What can we do?

THE BRIDGE TO A GLOBAL MIDDLE CLASS Kluwer Academic Press; Walter Russell Mead and Sherle Schwenninger, Editors, 2003

Book Review

Democracy seems to promote peace with other democracies, at least so far. But democracy is not a given; it requires an infrastructure and a middle class to operate it along with strong traditions of adherence to a legal system based on a constitution. The political evolution of the last two centuries has been one of gradual industrial development first, a natural transition to democracy of some form then typically follows.

Sometimes the transition is sudden, as in the case of the US, or Germany and Japan after World War II. In other cases, the approach to democracy is quite gradual. China is a case in point where it has come perhaps half way to a democratic society over a period of two decades. It is now irreversibly committed to a market economy, the very antithesis of Marxism. Since democracy and trade tend to bring peace more than war (the US excepted), it behooves the 52 developed nations to find the means to develop middle classes in those nations ready for it. This effort has complexities, for even more than politics, businesses need checks and balances on their behaviors. And it will take time to establish institutions up to the task of establishing: stable currencies, credible central-banking systems, regulated capital markets, and adequately capitalized regional and international financial institutions.

All this would have three purposes ensuring:

• sound econometric principles in managing the financial system, the mechanics in other words;
  
• social goals of democratic societies are met;
  
• latitude and flexibility sufficient to adjust to demographic and technological trends that vary from nation to nation as well as in time and place.

The Milkin Institute has addressed these issues in considerable detail. We reproduce their executive summary from chapter 1 here.


International financial architecture works best when it serves social goals that command widespread support and legitimacy. Without neglecting the more conventional goal of allowing the greatest possible global flow of capital with the least risk of financial crisis, for both economic and political reasons, the primary goal of international financial reform ought to be to promote middle-class-oriented development around the world.

1. Middle-class-oriented development is the key to global prosperity and stability. Extending the system of mass affluence found in the advanced industrial economies into the developing world as rapidly as possible is the key to global political stability and economic growth. It is also the key to building the kind of support that is needed in both developed and developing countries for sustaining the necessary reforms for stabilizing and strengthening the international financial system.

2. Much of the world is now ready for middle-class-oriented development. Thanks to the economic growth of the last generation, a substantial number of economies are ready for the transition to middle-class-oriented development. When considered on the basis of purchasing-power parity, fifty-two countries with a total population of 1.5 billion have reached levels of per capita GDP similar to those at which the United States inaugurated middle-class-oriented development policies. Other large economies, such as India and China, have already created substantial middle classes.

3. Middle-class-oriented development enhances poverty alleviation. Middle-class-oriented development does not mean taking resources from the poorest to concentrate on assisting those who already enjoy better living conditions. Rather, middle-class-oriented development seeks to expand the middle class by facilitating the rise of the working poor, thus increasing employment opportunities for both high- and low-skill workers. The reforms envisioned by the report would enhance the ability of the World Bank and other agencies to concentrate on poverty alleviation and would enhance the efficacy of their activities.

4. Access to reasonably priced, long-term credit is the single most important element in the formation of a mass middle class. Small business, municipal and other public investment in infrastructure, home ownership (either in single-family homes or apartments), post-secondary education, and other necessities of middle-class life depend upon access to credit. The thirty-year, self-amortizing mortgage is the "canary in the coal mine": if these mortgages are widely available, then credit markets are working for ordinary citizens who aspire to become middle class.

5. Middle-class-oriented development requires increased long-term capital flows to developing countries. To facilitate middle-class-oriented development, international financial architecture should promote more long-term capital flows from the capital-rich G-3 advanced industrialized countries to capitalize emerging economies. In addition, it should expand democratic access to capital within developing countries for such purposes as home ownership, education, and the start-up and expansion of small and medium-sized business.

II. Obstacles to Middle-Class-Oriented Development

The current international financial architecture poorly serves the middle-class-oriented development needs of emerging economies in three ways.

1. The lack of stable currencies not only makes developing economies more crisis prone but also distorts their development. Currency risk is the single greatest deterrent to long-term capital flows to emerging economies, and one of the principal barriers to the development of deeper and more efficient capital markets upon which middle-class-oriented growth depends. The high cost of capital and short-term structure of the financial markets in most developing countries preclude a whole range of investments that would otherwise be profitable. They also distort development by favoring big companies over smaller firms, foreign firms over domestic ones, and foreign exchange-earners over companies that produce for the domestic markets.

2. Shallow and badly regulated capital markets in emerging economies tend to deny credit to small businesses and ordinary citizens. As a result of poorly developed equity and secondary debt markets, most emerging economies are overly dependent upon the banking sector. In many emerging economies banks are not only crisis prone but also highly inefficient at allocating capital, especially to ordinary citizens and small businesses. Most emerging economies lack the legal infrastructure and regulatory machinery upon which deeper and more sophisticated capital markets depend

3. Poorly capitalized national and international financial institutions lack the resources and legitimacy needed to promote real capital market reform and to stem crises in emerging economies. In many emerging markets, national institutions are too small, too close, and in many cases too politically influenced to exercise effective regulation and supervision of middle-class-oriented capital markets. The International Monetary Fund, however, is too big, too distant, and lacks both the mandate and resources to exercise effective oversight or to promote reform in most emerging economies.

III Middle-Class-Oriented Reforms

Middle-class-oriented development requires institutional changes that substantially reduce risk for both domestic and international investors.Without attempting to prescribe in detail for each of the world's very different regions, we offer five recommendations and institutions necessary for effective market-based, middle-class-oriented development.

Recommendation 1: Create well-capitalized and well-managed regional central banks to serve as the front-line institutions for middle-class-oriented development. The creation of regional central banks (similar to the European Central Bank) would enable emerging economies to pool reserves, consolidate monetary policy, nd undertake effective capital-market regulation and development. A diversified shareholder base is the key to well-capitalized and well-managed central banks. The report, therefore, calls for the private sector as well as member and nonmember central banks and governments to become shareholders in a regional central bank. (RCB

Recommendation 2: Regional central banks should create or adopt hard regional currencies. To reduce interest rates and lower the cost of capital, regional central banks should create a stable currency that commands investor confidence. There is no one sure path to a stable currency, and each region will need to chart its own course. The report examines two options: dollarization and the creation of regional super-currencies (artificial currencies based on a basket or combination of currencies).

Recommendation 3: Establish binding covenants for good governance and good policies. In order to develop the deep and efficient capital markets necessary to provide greater democratic access to reasonably priced credit, regional central banks-along with other elements of a regional financial architecture-would need to use their size and influence to facilitate the legal, fiscal, and regulatory reforms needed for the development of such markets. The report envisions an accession process to the RCB similar but less onerous than that to the European Union. The RCB accession process would include three agreements: a fiscal stability pact; an agreement covering legal infrastructure and regulatory standards; and a third agreement relating to the RCB's regulatory authority.

Recommendation 4: Reduce the debt burden. To reduce excessive debt burdens, the report outlines a two-part process of debt reduction and restructuring. First, as part of the capitalization of the regional central bank, both official and private sector creditors would convert government debt into RCB equity. Second, for member countries adhering to the fiscal stability pact, regional central banks would help underwrite and place long- and short-term debt in international markets.

Recommendation 5: Create deep and liquid capital markets. The report calls for the RCBs to: 1) create a long-term mortgage and small-business credit market by chartering and spinning off regional Fannie Mae-like institutions; 2) expand equity and debt markets by chartering investment banks aimed at underwriting corporate debt and initial public offerings and by chartering and supervising for-profit pension management companies linked to compulsory savings programs; and 3) build a popular financial sector serving the needs of small- and medium-sized businesses by chartering and supervising popular financial institutions for mini lending (loans up to $25,000) for ordinary working people.

These recommendations and many others throughout the book are backed up by concise analysis and in certain cases by data as well. Financial architecture, capital flows, the currency conundrum, diminishing returns to export-led growth, and how these impact development and emerging economies make up half of the book. The balance of the book is devoted to interpreting events in the US stock market, Mexico's financial market, East-Asian economic crisis, post Communism Russia, South Korea's comeback, China's open-door policy and free markets in Indonesia.

This book is a tome, but it deserves careful consideration by those who wish to better understand the macro-economics in our day and age.

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The war for ideas has many components, economics arguably being the most important. The foregoing is the best economic roadmap we have found to date. It remains to start traveling with our allies in a serious way.

The foregoing is also a mere drop in the bucket of the information in this timeless book. It is as current today as it was the day it was published. Politicians and governors are well advised to study this volume carefully for it holds information of most importance to those who would leave positive legacies while creating history.

On the other hand, we still must do something about the Lucifer Effect as well as the Sociopaths among us.