LET me start with the obvious. We do live in a global economy. But it is important to be clear about what we mean by that. A global economy is characterized not only by the free movement of goods and services but, more important, by the free movement of ideas and of capital. This applies to direct investments and to financial transactions. Though both have been gaining in importance since the end of the Second World War, the globalization of financial markets in particular has accelerated in recent years to the point where movements in exchange rates, interest rates, and stock prices in various countries are intimately interconnected. In this respect the character of the financial markets has changed out of all recognition during the forty years that I have been involved in them. So the global economy should really be thought of as the global capitalist system.
Global integration has brought tremendous benefits: the benefits of the international division of labor, which are so clearly proved by the theory of comparative advantage; dynamic benefits such as economies of scale and the rapid spread of innovations from one country to another, which are less easy to demonstrate by static equilibrium theory; and such equally important noneconomic benefits as the freedom of choice associated with the international movement of goods, capital, and people, and the freedom of thought associated with the international movement of ideas.
But global capitalism is not without its problems, and we need to understand these better if we want the system to survive. By focusing on the problems I'm not trying to belittle the benefits that globalization has brought, as some readers of my previous Atlantic article assumed. The benefits of the present global capitalist system, I believe, can be sustained only by deliberate and persistent efforts to correct and contain the system's deficiencies. That is where I am at loggerheads with laissez-faire ideology, which contends that free markets are self-sustaining and market excesses will correct themselves, provided that governments or regulators don't interfere with the self-correcting mechanism.
Let me group the deficiencies of the global capitalist system under five main headings: the uneven distribution of benefits, the instability of the financial system, the incipient threat of global monopolies and oligopolies, the ambiguous role of the state, and the question of values and social cohesion. The categories are of course somewhat arbitrary, and the various problem areas are interconnected.
1. The benefits of global capitalism are unevenly distributed. Generally speaking, capital is in a much better position than labor, because capital is more mobile. Moreover, financial capital is better situated in the global system than industrial capital; once a plant has been built, moving it is difficult. To be sure, multinational corporations enjoy flexibility in transfer pricing and can exert pressure at the time they make investment decisions, but their flexibility doesn't compare to the freedom of choice enjoyed by international portfolio investors. There is also an advantage in being at the center of the global economy rather than at the periphery. All these factors combine to attract capital to the financial center and account for the ever increasing size and importance of financial markets.
2. Financial markets are inherently unstable, and international financial markets are especially so. International capital movements are notorious for their boom-bust pattern. During a boom capital flows from the center to the periphery, but when confidence is shaken it has a tendency to return to its source. I have seen many ebbs and flows and booms and busts, and though I fully recognize that international capital markets have become much more institutional in character and demonstrate much greater resilience, I cannot believe that the present boom will not be followed by a bust until history proves me wrong.
The risk of a breakdown is greatly increased by the fact that our theoretical understanding of how financial markets operate is fundamentally flawed. Economic theory has been built on the misleading concept of equilibrium. In my view, equilibrium is elusive because market participants are trying to discount a future that is itself shaped by market expectations. For instance, a company whose stock is overvalued can use that to justify the inflated expectations of its shareholders, but only up to a point. This renders the outcome indeterminate, and it is only by accident that the actual course of events corresponds to prevailing expectations. Market participants, if they are rational, will recognize that they are shooting at a moving target rather than discounting a future equilibrium. The theory of rational expectations makes the heroic assumption that market participants as a group are in a position to discount the future accurately. That assumption may yield a hypothetical equilibrium, but it has little relevance to actual market behavior—and neither market operators nor regulators have ever fully accepted the theory, exactly because they are rational people. I am told that economic theory has gone a long way toward recognizing and studying disequilibrium situations. Nevertheless, the laissez-faire idea that markets should be left to their own devices remains very influential. I consider it a dangerous idea. The instability of financial markets can cause serious economic and social dislocations.
The question poses itself: What should be done to preserve the stability of the financial system? This cannot be answered in the abstract, because every situation is different. Financial markets are best understood as a historical process, and history never quite repeats itself. The recent turmoil in Asian markets raises difficult questions about currency pegs, asset bubbles, inadequate banking supervision, and the lack of financial information which cannot be ignored. Markets cannot be left to correct their own mistakes, because they are likely to overreact and to behave in an indiscriminate fashion.
3. Instability is not confined to the financial system, however. The goal of competitors is to prevail, not to preserve competition in the market. The natural tendency for monopolies and oligopolies to arise needs to be constrained by regulations. The process of globalization is too recent for this to have become a serious issue on a global level, but since we are dealing with a historical process, in time it will.
4. But whose job is it to prevent undue concentration of power and to preserve stability in financial markets? This brings me to the role of the state. Since the end of the Second World War the state has played an increasing role in maintaining economic stability, striving to ensure equality of opportunity, and providing a social safety net, particularly in the highly industrialized countries of Europe and North America. But the capacity of the state to look after the welfare of its citizens has been severely impaired by the globalization of the capitalist system, which allows capital to escape taxation much more easily than labor can. Capital will tend to avoid countries where employment is heavily taxed or heavily protected, leading to a rise in unemployment. That is what has happened in continental Europe. I am not defending the antiquated European social-security systems, which are badly in need of reform; but I am expressing concern about the reduction in social provisions both in Europe and in America.
This is a relatively new phenomenon, and it has not yet had its full effect. Until recently the state's share of GNP in the industrialized countries taken as a group was increasing; it had almost doubled since the end of the Second World War. Although the ratio peaked in the 1980s, it has not declined perceptibly. The Thatcher and Reagan governments embarked on a program of reducing the state's role in the economy. What has happened instead is that the taxes on capital have come down while the taxes on labor have kept increasing. As the international economist Dani Rodrik has argued, globalization increases the demands on the state to provide social insurance while reducing its ability to do so. This carries the seeds of social conflict. If social services are cut too far while instability is on the rise, popular resentment could lead to a new wave of protectionism both in the United States and in Europe, especially if (or when) the current boom is followed by a bust of some severity. This could lead to a breakdown in the global capitalist system, just as it did in the 1930s. With the influence of the state declining, there is a greater need for international cooperation. But such cooperation is contrary to the prevailing ideas of laissez-faire on the one hand and nationalism and fundamentalism on the other.