I don't often write for the newspapers; I hope these few contributions make interesting retrospective reading, now that the stock market bubble has become apparent after the event to so many commentators who couldn't see one when it first developed. I'll post a few more in the coming days.
When Wall Street crashed in ‘87, we were assured that it could never happen again. Well, "it" has happened, and it hasn’t stopped yet. By the time the panic is over, 2-3,000 points will have been wiped off Wall Street. And if we survive this crash like we survived that of ‘87, then there’ll be another one a decade or so later. It’s time to accept the fact that the Stock Market is a force for instability in our economy.
This conclusion didn’t faze John Maynard Keynes. In 1937, he warned against handing the management of the economy over to the "whirlpool of speculation" that is Wall Street, saying with masterful English understatement that "When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."
Keynes was also dismissive of those who believe that the Stock Market is driven by the "fundamentals" such as the rate of economic growth.
Instead, Keynes compared the stock market to a newspaper competition "in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences". The prize is won by picking the face that most people think most other people will think is the prettiest.
This, said Keynes, was third degree madness, in which "we devote our intelligences to anticipating what average opinion expects the average opinion to be". So too the Stock Market, in which "the fundamentals" are not profit rates and inflation forecasts, but what you think the other speculators are going to do tomorrow.
The market is thus dominated by waves of sentiment and herd behaviour. After a crash like 1987, a recovery will lead to slowly rising optimism, which in turn causes rising stock prices. However as the price rise goes on, the niggling knowledge that "this can’t go on forever" will rise, until market speculators become extremely sensitive to small disturbances. Then, like anxious sprinters before the starter’s gun, everyone breaks at once to avoid coming last in the race to avoid losses.
If this speculative frenzy was confined to Wall Street, we could simply treat it as a macabre form of entertainment; but unfortunately it is not. The crash will have serious implications for the "real" economy.
America’s recent prosperity has to some extent been based on Wall Street’s bull run, with ordinary upper-middle class Americans "investing" in the market via mutual funds. Those near retirement age are about to find that their nest eggs are nowhere near as large as they thought, and effective demand will fall when the message sinks in.
America’s "fundamentals" are thus not quite as sound as many commentators argue. The Crash will bring the share price to earnings ratio back down towards historic levels, but it will also depress corporate returns, and thus lead to a further drop in share prices. The US’s real economy will thus both follow and lead its the paper economy down.
But the real danger today is not the American economy, but the Japanese. Japan is still depressed by the huge corporate debts accumulated during the "Bubble Economy" of the 1980s. A fall in American consumer spending will push many Japanese corporations one step closer to bankruptcy. We can expect the Japanese Government to support its companies, but the flow-on effects of this for Australian resource exporters and tourism will still be severe.
This prognosis is made worse, not better, by the prevailing low levels of price inflation. Another neglected commentator during the 1930s was Irving Fisher, who argued that the Great Depression was caused by ""over-indebtedness to start with and deflation following soon after". If the Crash leads to falling prices, these increase the real debt burden, leading to Fisher’s Paradox in which "The more the debtors pay, the more they owe".
The one force which can stabilise an economy in this state is government spending, and here we must disagree with the Prime Minister that "Australia would be in a much more vulnerable position if his Government had not taken action to reduce the budget deficit" (ABC Radio 28/10/97). Government deficits enable firms to repay during a slump the debts they accumulated during a boom. The global fetish for zero budget deficits has thus made our economies more vulnerable to downturns, not less.
Governments have managed their economies in accordance with the whims of the finance sector, and still the market crashes. It’s time we started managing the economy for the benefit of all its inhabitants, rather than in a misguided attempt to appease the volatile sentiments of the trading floor.
As so often happens, a few days in October have shaken the heady optimism which spawned such titles as “Dow 40,000” and “Dow 100,000”. Conceived as bold guides to the new Millenia, they risk instead becoming relics to the eternal madness of Stock Markets.
This time, we were told, things were different. The Internet was “a new paradigm”, which would completely revolutionise business. Computers and telecommunications had made stock markets far more efficient than ever before. We were in the Information Age, so that investors’ expectations were grounded in fact rather than supposition. Apparently outrageous price to earnings ratios were justified by the rosy future prospects of electronic commerce.
Similar claims were made for radio in 1929--and it was as revolutionary in its day as the Internet is in ours. But that “new era” came to an unpleasant end, as did earlier “new eras” promised by electricity, railroads, and even tulips. How many more “new eras” will humanity have to experience before we realise that the Market always overestimates the value of a novel product?
The Internet will undoubtedly revolutionise business--but it will not make business significantly more profitable.
All firms need an Internet presence--just as all businesses had to advertise on the radio seventy years ago. That means potential profits for Internet companies, but equally it means costs for other corporations. There is no guarantee that overall profits will rise, and yet they must rise dramatically to justify current stock prices.
The Internet could even cause profits to fall, since it is fundamentally a buyers medium. Internet-savvy companies like Dell have driven down profit margins in their industries, while businesses like eTrade profit by providing goods at low margins.
In the long term, the net impact of the Internet is all that matters, but just as with railways and radios in the past, today’s Stock Market is focusing on the gross numbers. A recent survey of US Internet consumers (which found that 95 per cent of all Internet transactions simply replaced what would have otherwise been an over the counter sale) implies that this age-old mistake could exaggerate the Internet’s importance by a factor of 20.
So the party will end, if not this October, then at sometime early in the new Millemium. The morning after promises to be quite some hangover, because what is truly new about this “new era” is just how big a mountain of debt has been accumulated to finance it.
Americans borrowed big during the 80s, and they’ve borrowed even more to ride the Internet wave. The 80s bull market was built on private debt, which rose from 110 per cent of GDP at the start of the 80s to 145 per cent by October 1987. It slowly dropped back to 135 per cent in the aftermath to the Savings and Loans Crisis, only to take off once more with the Good Ship Internet. At 150 per cent of GDP, it is at its highest level in history--and one and a half times the level at the start of the Great Depression.
This collective leverage paid off as stocks rose 25 per cent for each of the last five years. But when the indeces start to fall, the debt will not. The overburden of debt could leverage the US economy down much faster than the Internet craze pumped it up. The aftermath to the Internet bubble could be an America as depressed as Japan has been since its Bubble Economy burst in 1989.
If the world economy does fall into a post-Internet rut, there is little prospect that economic policy makers will know what to do to get it out. Japan has been limping along in a low-level Depression for a decade, despite expansionary monetary policy and substantial fiscal stimuli. IMF intervention made the Asian crisis worse, by forcing austerity on governments which should have been providing liquidity to their embattled corporations. America’s Federal Reserve has had its eye fixated on near-quiescent commodity inflation, while asset prices and private debt have exploded. Like generals who are prepared to fight the last war, our Economists are prepared to combat inflation and government debt, but have no idea of how to tackle deflation and private debt. Yet those twin demons of Depression are likely to be the main challenges of the next Millenium.
Why October?
It isn’t just superstition that says October is the “witching month” for Stock Exchanges: it’s fact.
The three biggest downturns on Wall Street this century have occurred during October: two of more than 10 per cent in 1929, and the biggest of all, over 22 per cent, in October 1987. But there’s more to it than just these three free-falls. October is twice as likely to have days when the index falls by more than 2 per cent than most other months, and five times as likely to have a fall of more than 4 per cent (the only other months which come close on both counts are September and November).
So what is it with the Northern Hemisphere autumn, October in particular, and Wall Street? Certainly there is nothing in actual economic data which could justify such a profound pattern in stock prices. It may simply be that the turn of the season amplifies the chance for a change in sentiment in this most emotional and fickle of markets.
The really telling critique of economics is not that it is immoral, writes Steve Keen, but that it is irrational.
Among the many banners in London’s M1 demonstration was one that demanded “Replace capitalism with something nicer!”. This amusingly vague protest is far from the full extent of the moral opposition to untrammeled market forces. No less a figure than the Pope has recently voiced the common complaint that the market is amoral, and must therefore be controlled for the betterment of society. Speaking to the Pontifical Academy of Social Sciences, and with noted economists Malinvaud, Arrow and Dasgupta in the audience, the Pope argued that “universal common good ... demands that control mechanisms should accompany the inherent logic of the market”.
Unfortunately, neither the M1 protestors nor the Pope are likely to sway the opinions of economists one jot. The accusation that the market is amoral means nothing to an economist because, from the economic perspective, amorality is precisely the point. Economists perceive the market, not as some enforcer of social standards, but simply as the means by which society achieves its ends. If some people object to what the market economy delivers, then they should attempt to reform society and social attitudes, not the market.
This belief in the independence of economy and morality is enshrined in the dominant definition of economics as “the science which studies human behaviour as a relationship between ends and scarce means which have alternatives uses”. When Robbins coined that definition in the 1930s, he emphasised that economics makes no moral judgments. Whether what consumers desire is base or exalted is irrelevant: “Economics is entirely neutral between ends; that, in so far as the achievement of
any end is dependent upon scarce means, it is germane to the preoccupations of the economist. Economics is not concerned with ends as such.”
Consequently, economists have been, and will remain, unfazed by criticisms that they ignore the social or moral dimensions of economic policy. From their perspective, it is not their role to make the aesthetic judgment as to whether the countryside looks better or worse with or without dairy farms. They believe it is their role, however, to tell us that milk will be more costly in a countryside where dairy farms are maintained by government regulation.
Economists are therefore impervious to moral criticism. The Achilles heel of economics is not morality, but logic.
Though most economists today would concur with Robbins that economics is “a body of generalisations whose substantial accuracy and importance are open to question only by the ignorant or the perverse”, that belief reflects their own ignorance, rather than that of the critics. Whenever economic theory is examined minutely, or measured by the intellectual standards of true sciences, it fails the test.
The ultimate root of these failures is the desire that economists have to make understanding and managing the economy appear no more complex than understanding the behaviour of an isolated individual on a desert isle. If coconuts take more effort to find, Robinson Crusoe (or Tom Hanks) switches to fishing; if there is an abundance of coconuts, Crusoe values them little. All the economic homilies about utility and value, effort and price, ring true.
The key to life’s simplicity for the shipwrecked is that there are no feedback effects: all that has to be considered are the direct consequences of any action. But those of us who live in a complex market economy with its millions of firms and billions of consumers are surrounded by feedback effects all the time. Thus if an indiviudal employer cuts her wages bill, she will definitely be better off; but what are the consequences going to be for the demand for her products if all other employers also cut wages?
The answer to such questions should be what economics is about. But when these questions are posed and confronted honestly, the simple homilies which economists believe become problematic. The feedback effects—in this instance, the negative impact of reduced demand counteracting the positive impact of reduced costs—can outweigh the direct effects.
Economists have coped with this dilemma by constructing economic theory so that feedback effects can be ignored. The most famous such construct is, of course, the “ceteris paribus” assumption: the “other things being equal” clause which is used to justify studying a single market in isolation from all others in supply and demand theory. But whereas economists can rightly claim that this assumption is dropped in high theory, it is also true is that even more extreme assumptions are made as the economic model is extended.
For example, the economic theory of consumer demand easily shows that any choice a single consumer makes maximises his utility, that he will buy more of a good as its price falls, and his welfare will rise because of the price fall. But the same is not true of market demand: if the price of a good falls, market demand for it could go up or down, welfare could fall rather than rise, and consequently the choices made by the market don’t necessarily maximise social utility.
The logical response to this result is to acknowledge that perhaps the M1 protestors and the Pope are on the right track: the market doesn’t produce the best outcome for society, and social welfare could benefit if “control mechanisms” were imposed on the market economy.
But how have economists responded to this? By dreaming up two assumptions which eliminate the issue. The first assumption is that all individuals have the same tastes. The second is that the distribution of income doesn’t matter, not merely between individuals, but to any single individual. As the profession’s signature textbook, Hal Varian’s Microeconomic Analysis, puts it, the dilemma that the market doesn’t maximise social welfare can be avoided by supposing:
that all individual consumers' indirect utility functions take the Gorman form... [where] ... the marginal propensity to consume good j is independent of the level of income of any consumer and also constant across consumers... This demand function can in fact be rationalized by a representative consumer...
This ruse eliminates the issue of the interaction between people. If you assume that all people have the same tastes, and that spending patterns remain the same as income rises, then you assume that the distribution of income is irrelevant. But the point of many of the moral objectors to the market economy is that, in their opinion, the distribution of income is unfair. Economists dismiss their concerns, not because they have proven them wrong, but because they have assumed the problem away.
Such behaviour is a mark of irrationality, not of science. And it is far from an isolated instance. A similar pair of assumptions are made in the economic theory of the stock market, and for the same reason. Economists can explain the behaviour of any one investor, but can’t aggregate from that to a coherent model of the whole market without imposing patently absurd conditions. In this case, the assumptions are that we can all borrow as much money as we want on equal terms, that we all agree on the future prospects of all companies, and (implicitly) that our expectations of the future are accurate. Once again, the effect of the assumptions is to eliminate the impact of feedback from one investor to another: why bother asking what your neighbour thinks of the prospects of a given company, when you know that he has exactly the same opinion that you do, and you know that your shared opinion is correct?
(A dinner party in Econoland would be a very boring affair indeed, wouldn’t it? With everyone having the same tastes, and the same opinion about all assets, what on earth would you talk about?)
Here at least, the theory’s developer recognised that his assumptions were extreme. Sharpe commented that “Needless to say, these are highly restrictive and undoubtedly unrealistic assumptions”. But he defended them on the grounds that “the proper test of a theory is not the realism of its assumptions but the acceptability of its implications”.
This methodological proposition is superficially reasonable, but on close examination, it is a furphy which is used to justify all manner of ills in economic theory. As first put by Milton Friedman, the argument was that
Truly important and significant hypotheses will be found to have “assumptions” that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions (in this sense). The reason is simple. A hypothesis is important if it “explains” much by little, that is, if it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained and permits valid predictions on the basis of them alone.
This proposition is valid when the assumption in effect says that the issue being assumed away is of negligible significance. Friedman gave the example of Galileo ignoring the effect of air resistance. This, said Friedman, was an unrealistic assumption—air resistance exists, and it did make a slight difference as to which ball hit the ground first (apparently the lighter ball beat the heavier one by about a foot).
However, while this argument has some merit when used to dismiss issues which are of minor significance, it is invalid when used to dismiss issues which are clearly not minor. Sharpe admitted as much about his theory of finance, acknowledging that “The consequence of accommodating such aspects of reality are likely to be disastrous in terms of the usefulness of the resulting theory...” If we introduce the reality that different people have different credit limits and pay different rates of interest for loans, and that different people have vastly different opinions of how different investments will fare over time, then “the theory is in a shambles”.
Equally, it is not valid to simply ignore differences in tastes, changing spending patterns as incomes change, and the distribution of income, when attempting to explain how the market works.
But economic assumptions go beyond simply assuming away the problems. In many pivotal parts of economic theory, the assumptions are not merely unreal, but mutually inconsistent.
One such example is the economic theory of perfect competition. The theory simultaneously assumes that the market price falls as output rises, while demand for each firm is constant regardless of its output. A bit of careful mathematics shows that these two assumptions are mutually inconsistent. If market demand falls as output rises, then each firm must also face a “downward sloping” demand curve; if every firm faces a horizontal demand curve, then the market demand curve must also be horizontal. Yet much of economic theory depends on the peaceful coexistence of these two mutually incompatible assumptions. And there are many other such logical conundrums.
The key reason why economics can practice its “science” so badly is that, unlike the physical sciences, economics cannot conduct experiments to decide between competing theories: there is no equivalent for economics of dropping two iron balls off the Leaning Tower of Pisa.
As a result, economics behaves like a pre-Galilean science. Before Galileo, scientists decided such issues by appealing to a priori logic, rather than by an interplay between experiment and reasoning. A priori reasoning made it obvious that a heavy object would fall faster than a light one—and besides, Aristotle said so.
A priori reasoning in the physical sciences began its death in Pisa, but lives on in economics because, if effect, economics has no Leaning Tower. There is no economic system on which we can test competing theories without damaging the experimental apparatus, or without being overwhelmed by extraneous influences which cloud the issue of whether a particular theory was verified or falsified.
For example, critics of Milton Friedman’s monetarism often cite the failure of the monetarist policies of Maggie Thatcher. But monetarism lives on—albeit no longer fashionably—because monetarists contend that Maggie’s policies weren’t implemented credibly enough, or that international forces conspired against her, and so on.
There is a fledgling movement for experimental economics, but even that tends to be infected by economic’s predeliction for a priori logic. Most of the experiments are attempts to verify predictions of economic theory, and the researchers are normally bemused and befuddled when the experiment doesn’t confirm the theory.
For example, one group of researchers tried to verify the theory of consumer behaviour by conducting an experiment with the price of a limited range of commodities at a shop in a psychiatric institution (I kid you not!). They were surprised to find that the inmates’ purchases didn’t conform to the economic definition of rational.
A similar result befell an experiment with university students—the students weren’t behaving “rationally”, according to the economic a priori definition of rational.
A scientific response would be to contemplate that perhaps the a priori definition of rational behaviour is flawed. But instead, the researchers mused as to what could possibly have disturbed the results. In their minds, the a priori definition of rationality remained sacrosanct.
Modern economic theory thus explains what life would be like if there were no feedback effects, when critics from the Pope down are complaining about the effect of applying economic theory to a world in which feedback effects abound.
The criticisms of the market, and globalisation, and the economic arguments in favour of them, are therefore as much logical criticisms as they are moral ones. As Keynes observed in the 1930s, when criticism of conventional economics was equally widespread, the public is objecting because while professional economists may not be disturbed “by the lack of correspondence between the results of their theory and the facts of observation”, the public is. As a result, the “man in the street”, from the M1 protestor to the Pontiff, has a “growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts”.
All this paints a bleak picture of economics, but there are some practitioners of economics who are as disturbed by the state of economic theory today as Keynes was in the 1930s, and like him, are trying to do something about it.
At a technical level, that means designing an economics which explicitly confronts the reality that a complex market economy will be dominated by complex feedback effects—feedbacks between people, since humans are more than simple selfish utility maximisers, between industries, so that the many complex dynamic linkages between industries take the place of “ceteris paribus”, and between economies, so that the distributional impacts of globalisation and free trade can be analysed rather than simply being assumed away.
An economics which confronts those feedbacks head on will be a very different beast to the current orthodoxy, and building it won’t be easy. Fortunately, a small but not insignificant minority are quietly attempting that task today.
And a fair number of them are also barracking for the protestor, and the Pope.
Steve Keen’s Debunking Economics (Pluto Press, Annandale; paperback, 335 pp.; $38.95) considers these and related issues in great depth. Dr Keen is a Senior Lecturer in Economics and Finance at the University of Western Sydney.