Now that we know the economic cost of the subprime crisis, is it too late for legal crisis resolution?

July 13, 2014

The subprime crisis has always had both a economic and a legal dimension. It was a crisis of millions of mortgage contracts with severe consequences for the financial and the household sectors of the economy. The effects linger on because the legal and the economic paths towards crisis resolution remained disjointed.

Across the transition between the Administrations of George W. Bush and Barack Obama, Treasury Secretaries Henry Paulson and Timothy Geithner came to the rescue of the financial sector with a fiscal program of relief for troubled assets (TARP). On the monetary side, Fed Chairman Ben Bernanke vowed to prevent the recurrence of the Great Depression by consistently providing massive liquidity through quantitative easing. That recurrence was indeed prevented.

What did occur, though, was a Great Recession. While the banking sector was saved, the household sector, as we now know for sure, was not. By 2011, it was obvious that the liquidity offered by the Fed ended up in emerging markets rather than the American household sector. Across the neoclassical-neokeynesian divide in economics, Martin Feldstein and Paul Krugman advocated mortgage modification for underwater homeowners as the most focused strategy for broad-based economic recovery. Their advice remained largely unheeded. A bill for mortgage relief submitted to Congress by the Obama administration failed in the House. Subsequent executive programs remained hampered by procedural impediments in both the public authorities and the banks or mortgage servers involved. The guts reaction of the legal profession responsible for the securitization of mortgage-backed securities was that the sanctity of contracts had to be preserved. Criminal prosecution of banks for securities fraud was not an equivalent alternative even though portions of the penalties were devoted to executive programs of mortgage modification as in the 13bn settlement with JP Morgan in 2013.

Today, thanks to “big data”, we can assess more precisely the economic cost of that legal guts reaction. In what Lawrence Summers recognized as the most important economics book of 2014 (The House of Debt, available at http://press.uchicago.edu/ucp/books/book/chicago/H/bo17241623.html ), Atif Mian and Amir Sufi have analyzed data provided by lenders on the financial situation of mortgage borrowers. They were able to put in aggregate numbers just how impaired the American household sector remained by the loss of equity of “underwater” homeowners. Since such equity is the most important source of consumption in the US economy, US growth remains anemic and unemployment too high for an economy with a growing population.

Is it too late for revitalizing the economy through efficient mortgage relief for subprime home owners? Does the sanctity of contracts, i.e. the law, stand in the way? The answer is no, and no.

If neither Congress nor Administration is able to overcome their structural impediments to effective crisis resolution, the resources of the law are still there to be discovered by borrowers and investors in search for judicial relief. The fundamental issues of contract law between the lenders and borrowers of mortgage loans as well as sellers and buyers of mortgage-backed securities (MBS) have as yet not even been raised.

These issues arise from flawed assumptions of financial engineering about future house price inflation and their sudden invalidation by severe house price deflation. Banks had offered mortgage loans to low income home buyers at “teasing rates” of about 2% for the first few years, thereafter rising to about 8%. Future house price rises, it was assumed, would make it easy for the borrowers to reschedule their debt. The expectation began to be frustrated in 2007, when the first American lenders defaulted, as subprime borrowers could not afford the rise to 8%. Successive waves of foreclosures brought real estate prices down in declines not seen since the Great Depression. MBS became “toxic assets”.

Mortgage contracts and MBS should be adjusted to the invalidation of the assumptions on which they were based. These assumptions were a near universal cognitive failure as certified to the Queen of England by the British Academy[1]. The contract law of most countries recognizes such “frustration of purpose” or “change in vital circumstances by supervening events”.

The leading American precedent for contract modification in cases of massive unforeseen changes in price levels in economic crises is ALCOA vs. Essex Group. It was a case of unforeseen inflation of energy prices resulting from the oil crises. With the support of Allan Farnsworth, the leading American authority on contract law, Judge Teitelbaum of the US District Court of the Western District of Pennsylvania found in favor of ALCOA obtaining an upward adjustment of the price of molten metal in its long-term contract with Essex. The ruling did not meet with unanimous approval in American legal scholarship, which was not used to distinguish between normal cyclical fluctuations in price levels and economic crises. But the doctrine of frustration of purpose developed in that case in 1980 must certainly apply to economic crises of historical dimension as in the deflation of house prices in the subprime crisis since 2007. Our detailed legal analysis of such a legal crisis resolution has just come out in the chapter ”Contract Modification as a rebus sic stantibus Solution to the Subprime Crisis”, in: M. Schmiegelow and H. Schmiegelow (eds) Institutional Competition between Common Law and Civil Law, Theory and Policy, Berlin, Heidelberg, Dordrecht: Springer, 2014 available at http://www.springer.com/law/book/978-3-642-54659-4

To avoid the risk of potential waves of class action of mortgage borrowers and MBS investors, banks may wish to offer mortgage modification voluntarily across-the-board to their subprime customers and adjust their balance sheets accordingly. Beyond the 7 million mortgages already delinquent or foreclosed, there is another 9,8 million households in “negative equity”, i.e. facing the prospect of foreclosure as the value of the home covers reduced percentages of the principal of the mortgage Maintaining the initial rate of about 2% and reducing the principal in line with levels of pre-bubble house values should be fair to both sides. Contract modification and balance sheet adjustment should be initiated simultaneously, the latter anticipating the former and the former correcting the latter. In this way, crisis resolution would extend from modified mortgage contracts “on the ground” through re-priced MBS to adjusted balance sheets of both the sell-side and buy-side of structured credit markets. The resulting recovery of the household sector would be in the own best interest of the financial sector.

 

[1] David Turner, “Credit Crunch Explained to Queen, Financial Times July 26, 2009 http://www.ft.com/intl/cms/s/0/7e44cbce-79fd-11de-b86f-00144feabdc0.html#axzz32ePL1vNm

 

Taking the Taming of Wall Street Seriously

January 26, 2010

Since David Stockman, former designer of the “Reagan Revolution” of fiscal policy, supports Obama’s efforts to tame Wall Street, and does so with arguments of supply-side economics that should please Republicans in the US Congress (see his op-ed “Taxing Wall Street down to size” in the  International Herald Tribune of January 23, 2010), President Obama’s adoption of the “Volcker Rule” for US banking  should perhaps be taken more seriously than a preposterous “maginot line” as in the Financial Time’’ editorial of Januar 23. Not that we believe the separation of deposit-taking banks and securities businesses will solve the problems of the “shadow banking sector”, which spawned the sub-prime bubble. For one, Germany’s industrial development from the 1860’s to the 1990’s has been financed by universal banks sticking, by and large, to conventional practice with reasonable risk management in both lending and securities businesses. What should be taken seriously is the emergence of bipartisan frustration in the US  Congress with the pattern of Wall Street selling fallacies as “financial innovation” with disastrous effects on the real economy, the balance-sheets of the middle class, as well as fiscal and monetary stability.

On the other hand, we agree with the Financial Times’ comment that taxing Wall Street will not make it less fallacy-prone. Nor will regulatory reform for the future bring it to its senses. As George Soros – who has the rare advantage of being a Wall Street insider and a superb detector of fallacies – keeps repeating: regulation will always be behind the curve of financial innovation.

The sobering of Wall Street will only succeed, if it is forced to face the cost of its fallacies, not next time, but this time. The debate on regulatory reform for the prevention of future crises masks the fact that the sub-prime crisis is still unresolved. As argued in our previous post, it has turned into a “balance sheet crisis” of both the US household sector and America’s and Europe’s financial sectors. Granted, while “Main Street” continues to suffer from banks’ reluctance to lend, “Wall Street” appears to have made healthy profits from extraordinary fiscal and monetary support. But the recovery of the financial sector will remain a mirage as long as “toxic assets”, the legacy of the sub-prime crisis, burden banks’ balance sheets.

The balance sheet crisis needs a solution at the beginning of the chain of causation: the mortgage contracts. They should be adjusted to the invalidation of flawed assumptions about future house price inflation by severe house price deflation. These assumptions were a near universal cognitive failure certified, among others, by the British Academy to the Queen. American common law, which is the one that counts in this crisis, offers contract modification as judicial relief in such cases. (For a detailed legal analysis see Henrik Schmiegelow and Michèle Schmiegelow, ”Contract Modification as a rebus sic stantibus Solution to the Sub-Prime Crisis”, Joint Working Paper Series of CRIDES, IRES and CECRI of the University of Louvain No. 02/09 (October 2009).

Not only  would it bring relief to the most affected part of the middle-class,  but it would be in the banks’ own best interest. They should offer mortgage modification voluntarily across-the-board to their sub-prime customers and adjust their balance sheets accordingly. Their recognized losses and resulting capital requirements would still be much lower than those they will face if they let foreclosure waves roll on unchecked. Timothy Geithner should act like Heizo Takenaka in ending Japan’s lost decade in 2002: prodd the banks to see the light of their own best interest in cleaning their balance sheets. See our previous post on “The Sub-prime Crisis: American Origins, Global Effects, Japanese Lessons?”

The Sub-Prime Crisis: American Origins, Global Effects, Japanese Lessons?*

November 25, 2009

* This post is an updated English excerpt of Henrik Schmiegelow”s article “Seikai Keizai Kiki no Dasshutsu no Kagi wa Ajia to Oushu” , Chuokoron (Tokyo), Vol 124 N° 8, p. 152-161 (July 15, 2009)

There is global agreement on both the origin and the effects of today’s world economic crisis, the worst since the Great Depression of the 1930’s. There is, however, global disagreement about the proper solutions. The divergence between unanimity in problem analysis and dissension on policy response is alarming. It suggests inability or unwillingness to learn the lessons of economic history. While the monetary lesson of the Great Depression is well rehearsed (Fisher, 1933; Friedman and Schwartz, 1963; Bernanke, 2002), reluctance to learn the fiscal lesson of that case may be forgivable, since only a war, the Second World War, brought the US a full recovery through fiscal expansion. But policies disregarding an example as recent and telling as Japan’s lost decade in the 1990’s are precarious policies indeed.

I. American origins

The crisis originated in the US. As traced by Felix Salmon in Wired, an application of a standard mathematical formula, the Gaussian copula function, to mortgage default correlations was published in 2000 by a “quant” at JP Morgan Chas. It was severely flawed by an implicit assumption of a continued rise of real estate prices far beyond historical trends (available in Robert Shiller 2005). The assumption was derived from a flimsy record of less than a decade of available price statistics of credit default swaps (CDS), conveniently the period of the last real estate boom.  But it was transformed into a mathematical constant reducing, as if by alchemy, the probability of mortgage defaults. American banks used this magic formula enthusiastically to justify extravagant mortgage lending to low-income (“sub-prime”) homebuyers in the US. Sub-prime mortgages were “packaged” in small slices beyond recognition with prime mortgages in “asset-backed” securities (ABS). ABS were, in turn, repackaged in structured credit instruments called “collateralized debt obligations” (CDO), CDO further reused as building blocks in a higher structured credit architecture called “CDO squared”, and CDO squared in CDO cubed. These securities were rated AAA by the three American rating agencies, insured at low cost by CDS and sold globally to banks blindly trusting “financial innovation” from Wall Street. The result was a financial bubble in the US with pervasive global effects. CDS reached a volume of 60,000 bn US $. Whereas the Japanese bubble was induced from abroad, i.e. intense US pressure on Japan to simultaneously appreciate its currency and expand domestic demand according to the Plaza Agreement of 1985 (see H. and M Schmiegelow”Obei Ijoni Obeitekina Nihon Keizai”(More Western than the West: the Japanese Economy), Chuokoron Vol. 108, No.1 (January 1993), pp. 72-83, p.77), the US bubble was “home-made”.

The crisis erupted in 2007, when the first American sub-prime lenders defaulted, as sub-prime borrowers could not afford the rise from the initial “teasing” rate of 2 percent to the eventual contractual rate of 8 percent of the mortgage. A wave of foreclosures brought real estate prices down. ABS and related CDS became “toxic assets”.  The global financial bubble burst a year later, when the US Treasury and the Fed allowed Lehman Brothers to default, apparently as a warning to the banking sector against reckless risk taking. The action was reminiscent of President Hoover’s stand in triggering the Great Depression and Governor Mieno’s stern monetary move in bursting the Japanese bubble.

II.  Global effects

While the effects of the bursting of the Japanese bubble, though severe and prolonged for Japan, remained contained within the Japanese economy, the US sub-prime crisis caused a crisis of confidence in the global banking sector and hence a global economic meltdown. Uncertainty about the exposure of individual banks to toxic assets put credit markets in a state of freeze. European banks had massively participated in the frenzy of securitization of US mortgages. With the notable exception of Deutsche Bank, which like Goldman and Sachs had doubts about the assumed rise of real estate prices and hedged its bets while selling ABS to other institutional investors, scores of European banks including Germany’s leading real estate lender Hypo Real Estate and several public “Landesbanken” “followed the herd” in blind trust of “financial innovation”. When they noticed that the trust was unwarranted, they realized their exposure was out of proportion with their capital. Unable to put a value on toxic assets and, just like their Japanese colleagues in the 1990’s, not daring to proceed to write-downs for fear of being nationalized, they stopped lending and no longer assumed their function of financing the national economy. Hence even loans unrelated to toxic assets became non-performing and the hidden need of further write-downs grew as in a vicious circle. In a first attempt at quantifying necessary global write-downs in April, the IMF estimated 4.1 trillion $, with 2.7 trillion $ of bad loans and securities originating in the US and 1.12 trillion $ in Europe. Japan, whose banks, sobered by their own bubble experience, had hardly touched ABS, faced “only” 149 billion $.

Early hopes that the still thriving industrial sectors of exporting countries like China, Germany and Japan might remain unaffected by the collapse of the US financial sector quickly evaporated. On the contrary, they became the countries worst affected with declines in exports in the first months of 2009 in the ranges of 21,1% (Germany), 25,7 % (China) and 46 % (Japan). On July 8, 2009, the IMF predicted a deeper recession in Europe and Japan than in the US, with declines of GDP in 2009 of 2,6% in the US, 6,2% in Germany and 6,0% in Japan. For Keynesians, the reason was obvious: the hitherto most important sources of global demand, i.e. the Anglo-Saxon countries combining low savings and high consumption propensities with structural fiscal and external trade deficits, have suddenly disappeared from the international trade equation.

While the October 2009 Global Financial Stability Report of the IMF acknowledges a reduction of global losses by 600 billion to $3.4.trillion – largely due to rising securities values in mid 2009 -, it warns of further credit deterioration, as over half of potential write-down needs through end-2010, estimated at $1.5 trillion, has yet to be recognized. It emphasizes that banks need to crystallize losses through realistic assessment of asset values and that capital levels may need to rise further to rebuild lending capacity to finance recovery. The IMF urges banks to use the chance of extremely low interest rates, wide spreads and, hence high profitability, still prevailing in late 2009 for this purpose. It warns that such favorable conditions may not last, as public credit demand resulting from the massive programs of fiscal stimulus in all major economies might soon exert upward pressure on interest rates.

These figures underscore the urgency of adopting the right strategies to solve the crisis faster than in Japan’s lost decade, but with the strategic pragmatism that helped Japan to recover within 12 months in 2002/2003 ( Michèle Schmiegelow, “Senryakuteki puragumatisumu ni tachi kaere: Nihon keizai e no shohosen” (Recover Strategic Pragmatism: the Prescription for the Japanese Economy) Tokyo: Japan Center for Economic Research Bulletin, 1/10/2002, N°895, pp.4-10) . Unfortunately, so far, dogmatic dissension and, hence, cognitive confusion prevail. Sometimes, the disagreement appears to be between nations, such as between France and Germany or France and the UK, or groups of nations, such as the transatlantic divisions or those between the “Anglo-sphere” and the “rest of the world”, or the G7 and the G20. In fact, the most acrimonious debates are domestic ones, between monetarist and Keynesian economists everywhere, US Republicans and Democrats, Wall Street and “Main Street”, defenders of the Common Law or of Civil Law, advocates of laissez-faire and proponents of social protection.

In early 2009, the US had the initial advantage of a new administration with huge popular support, while Germany’s coalition government was compelled to focus on elections in September 2009. To the global media, Japan, France and the UK appeared much more eager for action than Germany.  But as attested by the IMF’s study The Size of Fiscal expansion: An Analysis of the Largest Countries, in February 2009  with one of the most generous social security systems of the world functioning as an “automatic stabilizer”, Germany was devoting 3.4 percent of GDP to fiscal stimulus, the third largest proportion of major economies after the US (4.8 percent) and China (4.4 percent), but before Japan (2.2 percent), the UK (1.5 percent) and France (1.3 percent).  In May 2009, Japan surged to the top with a supplementary budget adding 3 percent, bringing the sum of all fiscal stimulus programs combined to 5.2 percent.  And yet, just as in Japan’s lost decade, the debate about whether Keynesian stimuli provided so far were sufficient or not, goes back and forth. “Exit strategies” are intensely discussed, while most participants in these discussions, foremost among them Ben Bernanke, are convinced that it is far too early to apply them.

However, even though more fiscal stimulus may be needed to preempt a “double-dip” or even “triple dip” recession with intermittent short-lived recoveries, it will not address the roots of the sub-prime crisis. The crisis has rightly come to be called a “balance sheet recession” because of its origins in the balance sheets of the financial and household sectors, just like Japan’s debt deflation after the bursting of the Japanese bubble in 1991.  The term “balance sheet recession” was first coined for the Japanese recession of the 1990’s by the Head of Nomura Research Institute,  Richard Koo, (see his Balance Sheet Recession: Japan’s Struggle with Uncharted Economics and its Global Implications (2003)). Michael Spence, the former Dean of Stanford Business School whose work on information asymmetries was awarded the 2001 Nobel Price, has emphasized the tremendous depth and destructive power of the balance-sheet destruction characterizing the sub-prime crisis. “In the future”, he writes, “central banks and regulators will not be able to afford a narrow focus on (goods and services) inflation, growth, and employment (the real economy) while letting the balance-sheet side fend for itself. Somewhere in the system, accountability for stability and sustainability in terms of asset valuation, leverage, and balance sheets will need to be assigned and taken seriously”. Japan’s lost decade should serve as a warning of what happens as long as balance sheets are not taken seriously.

President Obama has not only great charisma, but also a vision of structural change in the US economy. As explained in his speech at Georgetown University on April 14,2009  that vision no longer relies on “voracious consumption”, “excessive debt”, and “reckless speculation”, but on savings, education, health care and investments in scientific, technological and ecological innovation. His combination of strategic vision and American philosophical pragmatism is unmistakably reminiscent of the strategic pragmatism that enabled Japan to emerge post-war as the second largest economy of the world .

Unfortunately, US Treasury Secretary Geithner’s efforts to stabilize the American banking system by public-private partnerships are perceived even in the political spectrum favorably inclined to the administration,such as Paul Krugman, as relying to a worrying extent on the very same financial sector whose collective cognitive failures are at the origin of the crisis. Neil Barofsky, the Special Inspector General of the Troubled Asset Relief Program (TARP) has warned that not enough has been done to guard against fraud in a program offering public money to private investors who buy toxic assets. Geithner’s programs cling to the assumption that financial markets know best how to find a price for toxic assets. They require banks holding such assets to sell them, which for fear of having to write down the realized losses after such sales, they are reluctant to do, the more so as Barofsky calls for supervised screening of each security. As neither prospective sellers nor prospective buyers have a clear idea about the value of the toxic assets, the process will be protracted. The “market” cannot clear, as its “sell side” (banks and brokers) and its “buy side” (pension funds, hedge funds, insurers) are fighting each other about who will “control” the regulators. Law suits between mortgage lenders and borrowers as well as sellers, buyers and insurers of mortgage-backed securities have just begun in the US and may take many years at huge legal cost. The world economy seems “hostage” of the outcome of these American lobbying campaigns and legal battles.

While some green shoots began sprouting in the real economy in May/June 2009 as depleted inventories were replenished, and commodities hoarded for a future recovery, banks in the US and Europe continue to fail in their essential economic function of financial intermediation. Instead of being liquidity providers, they have become liquidity users. The German legislation, adopted in May 2009, to allow each German bank to isolate toxic assets in a separate “bad bank” is a strategy of buying time until market dysfunction ends in the US.

The “stress tests” conducted by US regulators at the 19 top US banks were designed to offer a perspective of survival of those banks rather than to encourage the building of sound new banks ready to channel credit to a struggling economy. The projection of combined losses of  599 bn US $ over 2009 and 2010 announced on May 7,2009 did not lift the cognitive fog covering ABS. For “just in time” for the stress tests, on April 2,2009, the Financial Accounting Standards Board (FASB) had responded to pressure from the US Congress to change the accounting rules for banks. Rather than applying the “mark-to-market” rule that force them to report the losses on ABS, they were allowed to use “internal models” in view of “conditions indicating that markets were dysfunctional”. While American banks pressured Japan to impose mark-to-market accounting on Japanese banks burdened by nonperforming loans in 2002, they asked key members of the US Congress to pressure the FABS to exempt them from this very same rule in April 2009 (Wall Street Journal “US Congress helped banks defang key accounting rule”, June 4,2009).

This presages a replay of Japan’s decade of fruitless attempts at different fiscal and monetary crisis solutions without prior cleaning-up of the financial sector. Only in 2002, when the Koizumi government finally imposed complete rigorous write-downs of bad loans, Japan’s banks recovered the ability of financial intermediation in the economy. They began responding functionally to the Bank of Japan’s path-breaking policy of quantitative easing under Governor Fukui. In the third quarter of 2003, the success of these policies was demonstrated:  the Japanese economy bounced backed with an annualized growth rate of 6 percent. Of course, the upswing of the global economy at the time, and more particularly Chinese demand for Japanese exports did help. The Japanese case is a historical example to be remembered today.

III.  Japanese Lessons ?

The case suggests that two cognitive efforts must be undertaken, before new policies can be designed to put the global economy on the path to recovery:

– Finding a method of re-pricing the toxic assets for rapid write-downs

– Identifying new sources of global growth

1. Re-pricing toxic assets

At first sight, the Japanese case seems to indicate an effective solution to solve the balance sheet crisis. Only in October 2002, when Prime Minister Koizumi appointed the determined reformer Heizo Takenaka as Head of Japan’s Financial Services Agency, were the balance sheet problems of the financial sector seriously addressed. Takenaka enforced a fair value re-pricing of bank assets and rigorous write-downs of non-performing loans combined with recapitalization and restructuring of the banking sector. As mentioned above, only then did Japan’s banks recover the ability of financial intermediation in the economy.

During the preceding decade, Japanese banks had been protected, just as US banks today, against revealing the extent of their capital shortfall. Similarly, they became liquidity users rather than liquidity providers. And similarly they failed to recover the confidence essential for the functioning of financial markets.  When Takenaka finally imposed fair value re-pricing of bank assets and corresponding write-downs of bad loans in 2002, he did so in response to intense prodding by the US government and American banks. The immediate success of that strategic policy reversal perfectly vindicated the validity of the American arguments at that time.

And yet, as evidenced by the successful efforts of the American Bankers Association to secure exemptions from fair value accounting as long as “dysfunctional market conditions”, US banks are not ready to adopt the strategy recommended to the Japanese colleagues at the time. Arguably, the differences between the Japanese bubble of the late 1980’s and the sub-prime bubble of the mid 2000’s may explain some of the reluctance of US banks to heed their own advice of that time. Although both Japan’s debt deflation and the US sub-prime crisis are balance sheet crises, the differences are significant on at least two levels, the degree of securitization of the non-performing assets on the balance sheets and the doctrines on a government role in recapitalization and restructuring of the banking sector.

Although securitization of debt had made advances in Japan just as elsewhere, nothing comparable to the hypertrophied financial engineering of the US sub-prime bubble described above was present in the Japanese bubble of the 1980’s. Although massive and debilitating, Japan’s decade long debt deflation was still essentially a classic crisis of banks burdened by non-performing loans, more comparable in the nature of its balance sheet problems to the Swedish banking crisis of the early 1990’s than to the “toxic assets” crisis of financial engineering in the sub-prime case. Arguably, what distinguishes the sub-prime crisis is that it is also a cognitive crisis. It was a failure of “many bright people”, as certified to the Queen of England by the British Academy. Hence bankers may feel justified to plead that it is difficult to re-price the toxic assets on their books.

In a working paper of the Joint CRIDES/IRES/CECRI Working Paper Series on Institutional Competition between Common Law and Civil Law on contract modification as a solution to the subprime crisis,  we show how cognitive crises can be dealt with in contract law and hence in the assessment of the value of mortgage loans. US banks do not yet seem to be aware of that solution, however, and the point remains that the cognitive failure of financial engineering in the sub-prime crisis continues to be invoked to justify their reluctance to re-price their toxic assets.

While in 2002 US banks have wholeheartedly welcomed Heizo Takenaka’s vigorous enforcement of the strategic triad of write-downs, recapitalization and restructuring of the banking sector in Japan, they would certainly balk at a similar treatment to themselves by the US government. Although even the strongest US banks have gladly accepted short-term bail-outs, and many not so strong ones continue to depend on what George Soros calls “artificial life support”, and although there was significant prodding even from the Bush Administration in the Bank of America/Merrill Lynch merger, an all-out government-led restructuring of the banking sector would be rejected as not in keeping with free market rules and share-holder rights. In view of the large literature on the uniqueness of the relationship between government and business in Japan, the Takenaka strategy can easily be discarded as not applicable to the West. Timothy Geithner has a much more restrained view of government’s role in financial markets, and his view is shared by the “centrist” spectrum of the Democratic Party. Together with the Republican Party, this spectrum appears to command the inclination of a majority of the US Congress in this respect.

In the West, if everything else fails, the endgame will inevitably involve protracted legal battles. We believe that there is indeed a legal solution to the balance sheet crisis resulting from the sub-prime failure. In the working paper already cited, we argue that the earlier the legal dimension of failed sub-prime lending is recognized, the easier it will be to avoid the enormous cost of such an endgame.

2. Identifying new sources of global growth

If we take President Obama by his word, the American economy will no longer be consumer of last resort for the world economy.  Unlike Japan’s economy in 2003, the recovery of today’s world economy will not be assisted by some “external” source of demand. Private enterprises and public policy-makers everywhere in the world will have to look beyond demand-pull from abroad and organize Schumpeterian supply-push innovation that creates its own demand. This is the most promising form of strategic pragmatism in the economic field. Japan’s microelectronic revolution in the 1970’s and America’s software revolution in the 1980’s are the leading examples. Post-war Europe did not offer a technological revolution, but mustered strategic pragmatism for political innovation: the functional integration of Europe’s economy. Its success demonstrated that prosperity springs not only from Ricardian comparative advantage in international trade, but also from trade between industrial nations producing similar goods and services.

There is, however, one new source of demand to consider: the domestic demand of 3 bn people in Asia. Except for Japan and urban coastal China, it is not yet fully present in markets. But it just waits to be awakened by adequate policies of economic and social development as well as economic integration in Asia. Western China’s pent-up demand and the emerging Chinese legislation of a social security system on the Northern European pattern will unleash enormous domestic dynamics, offsetting some of the declining US demand for Chinese products. ASEAN+3 seems on course to organize proper flows from savings to investments in the Asian region (see our post “is Asia’s integration less functional than Europe’s,”). Thanks to such an “Asian solution” to the American sub-prime crisis, Europe’s functional experience may yet be tested on a global level.

Which new world order: unipolar? bipolar? multipolar? non-polar?

November 23, 2009

Towards the end of the George W. Bush Administration, a series of essays by Richard Haass, former Head of Policy Planning of the State Department of the Bush Administration, now Head of the Council on Foreign Relations, marked a breathtaking change in the  analysis of America’s national interest in one or the other  conceivable structures of world order. Beginning with America’s self-assessment as the anchor of a unipolar world (Richard Haass, “The Case for Integration,” National Interest online, January 9, 2005), he then  shifted the focus to a multi-polar model to be used actively by Washington in a “Palmerstonian moment” (Richard Haass, “The Palmerstonian Moment,” National Interest online, February 1, 2008), and finally arrived at the preference for a non-polar world that would ultimately be in America’s own best interest (Richard Haass,  “What follows American Dominion?” Financial Times, April 16, 2008).

I. Thinking and Rethinking on Unipolarity, Bipolarity, Multipolarity,

Today, world opinion is essentially unanimous about the end of unipolar or bipolar ideology of the Neo-conservative spectrum. Multi-polarity appears to many as the obvious alternative to both.  But before mistaking the multi-polar alternative for a scientific certainty, it is worthwhile to retrace the thinking and rethinking of an acknowledged pragmatic voice of the Bush Administration about the sequence of changing world-views between 2005 and 2008.

Not much needs to be said about the passage from unipolar to multi-polar analysis. Unipolarity was empirically refuted by the failure of the US-led “coalition of the willing” in the Iraq war. The interesting aspect is the post-Iraq war, search for realist alternative by the Head of Policy Planning of the State Department of the Bush Administration. Almost inevitably, one might say, the search resulted in finding the classical balance of power prescription of the 18th and 19th centuries applied to the perceived situation of the 21st century. Of course, it seemed attractive for an US Statesman to be the “balancer” of such as system like Metternich, Palmerston or Bismark in their times.  The history of those older balance of power plays shows however, that multi-polarity is a structure that can easily turn against the “balancer” if other players feel threatened by his influence and coalesce against him.

This risk became immediately apparent in 2008 when neo-conservatives called for a “league of democracies” that would have challenged Chinese and Russian “autocracies” to enter a new bipolar competition of systems. Russian and Chinese political scientists quickly scrambled to counter the universalist dissemination of Western values by asserting Confucian values  (Xiang Lanxin, “What Prospects for Normative Foreign Policy in the New Multipolar World?” Paper presented at the 29th session of the CEPS/IISS/DCAF/GCSP European Security Forum, Brussels, May 26, 2008) values of the Russian Orthodox Church (Andrey Makarychev, “Rebranding Russia, Norms, Politics and Power,” CEPS Working Document No. 283, February 2008). Such a league would also have to get by without India, the world’s largest democracy. Despite bilateral territorial conflicts, an influential segment of the Indian political establishment feels greater cultural proximity to China than to the West, or at least to its neo-conservative form based on a violent, utopian idealism (Radha Kumar, “What Prospects for Normative Foreign Policy?” Paper presented at the 29 th session of the CEPS/IISS/DCAF/GCSP European Security Forum, Brussels, May 26,2008).

Both realists and idealists in the traditional sense had difficulties suppressing their dismay at how the Neo-conservative rhetoric of a bipolar conflict between democracy and autocracy misled Georgia into military action in South Ossetia in August 2008, inviting massive Russian intervention and certain Georgian defeat. Since the US was unable to come to the rescue of Georgia, the final effect of the bellicose rhetoric was to evidence the powerlessness of its authors. Richard Haass’s words remained unheard. Barbara Tuchman’s “March of Folly” came to mind.

The fundamental problem of multi-polarity is that it only gains attraction as the negation of unipolarity, as resistance to an existing empire or hegemonic state. This was the case with the Peace of Westphalia, which ended the universal claim of the Holy Roman Empire and established the international system of sovereign nation-states that henceforward bore its name. It was once again the case with De Gaulle’s sensational recognition of China in 1964, which he intended not only as a negation of the bipolar system but also of Anglo-Saxon hegemony West of the Iron Curtain.

The Westphalian system is the only historical example of a multi-polar world order  successfully established and maintained over a prolonged period of time. But this says nothing about its suitability as a positive strategy for preserving the peace between states. While the European states in the system endeavored to shape domestic peace, domestic economic developments and social coexistence in a more or less beneficial way, they regarded the international system as area in which they were free to  choose between diplomacy and war. They used this freedom with gusto, and mostly with the aim to expand their own power, state territory and access to economic resources at the expense of other states in the system or colonies not possessing statehood. The predominant state practice was in keeping with Hobbesian political theory,   in which Hobbes’ Leviathan ensures order within the states but in which the law of the jungle governs relations between states.  

Respected realists such as Henry Kissinger and Richard Haass have praised the European pentarchy (Great Britain, Russia, France, Prussia and Austria) as an exemplary world order, but in the eighteenth and nineteenth centuries, there were no fewer than 52 wars among the five members, not to mention wars with other states or in territories outside Europe not recognized as states. It appears doubtful that the willingness to switch alliances at any time, which Lord Palmerston saw as in Great Britain’s national interest, really contributed to preserving peace and the balance of power (see Graph 1)

In order to avoid wars at least part of the time, every system based on a balance of power requires statesmen of extraordinary analytic faculty, such as Palmerston, Bismarck and Kissinger. As soon as these statesmen “leave the ship” – in the figure of Bismarck in  Punch’s 1890 cartoon -, the system threatens to collapse. This is why the rest of the world could not find much comfort in Richard Haass’ plea for a “Palmerstonian moment” on the part of the US, not even as an alternative for the uni-polarity associated with the political adventure  of the Iraq war.

This is especially true of the EU, which has no foreign policymaking authority of its own, despite the name given its “Common Foreign and Security Policy”. Even after the adoption of the Treaty of Lisbon, it can make no decisions concerning war or peace without the approval of its member states. Germany will always remain the biggest hurdle, since any German consent for military missions needs prior democratic legitimization by the Bundestag.  Hence the EU  cannot keep up with China, India, Russia and other power centers organized as nation-states. As a consequence, Richard Haass believed that NATO was losing its value for the US and that changing alliances like in Palmerton’s day were preferable. The EU is not even included on most lists of a multi-polar global pentarchy in the twenty-first century, least of all Kissinger’s. The most dramatic implication of Richard Haass’  Palmerstonian Moment” was that the pentarchy had moved from Europe to the Pacific region, and that the majority of the five power centers  was henceforth constituted by three Asian states—China, India and Japan (Graph 2).

II. Beyond polarity

This does not mean, however, that a multipolar world order along the lines of a globalized Westphalian system had won the day. For the very nations considered by proponents of realism as the three new Asian power centers are also the driving force behind a renaissance of multilateralism and are pursuing a forward-looking strategy of functional integration in  Asia. The more unilaterally the Bush Administration has acted, the more China has championed multilateralism  (see Henrik Schmiegelow, “Asia’s International Order,” Internationale Politik (IP) Global Edition, Fall 2007, p. 17-22). The North Korean nuclear crisis marked the first time China voted in favor of sanctions in the UN Security Council—targeting a neighbor that has long been considered its charge. In the six-way negotiations on denuclearizing the North Korean end of  the “axis of evil”, Washington began relying on China to work out a solution. It is therefore no surprise that Richard Haass highlighted the North Korean settlement when he moved on to argue in favor of a non-polar world  in the last article of the series cited above. 

Like other Asian states, especially members of ASEAN,  Japan and China have closely observed Europe’s experience in functional integration. They have drawn their own conclusions from evidence of both the strengths and the weaknesses of the European model.  And they started a process with a sequence suitable to Asia (see our post “Is Asia’s Integration less Functional than Europe’s?”). As in Europe, the functional integration of Asia produces such large advantages for one-time warring parties that there is no reasonable cost-benefit relationship to justify wars. It is the best example of today’s opportunity for  a world order surmounting the risks of the Westphalian system.

Moreover, it is an example that cannot be criticized as an outgrowth of Euro-centrism or an aggressive expansion of western values. Fortunately, cost-benefit analysis can be performed using trans-cultural math. The integration of the Chinese national economy into the world economy, especially the supply chains between Chinese, American and Japanese companies, suggests that the Chinese see no contradiction of such a process to Confucian norms. Russia, which thus far has profited mainly from rich natural resource deposits and is much less integrated into the world economy than China, is already feeling challenged to learn lessons from this example. After 2006, Russia’s renewed power led to Putin’s deliberately sharp-edged foreign policy, but a “Medvedev moment” was supposed to convey a somewhat softer image of this reemerging power. The new president was quoted as saying that, in the end, Russia will not earn the world’s respect “through strength but through responsible action” (Nikolai Petro, “Seizing the Medvedev Moment,” International Herald Tribune, March 14, 2008). Unfortunately, the “moment” seemed abruptly suspended in the “bipolar” derailment of Georgia’s South Ossetian adventure. But eventually, cultural relativism will not stand in opposition to a functional understanding of national  interests in Russia either, however nationalist the tradition of the Russian-Orthodox Church be.  Much depends on the West’s recovery of its own capacity of functional calculation of interests in relation to Russia.

As we shall discuss in our next post, the global economic meltdown of 2008/2009, the worst since the Great Depression contributed to a new awareness of the world having no other choice than working as a problem solving community.

The world as problem-solving community

July 17, 2009

Like every new century, the dawn of the twenty-first tempted the pundits. They eagerly mustered an ample supply of adjectives to describe it: “American”,  “Pacific”, “Asian”, “unipolar” (American), “bipolar” (democracies/autocracies) and “multipolar” (USA, Russia, China, India and Japan), see our previous post on “Which New World Order?”. But the decade between 1997 and 2007 saw such a rapid succession of contradictory events that the validity of these predictions became easier to measure in months than in centuries: financial crises in Asia (1997), Russia (1997) and on Wall Street (LTCM 1998; US military interventions with UN Security Council mandate (Afghanistan, 2001) or without (Kosovo, 1999, Iraq 2003); economic rise-and-decline indicators favoring China since 2001, India since 2005, Russia since 2006; challenges to US power by terrorism (September 11, 2001), insurgencies (Iraq, Afghanistan 2003-2007), or diplomacy (“old Europe” against the Iraq war 2003, effective Chinese prodding in the six-way negotiations on denuclearizing North Korea replacing verbal US pressure in 2007); functioning nuclear deterrence taming conventional belligerence between India and Pakistan (2002); the growth of Middle Eastern and Asian sovereign funds (from 2007); climate change on the G-8 agenda (2007) and skyrocketing energy and foods costs (2007/2008); and, finally, a global economic melt-down  not seen since the Great Depression. The acceleration of changes forced pundits to ponder.

The foreign-policy schools of thought that have been competing for 300 years in the western world need revisiting. Idealism appeared to have been discredited after the Iraq war, while realism was drawing new followers. But this reaction did not do justice to either approach. For the neo-conservative war to spread democracy was the expression of a third school of thought, a combination of idealism and realism that is both aggressive and utopian (Table 1). The new world order we ought to look for, should pragmatically combine the still applicable virtues of traditional idealism and political realism without relapsing in the dogmatic contention that has gone on since John Locke and Thomas Hobbes. It should dispense with all polarities, all “rise-and-decline” predictions, and all power hierarchies in the international community. The events from 1997 to 2007 listed above make one thing clear: the powerlessness of the “power” of even the most powerful of the nation states as defined in the Westphalian system.

Table 1: Foreign Policy Schools of Thought

1. Multilateralism and functionalism

The new Asian power centers discussed in our previous post are not alone in initiating  integration processes. Multilayered, overlapping networks of functional cooperation span the globe. Figure 4 shows the most important regional organizations in Africa (AU, SADC), America (OAS, Mercosur, NAFTA, SICA), Asia (ASEAN, ASEAN+3, East Asian Summits), Eurasia  (SCO), the Gulf region (GCC) and the Pacific Rim (APEC, US-Japanese Treaty on Security and Cooperation).

Figure 2: Asymmetrical overlaps of functional organizations

Source: Michèle Schmiegelow & Henrik Schmiegelow, “Gulliver’s Shackles”,Internationale Politik Global Edition Vol 9 N°4 (Winter edition), p.54-61

These functional networks may appear suspect to traditional power centers since they function like the strings used by the Lilliputians to tie down Gulliver. For instance, Washington observed with initial skepticism how the ties between ASEAN, China, Japan and South Korea (ASEAN+3) led to an astonishing depth of economic integration without its involvement. And all this happened within the geographic area of APEC, which the US itself had inspired. On May 22, 2008, reviving the 1977 Fukuda doctrine of his father, Japanese former prime minister Yasuo Fukuda took the wind out of the sailsof such US concerns by advocating a long-term transformation of the Pacific into a “inland sea” analogous to the seventeenth-century Mediterranean. He invited the North American and Latin American countries bordering the Pacific to participate, along with Australia, New Zealand, the ASEAN states, China and Russia. A student exchange program emulating the European Erasmus system would establish this functional integration in the minds of future generations.

Yukio Hatoyama, Prime Minister of Japan since September 2009, went further. In an article entitled “My political philosophy” published shortly before his election in the Japanese monthly Voice , he referred to the ideas of Count Richard Coudenhove-Kalergi , the paneuropean visionary, and  advocated an East Asian Community. We are delighted that his advocacy is very close indeed to our arguments explained in our article “The Road an Asian Community” published in the November 2007 issue of the global edition of Internationale Politik, as well as in our blog posts on functional integration in Asia. It seems Europe has contributed to the emergence of a new world order, if only through the pale immateriality of thought.

Today’s interdependent world faces problems that truly demonstrate the powerlessness of “power”. Richard Haass emphasized this point using the example of American GIs in Iraq. Though equipped with high-tech weapons, they are powerless against “low-tech” ambushes by insurgents (On the remarkable evolution of Richard Haass arguments see our previous post on „Which New World Order?“). Another example is India’s and Pakistan’s reluctance to actually use either the millions of soldiers deployed at their border or their nuclear arsenals in the 2002 Kashmir crisis, which was provoked by an Islamist terror attack in New Delhi.

The recurring crises of US financial markets demonstrate the fallacy of the concept of “economic power.” For Henry Kissinger, the conservative political realist, the discontent globalization’s losers analyzed by liberal economist Joseph Stiglitz is a serious concern. He castigates the “profligate and obscurantist practices” that caused the US sub-prime crisis (and preceding crises). He advocates the combination of an economic and a political world order (Henry Kissinger, “Falling behind: Globalization and its Discontents,” International Herald Tribune, May 30, 2008.) This takes us far from the Westphalian system and the balance-of-power model, of which Kissinger has always been the foremost analyst.  Traditional political power cannot slow down or stop the melting of the polar icecap, global epidemics, the depletion of finite resources, and so on. There is increasing awareness throughout the world that everyone is in the same boat when it comes to finding solutions to global problems.

When the 2007 US sub-prime crisis grew into the worst economic meltdown since the great depression of the 1930’s between September and November 2008, major “powers”, regional organizations and multilateral institutions were pushed by a rapid succession of neo-functional spillovers:

–          in September: international policy coordination of central banks which had been considered out of fashion in the unipolar 1990’s,

–          in the second week of October: joint action of EU member states to recapitalize their banks and guarantee inter-bank lending, a method initially rejected but, once implemented in Europe, immediately adopted by the US.

–          in the third week of October, when the full impact of the financial crisis on the real economy in China as well as in G 7 countries became apparent: a meltdown of commodity prices including a “reverse oil shock”  (David Yergin) changing the perceived “power balance” between resource-rich “authoritarian” Russia, Venezuela and Iran and the G 7 countries

–          on October 24/25  at the ASEM summit:  basic agreement between EU members and ASEAN+3 members on the necessity to strengthen regulatory supervision and stabilization of global financial markets

–          on November 15th at US invitation: a second “Bretton Woods Summit” to adapt IMF and World Bank to the challenges of the 21st century.

Since then, the G 20 has emerged as a new global policy forum, diluting the “shares” of the G8 in world leadership. As a result, the world has become much more multilateral even in what had long been considered as its most influential multilateral policy procedures.

2.  The world as problem-solving community

In our previous post we have recalled the shift to a more dispassionate approach to foreign policy towards the end of the George W. Bush Administration.  It had been a significant recognition of US interest in a functional world order. President Barack Obama’s foreign policy discourse promises the return to important fundamentals of American idealism, most ostensibly in his plea for nuclear disarmament, his offer of dialogue with Islam, his prodding of Iran to turn its fist into an outstretched hand, his readiness to share leadership on major world issues with China. His foreign policy practice, which is perceived by some as lacking decisiveness and profile, in fact constitutes a welcome revival of American philosophical pragmatism (Charles Peirce, William James and John Dewey). It provides an effective antidote to the violence-prone utopianismof the neoconservatives, which intellectual historian John Gray sees as having much in common with the methodology of Marxist world revolution (Reviewed in Frankfurter Allgemeine Zeitung, “Der Übergang der Utopie zu den Neokons,”(“The Passage of Utopia to the Neocons”) April 16, 2008). The open debate within the Obama Administration on a new strategy in Afghanistan is the opposite to the neo-conservative decision-making style on Iraq. That style had been inspired by Chicago philosopher Leo Strauss (Table 1, right column) whose discourse on a platonic elite that should at times withhold the truth from the uneducated masses was a startling step backward from both critical rationalism, today’s universal standard for scientific theory (see Karl Popper, Conjectures and Refutations: The Growth of Scientific Knowledge (London Routledge & Kegan Paul (1962) New York: Basic Books (1963)),  and the political philosophy of the open society (see Karl Popper, The Open Society and Its Enemies (London, 1945) Princeton: Princeton University Press (1971)), which decisively shaped postwar Europe.

The advantage of American philosophical pragmatism is that it does not force praxis into the service of a theory that dogmatically seeks self-confirmation— such as neo-conservatism in the Iraq war. Inversely, fully aware of the fallibility of human knowledge, it examines all available theories with respect to their usefulness for problem-solving practice. European trans-atlanticists might also take a cue from it. At any rate, America’s partners in Asia feel more comfortable with American philosophical pragmatism than with neo-conservative dogmatism. Japanese economic policymakers have already used this philosophy as the basis for a strategic pragmatism that is recognized and used as a model throughout Asia (see our post on “What is Strategic Pragmatism”).

The world order that is urgently needed is, we submit, a problem-solving community. Its fundamental trans-cultural norm should be a simple categorical imperative, superbly defined by Hans Jonas (Das Prinzip Verantwortung: Versuch einer Ethik für die technologische Zivilisation (The Responsibility Principle: Essay on an Ethics for the Technological Civilization), Frankfurt am Main: Insel Verlag, 1979) :“Act in such a way that the maxim of your action is compatible with the survival of humanity”.



How Should the Atlantic Community View the Asian Community?

January 20, 2008

Before the recent Asia issue of Internationale Politik, the emerging Asian community did not receive much attention in the Atlantic Community. Inversely, European integration as inspired by American functionalism has attracted intense Asian interest for decades. The imbalance of attention is not in the Atlantic community’s own best interest. Here are six proposals to reduce the Atlantic deficit.

The first concerns political theory. The postwar international order was inspired by American idealism: Atlantic Community, United Nations, Bretton Woods system, Europe’s integration. Asia’s integration should therefore appear familiar and welcome, if not to political realists, at least to idealists. Instead, today’s contending Hobbesians and Lockeans agree on one thing: discounting Asian integration. Realists consider functional integration unrealistic anywhere, be it in Europe or Asia. European idealists perceive Asia as divided by power politics, cultural diversity or nationalism, and therefore incapable of applying the European pattern. Both schools should prepare themselves for refutation by Asian evidence.

Second, we need to revisit functionalist integration theory. If its (American) founding fathers could see the Asian evidence today, they would classify it as an advanced stage in the promotion of peace and prosperity between former enemy nation states through mutually advantageous exchange of goods, capital, services, infrastructures and information. Like Europe’s nation states, most ASEAN and ASEAN+3 states are former enemy states. The Philippines, Malaysia and Indonesia, on the brink of war over Borneo, thought better of it and, prodded by Singapore and Thailand, instead became cofounders of ASEAN in 1967. Today, China and Vietnam are linking their portions of the “Asian highway” at Lao Cai, theater of their bloody war for influence in South East Asia in 1979. However, the Asian case of functional integration exhibits a sequence of trade integration and institution-building strikingly different from the European case. Asia’s integration began with a classic functionalist pattern: enterprise-driven flows of foreign direct investment and trade despite tariff barriers. By 1997 already, intraregional trade accounted for 51 percent, close to Europe’s 62 percent. Asia’s economic institution building began only in 1997 in reaction to the Asian financial crisis. By contrast, Jean Monnet’s Europe needed first neo-functionalist strategy, i.e. the building of supranational institutions, before two-thirds of Europe’s trade finally flowed into the bed prepared by the customs union, the single market, and the currency union. This difference is certainly not a sign of dysfunctional weakness in Asia’s pattern of integration.

Third, we must realize what the Asian community may mean for the world economy and the international system. With Japan, it includes the second largest mature economy after the US, with China and India, the biggest emerging economies. American Palmerstonians have globalized the model of Europe’s 19th century balance-of-power pentarchy: US, Russia, China, India and Japan. Europe has disappeared in the process. Asia emerged with the majority of the players. American idealists may focus on the peaceful, autonomous spread of democracy in Asia and the free trade opportunities in ASEAN’s project to create an Asian trade zone of 3 bn people with an annual production of $ 9.000 bn. In the US subprime crisis, investors considered Asia’s emerging markets for the first time as “safe haven”, one sign this crisis may be a turning point for the world. Eminent economists discuss an Asian monetary regime. America continues to wield the greatest power and wealth for the foreseeable future, but it can no longer manage the world order alone, not even with Europe’s undivided support.

Fourth, ideological rearmament such as Robert Kagan’s vision of a struggle of Western liberalism against Chinese and Russian autocracies or Edouard Balladur‘s plea for a “union occidentale” circling the wagons against Asia’s rise is certain to feed the media’s hunger for big words. The convergence of neo-conservative and Gaullist paranoia is striking. But like all paranoia, it is full of risks and empty of solutions. The Atlantic Community should heed the lessons of the Iraq war and return to a more rational path.

Fifth, the Atlantic and Asian communities’ interests overlap functionally. For any of the most pressing multilateral issues, from climate change to non-proliferation, Asia’s contribution is indispensable. Foreign Minister Steinmeier’s call for partnership should be heard.

Sixth, the Asian case contains useful lessons. Asia’s functional integration avoids the contention between idealism and realism. It is the result of political and entrepreneurial decisions with strategic pragmatism. Europeans dismissing pragmatism as opportunism err. According to Kant, the necessity to decide exceeds the possibility to know. This makes strategic pragmatism ethically superior to dogmatism. As a philosophy, pragmatism was developed in America by Charles Peirce, William James and John Dewey. Today’s Asia stands out by strategic practice of that philosophy: Setting ambitious goals, but without ideological bombast, working with long-term horizons, but always ready for trial and error. Inspired by America’s best philosophy, Europe should learn from Asia.

Is Asia’s integration less functional than Europe’s ?

November 13, 2007

If we are asked, whether there are any differences between Asian and European integration processes, our answer is yes. There are strikingly different sequences of classical functionalist and neo-functionalist processes and evidently different levels of strategic reliance on one or the other of these two patterns of integration.

Is Asia’s integration less functional than Europe’s because it follows similar patterns in a different sequence and with a different emphasis than Europe ? Our answer is no.

Many of the eminent Asian authors cited in our previous post and in the November 2007 issue of Internationale Politik—Global Edition refer to the European experience when analyzing Asian integration. Ong Keng Yong emphasizes the discerning use of “low politics” in functional cooperation and “high politics” on strategic issues. This is precisely the differentiation the American creators of neofunctionalist integration theory led by Ernst B. Haas had recommended to the Europeans for overcoming inevitable crises of trust in the process of building a community.

Ong Keng Yong and Qian Qichen underscore the tension between unity and diversity. This sounds like a variation on a European theme, though the differences between development stages and political systems are still much larger in Asia than in Europe. Both authors underscore the necessity of a step-by-step process similar to the “incremental” approach recommended by American integration theorists to European policy makers.

Nonetheless, the ASEAN Charter, which will be signed at the ASEAN summit in Singapore in November 2007, is a document that can be termed a “constitutional framework,” as it is by Ong Keng Yong. It will presumably go into effect before the European reform treaty, which, since the rejection of the European draft constitution, may no longer be called a constitution. Perhaps that is because ASEAN has a much leaner institutional structure than the European Union, doing without a supranational commission of the European type. The ASEAN Charter is content with a standing committee of the permanent representatives of member states in Jakarta, comparable to the European Union’s Committee of Permanent Representatives (COREPER) in Brussels. The secretary general has a mandate to monitor the implementation of ASEAN agreements and decisions.

Does this leaner institutional structure mean that functional integration and community-building in Asia have less potential than the same processes in Europe? This would be a premature conclusion. To be sure, the Asian case exhibits a sequence of economic integration and institution-building strikingly different from the European case. As early as 1997, intraregional trade accounted for 51 percent of total foreign trade conducted by all the states in East and Southeast Asia, surpassing NAFTA’s 45 percent and coming within range of the European Union’s 62 percent. Asia’s integration began with a classic functionalist pattern: enterprise-driven flows of trade and foreign direct investment even across customs boundaries.

By contrast, Jean Monnet’s Europe had to start with neofunctionalist strategy and the building of supranational institutions before two-thirds of the trade flows posted by European member states finally flowed into the bed prepared by the customs union, the single market, and the currency union. This difference is certainly not a sign of dysfunctional weakness in Asia’s pattern of integration.

Asia’s interest in creating institutional structures in the economic realm was first triggered as late as 1997 by the Asian financial crisis. Haruhiko Kuroda was among the authors of the Chiang-Mai initiative for cooperation on monetary policy, the response by ASEAN+3 to the sudden drain of international capital. It was reminiscent of the numerous neofunctionalist spillovers through which Europe rallied and converted dangerous crises into ever-higher levels of institutional integration.

If the enormous currency reserves held by China and Japan are added together, the swaps that the two countries can provide to the other ASEAN+3 countries have the potential to eclipse the resources of the International Monetary Fund by far. Initiatives to create an Asian bond market as a way to channel Asian savings into Asian investments are being continually enhanced. See the article “How ‘Asian’ will Asia be in the 21st Century” offered for download on our website.

In carefully weighed words, Kuroda describes the possibilities for cooperation on financial and monetary policy in Asia. The brevity and cautious formulation of his paragraph on a common currency basket for ASEAN or ASEAN+3 (the latter including Japan and China) is understandable after the stir caused last year among Western observers by his proposal for an Asian currency unit patterned on the European currency unit in an earlier phase of Europe’s monetary integration. But one needs to read between the lines. Kuroda comments that Asia, unlike Europe in the run-up to the currency union, has no anchor currency like the German mark. This is not a rejection of the idea of Asia’s having its own model of currency integration, however. He diplomatically leaves unsaid that Asia has not only one but two anchor currencies—China’s and Japan’s.

A “common currency” does not need to be a single currency like the euro; national currencies need not be surrendered. It can be based on a basket of several anchor currencies provided it is possible to overcome the kind of competition for political prestige seen in the period predating the European currency union.

The fact that the exchange rate between the yen and renmimbi has meanwhile become remarkably stable (and that both currencies tend to move parallel to the dollar and the euro) can be explained by the economic interdependence of the two countries. (China is now Japan’s most important trading partner, surpassing even the United States.) Japanese economists like Kuroda have not been the only ones who have been thinking about Asian monetary integration for some years. Chinese economists have been pondering it too, and they are encouraged by the American “father” of the theory of optimal currency areas, Robert Mundell. At a conference organized by Beijing University in May 2002 on the subject of Asian economic cooperation in the new millennium, he was asked whether Asia needed a common currency. His response: “My answer is yes.”

Are the prospects for conciliation between Japan and its Asian neighbors as good as those between Germany and its European neighbors ? Our answer is yes, although we hasten to add, particularly to our German compatriots, that Germany’s and Japan’s burden of history are not comparable, since Japan’s history does not contain anything like the Holocaust.

In his essay in the November 2007 issue of Internationale Politik, the Editor of the liberal Japanese daily Asahi Shimbun, Yoshibumi Wakamiya disagrees with European skeptics of Asian integration who are still inclined to forecast that any Asian integration attempt will run aground on the rocks of Japanese and Chinese nationalism. He points out that it was Shinzo Abe who broke the political ice on the economically so hot Sino-Japanese relationship at the beginning of his short premiership in 2006 by visiting Bejing and abstaining from worship at the Yasukuni shrine. Rather than discounting this success as the result of opportunistic tactics of a political novice, we should extend the analysis to the remarkable fact of the Chinese willingness to accept Abe’s conciliatory gesture. Seen from this angle , it looks like Hegels’s “cunning of history” that it was left to Abe, grandson of Nokusuke Kishi, and thus heir to a political family associated with Japanese nationalism, to reopen the path to Sino-Japanese reconciliation. Wakamiya describes the long sequence of Japanese efforts to address the burden of Japanese history in relation to China and Korea.

The task of reconciling Japan’s former wartime enemies is in good hands with the present Prime Minister, Yasuo Fukuda, who succeeded Abe in September 2007. He can be expected to revive the “Fukuda doctrine” of his father, Takeo Fukuda, who was the first to place national policy toward Japan’s neighbors on an ethical basis, when he was Japan’s Prime Minister in 1978. Together with Helmut Schmidt, Takeo Fukuda later founded the Interaction Council whose aim is the global promotion of an ethical orientation of policy.

Read more in our article “The Road to an Asian Community” offered for download on our website.

Why Europeans discount Asia’s integration, wrongly

November 12, 2007

On the rare occasions that Europeans think about Asia’s integration, they seem to suffer from amnesia. Forgetting the impediments, setbacks, and crises that Europe had to overcome in the course of its own integration, they do not see much chance of success for functional integration and community-building in Asia. Rivalries between the great powers are said to be too great, nationalism too sensitive, cultural differences too large, ideological rifts too deep, markets too controlled, monetary cooperation too implausible, and competition for energy sources and raw materials too intense.

What many Europeans forget is that in 1945 few would have held out much hope for something like the Coal and Steel Community, which was established just six years later. And after the founding of the Fifth Republic in 1958, few figured that the French would consent to the United Kingdom entering the European Community (EC) in 1973. After all, had de Gaulle not resolved to bind Germany to France in the European Economic Community in order to counterbalance the Anglo-Saxon powers?

Few recall today that the project of forming a currency union seemed dead after the Werner Plan foundered on French mercantilism in the 1970s.1 Then it would have been unimaginable that a socialist president of France, François Mitterand, —fearing German preponderance in Europe after the fall of the Berlin Wall—would become the driving force behind a European currency union. His motive, to wrest the Bundesbank’s monetary policy hegemony from united Germany, has also been forgotten, in Germany the more so since German industry benefited hugely from the introduction of the Euro.

Europe’s loss of memory concerning its own experience of successful integration may also be understandable in view of present anxieties. Once again, with Nicolas Sarkozy, France has a rather mercantilist president, and he expresses dissatisfaction with a European Central Bank which, though led by a Frenchman, “outbundesbanks the Bundesbank” in the view of most anglo-saxon economists. Belgium, a founding member of the European Community as well as host to the “capital” of the European Union, threatens to disintegrate on the basis of language. “New Europe” seems driven by very old instincts of nationalism. “Idealism is mugged by reality”, a British realist writes triumphantly, though just a little worried. No wonder the rest of the world is seen through this prism, too.

But as confirmed by eminent Asian authors in the November 2007 issue of Internationale Politik, the trend is going in the opposite direction in Asia, where functional integration and community-building are understood as a strategy for the future. What had to be initiated in Europe with the political theory of idealism is in Asia the result of political and economic decisions inspired by strategic pragmatism. European idealist with a dogmatic frame of mind wrongly mistake strategic pragmatism as opportunism. As explained in more detail in our first post and in our web site www.schmiegelowpartners.com, pragmatism was developed as a philosophy by Charles Peirce, William James and John Dewey in the late 19th and early 20th century. But in more recent decades, the most impressive patterns of strategic pragmatism can be found in Asia. Since according to Kant, the necessity to decide excedes the capacity to know, strategic pragmatism is ethically superior to dogmatism.

Seeking the “win-win situations” described in Internationale Politik by both ASEAN’s former Secretary General Ong Keng Yong and China’s former Foreign Minister Qian Qichen, such strategic pragmatism has created impressive results over time.
The economic, sociocultural, and security policy ties of East and Southeast Asia described by Asian Development Bank President Haruhiko Kuroda and the President of the Japan Foundation, Kazuo Ogura, are strikingly reminiscent of the functionalist and neofunctionalist strategies of the European Community’s founding fathers, albeit in a different sequence. Whoever thinks Asian monetary cooperation is inconceivable should carefully read Kuroda’s essay. Building on ASEAN, ASEAN+3, and the East Asian Summits (EAS), the method of community-building established by the ASEAN states links the political, economic, and ecological objectives explained by Ong Keng Yong. It does so with an impressively realistic sense of the balance of power among Asia’s great powers. The fact that the heads of government of India, Australia, and New Zealand have been invited to the EAS since 2005 demonstrates a pragmatic usage of the geographical term “East Asia”. The network of asymmetrically overlapping regional organizations is developing as dynamically in Asia as in earlier phases of European integration.

Kazuo Ogura’s analysis of the historical commonalities of Asian cultures, their displacement by Western modernization in the form of colonialism, and their resurgence now casts doubt on the assertion by Western observers that the very lack of a shared culture prevents Asia from becoming a community. Yusuf Wanandi’s idea of an East Asian Community sharing the responsibilities of global governance is a strong indication that the concept of a forward-looking policy that Germany’s foreign minister, Frank-Walter Steinmeier, expounds once more in the same Asia issue of Internationale Politik as a way to manage the global challenges of the future will find receptive partners in Asia.

Read more at our web site or download the article “The Road to an Asian Community” by Michele Schmiegelow and Henrik Schmiegelow offered on our site or at www.internationalepolitik.de.

Asia is shaping the International Order

November 2, 2007

If the western community of values is complaining today about the decline of the international order, it has two cognitive problems. One is with itself and one is with that part of the globe it senses, with mixed feelings, will shape the economics of the 21st century—Asia. The West’s problem is a crisis of classical American idealism. It had inspired the international order after World War II: the United Nations, the financial system of Bretton Woods, the functional integration of Europe, and the determination to overcome colonialism as demonstrated in the U.S. rejection of Great Britain’s and France’s intervention during the Suez crisis.
Of course, political realism never yielded entirely as a countervailing doctrine among the elites of America and Europe. Under Nixon it even determined American foreign policy for the first time. But when Henry Kissinger played the “China card” in the then-bipolar play of forces, he remained committed to the maintenance of international order, especially arms control policy with the Soviet Union. Despite various differences, the same was true for the Reagan and George Bush administrations.
The rupture came in the George W. Bush administration, with its mix between balance-of-power policies and the belligerent idealism of the neoconservatives. In 2003 this mix discharged in the Iraq war. Robert Kagan interpreted idealistic America as a “dangerous nation.” To Europeans, who until then had been putting Kant’s paradigm of democratic peace into practice in Europe, realism suddenly suggests itself as an antidote to dangerous idealism. The western community of values is no longer always of one mind even in the international order it created and for that reason speaks of its decline.
All the while, Asia is showing the world that the international order’s decline or continued development is not a matter for the West alone to decide. At the multilateral level the West already knows that it depends on and is even pressed by Asian involvement, particularly by China, India, and Japan . The West’s greatest cognitive challenge, however, is the process of functional integration and regional community building in Asia, which is becoming an ever more attractive pattern of international order for half of the world’s population and the most dynamic part of the global economy. To the extent that western elites are aware of this process at all, most of them do not believe anything can come of it. Political realists consider functional integration unrealistic in both Europe and Asia. European idealists perceive Asia as molded by balance-of-power politics, cultural diversity, or nationalism, and therefore do not think the region capable of applying the European pattern. Both realists and idealists of the West have to prepare themselves for an uncomfortable refutation of their somewhat condescending assumptions by Asia’s strategic pragmatism and transcultural values.

Read more at our website or download the article “Asia’s International Order” here.

What is Strategic Pragmatism?

September 9, 2007

We coined this concept in 1989 when writing our book “Strategic Pragmatism: Japanese Lessons in Economic Theory

In terms of philosophy of science we are indebted to Karl Popper’s critical rationalism, which approaches any problem solving with the insight of human cognition being fallible. From this insight follows the necessity of seeking solutions to problems with what we call “strategic pragmatism”. The pragmatism we advocate is a philosophy developed by Charles Pierce and John Dewey, which considers theory to be in the service of practice and not the other way around. This philosophy eschews dogmatism. It reflects the awareness that all human knowledge is always just temporary. It demands readiness to act across the cleavages of dogmatic dissension, but also to correct and adjust one’s own action as soon as dysfunctions are recognizable.

A distinctive mark of Strategic Pragmatism is its focus on echeloned time horizons for what can be achieved short term with immediate impact based on the newest and best available knowledge, what requires more structured development over the medium term with constantly adjusted knowledge, and what can only be set as a long-term target involving fundamental reform or innovation, but with still high degrees of scientific uncertainty. If a goal is not immediately attainable, this does not necessarily justify the conclusion that it is impossible to attain. Strategic Pragmatism distinguishes itself from static dogmatism by its intensive focus on each phase of the time horizon.

Visit our website if you want to read more about examples of Strategic Pragmatism in the following areas:

  • Foreign policy
  • Economic policy
  • Business strategies
  • Environmental strategies
  • Location strategies
  • Development policy
  • Legal transformation policy

We are pleased to see that many others have come to use the term for the last ten years though rarely in the full sense of the philosophical concept as we defined it almost twenty years ago. Once more, Strategic Pragmatism as we define it requires of policy makers:

  1. Awareness of the fallibility of one’s own judgment
  2. Eschewing dogmatism of any kind
  3. Readiness to correct and adjust one’s own action as soon as dysfunctions are recognizable
  4. Focus on echeloned time horizons: short / medium / long
  5. Using newest and best available knowledge in the short term
  6. Seeking more structure development over the medium term with constantly adjusted knowledge
  7. Long term targets even though it means working under scientific uncertainty

Some people confuse Strategic Pragmatism with unprincipled “muddling through”. That is wrong for two reasons:

  1. Strategic Pragmatism is based on critical rationalism, that is the universally accepted standard of science.
  2. Strategic Pragmatism as we define it is not unprincipled, but guided by transcultural ethical standards (if you want to learn more about this, read “Preventing the Clash of Civilizations: A Peace Strategy for the Twenty-First Century” or the chapter ‘Cultures, Power, Economics and Civilisation’ in “Democracy in Asia“).

This post is intended to explain our method in our work as Analysts & Policy Advisors. It may also clarify some of the misunderstandings of the term Strategic Pragmatism that may have arisen from its use by others in the past 10 years.

Don’t hesitate to comment or offer any constructive criticism.

Henrik and Michèle Schmiegelow (Schmiegelow Partner GbR)