were not really terribly significant for the overall economy. So they should have been let to go bust and, in any case, they are now a bust.
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However, it will be extremely difficult for Russia to function without any financial structure and with a default situation. Where the danger is that there will be absolutely no credit available even for financing normal commercial transactions. So the situation in Russia is quite dire, very, very serious.
Chairman LEACH. Mr. LaFalce.
Mr. LAFALCE. Thank you, Mr. Chairman.
Mr. Soros, for a number of years I was Chairman of the House Small Business Committee; and during the time of 1990 to 1994, I held a great many hearings on the issue of privatization, the privatization that was taking place in the former communist counties.
And one of my chief concerns was that virtually everyone in the U.S. Treasury, in the IMF, European Bank for Reconstruction and Development, and so forth, was concerned with one issue and one issue only, and that was the efficiency of privatization as opposed to the equity of privatization. And I was concerned that the privatizations that were taking place were transferring the wealth of the society which was in the hands of the state into the hands of patrones, into the hands of the nomenclature, into the hands of transnational corporations. But we were losing a tremendous opportunity to help transfer that wealth into the hands of the people in a way that could foster small business and a medium-sized business class and in a way that could develop a middle-income class and also in a way that was almost inevitably going to lead to mammoth corruption.
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Number one, do you share any of that perspective? And, number two, whether you share that perspective or not on that issue, is the present situation where we see the virtual bankrupting of these oligarch groups not a crisis, but an opportunity to make lemonade out of lemons, to help develop a small business class, a medium business class, to help create a more equitable distribution of the potential wealth that exists in these countries?
Mr. SOROS. Well, as regards to the past, I very much agree with your position. I think we missed an historical opportunity to help what was then the Soviet Union to make the transition to what I call an open society. Because without that help, it was impossible to make the transition. You can't go from socialism to capitalism without a form of rubber capitalism, because there is no local capital available to buy the privatized companies. So it had to be the main way that capital could be created would be by stealing from the state.
It is not the only way, because there were actually some entrepreneurs who started building up their businesses, and they are still around. So one shouldn't overstate it. But the bulk of the economy fell into the hands of people who actually were, I say the insiders, the nomenclature, and gained control of the assets, established companies in Cypress, and then siphoned off the assets to their private benefit.
And the only way that this could have been avoided is if we had taken a more intrusive and more aggressively helpful attitude which, at the time, people there were really crying out for. I proposed some kind of a Marshall Plan at the meeting, and I was literally laughed at, so it was not an idea that—how should I say—had any kind of backing in the West. But I personally have been very engaged in Russia, and I think I have demonstrated that it is possible to do something and do it well, and it is possible to make things work.
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So as far as the past is concerned, I think we have lost the historical opportunity. As far as the present and the future, of course, there is always hope; and, of course, the biggest grounds for hope is the development of the human capacity in Russia. Because there has now been eight years of, let's say, not-very-well-functioning open society, and young people have really become very creative and very capable. There has been a lot of learning. A lot of capacity has developed.
Unfortunately, I can't be optimistic for the outlook, because the government that fell was actually the best government Russia could have produced. It had in it a pretty unified group of people who were, I would say, remarkably uncorrupt in a totally corrupt environment and moving toward serious reform. Now you have the reversal to the regime that has collapsed, and I don't think that you now have people who would be able to deal with the situation, this dire emergency.
But democracy is still there. I mean, they still have elections; and, hopefully, they will elect a better government; and then Russia can move forward.
Chairman LEACH. Mrs. Roukema.
Mrs. ROUKEMA. Thank you, Mr. Chairman.
I don't quite know how to ask the question, and I am going to introduce the question by referencing what I understood that you said, Mr. Soros, in your statement and also in your Wall Street Journal article. And I like it, but I want a little more specificity.
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As I said in my introduction, we need the reforms that we have already called for. I also referenced the idea of a Blue Ribbon Commission as we look forward, not that that would deny us capitalizing the program now. But you did say, and I was happy to hear, that imposing market discipline, particularly that kind of rhetoric that I hear from some who are opposing the IMF, but you very articulately said that any market discipline has to be supplemented because there are pros and cons and it is a two-edged sword. I like that.
But I want to know, taking the question of the moral hazard as you outlined it, you said that there must be penalty. Presently there are no penalties on lenders. That should probably be part of the reforms as we address the moral hazard question. I believe you said that this must be a central point in the soul-searching at the IMF. I wonder if you can amplify on what you meant by that. Does it relate directly in your Wall Street Journal article to your statement regarding the Special Drawing Rights, the creation of Special Drawing Rights that can be used to guarantee the rollover?
But then you go on to say, ''If there is no reward for good behavior, meltdowns and defections will multiply.'' How can we translate those truths into some sort of reforms with the IMF practices?
Mr. SOROS. There are actually two separate issues between the Special Drawing Rights and the moral hazard issue. So let me deal with them in turn. There is an asymmetry in the system as it has currently evolved between the way lenders and borrowers are treated. The system favors the lenders and basically punishes the borrowers, because all the tough conditions are imposed on the borrowing countries. They are given money which enables them to service their debt. So, indirectly, it enables them to make banks and other lenders whole.
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Of course, the big flaw in the Mexican bailout, where the holders of dollar-denominated Mexican treasury bills were paid off in full even though at the time they bought those treasury bills—there was already a significant risk premium built into the price and effectively the holders were paid out.
That created a moral hazard for the future. It actually led to a renewed bout of international lending. So you had a renewed boom very shortly after the Mexican crisis.
So, recognizing this, I think that the IMF ought to change the way it operates and impose conditions on the lenders or the investors as well as on the borrowing countries and specifically——
Mrs. ROUKEMA. The traders?
Mr. SOROS. Actually, even investors and banks. You see, you have a big problem, for instance, in Korea and Thailand that the borrowing companies have tremendous amount of debt and very little equity, and the only way that you can correct this is some kind of a bankruptcy or capital reorganization process which would convert the debt into equity. And then those companies with a changed financial structure would be perfectly viable because, particularly in Korea, they are quite efficient operations.
So you need a conversion of debt into equity, but that would penalize the holders of debt, and they would then refuse to lend to other borrowers, and so you would have a shortfall of credit, and so you cannot change—this makes it very difficult to impose such a program unless it is announced in advance. You can't do it at the height of the crisis—actually, the IMF does not have enough resources to replace the older private credit. It has to gain the support of the market for its program and, therefore, it cannot penalize those whose support it is seeking.
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That is a quandary which has led to this asymmetry and to the development of this moral hazard; and, therefore, I think that the change has to be implemented well in advance so that people know that in the future when a program is—when the IMF comes in a program, it may impose conditions on the lenders as well as on the borrowers.
Now, interestingly, unnoticed by the general—actually, practically by everyone, the IMF has taken this step already in the case of Ukraine following the meltdown in Russia. It has a support program for Ukraine, but it is not willing—it is not able to provide all the money that would enable Ukraine to pay off all the treasury bills. Therefore, it says, ''We will give you $2.2 billion, but only on condition that the holders of the treasury bills will accept lower interest rates and longer maturity.'' If they consent to it, then we will give the money. If not, Ukraine will go bust, and the holders of the treasury bills get nothing.
So here is an occasion where the IMF has already, through pragmatic development, taken this step of imposing a condition on the lenders as well as on the borrowers.
Mrs. ROUKEMA. We have no more time here, but I am going to submit a question which perhaps you could answer in writing as soon as possible as to how that very wonderful analysis could be translated into some kind of conditionality under the legislation that we are trying to get passed.
Mr. SOROS. The other step, you see, is that if you impose that conditionality, then the lenders will be much less eager to lend, so the flow of capital, the boom will not occur. There will be no flow of capital at all, and this program of the international credit guarantee corporation would be to enable those countries nevertheless to borrow within certain limits with that guarantee. So it would make funds available. So that is how it would balance it out.
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Mrs. ROUKEMA. Thank you very much. Appreciate it.
Chairman LEACH. Mr. Frank.
Mr. FRANK. Mr. Soros, I am a great admirer of yours. In fact, I was late because I was on the Floor defending you. The issue of medical marijuana was up. So I want to acknowledge my appreciation for the breadth of your social concerns, and I mean that quite seriously.
And I particularly thank you because I think you have helped us get to the kind of fundamental issues. There is a tendency to talk about this financial crisis as if it were a technical financing forum when you talk about mechanisms, and I think you have helped us in two ways.
I am going to ask you to make a comment. I also want to note I hope this is the beginning of a very important week. Because I think the President's speech yesterday to the Council on Foreign Relations was extraordinarily important, like yours, recognizing the full dimensions of this. And you noted, and I was very pleased we are talking here in the international economic situation not simply about trade and maybe primarily about trade, but about the mobility of capital.
It seems to me what has happened is technology has made capital physically mobile in recent times. We have been asked, we who are in government all over the world now, to create the conditions whereby capital is perfectly, legally mobile, and there was a period that may just be ending now when an awful lot of people argued that was sufficient to bring about the good life, that if we simply made capital as legally mobile as it can be physically mobile, it would disburse itself in the right ways and the overall product would be increased.
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Some of us for some time have been arguing that one problem with that is it can have negative equity consequences, and you have made that clear. As you say, the lenders have the whip hand over the borrowers. Well, not just over the borrowers, but over the people who work in the borrower's country or people concerned about the environment in the borrower's country or people concerned about everything else.
In a world in which there are no government institutions beyond the nation, as you know, we have very good ways of dealing domestically with these problems, but not internationally. The problem then becomes that everything is done in the public policy field to make the owners of capital happy and imbalances are created.
Now for some time some of us were concerned about the social imbalance. I want to stress how important it is, and I hope people will be paying attention to the President's speech and to the specific comments he made yesterday talking about the need for a social component and acknowledging that the international financial institutions' programs have not only not been cognizant of that but, in the case of the IMF even as recently as a year ago, may have exacerbated it by ongoing austerity.
It seems what you are adding to this is a second argument that not only can this focus on keeping capital happy, you have negative consequences. But there is no automatic stabilizing mechanism either.
It does seem to me we are, at the international level, to some extent where this country was in the beginning of the New Deal when Franklin Roosevelt said, yes, we will preserve the capitalist system. We will preserve the efficiency of the market as an incentive. We will preserve the distribution that you get, but we will do two things. We will address the excessive inequities and create a better safety net in a uniform way so we will have a national labor relations law and national fair labor standards law and national pension rights for Social Security, and we will do some regulation of the market, e.g. the Securities and Exchange Commission.
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And people then said, ''Oh, my goodness, the Securities and Exchange Commission, you will ruin the market.''
It seems to me, as I said, some of us have been focusing on the need for the social component. I understand you to be talking about the need for trying to also now do a regulatory component that allows us to get the benefit of the market, but does not unduly interfere. I realize we have the problem that we are trying to do this in an international context where there is no sovereignty, but I would ask for your comments.
It does seem to me you have brought us to a good point of discussion. It is not a narrow, technical issue, the notion that simply making the owners of capital happy has obvious advantages, but is an insufficient policy and particularly in the regulatory area. I would be interested in your response to what I just said.
Mr. SOROS. I think your remarks are right-on. I think we are victims of what I would call a false ideology which prevails. It is easy to see ideology in other people. It is very difficult to see it in ourselves.
There is a general agreement that government regulations are cumbersome, very often corrupt, inefficient. And I think those are very valid arguments. But then we take a step which is illogical and unsound, because markets are perfect. Markets tend toward equilibrium. And that is a false belief and it has created a lot of problems for us and we are suffering from those problems.
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Pragmatically, we have actually recognized that we need authorities whose mission it is to maintain stability in financial markets. We actually live with those, and we have great respect for those institutions, like the Federal Reserve. But certainly capital movements have become global, and we do not have any international authorities, and we have an even greater dislike of international authorities than we have of national ones, and that is the fatal flaw in the current situation.
Mr. FRANK. Let me just say, in closing, I think the problem we have today, to quote my colleague's predecessor, which is still the case, ''All politics is local, but all economics is global,'' and that creates severe dislocations. And what I take you to be saying is that it is important for us to work on some form of a global political system, given that you are not going to have a universal sovereignty, that allows you to do some things at the international level that the Federal Reserve and the Securities and Exchange Commission do at the domestic level.
Mr. SOROS. I think we have to remain pragmatic and just take a step at a time. And I think we have a crisis in our financial system, and we need to develop some mechanism for dealing with that.
Chairman LEACH. Let me turn to Mr. Bachus.
Before I do so, let me remind colleagues we have a large committee and to the degree we can contain it to the five-minute limit, it would be helpful.
Mr. Bachus.
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Mr. BACHUS. Thank you, Mr. Chairman.
Mr. Soros, you have agreed with Chairman Leach's statement that crony capitalism is one of the main problems in Russia; is that correct?
Mr. SOROS. Yes.
Mr. BACHUS. And I say this with sensitivity, but could not someone consider you as maybe one of the insiders in Russia, as maybe one of the cronies?
Mr. SOROS. I think that——
Chairman LEACH. I think there ought to be an explanation here.
Mr. BACHUS. He is answering the question.
Chairman LEACH. But I want to be very careful here. There is a distinction between crony capitalism that exists elsewhere. There is no implication of anyone on this panel that Mr. Soros is himself part of a—without doubt——
Mr. BACHUS. I am not asking you the question, Mr. Chairman. I was asking Mr. Soros.
Chairman LEACH. The Chair would indicate to all Members that courtesy to guests requires very careful attention to wording, and Mr. Soros is surely capable of responding to the question, but I want to be very careful.
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Mr. BACHUS. Could we start my time over again?
Chairman LEACH. The Chair's interruption will not count from the gentleman's time.
Mr. BACHUS. Mr. Soros.
Mr. SOROS. See, I have been very, very careful in Russia, because I have a foundation there that has played a significant role, and I have been involved with policymakers. I was responsible for bringing, for instance, Yavlinsky to Washington in 1990, so I hold true bias in all these people. It was a matter of great concern for me to avoid any potential conflict of interest, and, therefore, I have only invested where other people could invest on equal terms. There was no cronyism or special favors. So the major investment I made was in the auction of the telephone companies, Siogtiness, where I was part of a group that bid $2 billion, $1.8 billion, and we were the largest members of that group.
And that was the first honest auction held, and the reason I participated in it was because I thought that Russia is making the transition from rubber capitalism to legitimate capitalism.
Mr. BACHUS. Wasn't that an insider's auction?
Mr. SOROS. No, it was not an insider's auction, and there were two groups that were fighting. This group bid higher than the other group. The other group cried foul. And, actually, the fallout of that was actually a major factor in the collapse of the whole thing, because the oligarchs got at each other's throats. This was the first honest auction where the state actually received a significant amount of money.
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Mr. BACHUS. When was that?
Mr. SOROS. That was in probably around May or maybe early April of 1997.
Mr. BACHUS. Let me ask you this. It has been reported that, for instance, when you bid for the large oil company which is reported to have more reserves than Mobil Oil, I think Sedanko Oil, is it, you were only one of two people outside Russia that were allowed to bid on that.
Mr. SOROS. No, I was not involved in bidding for Sedanko. I had shares in an investment fund that was open to all investors on equal terms, including Harvard Endowment, and so we also bought shares in that investment fund, but they were passive investors and not involved in that.
Mr. BACHUS. I understand that, but weren't other foreign investors excluded from that auction other than you and the Harvard group?
Mr. SOROS. I think that there were no foreign investors in that because we were a part of a Russian group that bid. I would say I was part of the crony stuff that was going on, and it was that still the old deal where the various groups divided this place among themselves.
Mr. BACHUS. You did have an investor group that was a part——
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Mr. SOROS. We were investors in that, but we were not involved in the bidding of it.
Mr. BACHUS. Then you had the steel company. There was the same sort of situation.
Mr. SOROS. The same as the steel company, yes.
Mr. BACHUS. Thank you.
I see my yellow light is on.
Let me ask you this. The IMF, they failed to anticipate the Russian crisis, did they not?
Mr. SOROS. They failed to——
Mr. BACHUS. Failed to at least anticipate the size of it?
Mr. SOROS. Well, I think that the IMF did not have sufficient resources to replace the treasury bills that were maturing. There was a general flight from Russia, and the program that they brought in was not sufficient to reestablish the confidence of the market which would then have allowed them to roll over the maturing treasury bills.
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In my estimation, there was a shortfall of $15 billion, and I proposed setting up a currency board with a $15 billion contribution from outside to make it possible, which would then reestablish the confidence of the market, and the meltdown could have been avoided.
Mr. BACHUS. Thank you.
Chairman LEACH. Mr. Kennedy.
Mr. KENNEDY. Thank you very much, Mr. Chairman; and welcome, Mr. Soros.
I read some time ago of the proposal that you had made for this international credit corporation. I would like to hear a little bit more from you as to what it would do. I saw some of the criticism in the New York Times editorial recently, which I am sure you may have seen as well.
But, in any event, what I wanted to really get at, Mr. Soros, is that we have many people that sit in that same chair that you do that come here under the idea that they are economists. They talk about capital inflows and capital outflows and they measure our international economy in numeric terms and the like. They also level criticisms of the IMF, criticisms that we would all have at the World Bank.
But it is a little dangerous when you come up here and criticize those institutions. The danger is that this Congress today won't vote to put money into the World Bank, it won't put money into the IMF, it won't put money into the United Nations. And so the United States now is at a point where we have the world's largest economy and yet we give away less of our economy to the poorest country than any other major country in the world.
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And so I wonder whether or not there isn't an issue not just involving corruption in the developing world, but whether there isn't a political issue that is even more fundamental than corruption, which is the basic dichotomy between wealthy and poor people within those countries. Whether or not working families, whether or not the poor are going to be provided reasonable access to education, reasonable access to food, reasonable access to transportation, the kind of basic infrastructure that any economy needs if people are actually going to grow and be able to prosper?
And whatever institutions that we create, whether it is the IMF, which I am critical of, although I support it every time that they need the money, despite their screwups, we still have an obligation to try our best to make it work. And so what I am wondering is whether or not at the end of the day, even if we create your new international credit institution, even if we support the IMF and the World Bank, that do you really believe that we can get at what seems to me to be the root of this crisis?
The crisis doesn't start because of the capital outflows. The crisis starts because something is wrong inside those countries that doesn't allow people self-determination and willingness to work hard to be able to rise to the top. And I don't know if there is anything that we can do, that you believe that we can do, to really deal with that fundamental question.
Mr. SOROS. There are many things wrong in many of the countries that got into the crisis, that were caught in the crisis. But there is also something fundamentally wrong with the international financial system, because not every country is corrupt—or dictatorial or whatever. In other words, good guys got caught up in the maelstrom mayhem as well as bad guys. And I think that we should be more discriminating in the conditions that we set. I very much agree with you that, actually, certain standards of democracy, of open society, ought to be a part of the conditions for extending support.
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The international institutions have been far too blind to political conditions. They have sort of concentrated on financial conditions. And that is one of the things that I would certainly advocate changing. But to say that the crisis is due to those deficiencies, the corruption in Indonesia or whatever, would be wrong, because a number of countries get caught up in it that had nothing to do with—in other words, it is the financial market itself that has this instability in it; and the primary role of the international financial institutions is to counteract that instability. That is the primary mission of the IMF.
Mr. KENNEDY. And so, what would this credit organization that you have proposed do?
Mr. SOROS. Well, if you threaten to impose conditions on the lenders, if you remedy, if you eliminate the moral hazard problem so then there will be much less willingness to lend or to invest in those countries, there will be no flow. Right now, there is a reverse flow; and it will be very difficult to get that flow going again.
So instead of the moral hazard, instead of bailing out lenders, you guarantee the loans of the borrowers up to a certain limit that you consider to be sound, that they can, in fact, service that loan so that they have access to the financial markets, to open up the financial markets through them when the flow is interrupted, which is the case that is now occurring.
I mean, we now have this desire by everyone to get out of those countries. So, for instance, Korea or Thailand, when Malaysia shut down its financial markets, it really damaged the chances of Thailand to attract foreign investment because investors are now pretty worried. However, the Thai government actually is following pretty sound policies. So to reinforce the IMF program you would then have a credit guarantee as well. And the same applies to Latin America.
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Mr. KENNEDY. Mr. Chairman, can I just ask a 10-second question?
Chairman LEACH. The trouble is, if I can say to my friend, we have a group of people here and the second question is a four-minute answer. That is the problem.
Mrs. Kelly, who is here on a timely basis, has asked if she can go next because she has a conflict. Is that all right with my colleagues?
Mrs. Kelly.
Mrs. KELLY. Thank you, Mr. Chairman.
Mr. Soros, how high would you rate the probability of a serious risk of further shocks in all or part of Latin America, Russia and the G–7 markets to the U.S. and to the world economy?
Mr. SOROS. I think that there are severe tensions now in Latin America. I think I am not saying anything that the markets do not know. And, in fact, the contagion has spread to Latin America; and you have an acute crisis facing you. Latin American markets today—Brazil was up more than 10 percent on a rumor of a $100 billion bailout. Well, I do not think that any such bailout is possible, given the fact that the IMF does not have the funds. But, clearly, there will be a great need for IMF assistance; and the IMF needs to have greater capacity than it currently has to meet those needs. And I think that you will probably agree that we do have vital interests in Latin America.
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Mrs. KELLY. How high would you rate the probability of an increased risk there? Serious risk?
Mr. SOROS. I consider it quite serious. But I think the markets consider it quite serious, because interest rates in Brazil had to be raised to 50 percent, and in Argentina it is 35 percent, and that shows how dire the situation is. And it obviously is not sustainable in the long run. Raising interest rates can sort of help to hold the market together for a short period of time, but if you maintain it, the economy cannot function, and you do have to have a collapse.
Mrs. KELLY. Other than Russia and Brazil, what is the next country that you feel is the most vulnerable to a financial blowup, then? China? Argentina? Would you be willing to venture a guess?
Mr. SOROS. These statements can have a reflexive effect and, therefore, I would not like to.
Mrs. KELLY. Well, I understand and respect your willingness to hold your tongue on this one.
I also want to point out that, on page 3 in your testimony, you talk about the IMF programs. You say they do not seem to be working. The IMF has run out of money. You say that past IMF bailouts encouraged foolish behavior by banks and other lenders.
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But in response to the current crisis, do you believe that the IMF has really helped to alleviate the spread and the depth of the crisis? Or, in your view, has the IMF prescriptions that they have given on belt tightening made it worse? I am finding this a very difficult question.
Mr. SOROS. No, I think it is a very, very penetrating question. I think that, certainly, the IMF programs help. But, again, the problems in the individual countries are quite complex. Because they have a currency aspect, the currency may be overvalued. They have a credit aspect, and the credit aspect has, again, a foreign aspect that there may be too much indebtedness abroad and a domestic aspect.
Actually, in Korea for instance, the main problem was the domestic credit problem. In Japan, you have a domestic banking problem with a tremendous export surplus and no need for external assistance. But still the problem is not resolved in Japan or in Korea.
So, in tackling some aspects without tackling the others, you cannot regain the confidence of markets and you cannot get out of the crisis. So, in my view, the IMF has not gone far enough, because it ought to have also insisted on this debt-to-equity conversion in countries like Korea and Thailand to stabilize the exchange rate, allow interest rates to come down and to allow domestic demand to be restarted.
So the IMF has not done enough. But certainly what it has done is help to contain the crisis. Because if the IMF had not had a program, let's say, in Thailand and Korea, then those countries might be in the same position as Indonesia, where the program failed more explicitly.
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Mrs. KELLY. Thank you very much.
Chairman LEACH. Thank you, Ms. Kelly.
Mr. Sanders.
Mr. SANDERS. Thank you very much, Mr. Chairman; and thank you very much, Mr. Soros, for joining us today.
Mr. Soros, you wrote a very interesting article that appeared, I think, in the January Atlantic Monthly; and I would, Mr. Chairman, ask permission to introduce that into the record.
Chairman LEACH. Without objection, so ordered.
[The article referred to can be found on page 336 in the appendix.]
Mr. SANDERS. In your article in the Atlantic Monthly you talked about some of the deficiencies of the global capitalist system, and you mentioned specifically the ''uneven distribution of benefits.''
As I think you know, we are living in a world now where a few hundred very, very wealthy people own more wealth than millions of poor people, that in our own country the gap between the rich and the poor has grown significantly wider in recent years. How concerned are you about the growing inequality of wealth in the United States and in the world and what would you propose to do to address that problem?
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Mr. SOROS. I am, in fact, very concerned, as I expressed it in that article, and it is an issue that needs to be addressed. But if I may make a plea to you, you cannot address it by denying money to the IMF. In other words, if you have these financial collapses, then the rich and the poor will be much worse off.
So the IMF is a very flawed institution, and it really does need to change many of its ways, but it has to be preserved, and it has to be given the resources to remain active, and then we can look for other ways to try to correct.
Mr. SANDERS. Well, can you suggest some of those ways? Clearly, from a moral point of view, if not even an economic point of view, you would be concerned that a few hundred people own more wealth than billions of people, correct?
Mr. SOROS. Yes.
Mr. SANDERS. What ideas do you have for this committee as to how—I disagreed with you on the IMF. But putting that aside for the moment, what ideas do you have for this committee as to how we might address that worldwide and national problem?
Mr. SOROS. Well, I think that whatever—since capital is currently free to move around, whatever constraints you want to put on capital, let's say taxation, because, basically, the burden of taxation has shifted from capital effectively to labor, because capital can move much more easily than people—or lend for that matter. So you probably need to rebalance the taxation.
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I think particularly, for instance, estate tax, in my view, is the point at which wealth should be taxed. Because to tax the creation of wealth interferes with the creation of wealth, but when the creator passes it on to his heirs, you see, the heirs are not likely to be such—tremendously able to——
Mr. SANDERS. You are aware, I am sure, that the Republican majority here is moving exactly in the opposite direction.
Mr. SOROS. I realize that.
Mr. SANDERS. But you made a good point, if I might. I think what you are suggesting is that when you have corporations who are able to play one country off against the other in terms of low wages, lower taxes, that creates a bad situation. Would you agree with me?
Mr. SOROS. Yes.
Mr. SANDERS. And what I hear you also saying is that you feel that taxing people who have a substantial sum of money so that government can take care of those people who do not is also a reasonable thing to do?
Mr. SOROS. I am in favor of a greater degree of wealth redistribution than is currently being practiced, but that is my own opinion.
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Mr. SANDERS. No, I understand. And could you make that argument not only from an economic point of view, but from a moral point of view, as well?
Mr. SOROS. Well, I, personally, yes.
Mr. SANDERS. Now, you mentioned earlier in your testimony about the Mexican bailout, that you felt that—I do not want to put words in your mouth—but you seemed to indicate that there was a problem in that we were bailing out investors who made bad investments. Could you say a word on that, please?
Mr. SOROS. Well, I did, that the IMF programs enable the countries to service that debt better than they would have otherwise. So, indirectly, they have served to bail out, basically, the lenders to those countries. It did not particularly bail out the equity investors, because when markets went down they got hurt. So it is, basically, in terms of the creditors that have this, let's say, indirect benefit from the IMF programs.
Mr. SANDERS. Thank you very much, Mr. Soros.
Chairman LEACH. Well, thank you for that very extraordinary line of questioning.
Mr. Castle.
Mr. CASTLE. Thank you, Mr. Chairman.
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And, Mr. Soros, I will try to ask one question and you can answer it. I want to talk about the IMF programs and some of these solutions for the future.
Let's assume that Congress does do as you would will us to do and that is approve the money this year. But there is no way that is going to happen without Congress speaking to the fact that we need to do something about the way the IMF is doing its business. Not that we govern the IMF, but we certainly would try to influence it in our position as a major investor in it. And you have rightfully pointed out on page 4 of the written part of your statement that the Federal Reserve and the other financial authorities sort of look at the United States, but we are sadly lacking the appropriate financial authorities in the international area.
And then you talk about the IMF and you said, they have admittedly not been successful. Then you talked about what Mr. Kennedy—I believe it was Mr. Kennedy—asked you about the International Credit Insurance Corporation, which I do not think I totally understand, but you did talk about that a little bit. And then you went on to say in your testimony, ''I believe its' time has now come,'' meaning the International Credit Insurance Corp.
Then you say, ''We shall have to establish some kind of international supervision over the national supervisory authorities.'' And then you say, ''We shall also have to reconsider the workings of the international banking system and the functioning of the swap and derivative markets.''
I assume those are separate thoughts, although I am not 100 percent sure of that.
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Mr. SOROS. There are several points.
Mr. CASTLE. I would be interested in your comments on that.
And then, further on, in your next page you were talking about the IMF again, and you say, ''I believe there is an urgent need for the creation of Special Drawing Rights, SDR, which can be used to guarantee the rollover of the already existing debts of countries which receive the IMF's seal of approval. If there is no reward for good behavior, meltdowns and defections will multiply.''
Could you expand on those a little more specifically? All those are interesting suggestions, and I am just looking for whatever it is that we in Congress and the IMF should be doing to try to make that whole international market flow better than it does.
Mr. SOROS. The Special Drawing Rights is connected with this credit guarantee. That is, you see, you now have this reverse flow of funds, which is very dangerous for the capitalist system, and you will have to encourage the outflow of capital. And, effectively, the moral hazard has already been corrected by the meltdown in Russia, because it has really punished and shaken the banking system. I dealt with that in my testimony. It has really disrupted, in many ways, the banking system.
And, also, the IMF has learned from its experience and is now imposing conditions on the lenders in the Ukraine before it is willing to put out the money. So since the IMF is an institution that learns from mistakes, the IMF is, in fact, evolving. So it is already happening. And because it is happening, the next big task for the international authorities will be to encourage the outflow of capital, to make capital available to the countries on the periphery that need to borrow. And it is to make that possible that I propose setting up this International Credit Guarantee Corporation, whose capital would be the Special Drawing Rights, which would not be called on until a country defaults.
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So it would not be in any way inflationary, because they would not be issued, they would not be in circulation, until a country actually goes into default. So that is my proposal, because I think that giving the IMF additional money, while it is necessary, is not sufficient to keep the system going.
Mr. CASTLE. Then explain to me, if you will, what you mean by the other two sentences I read. ''We shall have to establish some kind of international supervision over the national supervisory authority,'' and ''We shall also have to reconsider the workings of the international banking system and the functioning of the swap and derivative markets.''
Mr. SOROS. They are two separate ideas. I should have perhaps made it more clear.
You see, the way the central banks in Korea and Indonesia operated were inadequate. And yet Korea, being a member of the OECD, the international regulations about capital requirements were very favorable to Korea. So if you want to have such favorable capital requirements, you also have to meet certain standards of performance; and, therefore, there would have to be, in my opinion, some international supervision of the behavior of the central banks in the periphery countries. That was one thought.
And the other one is that I think that some of the more sophisticated transactions in the international financial system today carry significant risks because they are built on a false theory of efficient markets. And these risks are not sufficiently recognized, and I think they need to be studied. Just as you had to study the use of derivatives in the financial markets and introduce circuit breakers, I think there are certain kinds of derivatives which are dangerous; and I think that the lack of any kind of margin regulation in these off-market transactions is also very dangerous.
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It is a bit of an anomaly that you have, let's say, a 50 percent margin on stock purchases, but no margin at all on a transaction that you may be entering in with a bank.
Mr. CASTLE. Thank you, Mr. Soros.
Thank you, Mr. Chairman.
Chairman LEACH. Mr. Hinchey.
Mr. HINCHEY. Thank you very much, Mr. Chairman.
Mr. Soros, I am very happy that you are here. I very much admire you and your work, and I was very pleased to learn that you had accepted our Chairman's very thoughtful invitation to be here.
Among other things in your testimony, you draw our attention to the potential social and political consequences of the current international economic crisis; and I think particularly of Russia in that context, and I think that perhaps you are thinking of that also.
At the end of the Cold War, the international community, the West, basically had two models from which to choose to pattern its behavior upon in this country, post-World War I, post-World War II. Unfortunately, it seems we have chosen a pattern of behavior more akin to the post-World War I circumstance than the post-World War II; and we are not acting in a way that is designed to bring the world, the economic circumstances and the political circumstances into equilibrium. Rather, that it is more of a circumstance where everybody is sort of fending for themselves.
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Would you feel comfortable in talking for a few minutes about the potential political and social consequences to Russia particularly, and the surrounding countries, if we are unable to bring about stability through the IMF and other means?
Mr. SOROS. Well, I should preface that, in the end, it is only the Russians who can do it, but they do need assistance. I think without, let's say, a political will and the capacity internally, there is very little that one can do. And one of the tragedies is that we actually did have a good group, a good government, in place just a few months before the collapse, and they never got a chance to actually be tested and to see what they could do.
But I think that the potential on the downside in Russia is practically limitless. Now, I had felt that way earlier, and it did not come to pass. In the early 1990's, in 1992 and 1993, I thought the system may just collapse and, you know, people would not get heat and would not get food and so on.
In actual fact, they did, they survived it. And the reason they survived it—because the formal system, the official system, was never the system that really operated. There was always an informal arrangement that made it work. So you will actually go back to barter. You will go back to where you were at that point.
The government may do a lot of harm by, let's say, issuing money which would either push the country into hyperinflation or combine it with price controls, which would make sure that no goods are available at the price at which they are supposed to be sold.
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So what concerns me particularly that Russia will be cut off from the rest of the world not only by their own, let's say, turning inward, but also because, by defaulting on their obligations, they will not be able to do business with the rest of the world and that I think could be so, that would make the situation worse than it was in the early 1990's.
Mr. HINCHEY. And the situation is not going to end there. If that happens, it is going to spread to other countries in Eastern Europe and Central and South America.
Mr. SOROS. This is what—for instance, in Moldavia, there is a capable, reform-oriented government, but they have no access to money whatsoever, and it creates a big crisis for Moldavia. That could be very easily solved by an IMF program, because they are eager to meet those conditions. So this is where the IMF could do the job, and I hope it will, even with the limited resources it has.
Mr. HINCHEY. At some moment we are going to be unable to continue to be the marketplace of last resort with this current situation, particularly with east Asia. In the interim, we need to adopt here in the United States some economic policies that are going to buttress us against the full effect of these forces that are about to fall upon us.
Do you think now that we ought to be thinking seriously about lowering interest rates since real interest rates in the United States are relatively high?
Mr. SOROS. I think we are thinking about it seriously; and I think that, if my expectations are correct, then I think that will be necessary.
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Mr. HINCHEY. Thank you very much.
Chairman LEACH. Thank you.
Mr. Barr.
Mr. BARR. Thank you, Mr. Chairman.
Mr. Soros, let me follow up on a different line of questioning, but it follows a remark that my colleague, Mr. Frank, made earlier regarding drugs.
I am somewhat familiar, as most of us are on the committee and those of us who serve on the Judiciary Subcommittee and Government Reform Subcommittee as well, of your activities in drug legalization matters, and I know or at least have read something about your views on drug legalization.
As an employer and a businessman, I am sure you are aware of the cost to employers and businesses caused to those businesses by the use of drugs. And these are costs that have nothing to do with the costs per se of enforcement. They are costs that employers suffer as a result of decreased productivity, absenteeism, health costs, theft, embezzlement, and so forth. And that was estimated in testimony earlier this year before the House Small Business Committee by Tom Donahue, President of the U.S. Chamber of Commerce, at something over $140 billion a year.
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Given the fact that if drugs are legalized, or if the restraints placed on their usage are relaxed, that will mean more people will do drugs, that would be the whole point of it. Does it concern you as an employer and as a businessman—aside from what your personal views on drug usage might be—that there is a tremendous cost to employers only here in this country, of $140 billion, but perhaps other countries as well, where businesses and employees operate on a much lower standard of living and the impact of those costs of drug usage might be more profound?
Mr. SOROS. Well, it is not strictly relevant to these hearings here, but I am glad to clarify that I do not know actually quite how this idea that I am a drug legalizer got around. I am not for legalization of drugs. I am for, for instance, legalization of medical use of marijuana where it has real medical benefit.
I am also for decriminalization of drugs. That is to say, we should not treat drugs as a crime but as a social problem, as a public health problem and try to not make the problem worse by the remedies that we apply.
Unfortunately, this drug issue is one where people's emotions get tremendously engaged, and there is a great deal of exaggeration and sort of extremism, that if you are not for the war on drugs, then you are a drug legalizer.
I would like to make it clear, I am not for legalization of drugs. I have got children, and I know that, for instance, marijuana is very harmful for learning. It affects short-term memory. But marijuana is a drug. It has an effect. Some of the effects are beneficial. It helps, for instance, to rebuild appetite for HIV victims or cancer patients, and it really is, effectively, a crime to deny them the benefit of that.
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But, on the other hand, it also has harmful effects. And the most obvious harmful effect is on children's learning, particularly students. So I am very eager that my children should not be potheads.
So I hope that clarifies my position.
Mr. BARR. Well, perhaps, in a very general sense, it does. Maybe you could explain the difference between drug legalization and decriminalization one more time. The nuances escape me there.
Also, you might comment if you are involved in any current efforts to donate money to drug legalization efforts, for example, in Florida, similar to monies you donated to their efforts in California and Arizona.
Mr. SOROS. I think that the difference between decriminalization and legalization is that, if you legalize drugs, then anybody can use it, and it is not a crime. It is not forbidden, not a misdemeanor. It is not forbidden.
I think that the use of drugs should be forbidden, but it should not be treated as a criminal matter. We should disassociate drugs and crime. Unfortunately, we have associated it, and we have created a lot of drug-related crime. If we could find our way to disassociate the two things and try to reduce the demand for drugs by treatment and prevention, our money would be much better spent, and there would be much less crime. So this is decriminalization as opposed to legalization.
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As far as donating money, yes, I am supporting a campaign for legalization of the medical use of marijuana, and I will continue to do so.
Mr. BARR. Thank you.
Chairman LEACH. Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Mr. Soros, first off, I want to go back to your comments.
You talked about George Schultz and his testimony and his apparent influence, at least on some Members of the House, with respect to the recapitalization or the increase of our share in the IMF. I was reminded that back in 1995 your colleague, your associate Stanley Drucenmiller, had made a comment with respect to potential default of the U.S. Treasury Department on Treasury bonds, saying that a short-term technical default would not be such a bad thing if it would force the President's hand on the budget policy. I think that short term, long-term, medium-term, technical, nontechnical, default on U.S. Treasury bonds would be catastrophic.
But, nonetheless, based upon that, my colleagues in the Republican leadership took great comfort in your associate's comments; and so I would hope that they would take great comfort in your comments with respect to the recap of the IMF; and I will make a point of bringing that up every opportunity that I get.
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I had a number of questions for you, and I may have to ask some for the record.
The first, you talk about efficiencies in markets and the fact that they do not tend to an equilibrium, and that very well may be true. But isn't the problem that we are seeing in Russia and certainly in Asia a problem of inefficiency of markets? And we talked about crony capitalism. But you do not have pure market systems in these countries and, ultimately, the hot money finds this out and moves out.
Second of all, with respect to the discussion of the Mexican bailout and the Ukraine example, I agree with you on the issue of moral hazard, but do you believe there should be a distinction between sovereign debt and private debt? You did say that equity holders took a loss because markets went down. And certainly in less capitalistic countries, sovereign debt is used for, in some cases, private operating purposes and private capital formation, but, again, wouldn't you treat that differently?
We have seen in the IMF prescription vis-a-vis South Korea that, in fact, private debt has been rescheduled, maturities extended and rates adjusted to the detriment in many respects of the creditors. We have also seen that in the public markets the sovereign debt or the sovereign entity has had to pay the price on their sovereign debt. Do you think there should be a distinction there?
Mr. SOROS. Well, on your first point, you, of course, are right. There are many problems in these countries. Particularly Russia has a very special problem. And I think we made a mistake originally that we put it in the hands of the IMF. Because Russia and the other ex-communist countries were not suitable for treatment to my way of dealing with them because the IMF——
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Mr. BENTSEN. They were more critical you think?
Mr. SOROS. No, no. You see, the IMF has a method of operation where it signs a letter of intent with the government and then disburses money. And if the government does not meet the companies, it stops disbursing money. That is the way it applies conditionality.
But those countries did not have effective governments. They could sign any letter of intent, but they could not fulfill it, you see. So this method was not suitable to those countries. There was a specific problem how to make the transition from communism to a market economy, and it ought not to have been entrusted to the IMF. It ought to have been a special program put together by the Western governments where they would have had to come to Congress for money and they would not have gotten it and, therefore, they put it onto the IMF where there was some money. That was a mistake, historic. So you have a very valid point there.
Your second point is also valid. There should be a distinction. However, there are pressures at the time of crisis to push the country to assume sovereign status for private credit, and so the debtor country is left holding the bag.
I remember a case of Chile under Pinochet where the banks were privatized, and actually the buyers paid for it by money they borrowed from the banks that they bought, and then they got caught up in the international debt crisis. But Chile then accepted sovereign responsibility for the debt of those banks, you see.
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So a little bit of the same thing is happening in places like Korea, but not so badly.
Mr. BENTSEN. Although we are advocating that the Japanese—and granted the Japanese are not at the IMF window at this point in time, but we are advocating that the Japanese step in and publicly fund the bad debt of the Japanese banking system, as we have done in this country. Now, maybe it is a different situation.
Mr. SOROS. Yes. You see, I think in the end, since the country does need a functioning banking system and since the banks are broke, they will have to be rescued. The discussion is on what terms. Should the banks be closed down and the Bank of Japan accept responsibility for the obligations of that bank? Or should the bank be bailed out and allowed to continue functioning? That is the debate at the moment.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman LEACH. Well, thank you Mr. Bentsen.
A fellow Texan, Dr. Paul.
Dr. PAUL. Thank you, Mr. Chairman.
Mr. Soros, I am a physician, and I agree with you that we ought to have the right to use medical marijuana. But it is very controversial. But on the IMF, I disagree with you.
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I would like to concentrate on a term, though, that we should deal with, and that is the word ''capitalism.'' Mr. Bentsen brought it up, but I want to talk about that a little bit more. The reason being, I think we all agree that we have a major crisis going on and that we may see a lot more problems before it is resolved, but if we casually say it was capitalism that was bad, we have to do away with it, that free markets do not work, that would not make some of us very happy, because we have a great deal of faith and confidence in free choices and capitalism.
So when you talk about capitalism, I think it is casually used. Because I see that we have a system that many of us refer to as ''interventionism,'' you know, governments are intervening continuously. We do not have a commodity standard for money, but we have an inflationism system, fiat money, along with we have a lot of welfare throughout the world. I mean, our system is based on welfarism, and we have a system inclined to favor corporations called corporatism. So it is a long distance from the classical notion of capitalism.
I agree with you entirely that there is a lot of disequilibrium in the system, and it seems that you conclude that it is the fault of capitalism. And it is almost like saying, well, we must absolutely throw out the invisible hand, that that concept was absolutely wrong, and yet I think we have the absence of the invisible hand, because we have had so much government involvement.
I want to concentrate also on the currencies. I see so much that the problem that we have is as a result of the way we have managed our currencies. We have all countries of the world working with fiat currencies and everybody inflates at a different rate and this causes by nature, and in a predictable fashion, a disequilibrium that I see.
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The notion being that once governments inflate, create new credit for the purpose of driving down interest rates, the low interest rates send bad signals, confusing signals, to business people, who do dumb things. They overinvest, there is overcapacity, they have malinvestment, and they tend to accumulate a lot more debt. Banks loan out more money. But this is a consequence of the central banks' error of creating too much credit. And then, again, this leads to the speculations and to the derivatives markets that you mentioned.
And if we ignore that and just say what we need is more inflation, we need to now not only inflate through our Federal Reserve Board by driving down interest rates. And when people say we need more liquidity, that, to me, means we need more money, we need more credit, and that is inflation.
At the same time, you suggest that internationally we create SDRs, which is international inflation. I see this may be temporarily helping the cause and may tide us over. But what about long term? Have you ever considered or do you consider the necessity for maybe sitting down and thinking seriously about revamping the international monetary system, something of the equivalency of the Bretton Woods Agreement, even considering commodities once again? The European Union are talking now of a 20 percent reserve in gold. Are those ideas that you have given any consideration to?
Mr. SOROS. Well, first of all, I am very glad you agree with me on medical marijuana; and it is very nice to hear actually a legislator having the courage to say that.
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Dr. PAUL. Especially if you are a Republican.
Mr. SOROS. Because most legislators, they talk about the third rail, that if you touch it you are dead. So I hope that, as a doctor, you will take care of yourself.
But, actually, there is some relation between the drug problem and this capitalism thing that you talk about. Because, you see, just because I think that the War on Drugs is wrong or it has bad effects, it does not mean that I am a legalizer. And the same way, just because I think that capitalism has its defects, you see, does not mean that I am opposed to capitalism or we ought to abolish capitalism.
All our constructs are flawed, and so we have to always be aware of where those deficiencies are, and we have to look to correct it. And it so happens that financial markets are inherently unstable, and I can give you a theory for it, and I think, therefore, we have to make stability an objective of public policy, not abolish markets. We want to keep markets, because they are a much more efficient allocation than bureaucrats. But we have to recognize that instability can do tremendous damage.
Now, you talk about having a stable money, presumably gold; and I think your argument would be, let's say, stronger if you did not have booms and busts during the gold standard. Because we did have the gold standard in the 19th century, and we had similar booms and busts as we have now. So the booms and busts are actually inherent with the wave that has come in the future. Our understanding is inherently biased, and you have self-reinforcing processes. So, actually, going to the gold standard would not solve that problem.
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The problem actually is with credit, not with money. You see, it is when you come to the use of credit that you have these imbalances. We do not like to admit it, so we talk of monetarism. And since there is some relationship between money and credit, money is something that you can measure so you can try to control the money supply. But, actually, underneath it you see, there is this willingness to extend credit, which is a reflexive process, self-reinforcing, and it can be self-reinforcing or self-defeating in both directions. So that is where the excess has come in.
Incidentally, you cannot eliminate it. In other words, to try to devise a system that does not reaffirm equilibrium would be an impossibility. It is just a question of trying to keep the excesses from being excessive. So that is the task. And that is why we need some institutions, which we have. We have the Federal Reserve. But we now have this global economy, and we do not have the global institutions.
Dr. PAUL. I have more challenging questions, but I am out of time.
Chairman LEACH. Well, thank you. And just so there is no misunderstanding, as a Libertarian, you are for the decriminalization for the nonpayment of income taxes; is that a fair description?
Dr. PAUL. I am not sure I figured that out. But I know we are against the income tax and almost all taxes.
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Mr. LEACH. Fair enough.
Mr. Bentsen had one very short question.
Mr. BENTSEN. Thank you, Mr. Chairman.
Let me say my colleague from Texas has touched the third rail many times. He glows, but it has yet to kill him.
The question I have is, yes or no? I do not understand. I was not clear from your exchanges. Are you advocating some form of currency flow control or not?
Mr. SOROS. You mean fixed exchange rates?
Mr. BENTSEN. No. No, not fixed exchange. Trying to regulate the flow of currency in and out of nations?
Mr. SOROS. I would say that it is something that has to be considered. I think that total free-flow can be destructive. And, actually, short-term capital flows basically actually do more harm than good. However, they are essential to allow the long-term capital to flow. In other words, you could not have investments, you could not have stock markets, and you could not have long-term bond markets if you did not have also freedom of movement of capital. So that is the main reason to have, let's say, open flow, open capital markets.
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But to discourage short-term flows the way, for instance, Chile has done by imposing a minimum reserve requirement on capital that is there for, let's say, less than a year is a good stabilizing move, and it is now recognized as such.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman LEACH. Let me say, we have another panel, and I want to bring them as soon as we can, but out of balance, we have a request on each side. So if Mr. Bachus would like to proceed.
Mr. BACHUS. Thank you.
Mr. Soros, I noticed in your statement you say, ''The IMF approach clearly did not work. Otherwise, we would not find ourselves in the current situation.'' And as I said in my opening statement, the IMF was urging Russia not to devalue at the same time you were urging Russia to devalue. That is correct, isn't it?
Mr. SOROS. You see, I think that was a little bit taken out of context. You mentioned it earlier. I proposed, as a last desperate measure, to introduce a currency board which would then fix the currency, reestablish confidence. The bad banks would go to the wall, but some banks would remain because some of their assets would recover value. And I think that would have, say, at least given that government a chance to actually collect taxes and have a functioning economy.
So I was advocating a currency board, and I was advocating the international community providing the funds needed for a currency board, which is $15 billion. And as part of that scheme I also suggested a modest adjustment in the value of the currency. Because if you fix the exchange rate at an overvalued level, you cannot make it work. But I only advocated devaluation as part of this scheme.
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Mr. BACHUS. So what got the headlines was that George Soros thinks that Russia ought to devalue its currency.
Mr. SOROS. Yes. It was something taken out of context.
Mr. BACHUS. You understand the IMF was opposed to devaluation?
Mr. SOROS. Yes. I think they were opposed to devaluation, yes.
Mr. BACHUS. Fine.
If the IMF is not working—they were wrong about Russia in January, they perhaps were wrong when they lent $5 billion, which they now agree was essentially wasted, in July—why do we not fix the IMF first before we put any more money into the IMF? Why do we continue to put money in a failed system?
Mr. SOROS. I tell you, it is very important, because we cannot fix it. We cannot fix it. You see, basically, managing the financial system or even participating in the financial system is not a science. I call it an alchemy. It is a manipulative art. And some things work, and they work for a certain period of time, and then they do not work, and then you have to start something else.
So if it were possible to write a recipe and now this is going to work, then I think we should insist on it before we are going to give them money. But I think to look for that recipe as a condition for giving them money means we will be looking for a long time and, in the meantime, they run out of money.
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Mr. BACHUS. You do agree, then, they really cannot be fixed?
Mr. SOROS. No. I think they are learning. What they have done in Ukraine, without giving it any publicity, shows that they have learned. So I mean, by all means, I think they really do need to be pushed to think harder and to do more soul searching. But I do not think that we should look for that magic bullet or that recipe that is going to tell them, do it, now it is going to work. Because nothing that we could design will work forever. It might work now, but in ten years' time something will come up to make it fail.
Chairman LEACH. Well, thank you very much. Let me thank you, Mr. Soros. It has been a long day, and I appreciate your coming down and giving us of your time. I thank you.
Our second panel is on the subject of corruption. It is composed of Mr. Paul J. Saunders, who is Director of The Nixon Center; Ms. Susan Rose-Ackerman, who is a Professor at Yale Law School; and Mr. Andrei Shleifer, who is Professor of Economics at Harvard.
I am sorry to say that another speaker, Daniel Kaufmann, who is one of the world's leading experts on the subject, decided he could not come because the World Bank thought it might be inappropriate to testify before a congressional committee.
In addition, I would like to ask unanimous consent to place a statement in the record of Mr. Garry Kasparov on the subject of corruption. Some of you know Mr. Kasparov as one of the world's, if not the world's, leading chess players.
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[The prepared statement of Garry Kasparov can be found on page 331 in the appendix.]
Chairman LEACH. If the panel is ready and unless there is a prior arrangement, I will begin in the order in which they have been introduced.
Mr. Saunders, are you prepared?
Mr. SAUNDERS. Yes, I am.
Chairman LEACH. Let me say, without objection, all your statements will be placed fully in the record.
Please proceed either to summarize or to read as you prefer.
STATEMENT OF PAUL J. SAUNDERS, DIRECTOR, THE NIXON CENTER
Mr. SAUNDERS. Thank you very much, Mr. Chairman and Members of the committee. It is indeed an honor and a privilege for me to appear before you today to share my views on the situation in Russia.
Before I begin, I would like to point out that, while I am Director of The Nixon Center, my remarks today reflect solely my personal views. The Center itself does not take institutional positions on substantive issues.
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We are here today to talk about corruption in Russia. Corruption in Russia today can be described only as vast. Russia's top prosecutor, Yuri Skuratov, called corruption ''one of the most significant threats to the national security of Russia.'' Corruption in Russia is also a very significant threat to a number of American interests, including our economic interests, our security interests, and our long-term interest in the success of Russia's transition.
To give you an idea of the extent of corruption in Russia, Russia's security services estimate that a sum equal to 40 percent of Russia's gross national product is concealed from Russia's government authorities. This is the so-called ''shadow economy.'' These transactions are concealed principally to avoid the payment of taxes.
These transactions are not all necessarily concealed through corruption. The government is probably simply not aware of many of the activities that are undertaken. But it is certainly true that a large share of that shadow economy is concealed from the government through the complicity of state officials.
At the same time, in addition to this tremendous horizontal extent, corruption in Russia has a tremendous vertical extent. It runs from traffic policemen on the streets who stop motorists and shake them down for bribes all the way up to senior government officials.
Unfortunately, some of the institutions most crucial to Russia's transition—the Finance Ministry and the Central Bank—are among the most corrupt sectors of the Russian government. A case that has just come to light in the last couple of weeks involving Russia's First Deputy Finance Minister Vladimir Petrov is very important to note in that regard.
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Mr. Petrov was the senior Finance Ministry official with direct responsibility for the allocation of the Russian government's budget funds. He is accused of accepting a $520,000 bribe to transfer $7.7 billion into a particular Moscow bank. Upwards of $600 million of that money went straight to a bank in Andorra illegally.
I cannot stress this enough. This is the person in the Russian government who has line responsibility for allocating budget money. It is the person through whom IMF credits and other international assistance go before they go into the Russian budget, before they are distributed to other Russian government agencies or to other institutions in society.
Moreover, Mr. Petrov could not have done this alone. His activities would have required the complicity of a number of his subordinates; and, accordingly, probably contributed significantly to a corrupt institutional culture at the Finance Ministry.
I want to point out just two other things. First, he was in that position for almost five years, since 1994. So there is really no telling how many other transactions of this nature were undertaken.
And, lastly, a more political point, Mr. Petrov was not arrested and charged until after Russia's massive financial crisis. This fits in with a pattern in the prosecution of corruption cases in Russia in which arrests and prosecutions are used to find scapegoats rather than fight corruption. Mr. Petrov was probably not alone in this behavior, people senior to him were probably also involved, and he is just the one taking the fall.
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And in light of Mr. Soros' comments about the Kiriyenko government being the best Russian government—and just about Russian reformers in general—it is important to remember that the Finance Ministry has been controlled by the people who we call reformers in Russia for the last five years.
These are not hold-over Soviet officials. They are the people to whom we have looked in the United States to make a difference—Anatoly Chubais, Boris Fyodorov, who served as deputy prime minister in Kiriyenko's government and is now under investigation for his role in authorizing the transfer of $180 million in diamonds from the Russian treasury to a California-based Russian company that was basically a front. This is a serious threat to Russia's transition and to any attempts to help Russia from the outside.
Corruption is also a major problem in the military. From 1994 to 1996, approximately $1 billion of weapons, including 84 T–72 tanks and 50 other armored vehicles, were illegally sold by the Russian military to Armenia.
Although we are often concerned about loose nukes or other kinds of nuclear proliferation, the proliferation of conventional weapons is also potentially very destabilizing. Moreover, 80 tanks are not easily concealed. You cannot just put them in your pocket and walk out of the Defense Ministry. Illegal exports on that scale require cooperation from a large number of officers.
Corruption in Russia has also permeated law enforcement agencies and courts. In some of Russia's regions, entire police departments are essentially subcontracted to businesses to serve as security. This is clearly not a situation that will permit the arrest and prosecution of criminal business people.
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Even members of President Yeltsin's close entourage and his family have been implicated in corruption scandals in Russia. In fact, it has been reported in the German media that President Yeltsin's daughter recently bought a castle in southern Germany in an alpine resort outside of Munich. That can't but raise serious questions.
As I suggested at the beginning of my statement, corruption has a number of costs. Many of these are within Russia. There are costs to Russia's economy, in direct terms to the revenue that the government can collect, and in taxes and in customs duties through privatization. There is also obviously a great cost to the businesses which are paying bribes. One estimate put that expense at 10 percent of income for small and medium businesses in Russia, or about $6 billion a year.
However, the indirect costs are in some respects more important. Corruption has a very corrosive impact on the rule of law in Russia. If there is one thing which is essential to the creation of a democratic capitalist system in Russia, something we all hope for, it is the breakdown of the rule of law. Today it has been largely undermined.
The Russian people see these corruption cases. They see that senior officials are involved. They see that they are not punished. This cannot but lead to widespread lack of respect for the law and a loss of confidence in the system as a whole.
Second, corruption also seriously undermines people's confidence in the Russian economy. Even Russia's own investors are not willing to keep their money in Russia. They stash it in foreign banks. It is estimated about $150 billion in Russian capital is now in foreign banks.
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Obviously, it is important to Russia's integration into the global economy that it have money abroad. Not all the money abroad is necessarily there illegally. But Russia certainly could have used a small share of that $150 billion in its banking system in recent weeks.
At the same time, at the individual level, the Russian people aren't willing to keep their money in the Russian banking system. The president of the Russian association of banks estimated that Russians are keeping $80 billion in cash at home. That is more than three times the IMF-led bailout announced in July. If Russians were more confident in the system and that money were in the economy, it could have made a profound difference in recent events in Russia.
I guess the second thing that I would like to talk about——
Chairman LEACH. Excuse me, if I could interrupt for a second.
Mr. SAUNDERS. Pardon me. Of course.
Chairman LEACH. We are going to have votes in the not too distant future, and I would like to be fair to the other two panelists. Perhaps you could conclude now, and we will turn to the next two.
Mr. SAUNDERS. Absolutely.
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To conclude, corruption in Russia has dramatically undermined the country's chances for reform. It has destroyed the legitimacy of the Russian government, and because of the failures of the economic policies, it has weakened the legitimacy of economic and political reform as a concept, which is certainly very disheartening.
In terms of American interests, why does this matter to us? I mentioned a few reasons. It obviously means lost opportunities for American businesses. It certainly contributes to the turmoil in our stock markets. But fundamentally, as I tried to suggest, there is a real threat to the success of the Russian transition.
We have limited options to help. We should try to give Russia whatever technical law enforcement assistance we can, but enforcement is really something that they are going to have to work out for themselves, at a political level.
Finally, despite the fact that much of the IMF's assistance to Russia has been wasted or stolen, the appointment of a new government does give Russia the opportunity to make a fresh start. Prime Minister Yevgeny Primakov is one of the few senior officials who has a reputation for not being corrupt, and that under the circumstances, with the crisis in Russia as severe as it is, the IMF should continue to provide assistance to Russia.
However, we have to make it clear to the Russian government, and almost more importantly to the Russian people, that if there is further credible evidence of systematic corruption, the assistance will be stopped. This is very important both to push the Russian government to crack down on corruption, and to put a little bit of public distance between the United States Government and Boris Yeltsin and his discredited regime.
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Thank you.
[The prepared statement of Paul J. Saunders can be found on page 292 in the appendix.]
Chairman LEACH. Thank you, Mr. Saunders.
Ms. Rose-Ackerman.
STATEMENT OF SUSAN ROSE-ACKERMAN, HENRY R. LUCE PROFESSOR OF LAW AND POLITICAL SCIENCE, YALE UNIVERSITY
Ms. ROSE-ACKERMAN. Thank you. I will try to be quick, and you have my statement. I want to focus not just on Russia, but to focus on corruption as a phenomenon more generally.
I think the economic crises in East Asia and in Russia have focused attention on the role of the state in economic development. But this problem of dysfunctional and corrupt public and private institutions is much deeper than these headline-grabbing events.
Many poor countries throughout the world have chronically low and negative growth rates. They are not in the paper every day, but the problems are just as serious. Even many countries that are well-endowed with natural resources, have poor growth records and low per capita income. So there are many countries that need institutional reform, not just macroeconomic adjustment.
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We don't just need a crisis response policy. Countries need much, much deeper reform. But this, of course, is difficult. You can build dams, highways, port facilities, they are technically straightforward, but reforming government and limiting corruption, nurturing a strong private sector is a much more subtle and difficult task.
I am speaking about corruption as the misuse of public office for private gain. In other words, it could be simple fraud and self-dealing, but I want to focus particularly on bribery and corrupt transactions that involve both private parties and public officials.
When money changes hands, the briber and the recipient might say they are better off, but there is some violation of government policy. Sometimes the public officials say, ''Well, this is just a gift of goodwill; we really didn't change our behavior,'' but the private individuals and firms might still believe a bribe was necessary in order to get anything done. And we don't want to just look at the small-scale, individual deals, but recognize that people with discretion will be tempted to create a large number of vaguely specified rules that create more chances for payoffs. They would be in control of the level of corrupt opportunities. And those who paid in the past may be tempted to pay in the future because it just seems like it is the norm.
There has been a surprising amount of empirical work in this area where data is obviously hard to get; there have been a number of recent studies which show some interesting things. They show that low levels of investment and growth are associated with relatively high levels of corruption and other measures of government incapacity. Corruption reduces the effectiveness of industrial policies and encourages business to operate in the unofficial sector thus violating tax and regulatory laws.
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Foreign direct investment seems to be discouraged by high corruption levels, and Asian economies are not an exception. I think that is probably less controversial in this past year, but sometimes people have claimed there was something special about the Asian countries. This doesn't seem to be true in most of these results. Even when you have corruption and economic growth going together, you can still have payoffs that introduce costs and distortions—too much unproductive public investment, more public investment relative to private investment, undermaintenance of past investments. In a corrupt regime, people who have few scruples, such as those in illegal businesses, have a comparative advantage.
The costs of corruption might not be obvious when you have coexisting strong growth, as in some of the countries in Asia, but I think you have got a one-way ratchet here. When a downturn occurs, those who have benefited in the past want to keep their benefits, and they think they should, because, after all, they paid for them. As a result, you get a sharper decline than you would have had otherwise, and the costs are more unequally spread than they might have been. One worry is that countries might get caught in a trap where corruption breeds corruption and discourages legitimate business investment. Mr. Saunders was suggesting this in the Russian example.
I think there is a special problem in the banking and finance sectors that your committee is particularly worried about. There are some places where bribes have been a precondition for obtaining loans when banks are under some kind of state control. Sometimes, of course, that is a response to credit controls, or to artificially low interest rates. It is the same reason why you get corruption in systems where prices are controlled; bribers are getting around those prices. But the policy response shouldn't be just to tolerate that corruption, but to have market-friendly changes in the credit system.
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One question, of course, is whether anybody would have an incentive to change. If you are benefiting from the corruption, why should you change? Sometimes, of course, a crisis can be a help. One advantage of a crisis is that it may mean you can do things you couldn't do before. But for reform to be maintained, it has got to be true that the people who benefit from the initial reform then push for further reforms. The worst cases occur when corruption just gets more entrenched over time.
I guess I am not one of these people who thinks that Russia is going through a stage, a cowboy stage, and eventually corruption will wither away over time. I think concrete steps really need to be taken.
Now, there are no single blueprints here. This is something that requires country-by-country analysis. I do think there are some general things that are a checklist of things that are important to think about when you are thinking about anticorruption strategies in a country.
First of all, you want to find out what the problems are. The World Bank has had some good success in supporting surveys of ordinary people and businesses. Surprisingly enough, people talk pretty openly about why things are the way they are, and where corruption is really having a bite on individuals in their day-to-day life.
Second, however, very high-level corruption might not even be noticed by ordinary people when it occurs in contracting, privatization, and concessions. That has to be taken on separately.
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And third, if you are paying bribes to get out of taxes or to get around environmental regulations or health and safety regulations, you may not look at it as a problem, although interestingly enough in some of the surveys that I have seen, people who are paying bribes—admittedly paying bribes—have expressed a willingness to substitute legally paid taxes and a well-run tax and customs system for the uncertainties and problems of a corrupt system. This is, I think, at least a relatively hopeful result.
I don't think that reform that just focuses on the criminal law makes much sense. You shouldn't just go around looking for bad apples or big fish and punishing them. You might have to do that in order to change people's attitudes, to get people thinking about this, but if all you have is a criminal law approach and don't change the structure, nothing much is going to happen.
I have a list of reform possibilities in my statement. I will just list them and not say anything more about them. You can read about them yourselves. They are reform in tax and customs; and reform of business regulation, (here I don't just mean getting rid of regulations, but reforming regulations that make sense, such as environmental regulations, ones that are actually performing some job and correcting market failures or facilitating the operation of society). Look at the kinds of infrastructure projects that are being constructed: Corruption has frequently distorted the investment choices of the state. The need for civil service reform varies in intensity across countries, but often is an important precondition for other reforms.
Finally, institutions are needed that can hear complaints and enforce the law. The government has to provide information. People have to have a way of complaining about what the government does, and there has to be some kind of follow-up that might actually lead to change.
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I do think we are seeing some changes in the way the international institutions are now taking on anticorruption policies as a priority. Both the World Bank and the IMF, and USAID, as well, and some of the aid and lending organizations outside of the United States are beginning to act. As someone was saying, there is not a clear blueprint for exactly what to do, but there is some effort here. The international business community is beginning to support international efforts.
Much of the discussion with Mr. Soros had to do with the IMF appropriations, but there is another issue that is before the House this fall—the OECD Antibribery Convention. That is a treaty that was approved by the Senate at the end of July, but there is some implementing legislation that is needed in order to have it go into effect. It is very important that the U.S. be out in front on this. We are the only country that so far has a Foreign Corrupt Practices Act, and once this Convention is ratified and becomes important, it at least creates the hope or the possibility that the playing field will be somewhat more level. And I think this is an important step in that direction.
Let me conclude. I have been working on the issue of corruption for a long time. I worked on it in the late 1970's and came back to it in the last five or six years, because it was suddenly on the table, and I thought I would like to think about it again. The issue has provided a lot of discussion, there is a lot of talk about it, and there is beginning to be good research. But now the people concerned with the problem of corruption have really got to move beyond establishing a more open discourse to some real experiments, some real attempts to change things. That is not easy, but that is where the people who have something to say about policy need to be moving.
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[The prepared statement of Prof. Susan Rose-Ackerman can be found on page 301 in the appendix.]
Chairman LEACH. Thank you, Professor Rose-Ackerman.
Professor Shleifer.
STATEMENT OF ANDREI SHLEIFER, PROFESSOR OF ECONOMICS, HARVARD UNIVERSITY
Mr. SHLEIFER. Thank you, Mr. Chairman.
Corruption, as you very well know, is pervasive in emerging markets, but corruption should not be viewed as an isolated phenomenon. It is an element of a much broader problem of poorly performing government that is also reflected in poor protection of private property, ineffective judiciary, overregulation of business, failure to provide essential public goods such as health and education, predatory taxation and so on.
Unfortunately, these elements of poor governance typically come together. Countries that are corrupt also have ineffective judiciary, heavy regulation, low schooling attainment, high infant mortality and insecure property rights. Countries like Russia, Indonesia, and many African countries tend to be at the bottom of world rankings on all of these measures of government performance. The United States, Hong Kong, Singapore, wealthy West European countries are at the top, while Latin American, East European and many Asian countries are in the middle.
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One of the crucial manifestations of a poorly performing government of particular relevance to this discussion is failure to collect taxes. In fact, countries with poor-quality government typically have very small public sectors. In poorly governed countries, tax collectors are corrupt; they overlook tax obligations in exchange for bribes. Moreover, businesses hide from predatory regulations by operating, at least in part, unofficially and thus further avoiding tax payments. According to some calculations, about 40 percent of the Russian economic activity today is unofficial, and this percentage is probably higher in the Ukraine. Last but not least, a lot of economic activity simply stops when regulations are too predatory, and of course there is no tax collection from the nonexisting economic activity.
The consequences of the failure of such poorly performing governments to collect tax revenues can be extreme. When a government fails to collect taxes, it needs to resort to other means of financing and spending, including printing money and unchecked debt finance. Russia followed the first strategy during 1991 to 1994; and the second strategy during 1995 to 1998. Of course, neither hyperinflation nor debt finance are good ways to pay for government spending, and each eventually ends with a crisis.
The current crisis in Russia, without any question, has its root in the failure of the government to collect sufficient tax revenue over the previous several years which has resulted in an unsustainable accumulation of public debt. Russia, of course, is not the only country in the world which has suffered from these problems. Many Latin American countries have had the same experience.
The ''privatization'' of law enforcement in Russia—the rise of organized crime—is also a very direct response to the failure of the government to protect the citizens and businesses by underfinancing police and failing to have organized police protection.
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I should say very briefly that many of the crises in emerging markets today can be understood from this perspective of poor quality government and corruption. I am very glad that you have raised this question of corruption in the discussion of the IMF, because I think the issues are very intimately connected. If you ask yourself which of the countries today are suffering the worst failures, it is countries like Indonesia and Russia and, to some extent, Ukraine, which also happened to be at the very bottom of the world rankings in corruption.
If you ask the question, ''Where is the IMF doing extremely well?'', it is countries like Poland and, to some extent, South Korea where the quality of governance and quality of government is much better.
In fact, as Mr. Soros said, this is not entirely surprising. IMF has a certain procedure that it operates under, and unless the government is capable of implementing its own policies and capable in following through with what it has committed to do to the IMF and to the international community, the IMF programs are going to have a much harder time working out.
So, in fact, it is not at all surprising that the poor quality government is very closely linked to the depth of the crisis we have seen in the last two years as well as to the difficulties the IMF programs have experienced.
The quality of governance and matters like corruption and the efficiency of the judiciary also explain the success of economic transition in Russia on the one hand and in Eastern Europe on the other hand.
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The East European countries and Russia have followed very similar economic policies, yet these policies ended up being much more successful in Eastern Europe than in Russia. The reason is very simple, and that is the quality of governance and the quality of execution of these policies. The extent to which these policies have been carried out, rather than undermined by the bureaucracy, has been much greater in Eastern Europe than in Russia. I elaborate on this point in my written testimony, but I will not go much further with it.
The conclusion of that testimony is simply that while economic reform and economic liberalization is very important for improving the quality of governance in different countries, it is not a cure-all, and the countries themselves, as well as the international community, will have to face squarely the questions of reorganizing the bureaucracies and public sector institutions, civil service reform, creation of multiparty systems, and various other changes aimed to improve the quality of governance.
It is important to understand, looking back at Russia over the last decade, that President Yeltsin has had a historic impact in both bringing democracy to Russia and liberalizing its economy to a significant extent. Yet despite these enormous successes, which ten years ago were quite inconceivable, Mr. Yeltsin has failed in the enormous task of improving the quality of political governance. Whoever is going to be the next leader of Russia is going to have to deal with this problem in a very direct way, and Russia is going to keep experiencing very significant difficulties until and unless these issues are addressed directly.
Thank you very much.
[The prepared statement of Prof. Andrei Shleifer can be found on page 314 in the appendix.]
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Chairman LEACH. Thank you very much, Professor.
I would like to turn first to Chairman Bachus, who has held a hearing on Russia and corruption in Russia. Why don't we—Spencer, why don't you go first? .
Mr. BACHUS. Thank you.
Mr. Saunders, is corruption widespread in Russia and can we put money into a corrupt system without expecting a lot of that money to be corrupted and to support a corrupt system?
Mr. SAUNDERS. I certainly do believe that corruption is quite extensive in Russia, and as I tried to suggest in my remarks, I think it has been a major problem for much of the assistance that has been given to Russia thus far.
At the same time, however, as I tried to suggest, I do think that Russia has an opportunity presented by the formation of a new government to make a clean break. Unfortunately, it is hard to know if they will really be able to do it, but I, for one, believe that the interest that the United States has in the success of this transition to democracy and to the market economy really demands that we try to help a little bit longer. As I said, the key is to make it clear to the new government that if there is further evidence of systematic corruption, we will not put any more money into the economy.
We must put real pressure on the Russian government to clean up. The fundamental problem in Russia's entire post-independence history has been a lack of political will to address this problem, first and foremost because of Boris Yeltsin, who is not really renowned for his own personal adherence to the rule of law.
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Mr. BACHUS. Professor Shleifer, you were actually a consulting director of the Russia project for the Harvard Institute for International Development. In that capacity, you were in Russia dealing with Chubais?
Mr. SHLEIFER. Yes.
Mr. BACHUS. The charges you heard that he basically promoted a group of insiders, do you find that to be true?
Mr. SHLEIFER. There is no question that since 1995 the reforms in Russia took the form of extreme closeness between the government and certain financial institutions.
Mr. BACHUS. Would you say kind of a buddy system?
Mr. SHLEIFER. I think that is not an unfair characterization.
I should be clear that in the end of 1995 and in early 1996 when that system has developed, the fear that many people in Russia as well as in this country, had was the fear of communism, and at that point, Mr. Yeltsin was coming up for reelection. That was going to be a very difficult reelection, and members of his government, as well as many other people in the country, felt that unless all the political forces opposed to communism united—and that included not just the people interested in bringing a liberal capitalist system in Russia, but also the oligarchs—unless these forces united, communism would win out in Russia.
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Whether or not it was possible for the forces of democracy to prevail in 1996 without the creation of that buddy system, I do not know. It is my firm belief that Russia in the last three years has paid a very heavy price for the creation of the buddy system.
Mr. BACHUS. Thank you.
Chairman LEACH. Thank you very much.
Mr. Hinchey.
Mr. HINCHEY. Thank you very much, Mr. Chairman.
Thank you, the three of you, very much for your very interesting testimony. You outlined some aspects of corruption which are in some senses exotic and in others more familiar to us.
For example, the substantial economic benefits that have flowed to Mr. Yeltsin as a result of arranging the publication of his memoirs by certain Russian tycoons is a situation with which we are somewhat familiar here in the United States, as well.
Nevertheless, the sum total of the testimony from the three of you and from some others is very, very troublesome indeed.
I wasn't at the hearing here yesterday, Mr. Chairman, but overnight I read much of the testimony of the witnesses who were here and one of the things that was suggested by one of the people who was here yesterday was that from an economic point of view, it might be more beneficial for us to try to work with the provinces, try to work with the local governments, the provinces, rather than the central government, because some of them are more serious about reform than others, some of them seem to be more serious about reform and more capable of it than the central government. And it may be that if we could get circumstances situated in some one or more of the provinces that would accommodate investment, that would get rid of some of the basic problems such as the hoarding of capital—$80 billion being hoarded at home minimally; it may even be substantially more than that—and start getting some of that money invested in the economy. Then outside money would more likely come in; you might see more stabilization.
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Do you think that has any relevance to attempts to deal with the problems of corruption as well? Would it be beneficial if the international community, the United States in particular, would try to target a particular province and try to work with that province and try to control corruption at that level?
Ms. ROSE-ACKERMAN. Let me say a couple of things.
There are two things here. One is the idea of focusing on one province or one smaller country so that that country's program could then become an example for other people to copy. Second, because a country made some changes, it might be getting more investment, or the people in the country might be happier with the government in the country. That is a possibility.
I am not so sure whether the right strategy is to focus on the provinces in Russia, where they are part of a bigger federal system and it is not clear how much freedom of action they have. The World Bank is currently carrying out its anticorruption program in three relatively small countries—Georgia, Latvia and Albania, and part of the reason for that, it is not just that those countries asked the World Bank to come in, but it is also they are relatively small countries.
Now, of course, there is really only so much you can do with an island, with a little place in the middle of a sea in which there are very serious problems. But I think there is something to be said for starting small.
But my hunch is that some of the problems in Russia are country-wide—for example, the banking problem that we were talking about. If the basic credit system is extremely corrupt, it is not going to make much difference if a small area is being focused on.
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So I don't think there is a straight answer here, but I wouldn't neglect some of those things which are obviously crosscutting general preconditions for business activity within Russia that can't be handled just at the local level.
Mr. HINCHEY. Anyone else?
Mr. SAUNDERS. I would generally agree regarding the situation in Russia. Many of the problems are on a national scale; and unfortunately, as a result, it would be very difficult to conquer corruption in one region or a group of regions. The pressures from the outside may just be too great to overcome.
Mr. SHLEIFER. My feeling is that the paramount objective is to keep Russia as part of the world economy and part of the world community. To that extent, my feeling is that it is important to work at every level and fight for every block. That means working with the national government under the auspices of bilateral relations or the World Bank or the IMF, but also working at a much more local level.
The most dangerous thing that can happen, which is not inconceivable, is that people get so fed up with the recurring problems of the Russian government that what follows is the isolation of the country which would have devastating consequences not just for Russia, but for the rest of the world as well.
Chairman LEACH. Well, thank you, Mr. Hinchey. Six or seven years ago when we had the famous Tiananmen Square episode, there was a very moving scene I witnessed one night on television. A BBC-type reporter interviewed a student a few weeks before the violence occurred, asked the student what the people were demonstrating for, and the student said, ''Democracy''; and then the BBC reporter said, ''What do you mean by 'democracy' ''? And we as Americans all have views that it has something to do with elections. Anyway, the student looked kind of startled and said, ''No more corruption.''
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And one has a sense in a lot of developing countries, including China, corruption is rather widespread and that if you think of antidotes to corruption, certainly symbolizing institutions that are democratic appear to have some effect some of the time. But decentralization appears to be a positive, as well, and greater competition appears to be a positive.
Which brings one to the systemic part of the economy that this committee is most responsible for overseeing, which is the banking system; and it appears, at least in Russia, virtually all banks are money laundering centers and used to among other things get money to safety for the controllers of the banks and safety implies capital flight. And we saw this for different kinds of reasons in Latin America a decade and a half ago, but it doesn't seem that any amount of money can replace the money that has gone out.
And so it strikes one that the minimum that has to be done is to establish a system where internal savings can be recycled in a fair and honest way. And that means putting perhaps central attention on the banking system itself, whether banks should be large, whether they should be community banks, whether they should be credit unions is of, I think, real interest.
And so one aspect, as we think about the International Monetary Fund, is what does its sister institution, the World Bank do. The Monetary Fund disproportionately deals with sums of money that appear to go to governments and whether we ought to be looking: A, that the money not go precisely to governments if its transferred, put in different ways; or B, what the World Bank does in terms of emphasizing different types of investments, particularly in the banking sector.
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Do any of you have advice on financial institutions?
Mr. SHLEIFER. The Russian savers have relied to an overwhelming extent on the bank that Mr. Soros has mentioned, which is Sberbank, and in fact one of the reasons why the effects of the moratorium and the other recent policies of the Russian government have been relatively contained is precisely because the commercial banks that have gone under take very few deposits from individuals. Those are the banks that take deposits from corporations and from the government, maybe from some foundations like Mr. Soros', and channel them to various investments. The reason for that is that there is no trust on the part of the public in the banking system, and so people do not put money in these private commercial banks.
My feeling is that Russia is going to start from scratch in building a banking system, that the existing one has been completely discredited. And whether the existing banks are going to go under or are going to be nationalized remains to be seen, but it seems virtually inconceivable that the system will stay.
As it is, at a broader level, I think banking is just a reflection of a broader question, whether people trust the institutions of a country. As long as people feel that the tax service can arrest their bank accounts whenever it feels that it wants to do so and when enterprises do not want to have bank accounts because they feel they can be captured by government authorities, it seems to me that the creation of a banking system is going to have to be part of a much more radical process of institutional reform where Russia begins to create institutions that have some public confidence.
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Ms. ROSE-ACKERMAN. Let me say one thing. I am certainly not an expert on Russian banking by any means, but you raised an interesting question suggested by Mr. Soros' remarks: How bad is the collapse? Has it really completely collapsed? At least in some parts of the country, there are some similarities between the situation in Russia and situation in some very poor countries throughout the world. There are efforts to reform the credit systems in very poor countries that involve small loans to households for very, very small things—small-scale entrepreneureship—and that use as a monitoring system the constraints that people, neighbors or members of the same area, impose on each other.
This is an old model that has been revived. The most famous modern example is the Grameen Bank in Bangladesh, but there are a lot of other examples, even in the United States, of microcredit organizations. It is a very different model of how to monitor something like banking or the provision of credit, in sharp contrast to a system that is more nationalized and that involves monitoring of the banking system.
Chairman LEACH. We are going to have a hearing in a week on microenterprise. But it is a very interesting circumstance that we think in the 20th century, the end of it as being very big and very sophisticated models of finance and investment banks, but throughout much of the world, very small lending has proven somewhat efficacious; and in our country—at least as of several years ago; I haven't seen recent statistics—over most of the last several decades virtually all job growth has been small business, not large business, which is a fairly stunning thought.
And we have very minor microenterprise approaches in the United States now. In virtually every State there are examples of it.
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But the other model in the United States which is growing is, of course, the credit union model. The credit union model is one that has a basis in Eastern Europe that preceded the United States, and some basis in Russia, although not large. These are models that maybe people are going to have or maybe should be looking at.
Mr. Saunders, your descriptions of corruption involving people in high places is very sobering.
Mr. SAUNDERS. It is a very disturbing problem. Unfortunately, the fundamental problem is Boris Yeltsin and his own lack of respect for the rule of law. This ties into the question that Professor Shleifer raised about people's confidence in the system.
Ms. ROSE-ACKERMAN. But you are not just saying a change in personality is enough, are you?
Mr. SAUNDERS. I don't think a change in personality will solve it entirely by any means, but it would certainly be a step in the right direction at this point.
Chairman LEACH. Mr. Bachus, do you have further questions?
Mr. BACHUS. I noticed—is it Dr. Ackerman?
Ms. ROSE-ACKERMAN. Professor.
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Mr. BACHUS. I noticed you talked about keeping our aid programs not affected by the corruption that we have in these foreign countries. And I noticed, Professor, you are part of that Harvard group. The mayor of Moscow recently singled out Harvard and its advisors as giving bad advice. What was that all about?
Mr. SHLEIFER. Well, the mayor of Moscow has singled out Harvard for giving bad advice and then hired himself a team from another part of Harvard to give him advice, which I thought was——
Chairman LEACH. If the gentleman will yield. Mr. Buchanan also singled out Harvard for giving bad advice.
Mr. BACHUS. Who did?
Chairman LEACH. Pat Buchanan.
Mr. SHLEIFER. There you go.
But there was a very substantial disagreement between Mr. Chubais and Mr. Luzhkov on the methods of privatization, when Mr. Chubais headed a mass privatization program that was implemented in Russia during 1992 and 1994. Mr. Luzhkov supported a different program for the City of Moscow and with the support of President Yeltsin, in fact, prevailed in his city. That is the background of the explanation of the comment that he has made. To his credit, he is not the only person who has accused various people at Harvard.
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Mr. BACHUS. Is he talking about the HIID? Is that what he is talking about?
Mr. SHLEIFER. My understanding of the context in which he has made this comment is that there were comments specifically directed at the privatization program, and then it was made in the context of a speech he gave at Harvard.
Mr. BACHUS. It was HIID that basically was setting the policy toward privatization for USAID, was it not?
Mr. SHLEIFER. The program, the advisory role that I was involved in, had started before USAID came to Russia, started with the support of the Ford Foundation, and at some point USAID began providing finances, yes.
Mr. BACHUS. Did HIID steer or advise USAID on where to spend their funds or how to use them?
Mr. SHLEIFER. No, I don't think that would be an accurate description.
Mr. BACHUS. What was the relationship between HIID and USAID?
Mr. SHLEIFER. USAID had a policy of supporting particular projects and particular activities, advisory activities in the Russian Federation. The various projects, as part of this policy, were performed by different institutions, one of which was HIID for which I have served as a consultant. But it would not be a fair characterization, to say that HIID directed U.S. aid, the policy.
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Mr. BACHUS. Did they have any control at all on USAID's recipients of funds? Did you make any suggestions or have any input?
Mr. SHLEIFER. I am not sure I know what you are asking. I am trying to understand. HIID, as part of its contract or cooperative agreement with USAID, hired subcontractors to perform particular tasks. Is that what you have in mind?
Mr. BACHUS. Was HIID one of the subcontractors?
Mr. SHLEIFER. HIID was a contractor on a project. As part of that contract, it hired various subcontractors. Including universities and some consulting firms. Is that what you have in mind when you——
Mr. BACHUS. I had read reports that HIID directed some of the USAID funding.
Mr. SHLEIFER. I think USAID is an organization perfectly capable of making their own decisions, and in fact, my understanding of the relationship was very much that USAID wanted particular tasks performed, including tasks related to privatization, to legal reform in the Russian Federation, to work on securities markets and it has had competitions, some of which were won by HIID.
Mr. BACHUS. In other words, on the privatization projects that USAID was funding, HIID would actually select or participate in choosing who received funding or advising USAID as to who would——
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Mr. SHLEIFER. USAID funded HIID to perform certain projects, yes.
Mr. BACHUS. Did HIID then fund certain projects?
Mr. SHLEIFER. Yes. HIID funded projects with USAID funds that were approved by USAID.
Mr. BACHUS. I see. Are you advocating additional IMF funding for Russia?
Mr. SHLEIFER. I believe that it would be a profound mistake for the West to disengage from Russia.
Mr. BACHUS. But how about IMF funding?
Mr. SHLEIFER. I believe that today IMF is the only game in town. I believe that there are certain ways in which things ought to be done in Russia that are quite different from the way in which they are being done, and in particular, consistent with comments I have just made, I believe that it is overwhelmingly important to put a lot more emphasis on the questions of governance in Russia, on the questions of the quality of government. The issues of corruption, the issues of the use of the IMF funds, the issues of the treatment of Western investors by the Russian government and a whole host of other issues should become not secondary matters in the broad macroeconomic context, but rather, central matters to the discussion.
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Having said that, I do not see in the near term any alternative to the IMF, and I think that given the virtually impossible situation that the IMF had to deal with in countries like Russia, Indonesia and Ukraine, they have done a reasonably good job.
Mr. BACHUS. This is my last question, Mr. Chairman, but is it especially important that those in government who are advising us on what to do as far as privatization not be investors in Russia themselves?
Mr. SHLEIFER. I would not take the same position as you are suggesting that these people should not be investors in Russia themselves; just like I would not believe that people who come in front of this committee to testify, who advise the Executive Branch and the Legislative Branch of the United States Government, should not invest in American stocks and American bonds on equal terms with other investors in this country.
Unless a person is a member of the Government, as far as I understand, this person is not precluded from investing in United States Government securities and is not presumed to be biased in giving their advice. If this person operates on the same terms and operates in markets together with all other investors, I do not see why—and I understand you have asked Mr. Soros this question—I do not understand why this situation is in principle different for other countries.
Mr. BACHUS. Thank you.
Chairman LEACH. Well, thank you very much. Let me thank you all and thank you for your patience. It has been a very long day. Welcome to Washington. Welcome to a lengthier stay than you expected. And we appreciate the three of you testifying on behalf of the best of all institutions.
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Thank you. The hearing is adjourned.
[Whereupon, at 5:35 p.m., the hearing was adjourned.]
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