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a symposium on the economic crisis « Previous | |Next »
June 19, 2009

The Crisis and How to Deal with It is a symposium hosted by the New York Review of Books on the global recession. The context of this debate is the ongoing conflict within the economic profession over what to do, given that the financial system as we know it actually collapsed, really ceased to function and had to be put on artificial life support. That collapse then caused a recession in the global economy.

The traditional classical economic position is that free markets are automatically self-adjusting to full employment. They were either continually at full employment or, if disturbed by an outside shock, rapidly returned to it. The only thing capable of wrecking the workings of the market’s invisible hand was the visible hand of government interference. The Great Depression of 1929-32 clearly showed that markets had no automatic tendency to full employment. This failing of the invisible hand justified government intervention to boost demand so as to maintain full employment.

In the 1960s the Chicago School lead by Milton Friedman reinstated classical theory using mathematics to argue that markets are instantaneously, or nearly instantaneously, self-adjusting to full employment. The message of the neo-classical economists was simple: markets were good, governments bad. Policymaker signed up in droves, persuaded that economics, unlike sociology, was a natural science that had discovered the truth about the real nature of things as expressed in mathematical theorems.

Then along came the global financial crisis recession and it showed that markets were not self-adjusting. The bubble-prone financial system had collapsed of its own weight, not from external shocks. Governments did so by running budget deficits and going into debt.

The counter attack by the neoclassical economists, such as John Taylor, concentrated on the level of debt of the US government. The argument was that the debt could do more damage to the economy than the recent financial crisis, with government now the most serious source of systemic risk. Neil Ferguson outlined the risk in terms of upward pressure on interest rates and rising inflation from too much money sloshing around because governments printed money to fund the deficit.

In the symposium Ferguson, defending the neo-classical position, stated that:

we're using two quite contradictory courses of therapy. One is the prescription of Dr. Friedman—Milton Friedman, that is —which is being administered by the Federal Reserve: massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the early 1930s. I'm fine with that. That's the right thing to do. But there is another course of therapy that is simultaneously being administered, which is the therapy prescribed by Dr. Keynes—John Maynard Keynes—and that therapy involves the running of massive fiscal deficits in excess of 12 percent of gross domestic product this year, and the issuance therefore of vast quantities of freshly minted bonds.

His argument is that there is a clear contradiction between these two policies, and we're trying to have it both ways. You can't be a monetarist and a Keynesian simultaneously—at least I can't see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.

Nouriel Roubini's response to this is the right one on counter-cyclical monetary and fiscal policy-- the stimulus in the short run and then to restore medium-term fiscal sustainability. He says:

on the question of policy responses, there is no inconsistency between monetary easing and fiscal easing. Both of them should be stimulating demand, and the monetary easing should be leading also to restoration of credit. Of course, in a situation in which the economy is suffering not just from a lack of liquidity but also problems of solvency and a lack of credit, traditional monetary policy doesn't work as well. You also have to take unconventional monetary actions, and you have to fix the banks. And we need a fiscal stimulus because every component of our economy is sharply falling: consumption, residential investment, nonresidential construction, capital spending, inventories, exports. The only thing that can go up and sustain the economy for the time being is the fiscal spending of the government.

The argument about the risk of government debt ignores that the policy response has been to socialize the bad debts of the financial institutions and to put them on the balance sheet of the government.

Ferguson's response is that this implies a massive expansion of the state to substitute for the private sector and re-regulating the market. He says:

The lesson of economic history is very clear. Economic growth does not come from state-led infrastructure investment. It comes from technological innovation, and gains in productivity, and these things come from the private sector, not from the state.

In the long term yes. In the short term governments need to kick start the economy.

| Posted by Gary Sauer-Thompson at 8:09 AM |