A Cambridge lesson for US Democrats
Source Juriaan Bendien
Date 04/03/16/10:29

Professor Lord John Eatwell, one of the brightest British reformist
economists( wrote a
very simple but quite prophetic article at the beginning of the Clinton era,
which I've edited a little, with ten new subheads to fit with the current
situation (although the essential argument is no different from what they
was then). If you happen to think his argument is a trivial platitude, just
calculate if you will, as a very simple exercise, what the size of real GDP
for all OECD countries combined would have been in 2003, if economic growth
had continued at about 4% for the last thirty years (the average economic
growth rate during the long boom 1947-1973, conventionally measured). You
will see then, that the discrepancy is astronomically large.

But that is just to say, as Marx frequently remarked, that the supreme
contradiction of the capitalist system is in fact Capital itself; at a
certain point, it begins to brake the growth of the productive powers of
human labour.

Mediating this contradiction by means of deregulation, has the global effect
that the gains of increased capital mobility are outweighed by the losses in
employment growth plus skyrocketing debts, and consequently the decline of
aggregate buying power and the displacement of that buying power from the
weak to the strong. This has the effect, that while socio-economic
inequality increases, capitalist development at the same forcibly compels a
search for alternative allocative principles, to claim and distribute
resources, which at least in part culturally prefigure new distributive
principles - JB).


The markets, exercising their influence not just through the domestic
funding of the government debt, but also in the foreign exchanges, determine
the monetary stability of the economy. Market hostility to government
expenditure plans would be expressed through falling bond prices, a falling
dollar, rising interest rates, and, in due course, the threat of a financial
crisis-- imposing the humiliation of political retreat, with plans abandoned
and policies reversed. (...)

But who are "the markets"? What determines that awesome collective opinion
expressed through millions of independent purchases and sales? What is the
relationship, if any, between the views of the markets and what might
generally be regarded as desirable government policies on employment,
industrial investment, or trade? Answering these questions is as important
as the design of the new economic initiatives. Getting the markets on
board--ensuring, by whatever means, that their role is supportive, not
destructive--is the key to breaking out of the economic failures of the
1980s, in America, and in all the other G-7 countries.


(...) In the domestic economy, there will be a race between the
revenue-generating benefits of growth and the deficit-enhancing expenditures
intended to make that growth possible. In the international economy, there
will be a race between the expansionary investment necessary to improve
competitiveness and the deterioration in the current account that expansion
will inevitably bring, as higher domestic growth stimulates imports. The two
races are really just one contest.

If American industry were so competitive that none of the growth-inducing
government expenditure leaked overseas into imports from abroad, then the
increased incomes derived from government spending would generate the extra
taxes and the extra savings needed to fund any addition to the public
deficit. That leakage overseas, due to lack of competitiveness, means that
taxes and savings are generated outside America and need to be borrowed
back. The leakage weakens the impact of government spending on the real
economy, and the financial impact of higher overseas borrowing threatens to
restrict the scope of [government policy].

But the restoration of competitiveness, necessary though it is, will not be
enough to secure long-term, sustainable growth. Enhanced competitiveness,
conventionally defined, essentially involves capturing markets and jobs from
trading partners--shifting the unemployment around the world--rather than
creating new prosperity within the western economic system as a whole. In a
period in which every government is facing the political pressures of
recession, enhanced competitiveness in one country may well produce
self-protecting retaliation in others--just think of the tensions now in
U.S.-Japanese trade relations.


To achieve his goals, [the US government] needs to break out of this
international game of pass the unemployment [and] create an economic
environment in which expansion at home is not wrecked by pressures in the
international money markets. That requires the creation of a new
growth-oriented framework for the world economy and the establishment of
international monetary stability where instability is now the rule. The
omens are not good. Apart from the occasional debt-driven bubble...
unemployment in every G-7 country has at least doubled. [...]. Productivity
growth in manufacturing industry is sharply down.

The very pervasiveness of economic underperformance suggests that something
has gone badly wrong in the workings of the international economy as a
whole, transcending the particular experience of individual countries.


To pick just one or two factors as the fundamental causes of the economic
deterioration of all the G-7 countries is, perhaps, somewhat ambitious.
Economic growth is a complex, interactive process in which uni-causal
explanations are likely to be naive and simplistic. Nonetheless, it seems
clear that, as far as the international economy is concerned, two
fundamental institutional changes mark a clear break between the 1960s and
1980s: first, the Bretton Woods system of fixed exchange rates of the 1960s
versus the post-Bretton Woods floating- rate, market-driven 1980s [and
1990s]; second, the regulated financial markets of the 1960s versus the
deregulated global markets [since] the 1980s.

There has been extensive analysis of the inability of the post-Bretton Woods
trading and payments system to deal with international trading imbalances
other than by deflation in weaker countries--a deflationary impulse that has
proved contagious. Less attention has been paid to the fact that this
deflationary pressure is reinforced by the huge growth in short-term capital
flows, by speculation.

Financial markets are today dominated by short-term flows that seek to
profit from changes in asset prices and currency shifts--in other words,
from speculation. The growth in the scale of pure speculation, relative to
other transactions, has been particularly marked in the foreign exchange
markets over the past twenty years.

In 1971, just before the collapse of the Bretton Woods fixed exchange rate
system, about 90 percent of all foreign exchange transactions were for the
finance of trade and long-term investment, and only about 10 percent were
speculative. Today those percentages are reversed, with well over 90 percent
of all transactions being speculative. Daily speculative flows now regularly
exceed the combined foreign exchange reserves of all the G-7 governments.

The explosive growth of short-term speculative flows originated in a
powerful combination of the carrot of potential profit and the stick of
financial risk. To an important extent, speculation is an inevitable outcome
of the abandonment of fixed rates. Under the Bretton Woods system, there was
little profit to be had in speculation, since currencies moved only in tight
bands, apart, that is, from the very occasional change in parity. Indeed,
the Bretton Woods system provided quite remarkable stability.

For example, the core currencies of the European Monetary System, locked
together today in their Exchange Rate Mechanism (ERM), enjoyed greater
stability in relation to one another during the Bretton Woods era than they
have been able to achieve since 1979 within the ERM. In the face of Bretton
Woods stability, it was not worthwhile maintaining the large-scale currency
dealing facilities with which we are familiar today; even if the
contemporary regulatory structures had not placed other significant barriers
in the path of short-term capital flows.


However once Bretton Woods had collapsed, and significant currency
fluctuations became commonplace, opportunities for profit proliferated.
Regulatory structures that inhibit flows of capital were then challenged as
"inefficient" and "against the national interest" and "unmarketlike"--and
the infrastructure of speculation was rapidly expanded. The Bretton Woods
system was finally abandoned in 1973. The U.S. announced the elimination of
all capital controls in January 1974.

The incentive to deregulate international capital flows, created by the
abandonment of fixed rates, was reinforced by the need to hedge against the
risk of fluctuating exchange rates. Under the Bretton Woods system,
foreign-exchange risk was borne by the public sector. With that system's
collapse, foreign-exchange risk was privatized.

This privatization of risk imposed substantial strains on the domestic and
international banking systems. The need to absorb and cover foreign-exchange
risk demanded the creation of new financial instruments, which in turn
required the removal of many of the regulatory barriers that limited the
possibilities of hedging risk. That, in turn, required a further
deregulation of financial institutions.

Combined with other, domestic, pressures for the removal of financial
controls, the collapse of Bretton Woods was a significant factor driving the
worldwide deregulation of financial systems. Exchange controls were
abolished. Domestic restrictions on cross-market access for financial
institutions were scrapped. Quantitative controls on the growth of credit
were eliminated, and monetary policy was now conducted predominantly through
management of short-term interest rates. A global market in monetary
instruments was created. All of this, of course, invited further


Today the sheer scale of speculative flows can easily overwhelm any
government's foreign-exchange reserves. The ease of moving money from one
currency to another, together with the ease of borrowing for speculative
purposes, means that enormous sums can be shifted across the exchanges,
especially for short periods of time. Prior to the recent run on sterling,
the British government boasted of a $15 billion support facility it had
negotiated in deutschmarks, to be used to defend the parity of the pound.
Yet that sum would be matched a few weeks later by the sales of sterling of
just one prominent player in the foreign exchange markets.

These huge flows not only increase market instability. They also tend to
induce governments to pursue deflationary policies. The overwhelming scale
of such potential flows means that governments must today, as never before,
keep a careful eye on the need to maintain market "credibility," even at the
expense of more substantive policies affecting the real economy. A credible
government is a government that pursues a "market friendly" policy--one that
is in accordance with what the markets believe to be "sound." Sound often
turns out to mean deflationary. Governments that fail to pursue "sound" and
"prudent" policies are forced to pay a premium on the interest costs of
financing their programs. Severe loss of credibility leads to a financial
crisis. But a government's credibility is often less the result of the
soundness of underlying policies and more the product of the way that
speculative markets actually work.


In his General Theory, John Maynard Keynes likened the operations of a
speculative market to a beauty contest. He had in mind a competition then
popular in the British Sunday tabloids in which readers were asked to rank
pictures of young women in the order which they believed they would be
ranked by a "celebrity panel." To win, then, the player expressed not his or
her own preferences but the preferences he or she believed were held by the
panel. In the same way, the key to playing the markets is not what the
individual investor considers to be the virtues of any particular policy but
what he or she believes everyone else in the market will think.

Since the markets are driven by average opinion about what average opinion
will be, an enormous premium is placed on any information or signals that
might provide a guide to the swings in average opinion and as to how average
opinion will react to changing events. These signals have to be simple and
clear-cut. Sophisticated interpretations of the economic data would not
provide a clear lead. So the money markets and foreign exchange markets
become dominated by simple slogans--larger fiscal deficits lead to higher
interest rates, an increased money supply results in higher inflation,
public expenditure bad, private expenditure good--even when those slogans
are persistently refuted by events. To these simplistic rules of the game
there is added a demand for governments to publish their own financial
targets, to show that their policy is couched within a firm financial
framework. The main purpose of insisting on this government commitment to
financial targeting is to aid average opinion in guessing how average
opinion will expect the government to respond to changing economic
circumstances and how average opinion will react when the government fails
to meet its goals.

So "the markets" are basically a collection of overexcited young men and
women, desperate to make money by guessing what everyone else in the market
will do. Many have no more claim to economic rationality than tipsters at
the local racetrack and probably rather less specialist knowledge. Over
time, the value of currencies may reflect the condition of the real economy;
in this sense average opinion is influenced by the likely impact of
government policies on growth and productivity or by long-term trends in
international trade. But at any given moment, average opinion is also guided
by fads and rumors, political fashion and prejudice; it is often swept up in
bubbles, fevers, and manias. These, of course, have real and persistent
economic costs.


The need for consistent, stable "signals" to guide average opinion would be
provided by the operations of the real economy if, and only if, the real
economy tended to adjust toward a well-defined equilibrium. The idea that
the economy is ultimately self-adjusting toward a full-employment
equilibrium is fundamental to the monetarist dogma that has dominated
economic policymaking in the West for the past decade. In a radio talk given
in 1934 in which he firmly rejected the self-adjusting ideology, Keynes
spelled out the sources of its pervasive influence:
On the one side are those who believe that the existing economic system is,
in the long run, a self-adjusting system, though with creaks and groans and
jerks, and interrupted by time lags, outside interference and mistakes
....On the other side of the gulf are those who reject the idea that the
economic system is, in any significant sense, self-adjusting....

The strength of the self-adjusting school depends on its having behind it
almost the whole body of organized economic thinking and doctrine of the
last hundred years. This is a formidable power. It is the product of acute
minds and has persuaded and convinced the great majority of intelligent and
disinterested persons who have studied it. It has vast prestige and a more
far-reaching influence than is obvious. For it lies behind the education and
habitual modes of thought, not only of economists, but of bankers and
businessmen and civil servants and politicians of all parties.

The self-adjusting view is also at the core of the idea that speculation is
ultimately benevolent. Once it is assumed that the market economy is driven
by strong self-adjusting forces, then it follows that even the occasional
speculative overshoot or "bubble" will in due course return to the real
equilibrium, leaving destabilizing speculators with their fingers severely
burned. In these circumstances, it is irrational to regulate capital flows.
Deregulation supposedly will lead to a more efficient allocation of capital,
a greater availability of capital for productive investment in enterprises
of all sizes, and hence result in higher levels of investment and growth and
enhanced stability.

Of course, financial deregulation, domestic and international, has brought
none of these benefits. As well as being associated with lower growth and
higher unemployment, financial deregulation has led to a rapid increase in
corporate and consumer debt, and significantly greater instability in
interest rates, exchange rates, and the availability of credit.


All this is not surprising if we recognize that the economy is not
self-adjusting. Markets are just as likely to settle in a low-growth,
high-unemployment equilibrium, as in any other state. Keynes pointed out
that the idea of self-adjustment was convincing only because of a common
confusion between the efficiency that the market may impose on the
operations of an individual firm and the fact that the market does not
ensure that the economy is operating efficiently as a whole. In Keynes's
characterization of the operations of a market economy, it is clear that
speculation may well be an important factor driving the economy toward a
low-growth, high-unemployment equilibrium. The markets are neither
omniscient nor benign. When their influence is combined with the persistent
search for government credibility, defined in terms of "sound money" and
"prudent" deflationary policies, then the low level position is virtually

The deflationary pressures created by deregulated speculative markets have
not been felt only through their impact on government policy. Financial
instability also has a severe impact on the ability of companies to invest
with confidence, and indeed, on their ability to survive. The chart, "U.S.
Corporate Default Rates," which is taken from a study entitled Prosperity or
Decline by Giles Keating and Jonathan Wilmot of the London office of Credit
Suisse First Boston, shows the default rate of U.S. companies over the past
seventy years. The striking element in the pattern of default is the very
low default rate between the end of the Second World War and the collapse of
the Bretton Woods system. The corporate survival rate was determined by a
combination of macroeconomic steady growth (although growth rates in the
Eisenhower years were not particularly high) and the microeconomic benefits
of the financial stability created by Bretton Woods.

Under a fixed-rate system, an adjustment of the rate results in a new
pattern of international prices which can be used, with reasonable
confidence, as a framework for long-term decision making. But in a
fluctuating system, the same absolute change will not be expected to persist
in the same way and therefore will be less of a reliable signal for long
term investment planning. The constant variation of exchange rates as a
means of adjusting to differences in international competitiveness, by its
very nature, increases uncertainty, exaggerates the psychology of
speculative movement, and creates more extreme swings in currency values
than are really appropriate--a further contribution to international


(...) The technical problems involved in creating suitable baffles in the
international financial markets are greatly exaggerated. The fact that
trading today is typically by electronic transfer makes effective monitoring
far easier than ever before; with international agreement, it would not be
too difficult to link the legal right to trade to the requirement to accept
appropriate monitoring. Effective monitoring is the starting point of
effective management. Both will be possible only if there is full and
consistent cooperation among the G-7 countries.

The real problems are political. The people and the institutions who have
benefited most from financial deregulation are characteristically some of
the most successful and powerful in every country. They can erect the most
convincing cases, economic and political, to demonstrate that deregulation
is economically efficient, is in the national interest, and that attempts to
regulate the markets won't work anyhow. The "neutral" wisdom of the markets
will be contrasted to the bungling of the interfering and venal politician.
The fact that unregulated markets have proved to be remarkably inefficient
will be carefully glossed over. Persistent recession will be blamed on
anyone and anything other than the markets. However, the fact that the
markets are led by average opinion, rather than by economic reality, means
that they can be led. A powerful political case presented within a coherent
ideology, underwritten by clear economic analysis, reinforced by firm action
can lead opinion and so change the parameters of speculative behavior.
Fundamental to the new position must be the resolve that speculative
disruption of employment and growth policies is unacceptable. The attainment
of stability will, in itself, lessen the profitability of a large
speculative infrastructure. But if the money markets cannot be led to
support a coherent growth strategy, if they cannot be persuaded to come on
board, then they must be obliged to come on board. Regulation has proved to
be a necessary part of an international growth strategy in the past. It may
well be necessary again.

The monetary instruments that markets trade are issued by governments, and
ultimately their value is dependent on the power and authority of
governments. And governments determine the legal framework without which no
financial institution can operate. Hence governments control the very
existence of financial institutions. It is ludicrous to suppose that
governments cannot, if they collectively so desire, reregulate the
operations of the international money markets. If the G-7 were determined to
achieve that goal, they have the means--whether through stiffer margin
requirements on the banks, taxes on short-term turnover, or direct capital
controls--to ensure that their wishes are not subverted "offshore."

The results [of government policy] -- low growth, high unemployment,
crumbling social and economic infrastructure--are there for all to see.


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