THE looming bankruptcy of Lehman Brothers and the forced sale of
Merrill Lynch, two of the greatest names in finance, mark the end of
an era. But what will come next?
Cycles of economic fashion are as old as business cycles, and are
usually caused by deep business disturbances. “Liberal” cycles are
followed by “conservative” cycles, which give way to new “liberal”
cycles, and so on.
Liberal cycles are characterised by government intervention and
conservative cycles by government retreat. A long liberal cycle
stretched from the 1930s to the 1970s, followed by a conservative
cycle of economic deregulation, which now seems to have run its
course. With the nationalisation of America’s two giant mortgage
banks, Fanny Mae and Freddie Mac, following the nationalisation
earlier this year of Britain’s Northern Rock, governments have started
stepping in again to prevent market meltdowns. The heady days of
conservative economics are over — for now.
Each cycle of regulation and de-regulation is triggered by economic
crisis. The last liberal cycle, associated with President Franklin
Roosevelt’s New Deal and the economist John Maynard Keynes, was
triggered by the Great Depression, though it took World War 2’s
massive government spending to get it properly going. During the
three-decade- long Keynesian era, governments in the capitalist world
managed and regulated their economies to maintain full employment and
moderate business fluctuations.
The new conservative cycle was triggered by the inflation of the
1970s, which seemed to be a product of Keynesian policies. The
economic guru of that era, Milton Friedman, claimed that the
deliberate pursuit of full employment was bound to fuel inflation.
Governments should concentrate on keeping money “sound” and leave the
economy to look after itself. The “new classical economics”, as it
became known, taught that, in the absence of egregious government
interference, economies would gravitate naturally to full employment,
greater innovation, and higher growth rates.
The current crisis of the conservative cycle reflects the massive
build-up of bad debt that became apparent with the sub-prime crisis,
which started in June 2007 and has now spread to the whole credit
market, sinking Lehman Brothers. “Think of an inverted pyramid,”
writes investment banker Charles Morris. “The more claims are piled on
top of real output, the more wobbly the pyramid becomes.”
When the pyramid starts crumbling, government — that is, taxpayers —
must step in to refinance the banking system, revive mortgage markets,
and prevent economic collapse. But once government intervenes on this
scale, it usually stays for a long time.
At issue here is the oldest unresolved dilemma in economics: are
market economies “naturally” stable or do they need to be stabilised
by policy? Keynes emphasised the flimsiness of the expectations on
which economic activity in decentralised markets is based. The future
is inherently uncertain, and therefore investor psychology is fickle.
“The practice of calmness, of immobility, of certainty and security,
suddenly breaks down,” Keynes wrote. “New fears and hopes will,
without warning, take charge of human conduct.” This is a classic
description of the “herd behaviour” that George Soros has identified
as financial markets’ dominant feature. It is the government’s job to
The neo-classical revolution believed that markets were much more
cyclically stable than Keynes believed, that the risks in all market
transactions can be known in advance, and that prices will therefore
always reflect objective probabilities.
Such market optimism led to deregulation of financial markets in the
1980s and 1990s, and the subsequent explosion of financial innovation
which made it “safe” to borrow larger and larger sums of money on the
back of predictably rising assets. The just-collapsed credit bubble,
fuelled by so-called special investment vehicles, derivatives,
collateralised debt obligations, and phony triple-A ratings, was built
on the illusions of mathematical modelling.
Liberal cycles, the historian Arthur Schlesinger thought, succumb to
the corruption of power, conservative cycles to the corruption of
money. Both have their characteristic benefits and costs.
But if we look at the historical record, the liberal regime of the
1950s and 1960s was more successful than the conservative regime that
followed. Outside China and India, whose economic potential was
unleashed by market economics, economic growth was faster and much
more stable in the Keynesian golden age than in the age of Friedman;
its fruits were more equitably distributed; social cohesion and moral
habits better maintained. These are serious benefits to weigh against
some business sluggishness.
History, of course, never repeats itself exactly. Circuit-breakers are
in place nowadays to prevent a 1929-style slide into disaster. But
when the financial system, left to its own devices, seizes up, as it
now has, we are clearly in for a new round of regulation. Industry
will be left free, but finance will be brought under control.
The cycles in economic fashion show how far economics is from being a
science. One cannot think of any natural science in which orthodoxy
swings between two poles. What gives economics the appearance of a
science is that its propositions can be expressed mathematically by
abstracting from many decisive characteristics of the real world.
The classical economics of the 1920s abstracted from the problem of
unemployment by assuming that it did not exist. Keynesian economics,
in turn, abstracted from the problem of official incompetence and
corruption by assuming that governments were run by omniscient,
benevolent experts. Today’s “new classical economics” abstracted from
the problem of uncertainty by assuming that it could be reduced to
measurable (or hedgeable) risk.
A few geniuses aside, economists frame their assumptions to suit
existing states of affairs, and then invest them with an aura of
permanent truth. They are intellectual butlers, serving the interests
of those in power, not vigilant observers of shifting reality. Their
systems trap them in orthodoxy.
When events, for whatever reason, coincide with their theorems, the
orthodoxy that they espouse enjoys its moment of glory. When events
shift, it becomes obsolete. As Charles Morris wrote: “Intellectuals
are reliable lagging indicators, near-infallible guides to what used
to be true.” — Project Syndicate
The writer, a member of the British House of Lords, is professor
emeritus of political economy at Warwick University