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A / W <cfj < ?tj /(S k iH t M b '4 r /? * r f* < / a'f' ~th(j yettf*! tv*s AvftVtQ- ie, f r u i t <Ctt 1 f tf* J A U T O N O M Y AND INTEGRATION IN A GLOBAL F R AM EWORK 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 appropriate. 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. I'm 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. Even 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 - 2 - 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 markets. - 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 efficiency. 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 - 3 - 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 economy. In a pure market economy, there would be no i nstitutions that we would call immovable objects. On 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. - 4 - 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 conditions. 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. - 5 - 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 on. 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. Much 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. - 6 - 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 activity. 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. Their 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 - 7 - 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; (2) The 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 -- financial all lead to what is called the "global village" or "borderless w o r l d " . A 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 services. 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, said "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 exchange. History demonstrates, however, that national - 10 - 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 - 11 - 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 rates. Mo n e ta r y sovereignty is incompatible with fixed-exchange rates. This is why inflation - 12 - 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 System. The Allies established Bretton Woods in 1944 to p ro mote rapid recovery among war-torn economies. Close 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 yen. The point is that the standard of value or unit - 13 - 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 if: (1) All regions in a monetary union have similar pr e fe r en c e s for inflation, reflecting similar - 14 - 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. Regions 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 issue. 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 country. 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. - 15 - 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 consideration. 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. Furthermore, m o n e t a r y integration cannot proceed in a credible manner, even among regions in which it is feasible, - 16 - 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, including 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. This 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 - 17 - 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 directions. I do not think that that is the case. The common element in both developments is that, in the case of Europe, the move toward political and economic - 18 - 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, it 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. Resources, 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 liberalization. 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 individuals. 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. - 21 -