Risk & Other Four-Letter Words

Wriston, Walter B.

1986

Gresham Revisited

Sitting in my office one day, attempting to collect my thoughts, I caught the eye of Sir Thomas Gresham, whose portrait hangs over my desk. It seemed to me that Sir Thomas was trying to tell us something. Gresham's law, expressed in but five words-bad money drives out good reminds us all that money has no value except that of scarcity, which is a good compass point to keep in mind when sailing through the verbal storms of both the new and the old economics.

In addition to understanding clearly the problems of the domestic money supply, Sir Thomas was also one of the first realists on the subject of manipulation of foreign exchange rates. He wrote to his sovereign, Edward VI, as follows:

I did raise the Exchange from sixteen to twenty-three shillings, whereby all foreign commodities and ours grew cheap; and thereby robbed all Christendom of their fine gold and fine silver. And by raising of the Exchange, and so keeping of it up, the fine gold and fine silver remains forever within our realm. -Sir, if you will enter upon this matter, you may in no way

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relent, by no persuasion of the merchants. Whereby you may keep them in fear and in good order: for otherwise if they get the bridle, you shall never rule them.

Here, in short, is realism of a very high order. For what Gresham did in a few blunt words was to pinpoint the intimate connection between international trade, monetary fluctuations, and nationalistic considerations.

We have a tendency today, in considering our modern-day global economic problems, to treat each of those factors in isolation, when in fact they are still very much connected. We get frequent reminders.

In the late 1970s, under the Carter administration, the dollar was periodically battered on the foreign exchange markets because foreign traders did not see any consistent economic policy coming out of Washington. One member of the Federal Reserve board would say, "We're going to pump up the money supply if there's any slowing of the economy," and other governors would avow that such action would not attenuate inflation. The result was that traders sold the dollar and moved into what they perceived to be harder currency. The swings got to be so great that the Federal Reserve put together a package to go in at the margin to stabilize the dollar, and it worked out pretty well. The blame, of course, was laid on the foreign exchange traders, just as a decade or so earlier a chancellor of the exchequer invented the Gnomes of Zurich to explain Great Britain's economic vicissitudes.

This situation about the futility of controls is not new. It was explained to Samuel Pepys in 1664. On January 27-29, Pepys recorded a conversation with a Mr. Slingsby about the mint and coinage of money.

... he made me fully understand that the old law of prohibiting bullion to be exported, is, and ever was a folly and an injury, rather than good. Arguing thus, that if the exportations exceed importations, then the

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balance must be brought home in money, which, when our merchants know cannot be carried out again, they will forbear to bring home in money, but let it lie abroad for trade, or keepe in foreign banks: or if our importations exceed our exportations, then, to keepe credit, the merchants will and must find ways of carrying out money by stealth, which is a most easy thing to do, and is every where done; and therefore the law against it signifies nothing in the world. Besides, that it is seen, that where money is free, there is great plenty; where it is restrained, as here, there is a great want, as in Spayne.

Samuel Pepys described Mr. Slingsby as "a very ingenious person," and I have to agree. Nothing much has changed except the method of moving money. Governments still attempt capital controls, often in an attempt to hold an exchange rate for its currency that the rest of the world regards as unrealistic. The difference is that such efforts now fail sooner rather than later.

My experience around the world, and I've been making the circuit for thirty years or more, is that whenever countries have poor fiscal and monetary policies, and their currency starts to depreciate, they look for an answer other than themselves. The Gnomes of Zurich disappeared from public view when they outlived their usefulness. To blame the foreign exchange traders now is like saying that the government bond market declined on Wall Street yesterday because Salomon Brothers doesn't like the U.S. Government. The fact is that the foreign exchange market now amounts to around fifty trillion dollars a year and is just too big for any one entity to move. If you took all the capital of all the banks in the United States and sold it in the foreign exchange market, it would amount to about ten minutes of trading. The myth that somebody can influence a market of that size is exactly that. No greater evidence exists than that provided a few years back when the British were fighting to keep the pound from being

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devalued. They lost their entire reserves and borrowed a billion dollars from the International Monetary Fund, and lost that too, all within a couple of months. They devalued the pound anyway. It was only when the IMF put Britain on a sound monetary policy that the pound began to improve. The market is just too big for even the central banks to do anything about it, as witness the failure of fixed exchange rates and the failure of the snake in Europe, and the success of floating exchange rates. In the global marketplace now, the value of the dollar at the end of the day-or that of any currency in our interdependent world-rests on the productive capacity of the issuer and how the rest of the world views the use or misuse of that capacity.

In the short term, sometimes countries or companies get into trouble with imports because they refuse to look at the real world. We lost the shoe business in New York not because of price but because of styling. The Europeans, particularly the Italians, beat us blind on styling. The international division of labor is always operative and has taken on the added dimension of consumer preference, which requires a new kind of capital.

In the United States, the sluggishness of capital formation, resulting from decades of shortsighted tax policy, has had a harsh impact on the competitive position of our older industries, for all of the reasons by now familiar and one less so.

To my mind, at least, the purpose of capital is to put in place the various tools that will permit our societies to increase their productivity. The productivity of manual workers is very largely related to the efficiency of the machines they operate. While this appears to be self-evident, not too many people have taken the second step in the thought process. This point was made most cogently by Peter Drucker when he said:

A little reflection will show that the rate of capital formation, to which economists give so much attention, is a secondary factor. Someone must plan and design the equipment-a conceptual, theoretical, and analytical

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task-before it can be installed and used. The basic factor in an economy's development must be the rate of brain formation, the rate at which a country produces people with imagination and vision, education, and theoretical and analytical skills.

The capital problems of the '80s can be divided into two categories: money capital and intellectual capital. The money needs of industry are generally reflected by numbers that appear to be finite even though the underlying input is often at best an educated guess.

A few examples illustrate the point. In 1948, the Pennsylvania Turnpike, the grandfather of major American toll roads, floated a bond issue of $135 million. That year government and private borrowers raised a grand total of $14 billion in American capital markets. If some study group had forecast in 1948 that toll road construction would require $3.5 billion over the next eight years, certainly the specter of a capital shortage would have reared its head. But by the time the roads were built, the size of the capital markets more than doubled. Similarly, in the mid-1950s, when the capital markets provided an average of about $30 billion, the computer industry and the airlines, to name just two, did not figure prominently in any widely publicized list for capital investment. Yet the airlines raised more than $7 billion and the computer industry more than $2 billion through underwriters in the U.S. capital markets in the 1960s. In those industries, where technology was advanced and where productivity was relatively high, capital investment grew rapidly and their competitive positions in world markets became dominant. On the other hand, when technology failed to produce sufficient increases in the rate on capital, investment dried up and some industries found themselves under pressure from imported products in their home markets.

This is another way of saying that superior intellectual capital always attracts the necessary financial capital over time because it produces a sufficiently attractive real rate of return.

The projected capital gap as such, which we hear so much about from time to time, is a misconception built on a fallacy. Everyone, whether in business, government, or academe, or even in our individual private lives, makes a list of aspirations, which then are formalized through elaborate rationales into projects with price tags on them. In that way we convince ourselves that we "need" whatever is involved and that dire consequences will occur if we do not fulfill that "need." The aggregate total of all those project lists always exceeds our resources by a wide margin. It makes a wonderful thing for clever people to write about, but those who employ the erroneous shopping-list approach to establishing a capital shortage may unwittingly invite an equally erroneous solution-capital allocation by government. Only a free market can efficiently and equitably allocate credit and capital. The so-called shortfall in capital, produced by comparing projected capital formation with our hopes and dreams, will be resolved in the same way it has always been resolved: that is, by canceling or reducing those capital investments which cannot economically be justified.

As some capital investments terminate and others take their place, our living standards and life styles are shaped differently from what we might expect, or they might fail to rise to the expectations of business, government, and consumers. But the failure of living standards to rise to our expectations will be determined not as much by the of capital formation as by the of capital formation.

Since business and finance need a constant injection of new capital investment, the reasoning runs that increased capital investment means more production, if all other things remain equal. More goods and services would relieve shortages, and thus ease prices and drive down the rate of inflation. That scenario has a natural logic which commends it, but the hooker is in the qualifying phrase, "if all other things remain equal." Since most things in this world are comparative, it becomes pertinent to point out the higher investment being made by other industrial countries. When we look around the world,

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comparative totals of gross investment as a percentage of GNP put the U.S. at the bottom of the list with a rate of 18.2 percent. Japan was at the top with 36 percent, then France with 28 percent, and Germany with 26 percent. Unfortunately, these higher investment rates did not produce lower inflation. The fact was that Japan, the country with the highest rate of investment, also had the highest rate of inflation. France, with the next-highest rate of investment, produced the next-highest rate of inflation. As we reflect upon these numbers, it becomes unfortunately clear that there is nothing in the relationship between levels of investment and inflation in this country or abroad to suggest that higher levels of capital formation desirable as that goal must be-will save any nation from inflation. Only governments create inflation and only governments can solve it. Similarly, governments now must face the new realities of international trade.

Although political ideology remains a disruptive force, many nations now recognize that self-interest and the common interest are not mutually exclusive. Instead of turning inward and building walls, developed and developing nations that have welcomed foreign trade and investment have been able to speed social as well as economic progress.

The Soviet Union, for example, which once closed itself off from the markets of the West, has become one of the largest markets in the world for advanced technology. Some Eastern European countries have long understood the importance of foreign goods and capital for their development. Funds from the West have supported an assortment of projects in Eastern Europe.

Anyone who has observed the gyrations of our global economy since the end of World War II cannot fail to be impressed by the spectacular growth of countries like Brazil. Credit for Brazil's progress and prosperity is due most of all to its willingness to rely on incentives rather than directives to attract foreign investors. Brazil's enlightened investment policies have made that country the largest recipient of development loans from the World Bank, and lured billions in direct

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investment from abroad. There is, perhaps, no better expression of world confidence in Brazil's future than the fact that roughly half the funds committed in that country are reinvested each year.

Although the tragic events in Southeast Asia overshadowed the region's economic picture, several nations there have been showcases for the effective encouragement of capital investment. Singapore is a stunning example of the advantages of being hospitable to foreign capital. At the beginning of 1960, the local economy depended almost entirely on services and Singapore's role as a distribution center. A decade later, the mangrove swamps were transformed into a modern industrial center, thanks to government-backed investment incentives.

Singapore, along with some of its neighbors, has adopted a sensible approach to the repatriation of funds. In general, there are no restrictions on full remittance of profits and capital, and in addition, there are tax holidays and tariff incentives. Singapore itself is essentially a free port, since goods can move in and out of the island as freely as money.

The booming economy of Singapore serves to illustrate and underscore the direct correlation that invariably exists between prosperity and economic freedom. West Germany, one of the most affluent of all nations, has had a minimum of restrictions on trade, as have Belgium and Switzerland. Both Japan and France have become less restrictive in order to create a more cordial climate for their own goods abroad.

There is no question, of course, that when inflation is rampant and countries are plagued by unemployment and an assortment of internal ills, there is always a temptation to institute controls to obtain short-term advantage. Protectionism in a variety of guises remains a real and constant threat. The history of the world, though, confirms again and again that not only do controls fail, but, on their way to failure, they distort the global marketplace-discouraging producers, causing shortages, and creating uncertainty.

The Smoot-Hawley tariff, which touched off a tidal wave of retaliation to deepen the global depression in the '30s, is a case in point. So are wage and price controls, which have been tried and found wanting since the time of the Roman Empire. Nevertheless, the exponents of protectionism and the advocates of expropriation remain alive and well. The emergence of the Burke-Hartke Bill in the U.S. in the mid-1970s, and certain other ill-fated proposals that come before the Congress from time to time to discourage foreign investment in the United States, are classic examples of such retrogressive thinking.

The World Bank has documented clearly the fact that if someone gains a dollar from protection, someone else in the same country loses a lot more. For every $20,000-a-year job in the Swedish shipyards, Swedish taxpayers pay an estimated $50,000 annual subsidy. Protection costs Canadian consumers $500 million a year to provide an additional $135 million of wages in the clothing industry. When Japanese consumers pay eight times the world price of beef, Japanese farmers are not made eight times better off. It costs them that much more to produce it. Moreover, protectionism slows economic recovery. Slow growth, the World Bank said, is less likely if protectionism is avoided, since protection itself would reduce the incentives that promote technological innovation and improvements in productivity.

The U.S. economy is becoming more and more dependent on foreign trade, exporting 20 percent of its manufactured goods and 40 percent of its agricultural produce. Foreign trade accounts for a third of all corporate profits and 16 percent of our country's factory jobs.

But this has not stopped the United States from seeking to curb imports of textiles, sugar, European steel, and Japanese automobiles. The U.S. Congress periodically considers legislation that would require virtually all automobiles in the United States to be built substantially of parts made in the United States.

Protectionism at best can only delay the inevitable; it can't

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stop change. Arthur Dunkel, the director-general of the General Agreement on Tariffs and Trade (GATT), recently used the textile industries of Europe as an example of what protectionism has achieved. Since 1977, European textiles have enjoyed more protection from so-called low-cost imports than ever before. Yet in the following three years, many European countries saw textile business failures, mill closures, and job losses at unprecedented levels. Dunkel concluded that the long struggle to preserve jobs in textiles has in many cases merely postponed their loss to a period when alternative employment is even more difficult to find.

Service industries are also facing new protectionist barriers. The reason is simple. World trade in services is now well over $600 billion a year. In many countries, a large portion of the gross national product, and consequently jobs, depend on the services sector of their economies. Barriers are most conspicuous in transportation, communications, and financial services.

For example, no operating license has been given to a foreign insurance company in Norway in four decades. Foreign engineers pay higher income taxes in Brazil than native born engineers. London's is printed in Germany and then flown to London by air freight, because of restrictions on the transmission of foreign data bases and typesetting files. Nor can the use the quiet hours on other people's leased lines, because of the British Post Office's restrictions on sharing leased lines. And the United States bars foreign shipping companies from competing for American coastal trade. All together, there are more than a thousand such barriers to international trade in services. Freely competing amidst change has never been easy. We are traveling in a political direction for services that is the fundamental equivalent of high tariffs on merchandise.

Those who call for a return to the jungle of protectionist controls forget that money is fungible. When government bureaucracy restricts or restrains it, capital takes flight. For example, Washington's efforts to attenuate the importance of

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Wall Street with the passing of the now defunct equalization tax merely served to exile American capital. American ceilings on interest rates merely served to develop and to fuel the Eurodollar market. This market, the creation of entrepreneurs -not politicians-has financed the great burst of trade and investment in modern history. Its success confirms beyond all doubt that in a mobile world-with an infinite demand for funds-controls are no match for market forces.

Those who oppose the free flow of capital also invariably exaggerate the power of capital. They assume that money alone can take over a company or a country. This simplistic view overlooks the fact that nation-states are governed, not by capital, but by people, by laws, and by the powerful forces of the market. If a foreign investor does not operate in the public interest, abide by the laws, and produce what people want, he will fail as others before him have failed.

Underestimating the sensitivity of capital and overestimating the power of capital indicate a lack of historic perspective. It should be obvious to those who look back into history that each nation on earth whose citizens have succeeded in bettering their lot in life has drawn heavily on the capital, experience, and expertise of others. In the end, each nation develops a unique system of its own. No two national structures are the same, nor should they be, for each, if it is to endure, must fit the temperament and the value systems of its people.

Since the early decades of American independence, the United States sought European capital to build its roads, canals, and railroads. What passed for our central bank in those days was owned and controlled by European investors. Our first Secretary of the Treasury, Alexander Hamilton, summed up the American attitude toward foreign capital in 1791 when he said:

Instead of being viewed as a rival, it ought to be considered as a most valuable auxiliary, conducing to put in motion a greater quantity of productive labor...than could exist without it.

Hamilton's view is perhaps more apt today than it was then. The planet has now become too small, and the fate of all of us too interwoven, to engage in nationalistic games that set nation against nation. Economic chauvinism is obsolete in a world where the prosperity of all nations depends more and more on cooperation and free trade.

The emergence of protectionist sentiments around the world is once again looming as a clear and present danger. Recently, Wilhelm Haferkamp warned that the "protectionism that kept millions on the dole forty years ago is now being presented in a new guise, with seductive, modern, rational sounding slogans." He is right, and there is no better example of the use of cosmetic language to disguise protectionism than the slogan "organized free trade." Like organized freedom, it is an Orwellian euphemism.

The strongly protectionist tone of some recent pronouncements on trade can be traced to the emergence of certain political and economic trends in developed and developing nations. There is, for example, a sluggishness of demand in the capital equipment areas of many industrialized countries. Slow growth has been accompanied by persistent high rates of unemployment. While conventional wisdom suggests that high unemployment and free trade are traditional enemies, history does not validate this assertion. The Reciprocal Trade Act of the United States, which pushed the world community toward freer trade, was passed by our Congress in 1936, when we had massive unemployment.

This time around, we have some new factors. A number of countries in Latin America and the Far East, now in the takeoff or miracle stage of their development, are pressing their exports upon the world. Low wages and a large and productive work force have enabled these nations to excel in the production of textiles, clothing, electronics, and other labor-intensive goods. As a result, their export industries have a strong advantage in European and American markets.

Unless these countries can continue to expand their exports of manufactured goods, their economic development

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will be stunted and the demand for foreign assistance will be accelerated. As they expand their exports, however, important and painful shifts in the industrial structure in the United States and Europe result.

We are all aware that real wages in much of the industrialized world have risen too fast. We recognize that the wage differentials have narrowed between modern, efficient industries and older, less efficient ones. Trade restrictions which coddle inefficiency invariably lead to economic stagnation.

What is needed is a readjustment of the structure of industry in many leading countries in order to respond to competition from new arrivals on the world industrial scene. It is the tendency of governments, however, to resist such adjustments and push them off on foreigners.

While all of these problems can never be solved to perfection, they can be coped with so as to do as little damage as possible to the general welfare. What the world needs are new trading rules to deal with new competitive realities. There is urgent need for more adjustment assistance and marketing agreements under GATT supervision to prevent what has been called guerrilla warfare in trade form erupting into open hostilities. The planet has become too small, and the fate of all of us too interwoven, for us to engage in those old nationalistic games, which dilute the talent and dissipate the resources of mankind.

Our global society is, as always, in a period of transition. The old notion that exports are good and imports are bad is being replaced by the idea that exports are the price we pay for trade and imports are the benefits we receive from it. The eternal conflict between what people pay to buy goods and what they earn to produce goods will never be easily resolved The simple truth, however, is that to the degree we cut our imports, we are increasing costs to the consumer and inviting retaliation, for the only way the world can sell more abroad is to buy more abroad.

One intellectual discipline can borrow from another. The work in theoretical chemistry by the Belgian Nobel laureate

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Dr. Ilya Prigogine has parallels in political philosophy. He has established that life can come into being and, contrary to the second law of thermodynamics, continue to expend energy without drifting into chaos or being entirely dissipated. Dr. Prigogine has explained his complex theory for laymen with an analogy of two towns-one, the walled city of feudal days, totally isolated from its surroundings, and the other in constant communication and interchange of goods, services, and ideas with its neighbors. The first city, representing the closed system of classical physics and chemistry, must inevitably decay and cease to function, while the second city, interacting with its surroundings and nourished by others, will, even as it gets more complex, become better organized, grow, and flourish.

The Prigogine parable, in my view, is equally applicable to nations. Those nations shortsighted enough to persist in raising protectionist walls against the ideas, goods, and capital of their more productive neighbors will over time share the fate of the walled city.

The conflict between protectionism and free trade is not of recent vintage. Indeed, it goes back to Biblical times, with Joseph's attempt to restrict the sale of grain in Egypt.

More than a century ago, the French economist Frederic Bastiat drew up a petition claiming that French manufacturers of candles, lamps, and other lighting devices were suffering from the "intolerable competition" of a foreign rival. This rival, he wrote, was "in a condition so far superior to our own for the production of light, that he absolutely inundates our national market with it at a price fabulously reduced." The rival Bastiat had in mind was none other than the sun.

He went on to urge the candlemakers to challenge the competitive advantage of the sun. The sun's monopoly could be destroyed and a demand for artificial light created, he argued, by simply passing a law ordering the shutting of all windows, skylights, and other openings.

Bastiat concluded his petition, however, with this admonition:

Make your choice, but be logical; for as long as you exclude, as you do, iron, corn and foreign fabrics, in proportion as their prices approximate zero, what inconsistency it would be to admit the light of the sun, the price of which is already at zero during the day.

Bastiat's satire on the fallacy of the extreme protectionist position is as pertinent today as it was then. Yet many men are as reluctant to accept the idea of the interdependence of nations in the global marketplace as they once were to accept the Copernican theory that the sun is the center of our universe.

Man's hesitancy to adopt new concepts intellectually and adjust to them emotionally is still the greatest obstacle of all to peace and prosperity on this planet. However, those of us who do not fear change and are able to view the entire world as a market for goods, services, and ideas now have as our allies the young men and women who know that a global economy is emerging and it makes no more sense for nations to turn inward than for the French candlemakers of the nineteenth century to try to shut out the light of the sun.