The New Chaos

Major depressions used to be common in the United States. We had them in 1837, 1857-8, 1873-8, 1897, and, most famously, 1929-1939. (As an aside, until 1929, the general attitude was to do nothing. It was not taken for granted that the president had a magic button in his office that he could push to end any economic problems that came along. Somehow, the economy always righted itself, and we continued to move forward.) But with one exception, we until recently had gone almost 70 years without one. The exception, the economic dysfunction of the late 1970s and early 1980s, was idiosyncratic because it was in a sense intentional, the result of having to wage extraordinarily contractionary monetary policy to fight the inflation caused by the misbegotten expansionary monetary policy during the oil-shock period.

But in 1994 on these events have been commonplace around the world. India in 1991, Mexico in 1994, East Asia in 1997, Brazil and Russia in 1998, Turkey in 2000, Argentina in 2001, the Arab Gulf states in 2006. And now, most of the planet.

It seems to me that the fact to be explained is not just why we are having this crash, but why we went so long without one, particularly in the advanced economies of the West. Financial crashes, I think, are usually the follow-up to financial bubbles. And those bubbles occur when major positive disruption to production possibilities brings overall opportunity, but great ignorance about how the opportunity is best to be exploited. The frequent depressions in the US through 1929 were caused by an economy dramatically remaking itself from predominantly agrarian to predominately industrial, the replacement of small farms with large factories. This was a revolutionary process that was not well understood at the time, so mistakes were frequent. When the mistakes reached critical mass, they had to be cleared out, and that was the function of the crashes.

In this view, the disappearance of major bubbles and crashes after 1929 was not due to government learning how to manage the business cycle better but to the much slower pace of economic transformation. Western economies matured, and so chances for speculative bubbles to build up essentially disappeared.

So what would explain the chaos of recent years? We are once again in a time of truly radical transformation. Part of it is technological -- the mainstreaming of the Internet in the late 1990s led to a huge number of highly speculative commercial ventures, all of which are plausible at the time but with the passage of time and the learning of knowledge about what consumers want proving that some of them were mistaken. This, I think, is the explanation for the Internet bubble during that period.

But the truly big story is the emergence of literally billions of people into the global economic system. They bring with them their energy, their dreams, and their ideas. Clearly, in the aggregate, the removal of these people in places like India, China, and Brazil from the imposed stagnation of state-dominated economies is a tremendous step forward for humanity. But how will the merging of all these people into the modern world change our possibilities? This has yet to be decided, and entrepreneurs have to decide it one gamble at a time. Even the current financial crisis is in part due to the introduction of new financial instruments, which are not currently well-understood. This is not unprecedented. The introduction of common stock led to the South Sea bubble, the introduction by John Law of paper currency into France did much the same there, and even the famous Dutch tulip bubble was driven in part by the introduction of tradeable futures contracts. All of these tools are still in use centuries later, and so too will be securitized mortgages, credit default swaps, and the other financial exotica that are blamed for the current mess. Being novel, they were often used irresponsibly, but it takes a while to learn the limits of any new invention.

More broadly, this introduction of people, the generators of ideas that change what is possible, into the global system is the phenomenon; the technological changes are only the epiphenomenon. And the scale of this great merging has brought with it a new instability -- the end of the artificial stability caused by the relative stasis in the number of people participating in the global system owing to the popularity of socialism. For centuries most of the heavy lifting with respect to advancing the human condition has been done by a relatively small number of countries -- the UK first, then continental Europe, the US, Canada and Australia, then Japan and the other early East Asian Tigers. Now, huge numbers of people in countries all over the world are getting into the game, and they will bring disruption with them. This will bring tremendous benefits, but it will be a bumpy ride. The current financial turmoil will not be the last.