“In more than 30 years of teaching introductory macroeconomics, says Alan Blinder of Princeton University, he has never seen interest as high as it was last year... the crisis has also highlighted flaws in the existing macroeconomics curriculum... Courses in many leading universities are already being amended... Discussion of the “liquidity trap,” in which standard easing of monetary policy may cease to have any effect, had fallen out of vogue in undergraduate courses but seems to be back with a vengeance. Asset-price bubbles are also gaining more prominence.”
excerpts from the article titled “Revise and Resubmit”
The financial crisis which later developed into a full-fledged economic crisis resulted into rising unemployment and a definite slowdown in economic activities in the USA. It has induced economic slowdown in other countries though some of the emerging economies like India and China are coping better with the recessionary trend in the aftermath. For a huge chunk of people across the world, it means a lot of hardship in the form of unemployment, cutting down on consumption and other expenditures and so on. By now, these are all known facts to almost everybody interested in economic happenings in the world. But, this has also been a defining time for the teachers, students and researchers in the subject of economics. Keynesian economics, which has been declared obsolete by numerous economists and commentators, is once again back in full relevance. Those who denounced Keynesian framework as a thing of past are now gradually understanding the efficacy of it as different parts of US corporate sector (particularly, the financial sector) are getting bailed out by USA Federal Government.
The history has repeated itself after around 70 years. The Great Depression of the 1930s brought in what is called in the annals of economics as “Keynesian Revolution.” Lord John Maynard Keynes, the liberal economist from Britain, gave economic theorisation a new outlook. Contrasting his analysis on the demand side of the economics with then prevalent supply side theorisation, Keynes propagated comprehensive “socialisation” of investment, where the State acting on behalf of society would ensure a level of investment in the economy, and hence a level of aggregate demand that is adequate for full employment. He was the first economist to show that achieving full employment is not automatic, rather the State has to economically act for it and only then full capacity utilisation is possible. Among other fundmental shifts in theorisation, Keynes also identified the incapacity of a free market system to distinguish between “enterprise” and “speculation.” The free market tends to get dominated by speculators who are interested not in the long term yield on assets but only in the short term appreciation in the asset values. And whims and fancies of such “speculators” boils down to sharp swings in asset prices which determine the magnitude of productive investment and hence the level of aggregate demand, employment and output in the economy. “The real lives of millions of people were determined by the whims of a bunch of speculators under the free market system.”1
In simple words, unbridled speculation also leads to a crunch in the availability of credit for “productive purposes.” The brick and mortar economy suffers at the expense of high speculative demand for money. Financial safeguards which were put in the aftermath of Great Depression had been gradually dismantled in decades of “complacent and peace-time economy.” Speculations were fuelled by asset price bubble in one or more segments in the financial sector. For example, in the last decade of the past millennium it was the bubble in IT (due to Y2K problem) and in recent times the bubble was sustained through buoyant prices in the housing sector in USA. The (finance) capital gain made using such continuous and spectacular asset price rise, in turn, would push economic growth upwards. However, within this process of rise in GDP the concerned economic actors and policy makers often forget the simple fact that any asset price cannot rise forever, and whenever it crashes, it brings down the economy along with that fall. Real economy also suffers because there is always a general apprehension during recessionary time to provide credit. On the manufacturing side also, there are always fears regarding existing demand for products and services, and that takes the economy into a downward spiral. Broadly this is the precise chain of events which happened in the USA. Given the size of US GDP and its strong trade links with most of the countries, the crisis got exported to different corners in the world. Going by the trends in policy reactions in most of the affected countries, a Keynesian response in the form of government fiscal intervention seems to be providing solution for the time being.
“Conor Clarke (Interviewer): So is it time for the Keynesians to declare victory?
Paul Samuelson: Well, I don't care very much for the People Magazine approach to applied economics, but let me put it this way. The 1980s trained macroeconomists – like Greg Mankiw and Ben Bernanke and so forth – became a very complacent group, very ill adapted to meet with a completely unpredictable and new situation, such as we've had. I looked up – (and by the way, the most of these guys are MIT trained; Princeton to MIT or Harvard to MIT) – Mankiw's bestseller, both the macro book and his introductory textbook, I went through the index to look for liquidity trap. It wasn't there!
Conor Clarke (Interviewer): Oh, I used those textbooks. There's got to be something in there on liquidity traps.
Paul Samuelson: Well, not in the index. And I looked up Bernanke's PhD thesis, which was on the Great Depression, and I realised that when you're writing in the 1980s, and there's a mindset that's almost universal, you miss a lot of nuances of what actually happened during the depression...
...My book, which over a period of about 50 years sold millions of copies, for the first time brought home - ... the gist of the Keynesian macroeconomic system.
...I had distrust – after 1967, let's say – of American Keynesianism. For better or worse, US Keynesianism was so far ahead of where it started. I am a cafeteria Keynesian. You know what a cafeteria catholic is?
Conor Clarke (Interviewer): I think so. Someone who picks and chooses the bits of the doctrine that they find agreeable.”
These are excerpts of an interview which appeared in “The Atlantic” in two parts on June 17 and 18, 2009, around six months before Paul Samuelson died on December 13 the same year.2 As far as macroeconomic policies to counter recessionary trends in an economy is concerned he made his position quite clear and did not mince any words while criticising the standard reactions of some of the better-known US macroeconomists to the occurence of financial and economic crisis in an economy. However, though claiming to be a so-called “cafeteria Keynesian” Samuelson himself was a stalwart of propagating certain neo-classical values in economics.
Denial or underestimation of concepts like “liquidity trap” by today's American macroeconomists is no isolated phenomenon. In their framework if there is an increase in easy credit availability then eventually there would be more credit offtake and as a result, an increase in aggregate demand and production. Then that would result into more credit demand and put an upward pressure on rate of interest. If increasing the monetary base can take care of the problem then why should one bother about a situation where rate of interest is at such a low level where people in general will hold liquid cash? Rate of interest can be raised sufficiently to avert any such kind of possibility. This logic completely ignores the possibility of low or no amount of credit demand in spite of easy supply of credit in the economy.
In fact, this is in continuation with the idea that 1930s' Great Depression would not have happened in USA if Federal Reserve Bank and American Government did not undertake a series of so-called “wrong” policies and if monetary base was expanded at the right time then the crisis could have been averted to a great extent. This was first propagated and best articulated within the mainstream theory by none other than Milton Friedman. In his 1963 book, “A Monetary History of the United States, 1867–1960” co-authored with Anna Schwartz, Friedman came out strongly against Fed and American government blaming them squarely for bringing in the recession by raising interest rates first, then increasing tax rates, and declaring “bank holidays” to restrict withdrawal of deposits from the banks starting panic all over the USA, resulting in bank runs in thousands of bank in that country. According to him, restrictive tariff policies also have to be blamed for worsening the situation.
Essentially free market proponents tend to undermine the efficacy of fiscal policy as it involves government intervention. This undermining, in turn, propagates the efficiency of market forces, and it also poses the government as a part of the problem in an economy and never a solution. Government is seen as an agency which only creates distortions in free market mechanism in the form of price distortion and distortions in other key macroeconomic variables. Essentially, according to this neo-classical framework any kind of government intervention will result into so called “market failures” (where market will be unable to reach at equilibrium price and quantity through free interaction between demand and supply) in different sectors of the economy. In his Presidential address delivered at 80th Annual Meeting of American Economic Association in December 1967, Friedman said,
“Keynes and most other economists of the time believed that the Great Contraction in the United States occurred despite aggressive expansionary policies by the monetary authorities – that they did their best but their best was not good enough. Recent Studies have demonstrated that the facts are precisely the reverse: the U.S. monetary authorities followed highly deflationary policies. The quantity of money in the United States fell by one-third in the course of the contraction. And it fell not because there were no willing borrowers – not because the horse would not drink. It fell because the Federal Reserve System forced or permitted a sharp reduction in the monetary base, because it failed to exercise the responsibilities assigned to it in the Federal Reserve Act to provide liquidity to the banking system. The Great Contraction is tragic testimony to the power of monetary policy – not, as Keynes and so many of his contemporaries believed, evidence of its impotence.”3
This kind of logical reasoning ultimately posits that the recessionary trends would not have happened if enough money were supplied at right time. Apart from creating a stable background for the economy by monetary policy, Friedman also talked about creating a balance while controlling the money supply. In essence, he debunked the idea of influencing key macroeconomic variables like rate of interest, inflation or unemployment in the long run. This means a very limited or no role for monetary policy in influencing the economy. The idea of fiscal intervention, in any case, was debunked by that time. Structurally monetarism (as propagated by Friedman) negates the idea of Keynesian fiscal activism on the part of the government. So in short and simple words, the government or the central bank would have almost no role to play in economic policy making. Friedman mentioned,
“A second requirement for monetary policy is that the monetary authority avoid sharp swings in policy. In the past, monetary authorities have on occasion moved in the wrong direction – as in the episode of the Great Contraction that I have stressed. More frequently, they have moved in the right direction, albeit often too late, but have erred by moving too far. Too late and too much has been the general practice. For example, in early 1966, it was the right policy for the Federal Reserve to move in a less expansionary direction – though it should have done so at least a year earlier. But when it moved, it went too far, producing the sharpest change in the rate of monetary growth of the post-war era. Again having gone too far, it was the right policy for the Fed to reverse course at the end of 1966. But again it went too far, not only restoring but exceeding the earlier excessive rate of monetary growth. And this episode is no exception. Time and again this has been the course followed – as in 1919 and 1920, in 1937 and 1938, in 1953 and 1954, in 1959 and 1960.”4
So, his prescription was to avoid such swings “by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total.” This, in his belief, may result into moderate inflation some times, but in his opinion moderate inflation or deflation with a publicised steady rate in money supply is easier to handle than wide-ranging fluctuations in the control variable which may result into runaway inflation or chronic deflation. Great amount of overall economic aloofness has always been prescribed for the central bank and the government within the structure of monetarist and neo-classical paradigm of economic theorisation simply because structurally these theories have strong belief in free market mechanism.
The broader battlelines of economic ideas are drawn with respect to these two theoretical positions – one Keynesian and the other neo-classical. However, there are many explanations provided by eminent economists at different times. For example, many commentators and economists are relating the current crisis with Hyman Mynski's thesis on financial crisis and named it as “Mynski meltdown.” Mynski's proposition has generated a lot of interest lately though his theorisation is there for many decades now. One may put it as Hyman P. Mynski's moment of posthumous vindication, but a few economists are even theoretically challenging this “Mynski moment.” Some economists of certain neo-classical streams are putting up a brave face and still trying to explain the crisis within a framework of so called “business cycle” theory. So, there are more nuances, complexities and subtleties involved in this than one can possibly think of while simply comprehending the crisis.
With lots of revisions in popular undergraduate basic economics textbooks around the corner, how many of these nuances get incorporated in the revised versions remains an interesting future to watch out for. Over the years, the basic textbooks of economics remained the primary and the most important source to inculcate neo-classical pro-market values in young impressionable minds. Those moulded minds throughout their lives have faith in a stream of economics which they often believe is “next to natural sciences” for its determinate pattern. This sense of “precise determination” is derived also by unnecessary mathematisation and liberal borrowing of tools and concepts from subjects like physics and some of the bio-sciences. This false sense of precision often clouds the mind of a typical economics student while economics remains a social science dealing with pure human beings where there is very little or no scope for experimentation and hence essentially a subject with definite indeterminate nature. This also possibly calls for an effort on the part of progressive economists of the world to popularise their alternative viewpoints through the standard textbook channel.
Friedman, Milton (1968), The Role of Monetary Policy, American Economic Review, Volume LVIII, March 1968, Number 1
Patnaik, Prabhat (2008), A Perspective on the Crisis, Networkideas (http://www.networkideas.org)