Stabilities and instabilities in the macroeconomy

My favorite sentence from this article, ” We lack an anchored understanding of the nature of the reality that economics is supposed to illuminate.”

*Post dedicated to James Montier

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Synopsis (Via Vox.eu)

Economics lacks an anchored understanding of the nature of the reality that economics is supposed to illuminate. This column, which introduces a new CEPR Policy Insight, says that instability of leverage, connectivity, and the potential instability of the price level have all been neglected in stable-with-frictions macro theory. Technical innovations will not bring real progress as long as “stability-with-frictions” remains the ruling paradigm. Meanwhile, governments are not prepared to face another crisis.

Introduction (Via Vox.eu)

Fifty-some years ago, students were taught that the private sector had no tendency to gravitate to full employment, that it was prone to undesirable fluctuations amplified by multiplier and accelerator effects, and that it was riddled with market failures of various sorts. But it was also believed that a benevolent, competent, democratic government could stabilise the macroeconomy and reduce the welfare consequences of most market failures to relative insignificance.

Fifty years later, around the beginning years of this century, students were taught that representative governments produce pointless fluctuations in prices and output but, if they can be constrained from doing so – by an independent central bank, for example – free markets are sure to produce full employment and, of course, many other blessings besides. Macroeconomic policy doctrine had shifted from stabilising the private to constraining the public sector.

This long swing in our understanding of the economy spans a half-century of prolific technical accomplishments in economics (Blanchard 2008). But what the story shows is that, ontologically, economics has been completely at sea, drifting on the surface in currents of our own making. We lack an anchored understanding of the nature of the reality that economics is supposed to illuminate.

Favorite sections (Via Vox.eu)

The economy is an adaptive dynamical system. It possesses the self-regulating, “equilibrating” properties that we usually refer to as “market mechanisms”. But these mechanisms do not always suffice to ensure the coordination of activities in the complex system. Almost forty years ago, I proposed the “corridor hypothesis”. The hypothesis suggested that the economy might show the desirable “classical” adjustment properties within some “corridor” around a hypothetical equilibrium path but that its self-regulating capabilities would be impaired in the “Keynesian” regions outside the corridor. For large displacements from equilibrium, therefore, the market system might not be able recover unless aided by stabilisation policy.

We have known about the endogenous instability of fractional reserve banking for some 200 years. It is Hyman Minsky’s contribution to have explained that this financial instability extends beyond just the commercial banking system. Minsky argued that a long period without crises – such as the late “Great Moderation” – would lead to an increased willingness to assume risk and thus cause the system to become financially fragile. And the fragile system will sooner or later crash.

4 Issues To Watch For (Via Vox.Eu)

1. Twin dangers looming ahead are Japanese-style stagnation on the one hand and Latin-American-style high inflation on the other. In more normal times, we would regard these prospects as both unlikely and very far apart on a spectrum of eventualities. High levels of public debt, large unfunded liabilities, and large current deficits mean that they are not at all far apart in the current situation. The apparent political difficulties in decisively remedying the public finances are likely to mean that this is not just a temporary predicament. The navigable channel between Scylla and Charybdis has become quite narrow.

2. One overwhelmingly important fact should guide policy over the near-term future – since current bailouts and stimulus policies have stretched public finances to the utmost, governments do not have the fiscal resources to handle another bubble bursting. Policy, therefore, should be conducted in a fail-safe mode. The current policies of extremely low interest rates are not fail-safe. They are aimed at reflating asset prices just enough to stave off a deeper recession. This is a delicate operation, not a robust, fail-safe move. It is creating strong incentives for the banks to return to the tables and resume the game of maturity transformation at high leverage that got us into our current troubles in the first place. It is evident that the banks are responding promptly to those incentives

3. High leverage has been the big culprit in the current disaster. To reduce the risk of another crash, we must curb leverage. But governments do not want the financial sector to deleverage now because the requisite falling asset prices and curtailed credit would deepen the recession. The question, of course, is: If not now, when?

4. The central banks are planning “exit strategies” by which they mean returning their balance sheets, which are presently bloated beyond recognition with a mix of strange assets, to a condition more resembling that normal to central banks. This will not be easy. If they succeed, however, they will still face the prospect of having to engage in many of the same desperate, unconventional policies in a future crisis. Under present arrangements, the responsibilities of central banks have no well-defined limits. This problem can only be solved by regulation of the financial sector. At present, it does not seem that we know how to do it.

Click Here To Read: Stabilities and instabilities in the macroeconomy