Free market capitalism is a dead end

The free market myth

Only a little later, the financial markets began to collapse.

In the greatest global economic crisis since 1928, the overwhelming majority of economists stood naked. Modern economics, with its highly complex mathematical models and its belief in the rationality of economic subjects, became the first victim of the crisis.

Economics, as it has been taught at elite American universities for more than three decades, not only did not foresee the danger, it played a decisive role in causing the catastrophe. A rethinking has now begun at the edges of the discipline.

In the third and last part of our series of conversations, "Wirtschaftweise hellos", about the failures of political economy and its dramatic political consequences, Stefan Fuchs speaks with the American economist James Kenneth Galbraith. He is the author of the book "The plundered state or: What speaks against the free market", published in German in 2010 (original from 2008).

In the first two parts of the series, Stefan Fuchs spoke to the editor-in-chief of the Financial Times, Martin Wolf, and the economist André Orléan.

Stefan Fuchs: Mr. Galbraith, we are experiencing a renaissance of rebellion, searching and poorly articulated, but carried by the feeling of blatant injustice. The Puerta del Sol in Madrid, the uprisings in London, general strike in Athens. With "Occupy Wall Street" the protest has now reached the cold heart of financially driven capitalism. Most likely that will not change anything either, if this demand for a "global revolution" will also lead to nothing. But isn't it another symptom that, deep underground in our societies, after so many disappointments, the desperate search for a change that is more than just marketing has broken out? The only question is whether it will take a regressive form like the Tea Party in the United States, or if it really emerges from something really new.

James K. Galbraith: For the first time since the outbreak of the crisis, the voice of decency and custom can be heard again in the United States. A calm protest that expressed with impressive moral clarity and without ideological constriction that politics must finally take care of the people who are threatened in their existence by the crisis, instead of just disappearing as a kind of pimp for them to play a small minority that also benefits from the crisis. In California, for example, there were protests over a woman who lost her home because the bank was ruthlessly enforcing its lending policy. The bankers have not even tried to find any other solution, despite the fact that the debtor was in a desperate position. She had lost her son and was therefore unable to pay her installments on time. This exclusively profit-oriented, deeply obscene behavior has long preoccupied people and is now the cause of widespread protest. In Europe the situation is even more dire. I have just come from Athens. There you can grasp the physical decay with your hands. The feeling of hopelessness prevails even more clearly than in the United States. These are real social uprisings now because the livelihoods and lives of people across the country are at stake.

Fox: How did we get to this impasse? How much responsibility do economics have, which for decades have acted as a kind of cheerleader for financially controlled capitalism? If you read your description of your experience as chairman of the finance committee in Washington in the 1980s, you get the impression that there is a bit of jealousy on the part of leftist intellectuals about the romantic idealism of people who promise general prosperity with a very simple program: tax breaks , Fighting Inflation, Liberalizing Markets. Is that this simple program that got us into this situation?

Galbraith: The early 1980s were a historic turning point in many ways. Doctrines that were developed then are, in part, causative of what has happened since. But when I compare this time with the more recent past, with the last ten or fifteen years, I have a certain sympathy for the conservatives in the eighties. They responded to the instability and inflation that had set in at the end of a social democratic period in the 1960s and 1970s. They actually acted as idealists who sincerely believed that their recipes would help. This idealism has long since vanished. Many who were conservatives back then have a very different attitude today. This applies to the USA, but in principle also to Europe. At that time, the preservation of public interests was the aim of conservative economic policy, but now state power is being abused to assert the interests of a very small elite, particularly in the financial sector. I call this the "Predator State", the state in the service of predatory capitalism. It is characterized by corruption and systematic abuse of state institutions. In the US it started with the Clinton administration. It peaked under President Bush and resulted in the total failure of government oversight of the financial sector. More and more financial firms were adopting a fraud-based business model. I regard the last fifteen years as an even more serious, dangerous, and more difficult to eradicate deviation from the principles of decency and public policy than the earlier epoch you have cited.

Fox: In the context of the current discussion in Europe about the debt crisis and fears of inflation, it must come as a surprise to find that monetarism, supply orientation, balanced national budgets, free trade, liberalization of the markets, i.e. the whole litany of the neoclassical creed, are a thing of the past, that it is only in the ivory tower of the economics faculties, has long since been retired from practical politics. Only used in talk shows. Isn't what the IMF and EU decree Greece, for example, exactly the standard recipe of the Washington Consensus?

Galbraith: Monetarism disappeared without a sound 30 years ago. The demand of supply-oriented economic theory for lower taxes was met without any positive effects. Deregulation and privatization have proven to be a plague that has plagued the whole world. Most countries in Latin America, for example, fear them like the devil feared holy water. As soon as democratic governments came to power there, the privatization of the water supply, for example, was reversed because it was only about making profits with the poorest sections of the population. The dogmatic insistence on these failed economic policy recipes now absurdly characterizes the way the strong members of the European Union deal with a very weak partner, namely Greece. They are demanding an aggressive sell-off of all government property from electricity to universities. There is even no shrinking from reducing the minimum wage. The Troika and the International Monetary Fund act as dogmatic representatives of the interests of the creditors. Without exception, they pursue recipes that have already been tried, that have failed and have been rejected as completely unsuitable by many other countries around the globe in the last 20 years.

Fox: But they are apparently still backed by certain parts of economics that pursue these theories.

Galbraith: It is difficult to say which economic policy is currently being advocated or rejected by economic theory. Surely there are economists who keep repeating such clichés and formulas. But there is also enough evidence in the economic literature of all the disasters these recipes led to. The claim that there is a consensus among scholars who support this policy has not been true for decades, if it was ever true. What is traded as the ultimate wisdom at the self-proclaimed American elite universities is not representative of the discipline. These faculties have completely isolated themselves. They have become breeding grounds for intellectual dogmatism. Critical research that takes its social consequences into account no longer takes place. But in the wider scientific community, at the smaller state universities and colleges, and especially in research institutes in the rest of the world, there is no shortage of independent economists who either never advocated these dogmas or who have since rejected them. In many cases, they have had to pay a heavy price for their scientific careers. But they do exist, and they have retained their independent point of view.

Fox: It seems like you don't have a great deal of sympathy for abstract modeling and theoretical discussions in economics. Is there a kind of division of economics into a pragmatic and a very theoretical, abstract direction?

Galbraith: Economists with pronounced dogmatic convictions, which often have drastic consequences when applied to reality, like to dress them up with sophisticated abstract terminology. They try to cover up their unreality and their isolation within the scientific community. But abstraction and theoretical models are not the real problem.

If we look at John Maynard Keynes' "General Theory", there is no lack of abstraction and theoretical models without being accused of being coarse and unrealistic. The correct answer therefore does not consist in a campaign against abstract modeling, but in resistance against barbaric simplification.

Fox: A fundamental questioning of what you call the "cult of the market" is at the heart of your analysis of the past 30 to 40 years in economics. What is wrong with this widespread belief that markets are an unsurpassable instrument of not only economic but also social organization?

Galbraith: When talking about the market, one has to turn off the theological undertone that is usually associated with this term, that element of omniscience, omnipotence. In the world in which we really live, every, but also really every individual economic activity is framed by a set of rules that originate from state activity. The efficiency of these rules makes the world habitable and the market possible in the first place. Just three examples. Nobody would get on a plane if they didn't believe in the competence of air traffic controllers. No one would buy fresh vegetables unless they were convinced that food controls were working reasonably well. Nobody would entrust their money to banks or financial institutions if they were not convinced that financial regulators are able to prevent criminal activities. Every single area of ​​our complex economic activities requires state regulation. If these rules are sabotaged or overridden, companies are not suddenly free and can do what they want, the markets themselves collapse. If we allow that, there will be enormous impoverishment of society, which is actually happening now.

Fox: One of the markets that, in their opinion, cannot function as a market with the best will in the world is the labor market. Why is that?
Galbraith: I always ask my students whether they have already been on the job market. Since many of them have already worked, they think they were in the job market. Then I ask whether they had negotiated wages with potential employers, for example whether they had offered lower pay to make up for gaps in their training or lack of experience. It regularly turns out that it just didn't work out that way. Employers look for employees who can master the tasks the company is dealing with. And they hire them with the usual remuneration, which includes a longer training period, which is already priced in. That is far removed from the usual economic labor market models. There one assumes a number of identical individuals who can negotiate their wages individually. That's not how modern society works. Presenting students with such a misleading model is devastating. Once you have swallowed this "great narrative", you will believe every other economist tale to be true. Furthermore, the problem of unemployment cannot be understood on this basis. The economics textbook says that unemployment is caused by excessive wages. If you follow this logic, you have to cut wages if you want to fight unemployment. In reality, it almost never works. This can sometimes be the case under very specific, rare circumstances. In the overwhelming majority of cases, however, employment depends on the company's sales opportunities. And that in turn is related to the state of health of the economy as a whole and not to the wage level of individual employees.

Fox: So there is no "natural" percentage of unemployment that is so to speak inherent that cannot be brought out of society at all?

Galbraith: The term "natural" gives the impression that nothing can be done about unemployment, that it makes no sense to oppose the fact that one has to accept 10, 12, 16, 20 percent because that is the result of a functioning market. This is the worst form of nonsense, the worst pretext for sneaking out of responsibility. When governments evade this responsibility of their own, they expose their people to a growing loss of quality of life and ultimately plunge them into poverty.

Fox: Closely related to this ideology of market efficiency in the labor markets is the idea that inequality in pay stimulates the willingness to perform better and thus generate greater prosperity. You have turned this relation on its head and shown that inequality creates unemployment and thus sets a downward spiral in motion. Why is that?

Galbraith: The question of magnitude is critical to inequality. There is always some of it. What matters is the relationship between inequality and economic efficiency, between inequality and unemployment. If one examines this relationship in Europe or in the relationship between Europe and the United States, one quickly sees that countries with less inequality in their wage structure have always suffered less from unemployment, while countries with more inequality in income have higher unemployment rates . One of the main reasons for this is the forced mobility of workers. They will always try to swap one of the many low paying jobs for one of the few high paying jobs. They are queuing for these better-paying jobs that are not available in sufficient numbers. The result is unemployment. When, after the end of the Franco dictatorship, many Spaniards left the impoverished villages to find better-paying industrial jobs in the cities, the unemployment rate rose abruptly to 20 percent. It only fell again with the real estate boom that followed the introduction of the euro. This shows quite clearly that we should regulate our societies so that there is less inequality, that we should gradually raise the lower end of the wage scale. Because in the longer term this will also strengthen the trend towards greater efficiency in the economy.
Fox: And then of course there is the impact of inequality on demand.

Galbraith: On the demand side, the key point is that inequality leads to extreme instability in the economic system. People will try to make up for the huge inequality in purchasing power by borrowing. The result is high household debt with low incomes. That is anything but sustainable. When interest rates rise, as happened in the US at the end of the last decade, these loans can no longer be serviced. Priceless loans are no longer paid.

Fox: After the collapse of the Bretton Woods system of fixed exchange rates and restricted capital movements, the ideology of market efficiency was extended to the capital markets. The central banks should only ensure monetary stability.Market forces alone would bring about growth. The promise was not kept. The question arises as to why this deregulation of the financial markets could not achieve the promised result.

Galbraith: We must seriously consider the possibility that these promises were not honest and that what emerged from them corresponded to the intentions of those who enforced the deregulation. That is, a world in which powerful private institutions could secure a greater share of the wealth created than had previously been the case. This was paid for with greater instability, greater inequality, lower growth rates, and the freezing of the standard of living for the majority of people. That is exactly what the protest we spoke of at the beginning expresses. The "Occupy Wall Street" movement would like to draw attention to this.

Fox: Perhaps we should remind the listeners that the decision to create the euro was made precisely because the chaos on the highly speculative and volatile currency markets after the collapse of Bretton Woods and after the deregulation was so great that it was hardly politically closed was to tolerate.

Galbraith: It is not without a certain irony that for the weaker member states, the countries on the periphery of the EU, the introduction of the euro was linked with the hope of stopping speculative attacks on their currencies. The crisis they are now facing is essentially a crisis affecting the major banks in the euro area. The Eurozone was built on foundations that are economically not viable. You could have known that when it was founded. This includes the mandate of the European Central Bank, which is limited to fighting inflation, and which deprives it of any flexibility in its reactions. This also includes the lack of political deepening of integration and the lack of a central institution to steer continuous and sustainable development on the periphery of the EU.

From 2000 onwards, the member states of the European Union borrowed to a similar extent as private households in the USA. In the case of Greece, these loans were granted on unsustainable terms. What the European institutions could have known and what they probably also knew. In Ireland there was a boom in the construction of industrial plants, in Spain there was a private real estate boom. But the responsibility does not lie solely with the debtors. The creditor must also check whether the conditions are acceptable for a debtor. However, creditors tend to get greedy and only look for a high return. In boom times they look for weak debtors and give them loans against their better judgment. If a crash occurs, the damage must therefore be borne equally by both sides. But that doesn't happen in the USA or in Europe. In the United States, borrowers experience next to no protection, they lose their real estate. Only the creditors will be saved by taxpayers ’money. The same thing is happening in Europe. The creditors are protected, the European Central Bank buys the bad loans, but the debtors are left out in the rain. Their impoverishment will create a dizzying downward spiral for the European Union economy. People will lose their hope, their loyalty to Europe will wane. There will be massive emigration from countries like Greece and Ireland. The European integration project will lose its attractiveness, the promise of more prosperity through a large, economically strong community will appear as a chimera or even as a deliberate fraud. And I don't think the EU will long survive this disappointment.

Fox: If what we've been experiencing for the past three years is a systemic crisis in the ideology of market efficiency that has brought us all under the domination of the financial industry, the question remains, what can be done? Can we do without stock markets, for example, in order to finance the real economy? Can at least some of the financial markets be closed?

Galbraith: We have to be aware that the financial markets as they functioned three years ago have come to an end. Nor can they be brought back to life. The business model of the American banks consisted mainly of personal loans, mortgage loans in particular. In Europe, banks have worked with business loans and government bonds. These markets have simply ceased to exist. They were destroyed by the enormous loss of trust and the invention of sophisticated derivatives, with which no one knows for sure how the creditworthiness of the respective contractual partner is to be assessed. There is no going back. The American middle class has lost its creditworthiness for a long time. The economically weaker European countries will no longer be able to use the international credit market for the foreseeable future. So we have to first rebuild the financial sector, give it a new institutional basis so that it can fulfill its function on a reliable and appropriate basis. The same problem was faced in the 1930s and, after the collapse of 1929, it took 40 years to rebuild a functioning financial sector. In the United States, for example, mortgage financing was entrusted to strictly regulated semi-public institutions at the time. The role of the banks in these greatly changed circumstances will certainly be very different. If you want banks that take care of the financing of small and medium-sized businesses, you need small and medium-sized banks. Big banks don't care. We should have smashed the mega-banks three years ago. The entire financial industry must be reduced to a reasonable size. A reduction of 30 percent would be the right thing to do. Top manager bonuses need to be cut. All those involved in the ruthless and fraudulent business practices of the past must be replaced. The establishment of new and smaller banks must also be tackled. Their competition should then take place within a narrow regulatory framework. This is the only way to ensure that they also fulfill the functions assigned to them by society. Banks must serve society; they must not dictate their terms to it, as they have done for the past 30 years.