Paul Davidson is Holly Chair of Excellence in Political Economy, Emeritus, at the University of Tennessee, US.  

​​​​​​​​​​​​​​His latest book Who's Afraid of John Maynard Keynes? Challenging Economic Governance in an Age of Growing Inequality (2017, Palgrave Macmillan) addresses this topic and presents a contemporary solution to restoring global economic balance. The following is an adapted extract from this book.

At the dedication of a new building at the London School of Economics (LSE) in 2008, Queen Elizabeth of Great Britain asked why nobody noticed the 2007-8 global financial crash developing. The director of research at LSE told her “At every stage someone was relying on somebody else and everyone thought they were doing the right thing”. How is it possible that the many intelligent investors, bankers, brokers, pension fund managers and other financial market participants thought they were doing the “right thing”, when it is clear from hindsight that financial market activity was creating a situation that ultimately caused global financial markets to collapse and result in the worse global economic performance since the Great Depression? Why did not any of the many Nobel Prize Laureates in Economics warn governments and the public of this forthcoming global economic storm?

The answer is that the mainstream economic theory that has dominated academic teaching, Nobel Laureate research, mainstream professional economic journals and the thoughts of financial market professionals and journalists is not applicable to the economic system in which we live. Consequently what was seen as a way of doing good in this theory of a fictional non-existent economy created destructive economic forces in the economic world in which we live.

There are a few economists, however, that have a better understanding of how the modern market economy works. These economists call themselves Post Keynesians since they use and further develop the general theory that, in 1936, the English economist John Maynard Keynes originated to explain why the financial crash of 1929 caused the Great Depression that encompassed the global economy. Before the economic crash, Post Keynesian economists publically warned that modern financial markets were creating an unstable situation that, sooner or later, was going to cause a terrible financial crisis.  

In my 2017 book entitled Who’s Afraid of John Maynard Keynes? I specifically noted that in a publication I wrote in 2002, it was obvious that many newly formed financial markets (e.g., for mortgage backed derivative securities) that were being advertised as liquid in that these derivative securities could be readily saleable for cash were creating a problem. My analysis was based on my Post Keynesian interpretation of Keynes’s theory of the importance of maintaining liquidity in order to have enough money to be able to settle contractual obligations as they come due.

Investment bankers, however, had created and sold to the public mortgage backed derivative securities. These derivatives were advertised to be “as good as cash” and also were rated AAA by financial rating agencies. This encouraged the buying public to believe that these securities were very liquid for they could be readily resold in the market for cash. If, at any time in the future, the derivatives asset holders wish to make a fast exit to obtain cash that they can then readily spend on any future contract that comes due.  Unfortunately, the markets for these derivative securities were not organized in a way that assured resale at orderly price movements was always possible. This potential lack of price orderly movements in resales were, I warned, creating the possibility of a forthcoming horrendous financial crisis.

As I explain in detail in my 2017 book, the bad aspect of these derivative securities markets was that, in circumstances when many holders of these “liquid” financial assets suddenly have increasing fears about what may happen in the uncertain economic future, then the liquidity of these derivative financial assets can evaporate. If many derivative security holders rush to sell in the market while  buyers disappear from these financial markets, the result is the market price of these assets can rapidly fall in a disorderly manner. This will result in severe economic liquidity and insolvency problems. To maintain price orderliness in any financial market there must be built in a “market maker” institution to offset extreme sell pressure and thereby assure orderliness and liquidity. These derivative markets failed to provide a market maker and so when selling pressures increased the price fell in a disorderly rapid manner.