Zombie Economics: How Dead Ideas Still Walk among Us

ZOMBIE ECONOMICS

ZOMBIE ECONOMICS

HOW DEAD IDEAS STILL WALK AMONG US

JOHN QUIGGIN

WITH A NEW CHAPTER BY THE AUTHOR

Copyright © 2010 by Princeton University Press

Published by Princeton University Press,

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In the United Kingdom: Princeton University Press,

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All Rights Reserved

Fifth printing, and first paperback printing, with a new chapter, 2012

Paperback ISBN 978-0-691-15454-1

The Library of Congress has cataloged the cloth edition of this book as follows

Quiggin, John.

Zombie economics : how dead ideas still walk among us / John Quiggin.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-691-14582-2 (hbk. : alk. paper)

1. Economics—History—20th century.

2. Economic policy—History—20th century.

3. Economics. I. Title.

HB87.Q54 2010

330—dc22

2010023189

British Library Cataloging-in-Publication Data is available

This book has been composed in Sabon

Printed on acid-free paper. ∞

Printed in the United States of America

5 7 9 10 8 6

CONTENTS

Preface to the Paperback Edition

Preface to the First Edition

Introduction

CHAPTER 1 THE GREAT MODERATION

Birth: Calm after the Storms

Life: The Great Risk Shift

Death: The Dissenters and Their Vindication

Reanimation: A Global Crisis or a Transitory Blip?

After the Zombies: Rethinking the Experience of the Twentieth Century

Further Reading

CHAPTER 2 THE EFFICIENT MARKETS HYPOTHESIS

Birth: From Casino to Calculating Machine

Life: Black-Scholes, Bankers, and Bubbles

Death: The Crisis of 2008

Reanimation: Chicago Revives the Dead

After the Zombies: The State and the Market

Further Reading

CHAPTER 3 DYNAMIC STOCHASTIC GENERAL EQUILIBRIUM

Birth: From the Phillips Curve to the NAIRU, and Beyond

Life: Rationality and the Representative Agent

Death: How Did Economists Get It So Wrong?

Reanimation: How Obama Caused the Global Financial Crisis

After the Zombies: Toward a Realistic Macroeconomics

Further Reading

CHAPTER 4 TRICKLE-DOWN ECONOMICS

Birth: From Supply-side Economics to Dynamic Scoring

Life: Excuses for Inequality

Death: The Rich Get Richer and the Poor Go Nowhere

Reanimation: Mobility without Movement

After the Zombies: Economics, Inequality, and Equity

Further Reading

CHAPTER 5 PRIVATIZATION

Birth: We Are All Market Liberals Now

Life: A Policy in Search of a Rationale

Death: Puzzles and Failures

Reanimation: Dead for Good?

After the Zombies: The Mixed Economy

Further Reading

CHAPTER 6 EXPANSIONARY AUSTERITY

Birth: The Treasury View

Life: The Great Depression

Death: The Success of Keynesianism

Reanimation: Expansionary Austerity and the Euro

After the Zombies: The Case for Hard Keynesianism

Further Reading

CONCLUSION ECONOMICS FOR THE TWENTY-FIRST CENTURY

Rethinking the Experience of the Twentieth Century

A New Approach to Risk and Uncertainty

What Is Needed in Economics

References

Index

PREFACE TO PAPERBACK EDITION

Zombie Rule #2, Double Tap: You think it’s dead (technically it was before you shot it); one more makes 100 percent sure.

—ZOMBIELAND (2009)

I began the task of revising Zombie Economics for a paperback edition in mid-2011. At the time, the global landscape reminded me of the closing scenes of one of those zombie movies that end badly. After a brief period when escape seemed possible, new hordes of zombies had emerged, overwhelming the remaining islands of sanity. The dead ideas that had caused the crisis had reemerged under the undead banner of Austerity.

But, as it turned out, the movie had a surprise twist to come. After years in which (at least in the United States) the only large-scale protest was that of the Tea Party, demonstrating in support of the zombie ideas of the financial sector, popular resistance suddenly sprang up. It began in Wisconsin with opposition to the public sector cuts proposed by newly elected Republican governor Scott Walker.

The Wisconsin protests were only partly successful, and despite continuing struggles in Ohio and elsewhere, it seemed as if the momentum might be lost. Then, apparently out of nowhere, came the Occupy Wall Street movement. Drawing their inspiration directly from the Arab Spring, and indirectly from Martin Luther King Jr. and the civil rights movement, a small band of protestors occupied a park in New York’s financial district.

The initial response from the established media and from the financial sector itself was a mixture of disregard and derision. The response was symbolized by a viral video of a group of investment bankers, gathered on a balcony to mock the protestors below while consuming a small part of their (doubtless well-earned) bonuses by sharing a bottle of champagne.

But to everyone’s surprise the movement grew and kept on growing. Unions, which had generally been wary of such forms of protest, joined in with marches in support of the occupiers. Police brutality, exemplified by the use of pepper spray on unresisting protestors, only served to provide new publicity. Within a week the movement had spread to Washington, DC, and then to hundreds of cities around the United States. Within a month, it had become a global phenomenon.

Equally striking has been the We are the 99 percent movement. Perhaps its most impressive output has been a website (http://wearethe-99percent.tumblr.com) where hundreds of people hold up handwritten statements describing their economic position. The themes of financial disaster arising from unemployment, health care emergencies, and student loan debt are repeated over and over with a striking impact.

The future of the Occupy movement remains unclear at this moment, but it has already transformed the policy debate in the United States. Issues that were considered unmentionable, such as the fact that the country has ceased to be a land of opportunity and in fact has less social mobility than its European rivals, were suddenly front-page news.

In the space of a few months, this mass movement had more impact on the U.S. political process than a decade’s worth of the books, journal articles, and opinion pieces produced by economists critical of the reigning orthodoxy. Nevertheless, the body of work produced by economists such as Paul Krugman and Joe Stiglitz played a crucial role in informing the analysis of the movement. It is my hope that this book will contribute to that body of work by showing how the market liberal ideology, amply refuted by evidence, nevertheless lives on in zombie form and continues to drive regressive and harmful economic policies. I would like, once again, to thank Seth Ditchik and everyone at Princeton University Press, particularly Terri O’Prey and Beth Gianfagna, for their help in producing this paperback edition. As with the earlier edition, I published drafts of the new austerity chapter on my blog, johnquiggin.com, and on crooked timber.org and received many useful comments. In addition, I received very helpful comments from Mark Blyth and Eric Rauchway.

PREFACE TO THE FIRST EDITION

The idea for this book began when I read this striking passage in Animal Spirits by George Akerlof and Robert Shiller:

The economics of the textbooks seeks to minimize as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so—and each of us has spent a good portion of his life writing in this tradition. The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually works. Our book marks a break with this tradition. In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith but rather from the deviations that actually do occur and can be observed. (Akerlof and Shiller 2009, 4–5)

This passage motivated me to write about its implications for macroeconomics in the Crooked Timber blog. In comments, economist Max Sawicky, posting under the pseudonym MiracleMax, suggested that this, combined with some earlier posts on ideas refuted by the financial crisis, would make a good book. Brad DeLong of the University of California at Berkeley picked up the idea, and the next day Seth Ditchik of Princeton University Press e-mailed me to say he thought it was a great idea. The result is before you.

More than most books, this one has been improved by comments from others, not all of whom I can name. As I wrote draft chapters, I posted them on crookedtimber.org, and on my personal blog johnquiggin.com, then combined them in a draft on wikidot.com. I asked for comments and received, in total, several thousand, from well over a hundred different commenters, most of them pseudonymous.

I can’t thank all those who commented, but I would like to mention Alice, Bert, Bianca Steele, Martin Bento, Kevin Donoghue, Kenny Easwaran, John Emerson, Freelander, Jim Harrison, JoB, P. M. Lawrence, Terje Petersen, Donald Oats, Andrew Reynolds, smiths, John Street, Uncle Milton, Robert Waldmann, Tim Worstall, and Zamfir.

I also received helpful comments from friends and colleagues, including George Akerlof, Chris Barrett, Mark Blyth, Brad DeLong, Joshua Gans, Paul Krugman, Andrew McLennan, Flavio Menezes, and Eric Rauchway. Several anonymous reviewers for Princeton University Press went above and beyond the call of duty in providing extensive and valuable comments. My wife and colleague, Nancy Wallace, read the entire text and made many helpful editorial and substantive suggestions.

Thanks also to the editorial and production team at Princeton University Press. Seth Ditchik was a marvelous and supportive editor, ably assisted by Janie Chan. Debbie Tegarden, my production editor, was unfailingly cheerful and supportive, not to mention highly efficient in turning a manuscript into a book on a very tight time frame. Other production staff including Jack Rummel and Jim Curtis gave able support. The marvelous cover design by Karl Spurzem and Dimitri Karetnikov, drawing on an idea from Seth Ditchik, speaks for itself (it says, Brraaaiiinnnssss).

In addition, I must thank all my cobloggers at Crooked Timber, Chris Bertram, Michael Berube, Harry Brighouse, Daniel Davies, Henry Farrell, Maria Farrell, Eszter Hargittai, Kieran Healy, John Holbo, Scott McLemee, Jon Mandle, Ingrid Robeyns, Belle Waring, and Brian Weatherson. Without the lively and supportive environment they’ve provided, this book would never have happened.

ZOMBIE ECONOMICS

INTRODUCTION

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air are distilling their frenzy from some academic scribbler of a few years back.

—J. M. KEYNES, The General Theory of Employment, Interest and Money

Ideas are long lived, often outliving their originators and taking new and different forms. Some ideas live on because they are useful. Others die and are forgotten. But even when they have proved themselves wrong and dangerous, ideas are very hard to kill. Even after the evidence seems to have killed them, they keep on coming back. These ideas are neither alive nor dead; rather, as Paul Krugman has said, they are undead, or zombie, ideas. Hence the title of this book.

Before the Global Financial Crisis ideas like the Efficient Markets Hypothesis and the Great Moderation were very much alive. Their advocates dominated mainstream economics. Their influence, acknowledged or not, guided the thinking of the practical men and women whose decisions created a financial system without parallel in history. Tens of trillions of dollars of interlinked obligations were built on a foundation of speculative, or entirely spurious, investments. The result was a global economy in which both households and nations lived far beyond their means.

Today the Efficient Markets Hypothesis and the Great Moderation look like defunct ideas. Commentators who were proclaiming, in the early 2000s, that the business cycle had been tamed, have admitted their error or, more commonly, moved on to talk of other things. The claim that financial markets make the best possible use of economic information and can never be subject to irrational bubbles is rarely made overtly and is usually hedged with all kinds of qualifications and escape clauses. In this zombie state, such claims continue to lumber around the intellectual landscape.

But habits of mind and thought are hard to change, especially when there is no ready-made alternative. The zombie ideas that brought the global financial system to the brink of meltdown, and have already caused thousands of firms to fail and cost millions of workers their jobs, still walk among us. They dominate the thinking of those who have determined the policy responses to the crisis and of many of the commentators and analysts who assess those responses.

If we are to understand the financial crisis, and reject the kinds of responses that set the stage for a new and even bigger crisis in a few years time, we must understand the ideas that got us to this point. This book describes some of the ideas that have played a role in the crisis. They are

the Great Moderation: the idea that the period beginning in 1985 was one of unparalleled macroeconomic stability;

the Efficient Markets Hypothesis: the idea that the prices generated by financial markets represent the best possible estimate of the value of any investment;

Dynamic Stochastic General Equilibrium: the idea that macroeconomic analysis should not concern itself with economic aggregates like trade balances or debt levels but should be rigorously derived from microeconomic models of individual behavior;

Trickle-down economics: the idea that policies that benefit the well-off will ultimately help everybody;

Privatization: the idea that any function now undertaken by government could be done better by private firms; and

Austerity: the belief that the best response to a crisis like that of the present is for governments to balance their own books and wait for the private sector to recover.

Some of these ideas, such as the Efficient Markets Hypothesis and Dynamic Stochastic General Equilibrium belong to the realm of technical economic theory. Others, such as privatization and austerity are policy prescriptions, derived from these abstract ideas. Still others, like the Great Moderation and trickle-down economics, are catchphrases for claims about how the economy works, or at least, how it worked in the thirty years or so before the current crisis.

Together these ideas form a package which has been given various names: Thatcherism in the United Kingdom, Reaganism in the United States, economic rationalism in Australia, the Washington Consensus in the developing world, and neoliberalism in academic discussions. Most of these terms are pejorative, reflecting the fact that it is mostly critics of an ideological framework who feel the need to define it and analyze it. Politically dominant elites don’t see themselves as acting ideologically and react with hostility when ideological labels are pinned on them. From the inside, ideology usually looks like common sense. The most neutral term I can find for the set of ideas described by these pejoratives is market liberalism, and this is the term that will be used in this book.¹

The book is organized in a way that I hope will help readers understand how market liberalism depends on ideas that have failed the test of the Global Financial Crisis. If these ideas continue to influence policy, they will ensure a repetition of the crisis.

Each chapter deals with a single idea and begins by describing the birth of the idea, followed by a section on its life, focusing on theoretical and policy implications. The next section describes the death of the idea brought about by the global crisis, but usually resulting from weaknesses that were evident well before the crisis. A brief section on reanimation looks at attempts to raise these dead ideas from the grave as undead zombies. The next section, entitled After the Zombies, looks at alternatives to the ideas of market liberalism. Finally, there are some suggestions for further reading.²

The final chapter, Economics for the Twenty-first Century looks more generally at the theoretical and policy ideas that will be needed in the light of the failure of market liberalism. A simple return to traditional Keynesian economics and the politics of the welfare state will not be sufficient. It is necessary to develop both theories and policies that respond to the realities of the twenty-first century economy.

It is clear that there is something badly wrong with the state of economics. A massive financial crisis developed under the eyes of the economics profession, and yet most failed to see anything wrong. Even after the crisis, there has been no proper reassessment. Too many economists are continuing as before, as if nothing had happened. Already, some are starting to claim that nothing did happen, that the Global Financial Crisis and its aftermath constitute a mere blip that should not require any rethinking of fundamental ideas.

The ideas that caused the crisis and were, at least briefly, laid to rest by it are already reviving and clawing their way through up the soft earth. If we do not kill these zombie ideas once and for all, they will do even more damage next time.

¹ There is a similar problem of terminology on the other side of the debate. Market liberalism emerged as a reaction against a set of ideas and policies commonly referred to as social liberalism or social democracy in Europe and simply as liberalism in the United States. These ideas included a commitment to full employment, based largely on Keynesian economic management, and a major role for the state in the provision of income security and services such as health and education. I will generally use the term social democracy to avoid the ambiguities surrounding liberal.

² For ease of reading, I have dispensed with the traditional apparatus of endnotes, which force the reader to keep the book open in two places to follow notes, many of which turn out to be nothing more than academic citations. Instead, I’ve made sparing use of footnotes like this one to cover points of tangential interest, notes about some of the economists whose work is discussed, and so on. The further reading section at the end of each chapter includes Harvard-style citations to books and journal articles that have been mentioned in the chapter, and detailed references are given in the bibliography.

CHAPTER 1

THE GREAT MODERATION

Stock prices have reached what looks like a permanently high plateau.

—ATTRIBUTED TO IRVING FISHER, October 1929

A zombie idea is one that keeps on coming back, despite being killed. In the history of economics, there can be no more durable zombie idea than that of a New Era, in which full employment and steady economic growth would continue indefinitely. Every sustained period of growth in the history of capitalism has led to the proclamation of such a New Era. None of these proclamations has been fulfilled.

As Irving Fisher’s famous prediction, made only a few days before the Wall Street Crash of 1929, illustrates, the belief that the era of boom and bust has finally been put behind us is not new. In fact, ever since the emergence of industrial capitalism in the early nineteenth century, the global economy has been shaken, and stirred, by periodic booms and busts. And, in every intervening period of steady growth, optimistic observers have proclaimed the dawning of a New Economy in which the bad old days of the business cycle would be put behind us. Even the greatest economists (and Irving Fisher was a truly great economist, despite some spectacular eccentricities) have been fooled by temporary success into believing that the business cycle was at an end.¹

In 1929, Irving Fisher’s confidence was based in part on the development of the tools of monetary policy implemented by the U.S. Federal Reserve, which had been established in 1913 and had dealt successfully with several minor crises. The central idea was that, in the event of a financial panic, the Fed would lower interest rates and release funds to the banking system until confidence was restored.

But the Fed proved unable or unwilling to produce an adequate response to the stock market crash of October 1929. The Great Crash was followed by four years of uninterrupted decline that threw as many as a third of all workers out of work, not only in the United States, but all around the world.

Economists are still arguing about the causes of the Great Depression, and the extent to which mistaken policies contributed to its length and depth. These disputes, once polite and academic, have taken on new urgency and ferocity in the context of the current crisis, which echoes that of 1929 in many ways.

In the aftermath of the Great Depression and World War II, the analysis that held sway over the great bulk of the economics profession was that of John Maynard Keynes.² Keynes argued that recessions and depressions were caused by inadequate effective demand for goods and services and that monetary policy would not always be effective in increasing demand. Governments could remedy the problem through the use of public works and other expenditure programs.

The rapid return to full employment in the war years seemed to confirm Keynes’s analysis. As Australia’s White Paper on Full Employment, published in 1945, put it:

Despite the need for more houses, food, equipment and every other type of product, before the war not all those available for work were able to find employment or to feel a sense of security in their future. On the average during the twenty years between 1919 and 1939 more than one-tenth of the men and women desiring work were unemployed. In the worst period of the depression well over 25 per cent were left in unproductive idleness. By contrast, during the war no financial or other obstacles have been allowed to prevent the need for extra production being satisfied to the limit of our resources. (Commonwealth of Australia 1945, 1)

In sharp contrast with previous wars, the full employment of the war years was maintained after the return of peace. For most developed countries, the years from the end of World War II until the early 1970s represented a period of full employment and strong economic growth unparalleled before or since. Referred to as the Golden Age or Long Boom in English, Les Trente Glorieuses in French, and the Wirtschaftswunder in German, this period saw income per person in most developed countries more than double.

By the 1960s, many Keynesian economists were prepared to announce victory over the business cycle. Walter Heller, chairman of the Council of Economic Advisors under John F. Kennedy, hailed the switch to active fiscal policy in the 1960s, saying We now take for granted that the government must step in to provide the essential stability at high levels of employment and growth that the market mechanism, left alone, cannot deliver.³ Attention turned to the more ambitious goal of fine-tuning the economy so that even growth recessions (temporary slowdowns in the rate of economic growth that typically produced a modest increase in unemployment rates) could be avoided.

Pride goes before a fall. In the 1970s, the seemingly endless postwar boom came to an abrupt halt. It was replaced by accelerating inflation and high unemployment. Keynesian fiscal policies, aimed at eliminating unemployment, were abandoned. Restrictive monetary policies and high interest rates allowed central banks to squeeze inflation out of the system over the course of the 1980s. The pressure for price stability was reinforced by globalization, and particularly by the growing size and influence of the global financial sector.

While price stability returned, the full employment of the postwar era was gone, and has never truly returned. Economic growth returned gradually, but, at least in developed countries, never regained the rapid rates of the postwar boom.

It seemed that the idea of a New Era was dead, once and for all. But zombie ideas are not so easily killed.

BIRTH: CALM AFTER THE STORMS

If only by comparison with the dismal 1970s and 1980s, the 1990s were an era of prosperity for the developed world, and particularly for the United States. The boom of the late 1990s produced improvements in income across the board, after a long period of stagnation for those in the lower half of the income distribution. The boom in the stock market produced even bigger gains for the wealthy. House prices were slower to move, but because they are such a large part of household wealth, contributed even larger capital gains.

The long and strong expansion of the 1990s, combined with political events such as the collapse of the Soviet Union, produced a new air of optimism and, at least in the United States, triumphalism. The success of books like Francis Fukuyama’s The End of History and Thomas Friedman’s The Lexus and the Olive Tree reflected the way they matched the popular mood.

Fukuyama argued that the great conflicts that made history something more than the passing of time were over, and that the end of the Cold War marked the end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government.⁴ Fukuyama assumed that Western implied capitalist. However, he showed some ambivalence about the meaning of capitalism. Fukuyama’s use of this term implied a triumphant market liberalism. But in defending the factual claim of a universalized social order, his use of capitalism encompassed the whole range of political and economic systems observed in Western societies, from Scandinavian social democracies to the winner-take-all society then emerging in the United States.

Friedman dispensed with such nuance. In a book full of cute phrases and memorable metaphors, the most prominent was the Golden Straitjacket. This was Friedman’s way of saying that, in a globalized economy, adherence to the principles of market liberalism would guarantee golden prosperity. On the other hand, any deviation from those principles would bring down the wrath of the Electronic Herd of interconnected global financial markets.

Fukuyama’s celebration of the new order made him an intellectual superstar. His books were widely cited, if not quite so widely read. Friedman’s breezy boosterism, by contrast, did not earn him so much intellectual credit, but it put him on the bestseller lists. Everyone wanted to be part of the new Lexus-owning world.

Economists were a little late to the party. Well into the 1990s, they worried about weak productivity growth, the possibility of resurgent inflation, and unemployment rates that remained high by the standards of the postwar boom.

By the early 2000s, however, it was possible to look at the U.S. data and discern a pattern that was the very opposite of a lost golden age. Rather, the data could be read as showing a decline in the volatility of output and employment. Most economists saw the decline in volatility as a once-off dropping that took place in the mid-1980s, after the early 1980s Volcker recession, so called because it was induced by the restrictive anti-inflation policies of Fed chairman Paul Volcker.⁵

Although most attention has been focused on the volatility of output, the most important impact of recessions is the variability of employment, which is best measured by the employment/population ratio. As with measures of GDP volatility, the standard measures of employment volatility declined noticeably after 1985.

This apparent decline in volatility largely coincided with the chairmanship, lasting nearly twenty years, of Volcker’s successor, Alan Greenspan. Whether deservedly or not, Greenspan, rather than Volcker, got the credit. Greenspan’s status as the source of all economic wisdom was symbolized in the ultimate Washington accolade, a biography (or rather, hagiography) from Bob Woodward, entitled Maestro.

Greenspan’s successor, Ben Bernanke, graduated summa cum laude from Harvard in 1975, and completed a Ph.D. at MIT in 1979. He is, therefore, a leading figure in the generation of economists whose careers began after the breakdown of the long postwar boom, and coincided with the Greenspan era. Unsurprisingly perhaps, Bernanke was among those who did most to promote the idea of a New Era of economic stability.

Bernanke also popularized the use of the term the Great Moderation to describe the New Era. This term was originally coined by James Stock of Harvard University and Mark Watson of Princeton University. Bernanke used it as the title of a widely publicized speech given in 2004.

The Great Moderation was hailed, like previous periods of prosperity, as representing the end of the business cycle. As Gerard Baker wrote in The Times of London in 2007:

Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smooth out the curves of economic progress. But the really important reason tells us much more about the best way to manage economies.

It is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods. (Baker 2007)

A