Ca ilalis111 in Crisis

Is Modern Capitalism Sustainable?

By Kenneth Rogoff

December 2, 2011
CAMBRIDGE - I am often asked if the recent global financial crisis marks the beginning of the end of modern capitalism. It is a curious question, because it seems to presume that there is a viable replacement waiting in the wings. The truth of the matter is that, for now at least, the only serious alternatives to today's dominant Anglo-American paradigm are other forms of capitalism. Continental European capitalism, which combines generous health and social benefits with reasonable working hours, long vacation periods, early retirement, and relatively equal income distributions, would seem to have everything to recommend it - except sustainability. China's Darwinian capitalism, with its fierce competition among export firms, a weak social-safety net, and widespread government intervention, is widely touted as the inevitable heir to Western capitalism, if only because of China's huge size and consistent outsize growth rate. Yet China's economic system is continually evolving. Indeed, it is far from clear how far China's political, economic, and financial structures will continue to transform themselves, and whether China will eventually morph into capitalism's new exemplar. In any case, China is still encumbered by the usual social, economic, and financial vulnerabilities of a rapidly growing lower-income country. Perhaps the real point is that, in the broad sweep of history, all current forms of capitalism are ultimately transitional. Modern -day capitalism has had an extraordinary run since the start of the Industrial Revolution two centuries ago, lifting billions of ordinary people out of abject poverty. Marxism and heavy-handed socialism have disastrous records by comparison. But, as industrialization and technological progress spread to Asia (and now to Africa), someday the struggle for subsistence will no longer be a primary imperative, and contemporary capitalism's numerous flaws may loom larger. First, even the leading capitalist economies have failed to price public goods such as clean air and water effectively. The failure of efforts to conclude a new global climate-change agreement is symptomatic of the paralysis. Second, along with great wealth, capitalism has produced extraordinary levels of inequality. The growing gap is partly a simple byproduct of innovation and entrepreneurship. People do not complain about Steve Jobs's success; his contributions are obvious. But this is not always the case:

great wealth enables groups and individuals to buy political power and influence, which in turn helps to generate even more wealth. Only a few countries - Sweden, for example - have been able to curtail this vicious circle without causing growth to collapse. A third problem is the provision and distribution of medical care, a market that fails to satisfy several of the basic requirements necessary for the price mechanism to produce economic efficiency, beginning with the difficulty that consumers have in assessing the quality of their treatment. The problem will only get worse: health-care costs as a proportion of income are sure to rise as societies get richer and older, possibly exceeding 30% of GDP within a few decades. In health care, perhaps more than in any other market, many countries are struggling with the moral dilemma of how to maintain incentives to produce and consume efficiently without producing unacceptably large disparities in access to care.
It is ironic that modern capitalist societies engage in public campaigns to urge individuals to be

more attentive to their health, while fostering an economic ecosystem that seduces many consumers into an extremely unhealthy diet. According to the United States Centers for Disease Control, 34% of Americans are obese. Clearly, conventionally measured economic growth- which implies higher consumption - cannot be an end in itself. Fourth, today's capitalist systems vastly undervalue the welfare of unborn generations. For most of the era since the Industrial Revolution, this has not mattered, as the continuing boon of technological advance has trumped short-sighted policies. By and large, each generation has found itself significantly better off than the last. But, with the world's population surging above seven billion, and harbingers of resource constraints becoming ever more apparent, there is no guarantee that this trajectory can be maintained. Financial crises are of course a fifth problem, perhaps the one that has provoked the most soulsearching oflate. In the world of finance, continual technological innovation has not conspicuously reduced risks, and might well have magnified them. In principle, none of capitalism's problems is insurmountable, and economists have offered a variety of market-based solutions. A high global price for carbon would induce firms and individuals to internalize the cost of their polluting activities. Tax systems can be designed to provide a greater measure of redistribution of income without necessarily involving crippling distortions, by minimizing non-transparent tax expenditures and keeping marginal rates low. Effective pricing of health care, including the pricing of waiting times, could encourage a better balance between equality and efficiency. Financial systems could be better regulated, with stricter attention to excessive accumulations of debt. Will capitalism be a victim of its own success in producing massive wealth? For now, as fashionable as the topic of capitalism's demise might be, the possibility seems remote. Nevertheless, as pollution,

financial instability, health problems, and inequality continue to grow, and as political systems remain paralyzed, capitalism's future might not seem so secure in a few decades as it seems now.

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

Is Capitalism Doomed?
By Nouriel Roubini

August 15, 2011

NEW YORK - The massive volatility and sharp equity-price correction now hitting global financial markets signal that most advanced economies are on the brink of a double-dip recession. A financial and economic crisis caused by too much private-sector debt and leverage led to a massive re-leveraging of the public sector in order to prevent Great Depression 2.0. But the subsequent recovery has been anemic and sub-par in most advanced economies given painful deleveraging. Now a combination of high oil and commodity prices, turmoil in the Middle East, Japan's earthquake and tsunami, eurozone debt crises, and America's fiscal problems (and now its rating downgrade) have led to a massive increase in risk aversion. Economically, the United States, the eurozone, the United Kingdom, and Japan are all idling. Even fast-growing emerging markets (China, emerging Asia, and Latin America), and export-oriented economies that rely on these markets (Germany and resource-rich Australia), are experiencing sharp slowdowns. Until last year, policymakers could always produce a new rabbit from their hat to reflate asset prices and trigger economic recovery. Fiscal stimulus, near-zero interest rates, two rounds of" quantitative easing," ring-fencing of bad debt, and trillions of dollars in bailouts and liquidity provision for banks and financial institutions: officials tried them all. Now they have run out of rabbits. Fiscal policy currently is a drag on economic growth in both the eurozone and the UK. Even in the US, state and local governments, and now the federal government, are cutting expenditure and reducing transfer payments. Soon enough, they will be raising taxes. Another round of bank bailouts is politically unacceptable and economically unfeasible: most governments, especially in Europe, are so distressed that bailouts are unaffordable; indeed, their sovereign risk is actually fueling concern about the health of Europe's banks, which hold most of the increasingly shaky government paper. Nor could monetary policy help very much. Quantitative easing is constrained by above-target inflation in the eurozone and UK. The US Federal Reserve will likely start a third round of quantitative easing (QE3), but it will be too little too late. Last year's $600 billion QE2 and $1 trillion in tax cuts and transfers delivered growth of barely 3% for one quarter. Then growth slumped to below 1% in the first half of 2011. QE3 will be much smaller, and will do much less to reflate asset prices and restore growth.

Currency depreciation is not a feasible option for all advanced economies: they all need a weaker currency and better trade balance to restore growth, but they all cannot have it at the same time. So relying on exchange rates to influence trade balances is a zero-sum game. Currency wars are thus on the horizon, with Japan and Switzerland engaging in early battles to weaken their exchange rates. Others will soon follow. Meanwhile, in the eurozone, Italy and Spain are now at risk oflosing market access, with financial pressures now mounting on France, too. But Italy and Spain are both too big to fail and too big to be bailed out. For now, the European Central Bank will purchase some of their bonds as a bridge to the eurozone's new European Financial Stabilization Facility. But, if Italy and/or Spain lose market access, the EFSF's 440 billion ($627 billion) war chest could be depleted by the end of this year or early 2012. Then, unless the EFSF pot were tripled - a move that Germany would resist - the only option left would become an orderly but coercive restructuring of Italian and Spanish debt, as has happened in Greece. Coercive restructuring of insolvent banks' unsecured debt would be next. So, although the process of deleveraging has barely started, debt reductions will become necessary if countries cannot grow or save or inflate themselves out of their debt problems. So Karl Marx, it seems, was partly right in arguing that globalization, financial intermediation run amok, and redistribution of income and wealth from labor to capital could lead capitalism to selfdestruct (though his view that socialism would be better has proven wrong). Firms are cutting jobs because there is not enough final demand. But cutting jobs reduces labor income, increases inequality and reduces final demand. Recent popular demonstrations, from the Middle East to Israel to the UK, and rising popular anger in China - and soon enough in other advanced economies and emerging markets - are all driven by the same issues and tensions: growing inequality, poverty, unemployment, and hopelessness. Even the world's middle classes are feeling the squeeze of falling incomes and opportunities. To enable market-oriented economies to operate as they should and can, we need to return to the right balance between markets and provision of public goods. That means moving away from both the Anglo-Saxon model of laissez-faire and voodoo economics and the continental European model of deficit-driven welfare states. Both are broken. The right balance today requires creating jobs partly through additional fiscal stimulus aimed at productive infrastructure investment. It also requires more progressive taxation; more short-term fiscal stimulus with medium- and long-term fiscal discipline; lender-of-last-resort support by monetary authorities to prevent ruinous runs on banks; reduction of the debt burden for insolvent households and other distressed economic agents; and stricter supervision and regulation of a financial system run amok; breaking up too-big-to-fail banks and oligopolistic trusts.

Over time, advanced economies will need to invest in human capital, skills and social safety nets to increase productivity and enable workers to compete, be flexible and thrive in a globalized economy. The alternative is - like in the 1930s - unending stagnation, depression, currency and trade wars, capital controls, financial crisis, sovereign insolvencies, and massive social and political instability.

Nouriel Roubini is Chairman of Roubini Global Economics, Professor of Economics at the Stern School ofBusiness, New York University, and co-author of the book Crisis Economics.

The Ideological Crisis of Western Capitalism

By Joseph E. Stiglitz

July6, 2011
NEW YORK- Just a few years ago, a powerful ideology- the belief in free and unfettered markets - brought the world to the brink of ruin. Even in its hey-day, from the early 1980's until 2007, American-style deregulated capitalism brought greater material well-being only to the very richest in the richest country of the world. Indeed, over the course of this ideology's 30-year ascendance, most Americans saw their incomes decline or stagnate year after year. Moreover, output growth in the United States was not economically sustainable. With so much of US national income going to so few, growth could continue only through consumption financed by a mounting pile of debt. I was among those who hoped that, somehow, the financial crisis would teach Americans (and others) a lesson about the need for greater equality, stronger regulation, and a better balance between the market and government. Alas, that has not been the case. On the contrary, a resurgence of right-wing economics, driven, as always, by ideology and special interests, once again threatens the global economy- or at least the economies of Europe and America, where these ideas continue to flourish. In the US, this right-wing resurgence, whose adherents evidently seek to repeal the basic laws of math and economics, is threatening to force a default on the national debt. If Congress mandates expenditures that exceed revenues, there will be a deficit, and that deficit has to be financed. Rather than carefully balancing the benefits of each government expenditure program with the costs of raising taxes to finance those benefits, the right seeks to use a sledgehammer - not allowing the national debt to increase forces expenditures to be limited to taxes. This leaves open the question of which expenditures get priority - and if expenditures to pay interest on the national debt do not, a default is inevitable. Moreover, to cut back expenditures now, in the midst of an ongoing crisis brought on by free-market ideology, would inevitably simply prolong the downturn. A decade ago, in the midst of an economic boom, the US faced a surplus so large that it threatened to eliminate the national debt. Unaffordable tax cuts and wars, a major recession, and soaring health-care costs- fueled in part by the commitment of George W. Bush's administration to giving

drug companies free rein in setting prices, even with government money at stake - quickly transformed a huge surplus into record peacetime deficits. The remedies to the US deficit follow immediately from this diagnosis: put America back to work by stimulating the economy; end the mindless wars; rein in military and drug costs; and raise taxes, at least on the very rich. But the right will have none of this, and instead is pushing for even more tax cuts for corporations and the wealthy, together with expenditure cuts in investments and social protection that put the future of the US economy in peril and that shred what remains of the social contract. Meanwhile, the US financial sector has been lobbying hard to free itself of regulations, so that it can return to its previous, disastrously carefree, ways. But matters are little better in Europe. As Greece and others face crises, the medicine du jour is simply timeworn austerity packages and privatization, which will merely leave the countries that embrace them poorer and more vulnerable. This medicine failed in East Asia, Latin America, and elsewhere, and it will fail in Europe this time around, too. Indeed, it has already failed in Ireland, Latvia, and Greece. There is an alternative: an economic-growth strategy supported by the European Union and the International Monetary Fund. Growth would restore confidence that Greece could repay its debts, causing interest rates to fall and leaving more fiscal room for further growth-enhancing investments. Growth itself increases tax revenues and reduces the need for social expenditures, such as unemployment benefits. And the confidence that this engenders leads to still further growth. Regrettably, the financial markets and right-wing economists have gotten the problem exactly backwards: they believe that austerity produces confidence, and that confidence will produce growth. But austerity undermines growth, worsening the government's fiscal position, or at least yielding less improvement than austerity's advocates promise. On both counts, confidence is undermined, and a downward spiral is set in motion. Do we really need another costly experiment with ideas that have failed repeatedly? We shouldn't, but increasingly it appears that we will have to endure another one nonetheless. A failure of either Europe or the US to return to robust growth would be bad for the global economy. A failure in both would be disastrous - even if the major emerging-market countries have attained selfsustaining growth. Unfortunately, unless wiser heads prevail, that is the way the world is heading.

Joseph E. Stiglitz is University Professor at Columbia University, a Nobel laureate in economics, and the author ofFreefall: Free Markets and the Sinking of the Global Economy.

The New Mercantilist Challenge

By Dani Rodrik

January 9, 2013
CAMBRIDGE - The history of economics is largely a struggle between two opposing schools of thought, "liberalism" and "mercantilism." Economic liberalism, with its emphasis on private entrepreneurship and free markets, is today's dominant doctrine. But its intellectual victory has blinded us to the great appeal - and frequent success - of mercantilist practices. In fact, mercantilism remains alive and well, and its continuing conflict with liberalism is likely to be a major force shaping the future of the global economy. Today, mercantilism is typically dismissed as an archaic and blatantly erroneous set of ideas about economic policy. And, in their heyday, mercantilists certainly did defend some very odd notions, chief among which was the view that national policy ought to be guided by the accumulation of precious metals - gold and silver. Adam Smith's 1776 treatise The Wealth of Nations masterfully demolished many of these ideas. Smith showed, in particular, that money should not be confused for wealth. As he put it, "the wealth of a country consists, not in its gold and silver only, but in its lands, houses, and consumable goods of all different kinds." But it is more accurate to think of mercantilism as a different way to organize the relationship between the state and the economy - a vision that holds no less relevance today than it did in the eighteenth century. Mercantilist theorists such as Thomas Mun were in fact strong proponents of capitalism; they just propounded a different model than liberalism. The liberal model views the state as necessarily predatory and the private sector as inherently rentseeking. So it advocates a strict separation between the state and private business. Mercantilism, by contrast, offers a corporatist vision in which the state and private business are allies and cooperate in pursuit of common objectives, such as domestic economic growth or national power. The mercantilist model can be derided as state capitalism or cronyism. But when it works, as it has so often in Asia, the model's "government-business collaboration" or "pro-business state" quickly garners heavy praise. Lagging economies have not failed to notice that mercantilism can be their friend. Even in Britain, classical liberalism arrived only in the mid-nineteenth century - that is,

after the country had become the world's dominant industrial power.

A second difference between the two models lies in whether consumer or producer interests are privileged. For liberals, consumers are king. The ultimate objective of economic policy is to increase households' consumption potential, which requires giving them unhindered access to the cheapestpossible goods and services. Mercantilists, by contrast, emphasize the productive side of the economy. For them, a sound economy requires a sound production structure. And consumption needs to be underpinned by high employment at adequate wages. These different models have predictable implications for international economic policies. The logic of the liberal approach is that the economic benefits of trade arise from imports: the cheaper the imports, the better, even if the result is a trade deficit. Mercantilists, however, view trade as a means of supporting domestic production and employment, and prefer to spur exports rather than imports. Today's China is the leading bearer of the mercantilist torch, though Chinese leaders would never admit it- too much opprobrium still attaches to the term. Much of China's economic miracle is the product of an activist government that has supported, stimulated, and openly subsidized industrial producers - both domestic and foreign. Although China phased out many of its explicit export subsidies as a condition of membership in the World Trade Organization (which it joined in 200 1), mercantilism's support system remains largely in place. In particular, the government has managed the exchange rate to maintain manufacturers' profitability, resulting in a sizable trade surplus (which has come down recently, but largely as a result of an economic slowdown). Moreover, export-oriented firms continue to benefit from a range of tax incentives. From the liberal perspective, these export subsidies impoverish Chinese consumers while benefiting consumers in the rest of the world. A recent study by the economists Fabrice Defever and Alejandro Riaflo of the University of Nottingham puts the "losses" to China at around 3% of Chinese income, and gains to the rest of the world at around 1% of global income. From the mercantilist perspective, however, these are simply the costs of building a modern economy and setting the stage for long-term prosperity. As the example of export subsidies shows, the two models can co-exist happily in the world economy. Liberals should be happy to have their consumption subsidized by mercantilists. Indeed, that, in a nutshell, is the story of the last six decades: a succession of Asian countries managed to grow by leaps and bounds by applying different variants of mercantilism. Governments in rich countries for the most part looked the other way while Japan, South Korea, Taiwan, and China protected their home markets, appropriated "intellectual property," subsidized their producers, and managed their currencies.

We have now reached the end of this happy coexistence. The liberal model has become severely tarnished, owing to the rise in inequality and the plight of the middle class in the West, together with the financial crisis that deregulation spawned. Medium-term growth prospects for the American and European economies range from moderate to bleak. Unemployment will remain a major headache and preoccupation for policymakers. So mercantilist pressures will likely intensify in the advanced countries. As a result, the new economic environment will produce more tension than accommodation between countries pursuing liberal and mercantilist paths. It may also reignite long-dormant debates about the type of capitalism that produces the greatest prosperity.

Dani Rodrik, Professor of International Political Economy at Harvard University, is the author ofThe Globalization Paradox: Democracy and the Future of theW orld Economy.

A Contagion of Bad Ideas

By Joseph E. Stiglitz

August 5, 2011
NEW YORK- The Great Recession of 2008 has morphed into the North Atlantic Recession: it is mainly Europe and the United States, not the major emerging markets, that have become mired in slow growth and high unemployment. And it is Europe and America that are marching, alone and together, to the denouement of a grand debacle. A busted bubble led to a massive Keynesian stimulus that averted a much deeper recession, but that also fueled substantial budget deficits. The response - massive spending cuts - ensures that unacceptably high levels of unemployment (a vast waste of resources and an oversupply of suffering) will continue, possibly for years. The European Union has finally committed itself to helping its financially distressed members. It had no choice: with financial turmoil threatening to spread from small countries like Greece and Ireland to large ones like Italy and Spain, the euro's very survival was in growing jeopardy. Europe's leaders recognized that distressed countries' debts would become unmanageable unless their economies could grow, and that growth could not be achieved without assistance. But, even as Europe's leaders promised that help was on the way, they doubled down on the belief that non-crisis countries must cut spending. The resulting austerity will hinder Europe's growth, and thus that of its most distressed economies: after all, nothing would help Greece more than robust growth in its trading partners. And low growth will hurt tax revenues, undermining the proclaimed goal of fiscal consolidation. The discussions before the crisis illustrated how little had been done to repair economic fundamentals. The European Central Bank's vehement opposition to what is essential to all capitalist economies - the restructuring of failed or insolvent entities' debt - is evidence of the continuing fragility of the Western banking system. The ECB argued that taxpayers should pick up the entire tab for Greece's bad sovereign debt, for fear that any private-sector involvement (PSI) would trigger a "credit event," which would force large payouts on credit-default swaps (CDSs), possibly fueling further financial turmoil. But, if that is a real fear for the ECB - if it is not merely acting on behalf of private lenders - surely it should have demanded that the banks have more capital. Likewise, the ECB should have barred banks from the risky CDS market, where they are held hostage to ratings agencies' decisions about what constitutes a "credit event." Indeed, one positive

achievement by European leaders at the recent Brussels summit was to begin the process of reining in both the ECB and the power of the American ratings agencies. Indeed, the most curious aspect of the ECB's position was its threat not to accept restructured government bonds as collateral if the ratings agencies decided that the restructuring should be classified as a credit event. The whole point of restructuring was to discharge debt and make the remainder more manageable. If the bonds were acceptable as collateral before the restructuring, surely they were safer after the restructuring, and thus equally acceptable. This episode serves as a reminder that central banks are political institutions, with a political agenda, and that independent central banks tend to be captured (at least "cognitively") by the banks that they are supposed to regulate. And matters are little better on the other side of the Atlantic. There, the extreme right threatened to shut down the US government, confirming what game theory suggests: when those who are irrationally committed to destruction if they don't get their way confront rational individuals, the former prevail. As a result, President Barack Obama acquiesced in an unbalanced debt-reduction strategy, with no tax increases -not even for the millionaires who have done so well during the past two decades, and not even by eliminating tax giveaways to oil companies, which undermine economic efficiency and contribute to environmental degradation. Optimists argue that the short run macroeconomic impact of the deal to raise America's debt ceiling and prevent sovereign default will be limited - roughly $25 billion in expenditure cuts in the coming year. But the payroll-tax cut (which put more than $100 billion into the pockets of ordinary Americans) was not renewed, and surely business, anticipating the contractionary effects down the line, will be even more reluctant to lend. The end of the stimulus itself is contractionary. And, with housing prices continuing to fall, GDP growth faltering, and unemployment remaining stubbornly high (one of six Americans who would like a full-time job still cannot get one), more stimulus, not austerity, is needed - for the sake of balancing the budget as well. The single most important driver of deficit growth is weak tax revenues, owing to poor economic performance; the single best remedy would be to put America back to work. The recent debt deal is a move in the wrong direction. There has been much concern about financial contagion between Europe and America. After all, America's financial mismanagement played an important role in triggering Europe's problems, and financial turmoil in Europe would not be good for the US - especially given the fragility of the US banking system and the continuing role it plays in non-transparent CDSs.

But the real problem stems from another form of contagion: bad ideas move easily across borders, and misguided economic notions on both sides of the Atlantic have been reinforcing each other. The same will be true of the stagnation that those policies bring.

Joseph E. Stiglitz is University Professor at Columbia University, a Nobel laureate in economics, and the author ofFreefall: Free Markets and the Sinking of the Global Economy.

Mercantilism Reconsidered
By Dani Rodrik

July 10, 2009

CAMBRIDGE- A businessman walks into a government minister's office and says he needs help. What should the minister do? Invite him in for a cup of coffee and ask how the government can be of help? Or throw him out, on the principle that government should not be handing out favors to business? This question constitutes a Rorschach test for policymakers and economists. On one side are freemarket enthusiasts and neo-classical economists, who believe in a stark separation between state and business. In their view, the government's role is to establish clear rules and regulations and then let businesses sink or swim on their own. Public officials should hold private interests at arm's length and never cozy up to them. It is consumers, not producers, who are king. This view reflects a venerable tradition that goes back to Adam Smith and continues a proud existence in today's economics textbooks. It is also the dominant perspective of governance in the United States, Britain, and other societies organized along Anglo-American lines - even though actual practice often deviates from idealized principles. On the other side are what we may call corporatists or neo-mercantilists, who view an alliance between government and business as critical to good economic performance and social harmony. In this model, the economy needs a state that eagerly lends an ear to business, and, when necessary, greases the wheels of commerce by providing incentives, subsidies, and other discretionary benefits. Because investment and job creation ensure economic prosperity, the objective of government policy should be to make producers happy. Rigid rules and distant policymakers merely suffocate the animal spirits of the business class. This view reflects an even older tradition that goes back to the mercantilist practices of the seventeenth century. Mercantilists believed in an active economic role for the state - to promote exports, discourage finished imports, and establish trade monopolies that would enrich business and the crown alike. This idea survives today in the practices of Asian export superpowers (most notably China). Adam Smith and his followers decisively won the intellectual battle between these two models of capitalism. But the facts on the ground tell a more ambiguous story.

The growth champions of the past few decades- Japan in the 1950's and 1960's, South Korea from the 1960's to the 1980's, and China since the early 1980's - have all had activist governments collaborating closely with large business. All aggressively promoted investment and exports while discouraging (or remaining agnostic about) imports. China's pursuit of a high-saving, large-tradesurplus economy in recent years embodies mercantilist teachings. Early mercantilism deserves a rethink too. It is doubtful that the great expansion of intercontinental trade in the sixteenth and seventeenth centuries would have been possible without the incentives that states provided, such as monopoly charters. As many economic historians argue, the trade networks and profits that mercantilism provided for Britain may have been critical in launching the country's industrial revolution around the middle of the eighteenth century. None of this is to idealize mercantilist practices, whose harmful effects are easy to see. Governments can too easily end up in the pockets of business, resulting in cronyism and rent-seeking instead of economic growth. Even when initially successful, government intervention in favor of business can outlive its usefulness and become ossified. The pursuit of trade surpluses inevitably triggers conflicts with trade partners, and the effectiveness of mercantilist policies depends in part on the absence of similar policies elsewhere. Moreover, unilateral mercantilism is no guarantee of success. The Chinese-US trade relationship may have seemed like a marriage made in heaven -between practitioners of the mercantilist and liberal models, respectively- but in hindsight it is clear that it merely led to a blowup. As a result, China will have to make important changes to its economic strategy, a necessity for which it has yet to prepare itself. Nonetheless, the mercantilist mindset provides policymakers with some important advantages: better feedback about the constraints and opportunities that private economic activity faces, and the ability to create a sense of national purpose around economic goals. There is much that liberals can learn from it. Indeed, the inability to see the advantages of close state-business relations is the blind spot of modern economic liberalism. Just look at how the search for the causes of the financial crisis has played out in the US. Current conventional wisdom places the blame squarely on the close ties that developed between policymakers and the financial industry in recent decades. For textbook liberals, the state should have kept its distance, acting purely as Platonic guardians of consumer sovereignty. But the problem is not that government listened too much to Wall Street; rather, the problem is that it didn't listen enough to Main Street, where the real producers and innovators were. That is how untested economic theories about efficient markets and self-regulation could substitute for common sense, enabling financial interests to gain hegemony, while leaving everyone else, including governments, to pick up the pieces.

Dani Rodrik, Professor of Political Economy at Harvard University's John F. Kennedy School of Government, is the first recipient of the Social Science Research Council's Albert 0. Hirschman Prize. His latest book is One Economics, Many Recipes: Globalization,
Institutions, and Economic Growth.

Is Chinese Mercantilism Good or Bad for Poor Countries?

By Dani Rodrik

September 9, 2010
CAMBRIDGE - China's trade balance is on course for another bumper surplus this year. Meanwhile, concern about the health of the US recovery continues to mount. Both developments suggest that China will be under renewed pressure to nudge its currency sharply upward. The conflict with the US may well come to a head during Congressional hearings on the renminbi to be held in September, where many voices will urge the Obama administration to threaten punitive measures if China does not act. Discussion of China's currency focuses around the need to shrink the country's trade surplus and correct global macroeconomic imbalances. With a less competitive currency, many analysts hope, China will export less and import more, making a positive contribution to the recovery of the US and other economies. In all this discussion, the renminbi is viewed largely as a US-China issue, and the interests of poor countries get scarcely a hearing, even in multilateral fora. Yet a noticeable rise in the renminbi's value may have significant implications for developing countries. Whether they stand to gain or lose from a renminbi revaluation, however, is hotly contested. On one side stands Arvind Subramanian, from the Peterson Institute and the Center for Global Development. He argues that developing countries have suffered greatly from China's policy of undervaluing its currency, which has made it more difficult for them to compete with Chinese goods in world markets, retarded their industrialization, and set back their growth. If the renminbi were to gain in value, poor countries' exports would become more competitive, and their economies would become better positioned to reap the benefits of globalization. Hence, Subramanian argues, poor countries must make common cause with the US and other advanced economies in pressuring China to alter its currency policies. On the other side stand Helmut Reisen and his colleagues at the OECD's Development Centre, who conclude that developing countries, and especially the poorest among them, would be hurt if the renminbi were to rise sharply. Their reasoning is that currency appreciation would almost certainly slow China's growth, and that anything does that must be bad news for other poor countries as well.

They buttress their argument with empirical work that suggests that growth in developing countries has become progressively more dependent on China's economic performance. They estimate that a slowdown of one percentage point in China's annual growth rate would reduce lowincome countries growth rates by 0.3 percentage points - almost a third as much. To make sense of these two contrasting perspectives, we need to step back and consider the fundamental drivers of growth. Strip away the technicalities, and the debate boils down to one fundamental question: what is the best, most sustainable growth model for low-income countries? Historically, poor regions of the world have often relied on what is called a "vent-for-surplus" model. This model entails exporting to other parts of the world primary products and natural resources such as agricultural produce or minerals. This is how Argentina grew rich in the nineteenth century, and how oil states have become wealthy during the last 40 years. The rapid growth that many developing countries experienced prior to the crisis was largely the result of the same model. Countries in Sub-Saharan Africa, in particular, were propelled forward by the growing demand for their natural resources from other countries - China chief among them. But this model suffers from two fatal weaknesses. First, it depends heavily on rapid growth in foreign demand. When such demand falters, developing countries find themselves with collapsing export prices, and, too often, a protracted domestic crisis. Second, it does not stimulate economic diversification. Economies hooked on this model find themselves excessively specialized in primary products that promise little productivity growth. Indeed, the central challenge of economic development is not foreign demand, but domestic structural change. The problem for poor countries is that they are not producing the right kinds of goods. They need to restructure away from traditional primary products to higher-productivity activities, mainly manufactures and modern services. The real exchange rate is of paramount importance here, as it determines the competitiveness and profitability of modern tradable activities. When developing nations are forced into overvalued currencies, entrepreneurship and investment in those activities are depressed. From this perspective, China's currency policies not only undercut the competitiveness of African and other poor regions' industries; they also undermine those regions' fundamental growth engines. What poor nations get out of Chinese mercantilism is, at best, temporary growth of the wrong kind. Lest we blame China too much, though, we should remember that there is little that prevents developing countries from replicating the essentials of the Chinese model. They, too, could have used their exchange rates more actively in order to stimulate industrialization and growth. True, all

countries in the world cannot simultaneously undervalue their currencies. But poor nations could have shifted the "burden" onto rich countries, where, economic logic suggests, it ought to be placed. Instead, too many developing countries have allowed their currencies to become overvalued, relying on booming commodity demand or financial inflows. And they have made little systematic use of explicit industrial policies that could act as a substitute for undervaluation. Given this, perhaps we should not hold China responsible for taking care of its own economic interests, even if it has aggravated in the process the costs of other countries' misguided currency policies.

Dani Rodrik is Professor of Political Economy at Harvard University's John F. Kennedy School of Government and the author of One Economics, Many Recipes: Globalization,
Institutions, and Economic Growth.

Is State Capitalism Winning?

By Daron Acemoglu and James A. Robinson

December 31, 2012

CAMBRIDGE- In the age-old contest of economic-growth models, state capitalism has seemed to be gaining the upper hand in recent years. Avatars of liberal capitalism like the United States and the United Kingdom continued to perform anemically in 2012, while many Asian countries, relying on various versions of dirigisme, have not only grown rapidly and steadily over the last several decades, but have also weathered recent economic storms with surprising grace. So, is it time to update the economics textbooks? In fact, economics does not say that unfettered markets are better than state intervention or even state capitalism. The problems with state capitalism are primarily political, not economic. Any realworld economy is riddled with market failures, so a benevolent and omnipotent government could sensibly intervene quite often. But who has ever met a benevolent or omnipotent government? To understand the logic of state capitalism, it is useful to recall some early examples - not the socialist command economies or modern societies seeking to combat market failures, but ancient civilizations. Indeed, it seems that, like farming or democracy, state capitalism has been independently invented many times in world history. Consider the Greek Bronze Age, during which many powerful states, organized around a city housing the political elite, formed throughout the Mediterranean basin. These states had no money and essentially no markets. The state taxed agricultural output and controlled nearly all goods production. It monopolized trade, and, in the absence of money, moved all of the goods around by fiat. It supplied food and inputs to weavers and then took their output. In essence, the Greek Bronze Age societies had something that looked remarkably like state capitalism. So did the Incas as they built their huge Andean empire in the century before the Spanish arrived. They, too, had no money (or writing); but the state conducted decennial censuses, built roughly 25,000 miles (40,000 kilometers) of roads, operated a system of runners to send messages and collect information, and recorded it all using knotted strings called quipus, most of which cannot be read today. All of this was part of their control of land and labor, based on centrally planned allocation of resources and coercion. How is it that societies as disparate as the Greek Bronze Age cities of Knossos, Mycenae, or Pylos, the Inca Empire, Soviet Russia, South Korea, and now China all ended up with state capitalism?

The answer lies in recognizing that state capitalism is not about efficient allocation of economic resources, but about maximizing political control over society and the economy. If state managers can grab all productive resources and control access to them, this maximizes control - even if it sacrifices economic efficiency. To be sure, in many parts of the world, state capitalism has helped to consolidate states and centralize authority - preconditions for the development of modern societies and economies. But political control of the economy generally becomes problematic, because those running the state do not have social welfare or optimal resource allocation in mind. The state capitalism of the Greek Bronze Age or the Inca Empire was not motivated by economic inefficiency; nor did it necessarily create a more efficient economy. What it did was help to consolidate political power. At a deeper level, the real dichotomy is not between state capitalism and unfettered markets; it is between extractive and inclusive economic institutions. Extractive institutions create a non-level playing field, rents, and narrowly concentrated benefits for those with political power and connections. Inclusive institutions create a level playing field and give incentives and opportunities to the great mass of people. But herein lies the problem for state capitalism: inclusive institutions require a private sector powerful enough to counterbalance and check the state. Thus, state ownership tends naturally to remove one of the key pillars of an inclusive society. It should be no surprise that state capitalism is almost always associated with authoritarian regimes and extractive political institutions. This is not an endorsement of unfettered markets. The state plays a central role in modern society, and rightly so. Modern economic growth, even under inclusive institutions, often creates deep inequalities and tilted playing fields, endangering those institutions' very survival. The modern regulatory and redistributive state can, within certain bounds, help to redress these problems. But the success of such a project crucially depends on society having control over the state - not the other way around. To argue that state capitalism's success proves its superiority is to put the cart before the horse. Yes, South Korea grew rapidly under state capitalism, and China is doing likewise today. But state capitalism emerged not because there was no other way to ensure economic growth in these countries, but because it enabled growth without destabilizing the existing power structure. The genius of China's state capitalism is that it ensured the continued dominance of Communist Party elites while improving the allocation of resources, not that it alone could have provided price incentives to farmers and then managed liberalization of urban markets. State capitalism will persist so long as existing elites are able to maintain it and benefit from it even if economic growth ultimately stalls. And there is a good reason why it eventually will. Sustained economic growth presupposes inclusive institutions, because innovation - and the creative destruction and instability that it wreaks - depends on them. Extractive institutions in

general, and state capitalism in particular, can support economic growth for a while, but only the sort of catch-up growth that South Korea experienced from the 1960's to the 1980's, before starting to transform its society and economy more radically. As the low hanging fruit from catch-up growth is consumed, China, too, will be forced to choose between the economic and social freedom, innovation, and instability that only inclusive institutions can underpin and continued economic, political, and social control in the service of the elites who control the state.

Daron Acemoglu, a professor of economics at MIT, and James A. Robinson, a professor of government at Harvard University, are co-authors ofWhy Nations Fail: The Origins of Power,
Prosperity, and Poverty.

The Price of Inequality

By Joseph E. Stiglitz

June 5, 2012
NEW YORK- America likes to think of itself as a land of opportunity, and others view it in much the same light. But, while we can all think of examples of Americans who rose to the top on their own, what really matters are the statistics: to what extent do an individual's life chances depend on the income and education of his or her parents? Nowadays, these numbers show that the American dream is a myth. There is less equality of opportunity in the United States today than there is in Europe - or, indeed, in any advanced industrial country for which there are data. This is one of the reasons that America has the highest level of inequality of any of the advanced countries- and its gap with the rest has been widening. In the "recovery" of 2009-2010, the top 1% of US income earners captured 93% of the income growth. Other inequality indicators - like wealth, health, and life expectancy - are as bad or even worse. The clear trend is one of concentration of income and wealth at the top, the hollowing out of the middle, and increasing poverty at the bottom.
It would be one thing if the high incomes of those at the top were the result of greater contributions

to society, but the Great Recession showed otherwise: even bankers who had led the global economy, as well as their own firms, to the brink of ruin, received outsize bonuses. A closer look at those at the top reveals a disproportionate role for rent-seeking: some have obtained their wealth by exercising monopoly power; others are CEOs who have taken advantage of deficiencies in corporate governance to extract for themselves an excessive share of corporate earnings; and still others have used political connections to benefit from government munificenceeither excessively high prices for what the government buys (drugs), or excessively low prices for what the government sells (mineral rights). Likewise, part of the wealth of those in finance comes from exploiting the poor, through predatory lending and abusive credit-card practices. Those at the top, in such cases, are enriched at the direct expense of those at the bottom.
It might not be so bad if there were even a grain of truth to trickle-down economics - the quaint

notion that everyone benefits from enriching those at the top. But most Americans today are worse

off- with lower real (inflation-adjusted) incomes- than they were in 1997, a decade and a half ago. All of the benefits of growth have gone to the top. Defenders of America's inequality argue that the poor and those in the middle shouldn't complain. While they may be getting a smaller share of the pie than they did in the past, the pie is growing so much, thanks to the contributions of the rich and superrich, that the size of their slice is actually larger. The evidence, again, flatly contradicts this. Indeed, America grew far faster in the decades after World War II, when it was growing together, than it has since 1980, when it began growing apart. This shouldn't come as a surprise, once one understands the sources of inequality. Rent-seeking distorts the economy. Market forces, of course, play a role, too, but markets are shaped by politics; and, in America, with its quasi-corrupt system of campaign finance and its revolving doors between government and industry, politics is shaped by money. For example, a bankruptcy law that privileges derivatives over all else, but does not allow the discharge of student debt, no matter how inadequate the education provided, enriches bankers and impoverishes many at the bottom. In a country where money trumps democracy, such legislation has become predictably frequent. But growing inequality is not inevitable. There are market economies that are doing better, both in terms of both GDP growth and rising living standards for most citizens. Some are even reducing inequalities. America is paying a high price for continuing in the opposite direction. Inequality leads to lower growth and less efficiency. Lack of opportunity means that its most valuable asset - its people - is not being fully used. Many at the bottom, or even in the middle, are not living up to their potential, because the rich, needing few public services and worried that a strong government might redistribute income, use their political influence to cut taxes and curtail government spending. This leads to underinvestment in infrastructure, education, and technology, impeding the engines of growth. The Great Recession has exacerbated inequality, with cutbacks in basic social expenditures and with high unemployment putting downward pressure on wages. Moreover, the United Nations

Commission of Experts on Reforms of the International Monetary and Financial System,

investigating the causes of the Great Recession, and the International Monetary Fund have both warned that inequality leads to economic instability. But, most importantly, America's inequality is undermining its values and identity. With inequality reaching such extremes, it is not surprising that its effects are manifest in every public decision, from the conduct of monetary policy to budgetary allocations. America has become a country not "with justice for all," but rather with favoritism for the rich and justice for those who can afford it -

so evident in the foreclosure crisis, in which the big banks believed that they were too big not only to fail, but also to be held accountable. America can no longer regard itself as the land of opportunity that it once was. But it does not have to be this way: it is not too late for the American dream to be restored.

Joseph E. Stiglitz, a Nobel/aureate in Economics, is Professor of Economics at Columbia University. His latest book is The Price of Inequality: How Today's Divided Society Endangers our
Future.

Balancing the State and the Market

By Josef Ackermann

April 30, 2010

BERLIN- The financial and economic crisis that erupted in 2008 will, in retrospect, be regarded as a transformative moment, because it raised fundamental questions about the future shape of our economic systems. These questions are not so much about the end of capitalism- as some perceive or even desire- but rather about the different ways in which capitalism is understood in different countries. What we are witnessing today is a reversal of the debates of the 1980's. Back then, Ronald Reagan used to joke: "The nine most terrifying words in the English language are: I'm from the government and I'm here to help!" Now that governments have spent trillions of dollars, euros, yen, and pounds on stabilizing financial markets and the economy in general, those words seem far less terrifying. In fact, faith in the market has been dented, while trust in government and regulation is increasing. After decades of consensus that the state should set the rules and otherwise leave the private sector alone, the state is now widely seen as a beneficial force that should play an active role in the economy. This is happening despite the lack of a clear indication of the superiority of the state. On the contrary, the US government's heavy intervention in the American housing market is probably the most pertinent example of the state's shortcomings, one that no doubt contributed significantly to the crisis. I sense a growing willingness to forego the benefits of innovation - not least financial innovation in exchange for a slower pace of change, which is assumed to be more controllable. This shift will not only impede future growth, but could bring other dangers as well. The first dangeris that the state overextends itself. The fiscal balances of the G- 20 economies will deteriorate dramatically as a result of the crisis. Deficits will improve somewhat as economies recover and support measures are withdrawn. But not all of the measures are temporary or economically reasonable. Most governments have used their stimulus packages to serve vested interests as well. The accumulated debt will constitute a lasting burden on public finances.

Moreover, we must remember that budgets were already strained before the crisis, and that governments' balances do not reflect all aspects of reality. In Germany, for example, overall debt jumps from the current 65% of GDP to 250% when pension liabilities are included. Interest payments account for an ever-larger share of budgets - and will continue to grow when interest rates start to rise again. In the absence of strong political commitment and credible plans for gradual fiscal consolidation, there is a distinct risk that at some point sovereign yields will rise markedly - with negative implications for the economy and politics. The second dangeris that governments will continue to see it as their duty to decide which firms to save and which to let fail. A line must be drawn between a time of crisis, when emergency measures are needed to avert economic collapse, and normal circumstances, in which the full force of market mechanisms applies. The instinct of governments, however, may be to revert to the idea of protecting national champions or reasserting national sovereignty in some sectors. But instinct is not necessarily a sound basis for decision-making. And in times of globalization, distinguishing between "national" and "foreign" is neither appropriate nor feasible. In order to preserve the state's ability to act while avoiding competitive distortions between and within industries, we should establish criteria to guide future decisions in this area. As a matter of principle, companies that were in trouble prior to a severe economic crisis should not be eligible for state assistance of the type that the world recently witnessed. Moreover, aid must be limited, lest firms become addicted to it. Governments should also be aware of the long-term costs: large-scale state interference in market processes will produce its own set of corporate winners and losers. Structural change may be delayed, depriving us of the opportunities offered by the crisis to build more competitive and dynamic industries - and accelerating the relative global decline of mature economies. Indeed, the third dangeris that greater state intervention in the economy entails a shift away from globalization, paving the way for various forms of national protectionism. We can see this in the financial industry, where increased state ownership has led to a distinct danger of re-nationalization and re-fragmentation of financial markets. Many financial institutions that received government funds have concentrated on their respective home markets and scaled back their activities abroad. Similarly, there is a risk that new regulation may, either deliberately or as an unintended side effect, lead to re-nationalization of markets.
It is understandable that governments seek solace in the presumed safety of national markets. But

the shelter that national markets provide is illusory: the only way to increase the resilience of financial markets and to ensure that recurrence of this kind of crisis becomes less likely is to build a regulatory framework that is commensurate with integrated markets. We need global (or at least

European) rules, and we need strong institutional structures to enforce these rules- a requirement that is not necessarily limited to the financial markets. We must resist the temptation to believe that a meddling, paternalistic state is the way of the future. Not only business, but also society as a whole, would lose out if we moved in that direction. Or, as has been said by many: "A government big enough to give you everything you want is strong enough to take everything you have."

This text is an abridgment of a keynote address given at a Berlin conference on post-crisis economic policies, hosted by the Center on Capitalism and Society, Columbia University, 11-12 December 2009.

Josef Ackermann is Chairman of the Management Board and Group Executive Committee of Deutsche Bank and Chairman of the Board of Directors of the Institute for International Finance (IIF).

Coming Soon: Capitalism 3.0

By Dani Rodrik

February 11, 2009

CAMBRIDGE - Capitalism is in the throes of its most severe crisis in many decades. A combination of deep recession, global economic dislocations, and effective nationalization of large swathes of the financial sector in the world's advanced economies has deeply unsettled the balance between markets and states. Where the new balance will be struck is anybody's guess. Those who predict capitalism's demise have to contend with one important historical fact: capitalism has an almost unlimited capacity to reinvent itself. Indeed, its malleability is the reason it has overcome periodic crises over the centuries and outlived critics from Karl Marx on. The real question is not whether capitalism can survive - it can - but whether world leaders will demonstrate the leadership needed to take it to its next phase as we emerge from our current predicament. Capitalism has no equal when it comes to unleashing the collective economic energies of human societies. That is why all prosperous societies are capitalistic in the broad sense of the term: they are organized around private property and allow markets to play a large role in allocating resources and determining economic rewards. The catch is that neither property rights nor markets can function on their own. They require other social institutions to support them. So property rights rely on courts and legal enforcement, and markets depend on regulators to rein in abuse and fix market failures. At the political level, capitalism requires compensation and transfer mechanisms to render its outcomes acceptable. As the current crisis has demonstrated yet again, capitalism needs stabilizing arrangements such as a lender of last resort and counter-cyclical fiscal policy. In other words, capitalism is not self-creating, self-sustaining, self-regulating, or selfstabilizing. The history of capitalism has been a process of learning and re-learning these lessons. Adam Smith's idealized market society required little more than a "night-watchman state." All that governments needed to do to ensure the division of labor was to enforce property rights, keep the peace, and collect a few taxes to pay for a limited range of public goods. Through the early part of the twentieth century, capitalism was governed by a narrow vision of the public institutions needed to uphold it. In practice, the state's reach often went beyond this

conception (as, say, in the case of Bismarck's introduction of old-age pensions in Germany in 1889). But governments continued to see their economic roles in restricted terms. This began to change as societies became more democratic and labor unions and other groups mobilized against capitalism's perceived abuses. Anti-trust policies were spearheaded in the Unites States. The usefulness of activist monetary and fiscal policies became widely accepted in the aftermath of the Great Depression. The share of public spending in national income rose rapidly in today's industrialized countries, from below 10% on average at the end of the nineteenth century to more than 20% just before World War II. And, in the wake ofWWII, most countries erected elaborate social-welfare states in which the public sector expanded to more than 40% of national income on average. This "mixed-economy'' model was the crowning achievement of the twentieth century. The new balance that it established between state and market set the stage for an unprecedented period of social cohesion, stability, and prosperity in the advanced economies that lasted until the mid-1970's. This model became frayed from the 1980's on, and now appears to have broken down. The reason can be expressed in one word: globalization. The postwar mixed economy was built for and operated at the level of nation-states, and required keeping the international economy at bay. The Bretton W oods-GA TT regime entailed a "shallow" form of international economic integration that implied controls on international capital flows, which Keynes and his contemporaries had viewed as crucial for domestic economic management. Countries were required to undertake only limited trade liberalization, with plenty of exceptions for socially sensitive sectors (agriculture, textiles, services). This left them free to build their own versions of national capitalism, as long as they obeyed a few simple international rules. The current crisis shows how far we have come from that model. Financial globalization, in particular, played havoc with the old rules. When Chinese-style capitalism met American-style capitalism, with few safety valves in place, it gave rise to an explosive mix. There were no protective mechanisms to prevent a global liquidity glut from developing, and then, in combination with US regulatory failings, from producing a spectacular housing boom and crash. Nor were there any international roadblocks to prevent the crisis from spreading from its epicenter. The lesson is not that capitalism is dead. It is that we need to reinvent it for a new century in which the forces of economic globalization are much more powerful than before. Just as Smith's minimal capitalism was transformed into Keynes' mixed economy, we need to contemplate a transition from the national version of the mixed economy to its global counterpart. This means imagining a better balance between markets and their supporting institutions at the

global level. Sometimes, this will require extending institutions outward from nation states and
strengthening global governance. At other times, it will mean preventing markets from expanding

beyond the reach of institutions that must remain national. The right approach will differ across country groupings and among issue areas. Designing the next capitalism will not be easy. But we do have history on our side: capitalism's saving grace is that it is almost infinitely malleable.

Dani Rodrik, Professor of Political Economy at Harvard University's John F. Kennedy School of Government, is the first recipient of the Social Science Research Council's Albert 0. Hirschman Prize. His latest book is One Economics, Many Recipes: Globalization,
Institutions, and Economic Growth.

Blaming Capitalism for Corporatism

By Saifedean Ammous and Edmund Phelps

January 31, 2012

NEW YORK - The future of capitalism is again a question. Will it survive the ongoing crisis in its current form? If not, will it transform itself or will government take the lead? The term "capitalism" used to mean an economic system in which capital was privately owned and traded; owners of capital got to judge how best to use it, and could draw on the foresight and creative ideas of entrepreneurs and innovative thinkers. This system of individual freedom and individual responsibility gave little scope for government to influence economic decision-making: success meant profits; failure meant losses. Corporations could exist only as long as free individuals willingly purchased their goods - and would go out of business quickly otherwise. Capitalism became a world-beater in the 1800's, when it developed capabilities for endemic innovation. Societies that adopted the capitalist system gained unrivaled prosperity, enjoyed widespread job satisfaction, obtained productivity growth that was the marvel of the world and ended mass privation. Now the capitalist system has been corrupted. The managerial state has assumed responsibility for looking after everything from the incomes of the middle class to the profitability of large corporations to industrial advancement. This system, however, is not capitalism, but rather an economic order that harks back to Bismarck in the late nineteenth century and Mussolini in the twentieth: corporatism. In various ways, corporatism chokes off the dynamism that makes for engaging work, faster economic growth, and greater opportunity and inclusiveness. It maintains lethargic, wasteful, unproductive, and well-connected firms at the expense of dynamic newcomers and outsiders, and favors declared goals such as industrialization, economic development, and national greatness over individuals' economic freedom and responsibility. Today, airlines, auto manufacturers, agricultural companies, media, investment banks, hedge funds, and much more has at some point been deemed too important to weather the free market on its own, receiving a helping hand from government in the name of the "public good." The costs of corporatism are visible all around us: dysfunctional corporations that survive despite their gross inability to serve their customers; sclerotic economies with slow output growth, a dearth of engaging work, scant opportunities for young people; governments bankrupted by their efforts

to palliate these problems; and increasing concentration of wealth in the hands of those connected enough to be on the right side of the corporatist deal. This shift of power from owners and innovators to state officials is the antithesis of capitalism. Yet this system's apologists and beneficiaries have the temerity to blame all these failures on "reckless capitalism" and "lack of regulation," which they argue necessitates more oversight and regulation, which in reality means more corporatism and state favoritism.
It seems unlikely that so disastrous a system is sustainable. The corporatist model makes no sense to

younger generations who grew up using the Internet, the world's freest market for goods and ideas. The success and failure of firms on the Internet is the best advertisement for the free market: social networking Web sites, for example, rise and fall almost instantaneously, depending on how well they serve their customers. Sites such as Friendster and MySpace sought extra profit by compromising the privacy of their users, and were instantly punished as users deserted them to relatively safer competitors like Facebook and Twitter. There was no need for government regulation to bring about this transition; in fact, had modern corporatist states attempted to do so, today they would be propping up MySpace with taxpayer dollars and campaigning on a promise to "reform" its privacy features. The Internet, as a largely free marketplace for ideas, has not been kind to corporatism. People who grew up with its decentralization and free competition of ideas must find alien the idea of state support for large firms and industries. Many in the traditional media repeat the old line "What's good for Firm X is good for America," but it is not likely to be seen trending on Twitter. The legitimacy of corporatism is eroding along with the fiscal health of governments that have relied on it. If politicians cannot repeal corporatism, it will bury itself in debt and default, and a capitalist system could re-emerge from the discredited corporatist rubble. Then "capitalism" would again carry its true meaning, rather than the one attributed to it by corporatists seeking to hide behind it and socialists wanting to vilify it.

Saifedean Ammous is a professor of economics at the Lebanese American University and Foreign Member of Columbia University's Center for Capitalism and Society. Edmund Phelps, the 2006 Nobel laureate in economics, is Director of the Center.

Giving the Well-Performing State Its Due

By Ana Palacio

May9, 2012
MADRID - The triumph of democracy and market-based economics -the "End of History," as the American political philosopher Francis Fukuyama famously called it- which was proclaimed to be inevitable with the fall of the Berlin Wall, soon proved to be little more than a mirage. However, following China's intellectual pirouette to maintain one-party rule while embracing the capitalist credo, history's interpreters shifted their focus to the economy: not everybody would be free and elect their government, but capitalist prosperity would hold sway worldwide. Now, however, the economic tumult shaking Europe, the erosion of the middle class in the West, and the growing social inequalities worldwide are undermining capitalism's claim to universal triumph. Hard questions are being asked: Is capitalism as we know it doomed? Is the market no longer able to generate prosperity? Is China's brand of state capitalism an alternative and potentially victorious paradigm? The pervasive soul-searching prompted by such questions has nurtured a growing recognition that capitalism's success depends not only on macroeconomic policy or economic indicators. It rests on a bedrock of good governance and the rule of law- in other words, a well-performing state. The West overlooked the fundamental importance of this while it was fighting communism. The standard bearers of the Cold War were not just the United States and the Soviet Union, but, in ideological terms, the individual and the collectivity. When competing in newly independent or developing countries, this ideological opposition became Manichean, fostering a fierce suspicion, if not outright rejection, of rival principles. As a result, strengthening state institutions was too often seen in the West as communist subterfuge, while the Soviet bloc viewed the slightest notion of individual freedom and responsibility as a stalking horse for capitalist counter-revolution. Leading economists have long argued that the West's greater reliance on markets resulted in faster and more robust economic growth. But viewing the state and the market in terms of their inherent conflict no longer reflects reality (if it ever did). Indeed, it is increasingly obvious that the threat to capitalism today emanates not from the state's presence, but rather from its absence or inadequate performance. Consider recent events in Argentina, which is facing certain economic losses as anxious investors have second thoughts about the country in the aftermath of the government's nationalization of

energy giant YPF. That response is only logical, as investors seek the security of a well-functioning legal system to protect them from capricious political decisions. Mexico provides further proof that the market alone is not enough. An efficient judiciary and effective policing are necessary for capitalism to thrive. In Brazil, the government is daring, for the first time, to address the lawlessness of the overcrowded favelas that ring the country's large cities. Or consider Ghana's prosperity and how, like Brazil's, it is going hand in hand with improved governance. At the opposite extreme, Venezuelan President Hugo Chavez's undermining of his country's institutions, prodding it onto a narco-state trajectory, places Venezuela alongside Haiti as an exception to Latin America's recent economic success. More generally, the world's thriving countries are those with strong and effective institutions, backed by legal frameworks that guarantee the rule of law. Latin America and Africa are not the only examples that prove the point. The European Union's internal problems, and its ongoing sovereign-debt crisis, are clearly linked to the weakness of its institutions, and, on Europe's periphery, it still confronts feckless democracies. Indeed, on Europe's doorstep, the show trial and imprisonment of former Ukrainian Prime Minister Yulia Tymoshenko is jeopardizing her country's international economic standing. In particular, President Viktor Yanukovich's contempt for the rule of law has put Ukraine's relations with the European Union in cold storage, with a comprehensive free-trade and association agreement on hold pending the release of Tymoshenko and other political prisoners. Meanwhile, political trials in Egypt are attracting international attention and deterring foreign investment. In Asia, China is exposing the fallacy of looking at state capitalism as a competing alternative to liberal capitalism. Approaching them as alternatives is, in fact, little more than an intellectual remnant of the Cold War, much like the concept of "state capitalism" itself. With its remarkable ability to adapt, China is making strides to accommodate the rising power of its markets and people. In the process, officials are acknowledging the importance of good governance, as demonstrated by recent efforts to justify the purge and investigation of Bo Xilai as an example of the Communist Party "safeguarding the rule of law." Adam Smith, that icon of market theory, argued that wealth is created when public institutions enable the "invisible hand" of the market to align interests. The Cold War distorted that wisdom. In a world free of that era's ideological constraints, it is time to say loud and clear that the future of capitalism is linked to effective governance and the rule of law, and thus to the consolidation of well-functioning states.

Ana Palacio is a former Spanish foreign minister and former Senior Vice President and General Counsel of the World Bank.

What Role for the State?

By Kemal Dervis

July 20, 2012

WASHINGTON, DC - The financial crisis of 2008 has spurred a global debate on how much government regulation of markets- and what kind- is appropriate. In the United States, it is a key theme in the upcoming presidential election, and it is shaping politics in Europe and emerging markets as well. For starters, China's impressive growth performance over the last three decades has given the world an economically successful example of what many call "state capitalism." Brazil's development policies have also accorded a strong role to the state. Questions concerning the state's size and the sustainable role of government are central to the debate over the eurozone's fate as well. Many critics of Europe, particularly in the US, link the euro crisis to the outsize role of government there, though the Scandinavian countries are doing well, despite high public spending. In France, the new center-left government faces the challenge of delivering on its promise of strengthening social solidarity while substantially reducing the budget deficit. Alongside the mostly economic arguments about the role of government, many countries are experiencing widespread disillusionment with politics and a growing distance between citizens and government (particularly national government). In many countries, participation rates in national elections are falling, and new parties and movements, such as the Pirate Party in Germany and the Five Star Movement in Italy, reflect strong discontent with existing governance. In the US, the approval rating of Congress is at a record-low of 14%. Many there, such as my colleague Bruce Katz at the Brookings Institution, believe that the only solution is to bring a larger share of governance and policy initiation to the state and municipal level, in close partnership with the private sector and civil society. But that approach, too, might have a downside. Consider Spain, where too much fiscal decentralization to regional governments contributed significantly to weakening otherwise strong public finances. A crucial problem for this global debate is that, despite the realities of twenty-first-century technology and globalization, it is still conducted largely as if governance and public policy were

almost exclusively the domain of the nation-state. To adapt the debate to the real challenges that we face, we should focus on four levels of governance and identify the most appropriate allocation of public-policy functions to them. First, many policies - including support for local infrastructure, land zoning, facilitation of industrial production and training, traffic ordinances, and environmental regulations -can largely be determined at the local or metropolitan level and reflect the wishes of a local electorate. Of course, defense and foreign policy will continue to be conducted primarily at the second levelthe nation-state. Most nation-states maintain national currencies, and must therefore pursue fiscal and economic policies that support a monetary union. As the eurozone crisis has starkly reminded us, decentralization cannot extend too far into the budgetary sphere, lest it threaten the common currency's survival. The US system is manageable, because the American states are largely constrained to running balanced budgets, while the federal government accounts for most fiscal policy. Moreover, banking regulation and deposit insurance are centralized in the US, as they must be in a monetary union. The eurozone has finally recognized this. So, governance at the nation-state level remains hugely important and is intimately linked to monetary sovereignty. The key problem in Europe today is whether eurozone members will advance towards something resembling a federal nation-state. Unless they do, it is difficult to see how the common currency can survive. There is also a third, regional or continental, level of governance, which is most advanced in the European Union (and is being tested in Latin America, Africa, and Asia) and can be very useful. Customs unions, free-trade areas, or a single market, as in Europe, allow greater mobility of goods and services, which can lead to benefits from economies of scale that remaining trade impediments at the global level do not permit. Europe's borderless Schengen Area is another example of regional supra-national governance. There are also aspects of infrastructure that can best be addressed at the continental level. Finally, there is the global level. The spread of infectious disease, global trade and finance, climate change, nuclear non-proliferation, counterterrorism, and cyber security are just some of the issues that require broad international cooperation and global governance. In today's interdependent world, the debate about the role of public policy, the size and functions of government, and the legitimacy of public decision-making should be conducted with the four levels of governance much more clearly in focus. The levels often will overlap (infrastructure and clean energy issues, for example), but democracy could be greatly strengthened if the issues were linked to the levels at which decisions can best be taken.

As Pascal Lamy, the director of the World Trade Organization, has said, it is not only the "local" that has to be brought to the "global"; the inherently "local" political sphere has to internalize the global or regional context. That is a huge challenge for political leadership and communication, but, if it is not met, democracy and globalization will be difficult to reconcile. How to conduct democratic debate with reference to these local, national, continental, and global levels, and to structure a political space that better reflects economic and social space, will be the great challenge of the decades ahead.

Kemal Dervis, a former minister of economics in Turkey, administrator of the United Nations Development Program (UNDP), and vice president of the World Bank, is currently Vice President and Director of the Global Economy and Development Program at the Brookings Institution.

A Berlin Consensus?
By Andrew Sheng

April 29, 2012

HONG KONG- A recent trip to Berlin brought back memories of an earlier visit in the summer of 1967, when I was a poor student who marveled at the Wall that would divide and devastate an entire society for another two decades. Berlin today is vibrant and rejuvenated, rebuilt by the German peoples' hard work and sacrifice to unify the country, and an apt setting for the conference of the Institute for New Economic Thinking (INET), which I was there to attend. The conference's theme was "Paradigm Lost," with more than 300 economists, political scientists, systems analysts, and ecologists gathering to rethink economic and political theory for the challenges and uncertainty posed by growing inequality, rising unemployment, global financial disarray, and climate change. Almost everyone agreed that the old paradigm of neoclassical economics was broken, but there was no agreement on what can replace it. Nobel laureate Amartya Sen attributed the European crisis to four failures - political, economic, social, and intellectual. The global financial crisis, which began in 2007 as a crisis of US subprime lending and has broadened into a European sovereign-debt (and banking) crisis, has raised questions that we cannot answer, owing to over-specialization and fragmentation of knowledge. And yet there is no denying that the world has become too intricate for any simple, overarching theory to explain complex economic, technological, demographic, and environmental shifts. In particular, the rise of emerging markets has challenged traditional Western deductive and inductive logic. Deductive inference enables us to predict effects if we know the principles (the rule) and the cause. By inductive reasoning, if we know the cause and effects, we can infer the principles. Eastern thinking, by contrast, has been abductive, moving from pragmatism to guessing the next steps. Abductive inference is pragmatic, looking only at outcomes, guessing at the rule, and identifying the cause. Like history, social-scientific theory is written by the victors and shaped by the context and challenges of its time. Free-market thinking evolved from Anglo-Saxon theorists (many from Scotland), who migrated and colonized territories, allowing fortunate individuals to assume that there were no limits to consumption. European continental thinking, responding to urbanization and the need for social order, emphasized institutional analysis of political economy.

Thus, the emergence of neoclassical economics in the nineteenth century was very much influenced by Newtonian and Cartesian physics, moving from qualitative analysis to quantifying human behavior by assuming rational behavior and excluding uncertainty. This "predetermined equilibrium" thinking - reflected in the view that markets always self-correct - led to policy paralysis until the Great Depression, when John Maynard Keynes's argument for government intervention to address unemployment and output gaps gained traction. By the 1970's, the neoclassical general-equilibrium school captured Keynesian economics through real-sector models that assumed that "finance is a veil," thereby becoming blind to financial markets' destabilizing effects. Economists like Hyman Minsky, who tried to correct this, were largely ignored as Milton Friedman and others led the profession's push for free markets and minimal government intervention. But then technology, demographics, and globalization brought dramatic new challenges that the neoclassical approach could not foresee. Even as the world's advanced countries over-consumed through leveraging from derivative finance, four billion of the world's seven billion people began moving to middle-income status, making huge demands on global resources and raising the issue of ecological sustainability. New thinking is required to manage these massive and systemic changes, as well as the integration of giants like China and India into the modern world. A change of mindset is needed not just in the West, but also in the East. In 1987, the historian Ray Huang explained it for China: "As the world enters the modern era, most countries under internal and external pressure need to reconstruct themselves by substituting the mode of governance rooted in agrarian experience with a new set of rules based on commerce .... This is easier said than done. The renewal process could affect the top and bottom layers, and inevitably it is necessary to recondition the institutional links between them. Comprehensive destruction is often the order; and it may take decades to bring the work to completion." Using this macro-historical framework, we can see Japanese deflation, European debt, and even the Arab Spring as phases of systemic changes within complex structures that are interacting with one another in a new, multipolar global system. We are witnessing simultaneous global convergence (the narrowing of income, wealth, and knowledge gaps between countries) and local divergence (widening income, wealth, and knowledge gaps within countries). Adaptive systems struggle with order and creativity as they evolve. As the philosopher Bertrand Russell presciently put it: "Security and justice require centralized governmental control, which must extend to the creation of a world government if it is to be effective. Progress, on the contrary, requires the utmost scope for personal initiative that is compatible with social order."

A new wave of what the economist Joseph Schumpeter famously called "creative destruction" is under way: even as central banks struggle to maintain stability by flooding markets with liquidity, credit to business and households is shrinking. We live in an age of simultaneous fear of inflation and deflation; of unprecedented prosperity amid growing inequality; and of technological advancement and resource depletion. Meanwhile, existing political systems promise good jobs, sound governance, a sustainable environment, and social harmony without sacrifice - a paradise of self-interested free riders that can be sustained only by sacrificing the natural environment and the welfare of future generations. We cannot postpone the pain of adjustment forever by printing money. Sustainability can be achieved only when the haves become willing to sacrifice for the have-nots. TheW ashington Consensus of free-market reforms for developing countries ended more than two decades ago. The INET conference in Berlin showed the need for a new one - a consensus that supports sacrifice in the interest of unity. Europe could use it.

Andrew Sheng is President of Fung Global Institute.

Our Children's Economics

By Barry Eichengreen
February 11, 2013
TOKYO - The economics profession has not had a good crisis. Queen Elizabeth II may have expected too much when she famously asked why economists had failed to foresee the disaster, but there is a widespread sense that much of their research turned out to be irrelevant. Worse still, much of the advice proffered by economists was of little use to policymakers seeking to limit the economic and financial fallout. Will future generations do better? One of the more interesting exercises in which I engaged at the recent World Economic Forum in Davos was a collective effort to imagine the contents of a Principles of Economics textbook in 2033. There was no dearth of ideas and topics, participants argued, that existing textbooks neglected, and that should receive more attention two decades from now. Economists working on the border of economics and psychology, for example, argued that behavioral finance, in which human foibles are brought to bear to explain the failure of the socalled efficient markets hypothesis, would be given more prominence. Economic historians, meanwhile, argued that future textbooks would embed analysis of recent experience in the longerterm historical record. Among other things, this would allow economists-in-training to take the evolution of economic institutions more seriously. Development economists, for their part, argued that much more attention would be paid to randomized trials and field experiments. Applied econometricians pointed to the growing importance of "big data" and to the likelihood that large data sets will have significantly enhanced our understanding of economic decision-making by 2033. Overall, however, the picture was one in which the economics of 2033 differed only marginally from the economics of today. A textbook two decades from now might be more sophisticated than this year's edition, fully integrating contributions that today constitute the frontiers of economic research. But it would not differ fundamentally in structure or approach from today's economics. The consensus, in other words, seemed to be that there would be nothing in the next 20 years as transformative as Alfred Marshall's synthesis of the 1890's or the revolution initiated by John Maynard Keynes in the 1930's. In contrast to the economics of those years, economics today is a

mature, well-established discipline. And, like any mature discipline, it advances incrementally rather than in revolutionary steps. This presumption is almost certainly mistaken. It reflects the same error made by scholars of technology who argue that all of the radical breakthroughs have already been made. As this view is sometimes put, the next 20 years will see no breakthrough as revolutionary as the steam engine or the transistor. Technological progress will be incremental rather than revolutionary. Indeed, insofar as the increments are small, the result is likely to be slower productivity growth and a "Great Stagnation." In fact, the history of technology has repeatedly refuted this pessimistic view. We can't say what the next radical innovation will be, but centuries of human experience suggest that there will be (at least) one. Similarly, we can't say what the next revolution in economic analysis will be, but more than a century of modern economic thinking suggests that there will be one. All of this suggests that the economics textbook of 2033 will look very different from the economics textbook of today. We just can't say how. Indeed, one might question the very premise that, two decades from now, there will be textbooks as we know them. Today, introductory economics is taught using a textbook in which an eminent professor authoritatively bestows the conventional wisdom on his or her (typically, his) students. Knowledge, as encapsulated in the textbook and interpreted by the professor, is delivered from above. This, of course, is also how newspapers traditionally delivered the news. Editors and publishers assembled and collated stories, and the newspaper that they produced was then delivered to the subscriber's doorstep. But the last decade has seen a veritable revolution in the news business. News is now assembled and disseminated via Web sites, wikis, and the comment sections ofblogs. News, in other words, is increasingly delivered from the bottom up. Rather than relying on editors, everyone is becoming their own news curator. Something similar is likely to happen to textbooks, especially in economics, where everyone has an opinion and first-hand experience with the subject. Textbooks will be like wikis, with faculty adopters and students modifying text and contributing content. There still may be a role for the author as gatekeeper; but the textbook will know longer be the font of wisdom, and its writer will no longer control the table of contents. The outcome will be messy. But the economics profession will also become more diverse and dynamic- and our children's economics will be healthier as a result.

Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.

Models Behaving Badly

By Robert Skidelsky
December 18, 2012
LONDON - "Why did no one see the crisis coming?" Queen Elizabeth II asked economists during a visit to the London School of Economics at the end of 2008. Four years later, the repeated failure of economic forecasters to predict the depth and duration of the slump would have elicited a similar question from the queen: Why the overestimate of recovery? Consider the facts. In its 2011 forecast, the International Monetary Fund predicted that the European economy would grow by 2.1% in 2012. In fact, it looks certain to shrink this year by

0.2%. In the United Kingdom, the 2010 forecast of the Office for Budget Responsibility (OBR)
projected 2.6% growth in 2011 and 2.8% growth in 2012; in fact, the UK economy grew by 0.9% in

2011 and will flat-line in 2012. The OECD's latest forecast for eurozone GDP in 2012 is 2.3%
lower than its projection in 2010. Likewise, the IMF now predicts that the European economy will be 7.8% smaller in 2015 than it thought just two years ago. Some forecasters are more pessimistic than others (the OBR has a particularly sunny disposition), but no one, it seems, has been pessimistic enough. Economic forecasting is necessarily imprecise: too many things happen for forecasters to be able to foresee all of them. So judgment calls and best guesses are an inevitable part of"scientific" economic forecasts. But imprecision is one thing; the systematic overestimate of the economic recovery in Europe is quite another. Indeed, the figures have been repeatedly revised, even over quite short periods of time, casting strong doubt on the validity of the economic models being used. These models, and the institutions using them, rely on a built-in theory of the economy, which enables them to "assume" certain relationships. It is among these assumptions that the source of the errors must lie. Two key mistakes stand out. The models used by all of the forecasting organizations dramatically underestimated the fiscal multiplier: the impact of changes in government spending on output. Second, they overestimated the extent to which quantitative easing (QE) by the monetary authorities- that is, printing money- could counterbalance fiscal tightening. Until recently, the OBR, broadly in line with the IMF, assumed a fiscal multiplier of 0.6: for every dollar cut from government spending, the economy would shrink by only 60 cents. This assumes

"Ricardian equivalence": debt-financed public spending at least partly crowds out private spending through its impact on expectations and confidence. If households and firms anticipate a tax increase in the future as a result of government borrowing today, they will reduce their consumption and investment accordingly. On this view, if fiscal austerity relieves households of the burden of future tax increases, they will increase their spending. This may be true when the economy is operating at full employment when state and market are in competition for every last resource. But when there is spare capacity in the economy, the resources "freed up" by public-sector retrenchment may simply be wasted. Forecasting organizations are finally admitting that they underestimated the fiscal multiplier. The OBR, reviewing its recent mistakes, accepted that "the average [fiscal] multiplier over the two years would have needed to be 1.3 - more than double our estimate - to fully explain the weak level of GDP in 2011-12." The IMF has conceded that "multipliers have actually been in the 0.9 and 1.7 range since the Great Recession." The effect of underestimating the fiscal multiplier has been systematic misjudgment of the damage that "fiscal consolidation" does to the economy. This leads us to the second mistake. Forecasters assumed that monetary expansion would provide an effective antidote to fiscal contraction. The Bank of England hoped that by printing 375 billion of new money, ($600 billion), it would stimulate total spending to the tune of 50 billion, or 3% of GDP. But the evidence emerging from successive rounds of QE in the UK and the US suggests that while it did lower bond yields, the extra money was largely retained within the banking system, and never reached the real economy. This implies that the problem has mainly been a lack of demand for credit- reluctance on the part of businesses and households to borrow on almost any terms in a flat market. These two mistakes compounded each other: If the negative impact of austerity on economic growth is greater than was originally assumed, and the positive impact of quantitative easing is weaker, then the policy mix favored by practically all European governments has been hugely wrong. There is much greater scope for fiscal stimulus to boost growth, and much smaller scope for monetary stimulus. This is all quite technical, but it matters a great deal for the welfare of populations. All of these models assume outcomes on the basis of existing policies. Their consistent over-optimism about these policies' impact on economic growth validates pursuing them, and enables governments to claim that their remedies are "working," when they clearly are not. This is a cruel deception. Before they can do any good, the forecasters must go back to the drawing board, and ask themselves whether the theories of the economy underpinning their models are the right ones.

Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University.

Why Did Economists Not Foresee the Crisis?

By Raghuram Rajan

February 7, 2011
CHICAGO - At the height of the financial crisis, the Queen of England asked my friends at the London School of Economics a simple question, but one for which there is no easy answer: Why did academic economists fail to foresee the crisis? Several responses to that query exist. One is that economists lacked models that could account for the behavior that led to the crisis. Another is that economists were blinkered by an ideology according to which a free and unfettered market could do no wrong. Finally, an answer that is gaining ground is that the system bribed economists to stay silent. In my view, the truth lies elsewhere.
It is not true that we academics did not have useful models to explain what happened. If you believe

that the crisis was caused by a shortage of liquidity, we had plenty of models analyzing liquidity shortages and their effects on financial institutions. If you believe that the blame lies with greedy bankers and unthinking investors, lulled by the promise of a government bailout, or with a market driven crazy by irrational exuberance, we had studied all this too, in great detail. Economists even analyzed the political economy of regulation and deregulation, so we could have understood why some US politicians pushed the private sector into financing affordable housing, while others deregulated private finance. Yet, somehow, we did not bring all this understanding to bear and collectively shout our warnings. Perhaps the reason was ideology: we were too wedded to the idea that markets are efficient, market participants are rational, and high prices are justified by economic fundamentals. But some of this criticism of"market fundamentalism" reflects a misunderstanding. The dominant "efficient markets theory" says only that markets reflect what is publicly known, and that it is hard to make money off markets consistently- something verified by the hit that most investor portfolios took in the crisis. The theory does not say that markets cannot plummet if the news is bad, or if investors become risk-averse. Critics argue that the fundamentals were deteriorating in plain sight, and that the market (and economists) ignored it. But hindsight distorts analysis. We cannot point to a lonely Cassandra like

Robert Shiller of Yale University, who regularly argued that house prices were unsustainable, as

proof that the truth was ignored. There are always naysayers, and they are often wrong. There were many more economists who believed that house prices, though high, were unlikely to fall across the board. Of course, these expectations could have been distorted by ideology- it is hard to get into the past minds of economists. But there is a better reason to be skeptical of explanations relying on ideology. As a group, neither behavioral economists, who think that market efficiency is a joke, nor progressive economists, who distrust free markets, predicted the crisis. Could it be corruption? Some academic economists consult for banks or rating agencies, give speeches to investor conferences, serve as expert witnesses, and carry out sponsored research. It would be natural to suspect us of bias. The bias could be implicit: our worldview is shaped by what our friends in industry believe. Or it may be an explicit bias: an economist might write a report that is influenced by what a sponsor wants to hear, or give testimony that is purely mercenary. There are enough instances of possible bias that the issue cannot be ignored. One remedy would be to ban all interaction between economists and the corporate world. But if economists were confined to the ivory tower, we might be unbiased, but we would also be ignorant of practicalities and thus even less capable of predicting problems. One way to restore trust may be disclosure - for economists to declare a monetary interest in a particular analysis and, more generally, to explain who pays us. A number of universities are moving in this direction. But I believe that corruption is not the main reason that the profession missed the crisis. Most economists have very little interaction with the corporate world, and these "unbiased" economists were no better at forecasting the crisis. I would argue that three factors largely explain our collective failure: specialization, the difficulty of forecasting, and the disengagement of much of the profession from the real world. Like medicine, economics has become highly compartmentalized - macroeconomists typically do not pay attention to what financial economists or real-estate economists study, and vice versa. Yet, to see the crisis coming would have required someone who knew about each of these areas - just as it takes a good general practitioner to recognize an exotic disease. Because the profession rewards only careful, well-supported, but necessarily narrow analysis, few economists try to span sub-fields. Even if they did, they would shy away from forecasting. The main advantage that academic economists have over professional forecasters may be their greater awareness of established relationships between factors. What is hardest to forecast, though, are turning points - when the old relationships break down. While there may be some factors that signal turning points- a runup in short-term leverage and asset prices, for example, often presages a bust - they are not infallible predictors of trouble to come.

The meager professional rewards for breadth, coupled with the inaccuracy and reputational risk associated with forecasting, leads to disengagement for most academics. And it may well be that academic economists have little to say about short-term economic movements, so that forecasting, with all its errors, is best left to professional forecasters. The danger is that disengagement from short-term developments leads academic economists to ignore medium-term trends that they can address. If so, the true reason why academics missed the crisis could be far more mundane than inadequate models, ideological blindness, or corruption, and thus far more worrisome; many simply were not paying attention!

Raghuram Rajan is Professor of Finance at the Booth School of Business, University of Chicago, and author ofFault Lines: How Hidden Fractures Still Threaten the World Economy.

Economics in Denial
By Howard Davies

August 22, 2012

PARIS - In an exasperated outburst, just before he left the presidency of the European Central Bank, Jean-Claude Trichet complained that, "as a policymaker during the crisis, I found the available [economic and financial] models oflimited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools." Trichet went on to appeal for inspiration from other disciplines- physics, engineering, psychology, and biology- to help explain the phenomena he had experienced. It was a remarkable cry for help, and a serious indictment of the economics profession, not to mention all those extravagantly rewarded finance professors in business schools from Harvard to Hyderabad. So far, relatively little help has been forthcoming from the engineers and physicists in whom Trichet placed his faith, though there has been some response. Robert May, an eminent climate change expert, has argued that techniques from his discipline may help explain financial-market developments. Epidemiologists have suggested that the study of how infectious diseases are propagated may illuminate the unusual patterns of financial contagion that we have seen in the last five years. These are fertile fields for future study, but what of the core disciplines of economics and finance themselves? Can nothing be done to make them more useful in explaining the world as it is, rather than as it is assumed to be in their stylized models? George Soros has put generous funding behind the Institute for New Economic Thinking (INET). The Bank of England has also tried to stimulate fresh ideas. The proceedings of a conference that it organized earlier this year have now been edited under the provocative title What 's the Use of

Economics?
Some of the recommendations that emerged from that conference are straightforward and concrete. For example, there should be more teaching of economic history. We all have good reason to be grateful that US Federal Reserve Chairman Ben Bernanke is an expert on the Great Depression and the authorities' flawed policy responses then, rather than in the finer points of dynamic stochastic general equilibrium theory. As a result, he was ready to adopt unconventional measures when the crisis erupted, and was persuasive in influencing his colleagues.

Many conference participants agreed that the study of economics should be set in a broader political context, with greater emphasis on the role of institutions. Students should also be taught some humility. The models to which they are still exposed have some explanatory value, but within constrained parameters. And painful experience tells us that economic agents may not behave as the models suppose they will. But it is not clear that a majority of the profession yet accepts even these modest proposals. The socalled "Chicago School" has mounted a robust defense of its rational expectations-based approach, rejecting the notion that a rethink is required. The Nobel laureate economist Robert Lucas has argued that the crisis was not predicted because economic theory predicts that such events cannot be predicted. So all is well. And there is disturbing evidence that news of the crisis has not yet reached some economics departments. Stephen King, Group Chief Economist of HSBC, notes that when he asks recent university graduates (and HSBC recruits a large number of them) how much time they spent in lectures and seminars on the financial crisis, "most admitted that the subject had not even been raised." Indeed, according to King, "Young economists arrive in the financial world with little or no knowledge of how the financial system operates." I am sure they learn fast at HSBC. (In the future, one assumes, they will learn quickly about money laundering regulations as well.) But it is depressing to hear that many university departments are still in denial. That is not because students lack interest: I teach a course at Sciences Po in Paris on the consequences of the crisis for financial markets, and the demand is overwhelming. We should not focus attention exclusively on economists, however. Arguably the elements of the conventional intellectual toolkit found most wanting are the capital asset pricing model and its close cousin, the efficient-market hypothesis. Yet their protagonists see no problems to address. On the contrary, the University of Chicago's Eugene Fama has described the notion that finance theory was at fault as "a fantasy," and argues that "financial markets and financial institutions were casualties rather than causes of the recession." And the efficient-market hypothesis that he championed cannot be blamed, because "most investing is done by active managers who don't believe that markets are efficient." This amounts to what we might call an "irrelevance" defense: Finance theorists cannot be held responsible, since no one in the real world pays attention to them! Fortunately, others in the profession do aspire to relevance, and they have been chastened by the events of the last five years, when price movements that the models predicted should occur once in a million years were observed several times a week. They are working hard to understand why, and to develop new approaches to measuring and monitoring risk, which is the main current concern of many banks.

These efforts are arguably as important as the specific and detailed regulatory changes about which we hear much more. Our approach to regulation in the past was based on the assumption that financial markets could to a large extent be left to themselves, and that financial institutions and their boards were best placed to control risk and defend their firms. These assumptions took a hard hit in the crisis, causing an abrupt shift to far more intrusive regulation. Finding a new and stable relationship between the financial authorities and private firms will depend crucially on a reworking of our intellectual models. So the Bank of England is right to issue a call to arms. Economists would be right to heed it.

Howard Davies, former Chairman of Britain's Financial Services Authority, Deputy Governor of the Bank of England, and Director of the London School of Economics, is a professor at Sciences Po in Paris.

Schadenfreude Capitalism
By Harold James

January 4, 2012
PRINCETON - The protracted financial and economic crisis discredited first the American model of capitalism, and then the European version. Now it looks as if the Asian approach may take some knocks, too. Coming after the failure of state socialism, does this mean that there is no correct way of organizing an economy? In the aftermath of the subprime crisis and the collapse of Lehman Brothers, fingers were pointed at the United States as an example of how badly things could go wrong. The American model had supposedly failed, its reputation weakened first by the Iraq invasion, and then by the financial crisis. Anyone who dreamed of the American way of life now looked stupid. Immediately after Lehman Brothers' collapse, German Finance Minister Peer Steinbriick put this diagnosis as a challenge not only to the US, but also to other countries - notably the United Kingdom - that had "Americanized" their financial system. The problem, Steinbriick argued, lay in over-reliance on highly complex financial instruments, propagated by globalized American institutions: "The financial crisis is above all an American problem. The other G-7 financial ministers in continental Europe share this opinion." Criticism of America did not stop there. Steinbriick's successor, Wolfgang Schauble, persisted in the same tone, attacking "clueless" American monetary policy, which was supposedly designed only to feed the American financial monster. But such criticism ignores the problems faced by banks that did not use or deal in complex financial products. Bank regulators had long insisted that the safest possible financial instrument was a bond issued by a rich industrial country. Then came the eurozone's sovereign-debt crisis, with its roots in lax government finance in some (mostly southern European) countries. Critics now had a new focus. Naturally, many conservative Americans were delighted by the imminent failure of what they saw as Europe's tax-and-spend model, with its addiction to a costly and inefficient welfare state. They were not the only critics. The chairman of China Investment Corporation, Jin Liquin, commented skeptically on a proposed Chinese bailout of Europe, which he called "a worn-out welfare society" with "outdated" welfare laws that induce dependence and sloth.

Criticism of large European transfer payments may have some justification, say, insofar as French, Greek, and Italian civil servants could indeed retire young. And restrictive labor laws have indeed discouraged many firms from hiring new workers. But such criticism captures only one small part of Europe's difficulties. The fiscal problems of Greece and Spain were also the result of spending a great deal on hightechnology and high-prestige projects: facilities for the Olympic Games, new airport buildings, high-speed train links. And Spain and Ireland before the crisis did not have a fiscal problem, owing to the rapid economic growth produced by a real-estate boom that seemed to promise a new era of economic miracles. One of the most widely used Chinese terms of recent years is???? (xing z?i le huo}, best translated as "schadenfreude": somebody else- some other society- tripped on an enormous political banana peel. Asian critics looking at America and Europe could easily convince themselves that the Western model of democratic capitalism was collapsing. But haven't similar capital investments and soaring property prices also been an increasingly important part of China's transformation since the 1990's? Chinese citizens are now not only frustrated with the high-speed trains' increasingly obvious imperfections and inadequacies, but are also wondering whether their government has set the right priorities. Schadenfreude comes in several flavors. Russia's Prime Minister Vladimir Putin and Argentina's President Christina Kirchner liked to think that their versions of a controlled economy and society built in the aftermath of default on foreign debt offered a more viable alternative to cosmopolitan international capitalism. Both now face major problems with disillusioned populations. In short, the world's major economies share many more vulnerabilities than is commonly supposed. A response to global challenges based simply on schadenfreude may promote a short-term sense of well-being, as people often like to think how lucky they are to have escaped a mess that originated elsewhere. But soon they encounter their own banana peel; indeed, today's global economy is a riot of slipping economic models. And tomorrow the cacophony will be even louder. So, is there any absolutely sure way of organizing economic life? If the quest is for a way of securing perpetual security or dominance, then the answer is "no." Underpinning comparisons of different models is the wish to find an absolutely secure way of generating wealth and prosperity. In a market economy, however, competition rapidly leads to emulation, and high profits associated with an original innovation turn out to be transitory. From a longer-term perspective, there are only temporary surges of relative wealth, just as there are only temporary surges of apparent success in a particular way of doing business. During the Industrial Revolution in Western Europe in the late eighteenth and early nineteenth centuries, the pioneers and innovators in textiles, steel, and railroads were not, on the whole,

rewarded with immense riches: their profits were competed away. The late nineteenth and the twentieth century produced a different sort of growth, because public policies and resources could be used to protect accumulated wealth from the otherwise inevitable erosion stemming from competitive pressure. Behind the idea of a particular model of growth was the belief that a sensibly ordered state could somehow capture and eternalize the fruits of economic success. Like it or not, states cannot organize themselves in that way any more than individuals can.

Harold James is Professor of History and International Affairs at Princeton University and Professor of History at the European University Institute, Florence. He is the author ofThe
Creation and Destruction of Value: The Globalization Cycle.

The Perils of Prophecy

By J. Bradford DeLong June 27, 2012
BERKELEY - We economists who are steeped in economic and financial history - and aware of the history of economic thought concerning financial crises and their effects - have reason to be proud of our analyses over the past five years. We understood where we were heading, because we knew where we had been. In particular, we understood that the rapid run-up of house prices, coupled with the extension of leverage, posed macroeconomic dangers. We recognized that large bubble-driven losses in assets held by leveraged financial institutions would cause a panicked flight to safety, and that preventing a deep depression required active official intervention as a lender oflast resort. Indeed, we understood that monetarist cures were likely to prove insufficient; that sovereigns need to guarantee each others' solvency; and that withdrawing support too soon implied enormous dangers. We knew that premature attempts to achieve long-term fiscal balance would worsen the short-term crisis - and thus be counterproductive in the long-run. And we understood that we faced the threat of a jobless recovery, owing to cyclical factors, rather than to structural changes. On all of these issues, historically-minded economists were right. Those who said that there would be no downturn, or that recovery would be rapid, or that the economy's real problems were structural, or that supporting the economy would produce inflation (or high short-term interest rates), or that immediate fiscal austerity would be expansionary were wrong. Not just a little wrong. Completely wrong. Of course, we historically-minded economists are not surprised that they were wrong. We are, however, surprised at how few of them have marked their beliefs to market in any sense. On the contrary, many of them, their reputations under water, have doubled down on those beliefs, apparently in the hope that events will, for once, break their way, and that people might thus be induced to forget their abysmal forecasting track record. So the big lesson is simple: trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry

Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are
the ones most likely to get the distribution of possible futures right.

But we - or at least I - have gotten significant components of the last four years wrong. Three things surprised me (and still do). The first is the failure of central banks to adopt a rule like nominal GDP targeting or its equivalent. Second, I expected wage inflation in the North Atlantic to fall even farther than it has- toward, even if not to, zero. Finally, the yield curve did not steepen sharply for the United States: federal funds rates at zero I expected, but 30-Year US Treasury bonds at a nominal rate of 2.7% I did not. The failure of central banks to target nominal GDP growth remains incomprehensible to me, and I will not write about it until I think that I have understood the reasons. As for wages, even with one-third of the US labor force changing jobs every year, sociological factors and human-network ties appear to exercise an even stronger influence on the level and rate of change- at the expense of balancing supply and demand - than I would have expected. The third surprise, however, may be the most interesting. Back in March 2009, the Nobel laureate Robert Lucas confidently predicted that the US economy would be back to normal within three years. A normal US economy has a short-term nominal interest rate of 4%. Since the ten-year US Treasury bond rate tends to be one percentage point above the average of expected future shortterm interest rates over the next decade, even the expectation of five years of deep depression and near-zero short-term interest rates should not push the 10-Year Treasury rate below 3%. Indeed, the Treasury rate mostly fluctuated between 3% and 3.5% from late 2008 through mid-2011. But, in July 2011, the ten-year US Treasury bond rate crashed to 2%, and it was below 1.5% at the start of June. The normal rules of thumb would say that the market is now expecting 8.75 years of near-zero short-term interest rates before the economy returns to normal. And similar calculations for the 30-year Treasury bond show even longer and more anomalous expectations of continued depression. The possible conclusions are stark. One possibility is that those investing in financial markets expect economic policy to be so dysfunctional that the global economy will remain more or less in its current depressed state for perhaps a decade, or more. The only other explanation is that even now, more than three years after the US financial crisis erupted, financial markets' ability to price relative risks and returns sensibly has been broken at a deep level, leaving them incapable of doing their job: bearing and managing risk in order to channel savings to entrepreneurial ventures. Neither alternative is something that I would have predicted - or even imagined.

J. Bradford DeLong, a former deputy assistant secretary of the US Treasury, is Professor of

Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research.

Life after Capitalism

By Robert Skidelsky

January 20, 2011

LONDON- In 1995, I published a book called The World After Communism. Today, I wonder whether there will be a world after capitalism. That question is not prompted by the worst economic slump since the 1930's. Capitalism has always had crises, and will go on having them. Rather, it comes from the feeling that Western civilization is increasingly unsatisfying, saddled with a system of incentives that are essential for accumulating wealth, but that undermine our capacity to enjoy it. Capitalism may be close to exhausting its potential to create a better life- at least in the world's rich countries. By "better," I mean better ethically, not materially. Material gains may continue, though evidence shows that they no longer make people happier. My discontent is with the quality of a civilization in which the production and consumption of unnecessary goods has become most people's main occupation. This is not to denigrate capitalism. It was, and is, a superb system for overcoming scarcity. By organising production efficiently, and directing it to the pursuit of welfare rather than power, it has lifted a large part of the world out of poverty. Yet what happens to such a system when scarcity has been turned to plenty? Does it just go on producing more of the same, stimulating jaded appetites with new gadgets, thrills, and excitements? How much longer can this continue? Do we spend the next century wallowing in triviality? For most of the last century, the alternative to capitalism was socialism. But socialism, in its classical form, failed - as it had to. Public production is inferior to private production for any number of reasons, not least because it destroys choice and variety. And, since the collapse of communism, there has been no coherent alternative to capitalism. Beyond capitalism, it seems, stretches a vista o .. capitalism. There have always been huge moral questions about capitalism, which could be put to one side because capitalism was so successful at generating wealth. Now, when we already have all the wealth we need, we are right to wonder whether the costs of capitalism are worth incurring.

Adam Smith, for example, recognized that the division of labor would make people dumber by robbing them of non-specialized skills. Yet he thought that this was a price- possibly compensated by education - worth paying, since the widening of the market increased the growth of wealth. This made him a fervent free trader. Today's apostles of free trade argue the case in much the same way as Adam Smith, ignoring the fact that wealth has expanded enormously since Smith's day. They typically admit that free trade costs jobs, but claim that re-training programs will fit workers into new, "higher value" jobs. This amounts to saying that even though rich countries (or regions) no longer need the benefits of free trade, they must continue to suffer its costs. Defenders of the current system reply: we leave such choices to individuals to make for themselves. If people want to step off the conveyor belt, they are free to do so. And increasing numbers do, in fact, "drop out." Democracy, too, means the freedom to vote capitalism out of office. This answer is powerful but naive. People do not form their preferences in isolation. Their choices are framed by their societies' dominant culture. Is it really supposed that constant pressure to consume has no effect on preferences? We ban pornography and restrict violence on TV, believing that they affect people negatively, yet we should believe that unrestricted advertising of consumer goods affects only the distribution of demand, but not the total? Capitalism's defenders sometimes argue that the spirit of acquisitiveness is so deeply ingrained in human nature that nothing can dislodge it. But human nature is a bundle of conflicting passions and possibilities. It has always been the function of culture (including religion) to encourage some and limit the expression of others. Indeed, the "spirit of capitalism" entered human affairs rather late in history. Before then, markets for buying and selling were hedged with legal and moral restrictions. A person who devoted his life to making money was not regarded as a good role model. Greed, avarice, and envy were among the deadly sins. Usury (making money from money) was an offense against God.
It was only in the eighteenth century that greed became morally respectable. It was now considered

healthily Promethean to turn wealth into money and put it to work to make more money, because by doing this one was benefiting humanity. This inspired the American way of life, where money always talks. The end of capitalism means simply the end of the urge to listen to it. People would start to enjoy what they have, instead of always wanting more. One can imagine a society of private wealth holders, whose main objective is to lead good lives, not to turn their wealth into "capital." Financial services would shrink, because the rich would not always want to become richer. As more and more people find themselves with enough, one might expect the spirit of gain to lose its social

approbation. Capitalism would have done its work, and the profit motive would resume its place in the rogues' gallery. The dishonoring of greed is likely only in those countries whose citizens already have more than they need. And even there, many people still have less than they need. The evidence suggests that economies would be more stable and citizens happier if wealth and income were more evenly distributed. The economic justification for large income inequalities - the need to stimulate people to be more productive- collapses when growth ceases to be so important. Perhaps socialism was not an alternative to capitalism, but its heir. It will inherit the earth not by dispossessing the rich of their property, but by providing motives and incentives for behavior that are unconnected with the further accumulation of wealth.

Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University, author of a prize-winning biography of the economist John Maynard Keynes, and a board member of the Moscow School of Political Studies.

Redesigning Capitalism
By Michel Rocard

November 27, 2008

PARIS - When the heads of state of the world's 20 largest economies come together on short notice, as they just did in Washington, D.C., it is clear how serious the current global crisis is. They did not decide much, except to call for improved monitoring and regulation of financial flows. More importantly, they committed themselves to launching a lasting process to reform the world's financial system. Of course, those who dreamed of a Bretton Woods II were disappointed. But the original Bretton Woods framework was not built in a day; indeed, the 1944 conference was preceded by two and a half years of preparatory negotiations, which is probably the minimum needed to decide such weighty issues. The recent G-20 summit occurred with virtually no real preliminary work. Three tasks must now be addressed. First, a floor must be put under the international financial system in order to stop its collapse. Second, new regulations are needed once the system revives, because if it remains the same way, it will only produce new crises. Finding the right mix will not be easy. For 25 years, the world has experienced a huge financial crisis every five years, each seemingly with its own cause. The third task is to focus on real economic activity, end the recession, sustain growth, and, above all, reform the capitalist system to make it be less dependent on finance. Long-term investments, not short-term profits, and productive work, rather than paper gains, need to be supported. The first task is already being tackled. But, although the United States and some European countries have gone a long way toward restoring the lending capacity of banks, that may not be enough. After all, if the economy is to grow again, banks need borrowers, but the recession has led entrepreneurs to cut their investments. The second task remains open. Disagreements about how to re-regulate the financial markets are deep, owing to countless taboos and the huge interests at stake. Moreover, there can be no comprehensive agreement that does not take into account the relationship between finance and the real economy. The essential problem in addressing the third task is to find out precisely what is going on in the real economy. Some states (Iceland and Hungary) are clearly bankrupt. Some merely face a

hazardous financial situation (Denmark, Spain, and others). Their financial crisis is the main reason for their weakness. All of these problems are so difficult to resolve because they have been festering for so long. It is now increasingly evident that today's crisis has its roots in February 1971, when US President Richard Nixon decided to break the link between the dollar and gold. Until that point, America's pledge to maintain the gold standard was the basis for the global fixed-exchange-rate system, which was the heart of the Bretton Woods framework. During the 27 years that it lasted, huge growth in international trade, supported by non-volatile pricing, was the norm, and large financial crises were absent. Since then, the international financial system has been highly volatile. The era of floating exchange rates that followed the end of the gold standard required the development of products that could protect international trade from price volatility. This opened the way to options, selling and buying on credit, and derivatives of all kinds. These innovations were considered technical successes. Prices were (mostly) stabilized, but with a slow, if continuous, rising trend. The market for these financial products grew over 30 years to the point that they delivered huge opportunities for immediate gain, which provided a strong incentive for market participants to play with them more and more. During this time, capitalism - smooth and successful between 1945-1975 (sustained high growth, low unemployment, and no financial crises) - weakened. Through pension funds, investment funds, and arbitrage (or hedge) funds, shareholders became well organized and seized power in developed countries' firms. Under their pressure, more and more processes were "outsourced." In real terms, wages no longer rose (indeed, the average real wage has been stagnant for 25 years in the US), and a growing share of manpower (currently around 15%) was without steady employment. Everywhere, the share of wages and incomes began to fall as a proportion ofGDP. As a result, consumption weakened, unsteady employment grew, and unemployment stopped declining. Under such circumstances, the upper middle classes in developed countries increasingly came to look for capital gains instead of improving their living standards through productive work. This promoted inequality, and led to the under-regulated financial system's seizure of power over the entire economy, destabilizing the real economy by fatally weakening its capacity to react to external shocks. Today's crisis marks the end of economic growth fueled only by credit. But untying the knot that an overweening financial sector has drawn around the economy will take time. Indeed, there is still no consensus that this needs to be done. Yet the G-20 has opened the way to discussion of these fundamental issues. Today's recession will be a long one, but it will compel everybody to consider its root causes.

Michel Rocard former Prime Minister of France and leader of the Socialist Party, is a member of the European Parliament.

How Capitalist is America?

By Mark J. Roe

June20, 2011
CAMBRIDGE- If capitalism's border is with socialism, we know why the world properly sees the United States as strongly capitalist. State ownership is low, and is viewed as aberrational when it occurs (such as the government takeovers of General Motors and Chrysler in recent years, from which officials are rushing to exit). The government intervenes in the economy less than in most advanced nations, and major social programs like universal health care are not as deeply embedded in the US as elsewhere. But these are not the only dimensions to consider in judging how capitalist the US really is. Consider the extent to which capital -that is, shareholders - rules in large businesses: if a conflict arises between capital's goals and those of managers, who wins? Looked at in this way, America's capitalism becomes more ambiguous. American law gives more authority to managers and corporate directors than to shareholders. If shareholders want to tell directors what to do -say, borrow more money and expand the business, or close off the moneylosing factory- well, they just can't. The law is clear: the corporation's board of directors, not its shareholders, runs the business. Someone naive in the ways of US corporations might say that these rules are paper-thin, because shareholders can just elect new directors if the incumbents are recalcitrant. As long as they can elect the directors, one might think, shareholders rule the firm. That would be plausible if American corporate ownership were concentrated and powerful, with major shareholders owning, say, 25% of a company's stock - a structure common in most other advanced countries, where families, foundations, or financial institutions more often have that kind of authority inside large firms. But that is neither how US firms are owned, nor how US corporate elections work. Ownership in large American firms is diffuse, with block-holding shareholders scarce, even today. Hedge funds with big blocks of stock are news, not the norm. Corporate elections for the directors who run American firms are expensive. Incumbent directors typically nominate themselves, and the company pays their election expenses (for soliciting votes from distant and dispersed shareholders, producing voting materials, submitting legal filings, and, when an election is contested, paying for high-priced US litigation). If a shareholder dislikes, say, how GM's directors are running the company (and, in the 1980's and 1990's, they were running it

into the ground), she is free to nominate new directors, but she must pay their hefty elections costs, and should expect that no one, particularly not GM, will ever reimburse her. If she owns 100 shares, or 1,000, or even 100,000, challenging the incumbents is just not worthwhile. Hence, contested elections are few, incumbents win the few that occur, and they remain in control. Firms and their managers are subject to competitive markets and other constraints, but not to shareholder authority. In lieu of an election that could remove recalcitrant directors, an outside company might try to buy the firm and all of its stock. But the rules of the US corporate game -heavily influenced by directors and their lobbying organizations- usually allow directors to spurn outside offers, and even to block shareholders from selling to the outsider. Directors lacked that power in the early 1980's, when a wave of such hostile takeovers took place; but by the end of the decade, directors had the rules changed in their favor, to allow them to reject offers for nearly any reason. It is now enough to reject the outsider's price offer (even if no one else would pay more). American corporate-law reformers have long had their eyes on corporate elections. About a decade ago, after the Enron and WorldCom scandals, America's stock-market regulator, the Securities and Exchange Commission (SEC), considered requiring that companies allow qualified shareholders to put their director nominees on the company-paid election ballot. The actual proposal was anodyne, as it would allow only a few directors- not enough to change a board's majority- to be nominated, and voted on, at the company's expense. Nevertheless, the directors' lobbying organizations - such as the Business Roundtable and the Chamber of Commerce (and their lawyers) -attacked the SEC's initiative. Lobbying was fierce, and is said to have reached into the White House. Business interests sought to replace SEC commissioners who wanted the rule, and their lawyers threatened to sue the SEC if it moved forward. It worked: America's corporate insiders repeatedly pushed the proposal off of the SEC agenda in the ensuing decade. Then, in the summer of 2010, after a relevant election and a financial crisis that weakened incumbents' credibility, the SEC promulgated election rules that would give qualified shareholders free access to company-paid election ballots. As soon as it did, the US managerial establishment sued the SEC, and government officials felt compelled to suspend the new rules before they ever took effect. The litigation is now in America's courts. The lesson is that the US is less capitalist than it is "managerialist." Managers, not owners, get the final say in corporate decisions. Perhaps this is good. Even some capital-oriented thinking says that shareholders are better off if managers make all major decisions. And often the interests of shareholders and managers are aligned.

But there is considerable evidence that when managers are at odds with shareholders, managerial discretion in American firms is excessive and weakens companies. Managers of established firms continue money-losing ventures for too long, pay themselves too much relative to their and the company's performance, and too often fail to act aggressively enough to enter new but risky markets. When it comes to capitalism vs. socialism, we know which side the US is on. But when it's managers vs. capital-owners, the US is managerialist, not capitalist.

Mark Roe is a Professor ofJaw at Harvard Law School.

Missing Growth Multipliers

By Ashoka Mody
November 14, 2012
PRINCETON- In April 2010, when the global economy was beginning to recover from the shock of the 2008-2009 financial crisis, the International Monetary Fund's World Economic Outlook predicted that global GDP growth would exceed 4% in 2010, with a steady annual growth rate of 4.5% maintained through 2015. But the forecast proved to be far too optimistic. In fact, global growth has decelerated. In its most recent WEO, the IMF forecasts global GDP to grow by only 3.3% in 2012, and by 3.6% in 2013. Moreover, the downgrading of growth prospects is remarkably widespread. The forecast errors have three potential sources: failure to recognize the time needed for economic recovery after a financial crisis; underestimation of the "fiscal multipliers" (the size of output loss owing to fiscal austerity); and neglect of the "world-trade multiplier" (the tendency for countries to drag each other down as their economies contract). For the most part, the severity and implications of the financial crisis were judged well. Lessons from the October 2008 WEO, which analyzed recoveries after systemic financial stress, were incorporated into subsequent forecasts. As a result, predictions for the United States - where household deleveraging continues to constrain economic growth - have fallen short only modestly. The April 2010 report forecast a US growth rate of roughly 2.5% annually in 2012-2013; current projections put the rate a little higher than 2%. By contrast, the fiscal multiplier was seriously underestimated- as the WEO has now recognized. Consequently, forecasts for the United Kingdom- where financial-sector stresses largely resembled those in the US- have been significantly less accurate. The April 2010 WEO forecast a UK annual growth rate of nearly 3% in 2012-2013; instead, GDP is likely to contract this year and increase by roughly 1% next year. Much of this costly divergence from the earlier projections can be attributed to the benign view of fiscal consolidation that UK authorities and the IMF shared.

Likewise, the eurozone's heavily indebted economies (Greece, Ireland, Italy, Portugal, and Spain) have performed considerably worse than projected, owing to significant spending cuts and tax hikes. For example, Portugal's GDP was expected to grow by 1% this year; in fact, it will contract by a stunning 3%. The European Commission's claim that this slowdown reflects high sovereigndefault risk, rather than fiscal consolidation, is belied by the UK, where the sovereign risk is deemed by markets to be virtually nonexistent. The world-trade multiplier, though less widely recognized, helps to explain why the growth deceleration has been so widespread and persistent. When a country's economic growth slows, it imports less from other countries, thereby reducing those countries' growth rates, and causing them, too, to reduce imports. The eurozone has been at the epicenter of this contractionary force on global growth. Since eurozone countries trade extensively with each other and the rest of the world, their slowdowns have contributed significantly to a decrease in global trade, in turn undermining global growth. In particular, as European imports from East Asia have fallen, East Asian economies' growth is down sharply from last year and the 2010 forecast- and, predictably, growth in their imports from the rest of the world has lost momentum. Global trade has steadily weakened, with almost no increase in the last six months. The oncepopular notion, built into growth forecasts, that exports would provide an escape route from the crisis was never credible. That notion has now been turned on its head: as economic growth has stalled, falling import demand from trade partners has caused economic woes to spread and deepen. The impact of slowing global trade is most apparent for Germany, which was not burdened with excessive household or corporate debt, and enjoyed a favorable fiscal position. To escape the crisis, Germany used rapid export growth - especially to meet voracious Chinese demand. Although growth was expected to slow subsequently, it was forecast at roughly 2% in 2012-2013. But, as Chinese growth has decelerated- owing partly to decreased exports to Europe- the German GDP forecast has been halved. And, given that this year's growth has largely already occurred, Germany's economy has now plateaued - and could even be contracting. In good times, the trade generated by a country's growth bolsters global growth. But, in times of crisis, the trade spillovers have the opposite effect. As the global economy has become increasingly interconnected, these trade multipliers have increased. Indeed, while less ominous and dramatic than financial contagion, trade spillovers profoundly influence global growth prospects. Failure to recognize their impact implies that export - and, in turn, growth - projections will continue to miss the mark. The projected increase in global growth next year will likely not happen. On the contrary, policy errors and delays in individual countries will seriously damage economies worldwide.

Ashoka Mody is a visiting professor ofInternational Economic Policy at the Woodrow Wilson School ofPublic and International Affairs, Princeton University.

The Narrative Structure of Global Weakening

By Robert J. Shiller

September 20, 2012

NEW HAVEN - Recent indications of a weakening global economy have led many people to wonder how pervasive poor economic performance will be in the coming years. Are we facing a long global slump, or possibly even a depression? A fundamental problem in forecasting nowadays is that the ultimate causes of the slowdown are really psychological and sociological, and relate to fluctuating confidence and changing "animal spirits," about which George Akerlof and I have written. We argue that such shifts reflect changing stories, epidemics of new narratives, and associated views of the world, which are difficult to quantify. In fact, most professional economists do not seem overly glum about the global economy's prospects. For example, on September 6, the OECD issued an interim assessment on the near-term global outlook, written by Pier Carlo Padoan, that blandly reports "significant risks" on the horizon - the language of uncertainty itself. The problem is that the statistical models that comprise economists' toolkit are best applied in normal times, so economists naturally like to describe the situation as normal. If the current slowdown is typical of other slowdowns in recent decades, then we can predict the same kind of recovery. For example, in a paper presented last spring at the Brookings Institution in Washington, DC, James Stock of Harvard University and Mark Watson of Princeton University unveiled a new "dynamic factor model," estimated using data from 1959 to 2011. Having thus excluded the Great Depression, they claimed that the recent slowdown in the United States is basically no different from other recent slowdowns, except larger. Their model reduces the sources of all recessions to just six shocks - "oil, monetary policy, productivity, uncertainty, liquidity/financial risk, and fiscal policy" - and explains most of the post-2007 downturn in terms of just two of these factors: "uncertainty" and "liquidity/financial risk." But, even if we accept that conclusion, we are left to wonder what caused large shocks to "uncertainty" and to "liquidity/financial risk" in recent years, and how reliably such shocks can be predicted.

When one considers the evidence about external economic shocks over the past year or two, what emerges are stories whose precise significance is unknowable. We only know that most of us have heard them many times. Foremost among those stories is the European financial crisis, which is talked about everywhere around the globe. The OECD's interim assessment called it "the most important risk for the global economy." That may seem unlikely: Why should the European crisis be so important elsewhere? Part of the reason, of course, is the rise of global trade and financial markets. But connections between countries do not occur solely through the direct impact of market prices. Interacting public psychology is likely to play a role as well. This brings us to the importance of stories - and very far from the kind of statistical analysis exemplified by Stock and Watson. Psychologists have stressed that there is a narrative basis to human thinking: people remember - and are motivated by- stories, particularly human-interest stories about real people. Popular stories tend to take on moral dimensions, leading people to imagine that bad outcomes reflect some kind of loss of moral resolve. The European crisis began with a Greek meltdown story, and it appears that the entire global economy is threatened by events in a country of only 11 million people. But the economic importance of stories bears no close relation to their monetary value (which can be measured only after the fact, if at all). It depends, instead, on their story value. The Greek crisis story began in 2008 with reports of widespread protests and strikes when the government proposed raising the retirement age to address a pension funding shortfall. Reports began to appear in global news media portraying an excessive sense of entitlement, with Greeks taking to the streets in protest, even though the increase was modest (for example, women with children or in hazardous jobs would be able to retire with full benefits at just 55, up from SO). That story might have invited some gossip outside of Greece, but it gained little purchase on international attention until the end of 2009, when the market for Greek debt started to become increasingly unsettled, with rising interest rates causing further problems for the government. This augmented news reports about Greek profligacy, and thus closed a negative feedback loop by attracting intensifying public interest, which eventually fueled crises in other European countries. Like a YouTube video, the Greek story went viral. One might object that most people outside of Europe surely were not following the European crisis closely, and the least informed have not even heard of it. But opinion leaders, and friends and relatives of the least informed in each country, were following it, and their influence can create an atmosphere that makes everyone less willing to spend. The Greek story seems connected in many people's minds with the stories of the real-estate and stock-market bubbles that preceded the current crisis in 2007. These asset bubbles were inflated by

lax lending standards and an excessive willingness to borrow, which seemed similar to the Greek government's willingness to take on debt to pay lavish pensions. Thus, people saw the Greek crisis not just as a metaphor, but also as a morality tale. The natural consequence was to support government austerity programs, which can only make the situation worse. The European story is with us now, all over the world, so vivid that, even if the euro crisis appears to be resolved satisfactorily, it will not be forgotten until some new story diverts public attention. Then as now, we will not be able to understand the world economic outlook fully without considering the story on people's minds.

Robert Shiller, Professor of Economics at Yale University, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global
Capitalism.

A People's Economics
By Robert J. Shiller

January 20, 2011

NEW HAVEN- We are in the midst of a boom in popular economics: books, articles, blogs, public lectures, all followed closely by the general public. I recently participated in a panel discussion of this phenomenon at the American Economic Association annual meeting in Denver. An apparent paradox emerged from the discussion: the boom in popular economics comes at a time when the general public seems to have lost faith in professional economists, because almost all of us failed to predict, or even warn of, the current economic crisis, the biggest since the Great Depression. So, why is the public buying more books by professional economists? The most interesting explanation I heard was that economics has become more interesting, because it no longer seems to be a finished and closed discipline. It is no fun to read a book or article that says that economic forecasting is best left to computer models that you, the general reader, would need a Ph.D. to understand. And, in truth, the public is right: while there is a somewhat scientific basis for these models, they can go spectacularly wrong. Sometimes we need to turn off autopilot and think for ourselves, and when a crisis occurs, use our best human intellect. The panelists all said, in one way or another, that popular economics facilitates an exchange between specialized economists and the broader public - a dialogue that has never been more important. After all, most economists did not see this crisis coming in part because they had removed themselves from what real-world people were doing and thinking. Successful popular economics involves the reader or listener, in some sense, as a collaborator. That, of course, means that economists must be willing to include new and original theories that are not yet received doctrine among professional specialists. Until recently, many professional economists would be reluctant to write a popular book. Certainly, it would not be viewed favorably in considering a candidate for tenure or a promotion. Since it does not include equations or statistical tables, they would argue, it is not serious work that is worthy of scholarly attention.

Worse than that, at least until recently, a committee evaluating an economist would likely think that writing a popular economics book that does not repeat the received wisdom of the discipline might even be professionally unethical. Imagine how the medical profession would view one of its members who recommended to the general public some therapy that had not yet passed scrutiny from the appropriate authorities. Medical professionals know how often seemingly promising new therapies turn out, after careful study, not to work, or even to be harmful. There is a rigorous process of scholarly review of proposed new therapies, associated with professional journals that uphold high research standards. Circumventing that process and promoting new, untested ideas to the general public is unprofessional. In the decades prior to the current financial crisis, economists gradually came to view themselves and their profession in the same way, encouraged by research trends. For example, after 1960, when the University of Chicago started creating a Univac computer tape that contained systematic information about millions of stock prices, a great deal of scientific research on the properties of stock prices was taken as confirming the "efficient markets hypothesis." The competitive forces that underlie stock exchanges were seen to force all securities prices to their true fundamental values. All trading schemes not based on this hypothesis were labeled as either misguided or outright frauds. Science had triumphed over stock-market punditry- or so it seemed. The financial crisis delivered a fatal blow to that overconfidence in scientific economics. It is not just that the profession didn't forecast the crisis. Their models, taken literally, sometimes suggested that a crisis of this magnitude couldn't happen. One way to interpret this is that the economics profession was not fully accounting for the economy's human element, an element that can't be reduced to mathematical analysis. The relatively few professional economists who warned of the current crisis were people, it seems, who not only read the scholarly economics literature, but also brought into play more personal judgment: intuitive comparisons with past historical episodes; conclusions about speculative trading, price bubbles, and the stability of confidence; evaluations of the moral purposes of economic actors; and impressions that complacency had set in, lulling watchdogs to sleep. These were judgments made by economists who were familiar with our business leadership - their inspirations, beliefs, subterfuges, and rationalizations. Their views could never be submitted to a scholarly journal and evaluated the way a new medical procedure is. There is no established scientific procedure that could prove their validity. Of course, economics is in many ways a science, and the work of our scholars and their computer models really does matter. But, as the economist Edwin R. A. Seligman put it in 1889, "Economics is

a social science, i.e., it is an ethical and therefore an historical science... .It is not a natural science, and therefore not an exact or purely abstract science." To me, and no doubt to the other panelists, part of the process of pursuing the inexact aspects of economics is speaking honestly to the broader public, looking them in the eye, learning from them, reading the emails they send, and then searching one's soul to decide whether one's favored theory is really close to the truth.

Robert Shiller, Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC, is co-author, with George Akerlof, of Animal Spirits: How Human
Psychology Drives the Economy and Why It Matters for Global Capitalism.

Labor's Paradise Lost

By Robert Skidelsky June 21, 2012
LONDON - As people in the developed world wonder how their countries will return to full employment after the Great Recession, it might benefit us to take a look at a visionary essay that John Maynard Keynes wrote in 1930, called "Economic Possibilities for our Grandchildren." Keynes's General Theory of Employment, Interest, and Money, published in 1936, equipped governments with the intellectual tools to counter the unemployment caused by slumps. In this earlier essay, however, Keynes distinguished between unemployment caused by temporary economic breakdowns and what he called "technological unemployment"- that is, "unemployment due to the discovery of means of economizing the use oflabor outrunning the pace at which we can find new uses for labor." Keynes reckoned that we would hear much more about this kind of unemployment in the future. But its emergence, he thought, was a cause for hope, rather than despair. For it showed that the developed world, at least, was on track to solving the "economic problem"- the problem of scarcity that kept mankind tethered to a burdensome life of toil. Machines were rapidly replacing human labor, holding out the prospect of vastly increased production at a fraction of the existing human effort. In fact, Keynes thought that by about now (the early twenty-first century) most people would have to work only 15 hours a week to produce all that they needed for subsistence and comfort. Developed countries are now about as rich as Keynes thought they would be, but most of us work much longer than 15 hours a week, though we do take longer holidays, and work has become less physically demanding, so we also live longer. But, in broad terms, the prophecy of vastly increased leisure for all has not been fulfilled. Automation has been proceeding apace, but most of us who work still put in an average of 40 hours a week. In fact, working hours have not fallen since the early 1980's. At the same time, "technological unemployment" has been on the rise. Since the 1980's, we have never regained the full employment levels of the 1950's and 1960's. If most people still work a 40hour week, a substantial and growing minority have had unwanted leisure thrust upon them in the form of unemployment, under-employment, and forced withdrawal from the labor market. And, as we recover from the current recession, most experts expect this group to grow even larger.

What this means is that we have largely failed to convert growing technological unemployment into increased voluntary leisure. The main reason for this is that the lion's share of the productivity gains achieved over the last 30 years has been seized by the well-off. Particularly in the United States and Britain since the 1980's, we have witnessed a return to the capitalism "red in tooth and claw" depicted by Karl Marx. The rich and very rich have gotten very much richer, while everyone else's incomes have stagnated. So most people are not, in fact, four or five times better off than they were in 19 30. It is not surprising that they are working longer than Keynes thought they would. But there is something else. Modern capitalism inflames through every sense and pore the hunger for consumption. Satisfying it has become the great palliative of modern society, our counterfeit reward for working irrational hours. Advertisers proclaim a single message: your soul is to be discovered in your shopping. Aristotle knew of insatiability only as a personal vice; he had no inkling of the collective, politically orchestrated insatiability that we call economic growth. The civilization of "always more" would have struck him as moral and political madness. And, beyond a certain point, it is also economic madness. This is not just or mainly because we will soon enough run up against the natural limits to growth. It is because we cannot go on for much longer economizing on labor faster than we can find new uses for it. That road leads to a division of society into a minority of producers, professionals, supervisors, and financial speculators on one side, and a majority of drones and unemployables on the other. Apart from its moral implications, such a society would face a classic dilemma: how to reconcile the relentless pressure to consume with stagnant earnings. So far, the answer has been to borrow, leading to today's massive debt overhangs in advanced economies. Obviously, this is unsustainable, and thus is no answer at all, for it implies periodic collapse of the wealth-producing machine. The truth is that we cannot go on successfully automating our production without rethinking our attitudes toward consumption, work, leisure, and the distribution of income. Without such efforts of social imagination, recovery from the current crisis will simply be a prelude to more shattering calamities in the future.

Robert Skidelsky's new book, co-authored with Edward Skidelsky, is How Much is Enough?

Inequality is Killing Capitalism

By Robert Skidelsky
November 21, 2012
LONDON- It is generally agreed that the crisis of 2008-2009 was caused by excessive bank lending, and that the failure to recover adequately from it stems from banks' refusal to lend, owing to their "broken" balance sheets. A typical story, much favored by followers of Friedrich von Hayek and the Austrian School of economics, goes like this: In the run up to the crisis, banks lent more money to borrowers than savers would have been prepared to lend otherwise, thanks to excessively cheap money provided by central banks, particularly the United States Federal Reserve. Commercial banks, flush with central banks' money, advanced credit for many unsound investment projects, with the explosion of financial innovation (particularly of derivative instruments) fueling the lending frenzy. This inverted pyramid of debt collapsed when the Fed finally put a halt to the spending spree by hiking up interest rates. (The Fed raised its benchmark federal funds rate from 1% in 2004 to 5.25% in 2006 and held it there until August 2007). As a result, house prices collapsed, leaving a trail of zombie banks (whose liabilities far exceeded their assets) and ruined borrowers. The problem now appears to be one of re-starting bank lending. Impaired banks that do not want to lend must somehow be "made whole." This has been the purpose of the vast bank bailouts in the US and Europe, followed by several rounds of "quantitative easing," by which central banks print money and pump it into the banking system through a variety of unorthodox channels. (Hayekians object to this, arguing that, because the crisis was caused by excessive credit, it cannot be overcome with more.) At the same time, regulatory regimes have been toughened everywhere to prevent banks from jeopardizing the financial system again. For example, in addition to its price-stability mandate, the Bank of England has been given the new task of maintaining "the stability of the financial

system."
This analysis, while seemingly plausible, depends on the belief that it is the supply of credit that is essential to economic health: too much money ruins it, while too little destroys it. But one can take another view, which is that demand for credit, rather than supply, is the crucial economic driver. After all, banks are bound to lend on adequate collateral; and, in the run-up to the

crisis, rising house prices provided it. The supply of credit, in other words, resulted from the demand for credit. This puts the question of the origins of the crisis in a somewhat different light. It was not so much predatory lenders as it was imprudent, or deluded, borrowers, who bear the blame. So the question arises: Why did people want to borrow so much? Why did the ratio of household debt to income soar to unprecedented heights in the pre-recession days? Let us agree that people are greedy, and that they always want more than they can afford. Why, then, did this "greed" manifest itself so manically? To answer that, we must look at what was happening to the distribution of income. The world was getting steadily richer, but the income distribution within countries was becoming steadily more unequal. Median incomes have been stagnant or even falling for the last 30 years, even as per capita GDP has grown. This means that the rich have been creaming off a giant share of productivity growth. And what did the relatively poor do to "keep up with the Joneses" in this world of rising standards? They did what the poor have always done: got into debt. In an earlier era, they became indebted to the pawnbroker; now they are indebted to banks or credit-card companies. And, because their poverty was only relative and house prices were racing ahead, creditors were happy to let them sink deeper and deeper into debt. Of course, some worried about the collapse of the household savings rate, but few were overly concerned. In one of his last articles, Milton Friedman wrote that savings nowadays took the form of houses. To me, this view of things explains much better than the orthodox account why, for all the moneypumping by central banks, commercial banks have not started lending again, and the economic recovery has petered out. Just as lenders did not force money on the public before the crisis, so now they cannot force heavily indebted households to borrow, or businesses to seek loans to expand production when markets are flat or shrinking. In short, recovery cannot be left to the Fed, the European Central Bank, or the Bank of England. It requires the active involvement of fiscal policymakers. Our current situation requires not a lender oflast resort, but a spender oflast resort, and that can only be governments. If governments, with their already-high level of indebtedness, believe that they cannot borrow any more from the public, they should borrow from their central banks and spend the extra money themselves on public works and infrastructure projects. This is the only way to get the big economies of the West moving again.

But, beyond this, we cannot carry on with a system that allows so much of the national income and wealth to pile up in so few hands. Concerted redistribution of wealth and income has frequently been essential to the long-term survival of capitalism. We are about to learn that lesson again.

Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University.

The Mirage of Youth Unemployment

By Steven Hill
August 15, 2012
PARIS - Economists worldwide need better ways to measure economic activity. Relying on GDP growth rates to assess economic health, almost all of them missed the warning signs of the 2008 financial crisis, including an $8 trillion real-estate bubble in the United States, as well as property bubbles in Spain, Ireland, and the United Kingdom. Together with households, financial institutions, investors, and governments, economists were swept up in the financial euphoria that led to excessive risk-taking and severe over-leveraging of banks and households. Even the eurozone's macroeconomic imbalances largely went unnoticed. Unemployment estimates also are surprisingly misleading - a serious problem, considering that, together with GDP indicators, unemployment drives so much economic-policy debate. Outrageously high youth unemployment- supposedly near SO% in Spain and Greece, and more than 20% in the eurozone as a whole- makes headlines daily. But these numbers result from flawed methodology, making the situation appear far worse than it is. The problem stems from how unemployment is measured: The adult unemployment rate is calculated by dividing the number of unemployed individuals by all individuals in the labor force. So if the labor force comprises 200 workers, and 20 are unemployed, the unemployment rate is 10%. But the millions of young people who attend university or vocational training programs are not considered part of the labor force, because they are neither working nor looking for a job. In calculating youth unemployment, therefore, the same number of unemployed individuals is divided by a much smaller number, to reflect the smaller labor force, which makes the unemployment rate look a lot higher. In the example above, let us say that 1SO of the 200 workers become full-time university students. Only SO individuals remain in the labor force. Although the number of unemployed people remains at 20, the unemployment rate quadruples, to 40%. So the perverse result of this way of counting the unemployed is that the more young people who pursue additional education or training, the higher the youth unemployment rate rises. While standard measures exaggerate youth unemployment, they likely understate adult unemployment, because those who have given up their job search are not counted among the

unemployed. As the Great Recession drives up the number of such "discouraged workers," adult unemployment rates appear to fall - presenting a distorted picture of reality. Fortunately, there is a better methodology: The youth unemployment ratio - the number of unemployed youth relative to the total population aged 16-24- is a far more meaningful indicator than the youth unemployment rate. Eurostat, the European Union's statistical agency, calculates youth unemployment using both methodologies, but only the flawed indicator is widely reported, despite major discrepancies. For example, Spain's 48.9% youth unemployment rate implies significantly worse conditions for young people than its 19% youth unemployment ratio. Likewise, Greece's rate is 49.3%, but its ratio is only 13%. And the eurozone-wide rate of20.8% far exceeds the 8.7% ratio. To be sure, a youth unemployment ratio of 13% or 19% is not grounds for complacency. But, while the eurozone's youth unemployment rate has increased since 2009, its ratio has remained the same (though both significantly exceed pre-2008 levels). During the 2006 French student protests, France's 22% youth unemployment rate appeared to compare unfavorably to rates of 11%, 12%, and 13% in the United Kingdom, the US, and Germany, respectively. But the Financial Times showed that only 7.8% of French under-25's were unemployed - about the same ratio as in the other three countries. France simply had a higher percentage of young people who were full-time students. Failing to account for the millions of young people either attending university or in vocational training programs undermines the unemployment rate's credibility. And, while some young people use higher education to escape a rocky job market, their choice to build new skills should not negatively impact perceptions of their country's economic health. Policymakers do, of course, need to address the problem of youth unemployment; but they must also acknowledge that the problem is not as serious as the headlines indicate. Unfortunately, these distorted results have become conventional wisdom- even for respected economists like the Nobel laureate Paul Krugman, who recently invoked the flawed "50% youth unemployment" figure. Thus, four years after the crisis erupted, methods for measuring and assessing economic health remain alarmingly inadequate. As any pilot knows, flying without radar or accurate weather forecasts is likely to end in a crash.

Steven Hill is the author of Europe's Promise: Why the European Way is the Best Hope in an Insecure Age and 10 Steps to Repair American Democracy.

The Bad Society

By Robert Skidelsky
July 19, 2012
LONDON- How much inequality is acceptable? Judging by pre-recession standards, a great deal of it, especially in the United States and Britain. New Labour's Peter Mandelson voiced the spirit of the past 30 years when he remarked that he felt intensely "relaxed" about people getting "filthy" rich. Getting rich was what the "new economy" was all about. And the newly rich kept an increasing part of what they got, as taxes were slashed to encourage them to get still richer, and efforts to divide up the pie more fairly were abandoned. The results were predictable. In 1970, the pre-tax pay of a top American CEO was about 30 times higher than that of the average worker; today it is 263 times higher. In Britain, the basic pay (without bonuses) of a top CEO was 47 times the average worker's in 1970; in 2010, it was 81 times more. Since the late 1970s, the post-tax income of the richest fifth has increased five times as fast as the poorest fifth in the US, and four times as fast in the UK. Even more important has been the growing gap between average (mean) and median income: that is, the proportion of the population living on half or less of the average income in the US and Britain has been growing. Although some countries have resisted the trend, inequality has been increasing over the last 30-40 years in the world as a whole. Inequality within countries has increased, and inequality between countries increased sharply after 1980, before leveling off in the late 1990's and finally falling back after 2000, as catch-up growth in developing countries accelerated. The growth of inequality leaves ideological defenders of capitalism unfazed. In a competitive market system, people are said to be paid what they are worth: so top CEOs add 263 times more value to the American economy than the workers they employ. But the poor, it is claimed, are still better off than they would have been had the gap been artificially narrowed by trade unions or governments. The only secure way to get "trickle-down" wealth to trickle faster is by cutting marginal tax rates still further, or, alternatively, by improving the "human capital" of the poor, so that they become worth more to their employers. This is a method of economic reasoning that is calculated to appeal to those at the top of the income pyramid. After all, there is no way whatsoever to calculate the marginal products of different individuals in cooperative productive activities. Top pay rates are simply fixed by comparing them to other top pay rates in similar jobs.

In the past, pay differentials were settled by reference to what seemed fair and reasonable. The greater the knowledge, skill, and responsibility attached to a job, the higher the acceptable and accepted reward for doing it. But all of this occurred within bounds that maintained some connection between the top and the bottom. Top business salaries were rarely more than 20 or 30 times higher than average wages, and for most people differentials were far less. Thus, the income of doctors and lawyers used to be about five times higher than that of manual workers, not ten times or more, as they are today.
It is the breakdown of non -economistic, common -sense ways of valuing human activities -framing

them in larger social contexts- that has led to today's spurious methods of calculating pay. There is a strange, though little-noticed, consequence of the failure to distinguish value from price: the only way offered to most people to boost their incomes is through economic growth. In poor countries, this is reasonable; there is not enough wealth to spread round. But, in developed countries, concentration on economic growth is an extraordinarily inefficient way to increase general prosperity, because it means that an economy must grow by, say, 3% to raise the earnings of the majority by, say, 1%. Nor is it by any means certain that the human capital of the majority can be increased faster than that of the minority, who capture all of the educational advantages flowing from superior wealth, family conditions, and connections. Redistribution in these circumstances is a more secure way to achieve a broad base of consumption, which is itself a guarantee of economic stability. The attitude of indifference to income distribution is in fact a recipe for economic growth without end, with the rich, very rich, and super-rich drawing ever further ahead of the rest. This must be wrong for moral and even practical reasons. In moral terms, it puts the prospect of the good life perpetually beyond reach for most people. And, in practical terms, it is bound to destroy the social cohesion on which democracy- or, indeed, any type of peaceful, contented society - ultimately rests.

Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University.

Re-Capturing the Friedmans

By J. Bradford DeLong
April 30, 2012
BERKELEY - On my desk right now are reporter Timothy Noah's new book The Great

Divergence: America's Growing Inequality Crisis and What We Can Do about It and Milton and Rose Director Friedman's classic Free to Choose: A Personal Statement. Considering them
together, my overwhelming thought is that the Friedmans would find their task of justifying and advocating small-government libertarianism much harder today than they did in 1979. Back then, the Friedmans made three powerful factual claims about how the world works- claims that seemed true or maybe true or at least arguably true at the time, but that now seem to be pretty clearly false. Their case for small-government libertarianism rested largely on those claims, and has now largely crumbled, because the world, it turned out, disagreed with them about how it works. The first claim was that macroeconomic distress is caused by the government, not by the unstable private market, or, rather, that the form of macroeconomic regulation required to produce economic stability is straightforward and easily achieved. The Friedmans almost always made the claim in its first form: they said that the government had "caused" the Great Depression. But when you dug into their argument, it turned out that what they really meant was the second: whenever private-market instability threatened to cause a depression, the government could avert it or produce a rapid recovery simply by purchasing enough bonds for cash to flood the economy with liquidity. In other words, the strategic government intervention needed to ensure macroeconomic stability was not only straightforward, but also minimal: the authorities need only manage a steady rate of money-supply growth. The aggressive and comprehensive intervention that Keynesians claimed was needed to manage aggregate demand, and that Minskyites claimed was needed to manage financial risk, was entirely unwarranted. Real libertarians never bought the Friedmans' claim that they were as advocating a free-market, "neutral" monetary regime: Ludwig von Mises famously called Milton Friedman and his monetarist followers a bunch of socialists. But, whatever its packaging, the belief that macroeconomic stability requires only minimal government intervention is simply wrong. In the United States, Federal Reserve Chairman Ben Bernanke has executed the Friedmanite playbook flawlessly in the current downturn, and it has not been enough to preserve or rapidly restore full employment.

The second claim was that externalities were relatively small, or at least that they were better dealt with via contract and tort law than through government regulation, because the disadvantages of government regulation outweighed the harm done by those externalities that the legal system could not properly address. Here, too, reality does not seem to have endorsed Free to Choose. In the US, this is most apparent in changing attitudes toward medical-malpractice lawsuits, with libertarians no longer viewing the court system as the preferred arena to deal with medical risk and error. The third, and most important, claim is the subject of Noah's The Great Divergence. In 1979, the Friedmans could confidently claim that, in the absence of government-mandated discrimination (for example, the South's segregationist Jim Crow laws), the market economy would produce a sufficiently egalitarian distribution of income. After all, it had appeared to do so - at least for those who did not suffer from legal discrimination or its legacies - for the entire post-WWII era. So the Friedmans argued that a minimal safety net for those whom bad luck or a lack of prudence had rendered destitute, and elimination of all legal barriers to equality of opportunity, would lead to the most equitable outcomes possible. Profit-seeking employers, using and promoting human talents, would bring us as close to a free society of associated producers as is attainable in this fallen sublunary sphere. Here, too, the Friedmans' hopes have been disappointed. The end of American preeminence in education, the collapse of private-sector unions, the emergence of a winner-take-all informationage economy, and the return of Gilded Age-style high finance have produced an extraordinarily unequal pre-tax distribution of income, which will burden the next generation and make a mockery of equality of opportunity.
It would have been nice if the political program laid out a generation ago in Free to Choose had

lived up to the Friedmans' billing. It would have been nice if a relatively equal and prosperous society with full employment and equal opportunity had followed from a government that stood back from the economy and provided nothing but a minimal safety net, courts, and a constantly growing money supply. Alas, that did not happen. And it did not happen because the world described by the Friedmans is not the world in which we live.

J. Bradford DeLong, a former assistant secretary of the US Treasury, is Professor of

Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research.

The Tyranny of Political Economy

By Dani Rodrik

February 8, 2013
CAMBRIDGE - There was a time when we economists steered clear of politics. We viewed our job as describing how market economies work, when they fail, and how well-designed policies can enhance efficiency. We analyzed trade-offs between competing objectives (say, equity versus efficiency), and prescribed policies to meet desired economic outcomes, including redistribution. It was up to politicians to take our advice (or not), and to bureaucrats to implement it. Then some of us became more ambitious. Frustrated by the reality that much of our advice went unheeded (so many free-market solutions still waiting to be taken up!), we turned our analytical toolkit on the behavior of politicians and bureaucrats themselves. We began to examine political behavior using the same conceptual framework that we use for consumer and producer decisions in a market economy. Politicians became income-maximizing suppliers of policy favors; citizens became rent-seeking lobbies and special interests; and political systems became marketplaces in which votes and political influence are traded for economic benefits. Thus was born the field of rational-choice political economy, and a style of theorizing that many political scientists readily emulated. The apparent payoff was that we could now explain why politicians did so many things that violated economic rationality. Indeed, there was no economic malfunction that the two words "vested interests" could not account for. Why are so many industries closed off to real competition? Because politicians are in the pockets of the incumbents who reap the rents. Why do governments erect barriers to international trade? Because the beneficiaries of trade protection are concentrated and politically influential, while consumers are diffuse and disorganized. Why do political elites block reforms that would spur economic growth and development? Because growth and development would undermine their hold on political power. Why are there financial crises? Because banks capture the policymaking process so that they can take excessive risks at the expense of the general public. In order to change the world, we need to understand it. And this mode of analysis seemed to transport us to a higher level of understanding of economic and political outcomes. But there was a deep paradox in all of this. The more we claimed to be explaining, the less room was left for improving matters. If politicians' behavior is determined by the vested interests to

which they are beholden, economists' advocacy of policy reforms is bound to fall on deaf ears. The more complete our social science, the more irrelevant our policy analysis. This is where the analogy between human sciences and natural sciences breaks down. Consider the relationship between science and engineering. As scientists' understanding of the physical laws of nature grows more sophisticated, engineers can build better bridges and buildings. Improvements in natural science enhance, rather than impede, our ability to shape our physical environment. The relationship between political economy and policy analysis is not at all like this. By endogenizing politicians' behavior, political economy disempowers policy analysts. It is as if physicists came up with theories that explained not only natural phenomena, but also determined which bridges and buildings engineers would build. There would then scarcely be any need for engineering schools. If it seems to you that something is wrong with this, you are on to something. In reality, our contemporary frameworks for political economy are replete with unstated assumptions about the system of ideas underlying the operation of political systems. Make those assumptions explicit, and the decisive role of vested interests evaporates. Policy design, political leadership, and human agency come back to life. There are three ways in which ideas shape interests. First, ideas determine how political elites define themselves and the objectives they pursue - money, honor, status, longevity in power, or simply a place in history. These questions of identity are central to how they choose to act. Second, ideas determine political actors' views about how the world works. Powerful business interests will lobby for different policies when they believe that fiscal stimulus yields only inflation than when they believe that it generates higher aggregate demand. Revenue hungry governments will impose a lower tax when they think that it can be evaded than when they think that it cannot. Most important from the perspective of policy analysis, ideas determine the strategies that political actors believe they can pursue. For example, one way for elites to remain in power is to suppress all economic activity. But another is to encourage economic development while diversifying their own economic base, establishing coalitions, fostering state-directed industrialization, or pursuing a variety of other strategies limited only by the elites' imagination. Expand the range of feasible strategies (which is what good policy design and leadership do), and you radically change behavior and outcomes. Indeed, this is what explains some of the most astounding turnarounds in economic performance in recent decades, such as South Korea's and China's breakout growth (in the 1960's and the late 1970's, respectively). In both cases, the biggest winners were "vested interests" (Korea's business establishment and the Chinese Communist Party). What enabled reform was not a reconfiguration of political power, but the emergence of new strategies. Economic change often happens not when vested interests are defeated, but when different strategies are used to pursue those interests.

Political economy undoubtedly remains important. Without a clear understanding of who gains and who loses from the status quo, it is difficult to make sense of our existing policies. But an excessive focus on vested interests can easily divert us from the critical contribution that policy analysis and political entrepreneurship can make. The possibilities of economic change are limited not just by the realities of political power, but also by the poverty of our ideas.

Dani Rodrik, Professor of International Political Economy at Harvard University, is the author ofThe Globalization Paradox: Democracy and the Future of theW orld Economy.

Free-Trade Blinders
By Dani Rodrik

March 9, 2012
CAMBRIDGE - I was recently invited by two Harvard colleagues to make a guest appearance in their course on globalization. "I have to tell you," one of them warned me beforehand, "this is a pretty pro-globalization crowd." In the very first meeting, he had asked the students how many of them preferred free trade to import restrictions; the response was more than 90%. And this was before the students had been instructed in the wonders of comparative advantage! We know that when the same question is asked in real surveys with representative samples - not just Harvard students- the outcome is quite different. In the United States, respondents favor trade restrictions by a two-to-one margin. But the Harvard students' response was not entirely surprising. Highly skilled and better-educated respondents tend to be considerably more pro-free trade than blue-collar workers are. Perhaps the Harvard students were simply voting with their own (future) wallets in mind. Or maybe they did not understand how trade really works. After all, when I met with them, I posed the same question in a different guise, emphasizing the likely distributional effects of trade. This time, the free-trade consensus evaporated- even more rapidly than I had anticipated. I began the class by asking students whether they would approve of my carrying out a particular magic experiment. I picked two volunteers, Nicholas and John, and told them that I was capable of making $200 disappear from Nicholas's bank account- poof! -while adding $300 to John's. This feat of social engineering would leave the class as a whole better off by $100. Would they allow me to carry out this magic trick? Those who voted affirmatively were only a tiny minority. Many were uncertain. Even more opposed the change. Clearly the students were uncomfortable about condoning a significant redistribution of income, even if the economic pie grew as a result. How is it possible, I asked, that almost all of them had instinctively favored free trade, which entails a similar- in fact, most likely greater- redistribution from losers to winners? They appeared taken aback. Let's assume, I said next, that Nicholas and John own two small firms that compete with each other. Suppose that John got richer by $300 because he worked harder, saved and invested more, and

created better products, driving Nicholas out of business and causing him a loss of$200. How many of the students now approved of the change? This time a vast majority did - in fact, everyone except Nicholas approved! I posed other hypotheticals, now directly related to international trade. Suppose John had driven Nicholas out of business by importing higher-quality inputs from Germany? By outsourcing to China, where labor rights are not well protected? By hiring child workers in Indonesia? Support for the proposed change dropped with each one of these alternatives. But what about technological innovation, which, like trade, often leaves some people worse off. Here, few students would condone blocking technological progress. Banning the light bulb because candle makers would lose their jobs strikes almost everyone as a silly idea. So the students were not necessarily against redistribution. They were against certain kinds of redistribution. Like most of us, they care about procedural fairness. To pass judgment on redistributive outcomes, we need to know about the circumstances that cause them. We do not begrudge Bill Gates or Warren Buffett their billions, even if some of their rivals have suffered along the way, presumably because they and their competitors operate according to the same ground rules and face pretty much the same opportunities and obstacles. We would think differently if Gates and Buffett had enriched themselves not through perspiration and inspiration, but by cheating, breaking labor laws, ravaging the environment, or taking advantage of government subsidies abroad. If we do not condone redistribution that violates widely shared moral codes at home, why should we accept it just because it involves transactions across political borders? Similarly, when we expect redistributive effects to even out in the long run, so that everyone eventually comes out ahead, we are more likely to overlook reshufflings of income. That is a key reason why we believe that technological progress should run its course, despite its short-run destructive effects on some. When, on the other hand, the forces of trade repeatedly hit the same people - less educated, blue-collar workers - we may feel less sanguine about globalization. Too many economists are tone-deaf to such distinctions. They are prone to attribute concerns about globalization to crass protectionist motives or ignorance, even when there are genuine ethical issues at stake. By ignoring the fact that international trade sometimes - certainly not always involves redistributive outcomes that we would consider problematic at home, they fail to engage the public debate properly. They also miss the opportunity to mount a more robust defense of trade when ethical concerns are less warranted. While globalization occasionally raises difficult questions about the legitimacy of its redistributive effects, we should not respond automatically by restricting trade. There are many difficult trade-offs

to consider, including the consequences for others around the world who may be made significantly poorer than those hurt at home. But democracies owe themselves a proper debate, so that they make such choices consciously and deliberately. Fetishizing globalization simply because it expands the economic pie is the surest way to delegitimize it in the long run.

Dani Rodrik, Professor of International Political Economy at Harvard University, is the author ofThe Globalization Paradox: Democracy and the Future of theW orld Economy.

Occupy the Classroom?

By Dani Rodrik

December 12, 2011

CAMBRIDGE - Early last month, a group of students staged a walkout in Harvard's popular introductory economics course, Economics 10, taught by my colleague Greg Mankiw. Their complaint: the course propagates conservative ideology in the guise of economic science and helps perpetuate social inequality. The students were part of a growing chorus of protest against modern economics as it is taught in the world's leading academic institutions. Economics has always had its critics, of course, but the financial crisis and its aftermath have given them fresh ammunition, seeming to validate longstanding charges against the profession's unrealistic assumptions, reification of markets, and disregard for social concerns. Mankiw, for his part, found the protesting students "poorly informed." Economics does not have an ideology, he retorted. Quoting John Maynard Keynes, he pointed out that economics is a method that helps people to think straight and reach the correct answers, with no foreordained policy conclusions. Indeed, though you may be excused for skepticism if you have not immersed yourself in years of advanced study in economics, coursework in a typical economics doctoral program produces a bewildering variety of policy prescriptions depending on the specific context. Some of the frameworks economists use to analyze the world favor free markets, while others don't. In fact, much economic research is devoted to understanding how government intervention can improve economic performance. And non -economic motives and socially cooperative behavior are increasingly part of what economists study. As the late great international economist Carlos Diaz-Alejandro once put it, "by now any bright graduate student, by choosing his assumptions .... carefully, can produce a consistent model yielding just about any policy recommendation he favored at the start." And that was in the 1970's! An apprentice economist no longer needs to be particularly bright to produce unorthodox policy conclusions. Nevertheless, economists get stuck with the charge of being narrowly ideological, because they are their own worst enemy when it comes to applying their theories to the real world. Instead of

communicating the full panoply of perspectives that their discipline offers, they display excessive confidence in particular remedies - often those that best accord with their own personal ideologies. Consider the global financial crisis. Macroeconomics and finance did not lack the tools needed to understand how the crisis arose and unfolded. Indeed, the academic literature was chock-full of models of financial bubbles, asymmetric information, incentive distortions, self-fulfilling crises, and systemic risk. But, in the years leading up to the crisis, many economists downplayed these models' lessons in favor of models of efficient and self-correcting markets, which, in policy terms, resulted in inadequate governmental oversight over financial markets. In my book The Globalization Paradox, I contemplate the following thought experiment. Let a journalist call an economics professor for his view on whether free trade with country X or Y is a good idea. We can be fairly certain that the economist, like the vast majority of the profession, will be enthusiastic in his support of free trade. Now let the reporter go undercover as a student in the professor's advanced graduate seminar on international trade theory. Let him pose the same question: Is free trade good? I doubt that the answer will come as quickly and be as succinct this time around. In fact, the professor is likely to be stymied by the question. "What do you mean by 'good?"' he will ask. "And good for whom?" The professor would then launch into a long and tortured exegesis that will ultimately culminate in a heavily hedged statement: "So if the long list of conditions I have just described are satisfied, and assuming we can tax the beneficiaries to compensate the losers, freer trade has the potential to increase everyone's well-being." If he were in an expansive mood, the professor might add that the effect of free trade on an economy's growth rate is not clear, either, and depends on an altogether different set of requirements. A direct, unqualified assertion about the benefits of free trade has now been transformed into a statement adorned by all kinds of ifs and buts. Oddly, the knowledge that the professor willingly imparts with great pride to his advanced students is deemed to be inappropriate (or dangerous) for the general public. Economics instruction at the undergraduate level suffers from the same problem. In our zeal to display the profession's crown jewels in untarnished form -market efficiency, the invisible hand, comparative advantage- we skip over the real-world complications and nuances, well recognized as they are in the discipline. It is as if introductory physics courses assumed a world without gravity, because everything becomes so much simpler that way. Applied appropriately and with a healthy dose of common sense, economics would have prepared us for the financial crisis and pointed us in the right direction to fix what caused it. But the economics we need is of the "seminar room" variety, not the "rule-of-thumb" kind. It is an economics that recognizes its limitations and knows that the right message depends on the context.

Downplaying the diversity of intellectual frameworks within their own discipline does not make economists better analysts of the real world. Nor does it make them more popular.

Dani Rodrik, Professor of International Political Economy at Harvard University, is the author ofThe Globalization Paradox: Democracy and the Future of theW orld Economy.

Asia's Dueling Duopoly

By Heizo Takenaka

July 1, 2010
TOKYO- In today's Asia, there are two economic powers of global standing, Japan and China. But the balance of economic power between the two is changing, and fast. Sometime this year, China's GDP will exceed that of Japan (if it has not already done so). China's economic footprint, moreover, is spreading rapidly across Asia and the rest of the world. Most Asian countries are recovering strongly from the global recession that set in following the collapse of Lehman Brothers in 2008. China's growth rate last year was 8.7%, and more than 10% in the past two quarters. Neighboring countries, like South Korea and Singapore, also are recording very high rates of growth. The only exception is Japan, where a lack of political leadership and a limited knowledge of basic economics among government ministers undermines mid-term growth prospects. While China's ability to maintain high growth through the "Lehman Shock" was a remarkable feat of economic management, three important changes in China hold geo-political implications for the region and the world. The first change concerns China's pattern of economic growth, which so far has been achieved mostly by rapidly increasing factor inputs -labor, capital, and energy. According to recent research, however, about one-third of growth in China now comes from technological progress, or an increase in total factor productivity. In other words, China's growth pattern is coming to resemble that of industrialized economies. Second, the renminbi is expected to appreciate substantially in the coming years, owing not only to pressure over China's huge trade surplus, but also to the Chinese government's understanding that a stronger renminbi, despite its negative impact on exporters, is needed to fight inflation. The question is how rapidly will China's authorities allow the renminbi to appreciate. In 1989, before the Tiananmen Square incident, the renminbi's exchange rate was 45% higher than it is now - a level that could be re-attained relatively soon. Between 2003 and 2005, the renminbi appreciated by 20%. Given rapid economic growth and continuous renminbi appreciation, Chinese GDP could exceed that of the US as soon as 20 15.

But around 2015, China will face a third dramatic change - a demographic shift reflecting the effects of its long-standing one-child policy. China's total fertility rate is estimated at around 1.5, implying that the working-age population will begin to decline by the mid-2010's. As a result, economic growth will slow, and China's domestic problems - such as income inequality - will worsen, even as political institutions that can channel popular grievances remain underdeveloped. Under such circumstances, the role of political leadership will become much more important. President HuJintao will step down in 2013, but will continue to hold his post on the all-important Central Military Commission until a complete succession is completed, also around 2015. So, all things considered, China's looming leadership transition is shaping up to be a very challenging period for China and the world. While China's economy is growing very rapidly, Japan is still struggling. Indeed, the country desperately requires strong political leadership to prevent a Greek scenario - political leadership that it is unlikely to find. On the contrary, the recent resignation from the premiership of Yukio Hatoyama created more uncertainty than his own government did. Hatoyama's cabinet, led by his Democratic Party of Japan (DPJ), ignored macroeconomic management after taking office in September 2009. Instead, as the DPJ had promised its voters, the government focused on increasing spending, including huge new grants to households and farmers. As a result, the share of tax revenue in total spending is less than SO% for the first time in Japan's post-war history. And the government debt-to-GDP ratio is around 190%, compared to 120% in Greece. Nevertheless, the market for Japanese Government Bonds (JGBs) has so far remained stable. Because JGBs are purchased mainly by domestic organizations and households, there is little risk of capital flight, despite the seriousness of the budget situation. In other words, the government's negative saving is being financed by the private and household sectors' positive saving. This situation, however, is changing. First, the volume of JGBs has soared relative to Japanese household assets. Japanese households hold about 1,100 trillion in net monetary assets, an amount that will be exceeded in about 3-5 years by the value of JGBs. At that point, government debt will no longer be backed up by taxpayers' assets. And, reflecting the aging of Japanese society, the household savings rate itself will decline dramatically, making it difficult for the private sector to finance annual budget deficits. At the same time, Japan's demographic trends will boost demand for fiscal expenditure, as pension and health-care costs rise. So, sooner or later, a tax hike will be necessary. Without comprehensive reform under strong political leadership, a tax hike alone cannot solve Japan's problems. And the impact on Asia and the global economy of a fiscal crisis in Japan would make Greece's troubles look like a walk in the park. Greece's GDP share in the European Union is about 3%. Japan's GDP share is about one-third of Asia and 8% of the world.

So the future in Asia now appears to belong to China, whose economic growth supports that of neighboring countries - and whose mercantilism is prevailing in the region. In order to compete with China's export-boosting public-private schemes, other Asian countries are now pursuing similar policies. In some cases, this will harm free trade, and governments should be careful to avoid measures that distort resource allocation. This matters for every country, because Asia is now an important center of global economic growth. The world's expectations for responsible economic management by the governments of both China and Japan- and thus the need for it- are growing by the day.

Heizo Takenaka was Minister of Economics, Minister of Financial Reform, and Minister of Internal Affairs and Communications under Prime Minister Junichiro Koizumi; he is currently Director of the Global Security Research Institute at Keio University, Tokyo.

Good and Bad Capitalism

By Michel Rocard

July 31, 2009

PARIS - The reality of market exchange - direct transactions between merchants and customers appeared gradually 3,000 or 4,000 years ago. In this novel social relationship, the customer was free to buy whatever he wanted, whenever and from whomever he chose, often bargaining with the seller about the price. Because of these features, the free market is part of a basic freedom that is rooted in everyday life. It remains dominant today, as all efforts to establish an alternative, even totalitarianism, failed. Indeed, it has been 20 years since the former communist countries of Eastern Europe rejoined the world of market exchange, a step taken as early as 1946 by social democrats around the world. For several thousand years, the free market was comprised of individuals: craftsmen, traders, and consumers. Capitalism when it arose three centuries ago was simply the same activity on a larger scale. Because of steam engines and electricity, a large number of people were enabled to work together, and corporations could attract a large number of small savers, who became capitalists. This system is fantastic. By the time of the French Revolution, the standard of living had hardly doubled since the Roman Empire. Today, it is 150 times higher. But capitalism is also cruel. At its inception, people were compelled to work 17 hours a day without a day off or retirement. It was a form of slavery. Thanks to democracy, social struggle, and workers' unions, together with the political efforts of social democracy, the inhumanity of the system was partly softened. Nevertheless, left to itself, the system is unstable. It undergoes a crisis about once a decade. The twentieth century's worst crisis, between 1929 and 1932, caused 70 million workers in Great Britain, the United States, and Germany to lose their jobs (with no unemployment benefits) in less than six months. It brought Adolf Hitler to power, leading to a war that left SO million dead. After the war, the belief that the system needed to be stabilized became widespread. Eventually, a more balanced system emerged, based on three main institutions: health insurance, Keynesian fiscal and monetary policy to soften the impact of the business cycle, and, of utmost importance, a policy of high salaries and reduction of economic inequality in order to boost household consumption.

The achievement was stunning: 30 years of consistent and rapid economic growth, full and permanent employment in all developed nations, and no financial or economic crisis. Standards of living rose nearly ten-fold during this period. Prosperity became the main weapon that ensured the West's victory over Soviet communism. The people of Eastern Europe were eager to embrace this kind of capitalism. Capitalism's political success, however, came at the very moment when the system was starting to deteriorate. High salaries drove growth but reduced earnings. Shareholders organized themselves into pension funds, investment funds, and hedge funds. Because of their pressure, employment fell, reducing the share of wages in total national income by 10% over the past 30 years. In developed nations, the number of the working poor reached 10-1 5% of the workforce, with another 5-10% of unemployed workers and 5-10% dropping out of the labor market altogether. Moreover, over the past 25 years, a severe financial crisis- regional or global- has erupted every four or five years. Annual growth fell below 3% on average. Today's crisis was triggered by widespread concealment of bad loans within pools of securities sold all over the world. The spread of bankruptcies triggered a severe credit crunch, which triggered a deep recession and with it a brutal rise in unemployment. Capitalism's three stabilizing devices lost their efficacy. While rich countries reacted more quickly and more wisely in stimulating their economies than in 1929, and the hemorrhaging of banks was stanched, this has not been enough to boost growth. We are now in a strange period in which governments, bankers, and journalists herald the end of the crisis just because large banks are no longer failing every week. But nothing has been solved, and unemployment continues to rise. Even worse, the banking sector is trying to take advantage of publicly financed rescue packages to protect its privileges, including immorally huge bonuses and extravagant freedoms to create speculative financial assets with no links to the real economy. Indeed, the so-called end of the crisis looks more like a reconstruction of the mechanisms that caused it. Everywhere, economic activity is painfully stabilizing at 5% to 10% below 2007 levels. The root of the crisis remains the fall in purchasing power on the part of the middle and lower classes, and the collapse of speculative bubbles created by the wealthy classes' greed for more. But if we are to have a system where nearly everybody can become better off, the wealthy cannot become ever wealthier at the same time. Otherwise, we can expect a long period of stagnation, punctuated by periodic financial crises. In these circumstances, a majority of European voters have recently shown, once again, that they favor the right and its tendency to support the fortune seekers. A bleak future awaits us.

Michel Rocard, former Prime Minister of France and leader of the Socialist Party, is a member of the European Parliament.

The Moral Limits of Markets

By Michael J. Sandel

December 31, 2012

TOKYO- Today, there are very few things that money can't buy. If you are sentenced to a jail term in Santa Barbara, California, and don't like the standard accommodations, you can buy a prison-cell upgrade for about $90 per night. If you want to help to prevent the tragic fact that, each year, thousands of babies are born to drugaddicted mothers, you can contribute to a charity that uses a market mechanism to ameliorate the problem: a $300 cash grant to any drug-addicted woman willing to be sterilized. Or, if you want to attend a US Congressional hearing, but don't want to wait for hours in line, you can enlist the services of a line-standing company. The company hires homeless people and others in need of work to wait in line- overnight if necessary. Just before the hearing begins, the paying customer can take his or her line-stander's place in the queue, and claim a front-row seat in the hearing room. Is there anything wrong with buying and selling these things? Some would say no; people should be free to spend their money to buy whatever someone else is willing to sell. Others believe that there are some things that money should not be able to buy. But why? What exactly is wrong with selling prison-cell upgrades to those who can afford them, or offering cash for sterilization, or hiring linestanders? To answer questions such as these, we need to pose a bigger question: What role should money and markets play in a good society? Asking this question, and debating it politically, is more important than ever. The last three decades have witnessed a quiet revolution, as markets and market-oriented thinking have reached into spheres oflife previously governed by non-market values: family life and personal relations; health and education; environmental protection and criminal justice; national security and civic life. Almost without realizing it, we have drifted from having market economies to becoming market societies. The difference is this: A market economy is a tool - a valuable and effective tool - for organizing productive activity. A market society, by contrast, is a place where almost everything is

up for sale. It is a way of life in which market values seep into social relations and govern every domain. We should be worried about this trend for two reasons. First, as money looms larger in our societies, affluence- and its absence- matters more. If the main advantages of affluence were the ability to afford yachts and fancy vacations, inequality would matter less than it does today. But, as money comes to govern access to education, health care, political influence, and safe neighborhoods, life becomes harder for those of modest means. The marketization of everything sharpens the sting of inequality. A second reason to resist putting a price tag on all human activities is that doing so can be corrupting. Prostitution is a classic example. Some object to it on the grounds that it typically exploits the poor, for whom the choice to sell their bodies may not be truly voluntary. But others object on the grounds that reducing sex to a commodity is inherently degrading and objectifying. The idea that market relations can corrupt higher goods is not restricted to matters of sex and the body. It also applies to civic goods and practices. Consider voting. We don't allow a free market in votes, even though such a market would arguably be "efficient," in the economist's sense of the term. Many people don't use their votes, so why let them go to waste? Why not let those who don't much care about an election's outcome sell their vote to someone who does? Both parties to the transaction would be better off. The best argument against a market in votes is that the vote is not a piece of private property; rather, it is a public responsibility. To treat a vote as an instrument of profit would be to degrade it, to corrupt its meaning as an expression of civic duty. But, if a market in votes is objectionable because it corrupts democracy, what about systems of campaign finance (including the one currently in place in the United States) that give wealthy donors a disproportionate voice in elections? The reason to reject a market in votes - preserving the integrity of democracy - may be a reason to limit financial contributions to political candidates as well. Of course, we often disagree about what counts as "corrupting" or "degrading." To decide whether prostitution is degrading, we have to decide how human sexuality is properly valued. To decide whether selling prison-cell upgrades corrupts the meaning of criminal justice, we have to decide what purpose criminal punishment should serve. To decide whether we should allow the buying and selling of human organs for transplantation, or hire mercenaries to fight our wars, we have to think through hard questions about human dignity and civic responsibility. These are controversial questions, and we often try to avoid addressing them in public discourse. But that is a mistake. Our reluctance to engage morally contested questions in politics has left us illequipped to deliberate about one of the most important issues of our time: Where do markets serve the public good, and where do they not belong?

Michael J. Sandel teaches political philosophy at Harvard University. He is the author, most recently, ofWhat Money Can't Buy: The Moral Limits of Markets, on which this commentary is based.