Daniel W. Drezner — Regulating Global Complexity

[By Daniel W. Drezner. Part of the series "Global Challenges in 2030"  (Goldstein & Pevehouse), January 2010.]

Outside of realists, mainstream international relations perspectives believe that the world benefits from complex interdependence. One of the biggest issues that international relations theorists will need to deal with in the coming decades, however, is dealing with the dark side of globalization.

With the end of the Cold War, the globalization phenomenon went truly global. At the same time, the number of banking and currency crises also began to mushroom. During the 1990s, the frequency of banking and currency crises rose to a level unseen since the interwar years. While most of these crises were concentrated in the developing world, with the Great Recession of 2008, instability went global as well. International markets in financial assets, food, and energy were buffeted by a series of shocks—and none of them functioned terribly well in response. This failure rattled even the most devout free market enthusiasts. Former Federal Reserve chairman Alan Greenspan made headlines when he admitted that his faith in the “intellectual edifice” of self-correcting markets had “collapsed.”

With the accelerating pace of technological innovation constantly reducing the transaction costs of cross-border trade, globalization is a fact regardless of how high governments set barriers to trade. How can the benefits of greater openness and greater interdependence be realized while minimizing the costs that come from economic crises?

Economists have been debating the best way to answer that question since the start of the Great Recession, with little to show for it beyond some very heated rhetoric. Many commentators argued that the laissez-faire, efficient markets, self-regulation approach allowed systemic risk to bubble up. Free-marketers placed the blame on government policies that subsidized home mortgages and kept interest rates too low for too long. This debate has produced more heat than light.

Here’s a truly subversive thought—perhaps the problem with this debate is the extent to which the rest of the world listens to economists. Keynesian or monetarist, all economists preach the virtues of maximizing economic efficiency. For all economists, the be all and end all of their policy prognostications is “Pareto optimality”—a world in which no one can be made better off without making anyone worse off.

If one looks at the globalized economy through the lens of organizational theory, however, then one’s perspective begins to shift. Globalization has transformed the world economy into a complex, tightly coupled social system. A globalized economy is hideously complex, with interactions between different sectors that become clear only after the fact. For example, U.S. government officials did not anticipate the ways in which the bankruptcy of Lehman Brothers would ripple across financial markets; other governments failed to understand how Lehman’s collapse affected their own financial sectors.

A globalized economy is also a tightly coupled organism—changes in one component of the economy have immediate effects on other sectors of the economy. The proliferation of interlocking financial markets, real-time information dissemination, and just-intime inventory systems has accelerated and, at times, magnified the impact of any perturbation in the global economy. The way in which the subprime mortgage crisis spread across national economies and from financial markets to the real economy demonstrates the speed with which a minor accident can metastasize into something far more serious.

Complex, tightly coupled systems are prone to what some scholars have labeled “normal accidents”—cascading catastrophes that grow naturally in the system. These systems also tend to have actors with a vested interest in avoiding change in the status quo. Unlike loosely coupled or less complex systems, the creation of safety mechanisms to try to prevent such a catastrophe often has unanticipated or debilitating effects.

Some counterintuitive notions come from thinking of the global economy as a complex system. For example, faith in regulatory solutions might be just as misguided as faith in efficient markets. Efforts to regulate capital markets might be well intentioned, but they might also have unanticipated effects precipitating an even bigger economic crash. This does not mean that no actions should be taken—but it does mean that the potential costs of regulation have been underestimated.

Another counterintuitive point is that because of complexity, sham agreements might actually be a good thing for the global economy. The natural political instinct is to “do something” in the wake of a crisis. A normal accidents perspective,  however, would argue that periodic financial crashes are something the world must live with. Politicians do not do terribly well with a “do nothing” message—so symbolic pledges on a number of issue areas can alleviate political pressure without bollixing up the global financial system.

Debates over how to regulate a complex global economy will persist for decades. An organizational lens leads to some unconventional thoughts. In addition to maximizing economic efficiency, policy makers will also want to think about robustness as a desirable outcome. Any regulation of a complex global economy should be concentrated on making a tightly coupled system more robust to shocks. This means adding some friction to markets that react quickly, in the hopes that contagion does not spread as quickly in the future. There are limits to this strategy—the world really does benefit from financial globalization—but that’s why something like a minimal tax on international capital movements makes some sense.

 

DANIEL W. DREZNER is professor of international politics at the Fletcher School of Law and Diplomacy at Tufts University. He is the author of All Politics Is Global (Princeton, 2007) and The Sanctions Paradox (Cambridge, 1999), and keeps a daily blog at foreignpolicy.com.