Economics as Drama

Robert Skidelsky has written a grand piece of economic history as an article for Prospect Magazine for January 2009. Here is a nice presentation of the ebb and flow of political and economic though as cycles in history. The article has broader scope -- and is well worth reading -- but this part caught my attention:

Historians have always been fascinated by cyclical theories of history. Societies are said to swing like pendulums between alternating phases of vigour and decay; progress and reaction; licentiousness and puritanism. Each outward movement produces a crisis of excess which leads to a reaction. The equilibrium position is hard to achieve and always unstable.

In his Cycles of American History (1986) Arthur Schlesinger Jr defined a political economy cycle as "a continuing shift in national involvement between public purpose and private interest." The swing he identified was between "liberal" (what we would call social democratic) and "conservative" epochs. The idea of the "crisis" is central. Liberal periods succumb to the corruption of power, as idealists yield to time-servers, and conservative arguments against rent-seeking excesses win the day. But the conservative era then succumbs to a corruption of money, as financiers and businessmen use the freedom of de-regulation to rip off the public. A crisis of under-regulated markets presages the return to a liberal era.

This idea fits the American historical narrative tolerably well. It also makes sense globally. The era of what Americans would call "conservative" economics opened with the publication of Adam Smith's Wealth of Nations in 1776. Yet despite the early intellectual ascendancy of free trade, it took a major crisis—the potato famine of the early 1840s—to produce an actual shift in policy: the 1846 repeal of the Corn Laws that ushered in the free trade era.

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In the 1870s, the pendulum started to swing back to what the historian AV Dicey called the "age of collectivism." The major crisis that triggered this was the first great global depression, produced by a collapse in food prices. It was a severe enough shock to produce a major shift in political economy. This came in two waves. First, all industrial countries except Britain put up tariffs to protect employment in agriculture and industry. (Britain relied on mass emigration to eliminate rural unemployment.) Second, all industrial countries except the US started schemes of social insurance to protect their citizens against life's hazards. The great depression of 1929-32 produced a second wave of collectivism, now associated with the "Keynesian" use of fiscal and monetary policy to maintain full employment. Most capitalist countries nationalised key industries. Roosevelt's new deal regulated banking and the power utilities, and belatedly embarked on the road of social security. International capital movements were severely controlled everywhere.

This movement was not all one way, or else the west would have ended up with communism, which was the fate of large parts of the globe. Even before the crisis of collectivism in the 1970s, a swing back had started, as trade, after 1945, was progressively freed and capital movements liberalised. The rule was free trade abroad and social democracy at home.

The Bretton Woods system, set up with Keynes's help in 1944, was the international expression of liberal/social democratic political economy. It aimed to free foreign trade after the freeze of the 1930s, by providing an environment that reduced incentives for economic nationalism. At its heart was a system of fixed exchange rates, subject to agreed adjustment, to avoid competitive currency depreciation.

The crisis of liberalism, or social democracy, unfolded with stagflation and ungovernability in the 1970s. It broadly fits Schlesinger's notion of the "corruption of power." The Keynesian/social democratic policymakers succumbed to hubris, an intellectual corruption which convinced them that they possessed the knowledge and the tools to manage and control the economy and society from the top. This was the malady against which Hayek inveighed in his classic The Road to Serfdom (1944). The attempt in the 1970s to control inflation by wage and price controls led directly to a "crisis of governability," as trade unions, particularly in Britain, refused to accept them. Large state subsidies to producer groups, both public and private, fed the typical corruptions of behaviour identified by the new right: rent-seeking, moral hazard, free-riding. Palpable evidence of government failure obliterated memories of market failure. The new generation of economists abandoned Keynes and, with the help of sophisticated mathematics, reinvented the classical economics of the self-correcting market. Battered by the crises of the 1970s, governments caved in to the "inevitability" of free market forces. The swing-back became worldwide with the collapse of communism.

A conspicuous casualty of the swing-back was the Bretton Woods system that succumbed in the 1970s to the refusal of the US to curb its domestic spending. Currencies were set free to float and controls on international capital flows were progressively lifted. This heralded a wholesale change of direction towards free markets and the idea of globalisation. This was, in concept, not unattractive. The idea was that the nation state—which had been responsible for so much organised violence and wasteful spending—was on its way out, to be replaced by the global market. The prospectus was perhaps best set out by the Canadian philosopher, John Ralston Saul, in a 2004 essay in which he proclaimed the collapse of globalisation: "In the future, economics, not politics or arms, would determine the course of human events. Freed markets would quickly establish natural international balances, impervious to the old boom-and-bust cycles. The growth in international trade, as a result of lowering barriers, would unleash an economic-social tide that would raise all ships, whether of our western poor or of the developing world in general. Prosperous markets would turn dictatorships into democracies."

Today we are living through a crisis of conservatism. The financial crisis has brought to a head a growing dissatisfaction with the corruption of money. Neo-conservatism has sought to justify fabulous rewards to a financial plutocracy while median incomes stagnate or even fall; in the name of efficiency it has promoted the off-shoring of millions of jobs, the undermining of national communities, and the rape of nature. Such a system needs to be fabulously successful to command allegiance. Spectacular failure is bound to discredit it.

In a different article entitled "This is a Crisis of Deviant Economics", Skidelsky explore a different theme: how the foundations of economic analysis are flawed when they assume rational agents and develop theories based on an "efficient market hypothesis". He notes that economists tried to "fix" this problem with the notion of asymmetric information:

In 1970, George Akerlof published a famous paper called The Market for Lemons. His main example was a used-car market. The buyer doesn't know whether what is being offered is a good car or a "lemon". His best guess is that it is a car of average quality, for which he will pay only the average price.

Because the owner won't be able to get a good price for a good car, he won't place good cars on the market. So the average quality of used cars offered for sale will go down. The lemons squeeze out the oranges.
Another well-known example concerns insurance. This time it is the buyer who knows more than the seller, since the buyer knows his risk behaviour, physical health and so on.

The insurer faces "adverse selection", because he cannot distinguish between good and bad risks. He, therefore, sets an average premium too high for healthy contributors and too low for unhealthy ones. This will drive out the healthy contributors, saddling the insurer with a portfolio of bad risks -- the quick road to bankruptcy.

But this fails since this branch of economics is still flawed:

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect knowledge about how the different parts of the economy fit together.

They differ only in believing that not everyone possesses it. In Akerlof's example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows well how likely it is to break down, and the buyer does not.

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse; but they are deceiving themselves that they know more than they do.

And his bottom line is that the foundation of economics must be changed to reflect reality:

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behaviour arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today.