SHOULDN’T WE LISTEN TO THOSE WHO PREDICTED THE CRASH? (PART TWO)

In the second of this three part series, Simon Radford gives a brief history lesson in post war economic thinking. Part one can be read here.

Political scientists often refer to events called “critical junctures”: events that set in motion path dependencies that set limits to individual agency to change the rules that shape results. Think of ratification of constitutions, the selection of a voting system, or the instantiation of an independent central bank. Easy to do, much harder to reverse. Two landmark events seem to have defined post-war economics in a way that have shaped everything that has come afterwards, and one man serves a central role in both: Paul Samuelson.

 

Samuelson was a Keynesian but he was also the economist who first grasped the potential of the behavioral revolution in the social sciences. John Maynard Keynes, author of the greatest work of economics ever-written in his General Theory, had re-founded the discipline of economics without using much in the way of mathematical equations or complex models. Keynes came from the tradition of ‘political economy’: an economics that was designed to solve certain political and moral questions. As Adam Smith had The Theory of Moral Sentiments as well as his Wealth of Nations, Marx had both Das Kapital as well as The Communist Manifesto and the Brumaire, so too Keynes had a political vision which economics was meant to solve. Free market capitalism and the prevailing doctrine of laissez-faire had led to depressions and the rise of the far-right and the far-left (much like today). Keynes set out to save capitalism from itself. Rather than abolish the state and capitalism, Keynes would set out a method to bend both to the ends of liberty and equality. In his Essays in Persuasion, Keynes declared himself the defender of bourgeois values over proletarian revolution, but a radical against the cruelty and stupidity of conservatism. Just as New Liberalism set out a liberalism that spoke to working class desires for empowerment and opportunity in the philosophical realm without resorting to revolutionary socialism and the overthrow of democracy, Keynes set out an economic doctrine that tried to serve the same purpose in the economic sphere. Liberalism would be dedicated to breaking up monopolies, managing demand, and acknowledging that the state had a role in bending economic and political currents towards empowering individuals in terms of boosting capabilities and providing opportunities.

Then Samuelson tried to write down the rules set out by Keynes- a literary economist understood by anyone who tried, and enjoyed by the vast majority who did so- in mathematical form for the benefit of students in what was to become the most influential undergrad textbook in economics history. Keynesianism became set down in models, abstracted away from reality with static equilibria with exact results discoverable by manipulating a few key variables. Political clashes between workers and bosses became “frictions” in models, like “sticky wages”, or psychological insights like “animal spirits” simply got spirited away. Economics went from being a form of engineering to serve political or moral ends into a separate “science’ that became a master science over these other disciplines. This reached its apogee in the application of economics tools (including bad 19^th century psychology in expected utility theory) to topics as diverse as suicide and voting.

Samuelson didn’t formalise Keynes away into what is now called neo-classical economics without a fight. For a start, Keynes’ old department and colleagues at Cambridge didn’t recognise what was happening to their mentor. Concepts would be cut up and measured to better solve the end of elegant formal models. The richness of Keynes’ insights would be rendered dull but tractable under the weight of formalism. This culminated in a public debate on the issue, the so-called “Cambridge Capital Controversy”, where Keynes’ heirs in the UK, Joan Robinson and Piero Sraffa, confronted the “other” Cambridge of MIT in saying that returns couldn’t be traced exactly to the different forces of production (“this much for capital, this much to labour, this much to land” etc). Disputes between the forces of land, capital and labour couldn’t be resolved according to their relative productivity, but were inherently political. Economics could not resolve who should get what, politicians and ethicists should make their cases. Liberals would often argue for cooperatives and mutual ownership, along a land value tax, to bring classes together, but “natural” or “equilibrium” prices for labour and land were regarded as dangerous fictions.

The political nature of labour vs. capital, and landlord vs. tenant, anchored post-Keynesian economics on the Left of the political spectrum. While Marxian economics, resting on the labour theory of value and bottom-up theories of economic behavior, disputed post-Keynesian economics because of an insistence that labour provided all value in the end, Keynesianism eschewed the more obscure by-ways of Marxian analysis without giving up an emancipatory view of the ends of economics. In the words of Joan Robinson in “A Letter from a Keynesian to a Marxist”, she has “Marx in her bones” and not her “mouth”. A literary form of economic analysis, a focus on the instability of capitalism, the political construction of “free” markets, and the necessity for intervention to serve human ends, remained the hallmarks of post-Keynesian economics.

Meanwhile, the MIT highjacking of Keynes and the mathematisation of economics saw the dominance of a debate between those who saw assumptions of neoclassical economics as actual realities[1] (Robert Lucas won a Nobel Prize in economics despite the fact that his models saw unemployment as voluntary holiday from work), and “Keynesians” who insisted that asymmetric information, adverse selection, sticky wages etc. allowed for policy interventions. But neoclassical economics shared Samuelson’s original assumptions, even if they disputed exactly how those models should be applied. This is the Krugman vs. Mankiw/Osborne/Friedman debate of today, or the so-called “saltwater vs. freshwater” debate. And the economics that has been jolted out of its position of dominance for its inability to predict and explain the 2008 crisis. This failure to see the Great Recession coming is the exogenous shock necessary for the paradigm to shift, but two conditions need be met first: there needs to be a more “progressive” research program that better explained what happened, and, secondly, people need to be told that there is a better way of doing things. Otherwise zombie economics will still win out.

Heirs to Keynesianism

The heirs to the post-Keynesian tradition still exist and two more of their number are worth mentioning as being incredibly influential and important for understanding the 2008 crash. Their names are Hyman Minsky and Wynne Godley. Hyman Minksy was a disciple of Keynes but he had one further, and major, insight: Keynes was correct that monetary and fiscal policy could “prime the pump” and grow the economy out of recession, but lowering interest rates every time bad loans dampened the economy (as those who misunderstood Keynes took to micromanaging) risked creating more and more credit which would eventually have to be paid off. George Cooper, in one of the best books about the financial crisis, uses the analogy of an engine: oscillations can get wilder and wilder until it spins out of control, if market actors think that the Fed will always catch them when they fall.

Ray Dalio, the head of Bridgewater Associates, one of the biggest hedge funds in the world, sums up the Minsky view of the world in a highly entertaining and informative video on “how the economic machine works”:

A concise and readable study of the role of private debt in economic crises backs up the Minksy/Dalio theorem: "From our analysis of these crises, our hypothesis is that for major economies, growth in private sector debt to GDP of roughly 18% in five years combined with an overall private debt to GDP ratio of 150% or more means that crisis is likely....In the United Kingdom, the 2008 crisis came after it had reached 24% private credit to GDP growth in five years and 208% total private debt to GDP." Richard Vague notes that this put the UK in a worse position than the US. But while stimulus allowed US consumers to pay down this private debt overhang, the UK's policy of reinflating a housing boom and cutting incomes (while overseeing a further collapse in UK productivity) means that further crisis is more, not less, likely.

The role of private sector credit creation and its potential for destabilising the macro economy, has even led some economists to call for the state to have a monopoly on the creation of money, and a report for the government in Iceland (a state with its own dramatic story during the financial crisis) also put bank credit creation under the spotlight as the main instigator of financial crises in Iceland’s history.

This rise and rise in private sector borrowing and its central role in causing a crash in demand is also at the heart of the work of the second main post-Keynesian whose work is worth following: Wynne Godley. His idea of sectoral balances rests on a simple- an undeniable- accounting relationship: liabilities have to equal assets. Of all the major sources of debt in the sectors of the economy- the government, private sector, families, trade balance- someone must hold that debt. The only problem? Only the government can print money to pay that debt off. If the private sector or families borrow to much, eventually they’ll hoard money to pay that debt off. This is why austerity makes no sense- if we want households and businesses to start spending money and hiring again, then the debt on their balance sheets need to be transferred to the government. If everyone tries to save at the same time we get stuck in what Keynes called “the paradox of thrift”: your spending is my income. If I save, someone else needs to spend or else someone else will need to save by laying someone off, or freezing pay. That means they spend less and so on and so on.

Godley’s use of sectoral balances meant that he saw the private sector (especially banks) and households were at their limit: they could not borrow any more and still pay their debts. Demand would have to creash and debt would have to be socialised. It might also be worth mentioning now that Godley’s prognostications were not limited to the Great Recession: he also called the ERM crisis and had an eerily prescient crystal ball which perfectly described the recent Greek crisis in an article he wrote…. In 1992!

What’s perhaps most remarkable is that these post-Keynesians- also known as heterodox economist- were the only ones who, as a group, called the 2008 crash with generally the right causes. Dean Baker, Thomas Palley, Wynne Godley and friends were right on the fact that a large recession was coming. The Levy Institute has been a leader in looking at the causes of financial instability in both the macroeconomy and in Wall Street. Richard Koo, the chief economist at Nomura, was the first to use sectoral balances to show that the US resembled strongly Japan’s crash and faced a lost decade.