There comes a time when tinkering with policy will simply not do. The problems become so grave and intractable that a change is required in the very framework of policy thinking. We in Pakistan and indeed the world are at such a moment. It may therefore be instructive to see how a change occurs in the mode of thought in economics.

It can be argued that John Maynard Keynes brought about a revolution in the science of economics in the 1930s by changing the prevalent “Classical” paradigm. The Classicists postulated that unfettered markets constituted the most efficient framework for resource allocation. It followed that governments should not intervene into markets. This view got into trouble during the 1930s when massive unemployment hit the free market economy. Within the Classical model, all you had to do to remove unemployment was to let wages fall, and more workers would be employed. Yet unemployment continued to rise even though wages were falling.

Along came Keynes a Cambridge economist, who changed the paradigm in a situation where the old one had failed. He argued that employment was not determined in the labour market, but was the result of capitalists’ decision to invest. If aggregate demand at present is low and therefore capitalists do not expect to make profits in future, they would refrain from investment, thereby resulting in underutilized production capacity and hence unemployment. The Keynesian paradigm created the space for government intervention: If the private sector investment was inadequate, then the government must step in to fill the gap in the level of investment required to achieve full employment. The governments in Europe and the US accepted this new thinking, undertook major public expenditure programs, and the world pulled out of the ‘’Great Depression’’.

In the next fifty years, belief in the efficacy of free markets re-emerged under the rubric of Neo- Classical economics. It began to dominate thinking in many governments as well as multilateral organizations. 

In the context of Neo-Classical economics it was of course anathema to regulate markets. This view continued to hold sway, even though a structural shift occurred in the world economy:  the financial sphere from being a relatively minor stratum became by the late twentieth century, bigger than the real economy. The fragility occurred because of two reasons: (a) In the financial sphere there was a greater possibility of banks and individuals taking speculative risks. (b) Unbeknown to the individual investor was the fact that individual risks were inter-linked at the macroeconomic level. Because of the inherent difficulty of estimating systemic risk, banks in failing to take it into account were actually taking much bigger risks than they imagined.

Instead of regulating the financial sphere in the face of this new fragility, the financial markets were further deregulated. For example, the Glass-Steagall Act of 1933 in the U.S. which had forbidden retail banks to engage in imprudent investments such as selling securities was repealed in 1999.

In an unregulated market environment and spiraling risks, the financial edifice began to collapse. The drama began on 18 September 2007 at 11 am when there was a run on banks as USD 550 billion were withdrawn from U.S. banks in one hour. Robert Skidelsky has quoted the Chairman of the U.S. Congress Sub-committee on Capital Markets.  If the U.S. Treasury had not stopped banking operations alongwith a guarantee of USD 250,000 per account to restore confidence by 2 p.m., it  “….would have collapsed the entire economy of the U.S. and within 24 hours the world economy would have collapsed...”

There are three key lessons of the present economic crisis: First, to prevent recurrent and disastrous market failures, markets must be embedded in sound regulatory institutional structures. Second, public spending to be sustainable must be underpinned by institutions for increasing the efficiency of this expenditure. Third, it is not the budget deficit per se that is the problem, but the composition of the deficit: It is necessary to increase the share of productive expenditure and reduce the share of unproductive expenditure in fiscal allocations.