WHEN THE DEEPEST economic crisis of the past fifty years finally ends, a changed world will be left in its wake. Capitalism will still be with us, but the new capitalism could differ substantially from the old. One key feature could be a new form of globalisation. In the current crisis it is already apparent that nations that were relatively ‘decoupled' from global markets as they entered this recession have done better than the more ‘globalised' ones. The lessons of their success are now under scrutiny.
Even though it's too soon to see the future clearly, the forces that will shape the new capitalism can be found in the underlying origins and peculiar character of this recession. This crisis differs from others over the past half-century, not just in its extent and intensity, but in its causes and course.
The current crisis presents two novel features. It has been precipitated by excess worldwide debt, not rising consumer prices, and the increasing complexity and integration of world markets shunted it around the globe with unprecedented speed and ferocity. How societies react to these forces will incubate the new form of capitalism. It is worth exploring further how these developments may play out, before considering how societies such as Australia might respond.
The current recession has been balance-sheet driven, not interest-rate driven. In previous postwar recessions, rising inflationary pressures typically triggered monetary tightening and a slowdown; the antidote was lower rates, which eventually promoted recovery. This time, a balance-sheet recession has stemmed from the weakened financial condition of both consumers and lenders – both have simply had too much debt.
While the crisis has surfaced in multiple forms – sub-prime housing loans, implosion of banks, collapse of automobile companies, country defaults, plunging (and skyrocketing) currencies, government fiscal crises – all are ultimately manifestations of excess leverage. Searching for causes, commentators have focused on the relatively superficial: lax financial-system oversight, overconfident mergers and corporate incompetence, and excessive executive compensation. But behind them all is the stubborn fact that global debt had simply risen to unsustainable levels.
The inevitable reaction to unsustainable debt is deleveraging – debt reduction. This will take time, perhaps several recession-and-boom cycles. But the implication is that this time, and in the future, rather than relying on ever more debt with lower interest rates to extricate ourselves from recession, global capitalism will need to learn to operate with much lower levels of leverage. It's not clear that we know any longer how to do this. Closer scrutiny reveals both how dependent our society has become on debt and how historically unprecedented are the levels to which it has risen.
While debt-to-GDP ratios have escalated furthest in the US, other developed nations including Australia and Britain face similar over-extension, and similar startling increases. To provide some sense of the disproportionate scale debt had reached prior to this crisis, at the start of the great bull market that began in August 1982, US household debt was 44 per cent of nominal GDP; by 1998-2000, it had climbed to 63 per cent; but by 2008, the ratio rocketed to 97 per cent. And that's only household debt. Add corporate and government debt, and the ratios rise to nose-bleed levels. Total US credit-market debt (households, corporations and governments) had reached almost three times GDP at the outset of the crisis, by far the highest ever recorded, and up by around five times its postwar norm.
It has been estimated that to return to its long-term average, around US$60 trillion in debt will need to be removed from the global financial system – that's US$60 trillion in buying power and assets. As total US household wealth (by far the world's largest) stood at US$51 trillion in mid-2009, this is a truly staggering sum. It dwarfs the US$3 trillion stimulus of the Obama administration, to say nothing of Australia's meagre triple-digit billions, or similar commitments in Europe.
Debt has become integral to the pre-crisis form of capitalism; a steeply rising share of all the profits of US corporations – notably including non-financial firms – now appears in financial form, largely interest on debt. Financial payments, including interest, dividends and stock buy-backs, now make up a solid majority of even US non-financial corporations' profits, and in some years virtually all net profits, up from around a third as recently as the mid-1980s. Financial assets now exceed tangible assets in aggregate. Economists have termed this shift ‘financialisation'. Rather than seeking to make a return on investment by producing goods and services at a particular cost, and selling with a margin to produce profit, companies have become increasingly reliant for their profits on the movement and manipulation of money. The basis for this extraordinary shift – and it is both huge and without precedent – has been steadily rising leverage. This raises the question of what happens if debt is no longer available.
BEFORE CONSIDERING THAT, the other striking feature of this crisis is its speed and virulence. A conscientious citizen in 2007 diligently keeping up with the financial and economic news, carefully scrutinising the business pages of the daily newspapers and business magazines, digesting the reports and analyses presented there, would have had no idea what was coming.
Part of the reason is that economic commentary generally focuses on the shallow and immediate. It tends to dwell on eye-catching stories of managerial blunders or power struggles, mergers, acquisitions, business cycles, currency-exchange and interest rates, taxes or fluctuations in energy prices. But these are not the forces that shape the evolution of societies. The deeper changes underlying this surface froth and bubble generally pass without comment; staggering levels of debt had become normal.
There was another, more fundamental reason, however, that so few forecasters saw the looming problem: the world financial system, even as it teetered on a Yertle-the-Turtle tower of derivatives-upon-options-upon-debt, had also become so complex and interconnected that perhaps it was now literally impossible for anyone to understand, let alone predict, its behaviour. It had become prone to sudden, apparently inexplicable, lurches.
Complexity can make a system difficult to understand, and inherently more unstable. Because everything is connected to everything else, in sometimes unexpected ways, problems that break out in one place can rapidly impact elsewhere. More interaction can make systems further prone to surprising and sudden outcomes. Consider this: conceptually, a system consisting of only fifteen elements can interact in only fifteen ways if the interactions are linear (each element interacts only with its neighbour and in one direction); allow the system to interact non-linearly but dyadically (each element can interact with one other element not necessarily its neighbour), and the system can create any one of 120 combinations; allow the elements to interact non-linearly and non-dyadically (each element can interact with any number of other elements), and a system of only fifteen elements can theoretically assume an impossible-to-comprehend 65,535 states.
The financial system is vastly more complex than this, and a mass of interlocking contingencies. At this level of complexity, no one can predict with certainty how it will behave under stress and how change in one part will affect others. We can predict with some accuracy the odds of a single security or commodity in isolation shifting in price by a given amount, but interconnectivity and complexity make it exponentially more difficult to forecast the impact of such events on the system. Much of the time, the world appears ‘normal'; assumptions about the systemic background hold, and we can analyse individual elements as standalones. Occasionally, however, complexity jars the system out of its boundaries, with unpredictable results. Under these conditions, models that predict the behaviour of individual elements are overwhelmed. Events on the other side of the world cascade through to system-wide shifts. This explains the puzzling observation that a decline in Californian sub-prime real estate prices can precipitate a chain reaction that implodes the Icelandic currency and wipes out superannuation funds in Australia.
THE UPSHOT OF this poisonous combination of debt and complexity is that nations abiding by the dominant economic prescription of the past two decades – be ‘open', ‘flexible', ‘outward' and ‘market' oriented – found themselves increasingly exposed to a global system that had become unpredictable, unstable and unsustainable. There are only two alternatives: either attempt to tame the system with regulation and ‘governance', or decouple from it.
The current orthodoxy favours the former: it argues that we need better regulation, and better regulators. Interestingly, this is the response popular with enthusiasts for globalisation and many of those formerly most committed to free-market capitalism. The essential proposition is either that the benefits of globalisation outweigh the risks, if the system can be properly managed, or more simply that ‘there is no feasible alternative'. Australian regulators and politicians have been prominently patting themselves on the back for avoiding the silly blunders that sank the Americans. And it would seem that indeed the Australian system has performed better than some others. But the Australian financial system is both relatively small and relatively un-complex, and it is contained within the borders of a single national government.
It's a very different matter to regulate effectively a much larger and more complex system, to say nothing of one that spans nations or is global. Reaching enforceable agreement across multiple nations and trading blocs is nigh on impossible, and if it does prove possible will surely favour the largest and strongest, whose interests may not coincide with those of smaller countries. Witness the fate of the tiny nation of Latvia: in June 2009 it was crucified by its insistence on maintaining a currency peg with the euro – its tight integration into the much larger and more complex European financial system and through that the world system. As Latvia haemorrhaged capital to support the peg, overnight interest rates hit 200 per cent, one-third of state teachers were laid off and unemployment reached 18 per cent. Latvia needed to devalue its currency and lower its interest rates, but it was locked into rates set to meet the needs of the large European economies.
And even if regulation of the global system were feasible, it would come at enormous cost. While commentators loudly call for more regulation of US capitalism, it's not as though the US is short of government-enforced rules. The Federal Register (which lists the rules US firms must comply with) contained 75,676 pages in 2004, a 6.2 per cent increase from 2003's 71,269 pages. The US has not been ‘deregulating'. In 2004, a total of 4,101 new rules were issued by government agencies, and Congress and President Bush signed into law (a comparatively low) 299 new bills. In the same year, US agencies reported 4,083 new regulations at various stages of implementation, by more than fifty federal regulatory entities. The previous year they issued 4,266. Of these, 135 were classed as ‘economically significant' – meaning that they would cost at least US$100 million in compliance – and added at least $13.5 billion a year to future compliance costs. The cost of all these rules and their enforcement is staggering: economists Thomas Hopkins and Mark Crain estimate the burden on the economy at $877 billion, equivalent to 38 per cent of all 2004 government spending. At that level, regulatory costs were more than twice the then budget deficit, or 7.6 per cent of US GDP, and exceeded all corporate pre-tax profits (at $745 billion) and both individual income tax ($765 billion) and corporate tax ($169 billion).
THE POINT IS that monitoring and controlling a system as complex as America's is already an exceedingly difficult and expensive proposition. Complexity of regulation must match the complexity of the system being regulated. But sometimes there are simply too many elements, and too many interactions. The costs impose a substantial drag on productivity. For the world system, the costs of regulating effectively would be even greater. These costs must be set against the alleged benefits of being tightly coupled to a world financial system that is becoming more complex and integrated at an exponential rate.
As well as being costly, increased regulation and oversight inevitably retard innovation. The more rules one must comply with in advance, the greater the barriers to new products or services. While a certain level of regulation is obviously necessary to avoid dangerous or otherwise undesirable products, system-wide regulation undoubtedly clogs change.
The challenges of management-through-regulation are akin to those of administering and controlling an economy through central planning – it is feasible in theory, but in practice the amount of information required and accuracy of judgements are beyond real human capacity. The system becomes slow; errors and ‘system gaming' create waste on a mounting scale. The ‘tame the system through regulation' school of thought advocates a watered-down version of old-fashioned central planning, with many of the same issues.
In the light of these dual problems of complexity and instability, we should at least explore the possibility of ‘decoupling' from such a system, and in the wake of the crisis a growing number of societies are doing so.
Any such call will inevitably be met with horrified cries of ‘protectionism' and ‘isolationism'. But decoupling implies neither. In a world where manufacturing makes up less than 10 per cent of the economy, tariffs make little sense, and nor does ‘going it alone'. What makes sense are the old-fashioned virtues of self-reliance and thrift. Being dependent on global capital to fund investment is a primary form of coupling for Australia. We spend more than we save, so we borrow from overseas to make up the gap. This makes perfect sense so long as the world is stable. But it binds us ever more closely to an unstable system.
Decoupling would begin with the recognition that becoming more self-reliant for capital and investment would be desirable. To achieve this, we would need to consume a little less and save a little more.
It would extend to the general recognition that smaller, simpler units are easier to understand and likely to be more stable than larger, more complex ones. Decoupling would not mean complete separation; that would be neither desirable nor feasible. The point, rather, is to be loosely coupled, to be able to tap the global system, trade with it, experience it, draw from it, but not have our destiny dependent on its vicissitudes.
In effect, decoupling would imply a return to the subsidiarity principle that governance be undertaken by the smallest, lowest, most local and least centralised unit possible. A now almost-forgotten foundation stone of western thought (so lost that my computer informs me ‘subsidiarity' is not a word), this principle is enshrined in the US Constitution's Tenth Amendment and the 1992 Treaty of Maastricht of the European Union. It is routinely breached by both. Subsidiarity implies that social units should seek to be as independent and self-reliant as possible, within the bounds of sustained prosperity and environmental responsibility.
One immediate difficulty in moving forward with such recognition is that it has become the height of ‘progressive' thinking in Australia to favour centralisation of powers and to support the expansion of regulation and control. Many a dinner party features sage nodding at the suggestion that local governments are hopeless, states should be abolished, small and simple is out of date, and powers should be passed to the national, and ultimately to the international. If the United Nations truly ruled the world, wouldn't it be wonderful!
Perhaps the current crisis will prompt some to reconsider.