The Marxian view is that capitalistic economies are inherently unstable and that excessive acc.u.mulation of capital will lead to increasingly severe economic crises. Growth theory, which has proved to be empirically successful, says this is not true. The capitalistic economy is stable, and absent some change in technology or the rules of the economic game, the economy converges to a constant growth path with the standard of living doubling every 40 years. In the 1930s, there was an important change in the rules of the economic game. This change lowered the steady-state market hours. The Keynesians had it all wrong. In the Great Depression, employment was not low because investment was low. Employment and investment were low because labor market inst.i.tutions and industrial policies changed in a way that lowered normal employment. (Prescott 1999: 13; emphases added) Prescott's culprit for these changes, predictably, is the government: 'government policies that affect TFP [total factor productivity] and hours per working-age person are the crucial determinants of the great depressions of the 20th century [...]' (Kehoe and Prescott 2002: 1).

The reason that Prescott and his fellow freshwater economists were led to such a frankly crazy interpretation of the Great Depression is that their model allowed no other alternative.

As a reminder, their model, in a nutsh.e.l.l, is the following. There is a single consumer, endowed with rational expectations, who aims to maximize his utility from consumption and leisure over the infinite future. His income emanates from the profits of the single firm in the economy, of which he is the sole owner, and in which he is the sole worker, where the profits he receives are the marginal product of capital times the amount of capital employed by the firm, and his wages are the marginal product of labor times the hours he works in the firm. The output of the firm determines consumption and investment output today, and today's investment (minus depreciation) determines tomorrow's capital stock. The single consumer/capitalist/worker decides how much of current output to devote to investment, and how many hours to work, so that the discounted expected future value of his consumption plus leisure plan is maximized. Technology enables expanding production over time, with productivity growing at a constant rate but subject to random shocks, and these shocks cause the equilibrium levels of labor and investment chosen by the consumer/capitalist/worker to alter but the choices made are always equilibrium choices.

With that bizarre vision of a market economy, while standard business cycle fluctuations in employment can be explained as a rational response by workers to work less today because productivity has increased owing to a series of positive technology shocks the only explanation for the sustained decline in employment that occurs during a depression is that it is a rational response by the household sector to a change in government policy to take more leisure.

The salt.w.a.terfreshwater dialectic Salt.w.a.ter neocla.s.sicals like Krugman, Stiglitz and so on can at least be congratulated for being realistic enough to reject this extreme Panglossian view of how the economy operates. But the dilemma for them is that the freshwater vision is more faithful to the underlying neocla.s.sical vision of the economy that they share with the freshwaters.

Herein lies the dialectic that has defined the development of neocla.s.sical macroeconomics over time, between theoretical purity on the one hand and reality on the other. To a neocla.s.sical, theoretical purity involves reducing everything to the Walrasian vision of a perfectly equilibrating economy in which case no macroeconomic crises can occur (since price movements will rapidly eliminate any macro imbalances caused by disequilibria in individual markets). Reality introduces the vexing counterpoint that recessions do occur, and persist for an inordinate period of time, and that it simply beggars belief that the dole queues of the 1930s and the ma.s.sive unemployment of the Great Recession are manifestations of workers voluntarily taking more leisure.

This in turn leads to a dialectical division of labor within neocla.s.sical economics. Ideologues who are most committed to the vision of the free market as the perfect system were the first to respond to any challenge to this vision thus firstly Friedman, then Lucas, Prescott and the other freshwater economists led the revolt against IS-LM Keynesianism, and the Real Business Cycle/DSGE approach to economics evolved.

Then the liberals or comparative realists within neocla.s.sical economics Stiglitz, Krugman, Woodford and the like reacted to the unrealism that the extreme purity approach embodies, though at the same time they took this perspective as the proper point from which to commence macroeconomic modeling. So they embellished the purist model with deviations from microeconomic perfection, and generated a model that can more closely emulate the economic data on which they focus predominantly the rates of real economic growth, employment and inflation. This became known as the 'New Keynesian' or salt.w.a.ter approach to economics, in contrast to the 'New Cla.s.sical' or freshwater approach: start from precisely the same vision of a macroeconomy that would be in perfect equilibrium with no involuntary unemployment if all consumers were h.o.m.ogeneous, markets were perfect and prices adjusted instantly to any shocks; then add in maybe two types of agents, imperfect compet.i.tion and other deviations from perfection to generate inflation and involuntary unemployment.

The founding editor of the American Economic a.s.sociation's specialist macroeconomics journal, Olivier Blanchard (Blanchard 2008, 2009) described the basic or 'toy' salt.w.a.ter/New Keynesian' model as starting from the freshwater/New Cla.s.sical model without capital, to which it added two 'imperfections': monopolistic compet.i.tion and inflation caused expectations of future inflation plus a gap between what output actually is and the higher level that neocla.s.sical theory says it would be if there were no 'imperfections.'36 It then added monetary policy conducted by a central bank using the Taylor Rule,37 with which it attempts to control inflation by setting the real interest rate on the basis of the rate of inflation and the output gap.

This results in a model that can be expressed in three equations one for consumption or aggregate demand as a function of the real interest rate and (rationally) expected future output, another for inflation, and a third for the central bank's interest-rate-setting policy. Blanchard stated that the model was simple, a.n.a.lytically convenient, and has largely replaced the IS-LM model as the basic model of fluctuations in graduate courses (although not yet in undergraduate textbooks). Similar to the IS-LM model, it reduces a complex reality to a few simple equations. Unlike the IS-LM model, it is formally, rather than informally, derived from optimization by firms and consumers. (Blanchard 2009: 21415) The weaknesses in the model38 are addressed by adding yet more microeconomic imperfections. These include adding the reality that the labor market is not h.o.m.ogeneous to explain involuntary unemployment 'One striking (and unpleasant) characteristic of the basic NK model is that there is no unemployment!' (ibid.: 216) and using the concept of asymmetric information to explain problems in credit markets. This salt.w.a.ter approach necessarily achieved a better fit to the data than the extreme neocla.s.sical vision of the freshwater faction, but for reasons that are hardly exemplary, as Solow observed: The simpler sort of RBC model that I have been using for expository purposes has had little or no empirical success, even with a very undemanding notion of 'empirical success.' As a result, some of the freer spirits in the RBC school have begun to loosen up the basic framework by allowing for 'imperfections' in the labor market, and even in the capital market [...]

The model then sounds better and fits the data better. This is not surprising: these imperfections were chosen by intelligent economists to make the models work better [...] (Solow 2001: 26; emphasis added) Nonetheless, the better apparent fit to the data from models engineered to do so by the salt.w.a.ters meant that, over time, and despite the vigorous protests of the freshwaters, the 'New Keynesian' approach became the dominant one within neocla.s.sical macroeconomics. It appeared to neocla.s.sicals that macroeconomics was converging on a 'New Keynesian consensus,' and Blanchard claimed so in 2008: there has been enormous progress and substantial convergence. For a while too long a while the field looked like a battlefield. Researchers split in different directions, mostly ignoring each other, or else engaging in bitter fights and controversies. Over time however, largely because facts have a way of not going away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and it suffers from extremism, herding, and fashion. But none of this is deadly. The state of macro is good [...]

Facts have a way of eventually forcing irrelevant theory out (one wishes it happened faster), and good theory also has a way of eventually forcing bad theory out. The new tools developed by the new-cla.s.sicals came to dominate. The facts emphasized by the new-Keynesians forced imperfections back in the benchmark model. A largely common vision has emerged. (Blanchard 2009: 210) Given the time lags involved in academic publishing, this unfortunate paper, which was first completed in August 2008 (Blanchard 2008) (eight months after the start of the Great Recession, according to the National Bureau of Economic Research), was published in an academic journal in May 2009, by which time the world as neocla.s.sical economists thought they knew it had come to an end. Forces their models completely ignored finally overwhelmed the economy, and took their vision of the economy with it.

Conclusion.

Though I can argue about logical fallacies till the cows come home, this is no subst.i.tute for an empirical proof that neocla.s.sical economics is wrong. This was provided in spectacular fashion by the Great Recession. Not only was this not predicted by neocla.s.sical models according to them, such an event could not even happen.

Box 10.1 The Taylor Rule.

The Taylor Rule was first devised by John Taylor as a reasonable empirical approximation to the way the Federal Reserve had in fact set nominal interest rates (Taylor 1993: 202). He noted that the Fed had increased the cash rate by 1.5 percent for every percent that inflation exceeded the Fed's target inflation rate, and reduced the cash rate by 0.5 percent for every percent that real GDP was below the average for the previous decade. When New Keynesian economists incorporated this in their model, they introduced the neocla.s.sical concept of an 'equilibrium' real rate of interest (which is un.o.bservable), so that if actual inflation and the rate of growth were equal to their target levels, the cash rate should be equal to the inflation rate plus this un.o.bservable 'equilibrium' rate.

After the crisis. .h.i.t, Taylor himself blamed it on the Fed deviating from his rule: Why did the Great Moderation end? In my view, the answer is simple. The Great Moderation ended because of a 'Great Deviation,' in which economic policy deviated from what was working well during the Great Moderation. Compared with the Great Moderation, policy became more interventionist, less rules-based, and less predictable. When policy deviated from what was working well, economic performance deteriorated. And lo and behold, we had the Great Recession. (Taylor 2007: 166) There is some merit in Taylor's argument certainly the low rates in that period encouraged the growth of Ponzi behavior in the finance sector. But his neocla.s.sical a.n.a.lysis ignores the dynamics of private debt, which, as I show in Chapters 12 and 13, explain both the 'Great Moderation' and the 'Great Recession.' Taylor's Rule was more of a statistical coincidence in this period than a reason for the stability prior to the recession.

The Rule also evidently gave Taylor no inkling that a crisis was imminent, since as late as 10 September 2007, he concluded a speech on his Rule with the following statement: Of course, we live in a fluid economic world, and we do not know how long these explanations or predictions will last. I have no doubt that in the future and maybe the not so distant future a bright economist maybe one right in this room will show that some of the explanations discussed here are misleading, or simply wrong. But in the meantime, this is really a lot of fun. (Ibid.: 15; emphasis added)

The economic crash of the Great Recession was accompanied by the crash of both the stock market and the housing market, and predictably the neocla.s.sical theory of finance known as the Efficient Markets Hypothesis also argued that a.s.set market crashes couldn't happen. In the next chapter, we'll take a diversion to the world of a.s.set markets before returning to the key empirical fact that neocla.s.sical economists were the last people on the planet to see the Great Recession coming.

Postscript: intellectual miasma or corporate corruption?

The extent to which economic theory ignored crucial issues like the distribution of wealth and the role of power in society leads many to extend a conspiracy theory explanation of how economics got into this state. Surely, they argue, economic theory says what the wealthy want to hear?

I instead lay the focus upon the teleological vision to which economists have been committed ever since Adam Smith first coined the phrase 'an invisible hand' as an a.n.a.logy to the workings of a market economy. The vision of a world so perfectly coordinated that no superior power is needed to direct it, and no individual power sufficient to corrupt it, has seduced the minds of many young students of economics. I should know, because I was one; had the Internet been around when I was a student, someone somewhere would have posted an essay I wrote while in my first year as an undergraduate, calling for the abolition of both unions and monopolies. No corporation paid me a cent to write that paper (though now, if it could be found, I would happily pay a corporation to hide it!).

What enabled me to break away from that delusional a.n.a.lysis was what Australians call 'a good bulls.h.i.t detector.' At a certain point, the fact that the a.s.sumptions needed to sustain the vision of the Invisible Hand were simply absurd led me to break away, and to become the critic I am today.

However, the corporate largesse interpretation of why neocla.s.sical economics has prospered does come into play in explaining why neocla.s.sical economics became so dominant. Many of the leading lights of US academic economics have lived in the revolving door between academia, government and big business, and in particular big finance. The fact that their theories, while effectively orthogonal to the real world, nonetheless provided a smokescreen behind which an unprecedented concentration of wealth and economic power took place, make these theories useful to wealthy financiers, even though they are useless and in fact outright harmful to capitalism itself.

The fact that both government and corporate funding has helped the development of these theories, while non-orthodox economists like me have had to labor without research grants to a.s.sist them, is one reason why the nonsense that is neocla.s.sical economics is so well developed, while its potential rivals are so grossly underdeveloped.

The corporate dollar may also have played a role in enabling neocla.s.sical economists to continue believing arrant nonsense as they developed their theories. So while I don't explain neocla.s.sical theory on the basis of it serving the interests of the elite, the fact that it does even though it is counterproductive for the economy itself and that the corporate and particularly financial elite fund those who develop it surely has played a role.

On this note, the website LittleSis (http://littlesis.org/) is well worth consulting. It doc.u.ments the links between business and government figures in the USA, and leading neocla.s.sical economists like Larry Summers feature prominently (see http://blog.littlesis.org/2011/01/10/evidence-of-an-american-plutocracy-the-larry-summers-story/).

11 | THE PRICE IS NOT RIGHT.

Why finance markets can get the price of a.s.sets so badly wrong.

In the first edition of this book, this chapter began with the following paragraphs: The Internet stock market boom was1 the biggest speculative bubble in world history.

Other manias have involved more ridiculously overvalued a.s.sets, or more preposterous objects of speculation such as the tulip craze in 17th century Holland, the South Sea Bubble and Mississippi Bubble of the 18th century, or j.a.pan's 1980s Bubble Economy speculation over Tokyo real estate. But no other bubble not even the 'Roaring Twenties' boom prior to the Great Depression has involved so many people, speculating so much money, in so short a time, to such ridiculous valuations.

But of course, an economist wouldn't tell you that. Instead, economists have a.s.sured the world that the stock market's valuations reflect the true future prospects of companies. The most famous and fatuous such a.s.surance is given in Dow 36,000, which its authors were defending even when the Dow had officially entered a correction from its all-time high of March 2000, and the Nasdaq was firmly in bear market territory (Time, 22 May 2000: 9293). The mammoth valuations, argued Ha.s.sett and Gla.s.sman, were simply the product of investors rea.s.sessing the risk premiums attached to stocks, having realized that over the long term, stocks were no riskier than bonds.

Economists were similarly rea.s.suring back in 1929, with the most famous such utterance being Irving Fisher's comment that: Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months. (Irving Fisher, New York Times, 15 October 1929) This was published less than two weeks before 'Black Monday,' 28 October 1929, when the Dow Jones Industrial Average closed 12.8% below its previous level, and fell another 11.7% the following day. In just 15 days of wild gyrations from the day of Fisher's comments, the market fell over 120 points (from a level of about 350): twice as far as even Fisher's bearish rival Babson had predicted, and twice as much as Fisher had believed would ever be possible. Three years later, the stock market indices had fallen 90%, and many a once-rich speculator was bankrupt. Investors who trusted economists back then lost their shirts. Trusting souls who accept economic a.s.surances that markets are efficient are unlikely to fare any better this time when the Bull gives way to the Bear.

At the time, I thought that the DotCom Bubble would be the last of the big a.s.set bubbles. I couldn't envisage then that any other a.s.set market could ever be more overvalued. I couldn't imagine that any more preposterous object of speculation could emerge than the plethora of 'DotCom' companies with negative cash flows and over-the-top valuations that lit up the Super Bowl in 2000, and had burnt their investors' money into oblivion months later.

Silly me: I had obviously underestimated the inventiveness of Wall Street. Even as the Nasdaq crashed and burnt, Wall Street had found an even more ridiculous way to entice the public into debt: the fantasy that money could be made by lending money to people with a history of not repaying debt. The Subprime Bubble was born. By the time it burst, the academic sub-discipline of Finance was finally starting to concede that its model of how a.s.set markets operate was seriously wrong. But by then, it was too late.

The kernel 'There's glory for you!'

'I don't know what you mean by "glory,"' Alice said.

Humpty Dumpty smiled contemptuously. 'Of course you don't till I tell you. I meant "there's a nice knock-down argument for you!"'

'But "glory" doesn't mean "a nice knock-down argument,"' Alice objected.

'When I use a word,' Humpty Dumpty said in rather a scornful tone, 'it means just what I choose it to mean neither more nor less.'

All sciences invent their own language, just as Lewis Carroll's famous egghead invented his own meanings for words. Many sciences harness words which are in are common usage, but give them a quite different technical meaning. But no other science plays so fast and loose with the English language as economics.

Physics, for example, calls the fundamental const.i.tuents of matter 'strings.' This isn't particularly confusing, since it's obvious that physicists don't believe that a length of yarn is the basic unit of matter.

However, when economists call stock markets 'efficient,' the usage is nowhere near as clear cut. A colloquial meaning of efficient is 'does things quickly with a minimum of waste,' and it's clear that this meaning can apply to modern, computerized, Internet-accessible bourses. Thus it often seems reasonable to the public that economists describe finance markets as 'efficient.'

However, when economists say that the stock market is efficient, they mean that they believe that stock markets accurately price stocks on the basis of their unknown future earnings. That meaning shifts 'efficient' from something which is obvious to something which is a debatable proposition. But that's not the end of the story, because to 'prove' that markets are efficient in this sense, economists make three bizarre a.s.sumptions: that all investors have identical expectations about the future prospects of all companies; that these identical expectations are correct; and that all investors have equal access to unlimited credit.

Clearly, the only way these a.s.sumptions could hold would be if each and every stock market investor were G.o.d. Since in reality the stock market is inhabited by mere mortals, there is no way that the stock market can be efficient in the way that economists define the term. Yet economists a.s.sert that stock markets are 'efficient,' and dismiss criticism of these a.s.sumptions with the proposition that you can't judge a theory by its a.s.sumptions. As Chapter 7 showed, this defense is bunk.

In a way, it's fitting that Lewis Carroll put those words in Humpty Dumpty's mouth, rather than equally appropriate vessels such as the Mad Hatter, or the Red Queen. Humpty Dumpty, after all, had a great fall ...

The roadmap The chapter begins by considering the development over time of the prevailing att.i.tude to finance, starting with the medieval prohibition against the lending of money at interest, and culminating in economists treating the lending of money as no different from any other commodity exchange. The main economist responsible for the economic theory of lending was Irving Fisher, who, as just mentioned, effectively went bankrupt during the depression by following his own theories. However, he subsequently developed a quite different theory, which argued that excessive debt and falling prices could cause depressions. After outlining this theory, I consider the modern theory of finance known as the 'efficient markets hypothesis.' The validity of the a.s.sumptions needed to b.u.t.tress this theory is a.s.sessed in the light of the logic outlined in Chapter 7. Since these are domain a.s.sumptions, the theory is inapplicable in the real world, so that markets cannot possibly be 'efficient' as economists define the term.

Fisher on finance: from rea.s.suring oracle to ignored Ca.s.sandra Irving Fisher was one of the many victims of the Great Crash of 1929, losing a fortune worth over $100 million in today's dollars, and being reduced to penury.2 But his greater loss, in many ways, was one of prestige. Before this infamous utterance, he was easily America's most respected and famous economist, renowned for developing a theory of money that explained the valuation of financial a.s.sets. After it, he was a pariah.

This was a great pity, because in the depths of the Great Depression, he developed an explanation of how financial speculation could lead to economic collapse. However, this new theory which rejected many of the a.s.sumptions of his previous model of finance was ignored. Instead, Fisher's pre-Great Depression theory of finance continued as the economic theory of how a.s.set prices are determined.

Decades later, Fisher's 'Debt Deflation Theory of Great Depressions' was rediscovered by the non-orthodox economist Hyman Minsky, while at much the same time Fisher's pre-Great Depression theory was formalized into the efficient markets hypothesis. Fisher thus has the dubious distinction of fathering both the conventional theory of finance which, like his 1929 self, rea.s.sures finance markets that they are rational and an unconventional theory which argues that speculative bubbles can cause economic depressions.

Pre-Depression Fisher: the time value of money In 1930 Fisher published The Theory of Interest, which a.s.serted that the interest rate 'expresses a price in the exchange between present and future goods' (Fisher 1930).3 This argument was a simple extension of the economic theory of prices to the puzzle of how interest rates are set, but it has an even older genealogy: it was first argued by Jeremy Bentham, the true father of modern neocla.s.sical economics, when in 1787 he wrote 'In defence of usury.'

Never a lender nor a borrower be ... Today, usury means lending money at an exorbitant rate of interest; in antiquity, it meant lending money at any rate of interest at all. However, the medieval objection was not to the rate of interest itself, but to the lender's desire to profit from a venture without sharing in its risks. A usurious contract was one in which the lender was guaranteed a positive return, regardless of whether the borrower's venture succeeded or failed: 'The primary test for usury was whether or not the lender had contracted to lend at interest without a.s.suming a share of the risk inherent to the transaction. If the lender could collect interest regardless of the debtor's fortunes he was a usurer' (Jones 1989).

As trade came to play a larger role in society, the prohibitions against usury were weakened, and the legal definition was modified to match today's colloquial meaning.4 By Bentham's time, the legal definition referred to a rate of interest greater than 5 percent.

Adam Smith supported this legal limit. Smith argued that the complete prohibition, 'like all others of the same kind, is said to have produced no effect, and probably rather increased than diminished the evil of usury' (Smith 1838 [1776]). However, Smith supported the concept of a legal limit to the rate of interest set just above the going market rate,5 because such a limit actually improved the allocation of the country's credit. The advantage of a legal limit, according to Smith, was that when set properly it excluded only loans to 'prodigals and projectors,' thus making more of the country's capital available for loan to industrious people: The legal rate [...] ought not to be much above the lowest market rate. If the legal rate of interest in Great Britain, for example, was fixed so high as eight or ten per cent, the greater part of the money which was to be lent would be lent to prodigals and projectors, who alone would be willing to give this high interest [...] A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it. Where the legal rate of interest, on the contrary, is fixed but a very little above the lowest market rate, sober people are universally preferred, as borrowers, to prodigals and projectors. The person who lends money gets nearly as much interest from the former as he dares to take from the latter, and his money is much safer in the hands of the one set of people than in those of the other. A great part of the capital of the country is thus thrown into the hands in which it is most likely to be employed with advantage. (Ibid.) In defence of usury Bentham's rejoinder to Smith's arguments may well have set the standard for fanciful and specious reasoning to which modern economics has since aspired.

Smith referred to two cla.s.ses of borrowers who could be expected to accede to rates of interest substantially above the lowest market rate: 'prodigals and projectors.' The former are individuals who would waste the money on conspicuous consumption; the latter are those who promote ill-conceived schemes to the public, which result in inappropriate investment. Smith's case in favor of a legal ceiling to the rate of interest thus had both a 'microeconomic' and a 'macroeconomic' aspect.

Macroeconomics was Smith's key concern: encouraging 'prodigals and projectors' would result in 'a great part of the capital of the country' being thrown into the hands of 'those which were most likely to waste and destroy it.' The ceiling, by removing the incentive to lend to such borrowers, would result in a higher overall quality of investment, and thus higher growth.

Bentham's riposte ignored macroeconomics. Instead, it began from the microeconomic and libertarian presumption that 'no man of ripe years and of sound mind, acting freely, and with his eyes open, ought to be hindered, with a view to his advantage, from making such bargain, in the way of obtaining money, as he thinks fit' (Bentham 1787).

He initially conceded that the restraint of prodigal behavior may give grounds for setting a ceiling to the rate of interest, only to then argue that in practice a prodigal would not be charged an exorbitant rate of interest. He began with the proposition that 'no man [...] ever thinks of borrowing money to spend, so long as he has ready money of his own, or effects which he can turn into ready money without loss.' Secondly, the exceptions to the above rule who have the requisite collateral can get a loan at the usual rate. Thirdly, those who do not have security will only be lent to by those who like them, and these friendly persons will naturally offer them the standard rate: 'Persons who either feel, or find reasons for pretending to feel, a friendship for the borrower, can not take of him more than the ordinary rate of interest: persons who have no such motive for lending him, will not lend him at all' (ibid.).

If Bentham were to be believed, the friendly bank manager of the 1950s had many a precursor in eighteenth-century Britain, while the rapacious Shylock perished with Shakespeare in the seventeenth.

A bit of empirical research would have revealed that, though rates of interest had fallen dramatically as finance became inst.i.tutionalized, there was no shortage of lenders willing to hand prodigals ready cash at high rates of interest, in return for ownership of their a.s.sets should they go bankrupt. But Bentham's more important sleight of mind was to ignore the macroeconomic argument that the legislative ceiling to the rate of interest improved the overall quality of investment by favoring 'sober people' over 'prodigals and projectors.'

The historical record favored Smith. The seventeenth, eighteenth and nineteenth centuries are awash with examples of projectors promoting fantastic schemes to a gullible public. The most famous have entered the folklore of society: the Tulip Mania, the South Sea Bubble, the Mississippi Land Scheme (Mackay 1841). What has not sunk in so deeply is that the financial panics that occurred when these bubbles burst frequently ruined whole countries.6 However, the tide of social change and the development of economic theory favored Bentham. The statutes setting maximum rates were eventually repealed, the concept of usury itself came to be regarded as one of those quaint preoccupations of a more religious age, and modern economics extended Bentham's concept that 'putting money out at interest, is exchanging present money for future' (Bentham 1787). Of course, the magnificent edifice economists built upon Bentham's morsel a.s.sumed that everything happened in equilibrium.

The time value of goods In keeping with the economic belief that the economy is fundamentally a barter system, in which money is merely a lubricant, Fisher restated Bentham's concept in terms of goods, rather than money: the rate of interest 'expresses a price in the exchange between present and future goods' (Fisher 1930).

Fisher's model had three components: the subjective preferences of different individuals between consuming more now by borrowing, or consuming more in the future by forgoing consumption now and lending instead; the objective possibilities for investment; and a market which reconciled the two.

From the subjective perspective, a lender of money is someone who, compared to the prevailing rate of interest, has a low time preference for present over future goods. Someone who would be willing to forgo $100 worth of consumption today in return for $103 worth of consumption next year has a rate of time preference of 3 percent. If the prevailing interest rate is in fact 6 percent, then by lending out $100 today, this person enables himself to consume $106 worth of commodities next year, and has clearly made a personal gain. This person will therefore be a lender when the interest rate is 6 percent.

Conversely, a borrower is someone who has a high time preference for present goods over future goods. Someone who would require $110 next year in order to be tempted to forgo consuming $100 today would decide that, at a rate of interest of 6 percent, it was worth his while to borrow. That way, he can finance $100 worth of consumption today, at a cost of only $106 worth of consumption next year. This person will be a borrower at an interest rate of 6 percent.

The act of borrowing is thus a means by which those with a high preference for present goods acquire the funds they need now, at the expense of some of their later income.

Individual preferences themselves depend in part upon the income flow that an individual antic.i.p.ates, so that a wealthy individual, or someone who expects income to fall in the future, is likely to be a lender, whereas a poor individual, or one who expects income to rise in the future, is likely to be a borrower.

At a very low rate of interest, even people who have a very low time preference are unlikely to lend money, since the return from lending would be below their rate of time preference. At a very high rate of interest, even those who have a high time preference are likely to be lenders instead, since the high rate of interest would exceed their rate of time preference. This relationship between the rate of interest and the supply of funds gives us an upward-sloping supply curve for money.

The objective perspective reflects the possibilities for profitable investment. At a high rate of interest, only a small number of investment projects will be expected to turn a profit, and therefore investment will be low. At a low rate of interest, almost all projects are likely to turn a profit over financing costs, so the demand for money will be very high. This relationship between the interest rate and the demand for money gives us a downward-sloping demand curve for money.

The market mechanism brings these two forces into harmony by yielding the equilibrium rate of interest.

11.1 Supply and demand in the market for money Economics, it appears, is back in familiar territory. But there are some special, time-based nuances to the credit market. In the goods market, transactions occur immediately: one bundle of goods today is exchanged for another bundle of goods today. However, in the credit market, the 'purchaser' (the company offering an investment opportunity) takes immediate delivery of the loan, but repays princ.i.p.al and interest in installments over time. Ancillary a.s.sumptions were therefore required to stretch the standard static vision of the market to the time-based creature that credit really is. These additional a.s.sumptions, in Fisher's words, were: '(A) The market must be cleared and cleared with respect to every interval of time. (B) The debts must be paid' (ibid.).

Fisher saw nothing wrong with these ancillary a.s.sumptions, until he and countless others personally violated them during the Great Depression.

Fisher during the Crash: 'don't panic'

To his credit, Fisher's response to the Great Depression was worthy of Keynes's apocryphal statement that 'when the facts prove me wrong, I change my mind.' But at first Fisher clung to his pre-Crash optimism that the American economy was fundamentally sound, that a wave of invention had introduced a new era of higher productivity, that the new medium of radio would revolutionize business. It all sounds so familiar today ...

A new era ... Fisher's comments to a bankers' forum on 'Black Wednesday' 23 October, when stocks fell by an unprecedented 6.3 percent in one day confirm the old adage that 'the more things change, the more they remain the same.' Every factor that Fisher then thought justified the stock market's bull run has its counterpart today: it was 'a new era,' a wave of invention (read 'the Internet') justified high valuations, stable prices reduced the uncertainty of share ownership, stocks were better long-term investments than bonds, investment trusts (read 'mutual funds') enabled much more intelligent stock selection, a debt-financed consumer boom was natural when a great increase in income was rationally antic.i.p.ated.

Fisher first recounted the ways in which the 1929 stock market boom was remarkable. Shares had doubled in value since 1926, and any investor who had 'followed the herd' and bought and sold shares simply on the basis of their popularity would have increased his wealth tenfold in those three years. Stock prices had risen so much that dividend yields were below bond yields. Brokers' loans effectively margin call lending were at their highest level in history. All these observations supported the notion that the market 'seems too high and to warrant a major bear movement' (Fisher 1929).

However, he then gave four reasons why the 1929 valuations were sensible: changed expectations of future earnings, reinvestment of dividends, a change in risk premiums, and a change in the way in which future income is discounted.

He supported the first argument with the statement that We are now applying science and invention to industry as we never applied it before. We are living in a new era, and it is of the utmost importance for every businessman and every banker to understand this new era and its implications [...] All the resources of modern scientific chemistry, metallurgy, electricity, are being utilized for what? To make big incomes for the people of the United States in the future, to add to the dividends of corporations which are handling these new inventions, and necessarily, therefore, to raise the prices of stocks which represent shares in these new inventions. (Ibid.; emphasis added) This wave of invention, with its return in years yet to come, meant that it was quite natural for the ratio of share price to historic earnings to rise. In fact, these new firms should be expected to make losses as they established their new inventions: 'In the airline industry very little attention is paid to the earnings today, because the price of the stock is purely a speculation on the far bigger returns that are expected in the future. Any new invention [...] at first does not give any profit [...]' (ibid.).

Low inflation also played a role in high stock valuations, since a stable price level gives 'an immense impulse towards prosperity' (ibid.).

The second factor, the reinvestment of dividends, was a positive force since firms that did this rather than handing dividends back to investors were able to grow more rapidly. Hence 'many of the stocks which sell the highest on the stock exchange and which have had the most spectacular rise are not paying any dividends' (ibid.).

The third reason, a change in the way the public estimates risk, occurred because Edgar Smith's influential book Common Stocks as Long Term Investments had shown that over the longer term stocks outperformed bonds. As a result, '[t]here has been almost a stampede towards stocks, and away from bonds' (ibid.; in the late 1990s, Ha.s.sett and Gla.s.sman's Dow 36,000 and its ilk spread the same delusion).

This movement had led to the establishment of the new profession of investment counseling, and then the new inst.i.tution of investment trusts, which 'can afford to make studies of stocks which the individual investor could not study' (ibid.). As well as diversifying and spreading risk, these inst.i.tutions enabled stocks to be scientifically selected. This explained why 'our stock market is highly selective today,' and as a result Fisher wasn't troubled by the fact that: 'Half of the stocks during the last year have fallen in spite of the fact that the average as shown by the index numbers had risen. The leaders are becoming fewer and fewer, and those stocks that are leading have a greater and greater scarcity value' (ibid.).

Fisher conceded that rank speculation played some role in the market, but he blamed this 'lunatic fringe' more for the crash in stock prices than for its run-up over the preceding four years: 'There is a certain lunatic fringe in the stock market, and there always will be whenever there is any successful bear movement going on [...] they will put the stocks up above what they should be and, when frightened, [...] will immediately want to sell out' (ibid.).

This speculative fringe ranked fifteenth out of Fisher's fifteen determinants of the level of stock prices, though he was not so confident of his ranking after the market's 6 percent fall on Black Wednesday. Nonetheless, he still argued that 'the other fourteen causes are far more important than this one cause itself.' He acknowledged that most speculation took place with borrowed money a theme that would later become his bete noire. But he argued that most of this money had been borrowed to finance consumption today rather than just rank speculation because consumers were simply cashing in on rationally antic.i.p.ated future increases in income: To a certain extent it is normal that during an era such as we are now pa.s.sing through, where the income of the people of the United States is bound to increase faster perhaps than ever before in its history, and it has during the last few years increased amazingly, that we should try to cash in on future income in advance of its occurring, exactly on the principle that when a young man knows he has been given unexpectedly a large bequest, and that it will be in his hands inside a year, he will borrow against it in advance. In other words, there ought to be a big demand for loans at a high rate of interest during a period of great increase in income. (Ibid.) He concluded with an expectation that the market's 12 percent fall in the preceding eight days was an aberration: Great prosperity at present and greater prosperity in view in the future [...] rather than speculation [...] explain the high stock markets, and when it is finally rid of the lunatic fringe, the stock market will never go back to 50 per cent of its present level [...] We shall not see very much further, if any, recession in the stock market, but rather [...] a resumption of the bull market, not as rapidly as it has been in the past, but still a bull rather than a bear movement. (Ibid.) Fisher after the Crash: the debt-deflation hypothesis Fisher was, of course, profoundly wrong, and at great personal cost to himself. The market receded 90 percent from its peak, and the index did not regain its 1929 level for a quarter of a century.7 As the Crash persisted, the slump deepened into the Great Depression, with, at its nadir, over 25 percent of America's workers unemployed. Fisher's personal fortune evaporated, and his perspective on the American financial system shifted from one of confidence to one of alarm.

He eventually developed a radically different a.n.a.lysis of finance, one in which his ancillary a.s.sumptions in The Theory of Interest that 'the market must be cleared, and cleared with respect to every interval of time' and that 'The debts must be paid' were systematically violated. Now he acknowledged that the market was never in equilibrium, and that debts could fail to be repaid, not just individually but en ma.s.se. Static reasoning gave way to an a.n.a.lysis of the dynamic forces which could have caused the Great Depression.

Whereas he had previously a.s.sumed that the economy was always in equilibrium, now he appreciated that even if the real economy actually momentarily reached equilibrium, this state would be short lived since 'new disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium' (Fisher 1933).

Equilibrium was also likely to be precarious. Whereas beforehand he had simply taken it for granted that equilibrium was stable, now he realized that equilibrium, 'though stable, is so delicately poised that, after departure from it beyond certain limits, instability ensues.' A slight movement away from equilibrium could set in train forces that would drive the economy even farther away, rather than returning it to balance.

While any of a mult.i.tude of factors could, according to Fisher, push the system away from equilibrium, the crucial ingredient needed to turn this limited instability into a catastrophic collapse was an excessive level of debt, where 'the breaking of many debtors const.i.tutes a "crash," after which there is no coming back to the original equilibrium.'

He ventured the opinion that the 'two dominant factors' that cause depressions are 'over-indebtedness to start with and deflation following soon after.' Though other factors are important, debt the entry into a contractual obligation to repay princ.i.p.al with interest and a falling price level are crucial: Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt. (Ibid.) The final sentence in this quote is rather poignant, since Fisher himself was a cla.s.sic instance of someone whom overconfidence had beguiled into debt.8 Overconfidence leads investors to overestimate the prospective gain from investment, or to underestimate the risks, and thus commit themselves to an unsustainable level of debt. In either case, the investor commits funds well beyond the level which returns an optimum gain. Such overconfidence is an inevitability in the real world because, as noted above, all real-world variables are bound to be either above or below their ideal equilibrium values.

A chain reaction then ensues that can tip the economy into depression. It begins with distress selling, at severely reduced prices, driven by the need to cover debt repayments. Falling prices means that the real burden of debt actually rises, even as nominal debt is reduced, and the repayment of debts also reduces the money supply. These effects cause further bankruptcies, reducing profits, investment, output and employment. Pessimism rises, causing those with money to h.o.a.rd it, which further reduces business activity. The falling price level also has the perverse effect that the real rate of interest rises even though nominal rates have fallen, and this drastically reduces investment.

Fisher's theory was thus an alternative explanation of the Great Depression to both Keynes's rejection of Say's Law and Hicks's 'liquidity trap' (discussed in Chapter 9). But though the chain reaction argument is plausible, Fisher provided no formal proof for it in contrast to his previous emphasis upon formal mathematical reasoning. Partly for this reason, his thesis was received poorly by the economics profession, and his insights were swamped by the rapid adoption of Hicks's IS-LM a.n.a.lysis after the publication of Keynes's General Theory.9 After the Great Depression, economists continued to cite his pre-Crash work on finance, while his debt-deflation theory was largely ignored.10 As a result, the antipathy he saw between the formal concept of equilibrium and the actual performance of a.s.set markets was also ignored. Equilibrium once again became the defining feature of the economic a.n.a.lysis of finance. This process reached its zenith with the development of what is known as the 'efficient markets hypothesis.'