Paul Davidson - International Financial Architecture

This is a referenced article posted by Joerg over at Bonobo about reforming the international financial architecture. It is excellent as it covers the arguments between the two schools of thought concerning Keynesianism and Monetarism - LPT vs. EMT. It is a great addition to my work and posts of recent. Ph.D. Paul Davidson is the greatest Keynesian economist I have yet come across. Check out his Keynes', Washington Concensus', IFA, etc., high quality writings.

Paul Davidson

How one interprets volatility in the international financial markets and therefore chooses a policy stance regarding these markets depends on the underlying economic theory that one explicitly, or implicitly, utilizes to explain the role of financial markets in a market oriented entrepreneurial economy. There are two major alternative theories of financial markets: (1) the classical efficient market theory (hereafter EMT) and (2) Keynes's liquidity preference theory (hereafter LPT). Each produces a different set of policy prescriptions. EMT advocates call for a liquidity plumber to patch up some short-run stresses in today's efficient international financial flow system. LPT proponents believe that the current system is structurally flawed. Consequently, it will require an architect to build a new international financial structure on more solid foundations.

EMT is the backbone of conventional economic wisdom. The mantra of EMT is "the market knows best" how to optimally allocate scarce capital resources and promote maximum economic growth. This EMT view was succinctly epitomized in U.S. Treasury Secretary Summers's statement: "the ultimate social functions [of financial markets are] spreading risks, guiding the investment of scarce capital, and processing and disseminating the information possessed by diverse traders...prices will always reflect fundamental values .... The logic of efficient markets is compelling" (Summers and Summers, 1989 , p. 166).

In contrast, the logic of Keynes's LPT indicates that the primary function of financial markets is to provided liquidity not efficiency. (And a liquid market requires orderliness.) If Keynes's LPT of orderly financial markets is relevant, then the real world's international capital markets may never deliver, in either the short-run or the long-run, the results claimed by EMT.

Peter L. Bernstein is the author of the best-selling book entitled AGAINST THE GODS (1996), a treatise on risk management, probability theory and financial markets. Bernstein argues that the LPT and not the EMT is the relevant theory for the world in which we live. Bernstein states "The fatal flaw in the efficient market hypothesis is that there is no such thing as an [efficient] equilibrium price... a market can never be efficient unless equilibrium prices exist and are known" (1998b, emphasis in original; also Bernstein, 1998a). In other words, in Bernstein's view, EMT is not applicable to real world financial markets.

If EMT theory is not applicable to the real world then there is an important role for rebuilding the system to permit some degree of international capital flow regulation as a necessary but not sufficient condition for producing a golden age of economic development for the global economy of the twenty-first century. Since the 1970s, however, the compelling logic of EMT has provided the rationalization for nations to dismantle most of the ubiquitous regulations of post-war international financial markets. The justification for this "liberalization" of financial markets is that it will produce lower real costs of capital, greater growth rates of output and productivity, and more employment opportunities compared to the rates experienced between World War II and 1973 when international capital flow controls were practiced by most countries of the world, including the United States. ...Theory Continued