Dimensions: 6'' x 9'' 226 pages AEI Press  (Washington) Publication Date: January 1999 Hardcover ISBN: 0844740810 Price: $ 24.95 Add to Cart   Examination Copies

January 1999
Economic Puppetmasters: Lessons from the Halls of Power
By Lawrence B. Lindsey

This book provides an insider’s perspective on the bureaucratic structure of governmental institutions that shape economic policy and on the incentives and limitations of the individuals who head those institutions. It offers readers a rare look at some of the intended and unintended effects of public policy on both U.S. and international political economy.

Lawrence B. Lindsey, who served as a governor of the Federal Reserve Board from 1991 to 1997, is a resident scholar at AEI. He is the author of The Growth Experiment: How the New Tax Policy Is Transforming the U.S. Economy (Basic Books, 1990).

So, this is a global economy? It sure doesn’t look very global. In America, we talked until recently of a New Era. Wall Street continuously set new records, having risen more than tenfold since the bull market began in 1982. For the first time in its history, the United States has had a sixteen-year expansion punctuated only by one short and shallow recession in 1991. Optimists tell us this is just the beginning--that we have two decades of prosperity ahead. Pessimists worry about a break in the market leading to another depression and, at this writing, in the fall of 1998, the pessimists’ case is looking stronger.

Once you leave America, there is plenty to worry about. In Asia, we are witnessing what one leading bank’s strategist described to me as a "train wreck in slow motion." Japan, the world’s second largest economy, is officially in recession, with no end in sight. Its banking system is on the brink of collapse. Reports suggest that Japanese banks may be carrying $1 trillion in bad loans on their balance sheets, and the nation’s insurance companies and other financial institutions are also in deep trouble. Further south, in Asia, things only get worse.

Meanwhile, Europe seems preoccupied with itself. Much of Europe has the highest unemployment it has suffered since the end of the Second World War. But European financial markets act like their American cousins and seem to ignore the grim reality of the unemployment statistics. European leaders are focused on a new project--currency union--and assure their electorates that it will solve Europe’s problems.

In short, the world’s three major economies--America, East Asia, and Europe--seem to be confronting radically different conditions. We don’t see much that is "global" about today’s world economic picture.

A Look at the World’s Economic Decisionmakers

This book is a work of contemporary history, written as events unfold. We do not know how today’s events will end, but without a doubt, they pose the greatest challenge since the Second World War to those who are responsible for the world’s economic health. The book is a guide to how the world’s economic decisionmakers think, what drives them, and what limits their scope of action.

In particular, the book explores the thinking of four key individuals: Alan Greenspan, chairman of the U.S. Federal Reserve Board; Eisuke Sakakibara, vice minister of finance for Japan; Helmut Kohl, former chancellor of Germany; and George Soros, arguably the world’s leading financier. The choices those men have been making as this crisis has unfolded will largely determine how many economic dominoes actually fall and how the world will go about picking up the pieces if they do fall.

It turns out that decisionmakers may never be the masters of the systems over which they hold sway, no matter how much they delude themselves and the public into believing that they are. More typically, they are the system’s servants. They are constrained by the prejudices of existing theory, by the information flow that has developed in the bureaucracies they oversee, and by the constraints that other decisionmaking forces impose on them.

The United States

Alan Greenspan is the thirteenth chairman of the Federal Reserve. The job of chairman has evolved into being a contrarian--one whose views actively run contrary to established wisdom. For example, if all businessmen confront falling sales and each cuts production and lays off workers, household incomes fall, sales fall still further, and a vicious downward spiral ensues for the entire economy. What is needed is for some economic agent to intervene to halt that process. The Federal Reserve acts as a stabilizer, as a contrarian, by controlling the price of money. The Fed is now central to stabilization policy.

The Fed and Greenspan are limited, however, in their ability to act as contrarians. The Fed has one tool: its control over the price of money. That tool must cover a variety of conditions. The contrarian keeps his eyes on the desire of people and businesses to spend. Observation of and policy reaction to those conditions are standard fare at the Fed. But Greenspan is very careful to distinguish between rapid economic growth and "too much" demand. Indeed, he and other observers think that we are witnessing not the traditional Keynesian cycle based on too little or too much demand, but a supply-driven cycle. The characteristics of a supply-driven cycle are rapid growth, stable or falling prices, and a booming market for financial assets like stocks and bonds. Many economic historians point to the developments of the late 1920s as an example of another era when our economy was driven by a positive supply shock.

Supply shocks are caused by changes in underlying production technology. If the changes are good ones, they involve a lowering of costs. But a lowering of costs can imply other changes in economic behavior that lead to the formation of a financial bubble, trouble in the banking system, and price collapses in certain industries that create regional economic distress, which may grow. The guideposts of monetary policy might not have their usual meaning during a supply shock. Investors, and particularly banks, get attracted to new industries (the high-tech sector) and into real estate in new areas (East Asia). Trouble then begins to afflict those sectors, and a banking crisis begins.

A supply shock may also lead to a boom in domestic asset prices as technology makes assets a lot more attractive. The stock market is there to set the price on claims of flows of future wealth. If society is permanently wealthier because of the supply shock, the value of those claims on future output should also rise. In short, the stock market should boom.

At some level, that creation of new assets comes to be known as a "bubble" or, more appropriately, as an "asset bubble." Such an asset bubble need not be accompanied by a rise in the general price level, although that might be a long-run consequence. The bigger the bubble in asset prices, the more dependent the economy is on the wealth-generated spending caused by the bubble. The economy will get a dose of "the higher they rise, the harder they fall."

And, as if the problems of an asset bubble were not enough, Greenspan faces another dilemma--Asia. One of the limitations facing economic management in America is that conditions here affect conditions elsewhere. What might be appropriate for the domestic economy might not be appropriate for the international economy. To understand those international ramifications, we must go to the other side of the Pacific Ocean.

Japan

Today, the Japanese economy and financial system are widely viewed as dragging down the economies of Asia and potentially the world. A protracted period of slow growth, lasting the better part of the 1990s, has turned into a recession that to all appearances is deepening. The financial system shows signs of severe stress. To meet the crisis, the government released a series of packages designed to stimulate the economy, to no seeming effect. New measures have come forward at the average rate of one every six weeks since the fall of 1997.

That is in decided contrast to just ten years ago, when it seemed to many observers that Japan would take over the global economy. "The Cold War is over and Japan won," claimed the New York Times. Today, that notion seems a cruel hoax. While the Japanese system of decisionmaking was a major cause of the country’s post-World War II success, it is also a major cause of the economy’s current difficulties.

It certainly seems that Japan has reached the limits of management by the economy’s puppetmasters. This most bureaucratically directed of all the Western economies is on the brink of financial collapse. Long confident of the superiority of its organizational structure, official Japan had been in a protracted period of denial that anything was amiss.

The capacity for a government to take bold and decisive action is most often thought of as an advantage. American admirers of Japan and many advocates of adopting Japanese practices such as "industrial policy" have certainly stressed that. But the capacity to take such action requires that decisionmaking power be quite concentrated. Japan finely honed its decisionmaking process and so had the capacity to be decisive. But decisive action, if wrongheaded, can lead to disastrous results.

A division of labor emerged between the politicians, the representatives of the people, and the bureaucracy. The politicians focused on electoral issues, the bureaucrats on policy. The politician usually turns to the bureaucracy to write the legislation to be introduced in parliament. In Shadow Shoguns, Jacob M. Schlesinger describes how the bureaucracy sometimes writes the script for the entire floor debate, including both the questions asked by the opposition and the answers given by the ruling party.

One of the supposed strengths of the Japanese paradigm had been that highly trained and educated bureaucrats made policy. Sympathetic observers have contrasted that professional management of policy with the narrow "political" focus of American decisionmaking. In essence, nonpolitical means "beyond debate."

But politics must be based on something. The bureaucratic emphasis on policy setting meant, effectively, that national policies were not the realm of the politicians. That left an undue emphasis on what all politicians everywhere try to deliver--pork.

The constitution that General MacArthur bequeathed to the Japanese contributed to that deemphasis of policy. MacArthur’s system required that members of the same political party compete against one another at election time. It is hard to run an "issues"-driven campaign when one or more of your competitors have endorsed the same political manifesto as you have. So the incentive to appeal on ideological grounds is replaced by the question, "Who in my party has done the most for me?"

It should surprise no one that such a process creates close ties among money, politics, and corruption. Some commentators, particularly Japanese critics of the system, identify corruption and money politics as the problem. While unsavory, the Japanese econo my and political system could well survive that. The root of the problem is that politics has been reduced to the delivery of pork. The corruption is just a natural outgrowth and a supporting pillar of a system in which too much money is simply wasted on pork-barrel projects.

Japan is world-renowned for having a high savings and investment rate. But a substantial portion of that investment is devoted to public works and private-sector projects related to those public expenditures. What do the Japanese get for all that extra money spent on infrastructure? The answer is far from clear.

The question for Japan, Asia, and the world is whether reform, led by the bureaucracy and instituted from the top down, is really the solution or whether instead reform will perpetuate the problem. At the moment, we wait for the answer. But one thing is certain; the bureaucracy is unlikely to reform fundamentally a system of which it is the central part.

Germany and Europe

The American system of political economy sought out a contrarian to play the role of economic stabilizer. In Japan, a Confucian bureaucracy, inadvertently entrenched in power by the American occupation, also produced a system that was the product of historical development. But in both the United States and Japan, history left its mark and then was left behind. That is not the case in Germany, where historical memories not only influence policy through the shaping of institutions but live on as the driving thoughts of today’s decisionmakers.

For the forty-four years before 1989, the prospect of invasion from the east was a central fact of German life. NATO planning indicated that Russian tanks could cross most of Germany in a matter of a few days, before support from across the Atlantic was possible. Universal conscription was therefore a fact of life for German teenagers. But casualties would likely go far beyond males of military age. Tactical nuclear weapons, as well as biological and chemical agents, might all be used in the event war broke out. It was possible that a war could leave much German territory essentially uninhabitable.

Helmut Kohl, Germany’s chancellor from 1982 until October 1998, also shared most of that history from personal experience. The prospective war that Kohl successfully avoided during his tenure--and on terms of which he (and Germany) should be justly proud--was not just an isolated prospect of the future. It was a logical extension of the past. Germany had been through three major wars in the century before Kohl became its leader.

Kohl’s vision of how to prevent a fourth war involved change on both the eastern and western fronts. In the west, it involved linking a reunified Germany inextricably into a unified European framework. In the east, it involved a reunified Germany, linking the eastern zone under Russian occupation to the rest of Germany.

Chancellor Kohl took the Western victory in the cold war--triumph on the Eastern front--to establish a deeper integration with the West. Reunification had only made the integration of Germany into something larger all the more imperative. Kohl looked to economics and in particular to a single European currency.

Europe is imposing on itself the discipline of a one-size-fits-all monetary policy. That is an extraordinary challenge both economically and politically. By and large, Europeans have been underestimating the challenge they face.

The economic ramifications of a single currency zone for a continental economy still exist. In any dynamic modern economy as big as the United States or the European Union, there are bound to be significant regional differences in economic performance. Economic policy tries to assuage such differences and set up automatic stabilizing mechanisms by which they become self-correcting. At present, movements in exchange rates can act as such an automatic stabilizer in Europe.

Under a single currency, an alternative mechanism is needed. The United States, for example, has a constant migration of people, much of which is economically related. In Europe, cross-national migrations occur but are largely secular in nature, not cyclical. While we see a constant flow from poorer regions to richer ones, we rarely see individuals depart a rich part of Europe for another rich part simply because of swings in the business cycle.

America also has an important automatic stabilizer in its national tax system. The tax system in Europe still operates at the nation-state level. Thus, the forces that tend to cushion the effects of regional recessions in the United States are far less present in Europe.

The most likely scenario in Europe is a greatly increased interest in deepening the political bonds among the members of the single currency area. Such a move toward tighter political union is not without its potential difficulties. Indeed, some commentators have been concerned about monetary union because of the political risks involved. Whether political integration is successful or not, the rest of the world is likely to be on the sidelines, as an entire continent wrestles with the dictates of its history.