Limits of openness
8/17/2009
Author : Daniel Daianu
THE ONLY EUROPE-WIDE IDEAS COMMUNITY
EUROPEAN IDEAS COMMUNITY
By Daniel Daianu, former MEP and former finance minister of Romania
The current world financial crisis compels to deep soul searching and scrutiny of where top politicians and their advisers were wrong. Never mind that stern warnings on the incoming crisis were made by astute economists and financiers years ago. Unfortunately, vested interests prevailed over the cautionary words of Warren Buffett, Edward Gramlich, Alexander Lamfalussy, Paul Volcker and others. This crisis underlines pitfalls and dangers of financial deregulation (lack of regulation) in global markets and raises fundamental issues for public governance; it should be seen in conjunction with the resounding fracas of the Doha trade round, with the resurrection of economic nationalism in industrialized economies, which is not of recent vintage, and not least with geopolitical consequences of the economic rise of China and other emerging global powers. This crisis should be judged against the backdrop of the effects of climate change, of the mounting fear about nearing limits of exhaustible resources —which raises huge security concerns.
Arguably, the coming to grips with the effects of this financial and economic crisis, together with food, environment, drinking water and energy-related concerns forces national governments to reassess the advantages of unrestrained economic openness; systemic risks, not only of a financial nature, will increasingly be a focus of public agenda in the years to come. This reassessment involves more government presence in the economy as well as broader regulatory frameworks; some of it is prompted by the exceptional circumstances of the crisis, but the whole context is undergoing a change of zeitgeist and policy paradigm.
What went wrong
During the last decades rapid technological change has reduced transportation and transaction (information) costs enormously and has speeded up the transfer of know-how, albeit in a highly skewed manner, among regions of the world; the internet connects hundreds of millions of people instantaneously nowadays. World trade has expanded at a very rapid pace and broadened the scope of choice for individuals throughout the world. The collapse of communism has expanded the work of market forces and democracy in a large area of the world. And the very dynamic of the EU can be seen as an alter ego of globalisation on a regional scale.
However, we are now in the midst of the deepest financial crisis after the Great Depression, which has erupted after a sequence of other episodes of crisis in the US and Europe during the last couple of decades; this indicates the increasing instability of the world financial system —as it has evolved during recent decades. Likewise, financial and currency crises have been recurrent in emerging markets in the same period of time and have caused economic and social havoc in not a few countries, while world trade liberalisation has left many poor countries in the dust. The distribution of wealth in the world seems to be more unequal nowadays than 20 years ago; the myth of the "new economy" dissipated and corporate scandals in the affluent world show that cronyism and bad governance are a more complex phenomenon than is usually assumed and ascribed geographically; social fragmentation and exclusion have been rising both in rich and poor countries; there is a sense of disorder and a rising tide of discontent and frustration in many parts of the world. Can we make some sense of all this in relation with policy dynamics?
The past two decades have been suffused with claims that economic policy, in the advanced countries, is bring driven by an emerging new consensus on principles and practice. One origin of this "consensus" could be ascribed to the ever longing desire of Man to control his environment and be more efficient. Max Weber’s “rationalization of life” referred to rational accounting, rational law, rational technology, which by extrapolation, can be extended to “rational economics”. Daniel Bell upheld the primacy of knowledge and theory-related activities in ordering our life, man’s technological and economic ascendancy — which would imply that economic wizards can secure a fool-proof policy. Even the clash between keynesism and monetarism, as the two main competing macro-economic paradigms, could be seen in the vein of searching the ultimate piece of wisdom. Another origin of policy amalgamation came out of the death of communism. Francis Fukuyama’s “End of History” was seen by many as an embodiment of a, presumably, single cosmology which was meant to rule the world. At that time Reagan's and Thatcher's revolutions were in full swing in the US and the UK, respectively. The fall of communism favoured immensely the advance of neo-liberal ideas. Internationally this dynamic was reflected by the expansion of global markets, globalization. “The world is flat”, to use Thomas Friedman´s sintagma, became synonymous with economic development reaching out to all corners of the earth provided adequate policies are put in place. By adequate policies one understood, mostly, the Washington Consensus., which encapsulated policies and practices advocated by IFIs.
Needless to say that the overwhelming superiority of the US on all fronts (economic, military, technological), offered a sui generis Pax Americana and created prerequisites for an international regime. The latter was supposed to order the world by providing international public goods, a widely embraced vision, and resolving/preventing possibly major conflicts.
But economics as a hard science is only a dream, while market fundamentalism has revealed its serious weaknesses over time, and its coup de grace is, arguably, the current financial and economic crisis. It is true that liberalization and extensive privatization did transform post-communist societies in Central and Eastern Europe and allowed most of them to join the EU. But their case is quite unique owing to geography, cultural and political consciousness, and considerable support from the US and Western Europe. It is also true that market-oriented reforms have unfettered entrepreneurship and have stimulated economic growth in China after 1978, and in India during the last decade, but those reforms have been implemented in a pragmatic way, with a close attention paid to social issues and rural development problems, while financial and trade markets have not been liberalized recklessly.
The interpretation of liberalization/globalisation, which I mention above, puts emphasis on unbridled markets, privatisation (of public utilities too) and downsizing of the public sector to the utmost. This philosophy has widened to international markets - finance and trade - and the IFIs have often championed it. Let me give an example. The IMF and the World Bank advocated capital account liberalization worldwide, and South Korea’s entry in the OECD was preconditioned by its capital account opening As many accept nowadays the Asian crisis, of a decade ago, was caused, primarily, by a premature opening of the capital account in the economies of that region.
Reinterpreting globalisation
But globalisation (and liberalisation) can be understood in a different vein, which looks at the actual functioning of global markets - with their pluses and minuses - and which takes into account insights of economic theory such as informational asymmetries, increasing returns (while technological progress is intense —endogenous growth), agglomeration effects (clusters), multiple (bad) equilibria, coordination failures, the role of economic geography, and so on. As these theoretical constructs and, a fortiori, the effects of the current financial crisis suggest, there are lessons to learn: the need for effective regulation of markets; the role of the state in providing public goods; the role of institutions (structures of governance); the need of public goods and effective governance in the world economy; the importance of variety and policy ownership in policy-making.
To some, this interpretation of globalisation may sow seeds of confusion. But, in this way, one can dispel a biased interpretation of it. By the way, I have always been baffled by the language used by some media when describing market-friendly reforms. Is a rescue package, like the ones destined currently to help banking sectors get out of trouble, against the logic of a market economy? For a market fundamentalist it may be, but for those who, while acknowledging governments failures, see market failures as well, the need for intervention—in order to prevent a meltdown, a terrible crisis—gets another connotation, which is not inimical to market economics. Similarly, is a Keynesian approach in policy-making not market-friendly? And I could continue along this line of reasoning. Moreover, globalisation would no longer be assigned an ideological mantra and one-sided policy implications. Instead, it becomes an open-ended concept, which purports to define the mutual "opening" of societies, under the impetus of technological change and the manifold quest for economic progress. Such an opening should be pragmatic and flexible. By flexibility one can imply policy reversals as a function of changing circumstances —be they in the realm of trade, finance, industrial policy, etc. Moreover, such an interpretation rids itself of a perceived West-centered origin. Such an unconstrained interpretation of globalisation would have major repercussions for national public policies and international politics.
Thus, national public policies could be fairly pragmatic, varied and geared towards the traditional goals of economic growth, price stability and social justice. There is no modern economy that does not blend the public and the private spheres. Some could say that too much variety in institutional and policy design would damage a level playing field and impede markets to function effectively. And there is truth in this argument, but which is one-sided. For it underplays the importance of working out policies that keep in mind the extreme diversity of conditions in the world economy and the fact that market forces do not bring convergence automatically. As a matter of fact they may even increase discrepancies, as they often do, because of cumulative causation processes. And if we add here the inexistence of a world government, which should try to do what the EU tries to achieve via its cohesion policy inescapable conclusions come to the fore (just keep in mind the abysmal results of the Millenium Agenda). Let me focus now on finance and trade as fields which relate national economies to each other and where policy reassessments seem to be in the making.
As the current crisis amply shows one of Keynes' intellectual legacies, which is enshrined in the Bretton Woods arrangements —namely, that highly volatile capital flows are inimical to trade and prosperity—has not lost relevance. For decades now a mantra has been heard worldwide: that not much can be done in national policy-making because global markets would punish a government. But is the complexion of global markets God given? Are n't global markets, aside from their technological drivers, also the product of human beings' decisions to set rules for finance, trade and investment. The argument that we should not turn the clock back may be right in the sense that open systems bring benefits and should be protected as much as possible. And here Pascal Lamy’s and other top international public servants’ worries are well founded. But to claim that nothing can be done about financial flows, when they bring about misery, is unconvincing. Can the parallel banking sector (including hedge funds and private equity funds) be regulated? Definitely, it can! Can we restrain leverage in finance? Sure we can. Can we forbid short-selling if the need arises? Certainly we can. Can we regulate rating agencies? Sure we can. Can we impose capital account restrictions in case of need, though one has to think about regulatory arbitrage? Sure we can. Those who say that it is hard to fetter capital movements in our times have a point, but not a peremptory one. Likewise, the argument that financial innovation should be unchecked sounds hollow in view of the toxicity of many of its products. For not all financial innovation is sound.
Free trade as a headline will continue to be paid lip service worldwide but, in the years to come trade patterns will likely be reexamined owing to growing security concerns of national states. One type of concerns originates in the costs of adjustment to competitive pressures. In a global economy where win-lose situations are not rare and in which currently leading economies can be on the losing side trade and investment restrictions, more or less subtle, would be resorted to. The are seminal studies (of Paul Krugman, Elhanan Helpman, Herschel Grossman, etc) which show that industrial, investment and trade policies can make a difference, for the better, for those which practice them. And western countries may try to use them in order to protect their competitive edges in the world economy. Le doyen of world economists, Paul Samuelson, also contributed to this debate ( Journal of Economic Perspectives: “ Where Ricardo and Mill rebut and confirm arguments of mainstream economists supporting globalization”, no.3/2004, pp.135-147). Other type of concerns relate to “hard security”. "Trading with the rival" worries may lead to the imposition of restrictions —very much in the vein of the old COCOM norms (which operated during the Cold War). Likewise, would the US, or major EU member states accept big chunks of their most sensitive manufacturing and IT sectors being acquired by Chinese, or Russian companies (or SWFs belonging to these countries)? Trade restrictions may pop up also due to the thinking that it pays not to rely too much on overseas suppliers regarding basic food. Climate change could also force governments to see indigenous farming as a way to protect the local habitat, which may filter down a narrowly defined rationalization of trade flows dramatically. The security and the cost of managing networks would also come increasingly into the picture —terrorism being a factor here too. We may think globally, but be forced, owing to various risk-related considerations, to limit ourselves to what are perceived as safer patterns of trade and production. In this way one can think of an optimal trade openness. Ironically, managed openness may be better for competition to the extent unrestrained liberalization leads to the formation of a few giant global companies in various fields (the current financial crisis favors big groups which can swallow weaker competitors)
This myriad of concerns could also stimulate the formation of alliances (trade and not only) among groups of countries that share common interests. The EU is already such a bloc. A transatlantic trade area could also emerge. We could see a replica of it in Asia, though the rivalry between China, India and Japan will be a big handicap in this respect. But keep in mind that there was talk about setting up a monetary union in the wake of the Asian crisis and such a proposal may come into being in the end. And if the yuan turns into a reserve currency the rationale for creating an Asian monetary area would grow.
How would the EU evolve in this world context? The logic of single markets would continue to dominate but policy-making will be quite nuanced at national level. There will be more regulation of financial markets, both at national and EU (MU) level. National governments will be more active in the economy. By activism I think of efforts to support sectors and companies that are deemed essential for national security. As long as the EU will not develop a common foreign and security policy, which should be supported by a larger collective budget as well, national governments will not give up what they see as vital for their security. Therefore the EU will continue to have a pretty complicated policy-making structure, while variable geometry will likely be on the rise.
Barriers to unrestrained free world trade, investment and finance would also stem from the global system getting multipolar. The effects of the current financial crisis have hit the western world at a time when tectonic shifts in the global economy had been taking place for more then a decade. The rise of China, India, Brazil, the resuscitation of a capitalist Russia (that benefits on huge natural resources) are ushering in an increasingly multi-polar world, with growing reverberations economically and geopolitically. The rise of sovereign wealth funds, which are heavily concentrated in Asia and the Gulf region illustrates the shifting balance of power in the world. The struggle for the control of exhaustible resources (oil and gas in particular) epitomizes this phenomenon.
Who would formulate and enforce a suitable international regime for the 21st century? On its own the US does not have this capacity any longer. And I hardly see the EU taking over such a role. If EU member states have such a hard time in seeing eye to eye when dealing with the causes of the financial crisis (ex: the British opposition to more regulation of the financial markets, as against the French and German view) think about insurmountable problems at the international level —where Realpolitik considerations play a critical role. Besides, in a multi-polar world the establishment of an international regime is a very complicated affair. The IFIs, the international architecture need to be reformed. But their reform hinges on what the main international actors wish to do in this respect and on how they relate to each other. That G20 seems to take the place of G8 is not a sufficient ground for optimism in this regard. Nevertheless, I dare to believe that if the US, the EU, and the emerging global powers (China, India, Russia, etc) can strike a deal to this end other significant players would come along eventually.
To conclude: I submit that a combination of two dynamics will develop as a means to preserve an open global economic system, be it in a looser form. One dynamic refers to a partial domestication of market forces in national governments’ quest to cope with systemic risks and social strain. This would involve more state presence in the economy (state capitalism) and broader regulations; elements of “war economy” conduct in public policy will also be quite visible, in liberal democracies too (a thesis I have argued about in a previous article of mine in Europesworld, and which is illustrated glaringly by how governments in the western world have reacted to the effects of this financial crisis). I should say that ideological propensities are less involved here, for governments act, basically, out of sheer necessity. The other dynamic refers to blocs of countries that decide to use a common currency and trade more intensively among themselves; such arrangements would be a means to avoid brutal disruptions to their internal activities were a global crisis occur. This is like saying that the global system needs several sub-global clusters in order to mitigate the potentially devastating effects of a completely open world system that would be prone to recurring major crises. The latter state of a global system being, in reality, unsustainable because of its unavoidable motion toward an eventual breakdown and proliferating fragmentation effects. About a decade ago Dani Rodrik, who is one of the most insightful development economists remarked that not any globalization is good for poor countries (The new global economy and developing countries. Making openness work, Washington DC, Overseas Development Council, 1998). I would paraphrase him and say that openness has to be made to work for the world as a whole, which implies shedding the blind belief in the self-healing and self-regulatory virtues of markets.
