Efficiency, Distribution & Growth: Anatomy of a Debt Crisis

The Section on Socio-Economics plans an all day meeting on January 7, 2010 addressing "The Economic Recovery and the Obama Presidency" at this year's Association of American Law Schools annual meeting in New Orleans. I will speak on a panel entitled "Efficiency, Distribution and Growth" from 9:40 to 10:40.

My presentation will focus on three points, each of which played a central role in the subprime debacle. First, the efficiency paradigm operated merely as a shill for deregulation, instead of as an occasionally useful theoretical construct. Second, the current crisis demonstrates the central role distributive justice plays with respect to growth. Third, the emergence of yet another bubble followed by a debt crisis highlights the intellectual bankruptcy of the neoclassical paradigm, as it lacks any ability to predict such a crisis, explain such a a crisis or remedy such a crisis. This post will summarize my comments regarding debt crises.

The economic framework that did predict the current crisis, with powerful explanatory power, is Hyman Minsky's Inherent Financial Instability Hypothesis: "Instability is an inherent and inescapable flaw in capitalism." Basically, extended prosperity imbues reckless optimism, leading to excessive debt that ultimately looks only to increasing asset values for repayment. The resulting bubble is bound to burst leading to excessively tight credit conditions until debt levels stabilize, resulting in a "collapse in asset values." Debt deflation then sets in, with "the potential to spin out of control." Debt deflation means massive asset liquidation, slashed expenditures, layoffs, and the destruction of investment incentives as the economy struggles to deleverage.

This approach directly contradicts the Efficient Market Hypothesis. As Minsky stated:

"from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system's reactions to a movement of the economy amplify the movement--inflation feeds upon inflation and debt-deflation feeds upon debt-deflation. . . .These historical episodes are evidence supporting the view that the economy does not always conform to the classic precepts of Smith and Walras: they implied that the economy can best be understood by assuming that it is constantly an equilibrium seeking and sustaining system."

Mainstream Law and Economics erred in embracing the Efficient Market Hypothesis as a foundation for policy analysis and prescriptions. The siren call of deregulation (which not coincidentally served to entrench the economic power of our financial elites) spawned disaster. Minsky on the other hand, in his famed Stabilizing and Unstable Economy, articulated powerful arguments for robust financial regulation as a means of countering financial excess and innovation (313-328).

The worry today is the continuing failure to embrace the implications of Minsky's work. The debt crisis has not been resolved, it has simply transmogrified into a sovereign debt crisis as witnessed in Greece, Iceland, Dubai, and who knows where else. Prodigious dangers still face the global economy. The credit crunch marches on.

Minsky argued that the road to macroeconomic stability required the government acting as employer of last resort. After all, deleveraging is a two way street--it can be achieved by either reducing debt (through painful debt deflation) or by expanding income (through government stimulation of employment and growth).

The Obama administration still fails to appreciate that this is no ordinary recession--it is a debt crisis that could drag on for years if the debt burden is allowed to continue to weigh down economic growth and become heavier and heavier.