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When Ritwik began his posts on economics with a rather good one on the weaknesses of various economic columnists and bloggers, I assumed that he would write something interesting. Then he resorted to copying out the further reading sections in his economics textbooks without doing any further reading.

Reviewing all economic theory now is pointless unless it is to pick one that may provide a solution to the current economic, financial or credit crisis.

Fortunately someone better than Ritwik has taken that argument up. Phelps´s column is brilliant in summarizing the entire history of economics in a single column focused on the present crisis. First, he focuses on the Robert Lucas Jrversus Keynes argument.  Lucas Jr he dismisses in a single sentence:

“To use the “new classical” theory of fluctuations begun at Chicago in the 1970s – the theory in which the “risk management” models are embedded – is unthinkable, since it is precisely the theory falsified by the asset price collapse.”

Keynes is more formidable and he takes him in steps. The first argument simply rephrases why Keynes failed in the late 1960s and early 70s stagflation period. Increasing money supply does not work, when asset price collapses are due to non-monetary reasons, as it would lead to a endless wage-price increase spiral, something that the central bankers are soon to find out over the coming months.

Then he attacks Keynes´s methods for stimulating consumer demand, saying that in an open economy, the stimulus would mainly go abroad. Then he takes apart Keynes´s case for boosting investment demand (the dig ditches and fill them argument), by saying that the private sector is better suited to it than the government. These sections are a bit weaker and can be nitpicked, but let us leave them for another day.

In short, to solve this crisis, neither fiscal policy nor monetary policy will work. And neither Lucas, nor Keynes. One has to think of something else or someone else.

The first attempt at a solution is already here, in the form of Shiller´s book, The Subprime Solution. What Shiller has done is to propose a Lucasian solution. His book can be summarized as “If the risk management assumed to be embedded by Lucas doesnt seem to exist, let us build a new financial architecture with that embedded risk management.”

The ball is in the new keynesians court now. Maybe they can think of a way out of the minsky moment.

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