That old wizard Alan Greenspan seems to have done it again. With a couple of deft interest rate cuts, the US Federal Reserve chairman has spurred Wall Street to bounce back to new highs. The threat of an end to the long Goldilocks boom in the US has been temporarily lifted.
Nevertheless, the underlying problems both for the US and the world economy remain acute. The US stock market is so high, and the wealth thus generated so impressive, that US consumers no longer save at all. They are now borrowing more than they are saving, an almost unprecedented phenomenon for a developed economy. Since corporate investment continues to outpace company savings, and the government's finances are merely in balance, it is foreigners who are funding much US investment. Over the past 12 months, net claims on the US rose by $210 billion dollars, and the pace is accelerating. More than a third of outstanding US government bonds are owned by foreigners. The US foreign debt is the largest in the world, and is already greater, relative to exports, than that of many traditionally indebted developing countries.
At any point, this circle could break. If the economy is seen to perform below expectations, then profits will come in lower than forecast. That in turn will undermine share prices, which could hit consumer confidence. The attempt to increase savings could then undermine spending, and slow the economy further. Alternatively, the foreigners could take fright first. That would depress the dollar and asset prices-and slow the US down. In short, the US position is extremely fragile.
Yet the US is performing a vital role as the motor of the world economy-the consumer of last resort. Japan is in no position to pick up the baton. National output has dropped by 3.6 per cent over the last year, and the consensus forecast is for a further 0.9 per cent drop in 1999. Policy-makers in Tokyo continue to be in a quandary over how to respond to their predicament, which will require much bolder measures than they are used to contemplating. So Europe is the last, best hope of maintaining growth in the global economy. Yet Europe-the new Euroland of the 11 members of monetary union-has no previous track record of powering a global recovery, and is ill-prepared to assume any such global responsibilities.
For doom-mongers, the situation is eerily reminiscent of 1929-31, when a financial crisis turned into economic disaster because the old master of the world system-Britain-was no longer able to rise to its responsibilities, and the new master-the US-was unwilling to do so. The euro is a great opportunity for Europe to rebalance the world financial system; but this is not an ideal time to take to the nursery slopes.
These issues of global demand management would be serious enough, but they are in part the result of more deep-seated trends which have been at work on the world economy for the past 30 years. The creation of a global capital market, which began almost by accident with the surpluses of the oil-producing nations in the first oil price shock of 1973-74, now entails huge and often short-term financial flows. For smaller countries and for the emerging markets, these flows can be highly disruptive. On the way into the economy, they can drive up the exchange rate, making exporters uncompetitive, and drive down domestic interest rates, creating local asset price bubbles. Then they can reverse as rapidly as they arrived, pushing interest rates up and the exchange rate down. The real economy of jobs and output is simply incapable of reacting quickly enough to these flows. This was an important part of the story in the Asian crisis which began in Thailand in July 1997, and then spread to Russia and Brazil.
In this respect, the modern world has begun to resemble the world before the 1929 crash much more than the world of 1945-73, which was largely devoid of big private capital flows. In the high period of the Victorian and Edwardian gold standard, capital flows were huge relative to the size of economies. Canada, an emerging market of the day, imported capital worth 8 per cent of its national income every year between 1880-1913, an extraordinary scale of investment.
Although the gold standard-whereby all significant currencies were linked to gold or to other currencies linked to gold-probably helped to stabilise markets, the most arresting feature of the period of high Victorian capitalism was recurrent financial crisis culminating in the grandmother of all crises in 1929. Financial capital appears to be inherently unstable-in part because of the phenomenon identified by Keynes when he said that the important thing in markets was not to pick the best investment, but the investment that other people would think is the best investment. In the markets, they say that the trend is my friend. Finance runs with the herd.
George Soros, as you might expect, is rather good on these matters. A cardinal of the church turned apostate, the wily old speculator describes the inherent instabilities of financial markets and the various ways in which these have been increased recently, both by the application of new technology and by financial innovations. The collapse of Long Term Capital Management is an example. It assessed the riskiness of its investments by looking at the volatility of price movements over a ten-year period, and by assuming that it would always be able to buy or sell its investments at a price. But the volatility was greater-the big shocks always are-and the markets did not allow investors to get in or out.
Soros's solution to these inherent instabilities in global finance is not particularly original; in fact, it is remarkably similar to the scheme put forward by Harold Lever and myself in our 1985 book on the last debt crisis. It is for an insurance mechanism to stabilise private flows. His proposals are clearly still evolving; he gives a rather clearer account of them in his article in the Financial Times of 4th January than he does in his book, which was written at breakneck speed. In the FT, he argues that the IMF should become a lender of last resort for countries which are prepared to meet certain basic conditions, including sound macro-economic policies, well-supervised financial institutions and so forth. For others, IMF support would be available on present terms and conditions with the proviso that any investors would automatically lose a part of their "premium" if IMF aid was necessary.
This sort of scheme is a useful way of stabilising the international system without providing blank cheques to investors, which would only encourage more instability in the future. But the IMF needs more money. One of the reasons why the IMF's packages have proved ineffective over the past year is because the markets no longer believe that they are large enough to turn round confidence. The more money the IMF has, the more time it can afford to give countries to adjust to the new realities which they face, and the fewer the social and political strains in implementing its conditions.
The gradual decline in the scale of the IMF's resources is one effect of what Soros calls "market fundamentalism." The IMF's quotas-which largely determine how much countries can borrow from it-have shrunk from more than 10 per cent of world exports in the late 1960s to just 4 per cent today. But at the same time, the need for resources has increased because capital flows have risen so dramatically. The IMF, now, must not merely close any gap in the trade accounts of a country in crisis, but also provide enough finance to ensure that foreign investors do not withdraw their money. If investors calculate that there is not enough-as in Russia last August-they will head for the door. Even for those countries where the IMF's packages have been slowly working-notably in Thailand and Korea-the adjustment now expected of them is far greater than the similar adjustments expected of developing countries, even in the early 1980s.
Because Soros is, on most of these issues, on the side of the angels, I am inclined to defend him against the monstrous regiment of my fellow members of the Amalgamated Union of Model-builders and Other Economic Professionals, most of whom have taken a dim view of his attempts to parlay his evident ability at making money into a less evident ability to write books. However, overall the book is a disappointing statement of a strong case. The first third is a restatement of the theory of reflexivity-the notion that social sciences are different from the physical sciences because people react to knowledge-which will be familiar to anyone who read Soros's Alchemy of Finance. The last third is a discussion of Popper's notions of the open society, and why market fundamentalism is now a threat to that society.
Edward Luttwak comes at some of the same issues, but with a focus on the real economy of jobs and output rather than finance. His concern is with the inadequacies of the Anglo-American model driven by deregulation and globalisation, and he describes some of the implications for inequality and job insecurity. Much of this material is well ploughed by Robert Reich and others, but Luttwak points out some of the problems of trying to export the essentials of one economic model without some of its alleviating characteristics. He is especially good at explaining the US brand of Calvinism, which implies large charitable donations and inconspicuous consumption.
Ultimately, however, Luttwak hankers nostalgically after a world of happy families where daddy goes into Lever Brothers every morning for 45 years before drawing a company pension, and where mummy chats merrily with the butcher, the baker and the candlestick-maker. In this pre-competitive world, jobs are safe, bosses are not so well-paid and crime is low. But what Luttwak fails to mention is how exceptional that world was: it lasted for a nanosecond of economic history, from 1945 to the first oil crisis. The world of job insecurity is one that our 18th and 19th century forebears would have recognised. In continental Europe, even the postwar period was marked by massive social upheaval because of urbanisation, although this had generally occurred earlier in Britain and the US.
Nor does Luttwak examine the substantial differences in the experience of European countries: it is not necessary, as he seems to imply, to have high unemployment in order to enjoy employment rights and all the other accoutrements of an inflexible labour market. Both Austria and the Netherlands are relatively egalitarian, high-income and successful economies with low unemployment. And his implied solution-protection against foreign imports-would be worse than the disease. Not only would it ensure a gradual divergence from world norms in any country adopting it, but it would also fail to help the unskilled employees Luttwak wants to help. The evidence suggests that the deterioration in the labour market position of the unskilled is more to do with technology than foreign trade.
Capitalism, like democracy, is the least worst system we have got. The right reforms for the new millennium will be the ones which make it more stable at the international and macro-economic level, while enabling people to cope with a world where the boss can trade them in. But remember that they can trade the boss in, too. Choice is not all bad.
The crisis of global capitalism
George Soros, Little Brown, ?17.99
