Today, we are walking out of your class, Economics 10, in order to express our discontent with the bias inherent in this introductory economics course. We are deeply concerned about the way that this bias affects students, the University, and our greater society.
Letter from Harvard students,
sent to professor Greg Mankiw
“Too Much Debt, Serviced By Too Little Growth, Under Too Politicized Conditions”1. This is the title of the theme I have been banging on about for years. Whereas the first two sections speak for themselves, “Too Politicized Conditions” stands for financial repression by governments and central banks.2 From now on I simply refer to “the theme”. The theme captures broadly the economic developments surrounding the Lehman collapse and continues to play out as a vicious circle, particularly in the developed economies. Although others have described it in similar terms I will explain what I think are its core characteristics. I will argue what needs to be done to change the theme and why this will be difficult.
We have to discuss the theory because economics and finance, with their models, inform and shape monetary, fiscal and investment policies. They are not innocent bystanders observing this mess. On that note, economists have some tidying up to do. As famously pointed out by Queen Elizabeth, it’s not just their track record that is abysmal, or the curriculum that upsets students. It also concerns the politics with which the various schools debate with each other. This is no longer limited to the ivory towers of their respective academic fortresses. A whole new battleground has opened up in the blogosphere. The sad aspect of this debate is, first, the vitriol used against experts from other disciplines who could provide new and likely more robust insights for the dismal science. Instead of soul searching the general attitude in the economic society is “We know what we’re doing and you don’t”. In psychology this is called denial. Second, the polemics disguise the shared but flawed premise, originating in Newtonian mechanical physics, of the economy as a machine. I will return to this later.
Let’s go through some of the recent twists and turns of this debate.
- Standard macro methodology is based on equilibrium models. It became painfully clear that these models did not include the capital markets, a big ‘miss’. Earlier this year I attended a conference and came away pessimistic about changed attitudes. Most presenters clearly have no clue about the true nature of markets.
- Traditional textbooks on economics still describe the financial system as banks taking in deposits which they subsequently lend out, constrained by required reserves at the central bank. They also advocate the money multiplier. Recently the BOE set the record straight. On the other hand, it confirms that our fiat currency system relies on faith in the monetary authorities.
- A few confessions of policy makers suggest that the crisis has challenged their assumptions and models. Alan Greenspan, former Fed chairman, acknowledged that “these models do not fully capture… the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve.” Larry Summers, former U.S. Treasury secretary, has come to the conclusion that, over the past few decades, we’ve moved into secular stagnation. Secular stagnation means that the economy needs bubbles to generate the wealth and spending to initially achieve sufficient employment. Those bubbles have been fueled by debt, available cheaply via decreasing interest rates. Now that the latter have reached the “lower bound” of zero, we have the additional problem that economic growth is now also required to service this debt. Secular stagnation is close in spirit to the theme.
In line with secular stagnation, additional research3 has shown that technological innovation—and the related productivity— have slowed down over the past few decades. A number of economists have highlighted related aspects to this theme. Nobel laureate Edmund Phelps argued that corporatism, not capitalism is the root of inequality. The Brookings Institute published a paper showing that corporations in the U.S. are aging and are becoming increasingly entrenched, choking creativity and innovations. In China the problem is government favoritism for large state companies. This imposes a glass ceiling on small companies which prevents them from realizing their potential, creating jobs and boosting productivity.4
The theme is clearly playing out in the Eurozone, for example:
Source: https://www.tradingeconomics.com/euro-area/government-debt-to-gdp
The increase in the debt/GDP ratio in the EU has been driven primarily by growth in debt, not a drop in GDP. Levels of sovereign debt have increased, among others, to finance the welfare state burdened by aging populations. Zooming in at the individual country level for growth in this ratio over the 1st quarter of 2014:
Source: https://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22072014-AP/EN/2-22072014-AP-EN.PDF
These ratios basically show there has been no austerity. Moreover they confirm the aforementioned vicious circle: what we call trend growth has only been sustained by adding more debt. It seems we have reached a point where this is no longer sustainable. Worryingly, Italy recently re-entered recession and Germany’s low bond yields show ‘Japan-like’ patterns.
Looking at growth and debt beyond developed countries, Moody’s forecasts that GDP growth for 2014 across the 20 largest emerging markets, excluding China, will only amount to 2.1%. Data from Thomson Reuters shows that 2014 is turning into a record year for issuing emerging market sovereign debt, with the tally above U.S.bn, up more than 50% over the same period in 2013.
[Read: Gold Is the Money of Kings, Debt the Money of Slaves]
These manifestations of the theme are symptoms of a deeper issue. To explain, we need to return to economic theory. Why am I (a bit) more sympathetic to the free market view of the Austrian School? Both von Mises and Hayek, for example, hinted in their writings to the link between minds and markets. Hayek in particular had a deep interest in the human mind and published his reflections in The Sensory Order. Von Mises discussed the mind-body problem. Unfortunately they never explored this any further.
Why is this important? Inspired by the mind sciences, the archetypal market hypothesis (AMH) takes an organic rather than machine perspective of the economic system. This leads to the premise of the market’s mind, i.e. capital markets manifest collective consciousness. Translated this means that the dynamics in markets are similar to those in minds with forces competing and cooperating. Motivated by avoiding pain (risk) and seeking pleasure (reward), by way of discovery we gain knowledge and experience. A key aspect of this analogy is the bridging of the physical and the psychic domains. In our case these concern the ‘real’ economy and the ‘perceiving’ markets, respectively. Crucially, growth in the economy is generated by ‘physical’ discoveries, i.e. technical breakthroughs, manufacturing innovations, etc. that allow us to adapt to our environment and improve our lives. These are valued by way of the ‘psychic’ discovery of prices in the capital markets. Prices contain highly concentrated information and are the numerical symbols that provide meaning relevant into decision making. Ultimately both originate with individuals who require the freedom to have these discoveries. This creativity is not about mechanisms and control! Still, if you insist to view it in terms of physics, the mental dynamics of creative discovery, for example culminating in insights, are akin to those of quantum physics. Logic and rational thought, on the other hand, are more akin to mechanical physics.5
Just like interference in the mind (brain washing being an extreme example) prevents it from healthy development and discovery, so does interference in markets. The most damaging feature is price manipulation. For example, if interest rates are manipulated, financial engineering (rather than real engineering) becomes a dominant trade for ‘innovations’. Specifically, if interest rates are artificially kept low, debt instruments are created (e.g. to increase leverage in order to earn some yield). A related symptom of centrally planned price manipulation is not only that it instigates manipulation by others, exactly because ‘mechanisms’ are operating. It also leads to an obsession with prices, i.e. capital rather than income returns. In short, it leads to an imbalance between (equity) investing and (debt) trading. Investing is about the long-term transfer of capital across the aforementioned bridge between the markets and the real economy, particularly the private sector. Trading, on the other hand, is about the temporary switch between securities on markets, of which the sovereign debt market has a growing proportion. High-frequency-trading shows that to make that switch as short as possible is the current obsession.
[Don't Miss: The Collapse of Macroeconomics: An Interview With Dr. Woody Brock]
Finally, in light of the theme, is it rational to largely ignore the current geopolitically charged environment? Keynes famously stated that “Markets can remain irrational longer than you can remain solvent.” I realize that it is quite a step up to imply that markets may have lost their ability to discover prices (and thus, by extension, to allocate capital efficiently to the real economy). Still, a key message from AMH in general and the theme in particular is that markets (or capitalism) are not the cause for our problems. It is the (often politically motivated) abuse of markets, particularly price distortions like subsidies, exchange rate controls, monopoly pricing, and interest rate policies, which have the unintended economic (and to some extent political) consequences we’re confronted with. Instead, like minds, the global economic system would benefit from freedom and transparency that its participants require to make discoveries.6 That should be the focus of regulations.
The status quo has strong supporters, including the “Too Big to Fail” institutions. In order to break the vicious circle I’m afraid something dramatic is required to cleanse the system of existing economic dogmas and vested political interests. Think about it for a moment. Governments aim for re-election and Keynesians will always state that they don’t do enough. Until, of course, they do too much. The same goes for the banking system and the monetarists. God forbid you have a situation where these two are combined into a neoclassical policy framework, ideal for monetizing debt. Under such conditions the risk of a drama beyond simply ‘the machine breaking down’ are significantly raised. Now that I think of it… Abenomics = Kamikazenomics?
Footnotes:
1 Acronym: TMD,TLG,TPC. Often I extended the title as “Too Much (off-balance-sheet) Debt, Serviced By Too Little (real) Growth, Under Too Politicized Conditions.”
2 A separate report on this topic is available upon request.
3 E.g. Cowen (2011), Gordon (2012), Fernald (2014).
4 Andrew Batson, forthcoming in the China Economic Quarterly (via Arthur Kroeber, GaveKal).
5 E.g. Bohm, D. and D. Peat. 2000. Science, Order, and Creativity.
6 There are many other characteristics of our current economic climate that can be judged in this context. For example, the crowding out of the private sector, inequality, international financial repression via currency wars and sanctions, etc. (see here).
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