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Book Review: The World Finance Crisis & the American Mission

Robert Skidelsky — 2009-06-17T15:04:00+00:00

Fixing Global Finance

by Martin Wolf

Johns Hopkins University Press, 230 pp., $24.95

By common consent, we have been living through the greatest economic downturn since World War II. It originated, as we all know, in a collapse of the banking system, and the first attempts to understand the resulting economic crisis focused on the reasons for bank failures. The banks, it was said, had failed to "manage" the new "risks" posed by financial innovation. Alan Greenspan's statement that the cause of the crisis was the "underpricing of risk worldwide" was the most succinct expression of this view.[1] Particular attention was paid to the role of the American subprime mortgage market as the source of the so-called "toxic" assets that had come to dominate bank balance sheets. Early remedies for the crisis concentrated on bailing out or refinancing the banks, so that they could start lending again. These were followed by "stimulus packages," both monetary and fiscal, to revive the real economy.

Now that we are—or may be—over the worst of the crisis, attention has partly switched to trying to understand its deeper causes. The two most popular explanations to have emerged are the "money glut" and the "saving glut" theories. The first blames the crisis on loose fiscal and monetary policy, which enabled Americans to live beyond their means. In particular, Greenspan, chairman of the Federal Reserve in the critical years until his retirement in early 2006, used low interest rates to keep money too cheap for too long, thus allowing the housing bubble to get pumped up till it burst.

The second explanation sees cheap money in the US as a response to a "global saving glut" originating in East Asia and the Middle East. The "exorbitant privilege" enjoyed by the US dollar as the world's key currency allowed the US to pursue a fiscal and monetary policy that pushed domestic demand for goods and services well beyond domestic output, thereby absorbing the foreign savings hurled at it. The trouble was that foreign, and particularly Chinese, "investment" in the US economy, which in recent years has taken the form of buying US Treasury bonds, failed to create a corresponding flow of American tradable goods and services with which to repay the borrowing. As a result, America's domestic and foreign debt just went on increasing. In the technical jargon, both the US current account deficit and its debt-financed housing boom were unsustainable: it was unclear whether the dollar or the housing bubble would collapse first.

Concern about the US current account deficit—the excess of expenditures over receipts in a country's balance of payments—long preceded the financial crisis. By 2005, it had already ballooned to 5 percent of GDP. How had this happened? The conservative explanation was that the US monetary and fiscal authorities had provided Americans with the money to make payments to foreigners for imports far in excess of the payments they received from foreigners for exports. This "spending beyond your means" is the classic road to ruin, for households as well as for countries. In the case of households, it is normally brought to an end by a notice from your bank or credit card company saying that you have reached your credit limit or your account has been frozen. In the case of countries, it is normally ended by the refusal of other countries to lend the profligate country the means to continue its spending spree. The puzzle, though, was why the countries with surpluses continued to pour their hard-earned savings into the debt-ridden American economy.

In a notable lecture in 2005, Ben Bernanke, about to become chairman of the Federal Reserve, gave the answer. At first, he said, it was because the US was a highly productive economy. But following the financial crisis of 1997–1998, East Asian countries had deliberately started accumulating foreign exchange reserves to guard against another flight of capital similar to what they had just suffered or observed. To accumulate reserves they had to run current account surpluses, by earning more in exports than they spent on imports. This tied in with their policy of undervaluing their currencies against the dollar in order to maintain export-led growth.

After the collapse of the dot-com boom in 2000, the US became a much less desirable place for direct foreign investment. So East Asian countries, especially China, started to buy US Treasury bonds. They adopted aggressive policies of buying large quantities of dollars and resisting market pressure for appreciation of their currencies. Investing their dollars in US securities was a way of segregating their dollar purchases from the domestic money supply, thereby preventing domestic price increases that would have eroded their export competitiveness. Like other economists at the time, Bernanke saw considerable merit in the arrangement: it enabled emerging and developing countries to reduce their foreign debts, stabilize their currencies, and reduce the risk of financial crises. Without US willingness to act as a "consumer of last resort," the global savings glut would exert a huge deflationary pressure on the world economy.

But Bernanke also pointed out three snags in the situation. First, for developing countries to be lending large net sums to mature industrial countries with abundant capital was undesirable: the flow should be going the other way—to countries with a capital shortage. Second, much of the inflow of capital to the US went not into improving productivity but into the housing sector and consumption. Third, the arrangement depressed US exports, encouraging instead the parts of the economy that produce nontraded goods and services, such as the financial industry. Yet to repay its foreign creditors, the US needed healthy export industries. A fall in the dollar was, therefore, needed to shrink the nontradable economy relative to the export sector. Nevertheless, Bernanke concluded, "fundamentally, I see no reason why the whole process [of rebalancing] should not proceed smoothly."

This was the standard view before the present crisis broke. Martin Wolf, the world's most respected financial columnist—mainly for the Financial Times —published a book in 2004 called Why Globalization Works.[2] He saw globalization as a mighty engine for ending global poverty, and was scornful of arguments against it, most of which he dismissed as lacking professional competence. He pointed to the huge success of China in reducing extreme poverty (people living on less than $1 a day). He saw no problem arising from the macroeconomic imbalances that resulted from lopsided trade. As he wrote:

The pattern of surpluses and deficits will create difficulties only to the extent that the intermediation of the flows from the savings-surplus to the savings-deficit countries does not work smoothly.... But no insuperable difficulty should arise. If some people [Asians] wish to spend less than they earn today, then others need to be encouraged to spend more.

As late as mid-2007, he thought that the possibility that "huge calamities" could be generated by world financial markets "looks remote."[3]

His message just two months later was very different:

Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter.... Today's credit crisis...is also a symptom of an unbalanced world economy.[4]

Wolf more recently argued that the accumulation of dollar reserves by China and other East Asian countries that have maintained undervalued exchange rates against the dollar explains the low long-term interest rates and monetary easing of the US in the 2000s. Cheap money, he writes, had "encouraged an orgy of financial innovation, borrowing and spending" that created housing bubbles:

High-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.[5]

Wolf's most recent book, Fixing Global Finance, marks a turning point in his worldview. Written in 2007, just before the first signs of the current financial crisis were starting to register, it explains how unprecedented macroeconomic imbalances have repeatedly created the preconditions for financial crises over the last three decades. It offers the reader a chance to test Wolf's predictions and prescriptions a few months after they were made.

Wolf's main argument is that the microeconomics of finance is intimately intertwined with the nature of the global macroeconomy. If the latter is not sound, the former will not be sound either. His eight chapters take us through a detailed account of the role of exchange rate regimes—i.e., policies used to maintain currencies at a desired level against the dollar—and their influence on balance of payments and, ultimately, on the availability and use of credit in domestic economies.

It was the large macroeconomic effects of financial crises in emerging markets in the 1990s that enabled America to become what Wolf calls the "borrower and spender of last resort." There were four steps toward these crises: mismanaged liberalization (and globalization), run-up to currency crisis, currency crisis, and, finally, full financial crisis. South Korea offers a good example. During the 1990s, in order to qualify for OECD membership, South Korea had been liberalizing its exchange controls and credit markets. Spurred by their government to keep growing, large Korean companies and banks started borrowing abroad despite dwindling profits. Rising foreign interest rates undermined their creditworthiness and increased the cost of servicing their debt. They therefore needed to borrow even more—but now under worse conditions. This led to a general skepticism among foreign lenders. Whether solvent or not, Korean companies were faced by an ever-worsening credit situation.

Under these conditions of uncertainty, Koreans and other foreigners started selling the domestic currency, which therefore plummeted in value and triggered a currency crisis. This is when the full financial crisis of the 1990s really got going. With a devalued domestic currency, neither private nor public institutions could afford to take out new loans in foreign currencies, and the old ones could not be repaid. Interest rates soared and insolvent companies were wiped out, bringing solvent banks down with them. "Domestic credit seizes up. Inflation surges as the currency tumbles. The economy falls into a deep recession." Partly because of similarity of circumstances and partly because of contagion effects, this was the fate of most East Asian economies in 1997–1998.

During the three decades preced- ing 1997, financial crises were always followed by periods of large inflows of capital into emerging market economies ranging from East Asia to Latin America, as foreign investors shrugged off their losses and cheerfully started lending again. However, East Asian countries realized that being a net importer of capital comes at huge cost when their domestic currency faces devaluation. Thus, at the end of the 1990s, most emerging economies simply said "enough." No longer would they run current account deficits; instead they would keep their currencies artificially low—but stable—to facilitate export-led growth and become net exporters of capital.

To prevent inflows of capital from private foreign interests and banks from jeopardizing this policy, the governments of these countries have since been accumulating huge foreign-denominated reserves. In particular, they have been hoarding dollars. As Wolf puts it:

In essence, this is government recycling of money earned through the current account and money received from private sector capital flows: the emerging market economies are...smoking capital, but not inhaling.

This set the stage for unprecedented global imbalances. There can be no net exporter of capital without a net importer of capital. And if the net exporters happen to include countries such as China, you need a really big economy to absorb that capital. Enter the United States.

What follows in Wolf's account is largely a rehash of Bernanke's 2005 lecture. Wolf explains the "saving glut"/"money glut" debate, which is also an argument about the conduct of US macroeconomic policy in the years leading up to the bank crash of 2008. The official view of the Federal Reserve was that the existence of a "global saving glut" required the US to step forward as the superborrower to rescue the world from a recession. The "money glut" view holds that the direction of causality was quite the opposite: US monetary excess brought about low interest rates, which sparked a rapid growth in credit while reducing the willingness of American households to invest. This then resulted in trade deficits that weakened the dollar. To preserve competitiveness, East Asian governments were forced to embark on open-ended foreign currency intervention.

Thus, in the "money glut" view it was excessive US spending that led to excessive saving in emerging markets and not the other way around. Wolf prefers the "saving glut" to the "money glut" explanation. As he puts it:

Many blame the United States' predicament on the policies of the Federal Reserve and lax regulation of the financial system. These arguments are not without merit, but they are exaggerated.

Wolf's book is overloaded with diagrams and tables to back up this argument. The very density of the material may obscure the reader's understanding of the causal mechanisms by which "surplus Chinese saving" became "excessive American spending." Evidently, Americans didn't directly spend Chinese savings. The US dollars earned by Chinese exporters weren't being borrowed by American firms and households: they were being borrowed by China's central bank, which then hoarded or segregated them to keep them out of the domestic money supply and to keep the exchange rate low.

The story goes somewhat like this. Instead of having to borrow from the American public to finance its fiscal deficit, the US government could borrow Chinese savings by issuing Treasury bonds that were bought by the Chinese. Therefore federal deficits did not raise the cost of domestic borrowing, which they would have done had the government had to borrow American savings rather than selling debt to China. If the economy is working to capacity, the more governments borrow, the less private investors borrow. This is called "crowding out." With Chinese savings available, the US government could run a deficit without crowding out private spending. This allowed the Fed to establish a much lower funds rate—the rate at which banks borrow from the Fed and one another—than it would otherwise have been able to do, helped in this by the downward pressure on prices exerted by the import of cheap Chinese goods produced by cheap Chinese labor. Cheap money, in turn, enabled banks to expand their deposits and their loans to customers more than they could otherwise have done. In short, it was via their impact on the financing of the federal deficit that Chinese savings made it possible for the US consumer to go on a spending spree.

Provided that the Chinese were prepared to go on lending money to the US, why was this position unsustainable? Wolf suggests the answer when he remarks that the glut of savings by the Chinese might be better thought of as an "investment dearth" in the United States. This echoes Alan Greenspan's finding that cheap money hardly raised the level of US investment. A key indicator of this, as Greenspan put it, was

the dramatic swing in corporations' use of their internal cash flow...from fixed investment to buybacks of company stock and cash disbursed to shareholders.

The lack of opportunities for profitable investment determined the pattern of American spending. Americans borrowed not to invest in new machines but to speculate in houses and mergers and acquisitions. The resulting growth in paper wealth triggered a consumption boom. The situation was unsustainable because no new resources were being created with which to pay back either domestic or foreign borrowing.

This much was apparent to Wolf by 2007. But he took the view that to take any action to correct this enormous imbalance between China and the US risked upsetting the delicate, if unsound, mechanism that was keeping the world economy afloat. Indeed, he remarked:

As I write these words in August 2007, there seems to be good reason to welcome the global imbalances...: the world economy is growing strongly and in a more balanced way than in previous years, as demand picks up across the globe; the developing world is also performing well, particularly in Asia; and the world has not experienced a significant financial crisis in emerging markets since 2001.

Yet the name Wolf gives to his fifth chapter—"Calm before a Storm"—provides a hint of coming trouble.

In fact the present financial meltdown is producing the market-led adjustment that has eluded policymakers. Willy-nilly Americans are having to spend less and save more; the decline of Chinese export markets forces China to shift its growth emphasis to domestic development; the weakening of the American economy has produced an automatic decline in the relative value of the dollar against other currencies. But unless these market-led adjustments to acute crisis become conscious policy choices in both China and the US, the global imbalances will recreate themselves and we will limp out of this crisis into the next. Crisis always enlarges the possibility for reform. Wolf's prescriptions for rebalancing the world economy are still relevant: emerging market economies need to spend more and save less, and mature market economies need to spend less and save more. This would automatically right the listing ship. But how is this to be done?

In line with the "saving glut" hypothesis, Wolf argues that it is up to the Chinese and other East Asian countries to take steps to eliminate the excess savings they have created. This is in their own self-interest. The Chinese save and invest almost 50 percent of their GDP. Wolf claims that they get very poor return for their frugality. Chinese employment has hardly grown, because investment in export-led growth is highly capital-intensive: in 2005, the excess capacity in China's steel industry was 120 million tons—more than the annual production of Japan, the world's second-largest producer. Moreover, there are political risks in channeling current account surpluses into foreign reserves instead of greater consumption, improved health care, and infrastructure. This is particularly the case when the nominal returns on dollar debt are as low as they have been in the last few years.

Emerging-market governments should pursue expansionary fiscal policies to stir more private demand since, if the provision of public goods improves, private actors will have less of an incentive to keep up their current rates of precautionary savings. Emerging-market governments should also undertake financial reforms to enable them to raise funds in their own currencies—the only way to avoid the exchange rate problem that frequently caused crises in the past. The best way to achieve this is to develop markets in emerging economies for bonds denominated in the local currency. Unless these domestic credit markets are developed, emerging-market governments will be unwilling to run deficits, since the only funding now available—mostly in dollar-denominated instruments—exposes them to the risk of being unable to service their debts if the exchange rate fluctuates.

Another element in the East Asian adjustment should be a move to more flexible exchange rates, though Wolf recognizes that floating exchange rates are an obstacle to securing net capital flows from rich to poor countries. Global reform is necessary alongside domestic reform. Wolf ends with a raft of small but useful ideas for reforming the World Bank, regional development banks, and the International Monetary Fund (IMF). The IMF must be better at delivering technical assistance, surveillance, coordination of macroeconomic policies and exchange rates, and crisis management. It must reform its system of representation and resume its role as a credible lender during economic crises. The decision by the G-20 in April to expand the IMF's special drawing rights (SDRs) available to its members by $250 billion is an important step in this direction. Fred Bergsten, director of Washington's Peterson Institute for International Economics, argues that this opens the door to China's proposal to create a new global reserve currency to replace the dollar. But the door is only slightly ajar. What will ensure the general acceptability of the SDRs as reserves? And how will their issue be regulated? These questions have hardly been discussed.[6]

Despite the density of its argument and its skepticism about the possibility of reform in the short term, Wolf's book offers important pointers to the way ahead. But his story is only half-told. He has very little to say about America's responsibility for both creating and ending the system of global imbalances. For the fact is that the present system has suited the United States—specifically the power holders in the United States—just as much as it has those in China. The phrase "it has enabled the Americans to live beyond their means" is too vague to be useful. One needs to ask: which Americans? Certainly many middle- and low-income American households have been given opportunities to borrow beyond their means.

But secondly, the American–Chinese symbiosis has been excellent for US business profits. American businessmen have been complicit in Chinese "super-competitiveness" by arranging for manufacturing jobs to be moved to China from the US in order to cut costs. The decline in US manufacturing and the growth in nontradable services, and the financial operations that secured this restructuring, have enabled financiers and businessmen to earn huge profits that should have been shared with their workers. Morally, the financial community has been living well beyond its means. But perhaps above all, by getting other countries to finance its imperial pretensions, the US government has been able to live beyond its means. Wolf refers in several places to the "exorbitant privilege" of the US dollar, but omits entirely to discuss the political benefits that this privilege buys.

This points to the main weakness of Fixing Global Finance: the lack of a historical perspective. The history of the overprivileged dollar, after all, goes all the way back to the 1960s. Its roots lie in the failure of John Maynard Keynes's plan for a Clearing Union, which he worked out during World War II. The Keynes plan was specifically designed to prevent creditor countries from hoarding reserves by trading at undervalued currencies. If they did not spend their surpluses, the surpluses would be confiscated and redistributed among debtor countries. In this way a global balance between saving and investment would be secured through a balanced trade position, which would in turn allow fixed, but adjustable, exchange rates.

The Bretton Woods agreement of 1944 adopted the proposal for fixed but adjustable rates, but failed to provide a remedy against countries with trade surpluses accumulating, or hoarding, reserves. In practice, the problem was solved by the United States taking the place of nineteenth-century Britain as the chief supplier of foreign investment funds. The outflow of American savings helped reconstruct Europe after the war, and kept global demand buoyant throughout the Bretton Woods era. The dollar replaced gold as the world's chief reserve currency. This allowed the US to print dollars to cover its growing trade deficit. The arrangement suited both the Europeans and the United States, because it not only enabled the Europeans to export to America at undervalued exchange rates, but it also covered the cost of America defending Western Europe and non-Chinese East Asia against communism. In other words, the "exorbitant privilege" of the dollar allowed the US to pursue an imperial mission that, in the era of the cold war, was greatly to the satisfaction of its partners and allies.

The privileged position of the dollar survived the collapse of the Bretton Woods regime of fixed-exchange rates in 1971. In theory, the resulting system of floating exchange rates removes the need for any reserves at all, since adjustment of current account imbalances was supposed to be automatic. But the need for reserves unexpectedly survived, mainly to guard against speculative movements of short-term investment—"hot money"—that could drive exchange rates away from their equilibrium values. Starting in the 1990s, East Asian governments unilaterally erected a "Bretton Woods II," linking their currencies to the dollar, and holding their reserves in dollars. This reproduced both the benefits and faults of Bretton Woods I: it avoided global deflation, but undermined the long-run credibility of the dollar as the global reserve currency.

The new arrangement allowed the United States to continue to enjoy the political benefits of "seigniorage"—the right to acquire real resources through the printing of money. The "free" resources were not just unpaid-for imported consumer goods but the ability to deploy large military forces overseas without having to tax its own citizens to do so. Every historian knows that a hegemonic currency is part of an imperial system of political relations. Americans acquiesced in the unbalanced economic relations initiated by East Asian governments in their undervaluation of their currencies because they ensured the persistence of unbalanced political relations.

A willingness by the US government to end macroeconomic imbalances thus depends on its willingness to accept a much more plural world—one in which other centers of power in Europe, China, Japan, Latin America, and the Middle East assume responsibility for their own security, and in which the rules of the game for a world order that can preserve the peace while effectively tackling the challenges posed by terrorism, climate change, and abuse of human rights are negotiated and not imposed. Whether, even under Obama, the US is willing to accept such a political rebalancing of the world is far from obvious. It will require a huge mental realignment in the United States. The financial crash has disclosed the need for an economic realignment. But it will not happen until the US renounces its imperial mission.

—June 17, 2009

Notes

[1]Alan Greenspan, The Age of Turbulence: Adventures in a New World (Penguin, 2008), p. 507.

[2]Yale University Press, 2004.

[3]"Risks and Rewards of Today's Unshackled Global Finance," Financial Times, June 26, 2007.

[4]"The Federal Reserve Must Prolong the Party," Financial Times, August 21, 2007.

[5]"Asia's Revenge," Financial Times, October 8, 2008.

[6]Fred Bergsten, "Beijing's Currency Idea Needs to Be Taken Seriously," Financial Times, April 9, 2009.

The Lost Continent

Robert Skidelsky — 2009-06-13T09:22:01+00:00

LONDON – Home to one-sixth of the world’s people, but contributing only one-fortieth of world GDP, Africa is the most conspicuous victim of the global recession. After a half-decade of 5% growth, the continent’s growth rate is expected to halve in 2009. Some countries, like Angola, are contracting. Elsewhere, the crisis has swept away the benefits of several years of economic reform. Many Africans will fall back into desperate poverty.

Development economists wring their hands in despair: Africa defies their best efforts to create a miracle. On the eve of decolonization in 1960, real GDP per head in Sub-Saharan Africa was almost three times higher than in Southeast Asia, and Africans were expected to live two years longer on average. In the 50 years since, African real GDP per head grew by 38% and people lived nine years longer, while in Southeast Asia GDP per head grew by 1000% and people lived 32 years longer.

At first, the solution for Africa’s under-development seemed obvious. Africa needed capital, but lacked savings. Therefore, money had to be provided from outside – by institutions like the World Bank. Since extracting commercial interest rates from starving people seemed like usury, the loans had to be offered on a concessionary basis – in effect, aid.

Throwing money at poverty became a panacea. It was easy to sell, and it appealed to people’s humanitarian instincts. It also assuaged the guilt of colonialism, as with parents who give their children expensive gifts to make up for neglecting or mistreating them. But it did no good. Most aid was stolen or wasted. Despite the eight-fold increase in aid per head to the Democratic Republic of the Congo between 1960 and 2007, real GDP per head decreased by two-thirds in the same period.

“Trade not Aid” became the new watchword. Spearheaded by the economist Peter Bauer in the 1980’s, it became the nostrum of the Washington Consensus. Africa, it was fashionable to say, would catch up only if it deregulated its economies and embraced export-led growth like the “miracle” economies of East Asia. Advisers from the World Bank and the International Monetary Fund told African governments to stop subsidizing “national champions” and drop their trade barriers. Provision of a reduced volume of aid was to be conditioned on dismantling the public sector.

By 1996, only 1% of the population in Sub-Saharan Africa was civil servants, compared to 3% in other developing regions and 7% in the OECD. Yet despite the rollback of the state, Africa has not made the leap to prosperity. In a complete affront to economic theory, the little capital there is in Africa is fleeing the continent to be invested in already capital-rich societies.

The problem with Africa, economists then started to say, was that it lacked effective states. Many countries had “failed” states that could not provide even the minimum conditions of security and health. With 15% of the world’s population, sub-Saharan Africa accounted for 88% of the world’s conflict-related deaths and 65% of AIDS victims. What historians have known for 2,000 years – and what the eighteenth century’s classical economists also knew – suddenly struck the new breed of mathematical economists in the 1990’s like a flash of lightning: prosperity depends on good government.

So how to get good government? Restoring or securing it conjures up the dreaded specter of colonialism. After all, for all its other failings, colonialism provided the essential precondition of economic development: peace and security. The development discussion today is essentially about how such preconditions of poverty reduction and economic growth can be achieved without colonialism.

The most interesting contemporary contribution is by the Oxford economist Paul Collier. He argues that many African states have fallen into one or several development traps that are extremely difficult to escape. Moreover, once a country is mired in one of them, it is easy to fall into the next. Being poor makes you prone to conflict, and being in conflict makes you poor. So what hope is there for a poor country torn by civil war?

Citing the British mission to Sierra Leone, Collier argues for military intervention, when feasible, to secure peace. He supports international involvement to enforce post-conflict peace. But ongoing international assistance should be limited to providing voluntary good-governance templates.

Frameworks for how governments should make public spending transparent or how foreign resource-extracting companies should report their profits would make yardstick comparisons easier for local political activists, as well as providing a source of legitimacy for the government. The much-discussed Kimberly Process is a pilot project. Diamond companies volunteer not to buy from conflict areas in an attempt to prevent diamonds from funding warlords. This would be good for business, as affluent Western customers are now put off by the thought of buying blood-soaked jewelry.

Regional integration has featured prominently only in the last 50 years in Europe, but it has already resulted in a host of political and economic benefits to Europeans. Considerable evidence indicates that integration could be beneficial for Africa as well, given a framework suitable for African conditions.

This is a project worth supporting. Other efforts worthy of attention include formalizing the huge informal economy in states such as Ghana. Typically, these are projects that employ international expertise under domestically issued mandates.

It is a sign of the poverty of development economics that proposals such as these are regarded as cutting edge. However, as long as there is a roadblock every 14 kilometers between Lagos and Abidjan – two of West Africa’s leading cities – progress on the ground will be slow.

With refugees spilling over borders, pirates hijacking ships, and terrorists finding shelter, it is clear that, although Africa’s solutions are its own, its problems are not. The rest of the world can no longer afford Africa’s poverty. But the evidence of 50 years of failed efforts is that it hasn’t a clue what to do about it.

Economists clash on shifting sands

Robert Skidelsky — 2009-06-10T08:26:00+00:00

History is replete with famous intellectual battles. In the natural sciences, these have usually led to decisive victories, with good science ousting bad. There are few Ptolemaic astronomers left, or believers in the phlogiston theory of combustion. In the social sciences, the situation is different. There have been famous battles galore, but no decisive victories. Indeed, it is characteristic of the social sciences that their battles are interminable, temporary defeats being followed by the regrouping of the defeated forces for a renewed assault.

That economics is not a natural science is clear from the inconclusive engagements that have punctuated its own history. A hundred years ago the classical theory reigned supreme. This “proved” that free markets were automatically self-adjusting to full employment. They were either continually at full employment or, if disturbed by an outside shock, rapidly returned to it. The only thing capable of wrecking the workings of the market’s invisible hand was the visible hand of government interference.

Then along came the Great Depression of 1929-32 and John Maynard Keynes. Keynes “proved” that markets had no automatic tendency to full employment. This failing of the invisible hand justified government policies to maintain full employment.

For 30 years or so Keynesianism ruled the roost of economics – and economic policy. Harvard was queen, Chicago was nowhere. But Chicago was merely licking its wounds. In the 1960s it counter-attacked. The new assault was led by Milton Friedman and followed up by a galaxy of clever young disciples. What they did was to reinstate classical theory. Their “proofs” that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment were all the more impressive because now expressed in mathematics. Adaptive Expectations, Rational Expectations, Real Business Cycle Theory, Efficient Financial Market Theory – they all poured off the Chicago assembly line, their inventors awarded Nobel Prizes.

No policymaker understood the maths, but they got the message: markets were good, governments bad. The Keynesians were in retreat. Following Ronald Reagan and Margaret Thatcher, Keynesian full employment policies were abandoned and markets deregulated. Then along came the almost Great Depression of today and the battle is once more joined.

Haunters of the blogosphere will know that the main ground of the current engagement is about the effect of the “stimulus”. FT readers will have caught a faint whiff of the intensity of this battle in Niall Ferguson’s column of May 30, headed “A history lesson for economists in thrall to Keynes”. Prof Ferguson and Paul Krugman, the economist and New York Times columnist, had previously locked horns at a public symposium in New York on April 30. The historian had asserted that large fiscal deficits would push up long-term interest rates. This implied they would have a zero stimulatory effect: public spending would simply “crowd out” private spending. An enraged Mr Krugman responded on his blog that Keynes had proved that such crowding-out could occur only at full employment: if there were unemployed resources, fiscal deficits would not drive up interest rates without also expanding the economy. Prof Ferguson’s ignorant remarks only confirmed that “we’re living in a Dark Age of macroeconomics, in which hard-won know-ledge has simply been forgotten”.

However, this is not a debate between economists and historians. It is a battle within the economic profession – between the New Class-ical Economists and the New Keynesians. What is fascinating is that it is an almost exact rerun of the debate between Keynes and the British Treasury in 1929-30. The Treasury view was that bond-financed public spending was bound to diminish private spending by an equal amount. Keynes replied that if this were true it would apply to any new act of private spending. “In short, the fatalistic belief that there can never be more employment than there is is altogether baseless”.

Later the Treasury retreated to a more defensible position. The danger of extra government spending, it came to argue, lay not in the “physical” crowding out of resources but “psychological” crowding out. If doubts arose about the government’s solvency – a concern Prof Krugman has acknowledged – it might lead to capital flight, which would push up the cost of government borrowing.

Are we doomed to rehearse the same arguments time and again? In this particular debate, I am on Prof Krugman’s side, but I do not agree that Prof Ferguson’s position represents a retreat to a phlogiston state of economics. This is to take economics to be like a natural science, which Keynes never believed it was, because he thought its subject matter was much too variable over time.

Keynes’s view was that we need different economic models at different times. The beauty of his General Theory of Employment, Interest and Money was that it was general enough to accommodate a variety of models applicable to different conditions. Markets could behave in ways described by the classical and New Classical theories, but they need not. So it was important to take precautions against bad behaviour. Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment.

House of Lords Debate: Government Statistics

Robert Skidelsky — 2009-06-01T10:54:01+00:00

My Lords, I should like to take the opportunity provided by the question of the noble Lord, Lord Hamilton, to raise two topics, one general and one relating to the particular issue of inflation statistics.

My general comment is that I am appalled by the degree of statistical illiteracy abroad. Almost every time I read a newspaper I am aware that the journalists writing it have no knowledge of statistics. They simply pluck out things to create stories, as the noble Lord, Lord Lipsey, said, and therefore there is constant statistical abuse. Of course, it is very hard to be against more information but sometimes I think we would be better off with less. A good example of that kind of statistical abuse is the debate on climate change.

I do not know what the answer is. You could say that, as part of their training, journalists ought to have a compulsory course in statistics and should not be licensed to write anything unless they do. That, of course, is not feasible. However, a more sensible suggestion is that health warnings should come with official statistical information. I know that ONS guidelines require that statistics come with health warnings, but the kind of health warnings that they come with are totally incomprehensible to anyone but those who write them. For example:

“The variance of the IoP is fairly insensitive to the assumptions made about the variance of the EPD. This continues to be the case at 4-digit level. Thus the assumption made about the variance of the EPD when deriving formula (4) should be suitable”.

You can do better than that.

If you want any of these official statistics to have any impact on the public, then alongside the necessary technical blurb you must provide much more user-friendly health warnings. One of the most useful that you could provide is a list of a few unlikely but possible events which would render the forecast invalid, such as the collapse by 25 per cent of US house prices between 2006 and 2008. A list of those kinds of unlikely “black swans”, as they have been called recently, would be useful to have.

My second topic involves the battle of the indexes—that is, the pros and cons of the RPI index and the CPI index. The change in the index for the purposes of inflation forecasting was made in 2003. I remember it very well because I was a member of the Lords Select Committee on Economic Affairs. The assumption was—we were told so by the Chancellor and other witnesses—that the two indexes would converge. That reflected the efficient market hypothesis: after all, you cannot have two indexes which measure roughly the same based on roughly the same things that may diverge in the long term. But, of course, diverge is exactly what they have done.

This raises the question of what the purpose of the change was. As I understood it at the time, the purpose was to lower the headline rate of inflation in order to present the inflation record of the Government in a better light and therefore to decrease wage pressure. What has happened though is that the two indexes have diverged considerably. Which index inspires more confidence as a measure of the rate of inflation? In terms of confidence in the economy, the consumer prices index is better since it regularly grinds out lower rates of inflation than the retail prices index. In terms of confidence in the statistics, however, the RPI might be better because, it seems obvious to me, any credible inflation index should include mortgage interest payments, especially in a country such as Britain where housing is such a huge economic component.

RPI, then, is a better index than CPI, but mortgage payments are not an accurate measure of the flow of consumption in the economy, especially if asset prices are going up. I wish we could find a way of incorporating the increasing prices of housing stock in the retail prices index so that it more accurately reflected the trend of transactions in the economy. I hope that we can work towards that, and that this may be one of the lessons we learn from the present wreck of inflation targeting.

Anatomy of Thatcherism

Robert Skidelsky — 2009-05-13T09:11:00+00:00

London – Thirty years ago this month, Margaret Thatcher came to power. Although precipitated by local conditions, the Thatcher (or more broadly the Thatcher-Reagan) revolution became an instantly recognizable global brand for a set of ideas that inspired policies to free markets from government interference. Three decades later, the world is in a slump, and many people attribute the global crisis to these very ideas.

Indeed, even beyond the political left, the Anglo-American model of capitalism is deemed to have failed. It is held culpable for the near financial meltdown. But 30 years of hindsight enable us to judge which elements of the Thatcher revolution should be preserved, and which should be amended in the light of today’s global economic downturn.

Most obviously in need of amendment is the view that minimally managed and regulated markets are both more stable and more dynamic than those subject to extensive government intervention. The Thatcherite assumption, in other words, was that government failure is far more menacing to prosperity than market failure.

This was always bad history. The record shows that the period 1950-1973, when government intervention in market economies was at its peacetime height, was uniquely successful economically, with no global recessions and faster rates of GDP growth – and growth of GDP per capita – than in any comparable period before or since.

One can argue that economic performance would have been even better with less government intervention. But perfect markets are no more available than perfect governments. All we have are comparisons between what happened at different times. What these comparisons show is that markets plus government have done better than markets minus government.

Nevertheless, by the 1970’s the pre-Thatcher political economy was in crisis. The most notorious symptom of this was the emergence of “stagflation” – simultaneously rising inflation and unemployment. Something had gone wrong with the system of economic management bequeathed by John Maynard Keynes.

In addition, government spending was on the rise, labor unions were becoming more militant, policies to control pay kept breaking down, and profit expectations were falling. It seemed to many as though government’s reach had come to exceed its grasp, and that either its grasp had to be strengthened or its reach had to be reduced. Thatcherism emerged as the most plausible alternative to state socialism.

Nigel Lawson was Thatcher’s second Chancellor of the Exchequer, or finance minister. Out of the government’s anti-inflationary efforts emerged the “Lawson doctrine,” first stated in 1984 and broadly accepted by governments and central banks ever since. “The conquest of inflation,” Lawson said, “should...be the objective of macroeconomic policy. And the creation of conditions conducive to growth and employment should be...the objective of microeconomic policy.”

This proposition overturned the previous Keynesian orthodoxy that macroeconomic policy should aim at full employment, with the control of inflation left to wage policy. Yet, despite all the “supply side” reforms introduced by Thatcherite governments, unemployment has been much higher since 1980 than in the 1950’s and 1960’s – 7.4% on average in the United Kingdom, compared to 1.6% in the earlier decades.

What about inflation targeting? Here, too, the record since 1980 has been patchy, despite the huge deflationary pressure exerted by low-wage competition from Asia. Inflation in 1950-1973 and 1980-2007 was about the same – just over 3% – while inflation targeting has failed to prevent a succession of asset bubbles that have brought recessions in their wake.

Nor has Thatcherite policy succeeded in one of its chief aims – to reduce the share of government spending in national income. The most one can say is that it halted the rise for a time. Now public spending is on the increase again, and record peacetime deficits of 10% or more of GDP stretch ahead for years.

In de-regulating financial markets worldwide, the Thatcher-Reagan revolution brought about the corruption of money, without improving on the previous growth of wealth – except for the very wealthy. The average world citizen would have been 20% richer had world GDP per capita grown at the same rate between 1980 and 2007 as it did between 1950 and 1973 – and this despite China’s high growth rates in the past 20 years. Furthermore, in unleashing the power of money, the Thatcherites, for all their moralizing, contributed to the moral decay of the West.

Against these formidable minuses are three pluses. The first is privatization. By returning most state-owned industries to private ownership, the Thatcher revolution killed off state socialism. The British privatization program’s greatest influence was in the former communist states, to which it gave the ideas and techniques needed to dismantle grossly inefficient command economies. This gain must be preserved in the face of the current clamor to “nationalize” banks.

Thatcherism’s second success was to weaken trade unions. Set up to protect the weak against the strong, labor unions had become, by the 1970’s, enemies of economic progress, a massive force of social conservatism. It was right to encourage a new economy to grow outside these congealed structures.

Finally, Thatcherism put paid to the policy of fixing prices and wages by central diktat or by tripartite “bargains” between governments, employers, and trade unions. These were the methods of fascism and communism, and they would, in the end, have destroyed not just economic, but political, liberty.

Political pendulums often swing too far. In rebuilding the shattered post-Thatcherite economy, we should be careful not to revive the failed policies of the past. I still find fruitful Keynes’s distinction between the agenda and the non-agenda of politics. As long as central government takes responsibility for maintaining a high and stable level of employment, Keynes thought, most of the rest of economic life can be left free of official interference. Building a proper division of responsibility between state and market from this insight is today’s main task.

The Treason of the Economists

Robert Skidelsky — 2009-04-13T09:06:00+00:00

LONDON – All epoch-defining events are the result of conjunctures – the correlation of normally unconnected events that jolt humanity out of a rut. Such conjunctures create what the author Nassim Nicholas Taleb calls “Black Swans” – unpredictable events with a vast impact. A small number of Black Swans, Taleb believes, “explain almost everything in our world.”

The prosperity of the first age of globalization before 1914, for example, resulted from a successful constellation of developments: falling transport and communication costs, the technological breakthroughs of the second industrial revolution, the pacific state of international relations, and Great Britain’s successful management of the gold standard. By contrast, in the interwar years poisonous international politics combined with global economic imbalances to create the Great Depression and set the scene for World War II.

Now consider recent financial innovations. On the back of the new computer and telecommunications technology, a giant market for derivative instruments was built. Collateralized debt obligations (CDOs, mainly tied to mortgages) made a new population of aspiring homeowners supposedly creditworthy by enabling the originating banks to sell “sub-prime” debt to other investors.

Before securitization, banks typically held mortgages; now they could get them off their books. But securitized credit taken off one bank’s balance sheet usually ended up on another bank’s books. What resulted was a wonderful system for diversifying individual bank risk, but only by magnifying the default risk of all banks that held what came to be called “toxic” debt. Because all the derivatives were based on the same assets, if anything happened to those assets, all the banks holding the debt would find themselves in the same soup.

What made the spread of derivatives possible was the ease with which the volume of debt for a given set of real assets could be expanded. This scalability was magnified by the use of credit default swaps (CDSs), which offered phony insurance against default. Since an unlimited number of CDSs could be sold against each borrower, the supply of swaps could grow much faster than the supply of bonds.

CDSs magnified the size of the bubble by hugely speeding up the velocity of monetary circulation. The CDO market grew from $275 billion to $4.7 trillion from 2000 to 2006, whereas the CDS market grew four times faster, from $920 billion in 2001 to $62 trillion by the end of 2007.

CDSs were the means by which derivatives found their way into the portfolios of banks all over the world. But the dependence of the whole structure on continually rising house prices was rarely made explicit. If the housing market started to fail, these paper assurances of safety would become, in Warren Buffett’s words, “financial weapons of mass destruction.”

But financial intermediation would never have brought disaster (or indeed gone so far) save for the global imbalances arising from America’s twin trade and budget deficits, financed to a large extent by Chinese savings. Floating exchange rates were supposed to prevent countries from manipulating their currencies, but, by accumulating large quantities of US treasury bills, East Asian countries, especially China, kept their exchange rates artificially low. This East Asian “savings glut” enabled a debt-fuelled consumption glut in the US, Britain, and much of the Western world.

But the marriage between Chinese savings and American consumption had a fatal flaw: it created non-repayable debts. Chinese investments increasingly took the form of official purchases of US Treasury bills. These investments did not create new resources to provide the means of repayment. For the counterpart of the US debt build-up was the relocation of much American manufacturing capacity to China. Chinese savings flowed not into creating new assets, but into financial speculation and consumer binges.

“Surplus” Chinese savings made possible America’s credit expansion between 2003-2005, when the federal funds rate (the overnight rate at which US banks lend to one another) was held at 1%. Ultra-cheap money produced a surge in sub-prime mortgage lending – a market that collapsed when interest rates increased steadily after 2005, reaching 5%.The financial crisis of 2008 was the start of a highly painful, but inevitable, process of de-leveraging.

This interpretation of the origins of the present slump is disputed by the ‘money glut’ school. In their view, there was one cause, and one cause only of the crisis: the excessive credit creation that took place when Alan Greenspan was chairman of the US Federal Reserve.

This view draws on the ‘Austrian’ theory of booms and slumps, and also Milton Friedman’s explanation of the Great Depression of 1929. It was wrong then, and it is wrong now.

This line of reasoning assumes that markets are perfectly efficient. If they go wrong, it must be because of mistakes in policy. This view is also self-contradictory, for if market participants are perfectly rational and perfectly informed, they would not have been fooled by a policy of making money cheaper than it really was. Greenspan is the sacrifice they offer to the god of the market.

This suggests a more fundamental reason for the economic crisis: the dominance of the Chicago school of economics, with its belief in the self-regulating properties of unfettered markets. This belief justified, or rationalized, the de-regulation of financial markets in the name of the so called “efficient-market hypothesis.” It led directly to the spread of financial risk-management models, which, by excluding the possibility of default, grossly underestimated the amount of risk in the system.

If we are going pursue the blame game, I blame economists more than bankers for the crisis. They established the system of ideas that bankers, politicians, and regulators applied.

John Maynard Keynes wrote that “practical men who believe themselves to be quite immune from intellectual influences are usually the slaves of some defunct economist.” Most of today’s crop of economists are not defunct, but continue to work in the ideological vicinity of Chicago. Their assumptions should be ruthlessly exposed, for they have come close to destroying our world.

A Warrant of Hypocrisy

Robert Skidelsky — 2009-03-13T11:49:00+00:00

LONDON – Earlier this month, the International Criminal Court (ICC) upheld the request of the court’s chief prosecutor to issue an arrest warrant for Omar el-Bashir, the President of Sudan, charging him with war crimes and crimes against humanity. Bashir responded by expelling foreign aid agencies looking after the refugee camps in Darfur. This is the first time that a sitting head of state has been indicted for war crimes, with reaction around the world mainly divided between those who hailed the move as a great step for international justice and those who condemned it as colonialism. Both positions are hopelessly buried in intellectual and moral fog. The warrant was no leap forward. From the legal point of view, it makes no difference whether the accused is a sitting or former head of state. But it makes an enormous practical difference that an incumbent ruler can do a lot more future damage to his people than an ex-ruler, and therefore should be given no incentive to retaliate. As a result of Bashir’s policies, 300,000 people are estimated to have died and 2.7 million displaced in Darfur. The expulsion of the aid agencies has put over a million Darfuris at risk of epidemics and starvation. According to the statute that established the ICC, the prosecutor is required to ensure that any prosecution is in the interests of the victims as well as of justice. But, to lawyers like the ICC prosecutor, the abstract claims of justice are more vivid than any concrete duty of protection. In this case, justice comes with poisoned arrows. Emboldened by the warrant and its elusive suggestion of international support, the Darfuri rebels, the Justice and Equality Movement, have walked out of peace talks with Sudan’s government. Meanwhile, Bashir, with little to lose, will no doubt take the opportunity to attack his enemies. The counter-argument is that the threat of indictment will deter rulers from wicked behavior. But the law will deter only if its sanctions are credible. A law that cannot be enforced deters no one. In fact, it weakens respect for law. Moreover, while the fear of being hauled off to The Hague may have some effect in deterring rulers from committing crimes against humanity, the claim that the Bashir warrant will deter the current crop of human rights’ violators is derisory. Indeed, it is likely to prolong wicked regimes. Robert Mugabe, for example, refuses to leave office – at great cost to Zimbabwe’s people – for fear of being put on trial. Whatever the attractions of giving criminals “nowhere to hide, whatever the consequences,” the consequences cannot be ignored when the criminals are heads of state. The policy of never negotiating with terrorists cannot be scaled up to state level when hundreds of thousands of lives are at stake. The charge of colonialism, meanwhile, is simply reflex: colonialism no longer exists. The charge that international law is just “western law” is also rubbish. International law is the conscience of mankind. But the perception that the law is selectively applied happens to be true. In the Nuremberg trial of 1946, which laid the basis of current international law, the main charge against the Nazi leaders was that of “planning and waging aggressive war.” Prohibition of war except for self-defense is embedded in the United Nations Charter. But the ICC’s creators deemed the waging of aggressive war – which the International Military Tribunal at Nuremberg called “the supreme international crime” – to be outside the court’s jurisdiction. This guaranteed legal immunity for the leaders who carried out the invasion of Iraq. The charge of selective application also applies to the Bashir warrant. Bashir stands accused of war crimes and crimes against humanity. The latter were first defined in the Nuremberg principles of 1950 to include murder, extermination, enslavement, deportation and “other inhumane acts.” In 1998, these other acts were clarified to mean false imprisonment, torture, rape, persecution of a group, enforced disappearance of persons, and apartheid. It comes as no surprise, then, to read in the Arab News that Bashir’s warrant “reeks of hypocrisy.” Where, indeed, are the arrest warrants for Bush and Cheney? Does extraordinary rendition not count as “enforced disappearance of persons”? Does the waterboarding of Khalid Sheikh Mohammed not count as torture? Why is Vladimir Putin not standing trial for war crimes in Chechnya? The answer is simple: where the interests of a UN Security Council member or one of their clients are at stake, the court’s jurisdiction ends. The ICC is like a cobweb: small flies get stuck, but wasps and hornets get through. Until the United States ratifies the ICC treaty, the Court is bound to seem to many to be little more than a politicized kangaroo court. Without American support, it has little hope of earning legitimacy, let alone doing its job effectively. The Security Council has the power to defer the warrant for Bashir’s arrest for renewable periods of one year. It can do this indefinitely, and it seems likely that it will. The idea is that deferring the warrant will give the Security Council leverage over Sudan. Gareth Evans, a former Australian Foreign Minister, has called it “a powerful diplomatic tool,” while the Washington Post has called for the warrant to be used “as a bargaining chip with Mr. Bashir and his Chinese and Arab allies.” They believe that the threat of arrest can be used to force Bashir to mend his ways. If this proves true, the ICC and its sponsors have muddled justice with diplomacy. If the world can dispense justice only at the expense of the weak and to the advantage of the strong, it should stick to the older tools of crime prevention: force and negotiation, and leave justice out of it.

Shaky Social Contracts

Robert Skidelsky — 2009-02-13T09:11:00+00:00

London – “Enrich yourselves,” China’s Deng Xiaoping told his fellow countrymen when he started dismantling Mao Zedong’s failed socialist model. In fact, elites everywhere have always lived by this injunction, and ordinary people have not minded very much, provided that the elites fulfill their part of the bargain: protect the country against its enemies and improve living conditions. It is this implied social contract that is now endangered by economic collapse.

Of course, the terms of the contract vary with place and time. In nineteenth-century Europe, the rich were expected to be frugal. Conspicuous consumption was eschewed. The rich were supposed to save much of their income, as saving was both a fund for investment and a moral virtue. And, in the days before the welfare state, the rich were also expected to be philanthropists.

In the opportunity culture of the United States, by contrast, conspicuous consumption was more tolerated. High spending was a mark of success: what Americans demanded of their rich was conspicuous enterprise.

Societies have also differed in how wealthy they allow their elites to become, and in their tolerance of the means by which wealth is acquired and used. One dividing line is between societies that tolerate self-enrichment through politics, and those that demand that the two spheres be kept separate.

In Western countries, politicians and civil servants are expected to be relatively poor. In most of the rest of the world, a political career is regarded as a quasi-legitimate road to wealth. But the broad conclusion remains: wealth is conditional on services. When the services fail, the position of the wealthy is threatened.

In the current crisis, popular anger is – no surprise – directed against bankers. Their speculative frenzies ruined shareholders, customers, and the economy. Anger has come to focus on banking executives’ huge compensation packages, composed largely of bonuses. Rewarding success is acceptable; rewarding failure is not.

Governments face a dilemma. Big banks cannot be allowed to fail; but the public expects bankers to be punished. Few will be ruined or imprisoned. But the banking system is sure to be re-regulated, as it was after the Great Crash of 1929-1932, when President Franklin Roosevelt promised to drive the money changers from the temple.

The global economy’s downturn increases countries’ political risk to varying degrees, depending on the severity of the shock and the nature of the implied social contract. Political systems in which power is least controlled, and the abuse of wealth greatest, are most at risk. The more corrupt the system of capitalism, the more vulnerable it is to attack. The general problem is that all of today’s versions of capitalism are more or less corrupt. “Enrich yourselves” is the clarion call of our era; and in that moral blind spot lies a great danger.

Despite efforts to give it precision, estimating political risk is not an exact science. It requires political theory, not econometrics. Forecasting models, based on “normal distributions” of risk over short slices of recent time, are notoriously incapable of capturing the real amount of risk in a political system.

One of the “safest” political systems of recent times was President Suharto’s regime in Indonesia. Suharto came to power in 1966, establishing a quasi-military dictatorship and encouraging Indonesians to “enrich themselves.” Despite the depredations of his family, enough Indonesians did so over the next 30 years to make his rule seem exceptionally stable – until the East Asian financial crisis of 1997-1998 sent the Indonesian economy into a tailspin, triggering violent riots that forced Suharto out.

Similarly, few regimes seemed more stable than that of the Shah of Iran, another long-term ruler, who, having bankrupted his country, was forced to flee the fury of a mob in 1979.

The lesson is clear. Autocracies, which are much praised for their decisiveness, and for guaranteeing “law and order,” are paper tigers. They appear immovable until the moment they are evicted by popular anger. In face of economic failure or military defeat, their emperors turn out to be naked.

In such situations, the great advantage of democracies is that they allow a change of rulers without a change of regime. Failure discredits only the party or coalition in power, not the entire political system. Popular anger is channeled to the ballot box. In such countries, there may be “New Deals,” but no revolutions.

In estimating political risk today, analysts must pay particular attention to the character of the political system. Does it allow for an orderly transition? Is it competitive enough to prevent discredited leaders from clinging to power? Analysts also must pay attention to the nature of the implied social contract. Broadly speaking, the weakest contracts are those that allow wealth and power to be concentrated in the same few hands, while the strongest are built on significant dispersal of both.

Deepening economic recession is bound to catalyze political change. The Western democracies will survive with only modest changes. But strongmen who rely on the secret police and a controlled media to maintain their rule will be quaking in their shoes. Even Venezuela’s Hugo Chávez, who built his power on populist anti-Americanism, must be praying for the success of US President Barack Obama’s stimulus package to lift his falling oil revenues.

The big countries with the highest political risk are Russia and China. The legitimacy of their autocratic systems is almost entirely dependent on their success in delivering rapid economic growth. When growth falters, or goes into reverse, there is no one to blame but “the system.”

Igor Yurgens, one of Russia’s most creative political analysts, has been quick to draw the moral: “the social contract consisted of limiting civil rights in exchange for economic well-being. At the current moment, economic well-being is shrinking. Correspondingly, civil rights should expand. It’s just simple logic.” The rulers in Moscow and Beijing would do well to heed this warning.

The Unreality of the “Real” Business Cycle

Robert Skidelsky — 2009-01-13T09:08:01+00:00

London – Testifying recently before a United States congressional committee, former Federal Reserve Chairman Alan Greenspan said that the recent financial meltdown had shattered his “intellectual structure.” I am keen to understand what he meant.

Since I have had no opportunity to ask him, I have to rely on his memoirs, The Age of Turbulence, for clues. But that book was published in 2007 – before, presumably, his intellectual structure fell apart.

In his memoirs, Greenspan revealed that his favorite economist was Joseph Schumpeter, inventor of the concept of “creative destruction.” In Greenspan’s summary of Schumpeter’s thinking, a “market economy will incessantly revitalize itself from within by scrapping old and failing businesses and then reallocating resources to newer, more productive ones.” Greenspan had seen “this pattern of progress and obsolescence repeat over and over again.”

Capitalism advanced the human condition, said Schumpeter, through a “perennial gale of creative destruction,” which he likened to a Darwinian process of natural selection to secure the “survival of the fittest.” As Greenspan tells it, the “rougher edges” of creative destruction were legislated away by Franklin Roosevelt’s New Deal, but after the wave of de-regulation of the 1970’s, America recovered much of its entrepreneurial, risk-taking ethos. As Greenspan notes, it was the dot-com boom of the 1990’s that “finally gave broad currency to Schumpeter’s idea of creative destruction.”

This was the same Greenspan who in 1996 warned of “irrational exuberance” and, then, as Fed chairman, did nothing to check it. Both the phrase and his lack of action make sense in the light of his (now shattered) intellectual system.

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust. Indeed, early theorists of business cycles understood this. (Schumpeter himself wrote a huge, largely unreadable book, with that title in 1939.)

In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the eighteenth century, railways in the nineteenth century, automobiles in the twentieth century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse.

Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Denis Robertson, an early twentieth-century “real” business-cycle theorist, wrote: “I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned.” Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary “real” business-cycle theory builds a mountain of mathematics on top of these early models, the main effect being to minimize the “destructiveness” of the “creation.” It manages to combine technology-driven cycles of booms and recessions with markets that always clear (i.e., there is no unemployment).

How is this trick accomplished? When a positive technological “shock” raises real wages, people will work more, causing output to surge. In the face of a negative “shock,” workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient automobile companies like General Motors only slows down the rate of progress. In fact, whereas most schools of economic thought maintain that one of government’s key responsibility is to smooth the cycle, “real” business-cycle theory argues that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today’s economic turbulence, or offers sound instruction about how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological “shock” that set off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions: it was the invention. It was called securitized mortgages. It left no monuments to human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such “shocks.” Indeed, “real” business-cycle economists typically argue that, but for Roosevelt’s misguided New Deal policies, recovery from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy banks, subsidizing inefficient businesses, and putting obstacles in the way of rational workers spending more time with their families or taking lower-paid jobs. It reminds me of the interviewer who went to see Robert Lucas, one of the high priests of the New Business Cycle school, at a time of high American unemployment in the 1980’s.

“My driver is an unemployed Ph.D. graduate,” he said to Lucas. “Well, I’d say that if he is driving a taxi, he’s a taxi-driver,” replied the 1995 Nobel Laureate.

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern “real” successors smothered his insights in their obsession with “equilibrium” and “instant adjustments.” For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny.

Book Review: Can You Spare a Dime?

Robert Skidelsky — 2008-12-26T17:20:00+00:00

The Ascent of Money: A Financial History of the World

by Niall Ferguson

Penguin, 442 pp., $29.95

The historian Alan Taylor used to say, mischievously, that the only point of history is history. The idea that one could use it to predict the future, still more to avoid past mistakes, was pure illusion. Niall Ferguson's The Ascent of Money, a history of financial innovation written as a television documentary[1] as well as a book, offers a neat test of Taylor's theory. Ferguson can claim some powers of anticipation. History convinced him in 2006 that the good times could not last "indefinitely." This was an insight to which the Nobel Prize–winning mathematical economists who devised the Black-Scholes formula—the complicated model for pricing share options used by the highly leveraged firm Long-Term Capital Management, which famously crashed in 1998—were oblivious. Their formula persuaded them that a massive sell-off could occur only once in four million years.

History has alerted Ferguson to the perils of the state relying on the bond market for its financing. On Lou Dobbs Tonight on November 13, 2008, he said:

How much can the international bond market absorb of new ten-year treasuries?... And if yields go up, the cost of government borrowing goes up, and the thing begins to spiral out of control....That's why you need the historical perspective....

Between the two opposed views that history can teach us nothing and that the future is simply a reflection of the past lies the sensible middle position that history, like any other way of experiencing the past, can give us "vague" knowledge of what may lie in store for humanity. Only history-free economists could have bought the "efficient market hypothesis," which claims that the market will price shares correctly, with deviations from accurate prediction occurring only at random. But knowledge of history would not have enabled anyone to predict the timing and extent of the present meltdown. Above all, history cannot settle the question of what our attitude should be toward money, which is at root a moral question.

The Ascent of Money is a superb book, which illustrates both the strengths and the weaknesses of history for understanding what is happening now. It is written with the narrative flair, eye for detail, range of reference, and playfulness of language that we have come to expect from this exceptionally versatile historian. Ferguson is clearly fascinated by the subject of finance, knows a huge amount about it, and communicates his enthusiasm to the reader. Many parts of the story will be familiar enough to specialists, but Ferguson has a special ability to color even the familiar with strange and unusual examples, and he weaves together the separate strands of the financial tapestry with great skill. Some of the financial material is quite technical, but there is no attempt to "dumb down." The book is an all too rare example of good, even dense, scholarship finding a way to engage the larger public.

Ferguson's strategically themed structure starts with the origins of money, and shows, in successive chapters, how money found a way of multiplying itself through the development of banking, bond, equity, and insurance markets, and derivative instruments of all kinds until the world economy came to resemble what Charles Morris has called an inverted pyramid of debt resting on an increasingly narrow base of real assets.[2] The large claim Ferguson makes is that we owe our prosperity more to finance than to technology. Throughout history men have been more ingenious at finding ways to make money than to make things. As Gibbon shrewdly noted, without the "incitement" given by money to the "powers and passions of human nature," societies could scarcely have emerged "from the grossest barbarism."[3]

Money, according to Ferguson, is not a thing but a relationship—above all, a relationship between creditor and debtor. As soon as time and distance start to elapse between exchanges of things of value—which happened at the start of civilization—people needed something more than barter. Farmers needed to borrow while they waited for the harvest to ripen; merchants needed to borrow while they waited for shipments to arrive; above all governments needed to borrow to finance their wars. The three functions of money—as a means of exchange, a unit of accounting, and a store of value—developed to bridge the interval between purchase and payment. Bills of exchange or "promises to pay" seem to have been used for the settlement of debts from the earliest times to overcome the inconvenience of shipping the precious metals.

Primitive banks, or safe depositories, must also have existed from the earliest times. The actual word "bank" originated from the Italian banca, or bench, at which the medieval moneychangers sat to do their business. Bankers soon learned how to augment their profits by lending out their deposits at interest. The Medici of fifteenth-century Florence were the first famous banking family. They made their fortune by buying and selling "bonds," the debts issued by cash-strapped monarchs. These bits of paper bound the borrower to repay within a specified period of time. The bond market started when these bonds became tradable. The bond market, the first truly modern financial market, was perfected in eighteenth-century England; great merchant bank underwriters of loans like the Rothschilds dominated the public finance of nineteenth-century Europe. Fractional reserve banking, an early innovation, starting with Sweden's Riksbank in 1656, enabled banks to make loans in excess of the money deposited with them—on the assumption that "depositors were highly unlikely to ask en masse for their money."

Ferguson rightly points out that the early growth of European finance was driven more by the needs of the state than by those of commerce. His thesis, familiar from his two volumes on the Rothschilds,[4] is that state policy determines the development of finance, not vice versa. This reverses the usual Marxist argument that finance controls governments. The Rothschilds started as court bankers. The Bank of England was created in 1694, mainly to help the government with war finance, by converting a portion of the government's debt into shares, in return for which the bank was given special privileges, such as a partial monopoly on issuing banknotes.

England's rise to world power in the eighteenth century was based on the ability of the British government to borrow larger sums at cheaper rates than any of its rivals; hence the importance for the nineteenth-century public mind of maintaining the state's creditworthiness by balancing the government budget. In the twentieth century it was the eagerness of democratic governments to extend home ownership—as an antidote to revolution—that later led to the practice by which home mortgages are converted into securities and sold around the world.

Long-term investment needed a different financing structure, and this was found in the development of the joint-stock, limited-liability company and the emergence of stock markets. By enabling many individuals to pool their resources by buying shares of a particular enterprise, while protecting them from losing everything if the project failed, the limited-liability company was one of the greatest innovations in financial history. The Dutch East India Company, formally chartered in 1602, was the first company to issue its own stock and bonds through the Amsterdam Stock Exchange. Over its two-hundred-year history the average dividend it paid out to its 358 shareholders was 18 percent a year. It helped that it was a chartered monopoly, with the power of the government behind it.

Ferguson notes that the history of stock markets has been punctuated by spectacular bubbles and crashes. Some of these have been caused by fraudulent company promoters: Kenneth Lay of Enron had a worthy predecessor in John Law, whose Mississippi Company went spectacularly bust in 1720. Many fraudsters, like Ivar Kreuger, the "Swedish match king" who committed suicide in 1932, were men of vision who turned to crime only to rescue great projects that had gone wrong. But the fraudsters could get away with it—for a time—because of what Alan Greenspan called the "irrational exuberance" of investors. Why are stock markets so volatile? Ferguson believes it is because they are

mirrors of the human psyche. Like homo sapiens, they can become depressed. They can even suffer complete breakdowns. Yet hope—or is it amnesia?—always seems able to triumph over such bad experiences.

This is a good analogy, but, as I shall argue, it is not an explanation.

As Ferguson tells it, volatility is inherent in financial markets, but bad monetary policy can make it worse. Central banks were created, in part, to stop the "over-issue" of notes by private banks, and to act as "lender of the last resort." Following Milton Friedman, Ferguson believes that the Great Depression of 1929–1933 was caused by bad monetary policy—money was kept so cheap that a huge stock market bubble formed, and, when it burst, the Federal Reserve Board failed to provide the banking system with sufficient liquidity. This view that monetary policy alone is sufficient to keep economies relatively stable is unlikely to survive its harsh confrontation with present reality.

The next step in money's ascent is the development of insurance markets to guard against risk. Ferguson tells the story through three central episodes. The start of insurance depended on the work of the mathematicians at Port-Royal in eighteenth-century France, who laid the basis for the modern theory of probability. Provided that the relative frequency of an occurrence was known from past information, it would be possible to insure people against the risk of it happening to them. This insight was applied by the two clergymen founders of the Scottish Ministers' Widows' Fund in Glasgow (Ferguson's hometown) in 1743. They worked out the premiums required to create a fund that, when invested, would cover payments to beneficiaries on the deaths of their husbands. As conditions of life eased, and people demanded greater protection against its hazards, insurance and pension funds "would rise to become some of the biggest investors in the world—the so-called institutional investors who today dominate global financial markets."

From the late nineteenth century onward, the state increasingly took on the "insurance" function, providing social security and health benefits to the whole population through the tax system. This was because private insurance companies left a sizable fraction of the population uninsured and uninsurable. Ferguson unusually, but effectively, uses Japan rather than Germany or Britain as his main example of the way the state nationalized risk—mainly, one suspects, because it bests illustrates his favorite thesis that financial systems grew up to serve the military needs of the state. Social security, in this view, was the reward for military sacrifice. This was particularly so in Japan.

Ferguson's third example comes from Chile, which he uses to illustrate the return from government social insurance to private—albeit compulsory—insurance. The tax-financed welfare state had never been fully accepted by conservatives, who believed it rotted the character by removing the incentive to save and by separating benefit from individual contribution. Influenced by Milton Friedman and the "Chicago boys," José Piñera, General Augusto Pinochet's minister of labor from 1979 to 1981, privatized Chile's cumbersome state pension scheme. According to Piñera, "What had begun as a system of large-scale insurance had simply become a system of taxation, with today's contributions being used to pay today's benefits, rather than to accumulate a fund for future use."

The Chilean reform encouraged workers to opt out of tax-financed state pensions into personal retirement accounts, managed by licensed but competing pension funds, and financed by compulsory deductions from wages. Although most Western countries remained wedded to their traditional single-payer welfare states, set up during and after World War II, the Chilean model was imitated across Latin America and emerging market economies. Despite what he calls its "shadow side"—it "leaves a substantial proportion of the population with no pension coverage at all"—Ferguson clearly approves of the Chilean reform, traveling to Santiago to see firsthand what he considers its beneficent results. It will be interesting to see whether the provision for universal health care promised by the Obama administration follows the European model—by extending tax-financed Medicare for everyone along the lines proposed by Paul Krugman[5]—or the Chilean/Singapore model in which compulsory insurance premiums, paid out of wages, provide the contributors with individual entitlements.

Land and the buildings on it—or in modern parlance "bricks and mortar"—have played a crucial part in the development of the financial (and economic) system, because "the land can't run away," and is therefore easy to use as collateral. Mortgaging their property became the way improvident landowners maintained extravagant lifestyles and, in later, more sober times, the way house owners raised money to start businesses. The spread of home ownership in the twentieth century—largely promoted by government in an attempt to make capitalism more popular—made possible a vast expansion of collateralized debt, and was the main stimulus to the development of the conversion of debt into securities.

Ferguson points out that property "is a security only to the person who lends you money.... By contrast, the borrower's sole security against the loss of his property to such creditors is his income." This is not quite true. The lender's security also depends on the income—actual or expected—of the borrower, because, although the property cannot "run away," it may lose its value, or it may be costly, and even impossible, for the creditor to get possession of it. Ferguson might have told the story of the costly mistake made by France's Credit Lyonnais, which set up its own proprietary credit-rating agency in the late nineteenth century. Its mistake was to rate the credit-worthiness of governments not on their debt-to-income but on their debt-to-property ratios. The imperial government of Russia got top rating, because, despite its disordered finances, of all governments it owned the most property. On the basis of this rating, French investors snapped up tsarist bonds. They lost all their money, not because the property disappeared but because the government did. Credit Lyonnais failed to take into account "political risk."

The tsarist government would now be considered a subprime borrower. Yet today's vastly more sophisticated credit-rating agencies made the same mistake in giving triple-A ratings to bonds that took no account of the income of the borrowers—what the professionals called "toxic waste." Ferguson notes that a disproportionate number of sub-prime borrowers were ethnic minorities and wonders whether subprime is a new euphemism for black. Both Democratic and Republican administrations brought pressure on lenders to relax their rules in order to spread home ownership—for example, not to press borrowers for full documentation. And indeed home ownership—or bank ownership of homes—did expand greatly in the last ten years. The bubble burst in 2007 when a rise in the federal funds rate from 1 percent to 5.4 percent coincided with the expiring of the enticing "teaser" rate periods that lenders had offered subprime borrowers. Repayments were then set at much higher interest rates and many could not pay.

The sober conclusion Ferguson draws from this fascinating story of financial incontinence and skullduggery is that property ownership is not the "magic bullet" it is often claimed to be. This is the basis of his criticism of the exaggerated claim of the economist Hernando de Soto that the path to Latin American prosperity lies in secure property rights.[6] "In short, there was irrational exuberance about bricks and mortar and the capital gains they could yield."

Ferguson's last chapter, "From Empire to Chimerica," argues convincingly that it was the investment of billions of dollars of Chinese savings in US Treasury bonds that fueled the US debt binge, by enabling Greenspan to keep money so cheap for so long. In a bravura passage that rounds off his story of money's ascent, Ferguson writes:

"Chimerica"—China plus America—seemed like a marriage made in heaven. The East Chimericans did the saving. The West Chimericans did the spending. [Cheap] Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs. As a result, it was remarkably cheap to borrow money and remarkably profitable to run a corporation. Thanks to Chimerica, global real interest rates...sank by more than a third below their average over the past fifteen years. Thanks to Chimerica, US corporate profits in 2006 rose by the same proportion above their average share of GDP....

The more China was willing to lend to the United States, the more Americans were willing to borrow. Chimerica, in other words, is the underlying cause of the surge in bank lending, bond issuance and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge fund population explosion. [It] was the underlying reason why the US mortgage market was so awash with cash in 2006 that you could get a 100 per cent mortgage with no income, no job or assets.

In the long sweep of history, the failures of money seem trivial in comparison with its triumphs, mere incidents on the road of financial innovation that leads to universal prosperity. Yet the failures have been extremely damaging to the generations that experienced them. The famous criticism made by John Maynard Keynes about the economics of his day can be applied to Ferguson's history:

In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.[7]

Ferguson, of course, is aware of the storms—in fact he writes brilliantly about them—but he never doubts that the journey has been worth it. The "ascent" of which he writes owes more to Reagan-Thatcher triumphalism than to the more sober assessments of the performance of markets currently in vogue. It also leaves out an important part of the drama of finance—the constant struggle between financial innovation and government attempts to protect populations from financial rapacity.

It is not till he comes to his "Afterword," interestingly, if ambiguously, entitled "The Descent of Money," that Ferguson seriously considers the question of why the "ascent" of money he celebrates is linked to extreme financial instability. Here he pays brief homage to the distinction made by the economist Frank Knight (and also Keynes) between "risk" and "uncertainty"—with risk referring to a situation in which the probabilities of different random outcomes can be determined, as in roulette, whereas uncertainty pertains when no such probabilities are possible, such as the prospect of a future war. And he concedes that Keynes may have been "thinking along the right lines" when he talked of investors falling back on "conventions" to disguise from themselves the fact that they do not know what the future will bring—the main convention being to behave like everyone else is behaving.

But he fails to follow up these crucial insights. The distinction between "uncertainty" and "risk" is essential, in my view, to a proper understanding not only of the present crisis but of the whole "roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes" that have punctuated economic history. The point is that the future cannot be decomposed into measurable risk, however much risk is spread across intermediary instruments. The illusion that it can be blinds investors to the ever-present possibility that the world may change in ways which set all their calculations at nought. The credit mountain was built on the belief that house prices would always go up; when they started to fall the balloon was pricked.

Ferguson realizes that mainstream economics is flawed, but then veers away to what I think is the dead end of "behavioral economics" and false analogies between financial evolution and Darwinian natural selection. Behavioral economics claims that we are "wired" to behave "irrationally"; theories purporting to derive from Darwinism claim that finance follows the law of the "survival of the fittest," whereby firms fitted to their environment flourish and weaker ones go to the wall—a process that inevitably involves "creative destruction." These attempts to explain the rise of money in terms of natural processes strike me as being both morally and philosophically naive.

Ferguson's mistake, I suggest, comes from an incomplete appreciation of the role of money. Evidently money is more than just a facilitator of trades. It is a way of coping with changing views about an uncertain future. Why, Keynes asked, should any rational person wish to "hold money" rather than spend it? Precisely because it is a way of postponing spending when confidence is low and the "conventions" promising a secure future have broken down. Keynes writes:

The desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.... It operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.[8]

Even a (modestly) depreciating currency may at moments of high uncertainty seem more "secure" (carry a higher premium) than any other asset. We are seeing the truth of this today. The failure to take account of this aspect of money is the missing dimension from an otherwise splendid book.

A final reflection on Ferguson as a historian. He is overimpressed by economics. Many historians feel that history is in some way inferior to the more exact sciences; the thought that he can "do" economics gives the historian an expanding sense of mastery. I know the feeling, because I've lived through it myself. Economics, especially in its mathematicized form, purveys a peculiar vision of society. Society to the mathematicians is a market imperfection. Among other imperfections, the idea is that allocation of resources is not as efficient and information for making choices is not as complete as they should be.

This delusive, but powerful, idea suggests that behind the imperfection lies perfection, a world in which the future will be perfectly known and therefore hold no surprises. Mathematics is the inheritor of the platonic ideal; and mathematically driven financial innovation is its handmaiden. At one time philosophers projected their utopias, and the early economists followed suit. Keynes was perhaps the last one who indulged in utopia building. In his essay "Economic Possibilities for Our Grandchildren" (1930), he looked forward to a time when the economic problem was solved and an age of abundance and leisure had arrived in which people would cultivate the arts of life.[9]

Instead, Keynes's grandchildren face a rerun of the Great Depression, and President-elect Obama promises a new New Deal. On December 6, he pledged to create an estimated 2.5 million jobs in the first two years of his administration by large-scale investments in infrastructure projects, including bridges, mass transit, and electrical grids. Estimates of the costs by members of Congress range from $400 to $700 billion.

Having taken on $7.8 trillion in financial obligations over the last year—roughly half the size of the entire American economy—the US government is now represented in some form on the boards of most major American companies. Obama has promised to help those facing foreclosure on their mortgages and those hit by the relocation of jobs overseas. He has vowed to curb the excesses enjoyed by those at the pinnacle of deregulated credit. While not addressing the fundamental direction of economic theory, ad hoc policies such as these may help to ensure that the ascent of money does not lead to the descent of man.

Notes

[1]The two-hour documentary The Ascent of Money airs on PBS on January 13, 2009.

[2]Charles R. Morris, The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash (PublicAffairs, 2008), p. xii.

[3]Quoted in The Oxford Book of Money, edited by Kevin Jackson (Oxford University Press, 1995), p. 18; from Edward Gibbon, The Decline and Fall of the Roman Empire, Book I (1776).

[4]The House of Rothschild: Money's Prophets, 1798–1848 (Viking, 1998) and The House of Rothschild: The World's Banker, 1849–1999 (Viking, 1999); reviewed in these pages by Robert Skidelsky, December 16, 1999.

[5]See Paul Krugman, The Conscience of a Liberal (Norton, 2007), pp. 236–237; reviewed in these pages by Michael Tomasky, November 22, 2007.

[6]In Hernando de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (Basic Books, 2000).

[7]John Maynard Keynes, "A Tract on Monetary Reform" (1923), in Collected Writings (Macmillan/St. Martin's/Royal Economic Society, 1971), Vol. 4, p. 65.

[8]Keynes, "General Theory of Unemployment" (February 1937), in Collected Writings, Vol. 14, p. 116.

[9]Keynes, Collected Writings, Vol. 9, p. 321.

Book Review: On the threshold - of what?

Robert Skidelsky — 2008-12-26T08:25:01+00:00

The Trillion Dollar Meltdown: easy money, high rollers and the great credit crash

by Charles R. Morris

Public Affairs £13.99

The Credit Crunch: housing bubbles, globalization and the worldwide economic crisis

by Graham Turner

Pluto Press. Paperback. £14.99

The Conscience of a Liberal: reclaiming America from the Right

By Paul Krugman

Allen Lane. £20.

Common Wealth: economics for a crowded planet

By Jeffrey Sachs

386pp. Penguin. £22.

New Frontiers in Free Trade: Globalization’s future and Asia’s rising role

By Razeen Sally

Cato Institute. $18.95

The Economists’ Voice: Top economists take on today’s problems

By Joseph E. Stiglitz, Aaron S. Edlin and J. Bradford DeLong. editors

Columbia University Press. £14.95

Of the six books under review, all published this year, only the two by non–economists, Charles R. Morris and Graham Turner, have an inkling of the economic blizzard in store. This reflects the fact that the crisis, at least in its severity, came as a complete surprise to professional economists. The eminent Nobel Prize-winners Paul Krugman, Jeffrey Sachs and Joseph E. Stiglitz, all represented here, have written as though the outstanding fault of the present capitalist system lies not in its instability, but in its distributional effect – both domestic and global. Even now it is not clear how far economists have started to question the economic assumptions that underlie the large–scale collapse we are living through.

Morris, an American lawyer and investment banker, seems to have anticipated the present credit crunch for some years. His book, The Trillion Dollar Meltdown, is the best account I have read of its genesis, written before the crunch had become global. In part, it is the story of financial innovation carried to self–destructive excess. At the same time, Morris unwittingly exposes the flaw in the financial system: it was too complicated for anyone but a professional investor to understand. This is also a problem with his book. Though it is excellently written, and full of arresting thoughts and phrases ("Intellectuals are reliable lagging indicators, near–infallible guides to what used to be true"), the world of financial legerdemain which it reveals is simply too opaque for the averagely well–educated reader to understand.

The credit crunch, originating in the American subprime mortgage crisis of 2007 and then spreading out to the global banking system, had its origins in a gigantic credit bubble. How did this arise? Morris identifies three enabling conditions. The first was the coming to power of the Chicago School of economists, with its deregulating philosophy. A key deregulating move was the repeal in 1999 of the Glass–Steagall Act of 1933, which aimed to separate retail from investment banking. "While Keynesians prayed to the idol of the quasi–omniscient technocrat, the Friedmanite religion enshrined the untrammelled workings of free market capitalism". The second condition was what he calls the "Greenspan put". Denouncing a "new paradigm of active credit management", Alan Greenspan, Chairman of the Federal Reserve from 1987 to 2006, held the Federal funds rate down to 1 per cent from 2003 to 2005 as the economy went into overdrive. His message to the market was: no matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles. The third condition was what Morris calls a "tsunami of dollars" – the result of America’s huge trade deficits, financed largely by East Asia. It was Chinese savings invested in US Treasuries which enabled Greenspan to keep the interest rate at 1 per cent for thirty months. "America’s housing and debt binge was made in China.”

It was in this regime of deregulated markets, cheap money and Asian–financed consumption demand that leveraged (debt–dependent) finance took off. The stages in the rake’s progress were the junk bond explosion of the 1980s, the development of mortgage–backed securities or "pass throughs", the creation of portfolio insurance to "manage" the extra risk, and the sprouting of hedge funds to buy up the riskiest debt and sell it to wealthy speculators. Credit agencies fed the bubble by giving bonds containing "toxic waste" triple–A ratings. Morris does not decry the value of all this financial engineering. But the new investment instruments, while hugely enlarging credit facilities by spreading risk, suffered from dangerous flaws only revealed in moments of stress. A small number of institutions – global banks, investment banks, hedge funds – built an unstable tower of debt on a tiny base of real assets. So long as a cheap–money regime forestalled defaults, the tower might wobble but stay erect. A rise in interest rates from 2005 onwards brought it crashing down. Morris comments tartly: "Very big, very complex, very opaque structures built on extremely rickety foundations are a recipe for collapse". His forecast of a "true shock–and–awe surge of asset write downs through most of 2008" proved to be all too accurate.

What needs to be done? The key requirement is to restore effective oversight of the financial services industry. Morris makes the excellent point that banks make high profits by taking large risks, but their losses are partly socialized. Banks cannot be both public utilities and risk–taking institutions. If the taxpayer is to be liable for losses, through deposit insurance or bail–outs, then risk–taking by banks must be severely limited. This points towards restoring some version of the old Glass–Steagall Act.

Morris’s book provokes an obvious reflection. The financial system should never be allowed to take on a life of its own. It provides a service to the public and should never be beyond the understanding of the public or at least of those who regulate it on the public’s behalf. In other words, it should be simple to understand. Banks should be banks, not speculators: insurance companies should insure real assets, not toxic waste: prudential rules should limit debt–to–equity ratios. There would then be less demand for the service of high–powered mathematicians to invent instruments which bamboozle the rest of us. Yes, there will be less credit available, conceivably a slower rate of economic growth. But most people will feel more secure, less stressed, and more in control of the machine that disposes of their future.

The economic consultant Graham Turner may also claim to have read the runes. The Credit Crunch: Housing bubbles, globalization and the worldwide economic crisis fills an important gap in Morris’s story, by relating recent credit bubbles to the changing structure of the real economy. We often forget that since the financial system was deregulated in the 1980s, we have had nine major financial collapses in different parts of the world, plus major stock exchange collapses. Turner’s thesis, in brief, is that globalization has resulted in a global shift in world GDP shares from wages to profits. The result has been a crisis of "realization" – over–investment in relation to worker demand. In the face of wage stagnation in the United States, American consumption demand could be kept going only by the expansion of debt. In other words, if you are a worker you don’t get your productivity gains but are encouraged to borrow at a cheaper rate. The housing bubbles in the West were deliberately created to mask the damage inflicted by American companies transferring jobs to China and East Asia to boost profits. Western governments acquiesced in job exports because this fitted their strategy of promoting free trade. The real requirement is to rebalance power in the American economy between "omnipotent capital and weak labour". This rebalancing requires, among other things, protection of American jobs.

It is good to see the venerable under–consumptionist story wheeled out to explain the present credit crunch. There is a problem, though, which Paul Krugman points out in The Conscience of a Liberal: Reclaiming America from the Right: the numbers don’t add up. True enough, "income inequality is as high as it was in the 1920s". But this is not due to globalization. Globalization might explain the rising gap between skilled and unskilled workers. It does not explain the gains of the super–rich, the main winners of recent years. In the 1970s CEOs at 102 major companies were paid $1.2 million on average in today’s money. This was only a bit more than in the 1930s and only forty times that of the pay of the average full– worker. By the early 2000s CEOs in the same companies were paid over 9 million a year, 367 times the pay of the average worker, whose benefits, additionally, had been greatly reduced. The explanation for this "great decompression", as Krugman calls it, lies in politics. From the 1980s, American politics was captured by "a vast right wing conspiracy" which set about dismantling the protective structures of the New Deal by creating "distractions". The chief of these was race. Race, in particular, duped the white voter into neglecting his material interests. Race is the main explanation for America’s lack of universal health–care: whites did not want integrated hospitals. But Krugman is hopeful that the neoconservative domination is coming to an end. The last part of the book explains his plan for creating "guaranteed universal health care" for all Americans.

Krugman provides a brisk romp through twentieth–century American history from a Democratic point of view. As he tells it, this history traces two great arcs. The first, political economy arc is from high inequality in the "gilded age" – the late nineteenth century to the 1920s – to relative equality in the middle years, and back again from Ronald Reagan onwards. The second, political arc parallels it from extreme polarization to bipartisanship and back. The reality of the first arc is readily attested by the statistics of income distribution, though Krugman provides no real explanation for these swings: why, for example, did arguments for financial deregulation and lower taxation gain such traction in the 1980s, having earlier been successfully resisted? However, the political arc doesn’t do the work Krugman wants it to. It is true that American politics became polarized again the 1980s, after a period of bipartisanship. But any change of governing philosophy is likely to start life as partisan. Krugman forgets that FDR’s New Deal was highly divisive too. Nor is there anything bipartisan about Krugman’s own history. The Republicans, in his view, were acceptable when they acted like Democrats; when they did not, they were trying to roll back the twentieth century.

What Krugman offers is a social democratic account of history’s trajectory, which is occasionally derailed by the antediluvian forces of fundamentalist religion and racist bigotry. But any historian knows that material progress is not history’s only storyline, and that religious and tribal feelings are not just "distractions" from humanity’s rational goals, but are as constitutive of human nature as is the desire for "more for less". There was an ideological, programmatic aspect to Democratic politics in the 1960s which Krugman intermittently acknowledges – indeed he espouses it today – but which plays no part in his explanation of why the bipartisanship of the mid century broke up. He conveniently forgets that the Democrats excoriated the complacent Eisenhower years which he now loves. A combination of Barack Obama and the excesses of neo–conservative economics will probably give America the chance to "complete the New Deal". But Krugman should remember that it was the limitations of the first New Deal that made it acceptable to Republican America.

Jeffrey Sachs’s Common Wealth: Economics for a crowded planet is also a cry for action. Its main idea is that human activity has now become so extensive that it has thrown every life–sustaining system on the planet out of kilter. If Sachs is troubled by the thought that humanity is on the wrong treadmill, he does not allow it to cloud his optimism. He comes to the reader not as a philosopher, but as a doctor offering readily available cures for the main planetary diseases he diagnoses: human pressure on the ecosystem leading to dangerous climate change, population pressure on scarce resources, and the extreme poverty of one–sixth of the world’s population. With only a modest investment, we can achieve sustainable development, stabilize the world’s population at 8 billion (it is now 6.6 billion), and end extreme poverty. All "we" need is the necessary political will”.

Sachs displays a disappointingly uncritical attitude towards the science he adduces in support of his plans. To some extent he is the victim of his own multidisciplinary approach. Working at the Earth Institute at Columbia University has been to him an "unalloyed gift". And his range of knowledge is impressive. But he inevitably has to take a huge amount on trust, and it shows. This is not a book of scholarship but an executive summary of hundreds of reports of blue ribbon commissions, research papers, convergences and UN declarations. The bullet points roll off the assembly line of his prose, with scarcely a hint of doubts, still less self–doubt.

Sachs presents himself as an economist of the toolkit, but in fact, he is a moralist who believes it his mission to save the planet. With such an attitude, it is almost impossible for the scientist not to become a preacher. Like his fellow moralist Paul Krugman. Sachs presents a one–sided dossier in support of his cause. A reader who knows at least something about the subjects being discussed, without fully sharing the passion of the author, is bound to deplore his lack of attention to opposing arguments, whether on climate change, population or the utility of aid for economic development.

Sachs’s uncritical attitude to science is matched by his naivety about politics. He seems to believe that the main reason for government failure to tackle global problems with the required vigour is organization deficiencies (for example, failure to mobilize available knowledge), forgetting that governments – and more generally politics – have not been set up to solve global problems but to protect their countries against domestic disorder and external attack. While berating Western governments for their failure to shape up to their planetary tasks, he pays surprisingly little attention to what it is now usual to call the problem of "governance" in the poorest countries. African countries fail to live up to their "convergence potential" because they lack basic levels of infrastructure, health, education "and governance". But for many development economists, "governance" is not something to be added to a list of infrastructural projects financed by the World Bank. It is what makes such projects possible. And the quality of "governance" is embedded in the habits and customs of the people. Sachs never faces up to the issue of how much "governance" will have to be imported from elsewhere to realize the millennium goal of poverty elimination, or how this is to be done.

Global networks, he thinks, may be the answer. "A wonderful new project, e–Parliament", he enthuses, "aims to knit together the world’s parliaments and assemblies by video conferencing and the Internet to forge a new kind of hybrid democratic institution at the transnational and even global scale". National Parliaments could mobilize the best brains through simultaneous teleconferences. He ends up by proposing a billionaires’ foundation to eradicate world poverty. I have no doubt that it will be established. No one else need apply for the post of director.

Despite the book’s deficiencies, Sachs’s main thrust is convincing: the problems he identifies can be solved, by the methods he outlines. His fault is that he is much too impatient and optimistic. Societies progress at their own pace. They can be tweaked a little by scientists. More likely, they will be jolted out of stagnation by disaster. There will be many of those to come, and many regressions as well, before Sachs’s dreams are realized. It is naive to imagine that it can be otherwise.

Razeen Sally is a wide–ranging historian of economic thought, and his clearly written monograph New Frontiers in Free Trade has been heavily influenced by his studies in the Scottish Enlightenment foundations of classical liberalism. He is an unqualified advocate of free trade and globalization, but points out that, historically, free trade was only one element in the Victorian political–economy package, which included domestic laissez–faire, low balanced budgets, and the gold standard. The international liberal order of the nineteenth century was not constructed by international organizations, but emerged as a by–product of acts of domestic liberalization. This unity between external and domestic liberalism broke down after 1945 when "[Adam] Smith abroad" had to be reconciled with "Keynes at home". The post–1945 theory of commercial policy developed by James Meade, Harry Johnson and Jagdish Bhagwati uncoupled free trade from laissez–faire by advocating targeted subsidies instead of protection for infant industries. The case for free trade came to be argued in purely technical terms. But social democracy at home was ideologically inconsistent with free trade abroad. This made free trade vulnerable to attacks by anti–globalizers.

The lesson that Sally draws from all this is that globalization today should be pursued by unilateral action rather than by complicated multilateral negotiations through the World Trade Organization. Attempts to secure common minimum standards as a condition for lowering trade barriers will lead to regulatory overload. Pressures to harmonize labour, environmental, food–safety, and other product standards will have a chilling effect on labour–intensive exports. An increasingly politicized WTO will have to bear the brunt of the anti–globalization backlash and NGO pressure. Sally points out that in Asia, unilateral dismantling of trade barriers has been the rule, with China as its driving force. This challenges the consensus that trade liberalization must be based on reciprocity. Welfare gains result directly from import liberalization, regardless of anyone else’s concession. The WTO could be retained as a useful auxiliary to "national market–based reforms".

Sally’s case for unilateral liberalization – for instance, dismantling American and EU farm subsidies without waiting for another trade round – is persuasive, but it has little chance of gaining a hearing in the West today. The problem, which he admits, is that globalization threatens the living standards not just of unskilled and skilled workers, but of the Western middle class as a whole. "The political challenge", he writes, "is to keep borders open and extend market–based reforms, while containing inevitable protectionist pressures". But he does not tell us how this is to be done.

In The Economists’ Voice: Top economists take on today’s problems, "more than thirty of the world’s top economists offer innovative policy ideas and insightful commentary on our most pressing economics issues". The book is divided into nine sections ranging from climate change – now the obligatory problem number one – to the pros and cons of the death penalty. Each section consists of two or more short non–technical essays, helpfully prefaced by a summary of the essays it contains. Although three essays warn of the coming collapse of the housing bubble, there is no sense of the scale of the impending crisis. For example, Robert Schiller writes that while homeowners face a "substantial risk of much lower prices", fortunately "derivative products, notably a futures market, are being developed [so] that they will soon be able to insure against this risk".

The collection illustrates the power and limits of economics. Economics is the most inventive of the social sciences in its ability to suggest how incentives might be rearranged so as to secure desirable outcomes at least cost in money, bureaucracy and liberty. But it lacks a realistic account of politics, the arena in which what is desirable can be made to happen. Joseph Stiglitz illustrates both features in his missionary essay on climate change: "The well–being of our entire planet is at stake. We know what needs to be done. We have the tools to hand. We only need the political resolve" – which to many will mean that we don’t have the tools to hand, since political resolve is a tool too, which Stiglitz doesn’t tell us how to invent.

The same lack of political understanding is apparent in the discussion of the costs of the Iraq war. From the economists’ point of view, the editors ask, "could not [the money] have been better spent on fighting global climate change, on providing vaccine commitments to fight tropical disease, on brokering Israeli–Palestine peace, or on giving ten million children in the United States or abroad each a $100,000 scholarship"? The answer is yes, but the economists cannot explain why these alternatives were not adopted.

The book is full of excellent cut and thrust. In his essay on international capital mobility, J. Bradford DeLong discusses how events have denied his faith in its untrammelled operation. Fifteen years ago, he supported capital mobility unreservedly. But now he believes that too many external costs are associated with financial crises. Capital also seems to want to flow, not from but to where it is already abundant – the United States has become a giant vacuum cleaner sucking in capital from all round the world – and even when efficient, capital flows benefit rich people from poor countries, not the poor. However, DeLong cannot abandon his neoliberalism; "in the end we may have to tolerate the equality–lessening reverse flow of capital in order to promote the equality–increasing and wealth–increasing diminution of corruption." At least he is honest enough to admit the dilemma.

The cumulative impression left by these six books is that we are on the cusp of one of those periodic changes in political economy caused by a crisis of the existing order. The end of the liberal/social democratic era lauded by Paul Krugman was brought about by the crisis of inflation and permissiveness. The succeeding neoconservative era supported by Razeen Sally is likely to end in a crisis of financial excess. Keynesianism and socialism, only recently proclaimed dead, are risen from their graves. The last Soviet leader, Mikhail Gorbachev, recently remarked that, what with all the bail–outs of banks and corporations going on, we now seem to have capitalism for the poor and Communism for the rich. This is a neat easy way of saying that we stand on the threshold of uncharted territory.

Perfect Losers

Robert Skidelsky — 2008-12-22T15:16:00+00:00

London – Economics, it seems, has very little to tell us about the current economic crisis. Indeed, no less a figure than former United States Federal Reserve Chairman Alan Greenspan recently confessed that his entire “intellectual edifice” had been “demolished” by recent events.

Scratch around the rubble, however, and one can come up with useful fragments. One of them is called “asymmetric information.” This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice versa. Interesting things happen – so interesting that the inventors of this idea received Nobel Prizes in economics.

In 1970, George Akerlof published a famous paper called “The Market for Lemons.” His main example was a used-car market. The buyer doesn’t know whether what is being offered is a good car or a “lemon.” His best guess is that it is a car of average quality, for which he will pay only the average price. Because the owner won’t be able to get a good price for a good car, he won’t place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behavior, physical health, and so on. The insurer faces “adverse selection,” because he cannot distinguish between good and bad risks. He therefore sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks – the quick road to bankruptcy.

There are various ways to “equalize” the information available – for example, warranties for used cars and medical certificates for insurance. But, since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

All of this is relevant to financial markets because the “efficient market hypothesis” – the dominant paradigm in finance – assumes that everyone has perfect information, and therefore that all prices express the real value of goods for sale. But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical “adverse selection” problem arises when banks can’t tell the difference between a good and bad investment – a situation analogous to the insurance market. The borrower knows the risk is high, but tells the lender it is low. The lender who can’t judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, i.e., asymmetric information lets toxic loans onto the credit market. Other models use principal/agent behavior to explain “momentum” (herd behavior) in financial markets.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment’s thought will show why these models cannot explain today’s general crisis. They rely on someone getting the better of someone else: the better informed gain – at least in the short-term – at the expense of the worse informed. In fact, they are in the nature of swindles. So these models cannot explain a situation in which everyone, or almost everyone, is losing – or, for that matter, winning – at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect information about how the different parts of the economy fit together. They differ only in believing that not everyone possesses it. In Akerlof’s example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows perfectly well how likely it is to break down, and the buyer does not.

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse; but they are deceiving themselves that they know more than they do. If only one person were perfectly informed, there could never be a crisis – someone would always make the right calls at the right time. But only God is perfectly informed, and He does not play the stock market.

“The outstanding fact,” John Maynard Keynes wrote in his General Theory of Employment, Interest, and Money, “is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” There is no perfect knowledge “out there” about the correct value of assets, because there is no way we can tell what the future will be like.

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behavior arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today.

An end to the Cold War?

Robert Skidelsky — 2008-12-18T15:19:00+00:00

At long last, America has decided to stop fighting the Cold War. On 1 December, the US Department of Defence approved a directive calling upon the American military to be ‘as effective in irregular warfare as it is in traditional warfare’. This means that the question of how best to fight ‘asymmetric conflicts’ will henceforth consume America’s military strategists as much as their more traditional preoccupation: planning WW3. This might seem like cause for celebration, but I am not so sure.

The directive’s architect, Secretary of Defence Robert Gates, thinks that the greatest threats to America are no longer ‘aggressor states’ but ‘failed states.’ Although no other conventional power can challenge America – by way of illustration he mentions that the US navy is the size of the next thirteen largest navies combined, eleven of which are allies –the wars in Afghanistan and Iraq exposed the mighty superpower’s vulnerable underbelly. Guerrillas armed with AK-47s and home-made bombs did what Soviet nuclear weapons and Chinese aircraft carriers failed to do.

Seven years in Afghanistan and five in Iraq have taught the US army a great deal. Belatedly, they have learned to fight ‘the war on terror’ and Gates wants the accumulated know-how to be institutionalized. He wants to beef up development agencies and the diplomatic corps. He believes US troops should do less of the fighting themselves and instead help strengthen the armies of their allies. He even thinks America should make an ‘effort to address the grievances among the discontented.’

Although Gates was appointed by George W. Bush in 2006, Barack Obama has taken the unprecedented step of asking him to stay on in his job. It is easy to see why. Gates makes no attempt to hide his contempt for the military strategy pursued by Bush: ‘we should look askance at idealistic, triumphalist, or ethnocentric notions of future conflict that aspire to transcend the immutable principles and ugly realities of war, that imagine it is possible to cow, shock, or awe an enemy into submission’.

Few will mourn the shelving of ‘shock and awe’, few will decry Gates’ pledge to intensify diplomacy, but we should all be concerned that fighting small wars is now the Department of Defence’s top priority. The lessons which Gates wants to see institutionalized are those of the surge. They rest on the assumption that the surge in Iraq has worked and that the strategy will work again in Afghanistan. I think it is too early to say whether the Americans have brought lasting peace to Iraq and I think the war in Afghanistan is doomed, however many soldiers they send.

‘Irregular warfare’ is as old as war itself. After the Vietnam debacle, America swore never again and concentrated instead on containing Soviet armies in Central Europe. Humiliating retreats from Lebanon in 1983 and Somalia in 1994 only reminded them again why they avoided small wars. But the temptation to intervene is – for a superpower – perennial.

Only two counter-insurgency methods have ever worked: extreme restraint and extreme brutality, and the latter more often than the former. Neither strategy is now available to the US. Today, wars are fought ‘in the spotlight of the media and the shadow of international lawyers’, as Sir Richard Dannatt, head of the British Army, put it. The brutality of the British in Malaya or the French in Algeria would today land their practitioners in court. Managing public relations has become all-important. Russia learned this to its cost in Georgia.

Gates says that America is unlikely to repeat another Iraq or Afghanistan ‘anytime soon’ but cryptically adds that it might face ‘similar challenges in a variety of locales.’ Military expertise operates according to Say’s law: supply creates its own demand. I fear counter-insurgency experts will need new wars in which to put their new ‘institutionalized’ knowledge into practice.

No doubt Obama will be more diplomatic than Bush. But do not expect any of America’s ‘small wars’ to end soon. Indeed, the era of small wars may only just be beginning.

Essay: A thinker for our times

Robert Skidelsky — 2008-12-18T11:17:00+00:00

John Maynard Keynes has been restored to life. Rusty Keynesian tools – larger budget deficits, tax cuts, accelerated spending programmes and other “economic stimuli” – have been brought back into use the world over to cut off the slide into depression. And they will do the job, if not next year, the year after. But the first Keynesian revolution was not about a rescue operation. Its purpose was to explain how shipwreck might occur; in short, to provide a theoretical basis for better navigation and for steering in seas that were bound to be choppy. Yet, even while the rescue operation is going on, we need to look critically at the economic theory that takes his name.

In his great work The General Theory of Employment, In terest and Money, written during the Great Depression of the 1930s, Keynes said of his ideas that they were "extremely simple, and should be obvious". Market economies were in herently volatile, owing to un certainty about future events being inescapable. Booms were liable to lead to catastrophic collapses followed by long periods of stagnation. Governments had a vital role to play in stabilising market economies. If they did not, the undoubted benefit of markets would be lost and political space would open up for extremists who would offer to solve economic problems by abolishing both markets and liberty. This, in a nutshell, was the Keynesian "political economy".

These ideas were a challenge to the dominant economic models of the day which held that, in the absence of noxious government interference, market economies were naturally stable at full employment. Trading in all markets would always take place at the "right" prices - prices that would "clear the market". This being so, booms and slumps, and prolonged unemployment, could not be generated by the market system itself. If they did happen, it was due to "external shocks". There were many attempts to explain the Great Depression of the 1930s along these lines - as a result of the dislocations of the First World War, of the growth of trade union power to prevent wages falling, and so on. But Keynes rightly regarded such explanations as self-serving. The Great Depression started in the United States, not in war-torn Europe, and in the most lightly regulated, most self-contained, and least unionised, market economy of the world. What were the "external shocks" that caused the Dow Jones Index to fall from 1,000 to 40 between 1929 and 1932, American output to drop by 20 per cent and unemployment to rise to 25 million?

We can ask exactly the same question today as the world economy slides downwards. The present economic crisis has been generated by a banking system that had been extensively deregulated and in a flexible, largely non-unionised, economy. Indeed, the American capitalism of the past 15 years strongly resembles the capitalism of the 1920s in general character. To Keynes, it seemed obvious that large instabilities were inherent in market processes themselves.

John Maynard Keynes was a product of Cambridge civilisation at its most fertile. He was born in 1883 into an academic family, and his circle included not just the most famous philosophers of the day – G E Moore, Bertrand Russell and Ludwig Wittgenstein – but also that exotic offshoot of Cambridge, the Bloomsbury Group, a commune of writers and painters with whom he formed his closest friendships. Keynes was caught up in the intellectual ferment and sexual awakening that marked the passage from Victorian to Edwardian England. At the same time, he had a highly practical bent: he was a supreme example of what Alasdair MacIntyre calls “the aesthete manager”, who partitions his life between the pleasures of the mind and the senses and the management of public affairs. After the First World War, Keynes set out to save a capitalist system he did not particularly admire. He did so because he thought it was the best guarantor of the possibility of civilisation. But he was always quite clear that the pursuit of wealth was a means, not an end. He did not much admire economics, either, hoping that some day economists would become as useful as dentists.

All of this made him, as his wife put it, "more than an economist". In fact, he was the most brilliant non-economist who ever applied himself to the study of economics. In this lay both his greatness and his vulnerability. He imposed himself on his profession by a series of profound insights into human behaviour which fitted the turbulence of his times. But these were never - could never be - properly integrated into the core of his discipline, which spewed them out as soon as it conveniently could. He died of heart failure in 1946, having worked himself to death in the service of his country.

The economic theory of Keynes's day, which precluded boom-bust sequences, seemed patently contrary to experience, yet its foundations were so deep-dug, its defences so secure, its reasoning so compelling, that it took Keynes three big books - including a two-volume Treatise on Money - to see how it might be cracked. His attempt to do so was the most heroic intellectual enterprise of the 20th century. It was nothing less than the attempt to overturn the dominant economic paradigm dating from Adam Smith and David Ricardo.

He finally said what he wanted to say in the preface to The General Theory: "A monetary economy, we shall find, is one in which changing views about the future are capable of in fluencing the quantity of employment and not merely its direction." In that pregnant sentence is the whole of the Keynesian revolution.

Keynes's understanding about how economies work was rooted in his theory of knowledge. The future was unknowable: so disaster was always possible. Keynes did not believe that the future was wholly unknowable. Not only can we calculate the probability of winning the Lottery, but we can forecast with tolerable accuracy the price movements of consumer goods over a short period. Yet we "simply do not know" what the price of oil will be in ten, or even five, years' time. Investments which promised returns "at a comparatively distant, and sometimes an indefinitely distant, date" were acts of faith, gambles on the unknown. And in that fact lay the possibility of huge mistakes.

Classical economists could not deny the possibility of unpredictable events. Inventions are by their nature unpredictable, especially as to timing, and many business cycle theorists saw them as generating boom-bust cycles. But mainstream economics, nevertheless, "abstracted" from such disturbances. The technique by which it did so is fascinatingly brought out in an argument about economic method between two 19th-century economists, which Keynes cited as a fork in the road. In 1817, Ricardo wrote to his friend Thomas Malthus: "It appears to me that one great cause of our differences . . . is that you have always in your mind the immediate and temporary effects of particular changes, whereas I put these immediate and temporary effects quite aside, and fix my whole attention on the permanent state of things which will result from them."

To this, Malthus replied: "I certainly am disposed to refer frequently to things as they are, as the only way of making one's writing practically useful to society . . . Besides I really do think that the progress of society consists of irregular movements, and that to omit the consideration of causes which for eight or ten years will give a great stimulus to production and population or a great check to them is to omit the causes of the wealth and poverty of nations . . ."

Keynes sided with Malthus. He regarded the timeless equilibrium method pioneered by Ricardo as the great wrong turning in economics. It was surely the Ricardo-Malthus exchange he had in mind when writing his best-known aphorism: "But this long run is a misleading guide to affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."

Ricardo may have thought of the "long run" as the length of time it took storms to disperse. But under the influence of mathematics, economists abandoned the notion of time itself, and therefore of the distinction between the long run and the short run. By Keynes's time, "risks", as he put it, "were supposed to be capable of an exact actuarial computation". If all risks could be measured they could be known in advance. So the future could be reduced to the same epistemological status as the present. Prices would always reflect objective probabilities. This amounted to saying that unregulated market economies would generally be extremely stable. Only very clever people, equipped with adequate mathematics, could believe in anything quite so absurd. Under the influence of this theory, governments withdrew from active management and regulation of economic life: it was the age of laissez-faire.

Keynes commented: "The extraordinary achievement of the classical theory was to overcome the beliefs of the 'natural man' and, at the same time, to be wrong." It was wrong because it "attempts to apply highly precise and mathematical methods to material which is itself much too vague to support such treatment".

Keynes did not believe that "natural man" was irrational. The question he asked was: how do we, as rational investors, behave when we - unlike economists - know that the future is uncertain, or, in economist-speak, know that we are "informationally deprived"? His answer was that we adopt certain "conventions": we assume that the future will be more like the past than experience would justify, that existing opinion as expressed in current prices correctly sums up future prospects, and we copy what everyone else is doing. (As he once put it: "Bankers prefer to be ruined in a conventional way.") But any view of the future based on "so flimsy a foundation" is liable to "sudden and violent changes" when the news changes. "The practice of calmness and immobility, of certainty and security suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct . . . the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning yet in a sense legitimate where no solid basis exists for a reasonable calculation."

But what is rational for individuals is catastrophic for the economy. Subnormal activity is possible because, in times of crisis, money carries a liquidity premium. This increased "propensity to hoard" is decisive in preventing a quick enough fall in interest rates. The mainstream economics of Keynes's day viewed the interest rate (more accurately, the structure of interest rates) as the price that balances the overall supply of saving with the demand for investment. If the desire to save more went up, interest rates would automatically fall; if the desire to save fell, they would rise. This continual balancing act was what made the market economy self-adjusting. Keynes, on the other hand, saw the interest rate as the "premium" for parting with money. Pessimistic views of the future would raise the price for parting with money, even though the supply of saving was increasing and the demand for investment was falling. Keynes's "liquidity preference theory of the rate of interest" was the main reason he gave for his claim that market economies were not automatically self-correcting. Uncertainty was what ruined the classical scheme.

The same uncertainty made monetary policy a dubious agent of recovery. Even a "cheap money" policy by the central bank might not be enough to halt the slide into depression if the public's desire to hoard money was going up at the same time. Even if you provide the water, you can't force a horse to drink. This was Keynes's main argument for the use of fiscal policy to fight a depression. There is only one sure way to get an increase in spending in the face of falling confidence and that is for the government to spend the money itself.

This, in essence, was the Keynesian revolution. Keynesian economics dominated policymaking in the 25 years or so after the Second World War. The free-market ideologists gave this period such a bad press, that we forget how successful it was. Even slow-growing Britain chugged along at between 2 and 3 per cent per capita income growth from 1950-73 without serious interruptions, and the rest of the world, developed and developing, grew quite a bit faster. But an intellectual/ideological rebellion against Keynesian economics was gathering force. It finally got its chance to restore economics to its old tramlines with the rise of inflation from the late 1960s onwards - something which had less to do with Keynesian policy than with the Vietnam War. The truth was that "scientific" economics could not live with the idea of an unpredictable world. So, rather than admit that it could not be a "hard" science like physics, it set out to abolish uncertainty.

The "new" classical economists hit on a weak spot in Keynesian theory. The view that a large part of the future was unknowable seemed to leave out learning from experience or making efficient use of available information. Rational agents went on making the same mistakes. It seemed more reasonable to assume that recurrent events would initiate a learning process, causing agents to be less often surprised by events. This would make economies more stable.

The attack on Keynes's "uncertain" expectations developed from the 1960s onwards, from the "adaptive" expectations of Milton Friedman to the "rational" expectations of Robert Lucas and others. The development of Bayesian statistics and Bayesian decision-theory suggested that agents can always be modelled as having prior probability distributions over events - distributions that are updated by evidence.

Today, the idea of radical uncertainty, though ardently championed by “post-Keynesians” such as Paul Davidson, has little currency in mainstream economics; however, it is supported by financiers of an intellectual bent such as George Soros. As a result, uncertainty once more became “risk”, and risk can always be managed, measured, hedged and spread. This underlies the “efficient market hypothesis” – the idea that all share options can be correctly priced. Its acceptance explains the explosion of leveraged finance since the 1980s. The efficient market hypothesis has a further implication. If the market always prices financial assets correctly, the “real” economy – the one involved in the production of goods and non-financial services – will be as stable as the financial sector. Keynes’s idea that “changing views about the future are capable of influencing the quantity of employment” became a discarded heresy.

And yet the questions remain. Is the present crisis a once-in-a-lifetime event, against which it would be as absurd to guard as an earthquake, or is it an ever-present possibility? Do large "surprises" get instantly diffused through the price system or do their effects linger on like toxic waste, preventing full recovery? There are also questions about the present system that Keynes hardly considered. For instance: are some structures of the economy more conducive to macroeconomic stability than others?

This is the terrain of Karl Marx and the underconsump tionist theorists. There is a long tradition, recently revived, which argues that the more unequal the distribution of income, the more unstable an economy will be. Certainly globalisation has shifted GDP shares from wages to profits. In the underconsumptionist tradition, this leads to overinvestment. The explosion of debt finance can be interpreted as a way of postponing the "crisis of realisation".

Keynes did not have a complete answer to the problems we are facing once again. But, like all great thinkers, he leaves us with ideas which compel us to rethink our situation. In the long run, he deserves to ride again.

Where do we go from here?

Robert Skidelsky — 2008-12-17T15:09:00+00:00

Any great failure should force us to rethink. The present economic crisis is a great failure of the market system. As George Soros has rightly pointed out, "the salient feature of the current financial crisis is that it was not caused by some external shock like Opec… the crisis was generated by the system itself." It originated in the US, the heart of the world's financial system and the source of much of its financial innovation. That is why the crisis is global, and is indeed a crisis of globalisation.

There were three kinds of failure. The first, discussed by John Kay in this issue, was institutional: banks mutated from utilities into casinos. However, they did so because they, their regulators and the policymakers sitting on top of the regulators all succumbed to something called the "efficient market hypothesis": the view that financial markets could not consistently mis-price assets and therefore needed little regulation. So the second failure was intellectual. The most astonishing admission was that of former Federal Reserve chairman Alan Greenspan in autumn 2008 that the Fed's regime of monetary management had been based on a "flaw." The "whole intellectual edifice," he said, "collapsed in the summer of last year." Behind the efficient market idea lay the intellectual failure of mainstream economics. It could neither predict nor explain the meltdown because nearly all economists believed that markets were self-correcting. As a consequence, economics itself was marginalised.

But the crisis also represents a moral failure: that of a system built on debt. At the heart of the moral failure is the worship of growth for its own sake, rather than as a way to achieve the "good life." As a result, economic efficiency—the means to growth—has been given absolute priority in our thinking and policy. The only moral compass we now have is the thin and degraded notion of economic welfare. This moral lacuna explains uncritical acceptance of globalisation and financial innovation. Leverage is a duty because it "levers" faster growth. The theological language which would have recognised the collapse of the credit bubble as the "wages of sin," the come-uppance for prodigious profligacy, has become unusable. But the come-uppance has come, nevertheless.

Historians have always been fascinated by cyclical theories of history. Societies are said to swing like pendulums between alternating phases of vigour and decay; progress and reaction; licentiousness and puritanism. Each outward movement produces a crisis of excess which leads to a reaction. The equilibrium position is hard to achieve and always unstable.

In his Cycles of American History (1986) Arthur Schlesinger Jr defined a political economy cycle as "a continuing shift in national involvement between public purpose and private interest." The swing he identified was between "liberal" (what we would call social democratic) and "conservative" epochs. The idea of the "crisis" is central. Liberal periods succumb to the corruption of power, as idealists yield to time-servers, and conservative arguments against rent-seeking excesses win the day. But the conservative era then succumbs to a corruption of money, as financiers and businessmen use the freedom of de-regulation to rip off the public. A crisis of under-regulated markets presages the return to a liberal era.

This idea fits the American historical narrative tolerably well. It also makes sense globally. The era of what Americans would call "conservative" economics opened with the publication of Adam Smith's Wealth of Nations in 1776. Yet despite the early intellectual ascendancy of free trade, it took a major crisis—the potato famine of the early 1840s—to produce an actual shift in policy: the 1846 repeal of the Corn Laws that ushered in the free trade era.

In the 1870s, the pendulum started to swing back to what the historian AV Dicey called the "age of collectivism." The major crisis that triggered this was the first great global depression, produced by a collapse in food prices. It was a severe enough shock to produce a major shift in political economy. This came in two waves. First, all industrial countries except Britain put up tariffs to protect employment in agriculture and industry. (Britain relied on mass emigration to eliminate rural unemployment.) Second, all industrial countries except the US started schemes of social insurance to protect their citizens against life's hazards. The great depression of 1929-32 produced a second wave of collectivism, now associated with the "Keynesian" use of fiscal and monetary policy to maintain full employment. Most capitalist countries nationalised key industries. Roosevelt's new deal regulated banking and the power utilities, and belatedly embarked on the road of social security. International capital movements were severely controlled everywhere.

This movement was not all one way, or else the west would have ended up with communism, which was the fate of large parts of the globe. Even before the crisis of collectivism in the 1970s, a swing back had started, as trade, after 1945, was progressively freed and capital movements liberalised. The rule was free trade abroad and social democracy at home.

The Bretton Woods system, set up with Keynes's help in 1944, was the international expression of liberal/social democratic political economy. It aimed to free foreign trade after the freeze of the 1930s, by providing an environment that reduced incentives for economic nationalism. At its heart was a system of fixed exchange rates, subject to agreed adjustment, to avoid competitive currency depreciation.

The crisis of liberalism, or social democracy, unfolded with stagflation and ungovernability in the 1970s. It broadly fits Schlesinger's notion of the "corruption of power." The Keynesian/social democratic policymakers succumbed to hubris, an intellectual corruption which convinced them that they possessed the knowledge and the tools to manage and control the economy and society from the top. This was the malady against which Hayek inveighed in his classic The Road to Serfdom (1944). The attempt in the 1970s to control inflation by wage and price controls led directly to a "crisis of governability," as trade unions, particularly in Britain, refused to accept them. Large state subsidies to producer groups, both public and private, fed the typical corruptions of behaviour identified by the new right: rent-seeking, moral hazard, free-riding. Palpable evidence of government failure obliterated memories of market failure. The new generation of economists abandoned Keynes and, with the help of sophisticated mathematics, reinvented the classical economics of the self-correcting market. Battered by the crises of the 1970s, governments caved in to the "inevitability" of free market forces. The swing-back became worldwide with the collapse of communism.

A conspicuous casualty of the swing-back was the Bretton Woods system that succumbed in the 1970s to the refusal of the US to curb its domestic spending. Currencies were set free to float and controls on international capital flows were progressively lifted. This heralded a wholesale change of direction towards free markets and the idea of globalisation. This was, in concept, not unattractive. The idea was that the nation state—which had been responsible for so much organised violence and wasteful spending—was on its way out, to be replaced by the global market. The prospectus was perhaps best set out by the Canadian philosopher, John Ralston Saul, in a 2004 essay in which he proclaimed the collapse of globalisation: "In the future, economics, not politics or arms, would determine the course of human events. Freed markets would quickly establish natural international balances, impervious to the old boom-and-bust cycles. The growth in international trade, as a result of lowering barriers, would unleash an economic-social tide that would raise all ships, whether of our western poor or of the developing world in general. Prosperous markets would turn dictatorships into democracies."

Today we are living through a crisis of conservatism. The financial crisis has brought to a head a growing dissatisfaction with the corruption of money. Neo-conservatism has sought to justify fabulous rewards to a financial plutocracy while median incomes stagnate or even fall; in the name of efficiency it has promoted the off-shoring of millions of jobs, the undermining of national communities, and the rape of nature. Such a system needs to be fabulously successful to command allegiance. Spectacular failure is bound to discredit it.

The situation we are in now thus puts into question the speed and direction of progress. Will there be a pause for thought, or will we continue much as before after a cascade of minor adjustments? The answer lies in the intellectual and moral sphere. Is economics capable of rethinking its core principles? What institutions, policies and rules are needed to make markets "well behaved"? Do we have the moral resources to challenge the dominance of money without reverting to the selfish nationalisms of the 1930s?

The enquiry must start with economics. If the case for the deregulated market system is intellectually sound, it will be very hard to change. Free- marketeers claim, contrary to Soros, that the crisis is the fault of governments. US money was kept too cheap for too long after the technology bubble burst in 2000 and the attacks of 11th September 2001. The market was temporarily fooled by the government. This is a shaky defence, to say the least: if the market is so easily fooled, it cannot be very efficient.

One can also argue that the problem is not with the market system, but the fact that markets are too few and inflexible. This seems to be the view of Yale economist Robert J Shiller. He likens the financial system to an early aircraft. Just because it is prone to crash doesn't mean we should stop trying to perfect it. Shiller claims that new derivative products will soon be able to insure homeowners against the risk of house prices going down. To my mind, this is an example of trying to cure a state of inebriation by having another whiskey. There are two things wrong with it. First, if financial innovation is, in fact, the route to greater market efficiency, the financial system would have been getting more stable in the last 25 years of explosive financial engineering. Instead it has become more volatile. Second, the assumption that, given enough innovation, uncertainty can be reduced to risk, is just wrong. There will never be sufficient knowledge to enable contracts to be made to cover all future contingencies.

An analogous argument is that there was not enough marketisation in the global monetary system. Instead of the "clean" floating of currencies, "dirty" floating became the rule. Importantly, China and most of east Asia refused to float their currencies freely. China reverted unilaterally to a form of Bretton Woods, deliberately undervaluing the yuan against the US dollar. The resulting imbalances enabled American consumers to borrow $700bn a year from the parsimonious but super-competitive Chinese, at the cost of losing millions of manufacturing jobs to them. The Chinese saved, the Americans spent, and their debt-fuelled spending created the asset bubbles that led to the credit collapse. This source of instability needs no revision of economic theory, simply the establishment of a free market in foreign currencies. However, the assumption that a world in which currencies were allowed to float freely would be immune from the financial storms we have experienced depends on the belief that currencies will always trade at the correct prices—the global version of the efficient market hypothesis.

A different claim, which goes back to Marx, is that certain structures of economy are less stable than others. Globalisation has increased instability by producing a shift in world GDP shares from wages to profits as the release of low-wage populations into the global economy has undermined the bargaining power of labour in rich countries. This has led to a crisis of under-consumption, staved off only by the expansion of debt (as Gerald Holtham points out, in Prospect's December 2008 issue). There is some truth in this. A greater equality of incomes would create more stable purchasing power.

But the main source of instability lies in the financial markets themselves. And here it is clear that the battle of economic ideas still needs to be fought. Keynes is important in this because he produced the most powerful case for supposing that financial markets are not efficient in the sense required by efficient market theory. As he explained in The General Theory of Employment, Interest, and Money (1936), classical economics had ignored the two main causes of systemic financial failure: the existence of (unmeasurable) uncertainty and the role of money as a "store of value." The first led to periodic collapses of confidence; the second led investors to hoard cash if interest rates fell too low, making automatic recovery from collapses difficult. The function of government was to remove the depressive effect of both by giving investors continuous confidence to invest.

Contrary to the belief of some recent economic theories, the future is just as unknowable as Keynes thought it was. The mathematical "quants" who set up the Long Term Capital Management hedge fund in 1994 worked to a risk model which showed that the kind of financial meltdown which, in fact, bankrupted them four years later, could occur only once every four million years. This was not a rationalisation of financial interests: it was self-deception.

What economics needs, therefore, if it is to have any purchase on real world behaviour, is a new starting point. It needs to accept that the changing nature of the world precludes people from having enough information to always make contracts at the "right" prices. Such a change is a necessary condition for a permanent change in policy. Each previous crisis has produced a leading economist with the authority to challenge the prevailing consensus. So the call for a new Keynes is not just rhetorical.

Opinion as to the degree of supervision, regulation and control needed to make a market economy well-behaved is to be found along a continuum. At one end are the free-marketeers who believe only the lightest touch only is needed; at the other are classical Marxists who believe it requires public ownership of the whole economy. In between are varieties of social democrats and middle wayers, the most famous of whom is Keynes. This territory is sure to be extensively explored over the next few years as the pendulum starts swinging back. For the question of making markets well behaved goes beyond the question of securing their efficiency. It involves making the market economy compatible with other valued aspects of life. The French social democratic slogan of the mid-1990s—"market economy yes, market society no"—encapsulates the idea that limits should be placed on the power of the market to shape social life according to its own logic.

The battleground will be about the role of the nation-state in the globalising economy of the future, for the nation-state is the main repository and guardian of the values and traditions threatened by the disruptive power of the global market. A paradox of globalisation—which was supposed to see a withering of the nation-state—is that it has led to a revival of nationalism. A deregulated world turned out, unsurprisingly, to be one dominated by the strong. This process reached its apogee with the presidency of George W Bush and the Iraq war—which emphasised US determination to act as a free agent. Other states, too, in Europe and elsewhere, are now acting as semi-free agents. The effective choice is between a more regulated global capitalist system and its possibly violent breakup into a menagerie of warrior nationalisms.

But to ensure we have an ordered system requires us to make globalisation efficient and acceptable. In the course of that debate, I expect one crucial point to emerge: the benefits of globalisation are real, but have been exaggerated. Improvements in the allocation of capital and reductions in opportunities for corruption are offset by increased volatility. Globalisation also raises huge issues of political accountability and social cohesion that are scarcely considered by economists, and only lazily by politicians.

There seem to be four main reasons for this blind spot. The first is the intellectual domination of economics in this debate, with its individualistic and developmental perspective. Globalisation—the integration of markets in goods, services, capital and labour—must be good because it has raised many millions out of poverty in poorer countries faster than would otherwise have been possible. Any interference with this process is impious. A second idea is that it is inevitable: technology—most conspicuously the internet—abolishes national frontiers. Technology cannot be undone. So, whether we like it or not, globalisation is our fate, and our morals and social conventions must adapt to it. The third idea is that globalisation is evolutionary; any check would be regressive. Fourthly, globalisation forces us to think of the world as a unit, which is necessary if we are to solve planet-wide problems.

These are powerful propositions, derived from the era of scarcity and not adjusted to the era of partial abundance, nor to the existence of natural limits to growth. Today the benefits of globalisation are much more obvious for poor than for rich countries. In the 1950s and 1960s, the northern hemisphere was for free trade, the southern protectionist. Today the position is partly reversed. Globalisation offers the best hope for poor countries to catch up with the rich. But growth has become less important for rich countries. In the early 1930s, Keynes thought that the international division of labour could be carried too far. "Let goods be homespun," was the title of an article he wrote in 1932. He wanted a "well-balanced" or "complete" national life, allowing a country to display the full range of its aptitudes, and not simply to be a link in a value-adding productive chain spanning the globe. Moreover, the economic benefits of offshoring are far from evident for richer states. Since 1997, Britain has lost 1.1m manufacturing jobs—29 per cent of its total—many of them to developing countries. The result has been a dramatic deterioration in Britain's current account balance, and a decline into deficit on the investment income balance too, meaning we pay more to foreign investors in interest and dividends than we receive from abroad. This makes it harder for Britons to pay down their huge debts to the outside world.

Keynes's warning that the pursuit of export-led growth is bound to set nations at each others' throats is still relevant. But that does not mean just sticking as we are. Some rowing back of financial globalisation and cross-border financial institutions is required to rebalance market and state. This process is underway, as national regulators take a tighter grip over the financial institutions they are bailing out. Regulators are increasingly sceptical of banks that depend excessively on wholesale funding. Without this, there will be a natural tendency for banks to shrink back within their own frontiers.

One of the biggest problems with the global trading order remains the enormous arbitrages in tax, labour and non-wage costs that exist. These have encouraged companies to relocate operations, and depressed the bargaining power of labour. Companies like WalMart of the US and Nokia of Finland have been huge outsourcers to Asia. The only solution short of raising barriers is for governments to co-operate in flattening out some of these differences—for China, for example, to increase wages. Ralston Saul has noted that the era of globalisation saw "multiple binding economic treaties… put in place while almost no counterbalancing binding treaties were negotiated for work conditions, taxation, the environment or legal obligations." It will be difficult to create new global systems that balance public good and self interest. But the alternative is the beggar-my-neighbour world of protectionism.

Another way to curb outsourcers would be to use antitrust powers. Breaking up megalithic multinationals would at least prevent them enjoying quasi-monopoly rents, and thus reduce the incentive.

Globalisation is necessarily blind to the idea of political accountability because none exists at the planetary level. Yet the crisis has challenged the idea that we should all unthinkingly follow the logic of the bond market. When the crunch came, we discovered that national taxpayers still stand behind banks, and national insolvency regimes matter. A more rules-based exchange rate system is not inconceivable. This might seek to put some curbs on capital movements—especially at times of economic stress.

And, in this new climate, national politicians are likely to reach for ideas and influences that until recently would have seemed exotic. The idea, for example, that economic growth does not, beyond a certain point, make people happier. David Cameron, a market-friendly Conservative, has talked about the importance of general wellbeing as an alternative to the mania for economic growth. Rich countries could probably abandon the globalist project without much damage to their material standards and with possible gain to their quality of life. Rejecting the inevitability of market-based globalisation would not necessarily be harmful—especially if it were accompanied by a reassertion of democracy at a national level. This is not a pipe dream. New Zealand, which was the first country to attempt to become a post-national nation state in the 1980s with a radical programme of privatisation and deregulation, changed tack in 1999. The electorate endorsed an interventionist government devoted to raising taxes, reimposing economic regulations and establishing a stable private sector. It happened because reform failed to deliver the goods. Other countries may follow suit if the political costs of maintaining a global economy are seen as too high. Rich countries surely have a duty to help poor countries, but not at the expense of an awful way of life.

"Well-behaved" markets should not only be more stable, they should be more morally acceptable. It is indefensible for a top American CEO to earn 367 times more than the average worker (against 40 times in the 1970s). Part of the swing-back in political economy will be to use the tax system to redress the balance between capital and impotent labour.

The crisis has rightly led to a revival of interest in Keynes. But he was a moralist as well as an economist. He believed that material wellbeing is a necessary condition of the good life, but that beyond a certain standard of comfort, its pursuit can produce corruption, both for the individual and for society.

He reunited economics with ethics by taking us back to the primary question: what is wealth for? The good life was one to be lived in harmony with nature and our fellows. Yet "we destroy the beauty of the countryside because the unappropriated splendours of nature have no economic value. We are capable of shutting off the sun and the stars because they do not pay a dividend." Not everything should be sacrificed for efficiency. And Keynes was a liberal nationalist.

In terms of our pendulum analogy, he was someone who instinctively sought an equipoise: not in the timeless equilibrium of classical economics, but in a balance in political economy between freedom and control, national and international wellbeing, efficiency and morality. He was an Aristotelian, who believed that vices are virtues carried to excess. This is a good philosophy for today.

The Remedist

Robert Skidelsky — 2008-12-13T23:35:00+00:00

Among the most astonishing statements to be made by any policymaker in recent years was Alan Greenspan’s admission this autumn that the regime of deregulation he oversaw as chairman of the Federal Reserve was based on a “flaw”: he had overestimated the ability of a free market to self-correct and had missed the self-destructive power of deregulated mortgage lending. The “whole intellectual edifice,” he said, “collapsed in the summer of last year.”

What was this “intellectual edifice”? As so often with policymakers, you need to tease out their beliefs from their policies. Greenspan must have believed something like the “efficient-market hypothesis,” which holds that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. Government officials who control the money supply have only one task — to keep prices roughly stable.

I don’t suppose that Greenspan actually bought this story literally, since experience of repeated financial crises too obviously contradicted it. It was, after all, only a model. But he must have believed something sufficiently like it to have supported extensive financial deregulation and to have kept interest rates low in the period when the housing bubble was growing. This was the intellectual edifice, of both theory and policy, which has just been blown sky high. As George Soros rightly pointed out, “The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil. . . . The crisis was generated by the financial system itself.”

This is where the great economist John Maynard Keynes (1883-1946) comes in. Today, Keynes is justly enjoying a comeback. For the same “intellectual edifice” that Greenspan said has now collapsed was what supported the laissez-faire policies Keynes quarreled with in his times. Then, as now, economists believed that all uncertainty could be reduced to measurable risk. So asset prices always reflected fundamentals, and unregulated markets would in general be very stable.

By contrast, Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes.

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.” (Today, you might add a further convention — the belief that mathematics can conjure certainty out of uncertainty.)

But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic.

Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics. Most economists have seen money simply as a means of payment, an improvement on barter. Keynes emphasized its role as a “store of value.” Why, he asked, should anyone outside a lunatic asylum wish to “hold” money? The answer he gave was that “holding” money was a way of postponing transactions. The “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” The same reliance on “conventional” thinking that leads investors to spend profligately at certain times leads them to be highly cautious at others. Even a relatively weak dollar may, at moments of high uncertainty, seem more “secure” than any other asset, as we are currently seeing.

It is this flight into cash that makes interest-rate policy such an uncertain agent of recovery. If the managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think that cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on different types of loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending in the face of an extreme private-sector reluctance to spend, and that was for the government to spend the money itself. Spend on pyramids, spend on hospitals, but spend it must.

This, in a nutshell, was Keynes’s economics. His purpose, as he saw it, was not to destroy capitalism but to save it from itself. He thought that the work of rescue had to start with economic theory itself. Now that Greenspan’s intellectual edifice has collapsed, the moment has come to build a new structure on the foundations that Keynes laid.

House of Lords Debate: Queen’s Speech (3rd Day)

Robert Skidelsky — 2008-12-08T11:24:00+00:00

My Lords, the opening paragraph of the gracious Speech pledges the Government to give overwhelming priority to ensure the stability of the British economy during the global economic downturn. We would all endorse that.

The Minister outlined several useful measures that the Government have taken or are planning to take, which remind me of the useful measures taken by Ramsay MacDonald’s Labour Government of 1929 to 1931, about which I wrote my first book, but which were far too small to stem the economic blizzard that was then sweeping the world.

The gracious Speech promised reforms to the banking sector. These are necessary, but here I sound my first cautionary note. In his open letter to President Roosevelt in 1933, John Maynard Keynes said that the President was engaged in,

“the double business of recovery and reform—recovery from the slump, and the passage of those business and social reforms which are long overdue”.

But—and here is the sting—he said that,

“even wise and necessary reform may ... impede and complicate recovery. For it will upset the confidence of the business world ... And it will confuse the thought and aim of yourself and your Administration by giving you too much to think about all at once”.

In other words, Keynes’s advice was: “Concentrate on getting the recovery and do your reforms on the back of the recovery”. Those wise words have lost none of their relevance.

How much stimulus will it take to bring about recovery and how is it to be done? There is no doubt that we are sliding into a severe recession, possibly the worst since the war. The latest OECD economic outlook projects a swing in output of about 4 per cent of GDP for OECD countries as a whole, with a decline of 3 per cent or more in the next 12 months. We should notice that these forecasts are lagging indicators; the output figures have had to be revised downwards each quarter for the last three quarters.

Some believe that we can deal with the problem by relying on monetary policy alone, but I do not think that it will do the job. I shall again quote from Keynes. In a lecture that he gave in 1932, he said:

“It may still be the case, that the lender, with his confidence shattered by his experience, will continue to ask for new enterprise rates of interest which the borrower cannot expect to earn ... If this proves to be so, there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidise new investment”.

That reminds us that getting the money to flow is a two-way business. It depends on the expected earnings of the borrowers as well as on the price and quantity of money provided by the lender. A great deal of investment will inevitably be delayed until profit expectations rise, whatever the rate of interest. I think that the Secretary of State indicated the importance of the expectations of the borrower.

The Bank of England’s base rate has come down to 2 per cent; mortgages are stuck at 5 to 6 per cent. Everyone from the Prime Minister downwards is telling the banks that they have to lend, but they will not lend until it is prudent for them to do so for two reasons: first, they fear more losses ahead from toxic assets or recession-induced business failures; and, secondly, the new capital put in by the Government is at such penal rates that they want to repay it as quickly as possible, the easiest way being to stop lending. This flight into cash is a familiar feature of all downturns. It gives people a sense of security. Cash postpones the decision that you have to make to spend. Even a relatively weak currency such as the dollar may at moments of high pessimism seem more secure than any other asset, as we are seeing at the moment.

That leaves fiscal policy. It would have been better had we been able to start the fiscal stimulus from a position of surplus, but, still, this weapon will certainly be needed. If the output gap figures are right, it will have to be more than the 1 or even 2 per cent of GDP that has so far been suggested; it will perhaps have to more like 3 to 4 per cent of GDP.

In devising this fiscal stimulus, I would certainly put my main emphasis on government spending. When private sector spending falls, the only secure way to get increased spending is for the Government to spend the money themselves. Many projects in the pipeline can be accelerated. I have only one suggestion: will the Government not consider suspending for one year the most important planning regulations that hold up the start of big projects? Many of them are based on worst-case scenarios; now we have a worst case of a graver kind, which should take priority.

That we will come through the crisis I have no doubt. We will need to think seriously and constructively about the kind of political economy with which we wish to emerge at the end of it. I shall make just four short points. First, we need to revise macro policy to be able to take into account asset bubbles and to make use of macro-prudential instruments. Secondly, we need to strengthen banking regulation on an international basis. Thirdly, we need a way of liquidating the huge global imbalances that have been a major cause of financial excess in America. That means talking about exchange rates. We cannot avoid that; it is an essential part of a Bretton Woods 2. Finally, we need to consider whether, as a society, we want to tolerate the extreme inequalities of wealth and income that have built up over the last 20 years, especially at the very top. The emergence of an insolent, largely footloose, financial aristocracy—or, I should say, plutocracy—is the direct result of the dominance of the financial services sector in our economy, the freeing of capital movements from national control and a reversal of the previously equalising tax policies in the Reagan and Thatcher years. A big crisis gives us the opportunity to consider that. But first the recovery.

Not what the doctor ordered

Robert Skidelsky — 2008-12-03T16:06:01+00:00

Two major reports on the Russian economy were published in November by the EBRD and the World Bank. Both reports make similar diagnoses and offer the same prescriptions for Russia’s ills.

Russia has not escaped the worldwide financial crisis. The stock market collapse saw $1 trillion wiped of the value of Russian companies. The non-oil external current account deficit increased to almost $62 billion in third quarter 2008. Gross capital inflows declined by 40 per cent over the last year. The global and domestic liquidity crisis and tumbling commodity prices have led the World Bank to revise down its growth forecasts for Russia in 2009 from 6.5 per cent to 3 percent. This calculation was based on an average oil price of $100 barrel for next year. Today, the price stands at $50 barrel. So Russia will almost certainly experience negative growth next year.

There is a chain reaction. The general meltdown in capital markets has reduced capital inflows which have dried up syndicate lending and the bond market just as the fall in commodity prices, which has resulted in a drop in export receipts, has increased external refinancing needs. Higher risk and slower growth feed back into the financial sector lowering confidence further.

Russia’s performance has not been too bad relative to other transition economies, including recently-joined EU members like Poland. The World Bank contends that Russia’s short-term macroeconomic fundamentals are strong. It applauds the Russian government’s response to the crisis as ‘swift, comprehensive, and coordinated’, and argues that the crisis presents an opportunity to combine short term policy responses with long term measures that ‘would ensure that Russia emerges from this global crisis with a stronger basis for dynamic, productivity-led growth.’

This is the problem. The main ingredients of economic growth are high investment in education, and a high level of competition. Further, countries successful in export markets, especially in non-commodities, tend to grow faster than others.

Unfortunately, Russia has not yet succeeded in developing new, higher-value manufacturing industries and is still deeply reliant on fuels and raw materials. There are, as there have always been, two choices for its industrial policy. The first is a horizontal policy, based on state intervention directed at the environment in which firms operate: investment in education and human capital, better access to finance for SMEs, support for innovation, and improving government services and legal frameworks. The second is a vertical policy where state intervention is used to promote particular sectors and firms. The two reports naturally favour the second strategy.

They provide the typical prescriptions which modern economics think suitable for any developing economy. They rarely ask why Russia has been so slow to adopt their policies. Economics is a science of incentives, but economists offering policy advice often conveniently forget about incentives for governments to act the way they suggest. The crisis will concentrate minds in the Kremlin, but there is no guarantee that this focus will be in the direction favoured by the World Bank and the EBRD. The Russian government largely failed to use the good times to diversify the economy, clean up banking system, reform capital markets, strengthen property rights and establish rule of law. Why should it start now?

Russia is a country with a turbulent past, entrenched local elites, huge territory, grand political ambitions, and a government that is often dysfunctional. What economists call ‘governance’ is its major problem. Until progress is made in this area the two reports will be so much more hot air.

What would Keynes have done?

Robert Skidelsky — 2008-11-22T09:26:00+00:00

Expect plans for higher borrowing, tax cuts, and more spending in Monday's pre-Budget statement. With Britain sliding into depression, it is not surprising that the old Keynesian tool kit is being ransacked. But Keynesian economics is not just about fixing damaged economies. You don't need very sophisticated economics to spend your way out of a depression. In one form or other – usually by war or war preparations – governments have been doing this throughout history.

It does require very sophisticated economics to prove that depressions cannot happen. This was the economics Keynes set out to challenge in his great book, The General Theory Of Employment, Interest And Money, written during the Great Depression of the 1930s. His own ideas, he wrote, were "extremely simple, and should be obvious". Economies were inherently unstable; governments had a vital role to play in stabilising them.

These heresies were too simple and obvious for the economics profession. For after a long and rather successful trial run, Keynesian economics was obliterated by the free-market revolution which swept the Anglo-American world under Thatcher and Reagan. In a notable comeback, updated versions of the theory Keynes had challenged "proved" that unregulated or lightly regulated market economics were very stable, and that government interventions only made things worse. In apparent disregard for mathematical demonstrations to the contrary, crises and crashes, booms and busts continued to occur, and politicians continued to try to mitigate their consequences, their common sense being stronger than their logic. This is roughly the situation we are in today. Economic theory points to non-intervention: politics points to intervention. Keynes's attempt to marry the two in the notion of "practical statecraft" failed.

Keynes's "simple and obvious" ideas can be summed up in two propositions. The first is that large parts of the future are unknowable. "The outstanding fact," he wrote, "is the extreme precariousness of our estimates of the basis of knowledge on which our estimates of prospective yield [of securities] have to be made." The "unknowability" of the future imparted an inherent instability to financial and investment markets, leading to periodic outbreaks of "herd behaviour", when "new fears and hopes will without warning take charge of human affairs". He called the economics of his day a "polite technique which tries to deal with the present by abstracting from the fact that we know very little about the future".

How was this "abstraction" achieved? By assuming, Keynes wrote, that uncertainty could be "reduced" to calculable probability, and therefore to the same status as certainty itself. This underlies today's "efficient market hypothesis" which treats uncertainty as measurable risk; its acceptance explains the explosion of the derivatives market since the 1980s, which has brought the financial system crashing down.

Keynes's second proposition is that depressions can last a long time, longer than it is politically safe to tolerate. He did not doubt that markets worked "in the long run". "But this long run," he wrote in his best-known remark, "is a misleading guide to current affairs. In the long run we are all dead."

Keynes offered a number of reasons why economies did not simply "bounce back" after a great shock (the Dow Jones index did not recover its 1929 prices till 1952). However, his clinching argument in his 1930s debates with free market economists such as Friedrich Hayek was political. It was much too risky to allow economies to slide into deep depression. The example of Hitler was vivid in the minds of all democratic politicians. In 1928, at the height of Weimar Germany's prosperity, the Nazis got 2 per cent of the vote. By 1930 they were up to 18 per cent. In 1933 Hitler was in power.

During that time, German unemployment had risen from two million to six million. Hayek and the free market economists never had an answer to this argument. So what should the British Government do now? In 1931 Keynes favoured the devaluation of sterling, but this is now irrelevant: the pound is not fixed to gold as it was in his day, and is sinking quite naturally. The suggestion most favoured by editorial columns is to cut interest rates and go on cutting them. Keynes was certainly not against this, but "cheap money" to counter depression is not specifically Keynesian, and he doubted the efficacy of monetary policy on its own.

The Bank of England might flood the market with money, but this would not necessarily produce lower interest rates – and therefore greater lending – if the tendency to hoard money was going up at the same time. "The possession of actual money," Keynes wrote, "lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude." As the adage has it: you can bring a horse to water but you can't make it drink.

This leaves fiscal policy as the unique instrument in the Keynesian tool kit. It is idle to speculate whether Keynes would have favoured tax cuts or public spending increases. His remedies were always tailored to their impact on the state of confidence. His essential point was that, in a depression, a government stimulus was needed to offset the decline in private spending. This would mean running a temporary budget deficit. If pessimistic analysts are right in predicting a shrinking of GDP next year in the order of 3 to 4 per cent, the increase in the current deficit might have to be very large, even larger than the 2 per cent Vince Cable is proposing.

With output and inflation falling, Keynes would not have worried now about the "dangers of inflation". He would have expected the budget deficit to shrink automatically as the economy recovered, and would have imposed new taxes as and when they were needed. "The boom, not the slump," he wrote in 1937, "is the right time for austerity at the Treasury."

The final question is this. Will we be content simply to take Keynes out of his cupboard from time to time, dust him down, and put him in charge of rescue operations, before putting him back firmly in his cupboard? Or will we now try to run our affairs paying proper attention to his insights into financial instability so as to prevent these alternations of mania and panic from periodically seizing control of our lives?

Fixing Russia’s foreign relations

Robert Skidelsky — 2008-11-19T13:36:01+00:00

Russia’s credit markets may have remained frozen these last few weeks but its foreign relations have begun to thaw. Foreign investors have yet to return after pulling out their money in the wake of the invasion of Georgia, but foreign diplomats are back.

At the end of October, Peter Mandelson, Britain’s business minister and a former EU trade commissioner, led a business delegation to Moscow. This was the first visit of a British cabinet minister to Russia for eighteen months and the choice of Mandelson was significant. Nicknamed ‘the prince of darkness’, he is Britain’s chief political fixer, and he was sent to Moscow to start fixing Anglo-Russian relations. The idea was to prise the two countries’ relations out of the hands of the two foreign ministries, where they have been stuck in ‘tit for tat’ mode since the Litvinenko-Lugovoi standoff of summer 2007, and resume dialogue on commercial and business matters.

Mandelson’s savoir-faire was up to the task. His friendships with Igor Shuvalov and Anatoly Chubais - both cultivated while he was trade commissioner – helped, and he left Russia declaring: ‘there is a real willingness to re-engage, to turn the page and start a new chapter in our relationship.’ He would not go so far as to say the Britain would drop its efforts to extradite Lugovoi but did say that ‘in the meantime life goes on.’

Another sign of the thaw was the EU’s announcement on 14 November that it planned to resume the security and trade talks it suspended ten weeks ago. It is clear that Saakashvili is no longer Europe’s flavour of the month. European leaders understand that, given Georgia’s disputed territorial borders, mounting evidence that it was the aggressor in the August war with Russia and Ukraine's deep political fissures, it would be both dangerous and undesirable for either country to be given NATO membership any time soon. Expect the issue of their accession to be shelved when Nato foreign ministers meet in Budapest on 1-2 December.

The election of Barack Obama should have provided Russia with another opportunity to haul itself out of the diplomatic deep freeze. Even the prime minister of Iran managed to write Obama a letter of congratulation. President Medvedev, however, threatened to deploy missiles in Kaliningrad if America moved ahead with its plans to build missile defence systems in Poland and the Czech Republic. His excuse – that he ‘absolutely forgot’ about the American elections taking place that day– was deeply disingenuous.

Democrats are traditionally less hawkish than Republicans but Obama’s own experience of Russia will have done little to soften him up. In August 2005, as a junior senator, he was detained for three hours in a small, stuffy room in Perm Airport while local officials attempted – in contravention of international law – to search his plane. There is an old English saying: never be rude to a girl because you never know whom she might end up marrying. Now that the young senator is president, Russia must avoid missile brinkmanship, which will only play into the hands of the hawks in his administration, like Vice-president Joe Biden.

Russia’s relations with the west will also benefit from the shift in attention. The world is sliding into a global recession. In the coming months, international efforts will focus on economic rescue operations such as the coordination of fiscal policies, more funding for the IMF, better banking regulation and unified accounting standards. Last Saturday’s Washington meeting of the G20, not the traditional obsessions of foreign and defence ministries, will set the agenda for 2009, giving Russia a great opportunity to play a constructive role in a common cause.