The Great Degeneration: How Institutions Decay and Economies Die

I’ve been deeply inspired by the thorough analysis done by Niall Ferguson, a celebrated Scottish historian, of how the big part of our Western World has entered the period of “great degeneration”. In his acclaimed book “The Great Degeneration: How Institutions Decay and Economies Die” he writes:

“In two seldom quoted passages of The Wealth of Nations, Adam Smith described what he called ‘the stationary state’: the condition of a formerly wealthy country that had ceased to grow. What were the characteristics of this state? Significantly, Smith singled out its socially regressive character. First, wages for the majority of people were miserably low. The second hallmark of the stationary state was the ability of a corrupt and monopolistic elite to exploit the system of law and administration to their own advantage.

I defy the Western reader not to feel an uneasy sense of recognition in contemplating those two characteristics, In Smith’s day, of course, it was China that had been ‘long stationary’: a once ‘opulent’ country that had simply ceased to grow. Smith blamed China’s defective eye ‘laws and institutions’ – including its bureaucracy – for the stasis. More free trade, more encouragement for small businesses, less bureaucracy and less crony capitalism: these were Smith’s prescriptions to cure Chinese stasis. He was a witness to what such reforms were doing in the late eighteenth century to galvanize the economy of the British Isles and its American colonies. Today, by contrast, if Smith could revisit those same places, he would behold an extraordinary reversal of fortunes. It is we Westerners who are in the stationary state, while China is growing faster than any other economy in the world. The boot of economic history is on the other foot”.

Niall Fergusson’s book is about the causes of our stationary state. It is inspired by Smith’s insight that both stagnation and growth are in large measure the results of ‘laws and institutions’. Its central thesis is that what was true of China in Smith’s day is true of large parts of the Western world in our time. It is our laws and institutions that are the problem. The Great Recession is merely a symptom of a more profound Great Degeneration. 

To demonstrate that Western institutions have indeed degenerated, the author opens some long-sealed black boxes. The first is the one labelled ‘democracy’. The second is labelled ‘capitalism’. The third is ‘the rule of law’. And the fourth is ‘civil society’. Together, they are the key components of our civilization. By showing that inside these political, economic, legal and social black boxes are highly complex sets of interlocking institutions, the author compares them to the circuit boards inside a computer or a smartphone and demonstrates that it is these institutions that make the gadget work.

Our Flawed Democracy

When exploring the first of these black-boxes – democracy – the author wants to make an argument about our modern representative government – and what ails it. His starting assumption is the conventional one that it is generally better for government to be in some way representative of the governed than not. This is not just because democracy is a good thing per se, as Amartya Sen has argued, but also because a representative government is more likely than an authoritarian government to be responsive to shifting popular preferences and is therefore less likely to make the kind of horrendous mistakes authoritarian rulers often make. Those today who dismiss Western democracy as ‘broken’ – and we hear their lamentations with growing frequency – are wrong to yearn for some kind of Beijing model of a one-party state in which decisions taken by technocrats on the basis of five-year plans. It was the same system that gave China both Special Economic Zones and the One-Child Policy: the former a success, the latter a disaster, the full costs of which are as yet incalculable.

But the critics of Western democracy are right to discern that something is amiss with our political institutions. The most obvious symptoms of the malaise are the huge debts we have managed to accumulate in recent decades, which unlike in the past cannot largely be blamed on wars. Often these debts get discussed as if they themselves are the problem, and the result is a rather sterile argument between proponents of ‘austerity’ and ‘stimulus’. Niall Ferguson suggests that they are a consequence of a more profound institutional malfunction.

The heart of the matter is the way public debt allows the current generation of voters to live at the expense of those as yet too young to vote or as yet unborn. In this regard. The statistics commonly cited as government debt are themselves deeply misleading, for they encompass only the sums owed by governments in the form of bonds. The rapidly rising quantity of these bonds certainly implies a growing charge on those in employment, now and in the future, since – even if the current low rates of interest enjoyed by the biggest sovereign borrowers persist — the amount of money needed to service the debt must inexorably rise. But the official debts in the form of bonds do not include the often far larger unfunded liabilities of welfare schemes – to give the biggest American programmes – Medicare, Medicaid and Social Security.

The best available estimate for the difference between the net present value of federal government liabilities and the net present value of future federal revenues is USD 200 trillion, nearly thirteen times the debt as stated by the US Treasury. These mind-boggling numbers represent nothing less than a vast claim by the generation currently retired or about to retire on their children and grandchildren, who are obliged by current law to find the money in the future, by submitting either to substantial increases in taxation or to drastic cuts in other forms of public expenditure.

In his Reflections on the Revolution in France (1790), Edmund Burke wrote that the real social contract is not Jean-Jacques Rousseau’s contract between the sovereign and the people or ‘general will’, but the ‘partnership’ between the generations. In the enormous intergenerational transfers implied by current fiscal policies we see a shocking and perhaps unparalleled breach of precisely that partnership. The author wants to suggest that the greatest challenge facing mature democracies is how to restore the social contract between the generations. But I recognize that the obstacles to doing so are daunting. Not the least of these is that the young find it quite hard to compute their own long-term economic interests. It is surprisingly easy to win the support of young voters for policies that would ultimately make matters even worse for them, like maintaining defined benefit pensions for public employees. A second problem is that today’s Western democracies now play such a large part in redistributing income that politicians who argue for cutting expenditures nearly always run into the well-organized opposition of one or both of two groups: recipients of public sector pay and recipients of government benefits.

Is there a constitutional solution to this problem? The simple answer – which has already been adopted in a number of American states as well as Germany – is some kind of balanced-budget amendment (or restriction) to engage in deficit spending, much as the practice of central banks' independence reduced lawmakers’ discretion over monetary policy. The trouble is that the experience of the financial crisis has substantially strengthened the case for using the government deficit as a tool to stimulate the economy in times of recession, to say nothing of the wider case for deficit-financed public investment in infrastructure. What’s more, most current voters are unlikely to support policies of intergenerational equity.

It seems as if there are only two possible ways out of this mess. In the good but less likely scenario, the proponents of reform succeed, through a heroic effort of leadership, in persuading not only the young but also a sizable proportion of their parents and grandparents to vote for a more responsible fiscal policy. Such leadership is likely to succeed if we alter the way in which governments account for their finances. The present system, to put it bluntly, is fraudulent. There are no regularly published and accurate official balance sheets. Huge liabilities are simply hidden from view. Not even the current income and expenditure statements can be relied upon. No legitimate business could possibly carry on in this fashion. The last corporation to publish financial statements this misleading was Enron. So, the public-sector balance sheets can and should be drawn up so that the liabilities of governments can be compared with assets. That would help clarify the difference between deficits to finance investment and deficits to finance current consumption. Governments should also follow the lead of businesses and adopt Generally Accepted Accounting Principles. And above all, generational accounts should be prepared on a regular basis to make absolutely clear the intergenerational implications of current policy.

We do not do these things – if we do not embark on a wholesale reform of government finance – then I am afraid we are going to end up with the bad, but more likely. Second scenario. Western democracies are going on in their current feckless fashion until, one after another, they follow Greece and other Mediterranean economies into the fiscal death spiral that begins with a loss of credibility, continues with a rise in borrowing costs, and ends as governments are forced to impose spending cuts and higher taxes at the worst possible moment. In this scenario, the endgame involves some combination of default and inflation. We all end up as Argentina did.

There is a third possibility, and that is what we now see in Japan and the United States, maybe also in the United Kingdom. The debt continues to mount up. But deflationary fears, central bank bond purchases and a ‘flight to safety’ from the rest of the world keep government borrowing costs down at unprecedented lows. The trouble with this scenario is that it also implies low to zero growth over decades: a new version of Adam Smith’s stationary state. Only now it is the West that is stationary.

Our Flawed Economy

What is the biggest problem facing the world economy today? To listen to some people, you might think the correct answer is insufficient financial regulation. According to a number of influential commentators, the origins of the financial crisis that began in 2007 and still does not seem to be over – lie in decisions dating back to the early 1980s that led to a substantial deregulation of financial markets.

The author does not try to whitewash the bankers and believes this story to be mostly wrong. For one thing, it is hard to think of a major event in the US crisis – beginning with the failures of Bear Stearns and Lehman Brothers – that could not equally well have happened with Glass-Steagall still in force. Both were pure investment banks that could just as easily have been mismanaged to death before 1999.

In the author’s view, the lesson of die 1970s is not that deregulation is bad, but that bad regulation is bad, especially in the context of bad monetary and fiscal policy.

The financial crisis that began in 2007 had its origins precisely in over-complex regulation. A serious history of the crisis would need to have several chapters on its perverse consequences. For example, the executives of large publicly owned banks were strongly incentivized to ‘maximize shareholder value’ since their own wealth and income came to consist in large measure of shares and share options in their own institutions. The easiest way they could do this was to maximize the size of their banks’ activities relative to their capital. All over the Western world, balance sheets grew to dizzying sizes relative to bank equity. How was this possible? The answer is that it was expressly permitted by regulation. To be precise, the Basel Committee on Banking Supervision’s 1988 Accord allowed giant quantities of assets to be held by banks relative to their capital, provided these assets were classified as low-risk such as government bonds.

Or, central banks – led by the Federal Reserve evolved a peculiarly lopsided doctrine of monetary policy, which taught that they should intervene by cutting interest rates if asset prices abruptly fell, but should not intervene if they rose rapidly, so long as the rise did not affect public expectations of something called ‘core’ inflation (which excludes changes in the prices of food and energy and wholly failed to capture the bubble in house prices). The colloquial term for this approach is the ‘Greenspan (later Bernanke) put’, which implied that Fed would intervene to prop up the US equity market, but would not intervene to deflate an asset bubble. The Fed was supposed to care only about consumer-price inflation but, for some obscure reason, not about house-price inflation.

The issue is whether additional regulation of the sort that is currently being devised and implemented can improve matters by reducing the frequency or magnitude of future financial crises. Niall Ferguson thinks it is highly unlikely and thinks the new regulations may have precisely the opposite effect. The problem we are dealing with here is not inherent in financial innovation. It is inherent in financial regulation. Private sector models of risk management were undoubtedly imperfect, as the financial crisis made clear. But public sector models of risk management were next to non-existent. Because legislators and regulators acted with an almost complete disregard for the law of unintended consequences, they inadvertently helped to inflate a real estate bubble in countries all over the developed world.

Today, it seems to me, the balance of opinion favours complexity over simplicity; rules over discretion; codes of compliance over individual and corporate responsibility. I believe this approach is based on a flawed understanding of how financial markets work. It puts me in mind of the great Viennese satirist Karl Kraus’s famous quip about psychoanalysis: that it was the disease of which it pretended to be the cure. I believe excessively complex regulation is the disease of which it pretends to be the cure.

Another and related way of thinking about the financial system is as a highly complex system, made up of a considerable number of interacting components that are asymmetrically organized in a network. This network operates somewhere between order and disorder – on ‘the edge of chaos’. Such complex systems can appear to operate quite smoothly for some time, apparently in equilibrium, constantly adapting as positive feedback loops operate. But there comes a moment when they ‘go critical”. A slight perturbation can set off a ‘phase transition’ from a benign equilibrium to a crisis. This is especially common where the network nodes are “tightly coupled’. When the interrelatedness of a network increases, conflicting constraints can quickly produce a ‘complexity’ catastrophe’.

Over-complicated regulation can indeed be the disease of which it purports to be the cure. Just as the planners of the old Soviet system could never hope to direct a modern economy in all its complexity, so the regulators of the post-crisis world are doomed to fail in their efforts to make the global financial system crisis-free. They can never know enough to manage such a complex system. They will only ever learn from the last crisis how to make the next one.

It there an alternative? I believe there is. First, strengthen the central bank as the ultimate authority in both the monetary and supervisory systems. Second, ensure that those in charge at the central bank are apprehensive as well as experienced so that they will act when they see excessive credit growth and asset-price inflation. Third, give them considerable latitude in their use of the principal central banking tools of reserve requirements, interest rate changes and open-market securities purchases and sales. Forth, teach them some financial history. Finally, we must ensure that those who fall foul of the regulatory authority pay dearly for their transgressions. Those who believe this crisis was caused by deregulation have misunderstood the problem in more than one way. Not only was misconceived regulation a large part of the cause. There was also the feeling of impunity that came not from deregulation but from non-punishment. The failure to apply regulation – to apply the law – is one of the most troubling aspects of the years since 2007. In US, the list of those who have been sent to jail for their part in the housing bubble, and all that followed from it, is visibly short.

Our Flawed Law

What exactly do we mean by the rule of law? In his book of that name, the late Lord Chief Justice, Tom Bingham, specified seven criteria by which we should assess a legal system:

-       The law must be accessible and so far, as possible, intelligible, clear and predictable;

-       Questions of legal right and liability should ordinarily be resolved by application of the law and not by the exercise of discretion;

-       The laws of die land should apply equally to all, save to the extent that objective differences [such as mental incapacity] justify differentiation;

-       Ministers and public officers at all levels must exercise the powers conferred on them in good faith, fairly, for the purpose of which the powers were conferred, without exceeding the limits of such powers;

-       The law must afford adequate protection of fundament human rights;

-       Means must be provided for resolving, without prohibitive cost or inordinate delay, bona fide civil disputes which the parties themselves are unable to resolve, and

-       Adjudicative procedures provided by the state should fair

Like democracy, the rule of law in this sense may be good. But it may also be good because of its material consequences. Few truths are today more universally acknowledged than that the rule of law, particularly insofar as it restrains the ‘grabbing hand’ of the rapacious state – is conducive to economic growth. According to Douglass North, ‘the inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment…’

How good in practice is thus the rule of law in the West today? There are four distinct threats to it that I would identify.

First, we must pose the familiar question about how far our civil liberties have been eroded by the national security state. The debates after September 11, 2001, about the protracted detention of terrorist suspects were in no way new. Somehow it is always a choice between habeas corpus [a writ requiring a person under arrest to be brought before a judge or into court, especially to secure the person's release unless lawful grounds are shown for their detention.] and hundreds of corpses.

A second threat is the obvious one posed by the intrusion of European law – with civil (and thus very prescriptive) character. Countless studies prove that common law is by far superior to the civil law.

A third threat is the growing complexity (and sloppiness) of statute law, a grave problem on both sides of the Atlantic as the mania for elaborate regulation spreads through the political class. We need a legal spring-cleaning of obsolete legislation and routine inclusion of “sunset provisions” (expiry laws) in new laws. We must also seek to persuade legislators that their role is not to write an instruction manual for the economy that covers every eventuality, right down to the remotest imaginable risk to our health and safety.

A fourth threat – especially apparent in the United States – is the mounting cost of the law. By this, I do not mean the nearly USD 100 million a year that the US federal government spends annually on law-making, law interpretation and law enforcement. Nor do I mean the spiralling cost of lobbying by businesses seeking to protect their interests. It is the cost of the consequences of their that is truly alarming: the USD 1.8 trillion a year, according to a report commissioned by the US Small Business Administration, in additional business costs arising from compliance and regulation. On top of this comes nearly USD 1 trillion in costs arising from the US system of tor law, which gives litigants far greater opportunities than in other countries to see damages for any “wrongful act, damage, or injury…”.

Americans could once boast proudly that their system set the benchmark for the world, the United States was the rule of law. But now it is the rule of lawyers, which is something very different [and the very reason the law is no longer effective]. And the United States is not isolated in this sense, all over the Western world we see this dysfunctional phenomenon unfolding if not to say firmly vested.

Our Flawed Civil Society

The black box called “the civil society” is the last place where our Western society shows signs of incredible stagnation. How is it possible for a truly free nation to flourish in the absence of the kind of vibrant civil society we used to take for granted?

Let’s first start with the simple definition of what civil society is. Civil society is the "aggregate of non-governmental organizations and institutions that manifest interests and will of citizens". Civil society includes the family and the private sphere, referred to as the "third sector" of society, distinct from government and business. Civil society organizations engage in advocating the public’s rights and wishes of the people, including but not limited to health, environment and economic rights.

As Tocqueville once pointed out, political (and non-political) associations are an indispensable counterweight to the tyranny of the majority in modern democracy. Such associations are everything, from belonging to sport clubs or libraries to participation in public meetings or school affairs.

Put differently, the civil societies fulfil important duties of checks and balances in democracies, they can influence the government and hold it accountable. Therefore, free and active civil societies are an indicator of a healthy participatory democracy.

The sad reality we face today is the decline of the civil society. Fewer and fewer individuals belong to voluntary associations or participate in the public life. We seldom hear these days of people belonging to trade unions, cooperatives, benefit societies, leagues, boards, commissions, committees, etc…

The erosion of this incredibly important social capital may be difficult to understand. According to Putnam, it is primarily technology – first television, then the internet – that has been the death of traditional associations in life. This may be disputed, especially if you realize that the Arab Spring has been triggered partly by the interconnectedness of people present on Facebook. It remains doubtful if technology is to be blamed for the hollowing out of our civil society. What’s more likely is that it is the state – with its seductive promise of “security from cradle to grave” – who is the real enemy of civil society.

Over the past fifty years, governments encroached too far on the realm of civil society. That had its benefits where (as in the case of primary education) there was insufficient private provision. But there was also a real cost. I believe that spontaneous local activism by citizens is better than central state action not just in terms of its results, but more importantly in terms of its effect on us as citizens. For true citizenship is not just about voting, earning and staying on the right side of the law. It is also about participating in the ‘troop’ – the wider group beyond our family – which is precisely where we learn how to develop and enforce rules of conduct: in short, to govern ourselves. To educate our children. To care for the helpless. To fight crime. To keep the streets clean.

Conclusion

We humans live in a complex matrix of institutions. There is a government. There is the market. There is the law. And there is civil society. This matrix has worked astonishingly well for centuries, with each institution complimenting and reinforcing the rest. That was the key to Western success in the eighteenth, nineteenth and twentieth centuries. But institutions of our times are out of joint. It is our challenge in the years ahead to restore them, to reverse the Great Degeneration, and to return to those first principles of a truly free society.

Why are some countries so much richer than others? Why is there so much inequality not just among countries but within individual countries? It is tempting to look for explanations in financial forces (“deleveraging”), international integration (“globalization”), the role of information technology (“offshoring and outsourcing”) or fiscal policy (“stimulus vs. austerity). However, we need to delve into the history of institutions to understand the complex dynamics of convergence and divergence that characterize today’s world. The democratic deficits, the regulatory fragility, the rule of lawyers, and the uncivil society offer better explanations of why the West is now delivering lower growth and greater inequality than in the past, and why, in Adam Smith’s words, it finds itself in a stationary state. onary state. 

So, what are you waiting for?

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