Great thinkers and the 2008 crisis

The Great Economists: How their ideas can help us today
Linda Yueh
Viking (Penguin)
357 pages; Rs 699

In the aftermath of the global financial crisis of 2008, there has been much soul searching among economists over why most of them failed to predict it. Since then, many books have attempted to trace the history of economic thought hoping to find answers to our current predicament.

One such attempt was that of Professor Meghnad Desai. In Hubris, Mr Desai traced the history of economic thought through the ages as he attempted to answer a simple question: Why did economists fail to foresee the crisis of 2008 that threatened to take down the world economy?

The author says the economists who have made the cut are those whose theories have changed the world and whose ideas can help with today’s challenges, so the list is hardly a novel one. All the giants in the profession — from Adam Smith to Karl Marx to John Maynard Keynes to Milton Friedman — are featured, and they are economists whose ideas have been discussed threadbare and perhaps with greater rigour than Ms Yueh’s treatment.

The book is lucidly written, however, with each chapter devoted to the life and work of these towering giants and to the social milieu that shaped their thinking. It offers glimpses into the lives of these influential economists, often laced with interesting nuggets of information.

The burden of the book is to examine how these economists would view the world of today — how they would have reacted to the policies adopted by governments and central banks to deal with the crisis of 2008. Perhaps a more interesting method would have been to pit two economists on either side of the debate.

Consider for example the role of fiscal policy.

Friedrich Hayek, the eminent Austrian economist, disputed the use of fiscal policy in moderating the business cycle. He believed that governments should simply resist the urge to interfere in the economy — a view diametrically opposite to that held by Keynes.

Hayek viewed recessions as necessary evils. As Ms Yueh points out, for him, recessions were periods of liquidation that resulted from the past over-accumulation of capital. He argued that any policy that would stimulate the economy would perhaps reduce some short-term suffering, but would “ultimately prevent recovery by helping maintain inefficient capital stock levels”.  

Keynes, on the other hand, was in favour of government spending during crisis. As Ms Yueh notes, he argued that there would not be any crowding out of private investment when the economy is operating below its potential.

Take the case of the British economy. It had lost over 6 per cent of its output during the recession of 2008. In such a scenario, Ms Yueh believes that Keynes would have argued that crowding out was unlikely as “there was enough scope for public and private sectors to invest before demand for funds pushed up borrowing costs”. However, contrary to what Keynes might have advocated, the British government initially swerved right,  imposing stiff austerity measures.

Hayek also believed that misallocation of capital could be a consequence of monetary policy as well, specifically if interest rates were kept too low. In fact, as Ms Yueh points out, he had argued that the US Federal Reserve had actually played a role in precipitating the great depression by keeping interest rates too low through the 1920s.

Fast-forward to the 2000s and perhaps Hayek would have argued that a similar situation existed. The US Federal Reserve had cut rates to record lows which many have argued facilitated the build-up in the real estate market. Ms Yueh argues that Hayek would not have been opposed to the liquidation of Bear Stearns and Lehman Brothers, in principle, but he would have strongly opposed the policy of quantitative easing adopted by the Fed to inject liquidity into the system. This view would place him in direct opposition to Milton Friedman.

In their seminal work, Friedman and Anna J Schwartz had argued that the Great Depression was essentially a liquidity problem. Friedman’s approach to tackle such episodes was to simply flood the economy with liquidity and “allow solvency issues to sort themselves out”.

Since he had been supportive of the Bank of Japan’s quantitative easing, Ms Yueh argues that he might have viewed the US Fed’s unconventional policies as necessary to get lending going again. Thus, he would have approved the vast amount of purchases of US government debt by the Fed to keep long-term interest rates down, though he might have viewed the purchase of mortgage-backed securities as a bailout.

On bailouts, though, he might have taken a different stance. Ms Yueh contends that Friedman might have viewed the targeted interventions by the Fed to save Bear Stearns and AIG but to allow Lehman Brothers to go under as undermining the institution’s independence and credibility.