The natural hit of the economic crisis – a discussion on global systems’ robustness and resilience

The world seems to be caught in a vortex of bifurcations, that may land us in a very different environment, with much more uncertainty and perils. What may be striking is that a very deep financial and economic crisis has hit most of the industrialized countries, which are presumed to have solid institutional arrangements. We are confronting the most severe financial crisis since the Great Depression of the last century. Economic decline in many economies has caused enormous strain, that shows up in social life and in politics (e.g. stalled dialogue/decision, augmented extremism in mature democracies including chauvinism and xenophobia).

The crisis of the welfare state, in conjunction with rising income inequality, have weakened a social milieu that got further hits from the financial crisis.  There is also dramatic climate change, which indicates basic disorders in the human – nature relationships. Some of these disorders are rooted in societies’ disregard, or misunderstanding of ecological needs. The proliferation of extreme events questions the very perception of them being rare events.

A working hypothesis can be submitted: even though there is ever more information and  scientific and technological advance never stops, societies do not automatically have superior cognitive capacities and capabilities to respond to shocks and challenges.

1. Conventional and unconventional shocks

The multiplication of conventional and unconventional shocks makes up a very tough test for the robustness and resilience of social (economic) and technological systems. As natural disasters test the robustness of infrastructure, so does a severe economic crisis when it comes to social systems.

The current financial/economic crisis has an impact equivalent to that of a war during peace time. This crisis has substantially increased public debts around the world. In the European Union the aggregated public debt of governments has increased by around 40% after 2008. The cumulated debts of the private sector are a multiple value of the EU GDP. In the US public debt is around 90% of its GDP. In the industrialized countries, potential economic growth  is estimated to have been halved by the current crisis; for the EU the average potential growth has come down from 2-2.5% to probably 1-1.5%.

Complications arise when shocks find systems unprepared, or insufficiently prepared. It is quite striking that European leaders kept talking about the “robustness” of their economies after the financial crisis hit; they did not realise that the same structural weaknesses, as in the US, were afflicting the European financial system. The Eurozone provides numerous lessons to be learned. Its troubles, apart from the impact of the financial crisis, originate in the wrong design and flawed policies, which have led to the creation of a ‘sensitive’ monetary area, lacking robustness. It is quite obvious that what the ECB did at the end of 2011 and in 2012, as a lender of last resort, has saved the euro zone - so far. But it is still an open question whether the Banking Union project is the convincing way out from the crisis in Europe. If it can foster deeper integration while giving voice to many frustrations and if it reduces the “democratic deficit” in the EU its chances of success go up.

Hurricane Katrina in the US, the gas leakages in the Gulf of Mexico that were caused by the installations of British Petroleum, the nuclear disaster at Fukushima in Japan, and other similar events show that there is no infallible technology, that erroneous decisions together with technical vulnerabilities invite bad events to happen.

It is justified for the robustness (resilience) of systems to be a topic of high interest. While geography makes the difference in nuances and how shocks, but also how economic development are perceived, the institutional robustness of systems worldwide are of paramount importance for ensuring stability. Considering the new threats – cyberfare and not only, systems resilience becomes a matter of interest for national security experts as well. Not to mention the fact that when economy looses vitality and therefore systems robustness goes down, security suffers the shocks through budget cuts. While the particular of geopolitics explains the way the world evolves, the general of economics (influenced by and influencing geopolitics) justifies today the need for systems’ resilience.

The response to threats tests the virtues of liberal democracies as against authoritarian states. Authoritarian systems, despite their capacity to mobilize large-scale resources relatively fast, feel vulnerable to free movement of information and, consequently, they try to limit the use of modern vehicles (the internet). But liberal democracies, too, may feel vulnerable when information is manipulated grossly.

2. Why has robustness (resilience) been falling?

Several explanations can be put forward.

• a rise in inter-connectedness weakens robustness (resilience) to the extent  the contagion of bad phenomena intensifies. An example is pandemics, which spread much faster when people and merchandise travel intensively and control is inefficient;
• the rapid technological advance in IT becomes a vulnerability when implementation of new information and communication technology doesn’t keep the same pace with innovation (defense against viruses and hackers is limited);
• in finance, the inter-connectedness of markets and the spread of “toxic” products, together with the rising importance given to (speculative) trading institutions have increased systemic risks exponentially;
• unmanaged globalisation has, arguably, made systems less robust even in the case of developed countries. Not even the best performing developed economies can withstand shocks effectively, over the longer term, if emerging economies assimilate advanced technologies at a faster pace. The dynamics of comparative advantages does not make everybody a winner in a global economy where zero sum games are frequent.
• systems (economies) that over-depend on structures producing shocks suffer more. Likewise, systems whose output depends on too few sectors are less robust. The structure of inward investment is also critical – whether it is based on borrowed funds, or it is in the form of direct investment. The latter have a different impact on the recipient systems depending on the robustness and resilience of the economies they come from.
• under-investment in education and in basic infrastructure and scarcity of reserves, which afflicts mature economies too;
• income distribution – healthy economies: OECD and IMF studies show that the increase of inequality in industrialised countries, during the last few decades, has worsened social cohesion;
• the social state dilemma: on one hand, the current financial crisis as well as previous dynamics (including demographics) have eroded the resources of the social state, asking for a reform of the social security system. On the other hand, if these corrections are made abruptly and recklessly, they could diminish the capacity of institutions to foster dialogue and compromise;
• complexity: if systems do not adjust fast enough, if they do not have the capacity to self-organise better and to learn, they get weaker, vulnerabilities increasing. Complexity can override the capacity of individuals and of organisations to cope with it. This has been a wide-spreading phenomenon in finance, which has turned into a sort of a black box, frequently for insiders too. The decline of robustness is visible in many financial institutions, where “compliance rules”, internal prudential mechanisms prove to be highly inadequate. This applies both to a global system and even the EU: the overhaul of governance structures need to take into account the capacity of member states and other players to cope with new regulations and procedures.
• demographics: a massive depopulation (migration) negatively influences the generational change, considering human resources available for the internal economic development of a country. Migration can ease unemployment for a while, but there are ensuing long-term costs;
• food: dramatic changes in the relative prices can be lethal, extremely disruptive, for poor societies; this should be seen in the context of the ecological crisis.
• geography; many of the points above relate to geography (from resources to demographics). Proximity is another important factor: The higher is the compatibility with a robust system, the higher are the benefits of geographic proximity.

The fall of robustness (resilience) is linked with cognitive problems and policy choices. For instance, in finance the blind trust in quantitative methods led to major failures at company level and system-wise. The collapse of the LTCM hedge fund in 1998 was a forerunner of the current crisis. At that time, the models used underestimated tail events, which proved to be lethal for the adopted strategy. The intervention of the Fed was needed, even if in an indirect way, in order to save the financial system (which was threatened by contagion). One decade later it became increasingly clear that models used by central banks are inappropriate, that systemic risks have been grossly overlooked. We are now in a period of reassessing modelling algorithms and non-linear dynamics (extreme events) are taken into account ever more.

Within the large topic of climate change it does make sense to discuss the logic of economic growth that ignores resource scarcity. The Club of Rome and other organisations were and are right in this respect. A certain life-style, especially in the industrialised world, and an economic logic that does not internalize climate change effects and resource scarcity (as powerful externalities, that should be attributed commensurate costs), make adaptation more difficult. “Steady state economics”, as an approach that thinks about sustainability, is not of recent vintage and, yet, progress is very slow in producing a change of hearts and of policies that should fit the magnitude of challenges. There are too many prisoners of day-to-day reality, of market competition, of struggle for Earth resources, who ignore the bigger picture. We have to keep in mind here  trade-offs among the use of limited resources, for instance land for food versus land for energy. Thence can emerge sources of future major conflicts.

Nor it is easy to strike positive compromises when the international regime does not have effective rules. The G2 (USA and China as superpowers which would “organise” the global dialogue), as compared to an ineffective G20 can be compared to a “G0”, as some see as the evolution of the global system. If the EU were more cohesive and stronger (the end of the Eurozone crisis would have such an outcome),it would get more punch in international affairs so that we could then talk about the formation of a G3 as a basis for a new international regime.

The current financial and economic crisis questions the dominant paradigm of recent decades. Fundamentalism in both theory and policy is disavowed. A free economy (markets) is a prerequisite of economic freedom, of democracy. However, full faith in perfect regulation through markets is sheer non-sense.

Public policies have favoured the growth of income inequality, as an uninspired policy-drift in some countries, including the US. This happened at the same time with rising macroeconomic imbalances in not a few industrialized countries, with the burdening of the social security system. This situation creates huge dilemmas and trade-offs for nowadays public policies. Economy, society, need moral values as public goods to function well.

3. A few ways of strengthening systems’ robustness (resilience)

a)Mobilisation of internal resources. In all societies efficiency reserves exist. In a system in which micro and macro inefficiency are high, robustness and resilience can be strengthened without additional costs; the same output can be obtained with a lower intake of resources and, what may sound strange, buffers can be increased. The mobilisation of internal resources is not automatically equivalent to a decrease of reserves as mobilisation would mean o more efficient use of resources, meaning that the same output would be achieved with a lower consumption of resources.

b) Figuring out an optimal relationship between government (the public sector) and market is essential in order to enhance the robustness, resilience of systems. The supply of “public goods” that increase the robustness of systems is critical: education and public health; infrastructure; measures that enhance a fair income distribution; financial sector reform that diminishes systemic risks, etc. The provision of an adequate amount of public goods demands effective public governance and market regulations.

The state is necessary in critical moments, when massive interventions are urgent; it is the only tool that can mobilise large amounts of resources in fighting major threats. There are cases when the weakening of robustness/resilience is caused by under-investment, by public policy myopia. In order to address and redress this situation additional resources have to be brought in, sometimes on a long-term basis; this is a matter of optimising investment inter-temporally. This logic applies to public goods, but also to individual organisations (when companies do not invest in human capital, in security systems sufficiently)

c) Institutional reforms. Wherever corruption is endemic, where “rent seeking” blossom sowing to the permissiveness of laws and, thereby, economic performance is damaged, deep institutional reforms are necessary. Adjustments to social security systems have to be done without going beyond a threshold that would cripple the homeostasis of the system irretrievably –though, it is not easy to evaluate what such critical thresholds are as Societies (economies) have specific thresholds.

d) The fairness issue becomes more acute when times are tough. For the very sake of preventing the spread of cynicism, of carelessness and selfishness, political leaders should embody correctness. The social cohesion, the robustness (resilience) of the system depend on the manner in which the social contract between citizens and the state takes concrete shape.

e) Moderation of people’s expectations is also key considering that we have probably entered a new age, featuring much diminished economic growth rates - a long term quasi-stagnation is anticipated for a large part of Europe, and painful adjustments of welfare schemes. Measures that strengthen feelings of solidarity, of concern for nature are needed. Here we can also discuss about identity, the functioning of a collective ethos that can increase system resilience.

f) Basic supply chains demand back-up instruments, reserves, as an optimisation that takes into account long distance risks. “Going back to the roots” could be a way of re-deeming proximity as an insurance policy, as a way to decrease risks. This does not mean that markets close. Also, it is good for a system (economy) to diversify its markets and investment funding in order to diminish vulnerabilities.  

g) In finance, its radical overhaul is badly needed in order to reduce systemic risks. A reform that leads to more simple arrangements, to simplicity, would be helpful, for it would lend more robustness/resilience to both finance and economic systems. Central banks should shift from attention given solely to price stability to a broader stance, that includes the care for financial stability. At the international level there is need for a regime that reduces the destabilising function of finance. The Financial Stability Board (FSB), the Bank for International Settlements (BIS), specialised public institutions in the US and the EU can play an essential role in this respect. Those who say that we need a new Bretton Woods are arguably right. Big players in the global space must be aware of the externalities that their actions produce.

h) A mismanaged globalisation causes more damages than benefits. If globalisation is unmanaged, it puts reversal forces into motion; it may backtrack as open international regimes did at the end of the XIXth century and in the interwar period of the XXtieth century, with spreading protectionism and the formation of rival commercial alliances

i) Reforms of the governance structures in the EU (of the Eurozone) that can counteract centrifugal forces. Otherwise, the very European project is under threat, which would bring back demons of the past.

j) A proper behaviour towards nature should consider the whole range of harmful products human activity entails; companies have to bear the costs of the externalities they cause.

k) The attitude of leaders, of the political elites Without responsibility and democratic institutions that force power-holders to be accountable, the void grows and corrodes the system, undermines its robustness. This observation is valid inside the EU also, in the relationship between European institutions and the citizens of member states. Leaders are expected to offer hope and a perspective that the system can work better. Faith in leaders is essential in order to mobilise internal resource, to overcome difficult moments. The quality of leadership is also critical, which implies the presence in key decision positions of highly qualified people

l) Correct and timely information is an essential ingredient to protect robustness and resilience. It is important that information is used adequately, that governments have the capacity to process it.

m) The reassessment of algorithms in decisionmaking implies a more holistic approach, which should make use of as large as possible an array of information and should consider extreme events

4. Is a new industrial revolution the solution?

It may be that the current financial and economic crisis puts us on the downswing of a very long cycle, of a Kondratiev (Schumpetarian) type, which would overlap with a deterioration of the morals (as a sort of Spenglerian syndrome). Can the traps of such dynamics be overcome? One could argue that this is feasible, theoretically at least. For instance, if a new technological revolution takes place together with a revival of moral values. Some believe that a new industrial revolution is in the offing, while others bet on nanotechnology, molecular biology, neuroscience, new materials science etc. The problem is, in essence, of the time we have to overcome constraints. If mankind manages to avoid a nuclear cataclysm and pandemics that would lead to its extinction, it may reach new technological advances that would send it to a different era – let us think of the exploration of other planets, of possibilities borne from delinking from the limited resources of the Earth. However, time is decisive considering the challenges of the present and of the foreseeable future. People judge their lives, the lives of their children in concrete terms, meaning that they think of the present and the next few decades, and much less about the very long-term perspective.

A few geopolitical aspects need to be considered when talking about the chances for a new industrial revolution to re-establish the competitiveness of industrialized countries globally. Emerging Asian economies participate ever more forcefully in capitalizing on new technologies. In addition, the US seem to be better equipped than Europe in terms of the capacity to invent and innovate.

And a final note: technology in itself does not solve social problems, conflicts among groups of people. Such as we distinguish between hard and soft power, so it is reasonable to look for new policy arrangements as they relate to resources allocation, income production and distribution. In other words, it is good for citizens to be incentivized, even assisted to become more self-reliant. However, the definitive solution cannot be achieved by resorting to social Darwinism; such a path would be a loop back in time, taking us back to barbarism. Governments must find a way that reconciles the need to re-dimension (adjust according to possibilities) the public goods offered by the state (so that “equal chances” are preserved), with a larger reliance of people on own efforts and with measures that keep “fairness” alive – in the sense of avoiding “losses being socialized” recurrently while some economic sectors (finance especially) are protected, as a matter of fact subsidized, because they pose “systemic risks”.

* shorter version of a paper presented at at the Romanian Academy, 26 November 2012

** Daniel Daianu is professor of economics, The National School of Political and Administrative Sciences, Bucharest; former minister of finance of Romania and former MEP