Money and Government: a lecture at the LSE, 17 September 2018

i.

Over the weekend, just ten years ago, the investment firm Lehman Bros collapsed, and the world economy collapsed after it. I feel a little reluctant to add to the torrent of words trying to read the runes of this catastrophe for the better management of affairs in the future.

But, by chance or cunning, a book of mine, called Money and Government: A challenge to mainstream economics, has just been published. This tries to set the collapse of 2008 in a historical context. It has been inspired by John Maynard Keynes, who believed that the collapse of the 1930s needed the response of a new economic theory, and a new, or rather very old, conception of statecraft.

Money was at the heart of his economic theory; and public management of the economy at the heart of his theory of government. He accused his profession of abstracting from both in their attempts to model ideal types of economy.

In the 1930s political extremism flourished, and Keynes was clear about the political importance of what he was saying:

‘The authoritarian state systems of today [he wrote in 1936] seem to solve the problem of unemployment at the expense of efficiency and freedom. …But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom’. (GT, 381)

All this you can read in my book. Tonight I concentrate on four topics: Why did it happen? Why was the recovery from it so botched? What precautions do we need to take to minimise the chances of it happening again? And what political dangers do we face if we fail to do so?

ii.

We know what happened, but have scarcely got to the bottom of why it happened. The proximate cause of the collapse of 2008 was the accumulation of private debt. A vast, global inverted pyramid of bank, business, and household debt was built on a narrow base of underlying assets -American real estate. When the base tottered, the pyramid fell. Notice it was private, not public debt, which was the problem. Persistent propaganda to the contrary, public profligacy played no causal role in the economic collapse.

The interesting question is: why had politicians allowed, even encouraged, the development of a financial sector with such an appetite for making unsound loans? The shortest answer is that they hadn’t got a clue about the risks the banks were running. A slightly longer answer is that they did have a clue, but were so ideologically hostile to state interference with market forces, that they were willing to run the risk.

Remember, politicians are consumers of ideas. This is what they were being fed by their policy advisers-the following from the IMF, 2006:

‘There is growing recognition that the dispersion of credit risk by banks to broader and more diverse groups of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and the overall financial system more resilient’

You could hardly get it more wrong. Dig deeper and you find Rational Expectations and Eugene Fama’s efficient market hypothesis. Dig a bit deeper and you find belief that markets are optimally self-adjusting. Dig into the politics of it and you come across Reagan’s famous ‘Governments are the problem, not the solution’, and Thatcher’s ‘you can’t buck the markets’.

To explain how the elements of bad theory, ideology, vested interest, and political calculation combined to construct a financial system virtually free of prudential regulation remains a major challenge to thought. But I would suggest that economics was guilty in at least four respects.

First, the standard macro-economic models of the day abstracted from the existence of money and banks. For example, the Bank of England’s main economic model between 2004 and 2010 omitted the banking system from its grouping of key economic agents.

This abstraction, I explain in my book, was the result of economic models treating banks as mere intermediaries between utility maximising households and profit-maximising firms. Keynes’s crucial insight that ‘money plays a part of its own and affects motives and decisions’ was ignored. This misguided view of money left the Bank unable to identify a burgeoning financial crisis in time.

Second, standard economic theory taught that the main problem to be guarded against was inflation. Provided inflation was controlled by central banks, the economy would be naturally stable. Since inflation was, in fact, subdued, central banks lost interest in maintaining financial stability. In fact, inflation was kept low, not by central bank policy, but by the entry of billions of low wage East Asian workers into the global market.

Third, the standard economic models failed to distinguish between risk and uncertainty, a distinction which lay at the heart of Keynes’s theory. All the risks run by banks in making loans were said to be calculable, and therefore all the loans they made were accurately priced on average. Banks could safely be left free to roam the world placing their bets where they wanted. Efficient finance theory ruled out the possibility of a widespread banking collapse. It is little wonder that Alan Greenspan, chairman of the Fed in the 2000s, admitted that the revelation that ‘risk had been underpriced world-wide’ destroyed his intellectual system.

Fourth, mathematical modelling of the herd behaviour or ‘momentum trading’ rife in financial markets is very difficult if not impossible, so standard financial models simply omitted it. ‘Behavioural economics’ is an attempt to plug this theoretical hole. ‘Gosh’, the old-fangled economist says, rubbing his eyes, ‘do you mean to say that people can behave irrationally?’

Let me now turn to the structural explanation of the collapse. This says that the creation of excessive debt is a necessary part of the contemporary capitalist economic structure.
The kernel of the argument is that the more unequal the distribution of wealth and income, the more difficult it will be to maintain continuous full employment. This is because the rich save a higher fraction of their incomes than do the poor. Growing inequality thus creates a contradiction. The more unequal the society is, the greater the investment needed to keep the economic machine going; yet the smaller are the earnings available to buy the increased output from the investment. Hence, barring steps to reduce inequality, consumption will become increasingly dependent on debt; and the savings of the rich will be increasingly employed in speculation rather than in expanding the output of consumer goods.

Marriner Eccles, Roosevelt’s chairman of the Fed, put the matter succinctly in 1938: ‘By taking purchasing power out of the hands of mass consumers, the savers denied to themselves the kind of effective demand for their products that would justify a reinvestment of their capital accumulations in new plants. In consequence, as in a poker games when the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped’.
Something like this happened in the run- up to 2008. Advanced country data show a sharp rise in the share of the post-tax income going to the top 1%; real hourly earnings lagging well behind the growth in labour productivity; a fall in the share of median, or typical, family income as a percentage of average family income; and a fall in the share of wage income in GDP.

Why did this happen? Standard economic theory offers us no glimpse at the power relations behind the growth of inequality. It assumes that, in competitive markets, all factors of production are paid what they are worth. Indeed the thrust of economic policy since the 1980s has been to remove market distortions, such as high marginal tax rates; that is to say, it has deliberately promoted inequality in the belief that by redistributing income from the poor to the rich it would improve the incentives to work and save.

This ‘supply side’ strategy had no empirical support, and its theoretical basis -as illustrated by the notorious Laffer Curve – was flimsy. The main effect of the Reagan-Thatcher reforms was not to speed up the rate of growth, but to speed up the rate of growth of private debt. In the UK, household debt (consumer debt plus mortgages) rose from 70% of GDP in the 1980s to 148% in 2008. Financialization – a measure of the ratio of financial transactions to total economic transactions- rose from 70% of GDP in 1980 to over 450% in 2011. With massive inflows of Chinese money keeping interest rates low, access to cheap credit became the new form of the social contract.

As the economist Thomas Palley pointed out in 2008, the American economy ‘relies on asset price inflation and rising indebtedness to fuel growth’. The need, he asserted, was to restore the link between wages and productivity. That way ‘wage income, not debt and asset price inflation, can again provide the engine of demand growth’.

Thus the excess credit creation, which Hayekians see as the cause of the financial collapse of 2007-8, can, on further reflection, be seen to be rooted in the stagnation or decline in earnings. ‘Consumption smoothing’ -consuming expected future wealth today -produced its nemesis in 2008.

ii.

I now turn to my second topic: why was recovery from the crash botched? The consensus view now is that whereas, massive government stimulus measures cut off the downward slide of 2008-9, subsequent fiscal austeriity delayed recovery by two or three years in the UK, and longer in the EU, leaving in its wake reduced productive capacity.

Even the Economist, certainly no beacon of radical thought, now admits (7 September 2018) that ‘fiscal and monetary policy could have done more sooner to bring about recovery. They were held back mostly by misplaced concerns about government debt and inflation’. But these concerns were the Economist’s own. On 8 October 2009 it wrote: ‘voters know that big spending cuts are inevitable. Sitting on the fastest-rising public debt relative to GDP of any large developed country, Britain is especially vulnerable to a loss of confidence by bond investors.. They need to believe that Britain’s probable new government is taking deficit reduction seriously’.

The context of these remarks is that in rescuing banks from disaster in 2008-9, governments transformed a great deal of private debt into public debt. Conservative rhetoric was then able to reverse the causation: the crisis was caused by the build-up of public debt.

In explaining the turn to austerity in 2010 we have the same problem of determining the respective parts played by bad theory, ideology, vested interest, and political calculation. But bad theory cannot escape blame.

One of the most telling arguments made for austerity involved the analogy between household and government debt. It’s still regularly trotted out, and the fallacy is hard to dispel, because it sounds intuitively correct. It’s like a beginner’s understanding of chess, where you can work out the first consequence of your move, but not the second and third.

Everyone knows, the argument runs, that if a household’s income falls it has to reduce its consumption. It can borrow temporarily, but this borrowing must be paid back by saving more. And the same must be true of a government which is only, after all, a large household. So when a government’s revenue falls, as a result of a slump, it should reduce its own consumption. Any temporary borrowing should be repaid as quickly as possible.
To explain persuasively that government finances are different from household finances creates a narrative difficulty. In the past, I’ve tried saying that a government in debt is not compelled to reduce its spending, because unlike a household, it has its own bank, which can print as much money as it tells it to. But I know from experience that what economists call ‘monetizing the deficit’ will sound dodgy to anyone but a new monetary theorist.

So I think you have to say, what Keynes in fact did say, that if a single household reduces its spending, this will have no effect on anyone but itself; but if a government reduces its spending this will affect the consumption of everyone else. The reason is simply that the government spends so much more money than any household or firm. Western governments spend about 40% of the national income. Let’s say they reduce their spending by 10%. That means total spending on the goods and services the economy produces drops by 4%. So my income falls and yours as well, and everyone else’s. We’re now three or four moves ahead in our chess game: but the logic should not be too difficult to grasp. Keynes called the inability to distinguish the spending of a household and the spending of the state the ‘fallacy of composition’. But this fallacy was rampant in the financial press ten years ago.

The logic of thinking the matter through is that, when an economy slumps, the government should increase, not reduce, its spending in order to offset the increased saving of the private sector: it should build new hospitals, schools, houses, not stop building them. That is the only healthy way to get the deficit down.

But this also raises narrative problems. I once used the argument above in a speech in the House of Lords. Nigel Lawson, Thatcher’s chancellor of the exchequer, sprang to his feet: ‘What you are saying is that the government should increase its deficit in order to reduce it. That is nonsense’. And he sat down with a satisfied grin, like a cat who had just got the cream.

Mr. Osborne’s Treasury was not stupid. They understood the Keynesian argument perfectly well. But they had an extra move to escape the trap. Yes, they agreed, cutting public spending would certainly depress total spending. But it would reassure all those who were lending the government money – the bond markets -that the government would not default on its debt. Without this reassurance they would charge the government higher and higher interest for lending to it. Not only would the government have to spend increasing sums on interest payments, but all interest charges in the economy would go up, so the stimulative effect of any increase in public spending would be lost.

The economist they were listening to in 2010 was Alberto Alesina, who was assuring European finance ministers that ‘many, even sharp reductions of budget deficits have been followed by sustained growth…even in the short-run’. Business confidence would improve even more if the deficit was cut by reducing payments to the poor rather than by increasing taxes on the rich.

Here I think we can see the baleful effects of post-modernist economics. Keynes had started this by introducing expectations into economics. However, for Keynes expectations were inherently uncertain -we didn’t know what would happen. But rational expectations theory turned expectations into a trap for Keynesian policy. If properly- informed, forward-looking, rational lenders like the bond markets believed that by cutting their spending government promises to repay would become more credible, then governments had no choice but to follow their wishes if they were to get their money. In return, lenders would rationally respond by lowering interest rates.
It is very hard to avoid the conclusion that this method of evading the Keynesian logic was determined less by science than by ideology. Businessmen don’t like the welfare state. So if you want to get them to invest in the economy governments have to cut spending on those who most need it. Conservative politicians like George Osborne used the so-called scientific arguments for deficit reduction as a cover for shrinking state spending on the poor.

Ideology also played a prominent role in QE -quantitative easing. This was the preferred alternative to increasing government spending by those who realised that some sort of stimulus was required. The theory was that by buying up government debt from its holders, the Bank of England would pump money into the economy. The extra money would then be spent. Money could be issued in any amount needed to offset, or even more than offset, the cuts in government spending.

The preference for QE over public spending was a mixture of ideology and science. On the one hand, it preserved the fiction of central bank neutrality. In August 2009, the Chicago economist Robert Lucas called it ‘the most helpful counter-recession action taken to date. It entails no new government enterprises…no government role in the allocation of capital. These seem to me important virtues’. The fact that the bulk of the new money went to sellers of existing assets -that is to say, the already wealthy – was, if anything an advantage. Feeling even wealthier than before they would spend the extra money, so it would ‘trickle down’ to the poor. In short, its effect would be similar to cutting their taxes.

But there was a theoretical hole in the argument, which Keynes had pointed out in 1936: the belief that money received will always be spent. Keynes warned that ‘If we are tempted to assert that money is the drink which stimulates the system to activity. we must remind ourselves that there may be several slips between the cup and the lip’. In their account of the transmission mechanism between money and prices, central bankers and most monetary economists ignored the existence of ‘liquidity preference’, that is, preferring to hold assets in liquid form rather than spend it buying goods and services. Much of the new money went into cash reserves or the purchase of liquid assets, at home and abroad, not into the production economy.

Let me sum up the response to the slump. Osborne’s ‘expansionary fiscal consolidation’ delayed recovery by at least two years. Its cumulative effect over seven years was to leave households between £4000 and £13,000 worse off than they would have been.

Quantitative Easing offset fiscal contraction to a limited extent, but produced a lop-sided recovery, increased inequality of wealth, and precisely because of its ineffectiveness, has left a lot of speculative cash sloshing around the global financial system, setting the scene for the next financial crisis.

iv.

Ten years on is a good time to ask what governments and policy makers, have learnt from the crisis. The answer is: not nearly enough.

One pretty obvious conclusion is that prevention is far better than cure. Once a downturn gathers speed, the scale of intervention needed to reverse it becomes frighteningly large. Budget deficits balloon, public debts soar, governments take over banks – all conjuring up visions of looming state bankruptcy, or worse, state control over the economy. So the most important question is: how can these catastrophes be stopped from happening?

By prevention, I do not mean trying to stop the semi-regular fluctuations of 1% to 2% of nominal income over, say, a ten year business cycle. Capitalist economies have these rhythmic movements, perhaps connected with Schumpeter’s cycles of creation and destruction. The authorities already possess the tools to dampen these fluctuations, if they want to.

No: prevention has to set itself the more ambitious job of preventing economic collapses: collapses in the order of 5% to 10% of nominal income and an unemployment rate double or treble from ‘normal’ times. These can happen at any time, because, as Keynes taught, the future is uncertain, and any number of unanticipated small shocks can have large effects.

The crisis we have seen started with the banks. It was the rapid spread of contagion through the banking system which brought it low in 2008. This was because big global banks held each others’ heavily-insured risky assets. When the value of these assets collapsed, the banks and their insurers went bust. They then had to be rescued because they were ‘too big to fail’.

Has banking been made more resilient? To some extent: capital and reserve requirements have been beefed up, big banks are now subjected to stress tests; they are required to produce ‘living wills’. But the big reform has not happened: which is to cut the global links between the big banks. This is the only way to stop contagion spreading like wildfire across the financial system. It implies restricting the international movement of money.

This is a huge and complex matter, on which I have no special expertise to offer. But the starting point has to be a challenge to the bankers’ claim that international banks, by efficiently matching savers and borrowers across the globe, reduce funding costs, and so maximise investment and growth. This ignores the speculative character of much of the so-called investment. The case has to be made that banks are not allocating capital efficiently if their bets lead to collapses like the one in 2007-8.

More fundamentally, the task of making banks more resilient to shocks depends on making economies more resilient to shocks. A healthy economy is the key to safer banking. An economic system which can only be kept going by the growth of private debt cannot enjoy a financially stable banking system.

A healthy economy requires reinserting the state into the management of demand, by strategic changes to the distribution of income and the source of investment funds. Governments must take much bolder steps than any yet contemplated to reverse the concentration of wealth and income, not being put off by spurious arguments about reducing the incentives to save and work. They must also, through Public Investment Banks, and their own capital budgets, guarantee the economy a sufficient stream of investment to offset the speculative character of private investment, ignoring the argument that they are bound to ‘pick losers’. Yes, they will: but so does the private sector, time and again.

A central implication of the above is that monetary policy should not be outsourced to central banks. Their mandates give them only one task -preventing inflation, and it is doubtful if they can do even that. Certainly they cannot stop deflation. The central bank mandate should be to support the economic policy of the government, and attend to the stability of their member banks. This limitation of the macro-scope of central banks follows directly from the principle that good money depends on having a good economy, not the other way round.

Other stabilising measures would require reforms beyond the scope of any national authority. But the British government should at least press for the reform of the international payments system to bring pressure on trading partners to balance their current accounts, as Keynes proposed in 1941. Without such a reform, trade and currency wars will become almost inevitable.

v.

The events of the last ten years have left a damaging legacy of political resentment. Between 2007-8 and 2015-6 support for extremist parties in Europe doubled- and that doesn’t include the election of Donald Trump in the USA (2016), our own vote for Brexit (2016), and more recent gains by the National Front in France (2017), the AfD in Germany (2018), the Northern League in Italy (2018), the Freedom Party in Austria (2017), and the Sweden Democrats (2018) . Growing support for populist movements has deeper roots than mere economic distress. But the correlation between the collapse of 2008 and the growth of such movements is too striking to be ignored.

The truth is that bad economics breeds bad politics By bad politics I mean xenophobic nationalism, hostility to immigrants, disregard of human rights, suppression of domestic freedoms. By good politics I mean an international outlook, freedom of expression, respect for human rights, and properly accountable government.

By bad economics, I mean allowing financial markets to dictate what happens to the economy. By good economics I mean recognising the duty of governments to protect their people against misfortune, insecurity, and calamity.

I am not suggesting that we are heading for a re-run of the 1930s. All I am claiming is that bad economics makes it more likely that bad politics will move from the fringes into the mainstream, as happened with Hitler’s National Socialists between 1928 and 1930, and is happening all over the western world today.

What the rise of extremism does suggest to me is that we must find ways of uncoupling political liberalism from the neo-liberal economics which allowed the disaster of 2008. This involves reinstating the kind of political economy which ruled from the 1940s to the 1970s, until it was swept away by Reagan and Thatcher. Friedrich Hayek was precisely wrong when he said that Keynesian social democracy was the slippery slope to serfdom. It was the antidote to it.

The dilemma is clear. If for ideological reasons you believe that wealth creation should be entirely left to the private sector, with governments providing only minimal public goods, then you have to ensure what Keynes called ‘a political and social atmosphere which is congenial to the average businessman’. (GT,162) But in doing so you risk a dreadful political backlash from those who suffer most from business collapses. The sensible middle way is to accept a mixed economy, in which the democratic state is given a positive role in creating and maintaining wealth and well-being.

By good economics today I mean an economics which, while allowing a wide field for decentralised decision-making, insures against catastrophe, takes heed for the future, and responds to the popular demand for fairness. This was the message of Keynes. And it is my message tonight.

If liberals neglect these matters, they risk bad politics providing its own answers.

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