Farewell to the Neoclassical Revolution

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The bankruptcy of Lehman Brothers and the forced sale of Merrill Lynch, two of the greatest names in finance, mark the end of an era. But what will come next?

Cycles of economic fashion are as old as business cycles and are usually caused by deep business disturbances. "Liberal" cycles are followed by "conservative" cycles, which give way to new "liberal" cycles, and so on.

Liberal cycles are characterized by government intervention and conservative cycles by government retreat. A long liberal cycle stretched from the 1930s to the 1970s, followed by a conservative cycle of economic deregulation, which now seems to have run its course. With the nationalization of the United States' two giant mortgage banks, Fannie Mae and Freddie Mac, following the nationalization earlier this year of Britain's Northern Rock, governments have started stepping in again to prevent market meltdowns. The heady days of conservative economics are over -- for now.

Each cycle of regulation and deregulation is triggered by an economic crisis. The last liberal cycle associated with President Franklin Roosevelt's New Deal and the economist John Maynard Keynes was triggered by the Great Depression, though it took World War II's massive government spending to get it properly going. During the Keynesian era, which lasted three decades, governments in the capitalist world managed and regulated their economies to maintain full employment and moderate business fluctuations.

The new conservative cycle was triggered by the inflation of the 1970s, which seemed to be a product of Keynesian policies. The economic guru of that era, Milton Friedman, claimed that the deliberate pursuit of full employment was bound to fuel inflation. Governments should concentrate on keeping money "sound" and leave the economy to look after itself. The "new classical economics," as it became known, taught that, in the absence of egregious government interference, economies would gravitate naturally to full employment, greater innovation and higher growth rates.

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The current crisis of the conservative cycle reflects the massive buildup of bad debt that became apparent with the subprime crisis, which started in June 2007 and has now spread to the whole credit market, sinking Lehman Brothers. "Think of an inverted pyramid," writes U.S. investment banker Charles Morris. "The more claims are piled on top of real output, the more wobbly the pyramid becomes."

When the pyramid starts crumbling, government -- that is, taxpayers -- must step in to refinance the banking system, revive mortgage markets and prevent economic collapse. But once government intervenes on this scale, it usually stays for a long time.

At issue here is the oldest unresolved dilemma in economics: Are market economies "naturally" stable or do they need to be stabilized by policy? Keynes emphasized the flimsiness of the expectations on which economic activity in decentralized markets is based. The future is inherently uncertain, and therefore investor psychology is fickle.

"The practice of calmness, of immobility, of certainty and security, suddenly breaks down," Keynes wrote. "New fears and hopes will, without warning, take charge of human conduct." This is a classic description of the "herd behavior" that U.S. investor George Soros has identified as financial markets' dominant feature. It is the government's job to stabilize expectations.

The neoclassical revolution believed that markets were much more cyclically stable than Keynes believed, that the risks in all market transactions can be known in advance and that prices will therefore always reflect objective probabilities.

Such market optimism led to deregulation of financial markets in the 1980s and 1990s and the subsequent explosion of financial innovation that made it "safe" to borrow larger and larger sums of money on the back of predictably rising assets. The just-collapsed credit bubble, fueled by so-called special investment vehicles, derivatives, collateralized debt obligations and phony triple-A ratings, was built on the illusions of mathematical modeling.

Liberal cycles, the U.S. historian Arthur Schlesinger thought, succumb to the corruption of power, conservative cycles to the corruption of money. Both have their characteristic benefits and costs.

But if we look at the historical record, the liberal regime of the 1950s and 1960s was more successful than the conservative regime that followed. Outside China and India, whose economic potential was unleashed by market economics, economic growth was faster and much more stable in the Keynesian golden age than in the age of Friedman. Its fruits were more equitably distributed and social cohesion and moral habits better maintained. These are serious benefits to weigh against some business sluggishness.

History, of course, never repeats itself exactly. Circuit breakers are in place nowadays to prevent a 1929-style slide into disaster. But when the financial system is left to its own devices and fails to operate, as it now has, we are clearly in for a new round of regulation. Industry will be left free, but finance will be brought under control.

The cycles in economic fashion show how far economics is from being a science. One cannot think of any natural science in which orthodoxy swings between two poles. What gives economics the appearance of a science is that its propositions can be expressed mathematically by abstracting from many decisive characteristics of the real world.

The classical economics of the 1920s abstracted from the problem of unemployment by assuming that it did not exist. Keynesian economics, in turn, abstracted from the problem of official incompetence and corruption by assuming that governments were run by omniscient, benevolent experts. Today's "new classical economics" abstracted from the problem of uncertainty by assuming that it could be reduced to measurable (or hedgeable) risk.

A few geniuses aside, economists frame their assumptions to suit existing states of affairs and then invest them with an aura of permanent truth. They are intellectual butlers, serving the interests of those in power, not vigilant observers of shifting reality. Their systems trap them in orthodoxy.

When events, for whatever reason, coincide with their theorems, the orthodoxy that they espouse enjoys its moment of glory. When events shift, it becomes obsolete. As Charles Morris wrote, "Intellectuals are reliable lagging indicators, near-infallible guides to what used to be true."

Robert Skidelsky, a member of the British House of Lords, is professor emeritus of political economy at Warwick University and a board member of the Moscow School of Political Studies. © Project Syndicate