A few things from the blog of Brad DeLong. First, Larry Summers says that it became apparent to him that there were specific categories of research that he knew would be useful to him to deal with our current crisis: 

"Mr Summers was more measured, refusing to be drawn into making blanket statements for the sake of being controversial.... But in its own way, his assessment of recent academic research in macroeconomics was pretty scathing.... [H]e talked about all the research papers that he got sent while he was in Washington. He had a fairly clear categorisation for which ones were likely to be useful: read virtually all the ones that used the words leverage, liquidity, and deflation, he said, and virtually none that used the words optimising, choice-theoretic or neoclassical (presumably in the titles or abstracts). His broader point--reinforced by his mentions of the knowledge contained in the writings of Bagehot, Minsky, Kindleberger, and Eichengreen--was, I think, that while it would be wrong to say economics or economists had nothing useful to say about the crisis, much of what was the most useful was not necessarily the most recent, or even the most mainstream. Economists knew a great deal, he said, but they had also forgotten a great deal and been distracted by a lot."
Next, DeLong examines two ways of looking at the cause of the financial crisis, and finds that they are in essence the proposals that Walter Bagehot put forth in Lombard Street, which came out in 1873: 

"Richard argued that--just as in Japan in the 1990s--the collapse of asset values had created a world desperately short of financial assets, in this particular case savings vehicles of moderate and long duration. The impairment of balance sheets thus left households and businesses anxious to cut back on their spending in order to rebuild their balance sheets. Since the interest rate could not fall any further to clear the market for savings vehicles, recession followed. The recession would, he said, last until and unless the supply of financial assets to serve as savings vehicles rose to levels consistent with financial-market demand. And government could materially accelerate this process if it stood up while the private sector was standing down: if it spent, invested, and borrowed in order to boost the market supply of savings vehicles.

Carmen by contrast argued that the world was desperately short not of savings vehicles but rather, due to overleverage, of safe financial assets. We had an excess supply of risky and leveraged financial assets and an excess demand for safe financial assets. Hence households and businesses cut back on their spending to try, in vain, to build up their holdings of safe financial assets that just were not there. Hence recession."

The common neoclassical/Efficient Markets argument against the idea that we could learn a thing or two from the economists of the past is something along the lines of: "But we know so much more now!" My response is: "Do we really?" Is there evidence for a supply (technology) shock causing our current crisis? Is there any evidence that Ricardian Equivalence is relevant to discussions of temporary stimulus? Is there any evidence that we are on the wrong side of the Laffer Curve? I would like to believe that anyone thinking rationally would respond to the above questions with "no", but that seems like too much to ask for in modern economics. Meanwhile, Walter Bagehot on why there can be sudden demand for safe assets: 

"Such a reserve as we have seen is kept to meet sudden and unexpected demands. If the bankers of a country are asked for much more than is commonly wanted, then this reserve must be resorted to. What then are these extra demands? and how is this extra reserve to be used? Speaking broadly, these extra demands are of two kinds--one from abroad to meet foreign payments requisite to pay large and unusual foreign debts, and the other from at home to meet sudden apprehension or panic arising in any manner, rational or irrational."

Walter Bagehot on dealing with fears of the safety of their assets: 

"In opposition to what might be at first sight supposed, the best way for the bank or banks who have the custody of the bank reserve to deal with a drain arising from internal discredit, is to lend freely. The first instinct of everyone is the contrary. There being a large demand on a fund which you want to preserve, the most obvious way to preserve it is to hoard it--to get in as much as you can, and to let nothing go out which you can help. But every banker knows that this is not the way to diminish discredit. This discredit means, 'an opinion that you have not got any money,' and to dissipate that opinion, you must, if possible, show that you have money: you must employ it for the public benefit in order that the public may know that you have it. The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times. "

Economists like Brad have been saying things like this for years. All you have to do is replace "bank" with "The United States Federal Government". There has been significant demand for safe assets. The fact that interest rates on short term U.S. Treasuries have fallen all the way to the zero lower bound shows that the market considers them safe assets. So what should the government do? Increase short term stimulus. Bring spending from the future into the present, finance it by issuing new debt, and don't stop until the market no longer demonstrates significant demand for safe assets.

Leave a Reply.