The world economy is like a person with a bad stomach flu; that horrible sick feeling keeps coming back. In 2008 it was mortgage-backed bonds and the failure of Lehman Brothers; last year it was the worst recession since the 1930s; this year it’s the European financial crisis. We still don’t know where this is going; there is plenty of good news out there. The National Association of Business Economists is upgrading its growth forecast for the US in 2010; China remains strong; the IMF is upgrading its growth forecasts worldwide. On the other hand, some of the world’s smartest investors are buying gold like there was no tomorrow, there is talk about a new global meltdown, and the world’s financial markets seem ready to plunge on the slightest whiff of bad news.It is still too soon to tell whether we are in the recovery phase or whether the global economy is still getting sicker. Already hundreds of millions of people around the world have lost their jobs, lost their homes, changed their retirement plans, pulled kids out of school and made other adjustments. Even those who’ve kept their jobs and homes are suddenly aware how fragile prosperity is. Government employees across Europe and North America wonder what will happen to their pensions; private sector workers are braced for new layoffs, and getting used to life in a more insecure and volatile job market than they once expected. stronger than anybody expected; the fat lady hasn’t sung yet and the American era is still here.2. Liberal capitalism works.If half the world’s commentators and pundits spent the last 18 months announcing the collapse of American power, many of the rest spent their time hailing the death of the American capitalist model: Piratical ‘Anglo-Saxon’ capitalism was obviously less effective than the more civilized, more humanistic model of, say, Europe. Wrong again. The crisis did what crises usually do: it tested the world’s companies, governments and currencies to see what they were made of. The preliminary results of that test are now in, and the United States again looks surprisingly healthy. The dollar held up well during the crash; when the chips were down investors still thought America was the best place for their money. America’s flexible labor markets meant that a lot of people lost their jobs, but also that the recovery would start more quickly here. The overwhelming lesson of the crash for Europeans is that they need to accelerate Europe’s slow and painful shift toward a more liberal form of capitalism. Europe’s socialist parties in Spain and Greece are introducing hated liberal reforms because, as Margaret Thatcher put it long ago, “there is no alternative.”3. The rogue states are parasites.It may seem unkind or gloating to say so, but the point needs to be made: the pathetic pretensions of regimes like the ones in Iran and Venezuela to some kind of world leadership have been cruelly exposed. The governments of these countries are parasites on the global economy and far from representing alternatives to the global model, they are entirely dependent on capitalist success. When the global capitalist system is booming, the price of oil goes up and Venezuela and Iran have the cash for subsidies at home and adventures abroad. When the hated global system goes bust, Venezuela and Iran go broke. The leadership of these countries are like adolescents criticizing the bourgeois habits of the parents they sponge off. Both Iran and Venezuela have immense potential to help shape world civilization and culture in the twenty first century, but to make that contribution they will have to use their oil wealth to join and help shape the world system, rather than using it to feed the egos and illusions of their leaders.
4. The old left is dead.Not even a global economic crisis can breathe new life into the world of Marxian socialism. Not only have most European countries moved to the right since the crash; the developing world has not seen any serious revival of ‘proletarian socialism’ in response to hard times. The world’s surviving ‘communist’ regimes continue to hold power by claiming credit for the successful management of increasingly capitalist economies. If you look hard, you can find a noisy fringe calling, say, for the nationalization of the banks or other old left responses to the crisis, and there are lots of places where people are protesting government austerity programs, but there is not a single free country in the world where serious political parties argue that socialist transformation will cure the economy’s ills. Increasingly, the politics of resistance and protest come from the right (and that isn’t always a good thing).
Greek Austerity Protests5. Nobody really understands the world economy.Sad, but true. For all the math and the theoretical models, economics remains an intellectual discipline rather than a predictive science. That is unlikely to change. Just as all the computer models in the world can’t tell you what the stock market will do tomorrow, all the world’s economists working together can’t tell you when the next crisis will come — or what you can do to avoid it. At any given point of time there will be economists predicting a crash and economists predicting good times along with every variant in between; some of them are bound to be right but so far this looks more like timing and luck than the repeatable and testable result of demonstrably better methods. The economics profession is full of dogmatic and pompous heretic hunters of all stripes, but as a group they are no better collectively at prediction than a similarly dogmatic and contentious group of medieval clerics. This doesn’t mean that economics is bunk (any more than theology is bunk); systematic and rigorous reflection on human economic activity yields many useful insights and an education in basic economic ideas remains an essential piece of intellectual equipment for any serious person.Economic outcomes remain hard to predict not because economists are stupid (they aren’t, by and large) but because the world economy is continually in flux. Facts change; China rises, new industries emerge, under the influence of new economic ideas, central bankers and investors change the way they behave. Investors and entrepreneurs have mood swings: too optimistic in 2007, too pessimistic in 2008. All this change feeds back into the world system in unpredictable ways. Economics can help us understand what is happening and give us more sophisticated tools for investigating the unknown — but it cannot protect us from uncertainty and risk. The “unknown unknowns” will always be with us.This means, among other things, that we are no closer to eliminating panics and crashes than the Dutch were in the wake of the Tulip Bubble.6. That goes double for financial markets.Financial markets are even more volatile than the real economy. Economists predict, with varying but rarely satisfying results, the behavior of the real economy. Few are so foolish as to predict the behavior of financial markets (and those who do often lose a lot of money). There are good reasons for this. Psychology of course plays a major role in short term fluctuations, and crowd psychology is so far at least largely beyond our power to predict. But there is more. Change in financial markets has been accelerating dramatically with the improvement of computers, communications and software. The avalanche of new securities products during the last twenty years transformed the way global financial markets work. The crash set this process back for a while, but it is sure to resume. Both borrowers and lenders are (and should be) always on the lookout for cheaper, more efficient ways to manage their portfolios and get the maximum results for the minimum cost. Financial firms are, and should be, ready to help make this happen. Over time, new securities products, larger trading volumes and complex hedging and trading programs change the nature of the financial marketplace. There are new risks and new interconnections that, increasingly, neither regulators nor market participants fully understand. As time passes after a crash, both regulators and market participants become more confident that the system is working, and there is a natural tendency for risk tolerance to increase even as risks are becoming harder to measure and price. Sooner or later this leads to a new crash as unexpected vulnerabilities emerge; at that point everyone from regulators to speculators recalibrates and the predictably unpredictable cyclical process restarts.Starting with the Dutch Tulip Bubble we’ve had about 350 years of financial crashes and panics. They are unlikely to stop anytime soon — and each one that comes will take most people by surprise.7. The Battle of Financial Markets is over; the Battle of State Finance has begun.“The Battle of France is over,” Winston Churchill said in 1940. “The Battle of Britain is about to begin.” We are at a similar juncture right now in the global economy. The financial markets failed to withstand a series of speculative assaults. The world’s governments rushed into the breach with large guarantees and bailouts. Now the markets are testing the governments: will the Europeans really be able to bail out Club Med? Beyond that, can the world’s governments armed with fiat currencies and facing enormous budget deficits provide enough credible stimulus to restart the world economy before fears of debt and default cause investors to lose faith in the ability of governments to manage the economic cycle?The bad guys lost the Battle of Britain and we can hope that governments will survive the present downturn with their financial credibility intact. However, it is now clear that governments do not have an unlimited power to bail out private firms or to stimulate the economy through deficit spending. This is not only true of smaller governments like that of Greece; it may be true even of the United States.This means that we have passed into a new economic environment, unlike anything we have seen since World War Two. For the last sixty years, we have operated under the assumption that the world’s leading governments were ultimately sovereign when it came to the economy: that they could do whatever it took to fix economic problems. In the future, we will be living in a world where this is no longer so obvious. New, large and unpredictable risks now hang over the global economy.8. The demographic crunch time is here.For more than a decade we’ve been worrying vaguely about the consequences of demographic change for government budgets. The problem is no longer abstract; the long-term deficits associated with rising entitlement spending in the US, Europe and even China are beginning to affect investor perceptions and to limit what governments can safely spend. Across the industrial world governments now face a long-term fiscal squeeze. For the foreseeable future, governments will be less able to respond to economic slowdowns with deficit spending. While the global slowdown has temporarily dampened inflationary forces, the unfunded liabilities for pensions and entitlement spending will begin to affect interest rates and inflation expectations when and if the world recovers to something more like a ‘normal’ growth pattern.Policy and politics will be dominated by efforts to raise retirement ages and otherwise adjust to an era of diminished government resources and rising demand for health and other services. Governments that are unable to get their long term finances in order will pay an increasingly heavy price — especially in times of economic crisis when their markets will come under speculative attack and when their efforts to bail themselves out by increased spending will only undermine their global credibility.9. Culture matters.The economic crisis has further dispelled the illusion that the post-World War Two western world had achieved a permanently prosperous, permanently stable social democratic wonderland. The idea that liberal capitalism would produce a stable and secure world of low risk, rising living standards and increased economic equality has been proved wrong — at least for the time being. Propelled by global competition and rapid technological change the west is shifting into a world of higher risk, faster change, less stability and more inequality. This will be a difficult transition for all countries and cultures; for some it will be more wrenching than others. The fragile social peace in some European countries will be tested by the continued erosion of the old social model. The countries (in Europe and around the world) who are able to spend their energies exploiting the new possibilities of the new capitalist era will grow more rapidly than those who waste their energies fighting a rearguard action against it. Ultimately the fast changers will become more prosperous and more powerful than the slow changers. Historically, the English-speaking world has been a world of fast-changers; this is one reason English speaking countries have prospered so greatly in the capitalist era. In the post-2008 world, the ability to roll with the punches and change with the times has become more important than ever. Understanding the risks and rewards of investment and the future trends of world power and prosperity is increasingly linked to an understanding of the cultural forces in each country that make it easier for some and harder for others to take advantage of the emerging world system.10. The politicization of economic governance is dangerous business.
The economic system we’ve built depends heavily on a small number of global financial firms who necessarily enjoy close links to national governments. Because of their power and their wealth (and also because they are sometimes ‘too big to fail’), these firms can potentially control the laws that govern their behavior and the regulators who enforce them. In the United States there has been a lot of attention paid to the close relations between current and former executives at Goldman Sachs and the Clinton, Bush and Obama administrations. The finance-government nexus in the US has its counterparts in other countries as well. These close connections, and the obvious danger of conflict of interest, have gotten a lot of attention — as well they should.But the problem of regulatory capture is much greater and more deeply entwined with our current economic structure than this one case. The rise in the economic importance of the state during the twentieth century–however necessary and in many ways benign this role may have been at various points along the way–inevitably brings politicized governance and regulation in its wake in ways that make bubbles, panics and crashes both more destructive and more likely.To take one important example, when government workers make up a substantial portion of the electorate, they can influence their own wages and pensions by voting as a bloc. They can — and they do. California, Illinois and Greece have a lot in common.But even this is just the tip of the iceberg. The increased economic role of the state naturally and inevitably multiplies conflicts of interest and creates moral hazard. American housing policy, widely and correctly blamed as a major contributing factor to the crisis of 2008, was an outstanding example. The combination of interest groups — consumers who wanted cheap loans and rising house prices, banks who wanted a safe and profitable business model, contractors and other businesses with a stake in the home-building industry, cities and towns whose tax bases increase with rapid growth, advocates for the poor who wanted to improve the access of marginalized groups to the Great American Wealth Machine of home ownership — put them all together and there was an irresistible political force driving the United States real estate market and the financial system into more and more dangerous territory. The housing bubble wasn’t an accident; it was the result of decades of national policy and we worked very hard and spent lots of money to make that bubble as big and as dangerous as it turned out to be.“Vote yourself a farm!” was a slogan of those who campaigned for the Homestead Act that gave free farmland in the west to anyone willing to settle it. Farm subsidies from the Homestead Act through price supports helped cause the Dust Bowl catastrophe and the great agricultural depression of the 1930s by encouraging over-investment in farming and the creation of marginal farmsteads. The crash was more brutal because government support had inflated the bubble past what would otherwise have been its ‘natural’ size.“Vote yourself a home!” has been our national motto for the last fifty years and today Americans are as addicted to the home mortgage deduction (and the even less justifiable deductions for second mortgages and home equity loans) as Greeks are to early retirement and government employment. Political popularity makes the policies harder to change — but no less damaging and destructive.There is no easy way out of these problems. Global markets need sophisticated firms and large firms can manage risks and survive shocks that smaller ones can’t. Civil servants do not and should not lose the right to vote when they take government jobs. The decision to favor home ownership on social and political grounds is one that politicians can properly make, and there is a lot to be said for policies that have helped millions of American families acquire substantial equity over the years.Yet it is clear that the mix of democracy and capitalism is a dangerous if necessary brew; after decades in which we failed to think the costs and risks through, we are now suffering the consequences of policies that create dangerously perverse incentives in both political and economic spheres. Reducing damaging but popular forms of state intervention in the economy while ensuring the state retains the authority and the ability to provide the effective legal and regulatory frameworks without which no modern economy can flourish is the fiendishly difficult and delicate task which Europeans and Americans alike must now undertake.
[ Second photo courtesy of Piazza del Popolo.]