The Market for Capital
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Review by Andrew Norton

The Well-being of Nations: The Role of Human and Social Capital
Tom Healy and Sylvain C™tŽ
OECD, Paris, 2001, 118pp,Ê ISBN 92 64 18589 5

THE STUDY of social capital was one of the great intellectual fashions of the 1990s, with hundreds of books and articles being written. This useful OECD book surveys the social capital literature, integrates it with the more established field of human capital, and says something about what the two mean for the 'well-being of nations'.

In their section on social capital, the authors show that it crosses the social sciences, with four main disciplinary approaches.

The first, which they designate 'anthropological', but which overlaps extensively with another of the 1990s intellectual fashions, evolutionary psychology, examines natural instincts for association. The book that made this link most explicitly was Francis Fukuyama's The Great Disruption, but James Q. Wilson's The Moral Sense and Matt Ridley's The Origins of Virtue were also important.

The second discipline is sociology. Though Robert Putnam is actually a political scientist, his 2000 book Bowling Alone: The Collapse and Revival of American Community is the single best survey of changing social association, though it is mainly limited to the American experience. While they are not mentioned in this book, the Centre for Australian Community Organisations and Management in Sydney, and the Australian Institute of Family Studies in Melbourne, are both doing interesting sociological work on social capital in Australia.

The third discipline is economics. While there are no stand-out books using the 'social capital' terminology, economists have analysed cooperation extensively using self-interest assumptions, and considered what kinds of interactions will give rise to what others call social capital.

The fourth discipline is political science. Again Robert Putnam is most prominent here, for his 1993 book Making Democracy Work, which provides an empirical case for what de Tocqueville argued in Democracy in America, that voluntary associations make a big difference to how democracy works.

While it is not covered in this book, perhaps because it uses different terminology and lacks an empirical edge, social capital also inter-connects with debates about individualism and community going on in philosophy and political theory.

This volume is not based on any original research, but its synthesis highlights connections obscured in the more specialist literature, and may be useful for policymakers who need to be concerned about the underpinnings of the 'well-being of nations'.

This takes us into debates on how national well-being is measured, and an appendix on various composite indexes, such as the 'Genuine Progress Indicator', peddled locally by the Australia Institute. The authors report on, but seem a little sceptical of this enterprise, and their main text makes little effort to add human and social capital.

More interesting than trying to add human and social capital is attempting to work out the dynamic between them. They seem to be mutually supportive. The authors describe several studies that find level of education is an important predictor of economic, social and political involvement, and Australian data suggests that the situation is similar here. On the other side of the equation, Putnam finds that children in high social capital families and communities do better at school. There is a 'virtuous cycle' (to use a Putnam phrase) between the two.

There are several reasons why education might be important. It can provide skills that both make individuals feel they can contribute, and encourage others to facilitate their involvement. The educational process can improve social skills and provide social opportunities. At least at the tertiary level, all this is more likely to be true in the US than Australia. There, many colleges require applicants to do community service, more are residential, and there is a greater pastoral care ethos.

In turn, high social capital creates a supportive environment for students, and makes studying more enjoyable. In Australia, 'emotional health' is the most commonly cited reason for first year university students considering deferring, a statistic almost certainly linked to the large minority with no close friends on campus. Higher levels of social capital on campus would minimise the loss of human capital suffered when students drop out. Appendix C of this book describes some of the research on social capital and schools.

Though the OECD's book misses the important Australian social capital literature, it does refer to Eva Cox's skippable writings, and-to my surprise-an article I wrote for Policy in 1998. Unfortunately, they raise this article to disagree with its suggestion (in turn taken from David Green) that the welfare state crowds out voluntary provision of welfare services. Historically, I think Green is right to say that the welfare state took away much of the friendly societies' role, and caused their decline as community organisations.

While this is an historical consequence of the welfare state, its effects in recent decades may be more mixed. Economic theory predicts that if the price of something goes down more of it will be consumed. In that sense if government subsidy of welfare organisations, a major trend over the last few decades, lowers the costs or burdens of involvement, it may encourage volunteering. Certainly, in recent years the welfare state and volunteering have both grown.

The great gap in the social capital literature has been policy proposals. It is not all that surprising then, that in an overview book, the section on policy suggestions is very short. The authors nominate support for families and for voluntary initiatives, community involvement in decision making-processes, use of ICT, and helping ill elderly people stay closer to their families. They could easily have added, given the importance of education, continuing efforts in that area.

This is all very unexciting, because-with the partial exception of community involvement in decision-making-it simply reflects longstanding policy orthodoxy, not innovative new directions.

Such conclusions are frustrating for policy wonks, but it is (thankfully) difficult for governments to influence social capital directly. Social connection for the sake of it requires a sociability, and perhaps emotional commitment, that has to come from within, whatever prompting others might give.Ê Other forms of social connection occur as incidental to activities carried out for another reason, and unless that reason is persuasive no social capital will be generated. At the margin, governments can through its other policy functions facilitate social capital creation, and avoid its unintentional destruction. A specific social capital policy, however, is almost certain to fail.

Reviews by Wolfgang Kasper

In Defense of Free Capital Markets: The Case Against a New International Financial Architecture
By David F. DeRosa
Princeton, New Jersey, Bloomberg Press, 2001, US$27.95Ê 230 pp, ISBN 1 57660 036 X

The Volatility Machine: Emerging Economies and the Threat of Financial Collapse
By Michael Pettis
Oxford-New York, Oxford University Press, 2001, US$45.00, 245 pp, ISBNÊ 0 19 514330 2

IT IS FASCINATING to see what two different authors-with different professional backgrounds, networks and different bodies of knowledge-discover when they examine the same problem. The two authors come up with differing conclusions, which are, I believe, compatible. David DeRosa and Michael Pettis looked at the increasing crises in international financial markets, from the Mexican crisis of 1994-95, the Asian 'meltdown' of 1997 to Russia's end-of-millennium debt default. DeRosa argues that national economies must not be squeezed into regulatory corsets, whereas Pettis advocates an internal bone structure that keeps national economic corpuses in crisis-resilient shape. Let me explain.

DeRosa, academic and journalist with the gilt-edged Bloomberg news service, also looked at the crises that shocked Europe's Exchange Rate Mechanism in the 1980s and at the financial side of Japan's protracted 'economic torpor'. He asked what might be achieved by regulation of international financial and capital markets (dubbed 'The New Financial Architecture'), which anti-market observers, ranging from Fred Bergsten , Eisuke Sasikabara and George Soros to UN bodies, and meddle-happy politicians, such as Clinton, Schršder and Mahathir, have been demanding, as before them dirigiste politicians such as Roosevelt.

DeRosa shows through well-documented, insightful case studies that all monetary crises started with wrong-headed policies and mismanagement at home. Capital market interventions and exchange-rate fixes postpone gradual adjustment, so that the unravelling of politically-created market disequilibria comes as an abrupt crisis. Politicians then blame foreign exchange markets rather than their own blunders and market interventions. DeRosa also spells out that there is no such thing as 'contagion' from currency crises, except among mismanaged regimes. Surprisingly, he makes little in this context of how well Taiwan and Singapore weathered 1997.

The Japanese sclerosis is analysed from a monetary angle, but-for my money-too little is made of the long tradition of 'guided' industry policy and interventionism in misdirecting capital investments. Neither does he acknowledge underlying factors, such as the ageing of the population. Mahathir's Malaysia comes in for particular criticism-for my money deservedly! In this case, DeRosa shows how megalomania, protectionism and the blatant cronyism of 'Mahathir Incorporated' (p. 108) saddled Malaysia with excessive foreign borrowing costs. They far exceeded the returns of the investments, which can over the long run be earned in a regulation-corrupted economy. Having myself served as an advisor to the Malaysian Treasury, I would also have spoken of the corruptive poison of 'positive' racial discrimination as the root cause of Malaysia's opportunistic interventionism. The initiators of a redistributionist 'New Economic Policy' (in the early 1970s) had floated the currency and liberalised capital flows, among other things to provide a 'safety brake' on excesses of political redistribution and interventionism. The brake had worked well in the late 1970s and early 1980s, when capital outflows and devaluation forced politicians to deregulate the economy and moderate redistribution. This paved the way for fast growth during the 1980s.

But, by the late 1990s, excessive debt, combined with growing interventionism and party-political cronyism, threatened a repeat of instability of the late 1970s/early 1980s. This time, Mahathir imposed capital controls and fixed the exchange rate, because he and his cronies were not going to accept external discipline. His egotistic power play was covered up by vituperative attacks on foreigners and capital markets, as well as internal witch hunts. In the process, economic freedom, the rule of law and much political freedom were destroyed, which will have dire long-term consequences. DeRosa appears oddly agnostic about this outcome of Mahathir's interventionism.

The policy conclusions of this well-informed and fluently written book are straightforward and compelling: no bunch of politicians or bureaucrats can handle the relevant knowledge about a dynamically changing, complex world as well as free currency markets do. DeRosa argues against all sorts of controls (which he, somewhat irritatingly, calls 'reforms' throughout the book). No bandwidths for currency movements. No prohibition of derivatives and hedge funds. No Tobin taxes on currency transactions. Above all, no fixing of the exchange rate! He shows that such devices are not workable in international markets and lead to costly subsequent crises.He sees a very small role for the IMF whose 'central planning from Washington' has aggravated various crises. Only free capital markets can give self-seeking politicians and their cronies the feedback necessary to inform them what institutions and policies are needed for stable growth.

Michael Pettis' book has a different thrust. Pettis, bond trader and Columbia University lecturer, argues that many emerging countries unwittingly acquire national balance sheets which expose them to financial market volatility, so that crises become inevitable. He applies the framework of corporate finance (summarised in Chapter 6, a gem!) to nations and shows that aggregate assets and liabilities of developing countries are often asymmetrically affected by reductions in global liquidity or exchange-rate fluctuations. Different from DeRosa, he takes free capital markets as given. Pettis argues that emerging economies should hedge against aggregate risks. For example exporters to the US dollar area should issue US dollar debt, so that a US dollar depreciation (which cuts export revenue in home-currency terms) is countered by an easing of the US dollar debt burden. This is sound advice, and I hope that an Australian PhD student or Treasury researcher analyses Australia's balance sheet on those terms. The real problems, which Pettis does not address, of course arise when countries no longer have the credit to borrow at almost any cost-such as Argentina at the time of writing-so that they cannot hedge by balancing assets and liabilities.

Pettis bases the analysis on Charlie Kindleberger's plausible insight that capital flows to and from peripheral economies are driven by the liquidity situation in the core of the global network-New York, London and Tokyo. He also bases his theory on an account of financial crises going back to 1820 in Chapter 4, another gem!

Abundant liquidity in the system as of 2001-02 makes financial crises less likely and is helping Latin American and East Asian countries, as well as Russia, to avoid serious reform and restructuring. But he rightly warns (in Chapter 10) that countries, which do not rid themselves of a liquidity trap in their balance-sheet structures, may face more serious collapses further down the track.

Pettis is at times oddly sceptical of the need for economic freedom and has the occasional stab at what he calls 'neoliberal policies'. But unfree economies rigidify and expose assets in the national balance sheet to risks when circumstances change. This detracts to my mind from an otherwise excellent book. Pettis also seems at times a bit starry-eyed about what bureaucracies can do, for example when he advocates that the IMF should evaluate a nation's sovereign risk management along his lines. This will certainly do some good, but it would be better if thousands of market participants adopted his analysis, incidentally also for the sales of his book!

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