Tuesday, August 5, 2008

Keynes and the current financial crisis

I don't like to get too deep into the US economy because this is not directly related to the stuff going on in the developing countries-- my primary field of interest. However, the stuff that goes in the US economy does have some impact on the developing country's economy. [Well, that said it is hard to believe that at a time when the world stock markets are going downhill, or at least are very vulnerable and fickle, the Nepali stock market (NEPSE) is going uphill-- a hard to believe happening at this point of time. I think the time lag in the Nepali economy is much more larger than in the West's economy (I presume, somewhere at least 8-10 months in the financial sector). I always am amazed by the deviance of Nepali economy from the standard predictions of fiscal and monetary theories!]

Anyway, back to the US economy. I somehow stumbled into the CEPR Policy Insight No. 23 (Keynes and the Crisis by Alex Leijonhufvud). It is an interesting and fascinating discussion (well, at least to those (like me) who are slightly inclined towards Keynesianism) about the Keynes and the current financial crisis in the US. What can we learn from Keynes(ianism) and the moral philosophy associated with it?

The most important lesson from his life and work may be that the macroeconomist should start from the important problems of the day and should face the following questions: (1) How are we to understand what is happening right now? (2) What can be done about it? What is the best policy to follow? (3) Do recent events force us to modify what is today widely accepted economic theory? If so, what is wrong and how might we go about arriving at a more satisfying theory?

Why did the Keynesian policies did not work in Japan (heavy spending on public transportation and other sectors leading to nearly insurmountable debts) when the policymakers tried to tackle two bursts- stock market and real estate? Ans: moral hazard and liquidity trap

The effective demand failure that plagued Japan rather was that business firms could not and later would not do the intertemporal trade of expected revenues from future output for the factor services in the present needed to produce that output; that is, they could not or would not borrow to finance investment. In the early post-crash years, the state of the banks was such that they would not lend. Even when the Japanese banks eventually got into healthier shape, many business firms still had balance sheets in such condition that they were loath to borrow...The other lesson to draw from the Japanese experience is that once the credit system had crashed, a central bank policy of low interest rates could not counteract this intertemporal effective demand failure.

He argues that the current financial crisis is a result of policy failure, particularly obsession with inflation-targeting and too low interest rates. The Fed maintained low interest rates without paying attention to the fact that price stabilization was being done by "competition from abroad and the exchange rate policies of the countries of origin of those imports."

He has a dire prediction about the near term future of the US markets: it is definitely going into stagflation and the "issue is how much inflation and how much unemployment and stagnation are we going to have."

Also, here is a challenge to Miltion Friedman, who said that the real interest rate was determined by real factors and could not be manipulated by the Central Bank. Leijonhufvud argues that the "real interest rate does not exist in reality but is a constructed variable." Why? Because the low interest rates during the Greenspan era produced "virtually no CPI inflation, but drastic asset price inflation and very serious deterioration of credit standards." He also takes on the validity of rational expectation based models and provides arguments showing empirical inconsistency to the Ricardian equivalence, modern financial theory, and the representative agent model.

He extols Keynes:

"More than seventy years ago, Keynes already knew that a high degree of downward price flexibility in a recession could entirely wreck the financial system and make the situation infinitely worse."

Three lessons should be learned from Keynes:

  • To take our social responsibilities seriously and focus on the macroproblems of our own day (the ongoing credit crisis and its gradually unfolding consequences).
  • To try to understand what can be done with #1 (standard Keynesian policies are not the answer and nor are the standard central banking doctrine)
  • To ask whether events proved that existing theory needed to be revised (dynamic stochastic general equilibrium theory is an intellectually bankrupt enterprise)

More importantly, we need to realize that macroeconomic is much more dynamic to just fit into the stochastic general equilibrium models and the current events should not be tied with standard economic theories, which have already fallen prey to empirical evidences, by hook or by crook. Though current economic events should be viewed in terms of standard economic theories, they should not be unnecessarily tied with the theories because the market is too dynamic to follow standard theories!

What we need to learn from Keynes, instead, are these three lessons about how to view our responsibilities and how to approach our subject.

The paper reminds me of my Intermediate Macroeconomic and Money and Banking classes!

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