Hayek and His Overcoat

There was an occasion on which the ruler of Balkh, in Central Asia, went to make war. Nomads, taking advantage of his absence, seized the city. The inhabitants put up a good fight, for themselves and their ruler, but lost. The ruler returned, despatched the invaders, and upbraided his subjects. War, he told them, was his business: theirs was to pay and obey. Their leaders promised not to repeat their lèse-majesté.

David Landes takes the story from the scholar of Islam, Michael Cook. It is, for him, a moral tale. Autocracies squeeze, steal and demean. ‘Only societies with room for multiple initiatives,’ he insists, ‘from below more than from above, can think in terms of a growing pie.’ That is why they become rich. And that is why ‘the very notion of economic development’ was a creation of the West. It was only in Western Europe that rulers were in sufficiently poor control for sufficiently long to allow those who made and traded to pursue their interest. It was only there, once the rulers got a grip, that they learnt it could be in their own interest, not least in competition with others, to let this continue. The curves of learning, it is true, were many and varied, and not a few were flat. Rulers who continued to fear for their power were often averse to energy from below. Many tried simply to protect their economies from the intrusive success of others.

The more conservative were also inclined to encourage those skilled in the arts of propaganda to instruct the people that no good would come from following their mercenary noses. In the years between 1405 and 1431, the Chinese embarked on a series of extraordinary expeditions that reached as far as Africa. Their huge junks, as Landes observes, were probably the largest that anyone had yet seen, five times the size of the three ships in which Columbus and his men were to sail into the western Indies at the end of the century. There were 317 of them on the first expedition, some carrying men, 28,000 of them in all, some horses, some food, some arms, one, fresh water. The object was not entirely clear. The Chinese took silk and porcelain and other fine products as gifts for those they might encounter, and, in what they would have seen as tribute, received jewels, exotic beasts and promising substances for their pharmacies at home. In 1430, however, a new emperor overthrew the old, and put a stop to it all. He ordered the shipyards to be dismantled and penalties to be imposed on anyone who dared to persist: by 1500, it was a capital offence to build a boat of more than two masts. The reason was in part fiscal; the expeditions had emptied the coffers. In part it was a matter of opinion. ‘A new Confucian crowd’, as Landes puts it in his breezy, readable way, had come to power in a new capital at Beijing (itself a cause of great expense), and set itself against the enthusiasm felt by the eunuchs in the old court, as well as by Buddhists and others, for travel and trade. The country turned in on itself. There was growth only in agriculture and that was slow.

In Europe and the United States there was a similar disposition to inwardness in the interwar years of this century and, to an extent, after 1945 also. The collapse of a revived Gold Standard in the Twenties, the stock-market crash in the United States and accelerating runs on weaker currencies prompted protectionism. At the extreme, this produced a politics of one or another kind of ‘national socialism’. In order to avoid a return to such self-defeating strategies, the International Monetary and Financial Conference of the United and Associated Nations at Bretton Woods in 1944 agreed to restore stability with a new kind of gold standard, to recover prosperity by means of freed international trade; by restraining speculative movements of money, it wanted to reassure governments and their citizens that states could nevertheless retain a degree of control over their economies. Only Russia, and China again, chose isolation. In the decolonised territories in Africa and elsewhere in Asia, and in Latin America, which had done well from the war, governments tried to find a line between the two. The order of the day was national capitalism with socialist characteristics. For thirty years, new theories ruled.

That, according to Daniel Yergin and Joseph Stanislaw, was the trouble. Yergin, like Landes, is a gifted narrator. The Prize, his 1991 history of what he called ‘the epic quest for oil, money and power’ in the 20th century, was an excellent read. The Commanding Heights is equally racy. With an army of assistants in Washington, he and Stanislaw have read a decent number of the published sources, talked to many interested people in the United States, and to 88 of the more important protagonists around the world, in order to bring us the epic ‘battle between government and marketplace that is remaking the modern world’. The history of oil was a comparatively easy one to write: greed explained almost everything. This new story has been driven by fear, courage, conviction, inertia, envy, vanity and panic, too. There has also been, as Harold Macmillan remarked when asked to say what had guided his premiership, the force of ‘events, dear boy, events’. It would be an impressive historian who, at this short distance in time, succeeded in mastering the complexity of all this. Yergin and Stanislaw have preferred simplicity.

They suggest, without irony, that the new battle has been started by the theory of a now dead economist, Friedrich von Hayek, and those who since the Sixties have refined it. Hayek’s argument, as Yergin and Stanislaw do not quite say, but as Keynes saw clearly and said very colourfully, strains credulity. He claimed that there is a ‘natural’ rate of interest. This is determined by the balance between people’s decisions to spend or to save. The more they save, the higher it is. Banks interfere with this rate at everyone’s peril. Credit extended below it leads to too much investment, hence slumps. Hence also the likelihood that Keynes’s remedy, predicated on the belief that there was too little investment – the remedy that was applied by the governments of the more advanced economies in the West between the Thirties and Seventies – could only make things worse. The structure of production would become even more unbalanced, and there would be inflation. One must wait for economies to right themselves. (‘Is it your view,’ Richard Kahn asked Hayek when he came to Cambridge to explain his theory in 1931, ‘that if I went out tomorrow and bought a new overcoat, that would increase unemployment?’ ‘Yes,’ was the reply. Keynes, although he greatly disliked Hayek’s argument, saw that to sustain his own, he would henceforth have to make it clear that the price of money, or the incentive people have to save, and the price of capital, or the incentive they have to invest, were two very different things.)

Yergin and Stanislaw find support for their argument that Hayek has made the difference. According to Lawrence Summers, formerly chief economist at the World Bank, now Deputy Secretary of the United States Treasury: ‘Things will happen in well-organised efforts without direction, controls, plans. That’s the consensus among economists. That’s the Hayek legacy.’ Professional politicians, too, were affected. Interrupting someone who was pressing what was then the conventional case for the middle way at the Conservative Research Department in the Seventies, Margaret Thatcher pulled out a copy of Hayek’s The Constitution of Liberty. ‘This,’ she proclaimed, ‘is what we believe.’ (The now elderly economist was in turn much affected by his disciple. Asked for his impressions on meeting her, he was, as always, very clear. ‘She is,’ he declared, ‘so beautiful.’)

The new economics seemed in an exhilaratingly simple way to address the problem of rising rates of inflation, institutional intertia and, behind these, a new international economy. Institutions, especially state institutions, rarely change very quickly. In this respect, though only in this respect, ENI in Italy was an exception. Franco Bernabè joined the oil company, still then wholly owned by the state, in 1983. It was losing money and he started arguing for change. The incumbent managers were not pleased. Fortunately for Bernabè, the ‘Clean Hands’ investigation took 20 of them off to jail, where one, the chairman, killed himself. Bernabè rose into the vacated space, implemented his plans, and by 1997, five years after taking over, reported a profit of $3 billion, allowing the Government to realise $17.6 billion on its shares. ‘A state company has to do with war, national interest and self-defence,’ he told Yergin and Stanislaw. ‘And economies were adapted to war until 1990. They were part of closed and antagonistic systems. Access to raw materials was considered the key to survival ... The nation-state, with all its paraphernalia, including state companies, is a relatively recent invention. The global economy already existed by the 14th and 15th century. And it’s the global economy in which we have to compete.’

The ‘global’ economy of the Nineties is of course somewhat different from that of the 1400s. And Yergin and Stanislaw understate its effects. The United States had been losing capital to the rest of the world since the late Forties, and was by the end of the Sixties having to finance its war in Vietnam. Nixon took the dollar off gold in 1971 and floated it two years later. The inflations that followed, extensive borrowing, and what Hayek had called ‘monetary incontinence’ were punished in the expanding currency markers. For many weaker economies, the easy credit of the Seventies turned into the fearsome debts of the Eighties. ‘State failure’, not that of the markets, was now the bogey. The New Political Economy persuaded Conservatives in Britain and Republicans in the United States. In an irony that Keynes would not have smiled at, it was also used by the newly energised Bretton Woods institutions, the International Monetary Fund and the World Bank, to force reform elsewhere. But even in America, where the Government serenely proceeded to amass a vast debt, it was events, not ideas, that drove those who were now in power.

Gonzalo Sánchez de Lozada was one of them. He had written a screenplay about Butch Cassidy and the Sundance Kid and how they fared in their flight to his native country. Someone else made the movie, but he made money, married Miss Bolivia 1959, got himself elected to the country’s Senate, and in 1985, became minister of planning. It was an equivocal honour. By the mid-Eighties the only good thing that could be said for the Bolivian economy was that it had put a stop to bank robberies: inflation was running at an annual rate of 24,000 per cent, and the central bank refused to issue higher-denomination notes; robbers realised that they would have to have a line of trucks to get away with anything worthwhile. Yet ‘no amount of intellectual persuasion’, Sánchez reflected, could have persuaded anyone to act. That needed the inflation, and the escalating debt. With the help of Jeffrey Sachs, a Harvard economist who had happened in a seminar to hear about Bolivia’s hyperinflation, the first anywhere for forty years, Sánchez took control of the state’s finances. In two years, he brought the inflation down to 9 per cent. Inspired by what had been done in New Zealand and by Deng’s intentions for China, and with the support of the IMF, he embarked on what was to be the first of a series of ‘shock programmes’ in a number of beleaguered countries. ‘We created a market economy overnight. Things that seemed impossible to do became possible,’ he recalled. Sadly, as Yergin and Stanislaw do not go on to explain, foreign investors remained uninterested, domestic savings stayed low, and exports did not rise. Bolivia continued to stagnate, redeemed only, as the two authors do say, by an imaginative, if partial, programme to alleviate poverty.

Poorer countries elsewhere were to do better. By the end of the Eighties, ‘emerging markets’, as a Dutch banker, Antoine van Agtmael, had thought of calling them (no one in the rich countries, he’d been told in the Seventies, would buy into a ‘Third World investment fund’), were very attractive. Investors treated them as one, spread their risk, and enjoyed high returns. Portfolio investments were even going into Africa. But the difficulties that became apparent last year in some of the economies in east Asia, the consequences of political mismanagement in Russia, and persistent problems of fiscal reform in Brazil have caused much of this money to move to safer places. By the Nineties, it was the flow of capital across frontiers, and the trade in currencies, that was largely deciding who would succeed, who fail.

Over the longer term, as Landes explains, this has not been the case; the answers have been more local. For Landes, as for Jared Diamond (whose history of the past 13,000 years, Guns, Germs and Steel, was reviewed in the LRB on 4 September last year), they lay at first in geography. What the Europeans came to call economic development started in the temperate zones and only later, and with fitful success, moved to the tropics. Diamond attributes the lack of advance outside Europe and Asia largely to the absence of domesticable plants and animals. And geography, he believes, continued to matter. The withdrawal of the Chinese fleet in 1431, he argues, could only have happened in a country with a smooth coastline. In western Europe, the coast is indented. Along the one, a single power could acquire command: along the other, none could. No Chinese, therefore, convinced that the expeditions should continue, could have done what Columbus did, and hawked his project from port to port, court to court, until he found someone to finance it. Landes, by contrast, argues that even if the Chinese expeditions had rounded Africa and sailed up to Europe, they would have been defeated because of their inferior firepower. Concentrating on the past two thousand years, he emphasises what to Diamond are the epiphenomena: ‘work, thrift, honesty, patience, tenacity’, ideas and, at the margin, a degree of decency to women.

It is to landes’s credit that he has no general theory. Instead, he has prejudices. Max Weber, he is convinced, ‘was right on’. It wasn’t only Calvinists, terrified by the idea of predestination and anxious to do God’s work in order to convince themselves that they were of the elect: ‘People of all faiths and no faith can grow up to be rational, diligent, orderly, productive, clean and humourless.’ What Protestantism did was to create sufficient numbers of such characters in Northern Europe to form a society committed to independence and effort, and in its shared faith, trusting. The new tendency also ‘gave a big boost to literacy, spawned dissents and heresies, and promoted the scepticism and refusal of authority that is at the heart of the scientific endeavour’. Argument, invention, investment, production, trade; more investment, invention, production and trade. (Before he retired from Harvard, Landes wrote a monograph on the importance of clocks in the economic life of Central Europe. He is particularly keen on inventions.) In Catholic Europe, by contrast and later in Islam, as well as among the Confucian crowd, things were very different. The wrong sort of priest too often had the ear of the wrong sort of king, and those, like the Jews, who had the nerve to defy either were not usually welcome.

What then of Japan? Christianity did take there. By the early 17th century, there may have been 700,000 adherents in a population of about 18 million. But these (most of them Catholics) put their God before the emperor. In 1612, Tokugawa Ieyasu accordingly banned the religion, and was taken seriously. In 1637-38, at Shimabara, 13,000 proud samurai died dispensing with 37,000 Christians. There was also something much more peculiar about the country. In the course of the Early Modern period, the Japanese stopped using glass (spectacles had been invented near Pisa in about 1300 and greatly improved the productivity of European inventors and the early accountants), ceased to see the point of accurate clocks, and forgot about the wheel. (‘We are not very good,’ a Japanese professor explained to a friend of mine, ‘with things that are round.’) Nonetheless, though obedient to a fault, the Japanese were rational, diligent, orderly and productive. And ‘at the heart of it’, Landes believes, was their long-standing sense of superiority. ‘The Japanese knew they were superior, and because they knew it, they were able to recognise the superiorities of others.’ (The Argentinian upper classes were much the same. Their mistake was to fix on the British aristocracy and take to polo.) Faced, by the middle of the 19th century, with inertia or rebellion in the provinces and intrusions from the West, and seeing also, though Landes does not mention this, that the country could perhaps take the place of an ailing China, a new group of Japanese politicians decided to take control. And they did so from above, with a cleverly constructed and determined central state. The lesson? ‘Different strategies in different circumstances.’ If one works hard.

In the spirit that he so admires, Landes could have written a very different book, as precise and in its way as satisfying as his Swiss timepieces. This would have sketched in the facts to be explained, laid out the necessary conditions of economic success, explained that none at any one moment is sufficient, and concluded that no combination has worked every time because each time has been different. Like a Swiss timepiece, it would have been exact and, in its intricacies, a wonder to behold. It would also have been less than compelling. Instead, Landes has put together a lifetime’s research of his own and a voracious reading of the work of others in a book that, in its sweep and detail, is almost impossible to put down. It is an ostensive demonstration of the vigour and scepticism that he admires in others. For all except a certain sort of king or priest, and all Argentinians, it is also very funny.

In the Hayekian world, however, economics remains a dismal science. ‘As countries anchor themselves in a world of open and connected markets,’ Yergin and Stanislaw observe, ‘they are to a significant degree transferring control of the commanding heights to the dispersed intelligence of the market.’ Yet even these authors agree with Landes that the new international economy is a threatening place for those countries that cannot attract capital and keep it, and for a significant number of the citizens of every country. Even Robert Rubin, Secretary to the United States Treasury, is anxious about the tendency of the dispersed intelligences to move as a herd and amplify the oscillations. This is not to say that the financial interests of what the economist Jagdish Bhagwati, no enemy of trade reform, has called the ‘Wall Street-United States Treasury-IMF Complex’ are not still strong. The Administration in Washington has been seeking Congress’s approval to amend the IMF’s articles of agreement to give it the power to insist that any government to which it lends remove all capital controls and move to the full convertibility of its capital account. The World Trade Organisation has persuaded 70 governments to commit themselves to open their banking, insurance and securities markets to foreign firms. And the Organisation for Economic Co-operation and Development is negotiating for a liberal Multilateral Agreement on Investment.

Some governments outside the United States have been ready to agree to such moves. South Korea was eager to secure its standing with the OECD, to which it had at last been admitted, and fatefully deregulated much of its financial sector before the crisis last year. Thailand and Malaysia opposed the WTO agreement, but capitulated as the crisis unfolded, fearing that they might jeopardise the help they were by then asking for from the IMF. A few, including Argentina, have even established a currency board. This removes the responsibility for setting interest rates from governments and central banks. At a fixed exchange rate, determined by the amount of gold and the size of foreign exchange reserves at the point at which the board is established, it automatically adjusts interest rates to the reserves. It is a fine reply to the sceptics where, as in Hong Kong in the early Eighties, the reserves are good, the economic and social hazards from deflation are slight, and there is sound banking. Other governments resist the liberalisations. It is more difficult for them now to protect their trade, and for many, no longer to their benefit. But many are wary, some already weary, of the unsettling effects of flows of money and of speculation against their currencies. Their solution is unilaterally to control the flows of short-term capital. This allows a government or central bank to set interest rates without fear of movements in the exchange rate. India and China have for some time resorted to controls of this kind. An exasperated Malaysia imposed them at the beginning of September. Even within the United States itself, opinions on further liberalisation are divided. The Administration, notwithstanding Rubin’s worry, would like the IMF to have more powers and resources. Republicans object to voting more money to feed the ‘moral hazard’ of the Fund re-imbursing investors. Dissident Democrats are willing to accede to an article insisting on the removal of any remaining capital controls and full convertibility if there is one also obliging the IMF to alleviate the distress that commonly follows its interventions.

But in few places is the difference of opinion at the moment more divided, more apparent, and possibly of more consequence than in Russia. Unable to finance its commitments through exports and taxation, as Edward Luttwak explained in the last issue of the LRB, the Russian Government has had to borrow, issuing short-term bonds to domestic and international investors and, in principle at least, accepting the terms of the IMF. But it has also been unable to stop its central bank allowing other banks to expose themselves in the forward dollar market. More money has recently been going out of the country than coming in. In the middle of August, the Government decided to extend its bonds, prompting cries of theft from those who were holding them. This triggered a steep devaluation and a consequent rise in debt. Boris Fyodorov, the acting Deputy Prime Minister, brought Domingo Cavallo, the architect of Argentina’s currency board, to Moscow to assess the suitability of such a device for Russia. Fyodorov will have known that its implementation would lead to high rates of interest and a corresponding shortage of cash. Many firms and individuals would suffer. But international finance would be reassured, investment might later increase, and trade could proceed on a more predictable foundation. Russia’s notorious new rich certainly saw the advantages of such a move; their TV stations instantly tangoed Cavallo onto their screens. One or another kind of nationalist, by contrast, as well as the Communists, have been insisting that if the citizens are to have work, the economy must be protected and directed from above with money that the Government has no option but to print. If these people get their way, a very small economy (for such a large country) will become smaller still. The currency will inflate, and production and trade, beyond internal barter, will wind down. It is not a solution for the longer term.

A week after Cavallo’s arrival, the acting Prime Minister, Victor Chernomyrdin, proposed a compromise: a currency board from January, with the reserves to support the rouble possibly being held abroad and forfeited if the board is abandoned within five years, a cut in taxes, with an amnesty on outstanding non-payments, and the immediate issue of 37 billion roubles (a little over $2 billion) to cover the arrears of pay and pensions, the measures to be supported by an additional $10-$15 billion from the G7 countries. Those speaking for the Communist majority in the Duma announced that it was not prepared to accept this or any other proposal from Chernomyrdin. Within a week, Yeltsin had withdrawn his candidature.

That things have been so bad in Russia in the past decade, Landes might say, suggests that there is something wrong with its ‘culture’. Yergin and Stanislaw would say that it has not yet fully grasped the truth. Neither book says enough about the independent power of politics in economic life. If culture is the problem, the problem is that there are several cultures. In differences that echo those of the past, one group leans towards the West, another turns away from it, and a third, realising that neither is in control of the military or the currency, is running rackets of the kind that preceded the emergence of every modern state. If it’s the truth that’s obscured, where does it lie? Theoretically, the liberals might seem to have the better argument. Yet currency controls have been working in China. The economy there, which is closely linked to others in east Asia, has, like Russia’s, although not so alarmingly, been faltering, the banks have much bad debt, and there is widespread corruption. But the Government has so far managed both to maintain its currency peg and to reduce interest rates by keeping the renminbi non-convertible. Even the West is now relieved that it has imposed controls. But there are no free elections in China. Radical liberals, of whom there are few, have no voice. In Venezuela, where the economy is also weak and there are elections, it hasn’t mattered to the liberals whether this December the country elects to the Presidency a former Miss Universe or the ex-colonel who tried to stage a coup in 1992, so long as one or other allows their view to prevail. Their gamble has been that, as in Argentina, the country would accept the outcome. (Their calculations are coming undone. They at first preferred the former Miss Universe. When she started to write her own script, they switched to the ex-colonel. But he, too, is now speaking for himself, and is high in the polls. Meanwhile, the price of oil, not least as a result of Venezuela’s own rashness in increasing its production last year, has fallen, and the markets have started to threaten. As a result, the liberals’ third possibility, the president of the state oil company, is unacceptable, and they have no other.)

Russia can neither ignore the liberals nor expect to reach a compromise with them. The country is committed to a competitive politics, but the parties are too opposed. Alexander Lebed, the former general who made his name in Chechnya, now governs a province in Siberia, and is presently the most popular choice to succeed Yeltsin in two years’ time, pointedly reminded President Clinton in Moscow that there are a large number of poorly guarded nuclear weapons in the country. In Latin America, a character of this kind might have been used by liberals to get the votes, give a semblance of unity, do most of what they wish, even perhaps accepting a currency board, mollify the workers and peasants, and keep the Army fed and distant. Ex-colonel Chávez may do this yet in Venezuela. In Russia, however, this strategy has not worked under Yeltsin, and as long as the nationalists are allied with the Communists, seems unlikely to do so. Yeltsin himself has conceded to the Duma. His new candidate for prime minister, Yevgeni Primakov, is a pragmatist from the ancien régime. He has long experience in foreign affairs and intelligence, but has never had economic responsibility. This has been given to Yuri Maslyukov, the chairman of the former Gosplan and still a member of the Communist Party. Victor Gerashchenko, chairman of the former Gosbank, has been put in charge of the money supply. Gerashchenko, notorious in the past for his money-printing proclivities, immediately announced that he would have to print again. Primakov added that the state would have to ‘interfere in and regulate’ many other parts of the economy. Meanwhile, Russia has begun defaulting on the interest on its foreign debt. All the banks have collapsed, as Vladimir Potanin, the head of one of the country’s most powerful financial groups admitted. His own group, he said, would default on forward contracts for the rouble and seek to renegotiate its other debt; creditors were welcome to take its industries and its property in Moscow. Another governor in Siberia has even stopped sending the gold that his province produces to Moscow. There is no sign of the compromise that Chernomyrdin was striving for, and that might have brought support from overseas.

The crisis in Russia exposes more than the problems of constructing a coalition for reform in a still unsophisticated democracy. It marks a new moment in ‘the battle between government and marketplace that is remaking the modern world’. In east Asia last year, the problems were largely in the banks. Too much money had been pouring in, too many loose loans had been extended, bad debts were rising, and exports were faltering. The countries with insufficient foreign reserves to support their currencies had to be rescued by the IMF. The Fund lent more than it had ever done before, and it was still not enough. The United States, Japan, Singapore and China saw that it was in their interest to help, and did so. Politically, each of the affected countries, even Indonesia, has – so far – had the strength at least to try to recover. In Russia the problems have been more widespread. Savings were low, tax was not being gathered, the real economy was inert, the state had to borrow, and money was leaving as soon as it arrived. An already depleted IMF lent as much as it dared, even using its long untouched General Arrangements to Borrow, which exist to be activated only when the international monetary system is thought to be at risk. That, as in the case of east Asia, was not enough, and in the absence of a credible programme for reform, the United States, Germany and other interested governments have been disinclined to help again. The IMF cannot afford a third large crisis. It could rescue a fairly small economy like that of Venezuela, though even this would cost more than it presently has, including the funds available for its General Arrangements to Borrow. It could not by itself effectively rescue an economy as large as that of Brazil, where the fiscal deficit continues to grow and capital flight is accelerating. Moreover, many are coming to accept that even if it could, the conditions that it usually sets might not be in the best interests of those who provide its funds or of the afflicted countries themselves.