Home > The Economics Profession > The power of economic theory: Graphically illustrated

The power of economic theory: Graphically illustrated

from Asad Zaman and the WEA Pedagogical Blog

A near perfect graphical illustration of the power of economic theory is provided by the following graph; copied from RWER Blog

The impact of the roaring 20’s can be seen clearly as the shares of the bottom 90% drop steadily from 20% to around 13%, while the shares of the top 0.1% shoot up. The Great Depression led to a slew of regulations on banking, and also eventually the development and implementation of Keynesian ideas, which provide an economic rationale for government interventions to reduce unemployment. From 1930 to 1980, we see the rise of populist ideas, implementation of Keynesian theories, and the eclipse of Hayek and the Chicago School. After reaching a nadir in 1978, we see an upswing in the fortunes of the top 0.1%. The stagflation of the early 1970’s sets the stage for a rejection of Keynesian theories and a resurgence of the Chicago School. The Reagan-Thatcher era translates these theories into policies. When I was going to graduate school in the 70’s, the Chicago School was still an outcast, but they were plotting a triumphant re-entry, as documented by Sabina Alkire & Angus Ritchie in Winning Ideas: Lessons from Free-Market Economics. Among the many important lessons from this well worth reading paper, I note here only their first. Free market economists attempted to seize the higher moral grounds – they argued for FREEDOM as an ideal, a vision for a great society (and not on rational grounds). These lessons are worth studying for those who (like me) would like to reverse the tide. The inexorable upward march of the fortunes of the top 0.1% from the 80’s is matched by the rise to ascendancy of the Chicago School. Among the many indicators of the change is the exceedingly large number of Nobel Prizes bestowed upon its members. Foucault’s Power/Knowledge thesis is so well borne out by this graph, where the wealth of the extremely wealthy marches upwards in perfect tune with the Chicagoization of Economics and corresponding decline of heterodox schools, as well as the previous Keynesian orthodoxy. The global story of this correspondence between the Chicago School and fortunes of the wealthy has been extremely well documented by Naomi Klein in her fantastic book: The Shock Doctrine. She has put together the pieces of a huge jigsaw puzzle; I believe that no one can claim to understand twentieth century economics without reading this book.

The last point that I want to make in connection with reading the graph above is a bit depressing. I think the Great Depression took everyone by surprise and there was a huge popular uprising which led to strict regulations of the financial sector, and the corresponding fifty year decline in their fortunes. However, this time, the Global Financial Crisis did not take the extremely rich by surprise. To the contrary, they precipitated the crisis and very smoothly managed the aftermath so as to prevent a repeat of what had happened after the Great Depression. For example, they carefully manipulated public opinion to block the natural solution – bailout of the distressed mortgagors (see my blog post Deception and Democracy). All legislation proposed to address problems which had led to the crisis was effectively blocked in Congress (unlike what happened after the Great Depression). For example, there was only an eight year gap between the repeal of the Glass-Steagall Act and the Global Financial Crisis. The Falsehood Fabrication industry has tried its best to hide the link between the two, but the following graphic is enough as refutation: (taken from Too Big Has Failed – Let’s reform Wall Street for good)

Although the Dodd-Frank act was passed as a replacement, it is a 300 page monstrosity full of loopholes, unlike the short and crisp 30 page Glass-Steagall act which effectively prevented banks from gambling. Similarly, Gram-Leach-Bliley Financial Services Modernization act of 1999 unleashed the power of derivatives – which are pure gambles – to allow the finance industry to buy up the rest of us – the bottom 90% that is. At the time of the global financial crisis, the value of derivatives was estimated at TEN times the global GNP. Since the crisis, all attempts to regulate derivatives have been blocked, and some laws which were passed in the heat of the moment have been quietly repealed. We used to talk about regulatory capture; the regulated industry captures the regulators. The problem we face now is of Government capture – the body which makes the rules has been captured by big finance.

  1. January 4, 2015 at 9:30 pm

    Reblogged this on Explorations in Political Economy and commented:
    Good piece by Zaman on the relationship between economic outcomes and economic ideology. One can think of the period from the 1930s to the 1970s as the Keynesian era, and the period since then as the Chicago era (or, more accurately – though clumsily, the Monetarist-Rational Expectations-Real-Business-Cycle era). During the Keynesian era the share of wealth owned by the bottom 90% grew, while the share of wealth owned by the top 0.1% declined. Then, in the current Chicago era the patterns were reversed, with the bottom 90% seeing their share fall while the top 0.1% saw their share rise.

    While I’m drawn to the implications suggested by this relationship, I’m not sure that causality is from ideology (or economic theory, if the suggestion that economic theory is ideological seems too extreme) to economic outcomes, mostly because the policies that account for the outcomes in both eras where not necessarily driven by theory. They were instead driven by changes in the balance of power that took place, and is still taking place, between capital and labor. The politics that emerged from that changing balance of power had a bigger impact on the resultant policies of the two eras than the arguments offered by Keynesian or Chicago economists.

    The two different ideologies that came to dominate these two eras were more a reflection of the underlying power relationships than a causal force leading to the different policy regimes.

    What’s more, while it’s true that economic ideology has gone through a transformation from Keynesianism to Chicagoism it’s a bit of stretch to suggest that Chicagoism was an outcast in the era of Keynes. True, Keynesian theory and policy were dominant in that era, but it was a type of Keynesianism that accepted, in principle, the Chicagoian belief in free markets.

    The major difference between these two ideologies, in this regard, was that the Keynesians saw all kinds of imperfections and rigidities interfering with the free market’s ability to do its wonders, while the Chicagoians were confident that, in the real world, free markets move toward full employment. In short, both ideologies accepted the magic of the market. It was just that the Keynesians saw the need for policies that nudge the free market toward outcomes it’s prevented from achieving because of imperfections and rigidities, while the Chicagoians are convinced that real world markets do just fine, even in the presence of imperfections and rigidities.

    The Keynesians were, and still are, unwilling to embrace the more radical conclusion arrived at by John Maynard; namely that, even if the free market system were purely competitive, there is no guarantee it will arrive at a full employment equilibrium.

    For this reason, the Chicagoians were never quite the outcasts. This helps explain the ease with which their ideology was so quickly accepted in the 70s. It also helps explain why the economics of Keynes never moved to center stage.

    The ideologies of the two eras never questioned the system’s ability to move toward that magical equilibrium. What instead happened was that the ideology that got the most play was the one most congenial to the structure of power of each corresponding era. But throughout both periods, the system’s capacity to move, of its own accord, toward full employment – even if only in principle – was never up to debate.

  2. Helge Nome
    January 4, 2015 at 9:34 pm

    Goes to show: The price of freedom is eternal vigilance

  3. January 5, 2015 at 9:20 pm

    If we are going to change things, most heterodox economists need to realize that, just like the Chicago School, they are practicing moral philosophy disguised by math.

    All economists must recognize that the lack of a coherent methodology is what lets moral philosophy creep in where it doesn’t belong. Economics under the sway of liberal Keynesians was equally flawed as the Chicago school. Recommending the right policy is not enough. The method that leads to that policy must be specific and determined so that outcomes don’t simply reflect the bias of the practitioner.

  4. January 6, 2015 at 2:14 am

    I agree with all the comments — Keynesian provide the minimum possible correction necessary to allow a capitalist economy to work — namely targetting full employment so that everyone can have enough to survive (perhaps). The free market systemeatically generates massive unemployment in cycles, Large numbers of people who have nothing to lose can change the system. Keynes actually saved capitalism from the more radical reforms that would have been necessary in its absence.

    Also the final comment by Thornton Hall is precisely right. When we argue that laborers should be provided food so that they can work harder (as nutritional wage efficiency theories do) then we have already lost the moral battle.

  5. January 16, 2015 at 2:35 am

    An excellent article in Counterpunch discusses “40 years of economic policy in one chart” This makes the same point as I do above – the last 40 years have been a disaster, and you can see clearly exactly when and where we went astray.

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