Economics and the Financial Crisis

The financial crisis is persistent; it has had and continues to have profound effects on the state of the UK Labour Market.

A few months ago the BBC’s Economics Editor Stephanie Flanders presented a series of three programmes reviewing the contributions of Keynes, Hayek and Marx to economic theory and the relevance of their observations and ideas to the current financial crisis and to the task of finding a way out of it.

This post summarises this and adds other comments about other ideas that are relevant to the economy and the crisis.

Keynes

In the 1970s the Keynesian approach to managing economies, the approach that had fixed the world after the Wall Street Crash and the Great Depression began to fail.

Keynes is referenced in current times by those who believe that investment in infrastructure will stimulate the economy, that we can spend our way out of recession.  Actually Keynes’ relevance to our current circumstances and to the Financial Crisis, from which we have yet to begin to recover, is rather his observation, made at the time of the Wall Street Crash and the Great Depression, that people behaved with a herd mentality, both when investing and when panicking.  Keynes’ lasting importance is this observation.

Hayek

Hayek wrote in “The Road to Serfdom” that while the government has a role to play in the economy through the monetary system, work-hours regulation, institutions for the flow of proper information, and other principles commonly accepted by most members of a free society.  He argued that central planning and for example government control, for example nationalised industries, tended toward totalitarianism.  He argued for individual freedom and choice and classical liberalism; limited government and laissez faire economic policy (the free market).

Economic advisers of Margaret Thatcher’s government proposed a ‘third way’ between post war central planning and the free market, but Margaret Thatcher rejected that stating that she believed in Hayek.

But first, the rise of neo-liberalism and deregulation, from the late 1970s to the financial crisis:

Leading economies at the time, led by the US and the UK put their trust in neo-liberal free market economics.  For more than a generation we have been told that market forces should be allowed to self regulate, but this is based on the assumptions that:

§  Markets are efficient

§  Markets are virtuous

§  Markets are ‘intelligent’

If all those are true, then why was there a financial crisis ?

Markets are made up of people, and while people can individually or in cooperative groups behave intelligently, in large groups, in which there is limited communication or active competition, e.g. in markets, people tend to behave with a herd mentality leading to ‘boom and bust’.  Also people and financial institutions can, as has been recently shown, be corrupt and insufficient regulation will allow markets to be manipulated, distorted.

The proposed responses to the financial crisis are austerity combined with a faith that the free market will adjust, or Keynesian investment in infrastructure, building, etc. to stimulate growth.

Marx

Marx: wrote more about economics than communism; didn’t foresee that capitalism plus technological change had the potential to deliver acceptable standard of living for the majority, did foresee the need for capitalism to adapt / evolve / reinvent.

Since the financial crisis that acceptable living standard for the majority has been eroded, while the wealthiest seem to remain untouched or to continue to prosper.  In terms of Marxian economics the time has come for capitalism to evolve and reinvent itself.  But what would this new capitalism be like ?

There are two other theorists to note:

Philips

Bill Philips had before becoming an economist been a hydraulic engineer.  He observed that money flowed in the economy like water and built a ‘hydraulic computer’ as a teaching aid to simulate the economy, using water to represent money and controls and reservoirs to model the flow of money and the effects of taxation, investment and stimuli.  This model gave rise to the concept of the ‘the machine of the economy’ and the economy being seen as mechanistic, predictable, like a complex hydraulic clock.  Recent experience has shown the economy is more like an organism, or a collection of organisms, responding to stimuli, but not in a predictable way, like a herd or flock, not a machine.

Schelling

Thomas Schelling applied ‘game theory’ better perhaps understood as ‘active decision theory’ to economics.  Game theory has been used to describe, predict, and explain behavior in a range of situations and disciplines, also to develop theories of ethical or normative behavior.  In economics scholars have applied game theory to help in the understanding of good or proper behavior.

The classic ‘game theory’ situation is one where two players cannot beat each other, but establish a state of equilibrium, a continuous draw.

In recent years software has been developed to help investment managers.  This software has been based on ‘game theory modeling’.  Unfortunately reliance on this software seems to have contributed to the development of the financial crisis, which poses two questions:

§  Has this produced computer assisted herd behaviour ?

§  Is the software intelligent enough ?

But perhaps the answer to the reinvention of capitalism lies not in a Keynesian response, though that proved to be the cure for the Great Depression, but in ‘Game Theory’.  The application of Game Theory to the cold war nuclear standoff led to strategic arms limitations.  Both sides saw greater advantage in limiting their destructive capability rather than continuing to build up weapon stockpiles.

Money: its origin and purposes:

Money is a human construct, a concept, traditionally given physical form, more recently recorded electronically. 

When we were little and first went to school we were told that before money people would barter.  This would only work where two participants in an exchange wanted what the other had to offer and could agree a price, e.g. how many chickens equal one goat, or how many sacks of grain.  Money was invented as a way of representing and quantifying relative value to facilitate exchange.  But this assumes that market economies predate money.

In non-market economies, much trade is gifted or exchanged as favours to be cashed at a later date; exchange is as much about cementing social bonds as it is about ‘commercial activity’.  People bound by family relationships or community cooperating for mutual benefit.

For money when it is introduced to facilitate exchange tends to be introduced by a central authority, primarily to facilitate the transactions of that central authority.  Money is easier to collect and store than agricultural produce or other bulky resources, it facilitates taxation, state payment for goods, services, etc.

Taxation began in pre-monetary societies that collected taxes in kind; food, labour, materials and used redistribution of the taxed resources to facilitate specialist functions; military, religious, specialist craft and art.  Records of transactions, in effect tax receipts, were kept on clay tablets or papyrus or as coded knots on strings.  Money, coinage, could stand in for resources and simplify record keeping.  Later it became a common means of commercial exchange.

Money has two functions; it is a medium of exchange, circulating in the economy, but also a store of wealth.

Austerity and uncertainty mean too little money is being used as a medium of exchange and too much as a store of wealth.  Corporations are sitting on wealth rather than investing, the general population are facing a combination of employment uncertainty and imported inflation. The UK is not exporting its way out of recession nor is the economy rebalancing.

Keynes would recommend investment in infrastructure, building homes and greening the economy, Marx would advise that capitalism must reform itself and Schelling would recommend that the wealthy should see it in their own interest to invest in social stability, then some, perhaps much, of the wealth that is currently accumulating in the hands of the wealthy can flow back to the rest, via taxation and investment, and capitalism can again deliver an acceptable standard of living for the majority.