As geography returns to history, capitalism lives on..

Financial crises will come and go, as the world rebalances. But reports of the death of capitalism are greatly exaggerated.

A couple of very intriguing questions: How healthy is the world economy? And how will it evolve over the next several years?

The first question is the topic du jour; the second however is almost wholly ignored in public discourse. I believe both are important; the second perhaps more so, if we are not to repeat the often-nasty and always costly economic surprises of recent years.

Here are my thoughts on both these questions:

How healthy is the world economy (today and over the next 3 years) ?

The basic capitalist fabric upon which the world's economic superstructure is built has been stretched badly by the events of the past 7-8 years, but not torn. The process of recovery from the recession began in July 2009 (as I wrote it would in April 2009, based on these five factors - a view that was markedly against the tide of expert opinion at the time), and is plodding on resolutely. The US recovery has cooled somewhat since March 2010 for a variety of reasons (some enumerated in the blog post below), but the probability of a double-dip in the US, European Union or any other major economic entity is vanishingly small (less than 10%). The world economy will continue to be in rude health (barring any unforeseen cataclysmic event – by definition, an extremely unlikely eventuality).

This doesn't mean the recovery will be painless: Jobs have been marching away from the developed world to China, India, etc. and so the West will have to get used to steady-state unemployment rates of near 10%. These unemployed folks will suffer and get poorer but nothing much will be done to help them (political fulminations notwithstanding).

However cries of the Death of Capitalism, another Great Depression, and so forth which we heard in late 2008 / early 2009 (and some of which came from respected Gurus of the establishment) have proven unfounded. Europe is doing quite well - the brouhaha about collapse of the EU, death of the Euro currency and so forth was similarly an overreaction.

How will the world economy evolve over the next 4 - 15 years?

Capitalism is not decrepit, but it’s been flogged by unscrupulous businesses intent on testing its limits nearly to breaking point. Regulators who were expected to rein in this reckless behavior looked on benignly (or fecklessly). The Gurus and thought leaders who should have sounded warning bells were trapped in ivory towers, rendering themselves essentially irrelevant.

More importantly, No lessons have been learnt from the recent financial crisis. Regulatory changes such as the Dodd-Frank Act are too weak, abstract or low on specifics to deter further recklessness. Cycles are an inherent economic phenomenon (despite what many naively believed during the halcyon dotcom days and the boom of 2003-2007); weak regulation will ensure that some cycles will go far enough to engender full-blown crises. So there will be more financial crises in the next 5-15 years (and we probably won't learn much from those either).

These crises will be most likely to originate in the US or China. Europe will continue its disciplined march and play a steadily smaller role in world affairs. India will grow (albeit quite rockily) but will be unlikely to create problems outside its own borders.

A hapless world will reel in response to each crisis. However, while we won’t get much better at preventing crises, we’ll continue to learn to manage these crises better. Crisis responses will (hopefully) be as admirably coordinated and effective as the response to the 2008 financial crisis was.

Few would argue today that the regulatory failures that cause free markets to occasionally plunge headlong into crises justify a switch to the opposite extreme – the abandonment of capitalist free enterprise[i]. However, the lines between Government and free markets will need some redrawing.

Capitalism will continue to thrive, partly because all alternatives have self-destructed. The major bastions of Communism and Socialism – in the Soviet Bloc and China – have fallen. A fragmented, fractious and adversarial worldview fostered in the Cold War era has allowed these totalitarian ideologies to survive in small pockets in Asia, Africa and Latin America long after having proven decrepit in the lands of their origin. However these final holdouts are merely the last vestiges of these once-powerful ideologies, and they too are crumbling.

But capitalism will thrive mainly because it has worked (but, it must be admitted, for the occasional crisis). Free-market democracies have emerged as the most effective method to unleash the creative and entrepreneurial energies of the human race. They have promoted widespread wealth and well-being. The new generation’s aspiration for freedom - of expression and enterprise - can only be met by the liberal pluralism that only free-market democracies can provide[ii]. In the annals of ideological battles, the market is the undisputed winner.

So the real battles will shift to social, cultural and technological issues – medical ethics, the propriety of creating clones and artificial life forms, energy security, the right response to changing world demographics, and so forth. These battles will largely be devoid of ideological content, and focus on pragmatic aspects.

Meanwhile, the inexorable forces rebalancing the world will soldier on. The historical anomaly of Western dominance set in motion by the Industrial revolution and the colonial era, and kept in place by the Cold War will be erased. In 2025 the world will look more like it did in the late 19^th century (in terms of relative apportioning of wealth between the geographical East-West, not in terms of absolute standards of living or technological advancement) !

Of course this rebalancing will not be painless as the newly emerging nations (China, India, Brazil,..) seek roles in world affairs proportionate to their growing economic clout.

So the world will hardly be devoid of conflict. But the conflicts of the next 15 years – and their resolution – will be guided by the invisible hand of Adam Smith, rather than by the ideological fist of Karl Marx. And we’ll continue to live in interesting times.

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[i] The fact that regulatory failure played such a big role in fostering recent financial crises is an argument against, and not for, more government.

[ii] This is why China will face issues as it transitions to a true capitalist free-market society. Currently it must be considered a work-in-process, as it attempts to make this transition without a corresponding transition to democracy. It is this disconnect that may provide fodder for incipient crises. Almost inevitably however, the country will move in the general direction of providing greater representation for its people, in the democratic spirit.