When the economy chugs along nicely, scarcely a thought is given to the more heterodox economists. The invisible hand is everywhere, everything is firmly in equilibrium and rational expectations rule the roost. Once a crisis occurs, however, long-forgotten theories are resurrected, economists hitherto banished are rehabilitated and the realization suddenly dawns that in spite of suffering crisis after crisis, mainstream economic theory barely acknowledges their existence.
The current global recession has been no different. All of a sudden, the virtues of a Keynesian fiscal stimulus are being rediscovered, Schumpeter’s “creative destruction” is being invoked and Fischer’s debt-deflation theory is being revived. Why, there’s even a renewed interest in that grey eminence, Karl Marx. The star of this crisis has undoubtedly been Hyman Minsky, the man famous for his “Financial Instability Hypothesis”. The common thread running through all of them is the heretical idea that the economic system is unstable.
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Minsky believed that years of investment and profits increase the confidence of individuals, firms and banks. They start believing the good times will last for ever. This spurs them to take more risk and increase leverage. As Minsky wrote in 1975: “As a recovery approaches full employment, the current generation of economic soothsayers will proclaim that the business cycle has been banished from the land and a new era of permanent prosperity has been inaugurated.” Sounds familiar? There comes a time when the bubble bursts and, once the investment cycle turns, leveraged market players start selling frantically. Since this is more or less exactly what happened during the current crisis, it’s no wonder that Minsky is a hero.
Minsky’s identification of the financial markets as the source of today’s crises is spot on. But there are also many similarities between his views and that of several other economists. Take Keynes, for example, who was Minsky’s guru. Wrote Minsky: “In the part of The General Theory that was lost to standard economics as it evolved into the neoclassical synthesis, Keynes put forth an investment theory of fluctuations in real demand and a financial theory of fluctuations in real investment.”
Schumpeter saw risk-taking by entrepreneurs as the key to growth and believed in a Darwinian survival of the fittest, with inefficient enterprises falling by the wayside. He had no fondness for stability, but instead celebrated the innovation that lay at the heart of making capitalism such a dynamic system.
And finally, here’s Marx in the third volume of Capital: “With the development of interest-bearing capital and the credit system, all capital seems to be duplicated, and at some points triplicated, by the various ways in which the same capital, or even the same claim, appears in various hands in different guises.” Could this be a visionary statement about CDOs, CDS and the alphabet soup of derivatives? Maybe not, but it shows that Marx was aware of the potential of what he called “fictitious capital” to create mischief.
The important question is: if these savants were so prescient, what were their prescriptions for dealing with systemic instability? Schumpeter, true to his Austrian roots, argued against expanding credit and the money supply in the depths of the Great Depression, believing that it was necessary to purge the economy of the malinvestment that occurred during the boom. That view, shared by US secretary of the treasury Andrew Mellon during the Great Depression, has been best described by President Herbert Hoover: “Mr Mellon had only one formula: liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate.”
In The General Theory, Keynes proposed “a somewhat comprehensive socialization of investment”. Later in the 1940s, he wrote if, “something like two-thirds or three-quarters of total investment will be under public or semi-public auspices, the amount of capital expenditures contemplated by the authorities will be the essential balancing factor... It has nothing whatever to do with deficit financing”. Minsky, too, was all for government investment as a stabilizing factor, arguing that “policy needs to enter upon the as-yet-uncharted course in which the rules for a somewhat comprehensive ‘socialization of investment’ and the containment of liability structures are being examined”. Simply put, both Keynes and Minsky were in favour of a permanent role for the government in investment.
It may be a surprise that Marx was no great fan of nationalization in a capitalist economy. When Napoleon III approved the setting up of a state-supported bank, the Credit Mobilier, Marx opposed it on the simple ground that Bonaparte’s reason for nationalizing the credit system would be “to save property from the dangers of Socialism”. Marxists believe that major crises in the capitalist system lead to changes in what they call the ‘social structures of accumulation’, which is not just a change in the organization of the economy, but also a political change. For instance, the Great Depression resulted in a shift from laissez-faire capitalism to the welfare state, while the stagflation of the 1970s led to globalization and a return to conservative ideology.
It’s impossible to predict what will be the outcome of the current crisis. Will it be a turning point for the system such as in the 1930s and 1970s? Will the government play a more active role even after the crisis gets over? At the moment, the focus of policymakers seems to be to try and get back to “business as usual”. Even if they succeed, that will only postpone the moment of reckoning.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com