The Butterfly Defect: How Globalization Creates Systemic Risks, and What To Do About It.

van Wyk, Jay

The Butterfly Defect: How Globalization Creates Systemic Risks, and What To Do About It, by Ian Goldin and Mike Mariathasian, Princeton, NJ: Princeton University Press, 2014.

A voluminous body of literature has explored the benefits of globalization, but the aim of this work is an attempt to analyze systemic risks associated with globalization. In this ambitious project, the authors cast a wide net to include risks that are the subject of serious analysis in various disciplines. The book is organized in eight chapters. Chapter 1 restates the benefits of globalization, bringing our attention to the rise of systemic risks in a global community characterized by growing connectivity and complexity. Chapter 2 through 7 deal with specific systemic risks as related to finance, supply chains, infrastructure, ecology, health pandemics, and inequality and social risks. In chapter 8, various suggestions for risk management are offered. Space prohibits a discussion of all the systemic risks discussed by the authors.

The authors infer 28 lessons from their analysis of systemic risks. The lessons broadly call for a better comprehension of systemic risks, greater efficiency in managing risk, and more regulations to prevent and to mitigate risks.

In Chapter 1, the well-known causes and benefits of globalization are succinctly summarized. The authors show that we are living in an interconnected world which has become increasingly complex. The downside is the rise in systemic risks, i.e "... the prospect of a breakdown in the entire system as opposed to the breakdown of individual parts" (p.27). Box 1.2 is a useful guide in understanding concepts such as risk, vulnerability, and hazard. The authors call for an increase in global governance in order to deal with systemic risks that transcend international boundaries and impact the global commons.

Chapter 2 deals with the financial crisis of 2007/ 2008 as a case study of systemic financial risk. The authors offer four lessons as suggestions of systemic risk management in the financial sector. First, current institutions, notably the IMF and Basel II, need reform to counter the manipulation of national politicians. Second, more systematic analysis is required of the complex financial system. Third, financial reform demands greater accountability. Four, simplicity, not complexity, will allow global institutions to manage local issues. Pragmatism may be a more prudent approach. The recent suggestions of the Basel Committee on Banking may be prudent policies for financial risk management: end the practice of regarding government bonds as risk free; raise minimum capital holdings required for banks; and reduce the manipulation of ratio of equity to risk-weighted assets.

In Chapter 3, global supply chain risks are investigated. For future work, a suggestion is to combine Chapters 3 and 4 since infrastructure and supply chain management are so closely integrated. Five lessons are inferred for supply chain management: network resilience should be promoted; negative externalities such as counterpart risk need to be recognized and addressed; regulations are needed to promote emergency planning for systemic shocks; adequate buffers must be ensured in strategic sectors; and competition policy needs to address risks emanating from industry concentration in specific locales. Most of these are really enterprise risks and their management is part of the competencies of successful companies. Network resilience is usually the result of collaboration between all the players in a supply chain based on the sharing of IT capabilities and best practices. A successful supply chain strategy will include contingency planning, including private-government collaboration. Outsource flexibility (just-in-case) is a superior strategy to buffer stock since the latter is not cost effective (obsolescence, warehousing, insurance); and, government policy regarding strategic industries is fraught with subjective considerations (protectionism). Counterpart risks are best dealt with by due diligence and sensible policy such as the known shipper principle. Industry concentration has advantages since the clustering of industry, suppliers, research laboratories, venture capitalists in a regulation friendly locale, provide national competitive advantage. The authors refer to the vulnerability of Toyota to supply chain interruptions, such as recalls and natural disasters. Toyota's approach is due to the business culture in Japan (keiretsu) wherein manufacturers have long-term relationships with suppliers and the lack of supplier flexibility exacerbates risk exposure.

Lessons challenging global inequalities and social risks are suggested; global governance must be transparent; and reducing inequality at the national level and global level is a prerequisite for the continued success of globalization. The authors make a fair suggestion that, on the national level, improved access to education and to broadband may alleviate inequality. Since poverty prevails in countries lacking in economic and political freedom, institutional liberalization, in the broadest sense, may be the most effective way to reduce such inequalities. The authors make a compelling case that globalization has made considerable contributions to national wealth creation, poverty reduction, and improving individual quality of life. However, blaming globalization for increased income equality is most probably a less convincing argument. The severe criticism of Thomas Piketty's treatise of growing global income inequality offers a cautionary tale. An understanding of taxpayer behavior (and changes in tax laws) and the value of government transfer payment shows that income distribution has remained remarkably stable over time. Government policies which address income inequality, such as increasing the minimum wage, often have unintended consequences including replacing full time jobs with part time jobs, the automatization of low skill jobs, and increasing middle class household income rather than that of low income families.

In conclusion, the authors' provide six lessons for global policy reform in order to manage systemic risks. First, promote resilience and sustainability: geography and accountability. Second, foster the transparent communication of choices, risks, and uncertainties concerning policy alternatives to address political and attrition challenges. Third, improve risk measurement. Fourth, rectify economic incentives. Fifth, prepare for contingencies. Sixth, define and enforce unified legal responsibilities. Again, these are worthy sentiments. The persistence of corruption (lack of transparency) on the national and international levels will continue to hinder international collaboration. The authors' idea of a carbon tax to fund global organizations is problematic at this stage. Australia recently scrapped its very unpopular carbon tax because of the increase in household power bills and the loss of competitiveness in Australian manufacturing. In general, the authors' did not address the additional cost of risk management and how governments will prioritize such expenditures, particularly in view of the growing demand of entitlements on national budgets and an ever decreasing budget allocation available for discretionary spending.

Goldin and Mariathasian make a contribution to the analysis of systemic risks and suggest that global governance may be the appropriate level to manage such risks. The continued debate on how to deal with systemic risks will be stimulated by the suggestions (lessons) they make to mitigate systemic risks. In fairness, the authors investigate many domestic sources of systemic risks and how government policy has fallen short in mitigating such risks. However, the authors' preferred solution for the problem is clear: Reformed supranational institutions with sufficient power to anticipate and to manage systemic risks. From an idealistic viewpoint, their proposed solution is fine, but pragmatism dictates that a top-down approach faces many obstacles. The main obstacles are lack of political will of national politicians, distrust by national citizenry, and the ideological divisions in the world community. In contrast, a bottom-up approach has many merits. The authors make a strong case that globalization is the product, among many factors, of the spread of democracy and free market capitalism since the mid-1990s. However, those very institutions are under threat with the resurfacing of authoritarianism and government manipulation of markets. The data compiled by The Heritage Foundation, The Wall Street Journal, The Economist, and Freedom House, respectively, substantiate this trend of backsliding of democratic capitalism.

A number of suggestions may be advanced to further the debate on systemic risks. First, without sound national institutions, effective global governance may be difficult to establish. As long as the nation state system exists, states will be the members of global institutions. The lack of institutional quality on the national level in the face of institutional decay or even institutional voids, has been the subject of a large and growing literature. Without the building blocks of effective national institutions, dysfunctional global institutions will remain the norm. Even when states sign agreements or resolutions involving global institutions, domestic implementation will be subject to lobbying, "embeddedness," and even worse, cronyism of local stakeholders. The authors call for better measurement and data on systemic risk is well noted. However, data on institutions are freely available. Such data illustrate the disparity in the quality of national institutions such as political freedom, civil liberties, competitiveness, transparency and corruption, economic freedom, governance, risk exposure and logistic performance. The inference of the studies based on this data is that the benefits of globalization, i.e. transnational trade, investment, risk management, will only be sustained and expanded if national institutional quality improves.

It is interesting that the authors did not pay attention to the successful transformation of GATT into WTO. The WTO has done much to promote cross-border trade and investment liberalization. However, the organization's inability to reduce agricultural tariffs and to protect intellectual property reflects the limitations of international organizations to affect change in the face of the persistence of North-South divisions in international relations.

A second suggestion is that the treatment of systemic risk must include an analysis of political risk. The authors analyze many instances where the actions or inactions of governments caused systemic risks. Leaving political risk out of systemic risk is analogous to analyzing World War II without reference to Hitler or Churchill. The systemic nature of political risk will influence all of the systemic risks discussed by the authors. For example, the pressure of the US government on banks to make risky mortgage loans to lenders with poor credit worthiness was motivated by rewarding constituents rather than prudent business judgment. The US housing bubble was a major cause of the systemic financial crisis of 2007/8. Another example, provided by the authors, is the incentive provided by the US government, in the form of insurance, to build and rebuild in vulnerable coastal areas subject to hurricanes and flooding. Another example of political risk related to pandemics is the misperception of the Mbeki Administration in South Africa regarding HIV/AIDS. By blaming poverty rather than a sexually transmitted virus, the inaction of the government not only worsened the HIV/AIDS pandemic, but hastened the death of more than 300, 000 South Africans.

Two broad forms of political risk raise major systemic concerns. The growth of big government to provide ever expanding entitlements heightens exposure to the dangers of sovereign risk and default. The authors recognize this threat in the discussion of the challenges faced by the EU in dealing with the systemic fallout of the Greek sovereign debt crisis. The specter of the US's sovereign debt of $17.5 trillion, with no end in sight of reckless fiscal spending, should be a concern for systemic risk monitors. The haphazard abdication of the US's superpower role under the Obama administration has enhanced global instability. At least since the Congress of Vienna, in the early 19th century, major powers have projected their power to provide acceptable norms of inter-state conduct and formed alliances to deter or punish deviant states or international non-state actors. Whenever real politique failed, devastating interstate wars erupted: the ultimate systemic risk in terms of destruction of the ecology, economies, human life, and infrastructures. The current international situation is fraught with dangers posed by militarized conflict. Such risks include, among others, the global spread of Islamic terrorism, the cross-border spill-over effect of instability in failed states, and the imperialistic behavior of Russia and China. Militarized conflict should be high on the list of any discussion of current and future systemic risk management.

Jay van Wyk

Professor of International Business

Pittsburg State University