Micro-blog: The market and the state: Recrimination at the G20 summit

Well, recriminations have already started at the G20 summit. Lots of news organizations are covering it, but here's a good one, the BBC's take:

http://news.bbc.co.uk/2/hi/business/7974190.stm

France is first out of the blocks, threatening a walk-out, if stricter financial regulations aren't introduced into the global economy. Already, a schism seems to be developing between the US, Britain, and Canada, on the one hand, and the European economies, on the other. The Anglo-Saxons want to pursue Keynesian-style stimulus, by pumping billions more into the economy, whereas the Continentals think that stimulus will be unhelpful or positively counter-productive unless much-needed reforms to the financial system are undertaken first.

These are two different takes on diagnosing the current mess, and starting on a corrective course. The Anglo-Saxons seem to be saying, basically, that the current balance between market and state, as exemplified in the regulatory regime that governs banks and the financial system, is working OK, and that our problem right now is a classic (note, I did not say "classical" -- sorry, inside economics joke!) case of unemployment due to deficient aggregate demand, and that we should dust off our copies of Keynes' General Theory and take it from there. The Continentals are suggesting that there are fundamental flaws in what is being called pejoratively Anglo-Saxon economics. Read, Thatcher and Reagan style deregulated capitalism as practiced in the UK, US, Canada (to a lesser extent) and other Anglo-inspired countries. It's interesting that the French President, when he was running for office, extolled the virtues of Anglo-American economic reforms for France, especialy its sclerotic labour market. Evidently, he's changed his mind on those.

So the battle lines are drawn. Stay tuned for more updates from the front lines, and from here in the trenches.

Micro-blog: The market and the state: On bailing out the US and Canadian auto industries

Just about everyone seems unhappy with the putative bailouts for the US (and Canadian) auto industries. One brand of critics complain either that the the aid is too little or too much. Let's leave that sort of carping aside. More significantly, quite a few economists are complaining that the aid is a bad idea. Let the auto industry die, and something else replace it. The jobs and capital would be more productively used in another part of the economy. We can import the cars we need. That's what free trade and the the "free market" (scare quotes necessary, recalling an earlier admonition against this term) would suggest. The government simply shouldn't get involved.

Now, as a matter of economic theory, this criticism is valid, unless a case can be made that the auto industry generates a positive externality (or, perhaps, plural positive externalities) that are not captured by the market. This is textbook economics from a first year principles course. One such externality might be an employment-related one. If we are indeed in a Keynesian-type situation with below full employment, preserving existing jobs may confer benefits on society greater than the private marginal product of the last person hired would suggest. As it happens, this is one of the oldest quasi-legitimate arguments for protection in the book, going back to the work of Gottried von Haberler in the early part of the last century. I say quasi-legitimate, because the "targetting" principle of Bhagwati and Ramaswami suggests that the best intervention would be directly in the labour market, not using tariffs or trade barriers as a proxy to preserve employment.

But frankly all of this misses the point entirely. When economistic critics say that the US administration is stupid to be bailing out the auto industry. they are revealing their own stupidity. Economic policy is not made by economists, it is made by politicians. Politicians who like to get re-elected. In other words, there is a political economy of the putative auto industry bailout, that is at least as important as the pure economics of it. If you were the government of the US or Canada, would you let thousands of people in pivotal electoral states (and provinces) such as Michigan, Ohio, and Ontario lose their jobs and vote against you in the next election? Now, doing that would be truly stupid for any politician. Good politics, of course, doesn't always make for good economics, but that's a tale for another time.

Micro-blog: The market and the state, a few further reflections

Earlier today I showed my freshmen economics students the second half of episode 1 of the PBS series, Commanding Heights. Here's a link:

http://www.pbs.org/wgbh/commandingheights/

Episode 1, "The battle of ideas", treats the pendulum swing between the market and the state, over the course of the 20th century, that I've written about at length in previous entries. What struck me on rewatching it on this occasion was how sanguine everyone (except one disgruntled British coal miner) appeared at the end of the episode (filmed in 2002) about how the battle of ideas had been won, and there had been a decisive turn towards the market and away from the government, summing up the conventional wisdom on the triumph of deregulation and "supply side" economics, some twenty years or so after the onset of the Reagan Revolution. Gordon Brown and Larry Summers were agreeing that recent experience had shown that it was the market that best harnessed entrepreneurial forces, and that old debates on which is a better way to govern the economy, the market or the state, were passe. It's interesting that those old debates, that were thought to be dead and buried, are back, alive and kicking, and insisting on a re-airing, and re-thinking, as we come to grips with the aftermath of the financial crisis. "All of this has happened before, and all of this will happen again," as the Cylons like to say.

Micro-blog: CBC Mini-series on India, continued

I've posted previously on the new CBC miniseries

http://www.cbc.ca/documentaries/indiareborn/index.shtml

The last two (of four) episodes aired last Sunday. All told, like the first two, they were pretty good --well balanced, and a good introduction to someone unfamiliar with the complexities of India. Worth checking out through the CBC website.

The market and the state: Capitalism caught between libertarianism and populism

One of the recurring themes in these blog entries is reflecting on the age old discussion about defining the respective roles of the state and the market in ensuring the efficient and equitable functioning of a modern economy. Today's entry will be yet another footnote to that ongoing conversation. I heard an interesting new way of framing this debate today from Eliot Spitzer, the disgraced former Governor of New York, who became famous in his earlier incarnation as Attorney General in pursuing crooked dealings on Wall Street, including a prosecution of AIG, which makes anything he has to say on the subject timely. Plus, he's a smart and thoughtful guy. Perhaps his prescience in predicting the sort of trouble that Wall Street (and for that matter, the nation, and the world) is going through now, and the fact that he actually tried to do something about it, will help revive his political career, laid low after the prostitution scandal that brought him down as Governor last year. We'll see.

But back to the point at hand. Spitzer was on Fareed Zakaria's excellent new CNN program, GPS, earlier today, commenting on the current controvery over AIG's executive bonuses, amongst other things, and legal avenues that the US government might pursue in recovering those monies for the American taxpayer. The whole interview is well worth watching, and, if you're reading this today, Sunday, March 22, you can catch it again at 5 pm Eastern time this afternoon. In due course, it will no doubt be archived on the show's website. Here is the link:

http://www.cnn.com/CNN/Programs/fareed.zakaria.gps/

Interesting and topical stuff, but much the most interesting part of his discussion was on the very subject of the market and the state, on which I've been opining recently. Spitzer framed the debate in an interesting way, by saying (and here I paraphrase) that we had during the last twenty years was libertarianism masquerading as capitalism, and, if we're not careful, what we're likely to get in the next twenty is rank populism instead, that, if not nipped in the bud, will threaten the system of capitalism itself. This is a more provocative and pungent way of saying what I'd put more prosaically, that we might be about to witness another pendulum swing, from the balance tipping from the market back to the state. Or, to be more precise, this would involve a putative move from an insufficiently regulated market to an over-regulated one. On this fundamental point, I believe that Spitzer's framing of it is accurate, and, alas, his predictions may once again prove to be prescient.

Mini-blog: Twitter as a microcosm of globalization?

If you've looked at the box just below the upper right hand corner of this page (below my non-existent list of followers), then you've realized I've recently joined a class of people, known dubiously as the twitterati. If you'd like to become one, you need only visit the following page and sign up:

http://twitter.com/home

Now, for those of you who are into social networking websites, you know that the flavour of the month, for the last many months (the last year or so at least), has been Facebook. So successful has it been, in fact, that it displaced the industry pioneer and front-runner for many years, MySpace, that has been relegated to second spot. Now, if you're a FB user, you know that it's great utility is not only in being a non-intrusive way to keep in touch with friends and family, but also a great way to reconnect with old friends one has lost touch with. I, myself, have used it to reconnect with old friends from high school that I'd lost touch with years. In fact, I had my first "Facebook reunion" (yes, that's what they're called) with a friend from seventh grade, last fall in Toronto. So, to summarize, FB is great for sharing information with current friends, and finding old ones again. FB also encourages this localization by encouraging you to sign up for alumni and regional networks, in other words, schools and universities you've studied at, and the place you're living (it lets you join only one at a time). Warm, reassuring, and friendly -- like a cold hug on a warm day.

Twitter is different. Edgier, for one thing. A pared down, no nonsense home page. Posts are limited to 140 words maximum. Concision is at a premium. Bios on the profile page are also short. There is only one one small thumbnail pic. No multimedia, unlike FB and MS. So a different look. But different substance? Yes. The main difference, from my point of view, is that Twitter is fundamentally democratic. Unless someone makes their status private (and, in my experience, very few people choose this option), anyone can track anyone else's status messages. Anyone can send an "@" reply to anyone else in Twitter-space. To send a direct message to someone, they must be following you (not the reverse). But following is not symmetric (unlike in FB, where "friending" is; that is, both parties to a putative friendship must agree before it is consummated). Clever. There are all kinds of software applications, as well as applications for mobile devices, that make Twitter easy to use from a computer or a mobile phone, smart or otherwise. Which is also why it's being used for things like political polling in real time, for example, during the recent US and Canadian election campaigns. Also, in emergency situations, where, for example, a firefighter can notify affected people in real time, with something as simple as  a text message on a cell phone, where to avoid in the path of an oncoming blaze. For the same reason, it wouldn't be terribly useful to terrorist or criminal groups, unless, of course, they have established an elaborate system of codewords, replies, counter-replies, etc. (I hope I haven't just inadvertently given anyone any ideas.)

Twitter, also being new, has acquired celebrity cachet. Barack Obama, while a candidate, posted regular updates. Now, in the past few days, his Teleprompter has begun blogging, and posting Twitter updates of his own. Don't believe me? Check out this link:

http://twitter.com/BOTeleprompter

But the best feature, in my opinion, is what is called the "public timeline". This is a way of tracking, in real time, everything going in in Twitter-space, that is, all recent posts (usually that means, within the past minute or so). Here is where you can find it:

http://twitter.com/public_timeline

What is cool about this is that at any one moment, you might have, to take a random sample: a undergrad student sending a post from his dorm room in Iowa; a software engineer in Bangalore, India sending a message on mobile internet from his smartphone; an art student in London sending a message from her iPhone at the Apple shop on Regent Street; a celebrity updating her status at their favourite nightclub in Los Angeles; a university professor updating friends and family on how his teaching and research on a particular day went. (I'll leave it to you to guess which one in that preceding list describes me.) All in real time. Unadultered, uncensored (not necessarily always good!), real time raw data from the world out there. And every one of these people is seeing everyone else's status updates, in real time. Can you think of a better metaphor for globalization itself? I'll let you ponder that, as I update my Twitter status. Catch you later.

Mini-blog: Keynes has not left the building

I realize I've commented on this one before, but I'm struck anew by the continuing impact of Keynes on the contemporary teaching of macroeconomics. I'm just in the midst of teaching a chapter on how government policy, both fiscal and monetary policy, can be used to affect aggregate demand, and, a fortiori, help to stabilize the economy when prices are sticky and hence the aggregate supply curve isn't vertical at its long run, potential level. The two key concepts in the chapter, thus far, are liquidity preference, and the multiplier. Pure, unadeltered Keynes. More on this, after I've taught the remainder of the chapter.

**********************************

And I'm back! The remainder of the chapter hasn't done much to change the picture. Keynes rules. The discussion of automatic stabilizers and the Friedman "insulation" argument for the flexible exchange rate also seem holdovers from older editions, and strangely irrelevant to the current macroeconomic crisis. Perhaps we're going to have to rewrite the textbooks now. One think is for sure, though: I expect that Keynes is likely to contine to figure prominently.

Mini-blog: New CBC TV series on India

Well, better late than never. The BBC, CNN, and other news channels were talking about the rise of India and China about five years ago. The CBC (Canada's state-owned broadcaster, our version of the BBC, not quite like NPR) did a series on China a while back. Finally, they've figured out than a documentary on a country that houses a billion people, give or take, or about a sixth of the world's population, is worth doing, if for no other reason than to educate "average Canadians" (read: old stock Angl0-Celtic and "pure wool" French-Canadian) on the Indo-Canadians in their midst, their strange smelling (but tasty) curries, their weird and wonderful costumes, their funny accents, and their elaborate weddding ceremonies, ripped from the latest Bollywood blockbuster.

Oh, before I forget. If you missed it (the first two episodes aired last night, the next two next Sunday night), here's a link to the CBC's website for the series:

http://www.cbc.ca/documentaries/indiareborn/index.shtml

For the most part, there wasn't a great deal that was novel or revelatory for anyone who knows India. But, for those who don't, the series, or at any rate the first two episodes, present a generally balanced view of the paradoxes and puzzles of contemporary India. The usual suspects, such as the ills of the caste system, poverty, deprivation, and so forth show up. As well as the scourge of Hindu fundametalism. An interesting lacuna is no discussion of Islamic fundamentalism, nor of the 26/11 Mumai terrorist attacks. I suspect the film was made beforehand. Also, in my judgement, insufficient attention to the colonial history, and how a knowledge of this is essential to frame the current situation. Let's not forget that the flames of Hindu-Muslim enmity were fanned by the British Raj, in a successful bid (well, for two hundred years or so) to keep the country from uniting and kicking out the colonizers. And as a parting gift they tore the country in two when they left. (Well, they had help from Nehru, Jinnah, and Gandhi -- but that's a tale for another time.) Churchill famously predicted that India would descent into chaos when the British left. I'm glad to report that he lived long enough to see his gleeful prophecy fail, although I doubt he would ever have admitted it.

Anyway, despite my cribbing, a series that for the most part is sensible and pens a cautiously optimistic epistle of the world's largest democracy. I'll stay tuned. Especially to see what Vijay Mallya's Goa mansion looks like from the inside (I've only seen the outside gates).

Mini-blog: Moises Naim seems confused on whether he's optimistic or pessimistic about the future of globalization!

The current issue of the magazine Foreign Policy has an opinion piece by the editor, Moises Naim, on globalization. Here is a link to the article on the magazine's website:

http://www.foreignpolicy.com/story/cms.php?story_id=4678

 While tendentious and not particularly novel or interesting, it is gratifying that Naim repeats some of the cliches that I was trying to debunk in a previous post on globalization, at the very least to show that I wasn't criticizing a straw man. Here is his bottom line on the future of globalization: "Globalization is such a diverse, broad-based, and potent force that not even today's massive economic crash will dramatically slow it down or permanently reverse it. Love it or hate it, globalization is here to stay." Now, Naim, at least in part, wants to act as a cheerleader for globalization, and, in so doing, I believe downplays the serious dangers that it faces. Indeed, in a later section of the piece, he admits that the fact that people are wrongly blaming globalization for the current financial crisis, does indeed pose serious risks for the whole enterprise. He writes: "... the gap between the need for collective action [to reinforce trends towards globalization] at the global level and the ability of the international community to satisfy that need is the most dangerous deficit facing humanity." That sounds pretty serious to me, and seems to difficult to reconcile with his earlier, uber-optimistic epistle. Perhaps the earlier statement represents wishful thinking and the latter his more measured and sober judgement on the very real challenges facing the future of our globalized world? Just a mini-thought, and a mini-question, to end this mini-blog, on a mini-spring-like day in Ottawa.

The perils of first year principles of economics and some possible lessons for our current mess

It's very timely that I've just been teaching my freshmen first year principles of economics students about aggregate demand and aggregate supply and the received textbook theory of business cycles, just as we're heading into (0r rather, already are) in a downturn, at a time when everyone is once again talking about John Maynard Keynes, invoking him in one way or another, to justifty the stimulus packages in the United States, Canada, and elsewhere. The basic textbook model argues that governments can step in when there's a drop in aggregate demand for goods and services, by filling the gap through government spending, a cut in taxes, or monetary easing. This, in theory, should get us back to, and maintain, full employment, and keep output at what economists call its "natural" or "potential" level (that is, where it would be, if the economy behaved as if it were in a long run situation in which all nominal wages and prices were flexible). All of this sounds fine. But the basic textbook model, at its first presentation, might make it appear that stabilizing the economy is a fairly easy matter, and thus puzzle my freshmen as to why it's taking so long to figure out just what to do in our current situation, and why there's so much disagreement, for instance, on whether the stimulus is too large, too small, just right, or just totally irrelevant.

The textbook AD/AS model, in its most stripped down form, suggests that stabilization policy is easy, indeed trivially so. All the government has to do is to keep track of the positions of the economy's AD and AS curves in the short run, and, when something goes out of whack, step in with the necessary corrective measures. A recession should last all of ten minutes, or maybe half a day, while the government does this. Very quickly, then, we warn our students that the model omits several important features of the real world, that make stabilizing the economy more difficult than might at first blush appear. To start off with, the textbook assumes that we all know the model, and the model is correct. In the real world, no one knows what model "truly" describes the economy (if one can take this sort of Platonic leap), and, even if we can guess at, we don't know the parameters that describe it. Everyone, including central banks, government ministries of finance, private sector banks, consultancies, and all the rest, has their own model, and the models don't necessarily coincide. As a second difficulty, and this is a big one, policy acts with a lag on the economy, both fiscal policy and monetary policy. Unfortunately, no one is exactly quite sure how long this lag is, and this again requires an educated guess (based on models) by policymakers. All of this creates the possibility, for instance, that by the time a stimulus package does kick in, a year or two down the road, it will be redundant, or, worse still, counterproductive, if the economy has already started to turn around. Government intervention, thus, can, despite the best of intentions, inadvertently make matters worse. You would think that this more nuanced picture would emerge when the relevant models are taught at higher levels. But, strangely, this isn't often the case. The current default model of choice for macroeconomists, known as the "SDGE" (that stands for stochastic dynamic general equilibrium, if you must know) model, in its various incarnations, also usually assumes that government policy can act instantaneously, or with a predictable lag, and that everyone shares the same information about the model. This makes government stabilization policy, if not trivially, then pretty easy, and leaves many of our students, armed with newly minted PhDs in economics, convinced of the truth of this proposition.

Now, I'm not meaning to reopen the big debate about the correct balance between the market and the state in our modern society. I tacked, or tried to, parts of that big debate in a previous entry. Nor do I want anyone to think that by questioning received Keynesian or neo-Keynesian doctrine I am thereby expressing some sort of knee jerk, libertarian antipathy to government involvement in the economy. No, the contours of the big debate have been mapped out by many, and most of us agree that any sensible society, one would that we care to live in, has to have some sort of balance between the market and the state, some level of government involvement in the economy, although the edges of each's appropriate sphere may be a bit fuzzy. One of those fuzzy edges, I'd like to suggest, is the debate between those who suggest that activist government policy (fiscal and/or monetary) can cure recessions, or, more generally, attenuate, if not eliminate, the vicissitudes of the business cycle, and those who are more than a bit sceptical of this possibility. If we purge the writings, musings, and pontifications of libertarian sages such as Mises, Hayek, and Friedman of their excessive ideological fervour, and nihilism about government's efficacy and role, that borders, at times, on the view tha the government doesn't have any important role in the economy (and we agree, or I hope we do, from my previous entry, that this is illogical and impossible), what remains is a healthy, and, in my judgement, essentially valid scepticism about the government's ability to fine tune imperfections in the market. Human beings are prone to failty and failure, and so, pari passu, are markets, and governments. This basic lesson of Hayek, Friedman, and the other libertarians, has been entirely swept away in the zeal to find a Keynesian fix for our current economic woes.

My freshmen often ask whether they think the stimulus package (in the US or Canada or for that matter) is too big or too small, and why there's such disagreement amongst economists about this point. I point out that economists who claim that a $1 trillion dollar fiscal stimulus is too small, eminest economists such as the Nobel laureate Paul Krugman, are on the "liberal" end of the political spectrum in the US, whereas those who claim it's too big, such as the Harvard historian Niall Fergusson, or the Canadian-born US Republican strategist David Frum, tend to be on the "conservative" end. In other words, the pundits' prognostications on the package align with their received ideology. I make no further inference, but leave it to my students to do so, if they wish. When I'm pressed, I say that I have no idea whether the stimulus is too large, or too small. All I can say is that $1 trillion is a lot of money, the current recession seems deep, so if we're going to try something it should be of sufficient magnitude. But, at the back of my mind, I have lingering doubts whether we're intervening because we think this is what will fix our economic travails, or whether it's simply politically impossible to do nothing. I'll leave that heretical thought with you, as I enjoy the setting sun on a glorious early spring evening here in Ottawa.

Democracy and Development, Redux.

Just when you thought that old chesnut, the debate about what's the connection (if any) between democracy and development, was finally laid to rest, it's back. Check out the current issue of Foreign Affairs, and you'll find an article entitled "How Development Leads to Democracy". Here is the link. Even if you aren't a subscriber, you can read a snippet and get the general idea:

http://www.foreignaffairs.org/20090301faessay88204/ronald-inglehart-christian-welzel/how-development-leads-to-democracy.html

Now, as it happens, I wrote a paper on the same subject when I was on sabbatical in India last year, but gave it the more equivocal title, "Democracy and Development: Friends or Foes"? (Mine wasn't published in Foreign Affairs, more's the pity.) Now mine you can read for free. It's a Carleton working paper. Here's the link:

http://www.carleton.ca/economics/cep/cep07-11.pdf

Now, there's general consensus that one can find a partial correlation relationship between the level of economic development (measured, say, by per capita national income) and the level of democractization (that's a trickier one to measure, but there are several indices, based on things like free and fair regular elections, free press, independent judiciary, etc.). By "partial correlation", I mean, holding other relevant factors constant, more developed economies tend also to be (more) democratic. This begs the question, is there a causal relationship underlying this correlation, or is the finding purely spurious? There are a variety of theories arguing each direction of a putative causal link. Some theories say thay that being democratic is good for development: people are more likely, say, to be entrepreneurial and take risks, thereby leading to more rapid development, if there's living in a free society. Other theories say that democracy is a "normal" good (in the economist's sense, that we demand more of it as we get richer), so that, the more developed a country is, the more likely it is that people are going to demand democracy. The latter is a rough and ready version of the classical political science argument, articulated by Seymour Lispett, amongst others, that economic development leads to the growth of a middle class, who in turn demand democratic reform (assuming that the development took place in an autocratic society).

There is another version of this argument, that I like, put forward by libertarian economists such as Friederich von Hayek, Milton Friedman, and Lord (Ralph) Harris. This argues that, in the long run, you cannot have a "free economy" without also having a "free society" (bearing in mind all of my previous caveats about the use and misuse of the word "free"). The two are inextricably linked, the argument goes. Try to have economic development, without democracy, and eventually pressures and contradictions will build up within the society that will lead to democratization (hopefully peacefully, but perhaps through violent revolution).

Now there are several exemplary cases of a transition from autocracy to democracy, mediated by economic development. South Korea and Taiwan come to mind in East Asia, as do several countries in Latin America, most notably, of course, Chile. Chile went through liberal or "neoliberal" (a term I don't like, but it's widely used in political science and development circles - why the neo?) economic reforms under the brutal Pinochet dictatorship. But it did eventually democratize, and is now, most observers would agree, the most stable and successful democracies in Latin America. It is fair to ask whether the process by which Chile got to where it is, and the egregious human rights violations that took place under Pinochet and his regime tarnish in an important way the current success of that country. To many observers, on the left in particular, Chile paid too high a price, while others, notably on the right, are more sanguine (especially as none of them had to suffer or die at the hands of Pinochet's goons). Without wanting to get into the ethical debate (that's for another time, perhaps), I just note that the prediction (development leads to democracy) worked in this case, as, indeed, Friedman predicted at the time.

What is also clear from recent experience is that democracy, imposed at the barrel of a gun (ironic and preposterous as that proposition is), does not work. Afghanistan and Iraq attest to that. End of story. Unless democracy arises organically, from within a society, it's not going to take root, and may be a democracy in form  but not in spirit or substance (i.e., elections take place, but the same guy always wins). Russia's backsliding from democracy into autocracy, under Tsar Vladimir, attests to this latter point.

The elephant in the room, of course, is China. So far, China's managed to buck the trend, and develop very rapidly, under a tightly controlled autocratic system, in which the Chinese Communist Party has refused to yield its monopoly in power, its opponents are jailed, and human rights violations are egregious and ubiquitous. The trillion dollar question is: Will China manage a peaceful transition to a more democratic system, or will the country implode as the party tries tooth and nail to keep its iron grip on power, and simmering protests from below eventually overwhelm the power of the state and lead to anarchy and chaos. Doomsayers about China, including me, have predicted this for a while, and we've been proved wrong so far. But now, with the global economy in a tailspin, Chinese exports plummeting, and Chinese growth decelerating, there's less "stuff" around that the Communists can use to bribe its populace with, and less to dangle in front of political opponents who need to be co-opted and brought into the system. So my prediction again is that change is on the horizon for China. I hope it's peaceful, but it may not be.

The crisis of globalization: Looking in the wrong place

A spectre is haunting the world. No, it's not a socialist revolution, but something that may have as cataclysmic an effect on the global political economy. It is a crisis of globalization. I, and many other bloggers, pundits, and putatively wise people generally have commented on the roots of the crisis, so I won't rehash that material here. What concerns me at present is the implications for the project of globalization. What is of greatest concern is that blame will be attached to globalization per se for the mess that we're in, whereas the primary faults lay in the failure of domestic regulatory regimes (especially as they pertain to banking and finance). So, while it might be fair to say that globalization has been poorly managed by national economies, it would be erroneous, in my opinion, to lay the blame at the doorstep of globalization itself. The reasoned response to our current mess is most certainly not going to lie in turning inward, whether through raising trade barriers, or creating regulatory systems for international finance so onerous that capital stops flowing across borders and nurtures purely its domestic garden. Yet there are early warning signs that such an unreasoned, knee jerk reaction may be exactly what is on the horizon.

One of the main lessons that I learned from my great teacher at Columbia, Jagdish Bhagwati, is what has come to be known to economists as the "targetting principle", a key idea in formulating sound economic policies. Basically it says, find the market where the underlying problem exists, and fix that. Fixing something else, that was indirectly affected, but is not the root of the problem, may or may not fix things, and, quite possibly, will make things worse overall. Sounds sensible, doesn't it? Medical diagnosis and treatment works in the same way, and would be the recommendation of what Jeffrey Sachs, another Columbia economist, calls "clinical economics". How does it apply to the current situation?

In our current mess, the root of the problem is a failure in domestic regulation, as I (and many others) have already mentioned. Banks were allowed to behave recklessly because they were insufficiently supervised and regulated. Some of that lending, of course, took place in foreign markets, and so there is an important global dimension to the fallout from the meltdown of the misbehaving banks and their toxic debts. British banks are collapsing and being nationalized, for example, not because of something inherently wrong in the British market, but because they imprudently bought too many derivatives, known as asset-backed commercial paper, based on risky and unsound sub-prime mortgages in the United States. Is this the fault of globalization? No. The fault lies in the failure of prudential and sensible bank regulation in each national economy. Globalization, by allowing this toxic debt to be spread around the world, has exacerbated the problem (although, arguably, made it less bad in the US, where the problem originated), but is not its proximate cause.

The wisdom of the targetting principle teaches us that where national governments should be looking to fix the problem, and prevent it from happening again, is is reregulating the banks and domestic financial systems in their national economies. That, of course, is starting to happen. But what is also happening, erroneously in my judgement, is that some analysts are pointing a finger of blame at globalization itself, suggesting that looking inward may be part of the necessary corrective to the excesses of the past decade. This is clearly wrongheaded. Now, openly protectionist language is rarely used, but there is always the Orwellian newspeak, that says, for example, that what we need now is not "free trade" but "free and fair trade". Why the qualification? If "free" trade is not "fair", then perhaps the the thinking underlying that proposition should be explained, rather than by confusing issues and lumping "free" and "fair" together. ("Free" anything is, in itself, of course, a potentially misleading concept, as my last couple of entries suggested, in the context of the term "free markets".)

One could take things back a step, and make a more sophisticated, second-order, argument, suggesting that globalization in some way induced risky behaviour by banks, or created pressure on domestic regulators to relax regulations excessively, because they wanted their national champions to succeed in a more competitive global environment. This is a species of what is often called the "race to the bottom" argument. This is a more difficult one to deal with, since no government is going to admit that it allowed regulations to become laxer because they wanted to compete more aggressively in global markets. (Unless you're Luxembourg, perhaps.) So the causal connection, while it may exist in theory, is difficult to confirm or confute in practice.

There might perhaps be some truth to this argument, when it comes to very small, highly open economies that hooked themselves on foreign capital. The problems in Iceland, or Ireland, or in several Eastern European emerging market economies might reflect a deliberate degradation of domestic banking norms and regulations in the hope of enticing foreign investors to their shores. But the correct response, surely, is not to throw the baby out with the bath water, and start deglobalizing as a response, but to repair the poor domestic regulatory framework that induced the problem in the first place.

This argument, in my judement, carries little weight, when applied to the United States and the United Kingdom, the chief culprits in the current global crisis. It was the deregulatory zeal of Ronald Reagan in the US and Margaret Thatcher in the UK that swept away a host of regulations, many bad, but, some, as we know now, not only good, but essential for the sound functioning of a modern global economy. The apparent (and in some ways, very real) success of deregulation in these two countries, along with the collapse of the Soviet system and the disappearance of a viable socialist alternative, is what acted as the driver for liberalizing and globalizing reforms in the transition and emerging countries, the "BRICs" (Brazil, Russia, India, and China) in particular.

Now, these four economies are amongst the most globalized amongst any major developing or emerging market economies, and they potentially stand the greatest to lose, if globalization goes into reverse gear, or even if stalls. Thinking through the attitudes and potential policy responses in these major emerging economies is an important challenge, both for policymakers there and for those of living in the West. That, though, is the subject of my next post ... so, as ever, watch this space!

The market and the state: Postscript, and a further irony.

One point I didn't bring out sufficiently in my last entry was in my discussion of the "free market", and how this is a misleading metaphor for how the market economy operates, which is always in tandem with the state. Now, Orwellian newspeak and ideological fervour may be two reasons. But yet another is the way that economics is taught nowadays, and for the last while. At least the last seventy years or so, since Paul Samuelson's Foundations and the Arrow/Debreu theorem. We teach our students based on stylized mathematical models devoid of any institutional detail or richness. So that in the model, whether partial or general equilibrium, the price system operates to get us to the equilibrium, without having to worry about niceties like property rights and contracts being enforced. So it's very easy to slip into a mode of thinking that the market functions on its own, if one thinks of the economy purely based on these stylized models.

Now, here's the irony. The point above is well known, and was made many times by libertarians such as Hayek, who was suspicious of mathematical modelling of the economy (whether of the classical or Keynesian varieties). To him, it was a slippery slope from a model to scientific socialism, to the notion that the economy is a machine that can be fine tuned and managed. In other words, the context in which the market operated was important, and, for Hayek and those of his ilk, that had to be a liberal society. But yet it's now often the folks on the libertarian end of the spectrum who forget this point, and imagine somehow that the economy can be disengaged from the rest of society, and the state, in which it's embedded, when they engage in discussions of the "free" market. Let's henceforth banish this term, and talk if we wish of a "minimally regulated market". It's less sexy, but more realistic, and will keep us honest about what's involved.

The market and the state, redux.

As Yogi Berra famously quipped, "It's like deja vu all over again." And so it is with discussions about the appropriate balance between the market and the state as a means of guiding the economy. A bit of history would be useful here. If we stick just to this past century (by which I mean, the early 2oth, to the early 21st), we've had two huge swings of the pendulum already, and are, possibly, in the midst of a third, although it's still too early to tell for sure.

But ... before getting to that, let's dispose of one canard. You'll notice I said that what's at issue is the appropriate balance between the market and the state. That logically presupposes that the market and the state are both involved in governing the economy. Indeed, they are, joined at the hip, like Siamese twins, although sometimes in denial of that fact. In some popular discussion of the issue, it's framed as one of whether it's the "free market" or the government that should control the economy. That's a fundamentally wrongheaded, and ideologically driven, way to see matters. For one thing, when people who advocate it talk about a "free market", what they really mean is a market with minimal but vitally important government involvement, in particular, to enforce property rights, enforce contracts, and generally set the rules of the game, so that, within those rules, folks can trade freely and without the fear of coercion. (After all, if a hooligan puts a gun to your head and forces you to trade with him, it's not really free. And the doctrine of the gains from trade in economics is premissed on mutual, voluntary cooperation. But more on that another time.) That's a far cry from a "free" market. A truly free market, with no government intervention, would rather be the sort of thing you'd find in a Hobbesian state of nature. People in such a world would be so busy defending themselves and their stuff, and trying to stay alive and fend off attacks from their neighbours, that they wouldn't have too much time to trade much in anything, and the market would be pretty primitive. Life would be, as it were, poor, nasty, brutish, and short.

I spend time on what seeems like a minor semantic point, because, well, it's not really that minor. Words do matter, and there's an Orwellian sense in which the proponents of minimal government use the term "free market", trading on the emotive and hortative appeal of the concept of freedom, when the real debate is not about the market vs. the government, but the more nuanced one, of what sort of rules of the game should the government set, so that the market can do what it does best, both for itself and for society. The last bit is the tricky one, since this takes us into debates about the possible tradeoffs between efficiency and (say) fairness. There's the crux of the debate between so-called "liberals" and "conservatives", in American argot, or what would be called "social democrats" and "liberals" in Europe. (Their "liberals" are "conservatives" in American usage, which can get confusing.) But, again, I'm getting ahead of myself. Before weighing in on that big debate, that I might do another time, we need to get our history straight. That old one of knowing one's history or being condemned to repeat it comes to mind.

If we look back exactly a hundred years ago, there was a general consensus on the minimal government, maximal market, view, that is associated with today's free marketeers. Trade barriers were low, goods and capital flowed freely, there was monetary stability provided by the gold standard, and, quite different from today's globalization, immigration barriers were low. People more or less went and settled where they wanted without the need for passports and elaborate border controls. New technologies such as the automobile, the airplane, the telephone and the radio were breaking down barriers and bringing people closer together. Replace telephone and radio with cellphones and the internet, and it's not so different from today. Well, there was one big difference, a huge one actually, that all this good stuff was happening mostly for people living in Europe and North America, and most of the rest of the world remained in the grip of imperalism and colonization, and so missed the boat on economic development. But that huge subject is another one for the future. Let's keep our Eurocentric perspective for the moment.

As we all know, this first globalization came crashing down with the outbreak of the First World War, and the confusion of the interwar years. Thanks to the Russian Revolution, revolutionary socialism, of the Marxist-Leninist variety, seeemed at the time to be a viable alternative to liberal democracy. The Great Depression sealed the deal. There was a general dissilusionment and loss of faith in the market economy, and that led to the first big swing of the pendulum. Through the New Deal, and similar programmes elsewhere, the balance in the equation tipped towards markets being reigned in, and more government intervention in, and regulation of, the economy. One facet of this new scenario was the Keynesian revolution in macroeconomics: it was felt that governments could, and ought to, eliminate, or at any rate to attenuate, fluctuations in the business cycle, so that something like the Great Depression couldn't happen again. Another facet was to impose a set of new regulations on banks and other industries to ensure that the reckless speculation that caused the great stock market crash in 1929 that tipped the world into Depression couldn't happen again. And yet another facet was increased cooperation amongst governments to ensure, for instance, that beggar-thy-neighbour trade policies wouldn't be used again, as they were, with disastrous effects, during the Depression (America's infamous Smoot-Hawley tariff and copycats elsewhere), hence the creation of new international organization such as the Bretton Woods twins (the World Bank and IMF), and the GATT, now the WTO.

All of these developments led to what has come to be known as the golden quarter-century, roughly from the rebound in economic prosperity a few years after the end of the Second World War until the early 1970s. As well all know, a series of events, including the oil shocks, ushered in the era of "stagflation", that is, a combination of economic stagnation (falling output, rising unemployment) and rising prices. This should have been impossible under a naive Keynesian view of the world. What followed is too complex and multi-faceted to summarize easily here, but suffice it to say that the economic difficulties of the 1970s led to the second pendulum shift, a move back towards the market and away from the state. This was the era of deregulation of the 1980s, the era of Ronald Reagan in the United States, Margaret Thatcher in the United Kingdom, and, for those of us in Canada, Brian Mulroney (remember the Shamrock Summit and "Irish eyes are smiling"?). Those of us who grew up in those days will remember the deregulation of telephones, the airlines, and other industries, most importantly the banks, that had faced stiff regulation since the New Deal era. The mantra of the time was inspired both by Hayek, and the Chicago and Virgina Schools, that followed in his wake. The basic tenet of these libertarian economists is, to put it simply, that markets tend to work well, and governments don't. End of story. You will have gathered from my earlier remarks that this was most certainly too simplistic, and ideologically driven, a view.

What, of course, evidently sealed the triumph, the hegemony, of Anglo-American-style capitalism was the demise of the Soviet Union and the first tentative, then more fervent, embrace of an emphasis on liberalizing domestic regulations and opening up to international trade and investment that swept the transition countries (that is, those formerly socialist economies of Eastern Europe and the former Soviet Union) and the developing countries, most notably, China, starting in the late 1970s, and India, in the early 1990s. This enthusiasm for economic liberalization, and, its international dimension, globalization, survived even the Asian financial crisis of ten years ago, and, miraculously, survived even the tragedy of 9/11 and the "war on terrorism" that followed.

Acolytyes of globalization, and liberalization, were, consciously or not, slipping into a smug and complacement triumphalism when it came to the future of the global economy, and the doctrine of a liberal economic policy regime that has sometimes (and generally pejoratively) been called the "Washington consensus". This, too, is redolent of the earlier globalization. Then, people like Norman Angell were saying things like war is now impossible, as the economies and peoples of the world are too closely intertwined for us to comtemplate destroying our collective prosperity by breaking those bonds asunder. Tragically, of course, that proved to be far too optimistic an epistle. Even in the year or months before the financial crisis, emanating from the sub-prime mortgage fiasco in the US, broke last summer, some pundits were pontificating that globalization was irreversible, recessions were a thing of the past, and the only question was one of fine tuning and managing globalization and the markets, rather than fundamental questions about whether we have the right mix between the market and the government. It was thought those debates wer done. Over with. That thinking was wrong.

In the wake of the financial crisis, and the current global recession (that may turn into a mini-depression, or worse), the blithe acceptance that Anglo-American economics and the system of globalization that has been supported by it will continue as before has disappeared, and been replaced, as it should, by the sobering reality that some of the difficulties we are in now were probably caused by a misguided and doctrinaire understanding of the correct role of the government in regulating the market. A fundamental rethink, in intellectual and policy making cricles, is now taking place, and the pendulum is starting to swing back the other way, the third time in the past century.

The contours of the current crisis and the reasons for this loss of faith in the market are well discussed elsewhere, so I will not repeat it here. It is touched on briefly in my previous blog entry. But what I want to finish with is the the thought that, as the balance between the state and the market is being titled back towards the state, globalization too, the international manifestation of capitalism and the market system, is facing serious strains. and may, if we're not careful, start to unravel in front of our very eyes. As Niall Fergusson has been saying (including today, on Fareed Zakaria's excellent programme, GPS, on CNN), there is a "crisis in globalization". That's the subject for my next blog. Until then, I hope, you'll stay tuned, and watch this space.

Why Hayek and Marx Might Agree with Each Other and Disagree with the Economic Rescue Package!

One of the many ironies of the current global financial crisis is that the largely unarticulated positions of the left and right coincide in disagreeing with the various stimulus and bailout packages proposed and implemented in the United States, Canada, and elsewhere. The standard defence for bailing out (say) banks who've screwed up and, therefore, should presumably have to pay for their mistakes is that the consequences of not doing so would be worse. So, even if we don't like those fat cat bankers who've gotten us into this mess, we have to hold our nose and help them out, and hope they don't get into the same or a bigger mess again.

Now the various critiques of bailing out the banks, in particular, usually boil down to some version or the other of what economists call the moral hazard problem: that is, bailing out someone who has behaved recklessly will make him more likely to be reckless in the future, because he knows that you're going to bail him out again. It's a species of economic problem that occurs when information is imperfect, or, to be more precise, asymmetric. Moral hazard is a problem of hidden action; the other classic such problem, adverse selection, occurs when there is hidden information. Both were probably at play in the case of the banks, but let's stick to moral hazard for the moment. The simplest example of moral hazard, that I always use on my college freshmen (and which appeals to them, for some strange reason): If every time you go to the casino, and you win money, you keep it, but, when you lose, your parents pay off your markers, will you be more or less likely to gamble more recklessly next time you go?

Now there's another version of this critique, which the gambling example fits as well, that says that bailing out bad banks (but not taxing them heavily say when they make fat profits) is "privatizing profits" and "socializing losses". This sort of behaviour would tend to exacerbate the moral hazard problem, as with my freshmen gamblers.

But all of this elides, or rather scants, the more radical critique of such bailouts, that, ironically enough, come from both left and right, although, of course, with somewhat different rationales. Let me sketch this out for you.

Someone on the right, a full-flooded libertarian who's a follower of Hayek or Friedman, would say that it's the nature of capitalism to be inherently volatile. Tampering with this inherent volatility of the capitalist system, trying to attenuate it, is a bad idea, because it dampens the creative entrepreneurial juices that keeps capitalism vibrant and gives us ongoing technological advance and higher economic growth in the long run. (This relates to an older debate, to which my colleague Nick Rowe and I have contributed, on whether business cycles are good or bad for growth, but that's for another time.) Don't forget that Hayek opposed any government intervention during the Great Depression itself. He would surely be opposed to the current bailout packages.

One should be careful at this point to distinguish bailing out the banks versus other affected sectors of the economy, such as the auto industry. It is the peculiar nature of banking that makes completely private sector banking with no or minimal government regulation inherently fragile and excessively volatile, because of the possibility of bank runs, for instance, which is why governments have figured out that they need to serve as a lender of last resort to banks. In other words, Hayek probably wouldn't have liked the status quo much either, and so the question is moot, I guess, on what he would have thought of bailing out the banks.

But for a normal industry, say the auto industry, the argument is much more clear-cut. The big 3 US automakers, and their Canadian susbsidiaries, clearly didn't adapt to the changing economy, and got stuck in a mode where they made big gas-guzzling cars, and cut deals with the unions in which they essentially shared monopoly rents with them. That would account for the ten paid spa days, apparently, that every auto worker at GM is entitled to. I don't think I need to convince you that the automakers, quite simply, screwed up, and so it is a fair question to ask, a la Hayek, why we should be expected to bail them out. If we do, we'll just subsidize their inefficiency, and prevent them from either going bankrupt and being replaced by something more efficient. Or maybe we should just stop producing autos altogether in North America and import them from China, Korea, India, and Brazil, where they're cheaper to make? Comparative advantage would suggest that.

Obviously, the political economy of the auto industry will preclude doing nothing. They employ two many people in Michigan and Ontario, in particular, people who vote, and are likely to be decisive in the next round of state and provincial and down the road federal elections in the US and Canada. So all the relevant branches of government have to, at least, be seen to be doing something, if they really don't want to, and, like Hayek, would prefer that the market sorted itself out. Interestingly, Canada's Finance Minister Jim Flaherty speaking from Washington the other day came as close to saying this as any politician recently.

So much then for the critique from the right. How about the folks on the left? I've picked Marx for obvious reasons as a focal character, although maybe I should have picked Lenin as he and Hayek were contemporaries, sort of. No matter. He would agree, up to a point: Yes, capitalism is inherently volatile, and the market, left to itself, will tend to go to excesses of one sort or another. But ... and here's the big different with the reformist centrist -- he would almost surely have opposed succour to the wounded bulls of Wall Street. Because it's only when capitalism gets into a major crisis that the socialist revolution that's meant to sweep it away will occur. And you can't have a socialist revolution if you keep intervening to save capitalism from itself.

Now I don't think anyone, at at least in the mainstream media, had had the courage to articulate the true left critique of the stimulus packages, being contented to bleat that it just bails out the fat cats on Wall Street and is unfair to Main Street. Here, I think there's something of a reversal of roles, and the the right, for once, is taking an intellectually more honest approach in articulating its objections to bailing out the banks. At least, that's what I'm thinking at the moment.

Now time to start making some pesto sauce in time for dinner this evening and let Hayek and Marx agree in disagreeing with the bailout!