Abstract
This article describes the contributions made by economic theory in understanding the financial crisis. The author contends that throughout history, economic problems were solved with theories that addressed the immediate problem, only to have new economic issues emerge afterward. Economic theory was targeted at maintaining monetary stability during the 1980s and 1990s, leaving insufficient theoretical analysis to address interests of financial stability, which is the economic problem the world is facing today. The author points to a new theoretical approach that balances the interests of previous economy theory with new and emerging challenges.
On the last page of General Theory [8] Keynes made his famous remark that ‘practical men … are usually the slaves of some defunct economist’. Keynes thus blamed the theories of past economists for the errors which had led to the Great Depression of the 1930s. Some would claim that the gravity of the current financial crisis is the result of the intellectual influence of living economists: not only did they fail to forecast the approach of the crisis, many economists, together with others, were responsible for the reforms and policies that gave rise to the crisis itself. I will examine three things in what follows:
the principal responsibilities of economic theory with regard to the current crisis; the differences between this crisis and the major crises of the last century; and the need for genuinely new theoretical thought (or revolution, perhaps) to obtain the right recipes for preventing such serious crises from repeating themselves.
1
It is, however, necessary to at least distinguish between US and European economists, because the latter are more committed alongside the policymakers. See Colander [4].
Without the correct understanding of what causes financial instability, we will never succeed in finding the right remedies for preventing new financial crises.
The great stability
The most serious financial crisis in recent centuries was preceded by an extraordinary period of macroeconomic success. Aided and abetted by the globalisation that started with the fall of the Berlin Wall 20 years ago and by the resulting reunification of the civilised world, the distinction between first, second and third worlds disappeared and some form of market economy spread throughout the world, along with some complacency over its virtues. The excessive optimism did not just concern emerging countries but was even more evident in countries which had developed more and for a longer period: the United States and the United Kingdom. In the former case, economists spoke of ‘the Great Moderation’ [1], referring to a substantial decline in macroeconomic volatility (growth in real output and inflation). Since the mid-1980s (i.e., for over 20 years) these positive developments occurred in the United States and in other major industrial countries (with the exception of Japan). They brought many benefits as a consequence: lower volatility for inflation and output meant that markets were more efficient, there was less economic uncertainty and fewer resources were needed to protect against risks. Similar analyses have been made of the United Kingdom, giving rise to the expression ‘the Great Stability’: ‘a period of nearly 15 years of continuous growth, low inflation and falling unemployment’ [7].
Why is it still important today to emphasise the point that the global financial and economic crisis that exploded in 2007 came after a long period (15-20 years) of macroeconomic successes? Because there is a reasonable suspicion that it is precisely the successful resolution of two historical problems of capitalism, unemployment and inflation, which directly and indirectly contributed to the problem that exploded in 2007.
The problems which have been understood and solved in theory and practice in the evolution of capitalism tend not to crop up again but, if anything, their solutions may favour the appearance of new and different problems. That is what we experienced in the last century with two dimensions of economic stability: employment and inflation. These were seen in the 1930s with mass unemployment and then in the 1970s with two-figure inflation. Once these problems were understood and solved, they did not appear again. Instead, we have had other problems.
Full employment and monetary stability
Macroeconomic stability has three at least partially distinct dimensions: the level of employment; the stability of the value of money; and financial stability. I will examine them in this order partly because this is the chronological sequence in which they appeared and in which we have studied them. The first two were of particular importance during two difficult decades of the last century: the Great Depression of the 1930s and the Great Inflation of the 1970s. In each case, once the causes and the necessary remedies were understood, the problem did not occur again.
In the 1930s this recognition happened through Keynes's General Theory, which explained what persistent high unemployment might depend on. Once the governments understood how to solve the problem and, better still, how to prevent the problem, it did not occur again. We have seen other problems, but not an entire decade of mass unemployment in the main developed countries.
Similarly, we did not experience two-figure inflation again, as we did in the 1970s, after we understood the true lesson of monetarism and therefore made the necessary reforms to prevent governments from manipulating the money supply to obtain a short-term political consensus. The various explanations advanced at the time to justify high inflation (oil shocks, loss of productivity, etc.) were no longer needed once that inflation was brought under the control of the rules which govern the medium-to-long-term money supply. And this was seen clearly with the third oil shock (2007-2008), when expected inflation, and therefore core inflation, remained practically unchanged despite the explosion in food and energy prices.
Has finding the solution to one problem helped produce the next? To what extent did the soaring inflation of the 1970s depend on the previous policies designed to keep unemployment down? It is my thesis that during the 1980s and 1990s, monetary stability took precedence over financial stability at several levels:
At an analytical level, it was claimed that monetary stability should be the priority and that it also favoured financial stability. The political economy taught in our universities has followed the same tendency. One need only consider one widely used textbook, Macroeconomics by Blanchard [2]. It contains many pages on unemployment and on inflation, and there is much on monetary policy designed to prevent inflation. However, there are only three pages (out of a total of 700) on ‘speculative bubbles’ and only seven pages on the Japanese stagnation (explained more as an example of a ‘liquidity trap’ than in terms of financial instability, as a general problem of capitalism). One further aspect that deserves attention is the monetary reforms that have been implemented. Again, in keeping with the great importance attributed to monetary stability, a series of reforms were implemented in many countries in the 1980s and 1990s that were designed to increase the independence of central banks from governments, and—for that and other reasons—in many cases governments lost their functions as supervisors of banks. Not only did this make the financial system more fragile, because it was less supervised, but it also made it more probable that the success of that monetary policy (low inflation and therefore very low interest rates) would give rise to the other problems we are now seeing.
I would argue that the priority assigned to monetary stability, along with the reforms and policies implemented to guarantee it, has resulted in insufficient theoretical analysis in terms of rules and policies dedicated to financial stability. It is not by chance that this is our greatest unsolved problem today.
Financial stability
It may be claimed that the success in reconciling stable employment with monetary stability—the phenomenon known as the Great Moderation that began in the middle of the 1980s—has encouraged growth in risk-taking. Twenty years of satisfactory macroeconomic stability—attributed variously to a more flexible economy and to the improved performance of macroeconomic policies—has reduced risks and also the actual aversion to risk. In other words, today's problems represent the price paid for the Great Moderation (which is, alas, now over!).
If this interpretation of the causes of the depth of today's crisis is accepted, two main corollaries follow. First, a correct theory of risk and its consequences for the stability of the financial system—which takes account of the main financial innovations that have occurred in recent years—still remains to be formulated. It is above all a problem of the relationships between banks and markets (i.e., between credit and finance), which form the basis on which the price of risk is formed.
The second point that follows concerns the effects of macroeconomic stability (employment and monetary stability) on systemic risk and financial stability: in the jargon of central banks, the idea that speculative bubbles cannot be prevented needs correcting. We have just seen that it can be too dangerous if action is restricted to dealing with their negative consequences.
New rules and policies
As an analogy to what has already been done with regard to the employment and monetary dimensions of stability, not only is new theoretical thinking needed to address the third dimension—financial stability—but the resulting new rules and therefore appropriate reforms of the wrong rules which have been followed to date are also needed, along with appropriate new policies. Without adequate theoretical thinking, however, there is a clear danger that the reforms that everybody wants to emerge from the crisis and thus prevent it from repeating itself will not be the right ones.
The main problem to solve is that of identifying who must address the issue of financial stability. Should the responsibility lie in a single place, or should it be joint and shared with other authorities? Or should the responsibility lie with one authority only, but together with other responsibilities? In the latter case, what would be the relative priorities and possible trade-offs between the different objectives?
The solution towards which people are moving, with more or less awareness, is that of extending responsibility for financial stability, above all by considerably increasing the responsibilities of central banks in this respect. But are we sure that it is best to have one single authority which has a set of instruments available to it, some more important than others, and a variety of objectives to achieve? The Bank of England reform has already moved in this direction (Banking Act, February 2009). Today it has a mandate to ‘ensure monetary stability and contribute to financial stability’, and to achieve this it has formed a new Financial Stability Committee.
This compromise (notice the difference between ‘ensure’ and ‘contribute to’) pleases nobody and will probably be revised by the next government [6,11], when it must be acknowledged that if financial stability is to be better guaranteed than it has been to date, it can only occur by intervening, even directly, in monetary policy; that is, by preventing those ‘bubbles’ and/or ‘imbalances’ which sooner or later produce financial crises.
But that is the same as acknowledging that the two dimensions of macroeconomic and financial stability are always connected in some way and therefore ‘belong’ to a single authority, equipped with a number of instruments that are not fully independent one from the other. This corresponds to the difference between the two families of central banks which we have had over the last 20 years: those like the US Federal Reserve, which has the dual objective of ‘maximum employment and stable prices’; and those like the Bank of England, which the 1997 reform made independent and accountable, with monetary stability as its only target. This orthodoxy of the last 20 years, which had stoutly resisted the criticisms of so many economists, 2 has run aground with the current crisis and no one today seems to want to reinstate it.
See Leijonhufvud [9]. See also the work of White [12] on the limits of monetary policy designed solely to achieve monetary stability. The focus of the 6 May 2006 issue of The Economist [5] had a prophetic title: ‘The weeds of destruction’. This article remains the clearest reply to those who claim that economists and not governments (or central bankers) are to blame for not having understood the trouble that was brewing.
It will not be possible, however, to decide on new rules and different policies without a broad consensus and without those rules and policies being theoretically based on the way financial instability is defined, measured and prevented. There is a need to make progress in the measurement of different institutional, analytical, operational and empirical aspects that indicate the different degrees of financial stability. 3 The work to be done is not insubstantial, especially if we compare it with what we already know today of the other two factors, employment and monetary stability.
See Borio and Drehmann [3] for an initial theoretical and empirical analysis.
One reason that the task will be significant is that the dynamics of competition between bankers have produced an incredible variety of new financial instruments in recent years, all within the area of financial innovation. Yet even today, we still do not know if and how much this process, which was moving towards increasing the degree of completeness and efficiency of markets (and therefore of reducing the risk), has already at least partly achieved its goals.
Most current economic theorists have probably forgotten how much the ‘Second Best Theory’ [10] had taught us, which is that even as the situation is proceeding towards an equilibrium that will be better, it cannot be assumed that the situation is continuously improving in the meantime. From this point of view, too, a little too much complacency over the satisfactory results achieved so far has prevented us from also recognising the unsolved problems that have been accumulating in the meantime. The gravity of the current crisis should help to get us back on the straight and narrow path again—typical of the best ‘defunct economists’ 4 —which lies between two extreme positions: that which considers financial instability to be to some extent a natural characteristic of capitalism, and on the other hand, that which considers it a problem that has already been solved.
It is not by chance that Leijonhufvud [9] cites Ricardo, Wicksell and Patinkin.