karl-henrik pettersson

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Filosofiska tankar om företagande och ekonomi

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Notes on a society in crisis (20): America’s belief in the market has become a religion

On April 1st 2012, my book,”Dagbok från USA”, came out in Sweden. It will also soon be published in English (as an e-book for Kindle and for other readers) with the title: “Diary from the United States – Notes on a society in crisis“. As an appetizer for English speaking readers, I will the coming weeks publish some excerpts from the book.

Reaganomics (=prevailing U.S. economic policy) is in a cul-de-sac

The recent crisis, 2008/2009, has meant that economists and other pundits have begun to question the market-oriented macroeconomic policy that have dominated Western politics during the past 30 years. Since the early 1900s, the West has experienced three dominant macroeconomic models – classical economics until the 1930s, then Keynesianism, particularly during the 1950’s and 1960’s, and from about 1980 to today, what I, in another context, has called “the post-modernist classical economics “, and what Roger Farmer has called “the rational expectations revolution “, in practice, a macroeconomic model where room for political intervention in the markets, or for public production, become less and less. The model, which has gone furthest in the United States, might be reconsidered when the experience of the debacle 2008/2009 is collected and analyzed. Let’s take a closer look at the issue.

Classical economics says simply that if you only let the markets be free from all forms of political interference (or almost all forms, basic rules of law, like property rights are important also for “the classicists”), the growth will be the highest possible, and it will also be fairly distributed among citizens. However, the reality was, not least in the 1920s and early 1930s, that the model didn’t keep its promises. John Maynard Keynes argued that when the level of demand in an economy suddenly drops sharply of some reason, the general optimism and the mood in society decreases. Pessimism and gloom exacerbates the situation, not least if unemployment is growing dramatically in a short time. Exactly that happened during the crises of the 1930s. Unemployment in the U.S. rose from the level of around 4% in early 1929 to almost 25% three years later (when the crisis 2008/2009 peaked, unemployment in the U.S. was a little over 10%). Keynes argued that the reason for the labor market not functioning as the classical model assumed was that the classic economists were wrong on one particular point – they postulated that the wages would go down when the demand went down. It didn’t happen; the wages were in reality “sticky” downwards. The result was more unemployment rather than wage adjustments, and unemployment had a tendency to become entrenched. Keynes’ prescription was simple and logical. As the private sector wasn’t capable of creating sufficient demand in the economy, the politicians must do it instead, for example in the form of big public investments. Keynes’ ideas rooted at many politicians in all Western countries. Moreover, World War II came with gigantic public investments in many countries. These large investments, both during the war and during the post war reconstruction period, gave the results Keynes had predicted. The Western economies were booming, the confidence came back, and employment rose. Keynesianism dominated politics in the Western economies.

What eventually came to be, figuratively, the nail in the coffin on Keynesianism was that the relationship between inflation and employment which Keynes thought existed – that high unemployment will never come together with high inflation – didn’t hold in reality. During the 1950s, we had periods of stagflation, in other words stagnation and high inflation at the same time. Of course, it gave rise to criticism and eventually to new macroeconomic theories and new ways for the politicians to tackle growth and employment. In the mid-1970s Keynesianism had reached its limits. What came instead was once again a more market-oriented policy, a kind of rebirth of classical economics. The markets had become more regulated and partly stiff and solidified under the economic policy that dominated the West in the first post-war decades, especially the period 1945-65. It was logical that the result was high inflation. In the 1970s, it wasn’t uncommon with inflation rates above 10% (and with mortgage rates at 15% and even more). Beginning around 1980 in the United States, a policy regime with an overall aim to bring down inflation was introduced by Federal Reserve (with Paul Volcker as chairman at the time). An active monetary policy lowered inflation expectations, a prerequisite for bringing down actual inflation. The markets for money and capital were step by step liberalized, and in the real economy, deregulation and privatization became a tool the politicians used to free the market forces.

On the whole, the more market-oriented macroeconomic policy after 1980 proved to be a success if success is measured in growth and employment. There were some major disruptions in the economies of some countries (for example, the Nordic banking crisis in the early 1990’s) but the success was true for virtually the entire Western world, and for most of the period from 1980 until the turn of the century.

It is in later years, in the late 2010s, as the market-oriented model has been called into question. In particular many economists are skeptical about what they see happening with and within the financial sector. The financial sector in many countries, and especially in the United States, has since the late 1990s left the expected link to GDP. In other words, it seems as if it is living a life of its own increasingly decoupled from the real sector. The financial sector has in certain periods been clearly speculative, but the politicians and central banks, especially in the U.S., have been unwilling to consciously dampen the speculation, and to offset the asset bubbles that have been created. We have had two examples of bursting bubbles in the U.S. over the past 10 years. First, the IT bubble in the early 2010s, and later the U.S. housing bubble, the subprime crisis, which in the next step became a global financial crisis, which in the OECD countries developed into the deepest crises of the real economy since the 1930s. Consequently, the economists’ critique of the macroeconomic model that has dominated since the early 1980s has grown in strength. Nobel laureate Joseph Stiglitz’s book Free Fall can be a concrete example of this criticism. Another example is economics professor Roger Farmer’s book, How the Economy Works.

Robert Farmer’s proposal for a new macroeconomic model is a kind of symbiosis between the classicists’ view of how the economy works and Keynes’. Farmer argues that classical economics is misguiding for two reasons. Firstly, because the self-correction presumption, assuming that unemployment after a shock springs back to a natural level, is not correct, at least not judging by how it looks in reality. Secondly, and this is central to Farmer, “the classicists” ignore the trust factor, the overall role of faith in future as an independent factor that drives the economy, both upwards and downwards. Keynes was right, Farmer states, in saying that markets alone are unable to restore full employment and a reasonable utilization of resources. At the same time Keynes was mistaken when he thought that it is changes in the income level that is most crucial for consumption, and hence employment. Rather, changes in wealth decide what will happen to consumption and employment. That makes it logical to give the stock market a central role in the model, says Farmer. For wealth increases when the stock market goes up, and the stock market goes up when confidence in the economy increases, or more precisely when economic agents believe in the future.

Classical economists argue that it is fundamentals – preferences, resources, technology, organization, management etc. – that drives the markets. Keynes stresses in the same way the importance of the trust factor. Farmer’s view is, as I understand it, that one can reconcile these two approaches by considering trust as a fundamental driving force. “By adding confidence as a separate fundamental, we can retain a theory in which everything is determined by fundamentals, including the value of stock prices. Confidence is an independent fundamental driving force of the business cycle. ” Nobody can know for sure what a future macroeconomic paradigm will look like. But a reconsideration of the post-modernist classical economics is arguably inevitable. Above all, as just said, it turns out that the paradigm that has dominated macroeconomic policy since the 1980s, leads the financial sector on as path of speculation as a modus vivendi. In some cases the speculation becomes a bubble, which when it bursts, at worst spreads to the real sector, affecting growth and jobs. Exactly the situation we got in the Western world after the subprime crisis of 2008/2009. Such reconsideration will be extra difficult for the United States and for American politicians. That it was Ronald Reagan (along with Margaret Thatcher in England) who introduced the new paradigm to the world in the early 1980s was no accident. The new way of thinking – with more room for the market and the private initiative and less room for government and common good – was guided by values and approaches that in many ways had deep roots in the American society. What makes it even more difficult for the U.S. is that over time the belief in the superiority of the market and of libertarianism for many policy makers have become, I would say, almost a religion. That such a central figure for the U.S. economy after 1980 as Alan Greenspan not only had personal contact with the libertarian Ayn Rand, but also much shared her worldview (which really leaves no room for political interference) are thought provoking. For example, one can understand why Alan Greenspan saw it as an important step forward when Glass-Steagall Act was removed in 1999 because it was about giving greater freedom to financial market participants.

The consequence has been that the United States in its belief in the superiority of the market, and its parallel distrust of “government” and political solutions, has taken an extreme position with its model of society. Reaganomics, which I think is a relevant term for this libertarian ideology, is in a cul-de-sac. It is my prediction that it will be very expensive in terms of growth and political stability for the U.S. to get out of this extreme position. When Sweden went too far with its welfare state-building during a couple of decades after the Second World War, the way back became very long and troubling. I’m sure that the U.S. will have to take step backwards, and that the retreat will take time and also be troubling in many ways.

Literature:

Farmer, R. E. A., 2010, How the Economy Works, Oxford University Press, Oxford;

Stiglitz, JE, 2009, Free Fall, W. W. Norton & Company, New York;

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2012-11-22

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