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The Non-Existent Hand

Joseph Stiglitz
Keynes: The Return of the Master by Robert Skidelsky
Allen Lane, 213 pp, 20.00, September 2009, ISBN 978 1 84614 258 1
It has become a commonplace to say, in the aftermath of the Great Recession, that we are all
Keynesians now. If this is so, then Keyness great biographer, Robert Skidelsky, should have
much to say about the recession, its causes and the appropriate cures. And so indeed he does.
I share with Skidelsky the view that, while most of the blame for the crisis should reside with
those in the financial markets, who did such a poor job both in allocating capital and in
managing risk (their key responsibilities), a considerable portion of it lies with the economics
profession. The notion economists pushed that markets are efficient and self-adjusting
gave comfort to regulators like Alan Greenspan, who didnt believe in regulation in the first
place. They provided support for the movement which stripped away the regulations that had
provided the basis of financial stability in the decades after the Great Depression; and they
gave justification to those, like Larry Summers and Robert Rubin, Treasury secretaries under
Clinton, who opposed doing anything about derivatives, even after the dangers had been
exposed in the Long-Term Capital Management crisis of 1998.
We should be clear about this: economic theory never provided much support for these free-
market views. Theories of imperfect and asymmetric information in markets had undermined
every one of the efficient market doctrines, even before they became fashionable in the
Reagan-Thatcher era. Bruce Greenwald and I had explained that Adam Smiths hand was not
in fact invisible: it wasnt there. Sanford Grossman and I had explained that if markets were
as efficient in transmitting information as the free marketeers claimed, no one would have
any incentive to gather and process it. Free marketeers, and the special interests that
benefited from their doctrines, paid little attention to these inconvenient truths.
While economists who criticised the ruling free-market paradigm often still employed, as a
matter of convenience, simple models of rational expectations (that is, they assumed that
individuals rationally used all the information that they had available), they departed from
the ruling paradigm in assuming that different individuals had access to different
information. Their aim was to show that the standard paradigm was no longer valid when
there was even this seemingly small and obviously reasonable change in assumptions. They
showed, for instance, that unfettered markets were not efficient, and could be characterised
by persistent unemployment. But if the economy behaves so poorly when such small realistic
changes are made to the paradigm, what could we expect if we added further elements of
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realism, such as bouts of irrational optimism and pessimism, the panics and manias that
break out repeatedly in markets all over the world?
Of course, one didnt have to rely on theoretical niceties in order to criticise the faith in
unfettered markets. Economic and financial crises have been a regular feature of capitalist
economies; only the period of strong financial regulation after the Second World War was
almost totally free of them. As financial market regulations were stripped away, crises became
more common: we have had more than 100 in the last 30 years.
The present crisis should lay to rest any belief in rational markets. The irrationalities evident
in mortgage markets, in securitisation, in derivatives and in banking are mind-boggling; our
supposed financial wizards have exhibited behaviour which, to use the vernacular, seemed
stupid even at the time. If we are to design policies to prevent crises or to deal with them
when they occur, it is essential to understand the critical flaws in the standard paradigm. It is
here that Skidelsky goes astray.
Skidelsky makes much of the distinction between risk and uncertainty. Risk refers to
situations in which we have good statistical data so that we can talk meaningfully about the
probability that a particular event will happen, like the probability of a 70-year-old man dying
within the next year. Uncertainty refers to situations in which we have no statistical basis to
go on. Clearly, the investment banks and rating agencies relied too heavily on flawed
statistical models, as did the regulators. Those models gave them confidence that the risk of a
serious problem was negligible, something that might happen once in a million years.
But much of the behaviour that led to the crisis (the irrational and sometimes predatory
lending, the excesses of leverage and other forms of risk-taking) did not depend on this
distinction. More important, for instance, were the incentives, which encouraged banks to
take on too much risk, and induced them not to think too deeply about the flaws in their
statistical models. Flawed incentives, inadequate regulation and a lack of scruples also help
explain the abusive lending practices that played so large a role in the crisis.
In accounting for the crisis, we have to explain both the bubble and why, after the bubble
burst, the economy went into a deep recession. We also have to explain the massively
inefficent capital allocation, the high level of volatility and the persistence of unemployment.
The distinction between risk and uncertainty, unfortunately, gives us little insight into the
failures in the labour market: why the usual laws of supply and demand, which should result
in full employment, have failed to work.
It should be clear that the failure of financial markets is at the centre of this crisis, but as
Skidelsky points out, Keynes himself had little to say about financial markets and their
management and regulation. One of the criticisms of the General Theory is its simplistic
treatment of capital markets (some progress has been made in rectifying this over the last 75
years). Accordingly, it might be thought that Keyness views were of only limited relevance in
this crisis, beyond his general scepticism as to the ability of markets to correct themselves.
That view of Keynes is wrong, however, because this is an economic as well as a financial
crisis: there is an insufficiency of global aggregate demand. Explaining why this is so is more
difficult than Skidelsky seems to suggest. It is not just a matter of the intrinsic uncertainty of
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the future. Standard economic theory the theory of demand and supply that is taught in
classrooms around the world says that if prices (including the price of labour, or wages, and
the price of capital, or the interest rate) are fully flexible and markets function as they should,
then even with such uncertainty there should be full employment. Wages or interest rates
might not be the same as they would be in the absence of uncertainty, but markets would still
ensure full employment.
Markets in capitalist systems dont work that way, though, and the question is why? Skidelsky
does not offer much insight here, not even as to what Keynes might have said about it. Those
who today see themselves as following in the tradition of Keynes especially in subscribing to
his view that government action is needed to help maintain full employment are referred to
as new Keynesians. One strand of (new) Keynesianism argues that unemployment persists
because wages and prices are rigid. It isnt hard to understand why many economists were
attracted to this theory. In the standard demand and supply model, if there is an excess
supply of labour (i.e. unemployment), the reason must be that (real) wages are too high. This
theory may not only misinterpret Keynes, but may also be potentially dangerous, because of
its obvious policy implications. If unemployment is caused by real wages being too high, the
obvious remedy is to lower wages. Hence the standard call of conservative economists for
more labour market flexibility, ensuring that the wages of workers which have stagnated in
the US for a quarter of a century will drop even further. But traditional Keynesian
economics argues that what matters is aggregate demand, and that lower wages reduce
aggregate demand. The current crisis demonstrates what can happen: countries with stronger
systems of social protection and less labour market flexibility have, in many ways, fared
better.
Skidelskys discussion of the various explanations that economists have come up with, both
for wage and price rigidity and as to why the economy does not quickly adjust to
equilibrium, is too unquestioning, too undiscriminating. There is, for instance, a silly theory
that says prices are rigid because of the costs of changing price lists (the cost of printing new
menus in restaurants would be an example); but these costs pale in comparison to those of
hiring and firing workers or increasing or decreasing production. Other theories that have
become more widely accepted since Keyness death are given scant attention by Skidelsky.
Efficiency wage theory, which argues that wages affect productivity, so that it doesnt benefit
firms to pay low wages, isnt even mentioned.
There is an alternative view (also labelled new Keynesian) as to why an economy can be
trapped for so long in a state of under-utilising resources: the debt-deflation theory originally
formulated by an American contemporary of Keynes, Irving Fisher, and more recently
developed by Greenwald and me. It perceives the key market failures to be not just in the
labour market, but also in financial markets. Because contracts are not appropriately indexed
(that is to say, payments arent adjusted to changing economic conditions), alterations in
economic circumstances can cause a rash of bankruptcies, and fear of bankruptcy contributes
to the freezing of credit markets. The resulting economic disruption affects both aggregate
demand and aggregate supply, and its not easy to recover from this one reason that my
prognosis for the economy in the short term is so gloomy.
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Keynes focused, as Ive said, on the problems posed by an insufficiency of aggregate demand:
what happens when people want to buy less than the economy is able to produce. Even 75
years ago, he saw the issue from a global perspective. He was concerned, for instance, about
the impact of the surplus countries those that produced more than they consumed on
global demand. Today, we talk about global imbalances. The soaring imbalances of the last
ten years are partly due to what happened during the East Asia crisis of 1997-98. Countries
without adequate reserves lost their economic sovereignty as the US Treasury and IMF came
to their rescue (or, more accurately, came to the rescue of their own banks the same banks
that have caused such devastation to our own economies). They foisted contractionary
monetary and fiscal policies higher interest rates, cutbacks on expenditure on these
countries, the opposite of the policies the US adopted in the current crisis. Not surprisingly,
these contractionary policies led to recessions and depressions. To reduce the likelihood of
having to turn again to the IMF and the West, developing countries around the world
accumulated massive reserves. But while these precautionary savings may have provided
them with some security, money saved is money not spent: it contributed to a lack of
aggregate demand. Other factors also contributed to the build-up of reserves. Low exchange
rates can help promote exports. Oil exporters knew there was a significant risk that prices
would not remain at the high level they had reached, and the prudent choice was to save a
great deal of the money that they were earning. Finally, aggregate demand was almost
certainly lowered by the huge increase in inequality, which in effect redistributed money from
those who would spend it to those who didnt, or at least didnt spend as much.
These factors help explain high savings ratios. But the problem of insufficiency of demand is
really a matter of the balance between savings and investment. The problem is sometimes
described as a savings glut, but could equally well be described as an investment dearth.
Why did it seem that even with record low interest rates, the only investment that could be
generated was in housing for poor Americans for which they couldnt afford to pay? A long
tradition in economics, of which Keynes was a part, has focused on the diminution of
investment opportunities. The path-breaking work of Schumpeter, another of Keyness
contemporaries, emphasised the role of innovation. The world is currently faced with serious
challenges that also present investment opportunities: retrofitting the world economy to face
the challenges of global warming, or making the investment necessary to reduce global
poverty. There is no shortage of opportunities for investments with high social returns. Here,
there have been both market failures and policy failures: a failure, for instance, of
governments to make carbon emissions sufficiently costly for there to be an incentive to
invest in reducing them, or of financial markets to devise better instruments for transferring
risk from those in less developed countries to those in more advanced ones, who can better
absorb it.
The central policy message of Keynesian economics is that in a deep recession, monetary
policy is likely to be ineffective, and fiscal stimulation is required. This, the argument goes, is
because monetary authorities find it increasingly difficult to lower real interest rates (even if
nominal interest rates go to zero, deflation can mean that there is a positive real interest
rate); and even at low interest rates, investment may not be much stimulated. Its like
pushing on a string. When interest rates were lowered after the technology bubble burst, the
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effect was mostly foolish real estate investment. But, since Keynes, our understanding of the
limitations of monetary policy has increased. For instance, even if central banks succeed in
getting treasury bill rates close to zero, the interest rates at which banks lend can remain
high; and it is now recognised that availability of credit matters as much as interest rates,
especially for small and medium-sized businesses that depend on the ability and willingness
of banks to lend. This is one of the reasons there is so much focus on the recapitalisation of
banks, and one of the reasons the Bush/Obama policy of giving money to the banks but
allowing them to pay it out in dividends and bonuses did not rekindle lending as promised.
Today, few look to monetary policy to reignite the economy. The achievement of our central
banks has been a more modest one: having brought the global economy to the brink of
disaster, they succeeded in avoiding a complete collapse by throwing enough money at the
financial system.
Fiscal policy worked, not in preventing a Great Recession, but in preventing the Great
Recession from turning into another Great Depression. But now the very actions that saved
the economies of the world have presented a new problem for fiscal policy, as questions are
being raised about governments ability to finance their deficits. There are speculative attacks
against the weakest countries, which find themselves caught between a rock and a hard place.
They worry that deficits will lead to higher interest rates, not because (as is usually argued)
public spending will crowd out private spending, but because of growing risk premiums. But
the effect is much the same: more government spending will force cutbacks in private
spending, with the obvious adverse effects on the economy. The financial markets that caused
the crisis which in turn caused the deficits went silent as money was being spent on the
bail-out; but now they are telling governments they have to cut public spending. Wages are to
be cut, even if bank bonuses are to be kept. The Hooverites the advocates of the pre-
Keynesian policies according to which downturns were met with austerity are having their
revenge. In many quarters, the Keynesians, having enjoyed their moment of glory just a year
ago, seem to be in retreat.
If markets were rational, there would be an easy policy response. Spending on investments
that yielded even moderate real returns (say, of 5 to 6 per cent) would lower long-term debt
levels; such spending increases output in the short run, thus garnering more tax revenue, and
the future returns generate still more tax revenue. If markets could be convinced, for
example, that European governments can and will meet their debt obligations, interest rates
would fall, and even the countries with the highest levels of debt would find it easy to meet
their obligations. But markets are not necessarily rational, and even when they are, they are
not always well intentioned. The objective of a speculative attack is to generate profits for the
speculators, regardless of the cost to the rest of society. They can make money by inducing
panic and then feel pleased with their insight: their concerns were justified, but only because
of the responses to which their actions gave rise.
Since the time of Keynes, the ability of markets to mount such speculative attacks has
increased enormously. But governments are not powerless to tame them, and in some cases
can counter-attack, as Hong Kong did in foiling Wall Streets famous Hong Kong double
play, when speculators simultaneously sold short both the currency and the stock market.
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The speculators knew that governments traditionally respond to a currency attack by raising
interest rates, which lowers stock prices. If Hong Kong failed to raise interest rates, they
would make money by shorting the currency. If Hong Kong did raise them to save its
currency, the speculators would make money by shorting the stock market. Hong Kong
outsmarted them by simultaneously raising interest rates and supporting the stock market by
buying shares. Taxes on short-term capital gains, regulations on the ever more powerful
speculative instruments (like credit default swaps), and especially for developing countries
the imposition of barriers on the uncontrolled movement of short-term capital across
borders, can reduce the scope for and returns from this kind of behaviour.
Keynes created modern macroeconomics; and as Ive indicated, he gave short shrift to the
financial markets. We can, accordingly, only conjecture what he might have thought about
one of the critical issues of our day: how to regulate the financial sector in ways that will make
a recurrence of the present crisis less likely and increase the likelihood that the financial
sector will do what it is supposed to do: manage risk, allocate capital, run the payments
mechanism, and all at a low cost. Here, the views of Skidelsky (immersed as he is in Keynes,
the macroeconomist) are less than convincing and far from complete. He is, for example,
sceptical of regulations that attempt to prevent excessive lending in booms (the so-called
macro-prudential regulatory framework).
Towards the end of his book, Skidelsky writes that his chief argument has been that
underlying the escalating succession of financial crises we have recently experienced is the
failure of economics to take uncertainty seriously. In the end, he fails to make this case.
Overconfidence in the flawed mathematical models used by rating agencies and investment
banks did account for many of the horrendous mistakes of this particular crisis, especially in
the United States. But these models played little role in the multitude of other bubbles,
booms and crashes that have marked the past quarter-century. Western banks have
repeatedly had to be bailed out because of their bad lending decisions.
We cant pass laws that ensure that people wont suffer from irrational optimism or
pessimism. We cant even be sure that banks will make good lending decisions. What we can
do, however, is ensure that those who make mistakes bear more of the consequences of their
decisions and that others bear less. We can ensure that those entrusted with the care of
other peoples money do not use that money for gambling. This is true whether those
decisions are based on flawed models of risk or irrational perceptions of uncertainty.
Taxpayers, workers, retirees and homeowners all over the world suffered because of the
mistakes of Americas financial markets. That is unacceptable, and it is avoidable.
Keyness great contribution was to save capitalism from the capitalists: if they had had their
way, they would have imposed policies that weakened the economy and undermined political
support for capitalism. The regulations and reform adopted in the aftermath of the Great
Depression worked. Capitalism took on a more human face, and market economies became
more stable. But these lessons were forgotten. Thatcher and Reagan ushered in a new era of
deregulation, growing inequality and weakening social protection. We are now seeing the
consequences, and not just in greater instability. Keyness insights are needed now if were to
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save capitalism once again from the capitalists.
Vol. 32 No. 8 22 April 2010 Joseph Stiglitz The Non-Existent Hand (print version)
pages 17-18 | 3444 words
Letters
Vol. 32 No. 10 27 May 2010
From Paul Davidson
Joseph Stiglitz criticises Robert Skidelsky, Keyness biographer, for not understanding
Keyness theory, but in doing so reveals his own imperfect understanding (LRB, 22
April). The basis of his complaint is Skidelskys distinction between risk and
uncertainty. Risk, Skidelsky explains, exists when the future can be predicted on the
basis of currently existing information (e.g. probability distributions calculated from
existing market data); uncertainty exists when no reliable information exists today
about the future outcomes of current decisions, because the economic future can be
created by decisions taken today. According to Stiglitz, this is a distinction without a
difference, and little insight into the causes of the Great Recession is gained from
Skidelskys emphasis on uncertainty as opposed to risk.
But this is not what Keynes believed. The classical economics of Keyness time
presumed that todays economic decision-makers have reliable information regarding
all future outcomes. I have labelled this the ergodic axiom. By contrast, Keynes argued
that unfortunate collisions occurred because the economic future was very uncertain.
By very uncertain, he wrote, I do not mean the same thing as very improbable. No
reliable information existed today for providing a reliable forecast of future outcomes.
This is the very proposition that Stiglitz denies. All that is needed to provide better
insight into the workings of the market, he thinks, is small and obviously reasonable
change in assumptions; for example, that reliable information about the future does
exist but that different individuals have access to different information. The only
necessary policy is transparency: to make complete information about the future
available to all. The classical ergodic axiom is correct, provided one accepts that not
everyone has access to all the information that exists.
For Keynes the inability of firms and households to know the economic future is
essential to understanding why financial crashes occur in an economy that uses money
and money contracts to organise transactions. Firms and households use money
contracts to gain some control over their cash inflows and outflows as they venture into
the uncertain future. Liquidity in such an economy implies the ability to meet all money
contractual obligations when they fall due. The role of financial markets is to assure
holders of financial assets that are traded on orderly markets that they can readily
convert these liquid assets into cash whenever additional funds are needed to meet a
contractual cash outflow commitment. In Keyness analysis, the sudden drying up of
liquidity in financial markets, occasioned by sudden drops of confidence, explains why
unfortunate collisions occur and have occurred more than a hundred times in the
last 30 years, according to Stiglitz.
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By contrast, Stiglitz implicitly accepts the orthodox view that all contracts are made in
real terms, as if the economy were a barter economy. Consequently peoples need for
liquidity is irrelevant. Stiglitz indicates that he and Bruce Greenwald have explained
that financial markets fail because contracts are not appropriately indexed, i.e.,
contracts in our economy are denominated in money terms rather than real terms. He
suggests that if only such contracts were made in real, rather than monetary, terms we
would not suffer the unfortunate collisions of economic crisis. If only we lived in a
classical world, where contracts would be denominated in real terms! But in a money-
using economy, this is impossible.
Paul Davidson
Journal of Post Keynesian Economics, New York
ISSN 0260-9592 Copyright LRB Ltd., 1997-2010 ^ Top
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