“any pro-capitalist argument must rest on long-run considerations. In the short run it is profits and inefficiencies that dominate the picture”. Joseph Schumpeter

In this quite dramatic financial and economic crisis, it isn’t easy to be someone not completely swayed by the common exaggerations about its gravity, as if it were the end of the world, nor by all the moralism that has been surrounding it. Those who say “wait a moment and think again” have the disadvantage of coming up with more reasoned approaches in an area where sometimes public ire seems to have taken the lead over reasoned discussion. Not that I believe that they matter to anyone, there are so many qualified authorities around, but I’ve been trying to structure my thoughts on the crisis and so share them modestly with anyone who’s interested.

The public’s attention, at least in rich Western countries, has been fed with views that smack of religion rather than anything close to sensible policy discussion. The Catholic Church took up its usual business of stirring up believer’s guilt by condemning the Profit Motive, whereas the Protestant Anglo-Saxons came up with scathing attacks on bankers’ Greed. Eco-fundamentalists say it’s all the fault of consumerism and China discovering it. They say we should go organic and stop economic growth, lest the Four Horsemen of the climate Apocalypse descend upon us and throw us into eternal Damnation. Leftists and communists responded that all we need is to re-nationalize the economy. Nobel-prize winning economists have been swayed by their religious – and star-status-enhancing – instincts. If one believes Joe Stiglitz, the cult for the GDP (gross domestic product) has been a root cause of this crisis. And Paul Krugman has been spreading his blind belief in the benefits of massive bail-out packages, as if they were a cost-free magic manna sent from heaven. Politicians preparing for the G20 summit in September make high-flying statements on curbing banker’s pay, cracking down on tax havens, after having been fixated on regulating hedge funds. Yet they too, only maximise their electoral utility.

How bad is this crisis, actually? First of all, this crisis has been oversold as being the worst since the Great Depression of the 1930s. As Allan Meltzer recently pointed out in a Wall Street Journal article, “the facts we face today are very different than the grim reality Americans confronted between 1929 and 1932. True, this recession is not over. But it would have to get improbably worse before it came close to the 42-month duration of the Great Depression, or the 25% unemployment rate in 1932.” In fact, it looks like we are slowly getting out of the crisis. Therefore the recession is likely to turn out to be a very classic post World War II recession, albeit of the severer type, like the 1973-1975 crisis.

What has caused our current bust? And is it Global Capitalism’s fault? The causes of this crisis are multiple. They have both to do with how the market economy works and with policy failures. One must face it: this crisis is a typical capitalist crisis of boom and bust. Like so many of these, it involves banks. Banks are the intermediaries that channel savings and investments in complex economies characterised by a sophisticated division of labour. Today this division of labour is global. Finance, unsurprisingly, is also global. Yet the mechanism of the good old business cycle is the same. Recurrent fluctuations in a private enterprise economy are caused by the changing outlook for profits. When that outlook is favourable, investment and production increase. The contrary happens when that outlook deteriorates. Rising investment fuels growth. This will produce more profits and further investment. But, the whole process is uncertain, because any act of investment is based on expectations about future relative prices. Every act of investment is necessarily a gamble. The higher one is in the upward slope of the business cycle, the more economic actors are likely to take wrong decisions, given that the availability of good investments is shrinking. In our crisis the diminishing returns on investment were on real estate and in subprime mortgages. One can’t defy gravity. The bubble always ends up bursting. Economic recovery only occurs when the bad investments have been liquidated.

But any boom and bust cycle can be smoothened or sharpened by good or bad policies. In this crisis several blatant policy failures have contributed to the collapse of September last year. Monetary policies: Excessive availability of cheap money due to the flooding of the US financial markets with Chinese savings; the Fed’s accommodating monetary policy that has not raised interest rates early enough and therefore fuelled the housing bubble that has come home to burst. It inly required a very slight increased in Fed interest rates and so the magic was gone. Regulatory failures: US regulations that exempt mortgage lenders from following the usual prudential rules for giving out credit to people who can’t afford a house; tax breaks on homeownership in several countries hit by the bursting of the housing bubble. And there is the failure to regulate the new complex financial products that emerged in the last years and have led to the spread of those toxic assets that still sit in many a country’s banks, waiting to be disposed of.

Why has no-one seen the crisis coming? In fact, contrary to what is often being stated, it is not true that no one saw a crisis coming. The IMF and other economists were discussing the risks of the global imbalances involving China and the US for several years. Doom-sayers like Nouriel Roubini (to name only one of the most prominent) were often dismissed as party-spoiling Cassandras when they pointed to the risks of the housing bubble. Pessimists full of anxiety were calling for the regulation of the new esoteric “structured” financial products called AMBS, CDOs etc. But as most events, the actual shape and timing of the event was impossible to predict. Honest and serious economists don’t even pretend to have any magic predictive power.

What should be done about this crisis? Clearly, the priority should be given to addressing the root causes of this crisis? This involves: prudent and well-thought-through regulation of the financial system as it is now, and of the new financial products that have emerged in the recent years; clean-up of the banking system (buy away the toxic assets); reassessment of monetary policies and finding effective ways of avoiding asset bubbles getting out of hand; rebalancing of the economies with surplus savings (China in particular but also many Asian economies and countries like Germany) and current account deficits (the United States but also the United Kingdom among others); winding back policies that unduly promote house-ownership; promote consumption in saver countries and savings in consuming countries; strengthen institutions to warn of an incipient crisis, such as the IMF’s Financial Stability Board. But these are complex tasks that cannot be undertaken in a short period of time lest costly blunders be made. They are also dull, politically explosive, and not amenable to quick fixes. So what about hedge funds, bankers’ pay, tax havens? Although looking closer at how to regulate these areas isn’t per se a bad idea, these have not caused the crisis.They have been a side-show. The structural causes lie elsewhere.

 Are we going in the right direction? The answer is a qualified No. Qualified, because there have been moves in the right direction on discussing international and domestic financial regulation, for example. But we are only at the beginning of a long process. Qualified, too, because one cannot deny that the bailout packages injecting millions into national economies have maintained a minimum of confidence in the economy. Beyond that, there are risks of major mistakes. The first is that many overdue changes in the financial system will not be done, due to the political process in Washington/Wall Street, Beijing, London, Brussels. There’s also reluctance of member states to give proposed supervisory bodies in the International Monetary Fund (FSB) or the European Union (Systemic Risk Council) appropriate powers. There’s simply too, the reluctance of rich countries to clean up their banks, thus perpetuating the current shortage of credit.

The second problem lies in the fiscal measures taken to counter the crisis. These risk choking off a still fragile return to economic growth.

It is important to find a sustainable path back to economic growth. This is why: Economic growth is not a cult-object irrationally pursued by economic fundamentalists. It is one of the most important – if limited – indicators that correlate with the rate of activity and development of a given country. When growth levels are low, those that suffer most are the silent majorities and the poor, the unemployed, the outsiders. This is not “trickle-down economics” but a fact. China’s and India’s examples are the plain proof of this. The moment these plugged into the global capitalistic production system, and therefore increased their rates of growth, these have, in less than a generation, produced a middle class as sizeable as the European Union each. That’s a billion Wretched-of-the-Earth less than in the 1980s. And they have improved everyone’s well-being. Anyone reading this article on his/her laptop or iPhone, might find it useful to be reminded of this. A similar process has taken place and Central and Eastern Europe, where plugging into European production networks has considerably increased well-being in the formerly bankrupt socialist economies.

After this digression, let me return to my argument. The life-support given to our economies in the bailout-packages, if pursued for too long can have deleterious effects. In fact it already does.

First, there is the basic rule of undergraduate macroeconomics stating that public investment “crowds out” private investment. The Heavy Hand of government renders the busy forces behind the Invisible Hand lazy and reluctant to put in their weight in the pursuit of prosperity. Or to put it less poetically: by pouring tons of money into the economy, the government contributes to rising interest rates, therefore rising borrowing costs. This in turn dis-“incentivises” private investment. The other alternative to rising interest rates is to create inflation, which leads to other economic disasters.

Second, the political-economy consequences can be devastating. Government agencies and industries that are put under life support tend to develop incestuous patron-client relationships that can lead to harmful economic decisions, in particular the resort to protectionism. This is precisely what is happening in the car industry of the US, Germany, France in particular. It is a morally laudable goal to want to avoid excessive unemployment. But the car sector is simply suffering from overcapacity and produces cars that the consumer no longer wants. The life support given to these industries delays their restructuring, slows down productivity, and diverts energies and public resources from more productive and beneficial activities. Furthermore, these industries develop a complacency that leads them to demand the kind of protectionism that will spare them the effort to restructure. The US’ recent decision to slap 35% duties on Chinese tyres, is such an example. Another example is the failure of the European Union to finalize the signing of a free trade agreement with South Korea. The uncompetitive elements in Europe’s car industry are blocking a deal that would provide Europe the opportunity to sell more products to South Korea, not least medical technology and environmentally-friendly high-tech products. Environmentalists in particular should also be wary of the bailout packages and the emerging protectionism. China’s activist rescue activities lead it to over-invest in the kind of heavy industries (steel, chemicals, cars) that contribute to the country’s ecological crisis. The rise in anti-dumping measures across the world is also a problem. These measures are always taken to the benefit of uncompetitive industries, chiefly among them the metals sector in Europe, the US, but also India and other emerging markets. These sectors are strong CO2-emission producers. In the EU they are the ones that lobby most in favour of obtaining gratis permits in the EU’s cap-and-trade scheme, for example, thus not exactly showing they are willing to contribute to the common good.

An economic crisis is an opportunity to become more efficient, and to drop productive activities that are no longer socially optimal. A plunge into government activism and protectionism is certainly not the right response to our current challenges. As a not-so-humoristic nod to readers with their heart on the “left” and on the “green” side of things: we simply need more people on this planet to be able to afford organic food! There’s no way around favouring growth and good old conservative macroeconomic policies. Let’s not be blinded by the forces that try to reign in Keynes’ “animal spirits”. Only their freedom of acton will bring us socially desirable benefits, even is the process is fraught with crises. Good policies can on top of that contribute to absorbing the shocks.

Germany and Japan, among the world’s most important economies, have held elections this week-end. Japan overthrew the long-ruling LDP and the coalition party members in Germany suffered severe blows in regional elections, not boding well for them in the forthcoming general elections. The economic crisis and its management so far has a lot to do with this. Both Germany and Japan suffer strains on their social systems and their economies due to their ageing societies. They also have had an economic model based on exports at any price with concomitant restrictions on domestic consumption. Both models – in particular Germany’s stakoholder capitalism - have often been portrayed in the past as less brutal and unstable than Anglo Saxon “shareholder”, or worse “casino”, (not to say “locust”…) capitalism.

As capitalism is deemed in crisis globally, and in particular, the Anglo-Saxon model, The Peterson Institute’s Adam Posen published on Friday a refreshing comment on these countries’ economic prospects:

Regarding economic policy, there is concern in both countries that entrenched politicians have pandered to their constituencies of older citizens for too long without sufficient regard for long-run fiscal sustainability.  And in both Germany and Japan, there is a legitimate sense that things have not been going well – legitimate because in both countries real wages have been stagnating or declining for years [...].

Is there a compelling economic alternative on offer in either election? Does the program of the likely winning party or parties show a fiscally sustainable way back to real income growth for average workers? This is not just a matter of who will set economic policy in two of the world’s largest countries. This is about the future of economic policy. A well-justified casualty of the global financial crisis is the confident consensus that we know what to do.

It is not enough for politicians to simply offer a program of avoidance of Anglo-Saxon finance. First, such avoidance has not conferred safety during the crisis, especially since restricted consumption is associated with export dependence, and thus external vulnerability as Japan and Germany experienced. Second, such self-assigned financial distinctions have done little to prevent sizable banking problems from emerging in Germany or Japan as well. Third, the approach of Germany and Japan has not delivered noticeably better results for citizens’ incomes looking at the long-term –even when the additional fiscal burden to the US and UK from recent crisis responses is rightly taken into account.

Most importantly, “don’t act like the US” is an insufficient guide to policy in the face of stagnant wages precisely because all advanced countries are already acting differently from the US in terms of saving, of social policies, and of compensation of bankers, as well as on environmental, education, health care, and tax policies. If not acting like the US were enough, the rest of the rich world would be doing far better economically than it is.

The most promising economic programs are those of parties which are trying to return economic liberalism to its core values. I characterize this effort as making a commitment to protect citizens not stakeholders. That means combining social protections for individuals with willingness to subject businesses to strong competitive pressure, and progressive taxation to pay for the safety net. This is a step away from the promotion of corporate interests that have deceptively donned the cloak of “free-market” policies in many advanced economies in recent years – and not coincidentally given liberalism a bad name. The recent excesses of the US in protecting financial businesses, however, if anything, show the need for such citizen-not-stakeholder policies. [...]

I have no personal horse in either of these electoral races, but in Germany it is the minority Green Party, with their emphasis on long-term sustainability and breaking down collusive business-labor barriers to competition, and the even smaller Christian Social Union*, with their opposition to bailouts, that offer a productive agenda of this kind. In Japan, it is the true heirs to former Prime Minister Koizumi in the Liberal Democratic Party who come closest, but who also are of the next generation in seniority, and thus will only come to power after the LDP loses this time, at soonest. Thus, for Germany and Japan the outlook is for continued economic underperformance, and mounting dissatisfaction, even after the coming electoral changes.

* Edit on 1 September 09 – My comment on this: The arch-conservative CSU is NOT the most economically liberal party in Germany. Given its deep often rural Bavarian roots, it is not exactly open to e.g. reforms of the highly protectionist EU Common Agricultural Policy, for example. It is rather the currently up-and-coming FDP that has a consistent liberal outlook. Given its current rise in polls, along with indeed the Greens, it is most likely to tilt the balance – if this is ever possible – in favour of changing German-style corporatism.  Daniel Schwammental at the WSJ Journal published an interesting article on the FDP today. Here it is (walled for subscribers).

As I read my way through the Deepak Lal book* I mentioned yesterday, I find an exposition on “The Classical Theory of the Business Cycle”. He wrote the book in 2004-2005. The text should have been a warning: never ever forget your classics! Please see this and this article as background to discussions of what went wrong with economics in the last years. One of these issues is the recent belief often expressed here pre-2008 that business cycles, or boom-and-bust cycles, had disappeared (at least almost).

I will allow myself to take Lal by his words – “While there may be a case for patents for industrial products because of the large required investments in R & D, does the argument also apply to pure research, books, music and films? (…) There was no patent when Pythagoras discovered his theorem or Newton his law of gravity” – and upload a pdf of a page in his book to make it available online for free [follow the link here: Deepak Lal Business Cycles]. In  these paragraphs one is reminded that the work that triggered Friedrich von Hayek’s nomination for the Nobel Prize for Economy was his theory of the business cycle developed in the 1930s and 1940s. Lal tells us:

“At the center of the business cycles in this classical [...] view are interacting movements in business profits, investments and credit. Recurrent fluctuations in a privte enterprise economy are caused by the changing outlook for profits. When it is favourable, investment and production increase, and conversely when it deteriorates. Rising investment fuels growth, which ceteris paribus will produce more profits and further investment. But, the whole process is uncertain, as any act of investment is based on expectations about future relative prices. Every act of investment is thus necessarily a gamble (…).”

What happens when in the process the money supply increases [read: excessive credit growth/central bank policies...]? This triggers the “injection effect”, i.e. the distortionary effects of how the money supply is increased.

“If the injection of money is through the credit markets, then even if the total ensuing increase in the money supply is proportionate to the increase in economic activity and hence noninflationary [read: global liquidity boom due to globalization, and China’s rise and accumulation of reserves], the changes in interest rates induced by the expansion of credit could lead to false signals in the patterns of intertemporal prices and thence to a misallocation of resources.
 

For changes in the interest rate [read: cheap money due to abundant liquidity not disciplined by a tightening of money supply by the Fed in the boom years following 2001] will have a systematic effect on the pattern of prices which allocate resources among different stages of production. In modern terminology, a fall in the interest rate due to credit expansion will lead to businesses undertaking relatively more capital-intensive investment projects with lower prospective rates of return [read: “subprime” for “low prospective rates of return”]. The artificially low rate of interest induced by injecting money through credit expansion will also lead to an unsustainable boom as more investment projects are undertaken than can be completed [sounds just like the housing boom, doesn’t it?], and as the accompanying resource scarcities emerge, the boom will turn into a bust [yessir]. The economy will only recover once the “malinvestments” are liquidated [we’re not quite there yet, the banks still have toxic assets sitting around waiting to be disposed of] and resources reallocated in line with intertemporal consumer preferences [right now US Americans are learning to save] and resource availabilities [they are currently broke].”

“But even with appropriate monetary policy, a private capitalist economy will inevitably have booms and busts. Unlike many contemporary theories of the business cycle which believe that shocks of various kinds are the true “causes” of business cycles, this older view sees the business cycle as being an endogenous self-sustaining feature of private capitalist industrial economies (…)”

Can public policy do anything to alleviate this boom-bust cycle? The simple answer is: very little. (…) They can perhaps soften the blow by easing monetary policy in the downturn. But, as the basic problem is the bad investments and excess capacity created in the boom, the only solution to this structural slump is to allow these distortions to be worked out, so that another period of expansion can begin.”

_____________

*the politics of this book are sometimes quite dubious. While the language in his passages on economics is relatively sober and certainly very professional, when it comes to his politics, we enter a realm of caricature and point-scoring. Anyway, at least it is entertaining. An interesting perspective coming from a conservative Indian, trained in Oxford (read: a lot of English Tory scepticism) and living in America. Here an example: What he thinks of the European Union? “The aim is to recreate a new Holy Roman Empire”. It is run by the French ENArque elite which “has seen its only hope of global influence in a Europe in which they would jointly exercise hegemony with the Germans”. Why the Mediterraneans and the Irish joined in the 1980s? “they have looked upon the subsidies, through the Common Agricultural Policy and other regional schemes they have obtained from Europe, as a drunk given free access to a liquor store”. Voila!

While many economists are on holiday, the debate rages on over the future of the profession.

In today’s FT, Robert Skidelsky contributes with a classic theme: the aloofness of perfect-equilibrium mathematical economics and all those models it produced. These model’s assumptions have led, for example, banks straight into bankruptcy, or laissez-faire-minded central banks into thinking we are living in a perfect world where businesses regulate themselves. This approach has, to put it mildly, shown its limits. Each time, financial crises are deemed a crisis of capitalism. As we shall see, they simply are. But these are the moments where social conservative/religiously-minded and/or socialist-minded get a hearing on the failures of the neo-liberal economic model and of the Devilish Market Economy per se.

But let’s go back to the roots, so that we get a better understanding of what this is all about. To start with, here a few quotes from Skidelsky’s article, who comments on the ongoing debate stirred by the Queen in the UK:

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

“An important implication of this view is that shares are always correctly priced. This is the basis of the so-called efficient market hypothesis that has dominated financial economics”.

[...] It has also led to the discrediting of mainstream macroeconomics. The efficient market hypothesis is simply an application of the recently triumphant New Classical school, which preaches that a decentralised market system is always at full employment. In their obsession with getting government out of economic life, Chicago economists claimed that any consistent set of policies will be learnt and anticipated by a population, and will therefore be ineffective.”

This article strikes at the heart of the distinction between “classic” and so-called “neo-classic” approaches in economics. Unfortunately “classic liberal” economists have indeed become marginalised eccentric mavericks in universities and public debate. Classic liberals are generally only supported by social conservatives as long as the “natural liberty” they advocate remains strictly circumscribed to the economic field, and are despised by the Left for being part of those “right-wing” “neo-liberals” who really-don’t-get-that-markets-don’t-work. In fact, they are generally simply misunderstood.

 I am currently reading a brilliant book by one of those (truly) maverick classic liberals, UCLA Development Economist Deepak Lal, whose book, published in 2006, “Reviving the Invisible Hand, The Case of Classical Liberal Liberalism in the Twenty-First Century” is, as one can imagine, not currently an international best-seller. Yet he raises a few points that are quite useful in the current discussion:

 “The laissez-faire doctrine has been caricatured as “the night watchman state” as assuming “a harmony of interests” and as assuming utility-maximizing rational actors. But all these are alien to the thought of the fathers of classical liberalism – Hume and Smith. They do not look upon man as a rational utility maximizer with perfect knowledge. Hume talks of “the imperfections and narrow limits of human understanding” and that “reason is, and ought only to be the slave of the passions and can never pretend to any office other than to serve and obey them”. Their central claim is that, a free market economy, by promoting the division of labour, and by coordinationg the division of knowledge (which necessarily exists in any society) through the price mechanism can goad individuals to become more rational. The specialization that then ensues allows a better allocation of a society’s resources and leads to greater national wealth. But, the free market is not considered to be one which has perfect competition as defined by modern-day economists.”

 “Moreover, instead of there being harmony of interests, a legal framework is needed to mediate between clashing interests and reconcile individual self-interest with the public good. Classical liberals strongly believe in “liberty under the law” and therefore a qualified, not an absolutist laissez-faire”. [see too Razeen Sally]

 “The classical liberals were not hostile to the state, nor did they believe that governments had only a minor role in economic life. Their view of the state was positive (…).  Adam Smith’s famous statement of the three functions of the state, viz. (i) to protect society from foreign invaders, and (ii) every member, as far as feasible, from oppression and injustice by other members of society, and (iii) provide and maintain various public works and public institutions which provided public goods, is almost identical with Keynes famous formulation in “The End of Laissez Faire”: “the important thing for government is not to do things which individuals are doing already, but to do those things which at present are not done at all”.

 Another crucial distinction between classic and neo-classic economics is the conception of competition.

“The modern concept of perfect competition, conceived as a market structure in which all producers are price takers and face perfectly elastic curves for their outputs [...] is foreign to the classical conception of competition as a process of rivalry in search for the unrealized profit opportunities, whose outcome is uniformity in both the rate of return on capital invested and the prices of identical goods and services, but not because producers are incapable of making prices.”

Furthermore, Lal points to Joseph Schumpeter, who sees capitalist progression as driven by recurrent, crisis prone and destabilising, innovative competition: what he called “creative destruction”.

 So. Classic liberal economic thinking is very well capable of capturing what is at work in this capitalist crisis. Just a few obvious examples:

•  many governments that during a boom have not done “what individuals [were] not doing”, e.g. curb the bubble that came home to … burst; through, for example, sounder monetary policies;
• regulators that have not been able to create institutions that regulate diverging interests. One thinks of the “clash of interest” problems between banks and ratings agencies. These have led to what Adam Smith has coined their “combination”, to the detriment of your average saver, investor, and, ultimately, tax payer.
• innovative competition, i.e. the one that has led to the creation and overselling of complex financial derivatives, now sitting in banks’ balance sheets as ”toxic assets”;
• insufficient “reason” and understanding. For example “irrational exuberance”, and other market dysfunctionalities picked up by behavioural economists recently, and the simple and plain fact that the new financial products were practically impossible to understand.

Back to Skidelsky – who obviously can’t help being a Britisher:

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

What Skidelsky forgets to say is that Adam Smith, founder of classic liberalism, understood indeed very well that economics is a moral science. Smith is also the author of a lovely “Theory of Moral Sentiments”. Smith’s view of why humans strive, work hard and take risks to get rich is, to put it simply, their vanity, their desire to be recognised and admired in society. Because being wealthy and happy is one of the ways of attracting public admiration and social recognition. Skidelsky is right in wanting to put economics into its wider context and in pointing to the world’s most excellent universities. However, he also omits to mention that the City of London, its regulatory bodies, and the list of economists that have written their mea culpa to the Queen, are themselves full of people who come out of Oxbridge. Driven – probably even more than any other less ambitious person in the Kingdom – by Smith-style vainglory. Despite their brainpower and ability to think more broadly than by numbers and econometric models, they too have failed to see the crisis coming, because they too have benefited from the unprecedented financial bubble that has burst spectacularly. The problem is we now also need these peoples’ brains to clean up this mess. Let’s hope that in the process they won’t throw away the babies with the bath: a capitalist market system that has proven to be the least inefficient in creating and spreading wealth in all human history, as well as the occasional usefulness of a mathemical model to help investors take risks.

or so would say Paul Ormerod:

“As late as the autumn of 2008, economic forecasters in general were far too optimistic about 2009. Are these same forecasters now too pessimistic about recovery? The historical evidence reveals a typical pattern of recession and recovery that suggests this may be so. Very few recessions last longer than two years. And most recoveries, once they start, are strong.

Since the late 19th century, there have been 255 recessions in western economies. Of these, 164 have lasted just one year and only 32 have lasted for more than two years. In other words, two-thirds of recessions last a single year, and only one in eight lasts more than two years. If we strip out the peculiar circumstances at the end of the two world wars, 70 per cent of all recessions last just one year.

The pattern of duration is virtually identical regardless of the size of the initial shock. Even when the initial fall in output has been more than 6 per cent, 70 per cent of recessions have lasted just one year. Even in the 11 examples where the initial fall in GDP was more than 8 per cent in a year, eight recessions only lasted that single year. This does not of course guarantee that the current recessions in western economies will be short-lived, but, equally, the speed of the fall does not imply they will be long.

An analysis of recessions since the second world war shows that those lasting one year or less typically end more abruptly. The average growth rate in the year after such a recession was 3.5 per cent, and in the subsequent year 3.8 per cent. This is compatible with the view that short recessions are essentially inventory cycles. Once inventories are reduced to satisfactory levels, normal production levels resume, and fixed capital investment expenditures postponed during the recession are carried out.

The 4.8 per cent GDP growth rate projected by the UK government from 2009 to 2011 has been criticised as too optimistic. It is in fact rather modest in this wider context.

Recovery was rapid even after the Great Depression. The nature of the economic catastrophe that started in 1929 varied enormously across countries, both in size and duration. The UK escaped relatively lightly with a 6 per cent fall in output spread over two years. In Japan, Denmark and Norway the recession lasted only a single year. But in Germany, Austria, Canada and the US, the cumulative fall in output was between 25 and 30 per cent, with the recession lasting four years in the latter three countries and three in Germany.

However, once the recovery began – in different calendar years in different countries – the average rate of growth was strong. GDP growth in the first year after the Great Depression averaged 4.7 per cent, followed by 4.6 per cent in the second and third years.

The caveat to all this is that the current circumstances are unusual. But so was the Great Depression.”

I happened to look up the London School of Economic’s website yesterday – pure chance, hadn’t happened in ages. The LSE is headed by one of the greatest advocates of the now much honed “light-touch” approach to financial regulation…. I couldn’t stop my colleagues from wondering yet again if I am really normal by laughing out loud in a silent office at the following annoucement on the home page:

“Wishful thinking and hubris – why the global financial crisis was not foreseen
When The Queen visited LSE last year she asked why no one had spotted the recession. Following a roundtable discussion at the British Academy, leading academics have written to The Queen in response.”

Here is the letter in question. Signed: “Your Majesty’s most humble and obedient servants”, followed by a long list of UK-based economists.

I wondered if I should blog about it, and thought I’d let it pass. But that story was duly picked up by the FT this morning…. with the paper’s usual seriousness/dullness. Oh Britannia…!

I still maintain: economists, take a good holiday!

The economic crisis is steep, worsening. Green shoots this spring proved elusive. Except in China, for which a generally pessimistic IMF forecasts 7.5% growth this year, where the stimulus package, tough government intervention, and probably some data massaging provide for more growth than elsewhere. Some at Goldman Sachs believe even that China is going to pull us out of the recession – if one believes the message brought to Brussels last week. I am sceptical, as it appears – read here and here – that the Chinese government tends to persist in its past mistakes: the current mini-boom might well be short-lived. And are the Chinese rich enough yet to pull and the US Americans, and the Europeans, let alone all the others, out of their rut? [EDIT 24 July: Michael Pettis blogs about all these issues! Have a look.]

The press and specialized publications are full of irrational economics-bashing and laudable self-bashing economists (here and here), their status and self-confidence strongly shaken by their inability to stop the crisis from happening. More cool-headed analysis shows that the economics discipline remains as strong and interesting as ever (read here again), although some lessons will have to be learnt. As it turned out, many dangers were actually well known and well publicised, only no one wanted to listen. The boom times being what they were, some economists were also human, all too human,  enjoyed the spectacle of the global economic party of 2003-2007 and became less vigilant. Barry Eichengreen (here again) attributes this among others to the lucrative consultancy fees received by high-flying academics for speeches during luxury conferences hosted by the triumphant global investment banks. It seems of course true however, that economists must learn more about finance and vice-versa, this gap being one of the blind spots in the understanding of the world before the crisis. And the inherent instability of capitalism analysed by oft-disdained Marx and even Schumpeter has not died out, contrary to many recent views about the end of the business cycle. The Economist also had views on this economics issue last week.  

It seems to me that it is not so much the economists that should reassess their profession full on. It’s the financiers I am worried about. Goldman Sachs, primus inter pares among the maverick investment banks of late, is bullish: it has paid the highest bonuses ever to its employees. In the meantime the financial establishment apparently continues to dominate the scene.

This means either two things: the economy is not doing as bad as many say. Or financiers have not yet quite learnt their lesson and continue business as usual, potentially pulling us down even further a few months down the road. In either case, it seems that economists need to go on holiday – to be able to become more discernible again on what is actually really happening in the economy, and to take a well deserved break in these stressful times, since it really is not all their fault.

This morning I received my daily “Eurointelligence” newsletter that updates me on the main macroeconomic issues in Europe. It said: 

“Dear Readers,

The flow of good economic and news and commentary affecting the euro area has reduced to a trickle, so that we have decided to take a holiday. The news briefing will return on Monday, August 17.”

Happy holidays!

Please see previous blog post. I am adding this one to complement the discussion. Someone drew my attention to this very interesting article in the NY Times on a European welfare system ( a case study of the Dutch system) as seen by a US expatriate. “Going Ducth”, by Russell Shorto. It has a rather positive outlook on the system. If I may, I am adding that the Dutch system cannot be compared with crumbling systems in other EU countries, further south, which have not, contrary to the Dutch, been able to modernize as well and integrate the dynamic elements of more market-based principles into their economies and the welfare system itself. Furthermore, the protestant collectivism he sees is a bit less prevalent in more Latin cultures further down south, such as the one I know best, the French one… Yet, sitting in, Brussels, the abode of Europeanism and a place where “social Europe” is a mantra, let me highlight the problems the author sees with it:

Something about this place rekindles the existential rage of my youth. Why are we here? How does a person achieve contact with his soul? Or in somewhat less grandiose terms: What do you do with yourself on a lazy Sunday afternoon? You pop into a shop. You sit at a cafe and read. You linger in a bookstore. Is this not why we have cities? Alas, such activity is largely impossible on a Sunday in my adopted city. A collusion of two forces in the mid-20th century — the workers’ movement and the church — resulted in a policy of restricted business hours, and the conservative Dutch system is resistant to change. The supermarket in my tiny hometown in western Pennsylvania is open 24 hours a day. I challenge you to find anything open 24 hours a day in this supposedly world-class city. Indeed, most shops close by 6 p.m. — precisely when people leaving work might actually want to patronize them.

This rant has a couple of deeper points behind it. For one, the sameness suggests a homogeneous population, which the Netherlands long had. A broad social-welfare system works if everyone assumes that everyone else is playing by the same rules. Newcomers, with different ways of life and expectations, threaten it. This is one reason the recent waves of non-Western immigration have caused so much disturbance. Can such a system work in a truly multiethnic society?

Then, too, one downside of a collectivist society, of which the Dutch themselves complain, is that people tend to become slaves to consensus and conformity. I asked a management consultant and a longtime American expat, Buford Alexander, former director of McKinsey & Company in the Netherlands, for his thoughts on this. “If you tell a Dutch person you’re going to raise his taxes by 500 euros and that it will go to help the poor, he’ll say O.K.,” he said. “But if you say he’s going to get a 500-euro tax cut, with the idea that he will give it to the poor, he won’t do it. The Dutch don’t do such things on their own. They believe they should be handled by the system. To an American, that’s a lack of individual initiative.”

 

Another corollary of collectivist thinking is a cultural tendency not to stand out or excel. “Just be normal” is a national saying, and in an earlier era children were taught, in effect, that “if you were born a dime, you’ll never be a quarter” — the very antithesis of the American ideal of upward mobility. There seem to be fewer risk-takers here. Those who do go out on a limb or otherwise follow their own internal music — the architect Rem Koolhaas, say, or Vincent Van Gogh — tend to leave.”

There is much talk about the US becoming “French“, “Swedish“, “socialist”….  because of its ongoing healthcare reform, stepped-up government intervention and high levels of public spending. This while the EU is having centre-right governments struggling to push through unpopular market-oriented reforms to boost economies that are lagging behind the US in dynamism. These are less prone to big hikes in public spending to sustain their economies in the ongoing crisis (not least because of a legacy of high levels of public debt and bigger welfare states).

The Wall Street journal today had an interesting feature comparing the fate of a laid-off industry worker in the US and in Germany and how the social systems in both countries affect their current well-being. Predictably: health care is the great dividing line. The US American also feels the crunch financially now, whereas the German has about one year to substantially start feeling the pain. Yet when reading the article with care one cannot avoid the impression that it looks overall rather equally tough on both sides, when it comes to uncertainty over the future. Which econonomy will ultimately be able to create jobs more quickly? seems therefore to be the fundamental question.

But are social systems between the US and EU so much different than is generally assumed? An article by the academic Peter Baldwin in Prospect Magazine this month says No. A highly recommended read. It certainly smashes a few deeply ingrained mutual (positive and negative) prejudices. Below a few highlights, but if you can, do take time to read the article, freely available online, in full:

“It is universally observed that America is an economically more unequal society than Europe, with greater stratification between rich and poor. Much of this is true. Income is more disproportionately distributed in the US than in western Europe. In 1998, for example, the richest 1 per cent of Americans took home 14 per cent of total income, while in Sweden the figure was only about 6 per cent. Wealth concentration is another matter, however. The richest 1 per cent of Americans owned about 21 per cent of all wealth in 2000. Some European nations have higher concentrations than that. In Sweden—despite that nation’s egalitarian reputation—the figure is 21 per cent, exactly the same as for the Americans. And if we take account of the massive moving of wealth offshore and off-book permitted by Sweden’s tax authorities, the richest 1 per cent of Swedes are proportionately twice as well off as their American peers.

What about poverty, not the same thing as inequality? Because inequality is greater in America, relative poverty is by definition also higher. But absolute poverty rates look different. If we take absolute poverty to be living on the actual cash sum equivalent to half of median income for the original six nations of the EU, we see that many western European countries in 2000 had a higher percentage of poor citizens than the US; not only Mediterranean countries, but also Britain, Ireland, France, Belgium, the Netherlands, Finland and Sweden. Unemployment benefits in the US, often portrayed as derisory in the European media, are actually higher than in many European nations. Greece, Britain, Italy and Iceland spend less than the US on unemployment, measured per capita.

The US welfare state is often portrayed as miserly and undeveloped compared to Europe. And so it is, if the standard is taken to be Sweden or Germany. But if we look at the span of social policy across Europe, a different picture emerges.

(…)

Yet despite the too large fraction of those who are not insured, Americans are relatively healthy and well-serviced by their healthcare system—to judge by disease survival rates. For diabetes, heart and circulatory disease and strokes, the incidence rates and the number of years lost to sickness are firmly in the middle of the European spectrum. And for the four major cancer killers (colorectal, lung, breast and prostate), all European nations have worse survival rates than the US.

Looking also at other forms of social policy, we see that the US fits broadly into the lower half of the European spectrum. As with its unemployment assistance, US spending on disability benefits is higher than in Greece and Portugal per capita, and practically at the same level as France, Italy, Ireland and Germany. (All figures used for comparison here account for differences in costs of living). State pensions in the US may fall into the lower half of the European spectrum. But examine instead the total disposable income of the retired in America as a percentage of what the still active receive. Only in Austria, Germany and France do the elderly fare better.

It is commonly known that the American state does not help out much in terms of family provision. Parental leave is not statutory and there are no guarantees that women can reclaim their jobs after pregnancy. Family allowances as such do not exist. On the other hand, if one counts resources channelled via the tax credit system, as well as outright cash grants and services, and if one measures them as a percentage of GDP, the US ranks higher than Spain, Greece and Italy for family benefits. Public spending on childcare (daycare and pre-primary education) puts the US into the middle of the European scale. Total spending on pre-primary care per child is higher than anywhere but Norway.

True, public social spending in America—that is, monies channelled through the state—is low compared to many European countries. But other avenues of redistribution are equally important: voluntary efforts, private but statutorily encouraged benefits (like employee health insurance) and taxes. Given all of these, the American welfare state is more extensive than is often realised: the total social policy effort made in the US falls precisely at the centre of the European scale.”

Who said IMF economists were bad guys serving the interests of financial globalization?

Simon Johnson, former IMF Chief Economist, is coming out in May’s edition of The Atlantic with a fascinating, highly provocative piece, on the collusion between the US’ “financial oligarchy” and the US government and how its persistence will contribute to prolonging the economic crisis. A long, but highly recommendable read. A few morceaux choisis:

One thing you learn rather quickly when working at the International Monetary Fund is that no one is ever very happy to see you (…)

The reason, of course, is that the IMF specializes in telling its clients what they don’t want to hear.(…)

No, the real concern of the fund’s senior staff, and the biggest obstacle to recovery, is almost invariably the politics of countries in crisis. (…)

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders (…)

Many IMF programs “go off track” (a euphemism) precisely because the government can’t stay tough on erstwhile cronies, and the consequences are massive inflation or other disasters. A program “goes back on track” once the government prevails or powerful oligarchs sort out among themselves who will govern—and thus win or lose—under the IMF-supported plan. (…)

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (…).

(…) elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations.

(…) the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. (…)

One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, once the co-chairman of Goldman Sachs, served in Washington as Treasury secretary under Clinton, and later became chairman of Citigroup’s executive committee. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury secretary under George W.Bush. John Snow, Paulson’s predecessor, left to become chairman of Cerberus Capital Management, a large private-equity firm that also counts Dan Quayle among its executives. Alan Greenspan, after leaving the Federal Reserve, became a consultant to Pimco, perhaps the biggest player in international bond markets.

A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true (…).

By now, the princes of the financial world have of course been stripped naked as leaders and strategists—at least in the eyes of most Americans. But as the months have rolled by, financial elites have continued to assume that their position as the economy’s favored children is safe, despite the wreckage they have caused (…)

Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here. In September 2008, Henry Paulson asked Congress for $700 billion to buy toxic assets from banks, with no strings attached and no judicial review of his purchase decisions. Many observers suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands—indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that plan was shelved.

Instead, the money was used to recapitalize banks, buying shares in them on terms that were grossly favorable to the banks themselves. As the crisis has deepened and financial institutions have needed more help, the government has gotten more and more creative in figuring out ways to provide banks with subsidies that are too complex for the general public to understand (…)

The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary (…)

In some ways, of course, the government has already taken control of the banking system. It has essentially guaranteed the liabilities of the biggest banks, and it is their only plausible source of capital today.

Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical—since we’ll want to sell the banks quickly—they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.

This may seem like a crude and arbitrary step, but it is the best way to limit the power of individual institutions in a sector that is essential to the economy as a whole. Of course, some people will complain about the “efficiency costs” of a more fragmented banking system, and these costs are real. But so are the costs when a bank that is too big to fail—a financial weapon of mass self-destruction—explodes. Anything that is too big to fail is too big to exist.

To ensure systematic bank breakup, and to prevent the eventual reemergence of dangerous behemoths, we also need to overhaul our antitrust legislation (…)

Caps on executive compensation, while redolent of populism, might help restore the political balance of power and deter the emergence of a new oligarchy. (…)

(…) Over time, though, the largest part may involve more transparency and competition, which would bring financial-industry fees down. To those who say this would drive financial activities to other countries, we can now safely say: fine”.

The Gramscian tones coming out of this piece certainly reveal the scale of the ideological crisis, and potentially, shift, occurring right now as the economic crisis unfolds. I tend to think Johnson’s views have a few weaknesses:

The first is an apparently not completely thought-through assessment of a government’s capacity to take control of an entire financial system, and to clean, slice it up and re-privatize it impartially. The risks of more governmental control are precisely what he is denouncing in his entire piece: growing, potentially corrupt, collusion between business elites and government officials.

Second weakness is that he thinks, quite optimistically, that it will be easy to replace current bank managements.  As Daron Acemoglu pointed out recently, we are in a situation of skill scarcity in financial markets. Any attempt to fix the financial system will have to involve those same bankers that created the mess in the first place. To push the analogy a bit strongly, Germany post 1945 and Iraq post 2003 still needed to work with some civil servants in the judicial and educational system that worked for the previous system, or with tainted industrialists. An unfortunate situation, but US liberators/occupiers couldn’t really help it.

In theory, the best way to dimimish the power of financiers is to let them fail and crash badly. Their clout and credibility will diminish accordingly. In practice it’s difficult to let this crash happen, given the stakes at hand – credit, mortgages, pensions, etc. Yet if the recent wave of globalisation has put a premium on returns to the financial sector, it might well be that the crisis is a welcome clean-up. One already starts reading here and there that jobs, wages, and skills will progressively shift elsewhere in the economy, letting the financial sector become a more “normal” sector, competing for skills equally with others and no longer attracting ambitious people by its previous lure. Nationalizations or not.