How economics became a religion

John Rapley in The Guardian



Although Britain has an established church, few of us today pay it much mind. We follow an even more powerful religion, around which we have oriented our lives: economics. Think about it. Economics offers a comprehensive doctrine with a moral code promising adherents salvation in this world; an ideology so compelling that the faithful remake whole societies to conform to its demands. It has its gnostics, mystics and magicians who conjure money out of thin air, using spells such as “derivative” or “structured investment vehicle”. And, like the old religions it has displaced, it has its prophets, reformists, moralists and above all, its high priests who uphold orthodoxy in the face of heresy.

Over time, successive economists slid into the role we had removed from the churchmen: giving us guidance on how to reach a promised land of material abundance and endless contentment. For a long time, they seemed to deliver on that promise, succeeding in a way few other religions had ever done, our incomes rising thousands of times over and delivering a cornucopia bursting with new inventions, cures and delights.

This was our heaven, and richly did we reward the economic priesthood, with status, wealth and power to shape our societies according to their vision. At the end of the 20th century, amid an economic boom that saw the western economies become richer than humanity had ever known, economics seemed to have conquered the globe. With nearly every country on the planet adhering to the same free-market playbook, and with university students flocking to do degrees in the subject, economics seemed to be attaining the goal that had eluded every other religious doctrine in history: converting the entire planet to its creed.

Yet if history teaches anything, it’s that whenever economists feel certain that they have found the holy grail of endless peace and prosperity, the end of the present regime is nigh. On the eve of the 1929 Wall Street crash, the American economist Irving Fisher advised people to go out and buy shares; in the 1960s, Keynesian economists said there would never be another recession because they had perfected the tools of demand management.

The 2008 crash was no different. Five years earlier, on 4 January 2003, the Nobel laureate Robert Lucas had delivered a triumphal presidential address to the American Economics Association. Reminding his colleagues that macroeconomics had been born in the depression precisely to try to prevent another such disaster ever recurring, he declared that he and his colleagues had reached their own end of history: “Macroeconomics in this original sense has succeeded,” he instructed the conclave. “Its central problem of depression prevention has been solved.”

No sooner do we persuade ourselves that the economic priesthood has finally broken the old curse than it comes back to haunt us all: pride always goes before a fall. Since the crash of 2008, most of us have watched our living standards decline. Meanwhile, the priesthood seemed to withdraw to the cloisters, bickering over who got it wrong. Not surprisingly, our faith in the “experts” has dissipated.

Hubris, never a particularly good thing, can be especially dangerous in economics, because its scholars don’t just observe the laws of nature; they help make them. If the government, guided by its priesthood, changes the incentive-structure of society to align with the assumption that people behave selfishly, for instance, then lo and behold, people will start to do just that. They are rewarded for doing so and penalised for doing otherwise. If you are educated to believe greed is good, then you will be more likely to live accordingly.

The hubris in economics came not from a moral failing among economists, but from a false conviction: the belief that theirs was a science. It neither is nor can be one, and has always operated more like a church. You just have to look at its history to realise that.

The American Economic Association, to which Robert Lucas gave his address, was created in 1885, just when economics was starting to define itself as a distinct discipline. At its first meeting, the association’s founders proposed a platform that declared: “The conflict of labour and capital has brought to the front a vast number of social problems whose solution is impossible without the united efforts of church, state and science.” It would be a long path from that beginning to the market evangelism of recent decades.

Yet even at that time, such social activism provoked controversy. One of the AEA’s founders, Henry Carter Adams, subsequently delivered an address at Cornell University in which he defended free speech for radicals and accused industrialists of stoking xenophobia to distract workers from their mistreatment. Unknown to him, the New York lumber king and Cornell benefactor Henry Sage was in the audience. As soon as the lecture was done, Sage stormed into the university president’s office and insisted: “This man must go; he is sapping the foundations of our society.” When Adams’s tenure was subsequently blocked, he agreed to moderate his views. Accordingly, the final draft of the AEA platform expunged the reference to laissez-faire economics as being “unsafe in politics and unsound in morals”.

 

‘Economics has always operated more like a church’ … Trinity Church seen from Wall Street. Photograph: Alamy Stock Photo

So was set a pattern that has persisted to this day. Powerful political interests – which historically have included not only rich industrialists, but electorates as well – helped to shape the canon of economics, which was then enforced by its scholarly community.

Once a principle is established as orthodox, its observance is enforced in much the same way that a religious doctrine maintains its integrity: by repressing or simply eschewing heresies. In Purity and Danger, the anthropologist Mary Douglas observed the way taboos functioned to help humans impose order on a seemingly disordered, chaotic world. The premises of conventional economics haven’t functioned all that differently. Robert Lucas once noted approvingly that by the late 20th century, economics had so effectively purged itself of Keynesianism that “the audience start(ed) to whisper and giggle to one another” when anyone expressed a Keynesian idea at a seminar. Such responses served to remind practitioners of the taboos of economics: a gentle nudge to a young academic that such shibboleths might not sound so good before a tenure committee. This preoccupation with order and coherence may be less a function of the method than of its practitioners. Studies of personality traits common to various disciplines have discovered that economics, like engineering, tends to attract people with an unusually strong preference for order, and a distaste for ambiguity.

The irony is that, in its determination to make itself a science that can reach hard and fast conclusions, economics has had to dispense with scientific method at times. For starters, it rests on a set of premises about the world not as it is, but as economists would like it to be. Just as any religious service includes a profession of faith, membership in the priesthood of economics entails certain core convictions about human nature. Among other things, most economists believe that we humans are self-interested, rational, essentially individualistic, and prefer more money to less. These articles of faith are taken as self-evident. Back in the 1930s, the great economist Lionel Robbins described his profession in a way that has stood ever since as a cardinal rule for millions of economists. The field’s basic premises came from “deduction from simple assumptions reflecting very elementary facts of general experience” and as such were “as universal as the laws of mathematics or mechanics, and as little capable of ‘suspension’”.

Deducing laws from premises deemed eternal and beyond question is a time-honoured method. For thousands of years, monks in medieval monasteries built a vast corpus of scholarship doing just that, using a method perfected by Thomas Aquinas known as scholasticism. However, this is not the method used by scientists, who tend to require assumptions to be tested empirically before a theory can be built out of them.
But, economists will maintain, this is precisely what they themselves do – what sets them apart from the monks is that they must still test their hypotheses against the evidence. Well, yes, but this statement is actually more problematic than many mainstream economists may realise. Physicists resolve their debates by looking at the data, upon which they by and large agree. The data used by economists, however, is much more disputed. When, for example, Robert Lucas insisted that Eugene Fama’s efficient-markets hypothesis – which maintains that since a free market collates all available information to traders, the prices it yields can never be wrong – held true despite “a flood of criticism”, he did so with as much conviction and supporting evidence as his fellow economist Robert Shiller had mustered in rejecting the hypothesis. When the Swedish central bank had to decide who would win the 2013 Nobel prize in economics, it was torn between Shiller’s claim that markets frequently got the price wrong and Fama’s insistence that markets always got the price right. Thus it opted to split the difference and gave both men the medal – a bit of Solomonic wisdom that would have elicited howls of laughter had it been a science prize. In economic theory, very often, you believe what you want to believe – and as with any act of faith, your choice of heads or tails will as likely reflect sentimental predisposition as scientific assessment.

It’s no mystery why the data used by economists and other social scientists so rarely throws up incontestable answers: it is human data. Unlike people, subatomic particles don’t lie on opinion surveys or change their minds about things. Mindful of that difference, at his own presidential address to the American Economic Association nearly a half-century ago, another Nobel laureate, Wassily Leontief, struck a modest tone. He reminded his audience that the data used by economists differed greatly from that used by physicists or biologists. For the latter, he cautioned, “the magnitude of most parameters is practically constant”, whereas the observations in economics were constantly changing. Data sets had to be regularly updated to remain useful. Some data was just simply bad. Collecting and analysing the data requires civil servants with a high degree of skill and a good deal of time, which less economically developed countries may not have in abundance. So, for example, in 2010 alone, Ghana’s government – which probably has one of the better data-gathering capacities in Africa – recalculated its economic output by 60%. Testing your hypothesis before and after that kind of revision would lead to entirely different results.

 

‘The data used by economists rarely throws up incontestable answers’ … traders at the New York Stock Exchange in October 2008. Photograph: Spencer Platt/Getty Images

Leontief wanted economists to spend more time getting to know their data, and less time in mathematical modelling. However, as he ruefully admitted, the trend was already going in the opposite direction. Today, the economist who wanders into a village to get a deeper sense of what the data reveals is a rare creature. Once an economic model is ready to be tested, number-crunching ends up being done largely at computers plugged into large databases. It’s not a method that fully satisfies a sceptic. For, just as you can find a quotation in the Bible that will justify almost any behaviour, you can find human data to support almost any statement you want to make about the way the world works.

That’s why ideas in economics can go in and out of fashion. The progress of science is generally linear. As new research confirms or replaces existing theories, one generation builds upon the next. Economics, however, moves in cycles. A given doctrine can rise, fall and then later rise again. That’s because economists don’t confirm their theories in quite the same way physicists do, by just looking at the evidence. Instead, much as happens with preachers who gather a congregation, a school rises by building a following – among both politicians and the wider public.

For example, Milton Friedman was one of the most influential economists of the late 20th century. But he had been around for decades before he got much of a hearing. He might well have remained a marginal figure had it not been that politicians such as Margaret Thatcher and Ronald Reagan were sold on his belief in the virtue of a free market. They sold that idea to the public, got elected, then remade society according to those designs. An economist who gets a following gets a pulpit. Although scientists, in contrast, might appeal to public opinion to boost their careers or attract research funds, outside of pseudo-sciences, they don’t win support for their theories in this way.
However, if you think describing economics as a religion debunks it, you’re wrong. We need economics. It can be – it has been – a force for tremendous good. But only if we keep its purpose in mind, and always remember what it can and can’t do.

The Irish have been known to describe their notionally Catholic land as one where a thin Christian veneer was painted over an ancient paganism. The same might be said of our own adherence to today’s neoliberal orthodoxy, which stresses individual liberty, limited government and the free market. Despite outward observance of a well-entrenched doctrine, we haven’t fully transformed into the economic animals we are meant to be. Like the Christian who attends church but doesn’t always keep the commandments, we behave as economic theory predicts only when it suits us. Contrary to the tenets of orthodox economists, contemporary research suggests that, rather than seeking always to maximise our personal gain, humans still remain reasonably altruistic and selfless. Nor is it clear that the endless accumulation of wealth always makes us happier. And when we do make decisions, especially those to do with matters of principle, we seem not to engage in the sort of rational “utility-maximizing” calculus that orthodox economic models take as a given. The truth is, in much of our daily life we don’t fit the model all that well.


Economists work best when they take the stories we have given them, and advise us on how we can help them to come true

For decades, neoliberal evangelists replied to such objections by saying it was incumbent on us all to adapt to the model, which was held to be immutable – one recalls Bill Clinton’s depiction of neoliberal globalisation, for instance, as a “force of nature”. And yet, in the wake of the 2008 financial crisis and the consequent recession, there has been a turn against globalisation across much of the west. More broadly, there has been a wide repudiation of the “experts”, most notably in the 2016 US election and Brexit referendum.

It would be tempting for anyone who belongs to the “expert” class, and to the priesthood of economics, to dismiss such behaviour as a clash between faith and facts, in which the facts are bound to win in the end. In truth, the clash was between two rival faiths – in effect, two distinct moral tales. So enamoured had the so-called experts become with their scientific authority that they blinded themselves to the fact that their own narrative of scientific progress was embedded in a moral tale. It happened to be a narrative that had a happy ending for those who told it, for it perpetuated the story of their own relatively comfortable position as the reward of life in a meritocratic society that blessed people for their skills and flexibility. That narrative made no room for the losers of this order, whose resentments were derided as being a reflection of their boorish and retrograde character – which is to say, their fundamental vice. The best this moral tale could offer everyone else was incremental adaptation to an order whose caste system had become calcified. For an audience yearning for a happy ending, this was bound to be a tale of woe.

The failure of this grand narrative is not, however, a reason for students of economics to dispense with narratives altogether. Narratives will remain an inescapable part of the human sciences for the simple reason that they are inescapable for humans. It’s funny that so few economists get this, because businesses do. As the Nobel laureates George Akerlof and Robert Shiller write in their recent book, Phishing for Phools, marketers use them all the time, weaving stories in the hopes that we will place ourselves in them and be persuaded to buy what they are selling. Akerlof and Shiller contend that the idea that free markets work perfectly, and the idea that big government is the cause of so many of our problems, are part of a story that is actually misleading people into adjusting their behaviour in order to fit the plot. They thus believe storytelling is a “new variable” for economics, since “the mental frames that underlie people’s decisions” are shaped by the stories they tell themselves.

Economists arguably do their best work when they take the stories we have given them, and advise us on how we can help them to come true. Such agnosticism demands a humility that was lacking in economic orthodoxy in recent years. Nevertheless, economists don’t have to abandon their traditions if they are to overcome the failings of a narrative that has been rejected. Rather they can look within their own history to find a method that avoids the evangelical certainty of orthodoxy.

In his 1971 presidential address to the American Economic Association, Wassily Leontief counselled against the dangers of self-satisfaction. He noted that although economics was starting to ride “the crest of intellectual respectability … an uneasy feeling about the present state of our discipline has been growing in some of us who have watched its unprecedented development over the last three decades”.

Noting that pure theory was making economics more remote from day-to-day reality, he said the problem lay in “the palpable inadequacy of the scientific means” of using mathematical approaches to address mundane concerns. So much time went into model-construction that the assumptions on which the models were based became an afterthought. “But,” he warned – a warning that the sub-prime boom’s fascination with mathematical models, and the bust’s subsequent revelation of their flaws, now reveals to have been prophetic – “it is precisely the empirical validity of these assumptions on which the usefulness of the entire exercise depends.”

Leontief thought that economics departments were increasingly hiring and promoting young economists who wanted to build pure models with little empirical relevance. Even when they did empirical analysis, Leontief said economists seldom took any interest in the meaning or value of their data. He thus called for economists to explore their assumptions and data by conducting social, demographic and anthropological work, and said economics needed to work more closely with other disciplines.

Leontief’s call for humility some 40 years ago stands as a reminder that the same religions that can speak up for human freedom and dignity when in opposition, can become obsessed with their rightness and the need to purge others of their wickedness once they attain power. When the church retains its distance from power, and a modest expectation about what it can achieve, it can stir our minds to envision new possibilities and even new worlds. Once economists apply this kind of sceptical scientific method to a human realm in which ultimate reality may never be fully discernible, they will probably find themselves retreating from dogmatism in their claims.

Paradoxically, therefore, as economics becomes more truly scientific, it will become less of a science. Acknowledging these limitations will free it to serve us once more.

The Humbug of Finance

Prabhat Patnaik in The Economic and Political Weekly


The renowned economist Joan Robinson (1962) had referred to the view that the government’s budget should always be balanced, as the “humbug of finance,” namely, as a false proposition with no theoretical merit which was nonetheless promoted by finance capital. These days, of course, the insistence is not exactly on balancing the budget as was the case during the pre-second world war years. A certain amount of fiscal deficit relative to gross domestic product (GDP), usually 3%, is considered “permissible,” though it is not clear what is so sacrosanct about the figure 3 and why 3 is better than zero. But this shift from zero to 3% does not signify any change in theoretical position: it still invokes the same logic that underlay the insistence on balancing the budget. In Robinson’s words, it still constitutes “the humbug of finance,” though with a slightly, and inexplicably, different number for the percentage of fiscal deficit to the GDP.

The argument which the insistence on balancing the budget advances is that a fiscal deficit “crowds out” private investment. Now, for this to happen there must be a fixity of supply of some economic variable, so that the government taking more of it (via a fiscal deficit) leaves less for the private sector. What exactly is this variable? Pre-Keynesian theory believed that this given variable (assuming for simplicity, a closed economy) was the magnitude of “savings”: a fiscal deficit, by drawing more “savings” towards the government would leave less “savings” for the private sector, and hence reduce private investment via a rise in the interest rate. (Even if the rise in the interest rate itself contributed towards an increase in “savings” so that their magnitude was not exactly fixed, this would still mean a partial crowding out of private investment because of the rise in the interest rate.)

This argument, however, was obviously false, since “savings” depended not just on the interest rate but also upon the level of income (and on the distribution of income too, though we shall not go into the question of distribution of income here). Since a fiscal deficit in an economy that was demand-constrained—namely, had unemployed labour and unutilised capacity—raised the level of income, it also increased “savings.” In fact at any given interest rate (as Richard Kahn’s famous proposition on the multiplier showed), a fiscal deficit (in a closed economy) generated an amount of private “savings” in excess of private investment that was exactly equal to itself. Hence private investment did not get “crowded out;” additional private savings got generated. And to believe otherwise was to subscribe to Say’s Law—that there could never be a deficiency of aggregate demand—which was absurd.

The other economic variable whose fixity is invoked these days to argue the “crowding out” proposition (since none can seriously profess a belief in Say’s Law today) is money supply. A rise in the fiscal deficit raises income; but, if money supply is fixed, then the interest rate rises which “crowds out” private investment. But, even leaving aside the fact of the endogeneity of money supply—namely, the fact that in a modern economy money supply simply adjusts to the demand for it at a given interest rate—and accepting this assertion for argument’s sake, such a situation can only arise if a government that is pursuing an expansionary fiscal policy is simultaneously pursuing a tight monetary policy. This is a mistake in policy and not any inherent flaw of the fiscal deficit itself.
There is therefore no logical reason why in a situation of deficiency of aggregate demand the government should not resort to a fiscal deficit to boost demand and hence output and employment.1 To be sure, a fiscal deficit is not the best way to finance larger government expenditure for stimulating demand in such a situation. Larger government expenditure financed by a tax on profits even within a balanced budget is better than a fiscal deficit for overcoming a deficiency of aggregate demand, for one obvious reason, namely, that it keeps down wealth inequality. Since a fiscal deficit generates an amount of private savings in excess of private investment exactly equal to itself, taxing away this excess rather than leaving it in the hands of capitalists, who are primarily the savers, keeps down wealth inequality (as savings constitute addition to wealth). But increasing government expenditure financed by a fiscal deficit is better than keeping down government expenditure and balancing the budget, as the “humbug of finance” would advocate.

A new consideration however intrudes here. Even though there may be nothing wrong with a fiscal deficit, and the view that the budget must be balanced (or nearly balanced with at most a 3% fiscal deficit) is no more than the “humbug of finance,” since finance capital does not like fiscal deficits, whatever the reason, in an economy open to cross-border financial flows, running such a deficit would lead to an outflow of finance that is obviously harmful to the economy. Hence the fiscal deficit has to be controlled, even though the arguments advanced for doing so are wrong, simply in deference to the caprices of globalised finance. Let us explore the implications of this argument a little further.

Opposition to State Intervention

The basic proposition established by the Keynesian Revolution was that in a capitalist economy, where all economic agents acted “rationally” in the sense of maximising some objective function subject to certain constraints that are given, the overall outcome could be socially “irrational” in an obvious sense, namely, that it could be characterised by both unemployment and unutilised capacity. In such a case, the outcome, quite apart from the fact that it did not satisfy Pareto-optimality, would not even satisfy private “rationality.”

What Keynes suggested, therefore, was that the state should intervene in the economy in order to realise social rationality, in the sense of an avoidance of what he called a state of “involuntary unemployment.” Implicit in this suggestion was the assumption that the state itself was free to act according to its own wisdom, unconstrained by the demands or pressures from any agency acting in accordance with its private rationality. The state, in other words, could fulfil its role of being an agency for realising social rationality only if it was external to the world of private rationality and was unconstrained by, and non-imitative of, the agents belonging to this world. (The Marxist critique of Keynesianism argued that this was not possible, but let us leave this aside for the present.)

The state’s being non-imitative of private agents, which is an obvious condition for its intervening successfully to achieve social rationality (for otherwise it will simply replicate the same result that is achieved through the mere agglomeration of private decisions), implies a fundamental break from a certain analogy that is often drawn. This analogy states that just as an individual cannot go on accumulating debt, likewise, the state too cannot simply go on piling up debt; that the state too has to tighten its belt in order to ensure that it does not fall irredeemably into debt. This analogy is doubly wrong: it is wrong in the sense that the state, because it has sovereign powers of taxation, is on a different footing from individuals; and it is also wrong in the sense that if the state acted like any individual does, then it would be incapable of achieving social rationality by overcoming the deficiency of aggregate demand.

Forcing the state to bow to the caprices of globalised finance, by making it “fiscally responsible” (namely, by keeping it within a fiscal deficit ceiling), makes it constrained by private rationality, and hence prevents it from being an instrument for the achievement of social rationality. Fiscal responsibility legislation enacted by the state, to which the state adheres, amounts therefore, to robbing capitalism of any means of achieving social rationality, particularly in the sense of overcoming “involuntary unemployment.”

The question immediately arises: since overcoming “involuntary unemployment” represents a Pareto-improvement in the sense that everybody stands to gain from it—the capitalists through obtaining higher profits and the workers through obtaining higher employment (and hence incomes)—why should finance capital be opposed to state intervention by fiscal means which serves this end? This opposition incidentally is not something that arises only in the age of globalised finance, it existed even before finance capital became globalised. The globalisation of finance only means that the demands of finance necessarily get accepted by the nation state, for fear that otherwise there would be a capital flight; but the demand for “sound finance” itself is characteristic of finance capital per se. This is the reason why Keynes’ proposal in 1929, put forward by Lloyd George, the leader of the Liberal Party to which Keynes belonged, for a scheme of public works financed by a fiscal deficit to alleviate unemployment in Britain, was turned down by the British Treasury under pressure from the City of London, the seat of British finance capital. The question therefore is, why is finance capital so opposed to fiscal deficits even when there are no palpable ill-effects of such deficits, other than those that might be caused by its own opposition to them?

The answer, I believe, lies in the fact that accepting the need for intervention by an agency entrusted with upholding “social rationality” undermines the social legitimacy of the economic system presided over by finance capital. Any demonstration that the universal pursuit of private rationality, which is what capitalism entails, leads to a socially irrational outcome, subverts the power of financial interests, which is why they vehemently deny the need for such direct state intervention. They would rather have the state intervening by creating a better situation for the play of private rationality. In short, indirect instead of direct intervention, or jogging private rationality instead of acting independently of it, is what they prefer.

Monetary policy is the pre-eminent means for such indirect intervention, apart of course from other means like guaranteed rates of return, tax concessions to the capitalists (which also enlarge the fiscal deficit but which are not frowned upon by them). Monetary policy acts through inducing the capitalists to invest more (or generally through making the affluent who constitute the “creditworthy” segment of the population to spend more). Changes in monetary policy as the means of overcoming “involuntary unemployment” do not give the impression of there being something intrinsically wrong with the system; they rather give the impression of creating the right atmosphere for its smooth functioning.

Indeed a focus on monetary policy goes much further; it even suggests that if there is “involuntary unemployment” then the reason for it lies not with the system itself but with the central bank whose monetary policy happens to be out of sync with the needs of the situation. The culpability for involuntary unemployment is thus neatly shifted from the system itself whose functioning is flawed, to the shoulders of the central bank.

The absurdity of such inverted thinking becomes particularly clear in times like the present, when in the United States (US), for instance, the long-term rate of interest has been pushed down close to zero, and yet there is no sign of a recovery from a state of substantial involuntary unemployment. In Europe, the central bank is even charging negative interest rates on loans to banks, provided these are given out as credit for certain purposes by the banks; and yet there is no sign of a recovery from the crisis that afflicts Europe. So inadequate has monetary policy become for stimulating the economy that some authors are now saying that pervasive negative interest rates even on deposits (and not just on central bank lending to banks) are the need of the hour, and, for achieving this, there must be an abolition of cash altogether, since the possibility of holding cash in lieu of bank deposits puts a floor to the interest rate at zero (Rogoff 2016).

This amounts to carrying the inversion of thought to an extreme degree: the flaws of the system are according to this argument blamed on the very existence of cash; and rather than having direct state intervention through fiscal means, including a fiscal deficit, as a way of achieving “social rationality,” what is advocated is “sound finance” combined with the very abolition of cash. The lengths to which reified thinking can be carried can be imagined from this.

What globalisation of finance has achieved, in short, is that the opposition of finance to fiscal deficits, or more generally to direct state intervention for increasing the level of activity, has become effective once again. This had been overcome, albeit temporarily, in the context of the changed correlation of class forces in the post-war period with the emergence of a militant (pre-Blairite) social democracy. The fact that finance is globalised while the state remains a nation state, ensures that the writ of finance runs; and this strips contemporary capitalism of any potential instrument for achieving even a semblance of social rationality.

There are only two possible ways that, even potentially, a semblance of social rationality can be achieved in contemporary capitalism. One is through a global state, or through a set of nation states globally coordinating their actions, providing a fiscal stimulus to the world economy by overcoming the opposition of globalised finance. The other is through individual states providing such a fiscal stimulus within their own particular economies by delinking themselves from the vortex of financial flows and thus withdrawing from the entanglements that contemporary globalisation entails. In either case, however, the opposition of globalised finance has to be overcome, and this requires a broad class alliance of working people which has to be organised in a manner appropriate to each case.

Whether such a class alliance can achieve a semblance of social rationality within the confines of capitalism itself, that is, whether capitalism will adapt itself to the new situation by making appropriate concessions, as it had done over large stretches of the capitalist world in the post-war years, or whether it will transcend capitalism in the process of introducing a semblance of social rationality, is a matter for the future. But the point is that until such an effort is made, world aggregate demand will remain constricted, and the world economic crisis will persist, apart from possible occasional “bubbles” that may cause temporary revivals, to be followed by collapses into crisis once more.

Legitimacy Crisis

Donald Trump’s economic strategy has to be understood in this context where he remains as tied to fiscal conservatism as other governments in advanced capitalist countries. Committed to increasing employment in the US, but unwilling to do so by expanding government expenditure, he is taking recourse to protectionism, which, in a situation where world aggregate demand is not increasing, amounts to a “beggar-my-neighbour” policy, that is, a policy of exporting unemployment to other countries.

True, Trump has said that he is not averse to increasing the fiscal deficit; but he is willing to do so only as a means of effecting a tax cut on the corporate sector (from 35% to 15%). This amounts to increasing the fiscal deficit for the sake of putting more purchasing power in the hands of capitalists. But putting more purchasing power in the hands of capitalists hardly increases aggregate demand: their marginal propensity to consume out of income is small, and they do not invest more, even if they have larger post-tax profits, as long as the market is not expanding. Hence, the Trump strategy really amounts not to an increase in aggregate demand in the US, but to a beggar-my-neighbour strategy imposed upon the rest of the world.

This strategy presupposes that the rest of the world would simply sit tight and tolerate an import of unemployment from the US: its success, in other words, depends upon the US action not facing any retaliation, that is, upon the US being able to impose “one-way free trade” upon the rest of the world, as Britain had done in the colonial period. But if other countries do retaliate, then competitive “beggar-my-neighbour” policies would ensue, which would increase uncertainties associated with investment, and hence aggravate the crisis.

But if the US individually or several (or all) countries on their own increased the fiscal deficit to expand government expenditure, and imposed protection only to the extent of preventing a leakage outwards of the additional demand so generated within their economies, without actually curtailing their imports in absolute terms, namely, without exporting any unemployment to other countries, then all countries would be Pareto-wise better off. No one country’s employment increase in such a case would be at the expense of some other country.

What comes in the way of such a move which would improve the employment situations in all countries without their adversely affecting one another, is the opposition of finance to fiscal deficits and to taxes on capitalists (taxes on workers would not raise aggregate demand as they already have a high propensity to consume). Unless finance capital’s hostility to fiscal deficits is overcome, which in turn requires that unless the hegemony of finance capital on the world economy is overcome, the world would remain mired in crisis.

Either way, therefore, world capitalism will be facing a legitimacy crisis in the coming days: on the one hand, if it remains committed to the “humbug of finance” then its legitimacy is threatened because of the persistence of the economic crisis, and with it of high unemployment; on the other hand, if it “permits” direct state intervention through fiscal means for overcoming the crisis, then its legitimacy is threatened because the flawed nature of the system gets exposed, thereby, opening the prospects of growing state intervention.

Bitcoin Survival Guide: Everything You Need to Know About the Future of Money

• BY ROBERT MCMILLAN AND CADE METZ
• 11.25.13
• 6:30 AM

Illustration: T.A. Gruneisen/WIRED

The price of a bitcoin topped $900 last week, an enormous surge in value that arrived amidst Congressional hearings where top U.S. financial regulators took a surprisingly rosy view of digital currency. Just 10 months ago, a bitcoin sold for a measly $13.

The spike was big news across the globe, from Washington to Tokyo to China, and it left many asking themselves: “What the hell is a bitcoin?” It’s a good question — not only for those with little understanding of the modern financial system and how it intersects with modern technology, but also for those steeped in the new internet-driven economy that has so quickly remade our world over the last 20 years.

The spike was big news across the globe, from Washington to Tokyo to China, and it left many asking themselves: ‘What the hell is a bitcoin?’

Bitcoin is a digital currency, meaning it’s money controlled and stored entirely by computers spread across the internet, and this money is finding its way to more and more people and businesses around the world. But it’s much more than that, and many people — including the sharpest of internet pioneers as well as seasoned economists — are still struggling to come to terms with its many identities.

With that in mind, we give you this: an idiot’s guide to bitcoin. And there’s no shame in reading. Nowadays, as bitcoin is just beginning to show what it’s capable of, we’re all neophytes.

Bitcoin isn’t just a currency, like dollars or euros or yen. It’s a way of making payments, like PayPal or the Visa credit card network. It lets you hold money, but it also lets you spend it and trade it and move it from place to place, almost as cheaply and easily as you’d send an email.

As the press so often points out, Bitcoin lets you do all this without revealing your identity, a phenomenon that drove its use on The Silk Road, an online marketplace for illegal drugs. But at the same time, it’s a system that operates completely in the public view. All Bitcoin transactions are recorded online for anyone to see, lending a certain transparency to the system, a transparency that can drive a new trust in the economy and subvert the anonymity sought by those on The Silk Road, which the feds shut down last month.

Bitcoin is much more than a money service for illegal operations. It’s a re-imagining of international finance, something that breaks down barriers between countries and frees currency from the control of federal governments. Bitcoin is controlled by open source software that operates according to the laws of mathematics — and by the people who collectively oversee this software. The software runs on thousands of machines across the globe, but it can be changed. It’s just that a majority of those overseeing the software must agree to the change.

In short, Bitcoin is kind of like the internet, but for money.

Birth of the Bitcoin

Click to enlarge. Illustration: T.A. Gruneisen/WIRED

What does that mean, specifically?

About five years ago, using the pseudonym Satoshi Nakamoto, an anonymous computer programmer or group of programmers built the Bitcoin software system and released it onto the internet. This was something that was designed to run across a large network of machines — called bitcoin miners — and anyone on earth could operate one of these machines.

This distributed software seeded the new currency, creating a small number of bitcoins. Basically, bitcoins are just long digital addresses and balances, stored in an online ledger called the “blockchain.” But the system was also designed so that the currency would slowly expand, and so that people would be encouraged to operate bitcoin miners and keep the system itself growing.

When the system creates new bitcoins, you see, it gives them to the miners. Miners keep track of all the bitcoin transactions and add them to the blockchain ledger, and in exchange, they get the privilege of, every so often, awarding themselves a few extra bitcoins. Right now, 25 bitcoins are paid out to the world’s miners about six times per hour, but that rate changes over time.

Why do these bitcoins have value? It’s pretty simple. They’ve evolved into something that a lot of people want — like a dollar or a yen or the cowry shells swapped for goods on the coast of Africa over 3,000 years ago — and they’re in limited supply. Though the system continues to crank out bitcoins, this will stop when it reaches 21 million, which was designed to happen in about the year 2140.

The idea was to create a currency whose value couldn’t be watered down by some central authority, like the Federal Reserve.

When the system quits making new money, the value of each bitcoin will necessarily rise as demand rises — it’s what’s called a deflationary currency — but although the supply of coins will stop expanding, it will be still be relatively easy to spend. Bitcoins can be broken into tiny pieces. Each bitcoin can be divided into one hundred million units, called Satoshis, after the currency’s founder.

The Key to the System

How do you spend bitcoins? Trade them? Keep people from stealing them? Bitcoin is a math-based currency. That means that the rules that govern bitcoin’s accounting are controlled by cryptography. Basically, if you own some bitcoins, you own a private cryptography key that’s associated with an address on the internet that contains a balance in the public ledger. The address and the private key let you make transactions.

The internet address is something everyone can see. Think of it like a really complicated email address for online payments. Something like this: 1DTAXPKS1Sz7a5hL2Skp8bykwGaEL5JyrZ. If someone wants to send you bitcoins, they need your address.

If you own some bitcoins, what you really own is a private cryptography key that’s associated with an address on the internet

If you want to send your bitcoins to someone else, you need your address and their address — but you also need your private cryptography key. This is an even more complicated string that you use to authorize a payment.

Using the math associated with these keys and addresses, the system’s public network of peer-to-peer computers — the bitcoin miners — check every transaction that happens on the network. If the math doesn’t add up, the transaction is rejected.

Crypto systems like this do get cracked, and the software behind Bitcoin could have flaws in it. But at this point, Bitcoin has been tested pretty thoroughly, and it seems to be pretty darned secure.

For the ordinary people who use this network — the people who do the buying and the selling and the transferring — managing addresses and keys can be a bit of a hassle. But there are many different types of programs — called wallets — that keep track of these numbers for you. You can install a wallet on your computer or your mobile phone, or use one that sits on a website.

With these wallets, you can easily send and receive bitcoins via the net. You can, say, buy a pizza on a site that’s set up to take bitcoin payments. You can donate money to a church. You can even pay for plastic surgery. The number of online merchants accepting bitcoins grows with each passing day.

But you can also make transactions here in the real world. That’s what a mobile wallet is good for. The Pink Cow, a restaurant in Tokyo, plugs into the Bitcoin system via a tablet PC sitting beside its cash register. If you want to pay for your dinner in bitcoins, you hold up your phone and scan a QR code — a kind of bar code — that pops up on the tablet.

How to Get a Bitcoin

If all that makes sense and you wanna give it try, the first thing you do is get a wallet. We like blockchain.info, which offers an app that you can download to your phone. Then, once you have a wallet, you need some bitcoins.

In the U.S., the easiest way to buy and sell bitcoins is via a website called Coinbase. For a one percent fee, Coinbase links to your bank account and then acts as a proxy for you, buying and selling bitcoins on an exchange. Coinbase also offers an easy-to-use wallet. You can also make much larger bitcoin purchases on big exchanges like Mt. Gox or Bitstamp, but to trade on these exchanges, you need to first send them cash using costly and time-consuming international wire transfers.

Ironically, the best way to keep bitcoin purchases anonymous is to meet up with someone here in the real world and make a trade.

Yes, you can keep your purchases anonymous — or at least mostly anonymous. If you use a service like Coinbase or Mt. Gox, you’ll have to provide a bank account and identification. But other services, such as LocalBitcoins, let you buy bitcoins without providing personal information. Ironically, the best way to do this is to meet up with someone here in the real world and make the trade in-person.

LocalBitcoins will facilitate such meetups, where one person provides cash and the other then sends bitcoins over the net. Or you can attend a regular Bitcoin meetup in your part the world. Because credit card and bank transactions are reversible and bitcoin transactions are not, you need to be very careful if you’re ever selling bitcoins to an individual. That’s one reason why many sellers like to trade bitcoins for cash.

The old-school way of getting new bitcoins is mining. That means turning your computer into a bitcoin miner, one of those nodes on Bitcoin’s peer-to-peer network. Your machine would run the open source Bitcoin software.

Back in the day, you could do bitcoin mining on your home PC. But as the price of bitcoins has shot up, the mining game has morphed into a bit of a space-race — with professional players, custom-designed hardware, and rapidly expanding processing power.

Today, all of the computers vying for those 25 bitcoins perform 5 quintillion mathematical calculations per second. To put it in perspective, that’s about 150 times as many mathematical operations as the world’s most powerful supercomputer.

And mining can be pretty risky. Companies that build these custom machines typically charge you for the hardware upfront, and every day you wait for delivery is a day when it becomes harder to mine bitcoins. That reduces the amount of money you can earn.

This spring, WIRED tested out a custom-designed system built by a Kansas City, Missouri company called Butterfly Labs. We were lucky enough to receive one of the first 50 units of a $275 machine built by the company.

We hooked it up to a network of mining computers that pool together computing resources and share bitcoin profits. And in six months, it has earned more than 13 bitcoins. That’s more than $10,000 at today’s bitcoin prices. But people who got the machine later than we did (and there were plenty of them) didn’t make quite so much money.

Online Thievery

Once you get your hands on some bitcoins, be careful. If somebody gets access to your Bitcoin wallet or that private key, they can take your money. And in the Bitcoin world, when money is gone, it’s gone for good.

This can be a problem whether you’re running a wallet on your own machine or on a website run by a third party. Recently, hackers busted into a site called inputs.io — which stores bitcoins in digital wallets for people across the globe — and they made off with about $1.2 million in bitcoins.

In the bitcoin world, when money is gone, it’s pretty much gone for good.

So, as their bitcoins start to add up, many pros move their wallets off of their computers. For instance, they’ll save them on a thumb drive that’s not connected to the internet.

Some people will even move their bitcoins into a real physical wallet or onto something else that’s completely separate from the computer world. How is that possible? Basically, they’ll write their private key on a piece of paper. Others will engrave their crypto key on a ring or even on a metal coin.

Sure, you could lose this. But the same goes for a $100 bill.

The good news is that the public nature of the bitcoin ledger may make it theoretically possible to figure out who has stolen your bitcoins. You can always see the address that they were shipped off to, and if you ever link that address to a specific person, then you’ve found your thief.

But don’t count on it. This is an extremely complex process, and researchers are only just beginning to explore the possibilities.

Bitcoin vs. the U.S.A.

Bitcoin is starting to work as a currency, but because of the way it’s built, it also operates as an extremely low-cost money-moving platform. In theory, it could be a threat to PayPal, to Western Union, even to Visa and Mastercard. With Bitcoin, you can move money anywhere in the world without paying the fees.

The process isn’t instant. The miners bundle up those transactions every 10 minutes or so. But today, payment processors like BitPay have stepped in to smooth things out and speed them up.

The feds have stopped short of trying to kill Bitcoin, but they’ve created an atmosphere where anybody who wants to link the U.S. financial system to Bitcoin is going to have to proceed with extreme caution

The trouble is that federal regulators still haven’t quite figured out how to deal with Bitcoin.

The currency is doing OK in China, Japan, parts of Europe, and Canada, but it’s getting its bumpiest ride in the U.S., where authorities are worried about the very features that make Bitcoin so exciting to merchants and entrepreneurs. Here, the feds have stopped short of trying to kill Bitcoin, but they’ve created an atmosphere where anybody who wants to link the U.S. financial system to Bitcoin is going to have to proceed with extreme caution.

Earlier this year, the U.S. Department of Homeland Security closed the U.S. bank accounts belonging to Mt. Gox, which has generally been the world’s largest Bitcoin exchange. Mt. Gox, based in Japan, let U.S. residents trade bitcoins for cash, but it hadn’t registered with the federal government as a money transmitter, and it hadn’t registered in the nearly 50 U.S. states that also require this.

The Homeland Security action against Mt. Gox had an immediate chilling effect in the U.S. Soon, American Bitcoin companies started reporting that their banks were dropping them, but not because they had done anything illegal. The banks simply don’t want the risk.

Now, other Bitcoin companies that have moved fast to operate within the U.S. are facing the possibility of being shut down if they’re not following state and federal guidelines.

Even if the feds were interested in shutting down Bitcoin, they probably couldn’t if they tried, and now, they seem to understand its promise. In testimony on Capitol hill earlier this week, Jennifer Shasky Calvery, the director of the Treasury Department’s Financial Crimes Enforcement Network, said that Bitcoin poses problems, but she also said that it’s a bit like the internet in its earliest days.

“So often, when there is a new type of financial service or a new player in the financial industry, the first reaction by those of us who are concerned about money laundering or terrorist finance is to think about the gaps and the vulnerabilities that it creates in the financial system,” she said. “But it’s also important that we step back and recognize that innovation is a very important part of our economy.”

It is. And Bitcoin richly provides that innovation. It just may take a while for the world to completely catch on.

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Once You Use Bitcoin You Can’t Go ‘Back’ — And That’s Its Fatal Flaw

• BY NICHOLAS WEAVER
• 11.26.13
• 9:27 AM 

Photo: Ariel Zambelich / WIRED

Bitcoin is the world’s most popular digital currency — not just a form of money, but a way of moving money around — and the darling topic du jour of the tech industry right now. [WIRED has its primer on what bitcoin is and how it works here.]

As a security researcher, I admire bitcoin-the-protocol. But I believe bitcoin-the-currency contains a fatal flaw.

As a security researcher, I admire bitcoin-the-protocol. It’s an incredibly clever piece of cryptographic engineering, especially the proof-of-work as a way of maintaining an indelible history and a signature scheme which, when properly used, can limit the damage that might be done by an adversary with a quantum computer. But I believe bitcoin-the-currency contains a fatal flaw, one that ensures that bitcoin won’t ever achieve widespread adoption as a currency.

The flaw? That bitcoin transactions are irreversible. That is, they can never be undone: Once committed, there is no “oops”, no “takeback”, no “control-Z”. Combined with bitcoin’s independence — it is a separate currency with a floating exchange rate — this flaw is arguably lethal to money systems.

Once committed, there is no ‘oops’, ‘takeback’, or ‘control-Z’.

Bitcoin advocates will argue that both its irreversibility and independence are benefits. That they were explicit design decisions to defy control by governments or banks. But to me these features are flaws, because a tenet of modern finance asserts that anything electronic must be reversible. If bitcoin really is the internet applied to money … then it, too, should have a “back” button.

Without an undo/ back button, it’s only possible to prevent fraud. With an undo, it would also be possible to detect and mitigatefraud; to see that something bad happened and then actually do something about it. Credit cards, bank account transfers, and all other electronic transactions involving a bank all have an “undo” button.

Banks rely on the reversibility feature every day to stop fraudulent activities. Bitcoin robbery casesaren’t just rising because of interest in the currency — the most recent is a European bitcoin payment processor losing $1M after a DDoS attack — they’re rising because robbing a bank online involves much less friction than doing so in person.

Nicholas Weaver

Nicholas Weaver is a researcher at the International Computer Science Institute in Berkeley and U.C. San Diego (though this opinion is his own). He focuses on network security as well as network intrusion detection, defenses for DNS resolvers, and tools for detecting ISP-introduced manipulations of a user’s network connection. Weaver received his Ph.D. in Computer Science from U.C. Berkeley.

In the current financial system, the only major irreversible transactions involve withdrawing cash. This is a process that must happen in person and therefore naturally imposes substantial limits; in-person requirements provide attribution, keep an attacker from automating the process, and limit the “attack surface”. For example:

• To steal a million dollars hidden under mattresses, a thief needs to break into thousands of homes.
• To steal a million dollars from a typical business’s bank account, thieves need to transfer it to a network of roughly 100 money mules.
• Each mule must then withdraw less than $10,000 from their account within a short period of time, take the cash to Western Union, and wire the money to the thieves. (This is why those running the mules can claim up to 40-50 percent of the take!)

To steal a million dollars worth of bitcoins stored by a business, however, a thief only needs the private key. Likewise, to steal $1000 worth of bitcoins each from 1000 people, the thief only needs to have his or her bot software running on enough victims with enough bitcoins to automate the process.

This means bitcoins should never be “stored” on an internet-connected device. That includes our computers and our smartphones. (And have you heard the one about the guy who keeps his key on his finger?) Let’s pause for a moment to reflect on that: What sort of online currency requires using offline computers and objects for all storage?

Now, it is theoretically true that stolen coins could be blocked. If a portion of the network blocks stolen bitcoins today, then the same mechanism could block bitcoins that passed through black markets or offshore exchanges (such as BTC-e) that don’t implement anti-money-laundering protections. Yet the bitcoin community strongly resists the idea of blacklists, because it eliminates fungibility — the notion that all bitcoins are identical — which is essential for a currency. If every dollar used in a drug deal couldn’t be used again, would dollars work as currency? Especially if, sometime after acceptance, a dollar becomes void and blacklisted after the fact because of its previous involvement in a crime?

Bitcoins should never be stored on an internet-connected device. But what sort of online currency requires using offline computers for all storage?

Bitcoin advocates insist that the theft problem is solvable. For the sake of argument, let’s assume that some bitcoin-centric hardware company deploys completely secure and free hardware bitcoin wallets for anyone to use. And let’s also assume consumers are happy with such an unregulatable model and don’t care that merchants can now rip them off with near impunity. Immunity from theft is not enough. Irreversibility, combined with volatility, ensures that bitcoin still will never see wide adoption.

Bitcoin’s irreversibility means that a bitcoin exchange can never accept credit cards or wire transfers to quickly provide bitcoins in significant quantities. These agencies must carefully audit customers, wait on any large purchases, and assign blame when attackers breach accounts. Any exchange that does not follow such precautions would be a magnet for fraud, and cease to exist once they start receiving chargebacks.

As a consequence, the only ways to quickly buy bitcoins require cash — again, I’m talking about convenience here which surely should be a feature of internet applied to money. This convenience can happen via a cash drop at a drugstore; a cash deposit into the exchange’s bank account; a face-to-face meetup; or at an actual ATM, complete with cameras and withdrawal limits. (The world’s first bitcoin ATM just went live a month ago in Canada. Incidentally, it takes cash, not ATM cards.)

Blacklists eliminate fungibility, which is essential for a currency.

And almost every bitcoin purchase needs to start with such a consuming, hastle-prone step if the buyer is unwilling to risk the wild swings in value that bitcoin experiences on a day-to-day basis. Since bitcoin has no stable value, the recipient should immediately go the other way. After all, if bitcoin’s volatility is desired by the merchant, they can just buy bitcoins independently. Instead, any sensible merchant receiving them will immediately turn them back into Dollars, Euros, or whatever local currency they need at a cost of roughly 1 percent. Which means the buyer first had to go the other way, turning dollars into bitcoins. Otherwise, the system would be out of balance.

Thus to actually buy something with the “digital currency of the future” — without having to wait, have funds predeposited at an exchange, or risk that one’s bitcoins drop in value — the buyer has to go to the bank, withdraw cash, turn it into bitcoins, and then spend it quickly.

The only way to quickly buy bitcoins requires cash: a consuming, hastle-prone step.

The need to go in person and withdraw cash conservatively costs the buyer 2 percent, as gas stations can charge over 2 percent to accept credit cards (and yet, people regularly use credit over cash). For reference, compare this to Square, which charges 2.75 percent to process credit cards. So even if you canconveniently get bitcoins from your local ATM — though we’re nowhere near there yet — a bitcoin transaction will cost the buyer and seller a combined 3 percent or more.

Even the much-vaunted international transfer use case doesn’t make sense here: A bitcoin transaction may be cheaper than a SWIFT wire transfer, but the cash requirement means it is not necessarily cheaper than Western Union. (To Mexico, it’s $8 plus a currency exchange fee. Europe is far more expensive, but that’s due to a lack of competition rather than something intrinsic.) If Western Union charges nearly double the currency conversion fee of a bitcoin exchange, it still comes out approximately the same since a foreign bitcoin transaction involves two currency exchanges rather than one.

Even at a 10 billion dollar market cap — the peak achieved by Beanie Babies in 1999 — bitcoin is almost irrelevant in financial terms.

Bitcoin therefore only works for merchants who face substantial chargebacks but who can’t say “pay cash”, are selling to bitcoin believers willing to pay the premium price to use bitcoins, or want to conduct business that the credit card system blocks. Yet many of the transactions blocked by the credit card system — namely gambling, drugs, and crypto-extortion — are themselves illegal. In those cases, does it really make sense to use such an innately traceable currency with a permanent record? I think not. (You can bet that redandwhite, the “hitman” Dread Pirate Roberts allegedly hired, is going to be asking himself that question over the coming months.)

This is not to say that bitcoin won’t retain its price. After all, the greater-sucker theory of speculation can ensure a large price for a long period. As long as bitcoin believers can recruit enough new money to balance the newly mined-for-sale coins, the price may sustain itself indefinitely. And, in the greater scheme of things, bitcoin is small: even at a roughly 10 billion dollar market capitalization it is almost irrelevant in financial terms. This is probably roughly the peak market capitalization achieved by Beanie Babies in 1999.

There are indeed important and valuable ideas that exist in bitcoin’s design. But bitcoin itself? Its volatility and built-in irreversibility will doom it to the ash-heap of history.

Don't blame the ratings agencies for the eurozone turmoil

Europe and the eurozone are strangling themselves with a toxic mixture of austerity and a structurally flawed financial system

• 
• • Ha-Joon Chang
  • guardian.co.uk, Sunday 15 January 2012 21.16 GMT

Standard & Poor's has decided to downgrade France's top-notch credit rating. Photograph: Philippe Huguen/AFP/Getty Images

 

Even the most rational Europeans must now feel that Friday the 13th is an unlucky day after all. On that day last week, the Greek debt restructuring negotiation broke down, with many bondholders refusing to join the voluntary 50% "haircut" – that is, debt write-off – scheme, agreed last summer. While the negotiation may resume, this has dramatically increased the chance of disorderly Greek default.

Later in the day, Standard & Poor's, one of the big three credit ratings agencies, downgraded nine of the 17 eurozone economies. As a result, Portugal pulled off the hat-trick of getting a "junk" rating by all of the big three, while France was deprived of its coveted AAA rating. With Germany left as the only AAA-rated large economy backing the eurozone rescue fund (the Dutch economy, the second biggest AAA economy left, is much smaller than the French economy) the eurozone crisis looks that much more difficult to handle.

The eurozone countries criticise S&P, and other ratings agencies, for unjustly downgrading their economies. France is particularly upset that it was downgraded while Britain has kept its AAA status, hinting at an Anglo-American conspiracy against France. But this does not wash, as one of the big three, Fitch, is 80% owned by a French company.

Nevertheless, France has some grounds to be aggrieved, as it is doing better on many economic indicators, including budget deficit, than Britain. And given the incompetence and cynicism of the big three exposed by the 1997 Asian financial crisis and more dramatically by the 2008 global financial crisis, there are good grounds for doubting their judgments.

However, the eurozone countries need to realise that its Friday-the-13th misfortune was in no small part their own doing.

First of all, the downgrading owes a lot to the austerity-driven downward adjustments that the core eurozone countries, especially Germany, have imposed upon the periphery economies. As the ratings agencies themselves have often – albeit inconsistently – pointed out, austerity reduces economic growth, which then diminishes the growth of tax revenue, making the budget deficit problem more intractable. The resulting financial turmoil drags even the healthier economies down, which is what we have just seen.

Even the breakdown in the Greek debt negotiation is partly due to past eurozone policy action. In the euro crisis talks last autumn, France took the lead in shooting down the German proposal that the holders of sovereign debts be forced to accept haircuts in a crisis. Having thus delegitimised the very idea of compulsory debt restructuring, the eurozone countries should not be surprised that many holders of Greek government papers are refusing to join a voluntary one.

On top of that, the eurozone countries need to understand why the ratings agencies keep returning to haunt them. Last autumn's EU proposal to strengthen regulation on the ratings industry shows that the eurozone policymakers think the main problem with the ratings industry is lack of competition and transparency. However, the undue influence of the agencies owes a lot more to the very nature of the financial system that the European (and other) policymakers have let evolve in the last couple of decades.

First, over this period they have installed a financial regulatory structure that is highly dependent on the credit ratings agencies. So we measure the capital bases of financial institutions, which determine their abilities to lend, by weighting the assets they own by their respective credit ratings. We also demand that certain financial institutions (eg pension funds, insurance companies) cannot own assets with below a certain minimum credit rating. All well intentioned, but it is no big surprise that such regulatory structure makes the ratings agencies highly influential.

The Americans have actually cottoned on this problem and made the regulatory system less dependent on credit ratings in the Dodd-Frank Act, but the European regulators have failed to do the same. It is no good complaining that ratings agencies are too powerful while keeping in place all those regulations that make them so.

Most fundamentally, and this is what the Americans as well as the Europeans fail to see, the increasingly long-distance and complex nature of our financial system has increased our dependence on ratings agencies.

In the old days, few bothered to engage a credit ratings agency because they dealt with what they knew. Banks lent to companies that they knew or to local households, whose behaviours they could easily understand, even if they did not know them individually. Most people bought financial products from companies and governments of their own countries in their own currencies. However, with greater deregulation of finance, people are increasingly buying and selling financial products issued by companies and countries that they do not really understand. To make it worse, those products are often complex, composite ones created through financial engineering. As a result, we have become increasingly dependent on someone else – that is, the ratings agencies – to tell us how risky our financial actions are.

This means that, unless we simplify the system and structurally reduce the need for the ratings agencies, our dependence on them will persist – if somewhat reduced – even if we make financial regulation less dependent on credit ratings.

The eurozone, and more broadly Europe, is slowly strangling itself with a toxic mixture of austerity and a structurally flawed financial system. Without a radical rethink on the issues of budget deficit, sovereign bankruptcy and financial reform, the continent is doomed to a prolonged period of turmoil and stagnation.

• © 2012 Guardian News and Media Limited or its affiliated companies. All rights reserved.