The IMF has said that it thinks the recession is over. The Economist celebrates the resilience of the Asian economies. In the OECD countries, it looks as if Germany and France are recovering faster than the Anglo-Saxon twins—the US and UK. The delicious paradox here is that the two who have recovered did not agree with the large Keynesian packages which the US and the UK tried and urged on other countries.
If the IMF is right, then the deep crisis which started in the wake of the Lehman Brothers in September 2008 is over within a year. When the crisis broke last year, there were comparisons made with the Great Depression. It was said that modern economics was bankrupt. Keynes was needed to be back at the centre if we were to get out of the rut. Modern macroeconomics, Paul Krugman said, was living in the dark ages.
So what has happened? The 2008-09 crisis is shorter than either the 1970s or the 1980s recessions. It was during the 1970s crisis and the stagflation which followed, that Keynesian policies lost their lustre. Chicago displaced Keynesian economics with monetarism ( Friedman ) at first and then the New Classical Macroeconomics( Lucas).
There were heated battles between the MIT/Harvard and the Chicago/Minnesota schools about issues such as : Is the economy capable of being at a full employment equilibrium perpetually unaided by fiscal interventions as Chicago claimed or can it be at underemployment equilibrium unless government stimulus brings it back to full employment? Chicago claimed that a budget deficit if unfunded would lead to money creation and inflation negating the stimulus or if funded the taxpayers will see through it as it would only lead to future tax rises. The MIT/Harvard people argued that there was a slack and various lags and rigidities in the economy gave a role for intervention.
After a turbulent twenty five years from mid sixties to the end of the eighties, a compromise was reached. Chicago conceded that the built-in stabilisers which Keynes had urged were useful for macro policy. The MIT people agreed that the fiscal policy must be framed in a medium term context and the monetary consequences of deficits could not be ignored. Suddenly peace broke out all over macroeconomics. Central bankers were to look after inflation and treasuries were to run a responsible fiscal policy.
What neither side had theorised about was the financial sector. Macroeconomics has a very thin financial sector in its theoretical structure. Money yes, but banking hardly and finance not at all. Financial economics was exploding with innovations most of which allowed the agents to stretch liquidity over vast structures of debt creation. The stability assured by the macro compromise and the low inflation thanks to Asian manufacturing exports allowed the financial innovations to have a free play.
This happy scene broke up in disarray in 2007. At first the markets ran wild in marking up commodity prices to compensate for weak equity performance. Inflation reignited and the Central banks tightened their policies. Hence the fragile real estate markets reversed their upward march and assets based on sub-prime mortgages lost value. The real economy began to slide into recession in the US sometime in the middle of 2007. As of then the European economies were not affected. It was the beginning of bank collapse, first in the UK in September 2007, a full year before Lehman Brothers which brought in a financial crisis in addition to the output recession. At first no one panicked and for the next twelve months banks were bought and sold but without serious loss of asset values.
No one worried about the failure of economics yet. It was only after the Lehman Brothers that liquidity dried up and we were into a new world which we had not seen before. The Central Bankers responded superbly by pouring money down the hatches of banks which were technically bankrupt. The response was not prescribed by Keynes; indeed Keynes did not discuss this possibility.
Yet it was the economists who had honed their skills in the turbulent battles who had the sense to innovate and not be confined by orthodoxies. Thus modern macroeconomics was not at all useless as Krugman argued. The answer was not back to Keynesianism of the sixties but a sophisticated understanding of the crisis. The German and French policymakers had less of a financial hole to tackle and they showed restraint in reflating their economies relying instead on built-in stabilisers. The Anglo-Saxons poured money into their banks and on top of that reflated like there was no tomorrow.
The result seems to be that innovative bankers schooled in modern macroeconomics tackled the financial collapse but the fiscal conservatives of Germany and France managed to tackle the recession better.If economics needs redoing it is in integrating finance better into macroeconomics and not in going back to Keynes.
—author is a prominent economist and Labour peer