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 period 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. Such fears 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 luminaries 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 platform 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 Renaissance 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. Moreover, 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", in accordance with 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 in view of 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 fears of reverse-colonization to find an outlet. 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 analyzed 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, like Alan Greenspan managed to do in 1987. But, the Fed's incompetence in 1920s and 30s 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 funds 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, large movements of the dollar against major currencies individually, "tend to translate to smaller movements against a US trade-weighted basket of currencies, and into still smaller effects of import prices because of imperfect pass-throughs". 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. Source: FOMC meeting minutes. See especially comment on WSJ).

My view: (i) President Barack Obama enjoys unprecedented 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-growing emerging markets like China, there is a huge appetite for 'American goods' -- speaking the English language, 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. (ii) This is why it is important not to follow a monetary policy that depreciates the dollar unilaterally. In Section III of my article, "A New Perspective on the Global Economic Crisis II: Fear of Reverse-colonization Did It", I had explained the mechanisms by which trillions of dollars of losses in the American financial system can be transmitted to the rest of the world, starting with engineering a dollar devaluation.


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 have collapsed resulting in 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, for the first year.


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 Pax Americana, 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).
Examine 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 by a failure of the markets or by 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) The natural price adjustment mechanism that I had described in my article "A New Perspective on the Global Economic Crisis" strongly suggests that the American financial system is capable of solving the financial crisis on its own. It is not necessary to transmit the trillions of dollars of losses due to financial crisis to the rest of the world by engineering a dollar devaluation. (iii) 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.

Whatever happened to the liberal agenda?

With unemployment hovering near the 10% rate, liberals are once again calling for a massive stimulus package. This type of policy making indicates a near certainty that the liberals are going to lose the rest of their political capital. Recall that the liberals had won a huge political mandate in the elections for US President and the US Congress in November 2008. But by the end of 2008, they had already done serious damage to the liberal agenda by letting the financial crisis spill over into a world-wide economic crisis. The three main mistakes they made were (i) to make an unqualified endorsement of the Federal Reserve's reckless monetary policy, (ii) to unnecessarily call for nationalizing the banks, (iii) to scare the world into believing that if consumption in America collapses then the emerging market economies could not sustain rapid economic growth. The liberals greatly amplified these three mistakes by making an organized promotion of Great Depression mania.

At present, the liberals are saying that the first stimulus package, worth $787-billion, is too small, and that they are leaving themselves open to criticism from the Republicans on this count. The Republicans are indeed saying that the stimulus bill is not stimulating anything, that hardly any money has been spent so far, even though it has been six months since the stimulus bill was enacted. A few weeks ago, Professor Paul Krugman appeared with Professor John Taylor for a 16-minute debate on Fareed Zakaria's GPS show on CNN. Zakaria asked, "What's wrong with the argument that if what you're trying to do is create rapid increase in purchasing power, that tax cut, permanent tax cut would actually deliver it faster?" Professor Krugman's reply: "... ... You can't have a ratchet where you always cut taxes and never raise them. Eventually, we end up with no government at all, which is, I guess, some people's goal. But, we can't have that".

At first, I couldn't believe that a renowned economist like Professor Krugman would make such a lame argument, after eight years of having the opportunity to criticize the Bush tax cuts. But, then I realized that Professor Krugman would make the same argument even if he had to answer the question all over again, at his own leisure. Basically, the problem is that the Western liberal tradition has been hijacked by the labor union movement. In an ideal world, Professor Krugman would have instead explained that in the modern economy, human capital is the most important form of capital. So, if the ultimate purpose was economic recovery, it would not be so effective to quickly enact a permanent tax cut and hand over all the money to the wealthiest people.

How about the permanent middle class tax cut (Making Work Pay) that Professor John Taylor was proposing in the debate? Would it be a good idea to quickly disburse the whole stimulus bill in this form of a permanent middle class tax cut, with the aim of creating "rapid increase in purchasing power"?

Well, the modern economy is constantly changing its structure. People feel the need to constantly learn new skills to keep themselves employed. In a severe downturn, many millions find themselves laid off from work. These millions are all engaged in a serious effort to update their skill-sets so that they can make themselves valuable in the job market. This is why it is important to back-load most of the stimulus spending to 2010, so that (i) the various government organizations get enough time to take into account, the changing structure of the economy, when they devise new spending programs, (ii) the people looking for employment get enough time to develop the skills that the market wants. A payroll tax cut only helps the saving and consumption behavior of those who are already employed. It does not facilitate the re-structuring of the economy, nor does it help directly in the learning process that people are going through to update their skills.

Another important point to note is that making the stimulus spending slow and steady provides a strong insurance against the economy going out of control into another free-fall. A massive one-time spending would have instead increased fears that once the spending loses its strength, the economy would go into another free-fall. Recall that when President Obama was sworn in this January, the liberals were claiming that if the stimulus bill is not massive enough to their liking, then it would not deliver an economic recovery. In two articles I had written in March (here and here), I had explained that not even Keynesian theory would provide a theoretical justification for a massive one-time stimulus spending. Moreover, one should not forget that recent developments in economic theory, that combined insights from Keynesian theory and business cycle theory, promised to make recessions mild, if not bypass them altogether. So, it would be prudent to admit that in the state that economic theory is currently in, it could not provide reliable guidance through the current economic crisis that has been surprisingly so strong and so devastating.

Next, we consider the unemployment problem. In its last FOMC meeting on June 23 - 24, (the minutes of which were released yesterday), the Fed had significantly raised its projections for GDP and inflation, but dropped the projections for unemployment for the remainder of 2009 to a range of 9.8 to 10.1% from the earlier projection of 9.2 to 9.6%. In the last few days, the Fed Chairman has also expressed concerns about a job-less recovery, which brought back memories of the George W. Bush presidency. Here again, the liberals are betraying their inability to free themselves from the labor movement's powerful hold. Unless the liberals give equal importance to globalization as they do to the issues of domestic labor, they run serious risks of bankrupting the American economy in the name of avoiding President Bush's job-less recovery from earlier in this decade.

With President Obama's unprecedented popularity around the world, it has become much safer for Americans to work around the world (except in the geo-politically high-risk regions). It would be possible to negotiate agreements with foreign governments to guarantee the safety of Americans working in their countries. Millions of Americans can find employment around the world as teachers of the English language, as business and political consultants, as sports coaches, as media personnel, and in so many other avenues of employment. It does not seem unreasonable to expect that in ten years time, 10 - 12 million Americans can be gainfully employed abroad. China alone could provide 3 to 5 million jobs for Americans. There is now a huge craze for American goods among the newly affluent Chinese consumers -- blockbuster movies from Hollywood, American food, fashion clothing, etc. There is really no serious argument for a second stimulus package running in the hundreds of billions of dollars.

A New Perspective on the Global Economic Crisis II:
Fear of Reverse-colonization Did It

I. Introduction

This is the second part of my article, "A New Perspective on the Global Economic Crisis". In Section II, I explain why my perspective on the global economic crisis is new. That is, we see how the consensus opinion among academic economists that focused on global imbalances led them to believe that, in the worst case scenario, if all else fails, the losses in the American financial system could be transmitted to the rest of the world by engineering a dollar devaluation.

Consequently, the global imbalances approach taken by academic economists prevented them from seeing that the American financial system is capable of solving the crisis on its own, for example, by employing the price adjustment mechanism that I had proposed in the first part of this article. Moreover, the financial crisis seemed to them to be a prelude to the Great Depression, rather than a 'stress-test' which indicated that the American financial system needs to be de-centralized as much as better regulated.

In my opinion, academic economists continue to believe in doomsday scenarios because of a deep underlying fear of reverse-colonization. I try to make this point clear by discussing, in particular, Professor Barry Eichengreen's latest article, "Can Asia Free Itself from the IMF?" on Project Syndicate. However, there is plenty of other evidence that a sizable number of economists are doomsday-believers. See, for example, Professor Paul Krugman's book, "The Return of Depression Economics and the Crisis of 2008". It is definitely the responsibility of the emerging market economies in Asia and Latin America to assuage such fears of reverse-colonization among Western intellectuals.

In Section III, I explain how the devaluation of the dollar would transmit trillions of dollars of losses from the American financial system to the rest of the world. We recall here that the price adjustment mechanism that I had proposed in the first part of my article, could provide an alternative to devaluing the dollar as a way of getting out of the financial crisis.

In Section IV, I pursue a question posed by Professor Michael Spence as the title of his latest article, "Does Growth Have a Future?", on Project Syndicate. I explain how my new perspective on the global economic crisis, combined with a new approach on durability of economic theories, would make it possible to provide estimates for growth in the world economy, that are substantially better than the "new normal for growth", that is being projected by the bond-traders on Wall Street.

In the last section, I use my new durability approach for economic theories, to examine some issues raised in Professor Dani Rodrik's latest article, "The Bumpy Road Ahead" on Project Syndicate.

II. How Come My Perspective on the Global Economic Crisis is New?

In his article, quoted above, Professor Eichengreen expresses concerns that Asia's efforts to form its own monetary fund (the Chiang Mai Initiative and its follow-ups) may run into trouble. Nevertheless, he opines, it is important for Asia to succeed in this effort. As he explains, "This scheme won't solve all of Asia's problems. But it would at least head off one danger, namely the urge to accumulate even more reserves. Recent volatility reinforces this temptation. If Asian countries succumb, global imbalances and all their associated problems will return. Pooling regional reserves as a way of making them go further is a better alternative". Certainly, the Asian countries have a serious responsibility for assuaging fears of reverse-colonization that seems to have been afflicting intellectuals in the Western countries for the last few years.

Indeed, as has been well-documented, ever since its inception in 1944, the IMF has been heroically shouldering the responsibility of preventing any chances of reverse-colonization ever occurring. In a recent article in the Financial Times, Professor Olivier Blanchard, the chief economist at IMF, explains "In 2007, worried about the growing size of current account imbalances, the International Monetary Fund organized multilateral consultations to see what should be done about it. There was wide agreement that the solution was conceptually straightforward. To caricature: get US consumers to spend less. Get Chinese consumers to spend more. This will be good for the US, good for China, and good for the world." To hear Professor Blanchard tell the story, "It was an impressive piece of global macroeconomic planning ...".

This concern about global imbalances that the IMF raised in 2007 seems to have spread quickly to the community of academic economists. For, within the first few weeks after the financial crisis hit, Professor Bradford DeLong remarked on this situation in an October 2008 article "The Wrong Financial Crisis", published on VoxEU.org. As he put it, "All of us from Lawrence Summers to John Taylor were expecting a very different financial crisis. We were expecting the `Balance of Financial Terror' between Asia and America to collapse and produce chaos." By the time the real financial crisis hit in September 2008, the economists had already arrived at a consensus among themselves that, to solve the crisis in the balance of financial payments that they had expected, the only way out was to devalue the dollar, especially with respect to the Chinese Renminbi-Yuan.

As it so happened, the cause of the real financial crisis did not involve global imbalances at all. The sub-prime mortgage crisis, which came to light in January 2007, spread to the whole of the housing sector and finally transformed into a full-fledged financial crisis with the government takeover of Fannie Mae and Freddie Mac in September 2008. Taken by surprise, economists scrambled to find the cause of the financial crisis. However, it was too difficult to develop a new framework for the rapidly unfolding financial crisis. It was much easier to simply fit the new problems posed by the real crisis to the old framework of global imbalances.

As a result, they announced the coming of a massive credit crunch. I tried to explain in my "FAQ on the Current Financial Crisis" that the crisis involved the accumulated capital rather than the working capital of the United States. But the economists would have none of it. They lobbied the world governments to cut interest rates drastically and in a coordinated fashion, and to spend trillions of dollars through lax monetary policy and deficit spending. They proclaimed the coming of the Great Depression and a prolonged deflation. Nine months later, they have gone through one solution after another -- buying toxic assets, equity injection, debt-for-equity swap, temporary nationalization, PPIP, TARP, TALF, buyback of treasuries and mortgage securities, etc -- but the crisis persists.

It now seems obvious that the only serious way to solve the financial crisis is to establish a direct channel of communication between the Wall Street banks and the property owners, as explained in the first part of my article. Every other solution that has been proposed fails to address the massive arbitrage opportunity that the Fed and the Treasury have created for the Wall Street banks (see Section IV in the first part for an explanation of this). Thus my perspective on the global economic crisis is new, because professional economists had been pre-occupied with a different framework for the crisis, a framework that had focused on global imbalances.

III. Dollar Devaluation

Through the devaluation of the dollar, there are essentially two ways** by which the losses to America in this financial crisis can be transmitted to the rest of the world. For the first way, we note that America's Net International Investment Position (NIIP) at the end of 2008 was -$3, 469.2 billion (source: http://www.bea.gov/newsreleases/international/intinv/intinvnewsrelease.htm). In fact, the gross external debt of America, as of September 2008, was $13.6 trillion (source: wikipedia). With the dollar devalued, the interest payments that foreigners receive, in dollars, for their holdings of America's gross external debt, would be equivalent to a reduced amount, when converted to their local currency. So, the foreigners would take huge losses in this way.

As an aside, we also note that, after a devaluation of the dollar, the interest payments that America receives in foreign currency for its loans given to foreign countries would be equivalent to an enhanced amount, when converted to dollars. Since the devaluation of the dollar is achieved by printing money and flooding the American financial system with excess dollars, the benefit that America obtains from the dollar devaluation is that these extra dollars that were printed could be used to provide vast quantities of cheap money to American banks so that they can get out of the financial crisis.

For the second way, we note that the unemployment rate has been very high (over 7%) in the last year, reaching 9.4% recently. Hiring decisions are made by firms only after they are certain that their business sector is picking up sustained demand. Moreover, hiring itself is a slow process requiring interviews, salary negotiations and re-locations. Hence, unemployment would continue to be high (over 9%) for another year or more. So the economy would continue to have enormous slack. With under-employed consumers not having as much income to make purchases, the threat of inflation is quite mild now, and it would remain so for another year or more.

However, the threat of inflation is only one factor affecting long-term interest rates. There is also the growth in economic output (GDP), and concerns about the long-term debt of the government which is set to rise rapidly during the next decade because of huge fiscal deficits. Here, rising long-term debt of the government has been successfully portrayed as a dire necessity to get the American economy out of the risks of repeating the Great Depression.

Moreover, by constantly pronouncing doomsday predictions that America is headed for a depression, liberal economists and the Federal Reserve had made it possible to achieve a consensus estimate of "new normal" for growth in the medium-term in the world economy. This "new normal" projection for growth was then taken up by the bond-traders on Wall Street, who appeared regularly in the media with patriotic fervor, to diligently educate the general public about this vision of "the new normal".

As a result, the Fed is not going to raise short-term interest rates, from its current range of 0 - 1/4%, for many more months. Figuring that cheap money is available for the asking in America, investment managers are going to borrow hundreds of billions of dollars and invest the money in the high growth emerging market economies (somewhat as a repeat of the run-up phase during 1992-96 for the Asian financial crisis of 1997-98).

With this situation, if the dollar gets devalued over the course of one, two or three years, then American fund managers would obtain higher returns when the profits in local currencies they make from their investments in foreign countries is converted back to dollars. In this way, by making available cheap money for investment managers in America and de-valuing the dollar, the growth opportunities in emerging economies can be channeled into America. This makes up for the losses in the financial crisis in America. In this transaction, the emerging market economies would bear the extra volatility caused by the cross-border movement of huge capital.

** Added in revision (Jul 10, 2009): There are two other ways by which the losses to the American financial system would spread to the rest of the world. The first way is that foreign banks operating in America would take losses on their balance sheets by writing down the values of the toxic assets that they hold. By far, the largest transmission of losses would occur through this way. But this way does not require the devaluation of the dollar. So I did not list this way in this section.

The second way is that by devaluing the dollar, exports from America would become more competitive in global markets. Thus the American economy would benefit while the economy of the rest of the world would be able to sell less to America. But this situation is quite complicated, because it is not clear how or whether the manufacturing industry in America would be able to take advantage of the dollar devaluation. So, I did not list this way in this section.

IV. Does Growth Theory Have a Future?

Professor Michael Spence explains in his article, "Does Growth Have a Future?" on Project Syndicate, that after the financial crisis is over, the world economy would not be able to go back to its pre-crisis level of growth. This is because the damage caused by the financial crisis is too extensive. Hence he suggests a "new normal" of lower growth for the world economy in the medium term. I presume that Professor Spence defines the term "growth" in a much broader sense than the bond-traders would, for he says in his article, "At the moment, the majority view in most countries is that the financial system failed badly, but that the incentives and dynamics of the broader market-based system in a relatively open global architecture remain the best avenues for wealth creation, poverty reduction, and the expansion of opportunity".

Does the theoretical study of economic growth promise to shed light on the path the world economy is going to take in the coming years? Would the tools and techniques that this topic of study employs, help economists to anticipate growth opportunities and prepare for them? Or would the world economy muddle along without any clear policy guidelines, unable "to avoid non-cooperative behavior and suboptimal equilibria"? Or perhaps should policy-makers abandon their focus on economic growth, and instead, promote social policies -- like income equality, health, sanitation, education and environmental preservation?

Such questions on economic growth can be profitably addressed, based on the concepts that I had elaborated in my recent article "A New Perspective on the Global Economic Crisis". The main argument to use for this purpose is that in different parts of the world, the underlying foundations for the prospects of growth are of varying durability. That is, the prospects for economic growth that the emerging market economies are enjoying come with secure foundations provided by a theoretical framework that has been in development for over a millennium. Whereas, the growth that advanced economies can expect would depend on relatively new and recent developments in economic theory, whose durability remains suspect. On the other hand, the predicament of the poor countries shows that securely founded economic theory alone could not guarantee sustained economic growth.

The focus on durability that I propose is in contrast to the concerns of investment managers who treat all assets uniformly under the risk-reward framework of modern portfolio theory. Their view treats asset classes as differing only in their risk-reward profiles, without any implications for systemic risk. No particular significance is attached to the transience or permanence of economic wealth, as the case may be. Whereas, with the durability approach, it is possible to study the requirements for generating growth in the advanced economies, which are markedly different from the requirements in the developing economies.

Taken together with this durability approach, the new perspective on global economic crisis that I had proposed in my recent article, opens up much better prospects for world-wide economic growth, in the medium-term, than those indicated by the "new normal" predictions of the bond-traders. At present, it could not be possible for me to develop such a wide-ranging theoretical frame-work as is plainly required before one can discuss, in a comprehensive manner, the issues concerning world-wide economic growth. However, if I receive a job offer for exploring the prospects for economic growth full-time, then I would be sure to take it up.

V. "New Normal" for the Efforts to Reform the Global Financial Infrastructure?

Professor Rodrik finishes his article, quoted above with, "It would be a mistake to respond by trying to take globalization to the next level. The economic and political obstacles that block deep integration cannot be wished away by exhortations. It would serve us far better to take these limits into account and scale down our ambitions." In this section, I use the durability approach to economic theories to provide further evidence that Professor Rodrik's conclusion is the right one. Basically, one should note that China's economy relies heavily on the industrial production process. The communist political structure in China is especially well-suited for an industrial economy.

The industrial production process has been intensely studied for nearly three hundred years now. It was the search for markets for Britain's industrial production in the 18th century, that resulted in Adam Smith's famous work, "The Wealth of Nations" which advocated free markets and globalization. In the 19the century, Karl Marx had studied the production process so thoroughly that he tried to build a whole new social theory based on it. In the 1930s, John Maynard Keynes envisioned "Economic Possibilities for our Grand Children" based on technological improvements in the production process. In the 1940s, Joseph Schumpeter thought about the production process and concluded in his famous book, "Capitalism, Socialism and Democracy" that capitalism could deliver on wealth creation, even if 10% of the working population is unemployed.

China's economy is currently on a secure growth path that is not only based on exports, but also the symbiotic relationship between a communist polity, a homogeneous society and an economy driven by factory-based manufacturing. It would be extremely ill-advised to try to disrupt the run of high rate of economic growth that China has been enjoying for the last 29 years or so. It is simply too dangerous to put pressure on China to replace its export-dependent growth model. One can be certain that the result of such pressures would be a strong political backlash from China. Instead, if the Western powers would wait for several years, then China would be in a position to address their concerns about trade, exchange rate, environment and geopolitics.

In a few years time, China's economy would graduate from an economy that is predominantly based on manufacturing, to a service-oriented economy. As early as five years from now, there would be upwards of 50 million Chinese people trying to break-free from a middle class existence, straining at affluent lifestyles. These newly affluent people would begin to have the same concerns about the environment as the Westerners do. Moreover, the government's policy of promoting consumption would bear fruit in five years or so.

Hence, the theories about global imbalances would stand a better chance of success, if they are pursued several years from now. For now, it is important not to de-stabilize the global financial architecture. Moreover, exchange rate stability is the policy that is being pursued by China as well as the European Union. Hence, it would be far easier for America to pursue the same policy, instead of raising concerns about global imbalances.


Notes: 1. Section IV. "Does Growth Theory Have a Future?" given above is essentially the same as the earlier post "In response to Professor Michael Spence's article "Does Growth Have a Future?" on Project Syndicate".
2. The 'It' in the title "A New Perspective on the Global Economic Crisis: Fear of Reverse-colonization Did It" does not refer to the global economic crisis. It refers to the oversight of academic economist -- their failure to see how the American financial system can solve the crisis by itself, without transmitting trillions of dollars of losses to the rest of the world.