Macroeconomics and the regulation of international financial markets John Eatwell This paper was presented at a seminar arranged

by CERF in Queens College, Cambridge, 5-6 April 2002.

Introduction Following the liberalisation of international financial markets in the mid 1970s there have been a series of major financial crises, many of which have resulted in substantial losses in real income. The Swedish bank crisis of the early 1990s bequeathed nearly a decade of stagnation, as did the Mexican financial crisis of the early 1980s. More recently, the Asian financial crisis has been associated with large cuts in real income in the region, with particularly severe consequences for Indonesia. The pattern of crises has also assumed a form unfamiliar since the 1930s their origins have been increasingly found within the private sector. For many years after the second world war economic crises were associated with mistakes in government macro-economic policies, and derived from the macro-economic problems such as excessive inflation or current account imbalances, and transmitted through macro-economic variables such as the interest rate, changes in credit controls or taxation, or foreign exchange crises (typically resulting in deflationary policies to maintain fixed exchange rates). This was a significant change from the inter-war world, where crises were typically generated in the private sector failures by institutions such as that of the Credit Anstalt in 1931 reverberated through the financial system to produce a general economic collapse. The removal of the extensive system of domestic and international financial and monetary controls that characterised the post-world war II world before 1971 has resurrected the pre-war origins of crises in micro-economic as well as macro-economic circumstances. Nonetheless, even where crises have micro-economic origins an important macroeconomic component remains. The negative externalities associated with financial risks are not propagated solely through micro-economic connections of trade (as is typically the case, for example, with environmental externalities). A major component of the externality is macro-economic. The reason why derives from the fact that whilst commodity markets (including the market for dirty smoke) involve the pricing of flows, financial markets involve the pricing of stocks. Moreover, the price of a financial asset depends on the expectation of its future price (and revenue and liquidity). Consequently, expectations play an extraordinary role in the determination of the prices of financial assets, and expectations are a potent source of macro-economic contagion. A wave of pessimism can result in a general fall in the prices of financial assets as the demand for liquidity rises. This is, of course, the standard stuff of liquidity preference theory. It is worth remembering that Keynes himself linked liquidity preference theory to microeconomic behaviour via the Beauty Contest. The idea that the demand for the stock of financial assets is

determined by the individual assessment of what average opinion deemed average opinion deemed average opinion .. to be, derives the determination of macroeconomic phenomena, and indeed macroeconomic contagion, from individual action. Of course, the relationship between micro-risk taking and macro-contagion is not a peculiarity of international markets. Exactly the same story may be told about domestic markets. International markets simply add a number of extra dimensions. And the liberalisation of financial markets also posed major new institutional and policy questions as regulation was dismantled, and the domain of the market now exceeded the jurisdiction of national regulators. Deregulation thus had two components the removal of pre-existing regulations and controls, and the migration of the market out-with national juridical boundaries and hence out-with national controls. The subsequent attempt to recover some regulatory control on an international scale has had only limited success. Thus successful financial regulation, particularly in the attempted management of systemic risk, must be based on a coherent understanding of the relationship between micro-risk, macro-contagion and macro-consequences. In addition, regulation and supervision are important components of macroeconomic policy. To a considerable extent regulatory rules define the relationship between the stock of financial assets and liquidity (the transmission mechanism). The pro-cyclical impact of regulation has been regulated recently, yet despite their potentially major impact regulatory rules have not yet been incorporated in to the fabric of monetary policy. An understanding of the need for regulation, of the impact of regulation, and of the limits of regulation, therefore requires an analysis of the relationship between micro-economic actions and the behaviour of the macro-economy. Yet it is exactly this analysis that appears at the moment to be absent from the discussion of international financial regulation, and to play little role, if any, in considerations of the future of the international financial architecture. In part this is because of the need to concentrate on the micro-economic nuts and bolts of regulation and supervision, but more generally it derives from the lack of a generally accepted, let alone satisfactory, macro-economic theory. An important goal of the CERF project is to establish a macroeconomics that relates financial markers, institutions, and actors, to macro-economic performance in a coherent manner. The Beauty Contest was a beginning. There is much further to go. Orthodox macro-economics The key issues in any consideration of' the relationship between macro-economic analysis and microeconomic behaviour can be revealed by the answers given to two questions: 1. Does the determination of relative prices in a market economy also involve the determination of the size and composition of output and, in particular, is the level of output such that labour is fully employed (in the

sense that at the going wage all workers willing to offer labour would be able to find employment)? 2. Are variations in relative prices associated with variations in output such that the economy tends towards a level of output compatible with the full employment of labour? Each of these questions can be supplemented with a further question: if not, why not? The significance of these questions can be illustrated in terms of the most elementary piece of orthodox neoclassical analysis. This involves the argument that the price of a commodity is determined by the relationship between demand and supply. According to this account, equilibrium, determined at the point of intersection of a function relating price to quantity demanded and another relating price to quantity supplied, is defined as market clearing. When this view of price determination is extended to the economic system as a whole, the equilibrium position of the economy is characterised by a set of market-clearing prices, with associated quantities (levels of commodity output and levels of factor utilisation), such that the markets for all commodities and all factors of production clear. In particular, the labour market clears at the equilibrium level of the wage (relative to the associated set of equilibrium prices). In terms of this familiar approach to the analysis of price formation the answer to the first question is obvious. Equilibrium prices and equilibrium quantities are determined simultaneously. The theory of price, based on demand and supply, is one and the same thing as the theory of output, including (by summation) aggregate output. If there exists an equilibrium set of prices then there exists an equilibrium set of outputs equilibrium in the sense of market clearing, including the full employment of labour, as defined above. Furthermore, this theory of the simultaneous determination of prices and quantities is typically presented in such a way by juxtaposing demand and supply functions that the idea that prices adjust automatically so as to clear markets, thus tending to push the economic system towards a full-employment level of output, seems to follow as a self-evident corollary of the theory. (It does not in fact follow as readily as might appear at first sight, since the stability of an equilibrium is less easily demonstrated than its existence; but these difficulties can be left to one side for the moment.) Here, then, one has the neoclassical analysis of prices and quantities in a nutshell: the equilibrium set of outputs (and levels of factor utilisation) is determined simultaneously with the equilibrium set of prices (of commodities and factors of production); variations in relative prices, sparked off by an imbalance between demand and supply, will be associated with variations in quantities in a direction which ensures that both prices and quantities tend towards their equilibrium levels. Neoclassical analysis, therefore, answers the first two questions posed above in the affirmative. An analysis of variations in aggregate output and employment may then be derived directly from these relationships between prices and quantities. Any inhibition to the tendency of prices and quantities to find their equilibrium (market-clearing)

levels will leave the economic system in disequilibrium with, perhaps, either an excess demand for labour or an excess supply of labour (i.e. unemployment). An enormous variety of analyses of unemployment are constructed in this way. The general tenor of the neoclassical analysis of aggregate demand and of the causes of unemployment is that while the economy would be self-regulating in the best of all possible worlds (i.e. the implicit tendency towards the full employment of labour would be realised) the market is inhibited from fulfilling this task by the presence of certain frictions or rigidities. In the literature on the problem of unemployment, examples of such inhibitions are legion. They include: sticky prices (particularly sticky or even rigidly fixed wages and/or sticky interest rates); institutional barriers to the efficacy of the price mechanism, such as monopoly pricing (by firms or individual groups of workers); inefficiencies introduced into the working of the real economy by the operations of the monetary and financial systems; the failure of individual agents to respond appropriately to price signals because of disbelief in those signals, the disbelief being derived from uncertainty about the current or future state of the market, or from incorrect expectations concerning future movements in relative prices, or from false conjectures about the actual state of the market. Indeed, examples of frictions and rigidities can be multiplied at will any factor that causes the market to work imperfectly will do. It will be convenient, therefore, to group all the authors of the myriad of arguments of this kind together under the general heading of imperfectionists. In marked contrast to the analyses outlined above are those theories of output that propose no particular functional relationship between prices and quantities. The central proposition of neoclassical analysis, that the theory of value is also the theory of output, is rejected, together with the connected notion that appropriate variations in relative prices will promote variations in quantities, so moving the economic system in the direction of a full-employment equilibrium. Unfortunately, this rejection of the neoclassical theory of value and distribution has sometimes been confused with an imperfectionist position. A striking ex-ample of this is the rejection by a number of writers of the neoclassical theory of value, and their advocacy of the idea that relative prices, far from being determined by demand and supply, are determined by a mark-up over normal prime cost where this mark-up is insensitive to variations in the conditions of demand (see, for example, Kalecki, 1939; Neild, 1963; Godley and Nordhaus, 1972). Quite apart from the limitations of mark-up analysis as a theory of price formation it is in essence a proposition about the stability of the ratio between prices and costs rather than a theory about the determination of either of those magnitudes, or even of the size of the ratio this attempt to separate the study of relative price determination from the analysis of output may readily be confused with an imperfectionist

argument based on sticky prices arising from the presence of monopolistic or oligopolistic influences in commodity markets. Similarly, financial market instabilities, such overshooting of exchange rate adjustment (Dornbusch, 1976), or rigidities (Patinkin 1948, 1965), empirically reasonable though they might be, are imported into the general equilibrium model as imperfections that determine aggregate outcomes. There is a quite different critique of the underlying neoclassical theory. It is to be found in the outcome of the debate over the neoclassical theory of distribution and, in particular, over its treatment of capital as a factor of production on a par, so to speak, with land and labour. While this debate is seen by many as a rather esoteric controversy in the more abstract realms of economic theory, its implications are more far-reaching than has hitherto been appreciated. The central conclusion of the debate may be summed up, in broad terms, as follows: when applied to the analysis of a capitalistic economy (that is, an economic system where some of the means of production are reproducible), the neoclassical theory is logically incapable of determining the long-run equilibrium of the economy and the associated general rate of profit whenever capital consists of more than one reproducible commodity. Since, in equilibrium, relative prices may be expressed as functions of the general rate of profit, the neoclassical pro-position that equilibrium prices are determined by demand and supply (or, more generally, by the competitive resolution of individual utility maximisation subject to constraint) is also deprived of its logical foundation (see Garegnani, 1970; 1983). The relevance of this critique of the neoclassical theory of value and distribution to the problem of the missing critique of the neoclassical theory of output and employment should be apparent from what has already been said. Because the neoclassical analysis of the determination of prices and the determination of quantities is one and the same theory (that of the mutual interaction of demand and supply), the critique of the neoclassical theory of value is simultaneously a critique of the neoclassical theory of output and employment. Therefore, the first of the two questions that were posed at the very outset of this discussion must, on the grounds of the requirement of logical consistency alone, be answered in the negative. The second question, from which neoclassical theory derives the idea that under the operation of the market mechanism there is a long-run tendency towards a determinate full-employment equilibrium, is rendered superfluous. But this is not all. If the general (or long-run) case of the neoclassical model has been shown to be logically deficient, then all imperfectionist arguments which are derived by examining the implications of the introduction of particular (or shortrun) modifications into the general case are incapable of providing a satisfactory analysis of the problem of unemployment. This is not to say that many of the features of the economic system cited by the imperfectionists will have no role to play in a theory of employment based on quite different foundations to those adopted by the neoclassicals. After all, much of the credibility of imperfectionist arguments derives from their pragmatic objections to the direct applicability of the assumptions of the more abstract versions of demand-and-supply theory. But pragmatism is not enough. The implications of more realistic hypotheses must be explored in the context of the general theoretical framework within which they are

applied. Since the account of a self-regulating market mechanism that operates according to the theory of demand and supply is unacceptable on the grounds that it is logically inconsistent, any analysis of unemployment that in turn derives its rationale from that very model is also unsatisfactory. The mechanisms of demandand-supply theory are just not there. However, this is not a paper on capital theory. These matters are pursued elsewhere. What is relevant to the development of a satisfactory theoretical underpinning to a macroeconomics of financial regulation is that much of Keyness theory presumes that prices do not clear markets in the approved general equilibrium manner. His analysis of the relationship between finance, output and employment is the starting point for a satisfactory positive theory. Keynes on output, employment, and liquidity There are ..., I should admit, forces which one might fairly well call automatic which operate under any normal monetary system in the direction of restoring a long-period equilibrium between saving and investment. The point upon which I cast doubt though the contrary is generally believed is whether these automatic forces will ... tend to bring about not only an equilibrium between saving and investment but also an optimum level of production (Keynes, 1973, vol. 13, p. 395). For the moment, for the sake of argument, let us accept that the position of the imperfectionists is untenable. It is important to realise that the issue at stake is not simply one of theoretical interpretation or empirical verification. It is a matter of the utmost practical importance. The formulation and justification of economic policy is rendered arbitrary by the imperfectionist position. The ultimate superiority of a policy of fiscal expansion vis--vis a policy of social legislation to, say, unstick the wage is not self-evident. Indeed, if the powerful mechanisms proposed by general equilibrium theory are present in the economy, then it seems almost perverse not to attempt to harness these (ultimately) beneficial forces. In contrast to the imperfectionist position is the view presented in the General Theory, which is particularly clearly stated in the drafts of the book. The novel idea that emerges is not that the market mechanism is obstructed or inhibited (there are ... automatic [forces] which operate ... in the direction of restoring long-period equilibrium) but rather that the way in which this mechanism functions is not such as to establish full employment by clearing the labour market i.e. the market mechanism will not even tend to bring about ... an optimum level of production. Keynes proposed, of course, that the level of output was determined by the level of aggregate demand, which was in turn determined by the level of investment and the size of the multiplier. The level of investment was determined by the prospective profitability of investment projects and the view taken of returns to and liquidity of financial assets. Essentially, the economy is driven by availability of liquidity and the assessment of future returns. There is no role for the neoclassical price mechanism. The price mechanism was reintroduced by the presumption that the rate of return and the volume of investment are inversely related (the marginal efficiency of capital, or, if you like, the demand function for capital). This is a

relationship of dubious empirical foundations and no theoretical foundation at all (Garenani, 1983). Unfortunately it provided the opening upon which the imperfectionist arguments of the neo-classical could be based. The development of an imperfectionist interpretation of the General Theory provided the grounds for a rapid absorption of Keynesian economics into what could be held up to be a more practical and relevant version of the older orthodoxy. Finance and output Restoring the pre-imperfectionist Keynesian position has significant consequences for an understanding of the relationship between financial variables and the behaviour of the economy as a whole. Instead of finance being imposed as an awkward imperfection of the general equilibrium equations that determine output and employment, it the financial markets that determine the liquidity of the economy, and hence permit spending decisions to be implemented. It is the appropriate spending decisions that then determine the overall level of output. In Keyness simple model the key spending decision was expenditure on investment. But the analysis is readily extended to include expenditure by the state, and debt financed expenditure by households. In all cases finance does not simply provide the option for spending or not spending, but the possibility of financial disruption, or of severe financial imbalances, can lead to a diminution (even a disappearance) of liquidity and hence to the disruption of spending or the absence of spending. In this respect the pricing of financial assets will be the key to the availability of liquidity and hence of the ability to spend. In contrast to the neoclassical story, markets for the stocks of financial assets will be driven by supply (virtually fixed) and the demand (heavily influenced by the expectation of future market conditions). Prices clear financial markets, they do not clear product markets. Note that this approach implies that there is nothing particularly efficient about the prices that clear financial markets. The supposed efficiency of financial markets derives from the combination of the Efficient Markets Hypothesis with the Fundamental Theorem of Welfare Economics. That Fundamental Theorem rest on the equations of neoclassical general equilibrium theory, and the interpretation of prices derived from that theory. The key to economic performance is thus the availability of liquidity and the desire to spend. Both of these factors may be influenced by real variables. For example the technological changes that created the internet in turn precipitated the expectation that investments in dotcom companies would yield substantial returns, and sharply increased the availability of liquidity for dotcom investments. The excess of liquidity that flowed into dotcom markets (a classic financial bubble) when contrasted with the paucity of realised returns in turn precipitated the collapse in price of dotcom stocks as liquidity vanished. But an important role is played by innovation in the financial sector itself. The development of new financial instruments has significantly increased the availability of liquidity. the increase in the supply of liquidity in turn increases the volume of lending as financial institutions are eager to secure returns to their

enhanced lending abilities. And with that increased lending goes the potential for increased risk. That risk feeds into the other fundamental characteristic of financial markets that value can disappear in an instant, as the price of assets adjusts to new information, or to new beliefs about what average opinion believes average opinion to be. This disappearance of financial value then precipitates a disappearance of the value of real assets as a result of the impact of reduced spending on real asset returns. This was particularly well characterised by Keynes in his portrayal of the Beauty Contest (Keynes, 1936; chpt.12). He was not referring to a 1930s equivalent of Miss World, in which expert judges decide the winner. He had in mind a competition that was at the time very popular in down-market British Sunday newspapers. Readers were asked to rank pictures of young women in the order that they believed would correspond to the average preferences of the competitors as a whole. So in order to win, the player should not express his or her own preferences, nor even try to estimate the genuine preferences of average opinion. Instead the successful player should anticipate what average opinion expects average opinion to be. In the same way, the key to success in the financial markets is not what the individual investor considers to be the virtues or otherwise of any particular financial asset, nor even what the mass of investors actually believes are virtues of that financial asset. The successful investor is concerned to establish what everyone else in the market will believe everyone believes. For substantial periods of time markets may be stabilized by convention - everyone believes that everyone else believes that the economy is sound and financial markets are fundamentally stable. But if convention is questioned, or, worst of all, shattered by a significant change in beliefs, then the values of financial assets may soar to great heights or collapse to nothing. Average opinion is reinforced by labelling these beliefs fundamentals, as if they were revealed truths. For many years it was believed that the UK balance of payments was a fundamental. Any deficit in the current account would result in selling pressure on the pound sterling, as the markets followed their beliefs. In the past decade opinion has changed, the current account is no longer a fundamental so deficits no longer produce the reaction they once did. A fundamental is what average opinion believes to be fundamental. Of course, this is not to say that some characteristics of the real economy will not eventually overwhelm even the most stubborn beliefs. Belief in the profitability of the stock of a non-existent silver mine will eventually be punctured by the evident lack of any silver. Belief in the sustainability of a large and persistent current account deficit may eventually be punctured by the accumulation of debt and debt interest that that deficit entails. The reversal of average opinion can then be frighteningly sudden. So long as the market follows what average opinion believes average opinion to be then anyone who bucks the trend will lose money. Anyone who invests for the long term against the conventional short-term wisdom will require extraordinary confidence in his or her predictions, as short-term losses pile up. Average opinion has its own history. It is heavily influenced by fashionable theories and by the exercise of the financial powers of national governments, particularly the

more economically powerful ones. The recent history of capital market liberalization has coincided with a swing in the balance of intellectual influence from a post-war theory of economic policy that urged national governments to limit international capital movements to the present-day theory that encourages free capital movements and the abdication of national regulatory powers. So financial stability is largely a matter of convention. Convention may be stable for long periods. But even stable conventions may contain the seeds of their own destruction. When stock markets are rising rapidly it quickly becomes the convention that they will rise forever. When convention breaks down, financial markets will be very unstable. Convention is peculiarly vulnerable when there is a shift in the balance of risk. Just such a shift took place in the early 1970s, when foreign exchange risk was privatised. The dangers of high-risk financial investments are reduced if those investments are highly liquid. A market that operates as a beauty contest is likely to be highly unstable and prone to occasional severe loss of liquidity as all opinion tends to shift in the same direction. Everyone wants to sell at the same time and nobody wants to buy. The operation of the beauty contest destroys the liquidity that would encourage risk-taking. Increased instability may well therefore result in systematic changes in the behaviour of both public and private sectors, as decision-makers become ever more risk-averse. Although these changes may succeed in reducing instability, they do so only at the cost of less risk-taking, less investment, and medium-term deterioration in overall economic performance. The potential instability of financial markets is based on the possibility of switching funds into and out of investments. Swings of convention translate into sharp fluctuations in asset prices that in turn reinforce the swings in confidence. In the circumstances it might be thought desirable to limit the ability of investors to make the switch. If investors were locked into long-term investments then markets would not be plagued by boom and bust waves of buying and selling. But here lies an important paradox. Without liquidity, without the ability to sell and recover cash invested, many investors would be simply unwilling to take risks at all. Although it is true that when the opinion of the whole market swings one way, liquidity vanishes, nonetheless the individual investor tends to believe that his or her investment is liquid, and that they will sell out in time. The ability to exit from an investment by selling a financial asset is, at one and the same time, a necessary foundation for investment in a market economy, and the source of the instability that can undermine investment, output and employment. The structure of the CERF approach is therefore constructed as follows: 1. The analysis of financial markets provides insight into the characteristics of the availability of liquidity, of speculative bubbles and of financial collapse. 2. The availability of liquidity defines the possibility of spending. 3. The composition of and financing of spending will determined the distribution of assets and liabilities in the economy.

4. The distribution and value of assets and liabilities will interact with current financial market conditions to determine the scale and content of current spending. The micro-economic analysis of financial markets can therefore be the starting point of an understanding of overall macro-economic performance. What is necessary is to link that micro-analysis to a macro-economic model, via the impact of financial variables on overall spending behaviour. This then provides the framework within which to examine the impact of regulatory proposals, and particularly the relationship between financial institutions, financial innovation and systemic risk. Analysing the impact of regulation in this context will ensure that regulation is seen as having macro-economic consequences; indeed many regulatory goals may be more readily achieved at the macro rather than at the micro level. For example, it is well known that Korean regulators have, since 1998, been keen to reduce the forex exposure of Korean companies. This has primarily been done by the enforcement of regulatory requirements for the risk analysis of balance sheets. The same goal may well have been attained, far less onerously, by introducing macro-economic controls on financial flows. But the key point is, of course, that a large component of systemic risk derives primarily macroeconomic contagion, and thus an understanding of the behaviour of financial markets and the inter-relationship between those markets and macroeconomic performance must be central to any coherent programme of regulatory reform, domestic or international.

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References Dornbusch, R. (1976). Expectations and exchange rate dynamics, Journal of Political Economy. Eatwell, J. and M. Milgate, eds. (1983). Keyness Economics and the Theory of Value and Distribution. London: Duckworth. Garegnani, P. (1970). Heterogeneous capital, the production function and the theory of distribution, Review of Economic Studies. Garegnani, P. (1983). Notes on consumption, investment and effective demand, in J. Eatwell and M. Milgate, eds. Godley, W.A.H. and W. Nordhaus. (1972) Pricing in the trade cycle, Economic Journal. Kalecki, M. (1939). Essays in the Theory of Economic Fluctuations. London: Allen and Unwin. Keynes, J.M. (1936). The General Theory of Employment, Interest and Money. London: Macmillan. Keynes, J.M. (1973). Collected Economic Writings. London: Macmillan. Neild, R.R. (1963). Pricing and Employment in the Trade Cycle. Cambridge: CUP. Patinkin, D. (1948). Price flexibility and full employment, American Economic Review. Patinkin, D. (1965). Money, Interest and Prices. New York: Harper and Row.

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