Financial crises and economic theory
On the last page of General Theory (1936) Keynes makes his famous remark that “practical men… are usually the slaves of some defunct economist”. Keynes thus blamed the theories of past economists for the errors which had led to the Great Depression of the 1930s. It is claimed by some that the gravity of the current financial crisis is the result of the intellectual influence of living economists: they had not forecast the approach of the crisis and many economists were responsible with others for the reforms and policies that gave rise to the crisis itself.
We examine three things in what follows:
i) the principal responsibilities of economic theory with regard to the current crisis;
ii) the differences from the major crises of the last century;
iii) the need for true and genuine new theoretical thought (or revolution perhaps) to obtain the right recipes for preventing such serious crises from repeating[1].
We will never succeed in finding the right remedies for preventing new financial crises without the correct theory of what causes the financial instability.The Great Stability
The most serious financial crisis in recent centuries was preceded by an extraordinary period of macroeconomic success. Aided and abetted by the globalisation that started with the fall of the Berlin wall twenty years ago and by the reunification of the civilised world which was the result, the distinction between first, second and third world disappeared and some sort of “market economy” spread throughout the world, with some complacency over its virtues. The excessive optimism did not just regard emerging countries, but was even more evident in countries which had developed more and before: the United States and the United Kingdom. In the former case, they spoke of the Great Moderation[2] in the sense of a substantial decline in macroeconomic (growth in real output and inflation) volatility. Since the mid-1980s (i.e. for over twenty years) these positive developments occurred in the United States and in other major industrial countries (with the exception of Japan). They brought many benefits as a consequence: lower volatility for inflation and output meant that markets were be more efficient, there was less economic uncertainty and fewer resources were needed to protect against risks. Analyses similar to these have been made of the United Kingdom for which they have spoken[3] of the Great Stability i.e. “a period of nearly 15 years of continuous growth, low inflation and falling unemployment”.
Why is it still important today to emphasise the point that the global financial and economic crisis that exploded in 2007 came after a long period (15-20 years) of macroeconomic successes? Because there is a reasonable suspicion that it is precisely these successes with two historical problems of capitalism, unemployment and inflation, which had directly and indirectly contributed to the problem that exploded in 2007.
The problems which have been understood and solved in theory and practice in the evolution of capitalism tend not to crop up again, but if anything to favour the appearance of new and different problems That is what we experienced in the last century with two dimensions of economic stability: employment and inflation. It was seen in the nineteen thirties with mass unemployment and then in the nineteen seventies with two figure inflation. Once they had been understood and solved, those problems did not appear again. We have had other problems.
Full Employment and Monetary Stability
Macroeconomic stability has three at least partially distinct dimensions: the level of employment; the stability of the value of money; financial stability. We will examine them in this order partly because this is the chronological sequence in which they appeared and we have studied them. The first two were of particular importance in two difficult decades of the last century: the Great Depression of the 1930s and the Great Inflation of the 1970s. The 1930s with mass unemployment and the 1970s with two figure inflation: in each case, once the causes and the necessary remedies were understood, the problem didn’t occur again.
In the 1930s that happened with Keynes General Theory which explained what persistent high unemployment might depend on. Once the governments understood what should be done to solve the problem and better still, what to do to prevent the problem, it didn’t occur again. We have seen other problems, but not an entire decade of mass unemployment in the main developed countries.
Similarly we have not had two figure inflation again, as occurred in the 1970s, after we understood the true lesson of monetarism, and we have therefore made the necessary reforms to prevent governments from manipulating the money supply to obtain a short term political consensus. The various explanations advanced at the time to justify high inflation (oil shocks, loss of productivity, etc.) were no longer needed once that inflation was brought under the control of the rules which govern the medium-to-long term money supply. And this was seen clearly with the third oil shock ( (2007-8), when expected inflation, and therefore core inflation, remained practically unchanged despite the explosion in food and energy prices.
Has finding the solution to one problem helped to produce the next? To what extent did the soaring inflation of the 1970s depend on the previous policies designed to keep unemployment down?
It is my thesis that during the 1980s and 1990s, monetary stability took precedence over financial stability from several viewpoints:
1) at an analytical level, it was claimed that monetary stability should be the priority and that it also favoured financial stability;
2) the political economy taught in our universities has followed the same tendency. One need only consider one widely used textbook, that by O. Blanchard, Macroeconomics, published by Prentice Hall in 2006. It contains many pages on unemployment and on inflation and there is much on monetary policy designed to prevent inflation; but there are only three pages (out of a total of 700) on “speculative bubbles” and seven pages on the Japanese stagnation (explained more as an example of a “liquidity trap” than in terms of financial instability as a general problem of capitalism);
3) one further aspect which deserves attention is the monetary reforms that have been implemented. Again in line with the great importance attributed to monetary stability, a series of reforms were implemented in many countries in the ‘80s and ‘90s of the last century designed to increase the independence of central banks from governments and – for that and other purposes – in many cases they lost their functions as supervisors of banks;
4) not only did this make the financial system more fragile because it was “less supervised”, but it also made it more probable that the “success” of that monetary policy (low inflation and therefore very low interest rates), gave rise to the other problems we have seen.
It is my thesis that the priority attributed to monetary stability, along with the reforms and policies implemented to guarantee it, have resulted in insufficient theoretical analysis in terms of rules and policies dedicated to financial stability. It is not by chance that this is our greatest unsolved problem today. Financial stability
It may be claimed that the success in reconciling stable employment with monetary stability – the phenomenon known as the Great Moderation that began in the middle of the 1980s – has encouraged growth in risk-taking. Twenty years of satisfactory macroeconomic stability – attributed variously to a more flexible economy and to the improved performance of macroeconomic policies – have reduced risks and also the actual aversion to risk. In other words today’s problems represent the price paid for the “Great Moderation” (which is, alas, now over!).
If this interpretation of the causes of the seriousness of today’s crisis is accepted, two main consequences result from it. Firstly, a correct “theory of risk” and its consequences for the stability of the financial system – which takes account of the main financial innovations that have occurred in recent years – still remains to be formulated. It is above all a problem of the relationships between banks and markets (i.e. between credit and finance), which form the basis on which the price of risk is formed.
The second consequence on the other hand concerns the effects of macroeconomic stability (employment and monetary stability) on systemic risk and financial stability: in the jargon of central banks, the idea that speculative bubbles cannot be prevented needs correcting. We have just seen that it can be too dangerous if action is restricted to dealing with their negative consequences.
New rules and policies
In analogy to what has already been done with regard to the employment and monetary dimensions of stability, not only is new theoretical thinking needed to address the third dimension – financial stability - but also the resulting new rules and therefore appropriate reforms of the wrong rules which have been followed to-date, along with appropriate new policies. Without adequate theoretical thinking however, there is a clear danger that the reforms that everybody wants - to emerge from the crisis and prevent it from repeating – will not be the right ones.
The main problem to solve is that of identifying who must address the issue of financial stability. Should the responsibility lie in a single and sole place or should it be joint and shared with other authorities or by one authority only but together with other responsibilities and in that case what are the relative priorities and possible trade-offs between the different objectives?
The solution towards which people are moving, with more or less awareness, is that of extending responsibility for financial stability, above all by considerably increasing the responsibilities of central banks in this respect. But are we sure that it is best to have one single authority which has a set of instruments available to it, some more important than others, and a variety of objectives to achieve? The Bank of England reform[4] has already moved in this direction. Today it has a mandate to “ensure monetary stability and contribute to financial stability” and to achieve this it has formed a new “Financial Stability Committee”.
This compromise (notice the difference between “ensure” and “contribute to”) is pleasing nobody and will probably be revised by the next Government,[5] when it must be acknowledged that if financial stability must be guaranteed better than it has been to-date, this can only occur by intervening, even directly, in monetary policy, i.e. by preventing those bubbles and/or those imbalances which sooner of later produce financial crises from occurring.
But that is the same as acknowledging that the two dimensions of macroeconomic and financial stability are always connected in some way and therefore “belong” to a single authority, equipped with a number of instruments, which are not fully independent one from the other. This would correspond to the difference between the two families of central banks which we have had over the last 20 years: those like the Fed which have the dual objective of “maximum employment and stable prices” and those like the Bank of England which the 1997 reform made independent and accountable with monetary stability as its only target. This orthodoxy of the last twenty years, which had stoutly resisted the criticisms of so many economists[6], ran aground with the current crisis and no one today seems to want to reinstate it.
The new rules and the different policies will not, however, be able to be decided without a broad consensus and without being theoretically based on how financial instability must be defined, measured, and prevented. There is the need to make progress in the measurement of different institutional, analytical, operational and empirical aspects which indicate the different degrees of financial stability[7]. The work to be done is not insubstantial, especially if we compare it with what we already know today of the other two cases, employment and monetary stability.
One reason is because the dynamics of competition between bankers has produced an incredible variety of new financial instruments in recent years, all comprised within the area of financial innovation. Yet still today, we do not know if and how much this process which was moving in the direction of increasing the degree of completeness and efficiency of markets (and therefore of reducing the risk) had already at least partly achieved its goals.
Much economic theory has probably forgotten how much the Second Best theory (1956) had taught us, i.e. that while the situation is proceeding to an equilibrium that is better, it cannot be assumed that the situation is continuously improving in the meantime. From this point of view too, a little too much complacency over the satisfactory results achieved has prevented us from also recognising the unsolved problems which were accumulating in the meantime. The gravity of the current crisis should help to get us back on the straight and narrow path again – typical of the best “defunct economists”[8] – between two extreme positions: those who considered that financial instability is to some extent a natural characteristic of capitalism and those who on the other hand considered that it was a problem that had already been solved.
References
Bernanke, B.S., The Great Moderation, Eastern Economic Association, Washington, DC, February 20, 2004.
Borio, C., - Drehmann. M., Towards an operational framework for financial stability: “fuzzy” measurement and its consequences, BIS Working Papers, n. 284, June 2009.
Colander, D., The Making of a Global European Economist, KyKlos, vol. 61, n. 2, 2008, 215-236.
Gieve, J., Seven lessons from the last three years, London School of Economics, London, 19th February 2009.
Leijonhufvud, A., Monetary and financial stability, CEPR, n. 14, October 2007.
Nixon, S., U.K.’s monetary-policy issue, The Wall Street Journal, July 23, 2009.
Rulers of last resort, The Economist, July 25th, 2009, 12.
The weeds of destruction, The Economist, May 6th, 2006, 82.
[1] It would, however, be necessary to at least distinguish between USA and European economists, because the latter are more committed alongside the policy-makers. See Colander (2008).
[2] See Bernanke (2004).
[3] See Gieve (2009).
[4] Banking Act, February 2009.
[5] See S. Nixon, WSJ (2009) and Economist (2009).
[6] See A. Leijonhufvud (2007). See also the work of W. White of the BIS , April 2006, on the limits of monetary policy designed solely to achieve monetary stability. The focus of the Economist (May 6th, 2006) which spoke of it favourably had a prophetic title: The weeds of destruction. That article in the Economist is still today the clearest reply to those who claim that economists and not governments (or central bankers), are to blame for not having understood the trouble that was brewing.
[7] See C. Borio-M. Drehmann (2009) for an initial theoretical and empirical analysis.
[8] It is not by chance that Leijonhufvud (2007) cites Ricardo, Wicksell, and Patinkin.