Asiaweek February 5, 1999
"The End of Market Fundamentalism"
By Sakakibara Eisuke
This paper was presented at the Foreign Correspondents Club, Tokyo, on January 22, 1999 by Mr. Sakakibara, Japan's Vice Minister of Finance for International Affairs. The views expressed here are personal and do not represent those of the Japanese Government
IT WAS IN 1926 that John Maynard Keynes wrote his now famous essay, "The End of Laissez-Faire." Since then, history has evolved through the Great Depression, "hot" and cold wars, the establishment of the Bretton woods regime, suspension of convertibility of the U.S. dollar into gold, oil shocks, and the information and telecommunications revolution. The situation at the end of the 20th century seems to be quite similar to that of the late 1920s, having come full circle.
Indeed, the classical gold standard system that prevailed between 1870 and 1913 under the Pax Britannica attained a level of economic integration that even surpassed the current one, at least in terms of the ratio of the flow of goods, services and capital across national boundaries as a percentage of GDP.
In his earlier, epoch-making essay, "The Economic Consequences of the Peace," published in 1919, Keynes wrote that this globalization or integration of the world economy seemed to ordinary British people at the time as "normal, certain and permanent, except in the direction of further improvement and any deviation from it as aberrant, scandalous and avoidable." This very widespread belief in globalization and laissez-faire in the 1910s seems to have resembled the strong and growing conviction in global capitalism in the 1990s. True, globalization today differs significantly from that of the gold standard period in that the information and telecommunications revolution has rendered international transactions, particularly international financial transactions, virtual. The speed and complexity of these virtual transactions are incomparably greater than those of the late 19th and early 20th century.
However, the pre-1913 prevalence of laissez-faire ideology together with strong interdependence among countries across national borders is quite comparable to the post Thatcher-Reagan dominance of market fundamentalism with the rapidly advancing globalization that has engulfed the entire world, including emerging countries. The question here is whether the surge of market fundamentalism during the last two decades or so would prove to be as unsustainable as the laissez-faire of the gold-standard period. George Soros, for one, believes that market fundamentalism will turn out to be as temporary as the pre-1913 victory of markets over social and political institutions.
Soros said: "I argue that the current state of affairs is unsound and unsustainable. Financial markets are inherently unstable and there are social needs that cannot be met by giving market forces free rein. It is market fundamentalism that has rendered the global capitalistic system unsound and unsustainable. This is a relatively recent state of affairs. At the end of the Second World War, the international movement of capital was restricted and Bretton woods institutions were set up to facilitate trade in the absence of capital movements. Restrictions were removed only gradually, and it was only when Margaret Thatcher and Ronald Reagan came to power around 1980 that market fundamentalism became the dominant ideology."
Soros is right in pointing out that during more than half a century after the declaration by Keynes of the "end of laissez-faire," private international capital movements were quite limited, and it was only after two oil shocks in the 1970s that international financial intermediation started to thrive again. The contemporary version of laissez-faire ideology - market fundamentalism - was implemented by new conservatives such as Thatcher, Reagan and Kohl, revitalizing financial markets like London and New York as the nucleus of global capitalism.
The gradual erosion of financial capital-centered market fundamentalism started to take place with the 1994-95 Mexican crisis and 1995 Argentine crisis. Unlike the Mexican crisis of 1982, when external factors such as a steep rise in the U.S. interest rate and sudden appreciation of the U.S. dollar played a major part in triggering the crisis, there were no apparent external causes in the 1994-95 crisis. International conditions including the U.S. market were stable and economic reforms in both Mexico and Argentina were well received by the international community.
Some economists, notably Rudiger Dornbusch, argued that overvalued currencies were direct causes, as in the case of the Asian crisis of 1997. Indeed, throughout the crisis from 1994 to 1998, overvaluation of the real effective exchange rate was one of the factors triggering the panic. Also, the short-term debts of Mexico and Argentina in 1994 exceeded their level of foreign reserves. In particular, the short-term official debt of Mexico denominated in U.S. dollars (tesobonos) of around $28 billion scheduled to be paid within several months in 1995, far exceeded the level of foreign reserves which at that time were only $6 billion.
A similar situation existed between private short-term debts vis-a-vis the level of foreign reserves in Thailand, Indonesia and South Korea in mid-1997. In Asian countries it was private, short-term debts and not official debts which had accumulated.
Despite some growing signs of vulnerability, these crises from Mexico to South Korea were not predicted by market participants and analysts until certain events, political uncertainty, or bankruptcies of big corporations, triggered panic. Risk premiums in loans remained low, and rating agencies such as Standard & Poor's and Moody's kept their relatively high ratings of sovereign bonds up to the onset of the crises. Many analysts and financiers, particularly at the outset of the crises, argued that the lack of proper disclosure or high level of transparency hampered the appropriate assessment of risks. However, objective evidence and data seem to indicate that the pertinent information was largely available, such as the real effective exchange rates, short-term foreign debts in the private sector, current account balances, and balance sheets of banking sectors.
The problem was that this information was not appropriately incorporated into the risk assessment of the markets. Particularly when one factors in the behavior of non-bank financial institutions such as hedge funds and pension funds, one is inclined to believe that riding with a herd mentality has been more prevalent than rational and detailed calculation of emerging market risks. Moreover, so-called "rational" calculations à la LTCM turned out to be misleading in that their models assumed some stable equilibrium.
Thus, looking more objectively at the details of these crises, one is led to believe that they are testaments to the inherent instability of liberalized international capital markets where sudden reversals of market confidence cause periodic panics of different magnitude and duration. Also, it is interesting to note that both the Mexican and
South Korean crises occurred immediately after these countries joined the OECD, conforming to the code of capital liberalization of the organization.
Indeed, after the substantial liberalization of the capital account of five Asian countries - South Korea, Indonesia, Malaysia, Thailand and Philippines - around 1993 and thereafter, approximately $220 billion in private capital flowed into the region during the three-year period from 1994 to 1996. The reversal of flows in 1997 due to the sudden shift in confidence amounted to roughly $100 billion. No country or region can tolerate this kind of sudden shift in market sentiment from euphoria to panic causing a huge reversal of private capital flows.
AT THE CENTER OF market fundamentalism lies the general acceptance of the Walrasian general equilibrium model, or the neo-classical paradigm. Although many economists came to doubt the universal validity of such models in view of economies of scope, bounded rationality, asymmetric information, and other types of market imperfections and ventured into institutional analysis, the orthodoxy still remains the one which postulates some type of rationality of atomized individuals and the market which mediate among these atomized individuals and firms to reach some stable equilibrium.
George Soros in his recent books contrasts rationality and atomicity to concepts he defines as "fallibility" and "reflexivity." Soros's formulation of the concepts appeals more to our common sense understanding of society and history. Once we assume the rationality and the atomicity of individuals we immediately jump into a timeless world without any social interactions. We simply observe the data as an immovable and timeless object to be analyzed by crude and simplistic mathematical models. Thus, economics becomes devoid of history and society as a dismal science mimicking natural science in its classical form. If one is willing to concede that human knowledge is extremely limited and our future, be it personal or societal, is unpredictable whatever data or analysis we might have, we could easily reason that "many of the greatest economic evils of our time are fruits of risk, uncertainty, and ignorance" as Keynes pointed out in his essay.
Given the limited knowledge and bounded rationality of economic agents and both the simultaneous and intertemporal interdependence of agents with the market, it is extremely difficult to conclude that markets always direct economic agents toward a stable equilibrium. However, in the Walrasian general equilibrium setting, classical or neo-classical or economists assume these problems away by imagining the auctioneer representing, in abstract, all public infrastructure necessary to implement numerous economic transactions in the market in a smooth and legitimate manner. The problem of asymmetric information, monopoly, deception and fraud do not exist because the auctioneer is assumed to be omnipotent in managing the "market." The fundamental issue between institutions, political and social, and markets is simply assumed away, here.
As was rightly pointed out by Karl Polany in the 1940s, the 19th century laissez-faire regime can be thought of as one in which society is forced to conform to the needs of the market mechanism. "Instead of the economy being embedded in social relations, social relations are embedded in the economic system" in this laissez-faire regime. However, it was precisely because of this that the system gradually disintegrated from the early 20th century into economic and social chaos. Polany said: "Since society was made to conform to the needs of the market mechanism, imperfections in the functioning of that mechanism created cumulative strains on the body social."
The situation we are confronted with today at the end of the 20th century seems to be quite similar. Market fundamentalism, the contemporary version of 19th-century laissez-faire, has imposed the market mechanism upon the society of many countries and the malfunctioning of markets has started to cause various social and political problems, particularly in countries in transition and emerging economies. The Russian crisis of August 17, 1998 was quite symbolic in this sense. Seven years of so-called "reforms" to try to adapt Russian society and polity to the market mechanism have not quite succeeded. Instead of transforming into a full-fledged market economy, Russia seems to have developed a virtual economy where substantial portions of economic transactions are conducted through barter. After having been forced to rapidly introduce the market mechanism under 1997-98 IMF programs, Indonesia is now undergoing a very difficult process of adjusting its social and political systems to conform to the market system.
In the process of overcoming the crises of 1997-98, one lesson we all learned was that the free movement of prices, be it exchange rates or interest rates, does not necessarily restore equilibria in markets. Many neo-classical economists argued that if the exchange rate, say that for the Indonesia rupiah, depreciated enough, supply and demand would balance at that level. Instead, in many cases the market simply collapsed and a free fall of the exchange rate took place. Economists call this a case of multiple equilibria and say that once we leave the neighborhood of one equilibrium, we may be thrown into a state of chaos or explosion. In other words, the system, except for the neighborhood of equilibrium, is inherently unstable. If this is the case, flotation of exchange rates, in crisis situations, would not stabilize the situation but could lead to the collapse of foreign exchange transactions. The same could hold for letting the interest rate rise to defend the prevailing exchange rate in some crisis situations. High interest rates would not lead to a stable equilibrium for the supply and demand of domestic and foreign money but would simply result in the collapse of financial transactions in general. In my view, this is exactly what happened in Indonesia in late 1997 and early 1998.
The existence of multiple equilibria and the instability of equilibria outside its neighborhood seem to derive from the fundamental characteristics of market in general but this phenomena may be particularly strong in financial markets. Thus, the so-called boom-and-bust cycle is an intrinsic attribute of any financial market. The financial bubbles in Japan or Asia were not necessarily created by mistakes in macreconomic policy alone but were natural consequences of markets where fallible market participants interacted with each other with less than perfect foresight. That is to say, securing appropriate disclosure and transparency with good macro policies do not necessarily prevent the types of crises we have experienced during the last several years.
IN APRIL 1990, JOHN Williamson defined what he called the "Washington consensus" in relation to conditionalities attached to Latin American countries at the time of the debt crisis of the 1980s. The censensus has served since then as guiding principles among G-7 countries and international financial institutions in managing the global economy of the 1990s. He identified and discussed the consensus on ten policy instruments, but here, it suffices to say that the basis for the consensus essentially boils down to "free markets and sound money."
Since we have already talked about the free-market aspect of the consensus, let me briefly touch on sound money now. Latin American countries in the 1980s and earlier experienced hyperinflation a number of times, and it was absolutely required for policy authorities to control inflation. As a theory of hyperinflation, monetarism seemed to have been the most relevant macroeconomic framework. Thus, it was only natural that monetarist thinking occupied the center stage for policy discussions in the 1980s in Latin American countries. The IMF's financial programming, which is quite monetarist in its theoretical orientation and which is the cornerstone of the IMF's thinking, originated from the Western Hemisphere Department as early as the 1960s, but it was no coincidence that this department dealt with the American continent and mostly Latin American countries.
Another development which served as a vehicle for the proliferation of monetarist thinking was the unification of Europe and the unification of European currencies in particular. The convergence of inflation rates and interest rates among countries was key to the unification of currencies. Thus, anti-inflationary policies through the reduction of fiscal deficits and through sound monetary policies became one of ten core elements in European unification policies. The key country in this unification process, namely Germany, had, like many countries in Latin America, a legacy of hyperinflation.
So far so good. However, if monetarism is enshrined as a universal theory of macroeconomic policy management rather than as a framework to cope with hyperinflation or potential hyperinflation, the problem could arise again. A director of the International Monetary Fund visiting my office a few years ago jokingly told me about an experiment he conducted at the Fund. He crossed out the name of the country from one of the consultation papers and circulated the document among experts in his department asking them to guess the name of the country, which happened to be a relatively small, developing country in Asia. No one was able to guess the name of the country from the paper which was full of Washington jargon, such as money supply, domestic credit, budget deficits, and debt-service ratios.
The blind application of the universal model, be it neo-classical or monetarist, on emerging economies seems to have been the predominant practice by international institutions or other public and private creditors. To some extent, emerging economies themselves accepted such unilateral imposition of dogmatic formulas fearing a negative reaction from the market if they rejected such prescriptions. In this sense, the "Washington" consensus was not only the consensus in Washington but represented the official position of G-7 and other IMF-World Bank member countries, creditors as well as debtors, and market participants. This perfect coordination, on the other hand, generated mutually reinforcing excessively optimistic and then pessimistic expectations about the country in question.
The Asian crisis seems to be a good example of this Washington-generated excessive optimism turned into panic. Asia, particularly Southeast Asia, in some sense, was an area well suited for global laissez-faire type financial and commercial transactions. Southeast Asia had been coordinating with Washington-led globalization with their own traditional structure of global commercialism. Between the 8th and 18th centuries, Asia was the center of world commercial activities among Islamic, Indian, and Chinese merchants and later with Venetian, Dutch and English merchants. Thus, the human networks for global transactions, both financial and commercial, were there and overseas Chinese and Indians could speedily adapt to newly emerging global markets. However, after the Asian crisis, we came to recognize that this resonance of Asian tradition with the Washington consensus had some serious problems.
To the extent that markets believed the payoffs for implementing the Washington consensus in Asia were high, Asia euphoria continued and resulted in huge inflows of capital during 1993 to 1996.
One major aspect of the combination of Asian commercialism and financial and telecommunication globalism was that it tended to skim over the surface of economic structures and weakened the manufacturing base. Projects tended to be concentrated in the services and real-estate industries, such as the construction of financial centers, rather than basic infrastructure or manufacturing. Thus, education and on-the-job training of workers or organizational improvements in corporations tended to lag behind.
Thus, it has been pointed out by many, including Paul Krugman, labor productivity and efficiency gains were not noticeable even in export industries which were affected by the appreciation of the real effective exchange rate. One-time gains in competitiveness due to low wages quickly dissipated, and skyrocketing costs for business offices also resulted in a loss in relative competitiveness.
Thus, it is fair to say that the Asian crisis was not necessarily generated by the unilateral imposition of the Washington consensus from institutions in Washington but was a result of worldwide euphoria about the market mechanism, including that of Asian countries, that created the bubble and eventually the bursting of bubbles in this region.
However, it may be a different matter to argue that crisis management by G-7 countries and international institutions after July 1997 in Asia was, at least initially, seriously flawed. The world establishment still believed in the neo-classical paradigm with a monetarist orientation, and that may have caused fiscal and monetary policy prescriptions that were too tight at the outset and allowed international institutions to impose unrealistic structural reforms which were politically and socially difficult to implement in the short run.
Since I was personally involved in the process and agreed, although reluctantly, in the end to what was recommended, I am in no position to criticize others for what has happened. I can only say that if I am confronted with similar situations in the future I will probably handle them differently. Since the Japanese position on this issue was clearly enunciated by Minister Miyazawa on December 15, 1998 in his speech on the new international financial architecture, it will suffice for me to say, here, that the establishment of a new paradigm for both new international architecture and development strategies is strongly called for today.
THE FINAL AND PROBABLY the most fundamental issue that we confront in addressing the question of a new international financial architecture is the one of globalization. Globalization has progressed quite rapidly during the last decade or so, and, as I pointed out earlier, the information and telecommunications revolution that powered the globalization of the 1990s seems irreversible. Thus, quite a large group of people, probably the majority at this moment, argues that globalization, or the ultimate goal of globalization, namely, the establishment of truly global capitalism, however virtual it may be, is desirable or at least inevitable given the rapid revolutionary developments in computer and telecommunications technology. It is true that the world's financial markets today are increasingly integrated, and real-time virtual transactions are being conducted 24 hours a day. To that extent, one might even argue that we already have global capitalism now, at least among developed countries. However, sovereign nation states still exist, and their policies and announcements affect markets in some fundamental way although their direct leverage on markets may have declined quite dramatically over the past decade or two.
Writers Daniel Yergin and Joseph Staniolau described the post- World War II process as the battle between government and the marketplace. But is this really true? To me, it is intellectually more satisfying to see government and the market as complements rather than substitutes. True, if one considers the market fundamentalists' viewpoint and the communists' perspective, the two could be viewed as substitutes, and developments since 1945 could be analyzed from that angle.
A much longer view of history spanning at the shortest a century seems appropriate. History, according to Fernand Braudel, has three time phases, that of evenement or events, that of conjuncture or cycle, and that of structure. The 50-odd year period since 1945 is too short to be analyzed in terms of structure and should be dissected as a cycle or part of a cycle. My tentative view here is that the period between the 1930s to the late 1990s could be viewed as a long cycle, from the period of strong government intervention after the Depression to a period of market fundamentalism.
As I argued earlier, the period of market fundamentalism in the 1980s and the 1990s under the strong influence of the United States seems to parallel the period from 1870 to 1913 under Pax Britannica. Instead of the gold standard from 1870 to 1913, we have had a de facto U.S. dollar standard during the last two decade or so. The question here is whether this new version of the laissez-faire regime under, say, Pax Americana will continue in the 21st century backed by the computer telecommunications revolution. My answer, as you can guess, tends to be on the negative.
First American dominance which seemed assured for some time after the demise of socialism seems to be declining both in political and economic grounds, partly because of the unification of Europe and partly because of potential anti-American sentiment in various parts of the world that has arisen in recent years. Second, more importantly, global capitalism has turned out to be inherently unstable, and the world cannot bear further turbulences of significant magnitude for long. The basic dilemma lies between free-wheeling global markets and sovereign nation states. Dani Rodik puts this point very succinctly quoting Karl Polanyi -
"Polanyi's enduring insight is that markets are sustainable only insofar as they are embedded in social and political institutions. The institutions serve three functions without which markets cannot survive: they regulate, stabilize, and legitimate market outcomes. This is why every functioning society has regulatory bodies that prevent unfair competition and fraud, monetary and fiscal institutions that help smooth out the boom-bust cycle as well as social insurance schemes that help bring market outcomes into conformity with a society's preference regarding the distribution of risks and rewards."
That is, social and political institutions, or governments, supplement and support markets and do not compete with them. The issue of government versus market should not be translated into regulation versus competition. Government is needed to ensure fair competition, and only with appropriate supervision can financial markets function well and deliver socially desirable market outcomes. The problem we have in the global context is that we simply do not have these global institutions. As long as we have sovereign governments with policy independence, international institutions like the IMF and the World Bank cannot logically play the role of supplementing and supporting global capitalism in a fully satisfactory manner. Coordination of policies does, to some degree. support globalization but to the extent that sovereignty remains, it falls short of fully supplementing global capitalism. Ironically, the waning of American hegemony could reduce the degree of coordination that exists today.
Thus, it is simply a matter of logic to realize that global capitalism cannot be sustained unless we have world government or a world empire dominated by the U.S. or another single nation. In the early 1990s it may have looked as if the U.S. could come close to having a financial empire but that is certainly not the reality we face at the end of the 20th century. What, then, is the alternative? First, we have to assume that in some form or another, nation states, or federations of nation states, will remain and that global capitalism needs to be restrained in its cross-border transactions, be it through disclosure, supervisory and prudential regulations, or outright controls.
Second, in order to limit unilateral sovereign actions from impairing the smooth functioning of markets, common international rules need to be established both in financial and trade areas. Here attention needs to be focused on the maintenance of effective competition and not necessarily insuring unconstrained freedom of market participants.
Third, the coordination of policies should be done on the political level as much as possible with effective technocratic advice from domestic and international bureaucracies. The political will of sovereign states should be respected even for global policy decision-making. This is not to say that the coordination of policies is not necessary. On the contrary, in this post-information revolution age, the need for coordination is absolutely essential, but coordination should remain coordination and not coercion.
Fourth, closely related to the third point, differences among national capitalist structures should be recognized to achieve effective coordination. To the extent that markets need to be effectively embedded in the social and political institutions of a nation state and to the extent that such institutions reflect their history and culture, differences in forms of capitalism remain. Each nation's capitalism must conform to agreed international rules and regulations but need not assimilate the domestic rules and regulations of another country. The world as a whole will probably gain from the systemic diversity of its participating nations as long as they abide by common international rules.
What I aspire to in the 21st century is a global world system that interconnects each region and country with their unique culture and socioeconomic regime. Globalization thriving amidst diversity is my vision for the next century, and I strongly believe this co-existence of diverse civilizations with global networking will create a much better world than the unilateral imposition of monolithic ideologies, such as market fundamentalism.
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