I

Ever since Adam Smith in the 18th century extolled the prospects for mutual gain inherent in free trade between nations, economics textbooks have tended to classify economic policies as either "welfare-enhancing" or "welfare-reducing." One implication of this tradition is that a macroeconomic policy ought to be judged on the basis of whether it provides broad benefits for those who live under the regime that implements the policy. In the last quarter of the 20th century, however, outside the realm of textbooks and inside the realm of practice, the merits of economic policies have come to be determined by the extent to which they adhere to neoliberal orthodoxy–the absence of government restrictions or regulations–regardless of their impact on the generation of wealth through productive activity or the distribution of that wealth. The rise of global finance in this period has all but severed the link between capital and its productive use, has privileged the freedom to engage in short-term speculation over the pursuit of policy goals such as full employment, and in the process has threatened the livelihoods of those who lack the means to exploit financial markets.

In response to the global cataclysms that followed in the wake of the American stock market crash of 1929–the Great Depression and the Second World War–international authorities were compelled to construct a financial architecture that would provide economic stability and pursue full employment as one of its chief objectives. Those efforts resulted in the Bretton Woods regime, a system of fixed exchange rates and relatively strict controls on international capital movements which would last until 1973. James Crotty and Gerald Epstein (1996) refer to this period as the "Golden Age of modern capitalism," the "age of the ’social contract’ or capital-labour ‘accord’ … under which the Keynesian state, with the acquiescence of capital, was to pursue full employment and build a stronger social safety network" (p. 118). During Bretton Woods, the international financial system assumed "its historical role of stimulating real activity, funding real investment" (Eatwell and Taylor 2000, p. 27).

By the late 1960s, however, it became clear that the United States was unwilling to forego policy autonomy indefinitely in order to shore up the international financial system. The United States’ bias toward fiscal expansion in the ’60s (to maintain a full employment situation, fund the war in Vietnam, and establish the "Great Society") forced the other members of the system to "import" inflation, and undermined the sustainability of the regime (Krugman and Obstfeld 1996, ch. 19). The collapse of Bretton Woods in 1973, then, provided the impetus for new theorizing about how liberalization of international capital flows–anathema to Bretton Woods–might more efficiently benefit the global financial system.

According to Robert Blecker (1999), such theorizing bases its conclusions on three central arguments. First, open capital markets increase allocative efficiency. "If the excess savings of some countries can freely flow to borrowers in other nations," he writes, "then total world savings should find their most beneficial uses, and the entire world economy should be more productive as a result" (11). For example, if there are profitable projects in Argentina that can’t be financed by Argentine savings, but there are excess savings in Japan (due to an absence of productive investment opportunities), in the name of productivity and efficiency those savings ought to be allowed to flow to Argentina. Second, financial liberalization enhances financial services, providing investors with new ways to diversify their assets and reduce their exposure to risk. Reducing the overall amount of risk in the financial system is assumed to be globally beneficial. Finally, financial liberalization is seen as imposing discipline on governments, ensuring that they maintain "sound fundamentals" particularly in terms of avoiding profligate fiscal and monetary policies. Investors will withdraw their favor from governments who pursue unsound policies.

Joseph Stiglitz¹ summarizes the arguments in favor of financial liberalization as being "based on standard efficiency arguments"–"capital market liberalization leads to higher output and greater efficiency" (2000, 1077). To Blecker’s summary, we can add Stiglitz’s observation that liberalization advocates believe countries pursuing their economic well-being ought to be concerned with maximizing GNP (income), not GDP (production output). That is, if a country’s citizens see more productive investment opportunities outside their country’s borders, they ought to be free to pursue them–their gains can be expected to redound to the economy at large. International competition for funds also leads firms to greater efficiency among businesses, resulting in widespread benefits, again according to the "standard efficiency" model. Along the lines of the argument from the point of view of financial services indicated by Blecker, Stiglitz writes that investors’ freedom to diversify is seen by the pro-liberalization camp as having stabilizing effects. For example, if an economy experiences a downturn resulting in lower wages, the freedom of funds to flow into that economy to take advantage of the new situation can help to remedy the downturn.

Given the durability of the pro-liberalization arguments–they provided the rationale for the "Washington Consensus" that would form the basis for international economic policy at least until Argentina’s financial collapse in 2001–one might expect that the truth of those arguments has been borne out in practice. Almost from the beginning, however, full financial liberalization has proven destructive to the economies that have implemented it. The Southern Cone of Latin America provided a laboratory for experimentation with liberalization policies during the years of transition out of Bretton Woods. Argentina, Chile, and Uruguay all implemented drastic liberalization reforms in the 1970s, and those experiences were marked by volatility, crisis, and poor economic performance. Some common policy features in these cases included a pegged exchange rate and the absence of government regulation in the real side of the economy, the financial sector, and especially the international capital market. With these features in place, the economies were exposed to pro-cyclical dynamics, in which both capital inflows and outflows tended to be self-reinforcing, resulting in speculative bubbles and inevitable busts. Initial periods of strong growth were followed by stagnation, subsequent financial fragility, and finally crisis (Frenkel 2003, 7-8).

Examining the cases in more detail, with financial liberalization we see an initial period of foreign capital inflows, which spurred the growth of the monetary base, bank deposits and the extension of credit. Next, there was a rapid appreciation of domestic financial and real asset prices, expansion of domestic demand, production and imports. Reserves continued to accumulate, but the increased demand for imports led to a widening trade deficit, which eventually became large enough to cause reserves to contract. Interest rates were increased in order to continue to attract foreign capital, which led to domestic illiquidity and insolvency. Interest rate increases exacerbated expectations of devaluation, which were in turn motivated by the persistent growth of the current account deficit. Eventually there was a run on central bank reserves, the exchange rate regime collapsed, and a devaluation was forced (Frenkel, 10-11).

The destructive consequences of full financial liberalization did lead to the emergence of a revisionist "sequencing literature" within the discipline of development economics, which continued to argue in favor of liberalization, but which suggested that certain real-sector reforms must precede it. Whatever the merits of this literature, it was curiously ignored when Latin America recovered from its "lost decade" of economic stagnation (the 1980s) and interest in free capital flows to the region gained momentum once again. As the case of Argentina’s most recent crisis amply demonstrated, the same mistakes were made with essentially the same (if even more ruinous) consequences (Frenkel 8-9).

Looking at the situation with a broader perspective, we can see that during the last few decades of financial liberalization in developing countries, the promised benefits have not been delivered. The presumption that funds would be channeled from rich countries to poor ones, where unexploited investment opportunities abound, has no counterpart in reality. The cost of capital is systematically higher in those countries than in the industrialized countries (Frenkel 2003, 17). Writing in 2003, Stiglitz noted that "the global financial system has allowed the United States to become the largest borrower in the world, absorbing about US $40 billion per month to finance a consumption binge amidst declining investment and savings." When funds did go toward emerging economies, they did so only in a few outstanding examples, such as China, not to countries most in need such as those in sub-Saharan Africa (Stiglitz 2003). Indeed, in the 1990s, countries that resisted pressure for liberalization (such as Chile and Colombia), employing such strategies as moving bands of exchange (to maintain a competitive real exchange rate) and otherwise regulating capital flows fared far better than liberalizing countries like Argentina, Brazil, and Mexico (Frenkel 2003, 15). Contrary to neoliberal theorizing, Stiglitz has shown how liberalization has promoted short-term capital flows that do not provide a solid basis for investment in productive, sustainable projects. Against neoliberal expectations, restrictions on capital flows have not had negative effects in terms of discouraging FDI or longer-term investment, as the cases of China, Chile and Malaysia show. Indeed, it is the volatility associated with liberalization that has discouraged such investment (p. 1080). Stiglitz has also shown how the neoliberal analogy that equates free capital markets with free markets for goods breaks down when we examine the extent to which the former are "plagued by severe information problems that are not found in ordinary trade in goods and services" (Blecker 1999, p. 17). Problems of incomplete information, incomplete markets, and incomplete contracts in these markets tend to encourage the kind of herd behavior that produces asset bubbles and panics.

II

While developing countries, particularly those in Latin America, provide perhaps the most interesting case studies for the impact of financial liberalization, these countries are not the only ones for which the opening of capital markets is problematic. The ill effects have been far more general. In this respect it’s worth quoting at length from John Eatwell and Lance Taylor’s 2000 study Global Finance At Risk: The Case for International Regulation:

Since the 1970s, the deregulated financial framework encouraged policies that elevate financial stability above growth and employment. This ratcheted up real interest rates which have in turn reduced domestic investment, reduced the growth of world trade, and slowed the rate of growth of effective demand. … High and volatile interest rates together with other uncertainties have reduced the potential return on investment and cut into the cash flow that finances investment. Public sector policymakers, seeking safety in a volatile financial world, set their objectives in terms of financial stability and hope that some stimulus may be forthcoming from the private sector (p. 119-120).

If the United States has been spared many of the worst effects of this downward adjustment, it is due largely to the international role of the dollar: undertaking expansionary fiscal and monetary measures within the U.S. does not pose the same dangers that it does for other countries (p. 121). Nonetheless lack of attention to the excesses of global financial deregulation has resulted in imbalances that are dangerous to all members of the international financial system, including the United States. As noted above, capital now flows primarily from poor countries to rich countries, especially the United States, textbook models to the contrary. Savings in countries with weak or developing economies is up in recent years, reflecting many factors, among them the lack of attractive investment opportunities and the difficulty of borrowing in countries that lack financial sophistication. The U.S. savings rate, on the other hand, has actually turned negative (-0.6%–the lowest rate on record), contributing to the country’s unprecedented $700 billion current account deficit: 6% of GDP. A recent survey of the global economy undertaken by The Economist (2005) is helpful in understanding this state of affairs:

Most of the time, mismatches between the desired levels of saving and investment are brought into line fairly easily through the interest-rate mechanism. If people’s desire to save exceeds their desire to invest, interest rates will fall so that the incentive to save goes down and the willingness to invest goes up. Across borders, exchange rates have a similar effect. If a country has a saving deficit, its currency will fall to the point where its assets are cheap enough to lure foreign savings in. … Classical economic theory suggests that interest rates automatically bring saving and investment into a productive balance. The central principle of Keynesianism, however, is that this alignment between saving and investment is not always automatic, and that a misalignment can have serious consequences. (8)

The survey goes on to note that while classical economic theory is applicable in the long run, "in the short term, firms’ appetite to invest is volatile, and policymakers may need to step in to shore up demand"–exactly the sort of Keynesian principle that is so unpalatable to neoliberal orthodoxy. Yet clearly the current global savings-investment equation is severely misaligned.

What is troubling is not necessarily the size of the current account deficit, but its composition. While the American economy is indeed dynamic, efficient and productive relative to many others, the inflows of capital into the United States are not financing productive investment, particularly since 2000. Rather than buying American shares or investing in American factories, foreigners are purchasing American bonds, thus financing an American consumption binge. The United States has become the world’s "consumer of last resort … saving too little and not investing enough in productive assets, especially in the export sector. Its economic health depends too heavily on housing wealth" (Economist 2005, 21). Indeed much of what’s behind the United States’ negative savings rate is the ease with which home owners can borrow against the value of their homes, through such financial innovations as home equity loans (Palley, 2000).

That the U.S. is currently assuming the role of "consumer of last resort" based largely on the ability to draw on (possibly) inflated real estate wealth leaves the global economy in a precarious position. To signal just one source of risk, much of the U.S. current account deficit is due to Asian central banks (chief among them China) who purchase dollars to maintain their own currencies low. If Asia loses its appetite for American dollars, U.S. interest rates could rise significantly and become one of a few possible factors (another being high fuel prices) that could curb U.S. consumption and send the global economy into a tailspin (Economist, 21).

III

It seems clear that the failure of economic indicators to maintain a reasonably close relationship with the productive use of capital–the "real" side of the economy–has imposed grave risks upon the global economy. Currency exchange markets may provide the best illustration for this disconnect. According to a standard textbook treatment of currency values, "when the quantity of any commodity supplied exceeds the quantity demanded, its price drops. When the supply of dollars needed for imports [comes] to exceed the demand for dollars needed by foreigners to purchase U.S. exports, the dollar [falls]. It [can] not … defy the rules of economic gravity" (Heilbroner and Thurow 1998, 207). Eatwell and Taylor point to the Salter-Swan model in which an exchange rate fluctuates relative to the price of non-traded goods in an economy (e.g., haircuts, the products of unskilled labor). Under this model, devaluing a currency reduces imports and stimulates import-competing and export industries, thus reducing the trade deficit. The exchange rate thus "clears" the trade account (p. 70). But in a context of capital market deregulation–when annual currency trading is eighty times as large as the yearly value of foreign trade and long-term investment, the trade account–an index of relative productive activity in an economy–no longer determines exchange rates: either it "is fixed by the authorities or it is determined in asset markets" (p. 71).

Keynes described the logic of this flight into what might be called the "unreal" as the result of subjecting financial markets to a "beauty contest" in the particular sense of the 1930s British newspaper phenomenon in which the player must anticipate "what average opinion expects average opinion to be," rather than casting a vote based on the merits of the subject at hand (Eatwell and Taylor 2000, p. 12). That is, success in financial markets is not based upon the real virtues of any financial asset but upon correctly anticipating the beliefs of others about those assets.

The "beauty contest" is key to understanding the underlying logic of speculation that tends to undermine any of the presumed benefits of financial liberalization. Basing investment decisions an average opinion rather than on the underlying value proposition has several consequences that are detrimental to sustainable economic development. As noted above, one is the tendency toward herd behavior that amplifies the business cycle, producing asset bubbles and destructive crashes, and indeed the kind of virulent contagion seen during the East Asian and Tequila crises of the 1990s (Blecker 1999, p. 17). Another is a short-term investment outlook that does not support productive investment in projects which need longer time horizons to become profitable. As Ilene Grabel (1998) notes:

Financial instruments afford the apparent protection of instantaneous withdrawal of funds by transforming illiquid real-sector investments in plant and equipment into financial claims that can trade hands as quickly as the institutional and technological structures permit. … A corollary of these opportunities, of course, is the diminution of the duration of financial ‘commitments’. The relative independence of financial-asset values from underlying ‘fundamentals’ imparts an extreme variability to these values. Indeed, the successful financial investor need be little concerned with the long-term profitability of the firms whose equities she buys and sells. (p. 225)

Additionally, in situations of complete financial liberalization, the problem of short-termism is exacerbated by the incentives to shift funds away from longer-term investments. As Eatwell and Taylor note, "the competition between institutional investors manifests itself as an ongoing race to demonstrate superior returns in order to attract more funds. Successive high short-term gains are more effective in this respect than longer-term gains" (p. 183). Even more problematic are situations in which this incentive compels firms normally engaged in productive enterprise to shift resources from that activity to opportunities for short-term gains Again, Grabel is instructive:

On the demand side, financial and erstwhile non-financial corporations, ranging (for example) from insurance to industrial manufacturing enterprises, may feel compelled to chase the higher returns apparently available through financial speculation, and they may come to divert resources from their primary activities to the financial arena. … A financial institution that does not validate these new speculative activities in the context of a boom may face slower growth of its capital base and a loss of market share. … In this context, even formerly ‘prudent’ financial institutions may be impelled toward speculative financing. These institutions may also be driven to abandon financing of real-sector activities. (p. 226).

IV

So what is to be done to address these problems, restore balance to, and reduce the amount of risk in the global economy? First it is necessary to recognize that there are powerful interests that benefit from the current state of affairs, and identify the extent to which they propose a political obstacle to reform. As Blecker notes, financial liberalization has been "driven in no small measure by interest group pressures, most notably from the financial industry itself (large banks, brokerage houses, mutual funds, insurance companies, and other financial institutions)" (p. 10). In general, it is easy to understand why such groups prefer the deflationary policies that place a premium on fighting inflation (and thus contrast with expansionary full employment policies): such policies preserve the value of financial assets (p. 25). Logically inflation tends to redistribute income from creditors to debtors.² Moreover, as Eatwell and Taylor note, "free international capital markets appear to go hand-in-hand with high real interest rates, that is, high returns to rentiers" (33). In advocating for the implementation of capital controls and full-employment policies, Crotty and Epstein recommend the construction of a "coalition of interests between labour and fractions of industrial and commercial capital against the parasitic interests of rentiers" (p. 121). Regardless of the political feasibility of such a coalition, recognizing that the interests of the financial industry do not necessarily correspond to those of the public at large is a first step.

It is also important to recognize the ideology behind the push for financial liberalization, which doesn’t admit empirical evidence that challenge its precepts. Again Eatwell and Taylor are most instructive here:

In many cases the assumed superiority of a liberal market strategy derives not just from conventional theory but also from a belief in the inherent economic incompetence and even venality of governments–an unflattering picture that some governments seem to have adopted about themselves. Of course, a number of examples exist which justify pessimism. But examples of bad and incompetent policy are not sufficient reasons to hand the future of the economy over the liberalized markets that render systematic policymaking impossible. Rather they should encourage the creation of an environment in which good and competent policy can be effective. (p. 138)

Once we realize that government must play a constructive role in overcoming the risks and imbalances that threaten the global economy, we can consider policy options in more detail.

The first order of business on this count would be to consider measures to restore the very ability of governments to conduct macroeconomic policy. Governments have been drastically weakened in this sense by liberalization. In the case of the United States, previously macroeconomic policy goals were achieved when the Federal Reserve altered the level of bank reserves. The demand for those reserves in turn causes interest rate adjustments. Its ability to effect such changes so has been undermined by the fact that the reserve requirements for banks have been reduced, but more importantly by the fact that with the financial innovation that has attended liberalization, banking assets now represent a much smaller share of overall financial sector assets than they once did. For example, the practice of banks "sweeping" their customer’s money into market funds, not subject to reserve requirements is now widespread. Restoring the influence of reserve requirements would be an essential measure here. According to a plan proposed by Thomas Palley (2000), a system of asset-based reserve requirements could even permit a government to address sectoral or regional imbalances by varying the level of such requirements.

Beyond restoring the ability of individual governments to conduct macroeconomic policy, proposals for reform are wide-ranging and far beyond the scope of this paper. A "Tobin Tax" on short-term capital flows seems to be the most modest of such proposals, and perhaps the most politically and technologically feasible. But in the spirit of this paper, I would like to suggest that proposals for a new financial architecture that would restore the link between the productive aspects of economy and its financing are the most compelling. Paul Davidson’s (1997) notion of an International Clearing Union (based on an earlier proposal by Keynes) is one such proposal. The ICU is a system in which surplus nations bear much of the burden for balancing the global economy by being compelled spending their excess reserves on imports or direct foreign investment. Countries with deficits can then sell more abroad and thus curtail those deficits. Oversavers can no longer contribute to a lack of global effective demand (p. 682). Provision 7 of Davidson’s proposal, which outlines "a system to stabilise the long-term purchasing power of the IMCU [International Money Clearing Unit, the ultimate international reserve asset, held only by central banks]," provides for a "a system of fixed exchange rates between the local currency and the IMCU that changes only to reflect permanent increases in efficiency wages" (p. 683). According to this provision, countries capture productivity increases either by letting the exchange rate appreciate "thereby capturing the gains from productivity for its residents", or keeping the exchange rate constant, thus sharing productivity gains with trading partners, and increasing its share of world export market (p. 683). Provision 8 states that "if a country is at full employment and still has a tendency towards persistent international deficits on its current account, then this is prima facie evidence that it does not possess the productive capacity to maintain its current standard of living." That in turn signals the need for a transfer of excess credit balances or a downward adjustment in the country’s standard of living by the country’s reducing relative terms of trade (devaluation of its exchange rate) (p. 684). Davidson’s system would ensure that the global economy remains rooted in the

Economists who propose such radical restructuring of the global financial architecture are well aware that, absent a cataclysmic economic crisis like the Great Depression, their proposals are unlikely to be taken very seriously by the international community at any level but a theoretical one. But for better or for worse, given the magnitude of current imbalances, that condition could well be met in the not-to-distant future.

BIBLIOGRAPHY

Blecker, Robert A., 1999. Taming Global Finance: A Better Architecture for Growth and Equity. Washington, DC: Economic Policy Institute.

Crotty, James y Gerald Epstein (1996). “In defence of capital controls.” In Leo Panitch, ed., Socialist Register 1996: Are There Alternatives?, pp. 118–149. London, UK: The Merlin Press.

Davidson, Paul, 1997. “Are grains of sand in the wheels of international finance sufficient to do the job when boulders are often required?” The Economic Journal 107, 671–686.

Eatwell, John and Lance Taylor, 2000. Global Finance At Risk: The Case for International Regulation. New York: The New Press.

Frenkel, Roberto, 2003. “Globalización y Crisis Financieras en América Latina.” Revista de la Cepal Nº 80, agosto.

Grabel, Ilene, 1998. “Financial Markets, the State and Economic Development: Controversies within Theory and Policy.” In The Political Economy of Economic Policies, Philip Arestis and Malcolm Sawyer, eds. New York: St. Martin’s Press. "The great thrift shift: A survey of the world economy." The Economist, 24 Sept. 2005.

Heilbroner, Robert and Lester Thurow, 1998. Economics Explained. New York: Touchstone.

Krugman, Paul and Maurice Obstfeld, 1996. International Economics: Theory and Policy. McGraw-Hill.

Palley, Thomas I., 2000. “Stabilizing Finance: The Case for Asset-Based Reserve Requirements." Financial Markets and Society, August.

[1]	Note that both Blecker and Stiglitz explicitly state that their comments are to be taken as applicable only to liberalization of portfolio capital flows and not foreign direct investment. Stiglitz notes that there is in fact a "much better case" for liberalization with regard to the latter.

[2]

The nuances of this argument are beyond the scope of this brief paper, but Blecker does note ways in which the expansionary vs. deflationary story becomes more complex. Capital flows have in fact "enforced contractionary policies in some situations and not in others." What matters is not the pursuit of expansionary policies per se, but "whether the current policy regime is unsustainable for some reason and allows them to bet on its demise." In the UK in the early 1990s, for example, speculators bet that the UK’s attempt to maintain the value of the pound in light of a rise in German interest rates would be politically unsustainable, and they "effectively compelled the British government to adopt a more expansionary policy stance" (p. 29).

The Other Canon

Reinert’s intention is not to innovate, but rather to resurrect a body of economic thought, largely Germanic in origin, that in fact helped establish England, Germany, and the United States as economic powers before the current Anglo-Saxon economic orthodoxy took hold. This school seeks to account for the unevenness of economic development, claiming that textbook economic theories that predict "factor price equalization" that leads to increasing equality among nations engaged in international trade are clearly mistaken in light of data that shows the increasing impoverishment of developing countries that have attempted to integrate with the global trading system.

The 1990s have brought a backlash against liberal economic dogma similar to that which led to the European revolutions of 1848. In the wake of those events, 19th century economists were far more interested in the "social question" than their late 20th-century counterparts, and were thus less likely to succumb to economic dogma without questioning its practical effects. To emphasize the heritage of Reinert’s "Other Canon," it’s worth reproducing some guidelines for the discipline of economics supplied by US economist Edwin Seligman in 1886. For Seligman, a responsible economics:

1. Discards the exclusive use of the deductive method, and stresses the necessity of historical and statistical treatment.
2. Denies the existence of immutable natural laws in economics, calling attention to the interdependence of theories and institutions, and showing that different epochs or countries require different systems.
3. Disclaims belief in the beneficence of the absolute laissez-faire system; it maintains the close interrelations of law, ethics and economics; and refuses to acknowledge the adequacy of the assumption of self-interest as the sole regulator of economic action.

One fundamental component of the "Other Canon" is activity-specificity. Reinert writes:

Today we intuitively understand that Bill Gates and Microsoft could not have achieved the same profits and the same wage levels if they had been raising sheep instead of producing software. A theory and policy distinguishing various types of activities were fundamental to centuries of economic policy.

Indeed, during the 19th century, US economists noted that England observed such activity-specific policies for centuries, and only after achieving economic dominance did they promote Ricardian trade. The US thus accused England of "pulling up the ladder" on other countries seeking increased competitiveness via industrialization. Reinert notes that "all presently industralized economies have passed thru a period of active and activity-specific economic policy" and that "such a period represents a mandatory passage point for any nation." Korea represents a contemporary example of a country that has achieved development along the lines of this strategy.

Another important aspect of alternative point of view of the "Other Canon" is that it challenges the excessive financial or monetary orientation of post-World War II economic policy, whether in the form of Washington Consensus policies or in the Keynesian demand-management policies that continue to be observed particularly in the European welfare states. Such an orientation takes for granted the productivity of capitalism without questioning the conditions under which productivity is possible.

Lest Reinert be dismissed as a socialist, he notes that Marxist analysis shares with Ricardian economics a mistaken mechanical conception of the "labor theory of value." At the same time as that theory furnishes the basis for orthodox trade theory that would ultimately find its expression in the Washington Consensus, the theory led Marx to insist that laborers should have the right to the whole of their product without taking into consideration the "human Geist of new ideas and leadership" that drives economic growth.

Finally, Reinert stresses the importance of subjecting economic policy to the light of experience and reason rather than dogmatic adherence to orthodoxy. He identifies the two "vices" of contemporary economics: the "Krugmanian vice" refers to the tendency of economists to insist that potentially useful economic theories not be applied in practice if they don’t accord with economic orthodoxy. Conversely, the "Ricardian vice" refers to the practice of basing economic policy on classical economic hypotheses even when they are demonstrably harmful.

The Rise of Illiberal Democracy

When the failure to find "weapons of mass destruction" in the aftermath of the US invasion of Iraq made evident the deceit in the Bush administration’s selling of the action to the American public, that administration gradually shifted its rhetorical strategy to emphasize the benefits that would redound to the Iraqi people as a result of America’s having toppled a repressive dictatorship and replacing it with a "democracy." The assumption was that the very notion of free elections would conjure the image of an Iraq entering the community of peaceful nations and thus inspire continued support for a war that was increasingly costly in both financial and human terms.

This calculation sought to exploit the confusion in the minds the American public of the word "democracy" with the phrase "liberal democracy." The distinction between the two is the subject of Fareed Zakaria’s article "The Rise of Illiberal Democracy." In defining liberal democracy, Zakaria writes:

[Liberal democracy] is a political system marked not only by free and fair elections, but also by the rule of law, a separation of powers, and the protection of basic liberties of speech, assembly, religion, and property. In fact, this latter bundle of freedoms–what might be termed constitutional liberalism–is theoretically different and historically distinct from democracy.

Importantly, he notes, the rise of the two types of freedoms may have conincided historically, but they’re not intrinsically linked. Without denigrating the value of elections, it’s clear that the prevalence of "constitutional liberalism" within a nation’s borders is far more important to the well-being of that nation’s citizens than the right to vote. Zakaria seems positively politically incorrect in evoking the relative beneficence of the British imperialism in light of the subsequent democratic experiences of its the British empire’s colonies:

British rule meant not democracy–colonialism is by definition undemocratic–but constitutional liberalism. Britain’s legacy of law and administration has proved more beneficial than France’s policy of enfranchising some of its colonial populations.

Indeed, democracy implies no guarantee at all of civic welfare, as the "rise of illiberal democracy" in the Middle East has demonstrated:

In the Islamic world, from the Palestinian Authority to Iran to Pakistan, democratization has led to an increasing role for theocratic politics, eroding long-standing traditions of secularism and tolerance. In many parts of that world, such as Tunisia, Morocco, Egypt, and some of the Gulf States, were elections to be held tomorrow, the resulting regimes would almost certainly be more illiberal than the ones now in place.

Zarkaria reminds us of "two common, and often mistaken, assumptions–that the forces of democracy are the forces of ethnic harmony and peace. … But without a background in constitutional liberalism, the introduction of democracy in divided societies has actually fomented nationalism, ethnic conflict, and even war."

None of this should necessarily be new. Tocqueville famously warned of the danger of the "tyranny of the majority" inherent in democracies, and anyone who’s had a high-school civics class can tell you that in a society with "majority rule" there must be protection for "minority rights." Now we see evidence that democracy exacerbates conflict in countries with no tradition of rule of law and weak civil societies.

But America’s enthusiasm for promoting free elections without attention to its liberal constitutional counterpart seems to disregard such lessons. Even before the Iraq debacle, (Zakaria was writing in 1997), American foreign policy was marked by a tolerance for all manner of illiberal behavior provided that the country in question hold free elections. Zakaria concludes with the following counsel: "Economic, civil, and religious liberties are at the core of human autonomy and dignity. If a government with a limited democracy steadily expands those freedoms, it should not be branded a dictatorship." "…Instead of searching for new lands to democratize and new places to hold elections, [the US should] consolidate democracy where it has taken root and … encourage the gradual development of constitutional liberalism across the globe."

Globalization and Its Discontents

Hardcore anti-globalization activists likely greeted the 2002 publication of Joseph Stiglitz’s Globalization and Its Discontents with the sense that a justification of their protests from a mainstream, authoritative source had arrived. After all, Stiglitz is a Nobel Prize-winning economist who has served as President Clinton’s chief economic adviser and president of the World Bank. But the book’s message is not so simple. From the outset, Stiglitz maintains alongside his ideological adversaries not only that globalization is here to stay, but that it carries with it the potential for improving the lot of the world’s poor.

Where Stiglitz parts company with his opponents is in his objection to what he terms "market fundamentalism," an ideology which holds that unregulated, unrestrained free market capitalism is the road to prosperity for all. Stiglitz finds the "Washington Consensus" that governs the actions of international financial organizations like the International Monetary Fund firmly rooted in this ideology, and it is the IMF which happens to be the bete noir of his book.

In Stiglitz’s account, the IMF was conceived in 1944 at the famous Bretton Woods meetings, whose purpose was to devise an economic framework for the postwar reconstruction of Europe. The field of economics was at that time dominated by the thought of John Maynard Keynes, who taught that markets, left on their own, often functioned poorly, that significant government regulation was thus needed, and that during hard times, an economy ought to be treated with expansionary policies that maintain employment and stimulate "aggregate demand," rather than be allowed to contract further through fiscal austerity measures which seek to reduce government spending.

The IMF, then, was designed to employ these Keynesian principles in the administration of the macroeconomic affairs (e.g., managing deficits, monetary policy) of countries in the need of aid. In the years since its inception, however, two things happened. First, as commonly happens in any large bureaucratic institution, the IMF fell victim to "mission creep"–that is, it started to extend its reach beyond its core competency in macroeconomics to offer recommendations in structural economic matters (e.g., stimulating competition, efficiency). Second, it betrayed its Keynesian heritage and took up the cause of the Washington Consensus, preaching the triumvirate of fiscal austerity, privatization and market liberalization.

What was the cause of this shift of allegiance? Stiglitz admits that the set of policies that came to be known as the Washington Consensus had considerable validity when first applied in Latin America during the 1970s and 80s. Governments there were profligate spenders and notoriously corrupt. Stiglitz argues, however, that these policies were later generalized and applied—with disastrous consequences—to countries whose circumstances were altogether different. Stiglitz charges the IMF and other defenders of the Washington Consensus with blindly adhering to a simplistic ideology that ignores evidence which suggests a more interventionist approach.

Among the most controversial aspects of Stiglitz’s book is his suggestion that the reason for the IMF’s adherence to a market fundamentalist ideology is that it works to protect the interests of Wall Street and the financial community, rather than the people of the countries where it operates. He summarizes the motivations of that community thus:

Wall Street regards inflation as the worst thing in the world: it erodes the real value of what is owed to creditors, which leads to increases in interest rates, which in turn lead to declines in bond prices. To financiers, unemployment is far less of a concern. For Wall Street, nothing could be more sacrosanct than private property; no wonder then the emphasis on privatization. Their commitment to competition is far less passionate…. And notions of social capital and political participation may never appear on their radar screen.

Regarding the first of these aspects of the Wall Street mentality, Stiglitz describes a typical IMF intervention:

The billions of dollars which it provides are used to maintain exchange rates at unsustainable levels for a short period, during which the foreigners and the rich are able to get their money out of the country at more favorable terms (through the open capital markets that the IMF has pushed on the countries).

The temptation to lay the blame for the collapse of developing economies at the feet of powerful rich-world organizations like the IMF becomes even stronger when one considers the hypocrisy inherent in the insistence on market liberalization in poor countries. Stiglitz offers a particularly illuminating example:

Bolivia not only brought down its trade barriers to the point that they were lower than in the United States but also cooperated with the United States in virtually eradicating the growth of coca, the basis of cocaine, even though this crop provided a higher income to its already poor farmers than any alternative. The United States responded, however, by keeping its markets closed to alternative agriculture products, like sugar, that Bolivia’s farmers might have produced for export–had America’s markets been open to them.

As recent events at the WTO meetings in Mexico have shown, Western European countries have proved similarly unwilling to open its markets.

But rather than charging IMF leadership with malicious greed, Stiglitz claims that they are (mis)guided by the notion that "what the financial community views as good for the global economy is good for the global economy and should be done. In some instances," Stiglitz concedes, "this is true; in many it is not." Stiglitz asks that the IMF and other global financial institutions discard uncritical ideology as a basis for decision-making and pay closer attention to empirical evidence that shows "what works" in restoring health to an ailing economy. As Stiglitz implies, with a rational approach of this kind we can expect that in some cases the interests of the financial community will intersect with those of citizens of countries under IMF tutelage; in others, they will not.

IMF policy failures in countries like Indonesia and Argentina showed that "excessive austerity led to high unemployment, without an adequate safety net, which in turn contributed to high levels of urban violence, an environment hardly conducive to investment." Stiglitz, like Keynes, places a premium on policies that encourage stability by, for example, maintaining high employment and availability of public services, and which thereby honor the "social contract" that binds a government to its constituents. One way that the IMF can become an organ which fosters respect for that contract is to become more transparent. As Stiglitz notes, international financial organizations are not subject to the kind of transparency that characterizes other organizations in a democratic society—too many of its dealings go on behind closed doors. There’s no equivalent to the Freedom of Information Act to permit ordinary citizens access to the activities of these entities.

Stiglitz’s recommendations for dealing with countries in need of economic aid contrast notions like "gradualism" and "sequencing" with the privatize, liberalize, and economize now approach employed by the IMF, and offers case studies showing how countries such as Zimbabwe, Poland and South Korea, which ignored IMF advice in favor of the kinds of policies Stiglitz advocates, prospered.

The enemy Stiglitz engages is a camp that has an "overly optimistic view of markets and overly pessimistic view of government." While Stiglitz provides ample evidence that markets usually cannot, on their own, efficiently generate and fairly distribute wealth, he does leave himself somewhat open to the charge of not taking seriously enough the corruption and inefficiency that can result from excessive government intervention.

Still, after reading Globalization and Its Discontents one is left to wonder where this "overly optimistic view of markets" comes from, and why it is so prevalent. A book that attempts to answer this question, at least as it relates to the American case, is Thomas Frank’s One Market Under God, a less balanced, but equally incisive and far more entertaining treatment of this same theme of "market fundamentalism."

One Market Under God

The book’s title is key to understanding Frank’s originality. Frank describes the current economic arrangement in the U.S. as being marked by the "diverging fortunes of top management and everyone else," in which these latter find themselves menaced by the "constant threat of termination." Throughout the ’90s, these "top managers were enriched in proportion to the amount of power and security that workers lost." With characteristic vitriol, Frank writes, "There is no social theory on earth short of the divine right of kings that can justify a five-hundred-fold gap between management and labor."

And yet, that justification is exactly what, according to Frank’s account, those who presided over the dubious economic expansion of the 1990s attempted to provide. In the face of stagnating wages and and ever-increasing income inequality, any such justification would almost have to be religious in character. And indeed Frank opens his book with an exhaustive catalog of examples of advertising that extols the divine attributes of, for example, financial products and computer software.

Still, unlike earlier attempts to manufacture the consent of the American public, the means of legitimating an economic regime which so lopsidedly favored the rich were decidedly secular in character. One of the most fascinating aspects of this book is Frank’s analysis of the political logic of the so-called culture wars, their emergence from the "backlash politics" of the ’70s, and how the right ultimately lost them. Frank cites Republican presidential adviser Lee Atwater: "In 1984, worried that the blue collar workers were becoming ‘liberal on economics’ and without culture wars to distract them, they had no compelling reason to vote Republican." Since then, in what Franks conspiritorially refers to as a "planned provocation by the right," the party has actively courted fundamentalist Christians, shoring up support for its dubious mixture of traditional morality and savagely free-market economics.

Frank accepts the popular notion that the culture wars exhausted themselves when the Clinton impeachment trial failed to elicit the kind of indignation from the American public that the former president’s enemies had hoped for. Indeed, the coarsening of the culture in the few short years since the Lewinsky affair is evident to any critic, moralizing or otherwise. Republican party support now consists as much of those who continue to believe in the party’s efforts to promote a conservative social agenda while uncritically accepting the existing economic regime, as it includes legions of so-called "libertarians" who have no use for Republican moralizing, but passionately support the party’s free-market economic agenda. Meanwhile, the Democrats, by Franks’ account, have outdone the Republicans themselves in their enthusiasm for market-friendly policies such as deregulation and their evisceration of social programs once regarded as indispensable to a civil society.

By and large, no longer did the polity of a once Christian nation face a choice between serving God or Mammon. God was Mammon. The Market was God. The management gurus whom Frank exhaustively surveys unanimously admonished their readers to "listen to the market" when in doubt, even on matters outside the economic sphere.

The divine omniscience and benevolence of the market has proved a particularly difficult notion to debunk, according to Frank, for it preaches that "markets express the will of the people" and "any criticism of business could be described as an act of contempt for the common man." For this reason, not only could politicians and business leaders be seen rushing regularly to the market’s defense, but so could academics, the same ones who were routinely castigated by Republican moralizers with charges of relativism and corruption of youth with unamerican ideas. Frank finds this latter situation particularly irksome, perhaps because as a committed leftist he might have expected to find natural allies in academe. But in his review of much of the "cultural studies" literature which defined the tenor of humanities scholarship throughout the ’90s, he finds little more than the "most egregious sort of apologia for existing economic arrangements." The "cult studs" provided a stark contrast to the Frankfurt School ideas that until recently prevailed in humanities departments–ideas grounded in a hermeneutic of suspicion regarding cultural production. Again, to infer that individuals were passive recipients of the collective output of a "culture industry" which may not have had their best interests in mind minimized the agency of those recipients, and therefore smacked of elitism. And "no error outranked the moral crime of elitism." The cult studs reversed the polarity of the logic of the "culture industry," and viewed acts of consumption (particularly of popular cultural artifacts) as opportunities for self-expression, or even "transgression" of the dominant order.

It is perhaps the breadth of the forces Frank sees deployed in the defense of the unrestrained free market which illustrates most vividly the fundamental weakness of One Market Under God. Unlike Stiglitz, Frank is unwilling to accept market capitalism as a given of modern economic life. "The logic of business is coercion, monopoly and destruction of the weak, not ‘choice’ or ’service’ or universal affluence," he fumes. Virtually the only category of people of that escapes Frank’s venom is the traditional labor union. Management gurus who would attempt to humanize the workplace through "post-Taylorist" reforms that reduce the monotony and attempt to restore creativity to labor are regarded with disdain by Frank. Similarly, "socially responsible" businesses are treated just so–within quotation marks. Still, Frank’s scathing account of the ’90s is a welcome antidote in the face of all the evidence that we remain, three years after the era’s "irrational exuberance" collapsed, a society consumed by greed.

Conclusion

One’s response to both books depends on one’s attitude toward the free marketeers’ proposition that "a rising tide lifts all ships." There is little doubt that at least in America free market policies have, by traditional economic measures such as GDP per capita and ability to purchase goods, benefited a vast majority over the past fifty years. But an economics that takes seriously the notion of a "social contract" recognizes that in the presence of great economic inequality, a "rising tide" is not sufficient to guarantee a just society and a healthy political life.

One final quote, pertaining to East Asian countries’ rejection of Washington Consensus prescriptions, from Stiglitz’s book is instructive:

While the Washington Consensus policies paid little attention to inequality, arguing implicitly or explicitly that the benefits would trickle down to the poor, the East Asian governments worked actively to reduce poverty and limit inequality, believing that such policies were important for maintaining social cohesion, which was necessary for a climate favorable to investment and growth.

Among the many virtues of The Economist is that it’s a publication that constantly questioning its own presuppositions, which are firmly rooted in liberal economic orthodoxy. Recently the magazine ran an article about the impact that economic inequality has on "happiness":

In one striking example, students at Harvard University were asked whether they would prefer (a) $50,000 a year while others got half that or (b) $100,000 a year while others got twice as much. A majority chose (a). They were happy with less, as long as they were better off than others. Other studies confirm that people are often more concerned about their income relative to others’ than about their absolute income.

This sort of evidence, while not conclusive, suggests that income inequality, no matter how prosperous a nation may be in terms of GDP, is very unlikely to conduce to the kind of social cohesion that Stiglitz believes essential to sustained economic growth.