My critique of the global capitalist system predates the outbreak of the recent financial crisis.  As you may be aware, I published an article at the beginning of 1997 under the title "The Capitalist Threat".  That article was widely misunderstood probably because of the title.  I am not advocating the abolition of capitalism; I want to preserve it by correcting its excesses.

The fact that global capitalism is flawed does not mean that we should turn to communism or withdraw into national isolation, just as the failure of communism does not mean that markets are perfect.  I am in favor of recognizing that all social arrangements are inherently imperfect.  Since perfection is beyond our reach, we must content ourselves with the second best, namely an imperfect society which holds itself open to improvement.  That is the idea of the open society.  I learnt that idea from Karl Popper, the philosopher, who wrote a book entitled "Open Society and its Enemies" which impressed me greatly in my student days.  At that time, open society was threatened by various totalitarian ideologies - fascism, Nazism and communism - which used the power of the state to impose their final solutions.  Open society is now also threatened from the opposite direction, from what I call market fundamentalism.  I used to call it laissez faire but I prefer market fundamentalism because laissez faire is a French expression and most market fundamentalists don't speak French.

My contention that market fundamentalism endangers the open society may sound rather shocking because private property and a market economy are indispensable elements of an open society.  But the market fundamentalists believe that markets are perfect and governments should stay out of the economy.  They base their arguments on economic theory, which claims that markets tend towards equilibrium.  It so happens that that claim is false with regard to financial markets.

Equilibrium applies to markets which deal with known quantities but financial markets deal with quantities which are not only unknown but unknowable.  They try to anticipate or discount a future which is contingent on how financial markets discount it today.

Financial markets are best understood in terms of reflexivity, not in terms of equilibrium.  There is a two-way interaction between financial markets and economic developments which may or may not tend towards equilibrium.  There are times when the market participants' bias is self-correcting and markets exhibit a tendency towards equilibrium; but at other times the bias is self-reinforcing until it becomes unsustainable and markets exhibit a boom/bust pattern.

The trouble with reflexivity is that the outcome is not only unpredictable but also genuinely indeterminate.  By contrast, equilibrium produces a determinate result.  However widely a pendulum may swing, it always comes to rest at the same point.  That is why economic theory is couched in terms of equilibrium.  Unfortunately, the analogy with the pendulum is false.  As we have seen recently, financial markets can sometimes move more like a wrecking ball, knocking over one economy after another.

My critique of the global capitalist system has three major themes.  First, the system favors financial capital but financial markets are inherently unstable and global markets even more so.  Second, the excessive reliance on market values and their penetration into areas where they do not properly belong has undermined the stability of our society.  Third, we cannot have a global economy without a global society.

In light of the recent financial turmoil, most of the interest is focused on the first point, namely the instability of financial markets.  We have financial institutions whose mission is to prevent systemic failure.  We have central banks and regulatory agencies and, although central banks always overshoot or undershoot, on the whole they do a creditable job.  There has been no systemic breakdown in any of the advanced countries since 1933.

But central banks and most of the regulatory agencies are national in scope, while financial markets have become truly global.  The development of regulatory agencies has lagged badly behind the development of financial markets.  We have the Bretton Woods institutions - the IMF and the World Bank -- but they were designed for a different epoch.  They are inadequate for the task they are called upon to perform.  Indeed they have become part of the problem.

When a country turns to the IMF, the IMF imposes strict conditions on the country concerned but it does not permit that country to impose conditions on it creditors.  The austerity imposed on the debtor countries helps them to meet their obligations but it has created a moral hazard because the lenders have come to expect that in case of trouble they will be bailed out.

Moral hazard is just another name for the asymmetric treatment of lenders and borrowers.  This was clearly demonstrated in the course of the current crisis.  When the crisis started to threaten markets at the center of the system, the Federal Reserve immediately lowered interest rates.  The IMF programs did the exact opposite: they imposed punitively high interest rates on the countries concerned.  The economies at the center escaped unscathed, at least so far; the economies at the periphery have
been plunged into deep depression.

In defense of the IMF it must be pointed out that their primary mission is to preserve the stability of the international financial system.  Faced with a currency crisis, an external debt problem, and an internal banking crisis at the same time, they must tackle the external problem first.  Only after the balance of payments has improved, can they allow interest rates to be eased, but by then the damage is done.

The current crisis has probably cured the moral hazard for good, not only because lenders and investors got burnt but also because they are on notice that bailouts have become politically unacceptable.  But this has aggravated the asymmetry between center and periphery.  The center has actually benefitted from the crisis, while the periphery is suffering from the outflow of capital and is wallowing in depression.  All the talk about moral hazard and capital controls is somewhat misdirected.  It is like building the Maginot Line after the First World War.  The flow of capital has been reversed. The task now is to reestablish the flow or to find a way to inject liquidity directly into the periphery.

I have proposed a system of international credit insurance and I am glad to see that the G7 is thinking along similar lines.  I have proposed that the credits should be guaranteed by SDRs or Special Drawing Rights authorized but not issued by the IMF but that is much more controversial.  The international credit insurance scheme could be used to create a sound banking system in the periphery countries which is subject to close supervision by the international credit agency.  This goes much further than the current thinking of the G7.  Current thinking favors opening up the countries concerned to direct investment by international banks and multinational corporations.  While I am in favor, I believe it needs to be supplemented by creating sound domestic banking systems in the periphery countries, otherwise the playing field will become more uneven than ever and  it will provide a fertile breeding ground for nationalistic political leaders like my friend Mahatir of Malaysia.  The rise of nationalism and xenophobia will, in turn, increase the risks of international investing and perpetuate the imbalance between center and periphery.

An international credit insurance scheme is only one of the things that need to be done.  The problem of the exchange rate system needs to be resolved.  The regulation of international financial markets needs to be tightened.  In my opinion international financial markets cannot be left unregulated.  The choice is between better international regulation or greater national regulation and capital controls ` la Malaysia.  The survival of both global capitalism and open society depends on which route we choose.

There is a lot of talk on a new international financial architecture but I should like to take advantage of speaking at the Council to discuss the international political architecture.

We used to have a very stable international political architecture: it was called the Cold War.  Two superpowers representing two different principles of social organization were locked in deadly conflict, but each was capable of destroying the other in a nuclear war, so each had to respect the vital interests of the other in order to avoid "Mutually Assured Destruction".

This stable world order was destroyed by internal disintegration of the Soviet Union and no new order has taken its place.  Indeed, many geopolitical realists doubt whether a new world order is either possible or desirable.

I believe that without some kind of order we are bound to have disorder and there is plenty of evidence to that effect.  The world is literally littered with trouble spots and most of the troubles have internal origins: repressive governments or the breakdown of government.
 
Sometimes the conflict spills over national borders as it did from Ruanda to Congo recently.

I believe the proliferation of disorder can be prevented only by paying more attention to what goes on inside the various countries.  Crisis prevention cannot start early enough.  How a country responds to a disaster, whether it is natural or man-made, depends very much on how it is governed.  This was quite evident in the recent financial crisis as well as the recent hurricane.

But who is going to do the preventing?  The U.S. is the world's sole surviving superpower but the U.S. refuses to act as the world's policeman - and rightly so.  It is neither right nor possible for one country to impose its will on the rest of the world.  My question is, would it be possible to form a coalition of like-minded countries which would cooperate in promoting the principles of open society.  They could establish certain standards for the relationship between state and society that would cover such areas as freedom of information, freedom of association, due process, transparency in state procurements, and the like.  Obviously these standards cannot be uniform.  It is in the nature of open society that it is a society that defines itself.  External pressure can only aim at allowing societies to define themselves.  It should manifest itself by offering incentives rather than imposing sanctions.  The coalition would have many subtle ways to exert pressure, provided its members agree among themselves.

I have a more utopian vision, namely that an open society coalition could gain control of the United Nations and convert the General Assembly from a talking shop into a genuine legislature in charge of establishing international laws.  The laws would be valid only in the countries that ratify them, but members of the open society coalition would pledge themselves to ratify the laws automatically, provided they have been ratified voluntarily by a qualified majority.  In that way, a body of international law could be developed without infringing on the principle of national sovereignty.

The principles of open society could never be the only guide to foreign policy, but is it utopian to expect that those principles should rank higher among the many conflicting considerations than they do at present?  Ironically, the U.S. ranks quite high in promoting open society principles in its foreign policy and at the same time it constitutes the main obstacle to international cooperation.  We used to be one of two superpowers and leaders of the free world.  Now that we are the sole remaining super power, is it too much to ask that we should resume our role as leaders of the free world?