Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
One of the puzzles that accompany this gruelling economic crisis is why neo-liberal economic thinking, which when applied caused the crisis and has delivered very little to so many, remains the dominant paradigm in economic policy making and has managed to turn a disaster for practitioners of that ideology into a triumph. How is it that the leading voices now are preaching exactly the same policies that caused the crisis as the solution to the crisis. Is there that much asymmetry? I noted a recent comment on my blog (Tom) that raised issues relating to the philosophy of science along the lines of how are we to judge whether the mainstream macroeconomics paradigm has failed. I understand the demarcation issues involved and the problems of “truth testing”. But we can take a more simple approach to the question. Here are two ways we know that the mainstream approach failed – they didn’t have a clue what was happening in the years leading up to the crisis and now they are scrambling in a stunned state to add banks and financial markets to their defective models. The problem is that they are just building more defective approaches. But the continued dominance demonstrates that their failures are not yet fully understood.
Prior to the crisis, the mainstream economics profession boasted how they had solved the business cycle by implementing inflation targetting-type policies and pursuing fiscal austerity. This was the narrative of the late 1990s and early 2000s.
The mainstream macroeconomists increasingly tried to claim in the 1990s and up until the recent crisis that they had “won” – been vindicated and those stupid Keynesians would never see the light of day again. They claimed that Keynesian policies had failed and vindicated their view that self-regulating markets would deliver the maximum prosperity for all of us.
It was government that was to blame for any economic ills – unemployment (excessive minimum wages, etc); poverty (welfare reliance); inflation (ill-disciplined central banks and treasuries) – and so the solution was to reduce the role of government in the economy.
The agenda was thus focused on deregulation of labour and financial markets, privatisation, rigid fiscal rules to promote budget surpluses and unaccountable central banks who narrowed their stated policy focus away from full employment and price stability to some austere inflation target.
The dodge that allowed the central banks to get away with that agenda – which effectively turned unemployment from a legitimate policy target of government (that is, true full employment) into a policy tool to curb inflation – was the invention of the NAIRU – the so-called natural rate of unemployment. Economists lined up to publish papers and given conference talks claiming that if inflation was stabilised then real economic growth would be maximised and the unemployment that was left would be “natural” and there was nothing the government could do about it without creating renewed inflation.
How inflation became the number 1 evil and unemployment was demoted from a policy target to becoming a policy tool is a sordid story of poor scholarship, misinformation and outright lies. The neo-liberal ideology triumphed and managed to convince us that mass unemployment was in some way the failing of the unemployment individuals themselves. They were cast as being lazy, of poor attitude, welfare-dependent, diverted by unproductive incentives (unemployment benefits) dangled in their faces by a misguided government.
The fact that the macroeconomic system failed to generate enough jobs was deliberately overlooked. There were even claims that the firms had stopped offering jobs because the unemployed were too poorly motivated to take them. So why would a firm offer them? At the time, I pointed out – as a demonstration of the idiocy of the claim – that these firms must have very long order books if demand was so strong but supply was being deliberately withheld.
The reality was that neither assertion was true. The firms would be complaining of slack demand on the one hand as a government handout or subsidy happened to waft by their noses. But then in their other mode – lobbying government to reduce welfare payments and employment protections and conditions they ran the “we won’t offer jobs because the unemployed won’t take them because the government feeds them too well” line.
They were able to get away with this inconsistent dichotomised logic because the ideological terrorists were always around taking out anyone who cared to challenge the view. In the academic circles this took the form of ridicule at conferences, vicious referees’ reports from journals, scathing and irrational assessment of research grant applications, and the rest of it.
My progressive colleagues around the profession will all have a story about this.
Please read my blog – The dreaded NAIRU is still about! – for more discussion on this point.
One notable example of the “business cycle is dead” bluster was the 2003 presidential address to the American Economic Association by Robert E. Lucas, Jnr of the University of Chicago. I have provided this quote in past blogs but it is relevant here and we should always recall these moments.
My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management.
The “Great Moderation” became the norm and economists focused on a sequence of non-issues and their models became increasingly bizarre (Real Business Cycles; DSGE models; New Keynesian models).
Please read my blog – The Great Moderation myth – for more discussion on this point.
This sentiment spilled over into the political arena.
In the Economic Report of the President, 2000 we read this (Page 74):
The End of the Business Cycle?
Growth has been a defining characteristic of the U.S. economic experience over the last century, but only when viewed from a long perspective: employment and income have often deviated, sometimes sharply, from their rising long-run trends. Time and again the economy has risen over a period of years to a temporary peak of activity, only to fall back downward, bottom out at a trough, and from there once again begin to rise. These peaks and troughs represent turning points of the business cycle; an expansion is defined as the period that starts from a trough and ends when a new peak is reached. Although the business cycle has been a recurring feature of the U.S. economy for as far back as we have reliable data, some observers have argued that the economy in the 1990s has fundamentally changed and that the concept of the traditional business cycle is outdated.
This was the “business cycle is dead” mantra that infected the public debate in the late 1990s and the virus was borne by my own smug profession.
President Clinton – the president who oversaw some of the worst demolitions of the welfare system in US history; the fast-tracking of financial market deregulation (under Rubin, Summers and Greenspan); and who implemented macroeconomic policies that ensured that the only way the economy could grow was by the private sector taking on increasing levels of debt. That debt exploded not many years after the President was claiming that “the concept of the traditional business cycle is outdated”.
Why wasn’t he impeached for that gross lie?
On Page 79, Clinton said:
Of course, it is premature to declare the business cycle dead. But there are reasons to believe that the economy will continue to perform as well as, if not better than, it has in the recent past, with less of the roller-coaster ride that characterized the 1970s and early 1980s (not to mention earlier decades). Unlike in the 1980s and early 1990s, fiscal discipline is now the order of the day. Projected surpluses can now be used to pay down the debt and free up capital for investment in education, business, and technology, spurring faster growth. Likewise, the Federal Reserve no longer follows the stop-and-go policies of the 1970s, but instead practices a systematic policy that fosters price stability and long-term growth.
It was very premature.
At a conference run by the Boston Federal Reserve Bank in 1998 – Beyond Shocks: What Causes Business Cycles – the then ageing US macroeconomist Paul Samuelson gave the Opening Address – Summing Up on Business Cycles. His words should have been heeded.
Paul Samuelson began by saying:
Is the business cycle dead? Or should the question be, “Was the business cycle ever alive?” After most periods of extended expansion, particularly if they also happen to be eras of bubbly capital gains, talk about a “New Era” geysers up and, what is more important, such talk is received with increasing credulity.
So the late 1990s was no exception. The growth and capital gains etc were driven by a new model of financial capitalism. Stifle the capacity of workers to participate in productivity growth via real wage gains then to address the realisation problem that such a radical redistribution of national income to profits creates – lend them back the money at interest.
This was neo-liberalism par excellence. The redistribution of national income made possible by coercive deregulations and government-sponsored and executed attacks on the trade union movement and related employment protections provide the largesse for the investment banks to begin their decade or more of accelerated gambling.
Please read my blog – The origins of the economic crisis – for more discussion on this point.
On June 19, 2012 – the boss of J.P. Morgan (Jamie Dimon) appeared before the US House of Representatives Financial Services Committee hearing – Examining Bank Supervision and Risk Management in Light of JPMorgan Chase’s Trading Loss – to explain the recent performance of his company.
You can see the hearing session HERE.
One veteran member of the Committee, Gary Ackerman made some very interesting statements in his interrogation of Dimon. His 5-minutes started at 2.02.27 in the tape.
He started by asking whether “gambling was investing” and then launched into his opening statement:
We seem to be treating them as quite the same. I used to think that all of Wall Street was on the level. That it facilitated investing. That it allowed people and institutions to put their money into something that they believed in and believed would be helpful and beneficial and grow and make money and especially help the economy and, on the side, create a lot of jobs and be good for our country and good for America.
Now, a lot of what we’re doing with this hedging — and you could call it protecting your investment or whatever – but it’s basically gambling. You’re just betting that you might have been wrong. It doesn’t help anything succeed any more. It doesn’t encourage anything any more.
Ah, it creates the possibility that people are saying do these guys really know what they are doing if they are now betting against their initial bets. And then if you go and hedge against your hedge, which means you are betting against your bets against your first bet – it seems to me that you are throwing darts at a darts board and putting a lot of money at risk just in case you were wrong in the first place.
I don’t see how that creates one job in America. I don’t see how it helps the American economy. I don’t see how it helps the housing market or the building market or the let’s-make-steel or widgets market. One-tenth of zillion percent.
What it helps is — if you were right a majority of the time — then it makes a bunch of money for the guys who did it and doesn’t help the company, the industry, the economy or the country at all. And if you were wrong, it puts systemically everything at risk. And when I say everything, I mean the confidence that the American people, the public, the investment community and everybody else has in the system. And that’s a loss you can’t hedge against. Because the more you hedge, the more questions you raise in the confidence of what you are doing in your initial investment.
Robert Skildesky (Keynes’ biographer) wrote about this today in his UK Guardian (June 25, 2012) article – Return to capitalism ‘red in tooth and claw’ spells economic madness.
Particularly in the United States and Britain since the 1980s, we have witnessed a return to the capitalism “red in tooth and claw” depicted by Karl Marx. The rich and very rich have become very much richer, while everyone else’s incomes have stagnated. So most people are not, in fact, four or five times better off than they were in 1930. It is not surprising that they are working longer than Keynes thought they would.
I will come back to this slow grinding down of the working class over the last 30 years or so later.
The point is that the Great Moderation – was not a triumph for a large number of workers and it was built on an unsustainable mix of radical redistribution of national income to profits and a radical deregulation of the sector that garnered that real income. Both policy failures ensured the business cycle was alive and well and would bite very hard when the next trough came.
In what he referred to as “my closing irony”, Paul Samuelson told the Boston conference in 1998 that:
The pre-1800 pattern of commercial panics had to be a case of NON MACRO-EFFICIENCY of markets. We’ve come a long way, baby, in two hundred years toward micro efficiency of markets: Black-Scholes option pricing, indexing of portfolio diversification, and so forth. But there is no persuasive evidence, either from economic history or avant garde theorizing, that MACRO MARKET INEFFICIENCY is trending toward extinction: The future can well witness the oldest business cycle mechanism, the South Sea Bubble, and that kind of thing. We have no theory of the putative duration of a bubble. It can always go as long again as it has already gone. You cannot make money on correcting macro inefficiencies in the price level of the stock market.
He added this final paragraph, presumably written after the draft was presented said:
After I delivered this lecture, a high Federal Reserve official asked for clarification as to whether the business cycle is after all still alive. So let me make clear that, like the below-median poor, economic instability we have always with us.
But his message was ignored. Consider that on February 20, 2004 the current US Federal Reserve Board Governor Ben S. Bernanke made one of the worst speeches by an official of a major policy institution ever. It was entitled The Great Moderation.
It was full of the same sort of blithe denial that the economics profession was flooding the public debate with. It is clear that none of these characters – many of them Nobel Prize winners – understood the inherent dynamics of the capitalist system and the way in which the neo-liberal policy regime that their economics papers and speeches motivated was fuelling the destructive nature of those dynamics.
It was obvious that a major crisis was coming and the only question was when. In 2004 I wrote an Op Ed article that concluded – when the downturn comes it will be very big. It has been that.
What the current crisis has reasserted is what the mainstream economists tried to deny – that left alone the private market will not be able to maintain long periods of output and employment growth.
That denial and ignorance – disguised by all the appeal to ideological purity and arrogant bluster that my profession brings to the public debate – is a simple demonstration that the neo-liberal paradigm has failed and is now what Lakatos would have called a degenerating paradigm.
Please read my blog – Sociopaths, closed minds and a bit of Mayan cosmology – for more discussion on the concept of a degenerating research program as defined by Imre Lakatos. Such a program is characterised by a lack of vitality and a failure to generate new ways of understanding the world or deal with the empirical evidence confronting it.
The mad scramble
The second simple demonstration that the mainstream macroeconomics has failed us is evidenced by the mad scramble in the academy to include banks and financial sectors in their models.
In this recent blog – Fiscal austerity damages real growth and prolongs the financial downturn – I discussed the sudden attraction by my profession to studying financial cycles. I noted that up until the crisis, mainstream macroeconomics (theories and models) mostly ignored financial markets and banking, thinking that they were largely peripheral to understanding the business cycle.
The only linkage between the financial sector and the real economy that was considered was via interest rates – the impact on investment spending and the demand for loanable funds to fund investment impacting back onto interest rates.
Even within this limited context, the theories developed were hopelessly deficient and incapable of explaining anything that relates to the real economy.
But now – more brash than ever – my profession is busily conjuring up financial markets to fit into their Dynamic Stochastic General Equilibrium (DSGE) models, despite these models being next to useless.
I noted that DSGE models, which are the dominant framework these days, combined with the Efficient Market Hypothesis are about fantasy land and have nothing meaningful to say about the actual monetary system.
I discussed the recent Bank of International Settlements’ working paper (BIS Working Papers No 380) – Characterising the financial cycle: don’t lose sight of the medium term! – which comments on the disregard by the mainstream of my profession for financial markets that:
… they could not account for financial crises. A rapidly growing literature is now seeking to remedy these shortcomings.
My reading of these current developments are that they remain within a deeply flawed understanding of how the monetary system operates. Ad-hoc additions to an already terminally flawed approach will not make the approach any the more relevant than it was prior to the crisis.
The models will become more elaborate and include various stylised observations about financial markets (for example, non-linear feedbacks between asset prices and funding in different states of liquidity where financial institutions mark-to-market and impose margin calls etc). But they will forever remain deficient and should be disregarded.
A whole generation of new PhD students is about to embark on programs embracing these “developments” and like the previous generation that ignored them they will finish their programs basically illiterate with respect to the way the real world operates although they will arrogantly strut around within the large institutions like the IMF etc solving complex (linear) models eventually, as their seniority progresses, they will tell governments what to do.
The advice given will be exactly what governments should not do.
So the point is that the failure is evidenced by the current work program. The mainstream is in full-scale catch-up mode but have such a deficient starting point that trying to fit the financial dynamics into a “Great Moderation” framework will lead to nothing productive or illuminating.
So is there some light?
The recent UK Guardian article (June 25, 2012) – Will this recession signal the end of neoliberalism? Don’t celebrate too soon – by one Tony Dolphin, claims that the reason the neo-liberals remain dominant is because the crisis hasn’t been damaging enough and that no alternative has been developed to capture the imagination of those in charge.
Tony Dolphin claims that despite the fact that the “UK economy has been in a terrible mess for the past five years” and that “may seem a strange thing to say, given the depth of the recession and the extent of the squeeze in the living standards of low- and middle-income families”:
But, at about 8%, unemployment is far below the levels seen in the Great Depression, when it exceeded 20% between 1931 and 1933. If unemployment is the biggest effect a recession has on people’s lives, the current experience falls a long way short of that which helped to usher in the Keynesian revolution in economic thinking and policymaking.
He also thinks the inflation of the early 1970s is much more damaging that the situation now.
The conclusion is that this crisis has not yet caused our “confidence in the political class’s ability to manage the economy” to collapse. We still have confidence that the dominant paradigm is the way forward.
He gives no reason to support that claim.
The interesting aspect of this crisis is that the costs being borne by the working class (and increasingly the middle class) now are really an acceleration of what they have been forced to bear for some three decades.
We have had two or three cycles in that period but also a steady attrition of employment conditions – as per Robert Skidelsky’s assessment above. The neo-liberals have undermined the concept of secure labour markets and promoted the urgency of consumption via lax credit as the sop to stop the working class revolt.
Robert Skidelsky said in his article:
Modern capitalism inflames, through every sense and pore, the hunger for consumption. Satisfying that hunger has become the great palliative of modern society, our counterfeit reward for working irrational hours. Advertisers proclaim a single message: your soul is to be discovered in your shopping.
Before the neo-liberal era consumption growth was mostly achieved because real wages growth kept pace with productivity growth. As noted above, in the recent era, credit replaced real wages growth and that approach to growth is unstable and unsustainable, quite apart from whether we want growth per se (see below).
The point is that it is questionable whether the damages caused by this neo-liberal era which have been slowly accumulating over many years are insufficient to generate a change in paradigm. We are seeing social instability emerging and extremist politics. I will come back to that discussion in another blog.
Tony Dolphin’s second argument is that:
… there are not enough new and sufficiently developed economic ideas waiting in the wings to coalesce into a new economic paradigm. Keynes said it took a theory to kill a theory; neoliberalism will survive until there is something to replace it … Opponents of neoliberalism need to formulate a new approach to economic policymaking, not one that tinkers at the edges of the existing model. This will involve rethinking the objective of economic policymaking to bring in non-monetary measures of progress, such as wellbeing, and to take account of resource constraints. It will involve a re-examination of the ways in which public policies can best promote full employment. And it will involve developing new rules for fiscal and monetary policy. There is much work to be done but, until it is done, politicians will struggle to build a consensus for change.
Modestly, someone should refer hims to Modern Monetary Theory (MMT). I will come back to that in another blog.
In closing, and really just a lead-in to a later blog, I have argued over the last several years that the best chance to replace the neo-liberal paradigm lies in the youth and their embrace of climate change thinking. I suspect that is one of the reasons the right are so urgently promoting climate change skepticism. They sense the threat.
Robert Skidelsky wrote:
Aristotle knew of insatiability only as a personal vice; he had no inkling of the collective, politically orchestrated insatiability that we call economic growth. The civilization of “always more” would have struck him as moral and political madness.
And, beyond a certain point, it is also economic madness. This is not just or mainly because we will soon enough run up against the natural limits to growth. It is because we cannot go on for much longer economising on labour faster than we can find new uses for it. That road leads to a division of society into a minority of producers, professionals, supervisors, and financial speculators on one side, and a majority of drones and unemployables on the other.
As the neo-liberal policy structures increasingly alienate the youth via persistently high unemployment and locking them out of the asset accumulation process I think challenges will occur.
From a MMT perspective, where full employment is a major policy priority, the need for less private consumption translates into a need for more public consumption – of the arts, music, recreation, and other more sustainable and community activities. These agendas will become increasingly attractive.
Marx said that religion was the opiate of the masses. In more recent times, household debt and mortgages have shackled the revolutionary spirit. But the youth are being excluded from that world and will hopefully form the vanguard against neo-liberalism.
That is enough for today!