Where are we now? Financial crises have supplanted kinetic warfare at the center of complex system dynamics. Financial crises in 1998 and 2008 are the analogues to the Russian, Franco-German, and Balkan wars of 1870 to 1912. They are warnings—tremors ahead of a misfortune beyond imagining. This is not conjecture, but an expected outcome given the system dynamics. This outcome is not inevitable. Still, it is likely. To step back from the brink requires smaller banks, fewer derivatives, less leverage, and sound money, perhaps with reference to gold. None of these remedies is in prospect; a systems failure is.
CHAPTER 7
BONFIRE OF THE ELITES
The tragedy of bad economic ideas is that once they grab hold of society’s imagination, it becomes nearly impossible to persuade people to abandon them. Instead, the ideas must be . . . disproved by experience.
Thomas I. Palley, economist and author From Financial Crisis to Stagnation (2012)
Wildebeest and Lioness
A wildebeest’s defense against a lioness is the herd. One wildebeest is no match for a lioness. At dawn on the Serengeti, straddling Kenya and Tanzania, a lioness walks toward a wildebeest herd, selects a target for her attack, and charges. The wildebeests respond as one, break into a panicked rout, create a cloud of dust, change direction, and, when the lioness strikes, converge in bands to kick the lioness into submission and retreat. But the lioness rarely goes away hungry. She eventually kills a wildebeest, devours the meat on the now sunlit plain, and with warm blood on her muzzle, shares it with her pride. From the wildebeests’ perspective, while one loss may be unfortunate, the herd survives.
This Serengeti scene encapsulates the elite monetary mind-set. Monetary elites are the herd. They are not a shadowy underground, but rather a specific group of individuals—finance ministers, central bankers, academics, journalists, and think tank denizens. They run wealth management firms from Boston to Beijing. They advise presidents and prime ministers, and have protégés to take their place in due course.
The cast changes over time. Today the elite list includes Christine Lagarde, Mario Draghi, and Larry Summers to name a few. In times past, Jean-Claude Trichet and Dominique Strauss-Kahn were front and center. They whirl from public to private platforms in the style of Bob Rubin. They greet one another at private dinners on the sidelines at Davos or Aspen. They meet in conclaves at BIS in Basel with no record of the conversation. They control global finance and, by extension, global politics, because politics are constrained by finance. They run the world.
Today they are a herd in full flight, stalked by a lioness. The lioness is the failure of their own ideas.
Elites conduct ritual disagreements for public consumption. These squabbles are mostly for show. There is a shocking conformity of core beliefs behind these debates. Central bankers like Lael Brainard, a Democrat, and Kristin Forbes, a Republican, agree on almost every policy point. Their political party affiliations open the door to powerful appointments regardless of which party the voters elect. Policy itself is unchanged; voters are undone.
Keynesians subscribe to monetarist orthodoxy and support central banks that promote growth. Monetarists make space for Keynesian stimulus financed by fiscal policy. Keynesians and monetarists hold hands under the umbrella of a soi-disant neoliberal consensus.
The herd agrees that markets are efficient, albeit with imperfections. They agree that supply and demand produce local equilibria, and the sum of these equilibria is a general equilibrium. When equilibrium is perturbed, it can be restored through policy. The herd agrees that floating exchange rates produce price signals and market reactions that contribute to the general equilibrium. They agree that free trade, rooted in Ricardian comparative advantage, optimizes wealth creation, albeit with individual winners and losers. They agree that gold is a barbarous relic.
Among Keynesians, there is a further phony divide between saltwater and freshwater schools. Saltwater is associated with coastal schools such as Harvard and MIT. Freshwater is associated with inland schools such as the University of Chicago. Both agree market imperfections exist, yet disagree on remedies. Saltwater scholars take the view that government intervention smooths out imperfections. Freshwater scholars take the view that intervention costs outweigh the benefits of smoothing; market imperfections should be left alone. Yet they agree on larger issues of equilibrium and efficiency. Neither school has confronted complexity and irrationality, except for lip service to the latter. There are no sides in these debates, just variations on a theme.
Elites agree that a Ph.D. in economics from a short list of schools is a prerequisite for serious consideration in policy discussions, although a few brilliant lawyers, like Bob Rubin and Christine Lagarde, or bright journeymen like Tim Geithner, also make the grade. Consistent views and exclusive vetting perpetuate this elite.
The neoliberal consensus is deeply flawed. This can be demonstrated empirically. The flaws are also proved politically in the Brexit referendum and the civic flowering of Donald J. Trump. Both Brexit and Trump were first ridiculed by the herd, then provoked vituperation as their causes evolved, and finally induced shock at their unforeseen success. We are witnessing an elite crack-up.
Markets are not efficient; they are shaped by irrationality. Equilibrium is a façade that masks unstable complex dynamics. Free trade, based on Ricardo’s theory of comparative advantage, does not produce optimal outcomes because it is never free; it is a house built on the quicksand of assumptions that don’t reign in the real world and never will. Floating exchange rates are not stabilizing; they are an invitation to currency wars. Gold is the best form of money because it serves as an anchor for other forms. Elite shared beliefs are uniformly obsolete. Evidence of obsolescence accumulates slowly through elite policy failures. Those failures are now too numerous to deny.
If elite consensus is so flawed, why has the consensus persisted so long? In truth, it hasn’t. Neo-Keynesian economics has held sway for just seventy years since its inception by MIT’s Paul Samuelson in 1947. Monetarism has been intellectually dominant for about sixty years since it emerged from the University of Chicago under Milton Friedman in the 1960s. Eugene Fama’s efficient markets hypothesis percolated in academic studies in the 1960s, yet only started to exert market influence in the 1970s with the options pricing model of Fischer Black, Myron Scholes, and Robert Merton. The Black-Scholes model enabled derivatives and leverage. David Ricardo’s theory of comparative advantage is two hundred years old, yet was first implemented in a widespread rules-based way after 1947 in the General Agreement on Tariffs and Trade. The link between money and gold was abandoned in stages from 1971 to 1973, concurrent with the rise of floating exchange rate regimes. In short, the herd’s cognitive map is relatively new.
None of these intellectual waypoints gained immediate allegiance. Each emerged in stages over the objections of a dwindling cadre of classical economists, Austrians, and heterodox dissenters. The elite consensus in full flower is only about fifty years old—the blink of an eye in the history of ideas.
Equilibrium is the Holy Grail of modern macro- and microeconomics. Equilibrium models start with the simplest concept of supply and demand—consumers will buy more of a good if the price is lower; producers will make more of a good if the price is higher. The downward-sloping demand curve intersects the upward-sloping supply curve. The intersection represents an equilibrium point at which supply equals demand at a price satisfactory to both sides.
Intersecting curves apply to supply-chain inputs and an infinite variety of finished products. The curves apply to labor and capital costs. The curves change shape based on shifting preferences. The curves may be elastic, where demand drops away at the slightest price increase, or inelastic, where buyers demand the same quantity regardless of price.
Free markets permit price signals to flash between buyers and sellers so that dislocations in supply and demand may be remedied. If consumers reduce demand for particular go
ods at a price, the seller can launch a 25-percent-off sale to move the merchandise. If a certain commodity is in short supply, consumers can bid up prices, encouraging farmers or fishermen to get to work producing more.
Finally, the integral of these supply-demand curves including interactions is rolled into a general equilibrium, ostensibly dominated by a few factor inputs including preferences for labor and capital. Those two factors of production—labor and capital—and preferences for each revealed as wages and interest rates—are the core of the Federal Reserve’s dual mandate. The elite view is if the right Ph.D. economist is seated as Fed chair, with the dual mandate firmly in mind, and money supply as a lever to move the world, the global economy may be pushed to equilibrium and made to run like a fine Swiss watch.
To recite this line of thought is to reveal its absurdity. Almost none of it is true. Self-deception once apparent turns quickly to deception of others to maintain a façade. The elite herd hears the lioness of neonationalism and has started to run.
Economists have spent decades identifying imperfections in the free market model. Price signals are moved by market manipulation. Monopoly power is used to restrict supply and peg prices. Information asymmetries allow sellers to deprive buyers through hidden defects. This and more are freely admitted without ruffling the general equilibrium. Instead elites propose public policy remedies. Monopolies are addressed by antitrust enforcement. Asymmetric information is addressed by warranties. Such remedies are legion. Remedial costs and benefits are hotly debated. Yet the general equilibrium goes unquestioned.
The root of general equilibrium is rational behavior. Rational people save for retirement. Rational people buy more on sale. Rational people buy and hold stocks. Rational people borrow when rates are low. Rational people think ahead. This bundle of beliefs is called rational expectations theory. It is all very neat.
Rational expectations theory holds that people behave predictably in response to price signals. Markets are a medium for the signals. When systemic equilibrium is perturbed through unemployment or recession, central bankers manipulate markets to emit price signals designed to induce preferred behaviors. Once the desired behavior results, equilibrium is restored, and growth is again optimized.
In the real world, behavior is rarely rational as economists define rationality. Economic systems are not in equilibrium; they are complex, dynamic, and subject to critical state chaos and collapse. The conundrum of useful price signals issuing from manipulated prices should give theorists pause. Reliance on MIT professor Jonathan Gruber’s belief in the stupidity of everyday Americans helps to reconcile this conundrum for policymakers. But that belief does not withstand scrutiny outside the faculty lounge.
Human behavior is not rational in the ways economists need it to be for their apparatus to work. Modern human irrationality (really rational if considered in an Ice Age context) has been demonstrated by sociologists Daniel Kahneman, Amos Tversky, Dan Ariely, and others over the past thirty years. People do not save enough. They buy on impulse. They react fearfully or exuberantly at different market stages. As a result, the theory of rational expectations is in shreds. Still, central bankers give the theory credence in their policy deliberations.
General equilibrium models also suffer from a fallacy of composition. Elites assume local equilibria can be aggregated into a larger equilibrium called the economy. This is like inferring the totality of human nature from a strand of DNA without ever meeting a human. Complete information on the chemical composition of a human does not allow one to infer speech, cognition, or love. These are emergent properties of the whole human. Likewise, perfect information about the shapes of an infinity of preference curves does not allow inference about the behavior of an economy.
The fatal flaw in equilibrium models is that the degree distribution of market price movements is assumed to be shaped in a bell curve, or so-called normal distribution. The difference between a bell curve system and the alternative power curve system is not just a dusty academic debate over the shapes of two curves. The curves themselves are merely graphical representations of what goes on in each system. The bell curve represents an equilibrium system with a mean-reverting nature. The power curve represents a complex system with an open-ended capacity for extreme events. Empirical data reveal that market prices and extreme events are distributed along a power curve. The normal distribution is a fantasy.
Apple and the Cat
General equilibrium, rational expectations, and efficient markets are not the only fallen pillars of the elite edifice. Free trade is another myth, and a costly one. The modern theoretical case against ostensibly free trade is newer than the critique of efficient markets, with even less support among elite economists. Acquaintance with this critique is needed to understand why elites are defensive, and why the herd’s sense of dread is spreading.
The theoretical foundation for free trade is found in the theory of comparative advantage articulated by David Ricardo in The Principles of Political Economy and Taxation (1817). It is no dishonor to Ricardo that his theory fails in conditions of globalization. His ideas were brilliant for their time, and advanced the then-young science of economics toward its classical phase.
The same can be said of Sir Isaac Newton, whose ideas on celestial mechanics were surpassed by Albert Einstein’s relativity. Newton is counted among our greatest geniuses; Einstein thought so himself. Yet one cannot probe distant galaxies with Newtonian mechanics, nor can one run a twenty-first-century economy on Ricardian principles. You need Einstein to probe galaxies, and you need new trade theories not to wreck the U.S. economy in a globalized age.
What is Ricardo’s theory and what are its fatal flaws? The theory of comparative advantage rests on the term “comparative.” Before Ricardo, there was a theory of absolute advantage. If two nations are trading partners, and one produces goods more efficiently than the other, it favors both nations for the less efficient producer to buy from the more efficient. The importer gets cheaper goods, and the exporter gets a market. Both are better off. It might be possible for Iceland to grow blueberries, but that is hardly efficient. It makes more sense for Iceland to import blueberries from Chile, which has ideal growing conditions. Chile has an absolute advantage in growing blueberries, so Chile wins markets for its produce.
Ricardo took this idea further. He said that even if a country does not have an absolute advantage in certain products, that is, even if it is a less efficient producer, it can still be an efficient exporter if it has a comparative advantage relative to other goods produced by two trading partners. This somewhat counterintuitive idea is explained succinctly by economist Ian Fletcher:
The whole theory [of comparative advantage] can be cracked open with one simple question:
Why don’t pro football players mow their own lawns?
. . . The average footballer can almost certainly mow his lawn more efficiently than the average professional lawn mower. . . . Because the footballer is more efficient in economic language he has absolute advantage at mowing lawns. Yet nobody finds it strange that he would “import” lawn-mowing services from a less efficient “producer.” Why? Obviously, because he has better things to do with his time. The theory of comparative advantage says that it is advantageous for America to import some goods simply in order to free up our workforce to produce more-valuable goods instead. We, as a nation, have “better things to do with our time” than produce these less valuable goods. . . . As a result, it is sometimes advantageous for us to import goods from less efficient nations.
In other words, it makes sense for the United States to import cars from Korea even if the United States is a more efficient car producer, if this frees up U.S. labor and capital to pursue nanotechnology where the comparative advantage is even greater than it is in cars.
This theory rests on a concept of efficiency. If one cannot measure efficiency, and compare measurements across borders, then the theory cannot reli
ably be applied. Efficiency derives from the utilization of factors of production. These factors are labor and capital. Labor comes in varied forms—skilled, unskilled, intellectual, and physical. Capital comes in diverse forms including finance, patents, trade secrets, know-how, and natural resources. A producer who applies factors of production to create output at least cost is the most efficient. Absolute efficiency produces absolute advantage, and relative efficiency across products and sectors produces comparative advantage. Efficiency comes down to cost measurement, which presupposes a system of prices measured in money, and derived from markets.
So the theory of comparative advantage relies entirely on a dense network of factors of production, costs, prices, markets, and money to work its will. If one of these network nodes is manipulated or distorted by policy or imperfection, the theory of comparative advantage does not work because there is no basis for comparison. Today every one of these nodes is distorted, imperfect, or both. Comparative advantage is a castle in the air—pleasant to imagine, yet totally unreal.
Comparative advantage is the touchstone of the neoliberal consensus, the theoretical foundation for free trade, open capital accounts, and other facets of globalization. When David Ricardo, and earlier, Adam Smith, developed these free market and free trade ideas the world was on a gold standard; exchange rates were anchored to gold. Price comparisons were possible. In the absence of a gold standard or fixed exchange rates, how is the comparison to be made? In theory, floating fiat exchange rates allow comparisons and easy adjustment to terms of trade. What about interest rate manipulation, currency wars, dirty floats, and the rest? Do terms of trade reflect bona fide comparative advantage or manipulated advantage? If the latter, what is the case for free trade?
The Road to Ruin Page 23
