MARK T. BERGER Bringing History Back In: The Making and Unmaking of the East Asian Miracle* T he East Asian crisis, which began in Thailand in July 1997 , has precipitated important changes in the contours of the post-Cold War international political economy. During the 1970 s and 1980 s Japan, South Korea, Taiwan, Hong Kong, and Singapore, followed by Thailand, Malaysia and Indonesia, were increasingly celebrated as miracles of capitalist development. In this period the dominant interpretations of the making of the East Asian Miracle were linked to the rise and spread of neo-liberalism as a growing number of commentators used the dynamic new Asian capitalisms to support their case for laissez-faire economic policies. By the time the Cold War came to an end, Japan, and the other miracle economies of Northeast and Southeast Asia, were also widely perceived as a challenge to the»West« generally, and to the United States more specifically. 1 However, despite expectations in some quarters that the end of the Cold War might signal the decline of the U.S . role in Asia, the United States remained the hegemonic power in the region and revised forms of neo-liberalism continued to provide the most influential understanding of the East Asian Miracle, and of capitalist development generally. In fact, since the second half of 1997 there has been a reassertion of U.S. hegemony in East Asia, via the International Monetary Fund( IMF ) in particular. The IMF , and advocates of neo-liberalism generally, blame the crisis on the state-centred elements of the East Asian model(»crony capitalism«) and continue to hold out liberalization and deregulation as the key to economic progress in East Asia and world-wide. 2 More broadly, it is clear that the United States is attempting to administer the last rites to Japanese-style developmentalism, and its imitators, sending a message about what form(s) of economic development are deemed to be acceptable in the post-Cold War era. 3 Despite the continued dominance of neoliberal ideas and practices, the crisis has called further into question many of the lessons which proponents of neo-liberalism have drawn from East Asia over the years. It has also raised questions about the descriptions and prescriptions provided by advocates of the developmental state, whose formulations are characterised by many of the problems associated with neo-liberalism. At the outset, this article will look at the way the dominant neo-liberal approaches to capitalist development, and the state-centred perspectives which have emerged as their main challengers, have increasingly extracted technocratic and ahistorical lessons from the East Asian development experience. This leads to an emphasis on the importance of a more historically grounded approach to capitalist development in East Asia and beyond. Of particular importance is the way in which the history of the Cold War provided the crucial foundation for the emergence of various, far from uniform, but usually authoritarian, developmental states at the same time as U.S. hegemony imposed a range of important limits on all states in the region. It will be argued that the likelihood of a significant and / or unified regional response to the * Support for the research and writing of this article was provided by the Asia Research Centre at Murdoch University, Perth, Western Australia, and a Special Research Grant, as well as a Small Australian Research Council Grant, from the Faculty of Arts and Social Sciences at the University of New South Wales, Sydney, Australia. I would also like to thank Anthony Aspden, Jasper Goss, Andrew Rosser and Catherine Waldby for assistance and / or comments. 1 . Mark T. Berger,»The Triumph of the East? The East Asian Miracle and Post-Cold War Capitalism« in Mark T. Berger and Douglas A. Borer, eds., The Rise of East Asia: Critical Visions of the Pacific Century[London: Routledge, 1997 ]. 2. Charles Wolf,»Blame Government for the Asian Meltdown« Asian Wall Street Journal February 5 1998 . p 14 . 3. Bruce Cumings,»The Korean Crisis and the End of ›Late‹ Development« New Left Review no. 231. 1998 . pp. 45, 51–52, 71–72 . IPG 3/99 Berger, East Asian Miracle 237

crisis is remote, and the reason for this is to be found in the close connection between the making and unmaking of the East Asian Miracle and the history of the Cold War. At this juncture, a renovated form of neo-liberalism, linked to the hegemonic position of the U.S. , remains the dominant approach to development in East Asia and beyond, and a romanticised laissez-faire version of the development path followed by the United States will continue to be held up to the rest of the world as the mirror in which they can observe their own future. However, although the end of the East Asian Miracle represents a moment of consolidation for neo-liberalism, it also represents a crisis of neo-liberalism which is characterised by both ominous and encouraging possibilities. 4 The East Asian crisis, and the looming crisis of neo-liberalism to which it is linked, have created political space for progressive alternatives to gain in prominence. But, this will only happen in East Asia when the elites and historic structures of social and political power, which were consolidated during the Cold War, are dramatically reformed or overthrown. Making Miracles: The State-Market Debate and the Lessons of East Asian Development The Rise and Renovation of Neo-Liberalism Despite the way in which the dominant laissezfaire interpretations of East Asian development, which gained prominence in the 1980 s, presented their conclusions as universal lessons in capitalist development which transcended history, they were the product of a highly politicised debate which occurred against the backdrop of the emergence and increasingly global diffusion of neo-liberalism. In the 1980 s neo-classical economic theories associated with a romanticised laissez-faire version of capitalism increasingly meshed with the aims and assumptions of a complex array of transnational socio-economic forces which possessed the power and influence to embark on the internationalisation of the neo-liberal project(a process which is also known as globalization). 5 A crucial turning point was the election of Margaret Thatcher in Britain, followed soon after by Ronald Reagan in the United States and Helmut Kohl in West Germany, which set the scene for the rapid, but uneven, spread of neo-liberalism world-wide. By the early 1980 s the main policy conclusions of neoclassical economics were becoming the received wisdom among most of the senior officials in the OECD nations and at the International Monetary Fund and the World Bank. 6 The increased pressure on governments around the world to liberalise, privatise and deregulate, coincided with a growing awareness of the economic resurgence of Japan and the rise of the East Asian tigers. By the end of the 1970 s, Japan, South Korea, Taiwan, Hong Kong and Singapore, were being held up as exemplars of the success of the free-market model, while the economic failure of governments in Latin America and Africa was increasingly represented as evidence of the short-comings of the state-centered model. 7 For example, writing in 1979 , Edward Chen argued that in the case of Japan, South Korea, Taiwan, Hong Kong and Singapore»state intervention is largely absent«. He argued that all»the state provided« was»a suitable environment for the entrepreneurs to perform their functions«. 8 In 1986 David Aikman asserted that the industrial dynamism of countries such as Hong Kong and Taiwan made clear just how faithful, consciously or not, the governments of these nation-states have been to U.S. »conceptions of free enterprise«. 9 While the rise of East Asia was increasingly attributed to laissez-faire economic policies, neoliberalism underwent a process of reorientation in the second half of the 1980 s and this was linked to wider changes in the international political economy. For example, there was a shift in Washing4. Mark T. Berger,»Up From Neo-Liberalism: FreeMarket Mythologies and the Coming Crisis of Global Capitalism« Third World Quarterly: Journal of Emerging Areas vol. 20 . no. 2. 1999 . 5. James E. Cronin, The World the Cold War Made: Order, Chaos and the Return of History[London: Routledge, 1996 ]. pp 177 , 185 . 6. John Martinussen, Society, State and Market[London: Zed Books, 1997 ]. pp. 260 – 261 , 263 . 7. Michael Barrat Brown, Africa’s Choices: After Thirty Years of the World Bank[London: Penguin, 1995 ]. pp. 5 – 6 , 29 – 49 . 8. Edward K. Y. Chen, Hyper-growth in Asian Economies: A Comparative Study of Hong Kong, Japan, Korea, Singapore and Taiwan[London: Macmillan, 1979 ]. p. 41 . 9. David Aikman, The Pacific Rim: Area of Change, Area of Opportunity[Boston: Little Brown, 1986 ]. p. 116 . 238 Berger, East Asian Miracle IPG 3/99

ton in the mid1980 s symbolised by James Baker’s emergence as Treasury Secretary in 1985 . In this post, Baker, who went on to serve as Secretary of State under George Bush( 1989–1993 ), made it clear that he was less opposed to economic intervention than his predecessor. Baker looked favourably on international economic cooperation with the major economic and financial powers(especially Japan and Germany) and began to pursue a series of initiatives to secure agreements with them, resulting in the 1985 Plaza Accord and the Louvre Accord of 1987 . These agreements were aimed at mitigating the negative effects of the economic policy excesses of the early Reagan years, particularly in relation to financial markets, debt repayment, and the decline in investment levels. However, by lowering the value of the dollar vis-àvis currencies such as the yen, U.S. exporters also gained a competitive advantage. This more pragmatic, but still neo-liberal, agenda became a hallmark of the Bush administration and continued under his successor, Bill Clinton. 10 At the same time, the re-orientation of the international political economy embodied by the Plaza Accord, coincided with a growing challenge to neo-liberalism being mounted by the government of Japan. In fact, in part as a result of the Plaza Accord, the »external reach« of the Japanese state, via foreign investment and aid programs, increased significantly by the end of the Cold War(the role of the Plaza Accord in this process will be discussed below). This trend was reinforced by a range of attempts by the Japanese government to encourage the political and economic elites in the countries over which it enjoyed growing influence, to view economic development in more strategic and interventionist ways than was advocated by powerful promoters of neo-liberalism such as the World Bank. 11 Meanwhile, in the early 1990 s the term »Washington Consensus« was increasingly deployed to characterise the dominant post-Cold War approach to international development. 12 It was against this overall backdrop that the now famous 1993 World Bank report on East Asia appeared. 13 The 1993 report, which was funded by the Japanese Ministry of Finance, was a profoundly political document which, reluctantly conceded that government intervention had played some role in economic development in East Asia. The report reflected the ongoing renovation of neo-liberalism which was grounded in the liberal notion of the state as neutral arbiter. 14 The effort to accommodate the state-centered approaches to the wider neo-liberal understanding of capitalist development which was apparent in the Bank’s 1993 report on East Asia, was even more apparent in»The State in a Changing World«, which was launched with considerable fanfare at the annual IMF -World Bank meeting in Hong Kong in the middle of 1997 . It was premised on the idea that the state is not just an important factor in economic development, but that»its capability«, which was»defined as the ability to undertake and promote collective actions efficiently«, had to be»increased«. 15 At the same time, the World Bank’s 1997 study defined an»effective state« in a way which remained inoculated from historical and political questions, while the wider social context was sidestepped and the authoritarian character of most of the developmental states in East Asia was given implicit, if not explicit, legitimacy. The renovation of neo-liberalism, manifested in the 1997 report, was facilitated in a significant fashion by the rise of rational choice theory. As with the approach to economic behaviour taken by neoclassical economics, rational choice theory built its explanations for political behaviour on assumptions about the rational calculations which informed the policies and actions of the individuals and groups concerned. This outlook exercised a direct influence on the approach to development taken 1o. Stephen Gill, American Hegemony and the Trilateral Commission[Cambridge: Cambridge University Press, 1990 ]. pp. 108 , 119 – 121 . 11. Robert Wade,»Japan, the World Bank, and the Art of Paradigm Maintenance: The East Asian Miracle in Political Perspective« New Left Review no. 217 . 1996 . pp. 6 – 7 . 12. John Williamson,»The Progress of Policy Reform in Latin America« in John Williamson, ed., Latin American Adjustment: How Much Has Happened?[Washington: Institute for International Economics, 1990 ]. pp 351 – 420 . 13. World Bank, The East Asian Miracle: Economic Growth and Public Policy[Oxford: Oxford University Press for the World Bank, 1993 ]. 14. Mark T. Berger and Mark Beeson,»Lineages of Liberalism and Miracles of Modernisation: The World Bank, the East Asian Trajectory and the International Development Debate« Third World Quarterly: Journal of Emerging Areas. vol. 19 . no. 3 . 1998 . 15. World Bank, World Development Report: 1997, The State in a Changing World[Oxford University Press, 1997 ]. pp. 3 , 6 , 24 , 46 , 61 . emphasis in original. IPG 3/99 Berger, East Asian Miracle 239

by the World Bank by the second half of the 1980 s. For example, the 1991 World Development Report rested on a synthesis of the work of the prominent rational choice theorists Robert H. Bates and Douglass C. North to strengthen its major conclusions. The World Development Report for 1994 also owed a major debt to rational choice theory. North and Bates work is widely cited by North American political scientists, while the terminology, if not the conceptual framework, which is a hallmark of their work is widely deployed. 16 Overall, rational choice theory has facilitated the refinement of neo-liberalism and the consolidation of an increasingly technocratic and ahistorical conception of development. The Emergence of Anglo-American Revisionism and the Idea of the Developmental State Before outlining an alternative and historically grounded approach to the making and unmaking of the East Asian Miracle, it is also necessary to look more closely at Anglo-American revisionism, which emerged in the 1980 s, and is closely associated with the idea of the developmental state. The genealogy of Anglo-American conceptions of the developmental state is generally traced back to the work of writers such as Max Weber and Friedrich List(and sometimes Karl Marx). But, it is the 1982 study of industrial policy in Japan by Chalmers Johnson(who has been characterised by the Japanese media as the»Godfather of Revisionism«) which is seen as the foundational text of Anglo-American revisionism. 17 Other important studies in the revisionist canon include the work of Alice Amsden, Robert Wade, Stephan Haggard, James Fallows, Peter Evans, Sanjaya Lall and Linda Weiss. 18 The emergence of the revisionist trend was connected to the wider effort in various branches of the social sciences(including political science, development economics and sociology) to »bring the state back in«. 19 The rise of state-centred challenges to neo-classical explanations for East Asian capitalism was an important part of the relative recovery of development economics and the growing significance of political economy as a subdiscipline of political science by the second half of the 1980 s. And, as the idea of the developmental state emerged as the main challenger to neo-liberal understandings of East Asia, revisionist formulations were partially domesticated by the dominant neo-liberal narrative via rational choice theory. While the work of revisionist authors has been embraced with varying degrees of enthusiasm by opponents of neo-liberalism, the progressive credentials of the revisionist tradition ought to be, and are being, subject to increasing scrutiny. Even if the East Asian crisis can be understood primarily in terms of unregulated financial markets(as numerous prominent economists have argued), rather than an indictment of state intervention, the increasingly technocratic image of a developmental state presiding over steady economic growth and widening prosperity, which is central to the revisionist narrative on East Asia, has still been undermined by the crisis. 20 Revisionist approaches have 16. Colin Leys, The Rise and Fall of Development Theory [Bloomington: Indiana University Press, 1996 ]. pp. 36 – 37 , 80 – 103 . Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies[Berkeley: University of California Press, 1981 ]. Douglass C. North, Institutional Change and Economic Performance [Cambridge: Cambridge University Press, 1990 ]. 17. Chalmers Johnson, MITI and the Japanese Miracle: The Growth of Industrial Policy 1925–1975 [Stanford: Stanford University Press, 1982 ]. 18. Alice Amsden, Asia’s Next Giant: South Korea and Late Industrialization[New York: Oxford University Press, 1989 ]. Stephan Haggard, Pathways from the Periphery: The Politics of Growth in the Newly Industrializing Countries[Ithaca: Cornell University Press, 1990 ]. Robert Wade, Governing the Market: Economic Theory and the Role of Government in East Asian Industrialisation[Princeton: Princeton University Press, 1990 ]. James Fallows, Looking at the Sun: The Rise of the New East Asian Economic and Political System New York: Pantheon, 1994 ]. Peter Evans, Embedded Autonomy: States and Industrial Transformation[Princeton: Princeton University Press, 1995 ]. Sanjaya Lall, Learning from the Asian Tigers: Studies in Technology and Industrial Policy [London: Macmillan, 1996 ]. Linda Weiss, The Myth of the Powerless State: Governing the Economy in a Global Era [Cambridge: Polity Press, 1998 ]. 19. Theda Skocpol,»Bringing the State Back In: Strategies of Analysis in Current Research« in Peter B. Evans, Dietrich Rueshemeyer and Theda Skocpol, eds., Bringing the State Back In[New York: Cambridge University Press, 1985 ]. 20 . The technocratic character of revisionism generally, and the revisionist view of the crisis more specifically, is nicely encapsulated by Linda Weiss’s emphasise on the difference between»state involvement« and»state transformative capacity«, arguing that if the state is»part of the problem« in the East Asian crisis it is as a result of » too little state capacity, rather than too much state involvement«. Weiss, The Myth of the Powerless State 1998 . pp. xii-xiii. emphasis in original. 240 Berger, East Asian Miracle IPG 3/99

been accommodated to neo-liberalism, and like neo-liberalism they perpetuate an elite-oriented ahistorical approach to capitalist development. More specifically, some revisionists, such as James Fallows, perpetuate a fixed conception of culture / race, while recent articles by Robert Wade and Frank Veneroso rely on an exceedingly homogenous conception of the»Asian Model« to inform their policy prescriptions for the region as a whole. 21 In general, it can be argued that revisionist writers are highly selective in their use of history and ignore issues of social change. Within the revisionist tradition the developmental state tends to be narrowly defined as a policy-making body with limited recognition of the complicated and contested social relations to which it is linked. For proponents of the developmental state, economic development involves the subordination of major social actors to state power, while complicated historical processes are reinvented as technocratic and managerial practices. 22 For example, Alice Amsden’s overall argument – that industrialisation in South Korea flowed from»government initiatives and not the forces of the free market« and this is»applicable to similar countries« – nicely captures the technocratic and ahistorical perspective at the centre of the revisionist tradition. 23 There is also an important intersection between revisionist conceptions of the developmental state and the politics-of-order approach which emerged as a challenge to classical modernization theory in the 1960 s, and held up the military as the only institutional force which had the administrative and technical skills to facilitate modernization. Not surprisingly the appearance of the politicsof-order approach(sometimes called military modernization theory) coincided with the trend towards military regimes in Asia, Africa and Latin America. 24 By the end of the 1960 s Samuel Huntington was regarded as a particularly prominent exponent of this perspective and his 1968 book»Political Order in Changing Societies« became one of the most well-known works of comparative politics. 25 The politics-of-order approach was explicit in the way it treated the emergence of authoritarian regimes, such as Suharto’s New Order in Indonesia( 1965–1998 ) and Park Chung Hee’s national security state in South Korea( 1961–1979 ), as a necessary response to instability, and focused on the need for, and the ability of, centralised authoritarian states and governments to better pursue capitalist development. While Huntington and the military modernization theorists were preoccupied with security and social order, advocates of the developmental state, such as Chalmers Johnson, focused on the state’s capacity to bring about economic development, setting out successful development under state auspices as the best guarantee for strengthening the power of the state. But, they both emphasised that the power and autonomy of the state was the basis for social and economic development. 26 During the Cold War, Huntington’s ideas about the need for a military-led technocracy to oversee the process of development was popular in Washington and with many military figures in Asia, Latin America and beyond. Huntington’s book was well received by the South Korean government – it was translated into Korean in order to give it a wide audience in the peninsula. The influence of Huntington’s ideas is also apparent in the writings of Ali Moertopo, an important New Order ideologue who served as Suharto’s intelligence chief for many years. 27 While the politics-of-order approach was explicit in its legitimation of military rule in the context of the Cold War, the technocratic and ahistorical approach of the revisionist literature on the developmental state has also worked over the 21 . Robert Wade,»The Asian Debt-and-development Crisis of 1997 –?: Causes and Consequences« World Development vol. 26 . no. 8 . 1998 . Robert Wade,»The Asian Crisis and the Global Economy: Causes, Consequences, and Cure« Current History vol. 97 . no. 622 . November 1998 . Robert Wade and Frank Veneroso,»The Asian Crisis: The High Debt Model Versus the Wall Street-TreasuryIMF Complex« New Left Review no. 228 . 22. Alex H. Choi,»Statism and Asian Political Economy: Is There a New Paradigm?« B ulletin of Concerned Asian Scholars vol. 30. no. 3. 1998 . pp. 51, 55-56 . 23 . Amsden, Asia’s Next Giant 1989 . p. 27 . 24 . On this shift see Mark T. Berger, Under Northern Eyes: Latin American Studies and U.S. Hegemony in the Americas[Bloomington: Indiana University Press, 1995 ]. pp. 101–153 , especially pp. 129–133. 25. Samuel P. Huntington, Political Order in Changing Societies[New Haven: Yale University Press, 1968 ]. 26 . Martinussen, Society, State and Market 1997 . p. 239 . 27. Ali Moertopo, Some Basic Thoughts on the Acceleration and Modernization of 25 Years of Development[Jakarta: Centre for Strategic and International Studies, 1972 ]. IPG 3/99 Berger, East Asian Miracle 241

years to provide implicit, if not explicit, intellectual justification for military dictatorship and authoritarian developmentalism. 28 Containing Communism: Cold War Capitalism and the Rise of Authoritarian Developmentalism The Bretton Woods Bargain and the Coming of the Cold War Contrary to the technocratic and ahistorical character of the dominant neo-liberal and state-centred narratives on capitalist development, the making and unmaking of the East Asian Miracle can only be understood in the context of the history of the Cold War, and the political and social struggles with which it interacted. While Europe was a major axis of the early Cold War confrontation, Asia also emerged as a crucial arena of the Cold War by the late 1940 s. In Asia, the Cold War formed the backdrop to the emergence and consolidation of various types of capitalist authoritarian developmentalism based explicitly on the repression and political exclusion and control of important social forces such as workers and peasants. 29 Beginning in the late 1940 s the U.S. embarked on a full-scale effort to facilitate the industrial rebirth of Japan and Germany as part of its wider effort to turn Western Europe and Northeast Asia into capitalist bulwarks against the Soviet Union and»international communism«. Among other things, this resulted in the Marshall Plan for Western Europe and a less ambitious, but still significant, version for Northeast Asia centred on Japan. 30 Although the U.S. approach had already begun to shift by 1947 towards the rebuilding of Japan as the linchpin of U.S. hegemony in the region, it was not until the Chinese Revolution and the Korean War( 1950– 1953 ) that the U.S. defence industry, and the governmental institutions and bureaucratic structures of U.S. Cold War hegemony, began to develop into distinct instruments of regional and global power. It is abundantly clear that the dramatic economic growth of an increasing number of nation-states in Northeast and Southeast after 1945 was grounded in the interaction of the geo-political and geo-economic interests of the United States and its key ally in the region, Japan. 31 At the same time, the arrangements laid down at Bretton Woods in 1944 , before the coming of the Cold War, had produced an»informal bargain« which meshed with subsequent Cold War imperatives. On the one side, the U.S. (with the dollar providing the central currency for the postwar order) accepted the increasingly large balance of payments deficits necessary to pay for its expanding network of military bases and the large quantities of foreign aid it was disbursing, which was paralleled by high-levels of foreign investments made by U.S .-based companies. On the other side, the United States’ allies(particularly Germany and Japan), which were also its economic competitors, were allowed to retain high levels of control over their economies in terms of the flow of capital and commodities. Furthermore, with the implicit agreement that its allies would not attempt to convert large amounts of their U.S. dollar holdings to gold(which was technically permitted by the gold standard), Washington threw open the North American market and turned a blind eye to the protectionist trading practices and restrictions on capital movement, practiced by its major Cold War allies. Ultimately, the fact that German and Japanese manufacturers were able to gain increasing access to the world market at the expense of manufacturers in the United States and 28. For example, Linda Weiss criticises the way in which»the South Koreans have increasingly relinquished state control over the past decade«. Weiss, The Myth of the Powerless State 1998 . pp. xiii-xiv. emphasis in original. There is no discussion of the way in which the relinquishing of state control over the economy was linked to the transition from authoritarian to»democratic« politics. 29. The concept of authoritarian developmentalism is derived from Takashi Shiraishi,»Japan and Southeast Asia« in Peter J. Katzenstein and Takashi Shiraishi, eds., Network Power: Japan and Asia[Ithaca: Cornell University Press, 1997 ]. pp. 192–193 . 30. Michael J. Hogan, The Marshall Plan: America, Britain, and the Reconstruction of Western Europe, 1947–1952 [Cambridge: Cambridge University Press, 1989 ; first published 1987 ]. Ronald L. McGlothlen, Controlling the Waves: Dean Acheson and U.S. Foreign Policy in Asia[New York: W.W. Norton, 1993 ]. 31. Bruce Cumings,»Japan in the World-System« in Andrew Gordon, ed., Post-War Japan as History[Berkeley: University of California Press, 1993 ]. pp. 45–51 . Bruce Cumings,»The Origins and Development of the Northeast Asian Political Economy: Industrial Sectors, Product Cycles and Political Consequences« in Frederic C. Deyo, The Political Economy of the New Asian Industrialism [Ithaca: Cornell University Press, 1987 ]. 242 Berger, East Asian Miracle IPG 3/99

Great Britain can be seen as»indispensable« to the rapid industrial resurrection of Germany and Japan after 1945 . 32 Reaping the Benefits of the Korean War Against the overall backdrop of the Cold War and the Bretton Woods bargain, it was the Korean War which provided a key stimulus to industrial production in Japan as a result of the dramatic increase in the purchase of military equipment and war-related products by the U.S. after 1950 . During the Korean War, the U.S. spent as much as U.S. $ 4 billion dollars on services and manufactured goods provided by Japanese companies. This, combined with the limiting of Japanese defence spending to 1 percent, resulted in major financial benefits for the government which were redirected into national reconstruction. At the same time, by the end of the 1940 s the U.S. fear of social upheaval and even revolution in Japan itself had already ensured the effective restoration of the»old order« minus the most notorious militarists. While the cooperative labour relations system which emerged in Japan in the 1950 s is often characterised as a»class compromise« between capital and labour, it was firmly grounded in labour’s subordination to capital following the defeat of the militant labour movement in the 1940 s, a process which was facilitated by the United States. Meanwhile, the reversal of U.S. plans to break-up the pre-war industrial conglomerates, which had direct links to the pre1945 imperial government, resulted in the resurgence, in a modified fashion, of the old»zaibatsu«, such as Mitsui, Sumitomo and Mitsubishi. At the same time, large new firms, such as Toyota, Toshiba, Nissan and Hitachi, which were established along the lines of the old»zaibatsu«, also took root and went on to reap the benefits of the Korean War. 33 The benefits of the Korean War were also felt further south. The concern that the war on the Korean peninsula might spread to Southeast Asia, combined with efforts by the major actors in the Cold War to increase their stockpiles of strategic raw materials, caused a significant increase in the price of commodities such as rubber and tin. The price of the former increased by 400 percent while the latter rose by 200 percent. The benefits from this commodity boom went particularly to British Malaya(renamed Malaysia after independence in 1957 ), which was the biggest rubber- and tin-producer in the world in the early 1950 s. At the same time, Singapore, which served as the main port for the outward shipment of rubber and tin was also well-positioned and the commodity boom ensured that profits in the colony’s commercial sector rose significantly, while the total tax revenue received by the government trebled in both British colonies. Driven forward by a determination to defeat the guerrilla insurgency led by the Malayan Communist Party, Malaya’s colonial rulers embarked on the extension and improvement of the colony’s railroad and highway system in order that the army and the police would be able to operate more effectively throughout the countryside. At the same time, the colonial administrations in Singapore and Malaya used their rising revenues to upgrade port facilities and construct new power plants. Despite the fact that the Korean War boom was confined to the period 1950–1953 , its significance for Singapore and Malaya was considerable. The boom contributed directly to the expansion and deepening of social and economic infrastructure, and of government capabilities, which were subsequently used to tame the labour movement and more or less successfully impose the top-down corporatist arrangements which underpinned the»soft« authoritarian developmentalism pursued by these states in the 1960 s and beyond. In fact, one historian says the boom’s effect was comparable to that produced by the larger and more direct influx of U.S. aid to South Korea and Taiwan in the 1950 s and 1960 s. 34 32 . Robert Brenner,»Uneven Development and the Long Downturn: The Advanced Capitalist Economies from Boom to Stagnation, 1950–1998« New Left Review no. 229 . 1998 . pp. 43 , 47 . 33 . Brenner,»Uneven Development and the Long Downturn« New Left Review 1998 . pp. 76-79 . Michael Schaller, The American Occupation of Japan: The Origins of the Cold War in Asia[New York: Oxford University Press, 1985 ]. William S. Borden, The Pacific Alliance: United States Foreign Economic Policy and Japanese Trade Recovery, 1947–1955 [Madison: University of Wisconsin Press, 1984 ]. 34 . Richard Stubbs,»The Political Economy of the AsiaPacific Region« in Richard Stubbs and Geoffrey R. D. Underhill, eds., Political Economy and the Changing Global Order[London: Macmillan, 1994 ]. p. 368 . Richard Stubbs, Hearts and Minds in Guerrilla Warfare: The Malayan Emergency 1948–1960 [Singapore: Oxford University Press, 1989 ]. pp. 107–114 , 260–264 . IPG 3/99 Berger, East Asian Miracle 243

The Emergence of Authoritarian Developmentalism in South Korea and Taiwan The sustained U.S. military and economic aid(and capital), which went to South Korea and Taiwan in the 1950 s and 1960 s played a crucial role in strengthening the capabilities of these emergent national security states. 35 This is not to deny other factors in the rise of South Korea and Taiwan, but the emergence of capitalist, and authoritarian, developmental states in Northeast Asia after 1945 was grounded explicitly in U.S. Cold War imperatives. More specifically, Christopher Chase-Dunn has argued that the comparative analysis of over 30 countries points to the»positive effect« of U.S. military aid on national economic development (in the period up to the early 1970 s) in those instances where levels of aid were particularly high as a result of geo-political considerations. Of the 32 countries examined the four success stories were South Korea, Taiwan, as well as Greece and Turkey. 36 ( U.S. military aid to South Korea between 1945–1979 was US $ 7 billion). At the same time, geo-politics also ensured high levels of economic aid(of course the distinction between economic and military aid often becomes very blurred in practice if not in theory). As much as 75 percent of Taiwan’s infrastructure investment came from U.S. economic aid in the 1950 s, while U.S . economic aid to South Korea from 1945 to 1973 was US $ 5.5 billion dollars. This was more than all the U.S. economic aid to Africa and half the figure for all of Latin America over the same period. In the 1950 s more than 80 percent of South Korean imports were financed by U.S . economic assistance. The growing power of these states was also linked to the relative weakness of capitalist elites in South Korea and Taiwan and the undercutting of large landowners after 1945 , as a result of the implementation of land reforms under U.S . auspices. In the 1950 s and increasingly in the 1960 s, manufacturers based in South Korea and Taiwan(and, of course, Japan) also gained privileged access to the North American market, for U.S. geo-strategic reasons, at the same time as the U.S. tolerated South Korea and Taiwan’s protected markets and their governments’ tight controls on foreign investment. Furthermore, South Korea, Taiwan (as well as Singapore and Hong Kong) all entered the world export markets in the 1960 s when a consumer boom was under way. Meanwhile, Japanesebased corporations had begun to emerge as a key element in the wider U.S. -centred Cold War political economy of Asia by the 1950 s. And, in the 1960 s and 1970 s, under U.S. auspices, Japanese companies avoided the rising cost of labour in Japan by relocating operations to their former colonies. At the same time, by the 1970 s Japanese trading companies controlled 50–70 percent of the international trade of South Korea and Taiwan. In this period Japanese corporations also provided a substantial portion of the machinery and the other components needed for industrialisation in Taiwan and South Korea, and they were also an important source of technology licenses. 37 Apart from the important role of Japanese companies in South Korea and Taiwan in the post1945 era, Japan also represented a model for its one-time colonies. Japanese colonialism had laid the foundations for authoritarian developmentalism prior to 1945 , at the same time it also provided a pattern for capitalist development. 38 Park Chung Hee, who ruled South Korea from 1961 until his assassination in 1979 , had been an officer in the Japanese Kwantung Army during the Pacific War, and he was one of many South Koreans who clearly remembered and was influenced by the Japanese colonial industrial pattern, most importantly the state’s close links with the»zaibatsu«. 39 Between the 1960 s and the 1980 s authoritarian developmentalism in South Korea rested on a close relationship between the national security state and the country’s burgeoning conglomerates, 35. Jung-En Woo-Cumings,»National Security and the Rise of the Developmental State in South Korea and Taiwan« in Henry S. Rowen, ed., Behind East Asian Growth: The Political and Social Foundations of Prosperity[London: Routledge, 1998 ]. 36. Christopher Chase-Dunn, Global Formation: Structures of the World-Economy[Oxford: Basil Blackwell, 1989 ]. p. 253 . 37 . Stubbs,»The Political Economy of the Asia-Pacific Region« 1994 . pp. 366–368 . 38 . Bruce Cumings,»The Legacy of Japanese Colonialism in Korea« in Ramon H. Myers and Mark R. Peattie, eds., The Japanese Colonial Empire 1895-1945 [Princeton: Princeton University Press, 1984 ]. Thomas B. Gold, State and Society in the Taiwan Miracle[Armonk: M. E. Sharpe, 1986 ]. 39. Jung-En Woo, Race to the Swift: State and Finance in Korean Industrialization[New York, 1991 ]. pp. 7–8 , 20–21, 40 . 244 Berger, East Asian Miracle IPG 3/99

while workers and trade unions were controlled via repression and top-down corporatist arrangements. Meanwhile, important and historically specific cultural practices and nationalist narratives emerged as constitutive elements of authoritarian developmentalism. As Roger Janelli has argued, the organisational form of the South Korean»chaebol« is a»unified, top-down, chainof-command system of control« which is best understood with reference to the»pervasive military influence« in South Korea. Meanwhile, South Korea’s corporate elite justified their control via the use of selected elements of popular knowledge about father-son relations and they represented the founding and operation of the»chaebol« as an integral part of a wider national project for the benefit of all citizens, effectively imposing a »moral duty« on their employees which blurred the boundaries between employee of the company and citizen of the nation. 40 Thus, the authoritarian developmentalism of the South Korean state in the Cold War era was legitimated via appeals to»tradition«, militarism, anti-communism and nationalism, backed up by a coercive national security apparatus. Despite, or because of, these authoritarian efforts to emphasise harmony and hierarchy, the history of South Korea in this period was a history of ongoing social and political struggles. 41 In the Shadow of the Vietnam War In the 1960 s and early 1970 s, at the same time as Cold War imperatives were providing the overall context for the rise of authoritarian developmentalism in South Korea, they were also ensuring an increasingly high level of direct U.S. military involvement in Vietnam which became a focal point of Washington’s wider commitment to the containment of communism. While communism in Southeast Asia was eventually»contained« to the boundaries of the former French colonial possessions in the region, the U.S. effort at nationbuilding in South Vietnam between the 1950 s and the 1970 s was a dismal failure. The inability of the U.S. to turn South Vietnam into a Southeast Asian version of South Korea or Taiwan, despite a truly massive military and economic commitment, highlighted the limits of Washington’s power in the region and beyond. 42 It also draws attention to the fact that, although the Cold War provided the crucial framework for the rise of various types of authoritarian developmentalism in East Asia, it represents a necessary but not sufficient condition for»successful« capitalist development. For example, the Philippines was also a major Cold War ally of the U.S. , which was seen to have the best economic prospects of virtually any country in Southeast Asia in the 1950 s. However, by the 1970 s, it had succumbed to»crony capitalism« under the predatory ministrations of Ferdinand Marcos, a long-time client of the United States, who was ousted by a broad-based populist revolt in 1986 . 43 At the same time, the ultimately unsuccessful U.S. effort to turn South Vietnam into a stable nation-state on the front-line of the Cold War brought major benefits to the other front-line states, including the Philippines. For example, South Korean»chaebol«, such as Hyundai and Daewoo, gained major war-related construction contracts in South Vietnam, while trade between Singapore and South Vietnam, particularly in petroleum products, increased precipitously between 1964 and 1969 . The tropical city-state’s entrepôt trade also rose dramatically. And Singapore, as well as Hong Kong, and other countries, especially Thailand, experienced the mixed benefits which flowed from the provision of»rest and recreation« for the large number of U.S. soldiers stationed in the region. Thailand’s role in the»rest and recreation« economy was linked to its role as a staging area for the Vietnam War. In fact Thailand had been viewed by the U.S. since the mid1950 s as a key country in the wider effort to»contain communism« in Southeast Asia. U.S. military aid augmented the capabilities of the Thai state and rein40. Roger L. Janelli(and Dawnhee Yim), Making Capitalism: The Social and Cultural Construction of a South Korean Conglomerate[Stanford: Stanford University Press, 1993 ]. pp. 232–239 . 41 . Martin Hart-Landsberg, The Rush to Development: Economic Change and Political Struggle in South Korea [New York: Monthly Review Press, 1993 ]. 42. Gabriel Kolko, Anatomy of A War: Vietnam, the United States and the Modern Historical Experience[New York: New Press, second expanded edition, 1994 ; first published, 1985 ]. p. 545 . 43 . Albert F. Celoza, Ferdinand Marcos and the Philippines: The Political Economy of Authoritarianism[New York: Praeger Publishers, 1998 ]. IPG 3/99 Berger, East Asian Miracle 245

forced the rise of authoritarian developmentalism under military stewardship. U.S. aid and the security imperatives of the Cold War led to the dramatic improvement of the country’s communication and transportation networks. As U.S. involvement in Vietnam intensified, there was a major increase in U.S. spending on everything from the building and operation of U.S. military and airforce bases to the»rest and recreation« activities of U.S. personnel stationed, or on leave, in Thailand. This Cold War foundation was a critical factor in what became known as the»Thai boom«. 44 The rise of a profoundly patrimonial version of authoritarian developmentalism in Indonesia in the 1960 s also needs to be located in the wider context of the Cold War. 45 The bloody foundation of Suharto’s New Order coincided with the deepening of the U.S. presence in the region. At the outset, the official interpretation of the ousting of Sukarno and the violent transition of 1965–1966 , became a key element in the state-centred discourse on the communist threat and was instrumental in the social reorganisation of the New Order around a version of Indonesian nationalism grounded in anti-communism and a complex mix of politico-cultural ideas which emphasised the relevance of»Indonesian« traditions, in contrast to unsuitable»Western« ideas such as marxism and liberalism. This was backed up by the dramatic deepening of the role of the military in the political system, the economy and in society. Meanwhile, Suharto’s elimination of the Indonesian Communist Party( PKI ) and his regime’s anti-communist credentials ensured that the U.S. and its allies quickly embarked on the(re)incorporation of Indonesia into the world economy. This included generous quantities of aid and a considerable amount of debt re-scheduling. Under the guidance of a group of U.S. -trained technocrats – the so-called Berkeley Mafia – the New Order solicited foreign investment, particularly from the U.S. and Japan. From the mid1960 s, until at least the early 1980 s, the New Order regime pursued an import-substitution industrialisation strategy financed by growing foreign investment, as well as by foreign aid and some domestic investment. Until the mid1970 s, Suharto was indebted to the U.S. -backed international agencies particularly, and a range of foreign investors more generally, for both the alacrity with which they had moved to support his regime and the quantity of their assistance. And this meant adopting an economic stance that was receptive to foreign investors and to the U.S. vision of laissez-faire. But, the dramatic increase in oil prices in the 1970 s provided the New Order with the means to move to an even more state-centred approach to capitalist development. This trend was short-lived, however, and the decline in oil prices in the 1980 s resulted in increasing debt and a decreased capacity on the part of the state to facilitate local capital accumulation, while greater use of foreign loans and foreign aid led to greater leverage on the part of the World Bank, the IMF and foreign investors. By the second half of the 1980 s, important liberalising reforms were under way. This shift in economic policy facilitated an increase in the influx of foreign capital in the late 1980 s, much of it from Japan(as well as South Korea and Taiwan), and the rapid rise of an export-industry sector, especially on Java. 46 The Nixon Doctrine and the Breaking of the Bretton Woods Bargain The deepening of authoritarian developmentalism in Indonesia in the 1970 s coincided with an important shift in U.S. hegemony in the region. By the end of the 1960 s the looming defeat in Vietnam had brought Richard Nixon to the White House with promises that his administration would find an»honourable solution« to the war in Southeast Asia. Outlining what became known as the Nixon Doctrine, the new president emphasised that the U.S. would seek to avoid direct intervention to contain revolution and increasingly move to assist its allies with military and economic aid. The Nixon Doctrine was explicitly aimed at avoiding another Vietnam; however, it did little to 44. Stubbs,»The Political Economy of the Asia-Pacific Region« 1994 . pp. 368–369 . Robert J. Muscat, Thailand and the United States: Development, Security, and Foreign Aid[New York: Columbia University Press, 1990 ]. 45. Mark T. Berger,»Old State and New Empire in Indonesia: Debating the Rise and Decline of Suharto’s New Order« Third World Quarterly: Journal of Emerging Areas vol. 18 . no. 2 . June 1997 . 46 . Jeffrey A. Winters, Power in Motion: Capital Mobility and the Indonesian State[Ithaca: Cornell University Press, 1996 ]. pp. 47–94 . 246 Berger, East Asian Miracle IPG 3/99

alter a deeply rooted Cold War outlook(which saw the Soviet Union as the major threat). 47 The Nixon Doctrine was linked to what the Japanese called the second»Nixon Shock«. This stemmed from U.S. overtures to China,(against the backdrop of an emerging U.S. détente with the Soviet Union) which led to the historic visit to China by Nixon in 1972 and the eventual establishment of ambassadorial level relations by the end of the 1970 s. At the same time, with the rise of Deng Xiaoping in the late 1970 s China’s overall economic policy shifted in a market-oriented direction and the central planning system was gradually wound back in favour of market mechanisms. This was linked to a dramatic opening to foreign capital and technology, foreign consumer goods and external export markets. 48 With China’s(re)turn to capitalism in the late 1970 s, a victory of sorts in the Cold War had been »won« in Asia, insofar as this shift marked an implicit acknowledgment of the relative success of capitalism generally, and the post-war capitalist dynamism of Japan, South Korea and Taiwan. 49 However, the victory was ambiguous because China’s discovery of capitalism actually did little to change the United States’ long-term assessment of the Middle Kingdom as a major»threat« second only to Russia. 50 At the same time, from Washington’s perspective, Japan was also emerging as an ambiguous Cold War success story of a somewhat different kind. By the end of the 1960 s, the Japanese government was under mounting pressure from the U.S. to revalue the yen given its recordbreaking current account and balance-of-trade surpluses. The Japanese government resisted this pressure and in 1971 Nixon ended the formal and informal aspects of the Bretton Woods bargain precipitating the first»Nixon Shock«. This involved floating the U.S. dollar and suspending its convertibility to gold; at the same time Nixon introduced a new 10 percent surcharge on all imports into the United States. This brought the Japanese government to the negotiating table, and in December 1971 it signed the Smithsonian Agreement which devalued the dollar by 7.89 percent against gold while revaluing the yen by 16.88 percent against the dollar(the German mark was also revalued by 13.5 percent against the dollar). This made North American goods more competitive and increased the cost of Japanese exports to the United States. But, despite Nixon’s efforts, the Japanese trade surplus continued to rise during the 1970 s. 51 This trend was linked to the way in which Japan had begun to surpass the U.S. as Asia’s most significant source of aid and investment. By the first half of the 1970 s, four times as much foreign direct investment( FDI ) was going to South Korea from Japan as from the United States. From the mid1970 s to the mid1980 s, investment by Japanese corporations in Northeast and Southeast Asia continued to increase at a steady rate. Then, in the second half of the 1980 s, the amount of Japanese FDI spreading around the region increased even more sharply. As a result of the ratification of the Plaza Accord in September 1985 – which reversed the rising U.S. trade deficit with Japan by getting the major G5 central banks to increase the value of the Japanese yen against the U.S. dollar – the value of the yen went from 238 to the dollar in 1985 to 128 to the dollar in 1988 . This encouraged a growing number of Japanese corporations to move their operations offshore to bring down production costs. In the early 1980 s Japanese investment in the ASEAN countries was about US $ 900 million annually. Then, following a slight drop, the figure rose to US $ 4.6 billion by 1989 . Meanwhile, South Korean and Taiwan-based companies also expanded into Southeast Asia and coastal China. Hong Kong-based investors also directed increasing attention at Malaysia and Thailand, and southern China. The growing presence of Japan-based investors in Northeast and Southeast Asia in the 1980 s was facilitated by the transfer of large quantities of official Japanese development aid. In the 1970 s and 1980 s the governments of Thailand, the Philippines, Malaysia and Indonesia were given 47. Thomas G. Paterson, Meeting The Communist Threat: Truman to Reagan[New York: Oxford University Press, 1988 ]. p. 75 . 48. Richard Baum, Burying Mao: Chinese Politics in the Age of Deng Xiaoping[Princeton: Princeton University Press, 1994 ]. 49. Arif Dirlik, After the Revolution: Waking to Global Capitalism[Hanover: Wesleyan University Press, 1994 ]. p. 44. 50 . Gilbert Achcar,»The Strategic Triad: The United States, Russia, and China« New Left Review no. 228. 1998 . 51 . Brenner,»Uneven Development and the Long Downturn« New Left Review 1998 . pp. 116–124 . IPG 3/99 Berger, East Asian Miracle 247

approximately one-third of all bilateral aid distributed by the Japanese government. In the wake of the dramatic rise of Japanese investment to Southeast Asia from the mid1980 s, the total amount of Japanese aid going to the region went from a figure of US $ 914 million for 1986 to US $ 2.3 billion by 1990 . By the 1980 s an attempt to build a»regional production alliance«, which would mirror politico-economic arrangements in Japan, could be discerned. However, by the early 1990 s and beyond, this remained more a set of intentions than an accurate picture of the situation on the ground. This is not to say that the regional influence of the Japanese state and Japanese-based corporations had not increased dramatically. For example, in 1986 US $ 15.2 billion dollars worth of exports from the ASEAN countries went to Japan ( 13 percent of which were manufactured goods). By 1991 , by which time the dust had settled somewhat following the end of the Cold War, the figure was US $ 30.26 billion and 32 percent of this was manufactured goods. 52 Domesticating Developmentalism: Post-Cold War Capitalism and the Decline of Authoritarian Developmentalism U.S. Hegemony and the End of the Cold War Despite the incipient economic integration of the region centred on Japan, which was apparent by the end of the Cold War, there were important constraints on Japan’s ability to rise to a position of regional hegemony. Although trade within East Asia had risen to surpass trade between the U.S. and East Asia, the North American market remained very important to all the economies in the region. In the context of the history of the Cold War and the continued influence of the U.S. there was also an unwillingness, or an inability, on the part of the Japanese government(as well as virtually all other leaders in the region) to stand up to Washington and create an economic(and certainly not a politico-military) framework aimed at greater regional integration and autonomy vis-àvis Washington. 53 Furthermore, the end of the Cold War coincided with, and reinforced, a growing array of economic problems in Japan linked to the decrepit character of the country’s politics. Walter LaFeber has characterised the Liberal Democratic Party, which has ruled Japan since the mid1950 s(apart from a brief period in the early 1990 s), as»more a financial cesspool than a political party«. 54 In fact, concerns in Japan about the country’s position in post-Cold War Asia were often overshadowed by the relative inertia of domestic politics and the apparent waning of the Japanese»economic miracle« by the end of the 1980 s. 55 Meanwhile, in a 1991 visit to East Asia, George Bush’s Secretary of State, James Baker reaffirmed a U.S. commitment to the Asia-Pacific, emphasising the continued importance of Washington’s bilateral security arrangements which connected allies such as South Korea and Australia, to a web centered on the United States. These arrangements maintain, in a somewhat revised fashion, the basic bilateral politico-military architecture of the Cold War. However, this did not mean that the U.S. was opposed to all regional and multilateral initiatives. 56 But, the only multilateral regional organisation to emerge has been the Asia Pacific Economic Co-operation forum( APEC ) which was set up in 1989 and has faded into insignificance with the onset of the East Asian crisis. 57 Prior to the crisis many observers in East Asia articulated the view that APEC might provide the mechanism for maintaining and extending U.S. hegemony. 58 Prime Minister Mahathir Mohamed of Malaysia expressed this concern and at the 52. Shiraishi,»Japan and Southeast Asia« 1997 . pp. 187–188 . Stubbs,»The Political Economy of the AsiaPacific Region« 1994 . pp. 371–373 . 53. Shiraishi,»Japan and Southeast Asia« 1997 . p. 186 . Stubbs,»The Political Economy of the Asia-Pacific Region« 1994 . pp. 373–374 . 54. Walter LaFeber, The Clash: U.S. -Japanese Relations Throughout History[New York: W.W. Norton, 1997 ]. p. 383 . 55 . Haruhiro Fukui and Shigeko N. Fukai,»The End of the Miracle: Japanese Politics in the Post-Cold War Era« in Berger and Borer, eds., The Rise of East Asia 1997 . 56 . Susumu Yamakage,»Japan’s National Security and Asia-Pacific’s Regional Institutions in the Post-Cold War Era« in Katzenstein and Shiraishi, eds., Network Power 1997 . pp. 291–292 . 57 . Mark T. Berger,» APEC And Its Enemies: The Failure of the New Regionalism in the Asia-Pacific« Third World Quarterly: Journal of Emerging Areas vol. 20 . no. 5 . 1999 . 58. Helen E. S. Nesadurai,» APEC : A Tool For U.S . Regional Domination?« The Pacific Review vol. 9 no. 1 . 1996 . p. 52 . 248 Berger, East Asian Miracle IPG 3/99

beginning of the 1990 s he sought to counter APEC with a proposal that Japan and other East Asian countries form an East Asian Economic Bloc ( EAEB ). The following year his idea of an exclusive regional bloc, which had initially been raised with Premier Li Peng of China, was presented to a postministerial meeting of ASEAN , by which time it was being called an East-Asian Economic Group ( EAEG ). While most Southeast Asia governments were wary of Mahathir’s proposal, it did lead directly to the formation of the ASEAN Free Trade Area( AFTA ) in June 1991 . The EAEG continued as an agenda item within ASEAN , with its name being changed again in October 1991 to the less threatening East Asian Economic Caucus( EAEC ). 59 By 1994 Mahathir had reluctantly agreed to incorporate the EAEC into APEC . The»Asia-first« approach emphasised by Mahathir continues to mesh with the outlook of some influential members of the Japanese elite; however, the prevailing view in Japan as the 1990 s unfolded was that the combination of the end of the Cold War and the dynamic character of the new Asian capitalisms made it possible for Japan to be both»internationalist« and »Asianist«. In the post-Cold War era it was widely assumed amongst Japanese policy-makers that the Japanese economic presence could be extended ever more deeply into the region, without challenging either the U.S .–Japan alliance or liberal forms of economic regionalism. 60 Up to the mid1990 s this meshed nicely with the optimistic visions of the coming Pacific Century being conjured within North America. 61 For example, the semiofficial U.S. view, which was articulated in this period by C. Fred Bergsten(Director of the Institute for International Economics based in Washington, and former chairman the APEC Eminent Persons Group), presented APEC as both an important institution for regional integration and economic prosperity and a»force for worldwide liberalisation«. 62 The Coming of the Asian Crisis and the Reassertion of U.S. Hegemony These ostensibly overlapping Japanese and U.S. visions for the Asia-Pacific, which were being conjured up against the backdrop of ongoing friction over trade and other issues, now represent an exceedingly fanciful set of expectations regarding the future of the region. The Japanese elite was as unable to see the coming of the Asian crisis as the vast majority of their neo-liberal counterparts. Prior to the onset of the Asian crisis in 1997 , the Japanese approach assumed that the various forms of authoritarian developmentalism in the region were basically the same as the»politics of productivity« which the conservative political coalition in Japan had presided over since the 1950 s. However, regardless of variations from country-to-country, authoritarian developmentalism is grounded in the exclusion and coercion of the majority of the population, and this, combined with rapid and uneven capitalist development, leads almost inexorably to some form of participatory crisis. In Japan a major participatory crisis occurred and was resolved during the U.S. occupation, prior to Japan’s era of high-speed growth. South Korea, Taiwan and even Thailand may also be said to have passed through crises of participation by the mid1990 s which have involved a greater or lesser degree of political and economic liberalization. However, as the financial crisis loomed, it was not at all obvious that other authoritarian developmental regimes would do so without considerable social and economic upheaval and this would in turn undermine the economic dynamism of the region. The Japanese elite failed to anticipate the financial crisis and was unprepared for the wider crisis of authoritarian developmentalism in parts of Southeast Asia, such as Indonesia(or the much more contained version in Malaysia) which the financial crisis helped precipitate, but did not cause. Nor was the possibility of political and social crises in China, as a result of the dramatic and uneven economic development of the past twenty 59. Shigeyuki Abe,»Prospects for Asian Economic Integration« in Shoji Nishijima and Peter H. Smith, eds., Cooperation or Rivalry?: Regional Integration in the Americas and the Pacific Rim[Boulder: Westview Press, 1996 ]. pp. 244–245 . 60 . Shiraishi,»Japan and Southeast Asia« 1997 . pp. 191–192 . 61. Mark. T. Berger,»A New East-West Synthesis? APEC and Competing Narratives of Regional Integration in the Post-Cold War Asia-Pacific« Alternatives: Social Transformation and Humane Governance vol. 23 . no. 1 . 1998 . 62. C. Fred Bergsten,» APEC and the World Economy: A Force for Worldwide Liberalisation« Foreign Affairs 73. no. 3. 1994 . IPG 3/99 Berger, East Asian Miracle 249

years, given much consideration prior to 1997 . At the same time, writing before the onset of the crisis, Takashi Shiraishi argues that if, or when, these sorts of crises come it would be»better« for the Japanese government to address them»collectively with the United States as the senior partner rather than making it an ›imperial‹ issue to be resolved by Japan alone«. 63 Certainly, this is what the Japanese government has done. In fact, the U.S. has reasserted its hegemony in the region to such a degree that it is doubtful if the role of the Japanese government can even be characterised as that of junior partner. The Asian crisis has provided the opportunity for the U.S. to more effectively domesticate, if not bring an end to, state-centered developmentalism in Japan itself, as well as in most of the rest of the region, except China. 64 In the second half of 1997 , the IMF embarked on major efforts to restore financial stability to the region via loan packages to the governments of Thailand, Indonesia and South Korea. Its overall approach was premised on the view that the crisis flowed from the distortions and inefficiencies which were characteristic of state-capitalism and the IMF loans were conditional on the implementation of a range of austerity measures. 65 However, by 1998 , the IMF was increasingly being seen to have failed, and / or aggravated a worsening situation. A growing number of policy-makers and economists – including writers such as Jeffrey Sachs, who played an important role in the spread of neo-liberal ideas and policies – now argue that the crisis in East Asia was the result of a»financial panic« which fuelled a dramatic and unnecessary shift in investor confidence and market expectation which led to the rapid movement of capital out of the region and the resultant currency collapses. 66 This implicit critique of the IMF plan for the region was soon followed by more explicit critiques and by the end of 1998 political support for controls on capital flows was on the rise in East Asia and beyond. 67 Major proponents of neo-liberalism were also starting to worry about a(re)turn to protectionist trade practices. 68 The Consolidation and Crisis of Neo-Liberalism Support for protectionism amongst elites, however, even in many parts of East Asia continued to be weak, despite the rising popularity of various forms of capital controls. 69 Whatever adjustments are made, renovated versions of neo-liberalism continue to provide the dominant narratives on economic development, backed up by U.S. hegemony in the region and beyond. Of course, a range of historically specific structures and practices in the region still constrain the spread of neo-liberalism. 70 However, no significant regional initiative to deal with the Asian crisis in an alternative fashion to the neo-liberal approach prescribed and implemented by the IMF has emerged. Prior to the annual APEC meeting in late 1998 , the idea of an Asian Monetary Fund was again being discussed. 71 However, as in 1997 , when the Japanese Ministry of Finance initially floated the idea of a regional monetary fund to manage the crisis, 63. Shiraishi,»Japan and Southeast Asia« 1997 . pp. 192–194. 64 . Cumings,»The Korean Crisis and the End of ›Late Development‹ New Left Review« 1998 . pp. 71–72 . 65 . Nicola Bullard(with Walden Bello and Kamal Malhotra),»Taming the Tigers: The IMF and the Asian Crisis«in Jomo K. S., eds., Tigers in Trouble: Financial Governance, Liberalisation and Crises in East Asia [London: Zed Books, 1998 ]. 66. Jeffrey Sachs,»Global Capitalism: Making It Work« The Economist September 12 1998 . pp 19–23 . Paul Krugman,»Saving Asia: Its Time to Get Radical« Fortune September 7 1998 . pp 32–37 . 67 . Robert Wade and Frank Veneroso,»The Gathering World Slump and the Battle Over Capital Controls« New Left Review no. 231. 1998 . pp. 19–21, 30, 41–42 . 68 .»A Bad Time to be an Ostrich« The Economist December 19 1998 . pp. 15–16 . 69 .»Liberalism Lives« The Economist January 2 1999 . pp. 53–54 . 70. Donald K. Emmerson,»Americanizing Asia?« Foreign Affairs vol. 77 . no. 3 . 1998 . pp. 46–48 . Mark Beeson, »The Political Economy of East Asia at a Time of Crisis« in Richard Stubbs and Geoffrey R. D. Underhill, eds., Political Economy and the Changing Global Order[London: Oxford University Press, second edition 1999 ; first published 1994 ]. 71 . Robert Wade and Frank Veneroso,»The Resources Lie Within« The Economist November 7 1998 . pp. 19–21 . Koichi Hamada,»Keeping Alive the Asian Monetary Fund« Capital Trends vol. 3 . no. 10 . September 1998 . pp. 8–9 . Masaki Shiroyama,»With IMF Cash-Strapped, Room for Asian Monetary Fund« Capital Trends vol. 3 . no. 10 . September 1998 . p. 10 . 250 Berger, East Asian Miracle IPG 3/99

no effort to implement such a scheme has materialised. And, if it did materialise, the U.S. Treasury would undoubtedly move quickly to oppose such an effort out of concern that an Asian Monetary Fund would undermine the high degree of control the U.S. now exercises via the IMF . 72 Meanwhile, the November 1998 APEC meeting produced even less of substance than in previous years, signalling to all that events will unfold despite, rather than because of APEC . 73 Nor did an important ASEAN meeting in December 1998 result in any significant initiatives to address the crisis. 74 All this points to the conclusion that the Asian crisis is unlikely to produce a serious or region-wide challenge to neo-liberalism. This results from the fact that the main structures and discourses of the post-Cold War international political economy, which were laid down during the Cold War, continue to constrain the sovereignty of governments and political actors in Northeast and Southeast Asia. In the wake of the East Asian crisis it is now clearer than ever that the twenty first century will be the»American Century« in a range of important ways. The U.S. remains the only truly world power in military and economic terms; at the same time it exercises a broad and diffuse political and cultural influence. 75 U.S. hegemony is mediated through numerous and complex sets of power relations, economic arrangements, social structures and cultural practices. Nonetheless, Washington maintains control over the important things and continues to set the boundaries as far as acceptable and unacceptable political and economic behaviour in the international arena is concerned. While the East Asian crisis represents a moment of consolidation for neo-liberalism, it has also signaled the onset of a crisis of neo-liberalism. The processes driving post-Cold War capitalism are contributing to both integration and fragmentation, throwing up new and reconfigured fault lines against a global backdrop of politico-military rivalry, national and ethnic mobilisation and rising socio-economic inequality. A defining characteristic of the spread of neo-liberalism has been a shift in international power relations from states to increasingly mobile types of capital and this has been accompanied by rising levels of inequality and the maldistribution of wealth world-wide. 76 The rising levels of inequality and the increased concentration of wealth, which has been a major international trend for the past two decades or more, stands in sharp contrast to the claim that economic liberalism is the key to general prosperity. At the same time, the increased levels of competition brought on by the shift to neo-liberalism has not reversed the»long downturn« which began in the major capitalist economies such as the U.S . and Germany in the 1970 s. In fact, neo-liberal policies generally, and the emphasis on competition more specifically, which were a response to the»long downturn«, can actually be seen as central to the failure to reverse the»long downturn« over the past two decades. And, in the context of continued financial deregulation, trade liberalization and over-production, the»long down-turn« could accelerate as the crisis of neo-liberalism takes on an increasingly global character. 77 Conclusion: Bringing History Back In This article has emphasised the way in which the dominant neo-liberal and state-centred approaches to capitalist development have continued to offer technocratic prescriptions based on highly selective readings of the making and unmaking of the East Asian Miracle. The complex history of development, and the often authoritarian character of the capitalist success stories of East Asia have been routinely down-played or ignored by the dominant neo-liberal approach and its main challengers. By contrast, it has been argued here that in order to understand the East Asian crisis(and the East 72 . David D. Hale,»The IMF , Now More Than Ever« Foreign Affairs vol. 77 . no. 6 . November-December 1998 . pp. 12–13 . 73 .» APEC s family feud« The Economist November 21 1998 p. 41 . 74. » ASEAN Looks to the New Year« The Economist December 19 1998 . pp. 29–30 . 75. Alfredo G. A. Valladão, The Twenty-First Century Will Be American[London: Verso, 1996 ]. 76. United Nations Development Program, Human Development Report 1996 [New York: Oxford University Press, 1996 ]. United Nations Development Program, Human Development Report 1997 [New York: Oxford University Press, 1997 ]. United Nations Development Program, Human Development Report 1998 [New York: Oxford University Press, 1998 ]. 77 . Brenner,»Uneven Development and the Long Downturn« New Left Review 1998 . pp. 7 – 9 , 258–262 . IPG 3/99 Berger, East Asian Miracle 251

Asian Miracle which preceded it) it is necessary to focus on the history of the Cold War and the often authoritarian forms of developmentalism which emerged in this period. The capitalist nation-states of Asia were incorporated into the post1945 U.S. -centered world order on terms which often ensured that the holders of state power had considerable autonomy within their territorial borders, at a time when sovereignty was dramatically limited in international terms. In turn, the history of the Cold War in the region, and the hegemonic role of the U.S . has important implications for the future of East Asia. While the East Asian crisis represents a victory for neoliberalism, it is a pyrrhic victory, which has heralded the coming of a wider international economic crisis. While no grand alternative to neoliberalism is likely to emerge, the situation at this juncture is still very fluid. The rise and spread of neo-liberalism has played a role in the appearance of an array of sinister reactions, but the current crisis can also provide the context for the emergence of progressive alternatives to neo-liberalism (and to the authoritarian developmentalism and state-socialism of the Cold War era). In East Asia today, millions of ordinary people, directly affected by the crisis, are calling for thorough reform, if not a revolution, of the structures of social and political power consolidated during the Cold War. It is to be hoped that this time, history is on their side. ̇ Achtung! Hier Anzeige plazieren! 252 Berger, East Asian Miracle IPG 3/99

PIA BUNGARTEN The Crisis of Thailand and the International Monetary Fund N ot so long ago, I heard a provincial governor in Thailand say that»the current crisis is twice as bad as the burning of Ayudhaya«. The sacking of the old capital city Ayudhaya by the Burmese army in 1767 , which marked the end of the so-called Ayudhaya period in Thai history( 1350–1767 ) has traditionally been regarded as the country’s worst national disaster. But to many Thais, the current economic crisis rivals and even surpasses this traumatic event. Few people blame outsiders for the outbreak of the crisis; most see it as homegrown. But many are united in regarding the IMF policies as having made a bad situation worse, and having caused a serious financial crisis, triggered by a currency devaluation, to deteriorate into an economic and social disaster. The IMF’s Success in Thailand The original approach of the IMF and the Thai government to the crisis in Thailand placed top priority on regaining stability in order to regain the confidence of investors, as recovery was thought to be unthinkable without continued foreign investment. For this purpose, a stablized exchange rate was considered essential which in turn required high interest rates. These policies were expected to halt and reverse capital flight. To promote stability, a strict financial and monetary policy was seen as essential, i.e. reducing government spending, maintaining a budget surplus, and increasing taxes. In a way, the policy has been successful: it has achieved its original objectives. The exchange rate has stablized which eventually helped reduce the high interest rates to pre-crisis levels(below 10 %) without undermining the stability of the baht or raising inflation. 1 Foreign reserves steadily improved. By April 1999 , the net international reserves were estimated to be$ 22.3 billion, thus almost equal to the amount of short term debt. 2 Thailand has pressed ahead with major reforms, particularly in the financial sector. Sixty-eight financial institutions were closed. New regulations were introduced on capital adequacy ratios and loans. The parliament passed key legal reforms, including legislation on bankruptcy and foreclosure, which is expected to speed up corporate restructuring. In September 1998 , the cabinet approved a Master Plan for State Enterprises that outlined a strategy and timetable for privatization in infrastructure and other key areas, including water and energy. Parliament has approved the Corporatization Law, which prepares enterprises for privatization by converting them into corporations. Final adoption, however, has been held up by an appeal. There are some first indications that the crisis might have bottomed out:( 1 ) the manufacturing sector is expanding for the first time since July 1997 (by 0.2 % in January 1999 and 3 % in February 1999 );( 2 ) most indicators of investment(such as imports of capital goods) seem to have stabilized, albeit at a low level, and( 3 ) the situation in the region as a whole looks less threatening than in 1998 . Foreign direct investment( FDI ) has continued to grow. Preliminary data(final figures on 1998 are not yet available) suggests that FDI rose to a record high of US $ 7.0 billion, continuing a trend visible since the devaluation of July 1997 . 3 Overall, international investors’ confidence in the region seems to have improved. The SET 1 . The exchange rate fell from 25 Bt / US $ in July 1997 to 56 Bt / US $ in January 1998 . It then stablized first at a rate of 40–41 Bt / US $, gradually gaining in strength throughout 1998 to reach an average of 34–35 Bt / US $ at the end of 1998 . Inflation was 2.6 % for the first quarter of 1999 and is expected to be 2.5 % for the whole year. 2 . The World Bank Thailand Economic Monitor, April 1999 , p. 9 ; http: // www.worldbank.or.th / monitor. 3 . The World Bank Thailand Economic Monitor, April 1999 , p. 8. IPG 3/99 Bungarten, Crisis of Thailand 253

(Stock Exchange of Thailand) composite index has risen considerably. In late April 1999 , the international rating agency Moody’ Investors Service upgraded its rating outlook to»stable« from »negative« for five Thai banks due to progress in bank recapitalization and declining risks in the financial sector, which gave a further boost to the stock exchange(by early May 1999 , the SET index had climbed to over 500 points). Moody also upgraded its rating outlook for Thailand from »stable« to»positive« due to the»improved external liquidity position that has greatly reduced nearterm vulnerability to sudden shifts in investors’ confidence«. 4 So is Thailand a success story for the IMF ? Other than the IMF itself, and its closest allies in the Finance Ministry and Bank of Thailand, nobody sees it that way. The»Side Effects» of the IMF Policies The IMF regarded the burden of higher interest rates as temporary, and as preferable to further depreciation of the baht, which would have undeniably raised the burden of dollar-denominated debts. But the negative side effects of this policy have been significant and by no means temporary, causing the economy to contract much more than anticipated. Thailand gets solid marks from the IMF , but both in the financial sector and in the »real economy«, most observers agree that it is too early to declare victory. 5 The Thai banking system remains»extremely weak and substantially undercapitalized«. 6 With many firms working at hardly more than 50 % of capacity, they are unable to service their debts. According to the Bank of Thailand, non-performing loans account for 49.7 % of total loans(as of January 1999 ). 7 Escalating loan losses erode the banks’ capital and earnings; loan-loss provisions remain insufficient to cover losses. The largest banks have made progress toward recapitalization, but medium-sized and small banks are well behind. To support recapitalization, the Thai government introduced a package on 14 August 1998 , offering to inject Bt. 300 billion into the banking sector, but demanding leverage to spur reform in return. Banks must accept writedowns by setting aside provisions for ailing loans before seeking capital from the government. The program was not compulsory, however, and many of the familyowned banks have resisted it for fear of loss of control and ownership. As a result of persistent problems, new lending remains scarce, which in turn hampers the prospects for recovery in the»real economy«. Firms across the manufacturing sector are operating at little more than 50 % capacity, with labour-intensive products faring worse than high-tech products. Production has remained at this low level since January 1998 . Without increasing output, a further increase in bankruptcies and resulting layoffs is likely. 8 Domestic demand has declined steeply without showing signs of improvement. Consumers remain reluctant to spend. The hope of being able to»export our way out of the crisis« has not materialized. Export volume growth has been stagnant since early 1998 , and export prices have been contracting on a year-onyear basis. 9 Most Thai exports go to the likewise crisis-ridden ASEAN countries. While there have been no dramatic new shocks, neither has the situation in the region improved significantly, and demand is expected to be weaker rather than stronger. Thailand is particularly hard-hit by the persisting crisis in Japan, as Japan took 25 % of Thailand’s exports. The size of the slump in demand and production and the absense of growth in exports all pose grave threats to long-term recovery, leading to charges that the IMF ’s medicine was worse than the disease. Many Thai observers see the improving macroeconomic indicators as possibly supportive of, but not as signs of, a real recovery. In fact, the indicators often reflect the persisting crisis:( 1 ) The 4 . Bangkok Post,»Moody’s revises rating outlook to positive«, 4 May 1999 . 5 . See International Herald Tribune,»Image vs. Substance in Asia’s recovery, 14 April 1999 . 6. Moody, as quoted by the Bangkok Post,» SET soars 6,2 % after upgrade for five banks«, 1 May 1999 . 7 . The World Bank Thailand Economic Monitor, April 1999 , p. 20 . 8 . The World Bank Thailand Economic Monitor, April 1999 , p. 1 , 6 . 9. The World Bank Thailand Economic Monitor, April 1999 , p. 6–7 . In addition to the high cost of credit during much of 1998 , exporters faced long-standing problems such as high import duties on certain raw materials and a slow return of VAT on exports. 254 Bungarten, Crisis of Thailand IPG 3/99

strengthened currency – the cornerstone and pride of the IMF policy and its allies in the Ministry of Finance and the Bank of Thailand – has been regarded by many policy makers(including the Minister of Commerce and the World Bank) as problematic. They argue for a weaker baht to boost exports.( 2 ) The current account has moved from a deficit to a surplus, but critics point out that this has come about as a result of a dramatic collapse of demand and imports, not as a result of a resurgence of exports.( 3 ) Interest rates have declined only nominally. Falls in interest rates have not matched the slowdown in prices, thus causing the real interest rate to rise. 10 ( 4 ) The upswing in foreign direct investment reflects mergers and acquisitions, rather than new productive investment. 11 The number of such deals has increased as foreign investors obtain Thai assets at bargainbasement prices. As a result, most observers do not agree with the IMF ’s optimistic prediction of a 1 % growth rate for Thailand in 1999 . They rather expect the crisis in emerging markets, including Thailand, to persist. The Social Costs The crisis has imposed high social costs. Unemployment has increased sharply and continues to rise. Neither employers nor workers are required to register lay-offs, so the true extent of unemployment can still only be estimated. The figures vary depending on the source. The World Bank and the Asian Development Bank( ADB ) assume an unemployment rate of about 5.3 %(at the end of 1998 ). Many of those who still have jobs are underemployed, as employers have cut working hours. The ADB has estimated that the number of underemployed has risen from 5.3 Million in 1997 by 2.1 Million. The social safety net is in no way prepared to help under the current circumstances. It provides support in the case of illness, child birth, disability, and death, but covers only those who paid into it(i.e. workers in the formal sector) and provides no benefits for the unemployed. Unemployment insurance is part of the 1990 Social Security Law, but no enabling law was ever passed. An older law requires severance payments for laid-off employees, but many companies simply ignore this. The labour courts are clogged with lawsuits demanding that the compensation be paid. Women are particularly hard-hit by layoffs. The 1998 Labour Department Statistics revealed that 57 % of the laid-off workers were women, but the real figures are likely to be higher. 12 According to a study by the Friends of Women Foundation of women workers in two industrial zones north of Bangkok, 70 % of the laid-off workers in the Omnoi-Omyai Industrial Zone are women; in the Rangsit Zone, 90 % of those laid-off are women. In the absence of any kind of safety net, about half of the laid-off women try to cope with the crisis by accepting jobs below the minimum wage rate, often under hazardous working conditions. 10–15 % become self-employed, trying to make ends meet for example as vendors and garbage collectors. Another 5–10 % become home-workers, often with very meagre pay. Only a handful succeed in going back to farming – contrary to the oft-repeated assumption that laid-off workers are re-absorbed by the agricultural sector. 13 The return migration to the countryside seems to be a convenient myth, not supported by evidence. In 1998 , a survey of the International Fund for Agricultural Development(Ifad) in villages in the poor Northeast of Thailand showed that most migrants are not returning, because»they do not want to create difficulties for their relatives.« Older people are somewhat more likely to go back to their villages(as their age makes it even more difficult to find another job), and unemployed parents also at times send back young children to be cared for by relatives. But younger adults at most return temporarily. Many no longer have farming skills 10 . They range from 8 %– 18.5 %, acccording to the World Bank’s Thailand Economic Monitor, April 1999 . 11 . William Shaw, principal author of the Global Development Finance Report of the World, as quoted in The Nation,»World Bank sees long wait for recovery«, 14 April 1999 . 12. The official statistics only cover those who petition the Labour Department for assistance. They are the wellinformed and well-organized, and many women workers are neither. 13. Study by the Labour Division of the Friends of Women Foundation, as reported by the Bangkok Post, »A life of hard labour«, 15 April 1999 . IPG 3/99 Bungarten, Crisis of Thailand 255

and jobs in the rural areas are scarce, so many return to Bangkok. 14 The family safety net is being overwhelmed. Many government officials still assume that any kind of public social safety net is to be avoided, as it undermines the traditional system of family self-help. But in a rising number of cases, the magnitude of the current problem is beyond the ability of families to cope and actually tears them apart, as shown by the increasing rates of divorce and abandoned children. Nothing reveals the social crisis more clearly than the problems of children. State-run hospitals and welfare homes report a 9.7 % increase in the number of abandoned children under the age of five, and a 34 % increase in abandonment of children between the ages of six and eighteen. Malnutrition among children, which had decreased from 19.6 % to 7.9 % between 1990 and 1996 , is up again and affects no less than 25.5 % of all children in the poor Northeast of Thailand, and 8.4 % of the children in Bangkok. The National Economic and Social Development Board( NESDB ) reported falling levels of education as parents take their children out of school because they can no longer afford the fees and other costs. 126,000 children left school in the middle of the school year, another 276,000 did not return after holidays. 7.2 % of the children have shifted to schools with lower fees. 15 Poverty is rising rapidly. An NESDB survey concluded that average income has dropped by 25 % while prices have risen by 40 %. 16 According to the Socioeconomic Survey( SES ) in 1998 , the proportion of the poor rose to 13 % and 12.4 % in the first and second quarter of 1998 ( 7.6 to 7.9 million people), compared to 11.3 % in 1996 . 17 Many observers assume that the number of people below the poverty line is much higher than the official government figures, if one considers for example the high number of farmers who are unable to pay their debts. There are increasing signs of social stress. Drugs top the list of problems, with slum children as main buyers. Theft has soared: slum dwellers break into each others’ hovels and carry away what has resale value. Prostitution is up, often done on a part-time basis by women desperate for income. The Critique of the IMF in Thailand During the first half of 1998 , more and more people in Thailand – social critics, NGO representatives, trade unionists, academics, but also business people – concluded that Thailand was getting no rewards for»being the pet of the IMF master«. People lost confidence in the IMF , which came to be seen more as a predator than as a helper, unable to understand the implications of its own policies. Criticism soon extended not only to the policy in Thailand, but to the entire development model. The IMF is perceived as highly secretive and arrogant. All»Letters of Intent«(the policy agreements negotiated between the IMF and the Thai government) were secret until they were finalized. Nobody outside exclusive government circles was ever informed, let alone consulted. The Fund generally does not seem to regard it as necessary to engage in dialogue and to explain the rationale behind policies. At best, dialogue occurs with a small elite of government representatives and academics. Furthermore, the Fund has at no point admitted that its own policies might have been wrong or caused serious»side effects«. On the contrary, the Fund appears rather self-congratulatory, which observers attribute to the fact that the Asian crisis has not badly affected Western economies. In response to the persistent criticism, the IMF has stated that the policy of high interest rates was necessary and successful in preventing an even worse fall of currency value, thereby ignoring 14. Numerous problems in the rural areas make an large-scale absorption of returnees difficult and unlikely: ( 1 ) The rural economy is badly affected by the bust, as various local enterprises(often set up with the savings of returned migrants) are now collapsing from lack of demand. The village economy is being shrunk back to its agricultural core.( 2 ) The problems of the farming communities are myriad: lack of secure land tenure, high indebtedness, degradation of soil, low productivity, high production costs, and loss of land due to speculative sales. 15. The figures are drawn from studies by the Health Intelligence Unit(on abandonment) and by the Public Health Ministry and the Health Systems Research Institute(on malnutrition), as reported by the Bangkok Post, »Children worst hit by the slump«, 16 April 1999 . 16. Bangkok Post,»Survey: Poor hit hard by crisis«, 22 March 1999 . 17. The World Bank Thailand Economic Monitor, April 1999 , p. 14 . 256 Bungarten, Crisis of Thailand IPG 3/99

other criticism that focuses on the wisdom of prescribing a tight fiscal policy of a surplus budget and a financial restructuring in the midst of a crisis. 18 Thai and many international critics believe that the Fund did indeed adopt the wrong policy in Thailand. The country’s problems stemmed from heavy private sector borrowing, not from public sector spending. Under these conditions, the IMF policy mix of high interest rates and a tight fiscal policy caused huge problems in their own right: ( 1 ) Investors interpreted them as a sign of great dangers ahead, making them more reluctant to invest. The Harvard economist Jeffrey Sachs accused the IMF of worsening rather than solving problems:»In normal times, high interest rates can pull in capital, but in abnormal times, they can provoke a deepening panic«. 19 ( 2 ) The high interest rates in combination with Fund-mandated austerity measures and the IMF ’s insistance on strict capital adequacy ratios pushed indebted companies much more quickly from illiquidity to insolvency, hitting small businesses particularly hard. This caused rapidly rising unemployment and increasing poverty.( 3 ) The collapsing production and demand became a serious threat in its own right, hardly any less dangerous than the previous currency devaluation. As a result of the IMF ’s many miscalculations, people have lost confidence in the Fund. Too often, basic assumptions of the IMF policy makers proved wrong as the economy deteriorated much faster than expected. The IMF is accused of having grossly underestimated the extent of the economic contraction and has had to revise forecasts several times(from an expected positive growth rate of 2.5 % in August 1997 , to 0.6 % in December 1997 , to 3.5 % in February 1996 , to 7 to 8 % in May of 1998 ). Letters of Intent became outdated shortly after being formulated. 20 Many Thais are still at ease with the IMF -mandated financial sector reforms. They do not deny problems(for example the fact that under the current legal structure, there is little social stigma and legal risk if a debtor defaults). But they resent the insistance on»crony capitalism« as the root cause of the crisis and point to the problems caused by the sudden flows of short-term capital. The IMF has long lobbied for lifting all capital controls. The Fund now seems to think that the worst of the crisis is over, and that there is no need for any major change in the international financial system, including the free movement of capital. Many Thai observers, however, rather support the idea that countries must build the right infrastructure before they ease capital controls. Critics conclude that the legal reforms and financial restructuring are leading toward the attempt to replace Asian capitalism(with its preference for bank loans rather than share capital, and its preference for family and personal connections rather than strict legal relations) with the Anglo-American variant. 21 Another bone of contention in the IMF policy basket is the push for privatization. Critics describe it as a fire sale that passes on the burden of the economic crisis to the poor. While the gains of the boom era disproportionally benefitted the business elite, the costs of the bust are now socialized – and this in a country where the gap between rich and poor did not narrow, but widened during the boom times. State enterprises are up for sale at what is perceived to be a low price, causing more suffering. Past experience leads people to believe that:( 1 ) A private monopoly will replace the public one, with no gains in efficiency of services.( 2 ) The prices of services will go up, which will further affect the poor.( 3 ) Some people will lose their jobs in the midst of a crisis; all will lose their job security. Privatization is being pushed on Thailand at a point when the country has little bargaining power. Not only workers, but also business people see it as a form of selling off the country when the country is broke. Some critics concede that privatization might bring some gains to consumers, and that it might not be bad in principle, but they argue that transparency is a prerequisite and transparency requires a strong civil society. For now, privatization is 18. The Nation, Chang Noi:»This is not the time for IMF complacency«, 28 April 1999 . 19. The Nation,»No solution for panic selling«, 25 March 1999 . 20. The Fund says that it did not have full access to the requisite information. But the problem of inadequate data in Thailand is well known and should have made the Fund extremely cautious. The IMF also argues that its policy would have been perfect but was undermined by the unexpected contagion around the region. But countries in the region tried to help Thailand because they were well aware of the possibility of a contagion. 21. The Nation, Chang Noi:»This is not the time for IMF complacency«, 28 April 1999 . IPG 3/99 Bungarten, Crisis of Thailand 257

only expected to extend the reach of»crony capitalism«, as fair competition is not yet very likely under the prevailing conditions. The regulatory mechanisms in the state and in the civil society are not yet strong enough. 22 In short, the IMF is seen as being far more interested in»serving others, not the Thais« and in safeguarding the interests of foreign creditors, rather than avoiding collapse in Asia. Anti-Western sentiment – though not strong – is being expressed. The Thai businessman Amarin Khoman, chairman of the Thai Star Group of Companies, for example, accused the IMF of being»a tool of the superpowers which take advantage of countries in trouble«. The author advocated self-reliance as in Malaysia, and warned that countries that have followed the IMF found that»after gaining economic recovery...their banks, their businesses were in the hands of rich people from North America, Europe, and Asia. The local people remain poor, or are even poorer«. 23 Policy Changes The deepening economic and social crisis has led to two responses of policy makers and development experts in Thailand:(a) attempts to reverse the original, IMF -mandated government policy, and(b) increased discussions of alternative development models. By the middle of 1998 , the Thai government had come under mounting pressure from a deepening recession and vocal critics. Not only the »usual suspects« in the academic community, NGO s, trade unions, and farmers’ associations, but also economists and business people urged the government to part company with the IMF ’s original prescriptions and to try to revive domestic demand. Business representatives charged that the IMF ignored the»real economy« and that the persistent lack of liquidity condemned them to death. Activists complained that the policies favoured the rich at the expense of the poor and threatened to demonstrate. The government re-negotiated with the IMF and changed course quietly but dramatically with the 4 th and 5 th Letter of Intent to»minimize any further decline in the economy and bring about an early recovery«. 24 Deflationary austerity was replaced by a more expansionary fiscal policy designed to compensate for the fall in demand. The public sector could now run a deficit, allowing the Thai government to inject billions of baht into the system to directly address social problems. The first Letters of Intent had talked about installing social safety nets, but had made no concrete proposals. The 4 th and 5 th Letters of Intent laid out more concrete plans, including programs for employment creation. Liquidity was improved with a number of measures such as increasing the money base, selling assets of the closed financial institutions and offering new bonds on the international market. Interest rates were brought down from 20 % at the beginning of 1998 to 9.8 % in the first quarter of 1999 . All of these measures contradicted what was regarded as IMF orthodoxy. On 30 March 1999 , the Thai Finance Minister Tarrin Nimmanhaeminda announced an additional stimulus package of Bt. 130 billion(to be financed by Japanese and World Bank loans) to increase domestic demand and lower production and export costs. This so-called»Tarrin fund« combined the planned(but not yet spent) Bt. 53 billion additional expenditure from the 6 th Letter of Intent with new tax cuts(such as a reduction in the VAT from 10 % to 7 %) and measures to lower energy prices. The majority of the new expenditures were to be used to create new jobs, for example through improvements of infrastructure, waste disposal and water supplies. Furthermore, money was to be spent directly on localities, e.g. to subsidize school lunches and to extend a scheme that helps elderly people through small monthly payments. ...with Few Effects So far, the policy shift has brought little if any beneficial effect for those most adversely affected 22. State enterprise workers demand(a) that the state should hold 70 % of the shares of each privatized firm,(b) that income from the state enterprise stock sale should not be used to pay the debts of the Financial Institutions Development Board and(c) that a public referendum should be used to solve the persisting deadlock in negotiations. 23. The Nation, 11 October 1998 . 24. The Nation, Chang Noi:»Thailand’s quiet revolution against the IMF «, 25 November 1999 . 258 Bungarten, Crisis of Thailand IPG 3/99

by the crisis. The government has announced numerous schemes designed to help people, but has been slow and inefficient in implementing them. Almost two years into the crisis, the people mostly are left to fend for themselves. The Thai government seems to be inexperienced when it comes to implementing a Keynesian strategy with a stimulus package. As one observer noted,»the scheme cuts across ingrained bureaucratic attitudes about conserving money and not wasting it on the poor. It must negotiate its way through a minefield of bureaucratic corruption and contractor gangs«. 25 One problem is the extremely slow disbursement of funds. Examples abound: The government has allocated US $ 29.5 million to training schemes, in hopes of bringing no less than 1.53 million people into the workforce. However, the Ministry of Labour has not yet received any money from the Finance Ministry. 26 Wherever one looks, disbursement seems to be moving at a snail’s pace. Contractors complain that as much as Bt. 160 billion earmarked for investment projects in the 1999 budget(which ends on 30 September) have not yet been spent. The slow disbursement is blamed on inefficiency and inertia, but also on fearful inaction in the face of rapid change. Bureaucrats are used to follow regulations step by step and adapt badly to new requirements. The Land Department, for example, was reluctant to comply with new rules that allow a waiver of property tax transfer to facilitate debt restructuring. The matter had to be brought back to the cabinet several times for confirmation before the Land Department officials felt it was safe to implement the new policy. 27 Funds are also held back by government officials’ demands for kickbacks. A contractor who wants money often has to»hold special discussions with the official«. 28 A number of government unemployment projects have flopped due to poor publicity and slow implementation. The already cited study by the Friends of Women Foundation found that two thirds of the workers do not know about any government measures designed to help laid-off workers. Those who do turn to the government for help are often frustrated by red tape. To be eligible for government loans, for example, a woman needs a government official to act as a guarantor, a frequently forbidding requirement. 29 In light of these experiences, many observers are sceptical about the chances for success of the »Tarrin Fund«. Critics point out that expenditure allocations across ministries have been made without any public or parliamentary discussion and wonder out loud if goals of transparency and efficiency can be met. 30 The Minister of Finance himself seems to have no faith in the implementation capacity and honesty of the usual government spending channels and plans to pass the funds directly to the local units of ministries(such as public health and public welfare departments). To prevent the ever present»leakages«, he wants to set up a special task force of»good men« to oversee the scheme. In short, its chances of success are doubtful. Critics charge that the principal motivation behind the stimulus package is the government’s desire for political survival, which means winning an election some time next year. The government has come under fire for lack of concern with and effective support for the poor. The stimulus package will do little to solve the fundamental problems of the rural communities. But as one observer concluded, in a drought, even a shower is welcome. 31 The Role of the World Bank The World Bank’s main response to the crisis has been the so-called Social Investment Project. A »Social Investment Facility«( SIF ) was set up to make Bt. 21.6 billion available. The main goal was 25. The Nation, Chang Noi:»A bit late, but Tarrin’s fund is worth the risk«, 1 March 1999 . 26 . Bangkok Post,»Critics target Tarrin as revival loses steam«, 4 March 1999 . 27. The Nation,»Red tape ties up contractors’ cash«, 6 April 1999 . 28. Numerous big corruption scandals were exposed in the course of 1998 , among others in the Public Health ministry(fixing procurement prices at above market level), in the Agriculture Ministry(buying overpriced seeds), in the school and university system(where reports and grades involve paying teachers with goods and money), and in the Police(extortion by high way policemen with false emission readings). 29 . Bangkok Post,»A life of hard labour«, 15 April 1999 . 30. The Nation,»New IMF targets impossible to achieve«, 6 April 1999 . 31 . The Nation, Chang Noi:»A bit late, but Tarrin’s fund is worth the risk«, 1 March 1999 . IPG 3/99 Bungarten, Crisis of Thailand 259

to provide funding for labour intensive projects and training, creating jobs for 1.7 million people and training for 920,000 . 32 For the implementation of the program, the World Bank primarily relies on government agencies, even though in its analysis of the country situation, the World Bank had doubted the capacity of the state agencies to implement the programs. Not surprisingly, the World Bank programs have run into»implementation constraints« – they are plagued by the same set of problems that have beset the government programs. The Government Savings Bank, for example, which is charged with disbursing funds to community based organizations, is accused by observers of»gumming up the social safety net schemes of the World Bank«. 33 Only about 10 % of the funds set aside have been spent. Furthermore, there is by now a rather bewildering array of funds, schemes, and programmes, financed by the World Bank and other international institutions and set up to aid various forms of industrial and agricultural restructuring. They all seem to have in common that few projects have been approved, let alone been started. Despite this criticism, the World Bank has been perceived in a more positive light than the IMF . It has decentralized, giving the Bangkok office more say in policy making for Thailand. The representatives are willing to expose their analyses and themselves to debate by participating in seminars and by inviting others, for example the representatives of local NGO s, to comment on their country analysis. But participants in this process express doubts how committed the World Bank really is, and what its real intentions are. While the World Bank office seems to take a greater interest in solving social problems and occasionally consults those who are immediately affected, the real meaning and impact of such»consultations« are unclear. The consultations can also hardly make up for the general lack of participation of poor people in designing policies that immediately affect them. Development in Thailand – Lack of Capital or Lack of Democracy? The magnitude of the Thai crisis has triggered many discussions of Thailand’s development model. Three points of view dominate the debate: ( 1 ) The»globalizers« essentially hang on to the export-oriented model that has guided Thailand’s policy making since the mid1980 s. They see foreign capital, foreign markets and liberalization as key to development. Thus they push for reform of the financial sector along the lines of more transparency and tougher laws and regulations to assure greater influx of foreign capital, and they oppose capital controls. In their opinion, the crisis forces Thailand to integrate more closely with the outside world, as barriers of various kinds are dismantled. They argue that Thailand has always benefitted from being open to the world, and that it now must reform its businesses and social institutions(including the bureaucracy) to survive and do well in the future. These more neo-liberal globalizers have fierce debates with those of a more Keynesian persuasion who have long argued for deficit spending, and who favor a weaker currency and the nationalization of non-performing loans. Both types assume that Thailand does not have the option to opt out of globalization, and that further modernization in all areas of society – from education to the public sector and agriculture – is both necessary and desirable. ( 2 ) The»localists« point to the negative results of Thailand’s rapid modernization under the export-oriented policy. The quickly growing economy caused widespread environmental degradation(witness the disappearance of the Thai rain forest). The gaps between rich and poor and between the city and the village deepened. Money overwhelmed politics and corrupted most involved with it. Agriculture was neglected and the educational system could not keep up. For the critics, this crisis showed not that Thailand cannot adapt to the standards of a modern society as defined by the West, but that this whole process is of dubious value for Thailand. The collapse of the economy demonstrates that 32 . Most of the money is made available to government agencies(e.g. the Tourism Authority of Thailand for Construction and Renovation). A smaller part is used as »Social Investment Loan« of the World Bank(Bt. 4.8 billion), and is accessible to NGO s. Bt. 1.2 billion is to be used for investment projects in cities and villages. The Thai government, the World Bank, ADB , UNDP , and the Overseas Economic and Cooperation Fund all participate in funding the program. 33. The Nation, Chang Noi:»A bit late, but Tarrin’s fund is worth the risk«, 1 March 1999 260 Bungarten, Crisis of Thailand IPG 3/99

the top priority of the past decade has been the »development of wealth«, not the»development of the society«. The crisis has been seen as a chance to redefine the priorities. A new balance has to be found between the power of the market and the traditional strengths of Thai society. The crisis can be confronted successfully by invoking Buddhist values such as self-examination and moderation and by learning again to rely on local knowledge. The new society has to build from the community level upward, rather than from the world downward. The concept of self-sufficiency, at the heart of Buddhist economic thought, must replace capitalist production and consumption, which is marred by its disregard for the social, environmental and cultural consequences. 34 There has been a surge in local barter networks, small-scale integrated farms, and microcredit schemes. Proponents have gathered locally and nationally to exchange ideas and experiences. While the»localist movement« might have some (though limited) impact on development thinking in the long run, it is unlikely to change the direction of national policy in the short run, as it is scattered and fragmented, up against a government firmly committed to a different concept, and devoid of a strategy for managing the economy above the community level. 35 ( 3 ) The concept of»limited de-globalization«, as proposed by Walden Bello, the head of the Center for the Global South at Chulalongkorn University in Bangkok and one of the most outspoken critics of the IMF in Asia, offers such a strategy. Bello shares much of the localists’ critique, such as the charge that the years of high growth in Thailand have left behind little of lasting value but have cost the country dearly(e.g. in form of a dangerously depleted»natural capital«). He argues that the financial flows benefit only a small elite. Nonetheless, the crisis is being used to more thoroughly integrate the financial sectors of developing countries into the global, Westerndominated financial system. Walden Bello advocates:(a) Growth must be financed primarily from domestic savings and investment, which requires a progressive taxation system.(b) While export markets are important, they are in his opinion too volatile to serve as reliable engines of growth. Bello proposes that development be re-oriented around the domestic market as principal engine of growth. This links growth and equity – enlarging the domestic market to stimulate growth means bringing more consumers into the market via asset and income redistribution, including land reform.(c) Bello advocates devising a set of effective capital and trade controls as well as regional cooperative arrangements that allow for a re-orientation of the economy toward a more inner-directed pattern of growth. The experiences of India, China, Chile, and Malaysia are cited as examples of capital control policies worth studying. 36 Bello does not analyze how this concentration on domestic production and consumption would differ from and avoid the problems of the longvilified»import substitution« strategy. The idea of capital controls, however, may be gaining support even among people who once were firmly in the » IMF camp«. During the first year of the crisis, many clung to the orthodoxy of the free market and trusted in the ability of the IMF . But now, more and more mainstream economists in Thailand are dismayed about the IMF ’s self-congratulation in the face of persisting problems. They resent the attempts to reform along Western lines a system that served the country well for decades and they fear that none of the steps taken so far is likely to prevent the re-occurrence of a similar crisis. Even Amma Siamwalla, one of Thailand’s most eminent economists, who long argued for liberalization, now favors»some degree of capital controls« and the Chilean model of discouraging short-term inflows by taxing funds that exit too fast. 37 But perhaps the key challenge of the future is not so much the lack or regulation of capital, but the lack of democracy, i.e. the public’s non-participation in social and economic policy-making. In September of 1997 , the Thai parliament passed a new constitution that aims at guaranteeing human rights, the rule of law, and political participation. Thus the preconditions for a more de34. The Nation, Chang Noi:»Don’t expect a widespread revolution«, 30 December 1998 . 35. The Nation, Chang Noi:»Don’t expect a widespread revolution«, 30 December 1998 . 36. The Nation, Walden Bello:»Don’t let global elites devise the financial architecture«, 23 March 1999 . 37 . The Nation, Chang Noi:»This is not the time for IMF complacency«, 28 April 1999 . IPG 3/99 Bungarten, Crisis of Thailand 261

mocratic decision-making process in Thailand are good. However, the poor continue to be marginalized not just economically, but politically. To date, no effective representation of their interest has emerged, no political party has consistently championed their needs. Politicians and civil servants feel little need to pay any real attention to the poor, as they occupy a low position in Thailand’s highly hierarchical society, and their organizations(trade unions and farmers’ associations) are fragmented and weak. Thus the indifference of politicians and bureaucrats, their failure to develop a clear and comprehensive social policy and their tendency to concentrate their best efforts on the financial sector reform are hardly surprising. At present, the welfare debate in Thailand is conducted not in parliament, but on the streets, as pressure groups try to communicate demands, for example for an unemployment insurance or land reform. So far they have not been very successful. 38 At a conference in Seoul, South Korea, in March 1999 , Amartya Sen, winner of the 1998 Nobel Prize in economics, put the lack of democracy in the center of a debate on the economic crisis in Asia:»The recent problems of East and Southeast Asia bring out, among other things, the penalty of undemocratic governance.« He insisted that the development of the financial crisis in some of these economies has been closely linked with the lack of transparency in business, and in particular with the lack of public participation in reviewing financial and business arrangements. »The absence of a democratic forum has been consequential in this failing. The opportunity that would have been provided by a democratic process to challenge the hold of selected families or groups could have made a big difference...The newly dispossessed did not have the hearing they needed. A fall in gross national product of say even 10 % may not look like much if it follows the experience of past economic growth of 5–10 % every year for some decades, and yet that decline can decimate lives and create misery for millions if the burden of contraction is not shared together but allowed to be heaped on those who can least bear it, the unemployed or those newly made economically redundant«. 39 A sustainable solution can be worked out only once Thailand’s gains in political democratization are translated into the participation of people also in economic and social decision-making. ̇ 38. Thailand’s largest labour congress, the Labour Congress of Thailand( LCT ), proposed in a letter to Prime Minister Chuan Leekpai, that the government »urgently consider organizing a special fund to assist the lives of the unemployed and to prevent further social unrest that might appear in the future«. The LCT proposed a mixture of cash hand-outs, low-cost loans, housing, and transport subsidies, and free health care to be funded by multilateral aid. But the government response has been anything but interested. Political parties rely more on rural votes. None have championed the urban poor. 39 . Amartya Sen, as quoted in The Nation,»The poor don’t get a hearing«, 17 March 1999 . 262 Bungarten, Crisis of Thailand IPG 3/99

NIKOLAS BUSSE / HANNS W. MAULL Enhancing Security in the Asia-Pacific European Lessons for the ASEAN Regional Forum* BEITRÄGE/ARTICLES W hile security and stability in the Asia-Pacific are commonly seen as being ensured through US military supremacy and a US -led system of alliances, more and more observers also recognise the value of multilateral security co-operation as support, as a complement and eventually perhaps even as an alternative to the present security order. In this context, the ASEAN Regional Forum( ARF ) generally is considered the most important multilateral regional security institution in the Asia-Pacific. The short history of the ARF is, to some extent, a history of rejecting European role models. From the very beginning, policy makers and academics in the Pacific Asia region have fiercely resisted any attempts at developing the ARF along the lines of OSCE , EU or NATO . Two arguments were usually put forward to justify this position. First and most importantly, many Asians felt that the security environment of their region was quite different from the European one. Thus, it was argued that many countries in the Asia-Pacific were preoccupied with problems of internal stability and economic development because the volatile process of nation-building had not yet been completed, while European states by and large had developed into strong, well-consolidated nationstates(Ayoob, 1995 ). While Europe is predominantly land-oriented, the Asia-Pacific is a maritime region, and while the European security system had been strongly bipolar during the time of the Cold War, geo-strategic patterns in the Asia-Pacific were more complex, with an overlaying strategic triangle formed by the US , the Soviet Union and China, but stronger local and subregional influences than in Europe. The AsiaPacific is also widely perceived as being qualitatively more heterogeneous, more diverse and more difficult to organise than Europe. Lastly, it was pointed out that Europe benefitted from a dense network of regional institutions, while the AsiaPacific was institutionally thin. Given all these differences, European security institutions with their focus on issues of military security seemed to be of little relevance(Mack / Ravenhill, 1995 ). A second line of reasoning leading to the same conclusion suggested that the institutional structure of European organisations was not in tune with the dominant political culture in many parts of Asia. For example, the processes in the OSCE were seen as too legalistic, formal and rule-based for many ASEAN states who had made consensusbuilding and informal discussions the cornerstone of their own approach to regional co-operation (Maull, 1997 b). Although some of these objections may have – as we shall argue below – less relevance than often assumed, they had considerable influence on the Forum’s development over the past four years. Not the European but the ASEAN model has served as the main blueprint for the institutional make-up of the ARF . The Association’s revered principles of »musyawarah«(consultations) and»mufakat«(consensus) now serve as the basic guidelines for the work of the ARF and its various intersessional bodies. The stress is on bringing policy-makers and security personnel from the region together in order to facilitate trust and mutual understanding. This form of security dialogue was regarded as more promising than formal Western-style mechanisms of conflict resolution. Only selected European ideas such as»Confidence Building Measures«( CBM s) have been considered for implementation. 1 * An earlier version of this text was presented at a seminar on»The Future of the ARF «, organised by the Institute of Defence and Strategic Studies, Nanyang Technological University, Singapore, April 27–28 , 1998 . 1. Even in this case, progress has been quite limited. So far, the ARF has shied away from introducing a rigid CBM regime based on reciprocity, monitoring and sanctioning. All measures carried out under the ARF umbrella, such as publication of defense white papers or observer missions, take place on a voluntary basis. IPG 3/99 Busse/ Maull, Security in the Asia-Pacific 227

Notwithstanding the merits and success of the » ASEAN way«, we feel that it was premature to discard the European experience altogether. First of all, there were misunderstandings about the nature of European institutions and their utility as role models. The most prominent one arose from the idea of a Conference on Security Co-operation in Asia( CSCA ), a proposal which was first discussed in the late 1980 s. At this time, leading politicians such as former Soviet president Michael Gorbatchev and Australian foreign minister Gareth Evans presented plans for a new Pacific security architecture along the lines of the Helsinki process. These initiatives, which were also supported by Canada, met with considerable scepticism in many Asian capitals due to the human rights mechanisms of the Helsinki model(so-called basket three). The truth of the matter was that neither Gorbatchev nor the Australians had any intention of talking about human rights in Asia or transplant CSCE in its entirety. All they wanted was to give multilateralism a chance in a region which was still dominated by Cold War balance-of-power thinking(Uhe, 1996 ). 2 Secondly, even if there are differences in the level of development between the two regions, a closer examination of the European experience might tell us more about the conditions for preserving stability at a regional level. During the past centuries, war was the rule in Europe’s history and peace was the exception. This»European civil war« ended with World War II , and after 1945 , interstate relations in Western Europe changed beyond all recognition – they assumed a completely new quality, especially with regard to the member states of the EU . As a result, relations between Germany, France and Great Britain are a far cry today from what they were during the nineteenth century and the first decades of the twentieth. Even Russia plays a more co-operative role these days and it is not seen as a threat by most European governments. Contrary to popular belief, this remarkable development has in fact less to do with the wealth and level of development in Western Europe. It is more due to the fact that European diplomacy was transforming interstate relations through the development of regional institutions( EU , NATO or CSCE ) and was then itself transformed by these very institutions. Membership in these regional bodies proved to exert lasting effects on the states involved by affecting their very statehood and identity. Hence, if Asia is contemplating its future it might find some guidelines in Europe’s present rather than in its past. The Pacific Asian Security Setting: Interstate and Intrastate Challenges The future of the ARF as a regional security framework ultimately will depend on its contribution to regional peace and security. This contribution, in turn, will be determined by the availability of alternative mechanisms of stability, by its own evolution, but also – and perhaps most importantly – by the type and extent of regional order challenges it will have to confront. Until now, ARF has been built around three assumptions. The first assumption is that future challenges to regional security and stability will arise only in the context of interstate relations. To enhance stability, mistrust and misperceptions between states had to be removed, their basically benign intentions had to be strengthened – but, according to the second assumption, this could be done and had to be done below the threshold of seriously constraining sovereignty. To the extent that intra-state violence, instability or revolutionary change have been taken into consideration at all, the logic of ARF has assumed (third assumption) that a) the likelihood of those types of violence could be reduced through strengthening member nation states and b) such conflicts could be contained and prevented from seriously affecting interstate relations. ARF thus has confined itself to the agenda of the traditional security dilemma. But what if those assumptions should turn out to be wrong? European experiences strongly suggest that the ARF ’s first and second assumptions need to be questioned. There is much evidence that the central challenges to international peace and security today emanate from intra-state violence, which in a world of interdependence easily transcends national boundaries. The international security implications of failing and failed states, rather than their aggressive intentions or misper2 . Interviews by Nikolas Busse in the Australian Department of Foreign Affairs and Trade, Canberra, September 1997 . 228 Busse/ Maull, Security in the Asia-Pacific IPG 3/99

ceptions, may thus be the key to ARF ’s future(Carnegie Commission on Preventing Deadly Conflict, 1997 ). Here, the experiences of the OSCE may be relevant for ARF . And the case for strong institutions built on a voluntary transfer of sovereignty and a relaxation of the principle of non-interference may also need to be revisited by ARF . Institution-building may offer ways to weaken and ultimately remove the practical relevance of the security dilemma, and thus offer better prospects for regional peace and stability. We pursue those two points below in some detail. It is however pertinent at this stage to provide a brief outline of the Pacific Asian security scene. Not all challenges to regional security and stability in Pacific Asia relate to inter-state conflict, but many do. This has led some observers to compare the Pacific Asia of today with Europe at the turn of last century: a region beset by Great Power rivalry, obsessed with military power and arms races and often hovering perilously on the brink of war(Friedberg, 1993/4 ). From this perspective, Pacific Asia seems»ripe for rivalry«. While we consider this view as unduly pessimistic, we do recognise the salience of unresolved territorial conflicts and proclivity towards Great Power rivalry. The most prominent among the many territorial issues in Pacific Asia are the claims by six states to all or some of the Spratly Islands – a set of reefs spread out in the South China Sea. The Spratlys comprise of very little land but cover a huge maritime domain: they are scattered over some 70,000 square kilometers. Although claims to large hydrocarbon resources in the South China Sea are completely unproven and somewhat speculative (Durkee, 1992 ), conflict over control and sovereign rights in the Spratly Islands has clearly been heightened by such speculation. In the pursuit of maritime territorial ambitions in the South China Sea, there have been both unilateral military acts of establishing de-facto control by several claimants(most recently, and most prominently, by China on the Mischief Reef, which is also claimed by the Philippines) and military clashes – notably between China and Vietnam. China also unilaterally took control from Vietnam of another group of islands in the South China Sea further North, the Paracels(Valencia, 1995 ). Beyond the conflicting territorial claims in the South China Sea, there are also numerous other unresolved conflicts over maritime and land borders. Examples include, among others, conflicting claims to small groups of islands between Korea and Japan (Takeshima / Tokdo), between China and Japan (Diaoyu / Senkaku Islands), between Russia and Japan(Southern Kurile Islands / Northern Territories) and unresolved conflicting claims on boundaries between Malaysia and the Philippines. Pacific Asia also has seen exhibits of Great Power rivalry and competition for influence, notably between the United States and the former Soviet Union, the United States and China, and – more obliquely – between China and Japan. Those patterns of Great Power competition during the Cold War were submerged, but not completely eliminated, by the broader confrontation between the blocks, with China changing strategic alignments from a pro-Soviet( 1949–1965 ) to a proAmerican position( 1972–1982 ), while simultaneously enhancing its margin for independent action. Since the end of the Cold War, elements of Great Power rivalry in Pacific Asia have become more apparent. While Russia has all but been eliminated as a major player in the region, Great Power rivalry and strategic competition has centred on the relationship between China and the US . China and Japan have also moved towards strategic competition. In both instances, however, patterns of rivalry and competition have been moderated by economic and diplomatic co-operation. It is therefore misleading to interpret those relations as determined by considerations of balance of power and geopolitical interests(Ross, 1999 ): Powerful forces of economic interdependence and shared political interests work towards accommodation, co-operation and even integration(Funabashi / Oksenberg / Weiss 1994 ; Shinn 1996 ). While Pacific Asia thus exhibits considerable potential for conflict and instability emanating from traditional interstate issues, most observers would nevertheless put two different kinds of conflict at the top of their security concerns: Korea and Taiwan. Both represent challenges in more than one sense to regional stability and security emanating from intra-state sources. First, both the conflict between North and South on the Korean peninsula and tensions between mainland China and Taiwan result from unresolved civil wars in which the parties organised themselves into states. IPG 3/99 Busse/ Maull, Security in the Asia-Pacific 229

The relationship between those states and the eventual resolution of the issue of national unification remain to be settled. Second, the fragility of existing political arrangements in both North Korea and China, as well as(in the case of North Korea) the blatant failure of the economy, exacerbate tensions between the two sides, albeit in quite different ways. In Korea, the People’s Democratic Republic’s regime hovers on the verge of collapse, but so far has remained in control through a bizarre and brutal mixture of indoctrination and repression. In China, confrontation between the People’s Republic and the Republic of China on Taiwan has been coloured by elements of a struggle between a non-democratic, precariously legitimate and a democratic system of governance. Thus, China apparently sought to influence the outcome of Taiwan’s first free presidential elections in March 1996 with large-scale military intimidation through extensive manoeuvres in Taiwan’s vicinity. Another example of a potential regional instability emanating from intra-state sources of conflict is Indonesia. There, the socio-political implications of the Asian financial crisis have produced internal unrest and enhanced secessionist movements. As a result, Indonesia has all but lost its previous role as a source of regional stability and moderation in South East Asia, and it may even change shape through the independence of East Timor. In short, Pacific Asia represents a complex mixture of open and latent conflicts, which are caused by sources both within and between states. Those sources interact with each other and with the broader forces of globalisation which sweeps international politics across the globe. Globalisation enhances both fragmentation and integration, both the quest for(national, religious or ethnic) identities and the need for joining others, and it puts political institutions under enormous pressure both nationally and regionally. The resulting fragilities of politics are exacerbated in countries which still have to complete the tasks of nation-building and master the transition towards market economies and more responsive and legitimate political systems, while being expected simultaneously to prepare for the age of globalisation(Maull, 1995 ). All this sounds familiar to European ears – and while there clearly are important differences between the two regions, the similarities and parallels should also not be underestimated. Thus, experts in the Asia-Pacific security often argue that Pacific Asia really consists of two remarkably different sub-regions: North and South East Asia. While South East Asia is marked by a modest but significant level of economic interdependence(intraASEAN trade represents roughly one fifth of total ASEAN trade) and – through ASEAN – by substantial regional institutionalisation, North East Asia shows much more patchy patterns of economic interdependence 3 and only very limited institutional arrangements(primarily in the form of the Korean Energy Development Organisation KEDO and the»four-party talks« between the two Koreas, China and the United States). Again, however, there are parallels to this in Europe: the sub-regional setting in the Balkans differs hugely from that, say, in North Western Europe, the Mediterranean, the Baltic region or Central Eastern Europe. While European experiences therefore obviously cannot simply be transferred and applied to Pacific Asia, they equally obviously hold useful lessons and can be used as»teaching material«, which, however, will have to be sifted, evaluated in its successes and failures, and adapted to suit the specific circumstances in Pacific Asia. It should also be clear that Europe, too, would benefit from a close look at Pacific Asian experiences, strategies and tools to address issues of regional security and stability. For the time being, however, we will now return to our main theme – the relevance of European experiences to Pacific Asian security and stability and, specifically, to the ARF . Learning From the EU Experience At first glance, it seems difficult to imagine that any lesson might be drawn from the EU experience for the further development of the ARF . The 3. Only economic interactions between China, Japan and South Korea represent significant levels of interdependence. The economic integration of Russia and North Korea into North East Asia is very limited, although ironically, North Korea, which has remained largely isolated from the world economy, has now become critically dependent on food, oil and currency supplies from China and Japan for its survival. 230 Busse/ Maull, Security in the Asia-Pacific IPG 3/99

reason is quite simple: the EU and the ARF are two very different international institutions with different objectives and different approaches. The ARF consists of an inter-governmental forum for security co-operation which is primarily concerned with building confidence and reducing tension among sovereign states. The EU , on the other hand, has always tried to go beyond mere cooperation and achieve regional integration. The founding fathers of the EU were inspired by a vision of the»United States of Europe« and favoured a gradual transfer of sovereignty from the national level to supra-national agencies. Since the ARF has no plans for a common market, a monetary union or a common foreign policy, there is indeed little that its participants might learn from studying the various institutional mechanisms invented by the EU . As we will discuss below, the OSCE might be much more relevant for this kind of inquiry because it aims at fulfilling functions similar to those of the ARF . But there is one important insight that can be gained from studying the history and development of the European Union. The EU is one of the rare examples of a successful process of communitybuilding at the regional level. In other words: it proves that international institutions do matter and that they affect state behaviour over time. This is a fundamental point which sometimes gets lost in the current debate between realists and liberals in Pacific Asia(Busse, 1997 ). The former have criticised the ARF from the very beginning as having little to offer for the solution of Pacific Asia’s pressing security problems. Incidents such as China’s gunboat diplomacy in the Spratlys or its wargames off the Taiwanese coast are often referred to as examples which allegedly show that Pacific Asia needs deterrence much more than multilateral security dialogues. From this point of view, the biggest challenge is the future role of China which can only be managed by creating a new balance of power. New alliances for the containment of China might be part of this strategy, as well as stronger armaments of America’s allies in the region(Bernstein and Munro, 1997 ). This line of reasoning even has adherents in some ASEAN capitals which seem to lack full confidence in the ARF , their very own initiative. They privately admit their reluctance to»put all their eggs into one basket«, i.e. the basket of co-operative security, which is why they informally support a stronger US military presence in the region. In this context, bilateral agreements, such as the 1995 Australian-Indonesian security arrangement, are sometimes portrayed as part of an informal spider-web among the lesser powers in the region which functions as a security guarantee against China. 4 The EU experience shows, however, that there is no need for this kind of double-edged diplomacy. Today, Western Europe lives in an unprecedented period of peace. The relations between the major powers are stable, nobody would seriously consider the use of force against neighbouring states, and conflicts are settled in a civilised manner through legal and diplomatic means. Moreover, with three Central European countries now in NATO , and five negotiating their entry into the European Union, the benefits of this paradigm are now rapidly being expanded into Central Eastern Europe. This is no mean achievement for a region which has suffered greatly from war over the past centuries and which was captured by exactly the kind of balance-of-power thinking which seems to dominate the informal security discourse in many parts of Asia. What brought about the change? Many observers from the Third World seek explanations in what they perceive as Europe’s longer history in the business of nationbuilding. In this view, Europe has consolidated its economies, increased trade and investment ties among neighbours, and all but completed the task of nation-state building. The combined effects of stable societies and economic interdependence are thus used to explain why European countries can no longer afford to fight wars against each other – favourable conditions which are missing in contemporary Asia(Friedberg, 1993/ 94 ). But this hypothesis is less compelling than one might think. First of all, the level of development among the different European states has varied considerably over the past 40 years or so. Some areas of Spain, Portugal, Greece, Italy or even Eastern 4. From the point of view of the two governments, the Indonesian-Australian security arrangement constitutes a confidence-building measure among the two neighbours and not a tacit alliance against China(Interviews by Nikolas Busse in Jakarta and Canberra, May / September 1997 ). IPG 3/99 Busse/ Maull, Security in the Asia-Pacific 231

Germany have economic problems not much different from rural areas in many parts of South East Asia. It is also a myth that the state has consolidated its control over society in all of Europe. Terrorism and separatism are familiar problems to many European countries, including Spain, Italy, Ireland and France, and societies like Belgium are anything else but homogenous nation-states. And even if economic interdependence might be high, this can by no means be seen as a protection against conflicts. In the period before World War One, interdependence among the European economies was even higher than today but this only caused a feeling of vulnerability and led to a major boost for nationalism. New research in international relations theory suggests that the enduring peace in Europe has different roots. It seems that the existence of European institutions played a decisive role. Over time, the various EU bodies such as the European Commission, the European Court of Justice or the European Parliament did much more than only influence the policies of the states involved. They also changed the identities of the states themselves. Today, there exists a widespread feeling of Europeanness among the elites in the EU which even reaches down to the level of mass public opinion in some countries(Risse-Kappen, 1996 : 391 ). Apart from exceptions such as Great Britain, most EU governments have abandoned old-fashioned strategic thinking when dealing with their neighbours; they have learned to think in regional terms. Balance-of-power theory with its grand coalitions and secret alliances, which has dominated European diplomacy for such a long time, has gradually been replaced by long-term co-operation in almost all areas of public policy. The crucial point is that this state of affairs was not brought about by some pre-existing feeling of common heritage or cultural affinity. Religious, linguistic, or ethnic cleavages are still prominent in Europe and will not cease to influence politics. The underlying cause for change was the adherence to commonly held norms and institutional procedures. These have helped to transform the way how European politicians see themselves and others. As a result of prolonged co-operation, they have begun to see their counterparts as partners rather than rivals and the EU ’s institutions as legitimate arenas for political decision-making. Constructivism, the theory which examines such processes, calls this state of mind a collective identity. This means that the members of a group of states identify positively with the fate of the fellow members and would not consider the use of force against one of them(Wendt, 1994 ). This collective identity has probably done more to remove the security dilemma among the EU members than all CBM s, joint military exercises and disarmament talks together. There are lessons in this for Pacific Asia. These lessons may even be particularly relevant against the background of a financial and economic crisis in the region, which is shaking the political, economic and social foundations of stability. It is hard to envisage how the region could escape from the reverberations of the Asia crisis without significantly enhanced levels of intra-regional co-operation in the economic, but also in the political realm. This applies to the sub-regional contexts of North and South East Asia, as well as to Pacific Asia as a whole. To take the example of South East Asia, the Asian crisis has severely affected both the reputation and the effectiveness of ASEAN , but it has also pushed the strengthening of ASEAN up on the political agenda(Hernandez, 1999 ). What is now being discussed among ASEAN experts in the region is a move of ASEAN towards further institutionalisation and partial transfers of operational sovereignty much along the lines of the evolution of European integration. The revered principle of non-interference in the internal affairs of other member states has openly been challenged by Thailand and the Philippines, and while this challenge has so far been repulsed, it has become clear that these are rearguard actions against an ineluctable trend. The central lesson of European integration for Pacific Asia, however, concerns not only South East Asia but the whole region, and notably the key relationships between China and Japan, Korea and Japan, China and Korea, and China and the United States. Those relationships need to be substantially transformed if regional security and stability is to be ensured in the long run. Present security arrangements are insufficient to do so: the United States is unlikely to be able to balance a rising China alone, but also unlikely to find willing allies in the region, if China played its cards well. And if Japan tried to balance China(whether 232 Busse/ Maull, Security in the Asia-Pacific IPG 3/99

in close alliance with America, or on its own), the results could easily be disastrous. A smooth adjustment of regional security arrangements to Korean unification is hard to envisage except in a context of fairly close co-operation of the major external powers; the introduction of a united Korea in a balance-of-power context could easily exacerbate tensions between Japan and China. ARF could provide a useful institutional framework for redefining interstate relations between China, Japan, Korea and perhaps even the United States. The European experience shows that the social effects of international institutions can hardly be overestimated. States do not only react to military threats and diplomatic pressure, as realists would have it, but also to norms and institutions. The idea of socialising states in world politics is no wishful thinking but a real possibility and definitely a smarter policy choice than throwing more and more weapons into a region. In this context, two policy recommendations might be formulated for the future of the ARF . First, ARF participants should be patient and give the forum a fair chance. The history of European integration has been full of disappointments, problems and setbacks. Many projects failed, others could only be implemented after long delays. The crucial point was that the process of co-operation never came to a complete stop and eventually was seen as legitimate and natural in the eyes of the governments concerned. Hence, Asian governments should remain committed to the ARF , even if this eventually might involve giving up parts of national sovereignty. Renouncing total control over all aspects of foreign policy is the price that states have to pay if they want international cooperation. The history of European integration shows that the pay-off can be the development of a strong collective identity which serves as a protection against armed conflicts. Second, governments in Pacific Asia should avoid any actions that could undermine the process of institutionbuilding. The EU experiment would not have succeeded if the member governments had secretly built up their arsenals and tried to forge informal alliances against each other in the early stages. Hence, Asian governments should be more willing to sacrifice short-term strategic gains for long-term stability. This especially applies to those voices who advocate a parallel strategy of balancing and engagement. The EU ’s success was based on a deliberate choice for institutionalisation, engagement and co-operation and would probably have failed if some parties had simultaneously followed a realist path. Learning From the OSCE Experience Europe’s recent history not only provides evidence for the successful transformation of inter-state relations through institution-building, it also amply illustrates the dangers of intra-state violence, its potential for poisoning inter-state relations, and the difficulties of containing such problems. The most obvious and dramatic case in this context is offered by former Yugoslavia – a state which had failed economically, politically and ideologically at the end of the Cold War. Within this state, politics were redefined along ethno-nationalist lines, and the old state in an orgy of violence then fell apart into its separate components. At least one of those component states, Serbia, pursued a strategy of territorial expansion through military force. Thus, the war in former Yugoslavia combined aspects of civil war with that of inter-state aggression. Similar forms of violence erupted in several parts of the former Soviet Union and also threatened to explode stability in Central Eastern Europe. In the case of former Yugoslavia, all major European institutions – the OSCE , the EU , the WEU , and NATO – were involved in efforts to quell the conflict; in Central Eastern Europe, the task fell primarily to the EU and the OSCE (though the prospect of NATO enlargement also played a major role), while in the former Soviet Union, efforts at stabilisation by international organisations were primarily carried out by the OSCE . The diversity of Europe, and the differences between its sub-regions, are, as we have argued already, hardly less dramatic than those in the Asia-Pacific. Even its institutional framework shows more similarities than is often granted: much of Eastern Europe is seriously under-developed in terms of regional institutions, and the institutions are less different between Asia and Europe than is often assumed if we compare, as we should, the ARF with the OSCE . In fact, there are striking similarities between the two organisations: both provide institutional expression to the logic IPG 3/99 Busse/ Maull, Security in the Asia-Pacific 233

of co-operative and comprehensive security, both are supplementary, rather than dominant security institutions geared towards prevention and confidence-building, rather than to conflict settlement and enforcement. Both function on the basis of consensus, neither has any capacity to coerce. They also share a preference for informal, discrete and personal diplomacy, and emphasise process over results, dialogue over settlement. OSCE and ARF differ, however, in their intrusiveness: the catalogue of principles, norms, rules and institutions which the OSCE has developed assumes that a whole range of internal affairs are legitimate concerns for other countries and the institution itself. The notion that»good governance« may be an important precondition for peace and international security is central to the activities of the OSCE . This gives the OSCE a potentially large role in internal affairs and thus qualifies the sovereignty of member countries. While the OSCE and its institutions thus get the right of initiative, however, the countries themselves remain firmly in control: their consent will be needed for any OSCE action. As the ARF , the OSCE is a young and relatively weak security organisation. Both certainly could benefit from their respective experiences(which, incidentally, suggests that there should be an institutional link, perhaps in the form of observer status for Secretariat representatives). What the OSCE may have to offer the ARF are thus less – as in the case of the EU – the long-term effects of institution-building than lessons from immediate efforts at conflict prevention. The need to secure consensus has been called both the greatest strength and the greatest weakness of the OSCE (Chigas, 1996 : 27 ). Much of the considerable institutional innovation and creativity which the OSCE has developed have been rooted in a desire to get around the constraints of the need for consensus. In this effort, the OSCE has developed a whole range of mechanisms and practices(and the experience to go with them, sometimes good, sometimes bad) which could be of potential interest to ARF . Among those are the Permanent Council as an ongoing framework for the discussion of issues of the day, and the role of the Chairman-in-Office of OSCE and of the High Commissioner for National Minorities, both of whom have been involved in informal, personal and discrete missions of mediation and negotiation as»insider third parties«(Chigas, 1996 ). The ARF has begun to recognise this connection between domestic and regional instability, and has shown considerable interest in evaluating European experiences in confidence-building and preventive diplomacy. While the initial focus of ARF was on confidence-building, the Forum in 1997 decided formally to move towards a new stage, which is to explore possibilities for preventive diplomacy. In this context, a lot of preparatory work has already been done both in the context of ARF Intersessional Groups and specialised workshops, as well as in so-called»track two« conferences, notably those organised by the Council for Security Co-operation in the Asia-Pacific, the most important track-two security organisation in the region. In terms of substantive proposals, ARF has focused on efforts to promote transparency in security affairs(e.g., through the publication of official»White Papers« on defence policies), and generally to build trust through dialogue(Leifer, 1996 ). It is clear, however, that results in the military security realm so far have not been very impressive, and almost irrelevant in the context of the major areas of tension. Intellectually, discussions in the Asia-Pacific about possibilities for confidence-building and preventive diplomacy have concentrated on the development of a regional early warning mechanism(such as a Regional Risk Reduction Center), on the potential for ARF Special Representatives or missions, and an enhanced role of the ARF Chair in mediation. More generally, the issue of norm building to foster co-operative behaviour and peaceful resolution of conflicts has been at the center of the political debate(Tay, 1997 ; CSCAP Singapore, 1999 ). Such efforts have been made most persistently in South East Asia – indeed, ASEAN itself can be seen as a very successful example of preventive diplomacy for relations between member states(Busse 1998 , 1999 ). ASEAN has also tried to shape domestic political developments in its new members Myanmar(through its policy of»constructive engagement« of the Myanmar military regime) and Cambodia(both during the 1980 s and, more recently, in early 1997 after the coup by Hun Sen, ASEAN has tried to steer Cambodia towards political reconciliation). The most important effort at preventive diplo234 Busse/ Maull, Security in the Asia-Pacific IPG 3/99

macy relating to a key security concern for South East Asia, which also involves one of the Great Powers of Pacific Asia, China, has been undertaken in the track-two workshops about the South China Sea chaired by Indonesia. While those efforts have led to a series of intensive technical discussions, attempts to develop binding norms(such as a common ASEAN declaration on the South China Sea, which committed signatory states to abstain from any unilateral military steps to promote their claims) were, as Chinese encroachment on the Mischief Reef in 1995 and 1998 showed, unsuccessful. While China diplomatically paid some lip service to the suggested common norms of peaceful settlement and selfrestraint(albeit under considerable diplomatic pressure from ASEAN and ARF ), its actual behaviour in the South China Sea suggested that Beijing was unwilling to abide by those norms. China has also refused to let third parties or regional security institutions get involved in its crucial bilateral relationship with Taiwan. The United States, however, clearly already is involved heavily in this relationship, and finds itself in the position of a de-facto mediator and moderator. For its own reasons, Washington has also not been interested in multilateralising the Taiwan issue. China has also been reluctant to see the involvement of regional security institutions in its bilateral relationships with Washington and Japan. On issues surrounding the division of the Korean peninsula, China has abstained from the one important multilateral institution which has potential for managing conflict between the two Koreas, the Korean Energy Development Organisation, but it has allowed itself to become involved on the fourparty-talks between the two Koreas, America and China, and has accepted discussions of the Korea problem in the context of ARF . Overall, the potential for ARF to contribute to regional security and stability has been stymied so far by a lack of political will to compromise sovereignty and foreclose perceived options of independent action. The People’s Republic of China has been the most reluctant power from this point of view, while Washington, after considerable skepticism in the past, has in recent years taken a more constructive attitude towards ARF . But the United States, too, shows little inclination to have its own policy options constrained through a multilateral security organisation. The most enthusiastic supporter of ARF among the powers in Pacific Asia has been Japan – but Japan’s margin of manoeuvre has been confined by the burden of its past, by its close security relationship with the United States, and most recently by its loss of stature and influence in Pacific Asia as a result of its economic malaise. Clearly, the ARF , ASEAN and any eventual subregional security arrangements in North East Asia still have a long way to go before they can make significant independent contributions to regional security and stability. Yet we argue that this should not discourage the countries of the Asia-Pacific from trying. Analysing European experiences can help in this context. Yet, in evaluating the experiences of the OSCE in preventive diplomacy, confidence-building and conflict resolution, the ARF should learn from failures as much as from successes, and it will have to be aware of the need for creative adaptation of European mechanisms and institutions to a different setting. The real issue for ARF is not so much the applicability or otherwise of European experiences – it is whether Pacific Asia would be willing to accept the link between domestic instability and international security, and to rethink its insistence on non-interference. As the OSCE experience suggests, a relaxation of this principle can be fully compatible with the desire of states to retain control over outside intervention in their internal affairs. So far, the ARF has not played a significant role in any of the key conflicts in the region – be it tensions on the Korean peninsula, across the Taiwan Straits, in the South China Sea or even the East Timor issue, where the United Nations and Portugal have served as intermediaries between the Indonesian government and the autonomy / secession movement. It will fail the region if it continues to follow those issues from the sidelines. ̇ References Ayoob, Mohammed( 1995 ): The Third World Security Predicament. State Making, Regional Conflict, and the International System, Boulder: Lynne Rienner. Bernstein, Richard / Ross H. Munro( 1997 ): The Coming Conflict with America, Foreign Affairs, vol. 76 , no. 2 , pp. 18–32 . Busse, Nikolas( 1997 ): Engaging China the safer bet. Insights from social psychology show that initiatives IPG 3/99 Busse/ Maull, Security in the Asia-Pacific 235

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STEPHANY GRIFFITH–JONES A New Financial Architecture for Reducing Risks and Severity of Crises* T he deep integration of developing countries into the global economy has many advantages and positive effects. In particular, capital flows to developing countries have clear and important benefits. They are especially clear for foreign direct investment, which is not only more stable but also brings technological know-how and access to markets. Other external flows also have important positive microeconomic effects, such as lowering the cost of capital for creditworthy firms. At a macro-economic level, foreign capital flows can complement domestic savings, leading to higher investment and growth; this is very valuable for low-savings economies, but may be less clear for high-savings economies like those of East Asia. However, large surges of short-term and potentially reversible capital flows can also have very negative effects. Firstly, they pose complex policy dilemmas for macro-economic management, as they can initially push key macro-economic variables, such as exchange rates and prices of assets like property and shares, away from what could be considered their long-term equilibrium. Secondly, and more important, these flows pose the risk of very sharp reversals. These reversals can result in very serious losses of output, investment and employment. This has been dramatically illustrated by the impact of the recent crisis in Asia. Asian-style currency crises raise a very serious concern about the net development benefits for developing countries of large flows of potentially reversible short-term international capital. While the high costs of reversals of those flows are evident, the benefits are less clear. This is in sharp contrast with foreign direct investment( FDI ) and trade flows, where the very large developmental benefits clearly outweigh the costs. As a result, volatile short-term capital flows emerge as a potential Achilles’ heel for the globalised economy and for the market economy in developing countries. If the international community and national authorities do not learn to manage these flows better, there is a serious risk that such volatile flows could undermine the tremendous benefits that globalisation and free markets can otherwise bring. Analysis of the East Asian Crisis Eighteen months after the outbreak of the crisis in Asia, its financial aspects have not yet been fully contained. Increasingly the East Asian financial crisis has been transformed in the affected countries into a serious crisis in the real economy, with highly negative social effects, as well as problematic consequences for political stability. It is noteworthy that the East Asian crisis itself, as well as its depth and length had been almost totally unexpected. The speed and extent of contagion was especially unexpected. It is therefore essential to understand both the causes that sparked off the East Asian crisis, as well as the causes that led to its deepening and spreading through contagion. Three key elements need to be noted. First, the roots of external imbalances were grounded in private sector deficits, as most East Asian economies were running budget surpluses(here an important difference emerges with Brazil, where to an important extent the current account deficit was explained by the fiscal deficit). Second, in East Asia the crisis was a consequence of over-investment(though some of it may have been misallocated, especially in the property and electronic sectors) and not of over-consumption. Third, an important cause of the crisis was a sharp deteriora* Revised version of a paper originally prepared for the colloquium»The Euro and the New International Financial Order«, organised by the Friedrich Ebert Foundation in Brussels, on March 22 and 23, 1999 . I thank Jenny Kimmis and Jacques Cailloux for their very valuable inputs into this paper. IPG 3/99 Griffith-Jones, New Financial Architecture 263

tion in confidence throughout the region, spread through contagion effects, rather than significant changes in macro-economic fundamentals, which were mostly strong. Indeed, the most disturbing element in the crisis was that it affected countries with long track records of good economic management that had been remarkably successful over extended periods, in terms of economic growth, dynamism of their export sectors, low rates of inflation and high rates of saving. How were these economies suddenly shaken by such major currency and financial crises? Clearly there were serious problems in the countries themselves including important weaknesses in their domestic financial systems and particularly in their banking systems, which were not appropriately regulated. There had been poor monitoring and regulation of short-term private debt, incurred both by banks and by corporate borrowers. Some mistakes also seem to have been made in the form in which the capital accounts were liberalised, as this was reportedly done in ways that particularly encouraged short-term flows. Furthermore, several of the East Asian countries had fixed exchange rate policies as their currencies were pegged to the US dollar; this policy became particularly problematic when the US dollar appreciated sharply vis-à-vis the Japanese Yen. But there is another crucial causal factor, which relates to the behaviour of international capital flows. This aspect is linked to certain imperfections of international capital markets, that have almost always featured in the financial panics of earlier times, but whose impact has increased significantly due to the speed with which markets can react in today’s global economy aided by highly sophisticated information technology. Paradoxically, this impact appears to be strongest for economies that either are – or are perceived to be in the process of becoming – highly successful. In these situations, euphoria in international capital markets interacts perversely with complacency by governments in recipient countries. Successful economies offer high returns by way of yields as well as capital gains. If international investors can find ways to enter these economies, or if their entrance is facilitated by capital account liberalisation, they tend to rush in, generating a surge of capital inflows that affects key economic variables. Exchange rates become over-valued; the prices of key assets – like shares or real estate – rise quickly and sharply. There is both an increase in real income, and in perceived wealth. Banks tend to relax lending standards, lifting liquidity constraints of business firms, as they assume that current trends will continue. The payments balance deteriorates, often quite rapidly, as both consumption and investment rise. Initially, this is not seen as a problem, as foreign lenders and investors are willing to continue lending / investing. Economic authorities delay necessary adjustment, confident that their previous success will be continued, and that crises happen elsewhere. Then, something changes. The change may be domestic or international, economic or political, important or relatively small. This change triggers a sharp modification in perceptions, leading to a large fall in confidence in the economy among internationally mobile investors, that is both foreign investors and nationals able to take their liquid assets out. The change of perception tends to be both large and quick. A country that was perceived as a successful economy or a successful reformer – for which no amount of praise was sufficient – suddenly is seen as fragile, risky and crisis prone. The change of perception tends to be far larger than the magnitude of underlying change in fundamentals warrants. Furthermore, any weakness in economic fundamentals is then discovered and magnified by markets. As in East Asia, there can be much overshooting. Exchange rates collapse, stock markets and property prices also fall sharply. This pattern helps explain the currency and banking crises in the Southern Cone of Latin America in the early 1980 s and the Mexican peso crisis. It also provides important elements to understand the 1997 East Asian crisis and the more recent crisis in Brazil. The boom-bust behaviour of short-term lenders and investors, driven not just by real trends, but by dramatic changes in perceptions is a common denominator to these crises. So is the complacency of the economic authorities in recipient countries during the period of boom. In the case of the East Asian crisis, the reversal of private capital flows has been quite dramatic. According to figures from the Institute of International Finance( IIF ), the five East Asian countries hardest hit by the crisis(South Korea, Indonesia, Malaysia, Thailand and the Philippines) experienced in a single year a turnaround of US $ 105 264 Griffith-Jones, New Financial Architecture IPG 3/99

billion, a shift from an inflow of US $ 93 billion in 1996 to an estimated outflow of US $ 12 billion in 1997 , an outflow projected to continue in 1998 . Most of this swing occurred in commercial bank lending, followed by short-term portfolio flows, whilst foreign direct investment remained constant. The turnaround of US $ 105 billion in the five Asian economies represents more than 10 % of their combined GDP ; as a consequence, this shift is larger than the 8 % shift that occurred in Latin America in the early 1980 s. Capital and financial markets are special, in that – though generally functioning well – they are prone to important imperfections. Asymmetric information and adverse selection play an important role in explaining these imperfections, as financial markets are particularly information intensive. Furthermore, there are strong incentives for»herding« in financial markets, as each individual short-term investor, lender or fund manager tries to choose the investment or loan that he / she thinks is most likely to be chosen by other investors or lenders. Herding seems strongly encouraged by the incentive systems(excessively short-term) with which financial market actors operate. Distortions are also caused by structures within private financial institutions, which give insufficient influence on decision-making to research departments concerned with analysis and risk assessment. The crises in Asia have had extremely negative economic and social effects on the worst affected countries. Indonesia’s GDP fell by about 15 % in 1998 , and people below the poverty line increased from 20 million to 80 million, reversing many years of successful poverty reduction. GDP in Thailand shrank by about 8 %. Other affected countries, like South Korea and Malaysia, saw somewhat smaller, but also very significant declines in GDP , leading to sharp falls in employment and real incomes. Of particular concern is the fact that the poorer and more vulnerable groups in those countries are the worst affected, even though they did not contribute to cause the problem. Also of relevance for understanding the East Asian crisis is the analysis of self-fulfilling attacks, that is crises arising without obvious current policy inconsistencies. The existence of self-fulfilling attacks and multiple equilibria for exchange rates, and for other key variables, implies that good macro-economic fundamentals are a very important and necessary but not sufficient condition for avoiding currency crises. There is at present limited understanding of what triggers self-fulfilling attacks. However, there are conditions of vulnerability that can be identified, such as the ratio of short-term debt to foreign exchange reserves, or high current account deficits as a proportion of GDP . Another important set of factors explaining the depth, length and geographical extension of the East Asian crisis relates to mistakes in the management of the Asian crisis. Capital account led crises, which relate to expectations of private investors and lenders, may need different responses to traditional balance of payments crises, provoked by problems on the current account, and caused by public sector deficits. In the»new style« of crisis, increasing confidence of private actors is absolutely central. In this new context, diagnosis and policy measures suggested by international institutions, which emphasise negative structural features of the crisis-hit countries and require sweeping structural reforms in short periods as a pre-condition for financial disbursements may exacerbate crises to the extent that they contribute to further undermine confidence, rather than rebuild it. Furthermore, even necessary structural reforms may be unnecessarily costly to implement if done very fast and in the middle of a crisis. A second problem has been that countries initially tend to postpone as much as possible going to international institutions like the IMF , partly because they fear that the IMF ’s required measures will be too draconian on stabilisation, as well as too intrusive on structural adjustment. Countries come to the IMF only when margin of manoeuvre for policy-making has become very restricted; as a result, the IMF policy conditions on stabilisation are particularly draconian. Mutual recriminations follow, negotiations are long, programmes are broken, which further undermines private sector confidence. Clearly, new more positive dynamics of interaction between crisis-prone countries and the IMF need to be urgently developed, and some suggestions are made below. Furthermore, policy conditionality need to be designed primarily so as to restore the confidence of both foreign and domestic actors. Though excessively loose monetary and fiscal policies would be counter-producIPG 3/99 Griffith-Jones, New Financial Architecture 265

tive in this context, so are excessively tight monetary and fiscal policies. A key objective in the design of macro-economic policies needs to be the protection both of growth and of the most vulnerable and poorest groups of the society. Furthermore, it may be desirable that crisis management should be based on a two-tier approach, which implies first stabilising and then undertaking structural adjustment. Lessons to be Learnt There is growing consensus that important changes need to be made urgently in the international monetary system as a whole and in recipient country policies to avoid costly crises, as well as to manage them better if they do occur. Care must be taken, however, that the measures adopted contribute to broaden access by all developing countries to capital flows, particularly long-term ones. In this context, foreign direct investment is especially beneficial. At the time of writing, the issue of better crisis containment and reversal was particularly urgent, due to the depth and width of the crises, affecting East Asia, Russia, Brazil and other countries in Latin America, and increasingly contributing to a slowing down of the developed economies. Especially important, in that respect, is that monetary authorities in the major developed countries are willing to relax monetary policy sufficiently and soon enough to help avoid widespread currency crises causing recessionary tendencies not only in the affected countries, but also in the world economy. From an institutional point of view, we can distinguish three levels of measures: ̈ Measures within existing institutional arrangements. Two important examples are more expansionary monetary policies in the developed countries, which has been done by Central Banks of the US and Europe and changes in the capital adequacy requirements for short-term and long-term lending, which could be done in the context of the expanded Basle Committee. ̈ Measures that require some development, expansion and adaptation of existing institutions, such as the IMF or the regulatory Committees that meet under the aegis of the BIS . Examples would be new facilities within the IMF or adaptation of existing ones, to cope with capital account caused currency crises; the filling of international regulatory gaps, to include regulation of mutual funds and hedge funds; the recently created Forum for Financial Stability. ̈ Measures that require more institutional radicalism, in the sense of creating new institutions or drastically adapting existing ones. Though this is clearly desirable from the perspective of having institutions and mechanisms designed for the new needs of a globalised private financial system, it is significantly more difficult to achieve; the key problem is that new global institutions are needed to effectively manage a globalised private financial system, but there is no global government to create them, and the political process for national governments to create global institutions could be complex and slow. However, it seems at the very least, highly desirable to develop a clear vision of an appropriate new international financial architecture that would allow an orderly global financial market to support the development process. Such a vision should inform current debates on a new financial architecture. In this context, there are three essential functions of global financial market management that are currently not properly met, and would best be met, at least in part, by new institutional developments. We sketch them out here, but discuss them in more detail below. ̈ Firstly, the provision of appropriate surveillance and prudential regulation of financial intermediaries. This function will hopefully now be met by the Financial Stability Forum, but there may be a case for something closer to a World Financial Authority. ̈ The provision of international official liquidity to countries or financial markets, including in particular last resort lending in distress conditions caused by currency crises that originate in capital account problems. This could be done by existing international institutions, like the International Monetary Fund( IMF ) and the Bank for International Settlements( BIS ), with co-financing from the private sector, but with an important change to the concept of conditionality, and the timing of these facilities. ̈ The provision of emergency standstill and orderly debt work-out procedures, that would 266 Griffith-Jones, New Financial Architecture IPG 3/99

allow suspension of payments during times of crisis without triggering default, and debt reduction where solvency problems exist, again without triggering default. Again here an optional institutional arrangement would require some new institutional developments; some of these, like the creation of an international bankruptcy court to apply an international chapter 11 may not be too feasible. However, an alternative procedure, suggested in UNCTAD ’s 1998 Trade and Development Report, could be more feasible. Table 1 provides a matrix of the categories of actions required and the actors that need to be involved. Measures to Prevent Future Crises As in medicine, so in finance, prevention is much kinder, more efficient and cost effective than cure. In this respect, the focus of the international community in the aftermath of the Asian crisis was on better information, on the one hand, and financial system strengthening, on the other. This focus was clearly illustrated by the agenda working groups set up under the G22 , an ad-hoc group of G7 and developing countries. Table 1: The Elements of a New International Financial Architecture Actors Types of Measures Crisis Prevention Better Crisis Management Capital-receiving Countries Authorities Markets Restrict short-term inflows Improve prudential regulation and strengthen domestic financial sector Liberalise more carefully Use interest rates policies with care Allocate rescue package to protect the poorest first Develop equity and forward markets Avoid uncovered foreign currency debt exposure Participate in burdensharing Capital-supplying Countries Authorities Markets Risk weighted cash requirements on foreign investments for institutional investors Avoid regulatory bias towards short-term lending Use more available information more efficiently Participate in burdensharing International Financial Institutions IMF Last-resort lending BIS IBRD Extend international regulation and supervision of bank loans and portfolio flows to emerging markets Make funds available faster Promote market confidence throuth conditionality Allow for orderly debt workouts Contain the social impact of crises IPG 3/99 Griffith-Jones, New Financial Architecture 267

Transparency and Information Disclosure Gaps in information certainly played a role in the genesis of the Asian crisis. As a result, much of the work of the IMF , the BIS and the G22 during 1998 focused on finding ways to encourage countries to improve the quality of information that they make available to the Fund and the public, and to improve the quality and effectiveness of international surveillance. Clearly, better information will certainly be welcome, but the current focus on information and transparency at the country level may be too narrowly focussed. Firstly, better and more widely available information on international financial markets may prove as, if not more, vital to international financial stability as information on developing countries. Secondly, there is little evidence to suggest that better information will be sufficient for financial markets to function well. The key issue is how information is processed and acted upon. It is now well recognised that in the leadup to the Asian crisis, markets ignored clear signals that the levels of short-debt had risen dramatically because of phenomena such as euphoria and herding discussed above. Thirdly, it is also worth remembering that information in financial markets can never be perfect and that asymmetries will always exist. In this context, it is important that policies are designed which accommodate such failures in financial markets. Financial System Strengthening The Asian crisis highlighted the importance of strong financial systems in maintaining the stability of national economies, as well as international currency and capital markets. One of the G22 working groups looked at the issues around strengthening domestic financial systems and improving international co-operation, building on the work of the BIS and a recent IMF publication on this theme(Folkerts-Landau et al., 1998 ). There is already a strong degree of international consensus on what constitutes sound practices in many areas of banking supervision and securities regulation, although effective implementation, even in industrialised countries, is complex. The Basle Committee has produced the»Core Principles for Effective Banking Supervision« and the International Organisation of Securities Commissions( IOSCO ) has produced similar guidelines for the securities industry. The G22 report emphasised the need for cooperation and coordination between national supervisors and regulators, as well as among international groups. This recommendation has now been met by the creation of the Financial Stability Forum, which will be discussed in more detail below. a. Responsibilities of capital receiving countries An important part of the responsibility for discouraging excessive reversible inflows lies with recipient countries. It is in the period of excessive surges of capital inflows that they have greater degrees of freedom for policy-making. The role of counter-cyclical monetary and fiscal policies are essential to reduce excessive growth of domestic absorption, and / or current account deficits. The recent experience and literature indicate that a tightening of macro-economic policies is particularly desirable when indicators of vulnerability to currency crisis start to deteriorate quickly or pass certain thresholds: when current account deficits start to grow rapidly; when the proportion of capital flows which are easily reversible in total flows is high and rising; and, particularly, when short-term external liabilities grow rapidly and approach or exceed the level of foreign exchange reserves. Thus, high levels of foreign exchange reserves and limits on the level of short-term external liabilities are crucial for currency crisis avoidance. An appropriate exchange rate regime is also essential for relatively small open economies, so as to make them less vulnerable to currency attacks. Though this is a complex issue, and the choice of the exchange rate regime should be linked to the country’s specific circumstances, international evidence seems to show that exchange rate regimes like wide bands – with a possible crawling peg element – offer a good combination of flexibility with some desirable guidance to the market and anchor for monetary policy. Fixed exchange rates – though they have some advantages – offer apparently secure yields to very short-term investors, leading to surges of such inflows, and can create fixed goalposts for hedge funds and others to attack, when the situation deteriorates. Further268 Griffith-Jones, New Financial Architecture IPG 3/99

more, if domestic inflation exceeds international inflation, fixed exchange rates can lead to overvaluation, which encourages domestic corporations to borrow abroad. A counter-cyclical approach should also be applied to the supervision and regulation of the financial system, and particularly the banking system. In boom times, supervision and regulation of banks – as well as credit decisions by banks themselves – should not be just based on expectations of a continued growth scenario among borrowers. This counter-cyclical approach would moderate booms of domestic bank lending which often exacerbate the impact of excessive surges of capital inflows. Where these surges of potentially reversible capital are excessive, it may also be appropriate for recipient countries to take measures to discourage them temporarily. Indeed, some countries(e.g. Chile and Colombia) have implemented measures (such as taxes and non-remunerated reserve requirements on flows during a fixed period) with this objective. Their aim has been threefold: ̈ decrease the share of short-term and potentially reversible flows, ̈ increase the autonomy of domestic monetary policy, ̈ help curb large over-valuation of the exchange rate. The major international financial institutions now explicitly recognise that market measures taken by recipient governments to discourage excessive short-term capital flows can play a positive role, if they are part of a package of policy measures that include sound macro-economic fundamentals as well as a strong and well regulated domestic financial system. b. The Financial Stability Forum The large scale of international funds – compared to the small size of developing country markets leads us to question whether measures to discourage excessive short-term capital inflows by recipient countries are enough to deal with capital surges and the risk of their reversal. Three strong reasons underpin the case for complementary international and source country action: ̈ Not all major recipient countries will be willing to discourage short-term capital inflows, and some may even encourage them. ̈ Even those recipient countries which have deployed a battery of measures to discourage short-term capital inflows have on occasions found these measures insufficient to stem very massive inflows. ̈ If attacks on their currencies make it difficult for countries to service their debt, official funding has to be provided. International private investors and creditors might simply continue to assume excessive risks, in the knowledge that they will be bailed out if the situation becomes critical. This is the classical moral hazard problem. The international financial crisis provoked a serious debate on how the surveillance and supervision of the international financial system could be strengthened in order to help prevent economic crises of this sort happening again in the future. At the more institutionally radical end of the scale, there have been proposals for the creation of a new international body such as a World Financial Authority(Eatwell and Taylor, in this issue) or a Board of Overseers of Major International Institutions and Markets(Kaufman, 1992 ). Such a body would have wide-ranging powers for the oversight of regulation and supervision globally. The other approach has been to develop existing institutional arrangements. Both the Canadian and the British government put forward proposals based on this approach in 1998 . In the aut u m n of 1998 , Chancellor Gordon Brown and Secretary of State Clare Short proposed a standing committee for global financial regulation to coordinate the multilateral surveillance of national financial systems, international capital flows and global systemic risk. It was proposed that the committee would bring together the World Bank, the IMF , the Basle Committee of the BIS and other regulatory bodies on a monthly basis to develop and implement ways to ensure that international standards for financial regulation and supervision were put in place and properly coordinated. In October 1998 , the G7 finance ministers and central bank governors asked Hans Tietmeyer, president of the Bundesbank, to develop the UK proposal and more generally consider the cooperation and coordination between the various international regulatory and supervisory bodies and to make recommendations for any new arrangements. Tietmeyer’s IPG 3/99 Griffith-Jones, New Financial Architecture 269

report, released in February 1999 , outlined areas where improvements to current arrangements were necessary, but stated that»Sweeping institutional changes are not needed to realise these improvements«(Tietmeyer, 1999 ). Instead it was proposed that a Financial Stability Forum, which would meet regularly to discuss issues affecting the global financial system and to identify actions needed to enhance stability, be convened. The Forum was formally endorsed by finance ministers and central bank governors from the G7 at their February meeting in Bonn. The Tietmeyer report outlined three main areas for improvement on current arrangements which have been highlighted by recent events in international financial markets: ̈ Efforts are needed to identify vulnerabilities in national and international financial systems and sources of systemic risk and to identify effective policies to mitigate them. ̈ Effective procedures are needed to ensure that international rules and standards of best practice are developed and implemented, and that gaps in standards are identified and filled. ̈ Improved arrangements are needed to ensure consistent international rules and arrangements across all types of financial institutions. The Financial Stability Forum will be limited in size to 35 members, in order to allow for an effective exchange of views and decision making. Each G7 country will have three representatives on the Forum, from the finance ministry, central bank and supervisory authority. The G7 stated that while the Forum will initially be limited to G7 countries, it is envisaged that other national authorities, including some from emerging market countries, will join the process at some stage. The IMF and the World Bank has two representatives each, as has the Basle Committee on Banking Supervision, the IOSCO and the International Association of Insurance Supervisors( IAIS ). The BIS , the OECD and the two BIS Committees all have one representative on the Forum. The setting up of the Financial Stability Forum is clearly a very necessary, positive first step towards enhancing the coordination of the various bodies which try to improve the way markets work. The Tietmeyer report succinctly analyses the deficiencies of the existing set of arrangements and draws what are almost certainly the right conclusions on where improvements need to be made. The question lies, however, in whether the Forum will be a representative enough and strong enough body to address all these issues. First, the omission of any developing country authorities in the initial years of the Forum appears to be a major error. Representation of developing countries on the Forum would be desirable for both legitimacy reasons, and because it would provide the body with a wider range of expertise and perspectives. Ways could easily be found to include developing countries without making the new Forum too large. If three developing countries representatives were included, the membership of the Forum would rise from 35 to 38 , that is by less than 10 %. Developing country representatives(e.g. from Central Banks or regulators) could for example be chosen on a regional basis; there could be one Asian, one Latin American and one African. These representatives could be appointed for a fairly short period(e.g. 2 years) and then rotated. This type of representation by developing countries has been working rather well in other contexts, for example in the Boards of the Bretton Woods institutions. Second, doubts have been voiced over the institutional strength of the new Financial Stability Forum. With a small secretariat in Basle, meetings only twice yearly, and no power of enforcement, will the Forum have the sufficient institutional muscle to deal with the tasks that have been identified? The setting up of the Forum represents a significant enhancement of the system of global regulation by agreement and peer pressure that has been shown to work reasonably well in the context of the Basle Committees of the BIS . International cooperation at the BIS has always been based on home country control, where sovereignty remains at the level of the nation-state, and agreements are reached through negotiation and then implemented, where necessary, through national legislation or regulation. Countries which are not represented at the Basle Committee have also adopted some of their directives(most notably, the capital adequacy standards). However, in the medium term, in a world of open financial markets, an international body with the power to make and enforce policy may well be needed(Eatwell, 1999 ). This would point towards a body more akin to some kind of World Financial Authority, which would be endowed with executive powers along 270 Griffith-Jones, New Financial Architecture IPG 3/99

the lines of a WTO for finance. In the meantime, however, the Financial Stability Forum is a very important step in the right direction. Time will tell whether this body is sufficient to promote international financial stability, and to fill the important gaps in financial regulation which undermine such stability. c. Regulatory gaps There are three categories of flows that seem insufficiently regulated and that have played a particularly prominent role in sparking off recent currency crises: ̈ short-term bank loans(particularly important in the Asian crisis); ̈ easily reversible portfolio flows, made by institutional investors, such as hedge funds(especially important in the Mexican peso crisis but also important in East Asia); ̈ activities by hedge funds, relating in particular to different types of derivatives. International bank loans are already regulated by industrial countries’ Central Banks; these national regulations are co-ordinated by the Basle Committee. However, existing regulations were not enough to discourage excessive short-term bank lending to several of the East Asian countries. A key reason was that until just before the crisis most of these East Asian countries were seen by everybody including regulators as creditworthy. Another, important reason seems to have been current regulatory practice. For example, for nonOECD countries loans of residual maturity of up to one year have a weighting of only 20 per cent for capital adequacy purposes, whilst loans of over one year have a weighting of 100 per cent for capital adequacy purposes. This was done to reflect the fact that it is easier for individual banks to pull out from renewing short-term loans. However, as a result of this rule, short-term lending is more profitable for international banks. Therefore, to the banks’ economic preference for lending short-term, especially in situations of perceived increased risk, is added a regulatory bias that also encourages shortterm lending. An overall increase in short-term loans, however, makes countries more vulnerable to currency crises and therefore, paradoxically, banks more vulnerable as well, to risk of non-payment. Therefore, a narrowing of the capital adequacy weighting differential may be desirable. As regards portfolio flows to emerging markets, there is at present no regulatory framework internationally, for taking account of market or credit risks on flows originating in institutional investors, such as mutual funds(and more broadly for flows originating in non-bank institutions). This important regulatory gap needs to be filled, both to protect retail investors in developed countries and developing countries from the negative effects of excessively large and potentially volatile portfolio flows(Griffith-Jones, 1998 ). However, the East Asian crisis confirms what was already clearly visible in the Mexican peso crisis. Institutional investors, like mutual funds, given the very liquid nature of their investments can play an important role in contributing to currency crises. It seems important, therefore, to introduce some regulation to discourage excessive surges of portfolio flows. This could perhaps best be achieved by a variable risk-weighted cash requirement for institutional investors, such as mutual funds. These cash requirements would be placed as interest-bearing deposits in commercial banks. Introducing a dynamic risk-weighted cash requirement for mutual funds(and perhaps other institutional investors) is in the mainstream of current regulatory thinking and would require that standards be provided by relevant regulatory authorities or agreed internationally. The guidelines for macro-economic risk, which would determine the cash requirement, would take into account such vulnerability variables as the ratio of a country’s current account deficit to GDP , the level of its short-term external liabilities to foreign exchange reserves, the fragility of the banking system, as well as other relevant country risk factors. It is important that quite sophisticated analysis is used, to avoid simplistic criteria which stigmatise countries unnecessarily. The views of the national Central Bank and the Treasury in the source countries and of the IMF and the BIS should be helpful in this respect. The securities regulators in source countries would be the most appropriate institutions to implement such regulations, which could be coordinated internationally by IOSCO . The fact that the level of required cash reserves would vary with the level of countries’ perceived »macro-economic risk« would make it relatively more profitable to invest more in countries with IPG 3/99 Griffith-Jones, New Financial Architecture 271

good fundamentals and relatively less profitable to invest in countries with more problematic macro or financial sector fundamentals. If these fundamentals in a country would deteriorate, investment would decline gradually, which hopefully would force an early correction of policy, and, a resumption of flows. Though the requirement for cash reserves on mutual funds’ assets invested in emerging markets could increase somewhat the cost of raising foreign capital for them, this would be compensated by the benefit of a more stable supply of funds, at a more stable cost. Furthermore, this smoothing of flows would hopefully discourage the massive and sudden reversal of flows that sparked off both the Mexican and the Asian crises. Given the dominant role and rapid growth of institutional investors in countries such as the US , the UK and France, this proposal – for a riskweighted cash requirement on mutual funds – could be adopted first in those countries, without creating significant competitive disadvantages. However, once implemented in that type of country, efforts to harmonise such measures internationally would need to be given urgent priority for global discussions at IOSCO , so as to prevent investments by mutual funds being channelled through other countries, and especially off-shore centres, that did not impose these cash requirements. Such IOSCO international guidelines would be formulated through international consultations similar to those employed by the Basle Committee in developing the»Core Principles for Effective Banking Supervision«. The guidelines could be developed by a working group consisting of representatives of the national securities’ regulatory authorities in source countries together with some representation from developing countries, in the context of IOSCO . Due account should be taken of relevant existing regulations, such as the European Commission’s Capital Adequacy Directive. Finally, it is important to stress that additional regulation of mutual funds should be consistent with regulation of other institutions(e.g. banks) and other potentially volatile flows. Careful analysis – both technical and institutional – is required on how hedge funds and other highly leveraged institutions can best be regulated to reduce their impact on magnifying volatility of capital flows, exchange rates and stock markets in developing countries. It is encouraging that there is a growing consensus, as reflected for example in the January 1999 Report by the Basle Committee on»Banking Supervision, on Banks’ Interactions with highly leveraged Institutions( HLI s)«, that HLI s can pose important risks both to direct creditors and, under certain market conditions, to the financial system as a whole. The impact of HLI s on magnifying volatility in developing countries – has not yet been sufficiently studied, nor have measures designed to deal specifically with this issue been proposed internationally. However, policy responses to address risks posed by HLI s to creditors and the financial system as a whole will also help reduce negative impact on developing countries. It is firstly important to stress that the problem does not just relate to hedge funds, but to other highly leveraged activities or institutions, such as proprietary desks of investment banks. HLI s can be defined as having three characteristics: ̈ they are subject to little or no regulatory oversight as a significant proportion operate through offshore centres, ̈ they are subject to limited disclosure requirements, and often their operations are very opaque, ̈ they take on significant leverage. There are three sets of responses that can be used to address risks posed by the HLI s. Often, they are presented as alternatives. However, it would seem better to consider them as complementary. The first response is indirect, through the major counter-parties of HLI s(mainly banks and securities houses). This can be done by promoting sounder practices in the way banks and securities houses assess risks when they deal with hedge funds and other HLI s. However, further actions by supervisory authorities also seem desirable. This refers, in particular to higher capital requirements on lending or other exposures of banks to HLI s, to reflect the higher risks involved in such exposures. It may also be desirable for supervisors to, either formally or informally, prohibit banks from lending to a particular class of risky counter-party. Such measures may not only protect banks, but could also possibly stimulate HLI s to manage risks in a more responsible way. A second avenue, which is clearly complementary to the first, is to increase transparency on total 272 Griffith-Jones, New Financial Architecture IPG 3/99

exposures to HLI s by all financial institutions. One possibility would be an extension of the concept of a credit register for bank loans(along the model of the French»central des risques«, which provides banks access to the aggregate amount of bank lending to each company). Such a register would collect, in a centralised place total exposures(both on and off balance-sheet positions) of different financial intermediaries to single counterparties, such as major hedge funds. Counterparties, supervisors and central banks(both of developed and developing countries) could then get information about total indebtedness of such institutions, which would help them assess risks involved far more precisely. For this purpose, the information would have to be both timely and meaningful (especially to take account of rapid shifts in HLI s positions). It would seem best if such a register would be based at the BIS itself or at the Basle Committee on the Global Financial System which already has experience in similar information gathering. A third avenue is to directly regulate hedge funds and other highly leveraged institutions. Such direct regulation could take a number of forms, including licensing requirements, minimum capital standards and minimum standards for risk management and control. In its recent report, the Basle Committee on Banking Regulation has argued that such a regulatory regime should focus on the potential to generate systemic risk by HLI activities due to their size and risk-taking. However, HLI s’ effects on the volatility of exchange rates in developing countries should also be addressed in attempts at their regulation. The most frequent argument against direct regulation of hedge funds is that they would be able to circumvent such regulations, because these institutions either are or could move easily offshore. However, if global supervision and regulation is genuinely accepted as essential in today’s world of globalised financial markets, there can be no justification for»no-go« areas, where such regulations could be evaded or undermined. Both as regards provision of information, and as regards global regulation of institutions such as hedge funds, it is essential that off-shore centres comply with international standards. If the G7 countries in particular backed this clearly, and if developing countries supported it, a political initiative in this respect should be both effective and useful. Measures to Improve Crisis Management Though prevention is far better than cure, if prevention fails and major currency crises do unfortunately occur, measures need to be in place to manage them as well as possible. Thus, measures for better crisis management – both nationally and internationally – are clearly complementary to measures for crisis prevention. National measures The policy options at a domestic level once a currency crisis explodes are very narrow, and the trade-offs very problematic. The standard response required by the markets, includes sharp increases in interest rates and significant fiscal tightening, the latter even in countries with fiscal surpluses. Rapid sharp rises in interest rates have been quite effective in some, but not in all, cases for preventing large currency depreciations. Interest rate increases seem to have been most effective when they are timely, sharp and temporary and when other measures(e.g. fiscal ones) are taken simultaneously or were previously in place. The effect of increased interest rates depends on whether they can restore confidence or not. If interest rates remain high for a significant period, they have very damaging and undesirable effects due to their recessionary impact on the real economy. This may contribute to second round negative effects on exchange rates. Account also needs to be taken of the specific features of individual economies, as for instance the high debt equity ratios in East Asian companies, which imply that increases in interest rates in East Asia were more likely to lead to companies’ insolvency than in other regions. As a consequence the transmission mechanism of contagion between the financial sector to the real economy was greater in East Asia than in Latin America or Russia. As regards fiscal tightening, it seems imIPG 3/99 Griffith-Jones, New Financial Architecture 273

portant to evaluate its relevance in contexts where budget deficits are not large or there are even budget surpluses. Sufficient international liquidity a. Improved and enhanced role for the IMF The first response internationally when a large currency crisis starts unfolding is to activate quickly a sufficiently large financing package to provide the important public good of stability. The key institution in this has been the International Monetary Fund, through its own resources and its catalytic role in attracting other resources, both public and private. In this context, it is a positive development that the IMF itself was given more resources, through an expansion of its quotas. To be effective for restoring confidence, the liquidity provided needs to be large. Therefore, complementary avenues for sufficient provision of early liquidity need to be explored. One possible modality is via enhanced central bank co-operative arrangements, through greatly enlarged swap arrangements. Another possible avenue is via precommitted stand-by arrangements with private banks, as Argentina and Mexico have recently done. However, these latter arrangements are still untested, and it is unclear how well they would operate in a severe crisis. The BIS could play an important role in co-ordinating the provision of liquidity by G10 Central Banks and private banks (as discussed below). Besides the crucial issue of scale of resources, other issues include: timing, conditionality and ways to avoid moral hazard. The issue of timing is important, as currency crises happen so quickly. Though the IMF and the international financial community have made important efforts to develop emergency procedures, the response to currency crises is still not fast enough. A currency crisis is able to unfold for a couple of weeks, before a financing package can be put in place. A great deal of damage can occur in that period. Due to contagion the crisis can spread rapidly to other countries. A solution worth considering is to have increasing recourse to IMF supported preventive programmes. This implies that a request for a country’s right to borrow from the IMF could be made well before a crisis happens, for example during the country’s Article IV consultations. The country would only draw on this facility if a crisis occurred, but could do so immediately. This would imply that the Fund would have a »shadow programme« with the country, including policy conditions that would make a currency crisis less likely; these would naturally be less stringent than would be called for in a crisis. Hopefully, the adoption of these measures would make the currency crisis less likely. However, if it still occurred, there would be no further conditionality as a pre-condition for immediate disbursement. The fact that Brazil had a sort of preventive package with the IMF (though it was agreed when the situation had already deteriorated significantly) and still had quite a large currency crisis does raise the question of whether preventive financing is enough to stop currency crises. The fact that IMF conditionality – in Brazil and elsewhere – was too deflationary, leading to economic contraction and to political resistance in the country, may have to some extent increased the probability of the crisis occurring. Therefore timeliness and appropriate conditionality need to be combined. An additional serious problem is that when such large volumes of IMF – as well as World Bank and Regional Development Bank – funding is channelled towards middle-income countries in crisis, funding available from those institutions for low-income countries can fall drastically. Moreover, sharp reversals in private capital flows have already created serious instability in lowincome countries. It is important that official support from the IMF and others should also be provided to»less important« countries in the same way as it is provided to»systemic threats« when they face identical difficulties. Pressure on the IMF to provide international liquidity will be less if there is more equitable burden sharing between public and private contributions. This makes it very important to develop orderly work-out procedures, which will reduce the required scale for international lending(as discussed below). A final issue is the nature of IMF conditionality that should accompany the large financial packages, linked to currency crises. A number of relevant criticisms have arisen of IMF conditionality in East Asia. Radelet and Sachs( 1998 ) have argued 274 Griffith-Jones, New Financial Architecture IPG 3/99

that some of the IMF conditionality(e.g. on bank closures, excessive tightening of fiscal policy) not only were inappropriate, but actually added to rather than ameliorated panic in international financial markets. Furthermore, Feldstein( 1998 ) has argued that IMF conditionality has been too intrusive and too comprehensive, trying to make dramatic changes in short periods. It is, therefore, crucial that IMF conditionality contributes to rebuild, and not undermine, markets’ confidence in countries. As far as possible, IMF conditionality should focus on macro-economic policies, and not be too intrusive and comprehensive. Only where more structural reforms are essential for confidence building, and can be effectively implemented in the short-run, should they be included as part of policy conditionality. Other structural reforms could be undertaken later, once stabilisation had been achieved and growth restored. b. Towards an international lender of last resort It would be highly desirable that improvements in global regulation be accompanied by steps towards an international lender of last resort. Just as the growth of domestic banking in the last century created the need for central banks to act as national lenders of last resort to prevent frequent crises, so at the end of the 20 th Century the rapid growth of global credit and capital markets and their extreme volatility poses the urgent need to develop steps towards an international lender of last resort. To be able to stop panic arising and spreading, a lender of last resort has to have the discretion to create any level of necessary liquidity. At a national level, central banks are the institutions that play this role, by providing as much liquidity as they consider necessary to private financial institutions – and especially banks – in trouble. At an international level, there is at present no global institution that performs such a function, nor is such liquidity available internationally. National financial institutions have on occasions played bilaterally the role of an international lender of last resort, as in the 1992 German Central Bank support for the French franc during the ERM crisis and in the 1995 US Treasury support to the Mexican government during the peso crisis. The IMF has increasingly become the main source of support to developing countries experiencing currency crises. However, the IMF – under its current mandate – is not a genuine international lender of last resort for several reasons. Firstly, and most importantly, the IMF cannot at present create unlimited liquidity. Secondly, the IMF lends to governments with conditions attached; an international lender of last resort would provide liquidity to countries in distress, at higher cost but without conditions. As a consequence, two separate institutional mechanisms could be envisaged. One would be an expanded and improved IMF , along the lines discussed above. The other would be a complementary facility for unconditional official lending. At a later stage, when a global central bank develops, it could become institutionalised. In the meantime it could be based on G10 Central Bank facilities, possibly combined with private sector lending. The BIS , which is and should increasingly play an ever increasing role in global financial regulation would also be very well placed to play a key coordinating role for rapidly assembling financial packages by G10 Central Banks, combined where feasible with private credit lines, to countries in currency crises, that have not been caused by countries’ policy mistakes, and that are thus not required to have changes in policy. Therefore, there would be three categories of situations. ̈ There would be countries which, during Article IV consultations with the IMF were deemed by the Fund to have good policies. If these countries had a run on their currency, and a crisis started to unfold, a non-conditional financial package would be assembled by the BIS , drawing possibly on its own resources, but mainly on those of G10 Central Banks and, if feasible, on private lending. ̈ There would be countries which during Article IV consultations with the IMF had agreed a »shadow programme« of conditionality with the IMF (see above). If the economic authorities implemented the programme fully, and a crisis still broke out, the IMF would disburse automatically(without additional conditionality). If a bigger package was necessary, the BIS could help co-ordinate additional financing from G10 Central Banks and private banks. ̈ There would be countries which, during Article IV consultations, did not want to accept a IPG 3/99 Griffith-Jones, New Financial Architecture 275

»shadow programme« with the IMF , and did not improve their policies. If these countries were hit by a currency crisis, they would have to go as a first step to the Fund for conditional lending. Such a procedure would provide very strong incentives for countries to have good policies, either implemented on their own or under a Fund »shadow programme«; this should make crises less likely. If, nevertheless, crises did occur, then large lending facilities by the IMF and / or lending by Central Banks and commercial banks co-ordinated by the BIS would be disbursed quickly and without additional conditionality. The role of the IMF conditionality would be greater in the preventing crises phase, but smaller in the managing crisis phase. As a result, its conditionality could be less draconian(in terms of growth) and thus less controversial. Orderly debt workouts The larger scale of capital flows to emerging market countries in recent years means that official funds can no longer be relied upon to offset the private outflows during a crisis. Moreover, the scale of the recent IMF -led rescue packages in Asia and Brazil have led to increased concern over the issue of moral hazard. The perception that official resources will be made available should a country experience difficulty in meeting its financial obligations can distort the incentives to both creditors and debtors. This moral hazard is particularly strong on the lenders’ side, as lenders and investors are spared from having to bear the full risks of their investment decisions by IMF -led bailouts. The need to reduce moral hazard does not, however, imply that the official sector has no role in the resolution of financial crises. The problems involved in collective action, and the risk of contagion are clear justification for official intervention in crises. Still, ways need to be found to encourage a greater assumption of risk by the private sector, as well as to involve the private sector at an early stage in crisis resolution in order to achieve equitable burden sharing vis-à-vis the official sector. One of the G22 working groups, assembled in 1998 , reviewed some of the proposals which appeared in a G10 report, produced in the wake of the Mexican peso crisis, which examined ways to deal with sovereign liquidity crises(Group of Ten, 1996 ). One issue common to both reports is the importance of promoting orderly arrangements to co-ordinate debtors and creditors in the event of a crisis. Difficulties associated with creditor co-ordination, particularly the creditor»grabrace« in which actions taken by individual creditors in pursuit of their self-interest can disrupt orderly debt workouts, can reduce the potential resources available to all creditors and help create a situation of panic. The greater diversity of recent capital flows to emerging market countries, with a more heterogeneous set of international creditors than in the past, has also added to the difficulties of coordinating debt workouts. The G22 group put forward the proposal that certain contractual clauses could be incorporated into sovereign bonds issued in foreign offerings. Such clauses would: ̈ provide for the collective representation of debt holders in the event of a crisis, ̈ allow for qualified majority voting to alter the terms and conditions of contracts, and ̈ require the sharing among creditors of assets received from the debtor. These clauses would encourage dialogue between debtors and creditors, as well as among creditors, and prevent a minority of dissident investors from holding up settlement. This would therefore facilitate a more orderly resolution of crises. The G22 report also examines alternative ways of achieving standstill-type arrangements. Countries, the report states, should make every effort to meet the conditions of all debt contracts in full and on time. However, in certain cases, a temporary suspension of payments may be a necessary part of the crisis resolution process. In such cases, a voluntary, co-operative and orderly restructuring, combined with a programme of reforms, constitutes the most efficient means of crisis resolution. An orderly and co-operative restructuring process would be aided by»an enhanced framework for future crisis management« 1 that would allow the international community to signal its approval of a temporary payments suspension by providing 1. See point 4.9 of the report of The Working Group on International Financial Crises. 276 Griffith-Jones, New Financial Architecture IPG 3/99

financial support to the crisis country. This signal would only be provided where the international community believed the government’s decision to suspend debt payments was the only reasonable course open to it, that the government is implementing a strong programme of policy reform, and that it is making every effort to reach agreement with creditors. Lending in such circumstances provides the IMF with the opportunity to manage a crisis by signalling confidence in the debtor country’s policies and longer-term prospects, and indicating to unpaid creditors that their interests would best be served by reaching agreement with the debtor quickly. Governments that impose a standstill as part of a process of co-operative and non-confrontational debt renegotiation, it is argued, would be unlikely to be penalised by creditors. The G22 report stops short of supporting proposals to provide sovereign debtors with greater formal protection from legal action by creditors during a payments suspension. It does not see this as feasible, and regards the general issue of protection from legal action as one requiring further consideration. One important concern often raised is that any mechanisms which would make it easier for borrowers to default on their financial obligations, even with the support of the international community, could make it harder for borrowing countries, and possibly emerging markets generally, to access international capital in the long-term or, at least, increase their cost of borrowing. The counter-argument is, that financial crises, like the one which began in Asia in the summer of 1997 , drastically reduces the access of affected countries to international capital and, when they can borrow, sends their borrowing costs sky-high. Similarly, some argue that payment standstills may spark off contagion; if markets get wind of a payments suspension in one emerging market economy, they may well pull out of other markets perceived to be»similar« in some way. This argument may well have validity, but the absence of declared payments suspensions during the early months of the Asian crisis did not stop contagion sweeping through East Asia. Another objection voiced over orderly workout procedures designed to assist countries which are forced to declare a temporary payments standstill is based on moral hazard. If countries can default on their debts with official blessing, it is feared, false incentives will be provided to borrow imprudently. However, moral hazard for borrowing countries would be limited by the painful experience of crises, and by the strict conditionality that the IMF currently imposes on lending in such circumstances. Furthermore, the possibility of a suspension of payments would reduce the moral hazard that encourages lenders to lend too much in the expectation that they will be bailed out by an IMF -led rescue should things go wrong. The search for more effective ways to manage financial crises remains a priority as, although prevention is undoubtedly better than cure, crises will never be eliminated altogether. The standard crisis response, which concentrates on imposing tough stabilisation measures on debtors, has contributed to undermine growth, as well as dramatically increase poverty, in the countries affected by the crisis. The lengthy negotiations to agree debt restructuring in Indonesia provides a potent example of the failings of the present arrangements. The absence of an adequate framework for crisis management has meant that valuable time was wasted in Asia, and crises which may well have been short-term liquidity crises at the outset became full blown economic, financial and social crises. ̇ References Agosin M. 1996, »El retorno de los capitales extranjeros a Chile« El Trimestre Económico, Mexico. Akyuz Y. 1998 ,»The East Asian Financial Crisis: Back to the Future?« http: // www.unicc.org / unctad / en / pressrefprasia 98 .htm. Bagehot W. 1873, Lombard Street: A Description of the Money Market(London, Reprinted John Murray, 1917) . Bank for International Settlements( BIS ) 1995 , 65 th Annual Report(Basle, BIS ). Boorman J. 1998 ,»Reflections on the Asian Crisis: Causes, Culprits, and Consequences«, paper prepared for the FONDAD conference on»Coping with financial crises in developing and transition countries: regulatory and supervisory challenges in a new era of global finance«, March 1998. Budnevich C. and Le Fort G. 1997, Capital account regulations and macro-economic policy: two Latin American experiences, Banco Central de Chile. March. Documento de Trabajo 06 . Santiago, Chile. Camdessus M. 1998 a,»Is the Asian Crisis Over?«, Address by Michel Camdessus at the National Press Club, April 2 1988 , Washington DC . http: // www.imf.org / external / np / speeches /1998/040298. htm IPG 3/99 Griffith-Jones, New Financial Architecture 277

Camdessus M. 1998 b,»Capital Account Liberalization and the Role of the Fund«, Remarks by Michel Camdessus at the IMF Seminar on Capital Account Liberalization, March 9 1998 , Washington DC http: // www.imf.org / external / np / speeches /1998/030998. htm Chote R. 1998 ,»Crystal Balls in Washington«, Financial Times, April 17, 1998 , p 19 . Corsetti, Giancarlo; Pesenti, Paolo; Roubini, Nouriel; 1998 ,»What caused the Asian currency and financial crisis?«, http: // www.stern.nyu.edu / ~nroubini / asia / AsianCrisis. pdf Eatwell J. 1999 ,»Brown achieves first step towards global stability«, The Observer, 28 February, 1999 . Eatwell J. and Taylor, L. 1998 ,»Towards an Effective Regulation of International Capital Markets«, Internationale Politik und Gesellschaft – International Politics and Society 3/ 99 . Eichengreen B. and Portes R. 1995 , Crisis? What Crisis? Orderly Workouts for Sovereign Debtors(London, CEPR ). 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Motamen(eds), International debt and central banking in the 1980 s(London, Macmillan). Group of Ten 1996 , The Resolution of Sovereign Liquidity Crises, A Report to the Ministers and Governors prepared under the auspices of the Deputies, May 1996 . IMF 1998 , Toward a Framework for Financial Stability, Prepared by a Staff Team led by D. Folkerts-Landau and C.-J. Lindgren(Washington, International Monetary Fund). IMF 1997 , World Economic Outlook: Interim Assessment, December 1997 (Washington, International Monetary Fund). IMF 1995 , International Capital Markets: Developments, Prospects and Key Policy Issues(Washington, International Monetary Fund). Interim Committee of the Board of Governors of the IMF 1998, Communiqué, April 16, 1998 . http: // www.imf.org / external / np / cm /1998/041698 a.htm Kaul I., Grunberg I., and Ul Haq M.(eds) 1996 , The Tobin Tax: Coping with Financial Volatility(New York, Oxford University Press). Kenen P. 1996 ,»The Feasibility of Taxing Foreign Exchange Transactions«, in I. Kaul, I. Grunberg and M. Ul Haq(eds) The Tobin Tax: Coping with Financial Volatility(New York, Oxford University Press). Keynes J. M. 1936 , The General Theory of Employment, Interest and Money,(Cambridge University Press, Cambridge). Khan M. and Reinhart C. 1995 ,»Macro-economic management in APEC economies; the response to capital flows«, in M. Khan and C. Reinhart(eds) Capital Flows in the APEC region. Occasional paper 122 , IMF, Washington, March. Mishkin F. 1996, »Understanding financial crises: a developing country perspective«, Proceedings of the World Bank Annual Conference on Development Economics, pp 29–77. McKinnon R. 1991 , The order of economic liberalisation: Financial control in the transition to a market economy, (Johns Hopkins, University Press, Baltimore). Obstfeld M. 1995 ,»International currency experience: new lessons and lessons relearned«, Brookings Papers on Economic Activity, No 2 , p 119–220 . Phillips S. 1998 ,»Risk weighted regulation«. Paper presented at FONDAD Conference, Holland, March. Radelet S. and Sachs J. 1998 ,»The Onset of the East Asian Financial Crisis«, 1 ST draft, 10 February 1998 . Rodrik D. 1998 ,»Who Needs Capital Account Convertibility?«, University of Harvard http: // www.nber.org / ~drodrik / essay.pdf Soros G. 1997 ,»Avoiding a Breakdown«, Financial Times, 31 December 1997 , p 12 . Stiglitz J. 1994 ,»The role of the state in financial markets«, Proceedings of the World Bank Annual Conference on Development Economics, IBRD , p 19–61. 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JOHN EATWELL / LANCE TAYLOR Towards an Effective Regulation of International Capital Markets* T he fundamental objective of all financial policy is to ensure the best possible outcome in the real economy. In this respect the simplistic complaint that the financial sector produces nothing by itself contains an element of truth. But it is only a small element. In a complex economy, with widespread division of labor through products, space and time, a sophisticated financial sector is necessary for the organization of production and distribution. An international financial system is necessary to sustain world trade and investment. An economy without money markets would not work at all. The mobilization of large quantities of capital, and the allocation of that capital to profitable investments is the device that has transformed standards of living throughout the world in the past 200 years. Financial institutions must therefore be judged by the contribution they make to that process and hence to growth and employment. There is no point in having a financial sector that is in some sense»efficient« in its own terms if the result is a less efficient real economy. Over the past year the persistent economic crisis in Asia has called into question much of the received wisdom that liberalization has enhanced the economic contribution of international capital markets. The Asian crisis is but the most recent example of other similar episodes: the financial crises in Latin America in the early 1980 s, the European exchange rate crises of 1992 , and the Mexican bond crisis of 1994 . The explanations offered for these severe disruptions are various; indeed each crisis has a set of local explanatory factors. But they also have a common element – the impact of highly liquid international capital markets. These recurring episodes, most of which involve severe costs in terms of unemployment, loss of real income, and even stagnation, pose important questions for policy-makers: ̈ Given that every crisis has its own specific characteristics, what do their common factors suggest about particular strategies in international financial policy? ̈ Should the ubiquitous policy stance of the past three decades in favor of international financial liberalization be qualified in the light of experience? If so, how? ̈ Is any consistent policy toward financial markets, other than liberalization, practically possible? Or can the genie never be put back into the bottle? The succession of financial crisis in the past 20 years, the scale of what is happening now in Asia, and the reverberations of the Asian problems throughout the word, suggest that there is an urgent demand for answers to these questions. Increasingly, financial crises are not»local«. They have worldwide systemic implications. Satisfactory answers will require a clear and convincing theoretical and empirical characterization of the relationship between financial liberalization and economic performance. For without such a widely shared characterization it will be almost impossible to formulate an internationally acceptable policy stance, even at the most general level. It is the objective of this article to present the skeleton of such a characterization, and to draw from the argument a number of specific policy recommendations. These are neccessarily tentative. If there is anything economists should have learned from the experience of the past two years, it is humility! Nonetheless, in distinctly un-humble manner, we believe the arguments presented here do provide an intellectual framework that might guide practical and successful reform. * The analysis in this article draws heavily on papers written by participants in a project on International Capital Markets and the Future of Economic Policy, organized by the Center for Economic Policy Analysis at the New School for Social Research and supported by the Ford Foundation. IPG 3/99 Eatwell/ Taylor, Regulation of International Capital Markets 279

The Argument in Brief International capital market liberalization began in the late 1950 s when American and British banking authorities permitted external Eurocurrency credit markets to emerge, beyond their regulatory control. However, the crucial change came in the early 1970 s with the collapse of the Bretton Woods system of fixed exchange rates buttressed by capital controls of varying effectiveness. With that collapse, foreign exchange risk, previously borne by the public sector, was privatized. The assumption of forex risk by the private sector required the dismantling of exchange controls to permit the hedging of risk, and so precipitated the development of the plethora of new financial instruments and the explosion of trading which characterize present day financial markets. Together with increased private sector risk went increased opportunity for profit: from the provision of risk-bearing services, from the potential for speculative profit inherent in fluctuating exchange rates, and, of course, from the extensive new opportunities for profitable arbitrage. Combined with domestic pressures for the removal of financial controls, the collapse of Bretton Woods was a significant factor driving the worldwide deregulation of financial systems. Exchange controls were abolished. Domestic restrictions on cross-market access for financial institutions were scrapped. Quantitative controls on the growth of credit were eliminated, and monetary policy was now conducted predominantly through the management of short-term interest rates. A highly geared global market in monetary instruments was created. Today the scale of activity in this market dwarfs payments associated with foreign trade. Daily flows approach 10 % of the world’s annual GDP . In stark contrast to most domestic financial markts, it is largely unregulated. Financial liberalization and the massive increase in financial flows have undoubtedly brought some benefits to some countries at some times. Flows of investment toward emerging markets were seen, in the early 1990 s, as a welcome replacement for official development financing. The relaxation of external capital constraints led to increases in growth and reductions in inflation. However, the overall economic record of the post-liberalization period, 1970 to the present, is less satisfactory. There has been the series of severe financial crises. But as well as these shocks and the associated losses in real income, trend growth rates have slowed throughout the world. In every G– 7 economy trend growth in the 1980 s and 1990 s has slowed to around two-thirds of the rate in the 1960 s. In developing countries taken as a whole the average rate of growth has also slowed, to roughly the same extent. Even prior to the current crisis in East and Southeast Asia, trend growth per capita slowed in four out of seven of the region’s major economies. The fundamental point at issue is what might be the connection between international financial liberalization and this widespread deterioration in performance. It has become the conventional wisdom that trend performance is determined by »the structure of the real economy«. From this perspective, financial factors may result in severe shocks and significant deviations from trend, but will not alter the underlying performance of the economy. Financial factors will not change the fundamentals. The only qualification of this separation of real and monetary phenomena is that liberalization, by removing financial imperfections, should improve trend performance. An alternative view is that financial institutions do indeed affect the medium- to long-term trend performance of the economy. Liberalization not only increases the likelihood of shocks, it also alters the fundamentals. Hence financial factors can effect the medium-term characteristics of the economy. They could be the factors behind the poor trend performance observed in many economies, as well as periodic crises. Three factors have forged a link between liberalization and low growth: volatility, contagion and changes in public and private sector behavior. ̈ Liberalization has undoubtedly resulted in financial markets becoming more volatile, whether measured by short term swings in exchange rates and interest rates, or the longer swings such as that in the real value of the dollar from an index of 100 in 1980 , to 135 in 1985 , down to 94 in 1990 , and up again to 134 in 1998 . Volatile financial markets generate economic inefficiencies. Volatility creates financial risk, and even if facilities exist for hedging that risk, the cost of capital formation is raised. The impact of financial market volatility is felt not only in Latin 280 Eatwell/ Taylor, Regulation of International Capital Markets IPG 3/99

America and East Asia. In the face of higher and more volatile real interest rates, US corporate defaults have increased enormously since the earl 1970 s. ̈ The damage done by financial volatility is not confined to countries with real economic imbalances – volatility is contagious. The Mexican bond crisis of 1994 propagated the»tequila effect« throughout Latin America. The Asia financial crisis has spread throughout emergingmarkets, including Eastern Europe, Latin America, and South Africa. The stock market crash of 1987 spread rapidly from New York to all financial markets. A recent study of the 1992 ERM crisis(Buiter, Corsetti and Pesenti, 1998 ) has concluded that systemic contagion makes the link between domestic macroeconomic conditions and the size of currency devaluations, let alone the likelihood of a crisis,»tenuous«. Indeed, the link may even have the»wrong« sign, with the financially virtuous suffering the greater punishment! ̈ It will be argued below, that the volatility, contagion, and hence uncertainty associated with liberal financial markets have not only imposed short-term shocks on the real economy of affected countries and regions, but have in fact led to changes in trend performance by inducing changes in behavior in both public and private sectors. That there has been a significant change in public sector behavior is incontestable, and that change is typically attributed to the»discipline« imposed on governments by the international financial markets. In contrast to the 1950 s and 1960 s when public sector objectives were typically expressed in terms of employment and growth, objectives are now defined in terms of financial and monetary targets, typically summarized as»macroeconomic discipline«. It is clearly true that lack of macroeconomic discipline is no way to secure sustainable growth. But what is most striking about the superior economic performance of the 1960 s, when objectives were customarily defined in terms of growth and employment, is that fiscal balances typically displayed lower deficits than has been the case since liberalization, and, indeed, fiscal surpluses were not uncommon(Matthews, 1968 ). The reason for this outcome was, of course, the interdependence between public sector and private sector balances. High levels of investment by the private sector, encouraged by a public sector commitment to growth and employment, in turn resulted in healthy fiscal balances, a result reinforced by relatively small current account deficits. Macroeconomic discipline is a necessary component of sustained economic growth. Burgeoning fiscal deficits and high and rising inflation will undermine any growth strategy. But discipline needs to be associated with a public sector commitment to high levels of investment and employment. Small fiscal deficits, or even fiscal surpluses, may be more readily achieved when private sector investment is encouraged both by the financial environment and by public sector commitment to employment. If private sector investment is discouraged by an absence of public sector commitment to the high levels of employment and growth, fiscal prudence may be combined with recession. Three elements link international financial liberalization to this change in public sector behavior: the potential threat posed to financial stability and the real economy by large capital flows, the belief that those flows are motivated by a particular view of»sound finance«, and the additional belief that contagious financial crises may strike without warning. As the Bank for International Settlements( 1995 ) has argued:»In the financial landscape which has been emerging over the past two decades, the likelihood of extreme price movements may well be greater and their consequences in all probability further reaching. ...At the macro level, the new landscape puts a premium on policies conducive to financial discipline. Strategically, a firm longer-term focus on price stability is the best safeguard, one which can only be achieved with the support of fiscal discipline«. However, the BIS then warns,»yet such a safeguard is by no means always effective«. The identification of changed behavior in the private sector is more problematic. Ratios of investment to GDP have typically been lower in all countries since liberalization, suggesting a fall in private sector confidence. More specifically, defaults on US corporate bonds, which were at an all time low in the 1950 s and 1960 s, have increased significantly since the early 1970 s. This finding may be explained by higher and more volatile real interest rates post1970 . Unsurprisingly, US businIPG 3/99 Eatwell/ Taylor, Regulation of International Capital Markets 281

ess failures, which were also low in the 1950 s and 1960 s have been much higher since, and are correlated with high real interest rates and high debtequity ratios. These patterns suggest, at very least, a less propitious climate for investment. A decline in confidence in the private sector would also produce an increase desire for the opportunity of exit, further reinforcing the possibility of extreme swings in market sentiment which inflict both short-term and long-term damage. These negative effects are reinforced by the emergence of pro-cyclical forces associated with liberalization. The ability of governments to moderate cyclical forces by monetary policy has been severely diminished both by international liberalization and by the shift in corporate finance from the banks to the securities market. The result is that all monetary policy is now focused on manipulating the demand for money via major swings in increasingly high short-term interest rates, damaging private sector investment. In developing countries, the recent round of crises has been associated with clearly destabilizing behavior by the private sector. The tell-tale signs included rapidly rising ratios of foreign and domestic debt to GDP as a consequence of external deficits readily financed by capital inflows(at least for a time), together with maturity and currency imbalances in national balance sheets. Standard market practices pushed local financial sectors toward taking long positions in domestic assets and short positions in foreign holdings. A private sector build-up of foreign currency borrowing (without proper hedging, despite the alleged ability of international capital markts to provide such services) was an immediate precursor of both the Mexican and East Asian crises. It was abetted by pro-cyclical financial regulation. Finally, the macroeconomic effects of liberalization can generate instability on a global scale. Industrialized economies can be destabilized by imbalances between flows and stocks induced by capital movements, although the time spans are likely to be longer and institutional responses more robust than those recently observed in Latin America, Eastern Europe and Asia. In the case of the major economies there can be important feedbacks from national developments to the global system: Does the major borrower or lender, for example, behave in stabilizing or destabilizing fashion? What are its own weak points in terms of changes in stocks and flows? Such situations evolve over time. It seems likely that when imbalances emerge they are lagging indicators of the more fundamental processes which international financial liberalisation has set in train. It follows that the global system can be at substantial»market risk«, in the phrase that regulators use for dangers transcending mere price fluctuations. If international financial liberalization has indeed led to a change both in the environment for investment and in public and private sector attitudes toward investment and has resulted in the mutually reinforcing hurt of severe swings in market sentiment and a general deterioration in medium-term confidence, then a deterioration in rates of growth and levels of employment is to be expected. The Policy Challenge The policy challenge is clear: Is it possible to secure the benefits of a flexible financial system, capable of mobilizing capital on a large scale, whilst at the same time ensuring that national economies and the wider world economy are protected from the systemic risks which financial liberalization brings in its wake? The basic components of a new international financial order may be gleaned from the above analytical sketch: ̈ Since international financial liberalization results in a major increase in risk to both the national and the international real economy, an effective policy toward capital markets must be international in character. That is in the best interests of all. ̈ The performance of international financial institutions should be assessed in terms of their contribution to growth and stability of the real economy. ̈ Financial stability requires an effective lender of last resort. ̈ Efficient regulation is a necessary condition for there to be an effective lender of last resort. ̈ In the face of the sheer scale of capital movements today an international financial policy will only be possible if there is a high degree of mutually reinforcing co-operation between national monetary and financial authorities. 282 Eatwell/ Taylor, Regulation of International Capital Markets IPG 3/99

̈ The international economy is made up of national economies at widely differing levels of development in both real and financial sectors. It is most improbable that one simple policy prescription will be appropriate to all. National policies must be respected and supported within the context of an overall international financial framework. A blanket commitment to liberalization, openness, and transparency will end in failure, and will endanger the development of the international market economy. ̈ It is a commonplace, accepted by virtually all, that national financial markets should be regulated. But once financial markets are open there is no meaningful distinction between the operations of national markets and the international market. Thus the regulatory principles which apply to the former also apply to the latter. The objectives of national regulator are consumer protection, the maintenance of the highest possible standards of integrity, market conduct and professional skills in the financial services industry, and the minimization of systemic risk. These should be the objectives of international financial regulation. ̈ The predominant task of international financial regulation is to minimize systemic risk arising from the operations of securities and futures markets. At the same time, the regulator must avoid the creation of moral hazard. It is vital to guard against the failure of firms endangering the effective operation of the market as a whole. Yet securities firms that make bad judgements must be allowed to fail. ̈ The demands of international financial regulation cannot be coped with by purely co-operative structures. A new international regulatory entity with appropriate powers is required. An agreed framework should link that entity and national regulatory structures which will play a vital component part. The history of the modern world economy teaches us that the disadvantages of the spread of liberal financial markets can be offset by sensible public intervention. After all the 25 years after World War II were characterized by strategic liberalization within a controlled international environment, and by the enjoyment of the highest rates of growth and employment in modern times. But in recent years indiscriminate deregulation has dominated domestic and international economic policy, and re-regulation has been in political disfavor. The Asian crisis should have changed all that. Some commentators continue to seek explanations of the crisis in the peculiar characteristics of the Asian economies – the same characteristics which a year or two ago were typically lauded for their contribution to the Asian miracle. But increasingly, economic policy-makers are recognizing the global risks inherent in international liberalization. The political equation will certainly change if western markets crash or global macro performance deteriorates significantly. It would be better to revise the system to avoid such misfortunes before they happen. Proposed Reforms The reforms proposed here are not supposed to be definitive. Rather they are proposed in order to provide a starting point for subsequent debate and development. These reforms would, we believe, substantially improve real economic performance, reduce systemic risk, and significantly diminish the likelihood of collapse. The overall objective of these proposals is to arrive at a pragmatic consideration of the relationship between capital market liberalization and economic performance, and to create an institutional framework that can put such a pragmatic consideration into effect. If liberal financial markets are not to be perceived as imposing unacceptable costs on national economic performance, then markets must be regulated. If necessary restrictions must be placed on capital flows, national governments must have the opportunity to exercise control over the opening of their own capital markets. Nothing brings liberal financial structures into disrepute so much as the spectacle of national economies being forced into recession by»contagion« effects that bear no relation to their real economic circumstances. The success of Chilean and Chinese restrictions on short-term capital movements in limiting the damaging impact of contagion has been a salutary lesson. The creation of an international body within which national policies on market openness can be debated and co-ordinated provides a route, perhaps the best route, to maintaining the beneIPG 3/99 Eatwell/ Taylor, Regulation of International Capital Markets 283

fits of liberal financial markets whilst minimizing the costs. The international body would also have the responsibility, in co-operation with national authorities, for directing and maintaining international regulatory structures. It was the Bank for International Settlements ( BIS ) which pioneered international financial regulation with the formation of the Committee on Bank Supervision and Regulation in 1975 . It was that Committee which formulated the capital adequacy requirements for banks in the 1980 s to which all 13 then BIS members agreed to adhere and use as a tool to keep foreign banks who did not adhere out of their markets. The result was that countries voluntarily signed on to BIS requirements in order to achieve market credibility. The BIS has also sponsored a tripartite committee of banking, securities and insurance regulators to propose regulatory standards for financial conglomerates. The International Organization of Securities Commissions( IOSCO ) is the forum within which national regulators are developing common standards, and developing techniques of cross-border regulation. But IOSCO is essentially a co-operative organisation. This is not enough. An executive authority with surveillance capabilities is required. The World Trade Organization( WTO ) illustrates that it is possible to establish an international executive authority with enforcement powers. The key task will be to devise a set of arrangements geared to the maintenance of national and international financial stability, and supportive of high levels of growth and employment. A World Financial Authority We propose that a World Financial Authority ( WFA ) be established. This organization would be complementary to the WTO . A central task of the WFA is the development of policies to manage systemic risk. The objectives of the WFA should include the requirement to pursue policies to maintain high rates of growth and employment. It would be the task of the WFA both to develop rules which would ensure the adoption of best regulatory practice and effective risk management procedures, and to oversee the development of a credible guarantor and lender of last resort function. It will therefore need to build on the achievements of IOSCO to develop a framework for international financial regulation(including risk management procedures) and to ensure, via the powers ceded to it, that those rules are implemented. But the WFA should not simply be a body that develops and imposes regulatory procedures. It should also be a forum within which the rules of international financial co-operation are developed and implemented. Many of the goals of an efficient international financial policy can be achieved by effective co-ordination of the activities of national monetary authorities. The problem is that the means of achieving that co-ordination are, at the moment, very limited. The WFA will fill that gap. It will also be the responsibility of the WFA to ensure that once national polices have been agreed by the WFA , states support each other’s national policies. It is that mutual support which is the key to success. The WFA should also be given the responsibility of ensuring transparency and accountability on the part of international financial institutions such as the IMF and the World Bank. There is at present no systematic evaluation of the activities of the Bretton Woods institutions, and this lacuna may well have contributed to the damaging criticism that the IMF in particular is imposing an essentially political program in the guise of technical conditionality. Martin Feldstein, for example, has argued that the IMF »should not use the opportunity to impose other economic changes that, however helpful they may be, are not necessary to deal with the balance of payments problem and are the proper responsibility of the country’s own political system«. Making the Bretton Woods institutions accountable to the WFA would introduce a»safety valve« of evaluation and accountability that would make the IMF more effective. Finally, the WFA should provide the necessary regulatory framework within which the IMF can develop as an effective lender of last resort. In many countries the WFA would simply certify that domestic regulatory procedures are effective. In those countries in which financial regulation is unsatisfactory, and which would therefore not have access to the IMF in a financial crisis, the WFA would assist with regulatory reform. It is clear that there is no appetite today(especially in Washington) for the creation of a new 284 Eatwell/ Taylor, Regulation of International Capital Markets IPG 3/99

international bureaucracy. Fortunately, the infrastructure for the WFA already exists in the form of the BIS and the co-operative cross-border regulatory framework already developed by IOSCO . With the backing of international agreement, adequate resources, and surveillance»teeth«, these institutions could be developed into the needed world authority. A Reorganized IMF The IMF should be reorganized to take responsibility on behalf of the WFA for co-ordinating and partially funding international rescue operations when the need arises and when WFA -approved regulatory procedures are in place. There should be explicit consideration of how the IMF procedures should be developed to deal with problems of liquidity, and the development of a lender-oflast-resort function. For example, the IMF could develop procedures to ensure that in the case of liquidity crises creditors should be»bailed-in« to support the rescue rather than have their own positions»bailed-out«. Whilst reducing systemic risk, care should be taken to minimize moral hazard. To the extent that creditors are protected, this should be at not insignificant cost. Most importantly, rescues should be based on prompt injections of liquidity instead of the current disastrous policy of prolonged attempts to restructure national economic systems using conditionalityladen credit disbursement as bait. A Refocused World Bank The World Bank should direct its lending activities towards poorer countries unlikely to get access to open credit markets, subject to oversight from the WFA . It should also act as a co-ordinator and guarantor for a new global closed-end investment fund for emerging markets, a task completely in accord with the powers and functions incorporated in the Bank’s charter. The fund could be capitalized by purchasing and holding government securities of the industrial countries in proportion to its shares held by residents of these countries. It would concentrate on long-term investments in the production of goods and services in developing countries, rather than short-term portfolio placements. The fund’s shares could be bought and sold freely in many markets and many currencies. Although its share values would fluctuate, the fund would not be forced to sell off its underlying portfolio in the event of a downswing. This would protect emerging markets from abrupt fluctuations in capital movements of the sort observed in Mexico, East Asia, and elsewhere, reducing the need for capital controls. The creation of such a fund should improve the efficiency of investment by significantly reducing the cost of information needed by investors to put together balanced and diversified portfolios. The Role of National Authorities Governments should be required by the WFA to improve control of national financial systems by imposing risk-weighted capital and / or reserve requirements on all major institutions, banks, mutual funds, insurance and pension funds, for all on-shore and off-shore and on-balance sheet and off-balance sheet operations(recognizing how difficult the identification of some of these operations may be). It should be recognized that traditional notions of capital adequacy monitoring are seriously inadequate in today’s capital markts. Capital is no substitute for effective management. Risk management should be central to regulatory activity, internalising, as far as may be possible, risk externalities, though the authorities will need to be aware of the pro-cyclical nature of risk assessment by firms. Particular attention should be paid to the management of foreign exchange risk. The goals of the development of a new financial framework are to give the authorities leverage over both the supply and demand sides of credit markets, and to prevent imbalances in which national financial systems have long internal and short external net positions or blatant stock-flow disequilibrium positions. The former task will take some of the pressure off short-term interest rates and limit the pro-cyclical consequences of a monetary policy that is directed only at the demand side. The latter task will reduce systemic risk by focusing more attention than at present to system-wide implications of individuals agents’ attempts to take profits as well as hedge and insure their portfolios. IPG 3/99 Eatwell/ Taylor, Regulation of International Capital Markets 285

The Management of Capital Movements The experience of the past twenty years has demonstrated that complete liberalization is inefficient. Unmanaged financial markets are too prone to volatility and contagion to provide the stable financial framework necessary for high rates of growth and employment. Instead, a regulated international system, operating through a WFA will create the possibility of securing the benefits of capital mobility, whilst diminishing the costs. Indeed, such management is necessary if there is not to be a swing back to widespread protectionism. Campaigns to rewrite the IMF articles to require full capital market liberalization by all nations, and OECD proposal to write full capital liberalization requirements into a multilateral agreement on investment, are without sound intellectual foundation and should be abandoned. National governments, after appropriate consultations with the WFA , should be empowered to impose restrictions on external capital movements as they see fit. Effective controls, particularly on short-term capital inflows may well be necessary if free trade in goods and services is to be sustained. Yet there is a significant difference between limiting short-capital flows into a country, and closing markets to foreign goods. In the latter case a country may attempt to acquire a beggar-my-neighbor advantage. The same argument does not apply to the former case. So the usual requirement of regulatory capital and reserve ratios imposed on firms may be supplemented with quantitative or taxbased obstacles to cross-border flows of funds. Whilst there should be a presumption in favor of national policies, the form, scale and duration of such restrictions(which may, if necessary, be deemed permanent) should, however, be determined in consultations with the WFA . Once particular conditions for the management of capital movement have been agreed then member states of the WFA should be required to provide assistance to fellow members in their operation. Financial Insurance To diminish the damaging effects of moral hazard on institutional decision making, national compulsory deposit insurance and similar financial guarantee insurance systems should be associated with individuals and households rather than institutions. ̇ References Papers prepared for the International Capital Markets and the Future of Economic Policy project (most are available on the website: www. newschool.edu/cepa). Blecker, Robert( 1998 ). International capital mobility, macroeconomic imbalances, and the risk of global contraction. Block, Thorsten( 1998 a). Financial market liberalization and the changing character of corporate governance. Block Thorsten( 1998 b). The gold standard, financial markets, and the Great Depression. Corbett, Jenny, and David Vines( 1998 ). The Asian crisis: competing explanations. D’Arista, Jane( 1998 ). Financial regulation in a liberalized global environment. Eatwell, John, and Lance Taylor( 1998 ). The performance of international capital markets. Frenkel, Roberto( 1998 ). Capital market liberalization and economic performance in Latin America. Galbraith, James, William Darity Jr., and Lu Jiaqing ( 1998 ). Measuring the evolution of inequality in the global economy. Neftci, Salih( 1998 ). FX short positions, balance sheets, and financial turbulence: an interpretation of the Asian financial crisis. Singh, Ajit( 1998 ).»Asian capitalism« and the financial crisis. Taylor, Lance( 1998 ). Lax public sector, destabilizing private sector: origins of capital market crises. Other references Bank for International Settlements( BIS )( 1995 ). 65 th Annual Report, Basle. Buiter, Willem, Giancarlo Corsetti, and Paolo Pesenti ( 1998 ). Interpreting the ERM Crisis: Country-Specific and Systemic Issues, Princeton Studies in International Finance, no. 84 , Princeton University, Princeton, New Jersey. Clinton, William( 1998 ). Remarks by the President to the Council on Foreign Relations, New York, September 14 th , 1998 . Greenspan, Alan( 1997 ). Globalization of Finance, remarks, delivered at the 15 th Annual Monetary Conference of the Cato Institute, Washington, D.C . October 14 th , 1997 . Matthews, Robin.( 1968 ).»Why has Britain had full employment since the War?« Economic Journal. 286 Eatwell/ Taylor, Regulation of International Capital Markets IPG 3/99

JOHN STEINBRUNER The Consequences of Kosovo T he humanitarian catastrophe in Kosovo has been contained by the international ground intervention initiated in June, and for the immediate victims, that is a vital accomplishment in the most literal sense of the word. It is also a precedent of considerable promise for the Balkan region and for many other parts of the world afflicted with endemic communal violence. The full consequences of this episode are still to be determined, however, and the prospects of a constructive outcome are seriously endangered by reverberations that have not yet been acknowledged let alone mastered. It is prudent to assume that the violence inflicted and the resentment implanted have put the viability of coherent government into question throughout the area and that political reconstruction will require an effort well beyond anything yet designed. It is quite evident that NATO ’s bombing campaign crystallized a sense of threat in Russia likely to affect the massive internal transformation occurring there, and Russia’s acute sensitivity is reflected in quieter form throughout the world. The engagement of the most capable alliance with a small dissident state is necessarily a matter that commands global attention. General lessons will be drawn from this experience. The fundamental conditions of international security will be reshaped as the extended outcome unfolds. It is of course difficult to discern what the extended outcome will be five years or a decade hence. A judicious combination of humility and courage is undoubtedly the prime qualification for attempting such a judgment. For those who dare to try, however, there are plausible grounds both for hope and for fear. A broadly constructive outcome to the Kosovo episode is conceivable, but it will require some remedial correction of the egregious mismatch between ends and means that threatened the NATO operation right up to the point that it succeeded. That in turn will require the most difficult of political feats – a recognition by the immediate victors of their own contribution to the catastrophe. Alternatively a cascading disaster is also conceivable, particularly if the ever powerful impulse for belligerent self-justification overcomes the practical interest in refined accommodation. It is customary in these situations to assume that results will fall somewhere in the murky middle, as does frequently happen. But in attempting to understand what has already occurred and to shape the extended outcome, it is important to explore the coherent edges of the situation before attempting to contend with its bewildering and demoralizing ambiguities. Developing a Constructive Outcome The document that now provides the legal basis for intervention in Kosovo, UN Security Council resolution 1244 , proclaims that violent displacement of the civilian population is a threat to international peace and security and thereby enables the assertive use of force under Chapter VII of the Charter. It specifically authorizes both an international military»presence« in the province and an international civil administration, in effect imposing comprehensive international authority in Kosovo to be exercised until an indigenous government can be established on the basis of legitimate consensus. Under the terms of the resolution all armed units within the province are to be effectively subordinated to international authority, and all segments of the population are to be given equal protection. The nominal sovereignty of Yugoslavia is acknowledged in principle, but the actual exercise of it has been categorically and indefinitely suspended. Those provisions represent an assertion of international responsibility going well beyond the standards of recent decades. If the international community had been willing to assert such decisive IPG 3/99 Steinbruner, The Consequences of Kosovo 287

responsibility earlier, many lives could have been spared and much of the social devastation prevented. If the principle is to be effectively enacted from this point forward and especially if it is to be extended to other instances, then its implementation clearly will require greater refinement than has accompanied its emergence. Resolution 1244 provides the foundations for a broadly constructive outcome, but the actual result is still to be achieved. The unusually assertive features of the resolution indicate that there has been a significant evolution of international attitudes over the course of the crisis. Prevailing opinion in most societies seems to have registered the systematic brutalization of civilians in Kosovo as a significant threat to their own well-being and seems to have absorbed the implication that minimum essential features of human civilization must be defended everywhere if they are to be preserved anywhere. Certainly the major governments did in the end endorse a greater degree of involvement than they were willing to accept a year ago. Even China, provoked by the bombing of its Belgrade embassy and clearly alarmed by any doctrine of international intervention, withheld its potential veto. And even rabid isolationists in the United States Congress did not make any major attempt to contest what promises to be a very lengthy commitment. It is perhaps too early to declare that apparent shift in sentiment to be an enduring accomplishment, but it does suggest that a new stage of political consciousness may be emerging. If the basic principle of international responsibility is in fact accepted, then a more penetrating understanding of its implications might follow. It might be possible to question, for example, whether the radical breakdown of legal order in Kosovo was so exclusively the work of Slobodan Milosevic that he can be assigned the preponderant blame. Convenient as it is to have a central demon to prosecute and guilty of criminal brutality as Milosevic does appear to be, the dynamic of violence that has engulfed Kosovo has almost certainly been generated by much more extensive causes. He could have prevented the social disaster that has occurred had he pursued policies of political accommodation rather than divisive repression extending back over a decade. The international community might have induced such policies had it made a dedicated effort to do so throughout the Balkan region. But those possibilities have long since been forfeited. The amount of violence that has been inflicted and the massive grievances that have accumulated have generated an endemic pattern of conflict defined in ethnic terms that is almost certainly beyond the capacity of any of the indigenous leaders to control with the means at their disposal. Particularly for future reference, it is important to question whether it was appropriate to conduct a bombing campaign for the purpose of securing Milosevic’s permission to enter Kosovo. From the outset there was never any reasonable prospect that air bombardment could protect the civilian population. The process of intimidation and expulsion to which they were subjected was conducted by small units whose most relevant actions could not be detected by remote observation and at any rate were too intricately interspersed with their victims to be controlled by that means. Even at the highest standards of feasible performance, air power cannot be directly applied to the fine scale of violence entailed, and the commitment to use it therefore required the indirect theories of effect that were applied – the general assault on the military establishment and civilian infrastructure of Yugoslavia rationalized as coercive pressure on the political leadership. Previous efforts of that sort have never been rapidly decisive and have always produced substantial social damage of their own. Since this one culminated in acquiescence, it is being hailed by those who conducted it as an exception, but that judgment will assuredly be contested in retrospect. The general bombing campaign did a great deal of damage but did not have any apparently decisive physical effect and appears to have done more to rally than to undermine immediate political support for the Milosevic government, as has happened in most previous instances. Agreement on resolution 1244 came at a moment when the air campaign was inflicting its highest levels of damage in Yugoslav units in Kosovo, but that was enabled by the fact that KLA ground operations had forced concentration of their forces. Moreover, NATO at that moment was observably beginning to contemplate a ground operation of its own, and that prospect is an alternative explanation for the timing of Milosevic’s acquiescence. As an issue of fact, it is a fair pre288 Steinbruner, The Consequences of Kosovo IPG 3/99

sumption that air bombardment intensified the danger to Kosovo’s population in the initial stages and it is not evident that it actually achieved the eventual agreement. As an issue of principle, it is highly questionable whether that agreement would justify the air campaign even if it were assigned full credit. In effect, the air operation accepted civilian casualties to prevent military ones and did so at an implicit rate of 1000 to 1 or even more. That is not a practice that could ever be resumed in Kosovo or defended in any other instance. If it is admitted that blame cannot be encapsulated and that the result so far achieved is not a triumph of air power but a failure of prevention, then it is more likely that the hard realities of the situation will be acknowledged and some serious efforts made to respond to them. The burden of restoring a shattered civil order in Kosovo will primarily fall on the international community for an indefinite period of time and that burden will have to be carried in comprehensive and equitable detail. There is no political formula currently available that could plausibly generate a consensual government. It is emotionally and politically tempting to impose the claims of the victimized Albanian majority on the Serbian minority heavily implicated in violence, but that is not a means of stable reconstruction. The neglect of minority rights has been a consistent theme in all the violent episodes that have accompanied the breakup of Yugoslavia, and it would be inexcusable to reiterate that failure. The international military force in Kosovo and the civil administration associated with it will have to accept primary responsibility for assuring that police functions, public services and judicial processes are all performed in an effective and equitable manner and will not be able to devolve that responsibility to an indigenous government until the political basis for it is reliably established. The necessary conditions, moreover, involve a great deal more than physical reconstruction and the safe return of refugees. The genesis of the conflict, it must be presumed, has a something to do with the endemic austerity and economic isolation of the entire region, and reliable regeneration of civil order will require substantial improvement in those chronic conditions. Indeed an outcome that is truly constructive in the sense that more good than harm is eventually done depends primarily on overcoming the historical separation of the Balkan region from the rest of Europe. Such an effort would have to be organized and financed on an international basis. The communities emerging from the Kosovo crisis will not themselves have adequate resources for reconstruction on that scale. They will require debt relief and new credit, but even more they will need much greater market access than has ever been granted to the Balkan region. One can take some hope in the fact that the theme of economic reconstruction appears in the background documents incorporated in resolution 1244 . A»comprehensive approach to the economic development and stabilization of the crisis region« was one of the seven general principles advanced by the G– 8 foreign ministers in a statement that was attached to the resolution. But obviously it remains to be seen whether that theme will be developed to the unprecedented extent that a truly constructive outcome would require. Understanding the Deeper Dangers On the pessimistic side of the spectrum, the most common speculation about how the disaster in Kosovo might be compounded centers, naturally enough, on the immediate region. It is all too readily imaginable that a massively aggrieved Albanian diaspora not successfully settled back into Kosovo might introduce into the Balkans some variation of the extended pattern of conflict associated with the displacement of Palestinians in the Middle East. It is also conceivable that the two situations might reinforce each other, might be mutually reinforced as well by the Kurdish insurgency in Turkey and Iraq, and might in combination infect the entire area with an endemic level of violence that would virtually preclude stable democratic government in most of the affected states. That in turn might so inflame the many interstate tensions within the region that the entire situation becomes a constant source of communal violence with periodic outbreaks of active warfare – a political equivalent of the AIDS epidemic. None of the security policies currently in effect or currently being contemplated could be expected to cope with that situation. IPG 3/99 Steinbruner, The Consequences of Kosovo 289

But unsettling as that possibility certainly is, it is not the exclusive danger and probably not even the predominant one. The potential effects on Russia are yet more ominous simply because the situation in Russia is itself more ominous even though it is less immediately visible or at any rate less explicitly recognized. That is not because a general Balkan conflagration is likely to spread directly to Russia or because Russia could be expected to be aggressively involved in it. Both of those things could occur, but they would probably be marginal complications of the Balkan problem. The much greater danger is that the Kosovo crisis might so thoroughly entrench a siege mentality within the entire Russian political system and so decisively preempt policies of constructive engagement that the internal crisis within Russia itself reaches explosive proportions. The path to comprehension of that problem begins with appreciation of some very stark economic facts. The aggregate Russian economy is extremely small for a society of 150 million people. Annual GDP is on the order of$ 165 billion at current exchange rates, and it has declined by roughly half over the history of the Russian Federation. That process of decline is driven by deeply ingrained structural defects that have not even been measured let alone addressed by any reform program yet developed within Russia or anywhere else. The limited segment of the economy that produces products of economic value under international market conditions – largely oil, gas and other resource commodities – is being utilized to sustain a larger component of the manufacturing sector whose products are less valuable in economic terms than the resources they consume. That practice, which has been systematically preserved through a pattern of barter trade, protects nominal employment and the many basic community services traditionally provided by manufacturing enterprises and is politically compelling for that reason. It does not generate productive investment, however, and it retards rather than facilitates the adjustment to market discipline necessary to support such investment. The longer it is sustained the more ruinous it will be in economic terms. At some point, presumably, a natural limit would be reached where the minimum requirements of economic subsistence could not be met and the fundamental elements of social coherence would come into question. There is no guarantee and in fact no reason to believe that such a limit would automatically produce a process of productive regeneration without conscious design. The Russian government embedded in this situation quite simply does not have the financial resources to perform any of its basic functions, and no amount of political will or procedural reform could alone provide them. Its nominal budget for the current year is 500 billion rubles – the equivalent of$ 20 billion at current exchange rates. Cash tax receipts are currently running at an annual rate somewhere between$ 8 and 12 billion. Debt service requirements alone are$ 17 billion for the year. There is no prospect that those debt requirements or any other major obligation can be met. As a result of that evident fact Russia is effectively severed from access to any new international credit. The consequences for the military establishment are extreme. It does not have adequate financial resources to perform any of its traditional security missions and is being subjected to an inexorable process of internal decay that brings its basic ability to preserve internal coherence into question. The limited forms of international collaboration in which it participates do not provide any material assistance in performing its core missions or any reliable assurance that those missions would not have to be performed. It stands in implicit confrontation with an expanding NATO , and most of its embryonic mechanisms of cooperation with the alliance have been suspended in reaction to the air campaign against Serbia. That campaign was received as evidence of a stark threat to Russia itself, and it is quite unrealistic to imagine that any amount of diplomatic visitation or rhetorical reassurance could overturn that impression. In Russia’s reading of the historical record, NATO has reneged on political promises not to expand eastward after German unification and not to initiate offensive operations outside of its treaty area. That perceived record of betrayal will effectively eliminate for quite some time the ability of NATO to provide credible reassurance to Russia. It is reasonably predictable that Russia will attempt to enhance its military investment in response to the Kosovo episode. That will almost certainly be seen as a security imperative 290 Steinbruner, The Consequences of Kosovo IPG 3/99

and probably presented as strategy of industrial development as well. It may well put the entire process of formal arms control into indefinite suspension. In suitably modest form that reaction might well have a helpful settling effect within Russia by preventing more extremist reactions, but it involves two major longer term dangers. Russia is even less able than was the Soviet Union to support active military confrontation with the rest of the world. A sustained effort to do so could readily preempt the very extensive form of economic engagement that clearly will be necessary to extract the country from its deep and enduring economic crisis. And yet more ominously a military investment program operating under severe financial restriction can be expected to put heavy reliance on nuclear weapons to cover not only core deterrent functions but also the major missions normally assigned to conventional forces. That in turn would further entrench the inherently unsafe operational practice of depending on rapid reaction to attack warning in order to compensate for physical vulnerability of the deterrent force. Those developments would make the pattern of military deployment in Europe a great deal less benign than has been commonly assumed over the past decade – not because of any impulse for aggression but rather for the far more serious reason that the extreme desperation of one side is not comprehended by the other. Extracting the Lessons As best anyone can yet judge, the ultimate consequences of the Kosovo crisis are still to be determined and will depend upon actions yet to be taken. The meaning of the event will be much more apparent in retrospect and emotionally easier to absorb than it is at the moment. One cannot postpone the effort to extract major lessons, however, since that will necessarily be a guiding feature of the efforts that must be made to devise a tolerably safe and reasonably constructive result. And the most fundamental of the lessons, it is immediately important to recognize, have to do with the scope of responsibility and the determination of interest – the underlying themes reflected in resolution 1244 . A disaster of the magnitude that has occurred in Kosovo inevitably evokes the ever powerful human instinct to assign blame and to indulge in recrimination. Fearing that instinct, all those who might be said to be responsible are currently very eager to deflect preponderant blame and to promote an interpretation of the event that enables them to do so. To the extent that the violence in Kosovo can be attributed to the individual criminals who clearly have been at work there and to historical animosities indigenous to the local cultures, the burden can be lifted from everyone else who has been involved. The deeper truth, however, is that there is plenty of blame to be shared. Massive crimes have occurred because there has been a systematic failure of prevention just as epidemics of infectious disease occur when there is a breakdown in public hygiene. Containing the catastrophe in Kosovo is closely related to determining what would have avoided it. Even without the full power of retrospect, there is ample evidence available to address that question. The egregious brutalization of the Kosovo population has had many recent precursors within the region and throughout the world. The artillery assaults on Dubrovnik and Vukovar in 1991 , the systematic expulsions conducted by all the ethnic communities in Bosnia from 1992 to 1995 and the mass execution of Muslim men by Serb militia in Srebrenica in 1995 set direct precedents, with some of the same people involved. The genocidal slaughter of the Tutsi population in Rwanda in 1994 demonstrated the danger on a yet greater scale. The members of NATO and of the international community generally tolerated these actions, were implicated in them and ratified the results despite the fact that in every case, it is now recognized, there was sufficient immediate warning of the incipient violence to have been able to prevent it. The level of effort and degree of risk entailed would not have been greater than that incurred in reacting belatedly to the consequences. Moreover all of these episodes emerged after a lengthy process of internal social deterioration that could have been substantially mitigated had the resources eventually devoted to reaction been provided in anticipation. The strong international interest in preventing massive communal violence eventually surfaced in reaction to these events but not until it was too late to act effectively. If we are to avoid an indefinitely continuing repeat of that misjudgment, it is vitally important IPG 3/99 Steinbruner, The Consequences of Kosovo 291

that this interest be more assertively formulated and more effectively defended. In a spontaneously globalizing economy with intensifying interactions across cultures and an inexorable diffusion of technology, common standards of law are of truly critical significance. They are the only plausible means of preserving fundamental order in a world that assuredly will not have any other form of comprehensive government any time soon. By their very nature the common standards able to provide this organizing effect would have to be equitably applied across all differences of culture, history, ethnicity, national sentiment or any other human distinction, and they would have to be assertively defended on a global basis. There is scope for reasonable argument about the content of such standards but not about the murder, rape, robbery and arbitrary expulsion that has occurred in Kosovo. Such actions are not consistent with any legitimate claim to sovereign authority and present a severe practical threat to the international community as a whole. It is a compelling international interest to restore them whenever they have broken down to the extent that they have in Kosovo, and for that reason it is a compelling interest as well to act both in immediate and in more distant anticipation of such a breakdown. Realistically it would require extensive and time-consuming effort to work out all the detailed specification that would have to accompany a doctrine of assertive international responsibility for fundamental legal standards. Obviously the world as a whole is at best at an early stage of that effort. But for exactly that reason it is important to recognize that the intervention in Kosovo is an occasion for intensifying that effort and that Russia is an even more critical venue. As a practical matter, most of the current citizens of Europe can reasonably expect to survive whatever ultimately happens in Kosovo. They cannot afford to be so assured about whatever happens in Russia and cannot consider current efforts there to be even remotely adequate. Practical Aspirations It is not plausible to expect that a decisively constructive outcome could be fashioned rapidly in either case. The level of political leadership and the degree of public responsiveness that would be required have not been demonstrated over the lengthy gestation of the overall crisis, and such qualities do not appear without notice. A stable political settlement in Kosovo, a credible program of economic engagement with the Balkan region and a comprehensive economic and security program for Russia all undoubtedly lie beyond a fiveyear horizon. But fortunately there is also no obvious reason to believe that the situation will generate some violent explosion of volcanic proportions within that time. The larger opportunities and the major dangers both appear to be longer term matters. There probably is time to rise to the occasion. The evolution of the international operation in Kosovo will inevitably be an immediate test of major significance. If the operation is primarily concerned with minimizing the immediate effort and perceived risk for those who conduct it, then it might well gravitate to some implicit partitioning of the province despite the current denial of that intention. That method would allow the intervening force to concentrate its efforts on maintaining the boundaries of separation between Serbian and Albanian communities and to limit its involvement in their internal affairs. It is the primary method that has in fact been applied in Bosnia, despite the nominal vision of a unified state advanced in the Dayton agreement, and it is quite explicitly the method used since 1974 to control conflict between the Greek and Turkish populations on Cyprus. The record, as most would read it, suggests that a minimized effort of that sort does control active communal violence, but it does not provide for social reconstruction and it must be indefinitely sustained. One can argue that an effort of that sort in Kosovo would be sufficient to provide immediate relief for the Kosovars and to contain the worst dangers of a regional conflagration, but it is very dubious that it would provide the basis for a constructive trend. Such a result would have to be welcomed but is hardly an occasion for celebration. As with many things, immediate effort can only be minimized at the cost of longer term risk. In the admittedly less probable event that immediate intervention in Kosovo is systematically conducted with longer term reconstruction in mind, as the G– 8 statement suggests it should 292 Steinbruner, The Consequences of Kosovo IPG 3/99

be, then it must not only preserve the nominal administrative integrity of the province but must assertively promote direct engagement and consensual collaboration between the communities rather than their functional separation. That specifically means suppressing the militia leaders on both sides, who can be counted on to assert themselves as aggressively as they are allowed, while actively recruiting the more accommodating personalities who are generally the political victims of a violent conflict. That would unquestionably involve a more intrusive effort of greater scope – not merely the patrolling of a cease-fire line but the assertive reconstruction of an integrated civil order. Thus a dedicated program would have to be undertaken to replace damaged infrastructure, both private homes and public services, on an equitable basis across the ethnic divisions of the population. Similarly the critical matter of reestablishing police functions and the judicial process in which they are embedded would have to be accomplished on a reliably equitable basis. The principle and effective practice of equitable management would be as important as the direct results of pacification and reconstruction. In order to conduct a more expansive effort of this sort the intervening parties would undoubtedly have to develop an appropriately refined distinction between the international responsibility to protect universal legal standards and the indigenous right to determine sovereign authority. In that sense the exercise would be more demanding. In terms of actual resource commitments and risk over time, however, a more expansive exercise can plausibly claim to be less costly. The difference between an effort that is imagined to have minimal requirements and one that is more demanding in its aspirations is largely conceptual. The latter clearly entails higher standards and a more advanced form of political consciousness, but it can certainly be expected to save lives and probably money as well. An intervention of this more expansive sort is much more likely to set a constructive trend that would eventually enable it to be phased out. As for the yet larger matter of reassuring Russia, perhaps the most important immediate aspiration is simply that of setting a credible rule that henceforth remote bombardment of the sort undertaken by NATO against Yugoslavia can only be undertaken by explicit authorization of the UN Security Council. The initial NATO operation was not an acceptable exercise of the right of self defense, even though the objective in question can be said to fit that category. It is truly imperative for all the members of NATO , the United States foremost among them, to align their collectively predominant military capacities with international standards of legal procedure. Otherwise they will create incentives for the development of countervailing capabilities that could be extremely dangerous over time. Again, acts of desperation are far more dangerous to the dominant alliance than the massive acts of deliberate aggression it was originally formed to prevent. If the alliance is to do more good than harm, then it must come to understand that basic fact better than it currently does. ̇ IPG 3/99 Steinbruner, The Consequences of Kosovo 293

THOMAS MEYER The Third Way at the Crossroads T he term Third Way in its most recent use was coined in 1992 by a group of policy consultants to Bill Clinton and taken over by Tony Blair and his intellectual aids with new emphasis half a decade later in order to brand a new centre-left approach to what they consider the inevitable new challenges of economic globalisation. It is by its authors understood as the opening move for a new wave of revisionism which aims at a new synthesis between traditional social democracy and liberalism in some of the key fields of social reform such as governance, welfare state, education, political culture and job creation in a new economy. The very brand-name and the new direction of political thinking for which it stands have proved highly controversial in the short time since they have entered the political arena. A Renewed Synthesis Between Socialism and Liberalism When the first wave of revisionism in the history of socialism occured a few years before the turn of the new century, Eduard Bernstein who had been its chief promoter declared it to be in essence a synthesis between the socialist heritage and liberalism. This interpretation was accurate in three different aspects: firstly, the revisionist brand of socialism – later called democratic socialism or social democracy – advanced an unambiguous acceptance of liberal democracy as the political framework for each further step of social reform. Secondly, the liberal principle of openness, pluralism, provisionality and tolerance was applied to socialism itself; and thirdly, the liberal concepts of free market and private ownership of the means of production were reconsidered and to a certain extent – within a dense framework of social control and responsibility – adapted to the basic values and overall objectives of democratic socialism. It would be a meaningful and highly informative endeavour to renarrate the whole history of socialism as a sequence of ever renewed steps towards actualised forms of syntheses between liberalism and socialism prompted either by changes in social, economic and political reality itself or the perception of them by the mainstream socialists – and the constant rejection of such a synthesis by dogmatic socialists and communists. Revisionist socialism as contrary to the dogmatic version of marxism, from its very outset, always has seen itself as an open process of learning from reality, from the results of its own endeavours in the different fields of society, but abiding without compromise by the basic values of freedom, justice and solidarity as the unchangeable guidelines for its reform programmes. Since the beginning of the 20 th century, in the eyes of mainstream revisionist socialists it was a truism that there is a substantial difference between the basic values of democratic socialism with its overall objectives and the actual means and tools of social change, which could bring society closer towards them. Even Karl Kautsky, a proponent of democratic marxism in German social democracy, as early as 1919 in an argument with Lenin and his idea of communism put this most important difference in unambiguous terms. We are, he said, in favour of the socialisation of the means of production, because we are convinced that they are the best means to create a society of equal liberty. If someone were to convince us tomorrow that this is not the case, we would have to discard the idea of socialisation without reluctance if we want to stay firm with our genuine objectives and basic values. 1 In this sense the political philosophy of social democracy had developed from dogmatism to value guided pragmatism. 1 . Cf. K. Kautsky: Die Diktatur des Proletariats, Wien 1918 . S. 4 f. 294 Meyer, The Third Way at the Crossroads IPG 3/99

The Godesberg Program of the SPD in 1959 makes this difference very clear. There are, however, some organisational and institutional means which are so directly and inseparably linked with the basic values that they can be considered as almost as basic and constant as the basic values themselves, such as democracy, pluralism, human rights, social security and workers participation. In the field of economy there has been constant strife within the socialist movement in almost every single Western nation concerning the social limits to private property, the forms of those limits and the limits to market economy and its forms. It was, however, always clear that market and private property are not basic values in themselves but only, within a certain framework of participation and social responsibility, appropriate means which can serve the ends of social democracy in a better way than the socialisation of the means of production and central state planning. It is thus neither a surprise nor a deviation from the traditions of revisionist mainstream socialism in Europe, when the key advocates of the Third Way argue that in an era of globalisation, it is time now for a new synthesis between social democracy and liberalism, or even neo-liberalism. With respect to the philosophy of revisionist social democracy there cannot be anything wrong with such an endeavour. The question, however, is which synthesis of social democracy and liberalism in the world of today will serve the ends of social democracy in the most appropriate manner. Social democracy could not survive in a highly complex and changing world if it rejected the ideas of pragmatism with respect to the means of its project and of permanent revisionism with respect to theories and hypotheses which guide its interpretation of the present world and its selection of the instruments and means of its policies. Third Ways The term»Third Way« is evidently without a welldefined meaning. Even in the history of socialism it was used in a variety of different situations for a variety of different purposes. The Austro-Marxists made use of it between the wars in order to strengthen the endeavours to find a way between Bolshevism and Socialism combining the best of both in order to develop a realistic strategy to gain the objectives of socialism in a world where forces like communism, fascism and big capital prevailed. After World War II , democratic socialism in Europe just declared itself to be a third way, the better way between the two extremes of untamed capitalism and dogmatic communism. In the years after World War II , the term was frequently made use of, meant to find an orientation between the two big emerging superpowers. In 1968 , during the short Spring of Prague, Ota Sik and others developed the project of a market socialism beyond communist central planning and private property dominated market systems, and called it in their turn»third way«. The term was used generally within the tradition of democratic socialism, however, with time, even extreme adversaries such as Franco fascism in Spain found the brandname suitable. Most recently, Tony Blair, following Clinton and his consultants, forwarded the idea to reanimate the term the third way in order to designate endeavours to shape a new synthesis between traditional social democracy and a neoliberalism which for too long, though not without a rationale, has dominated the discussions and to a certain degree also the policies of most western countries during the last two decades. Strategically the term is meant to bring social democratic thinking back into the offensive by adopting some of the most attractive ideas of neoliberalism. Those who are picking up the term and taking on this challenge spans from the think tanks associated with the Clinton administration in Washington, to those designing the intellectual message of Blair’s politics to some politicians and intellectuals on the continent who have started to join the project, in Germany, the label The New Middle – Die neue Mitte – has been declared by some as the full equivalent to the Third Way. Thus, it cannot be surprising that the project is yet rather vague and, as Tony Blair sees it, so far merely defined through some basic values, utterly a resolution to be pragmatic in order to find appropriate means to implement them in the world of today. This is coupled with the conviction that some of the ideals of neoliberalism concerning globalisation, the dominating roles of markets and the need for rethinking governance and renovating the welfare state will have to play a prominent IPG 3/99 Meyer, The Third Way at the Crossroads 295

role in this new pragmatic mixture of means and instruments which constitute the basic values in the world of today. 2 There can be no doubt that this effort in itself is legitimate and necessary, given the new economic, social and political problems which emerge in the wake of globalisation and the dissolution of the traditional socialist milieus in all democratic societies of today. The issue, however, is which synthesis best combines the basic values of social democracy with the functional requirements of today. In Europe the emerging discussion on the Third Way revolves around the Tony Blair success story and its foundations. Confusion has been created by a lack of proper distinction between the different layers and dimensions in Blair’s own genuine project which serves as a paradigm for what the new third way could or should be. In an amazingly short span of time Blair has pushed through a three-layered revolution in the British Labour Party which until then had been the embodiment of traditionalism amongst the various European social democratic parties. The first layer of the Blair revolution was the arrival at a Godesberg type of social democracy in which traditional ideas of the socialisation of the means of production are replaced by commitment to basic values and the party programme is opened up to pragmatic ideas about the role of markets, private property and the state in the economic process. In the British context, this was a major achievement which paved the way for regaining majority acceptance and an innovative and offensive role for the Labour Party in the current political arena. Secondly, this breakthrough towards Godesberg was accompanied by a very radical type of Clintonisation of the political communication on the part of the strategic apex of the Labour Party which subordinated everything else including the party discourse, the role of the party and even the parliamentary Labour group under the rule of the perceived necessities of successful media communication of the party leader’s image and his symbolic project. The term»designer socialism« as it has been coined by critics of this dimension of the Blair revolution may be an exaggeration, yet it covers a good deal of this innovation. The image of the leader hero, the selection of the issues and the design of the way they are presented to the media, the discipline of the party and all the actors beneath the strategic apex have not only created a new way to conduct politics but also a new type of relationship between the social democratic party, its members, its leadership and its relation with society as a whole. Therefore, it cannot be seen as a change in marketing and communication only, it is rather a substantially new type of defining the role of the party in the process of formulating and implementing policies – it amounts to a new type of media-democracy. The third layer of the Blair revolution is concerned with the closer issues of what is covered by the label»Third Way«: the adoption of many substantial parts of neo-liberalism into the project of social democracy. In the particular situation of Great Britain, where a comparatively radical type of neoliberalism has shaped the country during almost two decades, the courage, the resolution and maybe even the electoral necessity to go unprecedentedly far in that direction seem to be unique. This is why the Blair revolution and its transferability to other countries needs and deserves thorough discussion. Given the scope and the depth of the Blair revolution with respect to all three discernable layers, Blair’s claim to having created»New Labour« with a new political identity clearly and demonstratively distinguished from»old Labour« is fully justified. Since the foundation of the First Socialist International in 1864 , it has always been the hope of the democratic Left to organise a worldwide cooperation of the individual national forces which represented it and to create sufficient convergence at the programmatic level with respect to the key issues. It is therefore very pertinent to start, in a process of globalisation, a worldwide discourse on a Third Way for social democracy whatever the differences in the starting positions and the traditions of the various social democratic parties and groups might be. It is worthwhile to learn from each other in order to come to a new understanding of what social democracy means in the world today, to regain the offensive position in today’s debates. Such an understanding could possibly provide the centre-left parties with com2. T. Blair: The Third Way. New Politics for the New Century. Fabian Pamphlet 588. London 1998 . 296 Meyer, The Third Way at the Crossroads IPG 3/99

mon ground for coordinated action in order to cope politically with the challenges of globalisation. This above all seems to be the opportunity and the promise of the Third Way discourse. Basic Features of the Blair Project The main feature of Blair’s version of the Third Way is its foundation on basic values. Such values automatically entail certain structural and institutional commitments, such as democracy, human rights, pluralism and the like. With respect to the precise details of the social and economic order, and also with respect to the shape of economic, social and educational policies they are open for different options but the choice between various options always has to be made in the light of these basic values. The general approach of such a political concept is that of a principled pragmatism: unconditional validity of the basic values combined with conditional choice between policy alternatives. This is basically the Godesberg approach to social democratic thinking. It is a gross misunderstanding of the very concept itself when Tony Judt asked:»The third way to what? We need some direction.« 3 It is clear that in such a concept the basic values are the objective towards which the process should be driven, and they constitute its direction. Such a concept is a meaningful orientation for action as long as the basic values themselves are defined precisely enough to deliver effective yardsticks for pragmatic progress. In the framework of these basic values, it is Blair’s hope that at the policy level traditional contradictions such as patriotism and internationalism, rights and responsibilities, the promotion of enterprise and the attack on poverty and discrimination will be overcome. There is nothing wrong with such an approach, and Blair himself frankly confesses that it will need a decade or more to fill this framework with sufficient details to make it a working project of the Centre Left for the 21 st century. At a more down to earth level, Blair ̈ declares the main meaning of equal worth as inclusion, i.e. an opportunity for each individual to participate in the economic and social system, ̈ favours partnership between government and business, ̈ makes a case for a strong and self-confident civil society enshrining rights and responsibilities with the government being its partner, ̈ stresses the necessity to accept economic globalisation and the rule of markets as a hard fact of life to which value-based and effective policies have to adapt. The policy guidelines for the project which represent steps beyond the Godesberg type of social democracy, which has been prevailing in Europe during the last two or three decades, seem to be ̈ a neo-liberal approach to macroeconomics, ̈ supply side economic policies, ̈ unconditional acceptance of competition in goods and capital markets, ̈ welfare state reforms with the aim of maximising employability rather than guaranteeing employment or social security as citizens rights, ̈ a vague commitment to sustainable development. In addition, Blair is devoted to the decentralisation of the UK ’s political system, to a reform of the country’s educational system and to a more constructive participation of Britain in the European Union. 4 For a broader discussion of the politics of the Third Way within a global perspective, one has to distinguish between those features of the new concept which are obviously due to the particular British context and those which seem to be transferable to other societies. The radicalism with which Blair is ready to renew the traditional social democratic project is of course due to the thorough deregulation of the economy, including the labour market, which the Thatcher regime had brought about. The way in which the concept is designed and epitomised in Blair’s own personal performances has much to do with the role of the mass media and the attitudinal propensities of the new middle classes in the UK . The welfare consensus which is still intact in most of the continental and Scandinavian countries had been destroyed by Margaret Thatcher to such an extent that it seems no longer a restriction for Blair’s own endeavours. 3 . T. Judt: The Third Way to What? We Need Some Direction. 4 . Cf. P. Robinson: Britain’s Labour Government: a third way for social democracy? Paper: Institute for Public Policy Research, London 1998 . IPG 3/99 Meyer, The Third Way at the Crossroads 297

The essence of the new concept seems to be a strategy which aims at bringing about inclusion, opportunities for all(not social justice!), and employment not by way of structural reforms and macro-economic policies but of cultural revolution and related transformations of the welfare state which aim at better adjusting people to economic and social structures as they are determined by the present stage of globalisation. This shift to predominantly cultural strategies is symbolised in such terms as partnership between government and business, and government and society, employability and opportunities for all. The target is substantial changes in attitudes and modes of action rather than remodelling structures. Partnership means, whatever can be achieved has to be done through negotiation instead of state sovereignty within the framework of the established structures. Inclusion means that everybody should be given an opportunity to get included in economic and social life in some way at whatever level and under whatever conditions. That the rest is up to individual fitness, and employability means the welfare state can help people to acquire new work qualifications but ultimately it is the responsibility of the people themselves to integrate into economic and social life. Often Blair and other advocates of this particular version of Third Way thinking employ the term of a culture of entrepreneurship which should become the attitude of each individual in the emerging societies. The cultural revolution which is the objective of this strategy aims at a redefinition of the role of government and the responsibilities of the individual. The final risks of the labour markets are transferred to the individual with the state being only kind of an aide(welfare to work), whereas in the classical concept of social democracy the individual was entitled to social security as a citizen’s right due to a social democratic assessment that the very dynamics of the market are at default. This is a substantial take-over of cultural positions of neoliberalism and imply the downsizing of governmental structures and responsibilities. The change is highly consequential with respect to economic policies, welfare policies and the symbolic position of social democratic parties in the political arena of present day societies. Some of the issues implied are very controversial indeed. Third Way Issues Globalisation The starting point for both Clinton’s and Blair’s version of Third Way renewal is the acceptance of economic globalisation as a hard fact with all its consequences for ecomomic growth in a highly competitive world market and the type of jobs which it is going to make available. Globalisation, however, is a highly ambiguous term. It is multidimensional in its scope and ambivalent in its meaning. Evidently, communication, the effects of ecological destruction, diseases, cultural encounters and to a certain degree migration are transgressing political frontiers whether the individual nations like it or not. This process of transnationalisation is widening increasingly to a global scale. The financial markets have become thoroughly globalised already. This is however not the same thing as comprehensive economic globalisation. The markets for goods and services, and particularly for labour, are still very far from being global, they are rather selectively transnational. There is not yet one single worldwide marketplace in which all economic unities compete with each other. Large parts of the national economies, different from country to country, are not involved in transnational markets, and large parts of the transnationalised markets are rather regionalised than globalised. In the European Union for instance, more than 80 % of the transnational trade of the member countries is taking place within its own limits. The undifferentiated neoliberal use of the globalisation argument is to a high degree ideological, mainly designed to delegitimise labour demands, macro-economics and the claim of all political responsibility for the outcome of the economy, rather than depicting the new reality accurately. Thus it is one of the crucial watersheds between neoliberal and social democratic politics how the term globalisation is defined and which consequences are derived from it. For a critical use of the argument which takes into consideration its conditions and limitations, two consequences are crucial. The first is that the real shape and amount of globalisation does not render macro-economic policies and political responsibility for the entire economy completely obsolete. The second is that 298 Meyer, The Third Way at the Crossroads IPG 3/99

much of the political influence which has been lost to globalisation can be regained and reestablished at a regional level, an argument which is particularly valid for the European Union. In addition, concepts to develop more comprehensive and effective transnational and even global regimes to regulate the global economy are no mere illusions. GATT and the like show that there is scope for political framework setting, which possibly is subject to further amplification if only there is the political will to do so. Even for a renewed social democratic project there is no need to discard the concepts of macroeconomics, market regulation and political framework-setting altogether. There is scope for compensating the loss of political effectiveness at the national level by transnational cooperation. Partnership of Government and Society Rethinking or even»re-inventing« governance within the respective political roles of government and society is one of the central impulses of the Third Way. This concept has two dimensions. The first is a functional one; it stems from the experience that in highly complex modern societies it is increasingly difficult and even disfunctional to try to steer the development of societies from a strategical political apex which is placed at the top of the pyramid of society and unable to oversee to a sufficient extent its performances, problems and functions. The idea has become prominent that modern governance requires new forms of cooperation between the political system and civil society, in other words a new division of labour between state and social actors. Increasingly government becomes a partner of societal agents, acting as a broker, facilitating, inspiring and monitoring. This devolution of power to a certain extent seems to be a functional necessity in today’s complex post-industrial societies. As long as the monitoring function of the political system remains intact and enables it to take up its responsibility for the society and its individuals along the lines of shared basic values wherever the networks of civil society fail, this approach to political power devolution is an alternative to privatisation and fosters democratisation and societal autonomy. However, the opposite would be the case, if a government in a neo-liberal spirit would simply shed more and more of its political responsibilities and leave it simply to the individuals to cope with the consequences of market dynamics. Simple privatisation of erstwhile political responsibilities risks re-establishing the 19 th century situation where uncontrolled private powers dominated the lives and the opportunities of the large majority of the people, which ultimately caused massive political alienation and social unrest. The second dimension of the transfer of political functions onto civil society is a cultural one, based on ongoing processes and declared needs to rebalance the individual’s sense of rights and obligations in modern societies. This is the dimension stressed by communitarianism. A reinforcement of the individual’s sense of obligation can regularly strengthen the citizens’ propensity to see first whether they can themselves jointly solve problems which emerge in their daily life sphere by spontaneous cooperation, and only inasmuch as this is not possible, delegate it for effective resolution to the political system. In this dimension, a new division of labour between state and society is not in the first instance a question of simply discarding erstwhile state functions and leaving their fulfillment to the discretion of private actors. It is rather about rendering a good deal of state intervention superfluous as the job is done in society itself on a voluntary basis. Even in a country like Germany, more than a quarter of the population has been engaged in social self-help initiatives for a long time. The challenge today is to extend the readiness for such engagements to new problem areas and to foster the related spirit of community by public strategies such as discourse, convincing examples, partnerships and the like. The concept and the practice of communitarianism can well supplement social democratic philosophy and politics but only if it is not meant as a mere strategy of legitimising the reprivatisation of public responsibilities. The difference between the neoliberal concept of simple reprivatisation of public policy obligations and the social democratic concept of politicisation of civil society in order to take on new responsibilities is a crucial one, and it must be made very clear not only on a theoretical level but in the concrete shape of practical projects and the very concepts of government responsibility. Those political jobs IPG 3/99 Meyer, The Third Way at the Crossroads 299

which are not done in society itself by voluntary actors will still have to rest with government responsibility. In order to cope with such new challenges governance needs imaginative refashioning. Welfare state There is no doubt that today social democrats face the necessity of restructuring some key parts of the welfare state. There are changes within the society which make appropriate changes in welfare state structures unavoidable. To mention just the most consequential ones: ̈ The level of medical technology is expanding constantly and so are, as an unavoidable consequence, the costs of health-care systems. A system which entitles each individual to the full scale of medical treatment as indicated by his diseases will constantly raise the portion of income spent for health, which seems unaffordable already in the not so long run. ̈ The ratio of working-age population to old-age population is constantly decreasing. This makes new formulas for a sustainable general pension system mandatory. ̈ In some welfare states unemployment insurance has created a particular unemployment trap by taxing 100 per cent or more of low-wage income away. New ways of relating the welfare system and the labour market are needed. Even though the welfare state is badly in need of reform this should be done in such a manner as to preserve the basic objectives for which it has been invented and designed as a part of the social democratic project more than a century ago. The neoliberal remedy is straightforward: reduce the welfare state and resign vis-à-vis the power and the wisdom of the market. This will, so the neoliberals suggest, immediately ease the burden on public budgets and sooner or later adapt workers’ expectations and attitudes to the hard facts of the labour market. As neoliberal thinking considers the market both an unparalleled mechanism of rational decision-making and a basic value, the social costs of such a strategy are neglected in theory and tolerated in practice. Third Way thinking is definitely right in its basic assumption that it would be irresponsible and stupid to take refuge in merely defending the traditional welfare state while attacking neoliberal irresponsibility. Re-engineering the old welfare state structures is inevitable, but only insofar as this helps to make it sustainable. This holds true for all the classical pillars of the welfare state. With respect to old age pension, more scope for choice is needed. The individual should decide how much of his income he would like to save now in order to be able to spend it later, but a bottom line which guarantees a dignified life after retirement should be maintained. Unemployment benefits should be conditioned on the acceptance of job offers. Besides, they should be faded out in such a way as to leave a reasonable increase in income for those who pick up low-wage jobs. All this can and must be done and there are many ways to achieve it. Pragmatism, creativity and a spirit of innovation are required. The message of social democracy, however, must be a renewal of the idea that each citizen is entitled to a dignified standard of living when all his own efforts have failed. The guarantee of a decent life is not dependent on economic merit but a human right. It might be more necessary than before that the individual can prove that he has undertaken everything possible to earn his own living, but in case of failure, he has a right to social solidarity and he has a right that the blame for market failures are not put on his shoulders alone, so that in addition to poverty and insecurity he would be stigmatised with failure, remorse and blame. For all these reasons the Third Way will prove a meaningful concept for the renewal of social democracy only to the degree to which it offers meaningful welfare state reforms without discarding the guarantee of social security. Otherwise it would not only damage the public identity of social democracy and deny its confession of basic values, but contribute to social disintegration. Eventually social democratic parties would have to pay the political price for it. Two adversaries of social democracy would be the main winners: those neoliberals who are even more consequent than a half-way neoliberal social democracy and those right-wing forces which promise a more communitarian society and full acknowledgment for those who suffer social exclusion. Social democratic efforts to reshape the welfare state have to honour the fact that there are not only limits of economic globalisation to the welfare state but 300 Meyer, The Third Way at the Crossroads IPG 3/99

also welfare state limits to globalisation. 5 Once these are violated, increasing political opposition against free trade is to be expected. Therefore, a renewed social democratic project must abide by a concept not just of opportunities for all, but of social justice which implies the guarantee of a minimum standard of material wellbeing. Of course, such a guarantee implies the individual’s obligation to seize every opportunity offered to him by the markets or the society to make his own living. Thus, employability may be one of the useful objectives for welfare state reform, but not the sufficient condition for a renewed social democratic project as long as there are not enough jobs available for everybody. Flexible Man and Basic Security One of the most disputed features in the Third Way project as it is has been offered by Tony Blair is its concept of a general culture of entrepreneurship for all members of modern societies. It is meant to do away with the widespread attitude of entitlement, and, consequentially, allow for a major increase in labor market flexibility, welfare state reduction and a related increase in self-determined voluntary social activities. The main thrust of the concepts seems to be towards overcoming the deeply rooted welfare consensus which is prevalent in most European societies. Some of the distinguished promoters of the Third Way project such as Blair, Giddens, and in Germany Bodo Hombach, have repeatedly declared that the individual independent of the degree of education, job qualification, or social position must start to consider him or herself as an entrepreneur, fully responsible for his own fate in the world of markets. 6 Everybody should develop an awareness that the risks of the labour market are in the last instance one’s own risks and not failures created by default structures of society which entitle the individual to strong social guarantees. Such a major cultural change, which amounts to adopting a substantial portion of neoliberal culture would have serious consequences at two levels. At the structural level, it would reduce the welfare state subsidies to support for employability. At the sociopsychological level, the individuals at the lower strata of society would get the feeling, that beyond this limited support there is no reliable social security which they are entitled to, whatever the outcome of their efforts in the labour market in the last instance will be. Individuals would have to accept almost unlimited degrees of economic and social flexibility. Richard Senett recently has depicted some aspects of such a transformation towards a new capitalist culture and made a case for social limits to flexibility lest modern capitalist economies generate a corrosion of character, generalized uncertainty, fear and social instability on a large scale. 7 The social limits to flexibility concern both the higher and the lower strata of society. Both have to be aware that, for a variety of reasons, almost every job can come to a sudden end and they may have to accept ongoing degradation in job quality and payment. Even if they can expect to manage a continuous work biography, they will have to be prepared for ten or twelve changes of their jobs and even their living places in a lifetime. Thus, their lives become more and more incalculable, longterm commitment in communities, with friends, neighbours and the like becomes an improbable feature of their lives. The label»flexibility« taken at its surface value has overall positive connotations. It makes, however, a very big difference if somebody is in a financially secure socio-economic position and takes additional risks in order to gain additional incomes or if flexibility at the lower end of the labour market is tantamount to the threat of being pushed into poverty, dependence and deprivation, and being forced to accept any working or life condition which changing market fortunes have in store for him or her. Enforced flexibility of this sort creates frustration, instability, uncertainty and anxiety. Flexibility is, thus, a far cry away from meaning the same thing to the successful and to the unsuccessful. The comprehensive message of classical social democracy always has been that there is and must 5 . Cf. Rieger,E. / Leibfried, S.: Welfare State Limits to Globalisation, in: Politics& Society. Vol. 26 , N. 3 , Sept. 1998. 6. A. Giddens: The Third Way. The Renewal of Social Democracy. Cambridge 1998 ; B. Hombach: Aufbruch. Die Politik der Neuen Mitte. München 1998 . 7. R. Sennett: The Corrosion of Character. New York 1998 . IPG 3/99 Meyer, The Third Way at the Crossroads 301

be a guarantee of a decent living for each individual, irrespective of his or her economic fortunes, because the risks of the labour market are mainly created by the way markets function and not by individual failure. The concept of a generalised entrepreneurial culture, as it has been conceived thus far, seems to put an end to the very foundations of this social democratic philosophy. Inasmuch as this consequence is intentionally taken into account by the authors of the project, three arguments must be forwarded: Firstly, such a consequence would definitely run counter to the basic values of social democracy which even in the concept of the Third Way remain the undisputed basis for renewal and social change. However the basic values of social democracy might be defined in varying social and cultural contexts, they all demand solidarity to ensure the dignity of all citizens independent of their economic performance. This is exactly what the classical term»social justice« means. This standard has to mark the bottom line of social security as long as the social democratic basic values remain in force. There is of course a good deal of flexibility in interpreting this norm, there are also clearcut limits to such flexibility. Secondly, excessive demands for flexibility which induce a general feeling of insecurity and the loss of the individuals’ command over their lives risks driving many people into the arms of rightwing extremists who pretend to offer security, certainty of orientation and social protection. Thirdly, such a strategy inevitably would blur the political demarcation lines between a however renewed Social Democracy and Neoliberalism and consequentially worsen its electoral opportunities. Thus, the political message both as a strategic policy guideline and as symbolic identity of a renewed Social Democracy has to be flexibility cum social security. The cultural renewal as necessitated by social modernisation and economic globalisation should aim at a new culture of responsibility, creating a new balance of the individual’s rights and responsibilities, rather than at a generalised attitude of enterpreneurship. Alternatives at the Crossroads For the first time, the Third Way discourse opens up the opportunity for a world-wide political dialogue between the centre-left forces as, due to globalisation, they share more challenges, problems and options than ever before. Many of them are also increasingly aware that new forms of transnational coordination of action will be one of the conditions for effective problem resolution in a global era. It is, however, not surprising that the exact shape of social democratic renewal varies from country to country according to the different socio-cultural traditions of the individual societies, the electoral competitors in the political arena and the relative strength of the centre-left forces. Thus far three distinguishable paths on the Third Way have made their appearance. They range from a radical position which adopts substantial portions of present-day liberalism to a moderate position with a much more careful attitude to reconsider the role of markets and individual responsibilities. Ideal-typically, the New Democrats of the US represent the radical approach on the Third Way while most of the Continental European Social Democratic parties pursue the moderate path and New Labour occupies the middle lane. With respect to almost all of the key concepts which form the building blocks of a renewed social democratic project, some consequential alternatives are surfacing, though within a shared framework of some basic commonalities. They require and deserve a careful political discourse amongst those who want to promote a successful and sustainable renewal of social democracy but they also allow for some scope for remaining variations. 8 The ideal-typical positions and their different approaches to the individual issues of the Third Way discourse can be seen from table 1 . Basic Values, Political Cultures and Human Needs As outlined before, there are good reasons for a general reappraisal of the political projects of 8 . Cf. The individual contributions, in: R. Cuperus / J. Kandel: Transformation in Progress: Social Democratic Think Tanks Explore the Magical return of Social Democracy in a Liberal Era. Amsterdam 1998 . 302 Meyer, The Third Way at the Crossroads IPG 3/99

Concept Basic value Policy culture Economic globalisation Economic policy Government vis-à-vis business Government vis-à-vis society Communitarianism Welfare state Modernisation Ecology Role of party Strategy Table 1: The Range of Third Way Positions Moderate position Justice Flexibility plus basic security to be politically shaped Macro-economic regulation, supply and demand side Sovereign plus broker Accent on goverment responsibilities Supplementary policy Re-engineering for basic security (citizen rights) Multi-dimensional concept (economic, cultural, social) Substantial economic role Crucial for social discourse plus legitimisation Structural changes, deliberative discourse Radical position Opportunity for all Spirit of entrepreneurship to be accepted Supply-side Partner Accent on society’s duties Moral campaign Activating state for employability Economic rationalisation Vague commitment Nation first, marginalised party Cultural campaign, media-staged communication Social Democratic politics in an era of globalisation. As earlier in history it may again be conceived in terms of a new synthesis between the original theories of democratic socialism and liberalism. In such a new synthesis, whatever its shape in different countries will be, the basic values of social democracy must remain visible and effective even though there might be substantial changes in the advocated policies. Amongst those basic values, social security as a citizen’s right where no acceptable jobs can be offered by the market is the most outstanding one, which is by no means dispensable as long as the term social democratic in contrast to (neo-)liberal can rightfully claim to make any sense. Once this value is discarded the very idea of a social democratic project would in substance disappear from the political arena whatever labels would be offered. In those European countries which share a long tradition of welfare consensus and developed a related political programme, a strong dose of neoliberal»medicine« would most probably bear three undesirable consequences: ̈ a loss of social democratic identity vis-à-vis neoliberalism, ̈ increasing social disintegration and alienation, ̈ electoral losses in favour of liberal and right wing extremist parties. These risks, evidently, delineate the outer limits for change. It is most probable that in many of the highly developed capitalist democracies up to a quarter of the electorate, as exemplified in Austria and France, might consider the offers of rightwing populism and extremism as the only hope for an acceptable life in a world of almost unlimited flexibility to which social democracy, if it followed the radical lines of Third Way renewal, would have to offer no credible alternative. It is not sure how far a society like the American one could go in that direction. But history and present-day experience suggest that most of the European societies would soon fall prey to increasing influence of right-wing populism. At the present stage of development of modern societies and their pressure towards unprecedented degrees of flexibility in all realms of social life, it seems to be worthwhile to recall the fact that in the last instance there are effective anthropological limits to cultural change, uncertainty and flexibility. Evidently, basic anthropological needs such IPG 3/99 Meyer, The Third Way at the Crossroads 303

as communication or the need for security are to some extent culturally bound. But even cultural change cannot neglect the very substance of these basic needs. It can mould, shape, expand and reduce them, but it cannot bypass them altogether. Social democracy must maintain an acceptable bottom line of social security, however large the scope for new forms of flexibility may finally prove. ̇ 304 Meyer, The Third Way at the Crossroads IPG 3/99