Karl Marx was deeply moved by the plight of the exploited laborers in industrialized England in late nineteenth century. He theorized that the dynamics of capitalism would lead to increasing exploitation, until the laborers revolted against the system. After the revolution, the laborers would create a new economic and political system, which would be far more equitable than capitalism.  This Marxist prophecy was wrong, but did contain one core truth: increasing exploitation of workers did lead to a breakdown of capitalism during the Great Depression. The same dynamic has repeated itself in creating the global financial crisis of 2008. This article explains the parallels.

We can partition the economy into a real sector and a financial sector. The real sector is where the production takes place; these are the farms, factories, and other industries which produce real goods and services directly beneficial to human beings. The financial sector is based on activities which are not directly productive, such as lending money for interest, speculating on stocks, foreign exchange, and using derivatives and insurance contracts to gamble on the outcomes of real activities. In the roaring 20’s, wild appreciation in stock prices led to a situation where it became substantially more profitable to gamble on stocks than to invest in real productive activities. Increasing shares of wealth in hands of gamblers and decreasing returns to productive activities cannot be sustained for long, and led to a collapse of the real sector, which is called the Great Depression.

Collapse of the real sector led to massive unemployment, and human misery on a large scale. It is correctly said that Keynes rescued capitalism from the fate Marx had prophesied. Conventional economic theory holds that market forces of supply and demand will automatically eliminate unemployment. Keynes revolutionized economics by repealing the law of supply and demand in the labor market, and urging the government to intervene to help the unemployed laborers. The Keynesian compromise provided relief against the worst effects of capitalism, and prevented the more radical changes suggested by Marx.

In her brilliant book, The Shock Doctrine, Naomi Klein has provided a detailed picture of how a counter-revolution was planned and executed by a small segment of society which was unhappy with the Keynesian compromise. An opening was provided by the 1970’s oil crisis which led to stagflation in the USA, contrary to central premises of Keynesian theories. The monetarist school of Chicago was quick to stage a comeback. They argued that the Great Depression was caused by government mismanagement of the money supply, rather than a failure of the free market.  Using strategies described by Klein, these free market theories were applied all over the world.

Reagan and Thatcher implemented these free market policies in the USA and UK with predictable results. From 1980 to 2006 the richest 1% of America tripled their after-tax percentage of our nation’s total income, while the share of the bottom 90% dropped over 20%. Between 2002 and 2006, it was even worse: an astounding three-quarters of all the economy’s growth was captured by the top 1%. The same pattern of sharply increasing inequality holds globally; the wealthiest 250 people have more than the poorest 2.5 billion people on the planet.

Superficially, “Laissez-Faire” or no interference in markets seems like a fair and equitable philosophy – let everyone do whatever they want. In fact, it is highly inequitable; the poor don’t have choices, while the rich and powerful take advantage of this liberty to extract money from the less rich. Financial wheeling and dealing is used to transfer money from the real sector to the financial sector controlled by the wealthy. A simple method is the leveraged buy-out, which allows the wealthy to purchase a real productive business for peanuts, and extract all profits for themselves. More complex methods like CDO’s (collateralized Debt obligations)“… may not be properly understood even by the most sophisticated investors,” according to financial wizard George Soros. Just before the global financial crisis, the value of financial derivatives (which represent different types of complex gambles) alone was 10 times the GDP of the planet. The worth of the financial sector was more than 50 times that of the real sector. This illustrates the increasing inequity that arose between the real productive sector and the financial sector which ultimately broke the backs of the working people. Many people ranging from religious scholars to financial wizards have correctly traced the roots of the global financial crisis to the limitless greed of capitalists. Removal of traditional restraints to this impulse have led to an extraordinary concentrations of wealth combined with extraordinary exploitation and injustice.

Related Article: The Vacuum Cleaner Effect.  opposing trickle down economics.

The current crisis in economic theory has deep historical roots. To understand it, we must go back to sixteenth century Europe. Continual warfare and bloodshed among different Christian sects led to the search for a secular basis for society. How can we achieve cooperation in a society composed of religious groups with different goals? Secular thinkers promoted freedom and wealth as the core values of a secular society. One could expect different groups with conflicting goals to agree to these as common goals for the society. Freedom and wealth would provide each group with the possibility and material means to pursue whatever goal they desired.

Considerable effort was put into promoting freedom and wealth as desirable collective goals, because these were in conflict with prevailing and dominant religious conceptions. Efforts of secular thinkers led to the transition from the Biblical maxim“the love of money is the root of all evil” to its opposite: “lack of money is the root of all evil”. Duty to society takes precedence over individual liberty in traditional society. Secular thinkers created a political theory which puts individual freedom above claims of the social order.These momentous changes were fundamental in creating the modern world.

Secular thinkers disagreed about effects of allowing individual freedom and pursuit of wealth on society.  The disagreement was about the nature of human beings. Rousseau felt that human beings were naturally good, and hence advocated anarchy – no rules or regulations of any kind were required. On the opposite extreme, Hobbes thought that human beings were naturally evil. Without strong government enforcement of extensive laws, life would be “nasty, brutish and short,” if people were allowed complete freedom to act as they desire. Locke took an intermediate position, finding society and government necessary, but with minimal rules acceptable by all.

The debate between Locke and Hobbes continues to this day in various guises.  The Hobbesian view was that extensive government control and regulation in all spheres of life is required for a stable social order. Followers of Locke argued that minimal control would suffice. A very important ingredient in the victory of minimal government views was the “invisible hand” argument of Adam Smith.  He argued that even though people are selfish, society would benefit by allowing them freedom to pursue self-interest. This provided a counter to the Hobbesian idea that selfish individuals would destroy society unless there was extensive government control.

Laissez-Faire economics is based on intellectual grounds prepared by Locke and Smith. It argues that one should allow maximum freedom to individuals in the economic sphere. We are witnessing today the outcomes of a social experiment spanning two centuries. Whereas traditional societies warn strongly against pursuit of pleasure and wealth, secular thinkers thought that these baser tendencies of humans could be harnessed for the betterment of society. As long as the institutional frameworks of politics, justice, and society were sound, allowing freedom for pursuit of wealth would enrich society.

All religions and cultural traditions have asked individuals to sacrifice selfish pleasures to fulfill social obligations, and frowned on pursuit of wealth.  The outcomes of this social experiment make clear why this is so.Contrary to the expectations of secular thinkers, individualistic pursuit of wealth and pleasure did not remain confined to the narrow domain of economic activities. When profits were permitted to trump compassion, the odious actions of Shylock the Jew became socially acceptable.Bankers threw millions out of their homes for nonpayment of interest after the financial crisis of 2008. According to a recent report on Fractured Families, “the fabric of family life has been stripped away.” The relation between greed and the global financial crisis will be discussed in the third and last part of this essay.

For a collection of writings presenting critiques of conventional economic theories, see: Guide to Economics.

Valencia and Laeven document approximately 150 monetary crises over the period 1970-2011. The biggest of these was undoubtedly the Global Financial Crisis of 2007. The response to this crisis, in terms of major re-thinking of foundations of economic theory, has been surprisingly mild. This is because the roots of the crisis go very deep, and have not been properly understood. This is the first of a three part series designed to explore and expose these roots, as a first step towards the radical re-thinking required to re-create economic theories and institutions which would not be subject to these periodic crises which cause deep distress to millions.  The full three-part article, and links to newspaper published versions, can be accessed here: The Current Crisis in Economics.

20th Century Economics: Rise & Fall of Keynes

The human tragedy of the Great Depression has been graphically depicted by John Steinbeck in his moving novel, The Grapes of Wrath. The crisis it created for economic theory is not so well known. Leading economists kept forecasting prosperity and quick recovery, creating embarrassment for the profession as a whole. In 1927, Keynes had flatly stated that “there will be no more crashes in our time.” The shock of the Great Depression led him to create an entirely new economics. The Keynesian revolution created the field of Macroeconomics which gave a vital role to the government in removing unemployment.

At the dawn of the twentieth century, Laissez-Faire economics was the dominant school of thought. Laissez-Faire economics says that free markets without government intervention automatically lead to the best possible economic outcomes. The folly of this position was made obvious to all by the Great Depression. Paul Samuelson and other disciples of Keynes were the only economists with quantitative and, apparently, rigorous answers to questions about the Great Depression. They enjoyed a monopoly on the field of Macroeconomics until the 1970’s. Then things changed.

The OPEC countries imposed an oil embargo to retaliate for USA support of Israel in the Yom Kippur War in 1973. The sudden rise in energy prices led to “stagflation” – unemployment and recession occurring simultaneously with inflation – in the US economy. This was contrary to the central tenets of Keynesian economics which held that only one or the other (unemployment or inflation) was possible. The damaged prestige of Keynesian economics allowed a counter-revolution to be launched. Surprisingly, most of these new macroeconomic theories went back to the laissez faire ideas of pre-Keynesian economics.

Milton Friedman and his followers, labeled Monetarists, lost no time in re-interpreting the Great Depression along lines which would suit laissez-faire theories. On this re-interpretation, the Great Depression was actually caused by inept government policies related to the money supply. Many economists have remarked that theories so violently in conflict with facts became acceptable in the late 70’s only because the generation which had experienced the Great Depression had passed away.  Regardless, the old wine of laissez-faire was presented in new bottles, and rose to prominence once again. Reagan in USA and Thatcher in UK implemented these bold ‘new ideas’ by tax cuts and reduced spending to minimize the role of the government. The failure of Thatcher’s economic policies eventually led to her forced resignation.  It is a puzzle that the same policies were apparently quite successful at reducing unemployment and creating growth in the USA under Reagan.

A deeper look into the difference between what Reagan said and did can resolve this puzzle. Tax cuts for the rich were balanced by increased taxes on the poor.  Large reductions in government expenditure on social security and welfare were more than made up for by massive increases in defense expenditures. What was advertised as a reduction in the role of the government led to a quadrupling of the government budget deficit. Reagan restored the tarnished reputation of Laissez Faire economics by using traditional Keynesian methods of expansionary fiscal and monetary policy, labeled as free market economics.

The collapse of communism further enhanced the prestige of the Laissez Faire economists. The IMF and World Bank enforced the Washington Consensus all over the globe. The poor results of these free market policies disappointed even Williamson, the economist who invented the term. However, instead of rethinking the underlying paradigm, failures were attributed to the wrong sequencing of the economic reforms, and the lack of institutional structures necessary to support the free market. Thus Laissez Faire economics was again the dominant paradigm at the dawn of the 21st century. Economists were just as unprepared for their encounter with reality in the form of the Global Financial Crisis of 2008 as their predecessors had been for the Great Depression. The mistaken overconfidence of Keynes prior to the Great Depression was replicated by Robert Lucas, in his 2003 presidential address to the American Economic Association. Lucas declared that the “central problem of depression-prevention [has] been solved, for all practical purposes” just a few years prior to the Global Financial Crisis of 2008, which provided an empirical refutation of his Nobel Prize winning theories on rational expectations

In 1919, Walton Hamilton coined the term “institutional economics” in the manifesto presented at the American Economic Association Conference where he emphasized the foundations of a new approach to economic theory. In his own words: “The thesis here set for is that `institutional economics´ is `economic theory´.”. The American economist defended institutional economics as an economic theory in the sense of a generalized description of the economic order. The “innovative” aspect of his analysis was to consider institutions as the proper subject matter of economics.  Indeed, Hamilton’s  suggestion was to search for generalized statements which would serve as a point of departure for more specialized inquires within a general descriptive framework that could give unity to the investigations on the economic order. Hamilton rejected the neo-classical analysis of the market centered on general laws and prices of equilibrium and proposed a new approach where the economic order could be comprehended with its particularities of social arrangements. The relevance of institutional economics to the comprehension of contemporary economic problems – the wealth of nations and welfare in modern industrialism- is based on a new understanding of human motivations and restrictions.  He highlighted the concern with the ideas of place, time and process in economics in order to avoid any mechanistic analysis. Under his perspective, the evolution of the markets is articulated to political forces that favor the creation of economic practices and norms. As a result, Hamilton presented a new conception about the rationality of the markets within a market price-system and pointed out a deep tension between the market rationality -that leads to increasing economic power- and the political nature of society. Considering the current challenges to Economics education, it is undeniable the relevance of rethinking Hamilton’s effort to re-create the subject of economics.  The main supposition is that the understanding of the economic phenomena is meaningless apart from the social and political order.

The introduction of an economics textbook by Manikiw quotes Adam Smith regarding the invisible hand and deduces the following claims:

1. Participants in market economies are motivated by self-interest. (SI)
2. Decentralized market economies work very well, and maximize the welfare of society as a whole. (FM: free markets)
3. The reason for excellent functioning of decentralized market economies is that all participants are motivated by self-interest. This self-interest works better than love and kindness in terms of promoting social welfare. (GG: greed is good)
4. The principles listed above were summarized in the concept of the “Invisible Hand” by Adam Smith. (AS)

Manikiw writes that these ideas remain central to modern economics. Our paper on “Failures of the Invisible Hand” shows that all four of these claims are wrong. Some years ago, I was naive enough to think that a refutation of key claims of a central text would at least arouse debate. But I have long since learned that challenges to the core ideologies are simply not to be discussed. THe paper is rejected by many journals with superficial comments not engaging with or disputing the claims.

It is undeniable the actuality of Eric Hobsbawm’s Globalisation, Democracy and Terrorism, published in 2008. Throughout the book, the reader faces the inner tensions that overwhelm the outcomes of the social reality of the free markets and the current challenges to national-states in order to cope with public order.

Taking into account the collapse of the international balance of power since the Second World War, Hobsbawm emphasizes some trends that have not been generally recognized: although the number of international wars between sovereign states has declined since the mid-1960s, the number of conflicts within state frontiers became more common. The constant presence of arms and violence is an expression of the growing complexity of the objectives, actors and actions involved in the inter-state and civil conflicts.

Hobsbawm is sharp when he states that it is not possible to establish a clear distinction between the times of “war” and “peace” at the start of the new century, such as those related to Middle East and Iraq. Indeed, these conflicts have become endemic and can continue for decades. He points out a general crisis of state power and state legitimacy, that is to say, the crisis of the “so called sovereign nation-state to carry out its basic functions of maintaining control over what happened on its territory.”

His purpose is to show that public security requires special efforts at the beginning of the twenty first century since the current institutions do not cope with the main task to maintain the public order. In his multifaceted and complex analysis of the current features of the process of barbarization, Hobsbawm explores the contemporary threatens related to individual freedom, control on individuals and insecurity in social interrelations. In his opinion, the “war against terror”, since September 2001, and the transformations of political violence are also expressions of the recent overall changes in economy and society where a lengthy process of deregulation has been privileged.

Hobsbawm highlights that recent detailed evidences reinforced the menaces to social cohesion and justice in current capitalist societies. It is worth reading his own words: “They seem to reflect the profound social dislocations brought about at all levels of society by the most rapid and dramatic transformation in human life and society experienced within single lifetimes. They also seem to reflect both a crisis in traditional systems of authority, hegemony and legitimacy in the west and their breakdown in the east and the south, as well as a crisis in the traditional movements that claimed to provide an alternative to these.”

Indeed, contemporary political and social challenges are analyzed in a broader context and in a longer perspective. In his conclusions, an “age” of fear, insecurity and barbarization emerges as the characterization of his comprehensive reflection on the human condition at the beginning of the twenty first century. Although resisting to express opinions on the future, Hobsbawm presents a pessimistic view of the world’s future when he affirms: “A tentative forecast: war in the twenty- first century is not likely to be as murderous as it was in the twentieth. But armed violence, creating disproportionate suffering and loss, will remain omnipresent and endemic – occasionally epidemic- in a large part of the world. The prospect of a century of peace is remote.”

 

Nobel laureate Joseph Stiglitz has been writing about America’s economically divided society since the 1960s. His recent book, The Price of Inequality, argues that this division is holding the country back where rent-seeking increased. His work has been to question the marginal productivity theory, which is the theory that has been prevalent  in most economics curriculum.

 

In a recent interview to the Institute for New Economic Thinking, Stiglitz concludes  about the need for the field of economics to come to terms with  inequality. He pointed out some relevant issues to address in any attempt the rethink the foundations of wealth and income inequality:

1) Distinction between wealth and capital

In Stiglitz’ opinion, most readers of Piketty’s book (Capital in the Twenty-First Century) get the impression that the accumulation of wealth — savings —is responsible for the rise in inequality.   There is, therefore,  a link between the growth of the economy — the accumulation of capital— on the one hand and inequality and wealth.

Stiglitz’s recent paper, “New Theoretical Perspectives on the Distribution of Income and Wealth Among Individuals”, begins with the observation that a closer look at what has gone is necessary to apprehend the current trends.  Stiglitz suggests that a large fraction of the increase in wealth is an increase in the value of existing assets. Indeed, in addition to an increase in the wealth/income ratio, there is a capitalization of the increase in other kinds of rents, like monopoly rents supported by the market power of firms relative to workers and by government guarantees, for example. Therefore, wealth can increase, but it doesn’t increase capital.

2) The role of credit in wealth expansion

All  the recent changes are  very closely linked with the credit system.  The flow of credit didn’t go to more wealth accumulation as we normally use the term in economics, as capital goods. Through deregulation and lax standards, banks increased lending, but not for creating new business, not for capital goods. The effect of it has been actually to increase the value of land and other fixed resources (buildings, real estate, etc.). Therefore, the link is that credit affects land prices and fixed asset prices, and those go disproportionately to the rich.  While that is a major part of the increase in the wealth, the workers, who have no wealth, don’t benefit from that expansion

3) Increased market power

The ratio of wages to productivity is going way down and  the ratio of CEO pay to worker pay has gone up suggest increased exploitation founded on increased market power.  In the current scenario, weakened worker bargaining power and weaker unions, asymmetric liberalization where  only capital moves, corporate governance laws that do not cope with abuses of corporate power by CEOs, there are certainly a number of factors that suggest an increase in market power with consequences in terms of income inequality.

 

Sources:

Joseph Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future, http://www.amazon.com/The-Price-Inequality-Divided-Endangers-ebook/dp/B007MKCQ30

Joseph Stiglitz: Economics Has to Come to Terms with Wealth and Income Inequality, by Lynn Parramore on December 16, 2014, neteconomics.org/institute-blog/joseph-stiglitz-economics-has-come-terms-wealth-and-income-inequality

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