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Home > Macroeconomic Issues Viewpoints > Lessons from the Current Crisis

Macroeconomic Issues Viewpoints

Lessons from the Current Crisis

by Jagdish Bhagwati


Jagdish Bhagwati is University Professor, Economics and Law, at Columbia University and Senior Fellow in International Economics at the Council of Foreign Relations. One of the world’s leading economists today, he writes frequently in the leading newspapers and magazines.

Intertwined Crises

The current crisis—or perhaps two crises, one financial or Wall Street, the other macroeconomic or Main Street, both are intertwined—has caused not only panic, but also much anguished thought about its implications for capitalism and globalization. Clear thinking is necessary to prevent both of these principles being undermined in the populist reaction that seems to have emerged.

Market Fundamentalism

The financier George Soros and the economist Joseph Stiglitz, in particular, have gone around saying that the crisis has put an end to “market fundamentalism,” and that it represents for capitalism and globalization what the collapse of the Berlin Wall did for communism. Both arguments must be rejected.

The post-war shift to more reliance on markets, greater integration of national economies into the world economy (which we call globalization), and the shift away from knee-jerk expansion of public-sector enterprises into activities beyond utilities that are “natural monopolies” was a shift from “anti-market fundamentalism” towards a more pragmatic center. It was not, as these critics claim, a shift from pragmatism to “market fundamentalism.”

Besides, the analogy with the collapse of the Berlin Wall is laughable. The Wall’s collapse signified the epitaph of a failed communism, which had landed its supporters in authoritarianism and economic wilderness. The current crisis follows instead decades of post-war prosperity, ushered in by the shift to the pragmatic center and away from anti-market fundamentalism. It also follows a steady shift of more of the world’s nations to democracy, with economic and political liberalization often reinforcing each other.

Globalization and Financial Innovation

Again, we must avoid the fallacy of aggregation. Globalization, in the shape of freer trade and multinational investments, has been generally a force for good and economic prosperity. But it has also advanced, rather than harmed, social agendas such as gender equality and reduction of child labor, as demonstrated in my 2004 book, In Defense of Globalization. But, as every sophisticated economist knows, the financial sector offers asymmetries vis-à-vis international trade and, while it provides credit, which is the lifeblood of capitalist (or indeed any) systems, it can also lead to huge downsides and requires monitoring and informed regulation.

In relation to freeing capital flows and capital account convertibility that led to the East Asian financial crisis in the 1980s, I illustrate this asymmetry by using a couple of analogies.

Regarding trade, if I exchanged some of my toothbrushes for some of your toothpaste, and we both remembered to brush our teeth, we would both have white teeth and the probability of our teeth being knocked out in the process would be pretty slim.

However, the analogy for free capital flows is different. It is like fire, which enables me to turn veal into delicious “wiener schnitzel,” but it can also burn down my house. The downside is huge, as we discovered at the time of the East Asian crisis.

This insight applies to financial innovation, which underlies recent crises, including the one we are in right now, perfectly. The long-term capital management crisis was precipitated by the financial innovation of derivatives which few understood. The innovation, and its downside when things got rough, had gone beyond comprehension by most, including the regulators. Currently, we have had similarly dangerous financial innovations like the credit default swaps and securitized mortgages. I am afraid few people realized the downside potential of these instruments. Yes, there were some warning voices. But they did not belong to what I have called the Wall Street–Treasury Complex: players who go back and forth, like Treasury Secretary Robert Rubin, between the Treasury and Wall Street (in his case, he went from Goldman Sachs to the Treasury and back to Citigroup). This Complex shared the euphoria about the financial innovations. So, they took us right into what turned into the bonfire.

The point we need to learn is that nonfinancial and financial innovations have important differences. Nonfinancial innovations (such as the innovation of the personal computer) raise the issue of what Schumpeter called “creative destruction” (i.e. smoothing into obsolescence the typewriter). With financial innovations, the problem is that there is a potential downside which can turn it into a “destructive creation.” Therefore, we need a high-level “Standing Committee of Experts” whose job would be to look hard at the potential downside of whatever is the latest innovation being created by Wall Street.

Again, an analogy helps. The United States, under the Cheney–Rumsfeld leadership, went to war against Iraq based on the assumption that the war would last six weeks. They did not have a scenario where it would last six years, which it has! They had not worked out the downside scenarios, and the cost of that omission, as with the current financial crisis, has turned out to be enormous. We may not be able to figure out the downside with prescience; after all, Keynes once said, with characteristically brilliant exaggeration: “The inevitable never happens. It is always the unexpected.” The task of the “Standing Committee of Experts” which I have proposed would be to reduce the unexpected whenever possible.

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Further reading


  • Bhagwati, Jagdish. In Defense of Globalization. Revised paperback ed. New York: Oxford University Press, 2008.

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