THE RISE OF MARKET LIBERALISM

The world economy's plunge into the Great Depression of the 1930s resulted in major losses in terms of growth and employment, not to mention deflationary tendencies in virtually every corner of the globe. However, it also smoothed the way for a specific model of regulated capitalism. The world economic crisis engendered the conviction, among people of almost every political stripe, that only a regulated capitalism could have any chance of surviving. In contrast to the period after the First World War, at the end of the Second World War the United States actively developed a global hegemony in order to support economic development in Western Europe, as well as in other countries in the Western bloc.

One of the cornerstones of the regulatory model created at that time was the Bretton Woods Agreement. It was negotiated, first and foremost, by the United States and the United Kingdom at a conference in the small American town of Bretton Woods. Concluded in July 1944, while the Second World War was still raging, it was adopted in 1947. Every country in the developed Western world was included in the agreement, which was characterised by fixed exchange rates which, however, could be adapted in response to fundamental imbalances. The rates were permitted to fluctuate on foreign exchange markets only within a narrow range of plus or minus 1 per cent around the institutionally fixed central rate. If need be, central banks were called upon to stabilise the exchange rate by means of interest rates, foreign exchange market interventions or interventions in capital movements. In practice the agreement meant that only central banks outside the United States were responsible for defending exchange rates, while the US Federal Reserve (the Fed) was able to remain completely passive. Such asymmetrical burden sharing in exchange rate stabilisation can be explained by the absolute dominance of the United States during the closing stages of the Second World War and in its aftermath. In order to boost confidence in the US dollar the United States committed itself, apart from the Bretton Woods Agreement, to convert dollar credits from central banks into gold, for which a conversion rate of US$35 per ounce was laid down. For central banks outside the United States, therefore, holding dollar reserves was tantamount to holding gold.

The International Monetary Fund (IMF) and the World Bank were also created at the Bretton Woods Conference. The IMF was tasked with providing loans to support countries which encountered difficulties in defending their exchange rate. The World Bank, by contrast, assumed development-policy functions. Besides fixed exchange rates, the international financial system was subjected to a whole range of regulations. Capital movements in developing countries were very modest and there were practically no private loans, but there were international capital movements between the developed countries, and these were extensively regulated. It was taken for granted that countries could employ capital movement regulations to defend exchange rates and to limit current account imbalances. This right remains inscribed in the statutes of the IMF even today.

The Bretton Woods system conferred on the world economy a stable monetary framework. Although, in some countries, incessant current account surpluses developed – for example, in Germany – the imbalances, as a percentage of gross domestic product (GDP), were modest in comparison with the world economic situation of previous years. Since currency crises were few and far between, the IMF largely had little to do and, in comparison with the decades after the collapse of the Bretton Woods system, did not play a central role.

National financial systems were also strictly regulated, and different spheres were often separated from one another. Real-estate financing, for instance, was, as a rule, disconnected from the rest of the system or tightly controlled by the state. Consumer credit played a subordinate role: credit expansion was focused on the business sector. Dynamic consumer demand was based on income growth. In many countries, such as the United States, upper limits were imposed on interest rates. Even in countries such as the United States and the United Kingdom, which traditionally had capital-market-based financial systems, the stock market did not play an exceptional role. In continental Europe, Japan and the developing countries, bank-centred systems dominated, with so-called 'house banks' acting as the most important sources of external finance for enterprises.

The capitalist model of the post-war period took a number of different forms. In Asia – for example, in Japan and many other market-oriented countries – state intervention was extensive and included a far-reaching industrial policy, which in turn incorporated political allocation of loans. Foreign trade was characterised by protectionist intervention. In addition, in countries such as Japan, employees were bound to their companies and were at almost no risk of losing their jobs, based on a model in which employment was for life and exhibited a number of features that were openly paternalistic. Similarly, income distribution in these countries was markedly egalitarian. Although in Europe the role of the state was less all-encompassing than in Asia, there was industrial policy intervention on a massive scale there too.

Europe also featured a compromise between the classes that took the form of a strong welfare state. In Germany, for example, opportunities for workers' participation in enterprise management were created. So-called 'economic democracy' made it possible in Germany for employees to be represented in the supervisory boards and even the boards of directors of large companies. Wage development in Europe was, as a rule, regulated by collective agreements which were negotiated by strong trade unions and employers' organisations and applied to whole industries or even the whole economy. In Europe, too, in comparison with the situation today, income distribution was fairly balanced.

Even the United States, during the post-war period, was characterised by more or less the same basic model. As late as the end of the 1960s, J.K. Galbraith (1967) was able to characterise American managers as 'state bureaucrats committed to public welfare' – there was then no sign of the gamblers engaged in a ruinous capitalism with whom we have become all too familiar. Like Japan and Europe, the United States was a middle-class society, in which both absolute poverty and extreme wealth manifested themselves only occasionally.

This model, established after the Second World War, bestowed on the global economy a whole series of economic miracles like those in Germany and Japan. However, all Western countries were able to notch up positive development in terms of real growth. Unemployment was comparatively low during this period, and some countries – including the Federal Republic of Germany – even experienced labour shortages in the 1960s, which were made good by bringing in guest-workers.

The economic model that emerged from the Great Depression in the 1930s and managed to establish itself in the Western world – as it was constituted at the time – after the Second World War, can be contrasted with the current situation not only in its high growth and low unemployment, but also in a fair distribution of income. Welfare state provisions and labour market regulation guaranteed a high level of social security and of living standards to the overwhelming majority of the population. The model, which in these terms can be described as a 'golden age of capitalism', fell into a deep crisis in the 1970s which prepared the way for the market-liberal globalisation project.

THE END OF BRETTON WOODS AND ITS CONSEQUENCES

Not least because of the considerable privileges which Bretton Woods system afforded the United States, the system collapsed in February 1973 after a crisis which had lasted since the end of the 1960s. The United States had taken particular advantage of the privilege of not having to look after the stability of its currency itself but rather, as already mentioned, being able to pass the burden onto other countries. As a result, from the end of the 1960s, lack of confidence in the US dollar led to capital outflows in the United States, which the US central bank did nothing about. Triggering this falling confidence and the high capital outflows were the expansionary monetary and fiscal policy and the overheating of the US economy in the second half of the 1960s caused by the Vietnam War and domestic efforts to combat poverty. The loss of confidence in the dollar was intensified by President Nixon's announcement, in August 1971, that the dollar credits of foreign central banks would no longer be converted into gold. Clearly, the US government of the time feared that the weakness of the dollar would lead to massive outflows of gold from the United States. The so-called 'Nixon shock' caused the system of fixed exchange rates to totter. The Smithsonian Agreement of December 1971 was an attempt to rescue the system under modified conditions. Further capital outflows from the United States provoked increasingly drastic foreign exchange market interventions by central banks in order to prevent a devaluation of the dollar. This again impeded monetary policy in the countries affected. The Fed remained on the sidelines. The German Bundesbank, in particular, was forced into intervening since the deutschmark had begun to establish itself as the second reserve currency next to the US dollar. The Bundesbank was then one of the leading centralbanks which refused to keep on buying US dollars on 12 February 1973, permitting the drastic devaluation of the dollar.

The instability of international capital flows which characterised the Bretton Woods system in its final stage must be seen against the background of a gradual liberalisation of international capital movements, which in turn clearly hindered the defence of the system. In the end, fixed exchange rates found diminishing support, both politically and academically. In the academic sphere, the naïve view took hold that flexible exchange rates were a suitable way of allowing each country an autonomous economic policy, even with liberalised goods and capital movements. It was also believed that flexible exchange rates would lead to balanced current accounts. If a different economic policy had been adopted, particularly on the part of the United States, and if reform had been undertaken – for example, retaining certain regulations on capital movements that could have curtailed US privileges – the Bretton Woods system could have been saved. However, the political will was lacking and the collapse of the system was regretted by few at the time.

The case of Europe

It was also not realised at the time that the transition to flexible exchange rates would destabilise foreign exchange markets. Figure 1.1 shows that exchange rates between the yen, the mark and the dollar remained stable until the end of Bretton Woods (apart from the one-off revaluation of the mark in 1961). The ensuing period of weakness of the US dollar caused it to lose half its value in relation to the mark – the dollar's main rival at the time – by the end of the 1970s. Up to 1985 there was another period of dollar revaluation – by around 100 per cent – followed by another halving of the external value of the dollar against the mark. The euro did not bring stability, either. After its introduction at the beginning of 1999, it was devalued against the dollar by around 20 per cent, only to increase in value against the dollar by around two-thirds from 2003. The development of the dollar–yen rate witnessed similar somersaults. The exchange rates of the French franc, the UK pound, the Italian lira and other European currencies were also extremely unstable against the dollar and amongst themselves. Such crass exchange rate fluctuations transformed the global currency system into a shock generator in which countries' competitive positions could change rapidly and fundamentally, while fluctuating import prices could trigger welfare and price shocks. It soon emerged that exchange rate movements were not to be explained by differences in inflation rates, interest rates, real GDP growth rates or other fundamentals. Economists are, quite simply, unable to deliver reliable prognoses on the development of exchange rates between the leading currencies of the world.

Flexible exchange rates were established, after the collapse of the Bretton Woods system, between the world's leading currencies: the dominant US dollar was at the top of the currency hierarchy, followed by the mark and the yen, with a markedly lower international circulation, and some other currencies, such as the Swiss franc and the British pound. It would be incorrect to assume from this, however, that since 1973 exchange rates have been completely determined by the market between all the currencies in the world. Rather a large US dollar bloc emerged, in which many weaker currencies – above all in Asia and Latin America – were pegged to the dollar. In Europe the so-called European 'currency snake' developed, since different currencies had begun to gather around the mark. The yen, by contrast, was unable to form its own currency bloc, and other currencies are simply too insignificant to be a major trading or reserve currency.

Turning to a more detailed analysis of monetary integration in Europe, some currencies underwent chaotic fluctuations after the collapse of the Bretton Woods system; the Italian lira and the British pound, for example, experienced profound currency crises. This exchange rate turbulence inflicted considerable harm on European integration and further steps in that direction ran into difficulties. This was one of the main reasons why German Chancellor Helmut Schmidt and French President Valéry Giscard d'Estaing launched an initiative for the stabilisation of exchange rates in Europe. In 1979, the European Monetary System (EMS) succeeded the informal 'currency snake' and created a system of fixed exchange rates between France, the Federal Republic of Germany, Italy and the Benelux countries, although the rates could be modified if necessary, as was indeed the case from time to time during the lifetime of the EMS. As a number of other countries joined the system, the EMS grew, while currencies – such as the Austrian schilling – linked up with the deutschmark without joining the EMS. The crucial difference between the Bretton Woods system and the EMS was the fact that no reserve currency was established in the EMS. All currencies in the system were linked to the European currency unit (ECU), which represented a basket currency related to all the currencies in the system and functioned as the unit of account for fixing exchange rates. The EMS was so constructed that one of the currencies would emerge as a de facto reserve currency. As a result of its prestige among international investors, the mark immediately assumed this role, which to a considerable extent afforded the Bundesbank the privilege of setting interest rates in the EMS.

At the end of the 1980s, accelerated politically by German reunification, a new wave of deeper European integration began. In 1992, the Maastricht Treaty was signed, which foresaw the introduction of a European Monetary Union (EMU) for 1999.

At that time it was assumed that the transition from the EMS to the EMU could be accomplished without great problems. However, the EMS experienced its greatest turbulence in 1992 and 1993. In September 1992, the United Kingdom left the EMS, having entered the exchange rate mechanism (ERM) only in 1990. In 1993, the margin in relation to the institutionally fixed central rate had to be increased from plus or minus 2.5 per cent to plus or minus 15 per cent; devaluation pressures on some currencies in the EMS had become so great that this seemed unavoidable. The problem during this period was that, in order to combat modest inflationary tendencies which accompanied strong growth in West Germany after German unification, the Bundesbank imposed a tight monetary policy with high interest rates. At the same time, the other European countries found themselves in an economic downturn and wanted to lower interest rates. On top of that, the Bundesbank increased interest rates again in summer 1993, although a significant economic downturn had already been forecast in Germany, too. For a number of countries in the EMS the interest rate policy imposed on them by the Bundesbank was simply too much to bear, both economically and politically. Certainly, this was what international investors suspected, leading them to speculate against the pound and the French franc. The very restrictive monetary policy was justified by the Bundesbank as necessary to fight inflation. However, the EMS was not much liked by the Bundesbank, and nor was the EMU, which had been agreed upon in 1990. It is likely that the Bundesbank wanted to sabotage both the EMS and the EMU.