Saturday, June 14, 2014

Doctors without diagnoses

by Michael Roberts

You are feeling ill and you go to the doctor.  The doctor says that he/she does not know why you are ill, but no matter, take this medicine anyhow you like and you should soon be better.  If you don’t get better, then just wait until you do.  The doctor does not know why you are ill because you have not been ill often enough in the same way for the doctor to get a theory.  This, according to top Keynesian economics blogger, Noah Smith, is the state of understanding that economists have about recessions or slumps in capitalist economies

Smith says: “John Maynard Keynes, Friedrich Hayek and Irving Fisher wrestled with this question in the 1930s….but almost a century later, despite sending some of our best brains up against the problem, we’ve made frustratingly little progress.”  Smith goes on: “It’s hard to overstate how few solid conclusions have emerged out of a century of macroeconomic research. We don’t even have a good grasp of what causes recessions. Robert Lucas, probably the most influential macroeconomist since Keynes, had this to say in 2012: ‘I was [initially] convinced…that all depressions are mainly monetary in origin…I now believe that the evidence on post-war recessions (up to but not including the one we are now in) overwhelmingly supports the dominant importance of real shocks. But I remain convinced of the importance of financial shocks in the 1930s and the years after 2008. Of course, this means I have to renounce the view that business cycles are all alike!’

Smith notes that neoclassical perfect market equilibrium theory has nothing to say on imperfect, highly volatile capitalist market fluctuations. Now I have quoted Lucas before and his fellow neoclassical Nobel prize winner and founder the Efficient Market Hypothesis (that i.e. markets know best and we don’t know markets) Eugene Fama, to show they don’t know what causes slumps and moreover they don’t care (see my paper, The causes of the Great Recession.).  Smith goes onto to deliver a load of other quotes from leading mainstream economists, past and present, who say they don’t know what causes recessions.

What debate there is about recessions under capitalism is no more scientific, according to Smith, than “medieval doctors arguing over leeches versus bleeding… without a real understanding of what causes recessions, our medicines are largely a shot in the dark.”

But Smith says the reason why mainstream economics has no explanations is the lack of data. “Business cycles are few and far between. And business cycles that look similar to one another — the Great Depression and the Great Recession, for example — are even farther apart. … The main statistical technique we have to analyze macro data — time-series econometrics — is notoriously inconclusive and unreliable, especially with so few data points.”  Smith concludes that “The uncomfortable truth is this: The reason we don’t really know why recessions happen, or how to fight them, is that we don’t have the tools to study them properly. The fact is, there are just some big problems that mankind doesn’t know how to solve yet.”

But this is nonsense. Mainstream economics has nothing to say about capitalist crises not because there is a lack of data, but because their theories are just plain wrong or do not even address the issue. Contrary to the assumptions of the mainstream, markets are not perfect; economies do not tend to equilibrium steady growth paths; and investment does not depend on ‘effective demand’ but on profit.
While mainstream economics may have nothing to say about the cycle of booms and slumps under capitalism, what about Austrian economics (too much credit and malinvestment) or heterodox economics (inherent financial instability) or Marxist economics (the law of declining profitability)? Smith ignores all these explanations completely. For him, ‘economics’ is either neoclassical or Keynesian; and he is right, they have nothing to say on the causes of crises.

Even there, Smith does not deal with the latest versions of an explanation. The Great Recession, according to Ben Bernanke, was a traditional banking crash or ‘financial panic’, caused by the lack of regulation. The alternative fashionable theory is that the Great Recession was caused by wages being held down, allowing inequality to rise, thus forcing households to accumulate too much debt that eventually came crashing down.

This latter theory is the dominant one among heterodox circles, leaning on the inequality data of Piketty and others. A new book just released (House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again, by Atif Mian and Amir Sufi), has been praised as the best explanation by Keynesian economics elitist, Larry Summers. In a review, Larry tells us that House of Debt “looks likely to be the most important economics book of 2014; it could be the most important book to come out of the 2008 financial crisis and subsequent Great Recession.” So not Piketty, then.

Summers tells us that it refutes the Bernanke thesis and “persuasively demonstrates that the conventional meta-narrative of the crisis and its aftermath, which emphasises the breakdown of financial intermediation, is inadequate.” So it was not the banks that caused the crisis but that old Keynesian cause: a lack of consumption. This is music to Summers’ ears because in the years before the Great Recession, he firmly rejected suggestions that a huge credit bubble was being fostered by the deregulation of the banking industry.  He had firmly supported allowing banks to do what they liked when Treasury secretary under Clinton. He dismissed claims then that financiers were creating’financial weapons of mass destruction’.

Summers is now pleased to be told that he was not wrong then. The explanation of the Great Recession is to be found in too much mortgage debt and a lack of consumption.  Summers quotes House of Debt approvingly: “spending on housing and durable goods such as furniture and cars decreased sharply in 2006 and 2007, well before any financial institution became vulnerable. Likewise, they note that the initial impetus behind recession in the US appears to have been a decline in consumer spending. Summers goes on: “They argue that, rather than failing banks, the key culprits in the financial crisis were overly indebted households. So their story of the crisis blames excessive mortgage lending, which first inflated bubbles in the housing market and then left households with unmanageable debt burdens. These burdens in turn led to spending reductions and created an adverse economic and financial spiral that ultimately led financial institutions to the brink.”

But this crude Keynesian view is equally false along with the lack of banking regulation argument. Throughout the period prior to the Great Recession, US consumer spending rose as a share of GDP while wages at work dropped as a share.  It was not squeezed.
US labour share and consumption
Yes, this was partly due to a rise in debt, but also because households were compensated for wage stagnation with better social and health benefits. Yes, consumption fell in the crisis but not before investment collapsed, as I have shown on numerous occasions in this blog. It’s investment that is the swing factor in recessions and recoveries, not consumption. Or to be more exact, it is profits that call the tune, because investment demand drops off when profits do. As profitability falls over time, eventually the mass of profit will fall and this will force weaker businesses to cut back on investment or even close down. Then there is a cascade of falling ‘effective demand’ as companies go bust or lay off labour. Then consumption falls. That is the order of events – as the graph of US profits and business investment below shows.
US profits and investment
Of course, talk about profitability and investment as causes of recurrent crises is ignored or dismissed by mainstream economics of either wing, neoclassical or Keynesian. The mainstream does not want to focus on the exploitation of labour and profit.  The neoclassical wing either denies that there are recessions or that we can forecast or explain them. They are just unknown ‘shocks’ to an otherwise great system of production (see Lucas quote above). The Keynesians talk vaguely about ‘lack of demand’, which is really a tautology because a capitalist slump is a lack of demand for goods and labour, by definition. It is no explanation.

Keynesian economics is less interested in how an economy gets into a slump and more on how to get out of it. As Keynesian guru, Paul Krugman, put it in his book on the Great Recession, End the Depression Now!: “the point is that the problem is not with the economic engine, which is as powerful as ever. Instead, we are talking about what is basically a technical problem, a problem of organisation and coordination – a ‘colossal muddle’ as Keynes described it. Solve this technical problem and the economy will roar back into life”. (

British Keynesian economist, Simon Wren-Lewis delivers the same view in response to Smith’s view that we don’t know what causes recessions ( SWL says that we may not know but at least we know fiscal austerity won’t help. “While the reasons for the Great Recession may still be controversial, the major factor behind the second Eurozone recession is not: contractionary fiscal policy, in the core as well as the periphery. So this is something we really do know.” (6 June). Actually, as I have argued in this blog, the main cause of the Euro recession, first or second, was not austerity but the crisis in profitability. And Wren-Lewis offers no explanation of why the Great Recession or the ‘Euro recession’ started in the first place.

Neoclassical economists may be doctors using leeches, as Smith says. But Keynesian economists are also doctors offering herbal remedies without any diagnoses. Keynes once said that economists should really become just like dentists, able to fix your teeth when there is a problem. But even dentists need to know why problems arise in order to fix them.

There is a viable explanation of recurrent and regular crises of production. Marxist crisis theory, based around Marx’s law of the tendency of the rate of profit to fall, provides a coherent one.  Sure, the lack of data is an issue. But, contrary to Smith’s view, that should not hold back a scientific inquiry into these causes. G Carchedi and I, among many other Marxist economists, have published extensive empirical material that shows a convincing causal connection between profitability, investment and recurrent slumps (see our paper, The long roots of the present crisis).  And I remind my readers of the excellent theoretical and empirical paper by Tapia Granados

Using regression analysis, he found that, over 251 quarters of US economic activity from 1947, profits started declining long before investment did and that pre-tax profits can explain 44% of all movement in investment, while there is no evidence that investment can explain any movement in profits.

In other words, profits lead investment and investment leads demand and employment. And that’s a lot of data points.

For a summary of the empirical evidence of the Marxist explanation of crises, see my paper presentation-to-critique-conference-11-april-2014

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