Bill ------- start of forwarded message -------
With the Brazilian real reeling, the following short note written in December may be of interest.
THE CASE FOR CAPITAL CONTROLS
by Paul Davidson
In this decade there has been an international currency crisis every two to three years: the European Monetary System crisis in 1992, the Mexican peso crisis of 1994-5 and the 1997-98 Asian and Russian debacles. Does this periodic breakdown of international capital markets mean that the movement towards liberalizing capital markets started in the 1970s gone too far? Have international financial markets become so fragile as to threaten the economic health of the global economy?
Understanding the role of financial markets and the policy stance that should be applied depends on the underlying economic theory that one explicitly, or implicitly, relies on. There are two major theories of financial markets: (1) the efficient market theory and (2) Keynes's liquidity theory. The logic of the former inevitably leads to a laissez-faire policy, while the latter recommends some form of capital regulation.
The efficient market theory is the backbone of today's conventional economic wisdom. Its mantra is "the market knows best; markets are efficient and governments are inefficient". This view is epitomized in US Deputy Treasury Summers's statement: "the ultimate social functions [of financial markets are] spreading risks, guiding the investment of scarce capital, and processing and disseminating the information possessed by diverse traders...prices will always reflect fundamental values .... The logic of efficient markets is compelling".
Since the 1970s, Summers's "compelling" efficient market logic has provided the justification for nations to dismantle most of the immediate post-war ubiquitous capital market regulations. Deregulated financial markets, it is claimed, will produce lower real costs of capital and higher output and productivity growth rates compared to those experienced between the war and 1973 when international capital controls were practiced by most countries of the world, including the United States.
The facts, unfortunately, do not support this liberalization argument. The years between the war and 1973 were an era of unprecedented sustained economic growth in both developed and developing countries. The average per capita annual real growth rate of OECD nations from 1950 till 1973 was almost precisely double the previous peak growth rate of the industrial revolution period. Productivity growth was more than triple that experienced in the industrial revolution. The resulting prosperity of OECD nations was transmitted to the less developed nations through trade, aid, and direct foreign investment. From 1950-73, average per capita growth for all less developed countries was 3.3 per cent, almost triple the average growth rate experienced by the industrializing nations during the industrial revolution.
With liberalization, there has been as significant deterioration in economic performance. The annual growth rate in investment in plant and equipment in OECD nations fell from 6% (before 1973) to less than 3 % (since 1973). Less investment growth means a slower economic growth rate (from 5.9% to 2.8%) while labor productivity growth declined even more dramatically (from 4.6% to 1.6 %). Instead of delivering the utopian promises of greater stability and more rapid economic growth, the period of liberalizing capital markets has been associated with one economic crisis after another, e.g., stagflation and soaring interest rates in the 1970s, the Latin American and African Debt problems of the 1980s, and the recurrent international financial market crises of the 1990s. Since efficient market theory has not delivered on its promises, it is time to explore whether there may be an important role for international capital market regulations.
Keynes's theory is that the primary function of financial markets is to provide liquidity. The ability to readily liquidate one's position requires an orderly financial market. Orderliness means constraining market price movements by controlling the net cash flows into and out of the market, just as a theatre owner sells just as many tickets as seats to control crowd inflow into a West End hit, and laws preventing shouting fire in a crowded theatre encourage an orderly crowd outflow. In the absence of such flow controls, there can be a damaging crush to get in and even a greater disorderly rush to make a fast exit if anyone smells a whiff of smoke.
Keynes argued that orderly deregulated financial markets can provide liquidity as long as market participants accept the convention "that the existing state of affairs will continue indefinitely, except as we have specific reasons to expect a change". In other words, deregulated financial market price stability is based on the flimsy foundation of an expected inertia in future market forces. These expectations, however, can be subject to sudden and violent changes, especially when, as Keynes noted, " the conventional valuation is...the outcome of the mass psychology of a large number of ignorant individuals". Forces of "irrational exuberance" can set off a speculative bubble, while any sudden event that causes disillusion may cause the bubble to burst.
Protecting the market value of one's portfolio of financial assets against unforeseen and unforeseeable declines in financial market prices weighs heavily on every saver's mind. With instant global communications, any event occurring in a far off corner of the globe can set off rapid changes in people's expectation of financial market prices. Every portfolio fund manager must, in an instant, conjecture how other market players will interpret a news event occurring anywhere in the world. Mass speculation about the psychology of other market players interpreting any ephemeral event can result in lemming-like behavior which can become self-reinforcing and self-justifying. If, for example, enough market participants suddenly form the same bear expectations, the resulting bandwagon can create a crisis in financial markets. The first "irrational" lemmings on the bandwagon to hit the ocean of liquidity may not drown. They may survive to make more mistakes and lead more irrational leaps into liquidity in the future.
Financial markets can provide liquidity only if there is an orderly entrance and exit from the market.. Orderliness requires either a private or a public institution, a market-maker, who regulates the net flows into and out of the market -- just as the theatre ticket sales regulates inflows and prohibitions against shouting fire promotes an orderly exit. The presumption of orderliness, however, encourages each individual investor to believe he can make a "fast exit" the moment when he becomes dissatisfied with the way matters are developing.
Peter L. Bernstein is the author of the best-selling book entitled AGAINST THE GODS (1996), an authoritative treatise on risk management, probability theory and financial markets. Bernstein argues that liquid financial markets "can never be efficient", and that an efficient market would be one completely without liquidity. Bernstein argues, that without liquidity there can be no fast exit and therefore the risk of making an investment as a minority owner would be intolerable .The ability to make a fast exit promotes the separation of ownership and management. As long as a liquid capital market exists, therefore owners have no legal or moral commitment to stick around long enough to make sure their capital is used efficiently.
If, on the other hand, capital markets were completely illiquid then there would be no separation of ownership and control. Once some volume of capital was committed, the owners would have an incentive to use the existing facilities in the best possible way no matter what unforeseen circumstances might arise. Perhaps then capital markets might behave more like the efficient markets of economists: Bernstein's homily that "an efficient market is a market without liquidity" is a lesson that policy makers must be taught. Judicious use of capital controls can promote efficiency by constraining any sudden rushes into and fast exits out of a capital market that would adversely affect the real economy.
those of you who read my London paper will recognize the argument. In light of the debate that followed reading of my paper in London, I added the following explanatory paragragh: (BTW the others in the debate were Lord Nigel Lawson, John Flemming of Oxford, Lord Megnad Desai, and Lord Robert Skidelsky.)
Jeffrey Sachs and others have suggested a return to completely flexible exchange rates. Unfortunately whenever there is an persistent international payments imbalance, free market exchange rates flexibility can make the situation worse. For example, if a nation is suffering a tendency towards international current account deficits due to its payments for imports exceeding its receipts from exports, then free market advocates argue that a decline in the exchange rate will end the deficit by stimulating exports and retarding imports. If, however, the Marshall-Lerner condition does not apply, then a declining market exchange rate worsens the situation by increasing the magnitude of the payments deficit.
If, the payments imbalance is due to capital flows, there is a similar perverse effect. If, for example, country A is attracting a rapid net inflow of capital because investors in the rest of the world think the profit rate is higher in A, then the exchange rate will rise. This rising exchange rate creates even higher profits for foreign investors and contrarily will encourage others to rush in with additional capital flows pushing the exchange rate even higher. If then suddenly there is a change in sentiment (often touched off by some ephemeral event), then a fast exit bandwagon will ensue pushing the exchange rate perversely down.
You may remember my argument from the original SMF paper why Dornbusch's perscription for a currency board is due to failure.
In any case, it should becoming clear to all, that the current international financial and payments system does not serve the global economy well and that structural reform and not merely marginal patching of the system is necessary.
Paul
Paul Davidson Holly Chair of Excellence in Political Economy University of Tennessee SMC523 Knoxville, Tennessee 37996-0550 office phone# (423)974-4221 fax# (423)974-1686 home phone # (423)573-9160 email: pdavidson at utk.edu http://econ.bus.utk.edu/Davidson.html ------- end of forwarded message -------