Instability

An interesting debate is taking place in scholarly publications and on the internet about the causes of the crisis, the ideological convictions and political recommendations. A sense of cognitive instability is dominant, which is not strange, considering the importance on social studies of understanding the conditions which enable stability. We will consider the ideological, economic and political instability and how they can be understood.

The crisis of conservatism

A Failure of Capitalism, the book by judge Richard Posner, one of the best known and most influential conservative intellectuals, got much publicity in America. Its core ideas can be found in his piece Capitalism in Crisis published in The Wall Street Journal. His opinions can be read on a blog he is doing with Gary Baker, one of the best known conservative economists and a Nobel laureate, as well as on his blog at The Atlantic’s website, which is also called Capitalism in Crisis. More on that later, but right now we will consider the fact that Posner and Baker had criticized the dominant conservative ideology in America. Which is one of the symptoms of the crisis the conservative thought is facing.

Why is it called a crisis? Because Posner’s and Baker’s ideas are nothing new, only up to now these were the opinions of the minority among the American conservatives. However, the differences are not new because they were described very clearly by Hayek in his famous article “Why I Am Not a Conservative.” It is about the tension between the conservative and the liberal ideology, which is complicated by the fact that in America the term “liberal” is used to describe a leftist, or a person who is promoting various kinds of state intervention. However, the original liberals are promoters of personal freedoms and especially the freedom from state intervention. Therefore, as Hayek pointed out, they are promoting changes, and not preserving traditional institutions and values. In the last 20 years, conservatives became the predominant side in America – those who stand for state interventions which limit various kinds of individual rights and freedoms. The crisis is the result of the conservatives losing influence on the right and among the public in general.

What is the ideological difference? Baker is considering several examples, and we should keep in mind that he had published numerous books and articles on the subject. Therefore, it is not only about stating ones ideological opinions. For example, consider the issue of greatest importance for the conservatives: the right to abortion. Baker claims that the liberal standpoint is that a woman has a right to make decisions about her own body, consequently – she has the right to have an abortion. Moreover, Baker states an additional set of arguments why it is best that the woman should be the one who decides and not the state. Those arguments illustrate a strong connection between the economic or social science and the liberal thought. We will not go into details here, because they can be found on the blog.

Baker also states arguments against the interventionism in international relations, which is a viewpoint that Posner agrees with. If you feel that you have good reason, theoretic and empiric, not to believe in state efficiency, then there is no reason to expect that state interventionism, the military kind above all, but all other kinds as well, could have positive results, especially if your criterion of positivity is the broadening of individual freedoms.

Some comments point out that the positive side of conservatism is that it favors the inherited institutions and values that stood the test of time. There are two ways to prove that. One is the fact that institutions, are, in the long run, irrelevant; in other words, that all stabile institutions, the long-lasting ones, produce the same results, however we might value them. People’s basic interests and values, which are always the same, will be realized in any institutional environment, if the environment is not changed, if it is constant. The old institutions are intrinsically no better that the new ones, they are better because people found ways to use them so they achieve as many of their goals as they can: what sort of institutions these are is irrelevant.

Additionally, there are claims that the current or inherited condition is superior to any innovation. For instance, we could claim that the decisions on change should be reached unanimously, because everyone should benefit from them. This principle is sometimes in opposition to the principle of simple majority, because the latter is believed to be distributive, while the former is not. For instance, Jim Buchanan, who is also a well known conservative and a Nobel laureate in economics, suggests unanimity in political judgment, because he believes that this practice is identical to market judgment, because we can say that market decisions, in certain circumstances, are reached unanimously. In the widest sense possible, however, there is no categorical difference between the two ways of making decisions, therefore this cannot serve as a basis for a general choice between institutional conservatism and liberal reformism. Baker and Posner provide examples which illustrate that changes are needed, just as certain interventions are needed, although the ways to intervene can be debated. Generally, liberals advocate interventions which protect individual rights, and oppose conserving the institutions which violate those rights.

What can be understood from Baker’s casual remark that Reagan was not particularly religious is also of great importance for liberal thought. Liberals advocated enlightenment, science, the spreading of knowledge and they opposed religious obscurantism. In many countries today there is no need for the sort of critique of religion favored by the liberals of the older generation, so dialogue is possible and beneficial. However, where religion has been given a commissarial role, such as the case in the American conservative movement, liberals must point out the grave consequences of the ambition to gain ideological control based on any religion.

This is the crisis of conservatism. As Posner put it: “By the fall of 2008, the face of the Republican Party had become Sarah Palin and Joe the Plumber. Conservative intellectuals had no party.”

Economic instability

Posner believes that capitalism is in crisis because it is unsuccessful. These are strong words, but the evidence he offers for his assertions mostly relate to one feature of the modern business model, which is called capitalist, and that is instability. Ever since it was first discussed scientifically, it is clear that capitalist economy goes through business cycles, or periods of recession and high growth. What is new is the belief which gained ground in the last few decades that institutional and political conditions were made for these cycles to be mild and for severe recessions not to happen, let alone depressions. It is exactly this belief that is in crisis, especially in economic theory. I think Olivier Blanchard, the chief economist at the International Monetary Fund and one of the leading macroeconomists, also currently shares this belief.

Several well known economists pointed to the reasons why the economic science had somehow forgotten the importance of economic instability. There is a very interesting article by Daron Acemoğlu, one of the most creative modern economists, which points out one of the reasons why the economists concluded that banking crises became improbable. Game theory explains how it is possible that decentralized systems of judgment regulate themselves. The idea is that business relations over time start being carried out based on trust and reputation, so that, for instance, large and respectable banks will not allow themselves to embark on business ventures which could result in the loss of their accumulated prominence. Slightly different, Alan Greenspan offered the same argument. Acemoğlu based his belief in economic theory, while Greenspan say his beliefs confirmed by theory, but their argumentation is basically the same: the banks will not go into business ventures by which they not only risk financial loss, but also the loss of accumulated prominence. The latter is important, because it should restrain the behavior of the bankers, if they are not disciplined by the sense of responsibility to the owners.

There is also a very noted essay by the eminent economist Barry Eichengreen, which explains how it came to be that economists could not see the financial system taking a turn for the worse. Basically, their explanation is that high earnings in business schools and in teaching how to do business in the financial markets influenced the neglecting of all previous knowledge concerning the instability of the financial markets. This way no one wanted to hear out those who pointed out the crises was coming. The reason lies partly in the fact that those who pointed out the unsustainability of the financial trends based their arguments on the ideas which were in discord with the prevailing opinions in the profession. For example, no one paid any mind to the followers of Hyman Minsky, or to the finance behaviorists, or to those who proved that the conventional wisdom on risk distribution was wrong, that there are more events with low probability, the so called “black swans”, than the conventional models of risk distribution suggest.

Finally, there is a very influential study by Simon Johnson, a long-term IMF employee, in which he uses political economy to explain how the crisis came to be. According to him, the financial sector had “subjected” the political powers, so the US faced the Russian scenario, by which he mainly means of the Russian crisis of 1998. There was an enormous growth of the financial sector, which was not supported by the growth in the real economy. This was simply unsustainable, so America entered a crisis typical of the developing countries, where the institutions are not strong enough and do not serve the public interest.

Being that academic economics, according to these authors, had suffered a fiasco, everyone is re-reading Marx, Keynes, Minsky and other crisis theorists, as well as contemporary authors who explain the behavior of individuals and markets by building their case on the assumption that they are not sufficiently rational or not rational at all. Right now, the leading book of this kind is probably that by Nobel laureate George Akerlof and Robert Shiller on “Animal Spirits”. Let us say that by observing the financial markets we can see that investments had become unstable, and we are wondering why this is happening? If the investors would behave rationally they would have rational expectations and, according to the authors, there would not be instability. However, if there are no conditions for expectations to be rational, investors are, at least in part, led by their urges, which is a reason for lust and fear to dominate the markets. When optimism prevails, there is a more than rational amount of investments, and when pessimism predominates, investments are insufficient. This makes the financial markets unstable. Naturally, there are many more examples of insufficient rationality and the shortcomings of various types of rational judgment are known virtually ever since discussions on rationality began.

The problem with this explanation of the capitalist economy’s instability is that it is not quite indisputable that it really explains anything, neither is it indisputable that it is necessary to abandon the idea of rational judgment to explain instability. Let us take the game of chess as an example. It is easy to prove that this basically a solvable game. The possible outcome of every move can be essentially determined. However, so far it is impossible to calculate that. The day we are able to calculate it will be the day we stop playing chess. Meanwhile, in addition to calculations, chess players go by intuition, urge and many other impulses in order to achieve the best possible result. Therefore, it is not about irrationality, it is about lack of information or calculative ability. It is similar with investments and other business decisions. Basically, the outcome of every decision is predictable, but what is missing is information and the appropriate calculative technology. In these circumstances, investors count on urges or other incentives, including the social ones, such as imitation or other sorts of conformity.

But are there rational explanations to financial and economic instability? The answer is yes. The two major examples are the rational theory of financial panics and the real business cycle theory (RBC Theory). When it comes to instability of the banks, what is usually used is the Diamond-Dybvig model, by which it is rational that depositors panic and withdraw their money if they assess that the bank’s assets are insufficient to cover its obligations to the investors. The reason for the bank’s instability is simply the imbalance between the short-maturity of its obligations and the long-maturity of its investments. If the risk magnitude of the investments changes, the depositors have rational reasons to fear for their deposits and will therefore attempt to withdraw them as soon as possible, which will lead the bank to bankruptcy. This is the reason why short term deposits are usually insured, for instance by government guarantee.

The RBC theory, on the other hand, explains the macroeconomic instability by the influence of technological and other kinds of innovations. It is rational for businessmen to try and maximize profit by using various innovations, which, in turn, lead to structural changes that cannot momentarily be implemented throughout the entire economic system. Successively, this leads to an imbalance on the labor market, the goods market and the financial market. For instance, a considerable influence on the current crises is assigned to financial innovations. The banking system structure and the different regulations in different countries have contributed to the otherwise useful financial innovations having a destructive influence on the existing global financial system. The same can be said about the structural changes which happen because of the economic growth in the developing countries, which leads to global imbalances in the existent system of global trade and currency systems (or the systems of national economic policies.)

The advantage of the explanations which do not deviate from the rationalist paradigm is that the political recommendations are relatively clear and simple. The explanations whose starting point is that economic instability is a consequence of insufficient rationality of individuals do not lead to clear political recommendations. This is also noticeable in the domain which currently has most discussions on the problem, that is, in the domain of monetary policy.  In his recently published book “Getting Off Track”, John Taylor, who more than anyone else contributed to the notion that modern monetary policy should be based on rules and not on discretion, proves that the financial crisis is a consequence of bad monetary policy (Posner shares a similar opinion.) If it was too lax, it surely has stimulated too much economic activity, which means inflating the value of real estate, if we are, for example, discussing the housing market. Alan Greenspan and many others claim that this is not true and that it cannot be true, but the discussion on this has just began. But it is clear that if Taylor is right, there is no need for us to revise our perception of the rationality of the market participants, or to explain the instability by causes that are hardly comprehensible. It is enough to note that the global real business cycle explains the instability of the globalized economy, and add to that the rational maladjustment of, most importantly, the Federal Reserve and then other monetary policy makers, who, understandably, pursue above all national and not global goals.

Therefore, if we assume that instability is completely compatible with the modern market economy, that it is even a balancing phenomenon, then the theories about the crisis of capitalism more than anything speak of the wrong expectations that the political instruments for resolving the crises were discovered.

Political instability

Dani Rodrik, a famous liberal (in the American sense) economist, feels that the current crisis has damaged the theory on how economic growth is a result of working institutions and above all, the political system. If you believe, he says, like the above-mentioned Simon Johnson, that the American system is oligarchic, you can hardly claim that oligarchic systems cannot be successful. They can be unstable, but aren’t precisely those democratic systems claimed to be prone to instability?

We know, at least since Kenneth Arrow very accurately demonstrated it, that democratic systems are inherently unstable. This can be generalized to all systems of decentralized decision making, which includes the market. When it comes to democracy, instability is reflected in the fact that voters, at least most of them, can change their mind, to put it simply. If stability requires that the process of judgment provides consistency in decisions, it is clear that this is impossible to accomplish through voting. Dictatorships are more consistent, assuming that the dictator is consistent, which is practically impossible, at least if are to believe the teachings of political thought from Xenofon and Plato to modern times.

The possibility of changes in opinion in a democracy, however, contributes to adjustability, which is, of course, its greatest advantage. However, this is not only a consequence of the method of deciding, but also of its legitimacy. In order to see this, it is useful to consider the difference between the democratic and one or another type of authoritarian system. But an autocrat can be elected in democratic elections – this is one aspect of the instability of democracy. In addition, autocrats can hold free elections. Therefore, it is not easy to distinguish between systems by whether they use free elections or not. There is no democracy without free elections, but free elections can be used by undemocratic regimes too, usually precisely to justify the need for stability. The key test is whether this leads to change in the ruling party, for this insures responsibility and adjustability of democratic government.

This is important if we believe that economic instability can be influenced. In the Great Depression, we saw that insufficiently democratized states are not necessarily a strong enough barrier to hold off authoritarian and totalitarian movements. There are similar experiences in many developing countries. Therefore, it is essential for the preservation of a democratic regime for it to be able to restore the legitimacy and mandate of government through free elections. This is what happened in the United States. Even the prominent representatives of the Republican Party point out that it was to be expected for the voters to replace the governing party, because otherwise the democratic system could have really been destabilized. This makes at least one aspect of instability of democracy useful in a time of economic crisis.

A somewhat further reaching critique of democracy’s instability comes from those who believe that it inevitably undermines the capitalist system. There are different versions of this argument, from Shumpeter to Hayek to Buchanan. How do you stop the growth of redistribution, the growth of the welfare state, through continuous increase in public spending? At one time this seemed possible through boosting ideological competition.  For instance, if the conservative values of the majority are opposed to the inclination of that same majority to support the growing redistribution of wealth to its own advantage, it would be possible to insure the victory of conservative political parties which would dispose of the welfare state. Therein lies the real dispute between the conservatives and the original liberals. The former rely on the people’s fear of modernization, while the latter count on the increasing appeal of individual freedoms made possible by modernization. In democratic systems, the crisis does not help the former, while the latter are given ideological and political opportunity once the crisis is over and the question of liberation from the inflated government is raised.

In contrast to America, the restoration of ideological competition in Europe is not very likely. Probably, the coming elections for the EU Parliament will show a significant growth of the influence of the nationalist right, but this can hardly revive the ideological competition in EU member states. Besides, the EU provides stability precisely because it represents an obstacle to nationalistic movements and parties. The problem with the EU is that it lacks an efficient mechanism of relying on democratic instability, which will make the adjustment to the crises different and more complex than in America.

Conclusion

What is explained by stating that capitalism is in crisis? Basically, that economic instability can produce ideological and political reactions which will have far reaching negative consequences. If experience is of any use, the more democratized countries have greater adjusting abilities.  As for the others, that remains to be seen.

Peščanik.net, 22.05.2009.