The Great Economists Page 14

  During the 1980s, the Japanese economy had performed spectacularly. Japan grew at an average rate of 4.5 per cent per year, and there was a widespread belief that it might even overtake the US as the largest economy in the world. However, the Japanese boom had been fuelled by a colossal run-up in property and equity markets. Japan has struggled to recover from the sharp correction in these that occurred in 1991, ushering in over two lost decades of stagnant growth and falling prices.

  Since 1992, the Japanese economy has grown at an average rate of just 0.9 per cent per year, less than a quarter of its pre-1991 growth rate. In money terms, it was only in 2016 that Japanese national output surpassed its 1997 level. This is because its weak real growth had been accompanied by falling prices. Its benchmark stock index has also failed to recover since the early 1990s crash. The Nikkei 225, which peaked at over 38,000 at the start of 1990, had fallen to 14,000 in August 1992. After the recent financial crisis, the market fell to a low of under 9,000 before recovering to around 20,000. Despite its recent good performance, the Japanese stock market is still only valued at about half of what it was before the crash.

  Japan’s recovery is hampered by a rapidly ageing population and strong competition from its Asian neighbours. However, it is expectations of a stubbornly weak economy, where prices are falling, that have created a deflationary mind-set that is hard to break out off. This can become self-fulfilling where low expectations cause households and businesses to hold back spending, which then delivers the deflation they feared.

  Escaping a deflationary trap

  Irving Fisher’s debt-deflation theory about depressions was based on a small sample of just three short periods of deflation, 1837–41, 1873–79 and the Great Depression of the 1930s. While it is not uncommon for prices to be falling in certain sectors or product markets, a sustained deflation in the general or average price level was actually a rare event until it occurred in Japan.

  In such an event, Fisher’s solution, as he recommended repeatedly in letters to President Roosevelt and colleagues, was basically reflation. He proposed that the central bank should simply increase the price level to near its 1926 level by expanding the money supply in line with his formulation of the Quantity Theory of Money. He also suggested stabilizing the financial system by providing a government guarantee of bank deposits to curb harmful and destructive bank runs. He believed that membership of the gold standard prevented the necessary monetary expansion since the dollars in circulation were constrained by the amount of gold. Dropping the gold standard would free the dollar and allow it to fall in value during a depression, which could boost exports and therefore the economy.

  He also proposed a gift or loan to employers who increase their labour force. Otherwise, he had no enthusiasm for fiscal policy or public works programmes, which Fisher saw as simply the swapping of private sector debt for public sector debt. A fiscal stimulus might support output and employment over a short horizon (around two years), but would not address the underlying causes of the depression. As such, it was simply a painkiller rather than a cure.

  The US did devalue its currency and leave the gold standard but by 1933 the economy still wasn’t recovering. Fisher had believed that confidence would return the economy to prosperity immediately, but it did not.

  Nearly a century later, as Japan’s experience shows, it is clear that reflating an economy is not as easy as Fisher thought. Japan has undertaken a number of periods of aggressive monetary policies with the central bank injecting cash through quantitative easing (QE) programmes. It seems that the war against deflation cannot be won simply through robust action from the central bank.

  Combating deflation requires a change in consumer attitudes and firms’ behaviour, so it’s a more complex process than it appears. In a 2002 speech, Ben Bernanke argued that Japan should consider a ‘helicopter money drop’.18 It would inject money directly into the economy; in essence, a free gift of money to citizens. As a permanent gift, it could have a strong impact on consumer and producer expectations of inflation.

  So far no major central banks or Treasury departments have taken up Bernanke’s suggestion. It would certainly be unconventional, but radical solutions may need to be considered in economies hamstrung by high levels of debt.

  Japan indeed faces a number of barriers to economic growth besides deflation. First, it has a large overhang of public debt which has made governments reluctant to use fiscal policy. Second, structural changes in the economy and financial reforms are required. Bernanke argued in 2002 that political constraints rather than a lack of policy instruments were the reason Japanese deflation has been so long-lasting.

  In considering whether the US could suffer a similar deflationary episode to Japan’s following the collapse of the dotcom bubble between 2000 and 2002, Bernanke had correctly predicted it to be unlikely. His primary argument was the relative structural stability of the American economy compared to Japan’s, and its stronger ability to absorb shocks and grow. In particular, he mentioned the younger workforce, flexible markets, entrepreneurial spirit and openness to technological change all contributing to this resilience – and, by implication, that these were some of the factors absent in Japan. Bernanke would soon face a test of his theories with the 2009 Great Recession that followed the global financial crisis, and the prospect of repeating the 1930s loomed again.

  Minsky meltdowns

  Irving Fisher’s insights were revived in the 1990s by Hyman Minsky, who had incorporated ideas from Fisher as well as others in formulating his theory that private corporate debt, largely ignored in macroeconomic models, would lead to a financial crisis. He warned against speculative bubbles arising in inflated asset prices which had economy-wide implications.

  The financial instability hypothesis developed by Minsky describes how credit bubbles form,19 while Fisher’s debt-deflation described how they collapse and drag the economy into recession and depression. Minsky believed that, after prolonged prosperity, capitalist economies tend to move from a financial structure dominated by stable finance to one that increasingly emphasizes speculative and Ponzi finance, which are unstable. He viewed such cycles as endemic to a capitalist system, their severity depending on the dynamics of such a financial system and the regulations that govern the economy.20

  When he passed away in 1996 at the age of seventy-seven, Minsky hadn’t seen that the 2008 sub-prime mortgage bubble would cause The Economist to dub it ‘Minsky’s Moment’.21 During his lifetime, his work attracted little notice, but the global financial crisis would elevate Minsky and his ideas.

  Former Fed chair Janet Yellen, while vice-chair to Ben Bernanke during the 2009 recession, gave a speech entitled: ‘A Minsky Meltdown: Lessons for Central Bankers’. She pointed out: ‘As Minsky’s financial instability hypothesis suggests, when optimism is high and ample funds are available for investment, investors tend to migrate … to the risky speculative and Ponzi end.’ She added: ‘In retrospect, it’s not surprising that these developments led to unsustainable increases in bond prices and house prices. Once those prices started to go down, we were quickly in the midst of a Minsky meltdown.’22

  Much like Fisher, Minsky’s prescription would have entailed recognizing the importance of debt in causing the boom. Yellen agrees: ‘Regardless of one’s views on using monetary policy to reduce bubbles, it seems plain that supervisory and regulatory policies could help prevent the kinds of problems we now face. Indeed, this was one of Minsky’s major prescriptions for mitigating financial instability.’23

  It seems that interest in both Fisher and Minsky has been revived by the recent global financial crisis. However, the debt-deflation stage of the financial instability hypothesis so far remains a threat rather than a reality.

  The global financial crisis

  Just as the Great Recession offers parallels to the Great Depression, debt has once again returned as an issue for major economies after the 2008 global financial crisis. At the end of 2015, government debt as a share of
GDP was 243 per cent in Japan, 105 per cent in the US, 92 per cent in the euro area, and 90 per cent in the UK. Adding private sector debt would more than double these debt levels.

  A comparison with the 1930s gives a different picture. Debt-to-GDP ratios shot up in the 1930s because of deflation, when falling prices increased the value of debt to be repaid. Now they are high because there has been so much borrowing in the recent past.

  Large debts are, of course, a necessary condition for debt-deflation, but even though inflation rates have fallen below the 2 per cent target set by many major central banks, actual deflation is still the dog that hasn’t yet barked. But does this mean we have escaped debt-deflation? Did policymakers learn the lessons from the 1930s? And what might they still need to do?

  According to Irving Fisher, when inflation is low and the economy collapses, the central bank should act more aggressively than normal to avoid the onset of deflation. Central banks have, indeed, done just this, slashing interest rates to near zero per cent. However, this has created an additional problem of the ‘zero lower bound’ for interest rates.

  As Bernanke says, a central bank that sees its policy rate driven down to zero is not out of ammunition. In this instance, deflationary episodes may require the central bank to think in terms of unconventional policies to avoid outright price declines à la Japan. It is possible for the central bank to set a negative interest rate, charging commercial banks for depositing money with it in the hope that they will lend the money instead. This is the type of unconventional monetary policy that has been adopted by the European Central Bank, the Bank of Japan and others.

  Even if interest rates are close to zero, there should still be a policy response. Simply running the printing press is always an option. Money could be injected into the economy through asset purchases such as quantitative easing, or even more aggressively via the equivalent of a ‘helicopter drop’. This could work through fiscal policy, say through a tax cut or an increase in government spending funded not by borrowing but through the central bank printing money. Fisher thought that it should always be possible to reflate the economy back to where it ought to be. To him, central banks have not exhausted their armoury should they need to fight against deflation.

  Fisher had also in the 1930s called for monetary policy to act as a lender of last resort to stabilize the financial system in order to stop the debt-deflation process and reinstate the credit system. He had highlighted the connections between violent financial crises and fire sales of assets accompanied by a general decline in both aggregate demand and the price level. He, therefore, would have probably approved of the bailout of the investment bank Bear Stearns in March 2008, which meant that a series of defaults and asset price falls were not initiated as the bank went into liquidation. Would a bailout of Lehman Brothers just a few months later have helped to avoid the global financial crisis altogether? Ben Bernanke, Fed chairman at the time, didn’t believe that Lehman posed the same systemic risk as Bear Stearns. Fisher would probably have asked whether rescuing this bank would have prevented a series of defaults which could have served as a trigger for the financial crisis. But would the global financial crisis have been triggered by something else instead?

  Fisher would have agreed that a well-regulated financial system would guard against debt-deflation by avoiding large and unsustainable build-ups of debt in the first place. Well-designed regulatory and supervisory powers play a role in preventing deflation by maintaining financial stability. They can act to rein in exuberant financing from dangerous financial innovations, practices and attitudes. Regulations and reforms are also needed alongside lender of last resort facilities to curb potential moral hazard problems. In other words, if the central bank is always there to bail a bank out, then a bank has less of an incentive to act prudently. Regulation can reduce this risk. In this respect, he would have welcomed the new macroprudential regulatory powers given to central banks after the 2008 financial crisis to target financial stability alongside their existing mandate of price stability.

  Fisher’s final years

  The years 1933 to 1939 saw a period of frantic effort by Fisher to solve the country’s problems and his own financial doldrums. He failed at both. The country wasn’t following his recommendations, his own assets would never recover their value and his debts would never go away.

  By 1945, when his sister-in-law died and his debt to her of more than $1 million was forgiven, his life was winding down. Margie had died suddenly in 1940, the year he lost his house at 460 Prospect Street because he could no longer afford to pay the rent. On his own, and now seventy-three years of age, he lived in a modest apartment when he was not on the road.

  His death was in many ways a sad affair and reflective of Fisher’s character traits. In September 1945, he believed that a blockage in his bowels was due to a kink in the lower intestines, something he had experienced fifteen years earlier. It then had caused some discomfort but eventually cleared up by itself. He believed his diet and exercise would be sufficient to bring about good health, and did not seek a second or specialist medical opinion.

  When in the autumn of 1946 his health began to deteriorate, X-rays found an inoperable tumour in his colon that had spread to his liver. Had he acted the year before, his cancer may have been treatable and he could have lived several more years. In 1947, he passed away, and was buried next to his wife and daughter in New Haven, Connecticut, the home of Yale University.

  After his death, the net value of his estate was estimated at around $60,000. He would have been disappointed that it amounted to so little, and it was certainly not enough to fund an Irving Fisher Institute he hoped would cement his legacy to both economics and health. Nevertheless, what he did leave was considerable – in intellectual if not financial terms. Between 1891 and 1942 he wrote thirty books, with more than 150 English and foreign-language editions.

  Pictures show Irving Fisher to have been straight-laced, and throughout his life he was disciplined in all matters. Because of his seriousness, crusades and sometimes controversial beliefs, many people, including his economics colleagues, had thought Fisher odd and humourless.24 Despite growing recognition, he is still underappreciated and not quite as lauded as a Great Economist as is warranted by his work. Fisher was at the vanguard of modern economics, essentially inspiring the leading central bankers who were at the helm when the entire banking system was on the brink of collapse. There is no doubt his thinking continues to remain relevant today.

  CHAPTER 6

  John Maynard Keynes: To Invest or Not to Invest?

  Few questions have been as prominent since the banking crash: should the British and European governments have cut public spending and adopted austere policies in the aftermath of the 2008 financial crisis?

  In another parallel to the 1929 crash, this was also the question debated in Britain in the 1930s, which launched the Keynesian revolution in economics. John Maynard Keynes advocated government spending in a sharp break with neoclassical economics that eschewed the active use of fiscal policy in response to a downturn. Keynes gave an illustration:

  If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again … there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.1

  Recognizing it’s not ideal, but necessary, he adds: ‘It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.’2

  Today the debate is again over the role of government spending while policymakers contend with high levels of public debt amidst a sluggish recovery in the aftermath of the worst financial crisis since the 1930s. Thus, Keynesian economics i
s back in the spotlight.

  Keynes is not only influential because of his intellectual contributions. He was a compelling writer and known for his turns of phrase, including: ‘[Economics] should be a matter for specialists – like dentistry. If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!’3 And: ‘a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware’.4

  John Maynard Keynes dominated British economics until the Second World War, but his influence extends globally. Across the Atlantic, America’s first economics Nobel laureate, Paul Samuelson, was a standard bearer for Keynesian economics in the US. He helped to incorporate Keynesian thought into neoclassical economics, which became known as the ‘neoclassical synthesis’ – a term that he apparently coined – which underpins modern economics. Thus, without always being explicit, Keynes’s ideas pervade the subject. They have certainly framed much of the fierce post-crisis debates over austerity and the best course of economic policy.

  The life and times of John Maynard Keynes

  Keynes was born in 1883, to the ‘educated bourgeoisie’, in his self-description of his social class.5 As for his views of different social classes: ‘Aristocrats were absurd; the proletariat was always “boorish”. The good things in life sprang from the middle class.’6

  He attended Eton College on a scholarship, followed by another scholarship to King’s College, Cambridge. After working in the India Office of the British government, he returned to the University of Cambridge as a lecturer in 1909 and in 1911 was elected a fellow of King’s, where he remained until his death in 1946.