In the 1990s, the international economic and financial system was more stable than in previous decades, despite the turbulence of 1997-98. But that stability is now disappearing fast -- along with the fundamental consensus on which it rested.
One of the most important elements of the 1990s consensus -- exported globally as the "Washington Consensus" -- was the idea of fiscal responsibility. In the US, the commitment to fiscal rectitude followed then US President Bill Clinton's early realization that balanced budgets would stabilize financial markets, reduce borrowing costs and thus generate higher growth. He carried this policy through a skeptical Congress, even at the price of abandoning many of the social welfare promises he made during his 1992 presidential campaign.
In Europe, meanwhile, the consensus was embodied in the European Union's Growth and Stability Pact and made operational in the rigid Maastricht criteria that capped government budget deficits at 3 percent of GDP.
Now the fiscal consensus of the 1990s is under sustained attack worldwide. Portugal, Germany, and France proudly declare their intention to deviate from the Maastricht criteria. But it is the US that is leading the attack on fiscal discipline. The US federal budget deficit for 2001-2 was US$159 billion, quite respectable (in percentage terms) by European standards. But more red ink is likely, owing to the current administration's irresponsible commitment to tax reduction, and, unlike Clinton, or, indeed, the first US President George Bush, George W. Bush does not intend to break his campaign promises.
Bush's view on taxation is strikingly different from his predecessor's. Bush's election program promised big tax cuts, which he followed through on. When asked about the ballooning deficit, he explained that "we have a deficit because tax revenues are down;" and that the tax relief package "has helped the economy, and that the deficit would have been bigger without the tax-relief package." So, in Bush's eyes, tax cuts reduce the federal deficit. But this is precisely the so-called "supply side" argument that the president's father once famously mocked as "voodoo" economics when former US president Ronald Reagan expounded it.
Two scare stories underlie this theory. The Japanese scare story of the 1990s, in which monetary and fiscal policy prove powerless in the face of a sustained deflation, is the economic trauma now used to rationalize Bush's vast 10-year program of tax cutting.
Sept. 11th is the second scare story. At the beginning of 2002, the president proposed a US$48 billion boost in military spending -- a sum larger than the total defense budget of every country except Russia. Overall, the new US military budget is US$396 billion, just under 4 percent of GDP. A war with Iraq would add around another US$100 billion, or 1 percent of GDP, to the defense budget (the war in Afghanistan cost a humble US$10 billion.) Precedents abound in US history for using scare stories to justify fiscal expansion. Indeed, today's bout of fiscal stimulation seems historically better founded than the brief episode of stability in the 1990s.
In the 1980s, Reagan believed that America was losing its entrepreneurial edge and that Japan and Europe were overtaking it, so he let the deficit rip. In the 1960s, then President Lyndon Johnson feared the risk of a new 1930s-style Great Depression, and responded with an increase in domestic social spending ("the Great Society") at the same time as the escalation of the war in Vietnam boosted military expenditure.
In both periods, fiscal laxity stoked volatility in the foreign exchange markets, where the surge in inflation in the 1960s destroyed the fixed exchange rate system of Bretton Woods. This generated a wave of mutual recrimination across the Atlantic, with Europeans (especially the French and the Germans) accusing the US of irresponsible inflationism, while Americans blamed Europe for refusing to grow fast enough. The episode greatly strengthened anti-Americanism in Europe.
In the 1980s, the dollar first soared against the yen and European currencies, then it collapsed. Again, both sides of the Atlantic played a mutual blame game. Such instability would matter little if it produced only dizzying movements on currency traders' computer screens. But those movements produce big changes in real exchange rates, i.e., in manufacturing competitiveness and thus fuel demands for trade protection. When the dollar strengthened at the end of the 1960s and in the mid-1980s, US industry felt threatened by foreign imports and pressed for changes in the trading regime.
A new wave of deficits and exchange-rate instability would thus call into question the most fundamental and beneficial legacy of the 1990s -- the major push for trade opening and liberalization.
Sometimes people are so confident about the robustness of globalization that they assume that it can't be reversed, but this is exactly what each round of financial and economic turbulence threatens. The world is now more integrated than in the 1960s or in the 1980s. Recent events suggest that we are more vulnerable that ever to a sudden and sharp backlash.
Harold James is a professor of history at Princeton University and author of The End of Globalization: Lessons from the Great Depression.
Copyright: Project Syndicate
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