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Economic Forces and Political Institutions

Jerry L. Jordan
President and Chief Executive Of ficer
Federal Reserve Bank of Cleveland

Address delivered to the
European Forum
Alpbach, Austria
August 31, 1993

I've subtitled my paper,

Economic Forces and

Political I n s t i t u t i o n s , and I need to spend a few
minutes defining these terms.

While I know that there

have be e n m a n y forces at work over the 2 0th c entury - ­
certai n ly political,

social and religious forces have

h el p e d shape the course of events for these h u n dr e d
years -- I'm going to focus only on those that I call
"economic forces".

These include technological changes

or innovations; p r od u c ti v it y increases; lower
information, transactions, transportation and
communications costs;
r ef e r re d to as

the phenomenon sometimes

downsizing; and, of special note, as

the ce n t ur y draws to a close, the true value added
r ising from kn o w le dge-based industries as o p posed to
resource e x ploitation activities.
In the 19th century and at the beginning of the
2 0th century, we tended to measure the wealth of
n a tions b y tons of things and numbers of things.
Basically, tons of iron ore, tons of coal, the numbers
of logs cut, tons of wheat, and so on, all tended to be
added up to make a statement about the so-called output
or w e a l t h of countries.

But, that is no longer


Instead, in today's world those things

p ro duced b y companies such as Microsoft, the world's
leader in software, and other human- ca p it a l -e n ha n c in g
enterprises are more important in determining the
relative well-b e i ng of nations.

In fact, we see some

of the most natural-resources rich places in the world

such as Brazil, Russia, and A frica -- are actually

quite poor, while the natural-resources po o r places of
the wo r ld --such as Japan-- sometimes are among the
most p r o s p e r o u s .
Let me turn now to political institutions.


going to define two different types because of the
different ways we use the word institutions.

First, is

organizations, such as ministries, bureaus,
departments, agencies, and central banks -international organizations,

as well as

such as the IMF, the W or l d

Bank, and the Bank for International Settlements.


the U n i t e d Nations and NATO could be put into this type
of grouping.

The second way we use the word political

institutions is rules -- meaning contracts, g en e rally
a cc e p t e d accounting principles,

labor laws, laws of

incorporation, the judicial system, and the enforcement




of p r o p e r t y rights.

Rules also includes various types

of economic controls, such as wage, price, credit,
interest rate, exchange, and capital controls, or even
m ar g i n requirements.

One would also include

restrictions on financial industries such as loan-loss
reserves, capital adequacy standards, debt limitations,
credit allocations,

leverage ratios, and so on.

Some of b o t h of these types of institutions -- the
o rg anizations that are created and the rules that are
laid down -- are intended to improve the workings of

However, some of both types of institutions -

or g a nizations and rules -- are also intended to

inhibit or alter the working of markets because the
b e n efits of intrusion are pe r c eived to be g r eater than
the costs.

That is the case when political/social

o bjectives seem to be more important than economic

Such objectives as income redist r ib u t io n -

- a political decision to give prior it y to sharing
wealth, rather than creating wealth -- result in
institutional arrangements that reduce the e f f ic i en c y
of markets.
I'm going to argue that some of what I call




economic forces constitute an irresistible f o r c p . while
some of the political institutions tend, over time, to
become immovable o b j e c t s .

Even those political

institutions that are intended to improve the workings
of markets and are designed to have a great deal of
inherent flexibility or adaptability,
immovable objects.

tend to become

A conjecture is that the degree to

w hi c h political institutions tend to become immovable
objects depends on the scope of government involvement
in the economy.

The size of government, m ea s u re d in

terms of government spending as a percent of GDP, m a y
reflect the scope of government involvement in resource
a ll o c at i on and control, but it is not sufficient as a
complete measure of intrusion of government in the
In a pure market economy,

there would be no

i nstitutions that we would call immovable objects.


the other hand, in a total command economy, all
institutions would take on the characteristics of
immovable objects.

However, they would prove not to be

immovable after all, in the face of the irresistible
e co nomic forces in a global economy.




The architects of new rules or organizations
u su a l ly un d e rs t a n d the need to create institutions that
are "living organisms" capable of adapting to changing

This is true not only of constitutions for

governing, but also of the various agencies of
government wi t h specific missions.
The Br etton Woods System established in the final
days of Wo r l d W ar II had built into it rules for
exchange rate adjustment.

However, there was an

a sy m m e t r y in the w ay the rules worked that p ro v ed to be
the r ig i di t y that caused the system to break, rather
than bend, in the face of specific economic forces.
M u c h of the h i s to r y of the 20th century reflects
what I think of as the "contest of ideas" — de m o cr a cy
and ca p it a l is m on one hand locked in a struggled with
d ic t a to r sh i p and socialism.

Essentially, it was a

contest for the minds of the people of the world as to
the best ways to organize economic affairs and the best
ways to organize political affairs.
In m a n y respects, especially from a U.S.
standpoint, there were two watershed decades of the
century: the 1930s and the 1980s.




In the 1930s,

during the world-wide economic depression, there was a
massive increase in the intrusion of government in
economic affairs.

If governments did not outright

n ationalize and d ir ectly control resources in a command
structure, then they set up regulatory agencies that
were d es i g ne d to decide what was to be produced, where
it was to be produced, how m u c h could be charged for
products, how mu c h could be p a i d to workers, or for
other inputs to production, what interest rates could
be charged, what interest rates could be paid, and so
The subsequent several decades after the 193 0s were
a p e r i o d in which the role of the nation-state in
economic affairs was large and tending to grow.


of the u nd e r ly i ng conceptual framework was based on
what I think of as the "stagnation thesis," as set
forth b y John Ma y nard Keynes in
the 1930s.

The General T heory in

That thesis is that even economies that are

b a s e d on private pr o p er t y and that rely on market
forces to allocate productive resources, tend to
stagnate at less than full potential in the absence of
g ov ernmental initiatives to cause growth.




In other

words, a view w i de l y held through much of the 2 0th
century, one that maybe even continues to be held today
b y a lot of people, is that governments cause growth,
and the so-called economic "policies" of government are
appropriate and ne c es s a ry for influencing economic
The rival conjecture from the 193 0s, which ha d little
following for most of this century, was the "inherent
r es i l ie n cy proposition" of Friedrich A. v on Hayek
and o ther economists of the Au s trian school.


view was that an economy that relies on a price system
to allocate resources in a market environment, relying
on pr i va t e p r op e r t y rights, tends to be inherently
resilient -- that is, it naturally gravitates toward
full u t i l i z a t i o n of its productive resources without
any government pump priming.

Whenever shocks of

v a rious types -- such as oil price increases,
droughts, wars, or perverse government policies -­
k nock the economy down, there is a general tendency to
start to grow again as the perverse effects of these
n eg a t iv e shocks tend to dissipate.
C ommon threads of the contest of ideas in the 2 0th




century have been:

(1) That political and economic

institutions tend to ossify or to r i g idify over time,
ma i n l y because these institutions, especially
organizations created by people and operated b y people,
become resistant to changes of the status quo;



fundamental economic forces -- technological
innovation, falling information and transaction costs,
increasing economies of scale and economies of scope of
production, globali z a ti o n of goods markets,
markets, and asset markets --


all lead to what is

called the "global village" or "borderless w o r l d " .


recent book b y W alter Wriston titled the "Twilight of
S o v e r e i g n t y ." expressed this view.
The main thesis is that, while the efficient-sized
market p la c e for m a n y goods and services at the
b e g i n n i n g of the 20th century was a small town,
village, or a province, increasingly, over the course
of the century, the size of the naturally efficient
market expanded to the point that even large countries
such as the Un i te d States find it increasingly
difficult to regulate or control various products or

That is because,


for many products and

8 -

services, the entire world has become the na t u r a l l y
efficient market, so the ability to regulate or control
depends on the ability of the nation-states to collude
in common regulation.

The Basle Ac c o r d of 12 countries

a greeing on capital standards for commercial banks is
one example of this.
The ultimate implication of the conflict be t ween
the irresistible forces that are of an economic nature,
confronting the political institutions that take on the
characteristics of immovable objects,

is that

institutions must change, or they will fail.

In other

words, there must be an effective political and
economic regeneration in which various institutional
arrangements, especially organizations, take on the
characteristics of living organisms -- that is, they
must be adaptable to a changing e n v i r o n m e n t .
Jo s ep h Schumpeter, another Austrian economist,


"the essential point to grasp is that in dealing with
c a p i t a l i s m we are dealing with an evolutionary process
. . . .

Capitalism, then, is b y nature, a form or

m e t h o d of economic change and not only never is, but
n e v e r can be, stationary."


9 -

Schumpeter's ob servation about c apitalism applies
equally well to all of the institutions that define the
parameters of our global economy.

Propelled by

technological change and chance economic events, these
institutions undergo a continual process of change.
Those qualities that enhance economic well-be i n g tend
to survive, and those that do not eventually disappear.
People develop institutions -- laws, rules,
conventions, and customs - - t o define and enforce
p r o p e r t y rights and, more generally, to reduce the
costs of economic exchange.

The various laws, rules,

conventions, and customs that define money, protect its
p u r c h a s i n g power, and govern its use, are examples of
such institutions.
Recent international moneta r y developments can be
e x p l a i ne d in terms of these general ideas about
institutional transformation.

What appear as conflicts

b e t w e e n global m o ne t a r y integration and regional
m o n e t a r y autonomy are artificial, resulting largely
from v e s t e d interests in maintaining local governmental
mo n op o l i e s over the issuance of the national media of

History demonstrates, however, that national




currencies inevitably compete in the international
financial arena.

Earlier in this century, the U.S.

dollar gr a d ua l ly replaced the British p o u n d as the
dominant global reserve currency and as the p r i m a r y
unit of account for international transactions.
F ollowing Hayek, approaches to international m o n e t a r y
relations that foster competition among alternative
c u r rency units are more likely to enhance world welfare
than systems like Bretton Woods that mandate change
di r ected b y supranational governmental bodies which
will tend to r i g idify or ossify over time.
U nlike most people, economists think of m o n e y as
m e r e l y an institutional convenience for g r eatly
r ed ucing the costs of transacting.

Overall, a stable

m o n e t a r y unit allows greater specialization in
p r o d u c t i o n and wider choices in trade, thus enhancing
the a ss o ci a t ed economic benefits.
B ui l d in g on these ideas, m an y economists and
politi c al scientists contend that extending the
g e o graphical area in which a common monet ar y unit is
u s e d w o u l d confer significant gains on the residents of
that area.

M o n e t a r y integration can take two




institutional forms:

The first is complete m o n e t a r y

union wi t h a common currency and a single central bank.
This is a l ready the case among the 50 U n it e d States and
among the 10 provinces of Canada.

And, it is the

ultimate objective of the European M o n e t a r y Union.
A second and weaker form of mo n e t a r y integration is
fixed exchange rates, such as experienced under the
gold standard or the Bretton Woods System, as well, of
course, as under the European Exchange Rate Mechanism.
The conditions u nder which the second form is viable
needs to be addressed.
A l t h o u g h a system of fixed-exchange rates could
confer significant benefits on participants in terms of
r ed u c ed transaction costs, it also imposes specific
costs in terms of international cooperation and
ma c ro e co n o mi c p ol i c y coordination.

The external value

of a national currency ultimately reflects the relative
internal purcha s in g power of that currency.

So, to

m a i n t a i n an exchange-rate, participants must coordinate
their mo n e t a r y policies to generate the same inflation

Mo n e ta r y sovereignty is incompatible with

fixed-exchange rates.

This is why inflation




convergence is so crucial.
U nd e r certain circumstances, however, the costs of
integrating m on e t ar y policies across countries can
exceed the benefits of having a common currency.
Countries are most likely to form a m on e ta r y u n io n with
other countries that share common economic conditions.
To u n d e r s t a n d the macroeconomic sources of the
conflict, consider the hi story of the Bretton Woods
The Allies established Bretton Woods in 1944 to
p ro mote rapid recovery among war-torn economies.


cooper a ti o n was seen as ne c essary to avoid the
competitive devaluations and trade restrictions of the
1930s, w h ic h m a n y economists believe contributed to the
s e v er i t y of the Great Depression.
In the late 1940s, Germany and Japan for instance,
h a d a common unit of account, or standard of value - ­
it was called the United States dollar.
gave it different names.

However, they

In Germany, one quarter of

the U.S. dollar was called a mark and in Japan, one
three h u nd r ed and sixtieth of a dollar was called a

The point is that the standard of value or unit




of account was not the same as the media of e x c h a n g e .
The latter are created or issued by governmental
authorities, but the former is the crucial d im e n s i o n of
a currency.

There never has been a Phoenix-like

c ur rency that arose from nowhere, unlinked to anything
of a c cepted value.
The B r etton Woods System required all p a r t i c i p a t i n g
countries to define a p a r it y for their currency against
the dollar and to m ai ntain the resulting fixed-dollar
exchange rate.

The U n it e d States, as the "anchor", or

"key", currency, defined and maintained a dollar p e g to
a fixed qu a nt i t y of gold.

The dollar then functioned

as a stable unit of account for the entire B r etton
Woods System.

The rules of the game required all

countries to adopt a monetary policy similar to that of
the U n i t e d States.

In other words, the Bretton Woods

S ys t e m implied reduced monetary autonomy for
p a r t i c i p a t i n g countries.
M y review of macroeconomic factors suggests that
m o n e t a r y integration is more likely to be successful

(1) All regions in a monetary union have similar

pr e fe r en c e s for inflation, reflecting similar




theoretical or conceptual views of m o n e t a r y policy, and
(2) All regions w ithin a mo n et a r y union experience
similar ma c roeconomic conditions.
While common responses to macroeconomic shocks are
a desirable condition to enhance the likely success of
m o n e t a r y integration, they are not necessary.


of the U ni t e d States often experience different
ma c ro e co n o mi c conditions, especially responses to
shocks such as energy-price changes, defense spending
increases or decreases, and so on.

What is crucial is

that other avenues for adjustment between regions are
available, so that exchange rate changes are not the

In the 1980s, we had what was called a b i ­

coastal economy, referring to b o o m conditions in
Califo r ni a and New England while we had depressed
conditions through m uc h of the middle part of the

Now, in the early 1990s, we once again have a

bi-coa s ta l economy with the opposite implications.
Namely, we have severely depressed economic conditions
in Ca l i fo r ni a and a continuing recession in New
England, while the Rocky Mountains and the midwest are,
by comparison, considerably stronger.




If it were not

for the political integration and the associa t e d hi g h
degree of resource m o bi l it y (investible capital
resources as well as labor resources)

then it w o u l d be

more tempting for various regions within the Un i t e d
States to contemplate devaluation of their currencies
in today's environment.

The severe three-year old

r ec e ssion in California might lead some to believe that
d ev a luing the California dollar against the Ohio
dollar, or against the Rocky Mountain dollar, w ou l d be
an attractive option.

But, because of political u n i t y

and resource mobility, this option is not under
The recent hi s to r y of our global mo n e t a r y systems
suggests that attempts to impose m o n etary integration
b y a fixed-exchange rate on a broad scale are not
likely to succeed.

In part, as I've argued, this

results because regions of the world that experience
disparate economic conditions and low resource m o b i l i t y
can adjust to economic shocks more efficiently by
a l l ow i n g their exchange rates to change.


m o n e t a r y integration cannot proceed in a credible
manner, even among regions in which it is feasible,




unless governments first adopt domestic institutions
that credibly assure their commitment to m a in t a in
domestic price stability.
H is t o r y teaches us that institutions,


those that determine the use of national currencies,
inevitably compete.

Th rough competition, efficient

w ea l t h - e n h a n c i n g institutional forms tend to emerge.
In the interest of fostering greater international
stabil i ty and integration, we should encourage such
institutional competition.

This requires, above all

else, the free movement of resources through the
e l i m i n a t io n of artificial restraints on the movement of
capital, goods, services, and labor.

This could

include the removal of any national legal tender laws
so that individuals could be assured of enforcement of
c ontracts w ri tten in any currency.

More likely, we

could urge that the various parliaments legislate
"specific performance" so that the courts will enforce
contracts denominated in any currency unit.


w o u l d enhance the rule of law across borders of n a t i o n ­
states .
Individuals would then hold their assets in




currency units that are most stable in terms of their
expected long-term purcha s i ng power.

A free flow of

resources w ou l d foster a convergence of institutional
forms across pa r t ic i pa t i ng governments as they compete
for these resources b y providing stable economic and
political environments.

Governments that fail to

p rovide such an environment will lose resources as
markets vote on policies.

The resulting convergence of

m o n e t a r y and fiscal regimes will achieve the highest
sustainable degree of mo n e ta r y stability.
W h e n some observers look at the centrifugal and
centripetal forces at work in various regions of the
world, there seems to be a conflict.

That is, w h en one

looks at the efforts under way to achieve European
Co m mu n i t y objectives -- economic integration, and,
maybe u l t i m a t e l y political integration among twelve or
more E u ropean nations -- in contrast with the political
and economic disintegration of the former Soviet Union,
it might appear that these trends are going in opposite

I do not think that that is the case.


common element in both developments is that, in the
case of Europe, the move toward political and economic




integration involves a v er y large n umber of specific
steps to reduce the role of the p ar t i ci p at i n g n a t i o n ­
states in economic affairs.

In other words,


consists of specific actions to improve the workings of
the m arkets w ithin Europe -- to strengthen p r o p e r t y
rights w it h i n Europe and to eliminate a whole host of
rules, regulations, barriers, and obstacles to the free
m o b i l i t y of goods, labor, and capital.
In the former Soviet Union, we see that political
and economic disintegration is a process of tearing
down the h i gh l y centralized command and control
socialist economy.

It is a process of searching for

ways to make markets flourish in the 15 or so republics
of the former Soviet Union, as well as in the eastern
E ur o p ea n countries of the former COMECON.

So, the move

towards economic/political integration in Europe and
di s in t e g r a t i o n in the former Soviet bloc b ot h involve
the t e aring down of previo us l y erected political
institutional arrangements that interfered with the
wo r kings of markets.
In this final decade of the 2 0th century,

it seems

that the clearest trend around the world is to reduce
- 19


the role of the nation-state in economic affairs.
Deregul a t io n and denationaliz a ti o n /p r iv a t iz a ti o n and
tax reduction and tax reform, are all part of a process
of "economic regeneration" --

to once again restore

the w e a l t h- c re a t in g capability of markets.


e sp e c ia l ly investment capital, move qu ickly to those
regions that are m aking the most progress, such as
t oday in Mexico, Argentina, or the Czech Republic - ­
while resources move away from those regions m ak i ng
little or no progress.

This competition of political

institutions -- b o t h of the organization type and the
rules type -- is a part of what I view as a v e r y
h e a l t h y process of reinstituting 19th century economic

The end result of it will be a m u c h

freer and mu c h more prosperous world.

The ultimate

a u t o n o m y is not that of nation-states, but that of

The goal of "economic integration" should

be to create institutions in which individuals are free
to choose.

- 20


Works Cited:
John Ma y n a r d Keynes, The G en era l T h e o r y o f Employment
I n t e r e s t and Money, (New York: Harcourt, Brace & World,
Inc.) 1935.
Jo s ep h A. Schumpeter, C a p i t a l i s m , S o c i a l i s m and
Dem ocracy, T h ir d Edition, (New York: Harper), 1950.
W a l t e r B. Wriston, The T w i l i g h t o f S o v e r e i g n t y : How t h e
I n f o r m a t i o n R e v o l u t i o n i s Trans f o x i n g Our W orld,
(New York: Charles Scribner's Sons), 1992.