Financial Instability and Economic Security after the Great Recession 2011926845, 9780857934833

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Financial Instability and Economic Security after the Great Recession

‘Whalen and his colleagues explore the close relationship between Institutional and Post Keynesian economics, thereby contributing greatly to our understanding of the recent – indeed, still ongoing – crisis in the US economy and global financial markets. Together those schools of thought provide coherent diagnoses and prescriptions that are wholly lacking in conventional economics. We are reminded that institutions matter, unregulated financial markets are not self-correcting, economies stall at equilibriums far below potential, and activist government is the only path to rebuilding a stable and balanced economy. This book will help greatly in the important task of rethinking economics and pointing us in the direction of reform and recovery.’ – Timothy A. Canova, Chapman University School of Law, USA ‘For those who take the work of Minsky seriously, this collection provides a refreshing examination of economic reality. It also demonstrates how fruitful a conjoining of Post Keynesian and Institutionalist theory can be. Whalen has chosen his authors wisely, and, taken as a whole, their contributions provide an illuminating inquiry into what Minsky called “money-manager capitalism”. The authors continue in the Minsky tradition, complementing his theoretical work and driving it forward. I highly recommend this book to all who are looking for a way out of the theoretical impasse posed by conventional economics.’ – John Henry, University of Missouri–Kansas City, USA ‘Charles Whalen has been the torch-bearer for Post-Keynesian Institutionalism for many years. The fruit of his thought and time is reaped in the publication of this valuable work. It should be of interest to all economists, particularly those concerned with the macroeconomic workings of the real economy. While there are multiple authors, Whalen wrote or coauthored half of the chapters, giving the book coherence not usually found in a collection of essays; a first-rate book.’ – Charles K. Wilber, University of Notre Dame, USA ‘The end of the Great Moderation (a period characterized by moderate business cycles) and the demise of its intellectual underpinnings opens the door to fresh thinking about the evolution of the US and world economies. This volume responds with insights that grow out of Post-Keynesian Institutionalism. It provides a persuasive basis for reconstructing macroeconomics and developing policies that could lead to greater world prosperity.’ – Kenneth P. Jameson, University of Utah, USA ‘This book makes a major contribution toward an economic framework that addresses the policy failures precipitating the recent global financial crisis and slowing recovery from the Great Recession. It begins with clear analyses of the influence of earlier non-classical economic thinkers upon Keynes and Minsky – and then uses insights from that tradition to critique economic thinking that failed to anticipate the crisis. It also identifies policy options capable of preventing future crises and ensuring a more rapid recovery. The result is a solid foundation for refashioning economics and securing broadly shared prosperity.’ – Jane D’Arista, Political Economy Research Institute, USA ‘Institutionalists and Post Keynesians have a great deal in common, so much so that it is surprising how little cooperation there has been between them. This innovative and engaging volume will help to put that right. These essays deserve to be widely read; they will have important consequences.’ – John E. King, La Trobe University, Australia

Financial Instability and Economic Security after the Great Recession Edited by

Charles J. Whalen Congressional Budget Office, USA

Edward Elgar Cheltenham, UK • Northampton, MA, USA

© Charles J. Whalen 2011 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2011926845

ISBN 978 0 85793 483 3

03

Typeset by Cambrian Typesetters, Camberley, Surrey Printed and bound by MPG Books Group, UK

Contents List of figures and tables List of contributors List of abbreviations Preface

vii viii xi xii

Introduction: instability, prosperity and economics after the Great Recession Charles J. Whalen PART I 1.

2.

3.

1

FOUNDATIONS

Subverting Say’s Law: Harlan McCracken and the Commons-Keynes connection Steven Kates Towards a synthesis of Institutional and Post Keynesian economics W. Robert Brazelton and Charles J. Whalen Futurity: cornerstone of Post-Keynesian Institutionalism Glen Atkinson and Charles J. Whalen

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28 53

PART II THE AMERICAN ECONOMY 4.

5.

6.

Understanding and preventing financial instability: PostKeynesian Institutionalism and government as employer of last resort Fadhel Kaboub Towards a more rapid recovery: incorporating subsidiarity into macroeconomic policy David A. Zalewski and Charles J. Whalen Financial stability, regulatory buffers and economic growth after the Great Recession: some regulatory implications Éric Tymoigne

v

77

93

114

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PART III 7.

8.

9.

Regulating for stability: bank capitalization and the emergence of an international lender of last resort Jan Toporowski Evolution without fundamental change: the Washington Consensus on economic development and its significance for Post-Keynesian Institutionalism John Marangos and Charles J. Whalen Money-manager capitalism, capital flows and development in emerging market economies: a Post-Keynesian Institutionalist analysis Yan Liang

PART IV 10.

Index

THE GLOBAL ECONOMY

143

153

179

CONCLUSION

The future of Post-Keynesian Institutionalism Charles J. Whalen

205

211

Figures and tables FIGURES 4.1 4.2 6.1 9.1 9.2 9.3 9.4

Household debt as a percentage of disposable income Credit default swaps Real Gross Domestic Product and Genuine Progress Indicator per capita, USA Global fund management of conventional assets, 1999–2008 Shares of components of capital inflows to emerging market economies, 1999–2009 Estimate of market share of foreign institutional investors in emerging markets Growth of assets and leverage in the hedge fund industry, 1990–2008

81 83 134 181 184 184 191

TABLES 5.1 8.1 8.2 8.3 8.4 9.1

Composition of the American Recovery and Reinvestment Act The Washington Consensus The New Agenda The Amended Washington Consensus Main differences between the original Washington Consensus and its successors Global capital inflows to emerging market economies, 1997–2007

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97 155 157 161 164 183

Contributors Glen Atkinson is Foundation Professor Emeritus at the University of Nevada, Reno. He served as editor of the Journal of Economic Issues from 2000 to 2006, and as president of the Western Social Science Association, the Association for Institutional Thought, and the Association for Evolutionary Economics (AFEE). Atkinson received AFEE’s Veblen–Commons Award in 2010. He currently volunteers as director of the Center for Regional Studies at the University of Nevada, Reno. W. Robert Brazelton is Professor Emeritus at University of Missouri–Kansas City (UMKC). He was introduced to Institutional (Evolutionary) economics as a graduate student at the University of Oklahoma (after completing an undergraduate degree at Dartmouth College). At UMKC, he became interested in Post Keynesian analysis as a result of ongoing contact with Hyman Minsky and, later, Paul Davidson. He firmly believes that Institutional and Post Keynesian economics are compatible and has contributed much work pointing towards their integration. He also believes economics can learn much from sociology and psychology, especially as those fields have developed since the emergence in economics of the neoclassical synthesis. Fadhel Kaboub is Assistant Professor of Economics, Denison University, Granville, OH, and Research Associate at the Levy Economics Institute of Bard College, Annandale-on-Hudson, NY; the Center for Full Employment and Price Stability, Kansas City, MO; and the International Economic Policy Institute, Ontario, Canada. His research integrates the Post Keynesian and Institutionalist traditions and focuses on macroeconomics, monetary economics, and economic development, with a particular emphasis on job creation programmes. He has published in academic journals including the Journal of Economic Issues, Review of Social Economy, International Journal of Political Economy, and International Labour Review. From 2006 to 2008, he directed the Wall Street Semester Program at Drew University, Madison, NJ. Steven Kates is Senior Lecturer in the School of Economics, Finance and Marketing, Royal Melbourne Institute of Technology University, Melbourne, VIC, Australia. He spent most of his career working in the private sector as chief economist of Australia’s national employers’ association. His primary interest is the history of economic theory, especially the classical theory of the viii

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business cycle. His Free Market Economics: An Introduction for the General Reader (Edward Elgar, 2011) is about how market economies operate and interact with governments. Yan Liang is Assistant Professor of Economics at Willamette University, Salem, OR. She specializes in international trade, capital flows, and development with a focus on China and from a Post-Keynesian Institutionalist perspective. Her articles have appeared in International Journal of Political Economy, Journal of Economic Issues, The Chinese Economy, and China & World Economy. Before moving to the Pacific Northwest, she served on the faculty at University of Redlands, Redlands, CA, and Bard College at Simon’s Rock, Great Barrington, MA. John Marangos is Associate Professor of Political Economy in the Department of Economics, University of Crete, Greece. His research focuses on transition economics, international development, and innovative methods for teaching economics. He is editor of the Forum of Social Economics and section editor for the Global Business and Economic Review. Jan Toporowski is Reader in Economics and Chair of the Economics Department at the School of Oriental and African Studies, University of London, England. He has worked in fund management, international banking and central banking. He is author of Theories of Financial Disturbance (Edward Elgar, 2005) and co-editor, with Daniela Tavasci, of Minsky, Crisis and Development (Palgrave Macmillan, 2010). He is currently completing a book of essays on finance and financial economics, to be published by Anthem Press. Éric Tymoigne is Assistant Professor of Economics at Lewis and Clark College, Portland, OR, and Research Associate at the Levy Economics Institute of Bard College, Annandale-on-Hudson, NY. His areas of teaching and research include macroeconomics, money and banking, and monetary economics. He is the author of Central Banking, Asset Prices and Financial Fragility (Routledge, 2009) and has published articles on macroeconomics, financial reform, and the history of economic thought in edited books and in journals such as Journal of Post Keynesian Economics and Journal of Economic Issues. Charles J. Whalen is Principal Analyst in the Macroeconomic Analysis Division of the US Congressional Budget Office (CBO), Washington, DC. In 1986, he was the first recipient of the Wendell C. Gordon Doctoral Research Fellowship at The University of Texas at Austin and his doctoral research explored the compatibility of Institutional and Post Keynesian economics. Much of his career has involved work in academia, most recently as executive

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director (associate dean) of business and economics at Utica College, Utica, NY; he also served as associate economics editor at BusinessWeek as the dotcom boom unravelled. In the mid-1990s, he was a colleague of Hyman Minsky. David A. Zalewski is Professor of Finance in the School of Business at Providence College, Providence, RI. His research interests are in PostKeynesian Institutionalism, political economy, and economic history. His articles have appeared in the Journal of Economic Issues, Forum for Social Economics, The Journal of Economic History, Review of Business, and Essays in Economic and Business History.

Abbreviations AFEE AMH ARRA CBO CDO CDS ELR ELRA EME EMH FIH GDP IMF MMC NFIB OECD PKI PSE TARP TGT VTBC WC

Association for Evolutionary Economics adaptive marked hypothesis American Recovery and Reinvestment Act Congressional Budget Office collateralized debt obligation credit default swaps employer of last resort ELR authority emerging market economy efficient market hypothesis financial instability hypothesis gross domestic product International Monetary Fund money-manager capitalism National Federation of Independent Business Organisation for Economic Co-operation and Development Post-Keynesian Institutionalism public service employment Troubled Asset Relief Program The General Theory of Employment, Interest and Money Value Theory and Business Cycle Washington Consensus

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Preface In the mid-1980s, American economist Hyman Minsky wrote an article entitled ‘Global Consequences of Financial Deregulation.’ Minsky argued that deregulation and financial innovation – especially securitization – combined to make the global financial system more fragile, exposing the international economy to the possibility of a serious financial and economic crisis.1 When a securitization-fuelled crisis emerged in 2007 and 2008, Minsky’s ideas became popular almost overnight. But Minsky was not able to enjoy the notoriety or offer new insights, having succumbed to cancer a decade earlier. In his absence, many economists, Wall Street analysts and journalists have offered interpretations of Minsky’s economics and its relevance to recent events. Some of that new literature has been perceptive, but much of it has missed key points – and many commentators seem to have devoted little effort to actually reading Minsky’s books and articles.2 In contrast, nearly all the contributors to this volume have a long familiarity with Minsky’s economics and with the traditions of Institutional (or Evolutionary) and Post Keynesian economics that informed his thinking. Even before the global crisis, plans were underway for a book of essays outlining the enduring relevance of Minsky and integrating insights from those traditions. This book is the result of that collaboration. The extraordinary timeliness of this collection is, therefore, mostly unanticipated. The modest initial starting point was simply to outline the contours of a Post-Keynesian Institutionalism (PKI) as inspired in large part by Minsky. Nevertheless, the recent financial crisis and accompanying Great Recession highlight the need to rethink economics with an eye to analyzing economic instability and securing broadly shared prosperity in the United States and around the world. The crisis and severe recession also underscore the connection between the goals of this book’s contributors and the aims of John R. Commons and John Maynard Keynes, pioneers who laid the groundwork for PKI. Commons and Keynes were motivated by a desire to make economics relevant to understanding and preventing financial crises and deep cyclical downturns; the same is true for today’s Post-Keynesian Institutionalists. As indicated above, this book began a few years ago. By the fall of 2010, xii

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nearly all of it was finished, though there were still a few loose ends, and that is when I began a position as an economic analyst with the non-partisan, US Congressional Budget Office (CBO). However, this book is not a CBO product, and no CBO time was used to complete the volume. I finished it by devoting a few fall weekends to the task – and I thank my wife, Linda, for the support and understanding that made this possible. For the CBO to fulfil its obligation to Congress, it must not advocate policy – its mission begins and ends with a duty to provide analyses, information and estimates that are objective, timely and non-partisan. The views expressed in this volume are those of the authors and should not be interpreted as those of the CBO. Moreover, not even all of the collection’s authors agree entirely with each other, though there is, to be sure, wide agreement among contributors on many matters. Institutional economists actually have a long tradition of addressing unemployment and business fluctuations by providing analyses and outlining policy options without engaging in partisanship or policy advocacy. Institutionalist Wesley C. Mitchell helped found the National Bureau of Economic Research (NBER) and directed that organization in the 1920s when it participated in business cycles research in conjunction with a national committee led by Herbert Hoover, then Secretary of Commerce. According to Mitchell, the NBER confined itself strictly to fact finding: under its bylaws, he explained, the bureau ‘is prevented from making positive recommendations on any question of social policy, except the policy of basing actions on ascertained facts’.3 Moreover, this collection is not intended as the final word on PKI, and it certainly does not suggest that Post-Keynesian Institutionalists have either a definitive set of theories or a monopoly on innovative policy options. In addition to my wife, I wish to thank the contributors, not only for insightful chapters, but also for collegiality and valuable assistance throughout the project. Many of them have reviewed chapters, always offering useful suggestions. Additional readers of chapters in draft form include Ilene Grabel, Tom Kemp, Marc Lavoie, Joelle Leclair, Marty Wolfson, and Tim Wunder; I am grateful to each of them and also to the capable editors and staff at Edward Elgar Publishing, especially desk editor Bob Pickens, who gave careful attention to the volume. As this book made its way through the final stages of editing and pre-press production, challenges of financial instability and economic insecurity continued to make headline news at the local, national and international levels. Communities from coast to coast in the United States were laying off teachers, police officers and other public workers. The state of Minnesota shut down its government at the start of the Fourth of July holiday weekend due to a budget negotiations impasse. Public unions were under attack across the Northeast and Midwest. The US unemployment rate remained stuck at over 9 per cent

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and long-term unemployment reached unprecedented post-World War Two levels. US government officials were mired in a fiscal-policy stalemate as a debt-ceiling deadline loomed. And in Europe, Greek citizens took to the streets to protest austerity measures designed to stave off a national debt crisis that had the potential to trigger yet another global financial crisis. Unquestionably, there is much work to do. To all who wish to further explore these issues: Welcome aboard! Charles J. Whalen

NOTES 1.

See Hyman P. Minsky (1986), ‘Global consequences of financial deregulation’, The Marcus Wallenberg Papers on International Finance, 2 (1), 1–19. 2. See Charles J. Whalen (2010), ‘Minsky goes to Buffalo – and takes on the economics establishment’, Forum for Social Economics, 40 (2), 273–80. 3. See Wesley C. Mitchell (1923), ‘Unemployment and business fluctuations’, American Labor Legislation Review, 13 (1), 15–22.

In memory of Hy Minsky, who taught us the value of standing on the shoulders of giants when viewing the economic landscape and upon whose shoulders we now stand

Introduction: instability, prosperity and economics after the Great Recession Charles J. Whalen The recent global financial crisis was a devastating event. It was costly in economic and human terms, and it exposed fundamental weaknesses in conventional economics. This book responds by offering a fresh approach to economic theory and policy.

CRUSHED STOCKS, BROKEN DREAMS, AND USELESS THEORIES On 28 September 2008, a lingering credit crunch was transformed into a worldwide crisis. The value of corporate stocks tumbled on Wall Street, and investors watched helplessly as US$1.2 trillion in market value evaporated. The Dow Jones industrial average suffered its largest single-day point loss ever, and the Standard and Poor’s 500 index plummeted nearly 9 per cent (Twin, 2009). The losses spread quickly to other financial centres around the globe, and a CNN.com headline told the story in two words: ‘Stocks Crushed’. The financial losses associated with the crunch and subsequent crisis were staggering. The US stock market lost more than half its value between October 2007 and March 2009. And the Russell 3000 index was still 20 per cent below its October 2007 peak as recently as mid-November 2010.1 The crisis led to a Great Recession that reduced the value of household financial-market investments by as much as $10 trillion.2 It also produced trillions in losses from loan and debt-securities write-downs as well as falling housing prices, which helped raise mortgage foreclosures to record levels. The output and employment costs of the crisis have also been huge. Real gross domestic product (GDP) in the US did not expand in 2008, and fell 2.6 per cent in 2009, the year overall world economic output fell for the first time since the Great Depression (from peak to trough, real US GDP fell 4.1 per cent, the largest decline among post-war US recessions). The unemployment rate reached double digits in the US and many other countries, while large 1

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Financial instability and economic security after the Great Recession

numbers of those still employed saw their work hours cut. The US unemployment rate averaged 9.6 per cent in 2010, despite both falling labour-force participation (the result of discouraged jobseekers leaving the labour market) and an economic ‘recovery’ that began in mid-2009. The most troubling part of all this is the human impact. The stock market decline and related financial losses eroded individual and family well-being, forcing countless households to lower their short-term expectations and reassess their longer-term aspirations. The explosion in foreclosures distressed communities, traumatized families, and shattered lifelong dreams.3 Persistent macroeconomic stagnation and a high jobless rate continue to diminish economic opportunity and thwart the pursuit of self-reliance and personal responsibility (see, for example, Peck, 2010). Meanwhile, most of the economics profession had no idea a crisis was brewing until the economic storm arrived at full force. Using the dominant theories of the pre-crisis era, economists were simply unable to anticipate, analyze and address the problem. ‘It’s not just that they missed it; they positively denied it would happen’, says professor of finance Franklin Allen (Knowledge@Wharton, 2009; see also Krugman, 2009a).4

POST-KEYNESIAN INSTITUTIONALISM The alternative economic perspective offered by this book is Post-Keynesian Institutionalism (PKI). That approach builds on key insights offered by two overlapping traditions in economic thought: the Institutional school and Post Keynesianism. For the PKI movement, the writings of Hyman P. Minsky (1919–96) provide a valuable guide to contemporary theory and policy. The Institutional school of economics – a tradition also called Evolutionary economics – originated in the US in the early twentieth century. Major early contributors included Thorstein Veblen (1857–1929) and John R. Commons (1862–1945). Veblen stressed the dynamic nature of the economic system and the central role that institutional adjustment plays in coordinating economic activity. He also developed a theory of business cycles that emphasizes fluctuations in profit expectations, business capitalization, and confidence. Commons appreciated the economics profession’s attention to theory building, but sought to orient that work towards the analysis and resolution of practical problems. He also shared Veblen’s interest in business cycles: Commons was a labour economist who concluded that business cycles and unemployment were the most important of all labour problems.5 Post Keynesian economics emerged in the UK and US in the 1970s as a response to the worsening problem of stagflation (inflation and high unemployment) and to the profession’s movement away from the core insights of John

Introduction

3

Maynard Keynes (1883–1946). Joan Robinson – Keynes’s colleague at Cambridge University – was a central figure in the Post Keynesian camp in the UK, while Sidney Weintraub and Paul Davidson founded the Journal of Post Keynesian Economics and emerged as pioneering US Post Keynesians. The Post Keynesians departed from their mainstream colleagues by stressing the importance of uncertainty as a starting point for economic analysis and by emphasizing important interdependencies between money supply and money demand. From the outset, Institutionalists and Post Keynesians recognized they had much in common – and a number of economists felt at home in both camps. This group included Wallace C. Peterson (1977), who used a 1976 address before the Association for Evolutionary Economics to focus on how Institutionalism and the economics of Keynes can be viewed as ‘two trains on parallel tracks toward a common destination’. The group also included Charles K. Wilber and Kenneth P. Jameson (1983), who responded to the dominant economic theories and policies of the early 1980s by composing the first book to outline a synthesis called PKI – An Inquiry into the Poverty of Economics.6 Unfortunately, much of Wilber and Jameson’s book was so closely tied to the immediate problem of stagflation that the volume and its important insights on PKI were largely overlooked once high inflation abated (Whalen, 2008a: 47–49). Instead of concentrating on the phenomenon of stagflation, PKI needed a more dynamic focus. And that is precisely what Institutionalists and Post Keynesians found in the work of Minsky.7 At the heart of Minsky’s research agenda was the study of financial-system evolution and its impact on business cycles and capitalist development. He considered himself a ‘financial Keynesian’, yet also maintained that monetary economics ‘cannot escape being Institutional economics’ (Minsky, 1982: 280). Today, Minsky is best known for the financial-instability hypothesis, which argues that financial systems evolve endogenously from being robust to fragile; this evolution makes the overall economy susceptible to financial crises and deep recessions.8 In the 1990s, Minsky directed much of his attention to what he called ‘money-manager capitalism’. It emerged in the 1980s as the latest phase of US capitalist development, an era characterized by the economic dominance of institutional investors preoccupied with short-term goals (Minsky, 1993). Minsky argued that money-manager capitalism fuels worker insecurity, income inequality, and economic instability (Minsky, 1996).9 When the credit crunch hit global markets in 2007, the economics of Minsky – who had by then been dead for more than a decade – became fashionable almost overnight. And attention to Minsky increased as the economic situation deteriorated. Financial analysts peppered their reports with his insights; journalists wrote features on his ideas; and prominent economists discussed his contributions in major addressses.10 However, most commentators gave his

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work a superficial treatment and it appears few of them took time to read much of what Minsky wrote. In contrast, nearly all contributors to this volume have a long and deep association with the economics of Minsky as well as with the broader literature on Institutionalism and Post Keynesianism. They understand that Minsky’s works contain a compelling critique of conventional economics, a penetrating look at economic life, and a starting point for broader policy options than those offered by most economists. They also believe it is hard to look back on the recent crisis without pausing to regret that economics did not gravitate to Minsky’s ideas much sooner.11

OVERVIEW This volume is organized as follows. Part I explores the foundations of PKI. Part II focuses on the US economy. Part III extends PKI to the world economy. Part IV closes the book with the contributors’ thoughts on the future of PKI. Foundations Steven Kates (Chapter 1) begins Part I by demonstrating that Commons’s Institutional economics provided Keynes with insights that serve as the basis for The General Theory of Employment, Interest and Money. To the existing evidence connecting Keynes and Commons, Kates adds a vital and previously ignored link: Harlan L. McCracken, a student of Commons. Kates demonstrates that McCracken shared with Keynes what he learned from Commons, and that Keynes then applied McCracken’s reasoning to attack Say’s Law. W. Robert Brazelton and Charles J. Whalen (Chapter 2) bring the discussion of foundations forward by identifying key elements of Institutional economics and showing how those ideas manifest themselves in the more recent Post Keynesian tradition, which rests heavily on insights contained in The General Theory. They also look across traditional disciplinary boundaries to identify valuable socio-economic insights in psychology and sociology. Their chapter closes by combining insights from all the traditions examined and suggesting some essential features of PKI. Glen Atkinson and Whalen (Chapter 3) wrap up the exploration of foundations by probing the origin and development of Common’s notion of futurity, which they identify as a cornerstone of PKI. Their chapter dovetails with that of Kates because futurity – which indicates expectations and anticipation – is at the heart of what McCracken shared with Keynes. It also complements the Brazelton and Whalen essay by examining the role futurity can and should play in the further evolution of economic theory.

Introduction

5

The American Economy Fadhel Kaboub (Chapter 4) opens Part II by building on the earlier chapters to explain and address the economic instability observed in the US. The result is an analysis that rests on Minsky’s financial-instability hypothesis – with its emphasis on the volatility of finance and investment – but adds consumption and inequality to the conceptual framework. Kaboub’s chapter highlights publicservice employment (which was central to Minsky’s conception of government as ‘employer of last resort’) as a policy option capable of contributing simultaneously to economic stabilization and the pursuit of full employment.12 David Zalewski and Whalen (Chapter 5) also extend the work of Minsky. Their chapter brings attention to a major predicament confronting states and localities during slumps: balanced-budget rules force those governments to exacerbate downturns by eliminating jobs and cutting public spending when tax revenues fall. Drawing on the notion of subsidiarity, that chapter introduces a new policy option: a federal/state policy partnership designed to promote more rapid recovery from future recessions. Éric Tymoigne (Chapter 6) rounds out Part II by focusing on financial regulation from the standpoint of PKI. He begins by surveying the foundations of the current regulatory system. Then he critically assesses the widely held belief that improving capital and liquidity requirements would solve our financial instability problems. He concludes by outlining an alternative approach to financial regulation: a balance-sheet framework aimed at detecting (indeed, even preventing) what Minsky called Ponzi finance. The Global Economy Jan Toporowski (Chapter 7) begins Part III by extending Tymoigne’s emphasis on balance sheets to examine bank regulation in the international arena. Like Tymoigne, Toporowski begins by critically appraising the conventional wisdom in financial economics and its focus on bank capital adequacy. Then he outlines an alternative: a banking system in which contingent lending commitments to governments are an essential part of cross-border lending. Such a system is designed to reduce global financial fragility and foster emergence of an international lender of last resort. John Marangos and Whalen (Chapter 8) continue the international focus by reviewing the evolution of the ‘Washington Consensus’ on international economic development policy. The authors explain and compare three incarnations of the Washington Consensus, highlighting key shortcomings of their common foundations. They also discuss elements of an alternative approach to development economics. The chapter stresses that applying PKI to international development requires attention to social goals, time, context, power, and participation.

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Yan Liang (Chapter 9) brings Part III to a close with a chapter rooted in an appreciation of the elements mentioned by Marangos and Whalen. Liang examines the rise of money-manager capitalism as well as the flow of capital from countries where that system prevails and into emerging market economies (EMEs). She also explores the impact of those flows on financial development, market volatility and macroeconomic discipline in EMEs. What emerges is a critique of conventional economic theory and policy on capital flows and development, a critique that points to closer regulatory scrutiny of global money managers.

THEMES Three themes emerge in this book: analyzing economic instability, securing broadly shared prosperity, and rethinking economics. Analyzing economic instability has been at the heart of both Institutionalism and Post Keynesian economics from their inception; the same is true of PKI. According to PKI, business cycles are an inherent feature of advanced capitalist economies, and financial institutions play a key role in generating these cycles. The emphasis on fluctuations and finance is evident in this book’s sections devoted to the US and the global economy, but that emphasis is also reflected in the foundations section. Trace finance and cycles to their roots, and what do we find? Futurity. Pairing the concept of futurity with the reality that the future is largely uncertain forms a foundation for Institutionalism, the economics of Keynes, Post Keynesianism, and contemporary PKI. Commons (1921: 268) wrote that modern capitalism rests on the credit system ‘and the credit system is nothing but confidence in the future’. Keynes (1937: 221) looked at the same matter from a different angle and placed changes in our views of the future – changes in ‘the state of confidence’ – at the centre of his theory of output and employment. PKI proceeds from the same starting point.13 Securing prosperity is also at the heart of PKI and its antecedent traditions. The prosperity these economists envision extends beyond rapid GDP growth. It is a widely shared prosperity of high employment, rising standards of living, and even meaningful work. This perspective on prosperity is evident in the writings of both Commons and Keynes. They shared the goal of seeking to resuscitate and revitalize capitalism by (as Commons wrote) ‘making it good’. To that end, they wanted to influence the path of economic activity by using government as a creative and constructive force, but they also shared an abiding faith in markets and placed a high value on individual freedom (Whalen, 2008a: 44–46). The same aims and values can be found in Minsky (1986), and in PKI.

Introduction

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Moreover, PKI stresses that broadly shared prosperity is a meaningful goal across the globe, not just within the most advanced industrial economies. Rethinking economics, meanwhile, is not merely a theme in this volume; it is also its most immediate aim. Like Veblen, Commons, and Keynes, contributors to this volume strive to move beyond the outmoded theories of the past. Their goal is to shed fresh light on how our contemporary economy operates and to provide a foundation for more constructive thinking about public policy. Rethinking economics requires not only critical appraisal of the conventional wisdom, but also innovative reconstruction; readers will find some of both in each section of this book.

ROOM FOR FRUITFUL DISCOURSE The value of an alternative economic perspective is determined by whether it can address the central challenges of contemporary theory and policy. This book’s contributors meet the theory test by offering precisely what Nobel laureate Paul Krugman (2009a) argues economics needs most: scholarship that questions the efficient-market view of the financial sector and that strives to incorporate the realities of finance into macroeconomics. They also meet the policy test by responding with constructive analyses and policy options relevant to the still lingering effects of the Great Recession and the possibility of yet another financial crisis. In addition, there is another reason to have confidence in the value of PKI. Mounting evidence indicates that the mainstream of economics is moving more and more in its direction. Minsky believed it was necessary to move the discipline by communicating with its leading practitioners. That is why he devoted attention to Thomas J. Sargent’s Bounded Rationality in Macroeconomics in an address delivered less than a year before his death in 1996. Minsky (1996) argued that although Sargent was part of the New Classical tradition in macroeconomics, which developed as an alternative to Keynesianism, room for a ‘fruitful discourse’ between the followers of Keynes and the New Classical economists emerged as a result of Sargent’s adherence to the notion of bounded rationality. According to Minsky, bounded rationality introduced recognition of uncertainty, and uncertainty brought with it the importance of history, expectations and learning over time. To be sure, there was still a wide divide between most of the economics of Minsky and the economics of Sargent, but the appearance of bounded rationality in Sargent’s research meant there was also common ground. Since publication of Sargent’s book in 1993, there has been more mainstream movement in the direction of PKI. At the end of that same year, for example, Douglass North (1994) received the Nobel Memorial Prize in

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Economics and used the occasion to stress that standard economics erroneously assumes institutions and time do not matter. The result, he argued, is a theory that says nothing about economic performance through time: ‘Neoclassical theory is simply an inappropriate tool to analyze and prescribe policies that will induce development. It is concerned with the operation of markets, not with how markets develop’. To understand how markets evolve, he argued, economists must understand how choices are made ‘under conditions of uncertainty’ and how human learning shapes institutions. Another example of movement in the direction of PKI is found in the work of Joseph E. Stiglitz (2002). His 2001 Nobel lecture focused on the pervasiveness of information imperfections in the real world and on how they undermine the notion that a market economy can be left to operate by an ‘invisible hand’. Stiglitz shared the Nobel award with two other economists who also contributed to the economics of information, including George Akerlof, whose work receives some attention in Chapter 2 of this volume. Embedded in their attention to information imperfections and asymmetries is the same element that Minsky highlighted in Sargent’s work: uncertainty. An even more recent example of movement toward PKI is provided by Akerlof’s 2009 book, co-authored with Robert J. Shiller: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Their notion of animal spirits is borrowed from Keynes, and in both The General Theory and Animal Spirits that term refers explicitly to how humans make decisions and respond to events in a world of uncertainty (Akerlof and Shiller, 2009: 3–4). In the preface to Animal Spirits, the authors explain that their book ‘draws on an emerging field called behavioral economics’ as well as on inspiration from Keynes. But before mentioning either of those influences, the authors cite another: Minsky. Noting that Minsky’s work sought to avoid a repeat of the Great Depression, they write, in a footnote to the preface’s opening paragraph: ‘He, like us, was especially concerned with the psychology of speculative bubbles. Our line of thinking in this book parallels that of Minsky’. Of course, important differences still separate PKI from the economics of Sargent, North, Stiglitz, Akerlof, and Shiller.14 Nevertheless, room for fruitful discourse with such economists is clearly growing. And seeking to engage in such discourse is an important part of the ongoing PKI research agenda (see Chapter 10).

CONCLUSION: TOWARDS A BETTER ECONOMICS – AND A BETTER WORLD Institutionalists and Post Keynesians have often maintained that the ultimate purpose of economics is to make the world a better place in which to live. The

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9

same spirit can be found in PKI, whose adherents also believe in the need to advance economics. The authors of the chapters that follow strive to move towards a better economics, motivated by the hope that it will open up policy options and elevate academic and public discourse in a way that helps move us in the direction of that better world.

NOTES 1. 2. 3. 4.

5.

6.

7.

8. 9. 10. 11.

This chapter was prepared in mid-November 2010 (portions were later updated in January 2011). The estimate of $10 trillion in losses, arrived at by a number of financial economists, includes household investment in corporate equities and related mutual fund shares, as well as equity in non-corporate business and in life insurance and pension fund reserves. The foreclosure crisis continues even as this book goes to print. As Paul Krugman (2009b) stated in a lecture at the London School of Economics: ‘Most of what [mainstream economists] have done in macroeconomics for the past 30 or so years has turned out to be spectacularly useless at best, and positively harmful in some cases’. For a more recent critical look at macroeconomics, see Caballero (2010). It is interesting to note that a student of Veblen – Wesley C. Mitchell – created the National Bureau of Economic Research, recognized today as the authoritative voice on US business cycle dating, and that Commons served as associate director of the organization for most of its first decade. Indeed, Mitchell was also an Institutional economist and could easily be included along with Veblen and Commons as major Institutionalist pioneers, especially with respect to the analysis of cycles. According to Warren J. Samuels and Steven G. Medema (1990: 147), Gardiner C. Means (1896–1988) was both an Institutionalist and perhaps the first Post Keynesian. Their viewpoint underscores Peterson’s argument that Institutionalism and the economics of Keynes have always been headed in the same direction. Alfred S. Eichner (1985; 1991) also appreciated the need for a reconstruction of economics that centred the economy as a dynamic system, and he explicitly sought to integrate Institutionalist and Post Keynesian ideas toward that end (see also Arestis and Eichner, 1988). But his untimely death brought that work to a premature end in early 1988 (though much of his work in the microeconomic realm has been ably carried forward by Frederic S. Lee, a former student; see, for example Lee, 1994). More recently, Cornwall and Cornwall (2001) explored what they call Evolutionary Keynesianism, drawing in part on Institutionalism and Keynesianism, and Niggle (2006) outlined common elements within Institutionalism and Post Keynesianism, showing how they differ from what he calls postmonetarist New Consensus macroeconomics (a synthesis of New Keynesian Economics and New Endogenous Growth Theory). Drawing on Minsky’s financial instability hypothesis in the 1980s and 1990s, a number of economists generated important and often prescient analyses. For example, see Carter (1989), Wray (1990), and McClintock (1996). Minsky was right about money-manager capitalism in relation to insecurity, inequality, and instability; for example, see Whalen (2008b), Wray (2009), and Zalewski and Whalen (2010). See, for example, Magnus (2007), McCulley (2008), Lahart (2007), Cassidy (2008), Mihm (2009), Yellen (2009), and Krugman (2009b). The perspective of contributor Steven Kates differs from that of this volume’s other contributors, but there is still important common ground, especially a shared appreciation of money and uncertainty as fundamental elements in economics. Kates, a historian of economic thought, maintains that classical economics contains a long-overlooked theory of business cycles in which downturns are accompanied by high levels of involuntary unemployment

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(see Kates, 1998; and Kates, 2011). Kates’s viewpoint bears a resemblance to that of Joseph Schumpeter, who supervised Minsky’s Ph.D. thesis until his death in 1950 and whose influence is unmistakable in the economics of Minsky. 12. Prior to the Great Recession, the last time public-service employment (PSE) was tried on a large scale in the US was the 1970s. For an assessment of that experience see Briggs (1981), who concludes that PSE was ‘an effective instrument of fiscal policy’. And for a more recent, supportive discussion of direct job creation from an unlikely source, see Thompson (2010). 13. Economic journalist Peter Coy (2010) underscores the central role of futurity in modern economic life in a recent Bloomberg BusinessWeek commentary. Examining the confusion over mortgage documentation that led some banks to suspend foreclosures, Coy writes that this was not merely a clerical problem; rather, it was a matter that ‘erodes certainty about property rights – the key to capitalism’. At bottom, capitalism rests on futurity. 14. For an essay that contrasts the view of financial crises found in this volume with the perspective of economists such as Shiller, Akerlof, and Stiglitz, see Tymoigne (2010).

REFERENCES Akerlof, George A. and Robert J. Shiller (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton, NJ: Princeton University Press. Arestis, Peter and Alfred S. Eichner (1988), ‘The post Keynesian and institutionalist theory of money and credit’, Journal of Economic Issues, 22 (4), 1003–21. Briggs, Vernon M. (1981), ‘The revival of job creation programs in the 1970s: lessons for the 1980s’, in Barbara Dennis (ed.), Proceedings of the Thirty-Fourth Annual Meeting, Madison, WI: Industrial Relations Research Association, pp. 258–65. Caballero, Ricardo J. (2010), ‘Macroeconomics after the crisis: time to deal with the pretense-of-knowledge syndrome’, Journal of Economic Perspectives, 24 (4), 85–102. Carter, Michael (1989), ‘Financial innovation and financial fragility’, Journal of Economic Issues, 23 (3), 779–93. Cassidy, John (2008), ‘The Minsky moment’, The New Yorker, 4 February, accessed 25 November 2010 at www.newyorker.com/talk/comment/2008/02/04/080204taco_ talk_cassidy. Commons, John R. (1921), Industrial Government, New York: Macmillan. Cornwall, John and Wendy Cornwall (2001), Capitalist Development in the Twentieth Century: An Evolutionary-Keynesian Analysis, Cambridge: Cambridge University Press. Coy, Peter (2010), ‘Mortgages lost in the clouds’, Bloomberg BusinessWeek, 14 October, accessed 25 November at www.businessweek.com/magazine/content/ 10_43/b4200009860564.htm. Eichner, Alfred S. (1985), Toward a New Economics Essays in Post-Keynesian and Institutionalist Theory, Armonk, NY: M.E. Sharpe. Eichner, Alfred S. (1991), The Macrodynamics of Advanced Market Economies, Armonk, NY: M.E. Sharpe. Kates, Steven (1998), Say’s Law and the Keynesian Revolution: How Macroeconomics Lost its Way, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Kates, Steven (2011), Free Market Economics: An Introduction for the General Reader, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Keynes, John Maynard (1937), ‘The general theory of employment’, The Quarterly Journal of Economics, 51 (February), 209–23. Knowledge@Wharton (2009), ‘Why economists failed to predict the financial crisis’,

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27 May, accessed 25 November 2010 at www.knowledgeatwharton.com.cn/ index. cfm?fa=viewfeature&l=4&articleid=2041&&&languageid=1. Krugman, Paul (2009a), ‘How did economists get it so wrong?’, The New York Times, 2 September, accessed 25 November 2010 at www.nytimes.com/2009/09/06/ magazine/06Economic-t.html. Krugman, Paul (2009b), ‘The night they re-read Minsky’, 2009 Lionel Robbins Lecture III, London School of Economics, 10 June, accessed 25 November 2010 at http://cep.lse.ac.uk/_new/interviews/default.asp. Lahart, Justin (2007), ‘In time of tumult, obscure economist gains currency’, The Wall Street Journal, 18 August, accessed 25 November 2010 at http://online.wsj.com/ article/SB118736585456901047.html. Magnus, George (2007), ‘The credit cycle and liquidity: have we arrived at a Minsky moment?’, UBS Research, March. McClintock, Brent (1996), ‘International financial instability and the financial derivatives market’, Journal of Economic Issues, 30 (1), 13–33. McCulley, Paul (2008), ‘In the fullness of time’, Global Central Bank Focus, PIMCO, September, accessed 25 November 2010 at www.pimco.com/Pages/Global%20 Central%20Bank%20Focus%20McCulley%20Sept%202008%20In%20the%20Ful lness%20of%20Time.aspx. Mihm, Stephen (2009), ‘Why capitalism fails’, The Boston Globe, 13 September, accessed 25 November 2010 at www.boston.com/bostonglobe/ideas/articles/ 2009/09/13/why_capitalism_fails. Minsky, Hyman P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Minsky, Hyman P. (1993), ‘Schumpeter and finance’, in Salvatore Biasco, Alessandro Roncaglia, and Michele Salvati (eds), Market and Institutions in Economic Development: Essays in Honor of Paulo Sylos Labini, New York: St. Martin’s Press, pp. 103–16. Minsky, Hyman P. (1996), ‘Uncertainty and the institutional structure of capitalist economies’, Journal of Economic Issues, 30 (2), 357–68. Niggle, Chris (2006), ‘Institutionalist-post Keynesian economics and the post monetarist new consensus’, in Mark Setterfield (ed.), Complexity, Endogenous Money and Macroeconomic Theory: Essays in Honor of Basil Moore, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 368–88. North, Douglass (1994), ‘Economic performance through time’, American Economic Review, 84 (3), 359–68. Peck, Don (2010), ‘How a new jobless era will transform America’, The Atlantic Monthly, accessed 25 November at www.theatlantic.com/magazine/archive/ 2010/03/how-a-new-jobless-era-will-transform-america/7919/. Peterson, Wallace C. (1977), ‘Institutionalism, Keynes, and the real world’, Journal of Economic Issues, 11 (2), 201–21. Samuels, Warren J. and Steven G. Medema (1990), Gardiner C. Means: Institutionalist and Post-Keynesian, Armonk, NY: M.E. Sharpe. Stiglitz, Joseph E. (2002), ‘Information and the change in the paradigm in economics’, American Economic Review, 92 (3), 464–501. Thompson, Derek (2010), ‘Conservative economist: “find the unemployed and hire them”’, The Atlantic.com, accessed 26 November 2010 at www.theatlantic.com/ business/archive/2010/08/conservative-economist-find-the-unemployed-and-hirethem/62100/. Twin, Alexandra (2008), ‘Stocks crushed’, CNNMoney.com, 29 September, accessed

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25 November 2010 at http://money.cnn.com/2008/09/29/markets/markets_ newyork/index.htm. Tymoigne, Éric (2010), ‘Evolutionary views and imperfection views of financial crises’, Department of Economics, Lewis and Clark College, October. Whalen, Charles J. (2008a), ‘Toward “wisely managed” capitalism: post-Keynesian institutionalism and the creative state’, Forum for Social Economics, 37 (1), 43–60. Whalen, Charles J. (2008b), ‘Post-Keynesian institutionalism and the anxious society’, in Sandra S. Batie and Nicholas Mercuro (eds), Alternative Economic Structures: Evolution and Impact, London: Routledge, pp. 293–9. Wilber, Charles K. and Kenneth P. Jameson (1983), An Inquiry into the Poverty of Economics, Notre Dame, IN: University of Notre Dame Press. Wray, L. Randall (2009), ‘The rise and fall of money manager capitalism: a Minskian perspective’, Cambridge Journal of Economics, 33 (4), 807–28. Wray, L. Randall (1990), Money and Credit in Advanced Capitalist Economies, Cheltenham, UK and Brookfield, VT, USA: Edward Elgar. Yellen, Janet L. (2009), ‘A Minsky meltdown: lessons for central bankers’, Federal Reserve Bank of San Francisco Economic Letter, 2009–15, 1 May. Zalewski, David A. and Charles J. Whalen (2010), ‘Financialization and income inequality: a post Keynesian institutionalist analysis’, Journal of Economic Issues, 47 (3), 757–78.

PART I

Foundations

1. Subverting Say’s Law: Harlan McCracken and the Commons-Keynes connection Steven Kates INTRODUCTION Harlan Linneus McCracken (1889–1961) is possibly the least known economist of the twentieth century relative to his level of influence. McCracken’s Value Theory and Business Cycles (VTBC) – based on his doctoral thesis, written under the supervision of John R. Commons at the University of Wisconsin – may have been the largest single influence on John Maynard Keynes in the mid-1930s as he wrote The General Theory of Employment, Interest, and Money (TGT). In particular, it provided Keynes with the direction he took in attacking Say’s Law. This chapter argues that TGT owes its orientation to work undertaken by McCracken and important elements of TGT were likely derived from Keynes’s study of Commons’s writings. After laying the groundwork by reviewing the notion of Say’s Law and the aim of TGT, this chapter traces the connection between McCracken and Keynes as well as the relationship of Commons and McCracken. It also discusses the direct influence of Commons on Keynes. The purpose is to show the importance of Commons, and thus Institutional economics, in shaping Keynes’s thinking.

SAY’S LAW BEFORE THE GENERAL THEORY The theory of the business cycle, it need hardly be pointed out, was not invented by Keynes. In fact, by the 1930s, the theory of the cycle had been developing for more than a century. Indeed, ‘business cycle theory’ was actually many theories coming in a wide variety of types. There was no one school that dominated and no single theory that could have been designated as ‘the’ theory (Haberler, 1938). In the business cycle literature, no consensus existed on the causes of the cycle or their dynamics, but on one matter there was near unanimous agreement 15

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among mainstream economists: whatever might cause a recession to occur, it would never be because of a deficiency of demand. In TGT, Keynes describes this point of unity in terms of what he called Say’s Law. Keynes (1978a: 26) writes: In the previous chapter, we have given a definition of full employment in terms of the behaviour of labour. An alternative, though equivalent, criterion is that at which we have now arrived, namely a situation in which aggregate employment is inelastic in response to an increase in the effective demand for its output. Thus, Say’s Law, that the aggregate demand price of output as a whole is equal to its aggregate supply price for all volumes of output, is equivalent to the proposition that there is no obstacle to full employment. If, however, this is not the true law relating to the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.1

Although Keynes explained that Say’s Law indicates there is ‘no obstacle to full employment’, one does not have to reject Say’s Law to advocate increased public spending during recessions. Such proposals had been a staple among economists going a long way back into the nineteenth century. One of the palliatives for an economic downturn was infrastructure expenditure on projects kept in store for just such a contingency. The Law of Markets Thus, economics entered the twentieth century with a practical recommendation to assist the unemployed, but also with a body of theory indicating that demand deficiency – that is, overproduction or a general glut – could not be a cause of recessionary conditions.2 Despite having been embedded within economic theory for more than a century, there had been no specific name for this principle until the early 1920s. It was then that American economist Fred Taylor gave this notion the name it has kept to this day. In the 1920s, in publishing what was nothing more than an introductory text in economics, Taylor (1925: 196) wrote: Among the fallacious notions in popular thinking that have gained very wide currency are to be found a number which grew out of misconceptions as to the real source of the general or total demand for goods, and as to the methods by which that demand is increased or diminished. Several types of these fallacious notions may be cited. Thus, governmental improvements of all kinds, including even those of questionable value, are often supported by business men and others on the ground that such improvements increase the total demand for goods.

Taylor (1925: 201) continues with a sentence that is extremely ironic in light of the Keynesian revolution that would soon follow: ‘The points just

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brought out with respect to the relation between demand and the output of goods are so evident that some will consider it scarcely legitimate to give them the dignity derived from formal statement’. Yet, as apparent as this demand-issupply relationship might have seemed to Taylor and his contemporaries, he provided it with a name as the following passage makes clear: The continued prevalence throughout the larger part of the community of the fallacious notions which these considerations are designed to correct seems to furnish ample ground for any procedure which gives these points adequate emphasis. I shall therefore put the proposition we have discussed in the form of a principle. This principle, I have taken the liberty to designate Say’s Law; because, though recognized by many earlier writers, it was particularly well brought out in the presentation of [Jean-Baptist] Say. (Taylor, 1925: 201, emphasis added)

This is the origin of the term ‘Say’s Law’, though not the origin of the concept itself, which stretched back to the start of the nineteenth century if not before. It was a notion designed to remind economists that, so far as the aggregate economy was concerned, demand is supply. Keynes and Malthus During the decade prior to publication of TGT, discussions employing the term ‘Say’s Law’ were confined to the American side of the Atlantic. In the early 1930s, however, Keynes reached the conclusion that recessions were due to a deficiency of demand. He found his inspiration in Thomas Robert Malthus, whose correspondence with David Ricardo was unearthed by Piero Sraffa in 1930.3 While historians of economic thought have overlooked the impact of Malthus’s letters on Keynesian thought, the connection is well-nigh incontrovertible. Before commencing work on TGT, Keynes had on no previous occasion argued that demand deficiency was an important element in explaining recessions. Then, in late 1932 – the year he began TGT – Keynes read Malthus’s letters to Ricardo dealing with demand deficiency while writing an essay on Malthus for inclusion in his Essays in Biography (1978b). For Keynes, this was the moment when it all fell into place. His excitement is unmistakable in the Malthus essay, which was published at the start of 1933: ‘One cannot arise from a perusal of this correspondence’, Keynes wrote, ‘without a feeling that the almost total obliteration of Malthus’s line of approach and the complete domination of Ricardo’s for a period of a hundred years has been a disaster to the progress of economics’ (Keynes, 1978b: 98). Keynes found in Malthus the organizing principle for which he had been searching in trying to convince others of the important role public spending could play in bringing recessions to an end.

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THE GENERAL THEORY AND HARLAN MCCRACKEN In the 1920s, McCracken had undertaken graduate work at the University of Wisconsin, where Commons served as his dissertation advisor. A decade later, in 1933, his reworked thesis was published as VTBC (McCracken, 1933), and a copy was sent almost immediately to Keynes, just as the essay on Malthus was being published. The General Theory To appreciate the significance of the impact McCracken and Commons had upon Keynes, it is important to understand the role that the contrast between Ricardo and Malthus plays in TGT. The direction of the TGT is spelled out initially in Keynes’s brief opening chapter. In its second sentence, Keynes (1978a: 3) attempts to justify calling his theory the general theory: ‘The object of such a title is to contrast the character of my arguments and conclusions with those of the classical theory of the subject’. Keynes argues that the economists with whom he is to contrast his arguments are the classical economists, followers of Ricardo. This is spelled out in a footnote: ‘The classical economists’ was a name invented by Marx to cover Ricardo and James Mill and their predecessors, that is to say for the founders of the theory which culminated in the Ricardian economics. I have become accustomed, perhaps perpetrating a solecism, to include in ‘the classical school’ the followers of Ricardo, those, that is to say, who adopted and perfected the theory of the Ricardian economics, including (for example) J.S. Mill, Marshall, Edgeworth and Prof. Pigou. (Keynes, 1978a: 3, n. 1)

In other words, Keynes argues that the economists of his day had been adopting and perfecting an approach to economic theory laid out by Ricardo, whose On the Principles of Political Economy and Taxation had been published in 1817. The second passage in TGT that sets the direction for the rest of the work is a discussion of the contrasting views of Ricardo and Malthus. Keynes writes: The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the

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Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. But controversy ceased; the other point of view completely disappeared; it ceased to be discussed. The great puzzle of Effective Demand with which Malthus had wrestled vanished from economic literature. You will not find it mentioned even once in the whole works of Marshall, Edgeworth and Professor Pigou, from whose hands the classical theory has received its most mature embodiment. It could only live on furtively, below the surface, in the underworlds of Karl Marx, Silvio Gesell or Major Douglas. (Keynes, 1978a: 32)

The task Keynes set himself was to rid economic theory of what he saw as the false ideas that descended from Ricardo and to replace them with what he saw as the more accurate perspective presented by Malthus. The Keynesian revolution was to be a rerun of the general glut debates of the 1820s, but this time it was Keynes’s intention to see Malthus’s views prevail. But why did Keynes cast his revolution in this manner? To be sure, his reading of Malthus was crucial, yet that contained only the germ of an idea. Its development was driven forward by exposure to the ideas of McCracken and Commons. Value Theory and Business Cycles McCracken’s VTBC focuses on the contrasting views of Ricardo and Malthus. According to McCracken, if one begins from the position taken by Ricardo – which McCracken referred to as ‘embodied value’ theory – it is impossible to generate cyclical economic fluctuations. In his introduction, McCracken (1933: v) writes: The analysis [of VTBC] appears to show that no embodied value theorist can logically explain a business cycle. He either involves himself in a dual theory of value, a logical inconsistency, or explains nothing but a secular trend. The presentation is quite critical, since it deals, as we believe, with the ‘false trails’, based upon an erroneous theory of value, formulated by Ricardo.

This is the same set of consequences attributed by Keynes (1978a: 190–2) to Ricardo. Contrast the Ricardian view with the position of Malthus as presented by McCracken (1933: v–vi): Malthus serves as a logical starting point for the consideration of business cycles, first, because he stressed the importance of ‘short run’ factors, and second, because his value approach was from the demand side. Consistent with his theory of value, he held that business might be depressed, either by a voluntary failure of demand on the part of those who had the power but not the will, or by an involuntary failure of demand by those who had the will but not the power.

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Thus, McCracken attributes a theoretical position to Malthus that allows cyclical economic activity to occur. And the root of the issue is traced to a failure of demand. This is the very position put forward by Keynes (1978a: 32–3) in the TGT. Incomes are earned, but not spent. Savings accumulate and the economy equilibrates at an underemployment level of output (Keynes, 1978a: 161–3, 207–8, 245–9). What completes the connection between McCracken and Keynes is that McCracken is the source of the phrase, ‘supply creates its own demand’, that Keynes (1978a: 18–26) used as his definition of Say’s Law. That law, Keynes argued, continued to ‘underlie all orthodox economic theory’ and made economic theory incapable of dealing with recession. Yet what is significant is that there is no prior use of those words anywhere in the classical tradition. Indeed, within the entire economics literature the first use of those words to describe the notion behind Say’s Law appears in VTBC. Discussing what he called ‘the automatic production-consumption economists’, McCracken (1933: 159) wrote – using a different tense but with the identical intent – that in an economy in which Say’s Law applied, ‘supply created its own demand’.

KEYNES’S LETTER TO MCCRACKEN That Keynes had read at least part of McCracken’s book has not been in doubt since the publication, in 1979, of the ‘laundry basket’ of material related to the TGT. That material includes a footnote to a 1933 draft in which Keynes (1979: 81, n. 1) cites VTBC, but only in relation to Marx. Whether he had read other parts of the book was thus still an open question until a letter from Keynes to McCracken was discovered in McCracken’s archival material (see Kates, 2008). That letter, found in 2007, is dated 31 August 1933. It makes the standard story on the origins of the TGT largely obsolete. Keynes begins his letter to McCracken (reproduced in Kates, 2008) with the following straightforward statement: ‘Having now read your book …’. This resolves the question of whether Keynes read McCracken’s material in relation to Ricardo and Malthus. Indeed, in his letter to McCracken Keynes expresses his specific agreement with Malthus’s ‘line of thought’ regarding the business cycle. While Keynes does not provide details about his agreement with Malthus, he identifies Malthus as a pioneer of the appropriate direction in which such analysis should proceed. In his letter to McCracken, Keynes writes: ‘In the matter of Malthus, … I wholly agree with you in regarding him as a much under-estimated pioneer in the line of thought which to-day seems to me by far the most likely to lead to progress in the analysis of the business cycle’. In fact, Keynes’s letter goes even further. He specifically endorses McCracken’s conceptual approach in distinguishing the Malthusian line of

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thought from the Ricardian. Keynes concludes as follows: ‘Your contrast between Ricardo and Malthus contains, I am convinced, the essence of the matter’. The first chapter of the TGT contrasts Ricardo and Malthus in almost exactly the same terms as had McCracken. Keynes’s letter clearly implies that the approach he would take would be along similar lines to the views of Malthus as outlined by McCracken, and that is exactly what he did in TGT. Any explanation of the orientation of TGT must include the contribution of McCracken, which was arguably the most important influence on Keynes as he set out to write his book.

COMMONS AND MCCRACKEN To understand McCracken, however, it is also necessary to understand Commons. A member of the economics faculty at the University of Wisconsin from 1904 until his retirement from teaching in 1933, Commons had a major influence on the economic ideas of the Progressive Era. He remains a towering figure among Institutional economists. McCracken undertook his doctoral studies at Wisconsin in the early 1920s, studying under Commons and graduating in 1923. Some idea of the education McCracken would have received may be gauged by Commons’s review of Hobson’s The Economics of Unemployment, which appeared in print the year McCracken received his degree. In the review, Commons (1923: 639) wrote: Modern economic theory originated not so much in the work of Adam Smith as in the debates between Ricardo, Malthus and their friends, respecting the condition of England after the Napoleonic Wars. It is in the letters of Ricardo to Malthus (1813 to 1823) and in the Principles of Political Economy by Malthus (1821), which is evidently the reply of Malthus to Ricardo, that the modern theories of economics and the corresponding remedies for trade depression find their origin.

Thus, the differences between Ricardo and Malthus were an important aspect of what McCracken learned from Commons. Since publication of the TGT, the views on economic theory that Commons expressed in his book review have become somewhat commonplace; before 1936, however, this kind of insight was rare. Most remarkable is Commons’s recognition that the terms of the early nineteenth century debates formed the basis for the classical theory of the cycle, and that the two sides were properly delineated in Ricardo’s letters to Malthus and in Malthus’s Principles (which was actually published in 1820).4 According to University of Wisconsin library records, McCracken’s thesis was embodied in a 1922 article published in the Review of Economic Statistics

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as ‘Secular Trends and Business Cycles: A Classification of Theories’. Its coauthors are Commons, McCracken and William E. Zeuch (1922). Although the article reviews classifications of the theory of the cycle, its first pages discuss the differences between Malthus and Ricardo (Commons et al., 1922: 244–6). Today, the differences outlined by Commons, McCracken and Zeuch would be entirely familiar to anyone who has read the TGT. Near the end of the article, Commons and his co-authors return to the contrasting perspectives of Malthus and Ricardo. As they note: ‘Malthus differed from Ricardo at almost every point’ (Commons et al., 1922: 258) and as an example they write: According to Ricardo, there could be no universal or general overproduction of goods…. But Malthus contended that the great mass of commodities is exchanged directly or indirectly for labor, either productively or unproductively. Hence, compared with labor, all of the goods may fall in value at the same time. And this general fall in value proceeds from a ‘glut’, just as any one commodity falls in value from an excess of supply, compared with labor or money.

Public policy differences to address the state of the economy follow as well. Commons and his collaborators explain: It followed that Ricardo’s remedy for overproduction of some goods was more production of other goods. It followed that Malthus’ remedy for overproduction was an increase in unproductive consumption, such as taxes, public employment, highways, improvement of landed estates and more employment of menial servants instead of ‘productive’ laborers. (Commons et al., 1922: 258)

Given that Keynes’s policy prescriptions stressed government action to move an economy out of recession – including measures to stimulate consumer demand, increase public employment, and undertake road construction – it ought to be clear why Keynes preferred Malthus’s perspective to that of Ricardo. The Commons, McCracken and Zeuch article also discusses the views of J.C.L. Simonde de Sismondi, an early nineteenth century contemporary of Malthus’s who had also argued that there are overproduction crises, during which ‘the market becomes glutted because effective demand was lacking’ (Commons et al., 1922: 251). The authors add: ‘This question [Sismondi] argued heatedly with J.B. Say and Ricardo. The two latter consistently held that “goods exchange against goods” and therefore supply could never exceed demand’ (Commons et al., 1922: 251, n. 1). Here we find the theoretical underpinnings for the arguments found at the start of the TGT. Keynes learned from McCracken, and McCracken learned from Commons. The linkage between Keynes and Commons, which runs via McCracken, is unmistakeable.

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COMMONS’S DIRECT INFLUENCE ON KEYNES Although it is clear that McCracken was an important conduit through which Commons’s ideas reached Keynes, it is also clear that Keynes had been an admirer of Commons’s work since the 1920s. For example, Robert Skidelsky notes this in his biography of Keynes: ‘Commons, an Institutional economist who taught at Wisconsin University, is an important, if unacknowledged, influence on Keynes. Indeed, Keynes wrote to him in 1927 that “there seems to me to be no other economist with whose general way of thinking I feel myself in such [genuine] accord”’ (Skidelsky, 1992: 229).5 With respect to TGT, Commons’s greatest influence on Keynes involves what Commons called the concept of ‘futurity’. In 1925, Commons distributed a brief draft of a book that would eventually become Institutional Economics (Commons, 1934). It was titled Reasonable Value and Chapter 5 is devoted to futurity, the notion that all economic activity is oriented toward the future (Commons, 1925). According to McCracken, Commons was exploring and developing the concept of futurity through his university lectures in the early 1920s. In McCracken’s (1961: 70) Keynesian Economics in the Stream of Economic Thought, he writes: In class notes of 1921 the author found this statement: ‘Value is a mental appraisal in the present of future uses of incomes.’ The same idea was later included in Institutional Economics: ‘It is evident, indeed, that the entire concept of value is volitional instead of mechanistic, since value is a present estimate of something expected in the future.’

McCracken (1961: 71) then highlights the connection between futurity, which serves as the foundation of Commons’s ‘volitional’ conception of value, and Keynes’s TGT: ‘The meaning given to this formal definition [of value] was almost precisely the idea later expressed by Keynes in his General Theory (1936), in which Chapter 5 is devoted to expectations’. McCracken (1961: 70–1) is willing to credit both Commons and Keynes for bringing futurity to the attention of the economics profession. He writes: ‘It is the judgment of the writer that Commons and Keynes have here given us the greatest single contribution to economic theory in this century’. Still, he also notes Commons’s priority claim. Discussing Commons’s emphasis on futurity, McCracken (1961: 69) writes: ‘Commons definitely anticipated Keynes by approximately 20 years’. In Chapter 5 of Reasonable Value, Commons (1925: 71–2) anticipates Keynes’s discussions of expectations and the marginal efficiency of capital (internal rate of return) in TGT:

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Financial instability and economic security after the Great Recession When we observe that human willingness is the force with which economic science has to do…then we find that it is…the hopes and fears of the future that determine what shall be done in the present…. It is not difficult to picture the functional relations between futurity, thus defined, and the other dimensions of Willingness. What must I do, and how shall I do it, are the questions regarding the future that relate to efficiency. When must I do it, how much shall I get, and how long must I wait, are the questionings of the future that relate to scarcity.

In Institutional Economics, the chapter on futurity has expanded from four pages to 258. Here, too, Commons (1934: 520) discusses future value as a discounted sum based on expectations for the period ahead: There is the other variable dimension of value [in addition to price and quantity] … and economics operates with this third dimension, the measurement of Time. Time, in the transactional process, is always Future Time. Futurity operates in the two dimensions of waiting and profiting (risking). Each of these is a dimension of discount, by virtue of which the present worth of a future quantity is less in its monetary magnitude than it would be if there were no interval between the present point of time when the transaction takes legal effect and the future point of time when the results are expected. We have distinguished the effects of futurity as the profit discount and the interest discount. Each is highly variable. If either of them reaches 100 per cent discount, then present value totally disappears and industry stops.

In short, Commons argues that present action – or inaction – is determined by beliefs about the future. This is also a cornerstone of Keynes in TGT, which was then raised more forcefully a year later in an article in the Quarterly Journal of Economics (Keynes, 1937). There is no question that Keynes read Commons’s Reasonable Value. Commons sent Keynes a copy in 1925, and Keynes drew extensively on this material when preparing a pair of lectures later that year (Whalen, 2008). Given Keynes’s high regard for Commons, it is also likely that he read Institutional Economics when it was released in 1934, that is while he was in the midst of putting together his TGT. Thus, there are two channels of influence running from Commons to Keynes, one direct channel and the indirect channel that runs through McCracken.

CONCLUSION: WAS MCCRACKEN AWARE OF HIS INFLUENCE ON KEYNES? This chapter has argued that TGT owes its orientation to work undertaken by McCracken and that important elements of TGT were likely derived from Keynes’s study of Commons’s writings. It has reviewed the notion of Say’s Law and the aim of TGT; traced the connection between McCracken and

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Keynes; explored the relationship of Commons and McCracken; and discussed the direct influence of Commons on Keynes. As a consequence, it demonstrates the importance of Commons, and thus Institutional economics, in shaping Keynes’s ideas. The final question is whether McCracken was aware that Keynes’s ideas had been developed with reference to his own. In fact, there are reasons for believing that McCracken was aware of his direct influence on Keynes. While a full exploration requires its own separate essay, what should be seen at the threshold of this question is the existence of the very long chapter that McCracken (1961) devoted to Commons and futurity in a book designed to look at Keynesian economics. McCracken was a senior lecturer at the University of Minnesota when he wrote his book and sent it to Keynes. At the time, Keynes was the most renowned economist in the world, while McCracken was still attempting to become established. McCracken would eventually become a professor and head of the economics department at Louisiana State University, but he was an unknown author of a single book when TGT was written and published. At that time, any suggestion by McCracken that he had influenced Keynes would likely have appeared ridiculous. What he seemed to have done instead was draw attention to the close parallels between Keynes and Commons, two economists of near equal stature on opposite sides of the Atlantic. If one looks at the words chosen by McCracken, he is saying, and in no uncertain terms, that Commons reached the idea of futurity first. McCracken spells it out clearly: ‘Commons definitely anticipated Keynes by approximately 20 years’. Moreover, McCracken does not in any way imply that this was the case of a parallel discovery. He says that both said exactly the same thing and that Commons was the first to do so. In most other respects, he kept his own counsel. If he had hoped Keynes would acknowledge that McCracken had opened his eyes to certain aspects of the Malthus-Ricardo relationship, and had instructed him on the nature of their two perspectives on business cycle theory, then he would have been very disappointed. The only way for McCracken to draw attention to Keynes’s unacknowledged use of the work of others would have been to discuss Keynes’s use of Commons’s ideas and hope that someone might someday notice. This much satisfaction he would have had: he wrote a thesis under Commons, which was later turned into a book, in which the main point was that the business cycle theories of Ricardo were still embedded in the economic models of his twentieth-century contemporaries who could not, therefore, logically generate theories accounting for cyclical activity. If one uses the demand-side approach proposed by Malthus, however, then an explanation for recession based on demand deficiency becomes almost automatic.

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These were McCracken’s ideas, and he lived to see them incorporated into macroeconomic theory in a way that shook the foundations of economic thought. There is little doubt that this gave him at least some satisfaction, although not as complete as the pleasures that wider recognition would have produced and that were so thoroughly deserved.

ACKNOWLEDGEMENT The author thanks Charles Whalen for his editorial assistance with the manuscript.

NOTES 1.

In another passage, Keynes (1978a: 18) writes: ‘From the time of Say and Ricardo the classical economists have taught that supply creates its own demand – meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product’. Ricardo’s role in Keynes’s discussion is important, as will be discussed later in this chapter. Also important is the phrase ‘supply creates its own demand’, which, as will also be discussed, can be traced to McCracken. 2. For evidence that demand deficiency and overproduction were used interchangeably, see Mill (1921: 556–8). 3. The Malthus-Ricardo letters discovered by Sraffa were until the 1950s unpublished and available only to a limited number of people, most of whom were at Cambridge University. The letters attracted Keynes’s attention at the end of 1932, not because he was initially interested in Malthusian economics but because he was updating an essay on Malthus for Essays in Biography (Keynes, 1978b). 4. In 1923, of course, Malthus’s side of the correspondence with Ricardo had not yet been discovered. 5. Skidelsky’s transcription uses the word ‘general’, but this is an error. The actual word in Keynes’s letter is the much stronger ‘genuine’, not ‘general’ (Keynes, 1927).

REFERENCES Commons, John R. (1923), ‘Hobson’s “Economics of unemployment”’, American Economic Review, 13 (4), 638–47. Commons, John R. (1925), Reasonable Value, Ann Arbor, MI: Edwards Brothers. Commons, John R. (1934), Institutional Economics: Its Place in Political Economy, New York: Macmillan. Commons, John R., Harlan L. McCracken and William E. Zeuch (1922), ‘Secular trend and business cycles: a classification of theories’, Review of Economic Statistics, 4 (October), 244–63. Haberler, Gottfried (1937), Prosperity and Depression: A Theoretical Analysis of Cyclical Movements, Geneva: League of Nations. Kates, Steven. (2008), ‘A letter from Keynes to Harlan McCracken dated 31st August

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1933: why the standard story on the origins of the general theory needs to be rewritten’, History of Economics Review, 47. Keynes, John M. (1927), letter to John R. Commons, 26 April 1927, reproduced in the John R. Commons papers (microfilm edition, reel 4, 1982), State Historical Society of Wisconsin. Keynes, John M. (1937), ‘The general theory of employment’, Quarterly Journal of Economics, 51 (2), 209–23. Keynes, John M. (1978a), The Collected Writings of John Maynard Keynes. Vol. VII: The General Theory of Employment, Interest and Money [1936], edited by Donald Moggridge, London: Macmillan. Keynes, John M. (1978b), The Collected Writings of John Maynard Keynes. Vol X: Essays in Biography (Full Text with Additional Biographical Writings) [1933], edited by Donald Moggridge, London: Macmillan. Keynes, John M. (1979), The Collected Writings of John Maynard Keynes, Vol. XXIX: The General Theory and After: A Supplement, edited by Donald Moggridge, London: Macmillan. McCracken, Harlan L. (1933), Value Theory and Business Cycles, Binghamton, NY: Falcon Press. McCracken, Harlan L. (1961), Keynesian Economics in the Stream of Economic Thought, Baton Rouge, LA: Louisiana State University Press. Mill, John Stuart (1921 [1848]), Principles of Political Economy with Some of Their Applications to Social Philosophy, 7th edn, edited with an introduction by Sir W.J. Ashley, London: Longmans, Green, and Co. Skidelsky, Robert (1992), John Maynard Keynes, Volume II: The Economist as Saviour 1920–1937, London: Macmillan. Taylor, Fred M. (1925), Principles of Economics, 9th edn, New York: Ronald Press. Whalen, Charles J. (2008), ‘John R. Commons and John Maynard Keynes on economic history and policy: the 1920s and today’, Journal of Economic Issues, 42 (1), 225–42.

2. Towards a synthesis of Institutional and Post Keynesian economics W. Robert Brazelton and Charles J. Whalen INTRODUCTION As a result of the recent global economic crisis and subsequent Great Recession, conventional economics has attracted considerable negative attention (see, for example, Krugman, 2009). To point the way towards a constructive rethinking of economics, this chapter identifies key aspects of Institutional economics (sometimes called Evolutionary economics) and underscores their relevance to the newer, Post Keynesian tradition. It also probes the fields of psychology and sociology for additional insights that deserve the attention of economists. The chapter points towards a broader, less predetermined framework for economic analysis, but also towards a more secure foundation for exploring and crafting policy options.1

INSTITUTIONAL ECONOMICS A cornerstone of Institutional economics is its recognition of the holistic nature of social reality. Humans – each with varying needs and wants – exist, act, and react within a social system, not merely an economic system. Thus, Institutionalists treat economics as part of the study of a broad social system with multiple, interrelated dimensions. This conception of economics yields a ‘pluralistic’ orientation to scholarship and a ‘molecular’ view of the economic system. It also leads to a distinct approach to socio-economic change that builds on the work of Thorstein Veblen (1857–1929). In fact, Veblen adds other foundational elements to Institutional economics as well, including important conceptions of money and consumption. Pluralism and the Molecular View of the Economic System The Institutionalists’ holistic conception of social reality causes them to approach scholarship in a ‘pluralistic’ manner. For Institutionalists, the field of 28

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economics is not a self-contained (‘atomistic’) discipline. Rather, they recognize that economic activity is influenced – in expected and unexpected ways – not only by history (Chase, 1975), but also by phenomena studied in related fields such as anthropology, sociology and psychology (including, of course, social psychology) (Brazelton, 2005). Moreover, their pluralism leads to a ‘molecular’ view of the economic system, which contrasts sharply with the ‘atomistic’ view found in neoclassical economics. An economic system does not operate as a self-contained unit – its operation is conditioned by other, overlapping spheres, including the political system, the legal system, and, ultimately, the entire socio-cultural system. Neoclassical economists emphasize that ‘economics’ is capable of standing alone as its own, independent entity of analysis. For example, a central bank aiming to prevent the collapse of its nation’s currency might logically raise interest rates to discourage currency outflows and/or encourage an inflow of foreign currency. Based on conventional economic theory, such a policy is appropriate for the problem. In reality, though, there is more to the story. If the central bank raises interest rates too much or too fast, then market participants might think the bank is in a state of panic. Market participants could then begin to sell that nation’s currency, which would worsen its value instead of improving it. The example above raises three issues and each of them underscores that the economy is a molecular, socio-economic system. First, markets react to psychological and sociological influences as well as strictly economic ones. What causes market participants to perceive that central bankers are panicking? The answer is not found in economics alone. Second, this example illustrates the notion of ‘asymmetric’ information, which refers to a situation where some market participants have better information than others (in the above case, central bankers relative to currency traders). Researchers often focus on the consequences of information asymmetries, but for Nobel laureate George Akerlof (1970; 2002), a key contributor to the field of information economics, there is also a vital starting point for such scholarship: the willingness to borrow from other disciplines. According to Akerlof, ‘Neoclassical models do not make assumptions derived from psychology, anthropology, or sociology. I disagree with any rules that limit the nature of the ingredients in economic models’ (quoted in Campus News, 2001). Third, it is important to note that market responses to a perceived state of panic often make the situation worse. The economy is not necessarily selfcorrecting; instead, panic can set in and spread, and the resulting ‘contagion’ can exacerbate the original economic difficulty and deepen the problem of information asymmetry (as more and more economic participants take note of the spreading ‘herd’ behaviour). As discussed by a number of Institutionalists,

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including Veblen (1919; 1904), Gunnar Myrdal (1978: 774), and Wendell Gordon (1980: 98–100), behaviour reinforcement and cumulative causation often yield a vicious cycle, rather than homeostasis. To appreciate all of this, however, and to craft policies that constructively address the trouble, economists need a molecular view of the economy. The Veblenian Dichotomy Veblen (1919) long ago criticized conventional economics for failing to examine how real-world, socio-economic change occurs over time. He argued that such economics was instead interested primarily in the process that would, in a world of pure theory, bring a market back into equilibrium. The result was the depiction of a static socio-economic environment, devoid of historical change. The Veblenian dichotomy offers an alternative open to the possibility – indeed, reality – of ongoing socio-economic change. This dichotomy contains two essential concepts: institutions and technology. Their interaction determines the nature of socio-economic change (Veblen, 1904; Veblen, 1919). An institution represents the established way of doing things. This includes the industrial system, production processes, government, private organizations, private property, the profit motive, and, in fact, even other social concepts such as motherhood. Thus, the Veblenian definition of an institution is more than a social structure such as the central bank, and instead includes the whole set of habits, mores, and norms of that bank in terms of its decisions, operations and policies. It also includes how the entire socio-economic system reacts to or regulates such norms. An institution exists in the present and affects current human behaviour, but it is also linked to the past in that what exists is shaped by and inherited from history. Against these past-binding ‘institutions’ is technology – the forward-urging concept that allows us to do more efficiently or better what we are presently doing, and that lets us expand what we can do (as when our reliance on horses and carriages was replaced by engines and automobiles). Yet, there is also often resistance to new technology. Or perhaps it is more accurate to say there is often resistance to the social, economic, cultural and personal changes that the technology may imply. In fact, the fear driving such resistance does not even need to be realistic.2 It would be easy to say that if institutions win the struggle with new technology, then the socio-economic system remains largely unchanged, and if new technology wins, then the socio-economic system is altered. However, the technology–institutions relationship is more complex and dynamic, and even that struggle can permanently alter human understandings, interactions, and institutions. To be sure, there will be periods of more rapid and less rapid

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social and technological change, but the technology–institutions interplay is unending. Technology and institutions also become intertwined over time. Some form of technology is embedded in all our institutions; it may be outmoded technology, but it is technology nevertheless. For example, the spectacle of maidens waving palms in date tree groves may have been a less efficient method for the pollination of date trees than electric fans, but it did embody an amount of technology. Similarly, it is true that one finds technological aspects as well as ceremonial ones within the social institution of the family (Brazelton, 2004: 260). As a consequence of the dynamic and ongoing relationship between institutions and technology, economic policy has changed over time – and capitalism itself has evolved. The co-evolution of institutions and technology varies across nations as a result of differences in history and culture, but crossnational comparisons also demonstrate that the outcomes of this interplay are not inevitable. And not every new invention or application of knowledge is socially beneficial. It is up to humans – as a society, through its institutions – to determine what constitutes an increase in efficiency and an improvement in social welfare. Society also uses its institutions to search for and adopt new, forwardurging policies. Indeed, that reality was made apparent during the recent (2008) global financial crisis, when the Federal Reserve (Fed) and the US Treasury adopted policies never before used (at least not to the extent adopted). Thus, the Veblenian dichotomy sees institutions and technology as interconnected, changing and interacting – and these features contribute to the Institutionalist examination of socio-economic change over time. Veblenian Conceptions of Money and Consumption In addition to offering Institutionalists an approach to socio-economic change, Veblen provides an alternative to the neoclassical conceptions of money and consumption. John A. Hobson (1937) distills Veblen’s concept of money into four main points: 1.

Veblen designs his analysis not for the early days of commercial capitalism, but for a more advanced stage dominated not by the owners of capital in its material form (land, labour or plant and equipment), but by ‘the owners, or, more properly, the operators of finance’. 2. In this stage, ‘money alone’ is ‘the measuring rod’ of value; that is because the money market is ‘an active instrument’ that determines the value not only of financial securities, but also of the capital stock. 3. The market structure of this era deviates sharply from the Marshallian

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competitive model, which assumes that individual firms are mere price takers: the most efficient competitor in Veblen’s analysis has an advantage that enables it to weaken or destroy the less efficient. It also has the incentive and ability to reshape the industry ‘into a trust’. The control of industry by a few financiers allows them to ‘sabotage’ the system by a ‘deliberate restriction of the productivity of capital and labour in order to keep prices and profits higher’.

With these four points outlining the monetary structure of an industrial economy, Veblen advances both economic history and theory. He underscores the tremendous changes that reshaped Anglo-American financial markets and transformed commercial capitalism into finance capitalism by the end of the nineteenth century. In addition, his ideas about credit-driven business cycles help explain our most recent crisis (Veblen, 1904).3 Turning to consumption, the interest rate had long been the concept at the centre of economists’ approach to spending and saving. According to that approach, higher interest rates would lower consumption and encourage greater saving. In contrast, Veblen’s 1899 book on the ‘leisure class’ stressed an economy shaped by ‘conspicuous consumption’ (Veblen, 1967). Thus, he provided a new motive for consumption – one associated with social status or the desire for status. After World War Two, mainstream economist James Duesenberry (1949) provided an updated and expanded notion of Veblen’s consumption analysis in the form of the ‘relative-income hypothesis’. According to Duesenberry, who was based at Harvard University, consumption is a function of one’s income in relation to others. Thus, consumption is determined by a combination of income and the desire to ‘keep up with the Joneses’. Duesenberry recognized that one would not drive a Volkswagen to a country club parking lot full of Mercedes-Benzes. Both the Volkswagen and the Mercedes would get you there functionally; but the latter would get you there with more class, or at least convey the perception of greater affluence. Thus, the interest rate was not the only – and perhaps not the primary – determinant of savings. Many socio-economic processes were involved, which is consistent with a molecular, not an atomistic, conception of reality. Conventional economists soon backed away from Duesenberry’s approach, however, in favour of Milton Friedman’s ‘permanent-income hypothesis’. According to Robert Frank (2005) of Cornell University, this shift is puzzling. Friedman’s approach currently dominates neoclassical research on spending, but Duesenberry’s theory ‘clearly outperforms’ the permanent-income hypothesis. Frank’s explanation is consistent with this chapter’s depiction of conventional economics as rooted in an ‘atomistic’ conception of the economy. He

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writes: ‘Many economists felt uncomfortable with Duesenberry’s relativeincome hypothesis, which to them seemed more like sociology or psychology than economics. The profession was therefore immediately receptive to alternative theories that sidestepped those disciplines’ (Frank, 2005). Meanwhile, the Institutionalists have continued to follow the path prepared by Veblen, and have most recently extended their analyses to include reliance on consumer credit as a way to continue household spending in the face of decades of wage stagnation and increasing income inequality (Brown, 2008).

KEYNES AND THE POST KEYNESIANS The Keynesian revolution was primarily the result of the monetary crises of the late 1920s and early 1930s and the depression that followed. John Maynard Keynes (1883–1946) rejected the neoclassical assumption that an economy experiencing unemployment would inevitably return to full-employment equilibrium. Keynes believed there was no automatic process of stabilization that would return the economy to full employment; the economy might be in equilibrium, but it need not be at full employment (Keynes, 1935). The General Theory of Employment, Interest and Money was written to prove Keynes’s point (Keynes, 1936). It was also the result of his effort ‘to work out in some detail a monetary theory of production’ (Keynes, 1973: 411). His path-breaking book introduced or advanced such concepts as the consumption function, the average and marginal propensities to consume, economic multipliers, liquidity preference (a strategic economic factor in the years 1929, 1938, and again in 2008), and the marginal efficiency of capital. It also stressed business expectations and economic uncertainty as distinct from risk. As Keynes (1937: 219–21) explained in an article summarizing his volume, the analysis was not merely a theory of demand and supply of output as a whole, but also an explanation of ‘why output and employment are so liable to fluctuation’.4 However, Keynes’s concepts and the associated Keynesian revolution were later ‘neuterized’ (Brazelton, 1980–81). This began – by design or accident – with work by John Hicks, Alvin Hansen, and Abba Lerner. Then Milton Friedman and the monetarists denied parts of Keynes’s analysis, including the liquidity trap, which they marginalized as a concept (Friedman, 1956) and dismissed as irrelevant to the Great Depression (Friedman and Schwartz, 1963). During the stagflation of the 1970s, monetarism and neuterized Keynesianism shared the same theory – the neoclassical synthesis – and their debates were largely what Hyman Minsky (1986: 102) described as ‘academic nitpicking’. As in the pre-Keynesian era, unemployment was blamed on wage rigidities, while inflation was attributed primarily to the public sector’s lack of

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fiscal and monetary restraint. Keynes’s deeper monetary analysis – and its contention that economic instability is due to the behaviour of financial markets in relation to asset prices and profit flows – remained overlooked and largely ignored (Minsky, 1986: 99–140).5 Bucking that trend, a small number of economists refused to turn their backs on the ‘real’ Keynes. In fact, his insights were given a prominent place in the work of Post Keynesian economists such as Sidney Weintraub, Paul Davidson, and Hyman Minsky. The latter is perhaps most significant, having provided a foundation for other highly productive Post Keynesian scholars such as L. Randall Wray and others associated with the Levy Economics Institute of Bard College. But the contributions of all four of these Post Keynesians warrant some attention. Weintraub and Davidson The central contribution of Weintraub (1963; 1972; 1978) is a Post Keynesian alternative to neoclassical analyses of wages and prices. Weintraub incorporated post-World War Two institutional realities into his analysis, including unions and corporations that wielded power in oligopolistic markets. And, like the Institutionalists, he saw money as integral to economic activity. Writing at a time when economists were concerned about both inflation and unemployment, Weintraub, stressed that economic stabilization required three tools: fiscal policy, monetary policy, and incomes policy. The purpose of an incomes policy is to introduce wage and price restraint into the economy by means of policy-induced institutional adjustment. Conventional economists objected to the suggestion of this ‘deviation’ from market-determined incomes. But Weintraub responded that wages – and, by extension, prices – were in fact the product of a power-laden bargaining process, not competitive markets. Other key aspects of Weintraub’s analysis can be summarized as follows. Starting with a 2:1 ratio between prices (p) and wages (w), then p = ƒ (2w). But technology and efficiency (e) also affect the wage–price relationship, which can be shown as p = [ƒ (2w)]/e. A more efficient firm can pay higher wages and/or maintain a lower price than a less efficient firm, which are sources of competitive advantage for the efficient firm and its workers. Moreover, labour, product and financial markets are all connected in Weintraub’s Post Keynesianism; even without an incomes policy, the public sector is, unavoidably, a partner in the wage–price process as the Fed pursues its mandate of price stabilization. Note that this analysis re-introduces Veblen’s notions of market power and use of technology into the price determination process, both of which are important in contemporary analyses seeking to integrate Post Keynesianism and Institutionalism.

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Bringing Davidson (1977; 2007) into the discussion provides additional support for Keynes’s refusal to accept the neoclassical notion of self-regulating markets. To Davidson, a proper analysis of market adjustment must take into consideration the concepts of ‘non-ergodicity’ and ‘hysteresis’ (Davidson, 1993; 1996). Both concepts underscore the Institutionalists’ emphasis on the importance of history in determining economic outcomes. These concepts also make it clear that an economic disturbance alters the economy forever; it will never return to its previous state (see also Brazelton, 2005). The concept of non-ergodicity is the Post Keynesian response to the ‘ergodic hypothesis’ found in neoclassical economics. According to Davidson (2009: 38), to assume ergodicity is to proclaim ‘that statistical samples drawn from past or current market data are equivalent to drawing samples from future market data’; in other words, ‘the future is merely the statistical shadow of the past’. He adds: ‘It should not be surprising that all the highly complex computer models that investment bankers use as risk management tools … are based on a statistical analysis of historical market data …. These [past-based] computer model results led to the downfall of the American investment banking industry in 2008’. Davidson (1996) emphasizes that we actually live in a world of uncertainty, not a world in which the future path of the economy is predetermined. Thus, we live in a non-ergodic world, where each tomorrow is shaped by human action today. In the real world, economic disturbances are accompanied by socio-economic changes – in institutions, economic strategies, aims, and relationships – that prevent the system from reverting to a previous position. Moreover, as Davidson (1993: 320) notes, an external shock to the economy is not necessary to change the path of the system: ‘Things can change simply because people’s views (i.e., state of expectations) change’. Davidson also makes use of the concept of hysteresis, which economists have borrowed from physics. In economics, this concept refers to the permanent economic-system effects of a one-time disturbance. While hysteresis has been interpreted in various ways, Davidson (1993: 311) argues that Mark Setterfield offers a perspective most compatible with Keynes and the Post Keynesians. For Setterfield (1993: 361), hysteresis opens the door to the realization ‘that economies exist in real historical time and are comprised of sequential patterns of activity’. Thus, in Post Keynesian macroeconomics, we find that economic adjustments ‘do more than just select among pre-defined long-run outcomes – they help to determine the very nature of those outcomes’ (Setterfield, 2001: 96). And, as above (in the discussion of non-ergodicity), such adjustments do not require external shocks; thus, ‘Post Keynesian macrodynamics can actually be described as evolutionary, rather than just path dependent’ (Setterfield, 2001: 100, emphasis in original).

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Thus, the following provides a summary of Davidson’s (1991: 32) perspective, in his own words: In the Post Keynesian view, economic decisions are made by human beings facing an uncertain and unpredictable economic future, while they are moving away from a fixed and irreversible past…. In the context of this evolving economy, economic and political institutions play a significant role in shaping expectations about the otherwise unforeseeable future; … [and those] expectations create a path along which the economy travels. Post Keynesians believe, therefore, that human beings have the power to create and control their own economic destiny.

Minsky and Wray A major contribution of Minsky (1975; 1977a; 1977b; 1982) is an analysis of the business cycle in which finance and investment play vital roles. A brief summary is as follows (see also Brazelton, 2005). An economic downturn gives way to recovery when borrowing and lending increase and business investment starts to expand. There can be many triggers: dwindling inventories, a resurgence of demand prompted by government spending or the physical depreciation of investment goods and consumer durables, falling interest rates, or even the spread of optimism regarding the future. In fact, each recovery is a bit different than those that precede it. During the initial stage of an upturn, the memory of the recent downturn is vivid, resulting in conservative lending practices. But this changes as prosperity continues and profits rise. Thus, the optimism of borrowers and lenders – and often even monetary authorities – is transformed into exuberance, and speculative behaviour increases. In fact, an increasing number of enterprises become ‘Ponzi’ units, the term (deriving from the name of financial schemer Charles Ponzi) that Minsky gave to entities that must increase their debt load to make even the interest payments on existing loans. Eventually, however, the end must come. At some point, key firms find that their cash flow is not enough to meet their obligations, requiring them to liquidate assets. And once trouble appears, anxiety can spread quickly, extinguishing the optimism that drove the boom. The pessimism affects borrowers and lenders alike, which sends indebtedness, investment, and profits into a cumulative decline. Until recently, the classic real-world case of a finance-driven business cycle was the Great Depression. As John Kenneth Galbraith (1954) describes in The Great Crash, at the peak of the 1920s boom, people mortgaged their homes to invest in the stock market. In the years 2007–08, however, the housing market itself became the locus of a speculative bubble that triggered what is likely to serve as the textbook example of a Minsky crisis for some time to come. In the wake of the dot-com bubble and bust, the US housing market offered

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an attractive investment. Lured by rising home prices and appealing ‘teaser’ interest rates, people bought homes, often without a down payment, from countless lenders and brokers who had little regard for a borrower’s income or ability to make future mortgage payments. Lenders were willing to write such loans because they were passed on, in the form of mortgage-backed securities, to investors throughout the global economy. For a while, the economy was caught up in a heady speculative spiral. And then interest rates increased, monthly mortgage payments skyrocketed, some major financial institutions collapsed, speculators went into panic, credit markets froze, and the stock market plummeted (Whalen, 2010). The crisis was economic and financial, to be sure, but it was also sociological and psychological. Given the role of money and finance in both Minsky and Veblen, it is worthwhile to consider how the money supply actually works. In conventional economics, money is a neutral agent in the economic process, and its supply at any moment is determined by public policy. In contrast, most Post Keynesians hold a different view. Wray (1990; 1992; 1998), a student of Minsky, has shed considerable light on this subject concerning the role of the central bank and money. The central bank is a vital institution in modern economic systems. The central bank of the US, the Fed, was created in 1913 in response to the financial panic of 1907 and earlier financial crises. The Fed’s influence on interest rates is one of the main channels through which it seeks to smooth out the business cycle and sustain economic growth. In most economics textbooks, the money supply is depicted as exogenous to economic activity and invariant with respect to interest rates. This yields a vertical money-supply schedule. But let us assume the Fed seeks, as central banks often do, to maintain a certain annual economic growth rate, such as four per cent. It will then set a target federal funds rate (the rate that depository institutions charge each other) to generate private-sector interest rates that allow the economy to grow at that pace (Brazelton, 2005: 531). But achieving its lending-rate target requires open market operations, which alter the money supply. Thus, the money supply is endogenous, not exogenous (Wray, 1990). Money is also not neutral (Wray, 1996). Again consider the example in which the Fed aims for a four per cent annual growth rate. What happens when the economy slows and appears to be heading for a lower rate of growth? To reduce interest rates, the money supply is increased via open market operations. Conversely, the money supply would be decreased to maintain a four per cent economic growth rate in the face of a more vigorous expansion (Brazelton, 2005: 531). If neoclassical economists teach that the money-supply schedule is vertical (exogenous and invariant with interest rates), then do Post Keynesians teach that it is horizontal? This was fashionable for a short time, but the strength of

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Wray’s contribution is that it generated a more nuanced view, which suggests an upward sloping money-supply schedule due partly to changing attitudes toward ‘risk’. According to Wray (1990: 187–8), the money supply and interest rates are both determined endogenously, and the theory of interest rates that comes out of his endogenous money approach is as follows: Central bank policy does influence bank behavior and does go into the determination of costs faced by banks. However, such policy can be swamped by liquidity preference, innovations, competition, and profit expectations…. The interest rate is largely determined by the willingness of banks and other financial institutions to allow their balance sheets to expand. This willingness is determined by rules of thumb, custom, and expectations.

Wray’s approach also challenges the conventional economists’ assumption that interest rates should be used to dampen booms. Consistent with Minsky, Wray (1996: 141) maintains that the primary purpose of domestic monetary policy ‘should be to set asset price floors and prevent debt deflation. Low interest rates are encouraged if the central banks’ provision of reserves takes place at a low discount rate; this, in turn, can stimulate aggregate demand’. This would leave the job of controlling inflation – and addressing the moral hazard problem associated with lender of last resort activity – to other (more qualitative, rather than quantitative) central bank tools, perhaps in conjunction with fiscal policy and an incomes policy. ‘A central bank that sets a floor to asset prices must also try to encourage practices that set price ceilings on assets’, writes Wray (1996: 142). Thus, he calls for the Fed to contain or even prohibit speculative asset purchases by the institutions it protects. Similarly, he writes: Institutions that finance speculative booms would be subject to increased supervision and tighter regulation. When the central bank sees a speculative boom developing (say, in the real estate market in a particular region), it should be able to move quickly to make it more difficult for financial institutions to finance the boom (for example, it could require that regulated institutions increase collateral requirements, it could raise equity-to-asset ratios, it could increase supervisory rules of thumb regarding the amount of lending made to any individual borrower, and it could increase pressure for diversification). (Wray, 1996: 142)

The interest-rate policy advocated by Wray was actually the policy of the US during and immediately following World War Two. In that period, the Fed was willing to purchase all the government securities it needed to keep interest rates low. The era ended in 1951 with a Treasury-Fed Accord that restored Fed independence. Leon Keyserling (1964; 1979; 1980), the major economic advisor to President Harry Truman, believed strongly that the 1951 Accord was a major policy mistake. Concerned about inflation, the Fed slowed its purchase of

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government bonds, which led to higher interest rates as well as slower economic growth. While Friedman (1959) and other monetarists argued that interest rates should be free to increase as much as necessary to control inflation, Keyserling stressed – like Minsky and Wray more recently – the importance of keeping interest rates low enough to sustain robust economic expansion and maintain full employment growth (Brazelton, 1997; 2001; 2003). But the Accord set the direction for US policy; monetarists would eventually get their chance to shape Fed actions, while Post Keynesians have not yet been in such a position. Despite their lack of political clout, Post Keynesians offer a sensible and coherent alternative to neoclassical economics. And they help revitalize and extend many of the themes at the centre of the work of Veblen and other early Institutionalists. Wray shows that the central bank matters and that money is not neutral. Minsky shows that money and finance are vital determinants of the business cycle. Davidson allows us to recognize that the central bank and money are social institutions, and to appreciate how institutions shape economic life in a world characterized by uncertainty and the irreversibility of time. Weintraub helps us understand how labour, product and financial markets are not merely connected, but also influenced by public policy. How do institutions and public policies work? And how, when, and why do they evolve? The answers are only partly to be found in the realm of economics; these are questions with dimensions that also involve psychology and sociology (along with other social sciences). This fact serves to underscore the importance of the Institutionalists’ molecular conception of the economic system. It also provides a point of departure for the closer consideration of those related disciplines and their insights of relevance to economics.

DRAWING ECONOMIC INSIGHTS FROM PSYCHOLOGY AND SOCIOLOGY Once an economist is willing to look beyond his/her disciplinary boundaries, it is possible to find countless insights of relevance to the study of economic life. Since the notion of human rationality plays a central role in standard economics, research that sheds new light on that notion should be of special interest to economists. Looking further also reveals important findings about human interaction and the formation of shared memories. Efficient and Adaptive Markets A cornerstone of conventional economics has long been the assumption that humans are rational beings, always acting in their own self-interest and

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making decisions in an optimal fashion (Lo, 2005: 21). For a number of decades, economists have used this notion as the foundation for their Rational Expectations Hypothesis, which holds that economic participants do not make systematic errors when predicting the future. More recently, theories of investment and finance have taken rationality as their starting point to yield an Efficient Market Hypothesis (EMH), which maintains ‘markets fully, accurately, and instantaneously incorporate all available information into market prices’ (Lo, 2005: 21). However, the work of psychologists is not supportive of EMH. In fact, according to Andrew W. Lo (2005), of the MIT Sloan School of Management, economic analysis is often inferior to psychology. He writes: The field of psychology has its roots in empirical observation, controlled experimentation, and clinical applications. From the psychological perspective, behavior is often the main object of study, and only after carefully controlled experimental measurements do psychologists attempt to make inferences about the origins of such behavior. In contrast, economists typically derive behavior axiomatically from simple principles such as expected utility maximization, resulting in sharp predictions of economic behavior that are routinely refuted empirically. (Lo, 2005: 22)

To put investment theory on a more secure footing, Lo developed an Adaptive Market Hypothesis (AMH) as an alternative to the EMH. The AMH is based on concepts from evolutionary biology as well as insights from psychology, and the evolutionary emphasis is reminiscent of Veblen’s focus on socio-economic change (Lo, 2005: 22). Lo’s AMH is compatible with Institutionalism and Post Keynesianism in that it is much more dynamic and historically contingent than conventional economics. Consider, for example, the five ‘concrete insights’ he generates when applying the AHM to asset allocation, risk management, and investment consulting. According to Lo (2005: 22), the AMH implies that: (1) The equity risk premium is not constant through time but varies according to the recent path of the stock market and the demographics of investors during that path; (2) Asset allocation can add value by exploiting the market’s path dependence as well as systematic changes in behavior; (3) All investment products tend to experience cycles of superior and inferior performance; (4) Market efficiency is not an allor-none condition but is a characteristic that varies continuously over time and across markets; and (5) Individual and institutional risk preferences are not likely to be stable over time.

While Lo’s analysis was developed prior to the global financial crisis of 2008–09, it is clear that each of these five insights can be connected to aspects of that recent boom and crash. In contrast to the fully rational world of the EMH, in the world of the AMH, ‘behavioral biases abound’. (Lo, 2005: 32). In fact, Lo’s work is noteworthy

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not only because it develops an alternative to the EMH, but also because it draws on an extensive literature to catalogue the variety of ways that human decisionmaking deviates from the rationality assumption at the heart of standard economics. These include overconfidence, overreaction, loss aversion, herding, psychological accounting, miscalculation of probabilities, hyperbolic discounting, and regret. He writes: ‘For these reasons, behavioral economists conclude that investors are often – if not always – irrational, exhibiting predictable and financially ruinous behavior that is unlikely to yield efficient markets’ (Lo, 2005: 25). To be sure, proponents of the EMH admit that behavioural biases exist. They merely argue, Lo writes, that market forces ‘always act to bring prices back to rational levels, implying that the impact of irrational behaviour on financial markets is generally negligible and, therefore, irrelevant’. But Lo concludes that history and the broad social science literature indicate ‘the forces of irrationality can dominate the forces of rationality, even over extended periods of time’ (Lo, 2005: 26; see also Brazelton, 2005). Indeed, from the Dutch ‘tulip mania’ of the seventeenth century to the recent global financial crisis, history is strewn with examples of ‘irrationality’ on the upturn and downturn alike. Moreover, Lo draws on the work of Nobel laureate Herbert Simon to call into question the ability of human beings to engage in the sort of optimization required by neoclassical economics. Lo (2005: 30) explains: Because optimization is costly and humans are naturally limited in their computational abilities, they engage in something he [Simon] called ‘satisficing’, an alternative to optimization in which individuals make choices that are merely satisfactory, not necessarily optimal. In other words, individuals are bounded in their degree of rationality, which is in sharp contrast to the current orthodoxy of rational expectations, where individuals have unbounded rationality (the term ‘hyper-rational expectations’ might be more descriptive).

And in explaining how individuals determine that their behaviour is satisfactory, Lo (2005: 30–31) points to trial and error, a person’s ‘best guess’, and heuristics – precisely the sort of explanation one finds in Veblen and Keynes and in the writings of today’s Institutionalists and Post Keynesians.6 But with so much irrationality (or ‘bounded rationality’) and guesswork, what are we to make of ‘market efficiency’ in the AMH? Lo (2005: 31) explains: ‘Market efficiency cannot be evaluated in a vacuum because it is highly context dependent and dynamic, just as insect populations advance and decline as a function of the seasons, the number of predators and prey they face, and their abilities to adapt to an ever-changing environment.’ In fact, innovation and adaptability ‘are the primary drivers’ of survival in financial markets, he concludes (Lo, 2005: 37). This is a constructive addition that reinforces ideas

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found in Institutionalism and Post Keynesianism, whose adherents reach similar conclusions not only in the realm of finance and investments, but also on the economy as a whole. Interaction and Collective Memory Just as disciplines outside economics can help inform economists’ conception of individual decision-making, they can also provide insight into human interaction. It is clear that interaction is at the core of economics. In fact, Institutionalist John R. Commons (1934: 58) identified the transaction as the fundamental unit of economic analysis. But how do humans interact? Sociologist Herbert Blumer (1969), creator of the concept of ‘symbolic interaction’, offers valuable insight on that question. Blumer’s concept can be summarized in the form of three premises: (1) humans behave according to the meanings that things and events have for them; (2) the meanings of things and events stem from interaction with others; and (3) meanings entail individual interpretation (Larson, 1986: 143). In short, human interaction is based on meaning acquired from a combination of prior interaction and introspection. Moreover, meaning is not objective and absolute; it is socially created and transmitted, and subject to being renegotiated in the course of further interaction (Larson 1986: 145). Thus, Blumer offers insight not only into how humans interact, but also into the reasons for – and the consequences of – that interaction. All of this is compatible with the aforementioned contributions of Veblen, Duesenberry, and Davidson, who each give human interaction a vital role in shaping understandings, decisions and actions. Finally, since the present is shaped by the past in Institutional and Post Keynesian economics, memory – how we recall the past – becomes significant in both traditions. For that reason, sociologist Jeffrey Olick deserves attention. His work focuses on the role memory plays in society. According to Olick, society has a ‘collective memory’ just as individuals have their own memory. This group memory can be powerful. In his own work on the legacy of Nazi Germany and apartheid South Africa, as well as in a more far-reaching edited volume, Olick and his colleagues demonstrate how group memory can generate profound and wide-ranging outcomes, including nationalism, civil war, regret, and reconciliation (Olick, 2007a; 2007b; 2008; Olick et al., 2010). Here are three main conclusions of Olick’s work. First, although no individual is a repository of the full group memory, every individual within the group holds and is shaped by part of that memory. Second, group memory depends on the culture doing the remembering. Third, collective memory is not constant; there is continuity, but there is also change over time. In a related work on culture and memory, sociologist Jeremy Brooke

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Straughn (2009) emphasizes that people reshape culture even as they absorb it. After reviewing much of the prior thinking on the matter, he writes: ‘In order to explain both change and continuity, we require a more nuanced theoretical toolkit – one that refuses to reduce culture to a set of inculcated values or embodied dispositions, while acknowledging the role of cultural influences and mnemonic constraints on “rational’ deliberation” (Straughn, 2009: 488). A lesson here for economists, consistent with the work of Lo, is that the foundations of human decision-making are not only subject to group biases, but also subject to change. A related essay by Straughn (2006) also provides a lesson for those who wish to alter economic policy. To realize political change in a peaceful manner, one must combine a critique of the status quo with a commitment to society’s core values and principles (Straughn, 2006: 6). This is as true for Institutionalists and Post Keynesians as it is for President Barack Obama and for his opponents in the Tea Party movement. Moreover, Straughn’s contributions combine with the other sociological and psychological findings discussed in this chapter to generate a broader message: there are no problems, processes or solutions that can be neatly contained and fully addressed within the realm of economics – in all cases, the issues are thoroughly socioeconomic.

CONCLUSION: POST-KEYNESIAN INSTITUTIONALISM An economist must not also be a sociologist, historian and psychologist. One cannot be equally proficient in each of these complex fields. This chapter merely stresses that the interconnected nature of social reality demands a less pre-determined framework than the one used by conventional economists, and it argues that economists must be open to insights that originate in other socialscience fields. There is no ‘Homo economicus’ (economic man), there are only Homo sapiens: human beings whose lives have interrelated economic, political, psychological, social and cultural dimensions. The need for scholars who are open to multiple disciplines is recognized and addressed by a number of graduate programmes in the US. At the Massachusetts Institute of Technology (MIT), for example, a recent reshaping of the industrial relations programme, which can trace its roots to scholarship in Institutional labour economics, led to not only a name change (from the Industrial Relations Section to the Institute for Work and Employment Research) but also a requirement that doctoral students study the core curriculum of one of the major social sciences in addition to the core curriculum in employment relations (Piore, 2008: 171). And at the University of Missouri–Kansas City, the economics department participates in the university’s interdisciplinary PhD. programme. It

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requires doctoral students focusing on economics to also study an additional discipline, such as history, mathematics, political science, psychology, education, urban leadership, public affairs, or sociology. The need for more broadly trained economists is also seen in what French students and faculty members have dubbed the movement for a ‘post-autistic’ economics. Concerned that standard economics has become obsessed with mathematics, socially irresponsible, and devoid of critical thinking, this movement ‘demands that multidisciplinarity be placed at the heart of teaching economics’ (Fullbrook, 2002: 20). Writing in an essay that traces the history of this movement – which in some circles has been renamed a push for ‘realworld’ economics – Edward Fullbrook (2002: 20) adds that its members believe economics students should be required ‘to study cognate disciplines, such as sociology, history, law, psychology, etc., so as to become familiar with their contrasting views and methods of treating social-economic phenomena’. Proponents of a ‘post-autistic’ economics want more than exposure to multiple disciplines, however. They want economics to be studied as a ‘complex system’. Approaching economics in this manner opens the door to a dialogue between economists, biologists, neural scientists, and many other scholars who also study complex systems (Smith, 2004). But it also requires fundamental changes within economics. And this is where Institutionalism and Post Keynesianism can prove useful. Together, Institutionalism and Post Keynesianism provide a formidable alternative to conventional economics: a broader framework for economic analysis and a more secure foundation for exploring and crafting economic policy options. Institutionalism began with the same pluralistic approach to scholarship as that found within the growing ‘real-world’ camp. With that orientation as its foundation, Institutionalism’s contributors developed a molecular approach to the economic system. In more recent decades, the contributions of Post Keynesians have helped underscore the value of that approach as an alternative to the atomistic perspective of neoclassical economics. This chapter closes by drawing on the previous sections to identify some other elements that, along with a common molecular grounding, provide the basis for a (real-world) Post-Keynesian Institutionalism (PKI). What follows is intended merely as a starting point, not a comprehensive or definitive list. History PKI analyzes an economy that exists in real time, not a world in which time is merely a hypothetical concept or pure abstraction. To be sure, we live in a series of ‘short runs’, but it is not a world of ceteris paribus. And as for the ‘long run’, Keynes’s (1924: 80) famous line continues to ring true: ‘In the long run we are all dead’. Economics must understand how socio-economic reality evolves, and it cannot comfort us with an image of a self-regulating system that corrects itself

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when things turn sour. We live, as Davidson stresses, in a non-ergodic world, with an uncertain future and an irreversible past. Humans shape the future – through a ceaseless trial-and-error process that yields an evolutionary hysteresis involving cumulative change. Institutions In conventional economics, the price mechanism provides the balancing wheel of the economy; in PKI, institutions perform that role. Davidson emphasizes that institutions shape our expectations, and thus influence our actions. As a result, they link the past, present and future. In fact, institutions – in their interaction with new and existing technology – shape the nature of economic activity today and the direction and pace of socio-economic change over time. This was evident in the Institutionalism of Veblen, continues in the Post Keynesianism of Wray, and must be a cornerstone of any future PKI. Because institutions are not just structures, but also habits, mores and norms, the study of socio-economic institutions must be informed by psychology, sociology, and other social-science disciplines. Thus, PKI must learn from Lo, Simon, and other scholars (including Daniel Kahneman, and Amos Tversky, in addition to the authors discussed above) who have drawn on psychology in ways that advance economics well beyond the simplistic and unrealistic notion of rationality found in conventional economics. Understanding economic behaviour requires the study of social institutions, and such understanding is enhanced when economists are open to acquiring insights from scholars studying human interaction, memory, and culture.7 Markets PKI is not adverse to the study of markets. To the contrary, the profit motive and its manifestation in markets have been key elements in the work of Institutionalists and Post Keynesians from Veblen to Minsky and beyond. Indeed, although PKI should encompass the full range of institutions affecting social provisioning, markets are fundamental institutions in capitalist economies and therefore deserve a central place in such scholarship. It is also clear that PKI must, at least for the foreseeable future, continue to give financial markets the special attention that Institutionalists and Post Keynesians have always given them in their analyses of capitalist performance and development. But PKI must be focused on the study of actual markets, with all their deviations from perfect competition, not hypothetical ones. And it must be guided by recognition that reality can never be made to conform to that competitive model. In the real world, information asymmetries and power imbalances abound; these must be understood by scholars engaged in economic analysis and often also warrant the attention of economic policymakers. (For important scholarship that helps lay a foundation for the study of power in PKI, see Polanyi (1944), Galbraith (1983), and Dugger (1989a, 1989b).)

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Wages PKI is not just about studying the economy; it is also about solving economic problems. Thus, the study of wage determination must be a key element of PKI. Commons (1950: 118) explained the connection as follows: ‘As I have studied practical problems it has always seemed to me that the lifeand-death struggle of making a living and trying to get rich was at the bottom of all other problems’. The labour market has always been a segment of the economy where negotiating power and institutional considerations are controlling factors. This was clear in Weintraub’s time, when unions were more powerful than today and a few US-based firms dominated in most major industries, but it remains true even now. The difference is that the power imbalance between workers and employers is now much greater because global enterprises can locate operations anywhere, while most workers are tied to homes and communities – where jobs are often scarce. Some might argue that the current state of working America is merely due to impersonal market forces. However, Thomas I. Palley (2007) and other Institutionalists and Post Keynesians demonstrate that financial elites have increasingly gained influence over not only the economy, but also the political system, where they have used their influence to ‘box in labour’ by pressing for globalization, labour-market flexibility, smaller government (excluding business and banking bailouts, of course), and abandonment of full employment. Moreover, at the conceptual level, Institutional economist Bruce Kaufman (2008) recently presented a devastating critique of the neoclassical effort to treat labor as a commodity – revealing the internal contradictions that cause the entire conventional labour-market model to collapse. (A central element in his critique is the observation that the model can only be saved by assuming a world of zero transaction costs – a world in which there would be no need for firms to hire a workforce.) Consumption Finally, in addition to wages, consumption must be another focus of PKI. A convergence on this topic is already occurring among Institutionalists and Post Keynesians. As mentioned above, Institutionalists following Veblen’s lead on consumption have stressed the role consumer credit plays in sustaining household spending in an era of wage stagnation. More recently, Wray (2009, 2010) – operating from a framework rooted in the macroeconomics of Keynes – has underscored the role household debt played in both the economic boom of the early 2000s and the subsequent downturn (see also Chapter 4 in this volume). (To be sure, the study of investment is also central to PKI – as indicated in earlier sections of the current chapter and in Chapter 4 – but we have chosen to draw attention to consumption in this closing section because it is too often overlooked.) However, attention to consumption within PKI must do more than examine

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the role of emulation and find a way to enable robust aggregate consumer spending without aggravating the already serious problem of household indebtedness. It must also integrate the study of consumption with the study of environmental sustainability and the concepts and findings of ecological economics. The desire for increased consumption, especially when considered globally, seems to be propelling the worldwide socio-economic system – and the entire planetary environment – towards a sustainability crisis. To be sure, there is evidence Institutionalists and Post Keynesians are getting serious about this subject (for example, see Ozveren (2007) and Holt et al. (2009)), but the consumption-sustainability nexus must begin to take centre stage in PKI.

ACKNOWLEDGEMENT An early version of this chapter was delivered at the annual meeting of the Association for Institutional Thought (AFIT) in Albuquerque, New Mexico, on 17 April 2009 as part of a session on Post-Keynesian Institutionalism. The final version has been strengthened by the suggestions of those in attendance.

NOTES 1.

2.

3.

4. 5.

This chapter builds on an exploration of the compatibility of Institutional and Post Keynesian economics that its lead author conducted three decades ago (Brazelton, 1981), as well as on a more recent examination of Institutionalist and Post Keynesian common ground with respect to the study of business cycles (Brazelton, 2005). While scholars in both camps have made important advances in the last 30 years, and some have blended the insights of both camps – including Wilber and Jameson (1983), Eichner (1985) and Lee (1994) – it is only now that a contingent of economists is collectively aiming for the sort of synthesis described in this chapter. See also Whalen (2008). Technology has often been resisted on the basis of unrealistic fears. For example, some people resisted expansion of railroads out of a fear that train speeds would be harmful to the human body. Since then, of course, we have developed even faster modes of transportation and experience has shown that those earlier fears were unrealistic. At the same time, reasonable fears associated with new products and innovations have often been dismissed by interested parties, who hid knowledge of socially harmful consequences from the public. The lesson here is that decisions about technology must be made by a fully informed public. Veblen anticipates two key aspects of Institutionalist and Post Keynesian theory: he challenges the neoclassical concept of the neutrality of money by stressing that finance drives the production of goods and services; and he employs a monetary theory of production to explain business cycles. Veblen also helps us understand what happened in 2008 and 2009 when banks and corporations were given money by the Fed: most did not need to immediately use this money due to their market power. For insightful applications of Veblen’s conception of money, credit and finance, see Hake (1998; 2004; 2005) and Hake and King (2002). Keynes’s analysis was also institutionally specific and historically contingent (see Crotty, 1990; and Foster, 1981). The 1970s also saw the rise of ‘new classical’ economics. Rooted in a general-equilibrium model of economic activity, it suggests the economy is always at full employment (Lucas and Sargent, 1979).

48 6.

7.

Financial instability and economic security after the Great Recession Optimization is not merely impractical for the reasons suggested by Simon. Its practicality is also undermined by the passage of time, which allows for changes to the decision-making context and to the aims of the decision maker. As Douglass North (1994) observed in his Nobel lecture, neoclassical theory is inappropriate for the study of economic performance through time. For an important new book on public finance from the perspective of behavioural economics, see Congdon, Kling and Mullainathan (2011).

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Davidson, Paul (1977), ‘Post-Keynes monetary theory and inflation’, in S. Weintraub (ed.), Modern Economic Thought, Philadelphia, PA: University of Pennsylvania Press, pp. 275–94. Davidson, Paul (1991), Controversies in Post Keynesian Economics, Aldershot: Edward Elgar. Davidson, Paul (1993), ‘The elephant and the butterfly: or hysteresis and post Keynesian economics’, Journal of Post Keynesian Economics, 15 (3), 309–22. Davidson, Paul (1996), ‘Reality and economic theory’, Journal of Post Keynesian Economics, 18 (4), 479–508. Davidson, Paul (2007), John Maynard Keynes, New York: Palgrave Macmillan. Davidson, Paul (2009), The Keynes Solution: The Path to Global Economic Prosperity, New York: Palgrave Macmillan. Duesenberry, James S. (1949), Income, Saving and the Theory of Consumer Behavior, Cambridge, MA: Harvard University Press. Dugger, William M. (1989a), Corporate Hegemony, Westport, CT: Greenwood Press. Dugger, William M. (1989b), ‘The state: power and dichotomy’, in W. Samuels (ed.), Fundamentals of the Economic Role of Government, Westport, CT: Greenwood Press, pp. 49–57. Eichner, Alfred S. (ed.) (1985), Toward a New Economics: Essays in Post-Keynesian and Institutionalist Theory, Armonk, NY: M.E. Sharpe. Foster, John F. (1981), ‘Understandings and misunderstandings of Keynesian economics’, Journal of Economic Issues, 15 (4), 949–57. Frank, Robert H. (2005), ‘The mysterious disappearance of James Duesenberry’, The New York Times, 9 June, accessed 31 July 2010 at www.nytimes.com/2005/06/09/ business/09scene.html?scp=1&sq=he%20Mysterious%20Disappearance%20of%2 0James%20Duesenberry&st=cse. Friedman, Milton (1956), ‘The quantity theory of money: a restatement’, in Studies in the Theory of Money, Chicago, IL: University of Chicago Press, pp 3–21. Friedman, Milton (1959), A Program for Monetary Stability, New York: Fordham University Press. Friedman, Milton and A. Schwartz (1963), A Monetary History of the United States, Chicago, IL: University of Chicago Press. Fullbrook, Edward (2002), ‘The post-autistic economics movement: a brief history’, Journal of Australian Political Economy, 50 (December), 14–23. Galbraith, John K. (1954), The Great Crash, 1929, Boston: Houghton Mifflin. Galbraith, John K. (1983), The Anatomy of Power, Boston: Houghton Mifflin. Gordon, Wendell C. (1980), Institutional Economics: The Changing System, Austin, TX: The University of Texas Press. Hake, Eric R. (1998), ‘Financial innovation as facilitator of merger activity’, Journal of Economic Issues, 32 (1), 145–69. Hake, Eric R. (2004), ‘The appearance of impairment: Veblen and goodwill-financed mergers’, Journal of Economic Issues, 38 (2), 389–95. Hake, Eric R. (2005), ‘Financial illusion: accounting for profits in an Enron world’, Journal of Economic Issues, 39 (3), 595–611. Hake, Eric R. and Martin Bruce King (2002), ‘The Veblenian credit economy and corporatization of American meatpacking’, Journal of Economic Issues, 36 (2), 495–505. Hobson, John A. (1937), ‘The economics of Thorstein Veblen’, Political Science Quarterly, 52 (1), 139–44, accessed 31 July 2010 at www.marxistsfr.org/archive/ hobson/1937/03/veblen.htm.

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Holt, Richard, S. Pressman and C.L. Spash (eds) (2009), Post Keynesian and Ecological Economics: Confronting Environmental Issues, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Kaufman, Bruce E. (2008), ‘The original industrial relations paradigm: foundation for revitalizing the field’, in C. Whalen (ed.), New Directions in the Study of Work and Employment: Revitalizing Industrial Relations as an Academic Enterprise, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 41–7. Keynes, John M. (1924), A Tract on Monetary Reform, London: Macmillan. Keynes, John M. (1935), ‘A self-adjusting economic system?’, The New Republic, 20 February, 35–7. Keynes, John M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Keynes, John M. (1937), ‘The General Theory of Employment’, Quarterly Journal of Economics, 51 (2), 209–23. Keynes, John M. (1973), The Collected Writings of John Maynard Keynes, edited by Donald Moggridge, vol 13, The General Theory and After, part 1, London: Macmillan. Keyserling, Leon H. (1964), ‘The toll of rising interest rates’, Conference on Economic Progress, Washington, DC, archived at the Truman Memorial Presidential Library, Independence, MO. Keyserling, Leon H. (1979), ‘Liberal and conservative national economic policies and their consequences, 1919–79’, Conference on Economic Progress, Washington, DC, archived at the Truman Memorial Presidential Library, Independence, MO. Keyserling, Leon H. (1980), ‘Money, credit and interest rates: their gross mismanagement by the Federal Reserve system’, Conference on Economic Progress, Washington, DC, archived at the Truman Memorial Presidential Library, Independence, MO. Krugman, Paul (2009). ‘How did economists get it so wrong?’, The New York Times, 2 September, accessed 31 July 2010 at www.nytimes.com/2009/09/06/magazine/ 06Economic-t.html. Larson, Calvin J. (1986), Sociological Theory: From the Enlightenment to the Present, Bayside, NY: General Hall. Lee, Frederic S. (1994), ‘From post-Keynesian to historical price theory, part I: facts, theory, and empirically grounded pricing model’, Review of Political Economy, 6 (3), 303–36. Lo, Andrew W. (2005), ‘Reconciling efficient markets with behavioral finance: the adaptive markets hypothesis’, Journal of Investment Consulting, 7 (2), 21–44. Lucas, Robert E. and T.J. Sargent (1979), ‘After Keynesian macroeconomics’, Federal Reserve Bank of Minneapolis, Quarterly Review, 3 (2), 1–16. Minsky, Hyman P. (1975), John Maynard Keynes, New York: Columbia University Press. Minsky, Hyman P. (1977a), ‘The financial instability hypothesis: an interpretation of Keynes and an alternative to “standard” theory’, Nebraska Journal of Economics and Business, 16 (1), 5–16. Minsky, Hyman P. (1977b), ‘How “standard” is standard economics?’, Society, 14 (3), 24–9. Minsky, Hyman P. (1982), Can ‘It’ Happen Again? Essay in Instability and Finance, Armonk, NY: M.E. Sharpe. Minsky, Hyman P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press.

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Myrdal, Gunnar (1978), ‘Institutional economics’, Journal of Economic Issues, 12 (4), 771–83. North, Douglass C. (1994), ‘Economic performance through time’, American Economic Review, 84 (3), 359–68. Olick, Jeffrey K. (2007a), The Politics of Regret: On Collective Memory and Historical Responsibility, New York: Routledge. Olick, Jeffrey K. (2007b), ‘Collective memory and nonpublic opinion: an historical note on a methodological controversy about a political problem’, Symbolic Interaction, 30 (1), 41–55. Olick, Jeffrey K. (2008), ‘Collective memory: a memoir and prospect, Memory Studies, 1 (1), 19–25. Olick, Jeffrey K., V. Vinitzky-Seroussi and D. Levy (2010), The Collective Memory Reader, New York: Oxford University Press. Özverern, Eyup (2007), ‘Where disciplinary boundaries blur: the environmental dimension of institutional economics’, in Stavros Ioannides and Klaus Nielsen (eds), Economics and the Social Sciences: Boundaries, Interaction and Integration, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Palley, Thomas I. (2007), ‘Financialization: what it is and why it matters’, The Levy Economics Institute working paper no 525, Annandale-on-Hudson, NY. Piore, Michael J. (2008), ‘Revitalizing industrial relations’, in C. Whalen (ed.), New Directions in the Study of Work and Employment: Revitalizing Industrial Relations as an Academic Enterprise, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 163–72. Polyani, Karl (1944), The Great Transformation, Boston, MA: Rinehart. Setterfield, Mark (1993), ‘Towards a long-run theory of effective demand: modeling macroeconomic systems with hysteresis’, Journal of Post Keynesian Economics, 15 (3), 347–64. Smith, Lewis L. (2004), ‘Complexity economics and Alan Greenspan’, Post-Autistic Economics Review, 26 (2), accessed 31 July 2010 at www.paecon.net/PAEReview/ issue26/Smith26.htm. Straughn, Jeremy B. (2006), ‘The power of patriotic performances: a comment on Jeffrey Alexander’, Culture, Newsletter of the Sociology of Culture Section of the American Sociological Association, 20 (3), 1, 4–7. Straughn, Jeremy B. (2009), ‘Culture, memory and structural change: explaining support for “socialism” in a post-socialist society’, Theory and Society, 38 (5), 485–525. Veblen, Thorstein B. (1904), The Theory of Business Enterprise, New York: Charles Scribners Sons. Veblen, Thorstein B. (1919), The Place of Science in Modern Civilization and Other Essays, New York: B.W. Heubsch. Veblen, Thorstein B. (1967 [1899]), The Theory of the Leisure Class, New York: The Viking Press. Weintraub, Sidney (1963), Some Aspects of Wage Theory and Policy, Philadelphia, MA: Chilton Press. Weintraub, Sidney (1972), ‘Incomes policy: completing the stabilization triangle’, Journal of Economic Issues, 6 (4), 105–22. Weintraub, Sidney (1978), Capitalism’s Inflation and Unemployment Crisis: Beyond Monetarism and Keynesianism, Reading, MA: Addison-Wesley. Whalen, Charles J. (2008), ‘Toward “wisely managed capitalism”: post-Keynesian institutionalism and the creative state’, Forum for Social Economics, 37 (1), 42–60. Whalen, Charles J. (2010), ‘A Minsky perspective on the global recession of 2009’, in

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D. Tavasci and J. Toporowski (eds), Minsky, Crisis and Development, Basingstoke: Palgrave Macmillan, pp. 106–26. Wilber, Charles K. and K.P. Jameson (1983), An Inquiry into the Poverty of Economics, Notre Dame, IN: University of Notre Dame Press. Wray, L. Randall (1990), Money and Credit in Capitalist Economies: The Endogenous Money Approach, Aldershot: Edward Elgar. Wray, L. Randall (1992), ‘Commercial banks, the central bank and endogenous money’, Journal of Post Keynesian Economics, 14 (3), 272–310. Wray, L. Randall (1996), ‘Monetary theory and policy for the twenty-first century’, in C. Whalen (ed.), Political Economy for the 21st Century: Contemporary Views on the Trend of Economics, Armonk, NY: M.E. Sharpe, pp. 125–48. Wray, L. Randall (1998), Understanding Modern Money: The Key to Full Employment and Price Stability, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Wray, L. Randall (2009), ‘The rise and fall of money manager capitalism: a Minskian perspective’, Cambridge Journal of Economics, 33 (4), 807–28. Wray, L. Randall (2010), ‘Wall Street still doesn’t get it’, New Economic Perspectives blog, comment posted 16 February, accessed 31 July 2010 at http://neweconomic perspectives.blogspot.com/2010/02/wall-street-still-doesnt-get-it.html.

3. Futurity: cornerstone of PostKeynesian Institutionalism Glen Atkinson and Charles J. Whalen INTRODUCTION Institutional and Post Keynesian economists have long recognized shared views and interests. In fact, Wallace Peterson (1977) devoted his presidential address before the Institutionalists’ Association for Evolutionary Economics (AFEE) to a discussion of ‘bedrock, seminal ideas’ common to both Institutional (or Evolutionary) economics and Post Keynesian interpretations and extensions of John Maynard Keynes’s (1936) The General Theory of Employment, Interest and Money. Some years later, Peterson (1992: 337) again addressed his AFEE colleagues, this time on receipt of the VeblenCommons award for outstanding scholarship in Institutional economics, and his comments were more personal: ‘Keynes and Institutionalism are the two intertwined threads in my work as an economist’. Peterson is not alone. Many reflections by other Institutionalists practising in the wake of The General Theory – including Hamilton (1983), Dillard (1987a), Klein (1991), and Waller (2005) – also mention either the influence of Keynes’s ideas or an appreciation of the complementarity of Institutionalism and the economics of Keynes. In fact, the lines between Institutionalism and Post Keynesianism have recently started to blur as more and more economists are drawing on insights from both traditions. The result is emergence of the contours of a Post-Keynesian Institutionalism (PKI). This chapter explores a concept that deserves recognition as a cornerstone of PKI – futurity. According to its originator within the realm of economics, John R. Commons (1934: 58), futurity is ‘a factor that indicates anticipation’. He also described it in terms of an expectation or forecast (Commons, 1934: 84, 738–41). In a 1925 manuscript that eventually evolved into Commons’s Institutional Economics: Its Place in Political Economy, he explained the concept as follows: [All activities have their present values] not on account of what has happened in the past, nor even on account of what is happening at the present point of time, but on 53

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Financial instability and economic security after the Great Recession account of what I and others hope, expect, or fear will happen in the future. The extent to which this human ability of forecasting has its influence on present behavior and values may be given the name, Futurity. (Commons, 1925: 2)

This chapter is organized into four parts. The first accounts for Commons’s development of the concept of futurity and describes his related analysis of the changing meaning of property. The second reviews and extends his analysis of the co-evolution of industry and finance; that co-evolution is a key to explaining how futurity is a cornerstone of PKI. The third explores the connection between this concept and the Post Keynesian tradition. The fourth outlines implications for PKI.

LAW AND PROPERTY IN A MONETARY ECONOMY Hyman Minsky, a Post Keynesian widely admired by Institutionalists (see, for example, Brazelton, 1981; Dillard, 1987b; and Peterson, 1996), highlighted the link between Commons and Keynes when presented with AFEE’s VeblenCommons Award in 1996. At the start of that address, Minsky recalled a 1927 letter in which Keynes praised Commons for a recently published paper on monetary policy. Keynes wrote: ‘[T]here seems to be no other economist with whose general way of thinking I feel myself in such genuine accord’. According to Minsky, ‘Keynes’s letter to John R. Commons illustrates the affinity between the economics of Keynes and the American Institutionalists’ (Minsky, 1996: 357). Keynes’s praise for the economic contributions of Commons also surfaces in two essays based on lectures delivered in 1925 (Keynes, 1972: 303–6; 1981: 438–42). He wrote, ‘An eminent American economist, Professor Commons, who has been one of the first to recognize the nature of the economic transition amidst the early stages we are living, distinguishes three epochs, three economic orders, upon the third of which we are now entering’ (Keynes, 1972: 303). That global epoch is what Commons called the era of stabilization, preceded immediately by a period of abundance (which was ushered in by industrial revolution and ran from the late eighteenth century to the late nineteenth century) and before that by a time of scarcity. Commons, Keynes and Capitalist Evolution What is notable from the preceding quote is that Keynes praised Commons for appreciating the need to analyze economic problems from the perspective of the evolution of economic life. Scholars often recognize that Keynes and Commons shared the goal of seeking to understand business cycles, but the more important point is that they both placed the study of such cycles within

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a broader, evolutionary conception of capitalist development. What Keynes and Commons shared, and Minsky recognized and appreciated, is the conviction that understanding modern capitalism requires examining its evolution (Whalen, 2008).1 Keynes and Commons also agreed that the co-evolution of finance and industry is at the heart of capitalist evolution. In this regard, they paved the way for Minsky, who often argued that the ‘village fair’ paradigm of conventional economics must be replaced by a ‘Wall Street’ paradigm. The central image in modern economics must be of a banker making decisions about loans and investments, Minsky stressed, not of a farmer or craftsman trading in an outdoor market (Minsky, 1975: 57–8). In other words, capitalism does not involve a barter economy; it involves a monetary economy. According to Dudley Dillard (1987b: 1625), the central challenge in a monetary economy is the realization of the value of real output in money terms: that is, the selling of products for money. Dillard (1987b: 1631) adds that this is why Keynes explained in 1933 that he was at work on ‘a monetary theory of production’. The General Theory was the result. Commons, meanwhile, found it necessary to develop the concept of futurity to understand the co-evolution of finance and industry at the heart of a monetary (capitalist) economy. This co-evolution required radical changes in the concept of property and the meaning of property rights. Over decades, lawyers expanded the concept of property, and the focus shifted from the corporeal to the incorporeal and eventually to the intangible. From Use Value to Exchange Value If we are to understand the evolution of modern capitalism, we must probe the proprietary basis of modern capital; Commons (1924; 1934; 1950) did this by analyzing what he called the legal foundations of capitalism. In The Economics of Collective Action, Commons (1950: 107) writes: ‘Present value depends on expected scarcity, which is economic futurity, and this is property’. And in Institutional Economics, he writes: ‘Intangible property is the present value of future sales; whereas incorporeal property is the present value of expected payment of debts. The two together [intangible and incorporeal property] constitute modern capital’ (Commons, 1934: 452). He adds: ‘This is the modern meaning of capital divorced entirely from the obsolete meaning of savings’ (Commons, 1934: 456). In conflicts over the practical meaning of property, the Supreme Court is the final arbiter within the US. Commons’s (1924) Legal Foundations of Capitalism documents how that court changed the legal definition of property over time. It gives special attention to the shift in meaning caused by a change in focus from use value to exchange value, which occurred between 1872 and

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1897. This shift arose out of the resolution of disputes over the right of government to regulate business and disagreements about the legal definition of the tax base of an interstate corporation. This series of Supreme Court decisions begins with a trio of disputes collectively decided in 1873 and known as the ‘Slaughterhouse Cases’. The court heard the first of these in 1872 when independent butchers in New Orleans disputed the authority of the city to issue a monopoly franchise that established a central slaughterhouse (Commons, 1924: 11). The city argued this was necessary to ensure sanitary food processing and thus fell within its police power. Independent butchers could use the facility, but had to pay a fee set by the franchise. The butchers claimed that their property and liberty had been taken by the action of the city officials, but the majority of the Supreme Court disagreed. It argued no physical property had been taken. Thus, the decision affirmed the notion that property is based on use value, which had long been the central principle of law and economics, and rejected a definition based on exchange value. A similar ruling was issued by the court in 1876, when it found – in ‘Munn v. Illinois’ – that the State of Illinois had authority to regulate the prices a monopoly grain warehouse could charge and did not need to compensate the warehouse operator for a loss of income (Commons, 1924: 14). In both the Slaughterhouse Cases and Munn v. Illinois, there was no protection for lost future income because exchange value had no legal status. Another key case, decided in 1884, also involved meat cutting in New Orleans. Almost a decade after granting a 25-year monopoly privilege to the city’s central slaughterhouse, the city granted slaughterhouse rights to a second facility. The existing operation sued, claiming that its property was taken. Again the majority on the court held that no harm had been done because no physical property had been taken (Commons, 1924: 13). As in the earlier cases, the court’s minority argued that exchange value was taken, but it could not cite a legal precedent to justify that position. In 1890, however, the Supreme Court reversed its earlier view of exchange value in the ‘Minnesota Rate Case’ (Commons, 1924: 15). The court agreed with railroad owners that a state’s rate control could result in confiscation of property: such rate setting and other state regulation of business must pass the judiciary’s test of reasonableness. The court, by that action, established exchange value as a legal basis for economic value. As Commons wrote: ‘The majority … now held … that not merely physical things are objects of property, but the expected earnings power of those things is property; and property is taken from the owner, not merely under the power of eminent domain which takes title and possession, but also under the police power which takes its exchange-value’.

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The ‘Adams Express Company Case’ of 1897 reinforced this expanded definition of property. For the purposes of property tax assessment, the Ohio State Board of Assessment valued the property of Adams Express according to the estimated current value of its future stream of earnings. The company objected, noting that this ‘capitalized value’ was many times greater than the estimated worth of the company’s tangible property in state. (Commons, 1924: 172). The majority of Supreme Court judges rejected that claim, arguing that the value of the company’s tangible property came from ‘unity in use’ and resulted in a property, ‘intangible though it may be, which in value exceeds the aggregate value of the separate pieces of tangible property’ (majority decision quoted in Commons, 1924: 173). Commons adds: ‘In this opinion, the court completed a transition, that had been going on for 50 years, in the meaning of property from that of tangible property owned by individuals to that of a going business owned by a going concern’. This action established the ‘unit rule’ for taxing multi-state firms. Applying that rule begins with a calculation of the entire firm’s capitalized value. Then the total value of the firm is apportioned according to the proportion of business done in each state. In this way, exchange value – intangible property – is the measure of a firm’s property value. Today, the exchange-value principle continues to be used in legal disputes. A current example involves the downloading of music from the Internet. Downloads do not take possession of any physical property, but they do reduce the value of a recording company’s intangible assets. In a pair of recent cases, penalties for illegal downloading were assessed at $2250 per song (Murphy, 2010). Commons argued that any economics relevant to the real world must be fashioned around recognition of the modern meaning of property. It is understandable that classical economics restricted its definition of property to the realm of the corporeal or tangible; that was consistent with a long-accepted legal definition. But that definition changed, which required economics to change as well. The property that matters today in business is intangible property: the expected earning power of a right, regardless of whether it is associated with something corporeal, incorporeal (a loan that has a definite time period for repayment) or intangible (such as patents, trademarks, business goodwill, trade secrets, and the right to do business) (Commons, 1924: 19; Commons, 1950: 80). According to Commons (1924: 176), ‘[V]aluation proper is capitalization, which looks to the future’. This understanding derived from his study of law and property in a monetary economy. And it convinced him that economic inquiry must rest on the notion of futurity.

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THE CO-EVOLUTION OF INDUSTRY AND FINANCE Although Commons is best known as a labour economist, his early labour investigations convinced him of the need to study the evolution of finance in the course of seeking to understand the evolution of production and the condition of workers. Commons did not argue that all economies had to pass through the same industrial stages, and he certainly did not think his analysis would remain the final word on the subject. He was simply trying to offer an up-to-date understanding of the essential features of US capitalist development. Commons’s analyses of industrial and financial evolution gave special attention to shoemaking, which he saw as representative of American industry overall.2 An early analysis of that industry appears in his article ‘American Shoemakers, 1648–1895: A Sketch of Industrial Evolution’ (Commons, 1909). He extended the resulting evolutionary analysis in Institutional Economics (Commons, 1934: 763–73) and referred to it again in The Economics of Collective Action (Commons, 1950: 61–8). In the two-volume history of labour in the US that Commons co-authored with his students, David J. Saposs contributed an especially penetrating analysis of the early evolution of finance, including the emergence of commercial banking (Commons et al., 1918a: 88–107). More recently, Minsky (1990; 1993) offered an account of US economic development that helps further extend that analysis through the New Deal and into the decades following World War Two.3 Combining Commons’s article on the shoe industry with his related subsequent writings, what emerges is an analysis with three main industrial stages: merchant capitalism (circa 1648–1857), industrial capitalism (circa 1857–90 and also called employer capitalism), and banker capitalism (beginning about 1890 and also called financial capitalism). Merchant capitalism straddled the world epochs of scarcity and abundance. Industrial capitalism coincided with the flourishing of the era of abundance; and banker capitalism coincided with emergence of the era of stabilization. Merchant Capitalism Merchant capitalism was not static. Commons begins his analysis by focusing on a craft-guild phase that began in the late 1640s, but he also mentions an even earlier itinerant-journeyman phase. In addition, the craft-guild period was succeeded by the following phases: retail shop (originating circa 1789), wholesale order (1794), and wholesale speculation (1835). Commons did not suggest that each phase eradicated all signs of the previous period, only that a new industrial form was dominant. The craft-guild phase organized craftsmen into publicly chartered associa-

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tions designed to uphold quality standards. The first guild in America, established to organize shoemakers in Boston, received its charter from the Colony of Massachusetts in 1648 (Commons, 1909: 40). The guild’s officers were given broad authority (subject to judicial oversight) to oversee and control the quality of workmanship through imposition of penalties and restriction of entry into the craft. While guilds operated in much the same way as modern professional associations (at least in the days before professions were allowed to advertise), production in the craft-guild period was always customer-order – ‘bespoke’ – work. In this period, the customer placed an order in which the quality and price of the merchandise were agreed before production began. As in the earlier itinerant-journeyman phase, craftsmen would often work in a customer’s home and even use the customer’s own leather. In response to the growth of cities and the fact that craftwork was performed increasingly in a guild member’s home shop (where there was full access to his tools and equipment), master craftsmen began to establish retail shops and to employ their own journeymen. In that retail-shop period, the merchant-master dealt with customers, taking payment for the merchandise shortly after an order was placed, and supervised or inspected the work of his journeymen, who owned their own tools and often worked at home. To keep busy in slow periods, merchant-masters and their journeymen would produce work for in-shop display and sale. The ‘shop work’ had not been ordered by a customer, and thus represented the start of speculative work. While it was important for a shop to stock good-quality merchandise, there was uncertainty surrounding when and whether the displayed work would sell. And the most well-to-do customers would insist on custom orders. Thus, shop work was the first of many steps toward market differentiation and the decline in craftsmanship (Commons, 1909: 50). Improvements to roads and waterways during the retail-shop phase provided an opportunity for retailers to reach markets beyond their home city. The widening of markets was further encouraged by the nation’s new constitution, which prohibited restrictions on interstate trade (Commons, 1934: 767–8). The combination of improved transportation and a new legal environment encouraged some merchant-masters to carry samples ‘to distant merchants and take “orders” for goods to be afterwards made and delivered’. These masters became wholesale merchants, and, to meet the needs of regional markets in the emerging wholesale-order era, often hired many more journeymen than they had as retail-shop merchants (Commons, 1909: 49). Wholesale merchants eventually began to stock up on a surplus of goods, just as retail merchants did in the retail-shop period. They also began to specialize in their work as wholesalers, and contracted with others to oversee production. The result was the period of wholesale speculation. Because

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wholesalers realized they could purchase finished goods from any of a large number of producers, the supplier merchants (now ‘manufacturers’) and their journeymen were forced to ‘compete severely’, not only against other merchants and journeymen, but sometimes even against prison workers. This led to sweatshops, in which contractors – including former retail-shop masters – introduced the division of labour and ‘team work’ to boost production and enable use of less-skilled workers (Commons, 1909: 61–5).4 Production in the era of wholesale speculation laid the foundation for mass production via the factory system. However, emergence of factories also required developments in machinery and finance. The period of wholesale speculation saw machinery introduced into the workplace. As suggested above, merchant capitalism began in the epoch of scarcity. But, by the wholesale period, that epoch had given way to the era of abundance, which was driven by industrial revolution. For example, Commons (1909: 73) indicates that a tour of the workplace of the period would reveal use of ‘tin patterns for cutting, the stripper and sole cutter, adjustable lasts, levelers, skivers, and the machines for heel making, lasting, and sandpapering’. Nevertheless, most of that machinery required an operator with considerable physical strength and endurance. Commons (1909: 73) writes: ‘Whether operated by foot power or merely by facilitating the work of his hands, they were essentially shop tools and not factory machines’. In contrast, the machines of the factory era – the stage Commons called industrial capitalism – ‘usurped not only the highest skill of the workman but also his superior physique’. For example, Commons (1909: 73) mentions the pegging machine introduced in 1857 and the McKay sole-sewing machine introduced in 1862, noting that the McKay machine ‘did in one hour what the journeyman did in 80’. He adds: ‘These machines were quickly followed by others, either machines newly invented or old ones newly adapted, but all of them belted up to steam’. Since factory equipment is expensive, emergence of the industrial era required accommodative financial institutions. The credit institutions of merchant capitalism were inadequate for a factory era, however. In fact, the institutions of early merchant capitalism were inadequate even for the period of wholesale speculation (Commons et al., 1918a: 89). There was little need for finance in the early phases of merchant capitalism. There was no fixed capital, other than the merchant’s shop, and no working capital, other than a limited supply of essential raw materials. In fact, in the craft-guild era, there were no inventories or shipping costs to be financed. However, the need for finance grew substantially as speculative work for regional markets replaced bespoke and shop work. There was a need for larger stockpiles of raw materials and inventories. There was also the need to cover the often-considerable period between incurring costs of production and receiving revenue from the final sale of goods produced. In fact, these needs

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expanded as wholesale merchants became more ambitious, stockpiling larger inventories and shipping finished goods to more distant markets. To be sure, a number of financing tools did exist. Individual wholesalers and contractors relied on mutual aid societies and associations of influential community members to arrange credit in extraordinary circumstances. Wholesalers also secured funds by issuing promissory notes, selling stock, and using lotteries. Commission stores and marketing warehouses also served as bankers by issuing loans or advancing raw material (Commons et al., 1918a: 88–101). But ever-widening markets required specialized institutions devoted to finance. The result was the emergence of the banking system and the financier (Commons et al., 1918a: 8). Thus, Commons (1934: 768) writes that commercial banking appeared in the wholesale-speculation period of merchant capitalism. Yet there was still another hurdle: collateral. Saposs’s chapter in History of Labor in the United States notes that real estate was the only acceptable security in the early 1820s and that a tradesmen’s association in New York City loaned money only on tangible property in 1833. He adds: ‘The few banks that existed at the time when these new markets were opening up required chiefly land as security on loans.’ (Commons et al., 1918a: 89). The solution, of course, was to recognize incorporeal – and later also intangible (Commons, 1918b: 5) – property as acceptable collateral. According to Saposs, retail merchants were the first to make such loans: A merchant would agree with a manufacturer, who had contracts or notes, to honor orders, which he issued to his workmen in lieu of cash wages. He would then redeem the orders in merchandise. Such accounts would run until the manufacturer’s customers made their remittances. (Commons et al., 1918a: 89)

The banking system soon did the same: ‘The banking system expanded along with the activities of the merchant-capitalist, enabling him to convert the distant retailer’s orders into bank credits and to stock up a surplus of goods in advance of actual orders’ (Commons et al., 1918a: 101). In this manner, property rights were created out of a debt transaction, rather than out of land and structures. Property became the expected exchange value of goods for money. While financing working capital with debt secured on expected sales is a notion that seems simple and obvious to the modern student of economics, it was a radical step that put us on the path to present-day capitalism. Industrial and Banker Capitalism The factory system of industrial capitalism relocated enterprise production from disparate workshops to the factory floor. Workers no longer owned the

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tools of production; the need for handicraft skills was eliminated; and machines dictated the logic of production. The factory system began with the manufacture of textiles and spread quickly, spawning the mass production of goods in countless industries. The financial sector expanded in tandem with industrialization. Created to serve the wide markets, finance and industrialization helped widen markets even further. Real capital – property, plant and equipment – had to be financed along with huge quantities of working capital, and this enhanced the importance of finance even as industrial machinery became emblematic of the era. As establishment and expansion of factories required stock and bond issues as well as large loans, the New York Stock Exchange and investment banking firms such as that of J.P. Morgan emerged as especially important, but not yet dominant (Minsky, 1993: 108–9). By bringing many producers (and wholesalers) into competition with each other and by increasing productivity, wider markets put downward pressure on prices and squeezed profit margins. Thus, the era of industrialization was not just highly productive; it was also a period of cut-throat competition and business cycles (Commons, 1934: 779). Manufacturing enterprises responded by using trade secrets, patents, and trademarks – intangible property – to gain a market advantage. They also pursued vertical integration, not only by setting up retail stores, but also by securing ownership of raw materials (Commons, 1934: 771–2). Towards the end of the nineteenth century, corporate consolidation within an industry became still another strategy used to reduce competitive pressures, thereby enabling the stabilization of output, prices and profits. That consolidation elevated the position of financiers still further. In fact, it gave them a dominant place in the economy. Commons (1934: 773; 1950, 61) recognized this by writing that the movement toward mergers, acquisitions, trusts and cartels signalled the economy had transitioned from industrial capitalism to financial (banker) capitalism. Investment bankers not only arranged mergers and other forms of consolidation, they also secured key ownership and governance (corporate board) positions in the consolidated enterprises. The emergence of banker capitalism represented the end of the era of abundance and the start of the era of stabilization. Vertical integration and corporate consolidation were private-sector efforts to stabilize the economy in the face of both destructive competition and ‘periodic and general oversupplies of commodities, occurring in irregular trends and cycles’ (Commons, 1934: 779). In the 1920s, however, many manufacturing firms still found that profit margins were often fragile, and thus developed yet another private method of stabilization. The new method involved active financial management to reduce dependence on sales as a source of revenue. Manufacturing corporations protected

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themselves by using profits (above dividend payments) to buy not only assets that would yield rents and royalties, but also financial assets including the stocks and bonds of other corporations, government securities, and time deposits. In this manner, Commons (1934: 582–4) explained, a firm would convert its fragile profits into ‘vested rights’ – assets that do not depend on the performance of its own operations and that are therefore ‘free from the exposures of the narrow profit margins’. These developments contained the seeds of the corporate portfolio management of recent decades, and thus provide the starting point for what economists would later describe as a portfolio conception of non-financial corporations (Minsky, 1975: 71; Minsky, 1986a: 315–18; and Crotty, 2003: 272). Despite these attempts to achieve stability through private actions, the private sector was not able to prevent the major collapse that we call the Great Depression. In response to that economic crisis, the US government stepped in, not only to promote industry-wide business cooperation and collective bargaining (which aimed to eliminate wage cutting as a source of cut-throat competition), but also to promote recovery and reform via more active forms of public policy. Looking across the globe in the midst of that depression, Commons (1934: 773) wrote: ‘When the bankers reach the limits of their ability, as in 1932, then the government itself organizes a huge reconstruction finance corporation to relieve the bankers of liability. Meanwhile central banks controlled by bankers rise to a new importance and banker capitalism comes into control of industries and nations’. Managerial and Money-Manager Capitalism Looking at twentieth-century American economic history from the perspective of its final decade, Minsky (1995) accepted Commons’s suggestion that the Great Depression elevated the importance of the US central bank. From Minsky’s perspective, however, corporate managers, not the Federal Reserve (Fed), were the new dominant economic participants in the wake of the New Deal and World War Two (Minsky, 1993). In the war’s aftermath, America’s corporate leaders found themselves in a solid position. Most major corporations, having benefited from war production, entered the post-war era with little or no indebtedness. Fiscal and monetary policies aimed to support economic growth and prevent another depression. Stockholders did not pose a threat to management decision-making. And US firms dominated the global marketplace because the war had taken such a toll on other nations. The major flaw of this post-war managerial capitalism, argues Minsky (1993: 110), is that its managers – free from ownership, banker and marketplace pressures – became complacent. Using retained earnings and generous depreciation allowances, firms began to seek opportunities through conglomeration

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rather than growth of their own product lines. As a result, they were vulnerable to growing international competition and to financial innovators (Minsky, 1990: 68–9). Innovators eventually appeared in the form of financiers such as T. Boone Pickens and Carl Icahn, who launched hostile takeover bids to wrest corporate control from managers. The argument was that mangers had become too riskaverse and were not meeting their obligations to shareholders. The bids of these takeover architects spawned a shareholder movement, which forced corporations to focus on short-run financial pay-offs to the exclusion of other objectives, including long-run industrial development. (In 1986, Pickens even created a shareholder-rights grassroots group called United Shareholders of America, an organization Icahn revived more recently.) Leaders of the shareholder movement often made alliances with managers of pension funds. In the post-World War Two era, corporate and union pensions accumulated large sums of managed money. Because fund managers have an obligation to seek maximum returns for their clients, their funds often provided the resources raiders needed to secure corporate control. The result was emergence in the 1980s of what Minsky (1993) called money-manger capitalism. In addition to pension funds, other institutional investment funds, such as mutual funds and, more recently, hedge funds, also fuelled corporate takeovers and other organizational and financial restructuring (mergers, breakups, stock buy-backs, and so on). They also fuelled financial-system evolution by providing – to a global marketplace – a ready pool of buyers for securitized loans, the commercial paper of finance companies, and other innovative products. As money managers became dominant in the economy, corporations internalized the values of institutional investors. This had an impact on technological development, workers, and the economy overall. New technologies and product development took a back seat to the generation of short-term returns and aggressive corporate portfolio management (Hayes and Abernathy, 1980; Niggle, 1986; Dertouzos et al., 1989). Employees experienced wage stagnation and growing financial insecurity as corporations sought to minimize labour costs, eliminate layers of management, and downsize workers (Minsky and Whalen, 1996–97). And the overall economy became more prone to instability (Minsky, 1986b; 1992a; 1992b). Analyzing financial capitalism a century ago, Thorstein Veblen (1904: 159) offered a description that resonates today and gets to the heart of moneymanager capitalism: ‘The business interest of the managers demands, not the serviceability of the output, nor even the vendibility of the output, but an advantageous discrepancy in the price of the capital which they manage’. Transient shareholders want an enterprise managed in a way that enables them ‘to buy it up or to sell out as expeditiously and as advantageously as possible’,

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regardless of community well-being or even the long-term health of the corporation as a going concern (Veblen, 1904: 157). In the era of money-manager capitalism, finance has come to truly dominate the motives of business management, and it is no surprise that the financial sector has risen relative to the industrial sector since the 1980s (Palley, 2007). It is important to recognize there has been nothing inevitable about US industrial and financial evolution. For example, as Commons (1934: 788) observed in Institutional Economics, ‘modern stabilization may be communism, fascism, banker capitalism, or any of the concerted movements that endeavor to bring order out of conflict and instability’. Thus, there is a role for human decisions and creativity – and for public action in the form of property law and economic policy. Commons recognized this (as discussed in the previous section) and so did Minsky (1986b; 1990), who gave special attention to the role of government in fostering the rise of money-manager capitalism. Political and economic commentator Kevin Phillips also recognizes the role of government in promoting the rise of this new era of financial (moneymanager) capitalism. In a book written in the wake of the collapse of the dotcom boom, he provides an analysis that picks up where Commons’s discussion of banker capitalism left off, and that anticipates aggressive central-bank action in the wake of the recent global financial crisis. Phillips (2002: 228) writes that the US embraces a ‘financial strategy’ in lieu of an ‘industrial strategy’, and that ‘the Fed had quietly become its guarantor – and long before the securities market and terrorist traumas of 2001’ (Phillips, 2002: 228).

THE POST KEYNESIAN TRADITION Post Keynesian economics emerged in the early 1970s to challenge the direction of economic theory and policy advice. Post Keynesians were dissatisfied with the mainstream’s neoclassical synthesis, which they saw as a bogus interpretation of The General Theory, and were troubled by the analyses and policy stance of the profession’s burgeoning neoconservatives (see, for example, Turgeon, 1996). The neoclassical synthesis replaced Keynes’s attention to institutional processes, operating in real historical time, with timeless mechanisms and equilibrium solutions. It also treated money as a neutral commodity instead of debt grounded in evolving interpretations of property. Neoconservatives went further and proposed rational expectations, hence closed systems, as an alternative to the fundamental uncertainty highlighted by Keynes. Paul Davidson and Hyman Minsky are central figures in the development of Post Keynesian economics, and both give expectations – futurity – a central place in their analyses. Davidson (1978) and Minsky (1986a) begin by rejecting

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the neoclassical presumption that only exogenous forces throw the economic system out of equilibrium. They also reject the neoconservative claim that such disturbances will be followed by reestablishment of equilibrium at full employment. For both Davidson and Minsky, achieving widespread prosperity and stabilizing an evolving economy cannot be achieved by means of ‘laissez faire’, monetarism, or even macroeconomic (fiscal and monetary policy) finetuning; these goals also require attention to economic expectations and to the economy’s evolving institutional structure. In conventional economics, there was, and still is, little need to examine the basic institutional structure of the economic system. Thus, neither the neoconservatives nor the neoclassical ‘Keynesians’ saw anything remarkable, from the perspective of theory or policy, in the evolution from the American corporate hegemony of the 1950s and 1960s to the finance-driven global economy of the rapidly emerging Internet era (Whalen, 1995). The real economy and the financial system were transformed by endogenous changes that mainstream, equilibrium-oriented theories cannot apprehend. Davidson The Post Keynesian appreciation of futurity is reflected in its emphasis on uncertainty and money. According to Davidson (1991: 32, 58–9), Post Keynesianism is rooted in the assumption that ‘economic decisions are made by human beings facing an uncertain and unpredictable economic future, while they are moving away from a fixed and irreversible past’. Since ‘only a fool … would rush in to challenge the unknown future without some strategy to protect against failure’, business leaders ‘only undertake challenges when they can enter into long-duration forward contracts with workers and suppliers, where the date(s) and deliveries and money payments – hence liabilities – are fixed in advance’. These contracts reduce uncertainty by establishing clear expectations for the future, but they do not eliminate it. Moreover, managers must also ‘feel’ (expect) that they will have ‘sufficient liquidity [as a result of future business performance and cash flows] to meet these forward contractual obligations’. But how do enterprises engage in production in advance of payment for the final product? As Commons found in his analysis of industrial development, this too centres on futurity: production is financed not by tapping savings from previous production, but by incurring debt (Davidson, 1978: 61). If the output created by debt cannot be sold according to an enterprise’s original price or quantity forecasts, then the debt goes bad. This causes pain at the microeconomic level, but can also cause disaster at the macroeconomic level. That is because expectations across the economy are fragile and can be re-evaluated quickly when enterprises get into financial trouble.

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In short, Davidson captures the meaning of futurity in the following statement. ‘The existence of durable goods, money, financial assets, and contracts link the economic future to the present’ (Davidson, 1978: 13). As Commons demonstrated, it is modern money (credit and debt) that makes mass production possible. Thus, even the most productive, durable and technologically advanced contemporary business facilities are based on expectations, not certainty. ‘A monetary production-economy operating with complete certainty is a contradiction in terms’, concludes Davidson (1978: 13). Minsky Futurity also plays a major role in Minsky’s explanation of the US economic instability observed since World War Two. Cost commitments were made in the past, but revenues are based on forecasts. Moreover, the business challenge is not merely to meet obligations undertaken in the past. A going concern in a dynamic capitalist system must be able to raise capital for expansion and innovation to meet or stave-off the competition. And the time horizon for investment is often much longer than for financing current production (Minsky, 1986a: 164–96). According to Minsky (1986a: 206–13), the debt structure in an economy ‘is a major determinant of its stability’. In Stabilizing and Unstable Economy, Minsky (1986a: 206–13) describes three financial regimes, each with its own dominant debt structure, and explains how the economy cycles through those regimes over time. The most conservative regime is characterized by hedge financing, which occurs when a loan’s borrower and lender expect that the cash flow from business operations will be sufficient to cover the entire debt obligation. A more risky regime is characterized by speculative financing, which occurs when a short-term loan is used to cover a long-term position on the understanding that interest payments will be covered by the borrowing enterprise’s cash flow, but also that some fraction of the underlying principal will need to be refinanced. The most fragile regime is characterized by Ponzi financing (named after the infamous financial schemer Charles Ponzi), which occurs when there is an expectation that not even a loan’s interest payments will be covered by business operations, so it is understood that the requisite refinancing will lead to increased debt. Although Minsky does not use the term ‘futurity’, the concept is implicit in his work in the form of ‘expectations’ and ‘willingness’ (a term also found in Commons, 1934: 748), both of which are used to shed light on aspects of uncertainty and their connection to economic instability. Regardless of the particular debt structure (hedge, speculative or Ponzi), all loan obligations rest on a willingness to take on debt and on an expectation or an estimate of future developments. If market forecasts (expectations) are too optimistic, hedge

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loans can fail. If there are adverse (unexpected) developments in financial markets, such as a rise in interest rates, speculative and Ponzi loans can fail. And if economic conditions unexpectedly change, it is possible for an existing loan to move from one category to another (from hedge to speculative, for instance). While hedge financing is based on a lapse of time, speculative and Ponzi financing involve an unending flow of time. In a world of uncertainty, which is the world of economic reality, expectations are not fixed. In fact, they are inherently unstable. As Davidson (1991: 58) writes: ‘In a world of uncertainty, “to err is human”.’ But speculative and Ponzi financing have become accepted, and at times even necessary, to the performance of modern capitalism. And that is why Minsky (1986a: 173) writes: ‘Serious business cycles are due to financial attributes that are essential to capitalism’.

CONCLUSION: FUTURITY AND ITS IMPLICATIONS FOR ECONOMIC THEORY Contemporary economic life could not exist without the shift from a definition of property focusing on use value towards a definition recognizing exchange value. That shift opened the door not only to incorporeal property, but also to the broader category of intangible property. The value of bricks and mortar has since been overwhelmed by the value of patents, trademarks and copyrights. Even computer hardware is useless without software, whose creators’ incomes depend on protection provided by intellectual property law. In fact, when unattached to a going concern, the value of bricks and mortar is sometimes negative due to a need for demolition. That is why closed plants often sit vacant and owners and communities find they are unwanted at any price. This is one reason the US government wanted to keep General Motors Corp. functioning as a going concern – to keep its vast production facilities intact as operating, intangible property, rather than as idle, corporeal property. Capitalization, Forecasts and Instability Today, the value of a business as a going concern is determined most often by its market capitalization. It is calculated by multiplying the firm’s stock price by the number of shares issued. Capitalization looks to the future. It is based on a revenue stream forecast. To generate revenue in the future, cost obligations must be incurred in the present. Industrial capitalism, financial capitalism, managerial capitalism, and money-manager capitalism could not exist without financing based on capitalization. Each of these monetary-economy varieties is based on property as

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exchange value, not use value, and on recognition of incorporeal and intangible property, not merely corporeal property. The Supreme Court did not initially appreciate and validate these distinctions, but eventually adjusted its decisions to reflect evolving business practices. Conventional economic theory, however, has still not recognized these distinctions, though both Commons and Keynes tried – each in his own way – to bring them to the profession’s attention.5 Business contracts – orders, loans, leases, royalty agreements, and so on – help reduce economic uncertainty, but they cannot eliminate it. Fraud is not necessary to generate instability; irrational exuberance – indeed, even exuberance that seems fully rational at the time – is sufficient in a world of calendar time. Moreover, exuberance can be followed by extreme pessimism, which creates market conditions that compound an economic decline. Post-Keynesian Institutionalism Éric Tymoigne (2003: 541) is right that Commons and Keynes ‘were developing the same theoretical foundations’. Both sought ‘an analytical system’ in which money and expectations ‘play an essential role in the explanation of the business cycle’. Commons’s search for key concepts missed by conventional economics led him to study economic and legal history, and his effort to explain how those concepts were overlooked resulted in Institutional Economics. Keynes admired Commons’s broad historical analysis, and both economists eventually developed similar accounts of macroeconomic instability (Whalen, 1993; Atkinson and Oleson, 1998; Whalen, 2008). Institutionalists and Post Keynesians have continued to pursue compatible research agendas (Atkinson, 2010), and it appears a PKI is now both desirable and within reach. A fuller appreciation of the legal foundations of capitalism would contribute to construction of a robust PKI. What follows are some implications of the foregoing discussion that can contribute to this effort: PKI must develop an economic theory based on human expectations instead of on adaptation of concepts from the physical sciences. 2. That theory must be centred on a cause-effect sequence, one rooted in the fact that humans take action in the present based on expectations. 3. PKI must be a science of action – occurring within going concerns, such as businesses, public entities, communities, civic organizations, families, unions, and so on – that aims at creating the future. It cannot be a science of choices made from a menu of known alternatives. 4. PKI rejects the theory of rational expectations, and instead seeks a theory to explain economic action in an uncertain world. 1.

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The concept of futurity, where the cause-effect sequence is the reverse of physical science, can be the foundation of such a theoretical construct. Commons (1934: 7) observed that production and consumption ‘cannot be carried on without first obtaining legal control’. This ‘changes the idea of causation’, he suggested, because ‘it places causation definitely in the future instead of the past’. In other words, the market and non-market transactions we see in the present are in fact consequences (effects) of future events that exist in the present only as expectations. The difference between the world studied by physical scientists and the world studied by social scientists is that humans have a conception of time. The subject matter of physics and the other physical sciences has no such conception (Commons, 1934: 406–7). Commons adds: ‘A flow of time in the physical sciences is a succession of events. But in economics, which is the science of human expectations, a ‘flow’ of time is an expected succession of events’. Moreover, expectations drive organizations and groups, not just individuals. As Commons’s student Kenneth Parsons (1942: 256) observed, since a going concern functions within a time sequence, ‘it is really the expectation that transactions will continue in the future that keeps a concern going’.6 Thus, futurity brings into economics time, uncertainty, and expectations. It also brings in exchange value, as distinct from use value, as well as incorporeal and intangible property. Futurity even paves the way for an understanding of macroeconomic instability (for more on this, see Chapter 4). Futurity also underscores both the importance of ‘purpose’ in economic life and the difference between ‘action’ and ‘choice’. Because valuation always looks to the future, purpose drives action. Commons (1934: 7) recognized this when he stressed that Institutional economics offers a ‘volitional theory of future consequences of present negotiations and transfers of legal control’. He could just as easily have said that Institutional economics is purpose driven. ‘Action’, meanwhile, is strategic. It helps shape a path into the future. It signifies more engagement and creativity than ‘choice’, which merely suggests selection from a given menu of alternatives. Commons (1950: 179) stressed that we act strategically with the aim of removing the limiting factors that confront us. Effective strategic action removes a limiting factor and unleashes and harnesses complementary factors, thus reinforcing the move in a desired direction. For example, construction of the transcontinental railroad through the centre of the US removed the limiting factor of poor transportation. It boosted not only the railroad industry, but also others, especially the steel industry. It also created tremendous industrial and commercial possibilities in what had been a hostile region, thus buttressing the further development of the entire nation. PKI must, therefore, centre on purposive human action. In contrast, orthodox economic theory, adapted from physical science theories, is essentially a

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theory of corporeal property. To be sure, conventional economics discusses intellectual property and other intangibles. But their theory is inadequate for the task. Classical economics had a theory of value based on embodied cost, which placed ‘cause’ in the past and ‘effect’ in the present. Neoclassical economics, building on the work of Jeremy Bentham, said value was determined by present sensations of pleasure and pain, where neither past nor future were considered. An economic theory based on futurity, meanwhile, is concerned with future consequences, and it is this sort of theory that can help us understand – and even take action to strategically and constructively reshape – the direction of economic life (Commons, 1934: 7). In closing, it should be noted that Commons identified still one more consequence of the introduction of futurity into economics. It is the principle of timeliness. Commons (1950: 177–83) writes that futurity highlights the fact that there are two dimensions to problem solving: knowing what to do (including how far to go) and knowing when to do it. On the matter of reconstructing economic theory, Peterson’s AFEE addresses (discussed in this chapter’s introduction) suggest that Institutionalists and Post Keynesians have long known what to do. On the matter of when is the right time for both camps to join forces to forge a coherent PKI, it is the belief of the authors of this chapter that the time is now. The financial crisis that gripped the world economy in 2008, and triggered the Great Recession in the US, has revealed to a wide audience the inadequacy of conventional economics (Krugman, 2009). It is possible that a PKI grounded in futurity has never been more ‘timely’.

NOTES 1.

For an excellent discussion of how Keynes incorporated capitalist evolution into his economics, see Crotty (1990), which also mentions Keynes’s debt to Commons on this matter. 2. Just as Commons recognized that different national economies might pass through different industrial stages, he also recognized that different industries might follow different evolutionary paths. In fact, variations are evident in his Labor and Administration (Commons, 1913). Nevertheless, Commons illustrates the evolution of American industry by discussing the making of shoes because the case has broad relevance. This is evident in the conclusion to his ‘American Shoemakers’ article, where he writes: ‘Thus have American shoemakers epitomized American industrial history. Common to all industries is the historical extension of markets. Variations of form, factors, and rates of progress change the picture but not the vital force’ (Commons, 1909: 81). A similar view is expressed in Institutional Economics: ‘Different industries move at different rates of speed towards the final consummation. A typical American industry, shoe-making, whose product is transportable, will illustrate the evolution of these stages with their changes in technology and ownership. Similar investigations may be made and compared for other industries’ (Commons, 1934: 766). 3. For an extension of Commons’s labour analysis to the current era, see Atkinson (2004). It is also worth noting that Minsky worked for Saposs in the Manpower Division of the US Office of Military Government in post-World War Two Germany. 4. On sweatshop contractors, Commons (1909: 64) writes: ‘[T]he contract-prices he gets are dictated by the merchant-capitalist. His profits come solely out of wages and work. He organizes

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his workmen in teams, with the work subdivided in order to lessen dependence on skill and to increase speed of output. He plays the less skilled against the more skilled, the speedy against the slow, and reduces wages while enhancing exertion. His profits are “sweated” out of labor, his shop is the “sweatshop”, he is the “sweater” ’. 5. Veblen had a view of a monetary economy that was similar to Commons and Keynes in its treatment of capitalization and capital assets; see, for example, Hake (1998; 2005) and Hake and King (2002). 6. The discussion above is not intended to suggest that economics is incapable of learning from – or even borrowing concepts from – the physical sciences. The point here is merely that humans are purposeful beings, not inanimate objects, and must be studied accordingly.

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Development: Essays in Honour of Paulo Sylos Labini, New York: St. Martin’s Press, pp. 103–16. Minsky, Hyman P. (1995), ‘Longer waves in financial relations: financial factors in the more severe depressions II’, Journal of Economic Issues, 29 (1), 83–96. Minsky, Hyman P. (1996), ‘Uncertainty and the institutional structure of capitalist economies: remarks upon receipt of the Veblen-Commons Award’, Journal of Economic Issues, 30 (2), 357–68. Minsky, Hyman P. and Charles J. Whalen (1996–97), ‘Economic insecurity and the institutional prerequisites for successful capitalism’, Journal of Post Keynesian Economics, 19 (2), 155–70. Murphy, David (2010), ‘Is $2250 per song the new standard for online copyright infringement?’, PCMag.com, accessed 4 August 2010 at www.pcmag.com/article2/ 0,2817,2366296,00.asp. Niggle, Christopher J. (1986), ‘Financial innovation and the distinction between financial and industrial capital’, Journal of Economic Issues, 20 (2), 375–82. Palley, Thomas I. (2007), ‘Financialization: what is it and why it matters?’, The Levy Economics Institute of Bard College working paper no. 525. Parsons, Kenneth H. (1942), ‘John R. Commons’ point of view’, Journal of Land and Public Utility Economics, 18 (3), 245–66. Peterson, Wallace C. (1977), ‘Institutionalism, Keynes, and the real world’, Journal of Economic Issues, 11 (2), 201–21. Peterson, Wallace C. (1992), ‘What is to be done? Remarks upon receipt of the VeblenCommons Award’, Journal of Economic Issues, 26 (2), 337–48. Peterson, Wallace C. (1996), ‘Macroeconomics and the theory of a monetary economy’, in Charles J. Whalen (ed.), Political Economy for the 21st Century: Contemporary Views of the Trend of Economics, Armonk, NY: M.E. Sharpe, pp. 151–70. Phillips, Kevin (2002), Wealth and Democracy, New York: Broadway Books. Turgeon, Lynn (1996), Bastard Keynesianism: The Evolution of Economic Thinking and Policy-Making Since World War II, Westport, CT: Praeger. Tymoigne, Éric (2003), ‘Keynes and Commons on money’, Journal of Economic Issues, 37 (3), pp. 527–45. Veblen, Thorstein (1904), The Theory of Business Enterprise, New York: Charles Scribners Sons. Waller, William (2005), ‘Accidental Veblenian, intentional institutionalist, and inevitable feminist’, Journal of Economic Issues, 39 (2), 327–34. Whalen, Charles J. (1993), ‘Saving capitalism by making it good: the monetary economics of John R. Commons’, Journal of Economic Issues, 27 (4), 1155–79. Whalen, Charles J. (1995), ‘Structural change and the compulsive shift to institutional analysis’, in Charles M.A. Clark (ed.), Institutional Economics and the Theory of Social Value: Essays in Honor of Marc R. Tool, Boston, MA: Kluwer Academic Publishers, pp. 178–94. Whalen, Charles J. (2008), ‘John R. Commons and John Maynard Keynes on economic history and policy’, Journal of Economic Issues, 42, (1), 225–42.

PART II

The American economy

4. Understanding and preventing financial instability: Post-Keynesian Institutionalism and government as employer of last resort Fadhel Kaboub INTRODUCTION More than three years after the 2007 financial meltdown, we are still experiencing the devastating impact of the Great Recession on the world economy. After trillions of dollars of bailouts, fiscal stimulus, and money injected into the financial system by nations across the globe, policymakers are still incapable of lowering unemployment rates. Lessons learned from the Great Depression have been barely remembered by the mainstream of the economics profession. The neglect of these lessons is not surprising. Since the rise of neo-liberal political economy in the 1980s, the concept of full employment policies has been absent from the intellectual discourse in mainstream economic circles. It has become the norm to tolerate the so-called ‘natural rate of unemployment’ as long as inflation remains under control. Fiscal hawks dominate the policy think tanks, the pages of the business press, and the public airwaves, using all three to express opposition to policies aimed at full employment. The economic mainstream argues that government cannot afford to finance full employment programmes. Such policies, these economists contend, would exacerbate already unsustainably high deficits and a soaring national debt, both of which are considered inflationary. In the aftermath of the sub-prime financial crisis, however, a growing fraction of the public has begun to question mainstream economic theories and policies. In fact, there appears to be growing interest in new policy options, especially ones aimed at remedying the severe unemployment problem of the US economy. This chapter draws on and extends an alternative intellectual tradition represented by the work of Hyman P. Minsky: Post-Keynesian Institutionalism (PKI). That tradition helps us not only unravel the underlying forces that have 77

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caused more than 30 years of increasing financial instability, but also articulate a feasible plan of action for reducing high unemployment and preventing further instability. The chapter argues that the real cause of financial instability in the US is economic inequality, which has been fuelled by the emergence of ‘money-manager’ capitalism and has been accompanied by a growing household debt-to-income ratio and financial innovations that extended consumer credit to unsustainable levels. PKI provides a vital starting point for the investigation because this tradition is deeply rooted in an appreciation of the evolutionary nature of the capitalist institutional structure. The economic analysis in this essay is inspired by Minsky’s financial instability hypothesis (FIH), while the policy analysis is inspired by his work on the notion of government as ‘employer of last resort’ (ELR), developed in the 1960s in the context of the War on Poverty. The main question examined in the pages that follow is: how does economic inequality translate into financial crises and what can be done about it? The chapter is organized as follows. The first section uses the lens of PKI to uncover the inner workings of inequality-driven financial instability in the US. It highlights the importance of historical analysis, fundamental uncertainty, futurity (expectations), the institution of money, economic power, and conspicuous consumption. It also applies the FIH to examine events leading up to the Great Recession. The second section suggests that achieving greater economic stability requires an aggressive job-creation programme that guarantees an employment opportunity for anyone ready, willing and able to work at a socially established living-wage; such a policy is needed to break the debtdriven consumer spending cycle. The analysis outlines a specific ELR programme for the US economy, describing the institutional details required for implementation and providing cost estimates that demonstrate its affordability and efficiency. The chapter closes with summary and concluding remarks highlighting the importance of PKI in tackling financial instability and economic inequality and in fostering sustainable jobs-driven economic growth.

AN INCREASINGLY UNSTABLE ECONOMY Contemporary capitalism is an economic system characterized by long-lived, expensive, and illiquid capital goods as well as by short-term financing and position taking. Minsky’s views on capitalism were influenced by the work of John Maynard Keynes (1883–1946) as well as Minsky’s mentor, Joseph Schumpeter (1883–1950). Minsky constructed his work on financial instability and cyclical unemployment by building on Keynes and developed his views on the importance of technology and the evolutionary nature of capitalism by

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drawing on Schumpeter, though elements of both influences appear in Minsky’s short-term and long-term analyses. Minsky’s fundamental conclusion about the macroeconomics of modern capitalism is encapsulated in his famous phrase: ‘Stability is destabilizing’ (what he describes as ‘stability’ is what most economists think of as ‘prosperity’ or ‘economic growth’). His FIH demonstrates that business cycles are endogenous phenomena triggered by processes inherent to the capitalist system, including evolving expectations, financial innovation, and technological change. To explain the FIH, however, we need to go back to Keynes’s work on liquidity. For Keynes (1936), the purpose of capital assets is to generate financial returns, and such assets have three characteristics: liquidity (how quickly an asset can be turned into cash without significant loss of value), appreciation or depreciation, and carrying costs. When an individual is deciding which assets to hold, each of these dimensions must be taken into account. Because the past is unchangeable and the future is unknowable, the following concepts are also important: uncertainty and futurity (expectations), both of which are cornerstones of the PKI tradition. Business decisions to acquire illiquid capital goods (such as industrial machinery) versus liquid financial assets (such as a certificate of deposit) have important economic consequences, not only for individual investors, but also for society as a whole. Faced with uncertainty about the future and an opportunity to take an asset position, enterprise managers and individual investors must form expectations partly on their assessment of the overall mood of other participants in the economy. Keynes described this mood – a combination of consumer, business and investor expectations – as the mass psychology of the market, which he saw as continuously driven by waves of optimism and pessimism (Keynes, 1936). The state of consumer, business, and investor expectations shapes the demand for liquidity. An important point of Keynes’s analysis is that when the demand for consumer goods increases, enterprises and investors expect that capital goods used to produce such consumer goods will generate higher returns. Thus, all else equal, the demand for these capital goods rises and investors are more likely to take a position in such assets, resulting in a higher level of employment in firms that produce them. Conversely, when the economy experiences a wave of pessimism (low consumer and business confidence), investors prefer to hold liquid assets, with cash being liquidity par excellence. During financial panics, ‘cash is king’ on Wall Street. Money plays a crucial role in capitalist societies because of its special characteristics: negligible carrying cost, zero-elasticity of substitution, and near zero-elasticity of production (Keynes, 1936). During uncertain economic times, investors hoard money because it is the system’s safest asset; money

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provides a remedy for fundamental uncertainty. Yet, this also leads to unemployment. Over the course of the business cycle, when expectations shift from optimism to pessimism, investors shift their financial holdings away from jobcreating illiquid assets and towards more liquid financial positions. As a result, investment in capital assets falls, resulting in a decline in employment, disposable income, and consumption – and the resulting downward spiral is then accelerated through the Keynesian multiplier. This is the essence of the liquidity analysis of business cycles, and goes a long way to explaining many downturns including the Great Recession. Minsky’s (1986) FIH builds on Keynes’ analysis, bringing special attention to the constant evolution in the financial position of economic units (firms, banks, and households). That evolution shifts the economy’s centre of gravity from hedge financing to speculative financing and then to Ponzi financing – each stage more fragile than the one preceding it. Prosperous economic times encourage debt-driven consumption and business expansion, resulting in greater fragility: an economy increasingly prone to cash shortfalls that prevent debt repayment. Then, as soon as debt-to-equity and debt-to-income ratios reach what the collective psychology of the market deems unsustainably high levels, the market begins to experience a ‘Minsky Moment’ in which overindebted businesses attempt to sell off assets to reduce their debt-to-equity ratio and over-indebted consumers reduce spending to lower their debt-toincome ratio (Figure 4.1). Pessimism subsequently takes over the market, banks tighten their lending standards, and a credit crunch ensues. As a result, the economy enters a deleveraging phase characterized by lower levels of consumption, investment and employment (this also returns the economy to an environment dominated by the cautious practices of hedge financing). For Minsky, this is the incessant wave of optimism and pessimism that generates the inherent instability of contemporary capitalism. The Great Recession was not fundamentally different from the scenarios described by Minsky and Keynes, but there is a new element that must also be highlighted: the rise in US income inequality, due in part to the stagnation of the real incomes of lower- and middle-income groups since the 1980s. US Census (2010) data reveal a Gini coefficient of around 0.46 since the turn of the twenty-first century, compared with 0.42 in the 1980s. The Census Bureau recently reported that 43.6 million people – about one in seven Americans – lived below the poverty level of $22 000 for a family of four in 2009, up four million since 2008. These numbers pushed the national poverty rate to a 15year high of 14.3 per cent. The situation is even more alarming when one considers that the number of people with incomes less than half the poverty line has hit a record high of nearly 20 million – 6.3 per cent of the population. The Census Bureau also reports that one in three African American children lived in poverty in 2009, compared with one in five for all US children.

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Household debt as a percentage of disposable income

Widespread income stagnation and rising inequality has resulted in a less secure and more docile workforce. While real wages have stagnated since the 1980s, worker productivity has increased by 68 per cent (United for a Fair Economy, 2006: 12). This phenomenon is in part the result of a strategy to break unions since the 1970s, leading to a steady decline in the US unionization rate from about 27 per cent in the early 1970s to roughly 12 per cent when the Great Recession began in 2007. More recently, the source of wage stagnation and worker insecurity has been job offshoring (Bluestone, 1996; Galbraith, 1998; Zalewski, 2004; Toruño, 2004; Whalen, 2005; Blinder, 2007; Freeman, 2007). US economic growth is primarily driven by consumer spending; the puzzle for the American growth model, therefore, is how can economic growth continue to be fuelled by consumerism when the vast majority of consumers have been experiencing stagnation in the growth rate of their real income since the 1980s?1 The answer can be found in Figure 4.1: growth has been sustained by ever-greater extensions of credit to finance consumer spending (Scott, 2007; Brown, 2008). At the peak of the sub-prime euphoria, the US consumer debt-to-income ratio reached nearly 140 per cent. This ratio exceeded 260 per cent for the poorest 20 per cent of US households in 2007, while the richest 10

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per cent managed to keep their debt to income ratio stable at around 80 per cent since the late 1980s. For the nation as a whole, the fraction of after-tax income that a household devotes to debt payments represented 10.5 per cent of disposable personal income in the early 1980s and then reached a record-high of 14 per cent in 2006. The unsustainable nature of these ratios creates the trigger for a Minskian credit cycle of the kind experienced during the Great Recession. Given that a fall in consumption means a recession, the financial industry has worked hard to create a plethora of financial products (credit cards, home equity loans, reverse mortgages, NINJA loans, sub-prime loans, death bonds, and so on) that allow working families to consume in the manner the system needs to sustain its growth path. In this way, inequality has fuelled financialization (Brown, 2008). Yet financialization – the rise of what Minsky called ‘money-manager capitalism’ – is also at the root of the fight against unions, the spread of wage stagnation, and the rise of inequality (see, for example, Minsky and Whalen, 1996; Palley, 2007; and Whalen and Zalewski, 2010). Financialization and inequality are mutually reinforcing. Money-manager capitalism and worker insecurity are flip sides of the same coin (Whalen, 2010a: 253; Greenhouse, 2008). Working families must contend with marketers as well as money managers. These marketers target the human tendencies towards what Thorstein Veblen (1899) called ‘pecuniary emulation’ and ‘invidious distinction’. Workers and their families are surrounded by sophisticated marketing techniques and powerful sociocultural messages that promote conspicuous consumption and that institutionalize habits of thought and routines of behaviour necessary for sustaining consumption-driven growth. In fact, promotion of consumption occurs even at the risk of generating unsustainable debt-to-income ratios. Under money-manager capitalism, the captains of finance and their supporting cadre of marketers boost profits by increasing both employment insecurity and household indebtedness. The rise of institutional investors and other money managers and a climate of financial deregulation created fertile ground for speculative bubbles and unchecked financial innovation that enabled those bubbles to keep expanding. The explosion of the credit default swaps (CDS) market (Figure 4.2) is a case in point. In the wake of the Commodity Futures Modernization Act of 2000, the CDS market grew exponentially – from just a few billion dollars in 2001 to a phenomenal $62 trillion market in 2007 (after two years of write-downs, it is now about a $30 trillion market (ISDA, 2010)). This market was crucial during the sub-prime securitization mania because it created the illusion of an ‘insurance policy’ against default risk, which encouraged credit rating agencies to rate mortgage-backed securities favourably and enticed investors to purchase those securities. The fact that the issuance of CDS was not backed by prudential reserves was ignored by regulators.

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Figure 4.2 Credit default swaps (trillions of dollars) Despite the best efforts of enterprise leaders and financial innovators, such expansions cannot be sustained indefinitely. Indeed, the spread of moneymanager capitalism has been accompanied not only by a squeeze on working families and an explosion of financial innovation, but also by increasing financial instability (Wray, 2009; Whalen, 2010b). The stream of financial innovations has been endless; the processes generating financialization and inequality have shifted their focus from one market to another over time (information technology, housing, commodities, and so on); and policymakers have been able to stave off a worldwide depression. In recent decades, however, financial crises have appeared in the US and the global economy with alarming frequency, culminating, of course, in the recent (and, for many working families, still ongoing) Great Recession. The socio-economic consequences of that recession have been devastating: the official US unemployment rate has been stuck at just under 10 per cent, while long-term unemployment, underemployment and mortgage foreclosures are just a few of the indicators of hardship that have recently reached record levels. Meanwhile, the response of policymakers has often been slow and

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weak. The so-called ‘quantitative easing’ and other initiatives of the Federal Reserve, for example, have been effective in bailing out banks and other financial institutions, but largely ineffective in their goal of restarting the lendingspending cycle. Fiscal stimulus has also suffered from limitations: it has been too small and too indirect to be effective in restoring consumer and business confidence. Fiscal policy is least effective during a recession when it relies heavily on market mechanisms such as tax cuts and tax incentives to stimulate the economy, yet this, to a large extent, has been the approach pursued in the US over the past few years.

GREATER ECONOMIC STABILITY THROUGH FULL EMPLOYMENT Responding to the Great Recession requires a two-pronged strategy: recovery and reform. Quantitative easing, the Troubled Asset Relief Program, the American Recovery and Reinvestment Act, and the 2010 Tax Relief Act were all aimed at recovery. The Dodd-Frank Wall Street Reform and Consumer Protection Act offers financial reform and is a small step in the right direction (for a further discussion of financial reform from the perspective of PKI, see Chapter 6). However, as Minsky (1986) indicated in his Stabilizing an Unstable Economy, financial reform is necessary, but not sufficient to foster greater economic stability over an extended period. Inequality must be addressed head-on to prevent further financial instability, and the most effective way to reduce the consumer debt-to-income ratio is to guarantee income stability through full employment at a living wage. PKI underscores the ability of a targeted job creation programme to attenuate financial crises, and that is what the notion of government as ELR (employer of last resort) offers. A job guarantee contains inequality by providing working families with a productive and financially stable alternative to a debt-financed livelihood. An ELR job guarantee not only secures a decent income for workers, which helps stabilize aggregate demand in recessions, but it also stabilizes expectations of workers, employers, and financiers regarding future income streams. In short, ELR acts as an automatic stabilizer for expectations, employment, and economic growth. It is natural to observe more prudent spending among consumers and enterprises during uncertain times. Therefore, it is unreasonable to assume that private-sector spending will lead the US economy to a quick recovery from a deep recession, especially in the wake of serious financial-market troubles of the sort experienced recently. What is more likely is that Wall Street will be reluctant to extend credit to Main Street until it is clear that confidence is rebounding and becoming widespread.

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The public sector, in contrast, has the capacity to stimulate the economy without relying on consumer and business confidence. Thus, a well-designed job creation programme financed by the federal government has the capacity to produce full employment without inflation. The notion of a job guarantee is often associated with President Franklin D. Roosevelt’s (1941; 1944) ‘Four Freedoms’ speech and his ‘Second Bill of Rights’, as well as with full employment bills drafted at the end of World War Two, but the idea reappears throughout the literature of Institutional economics and can be traced back to at least the end of the nineteenth century, when The Arena published an article by John R. Commons (1899), entitled ‘The right to work’. John Dewey ([1919]1939: 420–21), whose pragmatism is an inspiration for many Institutionalists, also wrote in favour of the ELR, describing a guaranteed right to work as ‘the first great demand of a better social order’. In the mid-1960s, Minsky (1965, 1966, and 1986) was one of a handful of economists who revived the ELR idea, and he continued to promote it for the next three decades.2 Minsky (1986: 308) describes ELR as follows. ‘The main instrument of such a policy is the creation of an infinitely elastic demand for labor at a floor or minimum wage that does not depend upon long- and short-run profit expectations of business. Since only government can divorce the offering of employment from the profitability of hiring workers, the infinitely elastic demand for labor must be created by government’. The ELR programme would be federally funded, but locally managed. The aim would be to provide employment that neither competes with nor replaces existing jobs; ELR jobs would be designed as a net addition to the total employment pool. Under the ELR programme, the federal government would offer to hire anyone of working age who is ready, willing and able to work at a living wage plus benefits. State/local governments and non-profit organizations would select projects based on the needs of local communities. The hiring and supervision of workers and projects would occur at the local level. ELR would accept the unemployed as they are and design jobs to fit their capabilities; local programme administrators – the ELR authority (ELRA) – would strive to select projects appropriate for the skills and capabilities of the local unemployment pool. In addition, the ELRA would address local skill shortages by enabling job seekers to acquire education and training. The opportunity to further improve one’s skills would be an add-on benefit. The ELR would increase during recessions, to absorb workers displaced from the private sector, and decrease during economic expansions when ELR workers find employment in the private sector. Hence, ELR is conceived as a buffer stock employment programme; the ELR wage(s) would be fixed while the quantity of labour in the buffer stock fluctuates. (The ELR wage

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does not necessarily need to be a single wage level. One could think of a multi-step scale of wages based on skills and experience.) At any time, private-sector employers can hire workers at a mark-up over the ELR fixed wage; meanwhile, the unemployed would not be required to participate in the ELR. ELR jobs would be designed to provide employment that addresses unmet local needs. Thus, ELR would reduce the depreciation of skills caused by unemployment, and its training component would enhance worker preparedness for private-sector work. Following the example of past public-service employment (such as that offered by the Comprehensive Employment and Training Act of 1973), ELR would offer employment as companions to the elderly, public school classroom assistants, community safety monitors, lowincome housing restoration technicians, park restoration aides, environmental safety monitors, environmental clean-up technicians, daycare assistants for ELR workers, community and cultural historians, and ELR artists. Estimates for the US, UK and Australia suggest that the cost of financing an ELR programme ranges between less than 1 per cent of GDP for the US to about 3.5 per cent of GDP in Australia (Majewski, 2004; Mitchell and Watts, 1997; Gordon, 1997; Kitson et al., 1997).These estimates actually overstate the real cost of financing the programme because they ignore the multiplier effect of the new income earned by ELR workers. An ELR programme also helps to pay for itself by reducing the public spending (such as unemployment insurance) and social costs associated with unemployment. The Great Recession resulted in federal spending of nearly three trillion dollars in bailouts and stimulus initiatives without putting much of a dent in the unemployment rate. An ELR would have tackled the joblessness problem with money to spare; full employment would not ‘bankrupt’ the federal government.3 Indeed, this author estimates a generous ELR programme could employ 30 million workers – twice the number of people counted as unemployed in the US at the end of 2010 – for about $727 billion per year, or less than 5 per cent of GDP.4 ELR critics claim that the programme would increase labour bargaining power, because it eliminates the threat of unemployment, thus fuelling wagegenerated inflation (see, for example, Rochon and Vernengo, 2003). Yet, labour actually has less power when ELR workers are capable of being hired by private employers at any time, as compared with when large numbers of workers are idle and have been without work for an extended period. Thus, one should not expect runaway wage-push inflation to develop under the ELR programme (Wray, 1998). Indeed, the threat of such inflation is particularly limited in the current era of global labour markets and job offshoring across a wide range of occupations.

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ELR critics have also expressed a concern about the ability of such a programme to deal with structural unemployment (Sawyer, 2003 and 2005; Kadmos and O’Hara, 2000). Structural and technological change is a constant feature of capitalist economies. Currently, however, governments do not have any systematic way of dealing with it. As a result, they react to such change after it has happened and after workers have been displaced. ELR would have a structural and technological change research division that works closely with representatives of business and labour and that constantly monitors, assesses and forecasts structural and technological change. This would enable the ELR programme to provide technical training for displaced workers. Structural and technological change is an inherent part of a dynamic economy and it is an institutional problem; therefore the solution for it must be institutionalized as well (Kaboub, 2007). ELR critics have also questioned the ability of ELR to provide jobs to displaced workers in a timely manner (Sawyer, 2003 and 2005). To be sure, this requires considerable preparation, but it can be done. ELR authorities must create a reserve shelf of ELR projects (see Copeland, 1967). ELR administrators will have to be proactive, anticipating business downturns to avoid delays in the initiation of ELR projects; they will also need to avoid cancelling projects prematurely in response to an improvement in private sector activity. Introduction of ELR cannot be done overnight; ELR must be phased in gradually to allow for institutional adjustment. The PKI approach to full employment is inspired by J. Fagg Foster’s (1981) theory of institutional adjustment, which stresses it is important to give close attention to policy implementation. Once ELR is up and running, however, it will help tame swings in the business cycle through its stabilizing effect on investment, consumption and economic growth. A successful ELR requires cultivation of a positive and dynamic programme culture. This would need to be pervasive – exhibited not only by those at the top levels of ELR management and by ELR staff, but also by its participants, who would often work in public settings. Thus, ELR employment would begin with an orientation period stressing motivation, a positive attitude, recognition of the usefulness of services provided, self-respect, and pride in being an ELR worker. ELR workers would be expected to be as serious and productive on the job as workers in private sector employment. Workers could be fired from an ELR job for failing to meet the programme’s standards of service and integrity (employee assistance and counselling programmes would be available for workers failing to meet ELR standards). Satisfactory workers could also stay on the job indefinitely. An ELR programme is not means tested, does not impose any time limits, and does not restrict the number of people who can be hired. It is a true – and affordable – full employment programme.

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SUMMARY AND CONCLUSIONS: STABILIZING THE UNSTABLE ECONOMY Building on Minsky’s financial instability hypothesis, this chapter analyzed financial instability from the perspective of PKI. The main argument derived from its analysis is that an economy characterized by income inequality and worker insecurity has been both a consequence of and breeding ground for unregulated financial innovation and speculation. The theoretical synergies of the Post Keynesian and Institutionalist traditions provide the ideal analytical tools to unveil the inner workings of the economic institutions that breed and spread financial instability in the era of money-manager capitalism. The endogenous nature of economic instability underscores the need for government intervention to tame business-cycle fluctuations. The PKI analysis suggests that although monetary policy intervention is crucial for preventing a complete financial-system meltdown, fiscal policy intervention is of paramount importance for stabilizing employment and economic growth. In particular, an ELR jobs programme can break the decades-old link between inequality and financial instability. With a commitment to full employment and a bit of creativity, such a programme can be designed and implemented in a successful and affordable manner. The analysis of PKI does not claim that ELR will end all financial instability, but it will address a key source of the instability experienced in the US since the 1980s – instability driven by financial innovations that obscured and drew attention away from rising inequality and household over-indebtedness. The ELR policy option provides an opportunity to tackle inequality, poverty, and environmental problems – enabling us to achieve Minsky’s (1986: 293) goal of a humane economy as the first step towards a more humane society.5

ACKNOWLEDGEMENTS The author wishes to thank an anonymous referee, Charles Whalen, and Rana Odeh for their thoughtful comments and suggestions and for invaluable editorial assistance. The usual disclaimer applies.

NOTES Post-Keynesian Institutionalists have sought to draw attention to wage stagnation and the threat it poses to economic growth and social well-being for decades. See, for example, Wilber and Jameson (1991), and Whalen (1996). 2. For more on the ELR concept from viewpoints similar to the one described in this chapter, see Copeland (1967), Briggs (1981), Gordon (1997), Forstater (1999, 2002), Harvey (1989),

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3. 4.

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Kregel (1991, 1999), Majewski (2004), Mitchell (1997, 1998, 2005), Mosler (1997), Nell (1988), Papadimitriou (1998), Vickrey (1992), Wray (1998), and Kaboub (2007, 2008). See Lerner (1943 and 1947) and Vickrey (1992). A generous ELR programme would provide enough employment to cover not only the officially unemployed, but also discouraged workers, involuntary part-time workers, and people marginally attached to the labour force. My assumptions include the following: the ELR wage is $10 per hour; ELR employees work 40 hours per week; and ELR employees receive a benefits package that costs $10 000 per year. As a result, the total of wages and benefits would be $876 billion. Adding a generous material cost of $50 billion per year brings the total to $926 billion annually. Finally, if we assume a Keynesian multiplier of 1.5, an average income tax rate of 15 per cent, and an average sales tax of 6.5 per cent, then the net total ELR cost would be $727 billion per year, or 4.8 per cent of GDP. This estimate does not even take into account the reduction in government spending on social and welfare services that would be possible with an ELR programme in place. An ELR is also compatible with the United Nations Universal Declaration of Human Rights, article 23, which states that everyone has the right to work and to protection against unemployment (United Nations, 1948).

REFERENCES Blinder, Alan S. (2007), ‘How many US jobs might be offshorable?’, Princeton University Center for Economic Policy Studies working paper no. 142. Bluestone, Barry (1996), ‘Economic inequality and the macrostructuralist debate’, in Charles J. Whalen (ed.), Political Economy for the 21st Century: Contemporary Views on the Trend of Economics, Armonk, NY: M.E. Sharpe, pp. 171–94. Briggs, Vernon M. Jr. (1981), ‘The revival of job creation programs in the 1970s: lessons for the 1980s’, in Cornell University Industrial and Labor Relations School: Briggs Volume II, paper no. 14, accessed 30 December 2010 at http:// digitalcommons.ilr.cornell.edu/briggsII/14. Brown, Christopher (2008), Inequality, Consumer Credit and the Saving Puzzle, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Commons, John R. (1899), ‘The right to work’, The Arena, 21 (February), 131–42. Copeland, Morris A. (1967), ‘Implementing the objective of full employment in Our Free Enterprise Economy’, in Carey C. Thompson (ed.), Institutional Adjustment: A Challenge to a Changing Economy, Austin, TX: University of Texas Press, pp. 127–48. Dewey, John (1919), Intelligence in the Modern World: John Dewey’s Philosophy, reprinted 1939, New York: Modern Library. Federal Reserve Bank (2010), Household Debt Service Payments as a Percentage of Disposable Personal Income, Washington, DC: Board of Governors of the Federal Reserve System. Forstater, Mathew (1998), ‘Flexible full employment: structural implications of discretionary public sector employment’, Journal of Economic Issues, 32 (June), 557–64. Forstater, Mathew (1999), ‘Functional finance and full employment: lessons from Lerner for today’, Journal of Economic Issues, 33 (June), 475–82. Forstater, Mathew (2002), ‘Full employment policies must consider effective demand and structural and technological change: a prime point of Pasinetti’s political economy’, in Paul Davidson (ed.), A Post Keynesian Perspective on 21st Century Economic Problems, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 195–215.

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Foster, J. Fagg (1981), ‘Syllabus for problems of modern society: the theory of institutional adjustment’, Journal of Economic Issues, 15 (December), 929–35. Freeman, Richard (2007), America Works, New York: Russell Sage. Galbraith, James. K. (1998), Created Unequal: The Crisis in American Pay, New York: The Free Press. Gordon, Wendell (1997), ‘Job assurance: the job guarantee revisited’, Journal of Economic Issues, 32 (September), 826–34. Greenhouse, Steven (2008), The Big Squeeze: Tough Times for the American Worker, New York: Random House. Harvey, Philip (1989), Securing the Right to Employment, Princeton, NJ: Princeton University Press. International Swaps and Derivatives Association (ISDA) (2010), ISDA market survey historical data, accessed 30 December 2010 at www.isda.org. Kaboub, Fadhel (2007), ‘Institutional adjustment for full employment’, Journal of Economic Issues, 41 (June), 495–502. Kaboub, Fadhel (2008), ‘Elements of a radical counter-movement to neo-liberalism: employment-led development’, Review of Radical Political Economics, 40 (September), 220–27. Kadmos, George A. and Phillip A. O’Hara (2000), ‘The taxes-drive-money and employer of last resort approach to government policy’, Journal of Economic and Social Policy, 5 (Summer), 1–22. Keynes, John M. (1936), The General Theory of Employment, Interest and Money, London: Macmillan. King, John (2000), ‘Comment on: George Kadmos and Phillip O’Hara – “The taxesdrive-money and employer of last resort approach to government policy” ’, Journal of Economic and Social Policy, 5 (Summer), 72–6. Kitson, Michael, John Michie and Holly Sutherland (1997), ‘A price well worth paying? The benefits of a full-employment strategy’, in J. Michie and J.G. Smith (eds), Employment and Economic Performance: Jobs, Inflation and Growth, Oxford: Oxford University Press, pp. 234–53. Kregel, Jan A. (1991), ‘Is Keynesian full employment policy for “top countries” only?’, in C. de Neubourg (ed.), The Art of Full Employment: Unemployment Policy in Open Economies, Amsterdam, Netherlands: North Holland, pp. 309–19. Kregel, Jan A. (1999), ‘Price stability and full employment as complements in a new Europe: a market-based price stabilization policy for the new ECB’, in Paul Davidson and Jan Kregel (eds), Full Employment and Price Stability in a Global Economy, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 178–94. Lerner, Abba P. (1943), ‘Functional finance and the federal debt’, Social Research, 10 (February), 38–51. Lerner, Abba P. (1947), ‘Money as a creature of the state’, American Economic Review, 37 (May), 312–17. Majewski, Raymond (2004), ‘Simulating an employer of last resort program’, in G. Argyrous, M. Forstater and G. Mongiovi (eds), Growth, Distribution, and Effective Demand: Alternatives to Economic Orthodoxy, Essays in Honor of Edward J. Nell, Armonk, NY: M.E. Sharpe, pp. 163–80. Marshall, Mike (1995), ‘Lessons from the experience of the Swedish model’, in P. Arestis and M. Marshall (eds), The Political Economy of Full Employment: Conservatism, Corporatism and Institutional Change, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 202–16.

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Minsky, Hyman P. (1965), ‘The role of employment policy’, in M.S. Gordon (ed.), Poverty in America, San Francisco, CA: Chandler, pp. 175–200. Minsky, Hyman P. (1966), ‘Tight full employment: let’s heat up the economy’, in H.P. Miller (ed.), Poverty American Style, Belmont, CA: Wadsworth, pp. 294–300. Minsky, Hyman P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Minsky, Hyman P. and Charles J. Whalen (1996), ‘Economic insecurity and the institutional prerequisites for successful capitalism’, Journal of Post Keynesian Economics, 19 (Winter), 155–70. Mitchell, William F. (1998), ‘The buffer stock employment model and the NAIRU: the path to full employment’, Journal of Economic Issues, 32 (June), 547–56. Mitchell, William F. and Martin J. Watts (1997), ‘The path to full employment’, Australian Economic Review, 30 (December), 433–5. Mitchell, William F. and L. Randall Wray (2005), ‘In defense of employer of last resort: a response to Malcolm Sawyer’, Journal of Economic Issues, 39 (March), 235–44. Mosler, Warren B. (1997), ‘Full employment and price stability’, Journal of Post Keynesian Economics, 20 (Winter), 167–82. Nell, Edward J. (1988), Prosperity and Public Spending: Transformational Growth and the Role of Government, Boston, MA: Unwin Hyman. Palley, Thomas I. (2007), ‘Financialization: what is it and why it matters?’, The Levy Economics Institute of Bard College working paper no. 525. Papadimitriou, Dimitri B., Mathew Forstater and L. Randall Wray (1998), ‘Toward full employment without inflation: the job opportunity program’, The Jerome Levy Economics Institute of Bard College, Report, 8 (3), 5–8. Rochon, Louis-Philippe and Matias Vernengo (2003), ‘State money and the real world: or chartalism and its discontents’, Journal of Post Keynesian Economics, 26 (Fall), 57–67. Roosevelt, Franklin D. (1941), ‘Four freedoms’, speech delivered to the 77th US Congress on 6 January 1941. Roosevelt, Franklin D. (1944), ‘Second Bill of Rights’, State of the Union address delivered on 11 January 1944. Sawyer, Malcolm (2003), ‘Employer of last resort: could it deliver full employment and price stability?’, Journal of Economic Issues, 37 (December), 881–907. Sawyer, Malcolm (2005), ‘Employer of last resort: a reply to my critics’, Journal of Economic Issues, 39 (March), 256–64. Scott, Robert H. (2007), ‘An analysis of credit card debt default’, in R.P.F. Holt and S. Pressman (eds), Empirical Post Keynesian Economics: Looking at the Real World, Armonk, NY: M.E. Sharpe, pp. 110–38. Toruño, Mayo (2004), ‘Regressive norms, progressive possibilities, and labor justice’, in D.P. Champlin and J.T. Knoedler (eds), The Institutionalist Tradition in Labor Economics, Armonk, NY: M.E. Sharpe, pp. 273–85. United for a Fair Economy (2006), The Growing Divide: Inequality and the Roots of Economic Insecurity, Boston, MA: United for a Fair Economy. United Nations (1948), ‘The United Nations Universal Declaration of Human Rights’, General Assembly of the United Nations, 10 December 1948. United States Census Bureau (2010), Income, Poverty and Health Insurance in the United States: 2009, Washington, DC: US Department of Commerce. Veblen, Thorstein B. (1899), The Theory of the Leisure Class: An Economic Study of Institutions, New York: B.W. Huebsch. Vickrey, William S. (1992), ‘Chock-full employment without increased inflation’, American Economic Review, 82 (May), 341–45.

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Whalen, Charles J. (1996), The age of anxiety: erosion of the American dream’, USA Today (September), 14–16. Whalen, Charles J. (2005), ‘Sending jobs offshore from the United States: what are the consequences?’, Intervention: Journal of Economics, 2 (2), 33–40. Whalen, Charles J. (2010a), ‘An institutionalist perspective on the global financial crisis’, in S. Kates (ed.), Macroeconomic Theory and Its Failings: Alternative Perspectives on the Global Financial Crisis, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 235–59. Whalen, Charles, J. (2010b), ‘A Minsky perspective on the global recession of 2009’, in Daniela Tavasci and Jan Toporowski (eds), Minsky, Crisis and Development, New York: Palgrave Macmillan, pp. 106–26. Whalen, Charles J. and David A. Zalewski (2010), ‘Financialization and income inequality: a post Keynesian institutionalist analysis’, Journal of Economic Issues, 34 (September), 757–78. Wray, L. Randall (1998), Understanding Modern Money: The Key to Full Employment and Price Stability, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Wray, L. Randall (ed.) (2004), Credit and State Theories of Money: The Contributions of A. Mitchell Innes, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Wray, L. Randall (2009), ‘The rise and fall of money manager capitalism: a Minskian approach’, Cambridge Journal of Economics, 33 (4), 807–28. Zalewski, David (2004), ‘Wealth and power: ethical implications of executive compensation since the 1980s’, in D.P. Champlin and J.T. Knoedler (eds), The Institutionalist Tradition in Labor Economics, Armonk, NY: M.E. Sharpe, pp. 286–96.

5. Towards a more rapid recovery: incorporating subsidiarity into macroeconomic policy David A. Zalewski and Charles J. Whalen INTRODUCTION The recent global financial crisis had a devastating impact on the well-being of millions of people. It also brought critical public attention to the economics profession. In The New York Times, Nobel laureate Paul Krugman (2009a) revealed that the shortcomings of conventional economics are deeply rooted: ‘Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy’. Seeking an alternative path for economic theory and policy – or at least practical and near-term insights – a number of financial analysts, journalists, economists, and policymakers have rediscovered the Post-Keynesian Institutionalism (PKI) of the late Hyman Minsky. These include Janet Yellen (2009), president of the Federal Reserve Bank of San Francisco, and Paul McCulley (2008), managing director at PIMCO, which runs the world’s largest mutual fund. Krugman (2009b) has also taken a second look at Minsky; his 10 June 2009 lecture at the London School of Economics was entitled ‘The night they reread Minsky’.1 The widespread acknowledgment of Minsky’s contributions to economics is long overdue. Unlike most mainstream economists, scholars inspired by Minsky – such as Michael Carter (1989), Brent McClintock (1996), Christopher Brown (2008), Jan Kregel (2008), Charles J. Whalen (2007), and L. Randall Wray (2008) – predicted the onset of the recent crisis and provided convincing explanations for the causes and propagation of the resulting economic downturn. Minsky and today’s economists working in the tradition of PKI offer important ideas that are informative for policymakers.2 The financial and economic trouble that began in 2007, however, highlights the need for something more as well – greater attention to the challenge that an economic downturn poses for states and localities. In a recessionary period, 93

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state and local governments respond to a drop in revenues by cutting spending, but such belt-tightening serves to counteract federal stimulus measures and thus prolongs the downturn. It can also offset private job growth in a manner that threatens to choke off a recovery. For example, an Associated Press report describes the July 2010 US employment picture as follows: ‘Excluding the impact of the elimination of 143 000 temporary census jobs, the economy added a meager 12 000 positions, as layoffs by state and local governments almost canceled out weak hiring by businesses’ (Associated Press, 2010a, emphasis added). Thus, economists must give attention to the predicament that confronts states and localities during slumps. Finding a strategy to anticipate and evade the problem can place the economy on the path to a more rapid recovery from future recessions. This chapter, drawing on the principle of subsidiarity, presents such a strategy as a policy option and explains how it can be incorporated into the existing macroeconomic policy framework of PKI. The analysis follows Minsky in focusing on the experience and institutions of the US economy, but the general argument is likely to be applicable to other advanced capitalist economies as well.

BIG GOVERNMENT In his 1986 book, Stabilizing an Unstable Economy (SUE), Minsky (1986) outlined a number of steps towards US economic and financial reform. His aim was to reduce the tendency toward systemic instability and cyclical fluctuations, especially by means of public action to control the use of leverage and discourage excessive risk-taking. At the same time, however, Minsky recognized there is no set of reforms that will permanently eliminate the business cycle; the development of financial fragility is, he insisted, a normal process in capitalist economies. Government action aimed at recession prevention must therefore be supplemented by public policies that contain a downturn and promote a rapid recovery. Minsky’s main counter cyclical supplements to economic reform are often referred to as ‘Big Government’ and a ‘Big Bank’. According to Minsky (1986: 303), stabilizing the US economy means public policy ‘needs a handle by which it can affect profits’. Big Government – the federal government – provides this sort of handle. It helps sustain profits by running deficits that bolster aggregate demand when private spending falters. While some of this stimulus is often due to discretionary spending, Minsky stressed that the structure of Big Government ‘must have the built-in capacity’ to operate automatically as a stabilizing force (Minsky, 1986: 292). For example, this can be achieved on the revenue side by a progressive tax structure (which causes tax

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revenue to rise or fall as a counterweight to changes in incomes) and on the spending side by unemployment compensation – or, better yet, argued Minsky (1986: 26, 304–13), by federally sponsored public service employment as a backstop to the private sector labour market. A Big Bank – the Federal Reserve (Fed) – complements Big Government by intervening in financial markets as ‘lender of last resort’. Minsky (1986: 18–19) writes: ‘The income and financial stabilizers provided by Big Government take time to become effective. Meanwhile, financial pressures in the form of payment commitments on outstanding short-term debts and declining asset values threaten to turn financial tautness into a financial debacle. In order to prevent a full-fledged crisis, refinancing is needed’. Since the New Deal, this refinancing – or lender-of-last resort intervention – has been orchestrated by the Fed, often in collaboration with the US Treasury Department. In a downturn, the Fed lowers interest rates across the economy by cutting the federal funds rate (and/or discount rate) and infusing reserves into the banking system. It also arranges refinancing for specific banks and firms facing financial trouble, thus helping to stabilize asset prices and prevent a debt deflation. These Big Bank actions shore up cash flows and prevent financial trauma from spreading (Minsky, 1986; Minsky, 1982). In SUE, Minsky summarizes the collective impact of Big Government and a Big Bank with respect to the 1973–75 recession. He writes: A major depression did not occur in 1975 because of two types of government intervention: (1) Big Government’s fiscal policy: the massive federal deficits in the recession directly affected income, sustained private financial commitments, and improved the composition of portfolios; and (2) Lender of last resort: refinancings were aptly executed by the Federal Reserve System and cooperating private and public bodies. (Minsky, 1986: 19)

Today, Big Government and a Big Bank continue to play vital roles in the macroeconomic policy framework of PKI.

THE RECENT CRISIS In the US, federal-level policy responses aimed at containing and recovering from the recent economic crisis have been generally consistent with Minsky’s prescriptions. First there was Big Bank action: Fed and Treasury Department financial-stabilization measures have been unprecedented in both scope and magnitude. Then there was Big Government: in early 2009, for example, a stimulus package helped increase federal budget deficits to record post-World War Two levels.3 Since mid-2007, a central element of the federal effort to contain the

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economic crisis and promote recovery has been the rescue of financial markets. Through action taken in August and September 2007, for example, the Fed reduced the discount rate it charges to banks, lowered the quality threshold on collateral used by banks to secure overnight borrowing from the Fed, infused cash into the financial system, and engineered a decline in private-sector interest rates by cutting the federal funds rate. It also led a collaborative, lender-of-last-resort effort involving a number of central banks, which stepped in to help maintain orderly conditions in financial markets and to prevent credit dislocations from adversely affecting the broader economy (Thomson Financial, 2007). In addition, the Fed supported the Treasury Department’s takeover of Freddie Mac and Fannie Mae and enactment of the Troubled Asset Relief Program (TARP) in 2008. TARP funds have been used not only to prop up US banks, but also major companies including insurance giant American International Group Inc. and General Motors Corp. In all, the Treasury Department and the Fed has committed more than $2 trillion in loans, investments, and direct expenditure since the start of the recession; nearly 700 banks and insurance companies received $245 billion from Washington, and loans of approximately $300 billion were made to major corporations.4 The federal government also enacted two stimulus programmes – during the administrations of George W. Bush and Barack Obama – to prop up the economy. The Bush package, passed in February 2008, focused on tax reductions. At an estimated cost of $168 billion over a two-year period, the centrepiece of that initiative was an array of tax credits focused on middle- and lower-income families. In such households, individuals received a tax credit of $600; couples were given $1200 refunds; and parents received a credit of $300 per child. (The value of these rebates began to decrease for individuals with adjusted gross incomes above $75 000 and for couples whose earnings reached $150 000.) Another provision doubled, to $250 000, the business expenses eligible for immediate write-off. Almost exactly a year later, in response to deteriorating economic conditions, President Obama signed the American Recovery and Reinvestment Act (ARRA). At an estimated cost of $787 billion over two years, ARRA was composed mostly of public expenditures for initiatives in areas such as infrastructure, education and training, and energy conservation, though its largest single element (accounting for just over a third of the total package) involved tax relief (see Table 5.1). Combined with falling tax revenues and other nonstimulus expenditure increases, such as those to support military efforts in Iraq and Afghanistan, the federal deficit reached $1.41 trillion (9.9 per cent of GDP) in fiscal year 2009 and the US Congressional Budget Office (2010: 3) estimates a deficit of $1.34 trillion (9.1 per cent of GDP) in fiscal year 2010.

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Table 5.1

Composition of the American Recovery and Reinvestment Act

Stimulus category Tax relief State and local government relief Infrastructure Displaced worker aid Health care Education and training Energy Other Source:

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Amount ($ billions) 288 144 111 81 59 53 43 8

Appleman (2009).

Unresolved Issues While the broad contours of US macroeconomic and monetary policy since 2007 have been consistent with Minsky’s recommendations for responding to a financial crisis, there are some gaps and unresolved issues. One area involves the financial sector. According to an October 2009 policy brief by Post-Keynesian Institutionalists Éric Tymoigne and L. Randall Wray (2009), the Obama administration has been driven by an emphasis on buttressing the nation’s largest banks and by the belief that those institutions face merely a liquidity problem, rather than a solvency problem. As a result, they conclude, ‘massive indebtedness’ in the financial and household sectors has been overlooked and the widespread need for mortgage restructuring has received inadequate attention (Tymoigne and Wray, 2009: 4). These problems have continued into 2010, which has seen record mortgage delinquencies and foreclosures as well as news reports describing the administration’s foreclosure prevention programme as ‘a dud’ (Christie, 2010; Lazo, 2010; Puzzanghera, 2010). Also unresolved is the long-term erosion of US automatic stabilizers. In late 2002, on the heels of the bursting of the dot-com bubble, an article by Whalen and Jeffrey Wenger (2002) demonstrated that key automatic-stabilizing elements of the federal budget – taxes, unemployment insurance, welfare, and the minimum wage – had eroded considerably since the mid-1970s. In addition to suggesting a bolstering of those stabilizers, they echoed Minsky’s call for a public service employment programme that would automatically expand or contract with the unemployment rate and thus offset private sector joblessness; neither suggestion received much attention. In PKI, such an employment policy is often referred to as engaging government as ‘employer of last resort’ (ELR) (Wray, 1998). In recent years, the

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combined efforts of America’s Big Government and Big Bank have prevented economic disaster, but the focus has been (as Tymoigne and Wray have demonstrated) on large corporations rather than households and small businesses. By providing employment by means of a permanent, counter cyclical programme, an ELR policy would deliver relief directly to households.5 It would also help reduce a key obstacle to small business investment: economic uncertainty. A 1996 lecture by Minsky (1996) – entitled ‘Uncertainty and the institutional structure of capitalist economies’ – provides the link between the ELR and uncertainty. His message can be summarized as follows: (1) Economic life occurs in a world of uncertainty and in an evolving institutional setting. (2) Evolution of the US economy includes the transition from an era of finance capitalism (which collapsed in the early 1930s in large part due to widespread economic uncertainty); to an era of managerial capitalism (erected on a foundation of New Deal institutional innovations designed to attenuate uncertainty) and eventually to a new era of heightened uncertainty called money-manager capitalism (beginning in the early 1980s). (3) Unpredictability can be debilitating; thus, there are – and should be – limits to society’s tolerance for uncertainty. (4) Full employment, achieved by means of an ELR, provides a valuable way to attenuate economic uncertainty. What does economic uncertainty mean to small businesses? A lot. Although many economists declared the recession to be over in the autumn of 2009, Deborah Lynn Blumberg (2009) of The Wall Street Journal reported that small business owners had actually become more pessimistic. Blumberg’s article was based on results from a survey-based Small Business Optimism Index produced by the National Federation of Independent Business (NFIB). In November 2009, the NFIB index registered a 0.8-point decrease to 88.3, the sixth consecutive quarter below 90, a level indicative of a recession-mired economy. (By comparison, the index, compiled since the mid-1970s, was below 90 for only one quarter during the 1980–82 recession.) According to the NFIB, weak consumer spending was partly responsible for these results, but the survey also implicated the level of uncertainty created by government, which was then simultaneously pursuing major initiatives on many fronts, including financial reform, health care, energy, and the environment. ‘The “turbulence” created when Congress is in session is often debilitating, this year being one of the worst’, wrote the authors of the NFIB’s survey report (quoted in Blumberg, 2009). In an address given in early 2010, Federal Reserve Bank of Atlanta president Dennis P. Lockhart (2010) highlighted this problem: businesses are ‘reluctant to invest and hire’ when there is so much uncertainty about the future of government policy, he maintained.6 Small business is watched closely because it has in recent years been a major source of job growth and because it has also accounted for the vast

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majority of job cuts during the Great Recession (Fields, 2009; Lowrey, 2010). Unfortunately, as this chapter is being written, the NFIB index remains pessimistic. In July 2010 (the most recent month for which data are available at this writing), the index stood at 88.1, continuing an unprecedented trend of weak business expectations. While ‘economic conditions’ (poor sales) was the top reason respondents offered for being unwilling to expand their operations, it was followed by a concern about uncertainty related to public policy. According to the report’s authors, ‘Big banks and big manufacturers may be doing well, but the small firms are not. If this doesn’t change soon, the success of the large firms will be imperiled as well’ (Dunkelberg and Wade, 2010: 3).7 State and Local Governments In recent years, state and local budget officers have also been wracked by uncertainty in the effort to balance their books. As economist Gerald Friedman (2009) observes, budgetary conditions at these levels are procyclical: in recessions, for example, spending falls and legislators often feel the need to enact tax hikes to fill a budget gap. The main reason: nearly all states and localities have a constitutional mandate requiring a balanced budget over the fiscal (annual or biennial) period.8 The result is that a significant portion of recent federal stimulus spending has been counteracted by contractionary fiscal action at the state and local levels. Evidence is provided by the biannual report, The Fiscal Survey of States, produced by the National Governors Association (NGA) and the National Association of State Budget Officers (NASBO). The latest report (June 2010) indicates states sharply reduced spending from $687.3 billion in fiscal 2008 to $612.9 billion in fiscal 2010. The report indicates fiscal 2011 ‘will be equally challenging …. Unfortunately, states will have to make additional spending cuts or increase taxes to close their budget gaps, actions that will slow the economic recovery’ (Zaharais, 2010; NGA and NASBO, 2010). According to NASBO executive director Scott Pattison and NGA executive director Raymond Scheppach, states will continue to face recession-related tough times for at least a few more years. Pattison observes: ‘States are still reeling from the downturn after the unprecedented declines in year over year spending in fiscal 2009 and 2010. [And now they] face significant fiscal challenges going forward with the federal Recovery Act funds ending, revenues not expected to be returning to pre-recession levels, and higher demands for many services like health and education’ (quoted in Zaharias, 2010). Scheppach adds: ‘Our best estimate of the remaining state shortfalls for 2010–2012 is $127.4 billion. Because states lag behind national recovery, they expect 2011 to be as bad as 2010’ (quoted in Zaharias, 2010).

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As Pattison noted, states did get some relief from ARRA (see also Table 5.1). In August 2010, additional state aid was provided by a $26 billion federal initiative designed to preserve the jobs of teachers and other public employees (Montgomery and Anderson, 2010; Aarons and Klein, 2010). However, even with ARRA funds, there were 133 600 fewer state and local jobs in the US in July 2010 than at the start of the Great Recession in December 2007 (US Bureau of Labor Statistics, 2010a). Public sector budget woes have distributional consequences. Federal support for the nation’s social safety net began eroding long before the onset of the Great Recession (see Keohane, 2009; and Albelda, 2009), and state and local governments have not been able to pick up the slack. The result has often been cuts to programmes that provide vital assistance to the most vulnerable and financially insecure. For example, an August 2010 report by the Center on Budget and Policy Priorities found that since 2008, 43 states trimmed higher education budgets, 33 lowered expenditures on elementary and secondary education, 31 reduced health care spending, and 29 cut services to the elderly and disabled (Johnson et al., 2010).9

REDISCOVERING SUBSIDIARITY Although the broad contours of US macroeconomic policy may be consistent with Minsky’s approach to tackling a financial crisis and economic downturn, he would certainly not have been pleased to see federal progress offset by state and local policies that are deleterious from the perspective of both economic stability and social justice. After all, while Minsky devoted most of his attention to economic stabilization, his underlying aim was always ‘a humane economy as a first step toward a humane society’ (Minsky, 1986: 293). Moreover, state and local budget problems are a cause as well as a consequence of the economic uncertainty that Minsky sought to reduce. In fact, when the federal government is pumping money into the economy and state and local governments are simultaneously laying-off workers, cutting spending, and even increasing taxes and fees, it is no surprise that small business owners report confusion and uncertainty regarding public policy and its impact on future business conditions. Thus, PKI needs a policy to address the budget problem that confronts state and local governments in a downturn.10 The key is to incorporate the notion of subsidiarity into the existing Big Government and Big Bank macroeconomic policy framework of PKI. Subsidiarity has two, closely related definitions. The first, deriving from its use in the Roman Catholic Church, is ‘a principle of social doctrine that all social bodies exist for the sake of the individual so that what individuals are able to do, society should not take over, and what small societies can do, larger

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societies should not take over’. The second, used in public policy discussions, is ‘the principle of devolving decisions to the lowest practical level’.11 Minsky would have likely found both definitions compatible with his economic outlook. It is clear from SUE that he valued individual liberty, decentralized markets and small enterprises (Minsky, 1986). And in ‘Uncertainty and the institutional structure of capitalist economies’, Minsky stresses that the ‘primary interest of the government of a nation-state is the well-being of its populace’. Moreover, in a 1965 paper on poverty reduction, Minsky emphasized the need for a ‘bubble up’ policy approach – one that focuses on delivering targeted spending (in the form of employment and training) to the jobless and unskilled (Minsky, 1965; Wray, 2010). So far, however, subsidiarity has not been developed as a core principle of PKI. To be sure, there have been recent calls for the federal government to help ‘restore state finances’ (Tymoigne and Wray, 2009: 4) and to provide incentives that encourage states to move towards reversing the trend of rising inequality (Wray, 2009: 17). And Fadhel Kaboub touched briefly on the subsidiarity notion in an early 2010 public lecture, entitled ‘Can the US economy afford not to guarantee jobs for all?’ But the principle of subsidiarity still remains to be fleshed out as a concept and policy foundation. Wilber and Jameson The lack of attention to subsidiarity in PKI is actually ironic. That is because the concept appears in An Inquiry into the Poverty of Economics, by Charles K. Wilber and Kenneth P. Jameson (1983), the first book to explicitly outline a PKI perspective. In trying to tackle the major economic problems of the early 1980s, Wilber and Jameson (1983: 239) argue the effort to refashion institutions and revitalize the US economy requires beginning with an ‘underlying value structure’ that can guide individual and social decisions. They then identify three ‘central moral values’ – stewardship, jubilee, and subsidiarity – and relate them to three key economic goals, life-sustenance, esteem, and freedom, respectively. Thus, Wilber and Jameson have laid a foundation for the integration of subsidiarity and contemporary PKI. What remains for Post-Keynesian Institutionalists to do now is rediscover and build on that foundation with a serious effort to put subsidiarity into practice. Wilber and Jameson (1983: 259) explain subsidiarity as follows: Solutions to our economic problems will be found only if citizens are willing to cooperate in the difficult readjustments necessary to revitalize the economy. And that requires that policies be developed and implemented at the lowest feasible levels. This principle we call subsidiarity.

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Buoyed by optimism over the proliferation of non-profit community-based organizations, small credit unions, neighbourhood associations, and other local groups, Wilber and Jameson looked hopefully to small organizations as an alternative to transnational, mega-institutions and huge federal agencies: ‘National institutions have become too large, too uncontrollable, too unresponsive. We must develop smaller institutions more responsive to individual needs’. Wilber and Jameson are not impractical or simplistic believers in a world without nations and large firms. They recognize that national economic management – and even international economic cooperation – will be necessary to achieve and sustain full employment, price stability, and robust prosperity. In such a world, however, the vital role of the smaller organizations is to serve as ‘mediating structures’, filling a gap between the individual, who has limited power when acting alone, and the inherently impersonal and bureaucratic mega-institution (Wilber and Jameson, 1983: 260). Wilber and Jameson (1983: 259–63) maintain that community-level mediating structures – institutions including families, churches, unions, and voluntary associations – yield a number of beneficial outcomes for individuals and society. Perhaps most important are that such structures foster a sense of community and instill confidence in the future. A sense of community engenders a cooperative spirit that leads to creative problem solving, a sense of shared responsibility, and collaborative efforts that are usually more effective than individual action. For example, collective action can be used to influence government decision-makers; protect communities against gentrification; and secure media attention. While the conventional American notion of liberty involves freedom from collective action, Wilber and Jameson (1983: 260–61, 263) and contemporary PKI (Whalen, 2008) build on pioneering Institutionalist John R. Commons’s (1931) insights, which focus on the need that humans have for enabling institutions and thus on the possibility of freedom through collective action.12 Confidence in the future, meanwhile, is a product of the relationships that people establish through their participation in mediating institutions. In a neighbourhood, for example, such participation can result in civic pride that not only reduces vandalism and crime, but also encourages residents to make new investments in their property. As a result, such institutions can raise property values and enhance the quality of life for all area residents. The manageable scale of meditating structures also gives individuals a chance to engage in meaningful, participatory democracy. This is beneficial for individuals because it gives them a voice in collective decisions. It is also beneficial for institutions because it provides them with the vitality generated by multiple perspectives. In light of the many positive attributes of such structures, Wilber and Jameson (1983: 261) draw two policy conclusions: (1) ‘Public policy should

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protect and foster mediating structures’; and (2) ‘Whenever possible, public policy should utilize the mediating structures as its agents’. They also argue that ways should be found ‘to revitalize mediating institutions from the bottom up’. Thus, they offer the example of German works councils, which bring all employees into workplace and enterprise decision-making.13 Subsidiarity and State/Local Budget Woes The US experience in the Great Recession helps us clarify what PKI sees as necessary in the realm of macroeconomic policy. There is a place for large institutions: we need the deficits of Big Government and the lender-of-lastresort interventions of a Big Bank. But we also need complementary attention to the needs of states, localities, communities, small businesses, working families, and jobless individuals. Containing an economic crisis, preventing a widespread debt deflation, and promoting a rapid economic recovery require the simultaneous application of top-down and ‘bubble-up’ strategies. Rediscovering subsidiarity and restoring it to its rightful place as a key element in the macroeconomics of PKI enables us to keep that in mind. Rediscovering subsidiarity also highlights the possibility of devising policy initiatives that include both top-down and bubble-up dimensions. As Wilber and Jameson indicated, the key is to make national policy operate through mediating structures as much as possible. One way to do this would be to treat states and localities as mediating institutions in the execution of federal policy and to explicitly incorporate counter cyclical assistance to states and localities in the structure of the federal budget. In addition to easing state and local budget woes, such an arrangement would help public workers (and their local communities) by stabilizing employment. It would also reduce the uncertainty that business owners face in a downturn. An even more ‘bottom-up’ approach could be used to implement Minsky’s vision of an ELR policy. The job-creating contracts associated with such a national policy could operate through community-development corporations and other local and regional non-profit intermediaries. Some of this has occurred in the case of ARRA. Moreover, labour-market intermediaries and community-based, sectoral approaches to workforce development were emerging as state-of-the-art in the employment policy field even before the Great Recession (Benner, et al., 2007; Glover and King, 2010).

PUTTING SUBSIDIARITY INTO PRACTICE As mentioned above, Post-Keynesian Institutionalists have recently recommended federal assistance to states reeling from the Great Recession and

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incentives that encourage states to address the problem of rising inequality (Tymoigne and Wray, 2009; Wray, 2009: 17). Other writers also responded to the downturn with proposals aimed at improving the budgetary condition of states and localities. Economist Rick Wolff (2009), for example, observes that most state and local governments exempt intangible property from property taxation. He argues that introducing even a low tax rate on financial assets such as stocks and bonds should raise enough revenue to strengthen state and local budgets. It would also shift more of the tax burden to wealthier citizens. In contrast to Wolff, economic journalist Robert Kuttner (2009) focuses on the more immediate budgetary problems of states and localities. As early as the summer of 2009, Kuttner proposed a second stimulus in the form of emergency federal aid to state and local governments. His plan called for the federal government to write each state a cheque in exchange for their promise to abide by the tax and spending policies in effect on some earlier date (Kuttner suggested 1 January 2008). In addition to serving a macroeconomic purpose, such a stimulus would also restore trust in government by allowing the public sector to continue supplying vital public goods and services, Kuttner argued. While all of these are constructive suggestions (and, indeed, the state-aid bill enacted by the federal government in August 2010 is similar to Kuttner’s proposal in spirit, though not in size and scope), each proposal is flawed. They are either temporary (in the case of Kuttner as well as Tymoigne and Wray) or unlikely to be enacted out of fear that wealthy residents and businesses might move elsewhere (in the case of Wolff and Wray). As an alternative, we outline – at least for further consideration and development – a fiscal policy rule to address the problem faced by states and localities in a sluggish economy. It builds on the suggestion we offered in the previous section as a way to use states and localities as mediating structures. As such, this policy option is conceived as a long-term (‘permanent’) change, not a temporary measure. Its aim is to put subsidiarity into practice to promote a more rapid recovery from future downturns. The policy we describe also involves use of a predetermined formula for allocating federal funds to states and localities. Such a formula adds certainty that is intended to reduce the volatility of state and local budgets. It can also pre-empt emergence of recession-era concerns that recovery efforts represent a troubling expansion of the size and power of the federal government. Some might call this policy ‘revenue sharing’, which was first proposed by President Richard Nixon in the early 1970s, but that misses the point. The problem that states and localities face is that they cannot engage in deficit spending. Thus, the policy might be more accurately called ‘deficit sharing’, rather than revenue sharing. But that term is also inadequate because it is silent on the purpose of those deficits. A better term would be ‘shared stabilization’, or perhaps even ‘counter cyclical subsidiarity’.

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The Shared Stabilization Rule Although they have seldom referred to it as such, Minsky and his followers have long advocated the use of fiscal policy rules. Perhaps the best-known example of this is Minsky’s ELR policy, through which full employment could be maintained. Minsky (1986a: 308) writes: The main instrument of such a policy is the creation of an infinitely elastic demand for labor at a floor or minimum wage that does not depend upon long- and short-run profit expectations of business. Since only government can divorce the offering of employment from the profitability of hiring workers, the infinitely elastic demand for labor must be created by government.

In the course of developing the ELR policy further, Wray (1998: 343), explains that the programme operates as a buffer-stock mechanism in that the government stands ready to ‘buy’ or ‘sell’ labour at a fixed price as economic conditions warrant. Thus, the ELR programme may be viewed as a fiscal policy rule in which government spending would adjust, without discretionary action, in response to macroeconomic conditions. In addition, an implicit call for fiscal policy rules is evident in Minsky’s (1986: 292, 302–4) emphasis on the federal budget’s built-in capacity to generate deficits in downturns. It is also implicit in more recent Post-Keynesian Institutionalist advocacy of greater reliance on automatic stabilizers (Whalen, 2010a, for example).14 Interestingly, some conservative economists also support the adoption of fiscal policy rules. For example, John B. Taylor (2000), father of the ‘Taylor rule’ popular in monetary policy circles, suggests that a rules-based approach can be applied to fiscal policy as well as monetary policy. Taylor (2000: 31) argues that the actual budget surplus (or deficit) can be decomposed into ‘a cyclical part and a structural part’. His rule would call for the structural surplus (or deficit) to be the focus of discretionary fiscal policy and for the cyclical surplus (or deficit) to fluctuate inversely with the output gap, which measures the deviation of real GDP from potential GDP.15 Thus, the job of creating or expanding deficits in cyclical downturns would, except in extraordinary circumstances, be in the hands of automatic stabilizers, not policymakers.16 The Taylor rule just described can be infused with the insights of PKI to generate a shared-stabilization fiscal policy rule. As a result, the new rule would operate as follows: (a) discretionary policy would focus on issues surrounding the federal budget’s structural balance, while automatic stabilizers would be the primary method of counteracting cyclical fluctuations (that is, policy would aim for balance in the cyclical part of the budget in the absence of an output gap); (b) annual projections would be used to estimate the size of the deficit in the cyclical part of the budget in the coming fiscal

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year; and (c) in the event that a cyclical deficit is anticipated, an amount of federal dollars equal to some fixed proportion of that projected cyclical deficit would be created via federal borrowing and would be shared with states and localities, with funds allocated in proportion to each state and local government’s spending level at the onset of the downturn. Use of such a rule would offer a number of benefits over reliance on discretionary action to address state and local crises generated by a recession. For example, implementation lags would be reduced; policy uncertainty would be eliminated; and inequalities of political power would be irrelevant (at least in this policy realm). Most important is that such an arrangement would help preserve state and local employment levels, thereby maintaining critical public services. This policy innovation could also be combined with an ELR. Thus, state and local leaders, knowledgeable about their region’s needs, could play a vital role in identifying the community organizations and projects in their area that receive funds for job creation. As mentioned above, research on workforce development and labour-market policies shows that many mediating structures at the community level have already proven themselves to be effective servicedelivery institutions (for additional case studies, see Whalen, 2010b and Cortés, 2010). To be sure, there are many practical issues to be addressed before a sharedstabilization fiscal rule could be enacted and implemented effectively. For example, as Taylor (2000: 26) suggests, the magnitude of automatic stabilizers becomes crucial in an environment with a fiscal-policy stabilization rule; at present, however, counter cyclical stabilization ‘is at best a minor consideration when changing the tax law’. That would need to change. Other practical issues include determining what fraction of the cyclical deficit should be distributed to states and localities via this arrangement and deciding whether and how such federal borrowing might be offset by revenue generated in normal (non-recessionary) times.17 Still another issue is how to establish the permanency of this policy rule; since expectations of macroeconomic stability are often self-reinforcing, the credibility of the programme will be an important determinant of its effectiveness.18 Finally, a shared-stabilization policy would have to be implemented in a way that gains public support. Fortunately, Institutional economists have gained considerable insight on this matter over the past century. For example, Kaboub (2007), drawing on J. Fagg Foster’s insights on institutional adjustment, offers a number of pragmatic considerations relevant to introduction of an ELR programme. These include the need to pursue such institutional change in a gradual and holistic manner, rather than in the form of ‘shock therapy’; the need to ensure that states and localities are empowered by the change; and the importance of introducing major changes in a time of pros-

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perity, not in the midst of a crisis. Of course, all of these are also relevant in the case of the shared stabilization policy option.

CONCLUSION: COUNTER CYCLICAL SUBSIDIARITY An opportunity for PKI has been created by the inability of conventional economics to anticipate, comprehend and respond effectively to the global financial crisis and subsequent Great Recession. As Krugman (2009b) stated at the London School of Economics: ‘Most of what [mainstream economists] have done in macroeconomics for the past 30 or so years has turned out to be spectacularly useless at best, and positively harmful in some cases.’ Thus, this chapter has responded by presenting and extending the Post-Keynesian Institutionalist approach to macroeconomic stabilization. That has been done by drawing attention to the principle of subsidiarity, which was initially an important part of PKI, but has been overlooked by most of the tradition’s contemporary scholars. The extension offered in this chapter addresses the budget woes confronted by states and localities when a recession hits. This is necessary because recent US experience demonstrates that the aggregate demand impact of federal deficits will be limited unless steps are taken to counteract the budgetary problems of state and local governments during downturns. While retaining the Big Government and Big Bank policy elements that have become characteristic of the macroeconomic policy framework of PKI, the chapter has outlined the possibility of a standing programme through which the federal government supplies state and local governments with financial assistance when economic conditions deteriorate. This would make it easier for those governments to continue operating at pre-recession levels.19 The policy option outlined above highlights the usefulness of automatic stabilizers, fiscal policy rules, and institutional innovations designed for the long term. It is crafted with the recognition that economic life rests on expectations and that there are often adverse consequences associated with economic uncertainty. Of course, there will continue to be economic cycles. But when a downturn does occur, a shared-stabilization fiscal policy rule – which puts counter cyclical subsidiarity into practice – could help the economy achieve a more rapid recovery.

ACKNOWLEDGEMENT The authors wish to thank John Henry for suggestions on a paper that evolved into this chapter as well as for an ongoing dialogue on economic theory and policy that helped inform this work.

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NOTES 1. 2. 3.

4. 5.

6. 7. 8. 9. 10.

11. 12.

13.

On attention to Minsky, see also Lahart (2007) and Mihm (2009). Wilber and Jameson (1983) coined the term ‘Post Keynesian Institutionalism’. Other labels such as ‘Institutionalist Post Keynesian economics’ (Niggle, 2006) and ‘Evolutionary Keynesianism’ (Cornwall and Cornwall, 2001) describe roughly the same approach. Like the US government’s economic recovery strategy, its financial reform strategy has also been broadly consistent with Minsky’s prescriptions (though there are also shortcomings from a Minsky perspective, as emphasized in the chapter in this volume by Tymoigne). For example, the Wall Street Reform and Consumer Protection Act, enacted in July 2010, strengthens and extends public oversight of the financial sector and seeks to address the ‘toobig-to-fail’ problem, both of which were proposed by Minsky decades ago (Minsky, 1986: 318, 328–31; Phillips, 1997). Alan S. Blinder and Mark Zandi (2010) provide a comprehensive description of the federal response to the recession. To be sure, the ARRA’s support for ‘shovel-ready’ infrastructure and energy-conservation projects provided funds that put people to work. But the ARRA was designed to ‘save or create’ about 3.5 million jobs, while the number of unemployed persons in July 2010 alone was 14.6 million (The White House, no date; US Bureau of Labor Statistics, 2010b). In contrast, with Minsky’s ELR, government creates an infinitely elastic demand for labour: ‘For income from work to be available to all, the demand for labor must be infinitely elastic over a wide range of labor types and geographic regions…. As the program offers jobs to all, it effectively sets a minimum wage’ (Minsky, 1986: 308, 310). Wray (1998: 543) adds: ‘In a sense, ELR allows government to “make a market in labor” by establishing a “buffer stock of labor” as it stands ready to “buy” unemployed labor at a fixed price or to “sell” (provide it to non-ELR employers) at a mark-up’. For a similar discussion of the impact of policy-related uncertainty on small business and how it has impeded recovery from the Great Recession, see Fields (2009). While a number of recovery initiatives aimed at large firms have made it through Congress since 2007, a bill designed to provide relief to small businesses is blocked by a Republican filibuster as this chapter is being written (Montgomery, 2010). Vermont is the only exception among states. Distributional consequences of public budget crises are exacerbated by the fact that budget gaps often lead to increases in regressive fees and taxes (such as the sales tax). This chapter is being written in the wake of the July 2010 Congressional testimony by Fed chairman Ben Bernanke, who told Congress the economic outlook remains ‘unusually uncertain’. Summarizing Bernanke’s comments about the outlook of businesses, an Associated Press (2010b) reporter wrote: ‘Businesses, uncertain about the strength of their own sales or the economic recovery, are sitting on cash, reluctant to beef up hiring and expand operations.’ This is consistent with NFIB survey data and with the analysis of uncertainty underlying the policy perspective described in this chapter. Moreover, since some critics of increased public spending in downturns have argued that such spending makes the economy worse by exacerbating uncertainty, it is worth noting that there is no evidence of this in the yields of US Treasuries and in the spread of corporate bond yields relative to Treasuries (Federal Reserve Bank of St. Louis, 2010). Further, there is no evidence of this concern in the Fed’s July 2010 report on over 40 meetings with small business owners and lenders, ‘Addressing the financing needs of small businesses’ (Bernanke, 2010). These definitions of subsidiarity derive from the Collins English Dictionary: Complete and Unabridged; see thefreedictionary.com/subsidiarity (accessed 24 August 2010). Commons also stressed the ability of collective action to equalize economic power. In fact, he supported collective action in two distinct forms: institutions such as labour unions, which provide members with a source of countervailing power, and multi-stakeholder forums, which enable diverse interests to explore and pursue common objectives. As part of their discussion of subsidiarity and mediating structures, Wilber and Jameson (1983: 261–2) recommend the promotion of alternatives to conventional corporations,

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14.

15.

109

including not-for-profits and worker ownership. Another section of their policy discussion also calls for worker self-management (Wilber and Jameson, 1983: 244–7). Whalen has even called for a biennial federal budget (with provisions allowing Congress to act annually in emergencies) as a way to provide greater fiscal certainty and to increase the role of automatic stabilizers (see, for example, Whalen, 1995). Wray (2009) also stresses a need for the automatic, stabilizing force of government spending in a recession, but, instead of proposing that public expenditures move in a counter cyclical manner, he sees an additional need for fiscal stimulus after the economy recovers. He writes: ‘Government spending needs to operate like a ratchet: it should increase in bad times to get us out of recessions, and increase in good times to generate demand for growth of capacity’ (Wray, 2009: 18). For more on automatic stabilizers, see (Seidman and Lewis, 2002; Seidman, 2003). On the distinction between discretionary policy and automatic stabilizers, Taylor (2000: 26) writes: It is important to distinguish between discretionary changes in taxes and spending – for example, the legislative and executive actions proposed by Presidents Bush and Clinton in the early 1990s – and changes in taxes and spending due to the automatic stabilizers, like the increase in spending on such programs as unemployment compensation and the decrease in tax revenue as employment and income fall in a recession. The overall size of the actual changes in taxes and spending due to the automatic stabilizers are frequently much larger than even the proposed discretionary changes. Both types of changes in taxes and spending impact aggregate demand, but the automatic ones are more predictable and work more quickly than the discretionary ones.

16.

Although Taylor prefers using discretionary fiscal measures to accomplish longer-term goals, and employing monetary policy and automatic stabilizers for stabilization purposes, he outlines several scenarios in which discretionary fiscal action may be desirable as a way to address the gap between real (actual) and potential GDP. One scenario – as currently is the case in the US (August 2010) – is a situation in which the federal funds target approaches its ‘zero bound’ and cannot be lowered further, leaving fiscal policy as the only alternative (Taylor, 2000: 28–30). 17. Christopher Edley (2010) dean of the Boalt Hall School of Law at the University of California, Berkeley, offers a proposal – similar to the policy option we describe in this chapter – that amounts to a loan to states (in the form of an advance on federal aid, which would be repaid over a period of years once the economy has recovered). Economist Edward Glaeser (2010) of Harvard University offers another approach: encourage states (and, by logical extension, localities as well) to move from annually balanced budgets to cyclically balanced budgets, which would allow them to operate with more fiscal flexibility in downturns. 18. With an ELR component, the shared stabilization policy will also require guidelines to help policymakers identify public projects that could be started quickly, thus shortening the implementation lag and maximizing the multiplier effect associated with such public expenditures. 19. Just a few days after this chapter was finished, The New York Times published a short essay by Robert J. Shiller (2010) of Yale University, which called for a federal ‘revenue sharing’ policy consistent with the spirit of the policy option outlined above. The policy option described in this chapter is also similar to Copeland (1967), an essay that has only recently come to the authors’ attention.

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Whalen, Charles J. (1995), ‘Biennial budgeting for the federal government: lessons from the states’, Policy Studies Review, 14 (3/4), 303–22. Whalen, Charles J. (2007), ‘The credit crunch of 2007’, The Levy Economics Institute of Bard College public policy brief, no. 92. Whalen, Charles J. (2008), ‘Toward “wisely managed” capitalism: post-Keynesian institutionalism and the creative state’, Forum for Social Economics, 37 (1), 43–60. Whalen, Charles J. (2010a), ‘Economic policy for the real world’, Levy Economics Institute of Bard College policy note, 2010–1. Whalen, Charles J. (2010b), ‘Social unionism in Western New York: the case of the economic development group’, Labor Studies Journal, 35 (4), 453–79. Whalen, Charles J. and Jeffrey Wenger (2002), ‘Destabilizing an unstable economy’, Challenge, 45 (6), 70–92. The White House (n.d.), ‘Economy’, accessed 24 August 2010 at www.whitehouse. gov/issues/economy. Wilber, Charles K. and Kenneth P. Jameson (1983), An Inquiry into the Poverty of Economics, Notre Dame, IN: University of Notre Dame Press. Wolff, Rick (2009), ‘Economic crisis hits states and municipalities’, The Bullet ebulletin, no. 268, 2 November. Wray, L. Randall (1998), ‘Zero unemployment at stable prices’, Journal of Economic Issues, 32 (2), 539–46. Wray, L. Randall (2008), ‘Lessons from the sub-prime meltdown’, Challenge, 51 (2), 40–68. Wray, L. Randall (2009), ‘The return of big government: policy advice for President Obama’, The Levy Economics Institute of Bard College public policy brief, no. 99. Wray, L. Randall (2010), ‘Minsky’s approach to employment policy and poverty’, paper distributed at The Hyman P. Minsky Summer Seminar, Levy Economics Institute of Bard College. Yellen, Janet L. (2009), ‘A Minsky meltdown: lessons for central bankers’, Federal Reserve Bank of San Francisco Economic Letter, no. 2009-15, 1 May 1. Zaharais, Krista (2010), ‘Findings of biannual fiscal survey show states lag behind national economic recovery’, news release, National Governors Association, 3 June.

6. Financial stability, regulatory buffers and economic growth after the Great Recession: some regulatory implications Éric Tymoigne INTRODUCTION The three decades preceding the Great Recession were marked by a strong return of free-market ideas around the world. Those ideas justified an extended period of financial deregulation that peaked around the year 2000 in the US (with the passage of the Financial Modernization Act of 1999, the Commodity Futures Modernization Act of 2000 and amendments to the Employee Retirement Income Security Act in 2000) and in 2005 at the international level (Basel II Accord). Risk management, self-regulation, and market discipline became central financial-sector ‘pillars’ that were to be promoted and applied to as many institutions and countries as possible. According to the era’s guiding philosophy, there was to be minimal government regulation, supervision and enforcement. The overriding goal of regulators was to avoid limiting the creativity of financial institutions, creativity that was seen as vital to economic competitiveness. The Great Recession shattered the core foundations of that view. Risk management techniques encouraged unsound financial schemes involving massive leverage; self-regulation led to loose, hazardous and even fraudulent business practices; and market discipline meant an emphasis on short-term profitability with a ‘race to the bottom’ in terms of lending standards. The endresult was so disastrous that even prominent free-market advocates, including former Federal Reserve Chairman Alan Greenspan, expressed disbelief and conceded that their ideological framework had failed. At Congressional hearings, officials from the US Securities and Exchange Commission and other regulatory institutions were publicly humiliated for failing to detect signals of an impending crisis, and further inquiries revealed extraordinarily lax supervisory practices (US Senate, 2009a; 2009b). Given that such a disastrous regulatory and supervisory failure occurred, 114

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one may wonder why there has not been a fundamental change in the way we approach the regulation of financial institutions. Instead, discussion has aimed primarily at improving the existing regulatory framework. Thus, the focus has been on introducing liquidity requirements and flexible capital requirements, or on mandating maximum leverage ratios, and on increasing the size of common equity (Basel Committee on Banking Supervision, 2010). These reforms are supposed to yield the highest sustainable growth rate and simultaneously provide adequate protection against future financial crises. However, the core problem is that the entire analytical framework underlying this approach has failed. The problem is not that the mathematical models failed to recognize the economic risks; it is that the underlying economic principles also failed. This chapter argues that a much more fundamental reform of financial regulation is needed to deal with the intrinsic instability of market economies. It also argues that promoting financial stability may not be enough and that it may be necessary to change the management of our economic affairs in order to achieve broad sustainability. The first section of the chapter briefly surveys the foundations of the current regulatory system. The second section critically assesses the popular position that improving capital and liquidity requirements is the solution to our current problems. The third section outlines an alternative approach to financial regulation.

FOUNDATIONS OF THE CURRENT SYSTEM The current regulatory system rests on a particular understanding of financial crises and a specific view of the central goal of an economic system. These conceptions complement each other to create a coherent policy vision in which the economic goal is to maximize economic growth, while the regulatory goal is to provide the least intrusive oversight but also a high enough financial buffer to cope with any financial problems. Efficient Markets and Sophisticated Participants According to the viewpoint underlying the current regulatory system, market mechanisms have an inherent ability to promote stability, respond to the wants of the population, and correct for misallocations of resources. From that perspective, markets are not prone to financial instability and resource misallocation. Adair Turner, chair of the UK Financial Services Authority (FSA), explained this mindset in a recent speech: In the past, in the years running up to the crisis, it was the strong mindset of the FSA – shared with securities and prudential regulators and central banks across the

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world, it was almost part of our DNA – that we assumed that financial innovation was always beneficial, that more trading and more liquidity creation was always valuable, that ever more complex products were by definition beneficial because they completed more markets, allowing a more precise matching of instruments to investor demand for liquidity, risk and return combinations. And that mindset did affect our approach – and the approach of the whole world regulatory community – to the setting of capital requirements on trading activity; it affected our willingness to demand risk reduction in the CDS [credit default swaps] market; and it influenced the degree to which we could even consider short-selling bans in conditions of exceptional market volatility.… [Stepping out of that mindset] poses for regulators the challenge of complexity, because it involves rejecting an intellectually elegant but also profoundly mistaken faith in ever perfect and self-equilibrating markets, ever rational human behaviours. (Turner, 2009)

This free-market approach to economic affairs has three consequences. First, it suggests that financial crises are rare events induced by specific types of imperfections. A major category of imperfections is associated with the difficulty of establishing pure and perfect competition, which requires atomicity, transparency, homogeneity, perfect mobility and free entry/exit. In most discussions of this difficulty, emphasis is usually placed on the lack of transparency – on asymmetry of information between lenders and borrowers as a source of instability (Mishkin, 1991). However, the lack of homogeneity of some financial products has also recently received much attention for preventing market mechanisms from working properly (credit default swaps are an example). Another class of imperfections includes not only over-confidence and other ‘biases’ studied in behavioural finance, but also the limited cognitive capacities studied by Herbert Simon. Government intervention is still another type of imperfection. The argument is that government promotes inefficiency and instability through discretionary fiscal and monetary policies, programmes that allocate resources to particular economic units at preferential terms, and regulations that suppress financial innovations and waste resources (Taylor, 2009). In the end, if incentives are set properly and market participants are taught how to respond to incentives properly, then market mechanisms will promote stability and efficiency. The second consequence is that the free-market approach leads its believers to argue that the most effective way to promote financial stability is to aim for perfect competition. This can be done by improving the transparency of information in financial markets, which would give participants a better understanding of economic risks and improve market signals. For example, greater transparency could be achieved by creating new financial indices or improving existing ones. Aiming for perfect competition can also include supporting ‘fundamentals-oriented’ financial education, which proponents see as a way to help market participants make better-informed decisions (Shiller, 2000). This aim can also be pursued through the use of stock options and other compen-

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sation mechanisms that link the pay of managers and employees to the performance of their business. The third consequence is that the free-market approach leads to calls for protection against random shocks that may affect the system and create financial difficulties. This can be done by putting in place capital, liquidity and loan-loss reserve requirements to provide buffers against unexpected and expected losses. Ideally, however, the adequacy of those buffers should not be determined by regulators; they should be market determined. After all, according to this viewpoint, financial-market participants know their line of business better than regulators and have an incentive to preserve their business as a going concern. Thus, with the help of market signals, bankers are the most qualified to calculate the appropriate buffers against potential financial problems given existing risks. This is the essence of the thinking behind Basel II, now being amended by Basel III. The idea that business managers and other market participants know best – and would not implement decisions harmful to themselves and the economy – was pushed forward by the US Treasury even during the Great Recession: ‘Treasury believes market participants will be reluctant to self-certify rules harmful to the marketplace’ (US Department of the Treasury, 2008: 116). Thus, while Turner hints at a change in the mindset among regulators and Greenspan admits to a flaw in his laissez-faire philosophy, one has reason to doubt that there has been a real shift in thinking among business leaders, bankers and policymakers. Perhaps the best recent evidence of this is the lack of fundamental regulatory reform analogous to that seen in the 1930s. Growth and Investment as Overriding Economic Priorities The advocates of the free-market view believe that crises will be rare and that market design can prevent and protect against any possible crisis. This viewpoint is paralleled by a complementary belief that the fundamental goal of the economy is not social provisioning but rather to achieve continuing economic growth with the constant creation and satisfaction of manufactured human wants. Thus, economic growth must be preserved for its own sake, and this affects how the financial system is regulated and supervised. Indeed, the goal becomes to regulate in such a way that economic growth is minimally impaired, and, if possible, even promoted. This was reemphasized recently by US Treasury Secretary Timothy Geithner (2010) after the passage of the Dodd-Frank financial legislation: ‘The reforms that are now the law of the land will help us rebuild a pro-growth, pro-investment financial system’. As shown below, the emphasis on economic growth leads regulators to focus on specific indicators of financial health to guide their supervisory actions, but those indicators are not effective at identifying financial fragility.

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In addition, whenever regulatory actions are proposed to restrain innovations in financial practices, opponents argue that such regulations would lead to a decline in economic growth. Given that economic growth is considered sacred, an argument tying financial innovation to growth is usually powerful enough to delay or even reverse a regulatory action. This is especially so after a long period of stability, when regulations are widely seen as burdensome and irrelevant because there has not been any recent crisis. This entire narrative is reinforced by the associated argument that individuals (and businesses) will not be able to thrive – and will, in fact, be prevented from leading a better life – in an economy that restricts financial activities. A recent example illustrates this point. In December 2005, five federal regulatory agencies proposed to issue a socalled ‘guidance’ in response to their concern about innovations in the subprime mortgage sector. A guidance is not a law, but a statement to guide the priorities of in-field agency supervisors. It also provides financial institutions with an idea of what to expect from supervisors. The proposed guidance stated that financial institutions should carefully underwrite sub-prime mortgages by qualifying people on the basis of the full debt-service payment (instead of the initial interest payments) and by verifying income, assets and employment. All these are reasonable demands that deal with practices that have proven toxic since the earliest days of banking. The guidance was submitted to the industry for comments and received a barrage of criticisms. One argument against the guidance was that low default rates on mortgages proved the reliability of the mortgage practices and that there was no need to constrain them; periods of stability ‘prove’ markets are stable and regulation is an unnecessary burden. Opponents also argued the guidance would deny ‘good people’ access to the American Dream and reduce the competitiveness and flexibility of the US financial system. Here is a typical statement by an industry spokesperson, in this case George Hanzimanolis, president-elect of the National Association of Mortgage Brokers, testifying on the proposal at a Senate hearing: Many innovative loan products, such as the interest-only ARM [adjustable-rate mortgage] or the 40-year mortgage, have contributed to the greater availability of diverse loan products and enhanced consumer choice, which has directly resulted in increased competition and more affordable credit…. [I]nnovation and technological advancement in the mortgage marketplace has occurred because the market has been free to identify market needs and develop loan products to satisfy that need. Government regulation of this innovative spirit, whether in the area of pricing, compensation, or in product development, will only result in firm boundaries that will prevent the marketplace from adequately responding to consumer needs in the future.… The bottom line is that unwarranted tightening of underwriting guidelines could hurt the robust housing industry and deny deserving consumers the chance at homeownership. (Hanzimanolis, 2006)

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As a result of such opposition, the guidance was not implemented until June 2007. By that time, there were no more profits to be made on sub-prime mortgages and the guidance no longer mattered to the financial industry (Office of the Comptroller of the Currency et al., 2007). In addition, the guidance was limited to sub-prime lending even though the same practices were also associated with prime lending (Tymoigne, 2009c). A similar story can be told about leaving credit default swaps unregulated or allowing pension funds to buy dangerous securitized products. And the opposition’s arguments were the same: the regulation of innovation constrains economic growth, profitability, societal well-being, and even national competitiveness.1 These arguments were all the more compelling because many people benefitted from continuation of business as usual, regardless of the growing danger of financial fragility and the fleeting nature of the access to the American Dream.

CAPITAL BUFFERS AND ECONOMIC STABILITY This section assesses the capacity of capital and liquidity buffers to promote financial stability. In the wake of the recent global financial crisis, it is often argued that greater financial stability can be achieved by the introduction of capital and liquidity buffers that are larger and better (in the sense of capturing risks more accurately) than in the past. In fact, however, no matter how buffers are improved, they will not promote financial stability. And they will give regulators an inaccurate indication of the economic system’s financial health. Capital and liquidity buffers in place during a financial crisis are usually unable to provide adequate protection against significant financial difficulties. This is so not only because available buffers are too small but also because the regulatory buffers are set too low. In addition, merely putting in place buffers does not prevent the growth of financial fragility and may not lower moral hazard and risk taking. A Long Period of Stability and Inadequate Buffers Significant financial crises are almost always preceded by a long period of economic stability during which financial institutions lower their credit standards (as explained in Tymoigne, 2009a), which decreases the effective protection provided by a given buffer. Today, despite the recent crisis, several bankers argue that their less restrictive lending standards were necessary for business survival in a competitive environment. Lloyd Blankfein, CEO of Goldman Sachs, stated: ‘I regret that we participated in transactions that

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brought too much leverage into the world…. But those were the standards of the moment’ (Blankfein in Vikraman and Nair, 2010). Previously, he made very similar comments: ‘We rationalized and justified the downward pricing of risk…. We did so because our self-interest in preserving and extending our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak’ (Blankfein, 2009). Charles O. Prince III, former CEO of Citibank, recognized that his bank was involved in dangerous financial practices that contributed significantly to the crisis. In his view, the bank was merely responding to the demands of hedge funds, institutional investors, and private equity funds, which were seeking high returns through leveraged buy-outs and exotic mortgage-related deals. Prince believed Citibank’s practices were justified: ‘When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing’ (Prince in Nakamoto and Wighton, 2007). John Maynard Keynes (1936: 157) understood this phenomenon. More than 80 years ago, he wrote: ‘Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally’. Just as the effectiveness of a given level of buffers declines because of the increased riskiness of financial deals (in terms of assets and liabilities), institutions also have an incentive to lower the available buffers. Indeed, a long period of stability means that default rates will be low, profitability will be high and other financial information will be positive. Thus, a long period of stability will lead to lower financial buffers, not necessarily because of irrationality and other ‘biases’ but simply because the economy is performing better. Moreover, over a long period of stability, this tendency is all the more pervasive because the data used in the calculation of necessary buffers rarely looks back beyond two years, thus excluding financial crises (Gallati, 2003: 362). In addition, bankers make predictions over a limited time horizon, typically one year for credit risk and only a few days or months for portfolio value at risk (Gallati, 2003: 146, 371ff., 384). The result is buffers appropriate for only minor financial problems. This problem is reinforced by the fact that predictions are backward looking rather than forward looking and so fail to account for the implications of increased risk taking on the asset and liability sides of balance sheets. Prior to the recent collapse, these dynamics drove loan-loss reserves lower than at any time since 1985, even though the quality of loans declined dramatically (A.M. Best Company, 2007). Profitability and Required Buffers The capital and liquidity needed to deal with a significant financial crisis are more than financial institutions find economically attractive. This has been

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acknowledged by the financial industry’s Counterparty Risk Management Policy Group: To some extent … all risk management tools are unable to model/present the most severe forms of financial shocks in a fashion that is credible to senior management…. To the extent that users of stress tests consider these assumptions to be unrealistic, too onerous,… incorporating unlikely correlations or having similar issues which detract from their credibility, the stress tests can be dismissed by the target audience and its informational content thereby lost. (Counterparty Risk Management Policy Group III, 2008: 70, 84)

A proper determination of the adequate buffer would consider events like the Great Depression and the Great Recession even decades after their occurrence. But the results would be unacceptable to the financial industry. That means the capacity of a capital buffer to absorb significant problems is limited from the start. Moreover, a long period of stability dims the memory of past crises at the same time that it intensifies competition and thereby erodes sources of profitability. The Persistence of Financial Fragility: Return on Equity and Financial Innovations If one assumes that adequate buffers could be set, this would not prevent the development of financial fragility. From the point of view of the current regulatory system, merely applying buffers makes sense because financial crises are random, rare events. However, if one considers that financial crises are not random in the sense that the conditions for their occurrence are progressively laid out during a period of stability, then it makes sense to do more than provide buffers. The latter are necessary, but they are only a last and limited line of defence. By taking preventive actions, it is possible to avoid some situations in which using those buffers becomes necessary. A good way to see why buffers are not enough is to study the return on equity, which is profit divided by equity. Return on equity can be decomposed into its two components: the rate of return on assets (profits divided by assets) and the leverage ratio (assets divided by equity). As an economic expansion proceeds, the rate of return on equity tends to decline because profit is added to equity and the growth rate of profit tends to decline over time as markets saturate.2 Thus, economic prosperity creates tensions that promote instability. To counter a decline in the return on equity, financial institutions can increase their return on assets or their leverage. Improving the return on assets involves creating new markets or expanding existing markets by moving towards more risky endeavours in terms of creditworthiness, liquidity and funding sources. Increasing leverage (given existing

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asset quality, funding sources and regulatory requirements) also involves financial innovations in order to bypass leverage limits that regulators impose.3 In short, even if some constraints are put on the leverage ratio and asset quality, unless innovations are regulated, the constraints are bypassed because financial institutions must find ways to maintain their return on equity. As Campbell and Minsky write: To the extent that the examination procedure lags rather than anticipates financial innovation, higher insurance premiums [and capital requirements] on what examiners take to be riskier institutions may not be a deterrent to risk-taking. In an expanding economy, the increased cost of doing business caused by higher deposit insurance premiums [and capital requirements] will be an incentive for banks to invent new, unregulated forms of financing. (Campbell and Minsky, 1987: 258)

Financial institutions do not have a choice; market mechanisms compel them to find techniques that counter the tendency of the return on equity to decline over time during an expansion. This pressure to lower underwriting criteria, engage in high-stakes activities and increase leverage is compounded by the fact that institutions (and their investors) have in mind some targeted return on equity and competition among financial institutions can be expected to be strong. As a consequence, it is not difficult to see how financial fragility can emerge over a period of economic stability and why bank executives defend their actions in the way illustrated above. Risk-Taking and Capital Buffers Although a major argument for better and higher capital requirements is that they would limit the moral hazard and thus reduce risk-taking activities, this is not necessarily so. Having some ‘skin in the game’ may not prevent financial institutions from taking massive risks. In fact, quite the opposite might happen: a ‘large’ buffer might foster more risk taking by providing a greater sense of security and by fuelling the return on equity mechanics described above (Kregel, 2006; Wray, 2006).4 The recent crisis shows that unexpected results of this sort do indeed occur. Greenspan acknowledges he was baffled by what happened: ‘I made a mistake in presuming that the self-interest of organizations, specifically banks and others… [was] best capable of protecting their own shareholders and their equity in the firms’ (Greenspan in US House of Representatives, 2008: 34). Towards the end of the savings and loan crisis, James B. Thomson (1991), of the Federal Reserve Bank of Cleveland, concluded that ‘book solvency is positively related to failure’ and he noted that: ‘One possible explanation is that banks beginning to experience difficulties improve their capital positions

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cosmetically by selling assets on which they have capital gains and by deferring sales of assets on which they have capital losses’ (Thomson, 1991: 13). This is typical of Ponzi finance as explained below. Although it runs counter to the current regulatory and supervisory approach of banking, the conclusion generated by the preceding discussion is that regulators should not wait for declining profitability, declining net worth, or other signs of payment difficulties to take strong actions. That conclusion is also consistent with recent US economic experience. For example, most of the companies involved in highly dangerous financial activities during the housing boom recorded large profits and a high credit rating, and were able to meet their capital requirements; they were deemed healthy when they were, in fact, very fragile. The same is true for households, which were said to be in good shape (Greenspan, 2004) when their increases in net worth were actually based on weak financial positions. Thus the gains they accumulated since 2003 disappeared with the housing-market collapse and financial crisis (Tymoigne, 2010). There were also no profitability or payment difficulties before the savings and loan crisis, even though the most profitable thrifts were involved in massive, unsustainable and fraudulent financing in commercial real estate (Black, 2005). Strict underwriting requirements would be much more effective at promoting financial stability than buffers. Because asset values are prone to fluctuating, collateral-based lending is highly prone to instability and is exceedingly hard, if not impossible, to buffer properly (Suzuki, 2005; Knutsen and Lie, 2002). Meanwhile, financial fragility may grow long before losses materialize and capital and liquidity buffers decline. And when losses do materialize, years of bad underwriting may make the losses so large that buffers are woefully inadequate. Even worse, the entire economic system is at risk when growing financial fragility has served as the foundation for widespread profitability and economic growth.

ALTERNATIVE REGULATORY REFORM An alternative regulatory framework starts by recognizing that financial crises are created during extended periods of stable prosperity, periods during which there are, at worst, only minor recessions. Such crises are not random, rare events that can be addressed only by means of defensive protections. Financial instability, rather than market efficiency, is the inherent result of a market economy performing well for a relatively long period of time. Buffers may help to contain a problem, but they are of limited usefulness when the aim is to prevent crises and maintain financial stability. Moreover, asking financialmarket participants to determine those buffers is destined to fail because their

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incentive is to preserve growth and their main indicators of financial health are increasing profits and a high return on equity. This alternative framework also notes that, rather than putting investment and economic growth on a pedestal, the regulatory system should be tilted towards promoting financial and economic sustainability. The Financial Instability Hypothesis Minsky (1986) provides a framework for understanding and measuring how financial fragility develops. He distinguishes between three types of financial positions: hedge, speculative and Ponzi. Hedge finance means an economic unit is expected to be able to pay its liability commitments with the net cash flow generated from its routine economic operations (such operations entail work for most households, and production and sale of goods and services for most companies). Thus, even though indebtedness may be high, an economy in which most economic units rely on hedge finance will not experience a debt deflation (that is, a severe financial and economic crisis) unless there are unusually large declines in routine cash inflows and/or unusually large increases in cash outflows. Even then, cash reserves and liquid assets are usually large enough to cope with unforeseen problems. Speculative finance means routine net cash flow sources and cash reserves are expected to be too low to pay the capital component of liabilities. In other words, an economic unit engaged in speculative finance can make the interest payments on a debt, but would not be able to make principal payments or meet margin calls on the basis of its routine operations. As a consequence, such a unit must continue to borrow funds or sell some less-liquid assets to pay part of its liability commitments. Ponzi finance means an economic unit has neither the cash reserves nor the ability to generate net cash flow from its routine economic operations to meet the capital or even the income service due on outstanding financial contracts. Unlike a speculative unit, a Ponzi unit cannot even cover its interest obligations from the cash flow of routine operations, which means it must borrow a larger and larger amount over time. If a majority of economic units is involved in Ponzi finance, the economic system is highly prone to debt deflation. According to Minsky’s financial-instability hypothesis (Minsky, 1986), when an economy is stable and performs well over an extended period of time, more and more economic units move away from hedge finance and become involved in Ponzi finance.5 As illustrated during the recent housing boom, Ponzi processes (economic activities sustained by Ponzi finance) do not need to be masterminded by a single individual or a small group of individuals. Rather, they may be sustained and approved by the entire society because, in the short run, they

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may raise standards of living and promote economic growth, employment and competitiveness. In any case, those already in the Ponzi process have an incentive to promote an optimistic view of the future and entice others to participate. And the attractiveness of their message is enhanced by the high returns the process often generates before collapsing. As a result, even more cautious individuals and firms eventually feel the pressure to participate (Galbraith, 1961; Shiller, 2000). From the vantage point of the financial-instability hypothesis, the goal of financial regulation and supervision should be to detect – and, ultimately, to prevent – financial fragility, rather than to protect against financial crises (Tymoigne, 2010). Focusing on financial fragility implies a change in perspective regarding the proper means to regulate the financial system. Currently, regulators dare not touch the profitable institutions at the centre of a growing economic sector; if they do, then they are likely to be quickly challenged. But changing the viewpoint about what is a ‘healthy’ financial institution would allow regulators to intervene much earlier. More importantly, such a change would provide regulators with a solid reason to do so. Contrary to the current regulatory framework, indicators such as a low or decreasing default rate, rising net worth, rising business profitability, and dynamic private sector lending may not accurately reflect an economy’s underlying health. The case against business profits and net worth as sources of financial strength has already been described (above). The fact that these indicators were the overarching concerns and means of judging health before the Great Recession was clearly stated by Senator Christopher Dodd: ‘Banks’ regulators were so focused on banks’ profitability, they failed to recognize that loans so clearly unsafe for consumers were also a threat to the banks’ bottom line.’ (US Senate, 2009a: 2). Defaults are also problematic because low default rates may be based on looser underwriting practices rather than a robust capacity or willingness to service debts. This is what was observed during the recent housing boom, when various unsustainable underwriting practices and securitization techniques allowed banks to lower debt service for many customers for a short time (Tymoigne, 2009b). Economic growth is also not necessarily an indicator of a healthy economy, as will be explained in greater detail below. In short, one needs to look past the conventional variables of financial robustness. The key is to see how balance sheets are affected by financial practices. And that requires some alternative indicators. Detecting Ponzi Finance The central concept that defines financial fragility is Ponzi finance, also called interest-capitalization finance. As described above, a common way to define Ponzi finance is that net cash flow from core economic operations is expected

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to be insufficient to cover neither expected income nor capital commitments from financial debts. Economic units differ in their core economic operations. Some are directly related to income creation (households earn wages, bankers earn interest, and so on); others are only indirectly related to income creation and rely on dealing securities and profiting from fees and capital gains. In the latter case, financial institutions routinely perform simultaneous purchases and sales of asset positions.6 Instead of defining Ponzi finance in terms of cash flow, one may also define it in terms of position-making operations, that is from a balance sheet view point. In Ponzi finance, debt is expected to be covered by growing cash flows from defensive position-making operations, in other words an expected growth of refinancing loans and/or an expected liquidation of asset positions at growing asset prices. Ponzi finance does not require the existence of a bubble, and measuring financial fragility is different from detecting asset-price bubbles. It requires only rising prices of collateral assets or other assets held by the entity involved in the Ponzi process. This condition is required for cheap refinancing or for asset liquidation at a price that covers debt services. The main advantage of the balance-sheet definition of Ponzi finance is that its detection does not require the measurement of cash flows for which data is non-existent, incomplete, or unreliable. Instead, one looks at the interaction of debts and asset prices (given a unit’s income level) through an analysis of underwriting procedures and the type of asset involved. Ponzi finance differs from speculation and is not necessarily generated by greed or fraud. Speculation is defined as taking an asset position with the expectation of making a capital gain from selling the asset. In a speculative deal, liquidation is a means of making a monetary gain. In contrast, in a Ponzi process liquidation is a means of servicing financial commitments; it does not necessarily involve making a gain from liquidation. In fact, people involved in a Ponzi process may hope that they will never have to liquidate their asset position (at least in net terms) because this would lead to a collapse of the process.7 To be sure, speculation with borrowed money is a form of Ponzi finance, but Ponzi processes can be associated with speculative or non-speculative activities. For example, the recent mortgage boom was sustained by a Ponzi process that involved prime borrowers who truly wished to stay in their home (Tymoigne, 2009c). Ponzi finance is also different from fraudulent and abnormal liability practices because some individuals may enter Ponzi processes while playing by the existing legal rules and following established financial norms. Thus, everybody may behave ‘wisely’ or ‘properly’ and still contribute to rising financial fragility. Indeed, a central point of Hyman Minsky’s approach is that lending norms loosen over time and that what was previously considered a ‘too risky’ funding method may become commonly accepted

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(Minsky, 1986). However, this change in norms over time does not make Ponzi finance harder to detect; the Ponzi process is defined independently of those norms. Some forms of Ponzi finance are more dangerous than others, depending on the way the economic units involved plan to exit the process. This, in turn, depends heavily on the types of asset involved. The most dangerous of all Ponzi processes are those for which continuous liquidation and/or unlimited growth of refinancing are necessary for the process to continue. In such cases, called pyramid schemes, there is no way to terminate the process besides collapse or widespread restructuring of financial commitments. This type of Ponzi process usually involves the funding of assets that do not produce any cash flow from operation (such as an owner-occupied home) or that generate cash flows over which the owner has little or no control (such as shares of companies) and cannot be adjusted to meet the demands of debt service. Examples of those processes are the mortgage practices of the 2000s and the Madoff scheme (Wray, 2007; Kregel, 2008; Tymoigne, 2009b). The least dangerous Ponzi financial practices involve the temporary use of growing refinancing. This usually implies that the economic units involved in the process have some market power and assumes that the underlying assets are expected to eventually provide sufficient and reliable net cash flow in the course of unit operations. For example, the construction of investment goods takes time and must be financed; however, they do not generate any cash inflow from operation (for the producer and acquirer) until they are finished and installed in the production process. Thus, a producer’s (and his creditors’) profitability depends on the capacity to sell the finished product at a high enough price. In short, detection and measurement of financial fragility should be based on an analysis of balance sheets (‘off balance sheet’ items should not exist), cash flow, underwriting, and the underlying assets. Essential questions include: is continuous refinancing needed? Is this need growing relative to outstanding debt? Is underwriting collateral-based or income-based? Are rising asset prices needed for this economic process to continue? In exploring these questions, key financial indicators include the following: the proportion and growth of refinancing loans, the dynamics of debt and asset prices, and the source and time structure of net cash inflows relative to cash outflows. For residential housing finance, for example, home price, mortgage debt, cash-out refinance, and cashflow margin enable the detection of growing financial fragility (Tymoigne, 2010). Minsky (1975) and Campbell and Minsky (1987) used this conceptual framework to develop a regulatory framework for banking supervision that heavily relies on cash flows and an analysis of defensive position-making operations. Recently Hadley and Touhey (2006) at the Federal Deposit Insurance Corporation have suggested an equivalent approach.

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Note that ideally one wants to rely purely on financial indicators to detect fragility; it is an accounting matter and it is different from discovering the cause of financial fragility. The point is to understand how economic units finance and fund their economic activity, regardless of the merits of this activity. Moreover, even if an activity is beneficial to the population in the short term, its continued existence is difficult to justify when those gains rest on an unsustainable financial base. Managing Financial Innovations Financial innovation is defined as a structural change in the financial sector. This includes the creation of new financial products, companies, and other business practices, as well as changes in existing business practices. Given that financial innovations often lead to qualitative changes in the financial sector, it is important to ensure that current regulations can cope with such changes. As explained above, financial institutions have a strong incentive to bypass regulations through innovations, so regulators must keep up with innovations. Measuring financial fragility is not enough; a regulatory system that seeks to prevent the growth of financial fragility must keep abreast of financial innovations. In contrast, the regulatory approach followed in the US over the past 30 years has allowed financial-market participants to experiment with new innovations and has left those innovations alone as much as possible. This approach has been shown to lead to catastrophes, and it is at odds with what goes on in other economic sectors. In consumer products, mechanical tools, medical drugs, and many other areas, products are made available to customers only after inventions undergo extensive testing. And new regulations or changes in existing regulations are applied immediately when a new product enters a market. As a result, new products have been studied in detail so their properties and potential dangers are fully understood by regulators and shared with the public. In addition, their use is sometimes limited to a specific segment of the population. It seems inconceivable that this sort of approach does not also apply to financial innovations. No financial innovation should be left unregulated or unsupervised. History has shown time and again that, when left unchecked, financial innovations become a fertile ground for the growth of Ponzi finance and thus financial instability. Stocks, bonds, certificates of deposit, hedge funds, securitization, credit default swaps, pay-option mortgages, and many others have all ended up generating financial fragility leading to a financial crisis. While constraining the growth of financial innovations may have an impact on short-term growth, the evidentiary link between financial innovation and long-term economic growth has not been demonstrated. Take housing as an example. Most of the gains in home ownership were

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obtained before securitization; the recent frenzy in interest-only mortgages, credit default swaps, collateralized debt obligations (CDOs), and other exotic loans and securities contributed to an increase in US home ownership, but the gains did not last and the subsequent pain has often been devastating to households and entire communities. Regulators should have stepped in to slow the growth of home ownership at least a decade ago because the subsequent runup was based on unsustainable practices. This would have involved forbidding or severely constraining the use of many of the era’s hottest financial innovations. How to regulate financial practices? If regulators must wait until there is a bubble, then they will be hard-pressed to determine when to contain particular financial practices. Part of the problem is that there are many uncertainties regarding what constitutes the fundamental value of an asset and thus it is difficult to detect a bubble. In addition, since it is hard to get a solid measure of fundamental value, financial-market participants with a strong financial interest in the continuation of rising asset prices will find ways to justify their position (Galbraith, 1961; Shiller, 2000). The reticence of regulators to intervene and ‘remove the punch bowl after the party gets going’ will be even greater when a large part of the population benefits from the continuation of rising prices and when the underlying financial practices are associated with economic growth. Indeed, there was even a backlash when Greenspan expressed concerns about irrational exuberance in 1996; numerous financialmarket participants, economists and legislators were outraged by the suggestion that ‘the market’ might yield improper asset values. Thus, we need a more solid criterion that is not based on the views of people regarding the proper asset price level. The concept of Ponzi finance satisfies this criterion. From the point of view of systemic stability and longterm economic growth, both types of Ponzi finance – pyramid/collateral-based and production/income-based – are sources of concern because, as long as they exist, the economy is exposed to the risk of debt deflation. At the same time, banning income-based Ponzi finance may put too heavy a burden on economic growth; therefore, income-based Ponzi finance may be tolerated in government-insured activities, but should be strictly regulated and carefully monitored. In addition, financial innovations involving hedge finance should be promoted, possibly by means of incentives that promote the research and development of financial products and practices that are safe and that foster sustainable economic growth. Collateral-based Ponzi finance should be forbidden in all activities that have an implicit or explicit government guarantee. It might be tolerated in other economic activities, but even then regulators should check for potential spillover effects. Collateral-based Ponzi finance includes a number of recent practices and innovations: compensating loan officers via fee-based remuneration;

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introduction of CDO-squared (a security backed by a CDO pool); allowing pension funds to buy securities backed by toxic collateral; permitting pension funds to participate in hedge funds’ activities; allowing commercial banks to do proprietary trading directly or through their affiliates; reliance on level-3 security valuations (based on unobservable data); and provision of pay-option mortgages to borrowers who cannot make their full debt service payments. It is also important to engage in regulatory follow-up after a financial innovation has been allowed to exist. This is necessary because the use of an innovation often changes over time, especially as the return obtained from a product starts to decline and financial institutions feel pressed to find creative ways to keep their profitability on target. An example was securitization, which was progressively transformed from a hedge process into a Ponzi process (Tymoigne, 2009b). One may also cite interest-only mortgages that were given initially only to a very limited number of prime borrowers and were later extended to all prime and sub-prime borrowers. Thus, regulation should be flexible enough to deal with changes in business practices as they come along. As Campbell and Minsky (1987: 258) write: ‘Anticipatory vigilance upon the part of the regulators is required to prevent increased risk exposure. But such vigilance, combined with intelligence, could contain particular unit risk exposure without the imposition of risk-related premiums or capital requirements’. Reducing Competition in the Financial Industry Commercial banking used to be far less complicated. In fact, banking used to be treated much like a public utility (Kregel, 2010). This was made possible by protecting banks and thrifts from competition and by providing them a reliable and cheap refinancing source through the central bank. Thus, a better system of financial regulation requires a vital role for the central bank in protecting banks and the payment system from competition. The cost of funding should be kept low and stable; ideally, the short-term policy rates of the central bank should be at zero or at the very low rate paid on reserves (Wray, 2007; Fullwiler, 2006, 2009, forthcoming; Tymoigne, 2009a). At the same time, much more emphasis should be put on the Federal Reserve’s ‘discount window’ in order to better grasp changes in the practices of financial institutions and to influence their business practices (Kregel, 1992). This commitment to market protection and to low and stable refinancing costs was progressively eroded in the 1960s and 1970s, culminating in the collapse of savings and loans in the Volcker era (Minsky, 1969; Cargill and Garcia, 1982). It might also be useful to reward financial innovations that promote hedge finance by providing a patent to some financial institutions. Competition in the financial industry is currently so ferocious that companies have no incentive to spend time creating financial products that respond to the needs of customers:

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We need ‘innovation’, we were told. We created increasingly odd products. These obscure structures allowed us to earn higher margins than the cut-throat vanilla business. The structure business also provided flow for our trading desks.… New structures that clients actually wanted were not that easy to create. Even if somebody came up with something, everybody learned about it almost instantaneously.… Margins, even on structured products, plummeted quickly. (Das, 2006: 41)

Hall (2009) and Mergers (2003) have studied the potential impact of a patent system in the financial industry, but their goal was to examine whether a patent system would help spur more innovation. Instead, we need a patent system that can promote high quality, reliable financial innovations – products and practices that fulfill the needs of economic activity while also promoting hedge finance and helping to ensure sustainable economic activity. Ending ‘Too Big To Fail’ and Making Finance Work for the Economy When a Ponzi process collapses (as most do), then it should be allowed to unwind. If the problem spills over to the payment system and governmentprotected activities, then some temporary assistance to collateral-based Ponzi processes could be provided to avoid a complete financial collapse. However, this would only serve as bridge finance while the entire process is dismantled in an orderly fashion (such as receivership). For example, some bridge financing should have been provided to Lehman Brothers, but this should not have prevented closing down the company in an orderly fashion. The same should have been done with the major banks, hedge funds and other institutions that recorded devastating losses in the recent crisis and required more assistance from the government. Many (either directly or through their affiliates) should have been placed in receivership; management should have been fired and investigated for fraud; assets should have been valued carefully; and the least costly solution should have been used to deal with the problem institutions (Black, 2009). If it is necessary for some institutions to remain ‘too big to fail’, then nationalization may be required.8 While the US and UK are praised for their competitive financial sector, Wall Street has had only one goal in mind: to maximize shareholder value. Although it is a largely unsavoury world (see, for example, Das, 2006), large numbers of young and talented individuals are lured towards the financial sector, instead of towards solving social problems, by the extremely high pay. And in recent decades even non-financial companies have moved away from traditional business operations and towards financial services. As a consequence, in the US, the profit share received by the financial sector has gone from about 10 per cent in the mid-1980s to a peak of 45 per cent in 2005 (Palley, 2007; Crotty, 2005).

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In recent years, a number of well-known business leaders have suggested it is not healthy to have a finance-driven economy. For example, the FSA’s Turner expressed his concern before a London audience as follows: Not all financial innovation is valuable, not all trading plays a useful role, and … a bigger financial system is not necessarily a better one. And, indeed, there are good reasons for believing that the financial industry, more than any other sector of the economy, has an ability to generate unnecessary demand for its own services – that more trading and more financial innovation can under some circumstances create harmful volatility against which customers have to hedge, creating more demand for trading liquidity and innovative products; that parts of the financial services industry have a unique ability to attract to themselves unnecessarily high returns and create instability which harms the rest of society.… Yes, financial services form a vital industry and source of high-skilled employment. Yes, the City will continue to play a key and vibrant role in the UK economy. But not everything that a financial system does is socially useful; and sometimes bits of it can get too big and it would be better for society if they got smaller. (Turner, 2009)

A complementary view is held by Jack Welch, the father of shareholder value (that is, the idea that boosting the company’s share price should be a central goal of executives). Welch stated recently: On the face of it, shareholder value is the dumbest idea in the world … shareholder value is a result, not a strategy…. Your main constituencies are your employees, your customers and your products.… The idea that shareholder value is a strategy is insane. It is the product of your combined efforts – from the management to the employees. (Welch, in Guerrera, 2009)

High finance needs to be downsized and the original purposes of the banking system need to be restored. There was a time when investment banks were partnerships that cared about security underwriting rather than proprietary trading; when commercial banks were of a manageable size and cared about careful loan underwriting rather than mergers, acquisitions and exotic endeavours; and when financial markets provided relatively reliable risk pricing under a well regulated and supervised system. It was also an era of widening prosperity and more stable economic growth. To be sure, we cannot and should not try to turn the clock back to the 1950s or early 1960s, but we should be willing to admit that the US financial system of that era was in many ways superior to that of our own, and we should be willing to learn from the past. Economic Growth and an Investment-led Economy The challenge of promoting financial stability extends beyond the matter of appropriate regulation; it also requires a critical examination of the goal and

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source of economic growth. The problem is not just that ‘growth for the sake of growth’ is bad economics. It is also that the widespread emphasis on investment-led growth is highly prone to economic instability for economic and financial reasons. One shortcoming of investment-led growth is the traditional Harrod-Domar issue: it is difficult for aggregate demand to keep up with the additional supply capacities created by previous investment. This is probably less of a problem in underdeveloped economies where improvements in standards of living are badly needed (provided, of course, that the capacities of production are used for internal markets rather than exports to developed countries). But it is definitely a concern for mature economies. As a result, in the latter case growth should be refocused on socio-ecologically durable domestic consumption. At the same time, it is important to avoid the financial dynamics that have been at play in the US. The US has been following a strategy of consumption-led growth for the past 30 years, but it has been based on unsound financial practices induced in part by growing income inequality. Another shortcoming of investment-led growth is that it is prone to Ponzi finance. Minsky (1986) explained in detail how investment was prone to income-based Ponzi finance. As we observed in the wave of mergers and acquisitions in the 1990s and more recently in the housing market, investment is also prone to collateral-based Ponzi finance. Indeed, it creates durable assets that may rise in value, thereby providing an incentive to underwrite loans on the basis of rising asset prices rather than income (Suzuki, 2005; Knutsen and Lie, 2002; Black, 2005). While rising collateralbased lending might be fine in financial markets, especially when no government insurance is provided, it is more dangerous in the case of durable illiquid assets such as investment goods. Indeed, liquidation is not a viable option to service debt for investment goods because of the absence of an organized exchange; therefore, any drying out of refinancing resources will lead to a massive debt-deflation process if collateral-based lending is allowed to persist for a few years. It is also important to re-examine the goal of growth regardless of its sources. While economic growth may help to improve standards of living and to meet the needs arising from population growth, it is not clear that there is a direct relationship between improved welfare and economic growth, especially for developed economies. As shown in Figure 6.1, alternative measures to GDP, such as the Genuine Progress Indicator, show no significant improvement in US economic welfare since the mid-1970s. That is because rising socio-economic and environmental problems have outweighed the gains from increased output. Although long-term economic growth may help improve standards of living up to a point, history shows that market mechanisms push economic units to

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GPI per capita

35

US dollars (thousands)

30 25 20 15 10 5

1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

0

Note: Base year 2000. Source:

Talberth et al. (2007).

Figure 6.1 Real Gross Domestic Product and Genuine Progress Indicator per capita, USA focus on short-term results and to preserve short-term economic growth at all costs. As such, ‘more is always better’ when it comes to quarterly economic growth – even though the underlying financial conditions may be deteriorating rapidly. Given the current view that places a positive value on any growth in economic output and profits, it is difficult for regulators or financial-market supervisors to find a reason for action when the economy is growing. In fact, they see an argument to withdraw and avoid putting ‘unnecessary barriers’ on pursuit of the American Dream. The goal of long-term sustainable economic growth is laudable as a concept. But what often happens in practice is a complete disregard for sustainability, not only in financial terms but also in socio-ecological terms. There are other means to promote well-being that look beyond constantly rising production and finding new wants to fulfill. These warrant economists’ increasing attention, not only because the aim of growth with sustainability is often ignored, but also because the risks to sustainability seem to be rising rapidly.

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CONCLUSION: THE FUTURE OF FINANCIAL REGULATION The Great Recession was preceded by decades of financial-sector deregulation, reduced supervision, and a growing belief in self-regulation. Many of those who believed in market discipline have subsequently reconsidered their framework, but the economic philosophy underlying the regulatory framework has not changed significantly. Instead of a new regulatory direction, we now have a patchwork of reforms, which have focused on creating new buffers and marginally increasing existing buffers against future crises. While a new regulatory framework has been put in place in the US that gives some attention to consumer protection, systemic risk, and the separation of commercial and investment banking, the framework contains many loopholes that are easily exploitable. More importantly, the new regulatory framework does not contain enough flexibility to be able to be proactive in handling regulatory arbitrages and financial innovations. Finally, the current reform has been discussed with a narrow framework that puts economic growth at the centre of attention. We need a different type of regulatory framework and a different philosophy of regulation. At its centre must be the detection of financial fragility, which can emerge at any time but tends to develop and spread in periods of economic prosperity (periods that record either steady expansion or only minor recessions). The framework should be accompanied by proactive policies that supervise financial innovations and put in receivership any company, regardless of its size, that is insolvent or on the verge of insolvency. In fact, a strong supervisory component – including enforcement of law through prosecution – is needed to ensure that honest and conscientious entrepreneurs have a chance to prosper. Experience has shown that high profitability, a low default rate, rising net worth and strong economic growth are not good indicators of financial robustness. In fact, these are often sustained by dangerous, collateral-based Ponzi finance. The goal of regulators should be to prevent Ponzi finance from emerging and to root it out once detected. Some worry that this would lead to a much smaller financial system and that economic growth would be impaired. But the size of today’s financial companies exceeds the needs of even the largest international non-financial corporation; moreover, non-financial corporations are now deeply involved in financial services themselves and community bank lending has been underpromoted. All this should be reversed. Meanwhile, we should be more concerned about economists’ obsession with economic growth and disregard for the consequences of not maintaining a sound financial system and protecting economic (and ecological) sustainability. The recent financial crisis has shown that near-term growth often comes at an extraordinarily high price.

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Promoting financial stability is therefore more than just a matter of financial regulatory reform. It must also involve a de-emphasis of economic growth and a greater focus on broader measures of social well-being. And if the underlying economic rules are such that the survival of economic units forces them not only to rationalize fraud and dangerous financial practices, but also to overlook the adverse and long-term consequences of their actions, then perhaps the socio-economic rules need to be reconsidered as well.

ACKNOWLEDGEMENTS The author thanks an anonymous reviewer and Charles Whalen for comments and editing work.

NOTES 1.

An aversion to financial regulation is found not just within the financial industry. Consider the following from a 2008 US Treasury Department document, for example: The business conduct regulator should not have the ability to broadly prohibit products, limit entry through excessive licensing requirements, or control prices. In general, business conduct requirements that are too rigid can result in less competition, less innovation, and diminished flexibility to adapt to market conditions. For example, broad prohibitions on products should only be considered in circumstances where disclosures and regulation of business practices prove insufficient. (US Department of the Treasury 2008: 171)

2.

More formally, the Π/E = Π/A × A/E and ROEt = Πt/Et with Et = Et–1 + Πt–1 and Πt = Πt–1 (1 + g). (Note that Π, E and A represent profits, equity and assets, respectively.) Knowing this, one can compute the dynamics of ROE and given the growth rate of profit (g = g0): ROE0 ————————————————————— if g0 ≠ 0 1 1 1 — – ——————— ————— + ROE0 t–1 (1 + g ) g g (1 + g0)t–1 0 0 0 Π ROEt = — t= Et

(

)

Π0 ———— E0 + tΠ0

if go = 0

Therefore: lim ROEt = t→∞

g0 0

if g0 ∈ [0, +∞] if g0 ∈ [–1,0]

If ROE0 = g0 then ROEt = g0 ;t. If ROE is smaller (larger) than the growth rate of profit, ROE goes up (down). Overall, the actual dynamics of ROE over time depends on the value of ROE relative to the growth rate of profit and on the evolution of the growth rate of profit. However, as markets

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3.

4. 5. 6.

7. 8.

137

saturate the growth rate of profit declines and so the steady state value of ROE declines too. In addition, in new markets ROE is probably greater than g so ROE goes down over time to its steady state value, which itself declines over time. A recent article shows that regulatory arbitrage is already at play following the US regulatory reforms enacted in the summer of 2010 (Jenkins and Masters, 2010). Given the high cost of capital in the regulated financial industry, financial institutions have started to move further away from traditional banking and some non-financial institutions are getting even more involved in financial activities. Regulated financial institutions have created their own hedge funds and private equity funds, and ‘oil companies such as Total and BP and traders including Cargill and Vitol are in effect shadow banks for the commodities industry, replicating the services that the likes of Goldman Sachs and Morgan Stanley monopolized for years’. In other words, a higher level of capital may give a false sense of protection and boost optimism, and a higher capital ratio depresses the return on equity, which gives an incentive to search for a higher return on assets and boost leverage on any excess capital. Ponzi finance is named after the infamous financier Charles Ponzi, whose pyramid schemes have become legendary in financial history. Ponzi finance can be described as follows: E(CFPM) = ∆LR + ∆PAQA > 0 and ∆(E(CFPM)/L) > 0, where CFPM is net cash flow from position making operations, PA is the price of assets, and L is the amount of outstanding liabilities. Note that Ponzi finance does not require PA be above its ‘fundamental’ value, however defined. Gains for individuals involved in the Ponzi process come from holding the asset (such as a home), fees from managing the scheme, and other monetary and non-monetary compensation associated with attracting additional participants. In the aftermath of the recent financial crisis, legal prosecution is conspicuously absent, especially since there appears to be much evidence of widespread fraud.

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Tymoigne, Éric (2009a), Central Banking, Asset Prices and Financial Fragility, London: Routledge. Tymoigne, Éric (2009b), ‘Securitization, deregulation, economic stability, and financial crisis: do we need more of the same type of regulation?’, Levy Economics Institute working paper no. 573.2. Tymoigne, Éric (2009c), ‘The US mortgage crisis: sub-prime or systemic?’, in G.N. Gregoriou (ed.), Banking Crisis Handbook, London: Taylor and Francis, pp. 95–116. Tymoigne, Éric (2010), ‘Detecting Ponzi finance: an evolutionary approach to the measure of financial fragility’, Levy Economics Institute working paper no. 605. US Department of the Treasury (2008), Blueprint for a Modernized Financial Regulatory Structure, Washington, DC: Department of the Treasury. US House of Representatives (2008), The Financial Crisis and the Role of Federal Regulators, preliminary transcript of the hearing of the Committee on Oversight and Government Reform, 23 October, accessed 18 December at http://oversight. house.gov/images/stories/documents/20081024163819.pdf. US Senate (2009a), Modernizing The US Financial Regulatory System, Senate Committee on Banking, Housing, and Urban Affairs, Senate Hearing No. 111-42, 4 February, accessed 3 November 2009 at www.access.gpo.gov/congress/senate/ senate05sh111.html. US Senate (2009b), Oversight of the Securities and Exchange Commission’s Failure to Identify the Bernard L. Madoff Ponzi Scheme and How to Improve SEC Performance, Senate Committee on Banking, Housing, and Urban Affairs, Senate Hearing No. 111-368, 10 September, accessed 3 November 2010 at www.access. gpo.gov/congress/senate/senate05sh111.html. Vikraman, Shaji and Nair, S. (2010), ‘India is a very good investment: Lloyd Blankfein, CEO, Goldman Sachs’, The Economic Times, 21 May, accessed 17 September at http://economictimes.indiatimes.com/Interviews/articleshow/ 5955955.cms. Wray, L. Randall (2006), ‘Can Basel II enhance financial stability? A pessimistic view’, Levy Economics Institute public policy brief no. 84/2006. Wray, L. Randall (2007), ‘A Post Keynesian view of central bank independence, policy targets, and the rules versus discretion debate’, Journal of Post Keynesian Economics, 30 (1), 119–41.

PART III

The global economy

7. Regulating for stability: bank capitalization and the emergence of an international lender of last resort Jan Toporowski INTRODUCTION The recent global financial crisis has inevitably given rise to a major and widespread debate on bank regulation. But most of the academics in the fray – including scholars eager to revive John Maynard Keynes’s remedies in a postgold standard era – aim to correct the crises of the past. From a rhetorical perspective, their arguments sound plausible because the ideas of intellectuals and ‘practical men’ that academics seek to convince have been formed by past crises.1 And, from a methodological perspective, the appeal to redress the crises of the past fits in with the severely empirical canons of investigation that have characterized economics since the mid-twentieth century. The flaw here is that the most recent crisis is not like the crises of the past. Indeed, no crisis is like those that preceded it. The economy’s participants enter each crisis with a balance sheet that affects the course of the crisis, and that balance sheet is inevitably different from the balance sheets of previous crises. Meanwhile, ‘practical men’ – practitioners and policymakers – have displayed a different bias. They have been driven by a political necessity to ‘save’ the banking system. That system is supposed to be the main transmission channel for what, under the neoclassical economists’ New Consensus (Goodfriend, 2007), is believed to be the key regulator of the economy: the central bank rate of interest. The slide into recession, notwithstanding record low interest rates, merely increases the urgency to restore ‘the haven of familiar monetary practice’ that is believed to lie within the existing banking arrangements, to emerge as soon as banking returns to ‘normal’.2 This chapter goes beyond such pragmatic considerations by seeking to integrate financial regulation with the performance of the economy as a whole. This integration is achieved by highlighting the operation of capital markets, 143

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which represent the key nexus between such regulation and the overall economy and serve as the fundamental determinant of twenty-first century capitalist dynamics (Toporowski, 2000). In particular, the integration is illustrated by way of a critique of capital adequacy and presentation of an alternative regulatory approach.

FORCED INDEBTEDNESS Conventional wisdom since the 1980s maintains that banks can be made more secure by having capital sufficient to meet a decline in the quality of bank assets (loans or bonds). This thinking was reflected in the Basel Agreement of 1988, laying down minimum capital requirements in relation to the supposed riskiness of assets. Apart from the fact that there is considerable uncertainty about the precise riskiness of assets, the strategy of securing bank stability by capital adequacy is based on a fallacy of composition: what is good for one bank is not necessarily good for all banks taken together, or for the economy as a whole. The capital-adequacy strategy is based on a microeconomic presumption that each bank can determine its liabilities (that is, the scale and distribution of its liabilities between deposits and capital) without affecting the liabilities of other banks and firms in the economy. This is a fallacy because the process of issuing capital or liabilities is subject to two constraints. The first is a balancesheet constraint. The liabilities of each bank or firm must be assets of some other firm or bank. The second is an income constraint. Even if one assumes that the price system (in particular, the return offered and accepted on liabilities and assets) will somehow coordinate capital market operations in such a way as to allow all banks and firms to issue the kind of liabilities that they wish to have in their individual balance sheets, there is no guarantee that their assets will generate sufficient income to allow each individual bank or firm to make the payments required by their liabilities. In practice, banks cannot determine their capital without affecting the availability of capital for other economic enterprises. If we exclude the possibility of bank holding companies and bank capital cross-holdings (discussed below), the supply of capital today in the financially advanced markets of the Organisation for Economic Co-operation and Development (OECD) countries is principally determined by the cash flow and the respective liability structures of other financial intermediaries, such as pension funds and insurance companies.3 Given a certain capacity for purchasing equity on the part of other, non-bank, financial intermediaries, a regulatory requirement to increase bank capital reduces the amount of capital available for non-financial firms. If non-financial firms are unable to raise the amount of equity capital that they need, they are obliged to raise capital through the issue of debt instruments in

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the form of corporate bonds or company paper. In this way, stabilizing banks by raising capital requirements becomes a way of ‘forcing’ companies into debt. Capital Formation, Crowding Out and Securitization The ‘forced indebtedness’ of companies is a crucial factor in bringing about financial crisis and recession. Both the 1929 stock market crash and the global financial crisis of 2007–08 were preceded by an expansion of capital issues by financial intermediaries and an increase in the indebtedness of non-financial firms. Beyond a certain point, non-financial firms respond to rising levels of debt by reducing their (productive) investment in fixed capital. Such decreases in fixed capital formation are a key factor in bringing about recession in the real (non-financial) economy and in prolonging that recession into economic stagnation and depression (as was the case in the 1930s, and in Japan after 1992). The ‘crowding out’ of the non-financial business sector’s demand for equity capital also raises the cost of the capital that such firms eventually raise. Because banks have to satisfy a regulatory requirement for capital, they are willing to pay whatever price it takes to get the capital onto their books. With a given supply of capital, such an ‘inelastic’ demand for capital tends to increase the returns promised on the capital they raise. Non-financial firms wishing to raise equity capital must then match those returns – or offer even higher returns – on capital they wish to issue. This is reflected in the rising yields on corporate equity issues since 2000. The other way banks can accommodate demands for higher capital ratios (that is, ratios of capital to assets) is by securitization. That involves packaging bank loans as bonds, and selling the resulting bonds to other financial intermediaries (such as insurance companies and pension funds). This raises bank capital/asset ratios by reducing the amount of risky assets on their balance sheets. Securitization has recently had a bad press because of its role in the ‘business model’ of failed banks, such as Northern Rock. But there is also another channel by which securitization has contributed to financial fragility. That is through the sale of loan-backed bonds to other financial intermediaries. Such sales effectively reduce the pool of capital that non-financial firms can raise in the markets. Thus, securitization is another factor contributing to the forced indebtedness of companies. Bank Holding Companies and Increased Fragility The aforementioned considerations apply to bank capitalization through the sale of equity capital to financial institutions such as insurance companies and

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pension funds. The sale of equity capital to private individuals is not an effective means of raising capital because few private individuals are wealthy enough to be able to hold significant quantities of capital on the scale required by banks. However, there is another means of raising bank capital, which applies in the case of bank holding companies or cross-holdings of bank capital. A bank could issue equity capital that would subsequently be held by a holding company financed mostly with debt instruments, such as bonds. Alternatively, two banks could agree to issue capital to each other. The holding company method is a way of creating capital that is really debt, and this would show up in consolidated accounts. Moreover, it is a highly speculative form of financing because the holding company ends up with financial commitments that must be serviced out of less liquid assets whose value and income are much less certain than the holding company’s liabilities. This is one of the reasons why, in the past, bank holding companies were strictly regulated. The second method, involving cross-holdings, gives rise to a ‘layering’ of capital within the financial system, since it results in banks holding other banks’ capital in their asset portfolios. Such cross-holdings have adverse effects on competition among banks and on bank efficiency. These holdings also expose the banks involved to the risks that might affect the assets of a single one of them. The indebting of non-financial firms increases the financial fragility of the economy as a whole. Firms that would have preferred to finance themselves with equity capital find themselves holding levels of debt that, over their planning horizon, they would prefer to reduce. They can accommodate this excess debt in one of two ways. They can hold larger amounts of liquid assets (bank deposits, foreign currency deposits, and short term bills). But this means that capital which they have issued is ‘wasted’ by being held as financial assets, rather than being applied productively to the expansion of output or fixed capital. Alternatively, firms can, as mentioned above, reduce their fixed capital investment in order to build up those liquid assets. Either way, productive investment ends up being less than it would otherwise be. If a large number of firms succumb to indebtedness in this way, the economy moves to a lower growth trajectory. Moreover, this firm strategy can be self-defeating. Lower investment in fixed capital also reduces the liquidity of firms and diminishes their ability to service their debts. That is because fixed capital formation is a key factor in the liquidity of firms; higher investment in fixed capital by the business sector as a whole is associated with higher retained profits for individual firms (Steindl, 1952: 119–20). Therefore, a decline in the quality of bank assets can actually be an indirect result of the increase in company indebtedness enforced by raising capital requirements for banks.

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THE BUSINESS CYCLE AND VARIABLE CAPITAL REQUIREMENTS Looking at this issue over the course of the business cycle, it is easy to see how regulatory bank capital requirements may make fluctuations in economic activity even more extreme. Given even moderate business fluctuations, it is prudent for non-financial firms to raise additional equity capital as a boom proceeds because the longer the boom lasts, the closer is the eventual recession, and therefore the more likely is a fall in their return on productive assets. However, if banks are increasing their issue of equity capital, then non-financial firms may find themselves unable to issue additional equity and rely on debt finance. When the recession comes, it is therefore made worse by the greater indebtedness of companies. In a recession, the returns on all assets, including those in bank portfolios, deteriorate. As a result, non-financial firms should respond by converting debt to equity to help ensure their survival. But since the deterioration of their assets obliges banks to raise more equity capital themselves, this bank capitalization reduces the already diminishing pool of equity capital available to non-financial firms. More recently there have been proposals to stabilize bank balance sheets by requiring banks to raise the capital to risk-weighted assets ratios over the course of an economic boom. That is because fixed ratios of capital to riskweighted asset are pro-cyclical in the sense that the liquidity and net worth of balance sheets increase in the course of an economic boom. A fixed capital ratio would therefore fail to discourage banks’ risky lending and may even encourage it because the risks would be less apparent in the boom. The policy of requiring banks to raise capital ratios as a boom proceeds is sometimes referred to as ‘dynamic provisioning’ (Brunnermeier et al., 2009). There are three objections to this dynamic provisioning approach. First, the risks that are supposed to warrant higher capital ratios are rather nebulous and evidenced only by defaults in a recession if it comes. As a result, it would become difficult to enforce higher capital ratios if the boom is prolonged and defaults appear to be somehow permanently reduced. Second, the approach would require banks to drain the available pool of equity capital even more rapidly than under fixed capital ratios, causing correspondingly greater indebtedness on the part of companies, and forcing up even more the cost of capital that non-financial firms could issue. Far from stabilizing banks and the economy, dynamic provisioning would destabilize the economy and the credit system, including banks, by indebting companies more rapidly in a boom or discouraging company investment, and by these means increasing the risk of debt defaults. Third, a problem arises in an international setting in which some banks may

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have a diversified portfolio of assets spread across countries, some of which are in a boom and some of which are in recession. Such banks would on balance have a much more stable portfolio of loans and could reasonable argue that they should not be required to increase their capital ratios as much as banks exposed only to countries in recession (despite the fact that dynamic provisioning deliberately aims to raise such ratios in the balance sheets of institutions operating in a boom). A far more effective form of dynamic provisioning would be to require companies (and households with mortgages, if we are to extend our considerations to household debt) to increase the equity capital they have as a boom proceeds. This would make the remaining debt of companies more manageable in the face of a recession, thereby reducing the probability of default on that debt. The latter would, in turn, improve the quality of bank assets.

INTERNATIONAL BANK STABILIZATION The arguments presented here apply to a national economy, but they apply even more to the international economy insofar as national financial systems are integrated into an international system. The most recent Basel III agreements recommend that bank regulators raise additional capital requirements over the course of an economic boom, as well as increasing basic capital ratios, largely through tightening up the definitions of what counts as capital. The agreements also recommend maximum gearing or leverage ratios of bank borrowing to equity. If, as suggested above, equity finance is in limited supply, a fixed leverage ratio may encourage (non-financial) companies to indebt themselves to each other or through bond finance rather than to bank debt. This would not reduce the problem of non-financial debt or capitalization. In a situation in which banks have cross-border exposures in the form of assets in other countries, exposures are made more risky by the current mix of floating exchange rates with such rates fixed in particular regions (for example, the eurozone and associated member states of the European Union).4 The present Basel Agreement and European Commission Directives (as of August 2010) would require even higher capital ratios for such banks than in the case where individual bank assets and liabilities were confined to only one country. Those even higher capital ratios imply an even greater indebtedness of companies. In such an internationally integrated financial system, banks and economies would be much more effectively stabilized if cross-border lending to the private sector were matched by a commitment to lend (in the domestic currency of the bank) to the government of the country of that private sector in the event that lending in that country was reduced. For example, if a bank located in the UK lends to companies in South Africa, then the bank would

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commit itself to lend the South African government the equivalent of any reduction in lending by the bank to those companies. In this way, capital outflows would be matched by new capital inflows to governments, which would then be in a position to stabilize the foreign borrowing of banks and companies in their respective countries. Banks withdrawing funds from a country would have to commit themselves to receiving government bonds in the home currency of the bank, rather than bank deposits in that currency, as currently happens when domestic currency is exchanged for foreign currency. In effect, a bank wishing to liquidate private sector assets abroad would only have the option to swap them for claims on governments abroad. In practice, this is what has happened in the past, after pressure was brought to bear on foreign governments to guarantee the loans of international banks. But the result was achieved only after an extended period of political uncertainty. A major advantage of this policy option is that, by evoking increased commercial bank lending to governments when lending to the private sector is reduced, this requirement would provide a stabilizing mechanism that would be endogenous to commercial bank lending. This provision of an endogenous stabilizing mechanism contrasts with, but also facilitates and strengthens, the usual Keynesian and Post Keynesian stabilizing mechanisms based on government fiscal or lender-of-last-resort intervention (see, for example, Minsky, 1986). The government bonds thus issued to foreign banks would be long-term, or at least sufficiently long-term to avoid repayment pressures on the issuing governments in the midst of crisis. Banks holding such foreign government bonds should be given an option to sell them after a given period, but before they are repaid, to a multilateral monetary agency such as the International Monetary Fund (IMF) at a price mutually agreed. The provision of such capital refinancing, as a matter of routine but not as a guarantee, would give confidence to international lending. With such a system, the eventual outcome may be to have the IMF refinance the debts of member governments as it does at present with strict conditions. What distinguishes this policy option from existing practice is that commercial banks would approach the IMF to discount government debt, rather than desperate governments accepting penal conditions from the IMF. In effect, the proposed arrangement gives the IMF more of the character of a lender of last resort. The IMF would stabilize the international system, but its work would be mediated through the international banking system, where commercial banks would bear some broader responsibility for their lending and for the economic stability of the countries to which they lend. Such a system of advance or contingent lending commitments would encourage due caution with cross-border lending, while stabilizing cross-border bank capital flows. It would obviously be least taken up in countries with relatively

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little private sector foreign borrowing, such as some of the major OECD countries. However, smaller countries and emerging, developing and transition economies, and their banks and companies, could benefit from the greater stability that such a system would bring. And, as a result, the international financial system would be strengthened and stabilized.

CONCLUSION: REGULATING FOR STABILITY The capital market is a key nexus between the financial system and the real economy. A preoccupation with the credit channels by which monetary policy is supposed to become effective has largely ignored this key link. Recapitalizing banks depletes the capital available for non-financial firms. The result is a condition of greater indebtedness among such firms, which reduces their capital expenditure, weakens their finances, and thereby undermines the quality of bank assets. Increasing capital requirements over the course of a boom would bring forward the collapse of the boom. Because of the increased risks of cross-border lending, international banking integration results in higher capital requirements. Such integration thereby squeezes the amount of global capital available for non-financial firms. This chapter argues for a regulatory system that requires contingent lending commitments to governments as part of cross-border lending. Under the proposed system, banks lending abroad would have to increase their lending to governments abroad pari passu with any reduction in foreign lending; when bank lending to foreign companies contracts, banks would replace such lending with lending to foreign governments. The loans to foreign governments would then be discountable at the IMF, making it an effective lender of last resort. In a climate in which policy debate is driven by powerful vested interests (especially in the form of banks) and informed by economic theory that has largely lost touch with reality, it can be difficult for regulatory alternatives such as the one in this chapter to receive serious consideration. In adversity, however, there is a greater willingness to consider alternatives. As the consequences of the recent crisis wear on, the failure of conventional thinking will become even more obvious. International policymakers may then welcome policy alternatives such as this one, which can stabilize the financial system without the moral hazard that arises when guarantees are offered only to banks.

ACKNOWLEDGEMENTS This chapter is based on the author’s evidence to the Treasury Select Committee of the UK (Toporowski, 2009). The author would like to record his

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thanks for comments on early drafts from Jeff Powell, Eckhard Hein, Trevor Evans and participants in a workshop on finance-led capitalism at the Berlin School of Economics on 16 July 2009. He also thanks Charles Whalen and anonymous readers of a later draft.

NOTES 1.

2.

In the closing pages of The General Theory, Keynes (1936) wrote: ‘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.’ On the eve of the Great Depression, US economist O.M.W. Sprague is reported to have said: The gold standard has emerged triumphantly from the welter of disorganized currencies of the World War period and gold has now become more universally than ever before the foundation of the structure of credit throughout the world. This return to the haven of familiar monetary practice is significant of the widespread conviction that the gold standard is an essential factor in the maintenance of a reasonable measure of international stability, for which there is no promising or practical substitute. (Quoted in Aldcroft, 2004: 26)

3. This is further explained in Toporowski (2010). 4. In a world of fixed exchange rates, there should be no exchange rate risk. In a world of floating exchange rates, rationally managed banks will hedge against this risk. In a world of mixed floating and fixed exchange rates, however, economies bound by fixed exchange rate rules are vulnerable to foreign trade imbalances if they lose competitiveness to economies with floating exchange rates, while floating exchange rate economies are vulnerable to monetary instability. The wider range of the possible kinds of losses makes mixed exchange rate systems more risky. For example, the Argentine crisis of 2000–02 was due in part to the monetary instability of the 1990s, but it was also exacerbated by the loss of export markets to Brazil, where currency depreciation was a deliberate policy choice (see Halevi, 2002).

REFERENCES Aldcroft, Derek H. (2004), ‘Exchange rate regimes and economic performance in the inter-war years’, in Ross Catterall and Derek H. Aldcroft (eds), Exchange Rates and Economic Policy in the Twentieth Century, Aldershot: Ashgate, pp. 17–70. Brunnermeier, Markus, Andrew Crockett, Charles Goodhart, Avinash D. Persaud and Hyun Shin (2009), The Fundamental Principles of Financial Regulation, Preliminary Conference draft, Geneva: International Center for Monetary and Banking Studies. Goodfriend, Marvin (2007), ‘How the world achieved consensus on monetary policy’, Journal of Economic Perspectives, 21(4), 47–68. Halevi, Joseph (2002), ‘The Argentine crisis’, Monthly Review, 53 (11), 15–23. Keynes, John Maynard (1936), The General Theory of Employment, Interest and Money, London: Macmillan.

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Minsky, Hyman P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Steindl, Josef (1952), Maturity and Stagnation in American Capitalism, Oxford University of Statistics monograph no. 4, Oxford: Basil Blackwell. Toporowski, Jan (2000), The End of Finance: The Theory of Capital Market Inflation, Financial Derivatives and Pension Fund Capitalism, London: Routledge. Toporowski, Jan (2009), ‘Banking crisis: international dimension of the banking crisis’, Eleventh Report of Session 2008–09, HC 615, evidence in House of Commons Treasury Committee, 24 July, London: The Stationery Office, pp. 59–63. Toporowski, Jan (2010), ‘A theory of capital rationing’, University of London Department of Economics, The School of Oriental and African Studies, working paper.

8. Evolution without fundamental change: the Washington Consensus on economic development and its significance for Post-Keynesian Institutionalism John Marangos and Charles J. Whalen INTRODUCTION In 1989, economist John Williamson coined the term the ‘Washington Consensus’ (WC). Williamson, a senior fellow at the Peterson Institute for International Economics, was seeking to label the view towards international development that was widely held within the Washington, DC beltway, initially for Latin America and then for developing nations overall. However, the WC policy set soon generated criticism and many dissenters derisively referred to it as a neo-liberal manifesto. Even more importantly, Latin America continued to face economic stagnation in the 1990s. Since then, the WC has evolved, leading to the question: is it still relevant? For proponents and opponents alike, the answer is yes. Consider the following as evidence. As recently as 2008, there were 224 types of conditionalities imposed by the International Monetary Fund (IMF) on 15 countries (Hailu, 2009). And there has been no substantial modification of the IMF’s principles following the recent global financial crisis: strict inflation targeting remains central to monetary policy and budgetary austerity remains the cornerstone of fiscal policy (McKinley, 2010: 2).1 As three top IMF economists wrote in early 2010, ‘In many ways, the general policy framework [of the IMF] should remain the same’ (Blanchard et al., 2010: 16). While key elements of the WC remain intact, development economists working in the tradition of Post-Keynesian Institutionalism (PKI) and seeking to maximize their impact on the literature and public policy, need to understand the changing character of the WC. Thus, the purpose of this chapter is to highlight adjustments to the WC framework and recommendations. It begins by reviewing the emergence of the original WC and then introduces, in turn, 153

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the New Agenda presented by Williamson in 2003 and his more recent perspective, which we call the ‘Amended Washington Consensus’. That survey is followed by a discussion of the significance of this evolution for PKI. Our aim is to lay the groundwork for an alternative that advances both scholarship and economic development.

EMERGENCE OF THE WASHINGTON CONSENSUS Williamson (1999: 1) found himself at the centre of the debate over international economic policy reform ‘almost by accident’. It started when he drew attention to what he saw as a policy consensus that he labelled as such during a 1989 conference on the progress of reforms in Latin America.2 According to Williamson, WC was initially ten reforms that ‘most people in Washington believed Latin America (not all countries) ought to be undertaking as of 1989 (not at all times)’ (Williamson, 2002b: 1). Nevertheless, his reforms were quickly converted into the ‘Ten Commandments’ for international development policy (Williamson, 2004: 3). The WC policies, which Williamson (2003c: 320; 2003d: 6) eventually referred to as the ‘first-generation’ of reforms, are presented in Table 8.1. Williamson (2000: 262) argued that WC policies accelerate economic growth and eventually foster a more equitable distribution of income as a result of macroeconomic discipline, a liberal market economy, and openness to the world (at least with respect to trade and foreign direct investment). While these ideas were considered orthodox within Organisation for Economic Co-operation and Development (OECD) countries, Williamson believed there had been ‘a sort of global apartheid’ (Williamson, 2002b: 2) dividing the planet into First, Second and Third Worlds, ‘each with its own economic laws’ (Williamson, 2004: 12). The underlying assumption had been that developing countries were somehow unique with respect to economics. In particular, it was often suggested that developing nations benefit from inflation (which allowed them to reap an ‘inflation tax’ and boost investment) and import substitution, and from giving the state a lead role in initiating industrialization. The WC declared that ‘this era of apartheid was over’ (Williamson, 2002b: 2). The WC was based on the Reagan–Thatcher economic agenda, Williamson argues, discarding the ‘pretty nutty’ parts of that programme (Williamson, 2002a: 5), such as monetarism, supply-side economics, minimalist government and therefore minimal taxes, and capital account convertibility. Williamson (1999: 2) is not an opponent of government action. He believes an efficient economy requires government to preserve a stable macroeconomic environment (to reduce unreasonable uncertainty) and provide public goods. Government action is also recognized as necessary to address market failures

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Table 8.1

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The Washington Consensus

Policies

Description

Fiscal discipline

• Reduce budget deficits (financed without resort to the ‘inflation tax’) Public expenditure • Redirect expenditure from politically sensitive areas priorities to fields with the potential to improve income distribution, such as primary education, health care and infrastructure Tax reform • Broaden the tax base and cut marginal tax rates Financial • Ensure market-determined interest rates liberalization Exchange rates • Establish a unified, competitive exchange rate Trade • Replace quantitative trade restrictions with tariffs of liberalization around 10 to 20 per cent Foreign direct • Abolish barriers to entry for foreign firms investment Privatization • Privatize state enterprises Deregulation • Abolish regulations that impede entry of new firms or restrict competition (intended to apply to labour and product markets) Property rights • Secure and extend property rights to the informal sector associated with externalities and monopolies, and to address income inequality. On the latter, Williamson (1999: 16) writes: ‘The old and necessarily divisive question of income distribution is back on the table (some of us think it was scandalous that it was ever off the table, but the fact is that, at least in Washington, it practically disappeared as an issue in the 1980s)’. Any remaining economic activity, however, does not require government action and thus can be undertaken by the private sector.3

THE NEW AGENDA In late 1999, Pedro Pablo Kuczynski, who at the time ran three private equity funds specializing in Latin America, expressed concern to Williamson about economic stagnation in that region. The result was three meetings sponsored by the Institute for International Economics and a book, edited by Kuczynski and Williamson (2003), entitled After the Washington Consensus: Restarting Growth and Reform in Latin America.

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According to Williamson, the original WC did not contain all the answers to the policy questions of 1989, and circumstances had changed. ‘So of course we need to go beyond it’, he writes (Williamson, 2008a: 30). He expressed a similar view in 2004: ‘The proposition that there is a need to supplement what I laid out as the Washington Consensus seems to me unobjectionable, indeed compelling’ (Williamson, 2004–05: 199). This was the purpose of After the Washington Consensus.4 In other words, its policy aim was to outline a new agenda that would put Latin American nations ‘back on the road of catch-up growth that most people thought they had achieved before the debt crisis’ of the early 1980s (Williamson, 2003c: 305).5 Williamson (2003d: 5) begins After the Washington Consensus with an assessment of the region’s poor performance and the role of the WC. He identifies three reasons why economic outcomes did not match expectations. First, the region had been vulnerable to economic crises. It encouraged capital inflows, resulting in overvalued currencies; used fixed or crawling exchange rates as a nominal anchor; and pursued a pro-cyclical fiscal policy, which led to vulnerability to ‘sudden stops’ in capital inflows and the inability to relax fiscal policy in hard times. The WC, meanwhile, did not stress crisis avoidance because it was not an urgent issue in the late 1980s.6 Second, the reforms were incomplete in implementation (see also Williamson, 2004–05: 196): some reforms were neglected (for example, the labour market remained strongly dualistic, resulting in an ever-growing informal sector) and others were not fully implemented (including financial reform). While budget deficits were reduced, there was no attempt in good times to run budget surpluses that would have provided the opportunity for deficit spending in bad times. Thus, Williamson argues the WC cannot be responsible for performance that is attributable to a government’s failure to pursue the reforms as much as was necessary.7 Third, the objective of the reforms was too narrow. The goal had been to accelerate growth without worsening income distribution, not to achieve growth with equity. This goal was certainly the dominant one in Washington in 1989, and a legitimate criticism is that the WC reforms failed to deal with the structural causes of poverty. By 2003, this was obvious to Williamson. He writes: ‘It would be a mistake to treat further trade liberalization as a reliable weapon for overcoming the region’s inherited inequality. It is perfectly reasonable to seek further trade liberalization on efficiency grounds; the point is that this one stone cannot be relied on to kill two birds’ (Williamson, 2003c: 313–4). Williamson’s new agenda sought to address the aforementioned issues, but it also sought to move on from a term (WC) that had become a lightning rod for criticism and had acquired meanings beyond that which he intended. ‘When a term has come to acquire such different meanings, it is time to drop

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Table 8.2

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The New Agenda

Policies Fiscal discipline

Description

• Stabilize inflation • Ensure sub-national governments are subject to hard budget constraints • Increase domestic savings Public expenditure • Stabilize the real economy through Keynesian policies priorities • Establish a stabilization fund • Improve educational opportunities Tax reform • Establish property taxation as the major source of revenue • Eliminate tax loopholes and tax income earned on flight capital Financial • Target a low rate of inflation via monetary policy liberalization • Strengthen prudential supervision Exchange rates • Employ flexible exchange rates • Minimize use of the dollar Trade • Complement import liberalization with better access liberalization to export markets in developed countries Foreign direct • Same as in the original WC investment Privatization • Continue the privatization programme (learning from the fact that in some cases it was carried out badly) Deregulation • Liberalize the labour market Property rights • Introduce programmes that provide property rights to the informal sector • Enact land reform and provide micro-credit Institution • Maintain effective public institutions, infrastructure building and a strong human-resource base • Provide public goods, correct market failures (internalize externalities) and address income gaps with an eye to social equity • Establish a stable and predictable environment in macroeconomics, law and politics • Reform the judiciary, education system, and civil service • Build a national innovation system • Modernize the institutional structure of the market system and strengthen the financial sector via institutional reform

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it from the vocabulary’, writes Williamson (2003b: 12).8 As C. Fred Bergsten (2003: viii) explains in the preface to After the Washington Consensus, the book’s title was a conscious effort to call attention to the belief that ‘it is high time the world moved on from tendentious ideological debates in which the Washington Consensus is caricatured as a neo-liberal manifesto to serious discussion of the new wave of reform the region needs to restart growth and make it more equitable than it has been in the past’.9 The After the Washington Consensus title also reflected Williamson’s observation that there was no longer a consensus in Washington (Williamson, 2004–05: 200; Williamson, 2003d: 12). There was consensus among those in the Bretton Woods institutions of the IMF and World Bank, but the Treasury Department had a different view. In fact, the international financial institutions and the administration of President George W. Bush were ‘at loggerheads’ on a number of issues, including fiscal policy (the US did not share the institutions’ commitment to reducing poverty and inequality) and capital account liberalization (the administration moved to reduce even the slightest capital controls in countries like Chile and Singapore, for example) (Williamson, 2003b: 11–12; Williamson 2004–05: 200–201). Thus, After the Washington Consensus sought merely to put forth the policies its authors supported, not to reflect an inside-the-beltway consensus (Williamson, 2003a: 23, 330). And those policies, the New Agenda, aimed to extend, complete and complement the reforms of the original WC, not reject them. At the same time, Williamson (2003c: 321) stressed that After the Washington Consensus was ‘not presented as ultimate truth’ and that policies needed to be adapted to local circumstances (see also Williamson, 2004: 16; Williamson, 2008b: 1).10 Drawing on Kuczynski and Williamson (2003), Table 8.2 outlines the key elements of the New Agenda, which can be summarized as ‘crisis-proofing’; completing first-generation reforms; introducing secondgeneration reforms; and focusing on income distribution and the social sector. Crisis-Proofing The New Agenda gives highest priority to taking steps that would reduce the vulnerability of Latin American countries to economic crises. This is seen as important from the perspective of seeking a more equal distribution of income as well as faster growth. The agenda includes containing inflation through fiscal policy (consistent with the original WC) and monetary policy (inflation targeting); stabilizing the real economy through Keynesian policies (Williamson, 2004–05: 202); subjecting sub-national governments to hard budget constraints; establishing a stabilization fund; introducing flexible exchange rates;11 minimizing use of the dollar; strengthening prudential financial supervision; and increasing domestic savings.12

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Completing First-Generation Reforms Completing the original WC agenda has many parts. It includes liberalizing the labour market, to encourage workers back into the formal sector where they can get at least minimal social protection. It means complementing import liberalization with better access to export markets in developed countries. It involves continuing the privatization programme, even though in some cases it had been carried out badly. At the same time, Williamson (2003c: 308) stresses that reducing government intervention ‘is not the same as a desire for a minimalist government’.13 Second-Generation Reforms A vital role for the state is also part of what economic journalist Moses Naim (1994) calls ‘second-generation reforms’. These reforms are seen as complementary to the first-generation reforms of the original WC, and they draw on a key innovation in the mainstream development economics literature of the 1990s: recognition of the crucial importance of institutions in ensuring that the economy functions effectively.14 In particular, second-generation reforms stress the need to create and maintain effective institutions; provide public goods, decent infrastructure, and a strong human-resource base; internalize externalities; correct income distribution; and ensure a stable and predictable macroeconomic, legal and political environment. These reforms also involve reforming the judiciary; bolstering the education system and civil service; building a national innovation system (to promote the diffusion of technological information, fund pre-competitive research, provide tax incentives, and encourage venture capital and industrial clusters); and modernizing the market institutional structure (property rights and bankruptcy laws) and financial system.15 There is also recognition that the details of second-generation (institutional) reforms will differ for each country and cannot be determined a priori (Williamson, 2008a: 27). Income Distribution and the Social Sector According to the New Agenda, growth is always pro-poor, as benefits trickle down. But the agenda also recognizes that the poor will not benefit as much because of the limited resources they have at the outset. Hence, there is a case for supplementing the gains of growth with a degree of income redistribution. The New Agenda calls for establishing property taxation as the major source of revenue, eliminating tax loopholes, and taxing income earned on flight capital Williamson (2003d: 16). It also calls for using that revenue to

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reduce inequality, expand opportunities for the poor, spend on basic social services, strengthen the social safety net, and improve education and health.16 Rather than a massive redistribution of income (‘band aids’) via the tax system, the New Agenda strategy focuses on measures to empower the poor to develop potentialities (‘bootstraps’). It is a long-run strategy aimed at allowing access to assets that will enable the poor to earn their way out of poverty, and its emphasis is on improved educational opportunities, programmes that provide property rights to the informal sector, land reform, and micro-credit. ‘Hence, our focus is on both accelerating growth and improving income distribution. We believe that both are possible and both are necessary’, writes Kuczynski (2003: 31).

THE AMENDED WASHINGTON CONSENSUS Williamson’s position has continued to evolve since 2003. The result (as of this writing, in mid-2010) can be called the ‘Amended Washington Consensus’, which is summarized in Table 8.3. It covers 11 policy dimensions, each of which is discussed in turn. Fiscal discipline Williamson’s views in this area have changed little. Economist Joseph E. Stiglitz maintains that moderate inflation has no measurable growth effect and no serious welfare consequences, but Williamson is unconvinced. For Williamson, higher inflation and larger budget deficits are unacceptable. In arguing against more than minimal inflation, Williamson stresses that the inflation tax is regressive and that the Phillips curve is vertical in the long-run (Williamson, 2004: 3). Public expenditure priorities Williamson has increasingly stressed the need to redirect public expenditure in a pro-poor and pro-growth fashion. He calls for moving away from non-merit subsidies (that support the consumption of goods and services such as power, irrigation water, and diesel fuel) and towards basic social services and infrastructure (Williamson, 2008a: 16). To reduce inequality, he continues to advocate empowering the poor by means of education, encouraging micro-enterprises to operate in the formal sector, and expanding micro-credit so more micro-enterprises can buy physical capital (Williamson, 2003b: 13). Tax reform The general direction of tax reform remains the same, but there is greater focus on increasing tax revenue. That revenue is needed to fulfil the public sector’s multiple goals, which include correcting budget deficits, increasing public expenditures, and replacing revenue lost by trade reform. At the same time, Williamson is attuned to the need to ensure that revenue gener-

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Table 8.3

161

The Amended Washington Consensus

Policies

Description

Fiscal discipline

• Faster inflation and larger budget deficits are unacceptable Public expenditure • Reorder public expenditure priorities in a pro-growth priorities and pro-poor manner Tax reform • Increase tax revenue (important given the need to correct budget deficits, increase public expenditures, and replace the revenue lost by trade reform) Financial • Delay capital account liberalization liberalization • Create appropriate supervisory institutions Exchange rates • Reject the ‘two-corner’ doctrine Trade • Gradually reduce protective walls liberalization Foreign direct • Liberalize inward foreign direct investment investment Privatization • Privatize gradually (focus on doing it effectively) Deregulation • Retain regulations regarding (worker and consumer) safety, environmental protection, and prices in non-competitive industries Property rights • Enact land reform Institution • Accept government responsibility to provide the building institutional infrastructure and social organization that an economy requires ation does not worsen income inequality. For example, he writes that if revenue is generated by increased use of a value-added tax, then measures are required to counteract its regressive nature (Williamson, 2004: 5). Financial liberalization While financial liberalization is important as specified in the original WC, there are now two added stipulations: delay capital account liberalization and create appropriate supervisory institutions. Williamson (2004: 6–7) stresses that creation of appropriate supervisory institutions is a vital complement to financial liberalization. Exchange rates In contrast to Williamson’s original WC recommendation on exchange rates, what emerged in Washington was support for the ‘two-corner’ doctrine, which maintains a country must either fix their exchange rate firmly or allow it to float ‘cleanly’. Williamson (2004: 7) rejects the ‘infatuation’ with this bipolar solution and argues it does not promote development.17

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Trade liberalization Today, the mainstream consensus on trade is that there should be a gradual reduction of protective walls. The World Bank view is that import liberalization should proceed according to a predetermined timetable of three to ten years. In contrast, Williamson (2004: 7) argues that the speed of liberalization should be determined in individual countries according to macroeconomic conditions and the strength of their balance of payments. Foreign direct investment Williamson advocates ‘liberalization of inward foreign direct investment’ and emphasizes that this is a specific recommendation, not a general call for liberalization of capital flows (Williamson, 2004: 9). In fact, he believes premature capital account liberalization was responsible for the 1997 Asian crisis that cut short the East Asian miracle (Williamson, 2004: 9). Williamson was one of the few mainstream economists who opposed premature capital account liberalization in emerging market economies during the first half of the 1990s. Since then, economists’ support for such liberalization has diminished substantially. Privatization Experience demonstrates that privatization can be a highly corrupt process that transfers assets to privileged elites for a fraction of their true value. Still, Williamson argues privatization can actually be done in a socially beneficial manner (Williamson, 2004: 10). Yet Williamson (2000: 256) also stresses that effective privatization is more important than rapid privatization. ‘We need to be extra careful that all future privatizations are squeaky clean’, he writes (Williamson, 2004: 10).18 Deregulation In the original WC, deregulation never meant elimination of all regulations (Williamson, 2004: 10). Williamson has subsequently stressed that deregulation involves easing barriers to market entry and exit, while retaining regulations with respect to safety, protection of the environment, and prices in non-competitive industries (Williamson, 2003b: 10; Williamson, 2008a: 17). Property rights It is reported that Williamson confessed to adding property rights to the original WC primarily to round out a list containing ten items (Birdsall et al., 2001: 5). Since then, however, he has stressed that agrarian reform is often necessary to provide access to land (Williamson, 2003b: 13). Institution building Williamson (1999: 2) states that every economy requires an institutional infrastructure or ‘social organization’ that does not arise spontaneously. Hence, it is the responsibility of the government to establish and nurture such organization, he argues. This infrastructure provides the legal framework in which a market economy and financial institutions operate,

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including a judicial system capable of enforcing laws impartially and efficiently (Williamson, 1999: 2).

TOWARDS A MEANINGFUL ALTERNATIVE Post-Keynesian Institutionalists interested in engaging in today’s development policy debates can begin by understanding Williamson’s WC and its evolution. It does no good to ignore, caricature, or fixate on an outmoded version of the economic mainstream. Hyman Minsky (1996) stressed this in an address before the Association for Evolutionary Economics in 1996 as well as at a summer workshop in 1991, where he stated: ‘The perspective that underlies this workshop is that to move policy it is necessary to move the discipline. To move the discipline, we have to communicate with the dominant practitioners, even as we change the agenda’ (quoted in Whalen, forthcoming). Nearly a decade ago, Williamson called for doing away with the notion of a WC, but both the term and the policy agenda remain. The term lives on in his subsequent writings (including Williamson, 2004–05; Williamson, 2008a; Williamson, 2008b), and the agenda lives on in a set of recommendations that seem, even after close inspection, to fully warrant being called the ‘Amended WC’. The Amended WC is the contemporary version of Williamson’s New Agenda, which was his successor to the original WC. The WC has evolved, but the changes have not been drastic. It has changed in response to the economics literature (such as the attention to economic institutions that took hold in the 1990s), policy debates (such as emergence of the ‘two-corner’ doctrine), and – of course – real-world experience in developing nations. But the evolution has involved the addition of policies to complete, extend and complement the initial reforms, not replace them. Beyond that, there has really only been a change in emphasis, as indicated in Table 8.4, which identifies the most significant differences in the WC’s evolution. The WC has undergone some tinkering, but the fundamentals remain the same. There has also been a breakdown of ‘consensus’ since 1989, but even that has not amounted to very much. Although evidence of the breakdown has been presented in this chapter, the mainstream’s policy differences have actually remained quite small over the years, often centring (as suggested above) merely on how fast to push a particular reform. Differences have also narrowed over time. In fact, although Stiglitz initially criticized the WC as a neo-liberal manifesto and went so far as to offer an alternative he dubbed the ‘Post-Washington Consensus’, he subsequently declined to debate Williamson, arguing that the New Agenda included all the crucial issues and that their remaining differences amounted to semantics and were thus not worth debating (Williamson, 2003a: 326; Williamson, 2004: 14).19

Table 8.4

Main differences between the original Washington Consensus and its successors

Policies Fiscal discipline Public expenditure priorities

Tax reform 164

Financial liberalization Exchange rates Trade liberalization Foreign direct investment Privatization Deregulation

Property rights

Washington Consensus

New Agenda

• Reduce budget deficit (financed without resort to inflation tax) • Redirect expenditure from politically sensitive areas to fields with the potential to improve income distribution, such as primary education, health care and infrastructure • Broaden tax base and cut marginal tax rates • Ensure market-determined interest rates • Establish a unified, competitive exchange rate

• Increase domestic savings • Stabilize the real economy through Keynesian policies • Establish a stabilization fund

• Replace quantitative trade restrictions with tariffs of around 10–20 per cent • Abolish barriers to entry for foreign firms • Privatize state enterprises • Abolish regulations that impede entry of new firms or restrict competition • Secure and extend property rights to the informal sector

Amended Washington Consensus

• Tax income earned on flight capital • Strengthening prudential • Delay capital account supervision liberalization • Employ flexible exchange • Reject the ‘two-corner’ rates doctrine • Minimize dollar use • Gradually reduce protective walls • Privatize gradually • Liberalize the labour market • Retain regulations regarding safety, environmental protection, and prices in non-competitive industries

Institution building

165

• Maintain effective public institutions, infrastructure and a strong human-resource base • Provide public goods, correct market failures and address income gaps • Establish a stable and predictable environment in macroeconomics, law and politics • Reform the judiciary, education, and civil service • Build a national innovation system • Modernize the institutional structure of the market and strengthen the financial sector

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Opponents of the original WC argued it overlooks social equity, safety nets, and institutional development. That is largely true. Yet it also true that these issues have received attention as the WC has evolved. From the perspective of PKI, the problem with the WC in all its variants (and indeed with the Post-WC as well) is much more fundamental. For PKI, the trouble involves more than a matter of disagreement over one or more recommendations. It is that the WC is grounded in a neoclassical perspective of economic activity. While mainstream economists seek to fill in the gaps in the WC reform package, Post-Keynesian Institutionalists echo the observation of Institutional economist Philip A. Klein (1980: 880): the paradigm is the problem.20 The neoclassical framework overlooks much that is seen as essential from the perspective of PKI and that must, therefore, be considered in developing a meaningful alternative to the WC. This includes social goals, time, history and context, power, and participation.21 Social Goals Economic activity, as John R. Commons stressed and John Maynard Keynes understood, is always future-oriented. Thus, social goals must be the starting point for development of an alternative to the WC. Only after goals spell the ends can policies be developed to provide the means that move reality in the desired direction.22 Economic growth, which conventional economics associates with economic efficiency, is the goal that serves as the starting point for the WC, and its proponents never really look back. To be sure, they give attention to income distribution, but their literature does not match the focus on multiple goals that one finds in the writings of Keynes (1932: 344–5) and the Post Keynesians (such as Minsky, 1986: 8–9), where the central policy problem is identified as the need to combine economic efficiency, social justice, and individual liberty – and the dimensions of each goal are subsequently given careful consideration and development. Moreover, whereas proponents of the WC stress the trickle-down benefits of growth upon distribution, PKI emerges from a tradition that underscores the need to address inequality for the sake of growth and economic stability (Keynes, 1936: 372–7; Minsky, 1992; Brown, 2008; Zalewski and Whalen, 2010). Another set of goals appears in An Inquiry into the Poverty of Economics, by Charles K. Wilber and Kenneth P. Jameson (1983). Their book, the first to explicitly spell out PKI, offers an extensive development of three goals for economic activity: life-sustenance, esteem and fellowship, and freedom and equality of opportunity.23 Others may have a different conception of the ‘good society’, and a debate has long raged within Institutionalism about the possi-

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bility of identifying universal values, but a common element in both Post Keynesianism and Institutionalism has always been the belief that markets should serve social ends and that no conception of market efficiency should ever be the sole aim of socio-economic life.24 Time Upon receipt of the Nobel award in economics in the 1990s, Douglass North (1994) delivered a lecture entitled ‘Economic performance through time’. According to North: ‘Neoclassical theory is simply an inappropriate tool to analyze and prescribe policies that will induce development. It is concerned with the operation of markets, not how markets develop. How can one prescribe policies when one doesn’t understand how economies develop?’ Then North went further and identified the specific problem: in neoclassical economics, institutions and time do not matter. Since then, Williamson and other proponents of the WC have come to appreciate the context-setting nature of institutions. They have also come to recognize that reform takes time and that it is often better to introduce change effectively, rather than rapidly. But the underlying theory still has no room for time. To be sure, as North (1994: 369) acknowledged, economists engage in ‘comparative static’ analyses, but that introduces time and institutional change on the economists’ own terms. In the real world, multiple institutional changes occur over time, and such changes are not just those introduced on the recommendation of a policy advisor. Moreover, institutions aren’t the only aspect of the economic system subject to change; over time, learning occurs, preferences change, and, as a result, so do the goals, strategies and actions of those who participate in economic life. Fortunately, PKI does not have to start from scratch in dealing with time. Veblen and Commons both grappled with the challenge of conducting economic research and (at least in the case of Commons) offering policy advice in a world of institutional and social change, and those efforts continue in the Institutionalist and Post Keynesian literature. Atkinson and Oleson (1996) offer a useful method for case-based investigations of economic problems. Tavasci and Toporowski (2010) present a collection of essays that apply Minsky’s insights on cyclical and structural change in order to shed light on developing economies in the wake of the recent global financial crisis. And Stanfield (2006), in a call reminiscent of Joseph Schumpeter (1942, 81–6), stresses the need for economists to give attention to dynamic (or adaptive) efficiency. PKI must build on this literature to study not only specific development problems, but also the perennial cyclical and long-term structural challenges facing developing nations.

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History and Context A few years ago, José Antonio Ocampo (2004–05: 294), Under-Secretary General for Economic and Social Affairs of the United Nations, argued that the problem with the WC was not that it needs new ‘generations’ of policy reforms, but that economists need to better ‘understand the “context-specific” dynamics that facilitate growth with equity in specific institutional contexts’. Economist Alice Amsden (1996) made a similar argument nearly a decade earlier. In particular, she explained the need for an economic-development perspective that is broader in scope and more sensitive to institutional and historical factors than that offered by neoclassical economics. Her insights remain relevant for PKI. According to Amsden, successful future development in Latin America and elsewhere will depend heavily on the ability of countries to learn from the experience of other nations and to modify aspects of their own economies accordingly. Conventional economics is a weak guide to this process of ‘country-model transfer’, however, because it fails to generate sound analyses of what made a country succeed. Thus, Amsden offers development economists recommendations to follow – and pitfalls to avoid – in the course of seeking to generate such research. One of her recommendations relates to evaluation of government’s role in the development process, a particularly difficult issue for standard economics to address effectively. This has been an especially challenging issue because some of the most successful development experiences since World War Two have been in East Asia, where the state has exerted a pervasive influence on economic activity. Amsden argues that mainstream economists respond to this issue by allowing a laissez-faire outlook to shape their work and predetermine their conclusions. For example, she shows how those economists formulate tests for industrial policies that such policies cannot ‘win’ regardless of observed performance. Amsden (1996: 249–53) stresses that development economists must look beyond the existence (or absence) and level of government activism and probe more deeply to explore the actual nature of public sector efforts. There are also two other recommendations. One is the rejection of abstract theories of markets in favour of ‘theories about how institutionally specific markets work in particular countries’. The other is consideration of the role of the state not from the perspective of market failures and their resolution, but instead from ‘a historical examination of the real reasons’ for government intervention in the economy of fast-growing nations – which usually involve a government’s assessment of its nation’s competitive asset bundle and of economic, social and political tradeoffs (Amsden, 1996: 254–9).25 Of course, Amsden is not alone. The deep-seated significance of history

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and context – and thus of institutions and culture – is also evident in other scholarship, including Gay (2007) and Godard (2008). Such literature offers PKI a solid starting point for construction of an alternative to the WC.26 It is clear that this alternative will not be a new list of ‘essential’ and universally applicable reforms, but lessons can be learned to advance development scholarship and practice alike.27 Power In the first few decades after World War Two, John Kenneth Galbraith (1952; 1979) offered analyses of power that were integral to Institutional economics and appreciated by Post Keynesians (see, for example, Weintraub, 1978: 106; and Davidson, 1991: 83–92). Minsky (1990: 66) also recognized the importance of power; indeed, he made the balance of power between business managers and financial institutions a distinguishing characteristic of regimes of US capitalist development. More recently, Godard (2008: 73) stressed not only that institutional norms can give rise to power imbalances, but also that the interests of a society’s dominant groups are often embedded in the institutional status quo and thus ‘hidden from view or taken for granted’. Since the power and aims of social and economic interests influence a nation’s choice of policies, the development economics of PKI must also give consideration to power – including its domestic and international sources and dimensions, overt and covert uses, and consequences for economic performance and well-being. Economics must reveal, not conceal, power. Conventional economics, however, does indeed conceal power. It assumes that individual pursuits of selfinterest produce the greatest good for society overall, and then it uses that assumption to argue for economies to be ruled by the price mechanism except in cases involving market failure. But, as Institutional economist A. Allan Schmid (1999) argues in an essay entitled ‘Government, property, markets … in that order … not government versus markets’, there is no absolute freedom: individual pursuits of self-interest lead inevitably to conflicting freedoms.28 And those conflicts are resolved by government, which is shaped by economic and political power and embodies its decisions in the assignment of property rights.29 As Schmid (2008: 23) is fond of saying, ‘Freedom for the pike is death for the minnow.’ Thus, it is important to ask, ‘Where is the blood?’ In other words, whose interests matter? Investigating this question is a crucial part of Institutionalist analysis, and it must remain so in PKI.30 Participation Recognizing the role of economic and political power in shaping market outcomes, Commons understood that the price system offers no objective

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standard of economic value. He opted instead for what he called ‘reasonable value’, a measure of economic well-being determined by a process in which all stakeholders participate and resolve their differences on the basis of joint investigation and persuasion, not coercion. Thus, at the workplace and at all other levels of economic organization, including national policymaking, Commons saw the need for institutions (committees, commissions, stakeholder parliaments, and so on) that would provide room for such discussion and negotiated problem solving. In short, the participation of a wide range of economic voices – either directly or through representatives reflecting particular interests (such as workers, industry, farmers, finance, and so on) – is the cornerstone of Commons’s ‘negotiated economy’ and the key to arriving at reasonable value.31 From the perspective of contemporary PKI, such participation is also appropriate when it comes to formulating and assessing development policy. This view of PKI would not refuse the involvement of outside parties in an advisory capacity. For example, international financial institutions are one stakeholder group and, therefore, warrant some inclusion in a participatory process aimed at economic development in Latin America and elsewhere. But it is wrong to think that outsiders are any more objective than the inhabitants of a developing nation, or that outsiders’ policy ideas are inherently better informed or of a higher quality than those of the country’s residents (Gay, 2007).32 Indeed, there is a good chance that imposing a foreign approach will fail precisely because history and context matter and because people in different societies may have different goals and values.33 Drawing on fieldwork involving establishment of irrigation systems in the farming communities of developing nations, Elinor Ostrom (2008) – the 2009 Nobel recipient in economics – identifies a number of conditions likely to enhance the success of introducing institutional change aimed at improving development. Among her findings is that institutional adjustment most often yields successful results when those affected are participants in the changemaking process.34 Ostrom’s Institutionalist approach contrasts with the WC, where inattention to participation has often led to a ‘cookie-cutter approach’ to policy, despite Williamson’s occasional acknowledgment that specific policy principles must be adapted to local circumstances. What is missing in all variants of the WC is an emphasis on giving locals an opportunity to participate in that policy adaptation process.

CONCLUSION: EVOLUTION WITH FUNDAMENTAL CHANGE The Washington Consensus is still relevant, but economics and developing nations deserve a meaningful alternative. This chapter does not spell out all the

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details of that alternative, but it does identify elements that must be incorporated into the development economics of PKI: social goals, time, history and context, power, and participation. The result would be a richer development economics – evolution of the field with fundamental change.

ACKNOWLEDGEMENTS The authors thank Yan Liang for comments and suggestions. In addition, John Marangos is grateful to the University of Crete for providing a research grant, Small Grant Special Account for Research KA2969, which enabled him to present an earlier version of the chapter, as a sole author, with the title ‘Williamson’s retort to the critics: from the “after” to the “amended” Washington Consensus’ at the 2010 Conference of the History of Economic Thought Society of Australia in Sydney.

NOTES 1. 2.

3.

4.

5.

6.

While retaining a focus on inflation targeting, the IMF did increase its upper limit for inflation from 2 per cent to 4 per cent. Papers presented at that conference, held at the Institute for International Economics in Washington, DC, were compiled into a book edited by Williamson (1990), which is how the term ‘WC’ spread beyond the conference participants. According to Williamson, the reforms he identified were ‘practically universally agreed in Washington to be desirable in most Latin American countries’ (Williamson, 2004–05: 195). Williamson’s agenda is consciously restricted to economic issues, even as he recognizes the importance of other issues, ‘some of which (like national security) are also preconditions for economic prosperity and others which (like gender equality) demand their own reform agenda’ (Williamson, 1999: 2). Williamson (2003d: 2) believed Latin Americans had a right to feel disappointed with the outcome of their economic reforms. In 2001–02, there was no net increase in output at all, the worst performance since 1982–83, at the start of the debt crisis. Latin America remained the world champion of inequality (Navia and Velasco, 2003: 265). Thus, there was the need not only for an assessment of the past, but also for a new agenda for the future. In fact, Williamson’s twofold objective was to accelerate growth and improve income distribution. His new agenda also extended the debate over whether his recommendations were relevant only in Latin America or across the entire terrain of economic development. On the one hand, Williamson (2008a: 24) states: ‘Note that this new agenda, like the original Washington Consensus, was aimed specifically at Latin America at a particular moment of history, rather than claiming to be a text for all countries at all times as many critics have interpreted it to be’. On the other hand, he argues: ‘I need first to outline what our new strategy, presented in Kuczynski and Williamson, suggests (Latin American) countries ought to do’. (Williamson, 2004: 12). By placing Latin American countries in parentheses, Williamson caused some readers to wonder whether he was again implying a universal strategy for developing countries. While the WC did not stress crisis avoidance, it also did not compel countries to pursue the ‘foolish acts’ that led to the crisis (Williamson, 2003a: 328; Williamson, 2003d: 5). Nevertheless, Williamson also acknowledges that some bad policy guidance (though not strictly part of the WC) was indeed offered from Washington, including the recommendation

172

7.

8.

9. 10.

11. 12. 13. 14.

15.

16.

17. 18.

19.

Financial instability and economic security after the Great Recession of capital account liberalization (Williamson, 2003a: 328; Williamson, 2003c: 308). In Williamson’s second-generation reforms, the strengthening of institutions receives attention as a vital element that allows first-generation reforms to bear fruit (Williamson, 2002b: 3). Williamson (2003c: 329) admits that the original WC concentrated on policies, not institutions. But this merely reflects the state of mainstream economics in the late 1980s: the mainstream’s recognition of institutional reforms as an important element in economic development did not occur until the 1990s, after the original WC was fashioned. Williamson has consistently maintained that equating the WC with ‘neo-liberalism’ or ‘market fundamentalism’ is not accurate. Still, like the neoclassical version of Keynes’s macroeconomics, these interpretations persist (Davidson, 2004–05: 207). For a detailed analysis of the evolution and various meanings of the term ‘WC’, see Marangos (2009a). For a discussion the characterization of the WC as a neo-liberal manifesto, see Marangos (2009b: 200–205). Like the New Agenda, Williamson’s original WC was also not intended as ultimate truth – or as policy cookbook (Williamson, 2002b: 3; Williamson, 2004: 12; Williamson, 2004–05: 198). This is true even in the case of Argentina, which was widely regarded as the poster child for the WC (Williamson, 2003d: 2). Williamson (2003c: 320) accepts that there might be some situations favouring fixed rates, and dollarization is advised when the economy of the US has a dominant influence on a particular country. In 1997, Williamson (1997: 50–1) replaced ‘fiscal discipline’ with ‘high savings’. Completing first-generation reforms also underscores the need (previously mentioned as part of crisis-proofing) to supplement financial liberalization by strengthening prudential supervision. Of course, this recognition was not at all news to Institutionalists and Post Keynesians. Moreover, Williamson (2003b: 13; 2003d: 2) acknowledges that the term ‘second-generation reforms’ is a misnomer in that effective institutions are in many ways a prerequisite for liberalization, which suggests second-generation reforms ought to precede those of the first generation. Nevertheless, the generational reference does capture the actual chronology associated with development of these various reform proposals. Despite the New Agenda’s support for a national innovation system, going further to suggest an industrial policy that requires the government to ‘pick winners’ is considered a mistake (Williamson, 2008a: 27). For example, Williamson (2004: 17) writes: ‘While it may be right to leave the door slightly open for measures to subsidize investment, the fact is that I have yet to observe such measures – beyond competitive exchange rates and national innovation systems – that I would feel confident in recommending to other countries’. In a call for cost recovery, the New Agenda maintains university students should pay a substantial part of the cost of their education. Thus, Williamson argues that public expenditure on higher education should focus on providing students loans and on making scholarships available for the truly needy. He adds: ‘Middle-class students who riot against being charged for access to a lifetime of privilege are the true enemies of an assault on inequality, and they need to be told so’ (Williamson, 2003c: 315). As an alternative to free floating and firm fixity, Williamson (2004: 4) mentions ‘a competitive exchange rate (which implies an intermediate exchange rate regime dedicated to limiting misalignments)’. The insider-voucher privatization that occurred in Russia resulted in the appropriation of state assets for the benefit of the elite, which is not consistent with the goals of the WC. Williamson (2000: 256) criticized rapid privatization and was ‘skeptical about voucher privatization’. A well-conducted privatization process, consistent with the WC, would require competitive bidding to increase efficiency and improve public finances, thus providing benefits to all, including the poor. It is also difficult to sort out the main differences between the WC and ‘Post-WC’ by examining the literature. The reference point, ideas and proposals of the WC were produced as a result of the ‘dismal’ Latin American experience with state intervention, while the Post-WC was based largely on the East Asian ‘miracle’. Each side in this dispute had in mind historical experience not fully relevant to other regions. Still, when one looks beyond the context-

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20.

21.

22. 23. 24.

25.

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specific aspects, it appears that the differences between these camps amount not to blackand-white contrasts, but rather to different shades of grey. In 2004, José Antonio Ocampo (2004–05: 294), Under-Secretary General for Economic and Social Affairs of the United Nations, expressed a similar view: ‘Going “beyond the Washington Consensus” does not mean adding more areas of reforms to fill in the gaps of the original consensus, but rather overcoming the “reform fetishism” that has become deeply embedded in the development debate’. By themselves, these elements do not constitute a full-blown PKI alternative; they are merely concepts that are neglected by conventional development economics and that limit the real-world applicability of the WC (in all its variants). For a volume that takes Institutional economics as its starting point and nicely weaves norms, organization, regulation, capacity and incentives into an institutional matrix for economic development, see Stein (2008). For a more extensive discussion of social goals and their role in economic development in the case of transition economies, see Marangos (2004). Wilber and Jameson (1983: 5) build explicitly on the work of Denis Goulet, a specialist in economic and social development; see, for example, Goulet (1975; 1995). For the reader looking for universal social goals, there is perhaps no better starting point than the Universal Declaration of Human Rights, adopted by the United Nations in 1948, available at http://www.un.org/en/documents/udhr/ (accessed 3 September 2010). Moreover, for a classic work on the need to subordinate the economic system to social objectives, see Polanyi (1944), and for an application of that volume’s ideas to the international economic arena, see McClintock (1996). Here is an example of how Amsden’s ‘historical trade-off’ approach offers insight not found via the conventional, ‘market failure’ approach: A historical trade-off approach gives emulating countries: (1) a way of selecting the most appropriate country model to follow, based on a comparison (at the outset of growth) of their own existing endowments of competitive assets and those of different successful countries, and (2) a way of estimating the alternatives to government subsidization of learning if the existing competitive assets of emulating countries are insufficient to compete in world markets in labor-intensive (or raw-material-intensive) industries. (Amsden, 1996: 258)

Meanwhile, on pitfalls to avoid in the course of country-model transfer, see Amsden (1996: 251–2). 26. Although Godard (2008: 70–3) focuses on the study of employment-relations systems, he offers an ‘institutional-environments approach’ applicable to development economics. In particular, his approach has seven tenets: (1) ‘Social and economic actors do not behave as isolated entities, rationally pursuing innate needs or interests in an institutional vacuum, but are instead part of a broader community of actors subject to institutionalized rules’. (2) ‘Rules are embedded not just in behavior, but also in the economic, social, and political institutions or arrangements that constitute and are constructed by this behavior, including market and financial structures, state agencies, legal structures, education and training systems, and others’. (3) ‘Institutions tend to be complementary, comprising distinctive variants of capitalism’. (4) ‘Institutional environments shape (and are shaped by) the orientations and identities of the actors and the relationships between them’. (5) Nation-state paradigms play an important role in shaping institutional environments and the rules that underpin them’. (6) ‘National paradigms reflect, and can to a considerable extent be explained by, the conditions under which a modern nation was formed as a modern nation. These conditions and discourses around them give rise to deeply embedded “institutional norms”, or beliefs, values, and principles as to the role, rationale for, and legitimacy of established institutions’. (7) ‘Institutional norms and the arrangements associated with them may be seen to give rise to and perpetuate mobilization biases … that privilege one or more groups or institutions over others’.

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27.

While it is true that PKI will not generate a ‘Ten Commandments’ list like the WC, there are useful policy insights to be found in the Institutionalist and Post Keynesian literature; see, for example, Gnos and Rochon (2004–05); Palley (1999); Chang and Grabel (2005); Marangos and Astroulakis (2009); Marangos (2000–01; 2003); Street (1987); and Jameson (2003). 28. In Capitalism and Freedom, Milton Friedman (1982: 25–6) concedes there can be no absolute freedom. He writes: ‘As a Supreme Court Justice once put it, “My freedom to move my fist must be limited by the proximity of your chin” ’. 29. For a discussion of how institutional investors exert power and influence government on a global scale, see the chapter by Liang (Chapter 10) in this volume; see also Johnson (2009). 30. In contrast to the notion of the ‘corrective’ state found in conventional economics, there is the notion of the ‘creative’ state at the heart of PKI. The corrective state steps in to fix problems caused by market failure, while the creative state is deeply involved in shaping the economy and in defining and securing socio-economic order. For more on this, see Whalen (2008). 31. For a clear and concise summary of Commons’s view on reasonable value and the participative processes of problem solving and policymaking, see Ramstad (1991: 432–5). 32. In the case of outsiders (foreign ‘experts’) as well as insiders (developing-country residents), a useful ingredient in policymaking is, of course, reflexivity: ‘having an open mind’ and looking critically at a project (Gay, 2007: 95). 33. As Daniel Gay (2007: 97) writes, ‘Not all inhabitants of developing countries aspire to the same goals as those within developed nations: the Washington policymaker has [or at least may very well have] different ideas of the good life from the South Pacific subsistence farmer’. 34. Ostrom (2008: 68), quoting development sociologist Peter Evans, notes that the ‘dominant method of trying to build institutions that will promote development is to impose uniform institutional blueprints on countries of the global South – a process which I call “institutional monocropping”’. Based on her own experience, Ostrom adds: Institutional monocropping generates systems that have very little variety in their formal rules in environments with substantial variety in the ecological regions in which they are situated. While expert knowledge can be a great asset in the design and implementation of local resource systems, simply imposing a uniform set of formal rules and ignoring local ecological and social knowledge does not produce the variety needed to learn from experience. (Ostrom, 2008: 68) She also writes: ‘Even worse than the initial problems of having the wrong institutions imposed almost everywhere [due to institutional monocropping] is the “lock in” that can occur when powerful individuals gain advantage from such institutions leading to major problems of path dependence. The powerless and helpless are the ones who pay the big costs’ (Ostrom, 2008: 68).

REFERENCES Amsden, Alice (1996), ‘Late industrialization: can more countries make it?’, in Charles J. Whalen (ed.), Political Economy for the 21st Century: Contemporary Views on the Trend of Economics, Armonk, NY: M.E. Sharpe, pp. 245–64. Atkinson, Glen W. and Ted Oleson (1996), ‘Institutional inquiry: the search for similarities and differences’, Journal of Economic Issues, 30 (3), 701–18. Bergsten, C. Fred (2003), ‘Preface’, in Pablo Pedro Kuczynski and John Williamson (eds), After the Washington Consensus: Restarting Growth and Reform in Latin America, Washington, DC: Institute for International Studies, pp. vii–viii.

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Birdsall, Nancy, Augusto de la Torre and Rachel Menezes (2001), Washington Contentious: Economic Policies for Social Equity in Latin America, Washington, DC: Carnegie Endowment for International Peace and Inter-American Dialogue. Blanchard, Olivier, Giovanni Dell’Ariccia and Paulo Mauro (2010), ‘Rethinking macroeconomic policy’, International Monetary Fund staff position note SPN/09/10, 12 February, Washington, DC. Brown, Christoper (2008), Inequality, Consumer Credit, and the Saving Puzzle, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Chang, Ha-Joon and Ilene Grabel (2005), ‘Reclaiming development from the Washington Consensus’, Journal of Post Keynesian Economics, 27 (2), 273–91. Davidson, Paul (1991), Controversies in Post Keynesian Economics, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Davidson, Paul (2004–05), ‘A post Keynesian view of the Washington Consensus and how to improve it’, Journal of Post Keynesian Economics, 27 (2), 208–30. Friedman, Milton (1962), Capitalism and Freedom, Chicago. IL: The University of Chicago Press. Galbraith, John Kenneth (1952), American Capitalism: The Concept of Countervailing Power, Boston. MA: Houghton Mifflin. Galbraith, John Kenneth (1979), ‘The valid image of the modern economy’ and ‘Power and the useful economist’, in Annals of an Abiding Liberal, New York: Meridian, pp. 3–19, 353–71. Gay, Daniel (2007), ‘Modernism, reflexivity and the Washington Consensus’, Journal of Economic Methodology, 14 (1), 83–105. Goulet, Denis (1971), The Cruel Choice: A New Concept in the Theory of Development, New York: Atheneum. Goulet, Denis (1995), Development Ethics: A Guide to Theory and Practice, New York: Apex Press. Gnos, Claude and Louis-Phillippe Rochon (2004–05), ‘The Washington Consensus and multinational banking in Latin America’, Journal of Post Keynesian Economics, 27 (2), 315–31. Godard, John (2008), ‘An institutional environments approach to industrial relations’, in Charles J. Whalen (ed.), New Directions in the Study of Work and Employment, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 68–88. Hailu, Degol (2009), ‘Is the Washington Consensus dead?’, Centre for Inclusive Growth international policy one pager no. 82, Brasilia, Brazil. Jameson, Kenneth P. (2003), ‘Dollarization in Latin America: wave of the future, or flight to the past?’, Journal of Economic Issues, 37 (3), 643–64. Johnson, Simon (2009), ‘The quiet coup’, The Atlantic, (May) 46–57. Keynes, John Maynard (1932), Essays in Persuasion, New York: Harcourt, Brace and Company. Keynes, John Maynard (1936), The General Theory of Employment, Interest and Money, London: Macmillan. Klein, Philip A. (1980), ‘Confronting power in economics’, Journal of Economic Issues, 14 (4), 871– 96. Kuczynski, Pablo Pedro (2003), ‘Setting the stage’, in Pablo Pedro Kuczynski and John Williamson (eds), After the Washington Consensus: Restarting Growth and Reform in Latin America, Washington, DC: Institute for International Studies, pp. 21–32. Kuczynski, Pablo Pedro and John Williamson (2003), After the Washington Consensus: Restarting Growth and Reform in Latin America, Washington, DC: Institute for International Studies.

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Marangos, John (2000–01), ‘A post Keynesian view of transition to market capitalism: developing a civilized society’, Journal of Post Keynesian Economics, 23 (2), 301–11. Marangos, John (2003), ‘Price liberalization, monetary, and fiscal policies for transition economies: a post Keynesian perspective’, Journal of Post Keynesian Economics, 25 (3), 449–69. Marangos, John (2004), Alternative Economic Models of Transition, Aldershot, UK: Ashgate. Marangos, John (2009a), ‘The evolution of the term “Washington Consensus”’, Journal of Economic Surveys, 23 (2), 350–85. Marangos, John (2009b), ‘What happened to the Washington Consensus? The evolution of international development policy’, Journal of Socio-Economics, 38 (1), 197–208. Marangos, John and Nikos Astroulakis (2009), ‘The institutional foundation of development ethics’, Journal of Economic Issues, 43 (2) 381–8. McClintock, Brent (1996), ‘International trade and the governance of global markets’, in Charles J. Whalen (ed.), Political Economy for the 21st Century: Contemporary Views on the Trend of Economics, Armonk, NY: M.E. Sharpe, pp. 225–44. Minsky, Hyman P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Minsky, Hyman P. (1990), ‘Schumpeter: finance and evolution’, in Arnold Heertje and Mark Perlman (eds), Evolving Technology and Market Structure: Studies in Schumpeterian Economics, Ann Arbor, MI: University of Michigan Press, pp. 51–74. Minsky, Hyman P. (1992), ‘The capital development of the economy and the structure of financial institutions’, The Levy Economics Institute of Bard College working paper no. 72. Minsky, Hyman P. (1996), ‘Uncertainty and the institutional structure of capitalist economies: remarks upon receipt of the Veblen-Commons Award’, Journal of Economic Issues, 30 (2), 357–68. McKinley, Terry (2010), ‘Has the IMF abandoned neo-liberalism?’, Development Viewpoint, No. 51, 1–2. Naim, Moses (1994), ‘Latin America: the second stage of reforms’, Journal of Democracy, 5 (4), 32–48. Navia, Patricio and Andrés Velasco (2003), ‘The politics of second-generation reforms’, in Pablo Pedro Kuczynski and J. Williamson (eds), After the Washington Consensus, Washington, DC: Institute for International Studies, pp. 265–303. North, Douglass (1994), ‘Economic performance through time’, American Economic Review, 84 (3), 359–68. Ocampo, Jose Antonio (2004–05), ‘Beyond the Washington Consensus: what do we mean?’, Journal of Post Keynesian Economics, 27 (2), 293–314. Ostrom, Elinor (2008), ‘Developing a method for analyzing institutional change’, in Sandra S. Batie and Nicholas Mercuro (eds), Alternative Economic Structures: Evolution and Impact, London: Routledge, pp. 48–76 Palley, Thomas I. (1999), ‘Toward a new international economic order, goodbye Washington Consensus, hello Washington Alternative’, Dissent, (Spring), 48–52. Polanyi, Karl (1944), The Great Transformation, Boston, MA: Beacon Press. Ramstad, Yngve (1991), ‘John R. Commons’ reasonable value and the negotiated economy of Denmark’, Journal of Economic Isssues, 25 (2), 431–9. Schumpeter, Joseph A. (1942), Capitalism, Socialism and Democracy, New York: Harper and Brothers.

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Schmid, A. Allan (1999), ‘Government, property, markets…in that order…not government versus markets’, in Nicholas Mercuro and Warren J. Samuels (eds), The Fundamental Interrelationship Between Government and Property, Stamford, CT: JAI Press, pp. 223–37. Stanfield, James Ronald (2006), ‘From OIE and NIE toward EE’, Journal of Economic Issues, 40 (2): 249–59. Stein, Howard (2008), Beyond the World Bank Agenda: An Institutional Approach to Development, Chicago, IL: University of Chicago Press. Street, James (1987), ‘The institutionalist theory of economic development’, Journal of Economic Issues, 21 (45), 1861–88. Tavasci, Daniela and Jan Toporowski (2010), Minsky, Crisis and Development, London: Palgrave Macmillan. Weintraub, Sidney (1978), Capitalism’s Inflation and Unemployment Crisis: Beyond Monetarism and Keynesianism, Reading, MA: Addison-Wesley. Whalen, Charles J. (2008), ‘Toward “wisely managed” capitalism: post-Keynesian institutionalism and the creative state’, Forum for Social Economics, 37 (1), 43–60. Whalen, Charles J. (forthcoming), ‘Minsky goes to Buffalo – and takes on the economics establishment’, Forum for Social Economics. Wilber, Charles K. and Kenneth P. Jameson (1983), An Inquiry into the Poverty of Economics, Notre Dame, IN: University of Notre Dame Press. Williamson, John (1990), Latin American Adjustment: How Much Has Happened?, Washington, DC: Institute for International Economics. Williamson, John (1997), ‘The Washington Consensus revisited’, in Louis Emmerij (ed.), Economic and Social Development into the XXI Century, Washington, DC: Inter-American Development Bank, pp. 48–61. Williamson, John (1999), ‘Economic reform: content, progress, prospects’, presentation to the 50th Anniversary Celebration of the University of Baroda, India, 23 November. Williamson, John (2000), ‘What should the World Bank think about the Washington Consensus?’, The World Bank Research Observer, 15 (2), 251–64. Williamson, John (2002a), Review of Globalization and its Discontents, Washington, DC: Institute of International Economics. Williamson, John (2002b), ‘Did the Washington Consensus fail?’, outline of remarks delivered at the Centre for Strategic and International Studies, 6 November, Washington, DC. Williamson, John (2003a), ‘Our agenda and the Washington Consensus’, in Pedro Pablo Kuczynski and John Williamson (eds), After the Washington Consensus, Washington, DC: Institute for International Studies, pp. 323–31. Williamson, John (2003b), ‘From reform agenda to damaged brand name’, Finance and Development, 40 (3), 10–13. Williamson, John (2003c), ‘Summing up’, in Pedro Pablo Kuczynski and John Williamson (eds), After the Washington Consensus, Washington, DC: Institute for International Studies, pp. 305–21. Williamson, John (2003d), ‘An agenda for restarting growth and reform’, in Pedro Pablo Kuczynski and John Williamson (eds), After the Washington Consensus, Washington, DC: Institute for International Studies, pp. 1–19. Williamson, John (2004), ‘The Washington Consensus as policy prescription for development’, a lecture in the series ‘Practitioners of Development’, delivered at the World Bank, 13 January, Washington, DC. Williamson, John (2004–05), ‘The strange history of the Washington Consensus’, Journal of Post Keynesian Economics, 27 (2), 195–206.

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Williamson, John (2008a), ‘A short history of the Washington Consensus’, in Narcis Serra and Joseph Stiglitz (eds), The Washington Consensus Reconsidered: Towards a New Global Governance, Oxford: Oxford University Press, pp. 14–30. Williamson, John (2008b), ‘Letter: the Spence Commission and the Washington Consensus’, Economists’ Voice, 5 (4), 1–2. Zalewski, David A. and Charles J. Whalen (2010), ‘Financialization and income inequality: a Post Keynesian Institutionalist analysis’, Journal of Economic Issues, 47 (3), 757–78.

9. Money-manager capitalism, capital flows and development in emerging market economies: a Post-Keynesian Institutionalist analysis Yan Liang INTRODUCTION Conventional economic theory holds that capital flows from developed countries to developing countries generate significant benefits for the latter. These benefits primarily include better access to capital and more efficient capital allocation. However, reverse resource transfers from developing countries to developed countries provide an empirical challenge to this theory. That is, emerging market economies (EMEs) as a whole have been net exporters of capital. In addition, volatile capital flows have been associated with increased severity and frequency of financial crises in EMEs. Financial fragility and instability caused by free capital flows significantly undermine the efficacy of capital allocation. Despite that sobering reality, mainstream economists continue to advocate financial liberalization, adding only a few conditions such as getting the sequencing right or building the necessary ‘threshold’ levels of financial and institutional development (Fischer, 1998; Summers, 2000; Mishkin, 2006).1 And a recent effort by mainstream economists to justify financial liberalization focuses on the indirect benefits of capital flows. According to Kose et al. (2006), the most significant benefit of free capital flows is not that they provide development financing, but that capital flows contribute to favourable institutional changes in EMEs. These indirect effects, dubbed ‘collateral benefits’, include financial market development, institutional development, better corporate governance, and macroeconomic ‘discipline’. These indirect effects, in turn, increase total factor productivity growth and reduce consumer volatility, thus promoting long-term growth. Although the attempt to consider the institutional impacts of capital flows is laudable, mainstream economists have failed to depart significantly from the flawed efficient-market theory and the advocacy of capital liberalization. One 179

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major defect of their theory is that it ignores the evolving nature of the capitalist system in the advanced capitalist countries, where private capital is seeking investment opportunities in EMEs. In particular, establishment of money-manager capitalism (MMC) in the advanced countries has affected the types and features of private capital flows, which in turn has affected the recipient EMEs. This chapter examines the rise of MMC and the major characteristics of private capital flows to EMEs from the countries where MMC prevails. It also explores the impact of those flows on financial development, market volatility, and macroeconomic discipline in EMEs. What emerges is a critique of the conventional view of theory and policy on capital flows and development. This critique is informed by – and extends – the insights of Post-Keynesian Institutionalism (PKI) and points to closer regulatory scrutiny of global money managers. PKI draws inspiration not only from the tradition spawned by Thorstein Veblen and John R. Commons, but also from John Maynard Keynes and his associates and intellectual heirs such as Joan Robinson (Whalen, 2008).2 Minsky is a central figure in PKI, not only because of his work on the growing importance of money managers or institutional investors, but also as a result of his investigations of financial instability and business cycles. However, Minsky focused primarily on the US economy, even as he recognized the global reach of MMC. Thus, the chapter employs the MMC framework, but looks at institutional investors operating on a worldwide playing field. It also underscores money managers’ short-term horizons, as well as momentum trading, herding, and the collateral damage associated with reduced policy autonomy in EMEs.

MONEY-MANAGER CAPITALISM AND GLOBAL INSTITUTIONAL INVESTORS Capitalism is an evolving and complex social system. Since the 1970s, a process of financialization has been accelerating in western advanced capitalist countries.3 MMC, emergent since 1946, has consequently developed into a fully-fledged system (Minsky, 1996).4 According to Hyman Minsky – the notion’s originator – and contemporary PKI, there are several defining features of the MMC system. Those that interest us the most include the rise of institutional investors and the new layer of intermediation they add to the financial system. Institutional investors include pension funds, mutual funds, hedge funds, private equity, insurance companies, and other forms of managed money.5 In MMC, ‘the proximate owners of a vast proportion of financial instruments are mutual and pension funds’ (Minsky, 1996: 358). In the past decade or so, institutional investors have grown tremendously in

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Organisation for Economic Co-operation and Development (OECD) countries and exerted sweeping influence on the world’s economies. According to the OECD (2008), assets under institutional management in 17 OECD countries increased from $21.3 trillion to $40.3 trillion between 1995 and 2005 (measured in constant, US year-2000 dollars), a whopping 89 per cent increase; and the asset to gross domestic product (GDP) ratio increased from 110 per cent to 126 per cent. At the end of 2008, even after the losses caused by the global financial crisis, $61.6 trillion in assets were under institutional management worldwide – a 50 per cent increase over the level of assets managed at the end of the 1990s (see Figure 9.1).6 With the trend growth in assets, institutional investors have increasingly pursued active investment strategies. Take, for example, the case of US and UK pension funds. More than 50 years ago, following the ‘prudent man’ principle, pension-fund managers invested most of their assets in fixed income instruments that are typically safe, such as government and corporate securities. Today, however, pension funds are much more willing to take risks and invest in corporate stocks, real estate and commodity futures. In 2008, 79 per cent of institutional assets in the UK were under active management that sought above-the-market returns (Investment Management Association, 2009). There are many factors that led to the heightened preference for risk by institutional investors. At the macro level, price instability in the 1970s rendered fixed income investment undesirable, and continuous financial innovations opened up many novel and seemingly lucrative investment venues. At 80 70

$ million

60 50 40 30 20 10 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Note: Includes pension, mutual and insurance funds. Source: International Financial Services (2009).

Figure 9.1

Global fund management of conventional assets, 1999–2008

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the micro level, profit maximization motives and competitive pressures have driven fund managers to take on greater risks for higher returns. In addition to growing in size and evolving in the direction of riskier fund management, the money management industry is also becoming more concentrated. According to a survey conducted by Pensions and Investments in the mid-1990s, among more than 2000 funds (managed by banks, trust companies and investment advisors), the top five funds had a market share of 20 per cent and the top 20 had a market share of 40 per cent (Bloomestein, 1998). By the first quarter of 2009, the five largest funds accounted for 31 per cent of the market share whereas the top ten funds took up more than 66 per cent of the market share (Pensions and Investments, 2009). It is projected that advances in information technology, the increasing need to make large investments, and intensifying competition will lead to a small number of mega firms (assets of $100 billion or more) and specialist boutiques, thus eliminating mid-sized firms (Global Investment, 1996). The growth of institutional investors has had a far-reaching influence on the financial industry (Bloomestein and Funke, 1998), the production sector (Brown, 1998), and households (Broadbent et al., 2006) within OECD countries. But their impact extends far beyond their countries of origin. Since the late 1970s, institutional investors have replaced banks in dominating cross-border portfolio flows. International investments by institutional investors have accelerated since the 1980s and especially the 1990s, during which 50 per cent of capital flows to EMEs were portfolio flows of institutional investors (the rest included mainly direct investment or official flows) (Davis and Steil, 2001: 301). As shown in Table 9.1, portfolio inflows to EMEs were volatile in the late 1990s and the early 2000s; but portfolio inflows grew rapidly after 2002, from a trough of –$5.4 billion to $421 billion as of 2007. The share of total private inflows accounted for by portfolio inflows (most undertaken by institutional investors) also increased, almost reaching the same share as foreign direct investment (Figure 9.2). However, the recent global financial crisis caused a significant decline in portfolio inflows, from $421.1 billion in 2007 to $12.7 billion in 2008, before they rebounded to $196.7 billion in 2009. There are four main causes of the rising international investment by institutional investors. First, macroeconomic conditions in EMEs have stabilized and greatly improved since the Latin American debt crisis of the 1980s, boosting the confidence of institutional investors. Second, capital liberalization in EMEs, coupled with technological innovations in telecommunications, provided the possibility of large-scale, cross-border investments. Third, declining returns in OECD mature markets drove institutional investors to look to EMEs for higher returns. Fourth, as managed assets kept growing, it became increasingly difficult to diversify within mature markets.

Table 9.1 Global capital inflows to emerging market economies, 1997–2007 (in billions of US dollars)

183

Direct investment Portfolio investment Other investment

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

184.8 33.4 –14.6

169.9 30.5 28.3

182.6 2 1.7

173 –5.4 8.7

174.5 57.1 75.1

251.5 109.5 105

337.5 179.9 121.7

420.8 297.7 189.9

615.9 421.1 693.7

695.4 12.7 148

410.7 196.7 63.3

Note: Other investment includes bank loans and deposits. Source:

International Monetary Fund (2010).

Per cent

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Financial instability and economic security after the Great Recession 100 90 80 70 60 50 40 30 20 10 0 –10

Direct investment Portfolio investment Other investment

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: International Monetary Fund (2010).

Figure 9.2 Shares of components of capital inflows to emerging market economies, 1999–2009 International investments by institutional investors have a significant bearing on the EMEs, even though these investments may account for still only a small proportion of funds managed by institutional investors.7 There is scant Step 1

Step 2

Step 3

Step 4

Market share of emerging market mutual funds

Additional market share of worldwide invested mutual funds

Additional market share of all other forms of institutional investors

Effect of the relevant market, i.e. free float, is only 50–75% of the total capitalisation increase of 33–100%

increase of 50%

Result Estimated market share

39%

increase of 30%

5–10%

13%

Source: Frenkel and Menkhoff (2004: 1277, Figure 2).

Figure 9.3 Estimate of market share of foreign institutional investors in emerging markets

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comprehensive data on foreign institutional ownership in EMEs, but based on a reasonable estimate (Frenkel and Menkhoff, 2004), the share of assets managed by foreign institutional investors in EMEs at the end of the 1990s was about 26 per cent of the total assets, as shown in Figure 9.3. This suggests that institutional investors have established a significant presence in the EMEs.8

INSTITUTIONAL INVESTORS, PORTFOLIO FLOWS AND FINANCIAL DEVELOPMENT Mainstream economists argue there are three main reasons why the entry of large foreign institutional investors into EMEs enhances the financial development of those nations. First, pension funds and insurance companies typically pull together resources on the scale EMEs need to facilitate major, long-term undertakings. Second, institutional investors enhance the efficiency of capital allocation because their size provides a major advantage over individual investors gathering and processing information. Third, institutional investors help stabilize financial markets in EMEs through investment diversification and active trading, which reduce risks and increase liquidity. Unfortunately, these claims fail to meet both theoretical and empirical tests. Institutional investors have been found to play an important role in creating the 1992 European Economic and Monetary Union crisis, the 1994 Mexican peso crisis, the 1997 Asian financial crisis (Harmes, 2001), and the current global financial crisis (Lo, 2008). Some important features and behaviour of institutional investors render them a source of instability and inefficiency in financial markets. ‘Short-Termism’ It is often claimed that investment by pension funds and life insurance companies is based on a long-term horizon. This is because they have a long-term liability structure and low risks of premature withdrawal of funds, which allow them to follow a buy-and-hold strategy (Davis, 2000). However, it is important to note that many institutional investors are generally short-term oriented, especially mutual and hedge funds, to which pension funds increasingly delegate asset management. In the US, for example, other financial institutions – notably pension funds – have been found to hold 30 per cent of mutual fund shares (Davis and Steil, 2001: 17), and pension funds in the UK significantly increased their allocation to hedge funds in 2004 (Pazarbasioglu, Goswami and Ree, 2007). Therefore, even if the assets managed by pension and insurance funds are long-term, the management of those assets may be based on a short-term horizon.

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A growing literature documents the short-term focus of institutional investors. Some authors emphasize the incentive structures and competitive pressures faced by the fund managers. These managers are usually evaluated according to short-term performance, typically measured quarterly or over an even shorter period. As Lukas Menkhoff (2002: 913) writes, ‘[E]ven if customers receive detailed reports only on a quarterly or half-yearly basis, responsible fund managers and their superiors are informed about the running performance on a daily basis’. Bad performance relative to a benchmark or other managers would mean redemption or the threat of redemption. Therefore, competitive pressures force fund managers to focus on the short run. Remuneration of mutual and hedge fund managers is based largely on the size of assets managed. Boosting short-term performance and attracting an inflow of funds means more handsome returns. Although many authors attribute this ‘short-termism’ to the principal–agent problem, (that is, owners of the funds are long-term oriented, but the managers are short-term leaning), it is an overstatement to suggest that the owners of fund assets do not care about short-term performance. After all, owners are the ones that pose the redemption threat. Moreover, when superb short-term fund performance attracts new investors, the existing owners of the fund benefit from the reduction in investment costs. The high leverage of mutual and pension funds (that is, investing with borrowed funds to amplify shareholder investments) also forces the fund managers to focus on short-term performance (Harmes, 1998). Thus, even fund managers who believe that their investments are sound in the long run could be obliged to sell positions in the event that bad short-term performance devalues assets bought with borrowed money and triggers margin calls.9 Further, institutional investors must pay their creditors (usually banks) ‘per period’ fees when they borrow money or securities to enter a position; thus, the costs of leverage can become prohibitive when assets are carried over the long term. Therefore, the structure of transaction costs ‘induces a strong bias toward short horizons’ (Andrei Shleifer and Lawrence Summers, quoted in Harmes, 1998: 104). Information Quality Short-termism not only undermines the often claimed benefits of ‘patient’ investment by institutional investors, but also reduces the incentives of institutional investors to collect, process, and use information on the long-term performance of investment projects. As reported by Menkhoff (2001), a survey of 45 fund managers indicates that their ‘endurance horizon’ (how long a position is held) is short relative to their ‘anticipation horizon’ (how far in the future news regarding economic ‘fundamentals’ is considered). This suggests

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that even institutional investors with private information allowing them to reap high long-run returns would have trouble using that information when markets behave differently in the short run. As Menkhoff (2002: 914) writes, investors ‘have to justify their investment decisions so frequently that they run into problems trying to follow any private information if the markets do not share their view at a given time’. There are at least two other factors that also undermine the purportedly efficient use of information by institutional investors. One involves the peculiar feature of information in EMEs. As Frenkel and Menkhoff (2004) observe, information in EMEs is usually based on personal experience; it is rarely anonymous. This is different from the publicly available, ‘reliable’ information institutional investors are accustomed to using. Because of the importance of local knowledge, local investors have an advantage over foreign institutional investors in compiling and analyzing information on EMEs, even though the latter usually have better technology at their disposal for processing information. This suggests that the entry of foreign institutional investors would, in fact, lower the overall quality of information regarding investment in EMEs. The other factor concerns the fact that institutional investors often take emerging markets as one separate asset class. Institutional investors usually begin by determining the share of their portfolio to allocate to EMEs as a whole then allocate it to individual countries within the asset group. Fund managers are usually general experts in emerging markets, uninformed about the details of individual countries.10 Therefore, it is dubious that foreign institutional investors have informational advantages and enhance the quality of information in EMEs.

MARKET VOLATILITY It is often argued that institutional investors undertake sound risk management (through hedging, diversifying and insuring their investments) and hence help spread and reduce risks in financial markets. In this way, such investors are considered an important transmitter of the ‘collateral benefits’ of global capital flows. But it is important to note that, on the one hand, many institutional investors tend to take on excessive risks and, on the other hand, ironically, risk management techniques that reduce risks for individual institutional investors may in fact increase systemic risks. Risk Management and Derivatives Excessive risk-taking may be contained for some institutional investors, such as managers of defined-benefit pension funds, where minimum funding or

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solvency requirements are imposed. In general, however, competitive pressures and tactical asset allocation techniques encourage institutional investors to take on more risks. Because fund owners tend to favour the best-performing funds with new inflows, and owners are often slow to flow out of underperforming funds (the so-called ‘uphill’ bias) (Brown et al., 1996), there are incentives for mutual fund managers to take more risks when their investment performance is poor (Bogle, 1998; Menkhoff, 2002). Moreover, institutional investors usually manage their risks by relying on a heavy use of derivatives. Derivatives were developed in the 1980s and were designed mainly to meet the needs of international banking (such derivatives include instruments such as swaps, forward-rate agreements, interest rate options and short-term interest rate futures).11 However, they have more recently been oriented towards the needs of institutional investors (instruments such as programme trading index options and futures). Meanwhile, institutional investors from advanced countries tend to press foreign markets to adopt innovations they use at home. The result has been an expansion in the use of derivatives (Davis and Steil, 2001: 241). There are three main reasons why the use of derivatives may in fact intensify risk levels in an economy, even if it helps reduce idiosyncratic risks faced by individual institutional investors. First, derivatives make separate markets much more tightly connected than they otherwise would have been. When a mutual fund manager purchases a currency forward contract to hedge her investment in the foreign bond market, she helps connect the foreign exchange market and the bond market whereby disturbances in one market would be transmitted to the other. Second, it is well documented that derivatives are often used to mask risks involved in an investment, especially to evade regulations. As Lillian Chew (quoted in Kregel, 1998: 679) writes, ‘Structured notes are the epitome of how investment technology helped and continues to help money managers circumvent guidelines that were framed to protect the interest of small, unsophisticated investors ….’ Without proper, systemic regulations, investors tend to downplay systemic risks and engage in excessively risky projects. Third, the use of derivatives typically improves the capacity of institutional investors to increase leverage because capital adequacy requirements do not reach off-balance-sheet derivatives. That is, derivatives allow investors to commit little of their own capital and still take large positions. As a result, return over equity is multiplied when investors gain, but losses can also be large enough to overwhelm the capacity of the investors to absorb them with their own capital. Trading Behaviour Looking beyond risk management, it is argued that trading by institutional investors provides liquidity to the fledgling emerging markets and hence stabi-

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lizes and accelerates the development of their financial markets. Although institutional investors do not offer liquid liabilities like banks do, they demand liquidity and help to generate it through their own arbitrage, trading and diversification. Moreover, it is argued that institutional investors possess a form of countervailing power, which can be used to press EMEs for more transparent public disclosure systems, market-oriented accounting, reliable clearing and settlement facilities, and deregulation, all of which are said to encourage more efficient trading and reduce price volatility (Davis, 2000). However, the large amount of trading by institutional investors is not always based on investors’ private information or rational reallocation of portfolios. Rather, frequent trading could be because most funds are actively managed and simply cannot be held unchanged for a long time. In addition, institutional investors have an incentive to generate high turnover simply to show their superior management skills (Menkhoff, 2002) and to earn exorbitant fees for managing the reallocation of portfolios. Therefore, trading by institutional investors may in fact worsen volatility. As Sias (1996) shows, there was a positive contemporaneous relation between institutional ownership and securities market volatility after controlling for capitalization. Two other notable trading strategies adopted by institutional investors intensify market volatility. The first strategy is dubbed momentum trading. Presumably, if financial markets are efficient and asset prices reflect the ‘fundamentals’ (the long-term capacity of the asset to generate income flows), then institutional investors who trade based on fundamentals rather than market whims should buy undervalued assets and sell overvalued assets, the so-called contrarian trading, which would thereby stabilize asset prices. However, institutional investors are found to engage in momentum trading (Borensztein and Gelos, 2003; Kaminsky, Lyons and Schmukler, 2004); that is, they buy past winners and sell assets that performed poorly in the recent past. Momentum trading creates the potential for market overreaction and price overshooting because asset prices may further deviate from their ‘fundamentals’ due to the demand pressure generated by institutional investors. Moreover, because of their sizeable trading, institutional investors may help to generate a ‘reflexive’ bubble (Soros, 1987) or ‘displacement’ (Minsky, 1982), where the ‘fundamentals’ are affected and reshaped by the trading itself. It is possible that momentum trading is justified by a rational analysis of the ‘fundamentals’, but it is equally likely that it is a deliberate decision to ignore fundamentals. Knowing their influence, institutional investors may shape investors’ expectations through their own trading. Therefore, instead of arbitraging against noise traders to move asset prices towards the ‘centre of gravity’, institutional investors can in fact manipulate noise traders to create a rising trend of asset prices and then unexpectedly sell out their positions at the high point before the bubble collapses.

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The other trading strategy is herding, which refers to ‘a group of investors trading in the same direction over a period of time’ (John Nofsinger and Richard Sias, quoted in Menkhoff, 2002: 922). A stable market is one where a large number of investors hold diverse expectations. Herding increases volatility because the market is heavily tilted towards the buying or selling side, causing large swings in asset prices. While it is possible that institutional investors are less likely to engage in herd trading than individual investors due to their superior knowledge, it is also the case that herding can be much more destructive in a world with institutional investors. There are two reasons for this. First, large-scale selling (or buying) by institutional investors may easily overwhelm the available liquidity in a market, which may lead to cascading sales, price discontinuities and market crashes. Second, institutional investors are usually considered market-savvy and their investment strategies and behaviour are often imitated. This suggests there would be little counterbalancing activity by other market participants that would dampen the direction of trading. A well-known example of institutional trading causing market volatility is the 1987 stock market crash in the US, which has been blamed on institutional investors’ portfolio insurance and index arbitrage. The 1997 Asian financial crisis was also partly attributable to institutional investors, who unwound their positions and contributed to a sudden stop of portfolio equity flows. The recent global financial crisis also involved the widespread unwinding of highly leveraged hedge funds, behaviour that aggravated the liquidity crisis (more on this later). Herding behaviour is due partly to the perverse incentives faced by fund managers. As discussed above, fund managers are obliged to focus on shortterm portfolio performance, and may feel pressure to sell an asset performing poorly in the short run even when its long-term prospects are sound. Likewise, they may be reluctant to take a short position in assets with rising prices that they believe are overpriced for fear of passing up the short-term gains accruing to their competitors. Moreover, because performance evaluation is done on a relative basis, fund managers tend to follow other managers’ decisions ‘in order to show clients that they know what they are doing. If they follow other fund managers’ decisions and investment turns out to be unprofitable, they are more likely to be thought of as unlucky than as unskilled, since other fund managers will have made the same mistake’ (Amar Bhattacharya et al. quoted in Harmes, 2001: 405). As Keynes wrote, ‘Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally’ (Keynes, 1936: 158). Furthermore, herding seems to be an inevitable outcome of institutional investors’ trading strategies. Because of institutional mandates, such as

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6000 Estimated assets

Market positions

5000

$ bn

4000 3000 2000 1000 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

0

Source: Lo (2008, 10, Figure 3).

Figure 9.4 Growth of assets and leverage in the hedge fund industry, 1990–2008 minimum funding or solvency criteria imposed on pension funds, fund managers must adopt ‘stop-loss’ strategies where selling occurs automatically when losses reach a certain threshold level. Such programme trading heightens systemic risk even as it aims to reduce risk for individual institutions. The use of derivatives, which allows for highly leveraged positions (as described above), also contributes to herding. The 2007–09 global financial crisis provides a textbook example of how a house of cards of financial derivatives can be violently destroyed when falling asset prices trigger margin calls. As Figure 9.4 shows, hedge funds have increased their leverage significantly over time and have become increasingly fragile. The first half of 2007 witnessed the failure of multi-billion-dollar hedge funds that were deeply involved in mortgage-backed securities and credit-related investment strategies. In response, there was large-scale selling by marketneutral funds. These are two unrelated parts of the hedge fund industry: the significant dislocation in the latter was not caused by any change in market ‘fundamentals’, but instead by investors desperate to reduce risk and obtain cash to meet margin calls (Lo, 2008). Herding and Contagion Herding by institutional investors often leads to ‘contagion’ across EMEs.12 Institutional investors contribute to contagion not only because their leveraged positions often require them to liquidate assets in unrelated markets,

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but also because emerging markets are often grouped into one asset class, which means selling pressure in one country may entail an overall reduction of EME investments. When a single country experiences market volatility, risk-management systems employed by many institutional investors operate in a way that automatically makes an upward revision to credit and market risks in correlated countries. This revision triggers automatic margin calls and tightens credit lines. Worse still, prudential regulations in many OECD countries require that institutional investors hold only investment-grade securities. As a result, the downgrading of a country’s credit rating leads to an immediate sell-off of the affected assets and cuts off new funding (Davis and Steil, 2001). Evidence of this behaviour appeared in the recent global financial crisis, but also could be seen time and again in the 1990s. In fact, the contagion phenomenon intensified as the assets controlled by institutional investors continued to grow. Pointing to the Asian financial crisis, for example, E. Philip Davis and Benn Steil (2001: 277) write: The severe consequences for financial stability in the region showed again how, given the size of institutional portfolios, combined one-way shifts of this nature could lead to sharp adjustments or even dysfunction of the market price mechanism. Moreover, it was seen that in late 1997, mutual fund investors also began to sell Latin American funds, thus generating contagion across emerging markets in a way that was less present in 1994.

According to a study of inflows and outflows of custodial funds over 1994–99 in 46 countries, fund inflows and outflows were highly correlated across international investors and occurred in response to global trends, such as inflation and exchange-rate expectations, rather than to changes in local conditions within the countries concerned (Froot et al., 1998). In summary, despite the assertions that institutional investors provide long-term financing and improve financial market liquidity, stability and efficiency, evidence abounds to the contrary.13 Institutional investors tend to increase price volatility and market instability in EMEs because they operate with a short-term investment horizon, lack the incentive to extract vital information regarding long-term fundamentals in individual EMEs, and engage in practices that encourage momentum trading and herding. Higher volatility raises the cost of capital and reduces investor confidence by generating greater uncertainty. In such an environment, individual financial institutions may continually face liquidity constraints and suffer financial losses, and non-financial corporations and governments may face higher borrowing costs. All of this adversely affects the long-term growth prospects in EMEs.

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INSTITUTIONAL INVESTORS AND THE LOSS OF POLICY SPACE IN EMERGING MARKETS Disciplining government is deemed another desirable ‘collateral benefit’ of free capital flows. It is true that free capital flows impose policy constraints; however, whether such constraints are beneficial is questionable. The Mainstream View In mainstream economic theory, there have been three generations of currency crisis models. Despite differences in explaining the causes of crises in EMEs, all three generations highlight the perverse role of government. In first-generation models, government is directly responsible for the currency crisis because its monetization of fiscal deficits clashes with the pegged exchange rate. In second-generation models, self-fulfilling speculative attacks on the pegged exchange rate are the direct culprit, but governments create conditions that leave economies vulnerable to such attacks (for example, by setting up the pegged system and simultaneously accommodating inflation or depreciation expectations) (Obstfeld, 1996). In third-generation models, currency crises are accompanied by banking crises and this time governments are blamed for (explicitly or implicitly) guaranteeing bank lending, thereby encouraging excessive external borrowing; this leads to currency and maturity mismatches and sows the seeds of future crises. Therefore, a common thread across these generations of models is the conclusion that tying the hands of government represents the best solution to currency and banking crises.14 The mainstream perspective leads to a call for liberalization of capital flows. The argument is that liberalizing capital flows would require government to discipline itself to avoid capital flight. The disciplining effect is supported by empirical studies. For example, Kim (2003) finds that capital account liberalization helps to reduce fiscal deficits. Garrett and Mitchell (2001) present similar findings. In addition, Tytell and Wei (2004) report that countries with higher levels of financial opening tend to have better monetary policy outcomes in terms of lower inflation. An Alternative Perspective But there is another side to the story. A perspective compatible with PKI deems the loss of policy autonomy and the distorted policy mix not as a collateral benefit, but rather the ‘collateral damage’ of free capital flows (Priewe, 2008: 28). As Grabel (1996) argues, compromised policy autonomy due to financial liberalization appears before, during and after a crisis. Prior to a crisis, governments in EMEs tend to adopt restrictive fiscal and monetary policies to attract

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portfolio inflows and avoid portfolio reallocation. During and after a financial crisis, governments may not only have to increase interest rates sharply to stop capital outflows, but also accept bailout conditions imposed by multilateral institutions or foreign governments. It is often argued that a pegged exchange rate is the root of the ‘impossible trinity’ problem; that is, with a pegged exchange rate and an open capital account, it is impossible for monetary policymakers to autonomously set interest rates. Moreover, strong speculative attacks amid a sudden cessation of inflows make it difficult for governments to defend the exchange-rate target. These valid concerns notwithstanding, abandoning the peg for a flexible exchange-rate system is still not a panacea (Ocampo and Vos, 2008). Maintaining a stable, nominal exchange rate provides a general price anchor and reduces volatility in the terms of trade. Moreover, a flexible exchange rate does not stave off currency crisis. That is because currency can still be overvalued due to a surge in capital inflows and then undershoot when capital flows out, which may still lead to a massive currency depreciation and debt crisis.15 Therefore, the problem is more accurately understood as caused by procyclical capital flows that produce pro-cyclical macroeconomic policies, rather than by an inappropriate exchange-rate system. When capital inflows surge, borrowing costs are reduced and expected returns are increased; both effects encourage higher borrowing by the private sector and government. As a result, debt levels rise. At the same time, however, the exchange rate appreciates, reducing the capacity to generate foreign currency to meet debt obligations. Once an internal or external shock triggers a reversal of capital flows, government finds itself with no option but to raise interest rates and cut spending in an effort to attenuate the unwinding of positions (although this effort is often in vain). And here is where institutional investors enter the picture: the loss of policy autonomy in EMEs is aggravated by the rise of institutional investors and their international portfolio allocation. The rise of institutional investors centralizes investment decisions and strengthens the bargaining power of finance capital. While mainstream economics argues that financial markets represent the interests and decisions of ‘unconnected market players’ (Sinclair, 1994), financial markets are in fact controlled by a handful of money managers whose demands are neither democratic nor ‘rational’ (as we have seen above). The concentration of finance capital and investment decisions means EMEs face a serious threat of collective outflows during hard times. That means governments in EMEs feel pressure to accommodate the demands of the institutional investors. These demands are typically in accordance with the ‘Washington Consensus’ policy prescriptions (restrictive monetary and fiscal policies), which protect the interests of international investors at the expense

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of domestic economies.16 In addition, because institutional investors contribute to the creation of an investment community that ‘facilitates the diffusion and use of similar models for evaluating economic fundamentals’ (Harmes, 1998: 104), the demands of institutional investors are often supported by other investors and the actions of institutional investors are often closely followed by other investors. As a result, the demands of institutional investors can become insurmountable. In addition to making EME macroeconomic policies more pro-cyclical, institutional investors may further constrain EME policy manoeuvring by pressing for financial liberalization and deregulation as ways to reduce constraints on global portfolio allocation. For example, Justin Robertson (2007) provides a fascinating account of how the US government, representing the interests of investment banks and private equity funds, pressured the governments of South Korea and Thailand to further liberalize their financial markets. Robertson (2007: 292) writes: ‘From negotiating sales of Korean firms to foreigners to advising the Korean government on banking privatization to acquiring and managing distressed assets, Morgan Stanley [and others] participated in many of the central reform issues that faced Korea in the 1997–2002 period’. Increasing financial liberalization enables more portfolio flows by institutional investors, which further reduces EME ‘policy space’ (room for discretionary manoeuvrability) and causes more instability. And that, in turn, provides the opportunity for institutional investors to push for more liberalization. As this vicious cycle continues, the long-term development of EMEs is increasingly undermined. Indeed, capital account liberalization has strong forecasting power for financial crises (Kaminsky and Schmukler, 2008). Thus, policy space and some restoration of capital control are required to break this cycle.

CONCLUSION: POST-KEYNESIAN INSTITUTIONALISM AND EMERGING MARKET ECONOMIES Mainstream economists contend that free capital flows stabilize markets, enhance liquidity, and bring about collateral benefits to EMEs in the form of desirable institutional changes and greater macroeconomic discipline. Upon close inspection, however, one finds that these benefits are neither theoretically plausible nor empirically verified. By drawing on and extending the insights of PKI, this chapter has demonstrated that the rising presence and power of institutional investors in EMEs actually reduces the efficiency of the financial system. This is due to the shortterm nature of investment horizons, shortcomings associated with collecting

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and processing information, and increased market volatility (as a result of practices including momentum trading, herding, and use of derivatives). Furthermore, institutional investors concentrate resources and centralize investment decisions and thus exert considerable influence on governments in EMEs. Instead of generating collateral benefits, this reduction of EME policy space is more likely to result in collateral damage and even a vicious cycle that impedes development. To be sure, understanding the drawbacks of free portfolio flows does not mean it is desirable or feasible to eradicate institutional investors or capital flows altogether. However, in light of the adverse consequences of free capital flows, capital controls and more rigorous regulations on institutional investors are warranted. And beneath this policy need is also the need for economic theory that appreciates the evolving nature of the capitalist system, especially the emergence and maturation of money-manager capitalism and its consequences for advanced nations and EMEs. In closing this chapter, it is worth recalling an observation made a dozen years ago by Dani Rodrik of the John F. Kennedy School of Government. In an essay for a symposium on policy directions for the IMF, Rodrik (1998: 65) wrote: [E]conomic policy in the typical ‘emerging market’ [is held] hostage to the whims and fancies of two dozen or so thirty-something country analysts in London, Frankfurt, and New York. A finance minister whose top priority is to keep foreign investors happy will pay less attention to developmental goals. We would have to have blind faith in the efficiency and rationality of international capital markets to believe that the goals of foreign investors and of economic development will regularly coincide.

Such faith was not warranted then, and, given the recent global financial crisis, it is certainly not warranted now.

ACKNOWLEDGEMENTS An early version of this chapter was presented at the Twelfth Conference of the Association for Heterodox Economics (University of Bordeaux, France), 9 July 2010; the author thanks Diana Elson, Alicia Giron and other session participants for their comments. The author also thanks four referees for their suggestions and Charles Whalen for constructive comments and editorial assistance.

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NOTES 1. 2.

3. 4.

5. 6.

7.

8.

9. 10. 11.

Notable exceptions include Rodrik (1998), Baghwati (1998), and Stiglitz (2002), who have called for restraining capital flows. The reader will observe that many of the concepts introduced in this chapter (including short-termism, momentum trading, herding, contagion, and asset bubbles) are compatible with Keynes’s analysis of financial markets, especially as described in Chapter 12 of The General Theory (Keynes, 1936), and that elements of Keynes’s analysis can be traced back to Veblen and Commons, as other contributors to this volume demonstrate. Arestis (2006) and Grabel (2006) offer more contemporary analyses that are broadly compatible with the current chapter, though neither draws explicitly on the notion of MMC. According to Palley (2007: 2), financialization is ‘a process whereby financial markets, financial institutions, and financial elites gain greater influence over economic policy and economic outcomes’. For a discussion of the emergence of MMC in the context of Hyman Minsky’s broader analysis of the evolution of the capitalist system, see Minsky (1990) and Whalen (2001). According to Minsky and Whalen, MMC supplanted the previous stage of US capitalist development (managerial capitalism) in the early 1980s. For an exploration of the overlap in analyses of financialization and MMC, see Zalewski and Whalen (2010). In this chapter, I use the terms institutional investors and money managers as synonymous. However, strictly speaking, institutional investors may manage their portfolio in-house or employ professional money managers to do the work. As suggested by Figure 9.1, the recent global financial crisis has cost institutional investors billions of dollars. During 2008, total institutional assets in the US fell by 21.3 per cent to reach $22.25 trillion, and the total share of institutional assets to financial assets in the US fell to 15.8 per cent, a record low since the 1980s (Conference Board, 2009). The limited scope of international diversification and investments is due to two main factors. First, some institutional investors are subject to quantitative limits on foreign investments (in most OECD countries with regard to pension funds, except the US and UK where the ‘prudent man’ rule applies). Second, there is evidence that home bias greatly limits foreign investment by institutional investors (Reisen, 2000). The approach to estimating the share of institutional investors in emerging markets (Figure 9.3) is as follows. It is estimated that global mutual funds specializing in emerging market stocks account for 5–10 per cent of total emerging equity markets (step 1 in Figure 9.3). But, in addition to pure emerging market funds, there are additional investments in emerging markets by other mutual funds. Taking them into account would increase the total market share of mutual funds to around 7.5–15 per cent (step 2). Furthermore, there are other institutional investors, such as pension and hedge funds as well as insurance companies, which account for an additional 30 per cent of mutual funds. This suggests that all institutional investors have a market share in emerging equity markets of around 9.75–19.5 per cent (step 3). Finally, the free float of stocks is more relevant than market capitalization for the estimation. Free float is about 50 to 70 per cent of capitalization, which means market share of foreign institutional investors is underestimated if we use market capitalization as the total stock value. Based on the free float stock value, foreign institutional investors would account for 13 to 39 per cent of the emerging equity markets (step 4). Taking the middle of the range, we arrive at the 26 per cent of market share. For more details, see Frenkel and Menkhoff (2004). A margin call occurs when lenders call in credits when the price of collateral falls below a specified level. General experts are usually preferred as managers of such funds because it is difficult for observers to evaluate and compare the performance of the narrowly defined specialists (Davis and Steil, 2001). For example, when carrying out tactical asset allocation, it is desirable for institutional investors to buy or sell index futures without any transactions in the underlying assets, which helps to avoid disturbances of long-term portfolio holdings.

198 12.

13. 14. 15.

16.

Financial instability and economic security after the Great Recession Contagion occurs when the selling pressure in one market is transmitted to another market whose internal economic situation has not changed fundamentally. Contagion may happen when two countries are connected through trade or other economic activity. For example, currency depreciation in one country reduces the trade competitiveness of the other, thus generating external imbalances for the latter. However, in the case of financial turmoil, the transmission is usually through the loss of confidence or the need for liquidating assets. For a complementary analysis regarding market volatility – and useful suggestions for research on post-financial liberalization regimes (with a focus on developing economies) – see Grabel (2008). It is important to note that there are some exceptions in the third generation of modelling. For example, Krugman (1998) puts great weight on the perverse effects of pro-cyclical capital flows and calls for government action to curtail capital flight. Without official pegging, international investors may factor exchange risk into their lending decisions, which can prevent over-lending. However, during boom periods, international investors and home borrowers may both downplay the risks of lending and borrowing. As a result, balance sheets may still be overstretched and debt over-accumulated, sowing the seeds of future debt crises. Furthermore, as some economists insist, currency mismatches will inevitably develop in countries that have difficulty borrowing in their own currency (Eichengreen and Hausmann, 1999). For more on the Washington Consensus, see the chapter by Marangos and Whalen in this volume.

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Kim, Woochan (2003), ‘Does capital account liberalization discipline budget deficit?’, Review of International Economics, 11 (5), 830–44. Kregel, J.A. (1998), ‘Derivatives and global capital flows: application to Asia’, Cambridge Journal of Economics, 22 (6), 677–92. Krugman, Paul (1998), ‘Balance sheets, the transfer problem, and financial crises’, in Andrew Rose (ed.), International Finance and Financial Crises: Essays in Honor of Robert P. Flood, Jr., Boston, MA: Kluwer, pp. 31–44. Lo, Andrew (2008), ‘Hedge funds, systemic risk, and the financial crisis of 2007–2008’, testimony before the US House of Representatives Committee on Oversight and Government Reform, 13 November. Menkhoff, Lukas (2001), ‘Short-term horizons in foreign exchange? Survey evidence from dealers and fund managers’, Kyklos, 54 (1), 27–47. Menkhoff, Lukas (2002), ‘Institutional investors: the external costs of a successful innovation’, Journal of Economic Issues, 36 (4), 907–34. Minsky, Hyman (1982), ‘The financial-instability hypothesis: capitalist processes and the behavior of the economy’, in C. Kindleberger and J.P. Laffargue (eds), Financial Crises: Theory, History, and Policy, Cambridge: Cambridge University Press, pp. 13–38. Minsky, Hyman (1990), ‘Schumpeter: finance and evolution’, in Arnold Heertje and Mark Perlman (eds), Evolving Technology and Market Structure: Studies in Schumpeterian Economics, Ann Arbor, MI: The University of Michigan Press, pp. 51–76. Minsky, Hyman (1996), ‘Uncertainty and the institutional structure of capitalist economies’, Journal of Economic Issues, 30 (2), 357–68. Mishkin, Frederic (2006), The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich, Princeton, NJ: Princeton University Press. Obstfeld, Maurice (1996), ‘Models of currency crises with self-fulfilling features’, European Economic Review, 40 (1), 1037–47. Ocampo, Jose A. and Rob Vos (2008), ‘Policy space and the changing paradigm in conducting macroeconomic policies in developing countries’, Bank for International Settlements paper no. 36, Basel, Switzerland. Organisation for Economic Co-operation and Development (OECD) (2008), statistical extracts, accessed 10 April 2010 at www.oecd.org. Palley, Thomas I. (2007), ‘Financialization: what it is and why it matters’, The Levy Economics Institute working paper no. 525, Annandale-on-Hudson, NY. Pazarbaiolu, Ceyla, Mangal Goswami and Jack Ree (2007), ‘The changing face of investors’, Finance and Development, 44 (1), accessed 10 April 2010 at www.imf.org. Pensions and Investments (2009), ‘The 2009 Databook’, 29 December. Priewe, Jan (2008), ‘Capital account management or laissez-faire of capital flows in developing countries’, in Phillip Arestis and Luiz Fernando de Paula (eds), Financial Liberalization and Economic Performance in Emerging Countries, Houndmills: Palgrave Macmillan, pp. 24–51. Reisen, Helmut (2000), Pension, Savings and Capital Flows: From Ageing to Emerging Markets, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Robertson, Justin (2007), ‘Reconsidering American interests in emerging market crises: an unanticipated outcome to the Asian financial crisis’, Review of International Political Economy, 14 (2), 276–305. Rodrik, Dani (1998), ‘Who needs capital-account convertibility?’, in Margaret B. Riccardi (ed.), Should the IMF Pursue Capital-Account Convertibility?, Princeton

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University, Department of Economics, International Finance Section, essays in international finance, no. 207, pp. 55–65. Sias, Richard W. (1996), ‘Volatility and the institutional investor’, Financial Analysis Journal, March/April, 13–20. Sinclair, Timothy (1994), ‘Between state and market: hegemony and institutions of collective action under conditions of international capital mobility’, Policy Sciences, 27 (4), 447–66. Soros, George (1987), The Alchemy of Finance, New York: Simon & Schuster. Stiglitz, Joseph E. (2002), Globalization and Its Discontents, New York: W.W. Norton and Company. Summers, Laurence (2000), ‘International financial crises: causes, prevention, and cures’, American Economic Review, 90 (2), 1–16. Tytell, Irina and Shang-Jin Wei (2004), ‘Does financial globalization induce better macroeconomic policies?’, International Monetary Fund working paper 04/84, Washington, DC. Whalen, Charles J. (2001), ‘Integrating Schumpeter and Keynes: Hyman Minsky’s theory of capitalist development’, Journal of Economic Issues, 35 (4), 805–23. Whalen, Charles J. (2008), ‘Toward “wisely managed” capitalism: post-Keynesian institutionalism and the creative state’, Forum for Social Economics, 37 (1), 43–60. Zalewski, David A. and Charles J. Whalen (2010), ‘Financialization and income inequality: a post Keynesian institutionalist analysis’, Journal of Economic Issues, 44 (3), 757–78.

PART IV

Conclusion

10. The future of Post-Keynesian Institutionalism Charles J. Whalen INTRODUCTION Had there not been a global financial crisis and Great Recession in the past few years, economics would have still needed a volume exploring the intersection of Institutionalism and Post Keynesianism. The complementarity of these traditions has been evident for decades, and more and more economists have become comfortable in both camps over time.1 Today a growing number of scholars refer to themselves as Institutionalists and Post Keynesians.2 Yet the need for a Post-Keynesian Institutionalism (PKI) has become more urgent in the wake of recent economic developments. Mainstream economics professors and students are now interested in incorporating finance and instability into macroeconomics. Wall Street analysts are searching for books by and about Minsky.3 And a restless public is eager for constructive policy options that can restore robust prosperity. The essays in this volume identify key elements and applications of PKI, but they are only a starting point. The foundations, theories and policy insights associated with PKI need further development, extension and testing.4 This brief closing chapter offers a few possible directions for future research.

RESEARCH DIRECTIONS In preparing to write this chapter, I contacted the book’s contributors and asked for input on fashioning a research agenda for PKI. The response of Steven Kates stresses that the insights of John R. Commons have been neglected as a consequence of the way economics developed since the Great Depression. He writes: ‘Futurity remains one of the most crucial economic concepts ever developed. Yet economists only superficially note the existence of risk and uncertainty in the way the world operates; the profession doesn’t truly embed these concepts within all aspects of theoretical economics and policy. This must change if economics is to be genuinely relevant to the problems of the world as it actually is’. 205

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Glen Atkinson agrees on the centrality of futurity, but his emphasis is a bit different. While Kates recommends that economists deepen their understanding of how the operation of markets depends on entrepreneurial contemplation of the future – and how this mechanism can break down – Atkinson proposes that ‘economists continue the work that Commons began’ by probing the links between law and economics in an economy dominated by intellectual property and global commerce. In fact, work by PKI is necessary in both directions. Further attention to entrepreneurs would build on Minsky’s ties to Joseph Schumpeter, who had much to contribute to Evolutionary economics in general and to Minsky’s theory of capitalist development in particular.5 At the same time, further attention to law and economics would be of benefit not only to economists, who need to think seriously about the role of government in the economy and about intangible property, but also to legal scholars, many of whom have long been frustrated by the dominance of ‘Chicago School’ law and economics.6 David Zalewski suggests that next steps for PKI should include a comprehensive and thorough presentation of its foundations. For example, to the elements examined in this volume he would add an exploration of research methods and a deeper examination of the behavioural foundations of PKI.7 Zalewski and John Marangos also see the need to highlight the normative dimensions of PKI. In fact, to that end Marangos is now coordinating a Good Society project, which has produced thought-provoking discussions at professional conferences and will culminate in a forthcoming edited volume. Other contributors offer additional suggestions. These include more work on detecting financial fragility, policy research that paves the way for implementation of Minsky’s employer-of-last-resort initiative, and further explorations of policy options for international finance and development. Contributors also suggest attention to system-dynamics modelling and stockflow consistent modelling, more research on the dynamic interplay between developed and developing countries, and closer attention to comparative systems. Public finance is yet another area warranting further development from the vantage point of PKI, especially in the current era of widespread public concern over public deficits and federal debt. To the recommendations of my colleagues, I would add three more.8 First, I would like to see more attention to economic forecasting from a PKI perspective. Because the public looks to economists for forecasts, the tradition of PKI would elevate its profile and stature by maintaining a forecasting centre based on Post-Keynesian Institutionalist insights.9 Second, Minsky’s notion of money-manager capitalism needs to be further explored and integrated with his financial instability hypothesis. Minsky used money-manager capitalism to focus on the interconnected evolution of finance and the broader economy, and the concept offers a valuable lens through which economists can study the

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contemporary economy.10 Third, Post-Keynesian Institutionalists must continue Minsky’s effort to engage in ‘fruitful discourse’ with the rest of the economics profession; this includes a dialogue about economic pedagogy and the value of exposing students to alternative perspectives as well as to economic history and the history of economic thought.11

TOWARDS ‘WISELY MANAGED’ CAPITALISM In the face of threats to capitalism not only from socialism and fascism but also from financial crises and depressions, John R. Commons and John Maynard Keynes tried to engage in scholarship that moved their countries towards ‘wisely managed’ capitalism (Whalen, 2008a: 46). In the wake of a global financial crisis and the worst economic downturn since the Great Depression, the intellectual descendants of Commons and Keynes continue that endeavour. The effort to contain financial instability and secure and sustain broadly shared prosperity will always be a work in progress, but advances in theory and policy analysis are possible – and Post-Keynesian Institutionalism offers one promising way forward.

NOTES 1. 2. 3.

4. 5.

6.

7. 8. 9.

For an early examination of the compatibility and complementarity of Institutionalism and Post Keynesianism, see Keller (1983). See, for example, Waller (2005), Niggle (2006), and Todorova (2009). The scholarship of Todorova is also noteworthy because it integrates not only Institutionalism and Post Keynesianism, but also insights from feminist economics. In the wake of the financial crisis, publisher M.E. Sharpe reissued Minsky’s Can ‘It’ Happen Again? (Minsky, 1982) and Wall Street economist Robert J. Barbera (2009) wrote The Cost of Capitalism, which gives centre stage to Minsky’s financial instability hypothesis. A number of articles on Minsky have also appeared recently in the business press. There is also a need to consider how PKI is best incorporated into university economics curricula. For one possible approach, see Zalewski (forthcoming). On Schumpeter, see McCraw (2007). On the need to make a place for Schumpeter in contemporary Institutional (Evolutionary) economics, see Stanfield (2006). And on Schumpeter’s vital contributions to Minsky’s theory of capitalist development, see Whalen (2001). For a discussion of Institutionalism’s contribution to the original law and economics movement, see Fried (1998). For a contemporary view of the legal-economic nexus from a Commons-inspired, Institutionalist perspective, see Samuels (2007). And for an examination of how PKI is supported by the notion of the state as a creative entity, see Whalen (2008a). For useful discussions of research methods, see Atkinson and Oleson (1996), Wilber and Harrison (1978), and Zalewski (forthcoming); for a constructive look at human behaviour, see Fernández-Huerga (2008). A fourth item, the need for PKI to focus on economic sustainability, has already been underscored in Chapter 2. The Jerome Levy Forecasting Center played this role in the 1990s as part of the Levy

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Economics Institute at Bard College. But the Centre separated from the Institute in 2001 and was reorganized as a for-profit firm devoted to client-centred research and consulting. 10. A number of contributors to Tavasci and Toporowski (2010) look at recent economic activity using the MMC lens, as do Wray (2009) and Whalen (2008a; 2010). For a focus on MMC and two decades of rising worker insecurity, see Whalen (2008b). 11. As Institutionalist Wesley C. Mitchell (1927: 57) stressed in Business Cycles: The Problem and Its Setting, economic history and theory ‘supplement each other’, especially when it comes to the study of business cycles. In an ever-changing economy, theory must be grounded in history and explain how business conditions transform themselves. Moreover, theory must be subject to change, since ‘business history repeats itself, but always with a difference’ (Mitchell, 1941: ix). In fact, the reality of constant economic change means recent history ‘is no less important’ to the economist than history of the more distant past (Mitchell, 1927: 57).

REFERENCES Atkinson, Glen and Ted Oleson (1996), ‘Institutional inquiry: the search for similarities and differences’, Journal of Economic Issues, 30 (3), 701–18. Barbera, Robert J. (2009), The Cost of Capitalism: Understanding Market Mayhem and Stabilizing Our Economic Future, New York: McGraw-Hill. Fernández-Huerga, Eduardo (2008), ‘The economic behavior of human beings: the institutional/post-keynesian model’, Journal of Economic Issues, 42 (3), 709–26. Fried, Barbara H. (1998), The Progressive Assault on Laissez Faire: Robert Hale and the First Law and Economics Movement, Cambridge, MA: Harvard University Press. Keller, Robert (1983), ‘Keynesian and institutional economics: compatibility and complementarity?’, Journal of Economic Issues, 17 (4), 1087–95. McCraw, Thomas K. (2007), Prophet of Innovation: Joseph Schumpeter and Creative Destruction, Cambridge, MA: Belknap. Minsky, Hyman P. (1982), Can ‘It’ Happen Again? Essays in Instability and Finance, Armonk, NY: M.E. Sharpe. Minsky, Hyman P. (1986), Stabilizing an Unstable Economy, New Haven, CT: Yale University Press. Mitchell, Wesley C. (1927), Business Cycles: The Problem and Its Setting, New York: National Bureau of Economic Research. Mitchell, Wesley C. (1941), Business Cycles and Their Causes, Berkeley, CA: University of California Press. Niggle, Chris (2006), ‘Institutionalist-post Keynesian economics and the post monetarist new consensus’, in Mark Setterfield (ed.), Complexity, Endogenous Money and Macroeconomic Theory: Essays in Honor of Basil Moore, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 368–88. Tavasci, Daniela and Jan Toporowski (2010), Minsky, Crisis and Development, Basingstoke: Palgrave Macmillan. Todorova, Zdravka (2009), Money and Households in a Capitalist Economy: A Gendered Post-Keynesian Institutionalist Analysis, Cheltenham, UK and Northampton, MA, USA: Edward Elgar. Tymoigne, Eric (2010), ‘Evolutionary views and imperfection views of financial crises’, Lewis and Clark College, Department of Economics paper, October. Samuels, Warren J. (2007), The Legal-Economic Nexus: Fundamental Processes, London: Routledge.

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Stanfield, James Ronald (2006), ‘From original institutional economics and new institutional economics toward evolutionary economics’, Journal of Economic Issues, 40 (2), 249–58. Waller, William (2005), ‘Accidental Veblenian, intentional institutionalist, and inevitable feminist’, Journal of Economic Issues, 39 (2), 327–34. Whalen, Charles J. (2001), ‘Integrating Schumpeter and Keynes: Hyman Minsky’s theory of capitalist development’, Journal of Economic Issues, 35 (4), 805–23. Whalen, Charles J. (2008a), ‘Toward “wisely managed” capitalism: post-Keynesian institutionalism and the creative state’, Forum for Social Economics, 37 (1), 43–60. Whalen, Charles J. (2008b), ‘Post-Keynesian institutionalism and the anxious society’, in Sandra S. Batie and Nicholas Mercuro (eds), Alternative Economic Structures: Evolution and Impact, London: Routledge, pp. 293–9. Whalen, Charles J. (2010), ‘An institutionalist perspective on the global financial crisis’, in Steven Kates (ed.), Macroeconomic Theory and Its Failings: Alternative Perspectives on the Global Financial Crisis, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, pp. 235–59. Wilber, Charles K. and Robert Harrison (1978), ‘The methodological basis of institutional economics: pattern models, storytelling, and holism’, Journal of Economic Issues, 12 (1), 61–90. Wray, L. Randall (2009), ‘The rise and fall of money manager capitalism: a Minskian perspective’, Cambridge Journal of Economics, 33 (4), 807–28. Zalewski, David A. (forthcoming), ‘Teaching about financial crises: a methodological approach’, International Journal of Pluralism and Economics Education.

Index Aarons, Dakarai I. 100 Abernathy, William J. 64 Adams Express Company Case 57 adaptive efficiency 167 Adaptive Market Hypothesis (AMH) 40–42 After the Washington Consensus: Restarting Growth and Reform in Latin America 155, 156, 157 Akerlof, George 8, 29 Allen, Franklin 2 alternative regulatory reform 123–34 Amended Washington Consensus 160–63 deregulation 162 exchange rate 161 financial liberalization 161 foreign direct investment 162 institution building 162–3 policies 161 privatization 162 property rights 162 public expenditure priorities 160 tax reform 160 trade liberalization 162 see also Washington Consensus American Recovery and Reinvestment Act (ARRA) 84, 96, 97, 100, 103, 108 Amsden, Alice 168, 173 Anderson, Nick 100 Animal Spirits: How Human Psychology Drives the Economy... 8 anticipation horizon 186 Asian financial crisis 185, 190, 192 asset bubbles 197 asymmetric information 29, 116 Atkinson, Glen 4, 69, 167, 206 atomistic view of economics 29 automatic stabilizers 109 balance-sheet constraint 144

banker capitalism 61–3 banks Big Bank 94–5, 98, 100, 103, 107 capital ratios 147 cross-border exposure 148–9 holding companies 145–6 international stabilization 148–50 lending to governments 148–9 regulation 5 security and capital 144 Basel I 144 Basel II 114, 117 Basel III 117, 148 Benner, Chris 103 Bentham, Jeremy 71 Bergsten, C. Fred 158 Bernanke, Ben 108 Big Bank 94–5, 98, 100, 103, 107 Big Government 94–5, 98, 100, 103, 107 Black, William K. 123, 131, 133 Blanchard, Olivier 153 Blankfein, Lloyd 119–20 Blinder, Alan S. 81, 108 Bloomestein, Hans J. 182 Bluestone, Barry 81 Blumberg, Deborah Lynn 98 Blumer, Herbert 42 Bogle, John C. 188 Borenzstein, Eduardo R. 189 bounded rationality 7, 41 Bounded Rationality in Macroeconomics 7 Brazelton, W. Robert 4, 29, 31, 33, 35, 37, 39, 41 Bretton Woods 158 Broadbent, John 182 Brown, Christopher 33, 81, 93, 166, 182 Brunnermeier, Markus 147 budget surplus/deficit 105–6 Bush, George W. 96, 158 211

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business cycles 2, 3, 6, 15, 20, 25, 54, 147–8 buy-and-hold strategy 185 Campbell, Claudia 122, 127, 130 capital account liberalization 158 buffers 119–23 flows 179, 196 formation 145 inflows to emerging market economies 183, 184 layering 146 liberalization 179 capital-adequacy strategy 144 capitalism banker capitalism 58, 61–3 contemporary 78 evolution 54–5 financial capitalism 68 industrial capitalism 58, 61–3, 68 legal foundations 55, 69 managerial capitalism 63–5, 68 merchant capitalism 58–61 money-manager (MMC) 3, 9, 63–5, 68, 82, 179–96, 197, 206 wisely managed 207 Capitalism and Freedom 174 Cargill, Thomas F. 130 Carter, Michael 93 central bank interest rate 143 system 37–8, 63, 130 Chase, Richard X. 29 Chew, Lillian 188 Christie, Les 97 Citibank 120 classical economists 18 collateral benefits of capital flow 179, 187, 193 collateralized debt obligations (CDO) 129, 130 Commodity Futures Modernization Act (2000) 82, 114 Commons, John R. xii, 2, 4, 7, 15, 21–4, 42, 53, 54–5, 58, 60, 62, 63, 65, 71, 85, 102, 166, 167, 170, 180, 205, 207 comparative static analyses 167 compensation mechanisms and pay 117

competitive exchange rate 172 Comprehensive Employment and Training Act (1973) 86 consumption 46–7 contagion 191–2, 197, 198 contractionary fiscal action 99 conventional assets, global fund management of 181 Copeland, Morris A. 87 corporate consolidation 62 counter cyclical subsidiarity 104, 107 Counterparty Risk Management Policy Group 121 country-model transfer 168 craft-guilds 58–9 credit default swaps (CDS) 82–3, 116, 129 cross-holdings 146 Crotty, James 63, 71, 131 crowding-out 145 currency crisis models 193 cyclical surplus/deficit 105–6 Davidson, Paul 3, 34–6, 45, 65–7, 68 Davis, E. Philip 185, 188, 189, 192 debt 66 debt-to-equity ratios 80 debt-to-income ratios 80 deficit sharing 104 demand deficiency 16–17, 26 deregulation 162 derivatives 187–8, 191, 196 Dertouzos, Michael L. 64 Dewey, John 85 Dillard, Dudley 53, 55 discretionary policy 109 displacement 189 Dodd, Christopher 125 Dodd-Frank Wall Street Reform and Consumer Protection Act 84, 117 dot-com bubble 36 Duesenberry, James 32 Dugger, William M. 45 Dunkelberg, William C. 99 dynamic efficiency 167 dynamic provisioning 147–8 economic development 167 economic growth and investment-led economy 132–4

Index economic pedagogy 207 The Economics of Collective Action 55, 58 ‘Economic performance through time’, lecture 167 The Economics of Unemployment 21 Edley, Christopher 109 effective demand 19, 25 Efficient Market Hypothesis (EMH) 40, 41, 179–80 emerging market economies (EME) 6, 179–96 Employee Retirement Income Security Act (2000) 114 employer of last resort (ELR) see publicservice employment endurance horizon 186 equity capital sale 145–6 equity return 121–2 era of stabilization 54 Essays in Biography 17 European Economic and Monetary Union crisis (1992) 185 Evolutionary economics see Institutional economics; PKI exchange rate 161, 172, 193–4, 198 exchange rate risk 151 exchange value 55–7 expectations 67 Fannie Mae 96 federal/state policy partnership 5 Fields, Gary 108 finance industry co-evolution 58–65 competition 130–31 finance-driven economies 132 financial capitalism 68 financial downsizing 132 financial fragility 121–2, 127, 128, 146, 206 financial indicators 125, 135 financial innovation management 128–30, 132 financial instability hypothesis (FIH) 3, 78–88, 124, 125, 206 financial liberalization 161, 179, 195 financial market rescue 96 Financial Modernization Act (1999) 114 financial regulation 5, 114–36, 143–51

213

financial-system evolution 3 financialization 82, 180, 197 fiscal discipline in Amended Washington Consensus 160 Fischer, Stanley 179 fixed capital formation 145 fixed income instruments 181 flexible capital requirements 115 flexible exchange-rate system 194 forced indebtedness 144–6 foreign direct investment 162 foreign institutional investors 184–7 Foster, J. Fagg 87, 106 Four Freedoms speech 85 Frank, Robert 32–3 Freddie Mac 96 free-market consequences 116–17 freedom 174 Freeman, Richard 81 Frenkel, Michael 185, 187 Friedman, Gerald 99 Friedman, Milton 32, 33, 39, 174 full employment policies 77 Fullbrook, Edward 44 Fullwiler, Scott T. 130 fundamentals 189 fundamentals-oriented financial education 116 Funke, Norbert 182 futurity 4, 6, 24, 53–71, 205, 206 Galbraith, James K. 81 Galbraith, John Kenneth 36, 45, 129, 169 Gallati, Retro R. 120 Garcia, Gillian G. 130 Garrett, Geoffrey 193 Gay, Daniel 169, 174 Geithner, Timothy 117 Gelos, Gaston R. 189 The General Theory of Employment, Interest and Money (TGT) 4, 8, 15, 18–21, 23, 24, 33, 53, 55, 151 Genuine Progress Indicator 133, 134 global capital inflows to emerging market economies 183, 184 Global Consequences of Financial Deregulation xii global fund management of conventional assets 181

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global institutional investors 180–96 Global Investment 182 global money managers, regulatory scrutiny 180 Glover, Robert W. 103 Godard, John 169, 173 gold standard 151 Goldman Sachs 119 good society concept 166–7, 206 Goodfriend, Marvin 143 Gordon, Wendell 30, 86 Goswami, Mangal 185 Goulet, Denis 173 government bonds 149 as employer of last resort (ELR) see public-service employment intervention 116, 168, 193–4 role in development process 168 Grabel, Ilene 193 The Great Crash 36 Greenspan, Alan 114, 117, 122, 129 growth as economic priority 117–19 Haberler, Gottfried 15 Hadley, Kyle L. 127 Hailu, Dogol 153 Hake, Eric R. 72 Hall, Robert H. 131 Hamilton, David 53 Hansen, Alvin 33 Hanzimanolis, George 118 Harmes, Adam 185 Harrod-Domar issue 133 Hayes, Robert H. 64 hedge finance 67–8, 124, 130 hedge fund management 186, 188, 190, 191 herding 190–92, 196, 197 Hicks, John 33 historical trade-off 168, 173 History of Labor in the United States 61 Hobson, John A. 31–2 Holt, Richard 47 household tax credits 96 hysteresis 35 Icahn, Carl 64 impossible trinity problem 194 income constraint 144

incorporeal property 68 industrial capitalism 61–3, 68 industry-finance co-evolution 58–65 inflation 160 information quality 186–7 An Inquiry into the Poverty of Economics 3, 101, 166 insider-voucher privatization 172 institution building 162–3 institutional adjustment 2, 87 Institutional Economics: Its Place in the Political Economy 23, 24, 53–4, 55, 58, 65, 69 Institutional economics 4, 15, 28–33, 70 see also PKI institutional environments approach 173 institutional investors 3, 180–96, 197 institutional monocropping 174 institutional norms 173 Institutionalist Post-Keynesian Economics see PKI interaction 42–3 interest rates 38–9 interest-capitalization finance see Ponzi finance international bank stabilization 148–50 international development and PKI 5 international development policy Ten Commandments 154 International Monetary Fund (IMF) 149, 153 investment as economic priority 117–19 and growth 132–4 information quality 186–7 invidious distinction 82 irrationality 41 Jameson, Kenneth P. 3, 47, 88, 101–3, 108, 166 Journal of Post Keynesian Economics 3 J.P. Morgan 62 Kaboub, Fadhel 5, 87, 101, 106 Kadmos, George A. 87 Kahneman, Daniel 45 Kaminsky, Graciela 189, 195 Kates, Steven 4, 205, 206 Kaufman, Bruce 46

Index Keynes, John Maynard xii, 2, 4, 7, 15–26, 33–9, 54–5, 79–80, 120, 166, 180, 190, 207 Keynesian Economics in the Stream of Economic Thought 23 Keyserling, Leon 38–9 Kim, Woochan 193 King, Christopher T. 103 King, Martin Bruce 72 Kitson, Michael 86 Klein, Alyson 100 Klein, Philip A. 53, 166 Knutsen, Sverre 123, 133 Kose, M. 179 Kregel, Jan 93, 122, 127, 188 Krugman, Paul 7, 9, 28, 71, 93, 107 Kuczynski, Pedro Pablo 155, 158, 160 Kuttner, Robert 104 Larson, Calvin J. 42 Latin America see Washington Consensus law of markets 16–17 law and property 54–7 Lazo, Alejandro 97 Legal Foundations of Capitalism 55 Lehman Brothers 131 lender of last resort (IMF) 149, 150 lending standards 114 Lerner, Abba 33 leverage 114, 120, 121–2, 148, 186, 188, 190, 191 Liang, Yan 6 Lie, Einar 123, 133 liquidity 79–80 buffers 123 creation 116 in emerging markets 188–9 requirements 115 Lo, Andrew W. 40–42, 45, 191 Lockhart, Dennis P. 98 long-term investment management 185–6 Lyons, Richard 189 McClintock, Brent 93 McCracken, Harlan Linneus 4, 15, 18–26 McCulley, Paul 93 McKinley, Terry 153

215

Madoff, Bernard Lawrence 127 Majewski, Raymond 86 Malthus, Thomas Robert 17, 18, 19–21 managerial capitalism 63–5, 68 Marangos, John 5, 6, 206 markets capitalization 68 crashes 190 efficiency 41 fundamentalism 172 mechanisms 115–16 and PKI 45 volatility 187–92, 196 mechanisation in workplace 60 mediating structures 102–3, 104 Menkhoff, Lukas 185, 186–7, 188, 189 merchant capitalism 58–61 Mergers, Robert P. 131 Mexican peso crisis (1994) 185 Minnesota Rate Case 56 Minsky, Hyman P. xii, 2, 3–4, 5, 6, 7, 8, 33, 34, 36–9, 54, 55, 58, 63, 64–6, 67–8, 77–88, 93, 94, 97, 98, 100–101, 103, 122, 124, 126, 127, 130, 133, 149, 163, 169, 180, 206 Minsky Moments 80 Mishkin, Frederic S. 116, 179 Mitchell, Deborah 193 Mitchell, Wesley C. xiii, 9 Mitchell, William F. 86 molecular view of economics 28–30 momentum trading 189, 196, 197 money concept 31–2 during crises 79–80 money-manager capitalism (MMC) 3, 9, 63–5, 68, 82, 179–96, 197, 206 supply 37–8 Montgomery, Lori 100 Morgan Stanley 195 mortgage regulation 118–19, 128–9 mortgage restructuring 97 multidisciplinary economics 43–4 Munn v. Illinois 56 mutual fund management 186, 188 Myrdal, Gunnar 30 Naim, Moses 159 Nair, S. 120

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Nakamoto, Michio 120 National Bureau of Economic Research (NBER) xiii, 9 National Federation of Independent Business (NFIB) 98, 99 neo-liberalism 172 neoclassical synthesis 33 neoclassical theory 8, 71, 167 new classical economics 47 New Classical macroeconomics 7 Niggle, Christopher J. 64 Nixon, Richard 104 non-ergodicity 35 North, Douglass 8, 167 Northern Rock 145 Obama, Barack 43, 96, 97 Obstfeld, Maurice 193 Ocampo, José Antonio 168, 173, 194 O’Hara, Phillip A. 87 Oleson, Theodore Jr. 69, 167 Olick, Jeffrey 42 On the Principles of Political Economy and Taxation 18, 21 optimization 47 Organisation for Economic Co-operation and Development (OECD) 144, 154, 181, 182, 197 Ostrom, Elinor 170, 174 overproduction 22 Özverern, Eyup 47 Palley, Thomas I. 46, 65, 131 Parsons, Kenneth 70 participation in economic change 169–70 patient investment 186 Pattison, Scott 99, 100 Pazarbasioglu, Ceyla 185 pecuniary emulation 82 pegged exchange rate 193–4, 198 pension fund management 181–2, 185, 187 Pensions and Investments 182 permanent-income hypothesis 32 Peterson, Wallace C. 3, 53, 71 Phillips, Kevin 65 Pickens, T. Boone 64 Piore, Michael J. 43

PKI xii, 33–9, 43–7 An Inquiry into the Poverty of Economics 3, 101, 166 consumption 46–7 and economic stability 166 and emerging market economies (EME) 6, 179–96 and employment 87, 97 and financial instability 77–88 financial regulation 5 foundations 4 and futurity 4, 69–71 history 44–5 institutions 45 and international development 5 introduction to 2–4 and macroeconomic policy 103, 107 markets 45 and money-manager capitalism 3, 9, 63–5, 68, 82, 179–96 and power 169 and prosperity 6, 7 and shared stabilization 104, 105–7 and subsidiarity 101 and time 167 and US economy 5 and wages 46 and Washington Consensus 153–71 and world economy 5 see also Institutional economics pluralist view of economics 28–30, 44 Polanyi, Karl 45 Ponzi finance 5, 36, 67–8, 80, 123, 124–8, 129–30, 131, 133, 137 portfolio flows 185–7, 196 Post-Keynesian Institutionalism see PKI post-autistic economics 44 Post-Washington Consensus 163 see also Amended Washington Consensus Priewe, Jan 193 Prince, Charles O. III 120 privatization 162 pro-cyclical capital flows 194 profitability and capital buffers 120–21 progressive tax structure 94–5 property law 55–7 rights 162 taxation 104

Index prosperity 6, 7 public expenditure priorities 160 public-service employment (PSE) 5, 10, 77–88, 95, 97, 98, 103, 105, 106, 206 Puzzanghera, Jim 97 quantitative easing 84 Rational Expectation Hypothesis 40 Reagan/Thatcher era economics 154 Reasonable Value 23 reasonable value 170 recovery and reform strategy 84 Ree, Jack 185 reflexive bubble 189 reflexivity 174 regulatory arbitrage 137 relative-income hypothesis 32 retail-shop period 59 revenue sharing 104 revenue stream forecast 68 Ricardo, David 17, 18, 19 The Right to Work 85 risk management 114, 121, 187–8 risk-taking and capital buffers 122–3 Robertson, Justin 195 Robinson, Joan 2–3, 180 Rochon, Louis-Philippe 86 Rodrik, Dani 196 Roosevelt, Franklin D. 85 Saposs, David J. 58, 61 Sargent, Thomas J. 7 Sawyer, Malcolm 87 Say’s Law 4, 15–17, 20 Scheppach, Raymond 99 Schmid, A. Allan 169 Schmukler, Sergio L. 189, 195 Schumpeter, Joseph 78, 167, 206 Schwartz, A. 33 Scott, Robert H. 81 Second Bill of Rights 85 securitization 130, 145 Setterfield, Mark 35 shared stabilization 104–7 shareholder value maximization 131 Shiller, Robert J. 8, 116, 129 Shleifer, Andrei 186 shocks protection 117

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short-term investment management 185–6, 195, 197 Sias, Richard W. 189 Simon, Herbert 41, 45, 116 Sinclair, Timothy 194 Slaughterhouse Cases 56 small business 98–9 small business relief 108 Smith, Lewis L. 44 social goals and the Washington Consensus 166–7 Soros, George 189 speculative finance 67–8, 124 Sprague, O.M.W. 151 Sraffa, Piero 17 Stabilizing an Unstable Economy 67, 84, 94, 95, 101 stagflation 2, 3 Stanfield, James Ronald 167 Steil, Ben 185, 188, 192 Stiglitz, Joseph E. 8, 160, 163 stock market crash (2008) 1 stock-flow consistent modelling 206 Straughn, Jeremy Brooke 42–3 structural surplus/deficit 105–6 structured notes 188 subsidiarity 5, 93–107, 108 Summers, Lawrence 179, 186 Suzuki, Yasushi 123, 133 sweatshop contractors 60, 71–2 symbolic interaction 42 system-dynamics modelling 206 Tavasci, Daniela 167 tax reform 160 Taylor, Fred 16–17 Taylor, John B. 105, 106, 116 Taylor Rule 105 technology-institutions relationship 30–31 Thatcher/Reagan era economics 154 Thomson, James B. 122 timeliness 71 too big to fail institutions 131 Toporowski, Jan 5, 144, 167 Toruño, Mayo 81 Touhey, Alison T. 127 trade liberalization 162 transaction 42 transparency of information 116

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Financial instability and economic security after the Great Recession

Troubled Asset Relief Program (TARP) 84, 96 Turner, Adair 115–16, 132 Tversky, Amos 45 Tymoigne, Éric 5, 69, 97, 98, 101, 104, 119, 123, 125, 127, 130 Tytell, Irina 193 'Uncertainty and the institutional structure of capitalist economies', lecture 98 unconnected market players 194 underwriting practices 125 underwriting requirements 123 unemployment 1–2, 77 unit rule taxation 57 uphill bias 188 US debt-income ratio 81 economic growth 81 economy and PKI 5 federal stimulus programmes 96 financial instability 78–88 financial market rescue 96 GDP 2008 fall 1 Genuine Progress Indicator 133, 134 household debt 81 housing market 36–7 income inequality 80–82 pension fund management 181–2 post-WW2 interest rate policy 38 property law 55–7 public-service employment (PSE) 5, 10, 77–88 state/local budgets 99–100, 103 stock market crash 2008 1 Treasury-Fed Accord 38–9 unemployment 1–2 unit rule taxation 57 use value 55–7 value 23 Value Theory and Business Cycles (VTBC) 15, 18, 19–20 variable capital requirements 147–8 Veblen, Thorstein 2, 7, 28, 30–33, 45, 64–5, 82, 167, 180 Veblenian dichotomy 30–31 Vernengo, Matias 86

vertical integration 62 Vikraman, Shaji 120 Vos, Rob 194 Wade, Holly 99 wages and bargaining 34 and ELR 86, 89 and PKI 46 stagnation 88 Waller, William 53 Washington Consensus 5, 153–71 and crisis avoidance 171 crisis-proofing 158 differences with successors 164–5 emergence of 154–5 first-generation reforms 159 fiscal discipline 160 income distribution and social sector 159 inflation 160 meaningful alternative to 162–71 New Agenda 155–60 policies 155, 157, 158, 161, 194–5 second-generation reforms 159 social goals 166–7 Ten Commandments 154 two-corner doctrine 163 see also Amended Washington Consensus Watts, Martin J. 86 Wei, Shang-Jin 193 Weintraub, Sidney 3, 34–6 Welch, Jack 132 Wenger, Jeffrey 97 Whalen, Charles J. 4, 5, 6, 37, 55, 64, 66, 69, 81, 83, 93, 97, 102, 109, 166, 180 wholesale speculation 59–60 wholesale-order era 59 Wighton, David 120 Wilber, Charles K. 3, 47, 88, 101–3, 108, 166 Williamson, John 153–63, 167, 171, 172 willingness 24, 67 Wolff, Rick 104 world economic output 1 world economy and PKI 4 see also PKI

Index Wray, L. Randall 34, 36–9, 45, 46, 83, 86, 93, 97, 98, 101, 104, 105, 122, 130 Yellen, Janet 93

Zaharias, Krista 99 Zalewski, David 5, 81, 166, 206 Zandi, Mark 108 Zeuch, William E. 22

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