The election of a Democratic president who has
declared that his first priority is a set of active policies for economic
recovery has produced a mix of reactions all too familiar to European social
democrats. On the one hand, there is genuine relief, going far beyod enthusiasm
for Clinton himself, that after years of drift and decline there is the prospect
of something being done about slow growth, rising unemployment, and decaying
social and economic infrastructure. And "something being done" in
America will have reverberations around the world.
On the other hand, there is that nagging fear that today accompanies every
progressive politician into office-- the fear that once the new administration
attempts to initiate significant economic change it will be overwhelmed by
financial crises and will be forced by "the markets" to abandon even
its more modest objectives. In the British Labour Party, the schadenfreude
induced by the September 1992, humiliation of the Conservative government in the
currency markets is accompanied by the queasy feeling that, whatever the markets
have done to the Tories, they would have done far worse to us if we had won the
April 9 election. And they might do worse to President Clinton too.
The markets, exercising their influence not just through the domestic funding
of the government debt but also in the foreign exchanges, determine the monetary
stability of the economy. Market hostility to government expenditure plans would
be expressed through falling bond prices, a falling dollar, rising interest
rates, and, in due course, the threat of a financial crisis-- imposing the
humiliation of political retreat, with plans abandoned and policies reversed. If
the markets don't like President Clinton, then their vote will be the decisive
voice in shaping the policies that he could implement. He will, accordingly, be
urged to show prudence and pursue only those sound and sensible policies
acceptable to the markets.
But who are "the markets"? What determines that awesome collective
opinion expressed through millions of independent purchases and sales? What is
the relationship, if any, between the views of the markets and what might
generally be regarded as desirable government policies on employment, industrial
investment, or trade?
Answering these questions is as important as the design of the new economic
initiatives. Getting the markets on board--ensuring, by whatever means, that
their role is supportive, not destructive--is the key to breaking out of the
economic failures of the 1980s, in America, and in all the other G-7 countries.
GLOBAL CONSTRAINTS ON U.S. GROWTH
The commitment of the new Clinton administration to an expansionary,
job-creating economic policy shines like a good deed in a naughty world.
In Japan, the government plan announced in August 1992 to reinvigorate the
economy (essentially by nationalizing part of the financial sector's debt
burden, which has restricted the expansion of lending and spending) appears to
be running afoul of political infighting. In Germany, the "sound money"
policies of the Bundesbank that seemed so successful in an era of steady growth
and competitive success are proving sharply deflationary at a time when the
country is trying to deal with the massive economic shock of reunification. In
France, the high real interest rates that are believed to be necessary to
maintain the "franc fort" policy are pushing the country into
recession. In Italy, the Amato government has staked its political future on
deflationary fiscal reform. In Britain, a Conservative administration whose
entire economic policy collapsed under the weight of currency speculation last
September is grasping at reflationary straws. But locked into its old
Thatcherite ideology, it has failed to put together a coherent program for
recovery, producing instead a mixture of contradictory and ineffectual "initiatives."
It is the coherence of Clinton's approach that marks a decisive shift away from
the economics of the Reagan/Thatcher era (of which George Bush and John Major
were the ineffectual heirs). That shift is marked by a determination to put
growth and jobs first and by the conviction that recovery requires an active,
constructive partnership between government and the private sector, in place of
the simplistic slogans of minimalist government and the omniscient market.
The core of the economic proposals made during Clinton's campaign were directed
toward two interdependent goals: job creation and the enhancement of the
competitive base of the U.S. economy by long-term investment in new productive
capacity, in education and training, and in infrastructure. The emphasis is on
restoring America's lost competitiveness in international markets. The true
indicator of that competitive failure is the persistent deficit on the current
account of the U.S. balance of payments--the amount Americans must borrow from
abroad to maintain even today's very slow rate of growth. The higher rate of
growth necessary to achieve the new president's job-creation targets will widen
the current account deficit with the rest of the world.
In the domestic economy, there will be a race between the revenue-generating
benefits of growth and the deficit-enhancing expenditures intended to make that
growth possible. In the international economy, there will be a race between the
expansionary investment necessary to improve competitiveness and the
deterioration in the current account that expansion will inevitably bring, as
higher domestic growth stimulates imports.
The two races are really just one contest. If American industry were so
competitive that none of the growth-inducing government expenditure leaked
overseas into imports from abroad, then the increased incomes derived from
government spending would generate the extra taxes and the extra savings needed
to fund any addition to the public deficit. That leakage overseas, due to lack
of competitiveness, means that taxes and savings are generated outside America
and need to be borrowed back. The leakage weakens the impact of government
spending on the real economy, and the financial impact of higher overseas
borrowing threatens to restrict the scope of Clinton's program.
But the restoration of competitiveness, necessary though it is, will not be
enough to secure long-term, sustainable growth. Enhanced competitiveness,
conventionally defined, essentially involves capturing markets and jobs from
trading partners--shifting the unemployment around the world--rather than
creating new prosperity within the western economic system as a whole. In a
period in which every government is facing the political pressures of recession,
enhanced competitiveness in one country may well produce self-protecting
retaliation in others--just think of the tensions now in U.S.-Japanese trade
To achieve his goals, Clinton needs to break out of this international game of
pass the unemployment. He needs to create an economic environment in which
expansion at home is not wrecked by pressures in the international money
markets. That requires the creation of a new growth-oriented framework for the
world economy and the establishment of international monetary stability where
instability is now the rule.
The omens are not good. Apart from the occasional debt-driven bubble, economic
performance in the 1970s and 1980s has been poor throughout the industrial
nations of the OECD (Organization for Economic Cooperation and Development). In
every one of the G-7 countries, growth in the 1980s was about half that in the
1960s. Unemployment in every G-7 country has at least doubled. In Canada,
France, Italy, Britain, and the U.S., the trend inflation rate has also doubled.
Productivity growth in manufacturing industry is sharply down.
FROM MANAGED STABILITY TO DEREGULATED INSTABILITY
The very pervasiveness of economic underperformance suggests that something has
gone badly wrong in the workings of the international economy as a whole,
transcending the particular experience of individual countries.
To pick just one or two factors as the fundamental causes of the economic
deterioration of all the G-7 countries is, perhaps, somewhat ambitious. Economic
growth is a complex, interactive process in which uni-causal explanations are
likely to be naive and simplistic. Nonetheless, it seems clear that, as far as
the international economy is concerned, two fundamental institutional changes
mark a clear break between the 1960s and 1980s: first, the Bretton Woods system
of fixed exchange rates of the 1960s versus the post-Bretton Woods floating-
rate, market-driven 1980s; second, the regulated financial markets of the 1960s
versus the deregulated global markets of the 1980s.
There has been extensive analysis of the inability of the post-Bretton Woods
trading and payments system to deal with international trading imbalances other
than by deflation in weaker countries--a deflationary impulse that has proved
contagious. Less attention has been paid to the fact that this deflationary
pressure is reinforced by the huge growth in short-term capital flows, by
Financial markets are today dominated by short-term flows that seek to profit
from changes in asset prices and currency shifts--in other words, from
speculation. The growth in the scale of pure speculation, relative to other
transactions, has been particularly marked in the foreign exchange markets over
the past twenty years. In 1971, just before the collapse of the Bretton Woods
fixed exchange rate system, about 90 percent of all foreign exchange
transactions were for the finance of trade and long-term investment, and only
about 10 percent were speculative. Today those percentages are reversed, with
well over 90 percent of all transactions being speculative. Daily speculative
flows now regularly exceed the combined foreign exchange reserves of all the G-7
The explosive growth of short-term speculative flows originated in a powerful
combination of the carrot of potential profit and the stick of financial risk.
To an important extent, speculation is an inevitable outcome of the abandonment
of fixed rates. Under the Bretton Woods system, there was little profit to be
had in speculation, since currencies moved only in tight bands, apart, that is,
from the very occasional change in parity. Indeed, the Bretton Woods system
provided quite remarkable stability.
For example, the core currencies of the European Monetary System, locked
together today in their Exchange Rate Mechanism (ERM), enjoyed greater stability
in relation to one another during the Bretton Woods era than they have been able
to achieve since 1979 within the ERM. In the face of Bretton Woods stability, it
was not worthwhile maintaining the large-scale currency dealing facilities with
which we are familiar today; even if the contemporary regulatory structures had
not placed other significant barriers in the path of short-term capital flows.
However once Bretton Woods had collapsed, and significant currency fluctuations
became commonplace, opportunities for profit proliferated. Regulatory structures
that inhibit flows of capital were then challenged as "inefficient"
and "against the national interest" and "unmarketlike"--and
the infrastructure of speculation was rapidly expanded. The Bretton Woods system
was finally abandoned in 1973. The U.S. announced the elimination of all capital
controls in January 1974.
The incentive to deregulate international capital flows, created by the
abandonment of fixed rates, was reinforced by the need to hedge against the risk
of fluctuating exchange rates. Under the Bretton Woods system, foreign-exchange
risk was borne by the public sector. With that system's collapse,
foreign-exchange risk was privatized.
This privatization of risk imposed substantial strains on the domestic and
international banking systems. The need to absorb and cover foreign-exchange
risk demanded the creation of new financial instruments, which in turn required
the removal of many of the regulatory barriers that limited the possibilities of
hedging risk. That, in turn, required a further deregulation of financial
Combined with other, domestic, pressures for the removal of financial controls,
the collapse of Bretton Woods was a significant factor driving the worldwide
deregulation of financial systems. Exchange controls were abolished. Domestic
restrictions on cross-market access for financial institutions were scrapped.
Quantitative controls on the growth of credit were eliminated, and monetary
policy was now conducted predominantly through management of short-term interest
rates. A global market in monetary instruments was created. All of this, of
course, invited further speculation.
Today the sheer scale of speculative flows can easily overwhelm any
government's foreign-exchange reserves. The ease of moving money from one
currency to another, together with the ease of borrowing for speculative
purposes, means that enormous sums can be shifted across the exchanges,
especially for short periods of time. Prior to the recent run on sterling, the
British government boasted of a $15 billion support facility it had negotiated
in deutschmarks, to be used to defend the parity of the pound. Yet that sum
would be matched a few weeks later by the sales of sterling of just one
prominent player in the foreign exchange markets.
THE NECESSITY OF CREDIBILITY
These huge flows not only increase market instability. They also tend to induce
governments to pursue deflationary policies. The overwhelming scale of such
potential flows means that governments must today, as never before, keep a
careful eye on the need to maintain market "credibility," even at the
expense of more substantive policies affecting the real economy. A credible
government is a government that pursues a "market friendly"
policy--one that is in accordance with what the markets believe to be "sound."
Sound often turns out to mean deflationary. Governments that fail to pursue "sound"
and "prudent" policies are forced to pay a premium on the interest
costs of financing their programs. Severe loss of credibility leads to a
financial crisis. But a government's credibility is often less the result of the
soundness of underlying policies and more the product of the way that
speculative markets actually work.
In his General Theory, John Maynard Keynes likened the operations of a
speculative market to a beauty contest. He had in mind a competition then
popular in the British Sunday tabloids in which readers were asked to rank
pictures of young women in the order which they believed they would be ranked by
a "celebrity panel." To win, then, the player expressed not his or her
own preferences but the preferences he or she believed were held by the panel.
In the same way, the key to playing the markets is not what the individual
investor considers to be the virtues of any particular policy but what he or she
believes everyone else in the market will think.
Since the markets are driven by average opinion about what average opinion will
be, an enormous premium is placed on any information or signals that might
provide a guide to the swings in average opinion and as to how average opinion
will react to changing events. These signals have to be simple and clear-cut.
Sophisticated interpretations of the economic data would not provide a clear
lead. So the money markets and foreign exchange markets become dominated by
simple slogans--larger fiscal deficits lead to higher interest rates, an
increased money supply results in higher inflation, public expenditure bad,
private expenditure good--even when those slogans are persistently refuted by
events. To these simplistic rules of the game there is added a demand for
governments to publish their own financial targets, to show that their policy is
couched within a firm financial framework. The main purpose of insisting on this
government commitment to financial targeting is to aid average opinion in
guessing how average opinion will expect the government to respond to changing
economic circumstances and how average opinion will react when the government
fails to meet its goals.
So "the markets" are basically a collection of overexcited young men
and women, desperate to make money by guessing what everyone else in the market
will do. Many have no more claim to economic rationality than tipsters at the
local racetrack and probably rather less specialist knowledge. Over time, the
value of currencies may reflect the condition of the real economy; in this sense
average opinion is influenced by the likely impact of government policies on
growth and productivity or by long-term trends in international trade. But at
any given moment, average opinion is also guided by fads and rumors, political
fashion and prejudice; it is often swept up in bubbles, fevers, and manias.
These, of course, have real and persistent economic costs.
DEFLATION AND MINIMAL GOVERNMENT
The need for consistent, stable "signals" to guide average opinion
would be provided by the operations of the real economy if, and only if, the
real economy tended to adjust toward a well-defined equilibrium. The idea that
the economy is ultimately self-adjusting toward a full-employment equilibrium is
fundamental to the monetarist dogma that has dominated economic policymaking in
the West for the past decade. In a radio talk given in 1934 in which he firmly
rejected the self-adjusting ideology, Keynes spelled out the sources of its
On the one side are those who believe that the existing economic system
is, in the long run, a self-adjusting system, though with creaks and groans and
jerks, and interrupted by time lags, outside interference and mistakes ....On
the other side of the gulf are those who reject the idea that the economic
system is, in any significant sense, self-adjusting....
The strength of the self-adjusting school depends on its having behind
it almost the whole body of organized economic thinking and doctrine of the last
hundred years. This is a formidable power. It is the product of acute minds and
has persuaded and convinced the great majority of intelligent and disinterested
persons who have studied it. It has vast prestige and a more far-reaching
influence than is obvious. For it lies behind the education and habitual modes
of thought, not only of economists, but of bankers and businessmen and civil
servants and politicians of all parties.
The self-adjusting view is also at the core of the idea that speculation is
ultimately benevolent. Once it is assumed that the market economy is driven by
strong self-adjusting forces, then it follows that even the occasional
speculative overshoot or "bubble" will in due course return to the
real equilibrium, leaving destabilizing speculators with their fingers severely
burned. In these circumstances, it is irrational to regulate capital flows.
Deregulation supposedly will lead to a more efficient allocation of capital, a
greater availability of capital for productive investment in enterprises of all
sizes, and hence result in higher levels of investment and growth and enhanced
Of course, financial deregulation, domestic and international, has brought none
of these benefits. As well as being associated with lower growth and higher
unemployment, financial deregulation has led to a rapid increase in corporate
and consumer debt, and significantly greater instability in interest rates,
exchange rates, and the availability of credit.
All this is not surprising if we recognize that the economy is not
self-adjusting. Markets are just as likely to settle in a low-growth,
high-unemployment equilibrium, as in any other state. Keynes pointed out that
the idea of self-adjustment was convincing only because of a common confusion
between the efficiency that the market may impose on the operations of an
individual firm and the fact that the market does not ensure that the economy is
operating efficiently as a whole. In Keynes's characterization of the operations
of a market economy, it is clear that speculation may well be an important
factor driving the economy toward a low-growth, high-unemployment equilibrium.
The markets are neither omniscient nor benign. When their influence is combined
with the persistent search for government credibility, defined in terms of "sound
money" and "prudent" deflationary policies, then the low level
position is virtually assured.
The deflationary pressures created by deregulated speculative markets have not
been felt only through their impact on government policy. Financial instability
also has a severe impact on the ability of companies to invest with confidence,
and indeed, on their ability to survive. The chart, "U.S. Corporate Default
Rates," which is taken from a study entitled Prosperity or Decline
by Giles Keating and Jonathan Wilmot of the London office of Credit Suisse First
Boston, shows the default rate of U.S. companies over the past seventy years.
The striking element in the pattern of default is the very low default rate
between the end of the Second World War and the collapse of the Bretton Woods
system. The corporate survival rate was determined by a combination of
macroeconomic steady growth (although growth rates in the Eisenhower years were
not particularly high) and the microeconomic benefits of the financial stability
created by Bretton Woods.
Under a fixed-rate system, an adjustment of the rate results in a new pattern
of international prices which can be used, with reasonable confidence, as a
framework for long-term decision making. But in a fluctuating system, the same
absolute change will not be expected to persist in the same way and therefore
will be less of a reliable signal for long term investment planning. The
constant variation of exchange rates as a means of adjusting to differences in
international competitiveness, by its very nature, increases uncertainty,
exaggerates the psychology of speculative movement, and creates more extreme
swings in currency values than are really appropriate--a further contribution to
A NEW STABLE REGIME FOR TRADE AND FINANCE
The policy proposal that would seem to flow from this argument is that there
should be a return to Bretton Woods--not just the fixed rate system but the
ideological commitment to expansionary, full-employment policies and the limit
on speculative monetary movements that accompanied it. As far as the ideology is
concerned, the very election of the Clinton administration on a platform
committed to change is an important step in the right direction. Reworking
Keynesian economics for today's world will provide the hard-edged analytical
underpinning for that platform.
But "back to Bretton Woods" is not a feasible proposition. The
Bretton Woods system rested on the economic dominance of the United States. That
economic dominance produced a worldwide desire for dollar reserves and the
consequent ability to fund international imbalances by flows of U.S. capital.
Bretton Woods was not a multilateral system. It was U.S.-led and was therefore
incapable of dealing with the imbalances caused by the relative economic decline
of the U.S. itself.
Neither of the new economic great powers, Germany and Japan, occupies a
position comparable to that occupied by the U.S. in the immediate postwar
period. Leaving aside the temporary impact of reunification, Germany has run a
large and persistent current account surplus for the past thirty years. But
long-term capital flows out of Germany have never been sufficient to fund the
counterpart deficits in other countries, in the way that U.S. capital flows did
in comparable circumstances. As for Japan, the yen has not achieved the role in
international trade played by the dollar even today, especially in third-party
transactions. While Japanese exports amount to 16 percent of total G-7 exports,
only 7.5 percent of G-7 exports are invoiced in yen. By contrast, 42 percent of
G-7 exports are invoiced in dollars, even though the U.S. is the source of only
21 percent of those exports.
So a "new Bretton Woods" must be a genuine multilateral arrangement,
forged out of the current G-7 and dominated by the leaders of the world's three
main currency blocks, Germany, Japan, and the U.S. At the core of that new
system should be a renewed commitment to currency stability, which is necessary
to underwrite the coordinated international expansion needed to avert worldwide
recession. The largely ceremonial summits of the G-7 would need to be replaced
with meetings that actually deal with substantive issues. A permanent
secretariat should be created with the skills and authority to manage the
international payments system.
It is often argued that a new stable currency system is simply not feasible in
a world of deregulated finance linked by the modern technology of the money
markets. This argument fails to take into account the fact that fluctuating
rates are themselves the motive force behind the very existence of large-scale
speculative infrastructure and the product of deliberate policy decisions to
deregulate. Moreover, the recent successful defense of the French franc by the
combined efforts of the Banque de France and the Bundesbank confirms the fact
that full central bank cooperation can defeat speculative attacks. The
speculators may be able to borrow very large sums for short periods of time. The
central banks, as the creators of currencies, can, if necessary, provide
indefinitely large sums for just as long.
It will not, of course, be possible to create a new stable system if there are
persistent trade imbalances between the G-7 that are not funded by long-term
capital flows. Today the fundamental imbalance is between the U.S. and Japan.
European Community trade is broadly balanced--and has been for more than the
past decade. The yen losses suffered on Japanese financial investments in the
U.S., combined with current difficulties in the Japanese financial sector, both
suggest that financing a persistent U.S. deficit is going to prove more
difficult in the 1990s than it did in the 1980s. Sustained growth and expanding
trade will therefore require action to correct the trade imbalance between the
U.S. and Japan. Otherwise, there will be either persistent instability or the
stability of permanent recession.
A G-7 agreement to buttress economic policy coordination with a framework of
stable exchange rates must be reinforced by action to monitor and perhaps
regulate short-term international capital flows. All governments were clearly
shaken by the scale and ferocity of last September's speculative attacks on the
European Community's Exchange Rate Mechanism. At the IMF and World Bank annual
meetings in the week following the forced devaluation of sterling, U.S. Treasury
Secretary Nicholas Brady argued that "there is a clear need for a better
understanding of the changing face of financial markets and the implications for
the international monetary system." Brady proposed "an examination of
global capital flows, their size and movements."
Attempting to maintain stability in international currency markets under the
current deregulated regime is like trying to cross an uneven field carrying a
large volume of water in a shallow pan. It would be much easier if the pan
contained a number of baffles to prevent all the water slopping in unison from
side to side. Financial baffles are needed to slow down the rush of short-term
capital from one currency to another.
The technical problems involved in creating suitable baffles in the
international financial markets are greatly exaggerated. The fact that trading
today is typically by electronic transfer makes effective monitoring far easier
than ever before; with international agreement, it would not be too difficult to
link the legal right to trade to the requirement to accept appropriate
monitoring. Effective monitoring is the starting point of effective management.
Both will be possible only if there is full and consistent cooperation among the
The real problems are political. The people and the institutions who have
benefited most from financial deregulation are characteristically some of the
most successful and powerful in every country. They can erect the most
convincing cases, economic and political, to demonstrate that deregulation is
economically efficient, is in the national interest, and that attempts to
regulate the markets won't work anyhow. The "neutral" wisdom of the
markets will be contrasted to the bungling of the interfering and venal
politician. The fact that unregulated markets have proved to be remarkably
inefficient will be carefully glossed over. Persistent recession will be blamed
on anyone and anything other than the markets.
However, the fact that the markets are led by average opinion, rather than by
economic reality, means that they can be led. A powerful political case
presented within a coherent ideology, underwritten by clear economic analysis,
reinforced by firm action can lead opinion and so change the parameters of
MARKETS AND GOVERNMENTS RESTORING BALANCE
Fundamental to the new position must be the resolve that speculative disruption
of employment and growth policies is unacceptable. The attainment of stability
will, in itself, lessen the profitability of a large speculative infrastructure.
But if the money markets cannot be led to support a coherent growth strategy, if
they cannot be persuaded to come on board, then they must be obliged to come on
board. Regulation has proved to be a necessary part of an international growth
strategy in the past. It may well be necessary again.
The monetary instruments that markets trade are issued by governments, and
ultimately their value is dependent on the power and authority of governments.
And governments determine the legal framework without which no financial
institution can operate. Hence governments control the very existence of
financial institutions. It is ludicrous to suppose that governments cannot, if
they collectively so desire, reregulate the operations of the international
money markets. If the G-7 were determined to achieve that goal, they have the
means--whether through stiffer margin requirements on the banks, taxes on
short-term turnover, or direct capital controls--to ensure that their wishes are
not subverted "offshore."
Creating the international environment necessary for the attainment of his
domestic goals is therefore a major challenge to President Clinton. He will be
facing an economic and financial establishment distinguished by an unfailing
faith in the power and wisdom of the markets. That faith has propelled nearly
twenty years of economic change in which short-term financial advantage has
always been elevated over long-term real investment. The results--low growth,
high unemployment, crumbling social and economic infrastructure--are there for
all to see.
That unambiguous economic failure, and the political malaise it has generated,
is Clinton's trump card. No one can claim the system is working. He was elected
to change it. If he is to succeed, the markets must be the servants of economic
policy, not the masters.
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