BOOK REVIEW. The boom bang theory

The most insightful comment Meghnad Desai makes in Hubris comes on page 238. “There are no permanent laws in economics. Only historically contingent truths,” he declares, puncturing the hubris of economists and their certitudes. The book, as it turns out, is a valuable addition to a series of books that came out ever since the sub-prime crisis started unfolding in the West in 2007-08, sending the global economy into a tailspin.

Desai starts with the Great Depression of 1929, elaborating on how it unfolded and how governments and economists responded to the most devastating crisis capitalism had faced up till then.

Orthodox economists then believed the market would take care of the crisis and hence called for more austerity, severe wage cuts and higher interest rates. This painful panacea is exactly what a set of economists recommended almost 80 years later when Lehman Brothers’ collapsed.

Crisis and fixes In the 1930s, three economists — John Maynard Keynes, Gunnar Myrdal and Friedrich von Hayek — questioned the prevailing orthodoxy and made attempts to suggest alternatives to pull the economy out of the depression. As folklore has it, Keynes postulated that in a depression, investment was needed regardless of profit expectations and such investments could only come from the government. Hence he rooted for increased government spending.

That said, Keynes “was not advocating endless deficit and disregard for public debt”, writes Desai. But the latter day Keynesians forgot this crucial message of Keynes and thought that governments could permanently run high deficits. This was to have fatal consequences in the 1970s when western economies were hit by stagflation — high inflation coupled with slowing growth and rising unemployment.

The postwar period from 1945 to 1970 was one of unprecedented prosperity in the western world and marked by the “highpoint of Keynesian triumph”. But this Keynesian consensus started unravelling in the 1970s when two crucial events occurred — the end of the era of fixed exchange rates and the first oil shock. This was a period of stagflation and neither Keynesianism nor Monetarism had an answer to it.

It was in this background of stagflation that the birth of New Classical Economics took place. It was also a time when most governments in the West took a ‘right turn’ with Margaret Thatcher, Ronald Reagan and Helmut Kohl coming to power in the UK, US and West Germany, respectively. Their main concern was to control inflation, and rising unemployment took a backseat.

Markets marching By the mid-1980s, Desai observes, the new classical macroeconomics triumphed and Keynesianism was clearly on the descent. The deregulation of the financial sectors in most western economies also took place in 1980s. The demolition of the Berlin Wall and the collapse of communism led to many more markets joining the global economy for trade and investment. The demise of the Soviet bloc gave a new thrust to globalisation — the market was marching ahead triumphantly.

Though the smug victory of the market was briefly jolted by the Asian financial crisis of late 1990s, western governments were not too perturbed as they were happening in the global periphery. The rise of China as the world’s manufacturing hub resulted in an era of low prices in western economies.

Financial innovations were growing at breakneck speed where, “the buyers and often even sellers could not quite grasp the principles underlying such assets”. The US government also actively encouraged the lending of mortgage loans to people who probably wouldn’t have the means to repay them leading to the “sub-prime mortgage boom”.

Banks found a way to splice mortgages issued into equities and sold them to each others as well as investors with the fond hope that the prices of houses would keep increasing. A classic house of cards.

The crash came and it hit the banks first as they had overextended themselves and had quite simply run out of cash. Now how did the efficient market or participants with rational expectations fail to predict the crisis? As Desai says, “The malaise once again is in theory not in the real world.”

The latest recession is very different from the one that hit the world in the 1930s and Desai rightly doubts whether the standard Keynesian prescription would help this time around. The current recession was the result of a boom fuelled by cheap credit caused by overspending by both governments and households leading to major global imbalances.

To deal with the current recession, most western economies adopted the policy of ‘quantitative easing’ — pumping large amounts of money into the system. But Desai argues this has not really pulled the western economies out of recession.

We shall overcome Desai goes beyond this simple New Classical-Neo Keynesian duality and seeks an explanation of the present crisis from long forgotten economists such as Karl Marx, Knut Wicksell, Nikolai Kondratieff and Hayek. He firmly believes capitalist economies move through a cycle of booms and busts and we may now be in the middle of a bust after a prolonged boom which lasted from the early 1990s to 2007.

So, what’s in store for the future? Desai is cautiously optimistic. He says though growth will rise in developed economies it is unlikely to reach the level seen in the boom period of 1992-2007.

The growth in China, India and other Asian and African countries may yet save the global economy from the recessionary malaise. Desai is on the fence when he ends the book, “We shall solve the problems yet. No one can say just how.” No wonder economics is called the dismal science.

MEET THE AUTHOR: Meghnad Desai is emeritus professor of economics, London School of Economics, where he was also founder and former director of the Global Governance Research Centre. He is a member of the House of Lords.

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