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J. Bradford DeLong
Professor of Economics, University of California
Research Associate, National Bureau of Economic Research
Co-Editor, Journal of Economic Perspectives
Visiting Scholar, Federal Reserve Bank of San Francisco
for a World Affairs Council Program, March 16, 1999
As prepared for delivery
Far to the west of the established industrial centers of the world economy--across the broad ocean--an industrial revolution was in progress. Mammoth infrastructure projects laid the groundwork for cities and factories where before only rude farmers had dwelt. Natural resources are tapped, and rising exports of resource-based products raise living standards both in the new boom economies and in the older industrial core. Alongside the resource exports a flow of manufactured goods begins and grows, as the emerging industries find their competitive niches. All this is funded by an enormous flood of capital out of the established financial centers seeking higher returns, and willing to bear some extra risks as well.
But all is not well. Corrupt government officials have been siphoning off unbelievable amounts of money from state-funded infrastructure projects. Revelations of the extent of production lead to legislative censure of the truth-tellers. Meanwhile, the largest financial institutions have become overextended: poured their money into enterprises doomed to failure, and then tried to conceal their unsound fundamentals.
When a sudden shock lays bare the extent of official corruption and of unsound private business practices, investors in the industrial core realize that all is not well in the lands to the west across the ocean. Capital stampedes out, back to the industrial core, no matter what interest rates are paid or equity terms are offered. And with a shattering crash, the largest and most prominent financiers--those whose houses have been the vacation retreats of national presidents, and who have been the business partners of close relatives of national leaders--fail and go bankrupt.
East Asia in 1997-8? Yes, of course. But also the United States of America in 1873-4.
Jay Cooke, the wizard financier of the Civil War, bet double-or-nothing four times in succession in an attempt to salvage his investments in the Northern Pacific Railroad. He wound up spectacularly bankrupt when his tame congressment were not able to push through extra public subsidies.
Leland Stanford and his friends collected their governments subsidies for building their part of the transcontinental railroad, channeled the wealth through sweetheart deals with their own private construction company, and left the railroad's investors and creditors in possession of an overleveraged and near-bankrupt enterprise. The money that British investors had committed to the New World in the hope that it would provide for their old age wound up as the endowment of Stanford University.
Our robber barons had little if anything to learn about crony capitalism and corruption from the friends of Suharto. And British and other European investors reacted then just as American and other investors reacted in the past two years: pulling their capital out of the enterprises and economies that only a year before they had seen as profitable goldmines.
British and European capital fled the United States. The amount of railroad miles built in the United States fell by 80%, as the country entered a severe depression. Until 1933, it was the U.S. depression that followed 1873 that had the name of "Great Depression."
Yet in retrospect we are not sorry that our predecessors borrowed on a large scale from the world economy's core to finance the late nineteenth century industrialization of the United States. It was a roller coaster--boom, depression, overtime, unemployment, immigration, riot, and the bloodiest labor-relations history in the world. But by 1910, even with a very large immigrant population for which English was a second or third language, the United States was the richest country in the world.
Now we are watching the same movie. I do not think that we want to cancel the show--to cut off the flow of capital out from the center to the industrializing periphery of the world economy. The ability of newly industrializing countries to borrow on a large scale from the industrial core has the potential to cut a decade or two off of what is otherwise a half-century long or longer process of industrialization.
But in the past--both the distant past and the recent past--with growth have come fluctuations: spectacular financial manias, panics, and crises; and deep depressions.
For the root cause of the crises is a sudden change of state in international investors' opinions. Like a herd of not-very-smart cattle, they all were going one way in 1993 or 1996, and then they turned around and are all going the opposite way today. Economists dispute which movement was less rational: Was the stampede of capital into emerging markets an irrational mania disconnected from fundamentals of profit and business? Is the stampede of captal out of emerging markets today an irrational panic? The correct answer is probably "yes"--the market was manic, it is now panicked, and the sudden change in opinion reflects not a cool judgment of changing fundamentals but instead a sudden psychological victory of fear over greed.
Can we give the movie not a different ending--for the ending is a happy one, successful industrialization, a chicken in every pot, a roof over every head, a high-speed DSL internet link to every CRT screen--but a different middle, a middle without the manias, panics, crashes, and depressions?
Today we know a lot more about how to manage the financial sectors of industrial market economies than our predecessors knew a century ago. The U.S. Treasury and a Federal Reserve understand very well the need to safeguard the world economy as a whole. Today we remember 1873--and 1857, and 1866, and 1893, and 1907, and 1929, and 1933, and 1992, and 1994. We understand that good can be done at very little risk if we have institutions willing to collectively act as lenders of last resort. When financiers in the industrial core panic, it is possible to greatly shorten and lessen the subsequent depression with large loans to provide liquidity to keep the engine of capitalist development appropriately greased.
We can advise countries that seek to take advantage of the large benefits (and they are large benefits) of global capital flows need to make sure that they do not destroy their own ability to handle crises. In the current international monetary system it is assumed that one reaction to a crisis will be a devaluation: since the world economy has signalled that it is no longer willing to pay as much for a country's capital or goods as before, a devaluation is a way of reducing the price of a whole nation's goods, the analogue to a firm cutting its prices in response to falling demand. But devaluation does little good if the value of the debts owed by a country in crisis rise as the currency falls in value: if the banks and firms in a country in crisis have borrowed not in their local currency, but in dollars, pounds, yen, or marks.
Thus the first thing that a country seeking to take advantage of international capital flows must do is establish a system to detect and penalize home-country institutions and firms that borrow in money-center currencies, for a large amount of such borrowing is what turns a shift in animal spirits by foriegn investors from an annoyance to a catastrophe.
We can advise the creation of a good system of domestic banking regulation: a system that will detect--and close down--financial institutions that are insolvent or nearly-insolvent, and that thus have strong incentives to make risky but uneconomic investments. After all, if a firm is already insolvent any further investments it makes are "heads, we win; tails, our creditors lose" propositions. Only if the financial system can be kept well-capitalized and solvent will the inflow of foreign capital generate productive and profitable investments.
But most of all there needs to be sufficient international liquidity to handle the kind of large-scale financial crisis that springs from a shift in animal spirits on the part of investors in the industrial core. There need to be well-capitalized institutions to make large-scale loans to countries that have been hit by panics. There needs to be a willingness on the part of creditor countries to accept flows of imports from developing countries that are the real-side counterparts of financial flows. A rebuilt, reformed, and renewed international financial architecture seems to be called for.
And it is from this perspective that recent political developments are troubling.
As U.S. Representative Barney Frank remarked during the debate over boosting the IMF's resources, the end of the Cold War has robbed economic internationalists of 50 votes in the U.S. House of Representatives. As late as mid-September the then-leaders of both houses of Congress promising his political allies that the U.S. Congress would not approve giving the IMF more resources: "we're not turning $18 billion over to a French socialist [Michel Camdessus] so that he can throw it away."
Economic historian Charles Kindleberger thought that, at the deepest level, the cause of the Great Depression was that Britain could not longer and the U.S. would not take responsibility for dealing with international financial crises. Listening to Newt Gingrich and Trent Lott, it is hard to escape the conclusion that we are about to enter an era in which once again the U.S. will not take responsibility.
Outside the United States, the global economic news in 1998 was not good. There were several reasons for the sudden increase in the price of risk that we saw last summer--the increase that bankrupted the hedge fund Long-Term Capital Management, and that scared Federal Reserve Chair Alan Greenspan enough to lead him to reduce interest rates more than once last fall. The first was the failure of emerging markets in East Asia to resume strong growth--a failure blamed on the stagnation of the Japanese economy. The Mexican crisis of 1994-5 was brief in large part because rapid U.S. growth created strong demand for the products of Mexican industry. But in East Asia in 1998 the analogue of the U.S. was Japan, Japanese growth was not strong, and so the exports of Malaysia, Thailand, Indonesia, and Korea did not grow.
The second was Russia's suspension of payments. There had been a belief that the G-7 regarded ex-superpowers with large arsenals of nuclear weapons as "too big to fail," and that a way would be found to keep Russia current on its obligations. This belief proved false, and investors worldwide took note.
The third and most important reason for the rise in liquidity, risk, and default premia last summer was that when investors look to the future they see further failures of economic management--continued stagnation in Japan, European central banks that wring their hands and say they can do nothing about ten percent unemployment in Europe, and the prospect of refusal by the U.S. Congress to recognize that a global economy requires well-financed global institutions to regulate it.
Thus there is no world-wide political consensus, and so it is hard to see the emergence of financial institutions that will do as much to promote growth and avoid depression in the early twenty-first century as the Bretton Woods order did in the third quarter of the twentieth century.
Therefore it seems to me more likely than not that dreams of a rebuilt, reformed, and renewed international financial architecture will remain nothing but dreams.
of Economics J. Bradford DeLong, 601 Evans Hall, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
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