Markets and Morality

(a draft of a monthly column I write for a Chinese financial and economic magazine)

Economics is dubbed the dismal science because it studies scarcity.  A question that predates human society is how should scarcity be distributed.  Nature rewards the strong, the quick, and the cunning.  Societies mitigate this natural system in care for the young, weak, sick, and less fortunate. 

Two chief distribution mechanisms have emerged in human society:  command and demand. Command refers to authorities, whether sacred or profane, determining who gets what when.  Demand refers to the role of markets aggregating information and distributing scarcity through a price mechanism.   

It is possible that what has been dubbed the “shared economy” may offer a third distribution mechanism.  However, it is too early to say with much confidence.  There does seem to be something there, but the range of goods and services it can distribute may be marginal.  It may also turn out to be highly dependent on the command and demand mechanisms. 

While the different mechanisms can be distinguished for analytic purposes, in practice, it appears that the three exist in various combinations.  It is an oversimplification to say that there are demand and command societies anymore.  It is a question of emphasis rather than kind.  The state sector has grown in most high income countries over the last couple of generations. 

One measure of this is the government’s expenditures as a percentage of GDP.  In some countries in Europe, for example, the government expenditures are more than 50% of GDP.    Even in some of the so-called “small government” countries like the US and the UK, the government commands (expenditures) more than a third of GDP. 

The scarcity of particular goods and services may be distributed one way while other scarcities are distributed another way.   While the demand mechanism distributes auto ownership, the command system distributes the privilege of driving. 

Before the Great Depression in the United States, the demand system the well-being of older folks, the sick and the unfortunate.  Programs associated with the New Deal introduced some command features, such as social security.  Changing the emphasis from one mode to another is often the subject of high politics.  The healthcare debate in the US, which arguably began with Nixon’s proposal for national insurance, culminated only in the first Obama term (though there is rearguard attack).

Many countries recognize the superiority of the demand system for the distribution consumer goods and services.  Indeed, many come to see freedom residing in the range of consumer choices.  I often ask my students at the Center for Global Affairs at New York University to imagine that the government announces that there are too many breakfast cereals.  Henceforth there would be three.  One that gets soggy in milk; one that doesn’t, and finally a granola.     Consistently over half in international student body says they would be less free.  

While a price mechanism may be the best way to distribute consumer goods and services, few countries fully embrace this mechanism for the price of money.  Governments and/ central banks set some interest rates.   The other price of money is the exchange rate.  For most of the past few centuries, the exchange rate not set in the open market but was fixed to precious metals directly or indirectly. 

The end of Bretton Woods and the dollar-gold standard brought raised the issue anew.  The US, UK, Canada, and more recently, Australia and New Zealand are more inclined to let market forces determine the exchange rates.  Europe has created various mechanisms to limit the ability of their currencies, traditionally their main trading partners, to fluctuate.  Monetary union is the ultimate expression of this drive.  A single currency precludes fluctuations. 

There is a wide variety of combinations between command and demand mechanisms in Asia and the Middle East.  Some currencies, such as the Hong Kong dollar and OPEC currencies are tightly tied to the US dollar by virtue of command.  South Korea and Taiwan have very closely managed exchange rates.  This to say that command plays an important role, though there is a role for demand as well.  Japan used to have a strong proclivity toward intervention if it did not like the direction or magnitude that was generated from the demand mechanism.

The G20 and G7 have endorsed the demand mechanism for exchange rates.   A few voices try to defend it on moralistic grounds, but ultimately the reasons are pragmatic. 

First, too strong of a command element lends itself to seeking advantage.  In turn, this breeds the desire in others to retaliate or seek redress through other forms of protectionism. 

Second, manipulating exchange rates is a zero-sum game.  The country with the weaker currency simply take the aggregate demand of some other country.  Setting key interest rates through a command mechanism can be a non-zero-sum exercise by boosting overall aggregate demand, especially if other duplicate the measures.  

Third, by allowing freer hand to demand mechanisms, it is easier for countries to achieve other objectives.  For example, embracing demand mechanisms operationally would likely boost the probability that the yuan would be accepted into the IMF’s Special Drawing Right (SDRs).  It would facilitate a further opening of China’s capital account.  It would no longer drain China of reserves.

There is much debate over whether the August 11 yuan devaluation and declaration of a new central rate process represents a watershed.   A few weeks is too short a period to reach any hard conclusions.   Many observers continue to compare the daily fixes.  This has generated little fresh insight.  Instead, what Chinese officials have engineered is a closing of the gap between the spot market and the central reference rate.  In achieving this, if it is indeed sustained, represents an important convergence between the command and demand signals.  

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