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The best introduction to the vast and complex history of casino capitalism that I have found is the article by Gordon K Douglass Controlling speculation in world financial markets written for World Alliance of Reformed Churches Progressive Christians Uniting in November 9 2002. Here is an annotated copy (it is reformatted for Softpanorama readers):
- Financial markets 101
- Early history
- The Bretton Woods system
- The power of financial actors
- Consequences of global financial flows
- Policy options
- Theological and ethical considerations
- A new financial architecture
- What Christians can do
- Want to know more?
- Questions For Discussion
"During my whole career at Goldman Sachs - 1967 to 1991 - I never owned a foreign stock or emerging market bonds. Now I have hundreds of millions of dollars in Russia, Brazil, Argentina and Chile, and I worry constantly about the dollar-yen rate. Every night before I go to bed I call in for the dollar-yen quote, and to find out what the Nikkei is doing and what the Hang Seng Index is doing. We have bets in all these markets. Right now Paul [one of my traders] is long [on] the Canadian dollar. We have bets all over the place. I would not have worried about any of these twenty years ago. Now I have to worry about all of them."
Leon Coopermann, hedge fund manager1
Economic globalization is probably the most fundamental transformation of the world's political and economic arrangements since the Industrial Revolution. Decisions made in one part of the world more and more affect people and communities elsewhere in the world. Sometimes the consequences of globalization are positive, liberating inventive and entrepreneurial talents and accelerating the pace of sustainable development. But at other times they are negative, as when many people, especially in less-developed countries, are left behind without a social safety net. Globalization undermines the ability of the nation to tax and to regulate its own economy. This weakens the power of sovereign nations relative to that of large transnational corporations and distorts how social and economic priorities are chosen.
Economic globalization is most often associated with rapid growth in the flow of goods and services across international borders. Indeed, the economic "openness" of a nation is often measured by the value of its exports, imports, or their sum when compared to the size of its economy. Economic globalization also involves large investments from outside each nation, often by transnational corporations. These corporations often combine technology and know-how with their investments that enhance the productive capacity of a nation. Previous position papers of the Mobilization, contained in Speaking of Religion & Politics: The Progressive Church Tackles Hot Topics2, have dealt with globalization primarily in these terms.
But international trade and investment are only part of the openness that has come to be called globalization. Another part, and arguably the most important, is the quickening flow of financial assets internationally. While a small portion of this flow is directly associated with the "real" economy of production and exchange, its vast majority is composed of trades in the "paper" economy of short-term financial markets. This paper economy is enormous: The value of global financial securities greatly exceeds the value of annual world output of goods and services. Moreover, the paper economy often contributes to crises in the real economy. Thus it is important to the well being of humanity and the planet as a whole, yet it is little understood by most people. This essay undertakes to provide a basic understanding of this paper economy, especially as its more speculative features have multiplied during the last two or three decades, so that Christians and others concerned about what is happening in our world can join in an intelligent discussion of how the harmful consequences of financial markets can be controlled.
Financial markets 101
To better understand this paper economy, one first needs to know something about foreign exchange markets, international money markets, and "external" financial markets.
In an open economy, domestic residents often engage in international transactions. American car dealers, for example, buy Japanese Toyotas and Datsuns, while German computer companies sell electronic notebooks to Mexican businessmen. Similarly, Australian mutual funds invest in the shares of companies all over the world, while the treasurer of a Canadian transnational corporation parks idle cash in 90-day Bank of England notes. Most of these transactions require one or more participants to acquire a foreign currency. If an American buys a Toyota and pays the Japanese Toyota dealer in dollars, for example, the latter will have to exchange the dollars for yens in order to have the local currency with which to pay his workers and local suppliers.
The foreign exchange market is the market in which national currencies are traded. As in any market, a price must exist at which trade can occur. An exchange rate is the price of a unit of domestic currency in terms of a foreign currency. Thus, if the exchange rate of the dollar in terms of the Japanese yen increases, we say the dollar has depreciated and the yen has appreciated. Similarly, a decrease in the dollar/yen exchange rate would imply an appreciation of the dollar and a depreciation of the yen.
Foreign exchange markets can be classified as spot markets and forward markets. In spot markets currencies are bought and sold for immediate delivery and payment. In forward markets, currencies are bought or sold for future delivery and payment. A U.S. music company, say, enters into a contract to buy British records for delivery in 30 days. To guard against the possibility of the dollar/pound exchange rate increasing in the meantime, the company buys pounds forward, for delivery in 30 days, at the corresponding forward exchange rate quoted today. This is called hedging.
Of course, there has to be a counterpart to the music company's forward purchase of pounds. Who is the seller of those pounds? The immediate seller would be a commercial bank, as in the spot market. But the bank only acts as an intermediary. The ultimate seller of forward pounds may be another hedger, like the music company, but with a position just its opposite. Suppose, for example, that an American firm or individual has invested in 30-day British securities that it wants to convert back into dollars after the end of 30 days. The investor may decide to sell the pound proceeds forward in order to assure itself of the rate at which the pounds are to be converted back into dollars after 30 days.
Another type of investor may be providing the forward contract bought by the music company. This is the speculator, who attempts to profit from changes in exchange rates. Depending on their expectations, speculators may enter the forward market either as sellers or as buyers of forward exchange. In this particular case, the speculator may have reason to believe that the dollar/pound exchange rate will decrease in the next 30 days, permitting him to obtain the promised pounds at a lower price in the spot market 30 days hence.
The main instruments of foreign exchange transactions include electronic bank deposit transfers and bank drafts, bills of exchange, and a whole array of other short-term instruments expressed in terms of foreign currency. Thus, foreign exchange transactions do not generally involve a physical exchange of currencies across borders. They generally involve only changes in debits and credits at different banks in different countries. Very large banks in the main financial centers such as New York, London, Brussels and Zurich, account for most foreign exchange transactions. Local banks can provide foreign exchange by purchasing it in turn from major banks.
Although the foreign exchange market is dispersed in many cities and countries, it is unified by keen competition among the highly sophisticated market participants. A powerful force keeping exchange rate quotations in different places in line with each other is the search on the part of market participants for foreign exchange arbitrage opportunities. Arbitrage is the simultaneous purchase and sale of a commodity or financial asset in different markets with the purpose of obtaining a profit from the differential between the buying and selling price.
When foreign exchange is acquired in order to engage in international transactions involving the purchase or sale of goods and services, it is said that international trade has taken place in the real economy. When international transactions involve the purchase or sale of financial assets, they are referred to as international financial transactions. They constitute the paper economy.
Financial markets are commonly classified as capital markets or money markets. Capital markets deal in financial claims that reach more than one year into the future. Such claims include shares of stock, bonds, and long-term loans, among others. Money markets, on the other hand, deal in short-term claims, with maturities of less than one year. These include marketable government securities (like Treasury bills), large-denomination certificates of deposit issued by banks, commercial paper (representing short-term corporate debt), money market funds, and many other kinds of short-term, highly liquid (easily transferable) financial instruments. It is these short-term money market securities that account for most of the instability in the global paper economy.
Buying or selling a money market security internationally involves the same kind of foreign exchange risk that plagues buyers or sellers of merchandise internationally. If one wishes to guard against the possibility of an increase or decrease in the foreign exchange rate, one can insure against such fluctuations by "covering" in the forward market. By the same token, the decision about whether to own domestic or foreign money market securities is not simply a comparison of the rates of interest paid on otherwise comparable securities, because one must also take into account the gain (or loss) from purchasing foreign currency spot and selling it forward. Thus, choosing the security with the highest return does not necessarily imply the one with the highest interest rate.
People who trade in international money markets, moreover, need to take into account many other variables, including the costs of gathering and processing information, transaction costs, the possibility of government intervention and regulation, other forms of political risk, and the inability to make direct comparisons of alternative assets. Speculating in international money markets is a risky proposition.
International money markets involve assets denominated in different currencies. External financial markets involve assets denominated in the same currency but issued in different political jurisdictions. Eurodollars, for example, are dollar deposits held outside the United States (offshore), such as dollar deposits in London, Zurich, or even Singapore banks. The deposits may be in banks owned locally or in the offshore banking subsidiaries of U.S. banks. Deutsche mark deposits in London banks or pound sterling deposits in Amsterdam banks also are examples of external deposits. They are referred to as eurocurrency deposits. (The advent of a new common currency in the European Community - the Euro - will require the development of new nomenclature for external financial markets)
External banking activities are a segment of the wholesale international money market. The vast majority of eurocurrency transactions fall in the above $1 million value range, frequently reaching the hundreds of millions (or even billion) dollar value. Accordingly, the customers of eurobanks are almost exclusively large organizations, including multinational corporations, government entities, hedge funds, and international organizations, as well as eurobanks themselves. Like domestic banks, eurobanks that have excess reserves may make loans denominated in eurocurrencies, expanding the supply of eurocurrency deposits. The eurocurrency market funnels funds from lending countries to borrowing countries. Thus, it performs an important function as global financial intermediator.
The origins of what Karl Polanyi3 called haute finance can be traced to Renaissance Italy, where as early as 1422 there were seventy-two bankers or bill-brokers in or near the Mecato Vecchio of Florence.4 Many combined trade with purely financial business. By the middle of the fifteenth century, the Medici of Florence had opened branches in Bruges, London and Avignon, both as a means of financing international trade and as a way of marketing new kinds of financial assets. Many banking terms and practices still in use today originated in the burgeoning financial centers of Renaissance Europe.
By the early seventeenth century, the Dutch and East India Companies began issuing shares to the public in order to fund imperial enterprises closely linked to Holland and Britain. Their shares were made freely transferable, permitting development of a secondary financial market for claims to future income. Amsterdam opened a stock exchange in 1611, and shortly thereafter, the British government began issuing lottery tickets, an early form of government bonds, to finance colonial expansion, wars and other major areas of state expenditure. A lively secondary market in these financial instruments also emerged.5
Throughout these early years, financial markets were anything but riskless and stable. Consider the famous Dutch tulip mania of 1630, for example. This speculative bubble saw prices of tulip bulbs reach what seemed like absurd levels, yet "the rage among the Dutch to possess them [tulips] was so great that the ordinary industry of the country was neglected." Some investors in Britain and France shared this "irrational exuberance," though it was centered mostly in Holland. Then, not unlike speculative bubbles of more recent vintage, prices crashed6, pushing the economy into a depression and leaving many investors angry and confused.
Paris developed into an early financial center in the eighteenth century, but the Revolution of 1789 dissipated its power. The New York Stock Exchange was formally organized in 1792 and the official London Stock Exchange opened in 1802. The expansion westward of the railroads in the U.S. offered the financial community opportunity to sell railway shares and bonds that quickly became dominant in the financial markets. Indeed, the bond markets of London, Paris, Berlin, and Amsterdam were vehicles for collecting massive amounts of European savings and transferring it at higher returns to the emerging markets of the U.S., Canada, Australia, Latin America and Russia in the century preceding World War I.
Forward markets soon developed, especially in the U.S., in order to counter the impact of long distances and unpredictable weather. As capital and money markets expanded, other new financial instruments came into use. Joint stock companies were formed, enabled by legislation that clarified the distinction between the owners and managers of corporations. This, in turn, helped stimulate the growth of the American stock market in the late nineteenth century. To be sure, financial markets did not grow continuously in the nineteenth century. Lending to the emerging markets was interrupted by defaults in the 1820s, 1850s, 1870s and 1890s, but each wave of default was confined to a relatively small number of countries, permitting growth of financial flows to resume.7
In the four decades leading up to World War I, a truly worldwide economy was forged for the first time, extending from the core of Western Europe and the U.S. to latecomers in Eastern Europe and Latin America and even to the countries supplying raw materials on the periphery. Central to this expansion of trade and investment was an expanding system of finance that girded the globe. The amount was enormous: between 1870 and 1914 something like $30 billion,8 the equivalent in 2002 dollars of $550 billion, was transferred to recipient countries, in a world economy perhaps one-twelfth as large as today's.
During this "Gilded Age" of haute finance, the risks of participating in international trade and investment were generously shared with governments and the banking system. The reason is that foreign exchange rates were kept reasonably stable by the commitment of most governments to the "high" gold standard. In this way, businesses and individuals engaging in international transactions were reasonably certain that the value of their contracts was not going to change before they matured. Their exchange risk was shared with government by its willingness to buy or sell gold in order to keep the exchange rate constant. Because of this assurance, financial flows were reasonably free of regulation.
They were not immune from crises, however. When the sources of financial capital temporarily dried up, capital-importing countries occasionally found they could not expand export earnings sufficiently to avoid suspending interest payments on their debts or abandoning gold parity. On two occasions, the United States faced this possibility. The first was in 1893, when it switched in a sharp economic downturn to bimetallism (which caused William Jennings Bryan to denounce the "cross of gold"), and the second was in 1907, which led to the creation of the Federal Reserve System, handing to the government the function of lender of last resort previously carried out by Wall Street banks under the tutelage of J. Pierpont Morgan.
In his magisterial book The Great Transformation, Karl Polanyi reflected on the pervasive influence of haute finance on the policies of nations even in this "Gilded Age." The globalising financial markets and the gold standard, according to Polanyi, left very little room for states, especially smaller ones, to adopt monetary and fiscal policies independent of the new international order. "Loans, and the renewal of loans, hinged upon credit, and credit upon good behavior. Since, under constitutional government ..., behavior is reflected in the budget and the external value of the currency cannot be detached from the appreciation of the budget, debtor governments were well advised to watch their exchanges carefully and to avoid policies which might reflect upon the soundness of budget positions." Thus, even one hundred years ago the then-dominant world power, Great Britain, speaking as it did so often through the voice of the City of London, "prevailed by the timely pull of a thread in the international monetary network.9
Following World War I, the United States emerged not merely as a creditor country but as the primary source of new international financial flows. At first, the principal borrowers were the national governments of the stronger countries, but as the boom in security underwriting developed in the U.S, numerous obscure provinces, departments and municipalities found it possible to sell their bonds to American investors.10 Just as domestic construction, land, and equity markets went through speculative rises in the 1920s, so too did the U.S. experience a speculative surge in foreign investment. In the aftermath of successive defaults by foreign debtors in 1932, the Senate Committee on Banking and Currency concluded:
The record of the activities of investment bankers in the flotation of foreign securities is one of the most scandalous chapters in the history of American investment banking. The sale of these foreign issues was characterized by practices and abuses that violated the most elementary principles of business ethics.11
Speculation in the stock markets leading up to 1929 offers still another window on the instability of short-term financial flows. A speculative market can be defined as one in which prices move in response to the balance of opinion regarding the future movement of prices rather than responding normally to changes in the demand for and supply of whatever is priced. Helped by the willingness of Wall Street to allow people to buy stocks on margin, people were only too ready to bet prices would rise as long as others thought so too. Day after day and month after month the price of stocks went up in 1927. The gains by later standards were not large, but they had an aspect of great reliability. Then in 1928, the nature of the boom changed. "The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.12
Following World War I, the gold standard itself took on new form. Nations were allowed to hold their international reserves in either gold or foreign exchange. This worked for a while in the 1920s, but as speculation mounted and balances of payments disequilibria grew, fears of devaluation led central banks to try to replace their foreign-exchange holdings with specie in a "scramble for gold." The worldwide result of these shifts in central bank portfolios was an overall contraction of the supply of money and credit that sapped aggregate demand and forced prices to fall and output levels to shrink. Thus, it can be argued - persuasively in our view - that the Great Depression of the 1930s was as much, if not more, the result of mismanagement of money and credit as it was the result of protectionist policies. Protectionist policies were more likely the result of slowed growth and stalled trade. Countries that broke with the gold-exchange standard early, such as Britain in 1931, and pursued more expansionary monetary policies fared somewhat better.
The Bretton Woods system
During the darkest days of World War II, a radically new economic architecture was designed for the postwar world at a New Hampshire ski resort called Bretton Woods. With the competitive devaluation and protectionist policies of the 1930s still fresh in their minds, the mostly British and American delegates to the conference wanted most of all to design a system with fixed exchange rates that did not rely on national gold hoards to keep exchange rates stable. They decided to depend instead on strict controls of international financial movements. In this way, they hoped to allow countries to pursue full-employment policies through appropriate monetary (money and credit) and fiscal (tax and spending) policies without some of the anxieties associated with open financial markets. The role of monetary and financial stabilizer was given to the International Monetary Fund (IMF), which was provided with modest funds to assist nations to adjust imbalances in their external payments obligations. The International Bank for Reconstruction and Development (IBRD, later the World Bank) assumed the task of helping to finance post-war reconstruction.13
The IMF as it emerged from Bretton Woods had inadequate reserves to advance money for the long periods that many countries require for "soft-landings" from big current-account deficits. It would make only short-term loans. To make sure that borrowing nations were constrained, "conditionality" attached to IMF loans became standard practice, even in the early years of the Fund's operation. Policy limitations and "performance targets" tied to credit lines advanced under "standby agreements" began in the middle 1950s and were universal by the 1960s, long before the notions of "stabilization" and "structural adjustment" came into common parlance.
The Bretton Woods agreement also imposed a foreign exchange standard by which exchange rates between major currencies were fixed in terms of the dollar, and the value of the dollar was tied to gold at a U.S. guaranteed price of thirty-five dollars per ounce. By devising a system that controlled financial movements and assisted with the adjustment of countries' balances of payments, the new system succeeded in keeping exchange rates remarkably stable. They were changed only very occasionally, e.g., as when the value of sterling relative to the dollar was reduced in 1949 and again in 1966. This meant that companies doing business abroad did not need to worry constantly about the risk of exchanging one currency for another.
Among the reasons for this remarkable stability was the willingness of the central banks of other countries to hold an increasing proportion of their official reserves in the form of U.S. dollars. It was an essential part of the system that the dollars held by other countries would be seen as IOUs backe the 1960s, there were more and more U.S. dollars held by other countries, and this so-called "dollar overhang" became disturbingly large.15 General de Gaulle called it "the exorbitant privilege," meaning that the Americans were paying their bills - for defense spending to fight the Vietnam War among other things - with IOUs instead of real resources in the form of exports of goods and services.
Strict control over financial movements began to weaken as early as the 1950s, when the first eurodollar (later eurocurrency) deposits were made in London. At first a trickle, limited originally to Europe, these offshore banking operations soon expanded worldwide. The American "Interest Equalization Tax" (IET) instituted in 1963 raised the costs to banks of lending offshore from their domestic branches.16 The higher external rates led dollar depositors such as foreign corporations to switch their funds from onshore U.S. institutions to eurobanks. Thus, the real effect of the IET was to encourage the dollar to follow the foreigners abroad, rather than the other way around. Eurobanks paid higher interest rates on deposits and loaned eurocurrencies at lower rates than U.S. banks could at home. Still another large inflow of eurodeposits occurred in 1973-74 as the Organization of Petroleum Exporting Countries (OPEC) began "recycling" their surplus dollar earnings through eurobanks. Because of their existence, a country such as Brazil could arrange within a reasonably regulation-free environment to obtain multimillion-dollar loans from a consortium of offshore American, German and Japanese banks and thereby finance its oil imports. Net eurocurrency deposit liabilities that amounted to around $10 billion in the mid-1960s, grew to $500 billion by 1980.
These eurocurrency transactions taught the players in financial markets how to shift their deposits, loans, and investments from one currency to another whenever exchange rates or interest rates were thought to be ready to change. Even the ability of central banks to regulate the supply of money and credit was undermined by the readiness of commercial banks to borrow and lend offshore. Hence, the effectiveness of regulatory mechanisms that had been put in place to implement the Bretton Woods agreement - interest rate ceilings, lending limits, portfolio restrictions, reserve and liquidity requirements - gradually eroded as offshore transactions started to balloon.
The world economy developed at unprecedented rates during the roughly twenty-five years immediately following World War II. Growth and employment rates during these years were at historic highs in most countries. Productivity also advanced rapidly in most developing countries as well as in the technological leaders. These facts suggest that the system devised at Bretton Woods worked reasonably well, despite occasional adjustments. To be sure, it helped to sow the seeds of its own destruction by failing to retain operational control of international financial flows. But the twenty-five years of its survival leading up to August 15, 1971, when President Nixon closed the gold window, have nonetheless come to be called by some economic historians the "Golden Years."
Controlling private risk
Fixed exchange rates did not last long after the U.S. stopped exchanging gold for claims on the dollar held by foreign central banks. The pound sterling was allowed to float against the dollar in July, 1972. Japan set the yen free to float in February, 1973, and most European currencies followed suit shortly thereafter. The Bretton Woods gold-dollar system was doomed.
The fact that exchange rates no longer were fixed meant that companies doing business in different countries had to cope with the day-to-day shifts in the dollar's rate of exchange with other currencies. The risks of unexpected changes in the value of international contracts suddenly had shifted from the public to the private sector. Corporate finance officers now had to hedge against possible exchange losses by buying a currency forward and investing the equivalent in the short-term money market, or by investing in the eurocurrency market. The corporations' banks, in turn, tried to match each foreign currency transaction with another contrary transaction in order not to leave each of the banks exposed to foreign exchange risk overnight. Since no single bank was likely to balance its foreign exchange positions exactly, the need arose to swap deposits in different currencies in order to match corporate hedging transactions and to square the bank's books.
The price of this forward cover on inter-bank transactions - that is to say, the premium or discount on a currency's spot value - has tended to accord with the differences between interest-rates offered for eurocurrency deposits in different currencies. This is the connection between the foreign exchange market and the short-term credit markets, between exchange rates and interest rates. Whenever exchange rates move up or down, therefore, their influence is immediately transmitted through the eurocurrency markets to the credit markets.
It is this scramble to avoid private risk that accounted for the dramatic rise in international financial movements following the demise of the Bretton Woods system. By 1973, daily foreign exchange trading around the world varied between $10 and $20 billion per day. This amount was approximately twice the value of world trade at the time. Bank of International Settlements data suggests that the daily average of foreign exchange trading had climbed by 1980 to about $80 billion, and that the ratio between foreign exchange trading and international trade was more nearly ten to one. The data for 1992 was $880 billion and fifty to one, respectively; for 1995, $l,260 billion and seventy to one; and for 2000, almost $1,800 and ninety to one.
There is very little doubt, therefore, that the lion's share of international financial flows is relatively short-run. Indeed, about eighty percent of foreign exchange transactions are reversed in less than seven business days. Only a very small proportion is used to finance international trade and direct foreign investment. The vast majority must be used with the expectation of gain or to avoid losses that may result from changes in the value of financial assets. In general terms, they are speculative, made in hope of capital gain or to hedge against potential capital loss, or to seek the gains of arbitrage based on slight differences in rates of return in different financial centers.
The power of financial actors
Foreign exchange markets and markets for money and credit seem remote and abstract to most people. This section introduces the real institutions that operate these markets and assesses the nature of their power.
- Commercial banks. They take deposits, lend money, and create credit to the extent their capitalization allows. In Europe, they tend to combine commercial and investment banking services, but in the U.S. and Japan they are still kept at least partially separate by regulation. The foreign exchange trading facilities of the largest commercial banks, e.g. Citibank and J.P.Morgan/Chase in the U.S., tend to dominate the market. The banking industry as a whole represents the largest pool of world financial capital.
- Investment banks. They facilitate international payments, manage new issues of stocks and bonds, advise on mergers and acquisitions in all industries, and engage in securities and foreign exchange trading as allowed by law. Investment banks (previously called merchant banks in the U.K.) have specialized in particular kinds of derivative products. Derivatives are financial contracts whose value is based upon the value of other underlying financial assets such as stocks, bonds, mortgages or foreign exchange.
- Brokerage houses. They handle the bulk of stock exchange transactions and a major part of foreign exchange transactions. Investment banks recently have acquired several of the main brokerage houses in the U.S. The development of investor-friendly methods of buying and selling securities, e.g., over-the-counter markets and electronic brokerage, also have diminished the role of independent brokerage houses.
- Mutual funds. They are pools of funds provided by clients that are run by professional investment managers. These collective investments are held in portfolios with various mixes of money-market instruments, bonds and equities. Mutual funds account for the second largest pool of global financial capital.
- Hedge funds. They resemble mutual funds, but they are much less restricted in investment activities and techniques. Their customers are high net-worth individuals and large institutional investors. They specialize in complex financial instruments and tend to take significant speculative positions, especially on expected future changes in macroeconomic conditions. They exploit arbitrage opportunities embedded in the relative prices of related securities. They frequent offshore centers and tax havens.
- Tax havens. Offshore centers and tax havens shelter perhaps $10 trillion of wealth from capital and income taxation. The British Virgin Islands, the Bahamas, Bermuda, the Cayman Islands, Dublin and Luxembourg are among the most important. Many hedge funds are registered there.
- Wealthy individuals. They are an important source of funds, as many of them invest their liquid funds in financial markets. They account for about eighty percent of hedge fund investors.
- Private pension funds. They function like annuities, receiving funds today in return for a promise to pay future benefits. With large pools of funds to invest, they tend to depend on investment banks, mutual funds or hedge funds to supervise placement of their assets in global financial markets.
- Insurance companies. They pool risks by selling protection against the loss of property, income, or life. Since the risks they insure have various durations, they call for varied investment strategies. A portion of their funds is invested in short-term financial instruments, often through mutual and hedge funds.
- Transnational corporations. They produce and sell goods and services in a number of countries. Their finance departments seek the best ways to raise and transfer funds across borders, and administer the transfer prices18 of international trade conducted within the corporation. Some even have in-house corporate banks.
According to recent work by political scientists, the power of these financial actors is based in part on a complicated "process of multiplication" of loans, assets and transactions. Many investors in financial markets buy financial instruments on very thin margins, based on loans obtained by pledging the assets as collateral. This is called "leverage" in the jargon of financial markets. In turn, the borrowed funds are invested in other financial assets, multiplying the demand for credit and financial assets. As demand rises, more sophisticated financial assets are invented, including many forms of financial derivatives. A major portion of the accumulated debt remains serviceable only as long as the prices of most assets will rise or at least remain relatively stable. If prices turn down, they easily can lead to a chain-reaction. If investors respond instinctively like a herd, they will bring a far-reaching collapse that constitutes a crisis.
As the flow of financial assets climbs, some bankers, brokers, and managers of financial institutions become prominent players in the competition for investor dollars. Some become known for picking profitable places to invest and for promoting their selections successfully. This can influence markets if people have confidence in their advice. A notorious example of the influence of prominent players was the attack on British sterling in 1992 by George Soros' Quantum Fund. Believing that sterling was overvalued, the Fund quietly established credit lines that allowed it to borrow $15 billion worth of sterling and sell it for dollars at the then "overvalued" price. Its purpose, of course, was to pay back the loan with cheaper pounds after they had depreciated. Having gone long on dollars and short on sterling, Soros decided to speak up noisily. He publicized his short-selling and made statements in newspapers that the pound would soon be devalued. It wasn't long before sterling was devalued; he made $1 billion in profit.
The point can be made more generally: financial markets are subject to manipulation because they have become socially structured. Market leaders and financial gurus are admired and followed (at least until very recently). The heavyweights thus dominate the business. An obvious consequence of this is that there is a strong tendency in financial markets for further concentration of resources.
Another source of the power of financial actors is their obvious affinity for the rampant free-market philosophy of neo-liberalism. The freedom with which they move financial capital around depends, of course, on the market-friendly policies of the so-called Washington Consensus.19 As long as they are seen as part of the governing coalition, they derive special powers to regulate themselves rather than be controlled by an independent government agency or civil society. Their power also is reinforced by the activities of several collective associations of financial actors,20 which lobby on their behalf.
One more source of power for the financial actors is their knowledge that if they are big enough and sufficiently interlaced with other financial actors, then the "system" will keep them from failing. Consider the case of Long-term Capital Management, a hedge fund partnership started in 1994. It was able to borrow from various banks the equivalent of forty times its capitalization in order to make bets on changes in the relative prices of bonds in the U.S. and abroad. When the Russian government announced a devaluation and debt moratorium in August, 1998, it produced losses that the fund could not sustain. Nor could some of the banks that had loaned large amounts to the fund. Accordingly, the Federal Reserve Bank of New York, fearful that the risk to the entire system was too high, orchestrated a private rescue operation by fourteen banks and other financial institutions, which re-capitalized the company for $3.5 billion.
Financial actors also have the power indirectly to influence non-financial actors such as firms or states. By providing economic incentives to gamble and speculate on financial instruments, global financial markets divert funds from long-term productive investments. In all probability, they also encourage banks and financial institutions to maintain a regime of higher real interest rates that reduce the ability of productive enterprises to obtain credit. The volatility of global financial markets, moreover, brings uncertainty and volatility in interest rates and exchange rates that are harmful to various sectors of the real economy, particularly international trade.
The above stories about George Soros and Long-term Capital Management are good illustrations of the consequences for non-financial actors of actions by financial actors. Both episodes are examples of games that are basically zero-sum, at least in the short-run. Nothing new was produced; no new values were created. In the 1992 case about speculating against sterling, the Quantum Fund's profits were at the expense of the British government, especially the Bank of England, and British taxpayers. In 1998, the losses suffered by Long-term Capital Management came out of the pockets of the stockholders of the banks that bailed it out, as the stock-market value of their shares depreciated. Hence, the financial system tends to feed itself by drawing more resources from other sectors of the economy, undermining the vitality of the real economy.
Consequences of global financial flows
The dominant economic ideology of the last twenty-five years has been embodied in the so-called Washington Consensus. It is a "market-friendly" ideology that traces its roots to longstanding policies of the IMF that encourage macroeconomic "stabilization;" to adoption by the World Bank of ideas in vogue in Washington early in the Reagan period concerning deregulation and supply-side economics; to the zeal of the Thatcher government in England for privatizing public enterprises; and perhaps most of all to the neo-liberal tendencies of the business community and the economics profession in the U.S. The implementation of these policies of economic "reform," by first "stabilizing" the macro-economy and then "adjusting" the market so that it can perform more efficiently, are supposed to pay off in the form of faster output growth and rising real incomes
Among these policy prescriptions is financial liberalization in both the developed and the developing countries. Domestically it is achieved by weakening or removing controls on interest and credit and by diluting the differences between banks, insurance and finance companies. International financial liberation, on the other hand, demands removal of controls and regulations on both the inflows and outflows of financial instruments that move through foreign exchange markets. It is the implementation of these reforms that is perhaps the single most important cause of the surge in global financial flows. To be sure, the influence of technological advances has broken the natural barriers of space and time for financial markets as twenty-four hour electronic trading has grown. The fact that throughout most of the 1980s and 1990s the developed countries suffered from over-capacity and overproduction in manufacturing may also have led the owners of financial capital to look for alternative profit opportunities.
It now is time to ask whether the implementation of all these reforms, on balance, has produced good or bad results. The focus of this section will be mostly on the consequences of large and expanding international financial flows. After all, they are the main concern of this essay. But first, we should ask whether or not the policies of growth and rising real incomes promoted by the Washington Consensus have borne fruit.
Growth and income
There is little doubt that the introduction of the Washington Consensus' policy mix expanded the volume of interna ries' share of trade has risen from 23 to 29 percent. Increasing numbers of firms from developing countries, like their industrial-country counterparts, engage in transnational production and adopt a global perspective in structuring their operations. The flow of foreign direct investments and foreign portfolio investments has multiplied even more rapidly than trade, despite the financial instability experienced in Asia, Brazil, Russia, and elsewhere in recent years.
The effects of liberalization have not been uniformly favorable, however. After at least ten full years of experience with the Washington Consensus, several recent studies have begun to assess the consequences for developing countries of this experiment in more open markets.21 Except for the years of crisis in a number of the countries studied, most developing countries achieved moderate growth rates of gross domestic product in the 1990s - considerably higher than in the l980s in Africa and Latin America during the debt crisis, but remarkably unchanged in most other regions. Moreover, average annual growth in the 1990s was slightly lower than in the twenty-five years preceding the debt crisis when a strategy of substituting domestic production for imports was in fullest use. When population growth rates are taken into consideration, the growth rate of per capita income in the developing countries studied during the 1990s also was somewhat lower than in the 1960s and 1970s. Toward the end of the 1990s, growth tapered off in many countries due to emerging domestic financial crises or external events. There is little evidence in these figures, therefore, to suggest the strategy of liberalization boosted growth rates appreciably.
Nor did the distribution of income improve in most developing countries in the 1990s. On the contrary, virtually without exception the wage differentials between skilled and unskilled workers rose with liberalization. The reasons for this varied widely among countries, but one of the most important reasons was the fact that the number of relatively well-paid jobs in sectors of the economy involved with international trade, though growing, was insufficient to absorb available workers, forcing many workers into more precarious and poorly paid employment in the non-traded, informal trade, and service sectors or where traditional agriculture served as a sponge for the labor market. Between the mid-1960s and the late-1990s, the poorest 20 percent of the world population saw its share of income fall from 2.3 to 1.4 percent. Meanwhile, the share of the wealthiest quintile increased from 70 to 85 percent.22
Risk and reward
While all markets are imperfect and subject to failure, financial markets are more prone than others to fail because they are plagued with three particular shortcomings: asymmetric information, herd behavior and self-fulfilling panics. Asymmetric information is a problem whenever one party to an economic transaction has insufficient information to make rational and consistent decisions. In most financial markets where borrowing and lending take place, borrowers usually have better information about the potential returns and risks associated with the investments to be financed by the loans than do the lenders. This becomes especially true as financial transactions disperse across the globe, often between borrowers and lenders of widely different cultures.
Asymmetric information leads to adverse selection and moral hazard. Adverse selection occurs when, say, lenders have too little information to choose from among potential borrowers those who are most likely to use the loans wisely. The lenders' gullibility, therefore, attracts more unworthy borrowers. Moral hazard occurs when borrowers engage in excessively risky activities that were unanticipated by lenders and lead to significant losses for the lender. Yet another form of moral hazard occurs when lenders indulge in lending indiscriminately because they assume that the government or an international institution will bail them out if the loans go awry.
A good illustration of asymmetric information is the story of bank lending following OPEC's large increase in oil prices following 1973. Awash in cash, the oil exporters deposited large amounts in commercial banks that then perfected the Euro-currency loan for developing countries. Eager to put excess reserves to use, the banks spent little time discriminating among potential borrowers, in part because they believed host governments or international agencies would guarantee the loans. At the same time, developing countries found they could readily borrow not only to import oil, but also to increase other kinds of expenditures. This meant they could use borrowed funds to maintain domestic spending rather than be forced to adjust to the new realities of higher prices for necessary imports. There is considerable evidence that moral hazard also was present in the Mexican crises in 1982 and 1994, and in the Southeast Asian crises in 1997-8.
Yet another illustration of asymmetric information is the tendency of financial firms, especially on Wall Street and in the City of London, to invent ever more complex derivatives to shift risk around the financial system. The market for these products is growing rapidly, both on futures and options exchanges (two of the several places where derivatives are traded). A financial engineer, for example, can take the risk in, say, a bond and break it down into a series of smaller risks, such as that inflation will reduce its real value or that the borrower will default. These smaller risks can then be priced and sold, using derivatives, so that the bondholder keeps only those risks he wishes to bear. But this is not a simple task, particularly when it involves assets with risk exposures far into the future and which are traded so rarely that there is no good market benchmark for setting the price. Enron, for instance, sold a lot of these sorts of derivatives, booking profits on them immediately even though there was a serious doubt about their long-term profitability. Stories of huge losses incurred in derivative trading are legion. The real challenge before central banks and regulatory bodies is to curb speculative behavior and bring discipline in derivative markets.
A second source of risk in financial markets is the tendency of borrowers and lenders alike to engage in herd behavior. John Maynard Keynes, writing in the 1930s, suggested that financial markets are like "beauty contests." His analogy was to a game in the British Sunday newspapers that asked readers to rank pictures of women according to their guess about the average choice by other respondents. The winner, therefore, does not express his own preferences, but rather anticipates "what average opinion expects average opinion to be." Accordingly, Keynes thought that anyone who obtained information or signals that pointed to swings in average opinion and to how it would react to changing events had the basis for substantial gain. Objective information about economic data was not enough. Rather, simple slogans "like public expenditure is bad," "lower unemployment leads to inflation," "larger deficits lead to higher interest rates," were then the more likely sources of changes in public opinion. What mattered was that average opinion believed them to be true, and that advance knowledge of, say, more public spending, lower unemployment, or larger deficits, respectively, offered the speculator a special advantage.
A financial market that operates as a beauty contest is likely to be highly unstable and prone to severe changes. One reason for this is that people trading in financial assets, even today, know very little about them. People who hold stock know little about the companies that issued them. Investors in mutual funds know little about the stocks their funds are invested in. Bondholders know little about the companies or governments that issued the bonds. Even knowledgeable professionals are often more concerned with judging how swings in conventional opinion might change market values rather than with the long-term returns on investments. Indeed, since careful analysis of risks and rewards is costly and time consuming, it often makes sense for fund managers and traders to follow the herd. If they decide rationally not to follow the herd, their competence may be seriously questioned. On the other hand, if fund managers follow the herd and the herd suffers losses, few will question their competence because others too suffered losses. When financial markets are operated like a beauty contest, everyone wants to sell at the same time and nobody wants to buy.
The financial markets behaved as predicted shortly after several industrial countries, including the U.S. and Germany, abolished all restrictions on international capital movements in 1973. The new system proved to be highly volatile, with exchange rates, interest rates, and financial asset-prices subject to large short-term fluctuations. The markets also were susceptible to contagion when financial tremors spread from their epicenter to other countries and markets that seemingly had little connection with the initial problem. In less than five years, it already was clear that both the surpluses and the deficits on the major countries' balance of payments were getting larger, not smaller, despite significant changes in the exchange rates.
In some cases, a financial crisis can be self-fulfilling. A rumor can trigger a self-fulfilling speculative attack, e.g. on a currency, that may be baseless and far removed from the economic fundamentals (unlike the Soros story above). This can cause a sudden shift in the herd's intentions and lead to unanticipated market movements that create severe financial crises. Consider, for example, the succession of major financial crises that have pock-marked the recent history of international financial markets, including Latin America's Southern Cone crisis of 1979-81, the developing-country debt crisis of 1982, the Mexican crisis of 1994-95, the Asian crisis of 1997-98, the Russian crisis of 1998, the Brazilian crisis of 1999, and the Argentine crisis of 2001-02.
Perhaps the Asian crisis of 1997-98 is the most interesting in this regard, for there were relatively few signals beforehand of impending crisis. All the main East Asian economies displayed in 1994-96 low inflation, fiscal surpluses or balanced budgets, limited public debt, high savings and investment rates, substantial foreign exchange reserves and no signs of deterioration before the crisis. This background has led many analysts to suppose that the crisis was a mere product of the global financial system. But what could have triggered the herd to stampede out of Asian currencies? No doubt several factors were at work. Before the crisis that started in the summer of 1997, there was a rise in short-term lending to Asians by Western and Japanese banks with little or no premiums, a fact that the Bank for International Settlement raised questions about. Alert investors, especially hedge funds, also noticed that substantial portions of East and Southeast Asian borrowings were going into non-productive assets and real estate that often were linked to political connections. In fact, some of the funds pouring into non-productive assets were coming out of the productive sector, mortgaging the longer-term viability of some real economies. Information about the structure and policies of financial sectors was opaque. Thus, opinions began to change among key lenders about the regulation of financial sectors in several Asian countries and their destabilizing lack of transparency. Suddenly, several important hedge funds reduced their exposure by shorting currency futures, followed quickly by Western mutual funds. The calling of loans led quickly to deep depression in several Asian countries. It has been estimated that the Asian crisis and its global repercussions cut global output by $2 trillion in 1998-2000.
Loss of government autonomy
Both economic theory and the experience of managing the external financial affairs of nations tell us that it is virtually impossible to maintain (1) full financial mobility, (2) a fixed exchange rate, and (3) freedom to seek macro-economic balance (full employment with little inflation) with appropriate monetary and fiscal policies. Only two of these policy objectives can be consistently maintained. If the authorities try to pursue all three, they will sooner or later be punished by destabilizing financial flows, as in the run up to the Great Depression around 1930 and in the months before sterling's collapse 1992. If a government tries to stimulate its economy with lax monetary policy, for example, and players with significant market power like George Soros sense that at a fixed exchange rate, foreigners will be unwilling to lend enough to finance the country's current account deficit, they will begin to flee the home currency in order to avoid the capital losses they will suffer if and when there is a devaluation. If reserve losses accelerate and more players follow suit, crisis ensues. The authorities are forced to devalue, interest rates soar, and the successful attackers sit back to count their profits.
For nations wishing to retain reasonably independent monetary and fiscal authority in order to cater to domestic needs, the solution is to allow the exchange rate to move up or down as conditions in the foreign exchange markets dictate, or to establish some sort of control over the movement of financial instruments in and out of the country, or to devise some combination of these two adjustment mechanisms. The debate over whether fixed or flexible exchange rates is the wiser policy continues to rage in academic quarters and in finance ministries all over the world. For the most part, the international business community prefers reasonably fixed exchange rates in order to minimize their costs of hedging foreign currency positions. Thus instituting some form of control over speculative financial movements may be an appropriate solution to the "trilemma."
The capacity of a nation to levy enough taxes to finance needed public expenditures is another important reason to retain independent authority. A central function of government has been to insulate domestic groups from excessive market risks, particularly those originating in international transactions. This is the way governments have maintained domestic political support for liberalizing trade and finance throughout the postwar period. Yet many governments are less able today to help citizens that are injured by freer markets with unemployment compensation, severance payments, and adjustment assistance because the slightest hint of raising taxes to pay for these vital public services leads to capital flight in a world of heightened financial mobility.
This is a dilemma. Increased integration into the world economy has raised the need of governments to redistribute tax revenues or implement generous social programs in order to protect the vast majority of the population that remains internationally immobile. At the same time, governments find themselves less able to maintain the safety nets needed to preserve social stability. It seems reasonable to suppose, therefore, that doing things that will bolster the ability of governments to levy sufficient taxes - curbing tax avoidance by transnational corporations, controlling offshore tax havens, regulating capital flight - would help make globalization slightly more democratic.
Winners and losers
The people who benefit from speculative financial movements are, for the most part, better educated and wealthier than the vast majority of fellow citizens. They are the elites, whatever the country. As noted above, they have fewer connections to the real economy of production and exchange than most people. And their purpose in trading financial assets, again for the most part, is to make a profit quickly rather than wait for an investment project to mature.
People who do not participate directly in the buying and selling of short-term financial instruments are nonetheless influenced indirectly by the macroeconomic instability and contagion that often accompany interruptions in financial market flows. This is true for people both in developed and developing countries. In developed countries, the voracious appetite of financial markets for more and more resources saps the vitality of the real economy - the economy that most people depend upon for their livelihood. It has been shown that real interest rates rise as a result of the expansion of speculative financial markets. This rise in real interest rates, in turn, dampens real investment and economic growth while serving to concentrate wealth and political power within a growing worldwide rentier class (people who depend for their income on interest, dividends, and rents).23 Rather, the long-term health of the economy depends upon directing investable funds into productive investments rather than into speculation.
In developing countries, attracting global investors' attention is a mixed blessing. Capital market inflows provide important support for building infrastructure and harnessing natural and human resources. At the same time, surges in money market inflows may distort relative prices, exacerbate weakness in a nation's financial sector, and feed bubbles. As the 1997 Asian crisis attests, financial capital may just as easily flow out of as into a country. Unstable financial flows often lead to one of three kinds of crises:
- Fiscal crises. The government abruptly loses the ability to roll over foreign debts and attract new foreign loans, possibly forcing the government into rescheduling or default of its obligations.
- Exchange crises. Market participants abruptly shift their demands from domestic currency assets to foreign currency assets, depleting the foreign exchange reserves of the central bank in the context of a pegged exchange rate system.
- Banking crises. Commercial banks abruptly lose the ability to roll over market instruments (i.e., certificates-of-deposit) or meet a sudden withdrawal of funds from sight deposits, thereby making the banks illiquid and possibly insolvent.
Although these three types of crises sometimes appear singly, they more often arrive in combination because external shocks or changed market expectations are likely to occur simultaneously in the market for government bonds, the foreign exchange market, and the markets for bank assets. Approximately sixty developing countries have experienced extreme financial crises in the past decade.24
The vast majority of people in the developing world suffer from these convulsive changes. They are tired of adjusting to changes over which they exercise absolutely no control. Most people in these countries view Western capitalism as a private club, a discriminatory system that benefits only the West and the elites who live inside "the bell jars" of poor countries. Even as they consume the consumer goods of the West, they are quite aware that they still linger at the periphery of the capitalist game. They have no stake in it, and they believe that they suffer its consequences. As Hernando deSoto puts it, "Globalization should not be just about interconnecting the bell jars of the privileged few."25
Karl Polanyi in The Great Transformation sought to explain how the "liberal creed" contributed to the catastrophes of war and depression associated with the first half of the twentieth century. Polanyi's central argument, which in fact can be traced back to Adam Smith, is that markets do indeed promote efficiency and change, but that they achieve this through undermining social coherence and solidarity. Markets must therefore be embedded within social institutions that mitigate their negative consequences.
The evidence of more recent times suggests that the global spread of free-market policies has been accompanied by the decline of countervailing institutions of social solidarity. Indeed, a main feature of the introduction of market-friendly policies has been to weaken local institutions of social solidarity. Consider, for example, the top-down policy prescriptions of the IMF and World Bank during the developing world's debt crisis in the 1980s. These policies evolved into an intricate web of expected behaviors by developing countries. In order for developing countries to expect private businesses and financial interests to invest funds within their borders and to boost the growth potential of domestic economies, they needed to drop the "outdated and inefficient" policies that dominated development strategies for most of the postwar period and adopt in their place policies that are designed to encourage foreign trade and freer financial markets. Without significant adjustments in the ways economies were managed, it was suggested, nations soon would be left behind.
The list of Washington Consensus requirements was long and daunting:
- Make the private sector the primary engine of economic growth
- Maintain a low rate of inflation and price stability
- Shrink the size of the state bureaucracy
- Maintain as close to a balanced budget as possible, if not a surplus
- Eliminate or lower tariffs on imported goods
- Remove restrictions on foreign investment
- Get rid of quotas and domestic monopolies
- Increase exports
- Privatize state-owned industries and utilities
- Deregulate capital markets
- Make currency convertible
- Open industries, stock, and bond markets to direct foreign ownership
- Deregulate the economy to promote domestic competition
- Eliminate government corruption, subsidies and kickbacks
- Open the banking and telecommunications systems to private ownership and competition
- Allow citizens to choose from an array of competing pension options and foreign-run pension and mutual funds.
In a provocative article, Ute Pieper and Lance Taylor point out that market outcomes often conflict with other valuable social institutions. In addition, they emphasize that markets function effectively only when they are "embedded" in society. The authors then look carefully at the experience of a number of developing countries as they struggled to comply with the policy prescriptions of the IMF and the Fund. In almost every case, they demonstrate conclusively that the impact of these efforts was to make society an "adjunct to the market."26
An appropriate balance is not being struck between the economic and non-economic aspirations of human beings and their communities. Indeed, the evidence is mounting that globalization's trajectory can easily lead to social disintegration - to the splitting apart of nations along lines of economic status, mobility, region, or social norms. Globalization not only highlights and exacerbates tensions among groups; it also reduces the willingness of internationally mobile groups to cooperate with others in resolving disagreements and conflicts.
History confirms that free-markets are inherently volatile institutions, prone to speculative booms and busts. Overshooting, especially in financial markets, is their normal condition. To work well, free markets need not only regulation, but active management. During the first half of the post-war era, world markets were kept reasonably stable by national governments and by a regime of international cooperation. Only lately has a much earlier idea been revived and made an orthodoxy - the idea adopted by the Washington Consensus that, provided there are clear and well-enforced rules-of-the-game, free markets can be self-regulating because they embody the rational expectations that participants form about the future.
On the contrary, since markets are themselves shaped by human expectations, their behavior cannot be rationally predicted. The forces that drive markets are not mechanical processes of cause and effect, as assumed in most of economic theory. They are what George Soros has termed "reflexive interactions."27 Because markets are governed by highly combustible interactions among beliefs, they cannot be self-regulating.
The question before us then, is what could be done to better regulate financial markets and to bring active management back into the task of "embedding" markets in society, rather than the other way around? Monetary authorities such as the Federal Reserve System in the U.S. and the central banks of other countries were formed long ago in order to dampen the inherent instabilities of financial market in their home countries. But the evolution of an international regulatory framework has not kept pace with the globalization of financial markets. The International Monetary Fund was not designed to cope with the volume and instability of recent financial trends.
Given the problems outlined above about short-term speculative financial transactions, one might wonder why national policy-makers have not insulated their financial markets by imposing some sort of control over financial capital. The answer, of course, is that some have continued trying to do so despite discouragement from the IMF. For example, some have put limitations on the quantity, conditions, or destinations of financial flows. Others have tried to impose a tax on short-term borrowing by national firms from foreign banks. This is said to be "market-based" because it operates by altering the cost of foreign funds. If such transactions were absolutely prohibited, they would be called "non-market" interventions.
A more extreme form of financial capital controls, one that controls movement of foreign exchange across international borders, also has been tried in a number of countries. This form of control requires that some if not all foreign currency inflows be surrendered to the central bank or a government agency, often at a fixed price that differs from that which would be set in free market. The receiving agency then determines the uses of foreign exchange. The absence of exchange controls means that currencies are "convertible."
The neo-liberal argument opposing financial capital controls asserts that their removal will enhance economic efficiency and reduce corruption. It is based on two basic propositions in economic theory that depend for their proof on perfectly competitive markets in the real economy and perfectly efficient gatherers and transmitters of information in financial markets. Neither assumption is realistic in today's world. Indeed, a number of empirical studies have reported the effectiveness of capital controls in controlling capital flight, curbing volatile capital flows and protecting the domestic economy from negative external developments.
Developing countries have only recently abandoned, or still maintain, a variety of control regimes. Latin American countries traditionally have used market-based controls, putting taxes and surcharges on selected financial capital movements or tying them up in escrow accounts. Non-market based restrictions were more common in Asia until the early 1990s. Many commentators believe that their sudden removal in the early 1990s was a contributing cause to the Asian financial crises in 1997-8. The experience of two countries, Malaysia and Chile, with capital controls is especially instructive.
Malaysia, unlike its Asian neighbors, was reluctant to remove its restrictions on external borrowing by national firms unless they could show how they could earn enough foreign exchange to service their debts. Then when the Asian crises hit, its government imposed exchange controls, in effect making its local currency that was held outside the country inconvertible into foreign exchange. After the ringget was devalued, exporters were required to surrender foreign currency earnings to the central bank in exchange for local currency at the new pegged rate. The government also limited the amount of cash nationals could take abroad, and it prohibited the repatriation of earnings on foreign investments that had been held for less than one year. Thus, Malaysia's capital controls were focused mostly on controlling the outflow of short-term financial transactions. Happily, the authorities were able to stabilize the currency and reduce interest rates, leading to a degree of domestic recovery.28
Chile, on the other hand, tried to limit the inflow of short-term financial transactions. It did so by imposing a costly reserve requirement on foreign-owned capital held in the country for less than one year. Despite attempts to stimulate foreign direct investment of the funds, most of the reserve deposits were absorbed in the form of increased reserves at the central bank. In turn, this created a potential for expanding the money supply, which the government feared would lead to inflation. Rather than allow this to happen, the government "sterilized" the inflows by selling government bonds from its portfolio. But this pushed down the prices of bonds and pushed up the interest rates on them, discouraging business investment. Finally, when prices of copper (Chile's primary export) fell sharply in 1998, the control regime was scrapped.29
The Tobin tax
A global tax on international currency movements was first proposed by James Tobin, a Yale University economist, in 1972.30 He suggested that a tax of one-quarter to one percent be levied on the value of all currency transactions that cross national borders. He reasoned that such a tax on all spot transactions would fall most heavily on transactions that involve very short round-trips across borders. In other words, it would be speculators with very short time-horizons that the tax would deter, rather than longer-term investors who can amortize the costs of the tax over many years. For example, the yearly cost of a 0.2 percent round trip tax would amount to 48 percent of the value of the traded amount if the round trip were daily, 10 percent if weekly and 2.4 percent if monthly. Since at least eighty percent of spot transactions in the foreign exchange markets are reversed in seven business days or less, the tax could have a profound effect on the costs of short-term speculators.
Of course, for those who believe in the efficiency of markets and the rationality of expectations, a transactions tax would only hinder market efficiency. They argue that speculative sales and purchases of foreign exchange are mostly the result of "wrong" national monetary and fiscal policies. While we readily admit that national policies sometimes do not accord with desired objectives, they nonetheless have little relevance for speculators focused on the next few seconds, minutes or hours.
Tobin did not intend for his proposal to involve a supranational taxation authority. Rather, governments would levy the tax nationally. In order to make the tax rate uniform across countries, however, an international agreement would have to be entered into by at least the principal financial centers. The revenue obtained from the tax could be designated for each country's foreign exchange reserve for use during periods of instability, or it could be directed into a common global fund for uses like aid to the poorest nations. In the latter case, the feasibility of the tax also would depend on an international political agreement. The revenue potential is sizeable, and could run as high as $500 billion annually.
There are two other advantages often cited by proponents of the Tobin tax. Tobin's original rationale for a foreign exchange transactions tax was to enhance policy autonomy in a world of high financial capital mobility. He argued that currency fluctuations often have very significant economic and political costs, especially for producers and consumers of traded goods. A Tobin tax, by breaking the condition that domestic interest rates may differ from foreign interest rates only to the extent that the exchange rate is expected to change (see p. 10), would allow authorities to pursue different policies than those prevailing abroad without exposing them to large exchange rate movements. More recent research suggests that this is only a very modest advantage.31
An additional advantage of the tax is that it could facilitate the monitoring of international financial flows. The world needs a centralized data-base on all kinds of financial flows. Neither the Bank for International Settlements nor the IMF has succeeded in providing enough information to monitor them all. This information should be regularly shared among countries and international institutions in order to collectively respond to emerging issues.
The feasibility issues raised by the Tobin tax are more political than technical. One of the issues is about the likelihood of evasion. All taxes suffer some evasion, but that has rarely been a reason for avoiding them. Ideally all jurisdictions should be a party to any agreement about a common transactions tax, since the temptation to trade through non-participating jurisdictions would be high. Failing that, one could levy a penalty on transactions with "Tobin tax havens" of, say, double the normal tax rate. Moreover, one could limit the problem of substituting untaxed assets for taxed assets by applying the tax to forwards, swaps and possibly other contracts.
Tobin and many others have assumed that the task of managing the tax should be assigned to the IMF. Others argue that the design of the tax is incompatible with the structure of the IMF and that the tax should be managed by a new supranational body. Which view will prevail depends upon the resolution of other outstanding issues. The Tobin tax is an idea that deserves careful consideration. It should not be dismissed as too idealistic or too impractical. It addresses with precision the problems of excessive instability in the foreign exchange markets, and it yields the additional advantage of providing a means to assist those in greater need.
Reforming the IMF
The IMF was established in 1944 to provide temporary financing for member governments to help them maintain pegged exchange rates during a period of internal adjustment. With the collapse of the pegged exchange rate regime in 1971, that responsibility has been eclipsed by its role as central arbiter of financial crises in developing countries. As noted above (p. 20), these crises may be of three different kinds: fiscal crises, foreign exchange crises, and banking crises.
Under current institutional arrangements, a nation suffering a serious fiscal crisis that could easily lead to default must seek temporary relief from its debts from three different (but interrelated) institutions: the IMF, which is sometimes willing to renegotiate loans in return for promises to adopt more stringent policies (see above); the so-called Paris Club that sometimes grants relief on bilateral (country to country) credits; and the London Club that sometimes gives relief on bank credits. This is an extremely cumbersome process that fails to provide debtor countries with standstill protection from creditors, with adequate working capital while debts are being renegotiated, or with ways to ensure an expeditious overall settlement. The existing process often takes several years to complete.
There is a growing consensus that this problem is best resolved with creation of a new international legal framework that provides for de facto sovereign bankruptcy. This could take the form of an International Bankruptcy Code with an international bankruptcy court, or it could involve a less formal functional equivalent to its mechanisms: automatic standstills, priority lending, and comprehensive reorganization plans supported by rules that do not require unanimous consent. Jeffrey Sachs recommends, for example, that the IMF issue a clear statement of operating principles covering all stages of a debtor's progression through "bankruptcy" to solvency. A new system of emergency priority lending from private capital markets could be developed, he suggests, under IMF supervision. He also feels that the IMF and member governments should develop model covenants for inclusion in future sovereign lending instruments that allow for priority lending and speedy renegotiation of debt claims.32
At the Joint Meeting of the IMF and the World Bank in September, 2002, the policy committee directed the IMF staff to develop by April, 2003, a "concrete proposal" for establishing an internationally recognized legal process for restructuring the debts of governments in default. It also endorsed efforts to include "collective action" clauses in future government bond issues to prevent one or two holdout creditors from blocking a debt-restructuring plan approved by a majority of creditors. The objective of both proposals is to resolve future debt crises quickly and before they threaten to destabilize large regions, as happened in Southeast Asia in 1997-98.
Member countries rarely receive support from the IMF any longer to maintain a particular nominal exchange rate. Because financial capital is so mobile now, pegged exchange rates probably are unsupportable. But there are special times when the IMF still might give such support during a foreign exchange crisis. International lending to support a given exchange rate is legitimate if the government is trying to establish confidence in a new national currency, or if its currency is recovering from a severe bout of hyperinflation. Ordinarily the foreign exchange should be provided from an international stabilization fund supervised by the IMF.
National central banks usually supervise and regulate the domestic banking sector. Thus, banking crises normally are handled by domestic institutions. This may not be possible, however, if the nation's banks hold large short-term liabilities denominated in foreign currencies. If the nation's central bank has insufficient reserves of foreign currencies to fund a large outflow of foreign currencies, there may be circumstances when the IMF or other lenders may wish to act as lenders-of-last-resort to a central bank under siege. Nations like Argentina that have engaged in "dollarization" are learning about the downside risks of holding large liabilities denominated in foreign currencies. The best way to avoid this problem is for governments and central banks to restrict the use of foreign currency deposits or other kinds of short-term foreign liabilities at domestic banks.
Overall, what is most needed is the availability of more capital in developing countries and much quicker responses, amply funded, to emerging financial crises.. George Soros has argued powerfully that the IMF needs to establish a better balance between crisis prevention and intervention.33 The IMF has made some progress in prevention by introducing Contingency Credit Lines (CCLs). The CCL rewards countries that follow sound policies by giving them access to IMF credit lines before rather than after a crisis erupts. But CCL terms were set too high and there have been no takers. Soros also has recommended the issuance of Special Drawing Rights (SDRs) that developed-countries would donate for the purpose of providing international assistance. Its proceeds would be used to finance "the provision of public goods on a global scale as well as to foster economic, social, and political progress in individual countries."34
A growing number of civil society institutions, however, oppose giving more money to the IMF unless it is basically reformed. They point out that it is a committed part of the Washington Consensus, the application of whose policies have made societies adjuncts of the market. They see the IMF as an instrument of the U.S. government and its corporate allies. The conditions it attaches to loans for troubled countries often do more to protect the interests of first world investors than to promote the long-term health of the developing countries. The needed chastening of speculative investors does not occur under these circumstances. There is evidence that in several major crises, IMF requirements for assisting nations have in fact worsened the situation and protracted the crises. The IMF opposed the policies that enabled Malaysia to weather the crisis in Southeast Asia, for example, while it urged the failed policies of other Southeast Asian nations. The vast literature cited by Pieper and Taylor (p. 22) is a convincing chronicle of earlier missteps. For such reasons as these, some civil society institutions argue that, unless IMF policies are changed, giving the institution more money will do more harm than good.
Fortunately, the IMF's policies are beginning to change, partly as a result of criticisms by civil society institutions, but more through recognition of the seriousness of the problems with the present system. In the wake of recent financial crises, leaders in the IMF as well as the World Bank are looking for ways to reform the international financial architecture. Arguably, their emphasis is shifting away from slavish devotion to the prescriptions of the Washington Consensus and toward more state intervention in financial markets. Joseph Stiglitz, the Nobel Laureate who has been particularly critical of the IMF, nonetheless acknowledges that its policy stances are improving.35
The IMF has begun to recognize the importance of at least functional public interventions in markets and the need to provide more supporting revenues. It has realized that controls on external financial movements and prudent regulation can help contain financial crises. It has abandoned the doctrine, long the backbone of structural adjustment policies, that raising the local interest rate will stimulate saving and thereby growth. Both the IMF and the World Bank have rolled over or forgiven the bulk of official debt owed by the poorest economies.
Whether these and other promising changes in IMF thinking and policy formation are sufficient to assure that its future responses to crises will be benign still is not clear. While celebrating what they view as belated improvements, many critics of the IMF among civil society institutions are not convinced that they are sufficiently basic. Even if the IMF avoids repeating some of its more egregious mistakes, some believe that it is likely to continue to function chiefly for the benefit of the international financial community rather than the masses of people. Rather, they believe that, at least in the long term, it would be much better for control over international finance to reside in new institutions under a restructured United Nations. They favor the U.N. because it has a broader mandate, is more open and democratic, and, in its practice, has given much greater weight to human, social, and environmental priorities.
Many civil society institutions want the primary focus of reform to be on taming speculation, restoring the control of their economies to nations, and embedding economies in the wider society. They believe that if these policies are adopted there will be less need for large funding to deal with financial crises. There remains, however, the fact that such crises are occurring and will continue to occur for some time. The IMF is the only institution positioned to respond to these crises. Hence, even for those who sympathize with the goals of the civil society institutions, there is a strong argument for more financing for the IMF.
A world financial authority
A variety of public and private citizens and institutions have recently proposed the establishment of a World Financial Authority (WFA) to perform in the domain of world financial markets what national regulators do in domestic markets. Some believe it should be built upon the foundation of global financial surveillance and regulation that have already been laid by the Bank for International Settlements in Basel, Switzerland. Others regard it as a natural extension of the activities of the IMF. Still others are less interested in the precise institutional form it would take than in the clear delineation of the tasks that need to be done by someone.
Its first task probably should be to provide sufficient and timely financial assistance during crises to avert contagion and defaults. This requires a lender-of-last-resort with sufficient resources and authority to disperse rescue money quickly. Perhaps the best example to date is the bailout loan to Mexico by the U.S. Treasury and the IMF at the end of 1994. It supplied sufficient liquidity for Mexico to make the transition back to stability and to pay back the loans ahead of time. The management of the Asian crises in 1997-8, on the other hand, was badly handled. The bailout packages offered by the IMF were not only significantly smaller than in the Mexico case; they also were constrained with so many conditions that a year later only twenty percent of the funds had been disbursed. This slow response to the crisis probably worsened the contagion. Surprisingly, the error was repeated in the Russian crisis in 1998 and the Brazilian crisis in 1999.
A World Financial Authority also should provide the necessary regulatory framework within which the IMF or a successor institution can develop as a lender-of-last-resort. As long as domestic regulatory procedures function properly, there will be no need for a world authority to be involved, any more than to certify that domestic regulatory procedures are effective. In countries where domestic financial regulation is unsatisfactory, the WFA would assist with regulatory reform. In this way, the WFA could aid financial reconstruction, reduce the likelihood of moral hazard, and give confidence to backers of the operation.
There is little appetite today, especially in Washington, to create a new international bureaucracy. This fact gives support to the idea of building the WFA from the existing infrastructure of the Bank for International Settlements (BIS). The BIS is a meeting place for national central bankers who have constructed an increasingly complicated set of norms, rules and decision-making procedures for handling and preventing future crises. Its committees and cooperative cross-border regulatory framework enjoy the confidence of governments and of the financial community. It may well be the best place to govern an international regulatory authority at the present time.
Theological and ethical considerations
While Christian theology cannot provide us with detailed recommendations on how to correct the adverse consequences of speculative financial movements, it can provide us with an empowering perspective or worldview. Our theological expressions of the faith describe the source of our spiritual energy and hope. They betray our ultimate values and the source of our ethical norms. They shape how we perceive and judge the "signs of the times."
God's world and human responsibilities
Nothing in creation is independent of God. "The earth is the Lord's and all that is in it, the world, and all those who live in it." (Ps. 24:1 NRSV) Thus, no part of the creation - whether human beings, other species, the elements of soil and water, even human-made things - is our property to use as we wish. All is to be treated in accord with the values and ground rules of a loving God, their ultimate owner, who is concerned for the good of the whole creation. All of God's creation therefore deserves to be treated with appropriate care and concern, no matter how remote from one's daily consciousness or existence.
The doctrine of creation reminds us that our ultimate allegiance is not to the nationalistic and human-centered values of our culture, but rather to the values of the loving Maker of heaven and earth. When we seek plenty obsessively, consume goods excessively, compete against others compulsively, or commit ourselves to Economic Fate, we are worshiping false gods. Modern idolatries are often encountered in economic forms, just as in the New Testament's warnings about the spiritual perils of prosperity in the parables of the rich, hoarding fool (Luke 12:15-21) and the rich youth (Matt. 19:16-24 and Luke 18:18-25).
The fact that so much of financial speculation is divorced from the real economy of production and exchange suggests that its paper transactions are more like bets in a casino than an essential component of God's real economy, which seeks the good of all creation. It is wrong to subject people to the effects of wholesale gambling. The fact that the practice of financial speculation is secretive, compulsively competitive, and frequented by lone rangers, moreover, hints at a cult of false idols. Its practitioners, including especially day-traders, seem interested only in exceedingly short-term personal financial advantage, unconcerned about the long-term consequences of their actions or their impact on others. This also indicates a degree of idolatry that contradicts the doctrine of creation.
Image of God
The conviction that human beings have a God-given dignity and worth (Gen. 1:26-28) unites humanity in a universal covenant of rights and responsibilities - the family of God. All humans are entitled to the essential conditions for expressing their human dignity and for participation in defining and shaping the common good. These rights include satisfaction of basic biophysical needs, environmental safety, full participation in political and economic life, and the assurance of fair treatment and equal protection of the laws. These rights define our responsibilities in justice to one another, locally, nationally and - because they are human rights - internationally.
Financial speculation often leads to unmanageable floods of funds into and out of host societies, creating unwanted bubbles and panics. Financial speculators normally ignore the human consequences of their activities on the rights of people in host societies, where economic adjustments are shared widely and painfully. Their primary interest is short-term personal financial gain. The absence of a sense of covenantal unity with their brothers and sisters of the developing world is a sad commentary on the governing ethic of speculators in the capital markets. Their arrogance calls for some form of control over foreign exchange and financial capital markets.
Justice in covenant
The rights and responsibilities associated with the image of God are inextricably tied to the stress on justice in Scripture and tradition. We render to others their due because of our loving respect for their God-given dignity and value. The God portrayed in Scripture is the "lover of justice" (Ps. 99:4, 33:5, 37:28, 11:7; Isa. 30:18, 61:8; Jer. 9:24). Justice is at the ethical core of the biblical message. Faithfulness to covenant relationships, moreover, demands a justice that recognizes special obligations, "a preferential option" to widows, orphans, the poor, and aliens, which is to say the economically vulnerable and politically oppressed. Hence, the idea of the Jubilee Year (Lev. 25) was meant to prevent unjust concentrations of power and poverty. Jesus' ministry embodies concern for the rights and needs of the poor; He befriended and defended the dispossessed and the outcasts.
The fact that the liberalization of trade and finance has failed to improve the distribution of incomes, indeed, that it has widened the gap between rich and poor in virtually every country, is not a sign of distributive justice but of its opposite. The standard of living for the least skilled, least mobile, and poorest citizens of many developing countries has declined absolutely. This, too, is an unjust result of a broken system. The fact that governments that wish to assist the vulnerable and weak of their societies are less able to do so, in part because they no longer can levy sufficient taxes on foreign interests, is a violation of justice in community.
Sin and judgment
Sin is a declaration of autonomy from God, a rebellion against the sovereign source of our being. It makes the self and its values the center of one's existence, in defiance of God's care for all. Sin tempts us to value things over people, measuring our worth by the size of our wealth and the quantity of goods we consume, rather than by the quality of our relationships with God and with others. Sin involves injustice because its self-centeredness defies God's covenant of justice, grasping more than one's due and depriving others of their due.
Sin is manifested not only in individuals, but also in social institutions and cultural patterns. These structural injustices are culturally acceptable ways of giving some individuals and groups of people advantage over others. Because they are pervasive and generally invisible, they compel our participation. They benefit some and harm many others. Whether or not we deserve blame as individuals and churches for these social sins depends in part on whether we defend or resist them, tolerate or reject them.
The fact that the freeing of financial markets has permitted financial speculators to engage in high-risk gambles without regard to the consequences for others is abundant evidence of both individual and institutional sin. The policies of the Washington Consensus frequently lead to adverse consequences for the poor and the environment, even as its proponents gain advantages from the implementation of such policies. They are another serious expression of social sin in our time. These policies inevitably increase the concentration of economic power in fewer hands. The fact that the global spread of free-market policies has led to the decline of countervailing institutions of
social solidarity means that it is easier for the centers of economic power to corrupt governments, control markets, alienate neighbors, manipulate public opinion, and contribute to a sense of political impotency in the public.
The Church's mission and hope
The church is called to be an effective expression of the Reign of God, which Jesus embodied and proclaimed. This ultimate hope is a judgment on our deficiencies
and a challenge to faithful service. God's goal of a just and reconciled world is not simply our final destiny but an agenda for our earthly responsibilities. We are called to be a sign of the Reign of God, on earth as it is in heaven, to reflect the coming consummation of God's new covenant of shalom to the fullest extent possible.
A new financial architecture
In her path-breaking book, Casino Capitalism,36 Susan Strange likens the Western financial system to a vast casino. As in a casino,
"the world of high finance today offers the players a choice of games. Instead of roulette, blackjack, or poker, there is dealing to be done - the foreign-exchange market and all its variations; or in bonds, government securities or shares. In all these markets you may place bets on the future by dealing forward and by buying or selling options and all sorts of other recondite financial inventions. Some of the players - banks especially - play with very large stakes. There are also many quite small operators. There are tipsters, too, selling advice, and peddlers of systems to the gullible. And the croupiers in this global finance casino are the big bankers and brokers. They play, as it were, "for the house.' It is they, in the long run, who make the best living."
She goes on to observe that the big difference between ordinary kinds of gambling and speculation in financial markets is that one can choose not to gamble at roulette or poker, whereas everyone is affected by "casino capitalism." What goes on in the back offices of banks and hedge funds "is apt to have sudden, unpredictable and unavoidable consequences for individual lives."
It is this volatility, this instability in financial markets that has given rise to recurring financial crises. They must be tamed. In the wake of recent financial crises, people are beginning to look for ways to reform the international financial architecture. Although it is difficult to move from general theological convictions to specific proposals, we offer the following suggestions for consideration by Christians and other persons of good will.
- Capital controls should be an integral part of national strategies to tame the financial system. They can be made an effective and meaningful tool to protect and insulate the domestic economy from volatile capital flows and other negative external developments.
- Regulatory and supervisory measures should supplement capital controls when appropriate. They should include regulation of financial derivatives and hedge funds. Regulation is a necessary complement to domestic capital controls. Nations influenced by hedge funds and their complex financial instruments should seek international cooperation, including the governments of host countries, to regulate their practices.
- A new international legal framework should be created, which provides for de facto sovereign bankruptcy. The existing international system for dealing with insolvent governments is woefully inadequate. Provision must be made for automatic standstills, priority lending, and planned reorganizations.
- An international transactions tax (like the Tobin tax) should be designed and implemented to discourage short-term speculative capital movements. It is neither "too idealistic" nor "too impractical." It would reduce short-term trading and strengthen the defensibility of the exchange rate regime.
- International cooperation should be sought to curb dubious activities of offshore financial centers. Strict international regulation and supervision of offshore centers is essential to curb tax and regulatory evasions. They also are a primary conduit for money laundering and various criminal activities.
- The IMF's responsibilities as a lender-of-last-resort should be enhanced, expanding its authority and resources to make possible quick action to avert financial crises. The IMF must have effective and swift mechanisms to increase the Fund's access to official monies in times of crisis, including authority to borrow directly from financial markets under those circumstances.
- A World Financial Authority based on the cross-border regulatory framework of the Bank for International Settlements should be developed. It should provide the necessary regulatory framework within which the IMF or a successor organization can develop as a lender-of-last-resort.
Of these recommendations, perhaps the most controversial is that more funds be given to the IMF. We noted above that much of the criticism of the IMF is justified. We also acknowledged that the IMF is improving its policies. We hope that these improvements will continue. Meanwhile, there is no other viable candidate to serve as lender-of-last-resort - an absolutely essential feature of any new financial architecture.
The major reason some civil society institutions resist funding the IMF further is its history of misguided structural adjustment policies, policies that are now widely recognized to have caused widespread suffering. We hope that recent changes will improve this situation as well and enable the IMF to perform the important role we recommend for it.
Along with the World Bank, it is beginning to contextualize its performance criteria and conditionalities, taking much more seriously the unique circumstances of particular economies. It is listening more and nitpicking less. To be sure, the IMF is not likely to abandon its policy of making its loans conditional on the adoption by borrowing countries of mutually agreed economic policies. Even so, there is considerable evidence that when it has had more resources on hand, conditionality has been correspondingly wiser and less draconian.
The IMF now recognizes that it can leave more decisions to developing countries partly because these have better informed and more sophisticated employees than was once the case. Certainly in Latin America and Asia and increasingly in Africa, country economic teams are better qualified technically than the lower rung Ph.D.s from American and European universities to whom the IMF and World Bank entrust their missions. Local economists can do financial programming and standard macroeconomic modeling as well as or better than the people from Washington can; they also know how to do investment project analysis. To be sure, decisions about financial and project plans must include input from many other elements of a society.
We can encourage the IMF (and World Bank) to reverse the typical procedure in setting conditions for multilateral loans. Instead of waiting for it to specify the policies that must be followed to justify additional financing, country economic teams, in consultation with other agencies of their government, should be allowed to propose economic programs to the IMF. Disagreements between Washington staff assessments and the local teams could be resolved directly or by third-party arbitration. The scope of economic conditionality could also be restricted, for example, just to a balance-of-payments target, while the country could pursue its own agenda regarding inflation, income distribution, and growth.
What Christians can do
A primary part of the "principalities and powers" referred to in the Bible is composed of the political-economic institutions and processes that govern how people relate economically to each other and to God's whole creation. The church has a stake in their design. Yet many church members feel powerless to change basic political-economic reality. They think either that the economic conditions of society result "naturally" from the forces of markets that are only marginally within the power of human control, or that economic conditions result from powerful interests that are beyond the reach of ordinary citizens. Thus, there's nothing that can be done about it, or there's nothing we can do about it.
On the contrary, Mobilization for the Human Family believes that the political economy is shaped by deliberate social policy decisions; that conditions at any given time are the result of those decisions; that conditions can be changed by human decisions; and that the will of a nation's and the world's citizens about what the commitments and purposes of the nation and the world should be can be expressed in the political economy through the framework of democratic process provided in our national and transnational polity. Accordingly, we offer below some suggestions for action that may be taken by individual Christians and by our churches and their denominations to correct some correctable flaws of financial globalization.
Actions by individual Christian
- Pray for persons working in governments, international organizations, institutions, and non-governmental organizations who are trying to work toward a better world, including especially a world financial architecture that better assures fairness in capital markets.
- In the management of personal and family investments, seek fuller understanding of the uses to which the banks, companies, mutual funds, and investment counselors are putting your money. Avoid speculative investments that are likely to be made without regard to their consequences for others.
- Reflect upon decisions about work and career choices that are consistent with a Christ-like commitment to economic justice for all.
- Organize Bible study in your local congregation, where possible together with people of other backgrounds and life-styles, to learn and identify with God's continuing struggle to seek economic justice in the world.
- Commit oneself to some voluntary organization that is trying to promote greater economic justice in the local and/or global economy.
- Become involved politically in your area or nation, seeking political and economic change in the direction of economic justice.
Actions by churches and denominations
- Concern for economic justice must be fully reflected in the prayer life, worship, and educational programs and mission outreach of all congregations.
- Seek assistance from members who work for banks, brokerage houses, and mutual funds to help mould an educational program that will assist members of the congregation to become more socially responsible investors.
- Seek collaborative programs among clusters of congregations, perhaps with the aid of local Councils of Churches, to provide educational opportunities where Christians and other faith groups can come to understand some of the complex economic issues amidst which they live and work. Since virtually nothing is now available to explain the problems of financial speculation, this paper could be used to assist study of this phenomenon.
- Over and beyond educational programs, local churches - again perhaps best working together in the same neighborhood or town - can enter into a deliberate dialogue or partnership with one or more voluntary bodies in the civic society, so as to put their energies into the health of the wider society. Engagement with the International Forum on Globalization (l009 General Kennedy Avenue #2, San Francisco, CA 94129) is a good way to explore the means of influencing the debate on the globalization of trade and finance.
- At the denominational level, churches should review their investment criteria to reassure themselves that social responsibility is a primary goal of their financial management.
- Also at the denominational level, agencies responsible for the formation of social witness policies need to monitor global economic indicators on a continuing basis in order to assist its programmatic agencies to form effective and timely social witness regarding the local and national consequences of the globalization of trade and finance.
Want to know more?
Globalization is a vast topic. For a general introduction, see
- Sarah Anderson and John Cavanagh, Field Guide to the Global Economy (New York: New Press, 2000)
- Thomas Friedman, The Lexus and the Olive Tree: Understanding Globalization (New York: Farrar Straus Giroux, 1999). -[ I would not recommend Friedman -- NNB]
A classic introduction to the financial side of globalization is Susan Strange, Casino Capitalism, (New York: Mnchester University Press, 1986).
- Kavaljit Singh, The Globalisation of Finance: A Citizen's Guide (London: Zed Books, 1999)
- John Eatwell and Lance Taylor, Global Finance at Risk: The Case for International Regulation (New York: The New Press, 2000).
The best introduction to the Tobin Tax is Mahbub ul Haq et al (eds), The Tobin Tax: Coping with Financial Volatility (New York: Oxford University Press, 1996). For how church people might react, see Pamela Brubaker, Globalization at What Price? (Cleveland: Pilgrim Press, 2001).
Questions For Discussion
- How have the linkages and interconnections of international finance impacted your life? On balance, do you regard them as advantages or disadvantages for a healthy Christian life?
- The frequency and severity of recent financial crises have fueled calls for a radical redesign of the rules of global finance. If you were the advisor to an international commission asked to design "A New International Financial Architecture," what would you recommend?
- Do you favor allowing sovereign nations to declare bankruptcy? What Christian traditions might be invoked to support or deny such an action?
- A growing number of civil society institutions oppose giving more money to the IMF. They point out that it is part of the Washington Consensus, the application of whose policies have made societies adjuncts of the market. Yet this paper suggests that the IMF needs more money. As a committed Christian, which view do you favor?
- Is it too late to expect justice in a globalizing world? Since much of the direction the global economy has taken is irreversible, how can a balance between market and society be negotiated? How might Christians play a role in those negotiations?
1. Reported by Thomas L. Friedman, The Lexus and the Olive Tree (New York: Farrar Staus Giroux, 1999) p.101.
2. John B. Cobb, Jr., (ed), (Claremont, CA: Mobilization for the Human Family, 2000)
3. Karl Polanyi, The Great Transformation. The Political and Economic Origins of Our Time (Boston: Beacon Press, 1957/1944)
4. Denys Hay (ed), The Age of the Renaissance (New York: McGraw-Hill, 1967) p.22.
5. Heikki Patomaki, Democratising Globalization (London: Zed Books, 2001) p.40.
6. Peter Garber, Famous First Bubbles: The Fundamentals of Early Manias (Cambridge, MA: MIT Press, 2000). The quotation is from Charles Mackay, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds (London: Bentley, 1841) p.142.
7. For a summary of the vast literature on pre-World War I foreign lending, see Albert Fishlow, "Lessons from the Past: Capital Markets in the 19th Century and the Interwar Period," in M. Kahler (ed), The Politics of International Debt (Ithaca: Cornell, 1985).
8. Ibid, p.90.
9. Polanyi, op. cit. p.14.
10. J. T. Madden et al, America's Experience as a Creditor Nation (Englewood Cliffs, N.J.: Prentice-Hall, 1937), p.74.
11. Reprinted in Madden et al, p.205.
12. John Kenneth Galbraith, The Great Crash, 1929 (Boston: Houghton Mifflin, 1954), p.16.
13. For a helpful summary of the British and American plans at Bretton Woods, see Raymond F. Mikesell, The Bretton Woods Debates: A Memoir (Princeton: IFC Essays in International Finance no.192, 1994)
14. Jacques J. Polak, The Changing Nature of IMF Conditionality (Princeton: IFS Essays in International Finance, no. 184, 1991.
15. Robert Triffin, Gold and the Dollar Crisis (New Haven: Yale University Press, 1961.
16. The IET taxed foreign borrowings in the U.S. with the intention of reducing the acquisition of dollars by foreigners; the U.S. government thought the dollar "overhang" was getting too large.
17. This section draws upon Heikki Patomaki, Democratizing Globalization: The Leverage of the Tobin Tax, (New York: Zed Books, 2001), chap. 2.
18. The prices a company charges itself for goods or services purchased from one of its entities and sold by another. Multinational corporations with business operations in many different countries try to charge prices that minimize their overall tax liabilities.
19. Roughly, a consensus between the U.S. Treasury, the IMF, the World Bank, and the business community about the policies most likely to achieve free trade and rapid growth: fiscal austerity, privatization, deregulation, and free movement of financial capital.
20. International Organization of Securities Commissions, the Joint Forum on Financial Conglomerates, the International Swaps and Derivatives Association, and the Institute of International Finance..
21. See, for example, Amartya Sen, Development as Freedom. (New York: Alfred A. Knopf, 1999); Lance Taylor (ed), External Liberalization, Economic Performance and Social Policy.(New York: Oxford University Press, 2000); Dani Rodrik, The New Global Economy and the Developing Countries: Making Openness Work. (Washington: Overseas Development Council, 1999); Enrique Ganuza, Lance Taylor, and Rob Vos (eds), Economic Liberalization and Income Distribution in Latin America and the Caribbean. (New York: United Nations Development Programme, 2000).
22. United Nations Development Programme, Human Development Report. New York: Oxford University Press, 2000.
23. David Felix, "Asia and the Crisis of Financial Globalization," in Dean Baker et al., (eds) Globalization and Progressive Economic Policy (Cambridge, U.K: Cambridge University Press, 1998) pp.163-91.
24. Jeffrey D. Sachs, "Alternative Approaches to Financial Crises in Emerging Markets," in Miles Kahler (ed), Capital Flows and Financial Crises (Ithaca, N.Y: Cornell University Press, 1998)
25. The Mystery of Capital, (New York: Basic Books, 2000) p.207.
26. "The Revival of the Liberal Creed: the IMF, the World Bank, and Inequality in a Globalized Economy," in Dean Baker op cit., pp. 37-63.
27. See his Underwriting Democracy (New York: The Free Press, 1991), part 3, and his On Globalization (New York: Public Affairs, 2002) ch. 4.
28. For additional details, see K. S. Jomo (ed), Malaysian Eclipse: Economic Crisis and Recovery, (New York: Zed Books, 2001)
29. For more information, see Kavaljit Singh, Taming Global Financial Flows New York: Zed Books, 2000) pp. 158-78. See also Carmen & Vincent Reinhart, "Some Lessons for Policy Makers Who Deal with the Mixed Blessing of Capital Inflows," Miles Kahler (ed), Capital Flows and Financial Crises (Ithaca: Cornell, 1998) pp. 93-124.
30. Given in 1972 at Princeton University and published subsequently as "A Proposal for International Monetary Reform," Eastern Economic Journal 4 (July-October, 1978) pp 153-9.
31. Mahbub ul Haq et al (eds), The Tobin Tax: Coping with Financial Volatility (New York: Oxford University Press, 1996) passim.
32. Jeffrey Sachs, "Alternative Approaches to Financial Crises in Emerging Markets," in Kahler, op. cit., pp. 256-59.
33. George Soros, On Globalization, op cit, ch. 4.
34. Ibid, appendix.
35. Joseph E. Stiglitz,, Globalization and Its Discontents (New York: W.W. Norton, 2002)
36. (Manchester, U.K: Manchester University Press, 1986)
By SEBASTIAN MALLABY
AGE OF GREED
The Triumph of Finance and the Decline of America, 1970 to the Present
By Jeff Madrick
Illustrated. 464 pp. Alfred A. Knopf. $30.
Seven years ago, James Mann published “Rise of the Vulcans,” a history of the neoconservative foreign-policy advisers who rose to prominence with the presidency of George W. Bush. Mann traced the group’s origins to the 1970s, when figures like Dick Cheney and Donald Rumsfeld got their start in government, and told how events from East Asia to Kuwait solidified their faith in American assertiveness abroad. Of course, Mann was writing against the backdrop of the Iraq invasion. The belief system he chronicled had culminated in overreach.
Jeff Madrick’s “Age of Greed” almost seems to have set out to be the economic equivalent of Mann’s history. Writing against the backdrop of the 2007-9 financial crisis, Madrick, the author of “The End of Affluence,” also starts his story in the 1970s, tracing the regulatory and cultural changes that led to our current trouble. In Madrick’s telling, a cabal of conservatives, driven first by greed and second by “extreme free-market ideology,” gradually seized power. The result, as proclaimed in his bold subtitle, was “the triumph of finance and the decline of America.”
It’s clear from the outset that Madrick has his work cut out for him. Where Mann’s story concentrated on six individuals who held office through successive Republican administrations, Madrick draws in a far wider cast of characters: thinkers like Milton Friedman; business leaders like Jack Welch; presidents like Richard Nixon and Ronald Reagan. It’s not always obvious what connects these disparate figures, so the book jumps from pen portrait to pen portrait without always advancing its main theme.
And the theme itself is slippery. A history of neoconservatism can home in on self-professed neocons, whose actions are clearly informed by a defined body of beliefs. But it’s harder to identify a cabal that self-consciously embraced greed as a guiding philosophy. To be sure, the insider trader Ivan Boesky once defended greed at a forum in Berkeley, Calif. But an undertow of avarice is surely a human constant. Was Sandy Weill, the Wall Street executive who retained a corporate jet while slashing retired employees’ health insurance, really so very different from a 19th-century Rockefeller or Vanderbilt?
If the greed of Boesky or Weill is unsurprising, the lack of greed evinced by some of Madrick’s characters is striking. Paul Volcker, the Fed chairman whom Madrick eccentrically berates for his determined fight against inflation, was known to be frugal; John Reed, Citigroup’s boss during the 1990s, was by Madrick’s own account “thoughtful and unflashy.” Reagan himself was more enthusiastic about self-reliance and hard work than about material advancement, remarking that “free enterprise is not a hunting license.” Early in his career, Walter Wriston, Reed’s predecessor at Citi and perhaps the character whom Madrick conjures most successfully, was offered a salary of $1 million to move to Monaco and work for Aristotle Onassis. He chose to remain in a middle-income housing project in Stuyvesant Village.
If “Age of Greed” is an unhelpful label, what of Madrick’s secondary contention — that the era was defined by extreme free-market ideology? Well, the extreme was pretty mainstream. Free-market ideas were embraced by Democrats almost as much as by Republicans. Jimmy Carter initiated the big push toward deregulation, generally with the support of his party in Congress. Bill Clinton presided over the growth of the loosely supervised shadow financial system and the repeal of Depression-era restrictions on commercial banks. Centrist intellectuals like Lawrence Summers, who was fully aware of market failures — indeed, who had emphasized them in his academic writings — nonetheless embraced pro-market public policies because, he thought, they were more right than not.
Besides, free-market policies were never embraced with the unqualified enthusiasm that some imagine. Throughout Madrick’s period, entitlement spending grew and armies of supervisors at multiple agencies tried to keep the financial sector in check. Contrary to Madrick’s view that the regulators were always retreating, the 1980s saw the imposition of new capital-adequacy rules on banks, and the 2000s brought the passage of the ambitious Sarbanes-Oxley accounting reforms. These regulatory efforts proved hard to enforce, but the record hardly supports Madrick’s argument that policy was captured by free-market extremists.
The real causes of the crisis are more subtle and interesting than Madrick believes. Frequently, as the nation built the system that ultimately imploded, intelligent, pragmatic, nonideological and generally ungreedy individuals wrestled with the options that confronted them — and concluded that some measure of deregulation was the least bad way forward.
Consider the response to Wriston’s efforts in the 1960s to end-run Regulation Q, the rule that restricted banks’ freedom to pay interest on demand deposits. Regulators fully understood that the demise of Reg Q would drive up the banks’ borrowing costs, which would in turn lead them to chase higher-yielding loans to riskier customers. But regulators could also see that Q was an anachronism. Given the inflation of the Vietnam period, savers were not going to hand banks their money unless they were paid interest. If Q was enforced, depositors would lend directly to companies by buying their debt in the securities markets. The choice was between deregulating the banks, which would be risky, or seeing financial activity move into hard-to-monitor markets, which might be even more risky.
By allowing such stories into his narrative, Madrick rescues his book from his own unconvincing thesis. He makes extensive and generally good use of secondary sources (I am among the many authors cited), though there are some confusions and errors. He twice states that the hedge fund manager Julian Robertson escaped losses during the October 1987 crash. Actually, Robertson took a 30 percent hit that month, and afterward told his investors that “probably none of us have ever lost so much money so fast in our lives.” More seriously, Madrick misconstrues the Princeton economist Alan Blinder, citing him in support of the curious view that policy makers could have dealt with the Carter-era inflation by waiting it out. What Blinder actually wrote was that part of the 1970s inflation required no policy response, since it resulted from temporary spikes in food and fuel prices that would self-correct. But the other part of the decade’s inflation, Blinder acknowledged, reflected excessively loose money, and the Fed had no choice but to tighten the supply.
Even though Madrick does not deliver on his thesis, readers will still find worthwhile stories in his pages. In 1970 Walter Wriston, having loaded up on risky assets after sidestepping Reg Q, faced the prospect of a large loss when Penn Central railroad defaulted. He immediately called the Fed and announced that the financial system itself was at risk, demanding that the central bank’s emergency lending operations be kept open over the weekend. The Fed obliged, easing Wriston’s losses. Four decades ago, in other words, the “too big to fail” doctrine was already operative.Sebastian Mallaby, the Paul A. Volcker senior fellow at the Council on Foreign Relations, is the author of “More Money Than God: Hedge Funds and the Making of a New Elite.”
August 23, 2010
The conservative economic counter-revolution associated with the names of Ronald Reagan and Margaret Thatcher began some three decades ago. The Great Recession almost certainly marks its end. What follows will be something different, though how different it will is still unclear. This is a good opportunity to assess the broad economic consequences of that revolution.
For the sake of simplicity, I focus on gross domestic product per head in the six biggest high-income economies: the US; Japan; Germany; the UK; France; and Italy. (I also use the Conference Board database. These data are in purchasing power parity (Elteto-Koves-Szulc (EKS) method).)
There is much more to performance than GDP per head. These data ignore the distribution of income, which is of crucial importance, especially for the US, where a very large proportion of additional income seems to have accrued to the wealthiest. The data also ignore the underlying causes of changes in GDP per head: changes in output per hour, in hours per worker and in employment. Even so, they are revealing.
The single most important point from the chart on relative GDP per head is that the US remains where it has been for over a century: the most productive large economy in the world. At its peak, in 1991, Japan’s GDP per head reached 89 per cent of US levels. It then fell substantially in the 1990s. United Germany, France and Italy also experienced substantial relative declines in GDP per head over this period. The UK was the only one of these five countries to have achieved rising GDP per head, relative to the US, since 1990. This surely suggests that reforms led by American and British policymakers did bear some fruit.
The chart on growth of GDP per head elaborates this picture somewhat. The UK and US had the highest trend growth of GDP per head between 1980 and 2009. (All-German data are unavailable for the entire period.) But there are other interesting events: first, there is a progressive deceleration in trend growth: only Japan achieved faster trend growth in GDP per head between 2000-07 (that is, before the recent deep recession) than it did in the 1990s; second, the US growth deceleration in the most recent periods is marked, with growth in GDP per head only at the same rate as Japan between 2000 and 2007 – so much for the magic of the Bush-era tax cuts - and also between 2000 and 2009; third, GDP per head grew at less than 1 per cent a year in Germany, France and Italy in the most recent decade.
At first glance, then, the conservative revolution seems to have achieved some improvements in the previously lagging US and UK economies. But the magic potion started to lose effectiveness in the 2000s, particularly in the US.
The more interesting question, however, is how far this improved performance of the US and UK will turn out to have been a blip. There are two reasons for believing this.
First, the expansion of the financial sector and associated leveraging of the household sector played a big part in the growth of the economies of the US and UK. The question is how far growth driven by these two linked developments will turn out to have been a mirage. It is not difficult to see why that might be the case. The financial sector creates money and credit not only used to pay fees to itself and to a host of brokers and agents, but also to finance construction booms. Furthermore, the next decade is likely to see deleveraging in the US and UK, in both household and financial sectors, while the willingness to leverage up the government sector seems set to hit political or economic limits. This combination of factors might make these countries’ performance look a little like that of Japan in the 1990s, with chronically weak aggregate demand.
Second, the US and UK have run substantial current account deficits in recent decades. Andrew Smithers of London-based Smithers & Co argues that this has allowed the relative shrinkage of manufacturing, a capital-intensive sector. That, in turn, has permitted the two economies to grow quite fast, despite relatively low rates of investment in physical capital. In the coming decade, this process is likely to be reversed. Savings and investment would then have to rise substantially to sustain given rates of overall economic growth. Should this not happen, growth would slow further.
Bubbles induce severe over-estimates of underlying economic performance. Will the same prove true of the US and UK? I would guess so. Might the next decade belong to Germany or Japan, instead? That would not surprise me either. Expect the unexpected. It is a good rule.
- Kevin Alexander | August 23 9:07pm | Permalink
| OptionsThe "Great Recession"?
It may yet to turn out as the neo-Dark Ages, where stupidity reigns.
- Report Gavyn Davies | August 23 10:19pm | Permalink
| Options@ Martin Wolf
Martin - I think we need to ask four separate questions. First, did the Reagan/Thatcher reforms help the relative performance of the US and UK, compared to other economies, in sectors other than the financial sector? My answer to this would be a resounding "yes". Second, did the US and the UK also gain because they had comparative advantages in the financial sector, which was the area of the global economy which expanded most rapidly from 1982-2007. My answer would be "yes" again. Third, did the conservative revolution itself contribute to the forces which triggered the growth in the global financial sector? Clearly, yes again. And, fourthly, can the pre-2007 growth in financial services be maintained in the long run? That seems very doubtful, to say the least.
If this is all true, then the conservative revolution may have improved the performance of the non financial sectors in the UK/US, while also shifting resources excessively towards finance in those economies. We may not be able to judge the final outcome until finance has settled down its sustainable share of global GDP, which is probably less than it was in 2007. But we can ask ourselves this : is it possible to design the next revolution so that non financial sectors improve their performance, without also shifting resources (perhaps wastefully) into finance? It may require us to encourage market forces in some sectors, while regulating them in others. Not an easy message for politicians to get across.
- Report Richard W | August 23 10:38pm | Permalink
| OptionsI think in the context of future growth for Germany and Japan you would also need to calculate what impact a declining population will have on growth. Both countries have a declining population and an ageing population through declining births. Although the declining population will likely see GDP per capita growing. I would think nominal GDP will disappoint. Moreover, the demographics of an ageing population must have effects on the rate of new startup firms. Much will depend on whether the young can increase their per-capita output to support the inverted population pyramid. Although the US and UK face problems with deleveraging they do not have the declining population problem.
- Report Munzoenix | August 23 10:42pm | Permalink
| OptionsI agree with Martin on his last point -- that the relatively high growth in the US and UK could be due to higher leverage, and less investment in capital-intensive sectors like manufacturing.
But, I think Martin also did not mention two points I think are very valuable:
1) that growth rates in various countries are reported in domestic currencies. The US and UK have shown to have high growth rates, but when you standardize/normalize all the growth rates using one currency for comparison, the US and UK economy shrunk markedly in the past decade if all these economies were compared in euros or yens. The pound had lost almost 20% of its value in the last year, which in euro terms is a 20% decline in the UK's per capita income measured in euros. So, all the growth the UK experienced in relation to Germany, France and Italy is a mirage already.
2) per capita incomes are usually measured in purchasing power parity (and looking at how low Japan's figures were in Martin's graph, I'm assuming PPP was used). But this can be somewhat misleading. There is value in reading PPP, because it allows economists to measure what people can actually buy because it adjusts for varying price levels across countries. But, looking at nominal exchange rate also has value.
US PPP per capita income is high because prices levels are low -- NOT FOR GOOD reasons like higher productivity from greater capital-intensive utilization. US price levels are low because 1/3rd of the labor force lost their job in the manufacturing sector due to an overvalued dollar (thanks to Reagan excessive government debt). All this manufacturing labor flooded into the "booming" service sector, putting downward wage and price presses on service goods from restaurant meals to haircuts. Thus, haircuts and other services that comprise a country's price level are lower in America than a country like Sweden -- Thus using PPP makes Sweden look poorer, when in reality, the economy is more balanced for having more labor employed in a highly competitive goods-producing, capital-intensive manufacturing sector, that there is less labor in services that overall price levels are higher.
Therefore, using nominal market exchange rate to measure per capita income in the above countries maybe useful (alongside PPP). In that case, Japan and Germany are far better off (and balanced) than the US and UK. In addition, growth is far more equal across those societies than in the US where all growth is top heavy, as Martin mentioned.
Overall, good article, nonetheless.
- Report Francobollo | August 24 1:08am | Permalink
| OptionsThe idea that finance and leverage have made up part of the relative gains of US/UK seems eminently plausible. Nevertheless it doesn't seem, despite the Great Recession, that neo-con policies are dead. An example is Cameron's 'Big Society' concept which seems to be pure Gordon Tullock in seeking to transfer government activities to the voluntary sector.
- Report Padmanabha Rao Hari Prasad | August 24 2:07am | Permalink
| OptionsThe relatively poor and declining quality of physical and human capital in the US will surely limit its growth over the next decade or more. Raghuram Rajan has quite an extensive discussion in "Fault Lines" of how the US educational system and society are failing to provide an increasing portion of the population with the skills (and the socializing for the attitudes and work habits) needed for the more technologically sophisticated jobs of today. The policy consensus to address these constraints seems all the more difficult to achieve in a highly polarized political environment.
- Report Akira Chimura | August 24 4:14am | Permalink
| OptionsI am surprised by Martin's analysis, based on PPP. I can choose nothing but to seriouly doubt the economic theory or further all logical theories as well as logical and abstract thinking itself. Only one ironical conclusion is "I think, therefore I am", just as Descarters said. Concretely, Japan must unchangeably seek for a new catch-up model, successful in Ex-Japan Asia, signifying that more and more savings and capital-intensive investments in physical assets should be made. Does this signify a stronger inertia of continuing the conventionalities of the past, and so a more helpless vicious cycle of the debt-deflation dynamics, basically different from recently rising Germany? Greater havoc or collapse for Japan? Because no matter how based on PPP, the revenue by corporat tax peaked at a level of 13.4 trillion yen in 1991 and then sharply declined to a level of 5 trillion yen in FY 2009, and also other tax revenues similarly declined, except the revenue by consumption tax. Therefore, the country cannot stand up. Even though the tax system is the basics of the country, if Japan's tax system could be changed into the European-style tax system, centering around added value tax, would Japan get out from the vicious cycle of the debt-deflation dynamics and be really revived? What matters most importantly is that this task is the genuine difficulty for Japan, because it crucially and vitally needs a really strong leadership, differently different from "Leadersless Japan" ( The economist criticised ).
- Report Bryan Lewis | August 24 4:23am | Permalink
| OptionsMr. Wolf.
I am in Japan.
I just bought a new computer that is half the price of one I bought 5 yearsa ago.
It is much faster and has better features.
If this pricing and growth in efficiency was carried accross the board the GDP would fall by half.
So what kind of a measure of the economy is the GDP used in your graphs?
- Report Liberty | August 24 4:52am | Permalink
| OptionsEveryone can quote others' data and say "expect the unexpected." Wolf should find another job. Thatcher and Reagan did not achieve turning the tide of socialism in the west. They just stopped its progress for a while. That's why the West is not doing well. The real counter-revulutions were in China, India and eastern Europe, which are significantly less socialist now than before.
- Report Mycroft | August 24 6:38am | Permalink
| OptionsReagan/Thatcher slowed the growth of the State, but hardly did they roll it back by any objective measure... just look at the budget numbers, number of govt. employees, etc..
Reagan in particular disillusioned his Goldwaterite supporters on every front.. from failing to abolish the Dept. of Education, to burying the Gold Comission, to incurring in huge deficits... Since then the US Empire and it's Welfare state have done nothing but grow.
If you want to see the triumph of market reforms, look to China, where a little more freedom has gone a long way...
- Report Roy | August 24 7:55am | Permalink
| Optionshonestly.. this is a bit of a joke.. in these decadent days we call anything a revolution... even if it's just tinkering around the edges.
If you want a measuring rod which will show you just how lame Reagan reforms were... contrast to Thomas Jefferson's spending cuts (almost 50% of the Federal budget in 4 years)..
- Report kedarsat | August 24 8:04am | Permalink
| OptionsDoes conservatism allow for ZIRP?
In my book, low interest rates and a pernicious form of crony-capitalism brought the UK and US down. These need to be abandoned, rather than the conservatism that never was.
The decline in US public finances will lead to a partial dismantling of US public education, which could be the beginning of the re-skilling of the US.
- Report sceptic | August 24 8:16am | Permalink
| OptionsI love the way Krugman, Wolf and co. are trying to drive the keynesian dual narrative of "deregulation caused the bust" and "austerity killed the recovery".
Anything to focus the debate away from establishment sacred cows. I'll leave it to the reader to figure out what those are.
- Report Econoclast | August 24 8:29am | Permalink
| OptionsI am amazed by some of the comments here, which seem to imply quasi-socialism is a major constraint on the US and the UK. As Martin Wolf points out, we've had 30 years of deregulation, which simply encouraged massive over-investment in housing to the detriment of other physical capital. Thatcher-Reagan deregulation has failed. I regard the comparisons with China, India and eastern Europe has completely misplaced. Look at the mess in many eastern European economies who shared in the financial/housing mania. And China and India are reaping the benefits of putting hundreds of millions of people to work. The true test for their political and economic systems will come over the next 20 years.
- Report central economic plannning | August 24 8:31am | Permalink
| Options10 Planks of the Communist manifesto:
5. Centralisation of credit in the hands of the State, by means of a national bank with State capital and an exclusive monopoly.
- Report Gaute | August 24 9:58am | Permalink
| Options@ econoclast, "The true test for their political and economic systems will come over the next 20 years"
20 years is a very short perspective. Remember what Chou En Lai allegdly answered when asked about his opinion on the outcome of the French revolution. It was too early to tell.
- Report Brian Reading | August 24 10:15am | Permalink
| OptionsUS industrial ICOR fell substantially from the early 1980s (measured over 7 years to smooth the cycle). Less investment was needed. Meanwhile LSR calculates that TFE was close to zero in the 1970s, rose to over 0.5% pa over the next two decades and in the noughties fell back to zero. I wonder how far the take-up of new technology has substantially increased TFP.
From 1985 US NIPA does allow for quality changes using hedonic pricing covering 20% of expenditure categories. Non-residential investment has been on a declining trend as a share of nominal GDP while on a rising trend on chain linked.
A good many years ago I devised a method of looking at relative performance using the errors in successive OECD GDP growth and inflation forecasts. The idea was that models are slow to capture changes in regression relationships. The result of a structural improvement should show up as a bias towards under estimating growth and over estimating inflation. There was such a bias for the US and UK but not for Germany, France and Japan. I have not repeated this exercise for many years. How long ago this was can be guess by the fact that Anthony Harris reported in in the FT.
- Report StuBails | August 24 10:23am | Permalink
| Options@ Martin Wolf
You said that the conservative revolution seems to have achieved some improvements in the previously lagging US/ UK economies.
Is there an alternative explanation here? Could it be that in the early 90s outsourcing started in earnest? The US & UK farmed out commodity production to the East and concentrated on comparative advantages in Financial Services/ property/ professional services. Was it this that accelerated growth rather than the deregulation of the US/ UK economies?
Either way, both countries are facing monster issues in the coming thirty years. The UK does have to concentrate more on exports, but my guess is that this will not result in manufacturing comprising a bigger % of GDP than it currently does.
- Report Luis H Arroyo | August 24 10:40am | Permalink
| OptionsI do not think the conservative revolution was the direct cause of the crisis. Therefore, I do not think the solution is the return of Keynesianism. Keynesianism has had its day, and lost the battle miserably. Moreover, much of today's problems come from the debts accumulated by the European countries that have chosen to follow Keynes.
There are many factors that have strayed from their beds Conservative revolution. for example, the commercialism of China, which has devastated the productive sectors of the world. In the West we have praised China as a simpleton when it has never been a credible rival.
Then the history of the euro has played a key role in the crisis, as determined interest rates very low in the countries which embarked on the bubble. Now, the Euro is a huge barrier for these countries to adjust their failure competitiveness.
These and other conditions can not be charged to the account of the Conservative Revolution, that brought capitalism to depressed areas that are now very close to us.
- Report Itzman | August 24 10:50am | Permalink
| OptionsThe history of civilization is the history of economics, but it is not the history of economic theory or of political interference with it.
They merely lag the true economic history of it.
Wolf, Krugman et al would do well to step back from theories that express the conditions of limited populations with access to more resource bases than they can exploit, (the politics and economics of expansion) and look to develop an economics that reflects the situation today, of the only unlimited thing being our ability to generate people we have no hope of ever finding useful employment for. And print empty promises on banknotes.
Everything else is in short supply.
In short, stop behaving as though by believing in it, the world will become what we think it ought to be, and start treating with it, as it is, and must inevitably be. With or without political an economic fiddling.
The economic wealth of a nation is nothing more or less than the the resource bases it has access to, and its efficiency in exploiting them into desirable product, divided by its population (squared) . As higher density populations need proportionality higher use of resource per capita to regulate and organise. One man on an island needs no government or defence force or police force or waste disposal....60M need rather more..
Which leads to a simple conclusion. The only way forward to greater prosperity lies in managing populations down. The longer this distasteful alternative so at odds with expansionist economic and political theory is shied away from, the bigger will be the crash when some externality does what politicians and economists are so afraid to face.
The rest may be safely left to those engaged in economic activity: The best that government can do is not stand in the way. Economists, may not be worth the paper they write upon, sadly.
- Report Per Andersson | August 24 11:47am | Permalink
| OptionsMr Wolf overestimates the influence of individual politicians (Reagan/Thatcher). What he calls 'the conservative counter-revolution' consists of two developments:
1. The growth of the welfare state was halted.
2. Technology enabled product markets to be deregulated (or, perhaps more appropriate, de-monopolised) to a much larger extent than before.
Both these developments took place in other industrialised nations, even in those that did not have political forces as strongly identified as 'conservative' as Reagan or Thatcher.
The welfare state itself was not significantly cut back, either by Reagan or Thatcher. This is because the welfare state was and is overwhelmingly popular. A large-scale reduction in the size of government through a dismantling of the welfare state simply is not politically feasible, despite the protestations of 'Tea-Partiers'.
- Report maximus | August 24 11:50am | Permalink
| OptionsYes, Interesting article although I suspect that there is a bit of a sub text here- i.e all this deregulation - did it really deliver? Some really don't want to buy that argument! I think that RichardW below is on the right lines, although it is obviously variable by country/region. The developed world post WW II baby boom has coincided with much of these changes... looking at the UK.. greatly expanded higher education, student power, new families, house acquisition, overseas travel and rising real incomes, financial service needs, now retirement for many. It has run its course. You can measure some of these by tracking the "Branson Empire" as it has morphed along with that generation. I think it has very little to do with conventional economic theory and much to do with the available choices to most of those baby boomers. This has now run its course- ergo the pile of problems from pensions et al.
- Report Barry Thornton | August 24 1:05pm | Permalink
| OptionsA curious article.
you start by mentioning the deficiencies of using GDP as a metric, but then proceed to use it anyway and finally question the conclusions that can be drawn from the limited data.
It is not very surprising that since the 80s the GDP of the US and UK have surged ahead, what with the expansion of the financial sector and the flow of credit. However, the big gripe with conservative policies has been that this has only benefited a tiny minority (as you mention).
A far more instructive comparison would include median wages, inflation (including property inflation), average number of hours worked, employment (not unemployment), health care and crime.
I appreciate that the conservative reforms were mostly economic and financial in nature, but the success or otherwise of these reforms should be judged with a broad range of metrics, not just economic ones.
I suspect in such an analysis, the conservative revolution would not look as good.
- Report antitrust | August 24 1:27pm | Permalink
| OptionsAnybody who talks about regulation.. or deregulation.. and fails to mention that the monetary and banking system is set up as a government orchestrated cartel, that the whole financial sphere of economic life is, if not outright nationalized, pretty much directed by governments and a few govt-licensed players... is being short-sighted at best.
- Report Driftersescape | August 24 1:35pm | Permalink
| OptionsI would have thought that when one talks of ‘Reganomics’ in the very next breath Milton Friedman would be mentioned and then inevitably monetarism. John Maynard Keynes, one of the most brilliant minds of his generation has become persona non grata.
Rather oddly the article above mentions none of these. Those of a certain age will recall not awaiting the next unemployment number but that of the latest M4 and then M0.
Those have of course been assigned to the trashcan of history (about 1987) I think i.e. the same place as the conservative revolution you refer to.
The list of failures is too long to mention but in the charge sheet is rapid deregulation though to the shameless ‘jacking up’ of the UK economy to win the 1987 general election. Result, an overheating economy and galloping inflation brought under control, for many business and individuals by sky high interest rates leading to a very painful recession that lasted from 1989 to 1993/4.
You are right in one thing, it surely did begin thirty years ago and tragically that flawed theme (deregulation morphing into light touch regulation) was brought to a shuddering halt in the blood bath of that late 2008 early 2009 credit crunch.
The final analysis of the conservative revolution? An unmitigated disaster.
- Report Alasdair Rankin | August 24 1:42pm | Permalink
| OptionsThe problem is essentially one of goals. Wasn't the conservative counter-revolution simply a piece of ideological special pleading by the owners of capital? Look at the proportion of the increase in GDP in the US which went to the owners of capital. They also seem to believe that the state should only spend money on things they like. All the rest is best left to the "private sector". But what's "private" about driving the global economy into a deep recession, which would have been a depression without international government intervention?
The goal of capital is ever more capital. Conservative theorists will tell you at great length about the merits of individual responsibility but what do they have to say about economic responsibility or the responsibilities of capital? Rather less. Their economic theory, including "trickle-down"and Laffer curves, is no more than intellectual window-dressing.
Health care provision in the US is a classic case. The UK's health service has long consumed less GDP per head than the US health sector. That is, it is more efficient. But overall efficiency and human welfare have come second in the US to vested interests and maximizing private profit. We shouldn't be surprised - the economic system is set up that way.
For balanced, sustainable economic development find, and maintain, the balance between democratic goals and wealth creation. If there is an economic holy grail, maybe that's it.
- Report eian | August 24 2:17pm | Permalink
| OptionsI wonder if the US data on GDP per capita include the 10-12 million undocumented workers -- the vast majority active in the workforce -- who contributed to that GDP growth? If not, we should estimate and subtract their contribution to US GDP to make a fair comparison. Of course, other countries also have undocumented workers. But of the ones compared here, I would think that the scale of US reliance on such workers far exceeds the others.
- Report The Slog | August 24 2:39pm | Permalink
| OptionsThe Conservative Agenda made one entirely erroneous assumption: that the ethics of those in banks and business were up to less regulation.
We've all been paying for the mistake ever since.
For instance - the recent EU bank stress tests - Why has Barclays' exposure to Italian sovereign debt risen tenfold since the stress-tests? Stupidity - or economical reporting?
Ron said in reply to Michael Pettengill...
You can trace the change in dynamics back to the 1954 tax code change increasing the investment tax burden on dividends and leading to lower tax on capital gains. That imbalance fueled the equity consolidation leading to financialization. The first LBO was in 1955. Not much happened through the sixties, just increased horizontal M&A. With the seventies bank deregulation, much more M&A with more vertical due to relaxation of anti-trust, and lots more LBO, downsize and downwards wage pressure. In the eighties anti-trust was abandoned, more financial deregulation, more M&A (especially LBO), more downsize and R&D cut-backs to payoff leverage debt, withdrawal of tax exemption for commercial non-profit health insurance and health providers leading to for profit status and consolidation of New Deal era BC/BS and Catholic nuns's hospitals. In the nineties our first black Republican president allowed the gutting of remaining New Deal financial regulation and reinstitued bucket swaps, which were outlawed by TR in 1907, on his way out of office. It all started in 1954, despite the fact that it took two decades to show up in any significant manner. That is the way that economic changes evolve. It can take half a century for a crisis to arise from a ill-considered tax incentive policy that influences investment decisions. When you first kill the goose that lays the golden eggs, there is a wind fall of goose meat and some developing eggs. Now we got nothing left of it but feathers.
If one looks at history and the data, employment will continue to be a drag on the economy with millions suffering until taxes are hiked.
The 30s began with substantial tax hikes which enabled policies that created jobs at a rate, which conservatives claim was too low because of high taxes, equivalent to adding 40 million jobs while GW Bush was president.
Reagan cut taxes and we ended up with the worst job losses since the 20s, but then Reagan hiked taxes six times while engaging in massive Keynesian deficit spending stimulus on wasteful and useless military projects.
HW Bush and Clinton hiked taxes even more and were able to cut the Keynesian deficit spending over the 90s and create a budget surplus and record high employment, in spite of recovering from several asset bubbles popping, bubbles that formed as a result of bankers getting massive deregulation. Yes, the HW Bush years did suffer from job losses and slow job creation, but HW spent way more than Obama has on cleaning up the Reagan real estate bubble and massive bank failures and mortgage defaults, the worst since the 20s-30s.
But hey, Reagan said we no longer needed to sacrifice because American government hands out free lunches.
The chairman and CEO of Bertelsmann Foundation Dr. Gunter Thielen, speaking at the Bertelsmann/Financial Times conference on the worldwide financial crisis in Washington recently remarked , "If we continue with casino capitalism, then sooner or later the legitimacy of our entire economic system will come into question on a global level.
And, we all heard Senator Claire McCaskill at the hearings with Goldman Sachs senior executives exclaim, "You are all the house, you're the bookie. [Clients] are booking their bets with you. I don't know why we need to dress it up. It's a bet."
The casino comparison from diverse onlookers on the financial crisis is an apt and correct one. While the government regulators were asleep or looking the other way they were not regulating Wall Street. Simon Johnson feels that the "regulators are now completely captured by the big banks."
It is beyond me that there is not more outrage around the country. After watching the smug and arrogant Goldman executives, one felt like demanding that they be contrite and ashamed of what they had done to our financial system. Yet there they sat, looking bored, not being back in the Big Apple making their bets so they can rake in their bonuses. Can anyone seriously explain how you bet against investments that you are making to your clients? Is there not fraud or at least misrepresentation involved in these transactions?
And, let us not forget that Congress was also asleep at the wheel and did not foresee or try to prevent the financial crisis. While the traders from Goldman played their role as arrogant and aloof from the financial storm, the senators all performed their roles as outraged citizens who yelled before the cameras so the voters could see their populist anger. Where was their outrage while the economy was tanking and people who could not afford homes were given loans as if they were candy?
While Congress and the administrations' answer was to spend boatloads of our money on the stimulus package, the head of Pew Research Center Andrew Kohut, speaking at the Bertelsmann/FT conference said, "The public feels that the stimulus and TARP did not work".
While Americans continue to be bombarded by the reckless casino attitude and practices that exist on Wall Street and in our largest banks we see the rest of the world is not immune from similar economic and financial problems--most of them man -made.
Greece is trying to keep its head above water and not default on its large debt. Portugal and other European Union nations are also reeling from a large debt and too much public spending.
Having worked at the European Commission for fifteen years and given many talks on the euro in its early years I would point out that the introduction of the single currency was more of a political event than an economic one.
If this was purely an economic problem across Europe we would see a different outcome. However, the EU countries have too much invested in the success of the euro to see it collapse. They have too much political capital involved to let the single currency fail.
Europe and the U.S. are so intertwined with trade and investments that a collapse of the Greek economy (some are calling Greece the Lehman Brothers of Europe) would affect not only the rest of its EU partners, but America as well.
Are countries like banks too big to fail? Are traders at Goldman Sachs really allowed to go long and short on the same trade? Are government regulators who didn't regulate beyond being fired?
As Simon Johnson stated at his talk at Johns Hopkins, "There is no social value for having large banks. And, big banks should be able to fail."
As anyone who has taken Economics 101 knows the laws of capitalism provide winners and losers. If you provide enough campaign money and lobby effectively I guess that negates you from losing in today's America. This has to change. If traders take unacceptable risks and do it from our banks they need to suffer the consequences when their deals go south.
We should break up our largest banks, as being bigger does not provide any guarantee of anything these days except, it appears, immunity from any wrongdoing. We should control the outrageous behavior of casino gamblers posing as bankers and seriously curtail their activities in trading that cause more harm than good.
Big is not better and wrong is wrong. Get some serious financial reform with real teeth that can send people who break the law to jail. Move our casinos from the banks and insurance firms in New York back to Las Vegas where they belong. As Simon Johnson said, "Bets in Vegas don't upset the U.S. financial system".
We may not be able to change the smugness and arrogance of the Goldman traders who testified before Congress but we certainly can pass tougher legislation that could put them in prison if they break the law. Casino capitalism has to end before it is allowed to bring on another financial crisis.
Tyler Cowen agrees with our argument in 13 Bankers that there is a confluence of interests between the financial sector and the government that results in policies that are generally favorable to the banks. Cowen argues, however, that it is Washington, not Wall Street, that is calling the shots. The federal government needs a large and concentrated financial sector and liquid markets in order to finance its large and increasing debts, and for that reason has allowed the megabanks to flourish. In Cowen's words:It's our government deciding to assemble a cooperative ruling coalition -- which includes banks -- at the heart of its fiscal core. It's our government deciding who belongs to this coalition and who does not, mostly for reasons of political expediency and also a perception - correct or not -- of what is best for the welfare of American voters. If we don't in this year 'get tough' with banking regulation, it's because our government itself doesn't want to, not because of some stubborn recalcitrant Republicans.
One piece of evidence Cowen provides is the government's past willingness to bail out entities other than major banks, such as Mexico and (via the International Monetary Fund) emerging markets such as Indonesia. I find this not entirely convincing, since the indirect beneficiaries of those bailouts often included U.S. banks who had lent money indiscriminately to the latest developing-world "economic miracle." But it is certainly true that the federal government has motives other than simply looking out for Citibank.
More generally, I would argue that our interpretation and Cowen's are not necessarily contradictory. There is certainly a symbiosis between the banking sector and the federal government, although our book is predominantly about one side of that relationship. When push came to shove in late 2008, the banks' ultimate power was not that they were secretly controlling the levers of power, but that their place at the center of the financial system enabled them to hold the real economy hostage. It was politicians in Washington who made the decisions. In early 2009, President Obama tried to make it clear that he was taking orders from no bankers. But he, too, decided that the government needed the banks it had -- instead, for example, of taking over the weakest megabanks and making them wards of the state.
Cowen is no doubt right when he says that the government finds it convenient to manage its debts through a handful of broker-dealers. In fact, the government debt is handled by a continuum of entities, from the Treasury Department (part of the administration) to the Federal Reserve Board of Governors (an independent government agency) to the Federal Reserve Bank of New York (a private institution with a government mandate) to the Wall Street broker-dealers.
Still, though, I find it unsatisfying to say that the weakness of financial reform is that "our government itself doesn't want to [get tough]" -- unsatisfying because the government is the product, and the creature, of private interests. And if "the government" has a certain view of the world -- one in which large, sophisticated financial institutions play a central role -- in this case that view was largely promulgated by the financial sector and in service of its own interests.
The counterargument to my counterargument (I don't go to law school for nothing) is that governments, like banks, are made up of people, and those people have their own interests apart from those of either the voters who vote for them or the corporations who fund them. So "the government" can constitute a distinct interest group.
If this is the case, I still think the striking fact of the past few decades is that the "government employees" interest group and the "bankers" interest group came to see their interests as being largely identical, at least on issues affecting the financial sector. And the problem is that the interests of those two groups are not the same as the interests of the economy or society at large. The solution still lies in politics: convincing the government employees that they should represent the interests of society at large, not those of the banking sector. But insofar as the government independently needs the financial system we have, that only makes the job that much tougher.
A New Elite
There's a lot of talk about brain drain as a result of finance. Our smartest minds are dedicating their lives to finding ways to trade ahead of our pensions and 401(k)s 15 milliseconds in order to make a windfall, instead of leading the globe on any number of much more worthwhile endeavors. This is a major problem. Simon Johnson is a professor of entrepreneurship at the Sloan School of Management at MIT and must see this unfortunate trend firsthand. I would love to hear more from him on this matter.
But I'd like to go further and note that increasingly our elites, be it government, corporate, etc., will come from the financial sector. Notice Ezra Klein's interview with a Harvard student who works on Wall Street. For him, it's something to do for a few years before moving on to elite positions in other parts of the economy.
But what kind of future elites will the next decades feature when their primary experience of work and the economy will be fashioned through work in the financial market? Obviously, the superstar economy and "rip their face off" client relationship undermines any potential for solidarity. But it also undermines entrepreneurship, even though it is surrounded by business. When a business is something to manage from the aerial view of a spreadsheet, when it is something to breakup or build up solely for the purpose of manipulating a stock price in the short term, it isn't part of the organic process of finding a way of advancing the economy through meeting the needs of consumers and a work force.
A disadvantage to this crisis, as opposed to the 1970s Keynesian crash, was that it occurred so fast that it became another policy issue instead of a call to rethink the way our real economy is put together. With the clock already running on next major financial collapse, I hope there will be time to take a step back and realize that the problems here aren't some rich people ripping off other rich people, but that this new financial power is shaping the world and the experiences of millions of people who aren't directly on Wall Street.
Simon Johnson, James Kwak On 'Bill Moyers Journal' (VIDEO)- 13 Bankers Authors Explain Financial Crisis, Reform Effort
Simon Johnson- 'Most Observers' Do Not Agree With Larry Summers On Banking
Review of the Month more on Economics
This article was prepared for a panel organized by the Union for Radical Political Economics at the Left Forum in New York, March 11, 2007.
Changes in capitalism over the last three decades have been commonly characterized using a trio of terms: neoliberalism, globalization, and financialization. Although a lot has been written on the first two of these, much less attention has been given to the third.1 Yet, financialization is now increasingly seen as the dominant force in this triad. The financialization of capitalism—the shift in gravity of economic activity from production (and even from much of the growing service sector) to finance—is thus one of the key issues of our time. More than any other phenomenon it raises the question: has capitalism entered a new stage?
I will argue that although the system has changed as a result of financialization, this falls short of a whole new stage of capitalism, since the basic problem of accumulation within production remains the same. Instead, financialization has resulted in a new hybrid phase of the monopoly stage of capitalism that might be termed “monopoly-finance capital.”2 Rather than advancing in a fundamental way, capital is trapped in a seemingly endless cycle of stagnation and financial explosion. These new economic relations of monopoly-finance capital have their epicenter in the United States, still the dominant capitalist economy, but have increasingly penetrated the global system.
The origins of the term “financialization” are obscure, although it began to appear with increasing frequency in the early 1990s.3 The fundamental issue of a gravitational shift toward finance in capitalism as a whole, however, has been around since the late 1960s. The earliest figures on the left (or perhaps anywhere) to explore this question systematically were Harry Magdoff and Paul Sweezy, writing for Monthly Review.4
As Robert Pollin, a major analyst of financialization who teaches economics at the University of Massachusetts at Amherst, has noted: “beginning in the late 1960s and continuing through the 1970s and 1980s” Magdoff and Sweezy documented “the emerging form of capitalism that has now become ascendant—the increasing role of finance in the operations of capitalism. This has been termed ‘financialization,’ and I think it’s fair to say that Paul and Harry were the first people on the left to notice this and call attention [to it]. They did so with their typical cogency, command of the basics, and capacity to see the broader implications for a Marxist understanding of reality.” As Pollin remarked on a later occasion: “Harry [Magdoff] and Paul Sweezy were true pioneers in recognizing this trend….[A] major aspect of their work was the fact that these essays [in Monthly Review over three decades] tracked in simple but compelling empirical detail the emergence of financialization as a phenomenon….It is not clear when people on the left would have noticed and made sense of these trends without Harry, along with Paul, having done so first.”5
From Stagnation to Financialization
In analyzing the financialization of capitalism, Magdoff and Sweezy were not mere chroniclers of a statistical trend. They viewed this through the lens of a historical analysis of capitalist development. Perhaps the most succinct expression of this was given by Sweezy in 1997, in an article entitled “More (or Less) on Globalization.” There he referred to what he called “the three most important underlying trends in the recent history of capitalism, the period beginning with the recession of 1974–75: (1) the slowing down of the overall rate of growth, (2) the worldwide proliferation of monopolistic (or oligipolistic) multinational corporations, and (3) what may be called the financialization of the capital accumulation process.”
For Sweezy these three trends were “intricately interrelated.” Monopolization tends to swell profits for the major corporations while also reducing “the demand for additional investment in increasingly controlled markets.” The logic is one of “more and more profits, fewer and fewer profitable investment opportunities, a recipe for slowing down capital accumulation and therefore economic growth which is powered by capital accumulation.”
The resulting “double process of faltering real investment and burgeoning financialization” as capital sought to find a way to utilize its economic surplus, first appeared with the waning of the “‘golden age’ of the post-Second World War decades and has persisted,” Sweezy observed, “with increasing intensity to the present.”6
This argument was rooted in the theoretical framework provided by Paul Baran and Paul Sweezy’s Monopoly Capital (1966), which was inspired by the work of economists Michal Kalecki and Josef Steindl—and going further back by Karl Marx and Rosa Luxemburg.7 The monopoly capitalist economy, Baran and Sweezy suggested, is a vastly productive system that generates huge surpluses for the tiny minority of monopolists/oligopolists who are the primary owners and chief beneficiaries of the system. As capitalists they naturally seek to invest this surplus in a drive to ever greater accumulation. But the same conditions that give rise to these surpluses also introduce barriers that limit their profitable investment. Corporations can just barely sell the current level of goods to consumers at prices calibrated to yield the going rate of oligopolistic profit. The weakness in the growth of consumption results in cutbacks in the utilization of productive capacity as corporations attempt to avoid overproduction and price reductions that threaten their profit margins. The consequent build-up of excess productive capacity is a warning sign for business, indicating that there is little room for investment in new capacity.
For the owners of capital the dilemma is what to do with the immense surpluses at their disposal in the face of a dearth of investment opportunities. Their main solution from the 1970s on was to expand their demand for financial products as a means of maintaining and expanding their money capital. On the supply side of this process, financial institutions stepped forward with a vast array of new financial instruments: futures, options, derivatives, hedge funds, etc. The result was skyrocketing financial speculation that has persisted now for decades.
Among orthodox economists there were a few who were concerned early on by this disproportionate growth of finance. In 1984 James Tobin, a former member of Kennedy’s Council of Economic Advisers and winner of the Nobel Prize in economics in 1981, delivered a talk “On the Efficiency of the Financial System” in which he concluded by referring to “the casino aspect of our financial markets.” As Tobin told his audience:
I confess to an uneasy Physiocratic suspicion…that we are throwing more and more of our resources…into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. I suspect that the immense power of the computer is being harnessed to this ‘paper economy,’ not to do the same transactions more economically but to balloon the quantity and variety of financial exchanges. For this reason perhaps, high technology has so far yielded disappointing results in economy-wide productivity. I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitating nth-degree speculation which is short-sighted and inefficient….I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.8
Tobin’s point was that capitalism was becoming inefficient by devoting its surplus capital increasingly to speculative, casino-like pursuits, rather than long-term investment in the real economy.9 In the 1970s he had proposed what subsequently came to be known as the “Tobin tax” on international foreign exchange transactions. This was designed to strengthen investment by shifting the weight of the global economy back from speculative finance to production.
In sharp contrast to those like Tobin who suggested that the rapid growth of finance was having detrimental effects on the real economy, Magdoff and Sweezy, in a 1985 article entitled “The Financial Explosion,” claimed that financialization was functional for capitalism in the context of a tendency to stagnation:
Does the casino society in fact channel far too much talent and energy into financial shell games. Yes, of course. No sensible person could deny it. Does it do so at the expense of producing real goods and services? Absolutely not. There is no reason whatever to assume that if you could deflate the financial structure, the talent and energy now employed there would move into productive pursuits. They would simply become unemployed and add to the country’s already huge reservoir of idle human and material resources. Is the casino society a significant drag on economic growth? Again, absolutely not. What growth the economy has experienced in recent years, apart from that attributable to an unprecedented peacetime military build-up, has been almost entirely due to the financial explosion.10
In this view capitalism was undergoing a transformation, represented by the complex, developing relation that had formed between stagnation and financialization. Nearly a decade later in “The Triumph of Financial Capital” Sweezy declared:
I said that this financial superstructure has been the creation of the last two decades. This means that its emergence was roughly contemporaneous with the return of stagnation in the 1970s. But doesn’t this fly in the face of all previous experience? Traditionally financial expansion has gone hand-in-hand with prosperity in the real economy. Is it really possible that this is no longer true, that now in the late twentieth century the opposite is more nearly the case: in other words, that now financial expansion feeds not on a healthy real economy but on a stagnant one?
The answer to this question, I think, is yes it is possible, and it has been happening. And I will add that I am quite convinced that the inverted relation between the financial and the real is the key to understanding the new trends in the world [economy].
In retrospect, it is clear that this “inverted relation” was a built-in possibility for capitalism from the start. But it was one that could materialize only in a definite stage of the development of the system. The abstract possibility lay in the fact, emphasized by both Marx and Keynes, that the capital accumulation process was twofold: involving the ownership of real assets and also the holding of paper claims to those real assets. Under these circumstances the possibility of a contradiction between real accumulation and financial speculation was intrinsic to the system from the start.
Although orthodox economists have long assumed that productive investment and financial investment are tied together—working on the simplistic assumption that the saver purchases a financial claim to real assets from the entrepreneur who then uses the money thus acquired to expand production—this has long been known to be false. There is no necessary direct connection between productive investment and the amassing of financial assets. It is thus possible for the two to be “decoupled” to a considerable degree.11 However, without a mature financial system this contradiction went no further than the speculative bubbles that dot the history of capitalism, normally signaling the end of a boom. Despite presenting serious disruptions, such events had little or no effect on the structure and function of the system as a whole.
It took the rise of monopoly capitalism in the late nineteenth and early twentieth centuries and the development of a market for industrial securities before finance could take center-stage, and before the contradiction between production and finance could mature. In the opening decades of the new regime of monopoly capital, investment banking, which had developed in relation to the railroads, emerged as a financial power center, facilitating massive corporate mergers and the growth of an economy dominated by giant, monopolistic corporations. This was the age of J. P. Morgan. Thorstein Veblen in the United States and Rudolf Hilferding in Austria both independently developed theories of monopoly capital in this period, emphasizing the role of finance capital in particular.
Nevertheless, when the decade of the Great Depression hit, the financial superstructure of the monopoly capitalist economy collapsed, marked by the 1929 stock market crash. Finance capital was greatly diminished in the Depression and played no essential role in the recovery of the real economy. What brought the U.S. economy out of the Depression was the huge state-directed expansion of military spending during the Second World War.12
When Paul Baran and Paul Sweezy wrote Monopoly Capital in the early 1960s they emphasized the way in which the state (civilian and military spending), the sales effort, a second great wave of automobilization, and other factors had buoyed the capitalist economy in the golden age of the 1960s, absorbing surplus and lifting the system out of stagnation. They also pointed to the vast amount of surplus that went into FIRE (finance, investment, and real estate), but placed relatively little emphasis on this at the time.
However, with the reemergence of economic stagnation in the 1970s Sweezy, now writing with Magdoff, focused increasingly on the growth of finance. In 1975 in “Banks: Skating on Thin Ice,” they argued that “the overextension of debt and the overreach of the banks was exactly what was needed to protect the capitalist system and its profits; to overcome, at least temporarily, its contradictions; and to support the imperialist expansion and wars of the United States.”13
If in the 1970s “the old structure of the economy, consisting of a production system served by a modest financial adjunct” still remained—Sweezy observed in 1995—by the end of the 1980s this “had given way to a new structure in which a greatly expanded financial sector had achieved a high degree of independence and sat on top of the underlying production system.”14 Stagnation and enormous financial speculation emerged as symbiotic aspects of the same deep-seated, irreversible economic impasse.
This symbiosis had three crucial aspects: (1) The stagnation of the underlying economy meant that capitalists were increasingly dependent on the growth of finance to preserve and enlarge their money capital. (2) The financial superstructure of the capitalist economy could not expand entirely independently of its base in the underlying productive economy—hence the bursting of speculative bubbles was a recurrent and growing problem.15 (3) Financialization, no matter how far it extended, could never overcome stagnation within production.
The role of the capitalist state was transformed to meet the new imperatives of financialization. The state’s role as lender of last resort, responsible for providing liquidity at short notice, was fully incorporated into the system. Following the 1987 stock market crash the Federal Reserve adopted an explicit “too big to fail” policy toward the entire equity market, which did not, however, prevent a precipitous decline in the stock market in 2000.16
These conditions marked the rise of what I am calling “monopoly-finance capital” in which financialization has become a permanent structural necessity of the stagnation-prone economy.
Class and Imperial Implications
If the roots of financialization are clear from the foregoing, it is also necessary to address the concrete class and imperial implications. Given space limitations I will confine myself to eight brief observations.
(1) Financialization can be regarded as an ongoing process transcending particular financial bubbles. If we look at recent financial meltdowns beginning with the stock market crash of 1987, what is remarkable is how little effect they had in arresting or even slowing down the financialization trend. Half the losses in stock market valuation from the Wall Street blowout between March 2000 and October 2002 (measured in terms of the Standard and Poor’s 500) had been regained only two years later. While in 1985 U.S. debt was about twice GDP, two decades later U.S. debt had risen to nearly three-and-a-half times the nation’s GDP, approaching the $44 trillion GDP of the entire world. The average daily volume of foreign exchange transactions rose from $570 billion in 1989 to $2.7 trillion dollars in 2006. Since 2001 the global credit derivatives market (the global market in credit risk transfer instruments) has grown at a rate of over 100 percent per year. Of relatively little significance at the beginning of the new millennium, the notional value of credit derivatives traded globally ballooned to $26 trillion by the first half of 2006.17
(2) Monopoly-finance capital is a qualitatively different phenomenon from what Hilferding and others described as the early twentieth-century age of “finance capital,” rooted especially in the dominance of investment-banking. Although studies have shown that the profits of financial corporations have grown relative to nonfinancial corporations in the United States in recent decades, there is no easy divide between the two since nonfinancial corporations are also heavily involved in capital and money markets.18 The great agglomerations of wealth seem to be increasingly related to finance rather than production, and finance more and more sets the pace and the rules for the management of the cash flow of nonfinancial firms. Yet, the coalescence of nonfinancial and financial corporations makes it difficult to see this as constituting a division within capital itself.
(3) Ownership of very substantial financial assets is clearly the main determinant of membership in the capitalist class. The gap between the top and the bottom of society in financial wealth and income has now reached astronomical proportions. In the United States in 2001 the top 1 percent of holders of financial wealth (which excludes equity in owner-occupied houses) owned more than four times as much as the bottom 80 percent of the population. The nation’s richest 1 percent of the population holds $1.9 trillion in stocks about equal to that of the other 99 percent.19 The income gap in the United States has widened so much in recent decades that Federal Reserve Board Chairman Ben S. Bernanke delivered a speech on February 6, 2007, on “The Level and Distribution of Economic Well Being,” highlighting “a long-term trend toward greater inequality seen in real wages.” As Bernanke stated, “the share of after-tax income garnered by the households in the top 1 percent of the income distribution increased from 8 percent in 1979 to 14 percent in 2004.” In September 2006 the richest 60 Americans owned an estimated $630 billion worth of wealth, up almost 10 percent from the year before (New York Times, March 1, 2007).
Recent history suggests that rapid increases in inequality have become built-in necessities of the monopoly-finance capital phase of the system. The financial superstructure’s demand for new cash infusions to keep speculative bubbles expanding lest they burst is seemingly endless. This requires heightened exploitation and a more unequal distribution of income and wealth, intensifying the overall stagnation problem.
(4) A central aspect of the stagnation-financialization dynamic has been speculation in housing. This has allowed homeowners to maintain their lifestyles to a considerable extent despite stagnant real wages by borrowing against growing home equity. As Pollin observed, Magdoff and Sweezy “recognized before almost anybody the increase in the reliance on debt by U.S. households [drawing on the expanding equity of their homes] as a means of maintaining their living standard as their wages started to stagnate or fall.”20 But low interest rates since the last recession have encouraged true speculation in housing fueling a housing bubble. Today the pricking of the housing bubble has become a major source of instability in the U.S. economy. Consumer debt service ratios have been rising, while the soaring house values on which consumers have depended to service their debts have disappeared at present. The prices of single-family homes fell in more than half of the country’s 149 largest metropolitan areas in the last quarter of 2006 (New York Times, February 16, 2007).
So crucial has the housing bubble been as a counter to stagnation and a basis for financialization, and so closely related is it to the basic well-being of U.S. households, that the current weakness in the housing market could precipitate both a sharp economic downturn and widespread financial disarray. Further rises in interest rates have the potential to generate a vicious circle of stagnant or even falling home values and burgeoning consumer debt service ratios leading to a flood of defaults. The fact that U.S. consumption is the core source of demand for the world economy raises the possibility that this could contribute to a more globalized crisis.
(5) A thesis currently popular on the left is that financial globalization has so transformed the world economy that states are no longer important. Rather, as Ignacio Ramonet put it in “Disarming the Market” (Le Monde Diplomatique, December 1997):
Financial globalization is a law unto itself and it has established a separate supranational state with its own administrative apparatus, its own spheres of influence, its own means of action. That is to say, the International Monetary Fund (IMF), the World Bank, the Organization of Economic Cooperation and Development (OECD) and the World Trade Organization (WTO)….This artificial world state is a power with no base in society. It is answerable instead to the financial markets and the mammoth business undertakings that are its masters. The result is that the real states in the real world are becoming societies with no power base. And it is getting worse all the time.
Such views, however, have little real basis. While the financialization of the world economy is undeniable, to see this as the creation of a new international of capital is to make a huge leap in logic. Global monopoly-finance capitalism remains an unstable and divided system. The IMF, the World Bank, and the WTO (the heir to GATT) do not (even if the OECD were also added in) constitute “a separate supranational state,” but are international organizations that came into being in the Bretton Woods System imposed principally by the United States to manage the global system in the interests of international capital following the Second World War. They remain under the control of the leading imperial states and their economic interests. The rules of these institutions are applied asymmetrically—least of all where such rules interfere with U.S. capital, most of all where they further the exploitation of the poorest peoples in the world.
(6) What we have come to call “neoliberalism” can be seen as the ideological counterpart of monopoly-finance capital, as Keynsianism was of the earlier phase of classical monopoly capital. Today’s international capital markets place serious limits on state authorities to regulate their economies in such areas as interest-rate levels and capital flows. Hence, the growth of neoliberalism as the hegemonic economic ideology beginning in the Thatcher and Reagan periods reflected to some extent the new imperatives of capital brought on by financial globalization.
(7) The growing financialization of the world economy has resulted in greater imperial penetration into underdeveloped economies and increased financial dependence, marked by policies of neoliberal globalization. One concrete example is Brazil where the first priority of the economy during the last couple of decades under the domination of global monopoly-finance capital has been to attract foreign (primarily portfolio) investment and to pay off external debts to international capital, including the IMF. The result has been better “economic fundamentals” by financial criteria, but accompanied by high interest rates, deindustrialization, slow growth of the economy, and increased vulnerability to the often rapid movements of global finance.21
(8) The financialization of capitalism has resulted in a more uncontrollable system. Today the fears of those charged with the responsibility for establishing some modicum of stability in global financial relations are palpable. In the early 2000s in response to the 1997–98 Asian financial crisis, the bursting of the “New Economy” bubble in 2000, and Argentina’s default on its foreign debts in 2001, the IMF began publishing a quarterly Global Financial Stability Report. One scarcely has to read far in its various issues to get a clear sense of the growing volatility and instability of the system. It is characteristic of speculative bubbles that once they stop expanding they burst. Continual increase of risk and more and more cash infusions into the financial system therefore become stronger imperatives the more fragile the financial structure becomes. Each issue of the Global Financial Stability Report is filled with references to the specter of “risk aversion,” which is seen as threatening financial markets.
In the September 2006 Global Financial Stability Report the IMF executive board directors expressed worries that the rapid growth of hedge funds and credit derivatives could have a systemic impact on financial stability, and that a slowdown of the U.S. economy and a cooling of its housing market could lead to greater “financial turbulence,” which could be “amplified in the event of unexpected shocks.”22 The whole context is that of a financialization so out of control that unexpected and severe shocks to the system and resulting financial contagions are looked upon as inevitable. As historian Gabriel Kolko has written, “People who know the most about the world financial system are increasingly worried, and for very good reasons. Dire warnings are coming from the most ‘respectable’ sources. Reality has gotten out of hand. The demons of greed are loose.”23
Bernard D'Mello, 'Financialisation' and the Tendency to Stagnation
|'Financialisation' and the Tendency to Stagnation
by Bernard D'Mello
Beginning with the failure of two Bear Stearns hedge funds and the consequent freezing of the high-risk collateralised debt obligations market in June 2007, the financial crisis deepened in 2008, and at the time of writing in April 2009, the wheels of finance are yet to start turning again even though governments and central banks around the world have taken many measures -- "dropping money from helicopters", metaphorically speaking, into the financial markets, going much further than merely acting as "lenders of last resort", exercising their "too big to fail" policy, and so on. By all accounts, the financial catastrophe is the worst since the Great Depression, bringing in its wake a severe economic crisis, and it is time to seriously examine its causes and consequences, a challenge the book under review takes up quite admirably.
The feeding of the speculative bubble in the home mortgage market by massive credit expansion, the selling of large amounts of subprime mortgages, the peculiar securitisation of the mortgage loans and the speculative trading of such securities in the global financial markets, the credit rating agencies' fraudulent ratings, the off-balance sheet device of the structured investment vehicle, and role of credit default swap arrangements have, taken together, commanded a fair share of attention among financial analysts. To make sense of this whole host of factors, the authors, John Bellamy Foster and Fred Magdoff place their description of the unfolding of the crisis quite neatly into the basic pattern of speculative bubbles outlined by Charles Kindleberger in Manias, Panics, and Crashes: A History of Financial Crises -- a novel offering ("displacement"), credit expansion, speculative mania, distress, and crash/panic -- and, with the same clarity and wit so characteristic of the "literary economist".
Going by this, it might be tempting to view the crisis as a direct consequence of the deregulation of the financial system since the 1970s, especially the cumulative dismantling of Glass-Steagall that was finally buried when the then US President, Bill Clinton signed the Financial Services Modernisation Act in 1999. But this is not a liberal-left account. The authors come from an intellectual tradition (the Monthly Review school) that has its origins in Paul Sweezy's synthesis of Marx's political economy with J M Keynes' insights on investment, effective demand,1 and the structure and behaviour of modern finance, as well as the theory of oligopoly. They locate the roots of the financial bust in the "real" economy and in the underlying accumulation (savings-and-investment) process, both its financial and "real" aspects.
Finance to the Fore
Since the late 1970s, a gravitational shift of economic activity from the production of goods and non-financial services to finance has been underway. One indicator of this process has been the rapid growth since then of the share of financial profits in total corporate profits. Also reflective of this process of "financialisation" is the explosive growth of private debt -- household, non-financial, and financial business -- as a proportion of gross domestic product, and the piling of layers upon layers of claims with the existence of instruments like options, futures, swaps, and the like, and financial entities like hedge funds and structured investment vehicles. With financialisation, the employment of money capital in the financial markets and in speculation, more generally, to make more money, bypassing the route of commodity production, increasingly became the name of the game. In Marx's terms, financialisation entailed a shift from the general formula for capital accumulation, M-C-M', in which commodities are central to the generation of profits, to one "increasingly geared to the circuit of money capital alone, M-M', in which money simply begets more money with no relation to production" (p 133).
The flood of private debt to finance such activity has been sustained by successive booms in asset prices; indeed, such booms have, in turn, been fed by the explosion of debt.2 As long as the asset price bubble grows, consumers and businesses get access to more credit to buy more home or financial assets because their creditworthiness is determined by the market values of the assets they hold, which act as collateral. The rise of asset values and the intensification of the speculative mania contribute to the growth of borrowing, which, in turn, flames the fires of speculation and the further rise of asset values. On the supply side of the financial markets, in the competitive race to grab the hindmost of the profits in store, a whole array of players get into the act of frenzied "financial innovation", leading to the multiplication of financial assets of all kinds, for instance, the securitisation of mortgage loans through the collateralised debt obligation, or the credit default swap to speculate on the quality of credit instruments. It is only when the asset price bubble pops and the underlying collateral thus vanishes in thin air that all hell breaks loose across financial institutions and markets, and across countries in this world of globalised finance.
Weak Propensity to Invest
But what brought on the financialisation of the economy in the first place? The US economy entered a period characterised by slow economic growth, high unemployment/underemployment and excess capacity beginning with the sharp recession of 1974-75 after around 25 years of rapid ascent following the second world war. The inducement needed to generate investment high enough to sustain the vigorous growth of the so-called Golden Age was no longer to be found. But capitalism as a profit-directed system has an imperative to accumulate capital -- it cannot stand still; it either expands or it slumps. An important "solution" to the problem of long-term "stagnation" was found in financialisation, which proved functional for capitalism, in that, what growth the economy produced over the period of the 1980s to the present has, to a significant extent, been due to the financial explosion. Speculative finance became "the secondary engine for growth given the weakness in the primary engine, productive investment" (p 18). The system was now "more and more dependent on a series of financial bubbles to keep it going, each one bigger than the last" (p 18).
As the authors themselves give credit to, their analysis leans heavily on Paul Sweezy and Harry Magdoff's documentation and analysis of developments in the US and world economy in the pages of the Monthly Review over a period stretching from the late 1960s to the late 1980s (as also, short perspective articles by Sweezy up to the mid-1990s), a number of these pieces tracing the process of what later came to be called financialisation. The analytical framework of the book draws on Paul Baran and Paul Sweezy's 1966 classic, Monopoly Capital: An Essay on the American Economic and Social Order (New York: Monthly Review Press, 1966). Rather than a tendency for the rate of profit to fall,3 Baran and Sweezy hypothesised a tendency for the relative share of the economic surplus4 to rise. The main problem is one of finding ways to absorb this gigantic actual and potential economic surplus. "Underconsumption" -- the shift in the distribution of income from labour to capital exacerbating the problem of effective demand -- as an ex ante tendency draws the economy towards stagnation, for the process of accumulation of capital is predicated upon an increase in the rate of surplus value while at the same time having to rely on mass consumption to spur investment and economic growth. High levels of inequality hold down the relative purchasing power of the working class, weakening consumption and adding to overcapacity, thus lowering expected profits on new investment, and thereby dampening the willingness to invest.
The problem of capitalism is that individual units of capital strive to expand their wealth to the maximum possible extent without considering the ultimate overall effect this would have on effective demand in the context of the economy's expanding capacity. Truly, "The real barrier of capitalist production is capital itself", as Marx once put it.5 Under monopoly capitalism, this barrier is raised even higher. First, in the class struggle -- the relationship between the two main classes, involving exploitation by capital and the workers' resistance to it -- capital has the upper hand, thus raising the rate of surplus value to attain a higher rate of profit, and thereby making possible a higher rate of accumulation. Second, with oligopolistic pricing, the uniform rate of profit of competitive capitalism gives way to a "hierarchy of profit rates" -- highest in "tightly" oligopolistic product markets and lowest in the most competitive ones. This leads to a skewed distribution of the surplus value generated, one that favours the larger, more monopolistic firms; they, in turn, could "re-invest" a larger proportion of their profits, making possible a higher rate of accumulation. But on the demand side, the large oligopolistic units of capital tend to regulate and slow down "the expansion of productive capital in order to maintain their higher rates of profit".
Underconsumption as an ex ante tendency and the problem of effective demand thus asserts itself even more under monopoly capitalism than under its competitive counterpart. But there are counteracting tendencies. Civilian government spending picks up some of the slack in effective demand; however, there are forces opposing such spending, especially where the projects or activities undertaken either compete with private enterprise or undermine class privileges. But there are other offsetting tendencies, such as militarism and imperialism, expansion of the sales effort, and financialisation,6 which have been the main external stimulants boosting effective demand and thus aggregate output. As already mentioned, financialisation has been functional for capitalism in the context of a tendency to stagnation; indeed, more recently, it has been the main "response of capital to the stagnation tendency in the real economy". But the present crisis of financialisation, symptomatic in the financial crash, "inevitably means the resurfacing of the underlying stagnation endemic to the advanced capitalist economy" and there now seems to be "no other visible way out for monopoly-finance capital" (p 133).
'The Truth Is in the Whole'
It must be mentioned that the book focuses almost exclusively on the financial crisis in the context of the US economy. No doubt this is the epicentre of the catastrophe. Nevertheless, in these times of financialisation of the capital accumulation process globally (albeit an Americanisation of global finance), if one were to go by Hegel's dictum that "The Truth is in the Whole", then to understand what is going on in the US, one has to also take account of what is happening in the whole world, just as developments in the US make a difference elsewhere. In particular, the structure and distribution of world effective demand along with the huge imbalances reflected in the massive deficits and corresponding surpluses in the current accounts of the balance of payments of the major economies, and the structure of capital flows7 thereby engendered, need to be brought into the picture. The neo-mercantilist direction of the Chinese, German (also, some other European economies), and Japanese economies come to mind, which needs to be taken together with the fact that despite the phenomenal rise in inequality in the US, the country's savings rate has secularly declined, in part due to the wealth effect brought on by financialisation. These developments have, in turn, led to increasing US current account deficits, matched by huge capital inflows, and reflected in the accumulation of massive non-resident holdings of dollar-denominated financial assets. To what extent has all of this buttressed the speculative mania and the crash?
Again, confronted with Hegel's dictum, and reminded of Rosa Luxemburg's thesis of capitalism's imperative to move into the non-capitalist regions of the world, we might also ask whether as time has gone by in this post-cold war era of a fully globalised capitalism, the system is now more prone to deep crises, given that it can now grow only by internal expansion.
The main chapters, apart from the introduction, were "originally written as parts of a running commentary [in the Monthly Review] during the years 2006-08 as the present crisis took shape" (p 21). In fact, the four chapters following the introduction -- "The Household Debt Bubble" (May 2006), "The Explosion of Debt and Speculation" (November 2006), "Monopoly-Finance Capital" (December 2006), and "The Financialization of Capitalism" (April 2007) -- were all written before the crisis began. But this does not diminish their value. The chapter on "The Household Debt Bubble" presents interesting data, for instance, debt service payments as a percentage of disposable income by income percentiles, which together suggest that "financial distress is ever more solidly based in lower-income, working-class families" (p 31). The chapter on "The Explosion of Debt and Speculation", after presenting data on the sky-rocketing of debt -- household, non-financial sector, financial business, and government -- suggests a decline in the stimulatory effect of the expansion of debt on the economy as a result of its changing composition. In particular, "financial sector debt now larger than any other single component and growing faster than all the rest (a shift from M-C-M' to M-M'), may explain much of the decreased stimulation of the economy by debt expansion" (p 49).
Importantly, in the chapter on "Monopoly-¬Finance Capital", the authors argue that the new way monopoly capitalism has found of reproducing itself, namely, through the explosive growth of finance, suggests that it has moved into a "new hybrid phase", which they designate "monopoly-finance capital"8 (p 64). Drawing on Sweezy, the chapter outlines how the "financial explosion has reacted back in important ways on the structure and functioning of the corporation-dominated "real" economy"9 (p 66). And, in the chapter on "The Financialization of Capitalism", Foster and Magdoff profile its class and imperial implications (pp 84-88).
But, in order to absorb these and other insights in each of the six chapters, the reader will have to put up with a lot of repetition. And, there seems to be an analytical flaw. In chapter 6, in a section "From Financial Explosion to Financial Implosion" dealing with the instability and fragility of a system, while examining the massive increase in private debt, the authors state that "the problem is further compounded if government debt (local, state, and federal) is added in" (p 122). This is analytically untenable. Unlike private debt instruments, US Treasury securities have a zero default risk -- they can be held indefinitely (for they are continuously "rolled over") at no financial risk to the government or to the private sector holder, for the government can never become bankrupt if it borrows in the same currency it has the power to declare as legal tender (fiat money). In fact, in the midst of the present crisis, Treasury securities are preferred holdings, for they can be readily sold for money or pledged as collateral for availing of loans.10 But of course, Treasury securities face purchasing power risk -- inflation can erode their purchasing power or deflation can result in an increasing real value of the debt for the government.
There is apprehension though about the value of the dollar, the currency in which these securities are denominated -- a depreciation of the dollar relative to the asset holder's own currency -- but this foreign exchange risk is faced by such holders for all forms of dollar denominated assets that they may hold. A significant fall, though, in value of the dollar would adversely affect the very growth strategies of the US's neo-mercantilist rivals (China, Germany and some other European countries, and Japan), as also those of US financial interests (which exercise significant power and influence in shaping the US exchange rate policy), predicated as these grand designs are upon the maintenance of a "strong" dollar. Given this, and the fact that the portfolios of the foreign assets of the neo-mercantilist powers are largely dollar-denominated, presently, all the countries at the apex of the global pyramid of power and wealth want a "strong" dollar, and will thus do all they can to ensure this. So it is highly unlikely the neo-mercantilist powers will shift their foreign portfolios of wealth away from the dollar leading to a collapse in its value. However, with the plunge in the net worth of firms geared to the circuits of money capital alone, and the consequent decline in their relative power and influence, in the event of the dollar losing say 30-40% of its value, given its "overvaluation" in the light of persistently high US current account deficits, all hell is bound to break loose with a further deepening of the financial and economic crisis globally. The historical parallel over here is the loss of international confidence in the pound sterling in 1931 in the midst of the Depression and the many bankruptcies and financial failures that resulted therefrom. Is the international role of the dollar then at stake?11
Crying Out for Answers
Clearly, we are all crying out for answers and there is a lot to gain from working one's way through this book. However, with all its strengths, there is something, I feel, missing in this volume -- the authors refrain from taking on other Marxist writers on the subject. Marxists usually differ a great deal in many matters of interpretation and evaluation, and there is a lot to learn from their debates. There are, for instance, those who endorse Marx's falling rate of profit theory, with whom the Monthly Review school differs. The former focus on systemic tendencies that, they contend, have lowered the rate of profit, and seek to link these with the role of monetary and financial phenomena disrupting the accumulation process. The disinclination to debate with other schools of Marxist thought on the financial crisis is our loss. Picture the young Paul Sweezy, penning his The Theory of Capitalist Development in the 1930s, boldly taking on a whole bunch of Marxist thinkers on crisis theory, from Henryk Grossman to Mikhail Tugan-Baranovsky, and Marx too, and the positive "externalities" flowing from this initiative. Be that as it may, there is a whole new generation today wanting to know what caused the present financial catastrophe and what might be its likely ramifications. After all, not long ago, the cold war ended with the restoration and triumph of capitalism on a global scale, and then, less than two decades later, capitalism is bankrupt. This book, with its cogency that is the hallmark of the Monthly Review, needs to be widely read.
1 Keynes considered effective demand -- demand, at a profitable price, for the volume of goods and services that could be produced with existing capacity -- to be capitalism's most fundamental macroeconomic problem.
2 We follow what appears as the typical pattern of speculative bubbles from the 1980s onwards, as outlined by Paul Sweezy and Harry Magdoff, "The Stock Market Crash and Its Aftermath", in their book, The Irreversible Crisis (New York: Monthly Review Press), 1988, pp 43-55.
3 In Marxian terms, a rise in the "organic composition of capital" (the ratio of the value of used-up means of production and the value produced by "necessary labour") increases labour productivity, which raises the rate of surplus value -- the ratio of the value produced by "surplus labour" ("surplus value") and the value produced by "necessary labour". So an increasing organic composition of capital proceeds pari passu with a rising rate of surplus value, making the direction in which the rate of profit (the surplus value divided by the sum of the value of the used-up means of production and the value produced by "necessary labour") moves indeterminate. See Paul Sweezy's 1942 classic, The Theory of Capitalist Development (New York: Monthly Review Press, 1970), p 102.
4 The economic surplus is difference between total output and the "socially necessary" costs of producing it.
6 Here, effective demand is stimulated via the "wealth effect" -- a tendency for consumption to grow, even in the absence of the growth of incomes, due to rising asset prices.
7 The increase in net liability of a country to the rest of the world, represented by the current account deficit, if persistent and high, as in the case of the US, leads to a huge cumulative build-up of net claims by non-residents on the domestic economy. In contrast, in the case of a country with a current account surplus, there is a net outflow of funds, and, if that surplus is persistent and high, as in the case of countries following neo-mercantilist growth strategies, it will result in a huge cumulative build-up of net claims by residents on the rest of the world's economies. But, of course, there are also autonomous capital flows -- strategic rivalry between nations is not merely manifested in trade; it also takes the form of controlling resources beyond national boundaries through foreign direct investment and militarism. And, given the role of the dollar as international money, the US has an advantage over its neo-mercantilist rivals, China, Germany and Japan, in this respect -- it can finance much of its foreign investment and militarism by creating monetary liabilities abroad.
8 According to Paul Sweezy, from the latter half of the 1970s a "relatively independent -- relative, that is, to what went before -- financial superstructure sitting on top of the world economy and most of its national units" began to take shape, emerging around the mid-1990s. See his perspective piece, "The Triumph of Financial Capital" (Monthly Review, Vol 46, No 2, June 1994, pp 1-11).
9 There is also the need to take account of the impact of increasing "openness" (in the trade and financial sense) on product market structures, for instance, the impact of foreign direct investment on transforming a "tight" oligopolistic market into a "loose" one, or the impact of price competition from imports on profit rates in oligopolistic industries facing global excess capacity. All this may call for a relook at the hypothesis of the relative share of the economic surplus to rise, using more recent data.
10 Prabhat Patnaik also finds it untenable to lump together the private and the public debt "to show the fragility of the system". See his "The Economic Crisis and Contemporary Capitalism", EPW, Vol 44, No 13, 2009, p 49.
11 The reference here is to the central role of the dollar in the gigantic web of global private capital flows. For a different but interesting approach to this question, see Ramaa Vasudevan, "The Global Meltdown: Financialisation, Dollar Hegemony and the Subprime Market Collapse", EPW, Vol 44, No 13, 2009, pp 193-99.
Bernard D'Mello is deputy editor, Economic & Political Weekly, Mumbai. This article also appears in the EPW on 9 May 2009.
April 10, 1983The 'Hundred Days' of F.D.R.
By ARTHUR SCHLESINGER Jr.
xactly half a century ago, the Republic plunged into the Hundred Days - that time of tumultuous change when a flood of legislation swept away venerable market p ractices and gave the American economic system a new contour.
In the frenzied weeks from March to June 1933, Franklin D. Roosevelt sent 15 messages to Congress and steered 15 major laws to enactment: among them, central planning for industry and for agriculture, new regulation for banking and for the securities exchanges, the Tennessee Valley Authority, the Civilian Conservation Corps and a national system of unemployment relief.
''At the end of February,'' Walter Lippmann wrote when the special session adjourned, ''we were a con-geries of disorderly panicstricken mobs and factions. In the hundred days from March to June we became again an organized nation confident of our power to provide for our own security and to control our own destiny.''
The Hundred Days were only the start of a process that ended by transforming American society. Who can now imagine a day when America offered no Social Security, no unemployment compensation, no food stamps, no Federal guarantee of bank deposits, no Federal supervision of the stock market, no Federal protection for collective bargaining, no Federal standards for wages and hours, no Federal support for farm prices or rural electrification, no Federal refinancing for farm and home mortgages, no Federal commitment to high employment or to equal opportunity - in short, no Federal responsibility for Americans who found themselves, through no fault of their own, in economic or social distress?
These social changes have won general approval. Even the Reagan counterrevolution, for all its 19th-century laissez-faire and Social Darwinist passions, shrinks from abolishing the framework of social protection -the ''safety nets'' - created by the New Deal.
But what of the narrowly economic results? How effective was the New Deal in reducing unemployment, promoting economic growth and altering the distribution of income? And does the experience of half a century ago offer any guidance to the nation in its economic perplexities today?
The technique of the New Deal was improvisation and experiment. ''It is common sense to take a method and try it,'' F.D.R. said in the 1932 campaign: ''If it fails, admit it frankly and try another. But above all, try something.''
Except for that part about admitting failure frankly, this continued the rule for Roosevelt's 12 years in the White House. In the intellectual circumstances of the time, there was really no alternative to experiment. The Hundred Days found the country in a state of invincible ignorance. No one knew the causes of the Depression. No one knew the cure. Business leaders and academic economists alike were analytically baffled and impotent.
A fortnight before Roosevelt took office, the Senate Finance Committee summoned a procession of business leaders to testify on the crisis. ''I have nothing to offer, either of fact or theory,'' said John W. Davis, the head of the American bar. ''There is no panacea,'' said W.W. Atterbury, president of the Pennsylvania Railroad.
Economists had been so wrong in the recent past and were in such hot disagreement in the urgent present that no non-economist could take the profession seriously.
In its detail, New Deal experimentation was often chaotic and not seldom contradictory. But it was unified by F.D.R.'s definite conviction about the ends of economic policy - ends prescribed not only by the miseries of the Great Depression but by the President's alert, resourceful and generous-hearted personality.
Born in the Hudson River aristocracy, he inherited a sense of obligation to land and to community. He was indeed, as John T. Flynn labeled him in a once famous polemic, a country squire in the White House. The Republic was Hyde Park writ large, and he saw himself as trustee for a national estate that required vigilant protection and cultivation.
There was more than a touch of paternalism and noblesse oblige in all this, but there was also a vivid feeling of responsibility for the national community as a whole, especially its most defenseless members.
F.D.R. had had a reasonable exposure to the economic thought of his time. At Harvard he had taken more credits in economics than in any field except history and English. His teachers -William Z. Ripley, A. Piatt Andrew, O.M.W. Sprague - were in the reformist school that hoped to mitigate laissez-faire by regulation.
In the 1920's he had been active in the business self-regulation movement. As Governor of New York, he had pioneered in regional planning, conservation, electric power development and welfare legislation.
The President-elect emerged from this varied experience with a patrician disdain for business wisdom and a curiosity about economists. ''This nation asks for action, and action now,'' he said in his inaugural address.
He looked first to national planning, ''a fair and just concert of interests,'' with business, labor, agriculture and consumers working together under government leadership. Each unit ''must think of itself as a part of a greater whole; one piece in a large design.''
This integrative approach sprang from his sense of the nation as a great community. It found particular expression in the National Recovery Administration and the Agricultural Adjustment Administration. These mechanisms of negotiation and coordination soon arrested the fall in production and prices and brought about a measure of re-employment.
But they also encountered difficulties. N.R.A. especially tried to run too much; and, though it gave new status to organized labor, business used its dominating position in many industrial codes to fix prices and restrict production. In the end, the laws fell afoul of the Supreme Court.
The Second New Deal After 1935 Roosevelt embarked on a new tack: leftward in rhetoric, rightward in policy. Instead of seeking business partnership in the reorganization of economic institutions, the Second New Deal embraced the theory of a competitive economy and strove for recovery through a three-pronged reform campaign.
One prong, which naturally outraged those businessmen who endorsed competition in principle but hated it in practice, was a campaign against the ''economic royalists'' and the concentration of private economic power. The thesis, Roosevelt said in 1938, ''is not that the system of free private enterprise for profit has failed in this generation, but that it has not yet been tried.''
A second prong aimed at the stimulus of the economy through deficit spending. Keynes in his 1936 book ''The General Theory of Employment, Interest, and Money'' gave compensatory fiscal policy its classic rationale.
But the New Deal came to public spending earlier and for its own reasons. It created deficits to combat human suffering, and it found its early justification in the arguments of the Utah banker Marriner Eccles, whom Roosevelt made chairman of the Federal Reserve Board.
He took his ideas from two now forgotten American economic writers, William Trufant Foster and Waddill Catchings, whose irreverent critique of Say's Law in the 1920's had demonstrated the perils of oversaving, concluding with the brisk injunction: ''When business begins to look rotten, more public spending.''
F.D.R. had scrawled in his copy of the Foster-Catchings book ''The Road to Plenty'' (1928), ''Too good to be true - You can't get something for nothing.'' Very likely he continued to prefer structural to fiscal remedies. But ''above all, try something.''
The third prong in the Second New Deal was targeted attention to weak sectors in the economy - the South, the West, housing, railroads. Here the Reconstruction Finance Corporation, headed by a Texas banker, Jesse Jones, played a key role. The R.F.C., and later its wartime subsidiary, the Defense Plant Corporation, liberated the colonial South and West from the New York capital market and used government money to lay the foundation for the postwar boom in the Sun Belt.
(The Sun Belt today repays Washington's initiative by opposing, in the sacred name of free enterprise, government intervention on behalf of other parts of the country, as, for example, the decaying industrial heartland of the Middle West and Northeast.)
All this Rooseveltian hyperactivity brought the country through the worst of the Depression. By 1940 the gross national product was higher than in 1929 and over 60 percent higher than in 1933.
As has been often noted, the New Deal did not solve the problem of unemployment. By 1940 the jobless rate had been cut by nearly twothirds, to 9.3 percent of the labor force from 25.2 percent in 1933. Still five million people lacked jobs.
So much re-employment in half a dozen years was a not inconsiderable accomplishment, as Reagan economists, faced with their own problems of reducing unemployment, will perhaps agree.
A Budget Balancer The reason the New Deal did not do even better was that Roosevelt, though much denounced at the time as a profligate spender, remained at heart a budget-balancer and a planner. In any event, the hysterical opposition of businessmen to public spending for anyone but themselves made it politically impossible for him to spend very much.
The largest peacetime deficit the big spender produced was a feeble $3.5 billion in 1936. The increase in public debt through the 1930's hardly offset the contraction in private debt. It was not until war legitimized really effective deficits - $18 billion in 1942, $54 billion in 1943 - that unemployment disappeared; proving incidentally how right Eccles and Keynes were.
The New Deal, aided by wartime full employment, also had some impact on the distribution of income. The top fifth of American families received only 46 percent of aggregate personal income in 1946, down from 54.4 percent in 1929, while the share of the lowest two-fifths rose to 16 percent from 12.5 percent.
This was not a great change. But it was the only reversal in the trend of income distribution in American history before or since (except for a brief moment in the 1960's), and is thereby an achievement.
The Inflation Legacy Roosevelt was concerned not only with getting out of the Depression but with preventing new depressions in the future. For the Great Depression was a traumatic experience. Mass unemployment, doubt whether democratic institutions could master economic crisis, the waiting specters of Communism and fascism - all this gave democratic society such a scare in the 1930's that a primary New Deal goal was to make the American economy depression-proof.
Before the New Deal, in those glorious days of the gold standard and the unregulated marketplace, the nation had gone through a bad depression every 20 years or so - 1819, 1837, 1857, 1873, 1893, 1907, 1921, 1929. The New Deal now moved to equip the economy with built-in stabilizers designed to protect individuals against unemployment, businesses against bankruptcy and society as a whole against the roller coaster of boom-and-bust.
This effort to make the economy depression-proof was remarkably successful - as proven by the fact that, for the first time in American history, the nation has gone 40 years without a major depression. If we avoid such a depression today, it will be not because of voodoo economics, but because of the stabilizers that Franklin Roosevelt built into the economy.
The drive to secure the economy against depression had, however, one unforeseen consequence. The traditional cure for inflation had been to put the whole economy through the wringer. Denied that ancient remedy, the post-New Deal economy has experienced a chronic propensity to inflation, before which businessmen and economists appear as analytically impotent as they were before the chronic propensity to depression half a century ago.
By making the economy relatively depression-proof, we made it at the same time inflation-prone.
A Third New Deal? In dealing with the problems of our time, have we anything to learn from the brilliant experiments of the 1930's? In so far as New Deal issues remain, like mass unemployment, regional poverty, conservation and income distribution, it does no harm to consider New Deal remedies. Felix Rohatyn has long called for a resurrection of the R.F.C. The House of Representatives recently voted to establish an American Conservation Corps. Secretary Watt's effort to deliver the public domain to private greed has revitalized the conservation cause.
But what about problems unknown to the 1930's, like inflation? Here we may note the changing light that the rush of years casts on New Deal policies. For a long time historians condemned Roosevelt's First New Deal, with its focus on structure, negotiation and planning, as a bad turn on a wrong road. This judgment prevailed so long as fiscal and monetary fine-tuning appeared to contain the solution to our economic dilemmas.
But we have come to understand that, in an economy dominated by market power concentrated in large corporations and unions, fiscal and monetary policy can restrain inflation only by very crude-tuning - to put it bluntly, by inducing mass unemployment.
The economic logic of N.R.A. was perhaps not so irrelevant as conventional critics have assumed. Perhaps it was the Second New Deal that made the bad turn down the wrong road when it sought to revive the pure competitive model in an economy whose commanding heights had been seized by concentrated market power.
The First New Deal aimed to replace the institutionalized warfare of government against business, labor against management, by negotiation and coordination under government direction: instead of the adversarial cockpit, social partnership. The institutions of the early 1930's were too sketchy and improvised, too sweeping in their reach, too distorted by special interests, too confused by melodrama, to attain effective coordination.
But what is experiment, after all, but trial and error? The First New Deal at least operated in terms of a realistic model of the market.
If N.R.A. and A.A.A. could stop prices from plummeting in the 1930's, it is not beyond possibility that they may conceivably offer some clues as to how to stop prices from soaring in the 1980's. Nor will we ever get high employment, high utilization of plant and steady expansion if our only remedy for inflation continues to be recession.
We must evolve an incomes policy that effectively relates wage rates and profit margins to productivity growth - and we can only do that through experiment, through trial and error.
In the search for such a policy and for other pressing reasons - the deterioration of our infrastructure, the decline of Smokestack America, the global redivision of labor - we can no longer reject the idea of a concert of interests that F.D.R. affirmed in the 1932 campaign nor dodge the challenge of coordination he set out to explore in the Hundred Days.
There may also be something of value in the moral philosophy that animated the Hundred Days. We all recall from F.D.R.'s first inaugural that the only thing we have to fear is fear itself.
While magnificent rhetoric, that line isn't much help now. It didn't really make great sense even then. We had quite a number of things to fear in 1933 besides fear itself. Nor would the rejection of fear have sent our troubles away.
Rereading the inaugural today, one is struck by a different passage - by Roosevelt's stinging indictment of the ethic of the ''money changers'' who, ''stripped of the lure of profit by which to induce our people to follow their false leadership ... have fled from their high seats in the temple of our civilization.''
The time had come, Roosevelt said, to ''restore that temple to the ancient truths. The measure of that restoration lies in the extent to which we apply social values more noble than mere monetary profit. ... These dark days will be worth all they cost us if they teach us that our true destiny is not to be ministered unto but to minister to ourselves and our fellow men.''
Perhaps our nation will be more united, more equitable and more prosperous, too, if we abandon the current program of cutting taxes for the rich and social programs for the poor and recall the proposition Roosevelt set forth in his second inaugural:
''The test of our progress is not whether we add more to the abundance of those who have much; it is whether we provide enough for those who have too little.''
Arthur Schlesinger Jr., Schweitzer Professor in the Humanities at City University of New York, is now working on the fourth volume of The Age of Roosevelt.
By Amartya Sen
2008 was a year of crises. First, we had a food crisis, particularly threatening to poor consumers, especially in Africa. Along with that came a record increase in oil prices, threatening all oil-importing countries. Finally, rather suddenly in the fall, came the global economic downturn, and it is now gathering speed at a frightening rate. The year 2009 seems likely to offer a sharp intensification of the downturn, and many economists are anticipating a full-scale depression, perhaps even one as large as in the 1930s. While substantial fortunes have suffered steep declines, the people most affected are those who were already worst off.
The question that arises most forcefully now concerns the nature of capitalism and whether it needs to be changed. Some defenders of unfettered capitalism who resist change are convinced that capitalism is being blamed too much for short-term economic problems—problems they variously attribute to bad governance (for example by the Bush administration) and the bad behavior of some individuals (or what John McCain described during the presidential campaign as "the greed of Wall Street"). Others do, however, see truly serious defects in the existing economic arrangements and want to reform them, looking for an alternative approach that is increasingly being called "new capitalism."
The idea of old and new capitalism played an energizing part at a symposium called "New World, New Capitalism" held in Paris in January and hosted by the French president Nicolas Sarkozy and the former British prime minister Tony Blair, both of whom made eloquent presentations on the need for change. So did German Chancellor Angela Merkel, who talked about the old German idea of a "social market"—one restrained by a mixture of consensus-building policies—as a possible blueprint for new capitalism (though Germany has not done much better in the recent crisis than other market economies).
Ideas about changing the organization of society in the long run are clearly needed, quite apart from strategies for dealing with an immediate crisis. I would separate out three questions from the many that can be raised. First, do we really need some kind of "new capitalism" rather than an economic system that is not monolithic, draws on a variety of institutions chosen pragmatically, and is based on social values that we can defend ethically? Should we search for a new capitalism or for a "new world"—to use the other term mentioned at the Paris meeting—that would take a different form?
The second question concerns the kind of economics that is needed today, especially in light of the present economic crisis. How do we assess what is taught and championed among academic economists as a guide to economic policy—including the revival of Keynesian thought in recent months as the crisis has grown fierce? More particularly, what does the present economic crisis tell us about the institutions and priorities to look for? Third, in addition to working our way toward a better assessment of what long-term changes are needed, we have to think—and think fast—about how to get out of the present crisis with as little damage as possible.
What are the special characteristics that make a system indubitably capitalist—old or new? If the present capitalist economic system is to be reformed, what would make the end result a new capitalism, rather than something else? It seems to be generally assumed that relying on markets for economic transactions is a necessary condition for an economy to be identified as capitalist. In a similar way, dependence on the profit motive and on individual rewards based on private ownership are seen as archetypal features of capitalism. However, if these are necessary requirements, are the economic systems we currently have, for example, in Europe and America, genuinely capitalist?
All affluent countries in the world—those in Europe, as well as the US, Canada, Japan, Singapore, South Korea, Australia, and others—have, for quite some time now, depended partly on transactions and other payments that occur largely outside markets. These include unemployment benefits, public pensions, other features of social security, and the provision of education, health care, and a variety of other services distributed through nonmarket arrangements. The economic entitlements connected with such services are not based on private ownership and property rights.
Also, the market economy has depended for its own working not only on maximizing profits but also on many other activities, such as maintaining public security and supplying public services—some of which have taken people well beyond an economy driven only by profit. The creditable performance of the so-called capitalist system, when things moved forward, drew on a combination of institutions—publicly funded education, medical care, and mass transportation are just a few of many—that went much beyond relying only on a profit-maximizing market economy and on personal entitlements confined to private ownership.
Underlying this issue is a more basic question: whether capitalism is a term that is of particular use today. The idea of capitalism did in fact have an important role historically, but by now that usefulness may well be fairly exhausted.
For example, the pioneering works of Adam Smith in the eighteenth century showed the usefulness and dynamism of the market economy, and why—and particularly how—that dynamism worked. Smith's investigation provided an illuminating diagnosis of the workings of the market just when that dynamism was powerfully emerging. The contribution that The Wealth of Nations, published in 1776, made to the understanding of what came to be called capitalism was monumental. Smith showed how the freeing of trade can very often be extremely helpful in generating economic prosperity through specialization in production and division of labor and in making good use of economies of large scale.
Those lessons remain deeply relevant even today (it is interesting that the impressive and highly sophisticated analytical work on international trade for which Paul Krugman received the latest Nobel award in economics was closely linked to Smith's far-reaching insights of more than 230 years ago). The economic analyses that followed those early expositions of markets and the use of capital in the eighteenth century have succeeded in solidly establishing the market system in the corpus of mainstream economics.
However, even as the positive contributions of capitalism through market processes were being clarified and explicated, its negative sides were also becoming clear—often to the very same analysts. While a number of socialist critics, most notably Karl Marx, influentially made a case for censuring and ultimately supplanting capitalism, the huge limitations of relying entirely on the market economy and the profit motive were also clear enough even to Adam Smith. Indeed, early advocates of the use of markets, including Smith, did not take the pure market mechanism to be a freestanding performer of excellence, nor did they take the profit motive to be all that is needed.
Even though people seek trade because of self-interest (nothing more than self-interest is needed, as Smith famously put it, in explaining why bakers, brewers, butchers, and consumers seek trade), nevertheless an economy can operate effectively only on the basis of trust among different parties. When business activities, including those of banks and other financial institutions, generate the confidence that they can and will do the things they pledge, then relations among lenders and borrowers can go smoothly in a mutually supportive way. As Adam Smith wrote:When the people of any particular country have such confidence in the fortune, probity, and prudence of a particular banker, as to believe that he is always ready to pay upon demand such of his promissory notes as are likely to be at any time presented to him; those notes come to have the same currency as gold and silver money, from the confidence that such money can at any time be had for them.
Smith explained why sometimes this did not happen, and he would not have found anything particularly puzzling, I would suggest, in the difficulties faced today by businesses and banks thanks to the widespread fear and mistrust that is keeping credit markets frozen and preventing a coordinated expansion of credit.
It is also worth mentioning in this context, especially since the "welfare state" emerged long after Smith's own time, that in his various writings, his overwhelming concern—and worry—about the fate of the poor and the disadvantaged are strikingly prominent. The most immediate failure of the market mechanism lies in the things that the market leaves undone. Smith's economic analysis went well beyond leaving everything to the invisible hand of the market mechanism. He was not only a defender of the role of the state in providing public services, such as education, and in poverty relief (along with demanding greater freedom for the indigents who received support than the Poor Laws of his day provided), he was also deeply concerned about the inequality and poverty that might survive in an otherwise successful market economy.
Lack of clarity about the distinction between the necessity and sufficiency of the market has been responsible for some misunderstandings of Smith's assessment of the market mechanism by many who would claim to be his followers. For example, Smith's defense of the food market and his criticism of restrictions by the state on the private trade in food grains have often been interpreted as arguing that any state interference would necessarily make hunger and starvation worse.
But Smith's defense of private trade only took the form of disputing the belief that stopping trade in food would reduce the burden of hunger. That does not deny in any way the need for state action to supplement the operations of the market by creating jobs and incomes (e.g., through work programs). If unemployment were to increase sharply thanks to bad economic circumstances or bad public policy, the market would not, on its own, recreate the incomes of those who have lost their jobs. The new unemployed, Smith wrote, "would either starve, or be driven to seek a subsistence either by begging, or by the perpetration perhaps of the greatest enormities," and "want, famine, and mortality would immediately prevail...." Smith rejects interventions that exclude the market—but not interventions that include the market while aiming to do those important things that the market may leave undone.
Smith never used the term "capitalism" (at least so far as I have been able to trace), but it would also be hard to carve out from his works any theory arguing for the sufficiency of market forces, or of the need to accept the dominance of capital. He talked about the importance of these broader values that go beyond profits in The Wealth of Nations, but it is in his first book, The Theory of Moral Sentiments, which was published exactly a quarter of a millennium ago in 1759, that he extensively investigated the strong need for actions based on values that go well beyond profit seeking. While he wrote that "prudence" was "of all the virtues that which is most useful to the individual," Adam Smith went on to argue that "humanity, justice, generosity, and public spirit, are the qualities most useful to others."
Smith viewed markets and capital as doing good work within their own sphere, but first, they required support from other institutions—including public services such as schools—and values other than pure profit seeking, and second, they needed restraint and correction by still other institutions—e.g., well-devised financial regulations and state assistance to the poor—for preventing instability, inequity, and injustice. If we were to look for a new approach to the organization of economic activity that included a pragmatic choice of a variety of public services and well-considered regulations, we would be following rather than departing from the agenda of reform that Smith outlined as he both defended and criticized capitalism.
Historically, capitalism did not emerge until new systems of law and economic practice protected property rights and made an economy based on ownership workable. Commercial exchange could not effectively take place until business morality made contractual behavior sustainable and inexpensive—not requiring constant suing of defaulting contractors, for example. Investment in productive businesses could not flourish until the higher rewards from corruption had been moderated. Profit-oriented capitalism has always drawn on support from other institutional values.
The moral and legal obligations and responsibilities associated with transactions have in recent years become much harder to trace, thanks to the rapid development of secondary markets involving derivatives and other financial instruments. A subprime lender who misleads a borrower into taking unwise risks can now pass off the financial assets to third parties—who are remote from the original transaction. Accountability has been badly undermined, and the need for supervision and regulation has become much stronger.
And yet the supervisory role of government in the United States in particular has been, over the same period, sharply curtailed, fed by an increasing belief in the self-regulatory nature of the market economy. Precisely as the need for state surveillance grew, the needed supervision shrank. There was, as a result, a disaster waiting to happen, which did eventually happen last year, and this has certainly contributed a great deal to the financial crisis that is plaguing the world today. The insufficient regulation of financial activities has implications not only for illegitimate practices, but also for a tendency toward overspeculation that, as Adam Smith argued, tends to grip many human beings in their breathless search for profits.
Smith called the promoters of excessive risk in search of profits "prodigals and projectors"—which is quite a good description of issuers of subprime mortgages over the past few years. Discussing laws against usury, for example, Smith wanted state regulation to protect citizens from the "prodigals and projectors" who promoted unsound loans:A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.
The implicit faith in the ability of the market economy to correct itself, which is largely responsible for the removal of established regulations in the United States, tended to ignore the activities of prodigals and projectors in a way that would have shocked Adam Smith.
The present economic crisis is partly generated by a huge overestimation of the wisdom of market processes, and the crisis is now being exacerbated by anxiety and lack of trust in the financial market and in businesses in general—responses that have been evident in the market reactions to the sequence of stimulus plans, including the $787 billion plan signed into law in February by the new Obama administration. As it happens, these problems were already identified in the eighteenth century by Smith, even though they have been neglected by those who have been in authority in recent years, especially in the United States, and who have been busy citing Adam Smith in support of the unfettered market.
While Adam Smith has recently been much quoted, even if not much read, there has been a huge revival, even more recently, of John Maynard Keynes. Certainly, the cumulative downturn that we are observing right now, which is edging us closer to a depression, has clear Keynesian features; the reduced incomes of one group of persons has led to reduced purchases by them, in turn causing a further reduction in the income of others.
However, Keynes can be our savior only to a very partial extent, and there is a need to look beyond him in understanding the present crisis. One economist whose current relevance has been far less recognized is Keynes's rival Arthur Cecil Pigou, who, like Keynes, was also in Cambridge, indeed also in Kings College, in Keynes's time. Pigou was much more concerned than Keynes with economic psychology and the ways it could influence business cycles and sharpen and harden an economic recession that could take us toward a depression (as indeed we are seeing now). Pigou attributed economic fluctuations partly to "psychological causes" consisting ofvariations in the tone of mind of persons whose action controls industry, emerging in errors of undue optimism or undue pessimism in their business forecasts.
It is hard to ignore the fact that today, in addition to the Keynesian effects of mutually reinforced decline, we are strongly in the presence of "errors of...undue pessimism." Pigou focused particularly on the need to unfreeze the credit market when the economy is in the grip of excessive pessimism:Hence, other things being equal, the actual occurrence of business failures will be more or less widespread, according [to whether] bankers' loans, in the face of crisis of demands, are less or more readily obtainable.
Despite huge injections of fresh liquidity into the American and European economies, largely from the government, the banks and financial institutions have until now remained unwilling to unfreeze the credit market. Other businesses also continue to fail, partly in response to already diminished demand (the Keynesian "multiplier" process), but also in response to fear of even less demand in the future, in a climate of general gloom (the Pigovian process of infectious pessimism).
One of the problems that the Obama administration has to deal with is that the real crisis, arising from financial mismanagement and other transgressions, has become many times magnified by a psychological collapse. The measures that are being discussed right now in Washington and elsewhere to regenerate the credit market include bailouts—with firm requirements that subsidized financial institutions actually lend—government purchase of toxic assets, insurance against failure to repay loans, and bank nationalization. (The last proposal scares many conservatives just as private control of the public money given to the banks worries people concerned about accountability.) As the weak response of the market to the administration's measures so far suggests, each of these policies would have to be assessed partly for their impact on the psychology of businesses and consumers, particularly in America.
The contrast between Pigou and Keynes is relevant for another reason as well. While Keynes was very involved with the question of how to increase aggregate income, he was relatively less engaged in analyzing problems of unequal distribution of wealth and of social welfare. In contrast, Pigou not only wrote the classic study of welfare economics, but he also pioneered the measurement of economic inequality as a major indicator for economic assessment and policy. Since the suffering of the most deprived people in each economy—and in the world—demands the most urgent attention, the role of supportive cooperation between business and government cannot stop only with mutually coordinated expansion of an economy. There is a critical need for paying special attention to the underdogs of society in planning a response to the current crisis, and in going beyond measures to produce general economic expansion. Families threatened with unemployment, with lack of medical care, and with social as well as economic deprivation have been hit particularly hard. The limitations of Keynesian economics to address their problems demand much greater recognition.
A third way in which Keynes needs to be supplemented concerns his relative neglect of social services—indeed even Otto von Bismarck had more to say on this subject than Keynes. That the market economy can be particularly bad in delivering public goods (such as education and health care) has been discussed by some of the leading economists of our time, including Paul Samuelson and Kenneth Arrow. (Pigou too contributed to this subject with his emphasis on the "external effects" of market transactions, where the gains and losses are not confined only to the direct buyers or sellers.) This is, of course, a long-term issue, but it is worth noting in addition that the bite of a downturn can be much fiercer when health care in particular is not guaranteed for all.
For example, in the absence of a national health service, every lost job can produce a larger exclusion from essential health care, because of loss of income or loss of employment-related private health insurance. The US has a 7.6 percent rate of unemployment now, which is beginning to cause huge deprivation. It is worth asking how the European countries, including France, Italy, and Spain, that lived with much higher levels of unemployment for decades, managed to avoid a total collapse of their quality of life. The answer is partly the way the European welfare state operates, with much stronger unemployment insurance than in America and, even more importantly, with basic medical services provided to all by the state.
The failure of the market mechanism to provide health care for all has been flagrant, most noticeably in the United States, but also in the sharp halt in the progress of health and longevity in China following its abolition of universal health coverage in 1979. Before the economic reforms of that year, every Chinese citizen had guaranteed health care provided by the state or the cooperatives, even if at a rather basic level. When China removed its counterproductive system of agricultural collectives and communes and industrial units managed by bureaucracies, it thereby made the rate of growth of gross domestic product go up faster than anywhere else in the world. But at the same time, led by its new faith in the market economy, China also abolished the system of universal health care; and, after the reforms of 1979, health insurance had to be bought by individuals (except in some relatively rare cases in which the state or some big firms provide them to their employees and dependents). With this change, China's rapid progress in longevity sharply slowed down.
This was problem enough when China's aggregate income was growing extremely fast, but it is bound to become a much bigger problem when the Chinese economy decelerates sharply, as it is currently doing. The Chinese government is now trying hard to gradually reintroduce health insurance for all, and the US government under Obama is also committed to making health coverage universal. In both China and the US, the rectifications have far to go, but they should be central elements in tackling the economic crisis, as well as in achieving long-term transformation of the two societies.
The revival of Keynes has much to contribute both to economic analysis and to policy, but the net has to be cast much wider. Even though Keynes is often seen as a kind of a "rebel" figure in contemporary economics, the fact is that he came close to being the guru of a new capitalism, who focused on trying to stabilize the fluctuations of the market economy (and then again with relatively little attention to the psychological causes of business fluctuations). Even though Smith and Pigou have the reputation of being rather conservative economists, many of the deep insights about the importance of nonmarket institutions and nonprofit values came from them, rather than from Keynes and his followers.
A crisis not only presents an immediate challenge that has to be faced. It also provides an opportunity to address long-term problems when people are willing to reconsider established conventions. This is why the present crisis also makes it important to face the neglected long-term issues like conservation of the environment and national health care, as well as the need for public transport, which has been very badly neglected in the last few decades and is also so far sidelined—as I write this article—even in the initial policies announced by the Obama administration. Economic affordability is, of course, an issue, but as the example of the Indian state of Kerala shows, it is possible to have state-guaranteed health care for all at relatively little cost. Since the Chinese dropped universal health insurance in 1979, Kerala—which continues to have it—has very substantially overtaken China in average life expectancy and in indicators such as infant mortality, despite having a much lower level of per capita income. So there are opportunities for poor countries as well.
But the largest challenges face the United States, which already has the highest level of per capita expenditure on health among all countries in the world, but still has a relatively low achievement in health and has more than forty million people with no guarantee of health care. Part of the problem here is one of public attitude and understanding. Hugely distorted perceptions of how a national health service works need to be corrected through public discussion. For example, it is common to assume that no one has a choice of doctors in a European national health service, which is not at all the case.
There is, however, also a need for better understanding of the options that exist. In US discussions of health reform, there has been an overconcentration on the Canadian system—a system of public health care that makes it very hard to have private medical care—whereas in Western Europe the national health services provide care for all but also allow, in addition to state coverage, private practice and private health insurance, for those who have the money and want to spend it this way. It is not clear just why the rich who can freely spend money on yachts and other luxury goods should not be allowed to spend it on MRIs or CT scans instead. If we take our cue from Adam Smith's arguments for a diversity of institutions, and for accommodating a variety of motivations, there are practical measures we can take that would make a huge difference to the world in which we live.
The present economic crises do not, I would argue, call for a "new capitalism," but they do demand a new understanding of older ideas, such as those of Smith and, nearer our time, of Pigou, many of which have been sadly neglected. What is also needed is a clearheaded perception of how different institutions actually work, and of how a variety of organizations—from the market to the institutions of the state—can go beyond short-term solutions and contribute to producing a more decent economic world.
—February 25, 2009
Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, edited by R.H. Campbell and A.S. Skinner (Clarendon Press, 1976), I, II.ii.28, p. 292.
Smith, The Wealth of Nations, I, I.viii.26, p. 91.
Adam Smith, The Theory of Moral Sentiments, edited by D.D. Raphael and A.L. Macfie (Clarendon Press, 1976), pp. 189–190.
Smith, The Wealth of Nations, I, II.iv.15, p. 357.
A.C. Pigou, Industrial Fluctuations (London: Macmillan, 1929), p. 73.
Pigou, Industrial Fluctuations, p. 96.
A.C. Pigou, The Economics of Welfare (London: Macmillan, 1920). Current works on economic inequality, including the major contributions of A.B. Atkinson, have been to a considerable extent inspired by Pigou's pioneering initiative: see Atkinson, Social Justice and Public Policy (MIT Press, 1983).
"Government owning a stake in any private US company is objectionable to most Americans, me included," Mr Paulson said today.
"Yet, the alternative of leaving businesses and consumers without access to financing is totally unacceptable. When financing isn’t available, consumers and businesses shrink their spending, which leads to businesses cutting jobs and even closing up shop."
In the long sad history of contradictions this has to be catapulted to the top of the list. Essentially Paulson is saying that capitalism is good as long as it breathes in -- it must never breathe out.
The alternative he finds so objectionable is the very nature of capitalism. (emphasis added, CHS)
We must remind ourselves of where the crisis originated. Ironically, Paulson, in the second paragraph of the above statement encapsulates the entirety as well as the absurdity of the situation. People and businesses must borrow and spend regardless of their needs at exponentially increasing rates or the system collapses.
Conventional wisdom would have it, incorrectly so, that people trade labor for wages and those wages provide the means through which consumption of necessary and discretionary goods and services is made possible.
But as I have stated, this is incorrect. Why? First, stagnant wages. Allow me to digress. There is nothing wrong with stagnant wages -- as long as purchasing power remains constant. The hidden tax of inflation steals purchasing power because it devalues the currency. Let us not engage in semantics, stagnant wages combined with a consistent decline in purchasing power is in effect a decline in wages. So as long as the current economic paradigm persists I will call stagnant wages declining wages.
Wages haven't remained stagnant for a generation they have effectively declined. This is why it takes two wage earners in a household to accomplish the equivalent of one wage earner 30 years ago.
We have embraced "globalization". It sounds trendy, even cosmopolitan. Economist tell us its the only way. But for some reason we have yet to understand its effects -- and political hacks are not about to spell them out.
Americans have enjoyed a long period of time where our wages were several standard deviations above the rest of the world's. Now that we are forced to compete with people who have a much lower standard of living certain unpleasant things must happen. Our standard of living must decrease as developing nation's standard of living increases. (When a candidate promises to bring back jobs, look him straight in the eye and ask him/her, how can they do this when the competition can work for 1/20th our wages? Then stand back and watch him/her dissemble)
In order for Americans to maintain a high standard of living either asset prices have to lower (purchasing power has to increase), they must have wage and price levels that allow savings, or they must borrow. But this is not possible with the current system. Deflation is viewed as worse than death, especially since so many derivatives are collateralized by extremely overvalued assets. (emphasis added, CHS)
Deflation raises the cost of servicing debt. considering the level of public and private debt this is one of the reasons why all the stops are being pulled out to prevent it. Promoting saving would be to discourage spending (see second paragraph second sentence in the above quote). Rising wages, also a result of deflation, would make us uncompetitive (we already are). This leaves borrowing.
This brings us full circle in this absurd Greek tragedy. Borrowing has a saturation point. We have reached that point both at the private and public level. Because we have an economic system that requires exponential amounts of debt in order to grow, OTC (CDS) derivatives were given legal certainty, unsound mortgage policies were encouraged at the highest level (Alan Greenspan), people were encouraged to equity strip their homes (HELOC) to consume. Wealthy and poor were encourage to live wildly beyond their means in attempts to meet the exponential expansion of debt required to grow. Borrow we must because that is how new money (growth) is created absent real productivity. Therefore, in my opinion, none of what is occurring was or is accidental or incidental.
But as I have stated debt has a saturation point. At the point it takes infinite amounts of credit created instantly for infinity the circumstance is revealed for what it is: a Ponzi scheme, robbery, a fraud, a swindle that transfers wealth from the many to a few. It leads to collectivism. It destroys freedom. It indentures whole nations for many generations to come.
This is what this administration is fighting to preserve.
As others have stated, Paulson wants to solve a debt saturation problem by even greater debt saturation. But Starbucks is not closing 600 stores because it needs more debt. With three or more cars in most driveways across America GM and Ford are not struggling because they need more debt. Entire neighborhoods and high rise buildings have not become foreclosure ghost towns because the owners needed more debt.
In every stated situation it was the over-saturation of debt that brought about demise. The temperature of a liquid cannot be raised above its boiling point no matter how much heat is added, only its vapor can be superheated. Unfortunately money that has vaporized is not useful.
Its time to listen to Thomas Jefferson and tell the banks, NO. America chooses individualism over collectivism.
It is time to demand from our government that we want a real economy and a sound banking system no matter how painful the transition.
Asian stocks are continuing lower, and that is before the US markets show an appreciation of the harsh realities that are out there. That crisis of confidence will come soon enough. (Aug 22, '08)
R M Cutler runs his eye over the ups and downs in the week's markets.
Readers may know I am not much of a fan of Larry Summers' occasional comments in the Financial Times. He has a tendency to come forth with views of how things work that sound nice but too often are at odds with facts on the ground.
His latest offering scores better than previous offerings as far as engagement with reality is concerned, although it has a few attention-grabbing departures.
Summers starts by lamenting that international economic polities are getting short shrift in pre-election debate (ahem, have they ever been front burner?) and warns:
The next administration faces the prospect of having to make the most consequential international economic policy choices in a generation at a time when the confidence of governments in free markets is being increasingly questioned.This statement sound reasonable until you think about it. It presupposes that the next administration is an actor capable of making unilateral decisions that will affect the international game board. A growing theme on the FT's comment pages is that we are in a multilateral world, and key international bodies such as the IMF and World Bank need new governance arrangements that reflect the important role and economic weight of developing economies (even that sobriquet is looking dated).
Brad Setser keyed in on the likelihood of the US facing circumscribed policy choices:I don’t think it is realistic for the US to expect to be able to rely as heavily as it currently does on other governments for financing without giving up at least a bit of policy autonomy. The enormous holdings of Agencies by the world’s central banks (along with the Agencies held by US domestic banks) are — in my view — a constraint on the options available to US policy makers struggling to get ahead of a seemingly still deepening credit crisis.
Oddly, Summers in the very next paragraph notes how the fast the emerging world has risen and again draws some debatable inferences:
The current distribution of regional economic power is unlike anything that was predicted even a decade ago. The rise of the developing world, its growing share in global output and far greater share of global growth, is perhaps a quantitative but not a qualitative surprise. The qualitative surprise is this: with almost all the industrial world in or near recession, much of the momentum in the global economy is coming from countries with authoritarian governments that are pursuing economic strategies directed towards wealth accumulation and building up geopolitical strength rather than improving living standards for their populations. China, where household consumption has now fallen below 40 per cent of its gross domestic product – which must be some kind of peacetime record – is the most extreme example. Similar tendencies, however, can be seen in other parts of Asia, Russia and other oil exporting countries.Um, it's taken Summers this long to realize China, and before it, Japan, took a mercantilist stance towards the US? We noted in an earlier post:While Summers admittedly undercuts that argument later by discussing how a more open economy can come out a net loser if its trade partners are better competitors, there is a more basic reason to take this idea with a grain of salt: we have lower trade barriers because some of our biggest partners (read Japan and China) are mercantilist and fundamentally have no intention of opening their markets very much; the advanced European economies regard maintaining surpluses and protecting labor as priorities, which again limits how much they will concede. We have lower trade barriers because we enter into negotiations with different premises and aims (at least historically) than our counterparts. (Some would also argue that our trade policy is designed more to benefit major US multinationals than the broader populace; that is harder to prove but may not be inaccurate.)This is far from a new line of thinking. William Greider, for instance, made similar observations in 2005. At a minimum, trade negotiators with China and Japan have confronted this syndrome for years; many of our other trading partners play the game with more finesse.
Summers then has three rambling paragraphs which discuss, quelle horreur, how these developing countries, via their success in trade or by sitting on lots of oil, caused trouble:
The pressure created by the investment of these surpluses was one of the big factors driving the excesses that preceded our financial problems.
Note this comes perilously close to suggesting a causal relationship between high trade surpluses abroad and our financial meltdown. Back to Summers:
But the problems are much deeper than the question of who sits around the negotiating tables. For all the disagreements over the past decades, there has been a shared premise behind international economic policy discussions – the goal of increased economic integration, the spread of market institutions and more rapid growth for all nations. While companies may compete, the premise has been that nations co-operate to build a stronger economy in the interests of all.
Readers are welcome to correct me on this one, but whose consensus are we discussing, exactly? Again, China and Japan might give lip service to grand pronouncements while keeping their eye on the ball of what the gives and the gets were at the negotiating table. China, for instance, rebuffed Paulson in his recent entreaties to open its financial markets to foreign players. In fact, one could make a case that any country with a pegged currency (or as with China, a dirty float) is committed to maintaining a trade surplus, which means their commitment to achieving specific national outcomes ranks above any vision of international cooperation. And frankly, that's a rational stance.
Note that despite Summers' rhetoric, the US has not adhered strictly to this vision either. We've entering into bi-lateral and regional trade agreements, something the internationalists have decried.
Development economist and Harvard professor Dani Rodrik pointed out that deep economic integration, democracy, and national sovereignty cannot be pursued at the same time:
Sometimes simple and bold ideas help us see more clearly a complex reality that requires nuanced approaches. I have an "impossibility theorem" for the global economy that is like that. It says that democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full....
To see why this makes sense, note that deep economic integration requires that we eliminate all transaction costs traders and financiers face in their cross-border dealings. Nation-states are a fundamental source of such transaction costs. They generate sovereign risk, create regulatory discontinuities at the border, prevent global regulation and supervision of financial intermediaries, and render a global lender of last resort a hopeless dream. The malfunctioning of the global financial system is intimately linked with these specific transaction costs.....
So I maintain that any reform of the international economic system must face up to this trilemma. If we want more globalization, we must either give up some democracy or some national sovereignty. Pretending that we can have all three simultaneously leaves us in an unstable no-man's land.
I've omitted Rodrik's discussion of choices, which might interest some readers. Again, to Summers:
It is no longer clear that this premise remains valid. Nations are increasingly preoccupied with their relative economic standing, not the living standards of citizens. Issues of strategic leverage and vulnerability now play a bigger role in economic policy discussions.
Hhhm. One might argue, as Thomas Palley has, that the US has pursued economic policies without regard to the standard of living of our citizens. Again, who are these unnamed countries preoccupied with their relative standing? That charge does not ring true for the UK or EU. One assumes Summers at a minimum means China, and he's way off base. Joseph Stiglitz has determined that if you take China out of the equation, there has in fact been no reduction in global poverty (note that the improvements in conditions among the world's poor has been one of the strong arguments for more liberalized trade). And China remains committed to rapid growth, which will again benefit its citizens. What Summers means is that China needs to switch from export driven growth to a more balanced economy with a more robust consumer sector. It would be more useful if he would say so directly.
Instead, he again comes at his argument in a round-about way:
At the same time, it is unclear which underlying driver of global growth will replace the one in place for the past decade – the US as importer of last resort. Global growth has depended on US growth, which has depended on the US consumer; and the US consumer has depended on rising asset values first of stocks and more recently of real estate. With falling house prices and a challenged financial system, US consumer spending is falling. The US is no longer in a position to be a net source of demand for the rest of the world. Indeed, with the drop in value of the dollar, US growth – which had been focused on imports and which had enabled the export-led growth of other countries – is a thing of the past. Already, Europe and Japan are in or are very close to being in recession.
The current global policy debate is a cacophony. It is all very well to advocate increased US saving and a cut in the US current account deficit but the process for bringing it about will mean less US demand for foreign products. That will put pressure on jobs and output growth in other countries if no countervailing measures are put in place. Conversely, the return of a stronger dollar without other policy changes will raise US demand for exports but at the price of cutting demand for domestically produced goods and compounding the recession.
These problems will be with us for some time. They may not be at the top of anyone’s agenda right now. But the success of the next administration could depend on its ability to engage with a wider range of global economic stakeholders, on a broader agenda, at a time when disagreements are increasing not just about means but also about ultimate ends.
I suspect there was never as much agreement about "ultimate ends" as Summers suggests. Other countries fell to the US lead when the US was more powerful economically. Long-standing differences of perspective that were suppressed are now being exposed.
Summers is vague about what needs to happen if there is to be anything resembling an orderly transition. Mohamed El-Erain, former head of Harvard Management and co-CEO of Pimco, has been far more specific, and also intimated that the sort of discussions that Summers recommends have been held and failed. From an FT comment by El-Erian:
Whatever happened to the debate on global payments imbalances?...At its roots, the policy solution called for simultaneous implementation of three sets of measures. First, a reduction in US domestic aggregate demand to contain imports and encourage a shift to exports. Second, an increase in consumption in Asia and the Middle East, including having China adopt a higher and flexible exchange rate. Third, structural reforms in western Europe to enhance the growth potential of the global economy....
The policy solution stalled because of a basic co-ordination problem, or what is known in game theory as the “prisoners’ dilemma”. While all parties had an interest in the outcome, any individual party that moved first risked being worse off if others did not follow. With multilateral co-ordination mechanisms such as the Group of Seven industrial countries and the International Monetary Fund lacking representation and legitimacy, there was no way to provide parties with sufficient assurances that their actions would be accompanied by others. As a result, no one took sufficiently meaningful action.
Now I am most certainly not privy to high-level policy discussions, and when this piece ran, expressed some doubts as to how far these discussions went. However, El-Erian said with some certainty that the idea of a coordinated approach was dead on arrival. He viewed the outcome as not pretty:Under this scenario, the question for markets is no longer whether the global imbalances adjust. They will. Instead, the focus should be on the collateral damage of the adjustment process – damage that is region-specific given differences in policy flexibility and initial economic and financial conditions. In the US, look for renewed pressure for further fiscal stimulus and a monetary policy that, while appropriate for the US, is too inflationary for the rest of the world. In Asia and the Middle East, the spike in inflationary pressures may inadvertently slow the move towards more efficient tools of indirect economic management. In Europe, expect attempts to bypass fiscal responsibility guidelines in order to mute political protest.Those who would like to read El-Erian's article and our commentary can find them here.
Go Willem Buiter! The London School of Economics prof and former Bank of England and European Bank for Reconstruction and Development official has been saying for some time that the Fed suffer from s "cognitive regulatory capture" and has been far too responsive to the needs of Wall Street. It's been puzzling to watch his detailed, well argued criticisms go unnoticed, particularly when they have been offered at forums where one would think they'd be impossible to ignore (for instance, a conference co-hosted by the New York Fed where Buiter presented a pretty harsh paper on what he called the North Atlantic Financial Crisis).
Well, he finally seems to have gotten through, perhaps because he is forward enough to criticize Fed officials to their face at an event they are hosting. Or maybe it's because the pattern of conduct he decries is so patently obvious that the key actors can no longer fool themselves. From Bloomberg:
Former Bank of England policy maker Willem Buiter sparked the biggest debate at the Federal Reserve's annual mountainside symposium, saying the central bank pays too much heed to the concerns of financial institutions.
``The Fed listens to Wall Street and believes what it hears,'' Buiter said yesterday in a paper presented to the Fed's conference in Jackson Hole, Wyoming. ``This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous.''
The Wall Street Journal's Economics blog provides a similar account and a link to the paper.
Mr. Buiter slams the Federal Reserve, European Central Bank and Bank of England for what he says was a mishandling of the financial crisis and monetary policy over the past year. He gives the worst marks to the Fed, saying it’s too close to Wall Street and financial markets — responding to their needs to the detriment of the wider economy. Mr. Buiter, a former member of the BOE’s Monetary Policy Committee, said the Fed overreacted to the economic slowdown — misjudging the importance of financial stability to the overall economy — and created a deeper inflation problem as a result.
The paper is quite long, but it is very well written and moves very quickly for this sort of exercise (it does get geeky from time to time,). I will confess to having read only the first 30 pages, but his argument seems spot on:
My thesis is that both monetary theory and the practice of central banking have failed to keep up with key developments in the financial systems of advanced market economies, and that as a result of this, many central banks were to varying degrees ill-prepared for the financial crisis that erupted on August 9, 2007.
The Fed gets disproportionate attention, in part due to the venue of the presentation, in part because Buiter contends that the Fed did the worst job of the major central banks. Note that Buiter is more of inflation hawk than we are, but as a result, Buiter thinks that letting housing prices decline is not the end of the world and implicitly, adjustments need to run their course (per his point 4). Even though we think this deleveraging will be nastier than Buiter anticipates, we think that trying to hold asset prices at inflated levels will inevitably fail and the effort will only create more damage. To Buiter again:
[T]hree factors contribute to Fed’s underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.
The second is a sextet of technical and analytical errors: (1) misapplication of the ‘Precautionary Principle’; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on ‘core’ inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom
that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.
All three central banks have been too eager to blame repeated and persistent upwards inflation surprises on ‘external factors beyond their control’, specifically food, fuel and other commodity prices. The third cause of the Fed’s macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.
Of his three charges, Buiter is on solid ground on the first and third. The second set (his points 1-6) are debatable, but you can make a solid case for them, and he does.
Some of his comments are blunt:
In the case of the Fed, the nature of the arrangements for pricing illiquid collateral offered by primary dealers invites abuse....
All three central banks have gone well beyond the provision of emergency liquidity to solvent but temporarily illiquid banks. All three have allowed themselves to be used as quasifiscal agents of the state, providing subsidies to banks and other highly leveraged institutions, and assisting in their recapitalisation, while keeping the resulting contingent exposure off the budget and balance sheet of the fiscal authorities. Such subservience to the fiscal authorities undermines the independence of the central banks even in the area of monetary policy.
There is a lot of good stuff. For instance, Buiter discusses the "asymmetric" response of regulators to asset bubbles (they let the bubble run but jump in to try to arrest the collapse) and discusses remedies.
Unfortunately, a lot of participants seemed more interested in defending the Fed than in sifting through Buiter's analysis to see what might be valid and useful:
Fed Governor Frederic Mishkin said Buiter's paper fired ``a lot of unguided missiles,'' and former Vice Chairman Alan Blinder ``respectfully disagreed'' with his analysis of the central bank's crisis management.....
Mishkin lashed out against Buiter's assertion that the Fed's rate reductions may cause higher consumer prices.
``I wish he had actually read some of the literature on optimal monetary policy, because it might have been very helpful in this context,'' said Mishkin, who collaborated with Bernanke on inflation research in the 1990s.
Mishkin, a leading advocate of the Fed's effort to sustain economic growth through rapid rate reductions, said research shows that ``what you need to do is act more aggressively.''
In reply, Buiter said the value of such a strategy ``is not at all obvious to me.''
[Bank of Isreal's Stanley] Fischer, drawing laughter from the audience, held up a red fire extinguisher saying, ``I asked the organizers for some technical assistance in dealing with this discussion.''
While defending the Fed, Blinder said Buiter's papers ``often feature an alluring mix of brilliant insight and outrageous statements.'' The central bank's performance, though not flawless, has been ``pretty good'' given the magnitude of the crisis, he said.
European Central Bank President Jean-Claude Trichet also came to the Fed's defense, saying ``what has been done until now has been pretty well done under very difficult circumstances.''
Although the Wall Street Journal coverage of the response is less detailed, it says that Blinder, who was tasked with critiquing the paper, told a long-form version of the Dutch boy putting his finger in the dam, and said that Buiter would rather have the dam leak out of obedience to his belief in moral hazard, and let the dam burst.
I may be reading too much into this, but it strikes me that Blinder went out of his way to be insulting (anyone who regularly participates in critiques of academic papers please read the WSJ post and comment).
Part of the problem is stylistic. Even though Buiter is Dutch by descent and dislikes the idea of national identity, his writing style often echos the cut and thrust of Parliamentary debates, a posture that is also well received in English academe and drawing rooms but not well received in the US. So his bluntness is over-the-top by US standards.
From this vantage point, it's obvious that the Fed has become far too dependent on current Wall Street incumbents and thus can be manipulated by them (and in fairness, the people who are doing the persuading may be completely sincere in their views). There were ways to compensate: cultivate contacts with former executives who no longer have close ties, find independent analysts who have useful data and perspectives. No doubt Fed officials have extensive contacts, but it appears they have not been used in a deliberate, orchestrated fashion to test and validate information provided by those currently employed by major financial firms.
The second issue is that even if the Fed is too close to the financial services industry, it still may have made the right policy decisions. The jury is still out. Many people (probably including the Fed officials) hope the crisis has passed, while readers of this blog know there is good reason to think the worst has not arrived in earnest.
Buiter has taken a bold position, The Fed needs to be able to explain why what is good for Wall Street is also good for the economy as a whole. The sort of questions that Buiter is raising are notably absent from the media and US-based first rank economists. The Bloomberg story may not give a full enough account to be certain, but the responses to Buiter's charges do not seem persuasive. They amount to disputes over analytical methods and assertions that everything is working fine (after providing a $400 billion fix with no withdrawal plan and getting support from foreign investors equivalent to $1000 a person. So what's your next act?).
It will take some time to see if events prove Buiter right. And as Cassandras like Nouriel Roubini know, it can sometimes take longer than you anticipate for bad policies to finally yield the expected dismal harvest.
Whatever reason we wish to give for the rise in commodity prices—oil and food, especially--, I think we can safely say that many models point to large players distorting the market, be they hedge funds, Fed interest rates, or countries controlling the resources.
Slowly but surely, I am coming to the opinion that “local” has some advantages over “global.” To illustrate my point, consider how our trade agreement with Mexico was framed, particularly in terms of corn.
NAFTA shifted Mexico's production from grains to vegetables and fruits, making Mexico much more dependent on the U.S. for grains. One incidental effect of our ethanol subsidy--using corn, for example, to product ethanol--has been to expose Mexico's vulnerability when it shifted from grains to vegetables and fruits. Suddenly, tortillas are excessively expensive.
Corn was an important crop in Mexico, and corn is now one of those important commodities reaching record high prices.
The market place creates efficiencies. Mexico’s corn crop was subsidized. NAFTA removed those subsidies; we could more efficiently supply the corn. Let Mexico concentrate on fruits and vegetables.
Such efficiencies, while seemingly laudable, create dangers. These efficiencies are celebrated as one of the benefits of globalization. Each country decides on its role in the Ricardian scheme of things. Inefficient redundancies are dropped.
The trouble is: If one major primary producer (the U.S.) decides suddenly to march to a different drummer, the whole parade becomes a chaotic mess. Yes, it may straighten itself out, but the interim consequences are devastating.
I would argue that every country has the right and duty to ensure that it can feed its populace, even if it means subsidies. Trade agreements should not place this duty at risk.
The same argument applies to energy. For decades, we have allowed OPEC to be the primary producer of cheap energy. Each country should pursue as much energy independence as possible. We have talked about our doing it, but the will has been weak.
If you argue that hedge funds seeking a new asset class have created the problem, we are now at their mercy. Whatever the argument, our vulnerability is now exposed precisely because we did not think of energy as a local issue, as something for which we are primarily responsible.
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