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.

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8 thoughts on “The rise and fall of neoliberalsim”

  1. “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.”

    You’re saying this is essentially what the neo-classicals think? I’d say there was a fair bit of neo-classical thinking happening when the eurozone was constructed. One of my favourite articles on the topic was written as early as 1992 by Prof Wynne Godley. His concern at the time was:

    “The central idea of the Maastricht Treaty is that the EC countries should move towards an economic and monetary union, with a single currency managed by an independent central bank. But how is the rest of economic policy to be run? As the treaty proposes no new institutions other than a European bank, its sponsors must suppose that nothing more is needed. But this could only be correct if modern economies were self-adjusting systems that didn’t need any management at all.

    I am driven to the conclusion that such a view – that economies are self-righting organisms which never under any circumstances need management at all – did indeed determine the way in which the Maastricht Treaty was framed.

    So the whole idea of the euro is based on a flawed theory! It must seem incredible to any engineer that no testing was done before risking the European project that nearly everyone was wanting to succeed. Wynne Godley then goes on to ask:

    “What happens if a whole country – a potential ‘region’ in a fully integrated community – suffers a structural setback? So long as it is a sovereign state, it can devalue its currency. It can then trade successfully at full employment provided its people accept the necessary cut in their real incomes. ……… If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalisation, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation.”

    What many PK economists are saying in the aftermath of the GFC and about the flaws in the EZ is nothing new. The understanding to have avoided the mistakes we’ve seen made has been there all along. This is not to say economics should have stopped with Keynes. But, why not build on his ideas and fix up any deficiencies rather than throwing out the baby with the bathwater?

    https://www.lrb.co.uk/v14/n19/wynne-godley/maastricht-and-all-that

    1. Very few Anglo-Saxon economists were sympathetic to the Euro before and after its introduction. But there was an extensive discussion of its relative merits, with the points that Wynne-Godley raised being part of the picture. It was driven forward largely on political grounds, though, with Helmut Kohl in the lead. Why were people prepared to take that risk? I think the answer differs somewhat for each country that joined. But there was deep disillusionment with the floating exchange rate regime, and also a feeling that fixed or managed exchange rates could be undone by the malicious markets (as happened to Britain in 1992 – though in that case it hard to argue that the outcome then was bad for the country). There were a lot of comparisons with the US, after all one of the most successful economies the world has ever seen. I don’t think many people looked at India – another large single currency zone, which has a lot of similarities to the Eurozone. That these economies allow a higher level of fiscal transfers was balanced by the fact that member states have more fiscal autonomy – though this proved to be very constrained in fact.

  2. There’s a curious term known as “Expansionary fiscal austerity” in modern day Economic -Speak. The idea is that we can expand the economy by contracting it . Fiscal stimuli, as Matthew indicates, are frowned upon. Robert Barro, who’s a Harvard Professor and therefore influential in the profession, makes the argument that people respond to an increase in government spending by themselves spending less, so that they can save money to leave their heirs a bequest that will enable them to pay higher taxes in the future. Barro wrote in 1989:

    “A network of intergenerational transfers makes the typical person a part of an extended family that goes on indefinitely. In this setting, households capitalize the entire array of expected future taxes, and thereby plan effectively with an infinite horizon.”

    I’m not sure if this counts as neo-liberalism or neo-classicism. But , whatever, it’s bullshit all the same!

    1. Yes I remember studying this idea, and similar ones, when I was doing my Economics degree. I associate it more with the neoclassicists, but Harvard is definitely salt-water. There was quite a bit of cynicism at the time that practically any action the government took would turn out to be futile as the rest of the world responded to it. Other salt-water economists, like Paul Krugman, would have been very sceptical of this type of thinking though, and they were very much part of the neoliberal spectrum at the time (I know because as I read practically everything he wrote, since he was – and still is – one of the most accessible writers about economics I could find.

  3. Sorry to bombard you with comments, but one complaint I have against economists is that they don’t check out their ideas against the real world as they should. Never mind theories. Look at the facts.

    We might ask ourselves the very simple question of who’s done better after the GFC: The UK and the EU with their more neoliberal /ordoliberal policies?
    https://1drv.ms/i/s!Ahd6HBglf_oYgUFch7cqkvZBuCRr

    or the USA with their more reflationary Keynesian approach?
    https://1drv.ms/i/s!Ahd6HBglf_oYgUI-WGfRJ_MsInQw

    So why not choose the one we like and go with that?

    1. I would like pick apart these stats – as I think the picture is much more nuanced. But that will have to wait. The US performance looks much less impressive when you look at GDP per head, and total employment. And arguably a lot of it is down to a sharper handling of the banks, writing off debts more quickly, which allowed to them to resume lending more quickly. The UK has quite an impressive performance compared to the US when you look at employment, though it, like the US, was hit by the crash very hard in the first instance. And I’m not sure how much the US and UK fiscal regimes really differed in fact. France and Germany suffered much less in the crash itself, and you can argue that France’s struggles with unemployment have as much to do with its labour market as any lack of fiscal stimulus – stimulus might simply have led to inflation (like the 1970s). Italy, if memory serves, was hardly affected at all by the crisis directly, but suffered from continued low growth from before the crisis. You can make a much stronger case for greater fiscal leniency in Spain, Portugal and Greece, but that’s another story. By and large the non-UK European economies were much less neo-liberal than the UK and the US, it needs to be said.

  4. This blog’s characterisation of neo-liberalism as a belief in the efficacy of markets, and a claim that the incentives on politicians and regulators to not align with the public good, strikes me as a good one. In political theory, a third element is present; that libertarians (as extreme neo-liberals are called) have a belief that the sanctity of property rights is a fundamental part of liberty, where-as egalitarian liberals (such as Rawls) do not include property rights as a fundamental category on a par with, say, freedom of speech. Interestingly Mill was in the latter camp.

    With the growth in the past decade of professional campaigning techniques, and the popularist dissatisfaction with the views of mainstream politicians, the problem of the incentives on politicians seeking re-election not aligning with the public good seems to me to have been getting worse. I would like to feel that elections were ideally part of a deliberative process aimed at finding the right answers. But at present I would have to accept that Shumpeter’s well known model, in which democracy is characterised as a competition for votes involving the manipulation of a relatively ignorant electorate by political leaders, would be more to the point.

    As your blog says, Matthew, Government’s that try to defy market forces tend to come to sticky ends. And yet the effects of markets, as reinforced by the Conservative lead Governments up to now, are widely seen as unfair. For example:
    • From 2010 at least until recently, the Government was consistently trying to solve the escalating housing crisis mainly by making the market work better, with any other type of intervention being on a small scale. So problems getting on the Housing ladder create unfairness to the younger generation
    • This is compounded by the apparent unfairness of University tuition fees set at very high levels compared with continental standards, though justified in market terms as demonstrated by the ability of most universities to charge the maximum permitted. The younger generation (aged 40 and under) sense an unfairness – and flock in large numbers to support Corbyn, whose strong suit is his sense of justice.
    • Perhaps the most burning issue is the escalation in the pay of those at the very top, such as the chief executives of quoted companies and the elite within the banking community. As one statistic, the ratio of the average pay of the chiefs of FTSE 100 companies to the average pay of their employees went up from 47 in 1998 to 139 in 2011.The fact that the genii coefficient of the earnings spread – giving the best measure of average inequality in the economy – has been going down counts for little in the public perception.
    • The poor have to go to food banks as a result of welfare policies
    • The recent Grenfell tower fire was a gift to a left-wing narrative – the fire was suffered by poor people , in conditions where the capitalists were inadequately regulated; the public good was being ignored; and the wealthy next door were of course safe.

    Perhaps an egalitarian liberalism could attack some of these problems without getting too much at cross purposes with market forces? One lives in hope.

    1. I intend to return to this topic. I think there is a liberal approach, but there are some big gaps in convention economic thinking. This might entail some policies that look distinctly anti-market – but which allow healthier markets to develop. We also need to consider that genuine democratic accountability can substitute in some cases – but we have very little of that in the UK at present.

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