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Overdue farewell to dogma

Mainstream economics did not see the crisis coming - and so far it has not done much to overcome it. However, at least in the USA, a rethink has started.

Mainstream economics did not see the crisis coming - and so far it has not done much to overcome it. However, at least in the USA, a rethink has started.

Economists know about small market movements, "but they were overwhelmed when the situation became really serious", said Gustav Horn, the director of the Macroeconomic Policy Institute (IMK) at a recent conference in Washington. The science of economics must, in his view, change fundamentally as a result. It is not that there are no alternative approaches, but rather that in recent decades economists who start from the fallibility of the market have been increasingly marginalised. Horn identifies the fundamental mistake of the profession as lying in an excess "of dogmatism and a lack of pluralism". For example, in the model world of the self-regulating market economy there is no place for "fundamental instability" - the possibility of sudden market collapses that cannot be foreseen using calculations based on probability theory.

However, that was exactly what occurred in the great crises of both 1929 and 2008. The theoretical framework for an economic policy which can avoid such crises, or at least defuse them, has been around for a long time. John Maynard Keynes presented it to the public in 1936. However, as Horn points out, Keynes' ideas have once again been replaced by a belief in the stability of unregulated markets "particularly in Germany and to a lesser extent in the USA." This affects both attempts at an economic explanation and the economic policy which is put into practice.

So what were the causes of the most recent financial crisis\? And what can politics do about it\? Horn and the US economist Thomas Palley have jointly edited a new book with Horn on cooperative transatlantic economic policy. Palley identifies three ways of explaining the crisis which lead to different economic recommendations.

The "hardcore neoliberal explanation" sees the failure of the state as the cause of the global downturn, which began with a collapse in prices in the US property market. According to this view, the US central bank fuelled the speculative bubble with interest rates that were far too low, while state subsidies tempted large numbers of people who could not afford to buy their own homes into house purchases. The recommendation for the future is therefore that the state should stay out of the economy and the central bank should keep money tight.

The "softcore neoliberal explanation" sees market failure caused by mistakes in regulation as the cause of the crisis. In this view, the liberalisation of financial markets went too far, with the result that unsupervised bankers created financial products which operated in a way that no one could understand in the end. This led to panic selling followed by the collapse of banks and insurance companies. The proposed therapy is that financial markets should be better regulated and monetary and fiscal policies should be used to get the whole economy back on track. Then everything can continue as before. The costs of stimulus policy should be subsequently recouped by budget cuts.

The "structural Keynesian explanation", on the other hand, sees the crisis as "the logical result of 30 years of neoliberal policies, says Palley. Deregulation, privatisation, weakening of the unions and the abandonment of full employment as a policy have together resulted in stagnating wages and a widening gap between the highest and lowest paid. The negative consequences were hidden by a credit bubble which was inflated over a whole generation and finally burst. Dealing with the results requires a re-regulation of important areas of the economy. The position of employees must be strengthened through reforming the labour market and the collective bargaining system and minimum wages set at a level which protects living standards. There must be international cooperation to ensure that competition between countries does not become a "race to the bottom", as well as public investment and a stabilisation of the welfare state. Full employment should again become the first aim of economic policy.

There are also three views of the Eurozone crisis, Palley says. Number one: spendthrift politicians triggered a debt crisis. Number two: the crisis is the result of current account imbalances. Number three: neoliberal policies led to wage stagnation and a fall in demand, linked to a currency union, whose construction repeated the mistakes of the Gold Standard in the first half of the last century; this has created the current misery.

Palley notes that neoliberal ideas continue to be widespread across the globe, but, there are differences, for example between Germany and the USA. In Germany, using monetary or fiscal policy as a tool in employment policy remains a taboo; the welfare state, on the other hand, is by and large prized, or at least accepted. In the USA, exactly the reverse is true. Many conservatives support economic stimulus programmes but their attacks on the welfare state are all the fiercer as a result.

Palley has also identified another difference. Although radical market ideas have deeper roots in the USA than in Europe, a trenchant opposition to them has developed there. European politicians, in contrast, including social democrats, have backed away from interpreting the crisis in a non-mainstream way.

Indeed Germany at present has the "most neoliberal elite" in Europe. For Palley, looking at the USA, "in this historic moment, strife and division are good things," because that is how change starts.

Andreas Botsch, chief economist of the European Trade Union Institute (ETUI) has identified "seven deadly hypocrisies" of the economic mainstream. He argues that their dominance, which has also determined the policies adopted to deal with the crisis in the Eurozone, has not just led to social hardship but also a deep economic collapse in Southern Europe.

The belief in austerity. Botsch says that in the whole of economic history making cuts in the downturn has never produced the hoped-for results. If everyone tightens their belts then demand and production fall. The state's income drops, but in fact it has to spend more on increasing social problems.

The fabled debt-hating "Swabian housewife", introduced to the world by Angela Merkel, is not an appropriate model for financial policy. A remedy that makes sense for a private household and regards debt as morally reprehensible could be fatal when the patient is Europe, Botsch says.

Debts are a brake on growth. The view that public debt above a certain level will automatically damage economic growth was the conclusion of a study which was methodologically flawed but politically has been enormously influential. Botsch says policies should be based on empirical facts and not on fictional models.

The cliché of profligate government spending. The countries "on the periphery of the Eurozone" are often all presented as living "beyond their means". In reality, Botsch points out that only Greece can be accused as having an unsound budget policy.

The European Central Bank can only intervene in an emergency - and if it does help countries finding it difficult to borrow money in the markets, it should only do on conditions of stringent austerity. Botsch says that this widely held view ignores a basic problem of the Eurozone, that, only when the central bank can trade without restriction in the market for government debt, will it be able to play a stabilising role as the dominant monetary force in Europe - ideally alongside the European finance ministry, which has still to be created.

Competiveness is the panacea. Attempting to improve one's market dominance by cutting costs only makes sense in terms of a single country. If everybody makes savings, wages and social standards sink and nobody is more competitive - but everyone is poorer.

Financial markets have had enough regulation. Botsch emphatically disagrees with this. It is not sufficient to forbid the existing banks from engaging in this or that business. If banks are to serve the real economy rather than creating speculative bubbles, they must be smaller, more simply structured, less short-term in their approach and have better democratic controls.

Thomas Palley, Gustav Horn (eds): Restoring Shared Prosperity (pdf), December 2013

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