So, I’m planning to add a bit to each chapter, pointing to examples of these ideas being revived. I’d appreciate good examples for the rest: Trickle Down, Micro-based Macro the Efficient Markets Hypothesis and Privatisation (of course, the Queensland government gives an example v close to home).

With unemployment still above 10 per cent in the US, budget deficits in the trillions, and bankruptcy and foreclosure taking place on a massive scale, you might think that the idea of the Great Moderation would be, not just dead, but buried once and for all. You would be wrong.

This zombie idea was never really killed and it is already climbing out of the grave. In a blog post entitled ‘Does the Great Recession really mean the end of the Great Moderation?’ Coibion and Gorodnichnenko answer this question with a resounding ‘No’ present a series of graphs on the variability of real GDP growth to support the conclusion that ‘we are experiencing a particularly severe business cycle that nonetheless pales in comparison to the volatility experienced in the 1970s.’?Such a claim looks convincing if you look only at the absolute variability of GDP. But that variability reflects the combined impact of a massive fiscal stimulus from the public sector

Not only have the components of GDP fluctuated wildly, but so have all sorts of other macroeconomic variables. Brad DeLong points out that the variance of the employment/population ratio has shown the biggest spike since at least the Korean War.

More fundamentally, the idea that we are still in a ‘Great Moderation’ in which stability is the result of good policy fails the laugh test. The story used to be that the ‘good public policy’ that gave us stability consisted of the judicious adjustment of interest rates in line with a Taylor rule based on inflation rates and output growth. The response to the Global Financial Crisis started out that way, but the policymakers rapidly threw the rulebook out the window. Interest rates were cut all the way to zero. Then huge amounts of liquidity were pumped into banks and Wall Street firms through ‘quantitative easing’ and opening of the discount window. Then there was the trillion dollar bailout of late 2008, and the massive fiscal stimulus package of 2009.

Many words could be used to describe these responses, but ‘judicious’ and ‘moderate’ would not be among them. It could plausibly said that, massive as they were, the responses were still inadequate. But that just goes to point up the magnitude of the crisis.

Why then would anyone make such a claim? The answer can be sought in the internal dynamics of the economics profession. The Great Moderation vanished in 2008 and 2009, but the academic industry built to analyze it did not. Research projects based on explaining, measuring and projecting the Great Moderation, were not abandoned, and the careers based on those projects could not be diverted quickly into other ends.

Coibion and Gorodnichnenko are proponents of the view that the Great Moderation was the product of good public policy. They are the authors of a forthcoming paper in the American Economic Review making precisely this case. The paper is theoretically elegant and uses some impressive econometrics, reflecting the years of work that go into the production of such a piece (the article is based on a 2008 working paper and uses data from 1969 to 2002. But, if the Great Moderation is indeed over, such a paper becomes an exercise in economic history, and the ‘good policy’ explanation is clearly false.

Unsurprisingly, then, Coibion and Gorodnichnenko are attracted to the opposite view. A crisis that had destroyed whole national economies, bankrupted economies, doubled the US unemployment rate and threatened to bring down the entire financial system becomes, in their telling of the story, a ‘transitory volatility blip in 2009’.

We will be hearing a lot more of this kind of thing in the future. But, if we are to avoid repeating the mistakes of the last couple of decades, we must first recognise them for what they are. The Great Moderation is a dead idea, and it should be buried once and for all.

You can read most of the book (not always the final draft) at my wikidot site.

As always, comments and criticism much appreciated.

Implications

A policy in search of a rationale

From its earliest days, privatization was described as a ‘policy in search of a rationale’. Actually the problem was not so much the absence of a rationale as the presence of too many. As with the war in Iraq, different players in the policy process supported privatization for different reasons, and expected different outcomes. 

Sometimes it was a simple matter of class politics. Privatization is bad for unions, which tend to be stronger and more effective in the public sector. It is usually good for the incumbent senior managers of privatized firms, who move from being relatively modestly paid public sector employees, constrained by bureaucratic rules and accountability, to doing much the same job but with greatly increased pay and privileges, and far fewer constraints. It is always good for the financial sector, which earns billions in fees for managing asset sales, not to mention the returns from advising the bidders, and the pure profits gained in common cases where the asset is underpriced and can be quickly resold at a much higher market value. For politicians eager to bash unions, and politically beholden to the financial sector this was a great deal. Hostility to unions was strong on the political right, particularly after the upsurge in strikes and militancy in the 1970s. 

Governments mostly thought about privatization as a way of fixing problems of public finance. Government ministers short of money to pursue pet projects, to finance tax cuts, or simply to deal with growing budget deficits saw the sale of valuable assets as an easy and politically costless source of cash. The question of what would be done when there were no more assets to sell was left for another day. 

In other cases, faced with the need to spend money modernizing infrastructure, but unwilling to take the necessary steps to pay for it, by raising taxes and charges or by adding to public debt, governments used privatization as a way of shifting the problem to the private sector. The privatization of the water supply industry by the British government, in response to pressure from the European Union to improve environmental health and safety is one well known response.

Economists, at least when they were thinking clearly and speaking honestly, were as one in rejecting the most popular political reasons for privatization: that is was a source of cash for governments, or a way of financing desired public investments without incurring public debt. 

On the first point, it is a basic principal of economics that the value of capital asset is determined by the flow of earnings or services it generates. So the cash gained from selling public assets comes with the cost of forgoing the earnings it would have generated in continued public ownership. In a world where both governments and markets were perfectly efficient the cost would be exactly equal to the benefit and privatization would not change anything. As we’ll see below, things are more complicated than that. But that doesn’t make the idea that selling assets is a source of free cash any less silly.

A more sophisticated version of the same error is to suppose that governments facing debt constraints that restrict investment in desirable projects can get around those constraints by bringing in private investors. Once again, the problem is that the returns (such as proceeds from toll roads) needed to attract private investors represent money that could have been used to service public debt. So, the more private money is used to finance public infrastructure, the smaller the amount governments can invest without running into problems. As the exasperated secretaries of Australian state treasuries once put it, privatization and public private partnerships create no new ‘pot of money’ to spend on public infrastructure. 

Privatization will yield net fiscal benefits to governments only if the price for which the asset is sold exceeds its value in continued public ownership. This value depends on the flow of future earnings that the asset can be expected to generate. The question of how to determine this value remains controversial, and will be discussed later, in relation to the equity premium puzzle.

Because claims about the fiscal benefits of privatization so commonly involved confused or fallacious arguments, most economists generally to focus on the potential benefits of privatization in promoting competition. Although extreme market liberals gave unconditional support to privatization, the majority of economists favored breaking up public enterprises and stripping them of monopoly privileges before privatization. However, since such measures inevitably reduced sale prices, and the opportunities for incumbent managers to enrich themselves, they were rejected in many cases. Going beyond such structural changes, economists emphasized the importance of governance as opposed to ownership. 

The dominant view was that, given appropriate regulation and pro-competitive policies, it should not matter whether enterprises were publicly or privately owned. Hence, assuming private firms were more efficiently run, this view suggested that privatization should always be the preferred policy, provided that opportunities for competition were not compromised in the process.

A variety of rationales for privatization were put forward by a variety of political actors. But more and more, privatization was driven by the power of the financial sector, which benefits both directly and indirectly from privatization. The direct benefits include the massive fees and bonuses derived from managing privatizations. The indirect benefits include the enhanced economic and political power of the financial sector in an economy where all major investment decisions are driven by the demands of financial markets. In the era of market liberalism, this power extended over all major political parties.  As US Senator Dick Durbin said “the banks  are still the most powerful lobby on Capitol Hill. And they frankly own the place,””. He could equally well have been talking about the City of London and its dominance of British politics. The situation in other developed countries was rapidly becoming similar. In Australia, for example, it has become routine for retired politicians to be offered cushy jobs in the financial sector, provided of course that they have followed the right kinds of policies when in office.

The competing rationales for privatization share one common thread. This is the belief that there is always a net social benefit to be realized from converting a publicly owned enterprise into a private firm. Some advocates of privatization (including many politicians) hope that this benefit will take the form of an improvement in the net worth of the public sector, others (including economists) that it will mean lower prices for consumers, and yet others (notably including the financial sector) that they can appropriate the gains for themselves. But this disagreement over who should benefit masks a shared assumption that there are net benefits to be fought over. 

The claim that privatization always yields net social benefits was not always made explicit, but it was implicitly taken as common ground in most of the discussion of economic reform during the era of market liberalism. It is important, then, to understand what this claim entails.

Markets, governments and efficiency

When all the spurious arguments for privatization are stripped away, the central implication of the ideology of privatization is the claim that an economy in which all major decisions on investment, employment and production are left to private firms will outperform a mixed economy where governments play a significant role in such decisions. In particular, provided private firms are free to compete on a ‘level playing field’, they will always have a higher value than they would have under public ownership.

If the efficient markets hypothesis represents the negative side of the market liberal case, implying that no alternative institution can outperform markets, the case for privatization represents the positive side, implying that more private ownership will always improve economic outcomes.  The market liberal ideology of privatization asserts that, private firms can outperform governments in the production of goods and services of all kinds, including those that have long been funded and provided by the public sector, such as school education. This assertion includes both a short-run component, based on the claim that private enterprises will operate more efficiently than their  publicly owned counterparts and a long run component based on claims that privatization will improve investment decisions.

The short run claim is that, because of the incentives associated with private ownership, private enterprises are always more efficient than comparable public firms. Broadly speaking, this claim is true to the extent that profitability is a good guide to efficiency, which in turn depends largely on the absence of significant market failures. Private firms are controlled by their managers who may or may not be accountable to outside shareholders. In general, both managers and shareholders benefit significantly from increased profitability, though the relationship is more direct for shareholders.

By contrast, public enterprises are accountable to governments and therefore, indirectly to any group to which governments respond. In the presence of market failure, such accountability is likely to be beneficial, since government enterprises are under more pressure to promote better social outcomes, even at the expense of profitability. On the other hand where market failure is unimportant, requirements for accountability are likely to impede efficient decision-making. And, as public choice theorists pointed out in the 1970s, accountability requirements may be used by special interest groups to demand favorable treatment, such as above-market wages for unionized workers, or better service for politically influential customers.

The long-run case for privatization is based on the idea that the allocation of investment will be better undertaken by private firms than by government business enterprises. This claim in turn relies on the assumption that the evaluation of risk and returns undertaken by investment banks, with the assistance of ratings agencies, and the availability of sophisticated markets for derivatives like CDOs will be far superior than anything that could be obtained by, for example, using engineering calculations of the need for investment in various kinds of infrastructure, and seeking to implement the resulting investment plans on a co-ordinated basis. The GFC has shown that, for most of the past decade, market estimates of the relative riskiness and return of alternative investments have been entirely unrelated to related. 

Failure

The turning of the tide against privatization predated the financial crisis. Internationally, a number of major privatizations have been reversed. The UK government was forced to denationalize its rail network after the failure of the privately owned operator. In Australia, dissatisfaction with the privatized telecommunications monopoly has led the government to announce that it will get back into the telecommunications business by constructing a publicly-owned national broadband network. New Zealand, where market liberalism was implemented in a radical form in the 1980s and 1990s, renationalized its national airline in 2001 and its railways a couple of years later.  And even relabeled as “choice”, Social Security privatization proved so politically unsaleable that it was abandoned early in Bush’s second term.

More striking still was the collapse, under scrutiny, of nearly all the main theoretical and political rationales for privatization. Some, such as the idea that selling assets provided instant cash for governments were recognized as nonsensical early on, but, like the bigger zombie ideas discussed in this book, keep on coming back. Other rationales such as the hope that privatization would produce competitive markets in industries thought to be natural monopolies have held up longer but have ultimately proved unfounded.

The crucial issue, however, is the claim that privatization always yields net social benefits and therefore that, other things equal the price for which a public asset can be sold will exceed its value in continued public ownership. This claim has never had much empirical support. Rather it has been taken on faith as a consequence of the efficient markets hypothesis. With that hypothesis discredited, it is possible to consider how the public might lose from privatization. To understand the issues it is necessary to take a brief look at one of the enduring puzzles of economics – the high rate of return demanded by investors in equity (company stock and its derivatives) relative to the much lower rate of interest on government bonds.

The equity premium puzzle

The equity premium puzzle is one of those problems that is easy to state in summary form, but hard to explain in the detail necessary to understand it, and impossible to resolve (at least within the ‘rules of the game’ as played by economists in recent decades). The existence of a large equity premium has profound implications for economic analysis of issues ranging from climate change to macroeconomic policy, but it is most directly relevant in relation to privatization, and so I will discuss it here.

The facts are simple and well known. Over very long periods, and in many different countries, investments in equity (that is, stocks and shares) have yielded much higher returns, in the long run, than investments in bonds. The annual rate of interest on US government bonds, adjusted for inflation, has averaged between one and two per cent over the period since the late 19th century. Over the same period, returns on stocks (dividends and capital gains) have averaged around eight per cent.

The difference between the two rates of return, about six percentage points, is called the equity premium. The existence of the equity premium is not, in itself, a puzzle. Stocks are riskier than bonds, and investors expect a higher rate of return to compensate for this risk. The problem is that the premium is much higher than would be expected on the basis of the standard economic model, referred to as the Consumption Based Capital Asset Pricing Model (CCAPM).  

CCAPM starts with the observation that if financial markets are both complete and efficient, they will pool and spread all the individual risks¹ faced by households and firms, in much the same way as a life insurance company pools the mortality risks of its group of clients. Once this process of pooling and spreading is completed, the riskiness of the ‘average’ investment portfolio should be equal to the riskiness of the economy as a whole, as measured by aggregate consumption.  So, the risk premium for equity should be determined by the riskiness of aggregate consumption, which is determined by the cycle of boom and recession.

The problem is that when we look at economic fluctuations in this aggregated way, they don’t appear to be very important. A deep recession might produce negative growth of 3 per cent, compared to expected growth of 3 per cent in a normal year, while a powerful boom might produce growth of 6 per cent. But variations of 3 per cent one way or the other should not, on standard views about people’s risk attitudes, justify a significant risk premium.² In the classic paper that first pointed out the puzzle, Rajnish Mehra and Edward Prescott suggested that if the standard CCAPM model applied, the equity risk premium should be no more than half a percentage point as opposed to the observed value of six percentage points. Either the model is in need of refinement, or the assumption of complete and efficient financial markets is badly wrong. 

Unfortunately, in presenting the anomalously large risk premium as a ‘puzzle’ Mehra and Prescott encouraged subsequent writers in the literature to search for clever explanations, rather than to consider the economic implications of the puzzle. Under the implied rules of the puzzle solving game, two kinds of explanation were allowed. The first kind were clever refinements of CCAPM, usually based on alternative assumptions about risk and time preferences, such complete and efficient financial markets generated large equity risk premiums. The second, reminiscent of Blanchard’s macroeconomic haikus (see Chapter …) involved introducing a market imperfection into the standard complete and efficient financial markets model, and showing that a large equity risk premium would result.

Although many solutions along these lines have been proposed, none has been generally accepted. The problem is the same as in the micro-based literature. Financial markets are incomplete and inefficient in many different ways, most of which have the effect of making investments in the stock market riskier than they would be in the ideal world assumed in CCAPM. The equity premium is the outcome of complex interactions between investors who cannot insulate themselves from personal and business risks generated by the economy, must deal with banks who are sometimes willing to lend to them and sometimes not, and cannot easily form  expectations about the value of shares. It is unsurprising that they are unwilling to invest in the absence of an assurance of high long run returns.

What matters is not solving the ‘puzzle’ but understanding its implications. In a paper with Simon Grant, I have described some of the most important, as follows

* That the macroeconomic variability associated with recessions is very expensive

* That risk to corporate profits robs the stock market of most of its value

* That corporate executives are under irresistible pressure to make short-sighted, myopic decisions

* That policies—disinflation, costly reform—that promise long-term gains at the expense of short-term pain are much less attractive if their benefits are risky

* That social insurance programs might well benefit from investing their resources in risky portfolios in order to mobilize additional risk-bearing capacity

* That there is a strong case for public investment in long-term projects and corporations, and for policies to reduce the cost of risky capital

* That transaction taxes such as the Tobin tax could be beneficial

Privatization and the equity premium

In the case of privatization, the implications of the equity premium arise from the fact that governments can finance investments entirely by issuing bonds, with the guarantee of repayment based on their capacity to raise revenue from taxes. Private corporations must rely on a mixture of equity and debt with the result that, on average, their cost of capital is around 6 per cent, compared to around 2 per cent for governments. That is, investors value both a government bond returning a safe $2 each year at $100 and place exactly the same value on a typical investment in company bonds and stocks generating an an average of $6 a year. 

This creates a problem for privatization, which can be illustrated by an example. Suppose a government business enterprise is generating earnings of $60 million each year. At an interest rate of 2 per cent, that’s enough to service the interest on $3 billion in public debt (2 per cent of $3 billion is $60 million). Now suppose that the government decides on privatization.  they will want a return of 6 per cent. If potential buyers don’t see any opportunity to increase profits, they will only be willing to pay $1 billion (since 6 per cent of $1 billion is $60 million). So, if the government uses the sales proceeds to repay $1 billion in debt, saving $20 million a year in interest, it will need to find another $40 million a year to replace the lost earnings. 

On the other hand, if private buyers expect that they can increase annual profits to, say $300 million, they will be willing to pay $5 billion for the enterprise. If the government uses the proceeds to repay debt the interest saving will be $100 million a year, yielding a net fiscal benefit of $40 million a year.

If increases in profitability arise from improvements in operating efficiency or from improvements in the value of goods and services provided to consumers, the net fiscal benefit is also a net benefit to society as a whole. On the other hand, if private owners increase profits by cutting wages or reducing the quality of customer services, then losses to workers and consumers need to be taken into account in any assessment of privatization.

In view of the popularity of privatization, and the frequency with which it has been recommended, it is striking that assessments of this kind have rarely been undertaken. Bodies like the International Monetary Fund, which noted in 2000 that there had been few studies of the question, apparently did not feel that the lack of any empirical evidence should qualify their recommendations in favor of privatization. The IMF points to the difficulty of choosing a ‘counterfactual’, that is, of saying what would have happened in the absence of privatization. However, this problem can by overcome either by taking a conservative projection of future earnings under continued public ownership or by examining cases where a proposal for privatization was put forward, with an estimated sale price, but the enterprise was not sold, and remained in public ownership.

What evidence there is comes mostly from developing countries and is decidedly mixed. There are certainly cases, such as that of the steel industry in Brazil where privatization turned loss-making and declining public enterprises into profitable and growing private corporations. On the other side of the ledger, there are cases like that of Russia where privatization was the occasion for wholesale looting, allowing self-described democratic ‘reformers’, not to mention their Western advisors³, to enrich themselves massively. Most cases fall between these two extremes, but the view that privatization is always, or even mostly, beneficial to governments is not supported by the evidence.

Evidence on the fiscal effects of privatization in developed market economies is even more limited, so I’ll cite my own work on Australia. Examining a number of actual privatizations, I found that the government made net fiscal gains in only two cases. In both cases, the sale took place in a bubble atmosphere, with the result that the buyers subsequently resold at a loss. Looking at cases where privatization was proposed, but did not go ahead, the returns to government under continued public ownership clearly exceeded the benefits they would have obtained from selling the assets. On balance, then there was a net social loss in most cases, and this was not offset by benefits to workers (who were mostly worse off) or consumers (who experienced gains on some measures and losses on others).

Budgetary effects

The claim that selling off income earning assets provides governments with extra money that can be spent on public services is based on a confusion between income and capital. It is the same reasoning that led householders to finance consumption by borrowing against the equity in their homes. In the short run, it can produce apparent benefits, but in the longer term using asset sales to finance current expenditure is a road to financial ruin. 

The sale of assets to fund current expenditure and tax cuts was pioneered by the Thatcher government in the UK. By the late 1990s, Thatcher’s Chancellor of the Exchequer Nigel Lawson was proudly announcing that the government had replaced the deficits it inherited with surpluses, and celebrated with tax cuts all round. But by the mid-1990s, with the economy having been through a serious slump and no more assets left to sell, the budget deficit hit new records, exceeding 6 per cent of GDP [http://www.archive.official-documents.co.uk/document/hmt/budget94/chp04.htm]. It was left to the “New Labour” government of Tony Blair to clean up the mess.

The correct basis for an analysis of the fiscal impact of privatization is a comparison between the price at which a public enterprise can be sold and the present value of the flow of earnings that would be generated by the enterprise under continued public ownership.⁴ This comparison may also be expressed in flow terms, as a comparison between annual earnings foregone through privatization and the interest savings arising when the proceeds of privatization are used to repay debt. 

In most cases, the income foregone from privatization exceeds the interest saved, resulting in a net fiscal loss. An extreme example was the Thatcher government’s 1985 sale, by public float, of half of the public holding in British Telecom (BT), analyzed by Quiggin (1995). Net proceeds from the sale of the first 50 per cent of BT were about 3.65 billion pounds. 

In 1984-85, BT had a gross operating surplus of about 3 billion pounds and interest liabilities of 0.5 billion pounds, implying a net post-tax profit of around 2 billion pounds, or 1 billion pounds for the 50 per share holding that was sold.  The real bond rate at the time was around 5 per cent. Hence, the income flow from  BT could have serviced public debt of  20 billion pounds. Thus, the British public incurred a loss of more then 15 billion pounds on this transaction.

The loss was partly due to deliberate underpricing. This was reflected in the fact that the share price nearly doubled on the first day of trading.  However, even if the shares had been sold at market value, the loss (that is, the difference between the sale proceeds and the debt that could be serviced by BT earnings) would have been around 10 billion pounds. Quiggin (1995) presents a number of similar examples from Australia and New Zealand. Further evidence is presented by Walker and Walker (2000).

Only on rare occasions has the sale of public assets in sectors like telecommunications and electricity been profitable for governments. During the ‘dotcom’ mania, share prices were wildly inflated, to the point where sales of some public assets, particularly those related to the Internet and mobile telephony, were profitable. Similarly, during the deregulation of the early 1990s, US electric utilities pursued international expansion aggressively, paying high prices for assets that subsequently proved unjustified in commercial terms.  For example, a number of Victorian electricity distribution and generation enterprises, were bought by US utilities and subsequently resold at markedly reduced prices. It is only in exceptional circumstances like this that the privatization of profitable government infrastructure enterprises, run on a commercial basis, is likely to improve the fiscal position of governments.

Fiscal losses from privatization occur primarily as a result of the equity premium, that is, the difference between the rate of return expected by investors in private equity and the rate of interest on government.⁵ Estimates of the equity premium vary from four to eight percentage points. For illustrative purposes, suppose that the real rate of interest on government bonds is four per cent and the real rate of return on equity is ten per cent, so that the equity premium is six percentage points.

Now consider the privatization of a publicly-owned firm. Suppose, that privatization will not change the profitability of the firm, and that the proceeds of the sale will be used to repay government debt. For concreteness, suppose the firm will earn 100 million pounds per year. Given a required rate of return of 8 per cent, the market value of the firm will be 1 billion pounds. When this sum is used to repay debt, bearing an interest rate of 4 per cent, the resulting saving in interest will be 40 million pounds  per year. In net terms, the public is worse off by 60 million pounds per year.

Exactly the opposite calculation applies in relation to nationalization. If nationalized and privatized firms are equally profitable, governments can issue debt to finance nationalization, and receive profits more than sufficient to service the debt.

This argument does not depend on the relative size of governments and capital markets. The greater capacity of government to spread risk arises from the taxation power, which also facilitates borrowing and lending to smooth consumption over time.

Despite the evidence that privatization mostly makes governments worse off, it continues to be promoted as a solution to short-term financial difficulties. In my own home state of Queensland Australia, the state government has used a budgetary crisis to justify privatization. The publication of a statement by more than 20 of Australia’s leading economists (including some prominent supporters of privatization) pointing out that their rationale was entirely spurious has done nothing to deter them from pushing this bogus argument.

Some notable failures

The election of the Thatcher government, which signaled the rise of privatization as a central component of market liberalism, took place just over thirty years ago. In that time, there have been sufficiently many failures to give us a reasonable idea of when privatization is likely to work and when it is not. The following list of examples is selected to illustrate particularly problematic areas of privatization, as opposed to those where privatized firms fail as a result of bad luck or the failure of individual managers.

The privatization of railway systems has proved consistently problematic. In the United Kingdom, the last major privatization under the Conservative government of 1979-97 was that of the rail system which was divided into two parts. A single company Railtrack owned and managed the rail network itself, while a number of different companies, each responsible for a different region, ran the train services. A series of failures forced the Blair government to denationalize Railtrack in 2002. Dissatisfaction with the private train operators remains intense, and the biggest rail contract, the East Coast main line was renationalized in November 2009.  The partially privatized London Underground was renationalized in 2008. New Zealand similarly renationalized its rail network in 2003, and train operations in 2008. 

Privatization has been at best a mixed success in the telecommunications industry. In most cases, former public monopolies have remained dominant, with the result that the expected benefits of competition have been slow to emerge, while capital expenditure has focused on maintaining market dominance rather than on improving customer service. In Australia, the Rudd Labor government, elected in 2007 has announced plans for a new National Broadband Network which will, at least initially, be publicly owned.

Consistently poor outcomes have been observed where privatization has been extended to the core areas of the welfare state such as education, health, retirement income and criminal justice. 

There was a major push towards privatization of the school system in the United States in the 1990s, led by the Edison Schools corporation, which rapidly became a stock market darling, running hundreds of schools in dozens of states. But Edison was unable to deliver on its promises. The company was delisted in 2003, and is now largely out of the school management business.   Paradoxically, school privatization has been more successful in Sweden, where a voucher system was introduced in the 1990s. However, even with an effectively level playing field,  only 10 per cent of students attend private schools and most of these are non-profit.

In the 1990s, New Zealand attempted to commercialize its public hospital system, turning hospitals into “Crown Health Enterprises”. The results were disastrous, including huge blowouts in debt and a drastic decline in the quality of service to patients. Following the election of the Clark Labour government in 1999, the reforms were abandoned, and the Crown Health Enterprises were folded back into District Health Boards, run by elected members. The US, where the private sector plays a larger role in health services than in any other developed country, spends substantially more on health but achieves notably poor outcome. The reforms introduced by the Obama Administration and the introduction of a pharmaceutical benefit scheme under the Bush Administration have not really addressed these problems.

Perhaps the most pernicious form of privatization has been the expansion of the role of private police, prisons and mercenary military forces. What evidence there is suggests that privatization of the use of state power yields no cost saving. It does, however, yield significant political benefits to the governments that undertake. First, it allows them to avoid political responsibility for improper, and even criminal, use of force. Immigration detention centers are one noteworthy example as are the activities of companies like Blackwater, whose operatives can kill with impunity, subject neither to military nor to civil justice.

Not all privatizations have failed. For example, while infrastructure systems as a whole have strong natural monopoly characteristics, it is often possible to separate competitive or potentially competitive components of the system, in which case privatization may be feasible. In the case of electricity supply, for example, electricity generation is more competitive than transmission and distribution, while the retail functions (billing, arranging connections and so on) are more competitive still).  In such cases, partial privatizations

The most successful privatizations have been those of firms that never really belonged in the public sector, and particularly firms that have been rescued from imminent failure for social or political reasons. Rolls-Royce in the UK and General Motors in the US are notable examples. More generally, where a competitive market can be sustained and there is no special requirement for close regulation, privatization has commonly been successful.

Markets, competition and regulation

The ideology of privatization has some implications regarding regulation that appear, at least superficially, paradoxical. Privatization and deregulation are  commonly seen as going hand in hand (⁶. . Yet in practice, privatization has been accompanied by the creation of a vast range of new regulatory bodies, and expansion of the powers of many existing regulators. In the UK, the home of privatization has seen the creation of a string of regulatory institutions such as OFTEL (Telecoms), OFWAT (Water), Ofgem (Gas and Electricity Markets), OFSTED (Education) and OPRA  (Occupational Pensions Regulatory Authority) among many others. As well as these specific regulators, industry as a whole is subject to the Office of Fair Trading and the Competition Commission. 

None of these bodies existed in any form in 1970 and all have gained greatly enhanced powers in the era of privatization. And membership of the European Union adds a whole new layer of regulation.

The apparent paradox reflects the fact that public ownership was introduced as a response to market failures, and privatization did not resolve these market failures. In particular, even in cases where public infrastructure enterprises were broken up prior to sale, substantial natural monopoly elements remained. The hopes of privatization advocates that regulation would be needed only temporarily, until robust competition emerged, have largely gone unfulfilled.

There are some benefits associated with the new model of regulation. Under traditional models of public ownership, infrastructure service providers were responsible for management of all aspects of their industry, including such questions as environmental protection and pricing as well as service provision. This did not always work well. Environmental concerns, in particular, were often given scant attention by engineering-dominated organizations. Pricing was driven primarily by requirements for cost recovery rather than by the need to use resources efficiently. In some cases, the creation of separate regulatory bodies has yielded improved outcomes. But privatization is not a necessary step in this progress.

The continued heavy reliance on regulation, and the conspicuous failure of ‘light-handed’ regulatory models such as those applied to electricity markets in the United States and telecommunications in New Zealand substantially undermines the view that public enterprises represent a barrier to the emergence of competitive markets capable of generating socially optimal outcomes. Public ownership is not the only answer to market failure, but, in the absence of strong regulation, privatization is not an answer at all.

What next ?

The failure of the case for comprehensive privatization does not imply acceptance of the opposite extreme position in favor of comprehensive public ownership, or that privatization is never justified. There are large areas of the economy, such as agriculture and retail trade, where public enterprises have rarely operated at a profit. No fiscal benefit can arise from public ownership of a loss-making enterprise. Relatively modest reductions in profitability arising from the constraints associated with public ownership are sufficient to offset the benefits of a lower cost of capital.

In particular, arguments about the cost of equity capital are irrelevant for small unincorporated businesses, where there is no reliance on external equity.  Such small businesses typically face a high cost of external capital, relying primarily on bank loans. However, the higher cost of capital for small businesses, relative to both government enterprises and large private corporations, is offset by the efficiency advantages of combining ownership and control.

The idea that we must choose between pure laissez-faire capitalism and comprehensive socialization is part of what might be called the Great Forgetting of the lessons of the mixed economy. The mixed economy was not, and is not, a simple compromise between incompatible extremes. Rather it has given rise to an effective, and productive interaction between the private and public sectors. The balance of that interaction will change over time, sometimes requiring privatization of public enterprises and sometimes extension of the public sector through nationalization or the creation of new government business enterprises. 

This is, perhaps, not a surprising conclusion, being little more than a restatement of the conventional wisdom that prevailed for much of the period after World War II. Nevertheless, it is inconsistent with the neoliberal ideas that have been dominant since the economic crisis of the 1970s. In the neoliberal framework, the superiority of the private sector and the persistence of large-scale public sector provision of goods and services is assumed to be the result of unjustified political resistance to market-oriented reform.

The mixed economy

Determining the right balance between the public and private sectors in a mixed economy does not require any radical innovations in economic thinking. The main task remaining for economists is to understand more fully the capital market failures that make the cost of equity capital so high. There are a number of factors involved, and the implications for the cost of equity capital depend on the interactions between them. First, as was discussed in Chapter 2, equity markets are subject to irrational bubbles and busts. The result is that equity investments fluctuate more than does the true economic value of the corporate profits from which returns to equity are derived. Since equity is riskier than it should be under the assumptions of CCAPM, investors will demand higher average rates of return. Second, many important risks, such as the risk of becoming unemployed, cannot be traded away, and this ‘background risk’ leads investors to be more averse to equity investments that yield low or negative returns in a downturn, when the risk of unemployment is high. Finally, equity markets have shown themselves to be uneven playing fields where large and politically powerful firms like Goldman Sachs are guaranteed high returns while ordinary investors lose out.

To the extent that these failures can be overcome, the equity premium will decline and the case for private provision of goods and services will be strengthened.⁷ In the meantime, economists need to abandon the search for a clever solution of the equity premium ‘puzzle’ and  focus more on the implications of the messy reality.

The existing theory of natural monopoly and market failure provides an indication of the areas where public ownership is likely to prove beneficial, as does the observation that, across many different countries, the areas of the economy that have been allocated to the private and public sectors have been broadly similar. The boundaries have shifted from time to time, but, broadly speaking, public provision has been most common in capital-intensive natural monopoly industries, and in the provision of human services such as health and education.

The case for public ownership is strongest in  where market failure problems are likely to be severe. In the case of infrastructure industries, several market failures are important. First, because of the equity premium and the associated problem of short-termism, private providers of infrastructure may not invest enough, or in a way that maximizes long-run benefits. Second, infrastructure facilities often generate positive externalities that are not reflected in the returns to the owners of those facilities. For example, good quality transport facilities will raise the value of land in the areas it serves. Finally, there are problems associated with the natural monopoly characteristics of many infrastructure services.

As regards human services such as health and education, there is a large gap between the reality of providing these services and the theoretical requirements for market optimality is so great that economists have struggled to apply economic analysis to these activities. Among a wide range of difficulties, the biggest problems relate to information, uncertainty and financing.  The value of health and education services is derived, in large measure from the knowledge of the providers (doctors, nurses, teachers and others) and their skill in applying that knowledge to benefit patients and students. By contrast, the standard economic analysis of markets begins with the presumption that both parties are equally well informed about the nature of the good or service involved. The asymmetry of information is intimately linked to the fact that the benefits of health and education services are hard to predict in advance, or even to verify in retrospect. This in turn creates severe problems financing through market mechanisms such as health insurance and student loans. One way or another, substantial government involvement in the financing of health and education is unavoidable. Once governments are paying some or all of the bill, the most cost-effective solution is often direct public provision.

Conversely, the case for private provision is strongest where the efficient scale of operations is small enough to allow a number of firms to compete and where markets function well, rewarding firms that innovate to anticipate and meet consumer demand, and eliminating those that produce inefficiently or provide poor service. In particular, in sectors of the economy dominated by small and medium enterprises, where large corporations cannot compete successfully, it is unlikely that government business enterprises will do much better. My home state of Queensland provides historical support for this claim, having experimented, unsuccessfully, with state-owned butcher shops, hotels and cattle stations early in the 20th century.

There will always be a range of intermediate cases where no solution is obviously superior. Depending on historical contingencies or particular circumstances, different societies may choose between public provision (typically by a commercialized government business enterprise), private provision subject to regulation, or perhaps some intermediate between the two, such as a public-private partnership.

Unlike most of the ideas discussed, the failure of the ideology of privatization has already been reflected in ‘facts on the ground’. Most of the emergency nationalizations undertaken during the crisis will ultimately be reversed. But the idea that public ownership is always a policy option, and sometimes a necessary choice, cannot easily be banished from public debate. The mixed economy is back, and it’s here to stay.

¹ The technical term is ‘idiosyncratic risk’.

² The logical implication, that recessions don’t really cause any economic damage, was derived by Robert E Lucas. Perhaps the singleminded devotion to theory required to push economic logic to such absurd conclusions is one of the characteristics needed to win a Nobel Prize!l

³ In the most notable case, Harvard University paid $26 million to settle charges of self-dealing arising from the activities of its Russia Project, a team set up in the 1990s to promote privatization http://www.thenation.com/doc/19980601/wedel (

⁴ For a complete analysis of the welfare effects of privatization, it is necessary to take account of the effects of privatization on workers, consumers and the public at large. In most cases, privatization makes workers worse off. Effects on consumers are more mixed, but are rarely significant. It follows that, if governments are worse off in fiscal terms as a result of privatization, society as a whole is usually worse off as well.

⁵ Other factors, such as politically motivated underpricing are relevant in some cases, including that of British Telecom.

⁶ they are items 8 and 9 in the list of 10 policy prescriptions in John Williamson’s original description of the ‘Washington consensus’

⁷ The rise of the ‘information economy’ is a two-edged sword here. On the one hand, more information should improve the functioning of financial markets. On the other hand, information as an archetypal ‘public good’, suited to free public provision, so the areas of the economy where private markets yield the best outcomes are likely to contract in relative importance.

As always, comments, criticism and suggestions much appreciated.

Updated In response to comments, I’ve added a bit more material on the 1970s and the background to privatisation.

Privatisation

     `We hope the fund is maintaining its push for a more flexible exchange rate, far- reaching reforms in the banking sector and more privatization.’’ 

Mr Timothy Ash, head of emerging-market research at Royal Bank of Scotland in relation to an IMF rescue package for Ukraine during the global financial crisis. The Royal Bank of Scotland had just been nationalised as a result of failed speculation and catastrophic mismanagement.

The ‘mixed economy’ in which public provision of a wide range of services and economic infrastructure, such as telecommunications and electricity networks, coexisted with a largely capitalist market economy was one of the most striking features of the political and economic settlement that emerged in Western economies after 1945. Public ownership was not new. Governments in many countries had played a role in providing infrastructure, social welfare systems and services such as health and education. But, before World War II these measures had generally been seen, by supporters and critics alike, as steps towards full-scale socialism, defined in traditional terms as the elimination of private ownership of the means of production.

The one exception, first noted by John Stuart Mill was that of industries that are ‘natural monopolies’ in the sense that the efficient scale of operation is so large that costs are minimised when there is only a single firm in the market. In this case, Mill noted, “it is the part of the government, either to subject the business to reasonable conditions for the general advantage, or to retain such power over it, that the profits of the monopoly may at least be obtained for the public.”  The alternatives proposed by Mill, that natural monopolies should either be regulated or publicly owned have proved to be the only serious policy options, despite occasional attempts to argue that unregulated private monopolies may be benign, such as the theory of ‘contestable monopoly’ put forward by William Baumol and his co-authors in the 1980s.

The experience of the Depression and World War II produced a fundamental shift in thinking about the roles of governments and markets, described by Sheri Berman as ‘the social democratic moment’. Rejecting both 19th century classical liberalism, and the mechanistic determinism of orthodox Marxism, social democrats saw themselves, in the words of Australian historian as ‘civilising capitalism’. From the Swedish ‘Folkhemmet’ (people’s home) to the British reforms based on the Beveridge Report to Roosevelt’s New Deal and Four Freedoms, social democrats put forward a vision of a society in which markets and business enterprise played a central role, but one subordinate to the needs of a just society. In addition to Keynesian macroeconomic management and the social policies of the welfare state, this vision required governments to make investments in the physical and economic infrastructure needed to ensure prosperity. 

The growth of government intervention was supported by a series of new developments in microeconomics, collectively called the theory of market failure. In the 1920s, AC Pigou developed the idea of externalities as a way of incorporating obvious (but previously  disregarded) features of industrial society such as air pollution into economic analysis. Pigou’s analysis is still in use today, and forms the basis for policy proposals such as the idea of a carbon tax to limit emissions of carbon dioxide and other greenhouse gases.

Then in the 1930s, Joan Robinson and Edward Chamberlin independently developed the idea of monopolistic competition, extending earlier work on industry structures such as monopoly (dominance of a market by a single seller) and duopoly (two sellers). The rise of game theory in the 1940s and 1950s, due to von Neumann, Morgenstern and Nash, provided a rigorous basis for analysing markets that did not fit the standard competitive framework. 

The development of modern theories of information and uncertainty, also deriving from the work of von Neumann and Morgenstern suggested a range of ways in which market transactions might lead to suboptimal social outcomes. The classic instance was Akerlof’s discussion of the ‘lemons’ problem. This is the idea that the sharp decline in value of new cars, occurring as soon as they are driven out of the showroom reflects the fact that cars resold soon after purchases are likely to be those regarded by the initial buyers as ‘lemons’. In the absence of an easy way to detect such lemons, buyers of good cars will be unwilling to sell at the low price available for slightly used cars, producing a self-sustaining equilibrium in which the only near-new cars on the market are lemons.. Such ‘asymmetric information’ problems are particularly severe in the context of insurance markets where they go by the name ‘adverse selection’. 

All of these possibilities were grouped under the heading of ‘market failure’. The view that governments should act to correct market failures where they occurred was  used to justify a wide range of government action, and in particular the provision of goods and services by governments and government owned enterprises. Government provision of health services, for example, could be justified by the limitations of insurance markets, while public ownership of infrastructure utilities was justified as a response to problems of monopoly and oligopoly. 

Paradoxically,the crowning theoretical achievement of neoclassical economic theory, the demonstration by Arrow and Debreu of the existence and optimality of a competitive general equilibrium, also provided the theoretical basis for the theory of market failure. Arrow and Debreu showed that if competitive markets existed for every possible commodity, in every possible time and place and under every possible contingency, the resulting allocation of competitive resources could not be improved upon for everyone. But that’s a very big if. 

It is obvious that the complete set of time-dated, place-specific,contingent markets required for the Arrow-Debreu proof does not exist, and cannot possibly exist. But a large literature in the economics of finance explores the idea that if financial markets are sufficiently well-developed, the instruments traded in this markets can effectively encompass all relevant possibilities, the real world will be close enough to that of the Arrow-Debreu model that conclusions about the optimality of competitive equilibrium remain valid. This idea does not have a standard name, but we can call it the complete financial markets hypothesis.

The complete financial financial markets hypothesis makes sense only if these markets are efficient, in the sense of the strong form of the efficient markets hypothesis discussed in Chapter 2. Given the powerful evidence against the strong efficient markets hypothesis, this is obviously problematic. But there are even bigger problems. The complete financial market hypothesis requires much more than the existence of markets for bonds, corporate stocks and associated derivatives. It requires that households should be able to insure themselves, at reasonable cost, against such risk as unemployment, business failure, ill-health or a decline in the value of their home. With the exception of health insurance, which exists mainly as a result of public mandates, and publicly-provided‘unemployment insurance’ which is not really insurance, none of the required markets exist.[1]

The problems explored in the market failure literature can be interpreted as pointing to the absence of many of the markets needed to satisfy the complete financial markets hypothesis and thereby guarantee the optimality of competitive market equilibrium. Arrow, in particular, made this point, and showed that general equilibrium theory gave only the most qualified support to economic liberalism. 

For much of the 20th century, then, the general movement of economic policy in capitalist societies was towards an expanded role for the state, including an expansion of the scope and extent of public ownership of industry. In the light of movements towards a greater role for markets in communist countries, it was widely anticipated that capitalist and communist economic systems would converge in a ‘mixed economy’.

The term ‘mixed economy’ was popularised by British economist Andrew Shonfield to describe the economic system of the postwar era. This system was not a compromise between comprehensive state socialism and free market capitalism, as is often supposed. Rather, in seeking a market system actively managed by governments the mixed economy transcended this dichotomy. It was, and remains, unlike the vaporous offerings of Tony Blair and Bill Clinton in the 1990s, a genuine ‘Third Way’.

By 1970, the success of the welfare state and the mixed economy seemed undeniable. Hopes turned to the prospect of a further transformation, not fully defined, in which the remaining inequalities and injustices of capitalism would be greatly reduced, if not eliminated. The most promising proposals centred on notions of industrial democracy. In Sweden, the peak union body, the LO put forward a proposal, developed by economist Rudulf Meidner to require all companies above a certain size to issue new stock shares to workers, so that within 20 years the workers would control 52% of the companies they worked in.

In the event, of course, the real challenge to the mixed economy came from market liberals, who dominated the policy debate from the mid-1970s onwards. Milton Friedman’s success in macroeconomic debates attracted new attention to the market liberal position he presented in works such as Free to Choose where he (along with his wife and co-author Rose) argued that even core areas of state activity such as education could be left to private provision, funded through voucher schemes.

Meanwhile, the economic performance of public enterprises deteriorated sharply in the 1970s. In an inflationary environment, public enterprises found it hard to resist demands for increased wages, but equally hard to pass on the resulting costs in the form of higher prices. Weak economic growth and rising unemployment pushed government budgets into deficit. A common short-term response was to cut investment spending, including that of public enterprises. Although this response made little economic sense, it was enshrined in policy by rules limiting aggregate public borrowing, whether this was used to finance current expenditure or income generating investment. The most famous policy target of this kind was the Public Sector Borrowing Requirement in the UK

Over time, these problems were mostly overcome, and public enterprises returned to profitability. But, in the general atmosphere of disillusionment with government common in the 1970s, there was a receptive audience for claims that public enterprises were inherently inefficient, and represented a fiscal burden on governments.

The strength of public sector unions, at a time when unions in the private sector were being pushed onto the defensive by mass unemployment, also contributed to the push for privatisation. Governments keen to weaken the power of unions, but unwilling to confront their own employees, could resolve the problem by handing public enterprises over to private owners, keen to break unions and eliminate overstaffing and above-market pay and conditions (at the shopfloor level, if not for senior management).

The rise of ‘property rights’ theory in the late 1970s produced a theoretical critique of public ownership. It was argued that, since private corporations were responsible to their shareholders, their managers would always have stronger incentives to seek efficiency than would bureaucrats or managers of public enterprise. Although it contradicted decades of research showing that ordinary shareholders are virtually powerless, the property rights theory met the political needs of the time, and was widely embraced.

Theory turned to practice with the election of the Thatcher government in the United Kingdom in 1979. Starting with popular proposals such as the sale of council houses to the tenants who occupied them, Thatcher began a program under which publicly owned enterprises in telecommunications, electricity, water and transport were sold, usually through public floats. Thatcher’s example was soon emulated by governments of all political persuasions in the English speaking world. By the 1990s, privatisation was part of the standard policy agenda, referred to as the Washington consensus and promoted by the World Bank, IMF and US Treasury as essential to sound economic management in developing countries.

The large-scale privatisation of publicly-owned enterprises in the 1980s and 1990s played a big role in promoting the triumphalist claims of market liberals. Commentators and thinktanks rushed to conflate the (real but manageable) financial difficulties of long-established public infrastructure services in countries like the UK, New Zealand and Australia with the collapse of Communism in Eastern Europe and the stagnation of North Korea.

Public ownership of infrastructure was seen as a relic of the past, doomed to vanish as governments rushed to sell off assets. Having claimed victory in the infrastructure sector, market liberals turned their attention to the core of the welfare state with proposals for privatisation of health services, prisons and the school system. In the US, the most ambitious assault on the institutions of the New Deal era was the proposal, pushed hard by the Bush Administration, to privatise Social Security. 

Few would have predicted that, a decade or so later, governments would be debating, and in some cases undertaking, the nationalisation of such iconic capitalist enterprises as Citigroup, Bank of America and General Motors. Although  these rescue operations mostly involve only temporary public ownership, they make the rhetoric of the 1990s look absurd. And they raise the question of whether some or all of the privatisations of past decades should be reversed.

But despite these failures and reversals, systematic privatisation of public enterprises remains part of the standard package of policy reforms recommended by bodies like the IMF, and there has been little serious effort to reconsider the theoretical rationale for these policies, or to ask who gains and loses from their implementation.

#

Beginnings

During the era of the mixed economy, the boundaries between the public and private sector were regularly redjusted, and not always in the same direction. While the predominant trend was for the role of the state to expand through the nationalisation of existing private enterprises or the establishment of new public enterprises,  it was quite common enough for publicly owned enterprises to be returned to the private sector (the phrase commonly used at the time was ‘denationalisation’. Peter Drucker used ‘reprivatization. An earlier usage under the Nazis is noted http://michaelperelman.wordpress.com/2006/09/11/the-nazi-heritage-of-privatization/ The newly elected Thatcher government initially focused on monetarist macroeconomic policies. However, attention steadily shifted to the idea of privatisation. ). 

It was not until the 1979 election of the Thatcher government in the United Kingdom that the mixed economy came under serious challenge. Following the failure of Keynesian macroeconomic management in the 1970s, the generally disappointing performance of the UK economy since 1945 (or earlier) and the full-blown crises of the late 1970s, the stage was set for a reaction against social democracy in all its forms.

Whereas previous conservative governments had denationalised some of the acquisitions of their immediate Labour predecessors, the Thatcher government began selling off enterprises, such as British Telecom, which had been in the public sector since their establishment.  The idea of privatisation, conceived as the systematic removal of the state from the production and provision of goods and services, was born.

Thatcher’s radical measures were much admired, and imitated, in Australia and New Zealand, which still tended to follow the British lead with respect to economic policy.  Surprisingly, in both countries, the crucial steps were taken by governments associated with the labor movement [2]. In Australia, the Hawke and Keating governments, in office from 1983 to 1996 moved slowly and cautiously, but eventually privatised the national airline, Qantas, and the main publicly-owned bank, outraging many of their traditional supporters. 

In New Zealand, caution was thrown to the winds. Labour Finance Minister Roger Douglas rapidly gained a reputation as ‘more Thatcherite than Thatcher’. Among a series of radical free-market reforms, large-scale privatisation began with the sale (by public float) of the Bank of New Zealand, and continued apace thereafter with the sale of assets such as Air New Zealand. New Zealanders had tired of the reforms by 1990, and replaced Labour with the conservative National Party, which promised a more moderate approach. In office, however, the Bolger National government continued to push radical free-market measures notably including the sale of New Zealand Rail(1993) and corporatisation of the health system with a view to eventual privatisation. The Labour party split in Opposition, with the radical free-market group leaving to form the Association of Consumers and Taxpayers (later the ACT Party). The era of radical reform finally ended when Labour regained government under Helen Clark in 1999.

Thatcher’s radical reforms reversed the century-long trend towards greater state involvement in the capitalist economy. But it was the collapse of Soviet Communism that seemed to confirm that free-market reforms represented more than a swing of the political pendulum and constituted, in the words of the great triumphalist text of the age The End of History. It was inevitable, given the collapse of centrally planned economies, that large numbers of state-owned enterprises would be converted, one way or another, to private ownership. The ideology of privatisation encouraged the adoption of a radical ‘shock treatment’ approach based on wholesale privatisation.

In this context,it was inevitable that  privatisation should become part of the standard ‘Washington Consensus’, package of reforms advocated for less developed countries by the World Bank, International Monetary Fund (IMF and US Treasury.  And by the 1990s, the privatisation trend had spread to EU countries that were often dismissive of such ‘Anglo-Saxon’ notions.

[1] Robert Shiller has long argued that new financial instruments could reduce the riskiness of investments in home ownership, but his efforts to promote the development of such instruments have had only limited success

[2] For reasons lost to history, the Australian party uses the American spelling, Labor, while its NZ cousin uses Labour

• Looking at the blogroll, I feel like the last of the Mohicans. The bloggers of those days have nearly all retired, and hardly any has a solo blog anymore. CT is something of an exception – quite a few of us still keep our personal blogs going. Mine is here.

• I’m singing the same song now as I was all those years ago. The top post on the page is about how the financial crisis has discredited the efficient markets hypothesis, trickle down economics, privatisation and so on. Of course that was the dotcom financial crisis of 2000-01. I think a few more people are paying attention this time around, but we will have to wait and see.

One thing that would be really useful to me is references to publications (probably popular, rather than journal articles) by prominent academic economists that clearly espouse some of the implications of trickle-down discussed here. More than most of the ideas I’m criticising, trickle-down economics tends to be a background assumption rather than something which comes out into the open, and I want to avoid the suggestion that I’m attacking a straw zombie here.

Implications

…

Defenders of the trickle-down hypothesis frequently employ what my Crooked Tmber co-blogger John Holbo calls the 

‘the two-step of terrific triviality’. Say something that is ambiguous between something so strong it is absurd and so weak that it would be absurd even to mention it. When attacked, hop from foot to foot as necessary, keeping a serious expression on your face.

The self-evidently weak version of the trickle-down theory starts with the observation that we all benefit, in all kinds of ways, from living in an advanced industrial society, with access to modern medical care, consumer goods, the Internet and so on. Stretched widely enough, the term ‘capitalism’ includes all advanced industrial societies, from Scandinavian social democracies to the Hong Kong version of laissez-faire. So, in this sense, the benefits of capitalism have trickled down to everyone.

The strong version of the claim is obtained by shifting the meaning of ‘capitalism’ to mean ‘the free-market version of capitalism favored by market liberals’. Relatively few of the benefits mentioned above can be traced directly to this form of capitalism. Advances in medical care have come mostly from publicly-funded research, and from innovations developed in the public health sector. The contributions of for-profit pharmaceutical companies have been modest by comparison. SImilarly, the Internet was developed by the publicly-funded university sector, and even now the most exciting developments are non-profit innovations like Wikipedia.

The crucial question is not whether technological progress and economic development yields benefits to everyone (clearly it does, at least in material terms), but whether market liberal policies generate more such progress than more egalitarian alternatives, so much more that everyone is better off in the end. It is this strong claim that was made repeatedly during the era of market triumphalism in the 1990s, and repeated, though with somewhat less conviction, through the 2000s. 

 The growth in US inequality during the Great Moderation was undeniable (though that didn’t stop some commentators and thinktanks trying to deny it). So, optimistic assessments of economic performance during the Great Moderation appeared to support the claim that rising inequality must be good for, or at least consistent with, economic growth that would ultimately benefit everybody.

Now, in the wake of the global financial crisis, this claim can be seen to be unambiguously false.

#

Income, inequality and taxation

The most obvious implication of the trickle-down hypothesis is that inequality in market incomes is not only harmless, but positively desirable, producing benefits for everyone in the long run.  The general idea is that, the more highly owners of capital and highly-skilled managers are rewarded, the more productive they will be. This will lead both to the provision of goods and services at lower cost and to higher demand for the services of less-skilled workers who will therefore earn higher wages.

In the abstract language of welfare economics, the central implication of the trickle down hypothesis is that policy should be aimed at promoting efficiency, rather than equity since, in the long run, equity will take care of itself. Put in terms of a more homely metaphor, we should focus on making the pie bigger, rather than sharing it out more equally.

In reality, things are not that simple. It is easy to suggest that tax and other policies should apply neutrally to all sectors of the economy, but harder to define how this should actually work. It might seem that a ‘flat’ tax system in which all forms of income are taxed at a low, uniform rate would satisfy the efficiency criterion. But advocates of ‘trickle down’ have arguments to suggest that income from capital should not be taxed at all. 

Going further, market liberals have claimed that, since everyone benefits from many of the services provided by government, the most efficient and equitable form of taxation is a poll tax [1]. Such a policy was in fact introduced by the Thatcher government in the UK to finance local government services, but was abandoned in the face of massive protests and widespread rioting.

 Once we turn from theoretical policy debate o the details of design, implementation and enforcement, the well-off invariably do better than the poor, while the rich do best of all. This was true during the postwar Great Compression – although the system appeared steeply progressive, the use of deductions, loopholes and tax minimisation schemes mean that it was, at best, only moderately progressive. Under the systems in force since the 1980s, which are only marginally progressive in their design, the actual outcome has been that upper income earners probably pay a smaller proportion of their income in tax than the population as a whole.

The absence of substantial progressivity in the tax system is obscured by the focus, in the US and elsewhere on the fact that high income earners (almost by definition) pay the bulk of income tax. A good deal of the material appearing on this topic in the Wall Street Journal and elsewhere gives the impression that income tax is the only tax in the system. In reality, income tax is not even the sole tax imposed on income – most countries, including the US, levy payroll taxes which fall on labour income. Unlike the progressive income tax, which does indeed fall most heavily on high income earners, payroll taxes are regressive, falling primarily on wage employees. 

In most taxation systems, capital gains are accorded concessional treatment or not taxed at all. Unsurprisingly, a large share of capital income is taken in the form of capital gains, moving the tax system closer to the ‘trickle-down’ ideal where all taxes fall directly, or indirectly, on wage-earners.

Moreover, taxes on income and wealth only account for about half of government revenue in most tax systems. Consumption taxes typically make up about half of all government revenue, and these taxes are regressive. That is, those on low incomes typically pay a higher proportion of those incomes in consumption taxes than do those on high incomes. There are a number of reasons for this. Low income earners don’t generally save very much, so the ratio of consumption to income is higher for these groups. Taxes on items such as tobacco, alcohol, and gambling are levied at very high rates, and these items tend to make up a larger share of the expenditure of the poor (though absolute expenditure is higher only for tobacco).

Finally, there is tax avoidance and minimisation. A vast industry of lawyers, accountants, money-launderers and other agents exists solely to ensure that no one with sufficient means should pay any more tax than the minimum they are obliged to pay under the most creative possible interpretation of the law, and that those who don’t wish to pay even this much should be free to make this choice without any adverse consequences.

In summary, no matter how favorably the well-off are treated, there will always be arguments to suggest that they should receive even better treatment. Trickle-down theory offers no limit to the extent to which the burdens of taxation and economic risk can or should be shifted from the rich to the poor. In the end, according to the trickle-down story, that which is given to the rich will always come back to the rest of us, while that which is given to the poor is gone forever.

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The role of the financial sector

The financial sector is the crucial test case for trickle-down theory. During the era of market liberalism, incomes in the financial sector rose more rapidly than in any other part of the economy, and played a major role in bidding up the incomes of senior managers as well as those of professionals in related fields such as law and accounting. According to the trickle-down theory, the growth in income accruing to the financial sector benefitted the US population as a whole in three main ways.

First, the facilitation of takeovers, mergers and private buyouts offered the opportunity to increase the efficiency with which capital was used, and the productivity of the economy as a whole.

Second, expanded provision of credit to households allowed higher standards of living to be enjoyed, as households could ride out fluctuations in income, bring forward the benefits of future income growth, and draw on the capital gains associated with rising prices for stocks, real estate and other assets.

Finally, there is the classic ‘trickle-down’ effect in which the wealth of the financial sector generates demands for luxury goods and services of all kinds, thereby benefitting workers in general, or at least those in cities with high concentrations of financial centre activity such as London and New York.

The bubble years from the early 1990s to 2007 gave some support to all of these claims. Measured US productivity grew strongly in the 1990s, and moderately in the years after 2000. Household consumption also grew strongly, and inequality in consumption was much less than inequality in income or wealth. And, although income growth was weak for most households, rates of unemployment were low, at least by post-1970 standards for most of this period.

Very little of this is likely to survive the financial crisis. At its peak, the financial sector (finance, insurance and real estate) accounted for around 18 per cent of GDP and a much larger share of GDP growth. With professional and business services included, the total share was over 30 per cent.[1] The finance and business services sector is now contracting, and it is clear that a significant part of the output measured in the bubble years was illusory. Many investments and financial transactions made during this period have already proved disastrous, and many more seem likely to do so in coming years.In the process, the apparent productivity gains generated through the expansion of the financial sector will be lost.

fn1. Here I’m measuring the ratio of gross FBS output to gross domestic product, which is the figure most relevant to the argument. The value-added in FRB  (which nets out inputs purchased by the FRB sector) is smaller, around 20 per cent, but still indicates a highly financialised economy.

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Equality of outcome and equality of opportunity

The trickle down hypothesis is closely related to the distinction between equality of outcomes (like life expectancy) and equality of opportunity. This distinction has long been a staple of debates between market liberals and social democrats. Many market liberals argue that, as long as society equalises opportunity, for example by providing good-quality schools for all, it’s not a problem if outcomes are highly unequal. Even though some people may do badly, their children will, it’s claimed, benefit from growing up in a dynamic society where everyone has a chance at the glittering prizes.

Writing in the Wall Street Journal, Wisconsin Republican Paul Ryan attacked President Obama’s first budget saying

In a nutshell, the president’s budget seemingly seeks to replace the American political idea of equalizing opportunity with the European notion of equalizing results.

A year earlier, following his victory in the Republican primary in South Carolina, John McCain said

We can overcome any challenge as long as we keep our courage, and stand by our defense of free markets, low taxes, and small government that have made America the greatest land of opportunity in the world.

As these quotations suggest, the trickle-down hypothesis relies on the claim that equality of opportunity and equality of outcome are not only distinct concepts, but stand in active opposition to each other. By removing disincentives to work such as high tax rates and elaborate social welfare systems, it is claimed, an economic system that tolerates highly unequal outcomes will also provide those at the bottom of the income distribution with the incentives and opportunities to haul themselves up into the middle class and beyond.

The idea that the United States is a ‘land of opportunity’ and ‘the most socially mobile society the world has ever known’ (Scott Norvell, in a piece calling for patriotic consumer spending in the wake of 9/11 http://www.foxnews.com/story/0,2933,34378,00.html) is central to the American national self-image, and the belief that this high social mobility derives from free markets is widely shared. 

As we will see, empirical studies of social mobility do not support such beliefs. But most economists are not engaged in studies of social mobility and many of them share these popular assumptions. This is true not only of self-satisfied American economists, promoting the merits of the status quo and calling for more of the same, but also of European critics of the welfare state, who accept the characterization of their own societies as rigid and sclerotic by comparison with the dynamic and flexible United States.

[1] The word ‘poll’ means ‘head’, but is closely associated with voting. Poll taxes are typically levied using electoral registers to define the tax base and can therefore be used to disenfranchise the poor or, as in the US South in the Jim Crow era, blacks

It’s currently titled Zombie Economics:Undead Ideas that Threaten the World Economy. The title is pretty much locked in, but the subtitle is still open for change if anyone has any suggestions. You can read the first few chapters (not quite an up-to-date draft) at wikidot.

The chapter I’m working on now is Trickle-Down Economics, which seems a fairly soft target after the challenge of presenting a critique of the “micro foundations” approach to macroeconomics. But, there are still plenty of difficulties starting with the point that, of course, no-one espouses Trickle-Down Economics under that name. On the other hand, while the view that pro-rich policies will benefit everyone in the long run is widely held, I don’t know of a good general term that describes it.

Anyway here’s the opening section. As always, comments and criticism much appreciated.

Trickle down

Most labels are pejorative, and much of the time, ideas can be identified only by the labels attached to them by their opponents. So it is with the question of whether policies of income redistribution help or harm the poor in the long run. The claim that redistribution policies actually harm those they are intended to benefit and that reducing taxes on the rich would ultimately benefit the poor has long been derided as ‘trickle down economics’ (the phrase is widely attributed to humorist Will Rogers, and dated back to the 1930s). A more recent take on trickle-down is that of satirical magazine the Onion, which traces the process by which Reagan’s tax cuts and defense spending trickled down over two decades to produced the promised outcome ‘in the form of a $10 bonus, to Hazelwood, MO car-wash attendant Frank Kellener.’ Supporters of the claim return the favor, criticising advocates of redistribution as ‘class warriors’ who practise the ‘politics of envy’. 

The ‘trickle down’ idea been summed up, more positively, in the aphorism ‘a rising tide lifts all boats’ attributed to John F Kennedy, and a favorite of Clinton advisers such as Gene Sperling and Robert Rubin. (It should be noted that this phrase is also used in the context of debates over free trade and over the effects of macroeconomic expansion. While it generally implies that we should focus on expanding aggregate income without too much concern over distribution, it is less sharply focused than the ‘trickle down’pejorative.

One important version of ‘trickle down’ economics is the ‘supply-side’ school of economics which came to prominence in the 1980s. The extreme claims made by some supply-siders, summed up in the so-called ‘Laffer curve’ threw this school into disrepute. However, more moderate versions of the same claims, referred to using such terms as ‘dynamic efficiency’, came to be widely accepted by mainstream economists, during the years of the Great Moderation. 

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Beginnings

Regardless of nomenclature, the near-universal prosperity of the postwar boom seemed to constitute a refutation of trickle down economics every bit as decisive as the refutation of pre-Keynesian economics by the disappearance of mass unemployment. Throughout the developed world, the growing prosperity of the years after 1945 was accompanied by reductions in income inequality and a softening of the differences between classes.

The experience of the US in particular was striking. Emerging as the unchallenged economic leader of the world after 1945, US firms were in a position to pay manual workers at rates that propelled them into the middle class. And the middle class itself grew and prospered to an extent that seem to portend the end of class conflict and even the end of class itself. The American middle class enjoyed living standards that outstripped, in many respects, the best that had been enjoyed by the rich in any other time and place. 

All of this was achieved under policies that are, in retrospect, hard to believe were ever politically possible. Income taxes, a relative novelty at the time, were steeply progressive, with top marginal rates often exceeding 90 per cent. Inheritances were similarly heavily taxed, while ordinary people benefited from a variety of new welfare measures, such as the Social Security system in the US, which provided against the risks of old age, unemployment and ill-health.

Economic historians call the resulting period of high equality The Great Compression. It arrived with surprising suddenness as a result of the New Deal and World War II.

The Great Compression ended as suddenly as it began. From the early 1980s onwards, the gains in equality were reversed. This occcurred partly as result of the changes in the distribution of market incomes. Profits grew at the expense of wages and the distribution of wages became more equal. Changes in market income were reinforced by public policy. The steeply progressive income tax rates of the  postwar era were replaced by flat tax systems, with maximum rates of 40 per cent or less. Initially, and to some extent even today, these measures were presented as providing tax relief to the ‘middle class’, an elastic term but one that is typically taken to include families with incomes ranging from the median to the 90th percentile of the income distribution or sometimes even higher. Increasingly, however, tax reductions were focused on those in the top 10 per cent of the income distribution.

The pattern set by the United States in the 1980s, was followed, to a greater or lesser degree by other English-speaking countries as they embarked on the path of market liberalism.  The most striking increases were in the United Kingdom under the Thatcher government where the Gini coefficient (a standard statistical measure of inequality) rose from 0.25, a value comparable to that of Scandinavian social democracies to 0.33, which is among the highest values for developed countries. New Zealand started a few years later, but experienced even more radical reforms, cutting the top marginal rate of income tax from 66 percent in  1986 to 33 percent by 1990.  Unsurprisingly, this pushed the Gini index from an initial value 0.26 to 0.33 by the mid 1990s. http://www.eastonbh.ac.nz/?p=333. Ireland, Canada and Australia all followed a similar path. The main EU countries resisted the trend to increased inequality through the 1980s and 1990s, but recent evidence suggests that inequality may be rising there also. http://www.poverty.org.uk/summary/eapn.shtml

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Supply-side

As inequality increased, so did the demand for theoretical rationalisations of policies benefitting the wealthy, and in particular for reductions in taxation. A variety of ideas of this kind were put forward under the banner of ‘supply-side economics’.

The term ‘supply-side economics’ dates back to the 1970s, when it was popularized by Jude Wanniski, then an associate editor for the Wall Street Journal, and later an economic advisor to Ronald Reagan. Wanniski, a colorful figure, did not let his lack of academic credentials deter him from taking on big names in the economics profession including not only Keynes and his followers but Milton Friedman. [1]

The central idea of supply-side economics followed directly from the negative conclusions of new classical economics regarding the possibility of successful demand management. If, as the new classical school believed, such demand-side policies were bound to be ineffectual or counterproductive, the only way to improve economic outcomes was to focus on the supply side, that is, to increase the productive capacity of the economy. Although many different policies (improved education, for example) might be advocated as ways to improve productivity, Wanniski focused on the kinds of policies favored by economic liberals, such as reduced regulation and lower income taxes.

Wanniski started the process with his ‘Two Santa Claus’ theory of politics. This was the idea that, in a contest between one political party (the Democrats, in the US) favoring higher public expenditure, and another (the Republicans) favoring lower spending, the high-spending party would always win. Hence, the correct political strategy for conservatives was to campaign for tax cuts, without worrying too much about budget deficits. Any problems with budget deficit would be resolved by the higher growth unleashed by improved incentives and reduced regulation.

This idea was taken much further at a famous lunch meeting between Wanniski, Donald Rumsfeld, Dick Cheney, and University of Southern California economist Arthur Laffer. These four, relatively obscure figures at the time, were to play a central, and disastrous, role in the economic and political events of the next thirty years. Everyone knows the story of how Laffer drew a graph on a napkin, illustrating the point that tax rates of 100 per cent would result in a cessation of economic activity and therefore yield zero revenue. Since a tax rate of zero will also yield zero revenue, there must exist some rate of taxation that yields a maximum level of revenue. Increases in tax beyond that point will harm economic activity so much that they reduce revenue.

Wanniski christened this graph the ‘Laffer curve’, but as Laffer himself was happy to concede, there was nothing original about it. It can be traced back to the 14th century Arabic writer Ibn Khaldun, and Laffer credited his own version to the nemesis of supply-side economics, John Maynard Keynes.  And while few economists had made much of the point, that was mainly because it seemed to obvious to bother spelling out.

What was novel in Laffer’s presentation was what might be called the Laffer hypothesis, namely that the US in the early 1980s was on the descending part of the curve, where higher tax rates produced less revenue. 

Unfortunately, as the old saying has it, Laffer’s analysis contained a mixture of correctness and originality. The Laffer curve was correct but unoriginal. The Laffer hypothesis was original but incorrect.

More sophisticated economic liberals could also see that the Laffer hypothesis represented something of an ‘own goal’  for their side. If the debate over tax policy turned on whether tax cuts produced higher revenue, and were therefore self-financing, the advocates of lower taxes were bound to lose, at least in policy circles where empirical evidence was taken seriously. Embarrassingly for their more sophisticated allies, supply-siders made, and continue to make, obviously silly arguments.

 Fairly typical is the claim that, despite cutting taxes, Ronald Reagan doubled US government revenue, a claim made by commentators like Sean Hannity, and derived from the work of rightwing thinktanks such as the Heritage Foundation. Leaving aside the fact that revenues did not in fact double under Reagan (the Heritage institute figures add in some of the first Bush presidency, such claims ignore the fact that tax revenues, and the cost of providing any given level of government services, rise automatically with inflation, population growth and increases in real wages.  Even with cuts in tax rates, revenues are bound to rise over time as the nominal value of national income increases. 

For the Laffer hypothesis to be supported, tax cuts would have to increase revenue more rapidly than would be expected as a result of normal income growth. In fact, as the US Office of Management and Budget reported , “Income tax receipts grew noticeably more slowly than usual in the 1980s, after the large cuts in individual and corporate income tax rates in 1981.” (Quoted by CBPP http://www.cbpp.org/cms/?fa=view&id=119)

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The dynamic trickle down hypothesis

Mainstream market liberals were generally disdainful of the ‘voodoo economics’ of the Laffer hypothesis. But they nonetheless accepted to the central postulate of trickle-down economics, namely, that policies favorable to the wealthy will, in the long run, produce benefits for everyone, compared to the alternative of progressive taxes and redistributive social welfare policies. Rather than rely on the simplistic, and easily refuted, Laffer hypothesis, market liberals claimed that the trickle-down effect would work through so-called ‘dynamic’ effects of free-market reforms, and particularly tax reforms.

As with other economic terms, such as ‘efficiency’, the appeal of this argument depended, in large measure on conflating the ordinary language meaning and connotations of ‘dynamic’ with the technical economic meaning. In technical terms, ‘dynamic’ effects are those realised over time, as the capital stock in an economy varies. But in political discussion, it is easy to slide from this use into rhetoric about dynamism, sclerosis and so forth.

The crucial distinction between the two is that while dynamic effects, in the technical sense, can raise or lower the level of national income in the long run, they do not, in standard economic models, affect the long-term rate of economic growth, which depends ultimately on productivity. Standard economic analysis suggests that the adoption of tax policies more favorable to owners of capital will increase savings and investment, and therefore raise the level of national income in the long run. This idea formed the basis of a number of ‘dynamic scoring’ exercises aimed at estimating the effects of the Bush tax cuts of 2001. Supporters of the Laffer hypothesis hoped that these exercises would show tax cuts paying for themselves in the long run.

Dynamic scoring analyses typically found some positive effects on capital accumulation, but they were too small, in terms of their effect on incomes and tax revenues to offset the cost of the initial costs. The most optimistic study, undertaken by Greg Mankiw, former chairman of President Bush’s Council of Economic Advisors and Matthew Weinzierl found that, assuming that the conditions of the standard neoclassical model were satisfied, dynamic effects would offset about 17 per cent of the initial cost of a cut in taxes on labor income and about 50 per cent of the cost of a cut in taxes on capital income.

However, as subsequent analysis showed, these results depended critically on technical assumptions about how the tax cut was initially financed.  Mankiw and Weinzierl assumed that tax cuts are associated with expenditure cuts sufficient to maintain budget balance, and that these expenditure cuts do not create any additional market failures (that is, that the expenditure in question was a pure transfer). Eric Leeper and Shu-Chun Susan Yang examined the case when, as actually happened with the Bush tax cuts, the cuts were initially financed by higher debt. In this case, it turns out that dynamic effects can actually increase the initial cost of a tax cut.

A further difficulty was that, since the increased income was the result of additional savings, it could not, in economic terms, be regarded as a pure economic benefit. The relevant measure of economic benefit, netting out costs from benefits, is the change in the present value of consumption, which is typically much smaller than the final change in income – even for large tax cuts, the net dynamic benefit is rarely more than one per cent of national income. The same point may be made in terms of the effects on the government budget. Even if tax cuts eventually generated enough extra revenue to  match the annual cost of the cuts (and of course they never do!) the budget would still be in long-term deficit because of the need to service the debt built up in the transitional period.

The implications for the trickle-down hypothesis are even worse. Under standard assumptions about the way the economy works, all the benefits of additional investment go to investors (or those whose savings finance the investment). That is, cutting taxes for the rich may lead them to save and invest more, thereby making themselves still richer, but there is no reason to expect any benefit for the rest of the community, except to the extent that the cost of the original tax cut is partially defrayed.

Finally, and most importantly of all, the neoclassical model used to derive estimates of dynamic benefits implicitly incorporates the efficient markets hypothesis. The extra investment generated by more favorable tax treatment is supposed to be allocated efficiently so as to produce sustainable long-term economic growth. Until the financial crisis the experience of countries that followed this logic and cut taxes on capital income appeared to bear out this view. Iceland, Ireland and the Baltic States among others, experienced rapid economic growth as a result of high domestic investment and strong capital inflows. 

But the economic crisis proved that this apparent success was built on sand. Much of the extra investment went into real estate, or into speculative ventures that collapsed when the bubble burst. Having cut taxes drastically, governments were left with inadequate financial resources to convince (now-cautious) investors that their bonds were a safe investment.

[1] He was later to become one of the first commentators to suggest, correctly, that Saddam Hussein’s ‘weapons of mass destruction’ had been found and destroyed by the UN weapons inspection process.

Update In response to comments, I’ve fairly substantially revised the section on “avoiding stagflation”. While I don’t back away from the points I made previously, I took for granted some things that I’d mentioned in other places in the book. The result made for a fairly unbalanced treatment with an excessive focus on the role of labor militancy. I’ve now tried to put this into proper context. I don’t expect that will satisfy everybody, but this is closer to what I meant to say all along.End update

What next ?

The economics of the textbooks seeks to minimise as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so – and each of us has spent a good portion of his life writing in this tradition. The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually work.    Our book marks a break with this tradition. In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and can be observed. Animal Spirits, Akerlof and Shiller

It was reading this passage in Animal Spirits, and posting about its implications for macroeconomics in the Crooked Timber blog, that led to the writing of this book. A commenter suggest that this, and some earlier posts, would make a good book, Brad DeLong of UC Berkeley picked the idea up and the result is before you. 

Animal Spirits was mostly written before, or in the early stages of, the Global Financial Crisis, but the Crisis has made its central point more important than ever. For many years economists have worked like the anecdotal drunk who searches for his dropped keys under a lamppost because the light is better there. In the future, and particularly in macroeconomics, economists need to start looking where the keys are, and try to build tools that will improve the chances of success.

This does not mean abandoning all the work of the past thirty years and returning to old-style Keynesianism. But it does mean starting from the traditional Keynesian perspective that a general macroeconomic theory must encompass the reality of booms and slumps, and, particularly of sustained periods of high unemployment that cannot be treated as marginal and temporary deviations from general equilibrium. We must model a world where people display multiple and substantial violations of the rationality assumptions of microeconomic theory and where markets depend not only on prices, preferences and profits but on complicated and poorly understood phenomena like trust and perceived fairness. 

First, the program needs more realistic microfoundations. As Akerlof and Shiller observe, we need to look at how people actually behave, and how this behavior contributes to the performance of the economy as a whole. 

Second, we need to reconsider the concept of equilibrium. The whole point of Keynes “General Theory” was that the market-clearing equilibrium analysed by the classical economists, and central to DSGE models, was not the only possible equilibrium. An economy can settle for long periods in a low-output, high-unemployment state that may not meet the neoclassical definition of equilibrium, but does match the original concept, borrowed from physics of a state in which the system tends to remain and to which it tends to return. More importantly, perhaps, we need a theory which encompasses crises, and rapid jumps between one kind of equilibrium and another. Ideally this will combine ‘old Keynesian’ analysis of economic imbalances with a Minsky-style focus on financial instability.

Between these two levels, we need to consider the fact that the economy is not a simple machine for aggregating consumer preferences, and allocating resources accordingly. The economy is embedded in a complex social structure, and there is a continuous interaction between the economic system and society as a whole. Phenomena like ‘trust’ and ‘confidence’ are primarily social, but they affect, and are affected by the performance of the economic system.

Finally, now that Keynesian macroeconomic policy has re-emerged as a practical tool, we need to reconsider the real and perceived failures of the past, and in particular the emergence of stagflation in the 1960s. If the revival of Keynesian policy is to be sustained, it must provide not only an emergency response to the present crisis but a set of tools that can deliver sustained non-inflationary growth.

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Better microfoundations ?

It is now generally accepted that people are not, and cannot be, the infinitely foresightful, unbounded rational utility maximizers described by the axioms of dynamic stochastic general equilibrium theory. On the contrary, economic behavior, even that of highly sophisticated actors like the ‘rocket scientists’ who design financial instruments for investment banks, is inevitably driven by a partial view of the world, with heuristics and unconsidered assumptions inevitably playing a crucial role. For finite beings in a world of boundless possibilities, nothing else is possible.

The problem for a new macroeconomics is not so much a failure of economists to understand this point as an embarrassment of riches. Several decades of research in behavioral economics, non-expected utility decision theory and other fields have demonstrated, to anyone willing to look, a wide variety of ways in which real economic behavior differs from the neoclassical ideal. The problem is to focus on behavioral foundations that are most relevant to the problems of macroeconomics.

An obvious place to start is with attitudes to risk and uncertainty. Keynes himself wrote extensively in this topic, and was highly sceptical of the ideas that led to the emergence of the now-dominant expected utility theory (the first formal exposition, von Neumann and Morgenstern’s classic Theory of Games and Economic Behavior was published in 1994 only two years before Keynes’ death. The starting point for expected utility was the idea that people can, and should, reason about uncertainty on the basis of their perceived probability of relevant events such as an increase in interest rates or a slump in exports. 

“By `uncertain’ knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty…The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence…About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (J.M. Keynes, 1937)

Post-Keynesian economists like Davidson and Shackle argued, that this fundamental uncertainty was central to Keynes’ thought and that it had been ignored as part of the development of the Keynesian-neoclassical synthesis. But, as with so many ‘heterodox’ schools of economic thought, the post-Keynesians were much stronger on critique than on the development of a coherent and usable alternative. Shackle in particular ended up denying that we can know anything about probability, even in such simple cases as the toss of a coin, a nihilistic view that was never likely to convince many. 

Davidson took the critique in more productive directions and did some valuable work on the way in which attitudes to uncertainty affect individuals demand to hold money, which play a crucial role in Keynes theory of the ‘liquidity trap’, a situation where even at interest rates of zero, investors and households would prefer to save rather than invest. 

Mainstream Keynesians, such as James Tobin, had also developed the idea that liquidity preference could be seen as a reflection of risk attitudes. Tobin’s analysis, was developed using the standard financial portfolio analysis based on the idea that the investment involves trading off mean returns against measures of riskiness such as the variance, which depend on the assumption that we can always formulate sensible probabilities for events. Although Tobin himself was always highly critical of the irrational behavior of financial markets, his analysis was easily restated in terms of expected utility theory and  absorbed into models based on the efficient financial markets hypothesis. 

Over the past thirty years, however, a huge body of research has shown that people do not always make choices in line with the requirements of expected utility, and a great many models of choice under uncertainty have been developed over the past thirty years to produce more realistic representation of behavior. Probably the most famous is the prospect theory of Kahneman and Tversky, put forward in 1979, which earned Kahneman a Nobel prize in economics and Tversky a rare posthumous mention. 

My own academic career got its start with a paper published a couple of years later, giving a tweak to the idea of probability weighting by showing that the model worked better if low-probability extreme events (large gains and large losses) were overweighted, while events leading to intermediate outcomes were overweighted. Kahneman and Tversky incorporated this idea in a revised version of their original model, called cumulative prospect theory.

What specific features of a more general and realistic model of choice under uncertainty might contribute usefully to a renewal of Keynesian macroeconomics? There are at least two obvious examples. First, there is the problem of unknown unknowns, which is also, and not coincidentally, a critical problem for the efficient markets hypothesis. An obvious feature of economic crises is that people are forced to consider contingencies they might previously have disregarded, such as the possibility that their employer, or their bank might fail, or that currency might rapidly lose its value. When such a contingency suddenly enters the minds of many people, large macroeconomic shocks may result.

Second, as I’ve already mentioned, although people fail to consider some low-probability extreme contingencies, they tend (perhaps in compensation) to overweight those they do consider. It is this fact that keeps the sellers of lottery tickets and air crash insurance in business. In the macroeconomic context, a ‘normal’ situation in which people disregard or at least do not account for the risk of a serious recession may suddenly be replaced by a far more pessimistic outlook in which the same people place a high weight on the possibility of total economic collapse. Unsurprisingly, such a change in ‘animal spirits’ may represent a self-fulfilling prophecy. If a lot of people expect a recession and try to increase savings and reduce investment, these defensive actions may bring about the recession against which they are designed to guard. 

Of course, awareness of this fact will do nothing to moderate the potential impact; if anything the reverse. People who are suddenly worried about a recession will not, if they are looking to their own well-being, keep spending in the hope that others will do likewise and thereby keep the economy afloat. Rather they will reason that others are likely to think as they do, and that a recession is even more probable than the objective evidence would suggest. 

Keynes talked about such phenomena in terms of ‘animal spirits’. Such notions seemed hopelessly old-fashioned in the light of the development of rigorous models of choice under uncertainty based on the elegant axioms of expected utility theory, the apparent success of the theory in explaining a wide range of economic behavior and the dominance of the efficient markets hypothesis. But as the evidence against these models has mounted, the pendulum has swung. The idea of animal spirits has been revived in by George Akerlof and Robert Shiller in a recent book of the same name.

Akerlof and Shiller consider five deviations from the standard model of rational maximization (confidence/trust, fairness, corruption, money illusion and stories) and argue that some combination of these can be used to explain a range of economic outcomes inconsistent with the standard model. Their discussion makes a compelling case that macroeconomics needs new, and more realistic foundations.

If the prospects for a macroeconomic analysis based on alternatives to expected utility theory are so promising, why has so little work been done along these lines? In part, perhaps, this simply reflects the effects of specialisation. Decision theorists focus on individual choices, and when they seek economic applications, this leads them naturally to look at microeconomic problems (that’s certainly true in my own case).

But there is a more fundamental problem. Individuals who satisfy the conditions of expected utility theory display a property called ‘dynamic consistency’ which, as the name suggests is of fundamental importance in dynamic stochastic general equilibrium models. Dynamically consistent economic agents never change their view of the world in any fundamental way. They respond to new information by changing their subjective probabilities for particular events, but they never change their underlying prior beliefs and preferences about the world. That means, in particular, that they can fully anticipate how they will respond to any possible future situation, and would never wish to change their mind about this, or to ‘lock themselves in’ to a course of action they might be unwilling to carry through when the time comes. 

Such consistency is admirable (at least in the eyes of decision theorists) and makes it much easier to obtain well-defined solutions for dynamic stochastic general equilibrium models. But it is far from realistic. It turns out, however, that the decisions predicted by such models always display dynamic inconsistency under certain circumstances. This problem has been the subject of considerable controversy on the rare occasions when economists have sought to introduce non-expected utility preferences into macroeconomic theory (as with the robust control theory of Hansen and Sargent.

From the neoclassical viewpoint that dominates modern macroeconomics, the absence of a coherent dynamic equilibrium concept seems like a fatal objection. But from a Keynesian perspective, and on the basis of real world experience, this is a positive, indeed necessary, feature of a sensible macroeconomic model. The fundamental macroeconomic problem is precisely that an economy that seems to be enjoying an equilibrium path of steady growth can suddenly crash or veer off into an unsustainable boom.

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Aggregate models and equilibrium

If there is one thing that distinguished Keynes’ economic analysis from that of this predecessors it was the rejection of the idea of a unique full employment equilibrium to which a market economy will automatically return when it experiences a shock. Keynes argued that an economy could shift from a full-employment equilibrium to a persistent slump as the result of the interaction between objective macroeconomic variables and the subjective ‘animal spirits’ of investors and other decisionmakers. It is this perspective that has been lost in the absorption of New Keynesian macro into the DSGE framework.

The revival of notions like ‘animal spirits’ by leading economists such as Akerlof and Shiller offers the potential to revive these fundamental Keynesian insights. But this is not simply a matter of modifying the way we model individual behavior  Phenomena like animal spirits, social trust and business confidence can’t be reduced to individual psychology. They arise from economic and social interactions between people. 

It’s precisely for this reason that such social aspects of individual psychology are likely to be associated with multiple equilibria in the real economy. The aggregate level of trust and confidence in an economy cannot be derived by simply adding up individual values in the way in which DSGE models aggregate consumer preferences. 

As long as particular assumptions are implicitly taken for granted in a given social group, such as the business community, few members of that group are likely to consider the possibility that these assumptions might fail. Evidence against those assumptions will be ignored or explained away. So, for example, the spectacular examples of market irrationality and business corruption exhibited during the dotcom boom and bust did almost nothing to shake the faith of business and political leaders in the efficiency and stability of financial markets. This faith remained strong even as the evidence of fundamental problems grew through 2007 and early 2008. Then, in the space of a few months this confidence collapsed to be replaced by a panic in which even the most reputably financial institutions would not lend to each other, and instead threw themselves on the protection of the national governments they had previously dismissed as obsolete relics.

A realistic macroeconomics requires the incorporation of variables like trust and confidence in explanatory models. Fluctuations between ‘irrational exuberance’ and equally irrational ‘panics’ (this old term for a financial crisis is in many ways more useful than the technical language of ‘recessions’) give rise to bubbles and busts, which in turn drive much of the macroeconomic cycle. The insights of behavioral economics provide good reasons to expect such fluctuations, but they do not, at least as yet, admit the kind of rigorous derivation of aggregate values from individual preferences that is referred to in the standard demand for ‘microfoundations’.

Expressed in the language of systems theory, the traditional Keynesian approach treated macroeconomic behavior as an emergent property of the economic system, to be analysed in their own terms rather than being derived from supposedly more ‘fundamental’ microeconomic explanations.  [1]   In a world of boundedly rational economic decisionmakers, and, for that matter, boundedly rational economists, we need to simplify and the simplifications that are appropriate for doing macroeconomics may not be the same as those that are appropriate in microeconomics.

Obviously, it’s much easier to announce a new program for macroeconomics than to actually implement it. To give some more concreteness to the general proposals presented here, it’s worth thinking about some specific problems, such as bubbles and the ‘Minsky moments’ in which they burst.

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Bubbles and Minsky moments

Macroeconomists working in the micro-economic foundations framework did not ignore bubbles. Far from it. Dozens of papers were written on the possibility or otherwise of self-sustaining bubbles in asset markets. But, characteristically, the central concern was to determine whether or not bubbles could arise in markets with market participants who were perfectly rational, or nearly so. This focus on microeconomic foundations diverted attention from the real issues.

There was a rather smaller policy oriented literature, concerned with the question of whether central banks should intervene to prevent the emergence of bubbles, or to burst them early, before they became too damaging. Most of this literature followed the lead of Alan Greenspan, who initially showed some sympathy for the idea of intervention, but eventually became the strongest advocate of the view that central banks should not second-guess markets. But even interventionist participants in the discussion took it for granted that an anti-bubble policy had to be implemented within a policy framework of inflation targeting using interest rates as the sole policy instrument.  With these constraints, the conclusion that nothing could or should be done was largely inevitable. 

A realistic theory of bubbles would start with the observation that every bubble has a story to explain why, in the words of …, ‘this time it’s different’. And, for particular assets and markets, sometimes it is different. Those who got in early with shares in Microsoft or Google, or with land in … in … multiplied their money many times over. And although the days of spectacular growth came to an end in each case, there was no bursting of the bubble ending in losses all around.

So a theory of bubbles designed to inform a policy of bubble-pricking must begin with an attempt to understand how ‘this time it’s different’ stories emerge and come to be believed and how to distinguish true, or at least plausible, stories from those that involve a collective abandonment of reality. The story-telling aspect of animal spirits discussed by Akerlof and Shiller is important here.

Given a better understanding of bubbles it may be possible to develop an analysis of the costs and benefits of pricking putative bubbles. Such a policy reduces the damage from spectacular busts such as the one we have just seen, but it would require a willingness on the part of central banks to explicitly over-ride the judgements of capital markets, rather than merely ‘leaning against the wind’ by raising interest rates. 

An uncontrolled bubble must eventually burst, and the bursting of a bubble is a prime example of a ‘Minsky moment’, when euphoria suddenly turns to panic. In Minsky’s model there are three classes of financial enterprises – conservative ‘hedge’ financiers whose operations generate sufficient income to service their capital costs, speculative financiers who  rely on rising asset prices to service debt and who drive the market further upwards, and ‘Ponzi financiers’ cover their costs in either the short term or the long term, but who can conceal their insolvency long enough to reap substantial gains. Ponzi operators fail from time to time, but, in periods of growth, these failures are seen as isolated events of no general significance. However, in the later stages of a bubble, when a large proportion of economic activity has been devoted to speculative finance, the failure of a Ponzi financier can bring about a sudden shift in sentiment, as investors fear that the associated corruption is widespread. The rush to withdraw extended credit brings about more failures, not only of Ponzi financiers but of the speculative finance firms that relied on continued growth.

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Avoiding stagflation 

Avoiding stagflation 

The last Keynesian golden age ended in stagflation. The causes of this breakdown are many and complex, but they must be addressed if we are to avoid repeating them. In particular, it is important to avoid relying on easy excuses, such as the 1973 oil shock and to face the fact that the stagflationary breakdown reflected serious failures in the dominant version of Keynesian macro theories, and in the political and industrial strategies of the social democratic, left and labour movements. These failures were amplified by the expansion, from very small beginnings, of a global financial system that broke down the institutional framework of the Bretton Woods agreement. 

The discovery of the Phillips Curve around 1960, and the general success of Keynesian macroeconomic policies in the postwar period produced increasing support for policies of fiscal expansion aimed at reducing already low levels of unemployment even further, and an acceptance of higher rates of inflation and sustained budget deficits as a reasonable price to pay. This intellectual atmosphere fitted in neatly with the political needs of the Johnson Administration in the US, which sought to implement both an expensive (but initially quite successful) set of welfare programs dubbed the War on Poverty and an actual, if undeclared, war in Vietnam, while avoiding the political opprobrium of raising taxes. There were similar developments in other countries as pressure to expand the welfare state ran into the first elements of resistance that would later become the Tax Revolt of the 1970s. 

In the short run at least, expansionary fiscal policies resolved these problems, and an expansionary fiscal stance became accepted as the norm. This contrasted with the older Keynesian approach where expansionary policies used to stimulate the economy out of recessions and depressions were balanced by contractionary policies aimed at controlling overheated booms.

 From the late 1960s onwards, rates of wage and price inflation rose steadily. Throughout society, the combination of (seemingly permanent) full employment and economic growth with inflationary pressure led to the abandonment of attitudes of restraint that had, until then, been engendered by memories of the Great Depression and fears of a new one. Business leaders ceased to be the sober, socially-minded, technocrats described in works like JK Galbraith’s New Industrial State and started on the path that would lead to the lionization of figures like ‘Chainsaw Al’ Dunlap and Jack Welch.

Financial markets shook off the memories of the Great Crash and became, once again, places where vast fortunes could be made from abstruse transactions. Most attention was focused on stock markets, which went through their first real boom since the 1920s. More significant in the long run was the (re)emergence of an uncontrolled global financial market. This began, with the creation of the ‘Eurodollar’ market, in which mostly European banks located outside the regulatory control of the US dealt in dollar-denominated securities, with liquidity provided by the shift of the US balance of payments from a century old pattern of surpluses to an almost equally durable string of deficits. in one of history’s ironies, the most important single player in the early years was Moscow’s Narodny Bank, which faced increasingly pressing needs for access to Western financial markets and an equally pressing imperative to avoid the control of US authorities.

But the most striking manifestation of the inflationary breakout took place in labour markets. There was an explosion of labour militancy, reflected in an upsurge in strikes and in wage demands that could not be met except through continuing inflation. Even without the militant push, low unemployment would have strengthened the bargaining power of unions and put upward pressure on wages. But the revolutionary utopianism of the 1960s, exemplified by the events of May 1968 in Paris, produced an atmosphere where any kind of restraint became impossible. Unions that sought to focus on realistic and sustainable demands were pushed aside by their own members.

By 1973, after the breakdown of the Bretton Woods system and a failed attempt by the Nixon Administration to halt inflation through a wage-price freeze, the era of Keynesian dominance was drawing to a close. The coup de grace came in October of that year when, in response to US support for Israel in the Yom Kippur war, the members of the Organization of Petroleum Exporting Countries first cut off oil supplies to the West, then raised prices fourfold. 

The oil shock was a consequence, not a cause of the inflationary upsurge. Commodity prices were rising sharply across the board well before this event. However, the structure of the oil market, with a small group of oil companies (called the ‘Seven Sisters’) facing an increasingly well-organized OPEC meant that, when the price shift came, it took the form of a single dramatic leap. And, having been caused by stagflation, the oil shock amplified and entrenched it in the economic system, leading to decades of high unemployment and persistent inflation.

The stagflationary outbreak took a heavy toll on the Keynesian social-democratic welfare state and the organizations and ideas associated with it. In particular, the great wage push was disastrous for both for the unions and for the Keynesian/social democratic system. The seemingly-continuous strikes of the 1970s undermined popular support for unions and paved the way for a series of ever-more brutal assaults by governments and employers. Margaret Thatcher’s crushing victory over the National Coal Miners and Ronald Reagan’s equally successful action in firing striking air traffic controllers en masse brought an end to the idea that strikes represented a reliable route to improved wages and conditions, let alone to the collapse of the capitalist system. Particularly in the English-speaking world, union membership dropped rapidly as new laws made it easy for employers to keep unions out.

Keynesian economists were discredited and driven from positions of power by monetarist and new classical rivals. Only by making the massive theoretical and policy concessions involved in New Keynesianism were they able to regain a seat at the table.

Meanwhile, the financial sector, which had precipitated the crisis claimed victory, as did the economists who extolled its merits. Stagflation was seen as a demonstration that attempts to resist the logic of the market must ultimately fail. It took several decades to relearn the Keynesian lesson that an uncontrolled financial system will fail even more disastrously

The inflationary surge that began the late 1960s has some important lessons that must be learned if we are to avoid similar failures in the future. First, it is important to maintain a focus on keeping inflation rates low and stable as well as on maintaining full employment. Once inflation rates get signficantly above 3 per cent per year, the risk of embedding inflationary expectations, and the eventual cost of lowering those expectations, becomes greater. It is therefore important to maintain a commitment to low inflation and to adopting the policies necessary to contain and reduce inflation when some shock to the system produces a significant increase in the price level.

At a theoretical level, this does not involve huge modifications to the standard Keynesian view. The idea of a stable long-run trade-off between unemployment and inflation, represented by the Phillips curve, was a relatively late addition, and quickly abandoned. But the problem of how to deal with inflation remains largely unresolved.

In policy terms, inflation can’t be reduced unless macroeconomic policy acts to constrain excess  demand and liquidity. So Keynesian policies must be used consistently throughout the cycle, to reduce excess demand in boom periods as well as stimulating demand during recessions.

This still leaves the problem of what to do if high inflation becomes established. A number of countries showed, in the 1980s and 1990s, that a co-operative approach could reduce inflation and unemployment simultaneously. In Australia, following a deep recession in the early 1980s, the newly elected Hawke Labor government reached an agreement with the trade unions referred to as ‘The Accord’. Under the Accord, unions agreed to reduce the rate of growth of wages in return for an increase in the social wage, most notably the introduction of a national system of health insurance, called Medicare.

At about the same time, and facing similar problems, unions and employer groups in the Netherlands negotiated the Wassenaar agreement. In this case, the trade-off for wage moderation was a reduction in working hours and the adoption of a range of measures designed to promote employment growth. The Wassenaar approach survived the stresses of the early 1990s and, according to the ILO was “a ground breaking agreement, setting the tone for later social pacts in many European countries.”

The co-operative approach that motivated these policies was ultimately swept away by the ever-growing power of the financial sector. But, if a Keynesian policy framework is to be successful, it must be revived. Hopefully, the memory of past disasters will promote a more cautious and co-operative approach in future.

[1] Unfortunately, discussion of these ideas tends to get bound up in more or less mystical claims and counterclaims about reductionism and holism. But nothing of that kind is intended here. In principle, without doubt, all social phenomena are determined by interactions between individual people, whose behavior is in turned determined by their genes and the environment in which they grew up. Genes are collections of DNA molecules which in turn are made up of atoms made up of subatomic particles behaving according to the laws of quantum physics.  If we were the unboundedly rational individuals posited in the DGSE literature, , such we would presumably be doing quantum physical calculations whenever we made economic decisions.

The obvious criterion of success or failure for a macroeconomic theoretical framework is that it should provide the basis for predicting, understanding and responding to macroeconomic crises. If that criterion is applied to the current crisis, the micro-foundations approach to macroeconomics has been a near-total failure.

The failure of the dominant stream in macroeconomics was comprehensive.

First, during the bubble years the dominant approach gave little or no warning of the impending crisis. Neither sophisticated DSGE models nor the more pragmatic but less elegant micro-based models employed by the central banks gave much, if any, warning of the impending crisis.

Second, the dominant approach encouraged a benign view of the developments that gave rise to the crisis such as the growth and globalisation of the financial sector and the associated global imbalances. The boosterism of Alan Greenspan was an egregious example, but it was typical of the majority viewpoint.

Third, even as the crisis developed over the course of 2007 and 2008, its seriousness was persistently underestimated. This was exacerbated by the political context in which supporters of the Republican Administration in the US, a group little concerned with reality at the best of times, sought to deny the existence of a recession in an election year.

Fourth, the near-consensus apparent during the Great Moderation collapsed with the onset of crisis, revealing that the split between Keynesian and New Classical views had never been resolved, but merely papered over.

Fourth, it offered little or no useful guidance on the policy and theoretical issues raised by the crisis. The result that the public policy debate has been driven mostly by economists from outside the micro-foundations school. Advocacy of policies of fiscal stimulus has come, to a large extent,from economists such as Paul Krugman and Brad DeLong whose primary field is not macroeconomics, but who retain a historical understanding informed by Keynesianism. The most effective criticism has come from finance theorists like John Cochrane and Eugene Fama, mostly notable as advocates of the efficient markets hypothesis. Arguments on both sides have been couched in terms familiar to economists of 1970 and earlier, with each side accusing the other of holding views that had been refuted by the 1930s

The roots of this failure may be traced in part to problems with the micro-foundations approach itself. Micro-foundations models take general equilibrium as the starting point – modest variations of the standard classical assumptions suggest that deviations from classical properties are also likely to be modest. Macro models calibrated to the Great Moderation encouraged this assumption, as well as exclusive focus on monetary policy based on Taylor rules, which proved unavailing. The collapse of this position forced economists to shift either to the left (back to older versions of Keynesianism) or to the right (to extreme versions of classicism).

However, the broader intellectual climate of market liberalism, in which thinking about macroeconomic issues was conditioned by the assumptions of the efficient markets hypothesis and the apparent lessons of the Great Moderation. Concerns about market imbalances could not easily be reconciled with the implications of the efficient financial markets hypothesis or with the triumphalism of the Great Moderation.

Implications

The implications of the micro-foundations approach to macroeconomics can be assessed in the light of the introduction to Paul Krugman’s essay ‘How Did Economists Get it So Wrong’.

It’s hard to believe now, but not long ago economists were congratulating themselves over the success of their field. Those successes—or so they believed—were both theoretical and practical, leading to a golden era for the profession. On the theoretical side, they thought that they had resolved their internal disputes. Thus, in a 2008 paper titled “The State of Macro” (that is, macroeconomics, the study of big-picture issues like recessions), Olivier Blanchard of M.I.T., now the chief economist at the International Monetary Fund, declared that “the state of macro is good.” The battles of yesteryear, he said, were over, and there had been a “broad convergence of vision.” And in the real world, economists believed they had things under control: the “central problem of depression-prevention has been solved,” declared Robert Lucas of the University of Chicago in his 2003 presidential address to the American Economic Association.

These conclusions did not emerge as specific implications of any particular model. Rather, the micro-foundations approach, at least in its current form, can only work well under specific assumptions and conditions. The crucial assumptions are that the standard microeconomic model in which market outcomes are driven by the optimizing decisions of rational individuals (in typical macroeconomic models, those of a single rational individual).

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Rationality everywhere

The incorporation of rational expectations into micro-based macroeconomic models went hand in hand with the acceptance of increasingly strong forms of the efficient markets hypothesis, and both fitted naturally with the rise of market liberalism. In competitive markets where participants are perfectly rational and display high levels of foresight, it is very hard to see any beneficial role for governments. Even if governments happen to better informed than market participants, they should not, in a world of perfect rationality, act on that information. Rather, they should release the information to the public, allowing market participants to combine this public information with their own private information, and secure better outcomes than would be possible from government action.

Of course, many macroeconomists, and particularly those of the New Keynesian school, explicitly rejected the ultra-rational assumptions that produced such implausible conclusions as Barro’s Ricardian equivalence. One of the standard moves in the construction of Blanchard’s haikus was to allow the ‘representative individual’ to deviate in some small way from perfect rationality.

A common example is the assumption of ‘hyperbolic’ discounting. The idea is that in assessing a choice between getting some benefit immediately, or at some point in the relatively near future, say, in a month’s time, people display a lot of impatience. They are willing to offer a big discount to get the benefit now rather than wait to get something better. But, if they are asked about two points in the future that are a month apart, they will offer only a small benefit. Such preferences, if maintained over time, are not consistent with standard rationality. The choices people make now regarding choices in the medium future are not the same as they would make if they waited until the opportunity for immediate consumption was actually available. A paper by Liam Graham and Dennis Snower showed that the combination of staggered nominal contracts with hyperbolic discounting leads to inflation having significant long-run effects on real variables, that is, to the existence of a Phillips curve relationship that might persist into the long term.

Papers in this tradition showed that small deviations from rationality can sometimes have big effects on economic outcomes. But they rarely have big implications for public policy. Rather, they point in the direction of the idea set out by Cass Sunstein and Richard Thaler in their recent book Nudge. Sunstein and Thaler argue that governments can sometimes exploit deviations from rationality by framing choices that will ‘nudge’ people’s decisions in a socially desirable direction. George Lakoff in Don’t Think of An Elephant makes the same argument in a political context, suggesting that the Republican Party has had more success than would be expected based on underlying support for its policies, because it has done a better job of ‘framing’ political issues. Rather than seeking a more rational debate, Lakoff, argues, Democrats should respond in kind.

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Fiscal and monetary policy

The theoretical complacency with which the DGSE school viewed the state of macroeconomic theory was matched by a similar complacency regarding macroeconomic policy. From the early 1990s to the panic of 2008, macroeconomic policy was, for all practical purposes, monetary policy, or, more precisely interest rate policy. The standard approach involved what is called a Taylor rule, after … economist John Taylor, later the Under Secretary of the US Treasury for International Affairs under the George W. Bush|Bush Administration, who proposed in 1993. Taylor presented his rule as a way of describing the actual behavior of central banks, but it soon came to be used as a normative guide to policy.

The idea of the Taylor rule was to set interest rates in such a way as to keep two variables, the inflation rate and the rate of growth of Gross Domestic Product, as close as possible to their target values. Typical targets might be an inflation rate of 2 to 3 per cent, and a real GDP growth rate in line with long-term growth in the labour force and labour productivity, say 3 per cent for a developed country like the US. Given

Within this framework, the essential functions of macroeconomic theory are relatively simple. Complex macroeconomic models can be reduced to simple relationships between one policy instrument (interest rates) and two targets (inflation and growth). Since there are two target variables, it’s impossible to hit each target exactly, so the models give rise to a trade-off. Using the single representative agent who typically inhabits a DGSE model, it’s possible to calculate the optimal trade-off, which can be expressed as the range of acceptable variation in inflation rates.

During the Great Moderation, all this seemed to work very well, to the extent that commentators spoke of a ‘Goldilocks economy’, neither too hot, nor too cold but just right. Even with a tight target range for inflation, between 2 and 3 per cent per year, it seemed possible to stabilise growth and avoid all but the mildest recessions. In these circumstances, the comment of Robert Lucas that the “central problem of depression-prevention has been solved,” seemed only reasonable.

Most of what I’ve written in the book so far has been pretty easy. I’ve never believed the Efficient Markets Hypothesis or New Classical Macro and it’s easy enough to point out how the occurrence of a massive financial crisis leading to a prolonged macroeconomic crisis discredits them both.

I’m coming now to one of the most challenging section of my book, where I look at why the New Keynesian program (with which I have a lot of sympathy) and ask why New Keynesians (most obviously Ben Bernanke) didn’t, for the most part, see the crisis coming or offer much in response that would have been new to Keynes himself. Within the broad Keynesian camp, the people who foresaw some sort of crisis were the old-fashioned types, most notably Nouriel Roubini (and much less notably, me) who were concerned about trade imbalances, inadequate savings, and hypertrophic growth of the financial sector. Even this group didn’t foresee the way the crisis would actually develop, but that, I think is asking too much – every crisis is different.

My answer, broadly speaking is that the New Keynesians had plenty of useful insights but that the conventions of micro-based macroeconomics prevented them from forming the basis of a progressive research program.

Comments will be appreciated even more than usual. I really want to get this right, or as close as possible

New Keynesian macroeconomics 

In the wake of their intellectual and political defeats in the 1970s, mainstream Keynesian economists conceded both the long-run validity of Friedman’s critique of the Phillips curve, and the need, as argued by Lucas, for rigorous microeconomic foundations. “New Keynesian economics” was their response to the demand, from monetarist and new classical critics, for the provision of a microeconomic foundation for Keynesian macroeconomics.

The research task was seen as one of identifying minimal deviations from the standard microeconomic assumptions which yield Keynesian macroeconomic conclusions, such as the possibility of significant welfare benefits from macroeconomic stabilization. A classic example was the  ‘menu costs’ argument produced by George Akerlof, another Nobel Prize winner. Akerlof sought to motivate the wage and price “stickiness” that characterised new Keynesian models by arguing that, under conditions of imperfect competition, firms might gain relatively little from adjusting their prices even though the economy as a whole would benefit substantially.

The approach was applied, with some success, to a range of problems that had previously not been modelled formally, including many of the phenomena observed in the leadup to the global financial crisis, such as asset price bubbles and financial instability generated by speculative ‘noise trading’. 

A particularly important contribution was the idea of the financial accelerator, a rigorous version of ideas first put forward by Fisher and by Keynesians such as Harrod and Hicks. Fisher had shown how declining prices could increase the real value of debt, making previously profitable enterprises insolvent, and thereby exacerbating initial shocks. The Keynesians showed how a shock to demand would result in declining utilisation, meaning that firms could meet their production requirements without any additional investment. Thus the initial shock to demand would have an amplified effect on the demand for investment goods.

In a 1989 paper, Ben Bernanke and Mark Gertler integrated these ideas with developments in the theory of asymmetric information to produce a rigorous model of the financial accelerator. 

It would seem, then,  that New Keynesian economists should have been well equipped to challenge the triumphalism that prevailed during the Great Moderation. With the explosion in financial sector activity, the development of massive international and domestic imbalances and the near-miss of the dotcom boom and slump as evidence, New Keynesian analysis should surely have suggested that the global and US economies were in a perilous state.

 Yet with few exceptions, New Keynesians went along with the prevailing mood of optimism. Most strikingly, the leading New Keynesian, Ben Bernanke became,  the anointed heir of the libertarian Alan Greenspan as Chairman of the US Federal Reserve. And as we have already seen, it was Bernanke who did more than anyone else to popularise the idea of the Great Moderation.

Olivier Blanchard summarises the standard New Keynesian approach (which converged, over time with the RBC approach) using the following, literally poetic, metaphor

A macroeconomic article today often follows strict, haiku-like, rules: It starts from a general equilibrium structure, in which individuals maximize the expected present value of utility, ¯rms maximize their value, and markets clear. Then, it introduces a twist, be it an imperfection or the closing of a particular set of markets, and works out the general equilibrium implications. It then performs a numerical simulation, based on calibration, showing that the model performs well. It ends with a welfare assessment.

Blanchard’s description brings out the central role of microeconomic foundations in the New Keynesian framework, and illustrates both the strengths and the weaknesses of the approach. One the one hand, as we have seen, New Keynesians were able to model a wide range of economic phenomena, such as bubbles and …, while remaining within the classical general equilibrium framework. On the other hand, precisely because the analysis remained within the general equilibrium framework, it did not allow for the possibility of a breakdown of classical equilibrium, which was precisely the possibility Keynes had sought to capture in his general theory.

The requirement to stay within a step or two of the standard general equilibrium solution yielded obvious benefits in terms of tractability. Since the properties of general equilibrium solutions have been analysed in detail for decades, modeling “general equilibrium with a twist” is a problem of exactly the right degree of difficulty for academic economists – hard enough to require, and exhibit, the skills valued by the profession, but not so hard as to make the problem insoluble, or soluble only with the abandonment of the underlying framework of individual maximization.

A critical implication of Blanchard’s haiku metaphor is that the New Keynesian program was not truly progressive. A study of some new problem such as the incentive effects of executive pay would typically, as Blanchard indicates, begin with the standard general equilibrium model, disregarding the modifications made to that model in previous work examining other ways in which the real economy deviated from the modelled ideal. The cumulative approach would imply a model that moved steadily further and further away from the standard GE framework, and therefore became less and less amenable to the standard techniques of analysis associated with that model. 

This, I think, is what Paul Krugman had in mind when he suggested in his essay ‘How Did Economists Get It So Wrong?’ that economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth. The work described by Blanchard was beautiful (at least to economists) and illuminated some aspects of the truth, but beauty came first. An approach based on putting truth first would have incorporated multiple deviations from the standard general equilibrium model then attempted to work out how they fitted together. In many cases, the only way of doing this would probably be to incorporate ad hoc descriptions of aggregate relationships that fitted observed outcomes, even if it could not be related directly to individual optimization.

New Keynesian macroeconomics, of the kind described by Blanchard, was ideally suited to the theoretical, ideological and policy needs of the Great Moderation. On the one hand, and unlike New Classical theory it justified a significant role for monetary policy, a conclusion in line with the actual policy practice of the period. On the other hand, by remaining within the general equilibrium framework the New Keynesian school implicitly supported the central empirical inference drawn from the observed decline in volatility, namely that major macroeconomic fluctuations were a thing of the past.

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DSGE

Eventually, the New Keynesian and RBC streams of micro-based macroeconomics began to merge. The repeated empirical failures of standard RBC models  led many users of the empirical techniques pioneered by Prescott and Lucas to incorporate non-classical features like monopoly and information asymmetries. These “RBC-lite” economists sought, like the purists, to produce calibrated dynamic models that matched the “stylised facts” of observed business cycles, but quietly abandoned the goal of explaining recessions and depressions as optimal adjustments to (largely hypothetical) technological shocks.

This stream of RBC literature converged with New Keynesianism, which also uses non-classical tweaks to standard general equilibrium assumptions with the aim of fitting the macro data.

The resulting merger produced a common approach with the unwieldy title of Dynamic Stochastic General Equilibrium (DSGE) Modelling. Although there are a variety of DSGE models, they share some family features. As the “General Equilbrium” part of the name indicates, they take as their starting point the general equilibrium models developed in the 1950s, by Kenneth Arrow and Gerard Debreu, which showed how an equilibrium set of prices could be derived from the interaction of households, rationally optimising their work, leisure and consumption choices, and firms, maximizing their profits in competitive markets. Commonly, though not invariably, it was assumed that everyone in the economy had the same preferences, and the same relative endowments of capital, labour skills and so on, with the implication that it was sufficient to model the decisons of a single ‘representative agent’.

The classic general equilibrium analysis of Arrow and Debreu dealt with the (admittedly unrealistic) case where there existed complete, perfectly competitive markets for every possible asset and commodity, including ‘state-contingent’ financial assets which allow agents to insure against, or bet on, every possible state of the aggregate economy. In such a model, as in the early RBC models, recessions are effectively impossible – any variation in aggregate output and employment is simply an optimal response to changes in technology, preferences or external world markets. DGSE models modified these assumptions by allowing for the possibility that wages and  prices might be slow to adjust, by allowing for the possibility of imbalances between supply and demand and so on, thereby enabling them to reproduce obvious features of the real world, such as recessions.

But, given the requirements for rigorous microeconomic foundations, this process could only be taken a limited distance. It was intellectually challenging, but appropriate within the rules of the game, to model individuals who were not perfectly rational, and markets that were incomplete or imperfectly competitive. The equilibrium conditions derived from these modifications could be compared to those derived from the benchmark case of perfectly competitive general equilibrium.

But such approaches don’t allow us to consider a world where people display multiple and substantial violations of the rationality assumptions of microeconomic theory and where markets depend not only on prices, preferences and profits but on complicated and poorly understood phenomena like trust and perceived fairness. As Akerlof and Shiller observe 

…

It was still possible to discern the intellectual origins of alternative DSGE models in the New Keynesian or RBC schools. Modellers with their roots in the RBC school typically incorporated just enough deviations from competitive optimality to match the characteristics of the macroeconomic data series they are modelling, and prefer to focus on deviations that are due to government intervention rather than to monopoly power or other forms of market intervention. New Keynesian modellers focused more attention on imperfect competition and were keen to stress the potential for the macro-economy to deviate from the optimal level of employment in the short term, and the possibility that an active monetary policy could produce improved outcomes  

Because New Keynesians were (and still are) concentrated in economics departments on the East and West Coast of the United States (Harvard, …) while their intellectual opponents are most prominent in the lakeside environments of Chicago and Minnesota, the terms ‘saltwater’ and ‘freshwater’ schools have been coined (by Krugman?) to describe the two positions. But such a terminology suggests a deeper divide between competing schools of thoughts than actually prevailed during the false calm of the Great Moderation. The differences between the two groups were less prominent, in public at least, than their points of agreement. The freshwater school had backed away from extreme New Classical views after the failures of the early 1980s, while the distance from traditional Keynesian views to the New Keynesian position was summed up by Lawrence Summer’s observation that ‘We are now all Friedmanites, Lawrence Summers’. And even these limited differences were tending to blur over time, with many macroeconomists, and particularly those involved in formulating and implementing policy shifting to an in-between position that might best be described as ‘brackish’.  

However, the similarities outweigh the differences. Whether New Keynesian or RBC in their origins, DSGE models incorporate the assumption, derived from Friedman, that there is no long-run trade-off between unemployment and inflation, that is, that the long-run Phillips curve is vertical. And nearly all allowed for some trade-off in the short run, and therefore for some potential role for macroeconomic policy.

The differences between saltwater and freshwater DGSE models may be discussed in terms of the venerable Keynesian idea of the multiplier, that is, the ratio of the final change in output arising from a fiscal stimulus to the size of the initial stimulus. Old Keynesians had argued that the multiplier (as the name suggests) was greater than one since the beneficiaries of government expenditure would increase their consumption of goods and services, leading to more workers being hired who in turn would increase their own consumption and so on.  The ‘policy ineffectiveness’ proposition of the New Classical school implied that the multiplier should be zero or even negative, because of the incentive-sapping effects of government spending and the taxes required to finance it. The DGSE modellers tended to split the difference.

Although the issue was rarely discussed explicitly, the DGSE models favored by the New Keynesian school typically implied values for the multiplier that were close to 1, while those derived from RBC approaches suggested values that were positive, but closer to zero. Given the mild volatility of the Great Moderation, such models yielded no justification for active use of fiscal policy, and good reasons for governments to maintain budget balance as far as possible. New Keynesians also typically rejected active use of fiscal policy, and relied exclusively on monetary policy to manage the economy, But, compared to their freshwater colleagues they had a more positive view of the ‘automatic stabilisers’. Since tax revenues tend to fall and welfare expneditures to rise during recessions a government that maintains a balanced budget on average will tend to run deficits during recessions and surpluses during booms. On a Keynesian analysis, the fact that government spending net of taxes is countercyclical (moves in the opposite direction to fluctuations in the rate of economic growth) tends to stabilise the economy. Vast numbers of journal pages were devoted to refining these different viewpoints, and to defending one or the other. But in practical policy terms, the differences were marginal

Reflecting their origins in the 1990s, most analysis using DSGE models assumed that macroeconomic management was the province of central banks using interest rate policy (typically the setting of the rate at which the central bank would lend to commercial banks) as their sole management instrument. The central bank was modelled as following either an inflation target (the announced policy of most central banks) or a “Taylor rule”, in which the aim is to stabilise both GDP growth and inflation.

On the whole, while central banks showed a some interest in DSGE models, and invoked their findings to provide a theoretical basis for their operations, they made little use of them in the actual operations of economic management. For practical purposes, most central banks continued to rely on older-style macroeconomic models, with less appealing theoretical characteristics, but better predictive performance. However, neither DSGE models nor their older counterparts proved to be of much use in predicting the crisis that overwhelmed the global economy in 2008, or in guiding the debate about how to respond.

I’m in the process of setting up a site at wikidot.com where the whole draft will be presented in wiki format. But I’ve been travelling and haven’t managed to get it going yet.

The failure of the Great Moderation, like that of the Efficient Markets Hypothesis, has major implications for a wide range of government policies. The implications for the financial sector have already been discussed  and we will look in detail at implications for fiscal and monetary policies in Chapter 3. But the central implications of the end of the Great Moderation relate to the  need to reverse the Great Risk Shift, and reinvigorate the social and collective risk management institutions that constitute the social-democratic welfare state.

The end of the Great Moderation has already produced a massive increase in the economic risk faced by individuals, families and businesses. In the US, as many as 10 million households are expected to face foreclosure by 2012. Over the same period, and despite laws designed to make bankruptcy less accessible, it is likely that between 5 and 10 million households will face bankruptcy (of course, the two groups will overlap). 

The collapse of stock markets has wiped out, or drastically reduced, the life savings of many workers. More fundamentally, it has undermined the idea of a shareholding democracy, in which most households have sufficient financial wealth, earning good returns, to be at least partially independent of wage income during their working years, and reliably capable of financing their own retirement thereafter. (More on for retirement income in Chapter)

Around the world, tens of millions of workers have lost their jobs, and tens of millions more will do so before the crisis is over. And even after economic growth has resumed, the impacts will be felt for a long time to come.  In the absence of positive government action, unemployment will remain high for years after the economy hits bottom. The unstable state of the global financial system, and the lack of any significant movement towards more effective regulation, suggests there will be more shocks to come. 

The increase in inequality that produced this increase in risk is most evident in the United States, but it has occurred, with a shorter or longer time lag, in many other countries, both developed and developing. Where the social democratic welfare state has remained strong, growth in inequality has been less marked. But it is no longer possible to suppose that simply slowing the pace of market liberalisation will prevent growth in inequality, and the growth in risk and insecurity it implies.

All of these changes mean that risk can no longer be ignored, or wished out of existence through financial market conjuring tricks. Only a renewed social-democratic analysis provides any coherent basis for a response.

Social democrats have long stressed the idea that we have the capacity to share and manage risks more effectively as a society than as individuals. The set of policies traditionally associated with social democracy or (in the US, political liberalism) may be regarded as responses to a range of risks facing individuals, from health risks to uncertain life chances.

In his pathbreaking book, When All Else Fails, Robert Moss surveys two centuries of American history, in which he presents the state as ‘the ultimate risk manager’. Moss distinguishes three phases of public risk management in the United States. Although the United States is atypical in important respects, Moss’s three-phase model provides a useful framework for discussion.

Moss’ first phase, ‘security for business’, encompasses innovations such as limited liability and bankruptcy laws, introduced in the period before 1900. Many of these risk management policies are taken for granted now, but they were vigorously debated at the time. Adam Smith, the father of mainstream economics, denounced limited liability companies as providing an open invitation to managers to enrich themselves at the expense of shareholders. His critique sounds strikingly familiar, but he did not foresee the development of businesses on a scale so massive that a vast number of shareholders was a necessity rather than an option. As for bankruptcy, the US Constitution adopted 1789 allowed Congress to legislate on the topic, but it took more than 100 years to reach agreement. In the intervening century, bankruptcy laws were adopted, and later repealed, on three separate occasions. 

Moss’s second phase, ‘security for workers’, was produced by the shift from an economy dominated by agricultural smallholdings to a manufacturing-based economy in which most households depended on wage employment. Historically the phase includes Progressive initiatives such as workers’ compensation and the core programs of the New Deal like unemployment insurance and social security.

The third phase, ‘security for all’, began after World War II and includes such diverse initiatives as consumer protection laws, environmental protection and public disaster relief. These may be seen as responses to the ‘risk society’ (Beck 1992). Risks of environmental degradation and natural disaster are inherently social in their nature, and the success or failure of a society in responding to these risks is a measure of the capacity and responsiveness of its government.

The Great Risk shift in economic policy was part of a bigger backlash against social risk management, which was even more ferocious in the case of environmental risks. It’s hard to believe, looking at today’s debates, that the Clean Air Act of 1970 and Clean Water Act of 1972 were passed with overwhelming bipartisan support. Any proposal to protect the environment now produces automatic, and vitriolic, rejection from the political right.

Risk and inequality are closely linked. On the one hand, the greater the risks faced by individuals in the course of their life, including the risk associated with differences in initial opportunities, the more unequal society is likely to be. On the other hand, as the financial crisis has shown, radical inequality in outcomes, such as that associated with massive rewards to financial traders, encourages risky behavior and particularly encourages a search for opportunities to capture the benefits of risky actions while shifting the costs onto others, or onto society as a whole.

A social democratic response to the crisis must begin by reasserting the crucial role of the state in risk management. If individuals are to have security of employment, income and wealth, governments must act to establish and enforce the necessary legal and economic framework. The fact that government is the ultimate risk manager both justifies and necessitates action to mitigate the grotesque inequalities in both opportunities and outcomes that characterise unrestrained capitalism and were increasingly resurgent in the era of economic liberalism.

The interpretation of the welfare state in terms of risk and uncertainty may be illustrated by considering some of its core functions. For some of these functions, such as various forms of social insurance, the risk management function has always been emphasised.  However, concern with risk has traditionally been a subsidiary theme.

For instance, the public provision of retirement income and of services like health or education have commonly been justified with reference to notions of redistribution, public goods and the provision of basic needs. However, these interventions may equally be supported in terms of risk management.

A risk-based analysis may be extended to encompass more general programs of income redistribution. In a risk-based view, redistribution may be seen as providing insurance against a particular kind of risk, namely the risk of being born poor, socially dislocated and without access to human and social capital. These ideas have been explored by a number of policy analysts in recent years, notably including Nicholas Barr, Ulirch Beck, Anthony Giddens, Jacob Hacker and Robert Moss/ 

As Giddens observed in his 1999 Reith lectures

the welfare state, whose development can be traced back to the Elizabethan poor laws in England, is essentially a risk management system. It is designed to protect against hazards that were once treated as at the disposition of the gods – sickness, disablement, job loss and old age.

Pursuing the same theme, Nicholas Barr offers the metaphor of the welfare state as ‘piggy bank’ as against the traditional view of the welfare state as ‘Robin Hood’. The Robin Hood interpretation implies a zero sum view of the world in which the state acts to help the poor at the expense of the rich, or, more generally, the well-ff. At any given point in time, this is exactly what happens. But, over the course of a lifetime, everyone faces the risks to which Giddens refers, to some degree or another. And, taking a longer perspective, even those who are unlikely to suffer from these risks are just winners in the bigger lottery of life chances, consisting, to a very large extent, of having the right parents.

Collective risk management through the welfare state helps to stabilize the aggregate economy. When incomes decline as a result of a recession, the design of a progessive tax system means that government tax revenues decline more than proportionally. This helps to cushion the impact on private demand and offsets the downward multiplier effects of an initial shock to the economy. Similarly, when unemployment rises, this produces an automatic increase in spending on unemployment benefits which is commonly amplified by expansion of benefits and the creation of 

The mechanisms by the welfare state softens the impact of demand shocks are called ‘automatic stabilizers’, and, given robust welfare state institutions, the name is appropriate. But there is nothing automatic or guaranteed about those institutions. A balanced budget requirement such as exists in most US states, will force governments to cut expenditure precisely when it is most needed, producing, in Paul Krugman’s phrase ‘50 Herbert Hoovers’.

Similarly, if a government is so indebted that it can’t borrow money, or print money without the risk of inflation, an economic crisis will force retrenchment. That’s why its important to  stress the ‘hard’ side shared by social democratic risk management and Keynesian demand management.  Abandoning short term budget balance doesn’t mean that bills don’t have to be paid. Help when we face unemployment or health risks, or for those who are unlucky in their life chances, must be paid for by tax contributions made those who are, at least for the moment, healthy and well-off. Budget deficits to soften the impact of recessions must be matched by surpluses in good times. The ‘golden rule’ is to balance the budget over the course of the cycle.

No one can predict the future path of the economy with any accuracy. But at the aggregate level, we will almost certainly see more instability, with more frequent and sharper shocks, than during the false calm of the Great Moderation. And the end of the Great Moderation has not reversed the Great Risk Shift or, except partially and temporarily, the growth in inequality produced by the decades of market liberalism. The social-democratic response must combine better social provision to help people deal with risk at the individual and family level with a return to active use of fiscal as well as monetary policy to stabilise the aggregate economy. The two should be designed to work together, with social risk management policies that act as automatic stabilisers in the Keynesian sense and fiscal policies focused on helping those most directly affected by recession.

Failure

Whether it was a real economic phenomenon or a statistical illusion, the Great Moderation, considered as a pattern of long expansions punctuated by brief and mild recessions, is clearly over. In retrospect, it was over by the time its discovery was announced in the early 2000s. The recovery from the 2001 recession was not, as advocates of the Great Moderation supposed, the beginning of a third long expansion in the United States. Rather, it was weak, short-lived and overwhelmingly driven by the unsustainable bubble in housing prices and the expansionary monetary policies of Greenspan and Bernanke. The expansion lasted only six years, and it was four years old before total employment regained the pre-recession peak. All of the employment gains of the expansion, and more, were wiped out in the first few months of the global financial crisis.

The US experience was fairly typical of the developed countries. While some, such as Australia and Canada did rather better, others such as Ireland and Iceland suffered economic meltdowns with output losses in excess of 10 per cent.

But it is not sufficient to point out the obvious fact that the Great Moderation is finished. The thinking that made so many economists willing to endorse claims that the business cycle had been tamed by financial liberalisation remains influential and is implicit in many arguments about policy responses to the Crisis. So it is important to understand why the Great Moderation hypothesis was so badly wrong.

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The dissenters

While the boom persisted, the view that the Great Moderation was the product of unsustainable policies received little attention. It was espoused only by old-style Keynesians, a relatively marginal group on the left of the economics profession, and members of the Austrian School, a fringe group on the right. While the two groups agreed in offering a negative prognosis, they differed radically regarding both diagnosis and proposed cure.

Keynesians argued that, without adequate regulation, financial instability was inevitable. This view was part of the assumed background for Keynesians of all kinds, but it was particularly stressed by the post-Keynesian school associated with the late Hyman Minsky.

Minsky focused on the instability of credit and investment processes in a market economy and argued that capitalist financial systems are inherently unstable because large swings in investor expectations tend to occur over the course of the economic cycle. He argued that in a recession, expectations are subdued. As the recovery gathers pace, profits rise and balance sheets are restored. Caution remains for a period, reflecting memories of the previous downturn. As the economy continues to grow, perhaps spurred further by technological breakthroughs or unexpectedly high rates of growth, profits are rebuilt and expectations of future growth begin to rise. Caution begins to recede. Increasingly, animal spirits are stirred and banks begin lending more freely and credit expands. Even cautious investors are encouraged to join the upward surge for fear of forfeiting profit opportunities. Momentum builds behind what Minsky referred to as the “euphoric economy.” This attracts highly leveraged asset speculators—Minsky called them “Ponzi financiers”—who rely on rising asset prices to service debt and who drive the market further upward. Increasingly, the market is dominated by speculation about sentiments and movements in the market rather than about fundamental asset values.

Minsky’s work became a standard namecheck for Keynesians writing about financial crises past, present and future. For example, Charles Kindleberger used Minsky’s model as the basis for his study Manias, Panics, and Crashes, declaring that “the model lends itself effectively to the interpretation of economic and financial history. In my own work with political scientist Stephen Bell, I noted that the main obstacle to broader acceptance of Minsky’s work was the lack of a formal derivation from microeconomic foundations (see Ch …) and concluded that ‘Another significant cycle of asset price movements, especially in one of the major economies, could see a fundamental revision of thinking about the costs and benefits of liberalized financial systems.’

While Keynesians argued that instability is inherent in weakly regulated financial systems, economists of the Austrian school generally claimed that the business cycle was the product of government intervention, and particularly of central banking. This view was derived from the work of Friedrich von Hayek and Ludwig von Mises, economists who were literally Austrians by birth. But if the Austrians agree on the evils of central banking, they disagree on almost everything else. Some, endorsing the judgement of the mainstream economists who awarded Hayek the Nobel prize in economics, see him as having far surpassed the initial contributions of his teacher von Mises. Others see von Mises as the true source, and his American student Murray Rothbard as his intellectual heir.

The disagreements don’t stop there. Some Austrians, despite generally rejecting government, favor a government-enforced gold standard and the prohibition of fractional reserve banking (the system by which banks lend out most of the money deposited with them, retaining only a fraction to meet the needs of depositors who wish to withdraw their funds). Others advocate ‘free banking’ with no government role of any kind, a position which is perhaps more intellectually consistent, but somewhat undermined by the observation that free banking systems have been tried and failed (the 1890s boom and bust in Australia is a particularly clear-cut example.

Whatever their disagreements and theoretical limitations, Keynesians and Austrians mostly got it right as regards the bubble economy of the decade leading up to the crisis. This is not to say that they predicted the timing and course of the crisis in detail. It is in the nature of bubbles that their bursting is unpredictable and has unpredictable consequences. Even the most accurate prophets, such as Nouriel Roubini of the Stern School of Business focused more on international imbalances and unsustainable housing prices rather than on the largely opaque superstructure of financial transactions that financed and magnified these imbalances.

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Was there really a Great Moderation?

The abrupt end to the Great Moderation raises anew the question of whether it was a real phenomenon or an over-optimistic interpretation of the data. Even when the Great Moderation was generally accepted, it was not the only interpretation put forward. In a paper published by the Brookings Institute in 2001 Olivier Blanchard of MIT and John Simon of the Reserve Bank of Australia argued that the data implied a long-term decline in volatility since the 1950s, interrupted temporarily in the 1970s and early 1980s.

Although this interpretation fitted the data as well as the standard view, it was not widely accepted.The reason is obvious enough. A statistical test suggesting that the economy was much more volatile in the 1950s and 1960s than in the 1990s is hard to accept in view of the actual experience of the postwar boom as a period of strong growth and low unemployment. If measures of volatility contradict this experience, the obvious response is to suggest that they must not be measuring the right thing.

But if data on quarterly volatilty can so easily be used to derive results that are so obviously problematic, this must cast doubt on their use to support the standard Great Moderation story. It is therefore worth looking more closely at the measures and their interpretation.

The first difficulty with a focus on the volatility of output growth is that it takes no account of changes in the average rate of economic growth. Looking at US growth rates, for example, the standard deviation of the rate of economic growth was 2.0 per cent in the 1960s, as compared to 1.5 percentage points in the 1990s. This seems to support the usual story suggesting a decline in volatility

But the average rate of output growth was 4.3 per cent in the 1960s, and only 3.0 per cent in the 1990s. So, expressed relative to the average growth rate, volatility was actually lower in the 1960s.

A second problem is that quarterly volatility measures are sensitive to relatively short-term fluctuations (in the statistical jargon, this is called high-frequency volatility). The same is true of the NBER measure which defines a recession as a downturn lasting a few quarters. These measures have their advantages, but they miss some critical features of the cycle.

Although the post war boom was characterised by relatively frequent recessions these recessions were not felt as being particularly severe because they were typically followed by rapid and strong recoveries – they had to be, given the high average rate of economic growth.

The recoveries following the recessions of 1990-91 and 2001 were different, so different that the term ‘jobless recovery’ was coined to describe them. Well after output had begun to recover, employment kept falling and unemployment kept rising. In each case the recovery in output was sufficient to constitute a recovery according to the popular ‘negative growth’ definition, and also according to the somewhat broader criteria used by the NBER. But to the average person, the early years of these expansions felt much like recessions.

President George HW Bush was among the first casualties of the new-style business cycle. By the time of the 1992 US election, the economy was about 18 months into an expansion, according to the standard measures. But Bill Clinton, campaigning on the slogan ‘It’s the economy, stupid’ was able to capitalise on the actual experience which was that of continuing depressed conditions.

The same experience was repeated after the 2000 recession.

The jobless recovery phenomenon was not confined to the US. In Australia, for example, the economy went into recession in 1989 and, on the standard measures, began a renewed expansion in 1990. But unemployment peaked at … in … and did not regain its 1989 levels until … , … years into one of the longest expansions on record.

As in the US, … The Labor government that had presided over the recession managed to scrape back into office in 1993. By 1996, with an expansion more than five years old, and unemployment rates finally declining, Labor hoped to be rewarded for the recovery. But the opposition parties judged the public mood more accurately, arguing that ‘five minutes of economic sunshine’ was no reward for what was popularly perceived as a multi-year recession.

But if the standard measures of quarterly volatility did not match the experience of workers in general, they fitted very neatly with that of participants in financial markets. For these groups the recessions were periods of severe les

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Individual and aggregate volatility

Economic analysis of the Great Moderation showed a striking paradox. Even though economic aggregates appeared to be more stable than at any time in the past, individuals and families experienced ever-increasing risk, volatility and instability. Risk has, it seems, increased in every dimension. Income inequality has grown substantially, in part because income mobility has increased, but also because lifetime income has become more risky. Short term variability in income has also increased.

This is a surprise. Since aggregate income Is just the sum of all individual incomes, it would seem that an increase in individual risk should translate into an increase in the riskiness of aggregate income, even allowing for the fact that some gains and losses will cancel out.

Economic analysis of the paradox came to the conclusion that the development of financial markets had weakened links between economic variables such as income and consumption. Faced with a decline in income, households could borrow to maintain their consumption levels. As a result, the flow-on impact of a shock in one sector of the economy to consumer demand for the economy as a whole was reduced. This meant that high levels of volatility in individual incomes could co-exist with aggregate stability.

But, was such a pattern sustainable? If variations in income are transitory, then borrowing to maintain living standards through a rough patch makes sense. But responding to a permanent decline in income by going into debt is a recipe for disaster. And it’s obviously difficult to tell in advance whether an income decline is going to be temporary or permanent.

Not surprisingly, as income volatility increased, so did the number of people who got into trouble by relying on borrowing. The most direct measure is the number of people filing for bankruptcy. This has increased in most English-speaking countries, but nowhere more than in the United States. In the early years of the 21st century, more than 2 million people declared bankruptcy every year. In fact, in these years, Americans were more likely to go bankrupt than to get divorced. The commonest immediate causes of bankruptcy were job losses and unexpected health care costs. But the underlying cause was a culture of indebtedness which meant that most people who experienced financial stress rapidly ran into trouble meeting existing commitments.

In 2005, the credit card industry hit back at the rising bankruptcy rates with the Bankruptcy Abuse Prevention and Consumer Protection Act, which put a number of obstacles in the path of people seeking to resolve their debt problems through bankruptcy. In the year before the law came into effect, over two million households rushed to file. In the months immediately following ‘reform’, bankruptcies dropped almost to zero, and remained well below those of the pre-reform period for several years. But the pressures of increasing debt meant that many people had no choice but to negotiate the newly established obstacles to declaring bankruptcy, and the numbers doing so gradually increased.

The onset of the financial crisis was initially reflected more in foreclosures than in bankruptcies. Most mortgages in the US are (legally in some states and de facto in others) non-recourse, which means that, after foreclosing on the house offered as security creditors cannot go after the other assets of the borrower. This means that, even if a foreclosure yields far less than the amount owed, the borrower’s obligations are discharged. For this reason, as long as the crisis was primarily confined to housing markets, bankruptcy rates rose only gradually. But, with the onset of high unemployment, and the end of easy access to credit of all kinds, bankruptcy rates soared in early 2009. It now seems likely that the number of bankruptcies in 2009 will be more than 1.5 million, exceeding all previous years, except for 2005 when people were rushing to beat the deadline of bankruptcy reform.

Despite the volatility of individual income, and the risks of relying on credit markets, economists focused on macroeconomic aggregates continued to celebrate the Great Moderation right through 2007. 2008 came as a rude shock.

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The GFC

The Great Moderation has vanished with surprising rapidity, though in retrospect its unsustainability has been evident since the late 1990s.

Bernanke’s Great Moderation hypothesis was not the first claim that the business cycle had been tamed, and it is unlikely to be the last. Every sustained period of growth in the history of capitalism has led to the proclamation of a New Era, in which full employment and steady economic growth would continue indefinitely. None of these proclamations has been fulfilled.

But, even by the unexacting standards of past economic projections, the Great Moderation has been one of the more spectacular failures. The Golden Age of Keynesianism lasted three decades, and delivered big increases in living standards throughout the developed world.

By contrast, the Great Moderation in the US didn’t really begin until the end of the first Bush recession in the early 1990s, and almost collapsed in the dotcom crash of 2000. It was only the reckless monetary expansionism of Bernanke’s predecessor, Alan Greenspan, that reinflated the bubble economy of the 1990s, and paved the way for an even more disastrous crash a few years later.

It is clear that the global economy is undergoing a severe recession, which will generate a substantial increase in the volatility of output. But even the economy recovers in 2010, as is suggested by some optimistic forecasters, crucial elements of the Great Moderation hypothesis have already been refuted. Over the period of the Great Moderation, all the major components of aggregate output (consumption, investment and public spending) became more stable. By contrast, any recovery will be the result of a massive fiscal stimulus, with a huge increase in public expenditure (net of taxes) offsetting large reductions in private sector demand.

The crisis has also invalidated most of the popular explanations for the Great Moderation. As will be discussed in more detail in Chapter …, the idea that improvements in monetary policy have been a force for economic stabilization looks rather silly, now that a crisis generated within the financial system has brought about a crisis against which the standard tools of monetary policy, based on adjustments to interest rates, have proved ineffective.

It is to the credit of central banks that, when their standard tools failed, they were willing to adopt more radical measures such as quantitative easing (that is, printing money and using it to purchase securities such as government bonds and corporate paper). Such radical steps, which contrast sharply with the passive response to the financial shocks of the Great Depression, have helped to prevent a complete meltdown of the financial system. But willingness to abandon failed policies does not change the fact of failure.

But if the pretensions of central banks have been shaken, those of financial markets have been utterly discredited. There is now no reason to give any credibility to the view that financial markets provide individuals and households with effective tools for risk management. Rather, in aggregate, the unrestrained growth of financial markets has proved, as on many past occasions, to be a source of instability and not a stabilising factor.

Just as the failure of the efficient markets hypothesis has destroyed much of the theoretical basis of the policy framework dominant in recent decades, the collapse of the Great Moderation has destroyed the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s delivered sustained prosperity. If anything can be salvaged from the current mess, it will be in spite of the policies of recent decades and not because of them.

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China and India

In the wake of the GFC, some advocates of economic liberalism have sought to shift the ground of debate, arguing that, whatever the impact of financial globalisation on developed countries, it has been hugely beneficial for India and China which, between them, account for a third of the world’s population.

There are all sorts of problems with this argument.

The relatively disappointing economic performance of China and India in the postwar decades certainly provides strong grounds for criticising the economic policies of Mao Zedong and Nehru. But even in the days when some observers saw these policies as providing an appropriate development path for the countries that adopted them, no one seriously proposed their adoption by developed countries. And as more attention has been focused on the irrational aspects of these policies (such as the Great Leap Forward, in which people were made to melt down their cooking pots to provide scrap for backyard smelters, which presumably produced new cooking pots, or the dozens of licenses required to undertake the simplest economic activity in India) it has become easier to understand why their removal or relaxation

At the same time, neither of these rapidly-growing economies come anywhere near meeting the standard description of a free-market economy. China still has a huge state-owned enterprise sector, a tightly restricted financial system and a closely managed exchange rate. India began its growth spurt before the main period of market liberalisation and also retains a large state sector. In both countries, as earlier in Japan and South-East Asia, the state has played a major role in promoting particular directions of development.

In summary, while the development success stories of China and India, and, before them of Japan and the East Asian tigers, may have some useful lessons for countries struggling to escape the poverty trap, they can tell us nothing about the relative merits of economic liberalism and social democracy.

‘Stock prices have reached what looks like a permanently high plateau’, Irving Fisher October 1929

As this famous prediction, made only a few days before the Wall Street Crash of 1929, illustrates, the belief that the era of boom and bust has finally been put behind us is not new. In fact, ever since the emergence of industrial capitalism in the early 19th centuries, it has been shaken, and stirred, by periodic booms and busts. And, in every intervening period of steady growth, optimistic observers have proclaimed the dawning of a New Economy, in which the bad old days of the business cycle would be put behind us. Even the greatest economists (and Irving Fisher was a truly great economist, despite his eccentricities) have been fooled by temporary success into believing that the business cycle was at an end.

In 1929, Irving Fisher’s confidence was based in part on the development of the tools of monetary policy implemented by the US Federal Reserve which had been established in 1913 and had dealt successfully with several minor crisis. The central idea was that, in the event of a financial panic, the Fed would lower interest rates and release funds to the banking system until confidence was restored. But the Fed proved unable or unwilling to produce an adequate response to the crisis of 1929, which soon became the Great Depression, an uninterrupted four-year period of decline that threw as much as a third of all workers out of work, not only in the US, but in all the developed countries of the world.

Economists are still arguing about the causes of the Great Depression, and the extent to which mistaken policies contributed to its length and depth. These disputes, once polite and academic, have taken on new urgency and ferocity in the context of the current crisis, which echoes that of 1929 in many ways. In the immediate aftermath of the Great Depression, however, the analysis that held sway over the great bulk of the economics profession was that of John Maynard Keynes.

The global financial crisis bears obvious similarities to the crises that precipitated the world into the Great Depression of the 1930s. Unsurprisingly, perhaps, much of the debate about policy responses has focused on the way in which different countries handled (or mishandled) the Great Depression. In particular, in the United States, a great deal of time has been spent debating traditional views of the New Deal as a relatively successful (though imperfect) response to the Depression and revisionist accounts in which New Deal policies prolonged the Depression.

But the global success of Keynesian ideas in the postwar period owed little to the experience of the New Deal. The crucial contrast was between the experience of World War I and its aftermath, ending in the Depression, and that of World War II and the successful economic reconstruction that followed it.

The financing and economic planning of World War II was largely undertaken on Keynesian lines, and Keynesians were quick to draw the lessons for the postwar period. The interwar years were seen as a period of economic waste that contributed greatly to the rise of Hitler and the renewed outbreak of global war in 1939.

As Australia’s White Paper on Full Employment, published in 1945, put it

Despite the need for more houses, food, equipment and every other type of product, before the war not all those available for work were able to find employment or to feel a sense of security in their future. On the average during the twenty years between 1919 and 1939 more than one-tenth of the men and women desiring work were unemployed. In the worst period of the depression well over 25 per cent were left in unproductive idleness. By contrast, during the war no financial or other obstacles have been allowed to prevent the need for extra production being satisfied to the limit of our resources.

The architects of postwar reconstruction hoped to prevent a renewed slump like that of 1919, and to hold unemployment rates below 5 per cent. They succeeded beyond their wildest dreams. The decades following the war were a period of unparalleled prosperity for developed countries, with economic growth higher and unemployment lower than at any time before or since.

For most developed countries, the years from the end of World War II until the early 1970s represented a period of full employment and strong economic growth unparalleled before or since. Referred to as the ‘Golden Age’ or ‘Long boom’ in English, ‘Les Trente Glorieuses’ in French, and the ‘Wirtschaftswunder’ in German, this period saw income per person in most developed countries more than double. With declining inequality and the introduction of more or less comprehensive welfare states, the gains were greatest for those at the bottom of the income distribution. But in an environment of stable growth and ever-increasing demand for their products, business leaders were happy to accept a larger role for government and the implicit contract that guaranteed steady work and high wages for their unionised employees in return for a government commitment to keep the economy at or near full employment.

By the 1960s, many Keynesian economists were prepared to announce victory over the business cycle. Attention turned to more ambitious goals of ‘fine-tuning’ the economy, so that even ‘growth recessions’ (temporary slowdowns in the rate of economic growth that typically produced a modest increase in unemployment rates) could be avoided.

Pride goes before a fall. By 1970, the Bretton Woods system was under serious pressure. Inflation in the United States had rendered untenable the commitment to hold the price of gold at $35/ounce. And whereas previous episodes of inflation had been brought under control quite rapidly through Keynesian contractionary policies, these policies were becoming less effective as inflationary expectations became embedded and as the social restraint generated by memories of the Depression broke down.

The last years of the Keynesian Golden Age saw a struggle over income distribution that virtually guaranteed an inflationary outburst. Union militancy, fuelled by Marxist rhetoric came into sharp conflict with the emerging speculative capitalism, driven by revived global financial markets. Firms raised prices to meet wage demands, spurring yet further wage demands to compensate for higher prices.

The coup de grace came with the oil shock of 1973, which was both a reflection of the inflationary outburst that was already under way and the cause of a further upsurge. Within a couple of years the entire edifice of postwar prosperity had collapsed and the Long Boom came to a painful and chaotic end. The 1970s and 1980s were decades of high unemployment and inflation (the ugly term ‘stagflation’ was coined to describe the ugly and unprecedented appearance of these two economic evils simultaneously, rather than as part of a cycle of inflationary boom and deflationary slump). Repeatedly, seemingly promising recoveries fizzled or collapsed into even more severe recessions.

At least by comparison with these dismal decades, the 1990s were an era of prosperity for the developed world, and particularly for the United States. The boom of the late 1990s produced improvements in income across the board, after a long period of stagnation for those in the lower half of the income distribution. The boom in the stock market produced even bigger gains for owners of stocks. House prices were slower to move, but because they are such a large part of household wealth, contributed even larger capital gains.

The long and strong expansion of the 1990s, combined with political events such as the collapse of the Soviet Union produced a new air of optimism and, in many cases, triumphalism. The success of books like Fukuyama’s The End of History and Thomas Friedman’s The Lexus and the Olive Tree reflected the way they matched the popular mood.

Economists were a little late to the party. Well into the 1990s, they worried about weak productivity growth, the possibility of resurgent inflation and unemployment rates that remained high by the standards of the postwar boom.

By the early 2000s, however, it was possible to look at the US data and discern a pattern that was the very opposite of a lost golden age. Rather, the datacould be read as showing a decline in the volatility of output and employment. Although the statistics did not yield a definitive interpretation, most observers saw the decline in volatility as a once-off dropping that took place in the mid-1980s, after the early 1980s recession, induced by the restrictive policies of Fed Chairman Paul Volcker that put an end to the 1970s upsurge inflation. This apparent decline in volatility, coinciding with the Chairmanship of Volcker’s successor, Alan Greenspan became known as The Great Moderation, a phrase coined by James Stock of Harvard University and Mark Watson of Princeton University.

Greenspan own successor, Ben Bernanke, graduated summa cum laude from Harvard in 1975, and completed a PhD at MIT in 1979. Bernanke is a leading figure in the generation of economists whose careers began after the breakdown of the long boom, and have largely coincided with Greenspan era. Unsurprisingly perhaps, Bernanke was among those who did most to revive the idea of a New Age of economic stability. He also popularised the use of the term the “Great Moderation” to describe it, using it as the title of a widely-publicised speech given in 2004.

Beginnings

The simplest way to understand why so many economists saw a Great Moderation in the macroeconomic data is to look at recessions and expansions. Before doing this, it’s worth taking a moment to discuss how economists use the term ‘recession’.

Although it is common to describe the occurrence of two successive quarters of negative economic growth as the “technical” definition of a recession, economists rarely use this definition except as a rough guide to the current state of the economy. Rather, economists in the US generally rely on the National Bureau of Economic Research Business Cycle Dating Committee, which defines a recession as ‘is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales’ and issues judgements as to when recessions begin and end. Similar bodies in other countries make the same kind of judgement, though none has quite the authority of the NBER.

These judgements typically take place a year or so after the event, which is one reason so much attention is paid to the ‘technical definition’. A great deal of energy was expended in the course of 2008, arguing that, despite obvious signs of economic distress, the required two successive quarters of negative growth had not been observed. But in December 2008, the NBER announced that a recession had began a year earlier, in December 2007. The announcement of the end of a recession takes place with a similar delay.

Whatever the defintion, in the years before 1981 (the end of the Volcker recession) recessions in the US were relatively frequent, with the intervening expansions averaging a little over four years. The NBER Committee defined nine recessions between 1945 and 1981, two of which (those of the early 1970s and the double-dip recession of 1980-81, were both long and severe).

By contrast, the period from 1981 to 2007 was one of long expansions and short recessions as measured by the NBER. In the entire period, there were only two recessions, in 1990-91 and 2001, and each lasted only eight months. In the light of past experience of failed claims, it might seem premature to proclaim the end, or at least the taming, of the business cycle on the strength of two good cycles. However, history teaches us that we rarely learn from history, and the prevailing atmosphere of triumphalism ensured a positive reception for statistical analyses that seemed to show that the business cycle had been tamed.

The dating decisions of the NBER are inevitably somewhat subjective, and do not lend themselves to statistical analysis. As result, economists seeking statistical confirmation of the idea that the business cycle had been tamed focused on quarterly economic data. This approach was consistent with the popular idea of a recession as two quarters of negative growth.

The focus on the volatility of quarterly growth also fitted neatly with the prevailing approach to the assessment of macroeconomic policy, called the Taylor rule, after John Taylor details who first formalised it. Taylor argued that central banks should (and mostly did) seek to minimise the variance of the rates of output growth and inflation about their long-run average values.

A variety of statistical tests suggested that the volatility of economic growth rates in the US had declined sharply over the early 1980s. And the moderation was not confined to US output growth. A similar decline was observed in both the average rate of inflation and the volatility of inflation, and in the volality of employment and unemployment rates. Broadly similar patterns were observed in nearly all the main developed countries. The big exception was Japan, where a decades-long bubble in real estate and stock prices burst at the end of the 1980s, paving the way for a long period of stagnation, with occasional brief expansions punctuated by renewed downturns. At the time, though, Japan’s problems were regarded as specifically Japanese, in much the same way as the financial crisis of the late 1990s was seen as a specifically Asian problem of ‘crony capitalism’.

The discovery of the Great Moderation, and, even more, Bernanke’s imprimatur, spawned an instant academic industry. Hundreds of studies dissected the Great Moderation from every possible angle, considering alternative interpretations, causal hypotheses and projections for the future. Participants in the industry displayed the disagreements for which economists are notorious. But, as is commonly the case with specialists in any field, disputes over details concealed broad agreement on fundamentals. In particular, few, if any, writers on the Great Moderation suggested that it was approaching an abrupt end.

Implications

If the Efficient Markets Hypothesis provided the theoretical basis for the resurgence of economic liberalism, the Great Moderation appeared to represent empirical confirmation of its success. The apparent stabilization of the business cycle offered economic liberals the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s had delivered sustained prosperity. As Gerard Baker wrote in the Times of London in 2007

Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smoothe out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies.

It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods.

(A couple of years later, writing his farewell column for the Times, Baker described this piece as his biggest mistake.)

The Great Moderation seemed to show that, in macroeconomic terms, economic liberalism had succeeded where Keynesianism had failed. The collapse of the Bretton Woods system and the decade of economic disruption that followed it had, it seemed, paved the way for sustained and broad-based growth. Similar improvements in economic stability, observed in a number of English-speaking countries, could be attributed to the radical reforms implemented by such leaders or finance ministers as Margaret Thatcher in the UK, Roger Douglas in New Zealand and Paul Keating in Australia. The European Union was generally seen as a laggard, with little choice but to follow the lead of the Anglosphere.

Causes

Central bankers, and particularly Alan Greenspan and Ben Bernanke, were happy to take the credit for the positive outcomes of the Great Moderation, while, for the most part, ignoring or downplaying the evidence of unsustainable imbalances, and unmanaged risks. For Greenspan in particular, the Great Moderation appeared to be an enduring legacy.

Of course, the claim of improved monetary policy did not rest entirely on the supposed genius of Greenspan and his fellow central bankers. The more serious claim was that, thanks to financial liberalisation, the economy could be stabilised using only a single policy instrument, the short-term interest rate determined by the central bank (in the US this is the Federal Funds rate).

While some analysts focused primarily on the role of monetary policy and central banks, the Great Moderation also fitted naturally into broader triumphalist stories about economic liberalism globalisation. In particular whereas Keynesianism required national governments to manage macroeconomic risk, the rise of global financial markets allowed such risk to be spread around the world. Since, it was assumed, national economic fluctuations would largely cancel each other out, risk could be moderated without government intervention. All that was required was for investors to hold diversified portfolios, and for capital to flow freely where its return was highest.

A third possibility was, of course, that the Great Moderation was just a run of good macroeconomic luck consisting, in essence of a couple of cycles where the expansion went on a little longer than usual and the recessions were relatively mild. Academic studies tended to mention this possibility, but mostly only to dismiss it. Popular promoters like Baker ignored the question.

The econometric tests reported in studies of the Great Moderation showed a statistically significant change occurring in the mid-1980s. However, it is an open secret in econometrics that such tests mean very little, since the same set of time series data that suggests a given hypothesis must be used to test it. This is quite unlike the biomedical problems for which the statistical theory of significance was developed, where a hypothesis is developed first, and then an experiment is designed to test it.

A fourth possibility, not mentioned at all in most discussions of the Great Moderation was that the apparent stability was actually a reflection of policies that were bound to fail in the end. Simply put, the prosperity apparently generated by economic liberalism was just a bubble waiting to burst, or rather, a series of bubbles, each larger than the last, and each encouraged by a combination of financial deregulation and expansionary monetary policy.

The Great Risk Shift

Beyond bragging rights in the perennial disputes between economic liberals and social democrats, the Great Moderation provided essential support for a central part of the agenda of economic liberalism, the idea that individuals and businesses, rather than governments, were best placed to manage the risks associated with modern economic life. This idea found its expression in what Jacob Hacker has called The Great Risk Shift. Risks that had been borne by corporations or governments were shifted back to workers and households.

Since aggregate employment was seen as more stable than ever, people who lost one job were presumed to be easily capable of finding another, and failure in this task was attributed to personal failings rather than to the workings of the economy. In these circumstances, companies felt the need to be ‘nimble’ and ‘flexible’ in their operations, buzzwords that translated into a willingness to fire large number of workers whenever doing so would yield a short-run increase in profitability. Similarly, there was seen to be less need for generous benefits for the unemployed and these benefits were duly cut or frozen.

The Great Risk Shift extended to such areas as health care and retirement income. The ‘one size fits all’ systems of single-payer health care and retirement income provision introduced in the aftermath of the Depression and WWII were attacked as bloated bureaucracies that crippled individual choice. Instead, it was argued, ordinary households should make their own provision for health insurance and retirement, with a public sector ‘safety net’ being reserved for the indigent and improvident.

Even during the Great Moderation, it was notable that the wealthy elite showed much more enthusiasm for individual risk-bearing when it was undertaken by ordinary employees than they did on their own behalf.

Great show was made of remuneration devices such as options, which gave senior executives the chance to benefit when their company did well and the share price rose. The benefits were taken very happily during the boom years of the late 1990s, when almost all stock prices were going up, regardless of the quality of their management. But, once the bubble burst, enthusiasm for stock options declined. More strikingly, large numbers of companies repriced the options they had already issued, setting the price low enough that their executives were once again ‘in the money’.

Of the institutions that were seen as obstacles to improved economic performance by economic liberals, none has been more vilified than restrictions on dismissal of workers, or requirements for generous redundancy pay. The supposed sclerosis of the European economies was blamed, more than anything else, on the difficulty of firing workers, which, it was argued, acted as a disincentive to hiring. Yet these arguments were forgotten when it came to CEOs. In case after case, failed CEOs have been rewarded with payouts running into millions, or even tens of millions, of dollars, while the workers whose jobs were lost due to their incompetence were lucky to receive a few weeks pay.

The upshot was that, despite their vastly greater capacity to absorb financial shocks, senior executives as group faced no more risk, relative to their average income, than ordinary workers. Relative to their wealth, senior executives faced much less risk than most people. The most disastrous failures among CEOs rarely end up poor, or even back in the middle class. But as long as the Great Moderation continued, inconsistencies like this were disregarded. Companies abandoned any pretence of a social contract with their workers (who were, at an early stage in this process, relabeled as ‘human resources’).

Risk has both an upside and a downside, of course. In the later years of long expansions, the balance of bargaining power in labor markets shifts towards workers, resulting in improved wages and conditions. But, on the whole the downside predominated. Faced with the ever-present risk of job loss, employees accepted a faster pace of work and reduced working conditions as the price of continued employment.

Governments also sought to get out of the business of risk management. Throughout the years of the Great Moderation, economic liberals railed against the social protections of the welfare state, which they saw as both inefficient and outdated. They had some successes, most notably with welfare reform in the United States. But on the whole the welfare state proved surprisingly resilient. Core programs like Social Security in the United States and the National Health Service in Britain enjoy deep and broad popular support.

Also, I’ve come to the view that “market liberalism”, as opposed to “economic liberalism”, is a better name for the viewpoint, based on the efficient financial markets hypothesis and other ideas criticised here, that has dominated policy thinking in recent decades.

Any thoughts on these points, or the revised intro, would be most welcome.

Introduction

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. JM Keynes

Ideas are long-lived. They often outlive their originators, and, even when they have proved themselves wrong and dangerous, they are very hard to kill.

Before the global financial crisis ideas like the Efficient Markets Hypothesis and the Great Moderation were very much alive. Their advocates dominated mainstream economics and their influence, acknowledged or not, guided the thinking of the practical men and women whose decisions created a financial system in which tens of trillions of dollars of interlinked obligations were built on a foundation of speculative, or entirely spurious investments, and a global economy in which both households and nations lived far beyond their means.

Today these ideas appear to be defunct. Commentators who were proclaiming, a year or two ago, that the business cycle had been tamed, and replaced by a Great Moderation in economic activity, have admitted their error or, more commonly, moved on to talk of other things. The claim that financial markets make the best possible use of economic information, and can never be subject to irrational bubbles, is rarely made, and usually hedged with all kinds of qualifications and escape clauses.

But habits of mind and thought are hard to change, especially when there is no ready-made alternative. The ideas that brought the global financial system to the brink of meltdown, and have already caused thousands of firms to fail and cost millions of workers their jobs, still underlie the thinking of those who are trying to respond to the crisis and, to a large extent, of the commentators and analysts who assess those responses. These ideas are neither alive nor dead; rather, they are undead, or zombie ideas. Hence the title of this book.

If we are to understand the financial crisis, and avoid the kinds of responses that set the stage for a new and even bigger crisis in a few years time, we must understand the ideas that got us to this point. This book describes six ideas that have played a role … Some of them, like the Efficient Markets Hypothesis and Micro-based macroeconomics belong to the realm of technical economic theory. Others, such as privatisation and central bank independence are specific policy prescriptions, ultimately derived from these abstract ideas. Still others like the Great Moderation and Trickle-down economics, are catchphrases that incorporate a set of claims about how the economy works, or worked in the thirty years or so before the current crisis.

Together these ideas form a package which has been given various names: : Thatcherism in the United Kingdom, Reaganism in the United State, economic rationalism in Australia, the Washington Consensus in the developing world and “neoliberalism’ in academic discussions. Most of these terms are pejorative, reflecting the fact that it is critics of a dominant theoretical or ideological framework who feel the need to define it and analyse it. Politically dominant elites don’t see themselves as acting ideologically and react with hostility when ideological labels are pinned on them. From the inside, ideology usually looks like common sense.

The most neutral term I can find for the set of ideas described by these pejoratives is ‘market liberalism’, and this is the term that will be used in this book. [fn1]

The book is organised in a way that I hope will help readers to understand how market liberalism depends on ideas that have failed the test of the global financial crisis, and which, if they continue to influence policy, will ensure a repetition of the crisis. Each chapter starts with a section describing the beginnings of the idea, followed by a section on its theoretical and policy implications. The next section describes the failure of the idea. In most cases, problems were evident well before the current crisis, but those who pointed them out were dismissed or ignored. The final section, entitled “What next”, looks at alternative ideas that may point to an alternative to market liberalism. The final chapter, “Economics for the 21st Century” looks more generally at the kind of policy ideas that will be needed in the light of the failure of market liberalism. A simple return to traditional Keynesian economics and the politics of the welfare state will not be sufficient. It is necessary to develop both economic theories and policy programs that respond to the realities of the 21st century economy.

1. There’s a similar problem of terminology on the other side of the debate. The success of market liberalism was the result of a reaction against a set of ideas and policies commonly referred to as “social liberalism” or “social democracy” in Europe and simply as “liberalism” in the United States. The distinctions between the positions implied by these different labels will not matter for the purposes of this book. What matters is that all of them included a commitment to full employment, based largely on Keynesian economic management, and a major role for the state in the provision of income security and services such as health and education.