The Keynes solution

 

The Keynes solution: the path to global economic prosperity

Paul Davidson

Palgrave Macmillan 2009, pp 179

 This is a timely book: with the neoclassical paradigm discredited by a major global crisis, many people are looking for alternative ways to organize the financial sector, the global economy, the whole western society. Paul Davidson, dean of the post-Keynesian school, is well equipped to offer an alternative paradigm. He draws partly on previous writings and long thought ideas to offer a quick, non technical, truly “Keynesian” view about a very broad set of economic policy issues. The result is a strange mixture of old and new: problems, analyses, and solutions popping seemingly out of a distant past – almost directly from the debates surrounding the Great Depression -  are presented together with analyses of modern financial markets and heterodox policy proposals.

The axioms upon which Davidson builds his narrative are widely shared today: (1) deregulation has brought the global financial system to its knees; (2) laissez faire economics is unable to pull the global economy out of depression: (3) behind those failed policy approaches is a neoclassical theory that was discredited in the “30, whose marginalization was instrumental to the very high growth rates of the post WW2 era, but that managed to make a comeback and dominate economics after 1970.

How this domination came into being is an important part of Davidson’s remarks. In his view, it was partly the indirect result of political pressures in the McCarthyism period – in particular over the then leading American economist, Paul Samuelson, who later acknowledged the story -  and in part a failure to understand the scope and depth of Keynes’ revolution. Keynes’ theoretical innovations were thus reduced to a mere story of “sticky prices /wages” explaining persistent unemployment. But classical economists, such as Walras, already knew that these rigidities could hamper the automatic adjustment mechanisms that push markets towards equilibrium. Worse: this “Keynesian” theory is less consistent with Keynesian policies than are the neoclassic prescriptions to reduce stickiness (and the role of Trade Union, of regulation). And self appointed “Keynesian” economists forgot the “incomes policy solution”, thus were unable to cope with the inflation of the “70s. These fatal flaws made them an easy target of the resurgent neoclassical (new classical, rational expectations, efficient markets) school.

The door was thus open to a deregulation trend – even US democrats were involved -  that gradually but surely destroyed norms and institutions build during the New Deal to make capitalism more stable (and human). The repeal of the Glass-Steagall Act in 1999 (which separated banking institutions from investment banks) was the final stroke that opened the gate to the fraudulent securitization process of recent years.

But lo!, there’s a “Keynes solution” to all our current (and future) problems: regulation, anti-cyclical public expenditure, incomes policies, capital controls, and an International Monetary Clearing Union – half way between the IMF and a global central bank.

Some of Davidson’s views – especially on international economic relations -  appear undemonstrated, gratuitous, even fallacious. For example, a large empirical literature has not found international trade to be a major culprit of inequality in advanced economies, but Davidson disregards it. Or consider the author’s view that a trade deficit always implies a reduction – one to one! – of domestic aggregate demand: this is a well known fallacy; for any trade deficit implies a capital inflow that in turn may finance other domestic expenditures; the final result may be expansionary (as it was in the U.S. in 2004-07) or contractionary depending on whether households and firms are in the mood for spending. Finally, it is difficult to understand how (in today’s world) excess foreign currency accumulation in one country “[creates] unemployment … somewhere in the global economy”, à la gold standard, unless “somewhere” monetary policy is constrained by a fixed exchange rate.

But why argue? This is a book where one should pick up the pearls, and leave the rest aside. One such pearls is the provocative, practical proposal for international capital controls. Its main purpose would be “placing a major burden of correcting trade imbalances on the nation running persistent export surpluses”. But the author also outlines some potential side benefits: a restraint of the “race to the bottom” in the regulation of financial industry; and greater public control over tax evasion, money laundering, the financing of terrorism and other illegal activities, etc.. (Fine with me, provided that “Big brother” is not in charge of my, hum, “democracy”!).

A clear prose, an easy, almost basic explanation of what went wrong in the complex world of modern finance, a neat discussion of institutional/policy failures that allowed the sub-prime crisis into the current global meltdown, a call – based on history – not to worry about public deficits in times of recession: this and more will be enjoyed by those who want to reconnect the modern debate with our healthiest cultural roots of the XX century.

 

 

 

Lords of finance. The bankers who broke the world

By Liaquat Ahamed

Penguin Books 2009, pp.564

 Here is a masterpiece: a vivid, enjoyable, detailed, profound and revealing monetary history of 1914-33, that also holds important lessons for the Great Recession of our times. The author is a “one book man”, an economist and a speculator with a superior understanding of macroeconomic and financial relations, who spent the last ten years on this project.

Ahamed offers a well structured account of how monetary policy shaped the world but was also influenced by historical developments, the institutional set up of US, UK, German and French central banks, the characters of their governors, social structures, and mainstream economic and moral ideologies. The goings-on are presented through the interweaving biographies of Benjamin Strong, Montagu Norman, Hjalmar Schacht, and èmile Moreau  – the four leading central bankers -  and of their main critic  – a young, brilliant speculator and economist from Cambridge.

The book starts with an account of the global financial collapse of August 1914, at the outbreak of WW1 (the US had just created the Federal Reserve System). It goes on to describe the strategies pursued by central banks in the belligerent countries to finance the war; how – after 1918 – politicians burdened “a world economy still trying to recover” with “a gigantic overhang of international debts”; how central bankers “tried to mitigate some of the worst political blunders behind reparations and war debts”, but ended up keeping “Germany afloat” just “on borrowed money”; how they were responsible for the “fundamental error of economic policy in the 1920s”: taking the world back onto the gold standard – considered the foundation of central bank independence from government pressures -, while the post-war concentration of gold in the US made it a dysfunctional system; how they selected “grossly misaligned” exchange rates, and deflated their economies for the sake of restoring pre-war parities (favouring savers, to the detriment of the unemployed); how they defended these parities over time by keeping US interest rates artificially low; how these low rates encouraged the Wall Street bubble of 1927-29; how central bankers then were unable to offer any leadership, even “failing to act as lenders of last resort”.

A British ambassador remarked in 1930: “this is the most stupid recession I’ve ever seen”. I feel the same about the current one. Both recessions were caused by a sudden drop of aggregate expenditure, which in principle is very easily cured by giving purchasing power to those who would spend (the poor). This would be most easily done by supporting the expansion of public budgets with money creation. If it is not done, it is because of some intellectual, institutional or political failure. For example, in 2008 as in 1930, the high priests of orthodoxy rose to warn about the inflationary risks of money expansion. (But the truth is, money does not create inflation before it is spent; and when/if spending resumes, it will be extremely easy for central banks to reduce money supply). In 2009, as in 1931, they warned us about the dangers of rising public deficits (the truth is, short term deficits have very little to do with the solvency of debtor states). In 2010, as with the FED in 1932, the institutional setting forbids the ECB from supporting large troubled debtors; and most Treasury Ministers are willing to let large debtors fail (Lehman, Greece), again partly on “moral” grounds (remember Andrew Mellon, the failure of the B.U.S., and the bank crisis of 1932?).

As in 1931 the gold standard (and the FED’s Statute) proved too tight a jacket for the world (US) monetary system, so may prove to be today some contemporary (European, monetary) rules and institutions. In the 1930s, the no-more-young brilliant speculator and economist from Cambridge believed that “if only we could eliminate ‘muddled’ thinking in economic matters”, the crisis could be solved. I think John Maynard Keynes was right.

 

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