It’s Hard Being a Bear (Part Four): Good Economic Theory

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I delayed pub­lish­ing this on the blog because I thought it was worth sub­mit­ting it to a news­pa­per for first pub­li­ca­tion on the anniver­sary of the Lehman Broth­ers col­lapse. That has occurred: a slight­ly edit­ed ver­sion of this post (for rea­sons only of length, I has­ten to add!) is in today’s Syd­ney Morn­ing Her­ald (page 4 of the print ver­sion), WA Today, and prob­a­bly sev­er­al oth­er news­pa­pers in the Fair­fax chain.

You have just come from your annu­al med­ical check­up, where your doc­tor assures you that you are in robust health.

Walk­ing jaun­ti­ly down the street, you bump into a prac­ti­tion­er of alter­na­tive med­i­cine. He takes one look at you and declares “You have a seri­ous tumour! It must be removed or you will die”.

You ignore him as you always have, and con­tin­ue your mer­ry way down the street. One day lat­er, a stab­bing pain sud­den­ly crip­ples you, and you col­lapse to the pave­ment.

In agony, your call your doc­tor, who ini­tial­ly refus­es to send an ambu­lance because he knows you are well.

When you lapse into a coma and stop talk­ing mid-sen­tence, your doc­tor con­cludes that per­haps some­thing is wrong, and sends an ambu­lance to take you to hos­pi­tal.

Ini­tial­ly the doc­tor waits for you to revive spon­ta­neous­ly, because he still knows there’s noth­ing real­ly wrong with you. But as your pulse starts to weak­en, he reluc­tant­ly calls a retired doc­tor who had expe­ri­ence of a sim­i­lar inex­plic­a­ble mal­a­dy in the dis­tant past.

She pre­scribes mas­sive dos­es of tran­quilis­ers, painkillers, vit­a­mins, and oxygen—all sub­stances that had been removed from the med­ical panoply due to recent advances in med­ical the­o­ry. Reluc­tant­ly, your doc­tor fol­lows his retired col­league’s advice—and mirac­u­lous­ly, you start to revive.

After a year of expen­sive med­ical treat­ment, you return to the same robust health you dis­played before your inex­plic­a­ble ill­ness. Tri­umphant, if some­what puz­zled, your doc­tor declares you well once more, and releas­es you from inten­sive care.

As you stride con­fi­dent­ly away from the hos­pi­tal, you have the mis­for­tune to once again bump into the prac­ti­tion­er of alter­na­tive med­i­cine.

But they haven’t removed the tumour!”, he declares.

One should­n’t have to spell out the details of such an anal­o­gy, but in times of wide­spread denial, one has to:

  • You are the econ­o­my;
  • The tumour is a mas­sive accu­mu­la­tion of pri­vate debt;
  • Your doc­tor is Neo­clas­si­cal Eco­nom­ics, and the retired col­league is a so-called “Key­ne­sian” Econ­o­mist — who doesn’t know it, since her med­ical text­books were poor­ly writ­ten, but he’s actu­al­ly fol­low­ing anoth­er econ­o­mist called Paul Samuel­son, not Keynes (and your doc­tor’s text­books are so bad they don’t war­rant dis­cus­sion);
  • The alter­na­tive med­i­cine prac­ti­tion­er fol­lows Hyman Min­sky’s “Finan­cial Insta­bil­i­ty Hypoth­e­sis” (which is based on what Keynes actu­al­ly did say—as well as the wis­dom of Joseph Schum­peter and, in whis­pers, Karl Marx);
  • The moment you hit the pave­ment is the begin­ning of the Sub­prime Cri­sis; The col­lapse of Lehman Broth­ers is the moment when you slip into a coma; and
  • The day the doc­tor takes you off life sup­port and declares all is well … is next month.

The final rea­son for me being a bear is that I am that prac­ti­tion­er of alter­na­tive med­i­cine. Minsky’s “Finan­cial Insta­bil­i­ty Hypoth­e­sis” has been ignored by con­ven­tion­al econ­o­mists for rea­sons that are both ide­o­log­i­cal and delu­sion­al. A small band of “Post-Key­ne­sian” econ­o­mists, of whom I am one, have kept this the­o­ry alive.

Accord­ing to Minsky’s the­o­ry:

  • Cap­i­tal­ist economies can and do peri­od­i­cal­ly expe­ri­ence finan­cial crises (some­thing that believ­ers in the dom­i­nant “Neo­clas­si­cal” approach to eco­nom­ics vehe­ment­ly denied until reality—in the form of the Glob­al Finan­cial Crisis—slapped them in the face last year);
  • These finan­cial crises are caused by debt-financed spec­u­la­tion on asset prices, which leads to bub­bles in asset prices;
  • These bub­bles must even­tu­al­ly burst, because they add noth­ing to the economy’s pro­duc­tive capac­i­ty while simul­ta­ne­ous­ly increas­ing the debt-ser­vic­ing bur­den the econ­o­my faces;
  • When they burst, asset prices col­lapse but the debt remains;
  • The attempts by both bor­row­ers and lenders to reduce lever­age reduces aggre­gate demand, caus­ing a reces­sion;
  • If the econ­o­my sur­vives such a cri­sis, it can go through the same process again, with anoth­er boom dri­ving debt up even high­er, fol­lowed by yet anoth­er crash; but
  • Ulti­mate­ly this process has to lead to a lev­el of debt that is so great that anoth­er revival becomes impos­si­ble since no-one is will­ing to take on any more debt. Then a Depres­sion ensues.

That is where we were … in 1987. The great tragedy of today is that naïve Neo­clas­si­cal econ­o­mists like Alan Greenspan and Ben Bernanke allowed this process to con­tin­ue for anoth­er three or more cycles than would have occurred with­out their res­cues.

In 2008, they did it again—only with meth­ods they would have dis­par­aged a mere year ear­li­er (“Ratio­nal Expec­ta­tions Macro­eco­nom­ics”, a mod­ern neo­clas­si­cal fad, preach­es that gov­ern­ment inter­ven­tion can’t influ­ence the lev­el of eco­nom­ic activ­i­ty at all—yet anoth­er belief that real­i­ty has recent­ly cru­ci­fied). This time, while the res­cue has worked, the recov­ery they expect after­wards can’t happen—because there’s almost no-one left who will will­ing­ly take on any more debt.

This time, there’s no re-lever­ag­ing way out. The tumour of debt has to be removed.

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