International Capital Liberalisation: The Impact on World Development

Given that financial markets operate as a Keynesian beauty contest and the real economy has no automatic tendency to converge to full-employment growth, then the simple rules of the game embodied in the policy positions believed by market participants to be held by other market participants will be imposed on the economy. The downside risks involved in flaunting the rules of the game will create a deflationary bias in government policy. This is reinforced by the very high costs of debt in a situation in which real interest rates typically exceed growth rates by a substantial margin. High interest rates are themselves the outcome of the attempt to maintain financial stability in a potentially volatile world. So the post-war goal of "a high and stable level of employment" is abandoned, and replaced by the goals of "long-term price stability" - the path to which is defined according to the rules of the game. A liberalised, sophisticated financial system, with a premium placed on the possibility of exit, is a fragile financial system. That fragility is manifest in liquidity crises, some of which have substantial reverberations in reduced real output; in risk aversion in the private sector which produces a bias toward the short-term, and a corresponding reluctance to invest for the long-term; in risk aversion in the public sector, producing a bias toward deflationary policies; and in persistent demands for greater "flexibility" to increase the possibilities of exit. It is often argued that nothing can be done to change the present system, since capital flows can overwhelm the actions of any one government. This is certainly true. But it is equally true that the foundation stones of the world financial system are the monetary instruments issued by a small number of major governments. Ultimately, those governments acting together have the potential to control capital flows. But that potential will only be manifest if governments themselves have a different theory of economic policy than the theory which currently dominates economic and political debate. As Peter Temin has made clear, the Depression of the 1930s was a product both of the loss of international financial control and the fact that governments were convinced of the necessity of deflationary policies. They had no alternative theory. Without a change of theory by governments, without an active willingness to pursue expansionary monetary and fiscal policies, no formal structure of financial controls would deliver recovery. It took the experience of the Depression and of World War II economic management to change the theory. In the same way, it is unlikely today that a significant reassertion of control over international financial structures is possible without an equally major change in priorities and analyses by all major governments. Such seismic changes have historically been associated with the aftermath of world-wide economic and political disruption.