Globalisation and currency arrangements

In today’s blog, I continue the discussion that I started last Thursday, and, specifically, focus on the critique that commentators have made about the loss of state control of their economies as a result of globalisation. The thesis advanced by many analysts is that globalisation has reduced the capacity of the nation-state and forced governments to adopt free market policies at the microeconomic level and austerity at the macroeconomic level, for fear that capital flight will destroy their economies. It is a neatly packaged thesis that the political Left has imbibed, and, in doing so, has undermined the progressive basis of these institutions and left voters with little choice between right-wing parties and the social democratic parties who formally represented the interests of workers and acted as mediators in the class conflict between labour and capital. The major distinguishing feature these days between these two types of parties, who were previously poles apart in approach and mandate sought, is that the so-called progressive side of politics now claims it will implement austerity in a fairer way. These austerity-lite parties, buying into the myth that globalisation has undermined the capacity of the state to pursue full employment policies with equitable income distribution, do not challenge the basis of austerity, but just quibble over who should pay for it. The aim of this research which will appear in my next book (with co-author Thomas Fazi) is to outline a manifesto by which progressive activists and political movements can claim back the space the current generation of sham progressives have ceded to the neo-liberals.

The gold standard and beyond – constraints on sovereignty

The significant aspect of this research that is often lost these type of discussions is that the monetary system in most countries changed dramatically from August 1971 when the US president Richard Nixon abandoned US dollar-gold convertibility.

Prior to that, as part of the Post Second World War settlement, the majority of leading nations agreed in 1946 to create a fixed exchange rate system for all participating currencies.

The so-called Bretton Woods system was a modified gold standard, where convertibility to gold was abandoned and replaced by convertibility into the US dollar, reflecting the dominance of the US in world trade (and the fact that they won the war!).

This new system was built on the agreement that the US government would convert a USD into gold at $USD35 per ounce of gold. It was thought that this would provide the nominal anchor for the exchange rate system given the stability of the gold price.

Under the pure gold standard nations with sustained balance of payments deficits risked losing their entire gold stores to the surplus nations and were forced to engage in harsh domestic deflation to curb imports and attract capital flows (via higher interest rates).

The surplus nations who enjoyed gold inflows were meant to use the increased stock of gold to expand their money supply and thus stimulate their domestic economies and increase imports as a counterpart to monetary contractions in the deficit countries. The proponents of the system argued that these mutually reinforcing central bank actions would stabilise the system.

The reality was that the deficit nations were always forced to adjust as their gold reserves depleted but the surplus nations were under no pressure to meet their side of the bargain and so they just built up gold reserves unless their was a need to stimulate the domestic economy.

There were other institutional constraints on central banks (for example, required gold reserves, which limited the ‘free’ reserves available for currency stabilisation, and, restrictions on open market operations, which limited the scope of the banks to stimulate the domestic economies), which undermined these so-called ‘automatic’ balancing mechanisms.

The deflationary bias meant that deficit nations had to endure elevated levels of mass unemployment, which were politically difficult for nations to maintain and became a source of social instability.

Bernanke and James (1991: 33) argue that “Recent research on the causes of the Great Depression has laid much of the blame for that catastrophe on the doorstep of the international gold standard.”

Things came to a head in 1928 when the US central bank raised interest rates to quell the speculation in the share market and maintain its gold reserves. Romer (1993) argues that this act was the catalyst for the Great Depression.

France was also accumulating gold reserves as a result of balance of payments surpluses driven by a perception that it was secure nation to park surplus capital. The problem was that its government prevented it from expanding the money supply (via bond sales) and so it did not reduce the deflationary pressure on deficit nations (Eichengreen, 1986, Bernanke and James, 1991).

Temin (1989) described the way in which the policy positions of the US and France imparted a deflationary shock throughout the World economy because of the commitments by the central banks in other countries to maintain the gold standard (see also, Bernanke and James, 1991; Bernanke, 2004).

The classic constraint on governments existed, whereby any attempt by a single nation to reduce unemployment via easier monetary policy would be accompanied by further loss of gold reserves as capital flowed to higher interest rate nations.

It is also the case that “As with any system of fixed exchange rates, the gold standard was subject to speculative attack if investors doubted the ability of a country to maintain the value of its currency at the legally specified parity” (Bernanke, 2004).

As a result, the accelerating speculative currency attacks in the late 1920s demonstrated to many nations the unsustainability of the gold standard, which had created a deflationary bias in the world monetary system.

Britain abandoned the gold standard in 1931 after the “speculators attacked the British pound, presenting pounds to the Bank of England and demanding gold in return” (Bernanke, 2004). Thirteen other nations followed suit and left the gold standard.

The speculators then attacked the US dollar because they feared the failing US economy would force the central bank to devalue the currency. They wanted to avoid losses by converting into the more stable store of value – gold.

The US central bank ignored the pressure the speculative attacks were having on the banks (reductions in deposits) and raised interest rates in 1931 to shore up the dollar and stop the outflow of gold. The problem was that the domestic economy was in drastic need of stimulus and the monetary contraction exacerbated the situation.

Significantly, the nations that abandoned in 1931 resumed growth relatively quickly because their governments were not bound by the necessity to maintain deflationary domestic policy positions. In contradistinction, the Depression was deeper in nations that persisted with the gold standard, such as the US (Bernanke and James, 1991).

The US only began to recover when it abandoned the gold standard in 1933 and the new President stabilised the banking system and introduced fiscal expansion and job creation programs.

The mass unemployment and related social costs that accompanied the Great Depression not only convinced politicians that a return to the gold standard was unwise but made them receptive to a new framework for maintaining international monetary stability.

A key player in developing this new framework was John Maynard Keynes, who in several articles had questioned the sustainability of the pure gold standard.

Once World War 2 ended, focus turned to establishing this new system.

On May 23, 1944, the British House of Lords debated a “suitable foundation for further international consultation with a view to improved monetary co-operation after the war” (Hansard, vol 131 cc834).

Keynes then delivered a statement to the House where outlined the basis of the international monetary system that was proposed to replace the failed gold standard (Hansard, vol 131 cc 838-849). Central to the plan was the creation of an international Fund (which he called the International Clearing Union, which would have “substantial rights and duties to preserve orderly arrangements in matters such as exchange rates”.

He considered this a radical break from the rigid gold standard system, “relief from which we have rightly learnt to prize so highly”.

He said that the new system was “the exact opposite of” the gold standard. Under the proposed system Britain would “in consultation with the Fund” determine the parity that sterling would trade against gold.

In other words, there would be discretionary capacity for revaluation and devaluation in the system which would overcome the deflationary bias in the rigid gold standard system, whereby “the external value of a national currency is rigidly tied to a fixed quantity of gold which can only honourably be broken under force majeure; and it involves a financial policy which compels the internal value of the domestic currency to conform to this external value as fixed in terms of gold”.

These ideas were extremely influential in framing the British approach at the Bretton Woods Conference, which was held between July 1-22, 1944. The International Clearing Union was rejected by the Americans because it placed the adjustment burden on surplus nations, who would be charged interest if their trade surpluses and capital inflow exceeded some level.

The US, instead, proposed the creation of the International Monetary Fund (IMF) and required that the burden of adjustment for external imbalances remain firmly on the deficit and capital outflow nations – one of the major problems of the previous gold standard.

Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for more discussion on this point.

After World War II, the 44 allied nations agreed to return to a type of gold standard because they believed this would bring economic stability.

The so-called Bretton Woods system was established in July 1944 (and introduced in 1946) and required the central banks of participating nations to maintain their currencies at agreed fixed rates against the US dollar.

The newly created International Monetary Fund (IMF) was empowered (with contributions from the member states) to offer short-term funding to any nations that could not earn sufficient foreign currency reserves via trade to maintain the agreed exchange rate parities. The US government, in turn, agreed to convert US dollars into gold at a fixed price.

The system was under pressure from the start because countries with trade deficits always faced downward pressure on their currencies.

As in the previous system, in order to maintain their exchange rates they had to: buy their own currencies in the foreign exchange markets using their foreign currency reserves; push up domestic interest rates to attract capital inflow; and constrict government spending to restrain imports.

The nations with weaker currencies were thus often faced with recessed growth rates, higher unemployment, and depleted foreign reserves, and this created political instability. The effective operation of the system required the nations to have more or less similar trade strength, which was of course an impossibility and ultimately proved to be its undoing.

The use of the US dollar as a reserve currency also exposed the instability of the Bretton Woods system. The Belgian economist Robert Triffin warned in the early 1960s that the system required the US to run balance of payments deficits so that other nations, who used the US dollar as the dominant currency in international transactions, were able to acquire them.

In the 1950s, there had been an international shortage of US dollars available as nations recovered from the war and trade expanded.

But in the 1960s, the situation changed. Nations started to worry about the value of their growing US dollar reserve holdings and whether the US would continue to maintain gold convertibility.

These fears led nations to increasingly exercise their right to convert their US dollar holdings into gold, which significantly reduced the stock of US held gold reserves.

The so-called Triffin paradox was that the Bretton Woods system required the expansion of US dollars into world markets, which also undermined confidence in the dollar’s value and led to increased demands for convertibility back into gold. The loss of gold reserves further reinforced the view that the US dollar was overvalued and, eventually, the system would come unstuck (Triffin, 1960).

The way out of the dilemma was for the US to raise its interest rates and attract the dollars back into investments in US denominated financial assets.

But this would push the US economy into recession, which was politically unpalatable.

It was also increasingly inconsistent with other domestic developments (the War on Poverty) and the US foreign policy obsession with fighting communism, which was exemplified by the build up of NATO installations in Western Europe and the prosecution of the Vietnam War.

The US spending associated with the Vietnam War had overheated the domestic US economy and expanded US dollar liquidity in the world markets further.

The resulting inflation was then transmitted through the fixed exchange system to Europe and beyond because the increased trade deficits in the US became stimulatory trade surpluses in other nations. These other nations could not run an independent monetary policy because their central banks had to maintain the exchange parities under the Bretton Woods agreement.

Clearly, the fixed exchange rate system also restricted the scope for fiscal policy because monetary policy had to target the exchange parity. If the exchange rate was under attack (perhaps because of a balance of payments deficit) which would manifest as an excess supply of the currency in the foreign exchange markets, then the central bank had to intervene and buy up the local currency with its reserves of foreign currency (principally $USDs).

This meant that the domestic economy would contract (as the money supply fell) and unemployment would rise. Further, the stock of $USD reserves held by any particular bank was finite and so countries with weak trading positions were always subject to a recessionary bias in order to defend the agreed exchange parities.

Just like in the previous, rigid gold standard, the system was politically difficult to maintain because of the social instability arising from unemployment.

So if fiscal policy was used too aggressively to reduce unemployment, it would invoke a monetary contraction to defend the exchange rate as imports rose in response to the rising national income levels engendered by the fiscal expansion.

Ultimately, the primacy of monetary policy ruled because countries were bound by the Bretton Woods agreement to maintain the exchange rate parities.

Sure enough, the nation states could revalue or devalue (once off realignments) but this was frowned upon and not common.

Whichever system we want to talk off – pure gold standard or USD-convertible system backed by gold – the constraints on sovereign government were obvious.

Further, it is incorrect to think that the era of speculative capital flows began with the advent of transnational capitalism and global supply chains (globalisation).

These speculative attacks on currencies took a different form in the earlier period but were nonetheless destructive and, along with the persistent differences in trading position between nations, were the undoing of the fixed exchange rate system.

The growth of US multinationals

It is in this context, that we can better appreciate the early literature on globalisation and economic sovereignty loss.

In a Foreign Affairs article (October 1968) – Economic Sovereignty at Bay – was one of the earlier proponents of the view that the nation-state had lost its fiscal authority.

He later refined these ideas in his 1971 book, Sovereignty at Bay: The Multinational Spread of U.S. Enterprises.

Raymond Vernon argued that:

… as far as the advanced countries are concerned, the generalization holds: the pattern of coördination, consultation and commitment has evolved to such a point that freedom of economic action on the part of those nations is materially qualified.

He was referring to the creation of multi-lateral agreements regarding trade and exchange rate arrangements and agencies (such as the IMF) in this regard.

Note, he was writing before the Bretton Woods system of fixed exchange rates broke down in 1971. As we have seen above, the tenet that currency-issuing states were policy constrained under the Bretton Woods arrangements was perfectly true.

The central banks were responsible for setting domestic interest rates such that they could stabiise the exchange rate at the agreed parities. For nations with persistent trade deficits, this meant elevated interest rates and unemployment rates. That bias towards domestic recession was one of the principle reasons the system broke down in August 1971.

Expansionary fiscal policy was cautiously used because it risked pushing out imports and opening up trade deficits, which would then promote speculative movements in the currency as the anticipation of devaluation rose.

However, notwithstanding this, Vernon, also acknowledges that:

Nations still take it for granted that ‘the vital interests’ of any sovereign, as the sovereign perceives them, will take precedence over any international obligation.

And so it remains. But we need to establish that proposition.

There is no doubt that in the 1960s international trade grew rapidly as technological improvements in transport and communication were made. This was accompanied by a substantial increase in the volume of capital flows between nations, and, particularly, the growing presence of US industry in Europe.

Vernon writes that this growing US involvement through multinational enterprises created some fear that:

… as long as the multinational enterprise has the power, difficult or improbable though its use may sometimes be, to dry up technology or export technicians or drain off capital or reduce production or shift profits or alter prices or allocate export markets, there is a latent or active tension associated with its presence.

As we will see, these tensions persist today and are used as the basis for the claim that nation-states must compromise domestic policy to ensure they do not trigger a negative response from international capital and labour that is ‘parked’ within their borders.

Vernon also argued that the growing interdependency of economies through these trade and capital flow links meant that “whatever happens in any economy becomes the pressing business of all the others”.

However, this interdependence was significantly more constraining under the fixed exchange rate system, in which Vernon was writing.

After 1971, as nations began the new era of floating exchange rates, the constraints on domestic policy setting were clearly reduced because no longer was monetary policy tied to defending the agreed parity. The exchange rate would now adjust to imbalances in trade and financial flows, leaving fiscal and monetary policy, within limits, to pursue domestic objectives previously unattainable on a sustainable basis.

Vernon also suggested that the nature of international transactions became more complex with the advent of multinational enterprises, in the sense that, many financial flows were now conducted within the same enterprise but across national borders.

He concluded that “any state which senses an inadequacy in its capacity to impose effective restrictions at the border has ample reason for harboring that feeling”.

He argued that while governments could block flows for a short time, companies would develop new ways of shifting capital, which would leave “the regulating sovereign … increasingly at a disadvantage”.

Many commentators have used this line of reasoning to suggest that taxation bases are now unstable and can easily shift across national borders to exploit the most favourable tax regimes.

Governments in turn, worried about losing these enterprises, offer competing tax environments.

Mostly, the ‘tax shifting’ argument is used to demonstrate that the capacity of the government to spend is undermined as the tax base shifts. In order to overcome the limits imposed by a declining tax base, governments then have to run fiscal deficits, which, in the mainstream argument, push up interest rates, like the government with debt, and ultimately, lead to a refusal by bond markets to fund the government deficits.

These arguments are not really specific to concerns about globalisation because they are used to critique deficits under any circumstances.

As we will argue, much of this concern about tax shifting is misplaced when considering the options facing a currency-issuing government.

There is no question that a government that aims to achieve full utilisation of all of available productive resources in the nation and provide public goods and services to enhance the well-being of the population needs to be able to restrict the non-government use of the available resources.

Clearly this can be done through regulation or dictate, but, mostly it is done through taxation.

Taxation functions to promote offers from private individuals to government of goods and services in return for the necessary funds to extinguish the tax liabilities.

The orthodox conception is that taxation provides revenue to the government which it requires in order to spend. In fact, the reverse is the truth.

Government spending provides revenue to the non-government sector which then allows them to extinguish their taxation liabilities. So the funds necessary to pay the tax liabilities are provided to the non-government sector by government spending.

It follows that the imposition of the taxation liability creates a demand for the government currency in the non-government sector which allows the government to pursue its economic and social policy program.

This insight allows us to see another dimension of taxation which is lost in orthodox analysis.

Given that the non-government sector requires fiat currency to pay its taxation liabilities, in the first instance, the imposition of taxes (without a concomitant injection of spending) by design creates unemployment (people seeking paid work) in the non-government sector.

The unemployed or idle non-government resources can then be utilised through demand injections via government spending which amounts to a transfer of real goods and services from the non-government to the government sector.

In turn, this transfer facilitates the government’s socio-economics program.

While real resources are transferred from the non-government sector in the form of goods and services that are purchased by government, the motivation to supply these resources is sourced back to the need to acquire fiat currency to extinguish the tax liabilities.

Further, while real resources are transferred, the taxation provides no additional financial capacity to the government of issue.

Conceptualising the relationship between the government and non-government sectors in this way makes it clear that it is government spending that provides the paid work which eliminates the unemployment created by the taxes.

The point is that multinational corporations may be engaged daily in shifting revenue and costs across national borders in order to minimise their corporate tax liabilities under one regime relative to another.

That governments, as long as they can enforce the rule of law, have many options available to ensure they have sufficient taxing capacity to create the necessary real resource space to accommodate a public spending program.

We will deal with the generalised arguments against deficits later.

References

Bernanke, B.S. (2004) ‘Money, Gold, and the Great Depression’, Remarks by Governor Ben S. Bernanke
At the H. Parker Willis Lecture in Economic Policy, Washington and Lee University, Lexington, Virginia, March 2, 2004 – Link

Bernanke. B. and James, H. (1991) ‘ The Gold Standard, Deflation, and Financial Crisis in the Great Depression: An International Comparison’, in Hubbard, R.G. (ed.) Financial Markets and Financial Crises, Chicago: University of Chicago Press, 33-68

Eichengreen, B. (1986) ‘The Bank of France and the sterilization of gold, 1926-1932’, Explorations in Economic History 23, 56-84.

Romer, C. (1993) ‘The Nation in Depression’, Journal of Economic Perspectives, 7, 19-40.

Triffin, R. (1960) Gold and the Dollar Crisis: The Future of Convertibility, London, Oxford University Press.

Vernon, R. (1971) Sovereignty at Bay: The Multinational Spread of U.S. Enterprises, New York, Basic Books.

That is enough for today!

(c) Copyright 2016 William Mitchell. All Rights Reserved.