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Coronavirus Needs Not Kill Globalization

By Jack Gao | The COVID19 crisis is shaping up to be the most severe challenge the world has to confront since World War II. At present, almost 800,000 cases have been reported from virtually every country in the world, with the death toll nearing 40,000. Not only is much of the global economy frozen as we fight the virus, but national borders are also being shut down to contain its spread. As this battle goes on, many are already predicting that the world may never be the same again.

The knee-jerk reaction is to substantially roll back on the current globalization regime, so global pandemics may be eliminated for once and for all. But this reflex towards nationalism completely misses the point. Crises like this one reflect on the perversion of current globalization, not on globalization per se. We should not throw the baby out with the bathwater, but instead, take the crisis as an opportunity to improve on the version of globalization that prioritized some objectives but neglected others.

First of all, a more divided world in no way guarantees global pandemics will no longer happen. One only needs to turn to the 1918 Spanish flu pandemic that claimed 100 million lives or the even more lethal Black Death episode, both when the world was more divided, for some evidence. Periodic outbreaks of infectious diseases have plagued humanity throughout history, and, more than anything, it was progressing in science and healthcare that accounted for the gradual decline in fatality and damages, in spite of advances in globalization. In fact, we could reasonably argue that better health outcomes, nutrition access, sanitation facilities wrought by economic development are important reasons we have fewer and less deadly pandemics today, thanks to globalization. It’s wishful thinking that less globalization will result in fewer pandemics.

Second, when crises do strike, we are much better positioned to respond to them as a globally connected community. Although leaving much to be desired, information sharing has proved key to containing the coronavirus outbreak. China alerted the WHO by the end of last year of unusual pneumonia in Wuhan; within days, Chinese scientists posted the genome of the new virus, allowing virologists in Berlin to produce the diagnostic test of the disease for worldwide access. We often take for granted communications of this kind today, which we can ill-afford if balkanization was to rule the day.

Even as borders are shut to reduce human flow at the moment, global commerce continues to play a crucial role to ensure the supply of medical products and equipment as we fight the pandemic. For instance, the crisis may have already subsided in China, but Chinese companies are currently working around the clock as ventilator orders pour in from the rest of the world. Similarly, at least a few dozen pharmaceutical companies from around the world are racing to develop vaccines and treatments for the virus, knowing that they’ll have ready access to a global marketplace to recoup their investments. Just imagine how much harder this battle would be if countries were left to their domestic supply chains or scientific knowledge.

Finally, while much is still unclear about how the current outbreak unfolded, from the evidence we do have, it is national mishandling or in some cases deglobalization factors that contributed the lion’s share to its unbridled spread. China’s earlier misstep on information reporting, America’s testing debacle and obsession with travel bans, and UK’s initial flirtation with herd immunity are just a few examples of national blunders that hastened the transmission of the virus, which have little to do with globalization. Meanwhile, in a bid to have America go it alone, Trump’s elimination of epistemologist based in China, staff cuts at the CDC, and heightened tariffs on Chinese medical products may well have made this health crisis worse than it has to be.

Each crisis is an opportunity in disguise, the coronavirus is no different. It should be taken as a reminder that our disregard to some objectives and narrow-minded pursuit of others have tilted the world off-balance. In a globalization solely focused on promoting international trade and financial flows and centered around organizations such as the World Bank and the IMF, this outbreak caught the incumbent international regime completely off-guard. Either in funding, capacity, or power, the World Health Organization has been no match to its counterparts charged with commercial and financial affairs. Seen in this light, the outbreak should serve as a rude awakening to a world economy that prioritizes economic integration over public health, environmental, and climate concerns.

As the fight to contain the coronavirus continues, many believe this crisis will bring an end to globalization as we know it, some may even work hard to make sure this is so out of self-interest. However, it bears emphasizing that a balkanized and disintegrated world is neither feasible nor desirable. The coronavirus does not have to kill globalization, instead, it is our chance to rebalance the world economy to better serve collective social goals and tackle future challenges as a coordinated global community.

Jack Gao is a Program Economist at the Institute for New Economic Thinking. He is interested in international economics and finance, energy policy, economic development, and the Chinese economy. He previously worked in financial product and data departments in Bloomberg Singapore, and reported on Asian financial markets in Bloomberg News from Shanghai. Jack holds a MPA in International Development from Harvard Kennedy School, and a B.S. in Economics from Singapore Management University. He has published articles on China Policy Review and Harvard Kennedy School Review.

In Defense of Dodd-Frank

It’s been nearly a decade since we first felt effects of the Great Recession. While the recession officially ended, its consequences still affect us. Some are beneficial, others (like sluggish growth and the number of people leaving the labor market) not so much. One of the better side effects of the 2007-2008 crash, however, is likely to disappear rather soon: the Dodd-Frank act. The newly inaugurated White House is eager to scrap that set of financial regulations.

My goal with this post is to present a very simple explanation of what Dodd-Frank is, why some people want it gone, and why we should fight to keep it and strengthen it. Hopefully, this accessible explanation will motivate more people to join the fight. Maybe then we can have our voices heard. With this objective in mind, I am aware that some details will not be pursued to their full extent, but the overall message should still be whole.

Let me start with a very simplified analogy. Think of the financial system as a system of highways. In a modern highway, there are usually a few lanes on each side, separated by a median. There are many regulations put in place to make sure that the people zooming past each other inside two tons of metal–all the while sitting inches away from gallons of gasoline–do it safely. In this analogy, your average American with their savings, retirement account, mortgage, student debt and credit cards is driving north on the “commercial” lanes in their Peel P-50 (click the link, it will help you understand where I am going with this). Besides them are other entities such as big banks, hedge funds, insurance companies and the like. Those are heavy 18-wheelers and tanker trucks, so the massive gusts of wind that they create will shake smaller cars as they pass by. Of course, whenever a P-50 gets into a crash (like when a head of household goes bankrupt) it is tragic, but it does little to the overall flow of traffic. However, when one of those big vehicles crashes, it often leads to a chain reaction of other accidents, which affects all other drivers and overall makes everyone’s day a lot worse.

After the great crash of 1929 (the financial crash, I’m unaware of any major vehicular crashes from back then), a set of fairly stiff regulations were designed to keep the drivers of that industry–namely the banks and other financial institutions–from getting in other accidents of similar magnitude. Those regulations were known as the Glass-Steagall Act of 1933, enacted as an answer to the failure of almost 5,000 banks. The legislation was put in place to strengthen the public’s opinion towards the financial sector, to curb the use of bank credit speculation, and to direct credit towards more “real economy” uses. In our analogy, Glass-Steagall introduced a number of norms to the ‘financial highway’. Most notably, it created a solid median between the financial and the commercial banking lanes. Now, commercial banks could not use their clients’ funds to engage in risky investments in the financial markets. In our analogy, it means that before Glass-Steagall those big trucks were free to go across the road to the “wrong way” whenever they felt like doing so would be beneficial for them. In addition, Glass-Steagall also created the FDIC, which insures bank deposits; think of it as the weight-per-axis limitations that help preserve the roads from the damage caused by overloaded trucks.

Fast forward to the Clinton presidency, 1999 to be exact. By then, the broad belief that separation between financial and commercial banking was necessary had lost force, even though it had kept the American economy away from any significantly serious recession/depression for over 70 years. That year the barrier between the financial and commercial lanes was brought down. Now, banks and other financial players were free to drive on whatever side of the highway they wanted; banks (and others) are now able to use their clients savings and retirements accounts to buy and sell toxic financial assets such as CDOs. As a result, they were able to take bigger risks, which brought–in many cases–good rewards. This is the era of leveraging, or what Minsky called “Money Manager Capitalism.” To some, it was clear that such an environment would eventually lead to a big crash; a few smaller ones serving as a warning. Indeed, with 2007 came the worst financial and economic ‘accident’ in almost 80 years.

Financial regulations are naturally reactionary. As Minsky stated, the economy is inherently unstable, and in good part that is due to the financial sector’s insatiable thirst for financial innovation. Regulators need to remain attentive to the markets and introduce rules to curb too-risky behaviors as they surface. This is especially true in the days and weeks following a crisis. Once the dust has settled we can look into the causes for the downturn, and put in place measures that are supposed to keep it from happening again, not unlike the way traffic regulations are designed. As such, the Dodd-Frank Act was drafted to put a stop to some of the recklessness that drove us to the Great Recession.

In short, Dodd-Frank ended Too Big to Fail Bailouts, created a council that identifies and addresses systemic risks within the industry’s most complex members, targeted loopholes that allowed for abusive financial practices to go unnoticed, and gave shareholders a say on executive pay. It aims to increase transparency and ethical behavior within the financial sector, both of which are good things.

In no way is the Act perfect. Some, like me, would have advocated for much stiffer regulatory practices like rebuilding the division between financial and commercial banks, or taking a more definitive approach to dissolving Too-Big-To-Fail institutions. Therefore, during its somewhat short existence, Dodd-Frank has received much criticism. While some of those critiques were fair and well founded, the loudest critics were the ones coming at a wrong angle. As it happens the loudest critics now have the opportunity to scrap those safeguarding regulations altogether.

The most common criticism of the Act (and the main reason the administration has given to overrule it) is that it has made it harder for people and businesses to borrow. That criticism is untrue. For example, Fed Chair Janet Yellen showed in her latest address to the senate that “lending has expanded overall by the banking system, and also to small businesses.” A survey from the National Federation of Independent Businesses, cited by Yellen, shows that only 2 percent of businesses that responded cited access to capital as a great obstacle to their activities. Furthermore, to claim that Dodd-Frank has a macro impact on lending is, at least, sketchy. As Yves Smith puts it:

“For starters, big corporations use bank loans only for limited purposes, such as revolving lines of credit (which banks hate to give but have to for relationship reasons because they aren’t profitable) and acquisition finance for highly leveraged transactions (and the robust multiples being paid for private equity transactions says there is no shortage of that). Banks lay off nearly all of the principal value of these loans in syndications or via packaging them in collateralized loan obligation. They are facing increased competition from the private equity firm’s own credit funds, which have become a major force in their own right. Otherwise, big companies rely on commercial paper and the bond markets for borrowing. And with rates so low and investors desperate for yield, many have been borrowing, for sure….but not to invest, but to a large degree to buy back their own stock.”

In fact, the amount of cash held by American corporations reached an all-time high in 2013. This shows that companies are sitting in liquidity without investing in the real economy. The hoarding of liquidity could even be considered an actual fail of Dodd-Frank; unlike the stiffer Glass-Steagall act it did not focus on pushing investment into the production of real goods and services.

The publicized reasoning behind repealing Dodd-Frank is untrue, so what is the motivation for lobbying against the regulations? In my opinion, there are two main arguments. The less malicious one is that there is still people out there who believe than an unregulated, free-for-all financial sector is effective, benevolent, and will serve the greater good. It is almost a dogmatic position based mostly on circular logic, and unrealistic economics modeling (which often does not even take the financial sector into account!), and lack of supporting evidence. It should be put aside. The second argument seems to be popular among lobbyists and government officials: reducing regulations will allow (at least in the short run) for immense profits.

Without Dodd-Frank, Wall Street will most likely revert to the risky and reckless practices that led to the Great Recession. The repeal of the act would, in Minskian terms, act as a catapult launching us towards the Ponzi state of finance, in which risky borrowing and lending end in a financial crisis. Doomsday predictions aside, repealing Dodd-Frank would hurt the common folk like you and I. For example, the Fiduciary Rule is likely to also be erased, and it requires that investment advisers put their clients’ interests above their own. This puts people’s retirement savings at great risk. If money managers do not have to act in their clients’ best interest, they will make decisions that allow them to maximize their commission even if it means losing money for their clients. Additionally, to some extent, the repeal would kill thousands of jobs across the nation; because of Dodd-Frank, financial institutions had to create and staff entire departments focused on quality assurance and compliance, without the rules these employees are not longer needed. Finally, without the rules, banks can go right back to targeting the most vulnerable and financially illiterate among us, offering them loans, mortgages, and other predatory instruments they cannot possibly afford; it would be disastrous.

Reverting back to our simplified analogy. Since the repeal of the Glass-Steagall Act, the highways of the financial systems do not have a median, separating investment traffic from going the ‘wrong way’ into the commercial lanes. Further repealing rules such as the Dodd-Frank Act, without substituting with a set of better regulations, is like removing the usage of turning signals, the requirement for turning the lights on at night, and speed limits – all the while releasing the Bull from Wall Street right in the middle of heavy traffic. Accidents will happen, and in the case of our financial highway it does not matter if we are inside the vehicles involved, we are all going to become casualties of the crash.

Can we Learn from Minsky Before the Next Crisis?

Earlier this month I had a conversation with a regional manager from a major insurance company. She explained to me the many aspects of her industry: the commission based salaries, strategies to sell life insurance to one year-old children, and how to retain employees. To be honest, I don’t find insurance to be the most riveting topic out there, but I did have a question I wanted answered: What does her company do with the money their clients pay for their insurance packages? Her response surprised me for its candor, she said:

“You know, insurance companies don’t make their money from premiums and things like that anymore. Most profits come from investing in the stock market.”

We truly are in the era, as Minsky called it, of money manager capitalism. What this means is that insurance companies are no longer in the business of insurance, they are just another player in the financial markets; the only thing that differs is how they get their capital. Combine that with the fact that many of their employees have their entire pay check dependent on commissions and we have companies that are trying to sell as many policies as possible – sometimes to people who do not need it or can’t afford it – in order to have more capital for financial investments.

If that sounds familiar it is because those are the kind of practices (while obviously not the only one) that led to the Great Recession and specifically to the crash of insurance giant AIG (which was bailed out with 182 billion dollars). It is, to say the least, disheartening to see that those practices are still in place by insurers and elsewhere, but it is hardly surprising. To know why we must turn to Minsky’s Financial Instability Hypothesis.

minsky (1) — Illustration: Heske van Doornen

The Hypothesis is possibly the most notable part of Minsky’s extensive work, it is indeed brilliant in its accuracy and simplicity. Nevertheless, it seems to escape from the spotlight of economics and politics in an counter-cyclical manner: every time the economy does well, people seem to forget about it – but during the crisis his book Stabilizing an Unstable Economy went from costing less than 20 dollars, to over 800 (that is, if you could find it). Another example, The Economist had only mentioned him once while Minsky was alive, but since the 2007 crisis his ideas have appeared in over 30 of their articles. As the British newspaper puts it, “it remained until 2007, when the subprime-mortgage crisis erupted in America. Suddenly, it seemed that everyone was turning to his writings as they tried to make sense of the mayhem.” Therein lies the irony, it is exactly when the economy is booming that we should pay the most attention to the Financial Instability Hypothesis.

In short, Minsky postulated that stability is destabilizing, as Oscar Valdes-Viera has awesomely explained before in this blog. In his post, Oscar tells us to be skeptical of politicians who say the economy is doing well; that is when individuals and institutions are moving from hedge, to speculative, to Ponzi positions. In most cases, economic actors will become eerie of risk after a crisis and shun from risky investments such as CDOs. It seems, however, that this aversion to risk has not happened. One can speculate many reasons for this behavior, among which is the bailing-out of so called “Too-Big-to-Fail ” organizations.

As such, it is clear that although Minsky’s popularity increased during the last crisis, the people making important financial decision did not learn from his work. The problem of irresponsible behavior and borderline fraudulent financial innovations still remain. It is time to enact on a less popular, although still important, part of Minsky’s work: the “Big Bank”. That bank, naturally, is the Fed and it plays a number of roles: it sets interest rates, it regulates and supervises banks, and it acts as lender of last resort. However, as Randall Wray explains in a 2011 paper, “most Fed policy over the postwar period involved reducing regulation and supervision, promoting the natural transition to financial fragility.”

Case and point, the SEC and the IRS had their budget severely cut in 2014 and do not currently have the capacity effectively regulate the financial industry. To make matters worse, shadow banks and traditional banks – as demonstrated anecdotally by my conversation with the insurance agency manager – still intermingle in financial innovations. Common sense dictates that after the 2008 crisis companies should have reset to the more sustainable and safer hedge position, but it seems that many financial actors went right back to the more unsustainable speculative position after the crash. One could also have expected that financial jobs would decline in popularity post-2008, but the opposite has occurred; finance as an industry now takes 25% of corporate profits, but only makes up 4% of jobs in the US. The rising importance of the finance industry has other adverse effects besides increasing the possibility of crisis, it means that companies are not investing in producing real output for they can earn more by playing the markets.

Hence is the place in which we found the economy: misguided policy has created a weak regulatory environment where irresponsible risk-taking is ‘insured’ by the precedent set by bail outs, and where even the highest ever levels of liquidity do not lead to real investment and a strong economy. This bad omens have inspired many economists to declare that a crisis is coming. Add to that the fact that recently Minsky has been featured in mainstream media sources like The Economist, and that his seminal book in financial instability was recently the number one best seller on Amazon for Public Finance, and one has reason to feel a bit uneasy about the coming year.

Stability is Destabilizing

In a recent interview with Andrew Ross Sorkin, published in The New York Times, President Obama argued that the U.S. economy is in fine shape, despite public feelings that it might not be. Then a few days later the same newspaper ran an interview with William C. Dudley, the president of the Federal Reserve Bank of New York, in which he foresaw continued economic growth. And like the president of the Richmond Fed, Mr. Dudley made the case for slowly raising interest rates because the economy is “on track” and global conditions are “dramatically better.”

The rhetoric coming from these top policymakers can seem rather soothing to most people, including many economists. However, we know that Hyman Minsky would have remained highly skeptical. In fact, Minsky famously argued that “stability is destabilizing,” and that is because periods of economic instability and recessionary episodes emerge naturally out of the normal functioning of a prosperous modern capitalist economy.

For Minsky the nature of instability is linked to the relation between finance and investment in capital assets during the business cycle. Economic agents often compromise future incomes in order to secure the assets they need to undertake production. The accumulation of capital in the economy is largely financed by borrowing, which is recorded as liabilities on balance sheets. The liabilities represent a group of payment commitments on a future date, while the assets held represent a series of expected cash receipts from operations. The performance of the economy will later either validate or invalidate the structure of those balance sheets. Even though Minsky was talking about the capital development of the economy, his argument can be broadly extended to any economic unit; from a corporation borrowing to build its new headquarters to a person borrowing to buy a car or pay for college.

In his Financial Instability Hypothesis (FIH), Minsky identified the degree of financial fragility in the system by defining three income-debt relations for economic units: hedge, speculative, and Ponzi finance. For hedge financing units, the income flows from operations are enough to fulfill debt commitments outflows in every period. For units involved in speculative finance, the income flows are only enough to meet the interest component of their obligations and they will have to roll over debt because they cannot repay the principal. For Ponzi finance, the income flows from operations are not enough to cover the interest costs of their loans or the repayment of principal. Ponzi units highly depend on the possibility of refinancing their debt, otherwise they have to resort to the liquidation of assets or issuing new liabilities in order to meet their obligations.

The movement to more units engaged in Ponzi finance happens as a natural consequence of periods of stability and prosperity. During economic expansions, borrowers and lenders become confident in the ability of the former to meet cash commitments, which is a rational response based on recent past experiences and on the higher probabilities of success associated with the expansionary environment.

Thus, economic units are not likely to have difficulties to meet their payment commitments as they come due during economic expansions. However, such optimistic expectations lead to relaxing lending standards and reducing margins of safety. They also validate riskier projects, the use of more debt relative to assets, and lower liquidity; all of which increase the fragility of the economic system (for more see here and here).

Borrowers and lenders seem to operate on a hit-or-miss basis; if a behavior is successful, it will be rewarded and it will be repeated. So the behaviors described above will continue, and in fact be encouraged, until the turn of the economic cycle. Thus, while the economy prospers, financial positions are becoming increasingly fragile under the stable surface. Indeed, according to Minsky, during prolonged periods of prosperity the modern capitalist economy tends to move from a robust financial structure dominated by hedge financing units, to what he called a “deviation amplifying system” dominated by abundant speculative and Ponzi financing units.

The boom gives way to the bust when interest rates suddenly rise or when realized income flows fail to meet what was projected (note that economic units need not incur losses, but just have revenues depart from expectations – so basically any small shock to a fragile economy can potentially trigger a crisis). When the economic environment changes, income flows begin to fall and Ponzi units find it impossible to borrow to sustain their positions. They will then try to make position by selling out position; this means selling assets to meet their payments. The consequence of a generalized sell-off is to put downward pressure on asset prices, which can make the market prices too low as to generate sufficient income to meet the commitments – making this operation self-defeating. These dynamics, plus the excess supply, reinforce the necessity to sell and raise the real debt burden, leading to a potential Fisher-style debt deflation. These processes reset the system, starting again from a robust financial position – because all the fragile positions were washed off by the debt deflation – but will eventually give way to another crisis.

The idea that “stability is destabilizing” is summarized by Minsky’s two theorems of financial fragility in the FIH: (I) the economy has financing regimes under which it is stable (hedge) and financing regimes in which it is unstable (speculative and Ponzi); and (II) over periods of prolonged prosperity, the economy transitions from financial relations that make for a stable system to financial relations that make for an unstable system. In other words, the economy tends to move from a financial structure with abundant units engaged in hedge finance to a structure dominated by speculative and Ponzi units. The natural shift from hedge positions to speculative to Ponzi is a required condition for instability to arise, and, as explained above, the move (and the erosion of margins of safety) happens during periods of economic stability and prosperity. One of Minsky’s most important contributions was to point out that the process leading to an unstable system is an inevitable, endogenous, and evolutionary process of the modern capitalist economy.

So, what can we learn from all of this? Well, the next time you hear politicians or big shot economists talking about how stable the economy is and how on track it is, remember Minsky and remain skeptical.

Written by Oscar Valdes-Viera