A Twist in the Tale

The proposal to reconsider mercantilism, in Professor Dani Rodrik's latest article on Project Syndicate, provides a much needed creative outlet for fears of reverse-colonization among Western intellectuals. The history of the 20th century is one of American triumphalism. The development of economic theory during this time has proceeded with scrupulous adherence to mathematical principles. Consequently, public discussions among Western intellectuals about the current global economic crisis dwells almost exclusively on the Great Depression and the stagflation of the 1970s. Moreover, the only perspectives on these two landmark events that economists discuss in public or write about are the monetarist and the Keynesian. In particular, the internationalist view on the Great Depression that was pursued by Professor Robert Mundell among others has been overlooked.

While considerations of economic history has been restricted to the events of the 20th century for the reasons mentioned above, the application of behavioral psychology to economics has largely relied on techniques from within economics (i.e., from econometrics, Keynesian theory, game theory, information economics, etc.). As a result of such intellectual isolation for a prolonged period of time, the vast majority of economists are finding themselves ill-equipped to think effectively about the current economic crisis. Without an adequate intellectual framework for understanding the professional issues that have been bothering them, these economists are unable to find a release for the pent-up fears of reverse-colonization that have been building up steadily in their minds during the last few years, as a direct result of the worsening prospects for America to be recognized as the sole global economic superpower.

The situation is further complicated by the fact that modern economists have grown up being taught that economic liberalism began with Adam Smith. Other than studying Adam Smith's venerable works in economics, a student of the history of free market principles has very few intellectual avenues to explore. Adam Smith's associations with David Hume and other lumniaries of the Scottish Enlightenment are widely acknowledged. His religious sentiments are said to be strongly influenced by the Calvinists. Apart from these facts, there is simply no natural intellectual anchor that one could use, if one were to study the origins of economic liberalism, with the aim of getting a better understanding of the current economic crisis. Of course, in the 20th century, all interpretations of Adam Smith's teachings, like everything else in economics, have been subjected to mathematical formulations. For example, the first welfare theorem of economics is generally taken to be a confirmation of the role of the "Invisible Hand". On the flip side, considerations of imperfect information, incomplete markets or externalities like environmental pollution, R & D, etc., have demonstrated that the welfare theorem's assumption of perfect competition is almost always unrealistic (Greenwald-Stiglitz).

After reading Professor Anthony Pagden's, "Worlds at War: The 2,500-year Struggle between East and West" at the end of last year, I had arrived at the possibility of re-interpreting Adam Smith's work by placing it on a background of Roman law and jurisprudence. After all, what would Adam Smith have referred to, in his famous words, "Little else is required to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice", and "It is the great multiplication of the productions of all the different arts, in consequence of the division of labor, which occasions, in a well-governed society, that universal opulence which extends itself to the lowest ranks of the people"? Adam Smith's vision for the universal opulence of mankind was founded on the principles of liberty. Edward Gibbons, writing in that same age of Rennaisance Enlightenment, looked towards the universal civilization of ancient Rome as the intellectual guiding light for the Western liberal tradition. So, perhaps there is indeed something to be gained in re-examining Adam Smith's promise that an Invisible Hand would guide the market-based economy to universal opulence, under the new assumption that this was the same opulence that first shone so brightly as the universal civilization of Rome.

At the same time that I read Professor Pagden's book, I came across the following comment made by Judge Richard Posner on the Becker-Posner blog (November 2, 2008 entry):

"Different cultures, and within cultures, different occupations both select for different character traits and shape character traits. Let me start with culture. One can distinguish between a culture built on notions of honor, military prowess, and status within a hierarchy often based on birth, on the one hand, and a commercial culture on the other. English history is a case study of the transition from the first to the second, the second having been realized in the United States earlier and more fully than in the mother country."

Judge Posner's comment gave me the encouragement that even though economists consider the period before Adam Smith to be largely irrelevant to modern economic theory, there is, in fact, a long held tradition in law and jurisprudence that traces its way back to the legal system of the Roman civilization. Moroever, this legal tradition has been undergoing a continuous adaptation to the changing needs of Western society, by transforming its most valued character traits from those of an honor-based society to those of a commercial society. As an aside, I note here that I find it curious that Judge Posner himself did not examine the ongoing financial crisis from the perspective of law in his latest book, "Failure of Capitalism". Instead, he has chosen to focus on the two main economic perspectives -- Keynesian and monetarist -- both of which rely heavily on the 20th century's mathematization of economics.

Pursuing the search for a legal foundation for Adam Smith's teachings, I began to envision a framework in which much of the modern world functions, as if guided by an "Invisible Hand", according to certain natural laws. Each of these natural laws was first established when the ancient civilization, that was associated with that law, flourished politically and economically. In this framework, even though there is no explicit enforcement of these laws in modern times, violation of these laws result in enormous negative implications. Call it the Wisdom of the Ancients, if you will. This seemed to explain to me why there was so much resentment in the rest of the world against the policies of the previous George W. Bush administration. By the same token, the worldwide resurgence of hopes for an economic recovery upon the swearing-in of President Obama provided further evidence in support of this new framework. It was after thinking about this framework for several months, that I cited the main policy failure of the previous George W. Bush administration as being "the indiscriminate abuse of the rules and conventions of international systems of law, which have been in effect implicitly for so many centuries", in my article, "A New Perspective on the Global Economic Crisis", that I wrote in mid-June.

In a similar vein, I felt that the teaching of Confucius could provide a background for studying China from a perspective of law and jurisprudence. Moreover, I could view the current global economic crisis, with its tense economic, political and cultural interactions between America and China, as a confluence of two long held traditions in law. However, although this confluence of two ancient traditions of law provides a broad panoply for the current economic crisis, I must admit that I was struggling yet, to find effective techniques for drawing inferences about the day-to-day interactions of various economic forces that shape current events.

It is in this situation that Professor Dani Rodrik's proposal for re-considering mercantilism introduces an interesting "twist in the tale". I am, of course, not unaware that mercantilist practices run the risk of promoting various societal ills that include politician-businessman nexus, bureaucratic corruption, military adventurism, trade protectionism, stifling of innovation, xenophobia, racism and religious bigotry. Nevertheless, this proposal for reconsidering mercantilism promises that in exchange for going a little bit before Adam Smith's time in history, one could obtain a rich set of guidelines with which to anticipate forthcoming developments in the global economy.

Compendium of theories and techniques in Economics that could be used to study the current global economic crisis

In the following, I have made a compendium of theories and techniques that could be employed to study the current global economic crisis. It is notable that Professor Dani Rodrik's proposal to re-examine mercantilism is the only one that makes any allowance for studying reverse-colonization. Also, please note that I have not included behavioral economics and finance theory in this compendium. There are two reasons for this. The first is that while both these subjects have a lot to teach about how the crisis occurred, unfortunately, they don't provide much information about how to get out of the crisis. This is particularly clear when it comes to dealing with system-wide risk. The second reason is that both these subjects function as niche areas of economic theory, within the broad framework provided by the 20th century's mathematization of economics. As a result, they are not in a position to enable fundamental re-examinations of the core concepts of modern economic theory.

The vast majority of economists are, of course, pre-occupied with the framework of global imbalances in trade, savings and current accounts. This is the framework with which economists view the current global economic crisis. However, I had considered this issue in my earlier article, "A New Perspective on the Global Economic Crisis". I had indicated how this pre-occupation with global imbalances prevented economists from arriving at my perspective on the crisis. I had analyed the two main theories that economists use to explain global imbalances -- the savings glut theory and the de-coupling theory. I had explained why these theories do not provide sufficient background to deal with the global economic crisis. In my subsequent article, "A New Perspective on the Global Economic Crisis II: Fear of Reverse-colonization Did It", I had explained that it is more important to assuage the fears of reverse-colonization among Western intellectuals. Thus I assume here that the focus on reverse-colonization would subsume all the theories on global imbalances, including the savings glut theory and the de-coupling theory. So, they don't appear below.

Monetarist Theory

Fed's bad management leads to liquidity crunch. Panic attacks whose effects should pass away in a few months, instead, drag the economy down for years and years. E.g., Stock market crash of 1929 should have been an isolated incident -- a panicked market sell-off that could have been contained quickly. But, the Fed's incompetence led to frequent panics among bank depositors, which in turn, led to the closing of thousands of banks during the early 30s. In particular, the hoarding of gold in the Fed's vaults led to draining of money supply in the financial system, which resulted in deflation and the bank panics. Deflation was particularly painful for debtors, who had gotten into debt recklessly during the Roaring Twenties when credit was easily available. Prescription for avoiding the Great Depression: ample liquidity, rule-based monetary policy, and minimal government. (Milton Friedman. Irving Fisher).

Keynesian Theory

Liquidity trap. The Fed provides ample liquidity. (At present, the Fed keeps its target for overnight rate at a range of 0-1/4%, and makes available $800 billion of reserves to the banks). But the banks would not draw on this flood of liquidity, simply because there are no growth opportunities in the economy. To put it another way, businessmen do not see growth opportunities that are promising enough to stimulate their "animal spirits" -- the driving force that make them take risks in new ventures. Meanwhile, rising unemployment causes shortfalls in demand which leads to increased risks of price deflation, and contraction in GDP, which in turn, leads to further unemployment. Government needs to step-in with massive fiscal deficits to break this destructive cycle. (John Maynard Keynes. James Tobin).

Trade Theory

Rising unemployment during the early phase of the Great Depression led to short-sighted politicians enacting protectionist tariffs. Its effect was to increase tariffs and non-tariff trade barriers on worldwide trade during 1929 -- 32. This killed any chances of getting out of the Great Depression. The Great Depression happened between the two World Wars, when international relations between countries was at historical low points. Thankfully, this is not the case now. At the end of the cold war, there was a worldwide consensus that American style free market policies are the way forward. However, the market fundamentalist approach ("Washington Consensus") has resulted in widespread discontents on globalization. New Keynesian policies are needed to ensure free trade for all. (Joseph Stiglitz).

In practice, a just trade system is difficult to achieve because of the urge to accumulate massive surpluses among the emerging market economies and fears of reverse-colonization among the Western economies. Hence, Western economists should re-examine the principles of mercantilism. (Dani Rodrik).

Growth Theory

The political and cultural history of the Great Powers during the last 500 years has been determined by their relative rates of economic growth. (Paul Kennedy).

Gains in productivity (output per man-hour) due to technological progress promised to deliver economic growth throughout the 20th century. (John Maynard Keynes).

Economic growth depends on the (i) relative proportions of saving and consumption, (ii) relative proportions of investments in the factors of production -- land, labor and capital. (Robet Solow).

Although Adam Smith explained that wealth creation would happen primarily through division of labor, this division of labor in the modern workplace does not require prolonged specialization of skills. In the modern company environment, an employee with a basic education can perform the vast majority of tasks through on-the-job learning. Thus total output of the economy depends directly on the average worker who can steadily increase her productivity through "learning-by-doing". (Kenneth Arrow).

It might seem that, for this reason, policy makers should simply plan for full employment to maximize economic output. Unfortunately, when employment is maximized, inflation would set in, because people have a lot of money to spend. The analysis of this situation fundamentally involves inter-temporal considerations. Individual agents have incomplete information about the action of others. Due to factors like information asymmetry, money illusion, and stickiness of wages and prices, the individual agents must base their decisions on (adaptive) expectations. The result of this analysis is that unemployment rate should be above the Non-Accelerating Inflation Rate of Unemployment (NAIRU). (Edmund Phelps).

But, inflation is currently very low, and unemployment is very high. So, consumers' purchasing power is not going to increase. Moreover, commodity prices do not affect the prices of end products as much as they used to. As a result, inflationary expectations would be low for a long time. On the international front, in recent times the dollar is being steadily replaced, as a global reserve currency, by a basket of currencies. So, a depreciation in dollar value does not affect the average value of the basket of currencies so much. In the final analysis, keep interest rates low for an extended period of time. Watch the unemployment rate, productivity growth and output gap to know when the economy is about to show robust economic growth. Only then should rates be raised. (Ben Bernanke).

My view: President Barack Obama enjoys unprecendented worldwide popularity. Through the good offices of the President, many new parts of the world can be made safer for Americans to work in. Treaties and agreements can be signed with friendly countries to ensure the safety of Americans there. Moreover, in fast-growning emerging markets like China, there is a huge appetite for 'American goods' -- American food, fashion clothes, hollywood movies, etc. Using such strategies, the government could generate jobs abroad for 10 - 12 million Americans over the next decade. This would bring down the unemployment rate more effectively than the Fed's strategy of keeping interest rates low for an extended period of time till growth opportunities in the domestic economy appear. This time it is different because robust growth in the rest of the world would be able to drag the Western economies (America and EU) out of any tendency to sink towards a Great Depression.

Business Cycle Theory

Equilibrium theory of business cycles based on the rational expectations hypothesis. There would be short-term fluctuations in the business cycle, but in the long-term, factors like population growth and productivity growth would keep the economy on an equilibrium growth path. (Robert Lucas).

According to this theory, recessions would be short and shallow, if at all they occur. However, the current economic crisis does not seem like a short-term fluctuation. Rather it seems like whole portions of the economy has collapsed with massive destruction of wealth in the stock markets and the housing markets. (Paul Krugman).

The current crisis is not the Great Depression because marginal product of capital has remained high. (Casey Mulligan. Source: NY Times article in Fall 2008).

In the latter half of the 1930s, productivity showed a robust increase. However, due to the New Deal which gave away a lot of goodies to the labor unions, profitability in the economy was choked off. This resulted in the unnecessary prolongation of the Great Depression. (Lee Ohanian. Harold Cole. Edward Prescott).

My view: I can provide better estimates for growth in the world economy by separating it into two parts. For those parts of the world economy that are based on traditional economic theory (e.g., emerging market economies, factory-based manufacturing, small & medium businesses that deal with low-tech activities), the rational expectations economic model could be used to forecast growth rates. For the more advanced parts of the modern economy, a re-examination of what constitutes economic wealth is called for. Moreover, studying the production process could help determine how much government spending in the emerging market economies would translate into economic growth. With this approach, I predicted, way back in January, that China would be able to achieve 8% annual growth in its GDP for the next two years, even without counting on its exports to the advanced countries. This has now come true.

History of Global Reserve Currency

The study of currency systems explains all of political and cultural history. In particular, the availablity of proximate information makes it fruitful to study the events of the 20th century in this way. (Robert Mundell).

Internationalist view of the causes of the Great Depression. The peculiar length and depth of the Great Depression is blamed on the hesitancy of the US in taking over the leadership of the world economy when Britain was no longer up to the role after WW I. )Charles Kindleberger. Source: Wikipedia)

Economically, America had already surpassed the European powers by the end of the 19th century. (Jeffrey Frieden).

Note that an internationalist perspective on the global currency systems explains why conservatives like Andrew Mellon and Herbert Hoover insisted on purging the rot out of the system, instead of increasing government spending to provide employment. (New Keynesians simply portray these events as the actions of political leaders ignorant of economic matters).

In the end, upholding the gold standard in the 1920s proved too costly for the domestic economy. (Barry Eichengreen).

My view: An upcoming great power makes a pre-mature and ill-prepared attempt at becoming the predominant global power. When this new power comes up short against the economic standards of the existing great powers, chances are that a prolonged depression would set in. Against this international background, the occurrence of the following sequence of events resulted in the Great Depression -- collapse of the gold standard during World War I, Roaring Twenties, 1929 crash, Protectionist tariffs, Bank panics, Decline of Europe into Nazism and Fascism. In the 2000s, George W. Bush makes pre-mature and ill-prepared attempts at spreading democracy all over the world, by occupying Iraq. But this is a much milder version of the two World Wars of the 20th century. So there is hope.

Economic Implications of Law & International Relations

Consequences of the Iraq war, that arise when this war is examined under long-established international systems of law, are still being worked out. Modern economic theory does not provide effective methods to estimate these consequences. The only statement on the Iraq war that economists can all agree seems to be that occupying Iraq is going to cost much more than the government of George W. Bush claimed. The best estimate available is that the total cost of the Iraq war could reach three trillion dollars. (Linda Blimes & Joseph Stiglitz).

Transformation of the value system of the Western society from that of an honor-based society to that of a commercial society. (Richard Posner).

My view: interpretation of Adam Smith's Universal Opulence in terms of the Universal Civilization of Rome.

Econometrics

The current economic decline is every bit as bad as the first year of the Great Depression. Proof: tables and graphs of various economic indicators. (Barry Eichengreen).

It happened in Japan, it happened in Argentina and Mexico, it happened in Brazil and Russia, it happened in East Asia. So why couldn't it happen in America? (Paul Krugman).

Closely monitor short-term economic data to make doomsday predictions on economic output, stock market performance and unemployment. (Nouriel Roubini).

Create an index for housing prices across 20 major cities. (Robert Shiller).

Examining past financial crises -- going back to the 12th century. (Kenneth Rogoff & Carmen Reinhardt).

How come the Tech bust of 2000 didn't cause the collapse of the financial system but the housing bust of 2007-09 did? (Vernon Smith & Steve Gjerstad. Some of it is also discussed in Paul Krugman's Return of Depression Economics, 2008 edition).

Fed kept interest rates too low between 2002 -- 2005. The Fed diverged significantly from the Taylor rule. This led to the bubble in the housing markets. (John Taylor. Vernon Smith).

Current financial crisis was created by Ben Bernanke and Hank Paulson who went to the Congress and scared everyone into believing that there would be a repeat of the Great Depression if Congress did not provide them with $700-billion TARP funding. Financial markets collapsed at this point. Markets recovered by the end of 2008. (John Taylor).

My view: (i) The financial crisis was caused not just a failure of the markets or the incompetence of the government authorities. Markets are genuinely facing difficulties, because the market mechanism doesn't have prior expertise in dealing with residential matters. Historically, the daily trading of treasury securities and company shares involved only a small portion of the total outstanding securities. Whereas with mortgage securitization, the whole volume of economic wealth that was being securitized and traded had to go through the market in a short period of time. As a result, the market mechanism went through a ten-fold increase in volume when it took on morgage securitizations. The markets are slowly working their way to be able to deal with this challenge. Moreover, unlike company shares and treasury securities where marginal utility theory applies very well, evaluating the prices of houses based on marginal utility poses inherent difficulties. (ii) De-centralizing the American financial system would enable the local processing of price information about mortgage markets. This would make the system more stable and avoid the unnecessary accumulation of trillions of dollars in New York.