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title : FinancialCrisesandRecessionintheGlobalEconomy

author : Allen,RoyE.publisher : EdwardElgarPublishing,Inc.

isbn10|asin : 1840640871printisbn13 : 9781840640878ebookisbn13 : 9781840647648

language : English

subject Financialcrises,Recessions,Economichistory--1990-,Internationalfinance.

publicationdate : 1999lcc : HB3722.A361999ebddc : 338.5/42

subject : Financialcrises,Recessions,Economichistory--1990-,Internationalfinance.cover

FinancialCrisesandRecessionintheGlobalEconomySecondEdition

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ThisbookisdedicatedtothestudentsofSt.Mary'sCollegeofCalifornia

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FinancialCrisesandRecessionintheGlobalEconomy

SecondEdition

RoyE.AllenProfessorofEconomicsSt.Mary'sCollegeofCalifornia,USA

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©RoyE.Allen1994,1999

Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystemortransmittedinanyformorbyanymeans,electronic,mechanicalorphotocopying,recording,orotherwisewithoutthepriorpermissionofthepublisher.

PublishedbyEdwardElgarPublishingLimitedGlensandaHouseMontpellierParadeCheltenhamGlosGL501UAUK

EdwardElgarPublishing,Inc.136WestStreetSuite202NorthamptonMassachusetts01060USA

Firstpublished1994Secondedition1999

AcataloguerecordforthisbookisavailablefromtheBritishLibrary

LibraryofCongressCataloguinginPublicationData

Allen,RoyE.,1957—

Financialcrisesandrecessionintheglobaleconomy/RoyE.Allen.-2nded.Includesindex.1.Financialcrises.2.Recessions.3.Economichistory-1990-4.Internationalfinance.I.Title.

HB3722.A361999

338.5'42—dc21

99-21908

ISBN18406408712ndedition(18527899721stedition)

PrintedandboundinGreatBritainbyMPGBooksLtd,Bodmin,Cornwall

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Contents

Figures viiTables viiiPrefacetotheSecondEdition ixIntroduction xi1. TheExpansionandGlobalizationofFinancialMarkets 1I. TheRapidExpansionofInternationalFinance 1II. TheGlobalInformationRevolutionandGlobalFinance 3III. GovernmentalDeregulationandInternationalFinance 7IV. FinancialMarketGlobalizationandInterestRateParity 12V. FinancialStrategyParities 17

2. FinancialMarketGlobalizationandNewTradePatterns 25I. SaverandDissaverCountries 26II. CaseStudyofUS-ForeignTrade,1981– 34III. NewDefinitionsofTradeandtheFollyofProtectionism 42

3. NewUsesandFormsofMoney,MonetaryVelocity,andWealthTransfers 57

I. TransactionsandAssetDemandsforMoney,andMonetaryVelocity 58II. FinancialGlobalizationandMonetaryVelocity 63III. TheDeclineof(ml)IncomeVelocityintheUS 66IV. TheDeclineof(ml)IncomeVelocityintheUKandGermany 73V. TheRecentHistoryofMoneyandWealth 77VI. PolicyImplications 90AppendixRegressionsofUS(ml)IncomeVelocityandRelatedVariables 97

4. FinancialCrisesandRecession 99I. CommonPatterns 99II. The1982RecessionaryPeriod 102III. TheStockMarketCrashof1987 111IV. TheWorldDebtCrisis,1982– 116V. TheEarly1990sRecessionaryPeriod 123VI. The1994–95MexicanCrisis 130

VI. The1994–95MexicanCrisis 130page_v

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VII. Japan'sCrisis,1989– 133VIII. Asia'sCrisis,1997– 136

5. InternationalAdjustmentsandPoliticalResponses 145I. ANewPoliticalEconomyofMoney 147II. TheRoleoftheG7 159III. TheRoleoftheWorldBankandtheIMF 169IV. NationalStrategiesintheGlobalEconomy 176V. Conclusions 191

References 199Index 205

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Figures

2.1 Thetrade-weightedexchangevalueoftheUSdollar,1978–97 352.2 Changesinthedirectionofmerchandiseandservicestradebetweenthe

world'sthreelargesteconomies,1980–97(currentaccountbalances,$billion) 39

3.1Worldwideinstabilityandweaknessinthegrowthoftheincomevelocityofmoneyafter1980 59

3.2 Expandingvolumesofmoney-absorbingfinancialtransactionsintheUS($trillion/year),andtheUS(ml)incomevelocityofmoney,1975–1997 68

3.3 Therelationbetweenfinancialmarketgrowth(£million)and(ml)velocityintheUKduringtheBigBangderegulationperiod 75

3.4 Therelationbetweenfinancialmarketgrowth(marksbillion)and(ml)velocityinGermanyduringthechaotic1989–90period 77

4.1 CapitalflightfromLatinAmerica(1977–87,$billion) 1194.2 Explainingthe1990–91USrecession:thedeclineinnetidentified

capitalinflows(bycategory,$billion) 1284.3 NegativeconsequencesofrestrictiveJapanesemonetarypolicyafter

1989 1354.4 NegativeconsequencesofrestrictiveUSmonetarypolicyafter1993 139

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Tables

1.1 PurchasingpowerparityexchangeratelevelsofoneUSdollar(versusactualexchangerates) 16

2.1 TheturnaroundintheUSCapitalAccount,1980–85($billion) 373.1 Sourcesandusesofforeignsavingsindollars($billion) 854.1 USmonetaryandfiscalpolicyandthe1982recession 1044.2 USGDPcomponentsandthe1982recession(realGDP,1981–84in

billionsof1972dollars) 1054.3 ActualversuspredicteddeclinesinthegrowthratesofUSGDPand

inflation,1981:Q3to1982:Q4(percentagepoints) 1074.4Worldstockmarketsdecline,1987 1144.5 MoneyflowsintotheUSfinancialmarketsinthe1980sandsavesUS

banksfrombadforeigndebts 1214.6 Foreigndebtprices,beforeandafterthestockmarketcrash(incentsper

dollaroffacevalue) 1225.1 TheeconomiccostsofUStradequotaprotectionincars,steel,and

sugar($billion/year) 1895.2 Theeconomiccostsifadeficiencypaymentschemereplacedquotasin

cars,steel,andsugar($billion/year) 190

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PrefacetotheSecondEdition

ThefirsteditionofFinancialCrisesandRecessionintheGlobalEconomywaspublishedin1994.Inthefiveyearssincethen,additionaleconomiccriseshaveoccurred.ThisSecondEditionaddsadetailedaccountoftheMexicancrisisof1994-95,theJapanesecrisiswhichbeganin1989butworsenedinthelate1990s,andtheAsiancrisiswhichhitin1997.

Academicandjournalisticliteratureandpolicymakersthemselvesincreasinglyacknowledgetheriskandseverityofthesetypesofepisodes.Moresystemicandthoroughexplanationsaresought,whichincreasinglyidentifytheimportanceoffinancialglobalizationprocesses.Whenthefirsteditionwaspublished,amemberoftheUSFederalReserveBoardconcluded(inChoicemagazine,January1995)thattheauthor'grosslyoverstates[thatfinancialglobalization]istheprinciplecauseandexplanationofvariouseventsthatAllenexaggeratedlyreferstoascrises'.Yetnow,inlightofrecurringandpersistentepisodes,morepolicymakersandothersadmiteconomic'crisis'intotheirthinkingandlexicon.Forexample,theInternationalMonetaryFundnowconcludesthatapproximatelythree-quartersofitsmorethan180membercountrieshadencountered'significant'bankingsectorproblemsbetween1980and1995,one-thirdofwhichwarrantthedefinition'crisis'(Lindgrenetal.,1995).

Thenatureandcausesofrecenteconomiccrisesareincreasinglydebated,butthereisverylittleconsensus.Tohelpinthisregard,thisSecondEditionprovidesamorethoroughtaxonomyofthe'commonpatterns'.Also,itformalizes'anewpoliticaleconomyofmoney'which,intheauthor'sview,helpstoexplainthecommonpatternsbetterthanconventionalliterature.

ThisSecondEditionalsoupdatesthestatisticalandinstitutionalanalysisofhowmoneyisusedacrosstheglobaleconomy,anditprovidesnewdataandanalysisonvariousaspectsofeconomicglobalization.Inthisregard,asectionon'offshorefinancialmarkets'hasbeenadded.

SpecialthanksgotoPhilipCernyforhisencouragementandeditingofthefirsteditionofthisbookandhiswritingofitspreface,allofwhichlocatedthisworkwithinthevariousdisciplines.PrivatecorrespondenceandareviewofthefirsteditionbyG.Carchedi(Carchedi,1996)helpedtheauthoraddresslong-standingdebatesovereconomicvalueandwealthcreationinthisSecondEdition.Robert

LaurentattheUSFederalReserveistobe

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thankedforhisencouragementandhelpfulcorrespondenceregardingtheeconometricanalysisofChapter3.VariouscolleaguesatSt.Mary'sCollegeofCaliforniaaretobethankedfortheirsupportovertheyears,especiallyWilberChaffeeofthePoliticsDepartmentandAsbjornMoseidjordoftheEconomicsDepartment.

Excellenteditingandcamera-readypreparationsupporthasbeenprovidedbyEricDeloreandNicoleForst.ResearchhelphasbeenprovidedbyMarcPollardandHaydenMcKee.

Finally,theauthorwouldliketothankthemanystudentsatSt.Mary'sCollegeofCaliforniawhohavehelpedtheauthordevelopandclarifythismaterial.

RoyE.AllenMay,1999Moraga,California

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Introduction

Theauthororiginallydecidedtowritethisbookbecauseofhisdissatisfactionwiththetypicaltextbooksininternationaleconomics,macroeconomics,andtherelatedsubjectsthatheteaches.Thesetextbooksdonotpresentthemajorstructuralchangesandrecenteventsintheglobaleconomytohissatisfaction;insufficientattentionistypicallygiventofinancialmarketglobalization,newtradepatterns,newformsandusesofmoney,monetary-wealthprocesses,recentchangesinthevelocityofcirculationofmoney,andrecentfinancialcrisesandrecession.Chapters1–4coverthesetopics.

Chapters1–3areorganizedinamannerwhichprovidesbackgroundmaterialforChapter4'sdiscussionsofeconomiccrises.Thedetailedcasestudiesincludetheglobalrecessionoftheearly1980s,theworldstockmarketcrashof1987,the1980sandcontinuingworlddebtcrisis,theslumpsoftheearly1990s,Mexico'scrisisof1994–95,Japan'scrisisafter1989,andAsia'scrisisafter1997.LessdetailedmentionismadeoftheGreatDepressionofthe1930s,theUSsavingsandloancrisisofthe1980s,theRussiancrisisof1998,andvariousotherslumps.

TheconcludingChapter5,InternationalAdjustmentsandPoliticalResponses,summarizeswhatthebookmightcontributetothefieldsofinternationaleconomics,macroeconomics,andrelatedsubjectssuchasinternationalpoliticaleconomy.Inaddition,Chapter5providessuggestionsforpolicymakers—especiallyhowtheymightminimizetheriskofeconomiccrises.TheroleoftheG7,theWorldBank,andtheIMFaredeveloped,andpolicyproposalsareprovided.Chapter5alsodirectsattentiontothewaysthatnationsmightfinddomesticadvantagewithintheevolvingstructureoftheglobaleconomywithdomesticallydrivenmonetary,fiscal,andtradepolicies.Theconclusionsofpreviouschaptersarecontrastedwithcurrentthinkingontheprocessesofinternationaleconomicadjustment.

Thisbookisrootedmoreintheinternationaleconomics,macroeconomics,andinternationalpoliticaleconomyliteraturethaninotherdisciplines,buttheauthorhopesthatitcanbeusefultoawiderangeofsocialscientists,practitioners,andpolicymakers.Thecasestudiesarenottailoredtoaparticulardiscipline;insteadtheauthorhastriedtomakethemaccessibletoawideaudience.Ifthereaderhassomepracticalexperienceintheinternationaleconomyorsomeacademictrainingineconomicsandrelated

trainingineconomicsandrelated

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fields,thenmostofhisdiscussionsshouldbereadilyaccessible.Unlikemostscholarlybooks,therearemanycitationsfromperiodicalssuchasTheWallStreetJournalandTheEconomistinadditiontoacademicreferences.

Occasionally,asperthemoretheoreticalinterestrateparitydiscussionsofChapter1,foreignexchangemarketdiscussionsofChapter2,andmonetaryvelocitydiscussionsofChapter3,thelessacademicreaderornon-economistreadermaywanttoskipforward.Unfortunately,themoreprofoundandinsightfulconclusionsrequirethesedifficultsections,andthereaderisencouragedtodevoteextratimefightingthroughthem.Atleasttotheauthorsortingoutthistheoreticalmaterialhasbeenwellworththeeffort—ithasgainedhimmanynewinsightsintotheglobalizingeconomicsystem,andithasresolvedmuchofhisdissatisfactionwiththetypicaltextbooks.

Onesourceoftheauthor'sdissatisfactionwiththetextbooksininternationaleconomics,macroeconomics,andrelatedfieldsisthattheytypicallyexplainchangeasanout-of-equilibriumsituationwhichwilleventuallyadjustbacktoequilibriumbasedupontraditional,staticmodels.Instead,inthenewglobaleconomy,economistsandothersshouldthinkofchangeassomethingmoreevolutionary,andevenrevolutionary.Awholeseriesofrelatedstructuralchangesthatarepresentedinthisbookhavenohistoricalprecedent,andtheycontinuetoprovokeotherstructuralchanges.

Intheauthor'sview,itiswithinthiscontextofanevolvingglobaleconomythatonemustattempttounderstandrecentfinancialcrisesandrecession.HedoesnotseerecenteconomiccrisesasstagesoftypicalKeynesianbusinesscycles.Nordoeshebelievethatrecentcrisesarefullyexplainedbythewell-researchedexcesseswithinfree-marketcapitalistsystemsorothersystems.Ifthesecrisescouldbesorootedintraditionalmthinking,thentypicaltextbookcoverageofthemwouldsuffice.

Thisbookelaboratesawholeseriesofrelatedstructuralchangesintheglobalizingeconomythatthenmightallowthereaderamorerealisticunderstandingofrecenteconomiccrises.

understandingofrecenteconomiccrises.

Chapter1presentsastructuralchangewhichshadowsmostotherrecentdevelopmentsintheinternationaleconomy:therapidexpansionandglobalizationoffinancialmarkets.Thischapterdocumentsanddefinesfinancialglobalizationanddiscusseswhatcausedit:developmentsininformation-processingtechnologies;governmentderegulation;andthemoreglobalnatureofalleconomicactivity.Internationalinterestrateparitiesandfinancialstrategyparitieswithin‘one-worldfinancialmarkets’arediscussed,includingtherecentconvergenceofinternationaldebt/equityandprice/earningsratios.

Incontrasttotraditionaleconomicthinking,Chapter2arguesthatthefinancialmarketglobalization,interestrateparity,andfinancialstrategyparityprocessesasdiscussedinChapter1havecaused,ratherthan

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accommodated,largetradeimbalancessincethe1980s.Properconsiderationofthesestructuralchangesleadstonewconclusionsabouttheinternationaladjustmentmechanismsandkeyvariablesthataffecttradeandinvestmentflows.Increasingly,thenationshouldnotbeseenasaself-sufficientor‘balanced’economicregion.Identifyingexactlywhatismeantby‘trade’versus‘investment’inthenewglobaleconomyalsoleadstosomeinterestingconclusions.

InChapter2typicaltradeprotectionismisshowntobeincreasinglyimpracticalbecause:tradedeficitsarenowrequiredbycountrieswhich,duetointerestrateandfinancialstrategyparityconditions,receiveanetcapitalinflow;risingimportsasashareofnationalpurchasesareincreasingthenationalwelfarecostofusingtradeprotectionism;increasesininternationaljointbusinessventureactivityandoverseasproductionaremakingitlesslikelythattradeprotectionismwillachievethedesiredincometransfers;andtheincreaseininternationalownershipofoncenationalcorporationsisalsomakingitlesslikelythattradeprotectionismwillachievethedesiredincometransfers.

Chapter3arguesthattheexpansionandglobalizationoffinancialmarketsasdiscussedinChapter1hasinturnalteredtheuseofmoneyintheinternationaleconomy.Proportionallymoremoneyhasbeenusedtoaccommodatethefastgrowthoffinancialmarketsandproportionallylessmoneyhasbeenavailablefor

growthoffinancialmarketsandproportionallylessmoneyhasbeenavailablefornon-financialorGDPpurposes.Statedintermsofthefamousquantityequation,theincomevelocityofmoneyhasdeclinedfromitshistorictrend.ExplosionsoffinancialactivityleadtoincreaseddemandsformoneybalancesforfinancialmarketparticipationandlessoftheavailablemoneysupplyfacilitatestheproductionandsaleofGDP.Thisrecentabsorptionofmoneyforfinancialmarketpurposesisnotgenerallyacceptedbytheeconomicsprofession,butitisdemonstratedinChapter3.Ifcentralbankersdonotaccommodatethisextrademandformoneyforfinancialmarketparticipationbyincreasingmoneysupplies,thena‘money-liquiditycrisis’canresultandincreasetheriskofeconomiccrises.

Theauthorquantifiestheprofitabilityoffinancialversusnon-financialmarketactivityinChapter3byintroducing‘financialmarketturnover’asasignificantnewvariableintomonetarypolicyresearch.Hisbuildsuponhispreviousresearch(Allen,1989),andhisregressionanalysisappearsintheAppendixtoChapter3.Internationalflowsofcapitalalsoprovetobehelpfulinidentifyingwhichregionsoftheglobaleconomyareexperiencinglowerrelativeprofitability,andthereforewhichregionsaremorelikelytoexperiencefinancialcrisesandrecession.

AlsoinChapter3,‘therecenthistoryofmoneyandwealth’ispresented,whichincludescasestudiesoftheGreatDepression,therecentriseof‘offshorefinancialmarkets’,andanassessmentofhowmonetarywealthis

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currentlybeingcreatedandtransferredacrosstheglobaleconomy.Incontrasttomainstreameconomicthinking,theauthordemonstratesthatnewmoneyforms,newpaymentsystems,andthelaboroffinancialoperatorsin‘one-worldfinancialmarkets’cancreate,destroyandtransferwealthindependentlyoftherealeconomicactivitythatisoccurringinnon-financialmarkets.Changingperceptionsandexpectationsofunderlyingwealthorvaluein‘real’economicactivityhasalwaysprovokedchaoticandunpredictablerepackagingofthisvalueinfinancialmarkets,butvaluehasnonethelessbeenthoughttoflowfromtherealeconomicactivity.However,theauthorarguesthatwealthcanbecreated,destroyed,andtransferredindependentlyofwhatisevenperceivedtobehappeninginnon-financialmarkets.

happeninginnon-financialmarkets.

Chapter4presentsthecasestudiesofrecentfinancialcrisesandrecession,andfindscommonpatterns.Typicallyacountryorregioninitiallyexperiencesafinancialliberalizationphase.Thefinancialsectorexpandsasitcapturesprofitfromnewefficienciesandopportunitiesallowedbyglobalization.Thecountryorregion,foratime,maybefavoredbyinternationalinvestors;thusthebankingsystem,includinggovernment,iswell-capitalizedandabletoexpandmoney-liquidity.Assetsincreaseinmonetaryvalueandinterestratesarelow,andconsumption,borrowing,businessinvestment,andgovernmentspendingareencouraged.Productiveresourcesaremorefullyutilizedandeconomicgrowthiswellsupported.Thereisa‘boom’,asmeasuredbyincreased(a)monetarywealthheldbyprivateandpublicsectorsofaneconomy,suchasthevalueofstocks,realestate,currencyreserves,etc.,and/or(b)thecurrentproductionofmerchandiseandservices(GDP).Inthisfinancialliberalizationphase,excessive,riskyspeculationandinvestmentissometimesencouragedbythenotionthat‘ifIfail,alenderoflastresortorgovernmentinstitutionwillbailmeout’,i.e.the‘moralhazardproblem’.

Then,typically,thesupplyofbasemoney(m)timesitsrateofcirculationorvelocityforGDPpurposes(v)contracts,andthereforesodoestheequivalentnominalGDP.ThedeclineinnominalGDPisusuallysplitbetweenitstwocomponents,realGDPwhichisthevolumeofcurrentproductionmeasuredinconstantprices(q),andtheGDPpricelevel(p).Bydefinition,thequantityequationrequires(mxv=pxq).When(q)declinesforasustainedperiod(typicallyatleastsixmonths)wecallitarecession,andwhen(p)declineswecallitdeflation.Afterthisprocessstarts,monetarypolicymakersmayreactbyrapidlyexpanding(m),butthisactionmaybetoolittletoolate—individualsandinstitutionsmayhaveunpayabledebts,banksmayevenbefailing,andinternationalconfidenceinthecountryorregionmayalreadybedamaged.Aweakfinancialsystemmaybeunabletomaintainthecirculationrateofsecurecurrenciesforproductiveactivities,

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especiallyifpeoplearehoardingmoney.Anunsecureddomesticcurrencymaylosemuchofitsvalueinundesirableepisodesofinflationanddepreciation.

Theinitialcontractionin‘effectivemoney’(mxv)maybecausedbymonetaryauthoritiesornationalandinternationalinvestorsdrainingmoney(m)fromthecountryorregion,ortheremaybeadeclinein(v)forreasonshavingtodowiththeinabilityofthefinancialsystemtodirectmoneytowardproductiveactivities.Acontractionineffectivemoneysuppliesorwithdrawalofinternationalinvestmentmayundermineequitymarkets,debtmarkets,bankcapital,orgovernmentreserves,andmonetarywealthisthenrevalueddownwards.Generaleconomicorpoliticaluncertaintyworsensthesituation—theresultingausteritymentalitycausesacontractionofspendingandcredit,andanincreased‘riskpremium’attachedtobusinessactivityscaresawayinvestment.Interestratesrise,thedemandforquasi-moneyandcredit—i.e.thedesiretoholdandusetheinsecure‘monetaryfloat’—declinesandpeopletrytoconvertthemonetaryfloatintomoresecurebasemoneysuchascash.Noreserve-currencybankingsystemisabletocoverallofitsmonetaryfloatwithsecurebankreservesifcustomerstrytoredeemallofthefloatatonce,andthus‘runs’onbankscandestroythebanks.Adeterioratedbankingsectormaybeunabletohonoritsdeposits,badloanproblemssurfaceanda‘lenderoflastresort’suchastheInternationalMonetaryFund(IMF)mayneedtobefound.

Theauthorwouldcallthesetypesofepisodes(a)a‘financialcrisis’ifthereisasignificantdeclineinmonetarywealthheldbyprivateandpublicsectors,and/or(b)a‘recession’ifthereisasignificantdeclineinrealGDP.

BasedupontheseprocessesandthediscussionsofChapters1–4,inthisSecondEditiontheauthoroutlines‘anewpoliticaleconomyofmoney’(Chapter5).Essentially,hefindsthatfinancialmarketscanredistributewealthandredirectproductionandconsumptionintensitiessomewhatindependentlyofwhatisinitiallyhappening,orevenperceivedtobehappening,inthe‘real’economy.Thisfinding,notacceptedbyeithermainstreamorMarxisteconomics,canneverthelessaccountforwhatthemainstreamhasunderstoodas‘businesscycles’or‘debt-deflation’andwhatMarxistshaveunderstoodascrisesof‘underconsumption’,‘overproduction’,and‘disproportionality’.

Followinguponsomerecentdevelopmentsintheinternationalpoliticaleconomyliterature,theauthor'snewpoliticaleconomyofmoneytreatsmoney,stocks,andotherpecuniaryassetsas‘wealth’inthesensethattheygivetheholderaclaimonthesocialproduct.Monetarywealthisunderstoodnotonlyasconsumptionpowerandproductionpower,butalsoasthepowertodirectandcontrollargesocialprocesses.Theaccumulationofmonetaryassets,orwhatMarxistswouldcalltheaccumulationoffinancecapital,

Marxistswouldcalltheaccumulationoffinancecapital,

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representsasocial-power-claimthatbecomesakeydriverintheevolutionoftheworldsystem.ReversingMarx'scausality,itissometimestruethatautonomous(eventranscendental)financialprocessesdrivethephysical(empirical)relationsofproduction.Oncemonetarycapitalisunderstoodasownershipclaimsovertheentiresocialproduct,thenitsgrowthislimitedonlybythedegreetowhich‘differentialpower’canbegainedintheworldsystem.

Aspartofthisprocess,Chapter3documentsthefactthatcentralbanksandotherfinancialmarketparticipantscan(usuallyhaphazardly)increaseorreducenotonlynominalbutalsorealmonetarywealth,andthereforerealsocialpower,independentlyofanyinitialchangesintheproductionofGDP,perceivedratesofreturnoninvestment,orother‘real’economicprospects.Thesetypesofwealthrevaluationsandtransfershaveoccurredespeciallyacrossthewidespacesoftheglobaleconomy.

Alsoplayingaroleinthisprocess,asconfirmedbytheauthor'seconometricworkinChapter3(updatedsincethefirstedition),istheabilityoffinancialmarketsto‘absorb’moneysothatthemoneyisnotcontemporaneouslyavailabletosupportthe‘realeconomy’.Perhapsthisabsorbedmoney-powerisusedatalaterdatetocommandproduction,consumption,orothersocialprocesses,orperhapsitisdestroyedinaneconomiccrisisbeforeitstitle-holderscanexertthedifferentialpowerwhichitrepresents.Thus,claimsonthesocialproductcanberevaluedandtransferredovertimeaswellasspace.Dependingonthemagnitudesoftherevaluationsandtransfersofmonetarywealthover(howmuch)timeandspace,seriousrealeffectscanbeproducedovertimeandspace,i.e.monetarywealthisnotneutral.

Basedontheseprocesses,andasdemonstratedincasestudies,thisSecondEditionshowsthattheUSandtherestofthe‘hard-currency-core’oftheglobaleconomybenefitfromwhattheauthorwouldcall‘money-mercantilism’attheexpenseofthe‘soft-currency-periphery’.BecauseofthewaythattheinternationalmonetarysystemcurrentlyworkswiththeUSdollarasthedominantreservecurrency,overtimevariousmonetary-wealthtransfersfromtheperipherytothecorehaveoccurredindependentlyofanyotherinherent

instabilitiesintheglobaleconomy.

Inpresent-daymoney-mercantilistUS,economicgrowthmightthusbesignificantlydrivenbya‘thickening’and‘commodification’ofdomesticmarketsassocialagreementsandinstitutionsallowforeignandnewly-createddomesticmonetarywealthtobespentdomestically.Followingthispattern,inthe1990stheUSeconomyboomedaheadwithunexpectedlygreatwork-forceparticipationand‘stressed-out’industriousnessdespitenoobviousinitiatingincreaseintheinherentper-hourproductivityoftheaverageworker.

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1.TheExpansionandGlobalizationofFinancialMarkets

Therapidexpansionandglobalizationoffinancialmarketsshadowsmostotherrecentdevelopmentsininternationaleconomics.Thischapterdocumentsanddefinesfinancialglobalizationanddiscusseswhatcausedit:developmentsininformation-processingtechnologies;governmentderegulation;andthemoreglobalnatureofalleconomicactivity.Internationalinterestrateparitiesandfinancialstrategyparitiesarepresentedasnew,dominant,dynamicequilibriaintheglobaleconomy.

Anunderstandingofthesestructuralchangesandnewequilibriaprovidesanecessaryintroductiontosubsequentchapters,whereitwillbearguedthatthefinancialglobalizationprocesseshaveincreasedtheriskofeconomiccrises.InlaterchaptersitwillalsobearguedthatfinancialmarketglobalizationhasbeenadrivingforcebehindthelargeUStradedeficitsandothercontroversialnewtradepatterns.Inaddition,theself-adjustmentmechanismswithintheglobaleconomyhavebeenirreversiblychangedbyfinancialglobalization.

I.THERAPIDEXPANSIONOFINTERNATIONALFINANCE

Clearly,thelasttwodecadeshasseenanexplosionofinternationalfinancialactivity.TheLondonEurodollarmarket,nowthemajormarketfortheworld'slargestfinancialinstitutions,wasinitsinfancyseveraldecadesago—turnoverintheentireyearof1970was$59billion.Butbythemid-1980sitwasturningover$300billionoffinancialcapitalonanaverageworkingday.Thisvolumewasmanytimesthetotalreservesoftheworld'scentralbanksandatleast25timesthevalueofworldtradeinmerchandiseandservices.TheEuromarketforallcurrencies(inwhichsecuritiesissuersavoidhomecountryregulations)grewtoseveraltrilliondollarsofoutstandingsecuritiesin1997.1

From1980to1985,globalforeignexchangetradingvolumedoubledtoalevelof$150billionperaverageworkingday,whichwasatleast12timesthevalueofworldtradeinmerchandiseandservices.By1990,theaverage

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volumeofforeignexchangetradinghadreached$600billionperday2andduringtheEuropeancurrencycrisisinlate1992,$1trillionperday.Since1992,dailytradinghasaveragedover$1trillion.3Becauseeachforeignexchangetransactioninvolvestwoormorepayments,itmaybethat$3.2trillionmovesthroughtheforeignexchangesettlementsystemseachday.4

Virtuallyeverytypeofinternationalfinancialassetexperiencedasimilarincreaseintrading,andthelistofsuchassetsseemsendless.Notably,thecross-bordertradingofcorporatestock,whichhadincreasedfrom$100billionin1980to$800billionin1986,recoveredfromtheworldstockmarketcrashof1987toreach$1.6trillionby1990.5Short-termcommercialpaper(CP)borrowingbycorporations,oftenwithbankguarantees,grewfrom$40billioninissuesin1970to$700billionin1997.6

TheUSgovernmentsecuritiesmarket,with$3trillionofsecuritiesoutstandingbytheendofthe1980sandadailyturnoverofmorethan$100billion,becamethelargestsingle-assetcapitalmarketintheworld.TheUSgovernmentdebtlimitwasraisedinearly1996to$5.5trillionsothatthegovernmentcouldpayitsbills,andtheannualdeficithadbeenaddingmorethan$200billionperyeartothattotal.Notuntil1998wasthedeficitreducedtoasurplus,thuspeakingthedebtlimit.Thecertificationofforeignfirmsasprimarydealersgavethismarketaboostinthe1980s.Primarydealers,thefirst-roundtraderswiththeFederalReserveBank,haveanadvantagebecauselargeinstitutionalinvestorspreferdoingbusinesswithprimarydealers.BecausethebuyingandsellingofgovernmentbondsbytheFederalReserveBankisthemaininstrumentofUSmonetarypolicy,foreignfirmsandtheirforeignclientsnowplayanactiveroleinUSmonetaryaffairs.Upto30percentofnewUSgovernmentborrowingsweresuppliedbyforeign,especiallyJapanese,firmsbythemid-1980s.Todownplaythesignificanceofthis,theJapanesesecuritiesfirmshavebeenquicktopointoutthatmorethanhalfoftheclientsforwhomtheytradeUSgovernmentsecuritiesareUScitizens.7

InternationalfinancialtransactionsdenominatedinUSdollarsincreased,untilbythelate1980sdollarholdingsbyforeigninvestorsreached$1trillion,over60percentofwhichwereinJapanesebanks.Toputthisnumberinperspective,$1trillionwastheannualamountbeingspentbytheUSFederalGovernmentinthelate1980s,andequalto20percentofUSannualgrossdomesticproduct(GDP).

Thegrowthof‘offshorefinancialmarkets’(Chapter3)makesthistypeofdataincreasinglydifficulttomeasure.But,itislikelythatnon-US-ownedsavingsindollarsofalmost$300billionweremadeavailablefornewusesintheglobaleconomyin1996comparedtolessthan$150billionin1992.Sixtypercentoftheworld'smoneysupplyinrecentyearshasbeenprovidedbytheUSdollar,andmoredollarscirculateoutsidetheUSthaninside.

Bytheendofthe1980s,globalfinancialmarketsweregeneratinganetinternationalflowoffundsofmorethan$3trillioneachmonth,thatis,the

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flowoffundsbetweencountrieswhichreconcilesendofthemonthbalanceofpaymentsdata.Thegrossmonthlyflowisseveralordersofmagnitudehigherthanthisnetflow,anditisincreasinglyimpossibletomeasuregiventheoftenunregulateduseofelectronicfunds,transfers.Ofthe$3trillionnetmonthlyflow,$2trillionisso-calledstatelessmoney,whichisvirtuallyexemptfromthecontrolofanygovernmentorofficialinstitution,butavailableforusebyallcountries.8

Derivativesandothernewexotic‘off-balance-sheet’contracts,whicharebasedonunderlyingbalancesheetassetssuchasstocks,bonds,andcommodities,havealsoaddedtointernationalfinance.TheBankforInternationalSettlementsestimatesthatover-the-countertradinginderivatives,worldwide,was$1trillionin1995,baseduponoutstandingcontractsworth$40.7trillion.Outstandingcontractsincreasedto$55trillionin1997,andregulatoryauthoritieshadnotyetfoundawaytogetcompaniestoaccountforderivativesontheirbalancesheets.9Also,dailyturnoverofexchange-listed(asopposedtoover-the-counter)interestrateandfuturesderivativescontractswasevenhigher,baseduponoutstandingcontractsworth$16.6trillion.10

Thisrecentexplosionofinternationalfinancialactivityhasseveralrootcauses:perhapsmostimportantlyglobaladvancesininformationtechnologyandgovernmentalderegulationoffinancialmarkets.Bothdevelopmentsenhancedthepotentialprofitabilityofinternationalfinance,asdiscussednext.

II.THEGLOBALINFORMATIONREVOLUTIONAND

GLOBALFINANCE

Afinancialtransactioncanlooselybedefinedasanybusinessarrangementwheremoneychangeshandsbuttheonlyotherthingthatchangeshandsisdocumentation.Bothmoneyanddocumentationaremovedbyinformationtechnologies;thereforefinancialmarketactivityisenhancedbyadvancesinthosetechnologies.Expandinguseandperformanceofelectronicandregularmailservice,telephones,computers,faxmachines,imageprocessingdevices,communicationsatellites,fiberoptics,theWorldWideWebandsooncreatesbetteropportunitiesinfinance.

Theexplosionofinformationtechnologiesinrecentdecadesdoesparalleltheexplosionofinternationalfinance.Forexample,in1946theworldhadonlyonewidelyrecognizedcomputer,theENIAC,builtattheUniversityofPennsylvania,weighing30tons,utilizing18,000vacuumtubes,standingtwostorieshigh,covering15,000squarefeet,andcostingseveralmilliondollars.In1956,therewere600computersintheUS,in1968,30,000,in1976,halfamillion,in1988,severalmillion,andbytheendofthecenturyitisestimated

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thathalfofallthehouseholdsintheUSwillhaveafree-standingcomputer(Blumenthal,1988,p.529).

TransistorswereinventedatBellLaboratoriesin1947andintegratedcircuits—theabilitytoputlargenumbersoftransistorsononesiliconchip—weredevelopedinthelate1950s.Butbythelate1980sonememorychipcouldholdasmanyasonemillionbitsofinformation.Computertechnologybenefitedfromtheconvergenceofthreerecentbreakthroughs:artificialintelligence,wherebycomputerssolveproblemsbymanipulatingsymbolsanddecisionrules,makinginferencesandotherprobabilitydecisions,andgenerallysimulatinghumanmethodsofintelligence;siliconcompilers,whichallowthecompletedesignofintegratedcomputercircuitsonacomputerbyanycomputer-literatepersonwitha$50,000workstation;andmassivelyparallelprocessing,wherebymanycomputeroperationsoccursimultaneously.CarverMeadoftheCaliforniaInstituteofTechnology,oneoftheindustryexpertsandtheinventorofthesiliconcompiler,predictedthattheseandotherdevelopmentswillresultina

10,000-foldincreaseinthecost-effectivenessofinformation-basedcomputertechnologyoverthelasttwodecadesofthecentury.11

Othermajorscientificdevelopmentswhicharefuelingtheinformationrevolutionare:thedevelopmentoffiberopticcables,afewpoundsofwhichcannowcarryasmuchinformationasatonofcoppercables;andcontinuingdevelopmentanddeploymentofcommunicationsatellites,whichbounceinformationaroundtheworldatnearlythespeedoflight.Asinglecommunicationsatellitenowdisplacesmanytonsofcopperwire,andthisdisplacementfactorisincreasing.Bythemid-1980sapproximately60percentofthetrans-Pacificforeigncurrencytradingand50percentofthetransAtlanticforeigncurrencytradingwasdoneviasatellitetransmissions,12whichallowedforagreatlyincreasedglobalflowoffunds.SatellitetransmissionsfacilitiesarecollectivelyownedandoperatedbynationalgovernmentsthroughIntelsatinproportiontonationaluse.

Inthelate1980s,thetelecommunicationsindustrybecamethelargestsourceofnewjobsintheUSandperhapstheworld.Althoughthejobsaresoscatteredamongequipmentmanufacturers,installers,andusersthattheyarehardtokeeptrackof,itwasestimatedin1986thatmorethan2millionwereemployedinthisindustryintheUS,andthenumberwasgrowingby200,000eachyear.13IntheUSfewerletterswerewritteninthe1980s,butthereweremoretelephonecalls—anaverageoffourcallsperdayperperson.Morecallsweremadethroughcomputermodemstoretrieveinformationfromdatabases.In1980,veryfewUShomeshadmodems,butbythelate1980sclosetoonemillionhomeshadthem.14Thistechnologyandothers,includingthefacsimile(fax)machine,enhancetheefficiencyoflegalandbusinessdocumentation.First-generationfaxmachinesfromthe1970stooksixminutestosendonepageofdocumentation,butbythelate1980sthetransmissiontimewasdowntothreesecondsandthepopularityboomed.In

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1987,460,000facsimilemachineswereinstalledintheUS,comparedto190,000in1986.15Bytheearly1990s,therewereoveronemillioninstallationsperyear.Inthelate1980s,morethan$100millionworthofvideo

teleconferencingservicesandequipmentweresoldintheUSeachyear,andpricesweredecliningbyanaverageof15percentperyear.Manycorporationsbeganusingfull-motionimages,suchasthoseofasportingevent,intheirteleconferences.Tohandleallofthisgrowthinthelate1980s,thecapacityofinternationaldatacircuitshadtoriseby40percentperyear.16

Today,privatebanktelecommunicationsnetworksincludeManufacturersHanoverTrust‘sT1(high-speed)backbonenetworkbetweenitsUSlocationswhichlinkswithitsglobalX.25packet-switchingnetworkbasedonTelnet(nowSprinthardwareandsoftware)thatconnects52citiesin27foreigncountries.Inthe1980s,Citibankdeveloped100separateprivatenetworkscovering92countries,whichwerecombinedintoanintegratedglobalinformationnetwork(GIN)in1992.ChasehasasimilarnetworkprovidedbyTymnet,whichisownedbyBritishTelecom,andBankofAmericahasasimilarnetworktosupportitsWorldBankingDivision.BankersTrust(purchasedbyDeutscheBankin1998)isnotedforpreferringearth-basedtosatellitelinksinitssysteminordertoavoidsiveral-seconddelays.InEurope,theBelgian-basedSocietyforWorldwideInterbankFinancialTelecommunications(SWIFT)handlesmessagevolumesthathaverisenfrom3.2millionin1977to604millionin1995.

Changesincommunicationshavealwaysaffectedthestructureoffinance,butthesedevelopmentsofthelastfewdecadesareresponsibleforthetrulyglobalnatureoftoday'sfinancialmarkets.Asparticipantsusethesenewtechnologiesandnetworks,linkagesareformedbetweenvariousnationalandinternationalsub-economyfinancialmarkets.Newinternationalopportunitieshaveoccurredforcenturies,butonlyrecentlyhasinterdependencebecomesopervasivetomerittheword‘global’.Thetransatlanticcablewascompletedwaybackin1867,andthepriceofthedollarinLondoncouldthenbefoundoutintwominutesratherthantwoweeks.Evenfurtherbackinthehistoryofinformationfinance,theRothschildsusedcarrierpigeonstogainadvance(andthereforeprofitable)newsoftheNapoleonicwars.Perhapsnosingleexampleofnewinternationalfinancialtechnologyinthelastfewdecadesismoreimportantthanthese,butthousandsoflesserexampleshavebeencollectivelymoreimportantintheglobalizationprocess.

Theswitchingoffinancialmarketsfrompaper-driventradingfloorstocomputerscreensaswithAmerica'sNASDAQanditshookupswithLondon's‘off-(theLondonStock)exchangemarket’isoneexampleofhowanewcomputer-basedtechnologyhasencouragedglobaltrading.Itisestimatedthatbetween$200millionand$300millionofforeignstockshareschangedhandsdailyin

millionand$300millionofforeignstockshareschangedhandsdailyinLondon'soff-exchangemarketinthe‘BigBang’deregulationyearof1986,roughlydoublethelevelsof1981,withhalfof

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thatvolumeinUSstocks.17ThatlevelequaledasmuchashalfthevolumeontheLondonStockExchange,whichalsotradesmanynon-Britishsecurities.

NetworkswhichnowhandlestaggeringamountsofmoneyincludetheClearingHouseInterbankPaymentsSystem(CHIPS)whichisrunbyprivatebanksoutofNewYork.CHIPSmostlyhandlesforeignexchangeandotherlarge-value,wholesale-levelinternationaltransactions,andthenetsettlementofitstransactionsisindollarreservesthroughtheFederalReserveBankofNewYork.TransfersthroughCHIPSincreasedfrom$16trillionin1977tomorethan$310trillionin1997.TheFederalReserve'sFedwireisitselectronicfacility,whichtransfersreservebalancesamongprivatebanksthroughdedicatedwireandisthefavoredsystemforlargedomestictransfers.TransfersthroughFedwireincreasedfrom$2.6trillionin1977tomorethan$225trillionin1997.Onadailybasis,CHIPSandFedwirenowmovemorethan$2trillion.Retailsystemssuchascreditanddebitcardstransferanadditionalseveralhundredbilliondollarsperday.Thesedailyrecordedflowsamounttohalftheentirebroadmoney(M3)stockoftheUS,andmorethanone-thirdoftheUSgrossdomesticproductforthewholeyear.18ComparedtotheUS,Europeusesevenmoreelectronictransfers:forexample,itsGIROcredittransfersystemsendsmoneydirectlyfromthebuyer'saccounttotheseller'sandaccountsfor19percentoftransactions,whereasindirectanddebit-basedchecksaccountforonly2percent.

Countlessothernewtechnologieswhichenhancetheopportunitiesinboundary-lesselectronicfinanceincludeautomatictransfermachines(ATMs),electronicpointsofsale,telephonebanking,interactivescreencommunicationsbetweenfinancialintermediariesandtheirwholesaleandretailcustomers,evermoreinnovativedebitandcreditandsmartcards,andevenelectronicwallets.Computer,telecommunications,andother‘non-bank’firmshavebeguntoenterthesemarkets.TheDiscovercardwasoriginallyofferedbytheretailerSearsinthe1980s,andthensoldtothebrokeragefirmDeanWitter.Shortlyafter,

AT&T&sUniversalcreditcardbeganofferingVisaorMasterCardthroughUniversalBank.Globalizationofplasticpaymentcardsisnowbeingrealized.Worldwidespendingatmerchantlocationsongeneral-purposecardstotaled$1.47trillionin1995,andisprojectedtoincreaseto$3.26trillionin2000and$6.43trillionin2005.Ofthe1995total,theUShada47.5percentshare,Europe25.8percent,andAsia/Pacific18.0percent.19PerhapsglobalizationofpaymentsystemswillmovefromplastictotheInternetwithalliancesbetweencompanieslikeMicrosoftandbanks.BillGates,ChairmanofMicrosoft,envisionsafutureof‘frictionlesscapitalism’ontheInternet.20

ElectronicbankingprogramshavebeenusedforaslongastheInternet—morethantwodecades.Thephrasewhichhasstuckis‘electronicfundstransfer’(EFT),andEFTsystemshaveallowed‘fastmoney’or‘hotmoney’flows,andnow‘virtualmoney’.Virtualmoneyisacatchphraseforahostof

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innovativepaymentformssuchaselectronic(e-)cashanddigitalmoney.Aswithinternetcommunications,virtualmoneydeliveriescanbenon-centralizedand‘non-physical’beyondthe0-1on-offdigitalswitchingofcomputersystems.

Virtualmoneysystemsarenotalwayssubjecttobankingregulations.Forexample,inHongKongasofAugust1998,theOctopuscardsystemhadcreatedHK$4billion($516million)ofelectronicmoneyinaneconomywithapproximatelyHK$100billionofcurrencyandcoinscirculating.E-moneytransactionsintheOctopussystemamountedto$HK17billionperday.Octopuscards,ownedbytwo-thirdsofthelocalpopulation,areeasilyreadbysensorswithoutwaiting.TheOctopussystemisrunasajointventurebyvarioustransportcompanies,andisnottechnicallyabank(yet),butthecompaniesarefreeto‘reuse’andinvestmostoftheHK$4billionincustomerdeposits.Whetherriskmanagementandfundsonhandaresufficienttocoverreliablycustomer-redemptionsofthefloatiscontinuallyunderreviewbytheHongKongMonetaryAuthority.

Whatremainstobeseenisthedegreetowhichnewvirtualmoneysystemscreatenewmoneystock,versusthedegreetowhichthesesystemsmerelymovearound‘realmoney’whichalreadyexistsinbankaccountsindepositform.Chapter3developsthisissuefurther,byrelatingthemoneystockandits

Chapter3developsthisissuefurther,byrelatingthemoneystockanditsvelocityofcirculationtothe‘real’growthoffinancialandnon-financialmarkets.Increasingly,itisdifficulttoknowwhethereconomy-widegrowthintotaltransactionsisbeingaccommodatedbyincreasedmoneystockorincreasedvelocityofcirculationofmoney.Perhapsthedistinctionbetweenmoney‘stock’and‘circulationofthestock’willbecomelessusefulasthemonetarysystemco-evolveswithnewinformation-processingtechnologies.

Moreofthemoneystockmovesaselectromagneticwavesorphotonparticles.Theaverageretailuserofmoneystilldependsmostlyonpapermoneyandplasticcards,butthemultinationalcorporationorfinancialinstitutionortraderreliesmostlyonsatelliteandfiber-opticrouting.Thelargewholesaleamountsaretransferredelectronically.For1995theUSFederalReserveestimatedthevalueofUSelectronictransactionsat$544trillion,checktransactionsat$73trillion,andcurrencyandcointransactionsat$2.2trillion.However,thephysicalnumberorvolumeofcurrencyandcointransactionswasestimatedat550billion,checktransactionsat62billion,andelectronictransactionsat19billion.

III.GOVERNMENTALDEREGULATIONANDINTERNATIONALFINANCE

Theglobalizationoffinancialmarketshasalsobeenencouragedbygovernmentderegulation.Governmentshavebeenabandoningfinancial-

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marketprotectionism,decidinginsteadthatthebenefitsprovidedtotheircitizensbythenewinternationalopportunitieswilloutweighanylossestopreviouslyprotectedgroups.

Linkedtogetherwithnewinformation-processingtechnologies,borrowersandlendersarecompletingtransactionsinnewinternationalmarketswhicharemoreprofitablethananyopportunitieswithintheolddomesticmarkets.Governmentshaverecognizedthevalueofgivingtheircitizensaccesstothenewinternationalmarkets,especiallybeforeothercountriesextendthesameopportunitiestotheircitizens.Aswithanyprofitablenewmarkets,thosewhoareabletoparticipatefirstareoftenthemostsuccessful.Eventually,ascompetitionincreases,the

firstareoftenthemostsuccessful.Eventually,ascompetitionincreases,theprofitabilityisreducedtomorenormallevels.

Athresholdwasreachedbytheearly1980s:governmentsbeganrushingtowardfinancialmarketderegulationandinternationalizationinordertocapturealargeshareofthenewprofitabilityfortheirownmoneycenters,andinordertoattractnewinternationalfundsintotheirowneconomies.Policymakersremovedceilingsoninterestrates,reducedtaxesandbrokeragecommissionsonfinancialtransactions,gaveforeignfinancialfirmsgreateraccesstothehomefinancialmarkets,allowedincreasedprivatizationandsecuritizationofassets,andtookotherstepswhichallowedmoneytomovemorefreelyandprofitablybetweeninternationalandnationalmarkets.

MuchoftheglobalderegulationmovementcamefromtheReagan/Thatchersupply-sidemovementoftheearly1980sinwhichtheprivatemarketswereencouragedtotakethelead—oftenwithoutaclearunderstandingofwhat‘freemarkets’meanininternationalfinance.Speakingtotheauthor'sclassyearslater,theearly1980sUSComptrolleroftheCurrencystatedthathe,Reagan,FederalReserveChairmanVolkerandothers‘believedintheprincipleoffreemarketfinance,butwecouldnothavepossiblyimaginedthelongrunconsequences’.In1996,theUSComptrolleroftheCurrencyissuedarulepermittingnationalbanks,inprinciple,toownsubsidiariesinanyfinancialservicesbusiness,butdebatecontinuesregardingwhatthisrulemeansinpractice.

Deregulationwasadvancedundertheconsensusthatfinancialmarketprotectionismhadfailed.Forexample,TheUSInterestEqualizationTaxofthe1960swasaformofprotectionism;variousUSlendersweretaxedforlendingoverseas,andimmediatelyreducedtheirforeignactivitiesandincreasedtheirdomesticbusiness.Along-runproblemwithprotectionism,however,especiallyinfinancialmarkets,isthatbusinesspeopleusuallyfindawayaroundtheprotectionism.TheInterestEqualizationTaxreducedtaxablecapitaloutflowsfromtheUStonegligibleamountsin1964,butnon-taxableoutflowsrosetofillthegapby1966.Thetaxencouragedthedevelopmentofinternationalfinancialmarkets,especiallyinEurope,thatUSbankscouldlendfrom,butwhichUSpolicymakerscouldnotregulate.New‘non-European’bondissuesinEuropeincreasedfromlessthan$200millionin

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1962tonearly$1.5billionin1966.21TheInterestEqualizationTaxwasfinallyremovedin1974.

OtherregulationsthathadshiftedUSbankactivitytotheEuromarketswereRegulationQoninterestrateceilings,theForeignCreditRestraintProgramandrulesoftheOfficeforForeignDirectInvestment.Thesetypesofregulationsweredismantledinthe1980s.

On1April1986,theUSgovernmentendedthe5.5percentinterestrateceilingonpassbookaccountsasthelaststageinitsderegulationofconsumerinterestratespaidbybanksandsavingsandloaninstitutions.Especiallyimportantinthisprocesshadbeenthecreationofautomatictransferservices(ATS)in1978,negotiableorderofwithdrawal(NOW)accountsin1981,andSuperNOWaccountsin1983.Thesearecheckable‘money’accountswhich,forthefirsttime,offeredinterestrateshighenoughtoattractfundswhichotherwisewouldbespentonmerchandiseandservicesorputinto‘non-money’financialassetssuchasstocks,bonds,andmoneymarketfunds(MMF).By1984,8percentofallcheckingaccountsatUSbanksand30percentofallcheckingaccountsatUSthriftswereSuperNOWaccounts,22whichwereabletopayinterestratesalmostashighasMMFs.

Alsoin1986,threeofJapan'sbiggestsecuritiesfirmswereallowedtobecomeprimarydealersinUSgovernmentsecurities.NomuraandDaiwaSecuritiesCompanieswerethenabletotradedirectlywiththeNewYorkFederalReserveBankaspartoftheirbattleforglobalmarkets.Additionally,theIndustrialBankofJapangainedthisprivilegeviaitspurchaseofprimarydealerAubreyG.Lanston&Co.Onthatdatefiveotherforeignfirms—oneCanadian,oneAustralian,onefromHongKongandtwoBritishinstitutions—alreadyownedprimarydealers.23

TheUSGlass-Steagalllawsofthe1930swhichseparatecommercialandinvestmentbankingarealsobeingslowlydismantleddespitesomeattemptsatre-regulationduringeachfinancialcrisis.USbankscannowtradestocksfortheircustomers,butnon-bankcommercialenterprisescannotgenerallyownbanks.

UKfinancialderegulationinthe1980sparalleledthatintheUS,andduetotheinternationaldominanceofNewYorkandLondonasfinancialcenters,thesetwo

internationaldominanceofNewYorkandLondonasfinancialcenters,thesetwocountriesinfluencedfinancialdevelopmentselsewhere.InOctober1979theUKremovedallinwardandoutwardbarrierstocapitalflows.Consequently,Britainexperiencedanannualportfolioinvestmentoutflowforthe1980–83periodthatwas1800timeshigherthaninthe1975–78period(TaylorandTonks,1989).

Finally,on26October1986London's‘BigBang’financialmarketderegulationscrapped85yearsoffixedcommissionsforbrokersaswellasseparationofpowersbetweenbrokers.AsstatedbyJohnM.Hennessy,chairmanofCreditSuisseFirstBostonLtd.,aleadinginternationalinvestmentbankbasedinLondon,‘BigBangisanattempttogenerateafewglobalcompetitorsamongtheBritishinstitutions’.24Competitionincreased

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immediately.Forty-ninefirms,includingAmerican,EuropeanandFarEastfinancialgiantshadsignedupbefore26OctobertomarketBritishstocksandgovernmentbonds;only19companieshadbeendoingthistradingpreviously.25Inaddition,after26Octobercommissionschargedbyfinancialintermediariesdroppedasmuchas50percent.

Recognizingthemoreintegratedandglobalnatureoftheirfinancialsystem,theEuropeanCommunityCommissionbeganmovingtowardaunifiedfinancial-servicesmarketforthetwelveCommonMarketcountries(by1992),includinguniformlendingrestrictionsandreportingoflargeloans.26Also,asof1992allinternationalbankssubjecttotheauspicesoftheBankforInternationalSettlements(mostdevelopedcountriesandinthefuturesomeLDCs)mustmeetcommoncapitaladequacytargets—thefirstrealattemptataglobalstandardforbanking.

AnxiousnottolosebusinesstoNewYorkandLondon,othercountriesembracedtheinternationalfinancialmarketsinthe1980s.On4December1986,theOntario,Canada,governmentannouncedthatitwouldopenthehighlyrestrictedCanadiansecuritiesindustrytounrestrictedaccessbyforeignersandCanadianfinancialinstitutions.PreviouslawprohibitedforeignersandCanadiansoutsidethesecuritiesindustryfromowningmorethan10percentofasecuritiesdealer.Underthenewregulations,foreignerscouldown50percentof

aCanadiansecuritiesdealerafter30June1987and100percentafter30June1988.27

By1984,JapanhadgivenUSbanksvirtuallyfreeaccesstomanyoftheTokyofinancialmarketsincludingtheunderwritingofJapanesegovernmentbonds.TheJapanesegovernmenthaddecontrolledmostnationalinterestratesbythelate1980s,thusfinishingaprocessstartedin1979,whenincreasedcompetitionwascreatedbetweenJapanesebanks,securitiesfirmsandinsurancecompanies.Notably,JapanesereformoftheForeignExchangeandForeignTradeControllawinDecember1980allowedthesecompaniesgreaterabilitytoissuebonds,buyandsellsecurities,andholdforeigncurrencydeposits.WhiletheholdingofforeignsecuritiesbyJapaneseinsurancecompanieshasbeenrestricted,statutorylimitshavenotbeenbinding(Davis,1990).And,bythemid-1980s,USsecuritiesfirmshadbecomeactiveplayersintheTokyomarket.PaineWebberopenedalargeTokyobranchofficeinApril,1986,MorganStanley&Co.atthattimehadbuiltaTokyostaffof160,Goldman,Sachs&Co.had60people,SalomonBrothershad80,andMerrillLynchhad260.And,whathasbeencalledJapan's‘BigBang’occurredinApril1998whentheForeignExchangeLawabolishedtheremainingrestrictionsoninternationalfinancialtransactions.

Mr.YusukeKashiwagi,chairmanoftheBankofTokyo,prophesiedduringanimportantlecturetotheInternationalMonetaryFundinWashingtoninSeptember,1986,thatTokyowilleventuallybelinkedwithNewYorkandLondon,toforma‘three-partaxisofglobalfinance’.28TokyositsinatimezonebetweenNewYorkandLondonanditmakesanaturalbridgefor24-

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hour-a-daytrading.Mr.KashiwagiestimatedthattheAmericanfinancialmarkethadanannualvolumeof$7.1trillionin1986,Japanwassecondintheworldwith$2.2trillionandGreatBritainwasthirdat$1.6trillion.Between1970and1985,Japan'sfinancialmarketsgrewattherateof18.3percentperyear,GreatBritain'sat14.5percentandtheUSat8.8percent.Integrationbetweenthesemarketshasmorerecentlymadeitdifficulttoestimateseparatestatistics.TheUSFederalReservehasextendedtheopeningtimeofFedwireto12:30A.M.(Easterntime)from8:30A.M.,sothatthesystemcanreceiveandprocessforeignexchangetransactionswhilebothEuropeanandAsianmarketsarealsoopen.Arelatedinitiativebybanksfrom20largeindustrialcountriesiscurrently

open.Arelatedinitiativebybanksfrom20largeindustrialcountriesiscurrentlyinprogresstocreatealimited-purposebanktoclearforeignexchangetransactionsandthusremovepaymentdelaysinCHIPS.

Germany'smajorderegulationwasitsliberalizationofforeignexchangecontrolsinMarch1981.InternationalcapitalmovementswerealsoencouragedwhenGermanyabolisheditswithholdingtaxoninterestpaymentstoforeignersinAugust1984—onemonthaftertheUShadremoveditswithholdingtax,andduringthesameseveralmonthsthatJapanreciprocated.

Theprocessoffinancialglobalizationwasfurtherencouragedwheretherewasaneedtoreducebudgetdeficits,becausegovernmentsnowhadareadysourceoffundsintheinternationalprivatizationoftheirassets.Forexample,afterMitterrand'ssocialistrevolutionlostsupportinFranceandChiracwaselectedPrimeMinisterin1986,thecenter-rightcoalitionembarkedonanambitiousdenationalizationprogramtoprivatizeownershipofmanylargecompanies.Anunexpectedlypopular$40billionsell-offofgovernmentcorporationstotheprivatesectorseemedtomarktheendofthesocialistrevolution.Thedenationalizationprogramallowedforeigninvestorstobuyupto20percentofthenewlyprivatizedfirms.InOctober1986,theBritishbrokerMorganGrenfellSecuritiesInternationalplaceda$100millionpackageofFrenchsecuritieswithUSandBritishinstitutionalinvestors,thebiggesttransactionofitskindinFrenchhistory.29ByJanuary1990,Francehadcompleteditspiecemealliberalizationofforeigncapitalflowregulations.

Eventhehistorically-closedChinaandUSSRbegandevelopinglinkswithglobalfinancialmarketsintheexplosivemid-1980s.InNovember1986,agroupoftopWallStreetexecutivesmetwithhighChinesepoliticalandfinancialofficialsinPekingfortalksonhowsecuritiesmarketsshouldberunandonhowfinancialcapitalcanberaised.StocktradinginChinabeganon26September1986forthefirsttimesincetheCommuniststookpowerin1949:TheJingan-districtbranchofShanghaiTrust&InvestmentCo.,China'smainvenueforstocktrading,eventuallyhadtomoveinDecember1986fromabranchofficemeasuringonly430squarefeettoanewlocationfivetimesaslarge.30

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Besidesbeginningtotradelocalissuesinsecuritiesmarkets,Chinaalsosoldmorethan$2.5billionofdebtsecuritiesoninternationalmarketsin1985and1986andbegandevelopingamodernbankingsystem.31China'sfive-yearplanfor1986–90resultedinapproximately$30billioninnewforeignloans,whichincreasedChina'sforeigndebtfrom$14billionto$40billionoverthatperiod.ChinaissueditsfirstEurodollarbondsinAugust1987,twomonthsaftersettlinga38-yeardisputewiththeBritishgovernmentoverdefaultedbondsandBritishassetsthatwereseizedduringtheCommunistuprisingin1949.32

PerhapsthemostsignificanteconomicchangeintheUSSRduringtheGorbachevperiodwastheincreasedaccesstoWesternfinancialmarkets.In1987theUSSRsettledczaristdebtswithBritainandSwitzerlandinordertogainaccesstotheEuropeanbondmarkets.In1988,theUSSRhaditsfirstpublicbondofferingontheinternationalcapitalmarketsandowed$25.9billiontowesterncommercialbankscomparedto$11.3billionin1985.33

IV.FINANCIALMARKETGLOBALIZATIONANDINTERESTRATEPARITY

RichardO'Brienprovidessomehelpfuldefinitionsofglobalizationprocesses:

Internationalmeansactivitiestakingplacebetweennations...multinationaldescribesactivitiestakingplaceinmorethanonenation...globalshouldrefertooperationswithinanintegralwhole,ifitistohaveaseparatemeaningfromtheforegoingterms.Globalcombinestheelementsofinternationalandmultinationalwithastrongdegreeofintegrationbetweenthedifferentnationalparts...Atrulyglobalserviceknowsnointernalboundaries,canbeofferedthroughouttheglobe,andpaysscantattentiontonationalaspects.Thenationbecomesirrelevant,eventhoughitwillstillexist.Thecloserwegettoaglobal,integralwhole,thecloserwegettotheendofgeography(O'Brien,1992,p.5).

ForthepurposesofthisbookO'Brien'sdefinitionofglobalismisuseful—operationstakingplacewithinanintegratedwholewherebygeographicboundariesarenotimportant.GiventheincreasingfinancialopennessofevenChinaandtheCommonwealthofIndependentStatesthe‘integratedwhole’nowincludesmostdevelopingaswellasdevelopedcountries.

Theglobalizationoffinancialmarketshasmeantthatborrowers,lendersandotherinvestorshaveincreasedabilitytomakeinexpensiveinternational

otherinvestorshaveincreasedabilitytomakeinexpensiveinternationalcontractsthroughfinancialintermediaries.Globalizationisencouragedbytheinformationrevolution,whichmakesbusinesspeopleandfinancialintermediariesmoreawareof,andnetworkedto,alltheinternationalopportunities,sothatthefinancialmarketsbecomemoredynamicand

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competitive.Dynamicmeansthatthereactionsofmarketparticipantsarequicklyprovokedandaccommodated.Competitivemeansthatnobusinesspersonorfinancialintermediaryhasastrongadvantageoverothersforasignificantperiodoftime.Forexample,eachmustaccepttheinterestrateforcertaintypesoftransactionsthattheglobalmarketproduces.

Someefficienciesresultfromthedynamic,competitivenatureoftheglobalizedfinancialmarket.Financialintermediariesmustadoptthecheapestinformation-basedtechnologiesthatcanreliablyperformthenecessaryservicesiftheyaretoprofitablysurvive.Embracingtheinformationrevolutioniscrucialtothem.Also,financialintermediariesmustbewellinformedabouttheneedsoftheircustomers.Iftheydonotsupplythemixoffinancialserviceswhichtheircustomersaremostwillingtopayfor,thentheywillalsobecompetedoutoftheglobalmarket.

Withfewerrestrictionsoninternationalfinancialtransactions,interestrates—ormorepreciselythetotalexpectedreturnincludingforeigncurrencyrisk—forsimilartypesofloansaremoreuniformaroundtheglobe,andthesenewglobalinterestratesarelowerthantheaverageofalltheoldnationalinterestrates.Thenewglobalinterestratesarelower,becausecountriesorindividualsthatcanofferlowerinterestrateshaveexpandedloans,highinterestrateloanshavecontracted.Therehasbeenanetexpansionofthevolumeofloansbecausemorepeoplehaveborrowedatthelowerglobalinterestrates.Theissuersofthelowinterestrateloanshaveprofitablyexpandedtoaccommodatethesenewborrowers.Inotherwords,lowinterestratelendershavetakencustomersawayfromhighinterestratelendersandhavefurthermoreencouragedsomenewborrowerstogetintothemarket.

Forexample,thehighinterestratesininternationalmarketsintheearly1980swereinUSdollars,andthelowinterestrateswereinJapaneseyenandGerman

marks.Then,asfinancialmarketswererapidlyderegulatedandintegratedbetween1983and1988,thedollar'sshareofinternationallendingfellfrom72percentto53percentasUSbanksandthriftswereoutcompeted,theyen'sshareincreasedfrom3percentto10percent,andthemark'sshareincreasedfrom5percentto10percent.34Inaddition,thevolumeofinternationallendingincreasedfasterthanatanytimeinmodernhistory,asaverageinterestratesintheglobaleconomywerecutinhalf.Also,interestratesinthemajorcurrenciesmovedclosertogetherduringthisperiod.Long-termdollarinterestratesadjustedforinflationhadreachedapeakof10percentinthemiddleof1984,butthendeclinedsteadilyto3.5percentattheendof1986.Butthecomparableyenandmarkinterestratesroseslightlyoverthisperiod.

Animportantequilibriumpositionofglobalizedfinancialmarketsiscalled‘interestrateparity’(IRP).First,IRPrequiresthatnationalandinternationalinterestratesforthesametypesofloansinthesamecurrencyhavetobeequal.Otherwise,arbitragerswouldsimultaneouslyborrowinonemarketandlendinanotherandmaketremendousprofits,profitsmuchgreaterthan

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couldeverbeattainedfrommerchandiseandservicestrade.Sincetheearly1980s,financialmarketarbitragehasbecomemuchmoreprofitableonthemarginthanmerchandiseandservicestrade.Therefore,aselaboratedinChapter2,thefully-arbitragedIRPequilibriumpositionoffinancialmarketsislikelytobethedrivingforcethatmerchandiseandservicestrademustconformto.ThisdominanceofIRPdiffersfrommosttraditionalthinkingwherebyfinancialtransactionsareinsteadbelievedtoaccommodatemerchandiseandservicestrade.

Usingtheequalityofnationalandinternationalinterestratesinthesamecurrencyasameasureoftheglobalizationofnationalfinancialmarkets,itisclearthatmanytypesoffinancialtransactionsbetweenthemajorindustrialcountrieswerefullyglobalizedbytheearly1980s.Forexample,betweenOctober1983andMay1984theaveragedifferentialbetweenthree-monthEurodollarinterestratesandthecorrespondingratesinNewYorkwasaninsignificant0.1percentagepoints.ThesametestcomparingD-markinterestratesintheEuromarketandGermanmarketsshowedadifferentialof0.04

percentagepoints.35

Frankel(1989)hasshownthatdomesticversusinternationalown-currencyinterestratedifferentialsforGermanycollapsedin1974whenmostcapitalinflowrestrictionswereremoved.ThedifferentialforItalyandFrancecollapsedinaboutmid-1986whencapitaloutflowrestrictionswereremovedinthosetwocountriesandtheEuropeanMonetarySystemwasrealigned.Also,ArtisandTaylor(1989)haveshownthatthisdifferentialtendedtowardzerointheUnitedKingdomafterinwardandoutwardcapitalcontrolswereremovedinOctober1979.

Japan'scasestudyalsoshowstherelationshipbetweenfinancialmarketderegulationandglobalizationintheearly1980s.Between1975and1979,beforeJapanesederegulation,thedifferentialbetweenthree-monthyeninterestratesintheEurocurrencyandJapanesemarketsaveragedalarge2.06percentagepoints.TheJapanesegovernmentbeganremovingtherestrictionsonitsfinancialmarketsintheearly1980s,andin1984thisinterestratedifferentialhadbeenreducedto0.31percentagepoints.Finally,in1985,Japan'sfinancialmarkets,withrespecttothesestatistics,hadbecomeasglobalizedasthoseintheUS,UK,andGermany—thisyeninterestratedifferentialhaddroppedto0.05percentagepoints(ArtisandTaylor,1989).

Secondly,IRPrequiresthatthesametypesofloans,whichhavebeeninsuredagainstforeigncurrencyrisk,producethesametotalreturnfortheinvestoreventhoughtheyaredenominatedindifferentcurrencies.Currencyriskcanbecoveredorhedgedawayviatransactionsintheforward-lookingmarkets.

Forexample,supposethatEurodollarinterestrateswerecurrently8percent,Euromarkinterestrateswere13percent,andthecurrentspotmarketexchangeratewas$1for1.5DM.Supposealsothatonecouldagreetodaytoswap$1for1.57DMoneyearfromnow.Ifaninvestorhadhissavingsin

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dollarstodaybutwantedhissavingsconvertedintomarksoneyearfromnow,shouldhe:(a)convertonthespotmarkettodayat$1/1.5DMandbeginearning13percentonhisnewlyacquiredmarks;or(b)agreetodaytoconvertoneyearfromnowatthe$1/1.57DMfuturerateandcontinueearning8percentonhis

fromnowatthe$1/1.57DMfuturerateandcontinueearning8percentonhisdollarsuntilthattime;or(c)continueearning8percentonhisdollarsandconvertthemintomarksoneyearfromnowatwhateverthespotmarketexchangeratehappenedtobethen?

Ignoringcommissionsandanyothertransactionscosts,options(a)and(b)wouldproducethesameDMsavingsoneyearfromnowwithcertainty.Forexample,savingsof$100underoption(a)wouldbeconvertedinto150DMtodayandearn(150DMx0.13)=(19.5DM)ininterestforatotalof169.5DMoneyearfromnow,andunderoption(b)savingsof$100wouldearninterestof($100x0.08)=($8)foratotalof$108oneyearfromnowwhichwouldthenbeconvertedwiththefuturescontractat$1/1.57DM.The$108wouldthusbeconvertedinto(108x1.57)=169.5DMoneyearfromnow.(Note:thesecalculationsareapproximate,andexactequationsaredevelopedintextbooks.)

Therisk-freeequivalenceofoptions(a)and(b)demonstratestheIRPequilibriumfordifferentcurrencies,anditissummarizedasfollows:thecurrentinterestratedifferentialbetweencurrencies(inthiscasea5percentdifferentialinfavorofthemark)mustbeeliminatedbythedifferenceinthespotversusforwardexchangerate(inthiscasethedollarcarriesaforwardpremiumagainstthemarkofapproximately5percentfrom1.5to1.57),toyieldthesametotalreturnforoptions(a)and(b).

Forthemajorcurrencieswithwell-developed,forward-lookingmarketopportunities,suchas‘thosethatareactivelytradedintheEurocurrencymarkets,100percentofthedeviationsfrom(a)and(b)equivalencecanbeaccountedforbycommissionsandothernormaltransactionscosts(Taylor,1988),aresultcalled’coveredinterestparity's.WhenarbitrageeliminatesdifferencesinnationalversusEurocurrencyinterestratesonthesamecurrency,italsoeliminatesdifferencesintherisk-freetotalreturnondifferentcurrencies.Intheaboveexample,moneywouldbemovedbetweendollarandmarkloansuntilinterestratesand/orforwardversusspotexchangeratedifferentialsadjustedtoproducetheequivalence.Non-equivalencecouldnotbesustainedbecauseofthetremendousprofit-seekingflowsofcapitalthatwouldexploittheinefficiencyuntilequivalencewasproduced.

Option(c)intheaboveexamplewouldexposetheinvestortocurrencyrisk,unlikeoptions(a)and(b),andthereforemayormaynotbeusedgivenhisrisktolerance.Ifused,option(c)wouldresultinasuperiorreturntooptions(a)and(b)ifthespotexchangeratefor$1appreciatesabove1.57DMatyear-end,andoption(c)wouldproducealowerreturnifthedollarendedtheyearlowerthan

option(c)wouldproducealowerreturnifthedollarendedtheyearlowerthan1.57DM.Inotherwords,whetherornotthespotrateendstheforward-lookingtimeperiodaboveorbelowtoday'srisk-freeforwardratewilldeterminethedesirabilityofspeculatingasperoption(c)

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versushedgingasperoptions(a)and(b).Therefore,beliefsaboutfuturespotratesmayalsoleadtotremendousprofit-seekingflowsofcapitalandrealignmentofinterestratesandexchangeratesuntilinvestorsbelieveoption(c)tobeequallydesirabletooptions(a)and(b).

Ifoption(c)producesthesamereturnas(a)and(b)theresultiscalleduncoveredinterestparity.However,mostresearchindicatesthatsubstantialerrorsinpredictingfuturespotratesdoesnotallowforuncoveredinterestparity(FrankelandFroot,1989).Inotherwords,therisk-freeforwardrateisnotagoodpredictorofthefuturespotfate,andspeculatorsmustassumesubstantialriskwhenacceptingoption(c).

Ascurrencyexchangeratesadjustaspartoftheprocesswherebyinterestrateparityisachieved,internationalcurrency-adjustedpricesformerchandisecanbepushedsubstantiallyoutofalignment.Therefore,tradebalancescanfluctuatewildlyasdrivenbythesefinancialprocesses.AselaboratedinChapter2,historicrelationshipsbetweencurrencyexchangeratesandtradebalancesnolongerprevail.Purchasingpowerparity(PPP),thetheorythatcurrencyexchangeratesmoveupordowntoequatenationalandinternationalpricesofmerchandiseandservices(andthustradeisalwaysrebalanced),hasbecomeunreliableforforecastingpurposes.Forexample,nolongerdoesacountry'scurrencynecessarilyincreaseinvalueifithasanexportpriceadvantageandissellingmoremerchandiseandservicestotherestoftheworldthanviceversa.Ifanexport-drivencountryisabletolowertheinterestratesonitscurrency,itscurrencycouldevendepreciateduetoasubstantialoutflowofinvestmentfundstohigherinterestratecurrencies.

Table1.1showsjusthowmuchtheexchangerateoftheUSdollarhasdeviatedinthe1990sfromitsPPPlevelsrelativetotheJapaneseyenandtheGermanmark.ThesePPPexchangeratelevelsequatetheaveragepricesoftradablemerchandiseandservicesbetweentheUS,JapanandGermany.Therehasbeen

merchandiseandservicesbetweentheUS,JapanandGermany.TherehasbeennostabilityorconvergenceofexchangeratestoPPPlevels.Theyenandmarkremainedpersistentlyovervaluedagainstthedollarinthe1990s,yettheUScurrentaccountbalancefirstimprovedandthenworsened(seeFigure2.2).

Table1.1PurchasingpowerparityexchangeratelevelsofoneUSdollar(versusactualexchangerates)1990199319951997Japan(yen)195(134)184(112)169(103)163(130)Germany(mark)2.09(1.49)2.10(1.73)2.02(1.43)2.00(1.79)

Source:OrganizationforEconomicCooperationandDevelopment.

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V.FINANCIALSTRATEGYPARITIES

TheIRPequilibriumdiscussedaboveequatesthetotalexpectedreturnondifferentsourcesofinternationalborrowingandlending.Moneymovesbetweentheglobalizedcountriesandcurrenciesuntil,onthemargin,themarketforborrowingandlendingisefficient.Arbitragersarethenindifferentbetweencountriesandcurrenciesfortheirnexttransaction.

Borrowingandlendingisassociatedwithdebtorsandcreditors—thosewhoexchangebonds,commercialpaper,certificatesofdeposit,andotherfixed-incomeIOUs.ItisforthesetypesoffinancialtransactionsthatIRPhasbeenstatisticallyverified.Totalexpectedreturnsonthese‘puredebt’instrumentshaveindeedconverged.However,IRPcanbemoregenerallyunderstoodasfinancial-strategy-parity(FSP).ForthoseglobalizedcountriesandcurrenciesnowsubjecttoIRP,amoregeneralconvergenceoffinancialstrategieshasbeenoccurringasparticipantsarepresentedwithmoresimilaropportunitiesinother,non-pure-debtmarkets.Specifically,corporationsarechoosingmoresimilardebtvs.equityfinancingstrategies.Also,thepricetoearningsratiosofinternationalstockmarketsareconverging.Asarbitragersandotherparticipantscomparereturnsandrisksonamoreglobalspectrumoffinancialassets,thebestcommonstrategiesarechosen.

A.InternationalDebttoEquityRatiosConverge

TherecentincreaseinUScorporatedebtcanbeseenasaconvergencetowarddesirableinternationaldebttoequityratios.Beforefinancialmarketsbecamerapidlyglobalized,thatisbetween1972and1982,thepercentageoftotaldebtinthecapitalstock(machines,factories,etc.)ofJapaneseandGermanmanufacturersaveraged66percentand64percent,respectively,morethantwicethe30percentofUSmanufacturers.36Thesefiguresindicatethat,ineffect,30percentofthemachinesandfactoriesetc.usedbyatypicalUSmanufacturingcompanyduring1972–1982werenotownedbythecompany,butbythebankwhichloanedmoneytothecompany.Althoughpopularsentimentdisagrees,itislikelythatthislowerdebt-positionofUScorporationsdisadvantagedthemrelativetotheirJapaneseandGermancompetitorsbefore1982;and,itislikelythatthewell-publicizedincreaseinUScorporatedebtafter1982hasbeenamoveintherightdirection.

AnargumentdefendingtheincreaseinUScorporatedebtafter1982proceedsasfollows:USmanagers,especiallyinthepost-1982periodof‘nuclearfinance’,impatientowners,andhostileleveragedbuyoutsofcompanies,mustinsurehighshort-runreturnsonmachines,factories,land,etc.whichareownedoutright(i.e.theequityorstockofthefirm)inordertomaintainhighstockprices.Highstockprices,pricesthatfullyreflectthereplacementvalueofthemachines,factories,land,etc.,pleasethecurrentownersanddiscouragehostilecorporate‘raiders’frombuyingstockand

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gainingcontrolofcompanyassets.Inotherwords,duringtheboomyearsforfinancialmarketsintheearlyandmid-1980s,itbecamepopulartoradicallyreorganizetheownershipofbusinessassets,andthoseassetshadtobewell-presentedformarketability—highshort-runreturnsandprices.

However,managershavenotneededtoinsuresuchhighshort-runreturnsondebtcapital,becauseitisnottheequityofthefirm,butofthelendinginstitution.Debt-capitalneedonlyproduceenoughrevenuesoverthelong-runtojustifytheloanwhichfinancedit.Debt-capitalisnotsomarketableorsosubjecttonewownershipasequity-capital,andthusdebt-capitalhasbeenmoreinsulatedfromdisruptivereorganizationbynuclearfinanceandcorporateraiders.From1972through1982,theaveragebefore-tax,grossreturnoncapitalforequity-biased

USmanufacturerswas21.1percent,comparedwith14.2percentand15.7percentindebt-biasedJapanandWestGermany,respectively.37

Grossreturnsoncapitalshouldnotbeconfusedwithcorporateprofitabilityforfourreasons:(1)theyarebefore-taxreturns,andtaxsystemsvary;(2)othernon-capitalexpensessuchaswagesaffectprofitability;(3)thegrossreturnoncapitalbecomesinstitutionalizedasacostofcapital,forexampletothenewerfirmswhomustbuyorrentitawayfromcompetinguses.In1981thecostofraisingcapitalintheUSwas16.6percent,whichcomparedunfavorablywith9percentinJapanandWestGermany;38(4)theprofitabilityornetreturnonafirm'scapitaloperationsshouldbemeasuredasthedifferencebetweenthegrossreturnsandthecostsofraisingcapital.ThiscalculationindicatesthatprofitratesoncapitalinJapanandWestGermanywereonetotwopercentagepointshigherthanintheUSbeforetherapidglobalizationperiodbeginningintheearly1980s.

ThecapitalcostdisadvantageofUSindustrymayhaveworsenedintheearly1980s.EconomistsatGeorgetownUniversityconcludedthatin1985USindustryspent19percentmorethanJapantoserviceitscapital,i.e.raiseit,depreciateitandpaytaxesonit.39Taxeswereidentifiedasthekeyreason,becauseJapanwasfoundtotaxitscapitalformationata37percentlowerratethantheUS.‘IftheJapanesesystem[includinghigherdebt;non-existenttaxesbefore1986onthedividendsandcapitalgainsofindividuals;etc.]wereadoptedintheUS,thecostofUScapital...wouldfallby16percent.Thisistheequivalenttoanincreaseinprofitmarginsonoutputof5percentagepoints[aboutdoubleourpresentrate]andisanamountlargerthantotalUScorporateincometaxreceipts’.

ThelowerUSprofitratesonmachinesandfactoriescomparedtoJapanandGermanyinthe1970sandearly1980s,duetohighertaxesandlessdebt,meantthatfewercorporateinvestmentprojectscouldbejustifiedintheUScomparedtoJapanandGermany.EspeciallyhardhitintheUSwereinvestmentsinproductinnovationandtheopeningofnewindustriesandmarkets.Theseendeavorsareriskyandexpensiveatfirst,butarevery

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importanttothelong-runcompetitivenessofindustriesinanincreasinglyinternationalmarketplace.

internationalmarketplace.

Duetothelowerprofitability,‘grossfixedcapitalformation’asapercentageofgrossdomesticproductwaslowerintheUSthaninmostotherlargeindustrialnationsinthe1970sand1980s—theUSratioaveraged18percentcomparedto23percentinWestGermanyand32percentinJapan.40Also,lesseconomy-widecapitalformationintheUSduringthistimeperiodallowedlessimprovementinindustrycompetitiveness,asmeasuredbyoutputperworker(productivity).

Despitepopularsentiment,therefore,therecentincreaseinUScorporatedebtseemsdesirable,becauseUScapitalcostscanbeloweredatleastasmuchasthegrossreturnoncapital.Increasedprofitabilityoncapitaloccurs,moreinvestmentinUSindustrycanbejustified,andworkerproductivityimproves.ThereislesschancethatUScorporationshavetheliquidityproblemsandlowstockmarketvalueswhichinvitehostiletakeoversanddisruptlong-runstrategies.Instead,thecorporations’bankershavemorecontroloverthecorporation,andagreaterself-interestinseeingthatthecorporationissuccessfulinthelongrun.AsacknowledgedbyBenjaminFriedman(inFeldstein,1991,p.20):

Someobservershavearguedthatmostofthe[US]substitutionofdebtforequityinrecentyearshasoccurredinthecontextofreorganizationsthatarelikelytopromotebusinessefficiencyandhenceprovidethehigherearningswithwhichtoservicetheaddeddebt;also,thatthesetransactionsareexplicitlydesignedtominimizeconventionalbankruptcyproblemsintheeventthattheanticipatedhigherearningsdonotmaterialize.Othershavepointedoutthatevenaftertherefinancingsofthe1980s,UScorporationsonaverageremainmuchlesshighlyleveredthantheircounterpartsabroad.

Also,theglobalizationoffinancialmarketsinthe1980sprovidedthegreatestbenefitstotheborrowerswhohadhistoricallypaidthehighestinterestrates.Inthe1970sandearly1980s,beforetheglobalizationoffinancialmarkets,itwastheUSinterestrateswhichwerethehighest.Therefore,itwasUSborrowers,especiallythosewhocreativelytookadvantageofthenewinternationalopportunities,whofoundthegreatestsavingswithglobalization.Americancorporationsrealizedthebenefitsofincreasedborrowing,especiallyfromthenewinternationalmarkets:EurobondsissuedbyAmericancorporationsgrewfrom$7billioninallof1983to$35.1billioninonlythefirsttenmonthsof1986.41

By1990,theglobalizationofdebtandequitymarketshadalreadyledtosimilardebt/equityratiosbetweentheUS,Japan,Germanyandothers.Withinthemorecommonly-sharedfinancialenvironment,corporationswerechoosingmoresimilarfinancialstrategies.Forexample,in1990theaveragedebt/equityratioofcompanieslistedontheTokyoStockexchangewasapproximatelyequaltotheaveragedebt-equityratioofallUScompanies.42

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Computingthisratioisextremelyproblematicbecausemanynewfinancialinstrumentshavebothdebtandequitycharacteristics,butitislikelythataverageUSandJapanesecorporationshadapproximatelyequaldebttoequityratiosof50percentin1990.

Withreferencetothe1972–1982statisticspresentedabove,Japanesecompaniesthusreducedtheirdebtlevelsinthe1982–90periodjustassignificantlyasUScompaniesincreasedtheirdebtlevelsuntilcorporatedebtburdenswereapproximatelyequalinthetwocountries.RatherthanseeingincreasedUScorporatedebtinthe1980sasaworrisomedevelopmentoriginatingintheUS,therefore,itseemsbettertoviewthisincreaseddebtasanaturalandhealthyprocessofconvergenceorglobalization.US,Japaneseandothercorporationssettleduponsimilarfinancialstrategiesintheirnewcommonly-sharedfinancialmarkets.43Initially,moreattractivetakeovertargetswerefoundintheequity-biasedUScapitalstock,thatis,untilthelate1980swhenglobalizationhadbroughtinternationaldebt-equityratiosclosertogether,andwhenfinancialmarketsbecamemoresimilarlyregulatedandaccessible.

B.InternationalPrice-EarningsRatiosConverge

Anaturalprocessofconvergenceorglobalizationhasalsooccurredrecentlywithinternationalprice-earningsratiosofcorporatestock.

Differentinvestorsarewillingtopaydifferentstockpricesfortheownershipofcorporateassets,dependingupon:expectationsaboutthesizeandriskinessoffuturedividendsandothercashpay-outs;preferencesforhavingmorecashinthepresentversusthefuture;availabilityofcash;andtheavailabilityof

alternativeinvestments.Forexample,intheJapanesestockmarketinthe1980s,investorswerewillingtopayanaverageof$50dollarsforcorporatestockforeveryonedollarofcurrentannualearningsgeneratedbythestock,i.e.aprice-earningsratioof50.ForNipponTelephoneandTelegraph,whichhadatotalstockmarketvalueof$320billionon31March1987(morethantheentireWestGermanstockmarket),investorspaidaremarkablyhighprice-earningsratioof261.7.44

IntheUSstockmarket,investorsinthe1980swerewillingtopurchasestockatanaverageprice-earningsratioof15,lessthanone-thirdoftheJapanesestockmarketratio,indicatingacombinationofthefollowingstructuralconditions,labeled(1)–(5):

1. Futureearningsandthereforecashpay-outswerenotexpectedtobeashighonUScorporatestockcomparedtoJapanesecorporatestock;

2. Investorsasagroupfeltthatthedollarwaslikelytolosesomeofitsexchangevaluerelativetotheyen,andtheyhadnotfullyhedgedawaythiscurrencyrisk;

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1. InJapaninvestorswerewillingtopayahigherpriceandcommitmoresavingsfortheexpectationoffutureincomecomparedtothemoreconsumer-orientedUS.Also,savingshasbeengivenmorefavorabletaxtreatmentinJapanthanintheUS;

2. TheJapanesetendencytoretainearningswithinthecorporationratherthanpayitoutasdividends,andotherinstitutionaldifferencesmeantthatasignificantamountofJapaneseearningswashiddenfromthestatistics;

3. Therewasmorecash‘bottled-up’inthelessderegulatedJapanesefinancialmarkets,andtherewerefewerattractivealternativestostockownershipcomparedtotheUS,suchashomeownership.

Inthe1980s,structuralconditions(1)–(5)maintainedtheaveragepricesofJapanesecorporateassetsatlevelsmorethanthreetimeshigherthanUScorporateassets,relativetothecurrentincomegeneratedbythoseassets.Thesestructuralimpediments,whichmaintainedseparateinstitutionalandbehavioralidentitiesfortheworld‘stwolargeststockmarkets,havebecomelesssignificantinthenewglobaleconomy,however.Consequently,thereisatrendtoward

inthenewglobaleconomy,however.Consequently,thereisatrendtowardmoresimilarlypricedcorporateassetsintheUSandJapan.

Structuralcondition(1)hasbecomelesssignificantwiththeincreasedparticipationinjointventuresandoverseasproductionbyUSandJapanesefirms,thedual-listingofcorporatestockinbothexchanges,therecoveryofUScompanies,suchasthoseinautomobiles,fromexceptionalJapanesecompetitionoftheearly1980s,thematurationoftheJapaneseeconomicmiracle,theincreaseduseofdebt-financingintheUS,andthemassivenetinflowofforeignfundsintotheUSbeginninginthe1980swhichhasloweredUSinterestratesandthecostofcapitalwhileincreasingthemincapital-exportingJapan.

Condition(2)hasbecomelesssignificantwiththewidely-perceivedbottoming-outinthedeclineinforeignexchangevalueofthedollar,andwiththerapiddevelopmentoffuturesmarketswhereforeignexchangeriskcanbehedgedaspercoveredinterestrateparitydiscussedearlier.Condition(3)hasbecomelesssignificantwiththeremovalofvarioustaxincentivestosavewithinJapansince1986,andastheJapaneseeconomybecomesmoreconsumerandleisure-driven.Condition(4),whichismoreastatisticaloddityratherthananeconomiccondition,hasbecomelesssignificantwiththemorestandardizedaccountingtechniquesusedbymoreinternationalized(especiallyJapanese)corporations.And,condition(5)hasbecomelesssignificantwiththerapidderegulationandintegrationoftheUSandJapanesefinancialmarketsandincreasedlearning,especiallybyJapaneseinvestors,aboutforeignopportunities.

Asthesestructuraldifferencesbetweentheworld‘stwolargeststockmarketsbegantolosetheirimportanceinthe1980s,perhapsespeciallyas(5)becamelesssignificant,itwasinevitablethatJapaneseinvestorsbegantopurchasealotofUSstocks.Ineffect,thereasonsformaintaininghigher

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pricesforcorporateassetsinJapanrelativetocurrentcorporateearningsbegantolosetheirimportance,andthelowerUSprice-earningsratiosbecamequiteattractivetoJapaneseinvestors.

Thus,thereducedimportanceofstructuralconditions(1)–(5)explainsthewell-publicizedJapanese‘buyingofAmerica’inthe1980s.However,theremovalofstructuraldifferencesandimpedimentsbetweenfinancialmarketseverywhere

structuraldifferencesandimpedimentsbetweenfinancialmarketseverywherehasencouragedaless-publicized,moregeneralforeignbuyingofAmerica.Forexample,GermanpurchasesofUSbusinessassetsinthe1980srivaledpurchasesbytheJapanese,butneithercountrymaintainedaslargeahistoricclaimonUSassetsasBritainortheNetherlands.TheInternationalMonetaryFund(IMF,1989)hasestimatedthatabouthalfofbothJapaneseandGermandirectinvestmentandotherlong-termcapitaloutflowsinrecentyearshavebeentotheUS.However,‘thechannelsfromJapantotheUnitedStatesaremoredirectthanthosefromGermanytotheUnitedStates,’whichmightexplainsomeofthegreaterattentionpaidtotheJapanesepurchases.

StructuralintegrationofstockmarketsbegantoencouragetherapidforeignbuyingofAmericanbusinessassetsinthemid-1980s.Forexample,foreigninvestorspurchased$5billionofpublicly-ownedUScorporatestockin1985,$25billionin1986,and$30billionin1987.Theworldstockmarketcrashof1987slowedthisupwardtrendonlytemporarily.By1989,11.1percentor$500billionofAmerica's$4,550totalbusinessassetswereforeign-owned.

Asstructuralimpedimentsbetweenthemajorequitymarketscontinuetoerode,andasportfoliosareappropriatelyreallocated,price-earningsratiosseemtobeconvergingtowardsomethingliketwentytoone.Adjustingfordifferencesininstitutionsandaccountingruleswhichremain,a1992studyfoundthat‘true’P/EratiosforJapan,theUS,Britain,France,andGermanywere,respectively,22.1,26.5,19.6,14.5,and19.1.45Comparedtostockmarketlevelsofthelate1980s,andassumingreasonablyconstantgrowthratesofcorporateearningsintheUSandJapan,thisconvergencerequiredadoublingofUSstockmarketpricesanda50percentdeclineinJapanesestockmarketpricesfromthelate1980sto1992—whichisexactlywhathappened.

1.FederalReserveBankofKansasCity(1997),p.300.

2.‘CapitalMarketsSurvey’,p.7,TheEconomist,21July1990

3.FederalReserveBankofNewYork,April1995CentralBankSurveyofForeignExchangeMarketActivity,19September1995

4.Sesit,MichaelR.,‘CentralBanksIssueWarningonTrading’,NewYork

Times,28March1996,Cl

5.Ibid.

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6.FederalReserveBankofKansasCity(1997),p.263–4

7.‘JapaneseFirmsMakeControversialBidIntheUSGovernmentSecuritiesMarket’,TheWallStreetJournal,7January1986,p.32

8.‘TheGlobalizationoftheIndustrializedEconomies’,Barron's,4May1987,p.45

9.‘NewGuidelinesForDerivativesAreDelayed’,TheWallStreetJournal,9May1997,p.A4

10.BankforInternationalSettlements,CentralBankSurveyofDerivativesMarketActivity,Basle:BankforInternationalSettlements,18December1995

11.‘TheNewAmericanChallenge’,TheWallStreetJournal,3November1986

12.‘TheGlobalMoneyMarket’,TheNewYorkTimes,4May1986,p.10F

13.‘YourFutureinTelecommunications’,BusinessWeekCareers,November1986,p.59

14.Ibid

15.‘BusinessBulletin’,TheWallStreetJournal,10March1988,p.1

16.‘BusinessGoesBodyShopping’,Newsweek,10July1989,p.46–7

17.‘ForeignIssuesFloodLondonOTCTrade’,TheWallStreetJournal,18April1986,p.22

18.Solomon(1997),p.7

19.DatafromSpencerNilsonandTheNilsonReport(Oxnard,California,mid-1996)

20.Gatesetal.(1995)

21.Thiscasestudy,asitaffectedtheUSBalanceofPayments,isanalyzedin:Cooper,RichardE.,‘TheInterestEqualizationTax:AnExperimentintheSeparationofCapitalMarkets’,Finanzarchiv,Vol.24,Fasc.3,1965,p.447–71

22.‘BankandThriftPerformancesinceDIDMCA’,EconomicPerspectives,FederalReserveBankofChicago,September/October,1985,p.58

23.‘ThreeBigJapaneseFirmsEnterRanksOfPrimaryDealersDespiteOpposition’,TheWallStreetJournal,12December1986,p.D-1

24.‘StakesHighforBritain'sFinancialFirmsinFreerMarkets’,TheNewYorkTimes,6October1986,p.34

25.‘London'sExchangeBracesforBigBangSettoOccurMonday’,TheWallStreetJournal,24October241986,p.1

26.‘CommonMarketSeeksNewRulesonLimitingExposureofLenders’,TheWallStreetJournal,IDecember1986

27.‘OntarioWillOpenSecuritiesIndustrytoForeigners,DomesticFinanceFirms’,TheWallStreetJournal,5December1986,p.38

28.‘GlobalFinance:Taleof3Cities’,TheNewYorkTimes,31October1986

29.‘FrenchDenationalizationLuresUSFirms’,TheWallStreetJournal,24October1986,p.28

30.‘China'sEmbryonicStockMarketExpands’,TheWallStreetJournal,12November1986,p.38

31.‘SchoolatChina'sPeople'sBankTrainsNewGenerationofFinancialWhizKids’,TheWallStreetJournal,18November1986,p.39

32.‘China'sInitialOfferingOfEurodollarBondsisSet’,TheWallStreetJournal,21August1987,p.21.24

page_23

33.‘ConfrontingtheSovietFinancialOffensive’,TheWallStreetJournal,22March1988,p.34

34.Source:BankforInternationalSettlements(BIS),basedoninformationfrombanksintheBISreportingarea,comprising18industrializedcountriesandsevenoffshorebankingcenters

35.‘CapitalUnchecked’,TheEconomist,19October1985

36.‘USBusinessShouldTakeOnMoreDebt’,TheWallStreetJournal,1December1986

37.Ibid

38.Ibid

39.‘Japan'sTaxPolicy—ASystemthatWorks’,SanFranciscoChronicle,21November1985

40.Source:InternationalMonetaryFund

41.‘FinanceOfficers’WiderRole',TheNewYorkTimes,20October1986

42.‘EscapeFromDebt’,TheEconomist,21July1990,p.84

43.Thereplacementofequitywithhealthydebt-financingintheUSdoesseemtobeminimizingthedisruptive,uninsured,junk-bondfinancingtechniquesofcorporateraiders.In1990,shortlyaftertheindictmentofitsjunk-bond-kingMichaelMilken,DrexelBurnhamLambertdeclaredbankruptcy.DrexelBurnhamLamberthadaccountedfor40percent($10billion)ofjunk-bondtradingin1989,andinthelate1990sthismarkethasyettorecovertoitslevelsofthelate1980s

44.‘SoaringSharesOfJapan'sNTTWorryAnalysts,DelightHolders’,TheWallStreetJournal,24April1987,p.17

45.‘AlltheWorld'saRatio’,TheEconomist,22February1992,p.72

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2.FinancialMarketGlobalizationandNewTradePatterns

UnexpectedlylargetradeandinvestmentimbalancesdevelopedbetweentheUS,Japanandothersduringthe1980s,whichhavecontinuedthroughthe1990s.Since1984,theUShashadatradedeficitofmorethan$100billionperyear,andhasreceivedanetinflowofforeigninvestmentofmorethan$100billionperyear—bothofwhicharenowincreasinginthewakeofthe1997—Asiancrisistoapproximately$200billion.EarlyexplanationsoftheseimbalancesarefoundintheproceedingsfromaconferenceorganizedbytheInstituteforInternationalEconomicsinlate1990(Bergsten,ed.,1991),andintheproceedingsofthe1990conferenceofTheInternationalEconomicsStudyGroup(MilnerandSnowden,1992).

Despiteintensefocusonthistopicbytheeconomicsprofession,thereisstilldisagreementovertheinternationaladjustmentmechanismsandkeyvariablesthatlinktradeandinvestmentflows.Forexample,PaulKrugmanandmanyothersarguethatimbalancesinUStradeandfinancecanbeappropriatelyreducedbymovementsincurrencyexchangeratesandgovernmentpolicyresponsessuchasprotectionism:

Theneedtoreassessbecameespeciallyacuteinthelate1980saswidespreaddisappointmentemergedoverthecontinuationofsizableimbalancesdespitelargechangesinexchangeratesandotherpolicymeasuresaimedatreducingtheimbalances…[however]oncewecleanupthedata,itseemspossibletoarguethattradeflowshaverespondedtoexchangeratesinjustaboutthewaythataneconomistwhohadavoidedlisteningtoanynewideas[since1970]…wouldhaveexpected(inBergsten,ed.,1991,p.xi,11).

YetRobertMundellamongothershasarguedthatcurrencyrealignmentsandtradebarriersplaynousefulroleinimprovingtradebalancesandmayevenbeharmfulintheUScase:

Theclaimthat[favorableconsequences]willfollowfromdepreciationissheerquackery.ItisclosertothetruthtosaythatapolicyofappreciatingtheyenandtheEuropeancurrenciesrelativetothedollarwillcausedeflationabroad,inflationathome,alargerdollardeficit,andvastequitysalestoforeigninvestors.Ownershipoffactories,technology,andrealassetswillbeexportedto

investors.Ownershipoffactories,technology,andrealassetswillbeexportedtofinanceanevenlargertradedeficitwithouttherebeingmuch,ifany,realexpansioninexportsor

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reductioninthedollarvalueofimports.USassetswillbesoldabroadatbargain-basementprices.IftheAmericandoggetsfedbetter,itwillbebyeatingitsowntail(Mundell,1987).

TheMundellsidehasbeentakenbythose,especiallyfromtheJapaneseperspective,whoarguethatonlytheUScanimproveitstradedeficit,whenitsavesandinvestsmoreandimprovesitsproductivity:

Thefundamentalcausesofthedollar'sdepreciation[over1985–95]aretheUSbudgetdeficitandanunfavorablebalanceofpaymentswhichshowsnosignofimproving.OnlytheUSitselfcanrecoverthedollar'sstatusasaninternationalkeycurrency.Therefore,inthelongrun,decreasingthebudgetdeficitandenhancingproductivityarevitalsteps.1

Takingissuewitheachofthesequotes,thischapterarguesthatthefinancialmarketglobalization,interestrateparity,andfinancialstrategyparityprocessesasdiscussedinChapter1arenewdrivingforcesresponsibleforthelargetradeandinvestmentimbalancesofthe1980sand1990s.Moreautonomousandcontrollinginternationalfinancialflowsareoftencausingchangesintradeandeconomicgrowth,ratherthanviceversa.ProperconsiderationofthestructuralchangesfromChapter1leadstosomenewconclusionsabouttheinternationaladjustmentmechanismsandkeyvariablesthataffecttradeandinvestmentflows.Increasingly,thenationshouldnotbeseenasaself-sufficientor‘balanced’economicregion.Identifyingexactlywhatismeantby‘trade’versus‘investment’inthenewglobaleconomyalsoleadstosomeinterestingconclusions.Inthisnewenvironment,typicaltradeprotectionismisshowntobeincreasinglyimpractical.

I.SAVERANDDISSAVERCOUNTRIES

AsdiscussedinChapter1,morelendershavebeenputincontactwithmoreborrowersbyfinancialmarketderegulationandtheinformationrevolution.

borrowersbyfinancialmarketderegulationandtheinformationrevolution.Largersumsofmoneyhavebeenmovingmorequicklyandprofitablyaroundtheworld.Thosewhotendtospendmorethantheircurrentincome,dissavers,havebeenmorequicklyaccommodatedwithanappropriateinterestratebythosewhotendtospendlessthantheircurrentincome,savers.Inherenttendencies,whethertowarddissavingorsaving,havethusbeenencouragedforindividuals,firmsandcountries.

Theestablishmentofsaveranddissavercountrieswasespeciallynoticeableduringthe‘boomyears’forinternationalfinancialmarketsintheearlyandmid-1980s.ThebiggestnewsavercountrywasJapan,whereindividualsweresavingmorethan15percentoftheirdisposablepersonalincome.Inadditiontoaccommodatingtheborrowingneedsofitsbusiness

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andgovernmentsectors,personalsavingsallowedJapantoincreaseitsnetlong-termlendingtotheglobalfinancialmarketsfromlessthan$20billionin1983to$50billionin1984to$62billionin1985.2

ThebiggestnewdissavercountryhasbeentheUS,whereindividualsreducedtheirpersonalsavingsratesfrom9percentintheearly1980stoanaverageofonly4to5percentafterthemid-1980s.Inlate1998,USsavingsratesactuallyreachedzero.EuropeanpersonalsavingsrateshavebeenmidwaybetweentheJapaneseandUSratesinthe7–13percentrange.

NomatterhowUSpersonalsavingsismeasured,beginningintheearly1980sithasnotbeennearlyenoughtomeettheborrowingneedsoftheUSbusinessandgovernmentsectors.Forexample,withoutthebenefitofforeignlendingandinvestmentin1985,USpersonalsavingswouldhaveprovidedonly$58billionforthebusinesssectorafterfinancingthe$200billionfederalbudgetdeficit—notenoughtokeeptheeconomyrunningatits1985outputrateof$4trillion.

ItwastheincreaseinthenetinflowofforeignlendingandinvestmentintotheUSfrom$9billionin1982to$118billionin1985whichallowedtheUSbusinesssectortomaintainahighlevelofoutputandemploymentinthemid-1980s,whileatthesametimetheUSgovernmentwasrunningrecorddeficits.Sincethemid-1980s,theUSeconomyhascontinuedtodissaveor‘absorb’anaverageofmorethan$100billionperyear,net,oftherestoftheworld'ssavings.

averageofmorethan$100billionperyear,net,oftherestoftheworld'ssavings.Asdiscussedthroughouttheremainderofthebook,thiscontinuingabsorptionanduseofworldsavingsintheUSeconomyisoneofthemostsignificantstructuralchangesassociatedwiththenewglobaleconomy,anditaffectsjustabouteverythingincludingeconomicgrowth,governmentbudgets,tradepatternsandvariousfinancialcrisesandrecession.Forexample,asdiscussedinChapter4,the1997—Asianfinancialcrisisandthe1997—unexpectedlystrongUSeconomywere(notcoincidentally)associatedwithasuddenjumpinthisnetfinancialinflowintotheUStolevelsexceeding$200billionperyear.

WhyistheUSpersonalsavingsrateexceptionallylowcomparedto,forinstance,Japan?Thegenerallyacceptedreasonsare:

1. EarningsonUSsavings(interestanddividends)aretaxed,whereasinterestexpenseonborrowing(forhomeownershipandbusiness-relatedpurposes)istaxdeductible.Theincentiveisthereforetoborrowandspend,nottosave.InJapan,mostsavingshavebeencompletelyexemptfromtaxes,thatis,until1April1988,whenmanyof‘theworld'slargesttaxloopholes’wereclosed.3

2. TheUSbabyboom,thatis,peoplebornfrom1946to1958,havebeenintheirkeyspendingyearsforhousing,cars,etc.Thesavingsyearsandtheearningspowerarejustarrivingasthebabyboomersentertheirfifties.

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1. TheUSsocialsecuritysystemcoversabroaderbaseofpeoplethandoesJapan'ssystem,whichreducestheanxietytosave.AmoredevelopedcorporatepensionplanintheUSalsoreducesconcernforthefuture.TheJapanesemustgenerallysaveasindividualsfortheirretirement.SocialsecuritycontributionsintheUS,thelargestincomesecurityprogram,4arenotmeasuredaspersonalsavings;thusthecommonlyreportedUSpersonalsavingsrateunderstatesthetruelevelofsavings.

2. AmericansarehomeownerscomparedtotheJapanese.Byspendingmoneyonhomeownership,Americansarebuildingupequityandfinancialsecurityfortheirfuture,butthis‘residentialinvestment’reducesratherthanaddstothesupplyofloanablefunds.TheJapanesemustsavemoremoneyforfuturerentalofhousing,includingfurnitureandappliancesbecausethey

donotascommonlyownthesethings.Also,whentheJapanesebuyahometheymustsaveforamoresubstantialdown-payment.

3. ManycreditaccountsinJapanstillworkliketheUSsystemofdecadesago—littleblackbooksatthecornerstoreorpostoffice.ThecreditcardrevolutionintheUShasencouragedborrowingbymakingiteasierandmoresociallyacceptable.In1980,theaverageunpaidbalanceperAmericancardholderwas$375,in1986,approximately$940andby1990itexceeded$2000.

4. AlargershareoffarmincomehashistoricallybeensavedintheUScomparedtoothersourcesofincome,andfarmincomehasdeclinedfrom4percentofallpersonalincomein1973tolessthan1percentofallpersonalincomeafter1990.

5. Anadditional,rarelymentionedexplanationofthelowUSsavingsrate,whichhasappliedespeciallysincethe1980s,isthatthenewglobaleconomyhasprovidedtheUSwithnew,low-interestrateborrowingopportunities.TheUSsavingsratedeclinedfromover8percentintheearly1980sto4percentinthemid-1980s,whichwasthesameperiodoftimeduringwhichtheUSfinancialmarketswereintegratedwiththefinancialmarketsofJapanandotherlower-interest-rate,savercountries.USinterestratesdeclinedbyapproximately4percentagepointsfromtheearly1980stothemid-1980s,largelyduetotheinflowofnewlyderegulatedprofit-seekingforeignfunds.Consequently,theUSincentivetosavewasreduced,andtheincentivetoborrowandspendwasincreased,bothofwhichreducedtheUSpersonalsavingsrate.

Mostlikely,itwas(7)theglobalizationoffinancialmarketswhichreducedtheUSpersonalsavingsratetopost-WorldWarIIlowsbythemid-1980s.Mostoftheother(1–6)commonlyacceptedreasonsforthelowUSsavingsratewereinplaceinthe1970saswellasthe1980s,anditisunlikelythattheycausedthedramaticdropintheUSsavingsraterightafter1981.ButmanyofthefinancialmarketderegulationsmentionedinChapter1occurred

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rightatthebeginningofthe1980s,includingUKandJapaneseliberalizationofforeigncapitalcontrols.Profit-seekingforeigncapital,whichallowedforlowerUSinterestratesandlowerUSsavings,wasalsoattractedtotheUSbythebigReagantaxcutsof1981–83whichenhancedreturnsonUSinvestment.The

Reagantaxcutsof1981–83whichenhancedreturnsonUSinvestment.TheReagantaxcutsalsoledtothelargefederalbudgetdeficitsandgovernmentdissavingandattractivereturnsonTreasurysecurities(seeChapter4).

RemovaloftheUSwithholdingtaxoninterestpaymentstoforeignersin1984furtherencouragedforeignpurchasesofUSTreasuriesin1984–85.TherewasnoincreaseinforeignpurchasesofUScorporatebondsin1984–85duetoremovalofthewithholdingtax,becausecorporatebondshadbeenavailableintheEurodollarmarketforsometimewithoutbeingsubjecttowithholding.

LowerUSinterestratesandlowerUSsavingsafter1981werealsoallowedwhenUSbanksreducedtheirexposuretolessdevelopedcountry(LDC)debtandrepatriatedfundsbacktotheUS.VirtuallyallnewprivateloanstotheLDCsstoppedwhentheworlddebtcrisishitin1982.

ThelowUSpersonalsavingsratetogetherwithrecordfederalgovernmentbudgetdeficitscausedtheUStobecomea‘debtor’countryin1985;thefirsttimesince1914.Injustfouryears,from1982to1986,theUSreverseditspositionastheworld'sbiggest‘creditor’nationandbecametheworld'sbiggestdebtornation.Japanbecamethebiggestcreditornation.Bythemid-1990s,Japanhadaccumulated$800billionnetownershipofforeignassets,andtheUSfoundthatforeignownershipofUS-basedassetsexceededUSownershipofforeign-basedassetsbymorethan$1trillion.

Since1984,the‘netinternationalinvestmentposition’oftheUShasdeclinedbyanaverageofmorethan$100billionayear.CommonlyreportedastheannualincreaseinUS‘debt’toforeigncountries,actuallymuchofthis$100billionperyearisnotdebtinthenormalsense.Rather,muchofitindicatesthatforeignersarepurchasingmoreUSrealestate,businessassetsandotherpropertycomparedtoUSclaimsonforeignproperty.TheCommerceDepartmentestimatesthatmorethan10percentofthe$4.5trillioninUSbusinessassetswereforeign-ownedby1988,1.3percentofthe$7.5trillioninUSrealestate,and5percentofthe$8.4trillionindebtowedbyallUSsources—theforeignownershipportionoftheseassetshasthusbeenincreasingbyanaverageofmorethan$100billionperyear.

The$100billionperyearfiguresimplyindicatesthat,onbalance,$100billionperyearofforeignsavingsisconvertedintodollarsandinjectedintotheUSeconomy(overandabovetheamountofUSsavingssentabroad).TheUSisincreasingitsnetliabilitiestotherestoftheworld,i.e.theamountofmoneythat

itwilleventuallyhavetopayback,butnotby$100billionperyear.Instead,muchofthe$100billionreflects‘thebuyingofAmerica’byforeigners.

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AlthoughthisnetforeigndisinvestmentoftheUShadaccumulatedtomorethan$1trillionbythemid-1990s,thisdisinvestmentisbaseduponhistoricpurchasepricesofbusinessassets,realestate,andtruedebt-instruments,ratherthancurrentmarketprices.BecauseAmerica'sinvestmentsabroadareolderthanforeigninvestmentintheUSandhavethusappreciatedmore,America'sinvestmentsabroadarerelativelymoreundervaluedbytheofficialstatistics.AmoreappropriatemeasureoftheinternationalinvestmentpositionoftheUSwouldbethe‘netforeigninvestmentincome’,i.e.thecurrentflowofincomegeneratedbyUSinvestmentabroadminusthecurrentflowofincomegeneratedbyforeigninvestmentintheUS.ThisalternativestatisticshowstheUSmovingfromcreditorstatusof$25billioninflowin1985tozeronetinflowin1990.Basedupontheabilityofforeigninvestmenttogenerateincome,theUSwouldthusnotbea‘debtor’countryuntiltheearly1990s.

Determininghowmuchofthe$100billion/yearnetforeigninvestmentinflowintotheUSreflectsincreasingUSliabilitiestoforeigners,andhowmuchofitreflectssalesofrealpropertyisimpossibletomeasureaccurately.SixteenUSgovernmentagenciescollectdataonforeigninvestmentintheUS,differentmethodologiesareused,andthereisalotofconfusionwhenthedataisaggregated.Also,thecomplicatedchannelswherebymoneyisnowroutedthroughmultinationals,andvariousprivacyactswhichprotecttheidentityofinvestorscomplicatestheproblem.TheUSCongressitselfadmitsthatthedataisextremelyunreliable.

WhetherornotitisbadfortheUStobeadissaverrelativetoJapanandothercountriesisbecominganalogoustowhetherornotitisbadforoneUSstatetodissaverelativetotheotherstates.ThisanalogymakessensenowthattheUSeconomyislosingitsnationalcharacterandbecomingpartoftheglobaleconomy,especiallywithregardtofinanceasdocumentedinChapter1.Veryfewanalystsmakethisanalogy,however,eventhoughitseemseasytoarguethatitisnaturalandgoodforastateorregionwithhighborrowingneedsandashortageofinvestmentfundstoborrowmoneyfromanotherstatewhichhasasurplusofliquidity.

surplusofliquidity.

OnefearisthatUSinterestanddividendpaymentstotherestoftheworldwilleventuallydrainawaymuchUSwealthatatimewhenthismoneyiscriticallyneededforinvestmentintheeconomy,especiallyinfalteringindustries.ApopularsentimentseemstobethattheUSgovernmentandtheseindustriesshouldnothaveexpandedsomuchinthefirstplace,andwhatfinancingwasrequiredshouldhavebeensupplieddomesticallysothatthelargeinterestanddividendpaymentswouldbereceivedbyUScitizens.Thatis,apopularsentimentseemstobeinfavoroffinancialmarketprotectionism.

TheworryofprotectioniststhattheinflowofforeigncapitalwilldrainwealthoutoftheUSeconomyseemsstrangeatatimewhenmorethan$100billionofforeignsavings,net,hasbeensenttotheUSeconomyyearafter

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year—someasdebt,andsomeaspurchasesofUSbusinessassetsandrealestate.ProtectionistsarethusworryingaboutthefinancialsoundnessoftheUSatatimewhenarecordamountofforeignsavingsisbeingfreelyplacedintotheUS—moreinternationalfundsthanhaveeverbeforebeentransferredtoanycountry.Inaddition,asarguedinChapter1,theforeignbuyingofUSbusinessassetsandrealestate,andtheincreasedUScorporateborrowing,isaninevitableglobalizationprocesswherebyinterestrateparityisachievedandinternationaldebt/equityandprice/earningsratiosconverge.ItwasalsoarguedinChapterIthatUSbusinesseshaveimprovedtheirprofitabilitybyincreasingtheirdebttonormalinternationallevels.

Aselaboratedlaterinthischapter,USsalesor‘exports’ofbusinessassetsandrealestatebeginninginthemid-1980s,ifcombinedwithUSfinal-productexports,makeUS‘trade’approximatelybalancedsincethemid-1980s.Inthissense,the‘playingfield’ismuchmorelevelthanascharacterizedbymanyUSprotectionists.YetUSprotectionistscommonlybelievethatsalesofrealpropertytoforeigninterestsisnotasbeneficialtoUSeconomicinterestsassalesoffinalproductsmadefromtheproperty.Manyprotectionistsevensaythatitisalwaysbesttomaintainownershipoftheproperty,aslongastheownerreceivesanormalrateofearnings.

Butwhatisthenormalrateofearningsthatjustifiescontinuedpropertyownership?IntheUSduringthe1980s,theanswerwouldbe6.7percent,asdeterminedbytheaverageUSprice-earningsratioof15,i.e.(1/15)X(100)=6.7.IftheaverageUSinvestorinthe1980sexpectedacertainUScorporatestocktoyieldareturnofsignificantlylessthan6.7percent,thenhecouldnotjustifypurchasingthatstockormaintaininghisownershipofthatstock.Hewasbetteroffputtinghismoneyelsewhereinthestockmarketwhereheexpectedthereturnonequity,fromthesalesofproductsproducedbythatequity,tobeatleast6.7percent.Moneynaturallymovesinthismanneroutofbadstocksintogoodstocks,untilthepriceofbadstockshasdeclinedand/orthepriceofgoodstockshasincreasedenoughfortheaverageinvestortofindthemequallyattractive.

OfcoursemoneyalsomovesbetweentheUSstockmarketandtherestoftheeconomy.Investorswerecontinuallydecidinginthe1980swhethertheaveragereturnonUScorporateequityof6.7percentwasthemostattractivesavingsopportunity,and,givenallofthewaystosave,whethertheyweresavingenoughmoneyasopposedtopurchasingenoughfinalproducts.

Baseduponthesearguments,itwasbeneficialtotheUSeconomywhenJapaneseorotherforeigninvestorsboughtUSstocksinthe1980s,aslongasthesalespricesreflectedaverageprice-earningsratiosofmorethan15,or,equivalently,averagereturnsonequityofsignificantlylessthan6.7percent.InthesecasestheUSsellersbenefitedfromwindfallcapitalgains,i.e.thepremiumspaidbytheforeigninvestorsoverandabovenormalprices.ThesewindfallscouldbeusedbyUScitizenstoincreaseconsumptionoffinalproducts.Alternatively,windfallscouldbereinvestedinthefinancial

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markets,ineffectpostponinganowhigherlevelofconsumptiontosomefuturedate.

Clearly,theevidenceindicatesthatJapaneseandotherforeigninvestorshavepaidpricesforUSpropertyandbusinessassetsfarinexcessofwhattheUSsellerscouldreceivefromUSbuyers.Forexample,in1986andthefirstsixmonthsof1987,Tokyo-basedShuwaCorp.purchased$2billionworthofUS

realestate,includingthetwinArcoPlazatowersinLosAngeles,thePaineWebberbuildinginBoston,andtheAmericanBroadcastingCo.headquartersbuildinginNewYork.Thepricespaidforeach,accordingtoTheWallStreetJournal,were‘muchmorethancompetingoffers’,andthepricepaidfortheArcotowerswashigherthanforanypropertysaleinLosAngeleshistory.5

TheUSstockmarketwouldnothaveincreasedtentimesinvaluesince1980unlesstheforeigninvestorswerewillingtopayprice-earningsratiossignificantlyinexcessofthelevelswhichwouldotherwisehavebeendeterminedbyUSinvestors.ThedramaticdropintheUShouseholdsavingsratefrom7percentofdisposableincomeintheearly1980stopost-WWIIlowsof3to4percentinthelate1980sandzeroin1998,despiteonlymodestgainsinUSwagesandsalariessince1980,indicatesthatUSearnedincomewasnotsufficientlyavailabletoaccountformuchoftheUSstockmarket'sdramaticriseoverthisperiod.Instead,foreigncashwaslargelyresponsible.AsdocumentedinChapter1,theinflowofforeigninvestmenthasbroughttheprice—earningsratioonUSrealpropertyupto20/1inthe1990sfrom15/1inthe1980s,whichisacapitalgainof33percenttolong-termholdersofUSrealproperty—thankstoglobalizationandconvergenceofworldequitymarkets.

UScitizenswereabletojustifylowersavingsratessince1980partlybecauseofthesizablecapitalgainswhichtheywererealizingfromtheforeigncapitalinflow.ThevalueofUShouseholdwealth‘lockedinto’theUSstockmarketincreasedmorethan$1trillioninthe1980s,andmorethan$7trillioninthe1990s.Baseduponthesearguments,USpolicyrnakersshouldwelcometheforeignbuyingofAmerica.

Logic,asopposedtoprotectionistsentiment,suggeststhatsalesofUSrealpropertytoJapanandotherforeigninvestorssincethe1980shavebeenmorebeneficialtotheUSthanUSexportsoffinalproductsmadefromUSrealproperty.Tosummarize:

1. SalesofUSrealpropertytoJapanandotherforeigninvestorssincethe1980sresultedinsizablecapitalgainsforUScitizens.

2. TheUScapitalinflowfromtherestoftheworldimprovedtheprofitabilityofUSindustrybyreducingborrowingcostsandincreasingowned-equityvalues.

3. UScitizenshavehadtheabilitytoenjoymorefinalproducts,withouthavingtoincuranyadditionalliabilitiesorreducethevalueoftheir

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IntheUScase,fearofincreasedforeigndebtshouldbeseeneitherasasomewhatnaiveformofnationalism,orasafearof‘baddebt’.Therehasbeenabad-debtconcernaboutUSbanks,butitisaconcernthattheyloanedtoomuchmoneyoverseas,forexampletothelessdevelopedcountriesinLatinAmericainthe1980s,ornowtoAsiancountriesinthe1990s.InthiscasepopularsentimentwouldhavearguedinfavorofanincreaseinUSnetforeigndebt.FewerUSloanstoforeigners,i.e.morenetUSforeigndebt,wouldhaveimprovedtheprofitabilityofUSbanksandavoidedsomeoftheexcessivedebt-indulgenceintherestoftheworld.AsdiscussedbelowinthecasestudyofUStrade,thelargeincreaseintheUSnetforeigndebtduringthe1980sactuallybeganwhenUSbanksbeganwithdrawingmoniesfromtherestoftheworld,notwhenforeignersbeganlendingmoneytotheUS.

Ageneralfearofbaddebtisbaseduponconcernthattheborrowerwillbeunabletoachieveanetbenefitfromtheloan,orworse,thathewillbeunabletopaybacktheloanandhavetoforfeitbusinessorpersonalcollateral.Theborrowerisseenastoomuchofarisk-takerortoonaivetoassumesomuchdebt.IftheborroweristheUSgovernment,onemightalsoworrythattoomuchdebtwouldbeassumedbecauseoftheshort-sighted,‘pork-barrel’natureofpoliticaldecision-making.Whyworryaboutadebtthatcanbehiddenwithinamassivefederalbureaucracyandwillsoonbetheresponsibilityofotherofficials?

However,itshouldbepointedoutthatthe$100billionperyear,net,offoreignsavingsthatwasbeingsenttotheUSafter1984pushedUSinterestratesdowndramatically.Insteadofhavingtoborrowmoneyatlong-terminterestratesof12–14percentasintheearly1980s,thisincreasedforeigndebtallowedthefederalgovernmenttoborrowatlong-terminterestratesof7–9percentinthelate1980sandlessthan6percentinthemid-1990s.TheAsianfinancialcrisisresultedinmassivecapitalflightfromAsiatotheUS,and30-yearUSTreasuryBondswerepayinginterestratesoflessthan5percentinthefallof1998.Certainlypolicymakersshouldbeabletojustifyincreasedborrowingandspendingoncertaintypesofpublicgoodsatthelowerinterestrates.Totheextentthatmorepublicgoodscanbejustified,increasedgovernmentborrowing,especiallyfromforeignsources,canalsobejustified.

Theauthor'spositionisthatUSfederalbudgetswithdeficitsover$150billionwouldnothavebeenpassedbetweenthemid-1980sandthemid-1990swithoutthereadyavailabilityofforeignsavings.A(hypothetically)financiallyself-sufficientUSeconomyinthisperiodwith$100–$150billionofhouseholdsavings‘leftover’forthebusinesssectorassuminga$150billionfederaldeficitwouldhavebeenseverelyrecessionary.

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Nationalpolicymakers,whoseelectivenessandcareersfrequentlyrequirethemtomaintaineconomicgrowth,thusbeganencouragingtheinflowofforeignfundsinthe1980s.Inasurprisingturnaroundfrompreviousspeeches,PresidentReaganarguedon11January1987that‘inflowsofforeigncapitalarenotnecessarilyasignofaneconomy'sweakness’.6ComparingthenationaldebttoCalifornia'sexternaldebttootherstates,Reagansaid‘doesthisaugurbaddaysaheadforCalifornia?Onthecontrary,onemightargueit'sasignofstrength’.

Withcurrentinternationalsavingstrendscontinuing,withfurthergovernmentalderegulationoffinancialmarkets,andwiththeprofitmotivecontinuingtodrivetheinformationrevolution,nationaleconomiesarebecomingmoredependentuponeachotherthroughsaver-dissaverrelationships.Asdiscussedfurtherinthe‘CaseStudyofUS-ForeignTrade1981–’below,thesefinancialrelationshipsarethedrivingforcebehindmanynewtradepatterns.

II.CASESTUDYOFUS-FOREIGNTRADE,1981–

TheUS,acountryespeciallyexposedtotheglobalizationoffinancialmarketssincethe1980s,was,consequently,especiallyexposedtonewpatternsofmerchandiseandservicestrade.TheUSeconomy,therefore,providesagoodcasestudyfortheargumentsofthischapter.Forexample,itisarguednextthatthecontinuinglargeUStradedeficitisaresultofthecontinuinglargenetinflowofforeignsavingsintotheUS.Contrarytoconventionalwisdom,theinflowofforeignsavingsisarguedtobethemoreinitiating,autonomousdevelopment,andtheUStradedeficitisarguedtobethemoreaccommodatingdevelopment.

Beforethe1980s,themajorpurposeofmostinternationalfinancialtransactionswastoaccommodatemerchandiseandservicestrade.Growthintradeproducedanearlyequalgrowthininternationalfinancialmarkets,especiallytheamountof

anearlyequalgrowthininternationalfinancialmarkets,especiallytheamountofforeigncurrencythatwasswapped.Incontrast,bytheearly1980stheexpansionofinternationalfinancialmarketshadtakenonaprofit-seekinglifeofitsown.AsdiscussedinChapter1,thederegulationoffinancialmarketsandtheglobalinformationrevolutionmadeinternationalborrowingandlendingandotherinvestmentveryefficientandprofitablebythemid-1980s.Consequently,mostofthemoneywhichwasmovingbetweencountriesbythemid-1980shadlittletodowithmerchandiseandservicestrade,butinsteadwasaccommodating‘pure’financialtransactions—thosewhichinvolveonlytheexchangeofmoneyanddocumentation.Forexample,between1980and1986thevolumeofforeigncurrencytradingdoubled,sothatby1986thisvolumewasroughly12timesthevolumeofworldwidetradeinmerchandiseandservices.

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Whethertheinternationalbusinesspersonisengagedinfinancialornon-financialtransactions,oftenthecurrencyexchangerateisthekeydeterminantofhisprofitrate.Nootherproductionorsalesconditionislikelytohavesuchalargeimpactonthegapbetweencostsandrevenuesfromoneyeartothenext.Forexample,fromJanuary,1981toJanuary,1985thetrade-weightedexchangevalueoftheUSdollarincreased65percent,meaningthatthesideofaUS-foreigntransactionwhichmadethecurrencyconversioncouldhavelostorgainedasimilarchangeinrevenuedependinguponwhentheychosetomaketheconversion.Also,betweenJanuary1985andJanuary1987,thetradeweightedexchangevalueofthedollarreverseditsupwardtrendandfell50percent(Figure2.1).

Figure2.1Thetrade-weightedexchangevalueoftheUSdollar,1978–97(March1973=100)

Source:BoardofGovernorsoftheFederalReserveSystem.

Duetotheincreasedvolatilityofexchangerates,andtheincreasedimportanceofinternationalcommercetotheUSeconomy,bythelate1980soneoutoffourUScompaniessurveyedweretradingforeigncurrenciesasahedgeagainstforeignexchangelosses.7

AsdiscussedinChapter1,interestrateparitybecamethedominantequilibriumininternationalcommerceduringthe1970sand1980s,andparticipantswerepayingincreasingattentiontointerestratedifferentials.Increasingly,anyshocktothesystemwhichpushedinterestratesupinonecountryencouragedtheinternationalcommunitytolendmoneythere,anddiscouragedtheinternationalcommunityfromborrowingmoneythere.

TwosuchshockswereoccurringintheUSin1981thateventuallypushedUSinterestratesuptorecordhighs:theadministrationofnewly-electedPresidentReaganbeganpursuingpolicieswhichincreasedthesizeoftheFederalbudgetdeficit;andtheUSFederalReserveBoardwasrestrictingthegrowthoftheUSmoneysupply.TheincreasedFederalbudgetdeficitincreasedtheborrowingneedsoftheUSgovernmentandtheslowergrowth

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oftheUSmoneysupplyreducedtheabilityofUSfinancialinstitutionstomakemoneyavailableforlending.Inordertorationthescarcefundsoflendersamongcompetingborrowers,interestrateswereraisedtoveryhighlevelscomparedwithwhattheeconomywouldotherwisehaveproduced.

Forexample,theUSprimeinterestratemovedin1981to5or6percentagepointsabovetherateofinflationasmeasuredbytheUSconsumerpriceindex,andstayedthereuntil1984.Incontrast,throughthemidandlate1970s,theUSprimeinterestratehadstayedwithin2percentagepoints(aboveandbelow)therateofconsumerpriceinflation.

IftheUSfinancialmarketshadbeenclosedtoforeigninvestorsintheearly1980s,thentheextraUSgovernmentborrowingandreducedUSmoneygrowthmightormightnothaveincreasedthetotalloanvolumeintheUS—despitemoregovernmentborrowing,someborrowingbyUSbusinessesandindividuals

moregovernmentborrowing,someborrowingbyUSbusinessesandindividualswouldhavebeen‘crowdedout’bythehigherinterestrates.

However,giventherapidderegulationandglobalizationoffinancialmarketsthatwasoccurring,highUSinterestratesintheearly1980screatedastrongincentivefortheworlds'lenders:findawayinthenewglobalmarketstogainaccesstotheserates!Forexample,JapaneselenderssawUSmoneymarketinterestratesjumpup9percentagepointshigherthanJapanesemoneymarketinterestratesin1981,comparedtoanaverageUSadvantageofonly0.2percentagepointsfrom1971–1980.ManyUSlendersalsosuddenlyfoundthemselveswithmoneytiedupabroadatequallydisadvantageousinterestrates;theirportfolioswerethusoverexposedtoforeignborrowersintheearly1980sevenwithoutconsideringthenewrisksofdefaultthatbegantosurfaceonUSloanstodevelopingcountries.

Accordingly,intheearly1980s,USandforeignlendersbegantofavortheUSmarket.AsshowninTable2.1,whichisasummaryofUSinternationalfinancialtransactionsfrom1980–1985,USlenderswereabletodirecttheirfundsintotheUSfasterthanforeignlenders,certainlybecauseUSlendersalreadyhadmoreunregulatedconnectionstoUSborrowers.The‘capitaloutflow’fromtheUSmadeitssignificantdropfrom1982to1983,adropof$71billiondollars.However,ittookforeignlenderssometimeintherapidlyglobalizingfinancialmarketstotakeadvantageofthehighUSinterestrates.The‘capitalinflow’totheUSactuallydeclinedfrom1982–83beforeincreasing$20billionfrom1983–84and$24billionfrom1984–85.

ThestatisticaldiscrepancyaccountinTable2.1isusedtoreconcilemeasuredflowsofcommerceandpaymentsforthoseflows.Thisaccountbecameverylargeinthelate1970sand1980s—itassumedadebitbalanceaveraginglessthan$1billionfrom1960–77,thenacreditbalanceaveraging$21billionduring1978–86,thenlargedebitandcreditbalancessince1987includingacreditof$64billionin1990andadebitof$53billionin1996.

Thestatisticaldiscrepancyisgenerallyconsideredpartofthecapitalaccountbalance,i.e.itslargecreditpositionshowninTable2.1isassumedto

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reflectanunmeasuredpartoftheinternationalflowoffundscomingintotheUS.

reflectanunmeasuredpartoftheinternationalflowoffundscomingintotheUS.However,thereisnowaytoverifyexactlyhowmuchofthestatisticaldiscrepancyreflectsactualflowsofcapital.

Table2.1TheturnaroundintheUSCapitalAccount,1980–85($billion)198019811982198319841985CapitalinflowtoUS58839483103127Lesscapitaloutflow86111121502432Equalsnetidentifiedinflow-23-28-27357995Plusstatisticaldiscrepancy262136112723Equalsnetcapitalinflow-2-6947107118

Note:Componentsmaynotaddduetorounding.Source:USCommerceDepartment.

Forexample,whatifmuchofthe$64billioncreditpositionofthestatisticaldiscrepancyaccountin1990,itslargestimbalanceever,didnotreflectanactualinflowofcapitaltotheUS?Thenonecouldmoreeasilyconclude,astheauthordoesinChapter4,thattheUSrecessionof1990–91hasitsexplanation.Withoutsomeofthisinflow,especiallygiventhesimultaneousdropinthenetidentifiedinflow,USinvestmentandconsumptiongrowthcouldnotbesustained.Intheauthor'scasestudyoftheearly1990sUSrecessioninChapter4,hedocumentsthattheeconomicsprofessionisunabletoexplaintherecession,andalsothattheprofessionignoresthispossibility.Similarly,theauthorarguesin‘TheAsianCrisis,1997–’inChapter4thatunmeasuredaswellasmeasuredcapitalflowscomingintotheUSfromAsianandelsewheremadeforanunexpectedlystrongUSeconomy.

ThebottomlineinTable2.1sumsupyearlychangesintheinternationalfinancialpositionoftheUSoverthe1980–85period.ThisbottomlineiscalledthenetbalanceontheUScapitalaccount,whichwentfromadeficit(ordebit)toasurplus(orcredit)in1982.Aftersendingmoreinvestmentfundstoothercountriesthanwerereceivedfromothercountriesby$2billionin1980and$6billionin1981,thenetflowreverseddirectionandtheUSbeganreceivingforeigninvestmentonbalance.In1982,1983,1984and1985theUSreceivedmorefundsfromtherestoftheworldthanitsenttotherestoftheworldby$9billion,$47billion,$107billionand$118billion,respectively.

Whatwashappeningintheforeignexchangemarkettothevalueofthedollarasapproximately$157billion,net,ofinternationalinvestmentflowed

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intotheUSintheimportantreversalperiod1981–84?BecauseUSinvestmentisconductedindollars,andbecauseforeigninvestorshaveothercurrenciestoinvestwith,thedemandfordollarsfromtheforeignexchangemarketincreasedby$157billion,andthesupplyofothercurrenciestotheforeignexchangemarketincreasedbyanequivalentamount.Inotherwords,$157billiondollarsmovedoutoftheinventoriesofforeignexchangetradersintotheUSeconomyandanequivalentamountofothercurrenciesmovedoutoftheglobaleconomyintotheinventoriesofforeignexchangetraders.

However,merchandiseandservicestradeaswellasinternationalinvestmentrequirescurrencyswapsandthereforealsoexertspressureonexchangerates.From1981to1984,theUSbought$155billionmoreworthofmerchandiseandservicesfromtherestoftheworldthantheUSsoldtorestoftheworld.ThisexcessofUSimportsoverexports(includinggovernmentgrantsandprivateremittancesabroad)iscalleda$155billiondeficitordebitinthecurrentaccountoftheUS.8Thecurrentaccountsummarizesallnon-financialtransactionsbetweentheUSandtherestoftheworld,justasthecapitalaccountsummarizesallfinancialtransactions.

The$155billiondeficitintheUScurrentaccountfrom1981–84affectedtheforeignexchangemarketasfollows:foreignexporterstotheUSgenerallywanttoreceivetheirowncurrencyaspaymentandUSimportersgenerallyhavedollarstospend,thereforeonesideofaUSimportingtransactionmustbuytheforeigncurrencyfromtheforeignexchangemarketwiththeunwanteddollars.TheoppositehappensinaUSexportingtransaction.Therefore,becauseUSimportingexceededUSexportingby$155billionin1981–84,$155billiondollars,net,weresoldtotheforeignexchangemarketfromtherestoftheglobaleconomyandanequivalentamountofothercurrencieswereboughtfromtheforeignexchangemarket.ToaccommodatetheUScurrentaccountdeficitglobalforeignexchangetradingthusexerteddownwardpressureonthevalueofthedollarfrom1981to1984.

AtfirstglancethedownwardpressureontheexchangevalueofthedollarexertedbythedeficitintheUScurrentaccountseemstobeapproximatelyequalinmagnitudetotheupwardpressureexertedbythesurplusintheUScapitalaccount,i.e.$155billionofdownwardpressurecomparedto$157billionofupwardpressure.Onemightnaivelyconcludethatthevalueofthedollar

probablystayedconstantbetween1981and1984.

Nothingcouldbefartherfromthetruth,however,asthetrade-weightedexchangevalueofthedollarincreased50percentfrom1981to1984.Alessnaiveunderstandingisnecessary,whichresultsinthefollowingscenario:

1. Deregulationandglobalizationoffinancialmarketsinthe1980sledto:2. alargenetflowofinternationalfundsintotheUS(UScapitalaccount

surplus),adissavercountryduetoitshighinterestratesandproductive,safe-havenenvironment,whichledto:

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1. ahighervaluedforeignexchangepriceforthedollarasinternationalinvestorsonbalancedemandedmoredollarsfromtheforeignexchangemarketstogainaccesstothenewinvestmentopportunitiesandhighinterestratesintheUS,whichinevitablyledto:

2. moreUSimportsandalessUSexports,becausethehighervalueddollarmadeUSproductslesscompetitiveininternationaltrade,andthenetinflowofinternationalinvestmentintotheUSincreasedUSeconomicgrowthandimportsrelativetoothercountries;and:

3. thisUStradedeficit(UScrentaccountdeficit)hadtowidenuntilitwaslargeenoughtosupplyforeignexchangetraderswiththeamountofdollarsthattheyneededtoaccommodatetheincreasedflowofinternationalfundsintotheUS.

Figure2.2illustratesthisscenario.ThecurrentaccountsoftheUS,Japanand(West)Germanywerebalancedin1980–82.Then,thederegulationandglobalizationoffinancialmarketsresultedinsubstantialflowsofinvestmentfundsfromWestGermanyandJapanintotheUS,whichinturnresultedinthehigh-valueddollar,UScurrentaccountdeficit,andtheJapaneseandGermancurrentaccountsurpluses.Thesechangesinthedirectionofmerchandiseandservicestradebetweentheworld'sthreelargesteconomies,largelycausedbythederegulationandglobalizationoffinancialmarkets,arethemostsignificantdirectionalchangesinworldtradesinceWorldWarII.

Figure2.2Changesinthedirectionofmerchandiseandservicestradebetween

theworld'sthreelargesteconomies,1980–97(currentaccountbalances,$billion)

Source:IMF.

AselaboratedinChapter4,thesetradeimbalancesshrankduringtheearly1990sduetouniquecircumstances,suchasthePersianGulfcrisis,Germanreunification,andamoney-liquiditycrisisinJapan,buttheysoonreturnedto

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historicallyhighlevelsbecauseofthecontinuingflowofinvestmentfundsintotheUS.

Whycouldn'tthedeficitinUSmerchandiseandservicestradehavehappenedfirstin1981–84,thusforcingchangesintheUSinternationalinvestmentpositionuntilthecurrencyinventoriesoffinancialintermediariesweremaintained?MaybeforeignfirmsinJapan,WestGermany,andelsewherewereproducingsuperiorproductsmoreefficientlythanUSfirms,andforeignfirmsweremakingsomuchmoneytakingbusinessawayfromtheUSthattheyhadalotoffundstolend,andtheUSneededtoborrowalotoffundstomaintainitsoutputanddevelopnewindustries?

Inthe1981–84importantreversalperiodforinternationaltradeandinvestment,changesininvestmentmusthavebeenthedrivingforce,whilemerchandiseandservicestradefollowed,foronesimplereason:thedollardramaticallyincreasedinvaluetobalancethedollarsuppliesoffinancialintermediariesinthisperiod,ratherthandecreasinginvalue.TheUScurrentandcapitalaccountswereeachinapproximatebalanceatthebeginningofthisperiod.Therefore,ifthecurrentaccounthadstartedmovingfirsttowarditslargedeficitposition,thenthevalue

accounthadstartedmovingfirsttowarditslargedeficitposition,thenthevalueofthedollarwouldhavestarteddecreasingratherthanincreasing.Financialintermediarieswouldhavebeengainingdollarsonbalancefromtherestoftheglobaleconomy,ratherthanlosingthemaswasactuallythecase.

Inturn,thedollarwouldhavehadtocontinuefallinguntilitbroughttheUScurrentaccountbackintobalance,whichwascertainlynottheresultseen,i.e.thedollarincreasedinvalueapproximately50percentduring1981–84astheUScontinuedtohaverecordcurrentaccountdeficits.Also,theUSCapitalAccountwouldnothavebeenlikelytomovesoquicklytowardsuchalargesurpluspositionifthecurrentaccounthaddeterioratedfirst,becausenotsomanyforeigninvestorswouldhavewantedtobuydollarsforUSinvestmentpurposesifthedollarwas(expectedtobe)declininginvalue.

So,acause–effectscenarioasheadlinedbymanyanalysts,includingBusinessWeekonSeptember23,1985,that:‘thesoaring[US]tradedeficit…isdestroyingUSmanufacturingjobs…andturningtheUSintoadebtornation’9isquiteinconsistentwiththefacts.Theold-fashionedunderstandingofinitiatingandautonomousmerchandiseandservicestradeforcingthemajorchangesinaccommodatingfinancialflowsmustyieldinthiscasestudytoanewunderstandingthatinitiatingfinancialflowsforcedthemostsignificantchangesinmerchandiseandservicestradesinceWorldWarII.InChapters3and4,theauthoralsosupportsthisthesiswithstatisticalanalysiswhichidentifiesthetime-lagsbetweeneachphenomenon.

Sincetheearly1980s,whenaUSexporterfinishestheyearwithlowersales,itislikelytobebecauseforeignbuyersofUSproductshavefoundsomethingbettertodowithsomeoftheirdollarfunds:investthem,especiallyinUS-dollar-denominatedassets.Suchascenariohasbecome

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moreandmorelikelywiththeglobalizationofdollar-denominatedfinancialmarkets.USexporters(whoselltheirproductstogetdollars)arenolongerincompetitiononlywithotherinternationalsuppliersofthesamemerchandiseandservices,butalsowitheveryinternationalborrowerofdollars.Andintheearly1980sthelatterformofcompetitionbecamemoredifficulttoovercomethantheformer—itpushedtheweightedaverageforeignexchangevalueofthedollar

former—itpushedtheweightedaverageforeignexchangevalueofthedollarupby65percent,andthusreducedtheinternationalpricecompetitivenessofUSexportersmorethananyotherfactor.

WhentherewasanetflowofinternationalinvestmentintotheUSinthisperiod,thedollarincreasedinvalueuntilenoughforeigncurrencyproducts,suchasJapanesecars,wereboughtinplaceofUS-dollar-denominatedproducts,suchasAmericancars,thatforeignexchangetradersmaintainedtheirdollarinventories.Inthisperiodtheforeigncountries'shareofthemarketforallUSindustrialgoodsclimbedfrom14percentto20percent.10

TheUSautomobileworkerswhobecameunemployedinthisperiodandtheholdersofUSautomobilecompanystockswereunluckybecausetheylivedinacountrythatreceivedalotoffundsforborrowingandinvestment.Unless,forexample,theyhappenedtobecomesuccessfulborrowersintheexpandedUScreditmarkets—theloantoChryslerCorp.fromtheUSgovernment(whichinturnwasexpandingitsforeignborrowing)wassuccessfullyusedtomaintainthecompanythroughthisdifficultperiod.Ontheotherhand,peopleassociatedwiththeJapaneseautoindustrywereluckyinthisperiodbecausetheylivedinacountrywhichwassendingalotofmoneyintotheinternationalmarkets.However,theJapanesecapitaloutflowmeantthattherewaslessmoneyavailableforborrowersintheJapanesecreditmarkets.

WastheUS,overall,betteroffafterreceivingthenetflowofinternationalfundsin1981–84?Itdependsonthebalancing-outoftwoeffects:thesuccessfulnewUSborrowersandotherbeneficiariesofthisinvestmentcreatedjobs,economicgrowth,andothersocialbenefits;but,costswereimposedonvariousUSindustriesandconsequentlytheUSeconomyduetothestiffercompetitionfromimports.WastherestoftheworldbetteroffwhenitsentmoreofitsmoneyonbalancetotheUS?ThenewfoundsuccessesofforeignexportindustriescomparedtotheirAmericancompetition,combinedwiththenewfoundsuccessesofforeigninvestorsintheUSmarketscreatedvariousbenefitsforforeigneconomies;but,therewaslesssuccessfulborrowingandinvestingwithintheforeigneconomies.

Thesequestionsaredifficulttoanswerstatistically,becausethebenefitsofhouseholdandgovernmentspendingcannotbeadequatelyquantifiedbeyondtheirdollarmagnitude(unliketheprofitmeasureofnetbenefitusedinthebusinesssector).Certainly,however,thenewinternationalflowsofinterest-rateandfinancial-strategyparity-seekingfundswasaninevitableconsequenceofthederegulationandglobalizationoffinancialmarkets.

deregulationandglobalizationoffinancialmarkets.

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Also,thesestructuralchangesresultedinmoreprofitableinternationalborrowingandlending,andthereforemorespendingandeconomicgrowthfortheglobaleconomyasawhole.

Assessingthebenefitsandcostsofthesestructuralchanges,andallocatingthebenefitsandcoststovariouscountrygroupsisthetaskofChapters3and4.Generallyspeaking,thecasestudiesshowthattheUShasbenefitedgreatlyfromfinancialglobalization,andmanyotherpartsoftheworldhavesufferedlosses.

III.NEWDEFINITIONSOFTRADEANDTHEFOLLYOFPROTECTIONISM

Usingthetraditionaldefinitionoftradeastheflowofproductsacrossnationalboundaries,tradeprotectionismisthentheuseoftariffs,quotas,andothercustomsbarrierstorestricttheflowofforeignproductsintothedomesticmarket.Thehistoricaljustificationsusedbygovernmentstorestrictimportsarewellknown:tomaintainstableemploymentandprofitlevelsintheprotecteddomesticindustries;topreservedomesticproductionofcertain.productswhichareimportanttonationalsecurity;toprotectan‘infant-industry’whileitdevelops;toretaliateagainsttheunfairtradingpracticesofanothercountry;toreducethecountry'stradedeficit,etc.

Protectionismisprimarilyusedasameansofredistributingincome.Whenimportsaretaxedwithatariff,thegovernmentoftheimportingcountryattainsthetariffrevenueattheexpenseof:theconsumersoftheimportedproduct,whonowpayahigherprice;theforeignexportersoftheproduct,whoareleftwithalowerafter-tariffprice.Theprotectedindustryisabletoachievehigherconsumerpricesand/ormoreoutputofitsproductwhenthepriceofthecompetingimportproductisincreasedbythetariff.

Theincometransfersarethesamewitharestrictiveimportquota,exceptthatthegovernmentoftheimportingcountrymaynotreceiverevenuesfromsalesoftherestrictedimport.Ifthedomesticimportersorforeignexportersaregiventheexclusiverighttosellthenow-scarce,importedproduct,thentheyareoftenable

exclusiverighttosellthenow-scarce,importedproduct,thentheyareoftenabletogethigherwindfallprices.

Historically,whicheverformofprotectionismisused,whetherconsumerpricesareincreaseddirectlybytariffsorindirectlybyimportquotas,themajoreffectistotransferincomewithintheimportingcountryfromitsdomesticconsumerstoitsprotecteddomesticfirms.11Politicians,forobviousreasons,emphasizethebenefitsthatareprovidedfordomesticfirmsratherthanthecoststhatareimposedupondomesticconsumers.Yetonegroupusuallygainsonlyattheothergroup'sexpense—anetincreaseindomesticwelfareisseldomcreatedwhengovernmentsrestrictinternationaltrade.

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Inthenewglobaleconomy,restrictingforeignimportswithtariffsandquotasisbecominglesspracticalasawaytotransferincomefromdomesticconsumerstopolitically-favoreddomesticfirms.Itishardertoredistributesignificantamountsofincomewiththesedevices,andtheincomethatisredistributedismorelikelytoreachotherlesspolitically-favoredgroups.

Theincreasingfollyoftradeprotectionismisduetofourstructuralchangesassociatedwiththenewglobaleconomy:(A)asdiscussedintheprevioussection,tradedeficitsarenowrequiredbycountrieswhich,duetointerestrateandfinancialstrategyparityconditions,receiveanetcapitalinflow;(B)risingimportsasashareofnationalpurchasesareincreasingthenationalwelfarecostofusingtradeprotectionism;(C)theincreaseininternationaljointventuresandoverseasproductionismakingitlesslikelythattradeprotectionismwillachievethedesiredincometransfers;and(D)theincreaseininternationalownershipofoncenationalcorporationsismakingitlesslikelythattradeprotectionismwillachievethedesiredincometransfers.

Thissectionelaboratestheimportanceof(A)–(D)totradepolicymakingintheglobaleconomy.Aspartofthediscussion,theauthorexpandsthehistoricaldefinitionoftradetoincludetheintegrationofproductionprocessesandownershipbetweennations.Appropriatetradepolicymakingshouldofcoursebecoordinatedwithappropriatemonetaryandfiscalpolicystrategiesinordertoavoidfinancialcrisesandrecession,andthisdiscussionisthereforeimportantforthepurposesofthisbook.Appropriatepolicyalternativestotrade

forthepurposesofthisbook.AppropriatepolicyalternativestotradeprotectionismarepresentedinChapter5inthecontextof‘NationalStrategiesintheGlobalEconomy’.

A.TheFollyofProtectionismNowThatTradeDeflcitsareRequiredbyInterestRateParity(IRP)andFinancialStrategyParity(FSP)

AsdiscussedinChapter1,IRPandFSPexplaintheinitiating,profit-seekingflowsoffinancebetweencountries,and,aselaboratedintheprevioussection,itistheIRPandFSP-influencedequilibriumpositionofglobalizedfinancialmarketsthatmerchandiseandservicestrademustconformto.Otherwise,financialarbitragerswouldexploitinefficienciesinIRPandFSPandmaketremendousprofits,muchgreaterprofitsthancouldeverbeachievedfrommerchandiseandservicestrade.

TheexchangerateswhichareproducedbytheIRPandFSPprocessescouldinoneperiodgiveacountry'sexportersatremendouspriceadvantageininternationaltrade,andinanotherperiodatremendouspricedisadvantage.Inaddition,thesubsequentchangesinthatcountry'smerchandiseandservicestradebalancemaybelargebyhistoricalstandards,butsmallrelativetotheflowsofinternationalinvestmentfundsbetweenthatcountry'scurrencyandothercurrencies.

Inthefuture,policymakerswhodonotwanttheirnationaltradebalancestoaccommodateIRPandFSPwillincreasinglyhaveverylittlechoicebutto

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acceptthelinkage.Forexample,ifpolicymakersweresomehowabletoreducethenetflowofinternationalfundsintotheircountrytoalevelthatwoulddepreciatetheircurrencyenoughtoimproveprospectsfortheirexportindustries,adoptingsuchapolicywouldprovetobeunwise.Thecostsoflosingforeigninvestmentintheglobaleconomymightoutweighthetradebenefits,aswasarguedearlierintheUScase.Also,thereisnoguaranteethatpolicymakerswouldknowhowstrategicallytomanipulatetheinternationalfinancialflowssothatthedesiredeffectsonmerchandiseandservicestradewouldbeproducedatthecorrecttime.

Usingsomeformoftradeprotectionismtolimitimportsorexportsinsomeindustrieswillonlyencouragefurthermovementsinexchangeratesuntilthenecessarytradebalanceeffectsarederivedfromotherunprotectedindustries.Protectionismthatcoversallimportsorexportsisdoomedtofailureinthelongrunbecauseofthecurrencyshortagesthatwouldoccurintheforeignexchangemarkets.Forexample,whentheUSreceives$100billionofnetforeigninvestmentinoneyear,then$100billiondollarsmovesoutoftheinventoriesintheforeignexchangemarketandintotheUSeconomy.ForeignexchangetraderskeepthevalueofthedollarhighenoughsothattheirdollarinventoriesarereplacedviaaUSCurrentAccountdeficitofapproximately$100billion.Noothermechanismformaintainingforeignexchangeinventoriesispracticalinthenewglobaleconomy,noteveninterventionbycentralbanks.

Officialattemptstostabilizeinternationalmonetaryflowsbasedondifferentcurrencyreservecushionsandnationalmoneysuppliesareoftennotpossible.Privatefinancialflowscanpushexchangeratestoofast,andinflation/economicgrowthconsiderationslimittheabilityofcentralbankstocontrolexchangeratestothisdegree.Thegrowthofinternationalfinancialtransactionswillcontinuetooutpacethegrowthofthecurrencyreservesheldbynationalcentralbanks.Therefore,inChapter5theauthorproposesareductioninthenumberofcurrenciesandvariousothermeasuresinordertobringgreaterstabilitytotheinternationalmonetarysystem.

Thus,itisquiteinconsistentwiththestructureofthenewglobaleconomytoadvocatetradeprotectionismasameansofreducingtradedeficits.ButevenfinancialleaderswhopresumablyarewellawareofIRP,FSP,andhowtheforeignexchangemarketsworkcontinuetoproposesuchpolicymaking.Forexample,WillardButcher,chairmanandchiefexecutiveofficeroftheChaseManhattanCorporation,arguedin1990thattradecertificatesshouldberequiredinordertosellforeignproductstotheUS.12Howtoobtainthesecertificates?OnlybybuyinganequivalentdollaramountofUSexports.

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B.TheFollyofProtectionismasImportsCaptureaLargerShareofNationalPurchases

Countriesareincreasinglypurchasingmerchandiseandservicesfromeachother,bothinabsolutetermsandasapercentageoftheirtotalpurchases.From1962to1982,thetwodecadesbeforetherapidglobalizationoffinancialmarkets,importsasashareoftotalworldpurchasesincreasedatanaverageannualrateofapproximately3percent.Importsaccountedfor17percentoftotalworldpurchasesin1982.

After1982,thegrowthofinternationaltradeaccelerated.In1986,thevalueofworldcommerceamongthe92tradingnationsascribingtotheGeneralAgreementonTariffsandTrade(GATT)topped$2trillion,andin1989thisfigureexceeded$3trillion.13Annualincreasesintheactualdollarvalueofworldtradewere17percentin1987,14percentin1988,and7.5percentin1989,whichfaroutpacedthe2–4percentdollarinflationinthoseyears.Insomecountries,suchasGermany,Canada,andSouthKorea,importsplusexportsnowaccountforapproximatelyhalfofalleconomicactivity.

Whencountriesbuymoreforeignproductsinplaceofdomesticallyproducedones,thenlabor,capital,land,andotherproductiveresourcesaredivertedfromthedecliningimport-competingindustriesintothenewexportindustries.Insituationswhereresources,especiallylabor,havebeenforcedoutofdecliningindustriestooquickly,protectionismiscommoninorderthatadjustmentscanbemademoreslowlyandlesspainfully.Businessesneedtimetoretoolanddevelopnewproductssothatwastefulbankruptciesareavoided,andworkersneedtimetoretrainandrelocatethemselvessothatdifficultperiodsofunemploymentareavoided.However,inthenewglobaleconomythisreallocationofproductiveresourcesisinevitablyoccurring.

TheUSautomobileindustryprovidesanexcellentexampleofhowprotectionismhasbeenusedwhenproductiveresourcesareforcedoutofanimport-competingindustrytooquickly,yethowinthelongruntheinevitableincreaseinimportsharemakesprotectionismimpractical.ThislastpointisdevelopedafteradiscussionoftheincometransfersthatoccurredwhenUSautomobileimportswererestrictedinthe1980s.

IntheUS,competitionfromsmaller,morefuel-efficientimportedcarsbecameparticularlyintenseduringtheOPECoilpriceincreasesofthe1970s.TheimportshareoftheUSmarketjumpedfromlessthan10percentin1970to30percentin1980.14EventuallytheUSfirmswereunabletomeettheremarkablecompetition,especiallyfromJapan,whoseshareoftheUSmarketincreased

from14.5percentin1978to16percentin1979to21percentin1980.15TheUSindustrylostcombinedprofitsof$4billionin198016andthenumberoflaid-offworkersreached220,000.17

TheUSgovernment,inordertoprovideareasonableprofitandemploymentoutlookforthisindustrywhichdirectlyorindirectlyemployed

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oneoutofeverysevenUSworkers,beganarrangingforJapaneseimportstoberestricted.Japanagreedto‘voluntarily’restrictthenumberofcarsitsautomobilemanufacturerswouldshiptotheUSto1.68millionperyearbeginningonApril1,1981.TherestrictionwasintendedtolastforafewyearsuntiltheUSindustrywasabletodevelopmorecompetitive,fuel-efficientcars.Infact,the1.68millionlimitwasusedforthreeyears,thenfromApril1,1984toMarch31,1985theceilingwasraisedto1.85million.SinceMarch31,1985theceilinghasnotbeensetsoformally,butsomerestraintshaveremained.

Bythebeginningof1985theaveragepriceofUS-madecarswasestimatedtobeanywherefrom$300to$1000higherthanitwouldotherwisehavebeenintheabsenceofthefouryearsofvoluntaryexportrestraints.PriceincreasesontheimportedJapanesecarswereestimatedat$500to$2000.Clearly,policymakersfeltthatsevereimportrestrictionswerenecessarysothatUSbuyerswouldturntowardtheUSindustryinsufficientnumberstorestoreitsprofitability.

AlthoughthisprotectionismdidgivetheUSautomobileindustryenoughtimeandmoneytoprofitablyadapttoincreasedinternationalcompetition,itcameatagreatcosttoUScarbuyers.OfthetotalUSindustryprofitsof$9.8billionin1984,18$3.1billionor31percentofthetotalcanbeattributedsolelytotheprotectionism—tothehigherpricesthatUScarbuyerspaidforUScarsduetotheimportrestrictions(Babcocketal.,1985).Also,UScarbuyerspaidanaverageof$500–$2000moreforimportedcars(Japanesecarsaccountedformorethan80percentofimports)dependingonwhoseestimateisused.This$500–$2000perimportedcarisaroughestimateofthenetcosttotheUSeconomyofprotectingitsautomobileindustry,i.e.thenetamountofincomethatistransferredfromUScitizenstoforeigncitizensratherthanbetweenUScitizens.

So,inadditiontotransferringmoneyfromUScarbuyerstoUScarmakers,USautomobileprotectionismeffectivelycreatedaforeignexportcartelwhich,justlikeOPEC,attainedmonopolyprofitsbyrestrictingtheirexportsanddrivingupprices.ThevoluntaryexportrestraintagreementsgavetheJapaneseMinistryofInternationalTradeandIndustry(MITI)inconjunctionwithJapanesecarmakerstheauthoritytoformacartelarrangement,andtheweakbargainingpositionofthecompetitiveUSimportersallowedtheJapanese(andotherforeign)firmstocaptureallofthepricewindfallsonUSimports.

AlthoughtheJapanesecompanieswouldhavesoldanywherefrom15percentto40percentmorecarstotheUSby1984withouttherestrictions,19thepricewindfallfromUScarbuyersmorethancompensatedthemforthisdeclineinvolume.TheJapaneseauto-makersrealized80percentoftheirtotalprofitsfromtheUSin1984,arecordonetrillionyen(morethan$4billionat1984exchangerates).20ThiscontinuingwindfallencouragedMITItoretainthequota,a2.3millionlimitonpassengercarsalestotheUSin

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1989,undertheauspicesthatapoliticalfavorisbeingprovidedtotheUS.TheUSindustrypositionin1989,eightyearsafterthequotawasfirstputintoplace,wasthat‘thequotaisanecessaryeviluntiltheseriousimbalanceinUS-Japantradeiscorrected’.21

AsthiscasestudyofUSautomobiletradedemonstrates,withvoluntaryexportrestraintsorwithanyothertradequotaswhichallowforeignexporterstoreceivehigherprices,thereisanimmediatenetwelfarelosstotheprotectionistimportingcountry.Thesizeofthiswelfarelossdependsuponhowsignificantlytradeisrestricted(enoughtoincreaseimportedcarpricesby$500–$2000inthiscase)andhowimportantimportsaretotheeconomy(30percentofallcarspurchasedinthiscase).Asperthetitleofthissectionofthebook,ifimportsarealargershareofnationalpurchases,thenthesizeofthenationalwelfarelossduetoprotectionismincreases.

VoluntaryexportrestraintsarenowthemostcommonformofprotectionismusedbytheUS,negotiatedrecentlytoprotectitsautomobile,sugar,beef,steel,textileandotherindustries.DespitethenetwelfarelosstotheUSeconomy,

textileandotherindustries.DespitethenetwelfarelosstotheUSeconomy,thesetypesofrestrictionsarepopularbecausetheygivedomesticproducersthedesiredlevelofprotectionwithoutsufficientlyhurtingtheforeigntradingpartner,whomayinfactbenefitasintheUSautomobilecase.

Also,USpolicymakersprobablylikethepowerthattheyhavetochangetheshareofthevoluntaryexportquotawhichisallocatedtoparticularforeignexportingcountries,asinthecaseofsteel.Inrecentyears,20percentoftheUSsteelmarkethasbeendividedupandgiventoforeigncountries.Becauseofchangingeconomicandpoliticalcircumstances,Mexico'sshareoftheUSmarketfor1990wasalmostdoubledfrom0.48percentto0.95percent,whileJapan'ssharewasreducedfrom5.9percentto5percent.

Tradequotaswhich,alternatively,givethemonopolycartel-likepowertorestricttradetothedomesticimportersareseldomusedbecausetheforeigntradingpartnerswouldbetooseverelyhurt.Notonlywouldtheforeignexportersbesellinglessvolume,buttheymightalsohavetomakesomepriceconcessionstothemorepowerfulimporters.Currently,theUSisnotadministeringanytradequotasinthismanner.

Similarly,tariffsarerarelyusedasasignificantformofprotectionism.22Transferringsignificantamountsofincometopolitically-favoreddomesticfirmsorindustrieswiththesedeviceswouldalsohurtforeignexportersmorethanispoliticallydesirable.SincetheKennedyRoundofinternationaltradenegotiationsinthe1960s,whichresultedintheUScuttingtariffsanaverageof35percenton$40billionworthofimports,theinternationalcommunityhasconsistentlyreducedtariffbarriers.UndertheinternationalGeneralAgreementsonTariffsandTrade(GATT),whichhasnowbeenreplacedbytheWorldTradeOrganization,hightariffsareacceptableonlytocounteract

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unfairpracticesbyone'stradingpartner,suchasthe‘dumping’ofproductsatpricesbelowproductioncosts.

Forexample,the100percentUStariffsonvariousJapanesesemiconductorproductswhichcausedconsiderablecontroversyinMarchandApril,1987were

passedmoretopunishJapanforviolatingprevioussemiconductoragreementsthantotransfersignificantamountsofincomefromUSconsumerstoUSproducers.ManyoftherestrictedproductsarealsoavailablefromTaiwanese,SouthKoreanandotherforeignsuppliers,meaningthat‘USconsumersshouldnotbegreatlyhurt’,23meaningthatUSsemiconductorfirmsshouldnotbegreatlybenefited.Theserestrictionscoveredonly$300million-worthofJapaneseimports,andthereforecouldmakeonlyasmalldentintheUSelectronicstradedeficitwithJapan,whichwas$20.4billionin1986.24

TheseUSsemiconductortariffswereworrisometomanyUStradeofficialsbecauseofthepossibilitythattheymightigniteamutuallydestructivetradewarbetweentheUSandJapan.Thisconcernwaswidelyfelteventhoughthetariffsweredesignedtobepunitiveratherthanprotectionist,andthereforewithintheguidelinesofGATT.IfinsteadtheUSgovernmenthadwantedtotransferasignificantamountofincometoUSsemiconductorfirms,tariffswouldnothavebeenthechosenpolicyinstrument.TheGATTguidelineswouldhavebeenviolated,andtheUSwouldhavejeopardizeditstradingrelationshipwithJapanmorethanwaspoliticallyacceptable.

Asthesemiconductorcaseandotherrecentcaseshaveshown,ifprotectionismrestrictsimportsenoughtogreatlybenefitdomesticproducers,policymakerspreferthattheprotectionismdoesnotimposesignificantcostsontherestrictedforeignexporters,evenwhenitislikelythattheyhaveviolatedinternationaltradeagreements.Nationaleconomieshavebecometoointegrated,andthereforetoodependentuponthegoodwillofforeignpolicymakers.Japaneseinvestorsweresupplying30–40percentofthenewmoneyborrowedbytheUSgovernmentduringthesemiconductorcontroversy,andthethreatofaJapaneseinvestment‘pull-out’inresponsetothetariffssentaconfidencescarethroughUSfinancialmarketsandmayhavecontributedtotheconditionswhichledtothe1987stockmarketcrash.Notonlymightapull-outhavebeeninitiatedbyJapanesepolicymakers,butalsobytheJapaneseinvestorsthemselveswhowerefacedwiththeincreasedriskofexchangeratelosses.Whenthetariffswereannounced,theUSdollarimmediatelysankagainsttheyenduetotheconfidencescareandthethreatofacostlytradewar,andUSinterestratesjumpedupandincreasedtheUSgovernmentinterestexpense.

JapanesevoluntaryexportrestraintsimmediatelybegantobesubstitutedfortheUSsemiconductortariffsasthepreferredwayofresolvingthistradeconflict:on23March1987,MITIorderedJapanesemicrochipmakerstocutbackproduction11percentintheApril-Juneperiod;failurebyMITItoissueexport

production11percentintheApril-Juneperiod;failurebyMITItoissueexportlicensesfurtherreducedexportsinthisperiod;andmeanwhiletheUS

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governmentbeganreducingthenumberofimportedproductsthatwouldbesubjecttothe100percenttariffs.25Asintheautomobilecase,thevoluntaryexportrestraintshavenotprovokedworriesofatradewar.

Clearly,theimmediatenetwelfarelosstothedomesticeconomyofforeignvoluntaryexportrestraintshasnotpreventedthemfrombeingthedominantformofprotectionism.Suchprotectionismpersists,apparentlybecausethelong-termbenefitsofallowingbusinessesthetimetoadapttoincreasedimportcompetitionarefelttobegreaterthantheimmediatewelfarelosstoconsumersintheprotectionistcountry.

However,increasedimportcompetitionwillhavetobeadaptedto.Aselaboratedpreviously,importsasashareofnationalpurchasesareinevitablyincreasingattheaverageannualrateofmorethan3percent.Governmentsareunabletobuckthistrend.DespiteUSprotectionisminthe1980s,GM,FordandChryslersawtheirmarketshareintheUSdeclinesubstantially.

Asfirmsadapttothenew,morecompetitiveglobaleconomy,protectionismwillbecomelesspractical.Governmentpolicymakersandcorporateexecutiveswillincreasinglyhavetoaccepttheinevitabilityofincreasedtrade.Consequently,firmsmightbelessabletoclaimtheneedforspecialprotection,andlessabletoclaimthattheyhadtoolittletimetoadapttothestructuralchanges.Also,theimmediatecosttonationaleconomiesofcurrentprotectionistpolicies,whichincreasesinproportiontotheincreasedimportshare,willsoonoutweighthelong-termbenefitstotheprotectedindustriesinmostcases.

C.TheFollyofProtectionismasInternationalJointVenturesandOverseasProductionBecomeMoreCommon

Theneedtoadapttonewinternationalcompetitionintheglobaleconomyhasinturnprovokedanimportantstructuralchangeinthemarketplace:firmsareparticipatinginmoreinternationaljointventuresandshiftingmoreoftheirproductionoverseas.Thisstructuralchangealsomakestheuseoftariffs,import

productionoverseas.Thisstructuralchangealsomakestheuseoftariffs,importquotasandothertradebarrierslesspracticalasawaytotransferincometopolitically-favoredfirms.Forexample,merchandisemanufacturedbyanAmerican-ownedcompanyinJapanandshippedbacktotheUSiscountedasaJapaneseexportandaUSimport,andwouldbesubjecttotariffsjustasa‘pure’Japaneseexport.UStariffswouldhurtratherthanhelpsucha‘US’company,muchlikeshootingoneselfinthefoot.

Firmshaveincreasinglygoneglobalsincethe1980sthroughjointventuresandoverseasproductionarrangements,first,becausesellingtoforeigncustomersinthemoredynamicandcompetitiveinternationalmarketplacerequiresabetterunderstandingofandaccesstothoseforeigncustomers.Forexample,USsemiconductorfirmsdidan‘about-face’in1986whentheydecidedthatitiseasiertocracktheJapanesemarketfromwithinthroughfriendlyassociationsthanfromtheoutsideinanadversarialposture.Intel,

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oneofthefirmswhichbroughtasuitagainstJapanesefirmsforillegallydumpingtheirproductsinthemid-1980s,contractedwithaJapanesefirmin1987toproducevariousIntelchipsinJapan.AdvancedMicroDevices,alsoadefendantinthedumpinglawsuit,begancourtingJapanesebuyerswithlargebanquetsin1987.Forsimilarreasons,HondaMotorsofJapanshiftedresponsibilityforitsNorthAmericanoperationsfromTokyototheUSinJanuary1987.ThismovefollowedIBM'srelocationofitsAsia-PacificGroupheadquarterstoTokyo.26

Secondly,firmhavegoneglobaltoassurethemselveslegalaccesstoaprofitableshareofforeignmarkets.Theprotectionismwhichtheincreasedcompetitionfromimportshasprovokedcanbeavoidedthisway.Overseasproductionisawayaroundthetradebarriers.Forexample,in1987,HondabecamethefirstJapaneseauto-makertobuildallthemajorpartsforitscarsintheUS.ThecombinedproductionofToyota,NissanandHondaintheUSreached7percentofallUS-basedautomobileproductioninthelate1980s.

Thirdly,firmshavegoneglobaltotakeadvantageofcheapforeignlaborandotherspecialproductionopportunities.Forexample,theMexicanmaquiladoras

program,wherebyforeignfirmsaregivenfavoredtaxstatustomanufactureproductsinMexicoforexport,boomedinthe1980sduetotherapiddevaluationoftheMexicanpesoandotherconditionswhichmadeMexicanlaborextremelyinexpensivetoforeignproducers.Themaquiladorasprogramnowgeneratesmoretrade-relatedrevenuewithinMexicothanthetourismindustry,andisthesecondsourceoftrade-relatedrevenuenexttooilproduction.

Fourthly,firmshavegoneglobalinthe1980stoadapttotheincreasedvolatilityofforeignexchangerates,whichinturnhasbeencausedbythederegulationandexpansionofinternationalfinancialmarkets.Thesewildswingsinexchangeratescanbethemostimportantfactorintheinternationalcompetitivenessoffirms.Forexample,the50percentdropinthevalueoftheUSdollarrelativetotheD-markfrom1985to1988meantthatGermanfirmswouldhaveneededtodoublethedollarpricesoftheirexportstotheUSinordertocontinuereceivingthesameD-markprices.Alternatively,iftheGermanexportershadchargedthesamedollarpricesfortheirexports,theywouldhavereceivedhalfasmanymarksforeachunitsold.Typicallythedollarpricewasraisedsomewhat,butnotdoubled,asGermanexportersattemptedtomaintaintheirsalesvolumeaswellasareasonableprofitmarginperunitsold.

Inordertoavoidsomeoftheselargecurrency-relatedlossesonsalesvolumeorprofitmargins,aGermanexportermighthavebeenabletobuymoreofitsproductioninputsfromtheUS,whichwoulddecreaseinD-markpricewiththestrengtheningoftheD-mark.However,despitetheexportsuccessesachievedbyJapanandafewothernationswhichimportmostoftheirproductiveresourcesexceptlabor,itisgenerallymoreefficienttolocateproductionoverseaswheretheinexpensiveresourcesare.Transportation

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costscanbeavoidedwiththisstrategy,andsocanmuchofthecurrency-relatedrisk.

Asanotherexample,Japaneseexportscaptured18.3percentoftheUSlighttruckmarketby1986,butthe30percentfallinthedollarinthenexttwoyearsreducedthisshareto11.6percent.So,in1988,insteadofcompetingdirectlywithFord'spopularBroncoIIsportsutilityvehicle,MazdaagreedtoselltheseFordsthroughitsownUSdealerships—thefirstsuchmarketingagreementbya

FordsthroughitsownUSdealerships—thefirstsuchmarketingagreementbyaJapaneseauto-maker.

Increasingly,firmsshouldparticipateininternationaljointventuresandoverseasproductionsothatmarginalproductionlevelscanbeimmediatelyshiftedtothelow-costcountrywhenexchangerateschange.Forexample,thebiglosersfromthehigh-valueddollarofthemid-1980swerethoseUSexportingindustrieswithoutforeignaffiliates.TheAmericanmachinetoolindustryhadworldleadershipinthe1970s,butitoperatedalmostentirelyoutoftheUS.Thehigh-valueddollarcutitsexports,madeitdefenselessagainstimports,anddepriveditoftheprofitswhicharecriticallynecessarytomaintaineffectiveresearchanddevelopmentprojects.Ontheotherhand,whatsavedFordMotorCo.inthemid-1980swasitsleadershippositionthroughforeignpartnersintheEuropeanmarket.Thehigh-valueddollarallowedFordtodevelopitsnewmodelsinEurope,whichmadeFordhighlyprofitableagainintheUS.Ford'sprofitsinthefirstquarterof1988werearecordfortheUSindustry,‘asunexpectedlystrongoverseasresultsovercamelowerearningsintheUS’.27GM,thoughtwiceFord'ssize,operatedmoreessentiallyoutoftheUSinthelate1980s,andcontinuedtohavefinancialdifficulties.

Asanotherexample,the30percentfallintheforeignexchangevalueofthedollarfrom1986–8encouragedHondatoshipcarsproducedfromitsUSplantsacrossthePacificforsaleinJapan.Honda'sfirstsuchshipmentarrivedinJapanon8April1988,thesamedaythatitsone-millionthUS-producedcarrolledoffitsassemblylineinOhio.

Corporationshaverapidlyglobalizedtheiroperationsinthelasttwodecadesbecauseoftheabovereasons,sorapidlythateconomicpolicymakershaveoftenseemedignorantofhowextensivelytheglobalstrategiesareused.So,fortherecord,afewstatisticsareinorder:

Bythelate1980s,morethanfivemillionUSjobsdependeddirectlyoninternationaltrade,andapproximatelyhalfofUScorporateprofitscamefromabroad.28Incontrast,USbusinessesreportedthatonly13percentoftheirrevenuecamefromoutsideNorthAmericainthelate1980s.29Overseasbusinesswasmoreprofitablethandomesticbusiness,anditgrewmorequickly—UScorporationsearnedmorethan25percentoftheirrevenuefromoutsidetheUSinthe1990s.

MoreglobalthanUScorporations,morethan30percentofEuropeancorporate

MoreglobalthanUScorporations,morethan30percentofEuropeancorporaterevenuecomesfromoutsideEurope.And,morethan15percentofJapanesecorporaterevenuecomesfromoutsideJapan.

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TheEuropeanCommunityannouncementthatmostinternalbarrierswouldbedismantledby1992ledtoarapidincreaseinforeigninvestmentthere.Majority-ownedforeignaffiliatesofUScompaniesincreasedcapitalspendinginEuropefrom$15.4billionin1987to$18.8billionin1988to$21.1billionin1989.Totalforeigncapitalspendingbymajority-ownedforeignaffiliatesofUScompaniesincreasedby12percentfrom1988to1989,thethirdconsecutiveyearlyincreaseafteradecliningtrendfrom1982to1986(Quijano,1989,p.20–22).By1989,411JapanesemanufacturershadopenedormadeplanstobeginproductionintheEuropeanCommunity,whichwasnearlytriplethenumbersince1983.Japan'soffshoremanufacturing(everywhere)morethandoubledfrom3.5percentoftotalJapaneseoutputinthemid-1980sto8.7percentoftotaloutputin1990.30

From1983to1988,USandCanadiancompaniesmadeonly9percentoftheirinvestmentsoutsideNorthAmerica.From1989to1993,thatfigureroseto16percent.31

Noteworthystatisticssuchastheseregardingthegrowingpresenceofmultinationalcompaniesaretypicallyignoredintradedata.Forexample,merchandisemanufacturedbyanAmerican-ownedcompanyinanothercountryandthenshippedtotheUSiscountedasaUSimport.MerchandisemanufacturedbyanAmerican-ownedcompanyinanothercountryandthensoldinthatcountrydoesnotdirectlyaffecttradedata.However,firmsarefrequentlyprotectedonthebasisofexportandimportstatisticsfortheirindustry.Ifthestatisticsshowgreaterimportpenetration,theimportingcountryismorelikelytoresorttoprotectionism.Ifthestatisticsshowreducedexportpenetration,thentheexportingcountryismorelikelytoresorttoprotectionismtoretaliateagainstpossibleunfairrestrictionsonitsexports.

Insomecaseseconomicpolicymakersshouldbemorecarefultoinvestigatewhatitistheyareprotectingwithtariffsandquotas—reasonablesoundingtradestatistics,ornationaleconomicinterests?Forexample,USpoliticianswerequicktocalltheAmericantradedeficitwithJapanunacceptableandintolerable

quicktocalltheAmericantradedeficitwithJapanunacceptableandintolerablewhenitjumpedto$31.2billionin1984,meaningthattheUSimported$31.2billionmore-worthofmerchandiseandservicesfromJapanthanitexportedtoJapan.ItwascommonlyfeltthatthistradedeficitindicatednotonlyapoorperformancebyUSfirmsrelativetoJapanesefirms,butalsothatJapanmustbeunfairlybiasedagainstUSproducts.Loudcallstorestorethe‘levelplayingfield’wereheard.

However,inthatsameyear,Japanpurchased$43.9billion-worthofproductsmadeinJapanbyAmerican-ownedfirms,whereastheUSonlypurchased$12.8billion-worthofproductsmadeintheUSbyJapanesefirms32—aUSadvantageof$31.1billionduetotheactivityofmultinationals.Therefore,includingtheactivitiesofmultinationals,US-Japanesetradewasbalancedin1984.Furthermore,becausetheUShastwicethepopulation,USfirmsactuallysoldtwiceasmuchtothetypical

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JapanesebuyercomparedtothelevelofJapanesesalestothetypicalUSbuyerin1984.

FarfromindicatingapoorperformancebyUSfirmsorthatJapanmustbeunfairlybiasedagainstAmericanproducts,statisticswhicharerevisedtoreflecttheincreasingnumberofinternationaljointventuresandoverseasproductionactivitiescanshowjusttheoppositeresults.PeterDrucker,theUSmanagementexpertwhohelpeddesignJapan'seconomyinthe1950s,characterizedtheUS-Japanesetradesituationin1990bystating:

Idon'tknowasingleJapaneseinaresponsiblegovernmentaloracademicpositionwhobelievesinthe(Japanese)exportsurplus…Itisamirage…ItisnottheresultofJapan'sindustrialprowess.

Inthe1980s,oftheworld's100largest,publicly-ownedmultinationals,50wereAmerican,33wereJapanese,and17wereEuropean.ThebiggestUSearnerabroadwasIBM,withforeignearningsof$7billionperyearfromaphysicalpresencein83countries.33TheUSCommerceDepartmentdataforthelate1980sshowedthatoverseasaffiliatesofAmericancompaniesweregenerating

$800billioninannualrevenues.ThatwasthreetimesthevalueofUSmerchandise‘exports’.

Ultimately,analystswillviewmuchofinternationalcommercenotas‘trade’butastheintegrationofproductionprocessesacrossnationalborders.AccordingtoGeorgeGilder,anexpertonthegrowinghigh-technology‘trade’:

Sometwo-thirdsoftheUStradedeficitwithAsiaconsistsofcriticalcomponentsandsubassembliesforUSmanufacturers;devicesdesignedintheUSandassembledorpackagedabroad;uniquecapitalequipmentvitaltoUSproductivity;andcrucialitemsinAmericanproductlines.34

AndasestimatedbytheUSDepartmentofCommercein1997,

Cross-bordertransactionsbetweenaffiliatedunitsofmultinationalcompaniesaccountforamajorshareofUSinternationaltradeingoods.In1994,thesetransactions—commonlyreferredtoas‘intrafirmtrade’—accountedformorethanone-thirdofUSexportsofgoodsandformorethantwo-fifthsofUSimportsofgoods(DepartmentofCommerce,1997,p.23).

Inthisenvironment,typicaltradeprotectionism,i.e.restrictingtheflowofproductsacrossnationalboundaries,isincreasinglyimpracticalasperthecommonanalogyofshootingoneselfinthefoot.

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D.TheFullyofProtectionismastheInternationalOwnershipofOnceNationalCorporationsBecomesMoreCommon

Theincreasedinternationalownershipofoncenationalcorporationshasbeendramatic,especiallysincetheboomyearsforinternationalfinancialmarketsintheearlyandmid-1980s.Thederegulationoffinancialmarketsandthedevelopmentofinformation-basedtechnologieshavegiveninvestorsgreateraccesstoprofitableinternationalopportunities.Also,firmshavehadaccesstolow-costfundsformergersandacquisitions.

Forexample,between1983andmid-1987,Britishcompaniesspentatleast$25

billiononacquiringAmericanbusinesses—‘themostmassiveBritishthrustintotheworldeconomysinceVictoriantimes’.35TotalacquisitionsofUScorporationsbyforeigncompaniesgrewfrom$5.9billionin1983to$41.9billionin1987.36

Venturecapitalistsandotherfinancialintermediarieswereoftenthebuyers,suchasthefirmKohlbergKravisRoberts&Co.,whichacquiredmorethanfortycompaniesbetween1976and1992,includingRJRNabiscofor$31billionin1988.Similartotheyears1897–1904,when4,277Americancompaniesconsolidatedinto257corporations,therewasarebirthoffinancialcapitalism,butthistimeTheNewFinancialCapitalists(BakerandSmith,1998),weremoreglobal.

The1987worldstockmarketcrashinterruptedonlybrieflythedramaticincreaseininternationalmergersandacquisitionsandcross-bordertradingofcorporatestock.By1990,tradingofequitiesbetweennationshadreached$1.6trillionperyear,upfrom$800billionin1986.371996wasarecordyearforUSandinternationalmergersandacquisitions,butasthisbookiswrittenin1998itappearsthatbothrecordswillbebeaten.In1998,DaimlerBenzacquiredChryslertobecometheworld'sbiggestauto-maker,DeutscheBankacquiredBanker'sTrustfor$10billiontobecometheworld'sbiggestbank,andinthebiggestmergerofalltime,Citicorp(worth$82billionasthedealwasannouncedinApril)andTraveler'sGroup(worth$84billion)joined.

Governmentswhichtakemonthstopasstradelegislationcannotexpectthelegislationtobenefitonlytheircitizens.Theworldinformationnetworkquicklyevaluatesnationaleconomicpolicies,andmillionsofcomputerscreensandotherinformationtechnologiestransmithowinvestorsexpectthesepoliciestoaffectstockprices.Thelargestockbrokers,suchasMerrillLynchandNomura,nowhavetradingofficesinalmostallofthelargeindustrialcities,andcanbuyandsellsecurities24hoursadayfortheirinternationalclientsinwhichevermarketshappentobeopen.

Manysmallstockholdershavenotyetlearnedhowtodiversifytheirsavingsinternationally.Also,managersandemployeesofsomecorporationsmayownsizableportionsoftheircompany'sequity.Protectionismcanbenefitthesetwonationaleconomicinterestsifpolicymakersareabletotransferincometothemeffectivelywithtariffsandquotas.

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Yetonlyasmallandrapidlydecreasingshareofstockmarketcapitalizationaroundtheworldisownedbyindividuals,especiallyindividualswhoremaininternationallyundiversified.Themajorityofstockisnowownedbylargeinstitutionalinvestorswhoimmediatelyexploitnewinternationalopportunitiesincludingchangesinprotectionism.InTokyo,whereaccuratestatisticsarekept,theownershipbyindividualsdeclinedfrom50percentin1960to20percentin1989.38

Historically,themajoreconomiceffectoftradeprotectionismwastotransfermoneywithinacountry,fromdomesticconsumersofaproducttotheownersofdomesticcorporationswhichsupplytheproduct.Butrecently,asinternationalownershipofdomesticcorporationsincreases,moreofthismoneyendsupinthehandsofinternationalinvestors.Atsomepoint,asindividualinvestorsincreasinglytakeadvantageoftheinternationalopportunitiesthroughmutualfundsandretirementfunds,andrelinquishtheirstockownershiptoinstitutions,tradeprotectionismofnationaleconomicinterestswillbetoocostlytobepractical.Policymakersmightnolongerbeabletojustifytheincreasinglylargetransfersofincomefromtheirconsumerstointernationalinvestors.

1.Wakasugi,R.(1987),‘AttacktheProblematitsSource’,LookJapan,July,p.3.

2.‘Japan'sForeignFundings’,TheNewYorkTimes,13April1986.

3.‘JapantoEndOneoftheWorld'sLargestTaxLoopholes’,TheWallStreetJournal,23March1988,p.22.

4.In1986,accordingtotheUSCensusBureau,thevalueofUSpovertyprogramswasequalto$48.2billion,whileSocialSecuritybenefitsamountedto$196.1billion(‘BenefitsBeatTaxesasIncomeEqualizer’,TheWallStreetJournal,28December1988,p.A2.).

5.‘MaverickTokyoFirmAcquiresOfficeTowersInUSataFastPace’,The

WallStreetJournal,23September1987,p.1.

6.‘ReaganSaysOctoberCrashResultedFromMarkets,NotDeficitsandDollar’,TheWallStreetJournal,12January1988,p.3.

7.‘BusinessBulletin’,TheWallStreetJournal,14January1988,p.1.

8.Withoutincludinggovernmentgrantsandprivateremittancesabroad,thevalueofexportsminusimportswouldequalthemorecommonlymentioned‘TradeBalance’.

9.‘BushwackedbytheTradeIssue’,BusinessWeek,23September1985,p.32.

10.‘America'sWaronImports’,Fortune,19August1985,p.26.

11.Costsimposeduponforeignexportersbyprotectionism,whilefrequentlymentionedtohighlightthepoliticalfavorbeingdonefordomesticfirms,aregenerallysmallcomparedtothecostsimposedupondomesticconsumers.Foreignexportersmayevengainfromcartel-likepriceincreases,asintheautomobilecasediscussedinthischapter.

12.‘TradingAwaytheTradeDeficit’,TheNewYorkTimes,8April1990,p.13.

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13.‘TheGlobalizationoftheIndustrializedEconomies’,Barron's,4May1987,p.45.

14.AutomotiveNews,27October1980,p.50.

15.‘CongressmenCallForJapanAutoCurbs’,LosAngelesTimes,19November1980,PartIV,p.2.

16.‘SenatePanelWantstoCurbAutoImports’,SanFranciscoChronicle,4February1981,p.27.

17.‘ToyotatoLimitExportstotheUS’,ChicagoTribune,19February1980,Section1,p.10.

18.‘TalksWithJapanNeartheFlashPoint’,BusinessWeek,11March1985,p.34.

19.Ibid.

20.‘Nearly80PercentofTheirProfitsComeFromtheUS’,AutomotiveNews,22October1984,p.E16.

21.‘WhatisTooHighForSome,ButTooLowforOthers?’,Autoweek,30January1989.

22.OnenotableexceptionistheUS's42percenttariffonimportedwoolfabric—tariffasofJanuary,1987.

23.ThisquotereflectstheReaganadministration'swidelypublicizedposition.Thequoteisfrom:‘MixedReactiontoNewTariffs’,SanFranciscoChronicle,28March1987,p.48.

24.‘ChipsFight:ReaganPlantoRaiseTariffsMayBeWatershedinUS-JapaneseTies’,TheWallStreetJournal,30March1987,p.1.

25.‘JapanUrgesChipmakerstoCutProduction’,OaklandTribune,19February1987,p.B1.

26.‘Japan'sTradeFailure’,TheWallStreetJournal,1April1987,p.28.

27.‘Ford'sProfitJumpedby9percentIn1stQuarter’,TheWallStreetJournal,29April1988,p.3.

29.‘GoingGlobal:VisionVs.Reality’,TheWallStreetJournal,22September1989,p.R20.

30.‘Tokyo'sEndRunAroundits‘‘TradeProblem”,’BusinessWeek,13July1987,p.54.

31.‘GoingGlobal:VisionVs.Reality’,TheWallStreetJournal,22September1989,p.R20.

32.‘Japan'sTradeFailure’,TheWallStreetJournal,1April1987,p.28.

34.‘TradeGapIsInevitable—andGood’,TheWallStreetJournal,15January1988,p.22.

35.‘TheTransnationalEconomy’,TheWallStreetJournal,25August1987,p.8.

36.‘AccountingRulesfavorForeignBidders’,TheWallStreetJournal,24March1987,p.26.

37.‘CapitalMarketsSurvey’,p.7,TheEconomist,21July1990.

38.Ibid.p.26.

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3.NewUsesandFormsofMoney,MonetaryVelocity,andWealthTransfers

Structuralchangesintheglobaleconomyprovokeotherstructuralchanges,asistrueofmostevolvingsystems.InChapter1itwasarguedthatadvancesininformationtechnologyandgovernmentderegulationprovokedtherapidexpansionandglobalizationoffinancialmarkets.Becauseoftheir‘marriage’withthecommunicationsrevolution,financialmarketshavemorequicklyexpandedandbecameglobalizedthanmarketsformerchandiseandnon-financialservices.AnalystsincludingPeterDruckerwereemphasizingasearlyasthemid-1980sthattheevolvingfinancialmarketshadtakenonaprofit-seekinglifeoftheirown,quiteindependentlyofthemarketsformerchandiseandservices(Drucker,1985–6).Forexample,bythemid-1980sthevalueoftradingontheLondonEurodollarmarketwas25timesthevalueofworldtradeinmerchandiseandservices.Eurodollardepositsandtradingwerenon-existenttwodecadesearlier.

TheexpansionandglobalizationoffinanceallowedEurocurrency,whichiscurrencyusedoutsideitshomecountry,tobecomeadominantnewmoneyforminthe1980s.Continuingadvancesintechnologyandinternationalpaymentsystemsarenowallowingevenmoreexoticnewmoneyforms.Chapter1documentstheriseofemoney,virtualmoney,andother‘quasi-moneys’thatarenowbeingswappedwithmoretraditional‘realmoney’aselectronicpaymentsystemsexpand.Thecreationanduseofthesenewmoneyformshasallowedanexplosionoffinancialtransactions.IntheUSpaymentssystemsalone,theFederalReserveestimatedelectronictransactionsvalueat$544trillionfor1995,andgloballythisnumbermightbeanorderofmagnitudehigher—nobodyknowsforsurebecauseofthespeedwithwhichmoneycanrecyclebetweenaccountingmeasurements.

Revolutionarychangesrequireustorethinkhowthesystemworks.InSchumpeter'sterms,clustersofnewinnovationscandestroytheoldwaysofdoingthings,andcreatenewways—aprocessof‘creativedestruction’.Thischapteridentifiestwosuchphenomenawhicharenotconsistentwithtraditionaleconomicthinking.

First,SectionsI–IVdemonstratethatmoreofthemoneysupplyisbeingusedtoaccommodatethefastgrowthoffinancialmarkets,andproportionally

accommodatethefastgrowthoffinancialmarkets,andproportionally

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lessofthemoneysupplyisavailablefornon-financialorGDPpurposes.Intermsofthefamousquantityequation,thisphenomenonshowsupasadeclineintheincomevelocityofmoney.Explosionsoffinancialactivityleadtoincreaseddemandsformoneybalancesforfinancialmarketparticipation;andlessoftheavailablemoneysupplyfacilitatestheproductionandsaleofGDP.Therecentabsorptionofmoneyforfinancialmarketpurposes,sothatthemoneyisnotsimultaneouslyavailablefor‘real’economicactivity,isnotgenerallyacceptedbytheeconomicsprofession,butisdemonstratedinSectionsI–IV.

Secondly,SectionVdemonstratesthatnewmoneyforms,newpaymentsystems,andthelaboroffinancialoperatorsin‘one-worldfinancialmarkets’cancreate,destroyandtransfer‘wealth’independentlyoftherealeconomicactivitythatisoccurringinnon-financialmarkets.Changingperceptionsandexpectationsofunderlyingwealthor‘value’in‘real’economicactivityhasalwaysprovokedchaoticandunpredictablerepackagingofthisvalueinfinancialmarkets,butvaluehasnonethelessbeenthoughttoflowfromtherealeconomicactivity.However,SectionVshowsthatwealthcanbecreated,destroyed,andtransferredindependentlyofwhatisevenperceivedtobehappeninginnon-financialmarkets.Intheauthor'sview,aselaboratedfurtherinChapter5's‘ANewPoliticalEconomyofMoney’,appropriatedefinitionsofwealthandvalueincludeconsiderationsof‘socialconsensus’and‘differentialpower’.Thelaboroffinancialoperators,includingcentralbankersandothermonetaryofficials,isanimportant‘driver’inthisprocess.Theautonomousexpansionorcontractionofmoneyandcreditcanhaverealandlastingeffectsinthisregard.

TheexplanationsofrecentfinancialcrisesandrecessionsinChapter4relyuponthesetwophenomenaaswellasuponconventionaleconomicthinking.Anunderstandingofmoneydemandtheory,monetaryvelocity,andeconomicvalue-creationisthuscrucialforthepurposesofthisbook.

I.TRANSACTIONSANDASSETDEMANDSFORMONEY,ANDMONETARYVELOCITY

IntheUS,from1960–80,theincomevelocityofmoney(v),measuredasthe

IntheUS,from1960–80,theincomevelocityofmoney(v),measuredastheratioofnominalGDPtoanarrowmeasureofthemoneysupply(m1),grewpredictablyat2to4percentperyear(Figure3.1).(m1)includescoins,currency,andcheckabledemanddepositsinthebankingsystem.Thispredictabilityallowedfortheuseof(m1)moneysupplytargetsbycentralbankstoguidemovementsinincomeandinflation,asspecifiedbythe‘quantityequation’:

(m1)x(v)=(p)x(q) (3.1)page_58

where(p)istheGDPpricelevel,(q)isrealGDPand(pxq)isnominalGDP.

Figure3.1Worldwideinstabilityandweaknessinthegrowthoftheincomevelocityofmoneyafter1980

Source:IMF.

Before1980,USmonetarypolicycouldthereforebebaseduponthefollowingcause-and-effectrelationships:duetotherelativestabilityof(v),anincreaseinrealmoneybalances(m1/p)willincrease(q)byapredictableamount;theincreasein(q)occursbecausetheincreasein(m1/p)causesinterestratestodecline,whichinturnstimulatesborrowingandpurchasingacrosstheeconomy.Thus,aggregatedemandforGDPrises,andproducersrespondtomeetthat

Thus,aggregatedemandforGDPrises,andproducersrespondtomeetthatdemand.Becausecentralbankscandirectlycontrol(m1)butnot(m1/p),theymaystresstheimportanceofinterestratetargetsratherthanmoneysupplytargets.

Theexpansionofnarrowmoneysupplies(m1)isusuallysuccessfulinincreasingeconomicgrowth(q),because(m1)usuallyrisesfasterthaninflation(p),andbecausenominalinterestratesusuallyfallrelativetoinflation,i.e.realinterestratesfall.However,ifthereisnotmuchcapacityinthesystemtoexpandproduction,orifthereisnotmuchincentiveorability

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toexpandloansandpurchases,thentheexpansionof(m1)maybeineffective—inflationratherthaneconomicgrowthmaybetheresult.Also,excessiveinflationmayhurtgrowthandleadtootherundesirableinstabilitiesinthesystem.

Typically,asuccessfulexpansionof(m1),whichlowersrealinterestratesandstimulatesborrowingandspendingandeconomicgrowth,willbeassociatedwithaproportionateexpansionofbroadermonetaryaggregates,suchas(m2)and(m3).IntheUS,(m2)equals(m1)plusretailmoney-market-fundbalances,savingsdeposits,andsmalltimedeposits.(m3)equals(m2)pluslargetimedeposits,andvariousinstitutionalaccountssuchasrepurchaseagreements,Eurodollars,andinstitution-onlymoney-market-fundbalances.Whenthecentralbankexpands(m1)andgeneratesaborrowingandlendingexpansionandlowerrealinterestratesonthesenarrowmoneyaccounts,thentheexpansionwillusually‘spillover’intobroadmoneyaccounts.Growthofbroadmoneyaccountsalsoencourageseconomicgrowth,becausesomeoftheaccountswhichareincludedin(m2)and(m3)areheldforGDP-participationpurposes,althoughtheymaynotbeso‘liquid’as(m1)accounts.Thecomplicatedrelationshipsbetween(m1),(m2),and(m3),forexamplewhentheydonotchangetogether,iselaboratedinChapter4aspartof‘Japan'sCrisis,1989-’and‘Asia'sCrisis,1997-’.Forthepurposesofthischapter,anditscasestudies,itissufficienttoframetheanalysisintermsof(m1)andassumethatthevariousmonetaryaggregatesmovetogether,exceptwhereindicatedotherwise.

Since1980,the(m1)incomevelocityofmoneyhasbecomequiteunstable,andhasdeclined(orbrokendownwards)fromitshistorictrendinmanyofthemoneycenters(Figure3.1).InJapan'scase,asignificantdeclinebeganin1993.Hence,thehistoriccause-and-effectlinkagefrom(m1/p),tointerestrates,torealGDPhasbecomeunpredictable,andmonetarypoliciesnowseemtoreacthaphazardlytoeconomicconditionsinsteadoffindingasoundbaseineconomictheory.Theuseofmonetaryaggregateswhicharebroaderthan(m1)hasbeenlessthansatisfactory,leadingTheWallStreetJournaltocommentin1988withregardtotheUSsituation:

Money-supplygrowthtargetshavebeendethroned,andFedofficialsaredesperatelyseekingasubstitute.ChairmanAlanGreenspandissectsthemonthlyemploymentdata;ViceChairmanManuelJohnsoneyesthecreditmarkets,GovernorWayneAngellwatchesgoldandsoybeanprices.Andthefinancialmarketslookoninconfusion.TheFed,theyfear,isadrift.1

And,asechoedintheeconomicsliterature:

Includingdatafromthe1980'ssharplyweakensthepostwartime-seriesevidenceindicatingsignificantrelationshipsbetweenmoney(howeverdefined)andnominalincomeorbetweenmoneyandeitherrealincomeorpricesseparately.Focusingon

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datafrom1970onwarddestroysthisevidencealtogether(FriedmanandKuttner,1992,p.472).

ThissectionarguesthatthestructuralchangesinglobalizingfinancialmarketsasdiscussedinChapter1aretherootcauseoftheinstabilitiesanddeclinesinincomevelocitysince1980.AcarefulconsiderationofthesestructuralchangesinthecontextofmonetarytheoryhelpsregaintherelationshipbetweennarrowmonetaryaggregatesandGDP.Amoreoptimisticoutlookfortherationalizationofmonetarypoliciesisthuspossible.Justificationsareprovidedforthefollowingtwohypotheses:

1. Theincreasedprofitabilityandvalueoffinancialtransactionscomparedto

non-financialtransactionsareimportantmissingvariablesinmostmonetarypolicyresearch.Theirconsiderationallowsforbetterpredictionsoftheincomevelocityofmoney.Inglobalizingmoneycenters,themoneysupplyhasbeenusedlessfrequentlyforGDPtransactions,becausemoreofithasbeenusedinsteadtoaccommodatethefastgrowthoffinancialmarkets.

2. DuringadramaticfinancialupheavalorstructuralchangeaspertheUK'sBigBangderegulationin1986orGermany'sreunificationin1990orJapan'sfinancialcrisisinthe1990s,incomevelocityalsodeclinesasthenewopportunitiesarefiguredoutandreactedto.Temporarily,thereisnotsufficientinformationforinvestorstopursuerationalstrategies,andthepriceofmoney-liquidityrisessharply.Anincreaseinmoneydemandoccurstoreducetheriskoflossandinordertoregainanoptimalinvestmentportfolioquicklyoncetheinformationenvironrnentimproves.Intheauthor'sview,thisoptionsdemandformoneycandivertmoney-liquidityawayfromGDPandothermarketsduringchaotictimes,howeveritisnotgenerallyrecognizedinmonetarytheory.

Neithertheeconomicsprofessionnormonetarypolicyrnakershavefullyconsideredthesestructuralchanges,asindicatedbyarecurringbiasinmacroeconomicforecasts,andtherecurringuseofoverlyrestrictivemonetarypolicies.Incorporatingthesestructuralchangesintomoreconventionalmonetarytheoryistheobjectiveathand.

Thequantityequation(3.1)isfrequentlyrearrangedas:

(m1)=(1/v)x(pxq) (3.2)

Here,theequationbetterrepresentstheincomeversionofthequantitytheoryofmoney,whichoriginallyassumedthatpeoplewanttoholdaconstantfraction(1/v)ofnominalGDP(pxq)intheformofmoney.Morerecentresearchpredictsthatthefraction(1/v)willdecrease(increase)whenthereis:anincrease(decrease)intheinterestrate(Goldfeld,1973,1976);an

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increase(decrease)inrealGDP(Goldfeld,1973,1976);anincrease(decrease)intheexpectedrateofinflation(Judd,1983);andanincrease(decrease)inthestateoffinancialmarketinnovations(Dotsey,1985).Theempiricalevidencefor

stateoffinancialmarketinnovations(Dotsey,1985).TheempiricalevidenceforthesetheoriesandothersarecontainedinJuddandScadding(1982),Laidler(1985),StoneandThornton(1987),andFriedman(1988).

Historically,changesininterestrateshavebeenfoundtobethemostimportantreasonwhy(1/v)changes.Ifinterestratesincrease,thentheassetdemandformoneydeclinesrelativetotheassetdemandforhigh-interest-ratefinancialsecurities,moneyisusedmoreefficientlytoaccommodateGDPtransactions(aspeopletakeadvantageofthehighinterestratesinnon-moneyaccounts),and(1/v)declines.Theassetdemandformoneymightalsodeclinewithhigherinflation,becausemoneyismorequicklyspentratherthanheldaspeopletrytomaximizepurchasingpowerovertime.Also,athigherlevelsofrealGDPandwithimprovedfinancialmarketinnovations,thereareeconomiesintheuseofmoneyfortransactionspurposes,and(1/v)declinesduetoaproportionatedeclineinthetransactionsdemandformoney.

Inthe1960sand1970s,theincomeversionofthequantitytheoryofmoneywasgenerallypreferredinsteadofthetransactionsversion.ThetransactionsversionreplacesnominalGDPinequation(3.2)withthevalueofalltransactionsintheeconomy,includingnotonlyGDPtransactions,butalsotransactionsinvolvingsecond-handandintermediatesalesofmerchandiseandservices,andtransactionsinvolvingnon-moneyfinancialassets.Thetransactionsversionimpliesthatpeoplewanttoholdmoneyinproportiontoallofthetransactionswhichtheymake,ratherthanjusttheGDPtransactions.Adiscussionofthequantitytheoryofmoney,andthelimitationsofthetransactionsversionarecontainedinFriedman(1970).

Thetransactionsversiondrewincreasedattentioninthe1980s,however,becauseofwidespreadfailuretopredict(1/v)asitisdefinedintheincomeversion.Forexample,between1973and1980,UShouseholdsandbusinesseswereholdingmuchlessmoneythanpredictedbyGoldfeld'sequations,whichwerebasedupontheincomeversion.AsestimatedbyPorteretal.(1979),thisshortfallamountedtoapproximately$30billioninmid-1976and$55billioninearly1979.Then,after1981,the‘caseofthemissingmoney’wasreplacedbythe‘caseofthereappearingmoney’asmore.moneywasheldthanpredicted.

Theunexpectedrisein(1/v),i.e.declinein(v),beginningintheearly1980s,asitisdefinedbytheincomeversion,hasbeenespeciallytroublesome.Forexample,asperEquations3.1and3.2,itmeantthatthe1982USrecessionwasnotforeseen.From1981:Q3to1982:Q4,thegrowthrateofUSnominalGDP

declinedby9.7percentagepoints.But,forecastersmissedthecollapseofvelocityandpredictedadeclineofonly33percentagepoints(Chapter4).

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Spindt(1985)attemptedtoexplainthiscollapseofvelocitybyidentifyingtheusesofmoneydirectly,fromdataonthedebitstovariousmoneyaccounts.However,hisdirectmeasurementof(v),whenusedinthequantityequationhasnot‘demonstratedanyapparentgainover(m1)forpolicypurposes[ofpredictingnominalGDP],andismoredifficulttocalculate’(BattenandThorton,1985,p.29).

Thedirectmeasurementof(v)hasnotprovedtobepracticalbecause,foreachtypeofmoneyaccount,onemustdecidehowmuchoftheturnoverisforthepurchaseofafinalproduct(GDP)insteadoffor:checkcashingorothermovementsofmoneybetweenmoneyaccounts;non-finalproductpurchasing,includingrawmaterialspurchases,wholesalepurchasesbyaretailer,second-handsales;andthepurchasingofnon-moneyfinancialassets.However,thealternativestodirectmeasurementarealsonotpracticalbecause,inSpindt'swords,theyarenot‘equippedtodealwithachangingpaymentsmechanismormenuoffinancialassets’.

II.FINANCIALGLOBALIZATIONANDMONETARYVELOCITY

Theauthor'sresearch(Allen,1989)indicatesthatthestructuralchangesinfinancialmarketsdiscussedinChapter1—advancesininformationtechnology,deregulation,andinternationalization—areofcrucialimportanceinunderstandingtherecentdeclineandincreasedvariabilityoftheincomevelocityofmoney.

1. Advancesininformationtechnology:technologicaladvancescontinuetoreducethecostsoftransferringmoneyandpaperdocumentationandthereforethecostsoffinancialtransactions.Inthisregardimportantadvanceshavebeenmadeinelectronicandregularmailservice,telephones,computers,modemsandfaxmachines,imageprocessingdevices,communicationsatellites,fiberoptics,automatictransfermachines

(ATMs),electronicpointsofsale,telephonebanking,interactivescreencommunicationsbetweenfinancialintermediariesandtheirwholesaleandretailcustomers,debitandcreditandsmartcards,electronicmoneyandtransfersystems,theWorldWideWeb,etc.

2. Deregulation:policymakershaveremovedceilingsoninterestrates,reducedtaxesandbrokeragecommissionsonfinancialtransactions,givenforeignfinancialfirmsgreateraccesstothehomefinancialmarkets,allowedincreasedprivatizationandsecuritizationofassets,andallowedincreasedcompetitionbetweenbanks,securitiesfirms,insurancefirmsandotherfinancialinstitutions.Thesederegulationsandmanyothershaveincreasedtheprofitabilityofdomesticfinanceandblurred

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1. Internationalization:advancesininformationtechnologyandgovernmentderegulationhaveinturnallowedfundstomovemorefreelyandprofitablybetweeninternationalandnationalmarkets.AsdocumentedinChapter1,virtuallyeverytypeofinternationalfinancialassethasexperiencedadramaticincreaseintradingsincetheearly1980s.Financialglobalizationissupportedbyincreasedglobalizationofalleconomicactivity.

Inthenewglobaleconomythesestructuralchangesallowedfinancialtransactionstobecomecomparativelymoreprofitablethanmerchandiseandservicestransactions.Consequently,thedemandformoneyforfinancialmarketparticipationincreased.Deregulationaspernewinterest-earningNOWaccountsincreasedtheassetdemandformoney,asdidnewopportunitiestoshopgloballyforthebestmoney-assetaccounts.Improvedtechnologiesandnewinternationalopportunitiesincreasedthetransactionsdemandformoneyforfinancialmarketparticipation—opportunitiesforfinancialspeculation,hedging,andarbitragewerecreatedasneverbefore.

Transactionscostsassociatedwithfinancialmarketparticipationwerelowerandnewopportunitiesforfavorableinterestratesandportfolio-compositionwerecreated.Athresholdwasreachedwherebyincreasinglysignificantamountsoflaborandcapitalservicesweredevotedtothetransferofmoneyanddocumentation.Financialmarketactivityexpandedrapidly.

Mostresearchershavenotfounddefensiblerelationshipsbetweentheexpanded

Mostresearchershavenotfounddefensiblerelationshipsbetweentheexpandedtradingvolumesoffinanceandtheincomevelocityofmoney.WenningerandRadecki(1986)madeanoteworthyearlyattempt,buttheirapproachissubjecttoseverallimitations.

Theytreat(m1)or(m1/p)asthevariablestobepredictedwithaone-equationeconometricmodelwhenfinancialmarketvolumesareincludedasalternateindependentvariables,ratherthan(v)or(1/v)asthevariablestobepredicted.(m1)andtosomeextent(m1/p)havebeencontrolledasimportanttargetvariablesbythecentralbank,andthusWenningerandRadeckihavethesimultaneityproblemoftryingtoexplainmoneysupplyandmoneydemandwiththesamevariables.Alternatively,(v)hasnotbeensignificantlycontrolledbythecentralbank,and(v)canbepredictedwiththeone-equationapproachwithoutasignificantsimultaneityproblem.

Changesin(v)aremoredirectlyrelatedtochangesinmoneydemandthantochangesinmoneysupply,anditischangesin(v)andmoneydemandwhichforecastershavefailedtopredictsince1980,notchangesinmoney

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supply.WenningerandRadecki'ssimultaneityproblemlimitstheirabilitytocontributetopreviousresearchinthisregard.Forexample,theyconcludethatwhenGDPandfinancialmarketvolumes‘areincludedtogetherinthe…equationatmostoneperformswell’becauseboth‘arealternativeproxiesfortotaltransactionsintheeconomy…andoneofthetwoisredundant’.However,GDPandfinancialmarketvolumesmightnotberedundantinanequationwhichexplains(v);if,forinstancefinancialmarketvolumesareamoreimportantdemandvariableandGDPisamoreimportantsupplyvariable,i.e.centralbankmonetarypolicyreactsmoretoGDPtrendsthanfinancialmarkettrends.Theseproblemsshouldbeconsideredmoreexplicitlybeforetheyconcludethat‘themorerapidgrowthoffinancialtransactionsisnothavingaverylargeeffecton(m1)growth’.

And,theyusedataonlythrough1985,justwhenfinancialmarketsbeganexpandingthemostdramatically,andbeganreachingahighprofitabilityrelativetothenon-financialmarkets.Itwasthelastfewyearsoftheirdataset,especially1985itselfinwhich‘itseemsthatfinancialtransactionsplayedamajorrole,addingroughlytwopercentagepointsto(m1)growth’.However,theydismiss

addingroughlytwopercentagepointsto(m1)growth’.However,theydismissthevolumeoffinancialtransactionsasavariablewhichislikelytobesignificant,eveninthemid-1980s,becausethe‘rapidgrowthoffinancialtransactionsoverthelongerrun(1959–1985)hasnotbeenassociatedwithanaccelerationof(m1)growth.Forfinancialtransactionstoexplaintherapidgrowthof(m1)in1985,itwouldbenecessarytofindreasonswhythehistoricalrelationshipbetweenfinancialtransactionsand(m1)mighthavechanged’.Intheauthor'sview,themissedhistoricalchangesareadvancesininformation-processingtechnology,deregulation,andinternationalization.

PerhapsMiltonFriedman(1988)providesthemostnoteworthyattempttorelatetheexpansionoffinancialmarketstotheincomevelocityofmoney.Heputsforththefirstdirect‘econometricattempttorelatethelevelofstockpricestothedemandformoney’andalsoconsiderstheestimatesoffinancialandnon-financialtransactionsdebitscompiledbySpindt(1985).

Friedmanrationalizesaninverserelationshipbetweenstockpricesandmonetaryvelocity(ordirectrelationbetweenstockpricesandthelevelofrealcashbalancesperunitofincome)inthreedifferentways:

(1)Ariseinstockpricesmeansanincreaseinnominalwealthandgenerally,giventhewiderfluctuationinstockpricesthaninincome,alsointheratioofwealthtoincome.Thehigherwealthtoincomeratiocanbeexpectedtobereflectedinahighermoneytoincomeratiooralowervelocity.(2)Ariseinstockpricesreflectsanincreaseintheexpectedreturnfromriskyassetsrelativetosafeassets.Suchachangeinrelativevaluationneednotbeaccompaniedbyalowerdegreeofriskaversionoragreaterriskpreference.Theresultingincreaseinriskcouldbeoffsetbyincreasingtheweightofrelativelysafeassetsinanaggregateportfolio,forexample,byreducingtheweightoflong-termbondsandincreasingtheweightofshort-termfixed-incomesecuritiesplusmoney.(3)Ariseinstockpricesmaybe

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takentoimplyariseinthedollarvolumeoffinancialtransactions,increasingthequantityofmoneydemandedtofacilitatetransactions(Friedman,1988).

Offsettingtheinverseeffectofitems(1–3)isthepositiveeffectofwhat

Offsettingtheinverseeffectofitems(1–3)isthepositiveeffectofwhatFriedmandescribesasa(4)substitutioneffect:‘thehighertherealstockprice,themoreattractiveareequitiesasacomponentoftheportfolio’.Usingquarterlydatafrom1961to1986,heconcludesthatitems(1–3),especiallythewealtheffect,‘appearsstrongerthanthesubstitutioneffect…(however)annualdataforacenturysuggestthattheapparentdominanceofthewealtheffectistheexception,nottherule’.

Friedman'suseofSpindt'sdataleadshimtoconcludethat‘thevolumeof[bothfinancialandnon-financial]transactionshasanappreciableeffecton(m1)velocitybutnoton(m2)velocity’2.Inhis(m1)velocityequations,heisunabletoconcludewhetheritisnon-financialtransactionsdebitsorfinancialtransactionsdebits,asaratiotoGDP,whichisthemoresignificantvariable.Theseresultsdonotallowhimtoacceptthehypothesisthatfinancialtransactions‘would‘‘absorb”money,hencereducingincomevelocity’.Instead,Friedmanseemstosidewith‘thereceivedview(ofWenningerandRadeckiandothers)thatfinancialtransactionsaresohighlymoney-efficientthattheydonotabsorbanyappreciablequantityofmediaofexchangeandhavelittleifanyeffectonvelocity’.

Inotherwords,currentliteraturestillsideswiththeincomeversionofthequantitytheoryofmoneyratherthanthetransactionsversion.PeoplearebelievedtoholdmoneyinproportiontothelevelofGDPratherthaninproportiontoallofthetransactionswhichtheymake.However,asarguedbelow,thereisnowstrongevidencefromcasestudiesoftheUS,theUK,Germanyandothersthatjusttheoppositeistrue.

III.THEDECLINEOF(m1)INCOMEVELOCITYINTHEUS

Thedeclinefromtrend,andincreasedvariabilityofUS(m1)incomevelocityoccurredattheendof1981.AsdocumentedbyStoneandThorton(1987),replacingnominalGDPintheincomevelocityformulawithanyothermeasureofnon-financialtransactionsdoesnotsignificantlychangethebasicriseandfallofthevelocitychart;othermeasuresincludegrossdomesticfinaldemand,Spindt'sbroadmeasureofnon-financialtransactionsdebits,andpermanentincome.Also,replacing(m1)withmostothermeasuresofmoneyisconcludedtomakeverylittledifferencewithregardtothisdeclineofvelocity,includingtheFed's(m2),(msi),andSpindt's(mq).

However,replacingnominalGDPintheincomevelocityformulawithvarious

However,replacingnominalGDPintheincomevelocityformulawithvariousmeasuresofthevolumeoffinancialtransactions,suchasSpindt'sfinancialtransactiondebits,producesa‘financialtransactionsmonetary

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velocity’whichdoesnotdeclineinthe1980s.TheannualgrowthrateofSpindt'sfinancialtransactionsdebitsvelocityaveragedabout10percentoverthe1980s,comparedto12percentfrom1970to1981.Fromthelate1970stothelate1980s,thisfinancialmarketvelocityratioincreasedataremarkablyregularrateofabout20pointseachyear.Moneywasthususedmoreefficientlyinthe1980stoaccommodatefinancialtransactions,butthisincreaseinefficiencywasfairlysteadyandpredictable.

Intheauthor'sview,thegrowthinthevolumeoffinancialtransactionsbeginningintheearly1980swasfasterthantheincreaseintheefficiencywithwhichmoneywasusedtoaccommodatethesetransactions.Thesetransactionsthusabsorbedmoneytakenawayfromothermarkets.Whendataisconsideredthatshowsarapid,geometricgrowthbeginningintheearly1980sinthetotalvolumeofthosetypesoffinancialtransactionswhichareespeciallylikelytoabsorbmoneyawayfromotheruses(Figure3.2),thenthefollowinghypothesesbecomeobvious:therapidexpansionofUSfinancialtransactionsbeginningintheearly1980smaybeadominant,exogenousfactorwhichcausedthesimultaneousbreakintheUSincomevelocityofmoney.Furthermore,becausetechnologicalchange,deregulation,andinternationalizationaretherootcausesoftheincreasedprofitabilityandrapidexpansionofUSfinancialtransactions,thishypothesisimpliesthattheywouldbetherootcauseofthebreakintheUSincomevelocityofmoney.

SeveraltypesoffinancialtransactionincludedinSpindt'saggregatecannotbeexpectedtomakemoneyunavailableforalternateusesforasignificantperiodoftime;somenotevenasthedebititselfisentered.Theseinclude,especially,themovementoffundsbetweenmoneyaccounts,suchascheckcashing,andthemovementoffundsbetweenmoneyandnear-moneyaccounts,suchaswhencertificatesofdepositareredeemed.Thetypesoffinancialtransactionwhicharemorelikelytoabsorbmoneyarepurchasesandsalesofstocks,bonds,governmentsecuritiesandotherlonger-terminvestments,suchaswhenfiveworkingdayswererequiredbeforesecuritiessalescouldbecashed.

InJune1995theUSSecuritiesandExchangeCommissionshortenedthesettlementtimeforcorporateandmunicipalsecuritiesfromfivetothreedays,andinFebruary1996thesecuritiesindustryconvertedtoa‘same-dayfundssettlementsystem’.Therefore,money-absorptioninthesemarketswasreduced,whichcanbeseeninFigures3.1and3.2asanincreaseinUS(m1)velocityafter1995.

Internationaltransactionsmayespeciallytieupfundsinfinancialmarkets,atleastuntilinternationaltransfersmoveasefficientlyasnationaltransfers,anduntilthesamemargin-holdingrequirementsandquicksettlementsareapplied.InmostcountriesoutsidetheUS,funds-settlementisrarelyfasterthanfivedays.Furthermore,chaoticfinancialglobalizationtiesupfundsinfinancialaccountsduetoanincreaseintheoptionsdemandformoney-liquidity.Thechaospreventsinvestorsfrompursuingrationalstrategies,and

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thedemandforflexibleandsecuremoney-liquidityrisessharply.Anincreaseinmoneydemandoccurstoreducetheriskoflossandinordertoregainanoptimalinvestmentportfolioquicklyoncetheinformationenvironmentimproves.

Figure3.2Expandingvolumesofmoney-absorbingfinancialtransactions*intheUS($trillion/year),andtheUS(m1)incomevelocityofmoney,1975–1997

*Money-absorbingfinancialtransactions(NEWFMKintheAppendix)isthecombinedvalueofstock,bond,andgovernmentsecuritiestransactions.Sources:USDepartmentofCommerce,FederalReserveBank.

StoneandThorton(1987)recognizethat‘thefinancialtransactionsvelocitymeasuredoesnotshowthedownturninthe1980sthatcharacterizesthenon-

measuredoesnotshowthedownturninthe1980sthatcharacterizesthenon-financialandGDP-basedvelocitymeasures’.However,theyincorrectlystatethatthefinancialtransactionsvelocitymeasuredoesnot‘showsubstantialincreasesduringthe1980swhichwouldberequirediftheriseinfinancialtransactionsistoaccountforthedeclinein(m1)velocity’—anincorrectstatementbecauseregardlessofthequantityofmoneywhichpeopleusetofacilitateagivenvolumeoffinancialtransactions(andhowfastthatquantityischanging),andregardlessofhowmuchofthatmoneyisatthesametimeunavailableforGDPtransactions,thetotalvolumeoffinancialtransactionscouldexpandsufficientlytoabsorbmoneyawayfromGDPmarkets,thusreducingincomevelocity.Infact,theratioofSpindt'sfinancialtransactionsdebitstonon-financialtransactionsdebitsincreasedfrom7/1inearly1982to16/1inearly1987,suggestingthatfinancialtransactionscouldhaveabsorbedenoughmoneytosignificantlyreduceincomevelocityoverthisperiod.

Ifthemoney-absorptionhypothesisisrejected,howdopeopleexplaintherelationbetweenUSfinancialmarketactivity,GDP,(m1),interestratesandvelocityoverthisimportantperiod?TheexplosioninUSstockmarket

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activityandcapitaltransactionswhichbeganintheearly1980sandacceleratedinsubsequentyears,showninFigure3.2,iswidelybelievedtobearesultofdeclininginterestrates,andaneconomycomingoutofrecession.Thereceivedscenarioproceedsasfollows:thereductioninrealmoneybalancesof6percentin1981raisedinterestratesbyapproximately2percent;thehighinterestratescausedthegrowthrateofnominalGDPtodeclineby9.7percentagepointsfrom1981:Q3to1982:Q4,andamajorityofthisdeclinewasadeclineintheinflationcomponent;the15percentdropinworldcrudeoilpricesinearly1983furtherbroketheexpectations-fedinflationaryspiral;bythemid-1980sthedisinflationarytrendallowedexpansionarymonetarypolicy,whichbeganinlate1982,tobringinterestratesdowntotheirlevelsoftheearly1970s;andtheexpectationsofandeventualrealizationoflowinterestrates,lowinflation,andstrongeconomicrecoveryallfueledaboominstockandbondmarkets.Thelowerinterestrates,lowerinflation,andhigherrealGDPareseenasthecauseofthedeclineinincomevelocity.

Thiscommonview,thatUSinterestratesweredeterminedlargelybyUS

Thiscommonview,thatUSinterestratesweredeterminedlargelybyUSmonetarypolicyinthisperiod,andthatinterestrateswereadominant,exogenousfactorintheexpansionofnon-financialandfinancialmarkets,largelyignorestechnologicalchange,deregulation,andinternationalization.Theauthorbelievesthatlowinterestratesandanon-inflationaryexpansionofGDPintheUSwouldnothavebeenpossiblebythemid-1980swithoutthesestructuralchanges.TheUSsavingsratebegandecliningin1981untilithitapost-WorldWarIIlowof3.7percentin1985,andwithoutthebenefitofthenew,moreefficientinternationalfinancialmarketstheUSwouldhavehadawoefullyinadequate$60billionofdomesticsavingsin1985afterfinancingthe$200billionfederalbudgetdeficittokeepnominalGDPrunningatanannualrateof$4trillion.AselaboratedinChapters1and2,itwastechnologicalchange,deregulation,andinternationalizationwhichencouragedanetcapitalinflowintotheUSofcloseto$100billionperyearby1985comparedtoanetcapitaloutflowof$6billionin1981.Thenewprofit-seekingUScapitalinflowinthemid-1980sinturnallowedforthecontinuingexpansionoffinancialmarkets,lowUSinterestratesandthelongestpost-WorldWarIIexpansionofUSGDP.

Theauthor'sanalysisofthepre-1982and(1982-)causalitybetweenUSfinancialmarketexpansion(NEWFMK),interestrates(r),incomevelocity(v),andothergroupsofvariables(t,w,x,y,z),isrepresentedbythefollowingequations.Before1982financialmarketexpansionisseenasadomesticvariablewhichismoredependentonotherdomesticmacroeconomicvariables;after1982—asfinancialglobalizationproceeds—itisamoreexogenous,internationalizeddriverofdomesticmacroeconomicvariablessuchasinterestratesandincomevelocity:

Pre-1982: (r)=f1(t) (3.3)page_69

(NEWFMK)=f2(w) (3.4)(v)=f3(r,x) (3.5)

(1982-):(NEWFMK)=f4(tech.change,deregulation,internationalization)

(r)=f5(NEWFMK,y) (3.7)

(v)=f6(NEWFMK,r,z) (3.8)

Technologicalchange,deregulation,andinternationalizationintheauthor'sviewarethustherootcauseofmuchof:(A)therapidexpansionoffinancialmarketsbeginningintheearly1980sandthemassivenewcapitalflowintotheUS;(B)thesubsequentrapiddeclineinUSinterestrates;andtherefore(C)thesustainedexpansionofUSGDPbeginningin1983.Eachof(A)-(C)increasesmoneydemand,ceterisparibus.(A)and(C)increasethetransactionsdemandformoney,and(A)and(B)increasetheassetdemandformoney.(A)and(B)decreasetheincomevelocityofmoney;theeffectof(C)uponincomevelocityislesscertain,althoughsomeeconomiesofscaleintheuseofmoneywhenGDPincreasesmightcauseittoincreasevelocity.

Thefirstconsequenceoftechnologicalchange,deregulation,andinternationalizationistheexpansionoffinancialmarkets,anditislargelytheexpansionoffinancialmarketsfromwhichtheauthorbelievesthattheotherchangesflow.Yetresearch,andnotablytherecentworkofFriedman(1988),hasnotconclusivelyidentifiedalinkagebetweenfinancialmarketexpansionandincomevelocity.TheauthorbelievesthattheeconometricworkofFriedmanandothersfallsshortonthisscore,firstlybecauseofafailuretoidentifytheexacttimeatwhichthestructuralchangesbegantohavetheirstrongimpact;and,secondly,becauserecentchangeswithinaverydynamic,evolvingmarketplacecannotbepredictedwhentoomuchhistoricaldataisallowedtoobscuretherecentchanges.

Friedmantestsforastructuralshiftinhis(m1)velocityequation,byrunningthesameregressionsovertwosub-periods:(1970:Q1-1979:Q4)and(1980:Q1-1986:Q2).Hechooses1980:Q1tobeginthesecondsub-periodbecauseof‘theshiftfromacceleratinginflationtodisinflation’,and‘becauseitsohappensthattotaltransactionsacceleratedsharplyafter1980’.

IncontrasttoFriedman,theauthorhypothesizesthatthesecondsub-periodshouldbeginin1982:Q1,whenthemoney-absorbingfinancialtransactionsacceleratedandwhentheUSbeganreceivingthemassivenetinflowofforeigninvestment.Theinitial,rapidexpansionofSpindt'sfinancialtransactionsdebitsvariablein1980,asusedbyFriedmantodatethestructuralshift,wasduetotheearlyderegulation-reshufflingofmoneybetweenmoneyandnear-moneyaccounts.Thesetransactionsarelesslikelytocontemporaneouslyabsorbmoneyawayfromotherusescomparedto

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stock,bond,andgovernmentsecuritiestrading,especiallywheninternationaltradingisinvolved.

TheauthorhasusedlinearregressionanalysistoestimateEquations(3.3–3.8)fortheUS,andkeyresultsappearintheAppendixtothischapter.3

Theauthor'sregressionanalysisofthepre-1982periodcorroboratestheresearchofFriedman(1988)andotherswho,becauseofthedateormethodologyoftheirresearch,havenotletthe(1982-)periodaddsignificant‘noise’totheirequations(3.3–3.5).Yettotheauthor'sknowledge,nooneelsehasestimatedequations(3.6–3.8)specificallyforthe(1982-)period.Because(f4),intheopinionoftheauthor,isunquantifiable,hehastaken(NEWFMK)asgiven,where(NEWFMK)isthecombinedvolumesofUSstock,bond,andgovernmentsecuritiestransactions.TheUSgovernment3-monthT-billyieldisusedfor(r),and(v)isthe(m1)incomevelocityofmoney.

AsshownintheAppendix,regressionsovertheperiod(1982:Q1-1998:Q2)highlightthestrongnegativerelationshipthathasexistedbetweenfinancialmarketexpansionandbothinterestratesand(m1)incomevelocitysincethebeginningof1982.(EquationsA,B).TheseregressionsthusconfirmthecausalityofEquations(3.6–3.8)abovewherebyfinancialmarketsabsorbmoneyawayfromGDPmarkets.Indeed,amajority(approximately80percentasmeasuredbytheR2statistic)ofthefluctuationsininterestratesandincomevelocity(thedependentvariables)canbeexplainedsimplybythefluctuationsinfinancialmarkettransactions(theindependentvariable)inasimplelinearequation.Inthissimpleequation,a0–1dummyvariablewasincluded(D96Q1)toaccountforthereducedabsorptionofmoneybyfinancialmarkettransactionsbeginninginearly1996when,insteadofathree-daysettlementperiodfortransactionfundstobereleased,theSecuritiesandExchangeCommission(SEC)allowedasame-daysettlementperiod.Theregressionresults,aswellasFigure3.2,showasuddenincreaseinincomevelocitysince1995duetothisderegulation.Actually,theSECmovedfromfive-daysettlementtothree-daysettlementin1995,buttheauthor'sresearchindicatesthatthemovefromthree-daytosame-daywasmoresignificantforthe(m1)incomevelocity.

Whenthepre-1982and(1982-)periodsarecombined,theneconometric

Whenthepre-1982and(1982-)periodsarecombined,theneconometricequationsareunabletoexplainchangesinvelocity.Theauthorconcludesthatiftheperiodspriortoandfollowingtheinitialstrongimpactoftechnologicalchange,deregulation,andinternationalizationuponfinancialmarketexpansionarecombined,thentheirimpactuponinterestratesandincomevelocitycannotbeproperlyidentified.Friedman'sfailuretoidentifyastrongnegativerelationshipbetweenfinancialtransactionsandvelocitycanthusbeattributedtohisuseoftheperiod(1980:Q1-1986:Q2),whichincludestwoyearsbeforetherapidexpansionofmoney-absorbingfinancialtransactions.TheAppendixshowsthattwofinancialmarketexpansion

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variables,NEWFMKandNYSE(NewYorkStockExchangeCompositeIndex)4,haveastatisticallyindefensiblecoefficient(asmeasuredbythet-statistic)overFriedman'speriodwhen,asperEquation3.5andFriedman'sequations,theinterestrateisalsoincluded(EquationsC,D).

TheAppendixshowsadditionalincomevelocityequationsovertheperiods(1982:Q1-1995:Q3),whichwasaperiodstoppingrightbeforetheSECwentfromfive-daytothree-dayandthensame-dayfundssettlement,and(1982:Q1-1998:Q2),whichincludesthemostrecentdataavailable.Forthe(1982:Q1-1995:Q3)period,whenrealGDP(q)isincludedinadditiontothefinancialtransactionsvariable,thenapositivecoefficientisestimatedforrealGDP(EquationF).ThepositivecoefficientindicatesthatthereareeconomiesintheuseofmoneyfortransactionpurposesathigherlevelsofrealGDP,ceterisparibus,assuggestedbytheliterature.Theauthoralsoconsideredtheinflationrateasanadditionalexplanatoryvariableinhisincomevelocityequations.Inflation(INF)ismeasuredbytheGDPdeflator,andtheresultsofEquationFconfirmthat,wheninflationrises,moneyismorequicklyspentratherthanheldaspeopletrytomaximizepurchasingpowerovertime.Theinterestrate(r),asmeasuredbythethree-monthTreasurybillrate,isalsoincludedinEquationF,andtheresultsconfirmthatpeopledoholdlessmoney(velocityincreases)whentheyareabletotakeadvantageofincreasedinterestratesonnon-moneyinterest-earningaccounts.Ofcourse,asdocumentedbyEquationA,mostofthechangesininterestratesoverthisperiodcanbeexplainedbythefinancialtransactionsvariable,andincludingbothtermsasindependentvariablesissomewhat

redundantandbiasestheresults—EquationGexcludestheinterestrateandisthustheoreticallythebestequation.

EquationHintheAppendixextendstheregressionperiodto1998:Q2andthuscoverstherecentSECfunds-settlementchanges—onceagainthe0–1dummyvariableisincludedtocapturethefunds-settlementchange.Theestimateddummyvariablecoefficientindicatesthatwithmoreefficientquicksettlementtherateatwhichfinancialtransactionsabsorbmoneyhasdecreased.However,asthisbookiswrittenitistoosoonyettoquantifyexactlyhowthesettlement-deregulationwillchangethecoefficientsoverthelongrun.

RegardingFriedman's(1988)suggestionofaninverserelationbetweenincomevelocityandfinancialmarketexpansionthree-quartersearlier(thewealtheffect),andapositiverelationbetweenvelocityandcontemporaneousfinancialmarketexpansion,nosucheffectswerefoundovertheperiod(1982:Q1-1998:Q2).Laggingthefinancialmarketexpansionvariablereducesitslevelofsignificanceinproportiontothelengthofthelag,andthenegativecoefficientsaremaintained.

TheresultsshownintheAppendixthusallowthefollowingconclusions:(1)thedemandformoneyforfinancialmarkettransactionshasbecomean

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importantsourceofmoneydemandwhichabsorbsmoneyawayfromotheruses;(2)theexpansionoffinancialmarketsinthecontextofothervariablescausedthedeclineandincreasedvariabilityinUSincomevelocitysincetheendof1981;(3)becauseimprovedtechnology,deregulation,andinternationalizationaretherootcausesoftheexpansionoffinancialmarkets,theyarealsotherootcausesofthedeclineandincreasedvariabilityinincomevelocity.Asidefromtheauthor'spublication(Allen,1989)asupdatedinthisbook,theseresults(1)–(3)cannotbefoundintheeconomicsliterature.

IV.THEDECLINEOF(m1)INCOMEVELOCITYINTHEUKANDGERMANY

TheUKandGermanyexperiencedrecentdeclinesandincreasedvariabilityin(m1)incomevelocity,andforthesamestructuralreasonsastheUS.Althougha

(m1)incomevelocity,andforthesamestructuralreasonsastheUS.Althoughathorougheconometricanalysisforthesetwocountriesandothersisbeyondthescopeofthisbook,thecorrelationsbetween(m1)velocity,deregulation,internationalization,andfinancialmarketactivityseemobviousenoughthatthereaderwillhopefullytoleratetheauthor'sconclusions.However,theauthorencouragesothersmorefamiliarwiththeuniquefinancialhistoryoftheseandothercountriestopursueathorougheconometricanalysisofvelocityasperhisUSequations.FrenchandItalianfinancialderegulationandintemationalizationdidnotoccurassuddenlyandasforcefullyasintheotherG7countries,andtheauthorwouldespeciallyrelyonotherresearcherstotesthisUSequationsforthesecountries.ThedropinCanadian(m1)velocityparalleledtheUSdrop,andisespeciallycorrelatedwiththemajorCanadianfinancialderegulationsandincreasedfinancialturnoverin1986(Figure3.1).Thedeclinein(m1)velocityinJapanintheearly1990siselaboratedinthe‘PolicyImplications’sectionofthischapterandaspartof‘Japan'sCrisis,1989-’inChapter5.

A.TheUKCase

Figure3.1showsadeclineinUK(m1)velocitybeginningafter1980andthenabigdropafter1986.Thecollapseafter1986ispartlyduetotheinclusionofbuildingsocietymoneydepositsaspartofthenarrowmoneysupplybeginningin1987.BeginningJanuary1987,asdefinedbytheBuildingSocietiesActof1986,theInternationalMonetaryFundbeganincludingthesedepositsinitsseries34definitionof(m1)thattheauthorusesforthepurposesofthischapter.Giventhatbuildingsocietydepositsincreasinglyservedthepurposeofnarrowmoney,theauthorwouldrelyonotherstofigurethempreciselyintomonetaryaggregates.TheUK'smoney

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definitions,unliketheIMF's,donotincludetheprivateandofficialsector'sforeigncurrencydeposits,andthushavethislimitation—foreigncurrencydepositsbecameespeciallyimportanttotheUKeconomyafter1986.

WhicheverreasonabledefinitionsareusedformoneyintheUK,adeclineinincomevelocitydoesoccurcontemporaneouslywithderegulation,internationalizationandincreasedfinancialmarketactivity.InOctober1979theUKremovedallinwardandoutwardbarrierstocapitalflows.Consequently,

UKremovedallinwardandoutwardbarrierstocapitalflows.Consequently,Britainexperiencedanannualportfolioinvestmentoutflowforthe1980–83periodthatwas1800timeshigherthaninthe1975–78period(TaylorandTonks,1989),andtheinitialbreakinvelocitydidoccurin1980.

Theevenmoresignificantderegulation,internationalizationandincreasedfinancialmarketactivitywithinBritainwasthe26October1986‘BigBang’whichscrapped85yearsoffixedcommissionsforbrokersaswellasseparationofpowersbetweenbrokers.And,asstatedbyJohnM.Hennessy,chairmanofCréditSuisseFirstBostonLtd.,aleadinginternationalinvestmentbankbasedinLondon,‘BigBangisanattempttogenerateafewglobalcompetitorsamongtheBritishinstitutions’5.Competitionincreasedimmediately.Forty-ninefirms,includingAmerican,EuropeanandFarEasternfinancialgiantshadsignedupbeforeOctober26tomarketBritishstocksandoverrinientbonds;only19companieshadbeendoingthistradingpreviously.6AfterOctober26,commissionschargedbyfinancialintermediariesdroppedasmuchas50percent.

Figure3.3showshowtheturnoveroffinancialtransactionsintheUK,duetothisnewprofitabilityandinternationalization,increasedafter1980andthenexplodedupwardduringtheBigBangperiod.Theturnovervariable,whichaggregatesgovernmentsecurities,otherfixed-interestsecurities,andequities,doesmirrorthe(possiblyexaggeratedduetothebuildingsocietyissue)declinein(m1)velocity.Thelevelingoffoffinancialturnoverand(m1)velocitysince1987intheUKsuggeststhattheimpactsofderegulationandinternationalizationhadbeenmostlyrealizedayearafterBigBang.

Theauthor'shypothesis,thatthenewfinancialmarketsabsorbedmoneytakenawayfromnon-fmancialmarketsandcausedacollapsein(m1)velocity,thusappearstobeconfirmedfortheUK.Inadditiontothedirectabsorptionof(m1)asfinancialtransactionsturnover,theauthorwouldsuggestthatarelatedformofabsorptionoccurredintheUKcaseduetouncertaintyorofinformationfailureexperiencedbyholdersofmoney,thatis,duringadramaticupheavalorstructuralchangeasperBigBang,financialportfoliosmustbereallocateddramaticallyasthenewopportunitiesarefiguredoutandreactedto.Foratime,thereisnotsufficientinformationforinvestorstopursuerationalstrategies,andthepriceofmoney-liquidityrisessharply.Anincreaseinmoneydemandoccurstoreducetheriskoflossandinordertoregainanoptimalportfolioquicklyoncetheinformationenvironmentimproves.

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Intheauthor'sview,this‘optionsdemand’formoneycandivertmoney-liquidityawayfromGDPandothermarketsduringchaotictimes,butitisnotgenerallyrecognizedbytheeconomicsprofession.However,manysecuritiesmarketprofessionalsswearbyit.Forexample,JosephGrundfest,formercommissioneroftheUSSecuritiesandExchangeCommission,explainsthe1987stockmarketcrashasfollows:

Simplyput,Isuggestthatalargecomponentofrecentmarketvolatilityistherationalresultofan‘informationfailure’inthemarketforliquidityratherthantheconsequenceofrapidandirrationalchangesinthemarket'sassessmentofthevalueofsecurities…Thelackofinformationabouteitherfundamentalbusinessprospectsoraboutthemagnitudeandcompositionofanatypicallylargedemandforimmediatetradingcanbesufficienttoinducesubstantialmarketvolatility…[A]sharpincreaseinthepriceofliquidityisreflectedinasimultaneouswideningofspreadsandinageneralpricedeclineintheequitiesandfuturesmarketalike…Oncesufficientinformationcomestothemarketdescribingexpectedshort-termtradingflows,andoncethereturnstoprovidingliquiditybecomehighenough,thepeak-loadnatureofthedemandsubsides,theriskinvolvedintradingisreduced,thepriceofliquiditydeclines,spreadsnarrow,andequitypricesrecoveralargeportionoftheirlosses(Grundfest,1991,p.67–8).

Figure3.3Therelationbetweenfinancialmarketgrowth(£million)and(m1)velocityintheUKduringtheBigBangderegulationperiod

Sources:IMF,BankofEngland.

Theeconomicsprofessionhastroublewiththisoptionsdemandformoney

Theeconomicsprofessionhastroublewiththisoptionsdemandformoneybecauseitisnotveryseparablefromothersourcesofmoneydemand,becauseitisnotmeasurable,andbecauseitstandsinoppositiontothepopular‘efficientmarkethypothesis’(EMS).TheEMS,likemosteconomictheory,assumesawaythelikelihoodofsignificantinformationfailureorindeedthelikelihoodofsignificanttransactionscostsofanykind.

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Yetgiven‘thelackofinformationabouteitherfundamentalbusinessprospectsoraboutthemagnitudeandcompositionofanatypicallylargedemandforimmediatetrading’duringBigBang,Grundfest'sscenariomightexplainthebehavioroftheUKfinancialmarketsduringthe1986–88worldstockmarketcrashperiod.Thedropinvelocityofcertainmonetaryaggregatesduringthisperiod,theriseinUKshort-terminterestratesby1percentagepointshortlybeforethecrashasmoney-liquiditydemandwasnotaccommodatedbyanincreaseinmoneysupply,thesubsequentcrash,andthesubsequentrecoveryandultimatestabilityoffinancialmarketsasthemoneysupplywasincreased—allfitintoGrundfest'sscenario.

AselaboratedinChapter4,similarscenariosintheotherG7countriesduring1986–88,especiallytheUS,mightwellaccountfortheworldwidenatureofthe1987crash.YetitwastheUKBigBangwhichprovidedthemostobvious,sharpestmoney-liquiditydemandduetoinformationfailureshortlybeforethe1987crash.ThereforetheUKfinancialmarketsmayhavebeenthemostculpable.

B.TheGermanCase

Figure3.1showshowGermany's(m1)velocitybegandecliningfromitshistorictrendafter1981.ThisbreakcoincidedwiththemajorGermanliberalizationofexchangecontrolsinMarch1981,andtheone-year1989–90collapsecorrespondedwithGermanreunificationandtherevolutionsinEasternEurope.Germany'scasestudythusalsoseemstosupporttheauthor'sthesisthatderegulation,internationalizationandincreasedfinancialactivityhavedrivendeclinesinincomevelocity.

Figure3.4showstheinverserelationshipbetweenGermanfinancialactivityas

Figure3.4showstheinverserelationshipbetweenGermanfinancialactivityasmeasuredbystockmarketturnoverversusincomevelocityoverthechaotic1989–90period.The1989revolutionsinEasternEuropeandthefullGermanmonetaryreunificationon1July1990bothresultedininformationfailureandconfusionaboutfundamentalbusinessprospects.Anatypicallylargerdemandforfinancialassettradingoccurredasthenewopportunitieswerefiguredoutandreactedto,andthisdemandsubsidedin1991astheinformationenvironmentimproved.Initially,moneydemandincreasedinordertoreducetheriskoflossandinordertoregainanoptimalportfolioquicklyoncetheinformationenvironmentimproved.Therefore,incomevelocitycollapsedbeforereversingitsfallin1991.

TheincreasedGermanmoneydemandandcollapseinvelocityfrom1989to1990werenotaccommodatedbytheBundesbankwithanexpandedmoneysupply,thereforeamoney-liquidityshortageoccurredandinterestratesroserapidly.TheGermanmoneymarketraterosefrom4.0percentin1988to8.8percentin1991whereasthegovernmentbondyieldclimbedfrom6.1to8.6percent—indicatingaliquiditycrisisespeciallyinthemoremoney-relatedsideofthefinancialmarkets.

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ThesehighGermaninterestratesinthecontextoftheEuropeanExchangeRateMechanism(ERM)requiredoverlyrestrictivemonetarypoliciesthroughoutEuropetostabilizeexchangerates,whichinturnledtotherecessionary1990sandtheproblemswithintheERM.Germany'sEuropeanpartnencouldnottoleratesuchrestrictivemonetarypoliciesformorethantwoyears,andafter1991mostofthemchosetolowerinterestratesandrestoreeconomicgrowthattheexpenseofERM.Therecessionary1990-periodiselaboratedinChapter4.

Figure3.4Therelationbetweenfinancialmarketgrowth(marksbillionand(m1)velocityinGermanyduringthechaotic1989–90period

Sources:IMF,Bundesbank.

V.THERECENTHISTORYOFMONEYANDWEALTH

BackintheEuropeanRenaissance,gold,silver,andotherpreciousmetalswere‘realmoney,’whereaspaperIOUs,goldcertificates,etc.,thatcouldbeconvertedintopreciousmetals,were‘quasi-moneys’.Thebankerswhowereissuingthesenewquasi-moneyformswereoftengoldsmiths,becausetheyhadthebeststrongboxes.Quasi-moneyswereissuedwellbeyondtheamountthatcouldbeconvertedintopreciousmetalsallatonce,andthemoneysupplyexpanded.Thesystemofmoneycreationcouldsurviveaslongasthegoldsmithsdidnotunderestimatehowmuchquasi-moneytheircustomerswouldwanttoconvertintopreciousmetals‘onthespot’.Goldsmithstookingoldandloaneditout,inpaperform,forprofitatwhatwaseventuallycalledtherateofinterest.Thegoldsmith-bankerprofitedwhenhiscostoftakingingoldwaslowenoughcomparedtotheinterestearnedwhenheloaneditout.Theborroweralsoprofitedwhentheborrowedmoneywasusedinaventurethatjustifiedtheinterestexpense.

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Themodernbankingsystemadvancedthe‘moneypyramid’further.Whenpapermoneywasnolongerquasi-money,butinsteadbecameacceptedasrealmoney,thenitcouldbeusedasthe‘monetarybase’or‘high-poweredmoney’forfurthermoneyandcreditcreation.Regulatorslimitedthisprocess.Atypicalbankreserverequirementoftentoone,forexample,meantthatbankswereallowedtocreatequasi-money-on-demandaccountsuptotentimesthevalueofwhatrealmoneytheyactuallyheldinreserve.Governmentagencies,i.e.thetaxpayers,

increasinglyinsuredthesedemand-deposit-accounts,thusgivingquasi-moneyarealmoneyquality.Forexample,intheUSsavingsandloancrisisofthe1980s,manythriftinstitutionsattemptedtoprofitonthecreationandturnoverofquasi-moneybyinvestingitincommercialrealestateandotherriskyventures,butmanyoftheseventuresfailed.Consequently,asthelenderoflastresort,theUStaxpayerfundedapproximately$130billiontoresolvethethriftcrisis.Muchofthequasi-moneythatcouldnotbeconvertedintorealmoneyonthespotbythethrifts,wasinstead,eventually,swappedfortherealmoneyofthetaxpayer.Inthiscase,growthintheUSmoneysupplywasmaintained.

Inthe1990s,themoneypyramidexpandedevenfurther.AsdocumentedinChapter1,electronicfundstransfer(EFT)systemsandothercyberneticadvancesexpandedfinancialtransactionsfasterthaneverbefore.Themeasuredvalueoffinancialtransactionsisnowmostlyintheformofelectronicdebitsandcredits.Electronicmoneycreditscanbeconvertedtotraditionalcurrency,butmostofthesecreditsareneverconverted—theyremaininthesystemtoaccommodatenever-endingfinancialtransactionsandreconciliationsbetweenfinancialinstitutions.

Today'smoney:thesynthesis.[Bank]reservesperchatopthemoneypyramid.Conventionalmoney(themeasuredm's)isnext[asthepyramidwidens].Thee-transfers,orEFTasearlierknown,follow.Onelevelbelowisthenewestkindofe-money:thesmartcardandcomputercybermoneyformsslowlytakingshape.Freemoney,bydefinitionwithoutspecificformalbacking,ande-bartercollectatthebaseofthepyramid….Asyougetfurtherawayfromthereservebaseandthemoneythatpassesthroughbanks,itbecomeshardertotrack‘money’.Thisisespeciallytruewithbundlingalotofdifferentcorporateinformationorsettlementinsomekindofcommodityaccount(e.g.,oilorfutures).Thevalueofanaggregate-flowsgrossbecomessupportedbyadwindlingreserveandmoneybaserelativetotheexpandedelectronicblobasawhole(Solomon,1997,p.91,95).

Giventhesedevelopments,itisbecomingdifficulttoseparatethemoneystock(m)fromitsrateofuseorvelocity(v)asitrecyclesquicklythroughthesystem.‘Theexpandedelectronicblob’ofmoneytransactions,or(mxv),remainsmeasurableasanaggregate,butonelectronicnetworksthetwocomponentscoalesce.Thus,increasinglywedonotreallyknowwhattheunderlyingmoneystockis,andthereforehowmuchmoneyisbeingcreated.

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Globalmoneyandmonetary-processesarefurthercomplicatedbytheroleofthedollar(andtolesserextenttheyen,mark,euro,etc.)astheworldreservecurrencyor‘high-poweredmoney’.Justasquasi-moneysuppliescanbecreatedanddestroyedonthebasisofrealmoneysupplieswithinanationaleconomy,‘soft-currency’suppliescanbecreatedanddestroyedonthebasisoftheirconvertibilityintotheUSdollarandother‘hard-currencies’intheworldeconomy.

Forexample,theMexicanpesoandtheThaibahtfunctionedasquasi-moneysorsoft-currenciesduringtherecentfinancialcrisesinthosetwocountries.Initially,increaseddollarsuppliesinthosetwocountries,oftenborrowedfromabroad,orearnedthroughtrade,wereusedasthereservecurrencyuponwhichnewpesoandbahtloanswereissued.But,manynewloansandmoneyaccountswerenotusedprofitably.Forexample,toomuchcommercialrealestatewasbuiltwithborrowedmoney,anditcouldnotberentedorsoldprofitably.

Peoplecouldnotpaybacktheirloanstothebanks,andthebankshadto‘writeoff’variousaccounts.Themoneysupplyheldbythebanksthereforedeclined,andtheyhadlessabilityandincentivetocontinuecreatingmoneythroughlendingprocedures.Thesituationdeteriorateduntilbankscouldnothonortheirownfinancialcommitments.TheMexicanandThaigovernmentsthemselveswere‘banks’whichhadborroweddollarsandotherhardcurrencies,andbothgovernmentslosttheabilitytohonortheirhard-currencydebt.Therewasagenerallossofconfidenceinthefinancialsystem.Manywhocould,transferredtheirlocalsoft-currencyintodollarsandmovedthedollarsintosafe-havensoutsidethecountry.But,justasgoldnotesmaynotfullyconvertintogoldduringacrisis,orbankdepositaccountsmaynotfullyconvertintobankreserves,excessively-createdquasi-moneysuppliesofpesosandbahtsdidnotfullyconvertintodollars.

Asuddencurrencydevaluation(failuretofullyconvert)relativetothedollar,andasuddendropinthemonetarybaseinMexicoandThailandwereimportantcomponentsoftheircrises.Internationalholdersofpesosandbahts‘ran’onthosecurrenciesjustasdepositholderstypicallyrunonabankduringanationalfinancialcrisis.Nationalholdersalsoranonthesecurrencies,demandingdollars,becausethedollarwasavailabledomestically.Also,themostattractivethingtodowiththelimitedsuppliesofdollarsthatcouldbeobtainedwiththedevaluing

dowiththelimitedsuppliesofdollarsthatcouldbeobtainedwiththedevaluingdomesticcurrencywasoftentoputthedollarsinsafe-havenaccountsoutsidethecrisis-riddendomesticeconomy.

Morerecently,attheendofAugust1998,arunonrublesoccurredinRussiaasdomesticandinternationalholdersofrublesrushedtoconvertthemtodollarsandthenmovethedollarsoutofthecountry.Perhaps$40billionindollarswerethenhelddomesticallybyRussians.Beforetherun,approximately$20billioninrubleswasheld;attheendoftheruninSeptembertherublehadlostmostofitsexchangevalueandwhatrublesremainedwereworthlessthan$5billionmeasuredatinternationalexchange

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rates.TheRussiancentralbankcanceledruble-dollartradingontheMoscowInterbankCurrencyExchangeonAugust27,andRussianslinedupattheirbankstryingunsuccessfullytogetalloftheirmoneyout.ManybankaccountswerefrozenuntilNovember,anditwasnotclearhowmuchmoneyremainedinthesystem.SincethebeginningofJuly,theRussiancentralbankhadsold$8.8billionindollarsfromitsreserves,buyingrubles,inordertosupporttheexchangevalueoftheruble,buttonoavail.ForeigndollarloanstoRussiafromtheInternationalMonetaryFundandotherinstitutionswereusedinthisprocess,butunsuccessfully.Newsuppliesofdollarswereoftenappropriatedbytheveryfortunateorpolitically-connectedpartieswhowerethusallowedtoconverttheirrublesintoprivatedollarholdings.

Rublesarethequasi-moneyanddollarsaretherealmoneyinRussia,despitelong-standingattemptsbyauthoritiestoimplementjustthereverse.Whentherunoccurred,thedollarvalueofthequasi-money-rublesheldbyRussiansdroppedbymorethan75percent.Thedeclineinruble-wealthwasmuchlargerthanthewealththatcouldbeconvertedintodollars.Russiansexperiencedasuddendeclineinwealth—adeclineinthedollar-basedabilitytopurchasethings,includingtheirownproducts.Morewageswentunpaid,lessworkwasdone,moneyandgoodswerehoarded,incentivesandmeanstocoordinateeconomicactivitydeteriorated,andrecessionaryconditionsworsened.

Mexico,Thailand,Russiaandotherssufferednotonlyfromaseverecontractionofquasi-moneysupply,buttherushtoconvertlocalmonetarywealthinto

ofquasi-moneysupply,buttherushtoconvertlocalmonetarywealthintodollarsalsoinvolvedacapitalflightofwealthoutofthecountryinordertobestestablishinterest-earningdollaraccounts.TheUSandotherhard-currencycountriesthusgainedmonetarywealthattheexpenseofless-developedcountriesandotherquasi-moneyusers.Safehavensarealsowealthhavens.AsdiscussedinChapter4,intheinitialmonths,the‘AsianFinancialCrisis,1997-’wasanetbenefittotheUSeconomybecauseofthemonetarywealthtransferfromAsiatotheUS.

Inthissection,casestudiesoftheGreatDepression,offshorefinancialmarkets,andmonetary-wealthcreationdocumentthishistoryofmoneyandmonetarywealthfurther.

A.TheRoleofMoneyinTheGreatDepression

Themoneysupplytimesitsvelocityofuse,(mxv),wascalledeffectivemoneybyGottfriedHaberlerinhis1937book,ProsperityandDepression.Effectivemoneycanalsobethoughtofasmoneyliquidityormoneyflow,anditissomewhatlikethetotalflowofwateroutoffaucetsunderpressure.Intheanalogy,monetaryvelocity(v)representswaterpressure—thegreaterthewaterpressure,thegreaterthewaterflow;thegreaterthemonetaryvelocity,thegreaterthemoneyflow.Inotherwords,spendablemoneycredits(mxv)isanalogoustousablewater,anditdependsnotonlyonsome

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measureofthemoneysupply(m=‘groundwater’),butalsoonhowfastitcanberecycledunderpressurethroughthesystem.Ifbankfailuresoccur,andbaddebtsandotheraccountsarewrittenoff,thenintheanalogytherewouldbe‘contamination’oftheeffectivemoneysupply,i.e.wewouldhavetoadmitthatthereislessusablemoneyinthesystem.Bad-loanproblemstendtospreadthroughthesystemlikebacteriaspreadsthroughawatersystem,becausesomeaccountsareusedtobackupthecredibilityofotheraccounts.Therefore,whenacrisishits,authoritiesquicklytrytofindalenderoflastresorttoreplace(or‘sterilize’)badmoneywithgoodmoney.Otherwise,aprocessofbad-money‘contagion’canspreadthroughthesystemandthreatentheintegrityofthemoneypyramid.

DuringtheGreatDepressionintheUS,from1929totheworstyear,1933,annualrealgrossdomesticproduct(q)contracted30.5percentfrom$203.6to$141.5(numbersinbillionsof1958-equivalentdollars),themoneystock(m)contracted25.2percentfrom$26.6to$19.9,andeffectivemoney(mxv)contracted46.1percentfrom$102.96to$55.53.ThegeneralpricelevelofGDP(p)declined22.3percentfrom0.506to0.393(pin1958equals1.0),andtheGDP-velocityofmoney(v)declined27.9percentfrom3.87to2.79-themoneysupplywasrecycledonly2.79timesin1933toaccommodateandinduceGDP.Thus,thedeclineineffectivemoney(mxv),andthereforetheequivalentdeclineinnominalGDPduringtheGreatDepressionwascorrelatedwithadropin(v)thatwasevenlargerthanthedropin(m).AsacauseoftheGreatDepression,theslowdownintherateofmoney-recyclingwasevenmoreimportantthanthedeclineinthestockofmoneyavailableforrecycling.

IntheGreatDepression,money(m)wasbeingheldoutsidethebankingsystemandthusnotcirculating.Bankswerefailing(9,000overaspanoffouryears),therewaslesstrustinfinancialintermediaries,andmoneywashoardedinprivatelocationssuchasjarsandsafes.Somequasi-moneycreatedinthebankingsystembaseduponbankreserveswaslostinbadinvestments.Inaddition,moneydidnotcirculateveryfastoutofjarsandsafes.Ineffect,financialmarkets,i.e.jarsandsafes,absorbedmoneyawayfromthenon-financialmarkets.Moneydidnotcirculateasfastthroughfinancialintermediaries,sotherewaslessspendablemoneycredits(mxv)inthesystemtopaydebtsandbuythings.Afterdroppingfrom3.87in1929to2.79in1933,theGDP-velocityofmoney(Y)rangedbetween2.5and3.0fortherestofthedecade.Inthebankingsystem,banksthatwereunabletohonortheirdepositsduetobadloans,excessivecreditcreation,andthedeclineineffectivemoneyincirculation,hadtoclose—theyhadtotelltheirdepositorsthat‘wedonothavesomuchmoneyanymore’.Withoutdepositinsurance,theunhappydepositorshadto‘agreethatwedidnothavesomuch’.Secondly,inthestockmarketandotherfinancialmarkets,asimilarprocessoccurred.The

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stockmarketcrashin1929wasaspontaneousagreementthat‘wedonothavesomuchmoney-wealthanymore’.

Stockmarketpricesaremaintainednotonlybytheamountofeffectivemoney

Stockmarketpricesaremaintainednotonlybytheamountofeffectivemoneythatisavailableandusedtobuystocks,butalsobyvariousintangibleassessmentsofthevalueoftherealpropertythatisbeingpurchased.Mainstreameconomictheoryagreesthatstockpricesreflecttheexpectedstreamoffutureearningsofthecompany,preferencesformoney-wealthnowversusinthefuture(thediscountrate),expectedratesofreturnonalternativewaystostorewealth(bonds,gold,money,otherrealproperty,etc.)andvariousother‘invisibleexpectationsandpreferences’.Stockmarketprices,andotherrealpropertyprices,areaformofsocialconsensus.Traders,armedwithmoney-liquidity,negotiatewitheachothertodeterminehowmuchmonetarywealthanownerof,say,100sharesofMicrosoftisentitledto—ineffect,thereisanimpersonalconsensusonhowmuchoftheeconomicproducthe‘deserves’.Stockmarketvaluationsarea‘beliefsystem’whichallocateswealththroughtheinstitutionsofthemoneyeconomy.

Thestockmarketrun-upfrommid-1927tomid-1929,andthecrashof1929whichfollowedwerenotinitiatedbychangesinthemoneysupply(m)ortheabilityofinstitutionstohandlemoneycirculation(v).Frommid-1927tomid-1929themoneysupplyincreasedbyapproximately3percentandinstitutionswerestable;butmeanwhilethestockmarketdoubled.Then,thecrashin1929occurreddespitecontinuingstabilityofeffectivemoney(mxv)—thegeneralbankingcollapseanddeclineof(mxv)didnotoccuruntil1930–31.Therefore,theinvisibleexpectationsandpreferenceswereatplayalongsidetangiblemonetaryconditions,andthechangingsocialconsensusdramaticallyincreasedandthendramaticallyreducedmonetarywealth.Doesthisprocesssoundirrational?Itprobablyhasbothrationalandirrationalcomponents—whatFischerBlack,aPresidentoftheAmericanFinanceAssociation,distinguishesas‘information’versus‘noise,’respectively:

Thenoisethatnoisetradersputintostockpriceswillbecumulative,inthesamesensethatadrunktendstowanderfartherandfartherfromhisstartingpoint.Offsettingthis,though,willbetheresearchandactionstakenbytheinformationtraders.Thefartherthepriceofastockgetsfromitsvalue,themoreaggressivetheinformationtraderswillbecome.Moreofthemwillcomein,andtheywilltakelargerpositions.Theymayinitiatemergers,leveragedbuyouts,andotherrestructurings.Thus,thepriceofastockwilltendtomovebacktowarditsvalueovertime…thefartherthepriceofastockmovesawayfromitsvalue,thefasteritwilltendtomoveback…[However],allestimatesofvaluearenoisy,sowecanneverknowhowfarawaypriceisfromvalue’(Black,1985,p.532–3).

Inotherwords,economicvalueorwealthasrepresentedinstockpricescanneverbeperfectlycorrelatedwithanything‘real’.Socialconsensushasnotgeneratedafixedmeasureofvalue,thereforestockpricesandothernotionsofvalueandwealthremainsubjecttochangingbeliefsystems.Inthestock

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market,thisindeterminacycanbethoughtofas‘erageinvestortryingtofigureoutwhattheaverageinvestorbelieves,’or‘theherdtryingtofigureoutwhattheherdisgoingtodo’.

B.OffshoreFinancialMarkets

Eurodollars(dollarsheldinaccountsoutsidetheUS),andmanyoftheothernewmoneyaccountsandformsthathavebeencreatedsincethe1970s,donothavereserverequirementsinthebankingsystem;thereforequasi-moneyandloanscanbecreatedbasedupontheseaccountsalmostwithoutlimit.Theriseof‘offshorefinance’hasencouragedthisprocess,becauseoffshoreaccountsusuallydonothavereserverequirements.Offshorefinancecanbedefinedas‘marketswhereoperatorsarepermittedtoraisefundsfromnon-residentsandinvestorlendthatmoneytonon-residentsfreefromregulationsandtaxes’.Oncemoneyisraised,thenwithoutareserverequirementitcanbeloaned,deposited,re-loaned,re-deposited,re-loaned,etc.inoffshoremarketswithoutlimitsimposedbythebankingsystem.

Offshoremarketsaregenerallycategorizedintothreetypes:‘spontaneous’offshoresites,asintheUKandHongKong;‘InternationalBankingFacilities’(IBF)asinNewYorkandTokyo;and‘taxhavens’asintheCaymanIslandsandSwitzerland.Londonbecameanoffshoresite‘spontaneously’afterthenewThatchergovernmentabolishedforeigncurrencyexchangecontrolsin1979.IntheUK,minimumreserverequirementswerethenabolishedinAugust1981foronshorebanks.TheBankofEnglandwantedtomaintainthem,butthecommercialbankslobbiedsuccessfullytoabolishthemsothattheycouldcompeteintheEurocurrencybusinesswithnon-Britishinstitutions.

IBFs,whicharemorestringentlylicensedandcontrolled,wereallowedintheUSafter1980inordertocompetewithLondonandthetaxhavensoftheCaribbean.TokyofollowedsuitwithitsIBFin1984.Alloffshoresitescanhave

Caribbean.TokyofollowedsuitwithitsIBFin1984.Alloffshoresitescanhavetaxadvantages,butthetypicaltaxhavenisinhabitedby‘letterbox’or‘brassplate’companieswhoexistmostlyonpaper,withtherealactivitytakingplaceina‘properonshore’financialcenter.Taxhavensstrugglewithrespectabilityandanonymityinorderbothtoattractdepositsandavoidregulations.TheBahamas,forexample,wasidentifiedbytheIMFasthethirdlargestinternationalfinancialcenterin1983afterBritainandtheUS,intermsofforeignliabilities,butaftermuchpublicityaboutdrugtraffickingandcorruptionithasnowslippedtoseventhplace.Thenetworthofoffshoremarketsisdifficulttoestimate,butitmaybe$5–6trillionor25percentofworldGDP.

Bythe1990s,accordingtosomeestimates,‘asmuchashalfoftheworld'sstockofmoneyeitherresidesin,orispassingthrough,taxhavens’(Kochen,1991,p.73).AccordingtoIMFdata,theCaymansandtheBahamastogetherheldapproximately$400billioninforeignliabilitiesin1990,which

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comparedwith$1,073billioninforeignliabilitiesheldintheUK,$659heldinJapan,and$584billionheldintheUS(ofwhichtheNewYorkIBFheld$333billion).Muchofthemoneyintaxhavensisheldby‘residents,’andisthereforenotincludedaspartofforeignliabilities.TheninetaxhavensoftheCaribbeanarehometohalfoftheworld'sinsurancecompanies,and14percentoftheworld'smerchantshippingcompanies.Inaddition,individualprivatesavingsof$500billionwasheldintaxhavensin1993…anamountofmoneyapproximatelyequaltotheentiresavingsoftheworld's‘super-rich’(Norton,1993).Thus,LordRees-Moggwarned:

Theworldhasneverseenanythingquitelikethisbefore.Governmentsareunlikelytorecovertheircontroloffinance….Anyfutureattemptstorestorecapitalcontrolsorregaintaxingpowerarequiteimplausible….AmericanandEuropeanwelfaresystemswhichdependonhightaxmaybecomeinsolvent.Inthenewworld‘taxtherich’hasceasedtobeanoption;thericharenotgoingtositaroundwaitingtobetaxed(Rees-Mogg,1993).

Inthe1990s,wheninternationaltradedataisaddedupforallcountries,worldexportrevenuesfallshortofimportexpendituresbyapproximately$100billionperyear.Economistsagreethatmuchofthis$100billionrepresentsatrue

peryear.Economistsagreethatmuchofthis$100billionrepresentsatrueshortfall(notjustmeasurementerror)ofmoneywhichisnotrepatriated,butinsteadisaddedtooffshorefinance.Whencombinedwithotherflowsthataddtothestockofmoneyinoffshoremarkets,itmaybethatoffshoremarketsnowdirectasmuchmoneyasonshoremarkets.

Throughthe1990s,approximately60percentoftheworld'sofficialmoneyreserveshavebeenheldinUSdollars,20percentinGermanmarks,and10percentinJapaneseyen.MoreUSdollarscirculateoutsidetheUSthaninside.(Wewillseehowthisdominanceofthedollar,andthis90percentdominanceofthe‘bigthree’changesastheeuronowreplacesthemark.)Inoffshorefinancialmarkets,comparedtotheentireglobaleconomy,theUSdollarhasanunknown,butsignificantlylargershareofthestockofmoneyreserves.Whatispossibletoestimateistheyearlyflowofforeign(non-US)savingsofdollars.Table3.1showsarecentestimateoftheannualsourcesandusesofUSdollarfinancialflowsoutsidetheUS,for1992–96.

Table3.1estimatesthatthereisaflowofmorethan$50billiondollarsperyearintooffshorefinancialmarketsfrominternationaltransactionswhereinmoneyisnotrepatriated(ormeasured)throughofficialnationalbalanceofpaymentsstatistics.Thisflowisthenanon-USsourceofdollarsthatcanbeusedforjustaboutanythingintheglobaleconomy,anditisincreasing.Thesamecommentsapplytotheseparatecategoryofcapitalflight,whichalsoaddsapproximately$50billionperyearintotheavailablesupplyofnon-US-helddollars.Bydefinitionthereisnofirmdataforcapitalflight,becauseitdescribesfundswhichleaveacountryinsecretordisguisedaccountstoavoidtaxes,politicalrisks,inconvertibilityrisks,etc.Othersourcesofnon-

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US-helddollars,whicharemadeavailabletotheglobaleconomyeachyear,includedollarsheldinothercountrieswhich‘materialize’fromprivatesourcestobuydollarbonds,notes,directandequityinvestments,anddollarswhichare‘freed-up’inothercountriesfromofficialnationalreserveaccounts.Thegrandtotalofnon-US-helddollars,whicharemadeavailableforuseintheglobalfinancialmarketseachyear,hasbeenrisingfromanestimated$140billion1992toalmost$300billionin1995and1996.

1992 1993 1994 1995 1996SourcesAccumulatinginoffshorefinancialmarkets 45 50 55 65 75Non-USpurchasesofdollarbondsandnotes 10 20 25 30 45Capitalflight 35 40 50 55 40DirectandequityinvestmentintheUS 10 60 50 60 85NetflowsoutofthereservesofIndustrialcountries1 0 40 80 65 20LDC'sFuelexporters 0 0 -20 10 5Non-fuelexporters 40 30 15 10 15Total 140 240 255 295 285UsesNetfinancingindollarsby:Industrialcountries(ex-US) -35 -100 -20 -20 -25LDC'sFuelexporters2 10 20 25 25 15Non-fuelexporters 35 55 30 50 50USdirectandportfolioinvestmentabroad3 60 160 70 80 90UScurrentaccountdeficit 70 105 150 160 155Total 140 240 255 295 285

1Note:AdditionstotheUSTreasury'sholdingsofforeigncurrencysubtractfromthistotal.2Note:Mexicoisincludedunderthisheading.3Note:USpurchasesofforeigncurrencybondsisaddedtothistotal.Source:Brown(1996),p.119.

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Becauseoftheriseofoffshorefinance,perhapsone-fourthoftheworld'smoneystock(m)isnotsubjecttosignificantreserverequirements.Thus,quasi-money,loans,andeffectivemoney(mxv)canbecreatedonthebasisofaprocessofdeposit-lendingandaddedtotheworldsystemalmostwithoutlimit…theoffshorefinancialmarketscanexpandaslongastheplayersremainprofitable.Manyoftheplayersarelimitedbynationalregulationswheretheydootherbusiness,andtheycannotexpandoffshorebusinessbeyondacertainshareofonshorebusiness.However,someplayershavenosuchregulations,andtheyarethemodern-dayequivalentsofprivategoldsmithsintheEuropeanRenaissance.Dollar-creditstoday,justlikegold-notesintheRenaissance,canbeissuedalmostwithoutlimit,i.e.aslongasallprivatepartiestotheissuanceprofitfromtheuseofthosenotes.

C.Monetary-WealthCreation

Offshorefinancialmarketsandotherinnovationshavegivenfinancialplayersaderegulatedsupplyofmoney,andglobalnetworks,whichcanbeusedtoexploitnewopportunities.Someofthisactivityisrecklessspeculationandincreasesriskinthesystem,andsomeinvolveslessriskandmightevenbearbitragewherebytheplayerssimultaneouslyborrowatlowinterestratesandlendathighinterestrates,or‘buylowandsellhigh’withoutrisk.Aspartofthisprocess,advancesininformation-processingtechnologiesandmarket-driveninstitutionalchangehaveallowedadramaticreductioninfinancialtransactionscostsforallparticipants.Peoplehavebeenabletofindmorefavorableinterestrates.Inaddition,lessexpensiveownershipofstocks,commodities,andotherpropertyhasbeenpossible.

Asdiscussedfurtherin‘ANewPoliticalEconomyofMoney’inChapter5,inmanycasestheselaborsoffinancialoperatorscancreatewealth,becauseofthelowercostsandgreatereconomicefficiencieswhichtheyallow.Innovationswhichsupport,andarisewithin,thefinancialsectorcaninmanycasesbeawin-wingame,becausetheycanalsocreateanddistributenewwealth.However,insomeothercases,thelaboroffinancialoperatorscanappropriatewealthfromothersectorsoftheeconomyinawin-losesituation,forexamplewhenfinancialinstitutionsandplayershaveinordinatepoliticalpower.Alternatively,inthemostpessimisticcases,asdiscussedinthecasestudiesofChapter4,inappropriatelaborsoffinancialoperatorshaveresultedinlose-losesituations,forexampleifthesupplyofeffectivemoneyorthe‘moneypyramid’isallowedtocollapse,oriffinancialinstitutionsandnetworksaredestroyedbyreckless

tocollapse,oriffinancialinstitutionsandnetworksaredestroyedbyrecklessactivity.

Financialmarketparticipants,includingcentralbanks,canbethe‘drivingagents’whoseactionsmayeitherincreaseorreducetheeconomicproductofvariousnations.USFederalReserveBoardChairmanAlanGreenspanrecentlywrote:

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Thefiatmoneysystemsthatemerged[afterthegoldstandardsystemwaskbandonedintheearly1970s]havegivenconsiderablepowerandresponsibilitytocentralbankstomanagethesovereigncreditofnations.Underagoldstandard,moneycreationwasatthelimittiedtochangesingoldreserves.Thediscretionaryrangeofmonetarypolicywasrelativelynarrow.Today'scentralbankshavethecapabilityofcreatingordestroyingunlimitedsuppliesofmoneyandcredit….Thechangingdynamicsofmodernglobalfinancialsystemsalsorequirethatcentralbanksaddresstheinevitableincreaseofsystemicrisk.Itisprobablyfairtosaythattheveryefficiencyofglobalfinancialmarkets,engenderedbytherapidproliferationoffinancialproducts,alsohasthecapabilityoftransmittingmistakesatafarfasterpacethroughoutthefinancialsysteminwaysthatwereunknownagenerationago,andnotevenremotelyimaginedinthe19thcentury.Today'stechnologyenablessingleindividualstoinitiatemassivetransactionswithveryrapidexecution.Clearly,notonlyhastheproductivityofglobalfinanceincreasedmarkedly,butso,obviously,hastheabilitytogeneratelossesatapreviouslyinconceivablerate(Greenspan,1998,p.247,249)[italicsadded].

TheauthorwouldemphasizefromGreenspan'squotethat‘thecapabilityofcreatingordestroyingunlimitedsuppliesofmoneyandcredit’isequivalentto‘thecapabilityofcreatingordestroyingmonetarywealth’.Moneyandcreditare‘storesofvalue,’asdeterminedbysocialconsensuswithinnationsandbetweennations.

Regardingfinancialoperators,innovations,andproductivity,theauthorwoulduseJosephSchumpeter'sclassicdefinition(1934,p.66)of‘innovation’toincludetheopeningofnewmarketsandthepioneeringofnewformsofbusinessorcommercialorganization,aswellasthedevelopmentofnewproductsandmethodsofproduction.Clearlyfinancialoperatorshavebeeninnovativeineach

methodsofproduction.Clearlyfinancialoperatorshavebeeninnovativeineachsense,perhapsespeciallywithregardtonewglobalformsofcommercialorganization.Schumpeterarguedthatclustersofinnovationsdestroymanyoftheoldwaysofdoingthings,whilesimultaneouslycreatingnewwaystoproducevalue…aprocessof‘creativedestruction’.Economicdevelopmentthusproceedsasanevolutionaryprocess,withdifficult‘transitioncrises’.Innovationsareadoptedin‘searchandselection’processesasweproceedthroughtransitionperiods.

ModelskiandThompson'sworkprovidesanexcellentdatabasedaccountoftheseSchumpeterianprocessesoverthelonghistoryofeconomicdevelopment.Regardingrecenthistory,theyarguethat:

…theperiodsince1973,andlastinginouranalysisuntilabout2000,isoneoftransition.Theindustriesthathavebeenthebearersofpost-WorldWarIIprosperity—the‘auto-industrial’complex(includingoil)andelectronics(evenincludingmainframecomputers)—havebecomematureindustries.Theyarenolongersourcesofrapidgrowthandmajorinnovation…competition[worldwideintheseindustries]hasbroughtunemployment,restructurings,andshockstoworldtradebalances….Inthemeantime,the[1973-]informationindustrieshavebeenslowinmakingtheirimpactfelt.Thelargeinvestmentinthenewtechnologieshas

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notyethadnoticeableeffectsonproductivity[italicsadded].Thisisa‘lag’thatischaracteristicofparadigmaticshiftsinindustrialorganization.Earlyinthiscentury,asimilardelay,ontheorderoftwodecades,wasseenintheimpactofstrongcommitmenttoelectricpowerequipment‘(ModelskiandThompson,1996,p.223).

Theword‘productivity’asitisusedintheabovetwoquotes,andasitistypicallyusedineconomicsliterature,meanstherateofpurrentproductionofmerchandiseandservices(GDP)perunitofinput(land,labor,tangiblecapital,financialcapital,etc.).Theauthorwouldcallthisstatistic‘GDP-productivity’.Analternativestatisticwouldbetherateofcurrentproductionofwealthperunitofinput—‘wealth-productivity’.‘Wealth’includesGDP,butitalsoincludesthemonetaryvalueoffinancialassets,realestate,andotherproperty.The

themonetaryvalueoffinancialassets,realestate,andotherproperty.Thesocially-agreedvalueofthelattergroup,asdiscussedabove,isaffectedbytheflowofeffectivemoney(mxv),expectationsofthefutureaswellasassessmentsofthepresent,theinfluenceofnoisetradersversusinformationtraders,andotherinvisibleconditions.Tothebusinessperson,wealth-productivityispursuedthroughmaximizationofshareholdervalue,whereasGDP-productivityispursuedthroughmaximizationofnetincome.Economicmodelstypicallyfocusonnet-incomeprocessesratherthanshareholdervalueprocesses,althoughthelatterisusuallymoreimportanttotheownersandoperatorsofcorporations.

The(1973-)informationindustrieshavenotyetsignificantlyincreasedGDP-productivity,asnotedbyModelskiandThompson,buttheseindustrieshavenoticeablysupportedanincreaseinwealth-productivity.Financialoperators,usingthesenewinformation-technologies,andtakingadvantageofnewopportunitiesinderegulatedfinancialmarkets,haveincreasedthemonetaryvalueoffinancialassets,realestate,andotherproperty.Innovationhasreducedthetransactionscostsofcreatingandtransferringmoney,andinnovationhasreducedthetransactionscostsofowningandhandlingproperty.Thesereducedowningandmanagingcostsofpropertygivenewfoundvaluetotheproperty,whichisreflectedinhigherprices.Peoplehavebeenmoreabletoenjoyanetbenefitfrompropertyownership;thus,increaseddemandforexistingpropertyhasincreasedpropertypricesandrecognizedvalues.ThisprocesshasoccurredmostlyindependentlyofwhatcanbeobservedinGDPmarkets;insteadweobservehighstockandrealestateprices,higherpricesforbondsandthereforelowerinterestrates,etc.

Thus,the(1973-)informationindustrieshavealreadyhadthefollowingeconomicimpact:non-inflationarygrowthofGDPhasbeenpossibleconsistentwithhistoricaltrends,whilesocially-recognizedwealthandpurchasingpoweraccumulatesfasterthaneverbeforeinfinancialmarkets.Thiseffecthasbeenpossibleevenifitisassumed(increasinglyincorrectly)thatthe(1973-)informationindustrieshaveyettoimprovethe‘good-old’physicalproductivityofpeopletobringforwardtangiblegoodswithinthe

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household,office,andfactory.Ofcourse,expectationsofgood-oldGDP-productivitygainsthatwillberealizedfromthe(1973-)informationindustries

productivitygainsthatwillberealizedfromthe(1973-)informationindustriesalsoaddstocurrentwealth-productivity.

Todate,theentrepreneursandinnovatorsofthenewinformation-agecapitalismcanprimarilybeobservedrealizingthefruitsoftheirlaborsinfinancialmarkets,withstockoptions,arbitragetradingprofits,globalmoneyandcreditoperations,etc.Thoseanalystswholookonlyatthe‘good-old’household,officeandfactory,andclaimthat‘thenewtechnologyisoverrated,’mightbeunawareofthisimportantarenawithinwhichcapitalismreinventsitself,andwithinwhichcapitalistsmaintaintheirabilitytoaccumulatewealth.Globally,financialfirms'information-technologyspendingisestimatedtogrowfromalmost$100billionin1995toover$130billionin2000toalmost$200billionin2005.7

Wealth-creationascapturedinfinancialmarketsisnow,inturn,supportingGDP-productivity.Becausethecostofobtainingfinancinghasdropped,whetherfromloansorparticipatingowners,andbecausethepriceoflandandotherrealpropertyhasincreased,thereisanincreasedincentivetodeveloppropertyforthemarket.Someofthewealththathasrecentlyaccumulatedinfinancialmarketsisspentforthesepurposes,andan‘industriousrevolution’occursasresourcesaremorefullyexploitedandmoreintenselyusedforfurtherinnovation—businessinvestmentincreases.Also,accumulatedwealthallowsconsumptionspendingtoexpand.Forexample,massivewealth-productivityfrominformationindustriesrealizeditselfinthemid-to-late-1990sintheUS;theUSstockmarketsboomed,householdsavingsoutofcurrentincomedroppedclosetozeroastheextrawealthsupportedconsumption;unemploymentdroppedtorecordlowsandeconomicgrowthcontinuedbeyondallconsensusforecasts.Governmenttaxrevenuescollectedfromeconomicactivityexceededexpectationsandin1998theUSFederalBudgetmovedintosurplus.InflationinGDPmarketsdidnotincrease.

Whilecreatingthe‘oneworldfinancialmarket’andforcinginterest-rateandfinancial-strategyparities(Chapter1)acrossinternationalmarkets,deregulated,globalized,moreinnovativefinancialinstitutionshaveallowedamassivecreationandtransferofeffectivemoney,andamassiverevaluationofwealthbetweencountriesandindividuals.Therehavebeenwinnersandlosers,buttheneteffectofthese‘papertigers’(MaoTseTung'sphrase)has,todate,beenpositive—positiveasperthesocially-agreedvalueofoutstandingwealth.

Forexample,after1983thevolumeofinternationallendingincreasedfasterthananytimeinhistory,andaverageinterestratesintheglobaleconomywerecutin

anytimeinhistory,andaverageinterestratesintheglobaleconomywerecutinhalf—primarilybecauselow-interest-rateJapaneseyen-basedlendingwasallowedtoincreasefrom3percentto10percentofthetotal,andlow-interest-rateGermanmark-basedlendingwasallowedtoincreasefrom5to10percentofthetotal.JapaneseandGermanfinancial

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institutionsprofitablyexpandedastheirnewglobalcustomersbenefitedfromlowerinterestratesandlowertransactionscosts.ManyUSlendinginstitutionswereinitiallyoutcompeted,butimprovedefficiencieseventuallyallowedtheUSinstitutionstomaintaintheirglobalsharedespitelowerinterestratesandinterest-rate-spreads.Also,thefalloftheJapanesestockmarketafter1989,andtheriseoftheUSstockmarketwasanecessaryconvergencetowardglobalprice-earningsparityofapproximatelytwentytoone—equityownershipwealthwastransferredfromJapantotheUSandtherewasanetincreaseintotalvaluation.

ToholdersoftangibleandintangibleassetsintheUSorJapan,mostlyoblivioustothe‘whyandwherefore’ofthisprocess,hugechangesinwealthoccurred.WealthheldinJapan,whethermeasuredinyenordollars,hasbeencutinhalfsince1989,whilewealthheldintheUShasmorethantripled.Injusttwoyears,from1996to1998thevalueofallUSstockmarketsdoubledfrom$6trillionto$12trillion.USstockmarketsaccountforapproximatelyone-thirdofthe‘marketvalueoftheUS,’andtheothercomponentsofUSwealth,whicharelesstransferableinthefinancialsectorandlesssubjecttorevaluation,havenotappreciatedsofast.

DespiteJapan'scontinuingrecessionandfinancialcrisis,Japan'slossesthatcanbeattributedtofinancialinnovationandglobalizationhavebeenmuchsmallerthanUSgains—thusanetgaintotheglobaleconomyfromthelaborsoffinancialoperatorsinvolvedwiththesetwolargesteconomies.The(1973-)informationindustries,togetherwithfinancialindustries,haveincreasedwealth-productivity.Theprofitfromtheseinnovations,orwhatKarlMarxwouldcallthelaborsurplus,hasinitiallybeenappropriatednotonlybytheinformationandfinancialindustries,butalsobytheholdersoffinancialassets.BillGatesbecamewealthywithMicrosoft,andsodid(theother)holdersofUSstocks.Theformerisnowentitledtoapproximately$40billioninpurchasingpower,andthelatter,$12trillion,andbothshouldthankfinancialoperatorsaswellasinformation-

$12trillion,andbothshouldthankfinancialoperatorsaswellasinformation-industryoperatorswholaborinthenewglobaleconomy.

Theserecentcasestudiesaresomewhatanecdotal.Therefore,inChapter5,‘anewpoliticaleconomyofmoney’isexplainedwherebythehard-currency-accumulatingcountrycanincreaseitswealthattheexpenseofcapital-exportingcountriesattheperiphery—aprocessof‘money-mercantilism’.Furtherdefinitionsof‘wealth’and‘capital’areprovided,sothatthe‘sourceofvalue’intheeconomicsystemcanbemorethoroughlyidentified.

VI.POLICYIMPLICATIONS

ThestructuralchangesdiscussedinSectionsI-Vhaveprofoundpolicyimplications.Aslongasnew,profitableopportunitiesariseinfinancial

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marketsduetoadvancingtechnology,deregulation,andinternationalization,andaslongasareasonabledegreeofconfidenceinthemarketsismaintained,moneysuppliescanbeincreasedfasterthanhistoricalrateswithoutoverstimulatingthemarketsformerchandiseandservices.Financialmarketsabsorbtheabove-normalliquidityandaddextravaluetohousehold,business,andgovernmentassets.Assumingthatthisextrawealthisusedtobuyforeigngoodsorthatitisusedsparinglytobuydomesticgoods,thefinancialsideoftheeconomyexperiencesasustainable,profit-justifiedinflationwithoutthenecessityofGDPinflation.Theauthorwouldcallthisphenomenonthe‘goldenegg’.Similarly,failureoffinancialinstitutionstosupportthecirculationofeffectivemoney(mxv)can,unnecessarily,destroymonetarywealthandcauserecessions—thegoldeneggcanbe‘dropped’.

Asdiscussednext,theUSinthemid-1980sandJapaninthelate1980shadthegoldenegg,butbothcountriesdroppedit.TheUS‘pickeditup’quicklyandstillhasit,butJapandidnotpickitupandhasconsequently‘lostit’.

In1986,theUSFederalReservewassubstantiallymoreaccommodatingthaninpreviousyearsandallowedthe(m1),(m2),and(m3)measuresoftheUSmoneysupply(m)togrowby15percent,9percent,and9percent,respectively.YettheGDPpricelevel(p),andrealGDP(q)eachincreasedbyhistoricallylowrates

GDPpricelevel(p),andrealGDP(q)eachincreasedbyhistoricallylowratescloseto2percent.Asperthequantityequation,(mxv=pxq),andwhether(m1),(m2),or(m3)isusedasthemeasureof(m),therewasasignificantdeclinein(v)duetothestructuralchanges.

InsteadofstimulatingGDPmarkets,theextramoneysupplywasusedtoincreasethepricesandturnovervolumesoffinancialassets.Interestratesdroppedasbondpricesincreased,andas1987arrived,stockpricessoared.Also,baseduponfinancialstrategyparities(Chapter1)price-earningsratiosforUSstockswereclimbingtowardinternationalaveragesintheglobalizingmarkets—someoftheextramoneysupplywasprofitablyabsorbedforthispurpose.Inanunprecedenteddisplayofhowfastmoneycouldbeabsorbedintofinancialmarkets,UShouseholdwealthlockedupintheUSstockmarketincreasedbymorethan$250billioninJanuaryalone.

AsarguedinChapter2,itwaslargelythewealtheffectoflowinterestratesandfinancialassetinflationthataccountedforthehistoricallylowUSsavingsrateof3to4percentinthisperiod.ConsumersspentalargershareoftheircurrentincomeonmerchandiseandservicesthanatanytimesinceWorldWarII,withoutwhichtherewouldnothavebeeneventhemoderate2percentgrowthrateofrealGDP.

Thenin1987USmonetarypolicychangeddramatiscally.Armedwiththequantityequation,stillbelievinginastablevaluefor(v),andthusunawareofthemostlypositiveeffectsoffastermoneygrowth,theFederalReserve,asadvisedbymanyinfluentialeconomists,begantighteningthereins.Whethermeasuredby(m1),(m2),or(m3),theannualgrowthrateoftheUSmoneysupplydeclinedbyapproximately4percentagepointsinthefirstfivemonthsof1987,comparedtoitsgrowthratein1986.Andthereinsweretightened

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further.Theannualgrowthrateof(m1),whichhadbeenreducedto11percentinthefirstfivemonthsof1987,droppedto3.0percentgrowthinJune,5.3percentcontractioninJuly,2.1percentgrowthinAugust,and3.9percentgrowthinSeptember.

TheFederalReservewasreactingtoarisingfearthatGDPinflationwasjustaroundthecomer,andthatthedollarwouldfallprecipitously,thuscausing

aroundthecomer,andthatthedollarwouldfallprecipitously,thuscausingcapitalflightoutoftheUScurrency,furtherdeclinesinitsvalueandtheerosionofinvestorconfidence.Contractionarymonetarypolicywasimplementedtofendofftheserisks,anditwasfelttobejustifiedbecausetheprobabilityofarecessionwithinthenearfuturewasslim.

InfluentialeconomistshadactuallybeenwarningtheFedofimpendinginflationeversinceanexpansionarymonetarypolicywasstartedintheUSlatein1982.Insteadofinterpretingthecollapseinvelocityasastructuralshiftaspertheauthor'sequationsintheAppendix,theyemphasizedasperFriedman(1988)that‘velocityfellbecausewewereinaperiodofdisinflationandfallinginterestrates’.ButasemphasizedbynationallysyndicatedcolumnistWarrenT.Brooks:‘EveryJanuarysince1983,[thesesame]economistshavebeenwarningthatsoaringinflationwouldonceagainrearitsuglyhead.Andeveryyeartheyhavebeendeadwrong’.8

Forexample,on16January1986,Carnegie-MellonProfessorAllenMeltzer,oneoftheleadingmonetaryeconomistsandchairmanoftheprestigiousShadowOpenMarketCommitteewhichmonitorsUSFederalReserveBankpoliciessaidthat‘wewillsee8percentinflationbythefourthquarterof1986’.9Instead,inflationroseonly0.7percentinthefourthquarterandlessthan2percentfortheyear.Citingthethen-current13–16percentannualizedrateofgrowthinthe(m1)moneysupplyasakeyfactorinhisforecast,ProfessorMeltzerobviouslydidnotforeseethe8percentdropinthe(m1)velocityofmoneythatwouldoccurin1986.

QuotedinJuly,1985whentheUSinflationratewasover3percent,MiltonFriedmanpredictedthatinflationis‘morelikelytogoupthandown.Ithinkinflationwillbehigherthanitistoday—considerablyhigher.Isuspectthattheratewillreach8–9percentin1987or1988—butIhavenoconfidenceinthatforecast’.10Actually,inflationwaslessthan2percentin1986andlessthan5percentin1987.

WritinginFebruary1986,WalterHeller,formerchairmanoftheCouncilofEconomicAdvisorsunderPresidentsKennedyandJohnsonagreedwiththeReaganadministrationsforecastthatrealGDPwouldgrowby4percentfromthefourthquarterof1985tothefourthquarterof1986.Theactualincreasewas2.0percent.Helleralsopredictedthatinflationwod‘chugalongatabouta3.5percentratefor1986’,whicheventuallycomparedwiththeactualincreaseof

lessthan2percent.11

Andthe‘dynamicmathematicalmodel’developedbythreeeconomistsattheFederalReserveBankitselfin1986,whichusedtheentirefloatingexchangerateandpriceindexhistorysince1973,predicted6–8percent

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inflationbythefourthquarterof1987.12Theactualratewascloseto4percent.

TheFederalReserve'soverly-restrictivemonetarypoliciesin1987duetotheseandotherexaggeratedwarningsofinflationandcapitalflightcausedaverycostlyreversalintheexpansionofUSfinancialmarkets—anexpansionwhichhadbeenoccurringsteadilyinthemid-1980sduetoadvancesininformation-processingtechnology,deregulationandinternationalization,eachofwhichhadgivenparticipantsincreasedabilitytomakeprofitableinvestments.USinterestrateswereallowedtorise2percentin1987despitesluggishrealGDPgrowth.Thesupplyofeffectivemoney(mxv)collapsed—especiallyasdemandedforfinancialmarketparticipation.Thenewfoundprofitabilityandstore-of-wealthwithinfinancialmarketscouldnotbesupportedandinvestorconfidencewaneduntilthestockmarketfinallysoldoffinOctober.Thegoldenegghadbeendropped.

Similarlyrestrictivemonetarypolicyworldwidemadethecrashaglobalphenomenon.Worldstockmarketlosses,whichaddeduptomorethantheentire$900billiondebtoftheThirdWorld,mighthavebeenmostlyavoidedifcentralbankershadcooperativelymaintainedloosermonetarypoliciesinordertoaccommodatethenaturalexpansionofthemoneycenters.Instead,justwheninternationalmonetaryexpansionwasmostneededshortlybeforethecrash,WestGermanyraiseditsinterestratesandpromptedtheconfusedcentralbankerstomaketheirmoveintheoppositedirection—toachievewhatultimatelywasthetrivialandunobtainablegoalofexchangeratestability.

Immediatelyafterthcrash,theUSFederalReservedramaticallyloweredinterestratesandexpandedmoneysupplies,andthemonetarycontractionandwealthdestructionintheUSwassoonreversedbeforedebt-deflationprocessescouldbecomepervasive—theUSpickedupthegoldeneggquicklybeforeitwaslost.‘TheStockMarketCrashof1987’iselaboratedinChapter4.

‘TheStockMarketCrashof1987’iselaboratedinChapter4.

Japan,withitsappreciatingcurrency,non-existentGDPinflation,andmassiveexportationofcapital,wastheoneG7countrythatdidnotpursuerestrictivemonetarypoliciesduringthisperiod.TheaverageannualincreaseinJapan'sdomesticallycontainednarrow-moneysupplyduring1986–88was8percent.Japan'smassivecapitalandmoneyoutflowwasbuyingforeignassets,and‘JapanInc.’wasexpandinglikeaninvestmentbank.Thus,itwastheoneG7countrythatescapedtheworldstockmarketcrashin1987.Japanesestockpricesincreasedby45percentin1987,andthenanother10percentin1988and20percentin1989.Landpricessoaredevenfasterinmanyregions.

Japandidnotdropitsgoldenegguntilthe1989–90period.Worriedabouttheexpansionofdomesticcreditandassetpriceinflationdespitethefactthatmuchofthisincreasedwealthwasusedforforeigninvestment,theJapanesemoneysupplywasrestrictedto2.4percentgrowthin1989and4.4percent

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growthin1990.Domesticcreditwassqueezedsharplywithotherdirectives,andthepriceoflandandequitiescollapsed.Japanesestockpricesdroppedmorethan50percentover1990–91,andrealestatevaluesdeclinedinproportionbutoveramoreextendedperiod.Baseduponfinancialstrategyparities,price-earningsratiosforJapaneserealpropertyneededtodroptowardinternationalaveragesanywayintheglobalizingmarkets(Chapter1),buttherestrictivemonetarypolicyexaggeratedthiscorrection.

Japansoonlostitsfinancialsurplusandthereforeitsmeanstomaintainrecordratesofforeigninvestment.Itsnetoutflowofdirectinvestmentplusportfolioinvestmentplusothercapital(theidentifiedcapitaloutflow)droppedto$22billionin1990fromanannualaverageof$58billionover1986–1989.In1991,temporarily,theJapanesemoneysupplywasonceagainincreasedsignificantly,by9.5percent,andtheidentifiedcapitaloutflowjumpedbackup,to$72billion.However,onbalancemonetarypolicyremainedrestrictivethroughthe1990s(realshort-terminterestratesof4-to-5percent),andJapaneselandandequitypricedeflationspreadtoGDPmarkets.Aneconomy-widerecessionandlargecorporatefailuresaretheresult.Oncethegoldenegghasbeendropped,itisverydifficulttopickup—especially,asdiscussedin‘Japan'sCrisis,1989-’in

difficulttopickup—especially,asdiscussedin‘Japan'sCrisis,1989-’inChapter4,iftheBankofJapancontinuesto‘fightthelastwar[againstinflation]’.

SomeresearchhasconfirmedtheabovescenarioforJapan.InapaperpresentedattheannualconferenceoftheRoyalEconomicSocietyinApril,1993,13RichardWernerofOxfordandtheBankofJapansuggeststhatGDPinflationandfinancialassetinflationcanindeedbeseparatedandlinkedtodifferentusesofmoney.AfterdisaggregatingtheJapanesemoneysupplyperhapsmoresuccessfullythanSpindt's(1985)attemptintheUS,WernerconcludesthatJapan'sassetandlandpriceinflationduetoexpandingmoneysuppliesinthemid-1980sprovidedthemeanstobuyforeignassets.Furthermore,GDPinflationneednotberisked.

Similarly,RobertLaurentattheFederalReserve(1994,1995)hasshownthattheJapanesecrisisofthe1990s,liketheGreatDepressionofthe1930s,canbeexplainedbyoverlyrestrictivemonetarypolicy,andindeed,thedestructionofmoneyandquasi-money.TakingissuewiththeBankofJapan'sviewthatmonetarypolicyhasbeenaccommodative(Inoue,1995),Laurent'sstatisticalanalysisshowsthatlargeloanlossesandsolvencyproblemsforJapanesedepositoriescanbelinkedtoinappropriatelytightmonetarypolicies:

…thefundamentalsimilaritybetweenthesetwoperiods[US1930sandJapan1990s]wastheseverestressexperiencedbymoney-creatingdepositories.Theclosingofinsolventdepositories,theincreasedregulatorypressure,andincreasedcapitalrequirements,allcombinedtoweakenthenormalstimulativeimpactofagivencutinshort-terminterestrates.Achievingthesamegrowthinthebroadmonetaryaggregatesrequiredevensharpercutsinshort-terminterestratesinthese

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circumstances…theexistenceofdepositinsuranceinthemorerecentperiodisthemostimportantdifferencebetweenthemorerecentperiodandthe1930s.Whiledepositinsurancehasnotrescindedthecontractionaryimpactofdepositorystressonbroadmoney,ithascausedtheimpacttomanifestitselfinmuchdifferentwaysthaninthe1930s.Thepresenceofdepositinsuranceintheearly1990salsomakesitclearthatmonetarypolicyinthisperiodcouldcertainlyhaveoffsettheweaknessinbroadmoneygrowth[andthereforethe

certainlyhaveoffsettheweaknessinbroadmoneygrowth[andthereforethecurrentJapaneserecession](Laurent,1994,p.21–2).

InprivatecorrespondencewithLaurent,theauthorrealizedthat‘absorptionof(m1)byfinancialmarketsandthereforeadeclinein(m1)incomevelocity’(theauthor'sresearch),intimesoffinancialdistress,canalsobemeasuredbya‘weaknessinbroadmoneygrowth’(Laurent'sresearch).Namely,expandedsuppliesofhigh-powered(m1)maynotbeabletoserveasabaseforexpandedsuppliesofbroadmoney(m1plusCDs,credit,etc.,andthereforeeconomicgrowth)ifthe(m1)suppliesareinstead‘absorbed’byfinancialinstitutionstoresolvebankruptcies,increasereserves,andmeetothercapitalrequirements.Inthiscase,adeclineinbroadmoneyandGDPwouldcorrespondtoadeclinein(m1)incomevelocityas(m1)isabsorbedby(distressed)financialmarkets.

However,whendepositoriesarewell-capitalizedandprosperous,(m1)andbroadmoneywouldmorelikelygroworshrinktogetherbaseduponmonetarypoliciesandnormalcredit-creation.Hence,iffinancialmarketsabsorbmoney(fornewprofitableIRPandFSPactivities),thenthedeclinein(m1)velocity(whichmeasuresthisabsorption)wouldnotbeaccompaniedbyadeclineinbroadmoney.ThisconclusionisexactlyconsistentwithLaurent'sworkwhenheconcludes(Laurent,1994,p.21)thatbroadmoney‘hasseldom,ifeveroverthelast35years,forecastrealGDPasitdidintheearly1990s(atimeoffinancialdistress)’.Theauthor'sequationsintheAppendixthuscapturetheabsorptionofmoneybyfinancialmarketsandinstitutionsforreasonsbothofdistressandprosperousliberalization,whereasLaurent'sequationscapturemoney-absorptiononlyintimesofdistress.Theauthor'sequationsmightthusguidepolicymakersinallperiodsratherthanjustintimesofdistress.

Werner'sandLaurent'sresearchthussupportstheauthor'sunconventionalarguments.WhatwasgenerallyseenintheliteratureasarecklessandspeculativeexpansionofdomesticcreditinJapanduringthe1980s,anunsustainablebubble,canintheauthor'sviewbeseenasaverysuccessfulformofeconomicimperialism.JapanprintedthemeanstobuyforeignassetsandexpandwealthdomesticallywithoutacceleratingGDPinflation.Ifoverlyrestrictivemonetarypolicieshadnotbeenused,theexpansioncouldlikelyhavecontinuedbutatamoremoderatelevelinproportiontocontinuingbutslowerratesoftechnologicalchange,deregulation,andinternationalopportunities—aspertheauthor'sequations.‘Japan'sCrisis,1989-’iselaboratedinChapter4.

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Theeconomicsliteraturegenerallyexpectsamonetaryexpansionto(a)increaseGDPinflationviathequantityequationand(b)depreciatetheexchangerate.Theexchangeratewoulddepreciatedueto(c)lackofinvestorconfidenceintheinflatingcurrencyandcountryandwithdrawalsofforeigninvestmentand(d)alargertradedeficitgiventhemonetarilyinflated,andthereforelesscompetitiveGDPprices.However,inJapan'scase,justtheoppositeofeachof(a-d)occurredduringthe1980smonetaryexpansionduetothestructurallynewenvironmentformonetarypolicy.Duringthemonetarycontractionperiodsince1989,thesecause-effectrelationshipshavealsobeenpersistentlyviolated.

1.‘Reserve'sPolicyDriftsAsItsOfficialsHeedDifferentIndicators’,TheWallStreetJournal,22April1988,p.1.

2.Theauthor'sresearchcorroboratestheworkofothers,that‘since(m1)comescloserthan(m2)toapproximatingamedium-of-exchangeconceptofmoney,thereisreasontoexpectthatthedemandfor(m1)wouldbeaffectedmorebythevolumeoftransactionsthanthedemandfor(m2),andthathasturnedouttobethecase’(Friedman,1988).

3.Muchofthetheoryandstatisticalanalysisofthischapteriselaboratedintheauthor's1989publication(Allen,1989).

4.FriedmanconsideredtheDowJonesstockmarketindex,anarroweraggregatebutofcoursehighlycorrelated.

5.‘StakesHighforBritain'sFinancialFirmsinFreerMarkets’,TheNewYorkTimes,6October1986,p.34.

6.‘London'sExchangeBracesforBigBangSettoOccurMonday’,TheWallStreetJournal,24October241986,p.1.

7.‘ASurveyofTechnologyinFinance’,TheEconomist,26October1996,insertp.3.

8.Ironically,thearticleisentitled:‘ThisYear,TheyMayBeRightAboutInflation’,byWarrenT.Brooks,SanFranciscoChronicle,27January1987,p.32.

9.Brooks,WarrenT.(1986),‘WhyThereisNoSignificantInflationinSight’,SanFranciscoChronicle,2December.

10.Friedman,Milton(1985),‘IsHyperinflationInevitable?’,TheCommonwealth,8July1985,p.1.

11.Heller,Walter(1986),‘YeartoReachforEconomicStars’,TheWallStreetJournal,28February1986.

12.Brooks,WarrenT.(1987),‘ThisYear,TheyMayBeRightAboutInflation’,ibid.

13.‘TowardsaQuantityTheoremofDisaggregatedCreditandInternationalCapitalFlowswithEvidencefromJapan’.

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APPENDIXREGRESSIONSOFUS(m1)INCOMEVELOCITYANDRELATEDVARIABLES

QuarterlyData,1982:Q1-1998:Q2

(EquationA):(r)= (9.42)-(3.41×10-7)×(NEWFMK)+ (2.36)×(D96Q1)t-stat: (20.66)(-7.35) (3.29)

One-PeriodMovingAverage:MA(1)coefficient=0.76,t-stat=10.08Adj.R2:0.81

Durbin-Watsonstatistic:1.20

(EquationB):(v)= (6.78)-(3.67×10-8)×(NEWFMK)+ (1.20)×(D96Q1)t-stat: (61.73)(-3.23) (6.71)

MA(1)coefficient=0.70,t-stat=7.34Adj.R2:0.78

(EquationC):(v)= (6.14)-(2.22×10-7)×(NEWFMK)+ (0.090)×(r)t-stat: (10.78)(-0.34) (2.25)

(EquationD):(v)= (6.15)-(0.127×10-2)×(NYSE)+ (0.093)×(r)t-stat: (7.98)(-0.25) (2.45)

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(EquationE):(v)= (6.91)-(5.68×10-8)×(NEWFMK)t-stat: (77.1)(-5.91)

(EquationF):(v)= (3.94)-(5.03×10-8)×(NEWFMK)+ (0.062)×(r)t-stat: (4.85)(-2.45) (2.17)

+(0.028)×(INF)+(0-00136)×(q)

t-stat:

t-stat: (1.28)(2.45)

(EquationG):(v)= (3.23)-(5.63×10-8)×(NEWFMK)+ (0.077)×(INF)t-stat: (4.24)(-4.73) (6.16)

+(0.0189)x(q)t-stat: (4.08)

(EquationH):(v)= (1.54)-(6.95×10-8)×(NEWFMK)+ (0.069)×(INF)t-stat: (2.22)(-6.70) (5.19)

+(0.0030)×(q)+(0.48)×(D96Q1)t-stat: (7.48)(3.33)

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4.FinancialCrisesandRecession

Baseduponthestructuralchangesandcause-effectmaterialofChapters1,2and3,thischapterpresentscasestudiesofthe1982worldrecession,the1987worldstockmarketcrash,the1980sandcontinuingworlddebtcrises,theslumpsoftheearly1990s,the1994–95Mexicancrisis,theJapanesecrisisafter1989,andthecrisesinvariousAsiancountriesbeginningin1997.Variouscommonpatternsarefound,especiallywithregardtotheincreasedinternationaltransfersofinvestmentbaseduponinterestrateandfinancialstrategyparities(Chapter1),thesubsequentadjustmentsininternationaltrade(Chapter2),thedeclineandincreasedvariabilityofmonetaryvelocity,andthecreation,loss,andtransferofmonetarywealth(Chapter3).

I.COMMONPATTERNS

Recentepisodesoffinancialcrisesandrecessionintheglobaleconomyhavecommonpatterns.Inmostcases,acountryorregioninitiallybenefitsfromexpandedsuppliesofbasemoney,new‘quasi-moneys’whicharecreatedfrombasemoneys,andcreditsupplies—afinancialliberalizationphase.Thefinancialsectorexpandsasitcapturesprofitfromnewefficienciesandopportunitiesallowedbyglobalization.Thecountryorregion,foratime,maybefavoredbyinternationalinvestors;thusthebankingsystem,includinggovernment,iswell-capitalizedandabletoexpandmoney-liquidity.Assetsincreaseinmonetaryvalueandinterestratesarelow,andthiswealtheffectencouragesconsumption,borrowing,businessinvestment,andperhapsgovernmentspending.Productiveresourcesaremorefullyutilizedandeconomicgrowthiswellsupported.Thereisa‘boom’,asmeasuredbyincreased(a)monetarywealthheldbyprivateandpublicsectorsofaneconomy,suchasthevalueofstocks,realestate,currencyreserves,etc.,and/or(b)currentproductionofmerchandiseandservices(GDP).

Then,typically,thesupplyofbasemoney(m)timesitsrateofcirculationorvelocityforGDPpurposes(v)contracts,andsothereforedoestheequivalentnominalGDP.ThedeclineinnominalGDPisusuallysplitbetweenitstwocomponents,realGDPwhichisthevolumeofcurrentproductionmeasuredinconstantprices(q),andtheGDPpricelevel(p).Bydefinition,thequantityequationrequires(mxv=pxq).When(q)declines

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forasustainedperiod(typicallyatleastsixmonths)wecallitarecession,andwhen(p)declineswecallitdeflation.Afterthisprocessstarts,monetarypolicymakersmayreactbyrapidlyexpanding(in),butthisactionmaybetoolittletoolate—individualsandinstitutionsmayhaveunpayabledebts,banksmayevenbefailing,andinternationalconfidenceinthecountryorregionmayalreadybedamaged.Inthispessimisticcase,whichistypicalinless-developedcountrieswithweakfinancialsystems,thedesperateincreasein(m)mayreversetheslidein(p)andevenleadtohyper-inflation(destabilizing,rapidincreasesinp),but(q)wouldcontinuetofall.Aweakfinancialsystemmaybeunabletomaintainthecirculationrateofsecurecurrenciesforproductiveactivities,especiallyifpeoplearehoardingmoney,andthus(v)woulddecline.

Theinitialcontractionin‘effectivemoney’(mxv)maybecausedbymonetaryauthoritiesornationalandinternationalinvestorsdrainingmoney(in)fromthecountryorregion,ortheremaybeadeclinein(v)forreasonshavingtodowiththeinabilityofthefinancialsystemtodirectmoneytowardproductiveactivities.Acontractionineffectivemoneysuppliesorwithdrawalofinternationalinvestmentmayundermineequitymarkets,debtmarkets,bankcapital,orgovernmentreserves,andmonetarywealthisthenrevalueddownwards.Generaleconomicorpoliticaluncertaintyworsensthesituation—theresultingausterity-mentalitycausesacontractionofspendingandcredit,andanincreased‘riskpremium’attachedtobusinessactivityscaresawayinvestment.Interestratesrise,thedemandforquasi-moneyandcredit—i.e.thedesiretoholdandusetheinsecure‘monetaryfloat’—declinesandpeopletrytoconvertthemonetaryfloatintomoresecurebasemoneysuchascash.Noreserve-currencybankingsystemisabletocoverallofitsmonetaryfloatwithsecurebankreservesifcustomerstrytoredeemallofthefloatatonce,andthus‘runs’onbankscandestroythebanksthemselves.

Adeterioratingbankingsectormaybeunabletohonoritsdeposits,badloanproblemssurfaceanda‘lenderoflastresort’suchastheInternationalMonetaryFund(IMF)mayneedtobefound.TheIMFconcludesthatapproximatelythree-quartersofitsmorethan180membercountriesencountered‘significant’bankingsectorproblemsofthistypeduringtheperiodfrom1980to1995;oftheseapproximatelyone-thirdwarrantthedefinition‘crisis’(Lindgrenetal.,1995).

1995).

Moregenerally,thesetypesofepisodescanbecalled:(a)afinancialcrisisifthereisasignificantdeclineinmonetarywealthheldbyprivateandpublicsectors,and/or(b)arecessionifthereisasignificantdeclineinrealGDP.Variationsonthesedefinitionscanbefoundintheeconomicsliterature.ExcellentreferenceworksonthehistoryandnatureofeconomiccrisesincludeManias,Panics,andCrashes:AHistoryofFinancialCrises(Kindleberger,1989),TheRiskofEconomicCrisis(MartinFeldstein,ed.,1991),andMarx'sTheoryofCrisis(Clarke,1994).

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Intheglobaleconomicsystem,thedeclineineffectivebasemoney(mxv)inaperipheralcountryorregionmaybeinitiatedbythefinancialcentersordominantreserve-currencycountries.Thebasemoneyusedintheperiphery,whichbacksitslesssecurequasi-moneysandcreditexpansion,mayevenbethecentralizedglobalreservecurrency—typicallytheUSdollar.Forexample,the1982—worlddebtcrisishitLatinAmericawhentheUSdollarbecamescarce.DollarshadbeenloanedtoLatinAmericainthe1970satnegativerealinterestrates,whichprovidedthehard-currencymonetarybaseforthedramaticexpansionoflocalsoftcurrencyandcredit—LatinAmerica'sfinancialliberalizationandeconomicgrowthphase.Then,becauseofUSmonetaryandfiscalpoliciesintheearly1980s,dollarinterestratessoaredanddollarswerebothpushedandpulledoutofLatinAmericaintoUSdeposits.LatinAmericalostthedollarreserveswhichwerenecessarytopaydollar-denominateddebts;thusLatinAmericalostitsinternationallyrecognized‘sourceofvalue’whichcouldmaintainthe‘redemptionvalue’oflocalquasi-moneys.Policymakersdesperatelyincreaseddomesticcurrencysuppliestryingtoreversethisprocess.Confidenceinpesos,cruzados,andothersoftcurrencieswaslost,andtheydepreciatedrapidly,i.e.inflation(p)surgedevenfasterthanthegrowthin(m);thereforetherealmoneysupply(m/p)declined;andadeclineinrealGDP(q)followed.Fromthequantityequation,(m/p=q/v),and(v)declinedinmanycasesduetobankingproblems;therefore(q)hadtodecline.The1980sbecameknownas‘thelostdecade’forLatinAmerica.

Thesetypesofcrisesaregenerallymorelikelywhenexcessive,riskyspeculation

andinvestmentisencouragedbythenotionthat‘ifIfail,alenderoflastresortorgovernmentinstitutionwillbailmeout’,i.e.the‘moralhazardproblem’.IntheLatinAmericancaseinthe1980s,manycommerciallendersfeltthat,toacertainextent,theyhadanimplicitguaranteefromtheUSFederalReserveBankandothercentralbankstobailoutanybadcommercialloansthatwouldarisefromlendingtotheless-developedcountries(LDCs).ThefamousquotefromtheChairmanofCitibankwas‘countriesdonotgobroke’.AsimilarmoralhazardproblemwasidentifiedbetweentheUSgovernmentandtheUSsavingsandloaninstitutionsinthe1980s,whichcontributedtothesavingsandloancrisis.DepositinsuranceandotherFederalguaranteesencouragedrecklessuseoffunds,andUStaxpayersultimatelypaid$130billiontoresolvethesavingsandloancrisis.Inthe1990s,shiftingmoreofthebad-debtliabilitytothelenderhasbeenproposedtoreducethemoralhazardproblem,butauthoritiesalsowanttomaintaintheirlender-of-last-resortcapabilityinordertopreventbaddebtproblemsfromspreadingthroughthesystem(seeFederalReserveBankofKansasCity,1997).

Thebankruptcyofacountryorregioncanbesimilartothebankruptcyofabank.Thefailureresultsfromaninsufficientsupplyofhigh-poweredbasemoneyorhigh-qualityliquidcapitaltohonortheredemptionvalueoftheless

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securemonetaryformswhichhavebeencreatedinpyramidfashionfromthesecurebase.PrivategoldsmithbanksintheEuropeanRenaissancefailedwhentheydidnothaveenoughgoldtohonortheirgoldnotes;USthriftsfailedinthe1980swhentheyranoutofharddollarreservestohonorthesoftdollardemanddepositswhichtheyhadcreated;andLatinAmericaneconomiesfailedwhentheirmonetarybaseprovedinsufficienttohonorthemonetary‘float’thathadbeencreatedfromthatbase.

Inthenineteenthandearlytwentiethcenturies,Londonwasthesecurefinancialcenter,andtheUSwasmoreofaperipherythatdependedontheBritishpoundtobackdollar-expansion.AsdocumentedbyMishkin(1991),mostofthefinancialcrisesintheUSduringthisperiodbeganwithamonetary-contractionandariseininterestratesintheLondonmarkets,whichthencausedacontractioninUSmoney-liquidity,asharpriseinUSinterestrates,USbankproblemsandsoon.Incrisisepisodes,themonetarycontractionintheperiphery

problemsandsoon.Incrisisepisodes,themonetarycontractionintheperipheryisusuallymoreseverethaninthecenter,becausetheperipheryusesthelargemonetaryfloatwhichissustainedbythesmallermonetarybaseinthecenter.Furthermore,ifsavingsandmonetarywealthintheperipherycountryaretransferredtothefinancialcentertotakeadvantageofitshigherinterestrates,orforsafe-havenpurposes(typicallywhenthecrisishits),thentheperipheryexperiencesanevengreatercontraction.

SinceWorldWarII,thedollarhasbeenthedominantworldreservecurrency.Thus,recentfinancialcrisesandrecessionaretypicallyinitiatedbydollar-monetary-contractionandincreasesindollarinterestrates.Thenegativeeffectscanbeespeciallysevereattheperipheryoftheglobaleconomyifthecontractionoccurssuddenlyandfollowsamoreliberaldollarizationperiodintheperiphery.Asdiscussedinthischapter,recentcrisesinless-developedcountriesandsmallercountriesespeciallyfollowthispattern.

II.THE1982RECESSIONARYPERIOD

Historically,nationalpoliticalleadershaveenteredofficewithagranddesignfortheeconomicfutureoftheircountry.Significantchangesinmonetaryandfiscalpoliciesmaybemadeinordertofightinflation,unemploymentandotherillsinthenationaleconomy.Inaddition,thenewadministrationgenerallyhasanideologicalslantinthewaythatitregulatesbusinessandlabor.

Intheearly1980s,justastheinternationalfinancialmarketsbegantoexpandrapidlyandcreatethenewglobaleconomy,FrenchPresidentFrançoisMitterrandembarkeduponanexperimentineconomicsocialism.Atthesametime,newlyelectedleadersMargaretThatcherinEnglandandRonaldReaganintheUSwerepursuingconservativepoliciesaimedatrestoringamorecapitalisttradition.Eachoftheseone-countryeconomic

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experimentsfailedtorecognizethenewstructureoftheglobaleconomy,andasaconsequenceeachexperimentcreatedsevereeconomichardshipswithinoneortwoyears.

A.TheUSSituation

TheReaganAdministrationcametoWashingtoninJanuary1981,determinedtostimulatetheUSeconomywitha‘supply-side’policyoflargetaxcuts,andasubstantialincreaseingovernmentdefensespendingwhichwastobemorethanoffsetbyacutingovernmentnon-defensespending.Toreduceinflation,whichwasthen10percent,theFederalReserveBankaccelerateditsrecentlyenactedpolicyofrestrictingthegrowthrateoftheUSmoneysupply.

AsTable4.1shows,theReaganAdministrationwassuccessfulinrestraininggovernmentspendinginitsfirstfewyears.Governmentpurchasesofmerchandiseandservicesasapercentageoftheeconomy'stotal,long-termtrendpurchases,callednaturalgrossdomesticproduct(naturalGDP),declinedfrom18.6percentinthefirstquarterof1981to17.6percentinthesecondquarterof1983.Itwasactuallystateandlocalspendingthataccountedforthisdecline,asfederalspendingremainedapproximatelyconstant—bothareincludedin‘governmentspending’.

InitsfirstfewyearstheReaganadministrationwasalsosuccessfulinreducingtaxrates.Althoughtheadministrationdidnotachieveitsproposed30percentcutintotalpersonalincometaxrates,Congressdidapprovea25percentreduction—a5percentreductionon1October1981andtwosuccessive10percentreductionson1July1982and1July1983.ThefirsttwoofthesethreetaxcutsarereflectedinthefirstcolumnofTable4.1.

Ifeverythingelseexceptthesechangesingovernmenttaxingandspendinghadremainedthesamein1981–82,thentheUSeconomymighthaveexpandedalittlebitfaster.Thecontractionaryeffectofthegovernmentspendingrestraintswouldhavebeenmorethanoffsetbytheexpansionaryeffectofthetaxcuts,particularlyinlate1982asthefirstofthetwo10percenttaxcutsbegantohaveitseffect.However,everythingelsedidnotremainthesame:betweenearlyandlate1981,asshowninTable4.1,theFederalReserveBankreducedthemoneysupplybyapproximately6percentrelativetonaturalGDP.

ThisdramaticreductioninthemoneysupplycutthesupplyofloanablefundsintheUSeconomysomuchsothatinterestratesrosetohistoricallyhighlevels.AsshowninTable4.1,long-terminterestratesincreasedfromanalreadyhighlevelof14.4percentinthefirstquarterof1981tomorethan16percentinlate1981andearly1982.Itwasthesehistoricallyhighinterestratesthattriggeredtherecessionwhichbeganinlate1981andlastedthrough1982.Therecessionwas

recessionwhichbeganinlate1981andlastedthrough1982.TherecessionwascharacterizedbyarapidslowdowninnominalGDP.Theannualgrowthrateofthisstatisticslowedby9.7percent,from

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almost13percentinthethirdquarterof1981tojustover3percentinthefourthquarterof1982.Ofthis9.7percentdecline,slightlymorethanhalfcanbeattributedtoareductionininflationandslightlylessthanhalftoareductioninrealGDP.RealGDP,whichhadbeenincreasingsteadilysince1975atanaverageannualrateof3.5percent,declined2.1percentfrom1981to1982beforerecoveringtoincreaseby3.7percentfrom1982to1983and6.8percentfrom1983to1984.

Table4.1USmonetaryandfiscalpolicyandthe1982recessionYear:quarterRatiopersonaltaxpaymentstopersonalincomeRatiostonaturalGDPGov.spendingFederalbudgetdeficitMoneySupplyActualGDPLing-terminterestrate1981:Q115.918.61.314.497.114.41981:Q216.118.31.314.396.015.21981:Q316.218.31.814.095.816.31981:Q415.818.43.213.793.816.01982:Q115.818.13.313.892.816.11982:Q215.817.73.413.792.415.71982:Q315.418.04.713.691.514.71982:Q415.418.36.113.890.512.21982:Q115.117.85.214.090.412.01982:Q415.417.64.714.191.611.6

Sources:EconomicReportofthePresident(February1983),andSurveyofCurrentBusiness(July1983).

Table4.2showsthecomponentsofrealGDPfrom1981to1984,anditisclearthatthecomponentswhicharehistoricallydiscouragedbyhighinterestratesdeclinedsignificantlyfrom1981to1982:namely,householdpurchasesofdurableproductssuchasautomobiles;non-residentialfixedinvestment(businesspurchasesoffactories,machinesandequipment);residentialinvestment(housingpurchases),andinventoryinvestment(thechangeininventoriesoffinalproductsthatbusinesseskeeponhand).Together,thesepurchasesdeclinedby$37billionfrom1981to1982(1972dollars).Likewise,thesecomponentsofrealGDPexperiencedasignificantrecovery

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from1982to1983andfrom1983to1984asinterestrateschangedcourseanddeclineddramatically,increasingbyannualamountsof$43.7billionand$89.1

declineddramatically,increasingbyannualamountsof$43.7billionand$89.1billion.

GDP 1,515.2 1,480.0 1,543.7 1,639.0Consumption 950.5 963.3 1,009.2 1,062.6Durables 140.9 140.5 157.5 177.9Nondurables 360.8 363.1 376.3 394.2Services 448.8 459.8 475.4 490.6Investment 230.9 194.3 221.0 289.7FixedInv. 219.6 204.7 224.6 265.5ResidentialInv. 175.0 166.9 171.0 205.2Non-residentialInv. 44.5 37.9 53.7. 60.3InventoryInv. 11.3 -10.4 -3.6 24.2Gov.Purchases 287.0 292.7 291.9 302.2NetExports 43.8 29.7 12.6 -15.5Exports 160.2 147.6 139.5 145.8Imports 116.4 118.0 126.9 161.3

Source:EconomicReportofthePresident,1985.

BecauseUStaxrateshadbeenreduceddramaticallyintheearly1980s,andbecausetherecessionreducedeconomicgrowthandthetaxbase,theUSgovernmentcollectedlesstaxes.TheReaganadministrationin1981hadforecastmorebalancedbudgets,butin1982thefederalbudgetshowedadeficitofmorethan$100billion(actualdollars—not1972dollarsasinTable4.2)forthefirsttimeinhistory,andin1983thedeficitexceeded$200billion.USfiscalpolicythusrequiredrecordamountsofgovernmentborrowingtocoverthesedeficits,anditputupwardpressureonUSandworldinterestratesatatimewhenthesewerealreadyhighandtheworldwasstrugglingtoovercometherecession.

Historically,USnetexports,definedasUSexportsminusUSimports,havenotdeclinedsignificantlyduringaperiodofhighUSinterestratesand

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recession.Infact,duringarecession,USresidentsgenerallypurchasefewerimports,andnetexportsmaythereforeincrease.However,asshowninTable4.2,USimportsactuallyincreasedfrom1981to1982.Also,becausetherewasasimultaneousdropinUSexports,USnetexportsfell,by32percent,from1981to1982.AfallinUSnetexportsreducesGDPbecauseitreflectssaleslostbyUSexportingfirmsaswellassaleslostbyUSfirmswhichproduceimport-competingproducts.

WhydidUSimportsriseandUSexportsfallfrom1981to1982andthereforecontributetotherecession?Mostimportantly,becausethehighUSinterestratesandrestrictiveUSmonetarypolicies,atatimewhenfinancialmarketswereglobalizing,causedtheexchangevalueoftheUSdollartoincreaseby30percentagainstmajorforeigncurrenciesoverthesetwoyears.ForeignexchangetraderswereaccommodatingnewdemandforUSdollarsbyderegulatedinternationalinvestorswhowereattractedtothehighUSinterestrates.Baseduponthenewinterestrateparityconditions(Chapter1),the‘netcapitalinflow’intotheUSfromtherestoftheworldbegantoincreaseandthedemandfordollarsexceededthesupply.

The30percentincreaseinthevalueofthedollarover1981and1982causedUSimportstobecheaper,indollars,andUSimportersincreasedtheirtotaldollarpurchases.Similarly,USexportsbecamemoreexpensivetoforeignpurchasers,intermsofforeigncurrency,sofewerUSitemswerepurchasedbyforeignersandthedollarvalueofUSexportsdecreased.ThedeclineinUSexportscanalsobeattributedtoincreasedinternationalcompetitionfromJapanandothernewlydevelopedcountriessuchasSouthKoreaandTaiwan,aswellastoareductioninUSexportstomanylessdevelopedcountriesthatbeganusingmoreoftheirdollarreservestopayofftheirescalatinginternationaldebts.1

HowwelldidtheleadingeconomicforecasterspredictthedeclinesinUSnominalGDP,realGDPandinflation?Table4.3showstheforecasterrorscomputedasthedifferencebetweentheactualdeclinesandthedeclineswhichwerepredictedoneyearinadvance.

ItisclearfromTable4.3thatforecastersweretoooptimisticabouttheUSeconomy.Theypredictedafairlystraightcourse—thegrowthrateofrealGDPoverthis15-monthperiodwaspredictedtodeclinebyonly0.8percentfromthen-currentlevelsratherthantheactualdeclineof3.8percentfromthen-current

then-currentlevelsratherthantheactualdeclineof3.8percentfromthen-currentlevels.Inotherwords,forecasterspredictedthattheeconomywouldproduce3percentmoremerchandiseandservices,$95billionat1982prices,thanactuallywasproduced.Fromaworkers'perspective,thiserrormeansthatapproximatelytwomillionmoreUSjobswerelostthaneconomistspredicted,andexpectedUSwages,salariesandprofitsamountingto$95billionwerenotattained.

Tounderstandwhyforecastersfailedtopredictthe1982USrecessiononeshouldfirstunderstandthateconometricforecastingmodelsgenerallyrequiretwentytothirtyyearsofdatatoidentifytheunderlyingstructureofthe

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economicsystem.Recentstructuralchanges,includingtheincreasedinternationaltransfersofinvestmentbaseduponinterestrateandfinancialstrategyparities(Chapter1),thesubsequentadjustmentsininternationaltrade(Chapter2),andthedeclineofmonetaryvelocityduetoderegulation,internationalization,andtechnologicalchange(Chapter3)werethusonlymarginallyincludedintheforecastingmodels,andthemodelsthereforefailed.

NominalGDP RealGDP Inflation*ActualDecline 9.7 3.8 4.7PredictedDecline 3.3 0.8 1.9ForecastError 6.4 3.0 2.8

*AsmeasuredbytheGDPdeflator.Source:RobertJ.Gordon,Macroeconomics,3rdedn(1984),p.408.ThepredicteddeclineistheaverageofpredictionsmadebyDataResources,Inc.,ChaseEconometricAssociates,Inc.,theMAPCASTgroupattheGeneralElectricCompany,WhartonEconometricForecastingAssociates,Inc.,andthemedianforecastfromasurveyconductedbytheAmericanStatisticalAssociationandtheNationalBureauofEconomicResearch.

First,theincreasinginternationaltransfersofinvestmentallowedtheincreasedUSinterestratestohaveanunexpectedlystrongnegativeimpactonUSnetexportsandthereforeGDPviathetradeeffectdiscussedabove.Thistradeeffect,

exportsandthereforeGDPviathetradeeffectdiscussedabove.Thistradeeffect,wherebyhighinterestratesinacountrycausethatcountry'scurrencytoincreaseinvalue,whichinturnhurtsitsnetexports,wasnotsignificantbefore1971whencurrencyexchangerateswerefixedadministratively.Before1971,nationalcentralbankskeptexchangeratesfixedbybuyingandsellingcurrenciesaswellasredeemingcurrenciesforgoldatacceptedprices.

After1971,whenfixedexchangeratesandthegoldstandardwerenolongermaintainedbytheUSandmanyothercountries,economistshadtobeginincludingthetradeeffectofinterestratechangesintheireconomicmodels.Thetradeeffectwasdifficultforeconomiststoestimatenotonlybecauseoftheirlimitedexperiencewithit,butalsobecauseinterestratechangesaffectedcurrencyvaluesand,therefore,merchandiseandservicestrademorestronglyandunpredictablyeveryyear.

Everyyear,investorshadbetteraccesstoprofitableopportunitiesintheworld'smajormoneycenters,andtherewasanincreasedvolumeofmoney

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thatwas‘washingbackandforth’insearchofthebestinterestrates.Acountrywhich,forexample,raiseditsinterestratesastheUSdidin1981–2thusdiscoveredanincreaseddemandforitscurrencycomparedtohistoricalperiods;thereforeagreaterincreaseinthevalueofitscurrency;andthereforeagreaterreductioninitsnetexports.Econometricmodelswhichmustusedecadesofhistoricaldataunderestimatedthesignificanceofthistradeeffect.

Secondly,deregulation,internationalization,andtechnologicalchangewerebehindtheUSrecessionof1982whenpolicymakersunderestimatedthedegreetowhichthesestructuralchangeswouldproducenewfinancialmarketopportunitiesandabsorbdollarsawayfromthenon-financialmarkets(Chapter3).MoredollarsweresuddenlykeptonhandintheformofcurrencyandcheckingdepositstoaccommodatetheseinvisibletransactionscomparedtothevolumeofdollarsthatwerekeptonhandtoaccommodateGDPtransactions.Bothtypesoftransactionsborrowdollarsforashortperiodoftimeandthenrecyclethembackintotheeconomytobeusedagain.

Thesignificanceofthisdollar-absorptionbyfinancialmarketsbeginningintheearly1980sescapedmostanalysts.Therefore,theydidnotrecognizethefollowingfact:restrictingthesupplyofUScurrencyandcheckingdeposits(m1)atatimewhenincomevelocity(v)wasdroppingbecausemoreofthisspendablemoneywasbeingusedforfinancialtransactionswouldmorethanproportionatelyreducetheamountofmoneywhichwasbeingusedforGDPtransactions.Therefore,baseduponthequantityequation(m1xv=pxq),nominalGDP(pxq)woulddecreasemorethanexpectedfollowingrestrictivemonetarypolicies.ThedeclineinvalueofnominalGDPisusuallysplitbetweenadeclineinthephysicalvolumesofmerchandiseandservicesproduction,i.e.realGDP(q),andadeclineintheGDPpricelevel(p).AsshowninTable4.3,duringthe1982recessionrealGDPdeclinedby3.8percentandtheGDPpricelevelby4.7percent.

Clearly,theforecasterswhopredictedthatUSnominalGDPwoulddeclineby3.3percentfromthethirdquarterof1981tothefourthquarterof1982intheUSduetorestrictivemonetarypoliciesdidnotfullyanticipatewhatwashappeningtothevelocityofmoney.TheactualdeclineinnominalGDPwasasevere9.7percent.‘Forecastersmissedthecollapseofvelocityalmostentirely’(Gordon,1984,p.406).

B.TheUKSituation

TheBritisheconomicexperimentoftheearly1980s,liketheAmericanexperimentjustdiscussed,placedmajoremphasisonreducingthegrowthrateofthemoneysupplyinordertoreduceinflationand,ultimately,interestrates.And,asintheUS,thesegoalswereachieved:between1980and1983inflationhadbeenloweredfrom18percentto3percentandshort-terminterestrateshaddroppedfrom16percentto10percent.However,alsoasintheUS,thesegoalswereachievedatatremendous,unexpectedcosttothe

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economyintermsofunemploymentandlostoutput.During1980,thefirstyearofThatcher'sadministration,thegrowthrateoftheBritisheconomyplungedto-2.0percentandcontinuedtofallthrough1981.In1982,theunemploymentratehadincreasedto12.3percent,thehighestamongthemajorindustrialized

hadincreasedto12.3percent,thehighestamongthemajorindustrializedcountries.

BothThatcherandReaganmadeoverlyoptimisticpromisesofeconomicperformancewhichwerenotachievedduetowidespreadignoranceofjusthowpowerfulrestrictivemonetarypolicyhadbecome.Intheearly1980s,thefinancialsideofthenewglobaleconomybeganabsorbinganunexpectedlylargesupplyofnationalcurrenciesawayfromGDPmarkets.Therefore,GDPmarketswouldhavebeenfacedwithanunexpectedliquiditycrisisevenwithoutgovernmentalmovestotightencredit.Sodestructiveweretheshort-runeffectsoftheUK'smonetaryexperiment,that364universityeconomistsandnearlyalloftheretiredsenioreconomicadvisorstopastBritishgovernmentsissuedanunprecedentedpublicstatementcondemningtheexperiment:

First,thereisnobasisineconomictheoryorsupportingevidencefortheGovernment'sbeliefthatbydeflatingdemand[withrestrictivemonetarypolicy]theywillbringinflationpermanentlyundercontrolandtherebyinduceanautomaticrecoveryinoutputandemployment;Secondly,presentpolicieswilldeepenthedepression,erodetheindustrialbaseofoureconomyandthreatenitssocialandpoliticalstability;Third,thetimehascometorejectmonetaristpoliciesandconsiderurgentlywhichalternativeoffersthebesthopeofsustainedeconomicrecovery.2

FortunatelyfortheBritishpolicymakers,theydidnothighlighttheirignoranceofthenewglobaleconomy,asdidtheReaganeconomists,bysettingspecifictargetsforeconomicperformance.TheBritishpromiseswereforthemostpartonlygeneralizedcommitmentsforchange,buteventhesewerenotattained.Largereductionsincentralgovernmentspendingwerenotrealized,and,asintheUS,therewasultimatelyanincreaseinthecentralgovernment'sshareoftheeconomy—justtheoppositeofwhatbothThatcherandReaganhadpromisedtheirconstituents.Thatcher'sconservativemandatefromthevoterssoonlostsomeofitsmomentum,andinakeypowerstrugglewiththeNationalUnionofMineworkersthegovernmenthalteditsattempttoclosedownoperationsatredundantcoalpits.Industrywasnotfreedfrom‘theshacklesoflaborandgovernment’,instead,largeloansandsubsidiesweregiventoBritishSteel,BritishLeyland,Rolls-Royce,BritishShipbuilders,andBritishAirways.

C.TheFrenchSituation

WhiletheAmericanandBritishmonetaryexperimentswerecombiningwithaustereeconomicpoliciesinWestGermanytocreateaglobalrecessionin

austereeconomicpoliciesinWestGermanytocreateaglobalrecessionin

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theearly1980s,FrançoisMitterrandbeganimplementingpolicieswhichweredesignedtostimulatetheFrencheconomy.Increasedgovernmentspending,asmandatedbyMitterrand'ssocialistrevolution,allowedtheFrencheconomytogrowby1.7percentin1982,ayearwheneconomicgrowthintheUSandWestGermanydeclinedby2.1percentand1.1percent,respectively.OfthemajorindustrialcountriesbesidesFrance,onlyJapanrealizedmoderateeconomicgrowthrateinthisrecessionaryyear.

Insteadofusheringinaperiodofeconomicprosperityorstabilityrelativetoitstradingpartners,France'sattempttobucktherecessionarytrendoftheglobaleconomysoonranintoseriousdifficulties.ThestrongFrencheconomysuckedinmoreimportswhiletheweakereconomiesofothernationspurchasedfewerFrenchproducts.Asaresult,theFrenchtradedeficitalmostdoubled,fromFr50billionin1981toFr92billionin1982.Thisdeteriorationinthetradebalancewasunexpected,largelybecausepolicymakerswereunawareofjusthowmuchtheFrencheconomyhadbecomeintegratedintothenewglobaleconomy.

TheballooningFrenchtradedeficitsoonmeantalossofinternationalinvestorconfidenceintheFrenchfrancandlowlevelsofinvestmentinFrenchmanufacturingfirms.Ultimatelyprofitlevelsdeclinedandjobswerelost.Inmid-1982,Mitterrandwasforcedtoabandonhisstimulativeeconomicpolicies,andinsteadadoptthe‘mostdeflationarypostwarausteritypackage’.3Governmentspendingwascutandtaxeswereraisedtoreducethegrowinggovernmentbudgetdeficit.Frenchtravelerswereallowedonly$275peryearofforeigntravelexpenditures,andtheforeignuseofcreditcardswasbanned.Publicutilityrateswereraisedby8percent,andthemoneysupplywastightenedasintheUSandGreatBritain.ThesereformspromptedAndreBergeron,headofthemoderateForceOuvrièrelaboruniontoannounce:‘todaywehavehadacoldshower,andIassureyouthatourmilitantsandmemberswillnotacceptit’.4

TheFrenchausterityprogramsbegantohavetheirdesiredeffect,inthattheycutthetradedeficitinhalf,fromFr92billionin1982toFr44billionin1983.TheFrenchfrancfinallystabilizedagainsttheUSdollarandtheGermanmark,butataverylowrate.However,thegrowthoftheFrencheconomyslowedtozeroin

averylowrate.However,thegrowthoftheFrencheconomyslowedtozeroin1983,andMitterrand'sratinginthepublic-opinionpollssanktoalowof30–35percentbylate1983.OppositionpartiesbeganwinningmorelocalelectionsandseatsintheFrenchsenate,andMitterrand'smainopponent,JacquesChirac,substantiallyincreasedhispoliticalinfluence.

By1986,ChirachadbeenelectedPrimeMinister,andhiscenter-rightcoalitionbeganremoldingtheeconomysomewhatinAmerica'sfree-marketimage.Anunexpectedlypopular$40billionsell-offofgovernmentcorporationstotheprivatesectorseemedtomarktheendofthesocialistrevolution,arevolutionwhichmighthavecontinuedthroughthelate1980sandspreadelsewhereifMitterrandhadnotmadehisearlymistakes.

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France'sfailedattempttoactindependentlyofthenewglobaleconomyweakeneditsalliancewithothermembersoftheEuropeanCommunity(EC),whothoughtthatFrancehadmoreofacommitmenttostabilityandmoderation.AsamemberoftheEuropeanMonetarySystem(EMS),FrancewasexpectedtokeepthevalueofitscurrencystableinrelationtootherEMScurrencies,especiallytheGermanmark.However,whenthefrancbegandevaluingintheearly1980s,FrancedidnotimmediatelytakecorrectiveactionwithdomesticmonetaryandfiscalpoliciesassuggestedbytheEC.Instead,Franceattemptedtomaintainitsone-countryeconomicexperiment,whichmeantblamingsomeofthecurrencyproblemontheGermansandthreateningtopulloutoftheEMS.TheintegrityoftheEMSwasnotrestoreduntilthemid-1980swhenMitterrand'ssocialistrevolutionbecamemoremoderateand‘middle-of-the-road’.

Intheearly1980s,Mitterrand'ssocialistrevolutionhadhelpedtodefinethe‘left-wing’ofthepolitical-economicspectrumwithinthedevelopedwesternworld.Atthesametime,Reagan'sandThatcher'scapitalistrevolutionshadhelpedtodefinethe‘right-wing’ofelectablepolitical-economicphilosophies.Butasthedecadeprogressed,themoreferventideologicaldogmafadedfromeachoftheserevolutions;insteadmoregloballypragmaticpoliticsprevailed.Theserevolutionsfailedtomaintaintheiroriginal,moreextreme,‘grandstanding’formsbecausetheseformsrequiredmonetaryandfiscalpolicieswhichwerenotsufficientlycompatiblewithaverageglobaltrends.

Thenewglobaleconomymaythushavenarrowedthepolitical-economicspectrumofworkableideologieswithinthedevelopedwesternworld.Ithasbecomelesspracticalforthesemajortradingnationstopursuesignificantlydifferentmonetaryandfiscalpolicies,andthereforeithasbecomelesspracticalforthemtoadoptsignificantlydifferentmonetaryandfiscalphilosophies.Wheresignificantlydifferentpolitical-economicideologiesstillexist,theyareinsteadbasedmorenarrowlyupondifferenttypesofbusiness-laborrelations,buteventhesecontrastsarebecominglesscommonduetotheinternationalizationofcorporations.AsdiscussedinChapter2,theincreasednumberofinternationaljointbusinessventuresandoverseasproductionactivities,aswellastheincreasedinternationalownershipofoncenationalcorporations,isexposingbusinessandlaboreverywheretoamoreglobalblendofregulationsandincentives.

III.THESTOCKMARKETCRASHOF1987

AsdocumentedinChapter3,deregulation,internationalization,andtechnologicalchangecreatedthefollowingtrendwhichbeganintheearly1980s:moremoney-liquidityhasbeenrequiredbytheUS,UK,andother

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economiesinordertosupportthesimultaneousgrowthofnominalGDPandthenewfinancialmarkets.Howmuchmoremoney-liquidityhasbeenrequired?Despitetheresearchoftheauthorandothers,thefinancialsideofthenewglobaleconomyhasexpandedtoorapidlyandunpredictablycomparedtoGDPtoallowforanaccurateestimateasyet.

Forexample,inanunprecedenteddemonstrationofhowfastmoneycanbechanneledintothefinancialmarkets,somuchmoneyflowedintotheUSstockmarketsinJanuary,1987thatUShouseholdwealthlockedupinthesefinancialinvestmentsincreasedbymorethan$250billioninjustthisonemonth.5Then,whentheUSstockmarketcrashed22.6percenton19October1987,$500billionwaslostinoneday.

Asanotherexample,commerciallendingbyforeignbanks,whichcaptured9percentoftheUSmarketinthelate1970s,increaseditsshareto16percentby

themid-1980s.6ThisforeignlendinghasaddedtothevolumeofUSfinancialtransactions,and,becauseitcanquicklymoveinandoutoftheUSmoneysupply,itisverydifficulttoquantifyitseffectontheeconomy.ThesamethingcanbesaidaboutforeignlendingtotheUSgovernment,i.e.foreignpurchasesofUSgovernmentsecurities,whichtotaled$14.3billioninjustthefirstsixmonthsof1986,comparedto$10billioninallof1980.7

InternationalfinancialtransactionsdenominatedinUSdollarsexpandedtothepointwheredollarholdingsbyforeigninvestorsreached$1trillionby1990,approximately20percentoftheexpectednominalGDPforthatyear.PredictinghowtheseholdingswillbeusedintheUSeconomyinthefutureisverydifficult.

SimilarlyintheUK,the1986BigBangderegulationperiodalloweddramaticincreasesinboththeprofitabilityandturnoveroffinancialmarkets.AsshowninFigure3.3,UKfinancialmarketturnoverdoubledfrom1985to1986andthendoubledagainfrom1986to1987.

Asthevelocityofmoneycontinueditsdeclineinthemid-1980s,mostnotablyintheUSandUKbutalsoinotherglobalizingfinancialcenters(Figure3.1),expansionarymonetarypoliciespursuedbythemajorindustrial,nationshadonlyweakpositiveeffectsonnominalGDPcomparedwithhistoricalperiods.Moreoftheexpandingmoneywasabsorbedbythenew,moreinternationalfinancialmarketsandlesswasusedbypeopletoboosttheirpurchasesofmerchandiseandservices.Despitethemistakesofforecastersin1981–82,thisnewstructuralenvironmentformonetarypolicywasnotyetfullyunderstood.Forexample,scoresofarticlesappearedinreactiontotheexpansionarymonetarypolicythatwasstartedintheUSinlate1982,eachexpressingconfusionattheminimalresultingincreasesinrealGDPandinflation(p.92).

Analystscanhardlybechastisedfortheirconfusion,becausethestructuralenvironmentformonetarypolicychangedveryfastinthe1980s.Econometricforecastingmodelswhichmustusedecadesofdatacannotbeexpectedtofullyincorporatethesestructuralchanges.Also,direct

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measurementoftheshareof(m1)whichisabsorbedintheturnoveroffinancial

measurementoftheshareof(m1)whichisabsorbedintheturnoveroffinancialtransactionsandsimultaneouslyunavailablefornon-financial,GDPtransactionsisnexttoimpossible,despitethewell-respectedworkofSpindt(1985)andothers.Forexample,howdoweknowthedegreetowhichpeopleseetheirnegotiableorderofwithdrawal(NOW)accountsasinterest-earninginvestmentsratherthanascheckingaccountsformonthlyshoppingrequirements?

Theseresultsofthe1980s,restrictivemonetarypolicymorepowerfullyreducingnominalGDPandexpansionarymonetarypolicylesspowerfullyincreasingnominalGDP,willbetheoverridingtrendsaslongasfinancialmarketscontinuetoexpandrapidly.Theexactchangeinthese‘multipliers’willbeinfluencedbytherateatwhichfinancialtransactionsexpandandabsorb(m1).Clearly,thisabsorptionhasbeenunexpectedlygreatinthe1980s,asevidencedbythefailureofeconomiststoforecastnominalGDP—theyhavecontinuallyexpectedmorenominalGDPthanwhatactuallyoccurs,andthereforemorerealGDPandinflationthanwhatactuallyoccurs.

Inlightofthisnew,frequentlymisunderstoodenvironmentformonetarypolicy,theunprecedentedworldstockmarketcrashof1987cannowbeexplained.On19October1987,theDowJonesIndustrialAveragefellanastonishing508points,or22.6percent,itsbiggestone-daypercentagedeclineever.ThisunexpectedcrashintheUSmarkettriggeredpanicsellinginalloftheworld'smajorstockmarkets,whichhadbecomeinextricablylinkedinthe1980s.

AsshowninTable4.4,from25August1987,therecordhighfortheUSstockmarket,to11November1987,theworldmarketsdeclinedanywherefrom43.4percent(Australia)to18.7percent(Italy).Aftermid-November,themarketsbeganagradualrecoveryasfear-drivensellingmoderated,andascentralbanksdramatically(andfinally!)increasednationalmoneysupplies.

Whydidtheworld'sstockmarketscrash?Themostcommonlymentionedandcommonlyagreed-uponexplanationsseemedtobethefollowing:

1.Speculationhaddrivenstockmarketvaluationstoohighrelativetostockearnings,sothatamajorshiftoffundsoutofstocksintobonds,otherinvestments,andcashwasoverdue.

2.InvestorslostconfidenceintheeconomicpoliciesoftheUSgovernment,especiallyitsattemptstoreducethefederalbudgetdeficitandtomaintaintheforeignexchangevalueoftheUSdollar.Bothoftheseconditionswerefelttobenecessaryinordertoinsurehealthyinternationalfinancialmarkets.

necessaryinordertoinsurehealthyinternationalfinancialmarkets.

3.SuddenfearthattheUSdollarwouldlosemuchofitsvalue,especiallyaftertheannouncementofanunexpectedlylargeUStradedeficit,causedinternationalinvestorstomovemuchoftheirmoneyoutoftheUSstockmarket.AstheUSstockmarketcrashed,fearspreadthroughtheothermarketsandtheycrashedaswell.8

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Table4.4Worldstockmarketsdecline,1987Percentagechangeineachmarketbetween25August1987,therecordhighfortheUSmarket,and11November1987:US-27.8Japan-19.8UK-27.2WestGermany-38.4Canada-28.4France-34.7Switzerland-30.5Australia-43.4Italy-18.7Netherlands-33.6

Source:MorganStanleyCapitalInternationalPerspective.

4.Lessmentioned,lessagreed-upon,butmorefundamentalexplanationsattributedtheworldstockmarketcrashtomonetarypolicies.Forexample,on22October1987,theeditorialpageofTheWallStreetJournalcarriedtwoarticlesbyprominenteconomists,oneclaimingthatthecrashoccurredbecausemonetarypolicywastoorestrictive,andoneclaimingthatthecrashoccurredbecausemonetarypolicywastooloose.9

AlthoughtherearevalidpointsinbothoftheseWSJarticles,neithermentionsthenewstructuralenvironmentformonetarypolicythathasbeencreatedbythederegulation,expansion,andglobalizationoffinancialmarkets.Asdiscussedabove,inthe1980sanincreasinglylargermoneysupplyhasbeenneededtosupporttherapidgrowthoffinancialmarketsaswellasthenormalgrowthofGDP.Recognitionofthistrend,combinedwithanexaminationoftherelevanteconomicdata,shouldmakeitclearthattheworldstockmarketcrashoccurredbecausemonetarypolicywastoorestrictive—notonlyUSmonetarypolicy,butalsomonetarypolicyintheUKandothercountrieswhichhaveparticipatedintheexpansionofinternationalfinancialmarkets.

USmonetarypolicyinfactbecamequiterestrictivein1987inthetimeperiodleadinguptothestockmarketcrash.TheannualgrowthrateoftheUSmoneysupply,whethermeasuredby(m1)orthebroadermeasures(m2)or(m3),

supply,whethermeasuredby(m1)orthebroadermeasures(m2)or(m3),declinedbyapproximately4percentagepointsinthefirstfivemonthsof1987,comparedtoitsgrowthratein1986.Forexample,US(m1)grewby15percentin1986,aratewhichallowedtheglobalizingUS

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financialmarketstoexpandandatthesametimeallowedUSinflationandrealGDPtoexpandathistoricallylowratescloseto2percent.Then,inthefirstfivemonthsof1987,theUSFederalReserveBankreducedtheannualgrowthrateof(m1)tojustover10percent.

AfterMay,1987,theUSFederalReserveBankslowedtheannualgrowthrateof(m1)evenfurther,to3.0percentgrowthinJune,5.3percentcontractioninJuly,2.1percentgrowthinAugustand3.9percentgrowthinSeptember,thelastmonthbeforethestockmarketcrash.TheFederalReserveBankwasreactingtotherising,butincorrect,expectationthatinflationwasjustaroundthecorner,aswellasamountingfearthattheforeignexchangevalueofthedollarwouldfallprecipitously,thuscausingcapitalflightoutoftheUScurrency,furtherdeclinesinitsvalueandtheerosionofinvestorconfidence.Restrictivemonetarypolicywasimplementedtofendofftheserisks,anditwasfelttobejustifiedbecausetheprobabilityofarecessionwithinthenearfuturewasslim.

Yetinthelate1980s,theprobabilityofashort-runslowdownineconomicgrowthwasnotthegreatestdangercreatedbyrestrictivemonetarypolicies.Thegreatestdanger,andonethatcentralbankersfailedtounderstandfully,wasthatmanynewprofitableopportunitiesinfinancialmarketscouldbedestroyed,andwiththemhundredsofbillionsofdollarsofwealth.Ultimately,thedestructionofsomuchwealthwhenthe‘goldenegg’(Chapter3)isdroppedhurtseconomicgrowthaswell.

LeadinguptotheOctobercrash,contractionarymonetarypolicieswerebeingpursuedinJapan,WestGermanyandEnglandaswellasintheUS.FromJulytoOctober,interestrateson3-monthEurodepositsdenominatedinyen,marks,andpoundsincreasedby1percent,whilethosedenominatedinUSdollarsincreasedby2percent.SomewhattightermonetarypolicywaspursuedintheUStodefendthedollar,andto‘reassurefinancialmarketsbydemonstratingthattheFedwasonguardagainstinflation’.10

Theshort-termresultofrestrictedmoneyandhigherinterestrateswasaverycostlyreversalintheexpansionoftheinternationalmoneycenters.Thisexpansionhadcontinuedsteadilythroughthemid-1980sthankstoderegulation,internationalization,andadvancesininformation-processingtechnology,allofwhichhadgiventheworld'sborrowersandlendersincreasedabilitytomakeprofitableinvestments.HigherinterestratesdespitecontinuedsluggishrealGDPgrowtharoundtheworldsqueezedthenewfoundprofitabilityandshatteredinvestorconfidence.Nervousnessspreaduntilthemarketsfinallysoldoff.

Worldstockmarketlosses,whichaddeduptomorethantheentire$900billiondebtofthelessdevelopedcountries,mighthavebeenlargelyavoidedifcentralbankershadcooperativelymaintainedloosermonetarypoliciesinordertoaccommodatethenaturalexpansionofthemoneycenters.Instead,justwheninternationalmonetaryexpansionwasmostneededshortlybeforethecrash,WestGermanyraiseditsinterestrates.TheincreaseinWest

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GermaninterestratescreatedfearthattheUSFederalReserveBankwouldhavetoraiseinterestratesevenfurthertopreventawithdrawalofforeigninvestmentfromtheUSandadeclineintheforeignexchangevalueofthedollar.JustwhentheUSandothercountriesneededtolowerinterestratesandincreasemoneysupplies,Germanystubbornlyencouragedtheconfusedcentralbankerstomaketheirmoveintheoppositedirection,toachievewhatultimatelywasatrivialandunsustainablegoal:exchangeratestability.

Germany'soverlyrestrictivemonetarypolicy,relativetotheothermajorindustrialcountries,resultedina43percentdeclineintheGermanstockmarket,measuredfromthebeginningof1987totheendof1987.Whiletheotherstockmarketsbeganrecoveringattheendof1987ascentralbanksinjectedmoremoneyintotheireconomies,theGermanmarketwaslessabletorecover,makingitthebigloseroftheworld'smajorstockmarketsin1987.

Interestingly,shortlyafterthecrash,theUSstockmarketwasvaluedatroughlythesamelevelasitwasattheendof1986.Also,themonetaryreservesoftheUSbankingsystem,analternatemeasureoftheamountofmoney-liquidityintheUSfinancialmarkets,wasatthesamelevelshortlybeforethecrashasitwasattheendof1986.Withnoextramoney-liquidityavailablefortheUSfinancial

attheendof1986.Withnoextramoney-liquidityavailablefortheUSfinancialmarketsoverthefirstninemonthsof1987,itisnotsurprisingthattheUSfinancialmarketsultimatelymaintainedapproximatelythesamevaluationoverthisperiod.

Asindicatedbythiscasestudyofthecrashinworldstockmarkets,asof1987economistsstillhadnotlearnedtheimportantlessonsfromtheirforecastingerrorsoftheearlyandmid-1980s.Sufficientattentionwasstillnotbeingpaidtothecontinuingderegulation,expansionandglobalizationofthemoneycenters.Therefore,thecontinuingdropinthevelocityofmoneyinearly1987wasnotexpected,andmonetarypolicywasmademuchtoorestrictive.Theresultwasthedestructionofhundredsofbillionsofdollarsofwealthandtheerosionofinvestorconfidence.

Unlikethemoney-liquiditycrisisoftheearly1980s,whichprimarilydeflatedthethen-relativelylessprofitablenon-financialmarkets,theunaccommodateddropinvelocityinthelate1980sdeflatedthethen-relativelylessprofitablefinancialmarkets.

IV.THEWORLDDEBTCRISIS,1982-

Theeconomicintegrationofnationsispervasiveandcontinuestobeunderestimated.Asarguedabove,therecessionoftheearly1980sandthestockmarketcrashof1987couldlargelyhavebeenavoidedifeconomicpolicieshadreflectedagreaterunderstandingoftherapidlyevolvingone-worldfinancialmarket.Overly-restrictive,separatelyenacted,nationalmonetarypoliciesledtohighinterestrates,money-liquiditycrises,and

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ultimatelythesetwoglobalevents.USandUKmonetarypolicieswereespeciallyresponsible;theUSandUKfinancialmarketsaredominantandrequirethegreatestliquidity;andbothcrisesbeganintheUSandUKfinancialmarketsandrapidlyspreadtotherestoftheglobaleconomy.

Inthissection,afurtherexaminationofeconomicpoliciesintheUS,UKandelsewhereplacesevenmoreresponsibilityforglobaleconomicwelfareatthefeetofpolicymakers.Itisarguedherethattheseeconomicpolicieswerealsothe

feetofpolicymakers.Itisarguedherethattheseeconomicpolicieswerealsothesinglemostimportantcauseofthe1980sworlddebtcrisis.

Thestorystartsintheearly1980swhentheReaganAdministrationcutUSincometaxratesby25percenttostimulateeconomicgrowth.Unfortunately,restrictivemonetarypoliciesintheUSandUKduetotheunexpectedabsorptionofmoneybyglobalizingfinancialmarketspushedupUS,UKandthereforeworldinterestratestohistoricallyhighlevels.Thesehighinterestratescreatedthe1982worldrecession,andtheReaganandThatcheradministrationsdidnotachievethesupply-sideeconomicgrowththathadbeenpredicted.

TheprimeinterestratechargedbyUSbanksdiscountedby(i.e.overandabovetherateof)USinflationincreasedfromanaverageof0.4percentin1975–79toanaverageof6.5percentin1980–86.IntheUK,theequivalentratewasnegativeeveryyearfrom1975to1980,andthenpositiveeveryyearfrom1981to1986withanaveragevalueof5.0percent.Theinitial,1979–1981increasesintheserealcostsofborrowingwereduetotherestrictiveUSandUKmonetarypolicies;after1981,andespeciallyby1983thelargeUSfederalbudgetdeficitwasmoretoblame,asmonetarypolicieswereloosenedsomewhat.

Howdidthesemonetaryandfiscalpoliciesaffecttheworlddebtsituation?Between1972and1979,wheninterestrateschargedonUSdollarswereonlyslightlyabovetherateofUSinflation(aswastypicalinthedevelopedworld),theinternationalindebtednessoftheless-developedcountries(LDCs)hadincreasedatanannualaveragerateof21.7percent(Bogdanowicz-Bindert,1985–86,p.261).InthisperiodpriceimprovementsintheLDCs(asonLDCexports)werehigherthanintheUS,meaningthatinflation-adjustedinterestratesintheLDCsonUSdollarloanswerefrequentlynegative,andconsiderableborrowingfromtheUScouldbejustified.Also,theincreasinglyinternational,interest-rate-paritynatureoffinancialmarketsimpliedthatconsiderableborrowingfromLondon,Frankfurt,Tokyo,andothermoneycenterswassimilarlyjustified.

Then,in1980themoney-liquiditycrisishitastheUS,UK,andotherdevelopedcountriespursuedrestrictivemonetarypolicies.By1982thecontinuingliquiditycrisishadcreatedrecessionsinthedevelopedcountries,whichinturnmeantacollapseintheexportmarketsformanyoftheproductssuppliedbytheLDCs.Forexample,60percentofMexico'smerchandiseexportsgototheUS,andwhentheUSeconomy‘caughtacold’intheearly1980s,manyMexicanindustries‘caughtpneumonia’forthisreasonalone.

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HigherUSdollarinterestratesandlowerpricesforLDCexports,bothofwhichwerelargelyduetotheliquiditycrisisandrecessionthatbeganintheUS,soonmadeitimpossibleformanyLDCstocontinuepayingbacktheirloans.TheUSprimeinterestratediscountedbythepriceonnon-fuelexportsoftheLDCsincreasedfrom5.7percentin1975–79to19.5percentin1986.11This13.8percentincreaseintherealcostoffinancingnon-fuelproductionandexportswasdevastatingtotheLDCs.ManyoftheoldloanswerevariableandsoonreflectedthehigherUSprimerateandLondonInterbankOfferrate.Newloans,evenwhenneededonlytoservicetheolddebt,couldrarelybejustifiedintheprivatemarketplace.VirtuallyallnewprivatelendingtotheLDCsstopped.

Beforelong,the13.8percentincreaseintherealcostoffinancingnon-fuelproductionandexportsintheLDCsmeantthat(approximately)a13.8percentincreaseinthegrowthoftheseexportindustrieswouldhavebeennecessarytomaintainthesameabilitytoserviceforeigndebt.Suchgrowthwouldnothavebeenpossibleevenwithouttheglobalrecession.Theworlddebtcrisishadbeencreated,primarilybyUSandUKeconomicpolicies.

Thesituationformajorfuelexporters,suchasMexico,wasthemostdevastating.Bythetimeworldoilpriceshadfallenby$18abarrelfrom1981to1986,oil-dependentMexicohadlosttensofbillionsofdollarsofexportrevenues.Aone-dollardropintheworldoilpricereducesMexico'sexportearningsbyahalfbilliondollarsperyear.TheLDCdebtcrisiscannotbeblameduponanindependentcollapseofOPECandoilprices,however.Brazil'seconomyisnotsosignificantlyaffectedbychangesinoilprices,andBrazilbecamethebiggestandperhapsthemostheavily-burdenedLDCdebtor.Also,theinabilityofOPECtomaintainhighUSdollar-denominatedoilpriceswassignificantlyinfluencedbythedropinUSdollar-demandforoilduetotherestrictivedollarmonetarypoliciesandworldrecession.

Thestorycontinuesinthemid-1980s.TheUSfederalbudgetdeficitscontinuedtoexceed$100billionandeven$200billionperyearafter1983andtherewasstillabiastowardrestrictivemonetarypolicyintheUSandelsewhere.Consequently,USinterestratesremainedhigh,andintherapidlyintegratingworldfinancialmarketsthesehighinterestratesbegantopullinternationalfundsintotheUSatanunprecedentedrate.Thenetflowofinternationalfundsintothe

intotheUSatanunprecedentedrate.ThenetflowofinternationalfundsintotheUSexceeded$100billionperyearby1984and,directlyorindirectly,beganfinancingabouthalfoftheUSfederalbudgetdeficit.

Bythemid-1980s,USgovernmentborrowinginandofitselfwasnolongersignificantlyaddingtotheliquiditycrisesintheUSnorexertingsignificantupwardpressureonUSinterestrates—fortunatelyforUSfiscalpolicy,thenetinflowofforeignfundsbothrespondedtoandexceededthevolumesofnewUSgovernmentborrowing.UnfortunatelyformanyLDCdebtors,however,someofthemorethan$100billionperyear,net,thatwasbeingpulledintotheUScamefromtheiralreadycash-shorteconomies.

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Therefore,someoftheliquiditycrisiswaseffectivelytransferredfromtheUSandotherdevelopedeconomiestotheLDCsinthemid-1980s,thuscompoundingtheLDCdebtcrisis.

Forexample,despiteattemptstochannelMexicanloansintoproductiveinvestmentsfortheMexicaneconomy,ithasbeenestimatedthatone-halfofMexico'sforeignborrowingsinthelate1970sandearly1980sinsteadleftMexicoascapitalflight,withtheUSandSwitzerlandastheprimarysafehavensforthiscash.SizablecapitalflighthasalsobeenasignificantproblemforBrazil,Venezuela,Argentinaandothers(Figure4.1).Inthemoreglobalizedfinancialmarkets,capitalcontrolsusedbytheLDCscouldnotpreventtheultimatetransferofwealthtothemostattractiveinternationalinvestmentopportunities,whichincreasinglywereintheUS.

Figure4.1CapitalflightfromLatinAmerica(1977–87,$billion)

Source:MorganGuarantyTrustCo.

BacktoUSeconomicpolicies:USTreasurySecretaryJamesBaker,whopresidedoverUSeconomicpoliciesintheearlyandmid-1980s,proposedtheBakerPlanfordealingwiththedebtcrisisin1985.Theprimaryemphasisofthisplanwastoprotecttheshort-runsolvencyofUSbanks.TherewasnocallfordebtreductionoranyothereffectivemeansofultimatelyreducingthedebtburdenintheLDCs;insteadBakercalledfornewloanstoserviceexistingLDCdebtsothatUSbankscouldcontinuetoreceivenormalpaymentsandnothavetoclassifyasignificantportionoftheirLDCdebtasbaddebt.AsreigningFederalReserveBoardchairmanPaulVolckerstatedyearslateraboutthisperiod,‘wemakeachoiceastowhattoprotectandwhatnotto,andthestrategicelementtoprotectisessentiallythebankingsystem’(Feldstein,1991,p.178).

Indeed,thesolvencyofmanyUSbankswasatstakewhenthedebtcrisishitintheearly1980s.Forexample,asshowninTable4.5,theninemajorUSbankshad176.5percentoftheircapitalinheavilydebt-burdenedLatin

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Americancountriesattheendof1982.Thisratiomeansthat176.5percentoftheentirestock-marketvalueofthesebankshadbeenloanedtoLatinAmericaasofyear-end1982.HavingtowriteoffamajorityofthisdebtmightthereforehaveleftthemajorUSbankswithinsufficientcapitaltoremaininbusiness.

ProtectingthesolvencyofthemajorUSbanksduringthe1980srequiredoneorbothofthefollowing:eithersignificantwriteoffsinLDCdebthadtobeavoided,orthestockmarket(capital)valueofthebankshadtosignificantlyincrease.Asitturnedout,theBakerPlaninsuredtheformerintheshortrun,untiltherapidlyglobalizingfinancialmarketsandUSmonetaryandfiscalpolicyhadinsuredthelatter.

AsshowninTable4.5,thetotalstockmarketcapitalvalueoftheninemajorUSbanksincreasedfrom$29.0billionto$46.7billionto$55.8billionatyear-end1982,1986,and1988,respectively,thusloweringthepercentageoftheirtotalcapitalinLatinAmericato110.2percentatyear-end1986and83.6percentatyear-end1988.Bythelate1980s,therefore,themajorUSbankswerenolongerindangerofbeinginsolventifmajorwriteoffsofLatin-Americandebtoccurred,

indangerofbeinginsolventifmajorwriteoffsofLatin-Americandebtoccurred,andUSpolicymakerscouldturntheirattentiontobroaderissues,suchastheultimateresolutionofthedebtcrisis,andtheoverallhealthoftheUSandinternationalfinancialmarkets.Forexample,the(newTreasurySecretary)BradyPlanin1989finallyformalizedandencouragedseveralwaysinwhichprivatemarketswerealreadywriting-offLDCdebtincludingresalediscountsofthisdebtinthesecondarymarkets.

Question:whataccountedfortheincreasedstockmarketcapitalvalueand,therefore,thereturntosecuresolvencyofthemajorUSbanksfrom1982to1988,despitetheobviouslynegativeeffectthatthedebtcrisismusthavehadupontheirstockmarketvaluesoverthisperiod?Answer:thenetflowofforeignfundsintotheUSfinancialmarketsofmorethan$100billionperyearby1984.Asdiscussedpreviously,thesefundsallowedforanon-inflationaryexpansionoftheUSbankmoneysupply,thelongestpostWorldWarIIexpansioninUSeconomicgrowth,andthetriplingofUSstockmarketvaluesfrom1982to1988evenconsideringthestockmarketcrashof1987.

Thestorynowtakesanironicturn.Asdiscussedintheprevioussection,the15percentincreaseintheUSmoneysupplyduring1986wasperfectlyreasonablegiventheinflowofforeignfundsandincreasedabsorptionofmoneybyfinancialmarkets.However,excessiveconcernaboutinflationandlackofcooperationbetweenthedevelopedcountriesin1987ledtorestrictivemonetarypoliciesintheUSandelsewhere,whichinturncausedthestockmarketcrashofOctober1987.ItwastrulyaworldstockmarketcrashinthatthevalueofassetsintheLDCsdeclinedinproportiontothedevelopedcountrylossesshownearlierinTable4.4.

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NineMajorUSBanks%ofbankcapitalin:-Developingcountries: 287.7% 153.9% 108.0%-LatinAmerica: 176.5% 110.2% 83.6%AllOtherUSBanks%ofbankcapitalin:-DevelopingCountries: 116.0% 55.0% 32.2%

-DevelopingCountries: 116.0% 55.0% 32.2%-LatinAmerica: 78.6% 39.7% 21.8%TotalBankCapital(billionsofdollars)NinemajorUSbanks: $29.0 $46.7 $55.8AllotherUSbanks: $41.6 $69.4 $79.8

Source:FederalFinancialInstitutionsExaminationCouncil,‘CountryExposureLendingSurvey’,25April1983,24April1987,and12April1989.

Table4.6showsthediscountratesatwhichbankswereabletoselloffthedebtofvariousdevelopingcountriesbeforeandaftertheOctober1987worldstockmarketcrash.Thesediscountpricesrepresentprivatemarketperceptionsoftheabilityofcountriestorepaydebtandthusindirectlythepricesrepresenttheincomepotentialofcountryassets.Asanexample,Brazil'sforeigndebtsoldfor62–65centsperdollaroffacevalueinMay,1987,indicatingthat35–38centsonthedollarofBraziliandebtcouldbewritten-offduringdebt-equityswapsinthatmonth.InNovember,1987,onemonthafterthemoney-liquiditycrisiscausedthecrashinworldstockmarkets,Brazil'sdebtsoldfor37–41centsonthedollar,indicatingwriteoffsof59–63cents.

ReducedsellingpricesfromMaytoNovember,1987,forthedebtofallofthesedevelopingcountriesverifiesthetrulyglobalimpactofthestockmarketcrash.Thecrashreducedtheaveragemarketvalueofdeveloping-countryinvestmentsasperTable4.6justasmuchasitreducedthevalueofinvestmentswithintherichernationsasperTable4.4.

Asdiscussedintheprevioussection,stockmarketlossesinthedevelopedcountries,whichaddeduptomorethantheentire$900billiondebtoftheLDCs,mightlargelyhavebeenavoidedifcentralbankers,especiallyinthe

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USandUK,hadcooperativelymaintainedloosermonetarypoliciesinordertoaccommodatethenaturalexpansionofthemoneycenters.

Argentina 658–0 33–37

Argentina 658–0 33–37Brazil 62–65 37–41Chile 67–70 50–53Colombia 85–88 72–76Ecuador 52–55 31–34Mexico 57–60 48–52Peru 14–18 2–7Philippines 70–72 55–60Venezuela 72–74 49–53

Source:ShearsonLehmanBrothersInc.

Nowforthewhole,ironical,sequenceofevents:highinterestratesinthedevelopedworldintheearly1980s,especiallycausedbyUSandUKmonetarypolicies,createdaglobalrecessionandtheLDCdebtcrisis.Continuinghighinterestratesduringthemid-1980sinthedevelopedworld,stillprimarilyduetomonetarypolicies,butthenalsobecauseoftheUSfederaldeficits,pullednewly-loanedglobalfundsoutoftheLDCsascapitalflight.ThiscapitalflightdidnotreducetheofficialLDCdebt,butinsteadmadeitharderforLDCcountriestogeneratetheeconomicgrowththatwouldallowdebttobeserviced.

Then,capitalflightfunds(actually,largeramountsofmonetarywealth)weredestroyedbytheworldstockmarketcrash,itselfcausedprimarilybyUSandEuropeanmonetarypolicies.TherehasbeenmuchlesschannelingoffundsintoLatinAmericanLDCssincethe1980s,butinstead,poorerdevelopedaswellasdevelopingcountrieshavecontinuedtosendmorethan$100billionperyear,net,intotheUS(anamountapproximatelyequaltoeitherMexico'sorBrazil'stotalforeigndebt).

TheseglobalfundshavemaintainedthecapitalstrengthofthemajorUSbanks,allowedtheUSgovernmenttomaintainlargebudgetsthroughthe1990sfornationaldefense,socialwelfareandotherpurposes,andpavedthewayforacontinuingnon-inflationaryexpansionoftheUSeconomy.

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V.THEEARLY1990sRECESSIONARYPERIOD

Recessionaryconditionsintheearly1990scan,asin1982,beblamedonoverlystrictmonetarypoliciesgiventhecontinuallyincreasingmoney-liquidityandcapitalneedsoftheglobaleconomy.Forexample,Japan's8percentaverageyearlymoneygrowthfrom1986to1988wasslowedto2.4percentin1989and4.4percentin1990.TheresultwasthedestructionofJapan'sfinancialsurplusandlong-termcapitaloutflowsthathadhelpedsustaineconomicgrowthinEuropeandtheUS.ThewealthlostdomesticallyinJapanasitsstockmarketfell60percentfrom1989to1991temporarilyslowedgrowththere.But,unliketheUS,Germanyandothers,Japanhadthefiscalmeansintheearly1990s,includinga$120billionfiscalstimuluspackageinmid-1993,toavoidrecession.Aselaboratedbelow,restrictivemonetarypoliciesinEuropeandtheUS,togetherwithJapan's‘turninginward’contributedheavilytotheearly1990sglobalrecessionaryconditions.

Theglobalregionshitespeciallyhardbyrecessionsintheearly1990swerethosethatlostinternationalcapital.ThetimingofrecessionsintheUSandEuropedemonstratesthisfact.Also,theprobabilityofearly-1990srecessionsinthedevelopedcountriesincreasedduetothereturnofinternationalinvestmenttotheLDCs.NetinflowsofforeigndirectinvestmentintoLDCsaveraged$13billionperyearfrom1985to1989,thenjumpedto$18billionin1990and$31billionin1991.12Unlikeinthe1970s,AsianLDCsratherthanLatinAmericanLDCswerereceivingthemajorpartofthisdirectinvestment.AsdirectinvestmenttotheLDCssoaredin1991,developedcountriessawtheiraverageinflowsshrinkbyone-fifth.

A.TheEuropeanSituation

Thelate1980swasatimeofstrongeconomicgrowthforGermanyandotherswithintheEuropeanCommunity.TheSingleEuropeanActsignedin1987to‘completetheinternalECmarketby1992’beganabolishingbordercontrolsandothertechnicalbarrierstotradeincludinginconsistenthealth,safety,andenvironmentalregulations;itcommencedopeninguppublicprocurement,mostsignificantlyinenergy,telecommunications,transportation,andwatersupply;andbegancreatingaunifiedmarketforfinancialservices.

Theperceivedefficienciesof‘Europe1992’ledtoacross-borderEuropeaninvestmentboombeginningin1987,notonlyintheinternalEuropeanmarket,

investmentboombeginningin1987,notonlyintheinternalEuropeanmarket,butalsofromtheEuropeanaffiliatesofUS,Japanese,andotherforeignfirms.Forexample,majority-ownedforeignaffiliatesofUScompaniesincreasedcapitalspendinginEuropefrom$15.4billionin1987to$18.8billionin1988to$21.1billionin1989.Andby1989,411JapanesemanufacturershadopenedormadeplanstostartproductioninEurope,thustriplingthenumberofJapaneseplantssincetheearly1980s;theToyotaplant

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constructedinGreatBritainin1990wasthelargestforeigninvestmenteverinBritain.TheFrench,whohadlongbeenoneofthemostprotectionistagainstJapanesetradeandinvestment,reversedtheirstanceinApril,1989,whenIndustryMinisterRogerFaurouxsaidthattheFrenchgovernmenthasdecidedthat‘itisbettertohaveJapanese(factories)thantohaveunemployment’.13

Aidedbyinternationalcapitalandinternalefficiencies,economicgrowthforallofwesternEuropeaveragedover3percentperyearfrom1987to1990.AsthebiggestexporterofcapitalgoodswithinEurope,WestGermanygainedthemostfromEurope1992,achievingeconomicgrowthratesof4percentinboth1989and1990.Abletoexportmoreeasilytoitsstrengthenedneighbors,WestGermany'stradesurpluswithintheECwidenedfromDM32billionin1985toDM94billionin1989.Thus,60percentofWestGermany'stradesurpluswaswiththerestofEuropeby1989.

Germanreunificationwasforwardedinthehopethatthelate-1980sECeconomicgrowthrateswouldcontinuethroughthe1990s.UnderthisassumptiontheGermaneconomywouldhavebeenabletoabsorbtheestimatedcostofsuccessfulreunificationwithoutseverehardship.TheDM94billion($55billion)WestGermantradesurpluswiththeECin1989equaled4.6percentofitstotaleconomicoutput.Therefore,ifgrowthrateshadcontinuedandallofthistradesurpluswiththeECwasinsteaddirectedtowardEastGermaninvestmentwithoutanyimmediatereturn,theWestGermaneconomywouldhavebeeninaminorrecession,andEastGermanywouldhavehad$350–$400billionnecessaryformodernizationbeforetheyear2000.

Unfortunately,notonlyhastheinitialforecastof$350–$400billionnecessaryformodernizationofEastGermanyprovedtobetoolow,butalsotheECgrowth

ratehasslowed.Foreignfirm-to-firminvestmentintoEastGermanysincereunificationhasbeenslowerthanexpected,givenlegaltanglesoverownershipofrealestateandbusinessassets,dilapidatedtransportationandcommunicationsystems,andthegeneraluncompetitivenessofEastGermanindustrycomparedtointernationalstandards.Only30percentofEastGermancompanieswerecapableofcompetingintheECmarket,50percentneededoverhaulingtosurvive,and20percentweredoomedtobankruptcy.14

TheinabilitytocompetewithintheECledtosubstantiallyincreasedunemploymentwithinEastGermanyafterthefullmonetaryunionof1July1990.Obligedtoconductallbusinessinnewly-issuedWestGermanmarksafterthatdate,15EastGermanfirmswerethrownintomanyoftherigorsofwhattheEClaborandproductmarketscouldstand,buthowtocompetewhentheoutputperworkerinEastGermanywas40percentoftheoutputperworkerinWestGermany,approximatelyequivalenttoWestGermanyinthe

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late1960s?16UnemploymentdoubledinJulyto270,000workers,andthreetimesasmanyEastGermanswereplacedonreducedworktime.17

ClosingthisproductivitygapbetweenthetwoGermanieshasrequiredacontinuing$70–80billionperyeartransfertoEastGermanyfromtheglobaleconomythroughtheturnofthecenturyratherthanthe$50billionperyearoriginallyestimated.PerhapsDM200billion($118billionat$1toDMI.7)hasbeennecessarytorestoretheroadsandrailways,linkthecanalstoWestGermany's,andbuildanewinternationalairportinEastBerlin.18On20June1990,aDM55billion($32billion)plantomodernizetheEastGermantelephonesystemwasunveiled,DM30billionofwhichWestGermany'sstate-runtelecommunicationsgroup,BundespostTelekom,expectedtoraisefromthecapitalmarketsby1998.19Furthergovernmentalexpenditureswillberequiredforpostalandtelecommunicationssystems,andotherpublicworks,andevengreaterratesofprivateinvestmentarenecessary.

AttractingenoughinternationalcapitaltoGermanytohelpsupportthe$70–80billionperyearnecessaryforsuccessfulreunification,especiallygiveninitialpledgesnottoraisetaxes,requiredhighGermaninterestrates.TheGerman

pledgesnottoraisetaxes,requiredhighGermaninterestrates.TheGerman‘identifiedcapitalflow’withtherestoftheworld(directinvestmentplusportfolioinvestmentplusothercapital),whichhadbeenanetoutflowof$70billionin1988and1989,beganturninginwardtoanetoutflowof$50billionin1990andanetinflowof$11billionin1991.

Asisnowwellknown,thehighGermaninterestratesandcapitalinflowsintheearly1990sledtotheeffectualbreakupoftheEMSandthedelayofothereconomicefficienciesofEurope1992.Inaddition,therestrictivemonetarypoliciesoftheotherEMScountriesthroughmid-1992astheytriedtomaintainEMSinterestrateandexchangerateparitieswithGermanyledtorecessionaryconditions.

EconomicoutputoftheEC'stwelvememberstatesdeclinedslightlyin1993,thefirstshrinkagesince1975,andtheECunemploymentrateroseto11percent.Clearly,Germany'srestrictivemonetarypoliciesandfiscalrequirementsputitatthecenteroftheearly1990sECcrisis.DecliningcompetitivenessandconfidenceinGermanyduetotheappreciatingmarkand,still,highinterestrates,escalatingcostsofreunificationandwidespreadEasternEuropeanproblemsscaredsomeinternationalcapitalawayfromGermany.Pre-reunificationGermancapitaloutflowsreturned,andtheGermaneconomycontracted1.2percentin1993.Inmid-1993Germanunemploymentratesreached7.5percentintheWestand15.3percentintheEast.

B.TheUSSituation

TheofficialUSrecession,asdatedbytheNationalBureauofEconomicResearch(NBER),occurredduringthelasttwoquartersof1990andthefirstquarterof1991.Moregenerally,USeconomicgrowthaveragedlessthan1

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percentfromthebeginningof1989to1993,ascomparedto2.3percentfrom1973to1989.Comparedtoahypothetical2.3percentgrowthratecontinuing(the‘naturalpotentialrateofgrowth’),during1989–1991therewasa$225billionlossinpotentialGDP,approximatelyhalfofwhichwasadeclineinconsumptionandhalfadeclineinfixedinvestment.Asidefromthesefigures,asmallincreaseinnetexportswasbalancedbyasmalldecreaseininventory

smallincreaseinnetexportswasbalancedbyasmalldecreaseininventoryinvestmentandasmalldecreaseinnetgovernmentspending.

AttheAmericanEconomicAssociation(AEA)meetingsinJanuary1993,themainconclusionseemedtobethatestablishedmodelshavebeenunhelpfulinunderstandingthisUSrecession.InpapersgivenbyRobertHallofStanfordandtheNBER(1993),andOlivierBlanchardofMIT(1993),therewasonlythegeneralconsensusthatconsumersmayhavelostconfidenceaboutthefuture.FromHall:

Aspontaneousdeclineinconsumptionwouldprobablyresultinunusualbehaviorofconsumptionduringtherecessionrelativetoitspre-recessionvaluesandrelativetorealdisposableincome...Therewasaconsiderableswinginconsumptionatmuchlowerthanarecessionfrequencyfrom1987to1991.Atthesametime,surveymeasuresofconsumerconfidencefellfromrecordhightosomewhatsubnormallevels.Althoughasharpspontaneouscontractionofconsumptionwasnotpartofthestoryoftherecession,changesinconsumptionnotassociatedwithchangesindisposableincomemaybeanimportantpartofabiggerstoryaboutthelate1980sandearly1990s.

AndfromBlanchard:

Byfar,themainproximatecauseoftherecessionwasa‘consumptionshock,’,adecreaseinconsumptioninrelationtoitsnormaldeterminants.Becausetheeffectsofsuchshocksarelonglasting,thisalsoexplainswhy,incontrasttopreviousrecoveries,thelastrecoverywasaslowandweakone...

WhatisespeciallyrevealingaboutassessmentsofthisUSrecessionisthescantattentionpaidtoglobalconditionsincludingincreasedinternationaltransfersofinvestmentbaseduponinterestrateparity(Chapter1),thesubsequentadjustmentsininternationaltrade(Chapter2),andthestructuraldeclineinmonetaryvelocity(Chapter3).PresumablyreflectingtheresearchoftheNBERasitadvisestheUSgovernment,Hall's(1993)paperdevotesonlyafewsentencestotherestoftheworld:

Itappearsunlikelythateventsintherestoftheworldcontributedtotherecession…netexportsgrewalittleduringtherecession.ItwouldbealmostimpossibletotellastoryinwhicheventsinworldmarketscausedaUSrecessionbutUSnetexportsrose…Therewasnooutsideforcethatconcentrateditseffectsoverafewmonthsinthelatesummerandfallof1990…

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Aspertheexplanationsofearlierfinancialcrisesandrecessionsinthischapter,thereadermightalreadyunderstandtheauthor'sskepticismabouttheabovequote.Infact,oneonlyneedstolookatFigure4.2tofindaninternationalforcethatadverselyaffectedtheUSeconomybeginningin1990.AsshowninFigure4.2,theidentifiedcapitalinflowstotheUSfordirectinvestment,portfolioinvestment,andotherinvestment(monetaryauthoritiesplusgeneralgovernmentplusbanksplusothersectors)collapsedin1990.AggregatingthesecategoriesshowsanetidentifiedcapitalinflowtotheUSofcloseto$100billionperyearuntilthesuddendropto$13billionin1990and$30billionin1991.After1991,thenetinflowroseagaintoaverageover$100billion.

ThenetidentifiedcapitalinflowshowninFigure4.2excludestheverysuspect‘statisticaldiscrepancy’accountwhichreconcilesdifferencesbetweenmeasuredcommerceandpaymentsforthatcommerce.ThestatisticaldiscrepancyisgenerallyconsideredpartoftheCapitalAccountbalance;however,thereisnowaytoverifyexactlyhowmuchofthestatisticaldiscrepancyreflectsactualflowsofcapital.In1990,thestatisticaldiscrepancyaccounthada$64billioncreditposition,itslargestimbalanceever.Theauthor'sviewisthatsomeofthis$64billiondidnotactuallyflowintotheUS,whichthuscontributedevenmoretotheUScreditcrunchandrecessionaryconditions.

From1989,thelastpre-recessionyear,tothedepthoftheUSrecessionin1990–91,theUSeconomywasthusreceivingapproximately$100billion/yrlessnetforeigninvestment,andtheNBERandothersclaimthattherewasnooutsideforcethatconcentrateditsnegativeeffectsontheUSeconomyin1990–91!Certainlythe$225billionlossinpotentialGDPduring1989–1991couldbecompletelyaccountedforbythisdeclineinnetforeigninvestmentonceonefiguresoutthereducedUSincome,monetarywealth,andthereforereducedconsumptionthatwouldoccurcombinedwiththeimmediatelossoffixedandinventoryinvestment.Baseduponthetiminglagsandcause-effectmaterialdiscussedinChapter2,theauthor'spositionisthatthecollapseinforeigninvestmentinflowinitiatedtherecession,ratherthanvice-versa.

GermanreunificationwaspullinginternationalfundsintoGermany,andJapan'smoney-liquiditycrisiswaspullinginternationalfundsintoJapan—independentlyofUSdomesticeconomicconditions.Also,theapproximately

independentlyofUSdomesticeconomicconditions.Also,theapproximately$100billion/yearreductioninnetforeigninvestmentintotheUScouldcertainlyaccountforthedepreciationofthedollarduringtherecessionagainst,especially,theJapaneseyen—Japaneseforeigninvestmentespeciallydriedupduring1990.Inturn,thedepreciatingdollarandreducedUSincome(thereforemorecompetitiveUSexportsandlessUSdemandforimports)couldcertainlyaccountforthesmallriseinUSnetexportsduringtherecession.Yet,indirectcontrasttothisscenarioHall(1993)claimsthat:

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Figure4.2Explainingthe1990–91USrecession:thedeclineinnetidentifiedcapitalinflows(bycategory,$billion)

Source:USDepartmentofCommerce.

Anyforcethatdecreasedthevolumeofresourcesgoingtocapitalformationwouldraisethevolumegoingtootherpurposes,especiallyconsumption…itwouldbealmostimpossibletotellastoryinwhicheventsinworldmarketscausedaUSrecessionbutUSnetexportsrose.

ObviouslyHallamongothersdidnotacknowledgethepossibilitythatinternationalflowsoffinancebaseduponinterestrateandfinancialstrategyparitiescanbeaninitiating,profit-seekingforcethatdriveschangesintradeandGDPgrowthamongaffectedcountries.

Hall's(1993)regressionmodels,whicharebasedlargelyondomesticincometrends,donotexplainthedropinUSconsumptionduringtherecessionperiod

trends,donotexplainthedropinUSconsumptionduringtherecessionperiodwhenforeigninvestmentintotheUScollapsed,nordotheyexplainthesurgeinUSconsumptionduring1987and1988wheninternationalinvestmentintotheUSreachedrecordinflows:‘itisworthmentioning,however,thatconsumptionexceededitspredictedvaluebyalargemargin($41billion)in1987andbyover$20billionin1988’.Thisunder-predictionofconsumptionduring1987–88providesfurtherevidencethattheinternationalflowofinvestmentisamissingvariable.

TheUSeconomywentintoits1990–91slumpatthesametimethattheidentifiedcapitalinflowcollapsed,andtheUSdollarsubsequentlydepreciatedtoitslowestlevel.Then,thesetrendsbegantoreversethemselvessomewhatin1991and1992astheidentifiedcapitalinflowbegantoimprove.Also,inthefirsttwoquartersof1991theUSreceived‘officialunrequitedtransfer’netinflowsof$17.45and$7.61billionrespectively—a

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currentaccountlineitemreflectinginthisperiodpaymentsfromalliesduetotheUSPersianGulfactions.TheofficialunrequitedtransfersbalanceoftheUSisgenerallynegative.Itsannualbalanceover1987–1992was-$12.49,-$13.01,-$13.28,-$20.25,$20.98(in1991),and-$17.56billion,respectively.

The$35–$40billionimprovement(morepaymentinflow)inthisonecurrentaccountcategoryin1991plusthe$50billionincreaseinidentifiedcapitalaccountinflowtotheUSin1992(Figure4.2)initiatedtheweakUSeconomicrecoveryanddollarappreciationin1991–92.OnceagainfinancialflowsweredrivingchangesinGDPandtrade.TheUScurrentaccountbalance,whichhaddroppedclosetozeroin1991duetothePersianGulfcontributions,weakUSeconomyimportdemand,andlowUSdollar,begantodeteriorateagainin1992(Figure2.2)asthecapitalinflowresumed.

Thus,astrongerUSeconomy,asinthe1980s,remainsassociatedwithalargerUStradedeficit.ThisresultiscontrarytomosteconomicadjustmentliteratureasdiscussedinChapter2.Also,ithelpsexplainwhytheeconomicsprofessionhashadtroublemodelingtheearly1990sUSrecessionaryperiod.

Economicmodelsalsofailedtoexplaintheearly1990sUSrecessionbecause,as

Economicmodelsalsofailedtoexplaintheearly1990sUSrecessionbecause,aswith1980sfinancialcrisesandrecession,insufficientattentionwaspaidtotheincomevelocityofmoney.US(m1)velocityfell3percentfrom1990to1991atthesametimeastheFederalReserveBankwasrestrictingthegrowthrateofmonetaryaggregates.Theresult,asin1982,wasacontractionofnominalGDPfromitsgrowthpath,andthiswassplitbetweenitstwocomponents,realGDPandinflation.

InsteadofadjustingthemoneysupplytomaintainnominalGDPalongitsgrowthpath,whichwouldhaveappropriatelybeen6.5percentasin1988–90,theFedseeminglyreturnedtomoney-supplytargetingandoverconcernwithinflationinlate1990.WhileHall(1993)amongothersdiscussesthecollapseofnominalGDPbelowits6.5percentgrowthpath,velocityisnotdiscussed,nordoesthecollapseinnominalGDPseemtoworryhim.HeexcusesFedpolicyasasourceoftherecessionbecausehedoesnotfindthattheFedconsciouslyadoptedalowernominalGDPtarget,andbecauseUSinterestratesremainedlowandevenfellduringtherecession.

USinterestratesdiddeclineduringtherecession,butnotuntilthefourthquarterof1990whentheFedbeganreducingthediscountandfederalfundsrates.Also,thecutintheseshort-termratesmidwayintotherecessionwasnotfollowedbyasignificantfallinlong-termrates,suchasthe30-yearTreasurybond,untilayearortwolater.Theyieldgapbetweenthediscountrateandthe30-yeargovernmentbondthusapproached4percentattheendof1991,agapseenbeforeonlyduringthe,1982–84LDCdebtcrisisperiodwhenUSbanksolvencywasthreatened.

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Suchagap,twiceaslargeasnormal,helpsre-capitalizebanksandrestorestheirprofitability,becausebankscanborrowatthediscountrateandlendatthe30-yearbondrate.Ajokegoingaroundintheearly1990swasofa10–2–4club.Bankerswouldtakeinshort-term3percentdepositsordraw-downsattheFeddiscountwindowat10:00A.M.,investtheseRindsinlong-term7percentT-bondsat2:00P.M.,andthenhittheirprivateclubsat4:00P.M.Presumablytheyhadnotmanagedtoloanmoneytobusinessesorhouseholdsintheprocess.

Whendomesticyield-gapre-capitalizationisoccurring,domesticborrowingmaysuffer,whichwasthecaseduringtheearly1990sUSrecessionaryperiod.

maysuffer,whichwasthecaseduringtheearly1990sUSrecessionaryperiod.Ineffect,banksweresubsidizedasintermediariesbetweendomesticmonetaryandfiscalpolicy,andtherestoftheeconomyfeltamoney-liquiditycrisisfrombeing‘leftoutoftheloop’despiterapidlydecliningshort-termrates.

Longer-termUSinterestratesaremoresubjecttotheinternationalinterestrateparityconditionsthantheshorter-terminterestrates.Theshorter-terminterestratescanbesetmoredirectlybytheFedviachangesinthediscountandfederalfundsrates.Thehighinternationalinterestratesin1991inGermanyandelsewherekeptUSlonger-termrateshigh,andtheFed'smovetoreduceshort-termUSratesin1990–91probablyencouragedtheUScapitaloutflowanddollardepreciation.

Incontrast,attheendofthe1982recessiontheUSbeganreceivingbigincreasesinnetforeigninvestmentduetothestructuralchangesassociatedwithglobalization(Chapters1and2).Unliketheearly1990srecessionaryperiod,the1982–84capitalinflowsoonmadeupfortheshortfallindomesticinvestment.TheUSin1983and1984wasthusabletohavestrongeconomicgrowthwhileatthesametimecapitalizingitsbanks.Comingoutofthe1990–91recessionaryperiod,recoverywasslower;notuntil1994didthenetcapitalinflowriseabovethepre-1990levels(Figure4.2).

VI.THE1994–95MEXICANCRISIS

The1980sLatinAmericandebtcrisisappearedtoberesolvedbythelate1980s,andeconomicgrowthinMexicoandelsewherehadreturned.FinancialliberalizationandglobalizationinMexico,andlessuncertaintyregardingitseconomicandpoliticalprospects,ledtorapidcreditandquasi-moneyexpansionandinflowsofforeigninvestment.From1990to1993,Mexicoreceived$91billioninnetcapitalinflows,whichwasapproximatelyone-fifthofallnetinflowstodevelopingcountries.Bankcreditextendedtotheprivatenon-financialsectorincreasedfrom10percentofGDPin1988tomorethan40percentin1994.OversightbytheNationalBanking.Commissioninthisperiodwasweak,partlyduetotheriseofoffshore

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finance(Chapter3)andothercomplicatedinternationalmonetarychannelsthatdirectedfundsintoMexico.Dollar-denominatedbonds—tesobonos—whichwereguaranteedbytheMexicangovernmentbasedonitsdollarreserves,expandedrapidlyandwereclassifiedbytheMexicangovernmentasdomesticdebt.Bylate1994,therewere$18billionintesobonosheldbyforeigners,and$11billionintesobonosheldbyMexicans—allofwhichwereshort-termandcomingduein1995.

UnfortunatelyforMexico,contractionarymonetarypoliciesbeganintheUSinFebruary1994,whichwerereciprocatedintheotherhard-currencymoneycenters.From1Februaryto1August1994,interestratesonten-yeargovernmentbondsincreasedbythefollowingpercentagepointamounts:1.4percentintheUS,0.9percentinJapan,1.4percentinGermany,1.6percentinFrance,and2.4percentintheUK—severeincreasesgiventheabsenceofanygeneralriseininflationoreconomicgrowthrates.

Giventheseincreasesininterestratesinthemoneycenters,flowsofinternationalinvestmentintoMexicocouldnotbesustained.Furthermore,MexicaninvestmentwasdiscouragedbyincreasedpoliticalandeconomicuncertaintyinMexicofollowingtheChiapasuprising(whichbeganinJanuary1994tocoincidewiththeNorthAmericanFreeTradeAgreement),theassassinationofPresidentialcandidateColosio,andthecorruptionchargesagainstPresidentSalinasandhisfamily.Subjectiveperceptionscanbeextremelyimportantinthemarginaldecision-makingofinternationalinvestors,whoflirtwithsmalldeviationsinexpectedratesofreturnoninvestmentbetweencountries.AninternalmemoissuedtotheEmergingMarketsGroupofamajorUSbank,dated13February1995read,inpart:

WhileChiapas,inouropinion,doesnotposeafundamentalthreattoMexicanpoliticalstability,itisperceivedtobesobymanyintheinvestmentcommunity.ThegovernmentwillneedtoeliminatetheZapatistastodemonstratetheireffectivecontrolofthenationalterritoryandofsecuritypolicy(Hawkes,1996,p.189).

NationalandinternationalinvestorsalsoknewthattheMexicaneconomyhadbeenslowingandthatinflationhadoutstrippedproductivitygrowth,yettheSalinasadministrationhadnotallowedadevaluationofthepesotoreflectthesetrends.AsofearlyDecember1994,amajorityofinvestorsdidnotbelievethatthesetrendsrequiredadevaluation.CapitalinflowsintoMexicohadbeenmostlycurtailedsixmonthsearlier,yettheBankofMexicohadpledgedtosupportthe

curtailedsixmonthsearlier,yettheBankofMexicohadpledgedtosupportthepesowithexpenditureofitsdollarreserves.Dollarreserveshadthusbeendeclining,yettheBankofMexicohadbeenslowtoadmittheextentofthedecline.However,inDecember,whentheMexicangovernmentreleaseddataindicatingthatamajordevaluationwaslikely,tradersrushedtogetoutofthepeso.Furthermore,theyremovedtheirUSdollarholdingsoutofMexicaninstitutions.Thesedollarholdingswereveryliquid,becausedebtorshadissuedshort-termdollarbondsthatpromised

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redemptionatfacevalue.On21December1994,$29billionoftesobonoshort-termliabilitieswereforsale,$18billionofwhichweretheresponsibilityoftheMexicangovernment,andthisnewsmadethefrontpageofTheWallStreetJournal.

Justlikearunonabank,investorsranonMexico:

Likesmallsaverswhoseetheirneighborsliningupoutsideabankandjointhequeuetowithdrawtheirdepositsbeforethebank'scashreservesareexhausted,investorsingovernmentbondshaveanincentivetoliquidatetheirholdingswhenothersdolikewiseandtheyfearthatthegovernment'slimitedforeignexchangereserveswillbeexhausted…themagnitudeofcapitalflowscanleaveagovernmentfacingadebtrun,likeabankfacingarunbyitsdepositors,nochoicebuttosuspendpayments,regardlessofthedamagetoitscreditworthiness.Ontheeveofthecrisis,theMexicangovernmentwasresponsibleformorethan$18billionofdollar-denominatedanddollar-indexedliabilities,roughlytripleitsforeignexchangereserves.Onceinvestorsbegantoliquidatetheirholdings,theauthoritieswereattheirmercy(EichengreenandPortes,inFederalReserveBankofKansasCity,1997,p.195).

UnliketheLatinAmericandebtcrisisofthe1980s,whichinvolvedlargeloansfrommoney-centerbanks,thistimestocksandbondswerethevehiclesformuchoftheforeigninvestmentintoMexico.Sellingoftheseliquidsecuritieswasthusimmediate,anditcouldnotbeslowedbynegotiationsbetweengovernmentofficials,theIMF,andlargefinancialinstitutions.WhentheMexicanfinanceministerpresentedhiseconomiccrisismanagementprogramattheFederalReserveBankofNewYorkon21December1994,variousmutualfundandhedgefundmanagerswerepresent,whorepresentedonlyasubsetofthe

hedgefundmanagerswerepresent,whorepresentedonlyasubsetoftheexposedinvestors—ifMexicanofficialshadwantedtorenegotiatetermswithitscreditors,theywouldhavehadtroubleevenidentifyingthem.AsthepesoandtheMexicanstockandbondmarketscrashedinDecember,themarketpushedshort-termpesointerestratesabove100percentatanannualrate.ManyMexicanbanksandotherfirms,whichhaddebtobligationsinforeigncurrency,andwhichownedstocksandbonds,experiencedarapiddeclineinnetworthandcreditworthiness.In1995,Mexicowouldhaveitsworstrecessionindecades—realGDPwouldfall6percent,andtheindustrialoutputportionwouldfallmorethan10percent.

MuchofthetransferofMexicanmonetarywealthintodollarsandoutofthecountrywent,initially,intooffshorefinancialmarkets.Thisdataismostlynotreportedinbalanceofpaymentsstatistics,butTable3.1estimateswhatwashappeningatleastwith‘LDCfuelexporters’andoffshoredollarmarkets—Mexicocanbepresumedtoaccountforthemajorshareoftheseflow-changesbetween1993and1994.AsshowninTable3.1,in1992and1993theLDCfuelexportersdidnotaccumulateorlosedollarsreserves,but

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in1994therewasa$20billionloss(thisportionofthedataisfairlyreliableasreportedtotheIMF).Thislossinreservesoccurreddespite$20billionin‘netfinancingindollars’byLDCfuelexportersin1993and$25billionin1994(stillreliabledata).WheredidthesemonetaryreservesandcreditsuppliesofdollarsheldbyLDCfuelexportersgo?Table3.1estimatesthat,fromallsources(notjustLDCfuelexporters)therewasflowofhiddendollarincomeintooffshorecentersandtaxhavensof$50billionin1993and$55billionin1994,andadditional‘capitalflight’intothedollarisestimatedat$40billionin1993and$50billionin1994(unreliabledatanow).Industrialcountries(excludingtheUS)wereaccumulatingdollarreservesinthisperiod(anadditional$40billionin1993and$80billionin1994);thereforetheywerenotlikelytobecontributingdollarstooffshorefinancialmarkets.Likewise,theUSwasreceivingamassiveinflowofdollarsinallinvestmentcategories.Therefore,theLDCs,especiallyMexico,probablyaccountedforamajorityofthedollarflowsintooffshoremarkets,whichinturnweremostlytransferredtotheUSandotherindustrialcountries(see‘uses’offoreignsavingsindollarsinTable3.1).

Byearly1995,theonlysolutiontoavoidMexicangovernmentinsolvency,andbankruptciesacrosstheMexicaneconomy,wastofindaninternationallenderoflastresort.On31January,therescuepackagewasfinalizedwhentheIMFagreedtoprovide$10billioninfive-yearloansontopofthe$7.8billionincreditithadalreadypromisedMexico.Additionally,byexecutiveorder,USPresidentClintonapproved$20billioninloanswithtermsofasmuchastenyearsbytappingtheUSTreasury'sExchangeStabilizationFund(normallyusedtosupportthedollar);majorindustrialnationscontributed$10billioninshort-termcreditthroughtheBankforInternationalSettlements;Canadapledged$1billionandLatinAmericannationspledged$1billion.TheUSandIMFconditionsfortheseloansincludedstricttargetsformoneysupply,domesticcredit,fiscalspending,andforeignborrowing.Furthermore,unprecedentedinternationalcollateralizationwasobtained—Mexico'soilexportrevenuescanbeheldbytheFederalReserveBankofNewYorktoguaranteeUSloans.Thetotalrescuepackagethusamountedtoapproximately$50billion,whichwasenoughtostabilizetheMexicaneconomy.Foreigninvestors,whohadseentheirMexicanholdingsreduced45percentbythedepreciationinthepesosinceDecember,drovethepesoup18percenton1Februaryandstockpricesrose5.2percent.

VII.JAPAN'SCRISIS,1989–

ThestoryoftherecentAsianeconomiccrisisshouldbeginwithJapan'scrisis,whichhitin1989.Bythemid-1990s,mostJapaneserealestateaswellasstockmarketpriceshaddropped50percentfrom1989levels,economicgrowthwasstagnant,andthe‘Japanesemiracle’wasover.Theauthor's

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positionisthatthemonetarycontractionallowedbytheBankofJapanunderGovernorMieno,beginningwithinterestrateincreasesinMayandOctoberof1989,wasamistakewhichcausedmuchofthecrisis.

AreducedvaluationofJapaneselandandequitypriceswascominganywayintheearly1990sgiven‘thelawofoneprice’forrealpropertythatwasquicklybeingestablishedacrosstheglobaleconomyduetointegrationandglobalizationofmarkets(seethediscussionof‘interest-rate-parities’and‘financial-strategy-parities’inChapter1).Forexample,price-earningsratiosintheJapanesestock

parities’inChapter1).Forexample,price-earningsratiosintheJapanesestockmarketwouldnaturallydropclosertothe20/1globalaveragesfromtheirhistoriclevelsof50/1,asnewly-deregulatedinvestmentfundscouldleaveJapaninsearchofmorefavorableprice-earningsratioselsewhere.In1989,giventhisinvestmentoutflowwhichwasrequiredbythelawofoneprice,a‘hollowing-out’oftheJapanesemoneyandinvestmentbase,andGDP-deflation,weremoreofariskthaninflation—restrictivemonetarypolicyturnedtheriskintoreality.

TheBankofJapan'srestrictivemonetarypoliciescontinuedthroughtheearly1990s,despitetheassetdeflationandtheincreasingconsensusbyinternationalinvestorsthatJapanfaceddeflationaryriskssimilartowhathappenedintheUSduringtheGreatDepressionafterthe1929stockmarketcrash.Accordingtomanyinfluentialforeigninvestors,‘GovernorMienowasageneralfightingthelastwar[againstinflation]’(Brown,1996,p.24).Takingaccountoftheshiftinprivateconsumptiontowardsdiscountoutlets,theGDPpricelevelinJapanwasprobablyfallingby2percentormoreby1995,yetJapanesemoney-marketinterestrateswerekeptupattwotothreepercent—ahistoricallyhighrealrateof4to5percent.Thehighrealinterestratesdeepenedtherecession,andJapanesebanksbeganhavingtroubleswithnon-performingloans.Thisrecessionarydeflationary-debtspiralcontinuestoworsenattheendof1998asthisbookiswritten.

Theauthor'spositionisthatthe1990s‘hollowing-out’oftheJapaneseeconomycouldhavebeenlargelyavoidedwithmoreaccommodativemonetarypolicies.Instead,Japanlostitsfinancialsurplusandthereforeitsmeanstomaintainrecordratesofforeigninvestment.Itsnetoutflowofdirectinvestmentplusportfolioinvestmentplusothercapital(the‘identifiedcapitaloutflow’)droppedto$22billionin1990fromanannualaverageof$58billionover1986–1989.In1991,temporarily,theJapanesenarrowmoneysupply(m1)wasonceagainincreasedsignificantly,by9.5percent,andtheidentifiedcapitaloutflowjumpedbackup,to$72billion.However,monetarypolicyremainedrestrictiveonbalancethroughthe1990s(realshort-terminterestratesof4–5percent),andJapaneselandandequitypricedeflationspreadtoGDPmarketsastheBankofJapancontinuedto‘fightthelastwaragainstinflation’.

AselaboratedinChapter3,‘absorption’ofbasemoneybyfinancialmarketsandthereforeadeclineinitsrateofcirculationforGDPpurposes(v),intimesoffinancialdistress,canalsobemeasuredbyaweaknessinthe

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growthofbroadmoney.Namely,expandedsuppliesofhigh-poweredmoneymaynotbeabletoserveasabaseforexpandedsuppliesofbroadmoneyifthehigh-poweredmoneysuppliesareinsteadconsumedbyfinancialinstitutionstoresolvebankruptcies,increasereserves,andmeetothercapitalrequirements.Inthiscase,adeclineinbroadmoneywouldcorrespondtoadeclineinthevelocityofhigh-poweredmoneyasitisabsorbedbydistressedfinancialmarketsratherthanbeingusedtosupportgrowthinGDP.AsshowninFigure3.1,Japan's(m1)velocitybegandroppingsignificantlyintheearly1990s.

Figure4.3alsoshowsthisscenarioforJapan.AdramaticdeclineinthegrowthofJapan'sbroadmoneysupply(m2+CDs)wasallowedinthe1990swhichcorrelatedwithdeclinesinthestockmarket,realestatevalues,andrealGDP(inJuly1998aGDPrecessionbegan).Maintainingthegrowthofthenarrowmoneysupply(m1)hasnotpreventeddeflationandrecession,becausemoreofthe(m1)isabsorbedbydistressedfinancialinstitutions.Elaboratingthissituationfurther,researchin1998indicatedthat:

Figure4.3NegativeconsequencesofrestrictiveJapanesemonetarypolicyafter1989

ThedramaticdeclineinJapan'sbroadmoneysupplygrowthrate(m2+CDs)inthe1990swascorrelatedwithdeclinesinthestockmarket,realestatevalues,andrealGDP.Maintainingthegrowthofthenarrowmoneysupply,(m1),hasnotpreventeddeflation,becausemoreofthe(m1)isabsorbedbydistressedfinancialinstitutions.Japan'smonetarycontractionhascontributedtoAsianandworldwidemonetarydeflationandrecession.(Annualpercentratesofchange,1975–1997).

Source:IMF

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Acentralbankinadeflationarysituationwithtroubledbanksmustavoidinterpretinglow[nominal]interestratesasanindicatorofanexpansionarypolicy.WhenmonetarygrowthislowanddefaultrisksarehighasinJapantoday,lowinterestratesreflectexpectationsofbothlow(ornegative)inflationandratesofreturn.Insuchasituation,theappropriatefocusofmonetarypolicyisonmoneyandnotinterestrates[broadmoneysuppliesshouldbeexpandeddespitelowinterestrates)(FederalReserveBankofSt.Louis,p.1).

Thus,whatwasinitiallyseenintheliteratureasarecklessandspeculativeexpansionofdomesticcreditinJapaninthe1980s,anunsustainablebubble,wasinsteadincreasinglyseenasamoresustainableformofeconomicgrowthbaseduponmonetaryexpansion.AsshowninFigure4.3,monetaryexpansioninthe1980swasnothighcomparedtothe1970s.Intheauthor'sview,Japaninthe1980sprintedthemeanstobuyforeignassetsandexpandwealthdomesticallywithoutacceleratingGDPinflation.Ifoverlyrestrictivemonetarypolicieshadnotbeenused,theexpansioncouldlikelyhavecontinuedbutatamoremoderatelevelinproportiontothenewinternationalinvestmentopportunitiesthatwerebeingfoundby‘JapanInc.’intheglobaleconomy.Whilebeyondthescopeofthisbook,econometricworkasperChapter3'sanalysisoftheUSisneededinordertoidentifythelinkagesinJapanbetweenmonetarygrowthandtheratethatnon-inflationaryeconomicgrowthcanbesupportedinthiscurrentperiodwhichischaracterizedbytechnologicalchange,deregulation,andnewinternationalopportunities.

VIII.Asia'sCrisis,1997–

TheinvestmentflowsoutofJapaninthemid-1990sfound‘homes’,primarily,intherestofAsiaaswellastheUS.JapanbecamethemajorsourceofbankloanstoeverymajorcountryinAsiaexceptTaiwanandthePhilippines.Japan'soutstandingloanstoSouthKorea,Taiwan,Thailand,Indonesia,MalaysiaandthePhilippines,combined,rose76percentfromtheendof1993totheendof1996,includingadoublingoflendingtoSouthKoreaandThailand.Also,by1996Japanaccountedformorethan40percentofallbankloanstoHongKongandmorethan30percenttoSingapore.Japan'smonetaryoutflowthushelpedsupportwhatwasessentiallyamonetary-investmentexpansionintherestof

supportwhatwasessentiallyamonetary-investmentexpansionintherestofAsiaduringthemid-1990s.

GlobalinvestmentinflowsintothisregionduringthisperiodwerefurtherencouragedbythederegulationandinternationalizationofcapitalaccountsandforeignexchangetransactionsinallAsiancountries,privatization,andbygovernmentcommitmentstosupportAsianexchangeratesagainstthedollar(HaggardandMaxfield,1996).USandEuropeancompaniesweresettingupfactoriesinAsia(directinvestment),andtheportfolioinvestmentinflows

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fromtheUSandEuropeexceededthosefromJapan.TheWorldBankestimatesthattotalinternationalcapitalflowsto‘emergingmarkets’increasedfrom$50billionin1991to$250billionin1996,withthemajoritygoingtoAsia.Totalcapitalformation(corporate,housing,andgovernmentinvestment)inAsiaexcludingJapanincreased300percentfrom1990to1996,whichcomparedwithmuchlowerincreasesofapproximately40percentintheUSandJapanand10percentinEurope.

PerhapsThailandwasthemostobvioushomeforinternationalinvestmentfundsinthisperiod.Technocratshadevenmanipulatedinterestratesandcurrencyexchangerateswithaformuladesignedtobringininternationalcapital:

Since1987theThaiauthoritieshavekepttheircurrencylockedtotheUSdollarinabandofbaht25–26[toonedollar]whilemaintainingdomesticrates500–600[basis]pointshigherthanUSratesandkeepingtheirbordersopentocapitalflows.ThaiborrowersnaturallygravitatedtowardsUSdollarborrowingsandthecommercialbanksaccommodatedthem,withtheresultthattheThaibanksnowhaveanetforeignliabilitypositionequivalentto20percentofGDP.TheborrowersconvertedtobahtwiththeBankofThailandtheultimatepurchaseroftheirforeigncurrency.Fuelledbycheapeasymoney,theThaieconomygrewrapidly,inflationrose,andthecurrentaccountdeficitballooned(HGAsia,1996).

BecausethisThaiformulawassosuccessfulinattractingcapital,itwassooncopiedbythecentralbanksandfinanceministersinthePhilippines,Malaysia,andIndonesia.TheInternationalMonetaryFundandtheWorldBankpraised

andIndonesia.TheInternationalMonetaryFundandtheWorldBankpraisedthesepolicies,especiallytheeliminationofbarriersbetweendomesticandglobalfinancialmarkets.Aslateasthesecondhalfof1996,theIMFcitedThaipolicymakersfortheir‘consistentrecordofsoundmacroeconomicmanagementpolicies’(Chote,1997).

Inthisoptimisticfinancialliberalizationphase,Thailandreceivedlarge-scaleinternationalinvestmentinflowsmostlyfromprivatesources,includingoffshorefinancialmarkets.In1994–96,offshorebanks(BangkokInternationalBankingFacilities)wereallowedtoborrowfundsinternationallyandlendthemtoThairesidentswithoutlimit.Unlikemostbanks,thesebankswerenotrequiredtodiscloseassetmixes(suchastheextentofrealestateloans)ornon-performingloans,andtheywereallowedtopurchasefinancecompanies.In1994–96,Thailandreceivedanetinflowofapproximately$25billioninportfolioinvestmentandanother$50billioninloanstoThaibanksandenterprises.Thelattermostlyfounditswayintothestockmarket,consumerfinancingand,especially,realestate.Commercialbanksandfinancecompanieswereestimatedtohave40percentoftheirloansintorealestate.

Thus,themid-1990swasafinancialliberalizationphaseforAsiaassupportedbythedollar,yen,andotherhardcurrencies.Localcurrencyandcreditsupplieswereexpandeddramaticallybaseduponconfident

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convertibilityintothehardcurrencies,andthe‘money-float’or‘money-pyramid’encouragedsomerecklessspeculation.TheIMFandothergovernmentagenciesencouragedfinancialderegulationandfree-market‘dollarization’oftheseeconomies,andthepresenceoftheseoptimistic‘lendersoflastresort’increasedthemoral-hazardproblemwhereby‘evenifsomethinggoeswrongtheagenciesinvolvedhaveaninterestinbailingmeout’.

Thencamedollar-flight,dollar-contraction,andcrisis,asdiscussedbelow.

Atthecoreoftheglobalfinancialeconomyisthedollar,whichaccountsforapproximately60percentoftheworld'smoneysupply,andatthecoreofthis‘dollar-float’isthe(m1)inUScirculation,andatthecoreofthiscoreisthemoney-reservesofUSdepositoryinstitutions.TheUSFederalReservehassignificantcontroloverthegrowthoftheselattertwostatistics,andisthusa

significantcontroloverthegrowthoftheselattertwostatistics,andisthusapowerfuldriverofthehigh-poweredmoneybaseofnotonlytheUSeconomybutalsotheworldeconomy.Figure4.4showsthegrowthrateofbothstatisticsfrom1988toapeakin1992,andthenadeclineafter1992.Fearsofinflationacrossthedevelopedworldwereexaggeratedafter1992andtranslatedintocontractionarymonetarypoliciesandinterestrateincreasesof1–2percentagepointsforthehardcurrencies.Asdiscussedabovein‘TheMexicanCrisis,1994–95’,theseincreasesininterestratespulledmoneyoutofMexicowhichcontributedtoitscrisis.

Viewedfromthehigh-powereddollarcoreoftheworldeconomy,themid-to-late1990speriodwasthuscharacterizedbyextremelyrestrictivemonetarypoliciesandeven‘dollar-destruction’.Furtherevidenceforthisviewisprovidedbydollar-currency-appreciationandcapital-flighttothedollarrelativetovirtuallyallotherworldcurrencies,thehistoricallyhighinflation-adjustedUSdollarinterestrates,andthedramaticdeclineinvirtuallyallcommoditypricesmeasuredinUSdollars.

Regardingcurrencyexchangerates,thedollarappreciated20percentagainsttheGermanmark(andthereforemostoftheEuropeancurrencies)andtheJapaneseyen,measuredfromthebeginningof1997tothemiddleof1998.Japantriedtomaintainsomestabilitybetweentheyenandthedollarinmid-1997toavoidfurther‘crisesofconfidence’intheJapaneseeconomy,butthesepoliciesproveduntenablebyearly1998.Thisfree-marketappreciationofthedollaragainsttheotherhardcurrencieswasrequiredbysupply-demandconditionsaseffectedbytherestrictiveUSmonetarypolicies.

TherewasevenmoredramaticandsuddenappreciationoftheUSdollaragainsttheotherAsiancurrenciesoverthesametimeperiod.Asdiscussedabove,Thailandandtheothershadapolicyofkeepingdomesticexchangeratesfixedagainstthedollar,andaspartofthisstrategy,theywereexpandingdomesticcurrencysuppliesbaseduponaguaranteedconvertibilityintothedollar.Inotherwords,smallAsiancountrieswereconductinganormalreserve-currencyprocessofcreditexpansionwiththedollarserving

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as‘real-money’andtheThaibhatandotherlocalcurrenciesservingas‘quasi-

as‘real-money’andtheThaibhatandotherlocalcurrenciesservingas‘quasi-moneys’thatarefloatedbeyondanamountthatcouldallbeconvertedintodollarsatonce.

UnfortunatelyforAsia,bymid-1997therestrictiveUSdollarmonetarypoliciesandsupply-demandimbalancebetweenthedollarandAsiancurrenciescouldnolongerbedenied.AsianmonetaryauthoritiesnolongerhadenoughreservesofUSdollarstointervenewith(bysellingthemtotheprivatemarkets)insupportoftheirfixedexchangerates(bybuyinglocalcurrenciesofftheprivatemarkets).

Figure4.4NegativeconsequencesofrestrictiveUSmonetarypolicyafter1993

BothUS(m1)andbankreservesincreasedrapidlyin1992and1993,andthuscontributedtoaworldwidedollar-basedmonetaryexpansion;then,after1993,bothdeclinedrapidlyandcontributedtorestrictiveworldwidemonetaryconditionsandhighUSdollarrealinterestrates.HighUSdollarrealinterestratesattractedinternationalinvestmentintotheUS,especiallyasdepositedinbroad-moneyaccounts(m2andm3).TheUSexperiencedabroad-moneyexpansionafter1993andstrongeconomicgrowth,butmanyothercountriesexperiencedacontractioninbroad-moneysuppliesasinvestmentflowedtotheUS.FinancialcrisesinMexico(1994–95)andAsia(1997–)wereaffectedbythisreversalfromexpansionarytocontractionarydollar-basedpolicies.(Annualpercentratesofchange,1989–1997)

Source:FederalReserveBank.

Thecrisishit.Theimpossiblerushtofullyconvertlocalquasi-moneysandcreditintodollarshappenedfirstinThailandwithflightfromtheBaht,andthentherushtoconvertwasimmediatelycopiedinthePhilippines,Malaysia,

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SouthKoreaandelsewhere.UltimatelyIndonesiawasthehardesthitwiththebiggestdeclineindollar-valueofitsdomesticcurrency,adeclinethatcontinuedaftertheendof1997despitesomerecoverybytheotherAsiancurrenciesasinternationalbailoutswerearranged.SouthKorea,forexample,received$21billionincreditsfromtheIMF,andotherinternationalgroupsandnationsprovidedtherestofa$57billionpackage.

Thecurrencydevaluationprocessnotonlyreducesthedollar-valueofdomesticcurrencies,butitreducesreal(dollar-measured)domesticwealthincludingtheabilitytomaintainproductionandconsumption.Recession,andevendepressioninthecaseofIndonesia,wereimmediateanddevastating.Despitea$40billionlender-of-last-resortplanledbytheIMFforIndonesia,abjectpovertyroseto40percentandpoliticalinstabilityledtotheousterofPresidentSuharto.

Regardingcapitalflighttothedollar,notonlyAsiabutalsotherestoftheworldrapidly‘de-dollarized’theireconomiesafterthemid-1990s.USdollarshort-terminterestratesweremaintainedatapproximately5percentbytheUSFederalReservefrom1996through1998,despitedeclininginflationintheUSeconomy.USGDP-inflationdroppedfrom2–3percentinthemid-1990stoaslowas0–1percentin1998.Realinterestrates,ortherealrate-of-returnfromshort-terminvestingintheUSeconomythusclimbedfrom2–3percentinthemid-1990sto4–5percentin1998.Fourtofivepercentisanextremelyhighrealreturn,anditexceededanyothershort-termsafereturnintheglobaleconomy.InternationalinvestmentthuspouredintotheUS.

Officialstatisticsidentifykeyturning-points,inthelate1990swhenworldwidefinancialflowsbegantofavortheUS.ForeigninstitutionsandindividualsincreasedtherateatwhichtheywerepurchasingUSfinancialassetsfrom$563.4billionin1996to$733.4billionin1997.Thisrecordinflowin1997cameespeciallyinthethirdandfourthquartersasUSrealinterestratesincreasedandtheAsianfinancialcrisishit—inflowsof$182.5and$219.5,respectively.Then,inthefirstquarterof1998,thisinflowslowedtoamorenormal$90.5billion,reflectingdeterioratingAsianbalancesheetsandthesubsequentneedbyAsianbankstorepatriateforeignassets.Forexample,JapanesebanksreducedtheirassetsintheUSfrom$358billionin1997to$289attheendofMarch,1998,andthereweresimilarpercentagedeclinesinallotherAsianbankassetsintheUSexceptTaiwanwhichhadmostlyescapedthecrisis.

Similarlyinthelate1990s,USinstitutionsandindividualsreducedtherateatwhichtheywerepurchasingforeignfinancialassets,butthisreductiondidnotoccuruntiltheAsianfinancialcrisisbecamewidespreadandthreatenedotherregionsoftheworldearlyin1998.USpurchaseofforeignfinancialassetswas$368.8billionin1996,$478.5billionin1997,andthenonly$47.4billioninthefirstquarterof1998.CombiningforeignpurchasesofUSfinancialassets,andUSpurchasesofforeignfinancialassets,yieldsthe‘net

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identifiedfinancialflow’betweentheUSandtherestoftheworld,whichwasthusanetinflowintotheUSof$194.6billionin1996,$254.9billion1997,and$43.1billioninthefirstquarterof1998.ThesenetinflowsintotheUSweremuchhigherthaninpreviousyears,whereintransfersof$100billionperyearwerenormal.

AsdiscussedinChapter3,theriseofoffshorefinancialmarketsmakesthisdataunreliable,becausefinancialflowsthroughoffshoreinternationalbankingfacilities,‘spontaneousoffshoresites’,and‘taxhavens’aredifficulttomeasure.Aggregateworldwidedatashowsthatmonetaryflowsintoofficialcountryaccountsaresystematicallylessthanoutflows,andeconomistsbelievethatmuchofthisdifferenceaddstooffshorefinancialmarkets.InthecaseoftheUS,whatiscalledthe‘statisticaldiscrepancy’betweenmonetaryinflowsandoutflows(producttradeaswellasfinance)amountedto$59.6billion(anexcessofmeasuredoutflowsoverinflows)in1996,$99.7billionin1997,andonly$5.2billioninthefirstquarterof1998.However,flowsintooffshoremarketshaveastheirmajorcounterpart(oftenunmeasured)interbanktransfersofdollarstotheUSeconomy.

ThesehiddendollartransferstotheUSaremostlikelytoshowupinwhattheFederalReservemeasuresas‘overnightandtermEurodollars(net)’heldbyUSinstitutions.(AEurodollarisaUSdollarownedbyanon-UScitizenorinstitution.)OvernightandtermEurodollars(net)heldintheUS,whichdecreasedsteadilyfrom$117.0billionin1988(year-end)to$66.3billionin1993,thenincreasedsteadilyto$80.8billionin1994,$88.6billionin1995,$109.2billionin1996,and$145.3billionin1997.Inearly1998,theseholdingsbegandroppingonceagain,andstoodat$136.3billioninJune.ThesechangesinEurodollarholdingsintheUScorrespondtowhatwouldbeexpectedbasedupon

EurodollarholdingsintheUScorrespondtowhatwouldbeexpectedbasedupontheriseinUSdollarrealinterestratesafter1994,andthecapitalflighttodollar-havens(firstoffshoremarketsandthentheUS)asAsiaandotherregions‘de-dollarized’theireconomiesin1997.ItisthuslikelythatacertainamountofhiddennetdollartransferstotheUSshouldbeaddedtotheofficiallymeasurednetinflowsinrecentyears—afurthersignthatmonetarypolicies,institutions,andperceivedrisk-adjustedreturnhavefavoredthedollarandtheUSattheexpenseofothercurrenciesandregions.

FurtherproofthatUSdollarmonetarypolicieshavebeenquiterestrictive,withworldwideconsequences,isprovidedbytherecentcollapseinvirtuallyallcommoditypricesasmeasuredindollars.Fewerdollarsavailablefortransactionsininternationalmarketsmeansthatfewerdollarsareswappedforthesamevolumeofcommodities,i.e.thereisdollar-deflationininternationalcommoditymarkets.AccordingtotheglobalcommodityindexpublishedbyTheEconomist,fromend-July1997toend-July1998thedeclineindollarpricesofallcommoditieswas22.2percent,thedeclineindollarpricesoffooditemswas20.6percent,thedeclineindollarpricesofindustrialcommoditieswas24.1percent(includingmetals),andthedeclineindollarpriceofcrudeoilwas34.8percent.

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Thesepricedeclinesmirrorthepercentagebywhichthedollarappreciatedoncurrencymarketsagainstatrade-weightedbasketoftheworld'sothercurrenciesoverthesametimeperiod.Ofcourse,country-by-countryconsequencesofworldwidedollar-price-deflationandtherelateddollar-flighttodollar-havensvaryconsiderablybaseduponthedegreetowhichcountriesexportorimportcommodities,thedegreetowhichtheyrelyondomesticdollarsuppliesformonetarystabilityasdiscussedabove,etc.

Whatiscleartotheauthor,then,isthatrestrictiveUSdollarmonetarypoliciesinthemid-1990sinthecoreoftheglobaleconomyhavebeenanimportantcauseoftherecentworldfinancialcrisis,especiallybecausethesepoliciescamesoswiftlyontheheelsofthemoreaccommodativemonetarypoliciesandliberalworldwidedollarizationintheearly1990s.On4August1998,USFederalReserveChairmanAlanGreenspanstated:‘IntheSpringof1998theFederalOpenMarketCommitteewasconvincedthatariseininflationwastheprimary

OpenMarketCommitteewasconvincedthatariseininflationwastheprimarythreattothecontinuedgrowthoftheUSeconomy’.Later,inlateSeptember,hestatedthattheFederalReservehadbecomeevenlysplitinmid-AugustastowhetherthemajorthreattotheUSeconomywasinflationor,alternatively,deflationandrecession.

InconductingitsmonetarypoliciesfortheprimarypurposeofstabilizingtheUSeconomyandpromotingitsnon-inflationaryeconomicgrowth,theFederalReservecontributedtoaworldwidemonetarycontraction,financialcrisesandrecessioninthemid-1990s.Unlikeinthe1930s,moreUSdollarsnowcirculateoutsidetheUSthancirculateinside,andtheUSdollarisnowresponsibleforamajorityofthe‘high-poweredmoney’ormonetary-baseuponwhichworldsuppliesofmoneyandcreditaremaintained.Evenmorethaninthe1930s,itisthusnecessarythattheFederalReservecooperatewithotherhard-currencycountriesincludingWesternEuropeandJapantomaintainworldwide,andnotjustUS,suppliesofmoneyandcredit.Ifbroad-moneysuppliescontinuetoshrinkworldwide,measuredinUSdollarterms,thentheriskofdebt-deflation,recession,andevendepressionincrease.

Policymakersandanalystsrightfullynotethat,whileUS(m1)andbankreservesweredecliningafterrestrictivenarrow-moneypolicieswereimplementedin1994,broadmeasuresofmoney-liquidityintheUSwereincreasing,suchasm2(m1plusretailmoney-marketfunds,savingsdepositsandsmalltimedeposits)andm3(m2pluslargetimedeposits,Eurodollars,andinstitution-onlymoney-marketfunds).Figure4.4showsthesetrends.Partofthedisjunctionbetween(m1)andthebroaderaggregatesafter1994isappropriateandduetotheincreasein(m1)velocityaftertheSECreducedthesecurities-funds-settlementtimefor(m1)tobemadeavailable(Chapter3).

However,itislikelythatthenetinflowoffinancialinvestmentintotheUSfromtherestoftheworldissignificantlyresponsibleforthegrowthin(m2)and(m3)since1994.InternationalinvestmentlargelyshowsupinUSmoneysuppliesasmoney-marketfunddeposits,largetimedeposits,

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Eurodollardeposits,etc.,whichareincludedin(m2)or(m3)butnot(m1).Forexample,netforeignpurchasesofUSgovernmentsecuritiesdramaticallyincreasedfrom$100billionin1993and1994to$200billionin1995toalmost

increasedfrom$100billionin1993and1994to$200billionin1995toalmost$300billionin1996and1997.USgovernmentsecuritiesholdingsinthefinancialsystemareoftenthewholesalefundingbaseforretailmoneymarketfundandlargetime-depositaccounts.Also,asdiscussedabove,offshorefinancialmarketshavebeensendingalotofEurodollarsandlargeinstitutionalfundstotheUS,whicharefundingsourcesfortheseaccounts.

Thus,theFederalReservehastoleratedareductioninUS(m1)andbankreserves,ineffect‘sterilizing’orremovingbasemoneyfromcirculation,astheUSeconomyrunsonanincreased(m1)velocityofmoneyandforeign-supportedbroadmoney(m2)and(m3).Attheendof1998,USinterestrates,especiallyshort-termratespaidonthescarcenarrow-moneyaccountsremainedhigh.Longer-terminterestrates,suchasthosepaidonthebroadmoneyaccountswhichareheavilydemandedbyforeigninvestors,werenotsohigh.Insomecases,long-termrateswereevenlowerthanshort-termrates—aninverted‘yieldcurve’—whichisaveryrareoccurrence.Inthiscase,alikelihoodofeconomy-widedeflationwassignaled,anditwouldbelargelytransmittedtotheUSeconomyfrominternationalmarkets.

Asthisbookisbeingwritteninlate1998,theUSFederalReservehasjustreduceditsshort-terminterestratesandeasedcreditconditionsinordertobeginamonetary-expansionprocessandpreventworldwidedeflationaryconditionsfromhittingtheUS.HowUS(m1),(m2),and(m3)willbeaffectedinthelongrunremainstobeseen,butitappearsthat‘reflation’ofUSmonetaryaggregatesissufficientforthepurposesoftheUSeconomy.Thedanger,ofcourse,asrecentlyexperiencedbyJapan,isthat,atsomepoint,US(m1)growthmaynotbeabletotranslateintobroadmoneygrowthandthushelppreventfinancialcrisesandrecession.ThisdangerismorelikelyifthenetflowofforeigninvestmentintotheUSsubsides.

1.The‘CaseStudyofUS-ForeignTrade,1981–’isdiscussedinChapter2.

2.‘The364Economists'AttackonGovernmentPolicy’,BarclaysReview56,May1981,p.27.

3.BusinessWeek,4April1983,p.67.

4.Ibid.

5.‘WhileInvestorsareActingonTheir‘WishfulThinking…’,BusinessWeek,2March1987,p.24.

6.‘Banking'sBalanceofPowerisTiltingTowardtheRegionals’,BusinessWeek,7April1986,p.56.

7.‘FinancingUSDeficitAbroad’,TheNewYorkTimes,7November1985.

8.Anexcellentsummaryofvariouspotentialcausesofthecrash,especiallythetradedeficitannouncement,iscontainedin:MarkMullins(1989),‘Meltdown

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MondayorMeltdownMoney?:CausesoftheStockMarketCrash’,InternationalEconomicsandFinancialMarkets,Chapter3,Oxford:OxfordUniversityPress.

9.‘MonetaryPolicyCausedtheCrash…NotTightEnough…TooTightAlready’,TheWallStreetJournal,22October1987,p.34.

10.Ibid.

11.UnitedNations,WorldEconomicSurvey,1986.

12.‘EconomicandFinancialIndicators’,TheEconomist,20June1992,p.108.

13.‘TheTriumphofCapitalism’,TopicalStudy#17,Prudential-BacheSecurities,1August1989,p.14.

14.‘SpontaneousUnion,aSurveyoftheNewGermany’,TheEconomist,30June1990,p.12.

15.In10,000boothsandbanksaroundthecountry,EastGermanshadoneweektoexchange4,000EastGermanmarks(morefortheold,lessfortheyoung)atarateofone-to-oneintoWestGermanmarks.MostoftheremainingEastGermanmarksweretradedinforonlyhalfasmanyWestGermanmarks.Mostpricesandwageswereconvertedatone-to-one.Thismonetaryunionwentsmoothlyinamacroeconomicsenseinthattheincreasedsupplyof(WestGerman)marks

amacroeconomicsenseinthattheincreasedsupplyof(WestGerman)marksreflectedthevalueofEastGermanproduction.Therefore,WestGermaninflationdidnotsignificantlyincrease,andthemarkmaintaineditsvalueonforeignexchangemarkets.

16.‘SpontaneousUnion,aSurveyoftheNewGermany,’,ibid.

17.‘JustaQuestionofTime’,TheEconomist,11August1990,p.25.

18.‘SpontaneousUnion,aSurveyoftheNewGermany,’,ibid.

19.‘BundesposttoRaiseDM30bnForEGermanPhoneNetwork’,FinancialTimes,21June1990,p.1.

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5.InternationalAdjustmentsandPoliticalResponses

AsperthemorepersonalnotesintheIntroduction,theauthororiginallydecidedtowritethisbookduetohisdissatisfactionwiththetypicaltextbooksininternationaleconomics,macroeconomics,andtherelatedsubjectsthatheteaches.Thesetextbooksdonotpresentthemajorstructuralchangesandrecenteventsintheglobaleconomytohissatisfaction;insufficientattentionisgiventofinancialmarketglobalization,newtradepatterns,newformsandusesofmoneyandchangesinitscirculation,monetarywealthprocesses,andrecentfinancialcrisesandrecessions.HopefullyinChapters1–4theauthorhasbeenabletoenhancethereader'sunderstandingofthesetopics.

Itisnotonlytheconventionaleconomictheoryregardingthesetopicswithwhichtheauthorisdissatisfied.Healsofinds(anddarehesay)thatthemajor‘players’whoworkverycloselywiththeevolvingmarkets—theGroupofSeven(G7),centralbanks,theWorldBank,theInternationalMonetaryFund(IMF),variousnationalpolicymakers,etc.—alsoseemsomewhatnaïveoratleasttoodismissiveabouttheseparticulartopics.

Forexample,inareviewofthefirsteditionofthisbook,amemberoftheFederalReserveBoardconcludedthattheauthor‘grosslyoverstates[thatfinancialglobalization]istheprinciplecauseandexplanationofvariouseventsthatAllenexaggeratedlyreferstoas‘‘crises”’.1Thiscommentwasmadeinfulllightofthe‘lostdecade’and50percentdeclineinstandardoflivingduringthe1980sinmuchofLatinAmericaduetoitsinternationaldebtcrisis,andinfulllightofthe50percentdeclineinJapan'smonetarywealthfrom1989–94duetointernationalcapitalrevaluation,etc.Perhapsnowthat‘Asia'sCrisis,1997-’hasoccurred,andnowthatanadditionalfiveyearsofhistoricalperspectiveontheseverityofthe‘events’ofChapter4hasbeendigested,itispossibleformorepolicymakerstoadmiteconomic‘crisis’intotheirthinkingandlexicon.

Asanotherexample,thereisarecentbookco-authoredbyPaulVolcker,chairmanoftheUSFederalReserveSystemfrom1979to1987,andToyooGyohten,formervice-ministerforinternationalaffairsintheJapaneseMinistryofFinance,whichprovidesasweepinghistoryandanalysisofinternationalmonetaryaffairs.Thebook,ChangingFortunes:TheWorld'sMoneyandtheThreattoAmericanLeadership,doesnotoncementiontheearly1980sdecline

of(m1)incomevelocity,nordoesitcitethisdeclineas

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thereasonwhymonetarypolicywastoorestrictiveinhindsight.Whendiscussingcausesoftheearly1980sworldrecessionandtheinabilityofMexicoandotherstorepayforeignloans,Volckerstatesthat:

thegenerallevelofinterestratesreachedhigherlevelsthanIormycolleagueshadreallyanticipated…interestratesmovedstillhigher,withthecommercialbanks'primelendingratereachingtheunheard-oflevelof15.25percentinearlyFebruary1980…weattheFedsawnoalternativetotighteningagaingiventhegrowthinthemoneysupply(VolckerandGyohten,1992,p.170–71).

AsdiscussedinChapter4,thistargetingofmoneysupplybaseduponinflationgoalsandinattentiontochangesinmoneyvelocity,asistypicalofthemonetarismschool,resultedintheworldwidemoney-liquiditycrisesoftheearly1980s.Similarpolicyinattentiontoormisunderstandingofchangesinvelocityhelpexplainthe1987worldstockmarketcrashandtheearly1990sslumps.

Asof1998,moneysupplytargetingismuchlesscommon.Economistsandpolicymakersnowadmitdifficultiesinpredictingmorevolatilemonetaryvelocities,andtheyadmitincreaseddifficultiesevenmeasuringthenewhigh-techglobalmoneysupplies.Consequently,monetarypolicyhasbecomeevenmoreofanadhocartwhichrespondstochangesineconomicgrowth,financialvaluations,andawidevarietyofmarketconditions.

Variousanomaliestomainstreameconomicmodels,suchasthemonetaryvelocitypuzzlemighteventuallybeworkedoutaspertheauthor'sequationsinChapter3—thisbookhasquibbledenoughalready.Anevenmoreimportantdebatelooms:towhatdegreeisthenewglobaleconomyinherentlyunstable,andtowhatdegreearethetypesofcrisesdiscussedinChapter4avoidable?TheseconcernsareraisedforcefullybySimonClarke:

…thewholeofeconomictheoryisbuiltonthepremisethatthecapitalistsystemisself-regulating,theprincipaltaskofthetheoreticaleconomistbeingtoidentifytheminimalconditionsunderwhichsuchself-regulationwillbemaintained,sothatanybreakdownwillbeidentifiedastheresultofexceptionaldeviationsfrom

thatanybreakdownwillbeidentifiedastheresultofexceptionaldeviationsfromthenorm…Foralltheirmathematicalsophistication,theexplanationsofcrisesofferedbytoday'seconomistsarenodifferentfromthosethatwerebeingputforwardatthebeginningofthenineteenthcentury.Itwasalwaysrecognisedthatalargeexternalshock,suchasawarorharvestfailure,mightprecipitateatemporarydisruptionintherelationsbetweenbranchesofproduction,orintheinternationaleconomicrelationsofthenationaleconomy,butthecauseofsuchacrisis[economiststypicallyargue]liesoutsidethecapitalistsystem,anditwasassumedthatstabilitywouldsoonberestoredbythenormalprocessesofmarketadjustment…ForKeynesians,asfortheclassicaleconomists,thetendencytocrisisisnotinherentinthecapitalistmodeofproduction,butisaresultoftheinadequacyofinstitutionalarrangementsandpolicyresponses…Aftertwohundredyearsofrepeatingthisnonsenseonewouldhaveexpectedthattheeconomistswouldhavebeguntosmellarat(Clarke,1994,p.1–3).

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ThebusinessofChapter5,then,istwofold.First,Clarke'scritiqueisaddressed,andtheauthorprovides‘anewpoliticaleconomyofmoney’.Secondly,theauthortriestoprovideusefulanalysisandsuggestionsforthepolicymakersand‘players’.Inthefutureperhapsworldfinancialcrisesandrecessionscanmoreeasilybeavoidedandnationscanpursuemoreappropriateeconomicpolicieswithintheevolvingstructureoftheglobaleconomy.However,theauthordoesfindeconomiccrisestobeendemicinthecurrentstructureoftheglobaleconomy.

I.ANEWPOLITICALECONOMYOFMONEY

Itisunfortunateforthepurposesofthisbook,astheauthoraddresseshimselftointernationalpolicymaking,thatmuchoftheinternationalrelationsandinternationalpoliticaleconomyliteratureusesgametheorybetweenrational,‘utilitymaximizing’nation-statesasacentraltoolofanalysis.Typically,thisliteraturestrivestopredictwhennationswillchoosecertaincooperativeversuscompetitivestrategies(Axelrod,1984;Keohane,1984;Oye,ed.,1986).Baseduponthepayoffsandcostsofcooperationversuscompetition,onemightthenattempttoexplainpoliticaldecisionsandeconomicoutcomes.Rationalnationscouldpresumablyseekwin-wingainswithothernationsordeliberatelyimposeslumpsonothernationsinwin-losegames.

slumpsonothernationsinwin-losegames.

Theauthorwouldcitefourproblemswiththeuseofrationalnation-statemodelstoexplainrecentfinancialcrisesandrecession.

First,thefinancialcrisesandrecessionsasdiscussedinChapter4were,generallyspeaking,tooimpoverishingfortoomanynationstobethepredictableresultsofutility-maximizingstrategiesbygame-playingnations,evenifcompetitivegame-playingmodelsareused(eventhoughlose-losegamesareallowedinthesemodels).

Secondly,thereissomeignoranceonthepartofpolicymakersaboutwhatpolitical-economicgametheyareplayingintheevolvingglobaleconomy,andwhatthecostsandbenefitsofvariousactionsare.Rationalgame-playingstrategiesarelesslikelytooccurwhenignoranceorconfusionispresent.Majorstructuralchangeshaveoccurredtoorecently,andtheyhavecreatedamoredynamicandchaoticglobaleconomythanhasbeenpossibletopredict.Eveninthosecaseswherewinnersandloserscanbefound,thegainstothewinnersweremostlikelyaccidentalandgreatergainscouldhavebeenachievedwithoutimposingsuchcostsonothersifpolicymakershadindeedunderstoodwhatwasgoingon.Forexample,theUSandothercapitalimportersdidgainattheexpenseoftheLDCsandothercapitalflightcountriesduringthe1980s.However,whentheearly1980sUSComptrolleroftheCurrencyspoketotheauthor'sclassseveralyearsago,hehadthistosayaboutthefinancialderegulationswhichhe,Volckerandotherscarriedout:‘webelievedintheprincipleoffreemarketfinance,butwecouldnot

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havepossiblyimaginedthelongrunconsequences[includingthemassiveUScapitalinflowwhichthisderegulationhelpedallow]’.

Thirdly,thegloballyintegratednatureoffinancialand,increasingly,non-financialmarketsdoesnotallownationalpolicymakerstocontroltheallocationofimposedcostsandbenefitsonacountry-by-countrybasis.Thisfactwouldbetrueevenifpolicymakershadfullworkingknowledgeofthenewglobaleconomy.Forexample,probablylessthan30percentofG7stockmarketsisownedbyindividualsloyaltoaparticularnation,andthusitisnotclearhowpolicymakersidentifytheirnationalinterest.AselaboratedinChapter2,the

policymakersidentifytheirnationalinterest.AselaboratedinChapter2,theincreasedinternationalownershipofcorporations,combinedwiththeincreaseinoverseasproductionandjointventures,andintradeasashareofG7economiesmakesprotectionismandothercompetitivetradestrategiesimpractical.

Fourthly,privatemarketsratherthannationalgovernmentsincreasinglydetermineeconomicoutcomes.Forexample,globalfinancialmarketscannowrepositionmorethan$3trillionbetweendifferentcountriesfrommonthtomonth.Ofthis$3trillion,$2trillionisso-called‘stateless’moneythatisvirtuallyexemptfromthecontrolofanygovernmentorofficialinstitution,butavailableforusebyallcountries.2Privatecapitalflowscanswamptheresourcesofcentralbanks,makingcentralbankinterventiontostabilizeexchangeratesorinterestratesineffective.

Havingcitedthesefourproblemswiththeuseofrationalnation-statemodels,theauthorwouldthuscallfor‘anewpoliticaleconomyofmoney’.Theremainderofthissectiondevelopselementsofanewframework,whichemphasizestheimportanceofsemi-autonomousfinancialprocesses.Increasingly,‘moneyiswealth’asdeterminedbysocialconsensus.Also,tothelimiteddegreethatnationsorinternationalinstitutionscanrationallydirectinternationalmonetaryflowstosuittheinterestsoftheirconstituents,theauthorwouldcalltheprocess‘money-mercantilism’.

A.Money,Wealth,andSocialConsensus

Baseduponthefindingsofpreviouschapters,theauthor'sframeworkallowsforthepossibilitythatwealthcanbeinitiallycreatedinfinancialmarkets—notonly,ascommonlybelieved,throughtheproductionofmerchandiseandnon-financialservices.Independentlyoftheeffortsoflaborinnon-financialmarkets,financialmarketparticipantsmightreduceowningandhandlingcostsofproperty,revalueexistingfinancialassetsupward,createnewfinancialassets,establishnewformsofownershipovernewresources,andtranslatethisnewfound,socially-acceptedwealthintosustainablepurchasingpowerovertime,withoutGDPinflation.Likewise,financialmarketparticipantsalsohavethepowertoreversetheseprocesses,andreducewealthandrealpurchasingpowerovertime.Thereneednotbeanyother

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mitialdriversofthesechangesinmonetarywealththanthelaborsandsocialconsensusoffinancialmarketparticipants.

Regardingtheroleof‘socialconsensus’,theauthor'spositionisthatinvisible‘beliefsystems’canengenderwealthindependentlyofphysicalprocesses,andthiskindofwealthcanbefirstrepresentedanddistributedthroughtheinstitutionsoffinance.‘Wealth’,whichtheauthorwoulddefinetoinclude‘purchasingpower,productionpower,andawidevarietyofsocialpowers’isthusrecognizedtohavetranscendental(subjective,unobserved)contentaswellasempirical(objective,observed)content.Inotherwords,invisibleexpectations,preferences,andsocialconsensus,asincorporatedintotheideologiesandinstitutionsoffinance,canbe‘wheretheactionis’,andwheredifferentialeconomicpowerisdeterminedacrosstheworldsystem.Theauthorwouldliketomakeclearthatheisnotadvocating,asamatterofethicsorsocialpolicy,transcendentalnotionsofvalueoverempiricalnotions,butratherhefindsthattranscendental,belief-systemprocesseshavedrivenchangesinempirically-observedphenomenon,aswellasviceversa.

Autonomous,transcendentalnotionsofvalueneednotreflect,orevenbecompatiblewith,theobservedempiricalworld.Forexample,thepurelytranscendental‘lawofcompoundinterest’isasocialagreementwhichmayormaynotcorrelatewiththewaythatthephysicaleconomygrows.Growthinthephysicaleconomyissubjecttothermodynamics,biologicalgrowthprocesses,capacityofinfrastructure,endowmentsofresources,sunlightandrain,etc.Perhapsdebtorsasagroup,whoarerequiredtopayexponentiallyincreasinginterestunderthistranscendentallaw,cangenerategoodsandservicesandthereforeeconomicrevenuesonlyinarithmeticallyincreasingincrementsovertime.Ithasbeenhypothesizedthatsomedebtorsmighthavetofail,andyieldtheireconomicresourcestotheothers,sothattheotherscanmeettheirobligations.

Whetherornotthistypeofdebt-repudiationcrisisissystemicallyrequiredinmoderncapitalismhasbeendebated.Mainstreameconomicthinkingisgenerallyconfidentthat‘hard-to-qualify’lending-restrictionsandothermicroeconomicpolicies,aswellasmacroeconomicmanagementofthebusinesscycle,whereinallpartiesareconsciousofsystemicrisk,canavoidover-lendinganddebt-failure.Incontrast,Marxists(seeClarke,1994)andothers,suchasFrederick

Soddy(1933),areconvincedthatthesecrisesareendemictocapitalism,andcannotbepreventedwithcommonKeynesianormonetaristpolicies.Kindleberger,inhiswell-respectedbookonthehistoryoffinancialcrises,takesasomewhatmiddleroadbetweenthesepositionsbyarguingthatmainstreameconomicsisincomplete,butitcanbestrengthenedifappropriateconsiderationisgiventovariousinvisibleexpectationsandsocialagreements,i.e.transcendentalnotions:

TheheartofthisbookisthattheKeynesiantheoryisincomplete,andnotmerelybecauseitignoresthemoneysupply.Monetarismisincomplete,too.Asynthesis

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ofKeynesianismandmonetarism,suchastheHansen-HicksIS-LMcurvesthatbringtogethertheinvestment-saving(IS)andliquidity-money(LM)relationships,remainsincomplete,evenwhenitbringsinproductionandprices(asdoesthemostup-to-datemacroeconomicanalysis),ifitleavesouttheinstabilityofexpectations,speculation,andcreditandtheroleofleveragedspeculationinvariousassets(Kindleberger,1989,p.25).

AsdocumentedinChapter4,massivedebt-repudiationcrisescontinuetohappenintheworldsystem.Therefore,wehavenotyetbeenabletoavoidover-lendingandperiodicdisjuncture-crisesbetween,ontheonehand,thebeliefsystemwhichincludesmathematicalcompoundinterest,andontheotherhand,theabilitytogeneratemoneyfromtangible‘realworld’processes.Theauthor'spositionisthatsomeborrowersandlendersareconsciousrisk-takerswhoknowthatperiodicfailuresarerequiredin‘casinocapitalism’(Keynes'phrase),whereasotherborrowersandlendersunderestimatesystemicriskandallowover-lendingbaseduponamistakenideologyregardingthestabilityofcapitalism.Thus,onbothaccounts,debtcrisesarelikelytoremainwithus.

Invisiblebeliefsystems,includingthoseofmoney-gamblersandoptimisticmarketcapitalists,havesupportedamoneyeconomybasedonexponentialinterestpayments,andaneasingoflendingrestrictions.Theacceptanceandgrowthofoffshorefinance,asdiscussedinChapter3,withoutreserverequirementsorothersignificantregulations,isanexampleofhowbeliefsystems—inthiscasefreemarketcapitalistideology—driveinstitutionalchange.Offshoremarketinstitutions,suchastheBangkokInternationalBanking

change.Offshoremarketinstitutions,suchastheBangkokInternationalBankingFacility,encouragedunsustainableover-lending,excessiveunprofitableconstructionofrealestate,etc.,andultimatelycontributedtotheriskofcrisis,recessionandmiserythroughoutAsia.Transcendentalbeliefsystemsandtheirsupportinginstitutionscanthusbeimportantdriversofchange.Muchoftheeconomicwealththatwasinitiallycreatedthroughdeposit-lending,asitexerciseditselfinproductionpower,consumptionpower,andpowertochangeinstitutions,wasdestroyedintherecentAsiancrisis;butitneverthelessdidexistasabroadsocialagreement.Also,lesswealthwouldhavebeendestroyediffinancialcapitalistshadbeenmorepatientinacceptinglower,lessriskyratesofreturnwhichweremorecompatiblewiththeabilityofhumanpopulationsworkingwiththephysicalenvironmenttoyieldeconomicgrowth.

ReversingthecausalityofKarlMarx'smaterialism-philosophy,itisincreasinglytruethatautonomous,invisiblefinancialprocessesdrivechangesinthephysicalrelationsofproduction,ratherthanviceversa.Aspartofthisprocess,centralbanksandotherfinancialmarketparticipantscan(haphazardly)increaseorreducewealthindependentlyofanyinitialchangesintheproductionofGDPorother‘real’economicprospects.Moneyisnotaneutraldriveroftherealeconomyoverspace—especiallyacrossthewide

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spacesoftheglobaleconomy.Furthermore,theauthor'seconometricworkasinChapter3confirmsthatfinancialmarketscanabsorbmoneysothatthemoneyisnotcontemporaneouslyavailabletosupportandinducetherealeconomy,whichshowsupasadeclineintheGDP-velocityofmoney.Thisabsorbedmoney-powermightbeusedatalaterdatetocommandproductionorconsumption,oritmightbedestroyedinaneconomiccrisisbeforeitstitle-holderscanuseit.Therefore,monetary-wealthisalsonotaneutraldriveroftherealeconomyovertime.

Dependingonthemagnitudesofthetransfers,revaluations,andcreationofmonetarywealthover(howmuch)timeandspace,seriousrealeffectscanbeproducedovertimeandspace.Theseprocesses,generallynotacceptedbyeithermainstreamorMarxisteconomics,canneverthelesshelptoexplainwhatthemainstreamhasunderstoodas‘businesscycles’or‘debt-deflationcrises’(Fisher,1933)andwhatMarxistshaveunderstoodascrisesof

(Fisher,1933)andwhatMarxistshaveunderstoodascrisesof‘underconsumption’,‘overproduction’,and‘disproportionality’(Clarke,1994).

Totheauthor,‘moneyiswealth’inthesensethatitgivestheholderaclaimontheentiresocialproduct.The‘socialproduct’includesnotonlyconsumptionpowerandproductionpower,butalsothepowertodirectandcontrollargesocialprocesses—suchasthosewhicharedependenton(gainingaccessto)theinstitutionsofgovernment,courts,communications,culture,andsoon.Theaccumulationofmonetaryassets,orwhatMarxistswouldcalltheaccumulationoffinancecapital,representsasocial-power-claimthatbecomesakeydriverintheevolutionoftheworldsystem.Oncemonetary-wealthisunderstoodaspower-claimsoverthesocialproduct,thenmonetarywealthis‘real’,anditislimitedonlybythedegreetowhichpowercanbeexertedoverothers.Presumablythislimitwouldonlybefoundintheunlikelyeventthatanall-encompassingglobalmonopolyhasmaximizeditsdifferentialpower.

Intheauthor'sframework,socialagreementsare‘real’andtheycanthereforecreaterealvalueanddistributethisvalueinfinancialmarketsquiteindependentlyofwhatishappeningintangibleGDPmarkets.Infact,itisessentiallyasocialagreementthatdetermines,toasignificantdegree,theimportanceoftangibleGDPprocessescomparedtotheimportanceofintangiblebeliefsystemsandsocialagreements—botharecapableofdeterminingwhohasdifferentialpowerandwhohastheincentives,rights,andprivilegestocommandproductionandconsumption.Toasignificantdegree,especiallyoncewearebeyondbasicsubsistenceneeds,whetherthegrowthofGDPitselfcomparedtoothereconomic,political,andsocialgoalsismore‘valuable’restsuponbeliefsystems.

AreviewerofthefirsteditionofthisbookadvancedtheMarxistbeliefthat‘thelaboroffinancialoperators[andaccompanyingsocialagreements]cannotproducevaluebutisachannelthroughwhichvalueisappropriatedfromthosesectorsoftheeconomywherevalueisproduced…[whereas]for

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Allenthefinancialsectorcancreatevalue’(Carchedi,1996).Whoisright?Theauthorwouldsubmitthat,philosophically,eithercanberightdependingupontheself-justifyingdefinitionofvaluewhichischosen;but,forthepurposesofexplainingdifferentialeconomicpoweracrosstherecentglobaleconomy,his

explainingdifferentialeconomicpoweracrosstherecentglobaleconomy,hisownframeworkispreferred.

Somecurrentresearchinthefieldofinternationalpoliticaleconomyisconsistentwiththeauthor'snotionthatmonetary-wealth,orwhatMarxwouldcall‘unproductivefinancecapital’(asopposedtophysicalcapitalorcapitalgoodssuchasmachinesandfactories)canrepresentthefirst-roundappropriationofbroadsocialpowers.Thisresearchhasnotquite(butalmost)takentheauthor'snextsteptoclaimthatfinancecapitalcanalsobethefirst-roundcreationofnew(ratherthanappropriationoffullyexisting)socialpowers:

DrawingontheinstitutionalframeworksofVeblenandMumford,ourprincipalcontributionistointegratepowerintothedefinitionofcapital.Briefly,thevalueofcapitalrepresentsdiscountedexpectedearnings.Someoftheseearningscouldbeassociatedwiththeproductivity(orexploitation)oftheownedindustrialapparatus,butthisisonlypartofthestory.Ascapitalismgrowsincomplexity,theearningsofanygivenbusinessconcerncometodependlessonitsownindustrialundertakingsandmoreonthecommunity'soverallproductivity.Inthissense,thevalueofcapitalrepresentsadistributionalclaim.Thisclaimismanifestedpartlythroughownership,butmorebroadlythroughthewholespectrumofsocialpower.Moreover,powerisnotonlyameansofaccumulation,butalsoitsmostfundamentalend.Fortheabsenteeowner,thepurposeisnotto‘maximize’profitsbutto‘beattheaverage’.Theultimategoalofbusinessisnothedonicpleasure,butdifferentialgain.Inourview,thisdifferentialaspectofaccumulationoffersapromisingavenueforputtingpowerintothedefinitionofcapital…Intheeyesofamoderninvestor,capitalmeansacapitalizedearningcapacity.Itconsistsnotoftheownedfactories,mines,aeroplanesorretailestablishments,butofthepresentvalueofprofitsexpectedtobeearnedbyforceofsuchownership(Nitzan,1998,p.173,182).

Buildinguponthisquote,Nitzanarguesthatwealthaccumulationprocessesallowedbymonetarycapitalhavefavoredpecuniarybusinessactivitiesandownersovertangibleindustrialproductivityandworkingconsumers.Hearguesthat,increasingly,‘thecausallinkrunsnotfromthecreationofearningstotherightofownership,butfromtherightofownershiptotheappropriationofearnings’(p.180).ThiscausalityisconsistentwiththehistoricwritingsofThorsteinVeblen,whoinsistedthatthe‘naturalrightofownership’conferredbysocietytovariouspeople(initiallytoownslaves,thenanimals,land,andinVeblen'stime,capital),canbeusedcoercivelyorevenasaformofsabotagetoobtainfurthersocialpowersattheexpenseofothers:

obtainfurthersocialpowersattheexpenseofothers:

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Forthetransienttimebeing,therefore,anypersonwhohasthelegalrighttowithholdanypartofthenecessaryindustrialapparatusormaterialsfromcurrentusewillbeinapositiontoimposetermsandexactobedience,onpainofrenderingthecommunity'sjointstockoftechnologyinoperativeforthatextent.Ownershipofindustrialequipmentandnaturalresourcesconferssucharightlegallytoenforceunemployment,andsotomakethecommunity'sworkmanshipuselesstothatextent.ThisistheNaturalRightofInvestment…Plainly,ownershipwouldbenothingbetterthananidlegesturewithoutthislegalrightofsabotage.Withoutthepowerofdiscretionaryidleness,withouttherighttokeeptheworkoutofthehandsoftheworkmen,andtheproductoutofthemarket,investmentandbusinessenterprise[asdistinguishedfromothereconomicactivityorformsoforganization]wouldcease.ThisisthelargermeaningoftheSecurityofProperty(Veblen,1923,p.65–7).

Intheglobaleconomy,‘thenaturalrightofownership’isnowbeingconferredbysocietyonvariouspeopleovernewresourcesandnewwaystogaindifferentialpowerwhichcompetewitholdresourcesandoldwaystogainpower.Examplesincludeownershiprights,wherenonehadexistedbefore,overairwavesandbandwidths,variousintellectualproperties,andnewelectronicmoneys—thesenewlyrecognizedassetsaretoacertaindegree‘createdoutofthinair’,andsoaretheownershiprightsoverthem.Monetarywealth,evenmoresothanotherpropertyownership,mightespeciallybecreatedaswellastransferredbysocialagreement.

B.Money-Mercantilism

Basedonwealthcreationandtransferprocesses,theauthor'sresearchconfirmsthattheUSandthe‘hard-currency-core’ofthecurrentglobaleconomycanbenefitfromwhathewouldcall‘money-mercantilism’attheexpenseofthe‘soft-currency-periphery’.BecauseofthewaythattheinternationalmonetarysystemworkswiththeUSdollarasthedominantreservecurrency,overtimevariousmonetary-wealthtransfersfromtheperipherytothecorehaveoccurredwithoutanyotherinherentinstabilitiesintherealeconomy.‘Dollarization’oftheperipherymightincreasethewealthoftheperipherywithoutnecessarily

theperipherymightincreasethewealthoftheperipherywithoutnecessarilyaffectingthecore(afinancialliberalization-globalizationphasefortheperiphery),butthendollar-flightoutoftheperipherybacktothecoremightappropriatenewfoundwealthfromtheperipherybacktothecore.Thecoremightendupwealthierthanbeforethedollarizationphase,andtheperipherymightenduppoorer.IfworldsuppliesofthedollarareexcessivelyrestrictedbytheFederalReserveBankandotherfinancialinstitutionsinthecore,asin1981–2,thenboththeperipheryandthecoremightsufferaslump,butthecoremightstillgain‘differentialwealth’relativetotheperiphery.

Monetary-wealthtransferstothecoreneednottranslateproportionallyintoGDPinflation;theyneednotbeinflationaryatall.Whetherinflationis

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affecteddependsontheproductioncapacitywhichiscurrentlyavailableinthecore,thecapacitywhichcanbeadded,the‘thickening’and‘commodification’ofmarketsasnewactivityornon-marketactivitybecomespartoftheincome-expenditureflow,thedegreetowhichnewfoundmonetarywealthisspentdomestically,etc.

TheseremarkablysuccessfullaborsinthecorebytheFederalReserveBank,the‘WallStreet-USTreasurycomplex’(Bhagwati,1998),andthemillionsofinternationalfinancialmarketparticipants,asallowedbythedollar-basedinternationalmonetarysystem,neednotbeconsciousorconspiratorial,buttheyhavefavoredUSdollarhavens.Becausethedollarisapreferred‘storeofvalue’andnotneutral(whichisasocialagreement),dollarhavensarewealthhavens.Wealthhavensarepowerhavenswhereproductionpower,consumptionpower,andsocial-process-poweraregainedrelativetonon-havens.Asdocumentedinpreviouschapters,globalmonetary-capitalismcurrentlysupportsinstitutionalarrangementswherebydollarhavensgainmonetarywealthfrom‘dollarcolonies’.ThenetflowofinvestmentintotheUSfromtherestoftheworldwas$194.6billionin1996,$254.9billionin1997,andisexpectedtobemorethan$250billionin1998.

RegardingtheUSasa‘winner’duetointernationaltransfersofmonetarywealth,andsomeothercountriesas‘losers’,theauthorwouldliketobeperfectlyclearaboutthissomewhatunconventionalposition.Capitaloutflows,devaluation,anduseofsoftcurrenciesinthe‘periphery’oftheglobaleconomy

devaluation,anduseofsoftcurrenciesinthe‘periphery’oftheglobaleconomyhaspushedthoseregionsintorelativepovertyandpushedthedollar-haven‘core’oftheglobaleconomyintorelativewealth.TheperipheryhascertainlyincludedLatinAmericaandAfricasincetheearly1980s,butinthe1990sthecapital-losingperipheryhaswidenedtoincludemuchofEasternEuropeandAsia.TheJapaneseyenhasalsogivenwaytothedollar,notintermsoftheunit-to-unitcurrencyexchangerate,butintermsoftheshareoftheworld'swealthwhichisdenominatedinyen.From1989to1999,theshareoftheworld'swealthdenominatedinyenhasdroppedapproximately50percent.RonenPalan,amongotherinternationalpoliticaleconomistsfamiliarwithoffshorefinance,begangrapplingwiththisissueinthemid-1990s:

Indeed[afterWWII]ahierarchywasproducedasthenewglobalcurrency[mainlythedollar]becamethecorecurrencyof‘hard’towhichallothercurrencies,‘soft’currencieswereattached.The‘offshore’financialmarketsmaybeunderstoodasareproductionofoneofthecentralfeaturesofthepostwarinternationalfinancialsystem,namely,thishierarchyamongcurrencies…Thewholeoffshoremarketthenoperates,whetherintentionallyornot,asahugetransmissionmechanism,transferringtheaccumulatedcapitaloftheoldperipherytothefinancialcentersofthe‘core’.

…about30percentofthirdworlddebthasfounditswayintotaxhavens.ThefiguresrisesharplyconcerningLatinAmerica.By1981fiveofthehavens

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consideredbytheCaribbeanTaskForcereport(Bahamas,Bermuda,Liberia,theDutchAntillesandPanama)hadapproximately14.3percentofthetotalestimatedinvestmentstockwhichhadflowedfromOECDtoalldevelopingcountries,althoughtheeconomiesofthesefiveaccountedforlessthan0.3percentofthetotalGNPofalldevelopingcountries…WithcurrentthirdworlddebtoutstandingatUS$1.6trillion,thesefiguresimplyanet[accumulated]inflowofUS$500billionintothetaxhavens.Suchfiguresquitesimplydwarfanythingtraditionaltheoriesofthirdworld'sexploitationandunequalexchangehavemanagedtocomeupwith.Thisisarguablythesaddestofallaspectsofthirdworldplight(Palen,1994).

Wheredotaxhavensinvestandtransferthiswealth?Swissbanks,theearliest

Wheredotaxhavensinvestandtransferthiswealth?Swissbanks,theearliestmoderntaxhavens‘rarelysquanderit[moneyaccumulatedfromtheperiphery]orspeculatewithit.TheyinvestitprudentlyandcautiouslyintherichAtlanticworld’—thebigthreeSwissbanksactuallymadeapolicydecisionin1957toinvestonlyinthe‘firstworld’(Fehrenbach,1966,p.126).Morerecently,asshowninTable3.1asbackedupbyBrown(1996),flowsintotaxhavensandotheroffshoremarketshaveastheirmajorcounterpartinterbanklendingintotheUS.

Theauthorwouldcalltheseprocesses‘money-mercantilism’.

Historically,‘mercantilism’istheuseofrestrictivetradepoliciesandcolonialempires,especiallybytheEuropeanancienrégimeoftheseventeenthandeighteenthcenturies,inordertoaccumulatepreciousmetalscentrally.Variousnineteenth-centuryGermanhistorians,especiallyGeorgFriedrichList,gavecoherencetomercantilistnotionsofhowwealthisaccumulated,andtheycritiquedthelaissez-faireeconomicsofSmith,Ricardo,andSay.TheinstitutionaladvantageusedbypowerfulandhegemonicEuropeanstatestoappropriateunequalwin-winorevenwin-losegainsfrominternationalcommercewasrecognizedbytheGermanHistoricalSchoolasanimportantdeterminantof‘thewealthofnations’—perhapsamoreimportantdeterminantthanthedecentralized‘invisiblehand’interactionsandefficienciesofsupplyanddemand.MorerecentdefendersofthemercantilistperspectiveincludetheCaribbeanSchoolandtheWorld-SystemSchool(HopkinsandWallerstein,eds.,1982).

Whattheauthorwouldaddtothehistoricalmercantilistperspective,inordertomakeit‘money-mercantilism’,isthenotionthatextractionofmoney-wealthfromtheperiphery,throughinstitutionaladvantage,doesnotrequireGDPtradeflows—instead,itonlyrequiresdominanceinfinancialaffairs.Intheancienrégimeperiod,therewasaninternationalfinancialsystem,butitwasassociatedmorewithnationaldebtsratherthanwithcommercialfinance.Hence,itwaseasierforFranceandEnglandandotherstoextractmoney-speciesfromthecoloniesthroughfavorabletradeandexportsofgoodsandservicesratherthanmoredirectlythroughcommercialfinance.However,inthecurrentperiod,well-developedinternationalcommercialfinancialmarketsallowvarioustradechannelstobebypassed.

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Thecurrent‘mercantilists’,whoaretypicallyfinancialintermediaries,arelessgovernment-affiliated,andthusmercantilismisnotsointentionallyassociatedwithnationalism,butthewealth-enhancingeffectsobtainedforthehomecountryoritscurrencyblocaremostlythesameaswiththeoldmercantilism.Theofficialgovernment‘players’inthisprocessmightactasdirectorindirectagentsorpartnersfortheprivatefinancialintermediariesandthusmaintainmuchofthenationalismorcore-regionalismthatishistoricallyassociatedwithmercantilism.Forexample,casestudiesof‘TheWorldDebtCrisis,1982-’and‘Mexico'sCrisis,1994–95’inChapter4elaboratethedegreetowhichofficialUSinstitutionswereabletoprotectthesolvency,profits,andcapitalinflowstoprivateUSfinancialintermediaries.The1985US‘BakerPlan’andIMF‘austerityrequirements’generatednewrevenues(oftenfromLatinAmericanpopulations)andloanstoserviceexistingLDCdebtsothatUSbankscouldcontinuetoreceivenormalpaymentsandnothavetoclassifyamajorityoftheirLDCdebtasbaddebt.

MorerecentlyinApril1997,USTreasuryDepartmentSecretaryRobertRubinheadedameetingbythefinanceministersoftheG7largestindustrialcountrieswhichissuedastatement‘promotingfreedomofcapitalflows’andthederegulationandopeningofthefinancialmarketsofnewlyindustrializingcountriesinAsiaandelsewhere.EffortsweresimultaneouslymadetoamendthecharteroftheInternationalMonetaryFundsothatitcouldalsopromote‘capitalaccountliberalization’ofitsmembercountries.TheseeffortsareincreasinglyseeninbothacademicandbusinesscirclesasaggressiveeffortstopromoteandprotectthebusinessinterestsofUSfinancialfirmsandtheirmultinationalaffiliatesinforeignmarkets(Wade,1998–99;TheNewYorkTimes,1999).Furthermore,the‘netdissaver’USeconomybenefitsfromunrestrictedaccesstointernationalsavings.

SincetheAsianfinancialcrisis,thereisincreasingoppositionto‘financialliberalization’inAsiaandelsewherebymanywhoseeitasawin-losegamefavoringthestrongerUSandG7institutionsandexploitingthelessdevelopedcountries.Forexample,the$57billionrestructuringbailoutofSouthKoreainlate1997didnotrequireUSbankswiththebadloanstoputupsignificantnewmoneyorwriteoffbaddebts,butCitibank,J.P.Morgan,ChaseManhattan,BankAmerica,BankersTrustandotherswereallowedtwotothreepercentagepointhigherinterestratesandgovernmentguaranteesthatpassedtheongoingriskofdefaultfromtheirshareholderstoKoreantaxpayers.Themain‘burden’

riskofdefaultfromtheirshareholderstoKoreantaxpayers.Themain‘burden’acceptedbytheU.S.bankswasanextensionoftheseriskyloansforuptothreeyears.AsstatedbyMiltonFriedman:

Theeffortishurtingthecountriestheyarelendingto,andbenefitingtheforeignerswholenttothem…TheUnitedStatesdoesgiveforeignaid,butthisisadifferentkindofforeignaid.ItonlygoesthroughcountrieslikeThailandtoBankersTrust(TheNewYorkTimes,1999).

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Thedollar'sdominanceininternationalfinancesincetheUS-dominatedBrettonWoodsagreementsafterWorldWarIIhasattractedsomerecognitionofwhattheauthorwouldcallUSmoney-mercantilism.CharlesdeGaullecomplainedthattheinternationalreserveroleofthedollar‘enabledtheUnitedStatestobeindebtedtoforeigncountriesfreeofcharge’.Unilateraldevaluationsofthedollar,aslongasthedollarremainstheinternationalcurrencyofchoice,unilaterallydevaluesUSforeigndebt—aprivilegeenjoyedbytheUSastheonlymajorcountrywhoseforeigndebtismostlydenominatedinitsowncurrency.

Over50percentofallinternationalnotesandbondsaredenominatedindollarsasof1998,and45percentofallcross-borderbankloansareindollars.EconomistssuchasRichardPortesandHeleneReyestimatethatthisdominanceindebtmarketsgivesdollar-issuerssuchastheUSgovernmenta‘liquiditydiscount’orreducedtransactioncostsof25to50basispoints(hundredthsofapercentagepoint).Non-USholdingsofUSgovernmentdebtamountto$2trillion,whichmeansthattheUSgovernmentsaves$5–10billionperyearininterestexpenseonitsdebtduetotheliquiditydiscount.TheEconomistestimatesthatanadditional$5–10billionperyearmaybe‘earned’fromothercountriesbytheUSduetoseigniorage,whichistheprofitearnedbythemonopolyissueofcoinsandnotes.3Thatis,othercountriesgiveuprealgoodsandservicestoholders(andthereforeissuers)ofdollarsinordertoobtaindollarsfortheirreserveaccounts.

Intheauthor'sview,thesewidelyacknowledgedmoney-mercantilist‘profits’areonlypartofthemoney-mercantilistbenefitsthatcurrentlyaccruetotheUS.Thecurrent$200–$250billionannualnetinvestmentinflowintotheUS,mostly

channeledthroughprivatemarkets,isofcourseapproximatelymatchedinthebalanceofpaymentsaccountsbyasimilarlylargeUScurrentaccountdeficitingoodsandservices.However,asdiscussedinChapter2,amajorityoftheUScurrentaccountdeficitisintrafirmorreflectscriticalcomponentandsubassemblytransfersbetweenglobalaffiliates,andthusthemajorityofthiscurrentaccountdeficitshouldnotbeseenasanetprofitorwealthlosstothe‘real’sectoroftheUSeconomy—unliketheancienrégimeperiodwhentradedeficitsbetweenmoreseparatenationaleconomiescouldmoreclearlybeidentifiedwithnon-competitivenessandwealthoutflows.

Inthecurrentperiod,virtuallyallofthecapital-usageandmonetary-wealthenhancementbenefitofthe$200–$250billionannualnetinvestmentinflowsupportstheUSeconomy;yetsomeofthemonetaryoutflowduetothecurrentaccountdeficit(anoutflowwhichisactuallylessthanthesizeofthedeficit—seechapter2)enhancesUSmultinationals,oratleastremainsdenominatedindollarsandbuildsupthenon-USdollarcoreoftheglobaleconomy.AselaboratedinChapter2,UScurrentaccountdeficitsareincreasinglynotbadforUSeconomicinterests,andmightevenbegooddue

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tooverseasproduction,internationaljointventures,andinternationalownershiparrangements—itdependsonhowfirmshave‘goneglobal’.

USmoney-mercantilismisachievedviafavorableterms(aspertheliquidity-premiumandseigniorage)onmoreinitiatingcapitalaccountsurpluses,whicharerecycledthroughmoreaccommodatingcurrentaccountdeficits.Onbothaccounts,butespeciallyonthedollar-riggedfinancialside,USmultinationalsandtheirdollar-basedaffiliatesbenefit.Incontrast,ancienrégimemercantilismwasachievedthroughinstitutionally-riggedcurrentaccountsurplusesthatwerethenusedtoexpandthepolitical-economicpoweroftheregime.

Whichevertypeofmercantilismisidentified,theessentialelementisthedisproportionateaccumulationofmonetarywealthwhichisobtainedbytheinstitutionallymorepowerfulcountryorregionthroughinternationalcommerce.Howdoesthismonetarywealthaccumulationfrominternationalcommerceenhancethedomesticeconomyofthemercantilistcountry?Inaworkeditedby

theauthor,Daudin(2000)answersthisquestionfortheancienrégimeofeighteenth-centuryFrance.NotonlydidFranceusepoliticalandmilitarypowertoexploitwealthfromthecolonies,buttheinflowofpreciousmetals(monetary-wealth)actuallyallowedFranceamore-than-proportionateincreaseindomesticeconomicgrowthandwealth.Underthismercantilistrevisionofmainstreameconomicthinking,Francewaswelljustifiedinsacrificingvariousfree-tradeefficienciesinordertoaccumulatecentrallypreciousmetalsthatcouldserveashard-currency.Theaccumulationofgoldandsilverasreservecurrencyallowedanon-neutral(wealth-favorable)expansionofquasi-moneysandcreditwhichinturnintensifiedandcoordinatedeconomicactivityandfurtherenhancedFrencheconomicgrowthandpowerrelativetothe(capital-exporting)restoftheworld.Duringtheeighteenthcentury,therewasnorealbankingsysteminFrance,andmostmoneycreationwasdonebycommercialagentswhoissuedbillsofexchangeandpromissorynotesbaseduponreputation.Theestimated0.8percentgrowthperyearincirculatingmetallicmoneyduring1715–1788madeitpossibleforcommercialoperatorstoreliablycirculateamuchlargervolumeofcommercialpaperandexchangeablenotes.

Daudin'smercantilistanalysisisfurthersupportedbyClark(1998),whoidentifiesingreatdetailhowtheindustrialrevolutioninBritainwasmoreofamonetary-capitalist-driventop-down‘industriousrevolution’supportedbytheappropriationanduseofforeignwealthratherthanabottom-upindustrialrevolutioninitiallydrivenbynewtechnologiesandgreaterproductivityoftheaverageworker.Enhancedtransactionssystemsbrought,especially,under-utilizedrurallaborintotheformaleconomyinBritainaswellasFrance.

Inboththemercantilistancienrégimeandinpresent-daymercantilistUS,economicgrowthmightthusbelargelydrivenbya‘thickening’and‘commodification’ofdomesticmarketsassocialagreementsandinstitutionsallowforeignandnewly-createddomesticmonetarywealthtobespent

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domestically.Followingthispattern,inthe1990stheUSeconomyboomedaheadwithunexpectedlygreatworkforceparticipationand‘stressed-out’industriousnessdespitenosignificantincreaseintheper-hourproductivityoftheaverageworker.Furthermore,newwealthderivedfromtheinternationallaborsoffinancialoperatorsandfromtheinnovationsofthepost-1973information

offinancialoperatorsandfromtheinnovationsofthepost-1973informationindustriesaccumulatedfirstinUSfinancialmarkets,whichthenallowedgreaterUSinvestmentinfixedcapitalandconsumerismanddifferentialeconomicpowerwithintheworldsystem.

II.THEROLEOFTHEG7

ThemeetingoffinanceministersandcentralbankgovernorsatNewYork'sPlazaHotelinSeptember1985iscommonlymentionedasanimportanteventininternationalmonetaryeconomics.Itwasthefirsttimethatsuchameetingwasannouncedinadvanceandacommuniquéwasissuedafterwards.Withsuchpublicity,theG-5countriesoftheUS,Japan,Germany,France,andtheUKsoonexpandedandformalizedthemselvesintotheG7withtheinclusionofItalyandCanada.

Also,despitenomentioninitscommuniquéaboutinterventiontodrivedownthevalueofthedollar,thePlazaaccordwaswidelyknowntobeaconcertedefforttodoso.BytheendofthefirstweekafterthePlazameetingtheGShadsold2.7billiondollars(VolckerandGyohten,1992,p.255).Also,duringthatweektheJapaneseyen,Germanmark,Frenchfranc,andBritishpounddidappreciateagainstthedollarby11.8,7.8,7.6,and2.9percent,respectively.However,beforethemeetingthedollarhadalreadydeclinedmorethan10percentfromitsrecordFebruary1985heights,andthePlazameetingdidnotseemtochangethelong-runrateofdeclinewhichcontinuedinalinearfashion.

AsarguedinChapter1,inthisperiodthemajordrivingforcesweretherapidlyglobalizingfinancialmarkets,thelogicofinterestrateandfinancialstrategyparities,andflowsofprivateinvestment.The2.7billiondollarssoldbythecentralbanksintheweekafterthePlazaaccordisasmallnumbercomparedto$150billioninforeignexchangetradingthatwasthenoccurringonanaveragedayorthehundredsofbillionsofUSdollarsthatwereheldbyprivatenon-USinvestors.

WhatthePlazaaccorddidestablishwasquiteaprecedentforconcertedeffortsbycentralbanksandgovernmenttreasurydepartmentstorealignexchangeratesviadirectinterventionandinterestratepolicy.Andatatimewhentheprivatemarketswereuncertainwhichwaythedollarwasheaded,thefinancialofficialsdidhaveimportantpsychologicalinfluenceviatheirstrongannouncementsandimpressivecoordination.

Centralbankcoordinationcontinuedforayearorso.Forexample,economichistorianswerequiteimpressedbythebeautifullychoreographed,

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simultaneouscutsinUS,JapaneseandWestGermancentralbankinterestratesinMay,1986.4ButasdiscussedinChapter4,thelackofcooperationinOctober1987whenGermanyandJapanpubliclyindicatedthattheywouldnotfollowUSinternationalpolicyinitiativeshelpedcausethe1987stockmarketcrash.Shortlybeforethecrash,thesethreecountriesengagedinsomewhatcompetitiveratherthancooperativeinterestrateincreasestomaintaincurrencyalignments.Butthisgoalwasnotachievedasthedollar'slong-termdeclinecontinued.

Sincethelate1980s,especiallygiventhelackoffullcooperation,theeffectofG7actiononinterestratesandexchangeratesincreasinglyappearstobemorepsychologicalthanreal.Privatecapitalflowsincreasinglydominatecentralbankintervention,asEuropeansrelearnedduringthepartialbreakupoftheEuropeanmonetarysystem(EMS)latein1992.ForeignexchangeturnoverduringtheEMScrisisreached$1trillionperday,anddiscretionarycentralbankinterventiononbehalfofamajorcurrencywasrarelyasmuchas$10onagivendayor$50billion,net,overthewholecrisisepisode.

WhenG7cooperationisnotavailable,eventheUSFednowhasdifficultyreversingtrendsintheprivatemarkets.Forexample,justbeforeChristmasin1989theFed'sOpenMarketCommitteevotedninetotwotopushUSinterestratesdown.On20December,theFedboughtTreasurybills,providedmorecredittothebankingsystem,andlowereditsclosely-watchedshort-terminterestrates,thustelegraphingitsdesiretopushgeneralinterestrateslower.Historically,whentheFedpushedshort-terminterestratesdownbyhalfapercentagepoint,thisledtoadeclineofperhapsone-tenthofapercentagepointinlonger-terminterestrates.

UnfortunatelyfortheFedinthiscase,however,inearly1990interestrateswererisinginGermanyduetotheliquiditycrisisthereandthecapitalneedsofreunification.Inaddition,interestrateswererisinginJapanbecauseofexaggeratedfearsofinflationandtherestrictivemonetarypolicieswhichweresoontodestroyJapan'sfinancialsurplus.Therefore,themassiveprivateflowsoffundsmovingbetweencountriesinsearchofinterest-rateparityleftdollar-

fundsmovingbetweencountriesinsearchofinterest-rateparityleftdollar-denominatedassets,raisedlonger-termUSinterestrates,andcreatedrecessionaryconditionsintheUS.Twoandone-halfmonthsaftertheFederalReserveattemptedtoreduceUSinterestrates,yieldson30-yearTreasurybondswerethree-quartersofapercentagepointhigherthanbeforetheFedacted.

Economistsdebatethedegreetowhichcentralbanksshouldusetheirresourcestofixinterestratesandexchangerates.Becauseoftheriseofoffshorefinance(Chapter3)andotherprivatemarketgrowth,theauthor'spositionisthatspecificratescannotgenerallybesustainedevenwithG7cooperation,andhugetradinglossesbythecentralbanksarelikely.WhenprivatespeculationwithintheECeruptedon8September1992,within24hourstheItalianlirahadlost10percentagainsttheGermanmark,theBritish

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poundhadlost9percent,andtheSpanishpesetahadlost8percent.Themonetaryauthoritiesintervenedwithover$70billionofvariouscurrencies,includingtheusebytheBankofEnglandofapproximatelyone-thirdofitsreserves(Joffe,1992–93,p.37).TheBankofEnglandreportedlylostmorethan$5billiononitsunsuccessfulattemptstosupportthepound.5BritainlefttheEMSwithoutcommittingitselftoareturndate.Similarlyduringthiscrisis,SwedenhadtoabandonthepegbetweenitskronaandEuropeancurrenciesaftermassiveandcostlyinterventionbytheSverigesRiksbankfailed.

Officialinstitutionsshouldnotbeencouragedinthedirectionofunsustainablegoalsandtradinglosses—increasingly,attemptingtofixexchangeratesbetweenmajorcurrencieswithdirectmarketinterventionfallsintothiscategory.Instead,theauthorwouldproposevariousotherdirectionsforG7policy,whichinclude:(A)reducingthenumberofcurrenciesintheworld,aspertheintroductionoftheeuroasasinglecurrencyinEurope;(B)greaterdevelopmentofforward-lookingmarketsforinterestratesandexchangeratessothatafullerspectrumofinexpensivehedgingopportunitiesisavailable;and(C)maintainingsufficientmoney-liquidityacrosstheglobaleconomy.EachoftheseproposalsshouldbedesignedsothattheUSandotherglobalreservecurrencycountriesdonotbenefitexcessivelyfrom‘moneymercantilism’attheexpenseofothercountries.

A.Proposal1:ReducingtheNumberofCurrencies

Thecasestudiesofthisbookindicatethateconomiccrisestypicallyoccurwhenoneormoreofthemajorcurrencies,afterhavingbeendefactobutnotdejurereservecurrencyforaparticularcountry,suddenlyleavesthecountrythroughprivatechannels.Thenationalmonetaryauthoritiesthus,typically,havenomeanstocreateorreplacethelosthigh-poweredmoneysuppliesexceptbycostly,adhocinternationalborrowing.Becauseofthedominanceandvolatilityofprivatecapital,inevitablythistypeofcrisiswilloccur,anditwilloccurwithhigherprobabilitytothedegreethat‘foreign’currencyisuseddomesticallywithoutappropriatecentralbanktocentralbankarrangements.

Ofcoursemoreformalizeduseofaforeignglobalreservecurrencyrequirescentralbank-to-bankpolicycooperationandotherinstitutionalcooperation,andtoacertaindegreethesearrangementsarealreadyoccurring.However,theyshouldbeencouragedfurther,andsupportedwithgreatercentralbank-to-bankfundingandreconciliationoftherelevantcurrencies.Forexample,theMexicangovernmenthad$18billionofdollar-denominatedtesobonodebtclassifiedasdomesticdebtin1994beforeitscrisis.Whenthecrisishitandthreatenedtheregion,anemergencyrescuepackageof$50billionwascobbledtogethertoresolvethecrisis,butitdidnotpreventasevereone-yearrecessioninMexico(Chapter4).Inthe

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author'sview,asimilarfundingtransfercouldhavebeenprovidedmoreautomaticallyandmorequicklywithlowercostforbothsidesbaseduponcentralbankreservesandinternationaldiscountrates.

Asimilaradhocemergencylineofcreditofapproximately$40billionwasprovidedforBrazilinNovember1998,butonlyafterBrazil'sdollarreserveshaddeclinedfromapproximately$60to$30billionandinternationalinvestorconfidenceinBrazilhadseriouslydeteriorated.ByFebruary1999,eventhe$40billionrescuepackageprovedunabletostabilizetheBrazilianrealagainstthedollar,andauthoritieswereforcedbythemarketstoabandontheirmonetaryregimeandallowtherealtodepreciaterapidly.

Thesetypesofdollarizationandlenders-of-last-resortarrangementsare

Thesetypesofdollarizationandlenders-of-last-resortarrangementsarehappeninganyway;itistimetoformalizethemthroughcentralbankingratherthanthroughcumbersomeexecutive-branchandlegislative-branchone-shotdeals.Last-minutedealsareoftentoocostlyandultimatelyineffectiveasinthecaseofBrazil.Transitionaryperioddollarizationshouldaimattheestablishmentofglobalreservecurrency‘currencyboards’tofixsmallcountryexchangerates,asperHong-Kong(fixedsince1983)andArgentina(fixedthroughthe1990s).

Theauthorrecommendsthatcurrency-boardtransitionaryperiodsshouldbefollowedbyconsiderationofnewmoreregionalcurrencies.Regionalcurrenciesandsupportinginstitutions,patternedaftertheeuroandnewEuropeanCentralBankcouldbedevelopedforAsia,LatinAmericaandelsewhere.Thus,thereneednotbeconcernsabout‘moneymercantilism’or‘dollar-hegemony’asdiscussedearlierinthischapter,butonly‘dollarhedge-money’asdiscussedbelowinProposal2.

Theintroductionoftheeuroisagoodmodelforotherregions.Itisexpectedtoreduceliquidity-premiumsondebtforparticipatingcountriesandthereforebringaboutlowerfinancingcosts.Theuseofacommoncurrencyofcoursewipesoutexchangerateriskandvariousspeculationandhedgingflowsbetweentheparticipatingcurrencies.Theeuro-11countries'shareofinternationaltradeoutsidetheneweuroareaisexpectedtobe19percent,whichcompareswiththeUS'sshareofinternationaltradeoutsidethedollarareaof17percent.Thus,eliminationofthe11nationalcountrycurrenciesbringstrade-exchange-rateriskwaydowntothelevelenjoyedbythehistoricallymoreself-sufficientUS.Debtandequitymarketsneednotbecomecompletelyunified,however,becausedifferencesintaxrates,corporateproductivity,politicalandlegalrisks,etc.remainacrosstheeuroarea.TheEuropeanCentralBankdecideseuromonetarypolicywiththeprimarygoalofpricestability,whereasfiscalpolicy,economicgrowthconcerns,etc.,aremostlyleftuptothemembergovernments.Avalidconcernisthereforethateconomicdevelopmentmayremainunevenorevenbecomemoreunequalwhennationalgovernmentslosethemonetaryleverstoinflatetheirregionaleconomiesindependently(Feldstein,1998).

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InLatinAmerica,Africa,Asiaandelsewhere,theintroductionofregional

currenciesshouldjoinsimilarlyproductiveandsimilarlycompetitivecountriessothatregionalmonetarypolicycaninflateordeflateparticipatingcountriesfairly.‘Convergencecriteria’entryrequirementsintotheunionhelpsolvethesetypesofproblems.InadditiontoEuropean-styleconvergencecriteriabasedmostlyuponpricestabilitysuchasinterestrate,budgetandtradedeficitlevels,criteriabaseduponproductivitylevelsandstagesofdevelopmentareimportantindevelopingcountryblocs.TheEuropeanUnionhashistoricallyhadUnion-wideprogramstoequalizedevelopment,andsimilarfiscal-policyunionsshouldaccompanynewmonetaryunions.VeryfewoftheseprecautionsarecurrentlybeingtakenintheLDCsastheydollarizetheireconomiesinadhocfashion;thereforetheIMFandWorldBankareoftenbroughtin,alsoinadhocfashion,forcrisisandpovertymanagement.TheauthorwouldthusagreewithJeffreySachs(1998)thataG16groupincludingdevelopingcountriescouldbeconvenedtoworkonregionalizationoftheinternationalmonetarysystemincludinganincreasedroleforASEANinSouth-EastAsia,MercosurinLatinAmerica,andSADCinSouthernAfrica.

Theintroductionofaregionalcurrencyrequiresassetsandliabilitiestobedenominatedinthenewcurrency,andcanthusbedestabilizingifnotdonecarefullyandgradually.However,inorderforthenewcurrencyregiontogainliquiditypremiums,reducedtransactionscosts,seignioragebenefits,andtoprotectitselfagainstthemoney-mercantilismoftheUSandothers,theserisksseemworthtaking.Intheeuro'scase,euro-enthusiastssuchasFredBergstenthinkthatultimately30–40percentofworldfinancialassetswillbedenominatedineurosand40–50percentindollars.Thisoutcomewouldrequiretheone-timetransferandretirementof$500billionto$1trillionofdollarsintoeuros,oranequivalentdevaluationofthedollarofperhaps40percent.Thisoutcomeisprobablytooeuro-optimistic,because,accordingtotheIMF,USinternationalassetsandliabilitiestotal$3.5trillionand$4trillion,respectively,andprivateinvestorsassociatedwiththeseaccountswillprobablycontinuetopreferthedollarcomparedtoaBergsten-sizetransferintotheeuro.

Reducingthenumberofcurrenciesandmoney-creatingcentralbanksisnotaradicalproposal—therewereapproximately50independentcentralbanksattheendofWorldWarII,100in1970andnowthereareapproximately170.Independenceofcentralbanksfrompoliticalpressuresisimportant,butsoisaccountabilitytoelectedpoliticiansandpublicdebate,andtheseissuesmustbebalanced.Whicheverbalanceischosenrequiresthecentralbankstowinpublictrust,andthustheauthorwouldrecommend‘transparency’ofthebanks,includingtimelypublicationofminutesandreportstoelectedofficials.Unlike

includingtimelypublicationofminutesandreportstoelectedofficials.UnliketheFederalReserveandtheBankofEngland,thenewEuropeanCentralBankhascurrentlychosennottopublishminutesofpolicymeetings.

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B.Proposal2:DevelopingForward-LookingFinancialMarkets

Withafullerspectrumofforward-lookingfinancialmarkets,the‘coveredinterestrateparity’strategydiscussedinChapter1isthenmoreabletoremoveinterestrateandexchangerateriskfrominternationalbusiness.Businesspeopleandgovernmentswouldthusbemoreabletoassumewhateverlevelsofriskareappropriatefortheiractivities,andonlythosetraderswillingandabletoassumehighriskwouldhaveto—notmostofusasiscurrentlythecase.

Forexample,aconspicuousfeatureoftherecentAsiancrisisistheextenttowhichfinancialinstitutions,enterprisesandgovernmentswereexposedtoforeignexchangeriskthroughtheholdingofforeigncurrencyliabilities.Soesastro(1998)estimatesthat,basedonapost-crisisexchangeratedevaluedtoRp10,000tothedollar,currencylosseshadentirelywipedouttheaggregatenetassetsofallcompanieslistedontheJakartaStockExchange.PrivatesectorforeigndebtinIndonesiawasapproximately$70billion,and83percentwasunhedged;anadditional$27billioninforeigncurrencyhadbeenobtainedfromdomesticbanks.Thisstoryhasrepeateditselfoverandover,asinthe1982—worlddebtcrisisandthe1994–95Mexicancrisis(Chapter4).

Financialauthoritieswhoaredissatisfiedwiththecurrentfloatingexchangeratesystemdonotseemtorecognizeand/orsupportthepotentialforforward-lookingfinancialmarketstoremoveinterestrateandcurrencyriskfrominternationalbusiness:‘Whatiswrongwiththecurrentnon-systemisitslackofstabilityandpredictabilityinexchangerates,whichseemstohurtthestablegrowthoftradeandinvestment’(VolckerandGyohten,1992,pp.303–4).Insteadofsupportingforwardmarketsandencouraginghedging,centralbankers,treasurydepartments,andotherfinancialauthoritiesdevoteconsiderableresourcestotheirhistoricallyunsuccessfulattemptsatstabilizingexchangeratesandinterestrates:

ThestrengthoftheG-5orG-7,tomymind,restsonitsinformalityand

ThestrengthoftheG-5orG-7,tomymind,restsonitsinformalityandexibility…Whatseemstomepossiblewithinthatframeworkisthedevelopmentofsomereasonedandbroadjudgmentsaboutwhatrangeof[spotmarket]exchangeratefluctuationamongtheregionsisreasonableandtolerable,andwhatisnot…governmentsshouldstandreadytosupportabroadandagreedrangebymorethanjustinterventionincurrencymarkets.Theywouldhavetobepreparedtosupporttheiragreementsintheshorttermwithchangesinmonetarypolicy,andinthemediumandlongertermbyawillingnesstoalterthebasicorientationoftheirfiscalpoliciesaswell(VolckerandGyohten,1992,p.300).

Incontrast,theauthorwouldarguethat,withfurtherinstitutionaldevelopment,itwouldbemoreefficientandreliabletoremoveinterestrateandexchangeraterisksfrominternationalbusinesswithprivateforwardcontractsthanwithtradinganddirectinterventionbygovernments.Bythe

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late1980soneoutoffourUScompaniessurveyedweretradingforeigncurrenciesasahedgeagainstforeignexchangelosses,6andthatnumberhasincreased.Viaforward-lookinghedgingoperationsthesecompaniesareincreasinglyabletoknowwithcertainlywhattheirlong-termrateofreturnoninternationaloperationswillbe—regardlessofwildswingsinspot-marketrates.Nevertheless,muchgreaterdevelopmentandsubsidizationofforwardarrangementsbytheG7shouldbeencouraged.

Forward-lookingmarketinstrumentsincludetheforwardexchangemarket,thefuturesmarket,theoptionsmarket,andawidevarietyofprivateswapandderivativearrangements.Thesefinancialarrangementsareavailableinvarioustimestructuresforthemajorcurrencies,butmuchlessavailableinlessercurrencies.Nevertheless,itwouldbequiteeasyforfinancialauthoritiesofanon-G7countryincooperationwiththeG7tosanctionforward-lookingmarketsforthelessercurrency.Inthemajorcurrencies,forwardexchangecontracts,futures,andoptionsarewidelyavailableinliquidmarketsonlyforhorizonsuptoayearorso.Contractslongerthanoneyearshouldalsobeencouragedbettertomirrorbusinessandinvestorplanninghorizons.

Variousfinancialauthoritieshavetradedinforwardmarkets—thisisrareandshouldnotbeencouraged.Forexample,thecentralbankofSpainwaswidely

shouldnotbeencouraged.Forexample,thecentralbankofSpainwaswidelybelievedtohaveinformallyencouragedthewritingofforward-looking‘put’and‘call’optionsonthepesetainearly1993viathelargeSpanishbanks.ItsmotivationwasprobablytosupportthepesetaduringthisEMScrisisperiodandthusconsiderableriskwasinvolvedforthebankersdoingtheunderwriting.Currencytargetingwithforward-lookingmarketinstrumentsisnomorelikelytosucceedthanthetraditionalmeansofdirectinterventioninthespotmarkets.However,abenefitofunderwritingforwardcontractsistoprovidethemeanswherebymanyrisk-averseholdersofpesetascouldfindmutualadvantagewithrisk-seekingspeculatorsastheforwardmarketdevelops.

Theauthorwouldarguethatfinancialauthoritiesshouldnotdirectlyunderwriteforward-lookingmarketcontracts.Instead,theyshouldcreatearegulatoryenvironmentwherebytransactionscostsassociatedwithforwardcontractscouldbelowered.Privatepensionfunds,mutualfunds,insurancecompanies,andothersarealreadyfarmoreinvolvedinthesestrategiesthanmostindividualsareaware,buttherearesubstantial‘knowledgegaps’andregulatorylagsaswithmostnewmarkets.

For,example,manyinvestorsareawareoftheopportunitiestohave‘portfolioinsurance’againstfluctuationsinthevalueoftheirstocks.Butonlyabout$200billionofthe$5trillioninUSexchange-listedstockswerecoveredintheearly1990s;instead,moresophisticatedhedgingandspeculationstrategiescalled‘derivatives’havebecomepopular.Thegeneralpublicremainsignorantofderivatives,yettheUSFederalReserveestimatedasearlyas1993thatitsmemberbanksheld$7trillionofprivatelynegotiated

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derivatives.TheBankforInternationalSettlementsestimatesthatover-the-countertradinginderivatives,worldwide,was$1trillionin1995,baseduponoutstandingcontractsworth$40.7trillion.Inaddition,dailyturnoverofexchange-listedinterestrateandfuturescontractswasevenhigher,baseduponoutstandingcontractsworth$16.6trillion.

Thecurrentneedistoformalizewhatprivatetradersaredoingwithderivativesandotherforward-lookingmarketarrangementsandtoincreaseinvestorknowledgeandaccess.Forexample,thecentralbankofMexicoinalliancewithotherMexicaninstitutionsandtheG7couldsetbrokeragefeestructuresfor

otherMexicaninstitutionsandtheG7couldsetbrokeragefeestructuresforforwardarrangementsandsubsidizethosefeessufficientlyuntil,initially,asufficientnumberofthetypical30-day,60-day,and90-daycontractswouldbeavailableformosttypesofinvestors.Ifcurrencytargetingbytheofficialinstitutionsisstilldesired,changesinthefeestructure,includingasymmetriesbetweenbuyingandselling,wouldbeamoreefficientvehicletoexposetheofficialinstitutiontolessriskcomparedwithtraditionalmethodsofintervention.Eventually,iftheprivateforward-lookingmarketinstitutionsaresufficientlymature,thenthefeestructurecouldbederegulatedasperBritain'sBigBang.Marketsforcontractslongerthanoneyearwoulddevelopmoreslowly.

Therealquestionis:‘WhyshouldtheMexicangovernmentbebearingfullspotmarketcurrencyriskonitsdollar-denominateddebt,whenforasufficientfeevariousprivateunderwriterswouldbehappytobearthatrisk?Andisn'tthatfee(evenwhencontractingpartiesconsiderthemoralhazardproblemandothergame-theorystrategies)lessofaburdenontheMexicangovernmentandeconomythanthecostofrecurringcurrencycrises?’

C.Proposal3:MaintainingMoney-Liquidity

TheG7shouldensurethatthereissufficientmoney-liquidityintheglobaleconomytosupportthenewfinancialmarkets.Aspertheauthor'smoney-velocityequationsanddiscussionsinChapter3,thenewfinancialmarkets,manyofwhicharenotaffiliatedwithanynation,absorbmoneyawayfromnon-financialmarkets.TherisksofGDPinflationandexchangeratevolatilityhavebeenexaggeratedrelativetotheriskthatnewmoney-liquidityneedsarenotaccommodatedbytheG7.

Theauthor'sequationsintheAppendixofChapter3quantifyhowmuchmoney-liquidityisrequiredbyfinancialandnon-financialmarketturnoverintheUS,andthusmightbeastartingpointforworldmoney-liquiditytargeting.CombinedidentifiedbalanceofpaymentsdeficitsoftheG7,greateridentificationofflowsthroughoffshoremarkets,etc.shouldbecomparedwithinternationalfinancialmarketvolumes,justasnationalmoneysuppliesshouldbecomparedwithnationalfinancialmarketvolumes.Thistypeofinternationalmoney-liquidityresearchshouldbeencouraged.

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Supplyingagrowinginternationaleconomywithmoney-liquidityhasalwaysbeenanimportanttheoreticalandpracticalconcernofeconomists.However,growthsincethe1980s,especiallyinthefinancialside,hasbeensodramaticthateventhebestinternationalmonetaryarrangementsfacedifficulties.

FromWorldWarIItothelate1960s,itwastheUSdollarandgoldthatservedasthemaininternationalmeansofpaymentandsourceofvalueforthegrowinginternationaleconomy.IncreasedgoldproductionandincreasedsupplyofdollarsbytheUSFederalReservesystemwerefrequentlynecessary,especiallyasoilandotherprimaryproducttradeexpandedanddenominateditselfindollars.Thedollarbecametheinternationalcurrency,andthemainavenueforincreasingthesupplyofdollarsinforeignhandswasadeliberately-plannedUSbalanceofpaymentsdeficit.

Oneproblemwiththisdollar-basedinternationalmonetarysystem,asforcefullyputforwardbyRobertTriffininhisbookGoldandtheDollarCrisis:TheFutureofConvertibility(1961),wasthattheUSbalanceofpaymentsdeficitswouldeventuallyundermineconfidenceinthevalueofthedollarandthereforethesystemitself.However,iftheUSeliminateditsoverallfinancialdeficitswiththerestoftheworldandrestoredworldconfidenceinthedollar,therewouldnotbesufficientgoldorothermoney-liquiditytofinancethegrowingworldeconomy.

Thisdilemmacametobecalled‘theTriffindilemma’anditeventuallyledtothelate1960sbreakupoftheBrettonWoodsinternationalmonetarysystembasedongoldandthedollar.By1968thedollarwasfelttobeovervaluedbythesystem,insufficientgoldwasavailabletomaintainconfidenceinthevalueofthedollar,andPresidentNixoncouldfindnosolutionotherthantostopsellinggoldatitsfixeddollarprice.Attemptsweremadeforseveralyearstore-establishafixeddollar-goldlinkandcreateothersupportiveinternationalcurrenciessuchastheIMF'sSpecialDrawingRights,buttheseattemptsfailed.AlsocontributingtothebreakupoftheBrettonWoodssystemwere‘money-mercantilist’argumentsbyPresidentdeGaulleofFranceandothersthatthedollarsystemgavetheUSanunfairadvantagebyallowingtheUStofreelyfinanceitselfaroundtheworldandthensettleitsobligationsindollarswithoutlimit.

TheauthorwoulduseaTriffin-typesituationtodescribethelate1980sandearly1990sinternationaleconomy.Themoney-liquidityneedsoftheglobaleconomyexpandedfasterthantheG7anticipated,andtheUSdollarsuppliedmuchofthe

expandedfasterthantheG7anticipated,andtheUSdollarsuppliedmuchofthenewgloballiquidityneeds.Yet,becauseofdifficultiesindatacollection,theG7remainsomewhatunawareofthesizeofworlddollar-expansion.Forexample,in1990,achaoticyearofEasternEuropeanrevolutionandPersianGulfcrisis,theUSDepartmentofCommercerecordeda‘statisticaldiscrepancy’creditof$64billionwithintheUSCapitalAccount.Therefore,$64billionofunidentifiedcapitalwasassumedtocomeintotheUSbasedupontraditionaldouble-entryaccounting.However,the

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authordoubtsthatmostofthiscapitalcametotheUS;insteaditaddedtocashbalanceswithinEasternEurope,theMiddleEastandelsewhere.

Thedollarremainsthedominantsafehavenforcapitalflightandinternationalsavings.Anyworldtravelerknowsthis.Internationalcapitalflightandsavingsconversiontonon-USholdingsofdollarsin1990wasprobablyunprecedented,andthereforemuchofthe$64billionstatisticaldiscrepancywasprobablyaUSbalanceofpaymentsdeficittoaccommodatethisconversion.DollarscaneasilybeheldoutsidetheUSandcreatedinoffshoremarkets(Chapter3),andinordertomaintaintheUSmoneysupplytheFederalReserveanddepositmoneylendershaveexpandedtheworlddollarsupplymorethanmostanalystsrealize.

Aslongasnewforeigndemandfordollarsfromtheforeignexchangemarketsmatchesnewsupply,dollardepreciationisnotlikely.Infact,duringtheearly1980sthisdemandexceededsupplyandcontributedtodollarappreciation.However,inthelate1980sandearly1990sthereversewasmorelikelyasstatistically-hiddenUSbalanceofpaymentsdeficitsandoffshoredepositcreationexpandeddollarsuppliesfasterthandemand.Thedollarthusdepreciated.

Sincethemid-1990s,asdiscussedin‘Asia'scrisis,1997-’inChapter4,thereversehashappenedasidentifiedandunidentifiedcapitalflowshavefavoredtheUS,andasworlddollardemandhasexceededsupply.Thedollarappreciated20percentagainsttheyenandmarkfromthebeginningof1997tothemiddleof1998duetorestrictiveFederalReservePolicy,USbalanceofpaymentssurpluses,andworldwidecapitalflighttothedollar.TheworldwidedollarshortageanddollarflightfromAsiawasadominantcauseofAsia'scrisis.This

shortageanddollarflightfromAsiawasadominantcauseofAsia'scrisis.Thistime,authoritieserrednotonthesideofdollar-liberalizationandtheTriffendilemma,butontheotherside—dollarrestrictionsandUSmoney-mercantilism.

Goingintothenextmillenium,theauthorwouldrecommendlessdouble-entryaccountinguseofthestatisticaldiscrepancytodirectattentionawayfromidentifiedcapitalflows,bettermonitoringofoffshoremarketsandotherhistoricallyunidentifiedcapitalflows,andgreateruseofJapanese,German,andotherG7balanceofpaymentsdeficitstosupplynewmoney-liquidityneedswithintheglobaleconomy.Movinginthedirectionofmorethanonedominantworldcurrencydoesnotguaranteeareducedmonetarycycleofboomandbust,aswefoundoutinthe1920sand1930s,whentheBritishpoundandtheUSdollarhadanequalrole.However,theauthor'sviewisthatcurrencysuppliesshouldmorecloselymatcheachcountry'sshareofeconomicactivity.Intheperiodafter1994,theUSFederalReserveconductedmonetarypolicywiththemaingoalofmaintainingnon-inflationarygrowthintheUSeconomyratherthanconcerningitselfwithworldmoney-liquidity,andworldmoney-liquidityshortagesincreasedtheriskofcrisis.Thispossibilityislesslikelyifthedollarislessdominantglobally.

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AgreaterinternationalmonetaryrolefortheotherG7wouldreducetheUSabilitytounilaterallyinflateitswayoutofforeignobligations,andthereforereducethelikelihoodofTriffin-typecrisesofconfidence.ItwouldalsoreducethelikelihoodofUSmoney-mercantilism,andworldwidemoney-liquiditycrises.

Thedollaraccountsfor60percentofworldmoneyreserves,themark20percent,andtheyen10percent.ButtheUSonlyaccountsfor25percentofworldGDP,whereasGermanyaccountsfor7percentandJapanfor16percent.RealigningworldmoneyreservesinthedirectionofworldGDP,especiallywithagreaterrolefortheyenandtheneweuro,andalesserroleforthedollarshouldbeacooperativegoaloftheG7.ReducedUSbalanceofpaymentsdeficitsandincreasedJapaneseandEuropeanonesarenecessaryforthis.

III.THEROLEOFTHEWORLDBANKANDTHEIMF

TheWorldBankisownedbymorethan150oftherichercountries,anditisthebiggestinternationalsourceofaidformorethan100ofthepoorercountriesand4.7billionpeoplewhomitcallsits‘clients’asof1998.Itsabilitytoimpactonworldinvestment,tradeflows,poverty,andsocialprogressmakesitoneofthekeyplayersintheglobaleconomy.

Duringthe1980sLDCdebtcrisis,manypreviousWorldBankloanstotheLDCsfoundtheirwayoutoftheLDCsasbothlegalandillegalcapitalflight.HighinterestratesandsafehavensinthedevelopedcountriesattractedfundsfromthedevelopingcountriesandcorruptionandthederegulationofeffectivecapitalcontrolsintheLDCsallowedthemoneyout.Onlyabouthalfofthe1972–79LDCborrowingsremainedinproductiveinvestmentslocally(Bogdanowicz-Bindert,1985–86,p.261).Thus,inits1989WorldDevelopmentReport(p.19)theWorldBankemphasizedtheneedto:

…reducethemacroeconomicimbalanceswithinandamongtheindustrialcountries.SuchmeasuresincludeaprogramtoreducetheUSbudgetdeficit,followedbyaneasinginmonetarypolicy(moresointheUnitedStatesthanelsewhere).Realandnominalinterestratesthereforefall,ascomparedwiththe1980–88averages,andthedollardepreciatesfurtheragainstthecurrenciesoftheotherbigindustrialcountries.Structuraladjustmentpoliciesofthekinddiscussedaboveenablethelow-andmiddle-incomecountriestotakeadvantageofgrowth;thelowerinterestrateseasetheirdebtburden.

Thisquoterecognized,finally,thedegreetowhichtheUSandotherricheconomieshadbecomea‘sponge’thatwas‘absorbing’muchoftheLDC'sdiscretionarysavingsandinvestment.Moregenerally,itwasincreasinglyrealizedthatprospectsforgrowthintheLDCs,andalleviationofpoverty

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dependmoreoninternationalfinancialflowsthanontheavailabilityoflocaldevelopmentloans.

AselaboratedinChapter4,between1972and1979,theinternationalindebtednessoftheLDCsincreasedatanannualaveragerateof21.7percent.Duringthisperiodtheinterestrateschargedbybanksondollarloanswereless

Duringthisperiodtheinterestrateschargedbybanksondollarloanswerelessthantheprice-improvementsinLDCexports;thereforeconsiderableborrowingcouldbejustified.Incontrast,after1979,restrictivemonetarypoliciesintheUSandelsewhereraisedLDCborrowingratestohistorichighs,ledtoaglobalrecessionintheearly1980sandthecollapseofLDCexportmarkets,and,ultimately,theLDCdebtcrisis—allofwhichwereentirelyunexpectedinthelate1970s.

InfairnesstotheWorldBank,itscharterinthepost-WorldWarIIBrettonWoodsSystemwithitsaffiliates,theInternationalFinanceCorporationandtheInternationalDevelopmentAssociation,wastoprovidelong-runeconomicdevelopmentassistance.TheInternationalMonetaryFund(IMF)wasmorespecificallyobligatedtooverseeinternationalcapitalflowsincludingtheprovisionofborrowingfacilitiesfornationswithbalanceofpaymentsdifficulties.Whattheauthorwouldadvocateisanevengreatercharter-mergingandcooperationbetweentheseinstitutionsthanhasalreadybeenoccurring.Giventhepervasivenatureoffinancialdependencyandnewinvestment-tradelinkageswithinthenewglobaleconomy,acompletemergermayevenbeappropriate.

TheIMFhashistoricallybeeninabetterpositiontoinfluencefinancialflowsandoverseethemacroeconomicstabilityofmembercountries,buttheWorldBankismoreabletosupportandoverseeinvestmentprojects.Thismonetarypolicyversusfiscalpolicydivisionmakessensefornationswhenthefiscalpolicymakers(presidentsandlegislators)areelectedfrequentlyuponpartisanagendas,butitmakeslesssenseforinternationalagencieswithcareertrackemployees.

The1989(USTreasurySecretary)BradyPlaninitiatedsomenewpolicieswhichdidreflectgoodjointplanningoftheWorldBankandtheIMF.ThisPlanrecognizedtheimportanceofprivatecapitalflowsbyformalizingandsubsidizingprivatevaluationsandwriteoffsofdebt.Debt-equityswapsandothercreativewaysofreducingtheLDCdebtburdenwereencouragedwiththeprovisionofinsuranceandsubsidiesforthenewarrangementsoutoftaxpayerandinternationaldevelopmentbankfunds.

Forexample,adebt-reliefagreementforMexicoon23July1989providedtheMexicangovernmentwithnewloansanddebtreliefworth$12billionoverfouryears,anamountdesignedtoallowtheeconomytogrowandminimizefurthercapitalflight.InternationalcommercialbankswouldbeabletoswapsomeoftheirexistingloansnotdirectlyforMexicanassets,butinsteadforsecurities

theirexistingloansnotdirectlyforMexicanassets,butinsteadforsecuritieswhoseinterestpaymentswouldbeguaranteed(viatheBradyPlan)bytheInternationalMonetaryFundortheWorldBank.Mexico'snewagreementhelpedtoreducetheirtotaldebtburdenwhichwas

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then$107billion,ofwhich$54billionwasowedtocommercialbanksfromtheUS,EuropeandJapan.Inaddition,theinterestratethatMexicothenbeganpayingfornewloanswasbroughtdownto6.25percent,ascomparedtomorethan10percentlessthanayearbefore.SuchsubsidieswerenotavailablewhenMexicocompleteditsfirstdebt-equityswapsofapproximately$1billioninthesecondhalfof1986.

Debt-equityswapsandmostotherwaysofwritingoffLDCdebt,byreplacingtheLDC'sforeigndebtwithdomestically-denominatedinvestment,generallyincreasethemoneysupplywithintheLDC.TheIMFasperitschartertooverseemonetarypolicywithinmembercountrieshasthereforetocoordinatethetimingofthesearrangementswiththeWorldBank.To‘mopup’extradomesticmoneysupplies,domesticgovernmentbondsmaybeissued;thustheforeigndebtwouldsimplybereplacedbydomesticdebt.

However,evenbeforethe1989BradyPlan,manydevelopingcountriessawtheopportunitytoreducetheirforeigndebtwiththeirown‘soft’devaluingcurrencyasatremendousbenefit.Bytheendof1987,Chilehadreducedits$20billionforeigndebtby15percentthroughswaps.Inearly1988,Boliviaboughtbacknearlyhalfofits$670milliontotalforeigndebtfor11centsonthedollar.7Atotaldevelopingcountrydebtof$2billionwasswappedin1986,$5billionin1987andwiththehelpofBrady-Plan-likearrangementsthesemarketvolumescontinuedintothe1990s.

Thedevelopedcountriesarethuscooperatinginthenew,globalfinancialmarketstoreducetheriskoffurthermoney-liquiditycrises.Banksthatwouldsufferifdevelopingcountryloanswerenotrepaidhavealreadyreducedmuchoftheirexposureviaswapsandtheywillincreasinglyhavetheoptionofrecoupingmoreoftheirriskyloans.Lendingisincreasinglydonebythosemostwillingandabletobeartherisk,regardlessofwhotheoriginallenderwas.Theriskthatanyonecreditorwillloseenoughmoneyfrombadloanstoposeasystemicthreatto

onecreditorwillloseenoughmoneyfrombadloanstoposeasystemicthreattothefinancialmarketsisthusreduced.

JustastheauthorarguedearlierthattheG7shouldencouragethedevelopmentofforward-lookingfinancialmarkets,hewouldarguethattheIMFandWorldBankshouldencouragethedevelopmentofforward-lookingfinancialmarketsforitsaffiliatedcountries.Comparedtothecurrentsystemofmassiveandriskyinterventionandrefinancingbytheseagencies,itwouldseemmuchmoreefficientfortheIMFandWorldBanktoremovesomeoftheexchangerateandinterestrateriskfromLDCloans,investmentandbalanceofpaymentsarrangementsbysubsidizingforwardmarketcontractsbetweentheLDCsandprivatefinancialintermediaries.

AsfinancialliaisonsbetweentheLDCsandinternationalcapitalmarkets,theIMFandWorldBankareinapositiontosetupinterestrateandcurrencyhedgingoperationsfortheLDCs.TheLDCsandtheirforeignpartnerswouldthusincreasinglybeabletoknowwithcertainlywhatthelong-termratesofreturnonLDCdevelopmentwillbe.Muchofthe1980sLDCdebtcrisiswasduetounexpected,unhedgedswingsininterest-ratesandexchange

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rates,andthereforemuchoftheLDCdebtburdencouldhavebeenavoidedifappropriateforwardcontractshadbeenbuiltintotheoriginalloans.ThesameobservationistrueoftherecentAsiancrisis.Thefeepaidtotheprivaterisk-holderoftheforwardcontractswouldinmostcasesbelessthanthenegativeconsequencesofperiodicmoney-liquiditycrises.

Coveredinterest-rateparityasperChapter1shouldbemadeavailablewithintheLDCsaswellaswithinthedevelopedcountries.VariousLDCinvestmentprojectswouldthusbeabletoassumeonlywhatlevelofinterestrateandexchangerateriskisdeemedappropriate.Theexcessiveriskofunderwritingforwardcontractswouldbeshoulderedonlybyprivatefinancialinstitutionsthatareinthebusinessofhandlingsuchrisk,andtheofficialinstitutionscouldsubsidizethesearrangementsuntilamaturemarkethasdeveloped.

Significantly,recentLDCfinancialarrangementsareeffectivelydiscountingandwriting-offsubstantialportionsofLDCdebt,andencouragingthedevelopedcountriestotakemoreactiveinterestsinthetypesofinvestmentwhichare

countriestotakemoreactiveinterestsinthetypesofinvestmentwhichareoccurringintheLDCs.Insteadofthefamouspre-LDC-debtcrisisquotefromCiticorpChairmanWalterWristonthat‘countriesdonotgobroke’,whichencouragesbadmanagementandthemoralhazardproblem,thepost-debt-crisisperspectiveseemstobe‘howdoIgaingreatermanagementcontrolovertheuseofinternationalloansandsubsidies?’

Developingcountrydebt-for-natureswapsprovideoneexampleofhowmanagementrightstoglobalresourcescanbemademoreenforceableandeventransferable.In1989,CostaRicaandtheNatureConservancyconcludedthelargestdebt-for-natureswaptodate.TheNatureConservancy,aWashington-basedinternationallandconservationgroup,purchased$5.6millionofdiscountedCostaRicandebtwith$784,000ofdonatedfunds.TheNatureConservancyreceived$3millionininterestpaymentsfromthesebondsoverfiveyearswhichwasusedforconservationprojectsinCostaRica.8TheNatureConservancy,astheinternationalgroupwiththehighestwillingnesstopayformanagementrightstothisecologicallysensitiveregion,wasthusallowedtobethecaretaker.Ecuador,CostaRica,andBoliviahadconcludedfivedebt-for-natureswapswithinternationalorganizationsby1989.

Withdebt-for-equityswaps,debt-for-natureswaps,andothermarket-basedarrangements,theinternationalcommunitygainsmanagementrightstoundevelopedwaterandlandresources,businessassets,developedrealestate,andothereconomicassetswithintheLDCs.Typically,developed-countrygovernmentsprovideinsurance,subsidies,andgeneralguidanceforthesearrangementsaspertheBradyPlan.

Economistshavebeendevisingmanyothermarket-basedinternationalmanagementsolutionstodealwithenvironmental-economiccrises.DanDudek,aneconomistfortheEnvironmentalDefenseFundwhoservedonthe

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USdelegationatthesuccessful1987Montrealconferencetoreduceworldproductionofozone-depletingCFCs,hassuggestedthatBrazilandotherdevelopingnationscouldearncreditsagainsttheirinternationaldebtsbypreservingforestland.Butinsteadofdebt-for-natureswaps,permitstoburnfossilfuelswouldbeissuedaccordingtoaformulabaseduponGDP,population,

fossilfuelswouldbeissuedaccordingtoaformulabaseduponGDP,population,andthepreservationofforestland.Theformulawouldinitiallygivedevelopingcountriesmorepermitsthantheyneeded.DevelopedcountriessuchastheUSwouldbeissuedfewerpermitsthantheyneeded,thusinitiallyrequiringthemtoreducetheirfossilfuelburning.Aglobalmarketforthesepermitswouldallowcorporations,environmentalgroups,andotherinterestedinternationalpartiestobuythemfromthedevelopingcountries.Themarketcouldthusredistributeincomeinarationalway,whileatthesametimetheburningoffossilfuelscouldbereduced,andthepreservationofforestlandcouldbeencouraged.

Thesemarket-drivenresponsestotheworlddebtcrisisandLDCdevelopmentproblemsarefavoredbytheauthor,uptoapoint,notbecauseofanyferventbeliefinfree-marketcapitalism,butbecauseofthevirtuallyirreversiblefactthatprivatecapitalflowsincreasinglydominatetheabilityofofficialinstitutionstoinfluenceevents.Itisthereforeimportantthatofficialinstitutionsusetheirscarceresourcestoinfluencemarginallytheprivatemarketsratherthanwastingtheirresourcesimplementingpoliciesthatfailbecauseofcontraryprivatemarketforces.Inglobalizingeconomiesgovernmentswillincreasinglylosetheirabilitytoprovidepublicgoodswhentheywasteresourcesfightingtheprivatemarkets.

Justasitmakeslittlesenseforcentralbankstotakehugecurrencytradinglossestryingunsuccessfullytosupportacurrency,italsomakeslittlesensefortheWorldBanktolendmoneytoacapitalflightcountry,especiallyiftheBankdoesnothaveenoughmanagementinfluencetokeepfundsinvestedinspecifiedprojects.ItwouldseembetterfortheBanktoincreasetheefficiencyandfairnessbywhichprivatemarketstransferbothcapitalandmanagement.Forexample,theWorldBankmightexpanditsprogramofmatchingfundsforenvironmentalprojectssuchastheprotectionofresourcerichregionsinBrazilclosetotheBolivianborderandinthemountainrangesontheSouthAtlanticcoast.

ThemostdesirableinternationaltechniquescouldbedevelopedandpropagatedastheWorldBanksubsidizesandoverseesdesignatedlandandwateruseareas.Asanexample,representativesoftheWorldBankandotherinternationalagenciesthathaveincreasinglygainedmanagementinfluenceoverSouthAmerica'srainforestsmaynotbesufficientlytrainedintropicalagriculturemethods.ManyareunawareofhowslashandburntropicalagriculturalpracticesinSoutheastAsiaweregraduallyreplacedbythepaddyriceculture,whichutilizestheenergyofthesunmoreeffectively,controlsweeds,andmaintainsthenutrientcontentsofthesoil.Varioussocialandeconomicchangesarerequiredbythisecologicaltransformation,suchas

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increasedpropertyownership,regionalwatermanagement,andregionallaborexchange.9SlashandburnagricultureinmanyregionsofSouthAmericamightbereplacedwiththemorebeneficialpaddy-ricecultureifgovernmentofficialsandlanddevelopershadtheappropriatetrainingderivedfromhumanexperiencesontheothersideoftheglobe.TheWorldBankdidemphasizetheenvironmentinits1992WorldDevelopmentReport,butmuchworkstillneedstobedoneonthedesignofenvironmental-economicpolicyinitiatives.

MuchofLatinAmericahadlargelystabilizedbythelate1980s,butthesituationinAfricacontinuedtodeteriorate.AsstatedintheForewardofthe1988WorldDevelopmentReport:‘Forthepoorestcountries,especiallythoseinSub-SaharanAfrica,concessional.debtreliefandincreasedaidarenecessarytofacilitateresumedgrowth.In1988,theWorldBankloanedsub-SaharanAfrica$5billion.ByJune1988thesub-SaharanAfricannationsowedatotalforeigndebtofapproximately$110billion,notquite10percentoftheLDC’stotalforeigndebtof$1.2trillion.10Thisexcessivedebt,whichrequiredthetotalexportrevenuesofsomeAfricannationstoservicein1988,begantobepartiallyforgiven:inJune1988Franceindicatedthatitwouldcanceloutrightone-thirdofitsloansto20ofthepoorestnations;alsoinJune1988WestGermanydecidedtoforgive$50.3millionofitsloanstothepoorestcountries.11TheUSopenedthedoortotheseconcessionswhenitdecidedatthebeginningofJune1988nolongertoopposeinterest-ratereliefordebtforgivenessbyothergovernmentsinthecaseofsub-SaharanAfricaandother‘poorestofthepoor’.Unfortunately,thisdebtforgivenessinthelate1980swastoolittletoolate,assub-SaharanAfricacontinuedtofallfartherbehindotherdevelopingcountries.AccordingtotheIMF,thetotalexternaldebtasapercentageofGDPforsub-SaharanAfricarosefrom180percentin1981to330percentin1990.Foralldevelopingcountries,thisratiorosefrom100percentto130percent.

Whereasthe1980swasthe‘lostdecade’forLatinAmerica,the1980sand1990shavebeenlostdecadesforsub-SaharanAfrica.Inaddition,withneweconomiccrisesbeginningin1997and1998,partsofAsiaandEasternEuropenowriskenteringlostdecades.Meanwhile,LatinAmericaandotherpoorerregionscontinuetostruggle.

Clearly,moreisatstakeherethan‘financialcrisesandrecession’.AddressingthejointmeetingsoftheWorldBankandIMFon6October1998,PresidentoftheWorldBankJamesWolfensohnstated:

Twelvemonthsago,wewerereportingglobaloutputthatgrewby5.6percent—thehighestrateintwentyyears.Twelvemonthsago,EastAsiawasstumbling,butnoonewaspredictingthedegreeofthefall…therewasoptimismaboutRussiawithitsstrongreformistteam.Andthencameayearofturmoilandtravail.EastAsia,whereestimatessuggestthatmorethan20millionpeoplefellbackintopovertylastyear,andwhere,atbest,growthislikelytobehaltingandhesitantforseveralyears,tocome…17millionIndonesianshavefallenbackintopoverty,andacrossthe

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regionamillionchildrenwillnownotreturntoschool…anestimated40percentoftheRussianpopulationnowlivesinpoverty…acrosstheworld,1.3billionpeopleliveonlessthan$1aday;3billionhavenoaccesstosanitation;2billionhavenoaccesstopower…

WetalkoffinancialcrisiswhileinJakarta,inMoscow,inSub-SaharanAfrica,intheslumsofIndia,andthebarriosofLatinAmerica,thehumanpainofpovertyisallaroundus…Wemustgobeyondfinancialstabilization.Wemustaddresstheissuesoflong-termequitablegrowth,onwhichprosperityandhumanprogressdepend.Wemustfocusontheinstitutionalandstructuralchangesneededforrecoveryandsustainabledevelopment.Wemustfocusonthesocialissues…wecannotpretendthatalliswell…neithercanweaffordalostdecadeliketheonethatafflictedLatinAmericaintheaftermathofitscrisisintheearly1980s.Toomuchisatstake,toomanypeople'slives…

This‘humancrisis’,whichWolfensohndistinguishesas‘theothercrisis’asopposedto‘thefinancialcrisis’,ismorewithinthehistoricjurisdictionoftheWorldBankthantheIMF.Forexample,theWorldBankcanbeanemergencylenderforsocialassistance,andtheIMFcannot;whereastheIMFcanbeanemergencylenderformoney-liquidityandbalanceofpaymentsproblems,andtheWorldBankcannot.Thisinstitutionaldistinctionseemsappropriate,becausedifferentprocessesandexpertiseareinvolved.However,clearlybothtypesofassistanceaffectthesuccessoftheother,andcoordinationbetweenthetwois

assistanceaffectthesuccessoftheother,andcoordinationbetweenthetwoisessential.‘Moneyiswealth’asdiscussedearlierinthischapter,inthatitrepresentsthepowertoproduce,consume,aswellasdirectawidevarietyofsocialprocesses.

Theauthorwouldlikethereadertoknowthatheviewseconomiccrises,suchasthosediscussedinChapter4,associalcrisesaswell.Thus,inevaluatingWorldBankandIMFcrisismanagement,hetendstotakethesideofthosewhocriticizetheIMF(andnowtoalesserextenttheWorldBank,atleastsincethefour-year-to-dateregimeunderWolfensohn)foremphasizingmacroeconomicfinancialcriteriainitspolicydirectivesmorethansocialcriteria.Forexample,whentherecentAsiancrisishit,theIMFprovidedloansunderitsusual‘austerityrequirements’thatimposedseveresocialhardshipsonlocalpopulations.Localsubsidiesforfood,utilities,fuel,etc.werereduced,taxeswereraised,interestrateswereraised,etc.,sothatgovernmentbudgetdeficitsandbalanceofpaymentsdeficitscouldbereduced,andsothatforeignloanscouldbebetterserviced.Yes,thesemacroeconomicstabilitiesareimportant,buttheauthor'sviewisthatsocialcriteriawereunder-emphasized.Incomedistributionbecamemoreunequalandcontributedtoabjectpovertyandpoliticalinstability,andinsomecasesrecessionsweresuddenlydeepenedintosocially-devastatingdepressionsbytheausterityrequirements.

Inrecentcrises,theauthorwouldhavepreferredlessemphasisonstabilityofexchangeratesandbalanceofpayments;and,hewouldhavepreferred

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quickerdiscountingofforeigndebtdespitethemoralhazardproblemwhichcontinuesanywaytobeamajorproblem.

Intheauthor'sviewtheIMFshouldassisttheG7withProposals1,2,and3listedintheprevioussection,especiallymaintainingmoney-liquidityinacrisis-riddencountry.IMFloansofhardcurrencyhelpiftheycantrulybemaintainedinthemonetarybase(unlikeintherecentRussiancrisis),butlower-interestratemonetaryre-inflationstrategiesshouldbefavoredmorethanthecurrenthighinterestrateausteritypolicieswhichriskmonetarywealthdestructionasdebtorssuddenlyforfeit.ThesechangesinIMFpolicyemphasis,intheauthor'sview,couldallowjustasmuchmacroeconomicstabilizationandperformancewithoutsuchadversesocialconsequences.

suchadversesocialconsequences.

Forfurtherdiscussionofthecomplicatedlinkagesbetweeneconomic,social,andenvironmentalsystemsintheglobaleconomy,andthetypeofpolicymakingwhichtheauthorwouldrecommendbaseduponnon-economicaswellaseconomiccriteria,thereaderisreferredtoEncyclopediaofHumanEcology(2000),especiallythe‘EconomicSystems’sectionwhichtheauthoredited.

IV.NATIONALSTRATEGIESINTHEGLOBALECONOMY

A.MonetaryPolicies

AsdiscussedinChapter3,deregulation,internationalization,andtechnologicalchangeincreasedtheprofitabilityoffinancialmarketsinthe1980sand1990srelativetonon-financialmarkets,andthusreducedtheincomevelocityofmoney,ceterisparibus.IncomevelocityhasalsodeclinedduringchaoticeconomicepisodessuchasGermanreunificationaspeopleholdontomoneyandfigureouttheneweconomicenvironment—an‘optionsdemand’formoney.Also,whenfinancialinstitutionsareinseveredistress,asinJapanafterthemid-1990s,incomevelocitydeclineswhenmoneysuppliesareusedtore-capitalizeweakinstitutionsratherthaninduceGDP.

Despitethefailureofeconomiststoanticipatethe1982recessionbecausethey‘missedthecollapseofvelocityalmostentirely’(Gordon,1984,p.406),anddespitesubsequentinvestigationsofthevelocitydebacle,economistshavenotyetidentifiedthenewstructureformonetarypolicy.Decadesofhistoricaldatahavebeenallowedtoobscuretherecentchanges,andtherehasnotbeensufficientrecognitionthatexpandedmoneysupplieshavebeennecessarysincethe1980stosupportboththenaturalgrowthofthenewfinancialmarketsandthenaturalgrowthofnominalGDP.Asdocumentedin

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Chapter3,thedeclineinincomevelocityisstilltreatedasatemporaryanomalyratherthanacontinuingstructuralshift.

ThepossibilityofregainingaviablelinkbetweenmonetaryaggregatesandGDPisusuallydismissed.IneconomicliteratureasperBenjaminFriedmanand

isusuallydismissed.IneconomicliteratureasperBenjaminFriedmanandKennethKuttner(1992),onefindstheconclusionthat:

extendingthe[econometric]analysistoincludedatafromthe1980ssharplyweakensthetime-seriesevidencefrompriorperiodsshowingthatsuch[defensible]relationshipsexistedbetweenmoneyandnominalincomeorbetweenmoneyandeitherrealincomeorpricesconsideredseparately…thedeteriorationoftheevidencesupportingarelationshiptoeitherrealornominalincome,ortoprices,appearsnotjustforM1butforothermonetaryaggregatesandforcreditaswell.Thesechangesovertimeinobservableempiricalrelationshipsbearstronglynegativeimplicationsformanyfamiliarmonetary-policyframeworks…thereisnoevidencetoshowthatfluctuationsinmoneycontainanyinformationaboutsubsequentmovementsinincomeorprices.

Reflectingthisnewenvironmentformonetarypolicyinwhichincomevelocityisnolongerpredictable,evenMiltonFriedmaninhisrecentbookMoneyMischiefbeginstochangehishistoricemphasisontheimportanceoffixedmoneygrowthrules:‘Friedmannowhesitatestolegislatethemeansofmonetarypolicy,seeminginsteadtosuggestthatwepermitdiscretionintheuseofthosemeanstopursuelowandstableinflation’(Laidler,1993,p.206).

Whatpolicymakersshouldbedoingismonitoringfinancialmarketprofitabilityandtradingvolumesmorecloselyasnew,dominantfactorsinthedeterminationoftheincomevelocityofmoney,andthereforeinflation,economicgrowth,andothermacroeconomicaggregates.Thestructuralcoefficientsoftheauthor'sequationsintheAppendixofChapter3arelikelytochangesignificantlyovertime,andtheyshouldonlybeviewedasastartingpointforthisresearch.Nevertheless,theyquantifywhatismeantbytheappropriatemoneysupplylevelsforcentralbanktargetingofbothfinancialandnon-financialmarketexpansion.

Accurateforecastsofthevolumeoffinancialtransactionsisnotyetpossible.Technologicalchange,deregulation,andinternationalizationcontinuetoallowforamoredynamic,evolvingmarketplace—oneforwhichthereisnohistoricalprecedent.Butitseemsbettertocontinuewiththeresearchoftheauthorandothers,suchasRichardWerner(1993)andRobertLaurent(1994)whoseemtohaveregainedthelinkbetweenmoneyandGDPforJapan,thantoabandonmoneyasanimportantpolicytool.

InhistestimonybeforetheUSSenateBankingCommitteeinmid-July1993,

InhistestimonybeforetheUSSenateBankingCommitteeinmid-July1993,FederalReserve(Fed)ChairmanAlanGreenspansaidthattheFedwouldnolongerusegrowthinthemoneysupplytoguidetheeconomy.TheFedwouldinsteademphasizemovementsininterestratesandespeciallythedifferencebetweennominalinterestratesandinflation.Butasarguedpreviously,onecanincreasinglybepessimisticthattheFedcansignificantly

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controlimportantlonger-termUSinterestratesunlessthereishighlydirectedG7cooperation.Incontrast,theFedcancontroltheUSmoneysupply,atleastwiththepossibleexceptionintheshortrunofforeignholdingsofdollarsthatwashinandoutoftheUSeconomy.

Whatcanbeconcludedhereisthatdramaticdeclinesintheincomevelocityofmoneyhavenotbeenexpectedbecauseinsufficientattentionhasbeenpaidtothewayinwhichderegulation,internationalization,andtechnologicaladvancehavecausedfinancialmarketstoexpandandabsorbmoneyawayfromotheruses.Consequently,duringimportantepisodes,overlyrestrictivemonetarypolicieshavebeenused.OverlyrestrictivemonetarypolicieswereaprimarycauseofrecentfinancialcrisesandrecessionsaselaboratedinChapter4.Money-liquiditycrisisepisodesweremoresevereifthemonetarycontractionsoccurredsuddenlyontheheelsofafinancialliberalizationphase.Itisalsoimportantthatmoneysuppliesshouldnotbeincreasedfasterthanderegulation,internationalization,andtechnologicalchangeallowsnewfoundprofitabilityandwealth-formationinfinancialmarkets

Boomandbustcyclesremainaproblem,butasalonger-termtrendtherehasbeentoomuchworryofGDPinflationwithinworld-reserve-currencydevelopedcountries.InflationinGDP,ratherthandeflationandrecession,hasbeenseenasmorethreatening—justtheoppositeofwhattheauthorhastriedsohardtoarguesincehisfirstpublicationonthetopic(Allen,1989).Forexample,theriskofeconomiccrisisinthepost-1980internationaleconomyiselaboratedinaseriesofinterrelatedstudiesinitiatedbytheNationalBureauofEconomicResearch(NBER)andeditedbyFeldstein(1991).InFeldstein'sintroduction(p.17)onefindsthefollowing:

Inthedecadeofthe1980stheUnitedStatesfacedfourmajorshockstoitsfinancialsectorandtotheeconomymoregenerally.Eachofthesethreatenedto

financialsectorandtotheeconomymoregenerally.Eachofthesethreatenedtoprecipitateafinancialcrisisandamajoreconomicdownturn…Aprimaryculpritidentifiedineachofthefourcaseshasbeentherising[GDP]inflationratethatresultedfromthemonetaryandfiscalpoliciesofthelate1960sandthesecondhalfofthe1970s…[andtheriskofeconomiccrisiswasreducedwhen]theFederalReservebroughtdownthehighrateofinflationinheritedfromthe1970s…

The1970scertainlywasaperiodofworrisomeGDPinflation.Butsincetheearly1980s,excessiveworryaboutGDPinflationand,consequently,overlyrestrictivemonetarypolicieshaveincreasedtheriskoffinancialcrisesandrecessionasperthecasestudiesofChapter4,andhavereducedthesustainablegainsthatcouldappropriatelyberealizedfromassetpriceinflationandglobalization—the‘goldeneggs’ofChapter3.

Itisdifficulttopickupthegoldeneggonceithasbeendropped.Lostconfidenceinfinancialmarketsisregainedveryslowly.Theoptionsdemandformoneyliquidityincreases,moneysupplymayfallevenfartherbehindmoneydemand,andtheriskofliquiditycrisesmayremainhigh.For

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example,asfinancialinstitutionsinJapanexperiencedincreasingstressinthemid-1990sfromtheseprocesses,broadmoneysuppliescontinuedtodrop,andthentheinstitutionalcrisisdeepenedfurther.

JapanhasbeenthebiggestsavercountryandtheUShasbeenthebiggestdissavercountryfornaturaleconomicdevelopmentanddemographicreasonsaselaboratedinChapter2.Yetnewfoundgainsintheglobaleconomyfromexpansionarymonetarypoliciesareforthemostpartunrelatedtoacountry'ssaverversusdissaverstatus.Instead,thegainsdependuponthedegreetowhichthecountryhasbeenabletoparticipateintheprofitablenewopportunitiesinglobalizingfinancialmarketsandisthereforeabletoenjoythegoldeneggsallowedbyglobalizationandassetpriceinflationwithoutoverstimulatingGDPmarkets.

Japanandothermonetarily-expandingsavercountriescanincreasetheirmonetarywealthwhilegainingclaimsonforeignassets,whiletheUSandothermonetarily-expandingdissaverscanincreasetheirmonetarywealthwhile

monetarily-expandingdissaverscanincreasetheirmonetarywealthwhileincreasingforeigndebtsanddivestingabroad.However,asarguedinChapter2,countriesshouldbemuchlessconcernedwiththeiroverallfinancialbalancethanwiththequalityoftheirdebtsandinvestments.Presumablythereasonthatfinancialtransactionsoccuristhatbothpartiestotheagreementperceiveanetbenefit.Andtechnologicaladvances,deregulation,andinternationalizationcontinuetoincreasethepotentialnetbenefitsforbothpartiesbyreducingcostsandincreasingefficiencies.

B.FiscalPolicies

Structuralchangesintheglobaleconomycreateanewenvironmentfornationalfiscalpolicies.Thosepolicymakerswhomanipulategovernmenttaxandspendinglevelstoregulateeconomicgrowthandinflationmay,toquoteJohnMaynardKeynes,makeus‘slavestodefuncttheories’ifthesestructuralchangesarenotappropriatelyconsidered.Especiallyimportanttoconsideraretheincreasedinternationaltransfersofinvestmentbasedoninterestrateandfinancialstrategyparityconditions,andtheincreaseddominanceofprivatefinancialmarketsovercentralbanksandotherofficialinstitutions.

Aselaboratedthroughoutthisbook,thenewhegemonyofprivatecapitalhasbeenamostlyirreversibletrendthatpolicymakersmustacceptasa‘given’overthelongterm.IntheshortrunwhentheprivatemarketsarequiettheG7,theIMFandotherscanredirectnetcapitalflows,currencyexchangeratesandinterestrates,butinthelongruntheseofficialinstitutionsshouldnotbeexpectedtomaintainnarrowtargetrangesforthesevariables.

Intheeconomicsliterature,whenacountryfindsthatitsinterestratesandrelatedvariablesarefixedbyinternationalconditionsbeyonditscontrol,thenthecountryiscalled‘small’.Relativetointernationalfinancialmarkets,manycountriesincludingeventheUSarethusbecomingsmalloraresmallinsomecasestudies.

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Fiscalpolicymakers,whentheyattemptstrategicallytomanipulatethedomesticeconomy,shouldthereforepayattentiontotheeconomicsliteratureregardingsmallcountries.Forexample,asmallcountryisabletoborrowglobalfundsto

smallcountries.Forexample,asmallcountryisabletoborrowglobalfundstocoverrisinggovernmentbudgetdeficitsatafixedinterestrate,butalargecountrywouldhavetopayrisinginterestrates.Duetothesizeofgovernmentborrowingsrelativetotheglobalmarketforloanablefunds,risinggovernmentbudgetdeficitsinalargecountryincreasetheborrowingssignificantlyenoughtoraiseglobalinterestrates.Bycontrast,increasedgovernmentborrowingsinasmallcountrydonotdrawoninternationalfinancialmarketsenoughtoaffectglobalinterestratessignificantly.

Theinterestrateimpactofgovernmentborrowingiscrucialtofiscalpolicy.Iffiscaldeficitsraiseinterestrates,interest-rate-sensitivebusinessandhouseholdpurchasesarediscouragedor‘crowdedout’tosupportfiscalpolicygoals.Fiscalpolicymakersinlargecountriesthushaveacrowded-outconstituencytoconsider,whereasnosuchconstituencyexistsinsmallcountries.Symmetrically,reducedgovernmentdeficitsinlargecountrieswouldlowerinterestratesand‘crowdin’thissameconstituency,butreduceddeficitsinsmallcountrieswouldnotprovideanyspilloverbenefitstotheprivatesectorviathereducedinterestrateeffect.

Theconstituenciesthatarecrowdedoutandcrowdedinbythefiscalpoliciesoflargecountriesareglobalconstituencies.Forexample,therisingfederalbudgetdeficitoftheUSintheearlyandmid-1980sincreasedthenetUScapitalinflowbyatleast$50billionperyear,ceterisparibus,andraisedworldinterestrates.Intheearly1990s,Germangovernmentfinancingforreunification,andtheJapanesefiscalstimuluspackageeachindependentlyattractednetcapitalinflowsofperhaps$20–30billionperyear,ceterisparibus.

ThecombinedyearlydemandoninternationalcapitalofGermanandJapaneseexpansionaryfiscalpoliciesduringtheearly1990swasprobablysimilartothatofthelargerUSbudgetdeficitsduringtheearly1980s.However,intheearly1980sinternationalcapitalwaslessavailableandthereforetheUSdeficitsputsignificantupwardpressureonglobalinterestrates.Incontrast,duringtheearly1990sinternationalcapitalwasmorereadilyavailableandthereforetheearly1990sGermanandJapanesefiscalexpansiondidnotincreaseglobalinterestratessonoticeably—althoughtemporarilyintheearly1990sGermany'sEMSpartnerschosetoincreaseinterestrateswithmonetarypolicytomaintainEMSparitieswithGermanyandthustheyexperiencedsomecrowding-out.

Theearly1990sGermanandJapanesefiscalexpansiondidcompetesuccessfullywiththeearly1990sUSfederalbudgetdeficitforinternationalfundsandthe

withtheearly1990sUSfederalbudgetdeficitforinternationalfundsandthereducedUScapitalinflowcontributedtotheearly1990sUSrecession.However,notbeingconcernedaboutmaintainingitsexchange

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rate,theUSpolicyresponsewastoincreasemoneysuppliestopreventcontinuingrecessionandtherewasrecoveryin1992–94.

USgovernmentdebtincreasedfrom1993to1997.Thedebt-limitwasraisedin1996to$5.5trillionsothatthegovernmentcouldpayitsbills,andtheannualdeficitsremainedhigh.Thenin1997thedeficitbegandroppingquicklyandbecameasurplusearlyin1998,thuspeakingthedebt.However,duringthisperiod,theUSwassowellsuppliedwithanetinflowofforeigninvestment—$194.6billionin1996,$254.9billion1997,and$43.1billioninthefirstquarterof1998—thatchangesinthegovernmentdeficitappearedtohavenoeffectoncreditavailability,crowdingout,orcrowdinginofprivateconsumptionandinvestmentintheUS—instead,therewascrowdingoutinthecountriesofAsiaandelsewherethatweresendingmonetarywealthtotheUS.Asoflate1998,theUSnetinternationalinvestmentinflowremainshigh;thereforetheeffectofreducedUSgovernmentborrowinghasmostlytranslatedintoanincreaseinprivateborrowing.TheUShouseholdsavingsratedroppedtozeroinlate1998.

Asdiscussedearlierinthischapter,theUSisinauniquepositiontoavoidcreditcrunchesbecauseofits‘moneymercantilism’thatallowsittheuseofforeignsavingsandinvestment.VariouscountriesthusneedtomaintainmoneyliquidityandtakeotherstepsdiscussedinthischaptertoavoidUSmoney-mercantilismandglobalcrowding-outthatmightresultfromUSeconomicexpansion.

Ifappropriateglobalmonetarypoliciesareused,thentheauthorwouldarguethatfiscalpolicyeverywhereshouldbeconductedmoreonaproject-by-projectbasiswithcost-benefitanalysisasifitweremoreofamicroeconomicaffair.Currently,fiscalpolicyismoreofamacroeconomicaffairinwhichgovernmentspendingandtaxationlevelsareexpectedtohavecomplicatedimpactsoneconomicgrowth,inflation,andothereconomy-wideaggregatesviatheinterestrateeffect.Theinterestrateimpactisusuallyassumedtobesignificantbecauseofthelarge-countryassumption.Emphasizingtheinterestrateeffect,andfocusingonaggregategovernmentspendingandtaxationlevelshas,intheauthor'sopinion,directedtheeconomicsprofessionandpolicymakersawayfrom

author'sopinion,directedtheeconomicsprofessionandpolicymakersawayfromthemoreimportantbusinessoffiscalcost-benefitaccountabilitywithregardtothevariouspublicgoodsthatbeinghandled.

C.TradePolicies

Thetrade-weightedexchangevalueofthedollarpeakedin1985,andthenfellapproximately40percentfrom1985to1988.Thedollarfluctuatedmoderatelyaroundits1988levelsuntil1997,whenitbeganrisingsignificantly.Fromthebeginningof1997tothemiddleof1998thedollarappreciated20percentagainstthecurrenciesofitstradingpartners.

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Thosewhoexpectedthedevaluationofthedollarfrom1985to1988toeventuallyreducethelargeUScurrentaccountdeficit—whichreachedarecord-$163billionin1987—werefinallyheartenedwhenthedeficitdroppedto-$90billionin1990and-$4billionin1991(Figure2.2).However,inthefirsttwoquartersof1991theUSreceivednet‘officialunrequitedtransfers’of$17and$8billionrespectively—acurrentaccountlineitemreflectingpaymentsinthisperiodfromalliesduetotheUSPersianGulfactions,whichwasunrelatedtoexchangerates.TheofficialunrequitedtransfersbalanceoftheUSisgenerallynegative.Itsannualbalanceover1987–1992was-$12,-$13,-$13,-$20,$20(in1991),and-$18billion,respectively.

The1991improvementintheUScurrentaccountbalancecanbeexplainedbothbythetemporary$35–$40billionimprovementinthisonecategory,andbyatemporary$100billion/yrcollapseinUSnetcapitalinflowsfrom1989levelswhichledtoaweakUSeconomy,weakUSimportdemand,andaslightlymorecompetitivedollar.Chapter4arguesthatthistemporarycollapseofcapitalinflow,duetointerestrateparityconditionsinitiatedbyGermany(reunification)andJapan(money-liquiditycrisis)wasthemajorcauseofthe1990–91USrecession.

TheUSofficialunrequitedtransfersbalancereturnedtoitsdeficitpositionin1992,andthecapitalinflowresumed,increasing$50billionfromitslowlevelof1991.ThereturnofthecapitalinflowrestoredgrowthtoaweakUSeconomy,improvedUSimportdemand,andtoamodestdegreestrengthenedthedollar.

improvedUSimportdemand,andtoamodestdegreestrengthenedthedollar.TheUScurrentaccountdeficit,whichhaddroppedclosetozeroin1991,thusdeterioratedagainin1992to-$62billion.Since1992,thenetcapitalinflowandcurrentaccountdeficithaveconsistentlyincreased,andasof1998theybalanceeachotheratapproximately$200billionand-$200billion,respectively.

Itisdebatable,therefore,whetheramajorUSdollardepreciation,asper1985–1988,caneliminatetheUScurrentaccountdeficit.AsshowninTable1.1,thedollarremainedconsistentlyandsignificantlyundervaluedrelativetopurchasingpowerparity(PPP)levelsduringthe1990s,yetthecurrentaccountdeficitworsenedtonewrecordlevels.PPPlevelswouldpresumablybalancetradeprice-competitiveness,andtheundervalueddollarwouldpresumablygiveUSfirmsapriceadvantageandimprovetheUScurrentaccountbalance.Whyhasjusttheoppositehappened?AsarguedinChapters1and2,structurallyhighUScapitalinflowsarerequiredbyglobalfinancialconditions(interestrateandfinancialstrategyparities)whicharemostlyindependentoftradepricecompetitiveness.ThestrongUSeconomyandwealthenhancementcausedbycapitalinflowsincreasesUSimportsbyhouseholdsandbusinesses.WiththeUShigh-techbusinesssectorboomingandbecomingmoreglobal,manyoftheseimportsarecriticalcomponentsandsubassembliesthatwouldbe‘imported’atalmostanyexchange-rate-

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adjustedcostasintrafirm‘trade’(andthuspriceismostlyirrelevant)orfromforeignaffiliates.

Whetherarealdepreciationofthedollar(adjustedforinflationbyPPPcalculations)isaneffectivetoolforbalancingtheUScurrentaccount,orwhetherafundamentalreversaloftheUSnetcapital-importerdissaverstatusisrequired,isactuallyoneversionofanhistoricdebate.DavidRicardo,BertilOhlinandothershavearguedthatrealdepreciationisnecessarytocorrectatradedeficit,andJohnStuartMill,JohnMaynardKeynesandothershavedeniedthatinternationalpricemechanismsareanessentialingredientintheadjustmentprocess.AsummaryofthishistoricliteratureiscontainedinMundell(1991).

Morerecently,supportingtheMill-Keynesside,Mundell(1987)andothershaveclaimedthatnationalsavings-investmentimbalancescantranslatethemselves

claimedthatnationalsavings-investmentimbalancescantranslatethemselvesdirectlyintotradeimbalanceswithcurrencyalignmentsplayingnousefulrole.Inaddition,ifmisguidedcurrencyrealignmentsdotakeplace,itcanleadtoundesirableconsequencessuchasaninternational‘firesale’ofbusinessassetsandrealestate.ThisdoctrineofMundellandothershasbeencalledbyJohnWilliamson‘immaculatetransfer’,anditisflatlydeniedbyPaulKrugmanonbothempiricalandtheoreticalgrounds:

Theargumentthatdevaluationleadstoexcessivesellingoffofassetstoforeignersmustbemadeconsistentwiththeaccountingidentitythatcapitalinflowshaveastheircounterpartcurrentdeficits.Ifdepreciationleadstocapitalinflows,itmustleadtoawidenedtradedeficit—asMundellrecognizes.However,wehaveseenthatthereisnodirectchannelbywhichthesavings-investmentbalancesomehowgetstranslatedintothetradebalancewithoutaffectingtherealexchangerate(Krugman,1992,p.2–34).

Theauthor'spositionisessentiallyinsupportofthe‘immaculatetransfer’sideofthedebatetakenbyMill,Keynes,andMundell(asusual,Keynesturnsouttoberight).IncontradistinctiontothequotebyKrugman,theauthorwouldpointoutthatforeignsavingsincreasinglymovebetweenUSdollar-denominatedmerchandise,services(currentaccount),andassets(capitalaccount)indiscriminately.Forexample,corporateequity,particularlyequipmentand‘intellectualproperty’usedintheproductionofadvancedtechnologiesinthePacificBasin,isnotonlybeingphysicallymovedasafinal-productexport,butmayaccountformorethanhalfoftheUSofficialtradedeficitwithAsia.Furthermore,duetotheriseofoffshorefinance(Chapter3)andthe60percentglobalreserve-currencyroleplayedbythedollar,itisnotnecessarythatforeigncurrencytransactionsarerequiredintheseprocesses—immaculatetransfercanbefacilitatedbythe$250–$300billionofnon-USsavingsindollarswhicharemadeavailableeachyearfornewusesintheglobaleconomy(Table3.1).

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Immaculatetransferwherebysavings-investmentbalancesgettranslatedintotradebalanceswithoutaffectingtherealexchangeratecanalsobefacilitatedbychangesinthestockmarketandotherassetrevaluations.Forexample,theappreciationofUSstockmarketsfromacombinedvaluationof$6trillionin1996to$12trillionin1998raisedforeign-ownedwealthaswellasUS-ownedwealthheldwithintheUS.Asdiscussedin‘Money,Wealth,andSocial

wealthheldwithintheUS.Asdiscussedin‘Money,Wealth,andSocialConsensus’earlierinthischapter,asignificantportionofthisappreciationreflectsinvisible‘socialagreements’or‘beliefsystems’ratherthanmeasurableincomeandexpenditureflows—perhapsthisnewfoundmonetarywealthheldintheUScanbecalled‘immaculateconception’aswellastheauthor'searlierterm‘agoldenegg’.Newmonetarywealthcanbeimmaculatelyconceivedinanycurrencyinthehandsofbothresidentsandnon-residents(withalittlehelpfrombanking-systemmoneycreationandglobalizationopportunities),anditcanthereforebeusedfornewexportingorimportingwithoutanyinitialneedforforeign-currencyoperations.

TheUSCommerceDepartmentincreasinglyusesinternationalinvestmentandforeigndebtcalculationswhicharebasedonappreciatedordepreciated‘replacementcost’ofassetsratherthan‘initialpurchasecost’;althoughtechnicallyspeakingappreciationanddepreciationarenotchangesin‘investment’or‘savings’(GDPflowvariables)butratherchangesinwealth(non-GDPstockvariable).AsdiscussedinChapter3under‘Monetary-WealthCreation’,wealthcreationor‘wealth-productivity’canoccurindependentlyofGDPcreationorGDP-productivity.‘Immaculateconception’ofwealthand‘immaculatetransfer’ofwealthcantheninturnbeadrivingforceforchangesininternationaltradeandotherGDPflows.Inthiscase,itisnotthechangesinexchangerateswhichdrivetradebalances,butratherthe(independentofforeigncurrency)changesinwealthorappreciation-adjustedsavingswhichdriveinternationaltradeandotherGDPflows.Exchangerateswouldthenalsobedrivenbythemoreautonomousfinancialchanges,andtheyneednotmovetowardPPPlevels.

Toelaboratesomeoftheseprocesses,amajorityofthemostcontroversialtrade-imbalanceinthenewglobaleconomy,betweentheUSandAsia,maybeaccountedforbyshipmentsofcorporateequitythathasyetto(fully)generateincomeforitsowners.SimplyrecordingthevalueofproductsmovingbetweentheUSandAsiaisnotveryhelpfulinidentifyingUSeconomicinterests;itismoreconstructiveforpolicymakersalsotomonitorthechangingownershiprightsandequitycontentofthistradeflow.TotheconsiderableextentthattheUStradedeficitwithJapanandothersisaccountedforbyUS-owned-equity-productscomingin,thedeficitaddstotheproductivebaseofUS-ownedindustryandreflectsapotentialforfutureUSincomeandwealth.ThosewhoconsiderUStradewithJapantobeunbalancedinfavorofJapanmaybelessinclinedtothinksoaftertheseconsiderations.

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Whatshouldbeconsideredistheextenttowhichatrueeconomicdifferenceexistsbetweencurrentandcapitalaccounttransactions.Forexample,whenimportsofJapanesesemiconductorproductstotheUSwereslappedwith100percenttariffsinMarch1987,ToshibaincreaseditsUSdirectinvestmentforafabricationandsalesfacilityinIrvine,California.ToshibaproductsthusremainedcompetitivewithUSrivalssuchasZenith.YetwhentheauthorpurchasedhislaptopcomputerfromToshiba-Irvinein1988,itwasassociatedwithJapanesedirectinvestmentintheUS(capitalaccountinflow)andincreasedeconomicactivityinCaliforniaratherthanUSimports.

AndduringthesameyearUSSteel'sPittsburg,California,facilityreceived$200millionofforeigndirectinvestmentforajointventurewithKorea'sPohangIron&SteelCompanyLtd.Thisjointventurefirm,Posco,becamethelargeststeelprocessoronthewesterncoastoftheUS.Muchoftheoriginalinvestmentwasusedtobuyinternationalequipmentforastate-of-the-artfabricationfacilitythatcouldberunbysevenoperatorsratherthatthe100orsoneededfortheoldUSSteelplantastone'sthrowaway.TheauthorwastoldthatfavorablefinancingwasobtainedfrominternationallendersduetotheiraffiliationwithPohang.

IsthisjointventureUSforeigndebtortheforeignbuyingofAmerican,isitforeigndirectinvestmentorUSimports,andshouldwhateverbalanceofpaymentsdebitsorcreditsthatshowupbecauseforconcernandregulation?Similarexamplesareincreasinglyfound,suchastheToyotapurchaseofaGeneralMotorsplantinFremont,California—appropriatelycalled‘NewUnitedMotors’.

Distinctionsbecomeevermorefuzzybetweendebtandequity,equityversusintermediateandfinalproducts,andnationalversusinternationalactivities.Therefore,itbecomesevermoretroublesometointerpretcurrentaccountandcapitalaccountentries.GerritJeelofofHolland'sPhilipsgroupjokesaboutbuyingaship,equippingitwithcomputerassisteddesignandmanufacturing,anddroppinganchorontheshoreofwhatevercountryatthemomentoffersthebestcurrency-exchangeopportunity.

IntheUS-KoreanPoscojointventure,Koreansavingscouldbeusedto:(a)buyanexistingfacilityfromUSSteelforproductionasis;or(b)constructanewUS

anexistingfacilityfromUSSteelforproductionasis;or(b)constructanewUSfacilitythatusessomeexistingUSassets,someUSmerchandiseandservices,andsomeforeign-importedmerchandiseandservices.Option(a)wouldinvolveonlyaUScapitalinflow.Option(b)wouldinvolveaUScapitalinflowtotheextentthatUSassetsareused,andaUScurrentaccountdeficittotheextentthatforeignmerchandiseandservicesareused.TheUSmerchandiseandservicesthatareusedwouldnotdirectlyaffectthebalanceofpayments.

Inthisexample,USassetsthussubstitutedirectlyforUSmerchandiseandservices,fortheKoreans,andtherateofsubstitutionwouldprobablynotbeaffectedbychangesinthevalueofthedollar.Forexample,ifadeclinein

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therealdollarexchangerateincreasestheattractivenessofoption(a)totheKoreans,thenitwouldalsoincreasetheattractivenessofoption(b).Underoption(b)USassets,andnon-tradedUSmerchandiseandserviceswouldbesubstitutedforforeignimportswhenthedollardeclines.ThemainimportofPoscoisapproximatelyonemilliontonsannuallyofhotrolledsteelthatitpurchasesfromPohang.AtsomepointafallingdollarcouldleadtosomesubstitutionofUShotrolledsteelforPohangsteel.PerhapsPohangwouldevenbuyorbuildaUShotrolledsteelfacility,andoptions(a)and(b)wouldrepeatthemselvesinasecondround.

Therefore,unlikeKrugman'squote,afallinthedollarcouldinthiscaseleadtoanincreasedUScapitalinflowandanarrowedUStradedeficitasmoreofbothUSassetsandnon-tradedUSmerchandiseandservicesarepurchasedinsteadofforeignimports.AllUSassets,merchandiseandserviceshavebecomemoreattractivetotheinternationalfirmrelativetonon-USgoods,andmoneyflowstotheUS.Theinternationalsavings-investmentimbalancewhichattractedtheKoreanstotheUSinthefirstplacewasdirectlychanneledintoanarrowerUStradedeficitviathejointventure'ssubstitutionofUSforforeigncapitalgoods.Tomaintaintheaccountingidentitythatcapitalinflowshaveastheircounterpartcurrentdeficits,ofcoursethestatisticaldiscrepancyaccountcouldbeused,buttheauthorfailstoseethelogicofsuchartificialaccounting.

TheabovescenariohasalsotakenplaceintheUSautomobileindustry.Encouragedbythe50percentfallofthedollaragainsttheyenfrom1985to

1992,JapanesedirectinvestmentinUSvehicleproductionroserapidly.JapaneseproductionintheUSrosefrom400thousandvehiclesin1985to1.7millionin1992.ThefallingdollaralsohelpedtoincreasetheUS-partscontentofJapaneseautomobilesmadeintheUS.WhenJapanesecarmakersbeganbuildingcarsintheUSinthe1980s,theyreliedheavilyonJapaneseparts.But,theUSpartpurchasesbythesefirmsincreasedfrom$2billionin1986to$12billionin1992.12TheofficialUSauto-partstradedeficitwithJapanhoveredaround$10billionduringtheearly1990s,buttheofficialdeficitdoesnotincludethisincreasedUSauto-partssalesto‘Japanese’companies.Throughthe1990s,USautomobilecompanieshavedonewell.However,especiallynowthatDaimlerBenzhaspurchasedChrysler,andthenewcompanybegantradingontheNewYorkStockExchangeinNovember1998,whatisa‘US’autocompany?

Assumingthatfavorableprice/earningsratiosarearrangedasdiscussedinChapter2,internationaljointventureactivityintheUSandotherforeignbuyingofAmericawhichisencouragedbydollardevaluationprovidesanetbenefitfortheUSeconomyandpossiblyallowstheUStradedeficittoshrinkasashareoftheeconomy.TheauthorthusdoesnottakeissueonlywithKrugman—healsotakesexceptiontoMundell'sdoctrinethatanundesirableinternational‘firesale’ofUSbusinessassetsandrealestatewilloccuras‘theAmericandogeatsitsowntail.’

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AstheKoreanmanagerofthePoscoventuretoldtheauthor,thegoaloftheventureistocreateaworld-classspecialtysteelfactorythatcangeneratelocaleconomicgrowthandevenexportsuccessfully.SuchanexampleisalsoprovidedbyHonda.The30percentfallintheforeignexchangevalueofthedollarfrom1985to1988encouragedHondatoshipcarsproducedfromitsUSplantsacrossthePacificforsaleinJapan(anofficialUSexport).Honda'sfirstsuchshipmentarrivedinJapanon8April1988,thesamedaythatitsone-millionthUS-producedcarrolledoffitsassemblylineinOhio.

Morecompletescenariosofinternationaltrade-investmentlinkageswouldrequireanexplanationofwhythedollarwoulddeclineinthefirstplace.Forexample,inthischapter'sdiscussionofG7policy,theTriffindilemmawaspresentedasacauseofthedollar'sdepreciationfrom1985to1994;butinthe

presentedasacauseofthedollar'sdepreciationfrom1985to1994;butinthespiritoftheliteratureanimportantissueiswhathappenstoaneconomyassuminganarbitrarypolicy-imposeddevaluationofitscurrency.Incontrasttomuchoftheliterature,theabovediscussionconcludesthatanarbitrarydevaluationcouldbequitebeneficialtothedevaluingcountry'seconomicgrowthandbalanceofpayments.

Thelikelihoodofnew,misunderstoodtradepatternsincreasesasmultinationalsaccountforlargersharesofinternationalcommerce,andas‘latch-key’,internationalizedfacilitiesareincreasinglyabletosubstitutedomesticforforeignassets,materials,andservicesinconstructionandoperation.

Inthegrowinghigh-technologyandintellectualpropertiesindustries,domesticandforeignassets,servicesandmaterialsareespeciallysubstitutable.Also,itislessclearhowachangeinexchangeratesaffectsinternationalbalancesintheseindustries.Forexample,ifthedollardepreciates,moreinternationaltelephonecallsareinitiatedfromtheUSratherthantheforeignside,whichleadstoanincreasedUScurrentaccountdeficitastheUSsidepaysforforeignservicing.Becauseof(notinspiteof)unmatchedtelecommunicationscapabilitiesandlowcosts,theUShasrunatelecommunicationsservicedeficit(approximately$2billionperyear)duetothisstructuralcondition.IntryingtosortouttheeffectofdollardevaluationontheUStradedeficit,WilliamCline(1991)hashadsomesuccessexceptthat‘themainculpritiscomputers’andrelatedindustriesandthewaythattheyarepriced.

Chapter2discussestradeprotectionisminlightofthesenewtradepatterns,andconcludesthatprotectionismisincreasinglyimpracticalduetothefollowing:(A)tradedeficitsarenowrequiredbycountrieswhich,duetointerestrateandfinancialstrategyparityconditions,receiveanetcapitalinflow;(B)risingimportsasashareofnationalpurchasesisincreasingthenationalwelfarecostofusingtradeprotectionism;(C)theincreaseininternationaljointventuresandoverseasproductionismakingitlesslikelythattradeprotectionismwillachievethedesiredincometransfers;and(D)theincreaseininternationalownershipofoncenationalcorporationsis

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makingitlesslikelythattradeprotectionismwillachievethedesiredincome

makingitlesslikelythattradeprotectionismwillachievethedesiredincometransfers.

These(A)–(D)structuralchanges,eachofwhichwasencouragedbytherapidglobalizationoffinancialmarketsinthe1980s,haveallowedfortheinevitableflowsoffundsandwealth-revaluationsbetweensaveranddissavercountriesandtheinevitabletradeimbalancesdespiteallformsoftradeprotectionism.Recenttradeprotectionismhasevenencouragedtheintegrationofinvestmentandproductionprocessesacrossnationalboundariesas‘awayaround’theprotectionism,andtheflowofmerchandiseandservicesbetweennationsisincreasinglylikelytobeforintrafirmandintra-industrypurposes.

Giventheescalatingnationalcostsandinefficienciesoftradeprotectionism,othernon-trade-relatedpolicyinstrumentsarebeginningtolookmoreattractive.Alternativedomesticpoliciesexistwhichcouldtransferthesameamountofincometopoliticallyfavoredfirmsandindustries,andyetimposeamuchsmallercostonthenation.

Forexample,directgovernmentsubsidiestoagriculturehavebeenusedsuccessfullyintheUSfordecadesasameansofpreservingdesiredproductionlevelsandprofits.These‘deficiencypayments’arecurrentlyusedincombinationwithgovernmentloansandgovernmentpurchasestotransfermoneytoUSwheat,rice,andcornfarmers,aswellastotheproducersofmanysmallercrops.Thesameprogramscouldbeusedinplaceofthecostlytradequotaswhichhaverecentlytransferredincometoauto,steel,sugar,textile,beef,andotherindustries.Infact,beforetheUSSugarActexpiredin1974,theUSsugarindustrywasprotectedbythesedomesticpoliciesratherthanbytraderestrictions.

CarefulstudieshaveshownthatthenetUSwelfarecostsofUStraderestrictionscouldbereducedbymorethan90percentinsomecasesifproducerswereinsteadgiventhesamelevelofincomeprotectionwithdomesticpaymentschemes.Table5.1showstheeconomiceffectsoftradequotasestablishedinthe1980stoprotectUSauto,steelandsugarindustries,brokendownbyUSproducerbenefits,USconsumercosts,andnetUSwelfarecosts.TheannualnetwelfarecosttotheUSeconomyofusingtradequotastoprotectitsauto,steelandsugarindustriesintheyearsshortlyafterquotaswereputintoplacewas$1.06billion,$770million,and$1.36billion,respectively.ThesearetheannualamountsbywhichthecoststoUSconsumersfromtheprotectionismexceededthebenefitstoUSproducers.Also,giventhatapproximatelythesamelevelofbenefittoproducershasbeenmaintainedbysubsequentrevisionstothesequota

benefittoproducershasbeenmaintainedbysubsequentrevisionstothesequotalevels,thesecostshaveincreasedbyindeterminateamountssincethoseyearsduetostructuralchanges(A)–(D)mentionedabove.

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Cars Steel Sugar1984- 1985- 1983-

USproducerbenefitfromquotas 3.13 2.61 1.35USconsumercostfromquotas 4.19 3.38 2.70NetUSwelfarecostfromquotas 1.06 0.77 1.36

Sources:Babcocketal.(1985),Leuetal.(1985).

Table5.2showstheUSTreasuryexpenseandnetUSwelfarecostsifinsteadthesameamountofincomehadbeentransferredtotheseUSindustrieswithdomesticpaymentschemesofthetypecurrentlyusedinagriculture.ThenetUSwelfarecostscouldhavebeenreducedby95percent,94percent,and76percentinautos,steel,andsugar,respectively.

Whyaren'tdomesticpaymentschemesusedinsteadoftradeprotectionism,then,ifmostofthenationalwelfarecostofUSprotectionismcouldthusbeavoided?First,itisbecauseofthelargeTreasuryexpensesthatwouldhavebeenincurredattimeswhentheUSgovernmentwasreceivingconsiderablecriticismforitslargebudgetdeficit.AlthoughtheseTreasuryexpenseswouldonlyreflectanincometransferfromtaxpayerstoselectindustries,andthereforehavelittleeffectontheoverallUSeconomyincludingsavingsandinvestment,theyarewidelyandincorrectlyfelttobeanetcosttotheUSeconomy.Actually,asshowninTable5.2,thenetwelfarecosttotheUSeconomyofusingdomesticpaymentschemestoreplacethetradequotasincars,steel,andsugarwouldequalonly2,2,and24percent,respectivelyoftheactualUSTreasuryoutlay.NowthattheUSfederalbudgetisinasurpluspositionasof1998,maybeweshouldchoosetheselower-costdomesticpoliciesratherthanthehigh-costtradebarriers.

Secondly,domesticpaymentschemesarenotusedinsteadofUStradeprotectionismbecausetheymakethepublicveryawareoftheexact,discriminatorybenefitsthatareprovidedtotheprotectedindustries.IfGMorFordaretoreceiveXdollarsfromtaxpayersbecausetheyarefacinghardtimes,whyshouldn'tcompaniesPandQreceiveYdollars?Thesedebateswouldgoonforever,asindustrylobbyistswouldpittheirskillsagainstCongressmen,andtaxpayerswouldprotestthewell-publicizedsubsidiesandbureaucraticcosts.

Politiciansfinditeasiertousetradequotasbecausetheincometransfersaredifficulttomeasureandthusdifficulttocalldiscriminatory;becausethecostsarespreadovercountlessconsumerswhohavelittlepoliticalclout;and

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becauseforeignexportersarewidelyandincorrectlyperceivedtosufferamajorityofthecostsanyway.Tamperingwithtradeflowstotransferincomeinsteadofdirectlytransferringincomehasthusallowedpolicymakerstoescapefromconsiderableaccountabilityandcriticism.Theresponsibilityofdealingwithfirmsonacase-by-casebasisisavoidedeventhoughinmostprotectedindustries(forexampleautos,steel,sugarrefining)onlyafewfirmsaccountformostofUSdomesticproduction.

Cars Steel Sugar1984– 1985– 1983–

ActualTreasuryexpense 3.13 2.61 1.35NetUSwelfarecostofdeficiency 0.05 0.05 0.32ReductioninUSwelfarecostsifdeficiencypaymentsreplacetradequotas 95% 94% 76%NetUSwelfarecostasapercentofTreasuryexpense 2% 2% 24%

Source:Babcocketal.(1985).

Protectionismthatattemptstocoverallimports,suchasUSCongressmenGephardt'sbill(firstproposedunsuccessfullyin1988)tosystematicallyreduce

Gephardt'sbill(firstproposedunsuccessfullyin1988)tosystematicallyreducethetradedeficit,isundesirablebecause,asdiscussedinChapter2,thenetcapitalinflowintotheUSwouldhavetodeclinealongwithadeclineintheUStradedeficit.Atcurrentinternationalinterestratesandprice-earningsratios,USeconomicinterestswouldbeseverelyhurtbyadeclineinforeigninvestmentinflow,includingtheUSgovernmentwhichreliesuponthecapitalinflowtofinancemuchofitsborrowing.ThislessonshouldhavebeenlearnedbytheUSin1990–91whenthereducedforeigncapitalinflowledtorecessionaryconditions.TherecessionaryconditionsinturncontributedtotheousteroftheBushadministrationin1992.

PolicymakerswillthereforehavetoaccepttheinevitabilityofacontinuedlargeUStradedeficitaslongasglobalfinancialmarketscontinuetochannelfundsintotheUS.ProtectionismdesignedtoreducetheUStradedeficitwillbeineffectiveunlessitisaverycostlyfinancial-market-protectionismdesignedtostoptheinflowofforeigninvestment.Suchprotectionismwouldineffecthavetoreversethealmostcompleteintegrationoftheglobalmoneycentersthathasoccurredsincethe1980s—analmostimpossibletask.

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Severalhalf-heartedattemptsweremadeto‘protect’theUSfinancialmarketbeforethesimultaneouscrashinworldstockmarketsinOctober1987showedpolicymakersjusthowirreversiblyintegratedthemoneycentershadbecome.Forexample,in1986andearly1987,RepresentativeCharlesE.Schumer(Democrat-NewYork)wasleadingvariousattemptstolimittheactivitiesofJapanesefinancialfirmsonWallStreet,includingtheirabilitytobuyUSgovernmentbondsdirectlyfromtheNewYorkFederalReserveBank.Schumer‘freelyadmitsthatheknowsmoreaboutshakinghandsinfrontoftheSheepsheadBaysubwaystationinBrooklynthanaboutinternationalfinance’.13Afterthecrashinworldstockmarkets,Schumer'sbillsforfinancialmarket‘reciprocity’lostsupport.

Also,inearly1987theNewYorkStockExchangethreatenedtobanitsmembersfromtradingontheLondonStockExchangeinshareslistedonbothmarketsduringthetwoandone-halfhoursthatbothmarketswereopen.DenouncedbymanyanalystsandWallStreetfirmsas‘acrudelyprotectionist

effortbytheNYSEtohandicapLondonasacompetitorexchange’,14whichadditionallywouldhandicapWallStreetfirmswhohadbeencompletingmanyblocktradesthroughLondon,thebanlostsupport.AsTheEconomiststatedabouttheproposedbanevenbeforethecrashinworldstockmarkets,‘nationalpettinessill-fitsglobalfinancialmarkets’.15

TheauthorwouldthusagreewithJohnWilliamson(inMilnerandSnowden,1992)thatinter-countrydifferencesineconomicstructurescouldquiteappropriatelyrequireunbalancedtradeandinvestmentflowsfordecades.WilliamsoncalculatesthatappropriatecapitalinflowsandcurrentaccountdeficitsfortheUSandCanadawouldbe1percentand1.5percentofGDP,respectively,whileJapanandGermanywouldhavesurplusesof1.5percent,andItaly,FranceandtheUKwouldhavebalancedtrade.Overtimethesepercentageswouldchangeastheglobaleconomicstructureschange,andWilliamsonprovidesvariousforecasts.

V.CONCLUSIONS

Manylessonsshouldhavebeenlearnedbyeconomistsfromtheirexperiencessincethe1980s.First,therehasclearlybeenafailuretounderstandhowpervasivelyintegratedthenewglobaleconomyhasbecome.Thisfailurehasresultedfromthewidespreadbeliefthatthenationaleconomyshouldbethebasicframeofreference,andinternationalinfluencesshouldbeviewedasexternal‘shocks’tothesystem.Historically,macroeconomicforecastingmodelshavebeenbaseduponthisassumption,especiallythemorepopularcomputermodelssuchastheoneownedbyDataResourcesInc.whichaddontheinternationaleffectsalmostasanafterthought.Instead,economistsshouldhavelearnedfromtheirexperiencesinthe1980stoviewinternationaleffectsasextremelyimportant,internalpartsofnationalsystems.For

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example,inmanycountriesthereisnownoidentifiablenationalmarketformosttypesoffinancialassets—themarketisglobalaspertheinterestrateandfinancialstrategyparitiesofChapter1.

Secondly,economistsshouldhavelearnedfromthemonetaryvelocitydebaclesandothercasestudiesofthe1980sthattheyhavedifficultymodelingeconomies

andothercasestudiesofthe1980sthattheyhavedifficultymodelingeconomieswhenirreversible,structuralchangesaretakingplace.Changeistypicallythoughtofasanout-of-equilibriumsituationwhichwilleventuallyadjustbacktoequilibriumbasedupontraditionalmodels.Instead,inthenewglobaleconomy,economistsshouldthinkofchangeassomethingmoreevolutionary,andevenrevolutionary.Forexample,thedeclineintheincomevelocityofmoney,whenitwasfinallynoticed,wasfelttobeatemporarydisequilibrium,ratherthanamorepermanentconsequenceofthederegulation,expansion,andglobalizationoffinancialmarkets(Chapter3).Inaddition,asdiscussedinChapter4,thefailuretorecognize,explain,andreacttothedeclineinincomevelocitycouldverywellbethesinglemostimportantcauseoftheglobalrecessionoftheearly1980s,theworldstockmarketcrashof1987,the1980sandcontinuingworlddebtcrisis,andtoalesserdegreetheslumpsofthe1990s.

Otherrecognitionandpolicyresponsefailuresrelatetotheincreasedtransfersofinternationalinvestmentandnewtradepatterns.Forexample,newprofit-seekingflowsofforeigninvestmentintotheUSinthe1980swerenotpredicted,andthereforethelargeUStradedeficitwasnotpredicted.Tradeprotectionismhasprovenineffectiveinreducingthisdeficitbecauseofworldwideincreasesintradesharesofdomesticeconomies,increasedoverseasproductionandinternationaljointventures,andincreasedinternationalownershipofoncenationalcorporations(Chapter2).

Evenbeforethestructuralchangesexaminedinthisbookbegantomaketheirimpacts,economicforecastswerefrequentlyunreliableduetothecomplexityofeconomicsystems.In1985TVhostLouisRukeyserstated:

ThelateOttoEckstein,whobuiltDataResourcesintothemodelforalleconometricmodels,onceconfessedtomethathefiguredhisorganization'sresultswereonlyabout5percentbetterthanthescribblesonthebackofanenvelope.

Sincetheearly1980s,becauseofthestructuralchangesdiscussedinthisbook,thepopulareconometricmodelscannotbereliedontoforecasteven5percentbetterthanthescribblesonthebackofanenvelope.Therefore,itistimetoadmitthatasignificantchangeintheoryisneeded.Thischangeshouldformallyrecognizetheglobalizationprocessesaspertheauthor'smonetaryvelocityequationsandtheinterestrateandfinancialstrategyparityequilibria.Rethinkingof‘internationalinvestment’definitionsisnecessarytounderstandbetter‘debt’versus‘equity’nowthat,increasingly,‘everythingisforsale’asasecurity.Also,

versus‘equity’nowthat,increasingly,‘everythingisforsale’asasecurity.Also,rethinkingof‘trade’definitionsisnecessary

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toaccountforintermediatevs.finalproductsandtheincreasedactivitiesofmultinationalcorporations.

Regardingthecomplexityofeconomicsystems,theinterest-rate-parity‘equilibrium’isa‘tendentialequilibrium’orapatternthatemergesoutofadynamicevolvingsystem.Thatis,theabsolutemagnitudesofinterestratesandexchangerateshavenotbeensuccessfullypredicted;onlythepatternwhichrelatesthemhasbeenpredicted.Wherethereseemstobenewhopeforbettermodelingandpredictionofthemagnitudeofvariablessuchasinterestratesandexchangerates,thehopeseemstorestin‘thenewscienceofcomplexity’,whichincreasinglymakesitswayintoeconomicsasanalternativetomainstreamthinking[Waldrop,(1992);Arthuretal.,(1997)].

Slowly,theliteratureisrealizingthatfinancialprocesseshavebecomeamoreautonomousandcomplexdriveroftheglobaleconomy—andasomewhatrecklessandunpredictabledriver.PhilipCernycallsfinancethenew‘infrastructureoftheinfrastructure’andpossibly‘intheascendancyovertherealeconomy’,andsomeofhiscollaborators(includingthisauthor)‘gosofarastosuggestthatthetransnationalizationoffinanceisattheheartofthebooms,slumpsandausteritypoliciesofthe1980sand1990s’(Cerny,1993,p.10).Asdiscussedatthebeginningofthischapter,‘anewpoliticaleconomyofmoney’isthereforenecessary.Inthisregard,definitionsofmoneyandwealthneedtoberethoughtandrelatedtonotionsofsocialconsensusanddifferentialpower,andarevisitingofmercantilisttheoryseemsdesirable,especiallyasrecastbytheauthorintheformof‘money-mercantilism’.

Perhapsduringtheongoingglobalizationperiodmanyofthestructuralchangesaresodifficulttomodelwithformalmethodsthateconomistsshouldyieldtoamoreglobalizedintuition(andscribblingonenvelopes)forforecastingpurposes.Fromthe1993AmericanEconomicAssociationmeetingsisthisassessmentfromJohnHelliwellofHarvard:

Internationallinkagesareincreasinginstrengthandpervasiveness,yetmosttheoriesandappliedmodelsstilltendtorepresentgrowingtradeshares(which

theoriesandappliedmodelsstilltendtorepresentgrowingtradeshares(whichdoubledbetween1960and1985,onaverage,forallindustrialcountries)asbeingtheconsequenceofsomecombinationofhighincomeelasticitiesofdemandforimportedgoodscombinedwithtrendsofuncertainduration.Itwillnotbeeasytoexplaineitherthedeterminantsorthefullconsequencesofincreasingopenness…[Thereare]largeandpersistentdeparturesfrompurchasing-powerparity,and…failureofforward[currencyexchange]ratestobepredictorsoffuturespotrates…Thedeterminantsoflonger-terminternationalcapitalmovementsandthesplitbetweendirectandportfolioinvestmentalsoremainpoorlyunderstood(Helliwell,1993,p.294–99).

WhereHelliwelland,othersfindsomeprospectofsalvagingmacroeconomicmodeling:

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willbeincreasingattentionpaidtothedeterminationofthelonger-termgrowthratesoftechnicalprogress,andanalysisofthelinksbetweentechnology,investmentandtrade…[especiallyastheseaffect]theutilizationratesofbothcapitalandlabor(ibid.).

GeneGrossmanandElhananHelpman(1991)areevengoingsofarastoemphasizethattheinternationaltransferofideasmightexplaininternationalincomeandgrowthlevels.InChapter1newinformationtechnologieswerepresentedasareasonfortherapidexpansionandintegrationofinternationalfinancialmarkets,buttheimpactsoftheglobalinformationrevolutiononnon-financialmarketsarealsoimportant.

Regardingtherecentdifficultiesofhisprofession,theauthorbelievesthatglobalismprovidesaneworientationor‘camp’foreconomistsincontrasttothedominantmonetaristandKeynesianschoolsofthought.

Monetaristsbelievethaterraticnationalgovernmenteconomicpolicyisthemajorcauseofundesirablenationalunemploymentandinflation,andthereforemoderatefixedpolicyrulesarenecessary.Forexample,monetaristshavepresumedafairlyconstantlong-runrelationshipbetweenthemoneysupplyandnominalGDP,i.e.astablevelocityofmoney,andhavethusarguedfora

‘constantgrowthtarget’forthemoneysupplyinordertoachievestable,non-inflationaryeconomicgrowth.Thevelocitydebaclesofthe1980sprovedotherwiseandledtoasignificantdeclineinthepopularityofmonetarism.Theauthor'svelocityequationshelpregainsomeofthecorrelationbetweenmoneysupplyandeconomicgrowth,andtothatdegreetheauthorwouldadvocateactivistmonetarypolicy,especiallytomaintainmoney-liquidityacrosstheglobalsystem.But,thatdoesnotmaketheauthoramonetaristoraKeynesian—hesimplyandpragmaticallyacceptsthequantityequation(mxv=pxq)astruebydefinitionandagoodstartingpointforsolvingproblems.

Incontrasttomonetarists,Keynesiansbelievethatundesirablenationalunemploymentandinflationarecausedbyinstabilityofhouseholdandbusinessprivatesectorspending,andthereforeactivistnationalgovernmentmonetaryandfiscalpoliciesshouldbeusedtoregulatetheeconomy.Keynesiansaremoreoptimisticabouttheusefulnessofeconomicforecastsforpolicymakers,andtheyaregenerallymorepro-government.Afterreadinginthisbookthatactivist,Keynesian,nationally-orientedmonetaryandfiscalpolicieswereaprimarycauseoftheeconomiccrisesdiscussedinthisbook,thereadercanunderstandwhytheauthorisskepticalofKeynesianschoolsofthought.Inaddition,theauthorarguedearlierinthischapterthatfiscalpolicyshouldbemoreofamicroeconomiccost-benefitaffairratherthanaKeynesianattempttoregulatemacroeconomicaggregates.TheincreasedlikelihoodthattheUSandothersare‘small’countrieswithrespecttointernationalfinancialflowstrivializesmuchofthetraditionalKeynesiananalysisandleadstothisrecommendation(Crotty,1993).

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Also,bothKeynesianismandmonetarismtypicallyviewchangeasanout-of-equilibriumsituationwhichwilleventuallyadjustbacktoequilibriumbaseduponstaticmathematicalmodels.Inaddition,bothschoolsofthoughtdevoteconsiderableattentiontonationalbusinesscycles.Incontrast,theauthorviewsrecentchangeintheglobaleconomyassomethingmoreevolutionaryandevenrevolutionary.Awholeseriesofstructuralchangespresentedinthisbookhavenohistoricalprecedent,andtheycontinuetoprovokeotherstructuralchanges.Itiswithinthiscontextofanevolvingglobaleconomythatoneshouldattempttounderstandrecenteconomiccrisesandothereconomicphenomenon.Comparedtorecentstructuralchangesintheevolvingglobaleconomy,nationalbusiness

torecentstructuralchangesintheevolvingglobaleconomy,nationalbusinesscyclesarelikelytobetrivialaffairs.Asdiscussedearlierin‘ANewPoliticalEconomyofMoney’,theauthordoesnottakethecommonpositionthateconomiccrisesaregeneratedby‘outsideshocks’totheotherwisestablemarketcapitalistsystem,butratherhefindsthesecrisestobeendemicwithinthesystem,especiallynowthatfinancialmarketshavebecomemoreimportant‘drivers’.

Incontrasttoexistingorientationswhichprescribenationaleconomicpoliciestopreventundesirablenationalinflation,unemployment,financialcrisesandrecession,globalismprescribesinternationaleconomicpoliciesasthebestprevention.Globalismrecognizesthatinternationalfactorsaretheprimarysourcesofinstabilityinnationaleconomies,whetherornottheyaregovernment-related.Themonetarist-Keynesiandebateoverwhetheritisnationalgovernmentsthatcauseundesirableinstabilityinnationaleconomiesmissesthepoint.AreOPECoilpricechangesandtherecyclingofpetro-dollarsthroughtheLDCsgovernmentorprivatesectorsourcesofinstabilityinnationaleconomies?Likewise,aretechnologicalchange,deregulation,andinternationalizationofthetypethatledtothevelocitydebaclesofthe1980sgovernmentorprivate-sectorphenomena?

Shiftingthefocusofeconomicpolicymakerstowardamoreglobalperspectiveisindeedachange.Internationaleconomicpolicymakingisquitedifferentfromnationaleconomicpolicymaking.Managingtheglobalizedeconomywillrequiregreatercooperationbetweennationalgovernmentsthaneverbefore,especiallygiventheincreasinghegemonyofprivatecapital.Yetwithoutsuchcooperation,inflationandunemploymentproblemswillpersist,andnationaleconomieswillbedisruptedbythekindsofinstabilityandmismanagementwhichledtorecentfinancialcrisesandrecession.

Forexample,theUSFederalReserveisresponsiblefor60percentofworldmoneyreserves,andisineffectmoreofacentralbankfornon-UScitizensthanUScitizens.YettheFedactsprimarilyintheinterestofUScitizensandtheperformanceoftheUSeconomy.Therefore,asdiscussedinChapter4's‘Asia'sCrisis,1997-’,thisnationalism(insteadofinternationalpolicycoordination)allowedtheFedunilaterallytostabilizetheUSeconomyin1997–98withrestrictivemonetarypolicies.Unfortunately,theserestrictive

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monetarypolicieswerejusttheoppositeofwhatAsia'sincreasinglydollar-basedeconomiesneededduring1997–98,andthepoliciescontributedtoAsia'scrisis.

Earlierinthischapter,theauthorthuscallsforthedevelopmentofregionalcurrenciesandsupportingregionalcentralbanks(liketheeuroandtheEuropeanCentralBank)whichwouldslowlyreplacetheglobalroleofthedollarandtheFed.Intermsofexplainingwealthcreation,destruction,andtransferacrosstheglobaleconomy,perhapsthemostimportanterrorofmainstreameconomicsisthefailuretorecognizethe‘money-mercantilism’advantagesenjoyedbytheUSandothersinthe‘dollarcore’.

Theauthor'spolicyproposalsregarding‘TheRoleoftheG7’,‘TheRoleoftheWorldBankandtheIMF’,and‘NationalStrategiesintheGlobalEconomy’areneithermonetaristnorKeynesiannorMarxistnorpredominantlyfromanyotherestablished‘camps’,butrathertheyuseelementsofthesecampsincludinginstitutionalandevolutionaryeconomicsandpoliticaltheoriesofvalue,wealth,andpower.

Recentfinancialcrisesandrecessionshouldhavetaughteconomiststhatthepoliticalrealitiesofinternationalrelationsmustbedirectlyincludedincurrenttheoryifcurrenttheoryistobeusefultopolicymakers.Economicsshouldbecomemoreinterdisciplinaryinthissense.Whenmodelsoftheoveralleconomyaretoorigidtobe‘softened’and‘enriched’withaninterdisciplinaryapproach,thentheyshouldbeusedwithcaution.Wherepossible,themodelsshouldallowforwith-international-cooperationandwithout-international-cooperationscenarios,andtheyshouldallowfortheimportanceofinstitutionalregimesandcurrencyblocs.

Inthe1980s,themajorindustrialcountriesincreasinglydiscoveredthatcooperationwasintheirmutualinterest.ThePlazaaccordagreementon22September1985isonenotableexample.AnotherexampleistheVenicePresidentialsummitinJune1986whenstatementsweremadeaboutachievingcommoneconomicgrowthandinflationlevels.Yet,thedestructivelackofinternationalmonetarycooperationin1987,whichprecipitatedthecrashinworldstockmarkets,indicatedthattheglobalperspectivewasnotyetthedominantone.

Thesimultaneouscrashofworldstockmarketsmadeitalmostimpossibletoignorethegrowingeconomicinterdependenceofnationsandtheneedfor

ignorethegrowingeconomicinterdependenceofnationsandtheneedforgreaterinternationalpolicycoordination.Anothersignificanteventwastheperceivedfailureoftheall-mightyUSFederalReserveBankinlate1989todetermineindependentlythedirectionofUSinterestrates.

By1990manyprominenteconomists,especiallythosewhowerewell-connectedtothefinancialmarkets,hadadoptedamoreglobalperspective.Asstatedin1990byLyleGramley,chiefeconomicforecasterfortheUSFederalReserveBankinthe1970s:

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[Inthe1970s]Iconsideredtheinternationaldivisionmoreofanuisance.ThedirectlinkfrominterestratesabroadtointerestratesintheUStotheoutlookfromtheUSeconomy—Ineverhadtodealwiththatintellectuallybefore.WhoeverthoughtthatdevelopmentsinWestGermanyweregoingtobeaveryimportantinfluenceoninterestratesintheUS?Maybesomebodydid.Itwasn'tme.16

Andasechoedin1990byDavidJones,thewidelyquotedchiefeconomistatAubreyG.LanstonCo.:

WhenIstarted17yearsago,I'dspend80percentofmytimeworryingabouttheFederalReserveBank,worryingaboutdomesticinflation,domesticcapacity;nowIspend80percentofmytimeworryingabouttheforeignside—oratleasthowtheforeignsideaffectsthedomesticside.17

Theglobalperspectivethatisincreasinglyadoptedoutofnecessitybyeconomistssuchastheseemphasizesrecentstructuralchangesmorethantraditionalequilibriumprocesses.Itmustbesomewhat‘reactive’ratherthantheoretically‘active’inthesensethatcurrenteventsmustbefollowedcarefullyinordertounderstandthenewlyevolvingeconomicstructures.Forexample,thecasestudiesofthisbookemphasizedthenew,unexpectedeffectsthathighUSinterestratesintheearlyandmid-1980shaduponglobaleconomicwelfare.ThepowerofUSpolicymakerstoaffectworldeconomicwelfareviaUSinterestrateswasunprecedentedduringtheseearlyboomyearsforglobalizingfinancialmarkets.

However,asthe1990swerereached,themorefullyglobalizedfinancialmarketswereinsteadoccasionallytreatingtheUSasa‘smallcountry’withrespecttofinance.TheincreasedroleofprivateunregulatedmarketsnowmakesitmoredifficultattimesforUSeconomicpolicymakerssignificantlytoaffectinterestratesanywhere,evenintheUS.Also,howcanoneevaluatethedegreetowhichtheUSislosingcontroloveritsowninterestrates,andthereforeitsownfinancialsystem—iftrue,certainlyaprofoundnewdevelopment?Notfromeconomictheory,onlyfromacarefulanalysisofcurrentevents.

Muchempiricalresearchneedstobedonebyeconomistsbeforethemostusefulmodelsoftheevolvingglobaleconomycanbederived.Duringthistransitionaryperiodfornationaleconomies,itislikelythatmanyeconomistswillbetooconditionedbyout-of-dateandoverlytheoreticalnation-basedmonetaristandKeynesiantheories.Theauthor'ssuggestionisthatamoreglobalperspectiveisneeded.Globaleconomictrendsmustbeunderstoodbeforenationaleconomictrendscanbeidentified.

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1.Choice,January1995,Vol.32,No.5.

3.‘TheInternationalEuro,’TheEconomist,14November1998,p.89.

4.‘MakingtheTokyoSummitServeUpMoreThanRhetoric’,BusinessWeek,7April1986.

5.ObstfeldandRogoff(1995),p.73,77and80.SeealsotheBankforInternationalSettlements,SettlementRiskinForeignExchangeTransactions,‘ReportpreparedbytheCommitteeonPaymentandSettlementSystemsoftheGroupofTen’,Basle,March1996.

6.‘BusinessBulletin’,TheWallStreetJournal,14January1988,p.1.

7.‘BoliviaBuysBackNearlyHalfofItsDebtToBanksataFractionoftheFaceValue’,TheWallStreetJournal,18March1988,p.15.

8.‘ADebt-for-NatureSwapInCostaRicaBiggestYet’,TheWallStreetJournal,13January1989,p.As.

9.Theprocesseswherebypaddyriceculturesaredeveloped,andtheecologicalandeconomicbenefitsarediscussedin:E.Boserup(1965),TheConditionsofAgriculturalGrowth:TheEconomicsofAgrarianChangeUnderPopulationPressure,Aldine,Chicago;and,C.Geertz(1963),AgriculturalInvolution:TheProcessesofEcologicalChangeinIndonesia,UniversityofCaliforniaPress,Berkeley.

10.‘France,WestGermanyPlantoForgiveSomeLoanstoWorld'sPoorestNations’,TheWallStreetJournal,9June1988,p.25.

11.Ibid.

12.‘JapanAutoMakersBuyMoreUSParts’,TheWallStreetJournal,24August1993,p.A2.

13.‘WilltheTradeWarsSpreadtoWallStreet?’,BusinessWeek,22December1986,p.58.

14.‘StonewallStreet’,TheEconomist,14March1987,p.14.

15.Ibid.

16.‘Fed.HasLostMuchOfItsPowertoSwayUSInterestRates’,TheWallStreetJournal,12March1990,p.1.

17.Ibid.

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Mundell,R.(1987),‘ANewDealonExchangeRates’,presentedattheMITIsymposium‘TheSearchforaNewCooperation’,Tokyo,January.

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O'Brien,Richard,(1992)GlobalFinancialIntegration:TheEndofGeography,London:RoyalInstituteofInternationalAffairs.

Obstfeld,M.,andK.Rogoff,‘TheMirageofFixedExchangeRates,’TheJournalofEconomicPerspectives9,Fall1995.

Oye,KennethA.,(ed.)(1986),CooperationUnderAnarchy,Princeton:PrincetonUniversityPress

Palan,Ronen(1994),‘TaxHavensandtheMarketforSovereignty’,paperpresentedattheInternationalStudiesAssociationConvention,WashingtonD.C.

Porter,RichardD.,ThomasD.Simpson,andEileenMauskopf,(1979),‘FinancialInnovationandtheMonetaryAggregates’,BrookingsPapersonEconomicActivity,vol.10,no.1,p.213.

Quijano,AliciaM.(1989),‘CapitalExpendituresByMajority-OwnedForeignAffiliatesOfUSCompanies,1989’,SurveyofCurrentBusiness,March.

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Schumpeter,Joseph(1934),TheoryofEconomicDevelopment,Cambridge,MA:HarvardUniversityPress.

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WorldBank(annual),WorldDevelopmentReport,Oxford:OxfordUniversityPress.

page_204

Africa,debtproblems174

Allen,R.E.63,73,145,152,178

Artis,M.14

financialmarkets,deregulationin137–8,156

foreigninvestmentin136–7

monetarypolicies138–9

recession135,136–43,164,172,174–5

seealsoJapan;Thailand

Axelrod,R.147

Babcock,B.46,189,190

Baker,G.P.54

BakerPlan,fortheworlddebtcrisis119–20,156

balanceoftradeseetradebalances

andtheGreatDepression81

internationallending33,121

reserves78

andtheworlddebtcrisis119–20

seealsocentralbanks

barrierstotradeseeprotectionism

Batten,D.S.63

beliefsystems

effects150–51,152–3

andstockmarketvaluations82–3

andwealth-creation88,149,151,153

Bergsten,C.F.25,163

Bhagwati154

‘BigBang’deregulationseederegulation,intheUK

Bindert,C.Bogdanowicz-seeBogdanowicz-Bindert,C.

Black,F.82

Blanchard,O.126

Blumenthal,W.M.4

Bogdanowicz-Bindert,C.117,169

BradyPlan120,170,171,172

Brazil118,121,122,162

BrettonWoodsmonetarysystem167

seealsoInternationalMonetaryFund;WorldBank

BritainseeUnitedKingdom

broadmoneysupply,andabsorptionbyfinancialmarkets95,134–5

Brooks,W.T.92

Brown,B.85,134,155

capital

costs18

aspower152–3

retumson,UnitedStates18–19,31,32

seealsodebtcapital;equitycapital;monetary-wealth

capitalflight79,80,84,85,168

fromMexico119,131–3

intheworlddebtcrisis119,122,169–70

capitalinflowsseeforeigninvestment

capitalism,andfinancialcrises146,149–50

cartrade,protectionismin45–7

Carchedi,G.152

centralbanks160–61,163,195–6

Cerny,P.G.193

change,theoriesof192,195

China,financialmarketsin11–12

Chote,R.137

Clark,G.158

Clarke,S.100,146–7,149,151

Cline,W.R.187

communicationsseetelecommunications

computersseeinformationtechnology

conservation,anddebtreduction172–4

corporatedebt,UnitedStates17–20

corporatestockseestock

coveredinterest-rateparity15,164,172

Crotty,J.194

currencies

page_205

devaluation79–80,157

forward-lookingmarketsfor15–16,164–6,171–2

regional161–3

reserve79–80,84,101,102,153–4,161–2,168–9

tradingin1–2,6,34,35

seealsoeuro;exchangerates;headingsbeginningwithmoney;USdollar

currencyboards162

Daudin,G.158

Davis,P.10

debtcapital,returnson18

debt-equityswaps171

debt-for-natureswaps172

debttoequityratios17–20

oflessdevelopedcountriesseeworlddebt

management,incapitalism149–50

andmoneysupply81

seealsocorporatedebt;worlddebt

deficiencypayments188,190

depreciation,oftheUSdollar25–6

DepressionseeGreatDepression

deregulation7–12,38–9,63–4,156

inAsia137–8,156

inFrance11,14

inGermany11,14,76

andtheIMF156

inJapan10–11,14

andmonetaryvelocity73,74

andmoneysupply86–7

intheUK9–10,14,74,75

intheUS8–9,70,147–8

seealsooffshorefinancialmarkets

derivatives,tradingin3,165–6

devaluation79–80,157

developingcountriesseelessdevelopedcountries;worlddebt

dissavingsseeforeigninvestment;savings

dollarsseeEurodollars;USdollar

domesticpaymentschemes188,190

Dotsey,M.62

Drucker,P.F.53,57

EastGermanyseeGermany

ecologyseeconservation

economicforecasting

models191,192,193–4,196

problems106–8,193

economy,globalizationof195–6

effectivemoney

definition80–81

andtheGreatDepression81,82

andrecession100,101

electronicfundstransfers,growthof6–7,57,78

emissionpermits,trading,anddebtreduction172–3

EMSseeEuropeanMonetarySystem

environmentseeconservation

equitycapital

returnson17–18

seealsodebt-equity;stock

ERMseeEuropeanExchangeRateMechanism

euro162,163

Eurocurrency,andfinancialglobalization57

Eurodollars1,2,57,141

Europe

economicgrowth124

foreigninvestmentin52,123–4

recession(1990–91)123–5

EuropeanExchangeRateMechanism,andinterestrates77

EuropeanMonetarySystem111,125,160–61

exchangerates

andcurrencyboards162

andtheERM77

andinterestrateparity15–16

andprofitability35

andpurchasingpowerparity16

settingof107

stabilization164–5

andtradebalances16,25–6,183–4,185–6

USdollarseeUSdollar,exchangevalue

volatility,andoverseasproduction50–51

exports

UnitedStates105–6,107,127–8

seealsovoluntaryexportrestraints

page_206

Fehrenbach,R.R.155

Feldstein,M.100,119,162,178

financialcrises

Brazil162

andcapitalism146,149–50

definition100

Japan93–6,123,127,133–6

modelsfor147–8

Russia79–80

Thailand79,80,139

seealsorecession

financialmarkets

inChina11–12

deregulationseederegulationeffectsofcommunicationsdevelopment5–6,63

forward-looking15–16,164–6,171–2

inGermany11,14,76–7

globalization12–13,39,64,191–2

anddebttoequityratios19–20

effects193,196–7

andEurocurrency57

andinterestrates13–16,89–90

andmonetaryvelocity61–3,73,74

andsavings28

growth1–3,64

andmoney-liquidity111–12

UnitedStates69–70

andinterestrates71

inJapan10–11,14

andmonetaryvelocity66–73,76

moneyabsorptionby61–2,65–6,68,70,72–3,74–5,95

andbroadmoneysupply95,134–5

effects91,151

andforecastingofnominalGDP113

andinterestrates61–2

andinternationaltransfers67–8,71

measurementof112–13

andrecession108

andmoneysupply(m1)64–5,66

protectionismin191

turnover112

intheUK9–10,14,74,75

UnitedStates8–9,69–70,70,147–8

wealth-creationin148–9

seealsogovernmentsecuritiesmarkets;money-mercantilism;offshorefinancialmarkets

financialstrategyparities17–22,43–4

seealsointerestrateparity

fiscalpolicies

recommendations179–81

UnitedStates180–81

seealsointerestrates;monetarypolicies;taxation

Fisher,I.151

foreignexchangeseecurrencies;exchangerates

foreigninvestment

inAsia136–7

byJapan22,51,52–3,94,123–4,134,136

bytheUnitedStates51,52–3,140–41

inEurope52,123–4

inlessdevelopedcountries123

inMexico130–31

andtaxation29

inThailand137

intheUSseeUnitedStates,foreigninvestmentin

foreignlendingseeinternationallending

foreigntrade,UnitedStatesseeUnitedStates,trade

forward-lookingmarkets15–16,164–6,171–2

France

financialmarkets,deregulationin11,14

recession(1982)109–11

Frankel,J.14,16

Friedman,B.M.19,61,177

Friedman,M.62,65–6,70,71,72,92,156,177

Froot,K.A.16

G7,andmonetarypolicies159–61

forecasting113

inflation178

productivity,andwealth-creation88–9

UnitedStates70,103–8

Germany

capitalcosts18

currentaccount39

economicgrowth124

financialmarkets11,14,76–7

monetarypolicy93,115–16,125

monetaryvelocity59,76–7

page_207

reunification,effects76,124–5,127,

globalization

oftheeconomy195–6

effectsoninternationallending13,89–90

offinancialmarketsseefinancialmarkets,globalization

ofproductionseeinternationaljointventures;overseasproduction

Goldfeld,S.M.61–2

Gordon,R.J.107,108,176

governmentsecuritiesmarkets2,9,10,11–12

Gramley,L.196–7

GreatBritainseeUnitedKingdom

GreatDepression80–83

Greenspan,A.86–7,142,177

GrossDomesticProductseeGDP

Grossman,G.194

Grundfest,J.A.75,76

Gyohten,T.145–6,159,164

Haberler,G.80

Haggard,S.136

Hall,R.E.126,127–8,129

Hawkes,D.131

Heller,W.92

Helliwell,J.F.193–4

Helpman,E.194

Hennessy,J.M.74

Hopkins,T.155

IMFseeInternalionalMonetaryFund

imports

growth,andprotectionism45–9,50,52,187

UnitedStates105–6

incomevelocity,ofmoneyseemonetaryvelocity

inflation72,92–3,178

informationtechnology

developmentof3–4,5,6–7,63

andmonetaryvelocity73

andwealth-creation88–9

innovation

andtransitioncrises87–8

andwealth-creation88–90

Inoue,K.94

interestrateparity13–16,17,35,43–4,106,164,172

interestrates

effectsofG7160

andtheERM77

andfinancialmarkets13–16,61–2,71,89–90

andgovernmentborrowing180,181

andmonetaryvelocity61–2,72

stabilization164–5

UnitedKingdom76

UnitedStatesseeUnitedStates,interestrates

andtheworlddebtcrisis117

InternationalBankingFacilitiesseeoffshorefinancialmarkets

internationalfinanceseefinancialmarkets

internationaljointventures,andprotectionism49–53,187

internationallending

bybanks33,121

effectsofglobalization13,89–90

taxationof8–9

InternationalMonetaryFund170–71,175,176

andderegulation156

internationalownership,andprotectionism54–5,187–8

internationaltradeseetrade

IRPseeinterestrateparity

capitalcosts18

currentaccount39

financialcrisis93–6,123,127,133–6

financialmarkets,deregulationin10–11,14

foreigninvestmentby22,51,52–3,94,123–4,134,136

monetarypolicy93–6,115,123,134,135

monetaryvelocity59,135

moneysupply93–4,134–6

savings26–7,28

securitiestrade2,9,10

stock,price-earningsratio20–22

tradewithUnitedStates45,46–7,48–9,184–5

jointventuresseeinternationaljointventures

Jones,D.197

page_208

Judd,J.P.62

Keohane,R.147

Keynesianism194–5

Kindleberger,C.P.100,149–50

Kochen,A.83

Krugman,P.R.25,183,186

Kuttner,K.N.61,177

Laidler,D.62,177

LatinAmerica

recession101

taxhavens154–5

andtheworlddebtcrisis118,119–20,121,122

seealsoBrazil;Mexico

Laurent,R.D.94–5,177

lendingseeinternationallending

lessdevelopedcountries

andcapitalflight119,122,131–3,169–70

debtsseeworlddebt

effectsofUSpolicies118–22,153–4,156,169

foreigndirectinvestmentin123

andthestockmarketcrash120,121

seealsoAsia;LatinAmerica

Leu,G.-J.189

literalizationseederegulation

Lindgren,C.-J.100

Maxfield,S.136

Meltzer,A.92

mercantilismseemoney-mercantilism

Mexico

debtcrisis117,118,119,146,170–71

foreigninvestmentin130–31

recession(1994–95)79,80,130–33,139,161–2

Milner,C.25

Mishkin,F.S.102

Modelski,G.87–8

Mogg,W.Rees-seeRees-Mogg,W.

monetarism146,194,195

monetarypolicies146

andthe1982recession114–16

Asia138–9

effectsofG7159–61

effectsonMexico131

Germany93,115–16,125

andinterestrates,US35–6,103

Japan93–6,115,123,134,135

andmonetaryvelocity176–8

recommendations176–9

Thailand137,138

UnitedKingdom108–9,115

UnitedStatesseeUnitedStates,monetarypolicy

andtheworlddebtcrisis117–18

seealsofiscalpolicies

monetaryunionsseeEuropeanMonetarySystem;regionalcurrencies

monetaryvelocity60–63,80–81,192

andderegulation73,74

determining78

andfinancialmarkets66–73,76

globalization61–3,73,74

Germany59,76–7

andinformationtechnology73

andinterestrates61–2,72

Japan59,135

andmonetarypolicies176–8

predictionof64–5

andrecession99–100

UnitedKingdom59,73–6

seealsoeffectivemoney;UnitedStates,monetaryvelocity

monetary-wealth

creation86–90,148–9,184

aspower151,152,153,154

transfers,anddollarization153–4

moneyseecurrencies;effectivemoney;virtualmoneysystems

moneyabsorptionseefinancialmarkets,moneyabsorption

moneydemand,predictionof64–5

money-liquidity

andfinancialmarketgrowth111–12

maintenanceof166–9,176

seealsomonetaryvelocity

money-mercantilism153–9,181

seealsooffshorefinancialmarkets

moneysupply

andbaddebts81

deregulation,effects86–7

expansion,effects96

andforeigninvestmentintheUS142–3

andtheGreatDepression81,82

history77–8

page_209

Japan93–4,134–6

policyimplications90–96,177–8

andrecession99–100,101,102

UnitedStates91–2,103,104,114–15,142–3

seealsobroadmoneysupply;effectivemoney

moneysupply(m1)

definition73–4

andeconomicgrowth59–60

andfinancialmarkets64–5,66

Mundell,R.25–6,183,186

narrowmoneysupplyseemoneysupply(m1)

nation-statemodels,offinancialcrises148

Nitzan,J.152

Norton,R.84

O'Brien,R.12

offshorefinancialmarkets83–6

dollarflowsto84–5,132–3

effects150,154–5

reserverequirements83,86

overseaslendingseeinternationallending

overseasproduction49–53,50–51,184–7

Oye,K.A.147

Palan,R.154–5

personalsavingsseesavings

Porter,R.D.62

Portes,R.157

poverty,alleviationof174–5

price-earningsratios,ofstock20–22,31,32,134

protectionism42–3,187–91

costs188,189–90

infinancialmarkets191

andimportgrowth45–9,50,52,187

andinternationaljointventures49–53,187

andinternationalownership54–5,187–8

andoverseasproduction49–53

andtradedeficits43–4,187,190

UnitedStates8–9,25–6,30–31,45–7

purchasingpowerparity16,182

quasi-money77–8,79,80,81,101

Quijano,A.M.52

Radecki,L.J.64–5,66

recession

Asia35,136–43,164,172,174–5

definition100

andeffectivemoney100,101

LatinAmerica101

Mexico(1994–5)79,80,130–33,139,161–2

modelsfor147–8

andmonetaryvelocity99–100

andmoneysupply99–100,101,102

patterns99–102

seealsofinancialcrises;GreatDepression

recession(1982)102–3,117

effectonlessdevelopedcountries117–18

France109–11

andmonetarypolicies114–16

UnitedKingdom108–9

UnitedStates62–3,103–8

recession(1990–91)123

Europe123–5

UnitedStates125–30,160

Rees-Mogg,W.84

regionalcurrencies161–3

reservecurrenciesseecurrencies,reserve;USdollar,asreservecurrency

reunification,Germany,effects76,124–5,127

Rey,H.157

Russia,financialcrisis79–80

Sachs,J.163

savings

Japan26–7,28

UnitedStates27–8,29,32,69

savings-investmentimbalances,andtradebalances183–4

Scadding,J.L.62

Schumpeter,J.57,87

securitiesseegovernmentsecurities

Smith,G.D.54

Snowden,N.25

socialconsensusbeliefsystems

Soddy,F.149

page_210

Soesastro,M.H.164

Solomon,E.H.78

SouthAmericaseeLatinAmerica

Spindt,P.A.63,65,66,67,68,70,94,113

ownership54–5

price-earningsratios20–22,31,32,134

prices65–6,82–3

stockmarket

causes75,92–3,111–16,120

andlessdevelopedcountries120,121

andtheGreatDepression81–3

growth2,5–6,68–9

UnitedStates68–9,90

Stone,C.C.62,66,68

subsidies188,190

taxhavensseeoffshorefinancialmarkets

taxation

andforeigninvestment29

ofinternationallending8–9

UnitedStates103,104,105

Toylor,M.9,14,15,74

telecommunications,developmentof4–5,63

Thailand

financialcrisis79,80,139

foreigninvestmentin137

monetarypolicy137,138

thirdworldseelessdevelopedcountries;worlddebt

Thompson,W.R.87–8

Thornton,D.L.62,63,66,68

Tonks,I.9,74

policies,recommendations181–91

UnitedStatesseeUnitedStates,trade

tradebalances191

andexchangerates16,25–6,183–4,185–6

andoverseasproduction184–7

andprotectionism43–4,187,190

UnitedStates25–6,38,39–41,52–3,184–7

tradebarriersseeprotectionism

tradequotas47,188–9

transitioncrises,andinnovation87–8

Triffin,R.167

underdevelopedcountriesseelessdevelopedcountries;worlddebt

UnitedKingdom

financialmarkets,deregulationin9–10,14,74,75

interestrates76

monetarypolicy108–9,115

monetaryvelocity59,73–6

recession(1982)108–9

UnitedStates

banks,foreignlending33

capitalcosts18

capitalreturns18–19,31,32

corporatedebt,increase17–20

currentaccount38,39,40,157–8,182–3,186

economicpolicy,andtheworlddebtcrisis118–20

exports105–6,107,127–8

financialmarkets8–9,69–70,70,147–8

fiscalpolicy180–81

foreigninvestmentby51,52–3,140–41

foreigninvestmentin22,29–34,36–7,182

andthe1990srecession127–9,130

andtheAsianrecession140–41

effects27,37–42,120,121,153–4

andmoneysupply142–3

andtradebalances184–7

GDP70,103–8

governmentsecuritiesmarket2,9

governmentspending103,104

GreatDepression80–83

imports105–6

interestrates69,70,93,104,107,143

andthe1990–91recession129–30,160

andtheAsianrecession139,140

andcapitalinflows28,33

andmonetarypolicy35–6,103

andworlddebt29,117,146

monetarypolicy59,91–3,103,104,114–15,157

andthe1990–91recession129

effectsonAsia138–9,141–2

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