Monday, December 21, 2009

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.

4 comments:

  1. Instability is an inherent and inescapable flaw in capitalism ...

    Unlike the stability inherent in now now defunct communist and socialist systems, I guess.

    ... from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control.

    Capitalist economies? What about marxist Zimbabwe? The government has complete and absolute control of their economy and they are in the throws of hyperinflation? Or, socialist Japan, locked in a decade long struggle with deflation. What accounts for the stratospheric debt levels of socialist Greece, Italy and Belgium? These are all heavily regulated economies, and yet, they suffer from problems that you ascribe to a flaw in capitalism.

    Capitalism, like any system design by human beings, is not flawless. It is, unfortunately, subject to the hubris of political and academic elites.

    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. . . .

    This is a product of human nature, not any particular economic system. People are prone to anticipate future events as an extension of present realities. Persistent inflation causes people to anticipate higher future prices, just as the current spate of bankruptcies and foreclosures causes people to re-evaluate both the assumption of debt and it's future value.

    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."

    The market is a pricing mechanism, nothing more. It allows individuals, with particular knowledge, to execute mutually satisfactory exchanges. In that sense, it does constantly seek equilibrium and is far more sustainable and beneficial than any other system.

    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."

    The current level of indebtedness in the U.S. economy is not the result of "reckless optimism". It is the direct result of government policy. Perhaps, before embarking on another flawed government intervention in the economy, we should take a long critical look at how and why politicians and government regulators failed to adequately respond to the causes and consequences of this one.

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  2. Capitalism has proven superior to communism in virtually every way. Marxism has a record of total failure.


    Market based economies are the mark of every properous nation.

    OK, fine.

    Now how to perfect capitalism? Laissez faire is also a proven failure.

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  3. The idea that our economy has been anything close to purely market based since the New Deal is a farce. GW Bush, in particular, increased government regulation and spending significantly more than most (if not all) prior administrations. The solution to a government-enabled problem is not more intrusion from the government.

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  4. How to prevent debt? It is all people questions. How are we going to prevent debt? There are too many agencies that are telling that they can prevent debt. There are some that they are telling the truth but the most is just a joke and they are just a bunch of scams.

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