I'm an imbecile at economics. Over the years, I've tried to educate myself, but it never really works. My brain does philosophy and psychology; it doesn't do economics. Nevertheless, in case they might be of use to anyone, here are some notes I took about ten years ago on a few books I was reading, especially Barry Eichengreen's classic history of the international monetary system. Most historians don't study economic history closely, maybe because economics is difficult and rather boring; unfortunately, nothing is more important for collective human life than the economy. But we shouldn't be too critical of historians: the labor historian Jefferson Cowie is right that most economists are "small-minded" and do us no favors by refusing to be realistic about their subject matter. Or themselves refusing to study economic history!
I've posted other notes elsewhere, e.g. on this page. Interested readers might also consult Ha-Joon Chang's books, especially numbers 3, 12, and 13 on this page.
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Reading Fred Magdoff and Michael D. Yates’s The ABCs of the Economic Crisis: What Working People Need to Know (2009). Even a relatively introductory book like this gives a sense of how impossibly complex the economy is, how many moving parts there are. For example:
Under typical circumstances, a nation with a large trade deficit [which means it is taking in more imports than selling exports] will find its currency depreciated, that is, exchanging for less and less foreign currency. As with anything else, when supply greatly exceeds demand, prices fall. In this case, the price is the exchange rate of the dollar with foreign monies… If the exchange value of the dollar were to fall dramatically, this would make imports to the United States more expensive (for example, more dollars would have to be paid for a certain number of yen than before), and by raising the price of consumer goods that would increase inflation in the United States. If the foreign goods and services did not have acceptable substitutes, U.S consumers might continue buying them at the higher prices and cut back on things produced here, leading to unemployment. A weaker dollar would also encourage foreigners to buy U.S. exports, but this might not be enough to stop the devaluation of the dollar. If the decline in the dollar’s exchange value fell enough to whet the appetite of speculators who believed it might fall further, they would begin to speculate against the dollar and this would devalue it further. To stop the harmful consequences of this, the government, through the Federal Reserve, might have to push interest rates up to raise the demand for U.S. government bonds and thereby also raise the demand by foreigners for dollars. High interest rates would, however, reduce demand for houses, cars, and construction, causing more unemployment.
The U.S., however, isn’t a typical country. The dollar is the leading global currency. So every nation’s central bank has reserves of dollars with which, in the case of a depreciation in its own currency’s value, it can buy that currency (for instance, Japan would use its reserves of dollars to buy yen) and keep the exchange rate stable, thereby preventing foreign goods from being more expensive and so preventing domestic inflation. As a result, the dollar has been in high demand around the world—also because U.S. government bonds are safe, so that foreign countries and businesses buy them in high volume. The result is that “the United States can run up large international deficits without causing its currency to depreciate in value as much as it should, which means that interest rates in the United States can be lower than they would otherwise be. Therefore, foreigners in effect helped subsidize the housing boom and all other spending that relied on borrowing.” This has helped the U.S. economy, i.e. helped counteract trends toward stagnation.
Another note: supply-side economics tends to assume that by decreasing taxes on the rich, the rich will invest more in the real economy and thus create jobs for ordinary people. But the assumption is wrong. Because of the financialization of the economy, lower taxes simply cause the rich to invest more in stock-market gambling, which creates few jobs. –In his critiques of Reaganism, Paul Krugman never mentions this one (as far as I recall).
“There was so much money in the hands of the wealthy that they had no productive way to use it. If a greater share had been in the hands of workers, this money would have been spent on commodities of all kinds, generating output and employment without such a massive accumulation of household debt” as we’ve seen in recent decades. This point echoes underconsumptionism and Keynesianism. But capitalism has powerful tendencies toward polarization of income—“underconsumption” for the masses, or “too much money being in the hands of the wealthy for it to be used productively”—and this contributes to its tendencies toward stagnation.
Moreover, given the existence of all this wealth without productive outlets, it was inevitable that financialization would occur, i.e. that the wealthy would find some way to use their wealth to make profits. But financialization, the massive system-wide accumulation of debt, in the long run was inevitably going to come untethered from the real economy, which means that people and institutions were someday going to lose their ability to service their enormous debt (because of their insufficient income), which means that a virtual collapse of the system was going to occur. And these tendencies will persist as long as there is a paucity of investment opportunities in the real economy, largely as a result of the relatively little wealth possessed by the multitudes.
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Reading Golden Gulag: Prisons, Surplus, Crisis, and Opposition in Globalizing California (2007), by Ruth Wilson Gilmore. Here’s a summary of part of her argument:
California began to come apart during the world recession of 1973-75. After a false boom in the late 1970s, fueled by federal outlays that created jobs in both the military and aerospace industries and at the community level, California entered a new phase of political and economic restructuring in the early 1980s, during which time the bifurcation between rich and poor widened. While profits rose, capital’s need for infusions of investment dollars was increasingly met out of retained earnings. Deep reductions in well-waged urban jobs that had employed modestly educated men of color—especially African Americans and Chicanos—overlapped with changes in rural industrial processes and a long drought. These forces produced surpluses of capital, labor, and land, which the state, suffering a prolonged period of delegitimation, manifested in the taxpayers’ revolts, could not put back to work under its declining military Keynesian aegis. However, by renovating and making “critical already-existing activities,” power blocs in Sacramento and elsewhere did recombine these surpluses—and mixed them with the state’s aggressive capacity to act—by embarking on the biggest prison construction program in the history of the world.
The point is that as capital relocated in the 1970s, and automation made more and more workers redundant, and bad things happened to agriculture, and Pentagon funding shrank, etc., surpluses in land, labor, and capital developed. Since the Keynesian state that funded education and helped disadvantaged people was losing legitimacy (because of recessions, voters fed up with tax increases, conservative politics of “law and order,” and so forth) even as surpluses in land, people, and capital accumulated, the state turned to prison construction as a way to “legitimately” put surpluses to work. Financial capital was happy to lend to the state for prison construction (as for anything else, as long as it paid); politicians found it convenient to blame societal woes on drugs and crime; many voters were in the mood to crack down on those hooligans in Los Angeles and elsewhere who were ruining America; rural areas going through hard times welcomed new prisons because they could potentially create jobs and raise the value of land. Prison construction surely had an added benefit in that it didn’t necessitate the redistribution of wealth in a way that was unfavorable to elites, so it was politically “safe” in that regard. Just like military or “national security” spending. Criminal laws got tougher, in effect so that the expanding prison complex would have a raison d’être. For example, even though drug use declined in the 1980s, imprisonment of drug users increased. The “three strikes” law was also passed (in 1994), etc.
Now I’m reading the second edition of Barry Eichengreen’s Globalizing Capital: A History of the International Monetary System (2008). You probably know about the gold standard in the late nineteenth century; I won’t go over the history of how it came about. But I’ll discuss how it worked. David Hume’s price-specie flow model is still generally accepted, though it has to be modified in its particulars. Here are the essentials:
...Hume considered a world in which only gold coin circulated and the role of banks was negligible. Each time merchandise was exported, the exporter received payment in gold, which he took to the mint to have coined. Each time an importer purchased merchandise abroad, he made payment by exporting gold.
For a country with a trade deficit, the second set of transactions exceeded the first. It experienced a gold outflow, which set in motion a self-correcting chain of events. With less money (gold coin) circulating internally, prices fell in the deficit country. With more money (gold coin) circulating abroad, prices rose in the surplus country. The specie flow thereby produced a change in relative prices.
Imported goods having become more expensive, domestic residents would reduce their purchases of them. Foreigners, for whom imported goods had become less expensive, would be inclined to purchase more. The deficit country’s exports would rise, and its imports fall, until the trade imbalance was eliminated.
Modifying Hume’s analysis to take into account the circulation of paper money rather than (or in addition to) gold within each country doesn’t change its essentials.[1] The basic mechanism for adjusting relative prices and the balance of trade remains the same. (I guess it applies to any system of fixed exchange rates, right?) But it’s necessary to mention the role of central banks.
When a country ran a payments deficit and began losing gold, its central bank could intervene to speed up the adjustment of the money supply. By reducing the money supply, central bank intervention put downward pressure on prices and enhanced the competitiveness of domestic goods, eliminating the external deficit as effectively as a gold outflow. Extending [Hume’s] model to include a central bank that intervened to reinforce the impact of incipient gold flows on the domestic money supply thus could explain how external adjustment took place in the absence of substantial gold movements.
Typically, the instrument used was the discount rate. Banks and other financial intermediaries lent money to merchants for sixty or ninety days. The central bank could advance the bank that money immediately, in return for possession of the bill signed by the merchant and the payment of interest. Advancing the money was known as discounting the bill; the interest charged was the discount rate. Often, central banks offered to discount however many eligible bills were presented at the prevailing rate.... If the bank raised the rate and made discounting more expensive, fewer financial intermediaries would be inclined to present bills for discount and to obtain cash from the central bank. By manipulating its discount rate, the central bank could thereby affect the volume of domestic credit. It could increase or reduce the availability of credit to restore balance-of-payments equilibrium without requiring gold flows to take place. When a central bank anticipating gold losses raised its discount rate, reducing its holdings of domestic interest-bearing assets, cash was drained from the market. The money supply declined and external balance was restored without requiring actual gold outflows.
As it happens, central banks sometimes didn’t follow these rules about where to set the discount rate. Other considerations were important, such as the fact that raising interest rates to stem gold outflows might depress the economy. Also, “central banks hesitated to raise interest rates because doing so increased the cost to the government of servicing its debt.”
Let’s take a break for a minute. I want to answer some questions I have about exchange rates. The basic principle, I guess, at least for floating exchange rates, is that a country’s currency will rise in value if it is in demand—if there is excess demand relative to supply. It will decrease in value if there is excess supply relative to demand. A currency, therefore, is like any other commodity; it follows the laws of supply and demand. So, for example, if the U.S. Federal Reserve raises interest rates, foreign investors will exchange their own money for dollars in order to buy assets from the U.S. The international demand for dollars will thus increase, which will raise the value of dollars (just as the price of some product rises when demand for it does). Other currencies will lose value as investors exchange them for dollars. Conversely, lower interest rates tend to result in currency depreciation, because investors are less interested in assets denominated in that currency. So their demand for that currency declines, and its price falls.
Another factor that can influence exchange rates is the balance of payments. Let’s just think about the current account, as opposed to the capital account. According to a fairly reliable website, “A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country’s exchange rate until domestic goods and services are cheap enough for foreigners, [who then start buying more products from the country in question, which means that its currency is in greater demand, which raises its price, i.e. its exchange rate].” By the way, the balance of payments is related to the terms of trade. “If the price of a country’s exports rises by a greater rate than that of its imports, its terms of trade have improved. An improvement in terms of trade shows greater demand for the country’s exports,” and thus indicates greater demand for its currency (with which to buy exports), which means that its currency will appreciate. Conversely, “if the price of exports rises by a smaller rate than that of its imports, the currency’s value will decrease in relation to its trading partners.”
Now consider inflation. “As a general rule, a country with a consistently lower inflation rate [than other countries] exhibits a rising currency value, as its purchasing power increases relative to other currencies.... Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners.” In terms of demand and supply of currencies, I guess you could say that investors demand the low-inflation currency because when the assets they buy are paid off in the future, the real value of the money with which they’re paid will be relatively high. A country that has high inflation will pay its debt with money whose value is diminishing quickly. So investors will tend to shun that country, and its currency will depreciate.
Large-scale government debt, too, tends to cause currency depreciation, because it tends to cause inflation. The reason for this, I suppose, is that government spending increases aggregate demand, which encourages inflation. Also, the government might end up printing more money to pay its debt, which is of course inflationary.
But wait, according to another source, inflation can cause appreciation, at least in the short run. This is largely because when investors expect inflation, they expect that country’s central bank to raise interest rates in order to counteract the inflation.[2] [Similarly, high budget deficits can cause the cost of borrowing to rise--i.e., interest rates to rise--which means that the currency appreciates.] But even when investors don’t think the central bank is strongly committed to minimizing inflation, the country’s relatively low real interest rate “still creates some demand for its currency as global investors seek to do business there.” That is, the “other” kind of investors might want to borrow the country’s money (to do business there) because of low interest rates. In the long run, however, research shows that inflation does tend to reduce demand for the affected currency.
I also don’t have a clear understanding of foreign exchange reserves. Here’s a definition: they are “those external assets that are readily available to and controlled by monetary authorities for direct financing of payments imbalances, for indirectly regulating the magnitudes of imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes.” So, for example, if a country’s currency is depreciating, its central bank might artificially create demand for the currency by using some of its foreign exchange reserves to buy it. (That is, it releases foreign currency into the marketplace in exchange for domestic currency, which it takes out of circulation.) Similarly, “a central bank can intervene on the foreign exchange markets to prevent currency appreciation by selling its own currency for foreign currency-denominated assets, thereby building up its foreign reserves as a happy side effect.” This is what China has been doing, in order to boost its export economy.
Incidentally, it is called “sterilization” when a central bank mitigates the effects of foreign exchange interventions on its domestic money supply by buying or selling government bonds. For instance, taking some of its currency out of circulation (in order to defend its exchange rate) reduces the domestic money supply.[3] This will likely have a deflationary effect, slowing down economic activity. In order to prevent this outcome, the central bank will “sterilize” its foreign exchange intervention. “It can do this by engaging in open market operations that supply liquidity into the system, by buying financial assets such as local-currency-denominated bonds, using local currency as payment.” Thus it injects money into the domestic economy.
In the opposite case, when a country prevents its currency from appreciating by selling it for foreign assets, a similar sterilization can occur to prevent the domestic money supply from increasing. It’s true that the money “spent buying foreign assets initially goes to other countries, but then it soon finds its way back into the domestic economy as payment for exports. The expansion of the money supply can cause inflation, which can erode a nation's export competitiveness just as much as currency appreciation would.” So the central bank then sells bonds domestically, “thereby soaking up new cash that would otherwise circulate around the home economy.” Alternatively, reserve requirements for banks can be raised, which has the effect of preventing monetary expansion (because it means that banks have less money to lend out).
Anyway....back to the book. Before 1913, central banks were firmly committed to defending their country’s gold reserves and maintaining the currency’s convertibility (into gold). That was the highest priority. (Later in the twentieth century governments were pressured to subordinate currency stability to other objectives, such as high employment, but before World War I this wasn’t a problem. Labor parties were still in their formative years, the right to vote was mostly limited to men of property, and “the worker susceptible to unemployment when the central bank raised the discount rate had little opportunity to voice his objections....”) Investors’ knowledge of this caused them to act in ways that actually ended up stabilizing currencies—anticipating, as it were, central banks’ reactions to things like currency depreciations. “Knowing that the authorities would ultimately take whatever steps were needed to defend convertibility, investors shifted capital toward weak-currency countries, financing their deficits even when their central banks temporarily violated ‘the rules of the game.’”
The extent to which Europe’s central banks cooperated in pre-war times to help each other maintain gold reserves and defend their currencies during crises is impressive. It helps account for the relative stability of the system.
Until the late 1890s the gold standard was associated with deflation, and with economic hardship for farmers and workers. The Populist explanation is probably right: output worldwide was growing faster than the global gold stock. Money supplies finally started to grow only when new gold discoveries were made in Australia, South Africa, and Alaska, and when the cyanide process was invented to extract gold from impure ore. “The association of the gold standard with deflation dissolved.” The expansion of money supplies must have also played a role in the prosperity of the years before Word War I (or so it seems to me).
Here’s a good summary of what happened after the resurrection of the gold standard in the 1920s:
With the spread of unionism and the bureaucratization of labor markets, wages no longer responded to disturbances with their traditional speed. Negative disturbances gave rise to unemployment, intensifying the pressure on governments to react in ways that might jeopardize the monetary standard. Postwar governments were rendered more susceptible to this pressure by the extension of the franchise, the development of parliamentary labor parties, and the growth of social spending. None of the factors that had supported the prewar gold standard was to be taken for granted anymore.
The interwar gold standard, resurrected in the second half of the 1920s, consequently shared few of the merits of its prewar predecessor. With labor and commodity markets lacking their traditional flexibility, the new system could not easily accommodate shocks. With governments lacking insulation from pressure to stimulate growth and employment, the new regime lacked credibility. When the system was disturbed, financial capital that had once flowed in stabilizing directions took flight, transforming a limited disturbance into an economic and political crisis. The 1929 downturn that became the Great Depression reflected just such a process. Ultimately, the casualties included the gold standard itself.
A lesson drawn was the futility of attempting to turn the clock back. Bureaucratized labor relations, politicized monetary policymaking, and the other distinctive features of the twentieth-century environment were finally acknowledged as permanent. When the next effort was made, in the 1940s, to reconstruct the international monetary system, the new design featured greater exchange rate flexibility to accommodate shocks and restrictions on international capital flows to contain destabilizing speculation.
The first half of the 1920s was characterized mostly by floating exchange rates, which, given contentious political climates, were made unstable by volatile speculation. So Europe and much of the world returned to the gold standard, hoping greater stability would result. In the end, it didn’t work out that way. I’ll skip over the pre-Great Depression complexities—some countries having too much gold, others having too little, etc.—and focus on the 1930s. After the collapse of industrial production in 1929, governments “naturally wished to stimulate their moribund economies. But injecting credit and bringing down interest rates to encourage consumption and investment was inconsistent with maintenance of the gold standard. Additional credit meant additional demands for merchandise imports. Lower interest rates encouraged foreign investment. The reserve losses they produced raised fears of currency depreciation, prompting capital flight.” In short, expansionary initiatives and gold convertibility were incompatible.
Governments’ commitment to defending convertibility was no longer as credible as before World War I (because of the more politicized environment, workers and farmers having a greater capacity to influence the political process), so speculators were jittery. “As soon as speculators had reason to think that a government might expand domestic credit, even if doing so implied allowing the exchange rate to depreciate, they began selling its currency to avoid the capital losses that depreciation would entail.” Thus, they brought about what they feared: depreciation. Nevertheless, because central banks’ credibility was already in doubt, they “defended the gold parity to the bitter end” (so their credibility wouldn’t suffer even more). “Hence, the gold standard posed a binding constraint on intervention in support of the banking system.” International cooperation could have alleviated the problem, but it was prevented by the fact that governments had different interpretations of what the problem was. So, in the end, the gold standard collapsed.
First (in 1931) it was the Central European countries that abandoned the gold standard. Austrian and German banks had invested heavily in industry, so they were hit hard by the depression. Central banks couldn’t bail them out without causing a depreciation of the currency that effectively destroyed the gold standard, so this is what happened. Actually, currency depreciation didn’t go to hyperinflation extremes, because exchange controls (or capital controls) were implemented. (Capital controls are “regulations limiting the ability of firms or households to convert domestic currency into foreign exchange.”) These ensured that not much capital or gold was transferred abroad. Britain and other countries left the gold standard later in 1931, then the U.S. in 1933, etc. Floating exchange rates returned, but this time central banks managed them so that there was less volatility than in the early 1920s.
“Having severed the link with the gold standard, governments and central banks had greater freedom to pursue independent economic policies.” So they cut interest rates, initiated expansionary fiscal programs, etc. All this involved currency depreciation, which enhanced the competitiveness of goods produced domestically and stimulated exports (creating tensions with trading partners). “The timing of depreciation goes a long way toward explaining the timing of recovery. The early devaluation of the British pound helps to explain the fact that Britain’s recovery commenced in 1931. U.S. recovery coincided with the dollar’s devaluation in 1933. France’s late recovery was clearly linked to its unwillingness to devalue until 1936. The mechanism connecting devaluation and recovery was straightforward. Countries that allowed their currencies to depreciate expanded their money supplies. Depreciation removed the imperative of cutting government spending and raising taxes in order to defend the exchange rate. It removed the restraints that prevented countries from stabilizing their banking systems.”
Now for postwar events. The Bretton Woods system didn’t come fully into effect until the late 1950s, because of problems associated with Europe’s reconstruction. (Countries suffered from dollar shortages, they had to impose tariffs to encourage development, and so forth.) Some basic provisions of the system were that controls limited international capital flows—though less effectively by the 1960s—and currencies were pegged to the dollar, which was convertible to gold at $35 per ounce. So it was basically a regime of fixed (though adjustable) exchange rates. The problem with it was that it was too dependent on the dollar (and its conversion into gold).[4] As governments accumulated immense dollar reserves (which financed the U.S.’s increasing balance-of-payments deficits), the dollar’s convertibility into gold began to be called into question. A scenario became conceivable in which some foreign holders sought to convert all their dollar reserves into gold, thereby triggering the same behavior on the part of other holders worried about dollar devaluation. It would be like an old-fashioned run on the bank: everybody would want to get their gold out before the currency was devalued—thus forcing the currency to be devalued. Actually, for most or all of the 1960s it was recognized that the dollar was overvalued in terms of gold, but international cooperation and an array of ad hoc financial devices resorted to by the Kennedy and Johnson administrations postponed dollar devaluation (and/or an end to Bretton Woods). Again, the basic problem was that the U.S. refused to enact the policies needed to rectify persisting balance-of-payments deficits, for instance through devaluation or slashing government spending (in order to counteract inflation). Vietnam—and also the Great Society—was the problem, or a big part of it. The inevitable result was that investors transferred funds from the overvalued dollar to more reliable currencies like the deutsche mark. These trends became overwhelming in 1971, and in August it was reported that Great Britain and France planned to convert dollars into gold. So the Nixon administration abruptly ended the dollar’s convertibility. Subsequently the dollar was devalued, and in 1973 it was devalued again, but this didn’t reassure the market. (After all, it was perfectly conceivable that it would be devalued yet again.) So by 1973, most European countries had unpegged their currencies from the dollar and adopted floating exchange rates. This finally signaled the end of Bretton Woods.
The need for floating exchange rates was a consequence of the increasing mobility of capital. It got harder to maintain capital controls, which were necessary under Bretton Woods in light of the fact that governments tended to be unwilling to take the measures necessary to adjust balance-of-payments disequilibria (e.g. because there might be adverse implications for employment). Governments were even reluctant to devalue their currencies, because the merest hint that they were going to do so would provoke rampant speculation against their currencies. Actually, after Bretton Woods there were other alternatives to floating exchange rates: a region like Europe could move toward monetary union, which it eventually did. Or small, weak countries could make an absolute and uncompromising commitment to peg their currencies to those of a trading partner, thereby avoiding the destabilizing capital movements associated with floating exchange rates.
In terms of volatile exchange rates, the 1970s weren’t too bad. More volatile than Bretton Woods, but not as bad as the 1980s. The reason is that in the 1970s there was “more concerted intervention [by governments], more extensive use of capital controls, and greater willingness to adapt policies to the imperatives of the foreign-exchange markets” than in the 1980s. The latter decade is complicated, so....screw it. There was dollar overvaluation and then undervaluation into the 1990s. Bush and Clinton didn’t do much to counteract undervaluation. Why not? Because “an overvalued currency, like the dollar in the mid-1980s, imposes high costs on concentrated interests (producers of traded goods who find it difficult to compete internationally) who powerfully voice their objections. In contrast, an undervalued currency, like the dollar in the mid-1990s, imposes only modest costs on diffuse interests (consumers who experience higher inflation and import prices) who have little incentive to mobilize in opposition.”
I’ll skip Europe. As for developing countries, here are a couple of informative paragraphs:
Pegging [weak currencies to strong currencies] proved increasingly difficult to reconcile with the effort to liberalize financial markets. Developing countries had resorted to policies of import substitution and financial repression [i.e., anti-liberalization] in the wake of World War II. In Latin America, for example, where countries suffered enormously from the depression of the 1930s, the lesson drawn was the need to insulate the economy from the vagaries of international markets. Tariffs and capital controls were employed to segregate domestic and international transactions. Price controls, marketing boards, and financial restrictions were used to guide domestic development. The model worked well enough in the immediate aftermath of the war, when neither international trade nor international lending had yet recovered and a backlog of technology afforded ample opportunity for extensive growth. With time, however, interventionist policy was increasingly captured by special-interest groups. Trade and lending picked up, and the exhaustion of easy growth opportunities placed a premium on the flexibility afforded by the price system. As early as the 1960s, developing countries began to shift from import substitution and financial repression to export promotion and market liberalization.
The consequences were not unlike those experienced by the industrialized countries: as domestic markets were liberalized, international financial flows became more difficult to control. Maintaining capital controls became more onerous and disruptive. And with the increase in the number of commercial banks lending to developing countries, international capital movements grew in magnitude, making their management more troublesome. It became increasingly difficult to resist the pressure to allow the currency to appreciate when capital flowed in or to let the exchange rate depreciate to facilitate adjustment when capital flowed out.
As a consequence, more and more developing countries unpegged their exchange rates. The resultant volatility sometimes caused severe problems, though.
It seems to me that no option is very good: not ineluctable fixed rates, not fixed but adjustable rates, not completely floating rates, and not “managed floating” rates. And not monetary union, as the current crisis in Europe is showing. In the context of globalization, there are no good solutions. —But there were no “good” solutions under the pure gold standard either. Balance-of-payments adjustments were painful for the population. The problem, then, is capitalism itself, or maybe even the market system in whatever social context.
Last, I’ll say something about recent “global imbalances.” China and other countries in the South (“emerging markets”) have been growing at high rates, earning more than they could or would invest at home—i.e., their national savings have exceeded their investment—such that they have run current account surpluses. The U.S., on the other hand, has for many years had large current account deficits and very low savings rates. The emerging markets have chosen to invest most of their excess savings in the U.S., because by stockpiling dollar reserves they can keep their economies stable and growing. (Presumably the reasons are, first, that all this global demand for dollars keeps the dollar fairly strong, which lets U.S. consumers buy imports from these export-driven economies. Second—relatedly—stockpiling dollar reserves gives these countries the ability to manipulate their own exchange rates.) So, with the U.S. “absorbing the vast majority of [emerging markets’] excess savings, the result was a peculiar situation where savings in poor countries were financing consumption in one of the richest.” The poorer countries funnel money to the richer so that the latter can continue to buy products from the former. Strange.
Incidentally, I don’t really understand why U.S. saving has been so low in recent decades. I guess it has to do with low interest rates, which are in part a result of the Fed’s concern to keep the economy going. And this concern must exist because the corporate class war of recent decades has weakened aggregate demand, making the immense accumulation of debt a precondition for economic growth. To say it differently, households haven’t been able to save much probably just because they haven’t had enough income. And with all the financial bubbles, they’ve probably thought they didn’t have to save a lot but could borrow on the expectation of high future earnings.[5] As the last few years have shown, that plan didn’t work out so well.
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The Age of Diminished Expectations (1997), by Paul Krugman. A sort of primer on the U.S. economy. You have to take what Krugman says with a grain of salt, since he’s a mainstream economist, but if you sift through his arguments he can be useful.
“The slowdown of American productivity growth since the early 1970s [is] the most important single fact about our economy.[6].... Had productivity over the last 25 years grown as fast as it did for the first 70 years of this century, our living standards would now be at least 25 percent higher than they are.” Not exactly. Productivity growth has picked up in the last twenty years, but that hasn’t helped most of the population much. Why not? Because there’s no labor movement. [And because the government has abdicated its responsibility for popular well-being.] The corporate sector gets most of the gains from productivity growth—which gives it more resources with which to smash the labor movement, thereby making things even worse for the lower and middle classes.
(Just to be sure, I emailed those thoughts to the excellent left-wing economist Robert Pollin, who agreed with me.)
Krugman has no idea why productivity growth slowed down. But mainstream economists have a solution: we should all consume less now so that more resources are available for investment. Yes. Save more, spend less. That’s the answer. It’s brilliant, isn’t it? It doesn’t occur to these people that if consumption declines, companies won’t have much of an incentive to invest more. But that’s economists for you. [Well, the existence of global markets could presumably compensate, to some extent, for a shrinking of U.S. markets. But still: it's characteristic that economists focus on the supply side--more saving, etc.--rather than the demand side. Focusing on the latter, like Keynes and Marxists, wouldn't be sufficiently slavish to the capitalist class.]
Stuff on the U.S. trade deficit: One reason it’s a bad thing is that it implies a loss of jobs in manufacturing (because more imports are coming in than exports are going out). But it’s possible for that job loss to be made up elsewhere in the economy, for instance in the service sector. (What Krugman doesn’t mention, of course, is that service jobs, being harder to unionize, tend to be lower-paying. Krugman isn't very good at history or the nature of power relations, e.g. the importance of unions.) Another reason the trade deficit is bad is that it entails “a gradual mortgaging of future U.S. income to foreigners.” The reason is that the deficit has to be covered by our selling assets to foreigners, such as stocks, bonds, real estate, and even corporations themselves. Thus, our net international investment position has deteriorated from the early 1980s, when trade deficits started accumulating. “From now on, the U.S. will be obliged to deliver a stream of interest payments to foreign bondholders, rents to foreign landowners, and dividends to foreign stockholders.... Our payments to foreigners are a direct drain on our resources, and the longer the trade deficits continue, the larger this drain will become.”[7] Beautiful poetic justice: for almost two centuries the U.S. extracted surplus from other countries, but now, finally, those countries are starting to extract surplus from us. For now, it isn’t a huge problem; it may well become one, though. Especially if someday in the future the confidence of foreign investors in the U.S. is shaken and they abruptly sell off dollars and stop lending to us. Then an economic crisis might ensue, as it did in Latin America in the early 1980s.
I wouldn’t be terribly surprised if this is what happens eventually, decades from now. In that case, rapid inflation will occur (given the dollar’s depreciation), and the IMF, if it still exists, might have to bail us out on the condition of structural adjustment programs. What magnificent irony that would be! By the time it happens, though, the world will surely be in the midst of its generations-long evolution out of capitalism, and economic convulsions will be happening all over the place.
So why did trade deficits balloon in the 1980s? According to Krugman and other mainstream economists, it’s partly because of the ballooning budget deficit. (Hence the idea of the “twin deficits.”)
The basic story runs as follows: Beginning in 1981, U.S. national saving began to fall sharply. Only part of that fall was a result of the budget deficits [which soaked up private saving]—hence the need to qualify the “twin deficit” view a bit—while part of it represented a change in the behavior of households. In any case, what happened was that U.S. national saving began falling well short of U.S. investment demand, which remained strong. If the U.S. economy had not had access to world capital markets, this saving shortfall would have produced a crunch that pushed interest rates sky-high. Instead, the United States was able to turn to foreigners to fill the gap. Much of U.S. investment was financed, not out of our own savings, but through the sale of assets to foreigners.
As a matter of straightforward accounting, the United States always buys exactly as much as it sells from the rest of the world. If it sells foreigners more assets than it buys, it must correspondingly buy more goods than it sells. So the emergent U.S. dependence on foreign capital to finance its investment had as an inevitable counterpart the emergence of a trade deficit. The ultimate cause of the trade deficit therefore lies in a decline in U.S. saving—partly, but not entirely, due to the budget deficit.
I asked Pollin about that; he replied: “Krugman is right strictly in terms of accounting. But in terms of causation, he is wrong. I doubt that he himself would still hold to this position today. In terms of causation, the trade deficit is due to the rise of globalization—with manufactured goods getting produced in developing countries to a hugely growing extent. That, along with the high level of oil imports, swung the U.S. into a net deficit trade position.” It also must have to do with the decline in the competitiveness of American products in the 1970s and afterwards—their shoddy construction, etc.
I asked Dean Baker too; he wrote back, “My guess is that Krugman would no longer argue in the same way on the trade deficit. The proximate cause of the trade deficit is the over-valued dollar, that is what leads people to buy foreign goods rather than U.S.-made goods. It is pretty hard to come up with a story whereby the dollar would be appreciably lower today if the deficit fell or private savings rose, especially when you have governments like China committed to sustaining an over-valued dollar. I hope this is helpful.”
After discussing the crises in Mexico and Argentina in the 1990s, Krugman sums up a major problem with the world economy today: many countries are “vulnerable to what amounts to the whims of the capital markets. A country need not follow unsound policies to get in trouble; all that need happen is for investors to conclude, for whatever reason, that the country is at risk—and their loss of confidence will produce a crisis that justifies their fears.” That is, when they stampede to sell off the currency, it will depreciate precipitously; in order to keep capital in the country and prevent hyperinflation, the government will have to impose very high interest rates, which will depress the economy....thereby confirming investors’ fears about the economy’s stability! It’s a self-fulfilling prophecy. Behold the hazards of unregulated financial markets.
On the other hand, it is in part these deregulated markets that keep the world economy going, by means of bubbles that permit the extension of enormous credit to consumers and businesses.
Wolfgang Streeck remarks in his article “The Crises of Democratic Capitalism” (2011) that “democratic states [are] being turned into debt-collecting agencies on behalf of a global oligarchy of investors.” It’s the tyranny of the bondholder. For example, in Germany, “Populist rhetoric to the effect that perhaps creditors should also pay a share of the costs [of economic adjustment], as vented by [Angela Merkel] in early 2010, was quickly abandoned when ‘the markets’ expressed shock by slightly raising the rate of interest on new public debt.” Governments are quite afraid of that possibility: “Given the amount of debt carried by most states today, even minor increases in the rate of interest on government bonds can cause fiscal disaster.” Investors want austerity, so austerity is what they get. (Of course, the elite’s ideological obsession with cutting public spending plays a role too.)
[1] Of course paper money can circulate in a country that’s on the gold standard, as long as you can exchange a specified amount of paper money for a specified amount of gold. [2] The reason why higher interest rates reduce inflation is that they discourage borrowing and encourage consumers to save rather than spend. In other words, they reduce the money supply. [3] One way it does so is by creating or worsening a current account deficit “due to the propped-up exchange rate being more favorable for importers than for exporters. This deficit sends currency out of the country, further decreasing liquidity [i.e., the amount of local currency held by individuals, banks, etc.].” [4] Well, another problem was that mechanisms to adjust (or to force the adjusting of) balance-of-payments disequilibria were inadequate. These two problems cooperated to cause the downfall of the system. [5] Low interest rates come into play with these financial bubbles too. Eichengreen remarks, for example, that low rates fueled the housing boom. And “higher real estate prices made households feel wealthier,” so they took out more debt and spent more.
[6] That’s wrong. The most important fact is and was rising inequality. [7] [On the other hand, U.S.-owned assets abroad tend to be riskier and higher-yielding than foreign-owned assets in the U.S., so we still have a steady stream of income coming in to us from the outside. This is one of the perks of the dollar’s being the global reserve currency.]
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