The global financial crisis of 2007-08 has been regarded as a failure on the part of the economics profession, and of modern mainstream economic theory. Not only were economists – along with the banks, regulators and policymakers – its chief architects, they failed to foresee even the possibility of such a calamity in their elegant macroeconomic models. While approaches to economic policy were soon re-calibrated to adapt to the new normal, the change in academia has come about more slowly: many students of economics are still taught the apocryphal models and theories which abetted the crisis in the first place.
What’s required now is for the entire discipline of economics to be overhauled and restructured in order to strengthen its ability to successfully predict and prevent future crises. A good starting point would be to review the failings of conventional neoclassical economic theory in analysing the crisis, and then to explore a different perspective.
Neoclassical Analysis of the 2008 Financial Crisis
By 2007, neoclassical economic theory had dominated the profession for decades. With its theories of efficient markets, rational expectations and free competition, it brought about the very institutional changes that made the crisis possible. In the 2009 article, How Did Economists Get It So Wrong?, Nobel Prize-winning economist Paul Krugman argues that neoclassical theory describes a romanticised and sanitised version of the economy that blinded economists to irrational or unpredictable behaviour and market imperfections that can cause the system to undergo crashes. Mainstream economists not only championed their seemingly flawless theories, but could not even comprehend that a crisis of such a magnitude could ever occur in free markets.
In a recent analysis of the crisis, Prof. Lee Ohanian of California University states that current economic models cannot offer a suitable explanation for the recession; he attempts to give one nonetheless. Using general equilibrium business cycle theory, he attributes the cause of the recession to a decline in labour input. However, Mr Ohanian fails to elucidate upon what exactly these factors were, simply concluding that a “deeper exploration of labour markets” is needed. This example illustrates the fact that neoclassical economic models are simply not capable of providing an explanation for, or even successfully analysing, the 2007-09 crisis.
neoclassical theory describes a romanticised and sanitised version of the economy that blinded economists to irrational or unpredictable behaviour and market imperfections
Another economist, Victor Beker of Universidad de Belgrano, offers an explanation for this apparent blind spot. According to his 2012 paper, macroeconomics took a drastic turn when Robert Lucas, in the so-called “Lucas Critique”, proposed that macroeconomic policy should not be formed based on historical data, but instead through microeconomic analysis of the behaviour of individual agents. Mr Beker argues that microeconomic models ignore non-price interactions and treat individuals as separate entities who make decisions independent of each other. Therefore, he asks, how it is possible to explain macroeconomic phenomena (such as financial crises) using models that assume away the interactions between different economic agents? Mr Beker concludes, like many others, that the economics profession must revisit the theories and principles of John Maynard Keynes – the man who founded the discipline of macroeconomics.
Many other economists have attempted to analyse financial crises using similar neoclassical models; results have been ambiguous. Not only have these economists failed to acknowledge the flaws in their own perspective, but they have outright discouraged the study of alternate schools of thought – those which they deem to be ‘heterodox’. However, these schools, with Marxian being the most well known, often provide a more concrete and comprehensive analysis of capitalism and financial crisis. They should not be dismissed so easily.
A Marxian view of Capitalism
Karl Marx recognised in the 19th century the imperfections of capitalism that some were still gainsaying in 2007 – that crises are an inevitable aspect of capitalism, arising from the very way the capitalist system functions. For this reason, Marxism is still very much relevant to this day.
Marx believed that the working day is divided into the necessary labour time and that which is over and above what is necessary to cover the worker’s means of subsistence – the surplus labour time. He argued that the product of necessary labour accrues to the labourer in the form of wages, while the product of surplus labour is extracted by the capitalist in the form of surplus value. The capitalist sets aside a part of the surplus value for consumption, but uses the bulk of it to accumulate more capital and produce more thereby enabling him to extract more surplus value. This raises the demand for both capital and labour, causing their respective price levels to increase.
Karl Marx recognised in the 19th century the imperfections of capitalism that some were still gainsaying in 2007 – that crises are an inevitable aspect of capitalism
Producers of capital start to earn higher profits as a result of which capitalists from other industries too start producing this capital. This increases the supply and causes the price to fall back to the initial level. In the market for labour however, there are no capitalists who will enter the industry and ‘produce’ labour that will keep wages in check. Marx’s solution to this problem of excess demand for labour was the “reserve army of labour”. This comprised of a pool of unemployed workers who would enter the labour market in response to the increased demand thus exerting a downward pressure on wages.
Marx believed that crisis is an inevitable part of capitalism which can arise either due to insufficient generation of surplus value – leading to a ‘profitability crisis’ – or surpluses not being realised and causing a ‘realisation crisis’. Both of these phenomena are associated with Marx’s famous law which describes the tendency of the rate of profit to fall. He argued that the capitalist’s compulsion and desire to accumulate more capital in order to enrich themselves further causes the rate of profit to diminish. If profits were to fall below a certain threshold across industries, capitalists would cease to reinvest their surplus value and a profitability crisis would ensue. Alternatively, if capitalists were to continue accumulating capital and generating their surplus value by exploiting the working classes, a situation of over-accumulation would set in. If there were no outlet for this surplus value – ‘the demand gap’ in Keynesian terminology – then the capitalist system would reach a standstill and a realisation crisis would arise.
Marxian Analysis of the 2008 Financial Crisis
The neoliberal regime that emerged in the 1970s set the stage for the realisation crisis of 2008. Neoliberalism was based on the principles of free, competitive markets and neoclassical economics spearheaded by a strong stance against state intervention. From a Marxian point of view, this period saw two significant changes that ultimately lead to the Great Recession of 2008. The first was a new method of capital accumulation, known as accumulation by dispossession, which focused on centralisation of wealth and power in the hands of the capitalist class through the ‘dispossession’ of the working classes. The second was the curbing of the power of trade unions. The outsourcing of jobs overseas, among other policy changes, resulted in a continual decline of the real wages in the US from 1973 to 1996.
The neoliberal regime that emerged in the 1970s set the stage for the realisation crisis of 2008
This created a situation of over-accumulation since sustained conditions for realisation were not put in place by the neoliberal policies. Capitalists needed workers to increase their consumption to maintain profitability, but the need to maintain lower wages meant the only solution was to lend workers more and more money. Hence, corporations began investing their profits in buying securities that were backed by worker’s mortgages, auto loans and credit card loans. Marx had dubbed such forms of capital as ‘fictitious capital,’ and this exploded during the neoliberal period since it helped companies maintain high profits, earn interest on the loans taken out by workers, and maintain an outlet for realising the surplus value being generated. This form of capital was essentially money capital invested in future appropriation which in Marxian terminology translates into capital that is not engaged in the generation of current surplus value but has a claim on future surplus value. As financial institutions began trading these securities, they started engaging in risky behaviour selling to ‘subprime’ borrowers, assuming that government safeguard mechanisms would protect them. As a result, the value of these securities rose considerably, creating asset price bubbles. Yet, as Marx had predicted, once the claims on future surplus value exceeded the real surplus value being generated, these asset bubbles began to burst, causing the stock market to crash, financial institutions to declare bankruptcy and the US economy to go into freefall in what evolved into the worst economic crisis since the Great Depression.
The capitalist world has changed numerous times in the last century and yet capitalism has continued to survive, despite the severe crises that have originated from within the system. The economics discipline has also seen many changes, with various schools of thought rising to and falling from prominence over the years. Yet, eight years after the cataclysmic events of 2008, academic literature still largely focus on the mainstream neoclassical models and theories which have proven to be inadequate in the real world. The need of the hour is to train the next generation of economists, policymakers and academics in a more holistic manner emphasising on the imperfection of market economies – rather than clinging to the theoretical perfection which has proven to be all too illusory. This, along with more emphasis on the success and failure of different schools of economic thought – particularly in a historical context – and an inclusion of the so called ‘heterodox’ schools of thought will create a more comprehensive and unified approach to the discipline. By pursuing this agenda, the economics discipline would strengthen its ability to successfully understand, and perhaps better predict, future economic and financial crises.