Paper presented at Sunday's opening plenary at the Now We The People conference, University of Technology, Sydney, 24.8.03

Global crisis and Australia's options

John Quiggin

I thank Nancy Wallace for helpful comments and criticism.
This research was supported by an Australian Research Council Senior Fellowship and Australian Research Council Large Grant A00000873.

Globalization: Macroeconomic management and public finance
The received wisdom about globalisation and its implications for public policy are perhaps best summarised by Friedman's (1999) metaphor of the Golden Straightjacket. The metaphor embodies the claim that, while globalisation constrains the options available to governments, it offers unparalleled prosperity to those countries that comply with its requirements.

To fit into the Golden Straitjacket, a country must adopt the following (rather redundantly expressed) golden rules:

+ making the private sector the primary engine of its economic growth;
+ maintaining a low rate of inflation and price stability;
+ shrinking the size of its state bureaucracy;
+ maintaining as close to a balanced budget as possible, if not a surplus;
+ eliminating and lowering tariffs;
+ getting rid of quotas and domestic monopolies;
+ increasing exports;
+ privatizing state-owned industries and utilities;
+ deregulating capital markets and the domestic economy;
+ opening banking and telecommunications to private ownership and competition; and
+ allowing citizens to choose from an array of competing pension options.

Like other proponents of globalisation, Friedman argues that governments must adopt the neoliberal policy agenda or face the wrath of the 'Electronic Herd' of global financial traders. These arguments have been strongly contested. On the one hand, many critics of globalisation, notably Hirst and Thompson (1996) have rejected the claim that globalisation is the inevitable result of technological progress. On the other hand, many writers have rejected claims that globalisation is beneficial (for example, Baker, Epstein and Pollin 1998).

In this paper, I will consider both parts of Friedman's metaphor. First, is Friedman correct in describing globalisation as offering 'golden' opportunities? More precisely, have the fiscal and macroeconomic policies advocated by Friedman produced sustained improvements in economic performance in countries where they have been implemented? I will argue, in the contrary, that few of the policies listed above have yielded the claimed benefits and most have been positively harmful.

Second, regardless of the benefits and costs, does globalisation impose a straightjacket? Is the power of financial markets such that governments have no alternative but to accede to their demands. I will argue that, in reality, governments have considerably more room for manoeuvre than is commonly supposed. Moreover, while financial markets can impose substantial economic costs on countries in the event of a loss of confidence, adherence to the policy agenda of the 'Golden Straightjacket' does little or nothing to reduce the likelihood of such an adverse outcome. The only adequate response is the construction of a new regulatory framework for international financial markets.

Four sets of issues raised in Friedman's list will be addressed in this paper. First, there is the general claim that financial markets promote sound economic policies, rewarding governments that adopt them and punishing those that do not. Second, there are issues related to macroeconomic policy and the injunction to focus on fighting inflation. Third, there are questions of taxation and public expenditure. Finally, there are issues concerned with privatisation and deregulation. In each case, the neoliberal policy framework is assessed. The final section consists of an assessment of the options open to governments.

Financial markets and the Washington consensus
The policy settings advocated by Friedman have also been referred to as the 'Washington consensus'. John Williamson of the Institute for International Economics coined this term to describe the set of economic assumptions and policy prescriptions favoured by major Washington-based institutions including the IMF, the World Bank and the United States Treasury (Williamson 1990).

The Washington consensus arose following the breakdown of the system of fixed exchange rates adopted by the victorious allies meeting at Bretton Woods in 1945. By the late 1960s, the Bretton Woods system was breaking down under the strain of inflation in the major developed economies (which rendered fixed exchange rates untenable) and the gradual erosion of capital controls through developments such as the 'Eurodollar' market (trade in financial assets denominated in US dollars, but outside the control of US monetary authorities). The abandonment, during the 1970s, of fixed exchange rates and controls on capital movements paved the way for massive growth in the volume of financial transactions and led to the current era of globalisation.
During the 1970s, governments, particularly in less developed countries, engaged in large-scale borrowing. When the world economy declined at the end of the 1970s, many found themselves unable to service their debt, leading to a series of crises. In responding to these crises, the International Monetary Fund typically required governments to cut public expenditure, sell or close lossmaking public enterprise and remove a variety of regulatory policies. Although these policy responses were far from uniformly successful, it appeared to work better than any alternative, and formed the basis of the Washington consensus.

A central point in the Washington consensus was the belief that the debt crisis was the result of mistaken policies in the debtor countries, and not of problems in the financial markets that had made the borrowings possible. The Washington consensus discouraged the use of capital controls as a way of managing debt problems, and encouraged countries to deregulate their financial systems.

Faith in the Washington consensus reached a peak in the mid-1990s. The breakdown of Communism and strong growth in stock prices, particularly in the United States, supported the view that financial markets were the main engine of liberal capitalism. Less developed countries that had embraced the Washington consensus experienced large inflows of private capital and strong economic growth. Important examples included Argentina, which tied its currency to the US dollar in 1992, and East Asian economies which deregulated financial markets in the early 1990s.

Since the mid-1990s, international financial crises have occurred regularly. The majority have occurred in developing and formerly-communist countries including Mexico in 1994, a large number of Asian countries in 1997 and 1998, Russia in 1998, and Turkey and Argentina in 2001 and 2002. However, the failure of Long Term Credit Management, an unregulated 'hedge fund' based in the United States, threatened the solvency of a number of major banks and raised the possibility that even developed countries were not immune from serious financial breakdown.

The crises of the 1990s exposed weaknesses in the Washington consensus approach to financial stabilization. In general, the crises arose much more rapidly than in the 1980s. More importantly, the countries affected were generally perceived, at least prior to the crises as having followed the policy prescriptions of the consensus. Far from rewarding countries that followed sound policies, financial markets appear to have contributed to the crisis, first by financing unsound investments and then by facilitating capital flight when the crises began.

Events in the United States have also cast doubt on the idea that financial markets promote sound policy. The financial bubble of the late 1990s swept the entire financial markets into a speculative frenzy (Shiller 2000). Stock market analysts promoted worthless stocks, auditors signed accounts showing high profits for companies that were actually insolvent, and bond market analysts failed to predict defaults caused by fraud and mismanagement.

The series of financial crises since the 1990s has undermined faith in financial markets, but has yet to give rise to significant initiatives that would reduce their power or improve their operations. The status of financial market institutions today is something akin to that of the Communist Party in the declining years of the Soviet Union. The claims of omnipotence and omniscience made by writers such as Friedman are still the official orthodoxy, but few really believe them any longer.

Macroeconomic policy

The core of the neoliberal macroeconomic policy agenda may be summed up by the slogan 'fight inflation first'. This approach may be seen, in its strongest form, in the policy framework adopted in New Zealand in the 1990s (Quiggin 1998). The neoliberal approach eschewed any active form of fiscal policy, seeking instead to keep budgets as close as possible to balance. Monetary policy was directed solely at a target of controlling inflation. In the case of New Zealand the target was a range of 0-2 per cent, with no allowance for variations over the course of the economic cycle. Macroeconomic policy was not concerned with reducing unemployment, which was assumed to be determined by the institutional structure of the labour market.

A more moderate and eclectic version of the neoliberal framework was adopted in Australia. Having rejected active fiscal policy (pejoratively referred to as 'pump-priming') in the early stages of the 1989-92 recession, the Hawke-Keating Labor government embraced it in the One Nation package.

The Coalition government elected in 1996 has taken a somewhat ambivalent view of fiscal policy. Initially, the government adopted a neoliberal stance to justify cuts in public expenditure, in violation of its campaign commitments. More recently, Keynesian rhetoric has accompanied policies such as assistance to first-home buyers. Assessment of the Coalition's position is complicated by the complexity of Australian macroeconomic developments since 1996. Although economic growth has generally been fairly strong, suggesting that budget surpluses would be an appropriate fiscal policy, unemployment has remained high, and there have been a series of occasions on which an economic downturn appeared likely, including the Asian crisis of 1997-98 and the post-GST slowdown in late 2000.

Although fiscal policy has not been abandoned, monetary policy has clearly become the primary tool of macroeconomic management in Australia. At first sight, the policy framework adopted by the Australian Reserve Bank looks very similar to that of New Zealand, being based on an inflation target of 2-3 per cent per year.

There are, however, important differences. First, the Australian target allows for slightly higher rates of inflation and, more significantly, allows for higher inflation rates in peak periods, with the target being specified as the average rate of inflation over an economic cycle (typically about five years). Second, inflation targeting is not seen as an end in itself but as a summary statistic for a policy aimed at stabilising output and employment as well as inflation.

The Australian approach succeeded during the 1990s, whereas the New Zealand approach failed and was ultimately abandoned (Quiggin 1998). Although the failure of the New Zealand approach was due, in part, to bad luck, and in part to poor implementation, most studies have concluded that the rigidly neoliberal approach was fundamentally flawed because of the lack of concern about stabilising output and employment.

Taxation and public spending

The first item in Friedman's list of 'golden' constraints is the claim that the private sector should be the primary engine of growth. An obvious corollary, and a central item in the neoliberal policy program is the desirability of reducing the share of national resources allocated to the public sector. Beginning with the Thatcher government in the United Kingdom, neoliberal governments have made strenuous attempts to reduce the size of the public sector.

Several strategies have been adopted in attempts to achieve this goal. The first has been to reduce the quantity and quality of those services that are normally provided by the public sector, including health, education and social welfare services. For example, Australian governments in the 1990s have reduced education expenditure, leading to larger classes in schools and, more dramatically, in universities. (The ratio of students to academic staff rose by approximately 70 per cent between 1990 and 2000). Eligibility for a wide range of social welfare benefits has been tightened and, in some cases, the level of benefits has been reduced.

A second strategy, commonly referred to as 'user pays', involves the imposition of charges for services that were previously funded from general revenue. If imposed on a limited scale, as in the case of admission fees for museums and galleries, such charges simply change the financial basis of provision. More systematic commercialisation, as in the application of National Competition Policy to local government services generally involves a change in the nature of the services provided and is a first step on a path leading to corporatisation and, ultimately, privatisation.

A third strategy has been the replacement of publicly-provided services by private alternatives, usually with some public funding. Examples include voucher systems for education, tax incentives for reliance on private superannuation in place of age pensions and subsidies to private health insurance.

As with other aspects of globalisation, it has been claimed that reductions in the size of the public sector are both inevitable, if an internationally competitive economy is to be maintained and beneficial. The first part of this claim does not stand up to empirical scrutiny. Analysis such as that of Mitchell (1991) has shown that the share of government expenditure in GDP tends to be positively correlated with economic openness, as measured by the ratio of trade to GDP, not negatively correlated as the inevitability argument would imply. It is possible that, by increasing exposure to international shocks, economic openness enhances the demand for government intervention to manage risk.
Economic analysis gives little guidance with respect to the desirability of reducing the ratio of government expenditure to GDP, which is primarily a political question. Thus far, despite the political dominance of neoliberal governments in many countries, policies aimed at reducing the size of the state have had only limited political success. Resistance to neoliberal policies, and the failures of many policy initiatives, have meant that only limited steps have been taken to implement the neoliberal program with respect to taxation and public spending. In particular, growth in the share of national income taken by governments as taxation revenue, and returned in the form of public services and transfer payments has been slowed, but not reversed or even, in most places, halted.

Privatisation and deregulation

The boundaries of the public private sector established in most developed countries after 1945 remained largely unchanged until the 1980s. The private sector dominated agriculture, mining, manufacturing and retail and wholesale trade. The public sector dominated health, education and other community services and the provision of infrastructure services (roads, railways, electricity, communications and so on). Occasional nationalisations and denationalisations (for example, steel in the United Kingdom) did little to change this.

The first government to adopt a systematic policy of privatisation was the Thatcher-Major Conservative government in the United Kingdom. Over 15 years, the Conservatives privatised a wide range of industries including telecommunications, gas, water, electricity and railways. The Conservatives also pioneered the systematic contracting out of the provision of publicly-financed services such as health and education.

In retrospect, it is generally conceded, even by advocates of privatisation that the Thatcher government's fiscal rationale for privatisation as a device for reducing budget deficits and public sector borrowing requirements was faulty, that many of the assets were sold at bargain-basement prices and that subsequent regulation of privatised industries left much to be desired. Nevertheless, the popularity of privatisation spread rapidly to other English-speaking countries (except the United States, where public ownership had never been important) and then to the rest of the world. The popularity of privatisation was enhanced by the collapse of Communism in 1989.

In the last few years, the process of privatisation in the English-speaking countries has slowed drastically, and in some cases, been reversed. Renationalisation has been necessitated in some cases by the collapse of privatised firms such as Railtrack in the United Kingdom and Air New Zealand. Apart from these emergency measures, New Zealand, which led the way in adopting the neoliberal agenda, has now taken the first steps in reversing it, with the renationalisation of accident compensation insurance and the re-establishment of a publicly-owned bank.
The slowdown in privatisation has arisen, in part, from the gradual realisation that the profits generated by well-run public enterprises are, in many cases, greater than the interest savings that can be generated by selling assets and using the proceeds to repay debt. The first-stage privatisation of Telstra provides a fairly typical instance. In the first three years after privatisation, the interest savings resulting from privatisation totalled about $2.9 billion. By contrast, the public was deprived of dividends of $2.3 billion and retained earnings of $2 billion, for a loss of $1.4 billion. Since earnings are likely to grow over time, if only as a result of inflation, while interest savings are fixed, the loss can be expected to grow steadily. Far from increasing the net worth of the public sector, the Telstra privatisation reduced it by around $15 billion.

Utility deregulation

The first privatisations undertaken by the Thatcher government did little more than replace public monopolies with private monopolies, and, in the process, transfer wealth from the public to the private sector. Advocates of the neoliberal agenda saw the introduction of competition, rather than a mere change in ownership, as the crucial objective. As a result, privatisation gave rise to radical changes in the regulation of infrastructure services such as electricity and telecommunications. Similar changes took place in the United States where, although nominally private, the regulated monopoly providers of these services had acted, in many respects, like public enterprises.

The move towards competition had two main components. The first was to provide retail consumers with a choice between competing service providers. The second was to end central planning of infrastructure investment and replace it with market-generated signals. Experience with retail competition has been mixed, but, on balance, modestly positive. However, the shift away from planning infrastructure investment has been almost uniformly disastrous.

On the one hand, there have been financial bubbles leading to wasted and duplicated investments on an unprecedented scale. In the United States, investment in telecommunications infrastructure such as fibre-optic cable totalled $500 billion in 1999 and 2000 alone. More than 95 per cent of this cable remains 'dark', that is, it has never been used to carry signals. Paradoxically, the resulting string of bankruptcies has meant that this overcapacity has been accompanied by repeated service failures. Millions of users of broadband services have been disconnected, in some cases by four or five successive providers. Similarly, in Australia, competition between Telstra and Optus produced the bizarre result that half the country was wired up with two sets of broadband cables, while the other half got none (Quiggin 1996).

Meanwhile, in the electricity industry, vitally-needed investment has not been undertaken. At a time when improvements in electricity supply technology and the needs of computer users for uninterrupted power supplies should have led to substantial improvements in reliability, the new systems of regulation have produced repeated blackouts wherever they have been introduced, most notably in Auckland, California, Victoria and South Australia.

What can governments do?

The impossible trinity

In macroeconomic terms, the choices available to governments can be described in terms of the 'impossible trinity'. A government cannot simultaneously pursue an independent macroeconomic policy, maintain a fixed exchange rate and allow free international capital movements.

Over the last century, governments have responded to this dilemma in very different ways. The economy of the 19th century like that of the late 20th century, was one of unrestricted capital flows, and tight constraints on government policies. The 19th century global economy was disrupted by the outbreak of the Great War in 1914. Attempts to reconstruct it after 1918 failed, leading to the Depression of the 1930s and the renewal of war in 1939.

As noted above, a radically different system was adopted in 1945. The Bretton Woods system relied on fixed exchange rates and restrictions on international capital flows. With these restrictions in place, the main policy instrument used to stabilise the economy, avoiding recessions and excessive booms, was fiscal policy. In periods of depressed activity, governments stimulated demand by cutting taxes and increasing public expenditure. The opposite measures were used to restrain potentially inflationary booms.

The abandonment of controls on capital flows and the shift to floating exchange rates has had mixed effects on the scope for fiscal and monetary policy. As the impossible trinity idea shows, with no controls on capital flows, governments can adopt an independent monetary policy only if they are prepared to abandon any control over the exchange rate.

Few governments or central banks have been willing to disregard the exchange rate, often seen as an indicator of national economic worth, but Australian experience suggests that this is probably the optimal response. The willingness of the Reserve Bank to accept a sustained depreciation in the value of the Australian dollar, rather than raising interest rates to support the currency, was the main reason why Australia, unlike New Zealand, suffered little or no adverse effect from the Asian crisis in 1998.

Even assuming that the exchange rate is not targeted, it is necessary to determine the appropriate stance of monetary policy. It is generally agreed that monetary policy should focus primarily on keeping inflation rates low and stable, but the details of inflation targeting are important. A comparison between Australia and New Zealand is useful here. The New Zealand monetary system involved an exclusive focus on inflation, with a tight (0 to 2 per cent) annual target. The results included violent fluctuations in interest rates and unemployment that ultimately forced the abandonment of the system. By contrast, the Australian Reserve Bank takes unemployment and other variables into account in a more flexible system in which the average inflation rate, over the course of the economic cycle, is targeted.
The impact of globalisation on the scope for fiscal policy is complex and, in some respects paradoxical. In some important respects, the removal of controls on capital flows makes it easier for governments to adopt a flexible fiscal policy. In a closed economy, attempts to stimulate economic activity through tax cuts or higher public spending, financed by the issue of government bonds, tend to raise interest rates and may therefore 'crowd out' private investment (including the purchase of homes and consumer durables).

By contrast, in the absence of exchange controls, interest rates are set on world markets. Provided that budget deficits are not so large or sustained as to raise concerns that governments may repudiate their debt or resort to inflationary financing, budget deficits have no direct effect on interest rates.

There is, however, an indirect effect. The central bank, which is normally independent in an economy of this kind will in general have a view as to the desired degree of stimulus arising from the combined impact of fiscal and monetary policy. Other things being equal, central banks will respond to an unexpected shift to a more stimulatory fiscal policy by raising interest rates and offsetting the stimulus.

In recent years, however, many central bankers and others have concluded that exclusive reliance on monetary policy as a tool for economic management is misguided and potentially dangerous. There has been an increasing resurgence of interest in the active use of fiscal policy to stabilise the economy.

The international financial system

Since the Asian crisis, the deficiencies of the existing system of international financial relations have been recognised quite widely. This recognition has grown with subsequent crises, particularly that of Argentina. Proposals for reforms, often referred to, rather grandly, as a 'new global financial architecture' have been canvassed, and widely discussed among central banks and international financial institutions. However, as yet, little progress has been made. The most innovative suggestion to gain widespread support has been for the creation of a procedure analogous to bankruptcy that could be pursued by national governments unable to service their debts. Although potentially valuable, this idea would have been more useful as a response to the crises of the 1980s, which typically arose because governments were unable to repay their debts than to the more complex financial problems of the 1990s, which typically involve breakdowns in the financial system.

An alternative that has been frequently proposed, but remains at the margins of the international policy debate is the idea of a tax on international financial transactions, commonly referred to as a 'Tobin tax' after James Tobin, the economist and Nobel prizewinner who first proposed it (Tobin 1991, ul Haq, Kaul and Grunberg 1996)

The most obvious objection to a transactions tax is that the tax could be avoided/evaded either by substitution of exempt for taxable transactions or by shifting transactions to a financial centre that does not levy the tax. In particular, it is argued that unless a tax is imposed universally it would be nullified by such a shift in transactions. This latter claim appears premature. After all, it is, in principle possible to completely avoid income tax by making all income-generating contracts in jurisdictions that levy no income tax (tax havens) and considerable tax is in practice avoided in this fashion. Nevertheless, countries do succeed in levying income taxes (at widely divergent rates) on their inhabitants.

On the other hand, arguments concerning the possibility of substitution of exempt domestic transactions for taxable transactions appear well-founded. In many cases, it is possible to replace an international financial transactions with a set of domestic transactions that have the same ultimate effect. It would appear that the only feasible approach is to tax all financial transactions, domestic and international, at a common rate (Quiggin 2001). Many countries, including Australia, already tax a range of 'retail' financial transactions (for example, bank debits and credits, mortgages) often at rates higher than those envisaged for a tax on international transactions.

Taxation and public spending

In the absence of effective controls over global capital markets, the free movement of capital must be taken into account as a constraint on the policy options available to governments. However, this is a constraint, not, as Friedman would have it, a 'straightjacket'.

In the absence of restrictions on capital movement, capital will naturally flow where it can secure the highest post-tax returns. Hence, governments are likely to face increasing difficulty in levying tax on income from capital. The difficulties in taxing income derived from capital are not as great as have been suggested by some commentators. Particularly in Europe, moves are being made to harmonise rates of tax on income from capital, so as to prevent competitive bidding down of tax rates. Moreover, governments retain the option of taxing the capital income of residents, whether that income is derived from foreign or domestic assets. Nevertheless, the capacity of governments to tax income from capital has clearly declined.

By contrast, globalisation in itself does not impose significant constraints on the revenue that can be raised from taxes on consumption and personal income. During a decade in which globalisation has dominated public discussion, the ratio of tax revenue to national income has remained stable or increased in most countries. Moreover, contrary to what is implied in many discussions, the ratio of tax revenue to national income is generally higher in countries that are more exposed to international markets, because trade forms a larger share of total income.

Although there are economic limits above (and below) which it is very difficult to raise (or lower) tax revenues, the key issues are political. The Australian community must decide what proportion of income to allocate to improved public services and what proportion to allocate to private consumption. Unfortunately, this issue has never been seriously debated, and outcomes have been produced by a mixture of policy drift, bracket creep, unfunded tax cuts and expenditure cuts justified by incoming governments on the basis of spurious 'black holes'.

Concluding comments

The neoliberal policy agenda associated with globalisation is, in some respects, a return to the classical liberal economic orthodoxy of the 19th century, the first great era of globalisation. However, as the prefix 'neo' implies, neoliberalism can only be understood in relation to its historical background, namely, the reaction against the social-democratic and Keynesian mixed economy which prevailed from the end of World War II until the early 1970s.

The mixed economy undoubtedly needed restructuring. Nevertheless, despite having dominated the policy agenda for the past two decades, neoliberal globalisation has failed to produce the promised benefits. What is needed is not more market-oriented reform, but a modernised and internationalised version of Keynesian social democracy.

References

Baker, D., Epstein, G., and Pollin, R. e. (1998), Globalization and Progressive Economic Policy, Cambridge University Press, Cambridge.

Friedman, T. (1999), The Lexus and the Olive Tree: Understanding Globalization, Farrar Strauss Giroux, New York.
Hirst, P. and Thompson, G. (1996), Globalization in Question: the International Economy and the Possibilities of Governance, Polity Press, Cambridge, UK.

Mitchell, D. (1991), Income Transfers in Ten Welfare States, Avebury, Aldershot.

Quiggin, J. (1996), Great Expectations: Microeconomic Reform and Australia, Allen & Unwin, St. Leonards, NSW.

Quiggin, J. (1998), 'Social democracy and market reform in Australia and New Zealand', Oxford Review of Economic Policy 14(1), 76-95.

Quiggin, J. (2001), 'Globalization and economic sovereignty', Journal of Political Philosophy 9(1), 56-80.

Quiggin, J. (2001), 'The fall and rise of the global economy: finance', 19-34 in Sheil, C. (ed.), Globalisation: Australian Impacts, University of New South Wales Press, Sydney.

Shiller, R. J. (2000), Irrational Exuberance , Princeton University Press, Princeton, New Jersey.

Tobin, J. (1991), International currency regimes, capital mobility, and macroeconomic policy, No. August, For Greek Economic Review, Special Issue on Monetary Integration.

ul Haq, M., Kaul, I., and Grunberg, I. (1996), The Tobin Tax: Coping With Financial Volatility, Oxford University Press, Oxford, U.K.

John Quiggin is a Federation Fellow at the University of Queensland.

EMAIL j.quiggin@uq.edu.au
PHONE + 61 7 3346 9646
FAX +61 7 3365 7299
http://www.uq.edu.au/economics/johnquiggin

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