At the start of this decade America and its allies stood victorious in their long battle in the Cold War. Capitalism and democracy were seen as the models of the twenty-first century. Countries around the world which had stood on the sidelines during the ideological struggle between systems rushed to implement domestic versions of these successful models. The result was the entry of hundreds of millions of new workers into the global capitalist system and an expansion of world trade, living standards, and freedom that is unparalleled in world history.

Now, suddenly, there are some second thoughts about market-based capitalism. The market crises of the past year have caused tens of millions of people to lose their hard-earned places in the global middle class. Before this is over, some ten trillion dollars of household wealth will probably have been destroyed world wide. A global recession not unlike that of the 1930s is a possibility, and the history of that decade suggests that democracy, as well as capitalism, may be threatened.

Lessons from the Setback

Why did this happen? There are both political and economic lessons to be learned. If we are to avoid an outcome like that of the 1930s, supporters of democracy and capitalism must begin to take steps now to forestall a disaster. This is especially important for American conservatives. Conservatism’s ideological adversaries here at home—including some whose commitment to markets and capitalism is a recent development and not well entrenched—will soon be arguing (as they did during much of the Cold War) that big government must "direct" markets if they are to be truly successful. Their views must not be allowed to prevail.

First, it is important to remember that two factors accounted for our Cold War victory: the superiority of our system and the resolve of our leaders. Capitalism’s superiority at producing goods and services meant that we were able to fulfill our defense commitments with an ever-shrinking share of our national wealth while the Soviet Union was forced to spend an ever-larger share to keep pace. Nothing has changed in the 1990s with regard to the superiority of markets and capitalism.

What has changed is the resolve of our leaders. In 1992, having won the Cold War and reaffirmed our dominance in the Gulf War, voters turned away from an internationalist president, George Bush. Bill Clinton campaigned essentially on the promise that he would ignore international matters and focus on domestic concerns. He has more than fulfilled this particular promise.

We should note that after a victory in war such an electoral choice is actually quite common. In 1945, British voters surprised the world by resoundingly tossing Winston Churchill from office, opting for a Labour government that promised national health care. In 1920, we Americans overwhelmingly preferred Warren Harding’s promised Return to Normalcy after Wilson’s global involvement. But capitalism without clear-headed political leadership soon runs into problems.

One of the least attractive impulses of democracy is the demagogic appeal of getting something for nothing. Britain and France tried it after World War I in the form of reparations demands that bankrupted Germany and led to economic and political crises there. Our withdrawal from the world under Harding removed America’s potentially moderating hand. The same did not occur after World War II because America under Truman, with a newly internationalist Republican Congress elected in 1946, showed itself ready to assume global leadership, even as Britain dropped it.

But asserting global leadership often requires sacrificing your own narrowly defined national objectives. Domestic macroeconomic policy must be sensitive to the demands of global leadership. Trade policy must be international and evenhanded, and not controlled by the domestic export lobby. America and Bill Clinton were clearly not prepared to make those sacrifices. Instead, the new administration pursued a narrowly nationalistic economic policy which placed our short-term self-interest—and too often the economic interests of the president’s political and financial supporters—ahead of the demands of global leadership.

Unstable Policies, Unstable Exchange Rates

The new administration began by adopting a "weak dollar" strategy. Treasury officials abandoned time-tested statements on foreign-exchange policy and left the clear impression on markets that they sought a weak dollar in order to foster American exports, particularly at the expense of the Japanese. The use of devaluation as a stimulative economic tool had long been championed by key administration officials in their past academic lives, and was especially helpful to the industrial unions in the president’s political base. Administration statements helped take the dollar down to a new low of 80 yen in 1995. Many of the Asian countries tied to the dollar benefited, as they also became extremely competitive. Investmen t flowed into these countries.

Suddenly things changed. The Chinese, seeking to regain an edge over their competitors, devalued the renminbi. American firms saw their Japanese competitors buying up plants and equipment throughout Asia at bargain prices because the yen was so strong. The administration reversed course and started talking up the dollar against the yen, a policy which continued until the United States intervened in June of this year to again support the yen over the dollar.

All told, the dollar-yen exchange rate—the key to trade between the world’s two largest economies and the key to Asia’s economy—has gyrated down by a third and then up by 75 percent during the first five and a half years of the Clinton administration. Such wild swings helped destabilize Asian currency arrangements and trade flows and led directly to the present Asian crisis. Of course, currencies always fluctuate in a market environment. But these fluctuations were unduly large and were the result of deliberate policy preferences by the supposed global economic leader.

U.S. trade policy, particularly toward Asia, also abandoned any pretext of freedom from domestic political considerations. Allegations that Commerce Department trade missions to Asia were deliberately packed with Democratic donors dogged Secretary Ron Brown before his death. Most alarmingly, the administration ignored the deteriorating conditions in Asia last fall as it continued to pursue an aggressive trade strategy. In September, America’s trade representative slapped special sanctions on South Korea, just as its economy was entering a free fall. A month later, ocean-going trade between the United States and Japan ceased for a day over a $4 million dispute. Markets in both countries were disrupted over an expense that could have been covered by renting out the Lincoln bedroom a few extra nights.

The current second thoughts about democratic capitalism are the result not of a fundamental change in the merits of markets, but of the absence of leadership from the world’s leading market economy. Pursuing market advantages not through economic superiority but through political clout has become more and more widespread. This is something the world’s leader should discourage, and certainly not condone by example.

Supporters of democratic capitalism must now insist that America reassert its leadership role. Our next president must focus on global economic matters as well as security concerns, and must be willing to use the influence of his office to get our allies to join us in what will probably be a major clean-up effort.

The Business Cycle Lives

Defenders of global democratic capitalism must also be innovative economically. This must start with the recognition that markets are not perfect. There is always a "cycle" to business conditions because individuals are driven by emotions such as fear and greed. The current cycle is no exception.

As already noted, the productive capacity of millions of people was suddenly added to the world economy. Optimism was everywhere. We heard talk of a "New Age." In short, greed prevailed as investors everywhere believed this new environment offered a splendid chance to make money by taking risks they would not otherwise have taken. In the United States, people put ever-increasing fractions of their wealth into the stock market, while mutual funds invested in stock markets located in cities their investors probably couldn’t find on a world map.

That kind of irrational exuberance funds excessive investments, which ultimately do not provide expected returns. As disappointments mount, lenders suddenly become cautious. Economies tighten and credit becomes scarce. Liquidations occur to meet debt-service requirements. This drives down the prices of many commodities and spreads the losses into otherwise healthy businesses. Fear begins to take hold, replacing greed, as investors seek to preserve what capital they have and forget about taking risks to produce big returns.

No supporter of capitalism has ever argued that this cycle is pretty. But it is inevitable, and can even be seen as useful. Fear and greed drive decisions in command economies as well as in markets. Giant industrial works with no real market for their output and grandiose but impractical development projects littered the landscape of the socialist world. Carrying a party card or working for the state does not exempt one from thinking big thoughts. Nor does it protect one from the fear of being blamed should things turn out badly ("bureaucratic inertia" is just the non-market counterpart of "cover your ass").

But the market tends to correct fear- and greed-driven mistakes much more quickly than the bureaucratic system. It also tends to reward people more directly for economic correctness rather than political correctness. This means a more dynamic economic system driven by what Joseph Schumpeter term ed "creative destruction." The success of capitalism requires both the innovation and experimentation of booms and the termination of failed projects in busts.

Debtors’ Prison

Democratic capitalism has developed a set of devices to minimize the social pain of this process. One key element is bankruptcy. The individual who engaged in a failed experiment has his personal stake wiped out, but is allowed to restart from scratch, free of the obligations he incurred prior to his bankruptcy. So, bankrupt individuals have an incentive to become productive again. Meanwhile the capital assets that bankrupt individuals lose are placed in the hands of someone in a strong financial situation and so are quickly put back to productive use. Importantly, lenders are put at risk by this process, and thus have an incentive to be diligent about the loans they make.

In the current crisis, the United States has failed to exploit the advantages of bankruptcy as a way of resolving bad loans. Our government, along with the International Monetary Fund, has instead chosen to leave much of the world in the equivalent of debtors’ prison. While debt service is covered in the short term by the IMF, the debtors are expected to shrink their own consumption enough to allow them to repay their creditors over time.

Consider how this works. The crisis countries of Southeast Asia have, by devaluation and other IMF-imposed actions, increased their exports by $10 billion. They have reduced their imports by $110 billion. On net therefore, they are $120 billion better able to repay debts than before. But total demand has fallen $100 billion. As these hair-shirt policies are extended to more of the world, demand falls further and a localized problem turns into a global recession.

Insisting on debt repayment by countries that are obviously broke is as devastating to the world economy today as Smoot-Hawley and other beggar-thy-neighbor policies were in the 1930s. The administration has fallen into this disastrous trap largely because of its lack of imagination, but political constraints have also played a role. Repayment of American investors in the Mexican crisis of 1994-95 drove our policy then, and its alleged success has led us to make the needs of American money-center banks a top priority today.

Believers in global democratic capitalism have an obligation to get the world out of this dead-end debtors’ prison approach. This will require an assertion of national leadership, as our allies must go along with the new policies if they are to revive the global economy. Further, we must convince emerging countries that a truly global economy, in which anyone may invest and own assets anywhere, is in their interest too.

Those responsible for this mess will no doubt claim, once out of power, that global political and economic leadership is too costly. They prefer sacrificing the long-term benefits of global leadership to the demands of political donors and constituencies. Today we pay the price for that preference. Thus, conservatives must reassert our ideological leadership here at home. Voters need to be continually reminded that their sacrifices to make the world safe for capitalism and democracy are worth it. Short-term sacrifice to make long-term gains is what capitalism is all about. If we cannot persuade the voters of the United States that it is a choice worth making, what possible chance do we have of persuading the people of the world of the superiority of our system?

Lawrence B. Lindsey is a resident scholar at AEI.