Thursday, July 03, 2008

What to do...What to do?

Axel Leijonhufvud thinks we live in interesting times:
The important economic problem of today is the current financial crisis centred in the United States. What might we learn from Keynes about it? The current situation is almost the opposite of the one that Keynes dealt with in the General Theory.

....The Treatise on Money contains a piece of analysis that I have found illuminating. It deals with the financial side of a business downturn. Keynes assumes an initial equilibrium disturbed by a decline in expected future revenues from present capital accumulation.

Firms cut back on investment and, as activity levels decline, direct some part of cash flow to the repayment of trade credit and of bank loans. As short rates decline, banks choose not to relend all these funds but instead to improve their own reserve positions. Thus the system as a whole shows an increased demand for high-powered money and simultaneously a decrease in the volume of bank money held by the non-bank sector.

....What makes this analysis relevant in today's context is that it describes a process of general deleveraging as part of a business downturn. Causally, it is the decline of investment expectations and the consequent contraction of output that prompts deleveraging. Today, we are faced with the converse question of whether or not the deleveraging that the financial sector is rather desperately trying to carry through will of necessity bring about a serious recession.

Immediately following the above are some interesting thoughts on the Japanese and Scandinavian economic crises of the 1990s, that need not detain the FLUBA here. What does is, this delinetion of the current situation in the USA:
As in the Japanese case, the lesson of the Depression is that a collapse of credit cannot be reversed and that the consequences linger for a very long time. It is also true,
however, that until only a year or two ago Chairman Ben Bernanke was a consistent and outspoken advocate of a monetary policy of strict inflation targeting, which is to say, of a central banking doctrine that required an exclusive concentration on keeping consumer prices
within a narrow range with no attention to asset prices, exchange rates, credit quality or (of course) unemployment.

....There are two aspects of the wreckage from the current crisis that have not attracted much attention so far. One is the wreck of what was until a year ago the widely accepted central banking doctrine. The other is the damage to the macroeconomic theory that underpinned
that doctrine.

Critical to the central banking doctrine was the proposition that monetary policy is fundamentally only about controlling the price level.....The goal of monetary policy... could only be to stabilise the price level (or its rate of change). This would be most efficaciously accomplished by inflation targeting, an adaptive strategy that requires the bank to respond to any deviation of the price level from target by moving the interest rate in the opposite direction.

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the crash. In this, the Fed was successful.

But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be
feedback confirming that the interest rate is right.

In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.

Now for the really bad news; he doesn't think we know what to do about it:
In the old monetarism of Milton Friedman, the real interest rate was determined by real factors and could not be manipulated by the Central Bank. Any attempt to do so would quickly destabilise the price level in Wicksellian fashion. This property was carried over into rational expectations monetarism and then into real business cycle theory and dynamic stochastic general equilibrium (DSGE) theory in general.

The Federal Reserve System under Greenspan put this proposition to the test in the years following the crash, pursuing an extreme low interest policy.

The result was more Keynesian than Monetarist and...more Austrian than Keynesian: virtually
no CPI inflation, but drastic asset price inflation and very serious deterioration of credit standards (Leijonhufvud 2007c).

The problem is that the real interest rate does not exist in reality but is a constructed variable. What does exist is the money rate of interest from which one may construct a distribution of perceived real interest rates given some distribution of inflation expectations over agents.

Intertemporal non-monetary general equilibrium (or finance) models deal in variables that have no real world counterparts. ....

Modern financial theory is incorporated as a component of dynamic stochastic general equilibrium theories. Its core assumption that future returns are normally distributed
fits neatly into rational expectations models but has been proven false innumerable times. The
repeated occurrence of financial crashes or crises hardly seems consistent with intertemporal equilibrium theory.

....The usual objection to representative agent models has been that it fails to take into account well-documented systematic differences in behaviour between age groups, income classes,
etc. In the financial crisis context, however, the objection is rather that these models are blind to the consequences of too many people doing the same thing at the same time, for example, trying to liquidate very similar positions at the same time. ....The representative lemming is not a rational expectations intertemporal optimising creature. But he is responsible for the fat tail problem that macroeconomists have the most reason to care about.

....the main alternative to Real Business Cycle Theory has been a somewhat loose cluster
of models given the label of New Keynesian theory.

New Keynesians adhere on the whole to the same DSGE modeling technology as RBC macroeconomists but differ in the extent to which they emphasise inflexibilities of prices or other contract terms as sources of short term adjustment problems in the economy. The New
label refers back to the rigid wages brand of Keynesian theory of 40 or 50 years ago.

....The obvious objection to this kind of return to an earlier way of thinking about macroeconomic problems is that the major problems that have had to be confronted in the last twenty or so years have originated in the financial markets - and prices in those markets are anything
but inflexible.

....Today's problem is the ongoing credit crisis and its gradually unfolding consequences.

....standard Keynesian policies are not the answer. Neither is the central banking doctrine that has dominated in recent years. Fortunately, Ben Bernanke and Mervyn King have shown that they realise that we must move beyond that doctrine. ....I conclude that dynamic stochastic general equilibrium theory has shown itself an intellectually bankrupt enterprise.

But this does not mean that we should revert to the old Keynesian theory that preceded it (or adopt the New Keynesian theory that has tried to compete with it).

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