Dead Men Walking

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Abstract:

There is nothing like a really big economic crisis to separate the Cassandras from the Panglosses, the horsemen of the apocalypse from the Kool-Aid-swigging optimists. No, the last year has shown that all is not for the best in the best of all possible worlds. On the contrary, we might be doomed.

At such times, we do well to remember that most of today’s public intellectuals are mere dwarves, standing on the shoulders of giants. So, if they had e-mail in the hereafter, which of the great thinkers of the past would be entitled to send us a message with the subject line: “I told you so”? And which would prefer to remain offline?

It has, for example, been a bad year for Adam Smith (1723-1790) and his “invisible hand,” which was supposed to steer the global economy onward and upward to new heights of opulence through the action of individual choice in unfettered markets. By contrast, it has been a good year for Karl Marx (1818-1883), who always maintained that the internal contradictions of capitalism, and particularly its tendency to increase the inequality of the distribution of wealth, would lead to crisis and finally collapse. A special mention is also due to early 20th-century Marxist theorist Rudolf Hilferding (1877-1941), whose Das Finanzkapital foresaw the rise of giant “too big to fail” financial institutions.

Joining Smith in embarrassed silence, you might think, is Friedrich von Hayek (1899-1992), who warned back in 1944 that the welfare state would lead the West down the “road to serfdom.” With a government-mandated expansion of health insurance likely to be enacted in the United States, Hayek's libertarian fears appear to have receded, at least in the Democratic Party. It has been a bumper year, on the other hand, for Hayek's old enemy, John Maynard Keynes (1883-1946), whose 1936 work The General Theory of Employment,Interest and Money has become the new bible for finance ministers seeking to reduce unemployment by means of fiscal stimuli. His biographer, Robert Skidelsky, has hailed the “return of the master.” Keynes's self-appointed representative on Earth, New York Times columnist Paul Krugman, insists that the application of Keynesian theory, in the form of giant government deficits, has saved the world from a second Great Depression.

The marketplace of ideas has not been nearly so kind this year to the late Milton Friedman (1912-2006), the diminutive doyen of free-market economics. “Inflation,” wrote Friedman in a famous definition, “is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.” Well, since September of 2008, Ben Bernanke has been printing dollars like mad at the U.S. Federal Reserve, more than doubling the monetary base. And inflation? As I write, the headline consumer price inflation rate is negative 2 percent. Better throw away that old copy of Friedman's Monetary History of the United States, 1867-1960 (co-authored with Anna J. Schwartz, who is happily still with us).

Invest, instead, in a spanking new edition of The Great Transformation by Karl Polanyi (1886-1964). We surely need Polanyi's more anthropological approach to economics to explain the excesses of the boom and the hysteria of the bust. For what in classical economics could possibly account for the credulity of investors in Bernard Madoff's long-running Ponzi scheme? Or the folly of Richard Fuld, who gambled his personal fortune and reputation on the very slim chance that Lehman Brothers, unlike Bear Stearns and Merrill Lynch, could survive the crisis without being sold to a competitor?

The biggest intellectual losers of all, however, must be the pioneers of the theory of efficient markets—economists still with us, such as Harry M. Markowitz, the University of Chicago-trained economist who developed the theory of portfolio diversification as the best protection against economic volatility, and William Sharpe, inventor of the capital asset pricing model. In two marvelously lucid books, the late Peter Bernstein extolled their “capital ideas.” Now, with so many quantitative hedge funds on the scrap heap, their ideas don't seem quite so capital.

And the biggest winners, among economists at least? Step forward the "Austrians" —economists like Ludwig von Mises (1881-1973), who always saw credit-propelled asset bubbles as the biggest threat to the stability of capitalism. Not many American economists carried forward their work into the later 20th century, but one heterodox figure has emerged as a posthumous beneficiary of this crisis: Hyman Minsky (1919-1996). At a time when other University of Chicago-trained economists were forging the neoclassical synthesis—Adam Smith plus applied math—Minsky developed his own math-free “financial instability hypothesis.”

Yet it would surely be wrong to make the Top Dead Thinker of 2009 an economic theorist. The entire discipline of economics has flopped too embarrassingly for that to be appropriate. Instead, we should consider the claims of a historian, because history has served as a far better guide to the current crisis than any economic model. My nominee is the financial historian Charles Kindleberger (1910-2003), who drew on Minsky's work to popularize the idea of financial crisis as a five-stage process, from displacement and euphoric overtrading to full-fledged mania, followed by growing concern and ending up with panic. (If those five steps to financial hell sound familiar, they should. We just went down them, twice in the space of 10 years.)

Of course, history offers more than just the lesson that financial accidents will happen. One of the most important historical truths is that the first draft of history —the version that gets written on the spot by journalists and other contemporaries —is nearly always wrong. So though superficially this crisis seems like a defeat for Smith, Hayek, and Friedman, and a victory for Marx, Keynes, and Polanyi, that might well turn out to be wrong. Far from having been caused by unregulated free markets, this crisis may have been caused by distortions of the market from ill-advised government actions: explicit and implicit guarantees to supersize banks, inappropriate empowerment of rating agencies, disastrously loose monetary policy, bad regulation of big insurers, systematic encouragement of reckless mortgage lending—not to mention distortions of currency markets by central bank

Consider this: The argument for avoiding mass bank failures was made by Friedman, not Keynes. It was Friedman who argued that the principal reason for the depth of the Depression was the Fed's failure to avoid an epidemic of bank failures. It has been Friedman, more than Keynes, who has been Bernanke’s inspiration over the past two years, as the Fed chairman has honored a pledge he made shortly before Friedman's death not to preside over another “great contraction.” Nor would Friedman have been in the least worried about inflation at a time like this. The Fed's balance sheet may have expanded rapidly, but broader measures of money are growing slowly and credit is contracting. Deflation, not inflation, remains the monetarist fear.

From a free market perspective, the vital thing is that legitimate emergency measures do not become established practices. For it cannot possibly be a healthy state of affairs for the core institutions of the Western financial system to be effectively guaranteed, if not actually owned, by the government. The thinker who most clearly discerned the problems associated with that kind of state intervention was Joseph Schumpeter (1883-1950), whose “creative destruction” has been one of this year's most commonly cited phrases.

“[T]his evolutionary…impulse that sets and keeps the capitalist engine in motion,” wrote Schumpeter in Capitalism, Socialism and Democracy, “comes from…the new forms of industrial organization that capitalist enterprise creates…This process of creative destruction is the essential fact about capitalism.” This crisis has certainly unleashed enough economic destruction in the world (though its creativity at this stage is still hard to discern). But in the world of the big banks, there has been far too little destruction, and about the only creative thing happening on Wall Street these days is the accounting.

“This economic system,” Schumpeter wrote in his earlier The Theory of Economic Development, “cannot do without the ultima ratio [final argument] of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted.” Indeed, he saw that the economy remained saddled with too many of “those firms that are unfit to live.” That could serve as a painfully accurate description of the Western financial system today.

Yet all those allusions to evolution and fitness to live serve as a reminder of the dead thinker we should all have spent at least part of 2009 venerating: Charles Darwin (1809-1882). This year was not only his bicentennial but the 150th birthday of his paradigm-shifting On the Origin of Species. Just reflect on these sentences from Darwin's seminal work:

All organic beings are exposed to severe competition.”

“As more individuals are produced than can possibly survive, there must in every case be a struggle for existence.”

“Each organic being…has to struggle for life and to suffer great destruction.... The vigorous, the healthy, and the happy survive and multiply.”

Thanks in no small measure to the efforts of his modern heirs, notably Richard Dawkins, we are all Darwinians now—except in the strange parallel worlds of fundamentalist Christianity and state-guaranteed finance.

Neither Cassandra nor Pangloss, Darwin surely deserves to top any list of modern thinkers, dead or alive.

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