Warning: This is a long post, and it’s as much to do with politics as investing. Read at your peril!
There’s no doubt the financial crisis has cheered up anti-globalisation campaigners who had been getting dismayed with how much their countrymen enjoyed cheaper consumer goods, and how China and India seemed to be doing very well while being ‘exploited’ by the West.
The downturn has even put on a smile on the face of old, blind and illiterate idealists who’d love to dig up the corpse of communism.
I haven’t got much to say to the latter (except: get a job) but I got an interesting glimpse into the former when I attended a lecture at the London School of Economics on Tuesday to hear Professor Dani Rodrik of Harvard University.
Rodrik is a Professor of International Political Economy, and is widely considered to be a big thinker in the realm of markets, institutions and capitalism. (Click here for Rodrik’s full bio).
As I’ll discuss below, he gave some interesting insights into the problems of regulating the global economy.
But his talk also highlighted how people with an anti-free-trade agenda are going to try to hijack the financial crisis as their force majeure.
Why does this matter to you as an investor?
Well, financial regulation is on the agenda in a way that would have been unthinkable two or three years ago, as governments in the UK, Europe and the US seek their pound of flesh for the assistance they’ve given to the financial system.
More constructively, governments also hope (vainly in my view) to regulate away the chances of a crisis happening again.
President Obama is outlining his financial regulations for the US, while the UK government is locked in battle with Europe to try to stop financial regulation from crippling London. UK Chancellor Alastair Darling has his own plans for curbing bankers.
If policy makers get regulation wrong, we could see a rise in protectionism, a pointless curtailment in global trade, and terrible consequences for shares and the markets (and for economies and people, rich and poor).
Capitalism 3.0: A talking shop?
Professor Rodrik began his lecture with an apology for the cute Capitalism 3.0 moniker, but then went on to use it anyway as a framework in explaining how we got to where we are today. He outlined:
- Capitalism 1.0 – The discovery of the “the miracle of the market” as an economic engine. In the 19th Century this was allied to the idea that the State must be minimally involved to enable the market to work efficiently, with Governments providing merely “night watchman” services such as property rights, national defense, and justice.
- Capitalism 2.0 – The discovery (notably in the 1930s) that “markets are not self-creating, self-regulating, self-stabilising or self-legitimising”. This led to institutional underpinnings, and new State bodies responsible for monetary policy, redistribution, conflict management and so on. Basically Keynes and the Welfare State in Western Europe post-World War 2, along with a watered down version in the US.
The key problem with Capitalism 2.0 in Rodrik’s view was that it was all about national regulatory and oversight institutions rather than taking a global view, despite global trade being a reality.
To make international trade work, the much-vaunted Bretton Woods system ‘threw sand in the wheels’ of international trade, Rodrik argues, with capital controls and a highly permissive GATT agreement doing minor heavy lifting.
Developing countries were left outside of the club, in Rodrik’s view, while he said developed ones were “in many ways free to do what they want”.
As global trade multiplied, we got to:
- Capitalism 2.1 – Which Rodrik described as post-1990s financial deregulation allied to two “neo-liberal” errors of thinking: Namely that you can push integration of world markets and let institutions catch up, and that deep economic integration has no (or mostly benign) affects on national intsitutions. (If developing country’s institutions were rubbish to begin with, says Rodrik, then the neo-liberal agenda was they were better dead anyway).
Capitalism 2.1 caused the credit crisis, says Dani Rodrik
Blink and you’d miss it, but Rodrik then claimed this system was responsible for the credit crisis.
The professor cited…
- financial globalisation and deep integration under the WTO
- the erosion of the legitimacy of the trade system
- weak financial regulation
- poorly managed integration of US and Chinese style capitalism
- global macro imbalances that resulted from the above that enabled the US to go on a borrowing binge, and China to go on a savings binge
…as leading to a system that was “unstable” and “didn’t work”.
Rodrik said the resulting fundamental problem of the world economy was an imbalance between the reach of markets (increasingly global) and the scope of regulation governance (still mostly national).
What’s your problem?
Are you convinced by Dani Rodrik’s thesis? If so, you would have loved being in the audience at LSE. They lapped this stuff up.
But from where I was sitting it didn’t have much to do with the causes of the financial crisis.
This was no crisis of international trade. There was no huge problem caused by Brazilian banks investing in German securities without oversight from the Brazilian government, let alone a crisis caused by a shoe factory in Nepal or deforestation in Sumatra.
The credit crisis was caused by Wall Street bankers selling toxic, opaque and unexpectedly risky and correlated assets under the nose of US supervisors to other Wall Street firms, as well as those in Western Europe. (See this video explaining the credit crunch for a reminder).
Rodrik’s only really convincing point to this end was that Chinese buying of US Treasuries drove down yields and encouraged financial actors to look for better yields elsewhere, but it’s hard to see how regulation would have addressed this.
To get rid of such imbalances, you’d have to get rid of the cheap cars, trainers, TVs, iPods and everything else the US has exchanged for its assets that the Chinese have been hoarding.
Rodrik was tilting at windmills.
What would Capitalism 3.0 look like?
Having failed to make the case for globalisation causing the financial crisis, Professor Rodrik then set about describing how he’d fix it.
He made a much better fist of explaining why a truly universal, global system of trade regulation won’t work.
At the limit, to be legitimate it would require global standards, a global safety net, and eventually a global government. This won’t be practical anytime soon – just look at the problems Europe is having, and there cultures are broadly similar, at least compared to say South East Asia.
Rodrik also had a principle-based objection, which was that different countries have different needs to others: Developing countries with young populations trying to achieve a structural transformation have very different aims to Western countries overloaded with retiring baby boomers.
There are thus all kinds of problems that emerge from trying to impose global standards and a level playing field.
Rodrik himself pointed out as an example (to a stony silence from the audience) that a developing country may want to allow child labour that we wouldn’t consider acceptable in the developed world.
Why should it want to do this? Because the alternative is worse. Raising the country’s GDP brings in the money that could eventually pay for schools and a higher standard of living – it doesn’t work the other way around.
You could list any number of different examples, taking in environmental issues, redistribution, health and safety, financial assets and more.
Some of these issues are very valid (I’m most worried about the degradation of the environment) but realistically, we live in a heterogenous world of national states with national interests, and such issues will be decided at a domestic level, not through agreeing via global trade regulation.
A global regulatory framework isn’t desirable and won’t work anyway.
The solution: Traffic rules and space for discussion
Having won me back with his pragmatism, Professor Rodrik then lost me again with his solution.
He said any new approach should accept the following guidelines:
- Markets need to be deeply embedded in systems of governance to work well
- Understand we live in nation states
- There is no “one way” – domestic preferences and needs will play a role, even in developed countries
- Countries have a right to protect their own social arrangements and institutitions…
- …but not to impose them on others
- International economic arrangements should be of the maximum ‘thickness’ that is consistent with maintaining a space for domestic institutions (in other words, allow the like-minded to integrate)
- Where this doesn’t work, we should fall back on ‘traffic rules’
Central to his concept are these ‘New Traffic Rules‘ that would govern international trade.
The WTO already enables countries to impose tarrifs in certain conditions, but Professor Rodrik wanted to see much more of this. He wants to see “negotiated opt-outs” with “procedural constraints”.
The idea, stripped of academic language, is that when two countries come into conflict, everyone gets in a room and hammers out why it’s a problem, including (to Rodrik’s credit) those who’ll benefit from trade on both sides of the fence. It’s all meant to happen out in the open, to provoke a domestic debate.
If it can be shown that the complaining country has a more legitimate gripe than just that some aspect of the other country’s practices pisses off a few left-wing students, then “safeguards” would be called into play via a judicial hearing.
So what it all boils down to is Bretton Woods with even more sand in the wheels, combined with an optimistic view that more citizens will play a democratic role in understanding and caring about the micro-issues involved in steel production or kumquat farming, and so energize what is today a rather remote debate.
Yet GATT and other comprehensive(-ish) trade agreements are already bogged down – Rodrik’s proposed system would surely create even more friction and probably become unworkable in short order.
A little more conversation, a little less action
As far as I could see, Professor Rodrik would like globalisation to be curtailed for reasons unrelated to mortgage-backed securities, derivatives, or excessive risk-taking by financial companies.
There might be valid reasons for this viewpoint – he alluded to how India and China were able to develop their industry and institutions before opening the door to Western competition – but they have little or nothing to do with the credit crisis.
Rather, the financial status quo has been knocked off its feet, and not-so-liberal economists see the chance to get the boot in.
The follow-up questions with the audience made the anti-globalisation agenda even clearer.
When not praising his speech as offering a ‘magisterial framework’ for a new way of doing international business, staff and others asked things like:
- How would it allow ordinary people to get back at the bankers?
- How would the framework tackle US power?
- Why should lecturers lose their jobs due to banking bailouts? (This was said by a lecturer. At a school of economics.)
Thankfully, when it came to the very last question of day, an off-message member of the audience asked the crucial one: Would this framework have stopped the financial crisis, and if not then what’s the point?
Rodrik admitted it wouldn’t have, and said something about how he envisaged financial systems being much more ‘segmented’ then they are today.
All very well, but absent from his lecture.
We need risk and fear, not regulation
Like cuts to public services (inevitable and not before time), the normally arcane area of regulation is going to be making headlines for months to come.
Rather than learning the wrong lessons, or worse still using the financial crisis as an excuse to settle old grudges or score points, policymakers and voters need to decide:
- What they want regulation to achieve
- How much, if anything, regulation really can achieve.
I’m very much of the Minsky school that says you can’t regulate away risk (if only because the more seemingly stable you make a system, the more risky it actually is, since people stop evaluating risk properly).
Instead I’d prefer to see more preparations made (and money set aside for) dealing with problems when they arise, as well as curbs on unearned riches made by unjustified short-term risk-taking – if only on the grounds of social justice.
Transparency is almost always helpful, and forcing loan originators to retain some of their risk seems sensible.
But we’re still going to eventually get another instance of market participants failing to understand the risks they are taking simply because it has become the normal way of doing things, and everyone else is at it.
If you do favour radical regulation, at least George Soros’ proposals in the FT the other day addressed the causes of the financial crisis.
Soros offered three principles to guide financial reform:
First, since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. […]
Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone – we must also use credit controls such as margin requirements and minimum capital requirements. [..]
Third, we must reconceptualise the meaning of market risk. […] The efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances.
What’s clear is Soros understands the financial system that created the crisis, and thus might have something insightful to say about improving it.
A clear connect between the problem and the solution should be the litmus test for any new financial regulations.
Note: While everyone loves angry bloggers, I should say I liked Professor Rodrik’s talk and attitude, even when I didn’t agree with him. The fact he was linking his agenda to the financial meltdown was the most telling aspect of the evening, and overshadowed his actual ideas. But I enjoyed hearing them.
Update: Dani Rodrik has linked to this article from his weblog, as well as to another review of his lecture. If you’re keen on learning more, you might want to check out Professor Rodrik’s blog for more links to these alternative views as they emerge.