Zombie Economics

John Quiggin, “Zombie Economics” Princeton Univ. Press, 2010, 211 pp

The recent financial crisis has exposed as false many of the assumptions behind market liberalism--the theory that market-based solutions are always best, regardless of the problem. For the last thirty years, their advocates dominated economics and led us to the current crisis. The crisis should have killed off these ideas, but they still appear to live on like zombies.

John Quiggin, the author, is professor of economics at the University of Queensland in Australia. This is not an easy book to read but is well worth the effort.

My Notes:

Pg. 2: If we are to understand the financial crisis, and avoid the kinds of responses that set the stage for a new and even bigger crisis in a few years’ time, we must understand the ideas that got us to this point. This book describes some of the ideas that have played a role in the crisis (together the author calls these ideas that led us into the crisis “market liberalism”).
. Market liberalism is composed of:
• The Great Moderation: the idea that the period beginning in 1985 was one of unparalleled macroeconomic stability;
• The Efficient Markets Hypothesis: the idea that the prices generated by financial markets represent the best possible estimate of the value of any investment and all decisions are rationally made;
• Dynamic Stochastic General Equilibrium: the idea that macro-economic analysis should not concern itself with economic aggregates like trade balances or debt levels, but should be rigorously derived from microeconomic models of individual behavior;
• Trickle-down economics: the idea that policies that benefit the well-off will ultimately help everybody; and
• Privatization: the idea that any function now undertake by government could be done better by private firms.
Pg. 27: The onset of the financial crisis was initially reflected more in foreclosures than in bankruptcies. Most mortgages in the U.S. are (legally in some states and de facto in others) nonrecourse, which means that, after foreclosing on the house offered as security, creditors cannot go after the other assets of the borrower. Even if a foreclosure yields less than the amount owed, the borrower’s obligations are discharged.

Pg. 62: The current crisis has two features that should spell the end of the Efficient Market Hypothesis once and for all. The first is that, in scale and scope, it is larger than any financial failure since the Great Depression. The estimated losses from financial failures amount to $4 trillion or about 10 percent of the world’s annual income. And, unlike the Great Depression, this crisis was entirely the product of financial markets. Financial markets and major banks were lightly regulated by governments under systems that relied, in large measure, on risk assessments undertaken by the banks themselves, and based, in large measure on the ratings issued by agencies such as Standard and Poor’s and Moody’s (hired by the financial institutions to give the ratings).

All of the checks and balances in the system failed comprehensively. The ratings agencies offered AAA ratings to assets that turned out to be worthless, on the basis of models that assumed that house prices could never fall. This was not simple incompetence. The entire ratings agency model in which issuers pay for ratings, proved to be fundamentally unsound. But, these very ratings were embedded in official systems of regulation. Thanks to the Efficient Markets Hypothesis, crucial public policy decisions were, in effect, outsourced to for-profit firms that had a strong incentive to get the answers wrong.

Pg. 83: Macroeconomics began with Keynes. Before Keynes economic theory consisted of what is now called microeconomics. The difference between the two is commonly put by saying that microeconomics is concerned with individual markets and macroeconomics with the economy as a whole.

Note: The traditional distinction in economics is between two different approaches: Keynesian economics, focusing on demand, and neoclassical economics, based on rational expectations and efficient markets. Keynesian thinkers challenge the ability of markets to be completely efficient, generally arguing that prices and wages do not adjust well to economic shocks. None of the views are typically endorsed to the complete exclusion of the others, but most schools do emphasize one or the other approach as a theoretical foundation.