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Keynes versus the Classics: Round 2

Robert Skidelsky — 2009-10-13T14:56:00+00:00

LONDON – The economist John Maynard Keynes wrote The General Theory of Employment, Interest, and Money (1936) to “bring to an issue the deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory…” Seventy years later, heavyweight economists are still at each other’s throats, in terms almost unchanged from the 1930’s.

The latest slugfest features New Keynesian champion Paul Krugman of Princeton University and New Classical champion John Cochrane of the University of Chicago. Krugman recently published a newspaper article entitled “How Did Economists Get It So Wrong?” There was nothing in mainstream economics, Krugman wrote, “suggesting the possibility of the kind of collapse that happened last year.”

The reason was that “economists, as a group, mistook beauty, clad in impressive-looking math, for truth.” They purveyed an “idealized vision of an economy in which rational individuals interact in perfect markets.” Unfortunately “this sanitized vision of the economy led most economists to ignore all the things that could go wrong.” So now economists will have to accept “the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.”

Krugman’s heavy pounding of Chicago School economics goaded Cochrane, a professor of finance, into some bad-tempered counter-punching on the university’s Web site, much of which consisted of a personal attack on Krugman’s scientific integrity. When he gets around to economics, Cochrane aims his blows at two points: Krugman’s attack on the “efficient market theory” and his advocacy of “fiscal stimulus” for depressed economies.

Cochrane accuses Krugman of misleading his readers about the efficient market theory, which asserts that, given the available information, financial markets always get asset prices right. Rather than defend that theory, Cochrane admits that “asset prices move more than reasonable expectations of future cash flows.” Unfortunately, “no theory is particularly good at that right now.”

But it’s theoretical nihilism, Cochrane argues, to ascribe these excessive fluctuations to “irrationality” as Krugman does. What Krugman is really after (“though he can’t quite come out and say this”) is for the government to “take charge of the allocation of capital.” And the one thing we do know is that however badly asset markets behave, government control “has always been much worse.”

Cochrane’s heaviest punching is reserved for Krugman’s support for President Barack Obama’s fiscal stimulus. He invokes the hoary old “Ricardian equivalence theorem,” revived by the Harvard economist Robert Barro, according to whom “debt-financed spending can’t have any effect, because people, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered.”

In short, Krugman “has absolutely no idea about what caused the crash, what policies might have prevented it, and what policies we should adopt going forward” – except that the government should now spend money like a drunken sailor. Far from having too much math, economists need more, in order to “keep the logic straight.”

On the stimulus, though, Krugman achieves a knock-out punch. The view that extra government spending “crowds out” an equal amount of private spending, so that its net stimulus effect is zero, would be true only if the economy were at full employment. Indeed, the Chicago School tacitly assumes that economies are always at full employment. They are unfazed by the fact that America’s economy has shrunk by 4% in the last year and that over 6 million people have been added to the unemployment rolls.

To Chicago economists, an increase in the number of idle workers represents a voluntary choice for leisure. In a concession to commonsense, they concede that people may make mistakes and, to that extent, a stimulus may be beneficial. But they insist that the only stimulus that will work is printing money. This will drive down interest rates and lead to an economic rebound.

Against this view, Keynes pointed out that interest-rate reductions may not do the job, because at zero or near-zero rates investors hoard cash rather than lend it out. Hence, as he put it in 1932, there may be “no escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidize new investment” – which is what the Obama administration is rightly doing.

On the question of what caused the crash, the debate is more even. Krugman is hampered by the fact that he attributes the crash to “irrationality,” which, as Cochrane points out, is no theory.

This is because Krugman refuses to take seriously Keynes’s crucial distinction between risk and uncertainty. In my view, Keynes’s major contribution to economic theory was to emphasize the “extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” The fact of their ignorance forces investors to fall back on certain conventions, of which the most important are that the present will continue into the future, that existing share prices sum up future prospects, and that if most people believe something, they must be right.

This makes for considerable stability in markets as long as the conventions hold . But they are liable to being overturned suddenly in the face of passing bad news, because “there is no firm basis of conviction to hold them steady.” It’s like what happens in a crowded theater if someone shouts “Fire!” Everyone rushes to get out. This is not “irrational” behavior. It is reasonable behavior in the face of uncertainty. In essence, this is what happened last autumn.

Chicago School economics has never been more vulnerable than it is today – and deservedly so. But the attack on it will never succeed unless policy Keynesians like Krugman are willing to work out the implications of irreducible uncertainty for economic theory.

George Osborne fails to mind the output gap

Robert Skidelsky — 2009-09-20T13:23:00+00:00

It was John Maynard Keynes who first pointed out its importance, and its consequences for policy. Keynes said that policies which are sound and necessary when the economy is fully employed, are unsound and destructive when the economy is shrinking.

He knew what he was talking about. He had lived through the Great Depression of 1929-32 when governments did what they were supposed to do in normal times: balance the budget and hold fast to sound money. The result was the greatest economic disaster in modern history.

Keynes's crucial distinction between full employment and subnormal employment was totally ignored by George Osborne in his speech "The Conservative Strategy for Recovery" last week. At no point in his speech did Osborne mention that UK output has fallen by 5pc since last October and unemployment has risen by over one million. The gap between what we can produce and what we do produce has grown to more than £70bn. This is because, as a nation, we are spending £70bn too little.

Almost all that Osborne said is right and sensible in conditions of full employment; most of it is wrong and wrong-headed when there is heavy and persisting unemployment. Although he understands that we have been in the deepest recession since the war, his strategy for recovery assumes that there is nothing to recover from – except a Labour government!

His sole policy to counter recession is low interest rates to reduce "our enormous private and public debt burden". Low interest rates require "tight fiscal policy". Tight fiscal policy requires cutting government spending now.

What is the argument? Osborne is right to say that low interest rates are necessary to fight a recession. But they are not enough. They reduce the burden of existing debt; but, even when combined with the recapitalisation of zombie banks and guarantees on old debt, they may not lower the cost of borrowing enough to stimulate new investment.

For the volume of investment depends not just on the cost of borrowing but on the expectation of profit. Recessions are the result of a collapse in profit expectations. And it may be that no feasible reduction in interest rates can revive profit expectations sufficiently to produce a robust recovery.

Today depressive forces are rampant both on the lending and borrowing sides. Commercial banks have seized the opportunity offered by the lower Bank of England rate to rebuild their balance sheets by increasing the margins on their own lending. Since October last year profit margins measured as the spread between swap rate and the mortgage rate have more than tripled. The volume of private investment has also shrunk. Not only has it decreased in absolute terms by almost £60bn but, crucially, by 2010 we are projected to invest 25pc less than before the crisis relative to GDP. We're investing a smaller portion of a smaller cake.

This is the context in which a fiscal stimulus – deliberately increasing the size of the budget deficit – becomes not just relevant but necessary. Osborne's main argument is that Britain couldn't, and can't, "afford" a fiscal stimulus because the Government's finances were already deranged before the recession started.

Criticism of Gordon Brown's handling of the public finances in his 10 years as Chancellor is certainly valid: like home owners who banked on the prices of their properties going up for ever, he banked on permanent boom to bring his budgets back into balance and like them, was caught short when the boom collapsed. But Labour's fiscal record from 1997-2007 has no bearing on the question of what we can "afford" today. We couldn't afford not to have had a stimulus in the past year and we can't afford not to continue with it now.

The reason is quite straightforward. If output is falling, the Government's revenues fall automatically and its social spending rises automatically. If the Government tries to reduce the deficit by cutting its spending, it reduces total spending in the economy still further. This causes the recession to deepen and makes the deficit even larger. It is like a cat chasing its own tail.

In these circumstances a discretionary increase in the deficit – the deliberate injection of extra spending power into the economy large enough to reverse the fall in output – is the best way of reducing the deficit in the medium term. The logic of this seems to have escaped Osborne.

He is on sounder ground in criticising some of the actual measures taken. The temporary cut in VAT was useless. Further, some forms of fiscal stimulus, like spending on infrastructure programmes, take a long time to work their way into the economy. But this is an argument for a quicker-acting stimulus, not for no stimulus.

Had the Government given everyone a spending voucher of £500 last Christmas, the chances are we would have had no output gap and full employment today! And we would be facing a much smaller prospective budget deficit.

The idea that, in present conditions, a rising budget deficit is bound to drive up long-term interest rates is moonshine. Increased household spending, diffused through the economy, would multiply the volume of bank deposits, which would have the effect of reducing the rates banks charge on loans. So a policy of expanding the budget deficit is perfectly consistent with low interest rates when aggregate spending is severely depressed.

The Osborne effect – to coin a phrase – would occur only if there is a fixed money supply. Then, it is true that if the Government borrows more money from the public the banks will have less to lend the public. However, the Bank of England can always create the money for additional government spending by printing more money This is the meaning and purpose of "quantitative easing" – to enable interest rates to stay low even as the Government is increasing its own spending, and thus avoid "financial crowding out".

At full employment, "printing money" is the royal and pretty immediate road to runaway inflation. But one cannot repeat too often that when there is heavy unemployment the injection of additional money into the economy will arrest the economic slide and bring about a recovery in output and employment. This will increase the resources available to the banks for lending, and enable the Bank of England to reverse the "quantitative easing" in due course.

The dodgiest part of Osborne's argument is that "fiscal tightening" (during a recession) does not reduce output because "what you lose in government spending, you gain in exports". But you gain in exports only if the exchange rate depreciates. Osborne does not explain why "fiscal tightening" should cause the pound to sink against other currencies (the usual argument is that it is fiscal loosening which has this effect), and he does not begin to consider how far, in the absence of a stimulus, the pound would have had to depreciate to plug the output gap. To fill a 6pc output gap with increased revenues from exports, British exports would have to grow by about 25pc.

Between January 2007 and December 2008 the trade-weighted value of the pound depreciated by 27pc. In the same time exports only grew by 13pc. By this reasoning, and keeping everything else constant, the pound would have to lose another 50pc against its major trade partner currencies for exports to fill the output gap. In fact, the pound has recovered by 7pc since January 2009.

All the arguments for a stimulus go into reverse when the economy ceases to need stimulating.

Then, as Osborne rightly says, fiscal responsibility is the condition of low interest rates. And it is more than just a party point to say that Labour mismanaged the national finances before the recession, and that as a result the "size of the fiscal adjustment" needed to get the budget under control will be greater than it need have been. But as a guide for what needs doing now his analysis is way off target. By contrast, the TUC general secretary Brendan Barber was spot on when he told the Congress at Liverpool that to "try and cut a deficit during a recession and you make it worse... But in the medium and long term it must start to come down. And that is going to mean some hard choices."

Yes, our Government, like all governments, should have an exit strategy. But it is too early to take our currently traumatised economies off their life-support systems just because bank profits have started to recover. That should be the message Gordon Brown takes to Pittsburgh for Thursday's meeting of the G20.

Is Stimulus Still Necessary?

Robert Skidelsky — 2009-09-13T08:23:00+00:00

London – Have stimulus packages brought the world’s traumatized economies back to life? Or have they set the scene for inflation and big future debt burdens? The answer is that they may have done both. The key question now concerns the order in which these outcomes occur.

The theory behind the massive economic stimulus efforts that many governments have undertaken rests on the notion of the “output gap.” This is the difference between an economy’s actual output and its potential output. If actual output is below potential output, this means that total spending is insufficient to buy what the economy can produce.

A stimulus is a government-engineered boost to total spending. Government can either spend more money itself, or try to stimulate private spending by cutting taxes or lowering interest rates. This will raise actual output to the level of potential output, thereby closing the output gap.

Some economists – admittedly a diminishing number – deny that there can ever be an output gap. The economy, they argue, is always at full employment. If there are less people working today than yesterday, it is because more people have decided not to work. (By this reasoning, a lot of bankers have simply decided to take long holidays since last September’s financial meltdown.) So today’s output is what people want to produce. Attempts to stimulate it will produce only higher prices as people spend more money on the same quantity of goods and services.

A more sensible view is that today’s economy is not producing as much as it could and that there are many more people who want to work than there are jobs available. So a stimulus will boost both output and employment.

But how large must such a stimulus be? The United States Congressional Budget Office (CBO) estimates that American output will be roughly 7% below its potential in the next two years, making this the worst recession since World War II. American unemployment is projected to peak at 9.4% towards the end of 2009 or the beginning of 2010, and is expected to remain above 7% at least until the end of 2011.

The US government has pledged $787 billion in economic stimulus, or about 7% of GDP. Superficially this looks about right to close the output gap – if it is spent this year. But it is in fact a three year-program. Some $584 billion is allocated for 2009-2010, leaving perhaps $300 billion of extra money for this year. Even so, it is not clear how much of that will be spent.

This can be illustrated by a simple example. Suppose the government distributes the extra cash to its citizens. Some of it will be saved. American household saving has shot up from 0% to 5% since the start of the recession, understandably to pay off debt.

Another part of the extra money will be spent on imports, which does nothing to stimulate spending on US output. Let’s subtract 20% for these two items. The bad news, then, is that only 80% of the $300 billion, or $240 billion, will be spent initially.

The good news is that this figure is multiplied over successive rounds of spending, as one person’s spending becomes another person’s income, and so on. The value of the multiplier depends on assumptions about the size of the “gap,” “leakages” from the spending stream, and the effect of government programs on confidence.

Estimates vary from a multiplier of about two all the way down to zero. A multiplier of two would generate $480 billion of extra spending, compared to a multiplier of one, which would generate just the initial $240 billion. If the multiplier is zero, as conservative-minded economists believe, there will be no effect on output, only on prices.

A further source of stimulus is “quantitative easing,” or, more simply, printing money. By buying government securities, the central bank injects cash into the banking system. This is intended to stimulate private spending by bringing down the rate of interest at which banks lend to their customers. Extra hundreds of billions of dollars have been injected into banks worldwide by this means.

But the stimulus effect of quantitative easing is far less certain than even that of fiscal stimulus. While the policy caused credit spreads to narrow and bond market liquidity to improve, many banks have been using the extra money to rebuild their balance sheets (the equivalent of increased household savings) rather than lending it to businesses and individuals.

Several conclusions can be drawn from what admittedly are back of the envelope calculations. The first is that stimulus packages around the world arrested the slide into depression, and may have started a modest recovery.

Second, it is too early to scale down the stimulus, as Japan and the US seem ready to do. As one British official said ahead of the G-20 summit in Italy in July, “We should start to prepare exit strategies, but we should start implementing them only when [we] are sure [we] have got a recovery that is entrenched and self-sustaining, and I don't think anyone is saying we are at that point yet.”

Third, existing policy, even if maintained, will not produce self-sustaining recovery. At best, it offers the prospect of several years more of sub-normal activity. A double round of stimulus packages is needed to counteract the real prospect of a double-dip recession. The time to start worrying about inflation is when the recovery is entrenched. To pay back the debt without strain, we need a booming economy.Talk of cuts is premature. ‘A boom not a slump is the right time for austerity at the Treasury’ said Keynes. He was right

Keynesian reforms could stop us falling into more economic foxholes

Robert Skidelsky — 2009-08-30T07:52:00+00:00

One might almost say that economics is too important to be left to economists. Keynes, as his wife put it, was "more than an economist". Here are three things he believed:

1. The future is radically uncertain. To talk of risks being "correctly priced" is a nonsense term. Risks are conventionally priced, but because there is no firm basis of knowledge to hold their prices steady they are subject to "sudden and violent changes". This makes investment very volatile.

2. Holding money is a hedge against uncertainty. When confidence falls there is a flight into cash. This means that economies can run down, with people curtailing their spending.

3. Economies can stay depressed a long time unless government increases its own spending to offset the fall in private spending. This justifies "stimulus" policies.

Contrast this with the most influential macroeconomics taught today:

1. The future is known. We either know what is going to happen for certain, or we have mathematical probabilities about future events.

2. Markets continuously, or almost continuously, clear.

3. Shares are correctly priced on average.

These propositions amount to saying that a market system is almost always at full employment. If this is so, then stimulus policies will have no stimulating effect – they will only divert spending from the private to the public sector.

Obviously policy and regulation will be different depending which story one buys. In the last 30 years, governments and regulators have bought the second story, with the results we now see.

We are now coming out of a very severe recession. This is largely due to the stimulus policies adopted under the influence of Keynes. Hundreds of billions of dollars have been pumped into leaking economies all round the world.

Just compare this with the Great Depression of the early 1930s. Then, the world economy contracted for 12 quarters in a row. Now, it looks as if the contraction will be limited to four quarters. The difference is that then governments cut their own spending. This time they have done exactly the opposite. They have pumped money into the economy, either by expanding their own deficits or by getting central banks to print money.

Keynes showed that trying to balance the budget, which was correct at full employment, was radically unsound when the economy was contracting. In such a situation, the government's revenue base would contract, and raising taxes or cutting spending would only cause it to contract more.

Conversely, any stimulus which revived the economy would largely pay for itself by automatically increasing the government's revenues.

Yes, there would be a legacy of a higher debt. But this could be reduced gradually. After all, it took almost 100 years to pay off the debt incurred by the British government in the Napoleonic wars, during which time the British economy flourished mightily.

So, those economists and politicians who argue that the stimulus will bankrupt governments or raise the cost of future borrowing to astronomical heights are talking nonsense. This doesn't mean that budgets should not be restored to balance and the national debt gradually reduced.

The most important thing to do in the recovery phase is to set up a system which guards against severe future downturns. We shouldn't just rely on government stimulants. We should aim to give economies healthy lifestyles, so they don't depend on constant blowing up to keep them vigorous.

The starting point of reform is the recognition that economies can crash. So they need to be weaned off activities which are liable to make them crash. I would pick out three topics for reform.

Banks taking deposits should be forbidden from speculating with their depositors' money. There are different ways for achieving this. One could separate retail from investment banking. In the British context this would mean stopping high street banks giving mortgages. Less radically, one could stop banks securitising mortgages; or one could tighten up the conditions for mortgage lending. Another way of making banks "safer" for depositors (and for the economy) is to force them to hold more capital against their liabilities or more reserves against their deposits.

However, if retail is to be separated from investment banking, it is important to ensure that investment banks are not allowed to become "too big to fail". Governments (for which read taxpayers) should never be in the position of having to bail out banks in order to prevent the economy from collapsing.

Secondly, price stability is not enough. Macroeconomic policy should aim to preserve financial stability as well. That means preventing asset bubbles. Current proposals aim to vary bank capital adequacy requirements contra-cyclically. However, this approach presupposes both the existence of regular economic cycles and ability to judge where we are in the cycle. I doubt if either proposition is true.

A more durable way of preventing asset bubbles would be to reverse the trend to inequality. This has resulted in wealth being piled up in ever fewer hands, and poorer people becoming over-borrowed. The combination of concentrated wealth and stagnant median incomes is calculated to turn investment into speculation. How to reverse the trend to increasing inequality is the main unsolved question of political economy today.

Finally, we must correct the huge global imbalances which have enabled some parts of the world, notably China and East Asia, to pile up huge current account surpluses against the rest of the world. This has left much too large a part of our own economic activity dependent on foreign loans. It is one thing to borrow from abroad for investment, a different matter to borrow for consumption, since this does not create assets which can service the debt. The global imbalances helped pump up the inverted debt pyramid that brought the system crashing down.

These would be the lines of reform for a Keynesian Chancellor. It is not enough to say, with the economist Robert Lucas, "I guess, we are all Keynesians in the foxhole". We must stop falling into foxholes.

Fictional Sovereignties

Robert Skidelsky — 2009-08-19T13:07:00+00:00

London – A year ago, tiny Georgia tried to regain control over its breakaway enclave of South Ossetia. The Russians quickly expelled the Georgian army, to almost universal opprobrium from the West. South Ossetia, together with Abkhazia (combined population 300,000), promptly declared their “independence,” creating two new fictional sovereignties, and acquiring in the process all the official trappings of statehood: national heroes, colorful uniforms, anthems, flags, frontier posts, military forces, presidents, parliaments, and, most important, new opportunities for smuggling and corruption.

So far, only Russia and Nicaragua recognize the independence of Abkhazia and South Ossetia. Russian recognition was widely seen as retaliation for Western recognition of Kosovo (population two million), the breakaway province of Serbia, earlier last year.

A thousand miles to the west of Georgia is Moldova (population 3.5 million), which lies between Romania and the Ukraine. Annexed by Tsarist Russia in 1812, joined to Romania in 1918, and re-annexed by the Soviet Union in 1940, it seized its independence from Moscow in 1991. It is a member of the United Nations, the Council of Europe, the World Trade Organization, the Organization for Security and Cooperation in Europe, and various other prestigious international bodies.

Moldova’s main claim to fame is King Stephen the Great, who defeated the Ottomans in a great battle in the fifteenth century. It also produces rather good wine. An enduring memory from my own recent visit to its capital Chisenau is the election poster of a local politician called Lupu, who holds a pair of spectacles to his eyes, whether to suggest visions or wisdom isn’t clear.

To get to Moldova from Odessa (now in Ukraine) one must drive through the self-proclaimed “republic” of Transdniestria (population 700,000), a sliver of land on the north shore of the river Dniester. A clump of peeling buildings, rusting wire, and a filthy lavatory mark the start of Transdniestrian sovereignty.

Progress through this squalid, but well manned, frontier post involved the stamping of lots of documents and a liberal scattering of bribes, a process repeated on leaving the republic. A shadowy mafia-style company, Sheriff, owns most of the economy. It is said to have close links to the president and his family. It has built a giant football stadium in the capital, Tiraspol, which seems to be some kind of symbol of Transdniestrian virility. Unrecognized by the rest of the world, Transdniestrian “independence” is secured by a Russian garrison.

The world’s population is about six billion. Suppose it was divided into independent political units of two million people each. That would mean 3,000 micro-states, each refusing to accept any sovereignty superior to its own. Of course, this would be a recipe for global anarchy.

Yet the trend over the past century has been towards a continuous increase in the number of small states, mainly owing to nationalist revolts against multi-national empires: the latest bout of state creation followed the disintegration of the Soviet Union. Even long-established states like the United Kingdom now have strong separatist movements. In its political life, the world has been steadily regressing to a form of tribalism, even as its economic life has become increasingly globalized.

The equation of state with nation is the arch-heresy of our time. A “nation” is, at root, an ethno-linguistic – occasionally religious – entity, and because it is through language and liturgy that culture is transmitted, each nation will have its own distinctive cultural history, available for use and misuse, invention and discovery.

The state, however, is a political construction, designed to keep the peace in an economically viable territory. There are simply too many “nations,” actual or potential, to form the basis of a world system of states, not least because so many of them, having been jumbled up for centuries, cannot now be disentangled.

Micro-states can never be made small enough to satisfy their advocates’ exalted standards of cultural integrity. So the unraveling of multi-national states is a false path. The way forward lies in democratic forms of federalism, which can preserve sufficient central authority for the purposes of statehood, while respecting local and regional cultures.

Today’s upsurge of micro-nationalism is not just a consequence of the revolt against empires: it is also a revolt against globalization. There is widespread resistance to the idea that modern states’ chief function is to slot their peoples into a global market dominated by the imperatives of efficiency and cheapness and heedless of the damage it does to non-economic activities. This feeling is strengthened when the global economy turns out to be a global casino. National assertion is a way of combating impersonal forces and remote authorities.

Globalization promises too much in terms of welfare gains, particularly to developing countries, to be abandoned. But the main lesson from the current crisis is that we will have to develop styles of global economic governance to manage, regulate, and mitigate the creative, but often disruptive forces unleashed by the global market. In the absence of an actual world government, this can be done only through cooperation among states. The fewer “sovereigns” there are, the easier it will be to secure the necessary cooperation.

The Bretton Woods Agreement of 1944, which laid the institutional foundation for the post-war economy, was made possible because the United States and Britain called the shots. When objections were raised to Cuba being put on the drafting committee, Harry Dexter White, the American representative, remarked that Cuba’s function was merely to provide cigars.

Such a cavalier attitude to lesser powers demands to be heard is no longer possible. But all this means is that the facades will have to be more subtle and the fictions more elaborate. Provided we do not deceive ourselves about where power lies, let presidents and parliaments be three a penny if that is what makes people feel good about themselves.

How to rebuild a shamed subject

Robert Skidelsky — 2009-08-06T09:55:00+00:00

It was to be expected that our present economic traumas would call into question the state of economics. “Why did no one see the crisis coming?”, Queen Elizabeth reportedly asked one practitioner. A seminar at the British Academy tried to answer and the FT has taken up the discussion.

The Queen’s question is understandable, given the subject’s claims on its own behalf. Ever since modern economics started in the 18th century it has presented itself as a predictive discipline, akin to a natural science. Since the future a year ago included the present slump, it is natural that the failure of the economics profession – with a few exceptions – to foresee the coming collapse should have discredited its scientific pretensions. Economics is revealed to have no more clothes than other social science. One cannot imagine the Queen in, say, nine months’ time, asking a leading political scientist: “Why did no one tell me that Labour was going to win the election?” She would understand that this was not a prediction that any political scientist could make with conviction, however much time he had spent studying present and past opinion polls.

Nevertheless, the Queen’s question was wrong, because it accepted at face value the predictive claim of economics – a feature that has distinguished it from all other social sciences. Karl Popper produced a famous argument against the possibility of prediction in human affairs: one cannot anticipate a new invention because, if one could, one would already have invented it. However, this objection can be overcome if one assumes a stable and repetitive universe in which rational actors make efficient use of the information available to them. In this environment, uncertainty disappears to be replaced by calculable risk. Shocks and mistakes may occur but these will cancel each other out, so that, on average, people get what they expect.

An important implication of this view is that shares are always correctly priced. This is the basis of the so-called efficient market hypothesis that has dominated financial economics. It led bankers into blind faith in their mathematical forecasting models. It led governments and regulators to discount the possibility that financial markets could implode. It led to what Alan Greenspan called (after he had stepped down as chairman of the US Federal Reserve) “the underpricing of risk worldwide”.

It has also led to the discrediting of mainstream macroeconomics. The efficient market hypothesis is simply an application of the recently triumphant New Classical school, which preaches that a decentralised market system is always at full employment. In their obsession with getting government out of economic life, Chicago economists claimed that any consistent set of policies will be learnt and anticipated by a population, and will therefore be ineffective. Since people – apparently including the 10 per cent or so unemployed – are already in their preferred position because of their correct anticipations and instantaneous adjustment to change, “stimulus” policies are bound to fail and even make things worse. Recessions, in this view, are “optimal”.

Most of those unversed in New Classical economics assume that John Maynard Keynes exploded these fallacies 70 years ago. Their re-emergence is not just the result of the failure of Keynesian macroeconomic policy to anticipate or deal with “stagflation” in the 1970s. It reflects a persistent bias in economics towards an idealised account of human behaviour; what Joseph Schumpeter called the “Ricardian Vice” of excessive abstraction. It is only by imagining a mechanical world of interacting robots that economics has gained its status as a hard, predictive science. But how much do its mechanical constructions, with their roots in Newtonian physics, tell us about the springs of human behaviour?

One of the most interesting contributions to the FT.com debate was the argument that, after Keynes, economists should have aligned their discipline with other social sciences concerned with human behaviour. Keynes opened the way to political economy; but economists opted for a regressive research programme, disguised by sophisticated mathematics, that set it apart. The present crisis gives us an opportunity to try again.

The reconstruction of economics needs to start with the universities. First, degrees in the subject should be broadly based. They should take as their motto Keynes’s dictum that “economics is a moral and not a natural science”. They should contain not just the standard courses in elementary microeconomics and macroeconomics but economic and political history, the history of economic thought, moral and political philosophy, and sociology. Though some specialisation would be allowed in the final year, the mathematical component in the weighting of the degree should be sharply reduced. This is a return to the tradition of the Oxford Politics, Philosophy and Economics (PPE) degree and Cambridge Moral Sciences.

Beyond this, the postgraduate study of macroeconomics might with advantage be separated from that of microeconomics. Courses in microeconomics should concern themselves, as at present, with the building and testing of models based on a narrow set of assumptions. Their field of applicability lies in those areas where we have reliable views of the future. Macroeconomics, though, is an essential part of the art of government, and should always be taught in conjunction with subjects bearing on this.

The obvious aim of such a reconstruction is to protect macroeconomics from the encroachment of the methods and habits of the mathematician. Only through some such broadening can we hope to provide a proper education for those whose usefulness to society will lie as much in their philosophical and political literacy as in their mathematical efficiency.

Economic reform needs a dose of reality

Robert Skidelsky — 2009-07-13T09:11:00+00:00

Mainstream economics subscribes to the theory that markets "clear" continuously. The theory's big idea is that if wages and prices are completely flexible, resources will be fully employed, so that any shock to the system will result in instantaneous adjustment of wages and prices to the new situation.

This system-wide responsiveness depends on economic agents having perfect information about the future, which is manifestly absurd. Nevertheless, mainstream economists believe that economic actors possess enough information to lend their theorising a sufficient dose of reality.

The aspect of the theory that applies particularly to financial markets is called the "efficient market theory," which should have been blown sky-high by last autumn's financial breakdown. But I doubt that it has. Seventy years ago, John Maynard Keynes pointed out its fallacy. When shocks to the system occur, agents do not know what will happen next. In the face of this uncertainty, they do not readjust their spending; instead, they refrain from spending until the mists clear, sending the economy into a tailspin.

It is the shock, not the adjustments to it, that spreads throughout the system. The inescapable information deficit obstructs all those smoothly working adjustment mechanisms – ie, flexible wages and flexible interest rates – posited by mainstream economic theory.

An economy hit by a shock does not maintain its buoyancy; rather, it becomes a leaky balloon. Hence Keynes gave governments two tasks: to pump up the economy with air when it starts to deflate, and to minimise the chances of serious shocks happening in the first place.

Today, that first lesson appears to have been learned: various bailout and stimulus packages have stimulated depressed economies sufficiently for us to have a reasonable expectation that the worst of the slump is over. But, judging from recent proposals in the United States, the United Kingdom, and the European Union to reform the financial system, it is far from clear that the second lesson has been learned.

Admittedly, there are some good things in these proposals. For example, the US Treasury suggests that originators of mortgages should retain a "material" financial interest in the loans they make, in contrast to the recent practice of securitising them. This would, among other things, reduce the role of credit-rating agencies.

But there is no indication as to how much of the loan they would be required to hold, or for how long. Nor do these official responses to the crisis envisage limiting the amount of loans to some multiple of the borrowers' income or some proportion of the value of the property being bought. This, it is feared, might slow recovery. It would have been better for both recovery and reform to promise to introduce such limitations in (say) two years' time.

Most disappointing to reformers has been the official rejection of the "Glass-Steagall" approach to banking reform. This would have restored the separation between retail and investment banking, which was swept away by the deregulating wave of the 1980s and 1990s.

The logic behind the separation was absolutely clear: banks whose deposits were insured by the taxpayers should not be allowed to speculate with their depositors' money. Instead, the reform proposals have opted for a mixture of higher capital requirements for leading banks and pre-funding of deposit insurance by a special levy on banks.

There seems to be little appetite for proposals to vary capital adequacy requirements counter-cyclically. This would enable capital buffers to be created in good years, which could then be drawn down in bad years.

Admittedly, there are difficulties with all proposals to restrict the scope of "risky" banking, especially in the context of a global economy with free capital mobility. As is frequently pointed out, unless banking regulations are identical across frontiers, there will be plenty of scope for "regulatory arbitrage". Similarly, banks would have incentives to "game" capital-adequacy requirements by manipulating how capital and assets are defined. Indeed, investment banks like Goldman Sachs and Barclays Capital are already inventing new types of securities to reduce the capital cost of holding risky assets.

The underlying problem, though, is that both regulators and bankers continue to rely on mathematical models that promise more than they can deliver for managing financial risks. Although regulators now place their faith in "macro-prudential" models to manage "systemic" risk, rather than leaving financial institutions to manage their own risks, both sides lumber on in the untenable belief that all risk is measurable (and therefore controllable), ignoring Keynes's crucial distinction between "risk" and "uncertainty".

Salvation does not lie in better "risk management" by either regulators or banks, but, as Keynes believed, in taking adequate precautions against uncertainty. As long as policies and institutions to do this were in place, Keynes argued, risk could be let to look after itself. Treasury reformers have shirked the challenge of working out the implications of this crucial insight.

Book Review: The World Finance Crisis & the American Mission

Robert Skidelsky — 2009-06-17T14:04:00+00:00

Fixing Global Finance

by Martin Wolf

Johns Hopkins University Press, 230 pp., $24.95

By common consent, we have been living through the greatest economic downturn since World War II. It originated, as we all know, in a collapse of the banking system, and the first attempts to understand the resulting economic crisis focused on the reasons for bank failures. The banks, it was said, had failed to "manage" the new "risks" posed by financial innovation. Alan Greenspan's statement that the cause of the crisis was the "underpricing of risk worldwide" was the most succinct expression of this view.[1] Particular attention was paid to the role of the American subprime mortgage market as the source of the so-called "toxic" assets that had come to dominate bank balance sheets. Early remedies for the crisis concentrated on bailing out or refinancing the banks, so that they could start lending again. These were followed by "stimulus packages," both monetary and fiscal, to revive the real economy.

Now that we are—or may be—over the worst of the crisis, attention has partly switched to trying to understand its deeper causes. The two most popular explanations to have emerged are the "money glut" and the "saving glut" theories. The first blames the crisis on loose fiscal and monetary policy, which enabled Americans to live beyond their means. In particular, Greenspan, chairman of the Federal Reserve in the critical years until his retirement in early 2006, used low interest rates to keep money too cheap for too long, thus allowing the housing bubble to get pumped up till it burst.

The second explanation sees cheap money in the US as a response to a "global saving glut" originating in East Asia and the Middle East. The "exorbitant privilege" enjoyed by the US dollar as the world's key currency allowed the US to pursue a fiscal and monetary policy that pushed domestic demand for goods and services well beyond domestic output, thereby absorbing the foreign savings hurled at it. The trouble was that foreign, and particularly Chinese, "investment" in the US economy, which in recent years has taken the form of buying US Treasury bonds, failed to create a corresponding flow of American tradable goods and services with which to repay the borrowing. As a result, America's domestic and foreign debt just went on increasing. In the technical jargon, both the US current account deficit and its debt-financed housing boom were unsustainable: it was unclear whether the dollar or the housing bubble would collapse first.

Concern about the US current account deficit—the excess of expenditures over receipts in a country's balance of payments—long preceded the financial crisis. By 2005, it had already ballooned to 5 percent of GDP. How had this happened? The conservative explanation was that the US monetary and fiscal authorities had provided Americans with the money to make payments to foreigners for imports far in excess of the payments they received from foreigners for exports. This "spending beyond your means" is the classic road to ruin, for households as well as for countries. In the case of households, it is normally brought to an end by a notice from your bank or credit card company saying that you have reached your credit limit or your account has been frozen. In the case of countries, it is normally ended by the refusal of other countries to lend the profligate country the means to continue its spending spree. The puzzle, though, was why the countries with surpluses continued to pour their hard-earned savings into the debt-ridden American economy.

In a notable lecture in 2005, Ben Bernanke, about to become chairman of the Federal Reserve, gave the answer. At first, he said, it was because the US was a highly productive economy. But following the financial crisis of 1997–1998, East Asian countries had deliberately started accumulating foreign exchange reserves to guard against another flight of capital similar to what they had just suffered or observed. To accumulate reserves they had to run current account surpluses, by earning more in exports than they spent on imports. This tied in with their policy of undervaluing their currencies against the dollar in order to maintain export-led growth.

After the collapse of the dot-com boom in 2000, the US became a much less desirable place for direct foreign investment. So East Asian countries, especially China, started to buy US Treasury bonds. They adopted aggressive policies of buying large quantities of dollars and resisting market pressure for appreciation of their currencies. Investing their dollars in US securities was a way of segregating their dollar purchases from the domestic money supply, thereby preventing domestic price increases that would have eroded their export competitiveness. Like other economists at the time, Bernanke saw considerable merit in the arrangement: it enabled emerging and developing countries to reduce their foreign debts, stabilize their currencies, and reduce the risk of financial crises. Without US willingness to act as a "consumer of last resort," the global savings glut would exert a huge deflationary pressure on the world economy.

But Bernanke also pointed out three snags in the situation. First, for developing countries to be lending large net sums to mature industrial countries with abundant capital was undesirable: the flow should be going the other way—to countries with a capital shortage. Second, much of the inflow of capital to the US went not into improving productivity but into the housing sector and consumption. Third, the arrangement depressed US exports, encouraging instead the parts of the economy that produce nontraded goods and services, such as the financial industry. Yet to repay its foreign creditors, the US needed healthy export industries. A fall in the dollar was, therefore, needed to shrink the nontradable economy relative to the export sector. Nevertheless, Bernanke concluded, "fundamentally, I see no reason why the whole process [of rebalancing] should not proceed smoothly."

This was the standard view before the present crisis broke. Martin Wolf, the world's most respected financial columnist—mainly for the Financial Times —published a book in 2004 called Why Globalization Works.[2] He saw globalization as a mighty engine for ending global poverty, and was scornful of arguments against it, most of which he dismissed as lacking professional competence. He pointed to the huge success of China in reducing extreme poverty (people living on less than $1 a day). He saw no problem arising from the macroeconomic imbalances that resulted from lopsided trade. As he wrote:

The pattern of surpluses and deficits will create difficulties only to the extent that the intermediation of the flows from the savings-surplus to the savings-deficit countries does not work smoothly.... But no insuperable difficulty should arise. If some people [Asians] wish to spend less than they earn today, then others need to be encouraged to spend more.

As late as mid-2007, he thought that the possibility that "huge calamities" could be generated by world financial markets "looks remote."[3]

His message just two months later was very different:

Nothing that has happened has been a product of Fed folly alone. Its monetary policy may have been loose too long. The regulators may also have been asleep. But neither point is the heart of the matter.... Today's credit crisis...is also a symptom of an unbalanced world economy.[4]

Wolf more recently argued that the accumulation of dollar reserves by China and other East Asian countries that have maintained undervalued exchange rates against the dollar explains the low long-term interest rates and monetary easing of the US in the 2000s. Cheap money, he writes, had "encouraged an orgy of financial innovation, borrowing and spending" that created housing bubbles:

High-income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.[5]

Wolf's most recent book, Fixing Global Finance, marks a turning point in his worldview. Written in 2007, just before the first signs of the current financial crisis were starting to register, it explains how unprecedented macroeconomic imbalances have repeatedly created the preconditions for financial crises over the last three decades. It offers the reader a chance to test Wolf's predictions and prescriptions a few months after they were made.

Wolf's main argument is that the microeconomics of finance is intimately intertwined with the nature of the global macroeconomy. If the latter is not sound, the former will not be sound either. His eight chapters take us through a detailed account of the role of exchange rate regimes—i.e., policies used to maintain currencies at a desired level against the dollar—and their influence on balance of payments and, ultimately, on the availability and use of credit in domestic economies.

It was the large macroeconomic effects of financial crises in emerging markets in the 1990s that enabled America to become what Wolf calls the "borrower and spender of last resort." There were four steps toward these crises: mismanaged liberalization (and globalization), run-up to currency crisis, currency crisis, and, finally, full financial crisis. South Korea offers a good example. During the 1990s, in order to qualify for OECD membership, South Korea had been liberalizing its exchange controls and credit markets. Spurred by their government to keep growing, large Korean companies and banks started borrowing abroad despite dwindling profits. Rising foreign interest rates undermined their creditworthiness and increased the cost of servicing their debt. They therefore needed to borrow even more—but now under worse conditions. This led to a general skepticism among foreign lenders. Whether solvent or not, Korean companies were faced by an ever-worsening credit situation.

Under these conditions of uncertainty, Koreans and other foreigners started selling the domestic currency, which therefore plummeted in value and triggered a currency crisis. This is when the full financial crisis of the 1990s really got going. With a devalued domestic currency, neither private nor public institutions could afford to take out new loans in foreign currencies, and the old ones could not be repaid. Interest rates soared and insolvent companies were wiped out, bringing solvent banks down with them. "Domestic credit seizes up. Inflation surges as the currency tumbles. The economy falls into a deep recession." Partly because of similarity of circumstances and partly because of contagion effects, this was the fate of most East Asian economies in 1997–1998.

During the three decades preced- ing 1997, financial crises were always followed by periods of large inflows of capital into emerging market economies ranging from East Asia to Latin America, as foreign investors shrugged off their losses and cheerfully started lending again. However, East Asian countries realized that being a net importer of capital comes at huge cost when their domestic currency faces devaluation. Thus, at the end of the 1990s, most emerging economies simply said "enough." No longer would they run current account deficits; instead they would keep their currencies artificially low—but stable—to facilitate export-led growth and become net exporters of capital.

To prevent inflows of capital from private foreign interests and banks from jeopardizing this policy, the governments of these countries have since been accumulating huge foreign-denominated reserves. In particular, they have been hoarding dollars. As Wolf puts it:

In essence, this is government recycling of money earned through the current account and money received from private sector capital flows: the emerging market economies are...smoking capital, but not inhaling.

This set the stage for unprecedented global imbalances. There can be no net exporter of capital without a net importer of capital. And if the net exporters happen to include countries such as China, you need a really big economy to absorb that capital. Enter the United States.

What follows in Wolf's account is largely a rehash of Bernanke's 2005 lecture. Wolf explains the "saving glut"/"money glut" debate, which is also an argument about the conduct of US macroeconomic policy in the years leading up to the bank crash of 2008. The official view of the Federal Reserve was that the existence of a "global saving glut" required the US to step forward as the superborrower to rescue the world from a recession. The "money glut" view holds that the direction of causality was quite the opposite: US monetary excess brought about low interest rates, which sparked a rapid growth in credit while reducing the willingness of American households to invest. This then resulted in trade deficits that weakened the dollar. To preserve competitiveness, East Asian governments were forced to embark on open-ended foreign currency intervention.

Thus, in the "money glut" view it was excessive US spending that led to excessive saving in emerging markets and not the other way around. Wolf prefers the "saving glut" to the "money glut" explanation. As he puts it:

Many blame the United States' predicament on the policies of the Federal Reserve and lax regulation of the financial system. These arguments are not without merit, but they are exaggerated.

Wolf's book is overloaded with diagrams and tables to back up this argument. The very density of the material may obscure the reader's understanding of the causal mechanisms by which "surplus Chinese saving" became "excessive American spending." Evidently, Americans didn't directly spend Chinese savings. The US dollars earned by Chinese exporters weren't being borrowed by American firms and households: they were being borrowed by China's central bank, which then hoarded or segregated them to keep them out of the domestic money supply and to keep the exchange rate low.

The story goes somewhat like this. Instead of having to borrow from the American public to finance its fiscal deficit, the US government could borrow Chinese savings by issuing Treasury bonds that were bought by the Chinese. Therefore federal deficits did not raise the cost of domestic borrowing, which they would have done had the government had to borrow American savings rather than selling debt to China. If the economy is working to capacity, the more governments borrow, the less private investors borrow. This is called "crowding out." With Chinese savings available, the US government could run a deficit without crowding out private spending. This allowed the Fed to establish a much lower funds rate—the rate at which banks borrow from the Fed and one another—than it would otherwise have been able to do, helped in this by the downward pressure on prices exerted by the import of cheap Chinese goods produced by cheap Chinese labor. Cheap money, in turn, enabled banks to expand their deposits and their loans to customers more than they could otherwise have done. In short, it was via their impact on the financing of the federal deficit that Chinese savings made it possible for the US consumer to go on a spending spree.

Provided that the Chinese were prepared to go on lending money to the US, why was this position unsustainable? Wolf suggests the answer when he remarks that the glut of savings by the Chinese might be better thought of as an "investment dearth" in the United States. This echoes Alan Greenspan's finding that cheap money hardly raised the level of US investment. A key indicator of this, as Greenspan put it, was

the dramatic swing in corporations' use of their internal cash flow...from fixed investment to buybacks of company stock and cash disbursed to shareholders.

The lack of opportunities for profitable investment determined the pattern of American spending. Americans borrowed not to invest in new machines but to speculate in houses and mergers and acquisitions. The resulting growth in paper wealth triggered a consumption boom. The situation was unsustainable because no new resources were being created with which to pay back either domestic or foreign borrowing.

This much was apparent to Wolf by 2007. But he took the view that to take any action to correct this enormous imbalance between China and the US risked upsetting the delicate, if unsound, mechanism that was keeping the world economy afloat. Indeed, he remarked:

As I write these words in August 2007, there seems to be good reason to welcome the global imbalances...: the world economy is growing strongly and in a more balanced way than in previous years, as demand picks up across the globe; the developing world is also performing well, particularly in Asia; and the world has not experienced a significant financial crisis in emerging markets since 2001.

Yet the name Wolf gives to his fifth chapter—"Calm before a Storm"—provides a hint of coming trouble.

In fact the present financial meltdown is producing the market-led adjustment that has eluded policymakers. Willy-nilly Americans are having to spend less and save more; the decline of Chinese export markets forces China to shift its growth emphasis to domestic development; the weakening of the American economy has produced an automatic decline in the relative value of the dollar against other currencies. But unless these market-led adjustments to acute crisis become conscious policy choices in both China and the US, the global imbalances will recreate themselves and we will limp out of this crisis into the next. Crisis always enlarges the possibility for reform. Wolf's prescriptions for rebalancing the world economy are still relevant: emerging market economies need to spend more and save less, and mature market economies need to spend less and save more. This would automatically right the listing ship. But how is this to be done?

In line with the "saving glut" hypothesis, Wolf argues that it is up to the Chinese and other East Asian countries to take steps to eliminate the excess savings they have created. This is in their own self-interest. The Chinese save and invest almost 50 percent of their GDP. Wolf claims that they get very poor return for their frugality. Chinese employment has hardly grown, because investment in export-led growth is highly capital-intensive: in 2005, the excess capacity in China's steel industry was 120 million tons—more than the annual production of Japan, the world's second-largest producer. Moreover, there are political risks in channeling current account surpluses into foreign reserves instead of greater consumption, improved health care, and infrastructure. This is particularly the case when the nominal returns on dollar debt are as low as they have been in the last few years.

Emerging-market governments should pursue expansionary fiscal policies to stir more private demand since, if the provision of public goods improves, private actors will have less of an incentive to keep up their current rates of precautionary savings. Emerging-market governments should also undertake financial reforms to enable them to raise funds in their own currencies—the only way to avoid the exchange rate problem that frequently caused crises in the past. The best way to achieve this is to develop markets in emerging economies for bonds denominated in the local currency. Unless these domestic credit markets are developed, emerging-market governments will be unwilling to run deficits, since the only funding now available—mostly in dollar-denominated instruments—exposes them to the risk of being unable to service their debts if the exchange rate fluctuates.

Another element in the East Asian adjustment should be a move to more flexible exchange rates, though Wolf recognizes that floating exchange rates are an obstacle to securing net capital flows from rich to poor countries. Global reform is necessary alongside domestic reform. Wolf ends with a raft of small but useful ideas for reforming the World Bank, regional development banks, and the International Monetary Fund (IMF). The IMF must be better at delivering technical assistance, surveillance, coordination of macroeconomic policies and exchange rates, and crisis management. It must reform its system of representation and resume its role as a credible lender during economic crises. The decision by the G-20 in April to expand the IMF's special drawing rights (SDRs) available to its members by $250 billion is an important step in this direction. Fred Bergsten, director of Washington's Peterson Institute for International Economics, argues that this opens the door to China's proposal to create a new global reserve currency to replace the dollar. But the door is only slightly ajar. What will ensure the general acceptability of the SDRs as reserves? And how will their issue be regulated? These questions have hardly been discussed.[6]

Despite the density of its argument and its skepticism about the possibility of reform in the short term, Wolf's book offers important pointers to the way ahead. But his story is only half-told. He has very little to say about America's responsibility for both creating and ending the system of global imbalances. For the fact is that the present system has suited the United States—specifically the power holders in the United States—just as much as it has those in China. The phrase "it has enabled the Americans to live beyond their means" is too vague to be useful. One needs to ask: which Americans? Certainly many middle- and low-income American households have been given opportunities to borrow beyond their means.

But secondly, the American–Chinese symbiosis has been excellent for US business profits. American businessmen have been complicit in Chinese "super-competitiveness" by arranging for manufacturing jobs to be moved to China from the US in order to cut costs. The decline in US manufacturing and the growth in nontradable services, and the financial operations that secured this restructuring, have enabled financiers and businessmen to earn huge profits that should have been shared with their workers. Morally, the financial community has been living well beyond its means. But perhaps above all, by getting other countries to finance its imperial pretensions, the US government has been able to live beyond its means. Wolf refers in several places to the "exorbitant privilege" of the US dollar, but omits entirely to discuss the political benefits that this privilege buys.

This points to the main weakness of Fixing Global Finance: the lack of a historical perspective. The history of the overprivileged dollar, after all, goes all the way back to the 1960s. Its roots lie in the failure of John Maynard Keynes's plan for a Clearing Union, which he worked out during World War II. The Keynes plan was specifically designed to prevent creditor countries from hoarding reserves by trading at undervalued currencies. If they did not spend their surpluses, the surpluses would be confiscated and redistributed among debtor countries. In this way a global balance between saving and investment would be secured through a balanced trade position, which would in turn allow fixed, but adjustable, exchange rates.

The Bretton Woods agreement of 1944 adopted the proposal for fixed but adjustable rates, but failed to provide a remedy against countries with trade surpluses accumulating, or hoarding, reserves. In practice, the problem was solved by the United States taking the place of nineteenth-century Britain as the chief supplier of foreign investment funds. The outflow of American savings helped reconstruct Europe after the war, and kept global demand buoyant throughout the Bretton Woods era. The dollar replaced gold as the world's chief reserve currency. This allowed the US to print dollars to cover its growing trade deficit. The arrangement suited both the Europeans and the United States, because it not only enabled the Europeans to export to America at undervalued exchange rates, but it also covered the cost of America defending Western Europe and non-Chinese East Asia against communism. In other words, the "exorbitant privilege" of the dollar allowed the US to pursue an imperial mission that, in the era of the cold war, was greatly to the satisfaction of its partners and allies.

The privileged position of the dollar survived the collapse of the Bretton Woods regime of fixed-exchange rates in 1971. In theory, the resulting system of floating exchange rates removes the need for any reserves at all, since adjustment of current account imbalances was supposed to be automatic. But the need for reserves unexpectedly survived, mainly to guard against speculative movements of short-term investment—"hot money"—that could drive exchange rates away from their equilibrium values. Starting in the 1990s, East Asian governments unilaterally erected a "Bretton Woods II," linking their currencies to the dollar, and holding their reserves in dollars. This reproduced both the benefits and faults of Bretton Woods I: it avoided global deflation, but undermined the long-run credibility of the dollar as the global reserve currency.

The new arrangement allowed the United States to continue to enjoy the political benefits of "seigniorage"—the right to acquire real resources through the printing of money. The "free" resources were not just unpaid-for imported consumer goods but the ability to deploy large military forces overseas without having to tax its own citizens to do so. Every historian knows that a hegemonic currency is part of an imperial system of political relations. Americans acquiesced in the unbalanced economic relations initiated by East Asian governments in their undervaluation of their currencies because they ensured the persistence of unbalanced political relations.

A willingness by the US government to end macroeconomic imbalances thus depends on its willingness to accept a much more plural world—one in which other centers of power in Europe, China, Japan, Latin America, and the Middle East assume responsibility for their own security, and in which the rules of the game for a world order that can preserve the peace while effectively tackling the challenges posed by terrorism, climate change, and abuse of human rights are negotiated and not imposed. Whether, even under Obama, the US is willing to accept such a political rebalancing of the world is far from obvious. It will require a huge mental realignment in the United States. The financial crash has disclosed the need for an economic realignment. But it will not happen until the US renounces its imperial mission.

—June 17, 2009

Notes

[1]Alan Greenspan, The Age of Turbulence: Adventures in a New World (Penguin, 2008), p. 507.

[2]Yale University Press, 2004.

[3]"Risks and Rewards of Today's Unshackled Global Finance," Financial Times, June 26, 2007.

[4]"The Federal Reserve Must Prolong the Party," Financial Times, August 21, 2007.

[5]"Asia's Revenge," Financial Times, October 8, 2008.

[6]Fred Bergsten, "Beijing's Currency Idea Needs to Be Taken Seriously," Financial Times, April 9, 2009.

The Lost Continent

Robert Skidelsky — 2009-06-13T08:22:01+00:00

LONDON – Home to one-sixth of the world’s people, but contributing only one-fortieth of world GDP, Africa is the most conspicuous victim of the global recession. After a half-decade of 5% growth, the continent’s growth rate is expected to halve in 2009. Some countries, like Angola, are contracting. Elsewhere, the crisis has swept away the benefits of several years of economic reform. Many Africans will fall back into desperate poverty.

Development economists wring their hands in despair: Africa defies their best efforts to create a miracle. On the eve of decolonization in 1960, real GDP per head in Sub-Saharan Africa was almost three times higher than in Southeast Asia, and Africans were expected to live two years longer on average. In the 50 years since, African real GDP per head grew by 38% and people lived nine years longer, while in Southeast Asia GDP per head grew by 1000% and people lived 32 years longer.

At first, the solution for Africa’s under-development seemed obvious. Africa needed capital, but lacked savings. Therefore, money had to be provided from outside – by institutions like the World Bank. Since extracting commercial interest rates from starving people seemed like usury, the loans had to be offered on a concessionary basis – in effect, aid.

Throwing money at poverty became a panacea. It was easy to sell, and it appealed to people’s humanitarian instincts. It also assuaged the guilt of colonialism, as with parents who give their children expensive gifts to make up for neglecting or mistreating them. But it did no good. Most aid was stolen or wasted. Despite the eight-fold increase in aid per head to the Democratic Republic of the Congo between 1960 and 2007, real GDP per head decreased by two-thirds in the same period.

“Trade not Aid” became the new watchword. Spearheaded by the economist Peter Bauer in the 1980’s, it became the nostrum of the Washington Consensus. Africa, it was fashionable to say, would catch up only if it deregulated its economies and embraced export-led growth like the “miracle” economies of East Asia. Advisers from the World Bank and the International Monetary Fund told African governments to stop subsidizing “national champions” and drop their trade barriers. Provision of a reduced volume of aid was to be conditioned on dismantling the public sector.

By 1996, only 1% of the population in Sub-Saharan Africa was civil servants, compared to 3% in other developing regions and 7% in the OECD. Yet despite the rollback of the state, Africa has not made the leap to prosperity. In a complete affront to economic theory, the little capital there is in Africa is fleeing the continent to be invested in already capital-rich societies.

The problem with Africa, economists then started to say, was that it lacked effective states. Many countries had “failed” states that could not provide even the minimum conditions of security and health. With 15% of the world’s population, sub-Saharan Africa accounted for 88% of the world’s conflict-related deaths and 65% of AIDS victims. What historians have known for 2,000 years – and what the eighteenth century’s classical economists also knew – suddenly struck the new breed of mathematical economists in the 1990’s like a flash of lightning: prosperity depends on good government.

So how to get good government? Restoring or securing it conjures up the dreaded specter of colonialism. After all, for all its other failings, colonialism provided the essential precondition of economic development: peace and security. The development discussion today is essentially about how such preconditions of poverty reduction and economic growth can be achieved without colonialism.

The most interesting contemporary contribution is by the Oxford economist Paul Collier. He argues that many African states have fallen into one or several development traps that are extremely difficult to escape. Moreover, once a country is mired in one of them, it is easy to fall into the next. Being poor makes you prone to conflict, and being in conflict makes you poor. So what hope is there for a poor country torn by civil war?

Citing the British mission to Sierra Leone, Collier argues for military intervention, when feasible, to secure peace. He supports international involvement to enforce post-conflict peace. But ongoing international assistance should be limited to providing voluntary good-governance templates.

Frameworks for how governments should make public spending transparent or how foreign resource-extracting companies should report their profits would make yardstick comparisons easier for local political activists, as well as providing a source of legitimacy for the government. The much-discussed Kimberly Process is a pilot project. Diamond companies volunteer not to buy from conflict areas in an attempt to prevent diamonds from funding warlords. This would be good for business, as affluent Western customers are now put off by the thought of buying blood-soaked jewelry.

Regional integration has featured prominently only in the last 50 years in Europe, but it has already resulted in a host of political and economic benefits to Europeans. Considerable evidence indicates that integration could be beneficial for Africa as well, given a framework suitable for African conditions.

This is a project worth supporting. Other efforts worthy of attention include formalizing the huge informal economy in states such as Ghana. Typically, these are projects that employ international expertise under domestically issued mandates.

It is a sign of the poverty of development economics that proposals such as these are regarded as cutting edge. However, as long as there is a roadblock every 14 kilometers between Lagos and Abidjan – two of West Africa’s leading cities – progress on the ground will be slow.

With refugees spilling over borders, pirates hijacking ships, and terrorists finding shelter, it is clear that, although Africa’s solutions are its own, its problems are not. The rest of the world can no longer afford Africa’s poverty. But the evidence of 50 years of failed efforts is that it hasn’t a clue what to do about it.

Economists clash on shifting sands

Robert Skidelsky — 2009-06-10T07:26:00+00:00

History is replete with famous intellectual battles. In the natural sciences, these have usually led to decisive victories, with good science ousting bad. There are few Ptolemaic astronomers left, or believers in the phlogiston theory of combustion. In the social sciences, the situation is different. There have been famous battles galore, but no decisive victories. Indeed, it is characteristic of the social sciences that their battles are interminable, temporary defeats being followed by the regrouping of the defeated forces for a renewed assault.

That economics is not a natural science is clear from the inconclusive engagements that have punctuated its own history. A hundred years ago the classical theory reigned supreme. This “proved” that free markets were automatically self-adjusting to full employment. They were either continually at full employment or, if disturbed by an outside shock, rapidly returned to it. The only thing capable of wrecking the workings of the market’s invisible hand was the visible hand of government interference.

Then along came the Great Depression of 1929-32 and John Maynard Keynes. Keynes “proved” that markets had no automatic tendency to full employment. This failing of the invisible hand justified government policies to maintain full employment.

For 30 years or so Keynesianism ruled the roost of economics – and economic policy. Harvard was queen, Chicago was nowhere. But Chicago was merely licking its wounds. In the 1960s it counter-attacked. The new assault was led by Milton Friedman and followed up by a galaxy of clever young disciples. What they did was to reinstate classical theory. Their “proofs” that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment were all the more impressive because now expressed in mathematics. Adaptive Expectations, Rational Expectations, Real Business Cycle Theory, Efficient Financial Market Theory – they all poured off the Chicago assembly line, their inventors awarded Nobel Prizes.

No policymaker understood the maths, but they got the message: markets were good, governments bad. The Keynesians were in retreat. Following Ronald Reagan and Margaret Thatcher, Keynesian full employment policies were abandoned and markets deregulated. Then along came the almost Great Depression of today and the battle is once more joined.

Haunters of the blogosphere will know that the main ground of the current engagement is about the effect of the “stimulus”. FT readers will have caught a faint whiff of the intensity of this battle in Niall Ferguson’s column of May 30, headed “A history lesson for economists in thrall to Keynes”. Prof Ferguson and Paul Krugman, the economist and New York Times columnist, had previously locked horns at a public symposium in New York on April 30. The historian had asserted that large fiscal deficits would push up long-term interest rates. This implied they would have a zero stimulatory effect: public spending would simply “crowd out” private spending. An enraged Mr Krugman responded on his blog that Keynes had proved that such crowding-out could occur only at full employment: if there were unemployed resources, fiscal deficits would not drive up interest rates without also expanding the economy. Prof Ferguson’s ignorant remarks only confirmed that “we’re living in a Dark Age of macroeconomics, in which hard-won know-ledge has simply been forgotten”.

However, this is not a debate between economists and historians. It is a battle within the economic profession – between the New Class-ical Economists and the New Keynesians. What is fascinating is that it is an almost exact rerun of the debate between Keynes and the British Treasury in 1929-30. The Treasury view was that bond-financed public spending was bound to diminish private spending by an equal amount. Keynes replied that if this were true it would apply to any new act of private spending. “In short, the fatalistic belief that there can never be more employment than there is is altogether baseless”.

Later the Treasury retreated to a more defensible position. The danger of extra government spending, it came to argue, lay not in the “physical” crowding out of resources but “psychological” crowding out. If doubts arose about the government’s solvency – a concern Prof Krugman has acknowledged – it might lead to capital flight, which would push up the cost of government borrowing.

Are we doomed to rehearse the same arguments time and again? In this particular debate, I am on Prof Krugman’s side, but I do not agree that Prof Ferguson’s position represents a retreat to a phlogiston state of economics. This is to take economics to be like a natural science, which Keynes never believed it was, because he thought its subject matter was much too variable over time.

Keynes’s view was that we need different economic models at different times. The beauty of his General Theory of Employment, Interest and Money was that it was general enough to accommodate a variety of models applicable to different conditions. Markets could behave in ways described by the classical and New Classical theories, but they need not. So it was important to take precautions against bad behaviour. Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment.

House of Lords Debate: Government Statistics

Robert Skidelsky — 2009-06-01T09:54:01+00:00

My Lords, I should like to take the opportunity provided by the question of the noble Lord, Lord Hamilton, to raise two topics, one general and one relating to the particular issue of inflation statistics.

My general comment is that I am appalled by the degree of statistical illiteracy abroad. Almost every time I read a newspaper I am aware that the journalists writing it have no knowledge of statistics. They simply pluck out things to create stories, as the noble Lord, Lord Lipsey, said, and therefore there is constant statistical abuse. Of course, it is very hard to be against more information but sometimes I think we would be better off with less. A good example of that kind of statistical abuse is the debate on climate change.

I do not know what the answer is. You could say that, as part of their training, journalists ought to have a compulsory course in statistics and should not be licensed to write anything unless they do. That, of course, is not feasible. However, a more sensible suggestion is that health warnings should come with official statistical information. I know that ONS guidelines require that statistics come with health warnings, but the kind of health warnings that they come with are totally incomprehensible to anyone but those who write them. For example:

“The variance of the IoP is fairly insensitive to the assumptions made about the variance of the EPD. This continues to be the case at 4-digit level. Thus the assumption made about the variance of the EPD when deriving formula (4) should be suitable”.

You can do better than that.

If you want any of these official statistics to have any impact on the public, then alongside the necessary technical blurb you must provide much more user-friendly health warnings. One of the most useful that you could provide is a list of a few unlikely but possible events which would render the forecast invalid, such as the collapse by 25 per cent of US house prices between 2006 and 2008. A list of those kinds of unlikely “black swans”, as they have been called recently, would be useful to have.

My second topic involves the battle of the indexes—that is, the pros and cons of the RPI index and the CPI index. The change in the index for the purposes of inflation forecasting was made in 2003. I remember it very well because I was a member of the Lords Select Committee on Economic Affairs. The assumption was—we were told so by the Chancellor and other witnesses—that the two indexes would converge. That reflected the efficient market hypothesis: after all, you cannot have two indexes which measure roughly the same based on roughly the same things that may diverge in the long term. But, of course, diverge is exactly what they have done.

This raises the question of what the purpose of the change was. As I understood it at the time, the purpose was to lower the headline rate of inflation in order to present the inflation record of the Government in a better light and therefore to decrease wage pressure. What has happened though is that the two indexes have diverged considerably. Which index inspires more confidence as a measure of the rate of inflation? In terms of confidence in the economy, the consumer prices index is better since it regularly grinds out lower rates of inflation than the retail prices index. In terms of confidence in the statistics, however, the RPI might be better because, it seems obvious to me, any credible inflation index should include mortgage interest payments, especially in a country such as Britain where housing is such a huge economic component.

RPI, then, is a better index than CPI, but mortgage payments are not an accurate measure of the flow of consumption in the economy, especially if asset prices are going up. I wish we could find a way of incorporating the increasing prices of housing stock in the retail prices index so that it more accurately reflected the trend of transactions in the economy. I hope that we can work towards that, and that this may be one of the lessons we learn from the present wreck of inflation targeting.

Anatomy of Thatcherism

Robert Skidelsky — 2009-05-13T08:11:00+00:00

London – Thirty years ago this month, Margaret Thatcher came to power. Although precipitated by local conditions, the Thatcher (or more broadly the Thatcher-Reagan) revolution became an instantly recognizable global brand for a set of ideas that inspired policies to free markets from government interference. Three decades later, the world is in a slump, and many people attribute the global crisis to these very ideas.

Indeed, even beyond the political left, the Anglo-American model of capitalism is deemed to have failed. It is held culpable for the near financial meltdown. But 30 years of hindsight enable us to judge which elements of the Thatcher revolution should be preserved, and which should be amended in the light of today’s global economic downturn.

Most obviously in need of amendment is the view that minimally managed and regulated markets are both more stable and more dynamic than those subject to extensive government intervention. The Thatcherite assumption, in other words, was that government failure is far more menacing to prosperity than market failure.

This was always bad history. The record shows that the period 1950-1973, when government intervention in market economies was at its peacetime height, was uniquely successful economically, with no global recessions and faster rates of GDP growth – and growth of GDP per capita – than in any comparable period before or since.

One can argue that economic performance would have been even better with less government intervention. But perfect markets are no more available than perfect governments. All we have are comparisons between what happened at different times. What these comparisons show is that markets plus government have done better than markets minus government.

Nevertheless, by the 1970’s the pre-Thatcher political economy was in crisis. The most notorious symptom of this was the emergence of “stagflation” – simultaneously rising inflation and unemployment. Something had gone wrong with the system of economic management bequeathed by John Maynard Keynes.

In addition, government spending was on the rise, labor unions were becoming more militant, policies to control pay kept breaking down, and profit expectations were falling. It seemed to many as though government’s reach had come to exceed its grasp, and that either its grasp had to be strengthened or its reach had to be reduced. Thatcherism emerged as the most plausible alternative to state socialism.

Nigel Lawson was Thatcher’s second Chancellor of the Exchequer, or finance minister. Out of the government’s anti-inflationary efforts emerged the “Lawson doctrine,” first stated in 1984 and broadly accepted by governments and central banks ever since. “The conquest of inflation,” Lawson said, “should...be the objective of macroeconomic policy. And the creation of conditions conducive to growth and employment should be...the objective of microeconomic policy.”

This proposition overturned the previous Keynesian orthodoxy that macroeconomic policy should aim at full employment, with the control of inflation left to wage policy. Yet, despite all the “supply side” reforms introduced by Thatcherite governments, unemployment has been much higher since 1980 than in the 1950’s and 1960’s – 7.4% on average in the United Kingdom, compared to 1.6% in the earlier decades.

What about inflation targeting? Here, too, the record since 1980 has been patchy, despite the huge deflationary pressure exerted by low-wage competition from Asia. Inflation in 1950-1973 and 1980-2007 was about the same – just over 3% – while inflation targeting has failed to prevent a succession of asset bubbles that have brought recessions in their wake.

Nor has Thatcherite policy succeeded in one of its chief aims – to reduce the share of government spending in national income. The most one can say is that it halted the rise for a time. Now public spending is on the increase again, and record peacetime deficits of 10% or more of GDP stretch ahead for years.

In de-regulating financial markets worldwide, the Thatcher-Reagan revolution brought about the corruption of money, without improving on the previous growth of wealth – except for the very wealthy. The average world citizen would have been 20% richer had world GDP per capita grown at the same rate between 1980 and 2007 as it did between 1950 and 1973 – and this despite China’s high growth rates in the past 20 years. Furthermore, in unleashing the power of money, the Thatcherites, for all their moralizing, contributed to the moral decay of the West.

Against these formidable minuses are three pluses. The first is privatization. By returning most state-owned industries to private ownership, the Thatcher revolution killed off state socialism. The British privatization program’s greatest influence was in the former communist states, to which it gave the ideas and techniques needed to dismantle grossly inefficient command economies. This gain must be preserved in the face of the current clamor to “nationalize” banks.

Thatcherism’s second success was to weaken trade unions. Set up to protect the weak against the strong, labor unions had become, by the 1970’s, enemies of economic progress, a massive force of social conservatism. It was right to encourage a new economy to grow outside these congealed structures.

Finally, Thatcherism put paid to the policy of fixing prices and wages by central diktat or by tripartite “bargains” between governments, employers, and trade unions. These were the methods of fascism and communism, and they would, in the end, have destroyed not just economic, but political, liberty.

Political pendulums often swing too far. In rebuilding the shattered post-Thatcherite economy, we should be careful not to revive the failed policies of the past. I still find fruitful Keynes’s distinction between the agenda and the non-agenda of politics. As long as central government takes responsibility for maintaining a high and stable level of employment, Keynes thought, most of the rest of economic life can be left free of official interference. Building a proper division of responsibility between state and market from this insight is today’s main task.

The Treason of the Economists

Robert Skidelsky — 2009-04-13T08:06:00+00:00

LONDON – All epoch-defining events are the result of conjunctures – the correlation of normally unconnected events that jolt humanity out of a rut. Such conjunctures create what the author Nassim Nicholas Taleb calls “Black Swans” – unpredictable events with a vast impact. A small number of Black Swans, Taleb believes, “explain almost everything in our world.”

The prosperity of the first age of globalization before 1914, for example, resulted from a successful constellation of developments: falling transport and communication costs, the technological breakthroughs of the second industrial revolution, the pacific state of international relations, and Great Britain’s successful management of the gold standard. By contrast, in the interwar years poisonous international politics combined with global economic imbalances to create the Great Depression and set the scene for World War II.

Now consider recent financial innovations. On the back of the new computer and telecommunications technology, a giant market for derivative instruments was built. Collateralized debt obligations (CDOs, mainly tied to mortgages) made a new population of aspiring homeowners supposedly creditworthy by enabling the originating banks to sell “sub-prime” debt to other investors.

Before securitization, banks typically held mortgages; now they could get them off their books. But securitized credit taken off one bank’s balance sheet usually ended up on another bank’s books. What resulted was a wonderful system for diversifying individual bank risk, but only by magnifying the default risk of all banks that held what came to be called “toxic” debt. Because all the derivatives were based on the same assets, if anything happened to those assets, all the banks holding the debt would find themselves in the same soup.

What made the spread of derivatives possible was the ease with which the volume of debt for a given set of real assets could be expanded. This scalability was magnified by the use of credit default swaps (CDSs), which offered phony insurance against default. Since an unlimited number of CDSs could be sold against each borrower, the supply of swaps could grow much faster than the supply of bonds.

CDSs magnified the size of the bubble by hugely speeding up the velocity of monetary circulation. The CDO market grew from $275 billion to $4.7 trillion from 2000 to 2006, whereas the CDS market grew four times faster, from $920 billion in 2001 to $62 trillion by the end of 2007.

CDSs were the means by which derivatives found their way into the portfolios of banks all over the world. But the dependence of the whole structure on continually rising house prices was rarely made explicit. If the housing market started to fail, these paper assurances of safety would become, in Warren Buffett’s words, “financial weapons of mass destruction.”

But financial intermediation would never have brought disaster (or indeed gone so far) save for the global imbalances arising from America’s twin trade and budget deficits, financed to a large extent by Chinese savings. Floating exchange rates were supposed to prevent countries from manipulating their currencies, but, by accumulating large quantities of US treasury bills, East Asian countries, especially China, kept their exchange rates artificially low. This East Asian “savings glut” enabled a debt-fuelled consumption glut in the US, Britain, and much of the Western world.

But the marriage between Chinese savings and American consumption had a fatal flaw: it created non-repayable debts. Chinese investments increasingly took the form of official purchases of US Treasury bills. These investments did not create new resources to provide the means of repayment. For the counterpart of the US debt build-up was the relocation of much American manufacturing capacity to China. Chinese savings flowed not into creating new assets, but into financial speculation and consumer binges.

“Surplus” Chinese savings made possible America’s credit expansion between 2003-2005, when the federal funds rate (the overnight rate at which US banks lend to one another) was held at 1%. Ultra-cheap money produced a surge in sub-prime mortgage lending – a market that collapsed when interest rates increased steadily after 2005, reaching 5%.The financial crisis of 2008 was the start of a highly painful, but inevitable, process of de-leveraging.

This interpretation of the origins of the present slump is disputed by the ‘money glut’ school. In their view, there was one cause, and one cause only of the crisis: the excessive credit creation that took place when Alan Greenspan was chairman of the US Federal Reserve.

This view draws on the ‘Austrian’ theory of booms and slumps, and also Milton Friedman’s explanation of the Great Depression of 1929. It was wrong then, and it is wrong now.

This line of reasoning assumes that markets are perfectly efficient. If they go wrong, it must be because of mistakes in policy. This view is also self-contradictory, for if market participants are perfectly rational and perfectly informed, they would not have been fooled by a policy of making money cheaper than it really was. Greenspan is the sacrifice they offer to the god of the market.

This suggests a more fundamental reason for the economic crisis: the dominance of the Chicago school of economics, with its belief in the self-regulating properties of unfettered markets. This belief justified, or rationalized, the de-regulation of financial markets in the name of the so called “efficient-market hypothesis.” It led directly to the spread of financial risk-management models, which, by excluding the possibility of default, grossly underestimated the amount of risk in the system.

If we are going pursue the blame game, I blame economists more than bankers for the crisis. They established the system of ideas that bankers, politicians, and regulators applied.

John Maynard Keynes wrote that “practical men who believe themselves to be quite immune from intellectual influences are usually the slaves of some defunct economist.” Most of today’s crop of economists are not defunct, but continue to work in the ideological vicinity of Chicago. Their assumptions should be ruthlessly exposed, for they have come close to destroying our world.

A Warrant of Hypocrisy

Robert Skidelsky — 2009-03-13T11:49:00+00:00

LONDON – Earlier this month, the International Criminal Court (ICC) upheld the request of the court’s chief prosecutor to issue an arrest warrant for Omar el-Bashir, the President of Sudan, charging him with war crimes and crimes against humanity. Bashir responded by expelling foreign aid agencies looking after the refugee camps in Darfur. This is the first time that a sitting head of state has been indicted for war crimes, with reaction around the world mainly divided between those who hailed the move as a great step for international justice and those who condemned it as colonialism. Both positions are hopelessly buried in intellectual and moral fog. The warrant was no leap forward. From the legal point of view, it makes no difference whether the accused is a sitting or former head of state. But it makes an enormous practical difference that an incumbent ruler can do a lot more future damage to his people than an ex-ruler, and therefore should be given no incentive to retaliate. As a result of Bashir’s policies, 300,000 people are estimated to have died and 2.7 million displaced in Darfur. The expulsion of the aid agencies has put over a million Darfuris at risk of epidemics and starvation. According to the statute that established the ICC, the prosecutor is required to ensure that any prosecution is in the interests of the victims as well as of justice. But, to lawyers like the ICC prosecutor, the abstract claims of justice are more vivid than any concrete duty of protection. In this case, justice comes with poisoned arrows. Emboldened by the warrant and its elusive suggestion of international support, the Darfuri rebels, the Justice and Equality Movement, have walked out of peace talks with Sudan’s government. Meanwhile, Bashir, with little to lose, will no doubt take the opportunity to attack his enemies. The counter-argument is that the threat of indictment will deter rulers from wicked behavior. But the law will deter only if its sanctions are credible. A law that cannot be enforced deters no one. In fact, it weakens respect for law. Moreover, while the fear of being hauled off to The Hague may have some effect in deterring rulers from committing crimes against humanity, the claim that the Bashir warrant will deter the current crop of human rights’ violators is derisory. Indeed, it is likely to prolong wicked regimes. Robert Mugabe, for example, refuses to leave office – at great cost to Zimbabwe’s people – for fear of being put on trial. Whatever the attractions of giving criminals “nowhere to hide, whatever the consequences,” the consequences cannot be ignored when the criminals are heads of state. The policy of never negotiating with terrorists cannot be scaled up to state level when hundreds of thousands of lives are at stake. The charge of colonialism, meanwhile, is simply reflex: colonialism no longer exists. The charge that international law is just “western law” is also rubbish. International law is the conscience of mankind. But the perception that the law is selectively applied happens to be true. In the Nuremberg trial of 1946, which laid the basis of current international law, the main charge against the Nazi leaders was that of “planning and waging aggressive war.” Prohibition of war except for self-defense is embedded in the United Nations Charter. But the ICC’s creators deemed the waging of aggressive war – which the International Military Tribunal at Nuremberg called “the supreme international crime” – to be outside the court’s jurisdiction. This guaranteed legal immunity for the leaders who carried out the invasion of Iraq. The charge of selective application also applies to the Bashir warrant. Bashir stands accused of war crimes and crimes against humanity. The latter were first defined in the Nuremberg principles of 1950 to include murder, extermination, enslavement, deportation and “other inhumane acts.” In 1998, these other acts were clarified to mean false imprisonment, torture, rape, persecution of a group, enforced disappearance of persons, and apartheid. It comes as no surprise, then, to read in the Arab News that Bashir’s warrant “reeks of hypocrisy.” Where, indeed, are the arrest warrants for Bush and Cheney? Does extraordinary rendition not count as “enforced disappearance of persons”? Does the waterboarding of Khalid Sheikh Mohammed not count as torture? Why is Vladimir Putin not standing trial for war crimes in Chechnya? The answer is simple: where the interests of a UN Security Council member or one of their clients are at stake, the court’s jurisdiction ends. The ICC is like a cobweb: small flies get stuck, but wasps and hornets get through. Until the United States ratifies the ICC treaty, the Court is bound to seem to many to be little more than a politicized kangaroo court. Without American support, it has little hope of earning legitimacy, let alone doing its job effectively. The Security Council has the power to defer the warrant for Bashir’s arrest for renewable periods of one year. It can do this indefinitely, and it seems likely that it will. The idea is that deferring the warrant will give the Security Council leverage over Sudan. Gareth Evans, a former Australian Foreign Minister, has called it “a powerful diplomatic tool,” while the Washington Post has called for the warrant to be used “as a bargaining chip with Mr. Bashir and his Chinese and Arab allies.” They believe that the threat of arrest can be used to force Bashir to mend his ways. If this proves true, the ICC and its sponsors have muddled justice with diplomacy. If the world can dispense justice only at the expense of the weak and to the advantage of the strong, it should stick to the older tools of crime prevention: force and negotiation, and leave justice out of it.

Shaky Social Contracts

Robert Skidelsky — 2009-02-13T09:11:00+00:00

London – “Enrich yourselves,” China’s Deng Xiaoping told his fellow countrymen when he started dismantling Mao Zedong’s failed socialist model. In fact, elites everywhere have always lived by this injunction, and ordinary people have not minded very much, provided that the elites fulfill their part of the bargain: protect the country against its enemies and improve living conditions. It is this implied social contract that is now endangered by economic collapse.

Of course, the terms of the contract vary with place and time. In nineteenth-century Europe, the rich were expected to be frugal. Conspicuous consumption was eschewed. The rich were supposed to save much of their income, as saving was both a fund for investment and a moral virtue. And, in the days before the welfare state, the rich were also expected to be philanthropists.

In the opportunity culture of the United States, by contrast, conspicuous consumption was more tolerated. High spending was a mark of success: what Americans demanded of their rich was conspicuous enterprise.

Societies have also differed in how wealthy they allow their elites to become, and in their tolerance of the means by which wealth is acquired and used. One dividing line is between societies that tolerate self-enrichment through politics, and those that demand that the two spheres be kept separate.

In Western countries, politicians and civil servants are expected to be relatively poor. In most of the rest of the world, a political career is regarded as a quasi-legitimate road to wealth. But the broad conclusion remains: wealth is conditional on services. When the services fail, the position of the wealthy is threatened.

In the current crisis, popular anger is – no surprise – directed against bankers. Their speculative frenzies ruined shareholders, customers, and the economy. Anger has come to focus on banking executives’ huge compensation packages, composed largely of bonuses. Rewarding success is acceptable; rewarding failure is not.

Governments face a dilemma. Big banks cannot be allowed to fail; but the public expects bankers to be punished. Few will be ruined or imprisoned. But the banking system is sure to be re-regulated, as it was after the Great Crash of 1929-1932, when President Franklin Roosevelt promised to drive the money changers from the temple.

The global economy’s downturn increases countries’ political risk to varying degrees, depending on the severity of the shock and the nature of the implied social contract. Political systems in which power is least controlled, and the abuse of wealth greatest, are most at risk. The more corrupt the system of capitalism, the more vulnerable it is to attack. The general problem is that all of today’s versions of capitalism are more or less corrupt. “Enrich yourselves” is the clarion call of our era; and in that moral blind spot lies a great danger.

Despite efforts to give it precision, estimating political risk is not an exact science. It requires political theory, not econometrics. Forecasting models, based on “normal distributions” of risk over short slices of recent time, are notoriously incapable of capturing the real amount of risk in a political system.

One of the “safest” political systems of recent times was President Suharto’s regime in Indonesia. Suharto came to power in 1966, establishing a quasi-military dictatorship and encouraging Indonesians to “enrich themselves.” Despite the depredations of his family, enough Indonesians did so over the next 30 years to make his rule seem exceptionally stable – until the East Asian financial crisis of 1997-1998 sent the Indonesian economy into a tailspin, triggering violent riots that forced Suharto out.

Similarly, few regimes seemed more stable than that of the Shah of Iran, another long-term ruler, who, having bankrupted his country, was forced to flee the fury of a mob in 1979.

The lesson is clear. Autocracies, which are much praised for their decisiveness, and for guaranteeing “law and order,” are paper tigers. They appear immovable until the moment they are evicted by popular anger. In face of economic failure or military defeat, their emperors turn out to be naked.

In such situations, the great advantage of democracies is that they allow a change of rulers without a change of regime. Failure discredits only the party or coalition in power, not the entire political system. Popular anger is channeled to the ballot box. In such countries, there may be “New Deals,” but no revolutions.

In estimating political risk today, analysts must pay particular attention to the character of the political system. Does it allow for an orderly transition? Is it competitive enough to prevent discredited leaders from clinging to power? Analysts also must pay attention to the nature of the implied social contract. Broadly speaking, the weakest contracts are those that allow wealth and power to be concentrated in the same few hands, while the strongest are built on significant dispersal of both.

Deepening economic recession is bound to catalyze political change. The Western democracies will survive with only modest changes. But strongmen who rely on the secret police and a controlled media to maintain their rule will be quaking in their shoes. Even Venezuela’s Hugo Chávez, who built his power on populist anti-Americanism, must be praying for the success of US President Barack Obama’s stimulus package to lift his falling oil revenues.

The big countries with the highest political risk are Russia and China. The legitimacy of their autocratic systems is almost entirely dependent on their success in delivering rapid economic growth. When growth falters, or goes into reverse, there is no one to blame but “the system.”

Igor Yurgens, one of Russia’s most creative political analysts, has been quick to draw the moral: “the social contract consisted of limiting civil rights in exchange for economic well-being. At the current moment, economic well-being is shrinking. Correspondingly, civil rights should expand. It’s just simple logic.” The rulers in Moscow and Beijing would do well to heed this warning.

The Unreality of the “Real” Business Cycle

Robert Skidelsky — 2009-01-13T09:08:01+00:00

London – Testifying recently before a United States congressional committee, former Federal Reserve Chairman Alan Greenspan said that the recent financial meltdown had shattered his “intellectual structure.” I am keen to understand what he meant.

Since I have had no opportunity to ask him, I have to rely on his memoirs, The Age of Turbulence, for clues. But that book was published in 2007 – before, presumably, his intellectual structure fell apart.

In his memoirs, Greenspan revealed that his favorite economist was Joseph Schumpeter, inventor of the concept of “creative destruction.” In Greenspan’s summary of Schumpeter’s thinking, a “market economy will incessantly revitalize itself from within by scrapping old and failing businesses and then reallocating resources to newer, more productive ones.” Greenspan had seen “this pattern of progress and obsolescence repeat over and over again.”

Capitalism advanced the human condition, said Schumpeter, through a “perennial gale of creative destruction,” which he likened to a Darwinian process of natural selection to secure the “survival of the fittest.” As Greenspan tells it, the “rougher edges” of creative destruction were legislated away by Franklin Roosevelt’s New Deal, but after the wave of de-regulation of the 1970’s, America recovered much of its entrepreneurial, risk-taking ethos. As Greenspan notes, it was the dot-com boom of the 1990’s that “finally gave broad currency to Schumpeter’s idea of creative destruction.”

This was the same Greenspan who in 1996 warned of “irrational exuberance” and, then, as Fed chairman, did nothing to check it. Both the phrase and his lack of action make sense in the light of his (now shattered) intellectual system.

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust. Indeed, early theorists of business cycles understood this. (Schumpeter himself wrote a huge, largely unreadable book, with that title in 1939.)

In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the eighteenth century, railways in the nineteenth century, automobiles in the twentieth century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse.

Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Denis Robertson, an early twentieth-century “real” business-cycle theorist, wrote: “I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned.” Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary “real” business-cycle theory builds a mountain of mathematics on top of these early models, the main effect being to minimize the “destructiveness” of the “creation.” It manages to combine technology-driven cycles of booms and recessions with markets that always clear (i.e., there is no unemployment).

How is this trick accomplished? When a positive technological “shock” raises real wages, people will work more, causing output to surge. In the face of a negative “shock,” workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient automobile companies like General Motors only slows down the rate of progress. In fact, whereas most schools of economic thought maintain that one of government’s key responsibility is to smooth the cycle, “real” business-cycle theory argues that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today’s economic turbulence, or offers sound instruction about how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological “shock” that set off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions: it was the invention. It was called securitized mortgages. It left no monuments to human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such “shocks.” Indeed, “real” business-cycle economists typically argue that, but for Roosevelt’s misguided New Deal policies, recovery from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy banks, subsidizing inefficient businesses, and putting obstacles in the way of rational workers spending more time with their families or taking lower-paid jobs. It reminds me of the interviewer who went to see Robert Lucas, one of the high priests of the New Business Cycle school, at a time of high American unemployment in the 1980’s.

“My driver is an unemployed Ph.D. graduate,” he said to Lucas. “Well, I’d say that if he is driving a taxi, he’s a taxi-driver,” replied the 1995 Nobel Laureate.

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern “real” successors smothered his insights in their obsession with “equilibrium” and “instant adjustments.” For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny.

Book Review: Can You Spare a Dime?

Robert Skidelsky — 2008-12-26T17:20:00+00:00

The Ascent of Money: A Financial History of the World

by Niall Ferguson

Penguin, 442 pp., $29.95

The historian Alan Taylor used to say, mischievously, that the only point of history is history. The idea that one could use it to predict the future, still more to avoid past mistakes, was pure illusion. Niall Ferguson's The Ascent of Money, a history of financial innovation written as a television documentary[1] as well as a book, offers a neat test of Taylor's theory. Ferguson can claim some powers of anticipation. History convinced him in 2006 that the good times could not last "indefinitely." This was an insight to which the Nobel Prize–winning mathematical economists who devised the Black-Scholes formula—the complicated model for pricing share options used by the highly leveraged firm Long-Term Capital Management, which famously crashed in 1998—were oblivious. Their formula persuaded them that a massive sell-off could occur only once in four million years.

History has alerted Ferguson to the perils of the state relying on the bond market for its financing. On Lou Dobbs Tonight on November 13, 2008, he said:

How much can the international bond market absorb of new ten-year treasuries?... And if yields go up, the cost of government borrowing goes up, and the thing begins to spiral out of control....That's why you need the historical perspective....

Between the two opposed views that history can teach us nothing and that the future is simply a reflection of the past lies the sensible middle position that history, like any other way of experiencing the past, can give us "vague" knowledge of what may lie in store for humanity. Only history-free economists could have bought the "efficient market hypothesis," which claims that the market will price shares correctly, with deviations from accurate prediction occurring only at random. But knowledge of history would not have enabled anyone to predict the timing and extent of the present meltdown. Above all, history cannot settle the question of what our attitude should be toward money, which is at root a moral question.

The Ascent of Money is a superb book, which illustrates both the strengths and the weaknesses of history for understanding what is happening now. It is written with the narrative flair, eye for detail, range of reference, and playfulness of language that we have come to expect from this exceptionally versatile historian. Ferguson is clearly fascinated by the subject of finance, knows a huge amount about it, and communicates his enthusiasm to the reader. Many parts of the story will be familiar enough to specialists, but Ferguson has a special ability to color even the familiar with strange and unusual examples, and he weaves together the separate strands of the financial tapestry with great skill. Some of the financial material is quite technical, but there is no attempt to "dumb down." The book is an all too rare example of good, even dense, scholarship finding a way to engage the larger public.

Ferguson's strategically themed structure starts with the origins of money, and shows, in successive chapters, how money found a way of multiplying itself through the development of banking, bond, equity, and insurance markets, and derivative instruments of all kinds until the world economy came to resemble what Charles Morris has called an inverted pyramid of debt resting on an increasingly narrow base of real assets.[2] The large claim Ferguson makes is that we owe our prosperity more to finance than to technology. Throughout history men have been more ingenious at finding ways to make money than to make things. As Gibbon shrewdly noted, without the "incitement" given by money to the "powers and passions of human nature," societies could scarcely have emerged "from the grossest barbarism."[3]

Money, according to Ferguson, is not a thing but a relationship—above all, a relationship between creditor and debtor. As soon as time and distance start to elapse between exchanges of things of value—which happened at the start of civilization—people needed something more than barter. Farmers needed to borrow while they waited for the harvest to ripen; merchants needed to borrow while they waited for shipments to arrive; above all governments needed to borrow to finance their wars. The three functions of money—as a means of exchange, a unit of accounting, and a store of value—developed to bridge the interval between purchase and payment. Bills of exchange or "promises to pay" seem to have been used for the settlement of debts from the earliest times to overcome the inconvenience of shipping the precious metals.

Primitive banks, or safe depositories, must also have existed from the earliest times. The actual word "bank" originated from the Italian banca, or bench, at which the medieval moneychangers sat to do their business. Bankers soon learned how to augment their profits by lending out their deposits at interest. The Medici of fifteenth-century Florence were the first famous banking family. They made their fortune by buying and selling "bonds," the debts issued by cash-strapped monarchs. These bits of paper bound the borrower to repay within a specified period of time. The bond market started when these bonds became tradable. The bond market, the first truly modern financial market, was perfected in eighteenth-century England; great merchant bank underwriters of loans like the Rothschilds dominated the public finance of nineteenth-century Europe. Fractional reserve banking, an early innovation, starting with Sweden's Riksbank in 1656, enabled banks to make loans in excess of the money deposited with them—on the assumption that "depositors were highly unlikely to ask en masse for their money."

Ferguson rightly points out that the early growth of European finance was driven more by the needs of the state than by those of commerce. His thesis, familiar from his two volumes on the Rothschilds,[4] is that state policy determines the development of finance, not vice versa. This reverses the usual Marxist argument that finance controls governments. The Rothschilds started as court bankers. The Bank of England was created in 1694, mainly to help the government with war finance, by converting a portion of the government's debt into shares, in return for which the bank was given special privileges, such as a partial monopoly on issuing banknotes.

England's rise to world power in the eighteenth century was based on the ability of the British government to borrow larger sums at cheaper rates than any of its rivals; hence the importance for the nineteenth-century public mind of maintaining the state's creditworthiness by balancing the government budget. In the twentieth century it was the eagerness of democratic governments to extend home ownership—as an antidote to revolution—that later led to the practice by which home mortgages are converted into securities and sold around the world.

Long-term investment needed a different financing structure, and this was found in the development of the joint-stock, limited-liability company and the emergence of stock markets. By enabling many individuals to pool their resources by buying shares of a particular enterprise, while protecting them from losing everything if the project failed, the limited-liability company was one of the greatest innovations in financial history. The Dutch East India Company, formally chartered in 1602, was the first company to issue its own stock and bonds through the Amsterdam Stock Exchange. Over its two-hundred-year history the average dividend it paid out to its 358 shareholders was 18 percent a year. It helped that it was a chartered monopoly, with the power of the government behind it.

Ferguson notes that the history of stock markets has been punctuated by spectacular bubbles and crashes. Some of these have been caused by fraudulent company promoters: Kenneth Lay of Enron had a worthy predecessor in John Law, whose Mississippi Company went spectacularly bust in 1720. Many fraudsters, like Ivar Kreuger, the "Swedish match king" who committed suicide in 1932, were men of vision who turned to crime only to rescue great projects that had gone wrong. But the fraudsters could get away with it—for a time—because of what Alan Greenspan called the "irrational exuberance" of investors. Why are stock markets so volatile? Ferguson believes it is because they are

mirrors of the human psyche. Like homo sapiens, they can become depressed. They can even suffer complete breakdowns. Yet hope—or is it amnesia?—always seems able to triumph over such bad experiences.

This is a good analogy, but, as I shall argue, it is not an explanation.

As Ferguson tells it, volatility is inherent in financial markets, but bad monetary policy can make it worse. Central banks were created, in part, to stop the "over-issue" of notes by private banks, and to act as "lender of the last resort." Following Milton Friedman, Ferguson believes that the Great Depression of 1929–1933 was caused by bad monetary policy—money was kept so cheap that a huge stock market bubble formed, and, when it burst, the Federal Reserve Board failed to provide the banking system with sufficient liquidity. This view that monetary policy alone is sufficient to keep economies relatively stable is unlikely to survive its harsh confrontation with present reality.

The next step in money's ascent is the development of insurance markets to guard against risk. Ferguson tells the story through three central episodes. The start of insurance depended on the work of the mathematicians at Port-Royal in eighteenth-century France, who laid the basis for the modern theory of probability. Provided that the relative frequency of an occurrence was known from past information, it would be possible to insure people against the risk of it happening to them. This insight was applied by the two clergymen founders of the Scottish Ministers' Widows' Fund in Glasgow (Ferguson's hometown) in 1743. They worked out the premiums required to create a fund that, when invested, would cover payments to beneficiaries on the deaths of their husbands. As conditions of life eased, and people demanded greater protection against its hazards, insurance and pension funds "would rise to become some of the biggest investors in the world—the so-called institutional investors who today dominate global financial markets."

From the late nineteenth century onward, the state increasingly took on the "insurance" function, providing social security and health benefits to the whole population through the tax system. This was because private insurance companies left a sizable fraction of the population uninsured and uninsurable. Ferguson unusually, but effectively, uses Japan rather than Germany or Britain as his main example of the way the state nationalized risk—mainly, one suspects, because it bests illustrates his favorite thesis that financial systems grew up to serve the military needs of the state. Social security, in this view, was the reward for military sacrifice. This was particularly so in Japan.

Ferguson's third example comes from Chile, which he uses to illustrate the return from government social insurance to private—albeit compulsory—insurance. The tax-financed welfare state had never been fully accepted by conservatives, who believed it rotted the character by removing the incentive to save and by separating benefit from individual contribution. Influenced by Milton Friedman and the "Chicago boys," José Piñera, General Augusto Pinochet's minister of labor from 1979 to 1981, privatized Chile's cumbersome state pension scheme. According to Piñera, "What had begun as a system of large-scale insurance had simply become a system of taxation, with today's contributions being used to pay today's benefits, rather than to accumulate a fund for future use."

The Chilean reform encouraged workers to opt out of tax-financed state pensions into personal retirement accounts, managed by licensed but competing pension funds, and financed by compulsory deductions from wages. Although most Western countries remained wedded to their traditional single-payer welfare states, set up during and after World War II, the Chilean model was imitated across Latin America and emerging market economies. Despite what he calls its "shadow side"—it "leaves a substantial proportion of the population with no pension coverage at all"—Ferguson clearly approves of the Chilean reform, traveling to Santiago to see firsthand what he considers its beneficent results. It will be interesting to see whether the provision for universal health care promised by the Obama administration follows the European model—by extending tax-financed Medicare for everyone along the lines proposed by Paul Krugman[5]—or the Chilean/Singapore model in which compulsory insurance premiums, paid out of wages, provide the contributors with individual entitlements.

Land and the buildings on it—or in modern parlance "bricks and mortar"—have played a crucial part in the development of the financial (and economic) system, because "the land can't run away," and is therefore easy to use as collateral. Mortgaging their property became the way improvident landowners maintained extravagant lifestyles and, in later, more sober times, the way house owners raised money to start businesses. The spread of home ownership in the twentieth century—largely promoted by government in an attempt to make capitalism more popular—made possible a vast expansion of collateralized debt, and was the main stimulus to the development of the conversion of debt into securities.

Ferguson points out that property "is a security only to the person who lends you money.... By contrast, the borrower's sole security against the loss of his property to such creditors is his income." This is not quite true. The lender's security also depends on the income—actual or expected—of the borrower, because, although the property cannot "run away," it may lose its value, or it may be costly, and even impossible, for the creditor to get possession of it. Ferguson might have told the story of the costly mistake made by France's Credit Lyonnais, which set up its own proprietary credit-rating agency in the late nineteenth century. Its mistake was to rate the credit-worthiness of governments not on their debt-to-income but on their debt-to-property ratios. The imperial government of Russia got top rating, because, despite its disordered finances, of all governments it owned the most property. On the basis of this rating, French investors snapped up tsarist bonds. They lost all their money, not because the property disappeared but because the government did. Credit Lyonnais failed to take into account "political risk."

The tsarist government would now be considered a subprime borrower. Yet today's vastly more sophisticated credit-rating agencies made the same mistake in giving triple-A ratings to bonds that took no account of the income of the borrowers—what the professionals called "toxic waste." Ferguson notes that a disproportionate number of sub-prime borrowers were ethnic minorities and wonders whether subprime is a new euphemism for black. Both Democratic and Republican administrations brought pressure on lenders to relax their rules in order to spread home ownership—for example, not to press borrowers for full documentation. And indeed home ownership—or bank ownership of homes—did expand greatly in the last ten years. The bubble burst in 2007 when a rise in the federal funds rate from 1 percent to 5.4 percent coincided with the expiring of the enticing "teaser" rate periods that lenders had offered subprime borrowers. Repayments were then set at much higher interest rates and many could not pay.

The sober conclusion Ferguson draws from this fascinating story of financial incontinence and skullduggery is that property ownership is not the "magic bullet" it is often claimed to be. This is the basis of his criticism of the exaggerated claim of the economist Hernando de Soto that the path to Latin American prosperity lies in secure property rights.[6] "In short, there was irrational exuberance about bricks and mortar and the capital gains they could yield."

Ferguson's last chapter, "From Empire to Chimerica," argues convincingly that it was the investment of billions of dollars of Chinese savings in US Treasury bonds that fueled the US debt binge, by enabling Greenspan to keep money so cheap for so long. In a bravura passage that rounds off his story of money's ascent, Ferguson writes:

"Chimerica"—China plus America—seemed like a marriage made in heaven. The East Chimericans did the saving. The West Chimericans did the spending. [Cheap] Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs. As a result, it was remarkably cheap to borrow money and remarkably profitable to run a corporation. Thanks to Chimerica, global real interest rates...sank by more than a third below their average over the past fifteen years. Thanks to Chimerica, US corporate profits in 2006 rose by the same proportion above their average share of GDP....

The more China was willing to lend to the United States, the more Americans were willing to borrow. Chimerica, in other words, is the underlying cause of the surge in bank lending, bond issuance and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge fund population explosion. [It] was the underlying reason why the US mortgage market was so awash with cash in 2006 that you could get a 100 per cent mortgage with no income, no job or assets.

In the long sweep of history, the failures of money seem trivial in comparison with its triumphs, mere incidents on the road of financial innovation that leads to universal prosperity. Yet the failures have been extremely damaging to the generations that experienced them. The famous criticism made by John Maynard Keynes about the economics of his day can be applied to Ferguson's history:

In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.[7]

Ferguson, of course, is aware of the storms—in fact he writes brilliantly about them—but he never doubts that the journey has been worth it. The "ascent" of which he writes owes more to Reagan-Thatcher triumphalism than to the more sober assessments of the performance of markets currently in vogue. It also leaves out an important part of the drama of finance—the constant struggle between financial innovation and government attempts to protect populations from financial rapacity.

It is not till he comes to his "Afterword," interestingly, if ambiguously, entitled "The Descent of Money," that Ferguson seriously considers the question of why the "ascent" of money he celebrates is linked to extreme financial instability. Here he pays brief homage to the distinction made by the economist Frank Knight (and also Keynes) between "risk" and "uncertainty"—with risk referring to a situation in which the probabilities of different random outcomes can be determined, as in roulette, whereas uncertainty pertains when no such probabilities are possible, such as the prospect of a future war. And he concedes that Keynes may have been "thinking along the right lines" when he talked of investors falling back on "conventions" to disguise from themselves the fact that they do not know what the future will bring—the main convention being to behave like everyone else is behaving.

But he fails to follow up these crucial insights. The distinction between "uncertainty" and "risk" is essential, in my view, to a proper understanding not only of the present crisis but of the whole "roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes" that have punctuated economic history. The point is that the future cannot be decomposed into measurable risk, however much risk is spread across intermediary instruments. The illusion that it can be blinds investors to the ever-present possibility that the world may change in ways which set all their calculations at nought. The credit mountain was built on the belief that house prices would always go up; when they started to fall the balloon was pricked.

Ferguson realizes that mainstream economics is flawed, but then veers away to what I think is the dead end of "behavioral economics" and false analogies between financial evolution and Darwinian natural selection. Behavioral economics claims that we are "wired" to behave "irrationally"; theories purporting to derive from Darwinism claim that finance follows the law of the "survival of the fittest," whereby firms fitted to their environment flourish and weaker ones go to the wall—a process that inevitably involves "creative destruction." These attempts to explain the rise of money in terms of natural processes strike me as being both morally and philosophically naive.

Ferguson's mistake, I suggest, comes from an incomplete appreciation of the role of money. Evidently money is more than just a facilitator of trades. It is a way of coping with changing views about an uncertain future. Why, Keynes asked, should any rational person wish to "hold money" rather than spend it? Precisely because it is a way of postponing spending when confidence is low and the "conventions" promising a secure future have broken down. Keynes writes:

The desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.... It operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.[8]

Even a (modestly) depreciating currency may at moments of high uncertainty seem more "secure" (carry a higher premium) than any other asset. We are seeing the truth of this today. The failure to take account of this aspect of money is the missing dimension from an otherwise splendid book.

A final reflection on Ferguson as a historian. He is overimpressed by economics. Many historians feel that history is in some way inferior to the more exact sciences; the thought that he can "do" economics gives the historian an expanding sense of mastery. I know the feeling, because I've lived through it myself. Economics, especially in its mathematicized form, purveys a peculiar vision of society. Society to the mathematicians is a market imperfection. Among other imperfections, the idea is that allocation of resources is not as efficient and information for making choices is not as complete as they should be.

This delusive, but powerful, idea suggests that behind the imperfection lies perfection, a world in which the future will be perfectly known and therefore hold no surprises. Mathematics is the inheritor of the platonic ideal; and mathematically driven financial innovation is its handmaiden. At one time philosophers projected their utopias, and the early economists followed suit. Keynes was perhaps the last one who indulged in utopia building. In his essay "Economic Possibilities for Our Grandchildren" (1930), he looked forward to a time when the economic problem was solved and an age of abundance and leisure had arrived in which people would cultivate the arts of life.[9]

Instead, Keynes's grandchildren face a rerun of the Great Depression, and President-elect Obama promises a new New Deal. On December 6, he pledged to create an estimated 2.5 million jobs in the first two years of his administration by large-scale investments in infrastructure projects, including bridges, mass transit, and electrical grids. Estimates of the costs by members of Congress range from $400 to $700 billion.

Having taken on $7.8 trillion in financial obligations over the last year—roughly half the size of the entire American economy—the US government is now represented in some form on the boards of most major American companies. Obama has promised to help those facing foreclosure on their mortgages and those hit by the relocation of jobs overseas. He has vowed to curb the excesses enjoyed by those at the pinnacle of deregulated credit. While not addressing the fundamental direction of economic theory, ad hoc policies such as these may help to ensure that the ascent of money does not lead to the descent of man.

Notes

[1]The two-hour documentary The Ascent of Money airs on PBS on January 13, 2009.

[2]Charles R. Morris, The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash (PublicAffairs, 2008), p. xii.

[3]Quoted in The Oxford Book of Money, edited by Kevin Jackson (Oxford University Press, 1995), p. 18; from Edward Gibbon, The Decline and Fall of the Roman Empire, Book I (1776).

[4]The House of Rothschild: Money's Prophets, 1798–1848 (Viking, 1998) and The House of Rothschild: The World's Banker, 1849–1999 (Viking, 1999); reviewed in these pages by Robert Skidelsky, December 16, 1999.

[5]See Paul Krugman, The Conscience of a Liberal (Norton, 2007), pp. 236–237; reviewed in these pages by Michael Tomasky, November 22, 2007.

[6]In Hernando de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (Basic Books, 2000).

[7]John Maynard Keynes, "A Tract on Monetary Reform" (1923), in Collected Writings (Macmillan/St. Martin's/Royal Economic Society, 1971), Vol. 4, p. 65.

[8]Keynes, "General Theory of Unemployment" (February 1937), in Collected Writings, Vol. 14, p. 116.

[9]Keynes, Collected Writings, Vol. 9, p. 321.

Book Review: On the threshold - of what?

Robert Skidelsky — 2008-12-26T08:25:01+00:00

The Trillion Dollar Meltdown: easy money, high rollers and the great credit crash

by Charles R. Morris

Public Affairs £13.99

The Credit Crunch: housing bubbles, globalization and the worldwide economic crisis

by Graham Turner

Pluto Press. Paperback. £14.99

The Conscience of a Liberal: reclaiming America from the Right

By Paul Krugman

Allen Lane. £20.

Common Wealth: economics for a crowded planet

By Jeffrey Sachs

386pp. Penguin. £22.

New Frontiers in Free Trade: Globalization’s future and Asia’s rising role

By Razeen Sally

Cato Institute. $18.95

The Economists’ Voice: Top economists take on today’s problems

By Joseph E. Stiglitz, Aaron S. Edlin and J. Bradford DeLong. editors

Columbia University Press. £14.95

Of the six books under review, all published this year, only the two by non–economists, Charles R. Morris and Graham Turner, have an inkling of the economic blizzard in store. This reflects the fact that the crisis, at least in its severity, came as a complete surprise to professional economists. The eminent Nobel Prize-winners Paul Krugman, Jeffrey Sachs and Joseph E. Stiglitz, all represented here, have written as though the outstanding fault of the present capitalist system lies not in its instability, but in its distributional effect – both domestic and global. Even now it is not clear how far economists have started to question the economic assumptions that underlie the large–scale collapse we are living through.

Morris, an American lawyer and investment banker, seems to have anticipated the present credit crunch for some years. His book, The Trillion Dollar Meltdown, is the best account I have read of its genesis, written before the crunch had become global. In part, it is the story of financial innovation carried to self–destructive excess. At the same time, Morris unwittingly exposes the flaw in the financial system: it was too complicated for anyone but a professional investor to understand. This is also a problem with his book. Though it is excellently written, and full of arresting thoughts and phrases ("Intellectuals are reliable lagging indicators, near–infallible guides to what used to be true"), the world of financial legerdemain which it reveals is simply too opaque for the averagely well–educated reader to understand.

The credit crunch, originating in the American subprime mortgage crisis of 2007 and then spreading out to the global banking system, had its origins in a gigantic credit bubble. How did this arise? Morris identifies three enabling conditions. The first was the coming to power of the Chicago School of economists, with its deregulating philosophy. A key deregulating move was the repeal in 1999 of the Glass–Steagall Act of 1933, which aimed to separate retail from investment banking. "While Keynesians prayed to the idol of the quasi–omniscient technocrat, the Friedmanite religion enshrined the untrammelled workings of free market capitalism". The second condition was what he calls the "Greenspan put". Denouncing a "new paradigm of active credit management", Alan Greenspan, Chairman of the Federal Reserve from 1987 to 2006, held the Federal funds rate down to 1 per cent from 2003 to 2005 as the economy went into overdrive. His message to the market was: no matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles. The third condition was what Morris calls a "tsunami of dollars" – the result of America’s huge trade deficits, financed largely by East Asia. It was Chinese savings invested in US Treasuries which enabled Greenspan to keep the interest rate at 1 per cent for thirty months. "America’s housing and debt binge was made in China.”

It was in this regime of deregulated markets, cheap money and Asian–financed consumption demand that leveraged (debt–dependent) finance took off. The stages in the rake’s progress were the junk bond explosion of the 1980s, the development of mortgage–backed securities or "pass throughs", the creation of portfolio insurance to "manage" the extra risk, and the sprouting of hedge funds to buy up the riskiest debt and sell it to wealthy speculators. Credit agencies fed the bubble by giving bonds containing "toxic waste" triple–A ratings. Morris does not decry the value of all this financial engineering. But the new investment instruments, while hugely enlarging credit facilities by spreading risk, suffered from dangerous flaws only revealed in moments of stress. A small number of institutions – global banks, investment banks, hedge funds – built an unstable tower of debt on a tiny base of real assets. So long as a cheap–money regime forestalled defaults, the tower might wobble but stay erect. A rise in interest rates from 2005 onwards brought it crashing down. Morris comments tartly: "Very big, very complex, very opaque structures built on extremely rickety foundations are a recipe for collapse". His forecast of a "true shock–and–awe surge of asset write downs through most of 2008" proved to be all too accurate.

What needs to be done? The key requirement is to restore effective oversight of the financial services industry. Morris makes the excellent point that banks make high profits by taking large risks, but their losses are partly socialized. Banks cannot be both public utilities and risk–taking institutions. If the taxpayer is to be liable for losses, through deposit insurance or bail–outs, then risk–taking by banks must be severely limited. This points towards restoring some version of the old Glass–Steagall Act.

Morris’s book provokes an obvious reflection. The financial system should never be allowed to take on a life of its own. It provides a service to the public and should never be beyond the understanding of the public or at least of those who regulate it on the public’s behalf. In other words, it should be simple to understand. Banks should be banks, not speculators: insurance companies should insure real assets, not toxic waste: prudential rules should limit debt–to–equity ratios. There would then be less demand for the service of high–powered mathematicians to invent instruments which bamboozle the rest of us. Yes, there will be less credit available, conceivably a slower rate of economic growth. But most people will feel more secure, less stressed, and more in control of the machine that disposes of their future.

The economic consultant Graham Turner may also claim to have read the runes. The Credit Crunch: Housing bubbles, globalization and the worldwide economic crisis fills an important gap in Morris’s story, by relating recent credit bubbles to the changing structure of the real economy. We often forget that since the financial system was deregulated in the 1980s, we have had nine major financial collapses in different parts of the world, plus major stock exchange collapses. Turner’s thesis, in brief, is that globalization has resulted in a global shift in world GDP shares from wages to profits. The result has been a crisis of "realization" – over–investment in relation to worker demand. In the face of wage stagnation in the United States, American consumption demand could be kept going only by the expansion of debt. In other words, if you are a worker you don’t get your productivity gains but are encouraged to borrow at a cheaper rate. The housing bubbles in the West were deliberately created to mask the damage inflicted by American companies transferring jobs to China and East Asia to boost profits. Western governments acquiesced in job exports because this fitted their strategy of promoting free trade. The real requirement is to rebalance power in the American economy between "omnipotent capital and weak labour". This rebalancing requires, among other things, protection of American jobs.

It is good to see the venerable under–consumptionist story wheeled out to explain the present credit crunch. There is a problem, though, which Paul Krugman points out in The Conscience of a Liberal: Reclaiming America from the Right: the numbers don’t add up. True enough, "income inequality is as high as it was in the 1920s". But this is not due to globalization. Globalization might explain the rising gap between skilled and unskilled workers. It does not explain the gains of the super–rich, the main winners of recent years. In the 1970s CEOs at 102 major companies were paid $1.2 million on average in today’s money. This was only a bit more than in the 1930s and only forty times that of the pay of the average full– worker. By the early 2000s CEOs in the same companies were paid over 9 million a year, 367 times the pay of the average worker, whose benefits, additionally, had been greatly reduced. The explanation for this "great decompression", as Krugman calls it, lies in politics. From the 1980s, American politics was captured by "a vast right wing conspiracy" which set about dismantling the protective structures of the New Deal by creating "distractions". The chief of these was race. Race, in particular, duped the white voter into neglecting his material interests. Race is the main explanation for America’s lack of universal health–care: whites did not want integrated hospitals. But Krugman is hopeful that the neoconservative domination is coming to an end. The last part of the book explains his plan for creating "guaranteed universal health care" for all Americans.

Krugman provides a brisk romp through twentieth–century American history from a Democratic point of view. As he tells it, this history traces two great arcs. The first, political economy arc is from high inequality in the "gilded age" – the late nineteenth century to the 1920s – to relative equality in the middle years, and back again from Ronald Reagan onwards. The second, political arc parallels it from extreme polarization to bipartisanship and back. The reality of the first arc is readily attested by the statistics of income distribution, though Krugman provides no real explanation for these swings: why, for example, did arguments for financial deregulation and lower taxation gain such traction in the 1980s, having earlier been successfully resisted? However, the political arc doesn’t do the work Krugman wants it to. It is true that American politics became polarized again the 1980s, after a period of bipartisanship. But any change of governing philosophy is likely to start life as partisan. Krugman forgets that FDR’s New Deal was highly divisive too. Nor is there anything bipartisan about Krugman’s own history. The Republicans, in his view, were acceptable when they acted like Democrats; when they did not, they were trying to roll back the twentieth century.

What Krugman offers is a social democratic account of history’s trajectory, which is occasionally derailed by the antediluvian forces of fundamentalist religion and racist bigotry. But any historian knows that material progress is not history’s only storyline, and that religious and tribal feelings are not just "distractions" from humanity’s rational goals, but are as constitutive of human nature as is the desire for "more for less". There was an ideological, programmatic aspect to Democratic politics in the 1960s which Krugman intermittently acknowledges – indeed he espouses it today – but which plays no part in his explanation of why the bipartisanship of the mid century broke up. He conveniently forgets that the Democrats excoriated the complacent Eisenhower years which he now loves. A combination of Barack Obama and the excesses of neo–conservative economics will probably give America the chance to "complete the New Deal". But Krugman should remember that it was the limitations of the first New Deal that made it acceptable to Republican America.

Jeffrey Sachs’s Common Wealth: Economics for a crowded planet is also a cry for action. Its main idea is that human activity has now become so extensive that it has thrown every life–sustaining system on the planet out of kilter. If Sachs is troubled by the thought that humanity is on the wrong treadmill, he does not allow it to cloud his optimism. He comes to the reader not as a philosopher, but as a doctor offering readily available cures for the main planetary diseases he diagnoses: human pressure on the ecosystem leading to dangerous climate change, population pressure on scarce resources, and the extreme poverty of one–sixth of the world’s population. With only a modest investment, we can achieve sustainable development, stabilize the world’s population at 8 billion (it is now 6.6 billion), and end extreme poverty. All "we" need is the necessary political will”.

Sachs displays a disappointingly uncritical attitude towards the science he adduces in support of his plans. To some extent he is the victim of his own multidisciplinary approach. Working at the Earth Institute at Columbia University has been to him an "unalloyed gift". And his range of knowledge is impressive. But he inevitably has to take a huge amount on trust, and it shows. This is not a book of scholarship but an executive summary of hundreds of reports of blue ribbon commissions, research papers, convergences and UN declarations. The bullet points roll off the assembly line of his prose, with scarcely a hint of doubts, still less self–doubt.

Sachs presents himself as an economist of the toolkit, but in fact, he is a moralist who believes it his mission to save the planet. With such an attitude, it is almost impossible for the scientist not to become a preacher. Like his fellow moralist Paul Krugman. Sachs presents a one–sided dossier in support of his cause. A reader who knows at least something about the subjects being discussed, without fully sharing the passion of the author, is bound to deplore his lack of attention to opposing arguments, whether on climate change, population or the utility of aid for economic development.

Sachs’s uncritical attitude to science is matched by his naivety about politics. He seems to believe that the main reason for government failure to tackle global problems with the required vigour is organization deficiencies (for example, failure to mobilize available knowledge), forgetting that governments – and more generally politics – have not been set up to solve global problems but to protect their countries against domestic disorder and external attack. While berating Western governments for their failure to shape up to their planetary tasks, he pays surprisingly little attention to what it is now usual to call the problem of "governance" in the poorest countries. African countries fail to live up to their "convergence potential" because they lack basic levels of infrastructure, health, education "and governance". But for many development economists, "governance" is not something to be added to a list of infrastructural projects financed by the World Bank. It is what makes such projects possible. And the quality of "governance" is embedded in the habits and customs of the people. Sachs never faces up to the issue of how much "governance" will have to be imported from elsewhere to realize the millennium goal of poverty elimination, or how this is to be done.

Global networks, he thinks, may be the answer. "A wonderful new project, e–Parliament", he enthuses, "aims to knit together the world’s parliaments and assemblies by video conferencing and the Internet to forge a new kind of hybrid democratic institution at the transnational and even global scale". National Parliaments could mobilize the best brains through simultaneous teleconferences. He ends up by proposing a billionaires’ foundation to eradicate world poverty. I have no doubt that it will be established. No one else need apply for the post of director.

Despite the book’s deficiencies, Sachs’s main thrust is convincing: the problems he identifies can be solved, by the methods he outlines. His fault is that he is much too impatient and optimistic. Societies progress at their own pace. They can be tweaked a little by scientists. More likely, they will be jolted out of stagnation by disaster. There will be many of those to come, and many regressions as well, before Sachs’s dreams are realized. It is naive to imagine that it can be otherwise.

Razeen Sally is a wide–ranging historian of economic thought, and his clearly written monograph New Frontiers in Free Trade has been heavily influenced by his studies in the Scottish Enlightenment foundations of classical liberalism. He is an unqualified advocate of free trade and globalization, but points out that, historically, free trade was only one element in the Victorian political–economy package, which included domestic laissez–faire, low balanced budgets, and the gold standard. The international liberal order of the nineteenth century was not constructed by international organizations, but emerged as a by–product of acts of domestic liberalization. This unity between external and domestic liberalism broke down after 1945 when "[Adam] Smith abroad" had to be reconciled with "Keynes at home". The post–1945 theory of commercial policy developed by James Meade, Harry Johnson and Jagdish Bhagwati uncoupled free trade from laissez–faire by advocating targeted subsidies instead of protection for infant industries. The case for free trade came to be argued in purely technical terms. But social democracy at home was ideologically inconsistent with free trade abroad. This made free trade vulnerable to attacks by anti–globalizers.

The lesson that Sally draws from all this is that globalization today should be pursued by unilateral action rather than by complicated multilateral negotiations through the World Trade Organization. Attempts to secure common minimum standards as a condition for lowering trade barriers will lead to regulatory overload. Pressures to harmonize labour, environmental, food–safety, and other product standards will have a chilling effect on labour–intensive exports. An increasingly politicized WTO will have to bear the brunt of the anti–globalization backlash and NGO pressure. Sally points out that in Asia, unilateral dismantling of trade barriers has been the rule, with China as its driving force. This challenges the consensus that trade liberalization must be based on reciprocity. Welfare gains result directly from import liberalization, regardless of anyone else’s concession. The WTO could be retained as a useful auxiliary to "national market–based reforms".

Sally’s case for unilateral liberalization – for instance, dismantling American and EU farm subsidies without waiting for another trade round – is persuasive, but it has little chance of gaining a hearing in the West today. The problem, which he admits, is that globalization threatens the living standards not just of unskilled and skilled workers, but of the Western middle class as a whole. "The political challenge", he writes, "is to keep borders open and extend market–based reforms, while containing inevitable protectionist pressures". But he does not tell us how this is to be done.

In The Economists’ Voice: Top economists take on today’s problems, "more than thirty of the world’s top economists offer innovative policy ideas and insightful commentary on our most pressing economics issues". The book is divided into nine sections ranging from climate change – now the obligatory problem number one – to the pros and cons of the death penalty. Each section consists of two or more short non–technical essays, helpfully prefaced by a summary of the essays it contains. Although three essays warn of the coming collapse of the housing bubble, there is no sense of the scale of the impending crisis. For example, Robert Schiller writes that while homeowners face a "substantial risk of much lower prices", fortunately "derivative products, notably a futures market, are being developed [so] that they will soon be able to insure against this risk".

The collection illustrates the power and limits of economics. Economics is the most inventive of the social sciences in its ability to suggest how incentives might be rearranged so as to secure desirable outcomes at least cost in money, bureaucracy and liberty. But it lacks a realistic account of politics, the arena in which what is desirable can be made to happen. Joseph Stiglitz illustrates both features in his missionary essay on climate change: "The well–being of our entire planet is at stake. We know what needs to be done. We have the tools to hand. We only need the political resolve" – which to many will mean that we don’t have the tools to hand, since political resolve is a tool too, which Stiglitz doesn’t tell us how to invent.

The same lack of political understanding is apparent in the discussion of the costs of the Iraq war. From the economists’ point of view, the editors ask, "could not [the money] have been better spent on fighting global climate change, on providing vaccine commitments to fight tropical disease, on brokering Israeli–Palestine peace, or on giving ten million children in the United States or abroad each a $100,000 scholarship"? The answer is yes, but the economists cannot explain why these alternatives were not adopted.

The book is full of excellent cut and thrust. In his essay on international capital mobility, J. Bradford DeLong discusses how events have denied his faith in its untrammelled operation. Fifteen years ago, he supported capital mobility unreservedly. But now he believes that too many external costs are associated with financial crises. Capital also seems to want to flow, not from but to where it is already abundant – the United States has become a giant vacuum cleaner sucking in capital from all round the world – and even when efficient, capital flows benefit rich people from poor countries, not the poor. However, DeLong cannot abandon his neoliberalism; "in the end we may have to tolerate the equality–lessening reverse flow of capital in order to promote the equality–increasing and wealth–increasing diminution of corruption." At least he is honest enough to admit the dilemma.

The cumulative impression left by these six books is that we are on the cusp of one of those periodic changes in political economy caused by a crisis of the existing order. The end of the liberal/social democratic era lauded by Paul Krugman was brought about by the crisis of inflation and permissiveness. The succeeding neoconservative era supported by Razeen Sally is likely to end in a crisis of financial excess. Keynesianism and socialism, only recently proclaimed dead, are risen from their graves. The last Soviet leader, Mikhail Gorbachev, recently remarked that, what with all the bail–outs of banks and corporations going on, we now seem to have capitalism for the poor and Communism for the rich. This is a neat easy way of saying that we stand on the threshold of uncharted territory.

Perfect Losers

Robert Skidelsky — 2008-12-22T15:16:00+00:00

London – Economics, it seems, has very little to tell us about the current economic crisis. Indeed, no less a figure than former United States Federal Reserve Chairman Alan Greenspan recently confessed that his entire “intellectual edifice” had been “demolished” by recent events.

Scratch around the rubble, however, and one can come up with useful fragments. One of them is called “asymmetric information.” This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice versa. Interesting things happen – so interesting that the inventors of this idea received Nobel Prizes in economics.

In 1970, George Akerlof published a famous paper called “The Market for Lemons.” His main example was a used-car market. The buyer doesn’t know whether what is being offered is a good car or a “lemon.” His best guess is that it is a car of average quality, for which he will pay only the average price. Because the owner won’t be able to get a good price for a good car, he won’t place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behavior, physical health, and so on. The insurer faces “adverse selection,” because he cannot distinguish between good and bad risks. He therefore sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks – the quick road to bankruptcy.

There are various ways to “equalize” the information available – for example, warranties for used cars and medical certificates for insurance. But, since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

All of this is relevant to financial markets because the “efficient market hypothesis” – the dominant paradigm in finance – assumes that everyone has perfect information, and therefore that all prices express the real value of goods for sale. But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

A typical “adverse selection” problem arises when banks can’t tell the difference between a good and bad investment – a situation analogous to the insurance market. The borrower knows the risk is high, but tells the lender it is low. The lender who can’t judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, i.e., asymmetric information lets toxic loans onto the credit market. Other models use principal/agent behavior to explain “momentum” (herd behavior) in financial markets.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment’s thought will show why these models cannot explain today’s general crisis. They rely on someone getting the better of someone else: the better informed gain – at least in the short-term – at the expense of the worse informed. In fact, they are in the nature of swindles. So these models cannot explain a situation in which everyone, or almost everyone, is losing – or, for that matter, winning – at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect information about how the different parts of the economy fit together. They differ only in believing that not everyone possesses it. In Akerlof’s example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows perfectly well how likely it is to break down, and the buyer does not.

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse; but they are deceiving themselves that they know more than they do. If only one person were perfectly informed, there could never be a crisis – someone would always make the right calls at the right time. But only God is perfectly informed, and He does not play the stock market.

“The outstanding fact,” John Maynard Keynes wrote in his General Theory of Employment, Interest, and Money, “is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” There is no perfect knowledge “out there” about the correct value of assets, because there is no way we can tell what the future will be like.

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behavior arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today.

An end to the Cold War?

Robert Skidelsky — 2008-12-18T15:19:00+00:00

At long last, America has decided to stop fighting the Cold War. On 1 December, the US Department of Defence approved a directive calling upon the American military to be ‘as effective in irregular warfare as it is in traditional warfare’. This means that the question of how best to fight ‘asymmetric conflicts’ will henceforth consume America’s military strategists as much as their more traditional preoccupation: planning WW3. This might seem like cause for celebration, but I am not so sure.

The directive’s architect, Secretary of Defence Robert Gates, thinks that the greatest threats to America are no longer ‘aggressor states’ but ‘failed states.’ Although no other conventional power can challenge America – by way of illustration he mentions that the US navy is the size of the next thirteen largest navies combined, eleven of which are allies –the wars in Afghanistan and Iraq exposed the mighty superpower’s vulnerable underbelly. Guerrillas armed with AK-47s and home-made bombs did what Soviet nuclear weapons and Chinese aircraft carriers failed to do.

Seven years in Afghanistan and five in Iraq have taught the US army a great deal. Belatedly, they have learned to fight ‘the war on terror’ and Gates wants the accumulated know-how to be institutionalized. He wants to beef up development agencies and the diplomatic corps. He believes US troops should do less of the fighting themselves and instead help strengthen the armies of their allies. He even thinks America should make an ‘effort to address the grievances among the discontented.’

Although Gates was appointed by George W. Bush in 2006, Barack Obama has taken the unprecedented step of asking him to stay on in his job. It is easy to see why. Gates makes no attempt to hide his contempt for the military strategy pursued by Bush: ‘we should look askance at idealistic, triumphalist, or ethnocentric notions of future conflict that aspire to transcend the immutable principles and ugly realities of war, that imagine it is possible to cow, shock, or awe an enemy into submission’.

Few will mourn the shelving of ‘shock and awe’, few will decry Gates’ pledge to intensify diplomacy, but we should all be concerned that fighting small wars is now the Department of Defence’s top priority. The lessons which Gates wants to see institutionalized are those of the surge. They rest on the assumption that the surge in Iraq has worked and that the strategy will work again in Afghanistan. I think it is too early to say whether the Americans have brought lasting peace to Iraq and I think the war in Afghanistan is doomed, however many soldiers they send.

‘Irregular warfare’ is as old as war itself. After the Vietnam debacle, America swore never again and concentrated instead on containing Soviet armies in Central Europe. Humiliating retreats from Lebanon in 1983 and Somalia in 1994 only reminded them again why they avoided small wars. But the temptation to intervene is – for a superpower – perennial.

Only two counter-insurgency methods have ever worked: extreme restraint and extreme brutality, and the latter more often than the former. Neither strategy is now available to the US. Today, wars are fought ‘in the spotlight of the media and the shadow of international lawyers’, as Sir Richard Dannatt, head of the British Army, put it. The brutality of the British in Malaya or the French in Algeria would today land their practitioners in court. Managing public relations has become all-important. Russia learned this to its cost in Georgia.

Gates says that America is unlikely to repeat another Iraq or Afghanistan ‘anytime soon’ but cryptically adds that it might face ‘similar challenges in a variety of locales.’ Military expertise operates according to Say’s law: supply creates its own demand. I fear counter-insurgency experts will need new wars in which to put their new ‘institutionalized’ knowledge into practice.

No doubt Obama will be more diplomatic than Bush. But do not expect any of America’s ‘small wars’ to end soon. Indeed, the era of small wars may only just be beginning.