by Mario Rizzo
The Keynesian world view is leading to increasing stridency and dogmatism about economic stimulus. There used to be a joke that you can teach a parrot economics – all it needs to say is “supply and demand.” Now we can say that it is even easier to teach a parrot the policy prescription to prevent or cure a major recession: all it needs to say is “stimulus.” Most of the attention thus far has been on fiscal policy and the gathering of ideas on how to spend federal money. (For example, see the New Yorkers’ wish list.)
The new Obama Administration, like the Bush Administration, has signaled that another part of the stimulus program is to put pressure upon banks that received TARP funds to stop worrying about their balance sheets and get out there and lend. (Query: To whom, for what purposes and at what interest rates?)
So how is this stimulus supposed to work? Are we simply in a crisis of confidence in which if more banks extended credit then other banks would do so as well? (One possible rationalization is that Bank A won’t lend to Business B because A can’t be sure that Bank C will lend to Business D. And D is, say, a demander of A’s products. Another rationale is the more traditional liquidity trap.)
The critical theoretical issue is this. Has the current situation – even if triggered by unsustainable levels of mortgage credit and over-production in the housing industry as well as in other interest-rate sensitive areas – gone so far beyond its cause that we no longer need to worry about these previous misallocations of capital? In other words, is the correction of the cause now irrelevant to the cure?
To discover the answer to this question, let step back a bit. We must understand the respective roles of causes and of feedback effects. Consider a “Keynesian” argument. Suppose a fall or collapse in markets X, Y, and Z causes F (a financial meltdown). Then F itself causes X, Y, Z to fall further. Some of this is deleveraging and some is the result of falling confidence in, say, the credit worthiness of counterparties. There is a general lack of clarity about what resources and financial instruments are worth. The future begins to look radically uncertain rather than simply risky. A collapse of confidence thus contributes to a fall in production and employment in areas far removed from the initial bubble-burst. The process is not dampening, but explosive, in the absence of the deus ex machina, that is, fiscal or monetary intervention.
Now let us consider a cure that ignores the original misdirection of resources that resulted in the collapse of markets X, Y, and Z. The putative cure looks solely at the subsequent confidence effects. It treats the collapse in these markets as if they were mainly due to an exogenous loss of confidence. To illustrate, the Federal Reserve has decided to buy mortgage-backed securities causing credit to become available in the housing market at lower interest rates. This will likely cause the prices of homes to stop falling and to begin rising. When will the Fed stop this infusion of newly-created money, and hence the relative rise in resources, into the housing market? Presumably it should stop when it has offset the excess or “irrational” decline due to feedback effects. It should not go on to restore the previous over-expansion.
Where is the feedback-sanitized point? I doubt anyone knows.
This in a nutshell is also the problem with both fiscal stimulus and “forced lending.” The stimulus is likely to stimulate lines of production that are not sustainable.
In some cases, it will restore depressed markets to their previous condition when that previous condition was an over expansion. In other cases, it will prop up certain sectors like “infrastructure” and whatever else the near-trillion dollars will be spent on. Assuming, as we are told, these expenditures are temporary, what happens when the resources shift out of these previously-favored areas? More importantly, will lenders and related businesses know when the stimulus will end or shift? If not, policy uncertainty will take the place of the current uncertainty, (In fact, the current uncertainty is to a certain extent derived from the policy uncertainty about the future.) In still other cases, banks will be cajoled into lending to borrowers whose industries are experiencing sectoral decline since they may be hurting the most. Furthermore, if banks are urged to operate contrary to their own risk assessments of borrowers, what standards will be substituted?
The stimulus advocates don’t know the answers to these questions. They will simply try to get the housing market, other similar interest-sensitive markets and credit markets (plus the auto industry!) to such a point where general production and employment are considered non-recessionary. The standard, practically speaking, will be the status-quo ante. But the status-quo ante produced the status quo.
The root of the policy problem is that the “Keynesian” solution takes the simple aggregate demand model too seriously. It proceeds as though sectoral imbalances don’t matter. In this view, the current situation is not a coordination problem but some kind of confidence problem that leads to a deficiency of demand in general. The theory is inadequate and thus so is the solution.
Note: When I use the word Keynesian (with or without quotation marks) I do not intend necessarily to implicate John Maynard Keynes whose views on many issues differ from today’s Keynesians.