Five years before the financial meltdown of 2008, Robert Lucas famously declared that “the central problem of depression-prevention has been solved . . . and has in fact been solved for many decades”.
The University of Chicago economist was not alone. Up to the eve of the worst crash in 80 years, America’s economic luminaries, including Alan Greenspan, former chairman of the Federal Reserve, and his successor Ben Bernanke insisted there was no cause for alarm.
Having failed to foresee the crisis, many badly misread its aftermath. As early as December 2008, Mervyn King, governor of the Bank of England, anticipated breakaway wage growth. We are still waiting.
Greenspan, meanwhile, predicted double-digit inflation. Eleven years into America’s weakest recovery on record, US inflation remains stubbornly below its two per cent target. As recently as last February, Jay Powell, the current Fed chairman, said it was a “bit of a puzzle” why wage growth had not yet taken off.
Why do economists continue to get it so wrong? One answer is that not all of them do. David Blanchflower, who was on the Bank of England’s monetary policy committee during the 2008 crash, insists that evidence of an impending crash was hidden in plain view long before it happened. Blanchflower, whose book Not Working: Where Have all the Good Jobs Gone? is a stinging rebuke to his profession, was consistently outvoted eight to one on the MPC, which sets UK interest rates. Unlike his colleagues, who were using models based on a 1970s-style economy, Blanchflower went out and talked to people. He calls this “the economics of walking about”.
His peers, meanwhile, were relying on “largely untested theoretical models that amounted to little more than mathematical mind games”. Paul Romer, the former World Bank chief economist, calls this “mathiness” — playing with regression to give a false sense of precision. Others might call it alchemy. Lucas, whose Chicago School housed the high priesthood of mathiness, won a Nobel Prize for his rational expectations theory. It demonstrated that the market was always right.
The rise and fall of the Chicago School is chronicled by Binyamin Appelbaum in his admirable book The Economists’ Hour. As he shows, economists were treated as little more than backroom statisticians until the late 1960s. That was when the Chicago School, led by the Nobel-prize winning Milton Friedman, took over.
The economists’ age of glamour had arrived, propelling them into the centre of power and on to our television screens. They drew inspiration from Friedrich Hayek, whose book The Road to Serfdom (1944) argued that almost any government role in the economy created a slippery slope to autocracy.
The “economists’ hour” contained many overlapping schools. Some, like Friedman, were monetarists, who believed that inflation was solely a function of money supply — control the latter and you tame the former. Others, like Arthur Laffer, were supply-siders, who argue that tax cuts always pay for themselves through higher corporate revenues. All believed that the markets know best. As Greenspan once quipped: “I have never seen a constructive regulation yet”.
Appelbaum argues that their heyday ended on October 13 2008, when the chief executives of America’s largest banks were marched into the US Treasury for a crisis meeting. He is surely correct. The mother of all Wall Street bailouts shattered the reputation economics had gained over the previous 40 years. Yet economists’ hubris lingers. Perhaps it is a lagging indicator. Economists might call it “sticky”.
Three books on capitalism at a crossroads
Binyamin Appelbaum looks at how the financial crisis and ensuing bailouts shattered the reputation economics had spent decades establishing
David Blanchflower delivers a stinging rebuke to his profession, saying economists’ failure to get out into the real world muddled their models
Branko Milanovic argues there is only one system now. The new global competition, he says, is between different types of capitalism
One reason that wages have not picked up in Britain and the US is because central bankers continue to base decisions on outdated models. Real-term weekly wages for non-supervisory US production workers are 9 per cent below where they were in 1972. In the UK, the hourly wage is 5.7 per cent lower than it was before the great recession.
The traditional models — notably, “Nairu”, the non-accelerating inflation rate of unemployment — tell economists that a jobless rate of 3.5 per cent, which is the current US level, is well below the point at which higher wage demands would start to kick in. Just wait one more quarter, they say. The data will arrive.
This overlooks the importance of the low labour force participation rate, which captures those who have given up seeking work altogether and who are excluded from the jobless measure. One in 12 prime age American males are ex-offenders, which pretty much shuts them out of the jobs market. Walking about more might help central bankers grasp that the jobless rate no longer captures reality.
“Policymakers at the start of 2019 seem to be just as out of touch with what is going on outside the big cities as they were as the great recession was nearing,” writes Blanchflower.
Another ancient model, which was last put into practice by Herbert Hoover after the 1929 Wall Street Crash, holds that an economy should be punished for its excesses. Hoover’s fiscal contraction turned the stock market crash into the Great Depression. George Osborne, the UK chancellor after 2010, and the Tea Party of Republican populists, which took control of Congress the same year, revived that old saw. The dampening effects of Osborne’s policy of “expansionary austerity” helped pave the way for the Leave vote in the 2016 Brexit referendum. Washington’s fiscal gridlock helped tee-up Donald Trump’s victory in the US presidential election later that year.
Yet the hubris persists. One of Trump’s advisers is Arthur Laffer, whose wife famously goes on long runs “because it’s the only way I can stay married to a lunatic”. Trump’s $1.6tn tax cut was the wrong medicine for an economy suffering from low investment. The tax cut has neither paid for itself, as Laffer predicted, nor lifted the US growth rate. With interest rates so low, it would be the ideal time to modernise America’s infrastructure. As Blanchflower quips, America’s failure to do so is the equivalent of leaving a trillion dollar note on the sidewalk.
So where do we go from here? In his seminal book Global Inequality (2016), Branko Milanovic — a New York-based academic originally from Serbia — showed that we are living in the age of global convergence. As his now famous “elephant chart” showed, the world’s low-income economies are rapidly catching up with the west. The main body of the elephant shows income growth for the bulk of the world’s population. The downwardly curving trunk captures the ill-fated western middle classes. Finally the trunk tips sharply upwards to reflect the outsized gains of the west’s one per cent. Almost everyone, including the world’s poorest, are benefiting from global convergence. That includes the globalised elites in China, the US and elsewhere, who have never had it so good.
The big exception are the west’s blue-collar workforces, who are likely to feel the squeeze for decades to come. Support for globalisation tends to be high in the east and low in the west. Ninety one per cent of people in Vietnam say they are fans of globalisation, against just 37 per cent in France.
In his latest book Capitalism, Alone, Milanovic explains why capitalism no longer has competitors. China’s economy is now 80 per cent private sector-owned, versus 50 per cent in the late 1990s and zero per cent before it began its reforms in 1978.
The new global competition, Milanovic argues, is between different types of capitalism. This he divides into two: the west’s “liberal meritocratic capitalism” versus China’s “political capitalism”.
Each is beset with its own problems. China’s model is undemocratic and must generate high growth rates to maintain its legitimacy. Meanwhile, in most of the west, meritocracy is failing. For the first time, the top 0.1 per cent in America now own the same amount of wealth as the bottom 90 per cent (at 22 per cent of national wealth and 22.8 per cent respectively). As recently as the 1980s, the bottom 90 per cent accounted for more than a third of America’s wealth.
Part of this can be attributed to the fact that today’s working rich also live off their capital investments, which consistently achieve higher returns than the non-financial economy. Most of the owners of capital also work for a living. They are harder to tax than those living solely off economic rents “since their high incomes are viewed as being more deserved”. As a result, the west — and particularly the US — is becoming steadily more oligarchic. We can thank the Chicago School for that.
Inequality in China is even worse than in the US — and continues to grow. One explanation for Hong Kong’s current ferment is that the city-state is essentially ruled by its plutocratic elites who are appointed by China. Yet most people cannot afford basic housing. Corruption is also growing in China and other parts of the developing world. The more closely bound the rest of the world is into the global economy, the more corruption opportunities arise.
The International Monetary Fund’s errors and omissions on global trade, which tracks anomalies in the numbers, has doubled since 2008 to around $200bn. One of the easiest ways to hide the proceeds of graft is to under-invoice exports and over-invoice imports. By deflating your export earnings and inflating your import bill, you can make your ill-gotten gains disappear. The west’s battery of lawyers and real estate firms, especially in London and New York, handle the rest. They also provide what Milanovic calls “moral laundering” by facilitating generous kleptocratic donations to Ivy League universities and art galleries.
The closer one looks, the more it appears that Milanovic’s two types of capitalism are merging. The west’s claims to meritocracy look increasingly hollow, while China’s promise of eternal growth must surely be coming to an end. What we do know is that there is growing equality between nations and growing inequality within them. No system, whether liberal or illiberal, can tolerate plutocracy indefinitely.
“As long as capitalists used most of their surplus income to invest rather than to consume, the social contract held,” writes Milanovic. His book leaves little doubt that the social contract no longer holds. Whether you live in Beijing or New York, the time for renegotiation is approaching.
The Economists’ Hour: False Prophets, Free Markets, and the Fracture of Society, by Binyamin Appelbaum, Little, Brown, RRP$15.99, 448 pages
Not Working: Where Have all the Good Jobs Gone?, by David Blanchflower, Princeton, RRP$29.95/£25, 456 pages
Capitalism, Alone: The Future of the System That Rules the World, by Branko Milanovic, Belknap Press, RRP£23.5/€27/$29.95, 304 pages
Edward Luce is the FT’s US national editor
This story has been amended since publication to make clear that the reason wages have not picked up is because central bankers continue to base decisions on outdated models
Letters in response to this article:
Rush into property after past the age of 50 crash put basic housing out of reach for many / From Dr Deborah Potts, Emeritus Reader in Human Geography, Urban Futures Research Group, King’s College London, UK
Get alerts on Economics books when a new story is published