The rise and fall of neoliberalsim

The left loves to frame politics in terms of abstract nouns. And as is the human way, they are happier talking about what they are against rather than what they are for. Two abstract nouns in particular are top of the left’s hate list: “austerity” and “neoliberalism”. For the left’s challengers, it is usually best ignore this war on the abstract. It convinces few, after all – the left is much more effective when it campaigns on the concrete: food banks and bedroom tax, for example. Yet abstract ideas have their place, and it is worth exploring them more deeply sometimes. Austerity I will leave for now; I want to look a little more deeply at neoliberalism.

To most on the left “neoliberalism” is a scattergun term to brand all right and centre economic thinking that prevailed from the 1980s, after the collapse in confidence in the system known as “Keynesianism”, though Maynard Keynes would have disapproved of much of it. But if we are to understand what was actually going on we need to distinguish it from neoclassical economics, which was an important strand of thinking in this period. As its name suggests, neoclassical thinking harks back to classical economics, that evolved in the late 19th and early 20th century, before Maynard Keynes revolutionised economic thinking. This saw economies as self-correcting systems that did not need state interventions. At any point an economy is in an equilibrium, and any attempt to shift it would be self-defeating. Attempts to kick against this system would simply lead to such ills as inflation and unemployment.

Keynesianism fell out of favour in the stagflation of the 1970s, following the collapse of the Bretton Woods system of managed exchange rates and the an explosion in the price of oil.  Some economists used this to go back to classical ideas, saying that Keynesianism was a big mistake. In America these economists were often based in Chicago and the Midwest – and were known as “freshwater” economists in contrast to the “saltwater” sort on the American east and west coasts. They turned to the idea of “real business cycles”, which proposes that the fluctuations from boom to recession  are driven by changes to the “real” economy in equilibrium – and not a process of disequilibrium, as Keynes had suggested. So, for example, in pre-industrial societies the cycle might reflect the effect of weather and plague. In the modern age economists call this changes to technology. The true heroes of a neoclassical economy are the entrepreneurs who advance the productivity that make us all wealthier – the American author Ayn Rand was something of a hero. The state and taxes were loathed.

In spite of some rather superficial empirical studies which provided some evidence to support it, real business cycle theory is almost self-evident nonsense. Modern economies are almost never in equilibrium; state interventions are frequently helpful. Neoclassicism kept going because it was politically convenient to a certain class of wealthy American, who funded supportive institutions – and it was, and remains, politically influential amongst US Republicans. It lost all credibility to everybody else in the aftermath of the financial crash of 2008-2009, when the neoclassicists had nothing helpful to say. It was also clear by then that their advice in such places as Russia (post the fall of communism) and Iraq (post the US invasion) had been disastrous – they had advised the Republican US government to stand back and let things take their course – it was the economic wing of neoconservatism. Still, almost no idea is completely without merit. Technology has important implications for the workings of macroeconomics, and yet it is almost universally ignored by macroeconomists, who think that the economy worked much the same way in 1900, 1950 and 2000, and that all changes are explained by decisions in fiscal and monetary policy. In fact if you want to understand why Keynesianism worked so well in the 1950s and so badly in the 1970s, technology provides the most convincing explanation.

So, what is neoliberalism? It is an altogether more subtle economic analysis that sought to built on the insights of Maynard Keynes rather than throw them out. Indeed their ideas evolved into something referred to as “neokeynesianism”. At its heart are two ideas. First is that markets function as processors of information, and are the most efficient way that information about supply and demand can communicate and coordinate in our highly complex society. This is an idea developed by the Austrian economist (and sparring partner of Keynes) Friedrich Hayek, and who is the patron saint of neoliberalism (and much more pragmatic than his leftist critics pain him – he formed a common front with Keynes during the war). The second is that the incentives of people who manage institutions that are not subject to market forces, such as regulators and governments,  are generally not aligned to the public good. These insights lead to the conclusion that even well intentioned state interventions often do more harm than good – and that it is best to try and design such interventions so that they work closely with market forces, aligning incentives and making better use of information.

Neoliberals sought to repair the tattered state of the Keynesian conventional wisdom with the idea of “equilibrium unemployment” – a state of the economy at which any increase in demand would simply lead to inflation – with the insight that the level of this equilibrium could be much higher than what was conventionally regarded as full employment. It depended on the state of labour markets and technology – best addressed through “supply-side” policies, which often meant deregulation. In the 1970s, they said, the trouble arose from over-managed labour markets (the effect on trade unions in particular) and technological disruption (especially the relative rise of energy prices) that rendered much of the industrial economy obsolete.

In terms of economic management, neoliberals liked free capital markets, including floating exchange rates (in contrast to Keynes’s preference for managed international capital flows, exemplified by the Bretton Woods system). They disliked the use of fiscal policy (i.e. the deliberate management of government budgets to regulate deficiencies in demand), as it was rendered useless by misaligned incentives – there would be a tendency to let booms run too long. They did like the idea of “automatic stabilisers”, being tax and benefit policies that tended to increase or reduce demand according to the state of the business cycle – and as such accepted a large state sector – unlike the neoclassicists. Instead they preferred to regulate demand through government intervention in interest rates, delegated to arms-length central banks (an idea which neoclassicists hated, incidentally – they want to leave interest rates to the market).  Like their Keynesian predecessors, they thought that inflation was the critical sign of whether or not supply and demand in an economy were in balance – though they developed the idea that inflation could be built on expectations, as well as simply mis-matched supply and demand (i.e. if people expected inflation to be high, they would demand extra wages, turning this into a self-fulfilling prophecy). For all their scepticism of government, they still saw it as playing  a central role in the management of the economy – and searched for optimal levels and designs of intervention.

Neo-liberalism became the conventional economic wisdom in the 1990s, all the way through to the great financial crash. This period saw an unprecedented advance in living standards across our globe. So why do most people think it has failed? Because the picture in developed economies in that period is much more mixed. In the US in particular, the economic gains have been concentrated amongst the wealthy, with large companies amassing unprecedented levels of profit. The destruction of many industries through technological obsolescence and globalisation left a huge legacy in ruined lives and failing local communities. And finally there was the crash itself, which most neoliberals had failed to see coming and to head off – and whose fall-out they proved ill-equipped to deal with.

And yet. The main advance in human well-being in the neoliberal ascendancy came in the developing world – and the adoption of neoliberal insights was clearly responsible for this – in China, India, and many other countries. And the failure of attempts to defy neoliberalism, in France under Francois Hollande and, more dramatically, by the Kirchners in Argentina, has led to local revivals of neoliberal ideas. Something has clearly gone wrong, but is the whole system really rubbish?

I will examine that question in a future post.