Reform The International Financial System To Return To The Golden Age Of Full Employment

Restoring a golden age of low unemployment, rapid economic growth and a stable international competitive structure demands reform of the international monetary system. That is the central argument of Professor Paul Davidson, writing in the May 1998 issue of the Economic Journal. And as he points out, this proposal stands in stark contrast to today''s conventional wisdom, which blames the persistently high levels of OECD unemployment since the mid-1970s on rigidities in the supply-side of the labour market, encouraging truculent workers to refuse to accept the lower wage rate that theory presumes would end unemployment.

The conventional wisdom is that two things are necessary to solve the unemployment problem. First, reduce (eliminate) the social safety net that provides income support for those without gainful employment. Second, enact policies that force the reduction of the real wage of the employed workers to create more jobs. In other words, we must return today''s labour market to the state that existed in England between the wars!

Davidson demonstrates why this conventional wisdom is not only based on an incorrect theory but it is also inconsistent with the facts since the end of World War II. The Bretton Woods system negotiated in 1943-4 formed the basis of the immediate post-war international payments system. This system was shaped by Keynes''s revolutionary analysis, which indicated that flexible exchange rates and free international capital mobility are incompatible with global full employment and rapid economic growth in an era of multilateral free trade.

Operating until 1973 under an international trading system consistent with Keynes'' ''incompatibility thesis'', OECD nations experienced unparalleled growth and prosperity. The average real GDP per capita growth rate between 1950-73 was almost double the peak annual growth rate of the industrializing nations during the Industrial Revolution, while labour productivity annual growth was almost triple its previous peak.

In 1973, the Bretton Woods system was abandoned as the first oil price shock created huge international payments imbalances and unleashed inflationary forces in oil consuming nations. The resulting economic dislocation placed policy-makers in a difficult position. In the circumstances, they found irresistible the Panglossian siren song that ''all is for the best in the best of all possible worlds provided we let well enough alone''. Without having to admit that they didn''t know what to do, policy-makers used the developing counter-revolution against Keynes to justify the abandoning of attempts to constrain international financial flows and fix exchange rates.

The resulting new international world of finance made the exchange rate itself an object of speculation. Since the mid-1970s, international financial transactions have grown 30 times as fast as the growth in international trade. International financial flows now dominate trade payments. Exchange rate movements reflect changes in speculative positions rather than changes in patterns of trade. This has depressed investment on a global scale. When the free world changed from a fixed to a flexible exchange rate system, the annual growth rate in investment in plant and equipment in OECD nations fell from 6% (before 1973) to less than 3% (since 1973). Less investment growth means a slower economic growth rate in OECD nations (from 5.9% to 2.8%) while labour productivity growth declined even more dramatically (from 4.6% to 1.6%). Davidson argues that the abandonment of the international monetary system that embedded Keynes'' ''incompatibility thesis'' principle is a major factor in explaining why, since 1973, OECD economies have experienced slower economic growth, rising global unemployment and increasing inequalities of income within nations as well as between nations. Restoring a golden age of low unemployment, rapid economic growth and a stable international competitive structure that allows nations to specialize in their comparative advantage industries requires reforming the international monetary system, he argues.

Exacerbating the problem is the post-1973 conventional wisdom that (1) government spending is per se undesirable and government spending designed to increase employment is especially misguided; and (2) the worldly wisdom of central bankers is that inflation can only be held in check by promoting the fear of ''job insecurity'' among workers so that monetary policy is used to perpetuate unemployment rather than promote prosperity. Subscribing to the conventional wisdom rationalized by ''natural rate'' theories, politicians and central bankers have foisted on society a Hobson''s choice that has devastating real effects on industry and the global economy. Davidson argues that if OECD nations adopt his proposal for reforming the international payments system, then monetary policy and government cooperation with private investment initiatives policies could be used to increase investment opportunities. The result would be that, in the 21st century, the OECD nations could achieve a golden age of full employment, rapid economic growth, and large increases in labour productivity similar to that we experienced during the postwar Bretton Woods period that came to an abrupt end in 1973.

''Post Keynesian Employment Analysis and the Macroeconomics of OECD Unemployment'' by Paul Davidson is published in the May 1998 issue of the Economic Journal. Davidson holds the Holly Chair of Excellence in Political Economy in the Economics Department at the University of Tennessee, Knoxville, Tennessee 37996-0550.