Economists were indeed set back on their heels by the financial crisis of 2008 and by the depth of the recession and the levels of unemployment that followed. Though not well implemented, the aggressive financial rescue efforts of the government in 2008 nevertheless kept matters from getting far worse that year. Were it not for the social programs started in the New Deal of the 1930s and expanded in the 1960s, including Social Security, unemployment insurance, and Medicare, and those adopted later, including the earned income tax credit and food stamps—the great embrace of government, not its denigration—the nation would likely have entered a full-fledged depression by 2009. For all the criticism, President Obama’s roughly $800 billion stimulus package of government spending and tax cuts was also a vital contributor to a softer landing for the economy in 2009. Non-laissez-faire economics saved the day.
One of the more reasonable of the orthodox economists, Olivier Blanchard wrote with colleagues “Rethinking Macroeconomic Policy,” a short mea culpa published two years after he had proclaimed macroeconomics to be in such good shape. Although he supported temporary government stimulus to enable economies to recover, he had hardly changed his central views. “It is important to start by stating the obvious,” he asserted, “namely, that the baby should not be thrown out with the bathwater. Most of the elements of the precrisis consensus, including the major conclusions from macro-economic theory, still hold.”
The key assumption of the new laissez-faire consensus was that it is the natural order of things that economies rise from recession almost automatically. In recessions, prices rise slowly or fall; likewise, wages stagnate or fall, and interest rates slide downward, setting the stage for more buying by consumers, more hiring by businesses, and more capital investment. It’s an intoxicating idea. Economies rarely get too far out of balance, goes the thinking— they are far more likely to be stable than not at any given moment. Such economies require only modest government intervention, mostly to control inflation and relieve suffering as jobs are lost, or maybe just a little push from lower interest rates, but the fewer such government policies the better. Most of the time, government can only do harm. This was the new but deeply incorrect consensus.
In 2001, after the Clinton administration had left office, Lawrence Summers, a Harvard professor and Bill Clinton’s third Treasury secretary, endorsed this new faith in free markets and opposition to government intervention as a victory of new ideas. By contrast, in the 1930s John Maynard Keynes had advocated aggressive government spending—outright budget deficits—to stop recessions and support vigorous recoveries. “The political debates take place within a universe that is shaped by the development of new ideas,” Summers told an interviewer, attributing the change to good, fresh thinking, not merely the return of an old laissez-faire ideology in a more politically conservative time. “Of those new ideas, none is more important than the rediscovery of Adam Smith and the idea that a decentralized system relying on price signals collects information and provides much more insurance than any kind of centrally planned or directed type of system.” Summers, a onetime Keynesian, had for the moment changed his tune, and in this he represented economists generally.
Economists basically discarded Keynesian policy and relied on a narrow version of monetary policy: the manipulation of interest rates by the Federal Reserve, the nation’s central banking system. “We thought of monetary policy as having one target, inflation, and one instrument, the policy rate,” conceded Blanchard. “So long as inflation was stable, the output gap [the difference between potential and actual GDP] was likely to be small and stable and monetary policy did its job.” He noted that “old-style Keynesian stimulus,” by which he meant more government spending, was now “secondary.”
During this period, Clinton, the first Democratic president since 1981, chose to act on the advice of Summers and Robert Rubin, his second Treasury secretary and a former head of Goldman Sachs, and pay down the nation’s debt before seriously raising public investment. The federal deficit was widely thought to deter growth, limiting the money available to private businesses to distribute the nation’s savings. In Clinton’s last year in office, the level of federal public investment as a proportion of GDP was lower than in Ronald Reagan’s last year in office, especially for physical infrastructure and education spending. It was also substantially lower for research and development. The policy was part and parcel of the laissez-faire revolution.
Had economists been fully dedicated to their free-market views, they would also have been up in arms over the glaring lack of regulation of the new and deliberately opaque derivatives market on Wall Street. Based on securities that could be bought and traded with little down payment, these derivatives were at the heart of the financial crisis. If someone is selling a good or a security, competitors cannot offer it for less if they do not know the price asked. Yet the Clinton administration, following the new economic thinking, prevented regulators from setting federal standards of openness in this market.
The most damaging of the new financial derivatives were credit default swaps, a technical name for insurance sold by financial firms to protect investors against price declines of securities. The insurance to protect against losses on mortgage securities became especially popular as the housing boom progressed—particularly insurance for securities based on subprime mortgages. Because the prices of these insurance-like derivatives were traded secretly, however, there was not adequate competition to keep prices sensible. Economists should have rallied in opposition to the lack of rules, but I could find no research papers done on the phenomenon until it was too late. Some investors and professional traders bought the insurance at high prices, some sold at low prices. Moreover, there were no legal requirements to hold a reserve to ensure that someone selling insurance could pay off—as is done with traditional life and property insurance. When the value of mortgages collapsed as the housing bubble burst, those who sold such insurance—notably the insurance giant AIG—could not pay off, making the crisis far worse. Investors who thought they were protected against falling mortgage securities were now losing fortunes, forcing them to sell other securities to meet their liabilities. This drove the prices of other securities still lower, and market prices fell further in a vicious spiral.
Economists also said little when they should have proverbially shouted about the obvious conflicts between those who issued securities and the agencies they hired to rate the securities they sold. These agencies, Standard & Poor’s and Moody’s, were inclined to make their clients happy and gave their securities high ratings, even those based on subprime mortgages. Giving unjustifiably high ratings to the securities of clients who were paying for them seems, well, almost inevitable. After the collapse, the agencies sharply, and with at least temporary embarrassment, reduced their ratings for the large majority of securities they had previously given their highest ratings, the value of which had often fallen to zero.
“Get the incentives right” had become a cliché for economic reform, especially in poorer developing nations. But financial incentives were awry on Wall Street. Traders were paid lavishly when they were correct but were not penalized commensurately when they were wrong, thereby incentivizing them to take risks. Much of the profits earned on trading the new derivatives were kept secret from buyers and sellers so that customers could not seek a better deal elsewhere. It was said that the very high compensation of bankers and traders reflected their unusual talents and that high profits for financial institutions meant they were contributing ever more to the nation’s prosperity. Economists were barely disturbed by such implausible nonsense. Meanwhile, by contrast, laws to set higher minimum wages, it was argued by many economists, would only distort labor markets and result in lost jobs.
Wall Street itself exhibited the characteristics of a monopoly. Commissions were fixed at abnormally high levels for most financial transactions, suggesting the lack of true competition. Fees earned by bankers on transactions were always high but did not fall as a percentage of the soaring value of financial assets, which under normal competitive conditions should likely have been the case. Blanchard, looking back, wrote: “We thought of financial regulation as mostly outside the macroeconomic policy framework.” The silence of so many economists when even their most bedrock conservative principles were violated was disturbing. They had spoken up as a group before, sometimes vociferously, about the benefits of free trade, for example. Their current views on laissez-faire economics, including financial deregulation, were now markedly sympathetic to big business and Wall Street.
In the 1980s, 1990s, and 2000s, the prices of stocks, bonds, and housing rose to untenable levels on the watch of free-market economists who preached deregulation. During this period, over-speculation led to serious financial crises at home and abroad as free-market advocates successfully reduced controls on lending and investing around the world. A series of major financial crises affecting America began with a 1982 Mexican financing debacle involving U.S. banks and climaxed with the 2008 crisis. Mexico had borrowed significantly from U.S. banks in the 1970s and early 1980s, the careless banks essentially speculating on the future strength of the Mexican economy with loans to the government and for spurious industrial projects. With no guidelines from government or international institutions, the banks had recycled petrodollars through loans especially to Latin America; a favorite recipient was Mexico. When interest rates were pushed up sharply by Paul Volcker’s Federal Reserve in order to stanch U.S. inflation, interest rates on Mexican debt also rose sharply. At the same time, a resulting worldwide recession undercut Mexico’s oil exports. The nation declared that it could not pay its debts to American banks. The Fed and the International Monetary Fund, a world lending organization, helped bail out the banks.
Ensuing financial crises were variations on this theme. The investors in equity incurred huge losses because of overly optimistic speculative investments that initially earned a lot of money and then went bad, but banks were often bailed out. Economies typically slid into recessions when inflation rose and the prices of these financial assets fell. The 1982 recession in the United States, for example, was the worst since the Great Depression—until the recession of 2008. Despite wide-eyed assertions by well-schooled economists that Americans were now enjoying the Great Moderation, the financial collapses and ensuing recessions had, as noted, cost Americans trillions of dollars in lost wealth and jobs, diminished investment, and failed companies. The U.S. housing crash that began in 2006, along with the accompanying collapse in stock prices, reduced the wealth of Americans by roughly $8 trillion by the time it hit bottom. This crash was also of course the result of overspeculation fueled by borrowing—homebuyers and investors in complex and hard-to-understand mortgage securities kept buying at ever-higher and less sensible prices. While average wealth rose again in the years after the crash, the money essentially went to the wealthy. Banks had been rescued, stock prices came back, and the well-off held the large majority of stocks; housing prices rebounded only partially. The high-technology stock plunge that occurred in the early 2000s resulted in comparable losses for most Americans. Most high-technology stocks did not recover. Many economists insisted such speculation was necessary to encourage risk taking.
Devastation from financial crises was worse overseas. The Mexican crisis led to a widespread recession. Many South American countries also had large debts to U.S. and foreign banks, and the recession resulted in falling demand for their oil, copper, and other exports. The 1980s are generally known as the “lost decade” in South America, with excessive borrowing from eager American banks typically laying the foundation for weakness. On average, GDP across South America did not rise at all in the 1980s. During this period, Mexican wages, for example, fell by 25 to 30 percent. Asian nations, including Thailand, Indonesia, and Korea, suffered severe recessions after a deep financial crisis in 1997 that was stoked by fleeing capital in the new free market in international finance. More than ten million people fell below the poverty line in Malaysia, Korea, Indonesia, Thailand, and the Philippines between 1996 and 1998. Unemployment tripled in Korea and quadrupled in Thailand. There were innumerable corporate bankruptcies.
Many orthodox economists noted that poverty rates had fallen in the developing world. But the claims were misleading. Most of the poverty reduction was in China and, to a lesser extent, India, neither of which followed the free-market policies prescribed by the West.
In Europe, many nations had been struggling with slower growth since the 1990s. The property bubbles of the 2000s brought on by inordinate speculation had become their temporary salvation, only to burst badly, leaving them with piles of government and private debt. European economists urged austerity: higher taxes and cuts in social spending to reduce budget deficits, even at the expense of growth. A majority of Britain’s most influential economists supported the Conservative Party’s embrace of such policies in the face of economic weakness. These were the worst economic policy decisions made since early in the Great Depression. Granted, many American economists opposed such severe austerity in Europe, but these policies were driven by research done at prestigious American universities based on the assumption that economies were self-correcting. As a result of austerity economics, unemployment soared in the weaker economies of Spain, Portugal, Italy, and Greece, and recession overtook the entire Continent and Britain. In late 2013, the GDP of these nations remained below pre-2007 highs.
The free-market economics that had been in vogue were now failing badly. The old remedy advocated by John Maynard Keynes to cure recession—federal spending that would lead to a temporary budget deficit—had been accepted momentarily but was again soon disdained by many. Since the inflationary 1970s, a federal budget deficit was increasingly seen as the culprit, even among Democratic economists, and this view has been hard to shake completely even after the major recession. The thinking was that a deficit often, even usually, created too much demand for goods and services, thus pushing up prices. It created more demand than the wages and profits the economy itself was generating, requiring borrowing to do so. Once slack was taken up, it was believed, a deficit resulted in an overheated economy. Keynesians typically argued with the new free-market orthodoxy over whether full employment had been reached and whether the capacity of the economy was fully utilized. It was said that the debt financing that pushed up interest rates also left less room for businesses to borrow.
To call economists overconfident during the modern laissez-faire experiment understates their hubris. The susceptibility of economists to new fashions in thinking, their opportunistic catering to powerful interests, and their walking in lockstep with the rightward political drift of America are disturbing for a discipline that claims to be a science.
The philosopher Isaiah Berlin categorized writers who have one big idea as hedgehogs. The economist Dani Rodrik of the Institute for Advanced Study, borrowing the term, calls economists hedgehogs if they are overly devoted to a theory of self-adjusting economies and believe that the market can handle almost all products and services efficiently. Milton Friedman and his followers, including many leftist economists, certainly fit this bill. They were hedgehogs who feared government intervention.
Again borrowing from Berlin, Rodrik calls economists who entertain at least some doubts about how economies correct themselves foxes, who know many small things. Economic foxes usually want more regulation than do hedgehogs. They want to invest more in public goods. They want to protect workers more through higher unemployment insurance and other social programs.
Rodrik’s foxes, though, are in fact usually hedgehogs, too. They are indeed a little more willing to resort to government policies. They mostly hold that when markets fail—in the production of social goods, such as education and roads, or in the creation of such so-called externalities as pollution, or in paying workers what they deserve—the government should step into the gap to correct these inadequacies. But this is a fundamentally ambiguous school of thought. “I want to point out a bias built into that theory,” wrote the Columbia economist Richard Nelson. “By the way it is formulated, market failure carries a heavy normative load, to the effect that markets are preferred to other forms of governance unless they are basically flawed in some sense. . . . As one reflects on it, the argument that we need government because markets sometimes ‘fail’ seems rather strange, or at least incomplete. Can’t one make a positive case for government, or families, for that matter, as a form that is appropriate, even needed, in its own right?”
One of the characteristics of laissez-faire that is so alluring to economists is the fact that it is a clean economics, unsullied by muddy details and exceptions. The new laissez-faire period started as an attempt to stabilize the high unemployment and inflation of the 1970s, and in some respects it succeeded. But then the theorists sought universal principles to be applied to almost every situation, scrubbing economics of the particularities of individual episodes and events. Paul Krugman, the New York Times columnist and Nobel laureate, once argued that economists had to deal more with “messy” details, but he was mostly referring to the more extremist conservative economists who wanted to prohibit any government intervention at all. The admonition applies to moderate orthodox economists as well, including those on the left.
Excerpted from "Seven Bad Ideas: How Mainstream Economists Have Damaged America and the World" by Jeff Madrick. First Vintage Books edition August 2015. Published by Vintage Books, a division of Penguin Random House. Copyright © 2014 by Jeff Madrick. Reprinted with permission of the publisher. All rights reserved.