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Financial FAQs

Recent events have shown that financial markets are still very susceptible to crashes, and economies susceptible to serious recessions, such as the recent Great Recession. But does that have to be? The fault doesn’t only lie with the irrational exuberance of investors who believe that markets (and housing prices) only go up. Such financial gyrations also come from faulty economic thinking, thinking that hasn’t changed for more than 200 years.

Adam Smith, the founder of much of what is called classical economics, thought that an “invisible hand” (i.e., a free market) created maximum conditions for the production of goods and services—which suited the small market economies that existed in 1776, and provided a theoretical blueprint for the Industrial Revolution then sweeping Great Britain. His theories helped to solve the problems of mass production, but not how those goods should be distributed. And that is where the science of economics has fallen down.

In fact, most recessions result from overproduction, including the Great Depression. The current Great Recession resulted from an overproduction of housing, as the 2001 recession resulted from overexpansion of the dot-com sector. That is really the definition of an overheated economy. Some kind of inflationary asset bubble is created, which eventually causes prices to plunge (or crash), which leads to a downward spiral in production and jobs.

Only now are economists beginning to think about the consequences of mass production. They are beginning to look for a more sustainable model for economic growth, one that isn’t susceptible to such wide swings.

Economist John Maynard Keynes was the first modern economist to address this issue. He said in an essay entitled, “Economic Possibilities for our Grandchildren (1930)” that, “assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution, within a hundred years. This means that the economic problem is not—if we look into the future—the permanent problem of the human race.”

We are 20 years away from that date, and yet how close to achieving his utopian prediction, when “…the economic problem, the struggle for subsistence, always has been higherto the primary, most pressing problem of the human race…”?

There is not much research to date on sustainable markets, meaning markets that leave some wealth for our grandchildren, as Keynes wished. The current Great Recession is an excellent example. It left a mountain of debt, due to a massive deregulation of the financial markets and the consequent massive overleveraging of debt.

Even the sustainability of social security and Medicare are in doubt, as well as the credibility of the U.S. Treasury’s ability to repay some $10 trillion in federal debt. We are not the most indebted of developed countries, as this map shows. But the near-failure of our financial system has highlighted the dangers of over-indebtedness.

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There are other forms of sustainability beside responsible budgets that provide sustainable social safety nets, of course. There are sustainable production methods that don’t deplete non-renewable resources, and sustainable environmental practices that don’t emit toxic pollutants.

The most sustainable economic theory would still embrace an emphasis on increasing average household incomes, which have actually decreased since 2000 for those under 65 years of age. But that can only happen with an emphasis on job creation, which current economic policies and theories do not foster. In fact, household incomes have fallen back to 1998 levels, so severe has been this recession.

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The main problem with the various job creation theories is their total disagreement on methods that create what is called aggregate demand, the engine for any economic growth. That is the demand for goods and services that must grow for producers to have the incentive to produce more, and so create new jobs.

So-called neo-classical (mostly conservative) economists still believe in Say’s Law, for example, that says if more ‘things’ are produced, it will create demand, per se, which will in turn cause consumers and investors to want to buy/invest more. This is the faulty thinking that still underlies much of modern economics. It justified skewing tax breaks to producers and investors in 2001 while reducing government oversight, in the theory that with less restraints employers will automatically create new jobs.

But the main characteristic of a recession is that a surplus of things drives down prices, and so drives up unemployment, as we have said. This in turn reduces aggregate demand, which economists express as a formula:

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where aggregate demand (Yd) is the sum of all personal consumption (C) + private investment (I) + government expenditures (G) + any net of exports over imports (X-M).

We know that during most recessions personal consumption, private investment, and exports tend to fall, so in order to create stable aggregate demand during such downturns government has to step up its spending. Only then will the economy be stimulated by putting enough money in the hands of consumers, who comprise 70 percent of economic activity.

This in turn means taking the focus off individual, self-interest, as a goal of economic development, and focusing on the economic self-sufficiency of families, communities and countries. By focusing on the welfare of the whole, economists can begin to focus on the welfare of future generations, as well as those of past and present generations.

Harlan Green © 2010