Edward Hadas

There is only one good, proven, way to organise a political economy in the modern world – and that’s via the Big Honest State. Right now, one key aspect of the BHS is under serious threat.

What is the BHS? As the name suggests, it is large. In quantity, the various organs of a BHS account for 30-60 percent of GDP. In quality, the state dominates education, health care, industrial policy and the financial system. The BHS is also trustworthy. Its official bureaucracies are expected to be, and mostly are, meritocratic and dedicated to the common good. A BHS, though, is far from the total government of fascists and communists. One of the defining facets of the BHS, indeed, is that it works alongside a vibrant non-state sector.

The basic BHS model has been adopted in all advanced economies and it is aspired to by most leaders in almost every developing country. Universal adoption is easy to explain: the BHS works well. It has delivered a reasonable mix of prosperity, protection and social support. It has proved remarkably sturdy. Since the Second World War, no BHS country has had collapsed into chaos, become impoverished or suffered fundamental social breakdown. The system is also popular with voters, even if many government-hating Americans hate to admit it.

However, the BHS is vulnerable to moral decay. It relies on professional integrity and hard work. Such virtues are easily lost, either through corruption or a more insidious failure of will. It is the latter, what old fashioned philosophers called spiritual sloth, that threatens the monetary side of the BHS. Until recently, the BHS was able to produce money which basically kept its value and a financial system which served the common good. If politicians and regulators don’t wake up fairly soon, these accomplishments could be lost.

There are four threats. The first is fiscal laxity. Politicians around the world have become blasé about deficits. To be fair, the record deficits have as yet done no obvious harm and the mechanism which can turn unbalanced government spending into high inflation is poorly understood. Nonetheless, the lack of concern is disturbing, and the willingness of many American politicians to drive the government to the edge of a fiscal cliff is positively alarming.

The second danger is monetary incompetence. Again, the economic effects of years of zero policy interest rates and haphazard bank subsidies are basically unknown. The theory is inadequate and the current experiment is unprecedented. However, after four years of extreme policy it is intellectually lazy to assume, as most central bankers seem to, that all will be well soon enough.

The third risk is only regional, but the region in question holds great practical and symbolic importance. The euro zone has the world’s second largest GDP, only 15 percent smaller than that of the United States, and it is the spiritual home of the BHS. If the politicians and central bankers there fail to keep the single currency together, global economic chaos would be hard to avoid.

Finally, the BHS model could be undermined by poor management of international economic relations. Trade imbalances are still large enough to create political tension, through shifts of employment, financial havoc, and the foolish investment of the funds created by surpluses. Then there are investors who move money in and out of countries at whim, distorting the economic landscape.

How dangerous are these interlocking threats to the BHS model? A collection of “should” statements supports an optimistic judgement. Politicians around the world should be able to manage their budgets back towards balance. Central bankers should be able to manage the return to normal interest rates. Euro zone leaders should manage to unify the rest of their BHS enough to support the single currency. With a little less intellectual laziness about the virtues of free trade, it should be possible to manage cross-border economic in a more responsible way.

In addition, even if developed countries wallow in financial decay, China, Brazil and other developing countries should continue to strive for something like a BHS model. If anything, they should learn from the failures of others. Indeed, everyone should be studying history and everyone should be trying to find ways to make the financial system as solid as the other parts of the BHS – although sloth also seems to be creeping into the management of health care and retirement expense.

Perhaps the best reason for confidence is the scale of the problem. In comparison to the wealth of most of the countries currently stuck in a financial quagmire, the losses involved in reconstituting a solid and sustainable financial system are modest. They should be manageable.

Unfortunately, there is a very persuasive reason for pessimism – a shortage of the virtue ready to oppose to the vice of sloth. None of these “should” statements can possibly come true unless there is far more political fortitude than has been seen for many years.

Why has the recovery from the financial crisis of 2008 been so slow? To answer that question, it helps to reflect on two items in the newly opened Citi Money Gallery at London’s British Museum. The first is a photograph of a two-tonne carved stone which once served as money on the Pacific island of Yap. The second is the exhibit of counterfeit notes and coins.

Yap’s use of big rocks as currency poses some obvious problems, but the carved stones, known as rai or fei, did not actually pass from owner to owner. Possession was merely noted down by inscriptions. The economist Milton Friedman wrote an elegant paper about the Yap arrangement in 1991, explaining that the system worked because of the Yap residents’ “unquestioned belief” in it.

Friedman realised that modern monetary systems are also faith-based. The faith used to reside in the value of gold and silver, whether minted in coins or held in central bank vaults and represented by paper. Now people are asked to believe in the value of a currency which is almost entirely intangible and which can be created and destroyed by the fiat of central banks.

For a monetary system to continue working, the authorities, whether tribal leaders or central bankers, must defend the monetary faith. In Yap, the currency system was inextricably woven into the complex net of tribal social relations. The rai were trusted as long as – and because – the whole society worked as a unit. The modern system of fiat money and ample credit needs more active support. The authorities must ensure that the financial intermediaries that keep the accounts are trustworthy. Also, they should prevent sharp variations in the value of money (the quantity of stuff which a set sum of dollars or euros can buy).

For the most part, modern societies do these tasks very well. Even after the crisis, the “dematerialised” monetary system has not broken down. However, the crisis experience points to a serious problem: there has been too much tolerance for monetary manipulation. Consider the Money Gallery’s display of counterfeit coins and bills. The exhibit’s curator told me it was one of the most popular. That is hardly surprising; there is something compelling about trying to turn dross into gold, whether though Roman slugs or Bernard Madoff’s Ponzi scheme.

Illegality adds a frisson to the appeal, but legal money creation is also tremendously popular. The pertinent example came ahead of the 2008 crisis. For many years the financial system was allowed to create more funds than the economy needed. The new cash was used to bid up the prices of equities, bonds, houses, oil and other financial assets. Simultaneously, it amounted to a devaluation of money because more dollars or euros were needed to buy the same stuff.

If the monetary faith were pure, the distortion would have been considered sacrilege. Instead, most consumers, companies, savers, borrowers, politicians, central bankers, investment bankers and retail bankers were delighted. They wanted to get in on the game. As in Yap, today’s monetary system is woven into the fabric of society, but the contemporary social fabric has been weakened by the easy acceptance of money that was economically counterfeit.

The enthusiasm for this flimsy money is ultimately antisocial, and lies behind the current disarray of the financial and monetary system. The sequence of financial bubble, financial crisis and desperate financial policies has produced a widespread loss of confidence, and faith, which explains why the economy has been so slow to recover. Economic commitments are avoided because the financial system is distrusted.

A Yappite economist would explain that the official monetary response to the crisis has weakened belief. While financial institutions have not been allowed to fail, neither have they been reformed. They are still widely considered untrustworthy, as the latest uproar over the manipulation of the Libor system makes clear.

Worse, the mix of huge government deficits, irrationally low policy interest rates and abundant money creation amounts to the fiat money equivalent of bringing boatloads of rai onto to the island in the hope that more money will encourage more spending. The technique may work for a while, but the positive effects of such policies – cash-in-hand or stone-at-hand – will be neutralised by realisation that the value of monetary tokens has become more uncertain.

The social fabric behind the monetary system needs to be strengthened. So-called primitive societies such as that of Yap would probably begin with a ritual purification – a few sacrifices, the appointment of untainted high priests of money and a solemn commitment from all to restore the status of rai.

It is not hard to think of equivalents in advanced economies. More bankers could be forced to sacrifice pay and prestige; regulators and central bankers could be chosen for their passionate commitment to financial stability; and politicians could be obliged to swear opposition to all sorts of monetary excess. We should all learn from the stones of Yap.

The headline could have come from a hundred places any time in the last hundred years. “Market has gone wild”, it read. The accompanying news report explains that the price of a crucial financial asset is in “free fall”. Traders and businessmen are calling on the government to step in.

The asset in question could be peripheral euro zone government debt today, global equity markets in early 2009. The wild market could have been soaring rather than falling: the stocks of 1929 and 1999, the house prices in Florida or London in the 2000s, or the supposedly safe government bonds today.

The actual headline comes from a Hong Kong newspaper in 1983, when investors in the then British colony began to fear the worst from a Chinese takeover. The UK’s Minister of State told the locals to “have confidence in yourselves”, but, as today’s Spanish and Italian politicians can ruefully confirm, such rhetoric is not enough to stop an investor stampede. A few weeks later, the Hong Kong authorities did indeed take the matter out of traders’ hands – they fixed the exchange rate between Hong Kong and U.S. dollars.

Under the leadership of Alan Greenspan, the U.S. Federal Reserve took the opposite approach. With a few dramatic exceptions, it trusted the ultimate wisdom of markets. That laissez faire faith was a mistake. If the Fed had intervened to limit house price increases a decade ago, the current economic malaise might well have been avoided.

Interventions are helpful because wild financial markets are one of the worst aspects of the modern economy. Financial asset prices can move fast for no good reason. When they rise too high, they provide misleading signals, which misdirect the flow of investment. When prices fall too far, the damage to the real economy of goods and services can be severe and long lasting. Damage to factories and roads is relatively easy to repair; it only took a few months for the global supply chain to recover from 2011’s severe Japanese earthquake. The damage from the financial crisis of 2008 still lingers.

The financial sector is more fragile than the real economy for two reasons. The first is an unavoidable difference between financial assets and other purchased goods. The perceived value of stocks, bonds and the like depends on the buyers’ dreams and hopes. Dreams often exaggerate reality, for better or worse, and hopes once dashed, are not easily restored. It is much harder to get carried away in the rest of the economy, which deals primarily in actual products in the here and now.

The second reason is an intellectual mistake: an unjustified respect for the wisdom, efficiency and utility of financial markets.  Regulators, economists and much of the general public treat the market prices of shares, bonds and oil like the utterances of an infallible oracle, even when these prices are more like the random demands of an overtired two-year old.

If the financial toddler is not stopped, the tantrum can end in the economic equivalent of broken toys and hysterical tears. A calm parent is needed to calm financial frenzy. The authorities should restrain financial dreams and moderate financial hopes. In other words, they should be bold enough to just say no to markets.

For all the post-crisis talk of financial stability, central bankers and regulators remain shy about using their powers. The European Central Bank, for example, objects on principle to the obvious response to investors’ hysterical flight from some euro zone members’ government bonds: buy the unpopular instruments. The ECB’s hesitation could lead to the demise of the single currency. The right principle is that whenever financial asset prices are moving too fast in either direction, bank regulators and central bankers should feel free to intervene directly in markets, set new requirements for bank capital and loan collateral or print or destroy money.

Such an activist agenda infuriates enthusiasts of free markets, but they should recognise that freedom is often best protected by restraint. In the real economy, the freedom of airlines, food producers and the like is limited by detailed regulations on everything from product safety and labelling to labour practices and environmental impact. The constraints maintain competition that is helpful to society. More restraints on financial markets would make them more capable of doing their real job – allocating capital and setting prices in normal times.

Like parents, financial market overseers will not always get it right. The experts will sometimes exert too little discipline and sometimes too much. But just as toddlers are less trustworthy than fallible parents, overexcited traders deserve less respect than a group of intelligent people with a simple goal – to avoid financial excess.

Dramatic headlines may get most of the attention, but the economy would benefit from more dull ones, along the lines of “Tantrum averted”.

In one corner of the intellectual boxing ring is Stimulo. His fighting words: more economic stimulus. History and theory, he declaims, teach that governments should run much larger fiscal deficits in a downturn. In the other corner is the Cutback Kid, who delivers the opposite message: more austerity. He asserts that history and theory teach that governments should reduce their deficits. The two contestants for the Economic Policy Prize are in the midst of a long fight. Amazingly, they are both losing.

Stimulo has the open-hearted enthusiasm often associated with residents of the United States, for three decades known as the land of big fiscal deficits and small worries. His favourite example is the 1930s Great Depression, which only government spending could end. Now, almost four years after the collapse of Lehman Brothers, GDP growth remains slow and the unemployment rate high. The government deficit, he says, should be increased by as much as necessary to push the economy out of its current stagnation.

The Cutback Kid has a more restrained charm, the sort sometimes associated with suave European intellectuals. He praises the virtue of balanced government budgets: sound finances keep inflation far away, support the value of the currency and promote a strong economy by not stealing savings from the private sector, the source of durable growth. After four years of extraordinarily high government deficits, he says, it’s time to cut back.

There have been no knock-out blows. Neither stimulus nor austerity seems to work as predicted. The United States has tried stimulus and the UK austerity, but the results in both countries have been disappointing. The euro zone, which has tried less stimulus and more promises of austerity than either, has not done any better. Japan has been stimulating for years, without either recovery or inflationary disaster.

Here is a summary of the most recent round: Cutback Kid opens with a one-two punch – first Latvia, where punitive austerity is turning the suffering economy around, and then history, which shows that fiscal contractions often help restore economic growth, while large fiscal deficits usually have bad consequences. Stimulo is not deterred. He ducks Latvia – austerity isn’t really working there – and he punches back with examples of successful borrow-and-grow polices. Then he strikes hard with Greece, where austerity is crushing the economy.

And so it goes on. Stimulo responds to his failures with cries for more of the same, while Cutback Kid demands more policy finesse and more patience, because hard work cures slowly. As they argue, the economic news from almost every rich country does not get better. It’s hard to believe either side really has what it takes to win.

The boxing image fits the pugilistic tone of the stimulus-austerity argument. The protagonists often sound less like calm economists than politicians trying to “diss” their opponents. Indeed, the fervour reflects strongly held political views: the trust in governments and distrust of finance on one side and wariness of government and enthusiasm for fair markets on the other. However, the debate is emotional, not rational. The economic theory on both sides is flimsy and the historical evidence is ambiguous.

The intellectual obscurity is so great that even basic definitions are controversial. Does any fiscal deficit count as “stimulus”, or only increasing deficits? Or is stimulus limited to deficits that go beyond those created by the higher spending and lower revenue that inevitably arrive with an economic slowdown? Do virtuous intentions to reduce deficits count as “austerity”, or only actual reductions? Where does monetary stimulus – low policy interest rates, central bank purchases of debt and support for financial institutions – fit into the picture?

Despite the wild claims from the intellectual boxing ring, no one really knows how to restore financial order and economic health after a financial meltdown in countries which account for half of the world’s GDP. The best that can be said is that policymakers should restore confidence, strengthen institutions, avoid unnecessary financial pressure and reduce debts without destroying the financial infrastructure. The translation of those platitudes into policy is, to put it mildly, not obvious.

History’s lessons are hard to read, but there is one relevant – and frightening – precedent for the current problems: the discrediting of the orthodox 19th century model of laissez-faire capitalism and hard money. The failure started to become clear about a century ago; it then took 40 years – with depressions, great inflations and two world wars – to develop a more stable arrangement.

The post-war system evolved over the subsequent decades into one based on much debt, little regulation, free capital movements and narrowly focussed central banks. The Lesser Depression has discredited this model, and it will take time and imagination to find a replacement. The fight between Stimulo and the Cutback Kid is a pointless diversion from the task.

“Where all good things are bought and sold,” says Michael Sandel, “having money makes all the difference in the world”. And judging by the success of the book he has written based on the premise, the assertion is seductive.

In “What Money Can’t Buy: the Moral Limits of Markets”, the Harvard philosophy professor rails against “market reasoning” and its impact on modern societies. He says that justice suffers because money has become the predominant measure of social as well as economic value. He provides examples such as corporate life insurance policies on employees, advertising in bathrooms and payments for children’s academic success.

Sandel’s reading of contemporary society is wrong, and the examples he deploys are atypical. Overall, morals have been displacing markets, not the other way around. Considerations such as justice and the common good increasingly shape economic arrangements. Even where market reasoning does flourish, for example in the production of cars or food, the standards of social responsibility have steadily risen. Whether or not they are profitable, companies are expected to be good employers and good corporate citizens.

Consider the evolution of marriage. A century ago in most Western countries, spouses were chosen at least as much on economic grounds – dowries and future income – as on romantic ones. Love now rules, to the point that couples often choose impoverishment in divorce over wealth in a loveless marriage.

Marriage is not the only domain where Sandel’s “market reasoning” – the best way to allocate anything is by selling it to the highest bidder – is in retreat. In rich countries, most healthcare is made available at no or low costs to almost everyone, and is allocated on the basis of need, not income. The United States is, admittedly, a partial exception and the high ideals are rarely perfected in practice, but the market’s reasons are never considered the last word.

Education is similar. Students do not have to pay for primary and secondary school, while admission to the best establishments is determined, in theory at least, on the basis of academic merit – not the ability to pay.

According to market reasoning, everything should have a price. If that reasoning were in the ascendant in modern society, then surely everything about the internet, arguably the most impressive technological development in many generations, would be for sale. In fact, while the internet is a big business, the most important applications – search engines, social networks, email and Wikipedia – are made available at no direct cost.

A third claim of market reasoning is that prices are best set at the point where supply is perfectly balanced with demand. That principle is not followed in large parts of what might be the most important market of all, the job market. Supply and demand have only an indirect influence on the pay and career paths of most workers. Seniority and skills matter much more.

Given the evidence, it is puzzling that Sandel’s book, recently reviewed by my Breakingviews colleague Martin Langfield, has made such an impact. Sandel’s judgements about the triumph of crude materialist calculations over higher values should have at least been received more sceptically.

I blame the influence of Karl Marx, not as the founder of communism but as the great prophet of economic alienation. He warned that society would be torn apart by capitalism’s “cash nexus”, which used money to express values, and its “commodity fetish”, which treats all things as being up for sale as long as a price can be agreed.

Marxist claims still resonate, in part for good reasons. The expression of any human relationship in monetary terms is potentially dehumanising. Money really cannot buy love, should not buy sex and may damage the creative efforts of artists. Market reasoning adds selfishness to the picture – in the world of supply and demand it is each man for himself.

However, money and markets also have a good side, which Marx grudgingly admitted and Sandel blithely ignores. Buying, selling and the assignment of prices are effective and reasonably just tools for tying together the economic activity of strangers. The monetary system does not always create the best bond – unpaid voluntary efforts and compulsory arrangements can sometimes be better – but the global economy could not work without it.

The retreat of market reasoning shows that Marx underestimated the popular ability and desire to resist the commodity fetish. Marx also underestimated the future accomplishments of the industrial prosperity which the cash nexus helps create. These gains – modern societies feed the hungry, house the poor, spread knowledge and provide much interesting labour – far outweigh any losses from monetary alienation.

Sandel and other social critics may be right to think that society is damaged, even “broken”, as British politicians sometimes say. But markets and money are not to blame.

Sometimes big news stories seem unbearably dull. The euro crisis is often presented as an apparently endless stream of technical titbits that only a financial geek could love: alchemical recapitalisations of possibly insolvent banks, and the subtle differences between the European Financial Stability Facility and the European Stability Mechanism. But the mind-numbing details hide an exciting drama about the dysfunctional European family of nations.

Think of Greece as the wayward uncle who never seems to settle down and who keeps asking for a little money to tide him over. Spain is a younger sibling, finally interested in school but still reluctant to admit that she needs to change her ways. Italy is a voluble middle child, talented but with a taste for mischief. Germany is the slightly priggish older brother, who has trouble sympathising with his relatives’ weaknesses – although he usually relents in the end.

As in some tribes, the European family has appointed various councils of elders to guide group decisions. For the most part, the central authorities have worked well, but they have to be careful not to anger big brother Germany. Then there is the European Central Bank. When it was set up, most family members thought it would be just another elder-group, but the monetary authority is increasingly behaving like a sort of powerful Godfather to the whole clan.

If those stereotypes don’t please, others are available. The point is that the current debt crisis is a chapter in a story that started more than 2,000 years ago, with the ancient Roman conquest of Gaul and Britain. The European Union is the latest effort to create harmony within a group of diverse personalities, who are tied together by history and location and separated by history and character.

Will this chapter of European history end like that of Romulus and his twin brother Remus, who vied to found Rome? Their family struggle led to fratricide. Murder and war are not on the agenda now. Neither is the traditional technique for papering over European disputes – royal marriages. Instead, the members of the euro zone have to find a modern solution to the mess.

This is a family fight about right and wrong, because debts always raise moral issues. If nothing more prickly were involved than practical issues of regulations or money, as European leaders like to suggest, then there would be no crisis. After all, rules can be changed and the likely losses on the debts are not large by the standard of the euro zone – no more than 1 trillion euros in an economy with an annual GDP about 10 times larger. But behind each disputed detail of the euro crisis lurks an argument about the fair allocation of pain and blame.

This family fight is, naturally, bitter. It’s harder to accept betrayal from a relative than a blow from a stranger. Indeed, the acrimony and mistrust are far more dangerous than the actual bad debts. For the euro zone to survive, the European family must summon up large quantities of mutual goodwill. Their imperfect offerings of support and detailed commitments to fiscal virtue constitute what negotiators call trust-building exercises.

The intervention of an outsider, in the form of the financial markets, has worsened the crisis. European governments don’t only have to deal their internal debts and resentments; they must also persuade investors to continue to provide financial support. Politicians complain that these investors don’t understand how Europe works. That’s right – outsiders can’t really grasp the complexities of family relations. But then again, the politicians should never have thought that outsiders would have stayed faithful.

And the markets interloper is increasingly demanding. Last week, he dismissed the European bailout of Spanish banks, even though the 100 billion euros involved was twice as much as expected just a few weeks earlier. European politicians have been scrambling to create a more unified family front. Indeed, the external threat has provoked them to make more progress towards financial and fiscal unity in the last few months than in the preceding decade. But they have not managed to pacify those pesky investors.

Something more powerful is needed to keep the euro, the most tangible sign of family harmony, from ending in discord. Only the ECB Godfather has what it takes. The central bank might have to abandon some principles, but it has the ability to create enough money to keep governments and the financial system afloat for as long as necessary.

This chapter of the European story still has many tedious details to get through, but it has gone on so long that the only question that still matters is whether or not the ECB stands up for the family.

Stability has been one of the most elusive economic goods. Despite more than a century of effort, economies remain prone to downturns, which often come after booms that proved unsustainable. Rich countries are currently stuck in one of the down periods, a seemingly endless Lesser Depression.

Economists argue about the details of what went wrong, but they often miss something basic: persistent instability is surprising. Surely, societies which summon enough economic ingenuity and organisation to develop smart phones, manage global supply chains and pay for a dozen years of universal education can manage to maintain a steady pace of overall economic activity? All that is required is the identification and early correction of imbalances, in both the real economy and the financial system.

In the pre-industrial age, good macroeconomic management was all but impossible. As long as agricultural activity was the economic mainstay, a poor harvest led not only to less food but to less spending by farmers. Their purchases of ploughs and shoe leather declined, even though a temporary spell of bad weather had no effect on production capacity.

Governments had neither the information nor the resources required to compensate. In any case, monetary counter-moves were impractical when the only reliable money was coins struck from a strictly limited supply of precious metals. Governments and banks could theoretically give farmers paper money to buy readily available goods, but the currency would not be trusted.

More recently, economic instability could be blamed on ignorance and immature institutions. In particular, the mechanisms of financial excess, the cause of most of the crises of the last century, were poorly understood. While economists knew that speculation was dangerous, their analysis was primitive. In addition, governments were slow to put detailed regulation of the financial system on their list of responsibilities.

Now, though, booms and declines are inexcusable. Farming plays a minimal role in advance economies, and no significant sector is subject to large natural variations of output. On the contrary, far more than half of GDP is spent on services, which tend to be purchased very steadily. Statistics are ample, so economists can easily identify anomalies. Governments are well informed, dominate the economy and have full monetary flexibility.

Twice in the last half-century, experts thought they had found the secret to good macroeconomic management. In the 1960s they put their faith in the “fine-tuning” of monetary and fiscal policy. In the 2000s, they saw a “great moderation” come from inflation targeting, relaxed central banks and unencumbered financial institutions. After the latest failure, the professionals have mostly fallen back to their previous belief in unavoidable cycles of exuberance and depression. Like mood swings in love affairs, economic ups and downs are considered unfortunate facts of life.

The defeatism is unnecessary. Motor vehicle fatalities provide a good precedent. Starting in the 1960s, a coordinated campaign, including both behaviour modification and improved engineering, has succeeded in reducing the death rate in the United States (as a fraction of the total population) by more than half. Economic deviations can be reduced by much more.

Drivers were cajoled to change their behaviour: stop drinking, wear seat belts and reduce speeds. Economic actors can also learn that excessive enthusiasm, like reckless driving, eventually leads to trouble. Anti-greed education can teach that immoderate financial gains are bad for society and are likely to be followed by even larger losses.

The lessons should be backed by corrective policies. The authorities must be committed to use regulation, taxes and fiscal and monetary policy to stomp hard whenever any significant financial and economic indicator moves in a dangerous direction. The short current watch-list of consumer inflation, GDP growth and unemployment should be lengthened to include the prices of property, debt, shares and commodities. Rates of change in lending and financial activity are also important.

The engineering of the financial and economic system needs the same sort of upgrade that car and road design got when safety became a higher priority. Errors, of both drivers and investors, are less dangerous on safer roads. The economic authorities should develop automatic stabilisers to limit herd behaviour. They have the tools. They can both create and destroy money and credit. In the face of mob gloom, they can create new jobs, either directly or indirectly.

Defeatism should be replaced by a firm commitment to economic safety. Sadly, there are few signs of such a change. For all the talk about “macro-prudential regulation”, economists and politicians are still reluctant to restrain financial dreams. Monetary authorities balk at taking full advantage of their powers.

Ultimately, something like moral cowardice lies behind this unnecessary restraint, and behind the recurrence of financial crisis. The pattern cannot be broken until the authorities decide to identify and attack reckless financial behaviour wherever it occurs. The failure is discouraging, but there’s no need to abandon hope. Like driver safety, and like the legal protection of workers and the restriction of pollution, economic stability is an idea whose time will come.

Debt, a little like sex, is a two-sided relationship which, when used appropriately, pleases the partners and is good for society. But both are also intoxicating and can easily become excessive and anti-social.

The financial bubble of the 2000s was the financial equivalent of the 1960s enthusiasm for “free love”. The delights of nearly free debt set pulses racing. Since the financial collapse, the dangers of uncontrolled borrowing have been recognised, but the bad habits have hardly changed.

When debt is used as it should be, lenders receive a just return on their assets and borrowers pay a just price for the use of the fruits of other people’s labour. Loans finance helpful investments and assist governments and individuals to manage periods of adverse fortune. But debt can also be used for promiscuous pleasure-seeking, unaffordable consumption, unjustified corporate investments and excessive government spending.

In the recent debt party, the United States led the world. The ratio of total U.S. debt (private, corporate and government) to GDP increased from 256 to 373 percent between 1997 and 2008, according to Federal Reserve calculations. The whole country borrowed from foreigners to fund its trade deficit. The financial sector borrowed cheaply and invested dangerously to increase returns and remuneration. Homeowners borrowed more and more to buy more expensive houses.

At first, all this indulgence appeared to be beneficial. GDP growth was strong, consumption was high, unemployment was low and higher asset values – the other side of higher debts – made borrowers feel richer. But when Lehman Brothers failed in 2008, the dangers of frequent debt relations with multiple financial partners became clear. With everyone borrowing from each other, losses on bad loans, and the fear of further losses, spread rapidly around the world. A Lesser Depression set in, and there is no end in sight.

Despite much talk about the end of an era of hedonistic borrowing, financial rectitude remains a distant prospect. Governments have stepped up borrowing just about as much as the private sector has cut back. In the United States, debt remains an alarmingly high 359 percent of GDP.

What can be done to restore financial order? For irresponsible borrowing, a sudden outbreak of prudence would probably aggravate the economic problem. The economist John Maynard Keynes called it the paradox of thrift. If everyone tries to save more and spend less, the result will be a decline in total consumption, which leads to higher unemployment and then to more saving against rainy days. The desire to prevent such a spiral of decline lies behind the today’s low official interest rates, high government borrowing and generous support for banks.

These policies are supposed to spur enough GDP growth to reduce debts without economic pain. That sound like wishful thinking. As long as debts remain high overall, the whole financial structure will remain vulnerable and full recovery elusive. The euro zone crisis shows just how little it takes – a few small weak governments and some political wavering – to frighten lenders and deeply disrupt developed economies. With so much leverage about, other crises will be almost unavoidable.

What is needed is a large and fast decline in borrowing – a systemic deleveraging – to give over-indebted rich nations a fresh start. Sadly, there is no easy way to proceed. A gigantic debt write-down would do the trick, but creditors would be furious. Think of how the Chinese government would feel about being told that its $2 trillion dollars of U.S. government debt is now worth half as much, or how current and future pensioners would react to big losses in portfolios they thought were safe.

Mandatory inflation – say a law which doubled all wages tomorrow – would also reduce the ratio of debt to GDP, and would also infuriate savers and creditors. Alternatively, newly minted money could be used to stimulate economic activity through the creation of new jobs and the repayment of old debts. However, when governments feel free to create rather than to borrow money, they rarely stop before the rate of inflation rises dangerously high.

All of these techniques for deleveraging are risky. But I believe a clever and internationally coordinated combination of debt write-downs, inflation and controlled money creation is the best way to engineer a durable decline in leverage without destroying financial trust. Such radical techniques could work, given enough political support and sufficiently imaginative regulation.

The alternative to daring action along these lines is the continuation of something like the current policies. That amounts to persisting with the “nearly free debt” experiment, which will only lead to years of depressed economic activity and outbreaks of unpredictable financial losses. It’s worth trying something new and different to put debt back in its rightful place.

In the labour market, there is a fine line between inefficiency and wastefulness. “This place is so inefficient,” it is said, often with justification, especially in rich economies. “We could do everything we’re supposed to with a third fewer people.” Factories can be streamlined, high quality new equipment can save on labour, and offices are prone to the incubation of worthless bureaucracy.

It also said, sometimes by the same people, that “The unemployment situation is terrible. My young friends can’t get jobs and lots of not-so-old people I know are retiring early.” Such statements are also accurate. In many countries, the Lesser Depression has sharply worsened a longstanding problem of inadequate job creation. Spain’s official unemployment rate is 24 percent. Almost half of the young adults in Greece are jobless. And the employed portion of the working age population in the United States has fallen by three percentage points over the last four years.

Politicians and other leaders have watched the job destruction with something like horror. They shouldn’t have been surprised. The unending fight against inefficiency leads to a natural employment asymmetry. As technology advances, businesses and governments usually find it easier to cut than to add jobs. Some businesses can progressively expand headcount, but in tough times there are more employers looking for ways to use less labour.

Most politicians and economists believe that GDP growth is the cure. It is considered not only the highest economic good but also the best way to create jobs. In search of higher output, governments run huge deficits, while central banks pass out money for free. The policymakers often invoke the name of John Maynard Keynes. But they twist the great economist’s ideas. As Pavlina Tcherneva points out in a recent article in the Review of Social Economy, Keynes thought “the real problem” governments should address during the Great Depression was “to provide employment for everyone”. In Keynes’s view, output follows jobs, not the other way around.

Keynes’s own preferred solution was for governments to organise projects with a high “elasticity of employment”. “There are things to be done; there are men to do them,” he said. “Why not put the two together? Why not put the men to work?” The best way for governments to create jobs quickly is still to hire people directly. A look at the dilapidated infrastructure of the United States suggests that Keynes’ prescription is still relevant.

Enthusiasts for small government might want to privatise such programmes, but they should still agree with the true Keynesian principle: it is better to pay people to work than to pay them not to. Programmes which protect the unemployed and disabled serve a valuable social purpose and payments for early retirement may be defensible, but programmes which create jobs are far preferable to either.

This Keynesian message has largely been lost in the current official policy mix, which aims at growth and hopes for jobs. Policies which support the financial system, put money in consumers’ hands and cut bloated government bureaucracies may eventually encourage job creation. Four years into the Lesser Depression, however, these highly indirect methods are at best working slowly.

Employment asymmetry should be attacked more directly. Governments are even better placed to lead the charge than in Keynes’s day because their economic role has expanded so much. An eight-year experiment in Germany shows the power of relatively minor tweaks to the rules on jobs and benefits. Little more than tougher conditions for unemployment benefits and more helpful employment agencies have cut the number of people unemployed for more than a year from 1.7 million, about 4 percent of the potential workforce, to 800,000.

The precise German recipe is not applicable everywhere, but the principle is. The prime goal of government economic policy should be to fight the natural employment asymmetry of industrial economies. Lower taxes on workers’ income would make new jobs cheaper for employers and more lucrative for employees. In many countries, more stringent limitations on benefits would also help. Almost everywhere, the desire to establish and expand enterprises should be encouraged. In the United States, it would be helpful to find a way to give the rich a smaller share of the nation’s income. The money they don’t receive could be paid out to workers in newly created jobs.

The employment problems of the Lesser Depression are not grave enough to require a major reconsideration of the economy’s goals. A combination of short-term programmes and more gradual shifts in regulation and taxation should do the trick. But as the economy becomes more efficient, the surplus of labour is likely to become a more pressing social challenge. Keynes wondered “how to organise material abundance to yield up the fruits of a good life.” The answer is certainly not found in frequent periods of wastefully high unemployment.

On September 15, 2008 Lehman Brothers collapsed in a heap, a bankruptcy that was followed by a recession in most rich countries. As time goes on, the severity of the disruption becomes both more apparent and more puzzling.

When Lehman failed, it was reasonable to expect the pain to be brief and concentrated. While too many houses had been built in the United States, most of the world’s real economy (comprising factories, offices, retail outlets, construction projects) was doing well. The global financial sector was more distorted, even before investors took fright at the decision to let Lehman go under. But by the middle of 2009, governments and central bankers had agreed to provide bankers and brokers with anything needed to keep them healthy.

Optimism was not justified. Although the countermeasures stopped the deterioration, the rich world now seems stuck in a Lesser Depression – many years of poor economic results and a series of financial crises. In the United States, the euro zone, Japan and the UK, real GDP per person is still lower now than it was four years ago. In all of them, GDP growth is currently either slow or non-existent.

The consumption setback shouldn’t cause too much concern – it wasn’t so bad five or six years ago, when real GDP was last at today’s level. But the enduring recession in the labour market is another matter.

In April 2008 the unemployment rates in the United States, euro zone and UK were respectively 5, 7.3 and 5.3 percent. In April 2012, the corresponding percentages were 8.1, 10.9 and 8.4. More refined indicators – youth unemployment, involuntary part time work and disaffected ex-workers – are even more discouraging. The post-Lehman economy is failing a significant number of people in a fundamental way.

Some economists argue that this real suffering is the necessary price to pay to bring order to the financial world. That’s a dubious argument, since people are more important than money and credit. But the ethical debate isn’t necessary. Despite the real economic pain and the official aid, the financial world looks as ill as ever. On the monetary side, policy remains in shock territory – buyers of safe government debt receive negative real returns. Fiscal positions are equally alarming. Deficits everywhere remain at levels more suitable for wartime mobilisation than for a sputtering economy.

The puzzle is why a relatively small problem in the real economy has led to this Lesser Depression, especially when the authorities have followed expert advice throughout. Surely, if the counsel were sound, the depression would have lifted by now.

The experts offer several excuses. One is that the euro zone’s special problems have delayed recovery. That’s probably true, but European politicians and central bankers are following the best advice on how to compensate. Another is that the authorities should have been even more aggressive in their support for the financial system. Maybe, but even larger fiscal deficits and even easier money would create other distortions. Yet another claim is that governments should have cut back their spending faster. Possibly, but that would hit consumption harder and further increased unemployment.

The problem is actually the experts. Recent history provides a good reason to doubt their competence. Five years ago, economic gurus saw no end to the pre-Lehman “Great Moderation” – steady GDP growth, shrinking unemployment and rising asset prices. They were wrong about that, and they are still making two basic mistakes.

The first concerns the real economy, in particular the highly productive modern economy. Economists underestimate the difficulty of keeping unemployment down. It is much easier to destroy jobs, with labour-saving devices and more efficient procedures, than to create them by starting up enterprises, finding customers for new services or creating new bureaucracies. The employment asymmetry accounts for the persistent pain in the labour market. The jobs shed at the beginning of the Lesser Depression are not easily replaced, nor are the jobs currently being cut by governments searching for austerity.

The second mistake is financial. Economists underestimate the danger of debt. Whether the money is owed by companies, households or governments, the disadvantages of debt financing increase as the ratio of liabilities to income rises. Heavily indebted borrowers are less eager to take economic risks and more likely to default. In a highly leveraged and financially interconnected economy, one default often leads to other bigger collapses. In short, massive debts almost invite economic paralysis. It’s hardly surprising that the increase of debt-financed government spending has done so little good.

So what should be done? New ideas are required – and I’ll offer my contributions over the next few weeks. Without a fundamental change in the thinking, the global economy won’t reach its goal of steady growth and low unemployment.