NEW YORK: Start with the obvious: we live in a global economy. Let us be clear about what that means. A global economy includes not only the free movement of goods and services but, more importantly, the free movement of ideas and capital (everything from direct investments to financial transactions). Though both gained in importance since WW II’s end, globalization of financial markets accelerated in recent years so that movements in exchange rates, interest rates, and stock prices in various countries are intimately interconnected. Indeed, the character of the financial markets changed out of all recognition during the 40 years that I have worked in them. So the global economy should really be thought of as the global capitalist system.

Global integration brought tremendous benefits: the international division of labor, which are so clearly proved by the theory of comparative advantage; dynamic benefits such as economies of scale and the rapid spread of innovations from one country to another, which are less easy to demonstrate by static equilibrium theory; and noneconomic benefits such as the freedom of choice associated with the international movement of goods, capital, and people, and the freedom of thought associated with the international movement of ideas.

But global capitalism is not without problems; we need to understand these better if we want the system to survive. By focusing on these problems I am not trying to belittle globalization’s benefits. These benefits, I believe, can be sustained only by deliberate and persistent efforts to correct and contain the system’s deficiencies. Here is where I am at loggerheads with laissez-faire ideology, which contends that free markets are self-sustaining and that market excesses correct themselves, provided governments or regulators don’t interfere with the self-correcting mechanism.

There are five types of deficiencies in the global capitalist system which I would now like to discuss:

1. The benefits of global capitalism are unevenly distributed. Capital is in a much better position than labor because capital is more mobile. Moreover, financial capital is better situated in the global system than industrial capital; once a plant exists, moving it is difficult. To be sure, multinational corporations enjoy flexibility in transfer pricing and can exert pressure at the time they make new investment decisions, but their flexibility doesn’t compare to the freedom enjoyed by international portfolio investors. There is also an advantage in being at the center of the global economy rather than at the periphery. All these factors combine to attract capital to the financial center and account for the ever increasing size and importance of financial markets.

2. Financial markets are inherently unstable; international financial markets especially so. International capital movements are notorious for their boom-bust pattern. During a boom capital flows from the center to the periphery; when confidence is shaken it tends to return to its source. I have seen many ebbs and flows, booms and busts, and though I fully recognize that international capital markets have become more institutional in character and demonstrate greater resistance, I cannot believe that the present boom will not be followed by a bust until history proves me wrong.

Risks of breakdown are increased because our theoretical understanding of how financial markets operate is fundamentally flawed. Economic theory rests on the misleading concept of equilibrium. In my view equilibrium is elusive, because market participants try to discount a future that is itself shaped by market expectations. For example, a company whose stock is overvalued can use that to justify the inflated expectations of its shareholders, but only up to a point. This renders the outcome indeterminate, and it is only by accident that the actual course of events corresponds to prevailing expectations. Market participants, if they are rational, will recognize that they are shooting at a moving target rather than discounting a future equilibrium.

The theory of rational expectations makes the heroic assumption that market participants as a group are in a position to discount the future accurately. That assumption may yield a hypothetical equilibrium, but has little relevance to actual market behavior, and neither market operators nor regulators fully accept the theory because they are rational people. I am told that economic theory has gone a long way toward recognizing and studying disequilibrium situations. Nevertheless, the laissez-faire idea that markets should be left to their own devices remains influential. I consider this dangerous. The instability of financial markets can cause serious economic and social dislocations.

The question poses itself: What should be done to preserve the financial system’s stability? This cannot be answered in the abstract, because every situation is different. Financial markets are best understood as a historical process, and history never quite repeats itself. Recent turmoil in Asian markets raises difficult questions about currency pegs, asset bubbles, inadequate banking supervision, and the lack of financial information which cannot be ignored. Markets cannot be left to correct their own mistakes, because they are likely to overreact and behave in an indiscriminate fashion.

3. Instability is not confined to the financial system, however. The goal of competitors is to prevail, not preserve competition in the market. The natural tendency for monopolies and oligopolies to arise needs to be constrained by regulations. The process of globalization is too recent for this to have become a serious issue on a global level, but since we are dealing with a historical process, in time it will.

4. Whose job is it to prevent undue concentration of power and preserve stability? This brings me to the role of the state. Since the end of WWII the state played an increasing role in maintaining economic stability, striving to ensure equality of opportunity, and providing a social safety net, particularly in the highly industrialized countries of Europe and North America. But the capacity of the state to look after the welfare of its citizens has been severely impaired by globalization, because capital can escape taxation much more easily than labor can. Capital tends to avoid countries where employment is heavily taxed or heavily protected, leading to a rise in unemployment. This is what happened in Continental Europe. I am not defending the antiquated European social-security systems, which are badly in need of reform; but I am concerned about the reduction in social provision, both in Europe and America.

Until recently the state’s share of GNP in the industrialized countries taken as a group was actually increasing, almost doubling since WWII’s end. The Thatcher and Reagan governments began reducing the state’s role in the economy. What happened instead is that taxes on capital came down perceptibly while taxes on labor have kept increasing. As the international economist Dani Rodrik argues, globalization increases demands on the state to provide social insurance while reducing its ability to do so. This carries the seeds of social conflict. If social services are cut too far while instability is on the rise, popular resentment could lead to waves of protectionism, especially if (or when) the current boom is followed by a bust of some severity. This could lead to a breakdown as in the 1930’s. With the influence of the state declining, there is great need for international cooperation. But such cooperation is contrary to the prevailing ideas of laissez-faire on the one hand and nationalism and fundamentalism on the other.

The state plays another role in economic development: in countries deficient in local capital it allied itself with local business interests, helping them accumulate capital. This strategy proved successful in Japan, Korea, and the now wounded tigers of Southeast Asia. Although the model worked, it raises some important questions about the relationship between capitalism and democracy. Clearly, an autocratic regime is more favorable to the rapid accumulation of capital than a democratic one, and a prosperous country is more favorable to the development of democratic institutions than a destitute one. So it is reasonable to envisage a pattern of development which goes from autocracy and capital accumulation to prosperity and democracy. But the transition from autocracy to democracy is far from assured: those who in power cling tenaciously to it.

Autocratic regimes weaken themselves by restricting free speech and allowing corruption to spread. Eventually they may collapse of their own weight. The moment of truth comes when they fail to sustain prosperity. Unfortunately, economic dislocation and decline do not provide a good environment for the development of democratic institutions. So the political prospects for the Asian economic miracle remain cloudy.

5. This brings me to the most nebulous problem area, the question of values and social cohesion. Every society needs shared values. Market values cannot serve that purpose, because they reflect only what one market participant is willing to pay another in a free exchange. Markets reduce everything, including human beings (labor) and nature (land), to commodities. We can have a market economy but we cannot have a market society. In addition to markets, society needs institutions to serve such social goals as political freedom and social justice. There are such institutions in individual countries, but not in the global society. The development of a global society has lagged behind the growth of a global economy. Unless the gap is closed, the global capitalist system will not survive.

When I speak of a global society, I do not mean a global state. States are notoriously imperfect even at the nation level. We need to find new solutions for a novel situation, although this is not the first time that a global capitalist system has come into being. Similar conditions prevailed at the turn of the last century. Then the global capitalist system was held together by the imperial powers. Eventually, it was destroyed by a conflict between them. But the days of Empire are gone. For the current global capitalist system to survive, it must satisfy the needs and aspirations of its participants.

Our global society contains many different customs, traditions and religions; where can it find the shared values to hold it together? I should like to suggest the idea of what I call the open society as a universal principle that recognizes the diversity inherent in our global society, yet provides a conceptual basis for establishing the institutions we need.

What is the open society? Superficially, it describes the positive aspects of democracy: the greatest degree of freedom compatible with social justice. It is characterized by the rule of law; respect for human rights, minorities, and minority opinions; the division of powers; and a market economy. The principles of the open society are admirably put forth in the Declaration of Independence. But the Declaration states, “We hold these truths to be self-evident,” whereas the principles of the open society are anything but self-evident; they need to be established by convincing arguments.

There is a strong epistemological argument, elaborated by Karl Popper, in favor of the open society: Our understanding is inherently imperfect; ultimate truth, the perfect design for society, is beyond our reach. We must therefore content ourselves with a form of social organization that falls short of perfection but holds itself open to improvement. That is the concept of the Open Society: a society open to improvement. The more conditions are changing, and a global economy fosters change, the more important the concept becomes.

But the idea of the open society is not widely accepted. There are those, for instance, who argue that values are different in Asia. Of course they are different. The global society is characterized by diversity. But fallibility is a universal human condition: once we acknowledge it, we have a common ground for the open society, which celebrates this diversity.

Recognition of our fallibility is necessary but not sufficient to establish the concept of the open society. We must combine it with some degree of altruism, some concern for our fellow human beings based on the principle of reciprocity.

Any variety of Asian, or other, values would fit into a global open society, provided that some universal values reflecting our fallibility and our concern for others, such as the freedom of expression and the right to a fair trial, were also respected. Western democracy is not the only form that an open society could take. In fact, that the open society should take a variety of forms follows from the epistemological argument. This is both the strength and the weakness of the idea: it provides a conceptual framework that needs to be filled with specific content. Each society, each historical period, must decide on the specifics.

As a conceptual framework, the open society is better than any blueprint, including the concept of perfect competition. Perfect competition presupposes a kind of knowledge that is beyond the reach of market participants. It describes an ideal world with little resemblance to reality. Markets do not operate in a vacuum and do not tend toward equilibrium. They operate in a political setting, and they evolve in a reflexive fashion.

The open society is more comprehensive. It recognizes merits in the market without idealizing them, but it also recognizes other values in society. Also, it is a much vaguer, less determinate concept. It can not define how the economic, political, social, and other spheres should be separated from and reconciled with one other. Opinions may differ on where the dividing line between competition and cooperation should be drawn. Karl Popper and Friedrich Hayek, two champions of the open society, parted company over just this point.

Let me summarize my own views on the specific requirements of our global open society at this moment. We have a global economy that suffers from some deficiencies, the most glaring of which are the instability of financial markets, the asymmetry between center and periphery, and the difficulty in taxing capital. Fortunately, we have some international institutions to address these issues, but they must be strengthened and perhaps new ones created. The Basic Committee on Banking Supervision has established capital-adequacy requirements for the international banking system, but these did not prevent the current banking crisis in Southeast Asia. There is no international regulatory authority for financial markets, and there is not enough international cooperation for the taxation of capital.

But the real deficiencies are beyond economics. The state no longer plays the role it played previously. In many ways that is a blessing, but some state functions remain unfulfilled. We do not have adequate international institutions for the protection of individual freedoms, human rights, and the environment, or for the promotion of social justice, not to mention the preservation of peace. Most of the institutions we have are associations of states, and states usually put their own interests ahead of the commonweal. The United Nations is constitutionally incapable of fulfilling the promises contained in the preamble of its charter. Moreover, there is no consensus on the need for better international institutions.

What is to be done? We need to establish certain standards of behavior to contain corruption, enforce fair labor practices, and protect human rights. We have hardly begun to consider how to go about it.

As regards security and peace, the liberal democracies of the world ought to take the lead and forge a global network of alliances, like NATO, that could work with or without the UN. Their primary purpose would be to preserve peace; but crisis prevention cannot start early enough. What goes on inside states is of consequence to neighbors and the world. Promotion of freedom and democracy in and around these alliances ought to become an important objective. For instance, a democratic and prosperous Russia would make a greater contribution to peace in the region than any amount of military spending by NATO would. Interfering in other countries internal affairs is fraught with difficulties, but not interfering can be more dangerous.

Today, the global capitalist system is vigorously expanding in both scope and intensity. It exerts attraction through the benefits if offers and, simultaneously, it imposes tremendous penalties on countries that seek to withdraw. These conditions will not prevail indefinitely, but while they do, they offer a wonderful opportunity to lay the groundwork for a global open society.

With the passage of time, the deficiencies are likely to make their effect felt — boom is liable to turn into bust. But breakdown can be avoided if we recognize the flaws in time. For the global capitalist system to survive, it needs a society that strives to correct its deficiencies: a global open society.