What Happened? — Deepak Lal on the Bust

Written text here.  The rest of the video can be found here.

This is one of the more thought provoking accounts of what went wrong, why it went wrong, and what should be done about it.  Here’s a particularly interesting part of the analysis:

Wicksell asked: how could the price level be anchored in a pure credit economy? ..  His answer was that, if the Bank rate were set at the natural rate of interest, which balances productivity with thrift, the price level could be kept constant. This is, of course, the theory underlying inflation targeting, as embodied in the Taylor rule. As John Taylor has noted, it was the failure of the Greenspan Fed to follow this rule which led to the credit bubble after the dotcom bust.

The reasons for this failure are provided by Hayek’s refurbished Austrian theory of the trade cycle. Hayek saw divergences between the Wicksellian natural and market rates of interest as causing booms and slumps. If increased bank credit led to market interest rates below the natural rate, businesses will undertake relatively more capital intensive projects with relatively low rates of return. There will also be an unsustainable boom, with more projects undertaken than can be completed, leading to resource scarcities which end the boom. The financial crash which follows will lead to the liquidation of these ‘maladjustments’, followed by an economic recovery with resources being reallocated in line with inter-temporal consumer preferences and resource availabilities. Whilst broadly accepting the quantity theory of money, Hayek argues that it assumed the absence of ‘injection’ effects, which even with prices stable could lead to false signals in the pattern of inter-temporal prices, and thence to maladjusted investments. The recent US housing boom, with a stable general price level, provides an example of these ‘maladjustments’.

But Hayek’s prescription that the slump should be allowed to run its course, came to be disowned even by his LSE circle led by Robbins in the 1930’s. As Gottfried Haberler (a close friend and member of Hayek’s Austrian circle) noted in his astute appraisal of Hayek’s business cycle theory: “Keynes, Robbins, and many others were correct: if a cyclical decline has been allowed to degenerate into a severe slump with mass unemployment, falling prices, and deflationary expectations, government deficit spending to inject money directly into the income stream is necessary. Moreover, Hayek himself has changed his mind on this point”. (The Cato Journal, Fall 1986, p. 422).

Though Keynes’ General Theory, unlike Hayek’s, provides no explanation for the boom preceding the slump, he was right in emphasizing “effective demand” failures in the face of a financial crash, and the need for deficit spending. Though not, as advocated by many current Keynesians, through counter cyclical public works. Thus Keynes wrote in 1942: “Organized public works at home and abroad, maybe the right cure for a chronic tendency to a deficiency of effective demand. But they are not capable of sufficiently rapid organization (and above all cannot be reversed or undone at a later date), to be the most serviceable instrument for the prevention of the trade cycle” (Collected Works, vol. XXVII, p.122). A point reinforced by the Congressional Budget Offices’ assessment of the planned Obama infra-structure spending.

Friedman, unlike Hayek, was closer to Wicksell in concentrating on the effects of divergences between the natural and market rate of interest on the general price level and not as Hayek’s theory presupposes on relative prices. With the real (natural) rate being determined by productivity and thrift, monetary expansion will only raise nominal interest rates through inflationary expectations. Given the natural rate of interest there will also be a corresponding natural rate of unemployment. Monetary policy can only lead to transitory deviations from these natural rates, if capital and labour markets are efficient. There is little about credit markets in Friedman, or in his successors of the New Classical and Real Business cycle schools. As the current New Neoclassical synthesis is based on these models (with some twists of Keynesian ‘imperfections’), but contains neither money nor finance, it is useless in explaining or providing cures for the current crisis.

Thus, though Hayek provides the best diagnosis of the cause of the current crisis, neither he nor Keynes provide an adequate explanation of the financial aspects of business cycles, assuming these are endogenous to the fluctuations in the real economy. It is Irving Fisher (“The Debt-Deflation Theory of Great Depressions”, Econometrica, 1933) who provides the correct diagnosis of the nature and cures for the current crisis. Fisher saw a ‘balance sheet recession’ as an essential element in the Great Depression. He argued that, whilst there were many cyclical factors behind trade cycles, for Great Depressions the two dominant factors are “over-indebtedness to start with and deflation following soon after (p.341). Like the Austrians he saw over indebtedness as caused by “easy money” (p.348). This provides a succinct explanation of the current crisis and pointers to its cure. We have a Hayekian recession with Fisherian consequences. Having learnt the lessons of Friedman and Schwartz’ work on the Great Depression, Ben Bernanke has made sure that the second leg of a Fisherian debt deflation will not occur. But, past and present US authorities have failed to adequately restore the balance sheets of over leveraged banks, firms and households. US banks urgently need to be restored to health, perhaps through temporary nationalization as in Sweden in 1992. Whilst, stimulus packages have failed to adopt the obvious means to restore household and firm balance sheets, by a massive across the board tax cut accompanied by an equivalent fiscal deficit. It is argued that most of this extra income will be saved not spent. But this is to be bewitched by the wholly inappropriate Keynesian income-expenditure analysis, which fails to deal with balance sheets. If this Fisherian aftermath of a Hayekian recession is caused by attempts to reduce unsustainable debt, the ‘savings’ generated by the tax cut (i.e. reducing liabilities to the government) will allow the necessary deleveraging, without a downward spiral in income and increased bankruptcies. By facilitating households to pay off their mortgage and credit card debts, it will prevent further impairment of bank assets. Instead, we have the dog’s breakfast of the Obama stimulus package and a dubious Geithner ‘plan’ to clean up the banking sector. This, like Nero, is to fiddle while Rome burns.

This part is also worth thinking about:

I want to consider who are the winners from this on-going global financial crisis? The answer is: China, India and Goldman Sachs.

Let us consider the latter. This also provides a clue to the political economy behind the current crisis in its epicenter the US.  As in the numerous Third World financial crises the question to be asked is who are the ‘rent-seekers’ who created the crisis and whose reluctance to take a ‘hair cut’ prevents the domestic polity from accepting the obvious cures. So that ultimately the intervention of an external agency like the IMF is need to administer the necessary cures. The crisis was caused by financiers taking ever risky gambles with the complicity of the government. This is reflected in the changing share of US domestic corporate profits that have gone to the financial sector. From 1973 to 1985 it was 16%. In the 1990s it oscillated between 21-30%. In the last decade it reached 41%. This was accompanied by a dramatic increase in pay: which rose from 1999=108% of the average for all domestic private industries to 181% in 2007. This great increase and concentration of wealth has created a new financial oligarchy similar to the one in the early years of the last century, which has great political weight in the US. At its head is Goldman Sachs. It has provided the Treasury secretaries under the last 2 US presidents and numerous alumni have held and continue to hold influential posts in devising and implementing US economic policy. (see Simon Johnson: “The Quiet Coup”, The Atlantic Online, May 2009).

This explains some of the bailouts. Why for instance was Lehman allowed to go the wall but AIG was ‘saved’? Lehman had the misfortune of both being a major competitor to Goldman’s and being run and staffed by the ‘barrow boys’ from the Bronx rather than the Ivy League gentlemen manning its rival. AIG was saved I suspect because, as appeared when Congress forced AIG to disclose what it had done with its bail out money, it had to disclose that most if it was to pay off its counterparties, the major one being Goldman ..

UPDATE:  At the height of the financial meltdown Henry Paulson was conferring constantly with the head of Goldman Sachs.  With other executives? — not so much.

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One Response to What Happened? — Deepak Lal on the Bust

  1. Tim Worstall says:

    Terribly minor point but just amuses that you post video of a lecture I attended (and even asked a question at) about a book that I reviewed for the UK press….and then two posts up you link to me talkng about Cuban toilet paper.

    Not important, just amusing….

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