The Final Death and Next Life of Maynard Keynes
by James K. Galbraith
This was the keynote lecture to the 5th annual “Dijon” conference on Post Keynesian economics, meeting at Roskilde University near Copenhagen, Denmark on May 13, 2011.
It’s of course a great privilege to be here in this role and especially on the occasion of the 75th anniversary of the publication of the General Theory.
Two years ago, you may recall, our profession enjoyed a moment of ferment. Economists who had built their careers on inflation targeting, rational expectations, representative agents, the efficient markets hypothesis, dynamic-stochastic-general-equilibrium models, the virtues of deregulation and privatization and the Great Moderation were forced by events momentarily to shut up. The fact that they had been absurdly, conspicuously and even in some cases admittedly wrong even imposed a little humility on a few. One senior American legal policy intellectual – a
fellow-traveler of the Chicago School – announced his conversion to Keynesianism as though it were news.
The apogee of this moment was the publication in the New York Times Sunday Magazine of Paul Krugman’s essay, “How Did Economists Get It So Wrong?” In it Krugman admitted that
“a few economists challenged the assumption of rational behavior, questioned the belief that financial markets can be trusted and pointed to the long history of financial crises that had devastating economic consequences. But they were swimming against the tide, unable to make much headway against a pervasive and, in retrospect, foolish complacency.”
In keeping with mainstream practice, Krugman named almost nobody. So in a reply essay entitled “Who Are These Economists Anyway?” I described the neglected, ignored or denied second- and third- generation work, mostly but not entirely in the tradition of Keynes, who did get it right. I could have named many more than I did including quite a few in this room.
Let me begin here by distinguishing between the three major lines of Keynesian thought that did get it right. I will honor the well-remembered and beloved by identifying these lines with the late Wynne Godley, Hyman Minsky, and Galbraith père.
Godley worked in the Keynes-Kuznets-Kalecki-Kaldor tradition of macro models attentive to the national income accounting identities and to consistency between stocks and flows. The virtue of this approach is clarity and a comparative lack of overreaching ambition. Models of this type say nothing false, a huge advantage over the mainstream starting position which consists of nothing true. And the models direct you to check whether factual claims make sense given everything that they may imply. That federal surpluses implied unsustainable private debt was clear to
Godleyans in the 1990s, just as the fact that household debt burdens were again unsustainable was clear to them in the 2000s.
In contrast the Congressional Budget Office today asks no such consistency questions, and makes nonsense forecasts for that reason – in which for instance the ratio of net interest payments to GDP rises manifold with no effect on growth or inflation.
Hyman Minsky developed an economics of financial instability, of instability bred by stability itself, the intrinsic consequence of over-confidence mixed with ambition and greed. Minsky’s approach is mainly conceptual, rather than statistical. A key virtue is that it puts finance at the center of economics, analytically inseparable from real economic activity for the simple reason that capitalist economies are run by banks. And his second great insight is into the dynamics of phase transitions – hedge to speculative to Ponzi – arising from within the system and subject to
formalization in the endogenous instabilities of non-linear dynamical models.
To grasp Minsky is to go immediately beyond the coarse notion of “Minsky Moments” – a concept which implies falsely that there are also “non-Minsky moments.” It is to recognize that the financial system is both necessary and dangerous, that strict financial regulation is both indispensable and imperfect.
Right away the idiocy of a “Great Moderation” becomes clear.
Just as with a nuclear reactor (or any machinery, for that matter) a long record of stable performance does not prove that the controls and backup systems are perfect, any more than it can show that they are unnecessary. Either position, even when taken by authors of the Stability and Growth Pact, the leaders of the Federal Reserve System, or by applicants for license renewal before the Nuclear Regulatory Commission, is the mark of a crank.
The Galbraithian line is allied and descended from Keynes in the same sense that my father was, accepting the central role of aggregate effective demand, the national income accounts, the credit-circuit view of economic life, and the financial instability hypothesis. But it is also embedded in a legal-institutionalist framework, rooted in pragmatism, framed by Veblen and Commons, forged in the political economy of the New Deal. This tradition emphasizes the role played in financial crisis by the breakdown of law and the failure of governance and regulation –
and the role played by technology as a tool in the hands of finance for breaking down the law.
I’ll stress this line today not just for family reasons but because it remains the least familiar.
When you engage the mainstream on the national income accounts, at least they know what the damn things are. And these days you can even get – though who knows for how much longer – a respectful mention of Minsky even from Larry Summers, if not any sign that he has, actually, read him.
What you cannot get – not at a meeting at the IMF, not from the participants at INET – is any serious discussion of contract, law and fraud. I know, because I’ve tried. No one will deny the role of fraud in the financial debacle – how could they? But they won’t discuss it either.
Why not? Personal complicity plays a role, among present and former government officials, regulators, consultants and the academic ideologues who advised them and those either played the markets or took fees from those who did. (At INET, Larry Summers stated that he was “not among those who regard financial innovation as necessarily evil.”)
There is a vast web of negligence and culpability here, deeply abetted by the way universities (and especially business schools) are funded and by what they teach.
But it’s more than any of that. The commodity is the foundation-stone of conventional economics. The theory of exchange requires the commodification of tradable artifacts. Without that, there is no supply and demand. A world of contracts, each backed by a separate and distinct set of promises, each only as good as the commitments specifically made the ability of the laws and courts to enforce them, is a different sort of world altogether. Just because you can call a set of such contracts “collateralized debt obligations” or “credit default swaps” – and just because you can create something called an “exchange” to trade them on, does not make them into commodities with a meaningful “market price.”
Complexity defeats the market. With infinite variability in principle, and in practice more distinct features than one can keep up with, in great volume, contracts of these kinds are per se hyper-vulnerable to fraud. Examples range from the New Jersey phone company that printed made-up fees on its bills, to the fact that almost no one at AIG realized that the CDS contracts they were selling contained a cash-collateral clause. They range from the unnoticed provisions permitting CDO managers to substitute worse for better mortgages in previously-sold packages without notifying the investors, to the Mortgage Electronic Registration System and the pervasive incentive to document fraud in the foreclosure process.
The concession that “fraud was present” is like the phrase “Minsky Moment:” though true it doesn’t begin to cover the case. Even to say that “fraud overwhelmed the system” doesn’t go far enough. Read the Financial Crisis Inquiry Commission Report, the Report of the Senate Permanent Committee on Investigations, the many reports of the Congressional Oversight Panel and the Special Inspector General for the Troubled Asset Relief Fund. It’s plain as day: fraud was not a bug, but a feature. The word itself, along with “abusive,” “egregious,” “reckless” and even “criminogenic,” suffuses these reports.
Godleyans teach that stocks cannot be separated from flows. Minskyans teach that finance cannot be separated from reality. My father’s tradition teaches that the legal and the technological are one. The financial world as it exists has nothing to do with the commodity-world of real-exchange economics, with its delicate balance of interacting forces. It is the world of technology in the form of quasi- mass-produced legal instruments, of uncontrolled complexity.
It is the world of evolutionary specialization, in the never-ending dance of predator and prey. In nature when the predators achieve an overwhelming advantage the prey suffer a population crash, from which the predators in turn suffer later on. In economics, it’s a financial crash -- but the dynamics are essentially the same.
Corporate fraud is not new. Financial fraud is also not new. What was new here was the scale and complexity of debt obligations backed by mortgages. Mortgages are not like common stocks, which though also issued in the millions are each an identical claim on company’s net worth.
Mortgages are each a claim on the revenue stream of a different household, backed by homes of a diversity made irreducible by the simple fact that each one is in a different place. Long-term mortgages have existed since the New Deal, but they were rendered manageable by their simple uniform structure, their substantial margin of safety, and the fact that the secondary markets were public and imposed public standards.
All of this meant that supervision was possible. There could be a well-understood code covering what was right and what was wrong, alongside practitioners who understood professional ethics and enforcement officers who could work with them smoothly for the most part.
With computers we entered the world of private-label securitization of the negative-amortization payment-optional Adjustable-Rate-Mortgage with a piggy-back to cover the down-payment. Oh, and... documentation optional. There was a private vocabulary covering these loans and related financial products – liars’ loans, NINJA loans, neutron loans, toxic waste – which tells you that those who sold them knew their line of work was not one hundred percent honest. To learn that at the mortgage originator Ameriquest office chiefs fed their sales staff crystal methamphetamine
adds just a touch of telling detail.1
Rendering such complex and numberless debt instruments comparable requires a statistical approach, based on indicators. And that launches us into a world not imaginable in (say) 1927: a world of credit scores, algorithms and ratings, and a world of derivative and super-derivative instruments, of sliced-and-diced Residential Mortgage Backed Securities, of collateralized debt obligations, of synthetic CDO’s and of credit default swaps – all designed to secure that AAA
rating and to place the instruments – counterfeited, laundered and fenced – into the hands of the mark, who as Michael Lewis has told us (in The Big Short) was known to the industry by the nickname, Düsseldorf.
The Texas institutionalist Clarence Ayres stressed most strongly the role of technology and the irreversible contribution of new tools to the production process. In finance, the algorithm is that new tool – a radically-cheap substitute for underwriting, a device for converting the financial game into a computerized casino in the strict sense, where one can never be sure by how much the house is bending the rules. We only observe that RMBS ratings models did not factor in the default risk when teaser rates reset; nor did the holders of synthetic CDO’s know that the
managers could substitute sure-to-default 2006-7 vintage mortgages for the slightly-better 2005 vintages without notification.
Keynes I think understood these issues as far as they went in his time, and they led him to argue that the speculative markets should be small, expensive and restricted to those who could afford to play and lose – but that they should not repressed, on the famous grounds that it is far better for a man to tyrannize over his bank balance than over his fellow man. And in Keynesian terms, what we’ve seen since the financial crash is no surprise at all. Absolute distrust, leading to absolute liquidity preference, is the incurable consequence of overwhelming financial fraud.
I say incurable because – it is so. The diagnosis is of an irreversible disease. The corruption and collapse of the rule of law in the financial sphere is irreparable. It is not just that restoring trust takes a long time. It’s that under the new technologies it cannot be done. The technologies are designed to sow distrust and that is the consequence of their use. Recent experience is the proof.
And therefore there can be no return to the way things were before. It’s the true end of illusions – the illusion of a marketplace in the financial sphere.
Let me extend this analysis into Europe. It is commonplace to speak these days of the “Greek debt crisis,” the “Irish crisis,” the “Portuguese crisis” and so forth as though these were distinct financial events. This fosters the impression that each can be resolved by appropriate agreement between the creditors – headquartered in Frankfurt, Brussels, Berlin and Paris – and the debtors taken one by one. Good behavior, taking the form of suitable austerity, will be rewarded by a return to normal credit conditions and market access. The “financial market” in this imagery is severe but fair: she cracks the whip on the profligate, but praises and rewards the prim.
But that Greece has a weak tax system and a big civil service was not news. It was a fact overlooked in the good times and surfaced when convenient. The initial shock to Europe came from the American mortgage markets. When European banks and others realized the extent of their losses there, beginning in late 2008, they looked for ways to protect themselves. They did this by selling weak assets and buying strong. That is why yields rose on all the small peripheral countries despite their very different circumstances but fell for the large.
Greece cannot implement the cuts demanded of it without crashing its GDP. But even if it could, any event affecting any European country could sink Greece again, irrespective of what Greece does. So obviously there is no national policy solution, and no financial market solution. That is the meaning of the negotiations now underway. There will be a restructuring or a default. And there must be an economic and not merely a financial rescue, and a new European architecture not built around the banks and the credit markets. Either that or the depression in Europe will simply go on until the European Union falls apart. This is the practical meaning of an incurable disease.
Our challenge as Keynesians now is to work out the practical implications of this reality and to spell out a course of action. And the first aspect of this challenge is to condemn clearly the False Keynesianism that came briefly to power with the new administration in America in 2009.
In January, 2009, as you recall the new Administration announced the need for a “stimulus” or recovery program. Without it, they calculated, unemployment might rise as high as 9 percent by 2010 before beginning to decline again. With it, they forecast, the rise in unemployment would be held to 8 percent, recovery could begin in mid-2009, and by early 2011 unemployment would be down to 7 percent, on its way back to 5 percent by 2013.
The forecast was a political and economic disaster. But in retrospect it’s most interesting for what it tells us about those who made it. Plainly, they did not understand – perhaps they did not wish to understand – what was going on. The assumption of a glide path back to five percent unemployment meant that the natural rate of unemployment was built into the mentality and the computer model – the only issue was speed of adjustment. And the stimulus package was meant
to increase that speed slightly.
There was, in short, no real crisis in the minds of those who took office in 2009. There was, rather, just an unusually deep recession – a Great Recession, it came to be called. But the recession would end – Chairman Bernanke said so from the beginning – and when it did, things would return to the normal prosperity of the mid-2000s. It was the mindlessness of estimated output gaps, of consensus business cycle forecasting, of “Okun’s Law.” The “Minsky Moment” would surely pass.
We have, of course, seen this bad movie before. Recall that in 1960 Larry Summers' uncle c0-invented the Phillips Curve, stipulating on weak empirical evidence and no clear theory a relationship between unemployment rates and inflation. True Keynesians including Nicholas Kaldor, Joan Robinson, Robert Eisner and my father were appalled. The construct was doomed to collapse, and when it did after 1970 the school that most people thought of as “Keynesian” was swept away in the backwash.
Today the failure of the forecast behind the recovery package is conflated with the failure of the “stimulus” itself, and so the same thing is happening again. Those who failed most miserably to forewarn against the financial crisis have regained their voices as the scourges of deficits and public debt. There is a chorus of doom, as those who once thought the New Paradigm could go on forever now inveigh against “living beyond our means” and foretell federal bankruptcy and the collapse of the dollar and the world monetary system. This includes such luminaries as the leadership of the International Monetary Fund and the analytical division of Standard & Poor’s.
It would be pathetic if it were not so dangerous, but the fact is, these forces are moving down a highway cleared of obstacles by the retreat of the False Keynesians.
It is our task – whatever the odds against us – to build a new line of resistance.
I think that line must have at least the following elements within it.
First, an understanding of the money accounting relationships that pertain, within societies and between them, so that we cannot be panicked by mere financial ratios into self-destructive social policies or condemn ourselves to lives of economic stagnation and human waste.
Second, an effective analysis of the ongoing debt-deflation, banking debacle and of the inadequate fiscal and illusory monetary-policy responses so far. In America and in Europe this is a crisis primarily of banks, not of governments, and it is for us to call attention to this fact.
Third, a full analysis of the criminal activity that destroyed the banking sector, including its technological foundation, so as to quell the illusion that these markets can be made to work again.
As part of this, there must be a renewed commitment to expose crime, punish the guilty and enforce the laws.
Fourth, an understanding of the way in which financial markets interact with the changing geophysics of energy – especially oil – to choke off economic recovery, unless the energy problem is addressed squarely.
Fifth, a new strategic direction, to redesign and rebuild our societies for the challenges of aging, infrastructure, energy, climate change and shared development that we all face, and to create the institutions required to make this happen.
Sixth, a commitment to achieve these goals by mobilizing human brains and muscles, to overcome unemployment and to assure a widely-shared, decent and reasonably egalitarian society according to the most successful and enduring social models.
Seventh, the reconstruction of the instruments of state power – the power to spend, the power to tax, the money power and regulation – so as effectively to pursue these goals, with democratic checks and balances to help prevent the capture of new state institutions by predatory forces.
I will not pretend, as Keynes did, that nothing stands in the way but a few old gentlemen in frock coats, who require only to be bowled over like nine-pins and who might enjoy it if they were.
We should take on this challenged simply as a matter of conscience. We are not contestants for power. It is for us a matter of professional responsibility and civic duty.
As Bill Black likes to say, and in the words of William of Orange, it is not necessary to hope, in order to persevere.
1 See McLean and Nocera, All the Devils Are Here. Discussion with a conference-goer afterward suggested that this was taken as a metaphor, but it was not. She said, “But that’s a rape drug.” Precisely so.