Governments which deregulate their financial sector are no longer able to set low interest rates, direct credit to where it is needed in the economy, or to differentiate between loans that are for productive purposes from those that are for speculative purposes. Rather than the banks being accountable to governments, governments become accountable to the international financial markets.
According to Professor of Economics, Prabhat Patnaik:
The essence of democracy is the pursuit of policies in the interests of the people… An economy exposed to the free flow of international finance capital, however, is obsessed with the need to appease international financiers, to retain their ‘confidence’: the thrust of policies in such an economy therefore, even in principle, is not towards serving the interests of the people but towards serving the interests of the speculators, which represents an inversion of democracy.
For example, governments have to keep tax rates low to attract capital and are unable to have large budget deficits as this scares away investors. The Economics Editor of the Financial Times, Peter Norman, observed:
Because they process the many billions of dollars worth of investments flowing across national borders each day, the markets have become the police, judge and jury of the world economy—a worrying thought given that they tend to view events and policies through the distorting lenses of fear and greed.
Rising share prices have come to be the final arbiter of good policy. Forget opinion polls that show the public is opposed to privatization and deregulation and is fearful of massive corporate and government downsizing. The only real poll that counts is the stock market. And whilst such policies elicit positive market responses, politicians know them to be right.
Countries can still retain a veneer of democracy with choice between major parties, but because of the constraints imposed by the need to please international financial markets, the policy differences between the major parties is minimal. Whether it is a Labour Party in Britain or Australia, or a Peronist President in Argentina, or the BJP in India, they all adopt the same free market policies. Governments that try to deviate are punished by the markets.
The ‘soundness’ of policy settings in particular countries will be judged by those bodies that control international financial capital—particularly the major international banks, large transnational corporations with major financial dealing, fund managers within key private financial institutions, and the key credit-ratings agencies (such as Moody’s). These judgements will be reflected in the value the ‘markets’ place on the currencies of the particular countries, on the attractiveness of various countries for foreign investors, and on the cost and availability of credit.
Credit ratings agencies, particularly Moody’s and Standard and Poors can make or break a nation’s economy. For example, when these agencies downgraded the credit ratings of Brazil and Venezuela in September 1998 the financial markets of those countries collapsed. Direct investors, bond investors, pension and mutual funds all rely on credit agencies to tell them what investments are safe. The World Bank’s International Financial Corporation also categorizes countries into those that are investable and those that are not. Countries are thought to be a higher political risk if their governments are likely to ‘nationalize, change tax incentives, or give concessions to labor unions.’
Following the Asian crisis when speculators led the flight of capital out of Asia, the Malaysian government decided to introduce capital controls and fix the exchange rate of the Malaysian currency. The international financial community was incensed. Fund manager, Mark Mobius, fearing it could set a precedent, called for wealthy countries to ‘severely punish’ Prime Minister Mohammed Mahathir (pictured). He, himself, subsequently withdrew some $2 billion in investment from Malaysia. Morgan Stanley took Malaysia off its influential Capital International Index. It reinstated it when Mahathir lifted the controls.
Various analysts argue that in fact, Malaysia benefited from the capital controls. Kaplan and Rodrik from Harvard University found that ‘compared to IMF programs [which required financial deregulation] the Malaysian policies produced faster economic recovery, smaller declines in employment and real wages, and more rapid turnaround in the stock market.’
Similarly Edison, from the IMF, and Reinhart, in a paper provided by the US Federal Reserve, found that the controls did help to increase interest rates, stabilize the currency and give more policy autonomy to the Malaysian government.
Stiglitz, who was World Bank chief economist at the time, also admitted the success of the capital controls in Malaysia and some thought this heralded a change in policy at the Bank. Instead, Stiglitz was forced to resign from the Bank, following pressure on the Bank’s President from US Treasury Secretary, Lawrence Summers. The Bank had not turned, nor did investors. In order to attract foreign investors, Mahathir was finally forced in 2001 to lift the last of the controls, excluding the fixed exchange rate, so as to attract foreign investors back to Malaysia.