America’s China Policy Is Not Working
The Dangers of a Broad Decoupling
Across all classes and in all countries in the West, people feel a growing sense of being at risk. The shape of this "risk shock" varies, obviously, given the wide variety of welfare and employment structures among these countries, but the phenomenon emerges everywhere in one form or another. There is a process of marginalization and social exclusion in train that is reproducing some of the worst features of the nineteenth century in terms of both inequality and poverty. The United States has had rising income inequality since the early 1970s, and in Western Europe structural unemployment has forced a reconsideration of some aspects of the welfare state. All Western nations have suffered from a slowdown in growth. There have therefore been calls for an activist response -- both for more international policy coordination and for increased spending on education and worker training at home.
This approach is rooted in a proper concern for the dangerous social potential of current trends and represents an effort to face up to the problems. Yet while it is ambitious, in some respects it would not be ambitious enough. For what is driving the current process is now intrinsic to capitalism, and its solution requires something more dramatic. That is not to argue for old-fashioned, unworkable attempts at central planning and government ownership, but it is to insist that the economics of Keynes be revisited and updated in contemporary conditions. Western countries must attack the forces driving the current world economic order rather than simply manage their consequences.
The answer is not protectionism; in some respects aggressive free trade is good. Busy sea-lanes and teeming ports are the handmaidens of prosperity for all, not its enemies, although in some sectors, international competition causes profound dislocation, and part of the downward pressure on wages of unskilled workers is explicable in these terms. But there are areas of the international economy that do require active supervision and control. Regulations must be put in place to slow international financial transactions and reduce their destabilizing effects. International trade and investment grow best during a careful process of long-term planning and prediction. Uncertainty such as the current turbulence in the enormous currency markets and the high interest rates they cause are anathema to costly investment. Moreover, those same markets swiftly punish efforts to reduce the resulting unemployment and its attendant protectionist pressures through expansionary fiscal policy.
Recasting the world financial system is therefore absolutely central to any program for relaunching Western economies on a rapid growth trajectory. The freedoms celebrated by the extraordinarily well-paid denizens of the international dealing rooms now threaten the capacity of the world to sustain a free trade regime and promote economic growth. Here, not in free trade, lies the cause of current high levels of European unemployment.
THE REAL CAUSE OF THE DEPRESSION
We have embraced one lesson from the 1930s -- the malign impact of protectionism -- but discarded the other, the case for regulated currency markets. The case against protectionism is well known. The instant one country, especially a major trading country, interrupts the flow of trade, it breaks a link in the delicate chain holding the trade order together. With trade interrupted, some countries can no longer obtain the foreign currency required to finance their own trade and service their debt. That threatens the viability of banks, which pull back on credit to their own economies and write off poorly performing loans. That in turn triggers a fresh round of production cuts, employment losses, and protectionist measures. Depression becomes global. This, loosely, is what happened in the early 1930s. American tariffs, undertaken in response to social dislocation, provoked the Latin American states to default on their debt, intensifying the crisis in the U.S. financial system and causing the huge credit contraction that brought on the American depression, which then had repercussions in Europe.
In the 1990s these developments are barely remembered, but at the Bretton Woods conference in 1944 they were all too vivid. Delegates shared the view that, whatever else, protection had to be avoided. Financial markets must never be so insistent that a country uphold its currency that unemployment -- which had led to protectionism in the United States -- would have to be endured. An international financial system that would act as a shock absorber for economic surprises -- rather than, as in the 1930s, a trampoline -- was crucial. The system of international exchange rates needed to be under the control of governments and actively managed such that instead of diminishing trade flows it would become the instrument of adjustment. Although exchange rates would be pegged, rather than left up to free-wheeling arbitrageurs, as under the gold standard, adjustment would be smoothed by the International Monetary Fund. Finance was never again to be king; free trade and employment were to come first. This system remained in place until the early 1970s, when it unraveled amid American trade deficits and inflation, following U.S. expansionary fiscal policy of the late 1960s.
Today that lesson has been forgotten, and the world has once again invented an international financial system that is a source of economic instability. Free movement of capital and floating exchange rates prevent countries from pursuing expansionary economic policies. Although the financial markets may deplore France's approach to curbing unemployment, for example, the country's decision on how to organize itself socially and economically should be its own. But as matters stand, the French feel they have no choice. The financial markets will sell the franc and impose high interest rates if France tries to expand unilaterally. But if it tries to sidestep the markets by adopting a single European currency, that too implies running the economy at high levels of unemployment to meet the economic criteria set by Germany, a country with a wholly different institutional configuration. The situation is unstable, and it is unlikely that President Jacques Chirac will finish his term before there is a more violent political reaction to the strains in France.
The freedom of capital and floating exchange rates are justified by an appeal to the same theory that apparently underpins free trade. If there is a free market in world production, why should there not be a free market in world financial capital? And why is it wrong for prices to determine the allocation of financial assets if prices may determine the allocation of productive assets? The answer lies in the old Keynesian argument about the mismatch and tension between the time horizons of producers and financiers. Producers are driven by expectations of future sales, which they take into account when considering the costs of capital. Financiers, trading in the most liquid of assets, have much shorter time horizons. They set out to establish a network of short-term contracts that can be immediately unraveled in the financial markets as their assessment of risk changes.
When times are good, optimism disguises the short-term nature of their commitment and the flimsiness of the valuations that producers of real goods and services use to judge capital costs and make investment and production decisions. When times are bad, the asymmetries become clear. Financiers sell, asset prices fall, and capital flows fall off -- and suddenly producers must make painful and unexpected adjustments. As they learn that they run this risk, they become averse to investment, and would rather run their firms at lower capacity with smaller core labor forces than build up capacity and payrolls that might prove unwarranted.
Mexico is a classic example. It financed its growth with short-term dollar investments from American mutual funds, which closed the gap between imports and exports. All went well when the financial markets were bullish, but when sentiment turned sour at the end of 1994, the value of Mexican assets collapsed, and the investment around which Mexico had constructed its growth evaporated. To restore confidence, Mexico had to slash public expenditures, with a real impact on living standards, and obtain a gigantic support package from the International Monetary Fund and the U.S. government.
Some argue that Mexico needed to make this adjustment. Arguably it did, but now it must do so over a matter of months rather than years. Mutual funds could turn off the tap in December 1994 and reopen it in the autumn of 1995 with comparatively little pain. After all, they were simply riding short-term changes in the value of financial assets. But the Mexican economy and society cannot make adjustments of this magnitude so quickly, at least not without setting off powerful forces insisting that there must be better ways of organizing the economy. In less than a year Mexican GDP has contracted by more than five percent, and unemployment has nearly doubled. If it is important to earn foreign currency to service Mexican debts, ask siren voices in the country, why not simply limit Mexican imports? As in the early 1930s, the excessive power of unregulated finance compels countries to examine whether limiting trade is a better option.
Countries with stronger economies are finding themselves asking similar questions. France, fearing the veto of the financial markets, which wrecked its expansionary plans in the early 1980s, has worked for ten years to become sterner than the Germans about price stability. It wants to protect itself behind a single currency, merging the franc with the mark. But the transition costs are vast, even if they are exacerbated by -- as the financial markets describe it -- "excessive social charges" for French industry. As unemployment mounts, France may choose to protect its society not by looking to a European single currency, but by erecting tariffs and setting quotas.
The problem is not limited to France and Mexico. The conventional explanation for high European unemployment is that it results from heavy social charges and excessive labor market regulation. But these costs are a result, not a cause, of slow growth, which in turn is due to low investment. What is striking is the lack of correlation between social spending and unemployment. Danish social charges, for example, are among the highest in Europe, and trade unions are strong, but unemployment is around the European average. What is truer is that as growth has slowed, welfare spending has grown, creating higher budget deficits and narrowing the scope for an expansionary fiscal boost. Social security spending is a link in the chain of causation, but it is preceded by the growth slowdown.
Slow growth in turn is closely linked to the decline in investment spending across the continent. Paradoxically, the more the financial markets have internationalized and thus enlarged the pool of savings, the more real interest rates have risen. Capital mobility has empowered bondholders relative to national governments, enabling them to exact high real interest rates as the price for maintaining bond purchases, particularly in Europe, where markets benchmark all European interest rates against those in Germany, taking its inflation outlook into account. Bondholders prefer short-term assets, thus shortening time horizons even more. The combination of high short-term real interest rates and more short-termism has deterred investment; that has lowered growth rates, which sets in train the whole vicious circle and associated trade tensions.
While the financial markets deal in a homogeneous asset -- money -- that can be traded instantly in a series of immediately renegotiable contracts, trade patterns originate in the very heterogeneity of countries and their different cost structures. These cannot and should not be made to conform to one standard, and adjustments can never be made as quickly as in the financial markets.
SLOWING THE FLOW
The solution to the conundrum of rekindling world growth while preserving free trade is regulating the financial markets so that their speed is slowed and their power reduced. Countries must recover the power to regulate capital flows and to manage exchange rates; finance must be compelled to behave in a more considered, long-term fashion.
The heart of a new financial order is maintaining stability in the value of the dollar, yen, and mark. The governments that issue these currencies must accept that monetary and fiscal policy need to be closely coordinated, and that differential incentives to save and consume, which so upset the relationship between the high-consuming United States and high- saving Japan, must be gradually harmonized. This means, for example, higher gasoline taxes in the United States and more deregulation in Japan. The policy of American benign neglect of the dollar must end; indeed, one objective of European monetary union and the launch of the euro is to challenge the hegemony of the dollar so that American authorities will be forced to take their international responsibilities more seriously.
This triangular currency relationship needs to become the core of a new Bretton Woods system of bracketed but flexible exchange rates, protected against excessive speculative currency flows by some form of turnover tax on financial transactions. The limits on all forms of derivative trading need to be tightened, so that banks will have to charge higher fees for what are essentially speculative financial assets. Capital controls should be introduced where necessary. Such a financial order would ultimately mean lower real interest rates, longer time horizons, less financial speculation, and more real investment and growth.
Is this possible? The tools have existed before, and they can be reinvented, given the political will, the economic conviction, and the international structures in which such action can be taken. If it is not done now, it will be done later, after countries have fallen back on protectionism and discovered that its costs are too heavy to bear. The villain is free finance, not free trade, and if the world went after the right quarry, it could save itself much grief.
 Paul Volcker, former chairman of the Federal Reserve, has made a similar proposal, "Toward Monetary Stability," The Wall Street Journal, January 24, 1996, p. A12.