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Interview: Jane Knodell

Provost's new book offers heterodox theories on the 2008 financial crisis

Provost Jane Knodell
"We need some new kinds of financial institutions that aren’t completely profit-driven and have a more mission-based focus," says Provost Jane Knodell, professor of economics, whose new book provides an alternative look at the "why" and "what's next" of the latest financial crisis. (Photo: Sally McCay)

There’s been a multitude of theories why the financial crisis of 2008 occurred and numerous proposed reforms designed to prevent another one. Heterodox economists – those who analyze and study non-mainstream economics such as post-Keynesian economics and Marxian economics – were sounding warning bells well in advance of the recent recession, and have no shortage of proposals for how to create a more stable and sustainable economy.

A new book, Heterodox Analysis Of Financial Crisis And Reform, co-edited by Jane Knodell, professor of economics and provost and senior vice president, sheds new light on why the crisis occurred by examining the history of past financial crises and providing theoretical analysis and plans for reform. Knodell, an expert in money and banking, macroeconomics, economic history and in understanding the evolution and performance of monetary institutions over time, and other heterodox experts selected 12 presentations out of 50 given at the 2009 bi-annual Cross-Border Post Keynesian Conference at Buffalo State College to serve as the chapters of the new volume.

UVM Today recently sat down with Knodell, who co-wrote the introduction, to talk about the book from Edward Elgar Publishing Limited.

UVM Today: In the introduction, you write that the purpose of the book is to “bring forward one fundamental truth: that is, that the financial system is inherently unstable.” Can you elaborate?

Mainstream economists generally believe that markets are efficient and that they will self-adjust, and that if they get out of balance, then that will trigger some process that gets it back into balance. It’s the idea of self-equilibrating. Heterodox economics and everyone who wrote and participated in this volume thinks that a capitalist financial system is intrinsically unstable, and that because it’s inherently unstable, it will tend to get itself into trouble. Once it’s out of equilibrium we can think of lots of reasons why it will get more out of equilibrium and struggle to get itself back.

You also wrote that the U.S. hasn’t learned its lesson from past financial crises, largely because they were taught by heterodox economists whose writings were ignored by many in the profession, adding that Federal Reserve Chairman Ben Bernanke and Mervyn King (head of the British central bank) contributed to some of the earlier heterodox literature yet “neither learned their lessons well enough when it came down to apply what they learned.” Why is that? Too much pressure from Wall Street?

It was probably too late for Bernanke to do much about it since he came in at the end of the process. It was probably more on (Alan) Greenspan’s head than Bernanke’s. For one, they are no longer studying the economy, but are in an action, policy-making role and are spending a lot time with people who probably don’t have a heterodox perspective. A lot of this lack of (heterodox) policy is due to international competition. If you overregulate then all of the financial firms in New York will say, ‘Fine, we’re just going to move to London or Frankfurt or Tokyo.' What is really needed is a new international financial architecture. Since the period coming out of World War II up until the 70s we’ve had what is known as the Bretton Woods system of monetary rules (for commercial and financial relations among the world's major industrial states), which was a stable international foundation and it worked pretty well. But economies change, and finance is always looking for profits and ways of getting around regulations and that will undermine regulatory regimes, so you need a new one.

Should we be updating our own financial system and international monetary systems like Bretton Woods more frequently so we’re not forced to administer Band-Aid policies when crisis strikes?      

We had to do TARP (Troubled Asset Relief Program) because we got in a position where we had a liquidity crisis, and we had to respond. The Fed was actually pretty creative and developed some new mechanisms for responding to a crisis. Interestingly, UVM alum Brian Sack ’92, who is now the head of the government bond trading desk, was in the middle of all this at the time. So while there are always crises that have similar broad characteristics, it’s also true that each crisis is an entity unto itself. The system is always evolving and prone to crisis, but the economy is also always changing. For example, you didn’t have the subprime market in 1929, and that was a major source of the instability in 2008. Looking back it seems so obvious, but when it was happening everyone was saying, ‘This is great – housing prices are going up, our wealth is going up.’ But there were some minority voices within the heterodox community saying ‘This is a bubble, this is a bubble’ while everyone else was saying no. Well, it was definitely a bubble.

In Chapter 4, William T. Ganley cites increasing speculation on securities, deregulation in favor of Wall Street, and policy makers’ false belief in efficient markets as the primary reasons for both the crash of 1929 and the recession of 2008. Is it impossible to correct past mistakes if the system is the same?

Economics as a discipline needs to develop more research that focuses on understanding how systems work. Complex systems is a way to get at this and would help develop smarter regulators who could see sources of instability before it develops into a full-blown crisis. New knowledge is part of the answer, but we also need the political will internationally for the leaders to really get together and say, 'Okay, let’s work together as the leaders of governments and create a new regime that’s going to really constrain finance.’ A lot of people agree that the financial sector has gotten too big.

That relates to the section about the rise of the "money manager" and the need to manage the increasing amounts of retirement wealth instead of supporting real industrial production. How do you turn a system with a growing number of money managers who, as is stated in the book, act as parasites on real production?

We need some new kinds of financial institutions that aren’t completely profit-driven and have a more mission-based focus like the Vermont Community Loan Fund. It’s a very small intermediary, but its mission is not to grow and make a lot of profit. Its mission is to get capital to certain underfunded, important segments of the Vermont economy. There are lots of ways you could design different kinds of financial institutions. There’s been a lot of work done on pension systems and how some of them invest in sectors of the economy to support the state like the California retirement system, which allocates some of its portfolio to affordable housing and things that benefit its members. It’s really a question of your priorities.

In many ways your job as provost is a financially based position. Is there anything in the book relatable to UVM?

Obviously the financial crisis and the aftermath have dramatically changed the environment for higher education. The pace at which we are able to get ourselves out of the hole will really affect our ability to do what we want moving forward. So it’s relevant in that you really need to know what’s going on in your own environment, but it’s also relevant in the sense of what’s the new knowledge that UVM can help create to try to help prevent something like this from happening again that has been so devastating to so many people. It’s not as simple as ‘There are a lot of bad people on Wall Street and it’s all because of greed.’ The incentive structures were all wrong in these firms, and there was intense competitive pressure among the firms. But there are things we can do as a society to create a design for a better system; we can’t just regard ourselves as powerless in the face of these phenomena. From a research point of view, maybe within complex systems, there’s a role to play. When we teach financial history to our students who go into the market and trade on a daily basis, we are sending our kids out with important historical perspective that’s hopefully going to help them and their firms from making mistakes of the past.

What other research are you pursuing?

I’m working on a paper that I’ll present at a conference in Paris in March organized by the Bank of France. The theme of the conference is central banks and nationhood with a focus on how central banks can support nation states. There will be a lot of people there who are in the European Union, so it’s pretty timely given what’s going on over there right now. There is a European central bank, but because there are separate nation states under it, it has been causing some problems. In the United States, we have a central bank (Federal Reserve), which makes things easier for us. So my paper is looking at the very earliest decades of the United States coming out of the Revolutionary War when establishing the U.S. as a separate monetary entity meant developing our own monetary unit – the dollar, which is something we take for granted. But during the Colonial period we still used the monetary unit of England – the pound, shillings and pence. So my paper is about shifting from the Colonial currency to having our own dollar fully diffused throughout the economy. It ended up taking about 60 years to fully get rid of all foreign money circulating within the U.S. economy. Foreign coin was legal tender until 1857. The question is why did it take 60 years? I’ll be exploring that more in-depth.