Thursday, Jan. 29, 2009

The Great Fall

When you're looking for a way to describe the global economy, the thing that comes to mind is a mountain climber. High on a peak, he sees an inviting gully that seems to lead to the top. He starts scrambling, easily finds holds for his hands and feet, basks in the thin sunshine. Then the gully gets steeper, tougher and narrower; thunderclouds gather overhead. Soon our adventurer, perched on a ledge with nothing below but air, realizes he's stuck. At which point, this thought occurs: knowing precisely how he got into such a fix is an interesting question, one that he will enjoy discussing with fellow climbers at that nice bar in the valley. But the important thing right now is to get down. In one piece.

At last week's annual meeting of the World Economic Forum in Davos, there was no shortage of explanations for how the global economy had got into such a mess. Some were simple: bankers (and their clients, to be fair) were both stupid and greedy. Some were psycho- statistical: the inherent uncertainty of life had engendered an irrationality among economic decision makers. Some were historical: empires always overreach, in the process running up ruinous debts that must one day be paid. (See pictures of the global financial crisis).

Two Crises, Linked
The best explanations were comprehensive. Not the least of the pleasures of Davos was listening to the Premier of the People's Republic of China (albeit a man who claims to read and reread Adam Smith) on what had gone wrong. "The crisis," said Wen Jiabao, "is attributable to a variety of factors and the major ones are: inappropriate macroeconomic policies of some economies and their unsustainable model of development characterized by prolonged low savings and high consumption; excessive expansion of financial institutions in the blind pursuit of profit; lack of self- discipline among financial institutions and rating agencies and the ensuing distortion of risk information and asset pricing; and the failure of financial supervision and regulation to keep up with financial innovations, which allowed the risks of financial derivatives to build and spread." That pretty much gets it.

As George Santayana said, those who cannot remember the past are condemned to repeat it. But right now we can leave history to one side. Blaming this bank or that, this regulator or the other guy, my nation or yours, is somewhat beside the point. The thing to do now is to find a way out of the global economic catastrophe, because the scale of it is truly frightening.

In essence, the world is having to deal with two linked crises at the same time. The narrower one is a consequence of the collapse of the U.S. housing market. This put pressure on bankers, both in the U.S. and elsewhere, who held toxic assets supposedly backed by real estate but for which there was no genuine market or price. And it squeezed U.S. consumers, who for a generation had been the spendthrift engine of the global economy, but who could no longer use their homes as piggy banks. The broader one is a function of massive global imbalances between debtor and creditor nations that have developed over the last generation. The U.S., in particular, has run up huge debts; Asian nations, led by China, have become enormous pools of savings and reserves. One day, those imbalances will have to be unwound, preferably by fundamental changes to domestic policy that encourage saving (in the U.S.) and spending (in China).

In the developed world, as the credit crunch bites, economies are heading for the worst recession since at least the early 1980s. As demand contracts in the rich world, export-oriented economies, especially in east Asia, are hitting a wall. Production in China's manufacturing sector fell for the sixth straight month in January, according to the financial services firm CLSA. Taiwan, a key center of the high-tech industry, probably slipped into recession in the fourth quarter of 2008.

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Perhaps most serious of all, the developing world — where economic growth is the difference between comfort and an empty stomach — is feeling real pain. A central meme of Davos was the cry from emerging economies that they were being starved of capital, as domestic stimulus packages in the rich world sucked up financing and bankers retreated to local markets. The Institute of International Finance predicts that private capital flows to emerging markets will tumble this year to just $165 billion, a drop of more than 80% from the $929 billion of private money that flowed into them in 2007. "Countries that have done everything right can no longer raise money," complained Indonesia's Minister of Trade, Mari Elka Pangestu.

Dialogue and Coordination
Less noticed were two other knock-on effects of the recession in the rich world. First, with less money to spend, its consumers will be taking fewer trips overseas. Thailand's Prime Minister Abhisit Vejjajiva expects tourism in his country to contract by 20%, and African nations such as Kenya will be hit, too. Yet tourism is a major driver of wealth creation and entrepreneurship in destination nations. Second, as those in developing-world diasporas lose their jobs on automobile lines in Detroit and Germany, or as domestic servants in places such as Hong Kong and Singapore, so the remittances that have become important to nations as far flung as Mexico and the Philippines will shrink.

In senses narrow and broad, this is a truly global economic crisis, which is why global solutions are required. Twice this year, world leaders are going to gather to address problems that cannot be solved by any one of them alone. The meeting that has caught the public imagination, so far, is the conference that takes place in Copenhagen in December, charged with finding a successor to the Kyoto accord on climate change. But the more pressing date is April, when leaders of the G-20 leading economies will meet in London, continuing a dialogue they began in Washington last fall.

In Davos, there was a consensus that the London gathering needs to lead to more international coordination of a global economic stimulus and better regulation of international financial markets — and, indeed, that such an outcome is possible. "This is not like the 1930s," said Britain's Prime Minister Gordon Brown, when world leaders could not respond together to the Great Depression. Jean-Philippe Courtois, the Paris-based president of Microsoft's international operations, says that developing economies in particular are demanding a greater say in how the global economy is managed. "They want to have more dialogue on some of the core issues of the planet," Courtois says, "and there's a lot of expectation that this dialogue will happen."

To be sure, there were skeptics. Some market fundamentalists, such as Václav Klaus, President of the Czech Republic, will always be suspicious of attempts to regulate capitalism. Looking to the G-20 meeting, Klaus said, "I am more afraid of the reforms than I am of the crisis itself." But that was a minority view. Most political leaders showed a bias toward action. Any proposals for reform, said Christine Lagarde, the French finance minister, should be "politically sellable, technically sound and enforceable."

Sounds great; but such broad language leaves a lot of leeway. The agenda for the G-20 meeting is potentially vast and keeps changing. How far can national plans to stimulate demand be coordinated? What should be done with the toxic assets still on bank balance sheets and still destabilizing domestic financial systems? When the G-20 first met in Washington, it looked as though a short-term fix for the chronic instability of the banking system was bearing fruit, and swift government action to recapitalize banks in France, Britain, Germany and elsewhere was seen as a brilliant stroke. But it has become evident that the initial rescue packages didn't address the fundamental underlying problem of the toxic assets. Britain, the U.S. and Germany are among those who are implementing a second round of rescues. They are likely to sequester bad assets in special state-guaranteed banks or funds that will sort through them, discarding the junk and holding on to the rest in the hope that they will one day have value.

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Should such national bank-rescue schemes be subject to international control, and if so, by whom? At one limit, Angela Merkel, the German Chancellor, has advocated a sort of United Nations Economic Council, much like the Security Council. The idea has as yet won few backers — and the long, unsuccessful attempt to reform the membership of the Security Council itself would suggest it will get nowhere. Brown and others have urged reform and recapitalization of the Bretton Woods international financial institutions (IFIs), with a much greater role handed to the International Monetary Fund, to which Japan, quietly re-establishing the credibility in international financial debates it had in the 1980s, has pledged $100 billion. But reform of the IFIs, especially to give more weight to the views of developing economies (a key theme of Davos, with the chorus led by South Africa's finance minister Trevor Manuel) has been on the international agenda for the better part of two decades, to little evident effect. And then there is this week's issue: should the pay of bankers whose firms are being bailed out be limited, as the Obama Administration in the U.S. has said it plans to do?

Nor is there agreement on which private-sector financial institutions should be subject to international regulation, or how that might be done. The G-20 is supposed to have agreed that multinational banks will be subject to oversight by a "college of supervisors," though how this will work is far from clear. And what about hedge funds? Well before the crisis erupted, France and especially Germany had argued that they too should be subject to international regulation. That was rejected by the U.S. and Britain in 2007. Now Merkel has said that the hedge-fund question is back on the agenda.

A Return to Protectionism?
But the fundamental problem facing the G-20 meeting is not, actually, about its agenda. It is that world leaders have divided loyalties. On the one hand, they know that international coordination is vital if the global economy is to be gotten back on track. On the other hand, they are politically responsible to their domestic constituencies, not international ones. And in tough times, those constituencies do not like their politicians appearing to favor foreigners.

A recurrent theme at Davos was the dangers of a rise in protectionism as countries resort to beggar-thy-neighbor policies to shore up their economies. One U.S. provision caused particular ire: a "Buy American" stipulation in the House of Representatives version of President Barack Obama's stimulus package that would require steel bought through the spending program to be made in the U.S. Countries such as Canada, as well as the European Union, have loudly protested. (Obama subsequently said he would alter the language in the legislation because he didn't want "to start sending a message that somehow we're just looking after ourselves and are not concerned with world trade.") Merkel and others — not all of them with large domestic automobile industries to protect, as she has — also poured scorn on the U.S. plan to bail out Detroit. With an eye on the disastrous U.S. Smoot-Hawley tariff increases that followed the Wall Street crash of 1929, Brazil's Foreign Minister, Celso Amorim, warned that he was seeing "some signs of measures that could return us to the ideology of economic nationalism that would take us back to the '30s."

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It isn't just protectionism of the old kind — the vintage that looks after domestic metal-bashing industries — that is at issue here. Brown, one of the most ardent defenders of free trade, said that "financial protectionism" was a bigger problem than trade protectionism, as nations channel their increasingly scarce capital into projects at home — where voters can see them — rather than into ones in foreign countries. When it comes to looking after the base, Brown knows whereof he speaks, as anyone from Iceland will tell you. Last fall he played an important role in the collapse of Iceland's banking system when he decided that it was more important to protect British depositors in Icelandic banks than the banks themselves.

The American Problem
Nowhere is the division between the need to satisfy both international and domestic constituencies more acute than in the U.S. Few world leaders — not even Russian Prime Minister Vladimir Putin — were crass enough to come out and say it openly in Davos, but everyone knows that the roots of both aspects of the economic crisis lie in America's long, debt-fueled consumer binge. "We've been living beyond our means for 20 years," said Rupert Murdoch in Davos, "and we have to put that right. We have to get used to the idea that we cannot live and spend in the way we have been doing." Obama's election may have been greeted with enthusiasm in much of the world, but global enthusiasm and 25 cents will get you a phone call. The plain fact is that non-Americans expect much from the Obama Administration — a stimulus package that helps both the U.S. economy and the rest of the world, a reform of the IFIs that diminishes America's weight on their boards, regulation of the American financial system so that its excesses do not infect others and measures that will increase savings and so gradually unwind global imbalances. If Obama has not at least indicated that the U.S. is moving in such a direction when the G-20 leaders meet in London, then — whatever the adoring mood on the streets may be — he will find a chilly reception behind closed doors.

Trouble is, Obama may have no alternative but to disappoint. International leaders are about to rediscover a central fact about the U.S., one that they tend to forget in good economic times when they ask little of Americans. The U.S. has an unusually open and fragmented political system, with real power centers outside the White House. The Senate has a constitutional role in approving treaties; the House of Representatives' Committee on Ways and Means has always been key to passing trade legislation. Both houses of Congress, and the executive branch itself, are constantly besieged by the most sophisticated lobbyists in the world, able to whip up campaigns in the media for or against this or that aspect of international economic cooperation.

This is not a problem that other nations have at home. (Premier Wen is not going to worry about whether China's National People's Congress will back any fresh international agreements the Chinese government signs.) But because U.S. action is so vital to reform of the global economy, and to changing the institutional structure by which it is managed, everyone else shares America's problem.

In Davos, Valerie Jarrett, a senior adviser to Obama, said that "Our economy is global, our crisis is global and our solutions must be global." She's right, of course, and was applauded for the sentiment. Under Obama, she went on to say, "America stands ready to lead," and that sentiment, too, went down well. But the next few months will be a test not of whether those good intentions are sincere — they surely are — but whether they can be backed up by actions, sometimes in the teeth of opposition from powerful domestic lobbies, that will help get the world economy moving again.

If so, global capitalism may once more show that it can create and distribute prosperity better than any other economic system, and that old Chinese fan of Adam Smith will be proved right. "The harsh winter will be gone," said Wen Jiabao last week, "and spring is around the corner." Here's hoping.

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