THE CHALLENGE

Instead of a synthesis towards the Neoclassical thought (that gave birth to excessive formalism, equilibrium abstract models, like the DSGE, and efficient market hypothesis of Eugene Fama) which dominated the mainstream macroeconomics in the last decades, economist William White, wisely, search for a new partner for Keynesianism: the old “Austrian” school of Economics. Simultaneously, he points out the importance to return to the original thinking of John Maynard Keynes, cleaning the mess engineered by the neo-Keynesians.

Dr. White puts emphasis in particular aspects of “Austrian” thinking that seems useful to the understanding of current dynamics, almost like a surgeon does. And he adds: “This should not be taken as a blanket acceptance of all things Austrian thinking says. Much of it is, to me at least, impenetrable and many scholars would point out both errors and contradictions.”

AN INTRODUCTION

Opening “bridges” between Keynes and the “Austrian” economic school of thought (with 20th Century “stars” like Friedrich von Hayek and Ludwig von Mises) is one of the fields of economic research of Dr. William White, the economist the central bankers do not listened to during the bubble of the 2000’s.

His most recent conferences and articles argue for a “new synthesis” from both applied Keynesian economics and “Austrian” criticism of the procyclicality dynamics of the financialization wave of last decades. His quest is challenging: “How can we blend into the Keynesian framework some of the insights of “Austrian” theory?”

The way forward for the crisis of macroeconomics must be the search for a paradigm shift, he suggests, a shift in the mindset in academia and among policymakers in government (particularly ministers of Finance and their teams) and central banks directors and technical staff.

A shift for two reasons.

First, politicians tend to extend popular Keynesianism “remedies” beyond the “abnormal” and exceptional period that Keynes considered critical in severe recessions. “The Keynesian model remains of crucial importance, says White. It rightly focuses on the determinants of the flow of expenditures (i.e. aggregate demand) in an economy during a given time period, and recognizes that demand can be both excessive – this aspect of Keynes thinking is often ignored – and deficient.”

The trade-off of the addicted Keynesianism (which Keynes never professed) is resistance from politicians and business men from certain global sectors to needed structural adjustment in the depression period.

That resistance will bring with it decline in the level of potential growth and risk of stagflationary economics. “Keynesian demand-side stimulus might well have near-term benefits, but could eventually have less desirable effects if it impedes necessary adjustments in production capacities. Over time such considerations matter”, explained White. And he add: “Support for the financial system has the longer term effect of creating moral hazard, potential zombie banks and financial institutions that are even bigger, more complex and rent-seeking than they were before. Finally, government programs to support particular industries suffering from chronic over capacity threaten to create zombie companies to go along with zombie banks.”

Second, in the upward of the business cycle, central bankers used easy monetary policy to accommodate stock and housing bubbles despite the alerts from contrarian economists. We must remember Hyman Minsky study about the dynamics of excessive credit growth, monetary creation, debt accumulation, spending imbalances, massive increase in supply potential in many industrial and service clusters, bubbles ending in Ponzy mega-schemes, high volatility and violent crashes. Says White: “We need to resist more efficiently the credit driven expansions that fuel asset bubbles and unsustainable spending patterns” from economic agents and states (remember recent near-default from Dubai, the estimated high record fiscal deficits for 2010 in Ireland and UK, the high public debt in Greece, Italy or Belgium; the current bubble in China).

Excessive debt and bubble dynamics were engines of the financialization wave and consolidation trend inside certain oligopolistic sectors which dominated the economy of the last decades, a global complex of bigger and bigger financial services, construction, wholesale and retail distribution and car production (the automotive civilization), White refers.

Sectors that in the run-up to the crisis were making indeed huge sums of money, particularly in rentier activities more than in its core historical businesses, while in the downturn of the cycle reveal a surprising dramatic state of insolvency. Some of the big financial entities were even called zombies by the media in the peak of the Financial Panic of 2008. One of the political barriers to the needed adjustment is the popular theory of too big to fail (TBTF). White replies: “The upshot is that many of them are now too big and must be wound down.”

That’s why White picks from the “Austrians” some core arguments: “In contrast to the Keynesian framework, Austrian theory focuses on the creation of money and credit by the financial system, and how it leads to cumulative ‘imbalances’ over many periods.”

INTERVIEW HIGHLIGHTS

A CONTINUUM: “I would say that Hayek, (Anthony) Fisher and Keynes were all right. Hayek said try to avoid getting into this mess in the first place. Fisher added his support by noting that the downturn had been much more severe than even Hayek imagined and then explaining why. Keynes was right in saying that in such extreme cases there was a role for monetary and above all fiscal policy.”

THE BIG POLICY MISTAKE: “I do think the reliance on macroeconomic tools has got us on a very bad path. In effect we use such stimulus to avoid the need to restructure and the underlying problems then build up over time to truly unmanageable proportions.”

INTERVIEW by Jorge Nascimento Rodrigues © 2009, janelanaweb.com

Q: Reading your article “Modern Economics is on the Wrong Track” at Finance & Development IMF magazine (December, 2009, pp.15-18), it seemed that it can be useful to extract cirurgically the “Austrian” criticism about the pro-cyclical policies in the boom period, but reject its laissez-faire approach for the depression times. That’s your idea regarding the “Austrian” economics school of thought?

A: You are right. Even Hayek admitted the need to lean against the downturn in the case of a “secondary depression”. By this, he seemed to mean a cumulative downward spiral independent of (even if catalyzed by) the primary depression caused by “imbalances/maladjustments” in the upward phase of the cycle. I would say that Hayek, Fisher and Keynes were all right. Hayek said try to avoid getting into this mess in the first place. Fisher added his support by noting that the downturn had been much more severe than even Hayek imagined and then explaining why. Keynes was right in saying that in such extreme cases there was a role for monetary and above all fiscal policy. Note, however, that pump priming was for Keynes intended for extreme circumstances. In practice, it has been used repeatedly to deal with even minor downturns.

Q: The Austrian approach emphasizing the need for economic restructuring in depression times after the bubbles can be also useful, as an antidote against excessive Keynesian subsidizing and state intervention?

A: I do think the reliance on macroeconomic tools has got us on a very bad path. In effect we use such stimulus to avoid the need to restructure and the underlying problems then build up over time to truly unmanageable proportions. That is where we are now, I fear.

Q: The problem with popular Keynesianism is what Joan Robinson criticized as the “bastard Keynesianism”?

A: For a fuller examination of this, see Axel Leihonhufvud’s On Keynesian Economics and the Economics of Keynes (a book of 1968). Axel [Professor emeritus at the Department of Economics of University of California at Los Angeles] introduced the distinction between Keynesian Economics (Hicks and Samuelson “synthesis”) and the true Economics of Keynes.

Q: You refer macroeconomics is on the wrong track. What is the most important wrong aspect of the modern macroeconomics?

A: Probably the assumption of rational expectations on the part of a “representative agent”.

Q: Do you think the Irish approach facing the government deficit crisis (14.7 per cent, the largest one regarding GDP, estimated in the EU for 2010) is a practical “mix” of Keynesianism and Austrian thought?

A: I am not sure how to apply labels here. The Irish (and the Hungarians and others) have been strongly procyclical in that they used discretionary fiscal policy to offset the “automatic stabilizers” and reduce the overall increase in the deficit associated with the downturn. One rationale for this is that the structural deficit was originally far larger than earlier estimated. Many countries took the tax receipts associated with the “boom” as structural (rather than cyclical) and these were assumed to continue to flow forever. They didn’t, and thus adjustments had to be made to help ensure longer run sustainability. A second rationale would have a more Austrian flavor, but I do not think the Irish and Hungarians ever espoused it. Namely, when downturns put people out of work in sectors that had over-expanded in the boom (e.g. construction in Ireland and Spain), the government should get out of the way and let the private sector determine where cheaper labor might now be better deployed. The third rationale is I think the most important; namely, to respond to market concerns about the unsustainability of the fiscal situation. In the Irish case, this was manifest in rising bond and CDS spreads. Thus, the hope was that fiscal tightening would, by reducing these contractionary spreads, actually prove expansionary. This would have been a typical IMF recommendation for decades. For the Hungarians, with their own currency, the increased risk premium showed up both in spreads and downward pressure on the exchange rate. Given that so many Hungarian mortgages were denominated in Swiss francs (thus, depreciation is contractionary through this channel, as service requirements rise) we again conclude that tighter policy can actually be expansionary.

Q: But how we accomodate the anticrisis policies against severe negative effects (like unemployement growth, credit scarcity to small business and the real economy) simultaneously with the need to control public finances in red or orange alert?

A: The current state of the financial system is such that it cannot be assumed that a global recovery is assured. This raises the question of further negative feedback effects on the financial system, and what policies – a Plan B – might be required in such dire circumstances to facilitate an eventual recovery. It is also worth noting that the absence of a sustained economic recovery would not necessarily imply there was no need to contemplate “exit” policies.

Q: Can you explain how to blend anticrisis strategies and “exit” policies?

A: From a one period Keynesian perspective, it would seem evident that stimulus should not be withdrawn in such circumstances. However, thoso who worry about the negative, longer term effects of current policies must ask themselves whether the short term benefits are actually worth it. Longer run concerns about zero interest rates and Quantitative Easing have already been noted. Fiscal stimulus raises agreggate demand in the short run but also raises sovereign debt levels, in many cases from already high levels, and constrains similar policies in the future. In short, Plan B could conceivably encompass exit strategies as well.

FOCUS ON AXEL LEIJONHUFVUD

Another forgoten Economist

Besides Hyman Minsky, Dr. William White refer the importance of Swedish born economist Axel Leijonhufvud, 76, professor emeritus at UCLA, in the US, for the rediscovery of Keynes original thinking.

Peter Howitt, from Brown University, presented, in 2002, the main contributions of Axel for Keynesianism.

A few highlights from Howitt presentation of the core ideas of Axel:

1- He was one of the first in the 1960s and 1970s to claim that new-Keynesian theory was in need of a fundamental reorientation. He argued that the theory of markets underlying IS-LM (Investment/Saving- Liquidity preference/Money suply) model created by John Hicks was fatally flawed and should be replaced.

2- Axel argued that wage and price adjustment, which economists generally portray as stabilizing market forces, can sometimes be destabilizing, and that there are other market forces, which are usually ignored in macro theory, that are destabilizing.

3- Instead of the Walrasian general equilibrium theory, Axel proposed what he called a cybernetic approach for economics, one with no presumption that the system is in equilibrium state. Axel argued that in broad outline Keyne’s own theory was a cybernetic one. Axel introduced the economics of information into macroeconomic theory. Cybernetic approach is antithetical to the the Chicago School rational expectations theory engineered by the neo-conservative movement in the 1970s.

The financialization of the economy in the OECD countries was insane. Before the crisis, in 2007, the financial services sector accounted for only 16% of corporate output in the US, but it accounted for more than 40% of corporate profits. From 2000 to mid 2007, US financial services stocks increased in value by 78% while the US stock market increased by only 6% per year. The financial deepening from 2000 to 2007 was incredible: the ratio of financial assets to GDP was before the crisis, in 2007, 450% in the US, 550% in Japan and almost 600% in the Eurozone (the worst situation, with countries like Ireland with 900%, the UK with almost 700%, France with 650% and Spain with 550%). In Asia the average was less, around 400%.

L. Randall Wray is a professor at the Economics Department of the University of Missouri, a research director at the Center for Full Employment and Price Stability at Kansas City and a Senior Scholar at Levy Economics Institute of Bard College, in New York. He is a past president of the Association for Institutionalist Thought (AFIT) and has served on the board of directors of the Association for Evolutionary Economics (AFEE).He is a critic of the monetarist school and a specialist on Hyman Minsky economic thought. Minsky died in 1996 and didn’t live to see the catastrophic confirmation of his theory about the instability and fragility of the new wave of financial capitalism emerged after the 1970s, that he called “money manager capitalism”. Minsky is one of the worldly economic thinkers with a solid approach to understand systemic financial crisis.

Interview by Jorge Nascimento Rodrigues

Part I – «Monetary policy is in complete disarray.»

QUESTION: Historically, it seems the financial capital has a second life from the 1970s. Economists recognize a turning point in the early 1970s. The late management guru Peter Drucker referred to the Pension Fund Revolution of the 1970s as one of the founding trends of the new wave. We saw at that time a convergence of political and economical trends, beginning with the closing of the gold window with Nixon and the progressive growing of a rent-seeking system gaining hegemony in the developed countries. Voters were also gained with the mottos of ‘popular capitalism’ and ‘ownership society’. How this second wave of financial capitalism generated the present big crisis?

ANSWER: Early last century, Rudolf Hilferding (1877-1941) identified a new stage of capitalism characterized by complex financial relations and domination of industry by finance. He argued the most characteristic features of finance capitalism is rising concentration which, on the one hand, eliminates ‘free competition’ through the formation of cartels and trusts, and on the other, brings bank and industrial capital into an ever more intertwined relationship. Thorstein Veblen (1857-1929), J.M. Keynes (1883-1946), and, later, Hyman Minsky (1919-1996) also recognized this new stage of capitalism: for Keynes, it represented the domination of speculation over enterprise while Veblen distinguished between industrial and pecuniary pursuits. Veblen, in particular, argued that modern crises can be attributed to the “sabotage of production” (or “conscientious withdrawal of efficiency”) by the “captains of industry”. Much of this description of the finance capitalism stage can be applied to the current phase of capitalism—the money manager stage. Indeed, the intervening years, from the New Deal until the early 1970s, should be seen as an aberration. That phase of capitalism was unusually quiescent—the era of John Kenneth Galbraith’s “New Industrial State”, when the interests of managers were more consistent with the public interest. Unfortunately, the stability was interpreted to validate the orthodox belief that market processes are naturally stable—that results would be even better if constraints were relaxed. As New Deal institutions (broadly defined) were weakened, a new form of finance capitalism came to dominate the US and global economies. This is what Minsky called money manager capitalism—and what I am arguing is simply a return to finance capitalism. Finance capitalism is the normal version of modern capitalism. The ‘Golden Age’ of capitalism was not normal.

QUESTION: Most of the analysts refer to a neo-liberal approach dominant from the emergence of the monetarist school. But it seems - particularly since the end of the 1980s - that this second wave of the financial capitalism was driven by a "mix" of neo-keynesian and monetarist thoughts, an interesting new species in economic and financial though and ideology, whose "agent" of excellence was the Maestro Mr. Greenspan. The acceleration of this second financial wave is "transversal" to Reagan and Clinton, to rightwing and left in politics. Particularly at the end of Clinton Administration we saw the most important reversal of the legislative heritage from the 1930s (for instance the Glass Steagall Act). From a political-economic angle how we can deal with this "anomaly"?

ANSWER: In his new book, James K. Galbraith synthesizes Veblen’s notion of the predator with John Kenneth Galbraith’s new industrial state. The result is what the younger Galbraith terms the predator state. He argues the “industrial state”—related to Minsky’s notion of paternalistic capitalism– has been replaced by a predator state, whose purpose is to empower a high plutocracy that operates in its own interests. I link the Veblen/Galbraith notion of predators to the take-over of the state apparatus in the interest of money managers by neoconservatives (or what are called neoliberals outside the US). Yes, I do agree that monetary policy was guided by a “new monetary consensus” that combined elements of monetarism, the old ISLM approach [a relation between the two curves of investment saving/IS and liquidity preference money supply/LM; the intersection of both curves is the ‘general equilibrium’] of “bastard” Keynesians, and the so-called New Keynesian approach. It supposedly put policy in the hands of the central bank and downplayed fiscal policy. In reality, fiscal policy was still used, but in the interests of money managers. And now we know that the new monetary consensus policy never really worked. Monetary policy is in complete disarray.

QUESTION: Most of these "heroes" of the money manager capitalism, like Greenspan or Bernanke, thought that policies, particularly monetary manipulation and a growing rent-seeking financial system, can "moderate" the business or even the long cycles and that continuous growth was the perpetual horizon. These high qualified people have a weak memory from history?

ANSWER: Obviously, it was purely fantasy: the belief that the central bank can fine-tune the economy merely by controlling expectations of inflation. The central bank cannot control expectations, and it cannot control inflation. And, as everyone now recognizes, monetary policy has very little impact on the economy. That is why we have turned to fiscal policy.

QUESTION: This is the right moment to remember Hyman Minsky?

ANSWER: Minsky work has enjoyed unprecedented interest, with many calling this the “Minsky Moment” or “Minsky Crisis”. I am glad that Minsky is getting the recognition he deserves, but we should not view this as a “moment” that can be traced to recent developments. Rather, as Minsky had been arguing for nearly fifty years, what we have seen is a slow transformation of the financial system toward fragility. It is essential to recognize that we have had a long series of crises, and the trend has been toward more severe and more frequent crises: REITs (Real Estate Investments Trusts) in the early 1970s; LDC (least developed countries) debt in the early 1980s; commercial real estate, junk bonds and the thrift crisis in the US (with banking crises in many other nations) in the 1980s; stock market crashes in 1987 and again in 2000 with the Dot-com bust; the Japanese meltdown from the early 1980s; LTCM (the hedge fund Long Term Capital Management) crisis, the Russian default and Asian debt crises in the late 1990s; and so on. Until the current crisis, each of these was resolved (some more painfully than others; one could argue that Japan never successfully resolved its crisis) with some combination of central bank or international institution (IMF, World Bank) intervention plus a fiscal rescue (often taking the form of US Treasury spending of last resort to prop up the US economy to maintain imports).

Part II – «The strongest force in a modern capitalist economy operates toward an unconstrained speculative boom.»

QUESTION: Financial capitalism has in its DNA the fragility and instability that Minsky referred?

ANSWER: Minsky always insisted that there are two essential propositions of his “financial instability hypothesis”. The first is that there are two financing “regimes”—one that is consistent with stability and the other in which the economy is subject to instability. The second proposition is that “stability is destabilizing”, so that endogenous processes will tend to move a stable system toward fragility. While Minsky is best-known for his analysis of the crisis, he argued that the strongest force in a modern capitalist economy operates in the other direction—toward an unconstrained speculative boom. The current crisis is a natural outcome of these processes—an unsustainable explosion of real estate prices, mortgage debt and leveraged positions in collateralized securities in conjunction with a similarly unsustainable explosion of commodities prices. Unlike some popular explanations of the causes of the meltdown, Minsky would not blame “irrational exuberance” or “manias” or “bubbles”. Those who had been caught up in the boom behaved “rationally” at least according to the “model of the model” they had developed to guide their behavior. Following Hyman Minsky, I blame money manager capitalism—the economic system characterized by highly leveraged funds seeking maximum returns in an environment that systematically under-prices risk.

QUESTION: What have done the money managers financial social emergent group in the last 20-30 years?

ANSWER: With little regulation or supervision of financial institutions, money managers have concocted increasingly esoteric instruments that quickly spread around the world. Contrary to economic theory, markets generate perverse incentives for excess risk, punishing the timid. Those playing along are rewarded with high returns because highly leveraged funding drives up prices for the underlying assets—whether they are dot-com stocks, Las Vegas homes, or corn futures. Since each subsequent bust only wipes out a portion of the managed money, a new boom inevitably rises. However, this current crisis is probably so severe that it will not only destroy a considerable part of the managed money, but it has already thoroughly discredited the money managers. Right now, it seems unlikely that “business as usual” will return. Perhaps this will prove to be the end of this stage of capitalism—the money manager phase. Of course, it is too early to even speculate on the form capitalism will take.

QUESTION: Basle is obsolete?

ANSWER: Basle helped the money managers to create the conditions that led to collapse. I actually wrote in late 2005 that Basle II would generate financial fragility, and presented a paper in Brazil making that argument. It was published by the Levy Institute. And it was also published in Portuguese in Brazil. Basle requirements operated on the belief that higher capital ratios would reduce risk; and further that greater market efficiency could be achieved by adjusting those ratios based on the riskiness of assets purchased. And, finally, it was believed that “markets” are best able to assess risk. In practice, larger institutions were allowed to assess the riskiness of their assets. We now know that failed completely—because all the incentive was for institutions to underestimate risks. We must recognize, as Minsky did, that banking is a profit-seeking business that is based on very high leverage ratios. Further, banks serve an important public purpose and thus are rewarded with access to the lender of last resort and to government guarantees. What this means is that as soon as capital ratios decline toward some minimum (zero in the case of an institution subject only to market discipline, or some positive number set by government supervisors as the point at which they take-over the institution), management will “bet the bank” by seeking the maximum, risky, return permitted by supervisors. In any event, there is always an incentive to increase leverage ratios to improve return on equity. Given that banks can finance their positions in earning assets by issuing government-guaranteed liabilities, at a capital ratio of 5% for every $100 they gamble, only $5 is their own and $95 is the government’s. In the worst case, they lose $5 of their own money; but if their gamble wins, they keep all the profit. Imagine if you walked into a casino and the government gave you $95 to gamble with, for every $5 of your own—and you get to keep all the winnings. What would you do? Gamble! If subjected only to market forces, profit-seeking behavior would be subject to many, and frequently spectacular, bank failures. The odds are even more in their favor if government adopts a “too big to fail” strategy—although exactly how government chooses to rescue institutions will determine the value of that “put” to the bank’s owners.

QUESTION: But Basle was not supposed to curb that problem?

ANSWER: Note that while the Basle agreements were supposed to increase capital requirements, the ratios were never high enough to make a real difference, and the institutions were allowed to assess the riskiness of their assets for the purposes of calculating risk-adjusted capital ratios. If anything, the Basle agreements contributed to the financial fragility that resulted in the global collapse of the financial system. Effective capital requirement would have to be very much higher, and if they are risk-adjusted, the risk assessment must be done at arm’s-length by neutral parties. I think that if we are not going to closely regulate financial institutions, capital requirements need to be very high—maybe 100%. We used to have “double indemnity”: owners of banks were personally liable for twice as much as the bank lost. That, plus prison terms, would perhaps give the proper incentives.

Part III – «There’s no final solution to the fundamental flaws of capitalism»

QUESTION: Do you think the sovereign wealth funds and the Asian banks from high liquidity countries (now the 3 top banks in capitalization are Chinese!) will be dragged down by the crisis or they can lead the next financial capital wave?

ANSWER: Obviously, global financial losses are already huge, and will grow much larger over the coming years. Only the debt of sovereign nations is safe. Again, I hope, and expect, that we are seeing an end to this phase of finance capitalism. It will, of course, rise again—eventually. But with proper responses by governments around the world, we might be able to develop the conditions necessary for another “golden age”. Still, as Minsky said, stability is destabilizing so a golden age will allow finance capital to return. There is no “final solution” to the fundamental flaws of capitalism: an arbitrary and excessively unequal distribution of income and wealth, an inability to generate full employment, and a propensity toward financial instability.

QUESTION: Is it possible to forecast a new wave of financial capitalism based in the emergence of these new power brokers-financial segments (SWF, Asian state banks), or they are also part of the money manager capitalism and will die with it?

ANSWER: No, I do not think they will lead a new financial wave over the next few years. There is little doubt that the Chinese economy will continue to become important and in the near future will displace the US economy as the largest in the world. It is certainly possible that its currency will eventually displace the dollar as the global reserve currency–but I think that is a long way off. I do not think it is even a role that the Chinese authorities would want right now. Finally, China uses markets where they work, but happily intervenes where markets do not fulfill the public purpose as defined by the government. Hence, I do not believe they would let their own domestic money managers “run wild” in the same way that the more market-oriented (neo-liberal) governments have done. After all, the Premier of China has no fear of being labeled a “socialist”–unlike President Obama!

QUESTION: One of the constraints you mentioned in your analysis of the central bank policy in the US is the fact that Alan Greenspan (former chairman of the FED), Tim Geithner (Obama secretary of the Treasury), Ben Bernanke (chairman of the FED), Lawrence Summers (Director of the White House’s National Economic Council) are sons of the same “mother”, as you said are drawn from the same pool that created the current problems. Do you think that choosing Geithner and Summers was the main casting error from Obama Administration regarding the policy to manage the depression? The best solution is to lay-off this magnificent people?

ANSWER: Not a main error no. Not a main error in the sense that there were ready alternatives in terms of personnel to call on. Not a main error in the sense that there were many options for Obama in terms of what to do about the crisis in the short term once it had occurred. The issue now is what will be the long term structure of the finance system. Will it be mainly liberal with some intervention or mainly controlled with limited markets? Whatever the current rhetoric it will probably remain mainly liberal. A liberal system is driven by finance institutions as profit making organizations with a motive to develop ‘financial innovations’. These allow more financial transactions, more lending, more investment and speculation. There are advantages to this. But there is always the vulnerability because of the profit motive and the operation of markets. Such a system creates an arms race between regulators and the regulated. It creates a context in which regulators are always playing catch up. Any system has constitutional rules that make it what it is and indicative rules that provide guidance on how things are currently done. The problem with more liberal markets is that they encourage constitutional rules to be treated as indicative rules and as such the mentality becomes one of how to push the boundaries. A great deal of financial innovation could just as easily be called evasion. What else is a special purpose vehicle? There are always economic arguments that can be applied to these things to provide some form of justification.

Jamie Morgan: «Economics is method led in teaching and research rather than reality led. When things go wrong it is reality’s fault for failing to conform to the models created through method. Economists refer to this as problems of ‘distortion’, ‘exogeneity’, ‘political effects’ and so on. Economics is highly conservative in its approach to change.»

QUESTION: Economics is basically rhetoric to ‘cover’ other agent movements?

ANSWER: When securitization began it was hailed as a way to extend home ownership in the US. But it is important to remember that this wasn’t the motive of those creating the securities. They aren’t interested in the overall effects of what they do on the structure of the economy. They are interested in the individual technique and its profitability – whether it has a market and how it can be exploited. Exploiting it means pushing the new technique into new areas of business (expanding the market). It is a short step from securitizing credit worthy mortgages to the ‘toxic waste’ of later collateralized debt obligations (CDOs). There wasn’t enough skepticism, perhaps, regarding the broader questions of what is the role of economy in society and what is the role of finance and banking in society? Economics has become rather poor at asking and answering such questions. Social welfare has become a quantitative subject rather than an ethical debate. This brings one back to Greenspan, Bernanke and all the rest. Economics has had decades of development now in which it has become a highly technical discipline. Careers are made in terms of applying new statistical techniques and in developing new mathematical models of enduring problems of ‘resource allocation’. Economics is method led in teaching and research rather than reality led. When things go wrong it is reality’s fault for failing to conform to the models created through method. Economists refer to this as problems of ‘distortion’, ‘exogeneity’, ‘political effects’ and so on. Economics is highly conservative in its approach to change.

QUESTION: In what sense?

ANSWER: Just look at the dominance of the Efficient Market Hypothesis (EMH) over the last thirty years. The EMH states that rational individuals immediately evaluate and incorporate all available information for a financial asset (equities etc) and this is reflected in the pricing of that asset. As such it is impossible to develop a successful strategy to profit from speculation in the longer term because there are no irrational trends to be exploited. This has been a mainstay of prestigious MBA courses. It implies that ‘bubbles’ and market crashes are extremely rare if not impossible. The EMH has been criticized from within economics. But simply gaining a hearing for the idea that information is imperfect, people are not fully rational and markets do not necessarily sort themselves out has taken a long time. Information and behavioral economics have been developing since the 1970s. Joseph Stiglitz came from this field, so did Robert Shiller. The fact that one can win a Nobel Prize for saying what seems perfectly obvious to anyone other than an economist indicates just what the problem with economics as a field is. Would I fire Geithner, Bernanke, Volker and the others? No. I would advocate a sea change in how economics is studied and taught so that their eventual replacements are more diverse. Where is this generation’s J. K. Galbraith or J. M. Keynes? Who asks the difficult questions and sees things from a point of view that no one else is? I would also advocate a change in the way economic and financial policy is made. More checks and balances are required, more seemingly naïve questions need to be asked? Economic theory as is creates overconfidence.

QUESTION: Do you think in the ECB we have the same problem of group thinking?

ANSWER: Yes and no. The theoretical problem is perhaps similar since there is a limited range of economic theory and ways of modeling economies to draw on in providing ways of thinking about policy. The Taylor Rule Framework [the manipulation of short term interest rates to maintain stable inflation and economic growth] has been very influential for all central banks in the past decade. Price stability as part of a monetarist orthodoxy has been over-emphasized by all central banks. The ECB, however, is different than other central banks in terms of a practical problem. The ECB faces the problem of creating a consensus that is rather different than other domestic central banks. How does one pursue monetary policy across Europe when the individual economies are so diverse? What do the German and Italian economies have in common? Maintaining monetary union may well prove a real challenge in the next few years because there are good reasons for different economies to want to push interest rates and the Euro in different directions based on domestic growth, public debt, and inflation issues.

Jamie Morgan: «The idea that capitalist economies can grow consistently without recession is probably dead. It requires a combination of amnesia and over-confidence in both free markets and the powers of state intervention/regulation to believe that recession can always be avoided.»

QUESTION: The NICE (non-inflationary, consistently expansionary) economy invented by Mervyn King, the governor of the Bank of England, the ‘Great Moderation’ of volatility suggested by Bernanke a few years ago, all that mantra trying to convince the politicians that the business cycles and the instability of  the financial system were things of the past is finally dead?

ANSWER: The idea that capitalist economies can grow consistently without recession is probably dead. It requires a combination of amnesia and over-confidence in both free markets and the powers of state intervention/regulation to believe that recession can always be avoided. That said, some policies will be better than others and economies can be more or less stable. Also, when contracting they can be returned to stability more or less quickly. To do so requires a fuller understanding of the vulnerability of particular economic systems to crisis. To do so also, and rather paradoxically, requires the acknowledgement that the future is unwritten and economic systems are too complex to be simply predicted or presumed to continue in one form over the long term. It is important to look for broad systemic causes of possible instability (vulnerabilities). These are real characteristics that can then be addressed. For example, it doesn’t require any great genius to acknowledge that rising levels of debt in an economy create potential problems. Understanding the problem though requires exploring what the nature of that debt is and why it has occurred. Again, economists have proved rather poor at this kind of broader exploration of causes and future possibilities. Economists like narrow questions, often set up as hypothesis tests. Since much of economics is now quantitative and obsessed with statistical forecasting it is ironic that they have such a poor track record at identifying the key moments and forms of crisis that really matter to us. It was Keynes perhaps who said, it is better to be approximately right rather than precisely wrong.

Jamie Morgan: «The sources of that debt were of course also sources of growth in and of themselves – the financial sector. In some economies, housing, retail, finance and services associated with all of these became the main drivers of growth. In a sense these economies (the US, the UK, Ireland, Spain, Iceland, etc.) became increasingly reliant on unstable and unsustainable sources of growth.»

QUESTION: Regarding the crisis, it seems from your recent paper at Cambridge Journal of Economics that you would advice two extreme moves from the first moment in August 2007: a rapid cut to 0% in interest rates and a pre-emptive multi-trillion dollar exercise. You mean a big shock therapy in the first first moments? So the big political mistake from the central bankers and Treasury and Finance Ministers was they were reacting always slowly and too-late regarding the course of events?

ANSWER: Yes, but understandably so. As I suggest in the paper, they had become prisoners of discourse (their theories and attitudes) events and institutional arrangements (the rules and blind spots of the central banks and other regulators). The big mistake was really to allow economic development to follow a pathological course in the first place. On a global basis there has been a mismatch between export dependent economies and import dependent economies creating problems for the flow of capital. There has also been a general tendency for GDP to grow faster than incomes meaning that the economies with high levels of consumption necessarily required more debt to maintain growth. The sources of that debt were of course also sources of growth in and of themselves – the financial sector. In some economies, housing, retail, finance and services associated with all of these became the main drivers of growth. In a sense these economies (the US, the UK, Ireland, Spain, Iceland, etc.) became increasingly reliant on unstable and unsustainable sources of growth. The credit freeze that began in August 2007 in what then became known as the US sub-prime crisis with its associated problem of CDOs was a manifestation of systemic pathology. The systemic crisis could have begun in lots of different ways. It could of course have remained an attritional crisis of slow decline if Lehman Brothers had been approached in a different way by the Bush administration. Even that attritional crisis could have been ameliorated if the main central banks and treasuries had approached the issue of stabilizing the supply of credit differently.

QUESTION: From the 1970s it seems that the financial system developed an extreme rent-seeking dynamics coupled with an oligopolistic structure based on risky leverage. This system “engulfed” and “financialized” all the economy and markets, bringing systemic risk to the edifice. How we sort out of this box-trap if liquidity management and interest rates manipulation can’t fix it?

ANSWER: I think the role of finance has to be fundamentally rethought. Should the finance sector be a source of economic growth in and of itself or should it exist on a smaller scale to provide a controlled means of desired growth for other sectors? This is the key question. Ideas about economic development, knowledge economies, post-industrial societies etc. tend to lead to the notion that economies have to ‘progress’ in the direction of providing services since this is where their competitive advantage over newer economies lies. This argument is often conflated with the rise of finance. There are, however, no good reasons why economies should increasingly rely on their service sector and why they should also expand financial services. Who is being ‘serviced’? What does this mean?

Jamie Morgan: «Changing the finance system in any fundamental way therefore confronts a political problem and a basic economic problem of structural change and dislocation. That said, smaller finance with less ’rent seeking’ speculation, intra-financial multiplication etc. would be one where banking operations involved little or no proprietary trading, and would be mainly deposit based in its operations. If it was deposit based it would necessarily require a combination of higher savings rates and lower consumption rates. Do people want that? I can’t answer that question for them.»

QUESTION: The gurus say that “progress” is financial hegemony and financial globalization. Isn´t it? Hilferding’s financial capitalism of the beginning of the 20^th Century was a toddler if we benchmark with today’s financialization…

ANSWER: It is worth remembering that the overall cost to world economies of the financial crisis is far in excess of any employment and tax effects from those financial services in the last decade. One of the big confusions here is that globalization is often used as a ‘cause’ for changes that have occurred and that cannot be resisted. Globalization is an outcome not a cause. It is a power distribution that is expressed as a set of economic relations. Its current manifestation did bring growth of a kind, but a highly unstable, highly unequal kind. It had its ‘masters of the universe’. There is no reason why different relations are not possible. What is required is the will. One of the curious aspects of economics is that it usually relies on the basic assumption that we are rational individuals but at the same time it tends to simply reject the idea that as rational individuals we are capable of collectively engaging in dialogue to seek rational solutions to our collective problems. Economics is all about the power of individual action aggregated as mindless mobs that are described as optimal market effects. Willed collective action is seen as a distortion. This is anti-democratic and a rather depressing judgment on human potential. The main stumbling blocks of course are that financial capital is extremely influential in major economies and that financial sectors are large sectors of many important economies. Changing the finance system in any fundamental way therefore confronts a political problem and a basic economic problem of structural change and dislocation. That said, smaller finance, with less ’rent seeking’ speculation, intra-financial multiplication, etc., would be one where banking operations involved little or no proprietary trading, and would be mainly deposit based in its operations. If it was deposit based it would necessarily require a combination of higher savings rates and lower consumption rates. Do people want that? I can’t answer that question for them. If they did, it would be likely that capital markets would have less of the feel of casinos and more of the feel of chapels. Is this desirable? It really comes down to your faith in market forces. The more chapel-like the system became the less need there would be for ‘risk spreading’ and thus the less need for financial innovation and hedging. Derivatives markets and all the other areas of finance that so few people really understand would whither.

QUESTION: Those financial risky innovations must disappear?

ANSWER: They would not disappear, however, as long as global trade continued to occur in ways that required insurance on future currency and price movements. Here one comes back to the old argument for a single global currency, or at least a non-State official reserve currency, like Keynes ‘Bancor’. This is a radical step. Moreover, the simple reduction of capital markets would have a whole range of other social ramifications. Private pension systems would now operate in a radically altered investment environment and this might change the role of public pensions. By definition financialization has created a whole range of social effects that would have to be addressed. It would be a road that it would be difficult to take just a few steps down, which is one reason why states will hesitate. But if you look around you at mass unemployment, at the future tax burden and devastation of public spending, at the effects of consumption based societies that increasingly focus on individual satisfaction and confuse this with personal autonomy, then perhaps there is a mandate.

QUESTION: The financial crisis is near the end, or we risk have a double-dip recession?

ANSWER: No one genuinely knows. There are too many x factors involved. Behind every set of numbers are basic assumptions about what government, corporate and individual attitudes and behavior will be and how these will interact. Things could go ‘right’ and things could go ‘wrong’. Either way though, the effects of the recession on corporations, the heavy losses incurred by banks (affecting future lending) and the fiscal problems of most states mean that even if things go ‘right’ it is likely that any recovery will be slow. This is not necessarily a bad thing, painful though it is likely to be. One of the problems of a rapid return to rapid growth is that it would likely be based on pressure on banks to increase the supply of credit and improve the conditions under which it is given. This risks extending the period in which banks are poorly capitalized, which creates ongoing problems of bank solvency. At the same time, it risks reigniting many of the pathological developments – particularly in the UK and US – that resulted in the problems in the first place – from imprudent securitization to housing bubbles. There are no welcome answers once the kind of financial crisis we have had has manifested.

QUESTION: In the vast group of economies with a large “financial deepening” regarding the GDP, with the largest financialization of the economy, can we separate the cases of those that made also a big bet in the last technologic revolution? Cases like the US and Ireland, or Singapore, and their tech-led strategies, were not different than the other ones like Spain or Iceland or even the UK?

ANSWER: Yes they can be separated in some ways. All economies are different. This affects their causal role in economic events and also the consequences for each state of those events. That said, there are commonalities, leverage levels created by issuing financial institutions, for example. Housing market effects… The financial crisis is not a replay of the dot.com boom and the crash of 2000-2. That was an equity bubble begun in the US by particular characteristics (the growth of venture capital, deregulation of telecoms, new developments that increased the effectiveness and reduced the costs of information technology…). It had significant effects on world markets but not in the fundamental way that a finance and banking crisis has. Liquidity and the supply of credit are central to economies. Confidence in banks and its withdrawal has wide ranging effects that something like the collapse of Enron cannot emulate. A ‘run’ on a tech company doesn’t mean the same thing as a ‘run’ on a bank. Remember that the collapse of the finance system was effectively a series of runs of different kinds: a loss of confidence in the value of securities making them impossible to value, the withdrawal of counterparties and capital from investment banks, margin calls on financial organizations such as hedge funds that were highly leveraged using securities as collateral based in short term ‘rolling debt’, the withdrawal of deposits from commercial banks… knock on effects to equity markets. All of these things precipitated recession rather than responded to it.

Part II – The China factor – understanding China in the current financial system crisis

QUESTION: Your recent analysis about the limits of central bank policy is focused in the three major central banks, FED (The Reserve Federal System, of the United States), ECB (European Central Bank) and Bank of England (BofE). It seems that the moves and actions from other central banks like the Bank of China (BofCh) are also important, due to the actual power position of China in the real world financial system. How you evaluate the behavior of BofCh since the 2007 subprime crisis?  Just recently, BofCh said it will continue a “moderately loose monetary policy” and analysts continue worried with the risks of a big bubble in stocks and property in China.

ANSWER: The Bank of China is important but this needs some context. It cannot be viewed in isolation from the broader role of China. Over the last decade China has had 3 linked main roles. First, it has since joining the WTO been the preferred location for production and assembly of a whole range of export products. Clothes, shoes, computers, toys etc. Low wage levels and low margins helped to create underlying price deflation in the West that in turn helped enable the long term growth in consumption with low overall inflation there. This occurred in the context of a trade imbalance where China imported far less than it exported. As such China was accumulating foreign currency and became prone to pressure for its own currency, if allowed to float freely, to appreciate. Second, to avoid this appreciation China has managed its currency and spent billions on preventing currency appreciation since this would make its exports more expensive. The US in particular has frequently accused China of ‘currency manipulation’ in contravention of international regulations. Third, in ‘recycling’ foreign currency, particularly the US$, China has been a main buyer of US Treasury Securities, and also of other traded securities such as Collateralized Mortgage Backed Obligations issued by Fannie Mae, Freddie Mac and various others. It, therefore, also contributed to the capacity of Western economies to generate more debt, public and private, at higher levels of leverage.

QUESTION: Most American economists from right and left wing blame China for that West-China “marriage” of the last twenty years…

ANSWER: It would be wrong, however, to simply blame China for its role in the gradual development of the conditions that led to the recent financial and economic crisis. China did not create the system, it did not create the Basel Accords, it did not create the WTO, and it did not force other states to borrow and spend beyond their means or design increasingly exotic ways of producing debt. China has played a role in a dysfunctional system.

QUESTION: Sure, but has China power to change that dysfunctional system?

ANSWER: Of course, the problems of that system are also China’s problems. It is a one party authoritarian state. Its ruling party has little popular legitimacy based on ideas anymore. It has become a ‘performance regime’. This is one where the right to rule is based mainly on the capacity of the party to deliver improvements in material conditions or standards of living. Low growth or recession and rising unemployment in a country with no reliable formal avenues for genuine political participation or dissent to create genuine checks and balances is a huge potential problem for the state. Particularly when the country has accumulated so many other problems: corruption, environmental degradation, land disputes, rising income inequalities, ethnic divisions in the West, a failure to replace the old health and welfare system that was based on the work units and communes etc.

Jamie Morgan: «The current recovery in China’s economic growth seems to be mainly based on property speculation, and on government spending for existing or new projects. Property speculation never ends well, it is the illusion of growth. Since the new government spending, initiated since November 2008, has been very rapid one must question how well planned and effective that spending has been and is likely to be.»

QUESTION: The Chinese ‘performance regime’ is at risk?

ANSWER: Since China has a high export market dependency, contraction in Western markets has to be offset by new avenues of growth in China. Unlike most Western states, China has its huge reserves to draw on to generate spending and boost the domestic economy. As an authoritarian regime it also has a great deal of power to compel its banks and larger corporations (quasi-privatized or not) to comply with its policies. As such, China has moved very quickly to a Keynesian fiscal policy as well as, as you suggested, a ‘loose monetary policy’. The state is engaging in a wide range of new infrastructure projects, tax rebates, and spending incentives. At the same time all the major banks are being ‘encouraged’ to improve the terms and conditions of lending.

QUESTION: This Chinese Keynesianism will be successful?

ANSWER: However, that has created a series of tensions. China currently has a high savings rate. For China to become genuinely less export dependent it must create its own consumer society. The problem is that changing deep-seated behavior is difficult. Most Chinese view the state with great distrust. Any additional money is saved because it may be needed for unanticipated medical bills, for retirement (especially problematic due to the one child policy), for school fees for the next generation, to cover sudden unemployment… Consumption may be increasing in China but the prospect that such consumption will become a domestic economic driver to offset export dependency is unlikely. This didn’t work in Japan. The current recovery in China’s economic growth seems to be mainly based on property speculation, and on government spending for existing or new projects. Property speculation never ends well; it is the illusion of growth. Since the new government spending, initiated since November 2008, has been very rapid one must question how well planned and effective that spending has been and is likely to be. To a large degree one would guess that China is simply hoping that it can outspend the recession in the West i.e. that consumption and growth will recover there, restoring export growth.

QUESTION: Can China continue to be the financial power house of last resort for the US as the Italian and the German family banks were for the European empires of the 16^th Century?

ANSWER: China of course can contribute to the West recovery by buying Western Treasury securities to bankroll public spending there. This in itself creates several problems and dilemmas. Over the next few years the volume of Treasury securities issued is going to increase to an unprecedented degree (putting world wars aside). At the same time, no one knows what the effects of rising government spending are going to be. Economic models that forecast the future have always been problematic. At the moment they are all but useless because there is no reliable stable basis on which to model. Forecasts coming out of the IMF, World Bank and domestic institutions are currently no better than augury. The US is a big problem for China in this context. If government spending, and particularly forms of ‘quantitative easing’ or perhaps a return to bubble based housing markets, create inflationary pressures then the real value of the $ is reduced. Similarly, a weak US economy can result in a reduced value of the $. In either case China would be buying Treasury Securities now and be repaid in the future in $s of less value. At the same time, China has a vested interest in keeping the US spending in order to stabilize its own export markets. China has no control over US domestic economic policy and whether it will result in a less vulnerable structure of the US economy in the future. Ironically, of course, a less vulnerable structure would be one that was less reliant on consumption and on debt creation to maintain growth in consumption. This would be an economy that was less ‘globalized’ and less inter-dependent with China.

Jamie Morgan: «The Chinese Party can choose to respond to growing dissent by introducing new reforms that open the door to further uncontrollable changes… a Glasnost situation. This is unlikely under Hu Jintao but perhaps more thinkable by the following generation. The Party could choose to continue to act in contradictory ways: fostering a complex highly differentiated society and occasionally intervening in ways that indicate that the Party itself is an anachronism. This could also have repercussions. Either way, change is coming.»

QUESTION: So, paradoxically, China is in a very bad situation for the coming years?

ANSWER: Personally, I think China faces grave problems and the very real possibility of a transformation in its political structure because of the way it is embedded in a whole series of problems, domestic and international. This may occur as early as the Eighteenth Party Congress in 2012 at which Hu Jintao and Wen Jiabao are due to step down.

QUESTION: Can you be more specific how you vision that transformation?

ANSWER: The starting point in thinking about this is that the Chinese Communist Party (CCP) is committed to its own survival and thus to China as a single party authoritarian state. China’s economic reform has necessarily involved huge changes in society. This has created the need for social reform and, at the same time has created new social dynamics – groupings with wholly new needs and attitudes. As society has become more differentiated there has also arisen a demand for representation. A Marxist-Leninist ‘vanguard’ party traditionally represents the working class and peasantry. In a command economy where everything is administered by and provided by the state this ‘representation’ quickly becomes control and oppression and this can be highly effective. In an increasingly market economy it is not. The Party no longer has direct control over people’s daily lives and those lives are highly varied. The Party has to respond to this. It becomes a ‘performance regime’, as I mentioned before. But it also pursues other changes. In China’s case, the CCP gradually developed a more encompassing ideology, putting aside the notion of class conflict, putting back the idea that socialism would be fully achieved to some vague time in the future, and embracing the idea that the CCP can represent and have as members virtually anyone who is not deemed an enemy of the state. The CCP is now more of a ‘quanmindang’ or party of all the people. Current policy focuses on the idea of the ‘harmonious society’.

QUESTION: The CCP are suitable for that mission?

ANSWER: The problem is that the Party itself has become one of the main stumbling blocks to creating a harmonious society. There is a great deal of corruption and rather poor information control at the top end. Whenever the leadership feels threatened it responds in oppressive ways that make a mockery of limited moves towards the rule of law. This is not to say that there have been no changes but they cannot go far enough because they cannot create effective checks and balances. Only enfranchisement and a multi-party system can do that. So what ‘transformation’? If economic problems persist in China due to the financial crisis then one can easily see a situation where the Party is forced to confront growing dissent. There is already a great deal of dissent in China but it is not well organized and directed at the state. But it could be. Authoritarian regimes are both strong and brittle. The Chinese Party can choose to respond to growing dissent by introducing new reforms that open the door to further uncontrollable changes… a Glasnost situation. This is unlikely under Hu Jintao but perhaps more thinkable by the following generation. The Party could choose to continue to act in contradictory ways: fostering a complex highly differentiated society and occasionally intervening in ways that indicate that the Party itself is an anachronism. This could also have repercussions. Either way, change is coming.