The year 2008 will be remembered as the year of an epochal shift in the world political and economic order bequeathed by the 1930s and 1940s. We are now facing the end of a particular form of globalization that was driven largely by a dramatic expansion of financial flows.
We should remember that there have been several dramatic episodes of globalization. Like previous eras of globalization, the late 20th and early 21st century was characterized by a high pace of innovation, which produced a great deal of widely dispersed wealth and well-being. But there may have been too much innovation to digest.
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Previous waves of globalization were also characterized by the special dynamism of one economic sector. Eighteenth-century expansion was driven by big productivity gains in agriculture, which increased purchasing power and personal consumption during the so-called “First Industrial Revolution.” In the second half of the 19th century, the expansion of manufacturing, especially in iron and steel, created a transportation revolution, with the steam engine and the iron-hulled steamship leading the way.
Economic historians consequently identify two big shifts in activity and employment over the past 200 years: The shift from agriculture to manufacturing in the 19th century, and a new move away from “old” manufacturing into services in the 20th century. In each case, a dramatic crisis created the conditions for change to a new model of development.
The 1840s witnessed the last big famine in traditional rural Europe, owing to crop failures across most of the continent. The agricultural failure was sufficient to produce a major downturn for everyone else. When the crisis was over, many farmers moved to other activities, triggering a major boom in the core businesses of the First Industrial Revolution.
The Great Depression of the 1930s was similar to the agrarian crisis of the 1840s in its transformative effect on economic structures. In the short run, it looked devastating. But widespread industrial unemployment pushed workers into new occupations, and underlined the importance of the skills and education that propelled the service economy of the late 20th century.
In each economic transition, older businesses did not stop. They simply became more efficient.
The credit crunch of 2008 is a turning point because it has exposed serious weaknesses in the financial sector — the main driver of economic growth in recent decades.
Adaptation to the new environment will occur under one of two contrasting scenarios. First, the bad one: More regulation. Faced by agricultural distress, well-intentioned people in the 19th century called for greater regulation of agricultural prices. In the industrial chaos of the 1930s, forced amalgamations, cartels and state supervision seemed like a good answer.
The better answer has always been technological change. The use of new techniques and new equipment meant that agricultural and industrial activities could become much more productive, thereby employing fewer people and generating less macroeconomic vulnerability.
Innovation is likely to be the long-term answer to banking problems as well.
Algorithms that authorize or prohibit transactions can redress conflicts of interest. In the same way as trading floors are now mostly obsolete, most banking functions can and will be handled by machines. Financial intermediation will increasingly become a function of interacting software systems.
As in previous economic transitions, those who work in the financial industry will try to produce convincing arguments that their business depends on the human touch. Harvesting machines were supposed to lower the quality of grain, as it was no longer subject to immediate inspection by the human eye. British train drivers long insisted that two drivers were needed to ensure safety, whereas some mass transit systems now operate with driverless trains. Advanced automobile plants are now largely composed of robots. Likewise, a personal banker is no longer a necessity, and has become nothing more than a status symbol.
One achievement of the recent application of psychology to economics has been the demonstration of how irrational many human decisions are. The story of the credit crunch often has also been the familiar tale from previous financial crises of the flawed individual or the rogue trader. The application of computer technology would eliminate much of the potential for human errors and flaws. As the financial sector continues to shed labor in 2009, we may well find that slimmed-down finance turns out to be better finance.
Harold James is professor of history and international affairs at the Woodrow Wilson School, Princeton University and professor of history at the European University Institute, Florence, Italy.
