A Publication of the Egon-Sohmen-Foundation Herbert Giersch (Ed.) for the Egon-Sohmen-Foundation Money, Trade, and Competition Essays in Memory ofEgon Sohmen With 19 Figures Springer-Verlag Berlin Heidelberg New York London Paris Tokyo Hong Kong Barcelona Budapest Prof Dr Herbert Giersch Past President Kiel Institute of Wodd Economics P.O.Box 4309 W-2300 Kiell, FRG This book was produced with financial support of the Egon-Sohmen-Foundation ISBN -13: 978-3-642-77269-6 e-ISBN-13: 978-3-642-77267-2 DOl: 10.1007/978-3-642-77267-2 This work is subject to copyright All rights are reserved, whether the whole or part ofthe material is concerned, specifically the rights oftranslation, reprinting, reuse ofillustrations, recitation, broadcasting, reproduction on microfilms or in other ways, and storage in data banks Duplication of this publication or parts thereofis only permitted under the provisions ofthe German Copyright Law ofSeptember9,I965, in its version ofJune 24,1985, and a copyright fee must always be paid Violations fall under the prosecution act of the German Copyright Law © Springer-Verlag Berlin· Heidelberg 1992 Softcoverreprint of the hardcover 1st edition 1992 The use of registered names, trademarks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use 214217130-543210- Printed on acid-free paper Preface On June 1, 1990, Egon Sohmen would have reached the age of 60 had he not suffered from a fatal illness It demanded his death at the early age of 46 If he were still with us, he would playa prominent role in the current debate on monetary arrangements and on allocation theory, perhaps including environmental issues and urban economics His contributions are well remembered by his colleagues and friends, by his former students, and by many in the economics profession on both sides of the Atlantic In extrapolating his great achievements as a scholar and teacher beyond the time of his death, one is inclined to suppose that Egon Sohmen's name would figure high on many a list of candidates for honors and awards in the field of international economics For the reconstruction of economics in the German language area Egon Sohmen was invaluable Born in Linz (Austria), he studied in Vienna at the Business School (Hochschule fUr Welthandel, now Wirtscha!tsuniversitiit), then went to the US as a Fulbright scholar (1953), returned to Europe to take his doctorate in Tiibingen, Germany, (1954) and crossed the Atlantic again to teach at MIT (1955-58) where he obtained a Ph.D (1958) under Charlie Kindleberger He might have stayed permanently in the US, continuing a career that he started as Assistant Professor at Yale University (1958-61), if the US visa provisions had been applied in a more liberal fashion Fortunately for quite a few people in Germany, Egon was offered a chair at the young Saar University in 1961, after the faculty had been persuaded to waive the traditional Habilitation requirement We were glad that he accepted It gave us new opportunities to strengthen our ties with MIT and Yale, with Austrian economists like Gottfried Haberler and Fritz Machlup, who had become Egon's friends and mentors, with Willy Fellner, and with the international economists of Egon's age cohort Many students at the Saar University were deeply impressed by his teachings, including his later wife, our best female student, and quite a few who now hold prestigious posts in economics and public life I can frankly say without hesitation that Egon's influence was particularly strong among vi Preface those bright collaborators who went along with me in 1964 to establish the German Economic Expert Council (Sachverstiindigenrat) and who - in 1969 - helped strengthen international economic research at the Kiel Institute No economist teaching in Germany would have deserved the Kiel Institute's Bernhard Harms Prize more than Egon This acknowledgement must serve as a posthumous substitute Egon was not afraid of controversy; perhaps he even liked it Great controversies developed in Saarbriicken over the exchange rate issue, with Wolfgang Stiitzel defending fixed rates, Egon propagating flexibility, and some -like myself - pondering for a while until circumstances demanded a system switch in the interest of domestic price level stability In May 1969, when action was needed, Egon and I drafted a memorandum that we sent to the government When we went to the public it aroused a political turmoil when more than a hundred economics professors in Germany openly joined forces with us A few months later, exchange rates became the main issue in the general elections In stormy periods, one needs friends with a strong character Egon was a true friend He had an instinctive sense of the needs of others, notably his family Without his good advice and the generous financial support he diverted from his salary as a young professor in his early thirties, much of the scope for productive human capital formation in the Sohmen family would have remained unexploited, as I gather from remarks by his sister From his brother, Helmut, Egon quickly received high intellectual returns Those who have read the preface to the first edition of "Flexible Exchange Rates" will remember that he thanked his brother for having acted as Dr Wong, meaning Jacob Viner's Chinese draftsman who turned out to be an excellent amateur economist by discovering a mistake in Viner's reasoning about "Cost Curves and Supply Curves." It so happened that Helmut Sohmen, as if Egon's reference had had predictive power, made his way to the top of the world business community in the Chinese cultural and ethnic environment of Hong Kong with such success that he acquired the means for creating the Egon-SohmenFoundation Should sociologists have doubts about the viability of the family in a cosmopolitan environment, they would become more confident by looking at this example Egon surely was a father figure, and economics is now benefiting from it in a roundabout way The papers for this memorial conference cover the main areas of Egon's interest and research during the largest part of his academic life, i.e, exchange rates and adjustment problems; welfare economics and allocation theory; trade and factor movements; competition and economic growth The perspective is international, except for the paper on German monetary unification, a subject which Egon would have found fascinating Preface vii There was no planning behind the allocation of subjects to participants It just worked out this way by my calling upon persons who were known to have been influenced by Egon's teachings and writings in one way or another and vice versa No jawboning was necessary to support the invisible hand What was left for correction and coordination was mostly achieved in the free discussion during two pleasant conference days at Tegernsee in the Bavarian Alps The participants enjoyed the presence of the Sohmen family: Egon's wife and brother, his sister, and sister-in-law A verbatim record of the discussion would have shown that their intellectual contribution was not minor Bob Mundell had unanimous support when he recognized this at the end of the conference, after having expressed his opinion on the future role of the Egon-Sohmen-Foundation in the field of international economics The Egon Sohmen Memorial Conference was the second symposium organized by the Egon-Sohmen-Foundation The first one had taken place half a year before in Laxenburg, Austria, on "The Economic Transformation of Central and Eastern Europe." The papers were published in 1991 under the title "Towards a Market Economy in Central and Eastern Europe," edited by Herbert Giersch for the Egon-Sohmen-Foundation (Berlin: Springer-Verlag) The third symposium was held on "Economic Evolution and Environmental Concerns" in late summer 1991 in Linz, Austria, Egon Sohmen's hometown Herbert Giersch Contents Introduction Friedrich Schneider Part I: Money and Exchange Rates Free Minting Charles P Kindleberger 11 Profitable Currency Speculation: Service to Users or Destabilizing? Herbert G Grubel 23 Flexible Exchange Rates and Insulation: A Reexamination Joachim Fels 39 An Institutional-Economic Analysis of the Louvre Accord Rudolf Richter and Udo Schmidt-Mohr 59 The German Monetary Union Harmen Lehment 87 Financial Liberalization in Developing Countries Bela Balassa 105 Part II: International Trade Fiscal Policy and the Theory of International Trade Robert Mundell 125 Wage Agreements and Optimal International Factor Flows Stephen T Easton and Ronald W Jones 151 x Contents Protection and Exchange Rates John S Chipman 167 Aggressi ve U nila teralism Jagdish Bhagwati 201 Theory and Practice of Commercial Policy: 1945-1990 Anne O Krueger 233 Part III: Competition Welfare Economics, Economic Order, and Competition Manfred E Streit 255 Competition and Economic Growth: The Lessons of East Asia Wolfgang Kasper 279 List of Contributors 305 Introduction Friedrich Schneider The thirteen papers in this conference volume cover a wide range of topics They can be broadly categorized into three groups Six of the papers deal with money and exchange rates Five of them tackle problems of international trade theory and commercial policy The remaining two papers examine the relationship between competition and economic growth, as well as the issues of welfare economics, economic order, and competition Many of the ideas developed in this volume have already been treated in Egon Sohmen's works This demonstrates that his basic concepts and ideas are still very much alive and, moreover, can provide useful insights into the problems that economists face nowadays Sohmen was truly a leader in the field and has inspired many economists to continue his work Therefore, this volume can be seen not only as an attempt to apply Egon Sohmen's most important ideas and theories to current economic issues but also as encouragement to direct additional research towards developing these ideas further In the remainder of this introduction I will briefly summarize the different contributions to this volume Part I: Money and Exchange Rates The first paper by Charles Kindleberger adds to the current debate on free banking Kindleberger has written a historical piece on the seventeenth century experience with free minting He provides evidence on the spread of currency debasement in the so-called Kipper- und Wipperzeit in Germany and infers that free minting in a world of small states was - and by analogy, free banking unrestrained by regulation would be - a disaster Kindleberger concludes that the seventeenth century experience with free minting clearly points out the need to have some sort of public control of the money supply; a view that is opposed by the advocates offree banking (for example, Peter Bernholz and Roland Vaubel) While admitting that even under an installed public control inflationary bubbles might occur as the market monetizes credit beyond that decreed by government, Kindleberger Friedrich Schneider argues that under unregulated free banking, short-term profit seeking will go much further to destabilize the financial system Herbert Grubel's paper with the provocative title "Profitable Currency Speculation: Service to Users or Destabilizing?" takes up another hotly debated issue Grubel critically examines the view of some influential economists that the large variance of exchange rates in the post-Bretton Woods era can be attributed to widespread destabilizing speculation He argues that there is evidence that banks have made consistent profits from speculation and that such speculation has resulted in a stabilization of exchange rates over time in comparison to a situation in which the banks would not have earned such profits Grubel admits that some new theories have generated examples of destabilizing, profitable currency speculation, but stresses that so far neither direct empirical tests are available nor are valid empirical results obtainable The evidence cited in support of the thesis that speculation is destabilizing is, according to Grubel, not undisputed in the literature Therefore, one cannot make a clear case for speculation leading to destabilizing effects Grubel mentions another problem that arises in this context, namely, that up to now no general model explaining the fluctuations of exchange rates has been developed If a model of this type were available, it would then be possible to investigate whether or not one could observe destabilizing effects However, Grubel's final conclusion that currency speCUlation will stabilize exchange rates over time is also an assumption (made by him) that has not been empirically verified Another topic relating to flexible exchange rate theory is tackled by Joachim Fels in his paper "Flexible Exchange Rates and Insulation: A Reexamination." The author argues that, contrary to conventional wisdom, the early proponents of flexible exchange rates (such as Milton Friedman, Egon Sohmen, and Harry Johnson) never believed in the ability of the system of flexible exchange rates to provide complete and automatic insulation from all foreign disturbances However, they stressed that domestic monetary policies would be free to pursue domestic goals under flexible exchange rates and could, in some circumstances, be employed to neutralize undesired macroeconomic influences from abroad After elaborating on the work of the early proponents of flexible exchange rates, Fels confronts the hypotheses of the early advocates with data from the post-1973 period of flexible exchange rates Summarizing his empirical results, he arrives at two conclusions First, in the flexible exchange rate period countries have been able to set their price levels independently of foreign inflationary or deflationary trends, as was predicted by Milton Friedman and others Second, business cycles have been much more synchronized under flexible exchange rates than they were under fixed exchange rates This result is not in line with the argumentation of the 292 Wolfgang Kasper One may generalize: the more mobile a production factor, the more equal its return throughout space, and the less mobile, the more we observe locational rents and exposure to transportation costs/burdens Thiinen (similar to Ricardo) dealt with the agrarian, resource-centered world of the early 19th century In a more realistic adaptation to modern conditions, Losch (1954) treated most locational factors (comparative advantages) as man-made He also recognized the evolutionary change of increasingly knowledge-centered production systems and treated government as an immobile production factor that may raise or lower the productivity of the other production factors Losch therefore inspires a paradigm in which government authorities (as well as immobile labor and land) on the periphery have to absorb the transportation costs to the centers by asking for lower taxes as well as lower wages and land rents) By doing so, governments, land owners, and labor are able to create conditions that attract mobile production factors - including useful knowledge - from elsewhere 12 Where the "local flowers" (governments, land, and labor) offer low costs and low risks, they attract - so to speak - the "insects" of capital, skills, entrepreneurship, and knowhow By doing this, they enhance overall productivity of both "flowers" and "insects," and contribute to mutually beneficial growth, which will eventually - other things remaining equal reduce the slope of the income gradient between center and periphery Losch foreshadowed in some respects the "Tie bout hypothesis," which predicted that local authorities, when faced with mobile voter-citizens, had to provide public services at competitive tax cost The precondition for the "Tiebout hypothesis" of course is that sizable numbers of people can chose between alternative jurisdictions, a situation that now arises with globalization (Tie bout 1956) This approach to the nexus between competition, location, and growth has, in recent years, been validated by much research on international business strategy Porter (1990) has shown that industrial growth in specific countries does not owe all that much to natural endowments (as Ricardo taught us) or to differentials in factor prices (as Heckscher and Ohlin found), but to the dynamics of innovatory evolution (as first demonstrated by Schumpeter) Porter distinguishes four 12This model differs greatly from the Ricardo-Heckscher-Ohlin-Samuelson tradition of analyzing international economic exchange There, countries have given factor endowments and then specialize to exchange factor endowments indirectly through trade Indeed, trade is seen as a substitute for factor mobility (in the absence of trading costs) But in a Thiinen-Losch world with mobile factors, there is a second channel of profitable international economic exchange It guides policymakers from the focus on trade to growth by supply mobilization and dynamic learning - For an analysis along similar lines in a model with trade and the international mobility of some factors, see Jones (1980) He pointed to the importance of relative attractiveness of political conditions in locational choice Competition and Economic Growth: The Lessons of East Asia 293 mutually reinforcing elements that determine how rivaling oligopolistic competitors may interact to create strong competitive advantages in a given location: (a) local factor conditions (resources and their prices), (b) demand conditions that reflect the sophistication and standards set by the buyers, (c) supporting "supplier clusters" that provide linkages and inputs to the producer, and (d) national competition policy, company strategy, industry structures, and attitudes to competitive rivalry He showed how these four elements interrelate - like the parts of a dynamo - to create competitive advantages for certain activities in a given location In the spirit of what has been said, Porter shows in numerous case studies that openness and strict competition policies are essential in maintaining the competitive position of an industry in a given location The Lessons of East Asia The task is now to test at least cursorily whether such a complex model of growth by evolutionary competition in space, which seems compatible with Sohmen's implicit notions of competition, can explain the performance of the most dynamic economies of recent decades, those of East Asia The concept to test would have to reflect modern reality, in which the internationally mobile production factors that matter most are capital and technical knowledge (possibly unbodied in firms), and the immobile factors are workers and governments In this international setting, the Asia-Pacific region has far out-performed the old industrial countries, as well as Latin America, South Asia, and Africa (compare Figure 3) But many of the East Asian countries have not only been outstanding in their growth success, they have also achieved an unusually even interpersonal income distribution (see, for example, Scitovsky 1986; Riedel 1988; Kasper forthcoming) 2.1 The Broad Pattern In comparing the East Asian approach to economic development and industrialization with that of other regions on earth, I would draw at least seven lessons in the context of the above time-space model of growth and 294 Wolfgang Kasper log 30000 .Japan USA W Germany Singapore Hong kong Australia 20000 Taiwan 10000 S Korea 5000 Malaysia 3000 2000 Thailand 1000 Indonesia 500 f -./o!!:: -_j l:=;;;!"'OO~ j 300 f -/~_j -V + j 100 ~= _j -+_-+ China 1965 1980 1Nomura Institute 1987 1990 (prelim.) 2000 (forecast 1) Fig Income Growth in the Asia-Pacific Region - GNP per capita in 1980 USJ and at 1980 exchange rates- Competition and Economic Growth: The Lessons of East Asia 295 competition In drawing these lessons, one has of course to abstract, at least initially, from the peculiarities of different countries 13 Lesson 1: The countries of East Asia promoted growth by systematically mobilizing production factors at home and from abroad and keeping local factor prices low Government policy was not laissez-faire (except in Hong Kong) There were systematic interventions to promote saving and capital formation, learning and skill accumulation (building on a traditionally high social status for learning), the development of knowledge, and the provision of an effective infrastructure East Asian governments were very successful in this For example, the domestic savings rate (in gross domestic product) was over 30 percent in the mid-1980s in Korea, Taiwan, and Malaysia and over 40 percent in Singapore Government policy concentrated on being functional in making factor supplies highly elastic, whereas specific allocational interventions were fairly rare (exceptions are noted below) This is compatible with the lesson from aggregate growth theory By contrast, governments in other less developed regions normally had no consistent functional supplyside strategy, but rather intervened haphazardly or to allocate artificial rents Lesson 2: The mobilization of factor supplies extended to drawing on mobile production factors from abroad, either all kinds of production factors, including foreign firms, or (as was the case in Japan and South Korea) only capital and technology, but not entire foreign enterprises In part no doubt thanks to the isolationism of Mao's China, the insecure small states on China's fringe were increasingly forced to behave like the small open states in European history In the face of exposure and political adversity, the primary role of governments was to become a service organization to enhance the productivity of resident production factors, to attract complementary factors from outside, and to promote trade Like in European history, their demonstrated success spread the understanding that productivity promotion and not rent-creation is the proper role for government The policy to attract production factors from abroad was combined with a growing world-market orientation for the outputs of 13 When we talk here of an "East Asian pattern of growth," we think primarily of the postwar development of Japan, and the experience since the mid-1960s in Singapore, Hong Kong, Taiwan, South Korea, Malaysia, and Thailand - episodes in which living standards often doubled within one decade! In some respects, the experience of some industrial provinces of China in the 1980s might also be included By contrast, heavily rent-oriented economies like the Philippines and Indonesia are excluded For more detail and a survey of the literature, see Kasper (forthcoming) 296 Wolfgang Kasper industry (trade liberalization) The lowering of protection levels mattered greatly in making market niches insecure, thus stimulating productivity growth What matters for competitive behavior is often the change in intervention, not its absolute level It has to be stressed th~t the East Asian economies were fairly open to international influences, both in factor and in product markets Given the normal transaction costs in exchange, the dual openness was essential in influencing product and factor markets to adopt world-market prices and technologies The growing dual openness narrowly limited the scope for discriminatory political interventions When certain market interventions were found to prejudice international competitiveness in trade or the attractiveness to mobile capital, they were normally corrected quickly and pragmatically in the interest of growth The evidence shows that the East Asian countries were highly successful in maintaining the dual openness, not only as testified by their well-known spectacular import and export growth, but also by the fact that they are now rated amongst the most attractive locations for international investment (Figure 4).14 Lesson 3: The East Asian nations recognized that they had a peripheral location vis-a-vis the major central market places in far-away North America and West Europe, and acted on the whole as the Thiinen-Losch paradigm would suggest They understood that transportation costs had to be borne by local workers, land owners, and governments if their industries were to gain a foothold in the major markets overseas Wages were therefore kept low, land was offered cheaply, and taxes (and the size of government) were kept under strict control The avoidance of currency overvaluation and the gradual removal of exchange controls, which had kept some currencies overvalued in the 1950s, was part of a concerted strategy to enhance the exposure of local industry to international competition As economic growth took off in the 1960s, some of the original productivity handicaps were overcome (often with the help of international capital, know-how, and enterprise) At the same time, international transportation costs were reduced by systematic policies to upgrade transportation and communications facilities, as well 14 Openness of product and factor markets is relevant for containing rent-seeking and realizing sustained, growth-creating competition This is also demonstrated by the slow growth of economies like Australia and New Zealand, which have traditionally been very open to people, capital, and firms, but have been protectionist in trade Import-substitution to attract internationally mobile production factors by olTering them government-made, secure market niches does not create sustained growth, for it destroys the very motives for innovation and competitiveness Competition and Economic Growth: The Lessons of East Asia 297 Average rank out of 32 24 22 20 -+ 18 ~ Q Rankin the "Asia-Pacific f:f: league" o