Davidson: Efficient Market Theory Vs. Keynes’s Liquidity Theory

Paul Davidson gave a great talk to the Progressive Economics Forum at the recent Canadian Economics Association meetings. Below is a teaser; the full talk is here.

ALTERNATIVE EXPLANATIONS OF THE OPERATION OF A CAPITALIST ECONOMY: EFFICIENT MARKET THEORY VS. KEYNES’S LIQUIDITY THEORY

by Paul Davidson, Editor, Journal of Post Keynesian Economics

Politicians and talking heads on television are continuously warning the public that the current economic crisis that began in 2007 as a small sub prime mortgage default problem in the United States  has created  the greatest economic catastrophe since the Great Depression.  What is rarely noted , however, is that what is significant about this current economic crisis is that it origin, like the origin of the Great Depression,  lies in the operations of free (deregulated) financial markets. As I pointed out in two recent articles (Davidson, 2008a, Davidson 2008b), it is the deregulation of the financial system that began in the 1970s in the United States that is the basic cause of our current financial market distress.

Yet for more than three decades, mainstream academic economists,  policy makers in government and Central Bankers  and their economic advisors  insisted that (1) both government regulations of markets and large government spending policies are the cause our economic problems and (2) ending big government and freeing markets from government regulatory controls is the solution to  our economic problems.

In an amazing “mea culpa” testimony before Congress on October 23, 2008, Alan Greenspan admitted that he had overestimated the ability of free financial markets to self-correct and he had entirely missed the possibility  that deregulation could  unleash such a  destructive force on the economy. Greenspan stated:  “This crisis, however, has turned out to be much broader than anything I could have    imagined….those of us who had looked to the self interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief….

In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize [in economics] was awarded for the discovery of the [free market] pricing model that underpins much of the advance in [financial] derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, [has] collapsed.”

Under questioning by members of the Congressional committee Greenspan  admitted :“I found a flaw in the model that I perceive is the critical functioning structure that defines how the world works. That’s precisely the reason I was shocked….I still do not fully understand why it happened, and obviously to the extent that I figure it happened and why, I shall change my views”.

The purpose of this paper is to explain to Greenspan and others who believed that  the solutions to our economic problems are free efficient  markets why they are wrong.

THEORIES EXPLAINING THE OPERATION OF A CAPITALIST ECONOMY

There are two fundamentally economic theories that attempt to explain the operation of a capitalist economy. These are : (1) the classical economic theory which has many variants including “the theory of efficient markets”, “classical or neoclassical theory”, “general equilibrium theory”, “dynamic general equilibrium theory” or “mainstream economic theory including old and New Keynesian theory”.

The mantra of this analytical system is that free markets can cure any economic problem that may arise, while government interference  always cause economic problems. In other words, government economic policy is the problem, the free market is the solution.  (2) the Keynes liquidity theory of an entrepreneurial economy . The conclusions of this analysis is that government can cure, with cooperation of private industry and households,  economic flaws inherent in the operation of a capitalist economy especially when unfettered greed or fear is permitted to dominate economic decisions.

Time is a device for preventing everything from happening at once. Economic decisions made today will have outcomes that can only be evaluated days, months or even years in the future. The basic – but not only– difference between these two alternative theories is how they treat knowledge about future outcomes that will be the result of today’s decisions. In essence, the classical efficient market theory  presumes that by one method or another decision makers today can, and do, possess knowledge about the future.

Thus the only economic decisions that today’s markets have to solve is the allocation of today’s  resources to produce the most valuable of “known” outcomes  today and all future dates.  Since classical efficient market theory presumes all decision makers “know” their future intertemporal budget constraints and act accordingly, there can never be problems of loan defaults, insolvency, and bankruptcy.  Accordingly, if people are rational mainstream theory provides no guidelines for how to deal with these problems when they create a financial crisis domestically and/or globally. Such a crisis is impossible!

The Keynes liquidity theory on the other hand, presumes that decision makers “know” that they do not, and can not , know the future outcome of certain crucial economic decisions made today.  Thus the Keynes theory explains how the capitalist economic system creates institutions that permit decision makers to  deal with an uncertain future while making allocative decisions whose outcomes they can not “know” with actuarial certainty and  even to make  decisions not to decide, and then sleep at night.