Don't turn the world over to the bankers

Development financing, which had been influenced by the generous philosophies of John Maynard Keynes after the second world war, has been mistakenly returned to the commercial bankers in the past 20 years.

THE Bretton Woods Conference, in 1944 towards the end of the second world war, put in place the International Monetary Fund and the World Bank. The fame of John Maynard Keynes, after his far-reaching critique of the Versailles Treaty in 1919 (1), his theoretical revolution in the 1930s and his recommendations for policies against the great depression, had won him the leadership of the British delegation. As Robert Skidelsky (2) writes in his biography, Keynes there confronted a United States Treasury determined to impose on Great Britain (which was nearly bankrupt) a strict financial dependence. During the war President ranklin D Roosevelt had kept that wolf from the door by the Lend-Lease policy. But for the postwar period, larger and more enduring questions loomed. Keynes's effort to build a multilateral world financial order may yet be a source of inspiration for us.

Keynes sought a system for the postwar world in which great nations would not be obliged to place the meeting of commercial financial terms ahead of every goal of human social progress, including full employment. He sought a system of free trade that might co-exist with a generous and protective system of international financial institutions. A key feature of those would be creditor adjustment. Sanctions could be imposed on countries that ran trade surpluses, not on those that ran deficits. This would force the former to choose between accepting discrimination against their trade or expanding their domestic demand and absorption of imports. Meanwhile debtors would have access to an overdraft facility in an international clearing union, backed by the capacity to issue an international reserve currency (the bancor).

The Americans would not accept any such order. Their ideal was laissez-faire and the gold standard, in a world dominated as it then was by the crushing superiority of US manufacturing industry. An international financial facility representing debtor interests was as foreign to Wall Street thinking as a prison run by inmates. Debts contracted today are to be paid tomorrow. Postwar  inances were to be run by the rich. And so the Americans agreed to a dollar-based International Monetary Fund and World Bank on much more traditional lines than Keynes had hoped for, with some specific concessions to British interests. To this was added, in 1945, a US loan for Britain on terms Keynes found intolerably harsh.

In the course of time, two things happened to ease the situation for Britain. First, the cold war brought with it the Marshall Plan and a large, comparatively unstinting measure of material and financial relief. The Soviet military threat to Western Europe may have been (and indeed, was) overstated, but the Soviet economic and political models were far from discredited at this time. The Soviet challenge made rapid postwar reconstruction and the implementation of social democratic reforms indispensable (3).

In the US longer term transformation, based partly on the military but much more on the flowering over a generation of such New Deal and (later) Great Society (4) programmes as social security, Medicare, and support for housing, education and the credit markets, transformed household consumption and converted the US into a Keynesian locomotive for the rest of the world.
During this time, international convergence was a reality. The poor countries grew more rapidly than the rich.

But in the 1970s this system ended. The job of development finance was returned to the commercial banks. It took only a few years for them to prove Keynes had been right. By the 1980s, what the late Walt Rostow called the "barbaric counter-revolution"
was well under way. The entire system of development finance broke down, engulfing the developing world in waves of speculative instability and debt crisis. Twenty years on, that system remains unrepaired.

Brazil is an interesting case study. It is a country with some $250bn in debts, mostly owed in dollars to entities in the US, alongside an economy in deep recession and a trade surplus. The Keynes remedy, focusing on the recession and the surplus, would have been clear. For Brazil to expand, it should move toward full employment, and reduce its trade surplus, all financed by an issue of international reserves. Instead, today's IMF offers a $30bn loan, on the strict condition that domestic demand in Brazil continues to be repressed. This is not a loan for Brazil; it contributes nothing to its long-term prospects. It is simply a way to hold open the exits for existing creditors as their obligations mature and other opportunities permit them to cash out.

Moreover Brazil gets that much only because it is a large country with a grave debt load and a potentially threatening political left in the ascend ant. Argentina, where political currents remain undefined, gets much less, although during much of the 1990s it was widely celebrated as a model liberalising country, which Brazil was not (5). Substitute the name of Turkey, and the story is similar: a model liberaliser, overwhelmed by debts, and yet assisted only to the extent of its strategic importance and cooperation in the war with Iraq. The tragedy of financial liberalisation in Russia is too well known to require further comment (6).

Sad to say, the successful countries of the developing world are those like China (and there are few, if any, others even remotely like China) that have pursued mercantilist policies and detailed planning strategies throughout the era of globalisation. Whether China's prosperity will survive its recent commitments to liberalise under the WTO (if those commitments are met, which is always uncertain) remains to be seen. One may also mention India, an intermediate case which has at least maintained exchange and capital controls, and for this reason has enjoyed fairly steady if slow growth since the early 1980s.

And Europe? Here we see rising a curious project of monetary union, free trade and capital flow: an economic superstate. But it is married to a pre-Keynesian vision of its capacities and responsibilities. European countries are enjoined, under the stability and growth pact, to maintain small unified budget deficits almost at all costs, irrespective of either their rates of unemployment (except in an actual, and very steep, recession) or their investment needs. They and their private-sector companies and households are further enjoined by the European Central Bank to pay interest at whatever rates that central authority demands, for whatever purposes the bank may wish to pursue (under the charter, price stability above all other goals).

The governments of the poorer regions within Europe cannot isolate and industrialise, as China has done. Nor can they borrow to finance their own specialized contributions to European development, as every US state and city can and does do under a capital budget. Nor can they implement Keynesian mechanisms for macro-economic stabilisation and run a counter-cyclical budget policy except under extreme conditions. Nor can they devalue to protect the competitiveness of their industries. They are dependent on transfers from the community budget. These are large enough to make a material difference in the poorest regions, but too small to effect the macroeconomic stabilisation of large low-income regions, such as Spain and Greece in their entirety, let alone the vast new candidate- member regions of the East.

It is not an accident that convergence of Europe's less wealthy regions towards the incomes of its wealthiest regions has stopped. In the emerging European recession, these disparities are only likely to get worse. In today's Europe, as in the Atlantic Alliance of 1945, the creditors rule absolutely. And as Keynes feared in 1944-45, their rule is proving an economic disaster. 

The US has been able to overlook these issues and to remain relatively unaffected by them so far only for three reasons. First, the status of the dollar as the world's reserve currency has permitted the US to continue to live well despite having to run very high current account deficits at full employment and despite the vast decline in its industrial base since the new system got under way in the early 1970s. Second, the US has long enjoyed the status of a safe haven for financial investors fleeing crony capitalism, corruption and instability in other parts of the world, for some of which US financial and foreign policy have to be blamed.

Third, there has been the de facto continuing core Keynesianism of US domestic policy. This has three dimensions: the practical behaviour of the administration and Congress in slowdowns (they cut taxes), the practical behaviour of the Federal Reserve under similar conditions (it cuts interest rates without worrying too much about effect on prices), and a vast system of state support, mainly through unobtrusive credit guarantees and tax subsidies, for private consumption (notably in housing, medical care, education and pensions). This last is the US version of the "soft budget constraints" familiar to students of East European state socialism two decades ago.

But these US advantages may now be coming into question to some degree. The dollar's privileged status is unlikely to disappear soon. But neither is it an eternal gift, particularly given the emergence of the euro, the deepening crisis in Japan, and the disrepute into which US foreign policy has fallen. US asset markets no longer have a clean reputation, as the criminal penetration of US corporate life, the failures of the accounting profession, the decline in effective regulation and the collapse of the info-tech bubble all attest. The native Keynesianism of the US is also under threat, since too much devolution has left a large body of total social spending in the hands of states and localities, which face hard budget constraints and must cut sharply as their revenues
fall in the recession.

Should international wealth even begin to depart US shores, the deteriorated ability of the US to provide for its own needs will be exposed. There could be a big effect on US demand. This would soon be transmitted to the exports of countries that rely on the US market, and that will affect their ability to pay their debts. That in turn would affect the credit and reputation of US financial institutions, the bulwarks of international finance and the dollar system. The risk of a crisis arising from such a sequence is perhaps not imminent. But it is not negligible either.

The Iraq war opened with surging stock markets in psychological reaction to the release of tensions. But even if attention now turns to Syria (and to Lebanon), to North Korea, and to Iran, tensions will rise once again. Moreover the tensions may, soon enough, take on a nuclear dimension. This, given the reckless abandonment of collective security on nuclear issues now under way, could also begin to make the US look like less of a safe haven.

All of this raises a question. Is the position of the US today so very far removed from that of Britain in 1944-45? Do we not share a pattern of military over-commitment, weakened export capacity, a long but now threatened period of monetary hegemony, and illusions of indispensability on the world stage? 


To be sure, those who sit in the war councils of Washington today do not conceive the possibility that their empire is built on financial quicksand. Still, political change is possible even in the US. If the Bush war policy goes on from Iraq to the next places, a general disillusion with US war policy could set in, not only around the world but also within the US. We are not an especially martial population; our patience with military obligations is tightly related to their cost.

A wave of political change could, eventually, return the US military to the primarily defensive role that it would almost certainly prefer. It would make it possible for Americans to begin the reconstruction of our domestic economy along more peaceful lines, within a renewed framework of collective security arrangements. But this would also require that our capacity to mobilise resources not be constrained too much by considerations of international finance.

Thinking now about such a remote contingency may seem idle. But should such a thing happen, Americans, alongside the representatives of the rest of the world, will need the enlightened understanding of the citizens of the new centre of financial privilege. This will almost surely be on the continent of Europe.

The Europeans of that moment, if and when it comes, must not make the mistake that the Ameri cans made in 1945. They must not, as we did at that time, turn over the key decisions and the key institutions to people with the mentality of bankers.
* James K Galbraith is chair of Economists Allied for Arms Reduction, director of the University of Texas Inequality Project, chair in government/business relations at the Lyndon B Johnson School of Public Affairs at the University of Texas, Austin, and senior scholar at the Levy Economics Institute

(1) He was the representative of the British Exchequer at the Paris peace conference but resigned three days before the treaty was signed; he disagreed with the amounts of the reparations demanded of Germany, which he thought exorbitant, in his famous work The Economic Consequences of the Peace.

(2) Robert Skidelsky, John Maynard Keynes, Macmillan, London (3 volumes: 1983, 1992, 2000).

(3) See Eric Hobsbawm, Age of Extremes: the Short 20th Century, Michael Joseph, London 1994.

(4) The domestic policy programme initiated by President Lyndon Johnson in 1964.

(5) See Carlos Gabetta, "Argentina: IMF's show state revolts," Le Monde diplomatique, English language edition, January 2002.

(6) See Carine Clement, "Russia: the default option," Le Monde diplomatique, English language edition, February 2003.