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Book blogging: Introduction

July 18th, 2009

Discussion on the first post in this series went really well, so I’m carrying on. Here’s the proposed introduction.1 Again, comments, both favorable and critical are very welcome and the best will be rewarded with a copy of Dead Ideas from New Economists (I’m back with the original title at present).


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

It might be thought, more than 200 years after Adam Smith’s Wealth of Nations set out the classical framework that still guides much economic thought, that economics might have progressed beyond the stage conflict over basic ideas. But economic ideas do not develop in a historical vacuum. Big changes in economic thinking depend on major events such as economic crises, and such events occur only rarely.

The Great Depression of the 1930s was such a crises and it produced a revolution in economic thinking still associated with the name of its originator, John Maynard Keynes. Responding to what he perceived as the absurdity of a classical economic theory proclaiming that a market economy would inevitably return to full employment ‘in the long run’, Keynes observed tartly that ‘in the long run we are all dead’. In his General Theory of Employment, Interest and Money, Keynes developed a model of the economy in which high levels of unemployment could represent a persistent equilibrium. The classical full employment model was reduced to a special case of Keynes ‘General Theory’.

In the hands of Keynes’ successors, such as John Hicks, the Keynesian model of the aggregate economy became the new subject of ‘macroeconomics’, contrasted with the classical model of individual makrets, now christened ‘microeconomics’. Hicks produced a graphical synthesis of Keynesian and classical macroeconomic ideas, taught to generations of students as the IS-LM model after the two curves on which it relied. In the process, Hicks relied heavily on some of Keynes’ ideas, but ignored or discarded others, much to the dismay of more purist Keynesians such as Joan Robinson.

Whether or not it was entirely true to Keynes, the Hicks synthesis produced a theoretical framework to justify policies Keynes had long advocated, of using public works programs and other fiscal policy (that is, changes in tax rates and public expenditure) measures to stimulate demand for goods and services during periods of recession. Conversely, as Keynes argued in How to Pay for the War, the government should use budget surpluses in periods of strong economic growth to restrain demand and reduce the risk of inflation.

The combination of Keynesian macroeconomics and neoclassical microeconomics provided both an ideological justification for the ‘mixed economy’ that emerged after World War II and a set of practical policy tools for its economic managers. The mixed economy was, arguably, the first and most successful example of a ‘Third Way’ between the traditional antagonists of socialism and unrestrained capitalism. The increased macroeconomic role for government went hand in hand with the postwar expansion of the welfare state, already anticipated by such developments as the New Deal in the United States, and the anti-depression policies of social-democratic governments in such far-flung countries as Sweden and New Zealand.

The contrast between the privations of the Depression and war years and the prosperity of the 1950s and 1960s was striking, and transformed the political landscape in the developed world. The laissez-faire doctrines of economic liberalism were discredited, seemingly forever. While conservative parties continued to employ the rhetoric of the free market, the social-democratic reforms adopted in response to the Depression formed the basis of political consensus.
For the next thirty years, the combination of Keynesian macroeconomics and the liberal and social democratic versions of the welfare state were associated, at least in the developed world with strong economic growth, full employment, enhanced equality and improvements in public services of all kinds. It was these developments, and not the posturing of the Reagan era, that guaranteed the defeat of Communism.

During these decades, the victory of the Keynesian revolution was universally recognised and generally perceived as final, despite the grumbling of a relative handful of neoclassical critics, centred on the University of Chicago, and, on the left, an even smaller handful of post-Keynesians and Marxists who derided the new synthesis and its tools as ‘hydraulic Keynesianism’ and ‘a permanent war economy’.

But by the late 1960s, a counter-revolution was brewing. Inflation rates were rising, and the most compelling analysis of the problem was provided by Chicago economists such as Milton Friedman, who argued that expansion of the money supply would inevitably cause inflation, whatever fiscal policy responses Keynesians might propose.

The economic chaos of the early 1970s, including the breakdown of the ‘Bretton Woods’ postwar system of fixed exchange rates, the OPEC oil shock was seen as vindicating Friedman. The biggest blow to Keynesianism was ‘stagflation’, the simultaneous occurrence of high unemployment and high inflation. In the standard Keynesian model of the day, which postulated a trade-off between unemployment and inflation (the famous ‘Phillips curve’), this could not occur. Friedman’s model, which took into account expectations of inflation that were incorporated into wage bargains, appeared to explain stagflation.

In the space of a few years, Friedman’s ‘monetarist’ macroeconomic policies had largely displaced Keynesian demand management. But the counter-revolution did not stop there. In macroeconomic theory, Friedman’s relatively modest (and empirically well-founded) changes to the Keynesian IS-LM model were succeeded by a full-scale return to the orthodoxy of the 19th century, under the banners of ‘rational expectations’ and ‘new classical’ macroeconomics.

Friedman’s macroeconomic success prompted widespread acceptance of the free-market views on microeconomic issues he had long advocated both in academic research and in popular works such as Free to Choose and Capitalism and Freedom. Other advocates of the free market such as FA von Hayek enjoyed a similar vogue. The new version of free market ideology that emerged from the 1970s has been given various (mostly pejorative) names such as neoliberalism, Thatcherism and economic rationalism. I prefer the more neutral term ‘economic liberalism’.

Speculative activity in financial markets had been seen by Keynesians as a crucial source of economic instability. During the Bretton Woods stringent controls were imposed on national financial markets and international capital flows. During and after the monetarist counter-revolution, these controls broke down, ushering in an era of financial deregulation. Over the ensuing decades, the financial sector, a minor and tightly controlled industry during the postwar years, experienced an explosion in the volume and complexity of trade, the profitability of the industry and the lavish rewards to industry participants.

This development called for, and received theoretical support from the economics profession in the form of the efficient markets hypothesis. Building on the relatively innocuous observation that the efforts of stockmarket ‘chartists’ to predict the future movements of stock prices from their past behavior were futile, the efficient markets hypothesis was developed to the point where it was seriously suggested, in the wake of the September 2001 attacks, that the best way to predict terrorist attacks would be to open a futures market.

The general acceptance of the anti-Keynesian counter-revolution was predicated first on the necessity for a way out of the economic chaos of the 1970s and early 1980s and then on the widespread prosperity it delivered from the 1990s onwards. Although problems became steadily more evident, they were ignored as long as profits kept rising and economic growth kept on keeping on.

The economic crisis that began in the US housing market in 2007 and had engulfed global financial markets by late 2008 showed clearly enough that there was something wrong with the dominant economic paradigm. While old-fashioned Keynesians on the left, and advocates of the Austrian School on the right, had pointed to growing economic imbalances as a source of impending disaster, economic liberals continued until well into 2008 to argue that any problems were minor and easily contained.

While it may be satisfying to observe that so many experts got the crisis wrong, it is not really useful. The big question is “What economic doctrines have been refuted by the crisis and what new doctrines (or improved versions of older doctrines) should replace them?”. This book aims to answer the first of these questions, and to provide at least some suggestions on the second.

1 I’ve been out of order so far, but, after correcting with this post, I plan to offer excepts in the order I want them to appear.

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  1. boconnor
    July 18th, 2009 at 08:28 | #1

    JQ – Excellent introduction. Looking forward to the next chapter.

  2. Alice
    July 18th, 2009 at 08:40 | #2

    Its a great introduction JQ. Ill second BOConnor. Except I think “the anti Keynesian counter revolution” delivered prosperity unequally (after the 1980s and 90s) so it wasnt widespread in the usual sense of the word. It mostly flowed to higher income earners after the 90s.

  3. Ernestine Gross
    July 18th, 2009 at 09:31 | #3

    JQ, you refer to the 2007-08 financial crisis. However, there have been financial crises in various countries and regions for at least 20 years. It seems that only when the geographically mapped time series of crises converges to the financial centre, represented by the term ‘Wall Street’, is ‘the global economy’ prepared to look.

    A technical matter. To the best of my knowlege there are two quite distinct approaches to ‘rational expectations’, namely Lucas-type and Radner-type. IMHO, the distinction is important because it seems to me it is the former that entered policy discussions.

  4. July 18th, 2009 at 12:25 | #4

    Pr Q says:

    For the next thirty years, the combination of Keynesian macroeconomics and the liberal and social democratic versions of the welfare state were associated, at least in the developed world with strong economic growth, full employment, enhanced equality and improvements in public services of all kinds. It was these developments, and not the posturing of the Reagan era, that guaranteed the defeat of Communism.

    Yes, thats why the Chinese CP collapsed after the student uprising in Tianamen square. The students were protesting about the governments niggardly provision of public services and Friedmanite macro-economics…Hmm…maybe in some alternative universe.

    Seriously, I think Pr Q would do well to lose the tendentious conclusion to this paragaraph. Its based on a shaky pyramid of dubious propositions and will tend to alienate, rather than convince, the kind of people he is seeking to persuade.

    In fact, the collapse of communism came in the late eighties, at a time when Keynsian macro-economics and Beveridgian social policy was at an absolute low point in both East and West . This triggered a global wave of privatisations and a gutting of welfare state in both systems. Exactly the opposite to what Pr Q’s Keynsian interpretation of the Cold War would predict.

    The Communist Party’s legitimacy was based on its capable administration of the Soviet Russian warfare state, particularly the Wermacht-beating Red Army. May Day parade celebrated Soviet military might, not socialist brotherhood.

    Soviet communism collapsed because Russian elites could no longer advance their global power and privilege using the socialist warfare state. So they turned to the capitalist wealthfare state. The Russian peoples desire for a welfare state had little or nothing to do with this world-historical change. Ditto in China.

    The US military-industrial complex out-spent and and out gunned its USSR counter-part in a series of strategic contests (Space Race, stealth and smart weapons, F15 dog-fights in the Bekkah Valley, panzer battles in Gulf War I). “Reagan’s posturing” in the IRBM strategic missile contest drove the final nail into the coffin of the Soviet warfare state. Ably assisted by his fellow Cold War “posturers”, Thatcher, Kohl and Tanaka.

    By all means bash questionable parts of Reagan’s economic policy. But trying to score foreign policy points against the guy who hastened the dismantling of the Berlin Wall is a mugs game which only invites derision.

  5. Kevin Cox
    July 18th, 2009 at 14:49 | #5

    Your quote from Keynes could be changed by replacing “practical men” with “economists” and replacing “some defunct economist” with “an outdated accounting system”.

    I have been discussing for some time both here and elsewhere about mechanisms for creating money that does not require debt to be generated. No matter how much I pointed out that money is not the same as a loan – how many examples of how we can create money without creating a loan – I have been getting nowhere.

    I had one of those moments when it became clear why people cling to the concept. It is the technique of double entry bookkeeping that is the problem. If you think the economy has to be accounted for using double entry bookkeeping then you have to have some mechanism for getting the other entry when you create some money. Simply creating money out of thin air is deemed “irresponsible” and will lead to many bad outcomes.

    Similarly economics which uses double entry bookkeeping principles to determine states of stable equilibrium will have difficulty handling a growing economy.

    This has directly lead to the absurd situation of governments allowing banks to create money through debt and then the governments borrowing from the banks. This is unnecessary and the government can spend its way out of a fiscal crisis without a single loan being created. This has also lead to the promulgating of the idea of putting a price on pollution to solve the ghg issue instead dropping the cost of renewables by creating money with zero interest and no repayment period and requiring the money to be invested in ways of producing renewable energy.

    Double Entry Bookkeeping as the basis for controlling macro economic issues has had its day and economists should learn to handle the magic pudding of growth through investment. That is, equilibrium state models implied by double entry bookkeeping can be improved upon as the foundation for economic modelling.

  6. David
    July 18th, 2009 at 15:15 | #6

    Some of Keynes’ important macroeconomics concepts in fact pre-date the depression. For example, The Economic Consequences of the Peace Keynes (1920) analyses the consequences of the heavy taxation imposed on the German economy following WW1 by the Treaty of Versailles. Who knows if this book had been more widely read there might not have been a WW2?

  7. Don Arthur
    July 18th, 2009 at 20:16 | #7

    The combination of Keynesian macroeconomics and neoclassical microeconomics provided both an ideological justification for the ‘mixed economy’ that emerged after World War II and a set of practical policy tools for its economic managers. The mixed economy was, arguably, the first and most successful example of a ‘Third Way’ between the traditional antagonists of socialism and unrestrained capitalism.

    Arguably. But another view is that the first and most successful example of a ‘Third Way’ emerged in Germany after World War II independently of Keynes’ influence. The German ‘Third Way’ was known as ‘neoliberalism’ and some of its leading proponents were members of the Mont Pelerin society.
    Wilhelm Ropke’s 1942 book ‘The Social Crisis of our Time’ is a good place to start.
    Ropke attacked both socialism and laissez-faire capitalism. Like other German neoliberals he argued that there was no single capitalist model. Capitalism varied from country to country and from epoch to epoch (p 113).
    The market is always shaped by the laws and institutions which govern it and by what takes place in non-market spheres of society (eg social norms). He wrote:

    …it was a catastrophic mistake to consider the market system as something autonomous, something based on itself, as a natural condition outside the political sphere requiring no defense or support and to overlook the importance of an ethical, legal and institutional framework corresponding to the principles of the market system (p 118).

    He argued that “undiluted capitalism is intolerable, and among other things this is apparent from the deep dissatisfaction which the commercialization of arts, sciences, education, or the press rouses in us” (p 119).
    Human beings need more than material goods and this, said Ropke, put limits on the market:

    … men cannot bear, without excessive harm to themselves and to society, the constant mental, nervous and moral tension which is forced upon them by an economic system dominated by supply and deman, market and technology, nor can they withstand the insecurity and instability of the living conditions which such a system entails. The sum total of the material goods at our disposal may increase through this process, and the often cited living standard may reach those heights which intoxicate a naive social philosophy, but at the same time this leads to a rapid diminution of the sum of that immeasurable and inexpressible simple happiness which men feel in doing satisfying work and leading purposeful lives.
    Man’s nature, therefore, sets definite limits to the rule of the market principle and in the same way as democracy must permit spheres free from the interference of the state, if it is not to degenerate into the worst kind of despotism, the market system, too, must allow spheres free from the influence of the market, if it is not to become intolerable: there must be the sphere of community life and altruistic devotion, the sphere of self sufficiency, the sphere of small and simple living conditions and the sphere of the state and of planned economy (p 119).

    Ropke also recognised that economic crises could emerge from the mechanism of the market economy itself — not always from something outside (p 121). He stressed the importance of regulation and the prevention of large accumulations of wealth and power. It was vitally important that corporations were not able to manipulate the political system for their own private ends.
    The key to the ‘Third Way’ was to avoid intervening in the economy in a way that undermined the benefits of competition and the division of labour. Ropke supported adjustment packages to help producers withdraw from declining industries but opposed policy instruments like tariffs and subsidies that were designed to frustrate competition and postpone adjustment.
    In most ways Ropke was solidly neoliberal. He wanted to wind back the welfare state, put industry into private hands, abolish tariff protection and foster competition. But his neoliberalism was not laissez-faire of classical liberalism. That’s why he called it a ‘Third Way’.
    German neoliberals like Ropke helped create Germany’s social market model during the late 1940s. Over time there was some influence from Keynesian ideas, but the origins of the social market are quite separate from Keynesianism.
    It seems to me that the influence of Keynes is overstated. Sweden is another example.

  8. philip travers
    July 18th, 2009 at 22:56 | #8

    All that glitters isn’t gold.To get the gold,requires any number of methods,that have occured over many years.Gold did not create the technology, method, mine creek or deposit.Practical people don’t really want to know who is setting the intrinsic value of whatever exchange of value takes place,until life experience, or understandings other than value exchange require that as a necessity.I mean to say,why would anyone become a motor mechanic,when, they could be anti-social forever trying to find a nugget!? Many times it is stated about how the U.S.A. economy is destroying the hope of others in countries great distances away.Since the day of Keynes onward,there would not be one financial year,where strange accounting,call it economics has eluded the Defence areas.Didn’t the Rome Empire even the Greek Democracy have some strange economics when it came to Defence!? Practicality for most people doesn’t imply expenditure,but getting at least the thing done,because the expenditure proved essentially useless.Thus transaction value is determined by the intrinsic value of the good,rather than the expressed at sale or distribution value.People still make mud brick places today.The capacity of tools to do this more effectively,are not making the composition of mud-brick bricks dependent on a regularity of purchase directly with a number of bricks,as maybe the case with other materials.Maybe there is various versions of practicality,that require more accounting and efficiency or economising.

  9. gerard
    July 18th, 2009 at 23:39 | #9

    is there a date for this book?

  10. TerjeP (say tay-a)
    July 19th, 2009 at 01:09 | #10

    To say that post 1970 deregulation lead to an explosion of destabilising financial innovation is in my book a case of not seeing the forest for the trees. The key factor in the post war period that ensured financial stability was a gold standard and the associated fixed exchange rates. One hardly needs much in the way of hedging or forex derivatives either directly or as part of packaged wholesale loan schemes that transfer credit across borders when the world shares a common fixed and stable unit of account. Deregulation may have allowed a lot of innovation and there may have been a lot of instability but suggesting a causal linkage from the first to the second is in my view completely wrong. Ending the global gold standard and adopting a perverse (and still persistant) system of floating national accounting units created the hightened financial instability and the speculative flows that we have endured ever since, whilst financial innovation merely attempted to deal with the instability and to take advantage of it for profit. Heightened financial innovation is a symptom of the now sick and unstable system not a cause.

    Keynes was one of the architects of the Bretton Woods gold standard. He even foresaw the ultimate institutional weakness in having the US dollar as the centre piece of the system and fought, unsuccessfully, to avoid this aspect of the plan. For all this he deserves much credit. He ought to get it.

  11. SeanG
    July 19th, 2009 at 02:02 | #11

    Terje, it is even more subtle than that.

    Financial innovation goes hand-in-hand with the growth in technological development broadly and within banks. Do you think that the old computers can handle the volume of data to put together a Monte Carlo simulation? Or how about putting together an algorithm for trading strategies or modelling convexity in options within retail banks? Technological innovation has been critical. All aspects interacted but the simplistic version is welcomed by people who are suffering from confirmation bias.

  12. jquiggin
    July 19th, 2009 at 06:53 | #12

    Don, I agree that the influence of Keynes was greatest in the English speaking countries, and with what you say about the German social market economy. Sweden I’d regard as having developed a Keynesian form of social democracy independent of Keynes. I might have space in my next book for a more detailed discussion of these points, but for the purposes of a popular book in English, I think my statement is fair enough.

    Terje, you make a good point re the dollar peg, though of course Keynes also opposed a gold standard.

  13. cjoye
    July 19th, 2009 at 10:19 | #13

    Generally excellent. This as yet unsubstantiated comment stuck out like a bull’s balls, and will inevitably need clarification:

    “It was these developments, and not the posturing of the Reagan era, that guaranteed the defeat of Communism.”

  14. Paul H
    July 19th, 2009 at 11:01 | #14

    @Jack Strocchi

    Jack – musn’t discount the role of macro in leading to the unrest in China in the late 80s – according to the official stats inflation was running at 17-18% p.a. in those years. Sure, the chants weren’t “what do we want? a stable price level and full employment! when do we want it? now” – but this has to be one of the causes.

    John – without claiming that “It was these developments, and not the posturing of the Reagan era, that guaranteed the defeat of Communism.” you could certainly point out how the inability to control macroeconomic conditions certainly undermined the legitimacy of both capitalist (crisis of confidence / stagflation in the 1970s) and communist (up to the 1980s) regimes.

  15. cjoye
    July 19th, 2009 at 11:03 | #15

    Some stream-of-consciousness comments on the first excerpt of your proposed book, Dead Ideas from New Economists:

    1) Great opening quote—very germane;
    2) At some point it may be useful to deal with the Grossman-Stiglitz qualifications to the EMH;
    3) I think it’s also interesting to note that Stiglitz’s contemporary policy positions may conflict somewhat with the theoretical findings in this early 1980s paper;
    4) What is just as interesting is that Sanford Grossman very much falls into the camp of economists that have made large amounts of money trading financial markets (which you refer to)—he set up his own very successful hedge fund;
    5) A key paradox at the heart of the EMH, which I have seen little discussion of elsewhere, is as follows. First, one of the EMH’s critical conclusions is that you cannot systematically outperform “the market” (as proxied by an index) after taking account of transaction/search costs (where the latter derives from G-S above);
    6) This finding of Fama et al’s (I think it can be traced back to Harry Roberts) has in turn been used to develop a trillion-dollar plus “indexed” or passive investment industry. That is, the so-called indexed or “tracker” investment funds, which now dominate retail and institutional share investing (note that the average Australian super fund has an incredible 60% plus weight to equities);
    7) The biggest of these funds groups are Vanguard, Barclays Global Investors, State Street, and Dimensional Fund Advisors (off the top of my head);
    8) Dimensional Fund Advisors (DFA) was founded in part by Eugene Fama, one of the early proponents of the EMH (I remember the days in the late 1990s when financial economists thought he would win a Nobel Prize for his work);
    9) Eugene’s son works full-time for DFA, while Fama himself sits on one of the boards (all these facts are dated a few years, so you will have time to check them);
    10) The index investment industry radically altered asset-allocation globally away from the conventional approach of valuing businesses and working out whether they were worth investing in. But it is in turn heavily predicated on the validity of the EMH (you often hear Burton Malkiel and others quote the purported fact that the average mutual fund manager has underperformed the index, but the evidence is actually very murky—especially in Australia);
    11) Importantly, if you take the EMH and indexing to its extreme, that is to say, if most investment capital is allocated purely according to the weightings of a stock market index, and pays absolutely not attention to analysing the intrinsic worth of the companies in the index, then equity markets must over time become increasingly inefficient. To be clear, a passive or indexed fund is a purely naïve strategy that simply replicates, say, the allocation in the ASX/S&P 200 index. All other things being equal, taking the EMH and its industry proponents’ views to their extreme, the market effectively becomes perfectly inefficient (there must be interesting dynamics between the weight of money that is invested in an “active” or “passive/indexed” fashion—are more money is invested passively, the market becomes more inefficient, thereby increasing the returns to active managers, all other things being equal. This helps to reduce the inefficiencies in the market, and inevitably reduces the discrepancies between the strategies);
    12) Having watched this space for many years, I have seen a lot of “mission creep” in the strategies advocated by EMH/indexing world. In short, the rise of behavioral economists and the growing evidence of genuine market inefficiencies has forced these guys to offer hybrid strategies that try and get the best of both worlds (cf. DFA’s early attempts to exploit the small firm effect and the value and growth factors documented by Fama and French);
    13) I am sure there is more thought sitting behind your comment: “Although the details of intervention varied from country to country, the effect was the same everywhere. Banking in the 1950s and 1960s was a dull but secure business, resembling a public utility in many respects. Parents scarred by the Depression urged their children to look for ‘a nice safe job in a bank’”. Is there evidence to suggest that banking was not necessarily as safe and secure a business as you imply? For example, consider the long-term historical proliferation of banking crises that I document in this article for RGE;
    14) I think you need to provide more objective support for the statement: “During the decades of the long Keynesian boom, financial markets were tightly regulated, and, as a result, financial crises disappeared almost entirely from the experience and memory of the developed world”;
    15) As a final comment, I think Joshua and my paper on the notion of “liquidity as a public good”, which was an important, and I thought, initially, novel argument (it had been independently advocated by others) offers additional context to your thesis. I would also venture that the following analysis was one of the first public attempts (in Australia at least) to link the crisis back to the failures of the EMH and, crucially, a justification for government intervention:

    The Public Goods of Liquidity and Price Discovery (April 2008)

    The central tenet of this proposal is that a basic level of liquidity in key economic markets is a ‘public good’. The policy imperative here is reinforced by the fact that severe market dislocations, such as the credit crunch that we are presently observing, are becoming increasingly common and more quickly transmitted in today’s highly networked world. The presence and apparent regularity of these extreme events is consistent with recent academic innovations in the so-called ‘behavioural finance’ and ‘extreme value theory’ literatures.

    In standard finance theory, academics, and the commercial practitioners that follow their prescriptions, have all too often made the erroneous assumption (for analytical purposes) that asset returns are ‘normally distributed’ (ie, virtually never subject to events like the 1987 stock market crash or the 2001 tech wreck) and that financial markets are ‘frictionless’—ie, investors always benefit from perfect liquidity and price-discovery. These are, by way of example, some of the essential assumptions underpinning the ‘Capital Asset Pricing Model’ (CAPM), which is widely used around the world by investors and their advisors. Up until recently, the assumption of perfect liquidity and return normality were condition precedents in almost all financial models used by financial market participants.

    In the real world, however, investors are finding that they are increasingly faced with periods of profound illiquidity, extremely poor price discovery, and, in certain cases, complete market failure. In the financial market history of the last two decades, there are numerous examples of this illiquidity problem and governments acting to remedy it. In 1998 the massive hedge fund LTCM confronted severe illiquidity when the Russian government defaulted on its debt obligations, losing some US$4.6 billion in less than four months (LTCM was also hit by a sudden convergence in the ‘correlations’ of all of the assets it held, which it had previously assumed to be uncorrelated and hence well-diversified). Of course, at that time the US Fed acted to facilitate a bail-out of LTCM by a consortium of investment banks.

    In the past eight months, major institutions around the world have been subject to the specter of extreme illiquidity in the market for many of their debt securities, which has in turn made price discovery near impossible (ie, how do you value assets for which there are virtually no prices, and when prices do exist almost all participants—including the regulators and government—agree that they represent dramatic deviations from any understanding of fair market value).

    One of the primary problems here is that academics, practitioners, and regulators are discovering that financial markets are not always ‘efficient’ in the sense that was popularized by University of Chicago financial economists such as Eugene Fama33 (1965). This assumption of market efficiency has dramatically changed the financial market landscape and led, for instance, to the prolific use of ‘index’ funds provided by State Street, Vanguard and others. The market efficiency paradigm in turn hinged on the belief that investors are in aggregate highly rational ‘agents’ that are not subject to systematic behavioural biases. This assumption can in turn be traced back to the work of the US economist John Muth who developed the so-called ‘rational expectations’ theory under which individuals and institutions make forecasts about the future without any fundamental error or bias. That is, investors’ expectations are, on average, accurate. This rational expectations hypothesis has underpinned much macroeconomic analysis of the last half century.

    More recently, though, pioneering academics such as Kahneman and Tversky34 —the former of whom received the Nobel Prize in 2002— and Richard Thaler have applied principles from psychology, sociology and anthropology to document that in practice people behave in a manner that can deviate strikingly from the equilibrium predictions of the efficient markets hypothesis (and rational expectations in particular).

    This makes intuitive sense if we cast our minds back through history and consider the speculative fads and crashes of the Dutch tulip mania, the emergence of junk bonds in the early 1980s, the related 1987 stock market crash, the late 1990s tech craze and the inexorable tech wreck of 2001. Over the last 20 years a large body of evidence has built up illustrating that humans are fallible and subject to a wide range of biases, including irrational loss-aversion, framing, use of heuristic rules of thumb, hindsight biases, and cognitive dissonance (ie, avoiding information that conflicts with our assumptions).

    Many authors, such as Barberis, Shleifer, and Vishny35 and Daniel, Hirshleifer, and Subrahmanyam36 have demonstrated that there can be major mispricings, non-rational decision making, and return anomalies in financial markets due to these behavioural biases. In particular, the tendency of humans to identify fictitious ‘patterns’ in otherwise random return sequences, and for us to be consistently ‘over-confident’ in our assessment of our own forecasting abilities, can result in significant market over- and under-reactions in asset price returns (eg, consider the tech boom and subsequent crash). Behavioural economists have also found evidence of the anecdotally well-known market phenomenon of ‘herding’ and ‘groupthink’ whereby strongly anomalous market-wide effects can materialise where there is collective fear and greed (again consider the wild and seemingly irrational—at least judging by the actions of central banks—swings in the risk appetites of global debt investors before and after the US sub-prime crisis).

    It is now accepted by many economists that these behavioural biases that plague human decision-making under uncertainty can cause extreme asset price bubbles and subsequent crashes. In parallel with these innovations in the field of behavioural finance, academics have also started to accept that capital market returns are not ‘normally distributed’, but rather characterized by ‘fat-tails.’37 The presence of these fait-tails or so-called ‘black swans’ in asset returns, which suggests that extreme events (such as the 1987 crash or the current credit crunch) can occur with far greater regularity than the predictions of a ‘normal’ distribution, is also consistent with the tendency of investors to irrationally herd in one positive or negative direction, which can perpetuate clusterings of extremely positive or negative outcomes, such as that which we are observing today.

    For better or worse, it would appear that recent regulatory changes that require institutions to ‘mark-to-market’ securities that they would previously hold to ‘term’ sometimes serves to further exacerbate these liquidity crises and entrench the associated market failures (since these institutions are forced to report losses and raise equity to supplement their capital on the basis of inaccurate prices that are an artifact of irrational investor risk-aversion and the consequent unwillingness to trade).

    In the presence of highly uncertain prices, institutions are reluctant to lend to one another as they do not have sufficient visibility on the value of the collateral that they will use as security. This propagates potentially enormous problems for the financial system at large as transactions that were previously considered to be nearly risk-free are subject to perceptions of ‘counterparty risk’. This is precisely what happened with Bear Stearns, which on 10 March 2008 reportedly still had US$17 billion in cash. A few days later, the leading US investment bank Goldman Sachs announced to the world that it would no longer serve as a counterparty in Bear Stearns’ transactions. Goldman’s actions shattered confidence in Bear Stearns’ ability to service its obligations and meant that it could no longer raise any short-term debt funding to underwrite its working capital requirements. Once again, the Fed was forced to step in and inject liquidity into a market that had failed: in particular, the Fed took Bear Stearns’ otherwise illiquid and unpriceable assets as security and lent JP Morgan the US$30 billion that it needed to buy Bear Stearns.

    In 2005 paper, economists Cifuentes, Ferrucci and Hyun Song Shin,38 argue:

    When the market’s demand for illiquid assets is less than perfectly elastic, sales by distressed institutions depress the market prices of such assets. Marking to market of the asset book can induce a further round of endogenously generated sales of assets, depressing prices further and inducing further sales. Contagious failures can result from small shocks… At times of market turbulence the remedial actions prescribed by these regulations may have perverse effects on systemic stability. Forced sales of assets may feed back on market volatility and produce a downward spiral in asset prices, which in turn may affect adversely other financial institutions…In this way, the combination of mark-to-market accounting and solvency constraints has the potential to induce an endogenous response that far outweighs the initial shock.

    It should be clear that market failures and the absence of price discovery suggest that the provision of a minimum level of liquidity can be construed as a ‘public good’. While in practice it is hard for any good to unconditionally satisfy the two key conditions of a public good—namely ‘non-rivalness’ and ‘non-excludability’—many come close to approximating them (eg, the light from a lighthouse, clean air, and market infrastructures). It is well known that markets can fail to produce sufficient quantities of such goods, which is referred to as the ‘public good problem’. As a technical aside, there may be an argument that market liquidity is ‘rival’ but ‘non-excludable’, in which case it may be more appropriately classified as a ‘common pool resource’. In any event, you have similar problems to those found with public goods, albeit that in this case they are known as the ‘tragedy of the commons’.

    The argument that market liquidity has public good characteristics is an increasingly well-understood feature of the academic literature. Schwartz and Francioni39 note that a number of different ‘exchange goods’ have public good qualities. They nominate ‘price discovery’ in financial markets, wherein transaction prices are like the beam from a lighthouse. The quality of these prices in turn relies on the effectiveness of the market’s infrastructure, systems, procedures and protocols, which takes the bids and offers and transforms them into market-clearing trades that give rise to prices. Price discovery is also dependent on how the exchange discharges its self-regulatory obligations. Schwartz and Francioni assert that an exchange’s self-regulatory obligations and the provision of supplementary liquidity are other examples of ‘exchangeproduced’ public goods.

    Along similar lines, Holmström and Tirole40 address the question of whether “the state has a role in creating liquidity and regulating it either through adjustments in the stock of government securities or by other means?” They conclude that when there are liquidity shocks and “aggregate uncertainty” the private sector “…cannot satisfy its own liquidity needs. The government can improve welfare by issuing bonds that commit future consumer income…The government should manage debt so that liquidity is loosened (the value of bonds is high) when the aggregate liquidity shock is high and is tightened when the liquidity shock is low. The paper thus suggests a rationale both for government-supplied liquidity and for its active management.”

    The provision of supplementary liquidity and price stabilisation services by a government agency, such as we are seeing today with the RBA (on a limited basis that only ADIs can, in practice, benefit from), the US Fed, the Bank of England, the CHMC in Canada…is clearly consistent with the supply of the public goods of liquidity and price discovery. In short, these interventions are needed because the production of sufficient liquidity and accurate price discovery are not forthcoming in a pure market environment that is gripped for considerable periods of time by irrational investor behaviour—that is, by the complete closure of otherwise incredibly low-risk markets, such as the market for primary AAA Australian mortgage-backed securities. Importantly, the supply of liquidity and price discovery by these government agencies conveys non-rival and non-excludable benefits to all market participants.

  16. Jeff
    July 19th, 2009 at 12:28 | #16

    Good stuff. Assuming it’s pitched at the interested non-expert, minor editorial comments:
    ‘Austrian school’ – means? Hasn’t been mentioned before. Don’t tease. If it’s a reference to Hayek, say so.

    ‘The general acceptance of the anti-Keynesian counter-revolution was predicated first on the necessity…’ ‘Is predicated on’, for me, is one of those fashionable bureaucratic phrases which hovers unsettlingly around a meaning but never comes to roost. If you mean ‘…the counterrevolution was accepted because of the necessity… and then because of the prosperity…’, just say that. Best regards

  17. Donald Oats
    July 19th, 2009 at 15:21 | #17

    Perhaps have a later chapter on “Zombie Ideas”, namely ideas that are killed off by reality only to rise again in similar form? Like, “house prices never fall.”

    Good start to book.

  18. July 19th, 2009 at 15:49 | #18

    Thanks John

    I enjoyed reading this.

    I quite like Mike Kidron’s Permanent Arms Economy as an explanation for the post-war long boom,rather than some variant of Keynesianism.

    I’d suggest the collapse of the Stalinist state capitalist economies and their societies does have something to do with a bigger burden of arms spending falling on the Stalinist states. This might reflect their inability to compete militarily and economically in terms of things like production costs. (Maybe state capitalism is an historic method for dragging feudal societies up by the boot straps to become major capitalist players but was and is unable in the end to compete with the West’s more efficient exploitative processes.)

    Couple that with a dictatorial system and the entry of the masses on to the stage of history demanding political freedom and I think we have a basis for talking about the collapse of Stalinism in Russia and Eastern Europe.

    Perhaps all of this is because I too am the slave of a defunct political economist. But that particular current of thought (not Stalinism) seems missing so far from the discussion.

    In other words the defunct economists you are pitting against each other are, despite their differences, committed supporters of capitalism.

    That world view is of course perfectly legitimate and given the present state of the anti-capitalist movement around the world, seemingly appropriate.

    But I don’t think we should perceive the immediate as the eternal.

  19. Martin
    July 20th, 2009 at 01:58 | #19

    Your publisher will choose your title and your cover.

  20. Greego
    July 20th, 2009 at 06:24 | #20

    “In the long run we’ll all be dead”

    This statement sums up Keynes – superficially appealing yet inherently flawed and self-absorbed. Of course *we* may be dead but our kids and grandkids will be the ones suffering under Keynesian stagnation and debt.

  21. July 20th, 2009 at 09:19 | #21

    Arguably there’s a link from Smith to Marx, through Ricardo.

  22. David C
    July 20th, 2009 at 22:27 | #22

    This is good stuff. I became interested in economics a few years back after I picked up Paul Krugman’s “The Great Unravelling” while passing through Sydney airport. At the time I had no idea who he was, but when I finished the book I offered it to a colleague, who then told me that he was probably the only major economist to predict the Asian crisis of the late 90’s. If economics is good for anything then predicting financial turmoil would have to be up there.

    I must admit that what drew me to Krugman’s book was a doctored picture of Dick Cheney with the words “Got Oil?” scrawled across his forehead in crude. But Krugman’s writing style and his ability to communicate made for enjoyable reading. Making economics accessible to the general public is an important public service for academic economists who are able to do it well.

    It was these developments, and not the posturing of the Reagan era, that guaranteed the defeat of Communism.

    If you believe the recent conservative mythology you’d swear that Reagan had mastered the Vulcan mind meld to influence Mikhail Gorbachev into the policies of glasnost and perestroika. I’d recommend Will Bunch’s “Tear Down This Myth” for a more balanced view of Reagan’s legacy.

    Apparently upon hearing George H W Bush pledged to achieve a “kinder and gentler nation”, Nancy Reagan exclaimed “Kinder and gentler than who?”

  23. Don Arthur
    July 20th, 2009 at 23:04 | #23

    For the next thirty years, the combination of Keynesian macroeconomics and the liberal and social democratic versions of the welfare state were associated, at least in the developed world with strong economic growth, full employment, enhanced equality and improvements in public services of all kinds. It was these developments, and not the posturing of the Reagan era, that guaranteed the defeat of Communism.

    I know Jack’s not convinced but I think this claim about communism is interesting and defensible. When Richard Nixon debated Nikita Khrushchev at the American National Exhibition in Moscow, he promised to defeat communism in exactly this way. The most powerful weapons he deployed there were household appliances.
    When Nixon showed Khrushchev the model kitchen installed as part of the exibition, Khrushchev said: "You Americans expect that the Soviet people will be amazed. It is not so. We have all these things in our new flats." Nixon suggested that it might be "better to compete in the relative merits of washing machines than in the strength of rockets."
    That was 1959. Soon President Kennedy would be talking up the ‘missile gap’ sending military advisers into South Vietnam. When Johnson inherited the presidency he declared war on everything and turned Vietnam into a battlefield. Then Nixon was back, bombing Hanoi, bombing Cambodia and setting the scene for the Khmer Rouge.
    What a pity the they didn’t stick to washing machines.

  24. July 20th, 2009 at 23:15 | #24

    “In the long run we’ll all be dead”

    Funny how JQ doesn’t flaunt this phrase when discussing climate change policy.

  25. sdfc
    July 21st, 2009 at 00:48 | #25

    In the long run our descendants will still be alive Terje (I hope).

  26. July 21st, 2009 at 18:39 | #26

    SDFC – pick any particular descendant and in the really, really long term they also will be dead.

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