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In this issue, I summarize what I see to be the opposing viewpoints and corresponding policy prescriptions of the current recession. Most current policy has its roots in Keynesian Economics, and thus I frame the debate around this perspective.

At its core, Keynesian policy aims to influence aggregate demand in an effort to dampen the business cycle. A Keynesian economist believes that consumer demand in a recession is too low, and thus government should intervene to try to increase it. Monetary policy and fiscal policy are the tools used to accomplish this objective.

Ultimately, I have never fully embraced Keynesian Economics and thus don't believe the current policy direction is the right one. Unlike the Keynesian point of view, I generally view recessions as necessary periods of economic adjustment that follow broad misallocations of resources. Such a view seems especially appropriate since the current recession followed such a dramatic resource misallocation in housing and finance. Thus, I would prefer policies that encourage the transition process rather than try to stabilize industries that are in decline.

Are you a Keynesian economist?

I am not a macroeconomist by training, but the financial crisis has prompted me to learn a lot about Keynesian economics over the last few months. I began by reading John Maynard Keynes' General Theory of Employment, Interest and Money. I believe it was Paul Krugman who said: "Is it too much to ask that someone criticizing Keynes actually, you know, read Keynes?"

I have read most of General Theory but largely find it unconvincing and difficult to follow. The ideas were revolutionary, of course, but the book itself is a tough read. My advice: unless you want to slog through some dense text and economics, stick to online summaries. The best one I have found is Alan Blinder's article in The Concise Encyclopedia of Economics.

Blinder sums up Keynesian Economics with 6 fundamental tenets (paraphrased below):

1. Aggregate demand sometimes behaves erratically, due to both public and private factors.
2. Aggregate demand fluctuations affect quantities more than prices (especially output and labor)
3. Prices (especially wages) respond slowly to supply and demand.
4. Unemployment caused by aggregate demand fluctuations is not desirable.
5. Stabilization policy reduces the amplitude of business cycles.
6. Reducing unemployment is more important than conquering inflation.

According to Blinder, most economists accept 1-3 as true. The more you accept numbers 4-6, the more Keynesian you are. The labor market is the classic example where prices adjust slowly since recessions tend to raise unemployment rather than lower wages. See New Keynesian Economics by Greg Mankiw for a good primer on why prices might be slow to adjust.

Recessions occur when aggregate demand contracts. The appropriate policy response depends on how you interpret this contraction. Keynesian economists generally view such contractions as erratic, macroeconomic errors, and thus propose to fill in demand gaps via government spending. Classical economists tend to view most prices as ''correct'' - a rational response to changing market conditions - and are more reluctant to intervene. Austrian economists believe that economic booms tend to overallocate resources to the wrong sectors, so recessions are healthy adjustment processes that correct these misallocations.

Economist Arnold Kling has a nice summary of the Keynesian versus the Austrian interpretation of the current recession:

"Right now, the Keynesian perspective would say that we can afford to misallocate resources in order to avoid having them be unemployed. The Austrian perspective would say that we need to adjust downward our expectations in light of the fact that a significant amount of the wealth we thought we had a year ago does not in fact exist.

The Keynesian perspective is that the government might as well spend like crazy, because somebody has to. The Austrian perspective is that our ambitions need to be scaled back--both for private and for public consumption."

- Arnold Kling, More on Mandel, Austrianism, and Keynesianism, February 21, 2009

Most mainstream economists - and certainly those with the most policy influence - favor the Keynesian perspective. They believe that our economy is operating far below its potential output. Resources that could be productive are not being utilized due to lack of demand. Since private sector demand is too low, demand must be created by the public sector.

As for me, I have never really resonated with Keynesian Economics. I find it especially strange in the context of the current recession, where the largest fraction of our ''underutilized'' resources seem to be in housing and finance. Because I view these sectors as having attracted too much demand during the bubble years, trying to stimulate them makes no sense. See here, here, and here for some of my previous newsletter issues on these sectors before they imploded.

I don't see how anyone can consistently believe that we had a housing bubble, yet create policies designed to increase housing demand (i.e. First-Time Homebuyer Credit). Or how anyone can believe that mortgage securitization was out-of-control, yet try to save companies that failed when this market collapsed.

In terms of Blinder's 6-step Keynesian membership criteria, I break rank somewhere near step 3. That is, I agree that (1) demand sometimes behaves erratically (but most dangerously on the upside, not the downside) and that (2,3) prices are sometimes slow to adjust (see what I wrote in Slow-motion housing cycles). But I generally view (4) recessionary unemployment as necessary rather than undesirable, (5) stabilization policy as mostly ineffective, and (6) inflation as being worse than unemployment.

Markets aren't perfect, but that doesn't mean that perfect policies necessarily exist to correct them. Trying to do too much is often a mistake. Both private and public markets are susceptible to the same errors of human judgment, but over the long-run I generally prefer private-sector incentives to public-sector ones (see The financial crisis and the defense of free markets).

All else being equal, it's probably better for government to spend in a recession than in a boom. But it's not as if policy is designed to save money in the boom and spend in the recession. It's more like spend in a boom and spend more in a recession. Then when things get really bad, we throw fiscal responsibility completely out the window in order to spend even more. I have a hard time feeling comfortable with that.

Current policy

Here are the three "big picture" policy actions as I see them: (1) don't let the broad money supply fall, (2) increase government spending to spur aggregate demand, and (3) don't let the banking sector collapse.

(1) Don't let the broad money supply fall

To simplify, assume there are only two levels of the money supply: base money (M0 below) and broad money (M2 below). In a booming economy, the ratio of broad money to base money is large. Banks have lower reserve requirements, individuals and businesses are more leveraged, and so on. The ratio shrinks in a recessionary economy as reserve requirements go up and leverage goes down.

Suppose the central bank did nothing. Then the broad money supply could shrink rapidly in a recession:

Instead, the central bank tries to expand the base money supply to offset any decline in the money multiplier (M2/M0):

Conventional academic wisdom is that the Great Depression was caused, in part, by the Federal Reserve's failure to adequately expand the money supply. The shrinking broad money supply sent our economy into a deflationary liquidity trap. When the money multiplier dropped precipitously during the 2008 financial crisis (click here for the chart), the Federal Reserve responded by dramatically increasing the base money supply (click here for the chart). We shouldn't be too surprised because the Fed is essentially just doing what it said it would do in a crisis.

This monetary expansion will be inflationary only to the extent that the Fed will not be able to reverse it. Yes, the Fed is "printing money" like crazy, but with a specific purpose and exit strategy. Consider this important excerpt from one of Ben Bernanke's recent speeches:

"Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed's lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time.

However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink..." [emphasis mine]

- Chairman Ben Bernanke in Federal Reserve Policies to Ease Credit and Their Implications for the Fed's Balance Sheet, February 18, 2009

However, I suspect that unwinding these policies is easier said than done. The political pressure to keep the money flowing will be enormous. In addition, we've seen what happens when the Fed reverses policy only after visible signs of recovery are in place: the Fed tightening cycle that began in July 2004 was too late to prevent massive financial speculation in housing. Once these bubbles get going, they are difficult to stop. The counterfactual is tough to know for sure (would we have had such a large housing bubble if the Fed had not eased so much for so long?), but our experience over the last few years is enough to make me much more nervous than Bernanke (though I doubt he is exactly sleeping well these days).

(2) Increase government spending to spur aggregate demand

The second arm of current policy is to increase public sector spending to compensate for falling private sector demand. This is essentially every big-government politician's dream scenario.

To get a sense for the magnitude of such spending increases, see the following graph from one of John Hussman's latest articles:

Hussman writes:

"Milton Friedman was mostly right about inflation – inflation may be a monetary phenomenon, but only because governments ultimately can't help but monetize huge amounts of spending (as the Fed is doing now). He was entirely right about fiscal discipline – ''the burden of government is not measured by how much it taxes, but by how much it spends.''"

- Fed and Treasury - Putting off Hard Choices with Easy Money (and Probable Chaos), by John Hussman, March 23, 2009

In my view, the problem with spending so much is that we don't actually have the money. It's not as if we have trillions of dollars lying around: we are borrowing the money. Would you tell the family with too much credit card debt to borrow more in order to ease the pain? Maybe there are some circumstances where this could be justified, but in general you would tell them to be more conservative and to cut back on spending.

[Addendum: added on April 21, 2009

Here is an even better graphical representation of our projected fiscal policy (from Greg Mankiw):

]

(3) Don't let the banking sector collapse

This area is where I am most sympathetic to an active policy prescription. A complete laissez-faire attitude towards the banking sector would probably be too devastating institutionally. As I discussed in my November 2008 Newsletter, the general research consensus (led by Bernanke) is that the Great Depression lasted so long because (1) the Fed failed to adequately expand the money supply and (2) the banking sector collapsed. So we do what we can to save the banking system from failing.

But I am skeptical of any efforts to preserve the current banking system. I file the Geithner plan to buy troubled bank assets under this heading. In my view, the plan does not offer enough transition to new ownership, management, and business models and will inevitably result in huge taxpayer subsidies to currently existing banks. This is an area on which even Paul Krugman and I can agree.

Here are some excerpts from the best policy proposal I've read:

"The bondholders of distressed financial institutions – not the American public – should bear responsibility for the losses of those institutions. This can be accomplished, without harm to customers or the broader financial system, in one of two ways:

1) The bondholders could voluntarily agree to move a portion of their claims lower down in the capital structure, swapping debt for equity...

2) The U.S. government could take receivership of the financial institution, defend the customer assets, change the management, wipe out the stockholders and a chunk of the bondholders claims entirely, continue the operation of the institution in receivership, and eventually sell or reissue the company to private ownership, leaving the bondholders with the residual...

What should not be done is what was allowed in the case of Lehman Brothers...It was not the failure of Lehman per se, but the disorder resulting from its piecemeal liquidation, that caused distress to the financial markets...

...to defend all bondholders of financial institutions at public expense is to commit the future economic output of innocent citizens to cover the losses of mismanaged financial institutions. As a result of the intervention by the Federal Reserve and the U.S. Treasury, even the bondholders of Bear Stearns stand to receive 100% repayment of both interest and principal on their bond investments. This is absurd. [emphasis mine]

- On the Urgency of Restructuring Bank and Mortgage Debt, and of Abandoning Toxic Asset Purchases, by John Hussman, March 30, 2009

In other words, debts that cannot be repaid need to be restructured or wiped out, not simply transferred to taxpayers. Any policy that fails to recognize this is missing the point.

My view

In summary, I think that Policy (1) of expanding the money supply makes sense in theory, though in practice I would prefer something far less aggressive. Policy (2) of fiscal spending does not appeal to my non-Keynesian nature, so I think that most of the spending will be wasteful. And Policy (3) for saving the banking sector focuses too much on subsidies to current institutions and not enough on coordinating the transition to new ones.

To revisit the Kling article:

"I think that the Keynesian perspective is only valid up to a point. Unfortunately, our policies go way past that point. The policies fail to acknowledge that we hold some bad assets, in every sense of the term. Trying to deny the losses by encouraging bank prop-ups and other forms of extravagant collective spending worries me. Such policies risk causing more harm than good."

- Arnold Kling, More on Mandel, Austrianism, and Keynesianism, February 21, 2009

I have had a number of discussions over lunch and coffee with my graduate school classmates while doing research for this newsletter (especially those with stronger macro backgrounds than myself). But I find their views of the current crisis to be no more sophisticated than mine. Unfortunately, most policy disagreements between us come down to simple economic ideology: how strongly do you believe that governments allocate resources more efficiently than the private sector?

Economists who believed in big government before the crisis tend to want big government solutions. Those with less confidence in government favor private sector solutions. However, it seems to me that more and more economists from both sides are starting to worry that the policies may be going overboard:

"In short, Bernanke is making the biggest bet placed by a U.S. central banker in decades, wagering that he can pull the economy out of a deep crisis by creating money without unleashing high and long-lasting inflation...

Bernanke, the soft-spoken but authoritative academic, has redefined the Federal Reserve on the fly and exercised powers that Greenspan never dared touch. Bernanke's strategy is risky, and only time will determine whether he is being brave in averting a larger crisis, or reckless in unleashing inflation that could increase quickly and uncontrollably. Today, Bernanke's gamble looks like the worst possible alternative, apart from all the others." [emphasis mine]

- The Radicalization of Ben Bernanke, by Simon Johnson and James Kwak, The Washington Post, April 5, 2009

I suppose their final sentence is an endorsement of the Bernanke Doctrine, but it seems out of place by economists who otherwise sound terrified by the potential consequences (you can read the article and judge for yourself). Here is an alternative perspective by Chicago-trained (read: conservative) economist Ed Glaeser, who is sounding the alarm bells for other reasons:

"In the 1990s, American economists roamed the world preaching the virtues of fiscal restraint, the rule of law, free trade, and privatization. Today, those four policy pillars, once known as the Washington Consensus, are abandoned in the city that gave that consensus its name. These policies were never commandments from Mount Sinai, but they are important ingredients of long-run economic success. In a recession, putting today's needs ahead of tomorrow's prosperity is understandable, but even in bleak times, doing too much can be worse than doing too little.

This year's deficit is projected to be $1.7 trillion, and this may be appropriate... [but] protectionism, public ownership, and a breakdown in property rights will make it far harder for the future entrepreneurship of ordinary people to pay for today's deficits...

Eliminating fiscal restraint during a recession is understandable. Eliminating all four pillars of sound economic policy imposes too much of a cost on tomorrow for too little benefit today." [emphasis mine]

- Abandoning the pillars of sound policy, by Edward Glaeser, The Boston Globe, April 4, 2009

With regard to the fiscal stimulus and government policy more generally, I have been thinking about the crisis much in the same way as Arnold Kling's piece titled "Deficit Spending: A Scenario Analysis". The Kling analysis focuses on two possible Black Swans (unlikely events of large magnitude):

(1) "Depression Averted" - the fiscal stimulus prevents an economic depression
(2) "Catastrophic Collapse" - the fiscal stimulus is the tipping point for U.S. insolvency

In other words, fiscal stimulus is unlikely to actually result in Depression Averted or Catastrophic Collapse, but it increases the probability of each. Your view of fiscal stimulus should be based on the values and probabilities that you assign to each event.

As you probably guessed, I think that fiscal stimulus is unlikely to dramatically improve our chances of Depression Averted (whether we enter a depression or not). And I view the Catastrophic Collapse scenario as too devastating (and too possible) to risk moving in that direction. Instead, I would prefer that we bite the bullet, buckle down, and cut back on spending.

If you had to pin me down on my personal policy response to the crisis, it would be this:

1. Focus on policies that encourage an economic transition and restructure/wipe out bad debts. This includes: (1) providing a platform for insolvent banks to go through orderly bankruptcies (force them to if you must) and (2) providing streamlined legal methods for lenders to write-down individuals' mortgages (possibly coupled with modest financial incentives) without forcing them to do so.

   This does not include taxpayers taking responsibility for bad debts as a fundamental strategy, nor does it include using inflation as a blunt policy tool to wipe out debts (although it is certainly tempting given how much of the debt is held outside the U.S.).

2. Focus on helping the people who are caught in the transition rather than keeping the dying industries alive. For example, I would be more in favor of increasing unemployment programs than trying to support aggregate demand in certain industries - things to help people move to their next jobs rather than keep them in their current jobs (think: Detroit auto companies).

3. Expand the money supply if you must, but do so much less aggressively.

4. For fiscal stimulus, do something much, much smaller. I am not too particular on the specific agenda - things with obvious public benefits like infrastructure and research are fine. But I am not in the economist camp that believes that more spending is unambiguously better.

The common Keynesian view is we need massive government stimulus to kick-start our economy out of this slump. The bigger, the better. I am skeptical of this view for many reasons, most important of which is my interpretation of how we arrived at this point.

My personal view of this recession centers around individuals living beyond their means, thinking that good times would last forever. Above-average economic growth, rising home prices, double-digit stock returns - you name it, we overestimated it. Banks magnified the problem by adding optimistic estimates of calibration parameters in complex derivative models. Add a little leverage (or a lot of leverage), and you've got a full-blown financial crisis.

Now that the optimistic estimates have been discredited, individuals demand a new set of goods which is more consistent with realistic wealth expectations. Unfortunately, our economy is not set up to handle this demand (it is stuck in the old demand regime). As such, the most effective policies will focus on transitioning to meet the new demand rather than trying to stabilize what currently exists.

Conclusion

I'll like to finish with the following excerpt from NYTimes' David Brooks, who summarizes my skepticism with the current policy path:

"President Obama has concentrated enormous power on a few aides in the West Wing of the White House. These aides are unrolling a rapid string of plans: to create three million jobs, to redesign the health care system, to save the auto industry, to revive the housing industry, to reinvent the energy sector, to revitalize the banks, to reform the schools — and to do it all while cutting the deficit in half.

If ever this kind of domestic revolution were possible, this is the time and these are the people to do it. The crisis demands a large response. The people around Obama are smart and sober. Their plans are bold but seem supple and chastened by a realistic sensibility.

Yet they set off my Burkean alarm bells. I fear that in trying to do everything at once, they will do nothing well...

I worry that we’re operating far beyond our economic knowledge. Every time the administration releases an initiative, I read 20 different economists with 20 different opinions. I worry that we lack the political structures to regain fiscal control. Deficits are exploding, and the president clearly wants to restrain them. But there’s no evidence that Democrats and Republicans in Congress have the courage or the mutual trust required to share the blame when taxes have to rise and benefits have to be cut."

- David Brooks, The Big Test, February 23, 2009

Those who advocate massive government intervention are often upset when the actual policy is announced. "If only it were executed correctly", they say. But we need to be realistic about how policies work in practice. The market isn't perfect, but neither is intervention.

Not every economic problem can be solved via centralized policy. My biggest worry of all is that we are doing too much, too fast - so much so that we are losing our ability to manage it. The current policy path reminds me of the famous saying, "Having lost sight of our objective, we have redoubled our efforts." And so it goes.