When the financial meltdown of 2008 to 2009 occurred, most people said that the science of economics was in state of collapse. And yet conventional economics ploughed on with barely a wobble. To see this you only have to listen to the commentary around central banks, which uses language from old text books, with only slight adjustments to modern jargon, such as “forward guidance” and “quantitative easing”. And this in spite of the fact that monetary economics was at the heart of the failure of economics in 2008. This is leading to false optimism about the prospects for the world economy. It is the economics of denial.
The story so far. The collapse in 2008 exposed gaping holes in textbook economics. Standard microeconomics, with people regarded as welfare-maximising, rational agents, had long been a laughing stock, unless you had to use it to pass exams or get academic papers published. But the crisis showed that macroeconomists were not paying much attention to the financial system – and yet the crisis that unfolded had finance at its heart. And the question of how wealth and income was distributed was treated as an afterthought, with the real attention being on how aggregated statistics (like GDP and inflation) behaved. For these reasons, most economists failed to see the crisis coming, and they failed to understand how long-lasting the following recession would be.
To be fair, many at the fringes of economics are asking deeper questions. I get a glimpse of these through The Economist’s Buttonwood column (written by Philip Coggan). In this week’s print edition he reviews a book by fund manager George Cooper which tries to rethink economics. Mr Cooper sees the world in terms of social competition – which has the virtue of putting wealth distribution at the heart of the narrative. I am debating as to whether to buy this book- but I have been disappointed in this genre of writing on economics – long on criticism of conventional wisdom, short on substantive new ideas.
But on Monday Mr Coggan looked at another book, Capital in the 21st Century by the French economist Thomas Piketty. This book, published in French last year, with an English version about to be released, is in a different league. It has the weight of data behind it, and some serious thinking. It could conceivably change the direction that conventional economics takes. It puts distributional issues at the heart of economics – which is surely where it should be. Mr Piketty suggests that if economic growth slows down, the elites who own productive assets accrue a disproportionate share of the wealth. We are in just such a slow growth era now in the developed world, mainly because of demographics, but also because technological advance does not seem to be translating into higher economic productivity in the way that it used to. I am rather afraid that I will have to buy Mr Piketty’s book, even though I already have a substantial backlog of reading.
But none of this stops the incessant chatter around monetary policy and growth statistics. The narrative is now that growth in the developed economies has returned, so that we can get back to familiar old track of steady economic growth (about 2% a year). Asset prices have jumped. And yet the fundamental problems that led to the last financial crisis have not been fixed.
Now let me develop my personal take on the world economy, building on some of the ideas that these authors have raised.
The fundamental problem of the developed world economy is that a disproportionate share of the wealth is accruing to a small elite. This may be because of globalisation and newer technology. It may just be a fundamental law of economics that was concealed by temporary factors in the 60 years after 1945 (as Mr Piketty seems to be suggesting).
Many would consider this to be problem in its own right. But it also creates a wider problem. The rich elite does not spend all that it earns. This, as going back to the circularity of economic flows that forms the basis of macroeconomics, will cause the economy as a whole to shrink. The textbook way in which that shrinkage is prevented is if the surplus earnings (aka savings) are channelled into investments; indeed basic economics holds that savings equal investment as a law of nature (with the dread qualification of “in equilibrium”). But this investment involves giving people jobs to do real things – like building ships or factories or even just houses. It does not work if the investment is simply a financial merry-go-round chasing speculative profits – or bidding up the prices of pre-existing assets such as land. But this is exactly what is happening, and a burgeoning industry has been created to support it.
But there are two other ways to stop surplus savings from causing the economy to shrink. The first is to lend money to the not-so-well-off to support a lifestyle beyond their financial means. We have witnessed this, strikingly in the USA, since the 1990s. The second is for the government to make up the shortfall in demand by running large deficits. This is what took over after the crisis. The trouble is that neither path is ultimately sustainable. Both cause the build-up of debt that cannot be repaid, and onto a crisis of default, involving the mass destruction of financial assets. That process of default comes in quite a few guises: hyperinflation, revolution, depression – with war often associated. This is what the developed world experienced between 1914 and 1945. The wealth of the elite is destroyed, with substantial collateral damage on the poor. And then we start the process all over again.
Is disaster inevitable? No. A conventional economist would offer two ways out. First we could switch those savings from the merry-go-round to real, productive investment. Second we could generate economic growth through increased productivity and further globalisation, and with new wealth generated outside the property-owning elite.
But I’m afraid there is a fairy-tale quality to these ideas. There is only a limited amount of potential commercially-worthwhile investment out there. It is difficult to understand how rapid productivity growth can happen in developed economies. This leaves us with the need for tough political action, to pre-empt disaster by forced redistribution of the elite’s income and assets.
Once conventional economists start recommending these sorts of strategy, rather than treating them as suicidal, we will know that they are making the transition. This is happening only at the fringes at the moment. Meanwhile we are sailing serenely into the next financial crisis.
It will probably take this next crisis to shake things up, and finally break the world of denial that most politicians and financial professionals currently inhabit.