Like what you've read?

On Line Opinion is the only Australian site where you get all sides of the story. We don't
charge, but we need your support. Here�s how you can help.

  • Advertise

    We have a monthly audience of 70,000 and advertising packages from $200 a month.

  • Volunteer

    We always need commissioning editors and sub-editors.

  • Contribute

    Got something to say? Submit an essay.


 The National Forum   Donate   Your Account   On Line Opinion   Forum   Blogs   Polling   About   
On Line Opinion logo ON LINE OPINION - Australia's e-journal of social and political debate

Subscribe!
Subscribe





On Line Opinion is a not-for-profit publication and relies on the generosity of its sponsors, editors and contributors. If you would like to help, contact us.
___________

Syndicate
RSS/XML


RSS 2.0

Europe and economic philosophy : a necessary debate

By Ben Rees - posted Thursday, 21 June 2012


"Ideas, knowledge, science, hospitality, travel- these are things which should by their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible, and, above all, let finance be primarily national": J.M. Keynes,Dublin 1933

Europe is a financial mess that threatens another 1930 if Spain and Italy collapse. Underlying any economic system is an economic philosophy that determines policy direction and shapes the underlying structure of the economic system. Post World War II, the Bretton Woods international financial system based upon the economics of J. M. Keynes underwrote twenty five years of economic stability, full employment and rising living standards. When Bretton Woods collapsed in 1971, international financial arrangements were fluid until 1976 when the articles of the IMF were altered endorsing a different economic philosophy to Keynes.

The Bretton Woods era had as its objectives full employment and balanced trade. This was achieved through managed exchange rates and external policies that used protective instruments to ensure balanced trade and full employment. Modern monetarism, a particular school within neoclassical economic philosophy, replaced the economic philosophy of Bretton Woods. Modern monetarism has as central tenets free trade and globalized financial markets. A necessary requirement of both free trade and globalized capital flows is ineffectual national sovereignty. The lack of national sovereignty lies front and central in the crisis confronting the Euro area.

Advertisement

Modern monetarism direction has been shaped by the G7 nations through political influence over important international institutions such as: IMF, World Bank, United Nations and WTO. The world is now being asked to trust the G7 and the IMF to solve a financial crisis that evolved on their watch. Undermining this trust is a post 1976 performance record plagued by one financial crisis after another . Between 1981 and 1994, the US financial system was brought to its knees when the thrift industry collapsed. The thrift collapse was compounded by unprecedented defaults on US investment bank loans to Latin America. In the mid 1990's, the Asian financial crisis erupted. In 2008, the GFC began in the US and quickly spread threatening the international financial system. In Europe, the aftermath of the GFC now confronts the world with a strong possibility of another Great Depression.

This discussion seeks to explain the weaknesses in contemporary economic philosophy; and hopefully, to generate a much needed questioning of a system that has failed. Europe is a particularly interesting example because the European Union is a long term real world model of free trade whilst the Euro area presents a working model of globalization.

Keynes 1933 above quote becomes a framework to discuss post 1976 economic philosophy

An important distinction between the economics of Keynes and neoclassical philosophy is morality. By using abstract mathematical concepts and models neoclassical economics removes the moral question from economics. Keynes brought morality back to economics by posing a simple question: "does the purchase of a luxury item by a rich man have the same meaning as the same purchase by a poor man?"

In Europe taxpayers must underwrite rescue programs caused by political and financial incompetence, malpractice and greed. Do austerity programs that demand taxpayers underwrite recue programs meet the morality criteria?

Production of Goods

Advertisement

Free market theory relies upon an underlying model comprising a two country, three input model (land, labour, capital) that exchanges products in purely competitive markets. The model has neither a financial sector nor a government sector. Western governments and the European Union have pursued both domestic and international policy based upon this model.

Without a financial system, there is no monetary system. The model collapses into an exchange system in which goods are exchanged for goods. The model presents a make believe monetary system by imputing a notional price "p" multiplied by wages "w". With no monetary system, what does "p" mean? From where does capital originate? Is capital a factory or craft type activity? In effect the model reflects a labour theory of value in which goods are bartered for goods.

As there is no government, the model collapses into a tribal system in which two tribes exchange goods. In the models, cloth is exchanged for food. How is the imagined "capital" used in the production of theses product? How are the exchanged goods distributed amongst the members of the two tribes? When these questions are satisfactorily answered, then perhaps the ideology of free trade will gain some credibility

Supply and demand in free trade theory is Pigou's restatement of Jean Baptiste Say's Law of Markets commonly referred to as supply creates demand. Professor Pigou restated Say's Law nineteenth century interpretation by relating it to the aggregate demand for labour. Pigou argued that under flexible labour markets, unemployment could not persist. Provided flexible labour markets adjusted the price of labour to reflect demand, then all those seeking work would be employed. Consequently, flexible markets become the automatic mechanism that returns the economy to full employment. This theory of supply and demand is popularly understood as supply side economics.

Within the neoclassical genre, there are a number of sub groups one of which is monetarism. Their belief in supply side economics leaves them free to concentrate on monetary imbalance. As flexible markets are assumed to automatically restore full employment, monetarism asserts that economic dislocation is a monetary phenomenon. In Europe, government deficits are seen as a major contribution to excess demand for money generating monetary imbalance. By balancing budgets, government demand for money ceases to be a contributor to monetary imbalance. Structural reform of market imperfections then returns the economy to full employment. They wish!

Another neoclassical sub group is the Neo- Keynesian school. This school uses the principles of Keynes within a neoclassical general equilibrium model. It is this group that pushed for fiscal action during the GFC. The fallacy of their claims of a return to Keynes can be identified by Keynes' axiom of parallels comment. He states that as ancient mathematicians believed in the explanatory power of parallel line, similarly Say's Law of Markets becomes the neoclassical axiom of parallels. From the Law follows belief in free trade, monetarism, and the virtue of public thrift. As no GFC "Keynesians" questioned free trade, any claims to be a follower of J.M .Keynes have a political not economic basis.

Finance should be national

The GFC did not just happen. The 2008/09 financial crisis was an inevitable outcome of the economic philosophy that replaced the Bretton Woods managed exchange rate system. Mistakenly, Keynes is blamed for the collapse of the Bretton Woods system of managed exchange rates. The Bretton Woods system was the idea of Harry Dexter White from the US Treasury. As Skidelsky says in one of his books, Keynes lent the system prestige not substance. Nonetheless, all major figures involved in the design of Bretton Woods were middle of the road people who disliked both free trade and socialism. The principal negotiators had an agenda shaped by experiences during the Great Depression, and the Second World War. The Bretton Woods system had full employment and balanced trade as its main objectives.

Post 1976, the international financial system was shaped when the articles of the IMF were altered to shift emphasis from full employment and balanced trade to focus upon domestic price stability. This internationally endorsed modern monetarism as espoused by the Chicago School's Milton Friedman. A lot of contemporary writers think Hayek was the architect of modern orthodox economics. This is not the case. Whilst both Friedman and Hayek are monetarists, they have different views about the management of the money supply. Friedman believes in monopoly control whilst Hayek argues for individual institutions issuing their own money to ensure necessary competition within the monetary system. The mess in Europe is a hybrid animal comprising the worst features of both economists.

In the late 1970's, the US Congress legislated for the Federal Reserve to reduce inflation to 3% by 1982. Inflation targeting became legislated into US law. The Legislation forced a change in the structure of banking. US banking operated under a system of interest rate regulation. This disadvantaged the banking system with respect to a rapidly growing unregulated non-bank financial sector. To compete, the banking system changed its structure from an originator of loans to hold until maturity to one of originate loans and on sell.

The originate to on sell banking model has became an insidious animal. Once banks secure a loan, they are passed through a structured system in which loans are securitized and classified according to quality. Pools of securities are then offered as collateral in money markets seeking big business short term deposits. A necessary adjunct to this system was a rating system to independently evaluate the quality of securitised collateral. Hence the rating agencies came into being. In the eyes of players in international financial markets, rating agencies have assumed a role akin to that of policy police. National, state and regional governments now dance to the tune of rating status determined by institutional decisions often times beyond their shores

The new Queensland Government is a classic example of a sovereign government captive to the rating agencies. Immediately on election the new Government commissioned a report on Queensland finances which was all about regaining the lost AAA credit rating. The direction of the subsequent report was already determined by the political commitment of the Government. What was in the best interest of the Queensland economy and its citizens became subservient to the political objective of returning to AAA credit rating from some offshore institutions acting in the interests of players in international financial markets.

The mess that now pervades the European Union and in particular the Euro area is the culmination of an economic philosophy that failed miserably in the Great Depression. As a consequence, followers of the philosophy, monetarism, retreated into academia. The Chicago School of Economics became the most famous refuge of monetarism from where it re-emerged in the 1950's. The foot print of the Chicago School is unmistakeable across the dislocation in Europe. Robert Mundell , former Chicago School professor, wrote one of the first plans for a European single currency. He is recognised as a co-founder of supply side economics and the monetary model of balance of payments. His working life includes appointments to both the World Bank and IMF. In 1999, he was awarded the Nobel Prize in Economics. It was in 1999 that the single currency concept was accepted by eleven EU members. The Euro itself was introduced in 2002.

Paul Omerond in his book, "Death of Economics", provides a chronicle of monetarist political disciples who introduced the philosophy in western economies. Margaret Thatcher began the movement in the UK. Ronald Reagon took its principles to the US. Mitteraund adopted it in France whilst Gonzales introduced it into Spain. Lange took it to New Zealand whilst Hawke and Keating brought it to Australia. The principles of monetarism were adopted by right of centre political parties as well as left of centre. Omerond uses the term "notional social democrats" to describe t left of centre politicians that adopted the dogma.

The economic dislocation across the Euro area is directly the consequence of an underlying economic philosophy. Free trade, globalized capital flows have driven economic policy direction since 1976. Academics, politicians and business leaders support these policies. They must now accept responsibility for bringing the western world to where it now sits: facing a major financial crisis.

The time is overdue for a vigorous public debate to emerge and involve the community in a discussion on the merits and demerits of alternative economic philosophies. The problem in today's world is to find respected academics who taught economic philosophy when Keynes was not considered "unscholarly". The public is entitled to a higher standard of debate than the tiresome fear campaign mounted to defend contemporary economic orthodoxy against legitimate criticism.

  1. Pages:
  2. 1
  3. 2
  4. All


Discuss in our Forums

See what other readers are saying about this article!

Click here to read & post comments.

6 posts so far.

Share this:
reddit this reddit thisbookmark with del.icio.us Del.icio.usdigg thisseed newsvineSeed NewsvineStumbleUpon StumbleUponsubmit to propellerkwoff it

About the Author

Ben Rees is both a farmer and a research economist. He has been a contributor to QUT research projects such as Rebuilding Rural Australia. Over the years he has been keynote and guest speaker at national and local rural meetings and conferences. Ben also participated in a 2004 Monash Farm Forum.

Other articles by this Author

All articles by Ben Rees

Creative Commons LicenseThis work is licensed under a Creative Commons License.

Photo of Ben Rees
Article Tools
Comment 6 comments
Print Printable version
Subscribe Subscribe
Email Email a friend
Advertisement

About Us Search Discuss Feedback Legals Privacy