Teetering between Keynes and Friedman

TheGlobeandMail.com – opinion – Teetering between Keynes and Friedman
September 16, 2008. ROBERT SKIDELSKY

The looming bankruptcy of Lehman Brothers and the forced sale of Merrill Lynch, two of the greatest names in finance, marks the end of an era. But what’s next?

Cycles of economic fashion are as old as business cycles, and are usually caused by deep business disturbances. “Liberal” cycles are followed by “conservative” cycles, which give way to new liberal ones, and so on. Liberal cycles are characterized by government intervention and conservative cycles by government retreat. A long liberal cycle stretched from the 1930s to the 1970s, followed by a cycle of deregulation that seems to have run its course.

With the nationalization of American mortgage giants Fannie Mae and Freddie Mac, and the February nationalization of Britain’s Northern Rock, governments are stepping in again. The heady days of conservative economics are over for now.

Each cycle is triggered by crisis. The last liberal cycle, associated with the New Deal and economist John Maynard Keynes, was triggered by the Great Depression, although it took massive wartime government spending to get it properly going. During this era, governments in the capitalist world managed and regulated their economies to maintain full employment and moderate business fluctuations. The new conservative cycle was triggered by 1970s inflation. Milton Friedman, the economic guru of that era, asserted that the deliberate pursuit of full employment was bound to fuel inflation. Governments should concentrate on keeping money “sound” and leave the economy to look after itself. The “new classical economics” taught that, in the absence of egregious government interference, economies would gravitate naturally to full employment, greater innovation and higher growth rates.

The current crisis reflects the massive buildup of bad debt that became apparent with the subprime crisis, which has now spread to the whole credit market. “Think of an inverted pyramid,” investment banker Charles Morris has written. “The more claims are piled on top of real output, the more wobbly the pyramid becomes.”

When the pyramid starts crumbling, taxpayers must step in to refinance the banking system, revive mortgage markets and prevent economic collapse. But once government intervenes on this scale, it usually stays for a long time.

At issue is the oldest unresolved dilemma in economics: Are market economies “naturally” stable or do they need to be stabilized by policy? Keynes emphasized the flimsiness of the expectations on which economic activity in decentralized markets is based. The future is inherently uncertain; investor psychology is fickle.

“The practice of calmness, of immobility, of certainty and security, suddenly breaks down,” Keynes wrote. “New fears and hopes will, without warning, take charge of human conduct.” This is the “herd behaviour” that George Soros has identified as the dominant feature of financial markets. It is the government’s job to stabilize expectations.

The neo-classical revolution held that markets were much more cyclically stable than Keynes believed, that the risks in all market transactions can be known in advance, that prices will therefore always reflect objective probabilities.

Such market optimism led to deregulation of financial markets in the 1980s and 1990s, and the subsequent explosion of financial innovation that made it “safe” to borrow larger and larger sums on the back of predictably rising assets. The just-collapsed credit bubble, fuelled by so-called special investment vehicles, derivatives, collateralized debt obligations and phony triple-A ratings, was built on the illusions of mathematical modelling.

Liberal cycles, historian Arthur Schlesinger believed, succumb to the corruption of power, conservative cycles to the corruption of money.

Both have their characteristic benefits and costs. But if we look at the historical record, the liberal regime of the 1950s and 1960s was more successful than the conservative regime that followed. Except for China and India, whose economic potential was unleashed by market economics, economic growth was faster and much more stable in the Keynesian golden age than in the age of Friedman; its fruits were more equitably distributed; social cohesion and moral habits better maintained. These are serious benefits to weigh against some business sluggishness.

Of course, history never repeats itself exactly. Circuit-breakers are in place nowadays to prevent a 1929-style slide. But when the system seizes up as it has now, we are clearly in for a new round of regulation.

The cycles in economic fashion show how far economics is from being a science. One cannot think of any natural science in which orthodoxy swings between two poles. What gives economics the appearance of a science is that its propositions can be expressed mathematically by abstracting from the real world.

The classical economics of the 1920s abstracted from the problem of unemployment by assuming that it did not exist. Keynesian economics, in turn, abstracted from the problem of official incompetence and corruption by assuming that governments were run by omniscient, benevolent experts. Today’s “new classical economics” abstracted from the problem of uncertainty by assuming it could be reduced to measurable, hedgeable risk.

A few geniuses aside, economists frame their assumptions to suit existing states of affairs, then invest them with an aura of permanent truth. They are intellectual butlers, serving the interests of those in power, not vigilant observers of shifting reality. Their systems trap them in orthodoxy.

When events coincide with their theorems, the orthodoxy they espouse enjoys its moment of glory. When events shift, it becomes obsolete. As Charles Morris wrote: “Intellectuals are reliable lagging indicators, near-infallible guides to what used to be true.”

Lord Skidelsky is professor emeritus of political economy at Warwick University, England, and author of a prize-winning Keynes biography.

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