Instability may not be optional

Sydney Morning Herald commentator Gareth Hutchens commented that the Rogoff and Reinhart affair shows how slow economists are to realise that their data may be dodgy, but to my mind that is insignificant compared to how slow they are to realise that their theories are dodgier still.

A defining feature of mainstream economic modelling is the belief that the economy is stable: given any disturbance, it will ultimately return to a state of tranquil growth. Mainstreamers argue over how fast this will happen: Chicago/Freshwater /New Classicals argue it adjusts instantly, while Saltwalter/New Keynesians say it will take time because of ‘frictions’ in the economy’s adjustment processes. But they both take the innate stability of the economy for granted, and this belief is hard-coded into their mathematical models.

This stability is also seen as a good thing – so much so that anything which obstructs it being achieved should be removed. They argue over policy in a crisis like the world’s current one, with New Classicals falling firmly into the ‘Austerians’ camp while New Keynesians favour fiscal stimulus, but they speak almost as one in favour of eliminating monopolies, reducing union power, deregulating finance – or they did before the financial crisis came along.

One would think that after as disturbing an event as the Great Recession – and let’s call it as it is now, the Second (or perhaps Third) Great Depression in Europe – that this belief in the innate stability of capitalism might be at least reconsidered by the mainstream. But though they’re willing to tinker at the edges, their core vision of the economy as being either in or near a stable equilibrium remains an unchallenged mantra.

I come from a different tradition that sees the economy as inherently unstable, and which regards this instability as both creative and destructive. Schumpeter famously gave us the phrase “creative destruction” to describe the process by which capitalism develops new products and new institutions, and my work builds on his and that of his most famous pupil, Hyman Minsky.

Here there is also a bit of a “Freshwater vs Saltwater” divide, since Schumpeter focused on the industrial and entrepreneurial process – what you might call Main Street Capitalism – while Minsky focused on Wall Street Capitalism. In the latter case, the instability can be purely destructive, as inventive financiers find ways to portray what are innately Ponzi Schemes as good investments, and end up fleecing the public while conjuring financial crises into existence.

Minsky’s most famous phrase on this front is often paraphrased to three words: “Stability is Destabilising”. (The full sentence was “Stability – or tranquillity – in a world with a cyclical past and capitalist financial institutions is destabilising”). But I think there is a better (if longer) passage that gives the true flavour of Minsky’s perspective. He noted that in the “Chicago view” of capitalism, there exists a financial system “which would make serious financial dis­turbances impossible. It is the task of monetary analysis to design such a financial system, and of monetary policy to execute the de­sign…”

He then stated his alternative view – and I’ve highlighted the key propositions in it:  “The alternative polar view, which I call unreconstructed Keynes­ian, is that capitalism is inherently flawed, being prone to booms, crises, and depressions. This instability, in my view, is due to char­acteristics the financial system must possess if it is to be consistent with full-blown capitalism. Such a financial system will be capable of both generating signals that induce an accelerating desire to in­vest and of financing that accelerating investment.”

That’s a strong statement: capitalism is inherently flawed, and this is because of characteristics the financial system must have: the causes of instability are not an ‘optional extra’ that careful regulation or institutional design might eliminate. An eloquent supporter of this view is venture capitalist and INET co-sponsor Bill Janeway, who argues in his book Doing Capitalism in the Innovation Economy that “the Innovation Economy is driven by financial speculation”, and this is part of the creative process of capitalism. “Occasionally, decisively, the object of speculation is the financial representation of one of those fundamental technological innovations – canals, railroads, electrification, automobiles, airplanes, computers, the internet – the deployment of which at scale transforms the market economy, indeed creates a ‘new economy’ from the wreckage of the financial bubble that attended its birth,” he says.

Consistent with Keynes’s much derided phrase “animal spirits”, Janeway argues that the innovation and scale of investment would be much less if the giddy prospects of enormous financial gain was not there to dazzle the minds of both innovators and their financiers. Stifle this folly and you might stifle capitalism itself.

This was the essence of Keynes’s comments on animal spirits as well: businessmen, both entrepreneurs and financiers, embark on projects and gamble fortunes on hopes that well exceed rational calculation. But because they do, society advances – irregularly and unstably to be sure, but it advances all the same:

“Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities,” he said.

“Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; though fears of loss may have a basis no more reasonable than hopes of profit had before. 

“It is safe to say that enterprise which depends on hopes stretching into the future benefits the community as a whole. But individual initiative will only be adequate when reasonable calculation is supplemented and supported by animal spirits, so that the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death (empahsis added).”

I’ve tended to underplay the importance of this in my own reactions to the economic crisis, and in my suggestions for reform as well. I’ve argued that we can tame the tendency for finance to generate speculative bubbles, without paying sufficient attention to whether those bubbles, sometimes, may actually leave behind a worthwhile residue when the froth has subsided. Certainly that was the case with the internet bubble of the 1990s to early 2000s: numerous futile ventures were undertaken (remember Pets.com?) and far too much debt was generated. But the aftermath was the development of an “information superhighway” that few of us could imagine doing without today.

I still believe that capitalism would keep its dynamism even if we developed an institutional framework for banking that stopped it financing Ponzi schemes in real estate. But I’m now rather more inclined to treat bubbles in finance markets as perhaps a necessary price for innovation.

Part of this shift in sentiment is the result of recent modelling that I did as part of making a presentation to a staff seminar at the Australian Treasury last week. I’ll discuss that in my second instalment on this topic.