The Current Crisis in Economics

The Global Financial Crisis and the Great Depression have shown the problems of unrestrained Laissez-Faire on the global economy. The crises may have been solved, but the magnitude and spread of its effects show that our economic behavior can act like a systematic virus. In the end, millions of people are adversely affected, directly and indirectly. Dr. Asad Zaman provides an impassioned plea to rethink Western economic though in order to avert future crises.

Twentieth Century Economics

The human tragedy of the Great Depression has been graphically depicted by John Steinbeck in his moving novel, The Grapes of Wrath. The crisis it created for economic theory is not so well known. Leading economists kept forecasting prosperity and quick recovery, creating embarrassment for the profession as a whole. In 1927, Keynes had flatly stated that “there will be no more crashes in our time.” The shock of the Great Depression led him to create an entirely new economics. The Keynesian revolution created the field of Macroeconomics which gave a vital role to the government in removing unemployment.

           At the dawn of the twentieth century, Laissez-Faire economics was the dominant school of thought. Laissez-Faire economics says that free markets without government intervention automatically lead to the best possible economic outcomes. The folly of this position was made obvious to all by the Great Depression. Paul Samuelson and other disciples of Keynes were the only economists with quantitative and, apparently, rigorous answers to questions about the Great Depression. They enjoyed a monopoly on the field of Macroeconomics until the 1970’s. Then things changed.

          The OPEC countries imposed an oil embargo to retaliate for USA support of Israel in the Yom Kippur War in 1973. The sudden rise in energy prices led to "stagflation" - unemployment and recession occurring simultaneously with inflation – in the US economy. This was contrary to the central tenets of Keynesian economics which held that only one or the other (unemployment or inflation) was possible. The damaged prestige of Keynesian economics allowed a counter-revolution to be launched. Surprisingly, most of these new macroeconomic theories went back to the laissez faire ideas of pre-Keynesian economics.

          Milton Friedman and his followers, labeled Monetarists, lost no time in re-interpreting the Great Depression along lines which would suit laissez-faire theories. On this re-interpretation, the Great Depression was actually caused by inept government policies related to the money supply. Many economists have remarked that theories so violently in conflict with facts became acceptable in the late 70’s only because the generation which had experienced the Great Depression had passed away.  Regardless, the old wine of laissez-faire was presented in new bottles, and rose to prominence once again. Reagan in USA and Thatcher in UK implemented these bold ‘new ideas’ by tax cuts and reduced spending to minimize the role of the government. The failure of Thatcher’s economic policies eventually led to her forced resignation.  It is a puzzle that the same policies were apparently quite successful at reducing unemployment and creating growth in the USA under Reagan.

          A deeper look into the difference between what Reagan said and did can resolve this puzzle. Tax cuts for the rich were balanced by increased taxes on the poor.  Large reductions in government expenditure on social security and welfare were more than made up for by massive increases in defense expenditures. What was advertised as a reduction in the role of the government led to a quadrupling of the government budget deficit. Reagan restored the tarnished reputation of Laissez Faire economics by using traditional Keynesian methods of expansionary fiscal and monetary policy, labeled as free market economics.

          The collapse of communism further enhanced the prestige of the Laissez Faire economists. The IMF and World Bank enforced the Washington Consensus all over the globe. The poor results of these free market policies disappointed even Williamson, the economist who invented the term. However, instead of rethinking the underlying paradigm, failures were attributed to the wrong sequencing of the economic reforms, and the lack of institutional structures necessary to support the free market. Thus Laissez Faire economics was again the dominant paradigm at the dawn of the 21st century. Economists were just as unprepared for their encounter with reality in the form of the Global Financial Crisis of 2008 as their predecessors had been for the Great Depression. The mistaken overconfidence of Keynes prior to the Great Depression was replicated by Robert Lucas, in his 2003 presidential address to the American Economic Association. Lucas declared that the "central problem of depression-prevention [has] been solved, for all practical purposes" just a few years prior to the Global Financial Crisis of 2008, which provided an empirical refutation of his Nobel Prize winning theories on rational expectations.

Historical Roots

The current crisis in economic theory has deep historical roots. To understand it, we must go back to sixteenth century Europe. Continual warfare and bloodshed among different Christian sects led to the search for a secular basis for society. How can we achieve cooperation in a society composed of religious groups with different goals? Secular thinkers promoted freedom and wealth as the core values of a secular society. One could expect different groups with conflicting goals to agree to these as common goals for the society. Freedom and wealth would provide each group with the possibility and material means to pursue whatever goal they desired.

          Considerable effort was put into promoting freedom and wealth as desirable collective goals. Efforts of secular thinkers led to the transition from the Biblical maxim “the love of money is the root of all evil” to its opposite: “lack of money is the root of all evil”. Duty to society takes precedence over individual liberty in traditional society. Secular thinkers created a political theory which put individual freedom above claims of the social order. These momentous changes were fundamental in creating the modern world.

          Secular thinkers disagreed about effects of allowing individual freedom and pursuit of wealth on society.  The disagreement was about the nature of human beings. Jean-Jacques Rousseau felt that human beings were naturally good, and hence advocated anarchy – no rules or regulations of any kind were required. On the opposite extreme, Thomas Hobbes thought that human beings were naturally evil. Without strong government enforcement of extensive laws, life would be “nasty, brutish and short,” if people were allowed complete freedom to act as they desire. John Locke took an intermediate position, finding society and government necessary, but with minimal rules acceptable by all.

          The debate between Locke and Hobbes continues to this day in various guises.  The Hobbesian view was that extensive government control and regulation in all spheres of life is required for a stable social order. Followers of Locke argued that minimal control would suffice. A very important ingredient in the victory of minimal government views was the “invisible hand” argument of Adam Smith.  He argued that even though people are selfish, society would benefit by allowing them freedom to pursue their own self-interest. This provided a counter to the Hobbesian idea that selfish individuals would destroy society unless there was extensive government control. 

          Laissez-Faire economics is based on intellectual grounds prepared by Locke and Smith. It argues that one should allow maximum freedom to individuals in the economic sphere. We are witnessing today the outcomes of a social experiment spanning two centuries. Whereas traditional societies warn strongly against pursuit of pleasure and wealth, secular thinkers thought that these baser tendencies of humans could be harnessed for the betterment of society. As long as the institutional frameworks of politics, justice, and society were sound, allowing freedom for pursuit of wealth would enrich society.

All religions and cultural traditions have asked individuals to sacrifice selfish pleasures to fulfill social obligations, and frowned on pursuit of wealth.  The outcomes of this social experiment make clear why this is so. Contrary to the expectations of secular thinkers, individualistic pursuit of wealth and pleasure did not remain confined to the narrow domain of economic activities. When profits were permitted to trump compassion, the odious actions of Shylock the Jew became socially acceptable. Bankers threw millions out of their homes for nonpayment of interest after the financial crisis of 2008. On the family front, placing pleasure over duty has led to ever increasing divorces, infidelity, and illegitimate children. According to a recent UK report entitled Fractured Families, “the fabric of family life has been stripped away.”  This is social disaster, since children are trained in families, and societies are shaped by how children are trained. More than a third of children in the USA and UK are being brought up in broken homes. The tragic consequences are documented in many studies. Selfish pursuit of pleasure has led to the highest divorce rates in the world, millions of unwanted teenage pregnancies, record rates of alcohol and drug abuse, depression and suicide, and alarmingly high percentages of lying, cheating and theft among high school students. As we will show later, one of the economic consequences of promoting selfish pursuit of profits as a virtue has been the Global Financial Crisis of 2008.

 The New Millenium

Karl Marx was deeply moved by the plight of the exploited laborers in industrialized England in the late 19th century. He theorized that the dynamics of capitalism would lead to increasing exploitation, until the laborers revolted against the system. After the revolution, the laborers would create a new economic and political system, which would be far more equitable than capitalism.  This Marxist prophecy was wrong, but did contain one core truth: increasing exploitation of workers did lead to a breakdown of capitalism during the Great Depression. The same dynamic has repeated itself in creating the Global Financial Crisis of 2008. The parallels between the two are clearly evident and dearly shocking.

          We can partition the economy into a real sector and a financial sector. The real sector is where production takes place: these are the farms, factories, and other industries which produce real goods and services directly beneficial to human beings. The financial sector is based on activities which are not directly productive, such as lending money for interest, speculating on stocks, foreign exchange, and using derivatives and insurance contracts to gamble on the outcomes of real activities. In the “Roaring” 20’s, wild appreciation in stock prices led to a situation where it became substantially more profitable to gamble on stocks than to invest in real productive activities. Increasing shares of wealth in the hands of gamblers and decreasing returns to productive activities could not be sustained for long, and eventually led to a collapse of the real sector, now known as the Great Depression.

The collapse of the real sector led to massive unemployment and human misery on a large scale. It is correctly said that Keynes rescued capitalism from the fate Marx had prophesied. Conventional economic theory holds that market forces of supply and demand will automatically eliminate unemployment. Keynes revolutionized economics by repealing the law of supply and demand in the labor market, and urging the government to intervene to help the unemployed laborers. The Keynesian compromise provided relief against the ravages of the Depression, and prevented the more radical changes suggested by Marx.

In her brilliant book, The Shock Doctrine, Naomi Klein has provided a detailed picture of how a counter-revolution was planned and executed by a small segment of society which was unhappy with the Keynesian compromise. An opening was provided by the 1970’s oil crisis which led to stagflation in the USA, contrary to central premises of Keynesian theories. The monetarist school of Chicago was quick to stage a comeback. They argued that the Great Depression was caused by government mismanagement of the money supply, rather than a failure of the free market.  Using strategies described by Klein, these free market theories were applied all over the world.

Reagan and Thatcher implemented these free market policies in the USA and UK with predictable results. From 1980 to 2006 the richest 1% of America tripled their after-tax percentage of the nation's total income, while the share of the bottom 90% dropped over 20%. Between 2002 and 2006, it was even worse: an astounding three-quarters of all the economy's growth was captured by the top 1%. The same pattern of sharply increasing inequality holds globally: the wealthiest 250 people have more than the poorest 2.5 billion people on the planet.

Superficially, Laissez-Faire or no interference in markets seems like a fair and equitable philosophy – let everyone do whatever they want. In fact, it is highly inequitable. The poor do not have choices, while the rich and powerful take advantage of this liberty to extract money from the less rich. Financial wheeling and dealing is used to transfer money from the real sector to the financial sector, which is controlled by the wealthy. A simple method is the leveraged buy-out, which allows the wealthy to purchase a real productive business for peanuts, and extract all profits for themselves. More complex methods like CDOs (Collateralized Debt Obligations)“… may not be properly understood even by the most sophisticated investors,” according to financial wizard George Soros. Just before the global financial crisis, the value of financial derivatives (which represent different types of complex gambles) alone was 10 times the GDP of the planet. The worth of the financial sector was more than 50 times that of the real sector. This illustrates the increasing inequity that arose between the real productive sector and the financial sector which ultimately broke the backs of the working people. Many people ranging from religious scholars to financial wizards have correctly traced the roots of the Global Financial Crisis to the limitless greed of capitalists. Removal of traditional restraints to this impulse have led to an extraordinary concentrations of wealth combined with extraordinary exploitation and injustice.

The Future

The Global economy remains in enervated state. Growth has yet to reach pre-crisis levels and the Euro Crisis is causing jitters throughout the world. But there is a far greater sense of optimism now with established economies bouncing back slowly, and emerging economies showing much potential. Yet policy makers have not learned the lessons of the Great Depression and the Global Financial Crisis. The ongoing debate on austerity or stimulus to kick-start the global economy masks the systematic flaws within the Laissez-Faire economy. The idea that “greed is good,” and that selfish individuals can drive an economy to better performance has led to breakdown of communities and families, a steep rise in loneliness, as well as multiple financial and economic crises. The message of Islam transformed the Arabs from an illiterate and uncivilized people, to humane and compassionate leaders of the world. Today the whole world is desperately in need of this transformation. The challenge for the Ummah is to rise to the occasion by showing how societies and economies can be built around generosity and cooperation, instead of the greed and competition which is the basis of capitalist society.