Efficiency and fragile speculative financial markets: against the Tobin tax and for a creditable market maker - Special Invited Issue: Money, Trust, Speculation and Social Justice - Part 3: Trust and Speculation

American Journal of Economics and Sociology, The, Oct, 1998 by Paul Davidson

I

Introduction

Since the oil price shock of 1973 and the Mexican threat of default in 1982, there have been recurrent problems in international monetary payments balances. The result has been reduced global rates of employment, output, and economic growth from those experienced during the previous Bretton Woods period until 1973. This is not to say that the pre-1973 period was not without economic problems. From hindsight, however, despite two Asiatic wars, this early postwar period appears to be much more tranquil and beneficial in terms of economic processes.

In large measure, the postwar international payments system until 1973 was shaped by Keynes' thesis that flexible exchange rates and free international capital mobility are incompatible with global full employment and rapid economic growth in an era of multilateral free trade. The Bretton Woods period was a golden age of economic development because both the international payments system, and domestic fiscal and monetary policies in most OECD nations followed (not always deliberately) the policy prescriptions suggested by Keynes' principle of effective demand (Davidson, 1994, ch 16). The resulting average real gross domestic product (GDP) per capita growth rate for OECD nations from 1950 to 1973 was almost double the peak annual growth rate of the industrializing nations during the Industrial Revolution, while labor productivity annual growth was almost triple that of the Industrial Revolution (Adelman, 1991, p. 17). Moreover, even the non-OECD nations, that is the less-developed countries (LDCs) had unprecedented increases in the GDP per capita.

The 1973 oil price shock was the event that broke the Bretton Woods golden age relationships. The drastic oil price increase created huge international payments imbalances and unleashed inflationary forces in oil consuming nations. The resulting economic dislocation placed policy makers in a difficult position. Without having to admit that they did not know what to do, policymakers threw away Keynes' effective demand model and opted for the 1960s classical monetarist anti-Keynesian theories to justify their abandonment of any attempt to constrain international financial flows and fix exchange rates. If anything went wrong under the classical "leave it to the market" approach, policy makers could argue that they could not be blamed - for after all, the market "knows" best.

The result was to make the exchange rate itself an object of speculation. With the removal of all restrictions on international capital flows in a world of flexible exchange rates, international financial transactions have grown thirty times as fast as the growth in international trade. Today, international financial flows dominate trade payments and exchange rate movements reflect changes in speculative positions rather than changes in trade patterns.

When the world changed from a fixed to a flexible exchange rate system, the annual growth rate in investment in plant and equipment in OECD nations fell from 6 percent (before 1973) to fewer than 3 percent (since 1973). Less investment growth means a slower economic growth rate in OECD nations (from 5.9 percent to 2.8 percent) while labor productivity growth declined even more dramatically (from 4.6 percent to 1.6 percent).

Since the 1970s, Nobel Prize winner James Tobin (1974) has been almost the only voice with significant visibility in the economics profession warning that free international financial markets with flexible exchange rates can have a "devastating impact on specific industries and whole economies" (Eichengreen, Tobin, and Wyplosz, 1995, p. 164). Tobin advocates that governments constrain international flows via a "Tobin tax." In the past year I have written several articles on why Tobin's assessment of the problem is correct, but why the "Tobin tax" solution is the wrong tool to solve the problem.

In this article, I want to raise another issue that is clear to the hearts of many of Keynes' followers - namely whether international (or domestic) financial markets are inherently fragile. Hy Minsky and I have attempted to build on Keynes' monetary theory of production. But there were several places where we disagreed. At the risk of grossly oversimplifying our disagreement, one might say that Minsky was essentially the pessimist who saw the financial market glass as half empty and fragile, while I have been characterized as the optimist who see the glass as half full and surprisingly strong. In these days of Asian contagion and Russian bears, however, we are haunted by the Minsky fragility syndrome and his frightening rhetorical question: "can 'it' happen again?"

Peter L. Bernstein is the author of the best-selling book on the history of probability theory and financial markets entitled Against The Gods. In a forthcoming article, Bernstein (1998) notes that since World War II "the number of stock markets around the world has grown from 50 to just over 125 - even the Chinese, nominally still socialists, have seen fit to establish stock markets on their territory." Accordingly, one might ask, if financial markets are so fragile, why have almost all economies of the global turned to using them? In one word the answer is, according to Bernstein, liquidity.