Animal Spirits, Moral Hazard, and the Shadow of the Bretton Woods Conference: Clinton Adminstration International Economic Policy

J. Bradford DeLong

May 2001

Some preliminary thoughts for a joint paper with Barry Eichengreen, "Between Meltdown and Moral Hazard," on Clinton Administration international economic policy (note that many of the thoughts below aren't mine but Barry's--but I'm responsible for any you disagree with). We're going to be talking about this at 5 PM EDT on Wednesday, June 27, at Harvard's Kennedy School's ARCO Forum. Our discussants are Stanley Fischer, Allan Meltzer, and Larry Summers.

The full paper

International economic policy was at the center of the Clinton administration in a way that had not been true of any previous administration. Some of this was pure accident: the failure of President Clinton and the White House staff to put forward domestic initiatives (other than deficit reduction) that could win the support of the key middle third of the Senate. Some of this was the result of extraordinary opportunities and challenges posed by structural changes in the world economy: falling transport and communications costs raised the benefits--for developed and developing countries alike--of international trade; increased capital market integration raised the stakes at risk in the proper management of exchange rates and capital flows; and changing international economic structure demanded changes in international financial architecture so that future policymakers would find the opportunities easier to grasp, and the challenges easier to meet.

One way to view Clinton administration monetary and financial policies is that they were a total success. On the domestic side, deficit reduction created spaced for monetary ease which led to a high-investment recovery that ended the two decade-long productivity slowdown and to the longest, and one of the strongest, economic expansions in history. On the international side, strong U.S. demand served as a locomotive to boost growth in the rest of the world economy; the financial crises that struck the world in the 1990s did not lead to anything more than a transitory interruption of economic growth in any single country (except for Indonesia); largely successful international monetary and financial regulation supported the ongoing processes of growth and development that have now pulled more than four billion people past the take-off stage and onto the escalator that leads to modern industrial civilization; and reforms of the international financial architecture have given policymakers in the next few decades better tools and opportunities than the Clinton administration's policymakers had.

The story by which the 1990 Bush-Mitchell-Foley and 1993 Clinton-Mitchell-Foley deficit reduction packages broke the back of the Reagan-Baker deficits, allowed the Federal Reserve to reduce interest rates, and thus boosted the share of investment spending in GDP in the United States in the 1990s is well-known. The links between the investment boom and the rapid pace of productivity growth achieved in the United States in the 1990s are probable, but less certain. A large component of rapid productivity growth came from the technological revolutions in data processing and data communications. But such productivity growth does not fall from the air. It is built from the ground up as businesses slowly and methodically install and learn how to use the capital goods that embody the new revolutionary technologies. Budget deficits that raise interest rates discourage this process of investment, and increase the gap between the standard-installed and the innovative best-practice levels of technology. It is not clear how long the acceleration in United States productivity growth was delayed by the Reagan-Baker deficits in the 1980s. It is clear that productivity growth in the 1990s would have been significantly slower had the U.S. federal budget deficit remained high. Here the Clinton administration pursued good policies, and also got lucky as the economic payoff to deficit reduction turned out to be much larger than anyone had imagined.

On the international side, strong U.S. demand served as a locomotive to boost growth in the rest of the world economy. European policymakers spent the 1990s preparing for monetary union and trying to make sure that no single country was going to claim too much of the monetary union's debt capacity for its own uses. They paid little attention to managing aggregate demand to support worldwide growth. Japanese policymakers spent the 1990s trying to avoid embarrassing executives and organizations that had made bad choices and investments during the "bubble economy" of the late 1980s. They paid little attention even to managing aggregate demand to support their own growth. Only U.S. policymakers worried about the state of world demand, and they deserve credit for being willing to take the risk of allowing the U.S. trade deficit to grow--of making the U.S. the world's importer of last resort in the 1990s, and thus strengthening world growth.

A surprisingly large number of surprisingly virulent international financial crises struck the world economy in the 1990s. These crises came as a surprise because both economists' models at the start of the decade and a half-century of historical experience had taught that international financial crises arise when government can no longer sustain unsustainable policies. There are clear--although often ignored--warning signs of such unsustainability crises. When such an unsustainability crisis hits, the IMF appears to make a bridge loan with four purposes: (i) to allow the process of economic adjustment in the afflicted country to be longer and gentler so that the consequences in bankrupted enterprises and unemployed workers are not so dire, (ii) to allow time for a better political process to allocate the burden of adjustment across sectors and interest groups than would happen if the new policies had to be implemented overnight in a crisis, (iii) to provide advice to try to make sure that the new policies adopted are sustainable, and (iv) to make sure that the IMF gets paid back so it can lend its money out again the next time a crisis hits.

The Brazilian and Russian crises of the 1990s fit this pattern. The others do not. The collapse of the European Exchange Rate Mechanism in 1992, the capital flight from Mexico in 1994-1995, and the East Asian crisis of 1997-1998 all hit countries that had macroeconomic balance and were following sustainable policies. In each case there were structural weaknesses: in Europe, a political unwillingness on the part of countries to have their interest rates set (high) by the Bundesbank; in Mexico, a large overhang of dollar-denominated debt coupled with fears of political instability; and in East Asia, an overhang of dollar-denominated debt coupled with large numbers of non-performing loans and national systems of financial organization that made it hard for outsiders to determine what was really going on. But in each of these three cases the afflicted countries' sins against the gods of monetarism were small, but the punishment in terms of the magnitude of the crisis was large and swift.

Because these crises followed a different pattern, they blindsided policymakers in Washington D.C. when they hit. In the Mexican crisis, for example, policymakers in the year before it struck in December 1994 debated whether the Mexican peso was overvalued at all. The fundamental value of the Mexican peso depended on what the magnitude of the equilibrium long-term capital inflow to Mexico was. Almost all observers expected large long-term capital inflows to Mexico to resume after the election of August 1994 if Ernesto Zedillo won convincingly, won cleanly, and won without making bargains with the old-style barons of the PRI that ended reform. He did all these things. And so it came as a huge surprise when the inflow of capital to Mexico--the inflow that would have validated the then-current real exchange rate as in accord with fundamental values--did not appear.

Moreover, policymakers and observers in the year before the Mexican crisis--even Rudi Dornbusch--expected that any devaluation that might come would be relatively small, on the order of 20 percent or so, analogous to the devaluations in Europe in 1992. Such a devaluation does not pose significant macroeconomic or financial challenges. It was the--unexpected--magnitude of the crash of the peso that turned the Mexican situation into a severe crisis.

In the case of the Asian crisis of 1997-1998, there was more advance warning. IMF missions to Thailand had been advising the Thai government in ever more shrill voices to reform their economic policies before it was too late. But once again it was the magnitude of the exchange rate depreciation that came as a shock, and the interaction of depreciation with large unhedged foreign-currency borrowings that made East Asia in 1997-1998 into a major crisis.

Although these crises were unexpected, and although as a result the international policy response was hastily put together, nevertheless the handling of the crises was a success. It can be subject to criticism: too little attention early on to making sure that industrial core banks were "bailed in" to the process of solving the crisis, too much well-meant but inappropriate and perhaps irrelevant advice on how affected countries should reform their economies, too much of an interest in having the affected countries repay their loans too soon so that political victories could be declared, insufficient financial resources devoted to support packages, failure to recognize that financial reform should not be done piecemeal but in one fell swoop, and so on. But these criticisms are far less important than the fact that the IMF and the U.S. Treasury did make substantial loans to crisis-affected countries, that these loans did greatly ease the process of economic adjustment, and that largely as a result only one country--Indonesia--has found the crisis to be more than a short (albeit sharp) interruption in its economic growth.

Thus successful international monetary and financial regulation in the 1990s supported the ongoing processes of growth and development. Moreover, reforms of the international financial architecture have given policymakers in the next few decades better tools and opportunities than the Clinton administration's policymakers had. Compared to the problems caused by the dollar cycle and the Latin American debt crisis in the 1980s, or the problems caused by the oil shocks and the breakdown of the Bretton Woods system in the 1970s, the 1990s have to count as a very good decade--perhaps the best decade since before World War I.

From a second viewpoint, however, the story of the Clinton administration's international monetary and financial policies are of an administration blindsided by problems and crises that they should have seen coming. Worldwide disaster was avoided, but workers in Mexico, Korea, Indonesia, and elsewhere paid a heavy--and perhaps avoidable--price. The price that workers in crisis-hit countries paid was perhaps avoidable because the sources of the crises were not new. During the crises of the 1990s we were told of the dangers of fickle animal spirits in the industrial core causing destabilizing capital flows, of the vulnerability of international investment to crony capitalism, of how poor banking sector regulation in a country could generate an international financial crisis, and of how the existence of resources to provide support and rescue funds in a crisis could lead the private sector to hold imprudent portfolios that increased the risk to the system. But these were issues worried about by John Maynard Keynes's and Harry Dexter White's in their debates that culminated in the 1944 Bretton Woods agreement. Austria in 1931 provides a fine example of how poor banking sector regulation can generate a major international financial crisis. The work of Ragnar Nurkse in the early 1940s tells you all you need to know about destabilizing speculation in international currency markets.

It is not as though the major international policymakers of the 1990s had a blind faith that markets would always work well. U.S. Treasury Secretary Robert Rubin had spent his career at Goldman Sachs making money from the failure of the rest of the market to accurate value financial markets. U.S. Treasury Secretary Lawrence Summers had been a leading intellectual opponents of finance economists' casual reliance on the efficient markets hypothesis. IMF Principal Deputy Director Stanley Fischer had always in the classroom been able to draw on an extraordinarily broad knowledge of historical episodes to illustrate principles of monetary theory. And I know these men well enough to know that their judgment is better than mine, and I cannot think of anyone better qualified than they were--certainly their shoes are too big for me to fill.

So what is the answer? I think the answer is that everyone believed that the problems of the 1930s were well understood, and had been fixed. The existence of the IMF was the result of Keynes's and White's analysis of what had gone wrong in the 1930s--and the existence of the IMF was supposed to provide investors with confidence that crises would be succesfully handled, and that there was no need to run for the exits first and so cause the crisis. The increased thickness of financial markets was supposed to diminish the extent to which "herd behavior" could cause self-fulfilling attacks of optimism or pessimism. Sophisticated tools of financial management were supposed to make profit opportunities more visible. Yet sophisticated tools have sometimes simply made panic selling an automatic process. Better communications means that rumors can travel--and herd behavior arise--much more quickly today than when telegraph messages had to be delivered by messenger. And there is the fear of moral hazard--that successful handling of this crisis encourages financiers to hold portfolios that make the next crisis more likely.

So even though the forces that caused the crises of the 1990s were well-known to those of us who live in the shadow of the Bretton Woods conference, their strength and their speed still came as a surprise, and came close to overwhelming the institutional mechanisms to deal with them. So now one urgent task is to improve the international financial architecture so that it can deal with such larger-than-expected shocks. And a second is to improve on George Santayana's dictum: even though we remember the past, we may still have to repeat it.

Sign up for Brad Delong's (general) mailing list