A Berlin Consensus?

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.

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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.

The Washington 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.

Read more from our "Dismal Soothsaying" Focal Point.