John O. Ifediora.
The 2008 recession was the first time since the great depression of the 1930s that developed nations, as a collectivity, felt the full effect of the medicine they have been prescribing to developing nations; and like the former recipients, they did not care much for it. The financial meltdown that began from the housing market bubble in the US, and spread to the industrialized world in quick succession laid bare the fundamental weaknesses of free and unregulated capital market, and international trade. Developing nations were spared the anguish, but for how long? But a decidedly relevant question is why the economic downturn was more remarkable in developed economies, and less so for developing ones? Are we to assume that developing nations are relatively immune from financial and economic crises as a result of prudent macroeconomic policies they designed for their respective national economies or is it due to the infancy of their financial sectors, and credit-market isolation from the industrialized world?
In this paper, I intend to show that the economic world order devised by developed nations and set in motion since the mid 1980s is based on two different economic platforms each designed to address the respective needs of the world community of nations; one to accommodate macroeconomic policy needs of developed and donor nations, the other for developing ones, and aid recipients. I propose to use two policy-initiatives devised by developed nations and their multinational surrogates to spur global economic integration, and guide developing nations out of poverty to make my case. Specifically, my discussion would point to the neo-liberal policies of deregulation of capital markets, and free international trade as advanced by rich nations, and implemented by the ‘Unholy Trinity’ of the IMF, the World Bank and the WTO as the source of past and current global financial crises, and the primary reason for the abysmal economic realities extant in developing nations in Sub-Saharan Africa. Since the goals of sensible macroeconomic policies (monetary and fiscal policies) are stability and growth, it would be shown that neo-liberal policies in this regard have been catastrophic, and need to be modified, especially in light of their impact on the economies of developing countries.
Introduction
At the outset, a brief review of the current infrastructure of the global financial system is in order. The past thirty years of globalization effort by the developed world has seen incredible growth in capital flows engendered by progressive deregulations of capital account transactions, the drive to boost global investment through a combined strategy of price stability and high interest rate, and a strong agenda by the WTO to lift all remaining restrictions on foreign direct investment, and tariffs. On the upside, this neo-liberal push for deregulation and liberalization of trade and capital flows have the capacity to enhance domestic growth in recipient countries through relatively easy access to foreign funds that could be utilized to establish and expand the host country’s industrial capacity. But there is a catch; an untargeted and free flow of foreign capital could be a major source of financial crises that has the remarkable potential to destabilize a national economy and impede economic growth. More on this in due course.
For a better appreciation of how trade deregulation and liberalization of capital accounts affect national economies and the global financial system, a brief look at the constituent parts of a country’s balance of payment account is useful. A country’s Balance of Payment (BOP) account consists of two sub-accounts: current account, and capital account. The current account primarily records recurring economic transactions, trade in goods and services, and fund transfers by migrants into the country; the capital account on the other hand concerns itself with the country’s international exchanges of assets and liabilities, the flow of foreign direct investment (FDI), portfolio investments, and loans. Of the two sub-accounts that make-up a country’s Balance of Payment Account, the capital account is arguably the primary source of macroeconomic stability or dislocations attributable to the neo-liberal efforts at liberalization that the world has witnessed over the last three decades. I will return to this point momentarily.
The Role of the IMF, the World Bank, and Developed Countries in the current global Financial System
When developing countries run into financial crises, as they often do, their usual port of call is the International Monetary Fund (IMF), one of the Bretton Woods institutions formed by the allied powers (primarily the US and Britain) right after WWII. Then, its primary mandate was to extend short-term financial credit and loans to a war-turn-Europe, and to countries emerging from colonial rule. Its counterpart, the World Bank, was designed to assist in long-term infrastructure development and capacity building, and during a significant portion of the post-war years executed their mandates reasonably well until the rise of neo-liberalism in the mid 1970s. It must be noted that before these Washington Institutions or more informally, the ‘Washington Consensus’ became fully embedded in the neo-liberal orthodoxy, there were no banking crises in the developing world between 1945 and 1971, and only 16 currency crises within the same period in contra-distinction to 17 banking crises, and 57 currency crises between 1973 and 1997 when the IMF began the hard push for capital account liberalization (Friedman, 2000).
It should not come as a surprise, even to the disinterested observer, that much of what transpires in the global financial system or the global economy for that matter, is determined by the activities of rich industrialized countries. Collectively they produce on average 80% of the world’s total production of goods and services, account for 70% of all international transactions, and control up to 90% of all foreign direct investments (Ferguson, 2003). And since the richest ones amongst these countries are the major contributors to the IMF and the World Bank, they also shape the rules by which the global economy is run. Unfortunately, these rules of economic engagement are bifurcated: one set of rules that embody keynesian activism for rich countries, and neo-liberal orthodoxy and free market for the rest.
Neo-liberal orthodoxy as an economic philosophy is essentially an upgraded package of the ideas of 18th century classical economists of the likes of Adam Smith, and the 19th century economist, David Ricardo. Their mantra is simple enough: Sound monetary policy (low inflation), small government that should always strive for a balance budget, privatization of state-owned enterprises, free international trade, and deregulation of capital markets and foreign direct investments. These doctrines, since the mid 1980s, have shaped and motivated policy prescriptions emanating from developed nations, and have served as the primary force behind the drive towards global integration of national economies. The multilateral Washington Institutions, the IMF and the World Bank, cannot help but advance these same policies since they are funded and controlled by developed countries led by the US.
Until the 1970s, the aim of macroeconomic policy (monetary and fiscal policies) had been to minimize the magnitude of swings in economic activity; this required prudent intervention in the economy in order to tame the business cycle by using a mixture of fiscal policy tools and monetary instruments. But with the increasing dominance of neo-liberalism and its partiality to monetarism, the focus of international lenders, including the Washington Institutions, changed dramatically, and so did their policy recommendations to developing nations in need of financial assistance. To the Neo-liberals, inflation is the worst impediment to economic growth and stability, and must, therefore, be restrained. To achieve this, they recommend a two-pronged procedure — governments should live within their means, and central banks should not supply more liquidity than is absolutely necessary to sustain real growth. In order words, the central bank should embark on a single-minded approach to price stability. In the 1980s, New Zealand took this advice to heart and indexed the salary of its central bank’s governor to the inflation rate in reverse proportion.
The neo-liberal logic in this regard is really quite simple: investment is essential for economic growth; international investors and lenders abhor market uncertainty that comes with price instability and inflation; therefore in order to attract capital needed for economic growth, prices must be relatively stable. In the 1980s when hyperinflation coincided with the near collapse of several South American countries, i.e. Peru, Brazil, it was easy to convince many policy makers of the efficacy of this policy thrust. However, realizing that governments were not the only profligate spenders, that individuals and businesses were just as irresponsible, the Bank For International Settlements (BIS) weighed-in with yet another tool to contain inflation –Capital Adequacy Ratio requirements for commercial banks. The problem with Neo-liberal monetarism as advocated by developed countries in concert with the ‘Washington Institutions’ is that the facts do not support their theory, but that is a minor detraction; never mind that countries in the developing world have had to endure the consequences of such flawed logic for three decades. To the neo-liberals, the response by David Ricardo to similar questions would suffice. When asked ‘why do the facts not fit your free trade theory of Comparative Advantage? Mr. Ricardo answered, ‘so much worse for the facts’(Brisco, 1907).
Inflation is not necessarily a Bad Economic Phenomenon
Stanley Fischer, the erstwhile chief economist at the IMF, recommended an annual inflation rate of no more than 1-3% in order to sustain price stability and economic growth (Chang, 2005). However, in the mid 1960s and 1970s, Brazil maintained an average inflation rate of 42% per year but managed to boast one of the fastest growing economies in the world with a per capita annual growth rate of 4.5% within the same period. However, between 1996 and 2005, the period it was compelled by the IMF to adopt neo-liberal prescriptions, it reduced its annual inflation rate to 7.1% but its per capita income took a turn for the worse; it grew at an annualized rate of 1.3%. South Korea’s experience with the IMF is equally instructive. In the 1960s and 1970s, its inflation rate averaged 20% and 19% respectively; but coincidentally it was also a period when Korea experienced its ‘miracle growth’ of 7% per capita growth rate (Chang, 2005). Both research and experience have shown the neo-liberal prescription to be wrong.
A study by Michael Bruno, a former chief economist at the World Bank, and William Easterly, shows that when the rate of inflation is below 40%, a clear correlation between inflation and economic growth rate cannot be established. Indeed other studies have shown that moderate inflation (below 40%) is not necessarily harmful, and may actually coincide with rapid economic growth, and job creation (Irwin, 2002). What empirical evidence shows is that tight monetary and fiscal policies required to suppress inflation at the 1-3% rate suggested by Stanley Fischer are more likely than not to stifle economic growth, and impact workers in two very distinct ways: the value of the workers’ current and past income would be protected from an inflation ‘tax’, but their future earning capacities would be severely limited due to reduced economic activity. But again, this is a minor wrinkle in the Neo-liberal mantra that guides the globalization effort for both market and financial integration.
The Cost of Price Stability and Monetary Discipline: The case of South Africa
South Africa, in 1994, embraced macroeconomic policy recommendations by the IMF to stabilize prices in order to attract foreign capital that should lead to sustained economic growth and employment. The government thus kept interest rate artificially high at 10-12% through the late 1990s and early 2000. Inflation was definitely checked at an annual rate of 6.3% during this period. But also within the same period, the profit rate in the non-financial sector was 6%, but with interest rate between 10-12%, only a few firms could afford to borrow needed funds for investment. As a consequence investment fell from 25% to 15%; and its per capita income grew at an annual rate of 1.8%. Today its official unemployment rate stands at 26-28%; one of the highest in the world (World Bank, 2008).
It is important to note here that while rich industrialized countries prescribe high interest rate as means to monetary discipline, they frequently resort to lax monetary policies that generate income and jobs in their respective national economies. At the height of the post war economic expansion, real interest rates in developed countries were extremely low. Between 1960 and 1973 average interest rate in Germany was 2.6%, in France it was 1.8%, in the US it stood at 1.5%, and Sweden averaged 1.4% (Oxfam, 2003). The result, as expected, was unprecedented economic growth.
I now turn my attention to two important tenets of Neo-liberalism that have the most serious consequences on the global financial system, and by extension, national economies: deregulation of Foreign Direct Investment, and free international trade.
Should Foreign Direct Investment Be Regulated?
Foreign Direct Investment (FDI) is the most stable of all elements in the capital account. Debt and portfolio equity are very volatile sources of foreign funds, this is especially true of bank loans. For instance in 1998 total net bank loans to developing countries stood at $50 billion; but soon after the financial crises in Asia, Russia, and Brazil in 1997-1998, it dropped to an average of -$6.5 billion per year for four years. But by 2005, it had risen remarkably to $67 billion (Bhagwati, 2004). Portfolio equity investment, while not as volatile as bank loans, are not stable. A major problem with these two sources of foreign capital is that they come and exit at the wrong time; they are readily available when the domestic economy is doing well, and leave in an economic downturn — a period when they are critically needed to pull up the economy. The biggest danger they pose to a host country, however, lies in their ability to induce asset-price inflation that lead to artificial bubbles in certain sectors of the host economy if left unrestricted; when such bubbles deflate, as demonstrated by the 1997 Asian crises in Hong Kong, Korea, Malaysia and Indonesia, the ‘herd mentality’ of capital drains the economy of crucial funds.
Given the volatility of foreign capital, it becomes even more of a challenge when left unregulated as experience with deregulation of capital markets in the 1980s and 1990s has shown. Between 1945 and 1971 when governments regulated global finance to suit their development needs, developing countries experienced no banking crises, had 16 currency crises, and one case where a banking and currency crises occurred simultaneously. However, between 1973 and 1997 when the IMF and developed countries stepped up their effort to liberalize global finance, the developing world experienced 17 banking crises, 57 currency crises, and 21 simultaneous banking and currency crises (Allen, 2006). These are in addition to the biggest of them all …. the 1998 financial crises that pushed the economies of Brazil, Russia, and Argentina into a flux. The acute volatility and the pro-cyclical nature of international financial flows have, of late, given the IMF reasons to re-think its stance on opening up capital markets in the developing world. It now accepts the view that premature opening of the capital account could harm a country by making the form of the inflows unfavorable and by making the entire domestic economy susceptible to sudden swings of capital flows.
FDI on the other hand is a reasonably stable source of extra capital (in 1997 net FDI inflows into developing countries was $169 billion, between 1998 and 2002 it averaged $172 billion per year despite the financial crises the developing world was experiencing during this period); it also contributes immensely to a country’s external balance, and enhances domestic productivity through technology transfer and managerial expertise. This is because contributors generally seek to have direct influence or control of the firm or enterprise they are funding. But there is a catch; when the host country has an unregulated and open capital market, FDI can be monetized and sent out of the country in very short notice. Subsidiaries of transnational corporations can use their local assets in the host country as security for internal loans and transfer the funds out of the country, thus creating a negative impact on the country’s foreign exchange position. Transnational corporations operating in host countries can also negatively impact a recipient country’s foreign exchange position through imports of inputs they need for domestic operations, and contracting for external loans.
While FDI continues to be indispensable to economic growth and development, it can be problematic, and has the potential to retard long-term growth if left unregulated. This occurs through its ability to suppress current and potential future domestic competitors in the host country. With the ability to provide superior products and services at competitive prices, the level of productive capacity in the host country is effectively compromised in the long-run if endogenous industries are killed-off through competitive pressure. Moreover, transnational corporations, as a rule do not transfer their most valuable technology or productive activity to developing countries, thus limiting the quality of technology available to their subsidiaries in the host country. Despite the current advocacy of the WTO on deregulating FDI, and a ban on all restrictions, capital and innovative technologies remain nationalistic; the vision of a borderless world in international transactions remains illusive, and would remain so for a very long time given that protection of innovative technologies is at the heart of the disparity between rich and poor countries. With the possible exception of Nestle that produces less that 5% of its global output at home (Switzerland), the majority of international firms produce less that 30% of total output abroad; for Japanese firms it is it less than 10% (Tandon, 2007).
In order for a host country to experience the maximum benefit of FDI, it must regulate its entry, and direct it to targeted industries where it is most beneficial. China, for example, severely restricts FDI but still manages to attract 10% of total FDI in the world. This is principally because it offers a large and growing market, good infrastructure, and a pool of technically advanced labor force. The same is true with Korea, Singapore, and India; they all restrict the level of FDI that flows into their economies, and only allow those that are needed in specific sectors. This strategic approach to development has served these countries well; china used a 30% tariff to protect its industrial base, and India used one that is above 30% to achieve the same objective while imposing severe restrictions on FDI (Kessler, 2003).
Foreign Direct Investment follows economic development; not a cause of it
Capital, like all productive economic inputs, flows to where it can obtain the highest returns possible. It is in this context that one must understand what motivates investors to put their financial resources at risk. Countries that provide investors with the proper social infrastructure, a pool of relevant work force, a safe environment, and a potentially strong market for their products and services would attract foreign investment. This means that countries must either have the potential for, or have experienced sustainable economic growth before it gets the attention of transnational companies. It is in this sense that policy makers should not regard FDI as a cause of economic growth, but rather that FDI has the potential to contribute to economic expansion only after such expansion has begun. It is also for this reason that developed countries as a zone account for up to 90% of all FDI made and received annually.
Concluding Remarks
The neo-classical theory of free markets instructs countries to stick to the things they are already good at producing. The implication for poor and developing countries is that they should stay engaged in activities that have kept them poor because that is where they enjoy comparative advantage over rich and developed countries. The hard reality is that if poor countries are to grow economically, they must defy free market dictates, and make the difficult choices that require short-term sacrifices for future prosperity. Capacity-building through acquisition of advanced technology from developed nations, and innovation driven by emulation of successful countries requires unwavering dedication on the part of governments and captains of industries. Capacity-building requires not only putting in place social infrastructures amenable to high-level productivity, it also entails investing in human capital development through education and training opportunities. With determination and the right investment strategy, poor nations can ultimately gain the technological capacity they need to spur economic growth. But this requires patience, for capacity-building is a long-term exercise that does not come by waving a magic wand.If necessary, a combination of tariffs and subsidies may be put in place to protect and encourage new industries, and afford them enough time to accumulate new abilities, i.e. importing new technologies, improving organizational structures, and training workers to become internationally competitive. All these may mean short-term reduction in consumption abilities for the country, but it is inevitable if the hard choices must be made in the drive towards economic growth and development.
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