T he 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 relations.
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 speculation.
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 governments.
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 institutions.
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 pervasive influence:
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 stability.
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 international instability.
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 G-7 countries.
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 speculative behavior.
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.
