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Why couldn’t the theories predict the current crisis?

Why couldn’t the theories predict the current crisis?
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First Published: Wed, Nov 12 2008. 12 33 AM IST

Updated: Wed, Nov 12 2008. 12 33 AM IST
Is something seriously wrong with economics? After being cold-shouldered by the model-building, regression-fitting economist fraternity for long, Keynesian and other less orthodox economists are getting a bit of their own back. In an interview to The New York Times, economist James Galbraith, who has steadfastly stayed loyal to the liberal theories of his celebrated father John Kenneth Galbraith, said that the failure to foresee the mortgage crisis was “an enormous blot on the reputation of the profession”. He went on to say: “There are thousands of economists. Most of them teach. And most of them teach a theoretical framework that has been shown to be fundamentally useless.”
Lord Skidelsky, a professor of political economy and the author of a biography of John Maynard Keynes, goes even further. Referring to the current credit crunch, he says: “But what is in even shorter supply than credit is an economic theory to explain why this financial tsunami occurred, and what its consequences might be. Over the past 30 years, economists have devoted their intellectual energy to proving that such disasters cannot happen. The market system accurately prices all trades at each moment in time. Greed, ignorance, euphoria, panic, herd behaviour, predation, financial skulduggery and politics—the forces that drive boom-bust cycles—only exist off the balance sheet of their models. So mainstream theory has no explanation of why things have gone so horribly wrong.”
Well, the world has been having crises for years—the Latin American debt crisis, the Mexican meltdown, the Asian crisis—but none of them seems to have made much of a difference to economic theory. True, the names of heterodox economists such as Hyman Minsky and Joseph Schumpeter enjoy a brief spell of popularity, to be speedily forgotten as soon as normalcy returns. But who knows, now that the problem is closer to the heartland, perhaps this crisis will result in a re-examination of some fundamental principles, just as the Great Depression led to the publication of Keynes’ General Theory of Employment, Interest and Money.
The worry is: If mainstream economists didn’t know much about the origin of the crisis, how can they know an awful lot about its solution?
Consider the policies currently being implemented by Federal Reserve chairman Ben Bernanke and his ilk. In a speech in 2002 at a conference to honour economist Milton Friedman’s 90th birthday, Bernanke said: “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” He was referring to a famous book on the Great Depression by Friedman and Anna Schwartz which essentially said that the depression was the result of mistakes committed by the monetary authorities of the time. Said Bernanke, “Because of institutional changes and misguided doctrines, the banking panics of the Great Contraction were much more severe and widespread than would have normally occurred during a downturn…” Bernanke has been a scholar of the Great Depression and his present policy of throwing vast amounts of liquidity at banks and recapitalizing them is based on the premise that not doing so in time is what allowed the crash of 1929 to morph into the Great Depression. But is adding liquidity the solution to a crisis that came about as a consequence of too much liquidity?
At the heart of this reasoning lies the belief that the problem has to do with the credit system. But Rutgers University historian James Livingston in an article, Their Great Depression and Ours, says that the problems in the credit systems are only a reflection of an underlying trend in the real economy. The point Livingston makes is that the crisis is merely a symptom of a deeper issue: the inequality of income. He writes: “The underlying cause of the Great Depression was a distribution of income that, on the one hand, choked off growth in consumer durables—the industries that were the new sources of economic growth as such—and that, on the other hand, produced the tidal wave of surplus capital which produced the stock market bubble of the late 1920s. By the same token, recovery from this economic disaster registered, and caused, a momentous structural change by making demand for consumer durables the leading edge of growth.” Livingston then draws a parallel with the current crisis, pointing out that the share of real wages has stagnated for a long time in the US and the share of profits in national income has risen sharply. How did the US economy recover from the Great Depression? Livingston says the “shift of income shares away from profits, toward wages, which permitted recovery…was determined by government spending and enforced by labour movements”.
But perhaps Livingston, being a mere historian, hasn’t quite grasped the economics of it all. Maybe not, but John Kenneth Galbraith, in The Great Crash, 1929, also listed income inequality as one of the reasons for the crash, the others being leverage, innovations such as holding companies and investment trusts, too many banks and imbalances in foreign trade. It’s not difficult to understand why leverage was important in the 1920s and is so important now—what better way to stoke demand when real wages are stagnant than to?increase debt?
Incidentally, Galbraith also included the poor state of economics as another reason for the Great Depression. Here’s what he wrote, “Economists and those who offered economic counsel in the late twenties and early thirties were almost uniquely perverse.”
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com
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First Published: Wed, Nov 12 2008. 12 33 AM IST