The Coming Fight over Capital Flows

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The Coming Fight over Capital FlowsAuthor(s): Robert WadeSource: Foreign Policy, No. 113 (Winter, 1998-1999), pp. 41-54Published by: Washingtonpost.Newsweek Interactive, LLCStable URL: http://www.jstor.org/stable/1149231 .

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The Coming

Fight over

Capital Flows by Robert Wade

T he 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 cal- culation." In plainer English, when investors have developed strong confidence in the conventions for forecasting, and when this confi-

RO BE RT WADE is professor of political science and international political economy at Brown University and author of Governing the Market (Princeton: Princeton University Press, 1990).

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Capital Flows

dence 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 trade- off between the interests of international capital and those of working people. Third Way proponents talk about the 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.

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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 covert- ly 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

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.

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 tur- moil 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 Mon- etary 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 bal- ance, 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 enor- mous 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 lib- eralizing capital was a ghastly collapse. Longer-term solutions therefore require international financial markets to be more deeply embedded in

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Capital Flows

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 liber- alizing 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 strengthen- ing of domestic financial regulation and supervision.

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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 bor- ders. 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.

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Capital Flows

,,,. ,

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Wade

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 pre- vailed 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

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Capital Flows

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 compa- nies 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 consid- ering 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

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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 mael- strom, has led some to conclude that the relatively free flow of cap-

The United States sees free capital movement as

a wedge that will force other economies to move

in its direction.

ital is detrimental to economic growth and standards of living. Such conclusions, in my judgment, are decidely 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 thin- ness 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 rush 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 (typ- ically 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 min-

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ister, 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 con- fronting 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 trans- fer 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 gener- ous 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 Ger- man, 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 prior- ities 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.

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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 recon- struction. 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 euro- stability 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 sensi- tive 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.

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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 Inter- im 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 repre- sented in the Interim Committee. Again, the Europeans and the Japan- ese 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 tacti- cal 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. Accord- ing to John Gray, professor of European thought at the London School of Economics, "A year or so from now, it will be difficult to

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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 erod- ed the legitimacy of the idea of a single, integrated world market system not only in Asia and Europe but also among activist seg- ments 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 tur- moil 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 capi-

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tal 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 chang- ing the global financial structure should consult Michael Mandel and Dean Foust's "How to Reshape the World Financial System" (Busi- ness Week, October 12, 1998), which offers an evenhanded review of three directions of reform, including turning the International Mon- etary 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.

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Documents

The Coming Fight over Capital Flows