The Nobel Prize was created for the betterment of humanity. The prize for literature was meant to make us kinder and more intelligent. The Peace Prize was an encouragement to end wars and eliminate oppression. The prize for medicine was supposed to help defeat disease. Physicists and chemists were rewarded for increasing our knowledge of the world and to put it in the service of mankind.
Economics was in relative infancy when these awards were established but the work of Maynard Keynes and others who followed him opened the possibility that by pursuing scientific economic policies we could ensure broadly based prosperity and eliminate damaging economic crises. Belief in the power of economics underpinned American optimism in the 1960s and prompted Lyndon Johnson to inaugurate his War on Poverty. Accordingly, in 1968 Sweden’s central bank established the Nobel Prize for Economics.
The timing was poor as in the early 1970s things started to go haywire and economic policy prescriptions seemed to make things worse. The industrial world sank into a period of slow growth marked by high unemployment and inflation.
In the 1980s however, the global economy rebounded. Even though various crises still hit at regular intervals and some countries went through hard times, we have been living in an era of widely shared prosperity. A massive technological progress has been made, the free market has provided a remarkable variety of goods and services and quality of life improved for most people even in low-income countries.
This happened not because of economic policy prescriptions but, worse, contrary to them. Some of the basic relationships in economics seem to have broken down. Unemployment and inflation turned out not to be inversely correlated, the full employment/unemployment rate turned out not to exist, loose monetary and fiscal policy pursued at the same time didn’t produce inflation, high government borrowing didn’t crowd out private sector borrowing, negative interest rates didn’t seem to cause any damage to the economy, free trade didn’t increase economic efficiency, etc.
Unlike physics and other exact scientists, economics proved incapable of doing what science is supposed to be good at, i.e., use its laws to predict outcomes. That even though the amount of statistical data increased dramatically and could be analyzed in-depth with the help of powerful computers. Instead, economic forecasters became the laughingstock of financial markets.
However, like history, psychology, and other social sciences, economics remains relatively good at explaining what has already happened.
Money has always been the lifeblood of the capitalist economy, but around 1980 global industrial capitalism was increasingly transformed into financial capitalism. Roughly speaking instead of focusing on producing goods or services companies focused on producing cash flows and profits.
It may be a subtle difference but it caused considerable changes to the world we live in. In the past, for example, a clockmaker focused on his trade and made a profit to support his family and carry on with his business. Now, however, his factory with its real estate and equipment, his brand, marketing network and skills all became monetizable assets that could be used to create financial instruments.
As a consequence, financial markets took off. Nominal GDP in the US went up from around $3 trillion in 1982 to $23 trillion today. Meanwhile, the Dow Jones Industrial Average on Wall Street went from around 800 to 35,000 today. The cyclically adjusted price-to-earnings ratio of the S&P 500 index doubled during the same time period and is now at the level seen only once before — briefly — at the height of the dot-com bubble.
Equally telling, the global debt ratio has tripled and now makes up 360% of the world’s GDP, the annual value of goods and services produced by the world economy. Total debt outstanding is now close to $300 trillion.
This didn’t happen by itself. The transition was aided by historically low interest rates spearheaded by the US Federal Reserve. Because the dollar is the world’s reserve currency, loose monetary policy had to be followed by other central banks as well.
Naturally, low interest rates and plentiful liquidity produced credit-financed bubbles and periodic crises, to which the authorities responded by lowering interest rates still further and pumping even more liquidity into the financial system, while governments boosted their debt-financed public spending. After the 2008 financial crisis global interest remained at historically low levels despite a protracted period of expansion and tight labor markets.
Despite loose monetary and fiscal policy, inflation in most countries has been very low — averaging just below 2% worldwide in recent years despite rapid economic growth.
This data is deceptive. True, the generic consumer basket not only has not increased in price substantially over the past several decades but many items in that basket, especially manufactured goods, saw steep declines. The technological revolution which gave us outsourcing, automation and improved logistics, as well as intense competition (which was also a function of the technological revolution plus plentiful investment funds) kept consumer prices under constant downward pressure. Equally important, unlike the 1970s, when poor productivity growth was accompanied by steady wage increases, over the past 40 years we have seen higher productivity growth accompanied by stagnant and even falling wages. To get consumers to spend you now have to compete on price.
While traditional consumer price inflation has been nonexistent, the value of the paper currency has been steadily degraded. As recently as in 2006, when Google bought YouTube, the purchase price, $1.65 billion, seemed mind-boggling. Today companies worth $1-2 billion appear seemingly out of the thin air practically every week.
We now have two economies, separate and unequal: the bottom economy, where money is hard to come by and making ends meet is a challenge, and the top economy, where million-dollar net worth is a low-ball figure. The bottom economy has many more participants while those at the top, although much fewer in number, control the bulk of the world’s assets. Those who are close to the trough of financial capitalism emerge wealthier after every financial debacle and the gap with the lower majority keeps increasing. Between 1979 and 2018 incomes of the top 1% jumped 2.5 times while those of the bottom 90% inched up by less than 25%. The 2020-21 pandemic has made these trends far worse.
The situation today is comparable to Spain after the conquest of the Americas. Gold and silver pumped out of the new colonies led to rampant inflation at home, but it impacted only the upper classes. Ordinary people went on living off beans and turnips just as they had done before.
However, during the pandemic, the economic system that had prevailed over the previous 40 years started to show strains. Supply chains, labor market conditions and other economic relationships have broken down. Shortages are developing and since money remains plentiful inflation is spiking. It may prove temporary and the status quo may be restored relatively soon — at least this is what most central banks are betting on — but there are strong psychological factors at work as well.
In recent years, in light of failures of conventional economics, many practitioners have been working to incorporate the findings of other fields — especially psychology — to create a branch known as behavioral economics.
Up till now the collective psychology of the financial markets has been driving them higher and ignoring serious flaws in the fundamentals. Not only are stocks at an all-time high but bond prices are rising which according to conventional economics should not be happening. Essentially investors have been putting their blind faith in the Fed and other central banks, expecting the monetary authorities to bail them out with lower interest rates and more liquidity if the markets run into trouble.
This is what Nobel laureate Robert Shiller, one of the leading lights in behavioral economics calls animal spirits, a term first used by Keynes. In December 2020 Shiller predicted that the stock market rally had more room to run thanks to Donald Trump: “I put Trump as the primary cause of the recent strength of the market,” he said. “He is a motivational speaker. We’ve never had a motivational speaker president before. He knows how to create animal spirits.”
But now there are signs that those animal spirits are turning against financial markets. Twitter CEO Jack Dorsey recently warned about hyperinflation in the US, while big money such as Carl Icahn and Jim Rogers are preparing for a major market crash. Conventional economics may be finally vindicated — but at a substantial economic, financial and social cost to the world.
