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I

Ever since Adam Smith in the 18th century extolled the prospects for mutual gain inherent in free trade between nations, economics textbooks have tended to classify economic policies as either "welfare-enhancing" or "welfare-reducing." One implication of this tradition is that a macroeconomic policy ought to be judged on the basis of whether it provides broad benefits for those who live under the regime that implements the policy. In the last quarter of the 20th century, however, outside the realm of textbooks and inside the realm of practice, the merits of economic policies have come to be determined by the extent to which they adhere to neoliberal orthodoxy–the absence of government restrictions or regulations–regardless of their impact on the generation of wealth through productive activity or the distribution of that wealth. The rise of global finance in this period has all but severed the link between capital and its productive use, has privileged the freedom to engage in short-term speculation over the pursuit of policy goals such as full employment, and in the process has threatened the livelihoods of those who lack the means to exploit financial markets.

In response to the global cataclysms that followed in the wake of the American stock market crash of 1929–the Great Depression and the Second World War–international authorities were compelled to construct a financial architecture that would provide economic stability and pursue full employment as one of its chief objectives. Those efforts resulted in the Bretton Woods regime, a system of fixed exchange rates and relatively strict controls on international capital movements which would last until 1973. James Crotty and Gerald Epstein (1996) refer to this period as the "Golden Age of modern capitalism," the "age of the ’social contract’ or capital-labour ‘accord’ … under which the Keynesian state, with the acquiescence of capital, was to pursue full employment and build a stronger social safety network" (p. 118). During Bretton Woods, the international financial system assumed "its historical role of stimulating real activity, funding real investment" (Eatwell and Taylor 2000, p. 27).

By the late 1960s, however, it became clear that the United States was unwilling to forego policy autonomy indefinitely in order to shore up the international financial system. The United States’ bias toward fiscal expansion in the ’60s (to maintain a full employment situation, fund the war in Vietnam, and establish the "Great Society") forced the other members of the system to "import" inflation, and undermined the sustainability of the regime (Krugman and Obstfeld 1996, ch. 19). The collapse of Bretton Woods in 1973, then, provided the impetus for new theorizing about how liberalization of international capital flows–anathema to Bretton Woods–might more efficiently benefit the global financial system.

According to Robert Blecker (1999), such theorizing bases its conclusions on three central arguments. First, open capital markets increase allocative efficiency. "If the excess savings of some countries can freely flow to borrowers in other nations," he writes, "then total world savings should find their most beneficial uses, and the entire world economy should be more productive as a result" (11). For example, if there are profitable projects in Argentina that can’t be financed by Argentine savings, but there are excess savings in Japan (due to an absence of productive investment opportunities), in the name of productivity and efficiency those savings ought to be allowed to flow to Argentina. Second, financial liberalization enhances financial services, providing investors with new ways to diversify their assets and reduce their exposure to risk. Reducing the overall amount of risk in the financial system is assumed to be globally beneficial. Finally, financial liberalization is seen as imposing discipline on governments, ensuring that they maintain "sound fundamentals" particularly in terms of avoiding profligate fiscal and monetary policies. Investors will withdraw their favor from governments who pursue unsound policies.

Joseph Stiglitz¹ summarizes the arguments in favor of financial liberalization as being "based on standard efficiency arguments"–"capital market liberalization leads to higher output and greater efficiency" (2000, 1077). To Blecker’s summary, we can add Stiglitz’s observation that liberalization advocates believe countries pursuing their economic well-being ought to be concerned with maximizing GNP (income), not GDP (production output). That is, if a country’s citizens see more productive investment opportunities outside their country’s borders, they ought to be free to pursue them–their gains can be expected to redound to the economy at large. International competition for funds also leads firms to greater efficiency among businesses, resulting in widespread benefits, again according to the "standard efficiency" model. Along the lines of the argument from the point of view of financial services indicated by Blecker, Stiglitz writes that investors’ freedom to diversify is seen by the pro-liberalization camp as having stabilizing effects. For example, if an economy experiences a downturn resulting in lower wages, the freedom of funds to flow into that economy to take advantage of the new situation can help to remedy the downturn.

Given the durability of the pro-liberalization arguments–they provided the rationale for the "Washington Consensus" that would form the basis for international economic policy at least until Argentina’s financial collapse in 2001–one might expect that the truth of those arguments has been borne out in practice. Almost from the beginning, however, full financial liberalization has proven destructive to the economies that have implemented it. The Southern Cone of Latin America provided a laboratory for experimentation with liberalization policies during the years of transition out of Bretton Woods. Argentina, Chile, and Uruguay all implemented drastic liberalization reforms in the 1970s, and those experiences were marked by volatility, crisis, and poor economic performance. Some common policy features in these cases included a pegged exchange rate and the absence of government regulation in the real side of the economy, the financial sector, and especially the international capital market. With these features in place, the economies were exposed to pro-cyclical dynamics, in which both capital inflows and outflows tended to be self-reinforcing, resulting in speculative bubbles and inevitable busts. Initial periods of strong growth were followed by stagnation, subsequent financial fragility, and finally crisis (Frenkel 2003, 7-8).

Examining the cases in more detail, with financial liberalization we see an initial period of foreign capital inflows, which spurred the growth of the monetary base, bank deposits and the extension of credit. Next, there was a rapid appreciation of domestic financial and real asset prices, expansion of domestic demand, production and imports. Reserves continued to accumulate, but the increased demand for imports led to a widening trade deficit, which eventually became large enough to cause reserves to contract. Interest rates were increased in order to continue to attract foreign capital, which led to domestic illiquidity and insolvency. Interest rate increases exacerbated expectations of devaluation, which were in turn motivated by the persistent growth of the current account deficit. Eventually there was a run on central bank reserves, the exchange rate regime collapsed, and a devaluation was forced (Frenkel, 10-11).

The destructive consequences of full financial liberalization did lead to the emergence of a revisionist "sequencing literature" within the discipline of development economics, which continued to argue in favor of liberalization, but which suggested that certain real-sector reforms must precede it. Whatever the merits of this literature, it was curiously ignored when Latin America recovered from its "lost decade" of economic stagnation (the 1980s) and interest in free capital flows to the region gained momentum once again. As the case of Argentina’s most recent crisis amply demonstrated, the same mistakes were made with essentially the same (if even more ruinous) consequences (Frenkel 8-9).

Looking at the situation with a broader perspective, we can see that during the last few decades of financial liberalization in developing countries, the promised benefits have not been delivered. The presumption that funds would be channeled from rich countries to poor ones, where unexploited investment opportunities abound, has no counterpart in reality. The cost of capital is systematically higher in those countries than in the industrialized countries (Frenkel 2003, 17). Writing in 2003, Stiglitz noted that "the global financial system has allowed the United States to become the largest borrower in the world, absorbing about US $40 billion per month to finance a consumption binge amidst declining investment and savings." When funds did go toward emerging economies, they did so only in a few outstanding examples, such as China, not to countries most in need such as those in sub-Saharan Africa (Stiglitz 2003). Indeed, in the 1990s, countries that resisted pressure for liberalization (such as Chile and Colombia), employing such strategies as moving bands of exchange (to maintain a competitive real exchange rate) and otherwise regulating capital flows fared far better than liberalizing countries like Argentina, Brazil, and Mexico (Frenkel 2003, 15). Contrary to neoliberal theorizing, Stiglitz has shown how liberalization has promoted short-term capital flows that do not provide a solid basis for investment in productive, sustainable projects. Against neoliberal expectations, restrictions on capital flows have not had negative effects in terms of discouraging FDI or longer-term investment, as the cases of China, Chile and Malaysia show. Indeed, it is the volatility associated with liberalization that has discouraged such investment (p. 1080). Stiglitz has also shown how the neoliberal analogy that equates free capital markets with free markets for goods breaks down when we examine the extent to which the former are "plagued by severe information problems that are not found in ordinary trade in goods and services" (Blecker 1999, p. 17). Problems of incomplete information, incomplete markets, and incomplete contracts in these markets tend to encourage the kind of herd behavior that produces asset bubbles and panics.

II

While developing countries, particularly those in Latin America, provide perhaps the most interesting case studies for the impact of financial liberalization, these countries are not the only ones for which the opening of capital markets is problematic. The ill effects have been far more general. In this respect it’s worth quoting at length from John Eatwell and Lance Taylor’s 2000 study Global Finance At Risk: The Case for International Regulation:

Since the 1970s, the deregulated financial framework encouraged policies that elevate financial stability above growth and employment. This ratcheted up real interest rates which have in turn reduced domestic investment, reduced the growth of world trade, and slowed the rate of growth of effective demand. … High and volatile interest rates together with other uncertainties have reduced the potential return on investment and cut into the cash flow that finances investment. Public sector policymakers, seeking safety in a volatile financial world, set their objectives in terms of financial stability and hope that some stimulus may be forthcoming from the private sector (p. 119-120).

If the United States has been spared many of the worst effects of this downward adjustment, it is due largely to the international role of the dollar: undertaking expansionary fiscal and monetary measures within the U.S. does not pose the same dangers that it does for other countries (p. 121). Nonetheless lack of attention to the excesses of global financial deregulation has resulted in imbalances that are dangerous to all members of the international financial system, including the United States. As noted above, capital now flows primarily from poor countries to rich countries, especially the United States, textbook models to the contrary. Savings in countries with weak or developing economies is up in recent years, reflecting many factors, among them the lack of attractive investment opportunities and the difficulty of borrowing in countries that lack financial sophistication. The U.S. savings rate, on the other hand, has actually turned negative (-0.6%–the lowest rate on record), contributing to the country’s unprecedented $700 billion current account deficit: 6% of GDP. A recent survey of the global economy undertaken by The Economist (2005) is helpful in understanding this state of affairs:

Most of the time, mismatches between the desired levels of saving and investment are brought into line fairly easily through the interest-rate mechanism. If people’s desire to save exceeds their desire to invest, interest rates will fall so that the incentive to save goes down and the willingness to invest goes up. Across borders, exchange rates have a similar effect. If a country has a saving deficit, its currency will fall to the point where its assets are cheap enough to lure foreign savings in. … Classical economic theory suggests that interest rates automatically bring saving and investment into a productive balance. The central principle of Keynesianism, however, is that this alignment between saving and investment is not always automatic, and that a misalignment can have serious consequences. (8)

The survey goes on to note that while classical economic theory is applicable in the long run, "in the short term, firms’ appetite to invest is volatile, and policymakers may need to step in to shore up demand"–exactly the sort of Keynesian principle that is so unpalatable to neoliberal orthodoxy. Yet clearly the current global savings-investment equation is severely misaligned.

What is troubling is not necessarily the size of the current account deficit, but its composition. While the American economy is indeed dynamic, efficient and productive relative to many others, the inflows of capital into the United States are not financing productive investment, particularly since 2000. Rather than buying American shares or investing in American factories, foreigners are purchasing American bonds, thus financing an American consumption binge. The United States has become the world’s "consumer of last resort … saving too little and not investing enough in productive assets, especially in the export sector. Its economic health depends too heavily on housing wealth" (Economist 2005, 21). Indeed much of what’s behind the United States’ negative savings rate is the ease with which home owners can borrow against the value of their homes, through such financial innovations as home equity loans (Palley, 2000).

That the U.S. is currently assuming the role of "consumer of last resort" based largely on the ability to draw on (possibly) inflated real estate wealth leaves the global economy in a precarious position. To signal just one source of risk, much of the U.S. current account deficit is due to Asian central banks (chief among them China) who purchase dollars to maintain their own currencies low. If Asia loses its appetite for American dollars, U.S. interest rates could rise significantly and become one of a few possible factors (another being high fuel prices) that could curb U.S. consumption and send the global economy into a tailspin (Economist, 21).

III

It seems clear that the failure of economic indicators to maintain a reasonably close relationship with the productive use of capital–the "real" side of the economy–has imposed grave risks upon the global economy. Currency exchange markets may provide the best illustration for this disconnect. According to a standard textbook treatment of currency values, "when the quantity of any commodity supplied exceeds the quantity demanded, its price drops. When the supply of dollars needed for imports [comes] to exceed the demand for dollars needed by foreigners to purchase U.S. exports, the dollar [falls]. It [can] not … defy the rules of economic gravity" (Heilbroner and Thurow 1998, 207). Eatwell and Taylor point to the Salter-Swan model in which an exchange rate fluctuates relative to the price of non-traded goods in an economy (e.g., haircuts, the products of unskilled labor). Under this model, devaluing a currency reduces imports and stimulates import-competing and export industries, thus reducing the trade deficit. The exchange rate thus "clears" the trade account (p. 70). But in a context of capital market deregulation–when annual currency trading is eighty times as large as the yearly value of foreign trade and long-term investment, the trade account–an index of relative productive activity in an economy–no longer determines exchange rates: either it "is fixed by the authorities or it is determined in asset markets" (p. 71).

Keynes described the logic of this flight into what might be called the "unreal" as the result of subjecting financial markets to a "beauty contest" in the particular sense of the 1930s British newspaper phenomenon in which the player must anticipate "what average opinion expects average opinion to be," rather than casting a vote based on the merits of the subject at hand (Eatwell and Taylor 2000, p. 12). That is, success in financial markets is not based upon the real virtues of any financial asset but upon correctly anticipating the beliefs of others about those assets.

The "beauty contest" is key to understanding the underlying logic of speculation that tends to undermine any of the presumed benefits of financial liberalization. Basing investment decisions an average opinion rather than on the underlying value proposition has several consequences that are detrimental to sustainable economic development. As noted above, one is the tendency toward herd behavior that amplifies the business cycle, producing asset bubbles and destructive crashes, and indeed the kind of virulent contagion seen during the East Asian and Tequila crises of the 1990s (Blecker 1999, p. 17). Another is a short-term investment outlook that does not support productive investment in projects which need longer time horizons to become profitable. As Ilene Grabel (1998) notes:

Financial instruments afford the apparent protection of instantaneous withdrawal of funds by transforming illiquid real-sector investments in plant and equipment into financial claims that can trade hands as quickly as the institutional and technological structures permit. … A corollary of these opportunities, of course, is the diminution of the duration of financial ‘commitments’. The relative independence of financial-asset values from underlying ‘fundamentals’ imparts an extreme variability to these values. Indeed, the successful financial investor need be little concerned with the long-term profitability of the firms whose equities she buys and sells. (p. 225)

Additionally, in situations of complete financial liberalization, the problem of short-termism is exacerbated by the incentives to shift funds away from longer-term investments. As Eatwell and Taylor note, "the competition between institutional investors manifests itself as an ongoing race to demonstrate superior returns in order to attract more funds. Successive high short-term gains are more effective in this respect than longer-term gains" (p. 183). Even more problematic are situations in which this incentive compels firms normally engaged in productive enterprise to shift resources from that activity to opportunities for short-term gains Again, Grabel is instructive:

On the demand side, financial and erstwhile non-financial corporations, ranging (for example) from insurance to industrial manufacturing enterprises, may feel compelled to chase the higher returns apparently available through financial speculation, and they may come to divert resources from their primary activities to the financial arena. … A financial institution that does not validate these new speculative activities in the context of a boom may face slower growth of its capital base and a loss of market share. … In this context, even formerly ‘prudent’ financial institutions may be impelled toward speculative financing. These institutions may also be driven to abandon financing of real-sector activities. (p. 226).

IV

So what is to be done to address these problems, restore balance to, and reduce the amount of risk in the global economy? First it is necessary to recognize that there are powerful interests that benefit from the current state of affairs, and identify the extent to which they propose a political obstacle to reform. As Blecker notes, financial liberalization has been "driven in no small measure by interest group pressures, most notably from the financial industry itself (large banks, brokerage houses, mutual funds, insurance companies, and other financial institutions)" (p. 10). In general, it is easy to understand why such groups prefer the deflationary policies that place a premium on fighting inflation (and thus contrast with expansionary full employment policies): such policies preserve the value of financial assets (p. 25). Logically inflation tends to redistribute income from creditors to debtors.² Moreover, as Eatwell and Taylor note, "free international capital markets appear to go hand-in-hand with high real interest rates, that is, high returns to rentiers" (33). In advocating for the implementation of capital controls and full-employment policies, Crotty and Epstein recommend the construction of a "coalition of interests between labour and fractions of industrial and commercial capital against the parasitic interests of rentiers" (p. 121). Regardless of the political feasibility of such a coalition, recognizing that the interests of the financial industry do not necessarily correspond to those of the public at large is a first step.

It is also important to recognize the ideology behind the push for financial liberalization, which doesn’t admit empirical evidence that challenge its precepts. Again Eatwell and Taylor are most instructive here:

In many cases the assumed superiority of a liberal market strategy derives not just from conventional theory but also from a belief in the inherent economic incompetence and even venality of governments–an unflattering picture that some governments seem to have adopted about themselves. Of course, a number of examples exist which justify pessimism. But examples of bad and incompetent policy are not sufficient reasons to hand the future of the economy over the liberalized markets that render systematic policymaking impossible. Rather they should encourage the creation of an environment in which good and competent policy can be effective. (p. 138)

Once we realize that government must play a constructive role in overcoming the risks and imbalances that threaten the global economy, we can consider policy options in more detail.

The first order of business on this count would be to consider measures to restore the very ability of governments to conduct macroeconomic policy. Governments have been drastically weakened in this sense by liberalization. In the case of the United States, previously macroeconomic policy goals were achieved when the Federal Reserve altered the level of bank reserves. The demand for those reserves in turn causes interest rate adjustments. Its ability to effect such changes so has been undermined by the fact that the reserve requirements for banks have been reduced, but more importantly by the fact that with the financial innovation that has attended liberalization, banking assets now represent a much smaller share of overall financial sector assets than they once did. For example, the practice of banks "sweeping" their customer’s money into market funds, not subject to reserve requirements is now widespread. Restoring the influence of reserve requirements would be an essential measure here. According to a plan proposed by Thomas Palley (2000), a system of asset-based reserve requirements could even permit a government to address sectoral or regional imbalances by varying the level of such requirements.

Beyond restoring the ability of individual governments to conduct macroeconomic policy, proposals for reform are wide-ranging and far beyond the scope of this paper. A "Tobin Tax" on short-term capital flows seems to be the most modest of such proposals, and perhaps the most politically and technologically feasible. But in the spirit of this paper, I would like to suggest that proposals for a new financial architecture that would restore the link between the productive aspects of economy and its financing are the most compelling. Paul Davidson’s (1997) notion of an International Clearing Union (based on an earlier proposal by Keynes) is one such proposal. The ICU is a system in which surplus nations bear much of the burden for balancing the global economy by being compelled spending their excess reserves on imports or direct foreign investment. Countries with deficits can then sell more abroad and thus curtail those deficits. Oversavers can no longer contribute to a lack of global effective demand (p. 682). Provision 7 of Davidson’s proposal, which outlines "a system to stabilise the long-term purchasing power of the IMCU [International Money Clearing Unit, the ultimate international reserve asset, held only by central banks]," provides for a "a system of fixed exchange rates between the local currency and the IMCU that changes only to reflect permanent increases in efficiency wages" (p. 683). According to this provision, countries capture productivity increases either by letting the exchange rate appreciate "thereby capturing the gains from productivity for its residents", or keeping the exchange rate constant, thus sharing productivity gains with trading partners, and increasing its share of world export market (p. 683). Provision 8 states that "if a country is at full employment and still has a tendency towards persistent international deficits on its current account, then this is prima facie evidence that it does not possess the productive capacity to maintain its current standard of living." That in turn signals the need for a transfer of excess credit balances or a downward adjustment in the country’s standard of living by the country’s reducing relative terms of trade (devaluation of its exchange rate) (p. 684). Davidson’s system would ensure that the global economy remains rooted in the

Economists who propose such radical restructuring of the global financial architecture are well aware that, absent a cataclysmic economic crisis like the Great Depression, their proposals are unlikely to be taken very seriously by the international community at any level but a theoretical one. But for better or for worse, given the magnitude of current imbalances, that condition could well be met in the not-to-distant future.

BIBLIOGRAPHY

Blecker, Robert A., 1999. Taming Global Finance: A Better Architecture for Growth and Equity. Washington, DC: Economic Policy Institute.

Crotty, James y Gerald Epstein (1996). “In defence of capital controls.” In Leo Panitch, ed., Socialist Register 1996: Are There Alternatives?, pp. 118–149. London, UK: The Merlin Press.

Davidson, Paul, 1997. “Are grains of sand in the wheels of international finance sufficient to do the job when boulders are often required?” The Economic Journal 107, 671–686.

Eatwell, John and Lance Taylor, 2000. Global Finance At Risk: The Case for International Regulation. New York: The New Press.

Frenkel, Roberto, 2003. “Globalización y Crisis Financieras en América Latina.” Revista de la Cepal Nº 80, agosto.

Grabel, Ilene, 1998. “Financial Markets, the State and Economic Development: Controversies within Theory and Policy.” In The Political Economy of Economic Policies, Philip Arestis and Malcolm Sawyer, eds. New York: St. Martin’s Press. "The great thrift shift: A survey of the world economy." The Economist, 24 Sept. 2005.

Heilbroner, Robert and Lester Thurow, 1998. Economics Explained. New York: Touchstone.

Krugman, Paul and Maurice Obstfeld, 1996. International Economics: Theory and Policy. McGraw-Hill.

Palley, Thomas I., 2000. “Stabilizing Finance: The Case for Asset-Based Reserve Requirements." Financial Markets and Society, August.