John Cassidy, The New Yorker
As the masters of the universe (and many journalists, too) gather for their annual confab in the Swiss ski resort of Davos, the world economy that they will be gazing down upon isn’t looking very healthy.
As the masters of the universe (and many journalists, too) gather for their annual confab in the Swiss ski resort of Davos, the world economy that they will be gazing down upon isn’t looking very healthy. The financial markets are in turmoil. The oil price is in a free fall. China just announced its lowest G.D.P. growth rate in a quarter of a century. The European Union has been in crisis for years. The Middle East . . . enough said. Even the American economy, one of the world’s few bright spots, is showing some signsof slowing down.
What to think? The optimistic view, which is always well represented in Davos, is that the response to the market gyrations has been overdone. In a blog postearlier this week, Olivier Blanchard, a former chief economist of the International Monetary Fund, pointed out that exports to China make up less than two per cent of U.S. G.D.P., so even a serious slowdown in China shouldn’t be a big drag on the American economy. And lower oil prices should be good news for advanced economies, because that leaves their consumers with more money to spend on other stuff.
If you take a standard macroeconomic approach to things, it’s hard to argue with Blanchard’s analysis. In recent days, other economists, including Jan Hatzius, the chief economist at Goldman Sachs, and George Magnus, formerly the chief economist at U.B.S., have put forward a similar argument, arguing that fears of another global slump are overblown. “We have certainly never had a recession against a backdrop of a collapse in oil prices, while those from 1973 onwards were all preceded by a surge,” Magnus pointed out in a post for the British magazine Prospect.
Why, then, are the markets so disturbed? One possible explanation has to do with trading algorithms, which encourage trend-following and herding. Once stocks or bonds or oil prices make a sharp move, everyone piles on in the same direction, and the market’s over-all shifts are exaggerated. Even those hedge funds and other institutional investors that aren’t actively shorting tend to adopt a “risk off” strategy, which precludes them from buying very much in response to drops in the market.
Another possible explanation is that the markets, through the magic of aggregated private information, have discovered something that the economists have missed. Perhaps China’s economy is in much worse shape than the authorities are letting on, or big Western banks are much more exposed to the collapse in commodity prices than they are admitting. If you think that the oil price will drop to ten dollars a barrel, and that most of the BRICS nations (Brazil, Russia, India, China, and South Africa) are entering deep and prolonged slumps, it is possible to tell a story about contagion and financial fragility that ends with a serious downturn in the West.
Or perhaps a somewhat different process is at work, one that centers around pervasive uncertainty raising risk premiums (the extra return that a risky investment is expected to generate), and that affects not only financial investors, but also consumers and the capital-budgeting departments of big corporations. This is a story in which Keynes’s “animal spirits” are depressed, but it isn’t necessarily about individual irrationality. When the world seems dangerous and inexplicable, it can make sense to curl up in a corner and keep your head down.
To explain this in terms of game theory, deciding whether to invest in financial assets or any other form of capital can be viewed as a huge n-person game (one involving more than two participants), in which there are two options: trust in a good outcome, which will lead you to make the investment, or defect from the game and sit on your money. If you don’t have a firm idea about what is going to happen and the payoffs are extremely uncertain, the optimal strategy may well be to defect rather than to trust. And if everybody defects, bad things result.
The uncertainty that I am referring to isn’t merely confined to disagreement about whether the oil price will eventually stabilize at thirty dollars a barrel or fifty dollars a barrel, or whether U.S. G.D.P. growth for 2016 will come in at 2.4 per cent (the median forecast calculated by members of the Federal Open Market Committee) or 2.0 per cent. I am talking about the basic picture of the world economy that people, especially people who hold positions of authority and influence—the sort of people who go to Davos—carry around in their heads.
Twenty years ago, when the World Economic Forum—the official name for the Davos meeting—was coming to prominence, this model, which featured ongoing globalization, deregulation, and technological change, was generally held by attendees to be a benign one. They believed that as the world economy grew more integrated, inefficient restrictions on the market were gradually stripped away, and the power of digitization was given free reign, the future would be one of prosperity expanding and freedom spreading. Sure, there might be some hiccups along the way (and some annoying anti-globalization protesters to be overcome), but the logic of the free market and consumerism would ultimately win out.
This world view came to be known as the “Davos Man” model. The Asian crisis of 1997 and 1998 put a big dent in it, and the global financial crash of 2008 and 2009 rendered it no longer roadworthy. Fortunately for the Davos crowd, a new optimistic paradigm quickly emerged, which might be referred to as the post-Davos model. Assigning a prominent (if not dominant) role to China and other fast-developing countries, it was a bit of an ideological mishmash. On the one hand, it retained faith that expanding markets and the global division of labor would enhance efficiency and generate prosperity. But it also expressed a good deal of faith in government action—both in China, where rapid, state-led development was expected to continue indefinitely, and in the West, where the monetary authorities, in particular, would successfully nurse their economies back to health after the financial crisis.
Over the past year, and particularly during the past couple of weeks, the foundations of the post-Davos model have been wobbling alarmingly. What was once seen as a historic transformation in emerging economies now looks suspiciously like a global bubble in commodities and credit, which will end the way bubbles usually end: by bursting. In the advanced economies—particularly in Europe, but also in the United States—serious doubts have emerged about whether growth can survive the gradual withdrawal of the monetary stimulus that took place in response to the crisis. And with debt levels high, additional fiscal stimulus also seems problematic.
Look at China, and you will see an economy where the debt-to-G.D.P. ratio is approaching two hundred and fifty per cent and capital flight is becoming an issue. (Paging Hyman Minsky.) Look at Brazil, and you will see a classic commodities crash. (Think Houston in the nineteen-eighties.) Look at the Gulf States, with their generous welfare programs, and it’s easy to imagine the possibility of forced selling by those countries’ huge sovereign-wealth funds. Look at Europe, and there’s a fragile recovery that could easily be derailed. Look at the United States, and you will see a Federal Reserve that must now be in a quandary about whether to keep raising interest rates.
No wonder people are worried: the standard model doesn’t appear to be working, and, so far, nobody has come up with a reassuring alternative. That has left the field open to economists peddling more dystopian stories, such as the “debt supercycle” theory expounded by Ken Rogoff and Steve Keen, and the “secular stagnation” hypothesis, which Larry Summers has resurrected.
I’m sympathetic to elements of both of these theories, but my point here is a more general one. As Keynes pointed out, economic outcomes are often so uncertain (in a statistical sense) that emotions and systems of belief, ways of thinking about the world, matter quite a bit. When people act on these emotions and beliefs, and experience confirms them, it often leads to a self-reinforcing cycle. During an upswing, such a process, which George Soros many years ago dubbed “reflexivity,” can boost growth and generate big rises in asset prices. When things turn, the same process can convert downturns into slumps and market corrections into crashes.
At the moment, we seem to be on the cusp of such a shift, although even that is uncertain. It is conceivable that the optimists will be proved right, and that this is just a passing phase. If so, the post-Davos model will survive for another while. It is also conceivable that the pessimists will be proved right, in which case there are rough times ahead for the world economy, and someone will eventually have to construct a post-post-Davos model. The system will demand it: capitalism can’t run on pessimism.