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Carlo Scognamiglio Pasini Of Pluto and Mars

The financial crisis of 2008 has seen the United States relinquish its title of “world monetary leader” – or Pluto – that it has held since WWII. In the field of security – that of Mars – this means that the European “Venu- sians” will need to wake up from their dream of being able to free-ride for- ever on the public good generated by America. Likewise, the powerful en- gines of today’s real economy (particularly China) will need to realize that the days when they could just get on with selling their products to the world, in exchange for a currency issued by an inexhaustible lender of last resort, are over. Finally, those countries poor in everything, but rich in en- ergy resources will learn that they can no longer sit at the table set by wealthy countries without accepting the re- Carlo Scognamiglio Pasini, honorary chair- sponsibilities that come with it.

man of Aspen Institute Italia, is a professor

of Economics at LUISS Guido Carli in Rome. “I came to rescue capitalism, not to bury it.” Gordon Brown, speech to the House of Commons, October 2008

With the global financial market crisis, John Maynard Keynes has made a comeback: his “discovery” of the business cycle phenomenon and his stance against a self-reg- ulated international financial market – defeated at Bretton Woods way back in 1944 – appear more timely than ever. Among those who stand to benefit from this restitutio memoriae is his most modern reinterpreter, Hyman Minsky, who succeeded in build- ing on the work of the great English economist with his theory on financial instabili- ty1. As we will see, according to this theory, financial variables play a pivotal role in explaining economic crises. A perfect understanding of these works and the lessons 019-025-Scognamiglio-Pasini ing 41-42-43 20-01-2009 18:14 Pagina 20

which can be drawn from them to deal with the crisis currently shaking financial mar- kets, has led British Prime Minister Gordon Brown to earn an undisputed position of leadership on the international stage.

AFTER THE PANIC. The most dramatic and dangerous stage of the crisis – name- ly, dealing with a wave of panic as irrational as the rash enthusiasm shown for creative finance securities later downgraded to toxic assets – now seems to be drawing to a close. Yet its consequences on the “real” economy will persist for an unknown amount of time: the wealth destruction, caused initially by the “mania” for creative finance se- curities and then by the ensuing panic, is not yet quantifiable. For now, it is only pos- sible to attempt to provide answers to two questions that emerged simultaneously when the financial bubble burst: firstly, what was it that led to the blow-out of the specula- tive bubble; secondly, was it foreseen or not by the economic models to hand. There is no doubt that the most direct cause of the bubble’s blow-out was endogenous to the American system of home financing and the consequence of years of overly- expansive monetary policy. Yet media reports are also making endless comparisons with 20 the grave crisis that began in 1929. These comparisons are partly justified as far as the effects of the crisis are concerned, but they are unfounded as regards the causes.

THE CAUSES ARE DIFFERENT THAN IN 1929. The Wall Street financial bubble of 1929 was mainly fueled by the huge volume of capital flows triggered by the war reparations owed by defeated Germany to the victorious allies, as a conse- quence of what was a modern take on the Pax Carthaginiensis: the 1919 Treaty of Ver- sailles. In order to obtain the funds necessary to make reparations, Germany resorted to borrowing from the United States, which by then had already long been the world’s leading industrial power and, unlike today, had a massive current account surplus. These capital flows returned to the US in the form of industry orders and purchases of agricultural products, but also as speculative investment on the American stock mar- ket. In other words, the American trade surplus financed the country’s industry and agriculture, but also speculation on Wall Street. Hence, an excess of savings was transformed into a wave of speculation, precisely as described by Hyman Minsky. In the case of the current crisis, however, its origins lie in the American government’s excessive deficit and the deficit in the balance of payments current account – in oth- er words, in a savings deficit which, likewise, leads to an enormous growth in the vol- ume of financial resources in circulation. 019-025-Scognamiglio-Pasini ing 41-42-43 20-01-2009 18:14 Pagina 21

The twin deficit phenomenon is determined by the presence in a given economy of significant, persistent and simultaneous deficits in the government’s accounts and in the balance of payments current account. The first type of deficit indicates that the government’s tax revenues are not sufficient to cover public expenditure, while the second type indicates a savings deficit, which occurs when imports of goods and serv- ices exceed exports.

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GUNS AND BUTTER. The twin deficit made its appearance in the United States during the Reagan administration (1981-1988), as a consequence of the acceptance gained by the ideas of Arthur B. Laffer about supply-side economics, and of the es- calation of the Cold War during the period that preceded the collapse of the Soviet system. The tax burden was alleviated, thus leading to a reduction in tax revenues. At the same time, there was a sharp rise in arms spending, which reached over 6% of America’s gross domestic product. This policy, which we may term “guns and butter”, was made possible by America’s low level of foreign debt and, in particular, by the fact that the dollar represented then – as it does today – the principal currency for international trade and for the accu- mulation of currency reserves. The dollar bill and US Treasury Bonds were both well- 019-025-Scognamiglio-Pasini ing 41-42-43 20-01-2009 18:14 Pagina 22

accepted by the international community, and this made American rearmament pos- sible in a strategic race with the Soviet bloc, without having to lumber American tax- payers with a particularly hefty tax burden. This was the decisive battleground between the Western democracies and the Soviet empire. The latter was, in turn, forced to increase its military spending, which reached a “wartime” level of over 15% of GDP. The socialist economies, which were already in serious difficulty due to their lack of technological preparedness, were lit- erally devastated by the race to keep up with military spending, flinging their popu- lations into chaos and misery and thus bringing to a close the battle between the two power blocs, at odds with each other since the end of the second world war. The global division of roles, the specialization, or the “division of labor” – as Adam Smith would have put it – became glaringly evident during the first Iraqi crisis (in 1991), when the United Nations responded to the invasion of Kuwait by Saddam Hus- sein by authorizing military intervention. The military action was led predominantly by American forces, but was financed to a great extent by the Arab oil-producing na- tions. Later, during the Clinton administration, the United States resumed a policy of 22 multilateralism – or, if you like, a Jeffersonian profile of being “humble but strong”. Military expenditure was gradually reduced to 3% of American GDP and, thanks to the “dividend of peace”, the public deficit was lowered until it was transformed into a sur- plus. The flow of financial resources from abroad to the United States continued in the form of foreign investment, thus fueling the strong growth of the American economy. The “war on terror” – after the dramatic attacks of September 11, 2001 and the mili- tary campaigns led by Americans in Afghanistan and Iraq – saw a return of the situa- tion that had preceded the end of the Cold War. The United States simultaneously filled the role of “world security leader” – once again raising spending on strategic military deployment to 6% of GDP – and that of chief economic and financial center of the world. As a result, the twin deficit resurfaced in America’s public accounts. At present, the US current account deficit is 700 billion dollars a year (or 5% of American GDP). Mean- while, the world’s three principal exporters (China, Germany and Japan) have a surplus of 800 billion dollars, to which can be added the surpluses of the hydrocarbon-pro- ducing countries, which have been growing with the rise in oil prices. During this period, there was also a polite war of words conducted from the western shores of the Atlantic against European partners. The Europeans, “from Venus”, it was suggested, were able to enjoy the delights of their countries in peace because the Americans, “from Mars”, had taken care of security issues. The “specialization” of 019-025-Scognamiglio-Pasini ing 41-42-43 20-01-2009 18:14 Pagina 23

roles among countries even became the subject of literary and mythological forays. However, in order to measure up to these evocative claims, the United States, as the epicenter of world economic power, found itself playing the role of Pluto as well as that of Mars. Still, if during the time of the Pax Britannica the world had functioned more or less along these lines, then why should we not think that the golden age of Queen Victoria has returned?

A RUDE AWAKENING. As the saying goes: “all good things must come to an end.” Even during the golden years of the American century, a rude awakening lay in store: it would come well before it was expected. During the height of the “American century”, which corresponded with a very long phase of global economic expansion, the perils did not lie in the spirit of freedom which underpins capitalist laissez faire practices. Rather, they lay in the herd behav- ior which fuels speculative financial cycles, also described quite recently by the great economic historian Charles Kindleberger,2 and formalized, as has been noted, in a model devised by the economist Hyman Minsky,3 which further integrates the Keyne- sian business cycle model. 23 According to the definition shared by the two American authors, financial crises oc- cur at the height of a period of expansion and lead to a downturn in the cycle of ag- gregate demand. They start with a displacement, by some new event (such as the con- struction of railroads, the advent of the automobile, a war, the emergence of a new technology such as ICT and so on), followed by an expansion in credit and money sup- ply (the boom), then euphoria – expansion in business and trade (overtrading) – a ma- niacal fervor which leads to a “bubble”, until the realization dawns that there is no longer any lender of last resort (someone to take the hot potato, we might say). At this point, the next phase begins to take hold: namely, panic and then catastrophe (the crash). What was bought at absurdly high prices, without any relationship to its “real value”, is now sold off at equally absurd low prices in the stampede to recoup some cash. From the “South Seas crisis” of 1720 to the Wall Street crash of 1929 to the dot-com bubble of 2001, all financial crises have invariably followed the same pattern. The co- nundrum of how humans can prevent or remedy the follies of their herd behavior is probably unlikely to ever be solved. This is how it was in the past, how it has been during the present crisis and how it will probably remain, even when the great crash of globalized finance is but a faded memory. As regards the second question raised previously – namely, whether we knew the cri- 019-025-Scognamiglio-Pasini ing 41-42-43 20-01-2009 18:14 Pagina 24

sis was coming – it is not just the cited works of Kindleberger and Minsky which made the development of the crisis totally predictable. Minsky himself, in his 1982 work entitled Can it happen again? – together with a vast array of public commentary rang- ing from that of Charles Morris to George Soros – demonstrated that not only was the crisis predictable, but that it had effectively been accurately foreseen. Even conced- ing that the current wave of panic will subside (as have previous phases of mania, panic and crashes), we still need to ask ourselves what awaits us in the “aftermath”.

WHO WILL LEAD THE WORLD NOW THAT PLUTO’S GONE? Seen against this backdrop, the unipolar role of the United States as world leader of secu- rity – as it emerged from the second world war and the Cold War – and its role as undisputed economic leader – which stemmed from the Bretton Woods accords of 1944 – can never be the same. On the economic level, the United States wielded its might as lender of last resort with the nationalization of the two home loan giants Fannie Mae and Freddie Mac and of the insurance colossus AIG, but it proved powerless when the market called in the bill 24 for toxic assets. The allocation of 700 billion dollars by Congress, which tripled the American public deficit, was not enough to stop the wave of global panic sparked by the bankruptcy of Lehman Brothers, which led to the collapse of global money and in- terbank markets. Even if there were more than a few compelling “ethical” consider- ations that must have influenced the decision to let a major bank go under, that choice also represented the relinquishment by the US of its title as “world monetary leader”, or Pluto, which it had held, indisputably, from the post-war period until today. In terms of security, this break in continuity will mean that the European “Venusians” will have to wake up from their dream of being able to free-ride forever on the back of the public good embodied in a common security the Americans alone would pro- vide. Meanwhile, the powerful engines of today’s real economy – including China, Japan and Germany – will need to realize that they cannot just crank up their pro- duction lines to full speed and sell their products to the world in exchange for a cur- rency issued by an inexhaustible lender of last resort. Countries poor in everything, but rich in energy resources will also learn that they can no longer take a seat at the table laid by wealthy countries without assuming their share of responsibility. They will need to reflect on their future. Supranational-level institutions have already been heavily downgraded. The World Bank is not geared to dealing with any crisis involving developed countries. The In- 019-025-Scognamiglio-Pasini ing 41-42-43 20-01-2009 18:14 Pagina 25

ternational Monetary Fund – according to a commonly-held view among European governments – “has no more customers”. Today, its resources are limited and they are only effective in crises that are local and internal to individual monetary zones. The European Union itself has seen its most pre-eminent members act on their own in anxious efforts to keep the international crisis at bay. Only the external leadership of Gordon Brown, inspired by the ideas of Keynes and Minsky, has succeeded in re- establishing some degree of order among the eurozone countries. The Bretton Woods accords of 1944 had already been de facto abrogated by the dec- laration of the inconvertibility of the dollar (in August 1971, by Richard Nixon’s ad- ministration). Today, after the storm that has led various governments to underwrite commitments to the tune of over 10% of gross global product – with bank national- izations, rehabilitation of toxic assets and state guarantees of loans to instill confi- dence in interbank markets – the convening of a new United Nations Monetary and Finance Conference (as the conference held in the resort town of Bretton Woods, New Hampshire was called) only awaits a word from Barack Obama. This time, the loca- tion will probably be chosen again by the new US administration, but the Dollar/Gold Exchange Standard backed by Roosevelt, Morgenthau and White will not resurface. 25 Keynes’ ideas, however – if not also his final brainchild, Bancor – will be remembered fondly. A source of intellectual guidance has been rediscovered, which possesses the instruments needed to resolve this new crisis: provided by Keynes and Minsky, it was brought up to date for a financial system in the information age by the British Prime Minister Gordon Brown. On sailing ships, the arrival of a storm forces the crew to set aside any discussion on which route to follow: sailors focus exclusively on their own safety and that of the ship. Talk of which port to head to comes later. Similarly, it is first necessary for the wave of panic to subside. The time to repair the damage – and perhaps even to build a new ship – will come later. However, those responsible for designing that ship will need to keep in mind that, if America can no longer be both Pluto and Mars, and if Europe can no longer be just Venus, neither can Asia be Atlas alone.

1 See Hyman P. Minsky, Financial stability revised: the economics of disaster, Federal Reserve System, 1972. 2 Charles P. Kindleberger, Manias, Panic, and Crashes, Basic Books, MacMillan, New York, 1978. See also the fifth edition: Wiley and Sons, New Jersey, 2005. 3 Hyman P. Minsky, ibid. See also: Reappraisal of the federal discount mechanism, Federal Reserve Sys- tem, Washington DC, June 27, 1972, vol. 3, pp. 95-136.