http://www.ft.com/cms/s/0/8362b1d0-4b59-11dd-a490-000077b07658.html
Recession is not the worst possible outcome
By Wolfgang Münchau
Published: July 6 2008 17:53 | Last updated: July 6 2008 17:53
If this had been a mere financial crisis, it would be over by now. The fact that we are suffering its fourth wave tells us there might be something at work other than merely financial euphoria and bad regulation. Maybe this is not a Minsky moment after all. Hyman Minsky, the 20th century US economist, formulated the long forgotten, and recently rediscovered, financial instability hypothesis, according to which capitalist economies, after a long period of prosperity, end up in a vicious circle of financial speculation. The Minsky moment is the point when what economists call this “Ponzi game” collapses.
But there might be better explanations. 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.
So who are they? I recall a wonderful episode told by Jagdish Bhagwati in his book In Defense of Globalization when he quoted John Kenneth Galbraith as saying: “Milton’s [Friedman’s] misfortune is that his policies have been tried.” In fact, this is not the worst that could happen. The worst is for economists to try out their own theories themselves. This happened to several highly respected academics who have since become central bankers or finance ministers. If, or rather when, they turn out to be wrong, they risk a double reputational blow – as policymakers and as academics. So do not count on them to change their mind when the facts change.
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. An important aspect of these models is the concept of staggered prices – which says that most goods prices do not adjust continuously but at discrete intervals. This idea lies at the heart of some central bankers’ focus on core inflation – an inflation index that excludes volatile items such as food and oil. There is now a lively debate – to put it mildly – about whether an economic model in denial of a financial market can still be useful in the 21st century.
So when economists tell us that we need to keep real interest rates negative, just as we did for long periods in the past 15 years, or that we now need to bail out homeowners and banks and raise our national debt in the process, or ignore any considerations of moral hazard while the crisis is raging, we might want to question whether the recipes that got us into this mess are also most suited to get us out again.
If we believe, as the BIS does, that a rapid expansion of money and credit has either caused, or significantly contributed to, the build-up of asset price bubbles and higher inflation, the opposite policy conclusions might be more appropriate.
Under this setting, the priority might be not to impede the fall in asset prices. Real house prices in the US, the UK and several other economies might end up falling by some 40-50 per cent, peak-to-trough, in the downward phase of this cycle. Let this happen and do not implement policies to prevent this fall – such policies might alleviate some pain in the short run for some people but will make the adjustment last a lot longer.
Second, monetary policy should be geared towards price stability first and foremost. When inflation expectations rise, real interest rates should be positive. This would necessitate a large interest rate increase in the US and further interest rate increases in the eurozone as well.
Third, allow some defaulting banks to go bust.
Fourth, implement long-term policies designed to reduce volatility. Among these are: a change in the monetary policy framework to take explicit account of asset price developments; the removal of pro-cyclical incentives in the banking sector; stricter regulation of mortgages, such as the encouragement of fixed-rate loans and the imposition of maximum loan-to-value ratios; more exchange-rate flexibility in countries with fixed or semi-fixed exchange rates and, of course, the development of alternative energies to reduce our reliance on oil.
We might run a greater risk of a recession in the short term. But a recession is not the worst possible outcome. The worst is for this crisis to go on and on, for Minsky’s moment to become an eternity.
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