Why Do Markets Collapse?
Macroeconomics is about money and government, and their relationship. The unsettled questions in macroeconomic policy stem from disputes about the part money plays in economic life, and the part government should play. For 250 years, the dominant view of the economic profession has been that money is of no importance except when it gets ‘out of order’, and that government interference with the market usually makes things worse. ‘You can’t buck the market,’ Mrs Thatcher famously declared. A competitive market economy, it was claimed, has an automatic tendency to full employment. Disturbances to employment are the result of interference, usually by or at the behest of governments, creating or promoting monopolies, impeding price adjustments or, crucially, by ‘monkeying around’ with the money supply, thus inducing people to trade at the wrong prices. At first it was believed that control of money should be entrusted to the gold standard; when the gold standard broke down, to independent central banks. Government should be limited to ensuring the conditions required for efficient market exchange. The only task of macro policy was to control the money supply.
This view of policy was successfully challenged by the Keynesian revolution, which, starting as a new theory in the 1930s, dominated macroeconomic policy until the 1970s. The Keynesians denied that a monetary economy – one in which contracts are made in money, not goods – had any automatic tendency to full employment. This was because people could choose to hold money, rather than spend it, and the reason they might wish to do so was the omnipresence of uncertainty; as Keynes put it, the possession of money ‘lulls our disquietude’. Given the role of money as a ‘store of wealth’, the macroeconomy was inherently unstable, and was liable to settle down in a position of ‘underemployment equilibrium’. It was therefore the task of government to maintain a full employment balance between supply and demand, which included the management of money as part of the management of the economy. But it was not money that had to be kept in order; it was the market system itself. If it was left free of management and regulation, it would be socially and politically disruptive. In the Keynesian era, stretching from the end of the Second World War to the 1970s, the free world economy experienced a unique period of stability and growth.
In the 1970s, however, the Keynesian system succumbed to ‘stagflation’ – the simultaneous rise in inflation and unemployment – and the Keynesian attempt to manage the macroeconomy was abandoned. The core idea behind the new classical economic policy that succeeded it was that central banks should be mandated to control inflation, with unemployment left to settle at its ‘natural’ rate. This was taken to be a rate on which macroeconomic policy could not improve. The unemployed should get on their bikes and look for work.
In technical terms, familiar to economists, the question about the relationship between money and government is a question about the relationship between monetary and fiscal policy. The Keynesian innovation was that the government should influence the level of total spending through fiscal policy, with monetary policy made consistent with the aims of fiscal policy. By contrast, in new classical economics, monetary policy – keeping the economy supplied with the right amount of money – is the whole of macroeconomic policy, since fiscal policy cannot influence the level of total spending, only its direction. This was the doctrine ‘in power’ in 2008.
The collapse of 2008 and its aftermath was a test of the two theories of macroeconomic policy, not under laboratory conditions but in as close to a real-life experiment as we are likely to get. According to the mainstream view of the time, the collapse should not have happened and, even if it had, recovery should have been swift. In the second, Keynesian, hypothesis, its happening was always a possibility, and recovery was never likely to be fast or full. However, the old Keynesian recipe for running economies at full employment through fiscal policy had succumbed to inflation, and has not been rehabilitated, so policy for the future remains unsettled.
The proximate cause of the collapse of 2008 was the accumulation of private debt, much of it the result of fraud on the part of the lenders and myopia on the part of the borrowers. A vast, global, inverted pyramid of bank, business and household debt was built on a narrow base of underlying assets – American real estate. When the base tottered, the pyramid fell. The failure of the subprime mortgage market in the United States triggered a collapse in the prices of financial assets. The fall in the net wealth of banks in 2007–8 produced a global financial crisis. This was transmitted to the real economy through a tightening of credit by the banks and a fall in demand by consumers and businesses, whose wealth and confidence had evaporated.
It all developed with astonishing speed. The bankruptcy of Lehman Brothers on 15 September 2008 precipitated a stock market collapse in October. Once banks started to fail and stock markets to fall, the ‘real’ economy started to slide too. Banks stopped lending. Creditors foreclosed on loans to debtors. Businesses laid off workers. Total spending shrank. This brought about generalized conditions of slump throughout the world by the fourth quarter of 2008. It was eerily reminiscent of what happened in the Wall Street Crash of 1929.
The worst of the storm passed after a year. Unlike in 1929, governments intervened to prevent disaster. Governments and central banks around the world vigorously pumped money into their deflating systems. But in some European countries, governments were virtually bankrupted by the excesses of their banking systems. The collapse of state revenues brought public debts to unprecedented peacetime levels, reviving the most persistent of the economic orthodoxies: that governments are the problem, not the solution. As economies stabilized, policies of austerity were adopted to put governments back into the fiscal cage from which the severity of crisis had temporarily released them. Today, monetary expansion is being eased, in recognition that it has done as much as it can, while austerity is being eased in recognition that monetary policy is not enough. The future of the fiscal–monetary mix is unsettled.
From Money and Government by Robert Skidelsky. Published by Yale University Press in 2019. Reproduced with permission.
Robert Skidelsky is emeritus professor of political economy at the University of Warwick. He is the author of many books, most notably a three-volume biography of John Maynard Keynes.