Globalization agenda threatens market system

by Chakravarthi Raghavan

Geneva, 3 May -- The global market economy system may be closer to losing legitimacy, maintaining order in the system and assuring a welfare outcome due to the aggressive pursuit of globalization and ever-widening trade and capital liberalization agendas, the UN Economic Commission for Europe has warned.

The UN regional body has put the responsibility for the present situation of developing and transition economies on the policies recommended and pushed on them by "mainstream" consensus, which are dangerously close to becoming dogmas.

The main elements of the "Washington Consensus" -- of macro- economic stability by lowering inflation and pre-empting further outbreaks, and liberalisation of trade and "flexibility" in labour markets -- and the more recent moves to amend the IMF articles to enable the Fund to make capital convertibility a condition for IMF loans, were developed in the context of the inflation crisis of 1970s in the developed market economies and the Latin American debt crisis of the 1980s.

"The certainty with which they are proposed and pursued is not reflected in the available empirical evidence," and the tendency to simplification is not confined to policy recommendations for developing and transition economies, the ECE pointed out.

On the recommendations that Europe introduce labour market flexibility, the ECE said, "there is little evidence that reducing employment protection is a solution to high unemployment". Experience over the last two decades show that lowering unemployment will need stronger demand, and more investment to sustain this.

As for reducing and controlling inflation, "the evidence suggests that inflation is costly in terms of lost output only when annual rates exceed 40 percent - then there is a danger that high inflation will lead to low growth rates." Below this (40% rate), growth and investment can recover, even if inflation is still in double digits, if there are expectations that it will remain on a downward trend.

The view that close to zero inflation is a necessary, and even a sufficient condition, for strong, sustained growth and falling unemployment is not based on historical evidence, and "continuing to focus on such an objective is likely to have deleterious effects on prospects for reducing currently high rate of unemployment in western Europe," the ECE economists said.

As for the advice for rapid trade liberalization (advocating for the transition economies and developing countries), the ECE points out that these advices are based on an influential World Bank study of 17 countries which concluded that bold liberalization tends to be more sustainable than a staged one. But a careful review of the seven-volume study has pointed out that the great diversity of the individual countries did not support the extravagant claims made for the generality of the study's conclusions.

There is also "a similar degree of uncertainty" surrounding the relationship between trade liberalization and faster economic growth", since liberalization is essentially an instrumental policy and not an end in itself. While some economists suggest a positive relationship, others find that its validity depends upon specific micro-economic assumptions which rarely appear in reality.

"Once increasing returns to scale and productivity-boosting investment are brought into the picture, the standard case for liberalising trade to boost growth breaks down and a plausible case for interventionist policies can be made," the ECE has pointed out.

The argument for trade liberalization is that exposure to increased competition will force domestic enterprises to be more efficient, and the more quickly this is achieved the better.

But the scale of adjustment to liberalizing trade will depend on how far the domestic output, employment and relative price structures can change in response to the new competitive pressures. But for many transition economies the scale of restructuring required for change from central planning to competitive markets is so large that domestic economic, political and social institutions, which are also in a state of transition, are unable to cope with.

Economic growth and development is a highly complex process, with poorly understood causes. And while economic historians and economists outside the neo-classical persuasion, have always emphasized the crucial role of institutions in stimulating and facilitating the process of change and mobilizing and expanding the resources available for development. Even the successes in east Europe that are often cited (Poland, Czech Republic) suggest that the most successful reformers are those where initial conditions were more favourable to a faster rate of change than in other transition economies.

The governments of these countries were able to implement, and their electorates were willing to tolerate a faster rate of growth than in other transition economies. But this also meant that the pace of reform was largely determined by the historical legacy and not only by the choice, or the "political will" of governments.

On the issue of capital account convertibility, the ECE points out that liberalisation of the international capital markets is perhaps one of the most controversial elements in the ruling orthodoxy, especially since the Asian crisis broke in August 1997.

The official case for free capital movements is that it is merely an extension of the argument for free trade in goods - countries with insufficient domestic savings to finance their own investment can draw on the surplus savings of others, and by searching out the most profitable projects foreign capital will lead to a more optimal allocation of world resources and a convergence of per capita incomes.

"However," says the ECE, "although the estimated benefits from free trade may also be controversial, there is no doubt that serious efforts have been made to quantify them and there is a body of evidence which points to significant gains even if these range considerably in size. In the case of capital account convertibility, attempts to quantify the benefits, as Prof. Bhagwati has pointed out, are virtually non-existent and are more a matter of repeated assertion than careful analysis.

"In fact," the ECE survey adds, "the available evidence casts doubt on many of the presumed major benefits of free capital movements. Contrary to expectation, domestic investment and domestic savings rates tend to be closely correlated across countries: different rates of return on capital persist and are not equalized by foreign capital flows."

Analysing the capital flows (FDI, portfolio investments), the ECE notes that "despite popular claims to the contrary, both capital flows and international trade are still more regionally concentrated than truly global."

This helps to explain - but only helps since there are many complex factors involved - why there is little evidence in favour of income convergence in the world economy. Nor do the great benefits claimed for free international capital markets appear to be reflected in better economic performance, irrespective of its distribution.

"Growth rates of GDP in the last two decades have generally been much lower than in the 1960s, in both the developed and developing countries, and investment ratios (to GDP) have generally fallen. Although there are many factors involved in this deterioration, and it should not be denied that some countries have benefited from increased liberalization, the proponents of unfettered international capital movements cannot claim that they have been generally associated with higher growth rates, more efficient resource allocation, or a more equitable distribution of incomes per head."

"What is clear, however, is that the liberation of international capital flows, particularly by the developed market economies, has been accompanied in the 1980s and 1990s by a considerable increase in financial market volatility -interest rates, exchange rates and capital flows themselves all exhibit very much larger fluctuations than in the 1960s and early 1970s. Sudden inflows, and equally sudden outflows, of foreign capital create considerable difficulties for the management of domestic monetary policy;" the resulting uncertainty and higher risks implied by financial volatility lead to caution on the part of governments (which tend to set interest rates higher than they might otherwise have been) and of private business (faced with increased costs of capital and increased uncertainty over future demand). The net result is a tendency for growth rates to fall below what is feasible, a particularly serious consequence for the transition economies intent on closing the considerable income gap between themselves and the members of the EU."

Another aspect of financial volatility is its propensity to contagion.

Contrary to the textbook model of large numbers of investors making careful, independent judgements as to profitable opportunities, the capital markets are subject to bouts of "herd behaviour". Contagion is reinforced by the adjustment of portfolios whereby losses or margin calls in one market are balanced by the liquidation of assets in other markets which may very well show no weakness at all in the real economy. "Indeed, in this context, the stronger and more liquid markets may be the more vulnerable."

In the immediate aftermath of the Asian crisis there was a tendency to put the blame for it, not on the instability of the capital markets, but on the countries themselves: internal weaknesses such as weak regulatory frameworks, poor systems of corporate governance, a general lack of transparency in the financial and banking sectors, "crony" capitalism" and so on. The question is not whether such deficiencies exist but whether they played a significant role in causing and propagating the crisis.

The view that foreign investors were somehow "deceived" into placing their funds in these countries was difficult to accept since many of these perceived internal weaknesses were long known to be part and parcel of the definition of "developing" or "transition" economies.

While some of the proposals for improving transparency and better regulation were desirable in themselves, the ECE says that it was unlikely that these deficiencies played a major role in causing the crisis. Referring to some of the recent examples in the developed economies, as the LTCM hedge fund collapse, the ECE adds that the more serious weaknesses of governance and regulation would indeed appear to be located in the developed market economies of North America and western Europe.

"Swift action to repair some of these deficiencies in the developed market economies could make an important contribution to reducing instability: not only are these the principal sources of international capital flows, but they are also the countries where both the urgency and the capacity for reform are greatest. There does not seem to be any reason why such reforms should have to wait for the more comprehensive proposals for reforming the international financial system."

The ECE has cited from the resignation letter of Mr. Philippe Maystadt (from the chairmanship of the IMF interim committee) on the need to proceed cautiously and with good advice, and on no country being forced to liberalize immediately or remove controls (on capital) when justified by legitimate reasons.

In most of the reactions to the Asian crisis and the proposals for reform, the underlying assumption is that capital market instability can be tamed by better institutional frameworks, better supervision, greater transparency and a more careful preparation of transition and developing countries before they enter the liberalized international environment.

Although all these steps may help, a more fundamental question is whether instability is inherent to the international capital markets or whether it arises from inappropriate institutions and unwarranted interference in the market mechanism. This is in fact a variation on one of the basic issues over which economists have divided for most of this century, namely, the origins of uncertainty and the source of dislocation in the system of market coordination."

Referring to the views of von Hayek on the one side and that of Keynes on the other, the ECE says that "if the view that instability or volatility is inherent in international capital markets is accepted, although it may be reduced by better regulation, etc., it may be desirable to accept capital controls as a permanent instrument in the national policy tool-kit and to abandon attempts to include capital account convertibility as an ultimate objective for all IMF members."

Under present arrangements legitimate attempts to control foreign capital flows are in fact made, by changing interest rates, but these are clumsy tools for this purpose as they may conflict sharply with other national objectives such as growth or macroeconomic stability. More direct controls, such as those employed in Chile, would help to contain the disruptive effects of surges in short-term capital flows on economic growth, which if successful would actually make the environment more attractive for longer-term direct investment.

One of the standard objections to capital controls is that it is too late "to turn the clock back", that the process of capital liberalization is unstoppable.

"This is often little more than self-interested determinism by market operators and there seems to be no reason why Chilean-type control s could not be adopted by a country if it so chooses, although it may be more advisable to introduce them during a period of relative calm in financial markets, rather than as an emergency measure..."

The current policy attitudes share a number of characteristics. None of them could be considered wrong or undesirable, "but the confidence with which they are pursued and applied ignores the fact that the empirical support for them is more uncertain and more ambiguous than is usually recognized," and there is a tendency to downplay or even ignore the difficulties in institutional structures. The other characteristic is that most of the policies tend towards deflation.

A broader conclusion however is that growth and employment have to be restored to a more prominent position among the objectives of policy. "The idea that liberalization, structural reform and economic growth can be tackled in a temporal sequence is as mistaken for the transition economies as for mature western market economies. Instead measures directed at supporting growth need to be introduced along with stabilization and reform programmes in order to establish a mutual support between them."

The triumph of capitalism in the second half of the 20th century was largely based on its ability to regain popular legitimacy via the intervention of government to ensure low levels of unemployment and more acceptable distributional outcomes - capitalism with a "human face". This, essentially, was "the third way" and derived from a conjunction of the welfare state with "Keynesian economic policies.

To put it crudely, for any economic system to survive it must deliver the goods and distribute them in a reasonably equitable manner. The former centrally planned economies failed this test and they have been dismantled; but there are many people now living in some of the transition economies who are wondering whether the new market economy, however embryonic, will fail the test as well.

Another aspect of late 20th century capitalism is that it comes in many varieties and is supported by different institutional arrangements. This tolerance of national varieties, however, is increasingly under threat from those who see globalization in normative terms and insist that transition and developing economies should adopt all the values and institutions of the currently dominant market economies.

"This approach, which is partly reflected in the post-Uruguay agenda of the WTO and which seeks to harmonize policies and to set rules in areas which have traditionally been regarded as matters for national policy and national preferences, carries considerable risks. It represents a radical change from the original philosophy behind the creation of the Bretton Woods institutions which was to create an environment of international financial stability that would underpin the development of world trade and allow countries to develop according to their own preferences, subject to their avoiding actions that would 'beggar their neighbours'. The pursuit of the globalization agenda, however, increasingly appears to deny much room for any national preferences which clash with those of the major market economies.

"The crucial danger from this is to the market economy system itself, because economic and social preferences are closely entwined in the broader framework of social and political values which underpin a country's institutions including its form of economic organization.

If the social and political values - and preferences - of countries are attacked in the name of the new global economy, "the chances are that there will be a backlash against that economy rather than a change in values."

It is therefore not surprising that an increasing number of distinguished market economists have recently warned of the dangers of pushing the liberalizing agenda too rapidly and too widely.

The stability of any socio-political-economic system ultimately rests on three crucial conditions:

* on whether it has legitimacy, i.e. whether the rules and procedures according to which authority is conferred and exercised can be justified and can be seen to be rooted in Adam Smith's "moral sentiments of the population"; on whether the agreed rules, conventions of behaviour, etc., maintain order in the system by encouraging acceptable behaviour and penalizing the unacceptable; and on the welfare outcome, which recognizes that popular support for institutions and economic arrangements will not be sustained if the distribution of costs and benefits is considered by too many of the population to be unjust.

"The instability in the international financial system in the last decade, the aggressive pursuit of an ever-widening liberalization agenda, and the enormously costly turbulence of the last 18 months or so all suggest that the present global system may be moving closer to violating all three conditions," the ECE concludes in the overview of its survey. (SUNS4429)

* Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS) in which the above article first appeared.

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