Wednesday, March 11, 2009

The crisis of globalization: Looking in the wrong place

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

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

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

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

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

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

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

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


Bombay Beauty said...

By and large I agree with you. Two points though. First, you are right, I believe, that the globalization of financial markets means that banks in foreign countries could take very risky bets on US real estate markets. But UK banks in particular were involved in many risky bets on the overheated UK real estate market. It is still is the case, I think, that the countries with the hardest hit banking systems were hit hard on domestic rather than international bets, at least this time.

A second point which I've been pondering, related to your observations. In principle, banks like any other corporation are run for the benefit of their shareholders. So there are two questions in my mind. First, were banks taking larger risks than their shareholders would have wanted? One reason why traditional principal-agent theory may fail is the utter complexity and abstraction of these financial instruments. Even if an informed shareholder would have wanted banks to dial back the risk, it may have been difficult to know what was happening. Second, even if shareholders implicitly agreed, perhaps society wants banks to take less risk, since as we have all now seen there is a huge externality imposed by the banking system on the whole economy, more so than any other firm. BB

Vivek H. Dehejia said...

BB, you raise excellent points. Perhaps I was letting the UK off too easily, and certainly they experienced their own property bubble as did the US, which certainly contributed to the dire straights of the UK banks.

Your second point is a subtle and important one, and difficult to reply to, cogently, without careful thought. But I think there's fodder here for another separate short essay ....