Monday, October 11, 2010

The world is extremely uncertain and the remedy is not Keynesian economics

In the middle of 2008 when the financial crisis was hitting the major economies of world my former boss had been briefed by a group of management pundits about the financial crisis. Subsequently, it was conveyed to me and I strongly told her that she got completely wrong information about the so called ‘financial crisis. My point was we had (have) no financial crisis as such but a temporary slowdown which happened partly due to market distortion and partially due to government policy. In fact in India there was (is) no proof for saying the financial crisis emerged due to lack of effective demand and this was not a case either in US and elsewhere. It was not surprise when she disagreed with me. Even there was a co-worker who have not background of economics but understood what I said in the broader picture of demand vs supply management.

Mr.Desai also argues:

  • My own view has been for some time that the recession was not a Keynesian one; i.e., it did not arise from lack of effective demand. It is a Wicksell-Hayek recession where overexpansion of credit, caused by excessively low interest rates leads to mal-investments. It is the banking system that becomes the problem as it ceases to function. This theory was popular before Keynes wrote his General Theory. After Keynes’s triumph, economists forgot about banking and credit cycles and modelled every crisis as a result of lack of effective demand to be cured by fiscal action. Macroeconomics became an income-expenditure story with output playing a passive part and finance totally absent. Recovery was assured by fiscal action almost automatically.

  • But a Wicksell-Hayek recession is not amenable to fiscal reflation. Indeed, Hayek took the extreme point of view that it would make things worse by distorting prices further. There is some point to what he says. Despite nearly zero interest rate, there is little investment. Consumers are not spending the money they get but are saving it. After all, they entered the crisis with a high level of debt. Such credit as is being taken up goes into corporate deleveraging. We have already seen this in the Japanese recovery from its banking crisis. The recovery is long, slow and tepid.

And he concludes (may be rightly):

The crisis of the western economies is a crisis of economics not of capitalism. There are older theories that may yet guide us out of the crisis if only we could revive them. I doubt though that the world will listen.

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