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The Quiet Revolution

In the four decades since 1970, the world has undergone a “quiet revolution” characterized by profound economic and financial transformations in advanced and emerging economies.  This revolution may not have been as visibly disruptive as the first industrial and political revolution of 1789-1848, but its economic, social and political ramifications may be just as important.

These ramifications are threefold.  First, the exponential growth in the intensity of financial globalization and the deep structural changes in the international financial system have created unprecedented systemic risk to which most regions of the world are exposed.  Second, the emergence of regional supply chains has likely increased the synchronicity of economic cycles between developed and emerging economies, at least within regional supply chains.  Finally, the spread of information technology and the decimation of communication costs have tremendously increased humanity’s ability to disseminate information, much like the multiplication of the number of synapses in a nervous system.

In addition to these transformations, we are currently witnessing modern societies’ inability to supply three critical public goods: containment of environmental disruptions; international financial stability; and containment of nuclear risks. The inability to provide these public goods is arguably one of the most significant collective action failures of our societies.

The ages of revolutions

“Words are witnesses which often speak louder than documents,” wrote Eric Hobsbawm in The Age of Revolutions.

“Let us consider a few English words,” Hobsbawm continued, “which were invented, or gained their modern meanings, substantially in the period of sixty years [1789-1848 – the “Age of Revolutions”] with which this volume deals. They are such words as ‘industry’, ‘industrialist’, ‘factory’, ‘middle class’, ‘working class’, ‘capitalism’ and ‘socialism’. They include ‘aristocracy’ as well as ‘railway’, ‘liberal’ and ‘conservative’ as political terms, ‘nationality’, ‘scientist’ and ‘engineer’, ‘proletariat’ and (economic) ‘crisis’. ‘Utilitarian’ and ‘statistics’, ‘sociology’ and several other names of modern sciences, ‘journalism’ and ‘ideology’, are all coinages or adaptations of this period. So is ‘strike’ and ‘pauperism’.”

“To imagine the modern world without these words (i.e. without the things and concepts for which they provide names),” Hobsbawm argued, “is to measure the profundity of the revolution which broke out between 1789 and 1848, and forms the greatest transformation in human history since the remote times when men invented agriculture and metallurgy, writing, the city and the state.”

One could take Hobsbawm to task for trying to pin down the industrial revolution to a relatively narrow period. His claim that the state was “invented” in “remote times” is also problematic: the state was in fact at the heart of the process of industrialization and undergoing crucial changes during the very period he studies, such as the strengthening of the rule of law and the development of democratic accountability.  Yet the validity of his insight is indisputable: words reflect the era that spawns them.

This insight is particularly relevant today. The words that were created after 1970, much like those that were invented between 1789 and 1848, reflect the far-reaching dislocations that were spurred. In fact, it can be argued that our modern economic dislocations rival – and may even surpass – the transformations that took place with the dual political and industrial revolution of the late 18th and early 19th century in both scale and scope.

There are two reasons for this.  First, contemporary economic dislocations have created a degree of instability that is in some ways morally unacceptable given its potential implications.  Second, there is no obvious easy, “orderly” way to reduce the system’s instability, as the current turmoil in Europe painfully demonstrates.

The recent economic dislocations, notably a surge in the intensity of the centuries-old phenomenon of globalization and the growth of financial instability, are for everyone to see.  The political repercussions of those dislocations may have only begun to be felt.  The rise in standards of livings since 1970 may not be as dramatic as that which took place in the 19th century, and the fate of working classes may not have followed the same path, yet the magnitude of the economic and financial forces that have been unleashed may actually be larger. This explosion will inevitably have a powerful political and societal impact.

Taking a step back and considering the developments that define our current era, it is clear that something profound is at work.  The words “interest-rate swap,” “social media,” and “systemic risk” may not be as readily accessible or convey the same kind of sweeping ideas as “industry,” “middle class” and “capitalism,” yet the former are in many important ways the offspring of the latter, and the metamorphoses they reflect and announce may be every bit as large. These metamorphoses may in fact reshape our societies to the same extent as did the economic mutations of the Industrial Revolution, which ushered in a tumultuous century marked by numerous political revolutions, notably the Spring of Nations in 1848.

The industrial and post-industrial revolutions have both impressed massive changes on the world economy

What justifies the parallel between 1789-1848 and 1970-20(30?)?

After all, unprecedented rates of economic growth are one of the defining characteristics of the Industrial Revolution.  In contrast, advanced economies since the 1970s have suffered a sharp deceleration of growth (see the chart below by Dani Rodrik).

Standards of living in “rich” nations grew far more rapidly in the first revolution than in recent decades.  One might therefore be tempted to say that the current era is best described not as a revolution, but as an evolution. A slow, tentative attempt to rebalance growth.  A quest for a slightly more cogent economic and political order, at most.

From an economic perspective, one way of describing the current situation is that advanced economies have hit the inflection point of a forty-year Kondratiev wave, are on their way down, and will ultimately rebound as the wave reverses. From this perspective, there may not be that much in common between the previous industrial revolution and the current era.

There are two problems with this view.  First, it is not clear that growth can be sustained at current rates without durably depleting the natural resources on which this growth depends.  Second, the degree of instability that has crept into the global economic and financial system is such that one cannot rule out immensely disruptive shocks in years to come.

But, in addition to these objections, do these eras – call them industrial and post-industrial – not share important common characteristics?

Three common “stylized facts” of the industrial and the post-industrial revolutions stand out. First, both eras witnessed profound transformation in modes of production and trade patterns.  Second, they both saw an increase in the power of a narrow elite across countries (and concomitant increases in income inequality within countries) – broadly speaking, industrial capitalists in the 19th century and financial and corporate elites in the 21st century. Third, they were characterized by an unprecedented increase in the level of interconnectedness between and among major economies – and, more importantly, financial systems.  The latter point is especially true of the post-industrial, financial revolution.

Some key terms that were invented after 1970 capture these mutations.

“Interest-rate swaps” are a pure product of financial liberalization and globalization.  Before 1980, they were unheard off.  Today, interest-rate swaps are the largest market for over-the-counter (non-regulated) financial derivatives and total over $400 trillion dollars in notional amounts outstanding (world GDP is around $60 trillion), while the notional amount outstanding of all over-the-counter derivatives is around $700 trillion, or ten times the size of the world economy (see chart below). These derivatives are used pervasively by companies and investors all over the world and allow for a greater degree of flexibility in cash flow exchanges among counterparties and thereby create greater efficiency in hedging risk, which encourages investment, trade and growth.  One of the problems is that the colossal amounts at stake distort incentives, making derivatives “financial weapons of mass destruction,” in Warren Buffett’s words.

Source: Cleveland Fed

“Social media” emerged as a byproduct of rapid technological progress and innovation, especially in information and communication technologies, and the spread of personal computers after 1985, the combination of which slashed communication costs and sharply increased humanity’s ability to share ideas and connect people who before would never have been able to do so.  If humanity is conceived of as a single organism or body, one might say that the effect of these technological developments is analogous to the body’s nervous system experiencing a sudden surge in the number of synapses.  This process vastly increases neurons’ ability to pass information from one cell to another, ultimately connecting all cells in a seamless, empowering way.  Social media’s ability to create and sustain mass social movements, for example, was evident when, in 2010, the staff of Secretary of State Hillary Clinton pressured Twitter to delay its maintenance operations (which would have required the site to be shut off temporarily) in the midst of Iran’s “Green Revolution.”

“Systemic risk,” on the other hand, is in some ways the price we pay for financial liberalization. With universal banks playing a prominent role in modern finance, the interpenetration of advanced countries’ financial systems and the exposure to the failure of the “weakest link” in the system – think of Lehman Brothers in September 2008 – has never been greater.  The risks posed by this extreme degree of financial intertwining have already – partly – crystallized on more than one occasion (East Asia in 1997, Russia in 1998, U.S. in 2008), and they threaten to crystallize again – especially in the context of the European crisis – possibly on an even larger scale.

Excess elasticity in the world economy: an underappreciated phenomenon

Gary Gorton explains in great detail how the panic of 2008 was in fact a “classic” bank run.  The difference was that the run was not a run by commercial bank depositors, but by financial institutions on other institutions in the so-called shadow banking system.  When trust in other institutions’ solvency evaporated, the entire system became insolvent as a run on repo markets froze credit markets all over the world.  Part of the reason is that the repo market provides between a quarter and third of global banks’ short-term funding.  When repo markets stop functioning, it is the entire global financial system that is at risk of freezing.

Just as the 2008 crisis and its very real, disastrous human impact was in many ways a consequence of financial globalization, the transformation in methods of production is perceptible in our every day lives. While the first industrial revolution led to increased integration of markets for goods, capital and labor, in recent decades this process has intensified (although not for labor markets).

Richard Baldwin writes in a recent paper that “Revolutionary transformations of industry and trade occurred from 1985 to the late-1990s – the regionalisation of supply chains. Before 1985, successful industrialisation meant building a domestic supply chain. Today, industrialisers join supply chains and grow rapidly because offshored production brings elements that took Korea and Taiwan decades to develop domestically.”

As Baldwin explains, there are two crucial aspects to this “2nd unbundling” in terms of industrialization paths.  “Today,” he writes, “nations can industrialise by joining a supply chain – there is no need to build a supply chain. Indeed in some industries the concept of a one-nation supply chain has disappeared. No nation today produces all the parts and components necessary to make aircraft, cars, or electronics. Some nations are headquarter-economies, others are factory-economies, but no one has the whole value chain.”

If one buys Baldwin’s thesis, then “easier and faster doesn’t necessarily mean better. […] The 2nd unbundling made industrialisation less meaningful.  Before the 2nd unbundling, a nation had to have a deep and wide industrial base before it could export, e.g. car engines. Exporting engines was a sign of victory. Now it is a sign that the nation is located along a particular segment of an international value chain.”

Another key implication of Baldwin’s thesis is that the “decoupling” of economic performance between developed and developing economies may be less likely to occur, since “factory-economies’” exports depend on “headquarter-economies’” growth, at least within regional supply chains (see chart below for the transition from the 1st unbundling of the first industrial revolution, in the central illustration, to the 2nd unbundling of the more recent period, in the right-hand panel).

With many indicators – such as deeply damaged public and private balance sheets (see chart below), weak consumer confidence, and in some cases large housing supply overhangs – pointing to years of anemic growth in “headquarter” countries, the current organization of supply chain linkages and the industrialization path followed by many countries, notably in East Asia, may prove painfully vulnerable to low growth in rich countries.

Source: John Ross

These conjectures fit well with the empirical observation made by Kemal Dervis that recent crises challenge the notion of a real decoupling of growth between advanced, emerging and emerging Asian economies. Dervis uses three charts to make his point:

Yet the tightening of supply chain linkages and coordination in goods markets pales in comparison to the scale and scope of financial globalization.

While global trade has increased from 25% of world GDP in 1960 to about 50% of world GDP today, the intensity of financial globalization has been much bigger. As mentioned above, the over-the-counter financial derivatives market grew from zero in 1980 (the first swap, between IBM and the World Bank, was introduced in 1981) to over $700 trillion dollars today – that is, over 1000% of world GDP.

The effects of financial globalization are far from anodyne. Participation in regional supply chains since 1985 has likely increased the synchronization of growth cycles between developed and emerging economies, but this synchronization is vastly compounded by financial globalization, which has the effect of harmonizing (to some extent) credit conditions across different regions – for better or worse.

Deeply interconnected financial systems have the ability to spread financial turmoil alarmingly fast.  A key reason for this is the role played by global banks, which hold massive exposures to one another and are subject to a “domino effect” in the event that a bank or shadow bank fails.

One way of observing the role of global banks is by observing that capital flows have surged in parallel with the emergence of European global banks.  As Hyun-Song Shin explains in a fascinating paper titled “Global Banking Glut and Loan Risk Premium,” a key reason behind this surge is the deep financial liberalization that took place in Europe in the 1990s and 2000s, driven by the implementation of Basel II proposals (which were applied with more zeal than they were in the U.S., mostly to the benefit of European global banks) and the E.U.’s lax Capital Adequacy Directive.  These differences in financial regulation led to “permissive risk management practices” by European banks, incentivizing them to build enormous leverage and take advantage of regulatory arbitrage opportunities by boosting their activities in the growing U.S. shadow banking system, especially after 2003.

More broadly, the issue is the extreme degree of “elasticity” that financial globalization has introduced in the global financial system.  This elasticity stems largely from the prominent (but not widely understood) role that global banks, most of them based in Europe, play in shaping credit conditions in Europe, North America and Asia. As Shin points out, European global banks provide almost half of the loans to banks in countries as far away as South Korea and Australia.  More important, Shin documents the critical role played by large European banks in the U.S. shadow banking system and in determining loose credit conditions in the U.S. in the run-up to the financial crisis (see chart below).

Contrary to the conventional wisdom that the “global savings glut” in emerging Asia encouraged excessive debt in the U.S., the evidence suggests that it was the “global banking glut” that was largely responsible for the easy credit conditions – and huge banking sector profits – in the run-up to the financial crisis.

The chart below (from Borio and Disyatat) shows the extreme fickleness of global capital flows.  By 2007, gross capital flows into and out of the U.S. had grown to $2.13 trillion (20% of U.S. GDP), and they collapsed by about 75% to around $500 million (less than 5% of U.S. GDP) in 2008.  The timing of this collapse in flows fits perfectly with the timing of the credit crunch – and the rebound in capital flows matches the timing of the rebound in global growth, suggesting that gross capital flows are critical to our understanding of economic shocks.

Gross capital flows (% of U.S. GDP)

Consistent with Shin’s hypothesis, and contrary to the “global savings” hypothesis, the chart below suggests that it was not capital inflows from Asia into the U.S., but rather those from the eurozone and the U.K., which formed the bulk of the capital flowing into the U.S. in the run-up to the crisis.

Gross capital flows (% of U.S. GDP)

Just as the 19th century saw the rise of the limited liability company, the 21st century has seen the rise of the limited liability global bank, which takes huge risks and makes gargantuan profits while unloading most of the costs on the state when downside risks crystallize.

The collective action void

But beyond the intensification of global trade and capital flows, perhaps the single most important commonality between the industrial and post-industrial revolutions is that both periods exposed in a stark way the deep-seated internal contradictions in advanced countries’ societal modes of organization.

Chief among those contradictions is the fierce tension between individual and collective well-being.

This tension, and the contradictions inherent to the way modern democracies are organized, lie at the heart of the work Mancur Olson.  Olson is the most distinguished expositor of the structural inefficiency of collective action, notably in The Logic of Collective Action.  One of his main insights is that, paradoxically, a group of people who have a common interest and the means to pursue this interest (e.g., consumer protection) will not always spontaneously act this way.  Thus the extension from invididual to collective action is not automatic or spontaneous.  It depends on the existence of appropriate organizations and institutions.

Olson also argued that democracy, rather than causing the exploitation of the minority by a tyrannical majority, can sometimes cause the opposite, because the few have concentrated benefits while the many have diffuse costs.  According to Olson, democracy holds the seeds of economic decline, yet at the same time it protects societies against predatory behavior by private agents and autocratic governments.  Olson famously argued that a stable democracy inherently favors powerful interest groups that protect their vested interests, which in turn hampers economic dynamism.  In The Rise and Decline of Nations, for example, Olson draws a contrast between post-World War II Japan and Germany, both of which grew rapidly after overthrowing powerful elites, and the United Kingdom, which stagnated under the weight of old vested interests.

While democracy may, according to Olson contain the seeds of economic decline, it seems that democracy itself is currently under threat, with powerful interests capturing governments and shaping policy-making in most of the world’s rich nations.

More troubling still, the legacy we are collectively creating is a very dangerous one.  It is a legacy of immense instability and systemic risk: the risk of hugely disruptive climate change; the risk of deep financial instability with potentially disastrous effects on the real economy; finally, the risk of nuclear catastrophe.

The supply of key “public goods” – containment of climate change, financial stability, and nuclear security – is being undermined by a failure of collective action on an unprecedented scale.  One of the most troubling aspects of this situation is that the required international policy cooperation – or the appropriate domestic policy responses – to address the complex but immensely important question of the provision of these global public goods seems more elusive than ever.

The paradox is that the more international cooperation and domestic policy responses are needed, the more elusive they become.  The drama of Europe’s crisis and European elites’ woefully inadequate policy response to the crisis over the past two years are a case in point of the extreme fragility and deep contradictions of the West’s societal mode of organization.

Thus, far more than an economic crisis, what may be happening to the West in the wake of its post-industrial, financial revolution is something much more profound – the gradual realization, in its collective psyche, that it is on course to suffer the consequences of one the biggest collective action failures in history.

This post originally appeared at Global Policy and is posted with permission.

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