The Dangerous Delusions of Mainstream Capitalism

The economics profession is in a state of confusion unparalleled in the history of the social sciences.  The devastating stock market crash in 2008 had not been anticipated. In its aftermath, The Economist  [1] opined: 

[T]there is a clear case for reinvention, especially in macroeconomics. Just as the Depression spawned Keynesianism, and the 1970s stagflation fueled a backlash, creative destruction is already under way. * * * Paul Krugman, winner of the Nobel prize in economics in 2008, [has recently] argued that much of the past 30 years of macroeconomics was “spectacularly useless at best, and positively harmful at worst.” Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”

Recently, The Economist [2] underscored the field’s lack of progress over the last eight years:

Almost eight years have elapsed since the financial crisis took hold in August 2007 and still the same issues are being fought over. Who should suffer the most pain – creditors or debtors? Is the best way to achieve growth short-term fiscal stimulus or long-term structural reform? And, in Europe in particular, how does one reconcile democracy with international obligations?

Debt is a claim on future wealth: lenders expect to be paid back. The stock of debt accordingly tends to expand at moments of economic optimism. Borrowers hope that their incomes are set to rise, or that the assets they are buying with borrowed money will increase in price; lenders share that enthusiasm.

But if wealth does not rise sufficiently to justify the optimism, lenders will be disappointed. Debtors will default. This causes creditors to cut back on further lending, creating a liquidity problem even for solvent borrowers. Governments then step in, as they did in 2008 and 2009.

The best way of coping with too much debt is to spur growth. But developed countries, even America, have struggled to reproduce their pre-crisis growth rates. So the choice has come down to three options: inflate, default or stagnate.

The issue was, and remains, growth. How is it caused and controlled? Those questions cannot be answered by mainstream supply-side economics. The failure to understand growth, frankly admitted by some leading mainstream economists (including notably Paul Krugman and John Bates Clark Prize winner Raj Chetty) is, as Krugman once put it, the economics profession’s “dirty little secret.”  The lack of understanding is palpable: The Economist’s short list of options is incomplete: A fourth option — indeed the only remaining option — is to “equilibrate,” i.e., reduce the inequality of wealth and incomes. This argument, as yet, has occurred to very few professional economists, and it gets no attention at all in mainstream economic reports and debates .

Why the theoretical disarray? The “science” of economics made an abrupt about-face in the late 19th Century, when it  began to concentrate on the development of a new ideology. The new movement was called “neoclassical economics” and the movement has taken over mainstream economics in America and the world since the late 1950s. The excellent explanation of this phenomenon advanced by the prominent Georgist economist Mason Gaffney [3] begins with this:  

Neoclassical economics is the idiom of most economic discourse today. It is the paradigm that bends the twigs of young minds. Then it confines the florescence of older ones, like chicken-wire shaping a topiary. It took form about a hundred years ago, when Henry George and his reform proposals were a clear and present political danger and challenge to the landed and intellectual establishments of the world. Few people realize to what a degree the founders of Neoclassical economics changed the discipline for the express purpose of deflecting George, discomfiting his followers, and frustrating future students seeking to follow his arguments. The stratagem was semantic: to destroy the very words in which he expressed himself. Simon Patten expounded it succinctly. “Nothing pleases a … single taxer better than … to use the well-known economic theories … [therefore] economic doctrine must be recast” (Patten 1908; Collier, 1979).

George believed economists were recasting the discipline to refute him. He states so, in his last book, The Science of Political Economy. George’s self-importance was immodest, it is true. * * * George’s view may even strike some as paranoid. That was this writer’s first impression, many years ago. I have changed my view, however, after learning more about the period, the literature, and later events.

When I began my in-depth study of “The Economics of Inequality” a few years ago, I started with the work of John Maynard Keynes, the famous British economist who endeavored during the 1930s to explain recessions and depressions —  i.e., constraints on growth. I soon discovered from reviewing his General Theory of Employment, Interest, and Money that he, too, was critical of the neoclassical school, though that was a title not as yet given to it, and his General Theory was designed to refute its basic tenets. His primary target was the ideology of Alfred Marshall, a late 19th Century British economist. As Gaffney noted:

Major texts by Marshall, Seligman, and Richard T. Ely, written in the 1890s, went through many re-printings each over a period of 40 years with few if any changes. Not until 1936 was there another major “revolution.”  

That, of course was the “Keynesian revolution.” As Gaffney observes, there was an intense interest among American neoclassicists in discrediting Henry George, for he had identified the concentration of income and wealth as the source of inequality in his famous book Progress and Poverty (1878). Modern neoclassicism has also targeted the work of Keynes and Karl Marx; but Keynes had not dealt directly with inequality, and Marx was easier to discredit because of his association with communism.

Keynes is remembered mainly for his advice on how government could stimulate flagging economies: (1) monetary policy, to encourage borrowing with low interest rates, and (2) fiscal policy, government borrowing (deficit spending) to stimulate flagging economies with increased spending. The meat and potatoes of his General Theory has been all but forgotten: He established that growth depends on demand, not the mere availability of supply, and when aggregate demand is weakened, an economy declines. In today’s parlance, the capitalists are not the job creators: they react to the expectation of future profits, and that expectation lies behind investment decisions. It was the dynamic culmination of “classical” economics which, from Adam Smith on down, had been concerned with optimizing social welfare, and Keynes saw that goal as being fulfilled when an economy is at full employment. And Keynes presumed that progressive taxation would be employed to control the distribution of income and wealth. 

This all made good sense, but “neoclassical” economics had a different agenda. It was built upon “micro-economic” ideas designed to maximize individual success, and profits. Starting with Marshall’s fantasy about automatic growth and adjustment to full-employment equilibrium, neoclassicism went much further: The aggregation of individual actions designed to optimize personal success, said Paul Samuelson, optimizes society’s welfare as well. An entire system of ideology, starting from the allegation that “the invisible hand of Adam Smith” ensures perfect efficiency and resource allocation and running through Arthur Okun’s alleged trade-off between efficiency and equality, was created and proselytized. When I checked, the only support Okun cited for his argument was — the “invisible hand” of Adam Smith! Of course, Smith never meant the expression to be interpreted that way, and the term “neoclassical” is a misnomer: Classical and neoclassical economic ideas are opposed in both intent and result.  

Abandoning the demand-side paradigm made it impossible for mainstream economics to understand growth. The missing piece, which Keynes was on the verge of merging into his dynamic demand-side economics, was the distribution of income and wealth. Karl Marx and Henry George had been correct that the accumulation of wealth and concentration of income creates inequality and decline, though they both lacked a dynamic model to explain exactly how. Regardless, mainstream economics had buried their ideas so deeply in neoclassical ideology that when the current U.S. inequality cycle began in the 1980s with the Reagan revolution, no one had any suspicion that the growing income and wealth inequality had any macroeconomic significance at all!

in 2014 and 2015, the economics profession is beginning, like a fairy-tale princess, to awaken to the truth. And the truth is harsh. [4] The concentration of income and wealth at the top — a gradual process — automatically reduces economic growth; and it is caused by the lack of a sufficiently progressive system of taxation.

Everyone conveniently forgot about one piece of axiomatically correct theory that emerged from the late 19th Century — Irving Fischer’s “Quantity Theory of Money” (QTM): The problem supply-side theory keeps running into is that in a depressed economy, when growth is being continuously reduced, the money needed even to regain previously expected levels of effective demand is simply not in circulation. The QTM recognizes that income is a product of the money supply times the velocity of money, over a given time period (typically we think of GDP, or income in one year). When most of all new income growth is going high within the top 1% (even the top 0.1%) The velocity of money necessarily slows.

This is irrefutable. All of Milton Friedman’s theorizing about the causes of and remedies for the Great Depression were erroneous, because he presumed a constant velocity of money. That was a huge error, and it provided all the necessary support for the very wrong supply-side ideas that now control public policy — the austerity doctrine, and the trickle-down myth.

This brings us back to the recent musings of the Economist. Try rereading the latest piece on “The Debt Trap” with this distributional perspective in mind: Yes, there is a debt trap. Money, by the way, is debt in a modern economy. It is created and destroyed by the banking system when it makes loans and writes them off. When the amount of outstanding debt gets too large, bubbles form and, as happened in the Crash of 2008, they burst. Upon a crash, the artificially inflated value of assets collapses back down to a closer reflection of their real, tangible value. 

More debt bubbles are inflating as we speak. This is happening in the United States, with a gradually accruing and increasingly devastating level of damage, mainly because of the perpetuation of tax reductions granted on top incomes over the years, and also because of a lack of progressiveness elsewhere in the taxation system (sales and use taxes, property taxes, etc.)

Now the U.S. is threatened with a serious federal budget crisis which, as I have discussed in earlier posts, is not recognized for what it is by the Congressional Budget Office, which is still subject to wrongful neoclassical idealism. But CBO can certainly do arithmetic, and it expects interest on publicly held federal debt to rise exponentially and astronomically. CBO projects that within the next six years it will overcome the entire national defense budget.

The Economist reminds us that “debt is a claim on future wealth: lenders expect to be paid back.” But lenders to our federal government do not expect to be paid back. Ever. Even CBO is constrained to point out that, in these circumstances, this pace of debt growth is not “sustainable.” 

American capitalism is far more unstable, in our current environment and under current institutional circumstances, than almost anyone imagined possible. That is because for forty years the United States has pursued an idiotic fiscal policy. I keep asking: How much time do we have left?                   

JMH — 10/8/2015  


[1] “What went wrong with economics,” The Economist, July 16, 2009 (here).

[2] “The Debt Trap,” The Economists, July 11, 2015, p. 64. Buttonwood (here).

[3] Mason Gaffney, The Corruption of Economics, “Introduction: The Power of Neo-classical Economics,” 1976 (here).

[4] J. Michael Harrison, “The Economics of Inequality,” The Torch Magazine, (here).




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