Zombie economics_ how dead idea - john quiggin

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HOW DEAD IDEAS STILL WALK AMONG US John Quiggin PRINCETON UNIVERSITY PRESS PRINCETON AND OXFORD Copyright © 2010 by Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW All Rights Reserved Library of Congress Cataloging-Â�Â�in-Â�Â�Publication Data Quiggin, John. Zombie economics : how dead ideas still walk among us / John Quiggin. p. cm. Includes bibliographical references and index. ISBN 978-Â�Â�0-Â�Â�691-Â�Â�14582-Â�Â�2 (hbk. : alk. paper) 1. Economics—History—20th century. 2. Economic policy—History—20th century. 3. Economics.╇ I. Title. HB87.Q54 2010 330—dc22 2010023189 British Library Cataloging-Â�Â�in-Â�Â�Publication Data is available This book has been composed in Sabon Printed on acid-Â�Â�free paper. press.princeton.edu Printed in the United States of America 1╇ 3╇ 5╇ 7╇ 9╇ 10╇ 8╇ 6╇ 4╇ 2 Contents vii 1 Preface Introduction Chapter 1 The Great Moderation Birth: Calm after the Storms Life: The Great Risk Shift Death: The Dissenters and Their Vindication Reanimation: A Global Crisis or a Transitory Blip? After the Zombies: Rethinking the Experience of the â•… Twentieth Century Further Reading 5 8 13 19 30 31 34 Chapter 2 The Efficient Markets Hypothesis Chapter 3 Dynamic Stochastic General Equilibrium 79 83 106 110 121 123 133 Chapter 4 Trickle-Â�Â�down Economics 136 138 146 152 167 168 172 Birth: From Casino to Calculating Machine Life: Black-Â�Â�Scholes, Bankers, and Bubbles Death: The Crisis of 2008 Reanimation: Chicago Revives the Dead After the Zombies: The State and the Market Further Reading Birth: From the Phillips Curve to the NAIRU, and Beyond Life: Rationality and the Representative Agent Death: How Did Economists Get It So Wrong? Reanimation: How Obama Caused the Global Financial Crisis After the Zombies: Toward a Realistic Macroeconomics Further Reading Birth: From Supply-Â�Â�side Economics to Dynamic Scoring Life: Excuses for Inequality Death: The Rich Get Richer and the Poor Go Nowhere Reanimation: Mobility without Movement After the Zombies: Economics, Inequality, and Equity Further Reading 35 36 39 50 64 66 77 Chapter 5 Privatization Birth: We Are All Market Liberals Now Life: A Policy in Search of a Rationale Death: Puzzles and Failures Reanimation: Dead for Good? After the Zombies: The Mixed Economy Further Reading 174 178 182 187 199 200 204 Conclusion Economics for the Twenty-Â�Â�first Century Rethinking the Experience of the Twentieth Century A New Approach to Risk and Uncertainty What Is Needed in Economics 206 206 207 210 References Index 213 229 Preface The idea for this book began when I read this striking passage in Animal Spirits by George Akerlof and Robert Shiller: The economics of the textbooks seeks to minimize as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so—and each of us has spent a good portion of his life writing in this tradition. The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually works. Our book marks a break with this tradition. In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and can be observed. (Akerlof and Shiller 2009, 4–5) This passage motivated me to write about its implications for macroeconomics in the Crooked Timber blog. In comments, economist Max Sawicky, posting under the pseudonym MiracleMax, suggested that this, combined with some earlier posts on ideas refuted by the financial crisis, would make a good book. Brad DeLong of the University of California at Berkeley picked up the idea, and the next day Seth Ditchik of Princeton University Press e-Â�Â�mailed me to say he thought it was a great idea. The result is before you. More than most books, this one has been improved by comments from others, not all of whom I can name. As I wrote draft chapters, I posted them on crookedtimber.org, and on my personal blog johnquiggin.com, then combined them in a draft on wikidot.com. I asked for comments viii PREFACE and received, in total, several thousand, from well over a hundred different commenters, most of them pseudonymous. I can’t thank all those who commented, but I would like to mention “Alice,” “Bert,” “Bianca Steele,” Martin Bento, Kevin Donoghue, Kenny Easwaran, John Emerson, “Freelander,” Jim Harrison, “JoB,” P. M. Lawrence, Terje Petersen, Donald Oats, Andrew Reynolds, “smiths,” John Street, “Uncle Milton,” Robert Waldmann, Tim Worstall, and “Zamfir.” I also received helpful comments from friends and colleagues, including George Akerlof, Chris Barrett, Brad DeLong, Joshua Gans, Paul Krugman, Andrew McLennan, and Flavio Menezes. Several anonymous reviewers for Princeton University Press went above and beyond the call of duty in providing extensive and valuable comments. My wife and colleague, Nancy Wallace, read the entire text and made many helpful editorial and substantive suggestions. Thanks also to the editorial and production team at Princeton University Press. Seth Ditchik was a marvelous and supportive editor, ably assisted by Janie Chan. Debbie Tegarden, my production editor, was unfailingly cheerful and supportive, not to mention highly efficient in turning a manuscript into a book on a very tight time frame. Other production staff including Jack Rummel and Jim Curtis gave able support. The marvelous cover design by Karl Spurzem and Dimitri Karetnikov, drawing on an idea from Seth Ditchik, speaks for itself (it says, “Brraaaiiinnnssss”). In addition, I must thank all my cobloggers at Crooked Timber, Chris Bertram, Michael Berube, Harry Brighouse, Daniel Davies, Henry Farrell, Maria Farrell, Eszter Hargittai, Kieran Healy, John Holbo, Scott McLemee, Jon Mandle, Ingrid Robeyns, Belle Waring, and Brian Weatherson. Without the lively and supportive environment they’ve provided, this book would never have happened. Introduction 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. Madmen in authority, who hear voices in the air are distilling their frenzy from some academic scribbler of a few years back. —J. M. Keynes, The General Theory of Employment, Interest and Money Ideas are long lived, often outliving their originators and taking new and different forms. Some ideas live on because they are useful. Others die and are forgotten. But even when they have proved themselves wrong and dangerous, ideas are very hard to kill. Even after the evidence seems to have killed them, they keep on coming back. These ideas are neither alive nor dead; rather, as Paul Krugman has said, they are undead, or zombie, ideas. Hence the title of this book. Before the Global Financial Crisis ideas like the Efficient Markets Hypothesis and the Great Moderation were very much alive. Their advocates dominated mainstream economics. Their influence, acknowledged or not, guided the thinking of the practical men and women whose decisions created a financial system without parallel in history. Tens of trillions of dollars of interlinked obligations were built on a foundation of speculative, or entirely spurious, investments. The result was a global economy in which both households and nations lived far beyond their means. Today the Efficient Markets Hypothesis and the Great Moderation look like defunct ideas. Commentators who were proclaiming, a year or two ago, that the business cycle had been tamed, have admitted their 2 INTRODUCTION error or, more commonly, moved on to talk of other things. The claim that financial markets make the best possible use of economic information and can never be subject to irrational bubbles is rarely made overtly and usually hedged with all kinds of qualifications and escape clauses. In this zombie state, such claims continue to lumber around the intellectual landscape. But habits of mind and thought are hard to change, especially when there is no ready-Â�made alternative. The zombie ideas that brought the global financial system to the brink of meltdown, and have already caused thousands of firms to fail and cost millions of workers their jobs, still walk among us. They underlie the thinking of those who are responding to the crisis and, to a large extent, of the commentators and analysts who assess those responses. If we are to understand the financial crisis, and avoid the kinds of responses that set the stage for a new and even bigger crisis in a few years time, we must understand the ideas that got us to this point. This book describes some of the ideas that have played a role in the crisis. They are ºÂº the Great Moderation: the idea that the period beginning in 1985 was one of unparalleled macroeconomic stability; ºÂº the Efficient Markets Hypothesis: the idea that the prices generated by financial markets represent the best possible estimate of the value of any investment; ºÂº Dynamic Stochastic General Equilibrium: the idea that macroÂ� economic analysis should not concern itself with economic aggregates like trade balances or debt levels, but should be rigorously derived from microeconomic models of individual behavior; ºÂº Trickle-Â�down economics: the idea that policies that benefit the well-Â� off will ultimately help everybody; and ºÂº Privatization: the idea that any function now undertaken by government could be done better by private firms. Some of these ideas, such as the Efficient Markets Hypothesis and Dynamic Stochastic General Equilibrium belong to the realm of technical economic theory. Others, such as privatization are policy prescriptions, derived from these abstract ideas. Still others, like the Great Moderation INTRODUCTION 3 and trickle-Â�down economics, are catchphrases for claims about how the economy works, or at least, how it worked in the thirty years or so before the current crisis. Together these ideas form a package which has been given various names: “Thatcherism” in the United Kingdom, “Reaganism” in the United States, “economic rationalism” in Australia, the “Washington Consensus” in the developing world, and “neoliberalism” in academic discussions. Most of these terms are pejorative, reflecting the fact that it is mostly critics of an ideological framework who feel the need to define it and analyze it. Politically dominant elites don’t see themselves as acting ideologically and react with hostility when ideological labels are pinned on them. From the inside, ideology usually looks like common sense. The most neutral term I can find for the set of ideas described by these pejoratives is market liberalism, and this is the term that will be used in this book.1 The book is organized in a way that I hope will help readers understand how market liberalism depends on ideas that have failed the test of the Global Financial Crisis. If these ideas continue to influence policy, they will ensure a repetition of the crisis. Each chapter deals with a single idea and begins by describing the birth of the idea, followed by a section on its life, focusing on theoretical and policy implications. The next section describes the death of the idea brought about by the global crisis, but usually resulting from weaknesses that were evident well before the crisis. A brief section on reanimation looks at attempts to raise these dead ideas from the grave as undead zombies. The next section, entitled “After the Zombies,” looks at alternatives to the ideas of market liberalism. Finally, there are some suggestions for further reading.2 1 There is a similar problem of terminology on the other side of the debate. Market liberalism emerged as a reaction against a set of ideas and policies commonly referred to as “social liberalism” or “social democracy” in Europe and simply as “liberalism” in the United States. These ideas included a commitment to full employment, based largely on Keynesian economic management, and a major role for the state in the provision of income security and services such as health and education. I will generally use the term social democracy to avoid the ambiguities surrounding liberal. 2 For ease of reading, I have dispensed with the traditional apparatus of endnotes, which force the reader to keep the book open in two places to follow notes, many of which turn out to be nothing more than academic citations. Instead, I’ve made sparing use of footnotes 4 INTRODUCTION The final chapter, “Economics for the Twenty-Â�first Century” looks more generally at the theoretical and policy ideas that will be needed in the light of the failure of market liberalism. A simple return to traditional Keynesian economics and the politics of the welfare state will not be sufficient. It is necessary to develop both theories and policies that respond to the realities of the twenty-Â�first century economy. It is clear that there is something badly wrong with the state of economics. A massive financial crisis developed under the eyes of the economics profession, and yet most failed to see anything wrong. Even after the crisis, there has been no proper reassessment. Too many economists are continuing as before, as if nothing had happened. Already, some are starting to claim that nothing did happen, that the Global Financial Crisis and its aftermath constitute a mere “blip” that should not require any rethinking of fundamental ideas. The ideas that caused the crisis and were, at least briefly, laid to rest by it are already reviving and clawing their way through up the soft earth. If we do not kill these zombie ideas once and for all, they will do even more damage next time. like this one to cover points of tangential interest, notes about some of the economists whose work is discussed, and so on. The further reading section at the end of each chapter includes Harvard-Â�style citations to books and journal articles that have been mentioned in the chapter, and detailed references are given in the bibliography. Chapter 1 The Great Moderation Stock prices have reached what looks like a permanently high plateau. —attributed to Irving Fisher, October 1929 A zombie idea is one that keeps on coming back, despite being killed. In the history of economics, there can be no more durable zombie idea than that of a New Era, in which full employment and steady economic growth would continue indefinitely. Every sustained period of growth in the history of capitalism has led to the proclamation of such a New Era. None of these proclamations has been fulfilled. As Irving Fisher’s famous prediction, made only a few days before the Wall Street Crash of 1929, illustrates, the belief that the era of boom and bust has finally been put behind us is not new. In fact, ever since the emergence of industrial capitalism in the early nineteenth century, the global economy has been shaken, and stirred, by periodic booms and busts. And, in every intervening period of steady growth, optimistic observers have proclaimed the dawning of a New Economy in which the bad old days of the business cycle would be put behind us. Even the greatest economists (and Irving Fisher was a truly great economist, despite some spectacular eccentricities) have been fooled by temporary success into believing that the business cycle was at an end.1 In 1929, Irving Fisher’s confidence was based in part on the development of the tools of monetary policy implemented by the U.S. Federal 1 He was among other things a prohibitionist, health campaigner, and eugenicist. In his economic career though, he made fundamental contributions to the theory of interest rates and inflation and, ironically, to our understanding of the deflationary processes that deepen depressions. 6 Chapter 1 Reserve, which had been established in 1913 and had dealt successfully with several minor crises. The central idea was that, in the event of a financial panic, the Fed would lower interest rates and release funds to the banking system until confidence was restored. But the Fed proved unable or unwilling to produce an adequate response to the stock market crash of October 1929. The Great Crash was followed by four years of uninterrupted decline that threw as many as a third of all workers out of work, not only in the United States, but all around the world. Economists are still arguing about the causes of the Great Depression, and the extent to which mistaken policies contributed to its length and depth. These disputes, once polite and academic, have taken on new urgency and ferocity in the context of the current crisis, which echoes that of 1929 in many ways. In the aftermath of the Great Depression and World War II, the analysis that held sway over the great bulk of the economics profession was that of John Maynard Keynes.2 Keynes argued that recessions and depressions were caused by inadequate effective demand for goods and services and that monetary policy would not always be effective in increasing demand. Governments could remedy the problem through the use of public works and other expenditure programs. The rapid return to full employment in the war years seemed to confirm Keynes’s analysis. As Australia’s White Paper on Full Employment, published in 1945, put it: Despite the need for more houses, food, equipment and every other type of product, before the war not all those available for work were able to find employment or to feel a sense of security in their future. On the average during the twenty years between 1919 and 1939 more than one-Â�tenth of the men and women desiring work were unemployed. In the worst period of the depression well over 25 per cent were left in unproductive idleness. By contrast, during the war 2 As an economist, Keynes had a lot in common with Fisher, but in other respects he could scarcely have been more different. A bon vivant and member of the Bloomsbury Group of intellectuals, married to a glamorous Russian ballerina, Keynes was also a successful speculator, whereas Fisher lost much of his personal fortune in the Crash. THE GREAT MODERATION 7 no financial or other obstacles have been allowed to prevent the need for extra production being satisfied to the limit of our resources. (CommonÂ�wealth of Australia 1945, 1) In sharp contrast with previous wars, the full employment of the war years was maintained after the return of peace. For most developed countries, the years from the end of World War II until the early 1970s represented a period of full employment and strong economic growth unparalleled before or since. Referred to as the “Golden Age” or “Long Boom” in English, “Les Trente Glorieuses” in French, and the “Wirtschaftswunder” in German, this period saw income per person in most developed countries more than double. By the 1960s, many Keynesian economists were prepared to announce victory over the business cycle. Walter Heller, chairman of the Council of Economic Advisors under John F. Kennedy, hailed the switch to active fiscal policy in the 1960s, saying “We now take for granted that the government must step in to provide the essential stability at high levels of employment and growth that the market mechanism, left alone, cannot deliver.”3 Attention turned to the more ambitious goal of “fine-Â�tuning” the economy so that even “growth recessions” (temporary slowdowns in the rate of economic growth that typically produced a modest increase in unemployment rates) could be avoided. Pride goes before a fall. In the 1970s, the seemingly endless postwar boom came to an abrupt halt. It was replaced by accelerating inflation and high unemployment. Keynesian fiscal policies, aimed at eliminating unemployment, were abandoned. Restrictive monetary policies and high interest rates allowed central banks to squeeze inflation out of the system over the course of the 1980s. The pressure for price stability was reinforced by globalization, and particularly by the growing size and influence of the global financial sector. While price stability returned, the full employment of the postwar era was gone, and has never truly returned. Economic growth returned gradually, but, at least in developed countries, never regained the rapid rates of the postwar boom. 3 Heller (1966), 9. 8 Chapter 1 It seemed that the idea of a New Era was dead, once and for all. But zombie ideas are not so easily killed. Birth: Calm after the Storms If only by comparison with the dismal 1970s and 1980s, the 1990s were an era of prosperity for the developed world, and particularly for the United States. The boom of the late 1990s produced improvements in income across the board, after a long period of stagnation for those in the lower half of the income distribution. The boom in the stock market produced even bigger gains for the wealthy. House prices were slower to move, but because they are such a large part of household wealth, contributed even larger capital gains. The long and strong expansion of the 1990s, combined with political events such as the collapse of the Soviet Union, produced a new air of optimism and, at least in the United States, triumphalism. The success of books like Francis Fukuyama’s The End of History and Thomas Friedman’s The Lexus and the Olive Tree reflected the way they matched the popular mood. Fukuyama argued that the great conflicts that made history something more than the passing of time were over, and that the end of the Cold War marked “the end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government.”4 Fukuyama assumed that “Western” implied “capitalist.” However, he showed some ambivalence about the meaning of “capitalism.” Fukuyama’s use of this term implied a triumphant market liberalism. But in defending the factual claim of a universalized social order, his use of “capitalism” encompassed the whole range of political and economic systems observed in Western societies, from Scandinavian social democracies to the winner-Â�take-Â�all society then emerging in the United States. Friedman dispenses with such nuance. In a book full of cute phrases and memorable metaphors, the most prominent was the “Golden 4 Fukuyama (1992), 4. THE GREAT MODERATION 9 Straitjacket.” This was Friedman’s way of saying that, in a globalized economy, adherence to the principles of market liberalism would guarantee golden prosperity. On the other hand, any deviation from those principles would bring down the wrath of the “Electronic Herd” of interconnected global financial markets. Fukuyama’s celebration of the new order made him an intellectual superstar. His books were widely cited, if not quite so widely read. Friedman’s breezy boosterism, by contrast, did not earn him so much intellectual credit, but it put him on the bestseller lists. Everyone wanted to be part of the new Lexus-Â�owning world. Economists were a little late to the party. Well into the 1990s, they worried about weak productivity growth, the possibility of resurgent inflation, and unemployment rates that remained high by the standards of the postwar boom. By the early 2000s, however, it was possible to look at the U.S. data and discern a pattern that was the very opposite of a lost golden age. Rather, the data could be read as showing a decline in the volatility of output and employment. Most economists saw the decline in volatility as a once-Â�off dropping that took place in the mid-Â�1980s, after the early 1980s “Volcker” recession, so called because it was induced by the restrictive anti-Â�inflation policies of Fed chairman Paul Volcker. 5 Although most attention has been focused on the volatility of output, the most important impact of recessions is the variability of employment, which is best measured by the employment/population ratio. As with measures of GDP volatility, the standard measures of employment volatility declined noticeably after 1985. This apparent decline in volatility largely coincided with the chairmanship, lasting nearly twenty years, of Volcker’s successor, Alan Greenspan. Whether deservedly or not, Greenspan, rather than Volcker, got the credit. Greenspan’s status as the source of all economic wisdom was symbolized in the ultimate Washington accolade, a biography (or rather, hagiography) from Bob Woodward, entitled Maestro. 5 The cigar-Â�chewing, six-Â�foot seven Volcker literally towered over the economic scene in his day and remains active (at 81, he’s an adviser to President Obama) but has been almost entirely displaced in popular memory by Alan Greenspan.
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