Friday, March 13, 2009

Mixing ideas to mash (fg)

Everybody is talking about what policy can, cannot, must, must not do to either prevent a decline in economic activity or to let the market restore relative prices to a new economic equilibrium.

Indeed, we have
  • the "vulgar" Keynesians - if I may call those people claiming for an activist role of government in general),
  • the "pragmatics" - those who see an activist role for government in order to prevent a vicious cycle of declining domestic demand, falling asset prices and rising real debt burdens,
  • the asserters of letting the market do the whole job.
To be concrete, it is hard for policy makers to take a posititon without being exposed to massive critique by the other two groups.

When it comes to economic theory, there is a (qualified) basis to criticize state-of-the art economic models. May commentators make the wrong theory responsible for the recent boom-bust cycle. A few words on that: First, we must admit that nearly nobody favours policy recommendations derived from economic theory which would belong to the first group, i.e. the vulgar Keynesians. To adress the issue whether the New-Keynesian theory was the root of the crisis, the debate is about what is the very origin, the trigger and what are the effects of the crisis.

In my opinion (also held by many financial market participants), the cause of the mess was NOT insufficient regulation of financial markets. Banks knew that the Ponzi scheme would implode and , thus, they tried to make as much profit as possible in the boom period to cover the losses during the bust (or to close positions early enough). It was rather the extraordinary possibilty of financial institutions to raise massive funds for financing very risky positions. As economists, we would then conclude that unsustainable credit expansion in the hands of central banks was the root of the crisis. If the credit and real estate derivatives would not have been invented, the market would have just choosen another financial-services or goods sector in which it could have invested (it's all about a good story).

Secondly, the trigger was undoubtely the collapse of Lehman Bro. The big financial institutions of the US and Europe, together with the FED of New York and secretary Paulson decided to let Lehman die of thirst (the SPIEGEL writes that on the day the decision was made, a "private trading room" was installed so that most of the big institutions could net out their positions with Lehman so that when markets opened on Monday the losses were mainly taken by other institutions). The agreed intervention of central banks could only partly obviate the drying-out of the money market. Chain reactions did the rest and we rapidly saw effects on the real economy. And here is the big misjudgement of the media and of policy who still think that the cause of the crisis was the break-down of Lehman in light of deregulated markets. Lehman was just a trigger but not the origin!

In order to judge the accusation that the current applied economic theory is the reason for the crisis, I would say that most of the "New-Keynesian models" (which by the way do not give any significant role to fiscal policy in the policy process) nicely describe how monetary policy shocks are translated into an unsustainable boom-bust cycle. Moreover, recent model specifications show that the financial accelerator can aggravate economic swings. To this end, the FED did not react on a way to inflation dynamics that would have been on track with interest-rate reaction functions stemming from New-Keynsian models.

Albeit there is indeed the need to change the models of how we think about monetary policy transmission (amv is heavily working on that ;-)), I conclude that it was not the wrong theory that produced the crisis. It rather was the result of inadequate policy and too much "wall-street power" in the political decision-making process, especially in the US. My advice: adjust policy early enough in the business cycle so that we don't need to stomach the recuring fights of the policy camps producing solely mash!