SUPPLY-SIDE BIAS AND RATIONAL CHEATS: REFLECTIONS ON

THE STATUS OF POLITICAL ECONOMY AND NEIGHBOURING DISCIPLINES IN THE WAKE OF

THE GREAT FINANCIAL CRISIS

Bent Sofus TranøyUniversity of Oslo and Hedmark University College

Outline of the talk

A brief history of supermodels Supply side bias in political economy

(and economics) VOC, LME-hood and financialization Governing rational cheats and other

closing reflections

What is a supermodel?

A model economy that is fashionable for a while Becomes example of ”best practice” Emulation => imperfect institutional

isomorphism

Rises to prominence

Through goodness of fit with trends in the world economy. i.e ability to utilize cheap and abundant resources Untapped labour, “costless” dumping of pollutants, some raw

material Perceived ability to solve problems that seem

particularly pertinent at any given moment in time Inflation, unemployment, export performance, innovation,

female participation combined with fertility Indicates an ideational component:

The power to shape a discourse in game involving academics, international technocrats, think-tanks, journalists

Any accumulation of knowledge? Success factors at T0 morph into reasons for failure at T1

A brief history of supermodels I

US Fordism Masters of mass production

French indicative planning Impressive growth and infrastructure achievements

Northern European Corporatism Ability to handle inflation/stagflation

Japanese Coordination Industrial miracle

Model Deutschland Combining hard currency with export performance

Flexible specialization Regional response to the crisis of mass production

A brief history of supermodels II

Asian Tigers – export led growth Late, but impressive growth spurts

Celtic Tiger Impressive growth performance, successful “hotel state”

strategy Finnish innovation (and education) miracle

Generalizing from Nokia? Flexicurity – combining dynamic labour markets and

social security Danish growth and employment performance Dutch Miracle

Nordic Model Trust, welfare, coordination and productivity

Flashpoint: Rhenish vs Anglo-Saxon capitalism

The Albert position: Defending the longtermism and social embeddedness

of the Rhenish model Return fire: the US-”jobs machine” position

Always explained in micro-terms (flexibility), never macro

VOC adjudicates: Two institutional equilibriums identified, Based on complex interplay between five subsystems:

Inter-company relations, Finance (or a market for corporate governance), Industrial Relations, Skills and training, Intra-company authority relations

Supply side bias in political economy I

We have followed orthodox economics in focusing on supply side matters

Macro-issues got serious treatment last: after the great crises of Norway, Sweden and Finland

around the turn of the decade, and the EMS/ERM turmoil in 1992-93 (Notermans, Moses, Andrews)

Since then, more or less nothing Look at the VOC-agenda above, not much

macro there Add to this:

Innovation systems, childcare and female participation rates

Supply side bias in political economy II

Historical irony Serial bubble blowing

Emerging markets =>Dot.Com =>housing Gave an appearance of strengthened state

financesAnd allowed us to forget one bubble with the

help of the next one Financial instability relegated to a

development concern at best Immature, not deep enough markets, poor

governance etc

How could we (you guys actually) let this happen?

Out of sight out of mind? Many good things in life are only noticed when

they are gone

The influence of mainstream economics Representative agents with rational expectations. Do not suffer from “money illusion” Leaves no room for positive fiscal action, avoiding

inflation and/or unemployment above the “natural rates” becomes the only macro goal

Correspondingly large potential for improving efficiency through improving incentives and getting prices right

Supply side bias in financial economics

Efficient market hypothesis: All relevant info instantly baked into prices:

Þ Financial markets is a servant to the real economyÞ Markets are self correctingÞ Bubbles do not exist

*If they did it would violate either the rational expectations assumption or the representative agent or both.

A tremendous asymmetry in terms of what to worry about was created

The next two slides show a a favourite example of mine, OECD on Iceland (special thanks to Herman Schwartz)

OECD take one

• The Icelandic economy is prosperous and flexible. With its per-capita income growing at double the OECD rate since the mid-1990s, it is now the fifth-highest among member countries and more than a quarter above the OECD average. This impressive performance is attributable to extensive structural reforms that deregulated and opened up the economy, thereby unleashing entrepreneurial dynamism, as evidenced by an aggressive expansion of Icelandic companies abroad.

• OECD Economic Survey: Iceland, 2008, p. 11

OECD take two

• Iceland has plunged into its deepest economic recession in decades after succumbing to a widespread financing crisis and a collapse of domestic demand… While Iceland is in part a victim of the international crisis, its severe plight largely results from a recent history of ineffective bank supervision, exceptionally aggressive banks and inadequate macroeconomic policies.

• OECD Economic Survey: Iceland, 2009, p. 9

VOC, and LME-hood

Received wisdom from VOC school: Positive view of the effects of a given set of

institutional features of finance system Text-book economics with a dollop of

institutionalist flavour : Powerful incentives = incentives to work hard and

achieve over the short term Highly developed markets for venture capital

supports radical innovation Market based monitoring works Financial innovation is a good thing, supports

innovation in the real economy

Financialization – definition

’Financialization refers to the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international level’ (Epstein 2001)

(this and several of the following slides are taken from Ingrid Hjertaker, MA-student at the University of Oslo)

Financialization - indicators

Economic: The FIRE sector (Finance, Insurance and

Real Estate) has grown – measured in employment, as part of GDP, and above all profits.

Increase in rentier incomes also in non-financial businesses

Increase in household debt/income ratio Increase in both mortgages and unsecured

consumer debt

Indicators continued

Political: Lobby power: most notably in the US, but also

on the international level Ideational power - What’s good for Wall St is

good for the US or ’What’s good for the City is good for Britain’

Cultural: Changed status of the financial sector in society Example: Ivy League recruitment 1960 vs 2005

LME in light of financialization unhinged I

Powerful incentives tend to corrupt Abstract theft is easier on the mind than stealing actual

money Self-justification bias and low risk of getting caught Cultural change?

Market discipline and market based quality control cannot be taken for granted

Informational and transaction cost economics could have indicated as much?

Atomistic ownership structure conducive to management malfeasance

Coffee’s work on the Dot. Com crisis

LMEs in light of financialization unhinged II

Key Wall Street/financial sector players are too powerful

In politics Vis-a-vis regulatory bodies In the market place (Yves Smith and others on how the

market was played e.g.by stimulating issuance of paper to bet against

Financial innovation can lead to horrible results The banal level: Securitization US-style decouples risk

and decision making “Rocket science” level: Models for estimating and

pricing of risk

Financialization and the welfare state

What are the links if any?

Let them eat credit

Positive intepretation: a ’democratization’ of credit, extending

opportunities for material welfare and prosperity to new groups previously excluded from credit markets

Negative interpretation: providing the working and middle class

expensive credit in place of real wage increases

exploiting the poor and financially illiterate for profit

The financial sector and the state

The financial markets and the welfare state as alternative mechanisms for welfare allocation The more extensive the welfare state the lesser the demand

for financial market services for insurance, savings and credit Empirically this picture is more complex: The degree of financialization varies across countries, but

NOT along common distinctions such as Esping-Andersen or the Coordinated vs Liberal Market Economy dichotomy. The UK and US as the most financialized societies, but from

there on it’s tricky to fit other cases in these taxonomies This represents a challenge to the comparative study of

financialization

Financialization of the welfare state

The great risk shift – from governments and business to individuals and families. The defining economic transformation of

our time (Hacker) Broader trend: A shift from ’defined benefit’

to ’defined contribution’ (Pensions above all)

Payout subject to individual choice, market developments, timing and luck Financialization from within?

Approaches to instability – rational cheats

Equilibrium Disequilibrium

Rationality Standard neo-classical theory, + EMH

Agency problems, Going for broke (moral hazard) and going broke for profit (tunneling)

Animal spirits Stabilizing speculation, ”smart money” (Friedman)

Keynes; Minsky; Kindleberger, Akerlof &Shiller: Stories, confidence multiplier, money illusion

Opportunistic Keynesianism

Intellectual underpinnings “secured” through temporary application of animal spirits type theory of action

“Wall Street got drunk” (GWB) Note contrast to Asian crisis intellectual fall-

out Crony capitalism

Structural explanation requires structural reform, conjunctural explanation justifies Selective Keynesianism

Concluding remarks

Learning (or lack thereof) in mainstream and technocratic economics becomes a key issue

Structure vs conjuncture in Financial instability One promising way of linking structure and

conjuncture is through the study of housing finance systems

Welfare researchers should look to the systemic effects on the financial system of welfare reforms also

Link the good governance and financial regulation agendas – when do incentives lead to cheating?