One damn theory after another (1)
Those big economic theories all seemed like good ideas at the time. Only later did we realise the economists had wrecked the joint.
No one understands how the economy works and no one can
understand. The problems tend to arise when economists claim they do know, and
governments believe them.
The global economy has over eight billion moving parts, each
person making decisions and taking actions in response to their own situations.
It is an ultimate chaotic system, more complex and less predictable even than
the weather. And yet various groups of economists have developed models that
they assert can describe how this impossibly complex system works: pull on this
lever, and that will happen.
The best any group of theorists has been able to manage is
to construct a model that seems to describe the economic situation as it is at
the time. The test of its usefulness is not whether it seems to work now – it’s
no amazing feat to manage an economy that’s chugging along nicely on its own –
but whether it can predict major upsets and manage those when they happen. On
that, they have all failed.
Not only were the Great Depression, 1970s stagflation, the
1990s recession, the Global Financial Crisis and the post-pandemic inflation
not predicted: according to the prevailing economic orthodoxies, they were not
supposed to even happen. When they did happen, the theorists and the
governments that had believed them were in trouble. So, unfortunately, were the
people of the countries involved.
Throughout the whole saga of 20th and 21st
century booms and busts, the same themes have recurred: the battle between
fiscal and monetary policy as the best way of steering an economy; and two
long-discredited but persistent ideas: Say’s Law and the Quantity Theory of
Money.
Put crudely, Say’s Law (named after an early-19th
century French philosopher) says supply determines demand, not the other way
around. The money made from selling a product creates income for workers and
business owners, which is then spent on buying more goods. To work, Say’s Law
would require a closed economy with no external trade; all of the money
received by workers and proprietors spent quickly on buying new stuff; and
nobody saving that money instead of spending it. But Say’s Law is the basis of
the Reagan-Thatcher supply-side policies (better known today as trickle-down
economics).
The Quantity Theory of Money says that inflation and
employment are controlled by the amount of money in circulation. It claims that
increasing or decreasing the money supply causes prices to rise or fall, because
there’s more (or less) money chasing the
same quantity of goods. But this ignores the propensity for banks and other
institutions to hang onto that new money, either preferring to preserve
liquidity or failing to find enough potential borrowers. This theory surfaced
again, with all its faults, in the post-GFC era of quantitative easing. Trying
to correct a slump by creating new money, said Keynes, was “like trying to get
fat by buying a larger belt”.
Both of these ideas fed the ideologies that led to the
greatest disruptions of the past 125 years, starting with the Depression.
How to create a depression
For centuries, cash issued by governments was based on a set relationship with gold. A banknote was a promise to pay the bearer in a set amount of gold. That rigidity fell apart in the chaos of the First World War, when Britain went off the gold standard. Many countries allowed their currencies to float.
In his pamphlet The Economic Consequences of Mr Churchill, Maynard Keynes asked: “Why would he do such a silly thing? Partly, perhaps, because he has no instinctive judgement to prevent him from making mistakes; partly because, lacking this instinctive judgement, he was deafened by the clamorous voices of conventional finance; and, most of all, because he was gravely misled by his experts.”
Those experts, in the Bank of England and the Treasury,
miscalculated the strength of the British economy and embarked on a policy
which, rather than inducing inflation, produced its even more damaging
opposite: deflation. By 1931, when the time the gold standard was finally
abandoned, the damage had been done.
Churchill was not alone in his mistakes and in his obeisance
to the theories proffered by the conventional economic experts of the day. Many
other countries, including Australia, Canada, Denmark, the Netherlands, France
and Germany, also returned to gold. In doing so, they were prevented from
varying their money supplies to provide appropriate levels of liquidity for
businesses to invest and for people to consume. A recent study looking
at 27 countries found that leaving the gold standard helped them to recover from
the depression.
But that – understanding that monetary policy alone was not
powerful enough to control economic shocks and could instead worsen them – was
only the beginning. Fiscal policy --
major government intervention through money creation and targeted spending
– had to happen. But it took too long.
In the US, unemployment rose to 24% by 1932, the year before
Franklin Roosevelt took office. The ruling orthodoxy, embraced by the Hoover
administration in the US and by Baldwin and Churchill in Britain, was what
today is known as austerity: facing any downturn by reducing government
spending and “getting out of the way” of the private sector. The idea was that
markets would self-correct and eventually achieve equilibrium between supply
and demand, automatically providing full employment.
Later, after this orthodoxy had turned a stock market crash
into a global depression, Keynes demonstrated that equilibrium could indeed be
achieved, with employment stable but at permanently low levels.
Even under the Hoover administration, there was significant
fiscal stimulus following the 1929 crash. Over his term, federal spending
increased by 48% but was largely balanced by tax increases. Hoover’s measures
were too meagre to address the worsening slump.
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| Hoover and Roosevelt, 1933 |
“Our greatest primary task is to put people to work,” he
said in hist first inaugural
speech. “This is no unsolvable problem if we face it wisely and
courageously. It can be accomplished in part by direct recruiting by the government
itself, treating the task as we would treat the emergency of a war, but at the
same time, through this employment, accomplishing greatly needed projects to
stimulate and reorganize the use of our natural resources.”
Although Maynard Keynes is today closely associated with the
ideas contained in the New Deal, he was not responsible for its implementation.
That was the work of the three core members of Roosevelt’s Brains Trust: two
economists (Raymond Moley and Rexford Tugwell) and a finance lawyer (Adolf
Berle). They deserved far more credit than they ever received.
Other measures were in place elsewhere. By 1935, most
countries had once again abandoned the gold standard, this time forever.
Devaluation of the Australian dollar by 25% from 1931, making exports more
competitive and protecting local import-competing industries, began the long,
slow return to normality. The fightback was not as smooth as it now appears:
the US prematurely would back stimulus in 1937, causing a sudden and unexpected
fall in economic output and a rise in unemployment.
Slump, war … then sunshine
Broadly, that approach saw the western world through the
three-and-a-half decades of increasing prosperity and decreasing inequality. By
now, poorer people could vote. They were represented by their own parties:
variously labour, social-democratic and socialist. Those two factors – a shift
in political power and the rise in economic output – produced the welfare state
and perhaps the longest period of social improvement that the developed world
had ever seen.
Proportionally, the greatest advances in the era were among
the nations most devastated by war: Japan, Germany and France. Those countries,
starting from a very low base, were able to replace destroyed industrial plant
with new equipment and technology while the victors continued with most of
their less-efficient pre-war plant still in use. Nevertheless, the average
person in other developed countries was now – at least on paper – between 60%
and 120% richer by 1970 than at the end of the war.
By 1970, Germany had caught up with Britain and Japan wasn’t
far behind.
Just as importantly, that increased national income
was being more evenly distributed. Throughout the period of Keynesian
dominance, people in the bottom half of society benefited relatively more from
that growth than those at the top. There was a palpable sense that life, after
the deprivations of war and rationing, was getting better. Harold Macmillan,
the British Prime Minister – a Conservative and a Keynesian – was
famously able to tell
the British people in 1957: “You’ve never had it so good!”
Maynard Keynes died in 1946 and so did not live to see the
ascendancy of Keynesian economics. Keynes was the best of the economic
theorists but even he did not provide a system that could handle radically
changed conditions. Those new, intractable conditions arrived with the
stagflation of the 1970s. Stagnant growth and high inflation were not supposed
to happen together. But they did.
The art of going backwards
By the early 1970s, inflation had already begun to rise.
Militant trade unions led frequent, damaging strikes in the pursuit of higher
and higher wages. Those higher wages added to the costs of production, so
manufacturers increased their prices to maintain their profit levels. Then, in
response to higher costs of living, unions went on more strikes and secured
higher wages. Inflation soared but in the end, nobody was better off. The
wage-price spiral had arrived.
The cost of the Vietnam war so depleted US financial
reserves that in 1971, Richard Nixon tore up the centrepiece of the post-war
international settlement that had been hammered out at Bretton Woods, New
Hampshire, in 1944. Under that agreement, the US had undertaken to peg the
dollar to gold at $35 an ounce, so other countries could peg their currencies
to the dollar at an exchange rate that suited their differing situations.
Eventually, the United States did not have enough gold to cover the fast-growing
volume of dollars in worldwide circulation; as a result, the dollar was
overvalued, depressing its economy. Nixon ended American support, so the
dollar, sterling and most other rich-nation currencies were allowed to float.
An even greater shock arrived in 1973 when the Organisation
of Petroleum Exporting Countries – the Middle-Eastern oil cartel – quadrupled
the price of crude oil. It was both inflationary (adding to costs and therefore
to prices) and depressing to economic output. Under these conditions, Keynesian
fiscal management was irrelevant. Inflation could not be controlled by
decreased spending without further suppressing GDP; and GDP could not be
boosted by increased spending without feeding inflation.
In the absence of effective policy responses, that
inflationary shockwave pushed production costs – and consumer prices – to
extraordinary heights. Inflation peaked at 24% in Britain, 16% in Australia
after the first shock and, in the US, by 14% after the Iranian revolution.
Economic output fell heavily as the world entered an
oil-induced recession. An anaemic recovery from 1975 was interrupted again in
1979 by the Iranian revolution.
Ordinary people suffered the most. By 1975, unemployment in
the US reached 9%, with other economies not far behind. At the beginning of the
decade, the unemployment rate stood at from 2% in Australia and 4% in Britain;
by 1980 it was almost 7% in both countries and almost 8% in the US. The days of
full employment were over. The previous, fairly stable, trade-off between
unemployment and inflation had already broken down by the end of the 1960s;
now, there was simultaneous unemployment, high inflation and declining rates of
growth.
It couldn’t go on like this. And it didn’t.
NEXT: After the oil shocks of the seventies, Milton Friedman thought he had the answers.