ECON 329 Midterm
Capitalism and Crisis:
Assessing the Failure of Mainstream Economic Paradigms
and Approaches to Needed Reforms
“I hope you all had a good weekend,” then-US Treasury Secretary Hank Paulson
th 2008. laughed nervously at the onset of a press conference on Monday, September 15Determined to avoid widespread moral hazard, Paulson hoped he was leading the nation into the figurative eye of the financial storm by adhering to his conservative ideology and opting not to rescue investment bank and financial titan Lehman Brothers. Instead, the subprime mortgage crisis began to spiral further out of control before Paulson had even finished talking. As recounted in the Frontline documentary “Inside the Meltdown,” Lehman’s failure was only the beginning. With insurance giant A.I.G. next on the chopping block, new meaning was applied to the term “too big to fail” as a near-inactive
congress fiercely debated the consequences of passing what became the Troubled Asset Relief Program (TARP). Meanwhile, new classical and new Keynesian economists alike began to scratch their heads as the gravity of the crisis heightened. For over two decades prominent academics in economic departments all over the United States had championed the Efficient Market Hypothesis (EMH). Within the EMH’s theoretical
parameters a catastrophe of gargantuan proportions comparable to the present crisis was thought to be highly unlikely, even impossible. Regrettably, both “freshwater” and “saltwater” economists alike were wrong.
Perhaps at no point during the worst months of the crisis was this more evident than when former Federal Reserve Chairman Alan Greenspan, a champion of free markets, deregulation, and Ayn Rand, testified before congress and reluctantly conceded: “I made a mistake in presuming the self-interest of organizations, specifically banks, is such that they were best capable of protecting shareholders and equity in firms…I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works. I had been going for 40 iyears with considerable evidence that it was working exceptionally well.”
Though this is a stunning acknowledgement from a regulator notorious for his confidence and wit, as seen in PBS Frontline’s “The Warning,” the larger public remains
almost as unsympathetic as the economists who did recognize intrinsic flaws in both the
domestic and global economies. Four years after the collapse of former financial powerhouse Lehman Bros, TARP, as well as the bailouts of GM, Chrysler, AIG, Bear Stearns et al, one must reconcile any long-standing interpretations of the economy with the “common sense” approaches advocated by economists in the vein of Robert Skidelsky, George Cooper, Dean Baker, Peter Schiff and others.
The mainstream’s willful ignorance of the existence of bubble economies,
coupled with the preference for a sustained use of complicated mathematical formulas as evidenced by the “freshwater” economists seen in the PBS Nova special “Mind Over
Money,” would now seem to be little more than a laughably outdated characterization of
the economy, one woefully indicative of Robert Shiller’s Irrational Exuberance, if not for
the continued prevalence of the mindset in academic circles at highly respected institutions like the University of Chicago and for the continued dire straits presently besetting the economy.
Hence serious, open-minded considerations of the work of the likes of Hyman Minsky, John Maynard Keynes (before his academia-fueled “bastardization” in the latter
decades of the twentieth century), and Karl Marx (particularly as interpreted by James Crotty) lead one to conclude financial crises are indeed intrinsic to capitalist economies, especially as the financial system presently exists. Likewise, it follows the failure of dominant paradigms within mainstream economics, especially with regard to financial crises, can be largely explained by the writings of the above-mentioned “radical”
economists. For me, this truth was most memorably evident in Minsky’s succinct
statement put forth in the overture to his thoughts on financing and instability: “It is self-
evident that if a theory is to explain an event, the event must be possible within the theory” (Minsky, p. 16). In lieu of these conclusions, whether or not the necessary reforms can be implemented and whether they will be implemented are separate considerations. Can the necessary reforms be made? Given the evidence from the assigned texts and given the desperate economic circumstances at present, I will allow that they can be made if the
needed political impetus is aggressively developed.
II. Why Financial Crises are Intrinsic to Capitalist Economies
The authors of the various readings covered in this course are diverse in opinion regarding the period when the United States economic structure changed irrevocably.
Minsky traces the roots of instability back to 1965, others, such as Dean Baker and Thomas Palley, while not dismissive of trends since ’65 nor of trends subsequent to the
“Nixon Shock’s” unhinging of U.S. currency from the gold standard (thereby installing a global system of fiat currency), tend to ground the beginnings of the “point of no return”
with respect to the rise of the financial bubble economy in or around the year 1980, leveling blame upon the memory of the Reagan administration, whose policies of deregulation and diminished labor power make a strong case for one of the Republican Party’s most treasured figures as a leading early culprit. However, most of this course’s
sources agree that the economy failed to maintain the promise of the twenty “boom”
years subsequent to World War II.
Yet the intrinsic qualities of capitalism’s systemic failings were first characterized far prior to 1965 in the work of the ever-controversial economist Karl Marx. Marx’s
contribution to the field of economics, especially when viewed under the lens of James Crotty, is far more substantive than his Communist Manifesto, which I believe is a major
source of popular disregard for Marx to this day. According to Crotty, true Marxian analysis is about far more than inter-class conflict and modes of production. True Marxian analysis is at least as concerned with at the sphere of monetary circulation (Crotty, p. 2). Capitalism’s gradual supplanting of the ancient barter system
simultaneously introduced the then-novel concept of producing commodities not for direct consumption but for exchange (Crotty, p. 3). From this development emerged a heretofore unseen separation of sale and purchase (Crotty p. 8), the first widespread instance of a standard commodity (i.e. currency) with a store of value (Crotty, p. 10), as well as the premiere set of circumstances for fiscal instability with the subsequent inconsistencies in the velocity of currency circulation (Crotty, p. 10), which was in turn partly fueled by the introduction of credit and of contracts (Crotty, p. 14-15).
Recollecting Marx’s insightful interpretation of economic history since capitalism’s birth through Crotty’s work is crucial because only through a complete
understanding of the inherent instability of a system of currency circulation can one recognize the role of what Crotty identifies as Marx’s key variable: the rate of profit (Crotty, p.28). This insight has very clearly informed the work of multiple political economists of note examined in this course, especially within the work of Dean Baker
and George Cooper. For economic expansion to validly transpire, the overall economy must accrue an attractive rate of profit. James Crotty develops Marx further relative to market conditions circa 1985 (the year of the essay’s writing) observing that as more
quarterly and/or annual periods of profit occur, so too follows a rise in leveraged debt and another downgrade of financial risks (Crotty, p. 28).
Returning to Marx, the invention of money and its subsequent circulation proves financial crises are indeed intrinsic to capitalist economies because even at the most basic form of capitalism, even one newly transformed from a barter economy and still too young to have introduced binding financial contracts or to unwittingly have fomented other means as a catalyst to future crises, the split in the previously simultaneous act of sale and purchase by way of currency as store of value will nonetheless create an economic framework vulnerable to crisis precisely because of the introduction of the passage of time into the overarching system. Time, when construed as a variable in commodity exchange, engenders a network of uncertainty. Hypothetically, if one market participant in this system opted to hoard currency instead of gearing these assets toward consumption, an overproduction crisis could take root through an overlay of commodities available on the market. More than discarding Say’s Law from a macroeconomic
perspective, Marxian analysis illustrates capitalism’s intrinsic susceptibility to financial crises.
Marx was not long alone in his identification of uncertainty as a source of consternation within the market economy with respect to his more widely acknowledged and debated peers in the field of economics. Principal among economists who share Marx’s caution regarding the presence of uncertainty in the capitalist market economy is John Maynard Keynes. In fact, certain Keynesian insights, such as the oft-cited “Paradox
of Thrift,” are essentially logical developments derived in succession to Keynes’ initial
identification of uncertainty of individuals as a likely economic pratfall consistently present to the detriment of the wider economic system. Like Marx, Keynes recognizes the role of money as a store of value since its initial conception hundreds of years before (Skidelsky, p.78).
But it would be somewhat fallacious to assert a strong kinship between the ideas of Keynes and Marx. Even on the subject of uncertainty, Keynes and Marx diverge
considerably. Robert Skidelsky’s analysis of Keynes places great emphasis on the role of uncertainty: “Uncertainty pervades Keynes’s picture of economic life.” (Skidelsky, p. 83).
To Keynes, uncertainty surfaces in economics only once the individual’s livelihood or affluence is contingent upon affecting a stance in the present with respect to this person’s own perception of his or her personal future economic and financial outlook. Were market exchange limited to purchasing necessities, Skidelsky affirms Keynes’ stance on
uncertainty as a near non-issue; uncertainty would likely not occur without prevailing enigmas “like the weather or war” (Skidelsky, p. 83). Though people have been forced to
mete economic decisions of consequence for many years before 1980, the regularity of such decisions increased enormously in the years following the election of President Reagan.
Throughout George Cooper’s The Origin of Financial Crises, Cooper strongly
implies Hyman Minsky’s work was strongly influenced by Keynes (Cooper, p. 12).
Minsky even complements Keynes’ “Paradox of Thrift” with his own “Paradox of Gluttony” (Cooper, p. 119). More pertinent to the broader discussion of why financial
crises are intrinsic is Minsky’s emphasis on the role of uncertainty in market systems, as had his predecessors Marx and Keynes.
III. Explaining the failure of dominant paradigms and their role in financial crises
The failure of mainstream economic paradigms to account for growing market deficiencies are abundant but they are largely grounded in the rise of several economic trends since the seventies. They include: the “bastardization” of Keynesian thought, the acceptance of the Efficient Market Hypothesis, widespread prejudice toward and misinterpretation of Marx’s analysis of capitalism and finance in Capital, the increasingly
deregulatory practices advocated by conservative ideology since the eighties (partly embodied by Alan Greenspan’s long tenure as Chairman of the Federal Reserve), and
finally, the mainstream economic academia’s propagation of economic theories that are generally either misinterpretations of sound pre-existing theory or widely-acclaimed yet entirely inept theoretical constructs of academia’s own devise.
Paul Krugman, Robert Skidelsky and George Cooper each discuss the
bastardization of Keynes at some length. By Cooper’s account, the “General Theory” of
Keynes details how economies can remain trapped in a state of depressed market activity below equilibrium levels forecast by market efficiency theories (Cooper, p. 81). Keynes argued for the necessity of deficit spending in these circumstances, according to him, spending without increased taxation is preferable to not spending at all. Rather than embrace Keynes’s dismissal of market efficiency, policy makers instead opted to ignore this insight while simultaneously applying the Keynesian remedy of fiscal stimulus policy incorrectly, despite their aforementioned rejection of the logic from which Keynes’s remedy had been derived (Cooper, p. 82). Rather than utilize fiscal stimulus
policy to rescue ailing economies from recession, policy makers have instead opted to implement fiscal stimulus to avoid entering recession. The consequence of this action has led to a gradual rise in debt financing and inhibits investor ability to realize the excessive nature of their borrowing. Subsequently, investor confidence has risen to dangerous highs and even greater stock of debt is amounted (Cooper, p. 83).
The flaws of the EMH are numerous, but its most egregious failings stem from a foundation of fallacious assumptions and copious contradictions within the theory itself. Chief among these failings is the EMH’s inability to account for the existence of both
central banking and inflation (Cooper, p. 43). Minsky’s now-celebrated “Financial
Instability Hypothesis” (FIH) refutes the EMH model’s reliance on preceding economic developments to forecast the future of the economy:
“If a return distribution is derived during a period of an expanding credit cycle it will almost certainly be entirely unrepresentative of the return distribution produced in a contracting cycle.” (Cooper, p. 147)
But until the recent crisis, Minsky’s work was not widely embraced. Keynes’s influence on Minsky is evident within Cooper’s initial survey of the current state of the economy in the first chapter of Origins. Cooper disparages the EMH for assuming price asset
movements are random and unrelated to prior price shifts of a given asset. Hence, the EMH leads to the construction of financial systems that ignore the possibility of “…scenarios like bank runs….our risk systems may be inherently designed to work only when they are not required.” (Cooper, p. 18). From these remarks it is clear part of the
FIH’s superiority to the EMH is rooted partially through its embrace of economic realities like uncertainty.
However, the newfound popularity of Minsky’s analysis and the canonization of the term “Minsky Moment” have hinted at policy makers’ likely continued inability to
correctly interpret and apply theory competently. As Thomas Palley argues, centering reform entirely on the work of Hyman Minsky in lieu of the subprime mortgage crisis would only serve to ignore the fundamental flaws of the neoliberal growth model. Applying Minsky without reconsidering the neoliberal model would “fix” the financial system under the assumption the crisis is rooted in finance, rather than within the economic foundation supporting it. Palley cautions regulators not to enable a prolonged period of economic stagnation and petitions for a return to an economic model capable of restoring the link between growth in wages with growth in productivity (Palley, p. 1).
Palley’s trepidation is justified. The Reagan era precipitated a series of
deregulatory policies further accelerated by Alan Greenspan’s stay as Chairman of the Fed. In conjunction with shifting policy, Reagan crippled labor unions’ bargaining power and fought against increases in the minimum wage. His refusal to gradually elevate the minimum wage substantially diminished the spending power of laborers occupying jobs paying minimum wage by the end of the decade because of the lack of wage growth relative to inflation. Additionally, what Palley deems the “Treaty of Detroit” model linking wage growth to productivity growth was abolished (Palley, p. 12; see also graph on p. 9). Growth in aggregate demand was subsequently driven by increased borrowing and widespread inflation of asset prices. The presidencies of Bill Clinton and George W. Bush continued to ignore larger economic problems by knowingly pushing policies of unsustainable short-term growth, thereby facilitating the emergence of the bubble economy and a growing income gap between the poor and the extremely wealthy.
Politicians and regulators were oblivious to these realities because they often looked to advice on economic policy from the pillars of the community of mainstream economists in academia. Hence, even the majority of academics are not absolved. The tale of Long Term Capital Management is a case-in-point: the fund’s business model had
been oriented around highly leveraged bets grounded in arbitrage using a new derivative model developed by a pair of Nobel-prize winning MIT scholars. When the model failed in 1998, the Federal Reserve Bank of New York was forced to orchestrate a bailout of unrivaled scope until the present financial crisis began a decade later (Baker, p. 32-33).
Excessive credit accumulation, inflated asset pricing, and diminishing rates of profit have hailed the approach of economic downturns in the past. The recent financial crisis is no different, yet as always the crash was nevertheless a surprise for the majority of the financial community. Rather than wait to determine whether the economy has neared the end of one of Minsky’s super-cycles (Palley, p. 6-7), significant steps toward
reform should be taken as soon as policy makers can manage.
IV. Conclusion: How We Can Reform the Economics Discipline
There is a strong case for the necessity of systemic reform of both the economic and financial systems. Though a lack of political impetus on capital hill will likely inhibit the passage of these reforms in the foreseeable future, considerations of the various texts do lend some measure of clarity regarding what needs to be done.
First, investors need to learn from their excesses, not thrive on them. For this reason it is necessary for Keynesian policy to be applied once the economy is already in depression as originally intended, rather than implement his ideas to avert recession entirely. Second, the neoliberal growth model needs to be discarded in favor of a return to a system linking productivity growth to wage growth. It is no longer acceptable for economic growth to stem from a system that requires high levels of borrowing from its constituents. Third, any economic theories advocated by academia in the future should only be embraced if these theories can account for economic realities. Complex mathematical formulas depicting an idealized vision of the economy are without value if they regularly fail to explain and/or disregard what is possible in the economy simply because reality is directly at odds with a given theory. Fourth, moral hazard has become a serious problem because of the predictability of Federal Reserve policy. It may be in the national interest to engineer a fiscal system where the finance industry is uncertain as to whether the central bank will forgive excess and poor judgment through direct policy action and other protective measures. This leads me to my fifth proposed reform: if a firm is too big to fail, then it is certainly too big to exist. No single firm or industry should be so large or interconnected that it could ever conceivably sink the domestic economy. Federal measures should be taken to prevent troubled firms of this stature from becoming a staple of ailing economies.
i Clark, Andrew, and Jill Treanor. "Greenspan-I Was Wrong about the Economy. Sort of." The
Guardian. Guardian News and Media, 23 Oct. 2008. Web. 21 Mar. 2012.
1. Baker, Dean. Plunder and Blunder: The Rise and Fall of the Bubble Economy. Sausalito, CA:
PoliPointPress, 2009. Print.
2. Skidelsky, Robert Jacob Alexander. Keynes: The Return of the Master. New York: PublicAffairs, 2009.
3. Cooper, George. The Origin of Financial Crises. Petersfield: Harriman House, 2008. Print.
4. Palley, Thomas I. The Limits of Minsky's Financial Instability Hypothesis as an Explanation of the Crisis. Working paper. Washington D.C.: New America Foundation, 2009. Print.
5. Crotty, James. The Centrality of Money, Credit, and Financial Intermediation in Marx’s Crisis Theory: An Interpretation of Marx’s Methodology. Rep. 1985. Print.
6. Minsky, Hyman. Finance and Profits: The Changing Nature of American Business Cycles. Working
7. Clark, Andrew, and Jill Treanor. "Greenspan-I Was Wrong about the Economy. Sort of." The
Guardian. Guardian News and Media, 23 Oct. 2008. Web. 21 Mar. 2012.
8. "Why Has Real Wage Growth Been Lagging behind Productivity Growth in the United States?" Quora.com. Web. 21 Mar. 2012.
9. "Inside the Meltdown." Frontline. PBS. Television.
10. "The Warning." Frontline. PBS. Television.
11. "Mind Over Money." Nova. PBS. Television.