Monday, November 24, 2008

Back to Keynes

It is hard right now not to think about the economics of John Maynard Keynes. We appear to be in an environment where the lessons of the General Theory are once again relevant.

Given the developments in macroeconomics in the last 25 years it is a bit hard to type those words. Yet is surely seems to ring true today. After all, our current economic crisis is not the result of some external shock -- indeed, the boom continued while oil prices sky-rocketed. The crisis is related not to external events but to the unraveling of a bubble. In essence, it is essentially a failure of coordination. As investors fear for the future they rush for security. T-bill rates fall to near zero, lending to the private sector decreases dramatically, and income and employment start to spiral downwards. That is why so many now call for a severe dose of fiscal stimulus (see, for example, this article by Paul Krugman).

As my colleague Neil Wallace mentioned to me today, what is striking about our current situation is that unlike, say, Katrina -- which had serious, real destructive effects for both capital and labor but had little impact on the overall economy -- our current dilemma seems to stem directly from fear and expectations. Fear of the future has had very serious real effects. "Animal spirits," or the lack thereof, is the important factor. Investment is on strike right now and we seem to be in a liquidity trap where credit expansion is ineffective at combating the slump.

The return to the economics of Keynes at this moment makes me think about the "corridor hypothesis" that my former teacher Axel Leijonhufvud proposed. He argued that in normal times the market system works well to bring us back to equilibrium. Within the corridor of stability it is like a thermostat -- a negative feedback device. The problems that Keynes wrote about occur when we are outside the corridor. Then we cannot rely on the market to automatically restore equilibrium. That is where the economics of Keynes is relevant. Unfortunately, for us, we now appear to be in that situation.

I suppose that during a long period of stability it is not surprising that we ignore the lessons about effective demand failures. The lessons seem archaic. Now the same lessons seem very relevant. Good fortune allowed us to ignore the economics of Keynes for a while. Perhaps the consequence of assuming that those lessons were no longer applicable is the reason that we recklessly created an environment that caused us to leave the corridor.

1 comment:

kimrennin said...

Instability of unregulated economies in the boom years of the "Roaring '20s." In many ways, the 1920s were like the last 15 years in their technological dynamism, the extravagant lifestyles of the very rich and in their "irrational exuberance."
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kimrennin
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