Journal Issue

Book: Reviews

International Monetary Fund. External Relations Dept.
Published Date:
December 2005
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A blueprint for a benevolent hegemon

C. Fred Bergsten and others

The United States and the World Economy

Foreign Economic Policy for the Next Decade

Institute for International Economics, Washington, D.C., 2005, 488 pp., $26.95 (cloth).

IN these days of flourishing antiglobalization propaganda, it is heartening to read a book resolutely committed to multilateralism and free trade. In contrast with the protectionist opposition, the authors rely on serious analysis and persuasive empirical evidence. Their advice focuses on the national interest of the United States, but also gives warranted consideration to the needs and concerns of other countries. The title promises a blueprint for U.S. foreign economic policy for the next decade. And this it fully delivers.

Fred Bergsten identifies three important challenges in the short run: the large current account deficit, the energy problem, and trade liberalization. The preoccupation with the current account imbalance centers on the possibility of a “hard landing” adjustment involving rising U.S. inflation and interest rates and a precipitous decline in the dollar. A similar warning was issued in the first half of the 1990s, but the dangers predicted at that time did not materialize. The appreciation of the dollar was reversed later in the decade, the U.S. external position improved, and the feared “disorderly crash of the dollar” never happened. To some extent this mirrored the reduction of the U.S. budget deficit. As Bergsten and Michael Mussa rightly observe, fiscal deficits absorb national saving, boost U.S. interest rates, and attract foreign saving. This was true in the 1980s and is even more true today. Nevertheless, the argument that foreign capital inflows reflect the U.S. position as an attractive haven for foreign investors may still be relevant.

The solutions recommended by Mussa are inescapable. The United States must cut its budget deficit, and its major partners must increase domestic demand relative to output. Moreover, China and other Asian countries must stop intervention to maintain overvalued exchange rates—which is in violation of their international obligations—and contribute to the international adjustment process. Somewhat less convincing are Bergsten’s calls for “exchange rate action,” including coordinated intervention and possibly “target zones.” Earlier attempts to fix exchange rates have been costly, and it does not seem logical to advocate nominal exchange rate rigidities for the now-floating advanced countries while condemning them in the case of China and other emerging market countries.

The second issue is the threat of rising fuel prices. Philip Verleger warns that current strains in world energy markets signal a “gathering storm” and require urgent action. The sources of these strains include the expansion of world demand stemming from the emergence of China and India as major importers, political instability in several producing countries, insufficient inventories, bottlenecks in transportation and refining, and insufficient conservation by consumers. The steep rise in fuel prices predicted by the author has already materialized and models project that further increases could seriously damage the U.S. economy.

Despots or democrats?

“DISCUSS the implications of the following three facts for Africa today. All high-income countries in the world today are democracies. It is not generally the case that higher incomes lead to more democracy. The dozen or so initially poor countries that sustained high growth since 1960, and which are most likely on the path to wealth, all started out with—at best—a limited degree of democracy.”

This is an exam question for undergraduate nightmares and, one hopes, a paradox that also keeps thoughtful policymakers awake at night. Should one provide the traditional answer—that development requires autocracy first and democracy only once incomes are higher? Or should one go for the more modern leap of faith—if you build it (democracy), they (the investors) will come (and the terrorists will leave)?

The Democracy Advantage is an eloquent and refreshing attempt to bolster the modern pro-democracy position. The authors provide strong arguments against the idea that autocracies are good for development in low-income countries. As they show, most autocracies (or dictatorships of any kind) do badly in terms of both average growth and ability to deal with crises. Even initially pro-growth autocrats tend to lapse into corruption and allow too much rent seeking and too little productive investment. Even the best autocrats, once they die, are followed by a deluge.

But the book is less convincing on the success cases since 1960 (many of which are in East Asia). To the authors’ credit, they tackle the issue head on—for example, in the context of China. But you really cannot have it both ways. If China has grown rapidly (which it most certainly has), this was not initially due to democracy, and it has not yet led to democracy. There is no reasonable way to avoid acknowledging this point.

What did China and other recent successes do? As the authors acknowledge, for the most part they focused on manufactured exports. One way or another (and there are as many varieties of this approach as there are countries), they encouraged the private sector (domestic or foreign) to manufacture first simple goods, paying low wages, and over time to move into higher value-added production, paying higher wages. At the same time, they built better economic institutions—for instance, courts and other ways of resolving disputes over contracts. They lowered barriers to entry throughout the economy, so smaller firms could set up as suppliers to the larger exporters. Some of them, it is true, developed democracy (and this is what the authors emphasize) but others did not. All of these countries developed a middle class that has shown a strong interest in further improvements in how the economy operates; at the same time, some of these middle classes do not seem very interested in democracy.

Morton H. Halperin, Joseph T. Siegle, and Michael M. Weinstein

The Democracy Advantage How Democracies Promote Prosperity and Peace

Taylor & Francis, Inc., 2004, 290 pp., $28.50 (cloth).

Returning to the exam question, what, then, are the implications for Africa? Many low-income African countries have become more democratic and, over the past decade, growth has improved. But, as the authors caution (in some chapters more than others), democracy per se is not sufficient. Beneath the surface, many new democracies have serious problems with their economic institutions, particularly manifest in high levels of corruption.

The authors’ assessment of history over the past 100 years or more in Latin America clearly shows that democracies are not only capable of collapsing under the weight of populism and mis-governance but also that “democracy” often turns out to be a sham. The authors know this and rightly emphasize the need for real democracy, with true accountability, and they have constructive proposals for how to monitor and support this. But since “free and fair elections” became more fashionable, elites have gotten much better at “managing” the electoral process (sadly, it turns out not to be too difficult). So should developed countries help by providing massive inflows of aid to poor and somewhat democratic countries? Would this strengthen the middle class, enable a boom in manufactured exports, and lead to better institutions, such as the rule of law? Buy the book and draw your own conclusions.

Simon Johnson

Assistant Director

IMF Research Department and Ronald A. Kurtz Professor at the Sloan School of Management, MIT

Verleger supports the idea of a U.S. gasoline tax, matched by a cut in other domestic taxes, to achieve a substantial reduction in demand. But he knows the political obstacles are high. Short of this, the United States could encourage inventory accumulation and the upgrading of refinery capacity and encourage substitution away from petroleum products. Most important, it should negotiate an international agreement to stabilize world prices.

The third issue is trade liberalization. Scott Bradford, Paul Grieco, and Gary Hufbauer state that the United States has benefited greatly from globalization in the area of trade. This statement is consistent with the consensus among economists that trade fosters efficiency, exploits economies of scale, and helps to spread technological innovations. It is also supported by an impressive array of empirical evidence. The postwar gains from trade liberalization are estimated at $1 trillion for the world as a whole and $600 billion (5 percent of GDP) for the United States.

Very large gains can also be expected from future trade liberalization, notably in services and agriculture. Both of these areas are of particular importance to the United States, and agriculture is, of course, of special concern to developing countries. But further trade liberalization will require strong U.S. leadership. Congress will have to extend Trade Promotion Authority so that the Doha Round of trade negotiations can succeed, and reauthorize U.S. membership in the World Trade Organization. The United States will also have to resist domestic protectionist pressure—by explaining clearly the benefits of trade liberalization and by providing more generous assistance to those who bear the costs of globalization (even if they are relatively few compared with those who will gain from it).

Finally, the book looks at a number of other important policy challenges. Jan Boyer and Edwin Truman analyze the rising importance of the large emerging market economies—including Brazil, China, India, and Russia—and suggest a cooperative approach to addressing this development, including better representation of these countries in the international financial institutions. Other contributions deal with developing countries, the international monetary system, and the problems of U.S. immigration policy. All the authors offer thorough analysis and constructive advice. This book is essential reading for anyone interested in international policy.

Ernesto Hernandez-Cata School of Advanced International Studies Johns Hopkins University

Slowing the rush for the door

John Williamson

Curbing the Boom-Bust Cycle Stabilizing Capital Flows to Emerging Markets

Institute for International Economics, Washington, D.C., 2005, 126 pp., $22.95 (paperback).

JOHN Williamson’s book provides a first-rate analysis of the causes and effects of volatile capital flows to emerging markets. He argues that volatile capital flows have on the whole had a highly negative impact on the economic development of emerging markets. Since the early 1970s, periods of “excessive” capital inflows have contributed to overvalued exchange rates, slow growth, and repeated boom-bust cycles. And the balance of payments and banking crises that often accompany sudden stops in inflows have not only resulted in severe recessions in emerging markets but have also imposed large losses on investors and lenders in mature markets.

So why shouldn’t emerging market countries simply prohibit capital flows? Williamson insists that there is no completely effective way of stopping capital flows for an extended period. Moreover, countries shouldn’t forget that there are benefits associated with an open capital account. First, inflows may boost overall investment by making domestic investment less dependent on domestic savings. What is troubling, however, is that emerging markets as a group have become net capital exporters rather than importers. Second, capital inflows can help smooth consumption in the face of output fluctuations. But because emerging markets hit by shocks often lose market access, he does not think of consumption smoothing as a major welfare gain either. Third, capital inflows and outflows can help residents reduce risk by diversifing portfolios. Finally, capital inflows, if they take the form of foreign direct investment (FDI), may enable the country to engage in new activities by creating access to intellectual property rights and new financial services and products.

Minimizing volatility

What can countries do if they want to benefit from a more open capital account yet minimize the cost associated with volatility? Williamson suggests that overall volatility may be reduced by shifting the composition of capital flows from loans to equity and, within equity, from portfolio investments to FDI. As for debt issuance, he strongly favors emerging markets denominating much of their borrowing in their own currencies. Private firms in emerging markets should also be discouraged from issuing foreign currency-denominated debt since currency mismatches aggravate crises.

To further reduce the risk of currency mismatch, multilateral development banks should change their lending practices by borrowing in a synthetic currency whose value would be defined by a basket of emerging market currencies. The banks could then avoid currency exposure by lending to emerging markets in their own currencies. And commercial banks everywhere should be required to provision on the basis of historical experience with loan defaults.

Countries must do their bit

While Williamson thinks these measures will moderate the volatility of capital flows, he acknowledges that they will not end the boom-bust cycles. Emerging markets should thus implement policies that make them more resilient to volatility. First, public debt should be reduced to a level that allows for fiscal expansion during a recession and a countercyclical monetary policy. Second, countries should avoid overvalued exchange rates—leaving enough exchange rate flexibility to give borrowers an incentive to avoid currency mismatches. Third, governments should develop local government and corporate bond markets. Fourth, they should retain the right to use capital controls during periods of large-scale capital inflows.

While all these proposals make sense, some are more likely to be implemented than others. Williamson himself suggests that priority be given to a switch in lending practices by multilateral development banks, and that emerging markets begin issuing debt in domestic currency local bonds and GDP-linked international bonds.

Would these measures significantly reduce volatility? While I think they could help during “normal” periods, they would not fundamentally eliminate the incentives for international investors to be “first out the door” during crises. For households and the corporate sector, bankruptcy systems provide rules for the timely recovery of resources, and thus help prevent defaults from becoming overly disruptive. But when a shock hits an emerging market, the incentives to be first out the door are magnified by the perception that emerging market bankruptcy systems are slow, biased against creditors, and, in some cases, corrupt. The situation for emerging market sovereigns is even starker: there are no bankruptcy systems.

As a result, when a country fails to service its debt, it must either restructure or default. In my view, while Williamson’s policy recommendations would help mitigate the incentive to be first out the door, they do not fully make up for the absence of international bankruptcy procedures.

Donald Mathieson

Former Division Chief in the IMF’s International Capital Markets Dept.

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