Do the economists know how to fix the crisis?

Submitted by martin on 2 December, 2008 - 8:23 Author: Martin Thomas

Economists, and the governments advised by them, are pulling all they can out of the books and research papers in order to tame the current economic crisis. What have they learned, and what are its limits?

This version of the article is longer than the one in the printed paper.
Bail-outs, nationalisations

The most spectacular bit of recent crisis policies, the huge nationalisations and bail-outs of banks and other financial firms, is the least new, and the one owing least to economic theory.

It goes back to the lessons from the collapse of Overend and Gurney's bank, in 1866. The collapse brought much else down with it. Walter Bagehot argued that the Bank of England should avoid further such collapses by acting as "the lender of last resort" - the outfit that could and would extend credit to a failing bank when no-one else would.

The doctrine was put into effect to save Barings Bank in 1890. But it was more a matter of instinctive reflex than of theory. The same sort of thought made the USA, which had previously abolished its central bank, set up a new one (the Federal Reserve) after its crisis of 1907.

The current spate of bail-outs and nationalisations is vastly bigger than the Barings rescue, or for example Richard Nixon's nationalisation of the USA's passenger railways in 1971. But it is the same sort of thing.


Despite the downturn from 1873 to the mid 1890s, the crisis of 1907, and the huge economic dislocations in the years immediately following World War 1, there was no real attempt at a theory of crises in mainstream academic economics until the 1930s. Some economists researched the issue - Wesley Mitchell, Clement Juglar - but it was a sideline with no widely-discussed conclusions for crisis management.

John Maynard Keynes wrote the first attempt at General Theory in 1936. He commented that since the gloomy musings of Thomas Malthus in the early 19th century: "The great puzzle of Effective Demand [i.e. of capitalists not being able to sell their stuff profitably, i.e. of crises] vanished from economic literature... It could only live on furtively, below the surface, in the underworlds of Karl Marx" (and of a couple of crank writers with whom Keynes snottily bracketed Marx).

After Keynes's work, two main palliatives became current. In a crisis, central banks should seek to increase, or at least maintain, the money supply; and governments should spend more on public projects.

Money supply

There had been arguments about how to regulate the issue of notes and coins - relative to the gold reserves which were thought necessary to underpin them - since the early 19th century. In a victory for the more cautious school of thought, a British law of 1844 limited the value of notes and coins that the Bank of England could issue to the equivalent of the gold it held in its vaults plus £14 million. Just three years later the law was suspended as a panic measure to ease economic crisis.

But the notion of limiting crises through the money supply did not become high theory until 1963, when Milton Friedman and Anna Schwartz published their Monetary History of the United States.

According to Friedman, the best way to palliate downturns was for the central bank to have a rigid policy of increasing the money supply at a steady long-term rate. The main cause of the Great Depression was that the Federal Reserve had allowed the money supply to shrink destructively after 1929.

In everyday life people think of the total amount of money in the economy as a fixed pot. If B buys something from A - or A swindles or robs B, or B makes a money gift to A - then A's share of the pot increases, and B decreases; but nothing the ordinary individual can do in everyday life raises or lowers the total size of the pot.

On an economy-wide level, however, the total amount of the economy is an extremely fluid quantity. The government can print more notes. Even with a fixed supply of notes and coins, banks can and do "create" money. If A has £1000 and deposits it in a bank; then the bank lends out 90% of that £1000 to B, who in turn deposits it in another bank, which in turn lends out 90% of it, etc., then the banks have turned £1000 in notes or coin into £10,000 in bank balances.

When a crisis strikes, and lending dries up, then the total amount of money in the economy tends to shrink. That sharpens the general "dash for cash" and tends to push down prices.


Falling prices make crises worse. That happened in the early 1930s, when prices in the USA fell at about 10% a year. It also happened in Japan in the 1990s. When prices are falling, the burden of debt on firms and households becomes ever-heavier, because of the ratio of the debts (at yesteryear's higher prices) to income (at today's lower prices) always increases.

Business investment and consumer spending are depressed: there is always a good argument for postponing any expenditure which can be postponed, because tomorrow it can be done cheaper.

The ideal regime for capitalism is steady, mild inflation. I don't know when this idea became established: as late as the late 1960s, economists were still speaking of price stability as the ideal, though if the bulk of prices are stable then there will always be some product lines in which technology is advancing fast and prices decrease, and thus a mild net deflation.

The main concern behind the big reductions in official interest rates and the vast flow of government loans and credit-guarantees to banks is to keep up the supply of money and avoid deflation.

Counter-cyclical public spending

Official interest rates cannot, however, fall below zero. (They have been zero for long periods in Japan recently). Even if the official interest rate (at which the central bank lends to commercial banks) is very low, commercial interest rates may stay high. (That is happening now). In sharp crises, pumping up the money supply may not work. The government needs to get to grips with the snowballing chain of cancelled investment projects, company bankruptcies, and so on more directly.

It can do that, up to a point, by direct pay-outs to households - tax rebates, unemployment benefits, and so on. But in a severe crisis, that may not work either - the pay-outs are just soaked up by accumulated debt. The government should also create "effective demand" quite directly, by public investment projects.

Until the 1930s governments recoiled from such ideas, thinking that crises, when money was "short", demanded government spending cutbacks rather than expansion.

But as Keynes wrote: "If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.

"It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing".

Keynesian and monetarist

The supposed "return of Keynesianism" in this crisis is nothing to be surprised about. Actually it was only the blandest forms of neo-Keynesianism that ever "went away".

As Samuel Brittan notes, the arch-monetarist "Milton Friedman always spoke of Keynes with respect. Indeed he remarked that whenever he reread The General Theory his opinion of the author rose".

The Reagan administration in the USA in the 1980s ran vast budget deficits, of the sort that would have been rejected with horror by pre-Keynesian orthodox economists.

Nevertheless, there is dispute. More "Keynesian" economists tend to emphasise the effectiveness of direct public spending ("fiscal policy") and the limits of monetary policy; more "monetarist" economists push the effectiveness of monetary policy and stress the limits of direct public spending. The argument has a left/right political dimension, since it makes "Keynesians" more favourable to government welfare spending. But both sides make telling points about the limits of the other.

The "Keynesians" cite the limits of monetary policy already mentioned above. They also cite "Goodhart's Law" (named after Charles Goodhart, who formulated it in 1975), which in this context means that once the government resolves to control a measure of money supply (there are many, and very widely varying), it ceases to be the economically relevant one. A slump can shrink the economically-relevant measure of money supply even when the government is boosting another measure.

The "monetarists" allege the impossibility of selecting public-spending boosts with sufficient accuracy to counter crises. By the time the public construction projects supposed to palliate the crisis are well under way, the economy is turning up anyway, so the intervention designed to counter the boom-slump cycle actually worsens it. Or if not, the public investment may just "crowd out" private investment. (If public investment comes to dominate permanently, then - so it has been plausibly argued - a stop-go cycle will reappear in the form of a constant drift to inflation of investment credits acquired by particular public enterprises, followed by an emergency credit freeze, followed in turn by a new inflationary drift...)

International trade

Another counter-crisis measure came out of the recent G20 summit, but in the form of a decision not to do something, rather than a positive action. It was a pledge by the governments not to increase tariffs and trade restrictions, at least over the next 12 months.

The idea in theory that free trade is generally best goes back to David Ricardo in the early 19th century. All economists would agree on the destructiveness of a cycle in which each government successively erects barriers or adjusts exchange rates to save its international financial position, thus making things more difficult for the next government.

In the 1930s governments could see no choice but to do that. After World War 2 Keynes proposed the setting-up of an international "lender of last resort" which would enable governments to escape that cycle.

The IMF as actually established was a much-reduced version of his idea. In fact, for most of the 60 years since then, the US government, and then the governments running big trade surpluses with the USA, have de facto acted as a sort of "lender of last resort" by pumping billions of dollars out into the world.

The limits

In volume 3 of Capital Marx discussed the folly of Britain's 1844 law on money supply, and how the suspension of that law eased the crisis of 1847-8. Marxist theory recognises that bad bourgeois policy can worsen crises, and deft bourgeois policy ease them. What are the limits?

Some of them are discussed above. There are others. All the economists' lessons from crises are lessons from the crises of yesteryear. In the meantime capitalism, always dynamic, has changed.

Is an international "lender of last resort" possible now? It would need creditworthiness higher than that of any state. But all the money in the world now is pure "fiat money", deriving its worth only from the guarantee of this or that state. The system has grown beyond the point where gold can underpin an ultimate fallback source of credit.

And all the existing techniques for avoiding or limiting an implosion of credit were theorised before the enormous expansion in recent decades of "derivatives" (financial bits of paper which "derive" their value from yet other bits of paper), so enormous that the latest figure for the total value of derivatives outstanding is $600 trillion - $100,000 for every child, woman, and man in the world.

Can capitalist techniques for limiting implosions of credit ever catch up with the constantly-proliferating capitalist boom-time techniques for the expansion of credit?

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