The fifth of the Global Minotaur's Handmaidens: Toxic economic theory

The last two posts examined  four important contributors to the Global Minotaur: to America’s astonishing pre-2008 capacity to attract financing from the capital surpluses of the rest of the world sufficient for the purposes of funding its expanding twin deficits. They were, in turn,

I called these four the Minotaur’s Handmaidens. Today I add to that quattro another one: Toxic economic theory.

Toxic theory, Part A: Trickle down politics, supply side economics

When Ronald Reagan entered the White House in 1980, the fledgling Global Minotaur was already in residence, if not in complete control. Within the United States, its handmaidens[1] were cradling it, preparing it for the bigger and better things to come. With the twin US deficits gradually expanding, the beast’s imprint on American society and its influence on the world economy were growing by the day. What the Reagan Presidency undoubtedly added to the mix was a political and economic ecology that suited the Minotaur to the ground.

Reagan’s rhetoric struck a chord at the end of a confused decade during which the pride of the American nation had received the worst sequence of blows in its history: Ostensibly held to ransom by a bunch of Middle Eastern oil producers,[2] defeated on the battle field by the Viet Cong, rooted out of Iran by Khomeini’s revolution, passively standing by while the Red Army‘s march into Afghanistan, American society felt in its bones the ill effects of new social tensions caused by the disruption in rising real wages. The American public was hungry for a rousing call to arms, for a new ‘paradigm’ that would restore self-esteem. President Reagan obliged his ‘fellow Americans’, as he liked to address them: Lower taxes, armaments, and a return to good old puritan values were his offerings.

The basic idea was neither novel nor complicated: Get the government out of Americans’ way, let them keep their gains and allow them to get on with their lives. In reality, it constituted a wholesale retreat from the 1929-inspired notion that the market was too capricious to be left to business and consumers; that the US government had to discipline, cajole and shepherd the private sector’s progress in order to avert another Crisis not only at the local but also at the global level. In a sense, Reagan’s message was consistent with Volcker’s foreshadowed idea that US interests required the disintegration of the world economy.

The only difference was that the old B-movie actor put it more simply: Nothing succeeds collectively like unimpeded individual success, was his message. If America seemed to be stalling in the eyes of the many, it was because big government was holding it back. With a potentially productive private sector straining at the leash of a self-absorbed Leviathan, the only thing that was needed is that the leash be severed, the Leviathan put in his place. And what was his place, his only legitimate role? The defence of the Nation that could only be achieved if the American military was allowed to project its power to the four corners of the planet.

Once fully endorsed by the American electorate, Washington embarked upon supply-side economic policies and massive increases in the military budget. Privileging the economy’s ‘supply side’ was code for reducing all impediments to capital accumulation. In practice it meant large tax breaks for the highest incomes, reductions in social spending programs, and the removal of all restraints for Wall Street that were leftovers of the Global Plan era. Meanwhile, the fresh military spending proved a boon for the large industrial network connected to the arms industry and the state’s defence procurements.

When dissident voices pointed out that tax cuts favoured the rich (especially when combined with cuts in social provisions for the poor), the standard reply came in the form of the so-called trickle-down effect: As the rich enrich themselves further (the theory went), their spending and investment would trickle down to the less privileged more effectively than if would through transfers financed by taxing the rich.

The trickle up effect

The trickle-down effect was meant to legitimise reducing tax rates for the rich, by suggesting that their extra cash will eventually trickle down to the poor. All empirical evidence conspires against this hypothesis. Put simply, it never happened. The increasing riches of the inconspicuously rich never reached the suffering lower-middle class. In fact, exactly the opposite happened: A quite different effect, the trickle up effect, was occasioned by the securitised derivatives market. As we have seen, securitisation of the unsafe debts of the poor (e.g. the conversion of subprime mortgages into CDOs) had the effect of making the initial lender indifferent to whether or not the loan could be repaid (for she’d already sold the debt to someone else). These securitised packages of debt were then sold on and resold at tremendous profit (prior to the Crash of 2008). The rich, in an important sense, had discovered another ingenuous way to get richer: By trading on paper assets packaging the dreams, aspirations and eventual desperation of the poorest in society.

The combination of mountainous increases in military spending (of an order of magnitude well above the puny savings achieved through the cuts in the social welfare budget) and generous reductions in the taxation of the well off, splattered the US government’s accounts with oceanic quantities of red ink. The irony is truly delicious: The largest post-war expansion in government deficits was effected by the administration whose rhetoric against government profligacy was the strongest in living memory.

The Global Minotaur could not have hoped for better handmaidens in the White House and the various corridors of power. As the US budget deficit exploded, it accelerated the tsunami of foreign capital that rushed into New York. Eager to buy safe American debt at a time of generalised uncertainty, the world’s surplus was rushing into the US, allowing Wall Street to create even more private money that would fuel even greater consumer spending.

A year before Ronald Reagan’s victory, Margaret Thatcher had won office in the UK on a similar political manifesto. The difference was that her government inherited an economy which had been on the decline for almost a century. Moreover, it was a social economy in which the working class had managed, especially after World War II, to secure considerable power over economic affairs (both through the establishment of a large welfare state and through nationalisations of large industrial sectors, e.g. coal and steel).

The commentariat shaping public opinion hailed Prime Minister Thatcher for having successfully transplanted the American miracle onto European soil. The dominant story was: If Europe wants to become competitive again, it ought to follow the Iron Lady’s lead in privatising industries, deregulating labour markets and reducing unit labour costs.

The problem with that narrative was that it withstood no close scrutiny. Mrs Thatcher’s government never reduced unit labour costs. What she did do was to take a machete to industrial output, ‘ridding’ Britain of many of its traditional industrial sectors and, in the process, of the bothersome trades unions. This she undoubtedly succeeded in doing. But what effect did the destruction of the trades unions have on British labour costs?

The answer here is more complex than most commentators acknowledge. Together with the mining and steel industries, which bore the brunt of the reforms, millions of full time jobs disappeared forever. Naturally, the portion of national income that went to workers fell dramatically and whole areas of Britain were taken over by Third World conditions. But the one thing that did not happen is that for which Mrs Thatcher was given credit: Real wages per hour did not drop. In fact, and in sharp contrast to the US experience,[3] they rose considerably.

It is now clear that Mrs Thatcher’s impressive electoral successes (the first-past-the-post electoral system notwithstanding) was due to two factors: First, because most of the 4.5 million jobless people were too glum and disgruntled to bother to vote. Secondly, the workers who did hang on to their jobs saw their real wages rise. In addition, Mrs Thatcher gave them bonuses that roped them into a speculative mood, in tune with the financial frenzy in Wall Street and the City of London.

The bonuses came in two forms: selling (at very low prices) to the workers the council houses in which they had been living, and offering them shares in newly privatised companies (like British Telecom, British Gas and the Trustee Savings Bank[4]) at much less than the estimated market price. Both these offerings encouraged the still-working segments of the working class to consent to an economy which put all its eggs in the basket of speculation either on house prices or on share prices.

As anticipated, the much advertised shareowners’ democracy lasted but a few days as the co-opted workers sold their shares immediately to the conglomerates. They did the same thing with their council houses, in an attempt to move to better neighbourhoods and make some extra cash in the process, since much of the new house’s price would be paid for with a mortgage. The newly privatised housing encouraged banks to extend mortgages and credit card facilities to families that had never had one. The concomitant increase in the demand for houses boosted their prices and that gave the workers an illusory belief that they were getting richer. On the back of their rising ‘assets’, the banks fell on top of each other to lend them money to go on holiday, buy a car, upgrade their stereo etc. In the end, household debts, house prices and consumer spending all went up in perfect unison.

Meanwhile, the City of London’s traditional strength in the realm of finance, its deregulation under the Thatcher government (that was also known as the Big Bang), and the City’s links with Wall Street, ensured that a significant portion of the foreign capital flight to the United States passed through the City. That passage gave the City’s institutions access to large sums of money, even if for a short space of time. Nothing excites bankers more than the challenge of making money for themselves by using transient funds. Together with the proceeds from domestic privatisations of UK industries and of the nation’s stock of social housing, as well as the Great British public’s mountain of borrowing, these financial streams merged into a potent torrent which allowed the City of London to prosper.

In conclusion, over the past three decades, much ink has been spilled to assess the Reagan-Thatcher years. From this book’s perspective, it suffices to say that the famous duet’s politics proved immensely helpful to the rise of our Global Minotaur. Britain’s image as an entrepreneurial society, and all the razzmatazz generated by the cocky real estate agents and the slick bankers, depended heavily on the City’s paper trades and the rising housing prices. In turn, these twin bubbles developed for the simple reason that London had skilfully situated itself, as a refuelling stop, on a strategic spot along the migration routes which the world’s capital travelled to reach New York.

Toxic theory, Part B: Economic models and assorted delusions

The Global Minotaur relied on sympathetic governments that stood aside while its mammoth asymmetries were gathering pace. The politics of neoliberalism ushered in by Thatcher and Reagan served it well. But it needed more: a new variant of economic theory that would add a veneer of scientific legitimacy to the actual policies.

I have already discussed the essence of these economic theories in Chapter 1. Whatever their actual content, two were the prerequisites that economic theories had to fulfil to be considered realistic and timely at a time when the world economy was, in Paul Volcker’s words, in for some wilful disintegration: First, economic theories had to distance themselves from the idea that an economy could be rationally managed. Secondly, they had to feature a model of the economy in which regulatory constraints on capital accumulation and all forms of democratic restraint on unfettered markets appeared not so much as inefficient but, rather, as nonsensical.

Both prerequisites were met by a formalist model (which came in multiple guises, all of them adorned with impressive mathematical complexity[5]) in which capitalism appeared in one of two forms: Either as a static system of timeless interlocking markets in a state of permanent equilibrium or as a dynamic system, steaming ahead along time’s arrow, but comprising a single individual (called the representative agent) or a single sector. In short, a generation of economists grew up with economic models which could handle either complexity or time but never both at once.

The great advantage of these models was that they manifested a depiction of capitalism so mathematically complex that its practitioners could spend a lifetime delving into their infinitely convoluted formalist structures without ever noticing that their model, by construction, could never even begin to simulate really existing capitalism.

Now, all models are abstractions whose purpose is to simplify. In physics, for instance, one begins with many simplifying assumptions (e.g. that that there is no friction, or even gravity) in order to get a handle of some basic laws of Nature.  But then one begins steadily to relax the unrealistic assumptions. At the expense of added complexity, the physicist thus obtains more practicably useful variants of the theory.

Not so in economics: For in economic theory, the process of gradually relaxing restrictive assumptions comes to an abrupt halt before it even gets under way. If the lack of gravity is an example of a most restrictive assumption in physics, the economics equivalent is that there is no time. Or that all consumers and industries are identical. But unlike physics, which can relax its assumptions to get closer to the truth, economics cannot. Indeed, there is a remarkable theorem in economics proving that solvable economic models cannot handle time and complexity at once.[6]

The practical importance of this impossibility cannot be understated. Indeed, it explains largely how economic theory ended up as one of the Global Minotaur‘s most loyal handmaidens: For if no mathematised economic model is possible that depicts the real time transactions of different people and industries, then economic modelling must be divorced from any theory of crisis. After all, a crisis is, by nature, a dynamic phenomenon affecting a multi-person (and multi-industry) society that unfolds in real time. Robinson Crusoe may have been unhappy, hungry or go through an existentialist crisis but he could never experience an economic crisis (at least not before Friday’s arrival). Crises require a failure of coordination between different people and sectors, a collapse in an economy’s capacity collectively to utilise its individual resources. Is it not a most peculiar scientific failure that, for all its mind-boggling complexity, mathematical economics cannot even begin to wrap its equations around the idea of a Crisis?

Granted that the story of mathematical economics is the story of a dramatic scientific failure, why am I claiming that, as a body of theory, economics ended up as one of the beast’s handmaidens? For two reasons. The first is easy to discern: When the panoply of modern economic theory leaves no logical space for Crises and depicts capitalism as a system of interlocking markets in a timeless equilibrium, it serves as the free market fundamentalist’s ideological prop. The second, less obvious, reason has to do with Wall Street’s toxic money, whose role as one of the handmaidens has already been well established.

The CDOs that sliced up, and spliced together, disparate debts belonging to a heterogeneous multitude of families and businesses, were put together on the basis of certain formulae whose purpose it was, supposedly, to calculate their value and their riskiness. These formulae were developed by financial engineers working for Wall Street (e.g. for J.P. Morgan, Bank of America, Goldman Sachs etc.). To render the formulae solvable, certain assumptions had to be made. First and foremost was the assumption that the probability that one slice of debt within a CDO would go bad was largely unrelated to the probability of a similar default by the other slices in the same CDO. That is, it was assumed that what happened in 2007/8 was… impossible! That it was unnecessary to factor in the possibility of some crisis during which Bob lost his house for reasons that increased the chances that Jane would lose her job and eventually also default on her mortgage.[7]

The inescapable question, that everyone asked after the Crash, was: Why were these CDO valuations believed by numerous smart, self-interested, market operators, whose livelihood depended on the truth of the underlying assumptions? The answer is twofold: First, because they were captives of herd-like behaviour and would have risked their jobs if they moved against the pack.[8] Secondly, because during the Global Minotaur‘s heyday the economics profession had successfully peddled a form of mathematised superstition which armed the hand of the traders with the superhuman, and super-inane, confidence needed (perhaps against their better judgment and wishes) to bring down the system which nourished them. A very contemporary tragedy indeed.

The writing on the wall

The demise of the Global Plan, and the wilful disintegration of the world economy that followed, had their ideological counterpart: The doctrine that our collective attempts to control the world are doomed; that the markets are certain to outflank our best efforts to manage them.

Neoliberals cherished the thought that the ‘economy’ is too recalcitrant to be planned and it was, therefore, better left to the automated self-adjusting forces of the market. What they missed was that the successor phase to the Global Plan was anything but a case of spontaneous order. Instead, their treasured markets were ruled by the Global Minotaur‘s iron claws, aided and abetted by a band of merry handmaidens: among them successive US administrations, the effects of economic stagnation on the average American family, Wall Street shadowy operations, and lots of silly economics.[9]

The new creed was underpinned by a gut feeling that market forces resemble the ebb and flow of the great oceans and that, anyone who tries to get in their way, is a latter-day King Canute. The great paradox of the time was the incredible optimism that went along with this species of moral enthusiasm for market solutions: On the one hand they believed that nothing good can come out of government planning. But at the same time, they were convinced that unfettered markets would always perform miracles.

While one can understand the logic of pessimism regarding government’s effects on our lives, its coexistence with a touching, unexamined faith in the markets’ capacity to deliver success is baffling. How can a radical scepticism about the state be squared with a religious dedication to the notion that market outcomes are, by definition, optimal? What is the mechanism that guarantees the tidy immunity of market outcomes from the vindictiveness of human fate?

From the late 1970s to 2008, the reason why the world kept growing at a seemingly stable pace was the Global Minotaur. While deregulation, privatisation and financialisation were running riot, the lack of a discernible Global Plan was tempered by the beast’s active role as a surrogate Global Surplus Recycling Mechanism; a GSRM without which the world economy cannot function.

Under the Minotaur, as this book has been arguing, the United States and its satellites (e.g. Britain) were accumulating external national debt, Anglo-American families were amassing retail debt, and Wall Street was generating and accumulating toxic private money. Meanwhile, the oil producing nations, Germany, Japan, South East Asia (especially after the East Asian crisis of 1998) and, latterly, China, were all building up gargantuan currency reserves which they were pumping into Wall Street and the City of London. In a never-ending circle, these capital flows financed America’s twin deficits in ways that kept surplus production going in Europe and East Asia.

Was it a case of markets performing their miracle? Not really. For this type of precarious GSRM could never have been born out of spontaneously operating markets: It was a mechanism designed and supervised by knowledgeable, pro-active US policy makers. While there were quite a few of them, this book pays repeated tribute to one of the smartest of them all: Paul Volcker, the ex Fed Chairman, who had been in positions of power from 1971, when the Minotaur was but a glimmer in Washington’ eye, to well after its 2008 downfall.

In the introductory chapter, I began with the Queen’s question: Why had you not seen it coming?”, she had asked the economists. Well, Paul Volcker had.      As befits a true statesman, who had played a major role in creating the beast, he had what it took to do what others (e.g. the Europeans) had no stomach for: To look the Minotaur, his creation, in the eye and not blink. On 10th April 2005, when no one was interested in ‘bad news stories’, he had written:[10]

“What holds [the US economic success story] all together is a massive and growing flow of capital from abroad, running to more than $2 billion every working day, and growing… As a nation we don’t consciously borrow or beg. We aren’t even offering attractive interest rates, nor do we have to offer our creditors protection against the risk of a declining dollar… We fill our shops and our garages with goods from abroad, and the competition has been a powerful restraint on our internal prices. It’s surely helped keep interest rates exceptionally low despite our vanishing savings and rapid growth. And it’s comfortable for our trading partners and for those supplying the capital. Some, such as China, depend heavily on our expanding domestic markets. And for the most part, the central banks of the emerging world have been willing to hold more and more dollars, which are, after all, the closest thing the world has to a truly international currency… The difficulty is that this seemingly comfortable pattern can’t go on indefinitely. I don’t know of any country that has managed to consume and invest 6% more than it produces for long. The United States is absorbing about 80% of the net flow of international capital.

I could not have put it better. If the Global Minotaur requires an introduction, this Paul Volcker quote will do nicely. As further proof that US powerbrokers were completely aware and wary of the Minotaur‘s massive footprint on the planet’s economy, here is what Stephen Roach, the Chief Economist of investment bank Morgan Stanley, had to say three years earlier, in 2002:

“This saga is… about the unwinding of a more profound asymmetry in the global economy, the rebalancing of a US-centric world… History tells us that such asymmetries are not sustainable… Can a savings-short US economy continue to finance an ever-widening expansion of its military superiority? My answer is a resounding no. The confluence of history, geopolitics, and economics leaves me more convinced than ever that a US-centric world is on an unsustainable path.”[11]

In retrospect, we see that the creature’s originators (America’s top administrators and some of Wall Street’s high priests) could see that the writing was on the wall. Unlike the clueless handmaidens, they had foreseen the Crash. In painful slow motion.


[1] High interest rates, corporate America’s success at squeezing labour costs, Wall Street’s private money creation skills, rising US household debt, and the dwindling living standards of the average American worker.

[2] Even though, as explained in the previous chapter, the truth was rather different, in that the US government had, behind the scenes, acquiesced rather happily to the oil price rises.

[3] The last chapter has already highlighted how brutal the Global Minotaur proved toward the average American. It can be safely said that, as a result of its success, never before have so few Americans had so much while the many had to survive on so little. See James Galbraith. Created Unequal. The Crisis in American Pay, New York: The Free Press, 1989.

[4] These were called ‘stag’ issues: Selling shares so cheaply that they were heavily oversubscribed and hence rationed. When TSB was sold, it did not even belong to the British Government but, rather, to its account holders. The government had to bend the law to privatise it. In some cases, like BP, the advisors to the Government were also the underwriters of the issue and disaster following a stock market crash prior to the scheduled IPO was averted by the government guaranteeing the price of the share.

[5] Recall the three theories that were discussed in Chapter 1: Efficient Markets Hypothesis, Rational Expectations Hypothesis and Real Business Cycle Theory.

[6] This book is not the place to enter into the proof in any detail. If interested, you may consult the book I co-authored with Joseph Halevi and Nicholas Theocarakis entitled Modern Political Economics: Making sense of the post-2008 world, published by Routledge, April 2011.

[7] In more technical language, the formulae used to assemble the CDOs assumed that the correlation coefficient between the probability of default across the CDO’s different tranches or slices was constant, small and knowable.

[8] Doubt about the constancy of the correlation coefficient (see previous footnote) would have cost them their jobs, especially so given that their supervisors did not really understand the formula but were receiving huge bonuses while it was being used.

[9] In his The Crash of 2008 and What It Means, George Soros correctly states that: “The belief that markets tend towards equilibrium is directly responsible for the current turmoil – it encouraged the regulators to abandon their responsibility and rely on the market mechanism to correct its own excesses.”, New York: Public Affairs, 2009.

[10] In an article published in a Washington Post.

[11] Speech given in New York on 12th May 2002, entitled ‘Worldthink, Disequilibrium and the Dollar’.