James M. Lyon - Senior Vice President
Published December 1, 1996 | December 1996 issue
By Steven Solomon
Simon & Schuster
For anyone interested in the Federal Reserve and the ongoing public policy debates regarding the appropriate degree of independence and accountability for a central bank in a democratic society, The Confidence Game, by Steven Solomon is must reading. Based on interviews with over 250 senior central bank and government officials from around the world, including Chairman Greenspan and former Chairman Volcker, the book provides a fascinating insiders' view of the some of the major economic and financial crises of the last 20 years. In recounting the steadily expanding importance of the world's central bankers in addressing these crises, Solomon highlights their role, not well understood by the general public, in preserving financial stability.
Solomon's central premise is that the emergence of "stateless" capital over this period has fundamentally altered the conduct of monetary and economic policy and the performance of financial markets. The elimination in the 1970s of barriers to the free flow of capital across national borders, emanating from the collapse of the Bretton Woods system of fixed exchange rates, resulted in the dramatic growth of "stateless" capital. Solomon sees this "stateless" capital at the root of many of the major financial and economic crises of the last two decades and believes that resolution of these crises has increasingly fallen to unelected central bankers as elected public officials have proven unwilling, or unable, to meet the challenge.
For Solomon, the first international systemic shock of the new global financial era, and the basis for the title of his book, are tied to the failure in June 1974 of the private German bank I.D. Herstatt. Miscalculations in the foreign exchange market resulted in the failure of the bank and left $620 billion in foreign exchange transactions partially settled. It took over a year for the resulting mess to be sorted out. For several months, the volume and pricing of international lending was adversely impacted. The issue for the world's central bankers became whether an international lender of last resort was necessary. In September 1974, the central bankers issued a statement regarding the Herstatt situation that, while soothing in tone, was more symbolism than substance. But the guarantee of necessary action contained in the statement and the confidence that it conveyed to the market, even without additional specifics, turned out to be sufficient and thus represented an early manifestation in the new global financial era of the central bankers' "confidence game."
Under the Bretton Woods system of fixed exchange rates adopted after World War II, capital flows between countries were primarily related to the financing of trade and direct investment. Under the floating exchange rate system that emerged in the 1970s, capital was freed to flow across national borders in pursuit of profit-maximizing opportunities. The 1980s witnessed international capital flows growing at rates many times in excess of the underlying rate of economic expansion. Solomon notes that during the 1980s, while world trade roughly doubled, foreign exchange transactions expanded fourteenfold. But much more problematic than just the volume of this activity was the belief, held by many, that this global financial activity was not rooted in underlying economic fundamentals. According to Solomon: "by the mid-1980s finance had become a self-propelling, volatile roller coaster, often visibly driving determinants of real economic outcomes within and among nations."
While The Confidence Game provides a fascinating perspective on the increasingly daunting challenges facing the world's central bankers, it is not without its limitations. To enhance the book's readability, Solomon has adopted a thematic approach, focusing first on the 1987 stock market crash and then on the 1980s war on inflation, the LDC (lesser-developed countries) debt crisis and the superdollar (the surge in the trade-weighted value of the U.S. dollar), among others. There are two interrelated limitations with this thematic approach. First, it leads to a certain amount of redundancy in the description of events that occurred more or less contemporaneously, but are treated as parts of separate themes. Second, it serves to undermine the impact of one of Solomon's key pointsthe increasing complexity confronting the world's central bankers. As daunting as the challenges confronting Chairman Volcker in the early 1980s were in addressing runaway inflation and the LDC crisis, his success is all the more impressive because he had to address these crises simultaneously rather than sequentially. With Solomon's thematic presentation of topics, it is easy for the reader to lose sight of the overlapping, and even concurrent, chronology of many of the central bank challenges outlined in the book.
The extensive interviewing conducted by Solomon in researching the book provides for a wealth of highly readable insider perspectives on many of the events chronicled. But the sheer volume of detail presented goes beyond that necessary to substantiate the key points he is trying to establish. Moreover, Solomon presents the views of his subjects, primarily senior central bank officials, with relatively little critical analysis. To highlight the growing risks that he perceives associated with the emergence of stateless capital, Solomon's rhetoric at times borders on excessive. Thus, the reader is treated to descriptions of "Armageddon," "Dunkirk" and the "abyss." The lack of critical analysis of his interviewees' perspectives on the events that they are reporting coupled with the pejorative used to describe many of the crises outlined, serves to weaken the book.
One of the most significant omissions in Solomon's scholarship is the lack of a clearer articulation of why the development of stateless capital has become a negative force to be contained rather than a positive force to be encouraged. Solomon maintains that the effects of stateless capital have for significant periods of time over the last 20 years diverged from the underlying fundamentals of the real economy and resulted in "unprecedented exchange rate misalignments, economic imbalances, and financial booms and crashes." What is not clearly developed in the book is why these market imperfections exist and have grown to crisis-level proportions. Normally, one would assume that the removal of barriers to the unfettered flow of capital across national boundaries would result in economic gains overall. Instead, Solomon maintains that the growth of stateless capital has been a largely negative development, giving rise to an endless series of crises that elected public officials have proven unwilling or unable to address. It is into this breach that the world's central bankers have been thrust. A clearer articulation of the underlying dynamics of the problem would be helpful in evaluating the merits of the available remedies.
Perhaps most troubling, particularly in light of the scope of Solomon's research, is the weakness of the book's conclusion. After chronicling for nearly 500 pages how adroit central bankers rose to successfully meet every economic and financial challenge of the last 15 years, Solomon has little to offer in the way of specific structural changes to reduce the need for these ad hoc rescue efforts in the future. He makes three principal recommendations:
As Solomon himself acknowledges, however, the impediments to implementing such fundamental global financial and political reforms are virtually insurmountable.
Given difficulty of achieving the more basic reforms that he believes to be necessary, Solomon concludes that, for the time being at least, the best that can be hoped for is that democratic governments will see the wisdom of reinforcing the authority of their central banks. But he makes it clear that he believes that even with such expanded independence, central bankers will ultimately be overwhelmed by the forces of stateless capital unless more fundamental global market reforms are adopted.
One of the ironies of this conclusion is that the effectiveness of central bankers in mounting ad hoc rescue efforts may impede the more fundamental structural changes that Solomon believes are ultimately necessary. History suggests that the political will to undertake the fundamental reforms identified by Solomon is likely only to exist in reaction to great crises. Thus, if central bankers are effective, at least for the time being, in postponing this day of reckoning, their very successes may have the unintended collateral effect of delaying progress on reforms which would alleviate the need for such ad hoc actions in the first place.
In the concluding chapter of The Confidence Game, Solomon chronicles the worldwide trend during the 1980s toward expanded central bank independence. He also offers an excellent discussion of some of the difficult issues of accountability that central bankers must confront in connection with their broadened independence. Accountability depends, to a significant degree, on the ability of a democratic society to gauge the effectiveness of its central bank through objective performance measures. For a number of years the monetary aggregates served to provide such an objective framework within which to measure the Federal Reserve's execution of its monetary policy responsibilities. Unfortunately, in recent years the monetary aggregates have proved less useful as a framework within which to explain and measure the central bank's conduct of monetary policy. Moreover, no other objective framework has yet been identified to take their place. The challenges thus created for the central bank in the execution of monetary policy were the subject of Gary Stern's 1995 Annual Report essay, which appeared in March's issue of The Region.
The last decade has witnessed a marked increase in the independence of many central banks. Yet as we approach the 21st century and the 100th anniversary of the Federal Reserve, questions are being raised about virtually every aspect of the Fed's current responsibilities. In answering these questions and in considering the most basic question of the proper balance of central bank independence and accountability, we must heed the lessons learned from the crises of the last 20 years. In chronicling many of these experiences in such rich detail, Steven Solomon has made a valuable contribution to this debate.