THE EUROPEAN ECONOMIC CRISIS AND THE CRISIS IN ECONOMICS (1)

The European Economic Crisis and the Crisis in Economics (I) (06-08-2013)

Introduction

In 2008 the American financial crisis created a serious credit crunch in the Western world, followed by a global depression in 2009. China and the USA stimulated their economies, and were able to recover quickly. Brussels, however, began to blame the national governments for their debt ratio’s  being too high. Leading economists, especially in Germany and The Netherlands, saw the welfare state as the bottleneck for the free-market economy to flourish. They advocated government expenditure cuts and institutional labour market reform. Unfortunately this typical neoclassical policy has not achieved its goal of budget deficit reduction, and prolonged the depression. Over the years we see a growing debate between the hawks and the doves within the group of neoclassical economists. The hawks advocate increasing government expenditure cuts, while the doves  plea for less budgetary discipline, as long as the economy is in a recession (even now spenders are economically depressed, they call the situation still depressed!) . How come that European economists are doing such a bad job when advising their governments? In this essay I suggest that the neoclassical dominance on the ‘market’ of economic ideas has created a cognitive closure among leading economists, which leads to consistently biased policy advice.

Education at Economics Faculties

Until WW II programmes of education and research at Economics Faculties were more pluralistic, and students were taught that economic problems could be approached from different points of view. From then on the dominance of the neoclassical approach has increased, and has established an almost-monopoly. Especially the increasing use of quantitative methods on the basis of a biased theoretical foundation, has led to a reduction of economic science to a set of technical and quantitative problems.

I will illustrate this position by means of two propositions. In the first place, this dominance has led to the almost disappearance of genuine macroeconomics. Economies are interpreted as firms, which are operating on a very large and competitive global market, making problems of national economies to a micro problem. In the second place, this dominance has led to a biased view on the role of institutions. The opposing heterodox view defends the idea that institutions matter, and that every country must find out which institutional framework fits its economy best. The neoclassical view on institutions assumes that a system of free markets is superior, and that institutions should enhance the economic efficiency of the economic transactions between buyers and sellers.  In this first part of the essay I focus on the so-called micro-macro problem. In a second part I will discuss the role of institutions.

Genuine macroeconomics

When we study all serious approaches within economics, we discover that economics is a rich and pluralistic science. Neoclassical economics is based on the idea of humans as economic, rational and non-social actors. The term economic refers to the relationship between humans and their natural environment. This can include other people, but then they are also considered as a natural thing, and not as a human being. The term rational means that actors never operate irrationally – no hubris, not narrow-mindedness, for instance. The term social means that people recognise each other as humans, which might have positive or negative consequences. So, non-social means that neither solidarity nor rivalry play a role. The analysis of households, firms, markets, market economies and governments are based on this paradigm. The outcome is that – except in case of public goods – a free market (economy) will lead to optimal efficiency. So, the current crisis is interpreted as being the result of a too high level of government expenditures. All markets are competitive, which means that firms, which function badly, are going bankrupt. All markets are small relative to the whole of the economy, which means that disequilibrium on one market cannot create significant disequilibria on other markets and in the economy as a whole. There is one exception, which is the money market. Money is involved in every market transaction, which means that a significant disequilibrium on the money market is a threat for the stability of the economy as a whole. This makes it essential for a market economy to be accompanied by  proper monetary policies, which should be implemented by a central bank, which is independent from politicians. In times of an upturn the growth of the money supply should be lower than the structural growth of the total production; in case of a downturn money growth should be higher. Currently there are neoclassical economists, who defend  that actual money growth should be proportional to the structural production growth, and that the quantitative easing policy of the ECB just creates inflationary expectations.

This story is told in all textbooks, and there are hardly students and professors to be found, who are able to tell a different story about the crisis. Heterodox economics and economic sociology contain approaches, who differ significantly from this dominant analysis. Some of them are based on a sound macro-foundation. We discuss shortly the Post-Keynesian variant now.

Post-Keynesian Alternative

It is a typical macro approach, which means that it has its foundation in the macro-sociology. The behaviour of firms and consumers depends primarily on their confidence with respect to the short and medium run prospects of the economy as a whole. Is the spending climate optimistic, consumers and investors demand for goods, which stimulates production and employment. Is the climate pessimistic the actors use a larger part of their income and wealth for savings and for paying off their debts. In case of bank loans this leads to money destruction, which might make the climate more pessimistic. Post-Keynesians also assume that an economy is not a closed system, which function is determined by a mechanism. When they discuss relationships we must be aware that they are permanently subject to shocks – from a technical as well as from a psychological-sociological nature. This fact creates strong feelings of uncertainty, which drive people to develop rules of conduct so as to make reality more predictable. In good times, people are inclined to ignore important rules, while in bad times people are inclined to exaggerate the application of pre-cautionary rules. Post-Keynesians have applied modern insights of behavioural economics to the macro-level, which led them to advocate regulation of labour markets as well as financial markets. During the eighties and nineties they warned against the process of deregulation in the financial markets, and defended  European labour market regulation, including social security arrangements so as to minimise rivalry between the conflicting groups. Their macroeconomic approach is especially meant for relatively large economies, such as the European economy and the global economy. Brussels approaches the European economy, however, as a set of separate and relatively small national economies, and give them all the same advice: government expenditure cuts, so as to reduce budget deficits. Now most of these separate national economies are really doing it, does this advice have the opposite effect: it strengthens the decline and enlarges the deficits. This is not only at the detriment of Europe. Because the European economy is large relative to the global economy, is it realistic to expect a negative effect of a European decline on the growth of the global economy. This takes us all in a downward spiral, which can only be stopped by a globally coordinated stimulus programme. Price adjustments – lower interest rate, lower wages, depreciation of foreign currencies, as advised by neoclassical economists – do not help. On the contrary, they worsen the situation.

During the first decade of 21th century Post-Keynesians foresaw the crisis and delivered quite detailed descriptions of the crisis to come. The leading economists ignored these messages, or were not even aware of them as a result of the almost complete fragmentation of the economics discipline. In The Netherlands there are no heterodox macro-economists anymore, and in Germany they have a hard time. A typical Post-Keynesian policy advice to Europe would be: (1) reregulate the financial world; (2) advise the private households and firms to increase their buffers in terms of own capital and liquidity; (3) increase of government investments, to be financed by the central bank; and (4) no expansionary monetary policies.

Of course heterodoxy has more to offer than Post-Keynesian analysis. Unfortunately The North-Western world is overrun by economists, who had never been confronted with views different than the typical micro-founded neoclassicism. We read the effects of this cognitive closure every day in the media.

Dr. Piet Keizer

Associate Professor Economic Methodology; Utrecht University School of Economics

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