Is capitalism heading for breakdown?
News Analysis: George Soros's new book says that speculators threaten to destabilise the world economy
Wednesday 02 December 1998
When someone who has benefited to the tune of billions of dollars from the financial markets says that destabilising speculation threatens a complete breakdown of the capitalist system - which has delivered such amazing advances in prosperity over the past five decades - it is worth paying attention. Certainly, opponents of free market economics have hailed Mr Soros's recantation with glee. But is there analytical substance behind the emotional gloss of the Soros critique?
Financial markets have always been prone to crises. Human nature seems to contain a herd instinct, and besides, it can be rational for investors to create a bubble so long as they are confident about getting out before it bursts.
There is nothing inherently damaging about such self-fulfiling speculation. Indeed, in his Tract on Monetary Reform, John Maynard Keynes - usually quoted for his condemnation of "casino capitalism" - emphasises the importance of speculators to healthy capital markets. Speculators provide liquidity and reinforce existing trends rather than bucking them, he argued. The speculation has to have something to feed on in the first place.
Even so, the financial markets have clearly been a destabilising force in the world economy since the Asian crisis first erupted in July 1997. It raises the question of whether, as capital flows have grown larger and more footloose, the speculative froth has reached unacceptable proportions. In particular, would it be sensible to reintroduce capital controls, which have been steadily dismantled over the past three decades?
Although some economists - notably Paul Krugman of the Massachusetts Institute of Technology - think there is a good case for capital controls, Mr Soros is clearly against them "Capital controls are an invitation for evasion, corruption and the abuse of power," he writes.
Certainly, the first regime to reach for controls, post-crisis, was the authoritarian Malaysian government. Meanwhile Chile, which did have restrictions on capital inflows, has recently lifted them. Exchange controls were effective after the war, when so much economic activity was subject to planning and restriction, but by the early 1970s they were all but useless. So, while one lesson of the Asian crisis is that developing countries should liberalise slowly and cautiously, it must not be forgotten that there were good reasons for the abolition of capital controls in the first place.
But if this type of restriction is not the answer, what can be done? Mr Soros concludes that there should be international financial regulation, but not by the International Monetary Fund. The IMF is part of the problem, he says. Rather, he puts the onus on the Group of Seven countries but concludes that the prospects of the G7 taking effective action are dim as it has not yet intervened in Russia.
However, it is difficult to see the G7 as the right vehicle for international financial management, important as it might be in the case of a large and politically important country such as Russia. Apart from anything else the G7 itself is in flux, with the introduction of the euro in January likely to see the rapid emergence of a G3. In addition, the biggest countries cannot practically be involved in overseeing all of the rest of the world, which is why the IMF and other such bodies exist.
In the end, it is not the institutional arrangements that matter. If the IMF did not exist, there would be calls for its creation after this year's crisis. The two key problems are whether the response to financial market turbulence should include genuine international co-ordination through the creation of a worldwide lender-of-last-resort, and what sort of exchange rate regime should exist.
As Mr Soros knows, fixed exchange rates can easily become sitting ducks for speculators. They are sustainable only if the countries locking their currencies to another are prepared to adjust their domestic economic policies for the sake of the exchange rate. The gold standard survived only as long as they were. But the UK in 1992 was not prepared to match its macroeconomic policy to Germany's, and the pound's exchange rate mechanism link was doomed.
The only viable alternatives in a world of huge capital flows are freely floating exchange rates and currency union. Europe has opted for the latter. If the rest of the world is stuck with floating rates, how can governments hope to counter the instability of the financial markets?
One solution is to have perfect domestic policies at all times, giving speculators nothing to run against. But this is a touch utopian - even if they all had first-rate policy makers, economies are buffeted by all sorts of shocks.
Another would be to create a genuine international authority with the task of stabilising the world economy and markets. At present the work of adjusting to crisis is forced on to a combination of the IMF and national central banks.
The IMF, which has meagre resources, effectively bails out banks that face the risk of default by a borrower by providing liquidity to the borrower, while national central banks bail them out by providing liquidity to the lender within their own boundaries if there looks to be a serious threat to the domestic banking system.
Perhaps the creation of an international lender of last resort would be preferable to this messy ad hoc response. Mr Soros seems to think some such source of finance is needed to resolve the crisis in the markets he helped destabilise. So, too, do some G7 officials. But the proposal is controversial.
Others believe that lending to borrowers in emerging markets is a risky business whose risk should fall directly on the speculators themselves - not least Soros Fund Management.
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