Changing policy thinking

Markets must be embedded in sound regulatory institutional structures; public spending must be underpinned.

There comes a time when tinkering with policy will simply not do. The problems become so grave and intractable that a change is required in the very framework of policy thinking. In Pakistan and indeed the world, we are at such a moment. It may, therefore, be instructive to see how a change occurs in the mode of thought in economics.

It can be argued that John Maynard Keynes brought about a revolution in the science of economics in the 1930s, by changing the prevalent ‘classical’ paradigm. The classicists postulated that unfettered markets constituted the most efficient framework for resource allocation. It followed that governments should not intervene in markets. This view got into trouble during the 1930s, when massive unemployment hit the free-market economy. Within the classical model, all you had to do to remove unemployment was to let wages fall, and more workers would be employed. Yet unemployment continued to rise even though wages were falling.

Along came Keynes, a Cambridge economist, who changed the paradigm in a situation where the old one had failed. He argued that employment was not determined in the labour market, but was the result of capitalists’ decision to invest. If aggregate demand at present is low and therefore, capitalists do not expect to make profits in future, they would refrain from investment, thereby resulting in underutilised production capacity and hence, unemployment. The Keynesian paradigm created the space for government intervention: If the private sector investment was inadequate, then the government must step in to fill the gap in the level of investment required to achieve full employment. The governments in Europe and the US accepted this new thinking, undertook major public expenditure programmes, and the world pulled out of the “Great Depression’’.

In the next 50 years, belief in the efficacy of free markets re-emerged under the rubric of neoclassical economics. It began to dominate thinking in many governments as well as multilateral organisations. In the context of neoclassical economics it was, of course, anathema to regulate markets. This view continued to hold sway even though a structural shift occurred in the world economy: the financial sphere, from being a relatively minor stratum, by the late 20^th century became bigger than the real economy. The fragility occurred because of two reasons: a) in the financial sphere, there was a greater possibility of banks and individuals taking speculative risks and b) unbeknown to the individual investor was the fact that individual risks were interlinked at the macroeconomic level. Because of the inherent difficulty of estimating systemic risk, banks, in failing to take it into account, were actually taking much bigger risks than they imagined.

Instead of regulating the financial sphere in the face of this new fragility, the financial markets were further deregulated. For example, the Glass-Steagall Act of 1933 in the US, which had forbidden retail banks to engage in imprudent investments such as selling securities, was repealed in 1999. In an unregulated market environment and spiralling risks, the financial edifice began to collapse. The drama began on September 18, 2007 at 11:00 am when there was a run on banks as $550 billion were withdrawn from US banks in one hour. Robert Skidelsky has quoted the Chairman of the US Congress Subcommittee on Capital Markets. If the US Treasury had not stopped banking operations along with a guarantee of $250,000 per account to restore confidence by 2:00 pm, it “… would have collapsed the entire economy of the US and within 24 hours the world economy would have collapsed ...”

There are three key lessons of the present economic crisis: First, to prevent recurrent and disastrous market failures, markets must be embedded in sound regulatory institutional structures. Second, public spending, to be sustainable, must be underpinned by institutions for increasing the efficiency of this expenditure. Third, it is not the budget deficit per se that is the problem, but the composition of the deficit: it is necessary to increase the share of productive expenditure and reduce the share of unproductive expenditure in fiscal allocations.

Published in The Express Tribune, September 17^th, 2012.