Another section of the Great Moderation chapter from my book. I’m getting a lot of value from the comments, both favorable and critical, so please keep them coming.
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Failure
Whether it was a real economic phenomenon or a statistical illusion, the Great Moderation, considered as a pattern of long expansions punctuated by brief and mild recessions, is clearly over. In retrospect, it was over by the time its discovery was announced in the early 2000s. The recovery from the 2001 recession was not, as advocates of the Great Moderation supposed, the beginning of a third long expansion in the United States. Rather, it was weak, short-lived and overwhelmingly driven by the unsustainable bubble in housing prices and the expansionary monetary policies of Greenspan and Bernanke. The expansion lasted only six years, and it was four years old before total employment regained the pre-recession peak. All of the employment gains of the expansion, and more, were wiped out in the first few months of the global financial crisis.
The US experience was fairly typical of the developed countries. While some, such as Australia and Canada did rather better, others such as Ireland and Iceland suffered economic meltdowns with output losses in excess of 10 per cent.
But it is not sufficient to point out the obvious fact that the Great Moderation is finished. The thinking that made so many economists willing to endorse claims that the business cycle had been tamed by financial liberalisation remains influential and is implicit in many arguments about policy responses to the Crisis. So it is important to understand why the Great Moderation hypothesis was so badly wrong.
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The dissenters
While the boom persisted, the view that the Great Moderation was the product of unsustainable policies received little attention. It was espoused only by old-style Keynesians, a relatively marginal group on the left of the economics profession, and members of the Austrian School, a fringe group on the right. While the two groups agreed in offering a negative prognosis, they differed radically regarding both diagnosis and proposed cure.
Keynesians argued that, without adequate regulation, financial instability was inevitable. This view was part of the assumed background for Keynesians of all kinds, but it was particularly stressed by the post-Keynesian school associated with the late Hyman Minsky.
Minsky focused on the instability of credit and investment processes in a market economy and argued that capitalist financial systems are inherently unstable because large swings in investor expectations tend to occur over the course of the economic cycle. He argued that in a recession, expectations are subdued. As the recovery gathers pace, profits rise and balance sheets are restored. Caution remains for a period, reflecting memories of the previous downturn. As the economy continues to grow, perhaps spurred further by technological breakthroughs or unexpectedly high rates of growth, profits are rebuilt and expectations of future growth begin to rise. Caution begins to recede. Increasingly, animal spirits are stirred and banks begin lending more freely and credit expands. Even cautious investors are encouraged to join the upward surge for fear of forfeiting profit opportunities. Momentum builds behind what Minsky referred to as the “euphoric economy.” This attracts highly leveraged asset speculators–Minsky called them “Ponzi financiers”–who rely on rising asset prices to service debt and who drive the market further upward. Increasingly, the market is dominated by speculation about sentiments and movements in the market rather than about fundamental asset values.
Minsky’s work became a standard namecheck for Keynesians writing about financial crises past, present and future. For example, Charles Kindleberger used Minsky’s model as the basis for his study Manias, Panics, and Crashes, declaring that “the model lends itself effectively to the interpretation of economic and financial history. In my own work with political scientist Stephen Bell, I noted that the main obstacle to broader acceptance of Minsky’s work was the lack of a formal derivation from microeconomic foundations (see Ch …) and concluded that ‘Another significant cycle of asset price movements, especially in one of the major economies, could see a fundamental revision of thinking about the costs and benefits of liberalized financial systems.’
While Keynesians argued that instability is inherent in weakly regulated financial systems, economists of the Austrian school generally claimed that the business cycle was the product of government intervention, and particularly of central banking. This view was derived from the work of Friedrich von Hayek and Ludwig von Mises, economists who were literally Austrians by birth. But if the Austrians agree on the evils of central banking, they disagree on almost everything else. Some, endorsing the judgement of the mainstream economists who awarded Hayek the Nobel prize in economics, see him as having far surpassed the initial contributions of his teacher von Mises. Others see von Mises as the true source, and his American student Murray Rothbard as his intellectual heir.
The disagreements don’t stop there. Some Austrians, despite generally rejecting government, favor a government-enforced gold standard and the prohibition of fractional reserve banking (the system by which banks lend out most of the money deposited with them, retaining only a fraction to meet the needs of depositors who wish to withdraw their funds). Others advocate ‘free banking’ with no government role of any kind, a position which is perhaps more intellectually consistent, but somewhat undermined by the observation that free banking systems have been tried and failed (the 1890s boom and bust in Australia is a particularly clear-cut example.
Whatever their disagreements and theoretical limitations, Keynesians and Austrians mostly got it right as regards the bubble economy of the decade leading up to the crisis. This is not to say that they predicted the timing and course of the crisis in detail. It is in the nature of bubbles that their bursting is unpredictable and has unpredictable consequences. Even the most accurate prophets, such as Nouriel Roubini of the Stern School of Business focused more on international imbalances and unsustainable housing prices rather than on the largely opaque superstructure of financial transactions that financed and magnified these imbalances.
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Was there really a Great Moderation?
The abrupt end to the Great Moderation raises anew the question of whether it was a real phenomenon or an over-optimistic interpretation of the data. Even when the Great Moderation was generally accepted, it was not the only interpretation put forward. In a paper published by the Brookings Institute in 2001 Olivier Blanchard of MIT and John Simon of the Reserve Bank of Australia argued that the data implied a long-term decline in volatility since the 1950s, interrupted temporarily in the 1970s and early 1980s.
Although this interpretation fitted the data as well as the standard view, it was not widely accepted.The reason is obvious enough. A statistical test suggesting that the economy was much more volatile in the 1950s and 1960s than in the 1990s is hard to accept in view of the actual experience of the postwar boom as a period of strong growth and low unemployment. If measures of volatility contradict this experience, the obvious response is to suggest that they must not be measuring the right thing.
But if data on quarterly volatilty can so easily be used to derive results that are so obviously problematic, this must cast doubt on their use to support the standard Great Moderation story. It is therefore worth looking more closely at the measures and their interpretation.
The first difficulty with a focus on the volatility of output growth is that it takes no account of changes in the average rate of economic growth. Looking at US growth rates, for example, the standard deviation of the rate of economic growth was 2.0 per cent in the 1960s, as compared to 1.5 percentage points in the 1990s. This seems to support the usual story suggesting a decline in volatility
But the average rate of output growth was 4.3 per cent in the 1960s, and only 3.0 per cent in the 1990s. So, expressed relative to the average growth rate, volatility was actually lower in the 1960s.
A second problem is that quarterly volatility measures are sensitive to relatively short-term fluctuations (in the statistical jargon, this is called high-frequency volatility). The same is true of the NBER measure which defines a recession as a downturn lasting a few quarters. These measures have their advantages, but they miss some critical features of the cycle.
Although the post war boom was characterised by relatively frequent recessions these recessions were not felt as being particularly severe because they were typically followed by rapid and strong recoveries – they had to be, given the high average rate of economic growth.
The recoveries following the recessions of 1990-91 and 2001 were different, so different that the term ‘jobless recovery’ was coined to describe them. Well after output had begun to recover, employment kept falling and unemployment kept rising. In each case the recovery in output was sufficient to constitute a recovery according to the popular ‘negative growth’ definition, and also according to the somewhat broader criteria used by the NBER. But to the average person, the early years of these expansions felt much like recessions.
President George HW Bush was among the first casualties of the new-style business cycle. By the time of the 1992 US election, the economy was about 18 months into an expansion, according to the standard measures. But Bill Clinton, campaigning on the slogan ‘It’s the economy, stupid’ was able to capitalise on the actual experience which was that of continuing depressed conditions.
The same experience was repeated after the 2000 recession.
The jobless recovery phenomenon was not confined to the US. In Australia, for example, the economy went into recession in 1989 and, on the standard measures, began a renewed expansion in 1990. But unemployment peaked at … in … and did not regain its 1989 levels until … , … years into one of the longest expansions on record.
As in the US, … The Labor government that had presided over the recession managed to scrape back into office in 1993. By 1996, with an expansion more than five years old, and unemployment rates finally declining, Labor hoped to be rewarded for the recovery. But the opposition parties judged the public mood more accurately, arguing that ‘five minutes of economic sunshine’ was no reward for what was popularly perceived as a multi-year recession.
But if the standard measures of quarterly volatility did not match the experience of workers in general, they fitted very neatly with that of participants in financial markets. For these groups the recessions were periods of severe les
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Individual and aggregate volatility
Economic analysis of the Great Moderation showed a striking paradox. Even though economic aggregates appeared to be more stable than at any time in the past, individuals and families experienced ever-increasing risk, volatility and instability. Risk has, it seems, increased in every dimension. Income inequality has grown substantially, in part because income mobility has increased, but also because lifetime income has become more risky. Short term variability in income has also increased.
This is a surprise. Since aggregate income Is just the sum of all individual incomes, it would seem that an increase in individual risk should translate into an increase in the riskiness of aggregate income, even allowing for the fact that some gains and losses will cancel out.
Economic analysis of the paradox came to the conclusion that the development of financial markets had weakened links between economic variables such as income and consumption. Faced with a decline in income, households could borrow to maintain their consumption levels. As a result, the flow-on impact of a shock in one sector of the economy to consumer demand for the economy as a whole was reduced. This meant that high levels of volatility in individual incomes could co-exist with aggregate stability.
But, was such a pattern sustainable? If variations in income are transitory, then borrowing to maintain living standards through a rough patch makes sense. But responding to a permanent decline in income by going into debt is a recipe for disaster. And it’s obviously difficult to tell in advance whether an income decline is going to be temporary or permanent.
Not surprisingly, as income volatility increased, so did the number of people who got into trouble by relying on borrowing. The most direct measure is the number of people filing for bankruptcy. This has increased in most English-speaking countries, but nowhere more than in the United States. In the early years of the 21st century, more than 2 million people declared bankruptcy every year. In fact, in these years, Americans were more likely to go bankrupt than to get divorced. The commonest immediate causes of bankruptcy were job losses and unexpected health care costs. But the underlying cause was a culture of indebtedness which meant that most people who experienced financial stress rapidly ran into trouble meeting existing commitments.
In 2005, the credit card industry hit back at the rising bankruptcy rates with the Bankruptcy Abuse Prevention and Consumer Protection Act, which put a number of obstacles in the path of people seeking to resolve their debt problems through bankruptcy. In the year before the law came into effect, over two million households rushed to file. In the months immediately following ‘reform’, bankruptcies dropped almost to zero, and remained well below those of the pre-reform period for several years. But the pressures of increasing debt meant that many people had no choice but to negotiate the newly established obstacles to declaring bankruptcy, and the numbers doing so gradually increased.
The onset of the financial crisis was initially reflected more in foreclosures than in bankruptcies. Most mortgages in the US are (legally in some states and de facto in others) non-recourse, which means that, after foreclosing on the house offered as security creditors cannot go after the other assets of the borrower. This means that, even if a foreclosure yields far less than the amount owed, the borrower’s obligations are discharged. For this reason, as long as the crisis was primarily confined to housing markets, bankruptcy rates rose only gradually. But, with the onset of high unemployment, and the end of easy access to credit of all kinds, bankruptcy rates soared in early 2009. It now seems likely that the number of bankruptcies in 2009 will be more than 1.5 million, exceeding all previous years, except for 2005 when people were rushing to beat the deadline of bankruptcy reform.
Despite the volatility of individual income, and the risks of relying on credit markets, economists focused on macroeconomic aggregates continued to celebrate the Great Moderation right through 2007. 2008 came as a rude shock.
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The GFC
The Great Moderation has vanished with surprising rapidity, though in retrospect its unsustainability has been evident since the late 1990s.
Bernanke’s Great Moderation hypothesis was not the first claim that the business cycle had been tamed, and it is unlikely to be the last. Every sustained period of growth in the history of capitalism has led to the proclamation of a New Era, in which full employment and steady economic growth would continue indefinitely. None of these proclamations has been fulfilled.
But, even by the unexacting standards of past economic projections, the Great Moderation has been one of the more spectacular failures. The Golden Age of Keynesianism lasted three decades, and delivered big increases in living standards throughout the developed world.
By contrast, the Great Moderation in the US didn’t really begin until the end of the first Bush recession in the early 1990s, and almost collapsed in the dotcom crash of 2000. It was only the reckless monetary expansionism of Bernanke’s predecessor, Alan Greenspan, that reinflated the bubble economy of the 1990s, and paved the way for an even more disastrous crash a few years later.
It is clear that the global economy is undergoing a severe recession, which will generate a substantial increase in the volatility of output. But even the economy recovers in 2010, as is suggested by some optimistic forecasters, crucial elements of the Great Moderation hypothesis have already been refuted. Over the period of the Great Moderation, all the major components of aggregate output (consumption, investment and public spending) became more stable. By contrast, any recovery will be the result of a massive fiscal stimulus, with a huge increase in public expenditure (net of taxes) offsetting large reductions in private sector demand.
The crisis has also invalidated most of the popular explanations for the Great Moderation. As will be discussed in more detail in Chapter …, the idea that improvements in monetary policy have been a force for economic stabilization looks rather silly, now that a crisis generated within the financial system has brought about a crisis against which the standard tools of monetary policy, based on adjustments to interest rates, have proved ineffective.
It is to the credit of central banks that, when their standard tools failed, they were willing to adopt more radical measures such as quantitative easing (that is, printing money and using it to purchase securities such as government bonds and corporate paper). Such radical steps, which contrast sharply with the passive response to the financial shocks of the Great Depression, have helped to prevent a complete meltdown of the financial system. But willingness to abandon failed policies does not change the fact of failure.
But if the pretensions of central banks have been shaken, those of financial markets have been utterly discredited. There is now no reason to give any credibility to the view that financial markets provide individuals and households with effective tools for risk management. Rather, in aggregate, the unrestrained growth of financial markets has proved, as on many past occasions, to be a source of instability and not a stabilising factor.
Just as the failure of the efficient markets hypothesis has destroyed much of the theoretical basis of the policy framework dominant in recent decades, the collapse of the Great Moderation has destroyed the pragmatic justification that, whatever the inequities and inefficiencies involved in the process, the shift to economic liberalism since the 1970s delivered sustained prosperity. If anything can be salvaged from the current mess, it will be in spite of the policies of recent decades and not because of them.
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China and India
In the wake of the GFC, some advocates of economic liberalism have sought to shift the ground of debate, arguing that, whatever the impact of financial globalisation on developed countries, it has been hugely beneficial for India and China which, between them, account for a third of the world’s population.
There are all sorts of problems with this argument.
The relatively disappointing economic performance of China and India in the postwar decades certainly provides strong grounds for criticising the economic policies of Mao Zedong and Nehru. But even in the days when some observers saw these policies as providing an appropriate development path for the countries that adopted them, no one seriously proposed their adoption by developed countries. And as more attention has been focused on the irrational aspects of these policies (such as the Great Leap Forward, in which people were made to melt down their cooking pots to provide scrap for backyard smelters, which presumably produced new cooking pots, or the dozens of licenses required to undertake the simplest economic activity in India) it has become easier to understand why their removal or relaxation
At the same time, neither of these rapidly-growing economies come anywhere near meeting the standard description of a free-market economy. China still has a huge state-owned enterprise sector, a tightly restricted financial system and a closely managed exchange rate. India began its growth spurt before the main period of market liberalisation and also retains a large state sector. In both countries, as earlier in Japan and South-East Asia, the state has played a major role in promoting particular directions of development.
In summary, while the development success stories of China and India, and, before them of Japan and the East Asian tigers, may have some useful lessons for countries struggling to escape the poverty trap, they can tell us nothing about the relative merits of economic liberalism and social democracy.
John Quiggin 
This will be a good book.
I hope that these paragraphs will be interspersed with plenty of graphs. A picture says a thousand words.
Somebody commented something further back about how the inventory cycle effects volatility. Certainly there has been great progress in the field of Operations Research since the 60s, and the optimization of supply chains and so forth might have had some impact on this factor.
Minsky rightly gets a thorough mention. I think that the section of the EMH should contain a detailed discussion of his alternative “Inefficient Markets Hypothesis, and a comparison of both with a look at the evidence.
There seems to be a good opening in the section on Central Banks to go into one of the other great neoliberal shibboleths: Central Bank Independence, and how rumors of its effectiveness have been greatly exaggerated.
The China and India section is a bit short. I don’t like putting Mao and Nehru in the same sentence, Nehru was an economic nationalist, Mao was simply a deranged psychopath. The Great Leap Forward was just about the most catastrophic economic experiment in Chinese history – if not human history – and mentioning it as just “one of” several irrational policies in parenthesis hardly does it justice.
I don’t know if this book is planning to concentrate on economic development – that might be a whole book in itself. But certainly a comparison with the East Asian vs Latin American development models, particularly with regard to capital markets, is essential to a critique of neoliberalism (although neoliberal apologists will inevitably move the goalposts).
Two observations.
1. Free banking did not fail in Australia. At least no more so than riding without a bicycle helmet failed in Australia.
2. I agree that some Austrians have an unusual take on the gold standard and fractional reserve banking. However a gold standard should not be characterised as something imposed by government. The reality is that so long as taxation exists the government is going to have to use some unit of account for denominating tax liabilities and it could be gold, silver, greenbacks, euros, rand or any number of things. Gold is no more coercive than the others (no less so either). So it is wrong to characterise it as a coercive regime. What is coercive is imposing taxation in the first place or in dictating a specific medium of exchange for commercial transactions. Using gold as a unit of account for tax liabilities, government contracts and government loans is not an issue of state coercion.
It is a complete fallacy to claim that a managed exchange rate is less free market than any other fiat currency system. Australia has a managed interest rate, China has a managed exchange rate. There is no eternal law of markets that says fixing interest rates is more free than fixing exchange rates. Both entail a government policy in relation to a commodity (fiat currency) over which the government has monopoly production rights.
Fixing the exchange rate of the fiat currency with gold is also not free. However it is a damn fine idea.
“Free banking did not fail in Australia.”
You have heard of the 1890s Depression, right?
http://journals.cambridge.org/action/displayAbstract;jsessionid=6777CA34A61098650174B41990D1AB1E.tomcat1?fromPage=online&aid=142572
Hi John
a quibble:
“This view was derived from the work of Friedrich von Hayek and Ludwig von Mises, economists who were literally Austrians by birth.”
This doesn’t read very well- can’t you just say “… the work of Austrians Fiedrich von Hayek and Ludwig von Mises”.
It is pretty obvious to anyone, no matter how economically literate, that they are “literally Austrians by birth.”
Regards
Tim
haha- excuse my poor spelling 😀
Did you really want to underline everything in the “Was there really a Great Moderation?” section?
John – yes I’ve heard of the 1890s recession. So what? Are you claiming that ending free banking cured the country of recessions?
p.s. It’s also worth noting that the recession of the 1890s was primarily a problem for banks in Victoria and not so much elsewhere in the country.
TerjeP (say tay-a), I don’t know where you get your info but the 1890s depression was a severe financial crisis whereby in 1892 GDP fell 10% in the first year resulting in a number of trading banks to suspend payment and other non-bank financial institutions collapsing. Bank credit to GDP fell from above 70 per cent at its peak to about 40 per cent by the turn of the century.
‘Most mortgages in the US are (legally in some states and de facto in others) non-recourse, which means that, after foreclosing on the house offered as security creditors cannot go after the other assets of the borrower.’
This point might belong in a different chapter, but are you going to discuss how foreclosure rules in the US compensate for the lack of a welfare state (that is borrowing as an alternative to public provision)?
I had intended to include this point and forgotten to do so. Good catch!
To answer your question, since the adoption of Keynesian macroeconomic policies after 1945, there has been no crisis as severe as either the 1890s or 1930s Depression. Progress does happen, and it relies on the abandonment of failed ideas like free banking.
This is great! I’m really looking forward to this book. I have two questions that could poke holes in the argument about the golden age of Keynes. First, was the massive buildup of debt coming into the 70’s with the onset of stagflation. Second, the massive buildup of debt (govt) in the US after 911 wich was in effect a good old Keynesian pump prime. The “keynes” side works well in a crisis but the policymakers didn’t do enough (or reverse it) in the boom years.
Forgive my ignorance, but what do Keynesian macro policies have to do with free banking?
Also, why start with 1945 instead of the emergence of central banking?
Michael of Summer Hill – yes banks collapsed in Victoria. I’ve already acknowledged that. What about outside Victoria? Care to explain the differences? I don’t know for a fact but I suspect differences in bankruptcy laws was a factor.
John Quiggin – 1945 is a long time after 1890. What you are suggesting is that all the interum regulations were not sufficient (although perhaps necessary pre-conditions). Is it government borrowing and spending that is key to your Keynesian remedy or do you see the monopolisation of the money supply as essential. It seems to me that the Keynesian fiscal macro levers don’t require an end to free banking. Even monetary fiddling can be done in a free banking system by redenominating the national unit of account (eg changing the definition of the dollar / pound in terms of gold). So long as private banks are free to make contracts in other units (eg gold directly) then this does not technically prevent free banking. Ending free banking is a microeconomic reform not a macro manipulation. Whilst it would be a quite different version of a Keynesian response I don’t see free banking as preventing Keynesianism. Not that I’m an advocate for the keynesian approach.
p.s. Unless bank guarantees are part of the Keynesian model. I didn’t think they strictly were.
p.p.s. Completely off topic but I’d love it if you did a piece on the Integral Fast Reactor technology being touted by Hansen and others. As a way of getting rid of existing nuclear waste it seems quite superb. With masses of energy as a biproduct it sound quite phenomenal.
this is a test to see if everything I write gets put in moderation.
Apparently, yes. It appears that your IP number is exactly the same as mine, which may be causing WordPress some palpitations.
i know imanidiot
but
this disquisition on the monetary movements is about the legal economy.
it completely ignores the illegal economy(drugs,armaments,slaves,etc)that i read somewhere(can’t remember)is at least equal to the legal economy.
the effect of these huge dark pools of money on the world economy is nowhere addressed in any theory or practice.(except as a problem of law enforcement)
all the modelling in the world will not reflect reality until the effect of these various and diverse huge pools of money are taken into account.
not easy,if fact damn near impossible but ignoring the reality of black money will render all models ineffective.
so the theory might be correct but the numbers are wrong or the numbers might be correct and the theory is not.
my tuppence!
@may These things tend to be sensationalised and exaggerated. “At least equal to the legal economy” seems to be unjustified on the evidence.
But it was said long ago [1], if a man marries his maid, he reduces GDP — the non-cash economy, including housework, is important and not considered by traditional economics (for example, cook at home or eat out? changes are important)
[1] Quoted by Joan Robinson somewhere I recollect. Or here (last para) [per Google].
One point is that there is a tradeoff between the volatility of growth and the volatility of the output gap. If the economy undergoes a recession that leaves output 2.5% below potential, and its natural growth rate is 3%, a recovery that has 5.5% growth in the first year and 3% growth thereafter will have a higher variance in the growth rate than one with 5 years of 3.5% growth. It is the output gap, however, that matters for social welfare and inflation control.
As far as the 50s/60s vs the great moderation goes, keep in mind that growth in the former was boosted by convergence and growth in the 2000s held back by declines in the workforce. Productivity growth in the 2000s has been high and the NAIRU low.
Higher growth in the 50s/60s by itself increased the time between recessions; with higher average growth it took larger shocks to generate negative growth.
Also most studies date the start of the great moderation to the mid 80s; Volker’s expansion was nearly as long as the Vietnam war expansion of the 60s, which in turn was shorter than the expansion of the 90s. It is also worth noting that inflation rates became less volatile in the great moderation.
As for Chinas large publicly owned sector, this has been a drag on growth rather than a contributor; total factor productivity in this sector is below its levels under the gang of four.
I meant to say declines in the participation rate (in the US) rather than declines in the workforce.
TerjeP (say tay-a), I suggest you the RBAs ‘TWO DEPRESSIONS, ONE BANKING COLLAPSE’.
TerjeP (say tay-a), just for you I will post this piece from Edmund Rogers the second time “The Australian financial crisis of 1893 was one of the most catastrophic financial collapses in history. The GDP of the Australian colonies plummeted 17 per cent over 1891-3, and prices dropped 22 per cent over 1890-4, spelling excruciatingly high real interest rates. It took nine years for Australian GDP to return to its 1891 level. The Australian financial sector was left devastated. Forty building societies and mortgage ‘banks’ in Melbourne and Sydney failed between July 1891 and March 1892. Over 1890-3, seven of the colonies’ thirty-one trading banks shut down. During April-May 1893 alone, over half of the banks, holding 61.5 per cent of total bank assets in Australia, suspended payments to depositors. Undoubtedly 1893 was the annus horribilis of Australian banking, with the closure of fifty-four of the sixty-four banks and finance companies that had been open in 1891, thirty-four of them for good”.
“total factor productivity in this sector is below its levels under the gang of four”
where does that info come from?
Terje fixing the Aussie to gold will give away our monetary independence and take us back to the world of volatile short-term interest rates. The floating currency has been a great stabilising influence on the economy, though I reckon the RBA would rather it was 10c lower than what it currently is.
“Forgive my ignorance, but what do Keynesian macro policies have to do with free banking?’
This was a response to Terje who implied that economic performance was not improved by the end of free banking. And it’s true that there was no improvement up to 1939, which is a problem for those ( new classicals, for example) who want to advocate central banking without any use of Keynesian fiscal policy. I’m happy for free-bankers and anti-Keynesian central bankers to fight it out for the wooden spoon in terms of economic performance.
Gerard,
The stuff about TFP in Chinese nationalized industries was in the economist last year (I don’t remember the exact issue. I will have a look for you).
John Quiggin: what exactly does fiscal policy give you over monetary policy, in circumstances where the zero lower bound on interest rates is not binding?
Gerard,
The stuff about TFP in Chinese nationalized industries was in the economist last year (I don’t remember the exact issue. I will have a look for you).
John Quiggin: what exactly does fiscal policy give you over monetary policy, in circumstances where the zero lower bound on interest rates is not binding?
Michael – thanks for the history lesson.
SDFC – a gold standard does not give away our monetary “independance” any more than delegation to an “independent central bank” does. Also I’m not sure why you think a fluctuating spot price for credit is such a big deal whilst a fluctuating exchange rate isn’t.
John – you have refined the classification of economic schools of though but otherwise you have avoided my question. My question was not a point scoring exercise. I’m interested in knowing the key characteristics of the Keynesian remedy that free banking prevents. Is it government guarantees on bank accounts?
@Tim Peterson
Fiscal policy can be targetted to areas of need – it takes a damn long time for interest rates to work their way in…and interest rates are blunt as…with more burden on small business than large business and also who ever gave us negative interest rates…if it aint working at zero, Monetary policy isnt going to work. Im a bit over Monetary policy and the people who have had faith in its supposed “there is only one silver bullet that matters” and the obsession with the central banks and the overemphasis on inflation as a target. Its not the only damn target (but for the past thirty decades you would think thats all that mattered..)
@Michael of Summer Hill
Moshie – I was thinking that myself – that Terje doesnt have a handle on the financial crisis of 1890s and no Terje it wasnt only a Victorian problem.
Terje, I misunderstood your point. I haven’t considered whether the combination of a free banking system and Keynesian fiscal policies is consistent. As you will recall, I advocate a government guarantee for a narrowly defined banking system with (broadly speaking) a free banking system outside the guarantee, so I guess this comes pretty close.
To be specific how is the Keynesian remedy fundamentally distinct from old fashion borrow and spend plus currency devaluation?
Tim Peterson, redistribute wealth from those who save to those who spend it.
Thanks John.
Terje the floating currency has been working as intended, I’m not sure what you problem is with it. Our inflation problem last year would have been worse but for the adjustment in the currency. Volatile short-term interest rates are a problem if you want to borrow money.
Why gold anyway, iron ore and coal or a basket would be far more appropriate for our economy.
I also have this Terje
During the 1890s a substantial proportion of the financial system collapsed – 13 of the 23 trading banks were forced to close their doors and required reconstruction before opening, bank credit declined from a igh of 70% of GDP to 40% by the turn of the century. In contrast only 3 banking institutions failed in the 1930s crash and there was only s small decline in bank credit.
The difference in the two depressions was noted as an unprecedented building boom in the 1880s, a whole new set of financial institutions increasing competition on banks, a property price bubble (shades of the USA recently?), a rapid expansion of banks balance sheets and lending readily available from London (in the US case of the GFC – lending readily available from the rest of the world), and all the while the level of prudence in the banking system fell(again …much like the US recently).
There are lots of parallels… but this was your era of free banking Terje and you still maintain it works??
The collapse of the financial system in the 1890s extended the depression by many years.The key point is, the financial sector under your free banking performed significantky worse than the financial system after the shcok of the 1929/30s which was a more severe macroeconomic shock, than that of the 1890s, Terje.
Just as a freer banking system has performed poorly under the shock of the housing collapse in the US…
Point being…mayber your freer banking system helps blow up bubbles Terje.
Alice,
Monetary policy has longer transmision lags than fiscal policy but much shorter implementation lags, so the point is moot. When monetary policy hits the zero lower bound, quantitative easing can be employed to loosen policy.
Fiscal policy did not generate recovery in Japan in the late 90s; quantatative easing did so.
The Taylor rule puts weight on eliminating output gaps as well as targeting inflation.
@Tim Peterson
The point isnt moot at all Tim.
The implementation lag is a far lesser lag overall than the effectiveness lag. The former at a max generally we would allow a year for the budget process (in the case of fiscal policy – perhaps longer if it sits in a consultants office as a plan). For Monetary policy obviously its far shorter – how long to change the cash rate? Not long. The effectiveness lag is how long it takes to work and with interest rate changes that can be years depending on the nature of the investment project. For fiscal policy it depends when the first dollar is spent. For Monetary policy it deoends on when people change their plans and that can be a hell of a lot longer than the govt signing cheques or giving tax reductions.
Tim export demand seems to have been the biggest driver behind the Japanese recovery rather than quantitative easing.
@Tim Peterson
Further Tim – by the time Japan rolled out the Budget deficits it was because they realised they had hit so close to zero interest rates and guess what? It wasnt working…so two cannons needed which they did. Lets hope this isnt a lesson in why monetary policy is superior to fical policy — because history shows us they keep calling on fiscal policy when monetary policy fails despite the anti Keynesian rhetoric.
@sdfc
sdfc – quite agree. Japan turned into one of the three largest trade surplus nations in the globe with the boom before the GFC. Between 1997 and 2005 the Japanese trade surplus did nothing but expand. On a contrary note Monetary Policy created interest rates at almost zero by 1999. Classic liquidity trap with deflation as Krugman noted with a flat yield curve and 10 year govt bond yields less than 1%. If MP helped japan it wasnt enough which is the whole problem with monetary policy. It has a tendency to be sold as a single solution by too many for too long.
Tim Peterson, some might argue that during the 1990s in Japan there was a hoard mentality rather than savings and provides an insight into how thrift can take hold of consumption with disastrous impact.
A basket of globally traded commodities, along the lines of the Bancor proposed by Keynes, would be a great improvement over the current approach.
In terms of free banking history in Australia the following online book (I’ve only read snippets) has some interesting things to say on the experience in Australia in the 1890s. Chapter 3 seems very relevant:-
http://tinyurl.com/n6bfc8
In particular the author states that there is little evidence from the period that the banks were being reckless or that their reserve ratios and the like would have been regarded as inadequate by todays prudential regulators. He seems to claim that a severe economic down turn caused the banking crisis rather than the other way around. However I have only skimmed the text so far.
I am sure that eventually someone will write that “a severe economic down turn caused the GFC banking crisis rather than anything that the financial institutions, themselves, did”. As it is, the further away from the Great Depression the better the ‘explanations’ are getting, with Amity Shlaes “The Forgotten Man” being the best revisionist history so far. The further in time away from events the greater the scope for putting forward ‘explanations’ that would not have been credible at the time, simply because less is known about what happened and what went on. No doubt, free banking filled a gap, in the few places it was tried, before government stepped in but I think most economists would consider it a dangerous and highly speculative experiment to replace our current approach with it.
TerjeP (say tay-a), it was the banks practices and exposure to the property market through loans to the land finance companies which brought them unstuck.
Alice,
Most studies put the lag from monetary policy actions to peak impact on nominal GDP at one year; not that different to the implementation lag for fiscal policy.
The shortest effectiveness lags for fiscal policy are for taxes, transfers and recurrent government spending; givernment investment has lengthy design lags. Temporary tax cuts are mostly saves, recurrent government spending is not politically feasible to temporarily tamper with, which leaves transfer payments.
These can be increased to stimulate demand; but conversely cannot (and should not) be reduced to slow demand down.
Michael: Japanese quantitative easing reduced the value of the yen, stimulang exports as you mention.
@Tim Peterson
Tim – not my understanding of the effectiveness lag of monetary policy (being one year) – do you have any sources for that ?- even if firms rush off in a year to get loan approval – the point is when they actually spend more.
Is it possible to raise two other possible explanations of the “great moderation” being false:
1. Was the data false – I found official US figures that their recession did not begin till 2008 hard to believe at the time. They conflicted sharply with the perceptions of academic fiends who had returned from the USA. Could the figures be wrong? I note from Paul Krugman’s blog that by 2007 finance and banking firms in the US economy comprised 30% of reported profits for listed firms. If even 10% of them are reporting exaggerated results, or not reporting losses, that would be 3% of the total; enough to make the difference between growth or recession. Then there would have bene no moderation, just sufficient over-optimistic financial reporting to give the illusion of growth.
2. Were long term demographic trends the cause? – models make the ceteris parabus assumption but what if its false? The baby boom means that we do not have a homogenous age profile. During the great moderation we had a very high proportion of working age people, also saving for their retirement. So things coudl have improved naturaly in spite of policy. Just as part of the staglfation of the 70s could be explained by too many baby boomers looking for a job, combined with lots becoming first home buyers at the same time. Now we have a lot seekign to retire and cash in their investments. Do our economic models take account of these shifts? If not, then the great moderation could have been from circumstance and timing of demographic shifts, nothing to do with monetary policy.
Apology if the above is on the wrong track; I applaude the intent of the book.