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Guided by an invisible hand

The bank meltdown marks a turning point in our thinking about how the world works writes the Nobel L

Make no mistake: we are witnessing the biggest crisis since the Great Depression. In some ways it is worse than the Great Depression, because the latter did not involve these very complicated instruments - the derivatives that Warren Buffett has referred to as financial weapons of mass destruction; and we did not have anything close to the magnitude of today's cross-border finance.

The events of these weeks will be to market fundamentalism what the fall of the Berlin Wall was to communism. Last month in the United States almost 160,000 jobs were shed - making more than three-quarters of a million this year. My guess is that things will get considerably worse. I have been predicting this for some time, and so far, unfortunately, I have been right.

There are several reasons for my pessimism. The extreme credit crunch is a result of the banks having lost a lot of capital. And there is still uncertainty about the value of the toxic mortgages and other complex products on their balance sheets. The US economy has been fuelled by a consumption binge. With average savings at zero, many people borrowed to live beyond their means. When you cut off that credit you reduce consumption. This, in turn, will dampen the US economy, which helps keep the global economy growing. The American consumer has not only sustained the US economy, he has sustained the global economy. The richest country in the world has been living beyond its means and telling the rest of the world it should be thankful because America fuelled global economic growth.

There are further reasons for my pessimism about short-term economic prospects, in America and Europe. In the second quarter of this year, growth in the US would have been negative were it not for the growth in exports. But with the slowdown in Europe and problems in Asia it is difficult to see how we can maintain net export growth. The strengthening of the dollar - due not to greater confidence in the US but to reduced confidence in Europe - will make matters worse. The fall of energy prices will help a little, but not enough.

Treasury Secretary Hank Paulson has now come up with a new bailout scheme. The original plan - buying up the thousands of "troubled assets" (read: bad loans and complex products based on them that Wall Street created) - was badly designed and rife with problems. How would they have been priced? Call in the same Wall Street experts who got us into the mess and mispriced risk before? It is a heads I win, tails you lose situation.

The worry is that the taxpayer will be left holding the short end of the stick.

The British approach, which Paulson seems to be following, is far better, involving capital injections into banks, with preferred shares to protect against losses and warrants to share in some of the upside potential. This is the approach that I - along with most US economists and people with good street sense, like George Soros - had been saying America should adopt.

Ironically, though Paulson wouldn't listen to us, he seems to have listened to Gordon Brown.

Many of the problems our economy faces today are the result of the use of misguided models. Unfortunately, too many took the overly simplistic models of courses in the principles of economics (which typically assume perfect information) and assumed they could use them as a basis for economic policy. Many central banks use the notion of inflation targeting - that they should focus exclusively on inflation, raising interest rates when inflation increases. But I would argue that central banks have a broader responsibility; they are supposed to ensure the stability of a country's economy. While monetary authorities in the US and elsewhere focused on price stability, they allowed the financial system to undertake risks that put the whole economy in jeopardy.

This crisis is a turning point, not only in the economy, but in our thinking about economics. Adam Smith, the father of modern economists, argued that the pursuit of self-interest (profit-making by competitive firms) would lead, as if by an invisible hand, to general well-being. But for over a quarter of a century, we have known that Smith's conclusions do not hold when there is imperfect information - and all markets, especially financial markets, are characterised by information imperfections. The reason the invisible hand often seems invisible is that it is not there. The pursuit of self-interest by Enron and WorldCom did not lead to societal well-being; and the pursuit of self-interest by those in the financial industry has brought our economy to the brink of the abyss.

No modern economy can function well without the government playing an important role. Even free marketeers are now turning to the government. But would it not have been better to have taken action to prevent this meltdown? This is a new kind of public-private partnership - the financial sector walked off with the profits, the public was left with the losses. We need a new balance between market and government.

Professor Joseph E Stiglitz is chair of the Brooks World Poverty Institute at the University of Manchester and a 2001 Nobel prizewinner

This article first appeared in the 20 October 2008 issue of the New Statesman, My year with Obama

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The dark shadow

The Brexit proposal springs from panic and would certainly be terrible news for Britain’s economy – but it carries a threat even greater than that.

It cannot be said that the European ­Union is doing particularly well at this time. Its economic performance has been mostly terrible, with high unemployment and low economic expansion, and the political union itself is showing many signs of fragility. It is not hard to understand the temptation of many in Britain to call it a day and “go home”. And yet it would be a huge mistake for Britain to leave the EU. The losses would be great, and the gains quite puny. And the “home” to go back to no longer exists in the way it did when Britannia ruled the waves.

We live in a thoroughly interdependent world, nowhere more so than in Europe. The contemporary prosperity of Europe – and elsewhere, too – draws on extensive use of economic interconnections. While the unacceptable poverty and inequality that persist in much of the world, including Britain, certainly call for better-thought-out public engagement, the problems can be addressed better without getting isolated from the largest economy next door. The remarkable joint statement aired recently, by a surprisingly large number of British economists, of many different schools, that Brexit would be an enormous economic folly, reflects an appreciation of this glaring reality. Apart from trade and economic exchange with Europe itself, Britain is currently included in a large number of global agreements as a part of the European Union. Britain can do a lot – for itself and for Europe – to correct some of the big mistakes of European economic policies.

The Brexit-wallahs, if I may call the enthusiasts that (without, I hasten to add, any disrespect), sometimes respond to concerns of the kind I have been expressing with the reply that Britain can surely retain the economic interconnections with Europe, and through Europe, even without being in the European Union. “Isn’t that what Norway largely did?” Norway has certainly done well, and deserves credit for it. But the analogy does not really work, not just because Britain is a huge economy in a way Norway is not, but much more importantly because quitting is not at all the same thing as not joining. Britain’s extensive economic ties with Europe, and a great many EU trade agreements that go beyond Europe in the multilateral global economy, are well established now and disentanglement would be a very costly process – a challenge that Norway did not have to face.

But perhaps most importantly, it must be recognised that quitting is a big message to send to Europe and to the world: a message that Britain wants to move away from Europe. As four decades of economic studies have shown, signals can be dramatically important for economic relations. Conclusions will certainly be drawn on how dependable and friendly Britain can be taken to be. A jilted partner has more reason for angst than an unapproached suitor.

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While the economic arguments against Brexit are strong, the political concerns are even stronger. The unification of Europe is an old dream. It is not quite as old as is sometimes suggested: the dream is not of classical antiquity. Alexander and other ancient Greeks were less interested in chatting with Angles, Saxons, Goths and Vikings than they were in conversing with the ancient Persians, Bactrians and Indians. Julius Caesar and Mark Antony identified more readily with the ancient Egyptians – already strongly linked with Greece and Rome – than with other Europeans located to the north of Rome and the west. But Europe went through successive waves of cultural and political integration, greatly helped by the powerful spread of Christianity, and by 1462 King George of Podebrady in Bohemia was talking about pan-European unity.

Many other invocations followed, and by the 18th century even George Washington wrote to the Marquis de Lafayette: “One day, on the model of the United States of America, a United States of Europe will come into being.”

It was, however, the sequence of the two world wars in the 20th century, with their vast shedding of European blood, that firmly established the urgency of political unity in Europe. As W H Auden wrote in early 1939, on the eve of the Second World War:

In the nightmare of the dark
All the dogs of Europe bark,
And the living nations wait,
Each sequestered in its hate . . .

His worst expectations found chilling confirmation in the years that followed.

The fear of a repeat of what Europeans had seen in these wars continued to haunt people. It is important in this context to ­appreciate that the movement for European unification began as a crusade for political unity, rather than for an economic union – not to mention a financial unification, or a common currency. None of the follies that make the economics of the European Union so problematic arose from that vision. The remedies that are needed (on which I have written elsewhere: see “What happened to Europe?”, the New Republic, 2 August 2012) would need policy changes and institutional reforms, but not any rejection of the idea behind a united Europe.

The birth of the European ­federalist movement was motivated strongly by the desire for political unity, free from self-destructive wars, as can be seen in the arguments presented in the Ventotene Declaration of 1941 and the Milan Declaration of 1943. There was, of course, no hostility to economic integration (and its merits were understood), but the priority was not on banking and currency, nor even on trade and exchange, but on peace and goodwill and a gradually evolving political and social integration. That political unification has fallen way behind the ill-thought-out financial moves is a sad fact. The EU’s policy priorities need to be scrutinised and reworked – a process to which Britain can contribute, and from which it can benefit along with other Europeans.

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No wars, of course, will result from Brexit, yet that does not mean that the sense of rejection and distancing will have no adverse impact on the way Europeans see each other. That the dislike of having other Europeans settling in Britain is a major reason given in favour of Brexit – playing up the fear of “our” jobs, “our” economic opportunities being taken by “them” – makes this human distancing even more poignant. It is hard not to miss the recognition that this fear, exaggerated by dubious use of numbers, has been fanned politically by the enthusiasts for Brexit. And that adds to the intensification of relational adversity. Being “sequestered in hate” is a bit of a nightmare in its own right, even without the open violence which followed that terrible nightmare, shortly after Auden wrote his poem.

The EU did not create the idea of ­Europe, just as the idea of India was not a ­product of the nationalist movement (even though an otherwise brilliant European, Winston Churchill, failed to see any more unity in India than could be found around the Equator). The message of Brexit would have huge implications, given where the world is at this time. The Polish philosopher Leszek Koakowski has rightly asked, “If we would like the EU to be more than just a place for money temples of banks and the stock exchange, but also a place where material welfare is surrounded by art and is used to help the poor, if we want freedom of speech, which can be so easily misused to propagate lies and evil, as well as be used for inspiring works – then what is to be done?” When, at the end of the Second World War and after the defeat of Nazi Germany, Britain established its National Health Service and laid the foundations of a welfare state, it was inspired not merely by ideas originating in this country, but by thoughts that had sprung up across Europe, including the ideas of Kant and Marx and even Bismarck, in the country just defeated. There was no conflict between innovative British ideas and broader European thinking, nor between British and European identities (there is no reason for us to be incarcerated in one identity – one affiliation – per head).

The proposal of Brexit is born out of panic, and it is as important to see that the reasoning behind the panic is hasty and weak as it is to recognise that wisdom is rarely born of fright. In his Nexus Lecture, called “The Idea of Europe”, given a dozen years ago, George Steiner wondered about the prospects for Europe playing a leadership role in the pursuit of humanism in the world. He argued: “If it can purge itself of its own dark heritage, by confronting that heritage unflinchingly, the Europe of Montaigne and Erasmus, of Voltaire and Immanuel Kant may, once again, give guidance.” Brexit would certainly be a bad economic move, but the threat that it carries is very much larger than that.

Amartya Sen is Professor of Economics and Philosophy at Harvard and won the 1998 Nobel Prize in Economics.

This article first appeared in the 09 June 2016 issue of the New Statesman, A special issue on Britain in Europe