The Non-Existent Hand

Joseph Stiglitz

  • Keynes: The Return of the Master by Robert Skidelsky
    Allen Lane, 213 pp, £20.00, September 2009, ISBN 978 1 84614 258 1

It has become a commonplace to say, in the aftermath of the Great Recession, that ‘we are all Keynesians now.’ If this is so, then Keynes’s great biographer, Robert Skidelsky, should have much to say about the recession, its causes and the appropriate cures. And so indeed he does. I share with Skidelsky the view that, while most of the blame for the crisis should reside with those in the financial markets, who did such a poor job both in allocating capital and in managing risk (their key responsibilities), a considerable portion of it lies with the economics profession. The notion economists pushed – that markets are efficient and self-adjusting – gave comfort to regulators like Alan Greenspan, who didn’t believe in regulation in the first place. They provided support for the movement which stripped away the regulations that had provided the basis of financial stability in the decades after the Great Depression; and they gave justification to those, like Larry Summers and Robert Rubin, Treasury secretaries under Clinton, who opposed doing anything about derivatives, even after the dangers had been exposed in the Long-Term Capital Management crisis of 1998.

We should be clear about this: economic theory never provided much support for these free-market views. Theories of imperfect and asymmetric information in markets had undermined every one of the ‘efficient market’ doctrines, even before they became fashionable in the Reagan-Thatcher era. Bruce Greenwald and I had explained that Adam Smith’s hand was not in fact invisible: it wasn’t there. Sanford Grossman and I had explained that if markets were as efficient in transmitting information as the free marketeers claimed, no one would have any incentive to gather and process it. Free marketeers, and the special interests that benefited from their doctrines, paid little attention to these inconvenient truths.

While economists who criticised the ruling free-market paradigm often still employed, as a matter of convenience, simple models of ‘rational’ expectations (that is, they assumed that individuals ‘rationally’ used all the information that they had available), they departed from the ruling paradigm in assuming that different individuals had access to different information. Their aim was to show that the standard paradigm was no longer valid when there was even this seemingly small and obviously reasonable change in assumptions. They showed, for instance, that unfettered markets were not efficient, and could be characterised by persistent unemployment. But if the economy behaves so poorly when such small realistic changes are made to the paradigm, what could we expect if we added further elements of realism, such as bouts of irrational optimism and pessimism, the ‘panics and manias’ that break out repeatedly in markets all over the world?

Of course, one didn’t have to rely on theoretical niceties in order to criticise the faith in unfettered markets. Economic and financial crises have been a regular feature of capitalist economies; only the period of strong financial regulation after the Second World War was almost totally free of them. As financial market regulations were stripped away, crises became more common: we have had more than 100 in the last 30 years.

The present crisis should lay to rest any belief in ‘rational’ markets. The irrationalities evident in mortgage markets, in securitisation, in derivatives and in banking are mind-boggling; our supposed financial wizards have exhibited behaviour which, to use the vernacular, seemed ‘stupid’ even at the time. If we are to design policies to prevent crises or to deal with them when they occur, it is essential to understand the critical flaws in the standard paradigm. It is here that Skidelsky goes astray.

Skidelsky makes much of the distinction between risk and uncertainty. Risk refers to situations in which we have good statistical data so that we can talk meaningfully about the probability that a particular event will happen, like the probability of a 70-year-old man dying within the next year. Uncertainty refers to situations in which we have no statistical basis to go on. Clearly, the investment banks and rating agencies relied too heavily on flawed statistical models, as did the regulators. Those models gave them confidence that the risk of a serious problem was negligible, something that might happen once in a million years.

But much of the behaviour that led to the crisis (the irrational and sometimes predatory lending, the excesses of leverage and other forms of risk-taking) did not depend on this distinction. More important, for instance, were the incentives, which encouraged banks to take on too much risk, and induced them not to think too deeply about the flaws in their statistical models. Flawed incentives, inadequate regulation and a lack of scruples also help explain the abusive lending practices that played so large a role in the crisis.

In accounting for the crisis, we have to explain both the bubble and why, after the bubble burst, the economy went into a deep recession. We also have to explain the massively inefficent capital allocation, the high level of volatility and the persistence of unemployment. The distinction between risk and uncertainty, unfortunately, gives us little insight into the failures in the labour market: why the usual laws of supply and demand, which should result in full employment, have failed to work.

It should be clear that the failure of financial markets is at the centre of this crisis, but as Skidelsky points out, Keynes himself had little to say about financial markets and their management and regulation. One of the criticisms of the General Theory is its simplistic treatment of capital markets (some progress has been made in rectifying this over the last 75 years). Accordingly, it might be thought that Keynes’s views were of only limited relevance in this crisis, beyond his general scepticism as to the ability of markets to correct themselves. That view of Keynes is wrong, however, because this is an economic as well as a financial crisis: there is an insufficiency of global aggregate demand. Explaining why this is so is more difficult than Skidelsky seems to suggest. It is not just a matter of the intrinsic uncertainty of the future. Standard economic theory – the theory of demand and supply that is taught in classrooms around the world – says that if prices (including the price of labour, or wages, and the price of capital, or the interest rate) are fully flexible and markets function as they should, then even with such uncertainty there should be full employment. Wages or interest rates might not be the same as they would be in the absence of uncertainty, but markets would still ensure full employment.

Markets in capitalist systems don’t work that way, though, and the question is why? Skidelsky does not offer much insight here, not even as to what Keynes might have said about it. Those who today see themselves as following in the tradition of Keynes – especially in subscribing to his view that government action is needed to help maintain full employment – are referred to as new Keynesians. One strand of (new) Keynesianism argues that unemployment persists because wages and prices are rigid. It isn’t hard to understand why many economists were attracted to this theory. In the standard demand and supply model, if there is an excess supply of labour (i.e. unemployment), the reason must be that (real) wages are too high. This theory may not only misinterpret Keynes, but may also be potentially dangerous, because of its obvious policy implications. If unemployment is caused by real wages being too high, the obvious remedy is to lower wages. Hence the standard call of conservative economists for more ‘labour market flexibility’, ensuring that the wages of workers – which have stagnated in the US for a quarter of a century – will drop even further. But traditional Keynesian economics argues that what matters is aggregate demand, and that lower wages reduce aggregate demand. The current crisis demonstrates what can happen: countries with stronger systems of social protection and less labour market flexibility have, in many ways, fared better.

Skidelsky’s discussion of the various explanations that economists have come up with, both for wage and price rigidity and as to why the economy does not quickly adjust to ‘equilibrium’, is too unquestioning, too undiscriminating. There is, for instance, a silly theory that says prices are rigid because of the costs of changing price lists (the cost of printing new menus in restaurants would be an example); but these costs pale in comparison to those of hiring and firing workers or increasing or decreasing production. Other theories that have become more widely accepted since Keynes’s death are given scant attention by Skidelsky. Efficiency wage theory, which argues that wages affect productivity, so that it doesn’t benefit firms to pay low wages, isn’t even mentioned.

There is an alternative view (also labelled new Keynesian) as to why an economy can be trapped for so long in a state of under-utilising resources: the debt-deflation theory originally formulated by an American contemporary of Keynes, Irving Fisher, and more recently developed by Greenwald and me. It perceives the key market failures to be not just in the labour market, but also in financial markets. Because contracts are not appropriately indexed (that is to say, payments aren’t adjusted to changing economic conditions), alterations in economic circumstances can cause a rash of bankruptcies, and fear of bankruptcy contributes to the freezing of credit markets. The resulting economic disruption affects both aggregate demand and aggregate supply, and it’s not easy to recover from this – one reason that my prognosis for the economy in the short term is so gloomy.

Keynes focused, as I’ve said, on the problems posed by an insufficiency of aggregate demand: what happens when people want to buy less than the economy is able to produce. Even 75 years ago, he saw the issue from a global perspective. He was concerned, for instance, about the impact of the surplus countries – those that produced more than they consumed – on global demand. Today, we talk about global imbalances. The soaring imbalances of the last ten years are partly due to what happened during the East Asia crisis of 1997-98. Countries without adequate reserves lost their economic sovereignty as the US Treasury and IMF came to their ‘rescue’ (or, more accurately, came to the rescue of their own banks – the same banks that have caused such devastation to our own economies). They foisted contractionary monetary and fiscal policies – higher interest rates, cutbacks on expenditure – on these countries, the opposite of the policies the US adopted in the current crisis. Not surprisingly, these contractionary policies led to recessions and depressions. To reduce the likelihood of having to turn again to the IMF and the West, developing countries around the world accumulated massive reserves. But while these precautionary savings may have provided them with some security, money saved is money not spent: it contributed to a lack of aggregate demand. Other factors also contributed to the build-up of reserves. Low exchange rates can help promote exports. Oil exporters knew there was a significant risk that prices would not remain at the high level they had reached, and the prudent choice was to save a great deal of the money that they were earning. Finally, aggregate demand was almost certainly lowered by the huge increase in inequality, which in effect redistributed money from those who would spend it to those who didn’t, or at least didn’t spend as much.

These factors help explain high savings ratios. But the problem of insufficiency of demand is really a matter of the balance between savings and investment. The problem is sometimes described as a ‘savings glut’, but could equally well be described as an ‘investment dearth’. Why did it seem that even with record low interest rates, the only investment that could be generated was in housing for poor Americans for which they couldn’t afford to pay? A long tradition in economics, of which Keynes was a part, has focused on the diminution of investment opportunities. The path-breaking work of Schumpeter, another of Keynes’s contemporaries, emphasised the role of innovation. The world is currently faced with serious challenges that also present investment opportunities: retrofitting the world economy to face the challenges of global warming, or making the investment necessary to reduce global poverty. There is no shortage of opportunities for investments with high social returns. Here, there have been both market failures and policy failures: a failure, for instance, of governments to make carbon emissions sufficiently costly for there to be an incentive to invest in reducing them, or of financial markets to devise better instruments for transferring risk from those in less developed countries to those in more advanced ones, who can better absorb it.

The central policy message of Keynesian economics is that in a deep recession, monetary policy is likely to be ineffective, and fiscal stimulation is required. This, the argument goes, is because monetary authorities find it increasingly difficult to lower real interest rates (even if nominal interest rates go to zero, deflation can mean that there is a positive real interest rate); and even at low interest rates, investment may not be much stimulated. It’s like pushing on a string. When interest rates were lowered after the technology bubble burst, the effect was mostly foolish real estate investment. But, since Keynes, our understanding of the limitations of monetary policy has increased. For instance, even if central banks succeed in getting treasury bill rates close to zero, the interest rates at which banks lend can remain high; and it is now recognised that availability of credit matters as much as interest rates, especially for small and medium-sized businesses that depend on the ability and willingness of banks to lend. This is one of the reasons there is so much focus on the recapitalisation of banks, and one of the reasons the Bush/Obama policy of giving money to the banks but allowing them to pay it out in dividends and bonuses did not rekindle lending as promised. Today, few look to monetary policy to reignite the economy. The achievement of our central banks has been a more modest one: having brought the global economy to the brink of disaster, they succeeded in avoiding a complete collapse by throwing enough money at the financial system.

Fiscal policy worked, not in preventing a Great Recession, but in preventing the Great Recession from turning into another Great Depression. But now the very actions that saved the economies of the world have presented a new problem for fiscal policy, as questions are being raised about governments’ ability to finance their deficits. There are speculative attacks against the weakest countries, which find themselves caught between a rock and a hard place. They worry that deficits will lead to higher interest rates, not because (as is usually argued) public spending will crowd out private spending, but because of growing ‘risk premiums’. But the effect is much the same: more government spending will force cutbacks in private spending, with the obvious adverse effects on the economy. The financial markets that caused the crisis – which in turn caused the deficits – went silent as money was being spent on the bail-out; but now they are telling governments they have to cut public spending. Wages are to be cut, even if bank bonuses are to be kept. The Hooverites – the advocates of the pre-Keynesian policies according to which downturns were met with austerity – are having their revenge. In many quarters, the Keynesians, having enjoyed their moment of glory just a year ago, seem to be in retreat.

If markets were rational, there would be an easy policy response. Spending on investments that yielded even moderate real returns (say, of 5 to 6 per cent) would lower long-term debt levels; such spending increases output in the short run, thus garnering more tax revenue, and the future returns generate still more tax revenue. If markets could be convinced, for example, that European governments can and will meet their debt obligations, interest rates would fall, and even the countries with the highest levels of debt would find it easy to meet their obligations. But markets are not necessarily rational, and even when they are, they are not always well intentioned. The objective of a speculative attack is to generate profits for the speculators, regardless of the cost to the rest of society. They can make money by inducing panic and then feel pleased with their ‘insight’: their concerns were justified, but only because of the responses to which their actions gave rise.

Since the time of Keynes, the ability of markets to mount such speculative attacks has increased enormously. But governments are not powerless to tame them, and in some cases can counter-attack, as Hong Kong did in foiling Wall Street’s famous ‘Hong Kong double play’, when speculators simultaneously sold short both the currency and the stock market. The speculators knew that governments traditionally respond to a currency attack by raising interest rates, which lowers stock prices. If Hong Kong failed to raise interest rates, they would make money by shorting the currency. If Hong Kong did raise them to save its currency, the speculators would make money by shorting the stock market. Hong Kong outsmarted them by simultaneously raising interest rates and supporting the stock market by buying shares. Taxes on short-term capital gains, regulations on the ever more powerful speculative instruments (like credit default swaps), and – especially for developing countries – the imposition of barriers on the uncontrolled movement of short-term capital across borders, can reduce the scope for and returns from this kind of behaviour.

Keynes created modern macroeconomics; and as I’ve indicated, he gave short shrift to the financial markets. We can, accordingly, only conjecture what he might have thought about one of the critical issues of our day: how to regulate the financial sector in ways that will make a recurrence of the present crisis less likely and increase the likelihood that the financial sector will do what it is supposed to do: manage risk, allocate capital, run the payments mechanism, and all at a low cost. Here, the views of Skidelsky (immersed as he is in Keynes, the macroeconomist) are less than convincing and far from complete. He is, for example, sceptical of regulations that attempt to prevent excessive lending in booms (the so-called macro-prudential regulatory framework).

Towards the end of his book, Skidelsky writes that his chief argument ‘has been that underlying the escalating succession of financial crises we have recently experienced is the failure of economics to take uncertainty seriously’. In the end, he fails to make this case. Overconfidence in the flawed mathematical models used by rating agencies and investment banks did account for many of the horrendous mistakes of this particular crisis, especially in the United States. But these models played little role in the multitude of other bubbles, booms and crashes that have marked the past quarter-century. Western banks have repeatedly had to be bailed out because of their bad lending decisions.

We can’t pass laws that ensure that people won’t suffer from irrational optimism or pessimism. We can’t even be sure that banks will make good lending decisions. What we can do, however, is ensure that those who make mistakes bear more of the consequences of their decisions – and that others bear less. We can ensure that those entrusted with the care of other people’s money do not use that money for gambling. This is true whether those decisions are based on flawed models of risk or irrational perceptions of uncertainty. Taxpayers, workers, retirees and homeowners all over the world suffered because of the mistakes of America’s financial markets. That is unacceptable, and it is avoidable.

Keynes’s great contribution was to save capitalism from the capitalists: if they had had their way, they would have imposed policies that weakened the economy and undermined political support for capitalism. The regulations and reform adopted in the aftermath of the Great Depression worked. Capitalism took on a more human face, and market economies became more stable. But these lessons were forgotten. Thatcher and Reagan ushered in a new era of deregulation, growing inequality and weakening social protection. We are now seeing the consequences, and not just in greater instability. Keynes’s insights are needed now if we’re to save capitalism once again from the capitalists.