T. Domazet: Address to World Summit 2015

Address to World Summit 2015, Seoul, Korea, August 27 to 31, 2015

1. Financial and economic crisis – Great recession (2008 – )

This paper does not search causes of the Great Recession, but today it should be clear that the collapse of the Bretton Woods system of fixed exchange rates was the beginning of this crisis. This collapse in 1971 inaugurated a new stage, characterized by the development of globalised production and the domination of an international financial market. On the other hand, the EU crisis, most commonly called debt crisis, is primarily caused by the non-functionality of the EU and especially running a common currency without appropriate supportive basis.

We in this part of this old continent should find our own way to get out from the trap in which we are at the moment. No longer can old European, or Japanese or American models be the guide; we have to emulate now under different conditions those successful models from the past.

Very few predicted the crisis:

2. SEE analysis of the results through convergence view

In order to make an analysis of convergence, it is necessary to provide some background. For example, does regionalization drive convergence among integrating national economies, or does regionalization deepen existing macroeconomic inequalities? The mainstream theoretical approaches are at odds: orthodox economic theory and the political-institutionalist approach to markets predict convergence, whereas world systems theory and its interpretation of integration as exploitation suggest divergence. Economic theory highlights market mechanisms, whereas the political-institutional approach connotes rules and scripts of the new regional social order. Existing evidence on the convergence debate is marked by contradictory findings and a general failure to measure regional integration.

Economic theory

Many arguments that regional integration brings economic convergence come from economic theory. For instance, economic trade theory is especially relevant to European integration because trade liberalization is a central goal of the European Union and its forerunner, the European Economic Community.

World systems theory

World systems theory applies to the world economy the Marxian notion that capitalist exchange is inherently exploitive: the operation of the capitalist world economy increases inequality between core and periphery, and between elite and marginalized in peripheral countries.

Political-institutionalist theory

A political-institutionalist approach to convergence and regional integration can be synthesized from the political-cultural approach to markets, and the state-centered theory of economic development.

The strategy for this analysis is to begin by discussing the trends in economic convergence, political integration, economic integration, and economic development among the two populations of interest: the Western Balkans states (WBS), New Member state (NMS) and South East Europe (SEE) against the rest of the EU member states.

Time series analysis 

The impressions suggested by tables, graphs and other data are confirmed, in part, by the time-series regression models of the unweight dispersion measures.¹

Economic convergence may be interpreted and measured in [1] a very simple approach – to compare GDP per capita in current international dollars, in PPP terms of each SEE country with that of Germany.

The use of Germany as a benchmark is motivated by its role as the largest EU national economy, by its role as a trade partner of most of those economies and by its rate of growth in the 2000s and 2010s [2]. 

Source: IMF World Economic Outlook database, October 2014 

Source: IMF World Economic Outlook database, October 2014; According to IMF WEO geographical grouping Emerging and Developing Europe includes (as of October 2014) the following SEE countries: Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Kosovo, Lithuania, Macedonia, Montenegro, Poland, Romania, Serbia, and Turkey. 

It is easy to divide both groups of countries into two sub-periods: until 2007/2008 with solid catching up (convergence) and after 2008 with either de-convergence or no progress in further convergence, i.e., convergence followed by de-convergence.

It is quite easy to name factors behind the rapid convergence experienced in the first sub-period: (1) post-transition growth recovery (effects of transition-related reallocation of factors of production); (2) joining the Single European Market (or partial access in case of EU candidates); (3) global economic boom which resulted in large-scale capital inflows to the region (see Figure 3). The first two factors had a one-off character and the third one a short-term effect, which was largely reversed during the following crisis.²

It should be noted that when the global financial crisis hit the region in 2008-2009 (Hungary stopped converging in 2005), the convergence trajectory changed for worse everywhere. However, it is possible to see differences across the region.

The four EU new member states with the highest income per-capita level in the early 2000s, i.e., Slovenia, Czech Republic, Hungary and Croatia, have recorded a continuous decline in their relative GDP per-capita levels, as compared to Germany after 2008. The Western Balkan candidate countries (except Albania), Romania and Bulgaria, although with smaller amplitudes of changes in their convergence trajectories (especially in the case of Bulgaria), and Poland, Slovakia and Albania have convergence vis-à-vis Germany after 2008 although at a much slower rate.

Instead of providing, for the time being, the usual economic data of SEE countries in the past period, it is important to use gross national income, GNI, and gross domestic product, GDP, as indicators of a transition period.

Table 1: Relations GNI/c and GDP/c 2012 of SEE countries and some EU countries

Source: World Bank, Golden growth; Restoring the lustre of European economic model, 2014

Data from above table suggest that SEE transition under Washington consensus and EU assistance failed.

3. Necessity for new economics and a new model

For the moment, the traditionalists still rule. They managed to go beyond the ideological turf wars of the 20^th century by taking a leap towards a new generation of economic models that were technically complex – in the sense of 19^th-century mathematics. The models integrated what economists had learned about various markets with knowledge about the economy as a whole. The so-called dynamic stochastic general equilibrium (DSGE) models were even designed to cope with some unforeseeable disturbances like a technology shock. They were just not able to deal with the shocks we eventually got – a financial crisis, default and deflation.

Modern economics – Post-Keynesian school of economics thought

There are six key areas in which modern post-Keynesian macroeconomics differs from neoclassical macroeconomics: the role of equilibrium, the nature of expectations, the need for microfoundations, the model of production, the role of money and the role of government.

It is important that one cannot a priori reject this competing approach to macroeconomic modelling because it fails to incorporate some undoubtedly unscientific truths.³

(i) Equilibrium

The IS-LM model was developed by Hicks rather than Keynes (Hicks, 1937), but was accepted “as a convenient synopsis of Keynesian theory” by neoclassical economists. Post-Keynesian macroeconomics economists instead rejected “Mr. Keynes & the ‘Classics’” as “an article which…misses Keynes’ point completely.” John Hicks agreed with the critics and disowned the IS-LM model as an inadequate basis for macroeconomics, not because of its poor microfoundations but because it required the unacceptable assumption that the economy was in equilibrium at all times. Hicks therefore ignored the market for loanable funds (and also the labor market) in the IS-LM model.

(ii) Expectations

A long line of non-neoclassical economists have emphasised the role of uncertainty in economics. Keynes once famously described economic theory prior to his work as “one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.” To post-Keynesians, the “Rational Expectations Revolution” replaced this with the assumption that the future could be anticipated by agents endowed with “rational expectations.”

(iii) Microfoundations

The major argument of neoclassical macroeconomics in favour of a micro-founded macroeconomics was that microanalysis could provide the “deep parameters” that were invariant to policy changes. Post-Keynesians rejected the argument that macroeconomics could be derived from microeconomics, as microeconomic “deep parameters” are lost in the non-linear interactions between agents. Deriving macroeconomics directly from microeconomics was deemed a hopeless task.

(iv) Production

Substitutability of inputs, rising marginal costs and diminishing marginal productivity are familiar elements of neoclassical micro- and macroeconomics. Post-Keynesians instead assume fixed proportions between inputs, constant or even falling marginal costs, and abjure the relevance of changing marginal productivity.

(v) Money

Money neutrality is an essential aspect of the neoclassical approach, in which macroeconomic models abstract from the existence of money, private debt and banks. In contrast, in post-Keynesian models, money and debt matters and changes in debt lead to changes in unemployment.

(vi) Government

With its view of a market economy as self-equilibrating, the neoclassical school has had a tendency towards a critical perspective on the role of government, which culminated in the “Policy Inefffectiveness Proposition” which states: by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips Curve even for one period.

Post-Keynesian work has instead adhered to Keynes’s perspective that the market economy can generate insufficient aggregate demand to guarantee full employment (Keynes). This leads post-Keynesians in general to argue that the government has both a responsibility and a capacity to boost aggregate demand during recessions, though there are differences in how effective such policies are expected to be.

4. Modern evolutionary economics

Evolutionary economics studies the coevolution of mechanisms creating differences between economic agents (e.g., consumers, technologies, firms, industries, and countries), and mechanisms of selection that winnow in on those differences. The evolutionary perspective on innovation and market structure differs from the traditional neoclassical perspective for various reasons.

First, inter-firm variety is not seen as a result of “imperfections” in an otherwise perfectly competitive world (described by a “representative” agent), but rather as the outcome of a fierce competitive process characterized by firm-specific capabilities and innovation activities. Since the latter are a permanent characteristic of competition, there is no reason why variety should disappear, even in the long run.

Second, patterns characterizing industry structure, such as the firm-size distribution and level of instability, are not constrained by notions of “equilibrium” or “optimality” but are instead understood as properties emerging from interactions between heterogeneous agents. These interactions are characterized both by degrees of freedom at the firm level (which create inter-firm diversity) and by structural properties at the industry level (which constrain the degrees of freedom). The object of evolutionary economics – compatible with complexity theory – is to study the coevolution of the degrees of freedom and the structural constraints.

What are the benefits of synthesizing the two traditions (Keynes-Minsky, Schumpeter-Minsky)? Since innovation is an important part of capital development, we need to understand the innovation process itself, and how it gets financed. The synthesis will help us understand the money-finance process and how financial innovations have directed finance away from the capital development of the economy.

5. Economic Laws

It should be noted that a law (or generalization) is the establishment of a general truth on the basis of particular observations or experiments which traces out a causal relationship between two or more phenomena. But economic laws are statements of general tendencies or uniformities in the relationships between two or more economic phenomena.

The law and economics movement applies economic theory and method to the practice of law. It asserts that the tools of economic reasoning offer the best possibility for justified and consistent legal practice. It is arguably one of the dominant theories of jurisprudence. The law and economics movement offers a general theory of law as well as conceptual tools for the clarification and improvement of its practices. The general theory is that law is best viewed as a social tool that promotes economic efficiency, that economic analysis and efficiency as an ideal can guide legal practice. It also considers how legislation should be used to improve market conditions in return. Law and economics offers a framework with which to model legal outcomes, and common objectives with which to unify disparate areas of legal activity. The bringing together of legal theory and economic reasoning has also created new research agendas in the fields of behavioural economics: how rationality affects people’s behaviour within legal scenarios; public choice theory and how collective behaviour should have an effect on legislation; and game theory: understanding strategic action in a legal context.

This is because all men are not rational beings. Moreover, they have to act under the existing social and legal institutions of the society in which they live. As rightly pointed out by Schumpeter: “Economic laws are much less stable than are the ‘laws’ of any physical science…and they work out differently in different institutional conditions.”

Unlike scientific laws, economic laws are not assertive. Rather, they are indicative. For instance, the Law of Demand simply indicates that, other things being equal, quantity demanded varies inversely.

6. Twenty-first century economics

New Paradigm

Twenty-first century economics would include a new approach with a number of irrevocable bases, which include as follows:

6.1. Debt relief – write-off of private sectors’ debt

Debt reduction, or deleveraging as it is known in the inelegant argot of economists, is a painful process. Growth suffers as consumers and firms, let alone governments, try to reduce their debts. Countries that experienced the biggest asset busts, such as America, Britain and Spain, have had the most disappointing recoveries. And the pain will continue: a careful look at the numbers suggests that the process of deleveraging has barely begun.

At the end of World War II, Germany nominally owed almost 40% of its 1938 GDP in short-term clearing debt to Europe. But during World War II, almost all of Germany’s trade deficits with Europe were financed through this system, just as most of Southern Europe’s payments deficits towards Germany since 2008 have been financed through Target-2, a system that is in function in EU.

Given the assessment that one of the main causes of the financial crisis is private debt as well as the lack of evidence that this debt had been repaid, the first measure to be taken within this framework is debt relief, meaning a write-off of private sectors’ debt.

6.2. Innovation and economic growth

Innovation has increasingly become a key to long-term growth. Like all production, innovation must be financed, so finance is central to the innovation process. Hence, as stated by Schumpeter: “the money market is… the headquarters of the capitalist system.” Yet, in recent decades, finance has retreated from serving the real economy: the financial sector serves itself, and companies in the real economy have become “financialised” to an important extent.

This requires bringing together the thinking of Keynes, Minsky and Schumpeter, as well as understanding the role of the public sector as doing much more than fixing static market failures.

6.3. Full employment

It is common knowledge that John Maynard Keynes advocated bold government action to deal with recessions and unemployment. In a money-based market economy, unemployment is a monetary phenomenon, meaning there are people ready, willing and able to work for wages, but no wage offers are forthcoming. The private sector cannot be counted on to guarantee full employment even in good times.

Keynes provided the blueprint for designing fiscal policy for full employment. Good intentions, he argued, were never the problem; lack of conviction and creativity were. Minsky and others answered the call through different measures as follows:

1. The Employer of Last Resort,
2. Buffer Stock Employment,
3. Full Employment through Social Entrepreneurship,
4. Job Guarantee,
5. Public Service Employment and
6. Green Jobs

All of the above provide program design that aims to secure full employment over the long run.

6.4. Government’s new role

Long-run growth is a result of private and public sector actors working together dynamically and symbiotically. What we have today is an increasingly financialized private sector, hoarding cash and/or spending profits on boosting stock prices instead of on long-run areas like R&D and human capital formation of employees, and a public sector too fearful to invest in long-run areas due to the (ideological) pressure to keep government debt–to-GDP ratios low. Yet it is precisely long-run investments that create the growth of the future, which increases the denominator of the debt ratio. Indeed, the countries suffering most in Europe today are those that had modest deficits, but very few investments in areas like R&D, and hence had low growth (thus increasing only the numerator and not the denominator of the debt ratio).

There are two common fallacies in the political fetish for running government surpluses. The first is to believe that what happens to the private sector is the same as what happens to the government: if the government runs a surplus, then so will the private sector. In fact, one is the mirror image of the other – as we have been pointing out for over a decade now. The second is to make an analogy between households and the government, when the correct analogy is between banks and the government. Both are sources of money. Both may direct this money, but both have to provide it; otherwise economic contraction and instability will result.

6.5. Endogenous money

The most important part of 21^st-century economics is Modern monetary theory and its main part – endogenous money. With regard to monetary theory, early Post Keynesian work emphasized the role played by uncertainty and was generally most concerned with money hoards held to reduce “disquietude,” rather than with money “on the wing” (the relation between money and spending). However, the new economists or Post Keynesians always recognized the important role played by money in the “monetary theory of production” that Keynes adopted from Marx. Circuit theory provided a nice counterpoint to early Post-Keynesian preoccupation with money hoards, focusing on the role money plays in financing spending. The next major development came in the 1970s, which emphasized that central banks cannot control bank reserves in a discretionary manner.

6.6. Money and finance

The first principle emphasizes the importance of regulations that protect and strengthen the core economy. Finally, we have to change our way of thinking about the true requirements for quality care. The fashion for some time has been to think that health and education, for example, are just businesses and that a tough system of cost accounting and the use of performance indicators such as the number of patients treated or student test scores will get us the results we want.

There are very serious and important forecasts that the world is facing a new financial crisis.⁴ Take these two factors together and it is clear that, in recent years, China was the world’s “consumer of last resort,” a role more traditionally played by the US. As many other nations – particularly the US and much of Europe – embarked on a “great deleveraging,” Beijing provided the counterweight. As others saved, China borrowed – most obviously through a rapid expansion of so-called shadow banking.

Had China not performed this role, the world would have faced a far greater crisis.⁵  

Simple explanation on emerging new financial crisis

At some point this virtuous phase will give way to vice, when so-called “euphoric expectations” (by Minsky) take over as the memory of the global financial crisis, GFC, fades, and the resulting boom will prepare the grounds for the next bust. This especially relates to the US and the EU.

That is likely to happen sooner rather than later, because this economic law (of Minsky) is strongly confirmed by the data: each cycle tends to start from a higher level of debt than the preceding one, making the economy more fragile. This new cycle is commencing from a debt-to-GDP level more than one third higher than the previous one that began in 1994 and crashed in 2007.

The Eurozone is still faced with deflation.

6.7. Inequality

An important question to consider is “when should growing inequality concern any society?” This is a moral and political question. It is also an economic one. It is increasingly recognised that, beyond a certain point, inequality will be a source of significant economic ills.

This realisation has now spread to institutions that would not normally be accused of socialism. A number of research and reports suggest that inequality is not only rising but is having damaging effects on economies worldwide.

6.8. Environment and fighting climate change

The first and deepest reason is that, as the civilisation of ancient Rome was built on slaves, ours is built on fossil fuels. What happened in the beginning of the 19^th century was not an “industrial revolution” but an “energy revolution.” Putting carbon into the atmosphere is what we do. What used to be the energy-intensive lifestyle of today’s high-income countries has now gone global.

A second reason is opposition to any interventions in the free market. Some of this, no doubt, is driven by narrow economic interests. But it would be wrong to underestimate the power of ideas.

Conclusion

The malaise of the world economy has proved exceedingly difficult to understand. This article argues that it reflects to a considerable extent the failure to come to grips with financial booms and busts that leave deep and enduring economic scars. In the long term, this runs the risk of entrenched instability and chronic weakness. The coming global financial crisis, although the current crisis is not yet over, is a great danger especially for small and open economies.

If Minsky’s guiding principles are right – first that a current model of capitalism must be able to generate a depression as one of its possible outcomes, it is necessary to establish a new economics, a new model as it is commonly called – Twenty-first century economics.

Because the SEE and the Balkan countries need a new economic system as a new paradigm, Tihomir Domazet, professor at ECPD, outlined a consistent, comprehensive and new model in his book entitled Economics of Growth and Full Employment,⁴ fully based on Post-Keynesianism and Modern monetary theory.

Without any delay, however, the countries have to take responsibility themselves with a new economic paradigm – Economics of growth and full employment – as well as with full support from the EU to establish a new economic model.

Twenty-first century economics has to be the answer for solving the accumulated economic suffering of the last several decades.

This economics system is primarily focusing on small and open economies, especially the South East Europe economies.

A precondition to establishing and creating the new economics of the 21^st century is to understand evolutionary economics and the role of economic laws.

Evolutionary economics studies the coevolution of mechanisms creating differences between economic agents (e.g., consumers, technologies, firms, industries, and countries), and mechanisms of selection that winnow in on those differences. The evolutionary perspective on innovation and market structure differs from the traditional neoclassical perspective for various reasons.

The law and economics movement applies economic theory and method to the practice of law. It asserts that the tools of economic reasoning offer the best possibility for justified and consistent legal practice. It is arguably one of the dominant theories of jurisprudence. The law and economics movement offers a general theory of law as well as conceptual tools for the clarification and improvement of its practices. The general theory is that law is best viewed as a social tool that promotes economic efficiency, that economic analysis and efficiency as an ideal can guide legal practice.

Actual changes, however, require the integration of theoretical insights and a program of concrete action. This paper suggests a new approach through new economics, but regarding the above-mentioned required program of concrete actions it is obviously the Universal Peace Federation that could take the lead on an international level.

For more information about the World Summit, click here.

 Endnotes

¹ Jason Beckfield, “Regionalization and Convergence in the European Union,”Department of Sociology, Harvard University.

² Central and Eastern Europe: uncertain prospects of economic convergence – 25 years since the start of post-communist transition and 10 years since the first wave of EU eastern enlargement: two anniversaries and difficult questions by Marek Dabrowski on 9^th December 2014.

³ Steve Keen, “Predicting the ‘Global Financial Crisis’: Post-Keynesian Macroeconomics,”Economic Record, Vol. 89, No. 285, June 2013, 228–254.

⁴ Tihomir Domazet, “Shift EU's Balkanization – Build Modern Balkans Economies,” ECPD, October 2015.

⁵ Stephen King, “Why China’s Role as the World’s Shock Absorber is Changing,”Financial Times, Aug 19, 2015.

⁶ Tihomir Domazet, Ekonomika rasta i pune zaposlenosti u Hrvatskoj, HGK i Hrvatski institut za financije i računovodstvo, Zagreb, 2014.