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Hubris: Why Economists Failed to Predict the Crisis and How to Avoid the Next One
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Overview
A frank assessment of economists’ blindness before the financial crash in 2007–2008 and what must be done to avert a sequel The failure of economists to anticipate the global financial crisis and mitigate the impact of the ensuing recession has spurred a public outcry. Economists are under fire, but questions concerning exactly how to redeem the discipline remain unanswered. In this provocative book, renowned economist Meghnad Desai investigates the evolution of economics and maps its trajectory against the occurrence of major political events to provide a definitive answer. Desai underscores the contribution of hubris to economists’ calamitous lack of foresight, and he makes a persuasive case for the profession to re-engage with the history of economic thought. He dismisses the notion that one over-arching paradigm can resolve all economic eventualities while urging that an array of already-available theories and approaches be considered anew for the insights they may provide toward preventing future economic catastrophes. With an accessible style and keen common sense, Desai offers a fresh perspective on some of the most important economic issues of our time.
Product Details
| ISBN-13: | 9780300213546 |
|---|---|
| Publisher: | Yale University Press |
| Publication date: | 05/26/2015 |
| Pages: | 304 |
| Product dimensions: | 5.60(w) x 8.60(h) x 1.20(d) |
About the Author
Read an Excerpt
Hubris
Why Economists Failed to Predict the Crisis and How to Avoid the Next One
By Meghnad Desai
Yale UNIVERSITY PRESS
Copyright © 2015 Meghnad DesaiAll rights reserved.
ISBN: 978-0-300-21607-3
CHAPTER 1
THE BUILDING BLOCKS
Economics was born in a whirlwind of change. For centuries while the Roman Empire declined, Western Europe was caught in a stagnant feudal world with an unchanging cycle of poverty, misery, superstition and oppression. Year in and year out, life remained the same as if going around in a circular trap – same prices, same goods, same jobs, same short lives. The modern era which began with Christopher Columbus finding the Americas and Vasco Da Gama the Indies changed the economies of Western Europe. Spanish conquistadores brought large hoards of gold and silver from the New World. Between 1500 and 1700, 300 tons of gold and 33,000 tons of silver were extracted from South America by Spain and Portugal. The money did not stay in Spain but spilled over into the rest of Western Europe through trade and sometimes piracy on the high seas. Europe's stock of precious metals, which in 1492 was estimated at 35 million pounds sterling, went up to 87 million pounds sterling by 1599.
Prices rose rapidly. Across Western Europe between 1492 and 1589, they rose by between 400 percent and 700 percent depending on the particular country you look at. Wages rose faster than prices. Soon Spanish traders encountered difficulties in selling their goods abroad but found they could import from anywhere in the world. (This was later to be called the Dutch Disease where a national currency appreciates so much that exports are expensive for your customers abroad but imports from abroad are cheap for your citizens.) The gold that flowed out of Spain and into France, England and Holland to purchase goods for the Spaniards caused a boom in those countries and with it higher employment and higher prices. But Europe was not where the money rested; it flowed out abroad. In trade with India and Southeast Asia and the Middle East, Europe bought the silks and spices and other luxury goods but had to pay with gold because Europe had no commodities which the Easterners wanted. People felt bewildered. They wondered if the stability of their previous lives was lost. What was constant and what had changed? Were there stable "values" underneath the fast-changing prices? Was money, with its swift arrival and even quicker departure, like women who seduced by their charms and then vanished?
The Iberian loot of South America caused a "century of inflation" between the mid-sixteenth and mid-seventeenth centuries in Western Europe. Economics was no longer a study of household management as originally conceived by the Greeks, who coined the term. It now had to deal with the fortunes of nations and people, of movements of precious metals and the influence they had on prices and wages and incomes at home and abroad. How did money determine prices, the level of exports and imports, wages and employment?
The importance of gold and silver within the country as an indicator of wealth was recognized. Public policy was redirected to exporting goods to obtain gold but economizing on imports to prevent gold from being lost. Gold and silver equaled wealth. Wars and territorial conquests were seen as an alternative but expensive means of acquiring gold, as the Spaniards had proved. But the questions raised by the influx of treasures became increasingly urgent. Was gold an accurate representation of the wealth of a country, and why did the influx of gold and silver cause prices to rise? The answers came from two intellectual titans of the time.
John Locke (1632–1704) was born in a Puritan family and grew up while England was going through the Civil War. It was a conflict rooted in differences of religious beliefs between Catholics and Protestants but perpetuated by disagreement on how the kingdom should be governed. Locke's most celebrated book was written in this spirit and led him to be exiled to Holland. Two Treatises on Government questioned the theory of the divine right of kings and affirmed the rights of subjects to remove their king if his conduct did not meet with their approval. When the English aristocracy rose against James II and invited William of Orange (from Holland) and his wife, Mary, to take over the throne of England, Locke's influence was very much behind the move. Locke's argument about the right of subjects to revolt was invoked a century later by the American colonies when they rose in revolt against the British.
Once back in England with the new king and queen, Locke's power grew. He organized the Board of Trade to further foreign trade and became its Commissioner from 1695 to 1700. In those days, usury laws prevailed and Parliament would set the rate of interest. Parliament proposed to lower the rate from 6 percent to 4 percent. Locke argued that the interest rate being the price at which money was hired, it would be regulated by the demand for and the supply of money. All prices were determined by demand and supply and could not be dictated by the state. Locke was thus a pioneer in defining equilibrium (a word which he used) as being determined "naturally" by individual activity in the market.
He also pioneered a theory of inflation. He argued that money had value because it enabled people to buy goods and services. Its value would be inversely related to its quantity in circulation. The idea that blood circulated through the human body had recently been proved by William Harvey, who, like Locke, was a doctor. The notion that money also circulates was a natural extension. The more money there was in circulation the less its value would be. In other words too much money relative to goods available would cause inflation. How and why this happened would take centuries to figure out but for many ordinary people the idea that too much money relative to goods resulted in rising prices – inflation – became the only bit of economics they intuitively understood.
Locke's arguments were refined by David Hume (1711–76). Hume was a multifaceted genius. He was a philosopher, a historian and an economist. Religion had been a big issue in the seventeenth century. Now skepticism about the beliefs of earlier ages was spreading. Hume was a rationalist. His book A Treatise on Human Nature, written when he was 26, is acclaimed as a classic work. He traveled extensively to the continent, where he befriended Jean-Jacques Rousseau among others. He was the first major philosopher who also wrote extensively on economic issues of trade, money and exchange. Hume developed Locke's argument further. He showed that the influx of precious metals was a double-edged sword which had the initial effect of increasing economic activity by creating jobs, encouraging manufactures and increasing trade. But eventually, if money kept flooding in from outside (as was the case with Spain in the previous two centuries), there would be limits to how far economic activity could expand in the short term, and this constraint would result in inflation. As to the question of what constituted wealth, the answer was to come from a fellow Scotsman and friend – Adam Smith.
Determining the Wealth of Nations
Adam Smith, a lifelong bachelor who lived with his mother and sister all his adult life, was a friend of David Hume. Smith was elected a Professor of Moral Philosophy at Glasgow, and later gave up the post to become a tutor to the Duke of Buccleuch, which allowed him to travel all over Europe meeting the famous philosophers of his day. Smith revolutionized the way we conduct our lives and governments their policies. In the eighteenth century, kings still sought to increase their wealth through invasion and plunder – Britain was even then in the middle of its long century of war with France, which lasted, on and off, from 1695 to 1815. In his celebrated book An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, Adam Smith pointed out that it was the productivity of its workers which was the key to the prosperity of a nation and not the treasures of gold and silver it had accumulated. The productivity of the workers could be enhanced with tools and machines. The capital – the money to buy the tools and machinery as well as to pay the wages – was accumulated out of the profits that the providers of capital made by employing the workers. Workers who were employed by capital made goods with a value above what they were paid, that is, their output generated a profit above their wage. They were productive workers. Workers employed as servants by their master for daily help generated no surplus above their wage and hence were unproductive workers. Employing productive workers was an investment, while hiring workers as domestic servants was consumption. A nation had to divert its wealth from employing unproductive workers to employing productive ones. That was the way of increasing its wealth. The most productive workers were those who specialized in an activity who were part of a division of labor.
When shopping for groceries, we rarely contemplate how the goods that we are purchasing were produced. But if we were to take a loaf of bread, for example, its arrival at the store would have involved the cooperation of the farmer, the miller, the baker and the truck driver. Each of the links in this chain has its own connections, with the farmer, for example, relying on the suppliers of water, fertilizers, equipment, labor and veterinary assistance, to name just a few. This Smith termed the division of labor, whereby people specialize within a factory and across industries to be more productive. All this cooperation is done not so much by diktat from above or due to the kindness of the many people who brought the bread to you; it is because they all stand to make a living out of supplying the bread to you.
Of course, in the olden days there were self-sufficient households and even self-sufficient villages which conducted only limited trade with the outside world. But as the scope of the market expanded – thanks to roads and ease of transport – the division of labor became more extensive and now no household or village or even nation remains self-sufficient. This is a mark of prosperity despite the persistence of the appeal of the self-sufficiency model for nationalists.
The complex voluntary cooperation which exists beneath the surface of our daily economic life was called the invisible hand by Adam Smith. It is the interdependence of people far-flung and unknown to each other which is the most difficult thing to grasp about economics. It is wondrous that the myriad separate decisions made by millions of individuals about what to buy and what to sell, what to produce, which job to take and where to study ultimately hang together to ensure that when you go to the shops there are things to buy that you want, that there are jobs to go to for most of us and that the same will be the case tomorrow. It is as if, as Adam Smith said, an invisible hand is guiding us.
The invisible hand is not always benevolent. It may also work adversely. Why else would the bankruptcy of a New York firm, Lehman's, cause unemployment in Lancashire? Why would we debate the prospect of the eurozone or worry about Chinese growth causing petrol prices to rise? The complex interconnectedness threaded together by myriad independent decisions is central to an understanding of why economics is such a difficult and uncertain subject.
Each individual deciding to buy or postpone a purchase, or to take up a job or wait for a better one, acts on their own impulses and it is hoped uses their powers of reasoning as well. They are unpredictable individually. But collectively the decisions form a pattern. Think of what might happen if physical objects had a mind of their own and acted of their own volition. The apple that fell on Newton's head inspired the theory of gravity. But if an apple had its own volition, it might well have decided not to come down but to go back up to its perch. The subject matter of economics consists of individuals with volition. unlike the subjects of natural science. The economist's hope is that while individual agents may have their own reasons for behaving any way they like, as a group their behavior will show some regularity and predictability. Devices such as the invisible hand are ways of coping with this complexity so that we can grasp its working.
Adam Smith's other powerful idea was that in order to generate and guarantee prosperity, there should be minimal restrictions on people's choices. Governments should stick to providing law and order, guarantee secure property rights, create fair and broad-based taxes, spend prudently on matters such as education and infrastructure, and keep the budget in balance. Allowing people "to do their own thing," as we would put it today, would maximize prosperity. He called this the System of Natural Liberty.
In those days, the economy was riddled with monopolies granted by Royal Charter to companies such as the East India Company, which controlled all Eastern trade; rules of guilds as to who could enter a profession; and tolls and taxes on movement of goods across the country. Governments were interfering in every occupation and every kind of business, while being corrupt and inefficient at the same time. Much of the revenue received was spent on war, and when the revenue could not be collected the governments borrowed from the merchants and goldsmiths, or worse, clipped their coins to fool the people. In contemporary France, the tolls on movement of food grains were such that often famine in one part could not be relieved by bringing food from other parts. It was in response to one such incident that a group of businessmen in France told the King's Finance Minister, Colbert, "Laissez-nous passez; laissez-nous faire" [Let us pass; let us do things ourselves]. Adam Smith never used the expression laissez-faire but the idea of letting the economy be free of odious restrictions on the movement of goods and people caught on. Indeed, when the French Revolution broke out, many blamed it on the radical ideas of Adam Smith!
In his earlier book The Theory of Moral Sentiments (1759), Adam Smith had expressed a distrust of someone trying to regulate a society from above. "The man of system," he wrote,
seems to imagine that he can arrange the different members of a great society with as much ease as the hand that arranges the different pieces on a chess-board; he does not consider that the different pieces upon a chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own. Altogether different from that which the legislator might choose to impress upon it.
The "Principle of Motion"
Adam Smith and his Scottish contemporaries were part of the Scottish Enlightenment. They founded what we now consider to be the social sciences. They were deeply impressed by Isaac Newton's achievement in astronomy, delineating the principles upon which the planets moved in a systematic way unaided by any explicit agency. It was said that Newton had discovered God's system of how the heavens worked. Smith and his fellow Scotsmen wanted to discover the principles of social astronomy, as it were: what made societies function and evolve, grow or decay. Newton had based his work on the unifying principle of gravity. Was there such a unifying principle in human societies? Smith found the principle in self-interest. Not selfishness but self-interest. He was well aware of the role of benevolence and sympathy in social life, which he had discussed in The Theory of Moral Sentiments. There were restraints on the pursuit of self-interest by individuals in the laws of the land as well as social conventions. But the dynamic energy unleashed by millions of people pursuing self-interest was the key to the wealth of nations.
(Continues...)
Excerpted from Hubris by Meghnad Desai. Copyright © 2015 Meghnad Desai. Excerpted by permission of Yale UNIVERSITY PRESS.
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Table of Contents
List of Figures vi
Preface vii
Acknowledgements xii
Introduction: Unraveling the Threads 1
Part I
1 The Building Blocks 19
2 Cycles for the Curious 50
3 New Tools for a New Profession 77
Part II
4 Causing a Stir 115
5 Declining Fortunes 165
Part III
6 The New Globalization 205
7 The Search for an Answer 239
Notes 264
Bibliography 269
Index 273