27th August 2012
One of the major changes of the last forty years has been in attitudes over how economies worked. The victory of ideas emanating from the Chicago School (or the Austrians – take your pick) successfully supplanted the previous dominant meme that preceded it: that the state should be the dominant player in determining how resources were allocated.
In 1989, Francis Fukuyama proclaimed “the end of history.” The next two decades saw Capitalism rampant, supremely confident in its moment of triumph. This new meme of allowing the private enterprise’s “animal spirits” free rein became so dominant in fact, that even politicians and their supporters on the Left felt obliged to support it, even if they saw the Capitalist model as merely a means to an end. Talk of social equality became passé in polite circles.
One of the results of this change was the growth in the importance of the financial industry and derivatives in particular. John Lanchester characterises this as an attempt to understand, control and make money from risk – part of a humanitarian attempt to abolish the idea of an incomprehensible fate and replace it with a rational, quantifiable study of chance and probabilities. Finance underwent a profound change in the process, a shift Lanchester describes as “equivalent to the emergence of modernism in the Arts – a break from common sense, a turn towards self-referentiality and abstractions and notions that couldn’t be explained in common English.”
In a rational world, derivatives would be used solely to mitigate risk, but today they are more often used to increase risk – magnifying it – in the hope of increasing the reward. By their very nature however, they were not capable of recognising the unexpected, such as one of Nassim Nicholas Taleb’s “black swan events.” As a result, they became, as Warren Buffet so aptly named them, “weapons of mass destruction.”
When the Global Economic Crisis of 2008 hit due to the implosion of the house of cards that derivatives had become, it started to look as if Capitalism was being hoist by its own petard. Rather than being self-correcting via the market’s “invisible hand,” it had evolved into something that seemed to herald its own self-destruction, the victim of the very type of innovations Capitalism was meant to foster.
The financialisation of the markets, using technological sleights of hand to squeeze of fractions of a cent out of temporary arbitrage opportunities, managers looting companies by gaming the bonus system at the expense of shareholders and not being checked by fund managers – you name it – the crisis revealed a host of problems thrown up the deregulation of markets, touted as ‘necessary’ if you wanted economic growth.
While it all ended in tears, there is now a vacuum, no consensus as to the way forward. Instead the Right and the Left are equally determined to use the crisis as an opportunity to remodel the world economy in ways that suit their preferences. Moreover, both sides are in equipoise and determined to thwart the other.
The gridlock of the US Congress has been the major feature of American politics over the last three years. While the Democrats tried to move to centre (so that Obama governed in effect as a moderate Republican), the Republican leadership itself decided early not to co-operate. It figured if the stimulus succeeded, for example, Obama stood to get all the credit. If it failed, the Republicans could portray themselves as having been on the side of fiscal prudence. So committed was their opposition that they even opposed things that they supposedly supported, such as the Recovery Act’s deep tax cuts and emphasis on infrastructure. The Republican Senate leadership decided their primary goal was beating Obama by any means.
What really angered the Republicans was how the stimulus bill would be used as a tool to transform American society by promoting a low-carbon future, school and healthcare reform, and in creating government-sponsored jobs. Republicans believed all these should be left to the market, not picked by bureaucrats, while the latter should have been left to individual states. They are wedded to the belief that the American way was to let market forces do the repairs.
This goes to the heart of their philosophy: that it is business, not governments that creates wealth. Supply-side economists argue for example that it was WWII, not the New Deal that rescued America from the Crash of 1929 (which seems to ignore that the war itself acted as a giant government stimulus). In fact, the Republican base believes the Twentieth Century, at least following the advent of the New Deal, was a huge mistake, despite this being the period of America’s economic ascendancy. They wish to return to what they believe was a golden age when laissez faire Capitalism was unshackled from any social obligations.
Of course, success with the Federal Reserve’s quantitative easing has proved elusive for the Obama administration. This was the orthodox solution but it hasn’t worked as the panacea it was supposed to. Along with the bailout, it was meant to encourage the banks to start lending again. Instead they worried about new capital adequacy rules and raised the bar for borrowing to almost impossible heights for most (especially small) businesses. Lots of people felt the audacity of hope was over-promised and under-delivered without acknowledging that things could have be so much worse. They expected miracles and when the president failed to deliver many who voted for Obama last time lost the faith.
Conservatives reject the conventional wisdom that the answer to a severe economic contraction is government spending. As proponents of “free market Capitalism,” they say the Federal Government should have no role in bailing out failing firms and banks and instead should have allowed creative destruction free rein because without government intervention, businesses and markets would have recovered much more quickly. Conservatives also worry that increased spending will be supported by either printing money (leading to inflation) or borrowing money (driving up debt even more). They fear the time when all these bills will become due, and refuse to accept the idea that economic growth will solve the problem.
Given the rate of technological change, no modern economic crisis is the same as the last, but inevitably the only tools we have to use are the ones devised following previous crises. ‘We are always fighting the last war’ despite it being obvious things have changed. The situation in 1931 was also different as manufacturing facilities were idle where people could be employed and quantitative easing then helped with buying food, which meant farmers could buy farm equipment made by American workers in factories, triggering the start of a virtuous cycle. In 2009, however, there were no idle factories where people could be employed. Instead money was largely used for importing consumer goods from China – which benefited the most – while commodity prices boomed, benefiting the countries that produced them.
Today’s “anaemic” growth, meanwhile, is entirely due to private deleveraging over the past four years. While conservatives like to blame “regulatory uncertainty” for the low rate of growth, lack of demand is the real problem. It is ordinary folks, faced with the uncertain prospect of keeping their jobs that have been sitting on their wallets.
The single biggest issue that enrages conservatives is that the Obama chose to spend the money on trying to transform the American economy while trying to cushion the inevitable transition rather than on a flight to the moon, for example (something they might have supported). Republicans basically demanded that if any money came from government should be used for tax cuts.
There is also a strong suspicion that they would really have preferred a full-blown depression (which was missed by a whisker), as this would have allowed complete reform of the entitlement system. However, the problem with entitlements is that once they are in place, they are almost impossible to dismantle.
With the entry of Paul Ryan as Mitt Romney’s running mate, the upcoming US presidential election is starting to shape up as a real battle of ideas following the phoney war it has been up until now. It should help clarify what the important issues are between the visions of the two parties. While Romney has specialised in bland homilies and assumes new positions depending on what his pollsters told him, Ryan is unabashed in his ideological beliefs. (The accepted narrative is, however, that this is not entirely Romney’s fault; he had to go out to the extreme Right to secure the nomination and now has to try and segway back to the centre to win over the independents.) Ryan’s message meanwhile, energises the Republican base and the Tea Party with its small town, Norman Rockwell-view of America because it taps into visceral dislike of Washington, or any big city for that matter.
The notion that America faces a debt crisis caused by a government that taxes and spends too much is central to this, although the underlying premise of his ideas is not so much fiscal rectitude as small government. Ryan’s ideology was essentially shaped, as is often the case in America, by reading Ayn Rand when he was an adolescent. Neither philosophy or economics and, frankly, pretty dismal literature, Rand’s books paint an idealised picture of individual self-reliance: the iconoclastic businessman as James Dean. This goes to the heart of the debate about wealth, because both Rand acolytes and conservatives hold up rich people as the embodiment of American dream, which is why they see the Democrats threats to soak the rich as “class warfare.”
Ryan’s position is principled but also ideological. Even Newt Gingrich of all people, characterised Ryan’s budget ideas as “right-wing social engineering.” Rand’s ideas have had an enduring appeal amongst people who cleave to the notion that politics should be guided by clearly defined principles that transcend the petty compromises that usually plague politics in practice.
Like all ideologues, they are appalled by any necessity to compromise their ‘principles’, which will make their experience in governing – if they win – likely to be painful. This may well mean they end up disillusioned with democracy because it always involves messy compromises. If or when their programme fails, they will look around for someone to blame for “sabotaging” it. The tumbrels won’t be far behind.
We are now living in interesting times, as the Chinese curse attributed to Bill Clinton goes. The Global Economic Crisis hit the Western world in 2008, and despite momentary pauses, appears far from over. The question is whether this is just a momentary blip in the ever onwards trajectory of economic progress or whether we are facing something more profound.
Some, like The Economist magazine, have suggested this time is unlike previous corrections both in scale and scope. We now appear to be stuck in an interregnum between stages of the Industrial Revolution, between mass production and something entirely new. How long the new phase with take to be fully realised is almost impossible to guess, as a lag is inevitable.
In the meantime, systemic risks remain. The financial system is still broken, with finance companies continuing use similar methods to make money out of money. The crisis of 2008 casts a long shadow. Not only did it show that financial companies can quickly implode, but that subsequent government rescues are highly unpopular with voters. Recently it was Knight Capital that almost hit the wall, exposing the new threat from high-frequency trading.
As The Economist magazine notes, “society needs a stock market to allocate capital efficiently, rewarding the best companies with higher share prices…but high-frequency traders are not making decisions based on a company’s future prospects; they are seeking to profit from tiny changes in price. They might as well be trading baseball cards. The liquidity benefits of such trading are all very well, but that liquidity can evaporate at times of stress. And although high-frequency trading may make markets less volatile in normal times, it may add to the turbulence at the worst possible moment.” And what if it had been a much larger firm? Politicians might hesitate before bailing out another big financial firm, especially if the cause was reckless trading.
Then if Romney and Ryan win the election, which they stand a reasonable chance of doing, their withdrawal of the stimulus could plunge the US into the deep depression it has so far managed to avoid.
Meanwhile the American elite fiddle as the US economy burns. But then maybe they are being smart. The wealthy always do best out of a financial crisis – the deeper the better – because even if they lose half their wealth, they are usually sufficiently cashed up to buy cheap at the fire sale that follows.