Rebuilding the world after the twin crises - Obsolete economic thought !

Rebuilding the world after the twin crises
By ANDREW SHENG

FIFTEEN months after the panic triggered by the failure of Lehman Brothers, we should begin the debate how to rebuild the world after the crisis. Several disturbing questions remain. Are we still in the crisis? Should we reform at all? What should we rebuild?

After all, the rescue efforts by the leading central banks have brought financial markets back to almost pre-2007 levels. Commercial banks have been rescued through massive guarantees and liquidity, and interest rates have been brought down to near zero.

There are some who think that 2010 will be a good year with revived growth. Others believe equally fervently that the real crisis has yet to come. Who is right?

Several things are now clearer. We were dealing in 2007/2009 with two simultaneous crises – one financial, the other about climate change. One brought about a shift in the economic power balance, with the G-20 calling the shots instead of the G-7. The other is being resolved through the Copenhagen Round of negotiations. Three fundamental differences define the two crises. The first is that the financial crisis was primarily dealt with at the national level, whereas the climate crisis was dealt with at the global level.

The second is that financial crisis had short-term effects that required immediate action, whereas the climate crisis had uncertain long-term effects, where people do not feel the immediate pain and had no cause to support reform.

The third is that the Copenhagen negotiations confirmed the shift in power to the population giants of China, India, Brazil and South Africa, which brokered the deal with the United States.

The age of juggernauts has arrived

There was certainly a lot of hot air and emotions coming out of Copenhagen, with the African chairman of the developing economy caucus claiming that the amount of money offered by the advanced economies for climate change is just enough to buy coffins.

Those who are dead do not have to worry about climate change, so all the emotion is about what to do with the living.

However messy and unsatisfactory an agreement, Copenhagen is still a major achievement. Globalisation will never be the same again, because there is at last some universal recognition, however fuzzy, that we must solve the threat to climate change. But there is a major divide between the West and the rest.

The trouble with climate change is that all of us are dealing with unknown unknowns. Although the majority of the scientists are convinced that climate change has already passed the tipping point of irreversible damage to the environment, some think that these predictions of doom are a conspiracy to tax the wealthy countries.

The climate crisis and the financial crisis are inter-related, because both stem from excessive consumption of natural resources. The financial side collapsed first, because the West’s excess leverage was not sustainable.

The climate change crisis has a much longer time horizon. It may take 20 to 30 years before the weather change and resource scarcity become visibly so bad that those affected will then support the need for change. By then, it may be too late.

Mankind is like a frog in the pot of water. When the temperature in the pot is raised very quickly, the frog feels the pain and will jump out very quickly to escape. This was what happened in this financial crisis when G-20 acted decisively in the face of an immediate threat of financial meltdown.

However, since climate change is incremental, the frog will not react if the temperature rises slowly, until the moment comes when the frog is boiled.

Rebuilding from the ashes

I was partially wrong last year when I suggested that global solutions would not be as achievable as regional and national reforms.

In 2009, however, there was greater consensus at the global and national levels than at the regional level, but as recovery gathered steam, global opinion has once again diverged. The blame game is now rearing its ugly head.

Instead of being praised for being the first to have a substantial fiscal stimulus to regenerate domestic and global economic growth, China is now being blamed for maintaining a peg with the US dollar that gives it competitive advantage.

Hence, there are two things that must be rebuilt if the world is to move ahead on a stable keel. The first is the global financial architecture, which will involve transparent rule changes and architectural adjustments that reflect the changing balance of economic power.

The second is the hidden rules that underlie serious differences of views on the crises and their solutions, namely, the differences in economic thought and philosophy between the East and West.

Obviously, rebuilding physical structures is easier than re-building mindsets, but one cannot change without the other.

The global financial architecture revamp

So far, the only area of global consensus is that the present global monetary structure is flawed and unsustainable. Of course the global financial crisis happened because of problems and mistakes at the national level. But national problems had global origins.

The Triffin Dilemma states that the central bank of the major reserve currency has to run a monetary policy that may be contradictory to its domestic needs. As the issuer of the reserve currency, the United States provided the world with ample liquidity but at the cost of running larger and larger current account deficits.

The role as world’s consumer of last resort enjoyed global support because the East and South producers and savers (including Germany and Japan) were willing to finance that deficit.

Unfortunately, in 2008, the United States over-extended its leverage in the financial sector, had a bubble deflation and now needs to rebuild its balance sheet by deleveraging and increasing domestic savings.

Since the United States is nearly one quarter of global gross domestic product (GDP), the cutback in consumption will slow global growth, thus giving time to the world to restore its imbalances from both the regional and ecological points of view.

Unfortunately, the G-3 rescue plan of doing “whatever it takes” to relieve pain used huge public sector deficits to assume losses of the private sector.

The solution replaced excessive financial sector leverage with large unsustainable public sector leverage, and instead of changing the incentives to deter excessive speculation that worsened the bubble, it rewarded speculators by providing zero cost funding through the central banks.

It replicated the Japanese solution of the 1990s with almost identical consequences of large carry-trades, creating volatile capital flows to emerging markets.

In essence, the world is now suffering a reverse Triffin Dilemma. What appears appropriate for the monetary policy of the reserve currency country is wrong monetary policy for the rest of the world.

I for one would not object to zero interest rate policy if this went towards subsidising the damage suffered by the US real sector, but instead, most of the benefits were captured by the financial sector that paid itself more in the form of huge bonuses.

Hence, combating the deflation in the bubble in the West seems to require a bubble in the East instead.

The unspoken assumption is that if the Eastern savers were to become large spenders to replace lost Western spending, the world would return to its high-growth path. This argument forgets that it was excessive expenditure that drove unsustainable resource depletion in the first place.

There are four flaws to this line of reasoning, namely, consumption bias, price distortion, tool ineffectiveness and institutional misalignment.

First, there is an unspoken inference that increased consumption by the emerging markets to correct their excessive savings is the correct solution to the global imbalance.

However, if every Chinese or Indian were to consume at the per capita consumption level of the average American, there would be no natural resources left.

Clearly, once the emerging markets increase their consumption, their lifestyle must change to a more ecologically sustainable form, involving more green and energy/resource saving technology that will take time to evolve.

Every economic and ecological historian remembers that excessive consumption was the underlying cause of the fall of civilizations, from the Mayans to the Romans.

Second, the switch to more ecologically sustainable lifestyle will not happen without changing the fundamental incentives, particularly price signals.

Most market economists would agree that the main defect of this fossil fuel-based global economy is the under-pricing of energy and water through politically-driven subsidies.

This under-pricing of non-replaceable natural resources is the main reason why the current mode of production is wasteful, inefficient and destructive.

The world could be much more ecologically sustainable and efficient if more resources were devoted to correcting distorted prices, taxation and subsidies, and improving public education towards acceptance of more green technologies and lifestyles.

All these could be achieved at national levels, with a modest amount of global or regional assistance or aid.

Third, many serious Western economists seem to think that the silver bullet to the global imbalance (and also for China’s own good) is revaluation of the nominal exchange rate and that every argument to the contrary is “misguided”.

Unfortunately, two facts argue to the contrary. Given that China’s current GDP is US$4.8 trillion compared with the combined GDP of G-3 at US$37 trillion, a revaluation of the yuan by, say, 40%, would only increase China’s GDP by US$1.92 trillion or less than 5.2% of the G-3’s GDP.

Hence, to rely on China to replace the G-3 global engine in the short run is quantitatively unrealistic.

The other evidence to the contrary is the Japanese experience with the massive revaluation of the yen after the Plaza Accord in 1985, which had the opposite result of solving the global imbalance.

The Japan-US trade surplus did not disappear and Japan suffered a massive asset bubble that damaged its financial system and resulted in deflation for almost two decades. In other words, revaluing the exchange rate may be a cure worse than the problem itself, both for China and the world.

Fourth, the Bretton Wood institutions are neither geared nor prepared for the important roles of global public good providers that are required to restore global balance.

Quantitatively, their resources are now too small relative to global needs. The fact that their major resources depend on their capital base (which stems from the fact that they are controlled by the West) means that their combined financial resources are one-fourth of total official reserves of the surplus countries (US$4 trillion) and less than 0.5% of conventional global financial assets (US$214 trillion).

Quantitatively and qualitatively, the Bretton Wood institutions cannot act as central banks of last resort, nor undertake fiscal action to alleviate the effects of global imbalance or crises. These are still the domains of national authorities.

How to change this unsatisfactory global architecture is much more controversial and cannot be done overnight. It is one thing to complain about a single dominant power, but to build a global central bank, regulatory system and reform international financial institutions without global fiscal structure and with a G-20 of profoundly different views will be a daunting task.

My prediction is that there will be relatively little change, because there is no good unifying vision of what could be a viable alternative. To have a coherent architecture requires an architect. Sadly, we do not have anyone remotely like John Maynard Keynes to show us the way.

The crisis in economic thought

Our greatest obstacle to real reform is the failure of current economic thinking to predict and explain both crises in a consistent and coherent mode. Current economic theories are at best partial, explaining one crisis without taking into consideration the other.

Based on the historical delay in economic theory in predicting and explaining the Great Depression, we should not be surprised.

The Great Crash happened in 1929, but John Maynard Keynes’s General Theory was not published until 1936 to challenge the neo-classical orthodoxy. It took another decade before the General Theory was more widely accepted and adopted in using counter-cyclical fiscal tools.

Despite its failings in the 1930s, the neo-classical framework was revived in the 1970s through Milton Friedman and the Free Market School. Buttressed by the Efficient Market hypothesis and the wide adoption of financial models, the neo-classical orthodoxy proved very hard to dislodge, even today.

Rival theories of the European institutional school were basically ignored by the mainstream economists or begrudgingly incorporated at the fringes.

The neo-classical macro-economic theory was tautologically perfect, so long as its basic assumptions held. But the simplistic assumptions of perfect information, zero transaction costs and ceteris paribus (other things being equal) cannot hold because the market is dynamic and constantly evolving.

Other things cannot be equal. Central banks and monetary policies cannot be independent of the market. They are mutually inter-connected, interdependent and inter-active – a problem that even recent evolutions in game theory could not model effectively without very restrictive assumptions.

Clearly, we need much more complex non-linear explanations of human and market behaviour, including how different institutions react to imperfect information.

Without a more system-wide theory that embraces the crises of human interaction (financial crisis) and the human-natural interaction (climate change), we are reacting blindly. Partial solutions for one crisis may exacerbate the resolution of the other.

Hence, the real intellectual crisis today is one of obsolete economic thought, of departmental silos trying to cope with complex inter-related issues that are beyond the power of any single bureaucracy, and of fragmented nations dealing with global problems that affect all humanity.

To put it bluntly, our present economic theories cannot explain climate change adequately, just as Mayan priests found that more human sacrifices will not bring rain.

The twin crises are not just about man dealing with man’s follies but about man struggling with changing Mother Nature at the same time.

The dominant Western scientific logic of linear thinking has been operationally translated by traditional top-down bureaucracies into short-term “fixing the urgent rather than the important”, ignoring externalities that are difficult or cannot be measured, and sacrificing long-term benefits by dealing mostly with the immediate problem at hand.

Having consumed too much, the West is now blaming the East for saving too much, forgetting that the East’s savings come from producing for Western consumption at the expense of polluting their own environment and exploiting their cheap labour.

If the West did not consume, the East could not have had the income to generate their savings. Both sides gained but Mother Earth lost.

We ignored the externalities of ecological degradation because conventional economic theory and national statistics found them either difficult to measure or convenient to assume away.

Hence, the quick fix is not about asking the East to consume more to replace the decline in Western consumption, but to think a little more long-term on how to make human development more sustainable without destroying our environment.

We all need profound changes in economic thinking, including measures of “green” GDP that would enable us to measure more accurately the consequences of unsustainable consumption and production.

Parallel to building these new standards of sustainable growth will be the need to re-build our institutions.

The financial crisis was operationally an institutional crisis because the national and global institutional structures cannot cope with the externalities of financial institutions that operate globally, but are regulated and die nationally.

Rescuing these “too large to fail” dinosaurs are now beyond national resources. We need to appreciate that networked institutions are enmeshed into the global ecosystem and are not easy to remove surgically. Nor are their externalities easy to isolate or contain.

What is clear is that even though technology through scientific research and development has been able to defer the Malthusian doom, we must be realistic that as the world gets more and more inter-connected through telecommunications and modern transport, a more crowded world creates more and more disexternalities.

Hence, using lineal projections of growing prosperity in terms of conventional GDP cannot disguise the reality that there must be a change in the lifestyles of the majority of the world population in order to make our rise in standards of living more sustainable.

The clash of mindsets

An important consequence of the twin crises is that it has forced us to re-examine all options.

I am forced to conclude that the differences in approach are not one of Samuel Huntington’s “clash of civilisations”, but a more fundamental “short-term, partial and linear” mindset versus one that is more “long-term, system-wide and non-linear”.

The first one is easy to classify as current Western thinking, whereas the latter cannot be classified as distinctly Eastern, because there is no clearly articulated consensus amongst Eastern intellectuals whilst there is a growing strain of Western intellectuals moving in that direction.

In other words, we are caught between an unacceptable set of conventional follies that do not help us, and an intellectual wilderness without a “new Keynes” to guide us.

I am asking the emerging markets to start thinking seriously about how to change lifestyles in a manner that would be financially and ecologically sustainable.

Pragmatically, it is unlikely that there is a single person brilliant enough to think through the complex issues that we have before us.

The process of thinking through the implications of living in a smaller planet on a sustainable basis will have to be multi-disciplinary, with specialists from all fields, both physical science, ecology and even philosophy and behavioural science.

The issue of climate change is one that affects the future of all Mankind and not just any single nation. The debate in Copenhagen was unfortunate because it was framed as a blame game between the advanced countries and the rest.

The advanced countries are trying to stop the growing carbon emissions from the faster growing emerging markets without paying too much for it, whilst the emerging markets insist that since the advanced economies are responsible for most of the current status of carbon emission, they must bear the bulk of the burden.

The trouble with the climate change debate is that it is a tragedy of the commons on a global scale that cannot be resolved until we lower population growth and consumption levels to a more sustainable level.

It is a future disaster for which current economic thinking is not helpful. Like death, no one knows for sure when it will happen and perhaps no one wants to know. But we all have to deal with this, if not in our lifetime but for our children.

The world is clearly at the knife-edge of major changes that will require outstanding statesmanship between the West and the rest. When the world is crying out for heroic big decisions, global leaders are more likely to fudge the moment with good-sounding rhetoric but cautious small steps.

Experience will suggest that a muddled solution buys time for the community as a whole to digest what the options are. But the global clock is ticking.

Looking back at history, I now realise that turning points in history go through huge periods of turmoil, resolved either through war or profound intellectual conflict.

Thus, re-building a new intellectual framework to deal with the new environmental challenges will require first the creative destruction of the old economic orthodoxy.

China did not resolve the period of the Warring States till Confucianism won the clash of the Hundred Schools. The Renaissance in Europe resolved the separation between religion and the state that sowed the seeds of the scientific and industrial revolution.

So far, history has been written about how Man conquers Man, in which the conquest of the environment has been taken for granted.

Modern society has forgotten how Man emerged first amongst animals because he used knowledge to conquer Mother Nature. But the population of Man was small relative to the planet then. Human societies destroyed by the environment, such as the Khmer Civilization, the Mayan and the Easter Island cultures have been buried and ignored, because we all suffer from disaster myopia.

It is time that we begin once again a new intellectual revolution, about the application of science and technology to a sustainable living in a small planet.

If this cannot be done at the global level, then it must be done at the national and civil society levels. It is easy for Man to conquer other Men, but to conquer himself and his own greed, that is the most difficult task of all.

● Datuk Seri Panglima Andrew Sheng is adjunct professor at Tsinghua University, Beijing, and Universiti Malaya. He is a former chairman of the Hong Kong Securities and Futures Commission.