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What if what they taught you is wrong?

Tuesday, July 08, 2008

In this Financial Times commentary, Wolfgang Münchau comes ever so close to asking what must be one of the most difficult of all questions for any practicing economist to ask, "What if what they taught you is wrong?"

[Note: This is similar to what some U.S.-based financial advisers might be asking themselves today, eight years into a secular bear market in stocks where "stocks for the long run" may not make a whole lot of sense for someone whose "long run" is only 15 years or so and happened to begin around 2000.]

In a story appearing elsewhere at the Financial Times under the much more direct title of "The villains are not the bankers, but the economists", Mr. Munchau questions the very foundation of accepted economic theory and modern central banking.

As the Bank of International Settlements said in its latest annual report, subprime might have been the trigger for this crisis, but not the cause. We do not have a full understanding yet of what happened but the BIS suggested that fast expansion of money and credit must have played a role. I would go further and say this is not primarily a crisis of financial speculation, but one of economic policy. Its principal villains are therefore not bankers, but economists – not in their role as teachers and researchers, but as policy advisers and policymakers.
...
Several of them have been leading proponents of an economic theory known as New Keynesianism. It is, in fact, probably the most influential macroeconomic theory of our time. At the heart of the New Keynesian doctrine stands the so-called dynamic stochastic general equilibrium model, nowadays the main analytical tool of central banks all over the world. In this model, money and credit play no direct role. Nor does a financial market. The model’s technical features ensure that financial markets have no economic consequences in the long run.

This model has significant policy implications. One of them is that central banks can safely ignore monetary aggregates and credit. They should also ignore asset prices and deal only with the economic consequences of an asset price bust. They should also ignore headline inflation.
Wow! Distilled to its essential elements, this New Keynesian doctrine sounds like a real recipe for disaster!

Negative real interest rates, government bailouts, and moral hazard are all apparently part of what passes as "accepted wisdom" amongst modern-day economists.

Does any economist who proudly displays the letters PhD after his/her name have a reasonable explanation why we are now battling problems caused by too much easy money with even more easy money?

Are there still economists out there who believe that easy money was not a principle cause of the current mess?

Mr. Munchau's proposed solutions - let asset prices fall, focus on price stability including asset prices, and let banks fail - sound a lot more like Austrian Economics than the Keynesian variety as if he had channeled Andrew Mellon, Herbert Hoover’s Treasury Secretary, describing his solution to the 1929 downturn:
Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate... It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.
Should this approach be adopted, the important question will become, "Are there enough enterprising people left?"

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10 comments:

Anonymous said...

Are there enough enterprising people left? Great question!!

In China, sure. In the US, given enough incentive, perhaps.

Anonymous said...

so what's the solution, braniac???

Tim said...

I don't know but I like the part about, "High costs of living and high living will come down. People will work harder, live a more moral life."

Anonymous said...

The present US Government will always save the banks and pass the expense to the US Taxpayer. Incidentally, the percent of US Taxes paid by Corporations has dramatically declined over the last 10 years which doubly exposes the common middle class American to "Pick up the bill" in the form of oncoming inflation.

Anonymous said...

Great post.

You end it by writing "Should this approach be adopted...." But one way or another this approach WILL be adopted, sooner or later, voluntarily or involuntarily. Government can push the reckoning day off only so long, then it comes whether they like it or not. The only question will be whether the free market takes control again because the government voluntarily gets out of the way, or because the government drove the society into the ground and the free market of black markets, thugs, crooks, strongmen, and such asserts itself.

Nick said...

I don't think we need to worry about that approach being adopted; it would take more political will power and responsibility than seems to exist in our entire government as a whole to even propose letting all the reckless and irresponsible businesses and individuals suffer all the losses they richly deserve. There will be much protestation and indignation, but in the end, we will socialize the losses to the detriment of the responsible and productive members of our society, and in doing so sew the seeds for the next inevitable meltdown.

I, too, wish we would learn from history, and collectively posses more common sense than the simplest animals, who will eventually learn not to do the things which cause them pain over and over and over again. Unfortunately, America seems incapable of electing representatives who are both intelligent enough to understand what's best long-term, and unselfish enough to put those interest above their own ambitions. Instead, we get the latest party figureheads promoting vacuous "change" and empty rhetoric, and more short-term quick-fix bailout policies designed to buy votes.

It's so depressing.

Anonymous said...

The underlying problem has been the dramatic loss of purchasing power of the American middle class. This has occured because the US abandoned the basket-of-goods measure of inflation of the early 80's. Economist John Williams of www.shadowstats.com estimates that, using the yardsticks of 1980, the current inflation rate is 12% and unemployment 13%.

This has been temporarily compensated for by flooding the US with cheap money. In 2006 over 5% of the purchases of goods and services were made with home equity funds.

Clearly this is not sustainable. The most positive action the US could take would be to restore basket-of-goods CPI along with interest rates to match.

Otherwise we are just kidding ourselves into oblivion.

Anonymous said...

Rote training in action.

russ said...

Tim, you should probably use this wiki link instead:

http://en.wikipedia.org/wiki/New_Keynesian_economics

Tim said...

Done - thanks.

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