This was published in Express Tribune Opinion Pages on March 16th, 2015 –Keynes vs IMF. It is placed in the Pakistani context, but the same issues are relevant for Greece, Spain and Ireland.

Leading economists like Keynes and Fisher had forecast prolonged prosperity, just prior to the Great Depression of 1929. The shock of the Great Depression led Keynes to create Keynesian Economics. According to conventional economic theory, increasing the quantity of money in circulation has only one effect: increasing the level of prices. That is, printing money is inflationary, and has no effects on the real economy. Many economists of the time noted that massive bank failures had led to substantial reduction in the money supply. They came to a realization that these events were related. Contrary the classical theory that money only effects prices, the shortfall in the money supply caused the massive unemployment of labor and other factors of production and the contraction of the GNP.

Keynesian theory is based on a very simple idea that conduct of the ordinary business of an economy requires a certain amount of money. If the amount of money is less than this amount, then businesses cannot function – they cannot buy inputs, pay laborers or rent shops. This was the fundamental cause of the Great Depression. The solution was simple: increase the supply of money. Keynes suggested that we could print up money and bury it in coal mines and have unemployed workers dig it up. If money was available in sufficient quantities, businesses would revive, and the unemployed laborers would find work. By now, there is nearly universal consensus on this idea. Even Milton Friedman, the leader of Monetarist School of Economics and arch-enemy of Keynesian ideas, agreed that reduction in money supply was the cause of the Great Depression. Instead of burying it in mines, he suggested that money could be dropped from helicopters to solve the problem of unemployment.

But what about inflation? Isn’t it true that printing money in massive quantities would lead to inflation? According to Keynesian theories, this would happen after full employment was achieved. That is, once the economy reached its maximum production capabilities, further money could not contribute to an increase in production. At this point, printing more money would only lead to inflation, exactly as the classic economic theory predicts. Keynesian theory gives the Central Banks of the worlds an extremely important task: maintaining the money supply at exactly the right level to create maximum production without running the risk of inflation. Keynes also said that monetary policy may be insufficient for the task, and the government had direct responsibility to ensure full employment using fiscal policies.

Regulation of financial markets, social support for the poor, and government responsibility to provide jobs for all led to decades of prosperity in Western economies. The share in the wealth of the bottom 90% increased, while the share of the top 0.1% decreased. This state of affairs did not please the wealthy elites, who launched an extremely successful attack against Keynesian ideas in the 1970s. The Arab oil embargo led a sharp rise in oil prices and inflation, while simultaneously disruptingdisrupting productive activities and creating unemployment. Keynesian theories state that we can only have one or the other; “stagflation” or simultaneous presence of high inflation and high unemployment is ruled out.

This weakness in Keynesian theory was successfully exploited by the rich and powerful to argue that the main problem lay with government interventions. Reagan dismantled some of the post-Depression regulations which limited the powers of the wealthy financiers, as well as the social support and unions which strengthened the labor class against them. In particular, with great fanfare, Reagan de-regulated the Savings and Loan (S&L) Industry. Exactly as in the Great Depression, the banks took advantage of this to speculate in risky investment with the depositors’ money, and lost billions of dollars, creating a nation-wide banking crisis. However, the government had learnt its lessons from the Great Depression, and did a massive bailout to prevent a financial crisis entailed by the collapse of the S&LsL. Over the next few decades, deregulation unleashed the power of the financiers, and cuts in social services weakened the labor class, with predictable results. Speculative financiers gambled heavily with the money of others deposited in banks, leading to myriad monetary crises. At the same time the labor class was squeezed, resulting in rising inequalities and massive concentration of wealth at the top.

In the post-Keynesian era, the clarity of Keynes has been lost. Many Central Banks have gone back to pre-Keynesian ideas, abandoning the goal of full-employment, and focusing solely on controlling inflation. Substantial doubt has been created as to whether or not monetary policy, or helicopter money, can be useful in solving problems of unemployment. When countries spend more foreign exchange on imports than they can earn, they are forced to borrow dollars from the IMF. As a condition of such loans, the IMF insists on austerity – governments should balance budgets and not print money to finance deficits. According to the IMF, financing deficits with increases in money supply can lead to high inflation, with heavy economic costs. However, according to Keynes, we should increase money supply in an economy with high unemployment such as Pakistan. Printing money is not inflationary in such a situation. So who is right? Keynes or the IMF?

Recent research by Princeton economists Mian and Sufi sheds considerable light on the answer, which is obvious in retrospect: Both Keynes and IMF are right. What happens depends on who picks up the helicopter money and what they do with it. If those who get the money buy land, property values will go up. If they invest in stocks, this will create a bubble in the stock market. If they put it in their Swiss accounts, this will lead to depreciation of the exchange rate. However, if the money is used wisely, to invest in projects which increase the productive capacity of the economy, this will create employment and generate the economic returns needed to provide support and backing for the newly created money.

When Keynesian policies of full employment and social support for laborers eroded the wealth shares of the power of the rich, it is an article of faith for the wealthy elite, the counterattack created alternative policies, as well as theories and ideologies to support these policies. Decades of experience with these policies, codified in the Washington Consensus as privatization, liberalization and stabilization, has shown that they produce increasing inequality but do not produce growth. Alternative models for successful development are always corrupt. The historical record does not bear this out.available. The most spectacular recent example was labor leader Lula of Brazil. After being elected president in 2003, his deficit financed programs of social support and investment created progress and prosperity. Under Lula, Brazil went from being the most heavily indebted country in the world to the eighth largest economy, and 20 million people rose out of poverty. There are many other examples of wise public spending listed by Ellen Brown in The Public Bank Solution: From Austerity to Prosperity. Other kinds of examples also exist, where reckless and corrupt governments can wreak havoc on the economy, as the IMF fears. Can we rise to the challenge which faces us in Pakistan? That is, to curb corruption and spend efficiently on social services and productive investments, leading to the Keynesiian outdcomes of full employument wiithoujt inflation?

Modern history is largely driven by the battle of the rich (top 0.01%) against the masses (bottom 90%). Over the past few decades, the rich have been tremendously successful in having it all their way. A previous blog post on “Deception and Democracy” illustrates by examples their successful conversion of democracy into plutocracy in the USA. As pointed out by Polanyi, unregulated markets create disastrous outcomes for the majority. Therefore, in a democratic environment, theories which misrepresent facts and justify massive inequalities are essential pillars of support for the plutocrats. Spreading these theories via media and educational channels helps create an environment where people support policies which go against their common interests.

As many posts on austerity on the RWER blog have shown, austerity has only caused massive damages to the European Union (just search for “austerity” on the blog). Theories which support austerity as a policy are disseminated by premier educational institutions and provide a crucial pillar of support for enforcing such policies. Equally, educating the public about the flaws of such policies and providing a viable alternative is an essential element of a counter-attack. Ellen Brown has performed a tremendous service with her books “From Austerity to Prosperity: The Public Bank Solution” and also “Web of Debt: The Shocking Truth about our Monetary System and how we can break free.”  I have tried to pick up certain key insights from these books and summarized them as a solution to development problems in Islamic economies in my paper: “On the Nature of Modern Money.” However this paper is lengthy and complex, and meant for a professional audience. My newspaper article “Keynes vs. IMF” presents a brief and oversimplified version of some of the key ideas the public needs to learn, in order to be able to overcome the illusion that austerity is good for them.

An important point here is that the real world economists need to take their case to the public, which is victimized by the neoclassical economists. Talking among ourselves is not helpful except in terms of discovering the strongest arguments and best lines of attack. There is absolutely no point in trying to get published in leading journals, or trying to change minds of professional economists – they have the most to lose. Our natural audience are those who have the most to gain by listening to our message. This means that we need to make much greater efforts to convey our message to the general public. This involves participating more on popular forums like conventional blogs, writing book reviews for good books, providing critiques and alternatives for bad ones, writing for newspapers etc. It also involves making the efforts required to translate and present our theories and models in ways attractive and comprehensible to a general audience.

As Bagehot (1873) clearly said:  banks trade money. In the current banking scenario, the interconnections between credit and capital markets foster the growth of banks’ assets and profits. The other side of the “coin” shows higher corporate leverage and household debt. As a result, all society has been subordinated to trading private money.  Accordingly J.M.Keynes, money, as the institution that founds the exchange system, is a link between the present and the future. Money trade by banks fosters the capital accumulation process that develops through time and involves credit contracts.  In a context of uncertainty and speculation, the tensions between money as a public and as a private good overwhelms central banks’ actions, as we are seeing in the current bail-outs. The 2008 financial crisis has shown sources of worldwide financial fragility: the financial innovations regarding bank’s asset, liability and capital management, the movement toward securitized finance, the growing importance of institutional investors, besides the random investors´ behavior in a context of capital account openness.    Indeed, the evolution of banking practices can be apprehended in a changing historical context where tensions between the regulation of capitalist finance and the strategies of innovative profit-seeking banks arise.  In fact, since banks play a crucial role in determining the pace of growth, any new banking practices and products  turn out to affect the overall stability of the economy. From H. Minsky we learned that financial innovations are not just techniques or product phenomena, but involve institutional changes. Banking practices have increasingly included risk management, such as liquidity, credit, interest rate and currency risk. Banks have increasingly adopted an integrated approach called asset & liability management and enhanced further banking innovations. The target of this process is to expand the endogenous money creation by banking institutions since the new loans are considered profitable. Accordingly H. Minsky, the growth of financial innovations did not mainly occur because of competitive market forces. Under his opinion, the role of both banking regulation and monetary policy has been outstanding to explain new management practices and innovations.  In the context of the “New Deal” segmented system of financial regulation, commercial banks began to actively manage liabilities, in order to raise additional funds. In the 1960s, as a result of banks’ innovations, the development of the fed funds market in the US turned out to reduce the Fed’s ability to use legally required reserves to constrain bank lending. In other words, financial innovations turned out to subvert constraints imposed by financial regulation and monetary policy.  More recently, the 2008 financial global crisis revealed that the evolution of  banking practices deeply depends on the arbitrage/speculation made by global players in the financial markets. In the aftermath of the crisis, banks continue trading money, but the distinction between private and public debt has become blurred.  To fund banks’ assets, central banks have been expanding loans to commercial banks at both short and longer-term maturities.  In addition to low interest-bearing deposit facility, central banks’ actions have also included the acquisition of government bonds issued by Treasuries to face the debt crisis.     In this scenario, many nation- states – that used to defend the expansion of financial liberalization – have taken a stake of more than 50% in banks’ capital and implemented austerity programs that fostered unemployment and the lost  of social rights. Indeed, the social costs of the banking sector bail-outs have undermined the idea of efficiency of the self-regulated financial markets and the trust in the social dimension of public policies. Considering this background, two relevant questions arise: Which is the room for maneuver of nation-states to shape a financial  agenda towards sustainable economic and social growth? Could banking regulation induce more control over banks’ management practices in the future?.

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.


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