The dilemma of mainstream economists and politicians

by Michael Roberts

Mainstream economists and politicians in the main capitalist economies are in a dilemma.  They could not come up with a convincing explanation of why there was a financial collapse and the ensuing Great Recession.  When former Chairman of the US Federal Reserve, Alan Greenspan, was asked in the US Congress, right in the middle of the slump, if he could explain what had happened, he responded, “I am in a state of shocked disbelief.” He was questioned: “In other words, you found that your view of the world, your ideology was not right, it was not working (House Oversight Committee Chair, Henry Waxman). “Absolutely, precisely, you know that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well”.  The conventional wisdom was unable to explain the huge disruption in modern capitalism. Now mainstream economics is in a dilemma. They are not sure what to do to fix it.

Larry Summers is a longstanding mainstream economist, a former US treasury secretary under President Clinton and now the Eliot professor at the elite Harvard University.  So he ought to know if anybody does what to do.  Writing in the Financial Times (14 October), Summers explains the dilemma: “While there is agreement on the need for more growth and job creation in the short run and on containing the accumulation of debt in the long run, there are deep differences of opinion both within and across countries as to how this can be accomplished. What might be labelled the ‘orthodox view’ attributes much of our current difficulty to excess borrowing by the public and private sectors, emphasises the need to contain debt, puts a premium on credibly austere fiscal and monetary policies, and stresses the need for long-term structural measures rather than short-term demand-oriented steps to promote growth. . . The alternative ‘demand support view’ also recognises the need to contain debt accumulation and avoid high inflation, but it pushes for steps to increase demand in the short run as a means of jump-starting economic growth and setting off a virtuous circle in which income growth, job creation and financial strengthening are mutually reinforcing. International economic dialogue has vacillated between these two viewpoints in recent years.”

Which approach is right? That is the basis of the debate on the fiscal multiplier that erupted among economists after the IMF report on the world economy released last week (see my recent post, The smugness multiplier, 14 October 2012). As John Mauldin, a global investment analyst, put it baldly: “There is indeed considerable disagreement throughout the world on what policies to pursue in the face of rising deficits and economies that are barely growing or at stall speed. Both sides look at the same set of realities and yet draw drastically different conclusions. Both sides marshal arguments based on rigorous mathematical models “proving” the correctness of their favorite solution, and both sides can point to counterfactuals that show the other side to be insincere or just plain wrong.   One side argues that the cure for too much debt is yet more debt, while the other side seemingly argues that the cure for a lack of growth is to shrink the economy. It is as if one side argues that the cure for a night of drunken revelry is a fifth of whiskey while the other side prescribes a very-low-calorie diet of fiber and veggies.” (

The dilemma is between the need to contain expanding debt that can eat into available funds for future investment and the need to reverse collapsing growth as it already eating into ‘demand’.  In a way, the issue of the size of the fiscal multiplier is really a red herring.  As Mauldin says: “if you either cut government spending or raise taxes, you are going to reduce GDP over the short run (academic studies suggest the short run is 4-5 quarters). To argue that raising taxes or cutting spending has no immediate effect on the economy flies in the face of mathematical reality.” In that sense, the Austerians are badly wrong.  Cutting government spending and/or raising taxes to reduce government deficits at the same time as households are slowing their spending in order to pay off debt (or because they have defaulted on their mortgages) and businesses are either refusing to invest or cannot do so, must reduce GDP growth.  If every sector is cutting back or slowing down, that must reduce GDP growth. The evidence of the last four years proves that.

 But where the Keynesians are wrong is to ignore the truth that there is a limit to how much money a government can borrow (“to suggest there is no limit puts you clearly in the camp of the delusional” – Mauldin). Just look at the way both private and public sector debt has mushroomed, in the last 15 years in particular, to unprecedented heights. The graph shows public debt, but it was the same story for private debt up to 2006.

It is no accident that this rise in debt (what Marx calls fictitious capital) coincides with the downward trend in profitability on the major capitalist economies.  Since the mid-1990s, the average rate of profit in the top seven capitalist economies fell 5% to 2008 (at the start of the Great Recession) while private and public sector debt to GDP rose over 30%.  The rise in fictitious capital hid the underlying crisis in capitalist production up to 2008.

The Keynesians think that the crisis in capitalist production is simply one of insufficient spending or ‘effective demand’.  So the government must step in to fill the gap if the private sector cannot deliver.  But is the lack of spending not caused by a lack of income?  As Mauldin hints: “The problem is not merely one of insufficient spending: the key problem is insufficient income. By definition, income has to come before spending. You can take money from one source and give it to another, but that is not organic growth.” What Mauldin does not specify is that ‘organic growth’ (i.e. growth not based on fictitious capital) under the capitalist mode of production depends not on income as such but on the share that goes to profit. If that is insufficient,then organic growth based on productive investment will not materialise, whether the government spends more or less.

Mauldin gropes towards the nub of the dilemma for mainstream economics: “While deficit spending can help bridge a national economy through a recession, normal business growth must eventually take over if the country is to prosper. Keynesian theory prescribed deficit spending during times of business recessions and the accumulation of surpluses during good times, in order to be able to pay down debts that would inevitably accrue down the road. The problem is that the model developed by Keynesian theory begins to break down as we near the event horizon of a black hole of debt.”

The debt is now just too high to expect more borrowing to deliver enough new investment and growth to contain it. Keynesians sometimes seem to argue that debt does not matter and more borrowing is not a problem, at least not for now.  And yet all the analysis of all the historical evidence shows that once debt gets up to 85-100% of GDP, whether it is private or public debt, economic growth slows sharply to well below a trend level that can sustain employment or encourage investment (see recent studies by Reinhart and Rogoff, McKinsey and the IMF).  And that is where we are right now.

The Austerians complain that the Keynesian view that debt does not matter (at least for now) is just passing on the problem of paying for the servicing of that rising debt (repayments and interest) to future generations.  So there will be low growth, stagnation and crisis down the road.  This has led to a rather stale debate within mainstream economics between Austerians and Keynesians on whether there is burden for future generations (see

The result of this debate has been summed by arch-Keynesian, Simon Wren-Lewis (see his blog site, He concludes “government debt can be a burden on future generations. . . and is also likely to reduce future output, so we should really worry about the size of government debt in the longer term”  SWL then adds his important Keynesian proviso “but none of these worries applies when the economy is demand constrained as it is right now.”  But SWL adds the reason for capitalist production to be worried about mounting government debt.  If it diverts available saving away from “productive capital”, then it crowds out that capital.  In other words, if more government borrowing is spent on unproductive activities like welfare, it reduces spending on productive things building new homes or infrastructure. But this problem only arises when there is not enough savings to go round (“when investment in capital is governed by savings”). Exactly!  As households do little saving, we are really talking about business ‘savings,’ or profit.  If there are insufficient profits for investment and then government borrowing diverts some of this into buying government debt, that crowds out ‘productive investment’, i.e.investment for profit.  Then “we should be concerned” about the long run impact of government debt.

More or less government spending?  More or less debt?  Which is the best way?  Mainstream economists don’t know, or at least are divided. A recent survey of 60 leading US economists (Foreign Policy Survey on the economy, November 2012 issue, asked them: if we are ever going to get out of this slump, what will it take?  The general view was ‘don’t know’.  About 30 of these ‘leading economists’ reckoned President Obama’s limited fiscal stimulus package had been successful in avoiding a Great Depression, but another 28 thought it had just made things worse for the deficit and debt, while 3 did not know.  They were asked what was the reason for the slow economic recovery in the US; 31% said it was “uncertainty” and 26% said it was weak aggregate demand.  The rest thought it was too much debt, a failure to deal with the budget deficit or a weak housing market.  In other words, all sorts of explanations.  When you put nine economists in a room, you get ten answers (and two from Keynes).

It’s a sad irony that in the midst of this crisis in macroeconomic policy, with no progress from same theories and divisions in mainstream economics as in the 1930s between ‘New Deal’ policies and the orthodox ‘Treasury view’, this year’s Nobel prize for economics goes to two economists who never thought of these issues but instead engaged in the application of mathematical game theory to so-called micro-economic problems. Alvin Roth and Lloyd Shapley are awarded the prize for showing how game theory can be applied to ‘non-market’ situations like matching pupils to their selected schools in the most efficient way that does not require pricing.  This may be a useful mathematical contribution to problems in a non-monetary economy, but it’s not political economy.

Eugene Fama is the arch representative of mainstream neoclassical economics.  He was the ‘inventor’ of the Efficient Markets Hypothesis, which claims that if markets are left to themselves and markets agents have enough information, then an economy will perform efficiently and without disruption. Well, after the Great Recession, he too was asked what went wrong.  He replied casually, “We don’t know what causes recessions. I’m not a macro-economist, so I don’t feel bad about that! We’ve never known. Debates go on to this day about what caused the Great Depression. Economics is not very good at explaining swings in economic activity”.

Mainstream economics has no contribution to make on the major causes of economic crisis and slump and what to do about it.  So it’s better to find algorithms that can help match doctors with hospitals, or pupils with schools than to find a coherent approach to the crises of capitalist production.  In this area, the very justification of capitalism is under the microscope.  So let’s ignore it.

The above article is taken from Michael Roberts’ excellent blog, the next recession.