Political Confidence and Monetary Stability in the Age of Globalization

By Zalewski, David A. | Journal of Economic Issues, June 2000 | Go to article overview
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Political Confidence and Monetary Stability in the Age of Globalization

Zalewski, David A., Journal of Economic Issues

The most striking aspect of recent financial crises was the rapid reversal of capital flows in countries whose currencies fell victim to speculative attack. The largest relative turnaround occurred in Thailand, which experienced a net private capital flow reversal of 15 percent of GDP between 1996 and 1997, followed by Mexico with 12 percent from 1993 to 1995 and South Korea's 9 percent during the 1996-97 crisis. [L[acute{o}]pez-Mejia 1999, 29] Foreign banks were particularly responsible for this change during the Asian crisis because they withdrew nearly $50 billion from that region during the latter half of 1997 after lending more than $100 billion in 1996.

The 6-8 percent decline in GDP following capital flight from these countries has prompted economists to reexamine the effects of confidence on macroeconomic performance. For example, Paul Krugman [1999] argues that the International Monetary Fund forced crisis-stricken countries to play a "confidence game" as a condition for receiving financial assistance. The "rules" of the game required nations to demonstrate their commitment to monetary stability by raising interest rates, tightening monetary policy, and balancing public budgets. By agreeing to these terms, officials broke what Krugman calls the Keynesian compact in which governments are expected to counteract economic slumps with stimulative policies. Krugman [1999, 113-114] concludes: "In short, international economic policy ends up having very little to do with economics. It becomes an exercise in amateur psychology...No wonder the economics textbooks went right out the window as soon as the crisis hit." [1]

Because of the tremendous economic cost of restoring confidence during financial crises, some reformers recommend establishing rigid programs that promote currency stability to prevent a reoccurrence. This paper argues, however, that these regimes may undermine what John R. Commons [1950] calls political confidence, which is an important determinant of investment. It concludes that although monetary stability is an important goal, attaining it at the expense of higher unemployment and increased political instability hinders social provisioning and long-term economic growth. [2]

Monetary Stability and Confidence

According to John Maynard Keynes [1936, 148], investment flows are largely determined by the state of long-term expectations, which consist of the returns expected by investors and the confidence they have in these estimates. What, in turn, influences the degree of confidence? David Dequech [1999] argues that it is a function of uncertainty perception and uncertainty aversion. Uncertainty perception depends upon the level of knowledge about the existence of uncertainty itself and upon the institutional factors that increase or decrease uncertainty. Uncertainty aversion relates to "animal spirits," which Dequech defines as not only encompassing Keynes's description of the motivation underlying urges to undertake positive measures, but also those actions rooted in pessimism. Moreover, Dequech [1999, 421] observes that "Animal spirits are influenced by the institutional environment in which an individual operates."

Can government policy prevent currency crises by developing institutions that circumscribe uncertainty? [3] One possibility is to adopt a regime that stabilizes currency values by fixing exchange rates. For example, Bear Stearns economist David Malpass [1998, A18] recommends that developing countries attain credibility by adopting rigid regimes like currency boards or by joining monetary unions. Although these programs may provide an aura of stability, they do not guarantee against speculative attacks. This is especially true when a government's commitment to monetary stability becomes questionable after policies required to defend parity increase political instability.

Consider currency boards, which became popular during the Asian currency crisis.

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