Wharton professor Mauro Guillen explains why instability is rising.

You’re not imagining it: More global crises are arising today than in past decades. Economically, politically and socially, it appears as if the fractures in the world’s systems are only getting worse. As crises multiply, two questions seem key: First, can the global system hold together and tamp down some of these issues? And second, why is all this happening now?

Wharton professor Mauro Guillen answers both of those questions, and many others in his new book, The Architecture of Collapse: The Global System in the 21st Century. Guillen, who is also director of The Lauder Institute at Wharton, joined us on the Knowledge at Wharton Show on Sirius XM channel 111 to talk about what’s causing this surge of complex problems, and what, if anything, can be done to ameliorate it.

An edited version of that interview appears below.

Knowledge at Wharton: How strong or weak is the global system right now?

Mauro Guillen: In terms of the structure of the global economy — and the political and economic institutions that we have in place to make things happen in an orderly way — it’s under a lot of stress. A very clear symptom of this is that since 1982 or 1983, for around the last 25 years, we’ve had many, many more crises — banking crises, currency crises, debt crises — in various parts of the world, than during the preceding decades. We have gotten used to reading about a new crisis pretty much every other week in the newspaper. This is a sea change from the situation in earlier decades, and it is putting quite a bit of stress on all of those foundations that we hold so dear, that essentially help us get things done in the global economy.

Knowledge at Wharton: What was the tipping point that started us on this path?

Guillen: The 1970s gave us the answer to that and so I’m mostly focusing here on the argument of what happened after the 1970s.

The 1970s, as you know, were essentially years of turmoil in the world, driven by two things: one was the oil shocks of 1973 and 1979, and the other was the demise of Britain’s world system, the global-financial architecture that emerged from World War II, and in particular, the decision in 1971 by President Nixon to abandon the gold standard and put an end to the dollar’s convertibility into gold. From then on, what we have is fluctuating currencies and so much more volatility in markets.

That got worse, I think, in the 1980s and 1990s because we introduced a number of other policies around the world, especially policies having to do with the liberalization of capital flows in a way that I don’t think has been constructive.

Knowledge at Wharton: In the book, you use the term “complexity.” When you think about what’s going on in Europe right now with the Eurozone, and all the different players and all the different philosophies, you would think that there’s no way it could be anything but complex. Yet they have managed for the last 30 years or so to make it work. Why are we at this tipping point, where this “complexity” has really popped up again?

Guillen: I view complexity as something that is not necessarily bad, in the sense that it goes without saying that everything in the world has become more complex. We have more countries in the world today than ever before — nearly 200. We have more relationships among them. Some of those relationships [revolve around] trade, or the activity of multinational firms that invest in various markets — all of those kinds of linkages actually provide firewalls, cushions. We have more ways to cope with disturbances, shocks or with a small crisis, in one part of the global system so that it doesn’t spread throughout.

“We’ve had many, many more crises — banking crises, currency crises, debt crises — in various parts of the world, than during the preceding decades.”

Where I think the problem lies — and this is what I explain in the book in detail — is with a related concept, which is that of coupling. That is to say, the extent to which different components of the global system and the global economy are so tightly tied to one another that there’s very little room for error. If there’s a disturbance someplace and all of the parts are very tightly coupled, then that disturbance, that shock, reverberates throughout the entire system, diffuses extremely quickly.

The International Monetary Fund (IMF) finally recognized this [recently]. There are three main things that are driving this. One is the enormous rise in portfolio investment, which can be short-term capital flows. Next is the growth of cross-border banking. Then lastly, there’s the enormous growth in currency trading that has created a situation in which whenever there is a deviation from the normal state of markets in some part of the world, it very quickly spreads throughout the entire system.

An article three IMF economists published in early June made headlines around the world because it was the first time that the IMF recognized that the liberalization of short-term capital flows it had imposed on countries during the 1980s and 1990s has increased the probability of crises. They provide some estimates, to the effect that the probability of a crisis these days — especially in the emerging markets — is three times greater for those situations in which there are very high levels of short-term capital flows.

It’s the first time that the IMF has recognized this, and it’s remarkable that it has taken 20 years for the global financial community to understand that some of the steps that were taken for liberalization in the 1980s and 1990s have had the opposite effect.

They were meant to be reforms that would stabilize the situation. They were meant to be reforms that would help allocate capital more efficiently around the world. What we’re seeing is that the effects have been, most of the time, quite negative.

Knowledge at Wharton: You also talk of the impact that foreign direct investment has on complexity.

Guillen: Absolutely. Foreign direct investment, unlike portfolio investment, is when companies set up a plant in a foreign location. Or they make an acquisition. They do that not as a financial investment; they do that because they want to do business in that part of the world. From many different points of view, this is something that, I strongly believe, over the last few decades has contributed to the stability of the global system.

 “It has taken 20 years for the global financial community to understand that some of the steps that were taken for liberalization [of short-term capital flows] … have had the opposite effect.”

For a very simple example, consider a Japanese firm back in the 1960s that was producing in Japan — electronics, automobiles — and it was exporting throughout the world. That company, and the Japanese economy itself as a result, was more exposed to shocks. For example, it was sensitive to things that would affect the exchange rate, because it was producing in just one place and selling throughout the world.

Now take the same company, 20 or 30 years later — let’s say, like Toyota or Hitachi or Sony — a company like that by now has manufacturing facilities in 50 different countries around the world. That production network that they built through foreign direct investment enables them to deal with disturbances, with shocks in different parts of the world, much better. They are not as exposed. In a way, they are naturally hedged against disturbances because they have a network structure of facilities around the world. So I personally consider foreign direct investment, unlike portfolio investment, as a stabilizing factor, as something that contributes, through complexity, to the stability of the global economy.

Knowledge at Wharton: In that respect, the ability of companies to be able to have many pieces in different parts of the world brings an opposite result than coupling.

Guillen: Absolutely. And they can exercise their options. They can rearrange their operations in response to sudden, unanticipated changes in the environment. But the other thing that is important to keep in mind is that at the same time that we’ve seen a proliferation of these crises throughout the world, we’ve also seen a weakening of the state, a weakening of governments. Governments, in other words, in the world, have fewer tools at their disposal. We see this, for example, from the point of view that governments for the most part no longer can use fiscal policy because they are up to their necks in debt. They have to just use monetary policy.

But we see this in many other areas. We see this in the developing world with the phenomenon of failed states. We have about 50 countries in the world that fall under the category of failed states. An extreme case, of course, would be Libya these days, right? Or Afghanistan. But there are many, many others that have various degrees of state failure, and so they find it very difficult to cope with these shocks when they come their way. In other words, we’ve seen a weakening, a deterioration of state structures around the world.

There are a couple of other things that are making the situation really difficult. One is the increase in income inequality and wealth inequality, because that puts a lot of pressure on the political system. It increases the frictions. It increases the stakes, whenever there’s an election. We’ve seen this in rich countries in Europe and in the United States. That division of inequality is reshaping the political arena. And we also see this in emerging markets, where inequality has been growing very quickly. All of these changes are conspiring to produce a situation in which not only are there more crises, but also we have fewer tools at our disposal to cope with whatever crisis originates.

Knowledge at Wharton: We talk about income inequality so much here, yet we don’t necessarily think of it as a global issue. I’m sure there are a lot of smaller countries and emerging economies where the effect of income inequality may be greater than it is in some of the larger countries, because of how the political systems are set up.

Guillen: As you just pointed out, income inequality has grown in many different parts of the world. It has been growing in Eastern Europe, after the opening of those economies. It has been growing in China as a result of growth. Now, again, China is, as a country, better off, after all this growth. But it has generated tensions and inequality, especially between the rural areas and the urban areas. We see this in other South and East Asian countries. We see this in parts of Africa. All over the world. And, of course, in most of Western Europe, and here in the United States.

“Governments for the most part no longer can use fiscal policy because they are up to their necks in debt. They have to just use monetary policy.”

Again, this is putting an enormous pressure on the political system. The political system is one of our lines of defense against crisis. We want politicians and policymakers to have the tools at their disposal to cope with these difficult situations — whenever there’s a banking crisis, or a debt crisis, or a currency crisis. But right now, the background of growing inequality is undermining the ability of politicians to really get things done. It has also given room for extremist parties and populist parties to grow, which, again, is contributing to the lack of stability.

Knowledge at Wharton: You talk in the book about the relationship between the United States and China, which is making quite a bit of news these days. What is the biggest concern for you, first, with China, and second, with the relationship between the United States and China?

Guillen: I am concerned about that relationship. It is by far the single most important bilateral relationship in the global economy. These are two economies that have evolved in major ways over the last 30 years. China used to be destitute, and now it is a global power, financially and economically and in terms of trade. And the United States is a technologically driven society and economy, which it wasn’t 30 years ago.

My concern is that the terms of that relationship, the way in which that relationship is structured, have not evolved. We’re still under the old system where the United States is the consumer of last resort, and China is providing all the funding for all our consumption. China has an excess of savings, we have an excess of consumption, and the entire relationship is driven by those two assumptions. There is a limit as to how much longer that relationship can last.

Now, of course, those two economies are very important, very central to the world. Part of the issue is that China — which is facing some domestic problems with its own economy — is still far away in terms of how long it will take them to be ready to play a more important and constructive role, globally, in part because they don’t have the mechanisms at their disposal. They don’t have a currency that people may trust. They don’t have the institutions that people would be able to relate to.

So we have this big economy, almost as big as the United States, which is increasingly asserting itself, especially in its own region, politically and militarily, and so on and so forth. But we don’t have any good established channels to accommodate them. They’ve become the largest global trading power. They are about to become possibly the largest economy, but without really having the structures in place that would enable the world to welcome China as a major decision-making power along with Europe, the United States, India, and so on and so forth.

Knowledge at Wharton: What’s your expectation as you look at this global system over the next 20 years or so?

Guillen: It depends on a couple of factors. When you think about five or 10 years down the road, most listeners think this may have an impact on them. If we say 20, some will say “All right, somebody else deals with that.”

There are some distinct risks here, in the sense that we could get into another round of crises. That’s one distinct risk that we’re facing. But the other one is just anomie. We become so indifferent to the fact that, “Oh, we have very slow growth in many parts of the global economy.” Or, “we have high unemployment,” which, by the way, is happening not only in Europe. It’s also happening in some emerging markets, or bottom-of-the-pyramid markets, where there are a lot of young people who don’t have jobs.

“We’ve seen a weakening, a deterioration of state structures around the world.”

It’s the sense that it will be hard to introduce an element of dynamism. Our only hope is that not all economies go at the same time into those types of situations. Right now, for instance, India is doing pretty well, and some countries in sub-Saharan Africa continue to do rather well — for example, Ethiopia. The problem is that if things in the economies that are most interconnected with the rest of the world, like Europe, United States or China, are not going really well, then the beneficial effects don’t spread widely. Because the Indian economy is not an export-oriented economy; it has a modest contribution to global trade. So it doesn’t really help the rest of the world as much.

That’s why I think we should continue to pay a lot of attention to what’s going on in China, Europe, and the United States, because those are by far the three largest regions of the world that have the most impact on the global economy — in terms of trade, in terms of investment, in terms of financial markets, everything. The lack of dynamism — or, as we’re seeing in China, the deceleration of the economy — essentially spells trouble in this interconnected world. Because the temptation, as you know, is to say, “It’s an interconnected world, I’m not doing well, let me disconnect.”

That’s what happened in the 1930s, if you remember. In the 1930s, it happened in the form of protectionism. Today, we have international treaties that prevent countries from engaging in protectionism in the old way, which was to establish tariffs or restrictions. But there are other ways in which you can do it. And unfortunately, over the last six or seven years, we’ve seen many countries in the world engaging in another kind of protectionism that can be equally harmful, which is currency manipulation.

Many headlines in newspapers have brought to our attention that countries as disparate as Japan, China, Switzerland and the United States, and so on and so forth, have at various points since the 2008 crisis engaged in currency manipulation. This is very dangerous. Very dangerous.