Economics is not a morality tale

Western civilization can be seen as the liberation of technical theory (science, in the broadest sense) from moral values.  This battle continues to this day.  It is so much easier and enjoyable to be a witch-doctor than a scientist  (again, in the broad sense as devoted to rational thought).

  1. Machiavelli divorced poltical theory from the personal morality of the ruler — a ruler must do the right thing for his people, even at the cost of going to Hell (Shakespear sketches this out pleasantly in Measure for Measure).
  2. Modern medicine broke the connection (so evident in the Gospels) that sickness is not the consequence of sin (with a few possible exceptions).
  3. Keynes broke the connection between economic cycles and sin.

The current reminder of this dearly learned insight

Keynes offers us the best way to think about the financial crisis“, Martin Wolf, Financial Times, 23 December 2008 — Exp note #3.  Excerpt:

I see three broad lessons.

The first, which was taken forward by Minsky, is that we should not take the pretensions of financiers seriously. “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.” Not for him, then, was the notion of “efficient markets”.

The second lesson is that the economy cannot be analysed in the same way as an individual business. For an individual company, it makes sense to cut costs. If the world tries to do so, it will merely shrink demand. An individual may not spend all his income. But the world must do so.

The third and most important lesson is that one should not treat the economy as a morality tale. In the 1930s, two opposing ideological visions were on offer: the Austrian; and the socialist. The Austrians – Ludwig von Mises and Friedrich von Hayek – argued that a purging of the excesses of the 1920s was required. Socialists argued that socialism needed to replace failed capitalism, outright. These views were grounded in alternative secular religions: the former in the view that individual self-seeking behaviour guaranteed a stable economic order; the latter in the idea that the identical motivation could lead only to exploitation, instability and crisis.

Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge. He wished to preserve as much liberty as possible, while recognising that the minimum state was unacceptable to a democratic society with an urbanised economy. He wished to preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds.

This same moralistic debate is with us, once again. Contemporary “liquidationists” insist that a collapse would lead to rebirth of a purified economy. Their leftwing opponents argue that the era of markets is over. And even I wish to see the punishment of financial alchemists who claimed that ever more debt turns economic lead into gold.

Yet Keynes would have insisted that such approaches are foolish. Markets are neither infallible nor dispensable. They are indeed the underpinnings of a productive economy and individual freedom. But they can also go seriously awry and so must be managed with care. The election of Mr Obama surely reflects a desire for just such pragmatism. Neither Ron Paul, the libertarian, nor Ralph Nader, on the left, got anywhere. So the task for this new administration is to lead the US and the world towards a pragmatic resolution of the global economic crisis we all now confront.

The urgent task is to return the world economy to health.

… As Oscar Wilde might have said, in economics, the truth is rarely pure and never simple. That is, for me, the biggest lesson of this crisis. It is also the one Keynes himself still teaches.

Recessions as magneto trouble

Recessions are technical troubles with our economic engine, not the workings of a morality play.  As Keynes said in “The Great Slump of 1930“, economic cycles — even the Great Depression — has narrow technical causes:

The machine {is} jammed as the result of a muddle. But because we have magneto trouble, we need not assume that we shall soon be back in a rumbling waggon and that motoring is over.

Similarly, he argued that a downturn did not overthrow the moral basis of capitalism.  From his great The General Theory of Employment, Interest and Money (1936):

I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment; though this need not exclude all manner of compromises and of devices by which public authority will co-operate with private initiative. But beyond this no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community. It is not the ownership of the instruments of production which it is important for the State to assume.

Are recessions the inevitable payback for good times?

Since Keynes perhaps the greatest single essay breaking the mental equation between sin and economics is nobel laurate Paul Krugman’s essay “The Hangover Theory” (Slate, 4 December 2008) — Excerpt:

A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the “Austrian theory” of the business cycle-a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire. Oh well. But the incident set me thinking-not so much about that particular theory as about the general worldview behind it. Call it the overinvestment theory of recessions, or “liquidationism,” or just call it the “hangover theory.” It is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion.

The hangover theory is perversely seductive—not because it offers an easy way out, but because it doesn’t. It turns the wiggles on our charts into a morality play, a tale of hubris and downfall. And it offers adherents the special pleasure of dispensing painful advice with a clear conscience, secure in the belief that they are not heartless but merely practicing tough love.

Powerful as these seductions may be, they must be resisted—for the hangover theory is disastrously wrongheaded. Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality — with policies that encourage people to spend more, not less. Nor is this merely an academic argument: The hangover theory can do real harm. Liquidationist views played an important role in the spread of the Great Depression—with Austrian theorists such as Friedrich von Hayek and Joseph Schumpeter strenuously arguing, in the very depths of that depression, against any attempt to restore “sham” prosperity by expanding credit and the money supply. And these same views are doing their bit to inhibit recovery in the world’s depressed economies at this very moment.

The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity — of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes — investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover.

… the key to the Keynesian revolution in economic thought — a revolution that made hangover theory in general and Austrian theory in particular as obsolete as epicycles—was John Maynard Keynes’ realization that the crucial question was not why investment demand sometimes declines, but why such declines cause the whole economy to slump.

Here’s the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn’t that mean that they must be deciding to spend more on consumption goods — implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

Most modern hangover theorists probably don’t even realize this is a problem for their story. Nor did those supposedly deep Austrian theorists answer the riddle. The best that von Hayek or Schumpeter could come up with was the vague suggestion that unemployment was a frictional problem created as the economy transferred workers from a bloated investment goods sector back to the production of consumer goods. (Hence their opposition to any attempt to increase demand: This would leave “part of the work of depression undone,” since mass unemployment was part of the process of “adapting the structure of production.”) But in that case, why doesn’t the investment boom — which presumably requires a transfer of workers in the opposite direction — also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry — not just the investment sector—normally contracts.

… Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can’t stand the thought that positive action by governments (let alone—horrors!—printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism.

… The Great Depression happened largely because policy-makers imagined that austerity was the way to fight a recession; the not-so-great depression that has enveloped much of Asia {1997-98} has been worsened by the same instinct. Keynes had it right: Often, if not always, “it is ideas, not vested interests, that are dangerous for good or evil.”


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To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest these days:

These posts discuss Diagnosis, causes, and the larger context of the crisis:

  1. The post-WWII geopolitical regime is dying. Chapter One, 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  2. Diagnosing the eagle, chapter I — the housing bust, 6 December 2007
  3. Death of the post-WWII geopolitical regime, III – death by debt, 8 January 2008 – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
  4. Let us light a candle while we walk, lest we fear what lies ahead, 10 February 2008 – Putting the end of the post-WWII regime in a larger historical context.
  5. A vital but widely misunderstood aspect of our financial crisis, 18 September 2008 — Too many homes.
  6. A picture of the post-WWII debt supercycle, 26 September 2008
  7. Debt – the core problem of this financial crisis, which also explains how we got in this mess, 22 October 2008
  8. Causes of the financial crisis (no, its not the usual list), 29 October 2008
  9. Government policy errors and the Great Depession, 1 November 2008

Originally published at Fabius Maximus and reproduced here with the author’s permission.

2 Responses to "Economics is not a morality tale"

  1. Guest   January 20, 2009 at 4:25 pm

    “A few weeks ago, a journalist devoted a substantial part of a profile of yours truly to my failure to pay due attention to the “Austrian theory” of the business cycle-a theory that I regard as being about as worthy of serious study as the phlogiston theory of fire.”We shall see who best predicts the future….maybe the Keynesians will do as well as the Austrians. I doubt it but we shall see.To test a theory, it is best to let the real world decide. My bet is on the Austrians.Buying gold, guns, grub and praying to God have NEVER seemed like better bets than in the current: “Let’s stimulate a LOT more and be extra sure to give 10+ times more fiat money to the failing big banks than to anyone else. Inflation no problem. We shall take care of that later.” These are the flavors of logic used by the pols and economists and bankers during the Weimar Republic!We shall see.