HOW DEAD IDEAS STILL WALK AMONG US
John Quiggin
PRINCETON UNIVERSITY PRESS
PRINCETON AND OXFORD
Copyright © 2010 by Princeton University Press
Published by Princeton University Press,
41 William Street, Princeton, New Jersey 08540
In the United Kingdom: Princeton University Press,
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All Rights Reserved
Library of Congress Cataloging-��in-��Publication Data
Quiggin, John.
Zombie economics : how dead ideas still walk among us / John Quiggin.
p. cm.
Includes bibliographical references and index.
ISBN 978-��0-��691-��14582-��2 (hbk. : alk. paper)
1. Economics—History—20th century.
2. Economic policy—History—20th century.
3. Economics.╇ I. Title.
HB87.Q54 2010
330—dc22
2010023189
British Library Cataloging-��in-��Publication Data is available
This book has been composed in Sabon
Printed on acid-��free paper.
press.princeton.edu
Printed in the United States of America
1╇ 3╇ 5╇ 7╇ 9╇ 10╇ 8╇ 6╇ 4╇ 2
Contents
vii
1
Preface
Introduction
Chapter 1
The Great Moderation
Birth: Calm after the Storms
Life: The Great Risk Shift
Death: The Dissenters and Their Vindication
Reanimation: A Global Crisis or a Transitory Blip?
After the Zombies: Rethinking the Experience of the
â•… Twentieth Century
Further Reading
5
8
13
19
30
31
34
Chapter 2
The Efficient Markets Hypothesis
Chapter 3
Dynamic Stochastic General Equilibrium
79
83
106
110
121
123
133
Chapter 4
Trickle-��down Economics
136
138
146
152
167
168
172
Birth: From Casino to Calculating Machine
Life: Black-��Scholes, Bankers, and Bubbles
Death: The Crisis of 2008
Reanimation: Chicago Revives the Dead
After the Zombies: The State and the Market
Further Reading
Birth: From the Phillips Curve to the NAIRU, and Beyond
Life: Rationality and the Representative Agent
Death: How Did Economists Get It So Wrong?
Reanimation: How Obama Caused the Global Financial Crisis
After the Zombies: Toward a Realistic Macroeconomics
Further Reading
Birth: From Supply-��side Economics to Dynamic Scoring
Life: Excuses for Inequality
Death: The Rich Get Richer and the Poor Go Nowhere
Reanimation: Mobility without Movement
After the Zombies: Economics, Inequality, and Equity
Further Reading
35
36
39
50
64
66
77
Chapter 5
Privatization
Birth: We Are All Market Liberals Now
Life: A Policy in Search of a Rationale
Death: Puzzles and Failures
Reanimation: Dead for Good?
After the Zombies: The Mixed Economy
Further Reading
174
178
182
187
199
200
204
Conclusion Economics for the Twenty-��first Century
Rethinking the Experience of the Twentieth Century
A New Approach to Risk and Uncertainty
What Is Needed in Economics
206
206
207
210
References
Index
213
229
Preface
The idea for this book began when I read this striking passage in Animal
Spirits by George Akerlof and Robert Shiller:
The economics of the textbooks seeks to minimize as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so—and each of us has spent
a good portion of his life writing in this tradition. The economics
of Adam Smith is well understood. Explanations in terms of small
deviations from Smith’s ideal system are thus clear, because they are
posed within a framework that is already very well understood. But
that does not mean that these small deviations from Smith’s system
describe how the economy actually works. Our book marks a break
with this tradition. In our view, economic theory should be derived
not from the minimal deviations from the system of Adam Smith but
rather from the deviations that actually do occur and can be observed. (Akerlof and Shiller 2009, 4–5)
This passage motivated me to write about its implications for macroeconomics in the Crooked Timber blog. In comments, economist Max
Sawicky, posting under the pseudonym MiracleMax, suggested that this,
combined with some earlier posts on ideas refuted by the financial crisis,
would make a good book. Brad DeLong of the University of California at
Berkeley picked up the idea, and the next day Seth Ditchik of Princeton
University Press e-��mailed me to say he thought it was a great idea. The
result is before you.
More than most books, this one has been improved by comments from
others, not all of whom I can name. As I wrote draft chapters, I posted
them on crookedtimber.org, and on my personal blog johnquiggin.com,
then combined them in a draft on wikidot.com. I asked for comments
viii
PREFACE
and received, in total, several thousand, from well over a hundred different commenters, most of them pseudonymous.
I can’t thank all those who commented, but I would like to mention
“Alice,” “Bert,” “Bianca Steele,” Martin Bento, Kevin Donoghue, Kenny
Easwaran, John Emerson, “Freelander,” Jim Harrison, “JoB,” P. M. Lawrence, Terje Petersen, Donald Oats, Andrew Reynolds, “smiths,” John
Street, “Uncle Milton,” Robert Waldmann, Tim Worstall, and “Zamfir.”
I also received helpful comments from friends and colleagues, including George Akerlof, Chris Barrett, Brad DeLong, Joshua Gans, Paul
Krugman, Andrew McLennan, and Flavio Menezes. Several anonymous
reviewers for Princeton University Press went above and beyond the call
of duty in providing extensive and valuable comments. My wife and colleague, Nancy Wallace, read the entire text and made many helpful editorial and substantive suggestions.
Thanks also to the editorial and production team at Princeton University Press. Seth Ditchik was a marvelous and supportive editor, ably
assisted by Janie Chan. Debbie Tegarden, my production editor, was unfailingly cheerful and supportive, not to mention highly efficient in turning a manuscript into a book on a very tight time frame. Other production
staff including Jack Rummel and Jim Curtis gave able support. The marvelous cover design by Karl Spurzem and Dimitri Karetnikov, drawing on
an idea from Seth Ditchik, speaks for itself (it says, “Brraaaiiinnnssss”).
In addition, I must thank all my cobloggers at Crooked Timber, Chris
Bertram, Michael Berube, Harry Brighouse, Daniel Davies, Henry Farrell, Maria Farrell, Eszter Hargittai, Kieran Healy, John Holbo, Scott
McLemee, Jon Mandle, Ingrid Robeyns, Belle Waring, and Brian Weatherson. Without the lively and supportive environment they’ve provided,
this book would never have happened.
Introduction
The ideas of economists and political philosophers, both when they are
right and when they are wrong, are more powerful than is commonly
understood. Indeed the world is ruled by little else. Practical men, who
believe themselves to be quite exempt from any intellectual influences,
are usually the slaves of some defunct economist. Madmen in authority,
who hear voices in the air are distilling their frenzy from some academic
scribbler of a few years back.
—J. M. Keynes, The General Theory of Employment, Interest
and Money
Ideas are long lived, often outliving their originators and taking new and
different forms. Some ideas live on because they are useful. Others die
and are forgotten. But even when they have proved themselves wrong and
dangerous, ideas are very hard to kill. Even after the evidence seems to
have killed them, they keep on coming back. These ideas are neither alive
nor dead; rather, as Paul Krugman has said, they are undead, or zombie,
ideas. Hence the title of this book.
Before the Global Financial Crisis ideas like the Efficient Markets Hypothesis and the Great Moderation were very much alive. Their advocates
dominated mainstream economics. Their influence, acknowledged or not,
guided the thinking of the practical men and women whose decisions created a financial system without parallel in history. Tens of trillions of dollars of interlinked obligations were built on a foundation of speculative, or
entirely spurious, investments. The result was a global economy in which
both households and nations lived far beyond their means.
Today the Efficient Markets Hypothesis and the Great Moderation
look like defunct ideas. Commentators who were proclaiming, a year
or two ago, that the business cycle had been tamed, have admitted their
2
INTRODUCTION
error or, more commonly, moved on to talk of other things. The claim
that financial markets make the best possible use of economic information and can never be subject to irrational bubbles is rarely made overtly
and usually hedged with all kinds of qualifications and escape clauses. In
this zombie state, such claims continue to lumber around the intellectual
landscape.
But habits of mind and thought are hard to change, especially when
there is no ready-�made alternative. The zombie ideas that brought the
global financial system to the brink of meltdown, and have already caused
thousands of firms to fail and cost millions of workers their jobs, still
walk among us. They underlie the thinking of those who are responding
to the crisis and, to a large extent, of the commentators and analysts who
assess those responses.
If we are to understand the financial crisis, and avoid the kinds of responses that set the stage for a new and even bigger crisis in a few years
time, we must understand the ideas that got us to this point. This book
describes some of the ideas that have played a role in the crisis. They are
ºÂº the Great Moderation: the idea that the period beginning in 1985
was one of unparalleled macroeconomic stability;
ºÂº the Efficient Markets Hypothesis: the idea that the prices generated by financial markets represent the best possible estimate of the
value of any investment;
ºÂº Dynamic Stochastic General Equilibrium: the idea that macroÂ�
economic analysis should not concern itself with economic aggregates like trade balances or debt levels, but should be rigorously
derived from microeconomic models of individual behavior;
ºÂº Trickle-Â�down economics: the idea that policies that benefit the well-Â�
off will ultimately help everybody; and
ºÂº Privatization: the idea that any function now undertaken by government could be done better by private firms.
Some of these ideas, such as the Efficient Markets Hypothesis and Dynamic Stochastic General Equilibrium belong to the realm of technical
economic theory. Others, such as privatization are policy prescriptions,
derived from these abstract ideas. Still others, like the Great Moderation
INTRODUCTION
3
and trickle-�down economics, are catchphrases for claims about how the
economy works, or at least, how it worked in the thirty years or so before
the current crisis.
Together these ideas form a package which has been given various names:
“Thatcherism” in the United Kingdom, “Reaganism” in the United States,
“economic rationalism” in Australia, the “Washington Consensus” in the
developing world, and “neoliberalism” in academic discussions. Most of
these terms are pejorative, reflecting the fact that it is mostly critics of an
ideological framework who feel the need to define it and analyze it. Politically dominant elites don’t see themselves as acting ideologically and react
with hostility when ideological labels are pinned on them. From the inside,
ideology usually looks like common sense. The most neutral term I can
find for the set of ideas described by these pejoratives is market liberalism,
and this is the term that will be used in this book.1
The book is organized in a way that I hope will help readers understand how market liberalism depends on ideas that have failed the test
of the Global Financial Crisis. If these ideas continue to influence policy,
they will ensure a repetition of the crisis.
Each chapter deals with a single idea and begins by describing the
birth of the idea, followed by a section on its life, focusing on theoretical
and policy implications. The next section describes the death of the idea
brought about by the global crisis, but usually resulting from weaknesses
that were evident well before the crisis. A brief section on reanimation
looks at attempts to raise these dead ideas from the grave as undead zombies. The next section, entitled “After the Zombies,” looks at alternatives
to the ideas of market liberalism. Finally, there are some suggestions for
further reading.2
1
There is a similar problem of terminology on the other side of the debate. Market liberalism emerged as a reaction against a set of ideas and policies commonly referred to as
“social liberalism” or “social democracy” in Europe and simply as “liberalism” in the United
States. These ideas included a commitment to full employment, based largely on Keynesian
economic management, and a major role for the state in the provision of income security and
services such as health and education. I will generally use the term social democracy to avoid
the ambiguities surrounding liberal.
2
For ease of reading, I have dispensed with the traditional apparatus of endnotes, which
force the reader to keep the book open in two places to follow notes, many of which turn
out to be nothing more than academic citations. Instead, I’ve made sparing use of footnotes
4
INTRODUCTION
The final chapter, “Economics for the Twenty-Â�first Century” looks
more generally at the theoretical and policy ideas that will be needed in
the light of the failure of market liberalism. A simple return to traditional
Keynesian economics and the politics of the welfare state will not be sufficient. It is necessary to develop both theories and policies that respond
to the realities of the twenty-�first century economy.
It is clear that there is something badly wrong with the state of economics. A massive financial crisis developed under the eyes of the economics profession, and yet most failed to see anything wrong. Even after
the crisis, there has been no proper reassessment. Too many economists
are continuing as before, as if nothing had happened. Already, some are
starting to claim that nothing did happen, that the Global Financial Crisis and its aftermath constitute a mere “blip” that should not require any
rethinking of fundamental ideas.
The ideas that caused the crisis and were, at least briefly, laid to rest by
it are already reviving and clawing their way through up the soft earth. If
we do not kill these zombie ideas once and for all, they will do even more
damage next time.
like this one to cover points of tangential interest, notes about some of the economists whose
work is discussed, and so on. The further reading section at the end of each chapter includes
Harvard-�style citations to books and journal articles that have been mentioned in the chapter, and detailed references are given in the bibliography.
Chapter 1
The Great Moderation
Stock prices have reached what looks like a permanently high plateau.
—attributed to Irving Fisher, October 1929
A zombie idea is one that keeps on coming back, despite being killed.
In the history of economics, there can be no more durable zombie idea
than that of a New Era, in which full employment and steady economic
growth would continue indefinitely. Every sustained period of growth in
the history of capitalism has led to the proclamation of such a New Era.
None of these proclamations has been fulfilled.
As Irving Fisher’s famous prediction, made only a few days before the
Wall Street Crash of 1929, illustrates, the belief that the era of boom and
bust has finally been put behind us is not new. In fact, ever since the emergence of industrial capitalism in the early nineteenth century, the global
economy has been shaken, and stirred, by periodic booms and busts.
And, in every intervening period of steady growth, optimistic observers have proclaimed the dawning of a New Economy in which the bad
old days of the business cycle would be put behind us. Even the greatest
economists (and Irving Fisher was a truly great economist, despite some
spectacular eccentricities) have been fooled by temporary success into
believing that the business cycle was at an end.1
In 1929, Irving Fisher’s confidence was based in part on the development of the tools of monetary policy implemented by the U.S. Federal
1
He was among other things a prohibitionist, health campaigner, and eugenicist. In his
economic career though, he made fundamental contributions to the theory of interest rates
and inflation and, ironically, to our understanding of the deflationary processes that deepen
depressions.
6
Chapter 1
Reserve, which had been established in 1913 and had dealt successfully
with several minor crises. The central idea was that, in the event of a financial panic, the Fed would lower interest rates and release funds to the
banking system until confidence was restored.
But the Fed proved unable or unwilling to produce an adequate response to the stock market crash of October 1929. The Great Crash was
followed by four years of uninterrupted decline that threw as many as
a third of all workers out of work, not only in the United States, but all
around the world.
Economists are still arguing about the causes of the Great Depression,
and the extent to which mistaken policies contributed to its length and
depth. These disputes, once polite and academic, have taken on new urgency and ferocity in the context of the current crisis, which echoes that
of 1929 in many ways.
In the aftermath of the Great Depression and World War II, the analysis that held sway over the great bulk of the economics profession was
that of John Maynard Keynes.2 Keynes argued that recessions and depressions were caused by inadequate effective demand for goods and
services and that monetary policy would not always be effective in increasing demand. Governments could remedy the problem through the
use of public works and other expenditure programs.
The rapid return to full employment in the war years seemed to confirm Keynes’s analysis. As Australia’s White Paper on Full Employment,
published in 1945, put it:
Despite the need for more houses, food, equipment and every other
type of product, before the war not all those available for work were
able to find employment or to feel a sense of security in their future.
On the average during the twenty years between 1919 and 1939
more than one-�tenth of the men and women desiring work were
unemployed. In the worst period of the depression well over 25 per
cent were left in unproductive idleness. By contrast, during the war
2
As an economist, Keynes had a lot in common with Fisher, but in other respects he could
scarcely have been more different. A bon vivant and member of the Bloomsbury Group of
intellectuals, married to a glamorous Russian ballerina, Keynes was also a successful speculator, whereas Fisher lost much of his personal fortune in the Crash.
THE GREAT MODERATION
7
no financial or other obstacles have been allowed to prevent the need
for extra production being satisfied to the limit of our resources.
(Common�wealth of Australia 1945, 1)
In sharp contrast with previous wars, the full employment of the
war years was maintained after the return of peace. For most developed countries, the years from the end of World War II until the early
1970s represented a period of full employment and strong economic
growth unparalleled before or since. Referred to as the “Golden Age”
or “Long Boom” in English, “Les Trente Glorieuses” in French, and the
“Wirtschaftswunder” in German, this period saw income per person in
most developed countries more than double.
By the 1960s, many Keynesian economists were prepared to announce
victory over the business cycle. Walter Heller, chairman of the Council
of Economic Advisors under John F. Kennedy, hailed the switch to active fiscal policy in the 1960s, saying “We now take for granted that the
government must step in to provide the essential stability at high levels of
employment and growth that the market mechanism, left alone, cannot
deliver.”3 Attention turned to the more ambitious goal of “fine-Â�tuning”
the economy so that even “growth recessions” (temporary slowdowns in
the rate of economic growth that typically produced a modest increase in
unemployment rates) could be avoided.
Pride goes before a fall. In the 1970s, the seemingly endless postwar
boom came to an abrupt halt. It was replaced by accelerating inflation
and high unemployment. Keynesian fiscal policies, aimed at eliminating unemployment, were abandoned. Restrictive monetary policies and
high interest rates allowed central banks to squeeze inflation out of the
system over the course of the 1980s. The pressure for price stability was
reinforced by globalization, and particularly by the growing size and influence of the global financial sector.
While price stability returned, the full employment of the postwar
era was gone, and has never truly returned. Economic growth returned
gradually, but, at least in developed countries, never regained the rapid
rates of the postwar boom.
3
Heller (1966), 9.
8
Chapter 1
It seemed that the idea of a New Era was dead, once and for all. But
zombie ideas are not so easily killed.
Birth: Calm after the Storms
If only by comparison with the dismal 1970s and 1980s, the 1990s were
an era of prosperity for the developed world, and particularly for the
United States. The boom of the late 1990s produced improvements in
income across the board, after a long period of stagnation for those in
the lower half of the income distribution. The boom in the stock market
produced even bigger gains for the wealthy. House prices were slower to
move, but because they are such a large part of household wealth, contributed even larger capital gains.
The long and strong expansion of the 1990s, combined with political
events such as the collapse of the Soviet Union, produced a new air of
optimism and, at least in the United States, triumphalism. The success of
books like Francis Fukuyama’s The End of History and Thomas Friedman’s The Lexus and the Olive Tree reflected the way they matched the
popular mood.
Fukuyama argued that the great conflicts that made history something
more than the passing of time were over, and that the end of the Cold
War marked “the end point of mankind’s ideological evolution and the
universalization of Western liberal democracy as the final form of human
government.”4 Fukuyama assumed that “Western” implied “capitalist.”
However, he showed some ambivalence about the meaning of “capitalism.” Fukuyama’s use of this term implied a triumphant market liberalism.
But in defending the factual claim of a universalized social order, his use
of “capitalism” encompassed the whole range of political and economic
systems observed in Western societies, from Scandinavian social democracies to the winner-�take-�all society then emerging in the United States.
Friedman dispenses with such nuance. In a book full of cute phrases
and memorable metaphors, the most prominent was the “Golden
4
Fukuyama (1992), 4.
THE GREAT MODERATION
9
Straitjacket.” This was Friedman’s way of saying that, in a globalized
economy, adherence to the principles of market liberalism would guarantee golden prosperity. On the other hand, any deviation from those
principles would bring down the wrath of the “Electronic Herd” of interconnected global financial markets.
Fukuyama’s celebration of the new order made him an intellectual
superstar. His books were widely cited, if not quite so widely read.
Friedman’s breezy boosterism, by contrast, did not earn him so much
intellectual credit, but it put him on the bestseller lists. Everyone wanted
to be part of the new Lexus-�owning world.
Economists were a little late to the party. Well into the 1990s, they
worried about weak productivity growth, the possibility of resurgent inflation, and unemployment rates that remained high by the standards of
the postwar boom.
By the early 2000s, however, it was possible to look at the U.S. data
and discern a pattern that was the very opposite of a lost golden age.
Rather, the data could be read as showing a decline in the volatility of
output and employment. Most economists saw the decline in volatility
as a once-�off dropping that took place in the mid-�1980s, after the early
1980s “Volcker” recession, so called because it was induced by the restrictive anti-Â�inflation policies of Fed chairman Paul Volcker. 5
Although most attention has been focused on the volatility of output,
the most important impact of recessions is the variability of employment,
which is best measured by the employment/population ratio. As with
measures of GDP volatility, the standard measures of employment volatility declined noticeably after 1985.
This apparent decline in volatility largely coincided with the chairmanship, lasting nearly twenty years, of Volcker’s successor, Alan
Greenspan. Whether deservedly or not, Greenspan, rather than Volcker,
got the credit. Greenspan’s status as the source of all economic wisdom
was symbolized in the ultimate Washington accolade, a biography (or
rather, hagiography) from Bob Woodward, entitled Maestro.
5
The cigar-�chewing, six-�foot seven Volcker literally towered over the economic scene in
his day and remains active (at 81, he’s an adviser to President Obama) but has been almost
entirely displaced in popular memory by Alan Greenspan.
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