Keynes’s Theory in the Era of Global Finance

8/7/2019 Keyness Theory in the Era of Global Finance

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Keyness Theory in theEra of Global Finance

Jan KregelKeynes Seminar UAM Xochimilco

Mexico City,October 16-17


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Which Era of Globalisation? International Financial Flows andinternational market integration at the end

of the 19th century was as great as it isin the end of the 20th century

Keynes early experience as an economist was

formed in this earlier period ofglobalisation

Early work Indian Currency and Finance,

Tract on Monetary Reform, Treatise on Moneyall dealt with the problems of thebreakdown of this period of financialglobalisation and the Gold Standard


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And the General Theory? The General Theoryis usually considered to:

Refer to a closed economy

Presume fixed exchange rates

Ignore international aspects

International capital flows

international trade flows


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Indications from KeynessTreatise on Money

In The Treatise on MoneyVolume II

the Applied Theory of MoneyKeynesmakes a detailed analysis of the impactof an international system with global

financial flows under an internationalstandard such as the Gold Standard

Definition of Financial Globalisation- Uniform rates of interest in all countries

Loss of policy autonomy


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National Policy Autonomy In Chapter 36 of the TreatiseKeynes givesa very clear assessment of the impact ofinternational finance on domestic economicconditions in the chapter entitledNational Policy Autonomy

It deals with the potential policy conflict

between international investment flowsunder an international monetary standardsuch as the gold standard, and the need to

offset the impact on the economy of thecyclical behaviour of domestic investmentdecisions.

Today we would talk of national policyspace for developing countries


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National Policy Autonomy A single international monetary standard requires the

Central Bank to relinquish control over domestic interestrates

This implies a uniform rate of interest across countries. Any attempt to use interest rates to offset domestic

fluctuations in investment would then create interest ratedifferentials and international capital flows that would

eventually undermine the countrys commitment to theinternational standard.

To resolve this policy conflict Keynes suggests the controlof net capital flows -- the foreign capital balance. His analysis assumed the (often criticized) assumption that

the commercial balance is slow to adjust to changes inrelative prices (leading to Ohlins accusation that Keynesignored the impact of changes in the level of income and themultiplier effect), compared to the response ofinternational capital flows to international interest rate

differentials


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Long-term Capital Flow Controls Keynes recommends formal controls over long

term capital flows. He notes that most countries have always

had registration requirements for capital

issues in their own markets and that thesecould be expanded internationally.

He also suggests a tax on purchase of

foreign securities not listed in the UK

market of 10 per cent.


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Short-term Capital Flow Controls To influence short-term flows

he recommends a dual rate structure that differentiates

between financial flows and trade finance, given preferenceto the later.

He also recommends a more flexible exchange ratestructure through variation in the rates at which the Central

Banks bid and offer rates within the gold points He also recommends the active use of intervention in the

forward market, a suggestion that was first made in theTract, to set short-term interest rates on short term capital

transactions. He concludes that Central Banks should use bankrate, the forward rate and flexibility in its bid andoffer rates to influence short-term flows.


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The Ideal International FinancialSystem

However, he also notes that an ideal system wouldbe one in which all countries set similar gold

points for exchange of their currency with anexternal asset issued by a Supranational Bank,leaving substantial flexibility of rates withinthose points:

From the time of the Tract on Monetary ReformKeynes argued that a flexible exchange rate systemwas preferable to a fixed rate system as long asthere was a forward foreign exchange market in

which traders could cover their exchange risks. This is basically the same position that was

incorporated in the proposal for the ClearingUnion and the position that he took to the Bretton

Woods Negotiations in 1944.


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Implications of this Analysis forCurrent Financial Globalisation

The most important point of Keynessanalysis of these issues for current

conditions is his implicit acceptance ofthe position that dominated pre-warthinking on these issues,

and what constitutes the basic difference fromthe position of the expansion of the closedKeynesianmodel to an open economy in the post-war period

Fluctuation in international capital flowsdetermine domestic conditions and tradeflows, rather than the other way around


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In Keyness Words from the Treatise The belief in an extreme mobility of international lending

and a policy of unmitigated laissez-faire towards foreignloans has been based, on too simple a view of thecausal relations between foreign lending and foreign

investment. Because netforeign lending and netforeign investmentmust always exactly balance, it is been assumed that noserious problem presents itself.

Since lending and investment must be equal, an increase of

lending must cause an increase of investment and adecrease of lending must cause a decrease of investment;

Indeed, the argument sometimes goes further, and -- insteadof being limited to netforeign lending -- even maintains

that the making of an individual foreign loan has in itselfthe effect of increasing our exports.

All this, however, neglects the painful, and perhapsviolent, reactions of the mechanism which has to be broughtinto play in order to force net foreign lending and netforeign investment into equality.


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In Keyness Words from the Treatise I do not know why this should not be considered

obvious.

If English investors, not liking the outlook athome, fearing labor disputes or nervous about achange of government, begin to buy more Americansecurities than before, why should it be supposed

that this will be naturally balanced by increasedBritish exports? For, of course, it will not. Itwill, in the first instance, set up a seriousinstability of the domestic credit system -- the

ultimate working out of which it is difficult orimpossible to predict.

Or, if American investors take a fancy to Britishordinary shares, is this going, in any direct way,

to decrease British exports?


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In Keyness Words from the Treatise It is, therefore, a serious question whether it is

right to adopt an international standard, which

will allow an extreme mobility and sensitivenessof foreign lending, while the remaining elementsof economic complex remain exceedingly rigid.

If it were as easy to put wages up and down as itis to put bank rate up and down, well and good.But this is not the actual situation.

A change in international financial conditions or

in the wind and weather of speculative sentimentmay alter the volume of foreign lending, ifnothing is done to counteract it, by tens of

millions in a few weeks.


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Flexible Exchange Rates Necessary

for Domestic Policy Space This led Keynes to support flexible exchange rates, something he considered

necessary for national policy autonomy, until faced with the decision takenby the United Kingdom to return to gold. He thus notes in the conclusion tothe Chapter on National Autonomy:

On a balance of these various considerations, it seemed, before the defacto return to the Gold Standard that there were better prospects for themanagement of a national currency on progressive lines, if it were to befreed from the inconvenient and sometimes dangerous obligation of beingtied to an unmanaged international system; that the evolution of theindependent national systems with fluctuating exchange rates would be thenext step to work for; and that the linking up with these again into amanaged international system would probably come as the last stage of all.

I am disposed to conclude, therefore, that if the various difficultiesin the way of an internationally managed gold standard -- could be overcomewithin a reasonable period of time, then the best practical objective mightbe the management of the value of gold by a Supernational Authority, with anumber of national monetary systems clustering round it, each with adiscretion to vary the value of its local money in terms of gold within therange of (say) 2 per cent. (Chapter 36, pp. 334 to 338)


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Keynes in the 20th century It is thus something of an anomaly to note that the Keynesian

theory of international trade that emerged in the post-war periodwas one that fully supported fixed exchange rates, and initially

ignored the potentially destabilizing impact of foreign investmentflows.

Part of the reason for this is to be found in the common acceptanceby politicians of this position in their planning for the BrettonWoods System.

In the words of US Treasury Secretary Mongenthau, the purpose ofthe post-war reforms was to drive the private money lenders fromthe temple of international finance.

Paul Einzig, in a book written before the conclusion of the BrettonWoods Conference noted that the proposals being discussed would

eliminate private market currency trading. A well-known post Bretton Woods UN expert panel that includedNicholas Kaldor proposed that all international lending be done bynational governments issuing domestic bonds the proceeds of whichwould be administered through the World Bank.


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Resistance of Private Bankers

Private bankers launched stiff resistance to thisapproach

The end result was one in which gold remained atthe centre of the system, but with its namechanged to the dollar.

Nonetheless, the presumption remained that privatecapital flows would be minimal in the post warsystem.

This implied that trade would dominateinternational transactions and that any imbalanceswould be short-lived and financed through theBretton Woods institutions.


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Putting International Trade into theclosed model of the General Theory

The aggregate demand model of the General Theory,designed for a closed system:

Y = C+I+G could be adapted to international trade bysimply adding net exports

Y = C(Y)+I(i)+G+(X-M(Y))

with G and X considered exogenous

Negligible private capital flows need not beconsidered.

Thus, there is an implicit assumption CA=NX, the current account balance is equal tothe commercial balance plus unilateral incometransfers.


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The IMF insured low capitalflows

If a country had a persistent deficit

it was financed by running downreserves

When reserves ran low it accessed its

Fund position And implemented policies to return to

surplus The only capital flow was the Fundborrowing limited to quota


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National Policy Space in theOpen Keynesian Model

The policy dilemma created by the possibility that the levelof domestic demand required to reach full employment mightproduce an external deficit created a new policy dilemma and

the search for national policy space. The solution was the Fleming-Mundell open economy model

which rewrites the equation for the current account as

CA = NX-NCF

where NCF(iD,iF) is net foreign borrowing determined ofinternational interest rate differentials.

The solution to the policy dilemma was to resolve theassignment problem by

setting fiscal policy (G-T) to produce full employment and monetary policy to finance any resulting deficit bysetting domestic interest rates to produce an interestrate differential large enough to attract the requiredforeign lending.


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Fleming-Mundell does not avoidpolicy dilemma

However as Keynes had already noted, thiswas an attempt to use interest rate policy

to meet domestic policy goals and wouldquickly lead to conflict in a system withan international standard such as the

Bretton Woods System. Triffin had pointed out why the BrettonWoods System was inherently unstablebecause it determined internationalliquidity creation on the external positionof the US so that any sustained demand forincreased international liquidity would

eventually produce external dollar claimsin excess of the ability of the US to meetthem.


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The Error in Fleming-Mundell However, the error in the Fleming-Mundell solution

to the policy dilemma is rather different.

Any sustained foreign borrowing will create adebit entry in the current account balance equalto the interest on the outstanding borrowing.

Thus, CA=[NX-(iD(NCF))]. If rising external

indebtedness creates a higher risk spread, thenthe interest differential will be continuallyrising and the debt service burden will offset thecapital inflows.

In short, the B curve bends back on itself andeventually there is a capital flow reversal thatmakes preservation of the international standardimpossible.

NCF


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+NCF

X=M

IS

B

i1

MX,M

id -if

X

Y

-NCFi L

i1

Ye Yf Y


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Can the Fleming-Mundell Dilemmabe Resolved?

This is the same question we ask

about the current US deficit The same question was asked after the

Second World War but in reverse

Is a permanent US trade surplus possible

i.e. will the dollar shortage be

permanent

The Answer was given by Domar


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The Domar Condition A net export surplus can be maintained onlyif the stock of foreign lending increasesat a rate equal or greater than theinterest rate charged on the foreignlending

For a deficit, foreign borrowing mustincrease at a rate equal or greater thanthe rate of interest paid on the lending

If interest rate rises with increasingstocks of foreign loans, then the rate ofborrowing must also increase


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Domar and Ponzi The Domar condition is the same as thecondition for a successful Ponzi Finance

scheme Such schemes are inherently unstable

Thus, Keyness recommendation to use

capital controls But long-term stability will require abalanced structure of production that

creates exports sufficient to meet debtservice

Industrial policy is also necessary for

policy space


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ConclusionPolicy Space Requires:

Controls over capital flows Including management of exchange rate

Control over trade flows

Sectoral Policy to Build an export platform

Keynes’s Theory in the Era of Global Finance

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