The coming fight over capital flows. international capital and those of working people.
international capital and those of working people. Third Way proponents talk about the
by Robert Wade
The test of a first-rate intelligence, said F. Scott Fitzgerald, is the ability to hold two
opposing views at the same time and still function. In today's convulsing economy, this
ability is essential to sanity, if not survival. One day the Federal Reserve cuts interest rates,
and the Dow jumps 350 points; the next day brings news of labor unrest in Brazil, and the
Dow plunges. One week the situation seems to be stabilizing; the next week Alan
Greenspan, chairman of the Federal Reserve, tells a group of business economists that in
his 50 years of monitoring economic events, he has never seen the kind of economic and
financial shocks that grip the world today.
As Dorothy said to Toto in the Wizard of Oz, "I have a feeling we're not in Kansas
anymore." Or as John Maynard Keynes would have said, we are in "abnormal times"
when "the [conventional] hypothesis of an indefinite continuance of the existing state of
affairs is less plausible than usual even though there are no express grounds to anticipate a
definite change, [and when] the market will [therefore] be subject to waves of optimistic
and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no
solid basis exists for reasonable calculation." In plainer English, when investors have
developed strong confidence in the conventions for forecasting, and when this confidence
is shown by events to be badly misplaced, they lose faith in the conventions and enter
abnormal times. Here, sentiment swings up and down, based on not much at all. The
swings are all the greater in a world of financial derivative instruments, which we now
know actually amplify the risks they supposedly insured against.
THE THIRD WAY
In abnormal times, people listen to prophets, and politicians aspire to prophecy.
Especially in Europe and the United States, hardly a week goes by without a public figure
hailing the coming of the Third Way, a new "postideological" route to stability and
progress. The Third Way promises to chart a path between market liberalism and social
justice, to civilize the marketplace without replacing it with big government. It is intended
to give a sense of confidence that events are, after all, under control and headed in the
right direction. "We need to have fiscal rectitude and a different role for government, as
enabler. We don't need to sit with the old paradigms. I believe we can construct a new and
different kind of politics for the 21st century," declared British prime minister Tony Blair,
one of the Third Way's chief theoreticians. During his October 1998 visit to China, he and
Chinese premier Zhu Rongji became the best of friends over their common endorsement
of the Third Way, with a display of mutual backslapping not seen since the last big row
broke over Hong Kong in 1992.
But the old paradigms ostensibly superseded by the Third Way did at least pose hard
choices on issues such as tax cuts, spending, and redistribution. The Third Way does not.
It comes from the fabled land of Both, promising that you can have your pablum and eat
it too. Not only does it gloss over the choice between tax cuts for the middle classes and
more government spending to improve the life chances of the poor, but it falsely invokes
a rejuvenated internationalism that dissolves the tradeoff between the interests of
need for more "transparency" in international finance, but they say little about the need
to shrink the amount of funds devoted to speculative activity and stop the gale that is
blowing through the world economy, capsizing banks and countries in its wake.
The Third Way shares with the free market school of thought the ideal of a single best
approach for all countries in a global financial system where everyone is subject to the
same rules. Yet the world remains ruled not just by hard choices about the distribution
of income and power between capital and labor but also by stark differences among
nations in their economic goals and interests. While political leaders call for the Third
Way, they covertly pursue the logic of My Way.
In the face of the Asian economic crisis and gathering world slump, deep differences
have opened up between the United States on the one hand and Asia and Europe on
the other. These differences bear directly on the American design for a new world
financial architecture and on American leadership of the world economy.
First, the United States believes that the current economic turmoil in Asia, Latin
America, Russia, and much of the rest of the world has "home-grown" causes,
particularly corrupt national banking systems that promoted the misallocation of
resources away from their most efficient uses. ("Crony capitalism" has become the
generic term of choice for these home-grown ills.) The International Monetary Fund
(IMF) has tended to agree with the U.S. diagnosis and has made further capital opening
a condition of its huge bailout loans for Indonesia, South Korea, and Thailand.
Asia and the European Union (EU) do not share this view. On balance, they believe
that the Asian crisis had its roots in the radical financial liberalization undertaken by
governments of the region during the 1990s, reforms encouraged by the IMF. These
changes allowed an enormous speculative balloon fueled by foreign financial inflows to
develop in the stock market, the property market, and industrial capacity. Most of the
inflows were in the form of loans to domestic firms. In the rush to financial
deregulation, the buildup of private debt to foreign lenders occurred with little overall
coordination and regulation by governments on either side of the borrower-lender
relationship. The "reward" for liberalizing capital was a ghastly collapse. Longer-term
solutions therefore require international financial markets to be more deeply embedded
in regulations and restrictions set by both governments and multilateral organizations,
say Asians and Europeans.
Second, the United States proposes a "new global financial architecture" based on
transparency, accountability, globally uniform standards, minimization of scope for
"moral hazard," and free capital movements. The EU is cautiously suggesting a new
global architecture in which the world would be divided into monetary zones, each with
some degree of protection through government controls on the movement of capital.
This idea is also receiving support in Asia. The growing convergence of views between
Europe and Asia on such proposals is underappreciated in the United States.
The context for this convergence is the worsening world economy. What began as the
Thai crisis in July 1997 became the Asian crisis by the end of the year. The abrupt shift
to negative growth in what had been the world's fastest-growing region sent a
contractionary wave coursing through the world economy, setting off a cycle of
damaging events elsewhere. The combination of deflation, debt, and highly integrated
international financial markets is proving to be explosive. With free international financial
flows and huge amounts of money in hedge funds, currencies become vulnerable to
speculative attacks, which lead either to sharp devaluations or increases in interest rates
that further squeeze domestic economies. Investors now see danger everywhere, and their
withdrawal from one market causes withdrawals from others. In just six weeks, between
mid-July and late August 1998, emerging-market stock indices plummeted by more than
30 percent.
In Asia, the IMF has had a near monopoly on the rescue effort and has been steered, in
turn, by the U.S. Treasury. The fund has used its control of bail-out money to obtain two
kinds of policy changes from the crisis-affected countries. The first is to restrict domestic
demand using higher interest rates, lower government spending, and stiffer taxes, the
objective being to stabilize the currency and make it easier for countries to repay foreign
debts. The second is to undertake liberalizing reforms in finance, corporate governance,
and labor markets. In particular, the IMF has pressed the governments involved to keep
making it easier for financial capital to move in and out of their countries (in other words,
to liberalize their capital account), though in the wake of the crisis it has also emphasized a
complementary strengthening of domestic financial regulation and supervision.
The IMF'S strategy has attracted criticism from across the political spectrum. Since the
second quarter of 1998, Asian governments have been moving to relax fund-prescribed
austerity programs, expand domestic demand, and introduce various restrictions on the
free movement of finance across national borders. This trend accelerated in August and
September, leading the Wall Street Journal to identify a region-wide policy backlash that
constitutes "the most serious challenge yet to the free-market orthodoxy that the globe
has embraced since the end of the Cold War." Meanwhile, European leaders have been
going out of their way to disassociate themselves from U.S. plans for world recovery and a
new world financial architecture. Indeed, historians looking back on the late summer of
1998 may well see it as a fulcrum in the world economy since the end of the Cold War.
IRRECONCILABLE DIFFERENCES
The great slump has brought these policy differences between the United States and Asia
and Europe to the fore. But what are the interests underlying the differences between U.S.
plans for the world economy and those of Asian and European countries?
The United States
The United States has a powerful interest in maintaining and expanding the free
worldwide movement of capital. Trade liberalization has progressed during the past
decade to the point where capital liberalization has replaced it at the top of the U.S.
foreign economic-policy agenda. For one thing, the United States needs to tap the rest of
the world's savings, which is much easier to do if world financial markets are highly
integrated. The U.S. savings rate is extremely low by international standards. Its ratio of
gross domestic savings to gross domestic product (GDP) ranks at the bottom among the
major industrial countries (together with Britain); its household savings rate out of
disposable income is by far the lowest. To maintain its high levels of consumption and
investment, the United States must borrow from the rest of the world. The alternative -
financing investment via higher domestic savings - would require a sharp cut in
consumption (to allow the extra savings), causing massive recession.
Moreover, Wall Street banks and brokerage firms want to expand their sales by doing
business in emerging markets, which, until the crisis, were growing much faster than the
home market. But capital controls and a variety of other impediments in these markets
have hindered such an expansion. Not surprisingly, U.S. firms want the impediments
removed. Behind the Wall Street firms are savers and pensioners who wish to ensure
that their savings are put wherever returns are highest.
Finally, an even more fundamental reason the United States needs unrestricted capital
markets relates to the broader effects of free capital movements on the national
political economy of other countries. It is in the U.S. interest to have the rest of the
world play by American rules for both international finance and multinational
corporations. The goal is to make the rest of the world adopt the same arrangements of
shareholder control, free labor markets, low taxes, and minimal welfare state that U.S.
corporations enjoy at home. U.S. firms could then move more easily from place to
place and compete against national or regional firms on a more equal basis. This goal is
especially important in Asia because the Asian system of long-term market relationships
and patient capital (investors that are more willing to wait for returns) has put U.S.
firms at a significant disadvantage.
The United States sees free capital movement as a wedge that will force other
economies to move in its direction. Indeed, the Asian crisis is dreadful confirmation
that financial liberalization and capital account opening make it more difficult to sustain
the long-term relationships and national industrial-policy arrangements that have
prevailed in the Asian political economy.
In other words, there is a powerful confluence of interests between Wall Street and
multinational corporations in favor of open capital accounts worldwide. In response,
the U.S. Treasury has been leading a campaign to get the main international economic
and financial institutions to promote capital liberalization. One such effort is the
revision of the IMF's constitution (its articles of agreement) to require countries to
commit themselves to capital account liberalization as a condition of fund membership.
Another is the World Trade Organization's financial-services agreement. Many
developing countries, particularly in Asia, had opposed this agreement as it was being
negotiated in 1996-97. Then came the Thai crisis. By December 1997, Asian leaders had
dropped their objections and signed on to an agreement that commits them to open
their banking, insurance, and securities markets to foreign firms. They saw no choice.
Either they signed or U.S. and IMF help in dealing with the crisis would be less
forthcoming.
Since the summer of 1998, when the crisis began spreading close to home, the
conversation in the United States has somewhat shifted. Until then, capital controls had
been dismissed as an idea of the looney Left. Now mainstream publications such as
Fortune and Business Week weigh the pros and cons. It is becoming more widely
accepted that the deflationary wave will be difficult to stop if nothing is done to limit
capital movements. Panic can swamp "fundamentals," and panicked markets need
dams, dikes, spillways, and other control structures if they are not to cause immense
damage. But while the conversation in the United States is shifting, the official U.S.
position remains the same, and opposition to capital controls from Wall Street is strong.
Asia
The crisis has taught Asian governments just how risky it can be to open their economies
to inflows and outflows of short-term finance. Malaysia imposed exchange controls on
September 1, 1998, in response to speculative attacks on its currency and depletion of its
foreign-exchange reserves. The controls were also intended to enable the government to
cut interest rates and expand demand without sending the currency (the ringgitt) through
the floor. In August and September, Hong Kong's iconically free market government
introduced restrictions on various kinds of speculative trading against the Hong Kong
dollar and Hong Kong stocks in the face of intense attacks by hedge funds. As part of its
defense, the government bought 6 percent of the stock market to keep the price up,
acquiring a massive "national" stake in private Hong Kong companies and becoming the
territory's largest shareholder. The Taiwanese government, in late August and early
September, also intensified its intervention against speculators, curbing the flow of finance
in and out of the country. The Japanese government has been seriously considering capital
controls for Japan and has given its blessing to their use elsewhere in Asia. In September
1998, the vice minister of finance for international affairs, Eisuke Sakakibara, said that his
government wished the Group of Seven, the club of the seven major industrial countries,
to review policies toward capital liberalization. China has also voiced support for these
developments.
The response from the IMF and the United States has been highly critical. Michel
Camdessus, the fund's managing director, said that Malaysia's exchange controls were
"dangerous and indeed harmful." U.S. Treasury Secretary Robert Rubin said, "The actions
Malaysia took yesterday are of concern to the U.S. and obviously . . . not the path that we
think best lends itself to economic growth and stability over time." Commenting in mid-
September on the perils of capital controls, Greenspan stated that "the relative stability of
China and India, countries whose restrictions on international financial flows have
insulated them to some extent from the current maelstrom, has led some to conclude that
the relatively free flow of capital is detrimental to economic growth and standards of
living. Such conclusions, in my judgment, are decidedly mistaken." "Decidedly mistaken"
is strong language for the Federal Reserve chairman.
Asian governments see capital controls as a way of buffering their economies from the
instabilities caused by fast inflows and outflows. This buffering is all the more important
in view of the region's lack of experience in dealing with international capital markets and
the relative thinness in its banking regulation and supervision. Experience and effective
supervision take years to build up. And there is a more immediate reason for capital
controls: Asian governments are undertaking expansionary monetary and fiscal policies to
counter the slump. They worry that without limits on outflows, they may face a further
currency collapse as investors fearing inflation or lower interest rates again rash for the
exits.
In addition, the growing Asian sympathy for capital controls is based on the realization
that Asian economies do not need to draw on the rest of the world's savings. They are the
world's biggest savers (typically saving 35 percent or more of GDP, compared with the
United States' 15 percent). They cannot productively invest even their domestic savings,
let alone the extra savings that come from abroad.
Asian perceptions of Asia's interests are colored by resentment of American
triumphalism. Mahathir Mohamad, Malaysia's prime minister, has warned his people
that they risk being "recolonized" by foreign powers. Henry Kissinger has noted that
"even [Asian] friends whom I respect for their moderate views argue that Asia is
confronting an American campaign to stifle Asian competition." The extent to which
foreign firms have gone bargain hunting in Asia remains unclear. But many people in
the region believe that the transfer of ownership has been huge, propelled by the
sentiment expressed by the head of one U.K.-based investment bank that "if something
was worth $1 billion yesterday and now it's only worth $50 million, it's quite exciting."
Or as the financier Andrew Mellon said more than 50 years ago about the merits of an
earlier global economic crisis: "In a depression, assets return to their rightful owners."
Europe
The differences between Europe and the United States were evident in the European
response to President Bill Clinton's outline of the U.S. strategy for checking the
spreading financial crisis. On September 14, 1998, Clinton proposed a thorough reform
of corrupt financial systems around the world, rewarding countries making good
progress with generous liquidity through the IMF, among other channels. He also
proposed a coordinated lowering of interest rates between the United States and
Europe in order to promote world economic expansion. The next day, three senior
members of the German Bundesbank warned that there would not be a coordinated
lowering of interest rates in Europe. French officials, including the finance minister,
agreed. Some European leaders said that the United States was more exposed than
Europe to the Asian flu, implying that Europe was not too worried about contagion.
The EU's refusal to cooperate with the United States in a coordinated interest rate
reduction reflects the European, especially German, preoccupation with inflation. But
the election of the social democratic government in Germany at the end of September
1998 brought to power a set of people more concerned with reducing unemployment
than with curbing inflation. The German stance on the need for high interest rates has
begun to soften. As a result, the priorities of the German government now look much
more like those of its French socialist counterpart. Their convergence on demand
expansion and employment creation has opened a new tension within Europe between
them and the Bundesbank
and European Central Bank, which both remain committed to minimizing inflation.
The new German government has fortified the EU's opposition to capital liberalization.
European policymakers are worried about the fragility of European financial systems in
the face of free capital flows, especially when policy shifts toward demand expansion.
The financial systems of continental Europe are dominated by banks, over half of
which are government owned and subsidized. The profits of banks come largely from
interest income. (U.S. banks, in contrast, get more of their profits from trading income,
such as dealing in swaps and derivatives.) Opening these systems to free capital
movements would squeeze banks' interest rate spreads and hence their profits. But the
banks are already thought to be suffering from a buildup of bad loans, though the opacity
of European financial information makes the quality difficult to judge.
The fragility of European financial systems could jeopardize the launch of the euro on
January 1, 1999. Europeans see the euro and the European Monetary Union as the
culmination of a half century of postwar reconstruction. They see it as, above all else, a
political project, and they are prepared to incur sizable economic costs in order to sustain
it - costs that American commentators often underestimate. They will do whatever it takes
to keep the euro and monetary union on track in the face of the current global crisis,
including controls against surges in capital flows.
Europe also calculates that its policies of capital controls and eurostability will make the
euro a more attractive international reserve currency than the dollar. Europe would then
acquire much more weight as a shaper of decisions about the world economy.
Besides European self-interest, European political leaders have been more prepared than
their American counterparts to recognize the damage that volatile money has done in the
Asian crisis and thus to support capital controls as an integral part of the new world
financial architecture. Indeed, shortly after Hong Kong authorities made their decision to
intervene in the territory's markets, the British government - the least "European" of
European governments - applauded the measure, commenting that "we are sensitive to
the concerns felt in Hong Kong about the distorting and destabilizing effects on financial
markets of huge and volatile capital flows." Having longer memories, Europeans also
recall that most Organisation for Economic Cooperation and Development countries had
capital controls until the 1980s. The recentness of their removal in the rich countries
makes it hard to argue that capital controls are by their nature inimical to growth.
More broadly, current European leaders tend to believe in governing the market. With the
victory of the Social Democratic Party in Germany, 13 out of 15 EU governments are
center-left. It is now acceptable to declare, along with French prime minister Lionel
Jospin, that "capitalism is its own worst enemy. The crises we have witnessed teach us
three things: Capitalism remains unstable, the economy is political, and the global
economy calls for regulation."
For all these reasons, European leaders tend to oppose the U.S. thrust for a world regime
of free capital markets. They have opposed U.S. plans in other fields as well. At the annual
meetings of the World Bank and IMF in early October 1998, European leaders argued
that the fund's Interim Committee should be the central body for discussing and agreeing
on new initiatives in global economic management. (The day-to-day business of the fund
is the responsibility of the board of directors, which is made up of officials from a subset
of the total membership. The Interim Committee is a higher-level body consisting of the
finance ministers of those same countries.) The European argument is implicitly contrary
to the U.S. plan to raise the importance in global economic management of the Group of
Twenty-two, a group of U.S.-picked industrial and developing countries. Not
coincidentally, the Europeans are well represented in the Interim Committee. Again, the
Europeans and the Japanese contributed little to the rescue package being put together in
late October 1998 for Brazil, which they say is an American problem. The United States,
in turn, wanted the IMF tO play a large role.
ONE WORLD, MANY CAPITALISMS?
A vast canvas of political battle has opened up. If the world deflation continues, and
especially if the Europeans and the Japanese raise the stakes by talking seriously of a
new Marshall Plan and debt write-offs as a new basis for world reflation, the United
States may make tactical concessions on emergency capital controls as the lesser of two
evils. But the differences in interests are real, and the United States - the U.S. Treasury,
Wall Street, and multinational corporations - will resume pushing for free capital
markets worldwide when the emergency passes. Some leftish observers claim, on the
contrary, that a gestalt shift away from free markets is well under way. According to
John Gray, professor of European thought at the London School of Economics, "A
year or so from now, it will be difficult to find a single person who admits ever having
believed that the global free market is a sensible way of running the world economy." If
Wall Street crashes and the U.S. economy goes into deep recession, Gray may be
proved right. If not - or as soon as the end of any such recession is in sight - he will be
proved wrong. The U.S. interest in free capital markets is more robust than his
statement implies.
In the changed political landscape, however, it is by no means clear that the United
States will win. The current crisis has eroded the legitimacy of the idea of a single,
integrated world market system not only in Asia and Europe but also among activist
segments of the U.S. population. In so doing, it provides us with the opportunity to
create rules and institutions that will allow different kinds of national or regional
capitalisms to prosper side by side rather than force convergence to one basic model.
The postwar Bretton Woods system was designed to deliver international economic
stability and national economic prosperity rather than maximize the flow of
international trade and capital. It worked. The Reagan and Thatcher "revolutions" of
the 1980s returned us to the path of a free world market that we had been on in the
early years of the twentieth century. Then, a free world market gave us the turmoil of
the interwar period; during the 1980s and 1990s, it has given us slower growth, fast-
rising inequality, and now a crisis that in much of the world bears comparison with the
Great Depression of the 1930s. If we are wise, we will now strive to re-create an
international regime that permits multiple forms of national political economy to
flourish.
WANT TO KNOW MORE?
Readers interested in the growing conflicts over international financial issues between
the United States and Europe and the United States and Japan should read Benjamin
Cohen's The Geography of Money (Ithaca: Cornell University Press, 1998). Robert
Wade and Frank Veneroso's "The Gathering World Slump and the Battle over Capital
Controls" (New Left Review, September/October 1998) gives an extended version of
the arguments made in this article.
For an in-depth analysis of the roots of the financial crisis, see Fred Block's
"Controlling Global Finance" (World Policy Journal, Fall 1996), which shows how the
progressive liberalization of capital flows has biased the world economy away from
growth and toward deflation, causing a steady increase in global unemployment. Block
also cites three essential reforms for the international financial system that could reduce
global unemployment. Robert Brenner's "The Economics of Global Turbulence: A
Special Report on the World Economy, 1950-98" (New Left Review, May/June 1998)
examines the trends in the world economy that have led to periodic crises of which the
Asian crisis is only the most recent. Wade's "The Asian Crisis and the Global Economy:
Causes, Consequences and Cure" (Current History, November 1998) surveys the
evolution of the Asian crisis and the debate over its causes and cures. In "Not for the First
Time: The World Sours on Free Markets" (The Nation, October 19, 1998), John Gray
highlights the dangers of moving toward a world economy made up of free market
national economies of the Anglo-American type.
Readers seeking to make sense of the myriad proposals for changing the global financial
structure should consult Michael Mandel and Dean Foust's "How to Reshape the World
Financial System" (Business Week, October 12, 1998), which offers an evenhanded review
of three directions of reform, including turning the International Monetary Fund into a
real lender of last resort, a chapter 11 - type system for countries, and instituting controls
on the international movement of capital. One noteworthy proposal comes from Dani
Rodrik in "The Global Fix" (New Republic, November 2, 1998), which explains what sort
of changes need to be made in world institutions to allow different varieties of capitalism
to flourish.
For links to relevant Web sites, as well as a comprehensive index of related FOREIGN
POLICY articles, access www.foreignpolicy.com.
ROBERT WADE is professor of political science and international political economy at
Brown University and author of Governing the Market (Princeton: Princeton University
Press, 1990).
Publication Information: Article Title: The Coming Fight over Capital Flows.
Contributors: Robert Wade - author. Magazine Title: Foreign Policy. Issue: 113.
Publication Date: Winter 1998. Page Number: 41. COPYRIGHT 1998 Carnegie
Endowment for International Peace; COPYRIGHT 2002 Gale Group