The failure of the Great Moderation, like that of the Efficient Markets Hypothesis, has major implications for a wide range of government policies. The implications for the financial sector have already been discussed and we will look in detail at implications for fiscal and monetary policies in Chapter 3. But the central implications of the end of the Great Moderation relate to the need to reverse the Great Risk Shift, and reinvigorate the social and collective risk management institutions that constitute the social-democratic welfare state.
The end of the Great Moderation has already produced a massive increase in the economic risk faced by individuals, families and businesses. In the US, as many as 10 million households are expected to face foreclosure by 2012. Over the same period, and despite laws designed to make bankruptcy less accessible, it is likely that between 5 and 10 million households will face bankruptcy (of course, the two groups will overlap).
The collapse of stock markets has wiped out, or drastically reduced, the life savings of many workers. More fundamentally, it has undermined the idea of a shareholding democracy, in which most households have sufficient financial wealth, earning good returns, to be at least partially independent of wage income during their working years, and reliably capable of financing their own retirement thereafter. (More on for retirement income in Chapter)
Around the world, tens of millions of workers have lost their jobs, and tens of millions more will do so before the crisis is over. And even after economic growth has resumed, the impacts will be felt for a long time to come. In the absence of positive government action, unemployment will remain high for years after the economy hits bottom. The unstable state of the global financial system, and the lack of any significant movement towards more effective regulation, suggests there will be more shocks to come.
The increase in inequality that produced this increase in risk is most evident in the United States, but it has occurred, with a shorter or longer time lag, in many other countries, both developed and developing. Where the social democratic welfare state has remained strong, growth in inequality has been less marked. But it is no longer possible to suppose that simply slowing the pace of market liberalisation will prevent growth in inequality, and the growth in risk and insecurity it implies.
All of these changes mean that risk can no longer be ignored, or wished out of existence through financial market conjuring tricks. Only a renewed social-democratic analysis provides any coherent basis for a response.
Social democrats have long stressed the idea that we have the capacity to share and manage risks more effectively as a society than as individuals. The set of policies traditionally associated with social democracy or (in the US, political liberalism) may be regarded as responses to a range of risks facing individuals, from health risks to uncertain life chances.
In his pathbreaking book, When All Else Fails, Robert Moss surveys two centuries of American history, in which he presents the state as ‘the ultimate risk manager’. Moss distinguishes three phases of public risk management in the United States. Although the United States is atypical in important respects, Moss’s three-phase model provides a useful framework for discussion.
Moss’ first phase, ‘security for business’, encompasses innovations such as limited liability and bankruptcy laws, introduced in the period before 1900. Many of these risk management policies are taken for granted now, but they were vigorously debated at the time. Adam Smith, the father of mainstream economics, denounced limited liability companies as providing an open invitation to managers to enrich themselves at the expense of shareholders. His critique sounds strikingly familiar, but he did not foresee the development of businesses on a scale so massive that a vast number of shareholders was a necessity rather than an option. As for bankruptcy, the US Constitution adopted 1789 allowed Congress to legislate on the topic, but it took more than 100 years to reach agreement. In the intervening century, bankruptcy laws were adopted, and later repealed, on three separate occasions.
Moss’s second phase, ‘security for workers’, was produced by the shift from an economy dominated by agricultural smallholdings to a manufacturing-based economy in which most households depended on wage employment. Historically the phase includes Progressive initiatives such as workers’ compensation and the core programs of the New Deal like unemployment insurance and social security.
The third phase, ‘security for all’, began after World War II and includes such diverse initiatives as consumer protection laws, environmental protection and public disaster relief. These may be seen as responses to the ‘risk society’ (Beck 1992). Risks of environmental degradation and natural disaster are inherently social in their nature, and the success or failure of a society in responding to these risks is a measure of the capacity and responsiveness of its government.
The Great Risk shift in economic policy was part of a bigger backlash against social risk management, which was even more ferocious in the case of environmental risks. It’s hard to believe, looking at today’s debates, that the Clean Air Act of 1970 and Clean Water Act of 1972 were passed with overwhelming bipartisan support. Any proposal to protect the environment now produces automatic, and vitriolic, rejection from the political right.
Risk and inequality are closely linked. On the one hand, the greater the risks faced by individuals in the course of their life, including the risk associated with differences in initial opportunities, the more unequal society is likely to be. On the other hand, as the financial crisis has shown, radical inequality in outcomes, such as that associated with massive rewards to financial traders, encourages risky behavior and particularly encourages a search for opportunities to capture the benefits of risky actions while shifting the costs onto others, or onto society as a whole.
A social democratic response to the crisis must begin by reasserting the crucial role of the state in risk management. If individuals are to have security of employment, income and wealth, governments must act to establish and enforce the necessary legal and economic framework. The fact that government is the ultimate risk manager both justifies and necessitates action to mitigate the grotesque inequalities in both opportunities and outcomes that characterise unrestrained capitalism and were increasingly resurgent in the era of economic liberalism.
The interpretation of the welfare state in terms of risk and uncertainty may be illustrated by considering some of its core functions. For some of these functions, such as various forms of social insurance, the risk management function has always been emphasised. However, concern with risk has traditionally been a subsidiary theme.
For instance, the public provision of retirement income and of services like health or education have commonly been justified with reference to notions of redistribution, public goods and the provision of basic needs. However, these interventions may equally be supported in terms of risk management.
A risk-based analysis may be extended to encompass more general programs of income redistribution. In a risk-based view, redistribution may be seen as providing insurance against a particular kind of risk, namely the risk of being born poor, socially dislocated and without access to human and social capital. These ideas have been explored by a number of policy analysts in recent years, notably including Nicholas Barr, Ulirch Beck, Anthony Giddens, Jacob Hacker and Robert Moss.
As Giddens observed in his 1999 Reith lectures
the welfare state, whose development can be traced back to the Elizabethan poor laws in England, is essentially a risk management system. It is designed to protect against hazards that were once treated as at the disposition of the gods - sickness, disablement, job loss and old age.
Pursuing the same theme, Nicholas Barr offers the metaphor of the welfare state as ‘piggy bank’ as against the traditional view of the welfare state as ‘Robin Hood’. The Robin Hood interpretation implies a zero sum view of the world in which the state acts to help the poor at the expense of the rich, or, more generally, the well-ff. At any given point in time, this is exactly what happens. But, over the course of a lifetime, everyone faces the risks to which Giddens refers, to some degree or another. And, taking a longer perspective, even those who are unlikely to suffer from these risks are just winners in the bigger lottery of life chances, consisting, to a very large extent, of having the right parents.
Collective risk management through the welfare state helps to stabilize the aggregate economy. When incomes decline as a result of a recession, the design of a progessive tax system means that government tax revenues decline more than proportionally. This helps to cushion the impact on private demand and offsets the downward multiplier effects of an initial shock to the economy. Similarly, when unemployment rises, this produces an automatic increase in spending on unemployment benefits which is commonly amplified by expansion of benefits and the creation of new programs for the unemployed
The mechanisms by the welfare state softens the impact of demand shocks are called ‘automatic stabilizers’, and, given robust welfare state institutions, the name is appropriate. But there is nothing automatic or guaranteed about those institutions. A balanced budget requirement such as exists in most US states, will force governments to cut expenditure precisely when it is most needed, producing, in Paul Krugman’s phrase ‘50 Herbert Hoovers’.
Similarly, if a government is so indebted that it can’t borrow money, or print money without the risk of inflation, an economic crisis will force retrenchment. That’s why its important to stress the ‘hard’ side shared by social democratic risk management and Keynesian demand management. Abandoning short term budget balance doesn’t mean that bills don’t have to be paid. Help when we face unemployment or health risks, or for those who are unlucky in their life chances, must be paid for by tax contributions made those who are, at least for the moment, healthy and well-off. Budget deficits to soften the impact of recessions must be matched by surpluses in good times. The ‘golden rule’ is to balance the budget over the course of the cycle.
No one can predict the future path of the economy with any accuracy. But at the aggregate level, we will almost certainly see more instability, with more frequent and sharper shocks, than during the false calm of the Great Moderation. And the end of the Great Moderation has not reversed the Great Risk Shift or, except partially and temporarily, the growth in inequality produced by the decades of market liberalism. The social-democratic response must combine better social provision to help people deal with risk at the individual and family level with a return to active use of fiscal as well as monetary policy to stabilise the aggregate economy. The two should be designed to work together, with social risk management policies that act as automatic stabilisers in the Keynesian sense and fiscal policies focused on helping those most directly affected by recession.
Rethinking the experience of the 20th century
The failure of the Great Moderation calls for a rethinking of the macroeconomic experience of the 20th century, and, in particular, the crisis of the 1970s. Considered as a whole, the performance of developed economics in the era of market liberalism looks considerably less impressive than that of the postwar period of Keynesian social democracy.
Yet the Keynesian era ended in the chaos and failure of the 1970s. Until the current crisis, that failure was taken as conclusive. Whatever its merits, Keynesian economic management had proved unsustainable in the end, while the methods of market liberalism seemed to promise the continuing stability of the Great Moderation.
That view can no longer be sustained. The Great Moderation has ended in a failure at least as bad as that of the postwar boom. And, if there is a recovery, it will be due to the very measures that market liberalism was supposed to have rendered obsolete. How then, should we think about the Keynesian era and its failure?
One possible interpretation, a pessimistic one, is that business cycles are so deeply embedded in the logic of market economics (and, perhaps of all modern economies) that they cannot be tamed. Success breeds hubris, and hubris leads us to ignore the lessons of the past: that resources are always constrained, that budgets must ultimately balance, that wages and other incomes cannot, for long, exceed the value of production and so on. It the 1960s, this hubris manifested itself in massive budget deficits and the wage-price spiral. In the 1990s and 2000s, it was seen in the speculative frenzy unleashed by the self-styled Masters of the Universe in the financial sector.
But this is not the only possible interpretation. Perhaps the failures of the 1970s were the result of mistakes that could have been avoided with a better understanding of the economy and stronger social institutions. If so, the current crisis may mark a return to successful Keynesian policies that take account of the errors of the past.
The end of the Great Moderation has forced policymakers to relearn the basic lessons of Keynesian economics. Economies can collapse to a point where only large scale monetary expansion and fiscal stimulus can revive them. But having revived the economy, can Keynesian policies restore and sustain full employment in a system that is inherently prone to crisis. To answer this question, we requires radical new directions in macronomics. As we will argue in the following chapter, that means the abandonment of yet more dead or obsolete ideas.
On to next Chapter Micro-based macro
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