Mankiw on ‘what Keynes would have done?’
Greg Mankiw explains Keynesian policy prescriptions in current situation — Government now becomes the last resort to generate aggregate demand, but he is worried about the long-term impact of budget deficits; The Fed should have a bigger role to play and it has some secret weapons. This is a must-read.
IF you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. His insights go a long way toward explaining the challenges we now confront.
According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.
The situation reverses, Keynesian theory says, only when some event or policy increases aggregate demand. The problem right now is that it is hard to see where that demand might come from.
The economy's output of goods and services is traditionally divided into four components: consumption, investment, net exports and government purchases. Any expansion in demand has to come from one of these four. But in each case, strong forces are working to keep spending down.
CONSUMPTION The Conference Board reports that consumer confidence is near its record low. It is easy to understand why consumers are so scared. House values have declined, 401(k) balances have shrunk and unemployment is up. For many people, the sense of economic uncertainty is greater than they've ever experienced. When it comes to discretionary purchases, like a new home, a car, or a washing machine, wait-and-see is the most rational course.
A bit more saving is not entirely unwelcome. Many economists have long lamented the United States saving rate, which is low by international and historical standards.
For the overall economy, however, a recession is not the best time for households to start saving. Keynesian theory suggests a "paradox of thrift." If all households try to save more, a short-run result could be lower aggregate demand and thus lower national income. Reduced incomes, in turn, could prevent households from reaching their new saving goals.
INVESTMENT In normal times, a fall in consumption could be met by an increase in investment, which includes spending by businesses on plant and equipment and by households on new homes. But several factors are keeping investment spending at bay.
The most obvious is the state of the housing market. Over the past three years, residential investment has fallen 42 percent. With house prices continuing to decline, increased building of new homes is not likely to be a source of robust demand over the next few years.
Business investment has lately been stronger than residential investment, but it is unlikely to pick up the slack in the near future. With the stock market down, interest rates on corporate bonds up and the banking system teetering on the edge, financing new business projects will not be easy.
NET EXPORTS Not long ago, it looked as if the rest of the world would save the United States economy from a deep downturn. From March 2004 to March 2008, the dollar fell 19 percent against an average of other major currencies. By increasing the price of foreign goods in the United States and reducing the price of American goods abroad, this depreciation discouraged imports and bolstered exports. Over the last three years, real net exports have increased by about $250 billion.
In the coming months, however, the situation may well go into reverse. As the United States financial crisis has spread to the rest of the world, fast-moving international capital has been looking for a safe haven. Ironically, that haven is the United States. Since March, the dollar has appreciated 19 percent, a move that will put a crimp in the export boom.
GOVERNMENT PURCHASES That leaves the government as the demander of last resort. Calls for increased infrastructure spending fit well with Keynesian theory. In principle, every dollar spent by the government could cause national income to increase by more than a dollar if it leads to a more vibrant economy and stimulates spending by consumers and companies. By all reports, that is precisely the plan that the incoming Obama administration has in mind.
The fly in the ointment — or perhaps it is more an elephant — is the long-term fiscal picture. Increased government spending may be a good short-run fix, but it would add to the budget deficit. The baby boomers are now starting to retire and claim Social Security and Medicare benefits. Any increase in the national debt will make fulfilling those unfunded promises harder in coming years.
Keynesian economists often dismiss these long-run concerns when the economy has short-run problems. "In the long run we are all dead," Keynes famously quipped.
The longer-term problem we now face, however, may be more serious than any that Keynes ever envisioned. Passing a larger national debt to the next generation may look attractive to those without children. (Keynes himself was childless.) But the rest of us cannot feel much comfort knowing that, in the long run, when we are dead, our children and grandchildren will be dealing with our fiscal legacy.
So what is to be done? Many economists still hope the Federal Reserve will save the day.
In normal times, the Fed can bolster aggregate demand by reducing interest rates. Lower interest rates encourage households and companies to borrow and spend. They also bolster equity values and, by encouraging international capital to look elsewhere, reduce the value of the dollar in foreign-exchange markets. Spending on consumption, investment and net exports all increase.
But these are not normal times. The Fed has already cut the federal funds rate to 1 percent, close to its lower bound of zero. Some fear that our central bank is almost out of ammunition.
Fortunately, the Fed has a few secret weapons. It can set a target for longer-term interest rates. It can commit itself to keeping interest rates low for a sustained period. Most important, it can try to manage expectations and assure markets that it will do whatever it takes to avoid prolonged deflation. The Fed's decision last week to start buying mortgage debt shows its willingness to act creatively.
It is hard to say how successful monetary and fiscal policy will be in avoiding a deep downturn. But as events unfold, you can be sure that policymakers in the Fed and Treasury will be looking at them through a Keynesian lens.
In 1936, Keynes wrote, "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slave of some defunct economist." In 2008, no defunct economist is more prominent than Keynes himself.
The return of Larry Summers
Take a deep look at Obama's economic policy from the viewpoints of his chief economic adviser: Larry Summers. (source: NYT)
Summers, Merton and Soros in one Panel
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Jeremy Grantham Interview
Interview of legendary investor, Jeremy Grantham:
2008: The most volatile market ever
This is from Bespoke:
Over the last 50 trading days, the average absolute daily percentage change of the S&P 500 has been…wait for it…3.82%! That means the S&P 500 is averaging a daily move of up or down nearly 4%. This is definitely one of the craziest statistics of the current bear market, and unfortunately, the majority of the daily moves have been down. In the history of the S&P 500, there has never been a more volatile period. Back in February of last year, the 50-day average absolute change was just 0.33%. When we ever do get back to daily moves of less than 1%, traders are going to be falling asleep at their desks after going through this turmoil.
![[China's Steel Production chart]](https://s.wsj.net/public/resources/images/AI-AS351_CSTEEL_NS_20081125154428.gif)
Wallet Biopsy
BW has an interesting story on how hospitals may be using your financial records against you. Sometimes, a good credit score may hurt you.
Why don’t ‘we’ see it coming?
Paul Krugman writes on NY Times:
Lest We Forget
A few months ago I found myself at a meeting of economists and finance officials, discussing — what else? — the crisis. There was a lot of soul-searching going on. One senior policy maker asked, “Why didn’t we see this coming?”
There was, of course, only one thing to say in reply, so I said it: “What do you mean ‘we,’ white man?”
Seriously, though, the official had a point. Some people say that the current crisis is unprecedented, but the truth is that there were plenty of precedents, some of them of very recent vintage. Yet these precedents were ignored. And the story of how “we” failed to see this coming has a clear policy implication — namely, that financial market reform should be pressed quickly, that it shouldn’t wait until the crisis is resolved.
About those precedents: Why did so many observers dismiss the obvious signs of a housing bubble, even though the 1990s dot-com bubble was fresh in our memories?
Why did so many people insist that our financial system was “resilient,” as Alan Greenspan put it, when in 1998 the collapse of a single hedge fund, Long-Term Capital Management, temporarily paralyzed credit markets around the world?
Why did almost everyone believe in the omnipotence of the Federal Reserve when its counterpart, the Bank of Japan, spent a decade trying and failing to jump-start a stalled economy?
One answer to these questions is that nobody likes a party pooper. While the housing bubble was still inflating, lenders were making lots of money issuing mortgages to anyone who walked in the door; investment banks were making even more money repackaging those mortgages into shiny new securities; and money managers who booked big paper profits by buying those securities with borrowed funds looked like geniuses, and were paid accordingly. Who wanted to hear from dismal economists warning that the whole thing was, in effect, a giant Ponzi scheme?
There’s also another reason the economic policy establishment failed to see the current crisis coming. The crises of the 1990s and the early years of this decade should have been seen as dire omens, as intimations of still worse troubles to come. But everyone was too busy celebrating our success in getting through those crises to notice.
Consider, in particular, what happened after the crisis of 1997-98. This crisis showed that the modern financial system, with its deregulated markets, highly leveraged players and global capital flows, was becoming dangerously fragile. But when the crisis abated, the order of the day was triumphalism, not soul-searching.
Time magazine famously named Mr. Greenspan, Robert Rubin and Lawrence Summers “The Committee to Save the World” — the “Three Marketeers” who “prevented a global meltdown.” In effect, everyone declared a victory party over our pullback from the brink, while forgetting to ask how we got so close to the brink in the first place.
In fact, both the crisis of 1997-98 and the bursting of the dot-com bubble probably had the perverse effect of making both investors and public officials more, not less, complacent. Because neither crisis quite lived up to our worst fears, because neither brought about another Great Depression, investors came to believe that Mr. Greenspan had the magical power to solve all problems — and so, one suspects, did Mr. Greenspan himself, who opposed all proposals for prudential regulation of the financial system.
Now we’re in the midst of another crisis, the worst since the 1930s. For the moment, all eyes are on the immediate response to that crisis. Will the Fed’s ever more aggressive efforts to unfreeze the credit markets finally start getting somewhere? Will the Obama administration’s fiscal stimulus turn output and employment around? (I’m still not sure, by the way, whether the economic team is thinking big enough.)
And because we’re all so worried about the current crisis, it’s hard to focus on the longer-term issues — on reining in our out-of-control financial system, so as to prevent or at least limit the next crisis. Yet the experience of the last decade suggests that we should be worrying about financial reform, above all regulating the “shadow banking system” at the heart of the current mess, sooner rather than later.
For once the economy is on the road to recovery, the wheeler-dealers will be making easy money again — and will lobby hard against anyone who tries to limit their bottom lines. Moreover, the success of recovery efforts will come to seem preordained, even though it wasn’t, and the urgency of action will be lost.
So here’s my plea: even though the incoming administration’s agenda is already very full, it should not put off financial reform. The time to start preventing the next crisis is now.