Whistling Past the Graveyard
A decade after the financial crisis, economists still have not rethought macroeconomics. A new history takes on the field's unrepentant hubris.
April 9, 2019
Apr 9, 2019
15 Min read time
A decade after the financial crisis, economists still have not rethought macroeconomics. A new history takes on the field's unrepentant hubris.
Money and Government: The Past and Future of Economics
Yale University Press, $35 (cloth)
“Has economics failed us?” Larry Summers, the former president of Harvard and economic adviser for presidents Barack Obama and Bill Clinton, recently asked in an op-ed for the Washington Post. “Hardly.” On the contrary, he declares, “textbook macro . . . has stood up very well.” Dismissing the notion that economists ought to have seen the financial crisis coming with a hand-waving “market breaks are inherently unpredictable,” Summers conveniently forgets that the economic theories he championed in the Clinton administration provided crucial intellectual succor for the deregulation of the financial sector—policy blunders that made something like the global financial crisis an accident waiting to happen.
Macroeconomics became a monoculture, and like many monocultures, it was vulnerable to catastrophe.
Summers’s self-confidence is legendary, but he is hardly alone—his sentiments reflect a broad consensus among mainstream economists. In the unhappy 1970s, academic battles were pitched over macroeconomic theory as Keynesians, stumbling over stagflation (high unemployment and high inflation at the same time), were challenged by those who would return economic theory to its pre-Keynesian days under the banner of “new classical economics.” By the 1990s the Keynesians were chased from the scene, and in macroeconomics at least, everybody pretty much agreed on everything important—that is, with modest variations to taste on how to model and manage the aggregate economy.
In 2003 the leading anti-Keynesian Robert Lucas, in his presidential address to the American Economic Association, triumphantly announced “the central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades.” And it was not just zealous new classical economists who held such views; MIT’s Olivier Blanchard, in a stock-taking paper with the unfortunate publication date of 2009, declared “the state of macro is good.” Macroeconomics had become a monoculture, and like many monocultures, it was vulnerable to catastrophe.
The global financial crisis, sustained dismal economic performance in its aftermath, and the existential crisis of ever widening inequality might have led to some scholarly soul-searching, not unlike what many international relations specialists experienced after the unanticipated end of the Cold War. But economists don’t do humility well. Presented with evidence inconsistent with their models, elite economists typically respond less like curious, dispassionate scientists and more like the celebrated military strategist described by Tolstoy: “in the failure of that war he did not see the slightest evidence of the weakness of his theory. On the contrary, the whole failure was to his thinking entirely due to the departures made from his theory.”
Blanchard, admirably, produced a thoughtful paper about “rethinking macro” shortly after the crisis, but a decade later, it is fair to say that macroeconomics has not been rethought. With Money and Government, Robert Skidelsky, author of the magisterial, justly celebrated three-volume biography of John Maynard Keynes (as well as numerous other accomplished books), aims to take on this unrepentant hubris. His opening gambit: “We are at a junction where the whole of macroeconomic policy is up for grabs.” The crisis and the feeble recovery that followed demands changes to the way macroeconomics is understood and, crucially, taught. “That it has barely done so is my main excuse for writing this book.”
Money and Government gets off to a strong start with summaries of the factors that left us stranded on the sandbars of economic distress. At the theoretical level, the rise and fall of Keynesian economics left the discipline with breathtakingly “sophisticated” and “elegant” models that the global financial crisis revealed to be little more than the emperor’s new clothes. As a matter of policy, those models served as the handmaidens to the zeitgeist of financial deregulation and what is, in retrospect, the “plainly absurd” belief that we should encourage the financialization of the economy. As Skidelsky observes, “Surely it is here—in the world of economic ideas—that the original flaw in the regulatory design is to be found.”
Skidelsky makes plain an inconvenient truth: that for all its aspirations to be received as a science, the analysis of many economists flows from their underlying social-political preferences.
More novel, and more subversive, is Skidelsky’s very fine job in making plain an inconvenient truth: that for all its aspirations to be received as a science, the analysis of many economists flows from their underlying social-political preferences. Economists, imagining their discipline as prestigious and pristine as physics, routinely hide behind the skirts of neutrality—the third law of thermodynamics has no political bias, after all, so why should monetarism? Money and Government has little patience for this fairy tale, noting the “silent ideological slant” of economic theory, and the book is savvy about how political power shapes economic possibility, attributing the shattering of the Keynesian consensus to a basic change in the balance of power that has “shifted decisively from labour to capital.”
Even if they could be stripped of their inherent politics, economic theories imagined as social physics will still end in tears. The great international relations theorist Hans Morgenthau urgently warned against “the illusion of a social science imitating a model of the natural sciences.” There is a fundamental difference between the two, namely the technical matter regarding the stability of behavioral relationships between the variables. The speed of light is a constant; social relations are not. In Skidelsky’s words, “It is the changeability of the object being studied which demarcates the social sciences from the natural sciences.” Surveying the state of contemporary macroeconomic theory, he calls for a do-over.
In that spirit, Money and Government takes a deep, erudite dive into the history of monetary theory, its controversies, and its intricacies, going way, way back. Monetary theory is more interesting than you might think (it is not a coincidence that many of the great economists throughout history made their early careers in this specialization), and these chapters suggest there may be an untapped market for “Wicksellians do it with interest” bumper stickers. Most general readers, however, will likely be inclined to skim these passages.
More vital and, not surprisingly, handled with a combination of precision and élan, is the second quarter of the book, which is devoted to Keynes, the unfortunate shift from Keynes to Keynesianism, and the overthrow of that version of Keynesianism which then led to the overconfident macroeconomic monoculture—the one that went sleepwalking into the global financial crisis.
Keynes more or less invented macroeconomics. Of his many contributions, two are central here: that the macroeconomy is a system (that is, it cannot be understood by trying to reduce it to constituent parts because it is the interactive effects that are decisive), and that economic decisions are made in the context of radical uncertainty (think of Donald Rumsfeld’s unknown unknowns) as opposed to actuarial risk (where the underlying probability distribution is certain, such as the odds of getting a seven when rolling two dice). But Keynes barely participated in the development of the Keynesian revolution, which took place after World War II. He had a major heart attack in 1937, shortly after the publication of The General Theory (1936), and for the last years of his life (1939-1946) he served as a Treasury advisor preoccupied with the pressing practical problems of financing the war and its immediate aftermath.
Although the global financial crisis did not shake macroeconomists’s faith in their models, it turned out pretty much everyone was a Keynesian in a foxhole.
Postwar Keynesianism—which attempted to domesticate and formalize The General Theory by stripping away many of its core tenets, including the role of uncertainty—was developed by “arrogant and clever” U.S. economists such as Paul Samuelson, who were characterized, in Skidelsky’s words, by an “exuberant self-confidence.” Keynes affiliate Joan Robinson, in her minority dissent, famously dubbed this “bastard Keynesianism.” But as Skidelsky reminds us, “Keynes [broke] decisively with the neo-classical model of rationality, in which agents with perfect foresight accurately calculate the risk they run by committing present funds to secure future income streams.” With each passing year, then, there was less and less Keynes in Keynesianism, but few bothered with such distinctions when the Keynesians of the day “had no compelling theoretical story to explain” the disastrous stagflation of the seventies.
Out went Keynes. Skidelsky quotes a triumphant Robert Lucas in 1980: “At research seminars, people don’t take Keynesian theorizing seriously any more—the audience starts to whisper and giggle to one another.” To this Skidelsky adds, and it is an irretrievable blow: “But these giggling economics students became the architects of the policy that led to the great crash of 2008.” And they were not alone. Former and would-be “Keynesian” economists fell over themselves trying to reconstitute their models. They did so by embracing the core tenet of new classical macroeconomics—rational expectations theory—which holds that economic actors share knowledge of the same underlying (and more or less correct) model of the economy and respond to new information by processing it efficiently through that shared model. Add some minor market imperfections to leave space for policy discretion, and “New Keynesianism” was christened. But what, if any, remnants of Keynes there were in New Keynesianism was unclear at best; Nobel laureate (and old Keynesian) James Tobin lamented that if he “had a copyright on who could use the term Keynesian I wouldn't allow them [New Keynesians] to use it.” In any event, the damage was done. And the dubious, misguided and empirically suspect rational expectations assumption was the rotten heart of the macroeconomic monoculture of the ’90s and ’00s.
Although the global financial crisis did not shake macroeconomists’s faith in their models—which essentially ruled out the possibility of such an upheaval by assumption—it turned out pretty much everyone was a Keynesian in a foxhole. A second Great Depression was prevented by the fiscal stimulus—which was buttressed by automatic (Keynesian) counter-cyclical stabilizers—and the provision of a tidal wave of liquidity. But once it became apparent that the bullet had been dodged, normal politics resumed, and public policy took a dysfunctional turn as the guardians of the status quo enforced a premature withdrawal of fiscal stimulus, again leaving monetary policy as the sole tiller of the economy and exacerbating the lingering Great Recession. (Keynes, it should be noted, had been so shaken by his experience as a member of the Macmillan Committee in 1931 that he emerged with the epiphany that monetary policy alone would be inadequate to the task of resolving the great slump.) For Skidelsky the general abdication of urgently needed fiscal levers is a costly consequence of the enduring macroeconomic monoculture.
The efficient market hypothesis caused the orgy of irresponsible, inefficient, and ultimately ruinous speculation that caused the global financial crisis.
Money and Government takes contemporary macro to task on two additional dimensions: inequality and financial regulation. Regarding the former, Skidelsky reviews how inequality as a question for economic “science” was nudged off the agenda by the turn of the twentieth century. Economists, he reminds us, concern themselves with efficiency, not outcomes. And a world in which one person owns everything is a world about which economic science insists it cannot improve—it is a “Pareto optimal” outcome: no individual’s welfare can be improved except by harming someone else. Done and done. But Skidelsky has a slightly less narrow definition of economic efficiency and does not consider it a coincidence that the economic crashes of 1929–33 and 2008–09 were preceded by very high levels of inequality. Situating Keynes in the company of “under-consumption” theorists, he argues that distribution is a macroeconomic problem, because when wealth is skewed towards the top, rich people’s lower marginal propensity to consume (regular folks tend to spend a higher percentage of their money) can create a problem of inadequate aggregate demand.
Inequality also has important political implications, which are not as easily walled off from economic analysis as many would have us believe. As noted, post-war Keynesianism was only possible due to a balance of political power between capital and labor that has now, due to increased automation, deregulations permissive of greater capital mobility (Keynes warned explicitly against such measures), and globalization, shifted dramatically in favor of capital and against the working classes. Public policy has followed. Is this just? Surely not. Is it sustainable? In the debate between Keynes and Friedrich Hayek (they were cordial correspondents), Hayek’s position was that government intervention would inevitably lead to totalitarianism. Keynes, accurately described by his colleague and first biographer Roy Harrod as “an individualist to his fingertips,” also feared encroaching collectivism, but saw the opposite danger, that capitalism unchecked from its flaws and worst excesses would, he wrote, “lead in practice to disillusion with the results of your philosophy.” Once again, Keynes looks prescient, and alarmingly so, as seen in the rise of personalist authoritarianism exploiting the worst of these instincts.
When it comes to the question of financial regulation, Skidlesky refuses to participate in the willful forgetting that the banks—abetted by economic theory—got us into the mess that we are still, ten-plus years later, wallowing in. Contra Summers (who amassed a tidy fortune collecting fees from the financial sector before and after advising the president of the United States as to how that sector should be governed), Skidelsky returns to the original sin of the macroeconomic consensus, rational expectations, as a crucial cause of the global financial crisis. It was that fellow traveler of rational expectations, the efficient market hypothesis—which held that the value of financial assets were always correctly reflected by their market price—that provided “the intellectual underpinning of financial market deregulation,” and the orgy of irresponsible, inefficient, and ultimately ruinous speculation that followed. Here Skidelsky drops the mic: “A dose of realism, or even a cursory knowledge of history, would have told these savants that markets do not work in this way.”
Money and Government spends several hundred pages getting to its punch line—a slim forty pages on “reinventing political economy.” It is on this chapter that the book must rise or fall, and ultimately it is a very mixed bag, with the eminently sensible and occasionally contestable mixed in with an utterly dismal blind spot. Sensible notions include a reimagined and reinvigorated fiscal policy (cover current spending with taxes, but create a separate capital budget for long term investments, which can be modulated counter-cyclically); recognition that monetary policy, which has its limits, nevertheless must be about more than vigilance against inflation and otherwise staying out of the way; and various proposals for reducing financialization and banking reform more generally, such as requiring issuers of mortgages to hold them for some minimum period and measures to curb cross-border speculative capital flows. (A “Tobin tax,” which is a tiny fee on financial transactions, remains an excellent idea for discriminating between productive and speculative capital flows.)
With obtuse passages (and loud silences) about Trump, Skidelsky is, at best, whistling past the graveyard.
Less impressive is a casual call for changing the culture of banking (no argument here, but that will take some heavy lifting); a surprisingly cursory discussion of fixing inequality, a problem described as beyond the scope of the book but seems rather central to it; and a casual introduction of the rather radical notion that Central Bank autonomy over interest rates should be reduced and transformed into something like an advisory capacity serving at the pleasure of elected officials. On the one hand, it is extremely helpful to remind (or inform) readers that “any monetary policy will always produce winners and losers,” and entrusting monetary policy to an independent central bank does not make monetary policy “neutral.” Nevertheless—and speaking as a scholar who was sharply critical of monetary policy back when Central Bank Independence and the policy of single-minded devotion to suppressing any hint of inflation was a fetishized article of faith in both economics and political science—stripping Central Banks of their independence is a rash measure that flirts with considerable danger. Better to change their mandates, or have their boards populated (as the founders of the U.S. Federal Reserve intended) with representatives of various sectors of the economy (as opposed to a bunch of bankers).
Plainly alarming, however, is Skidelsky’s penultimate section, on globalization and its discontents. Skidelsky rightly observes that unmitigated capitalism is harsh, double-edged, disruptive, “includes a great deal of human breakage,” inherently amoral, and often arbitrary, unjust, and unforgiving. “That is why a market system, to be generally acceptable, requires a state to curb its excesses, distribute its fruits in an equitable way, and mitigate its hardships.” (A tidier summary of the entire Keynesian disposition could hardly be imagined.)
What is necessary now is not just a return to Keynes (certainly), but, as Keynes would have urged, “A reopening of the economics discipline to sociology, history, politics and ethics.”
Skidelsky is thus not at all surprised by a populist backlash against globalization—but his assessment of its worst political manifestations is naïve and dangerous. “Donald Trump is the most important populist to have won office so far,” he announces. But while Trump’s ignorant, race-baiting nativism and untutored protectionist proclivities certainly sound anti-globalist, he is, eminently and transparently, no populist—he is a faux-populist plutocrat. One would expect the author of Money and Government to recognize that the president’s signature (only?) public policy accomplishment has been profoundly and fundamentally anti-Keynesian: a massive pro-cyclical tax cut targeted overwhelmingly at the wealthy. (Keynes advocated for counter-cyclical fiscal policy, with tax cuts, when appropriate, targeted at those with the greatest “marginal propensity to consume”—that is, the middle and working classes.)
Here and elsewhere, with obtuse passages (and loud silences) about Trump, Skidelsky is, at best, whistling past the graveyard. Surveying the state of the capitalist democracies, he assesses “our political systems” as “sophisticated” and “resilient” and protected by the steady guardrails of “taboos against racism” and populations “better educated and less submissive to the unbridled will of rulers.” There is a real danger that such spit-take inducing passages risk shredding the well-earned credibility and savvy insights Money and Government brings to the very different and vital discussion of reforming macroeconomic theory.
On the need to reform macroeconomics, Skidelsky is magnificently right. We live in a world of uncertainty, not risk. The new classical effort to ground macroeconomics in microeconomics “must be judged a failure.” As must the attempt to derive macroeconomics “from the optimizing decisions of well-informed, forward looking rational agents subject only to logic of competitive markets.” What is necessary now is what Money and Government calls for—not just a return to Keynes (certainly), but, as Keynes would have urged, “A reopening of the economics discipline to sociology, history, politics and ethics.”
Because economics has failed us. Miserably.
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April 09, 2019
15 Min read time