The economics behind the financial crisis.

‘Don’t fix it if it ain’t broke’ is a maxim that neatly encapsulates human tendency to stick to a strategy which has proven successful in the past and to apply it to new situations. The problem is not that it isn’t true but when it’s finally ‘broke’ the failure can be catastrophic.

Individuals develop heuristics to succeed in an environment. The more time they spend in that environment, more strongly are the heuristics corroborated through practice. However, when the environment changes these heuristics may need to be modified and new ones adopted for success. Society, being the aggregate of individuals, also develops such heuristics. These are the theories which become dominant and induce societal institutions to act according to their precepts. Usually, the dominance of a particular theory is not permanent. There is a cycle wherein a previously accepted theory is shown to be false and a new one takes its place only to be replaced by another more improved theory when it comes along. Usually a vigorous debate on the dominant theory constantly takes place within narrow academic confines. However, acceptance by the masses provides continuing dominance and democratic sanction to the proponents of the theory. When changed circumstances show the shortcomings of a prevailing theory its opponents are strengthened. And if the failure is serious enough, they supplant it with their own theory.

In contrast to individuals, society takes longer to adapt and embrace a new theory. Not only do a majority of people need to be convinced that the old theory is failing, which in itself takes time as events unfold, but also the opposition needs to be successfully countered. This delay adds to the fact that a dominant theory is usually elevated to the level of dogma with blind following by practitioners, and leads to the consequences of failure being amplified. Such amplification has the unwarranted effect of the theory being rejected lock, stock and barrel for another supposedly superior theory assumed to be truly universally applicable. The nuance that a theory has limits and only operates under a certain set of circumstances is lost.

This is the situation that we find ourselves at present in economics. Keynesianism was rejected due to egregious government excesses and its failure to counter stagflation in 1970s. Monetarism gained acceptance along with supply-side policies. Under Alan Greenspan, it morphed into the dogma that monetary policy alone is sufficient to counter economic cycles and fiscal policy should operate in a narrow region of automatic stabilisers. The belief of government incompetence in fiscal policy but supreme ability in monetary policy is Orwellian doublethink.

This dogma led to asset price bubbles, most recently the housing bubble. It also led to over-indebtedness of governments. Freed from the responsibility of building fiscal reserves to use during recessions and confident in the ability of central bankers to smooth booms and busts, politicians did what is rational for them – spend to make their constituents happy.

As the housing bubble collapsed, many governments found that they had no fiscal room to manoeuvre. When banks are unwilling to lend, monetary policy is useless. However, the orthodoxy still holds sway. Greenspan, the high priest, and others are back professing their faith after flirting with apostasy at the bottom of the crash. The dogmatic remedy for present ills is for fiscal policy to be contractionary and monetary policy to be super-expansionary. In an environment where unemployment is high and private spending by individuals and corporates subdued, the government is being asked to lay-off people and spend less. This travesty is supposed to be more than countered by central banks offering almost unlimited amounts of cheap money. The rationale is that cheap money will make it easier for debtors to pay their loans and thus prevent the economic chaos which widespread bankruptcies cause. It will also induce people to borrow and invest. The first objective has only been achieved partially. If debtors are out of work, they cannot pay their loans regardless how low the interest rate is. The second objective has failed miserably. Investment is inherently risky and in a recessionary environment, risk appetite is low amongst both lenders (banks) and borrowers (companies and individuals). No one is going to borrow to consume as the perceived risk of loss of job increases.

The perverse effect that cheap money has achieved is asset hyperinflation. The few who have access to central bank largesse have used it to speculate on everything from equities to government bonds and foodgrains to metals. The prevailing economic dogma is not only causing serious hardship amongst the general public but also choking off the very recovery that it is supposed to induce. High commodity prices lead to higher inflation, affecting everyone in that it increases the proportion of income spent on necessities. It hits the poorest the hardest and leads to a disproportionate impact on aggregate demand. For example, a lower quartile income earner might postpone the purchase of the latest iPad in order to meet his increased fuel and grocery bills. This is not going to be made up by the upper quartile income earner who is unlikely to buy an additional iPad even if the price falls somewhat.

The financial markets are swamped with speculative money which distorts price signals and leads to the pursuit of speculative gains. With money almost free, wealth preservation becomes more important than wealth creation. Everyone rushes to lock in their wealth by buying what are thought to be inflation-adjusted assets such as land or commodities. This is a vicious cycle in which asset prices rise and lead to inflation which induces a demand squeeze leading to more cheap money provided by dogmatic central bankers causing another round of asset purchases. In cases where this money trickles down to the masses, one sees the familiar textbook hyperinflation when any good is preferable to paper money and the economy breaks down into a barter system.

The longer this dogmatic approach of the Fed is followed, the more catastrophic the eventual denouement. High unemployment and inflation is a recipe for social upheaval. Throw in a privileged elite seemingly reaping the rewards from this dogmatic policy and we have a chapter being written for future high-school history texts. 

The views expressed in this article are the author's own and do not necessarily reflect Fair Observer’s editorial policy.