A Keynesian Explanation for the Great Recession
February 6th 2010 21:20
Previously I wrote about the Monetarist explanation of this current recession. Today, I will take a look at a rather different view: Keynesianism. This school of thought became dominant during the Great Depression; however, it was eventually overtaken, in its original form at least, by Monetarism. I will focus on the original form of this theory, with some of the neo-Keynesian aspects included to make the theory more robust.
What a good ol' Keynesian would call "animal spirits" led to over-confidence in the stock and housing markets. Eventually this exuberance reversed itself and the animal spirits turned pessimistic. This led to crashes in both the housing and stock markets. As people began losing money, there was an increased tendency to save money. Unfortunately, this leads to the Paradox of Thrift: when people start saving money due to bad times, then businesses start making less money, and they start firing workers, who then need to save more money, and round and round we go. In normal recessions, the Federal Reserve can just pump more money into the system, which creates extra money to spend. This would overcome the desire to save in the short-run. If the story ended here, then there would be little significant difference between Keynesians and Monetarists. However, the Great Recession of 2007-2009 and the Great Depression were unique stories.
Like Monetarism, the Keynesians see the major problem of this recession occurring when the Fed Funds rate hit zero (note: the rate did not actually have to hit zero but for simplicity we will say that is the case). At this point, the Fed became powerless to use conventional tools to increase the money supply. As well, the effectiveness of the Fed policy was losing steam because people had such an extremely high desire to keep cash saved away and not being used productively in the economy. Such a position is the dreaded Liquidity Trap. Due to sticky prices and wages, which prevent the economy from rapidly adjusting to the recession, it would be impossible to avoid unemployment in a Liquidity Trap if the government did nothing.
SOLUTION TO RECESSION: The government needed to step in to prevent the Paradox of Thrift from taking down the economy. With the Fed out of the picture (in the heads of Keynesians, but not Monetarists as we discussed in the previous post), this meant the Federal Government would have to step in by spending enormous sums of money.
CRITICISM:
1. The government is simply transferring money from some people to other people, which does nothing to help the economy.
RESPONSE: Normally it does not help, but we are in a Liquidity Trap and the government needs to spend because the private sector has stopped spending.
2. Monetarist critique: The Fed will simply nullify the effect of the stimulus bill, because it is targeting its own growth rate.
RESPONSE: The Fed wouldn't do that. It realizes that the Fiscal Stimulus is needed in a Liquidity Trap and that the Fed cannot provide stimulus.
3. By propping up failing parts of the economy, the government is just delaying an eventual shift of resources in the economy.
RESPONSE: The problem during a Liquidity Trap is not one of "recalculation" in the economy, but rather a shortage of people willing to spend money. Any recalculation can occur later, but the government needs to do whatever it takes to get the economy churning and people spending again.
STANCE ON FISCAL STIMULUS: As was seen with TARP and the huge Stimulus Bill, the Keynesians won the day, although some die-hard Keynesians thought that both this and the New Deal of the 1930s were way too small (!).
Funny comment by Will Wilkinson on Liquidity Traps here.
Best resource for Keynesian-influenced views here.
Follow me on Twitter: @AGoldenDoor
What a good ol' Keynesian would call "animal spirits" led to over-confidence in the stock and housing markets. Eventually this exuberance reversed itself and the animal spirits turned pessimistic. This led to crashes in both the housing and stock markets. As people began losing money, there was an increased tendency to save money. Unfortunately, this leads to the Paradox of Thrift: when people start saving money due to bad times, then businesses start making less money, and they start firing workers, who then need to save more money, and round and round we go. In normal recessions, the Federal Reserve can just pump more money into the system, which creates extra money to spend. This would overcome the desire to save in the short-run. If the story ended here, then there would be little significant difference between Keynesians and Monetarists. However, the Great Recession of 2007-2009 and the Great Depression were unique stories.
Like Monetarism, the Keynesians see the major problem of this recession occurring when the Fed Funds rate hit zero (note: the rate did not actually have to hit zero but for simplicity we will say that is the case). At this point, the Fed became powerless to use conventional tools to increase the money supply. As well, the effectiveness of the Fed policy was losing steam because people had such an extremely high desire to keep cash saved away and not being used productively in the economy. Such a position is the dreaded Liquidity Trap. Due to sticky prices and wages, which prevent the economy from rapidly adjusting to the recession, it would be impossible to avoid unemployment in a Liquidity Trap if the government did nothing.
SOLUTION TO RECESSION: The government needed to step in to prevent the Paradox of Thrift from taking down the economy. With the Fed out of the picture (in the heads of Keynesians, but not Monetarists as we discussed in the previous post), this meant the Federal Government would have to step in by spending enormous sums of money.
CRITICISM:
1. The government is simply transferring money from some people to other people, which does nothing to help the economy.
RESPONSE: Normally it does not help, but we are in a Liquidity Trap and the government needs to spend because the private sector has stopped spending.
2. Monetarist critique: The Fed will simply nullify the effect of the stimulus bill, because it is targeting its own growth rate.
RESPONSE: The Fed wouldn't do that. It realizes that the Fiscal Stimulus is needed in a Liquidity Trap and that the Fed cannot provide stimulus.
3. By propping up failing parts of the economy, the government is just delaying an eventual shift of resources in the economy.
RESPONSE: The problem during a Liquidity Trap is not one of "recalculation" in the economy, but rather a shortage of people willing to spend money. Any recalculation can occur later, but the government needs to do whatever it takes to get the economy churning and people spending again.
STANCE ON FISCAL STIMULUS: As was seen with TARP and the huge Stimulus Bill, the Keynesians won the day, although some die-hard Keynesians thought that both this and the New Deal of the 1930s were way too small (!).
Funny comment by Will Wilkinson on Liquidity Traps here.
Best resource for Keynesian-influenced views here.
Follow me on Twitter: @AGoldenDoor
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