In my version of events, I'm not here voluntarily. At least, I do not recall actually having said yes to Charles Dallara's several invitations to speak. I may be naive. But I do know enough to know this would be a tough audience, frustrated about intractable problems in difficult markets.

In any event, an invitation to dinner arrived with me listed as speaker. Charles, faced with systemic risk to his planned dinner program, obviously acted with the vigor and decisiveness that he learned in government service.

Well, there is no doubt we meet at an interesting time. And even if it's already late on a Saturday night, I welcome the challenge to make some sense of it all.

You all know the general setting:

· the United States, as the largest and most powerful economic engine and at the center of world financial markets, has enjoyed an expansion of unparalleled length, spawning alluring visions of endless prosperity.

· Investment returns have quite literally been historically unprecedented. Complex financial instruments and new investment vehicles have sprouted up on every corner of Wall Street or Lombard Street. They are mainly designed to leverage the gains further, typically under the rubric of names that suggest both prudence and continuity.

· All this has happened against the background of a truly fundamental change in policy thinking right around the world. The ideology of free markets reigns triumphant. Trade barriers, capital controls, government ownership -- all have been falling away right before our eyes.

· At the same time, many small economies have emerged on the world economic scene. Some of them, especially in Asia, had been able to sustain patterns of growth seldom if ever seen in all of economic history.

No wonder visions of a New Era came to be seen less of a mirage and more of a reality.

Now, suddenly it all seems in jeopardy. All that real growth - all the trillions of in paper wealth creation - is at risk. What started as a blip on the radar screen in Thailand - about as far away from Washington or New York as you can get - has somehow turned into something of a financial conflagration.

How attitudes change. Just a few years ago when Alan Greenspan suggested concern about "irrational exuberance", the collective market response was a big shrug. Markets know best; don't even think of intruding.

What a difference now, with some of the proudest and richest capitalists looking to the warm embrace of the same Federal Reserve when fortunes are threatened.

What is this all about?

Well, I do not want to be alarmist. The Europeans and American economies still have forward momentum. The basic economic potential of the emerging world remains strong, very strong. Open competitive markets for goods and capital should help them realize that potential.

But we shouldn't kid ourselves. I said a year ago, and I continue to believe, the problems we see with such force today are systemic - systemic in the literal sense that they arise from within the ordinary workings of global financial capitalism. The present crisis can be constructively resolved. But it is bound to take time, and it's going to involve a real willingness to re-examine the way we have organized (or failed to organize) the international financial system.

A year ago, to express that view was enough to raise questions about my allegiance to all that is holy and good: the sanctity of markets and their unfailing ability to adjust, the freedom of capital and trade, maybe even to democracy itself. The then prevailing view was that the difficulties lay not in the system but in its housekeeping.

Specifically, the emphasis was entirely on the policies and the practices of small countries.

· Thailand had mismanaged its exchange rate.

· There and elsewhere banks were not as well capitalized as we would have liked; their risk management was weak; there was no SEC or Chapter II.

· Mr. Soharto was greedy, and his family was too big.

· There were unholy mixtures of industry and finance everywhere in Asia.

· And there was, of course, cronyism and corruption.

Now I want to be clear. All those things were and are true. I would like to see changes. In fact, I'd like more attention to some defects in our own markets as well.

What I find totally unconvincing is that those shortcomings are uniquely or primarily responsible for the predicament in which we find ourselves.

· Recall that the Southeast Asia countries in particular, with all those bad practices, had sustained strong growth for a decade or more.

· Emerging economies increasingly have in fact taken the advice to open markets, financial and
otherwise, with, in any historic context, remarkable speed.

· Precisely those countries where the storm hit hardest -- Indonesia a prime example -- had come to be considered models of good macro policy by the IMF and the World Bank alike.

· Moreover, there was no sudden change in those policies or in internal circumstances to trigger a crisis.

Suppose all those policies and practices were somehow magically changed to something closely in tune with the American or European model. I find no evidence in history that financial crises would be ended. What of the latest bit of evidence in the U.S. itself, one inscrutable, unsupervised and unregulated financial institution - an institution boasting the most elaborate models of market behavior and sophisticated advisors - - carried the possibility, by testimony of our central bank, of pulling down the financial tent.

In seeking a diagnosis for the present problem, let me make one further observation. By and large, the crisis first hit countries which, in the eyes of the market, were deemed to have exceptionally good prospects and policies.

The basic story is as old as financial capitalism itself. Success breeds confidence and over-confidence. Greed overcomes prudence.

Then something unexpected happens -- perhaps at home, perhaps abroad - to raise doubts. Fear becomes contagious. Individual efforts to protect ones self help spread distress. And if the excesses are wide-spread enough and the fears pervasive enough, a financial crisis becomes a true economic crisis --which is where much of the emerging world is today.

It is also true that large economies with trusted currencies, strong central banks and diversified business organizations are seldom thrown way off course for long. That has been the case with the United States and Europe for decades, and I believe that should remain the case today.

However, there are two large differences in financial markets today that add to the vulnerabilities of many other nations.

One is a difference in degree, and it's something with which everyone in this audience is totally familiar. The communication revolution has made it a lot easier to keep in touch with events right almost anywhere. At the same time, irreversible technological change means the amount of money ready, willing, and able to move around the world, whether out of greed or fear, has risen exponentially - right off the charts.

The second difference is really a change of kind. In the space of 15 years or so, the ideology of free and open markets has swept over virtually the entire world. One consequence has been the sizable number of what we used to call developing countries emerging into the international market place and the world financial scene. One common characteristic of those countries, some large in population and area, is the small size of their financial sector. While obviously varying by particular country, I remind you the aggregate size of the banks in the typical emerging country is now the size of a single regional bank in the United States - precisely the kind of bank that is told insistently by its advisors that it is too small to survive in today's turbulent markets.

Put those two changes together -- on the one side huge and potentially volatile financial flows and, on the other side, small emerging financial markets -- and we have the ingredients for a new variant of an old story.

We are all by now familiar with the pattern.

· A strong inflow of portfolio capital into an emerging economy reinforces growth, keeps the currency strong and interests rates down.

· Eventually it also swamps the local financial system and, almost inevitably, leads to a real estate boom and other excesses, including a growing current account deficit.

Then something happens to trigger concern. The capital inflow reverses, interest rates rise, the exchange rate sinks, confidence is lost, banks go bad and their customers follow.

Something like that has happened in the best of countries. What is different now is the size, volatility and interdependence of international capital flows impinging on small financial systems. By its nature, it's a situation that breeds contagion and enormous instability in both exchange rates and interest rates.

Well, if we have a systemic problem, what to do?

The first recourse, quite naturally, has been to the established mechanisms for dealing with financial crises -essentially the IMF, the US Treasury and the G-7 consortium. That seemed to work in Mexico in - massive liquidity support with manageable macro-economic conditionality. But that approach was not easily adaptable to the more complex East Asian situation. For one thing, much less "upfront" money was

available. At the same time, much stronger conditionality, extending this time far into the established economic and social structure was deemed essential. When the terms weren't met and money withheld, confidence collapsed.

That approach, whether in Asia or Russia, seems to have been overtaken by events. Now we see experimentation with its polar opposite: the introduction of sweeping exchange and capital controls in defense of the established economic and social order. That alternative surely cannot be workable in today's world. The attempt to maintain comprehensive controls for any length of time will undercut growth and efficiency.

We still hear the siren song that somehow floating exchange rates will solve the problem. That seems to me a strange and sad song. Surely, the extremely wide swings in the exchange rate of the world's two largest economies, Japan and United States, has been a critically important factor contributing to the instability in East Asia generally. How can there be a "correct" exchange rate, fixed or floating, for Thailand or Indonesia or the Philippines when the exchange rates of their major trading partners are moving in sharply diverging directions? And if you're not confused, I am, when I read at one and the same time, urgent appeals to other countries in Asia stand firm in fixing their exchange rates, even if their competitive positions are deteriorating, while others are blithely advised to float? The fact of the matter, it seems to me, is that the smaller emerging nations heavily dependent on trade simply do not have the breadth of financial markets or the resiliency of real economies to withstand sharp fluctuations in exchange rates - their own or their major trading partners.

If those approaches have been inadequate, the basic economic response to the crisis seems clear enough. We are indeed in a process of globalization: we talk about it ad nauseam. But we have been only part way there. The process is speeding up under the stress of financial and economic volatility. The natural defense mechanism is to seek size and diversity. We see one reflection of that basic fact in the surge of mergers and acquisitions within the industrialized world.

In the emerging economies, the need for size and diversification necessarily entails more foreign ownership.

· In Argentina, in the wake of the Tequila crisis, there is today only one bank of any size not owned or controlled by a large international bank. In Mexico - a country that a few years ago fought tooth and nail to preserve national ownership of banks in the NAFTA negotiations - has four of its "big six" owned or partly controlled from abroad. Asian countries now eagerly invite foreign participation in their institutions; even Japan now finds it acceptable.

· The same tendency is at work, perhaps a little more quietly, in the industrial world. Big multilaterals may have difficulties in emerging markets, but the ones I see are also busy considering purchases to prepare themselves for tomorrow.

That adds up to more financial and industrial integration, not less. The currency counterpart seems almost as clear. The tendency will be to seek stability in regional arrangements, formal or informal. All of that is plainly apparent within Europe, capped now with the ultimate of fixed exchange rates, a common currency.

Suppose with me that that kind of further global integration, accompanied by a free flow of capital, is the economically desirable outcome of this crisis - the outcome most likely to produce growth and stability. But worry a bit with me as well.

What if, in 2002, five years after the Thai crisis, we collectively look back and see growth in the emerging world has dropped from a fast run to a slow walk. Suppose at the same time they are caught in a web of currency instability. Add to that a sense that they have lost control of their banks, their finances, and their destiny.

Then, unproductive as the reaction might be, the temptation to look back, to close markets, to withdraw, might be strong.

So there is a lot at stake. We do need to make the world safer for global finance. And I think it's obvious that the kind of basic reform required - true financial architecture - won't come easily.

What is promising, I think, is that for the first time in decades, political leaders in Europe and America have begun to recognize the need. But they shouldn't be misled. There is not, so far as I can see, anything like a strong intellectual consensus. The technical problems are formidable. The issues won't be solved in a conference or two or by a reassuring communique emphasizing the need for good behavior.

Consider a few of the items that need to be on the agenda.

Recent support packages have been relatively ineffective partly because of the absence of any clear strategy toward private debtors and creditors. Normal bankruptcy approaches are not feasible for sovereign countries (nor apparently are we willing to contemplate them for large financial institutions deemed of systemic importance). But heiter skelter, -with purely ad hoc official intervention, can't be a good model either. I mention this first because obviously, it is an area in which the Institute of International Finance (and indeed Jacques de Larosiere) has had a particular interest. I urge you to re-examine the issue realistically, recognizing that when markets break down, extraordinary work out techniques are necessary.

Plainly the IMF and official lenders generally do not have the capacity to provide full liquidity bailouts A la Mexico 1995. The IMF is not - not yet at least - a world central bank. But what role do we want it to play? In emergencies, should that institution extend its precepts beyond macroeconomic policy into economic and social structures? Or can those efforts be better left to the World Bank and others, working with a longer term perspective. In any event, we can't leave the institutions helpless, without adequate funding.

Efforts of small emerging economies to retreat into a network of exchange controls will be counter-productive and only breed evasion and corruption. But should we condemn countries that experiment with various means of discouraging the inflow of hot money, particularly when those measures are consistent with reinforcing the stability of domestic financial institutions. If we are to avoid more extensive controls, don't we need to clarify the policy and strengthen the authority of the IMF to oversee to such matters.

Going further, how should multinational financial conglomerates be regulated and strengthened? Do we really want to extend the official safety net beyond banks, and if so how do we extend cooperation and coordination among regulators, building on the precedent of Balse capital agreements.

Finally, I cannot help but emphasize the fundamental importance of reform of the exchange rate system. We are a very long ways from a world currency. But indifference to swings in the major exchange rates, ranging to 50 percent or more over a year or two, can't any longer be justified. There is a clear possibility the introduction of the Euro will, in that respect, complicate matters.

It is a large agenda. None of it should distract the authorities from the potential need to help stabilize Brazil or others caught in the backwash of the current crisis. A lot needs to be done in Thailand, Indonesia, Korea and elsewhere. There is no substitute for recovery in Japan and sustaining growth in the United States and Europe.

But we do have an all too rare opportunity for real international financial reform. I trust we will seize the day. A lot rides on the success of the effort, and not just for emerging nations.