A New Keynes

Last week, Dani Rodrik -- a political economist at Harvard's Kennedy School of Government -- wrote a column entitled, "Globalizers Lose Their Faith." To my mind, the most significant paragraph contained a litany of highly regarded economists who have become skeptical about the benefits of globalization.

"So we have Paul Samuelson," wrote Rodrik, "the author of the post war era's landmark economics textbook, reminding his fellow economists that China's gains in globalization may well come at the expense of the U.S; Paul Krugman, today's foremost international trade theorist, arguing that trade with low income countries is no longer too small to have an effect on inequality; Alan Blinder, a former U.S. Federal Reserve vice-chairman, worrying that international outsourcing will cause unprecedented dislocations for the U.S. labour force; Martin Wolf, the Financial Times columnist and one of the most articulate advocates of globalization, writing of his disappointment with how financial globalization has turned out; and Larry Summers, the former U.S. Treasury chief and the Clinton administration's "Mr. Globalization," musing about the dangers of a race to the bottom in national regulations and the need for international labour standards."

It is the lack of regulation, Krugman argues, which is at the heart of the current financial crisis. In his column in today's New York Times, he writes: "The back story to the current crisis is the way traditional banks -- banks with federally insured deposits, which are limited in the risks they are allowed to take and the amount of leverage they can take on -- have been pushed aside by unregulated financial players." These players essentially lent money on the value of assets -- not on the borrowers' ability to repay; and they assumed that the value of those assets would do nothing but grow. They then divested themselves of the loans they arranged, selling them off to pension funds and individual investors. The theory was that failure would always come in small pieces; and, in that event, no one would be badly burned.

What they forgot was the lesson of The Great Depression: there is such a thing as catastrophic asset failure -- something which world financial markets are now experiencing. To government's credit, it is acting faster than it did in the wake of Black Tuesday. But, as Krugman reminds his readers, much more must be done. "The moral of this story seems clear," he writes, ". . . financial regulation needs to be extended to cover a much wider range of institutions. Basically, the financial framework created in the 1930's, which brought generations of relative stability, needs to to be updated to 21st century conditions."

Unfortunately, for the last generation, governments -- taking their cue from Milton Friedman -- have operated on the principle that financial regulation is the root of all evil. And, hence, we find ourselves in a situation similar to 1928, on the eve of The Great Depression. Wealth is concentrated in a few hands; and there is not enough purchasing power at the bottom of the ladder to keep the economic engine going. If this story sounds familiar, it's because it is. The situation is more complicated than in 1929, because fixing the problem in the United States will not be enough to set the world right. It will take international cooperation and wise policy. In the 1930's, John Maynard Keynes provided the policy prescriptions which eventually set things right. "The world," Dani Rodrik wrote last week, "desperately awaits its new Keynes."