Wednesday, December 1, 2010

Politics Versus Economics

As you all know, FLG has got his time horizons theory -- liberals are relatively short-term focused, conservatives relatively long-term. Well, even before he had his time horizons theory for political dispositions, FLG had a theory regarding politics versus economics. He hasn't explored it, even in his own mind, as deeply, but it's one of those things that informs FLG's thinking on a lot of issues.

Basically, FLG views politics as short-term and economics as the long run. What he means by that is at the end of the day underlying financial and economic forces win out. So, policies aimed at mitigating the unpredictability of economic and financial forces, pretty much the central tenet of progressive economic policy, are bound to fail.

Now, the obvious response from anti-market, pro-government, or pro-regulation folks is to say markets fail too. That's true. But implicit in the market mechanism is an inherent fluctuation. Everybody knows that prices fluctuate with supply and demand. Sometimes there'll even be a huge swing. But it's all sort of baked in there. The very idea of government involvement is to take that fluctuation out of it, which creates a bunch of problematic assumptions and incentives if the policy cannot hold. And FLG questions whether these policies can hold over the long-term.

A bit of a digression here. Look at Social Security. Its entire goal is to take the unpredictability out of one portion of retirement funding. Yet, it's been rejiggered several times and will need to be rejiggered again. In this case, it's not specifically economic forces, but demographic ones, and what FLG calls the supposedly short-term has lasted three-quarters of a century. But there's something inherently different between a stock market fluctuation or even crash, which people don't like but sort of expect to happen at some point, and an "adjustment" of what was supposed to be insurance, in other words, a guarantee. In some important way, at least to FLG, each time it is readjusted is a failure of the policy. End of digression.

Anyway, a post over at LOG by Jon Rowe, on Chinese currency somewhat sparked this here post. Rowe writes:
We sell to China a lot more than they buy from us (the US for our foreign readers). They finance a lot of our debt. Hence they hold a lot of US dollars.

They are, therefore, rationally concerned about how much money we are printing to deal with our economic problems. And we in turn are also rationally concerned about how they artificially peg the value of the yuan against the dollar at a low rate so they can continue to sell us so many goods.

FLG hears a lot that China artificially pegs their currency to the dollar. Whenever FLG hears this he cringes a little bit. Look, there's this thing called a trillema in international economics, which states that a country cannot simultaneously have a fixed exchange rate, open capital account, and independent monetary policy. Given that a choice between the three, all of which are desirable, must be made it ends up as a political decision.

America has chosen a floating currency, open capital accounts, and an independent monetary policy. China has, at least in theory, chosen a fixed exchange rate, closed capital accounts, and an independent monetary policy. In practice, it's more of a fixed exchange rate, somewhat closed capital account, and not so independent monetary policy. These are legitimate political decisions.

Look, if you want to call China's currency peg artificial, then fine. But then so is the Fed setting interest rates. And as is implied by the defintion of the trilemma, setting interest rates affects the exchange rate. If interest rate parity holds, which it pretty much does, then managing the interest rate is somewhat akin to a soft peg or managed float. The Europeans, who have floating exchange rates (at least external to the monetary union), open capital accounts, and independent monetary policies are just as pissed about the Fed printing money because the dollar is falling because of it.

From a practical perspective, FLG finds the independent monetary policy choice superior because, as he mentioned earlier, he is concerned about guarantees. Pegging a currency is a long-term guarantee. Indeed, the implicit length of time for that peg is forever. Setting interest rates is not a long-term guarantee. On contrary, people try to decipher what the central bankers are thinking precisely because they have an exception that interest rates will change. FLG much prefers a dynamic system to a static one for long-term policy management.

In case any of you are interested, here's a short write-up FLG did when he took that PhD course on the political-economy of international finance last year:
Democracy and Globalized Capital

Barry Eichengreen begins Globalizing Capital by asking whether “democratization again came into conflict with economic liberalization?” In the second half of the 20th century, a shift in what economic outcomes were politically acceptable and preferable created difficulties when trying to reestablish a stable and predictable international financial system. Increases in political desire for full employment and sticky wages, the result of increased labor and worker preference representation in political institutions, complicated the job of policymakers in the international monetary system. The desires of democratic societies vis-à-vis the international economic system may ultimately be irreconcilable with economic reality.

The fundamental economic issue is the “trilemma” or “impossible trinity,” which states that a country cannot simultaneously have a fixed exchange rate, open capital account, and an independent monetary policy. According to Eichengreen, the gold standard emerged by historical accident, but was able to continue because policymakers were largely concerned only with maintaining the stability of their country’s convertibility to gold. Gold in turn acted as an international currency for balance-of-payments. This goal alone, stability of the currency, almost entirely determined interest rates. Therefore, the Bank of England did not have an independent monetary policy that could be used to pursue other goals, such as full employment, during the heyday of the gold standard.

Political norms have changed since then. Governments, and developed nations in particular, are far more concerned about the economic well-being of their average citizen. Furthermore, economics has conclusively determined that a link exists between interest rates, economic output, and inflation. Sacrificing an independent monetary policy on the altar of exchange rate stability is no longer a forgone political conclusion. Indeed, domestic goals, such as full employment and controlling inflation, often take precedent over international economic concerns. These domestic concerns then change the decisions made in light of the impossible trinity.
There are two broad issues relating to capital controls. First, are they politically desirable? Second, are they effective? Any combination of exchange rate regime, capital account liberalization or control, and monetary policy besides the trilemma is possible. Which combination chosen is determined by the domestic goals, not typically international ones. For example, in the 1990s, Argentina chose to shift to a currency board primarily to fight domestic inflation. The UK resists adopting the euro largely to retain an independent monetary policy for managing the British economy. These are political choices, not narrowly economic decisions.

Jagdish Bagawati objects to the Washington consensus idea that capital markets should always be open on economic grounds, but one of his major concerns is entirely political. He writes, “Besides suffering these economic setbacks, these countries have lost the political independence to run their economic policies as they deem fit.” According to Bagawati, the decision to impose or continue capital controls is an important sovereignty issue. Controls are a legitimate policy that a government may choose to pursue its economic ends. But that raises the question of whether controls are effective.

Rawi Abdelal and Laura Alfaro offer Malaysia as an example of capital controls that worked. Importantly, the impetus for the capital controls was political. The prime minister of Malaysia wished to replace the finance minister, who was liked by important international financial players, and expected a deleterious market reaction. Malaysia was also in a relatively comfortable economic condition compared to its Asian neighbors at the time. This led the authors to conclude that “governments can unilaterally control capital when they least need to.” In this case, the Malaysian government was not instituting capital controls directly as a result of a financial crisis or to stem economic pressure, but rather as an indirect result of a political desire to replace a key economic policymaker.
Both “A Pragmatic Approach to Capital Account Liberalization,” by Eswar Prasad and Raghuram Rajan, and a recent IMF report on capital controls reflect a softening of the Washington consensus’ strict opposition. Countries, under certain circumstances, can utilize capital controls to their benefit. Nevertheless, both papers raise serious issues.

First, capital controls are subject to capture by entrenched interests and corruption. This reconciles with Rajan and Zingales’ thesis that the availability of finance helps usurpers and hurts incumbents. Second, the competition from international finance appears to enhance domestic firms and institutions over the long run. Therefore, looking at the two previous issues together, long-term economic growth may be harmed by denying innovative new firms financing and insolating domestic financial firms from foreign competition. Lastly, there are international questions. If one country decides to control capital and benefits, then it may spur others to imitate it. This may lead to less internationalization at the systematic level.
If capital controls are a legitimate policy undertaken by countries to pursue their politically determined economic priorities, as Bagawati argues and others seem to increasingly agree with caveats, then the question becomes whether they are effective.

The evidence appears mixed. China has a closed capital account with surrender requirements, but has also been successful at attracting FDI. Malaysia was able to convince and cajole banks and firms into cooperating with its capital controls. Latin America provides the opposite example with black markets and various workarounds providing effective circumventions of the controls.

Where does this leave policymakers looking at capital account liberalization? Capital controls appear to be effective only when the government has strong control over financial firms and when there is not a tremendous pressure on the currency, almost precisely when capital controls are not needed. Trying to impose capital controls in the midst of a crisis which is when a government would most desire to do so, in an attempt to stem the consequences appears to be rather ineffective.

Policymakers are therefore caught in a bit of a catch-22. Democratic governments will probably feel pressure to liberalize capital accounts during good times to receive financing to fuel additional economic growth. This leads to pressure from investors to maintain a relatively fixed exchange rate so that they are not subject to exchange risk. Yet, these two cannot exist with an independent monetary policy directed toward the domestic economy. Policymakers need to make a medium- to long-term decision regarding whether it is in the best interest of their country to liberalize their capital account. It comes with both benefits and risks, but it is ultimately a political decision; a decision that ought to be made in a rational way while free from the pressures created by a panic.

Democracies face unique difficulties in making these types of decisions. Since the decision to liberalize capital accounts is primarily driven by domestic economic priorities, which change frequently due to shifting public sentiment or administration, democracies may have more difficulty creating a rational and coherent approach to solving the impossible trinity. At any given time there are interests lobbying for all three of the impossible simultaneous outcomes. Choosing when to change from a closed to open capital account and vice versa may be made with too much emphasis on the present economic circumstances and goals.

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