The culture war behind the ‘credit crunch’

There seems to be a diametric divide between economic theories of under-consumption and over-consumption. In fact, both camps – with their focus on consumer habits rather than productive forces – share a common currency.

Daniel Ben-Ami

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Paul Krugman is arguably the most influential economist in the world today. Not only did he win the 2008 Nobel Prize for economics, he also has a widely read column in the New York Times. He used the NYT as a platform to attack what he saw as the crude free market economics of the Bush administration (1).

The Return of Depression Economics is likely to enhance his reputation further. It is an updated version of a book first published in 1999, which seemed to anticipate many of the main trends that surfaced in the economic crisis of 2008. Although much of the material is new – a lot has happened in economics and finance in the past decade – the basic argument and structure of the book is the same as the earlier edition. Indeed, Krugman argues that many of the themes of ‘depression economics’ were already clear in financial crises in Latin America in the mid-1990s, in Japan in the 1990s, and in the Asian financial crisis of 1997-8:

‘The world economy is not in depression, despite the magnitude of the current crisis… But while depression itself has not returned, depression economics, the kinds of problems that characterised much of the world economy but have not been seen since – has staged a stunning comeback.’

For Krugman the fundamental problem is what he calls a ‘liquidity trap’, or what others have referred to as under-consumption. For him the bursting of the financial bubble has left individuals in a state of anxiety about consuming. They would rather hold on to their money than engage in what they see as excessive spending. As a result, Krugman argues, the world is suffering from a lack of demand: ‘For the first time in two generations, failures on the demand side of the economy – insufficient private spending to make use of the available productive capacity – have become the clear and present limitation on prosperity for a large part of the world.’ His solution is for Keynesian measures, such as spending on infrastructure, to bolster demand and get the economy moving again.

There are fundamental problems with Krugman’s argument, but to understand them it is necessary to examine how he reaches his conclusions. It is not enough simply to reject his policy proposals. Before that, his underlying assumptions must be interrogated.

Krugman uses a simple model to explain his argument. He points to the example of a Washington babysitting co-op to explain what he means by a liquidity trap. The co-op issued its members with coupons, which each represented an hour of babysitting time. The idea was that over time every member of the co-op would do an equal amount of babysitting as they cashed in their coupons.

Unfortunately the coupon system did not work as planned. Some couples who were worried about not having enough coupons were anxious about going out. As a result they started hoarding their coupons. Such hoarding made couples even more nervous about going out. Eventually there were not enough coupons in circulation for the co-op to operate. In effect, the co-op was in recession. For Krugman this provides a simplified version of the economic crisis.

It is important to recognise that, in principle, there is nothing wrong with this kind of model-building. Economists do it all the time, and for good reason. It means isolating the most important factors in the operation of an economy rather than focusing on relatively peripheral questions. For example, an initial model of an economy might assume that it is closed – that is, not involved in international trade and investment – so that the main domestic trends can be identified. Later on, more complex factors can be added to the model to account for more subtle variations of the argument.

The problem with Krugman’s approach is not model-building itself but the ahistorical character of his assumptions. His book does not grapple with the specific features of the contemporary economy that mark it out from previous times. Indeed, it can be argued that there is a circularity to Krugman’s argument. His conclusion – that a Keynesian fiscal boost is the solution – is built into his under-consumptionist model of the economic crisis.

Krugman’s under-consumptionist explanation for the economic crisis is closer to the main competing explanation than may first appear. Many critics of the contemporary economy point to what they see as a problem of over-consumption. From this perspective, irresponsible financial institutions, usually the main villains of the piece, met feckless consumers to create an unsustainable consumption and house price boom. Often the state authorities are also criticised for allowing a bubble to develop through easy credit and failing to regulate financial institutions tightly enough (2). Eventually, it is argued, it was bound to end painfully.

Although these two arguments may appear diametrically opposed – one focusing on over-consumption and the other on under-consumption – they have much in common. Both of them focus on consumption, rather than production, as the real driver of economic activity. Indeed, the difference between the two is often simply one of timing. Many would argue that the over-consumption binge has led to the current crisis of under-consumption.

Proponents of these two views are currently engaged in what could be called a phoney culture war. The over-consumptionists argue, puritan-style, that individual consumption needs to be curbed if the world’s economic problems are to be overcome. Some advocates of this view are openly embracing the credit crunch (3). In contrast, the spendthrifts argue that now is the time to bolster the economy to offset flagging demand.

Today, with governments desperately launching fiscal packages to get their economies moving again, the spendthrifts are in the ascendant. John Willman, the UK business editor of the Financial Times, expressed the mainstream view in his newspaper: ‘The task facing the world’s leaders is to persuade terrified consumers to spend like there is no tomorrow – and that a return to thrift would make matters much worse.’ (4)

But it is likely to be only a matter of time until puritanism becomes the majority view. Pumping money into a fundamentally weak economy can only maintain momentum for a limited time. At some point inflationary forces are likely to emerge as a result of the huge amount of money being pumped into the world economy by finance ministries and central banks. Once that happens the drive to austerity looks set to become more overt.

A working model of the economy, in contrast to a one-sided outlook based on consumption, would need to be based on a critical examination of its defining characteristics. In Cowardly Capitalism (2001), I argued that there were two key features underlying the workings of the contemporary economy.

First, the productive economy of the West has atrophied. The dynamic to growth of the productive side of the economy has become weak. This weakness was partially hidden by the artificial boost to consumption from the extension of credit in recent years. The relative dynamism of Asia, which subsidised consumption in the West with many billions of dollars of capital flows, also disguised the extent of Western stagnation. Indeed, the financial bubble can itself be understood as the result of an attempt to offset the tendencies to atrophy in the Western economies. Such measures worked for a while but their limits were reached in 2008.

Second, the pervasive culture of risk-aversion in contemporary society has given shape to the financial markets. Financial markets have become more about transferring risks than channelling capital. Instruments such as mortgage-backed securities and credit derivatives are primarily mechanisms to allow those involved to transfer risk. Yet they have provided the mechanism for ‘contagion’ from one financial party in a transaction to another. The attempt to diversify risk has, paradoxically, led to many financial institutions holding what have become known as ‘toxic’ assets.

More recently, an additional factor has become paramount: the ‘greening’ of capitalism. In the name of such vacuous concepts as ‘sustainability’, the expansion of production is being constrained. There is a strong cultural aversion to genuine innovation and dynamic growth. This pervasive mood in society has intensified the problem of economic atrophy still further.

Any solution to the economic crisis must take into account these characteristics of the contemporary economy. Crude models of the downturn inevitably lead to flawed solutions. Krugman’s proposals to bolster the sagging economy may be at the height of fashion, but they look destined to fail to counteract the descent into depression economics.

Daniel Ben-Ami is a journalist and author based in London. Visit his website here. An earlier version of this review appeared in Fund Strategy magazine.

The Return of Depression Economics and the Crisis of 2008, by Paul Krugman is published by Allen Lane. (Buy this book from Amazon(UK).)

(1) See Is ‘hyperpartisanship’ paralysing American politics, by Sean Collins, January 2008

(2) For an example of this view see Capitalist fools, Joseph Stiglitz, Vanity Fair, January 2009. Stiglitz won the Nobel prize for economics in 2001.

(3) See New Year, new low, by Neil Davenport, 7 January 2009

(4) Puritans versus spendthrifts: recession’s culture war, Financial Times, 9 January 2009

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