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Saturday, December 5, 2009

Leijonhufvud tracks the collapse of monetary theory

The fascination with monetary policy exceed by a hundred times its effectiveness. As John Kenneth Galbraith said, (approximately) No policy has survived better a complete lack of success than monetary policy. Here is some very good analysis from a very good economist.  As the intro to the VoxEU.org version says:  Economics lacks an anchored understanding of the nature of the reality that economics is supposed to illuminate.
Stabilities and instabilities in the macroeconomy
Axel Leijonhufvud
21 November 2009

Fifty-some years ago, students were taught that the private sector had no tendency to gravitate to full employment, that it was prone to undesirable fluctuations amplified by multiplier and accelerator effects, and that it was riddled with market failures of various sorts. But it was also believed that a benevolent, competent, democratic government could stabilise the macroeconomy and reduce the welfare consequences of most market failures to relative insignificance.

Fifty years later, around the beginning years of this century, students were taught that representative governments produce pointless fluctuations in prices and output but, if they can be constrained from doing so – by an independent central bank, for example – free markets are sure to produce full employment and, of course, many other blessings besides. Macroeconomic policy doctrine had shifted from stabilising the private to constraining the public sector.

This long swing in our understanding of the economy spans a half-century of prolific technical accomplishments in economics (Blanchard 2008). But what the story shows is that, ontologically, economics has been completely at sea, drifting on the surface in currents of our own making. We lack an anchored understanding of the nature of the reality that economics is supposed to illuminate.

Neoclassical syntheses

Around the turn of the century the pendulum began to swing back – although not very far. “Freshwater” and “saltwater” macroeconomists came to a “brackish” compromise known as the New Neoclassical Synthesis. The New Keynesians adopted the dynamic stochastic general equilibrium (DSGE) framework pioneered by the New Classicals while the latter accepted the market “frictions” and capital market “imperfections” long insisted upon by the former.

This New Synthesis, like the Old Synthesis of fifty years ago, postulates that the economy behaves like a stable general equilibrium system whose equilibrating properties are somewhat hampered by frictions. Economists of this persuasion are now struggling to explain that what has just happened is actually logically possible. But the recent crisis will not fit.

The syntheses, Old and New, I believe, are wrong. They stem from a fundamental misunderstanding of the nature of a market economy. Further technical innovations in economic modelling will not bring real progress as long as “stability-with-frictions” remains the ruling paradigm. The genuine instabilities of the modern economy have to be faced.

A complex adaptive system

The economy is an adaptive dynamical system. It possesses the self-regulating, “equilibrating” properties that we usually refer to as “market mechanisms”. But these mechanisms do not always suffice to ensure the coordination of activities in the complex system. Almost forty years ago, I proposed the “corridor hypothesis”. The hypothesis suggested that the economy might show the desirable “classical” adjustment properties within some “corridor” around a hypothetical equilibrium path but that its self-regulating capabilities would be impaired in the “Keynesian” regions outside the corridor. For large displacements from equilibrium, therefore, the market system might not be able recover unless aided by stabilisation policy.

The original argument for the corridor concerned the conditions under which to expect significant deviation-amplifying multiplier effects and might not be all that persuasive by itself. It is the case, however, that all other known complex dynamical systems, whether human-made or occurring in nature, are known to have the property that their homeostatic capabilities are bounded. It is extremely unlikely that the economy would be different in this regard.

It is reasonable to believe, therefore, that the state-space of the system – in addition to regions with good equilibrating properties – has regions where deviation-amplifying processes have impaired these properties. But the story does not end there. The present crisis has shown us a whole array of destabilising, positive feedback processes that are not as tightly bounded as the multiplier. Deleveraging by banks, for example, cuts off credit to businesses, which leads to a recession, which in turn impairs bank assets and adds to the incentive to shorten bank balance sheets. The most dangerous of these destabilising feedback loops, which we have so far managed to avoid, is Fisherian debt-deflation. There are regions of the state-space that should be avoided at all cost.

This kind of impulse-propagation reasoning asks what the system's behaviour will be if it is displaced far from equilibrium. It treats the impulse as exogenous and misses, therefore, the possibility of endogenously generated instability.

We have known about the endogenous instability of fractional reserve banking for some 200 years. It is Hyman Minsky's contribution to have explained that this financial instability extends beyond just the commercial banking system. Minsky argued that a long period without crises – such as the late “Great Moderation” – would lead to an increased willingness to assume risk and thus cause the system to become financially fragile. And the fragile system will sooner or later crash.

Systemic problems

The currently pressing problems all concern instabilities that have been neglected in stable-with-frictions macro theory. They constitute three themes I discussed in more detail in previous Vox columns (Leijonhufvud, June 2007, January 2009, and July 2009).
  • Instability of leverage. Competing to achieve rates of return several times higher than returns in industry, financial institutions were at historically high levels of leverage towards the end of the boom, earning historically minimal risk spreads – and carrying large volumes of assets soon to be revealed as “toxic.” 
  • Connectivity. In the US, under the Glass-Steagall regulations, the financial system had been segmented into distinct industries each characterised by the type of assets they could invest in and liabilities they could issue. Firms in different industry segments were not in direct competition with each other. Deregulation has dramatically increased connectivity in the global network of financial institutions. The crisis of the American savings and loan industry in the 1980s, although costly enough, was confined to that market segment. The present crisis also started in American home finance but has spread and amplified across the world. 
  • Potential instability of the price level. Over the current decade, the American consumer goods price level has been stabilised largely through the exchange rate policies and competitive exports of China and several other export-oriented emerging countries. The Great Moderation has left a legacy of low volatility of inflation expectations. If these conditions were to change, inflation targeting with endogenous base money and the federal funds rate as the only instrument is bound to prove inadequate for monetary control.
Current issues

There are four issues to watch for:

  • Twin dangers looming ahead are Japanese-style stagnation on the one hand and Latin-American-style high inflation on the other. In more normal times, we would regard these prospects as both unlikely and very far apart on a spectrum of eventualities. High levels of public debt, large unfunded liabilities, and large current deficits mean that they are not at all far apart in the current situation. The apparent political difficulties in decisively remedying the public finances are likely to mean that this is not just a temporary predicament. The navigable channel between Scylla and Charybdis has become quite narrow. 
  • One overwhelmingly important fact should guide policy over the near-term future – since current bailouts and stimulus policies have stretched public finances to the utmost, governments do not have the fiscal resources to handle another bubble bursting. Policy, therefore, should be conducted in a fail-safe mode. The current policies of extremely low interest rates are not fail-safe. They are aimed at reflating asset prices just enough to stave off a deeper recession. This is a delicate operation, not a robust, fail-safe move. It is creating strong incentives for the banks to return to the tables and resume the game of maturity transformation at high leverage that got us into our current troubles in the first place. It is evident that the banks are responding promptly to those incentives 
  • High leverage has been the big culprit in the current disaster. To reduce the risk of another crash, we must curb leverage. But governments do not want the financial sector to deleverage now because the requisite falling asset prices and curtailed credit would deepen the recession. The question, of course, is: If not now, when? 
  • The central banks are planning “exit strategies” by which they mean returning their balance sheets, which are presently bloated beyond recognition with a mix of strange assets, to a condition more resembling that normal to central banks. This will not be easy. If they succeed, however, they will still face the prospect of having to engage in many of the same desperate, unconventional policies in a future crisis. Under present arrangements, the responsibilities of central banks have no well-defined limits. This problem can only be solved by regulation of the financial sector. At present, it does not seem that we know how to do it.


Blanchard, Olivier (2008), “The state of macro,” NBER Working Paper 14259.

Leijonhufvud, Axel (2007), “The perils of inflation targeting”, VoxEU.org, 25 June 2007

Leijonhufvud, Axel (2009), “Fixing the crisis: Two systemic problems”, VoxEU.org, 12 January.

Leijonhufvud, Axel (2009), “Curbing instability: policy and regulation”, VoxEU.org, 11 July.

Leijonhufvud, Axel (2009), “Macroeconomics and the Crisis: A Personal Appraisal”, CEPR Policy Insight 41, November.

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