Download Proposition III (the principle of policy effectiveness)

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
By
Giuseppe 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 Classics
The classical theorists resemble Euclidean geometers in
a non-Euclidean world who, discovering that in
experience straight lines apparently parallel often meet,
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
throw over the axiom of parallels and to work out a nonEuclidean 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 policies,
very 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
liquidity into the system. This easy money, easy credit condition
propagated a search for higher yields than those that
were 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
prudence 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
sophisticated and effective techniques for measuring and managing 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
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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