Keynesian Recession Coming

It looks like we are in for a real Keynesian recession. The liquidity crisis seems to have led to a stop to bank lending, so we are approaching a liquidity trap. Demand is now falling, witness the drop in retail sales announced today which shook the markets, and this is a sign that the recession is already underway. If monetary policy is ineffective due to bank's unwillingness to lend, we are in the almost classic "Keynesian type" recession of old textbooks.

The relevance of Keynes to our current experience was highlighted by Robert Skidelsky in this column. He is perhaps correct when he writes that

To understand how markets can generate their own hurricanes we need to return to John Maynard Keynes.

But I think he overstates his case considerably when he argues that " mainstream theory has no explanation of why things have gone so horribly wrong." In particular, he expresses the view that is prevalent now that economists focus on efficient markets blinded them to

Greed, ignorance, euphoria, panic, herd behavior, predation, financial skulduggery and politics -- the forces that drive boom-bust cycles -- only exist off the balance sheet of their models.

This is factually incorrect. We have models of bubbles and herd behavior. But more important it ignores the point that much of the problems we have now are the result of ignoring market efficiency. When investors believed they could earn extra return for no extra risk they were not basing their behavior on efficiency. The carry trade is an example of profiting from the absence of efficiency. The problems we now face are that markets caught up. The excess returns they were earning were just a compensation for the losses that are now incurred. If savers and investors had assumed that they could not earn extra return for no extra risk they would have been in index funds not CDO's. They would not have been fooled by ratings from ratings agencies.