The New Consensus Macroeconomics and the Current

Economic and Financial Crisis

Presentation prepared for the 7th International AISPE Summer School, “The Global Financial Crisis: Historical and

Theoretical Approaches”, Lucca (Italy),9-12th September 2009

ByGiuseppe Fontana

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Outline• Introduction:

– The Current Crisis and Keynesian Economics• Nature of the Crisis:

– Keynes versus the Classics– The distinctive features of Keynesian economics– The NCM and its New Keynesian roots

• Origin of the Crisis:– Conventional arguments

• Accommodative (‘loose’) monetary policy: the ‘Greenspan put’• World financial imbalances• Misguided under-pricing of risk

– Conventional arguments again: myths or realities?• Lessons learnt … and forgotten

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Nature of the Current Crisis

• Keynes versus the ClassicsThe classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in discovering that in experience straight lines apparently parallel often meet, experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight rebuke the lines for not keeping straight as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-throw over the axiom of parallels and to work out a non-Euclidean geometry.Euclidean geometry. Something similar is required today in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible (Keynes, GT, Ch. 2, p. 16)

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Nature of the Current Crisis• The distinctive features of Keynesian

economics– Proposition I (the possibility of involuntary

unemployment): the economy does not automatically and effectively self-adjust towards the social macroeconomic optimum.

– Proposition II (the principle of effective demand): aggregate demand plays an important role in determining the adjustment path of the economy.

– Proposition III (the principle of policy effectiveness): fiscal and monetary policies are effective for determining, under certain circumstances, the level of output and employment in the economy.

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Nature of the Current Crisis

• The NCM and its New Keynesian roots: Proposition I-III are only valid in the short run, never in the long run:– PI (the possibility of involuntary unemployment)

Acceptance of Say’s Law– PII (the principle of effective demand)

Aggregate demand has (if any) only a transitory impact on the degree of utilization of existing productive resources and their rate of expansion over time

– PIII (the principle of policy effectiveness) Fiscal policy is rejected in favour of monetary policy Acceptance of the classical axiom of neutrality of money and monetary policy

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Origin of the Current Crisis

• Conventional Arguments– Accommodative (‘loose’) monetary policy: the

‘Greenspan put’• When a crisis arose the Fed came to the rescue of financial

markets by significantly and consistently lowering the funds rate.

– World financial imbalances• Chronic and persistent trade deficit in the US (but also UK,

Ireland and Spain) vis-à-vis chronic and persistent trade surpluses of oil exporting and East Asian countries (e.g. China).

– Misguided under-pricing of risk• Financial investors ‘played with fire’ by being overconfident

about the ability of their mathematical models of measuring and managing risk.

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The main fundamental cause of what happened was the piling up over 10 or 15 years of easy - too easy - monetary policies10 or 15 years of easy - too easy - monetary policies, very large current account imbalances in the United Statesvery large current account imbalances in the United States in particular, matched by large structural surpluses in a number of emerging countries which pegged their currencies to the dollar more or less and therefore injected very large amounts of very large amounts of liquidity into the systemliquidity into the system. This easy money, easy credit condition propagated a search for higher yields than those thatwere offered by very low interest rates which were associated with this easy monetary policy; financial institutions’ investors engaged in search of higher yields, therefore paying less attention to the quality of credits, accepting relatively low spreads for high risks, therefore undermining the fundamental undermining the fundamental prudence of the banking systemprudence of the banking system. This was the basic set of circumstances that led to the present crisis (de Larosière, in House of Lords Report, 2009).

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Global Current Account Balances

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The increasing scale and complexity of the securitised credit market was obvious to individual participants, to regulators and to academic observers. But the predominant assumption was that increased complexity had been matched by the evolution of mathematically complexity had been matched by the evolution of mathematically sophisticated and effective techniques for measuring and managing sophisticated and effective techniques for measuring and managing the resulting risks.the resulting risks. Central to many of the techniques was the concept of Value-at-Risk (VAR), enabling inferences about forward-looking risk to be drawn from the observation of past patterns of price movement. This technique, developed in the early 1990s, was not only accepted as standard across the industry, but adopted by regulators as the basis for calculating trading risk and required capital. …The very complexity of the mathematics used to measure and manage risk, moreover, made it increasingly difficult for top management and boards to assess and exercise judgement over the risks being taken. Mathematical sophistication ended up not containing risk, but providing Mathematical sophistication ended up not containing risk, but providing false assurance false assurance that other prima facie indicators of increasing risk (e.g. rapid credit extension and balance sheet growth) could be safely ignored (Turner Review, 2009, p. 22)

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Origin of the Current Crisis• Conventional Arguments Again: Myths or Realities?

– Loose monetary policy and the ‘Greenspan put’: From Maestro to Villain of modern monetary policy?

• What is the role of a central bank in modern economies? What is the transmission mechanism of monetary policy? Are low interest rates a problem (how and when)?

• The New Consensus Macroeconomics (NCM) and its monetary policy implications: the Aggregate Demand (AD) channel and the Expectation channel of the monetary policy transmission mechanism

• NCM only consider demand-pull (commodity) inflation• Insiders’ Criticisms of the NCM model: lack of proper analysis of

the credit and financial markets, labour market and goods market

• Outsiders’ Criticisms of the conventional monetary policy: unemployment bias; distributional effects; financial instability effects

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Origin of the Current Crisis

• Conventional Arguments Again: Myths or Realities?– World financial imbalances

• “What was happening was that foreign nations were buying U.S. and U.K. government securities and that merely meant that whatever happened in the financial markets of the local economies would now going to be transferred immediately to foreign nations.  And now people start talking about ‘decoupling’: getting one nation’s financial system not to affect the other nations’ financial systems. It’s not a symptom, is a mechanism of contagion” (Davidson, 2009).

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Origin of the Current Crisis

• Conventional Arguments Again: Myths or Realities?– Misguided under-pricing of risk

• Lack of information or wrong information: would you doubt what Lehman Brothers or JP Morgan said? Would you doubt what rating agencies gave AAA rating? The problem is then wrong information due to the conflict of interest in the financial markets, and the lack of regulation of agencies

• Lack of Regulation: Replacement of the traditional “Originate-and-Hold” model of bank loans with the modern “Originate-and-Distribute” model

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Lessons learnt … and forgotten

Keynes’s view was that we need different economic models at different times. The beauty of his General Theory of Employment, Interest and Money was that it was general enough to accommodate a variety of models applicable to different conditions. Markets could behave in ways described by the classical and New Classical theories, but they need not. So it was important to take precautions against bad behaviour. Ultimately, the Keynesian revolution was a triumph not of good science over bad science, but of good judgment over bad judgment. (Robert Skidelsky, FT, 2009)

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Lessons learnt … and forgotten

• Monetary policy beyond the New Consensus Macroeconomics (NCM)

• Fiscal policy is back! (but for how long?)

• The role of macro-prudential regulation in financial markets

• The ‘exit strategy’ from the current monetary and fiscal stimulus

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