Furthermore, the trade dispute between the United States and China has excited commentators who fear that Trump may repeat the mistakes of the Hoover government. Even the Wall Street Journal editorial team has warned that the Trump trade team is like Senator Reed Smoot and Representative Willis Hawley, promotors of the disastrous 1930 Smoot-Hawley Tariff Act that aided and abetted the onset of the Great Depression with the introduction of tariffs of up to 60 percent on twenty thousand types of goods imported into the United States.11 The net effect of the act was to squash any hope of an economic recovery in the aftermath of the Great Depression and to cut world trade by 33 percent.
In addition, readers might tremble to know that Hoover took office with US equity valuations at very high levels. Robert Shiller’s excellent database highlights that the US long-term market’s price to earnings ratio was at 32 in January 1929 (the highest it reached was 44 in December 1999) and that it reads 28 today, which is 69 percent higher than the historical average of 16 and thus puts the market in expensive territory from a valuation standpoint.12 Eight months into Hoover’s term the Wall Street Crash occurred, and the United States lurched first into recession and then into the Great Depression.
One of the lessons from the Hoover period, which has been pored over by the likes of Ben Bernanke,13 is that the erection of trade barriers and tariffs is not an effective way to fight an international recession because they tend to quench any burning embers of economic recovery by causing a retrenchment in risk appetite and investment. That the world did not lapse into protectionism after the global financial crisis period has much to do with the fact that policy makers like Bernanke have digested the lessons of history.14 Other people, it seems, have not.
To a large extent, the 2008 global financial crisis was caused by the steady buildup and overreach of financial globalization. That the world economy and international political system did not lapse into protectionism and generalized hostility is testament to the ongoing lure of globalization, the mind-set of key policy makers, and international institutional arrangements. Yet there is a sense that the way in which the crisis has been addressed provides the basis for the next economic crisis (as with the title of Keynes’s book The Economic Consequences of the Peace: Keynes argued that the harsh treatment of Germany laid the seeds for the next conflict). In fact, one can argue that the true economic crisis has simply been postponed, and that the methods employed (and those not employed) to stave off the financial crisis have simply bought time. In doing so they have exacerbated fault lines, replenishing financial wealth but not leading to a broader recovery in prosperity and human development.
Any book that looks forward and projects economic and political trends must indulge in the dark arts of forecasting and prediction. In my view, it is always best not to record predictions lest their inaccuracy be later uncovered. I have spent a good deal of time both building frameworks that produce forward or future-focused investment views and predicting economic trends. In that respect, I know enough about the process not to disagree with the view—attributed by some to John Kenneth Galbraith—that one of the few functions of economic forecasting is to make astrology respectable. As an aside, a relatively recent paper in the National Bureau of Economics Research (NBER) Working Paper series shows that fertility is a useful lead indicator of the business cycle, especially with the onset of recessions.15 So “animal spirits” of some sort can help with forecasting. Indeed, Galbraith’s books, notably The Great Crash, skillfully capture the wild manner in which economic animal spirits can sway markets and economics and can undermine the conventional wisdom of policy makers.
There are plenty of biases and temptations inherent in the forecasting process. Notably, for those writing books on economics or finance, it is now almost obligatory to christen a publication with a bold proposition or a headline-grabbing prediction, often one that foretells an economic or financial crash. Often the amplitude of the prediction is inversely proportional to the quality of the analysis. Exaggeration is not the preserve of economics alone. In his book The Future of War, Lawrence Freedman notes Major General Bob Scales’s views on the think tanks, industrial conglomerates, and lobbyists who ply the government with solutions to “the next war” and says he holds that “the least successful enterprise in Washington DC… was ‘the one that places bets on the nature and character of tomorrow’s wars.’… ‘Virtually without exception, they get it wrong.’”16
My own sense is that long-term trends tend to evolve rather than materialize suddenly. I am reminded of the German economist Rudiger Dornbusch’s overshooting economic model, which helps explain how economic trends take longer than expected to turn but when they do turn, they do so faster than expected.17 Financial markets tend to amplify trends in economics, often in an exaggerated way where banks create financial products to reflect those trends. For example, one of the more profitable investment strategies in recent years has been to buy low volatility ETFs, whose value rises as market volatility falls. Billions of dollars poured into ETFs until a rise in market volatility in February 2018 caused them to unwind their positions, ironically resulting in one of the biggest spikes in volatility historically and in the collapse of the “low volatility” funds.
It is often the case that once a new trend arrives, it is christened by the forecasting community. Many of them will have failed to spot the emergence of the new trend but are quick to align themselves with it (which tells us more about the labor market than about anything else: people align their careers with hot trends). For instance, the December 2017 spike in the price of bitcoin was accompanied by a raft of new research opinions on the cryptocurrency from new cryptocoin brokers and large banks. For what it is worth, my own view on cryptocurrencies is that the future will be characterized as “Blockchain everywhere, bitcoin nowhere”—that is, the distributed ledger technology behind bitcoin will become more pervasive across economic sectors, but bitcoin will fail to prove itself as a currency proper and will live out an existence as a lurid, speculative asset.*
To return to the business of forecasting, I am also often struck by the number of times that bodies like the IMF and central banks follow up a crisis or market event with a downward adjustment to their GDP forecasts. In doing so, they succeed only in giving the impression that the policy fire brigade is late to the scene or behind the curve, following a crisis rather than getting ahead of it. In many ways, sharp changes to GDP forecasts are a sort of rite of passage for new economic trends. Forecast downgrades mark the end of one phase, and optimistic forecast upgrades signal the arrival of a new phase. Yet by the time the forecasters have reacted, the event is already well underway.
Why Did Nobody Notice?
So to an extent, forecasting is a code that says more about the forecasters and their relationship with the subject of the forecast than it does about the future outlook. The failure of the economics profession to foresee the global financial crisis has tarnished it in the eyes of many, and, famously, Queen Elizabeth demanded about the debt bubble, “Why did nobody notice it?” during a visit to the London School of Economics in November 2008.18
There are many culpable parties here: markets, politicians, and economists, to name the usual suspects. Take markets first: I often explain the ability of financial markets to ignore obvious risks by making an analogy either to Jekyll and Hyde or to a personal favorite, Elio Petri’s 1970 film Investigation of a Citizen Above Suspicion. In this movie a police inspector kills his girlfriend and then provocatively leaves clues to his culpability for his colleagues to find. They never suspect him. Then he confesses to the crime, but his bosses ignore him. The film, to stretch its meaning a little, is a good metaphor for how markets sometimes behave. Quite obvious risks can build—such as asset bubbles and indebtedness—but markets are not sensitized to them.
In the run-up to the global financial crisis, there were few telltales that markets were prepared for the magnitude of what later transpired. One widely cited system failure was that the maj
ority of academic economists were blinkered by a consensus that valued restrictive mathematical models of how economies and markets operate.19 In the United States, the job market for academic economists, and the fact that the Federal Reserve System is the largest employer for trained economists, helped produce a very conformist economics field. Indeed, there continue to be blistering attacks on this approach to economics from such experts as former World Bank chief economist Paul Romer, author Nassim Taleb, and former Federal Reserve governor Kevin Warsh. In their own ways they highlight the shortcomings in the socialization and groupthink of academic economists. Romer states, “As a result, if facts disconfirm the officially sanctioned theoretical vision, they are subordinated.” Taleb more provocatively holds, “Beware the semi-erudite who thinks he is an erudite. He fails to naturally detect sophistry.” And Warsh criticized the Federal Reserve: “Its models are unreliable, its policies erratic and its guidance confusing. It is also politically vulnerable.”20
A more conventional critique of economics by Oxford University’s David Vines and Samuel Wills continues to support many of the conventional economic models but criticizes their failure to, say, fully incorporate financial market variables.21 Today, the failure of such dry models may be to not take into account the kind of social and political behavior we are now seeing (e.g., the impact of social media on productivity or the impact of populism on asset prices) and the impact that behavior can have on consumption and investment patterns.
To be unkind, another problem with forecasting and economic forecasting in particular is that economists as a species are not well socialized. A US-based PhD program involves over four years of being locked away writing code, papers, and equations, and that is maybe not the best training to understand the world of humans. My own experience, having started off my professional life as an academic and having then spent the lion’s share of my career in the rough-and-tumble of financial markets, is that an enormous amount of academic research (at least in economics and finance) is not representative of the more practical ways in which economies function and does not sufficiently aim to tackle real-world problems. If I had to return to academia, my approach to research would be very different from what it could have been if I had remained in the university.
Economists and analysts may in the future be better served by taking more the approach of a sleuth than of an econometric modeler. Specifically, they should employ a wider variety of skills, ferret out facts and use firsthand experience to better understand them, and be more wide-ranging in their choice of the factors they choose to study. For instance, anthropology and sociology can sometimes better help understand the behavior of bankers and markets than can finance theory.22 If the pendulum of the economics profession is swinging away from a modeling-based approach, better that it swing toward development economics, for instance, which very often requires a more granular appreciation of how policy formulation works in practice.
Development economics is also the field where we can study the impact on economic growth of a relative change in the quality of institutions or in rule of law, simply by virtue of the fact that the potential incremental change in both variables is much larger in developing than developed countries.23 In more detail, the policies, actions, and actors that affect development in emerging nations are complex, both individually and in the ways they interact with each other. In the Trump/Brexit/Macron age, politics and institutional quality are exerting a very significant role on markets and economies, and a multipronged, more bottom-up approach may be required to open the black box of how policy decision making is undertaken, how it might be improved, and, as I will discuss later in this book, how politicians can make good use of it.
The failure of mainstream economics to foresee the arrival and path of the global financial crisis should also be a warning to the many critics of unexpected events like Brexit and the election of Donald Trump. Far too much time is devoted to lamenting such events rather than trying to locate them as part of a process of change and then trying to come up with better alternatives, moving beyond the “shock and awe” of recent political events and plotting a course for the future. The idea of levelling enables us to frame unexpected and new political events as part of a new process or phase in history. It is a consequence of the tide of globalization, the buildup of imbalances, and a sense among ordinary people that the array of technological, health, and social challenges they face is overwhelming. The focus should be not on the events but, rather, on the process.
The process philosophers and scientists call a “paradigm shift” helps explain how the levelling is unfolding. In science, the paradigm shift describes how scientific revolutions have come about. Established ideas and theories held by consensus are broken down by dissent from outsiders. Then processes of rebuttal and falsification break down existing frameworks. This examination does not often accomplish the task of constructing a better alternative early on. It usually takes time and experimentation, but ideally it produces better ideas and better frameworks.
This is a very shorthand way of describing the formal structure of the creation of new ideas (principally in science) that was outlined in The Structure of Scientific Revolutions by the American physicist and philosopher Thomas Kuhn in the early 1960s. He outlined the process through which ideas are established, identifying several stages. In the preparadigm stage, a theory is held by consensus. But then anomalies appear, and soon a crisis of truth and belief occurs, prompting a reexamination of the concept. This process of reexamination produces a paradigm shift, which is as much about the changed reference points and models that scientists use to interrogate the world as it is about producing a new model of the subject of their debate. Innovation, in the form of new ideas and new technologies, is a key part of the passage from the old paradigm to the new. (The scientist Geoffrey West, who is in fact eminent across a number of disciplines, underlines the importance of innovation in his excellent book Scale. From an economic point of view, he makes the point that innovation is especially urgent where the sustenance of growth is concerned.) Then, as the new theory of reality gains acceptance, the postrevolution phase begins.
Other philosophers, notably Karl Popper, sought to overlay more stringent rules that would help prove or disprove the new models resulting from paradigm shifts (he introduced the idea of falsifiability or “black swan” principle, which states that the test of whether something can be called scientific depends on whether it can be proven to be false). Indeed, Kuhn’s paradigm shift is as badly abused and misused as Popper’s notion of black swans. Both phrases have become popularized and have fallen into the vocabulary of management consultants, and as a result they have lost their meaning. For example, many people today refer to a risky scenario (e.g., could the stock market fall by 5 percent?) as a black swan event, though the original meaning of the term is quite different.
The idea of the levelling fits into the frame of a paradigm shift. Think of the levelling as a series of waves or reverberations of change. The global financial crisis was the first rupture, when the slowing of growth and the revelation of the shortcomings of globalization sent early tremors. Many social trends—such as obesity, the overuse of social media, and the reemergence of developed-world poverty—are raising the level of concern that human-specific factors, to put it as dryly as that, are being neglected. In politics, cracks are appearing in the system as voters begin to act, gravitating toward radical parties and sanctioning extreme events. Geopolitically, the idea of the liberal world order is under attack, and China is now a clear rival to the United States. American foreign policy is seen as aggressive, whereas it was once seen as benevolent. More change will come. Another recession or geopolitical crisis would only compound the sense of confusion. We are still simply at the early part of the paradigm shift, when the existing or consensual order is crumbling and slowly being rejected. This will continue.
In the framework of the levelling, the next stage is for the debate to move away from the ruptures and toward
a realization and acceptance that change is afoot, and toward a sense of what the future may look like economically, politically, and diplomatically. Then this skeleton worldview can be filled out by ideas, frameworks, and new institutions that can revitalize society.
The writings of Kuhn and especially Popper are useful in that they set out the template for paradigm shifts and also conceive ideas that are useful today. Specifically, Popper developed the idea of the open society. For many people, this is the basis for modern liberal democracy in the postcommunist era. An open society is one characterized by freedom, by transparent and active government, and by an absence of what philosophers call domination. It is surprising in the light of today’s political dislocation that the idea of the open society is not more widely debated and used. This may be because it lacks a tangible and practical framework, and also because it is associated with a liberal worldview that is increasingly being rejected. In this light, it is worrisome that in countries like Poland and Hungary, the idea of the open society and its proponents, such as George Soros (a pupil of Popper), are being rejected. As with many political ideas, Popper’s development of the concept of the open society came as a reaction to darker forces—in particular, the totalitarianism of Nazi Germany and Stalin’s Russia.
This helps remind us that new ideas, and more so the impetus for them, are often born out of crises. A neat way of seeing the progression of ideas and how they shaped history is to follow the chapters in the Foreign Affairs book The Clash of Ideas. It is a collection of essays that mark the passage of events and mind-sets through the twentieth century, opening with Harold J. Laski’s 1923 essay “Lenin and Mussolini,” progressing through, among others, Erich Koch-Weser’s “Radical Forces in Germany” (1931), Alvin Hansen’s and Charles Kindleberger’s pre–Marshall Plan thoughts in “The Economic Tasks of the Postwar World” (1942), and Charles Kupchan’s “The Democratic Malaise” (2012).
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