The Ascent of Money: A Financial History of the World

 

The historian Alan Taylor used to say, mischievously, that the only point of history is history. The idea that one could use it to predict the future, still more to avoid past mistakes, was pure illusion. Niall Ferguson's The Ascent of Money, a history of financial innovation written as a television documentary[1] as well as a book, offers a neat test of Taylor's theory. Ferguson can claim some powers of anticipation. History convinced him in 2006 that the good times could not last "indefinitely." This was an insight to which the Nobel Prize–winning mathematical economists who devised the Black-Scholes formula—the complicated model for pricing share options used by the highly leveraged firm Long-Term Capital Management, which famously crashed in 1998—were oblivious. Their formula persuaded them that a massive sell-off could occur only once in four million years.

 

History has alerted Ferguson to the perils of the state relying on the bond market for its financing. On Lou Dobbs Tonight on November 13, 2008, he said:

 

How much can the international bond market absorb of new ten-year treasuries?... And if yields go up, the cost of government borrowing goes up, and the thing begins to spiral out of control....That's why you need the historical perspective....

Between the two opposed views that history can teach us nothing and that the future is simply a reflection of the past lies the sensible middle position that history, like any other way of experiencing the past, can give us "vague" knowledge of what may lie in store for humanity. Only history-free economists could have bought the "efficient market hypothesis," which claims that the market will price shares correctly, with deviations from accurate prediction occurring only at random. But knowledge of history would not have enabled anyone to predict the timing and extent of the present meltdown. Above all, history cannot settle the question of what our attitude should be toward money, which is at root a moral question.

 

The Ascent of Money is a superb book, which illustrates both the strengths and the weaknesses of history for understanding what is happening now. It is written with the narrative flair, eye for detail, range of reference, and playfulness of language that we have come to expect from this exceptionally versatile historian. Ferguson is clearly fascinated by the subject of finance, knows a huge amount about it, and communicates his enthusiasm to the reader. Many parts of the story will be familiar enough to specialists, but Ferguson has a special ability to color even the familiar with strange and unusual examples, and he weaves together the separate strands of the financial tapestry with great skill. Some of the financial material is quite technical, but there is no attempt to "dumb down." The book is an all too rare example of good, even dense, scholarship finding a way to engage the larger public.

 

Ferguson's strategically themed structure starts with the origins of money, and shows, in successive chapters, how money found a way of multiplying itself through the development of banking, bond, equity, and insurance markets, and derivative instruments of all kinds until the world economy came to resemble what Charles Morris has called an inverted pyramid of debt resting on an increasingly narrow base of real assets.[2] The large claim Ferguson makes is that we owe our prosperity more to finance than to technology. Throughout history men have been more ingenious at finding ways to make money than to make things. As Gibbon shrewdly noted, without the "incitement" given by money to the "powers and passions of human nature," societies could scarcely have emerged "from the grossest barbarism."[3]

 

Money, according to Ferguson, is not a thing but a relationship—above all, a relationship between creditor and debtor. As soon as time and distance start to elapse between exchanges of things of value—which happened at the start of civilization—people needed something more than barter. Farmers needed to borrow while they waited for the harvest to ripen; merchants needed to borrow while they waited for shipments to arrive; above all governments needed to borrow to finance their wars. The three functions of money—as a means of exchange, a unit of accounting, and a store of value—developed to bridge the interval between purchase and payment. Bills of exchange or "promises to pay" seem to have been used for the settlement of debts from the earliest times to overcome the inconvenience of shipping the precious metals.

 

Primitive banks, or safe depositories, must also have existed from the earliest times. The actual word "bank" originated from the Italian banca, or bench, at which the medieval moneychangers sat to do their business. Bankers soon learned how to augment their profits by lending out their deposits at interest. The Medici of fifteenth-century Florence were the first famous banking family. They made their fortune by buying and selling "bonds," the debts issued by cash-strapped monarchs. These bits of paper bound the borrower to repay within a specified period of time. The bond market started when these bonds became tradable. The bond market, the first truly modern financial market, was perfected in eighteenth-century England; great merchant bank underwriters of loans like the Rothschilds dominated the public finance of nineteenth-century Europe. Fractional reserve banking, an early innovation, starting with Sweden's Riksbank in 1656, enabled banks to make loans in excess of the money deposited with them—on the assumption that "depositors were highly unlikely to ask en masse for their money."

 

Ferguson rightly points out that the early growth of European finance was driven more by the needs of the state than by those of commerce. His thesis, familiar from his two volumes on the Rothschilds,[4] is that state policy determines the development of finance, not vice versa. This reverses the usual Marxist argument that finance controls governments. The Rothschilds started as court bankers. The Bank of England was created in 1694, mainly to help the government with war finance, by converting a portion of the government's debt into shares, in return for which the bank was given special privileges, such as a partial monopoly on issuing banknotes.

 

England's rise to world power in the eighteenth century was based on the ability of the British government to borrow larger sums at cheaper rates than any of its rivals; hence the importance for the nineteenth-century public mind of maintaining the state's creditworthiness by balancing the government budget. In the twentieth century it was the eagerness of democratic governments to extend home ownership—as an antidote to revolution—that later led to the practice by which home mortgages are converted into securities and sold around the world.

 

Long-term investment needed a different financing structure, and this was found in the development of the joint-stock, limited-liability company and the emergence of stock markets. By enabling many individuals to pool their resources by buying shares of a particular enterprise, while protecting them from losing everything if the project failed, the limited-liability company was one of the greatest innovations in financial history. The Dutch East India Company, formally chartered in 1602, was the first company to issue its own stock and bonds through the Amsterdam Stock Exchange. Over its two-hundred-year history the average dividend it paid out to its 358 shareholders was 18 percent a year. It helped that it was a chartered monopoly, with the power of the government behind it.

 

Ferguson notes that the history of stock markets has been punctuated by spectacular bubbles and crashes. Some of these have been caused by fraudulent company promoters: Kenneth Lay of Enron had a worthy predecessor in John Law, whose Mississippi Company went spectacularly bust in 1720. Many fraudsters, like Ivar Kreuger, the "Swedish match king" who committed suicide in 1932, were men of vision who turned to crime only to rescue great projects that had gone wrong. But the fraudsters could get away with it—for a time—because of what Alan Greenspan called the "irrational exuberance" of investors. Why are stock markets so volatile? Ferguson believes it is because they are

 

mirrors of the human psyche. Like homo sapiens, they can become depressed. They can even suffer complete breakdowns. Yet hope—or is it amnesia?—always seems able to triumph over such bad experiences.

This is a good analogy, but, as I shall argue, it is not an explanation.

 

As Ferguson tells it, volatility is inherent in financial markets, but bad monetary policy can make it worse. Central banks were created, in part, to stop the "over-issue" of notes by private banks, and to act as "lender of the last resort." Following Milton Friedman, Ferguson believes that the Great Depression of 1929–1933 was caused by bad monetary policy—money was kept so cheap that a huge stock market bubble formed, and, when it burst, the Federal Reserve Board failed to provide the banking system with sufficient liquidity. This view that monetary policy alone is sufficient to keep economies relatively stable is unlikely to survive its harsh confrontation with present reality.

 

The next step in money's ascent is the development of insurance markets to guard against risk. Ferguson tells the story through three central episodes. The start of insurance depended on the work of the mathematicians at Port-Royal in eighteenth-century France, who laid the basis for the modern theory of probability. Provided that the relative frequency of an occurrence was known from past information, it would be possible to insure people against the risk of it happening to them. This insight was applied by the two clergymen founders of the Scottish Ministers' Widows' Fund in Glasgow (Ferguson's hometown) in 1743. They worked out the premiums required to create a fund that, when invested, would cover payments to beneficiaries on the deaths of their husbands. As conditions of life eased, and people demanded greater protection against its hazards, insurance and pension funds "would rise to become some of the biggest investors in the world—the so-called institutional investors who today dominate global financial markets."

 

From the late nineteenth century onward, the state increasingly took on the "insurance" function, providing social security and health benefits to the whole population through the tax system. This was because private insurance companies left a sizable fraction of the population uninsured and uninsurable. Ferguson unusually, but effectively, uses Japan rather than Germany or Britain as his main example of the way the state nationalized risk—mainly, one suspects, because it bests illustrates his favorite thesis that financial systems grew up to serve the military needs of the state. Social security, in this view, was the reward for military sacrifice. This was particularly so in Japan.

 

Ferguson's third example comes from Chile, which he uses to illustrate the return from government social insurance to private—albeit compulsory—insurance. The tax-financed welfare state had never been fully accepted by conservatives, who believed it rotted the character by removing the incentive to save and by separating benefit from individual contribution. Influenced by Milton Friedman and the "Chicago boys," José Piñera, General Augusto Pinochet's minister of labor from 1979 to 1981, privatized Chile's cumbersome state pension scheme. According to Piñera, "What had begun as a system of large-scale insurance had simply become a system of taxation, with today's contributions being used to pay today's benefits, rather than to accumulate a fund for future use."

 

The Chilean reform encouraged workers to opt out of tax-financed state pensions into personal retirement accounts, managed by licensed but competing pension funds, and financed by compulsory deductions from wages. Although most Western countries remained wedded to their traditional single-payer welfare states, set up during and after World War II, the Chilean model was imitated across Latin America and emerging market economies. Despite what he calls its "shadow side"—it "leaves a substantial proportion of the population with no pension coverage at all"—Ferguson clearly approves of the Chilean reform, traveling to Santiago to see firsthand what he considers its beneficent results. It will be interesting to see whether the provision for universal health care promised by the Obama administration follows the European model—by extending tax-financed Medicare for everyone along the lines proposed by Paul Krugman[5]—or the Chilean/Singapore model in which compulsory insurance premiums, paid out of wages, provide the contributors with individual entitlements.

 

Land and the buildings on it—or in modern parlance "bricks and mortar"—have played a crucial part in the development of the financial (and economic) system, because "the land can't run away," and is therefore easy to use as collateral. Mortgaging their property became the way improvident landowners maintained extravagant lifestyles and, in later, more sober times, the way house owners raised money to start businesses. The spread of home ownership in the twentieth century—largely promoted by government in an attempt to make capitalism more popular—made possible a vast expansion of collateralized debt, and was the main stimulus to the development of the conversion of debt into securities.

 

Ferguson points out that property "is a security only to the person who lends you money.... By contrast, the borrower's sole security against the loss of his property to such creditors is his income." This is not quite true. The lender's security also depends on the income—actual or expected—of the borrower, because, although the property cannot "run away," it may lose its value, or it may be costly, and even impossible, for the creditor to get possession of it. Ferguson might have told the story of the costly mistake made by France's Credit Lyonnais, which set up its own proprietary credit-rating agency in the late nineteenth century. Its mistake was to rate the credit-worthiness of governments not on their debt-to-income but on their debt-to-property ratios. The imperial government of Russia got top rating, because, despite its disordered finances, of all governments it owned the most property. On the basis of this rating, French investors snapped up tsarist bonds. They lost all their money, not because the property disappeared but because the government did. Credit Lyonnais failed to take into account "political risk."

 

The tsarist government would now be considered a subprime borrower. Yet today's vastly more sophisticated credit-rating agencies made the same mistake in giving triple-A ratings to bonds that took no account of the income of the borrowers—what the professionals called "toxic waste." Ferguson notes that a disproportionate number of sub-prime borrowers were ethnic minorities and wonders whether subprime is a new euphemism for black. Both Democratic and Republican administrations brought pressure on lenders to relax their rules in order to spread home ownership—for example, not to press borrowers for full documentation. And indeed home ownership—or bank ownership of homes—did expand greatly in the last ten years. The bubble burst in 2007 when a rise in the federal funds rate from 1 percent to 5.4 percent coincided with the expiring of the enticing "teaser" rate periods that lenders had offered subprime borrowers. Repayments were then set at much higher interest rates and many could not pay.

 

The sober conclusion Ferguson draws from this fascinating story of financial incontinence and skullduggery is that property ownership is not the "magic bullet" it is often claimed to be. This is the basis of his criticism of the exaggerated claim of the economist Hernando de Soto that the path to Latin American prosperity lies in secure property rights.[6] "In short, there was irrational exuberance about bricks and mortar and the capital gains they could yield."

 

Ferguson's last chapter, "From Empire to Chimerica," argues convincingly that it was the investment of billions of dollars of Chinese savings in US Treasury bonds that fueled the US debt binge, by enabling Greenspan to keep money so cheap for so long. In a bravura passage that rounds off his story of money's ascent, Ferguson writes:

 

"Chimerica"—China plus America—seemed like a marriage made in heaven. The East Chimericans did the saving. The West Chimericans did the spending. [Cheap] Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs. As a result, it was remarkably cheap to borrow money and remarkably profitable to run a corporation. Thanks to Chimerica, global real interest rates...sank by more than a third below their average over the past fifteen years. Thanks to Chimerica, US corporate profits in 2006 rose by the same proportion above their average share of GDP....

The more China was willing to lend to the United States, the more Americans were willing to borrow. Chimerica, in other words, is the underlying cause of the surge in bank lending, bond issuance and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge fund population explosion. [It] was the underlying reason why the US mortgage market was so awash with cash in 2006 that you could get a 100 per cent mortgage with no income, no job or assets.

2.

In the long sweep of history, the failures of money seem trivial in comparison with its triumphs, mere incidents on the road of financial innovation that leads to universal prosperity. Yet the failures have been extremely damaging to the generations that experienced them. The famous criticism made by John Maynard Keynes about the economics of his day can be applied to Ferguson's history:

 

In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.[7]

Ferguson, of course, is aware of the storms—in fact he writes brilliantly about them—but he never doubts that the journey has been worth it. The "ascent" of which he writes owes more to Reagan-Thatcher triumphalism than to the more sober assessments of the performance of markets currently in vogue. It also leaves out an important part of the drama of finance—the constant struggle between financial innovation and government attempts to protect populations from financial rapacity.

 

It is not till he comes to his "Afterword," interestingly, if ambiguously, entitled "The Descent of Money," that Ferguson seriously considers the question of why the "ascent" of money he celebrates is linked to extreme financial instability. Here he pays brief homage to the distinction made by the economist Frank Knight (and also Keynes) between "risk" and "uncertainty"—with risk referring to a situation in which the probabilities of different random outcomes can be determined, as in roulette, whereas uncertainty pertains when no such probabilities are possible, such as the prospect of a future war. And he concedes that Keynes may have been "thinking along the right lines" when he talked of investors falling back on "conventions" to disguise from themselves the fact that they do not know what the future will bring—the main convention being to behave like everyone else is behaving.

 

But he fails to follow up these crucial insights. The distinction between "uncertainty" and "risk" is essential, in my view, to a proper understanding not only of the present crisis but of the whole "roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes" that have punctuated economic history. The point is that the future cannot be decomposed into measurable risk, however much risk is spread across intermediary instruments. The illusion that it can be blinds investors to the ever-present possibility that the world may change in ways which set all their calculations at nought. The credit mountain was built on the belief that house prices would always go up; when they started to fall the balloon was pricked.

 

Ferguson realizes that mainstream economics is flawed, but then veers away to what I think is the dead end of "behavioral economics" and false analogies between financial evolution and Darwinian natural selection. Behavioral economics claims that we are "wired" to behave "irrationally"; theories purporting to derive from Darwinism claim that finance follows the law of the "survival of the fittest," whereby firms fitted to their environment flourish and weaker ones go to the wall—a process that inevitably involves "creative destruction." These attempts to explain the rise of money in terms of natural processes strike me as being both morally and philosophically naive.

 

Ferguson's mistake, I suggest, comes from an incomplete appreciation of the role of money. Evidently money is more than just a facilitator of trades. It is a way of coping with changing views about an uncertain future. Why, Keynes asked, should any rational person wish to "hold money" rather than spend it? Precisely because it is a way of postponing spending when confidence is low and the "conventions" promising a secure future have broken down. Keynes writes:

 

The desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.... It operates, so to speak, at a deeper level of our motivation. It takes charge at the moments when the higher, more precarious conventions have weakened. The possession of actual money lulls our disquietude; and the premium which we require to make us part with money is the measure of the degree of our disquietude.[8]

Even a (modestly) depreciating currency may at moments of high uncertainty seem more "secure" (carry a higher premium) than any other asset. We are seeing the truth of this today. The failure to take account of this aspect of money is the missing dimension from an otherwise splendid book.

 

A final reflection on Ferguson as a historian. He is overimpressed by economics. Many historians feel that history is in some way inferior to the more exact sciences; the thought that he can "do" economics gives the historian an expanding sense of mastery. I know the feeling, because I've lived through it myself. Economics, especially in its mathematicized form, purveys a peculiar vision of society. Society to the mathematicians is a market imperfection. Among other imperfections, the idea is that allocation of resources is not as efficient and information for making choices is not as complete as they should be.

 

This delusive, but powerful, idea suggests that behind the imperfection lies perfection, a world in which the future will be perfectly known and therefore hold no surprises. Mathematics is the inheritor of the platonic ideal; and mathematically driven financial innovation is its handmaiden. At one time philosophers projected their utopias, and the early economists followed suit. Keynes was perhaps the last one who indulged in utopia building. In his essay "Economic Possibilities for Our Grandchildren" (1930), he looked forward to a time when the economic problem was solved and an age of abundance and leisure had arrived in which people would cultivate the arts of life.[9]

 

Instead, Keynes's grandchildren face a rerun of the Great Depression, and President-elect Obama promises a new New Deal. On December 6, he pledged to create an estimated 2.5 million jobs in the first two years of his administration by large-scale investments in infrastructure projects, including bridges, mass transit, and electrical grids. Estimates of the costs by members of Congress range from $400 to $700 billion.

 

Having taken on $7.8 trillion in financial obligations over the last year—roughly half the size of the entire American economy—the US government is now represented in some form on the boards of most major American companies. Obama has promised to help those facing foreclosure on their mortgages and those hit by the relocation of jobs overseas. He has vowed to curb the excesses enjoyed by those at the pinnacle of deregulated credit. While not addressing the fundamental direction of economic theory, ad hoc policies such as these may help to ensure that the ascent of money does not lead to the descent of man.

 

Notes

[1]The two-hour documentary The Ascent of Money airs on PBS on January 13, 2009.

 

[2]Charles R. Morris, The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash (PublicAffairs, 2008), p. xii.

 

[3]Quoted in The Oxford Book of Money, edited by Kevin Jackson (Oxford University Press, 1995), p. 18; from Edward Gibbon, The Decline and Fall of the Roman Empire, Book I (1776).

 

[4]The House of Rothschild: Money's Prophets, 1798–1848 (Viking, 1998) and The House of Rothschild: The World's Banker, 1849–1999 (Viking, 1999); reviewed in these pages by Robert Skidelsky, December 16, 1999.

 

[5]See Paul Krugman, The Conscience of a Liberal (Norton, 2007), pp. 236–237; reviewed in these pages by Michael Tomasky, November 22, 2007.

 

[6]In Hernando de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (Basic Books, 2000).

 

[7]John Maynard Keynes, "A Tract on Monetary Reform" (1923), in Collected Writings (Macmillan/St. Martin's/Royal Economic Society, 1971), Vol. 4, p. 65.

 

[8]Keynes, "General Theory of Unemployment" (February 1937), in Collected Writings, Vol. 14, p. 116.

 

[9]Keynes, Collected Writings, Vol. 9, p. 321.

 

 

The Trillion Dollar Meltdown: easy money, high rollers and the great credit crash Of the six books under review, all published this year, only the two by non–economists, Charles R. Morris and Graham Turner, have an inkling of the economic blizzard in store. This reflects the fact that the crisis, at least in its severity, came as a complete surprise to professional economists. The eminent Nobel Prize-winners Paul Krugman, Jeffrey Sachs and Joseph E. Stiglitz, all represented here, have written as though the outstanding fault of the present capitalist system lies not in its instability, but in its distributional effect – both domestic and global. Even now it is not clear how far economists have started to question the economic assumptions that underlie the large–scale collapse we are living through.

 

Morris, an American lawyer and investment banker, seems to have anticipated the present credit crunch for some years. His book, The Trillion Dollar Meltdown, is the best account I have read of its genesis, written before the crunch had become global. In part, it is the story of financial innovation carried to self–destructive excess. At the same time, Morris unwittingly exposes the flaw in the financial system: it was too complicated for anyone but a professional investor to understand. This is also a problem with his book. Though it is excellently written, and full of arresting thoughts and phrases ("Intellectuals are reliable lagging indicators, near–infallible guides to what used to be true"), the world of financial legerdemain which it reveals is simply too opaque for the averagely well–educated reader to understand.

 

The credit crunch, originating in the American subprime mortgage crisis of 2007 and then spreading out to the global banking system, had its origins in a gigantic credit bubble. How did this arise? Morris identifies three enabling conditions. The first was the coming to power of the Chicago School of economists, with its deregulating philosophy. A key deregulating move was the repeal in 1999 of the Glass–Steagall Act of 1933, which aimed to separate retail from investment banking. "While Keynesians prayed to the idol of the quasi–omniscient technocrat, the Friedmanite religion enshrined the untrammelled workings of free market capitalism". The second condition was what he calls the "Greenspan put". Denouncing a "new paradigm of active credit management", Alan Greenspan, Chairman of the Federal Reserve from 1987 to 2006, held the Federal funds rate down to 1 per cent from 2003 to 2005 as the economy went into overdrive. His message to the market was: no matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles. The third condition was what Morris calls a "tsunami of dollars" – the result of America’s huge trade deficits, financed largely by East Asia. It was Chinese savings invested in US Treasuries which enabled Greenspan to keep the interest rate at 1 per cent for thirty months. "America’s housing and debt binge was made in China.”

 

It was in this regime of deregulated markets, cheap money and Asian–financed consumption demand that leveraged (debt–dependent) finance took off. The stages in the rake’s progress were the junk bond explosion of the 1980s, the development of mortgage–backed securities or "pass throughs", the creation of portfolio insurance to "manage" the extra risk, and the sprouting of hedge funds to buy up the riskiest debt and sell it to wealthy speculators. Credit agencies fed the bubble by giving bonds containing "toxic waste" triple–A ratings. Morris does not decry the value of all this financial engineering. But the new investment instruments, while hugely enlarging credit facilities by spreading risk, suffered from dangerous flaws only revealed in moments of stress. A small number of institutions – global banks, investment banks, hedge funds – built an unstable tower of debt on a tiny base of real assets. So long as a cheap–money regime forestalled defaults, the tower might wobble but stay erect. A rise in interest rates from 2005 onwards brought it crashing down. Morris comments tartly: "Very big, very complex, very opaque structures built on extremely rickety foundations are a recipe for collapse". His forecast of a "true shock–and–awe surge of asset write downs through most of 2008" proved to be all too accurate.

 

What needs to be done? The key requirement is to restore effective oversight of the financial services industry. Morris makes the excellent point that banks make high profits by taking large risks, but their losses are partly socialized. Banks cannot be both public utilities and risk–taking institutions. If the taxpayer is to be liable for losses, through deposit insurance or bail–outs, then risk–taking by banks must be severely limited. This points towards restoring some version of the old Glass–Steagall Act.

 

Morris’s book provokes an obvious reflection. The financial system should never be allowed to take on a life of its own. It provides a service to the public and should never be beyond the understanding of the public or at least of those who regulate it on the public’s behalf. In other words, it should be simple to understand. Banks should be banks, not speculators: insurance companies should insure real assets, not toxic waste: prudential rules should limit debt–to–equity ratios. There would then be less demand for the service of high–powered mathematicians to invent instruments which bamboozle the rest of us. Yes, there will be less credit available, conceivably a slower rate of economic growth. But most people will feel more secure, less stressed, and more in control of the machine that disposes of their future.

 

The economic consultant Graham Turner may also claim to have read the runes. The Credit Crunch: Housing bubbles, globalization and the worldwide economic crisis fills an important gap in Morris’s story, by relating recent credit bubbles to the changing structure of the real economy. We often forget that since the financial system was deregulated in the 1980s, we have had nine major financial collapses in different parts of the world, plus major stock exchange collapses. Turner’s thesis, in brief, is that globalization has resulted in a global shift in world GDP shares from wages to profits. The result has been a crisis of "realization" – over–investment in relation to worker demand. In the face of wage stagnation in the United States, American consumption demand could be kept going only by the expansion of debt. In other words, if you are a worker you don’t get your productivity gains but are encouraged to borrow at a cheaper rate. The housing bubbles in the West were deliberately created to mask the damage inflicted by American companies transferring jobs to China and East Asia to boost profits. Western governments acquiesced in job exports because this fitted their strategy of promoting free trade. The real requirement is to rebalance power in the American economy between "omnipotent capital and weak labour". This rebalancing requires, among other things, protection of American jobs.

 

It is good to see the venerable under–consumptionist story wheeled out to explain the present credit crunch. There is a problem, though, which Paul Krugman points out in The Conscience of a Liberal: Reclaiming America from the Right: the numbers don’t add up. True enough, "income inequality is as high as it was in the 1920s". But this is not due to globalization. Globalization might explain the rising gap between skilled and unskilled workers. It does not explain the gains of the super–rich, the main winners of recent years. In the 1970s CEOs at 102 major companies were paid $1.2 million on average in today’s money. This was only a bit more than in the 1930s and only forty times that of the pay of the average full– worker. By the early 2000s CEOs in the same companies were paid over 9 million a year, 367 times the pay of the average worker, whose benefits, additionally, had been greatly reduced. The explanation for this "great decompression", as Krugman calls it, lies in politics. From the 1980s, American politics was captured by "a vast right wing conspiracy" which set about dismantling the protective structures of the New Deal by creating "distractions". The chief of these was race. Race, in particular, duped the white voter into neglecting his material interests. Race is the main explanation for America’s lack of universal health–care: whites did not want integrated hospitals. But Krugman is hopeful that the neoconservative domination is coming to an end. The last part of the book explains his plan for creating "guaranteed universal health care" for all Americans.

 

Krugman provides a brisk romp through twentieth–century American history from a Democratic point of view. As he tells it, this history traces two great arcs. The first, political economy arc is from high inequality in the "gilded age" – the late nineteenth century to the 1920s – to relative equality in the middle years, and back again from Ronald Reagan onwards. The second, political arc parallels it from extreme polarization to bipartisanship and back. The reality of the first arc is readily attested by the statistics of income distribution, though Krugman provides no real explanation for these swings: why, for example, did arguments for financial deregulation and lower taxation gain such traction in the 1980s, having earlier been successfully resisted? However, the political arc doesn’t do the work Krugman wants it to. It is true that American politics became polarized again the 1980s, after a period of bipartisanship. But any change of governing philosophy is likely to start life as partisan. Krugman forgets that FDR’s New Deal was highly divisive too. Nor is there anything bipartisan about Krugman’s own history. The Republicans, in his view, were acceptable when they acted like Democrats; when they did not, they were trying to roll back the twentieth century.

 

What Krugman offers is a social democratic account of history’s trajectory, which is occasionally derailed by the antediluvian forces of fundamentalist religion and racist bigotry. But any historian knows that material progress is not history’s only storyline, and that religious and tribal feelings are not just "distractions" from humanity’s rational goals, but are as constitutive of human nature as is the desire for "more for less". There was an ideological, programmatic aspect to Democratic politics in the 1960s which Krugman intermittently acknowledges – indeed he espouses it today – but which plays no part in his explanation of why the bipartisanship of the mid century broke up. He conveniently forgets that the Democrats excoriated the complacent Eisenhower years which he now loves. A combination of Barack Obama and the excesses of neo–conservative economics will probably give America the chance to "complete the New Deal". But Krugman should remember that it was the limitations of the first New Deal that made it acceptable to Republican America.

 

Jeffrey Sachs’s Common Wealth: Economics for a crowded planet is also a cry for action. Its main idea is that human activity has now become so extensive that it has thrown every life–sustaining system on the planet out of kilter. If Sachs is troubled by the thought that humanity is on the wrong treadmill, he does not allow it to cloud his optimism. He comes to the reader not as a philosopher, but as a doctor offering readily available cures for the main planetary diseases he diagnoses: human pressure on the ecosystem leading to dangerous climate change, population pressure on scarce resources, and the extreme poverty of one–sixth of the world’s population. With only a modest investment, we can achieve sustainable development, stabilize the world’s population at 8 billion (it is now 6.6 billion), and end extreme poverty. All "we" need is the necessary political will”.

 

Sachs displays a disappointingly uncritical attitude towards the science he adduces in support of his plans. To some extent he is the victim of his own multidisciplinary approach. Working at the Earth Institute at Columbia University has been to him an "unalloyed gift". And his range of knowledge is impressive. But he inevitably has to take a huge amount on trust, and it shows. This is not a book of scholarship but an executive summary of hundreds of reports of blue ribbon commissions, research papers, convergences and UN declarations. The bullet points roll off the assembly line of his prose, with scarcely a hint of doubts, still less self–doubt.

 

Sachs presents himself as an economist of the toolkit, but in fact, he is a moralist who believes it his mission to save the planet. With such an attitude, it is almost impossible for the scientist not to become a preacher. Like his fellow moralist Paul Krugman. Sachs presents a one–sided dossier in support of his cause. A reader who knows at least something about the subjects being discussed, without fully sharing the passion of the author, is bound to deplore his lack of attention to opposing arguments, whether on climate change, population or the utility of aid for economic development.

 

Sachs’s uncritical attitude to science is matched by his naivety about politics. He seems to believe that the main reason for government failure to tackle global problems with the required vigour is organization deficiencies (for example, failure to mobilize available knowledge), forgetting that governments – and more generally politics – have not been set up to solve global problems but to protect their countries against domestic disorder and external attack. While berating Western governments for their failure to shape up to their planetary tasks, he pays surprisingly little attention to what it is now usual to call the problem of "governance" in the poorest countries. African countries fail to live up to their "convergence potential" because they lack basic levels of infrastructure, health, education "and governance". But for many development economists, "governance" is not something to be added to a list of infrastructural projects financed by the World Bank. It is what makes such projects possible. And the quality of "governance" is embedded in the habits and customs of the people. Sachs never faces up to the issue of how much "governance" will have to be imported from elsewhere to realize the millennium goal of poverty elimination, or how this is to be done.

 

Global networks, he thinks, may be the answer. "A wonderful new project, e–Parliament", he enthuses, "aims to knit together the world’s parliaments and assemblies by video conferencing and the Internet to forge a new kind of hybrid democratic institution at the transnational and even global scale". National Parliaments could mobilize the best brains through simultaneous teleconferences. He ends up by proposing a billionaires’ foundation to eradicate world poverty. I have no doubt that it will be established. No one else need apply for the post of director.

 

Despite the book’s deficiencies, Sachs’s main thrust is convincing: the problems he identifies can be solved, by the methods he outlines. His fault is that he is much too impatient and optimistic. Societies progress at their own pace. They can be tweaked a little by scientists. More likely, they will be jolted out of stagnation by disaster. There will be many of those to come, and many regressions as well, before Sachs’s dreams are realized. It is naive to imagine that it can be otherwise.

 

Razeen Sally is a wide–ranging historian of economic thought, and his clearly written monograph New Frontiers in Free Trade has been heavily influenced by his studies in the Scottish Enlightenment foundations of classical liberalism. He is an unqualified advocate of free trade and globalization, but points out that, historically, free trade was only one element in the Victorian political–economy package, which included domestic laissez–faire, low balanced budgets, and the gold standard. The international liberal order of the nineteenth century was not constructed by international organizations, but emerged as a by–product of acts of domestic liberalization. This unity between external and domestic liberalism broke down after 1945 when "[Adam] Smith abroad" had to be reconciled with "Keynes at home". The post–1945 theory of commercial policy developed by James Meade, Harry Johnson and Jagdish Bhagwati uncoupled free trade from laissez–faire by advocating targeted subsidies instead of protection for infant industries. The case for free trade came to be argued in purely technical terms. But social democracy at home was ideologically inconsistent with free trade abroad. This made free trade vulnerable to attacks by anti–globalizers.

 

The lesson that Sally draws from all this is that globalization today should be pursued by unilateral action rather than by complicated multilateral negotiations through the World Trade Organization. Attempts to secure common minimum standards as a condition for lowering trade barriers will lead to regulatory overload. Pressures to harmonize labour, environmental, food–safety, and other product standards will have a chilling effect on labour–intensive exports. An increasingly politicized WTO will have to bear the brunt of the anti–globalization backlash and NGO pressure. Sally points out that in Asia, unilateral dismantling of trade barriers has been the rule, with China as its driving force. This challenges the consensus that trade liberalization must be based on reciprocity. Welfare gains result directly from import liberalization, regardless of anyone else’s concession. The WTO could be retained as a useful auxiliary to "national market–based reforms".

 

Sally’s case for unilateral liberalization – for instance, dismantling American and EU farm subsidies without waiting for another trade round – is persuasive, but it has little chance of gaining a hearing in the West today. The problem, which he admits, is that globalization threatens the living standards not just of unskilled and skilled workers, but of the Western middle class as a whole. "The political challenge", he writes, "is to keep borders open and extend market–based reforms, while containing inevitable protectionist pressures". But he does not tell us how this is to be done.

 

In The Economists’ Voice: Top economists take on today’s problems, "more than thirty of the world’s top economists offer innovative policy ideas and insightful commentary on our most pressing economics issues". The book is divided into nine sections ranging from climate change – now the obligatory problem number one – to the pros and cons of the death penalty. Each section consists of two or more short non–technical essays, helpfully prefaced by a summary of the essays it contains. Although three essays warn of the coming collapse of the housing bubble, there is no sense of the scale of the impending crisis. For example, Robert Schiller writes that while homeowners face a "substantial risk of much lower prices", fortunately "derivative products, notably a futures market, are being developed [so] that they will soon be able to insure against this risk".

 

The collection illustrates the power and limits of economics. Economics is the most inventive of the social sciences in its ability to suggest how incentives might be rearranged so as to secure desirable outcomes at least cost in money, bureaucracy and liberty. But it lacks a realistic account of politics, the arena in which what is desirable can be made to happen. Joseph Stiglitz illustrates both features in his missionary essay on climate change: "The well–being of our entire planet is at stake. We know what needs to be done. We have the tools to hand. We only need the political resolve" – which to many will mean that we don’t have the tools to hand, since political resolve is a tool too, which Stiglitz doesn’t tell us how to invent.

 

The same lack of political understanding is apparent in the discussion of the costs of the Iraq war. From the economists’ point of view, the editors ask, "could not [the money] have been better spent on fighting global climate change, on providing vaccine commitments to fight tropical disease, on brokering Israeli–Palestine peace, or on giving ten million children in the United States or abroad each a $100,000 scholarship"? The answer is yes, but the economists cannot explain why these alternatives were not adopted.

 

The book is full of excellent cut and thrust. In his essay on international capital mobility, J. Bradford DeLong discusses how events have denied his faith in its untrammelled operation. Fifteen years ago, he supported capital mobility unreservedly. But now he believes that too many external costs are associated with financial crises. Capital also seems to want to flow, not from but to where it is already abundant – the United States has become a giant vacuum cleaner sucking in capital from all round the world – and even when efficient, capital flows benefit rich people from poor countries, not the poor. However, DeLong cannot abandon his neoliberalism; "in the end we may have to tolerate the equality–lessening reverse flow of capital in order to promote the equality–increasing and wealth–increasing diminution of corruption." At least he is honest enough to admit the dilemma.

 

The cumulative impression left by these six books is that we are on the cusp of one of those periodic changes in political economy caused by a crisis of the existing order. The end of the liberal/social democratic era lauded by Paul Krugman was brought about by the crisis of inflation and permissiveness. The succeeding neoconservative era supported by Razeen Sally is likely to end in a crisis of financial excess. Keynesianism and socialism, only recently proclaimed dead, are risen from their graves. The last Soviet leader, Mikhail Gorbachev, recently remarked that, what with all the bail–outs of banks and corporations going on, we now seem to have capitalism for the poor and Communism for the rich. This is a neat easy way of saying that we stand on the threshold of uncharted territory.

 

Scratch around the rubble, however, and one can come up with useful fragments. One of them is called “asymmetric information.” This means that some people know more about some things than other people. Not a very startling insight, perhaps. But apply it to buyers and sellers. Suppose the seller of a product knows more about its quality than the buyer does, or vice versa. Interesting things happen – so interesting that the inventors of this idea received Nobel Prizes in economics.

 

In 1970, George Akerlof published a famous paper called “The Market for Lemons.” His main example was a used-car market. The buyer doesn’t know whether what is being offered is a good car or a “lemon.” His best guess is that it is a car of average quality, for which he will pay only the average price. Because the owner won’t be able to get a good price for a good car, he won’t place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.

 

Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behavior, physical health, and so on. The insurer faces “adverse selection,” because he cannot distinguish between good and bad risks. He therefore sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks – the quick road to bankruptcy.

 

There are various ways to “equalize” the information available – for example, warranties for used cars and medical certificates for insurance. But, since these devices cost money, asymmetric information always leads to worse results than would otherwise occur.

 

All of this is relevant to financial markets because the “efficient market hypothesis” – the dominant paradigm in finance – assumes that everyone has perfect information, and therefore that all prices express the real value of goods for sale. But any finance professional will tell you that some know more than others, and they earn more, too. Information is king. But just as in used-car and insurance markets, asymmetric information in finance leads to trouble.

 

A typical “adverse selection” problem arises when banks can’t tell the difference between a good and bad investment – a situation analogous to the insurance market. The borrower knows the risk is high, but tells the lender it is low. The lender who can’t judge the risk goes for investments that promise higher yields. This particular model predicts that banks will over-invest in high-risk, high-yield projects, i.e., asymmetric information lets toxic loans onto the credit market. Other models use principal/agent behavior to explain “momentum” (herd behavior) in financial markets.

 

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

 

But a moment’s thought will show why these models cannot explain today’s general crisis. They rely on someone getting the better of someone else: the better informed gain – at least in the short-term – at the expense of the worse informed. In fact, they are in the nature of swindles. So these models cannot explain a situation in which everyone, or almost everyone, is losing – or, for that matter, winning – at the same time.

 

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect information about how the different parts of the economy fit together. They differ only in believing that not everyone possesses it. In Akerlof’s example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows perfectly well how likely it is to break down, and the buyer does not.

 

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse; but they are deceiving themselves that they know more than they do. If only one person were perfectly informed, there could never be a crisis – someone would always make the right calls at the right time. But only God is perfectly informed, and He does not play the stock market.

 

“The outstanding fact,” John Maynard Keynes wrote in his General Theory of Employment, Interest, and Money, “is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” There is no perfect knowledge “out there” about the correct value of assets, because there is no way we can tell what the future will be like.

 

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behavior arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today.

 

 

The directive’s architect, Secretary of Defence Robert Gates, thinks that the greatest threats to America are no longer ‘aggressor states’ but ‘failed states.’ Although no other conventional power can challenge America – by way of illustration he mentions that the US navy is the size of the next thirteen largest navies combined, eleven of which are allies –the wars in Afghanistan and Iraq exposed the mighty superpower’s vulnerable underbelly. Guerrillas armed with AK-47s and home-made bombs did what Soviet nuclear weapons and Chinese aircraft carriers failed to do.

 

Seven years in Afghanistan and five in Iraq have taught the US army a great deal. Belatedly, they have learned to fight ‘the war on terror’ and Gates wants the accumulated know-how to be institutionalized. He wants to beef up development agencies and the diplomatic corps. He believes US troops should do less of the fighting themselves and instead help strengthen the armies of their allies. He even thinks America should make an ‘effort to address the grievances among the discontented.’

 

Although Gates was appointed by George W. Bush in 2006, Barack Obama has taken the unprecedented step of asking him to stay on in his job. It is easy to see why. Gates makes no attempt to hide his contempt for the military strategy pursued by Bush: ‘we should look askance at idealistic, triumphalist, or ethnocentric notions of future conflict that aspire to transcend the immutable principles and ugly realities of war, that imagine it is possible to cow, shock, or awe an enemy into submission’.

 

Few will mourn the shelving of ‘shock and awe’, few will decry Gates’ pledge to intensify diplomacy, but we should all be concerned that fighting small wars is now the Department of Defence’s top priority. The lessons which Gates wants to see institutionalized are those of the surge. They rest on the assumption that the surge in Iraq has worked and that the strategy will work again in Afghanistan. I think it is too early to say whether the Americans have brought lasting peace to Iraq and I think the war in Afghanistan is doomed, however many soldiers they send.

 

‘Irregular warfare’ is as old as war itself. After the Vietnam debacle, America swore never again and concentrated instead on containing Soviet armies in Central Europe. Humiliating retreats from Lebanon in 1983 and Somalia in 1994 only reminded them again why they avoided small wars. But the temptation to intervene is – for a superpower – perennial.

 

Only two counter-insurgency methods have ever worked: extreme restraint and extreme brutality, and the latter more often than the former. Neither strategy is now available to the US. Today, wars are fought ‘in the spotlight of the media and the shadow of international lawyers’, as Sir Richard Dannatt, head of the British Army, put it. The brutality of the British in Malaya or the French in Algeria would today land their practitioners in court. Managing public relations has become all-important. Russia learned this to its cost in Georgia.

 

Gates says that America is unlikely to repeat another Iraq or Afghanistan ‘anytime soon’ but cryptically adds that it might face ‘similar challenges in a variety of locales.’ Military expertise operates according to Say’s law: supply creates its own demand. I fear counter-insurgency experts will need new wars in which to put their new ‘institutionalized’ knowledge into practice.

 

No doubt Obama will be more diplomatic than Bush. But do not expect any of America’s ‘small wars’ to end soon. Indeed, the era of small wars may only just be beginning.

 

 

 

 

In his great work The General Theory of Employment, In terest and Money, written during the Great Depression of the 1930s, Keynes said of his ideas that they were "extremely simple, and should be obvious". Market economies were in herently volatile, owing to un certainty about future events being inescapable. Booms were liable to lead to catastrophic collapses followed by long periods of stagnation. Governments had a vital role to play in stabilising market economies. If they did not, the undoubted benefit of markets would be lost and political space would open up for extremists who would offer to solve economic problems by abolishing both markets and liberty. This, in a nutshell, was the Keynesian "political economy".

 

These ideas were a challenge to the dominant economic models of the day which held that, in the absence of noxious government interference, market economies were naturally stable at full employment. Trading in all markets would always take place at the "right" prices - prices that would "clear the market". This being so, booms and slumps, and prolonged unemployment, could not be generated by the market system itself. If they did happen, it was due to "external shocks". There were many attempts to explain the Great Depression of the 1930s along these lines - as a result of the dislocations of the First World War, of the growth of trade union power to prevent wages falling, and so on. But Keynes rightly regarded such explanations as self-serving. The Great Depression started in the United States, not in war-torn Europe, and in the most lightly regulated, most self-contained, and least unionised, market economy of the world. What were the "external shocks" that caused the Dow Jones Index to fall from 1,000 to 40 between 1929 and 1932, American output to drop by 20 per cent and unemployment to rise to 25 million?

 

We can ask exactly the same question today as the world economy slides downwards. The present economic crisis has been generated by a banking system that had been extensively deregulated and in a flexible, largely non-unionised, economy. Indeed, the American capitalism of the past 15 years strongly resembles the capitalism of the 1920s in general character. To Keynes, it seemed obvious that large instabilities were inherent in market processes themselves.

 

John Maynard Keynes was a product of Cambridge civilisation at its most fertile. He was born in 1883 into an academic family, and his circle included not just the most famous philosophers of the day – G E Moore, Bertrand Russell and Ludwig Wittgenstein – but also that exotic offshoot of Cambridge, the Bloomsbury Group, a commune of writers and painters with whom he formed his closest friendships. Keynes was caught up in the intellectual ferment and sexual awakening that marked the passage from Victorian to Edwardian England. At the same time, he had a highly practical bent: he was a supreme example of what Alasdair MacIntyre calls “the aesthete manager”, who partitions his life between the pleasures of the mind and the senses and the management of public affairs. After the First World War, Keynes set out to save a capitalist system he did not particularly admire. He did so because he thought it was the best guarantor of the possibility of civilisation. But he was always quite clear that the pursuit of wealth was a means, not an end. He did not much admire economics, either, hoping that some day economists would become as useful as dentists.

 

All of this made him, as his wife put it, "more than an economist". In fact, he was the most brilliant non-economist who ever applied himself to the study of economics. In this lay both his greatness and his vulnerability. He imposed himself on his profession by a series of profound insights into human behaviour which fitted the turbulence of his times. But these were never - could never be - properly integrated into the core of his discipline, which spewed them out as soon as it conveniently could. He died of heart failure in 1946, having worked himself to death in the service of his country.

 

The economic theory of Keynes's day, which precluded boom-bust sequences, seemed patently contrary to experience, yet its foundations were so deep-dug, its defences so secure, its reasoning so compelling, that it took Keynes three big books - including a two-volume Treatise on Money - to see how it might be cracked. His attempt to do so was the most heroic intellectual enterprise of the 20th century. It was nothing less than the attempt to overturn the dominant economic paradigm dating from Adam Smith and David Ricardo.

 

He finally said what he wanted to say in the preface to The General Theory: "A monetary economy, we shall find, is one in which changing views about the future are capable of in fluencing the quantity of employment and not merely its direction." In that pregnant sentence is the whole of the Keynesian revolution.

 

Keynes's understanding about how economies work was rooted in his theory of knowledge. The future was unknowable: so disaster was always possible. Keynes did not believe that the future was wholly unknowable. Not only can we calculate the probability of winning the Lottery, but we can forecast with tolerable accuracy the price movements of consumer goods over a short period. Yet we "simply do not know" what the price of oil will be in ten, or even five, years' time. Investments which promised returns "at a comparatively distant, and sometimes an indefinitely distant, date" were acts of faith, gambles on the unknown. And in that fact lay the possibility of huge mistakes.

 

Classical economists could not deny the possibility of unpredictable events. Inventions are by their nature unpredictable, especially as to timing, and many business cycle theorists saw them as generating boom-bust cycles. But mainstream economics, nevertheless, "abstracted" from such disturbances. The technique by which it did so is fascinatingly brought out in an argument about economic method between two 19th-century economists, which Keynes cited as a fork in the road. In 1817, Ricardo wrote to his friend Thomas Malthus: "It appears to me that one great cause of our differences . . . is that you have always in your mind the immediate and temporary effects of particular changes, whereas I put these immediate and temporary effects quite aside, and fix my whole attention on the permanent state of things which will result from them."

 

To this, Malthus replied: "I certainly am disposed to refer frequently to things as they are, as the only way of making one's writing practically useful to society . . . Besides I really do think that the progress of society consists of irregular movements, and that to omit the consideration of causes which for eight or ten years will give a great stimulus to production and population or a great check to them is to omit the causes of the wealth and poverty of nations . . ."

 

Keynes sided with Malthus. He regarded the timeless equilibrium method pioneered by Ricardo as the great wrong turning in economics. It was surely the Ricardo-Malthus exchange he had in mind when writing his best-known aphorism: "But this long run is a misleading guide to affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again."

 

Ricardo may have thought of the "long run" as the length of time it took storms to disperse. But under the influence of mathematics, economists abandoned the notion of time itself, and therefore of the distinction between the long run and the short run. By Keynes's time, "risks", as he put it, "were supposed to be capable of an exact actuarial computation". If all risks could be measured they could be known in advance. So the future could be reduced to the same epistemological status as the present. Prices would always reflect objective probabilities. This amounted to saying that unregulated market economies would generally be extremely stable. Only very clever people, equipped with adequate mathematics, could believe in anything quite so absurd. Under the influence of this theory, governments withdrew from active management and regulation of economic life: it was the age of laissez-faire.

 

Keynes commented: "The extraordinary achievement of the classical theory was to overcome the beliefs of the 'natural man' and, at the same time, to be wrong." It was wrong because it "attempts to apply highly precise and mathematical methods to material which is itself much too vague to support such treatment".

 

Keynes did not believe that "natural man" was irrational. The question he asked was: how do we, as rational investors, behave when we - unlike economists - know that the future is uncertain, or, in economist-speak, know that we are "informationally deprived"? His answer was that we adopt certain "conventions": we assume that the future will be more like the past than experience would justify, that existing opinion as expressed in current prices correctly sums up future prospects, and we copy what everyone else is doing. (As he once put it: "Bankers prefer to be ruined in a conventional way.") But any view of the future based on "so flimsy a foundation" is liable to "sudden and violent changes" when the news changes. "The practice of calmness and immobility, of certainty and security suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct . . . the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning yet in a sense legitimate where no solid basis exists for a reasonable calculation."

 

 

But what is rational for individuals is catastrophic for the economy. Subnormal activity is possible because, in times of crisis, money carries a liquidity premium. This increased "propensity to hoard" is decisive in preventing a quick enough fall in interest rates. The mainstream economics of Keynes's day viewed the interest rate (more accurately, the structure of interest rates) as the price that balances the overall supply of saving with the demand for investment. If the desire to save more went up, interest rates would automatically fall; if the desire to save fell, they would rise. This continual balancing act was what made the market economy self-adjusting. Keynes, on the other hand, saw the interest rate as the "premium" for parting with money. Pessimistic views of the future would raise the price for parting with money, even though the supply of saving was increasing and the demand for investment was falling. Keynes's "liquidity preference theory of the rate of interest" was the main reason he gave for his claim that market economies were not automatically self-correcting. Uncertainty was what ruined the classical scheme.

 

The same uncertainty made monetary policy a dubious agent of recovery. Even a "cheap money" policy by the central bank might not be enough to halt the slide into depression if the public's desire to hoard money was going up at the same time. Even if you provide the water, you can't force a horse to drink. This was Keynes's main argument for the use of fiscal policy to fight a depression. There is only one sure way to get an increase in spending in the face of falling confidence and that is for the government to spend the money itself.

 

This, in essence, was the Keynesian revolution. Keynesian economics dominated policymaking in the 25 years or so after the Second World War. The free-market ideologists gave this period such a bad press, that we forget how successful it was. Even slow-growing Britain chugged along at between 2 and 3 per cent per capita income growth from 1950-73 without serious interruptions, and the rest of the world, developed and developing, grew quite a bit faster. But an intellectual/ideological rebellion against Keynesian economics was gathering force. It finally got its chance to restore economics to its old tramlines with the rise of inflation from the late 1960s onwards - something which had less to do with Keynesian policy than with the Vietnam War. The truth was that "scientific" economics could not live with the idea of an unpredictable world. So, rather than admit that it could not be a "hard" science like physics, it set out to abolish uncertainty.

 

The "new" classical economists hit on a weak spot in Keynesian theory. The view that a large part of the future was unknowable seemed to leave out learning from experience or making efficient use of available information. Rational agents went on making the same mistakes. It seemed more reasonable to assume that recurrent events would initiate a learning process, causing agents to be less often surprised by events. This would make economies more stable.

 

The attack on Keynes's "uncertain" expectations developed from the 1960s onwards, from the "adaptive" expectations of Milton Friedman to the "rational" expectations of Robert Lucas and others. The development of Bayesian statistics and Bayesian decision-theory suggested that agents can always be modelled as having prior probability distributions over events - distributions that are updated by evidence.

 

Today, the idea of radical uncertainty, though ardently championed by “post-Keynesians” such as Paul Davidson, has little currency in mainstream economics; however, it is supported by financiers of an intellectual bent such as George Soros. As a result, uncertainty once more became “risk”, and risk can always be managed, measured, hedged and spread. This underlies the “efficient market hypothesis” – the idea that all share options can be correctly priced. Its acceptance explains the explosion of leveraged finance since the 1980s. The efficient market hypothesis has a further implication. If the market always prices financial assets correctly, the “real” economy – the one involved in the production of goods and non-financial services – will be as stable as the financial sector. Keynes’s idea that “changing views about the future are capable of influencing the quantity of employment” became a discarded heresy.

 

And yet the questions remain. Is the present crisis a once-in-a-lifetime event, against which it would be as absurd to guard as an earthquake, or is it an ever-present possibility? Do large "surprises" get instantly diffused through the price system or do their effects linger on like toxic waste, preventing full recovery? There are also questions about the present system that Keynes hardly considered. For instance: are some structures of the economy more conducive to macroeconomic stability than others?

 

This is the terrain of Karl Marx and the underconsump tionist theorists. There is a long tradition, recently revived, which argues that the more unequal the distribution of income, the more unstable an economy will be. Certainly globalisation has shifted GDP shares from wages to profits. In the underconsumptionist tradition, this leads to overinvestment. The explosion of debt finance can be interpreted as a way of postponing the "crisis of realisation".

 

Keynes did not have a complete answer to the problems we are facing once again. But, like all great thinkers, he leaves us with ideas which compel us to rethink our situation. In the long run, he deserves to ride again.

 

 

 

There were three kinds of failure. The first, discussed by John Kay in this issue, was institutional: banks mutated from utilities into casinos. However, they did so because they, their regulators and the policymakers sitting on top of the regulators all succumbed to something called the "efficient market hypothesis": the view that financial markets could not consistently mis-price assets and therefore needed little regulation. So the second failure was intellectual. The most astonishing admission was that of former Federal Reserve chairman Alan Greenspan in autumn 2008 that the Fed's regime of monetary management had been based on a "flaw." The "whole intellectual edifice," he said, "collapsed in the summer of last year." Behind the efficient market idea lay the intellectual failure of mainstream economics. It could neither predict nor explain the meltdown because nearly all economists believed that markets were self-correcting. As a consequence, economics itself was marginalised.

 

But the crisis also represents a moral failure: that of a system built on debt. At the heart of the moral failure is the worship of growth for its own sake, rather than as a way to achieve the "good life." As a result, economic efficiency—the means to growth—has been given absolute priority in our thinking and policy. The only moral compass we now have is the thin and degraded notion of economic welfare. This moral lacuna explains uncritical acceptance of globalisation and financial innovation. Leverage is a duty because it "levers" faster growth. The theological language which would have recognised the collapse of the credit bubble as the "wages of sin," the come-uppance for prodigious profligacy, has become unusable. But the come-uppance has come, nevertheless.

 

Historians have always been fascinated by cyclical theories of history. Societies are said to swing like pendulums between alternating phases of vigour and decay; progress and reaction; licentiousness and puritanism. Each outward movement produces a crisis of excess which leads to a reaction. The equilibrium position is hard to achieve and always unstable.

 

In his Cycles of American History (1986) Arthur Schlesinger Jr defined a political economy cycle as "a continuing shift in national involvement between public purpose and private interest." The swing he identified was between "liberal" (what we would call social democratic) and "conservative" epochs. The idea of the "crisis" is central. Liberal periods succumb to the corruption of power, as idealists yield to time-servers, and conservative arguments against rent-seeking excesses win the day. But the conservative era then succumbs to a corruption of money, as financiers and businessmen use the freedom of de-regulation to rip off the public. A crisis of under-regulated markets presages the return to a liberal era.

 

This idea fits the American historical narrative tolerably well. It also makes sense globally. The era of what Americans would call "conservative" economics opened with the publication of Adam Smith's Wealth of Nations in 1776. Yet despite the early intellectual ascendancy of free trade, it took a major crisis—the potato famine of the early 1840s—to produce an actual shift in policy: the 1846 repeal of the Corn Laws that ushered in the free trade era.

 

In the 1870s, the pendulum started to swing back to what the historian AV Dicey called the "age of collectivism." The major crisis that triggered this was the first great global depression, produced by a collapse in food prices. It was a severe enough shock to produce a major shift in political economy. This came in two waves. First, all industrial countries except Britain put up tariffs to protect employment in agriculture and industry. (Britain relied on mass emigration to eliminate rural unemployment.) Second, all industrial countries except the US started schemes of social insurance to protect their citizens against life's hazards. The great depression of 1929-32 produced a second wave of collectivism, now associated with the "Keynesian" use of fiscal and monetary policy to maintain full employment. Most capitalist countries nationalised key industries. Roosevelt's new deal regulated banking and the power utilities, and belatedly embarked on the road of social security. International capital movements were severely controlled everywhere.

 

This movement was not all one way, or else the west would have ended up with communism, which was the fate of large parts of the globe. Even before the crisis of collectivism in the 1970s, a swing back had started, as trade, after 1945, was progressively freed and capital movements liberalised. The rule was free trade abroad and social democracy at home.

 

The Bretton Woods system, set up with Keynes's help in 1944, was the international expression of liberal/social democratic political economy. It aimed to free foreign trade after the freeze of the 1930s, by providing an environment that reduced incentives for economic nationalism. At its heart was a system of fixed exchange rates, subject to agreed adjustment, to avoid competitive currency depreciation.

 

The crisis of liberalism, or social democracy, unfolded with stagflation and ungovernability in the 1970s. It broadly fits Schlesinger's notion of the "corruption of power." The Keynesian/social democratic policymakers succumbed to hubris, an intellectual corruption which convinced them that they possessed the knowledge and the tools to manage and control the economy and society from the top. This was the malady against which Hayek inveighed in his classic The Road to Serfdom (1944). The attempt in the 1970s to control inflation by wage and price controls led directly to a "crisis of governability," as trade unions, particularly in Britain, refused to accept them. Large state subsidies to producer groups, both public and private, fed the typical corruptions of behaviour identified by the new right: rent-seeking, moral hazard, free-riding. Palpable evidence of government failure obliterated memories of market failure. The new generation of economists abandoned Keynes and, with the help of sophisticated mathematics, reinvented the classical economics of the self-correcting market. Battered by the crises of the 1970s, governments caved in to the "inevitability" of free market forces. The swing-back became worldwide with the collapse of communism.

 

A conspicuous casualty of the swing-back was the Bretton Woods system that succumbed in the 1970s to the refusal of the US to curb its domestic spending. Currencies were set free to float and controls on international capital flows were progressively lifted. This heralded a wholesale change of direction towards free markets and the idea of globalisation. This was, in concept, not unattractive. The idea was that the nation state—which had been responsible for so much organised violence and wasteful spending—was on its way out, to be replaced by the global market. The prospectus was perhaps best set out by the Canadian philosopher, John Ralston Saul, in a 2004 essay in which he proclaimed the collapse of globalisation: "In the future, economics, not politics or arms, would determine the course of human events. Freed markets would quickly establish natural international balances, impervious to the old boom-and-bust cycles. The growth in international trade, as a result of lowering barriers, would unleash an economic-social tide that would raise all ships, whether of our western poor or of the developing world in general. Prosperous markets would turn dictatorships into democracies."

 

Today we are living through a crisis of conservatism. The financial crisis has brought to a head a growing dissatisfaction with the corruption of money. Neo-conservatism has sought to justify fabulous rewards to a financial plutocracy while median incomes stagnate or even fall; in the name of efficiency it has promoted the off-shoring of millions of jobs, the undermining of national communities, and the rape of nature. Such a system needs to be fabulously successful to command allegiance. Spectacular failure is bound to discredit it.

 

The situation we are in now thus puts into question the speed and direction of progress. Will there be a pause for thought, or will we continue much as before after a cascade of minor adjustments? The answer lies in the intellectual and moral sphere. Is economics capable of rethinking its core principles? What institutions, policies and rules are needed to make markets "well behaved"? Do we have the moral resources to challenge the dominance of money without reverting to the selfish nationalisms of the 1930s?

 

The enquiry must start with economics. If the case for the deregulated market system is intellectually sound, it will be very hard to change. Free- marketeers claim, contrary to Soros, that the crisis is the fault of governments. US money was kept too cheap for too long after the technology bubble burst in 2000 and the attacks of 11th September 2001. The market was temporarily fooled by the government. This is a shaky defence, to say the least: if the market is so easily fooled, it cannot be very efficient.

 

One can also argue that the problem is not with the market system, but the fact that markets are too few and inflexible. This seems to be the view of Yale economist Robert J Shiller. He likens the financial system to an early aircraft. Just because it is prone to crash doesn't mean we should stop trying to perfect it. Shiller claims that new derivative products will soon be able to insure homeowners against the risk of house prices going down. To my mind, this is an example of trying to cure a state of inebriation by having another whiskey. There are two things wrong with it. First, if financial innovation is, in fact, the route to greater market efficiency, the financial system would have been getting more stable in the last 25 years of explosive financial engineering. Instead it has become more volatile. Second, the assumption that, given enough innovation, uncertainty can be reduced to risk, is just wrong. There will never be sufficient knowledge to enable contracts to be made to cover all future contingencies.

 

An analogous argument is that there was not enough marketisation in the global monetary system. Instead of the "clean" floating of currencies, "dirty" floating became the rule. Importantly, China and most of east Asia refused to float their currencies freely. China reverted unilaterally to a form of Bretton Woods, deliberately undervaluing the yuan against the US dollar. The resulting imbalances enabled American consumers to borrow $700bn a year from the parsimonious but super-competitive Chinese, at the cost of losing millions of manufacturing jobs to them. The Chinese saved, the Americans spent, and their debt-fuelled spending created the asset bubbles that led to the credit collapse. This source of instability needs no revision of economic theory, simply the establishment of a free market in foreign currencies. However, the assumption that a world in which currencies were allowed to float freely would be immune from the financial storms we have experienced depends on the belief that currencies will always trade at the correct prices—the global version of the efficient market hypothesis.

 

A different claim, which goes back to Marx, is that certain structures of economy are less stable than others. Globalisation has increased instability by producing a shift in world GDP shares from wages to profits as the release of low-wage populations into the global economy has undermined the bargaining power of labour in rich countries. This has led to a crisis of under-consumption, staved off only by the expansion of debt (as Gerald Holtham points out, in Prospect's December 2008 issue). There is some truth in this. A greater equality of incomes would create more stable purchasing power.

 

But the main source of instability lies in the financial markets themselves. And here it is clear that the battle of economic ideas still needs to be fought. Keynes is important in this because he produced the most powerful case for supposing that financial markets are not efficient in the sense required by efficient market theory. As he explained in The General Theory of Employment, Interest, and Money (1936), classical economics had ignored the two main causes of systemic financial failure: the existence of (unmeasurable) uncertainty and the role of money as a "store of value." The first led to periodic collapses of confidence; the second led investors to hoard cash if interest rates fell too low, making automatic recovery from collapses difficult. The function of government was to remove the depressive effect of both by giving investors continuous confidence to invest.

 

Contrary to the belief of some recent economic theories, the future is just as unknowable as Keynes thought it was. The mathematical "quants" who set up the Long Term Capital Management hedge fund in 1994 worked to a risk model which showed that the kind of financial meltdown which, in fact, bankrupted them four years later, could occur only once every four million years. This was not a rationalisation of financial interests: it was self-deception.

 

What economics needs, therefore, if it is to have any purchase on real world behaviour, is a new starting point. It needs to accept that the changing nature of the world precludes people from having enough information to always make contracts at the "right" prices. Such a change is a necessary condition for a permanent change in policy. Each previous crisis has produced a leading economist with the authority to challenge the prevailing consensus. So the call for a new Keynes is not just rhetorical.

 

Opinion as to the degree of supervision, regulation and control needed to make a market economy well-behaved is to be found along a continuum. At one end are the free-marketeers who believe only the lightest touch only is needed; at the other are classical Marxists who believe it requires public ownership of the whole economy. In between are varieties of social democrats and middle wayers, the most famous of whom is Keynes. This territory is sure to be extensively explored over the next few years as the pendulum starts swinging back. For the question of making markets well behaved goes beyond the question of securing their efficiency. It involves making the market economy compatible with other valued aspects of life. The French social democratic slogan of the mid-1990s—"market economy yes, market society no"—encapsulates the idea that limits should be placed on the power of the market to shape social life according to its own logic.

 

The battleground will be about the role of the nation-state in the globalising economy of the future, for the nation-state is the main repository and guardian of the values and traditions threatened by the disruptive power of the global market. A paradox of globalisation—which was supposed to see a withering of the nation-state—is that it has led to a revival of nationalism. A deregulated world turned out, unsurprisingly, to be one dominated by the strong. This process reached its apogee with the presidency of George W Bush and the Iraq war—which emphasised US determination to act as a free agent. Other states, too, in Europe and elsewhere, are now acting as semi-free agents. The effective choice is between a more regulated global capitalist system and its possibly violent breakup into a menagerie of warrior nationalisms.

But to ensure we have an ordered system requires us to make globalisation efficient and acceptable. In the course of that debate, I expect one crucial point to emerge: the benefits of globalisation are real, but have been exaggerated. Improvements in the allocation of capital and reductions in opportunities for corruption are offset by increased volatility. Globalisation also raises huge issues of political accountability and social cohesion that are scarcely considered by economists, and only lazily by politicians.

 

There seem to be four main reasons for this blind spot. The first is the intellectual domination of economics in this debate, with its individualistic and developmental perspective. Globalisation—the integration of markets in goods, services, capital and labour—must be good because it has raised many millions out of poverty in poorer countries faster than would otherwise have been possible. Any interference with this process is impious. A second idea is that it is inevitable: technology—most conspicuously the internet—abolishes national frontiers. Technology cannot be undone. So, whether we like it or not, globalisation is our fate, and our morals and social conventions must adapt to it. The third idea is that globalisation is evolutionary; any check would be regressive. Fourthly, globalisation forces us to think of the world as a unit, which is necessary if we are to solve planet-wide problems.

 

These are powerful propositions, derived from the era of scarcity and not adjusted to the era of partial abundance, nor to the existence of natural limits to growth. Today the benefits of globalisation are much more obvious for poor than for rich countries. In the 1950s and 1960s, the northern hemisphere was for free trade, the southern protectionist. Today the position is partly reversed. Globalisation offers the best hope for poor countries to catch up with the rich. But growth has become less important for rich countries. In the early 1930s, Keynes thought that the international division of labour could be carried too far. "Let goods be homespun," was the title of an article he wrote in 1932. He wanted a "well-balanced" or "complete" national life, allowing a country to display the full range of its aptitudes, and not simply to be a link in a value-adding productive chain spanning the globe. Moreover, the economic benefits of offshoring are far from evident for richer states. Since 1997, Britain has lost 1.1m manufacturing jobs—29 per cent of its total—many of them to developing countries. The result has been a dramatic deterioration in Britain's current account balance, and a decline into deficit on the investment income balance too, meaning we pay more to foreign investors in interest and dividends than we receive from abroad. This makes it harder for Britons to pay down their huge debts to the outside world.

 

Keynes's warning that the pursuit of export-led growth is bound to set nations at each others' throats is still relevant. But that does not mean just sticking as we are. Some rowing back of financial globalisation and cross-border financial institutions is required to rebalance market and state. This process is underway, as national regulators take a tighter grip over the financial institutions they are bailing out. Regulators are increasingly sceptical of banks that depend excessively on wholesale funding. Without this, there will be a natural tendency for banks to shrink back within their own frontiers.

 

One of the biggest problems with the global trading order remains the enormous arbitrages in tax, labour and non-wage costs that exist. These have encouraged companies to relocate operations, and depressed the bargaining power of labour. Companies like WalMart of the US and Nokia of Finland have been huge outsourcers to Asia. The only solution short of raising barriers is for governments to co-operate in flattening out some of these differences—for China, for example, to increase wages. Ralston Saul has noted that the era of globalisation saw "multiple binding economic treaties… put in place while almost no counterbalancing binding treaties were negotiated for work conditions, taxation, the environment or legal obligations." It will be difficult to create new global systems that balance public good and self interest. But the alternative is the beggar-my-neighbour world of protectionism.

 

Another way to curb outsourcers would be to use antitrust powers. Breaking up megalithic multinationals would at least prevent them enjoying quasi-monopoly rents, and thus reduce the incentive.

 

Globalisation is necessarily blind to the idea of political accountability because none exists at the planetary level. Yet the crisis has challenged the idea that we should all unthinkingly follow the logic of the bond market. When the crunch came, we discovered that national taxpayers still stand behind banks, and national insolvency regimes matter. A more rules-based exchange rate system is not inconceivable. This might seek to put some curbs on capital movements—especially at times of economic stress.

 

And, in this new climate, national politicians are likely to reach for ideas and influences that until recently would have seemed exotic. The idea, for example, that economic growth does not, beyond a certain point, make people happier. David Cameron, a market-friendly Conservative, has talked about the importance of general wellbeing as an alternative to the mania for economic growth. Rich countries could probably abandon the globalist project without much damage to their material standards and with possible gain to their quality of life. Rejecting the inevitability of market-based globalisation would not necessarily be harmful—especially if it were accompanied by a reassertion of democracy at a national level. This is not a pipe dream. New Zealand, which was the first country to attempt to become a post-national nation state in the 1980s with a radical programme of privatisation and deregulation, changed tack in 1999. The electorate endorsed an interventionist government devoted to raising taxes, reimposing economic regulations and establishing a stable private sector. It happened because reform failed to deliver the goods. Other countries may follow suit if the political costs of maintaining a global economy are seen as too high. Rich countries surely have a duty to help poor countries, but not at the expense of an awful way of life.

 

"Well-behaved" markets should not only be more stable, they should be more morally acceptable. It is indefensible for a top American CEO to earn 367 times more than the average worker (against 40 times in the 1970s). Part of the swing-back in political economy will be to use the tax system to redress the balance between capital and impotent labour.

The crisis has rightly led to a revival of interest in Keynes. But he was a moralist as well as an economist. He believed that material wellbeing is a necessary condition of the good life, but that beyond a certain standard of comfort, its pursuit can produce corruption, both for the individual and for society.

 

He reunited economics with ethics by taking us back to the primary question: what is wealth for? The good life was one to be lived in harmony with nature and our fellows. Yet "we destroy the beauty of the countryside because the unappropriated splendours of nature have no economic value. We are capable of shutting off the sun and the stars because they do not pay a dividend." Not everything should be sacrificed for efficiency. And Keynes was a liberal nationalist.

 

In terms of our pendulum analogy, he was someone who instinctively sought an equipoise: not in the timeless equilibrium of classical economics, but in a balance in political economy between freedom and control, national and international wellbeing, efficiency and morality. He was an Aristotelian, who believed that vices are virtues carried to excess. This is a good philosophy for today.

 

Among the most astonishing statements to be made by any policymaker in recent years was Alan Greenspan’s admission this autumn that the regime of deregulation he oversaw as chairman of the Federal Reserve was based on a “flaw”: he had overestimated the ability of a free market to self-correct and had missed the self-destructive power of deregulated mortgage lending. The “whole intellectual edifice,” he said, “collapsed in the summer of last year.”

My Lords, the opening paragraph of the gracious Speech pledges the Government to give overwhelming priority to ensure the stability of the British economy during the global economic downturn. We would all endorse that.

 

The Minister outlined several useful measures that the Government have taken or are planning to take, which remind me of the useful measures taken by Ramsay MacDonald’s Labour Government of 1929 to 1931, about which I wrote my first book, but which were far too small to stem the economic blizzard that was then sweeping the world.

 

The gracious Speech promised reforms to the banking sector. These are necessary, but here I sound my first cautionary note. In his open letter to President Roosevelt in 1933, John Maynard Keynes said that the President was engaged in,

 

“the double business of recovery and reform—recovery from the slump, and the passage of those business and social reforms which are long overdue”.

 

But—and here is the sting—he said that,

 

“even wise and necessary reform may ... impede and complicate recovery. For it will upset the confidence of the business world ... And it will confuse the thought and aim of yourself and your Administration by giving you too much to think about all at once”.

 

In other words, Keynes’s advice was: “Concentrate on getting the recovery and do your reforms on the back of the recovery”. Those wise words have lost none of their relevance.

 

How much stimulus will it take to bring about recovery and how is it to be done? There is no doubt that we are sliding into a severe recession, possibly the worst since the war. The latest OECD economic outlook projects a swing in output of about 4 per cent of GDP for OECD countries as a whole, with a decline of 3 per cent or more in the next 12 months. We should notice that these forecasts are lagging indicators; the output figures have had to be revised downwards each quarter for the last three quarters.

 

Some believe that we can deal with the problem by relying on monetary policy alone, but I do not think that it will do the job. I shall again quote from Keynes. In a lecture that he gave in 1932, he said:

 

“It may still be the case, that the lender, with his confidence shattered by his experience, will continue to ask for new enterprise rates of interest which the borrower cannot expect to earn ... If this proves to be so, there will be no means of escape from prolonged and perhaps interminable depression except by direct state intervention to promote and subsidise new investment”.

 

That reminds us that getting the money to flow is a two-way business. It depends on the expected earnings of the borrowers as well as on the price and quantity of money provided by the lender. A great deal of investment will inevitably be delayed until profit expectations rise, whatever the rate of interest. I think that the Secretary of State indicated the importance of the expectations of the borrower.

 

The Bank of England’s base rate has come down to 2 per cent; mortgages are stuck at 5 to 6 per cent. Everyone from the Prime Minister downwards is telling the banks that they have to lend, but they will not lend until it is prudent for them to do so for two reasons: first, they fear more losses ahead from toxic assets or recession-induced business failures; and, secondly, the new capital put in by the Government is at such penal rates that they want to repay it as quickly as possible, the easiest way being to stop lending. This flight into cash is a familiar feature of all downturns. It gives people a sense of security. Cash postpones the decision that you have to make to spend. Even a relatively weak currency such as the dollar may at moments of high pessimism seem more secure than any other asset, as we are seeing at the moment.

 

That leaves fiscal policy. It would have been better had we been able to start the fiscal stimulus from a position of surplus, but, still, this weapon will certainly be needed. If the output gap figures are right, it will have to be more than the 1 or even 2 per cent of GDP that has so far been suggested; it will perhaps have to more like 3 to 4 per cent of GDP.

 

In devising this fiscal stimulus, I would certainly put my main emphasis on government spending. When private sector spending falls, the only secure way to get increased spending is for the Government to spend the money themselves. Many projects in the pipeline can be accelerated. I have only one suggestion: will the Government not consider suspending for one year the most important planning regulations that hold up the start of big projects? Many of them are based on worst-case scenarios; now we have a worst case of a graver kind, which should take priority.

 

That we will come through the crisis I have no doubt. We will need to think seriously and constructively about the kind of political economy with which we wish to emerge at the end of it. I shall make just four short points. First, we need to revise macro policy to be able to take into account asset bubbles and to make use of macro-prudential instruments. Secondly, we need to strengthen banking regulation on an international basis. Thirdly, we need a way of liquidating the huge global imbalances that have been a major cause of financial excess in America. That means talking about exchange rates. We cannot avoid that; it is an essential part of a Bretton Woods 2. Finally, we need to consider whether, as a society, we want to tolerate the extreme inequalities of wealth and income that have built up over the last 20 years, especially at the very top. The emergence of an insolent, largely footloose, financial aristocracy—or, I should say, plutocracy—is the direct result of the dominance of the financial services sector in our economy, the freeing of capital movements from national control and a reversal of the previously equalising tax policies in the Reagan and Thatcher years. A big crisis gives us the opportunity to consider that. But first the recovery.

 

 

Russia has not escaped the worldwide financial crisis. The stock market collapse saw $1 trillion wiped of the value of Russian companies. The non-oil external current account deficit increased to almost $62 billion in third quarter 2008. Gross capital inflows declined by 40 per cent over the last year. The global and domestic liquidity crisis and tumbling commodity prices have led the World Bank to revise down its growth forecasts for Russia in 2009 from 6.5 per cent to 3 percent. This calculation was based on an average oil price of $100 barrel for next year. Today, the price stands at $50 barrel. So Russia will almost certainly experience negative growth next year.

 

There is a chain reaction. The general meltdown in capital markets has reduced capital inflows which have dried up syndicate lending and the bond market just as the fall in commodity prices, which has resulted in a drop in export receipts, has increased external refinancing needs. Higher risk and slower growth feed back into the financial sector lowering confidence further.

 

Russia’s performance has not been too bad relative to other transition economies, including recently-joined EU members like Poland. The World Bank contends that Russia’s short-term macroeconomic fundamentals are strong. It applauds the Russian government’s response to the crisis as ‘swift, comprehensive, and coordinated’, and argues that the crisis presents an opportunity to combine short term policy responses with long term measures that ‘would ensure that Russia emerges from this global crisis with a stronger basis for dynamic, productivity-led growth.’

 

This is the problem. The main ingredients of economic growth are high investment in education, and a high level of competition. Further, countries successful in export markets, especially in non-commodities, tend to grow faster than others.

 

Unfortunately, Russia has not yet succeeded in developing new, higher-value manufacturing industries and is still deeply reliant on fuels and raw materials. There are, as there have always been, two choices for its industrial policy. The first is a horizontal policy, based on state intervention directed at the environment in which firms operate: investment in education and human capital, better access to finance for SMEs, support for innovation, and improving government services and legal frameworks. The second is a vertical policy where state intervention is used to promote particular sectors and firms. The two reports naturally favour the second strategy.

 

 

They provide the typical prescriptions which modern economics think suitable for any developing economy. They rarely ask why Russia has been so slow to adopt their policies. Economics is a science of incentives, but economists offering policy advice often conveniently forget about incentives for governments to act the way they suggest. The crisis will concentrate minds in the Kremlin, but there is no guarantee that this focus will be in the direction favoured by the World Bank and the EBRD. The Russian government largely failed to use the good times to diversify the economy, clean up banking system, reform capital markets, strengthen property rights and establish rule of law. Why should it start now?

 

Russia is a country with a turbulent past, entrenched local elites, huge territory, grand political ambitions, and a government that is often dysfunctional. What economists call ‘governance’ is its major problem. Until progress is made in this area the two reports will be so much more hot air.

 

 

It does require very sophisticated economics to prove that depressions cannot happen. This was the economics Keynes set out to challenge in his great book, The General Theory Of Employment, Interest And Money, written during the Great Depression of the 1930s. His own ideas, he wrote, were "extremely simple, and should be obvious". Economies were inherently unstable; governments had a vital role to play in stabilising them.

 

These heresies were too simple and obvious for the economics profession. For after a long and rather successful trial run, Keynesian economics was obliterated by the free-market revolution which swept the Anglo-American world under Thatcher and Reagan. In a notable comeback, updated versions of the theory Keynes had challenged "proved" that unregulated or lightly regulated market economics were very stable, and that government interventions only made things worse. In apparent disregard for mathematical demonstrations to the contrary, crises and crashes, booms and busts continued to occur, and politicians continued to try to mitigate their consequences, their common sense being stronger than their logic. This is roughly the situation we are in today. Economic theory points to non-intervention: politics points to intervention. Keynes's attempt to marry the two in the notion of "practical statecraft" failed.

 

Keynes's "simple and obvious"