We now come to the financial crisis and deep recession that began just a few years ago. You may have skipped ahead to this chapter. I would not blame you if you had. What caused the financial crisis? Was it “irrational exuberance” of the private sector or “monetary mischief ” on the part of the Federal Reserve? Before we get our exercise jumping to conclusions, hitting the ceiling, and running amok, let’s take another quick look at the alternative theories that purport to explain what happened. A quick review of the troops reveals a startling lack of consensus, which we know is the usual state of affairs in macroeconomics. In rough chronological order. Austrian business cycle theory (von Mises and Hayek) states that, left to its own devices, a market economy will generate savings just equal to the proper amount of resources to allocate to real investment. The problems arise when the central bank causes the interest rate to fall below its “natural” rate. Monetary mischief distorts investment incentives – too much investment in houses and other things that will not be needed in the long run. The crash comes when people (or the monetary authorities) catch on to the distortion of asset values. The Austrians give themselves credit for predicting the Great Depression and the latest financial crisis. John Maynard Keynes blamed the depression on a decline in aggregate demand, which was caused mainly by a collapse of private investment spending. Keynes recognized that investment can be influenced by the interest rate, but the primary determinant of investment is a psychological attitude about the future he called “animal spirits.” When investors are in a depressed state because of imponderable uncertainty about the future of the economy, Keynes argued that the national government needs to step in during a depression and raise aggregate demand. Monetary
policy can work in more ordinary situations, but direct spending on goods and services (fiscal stimulus) is needed under more dire circumstances. The late Hyman Minsky, a Keynesian who was ignored by most Keynesians in his lifetime, is now back in fashion. Minsky supplemented the Keynesian approach by arguing that, during a boom period, the private sector will figure out ways and means of expanding credit and financial leverage that defeat attempts at regulation. Financial bubbles can exist. Then some event occurs that starts financial collapse and the process of de-leveraging. Hedge investors (cash flow sufficient to cover all debt service) become speculative investors (cash flow only covers interest on debt), speculative investors become Ponzi investors (cash flow insufficient to cover interest payments), and Ponzi investors become zombies. Investment collapses, and Keynesian remedies are needed. Modern Keynesians also acknowledge that expectations of both inflation and Fed policies matter, but are not necessarily “rational.” They realize that policy mistakes have happened. They also recognize that supply shocks such as oil price jumps can happen – because they did. Now let’s turn our attention to the Monetarists and their descendants. Milton Friedman was the most prominent Monetarist, of course. His basic premise was that the money supply determines only the level of prices in the long run, but in the short run fluctuations in the money supply influence the level of real output as well. Because this is true, the monetary authorities can (and do) cause real monetary mischief. Indeed, the headline from A Monetary History of the United States (with Anna Schwartz) is that a garden-variety recession was turned into the Great Depression by a 33 percent drop in the supply of money. Consequently, Friedman argued that the monetary authorities should follow the simple rule of increasing the money supply by 3 to 5 percent per year (to accommodate real growth) and not engage in discretionary monetary policy. Anna Schwartz argued that the current crisis was caused largely by the Federal Reserve and its policy of rock-bottom interest rates following the recession of 2001, which was followed by the housing boom and subsequent crash. Friedman’s intellectual descendants include the rational expectations school (led by Robert Lucas and Kydland and Prescott), which made useful additions to the basic classical (conservative) approach. The rational expectations school points out that you can’t fool all of the people all of the time. People form expectations about the economy in a rational manner – which includes the anticipation of changes in monetary and fiscal policy. For example, if people correctly anticipate that the monetary authorities will increase the supply of money, they will increase prices and wages so that monetary policy will have no impact on the real economy. There is no trade-off between inflation and unemployment, unless you “fool” the people. Kydland and Prescott gained fame by pointing out the “time inconsistency” problem. If policy makers say one thing (money supply will increase modestly), and then do something different (big increase in money supply), the private economy will have undertaken actions that turn out to be mistakes. Policy makers need to follow rules that make them predictable. The most famous rule is called the Taylor
rule (after John Taylor), which stipulates that the federal funds rate should increase when inflation increases and should decrease when the economy is operating below capacity. Taylor has provided evidence that, if the Federal Reserve had following the Taylor rule during 2002-2004, the federal funds rate would not have been so low for so long, and that housing starts would not have ballooned. Lucas and Kydland and Prescott are also among the originators of the real business cycle school, which argues that variations in real output stem from shocks on the supply side – rather than shocks on the aggregate demand side that only affect prices. They have returned to the classical economists’ view that the market economy will react efficiently to these shocks, and that public policy should not be used to attempt to mitigate their effects. Now let’s return to Minsky and his intellectual heirs. The late Charles Kindleberger’s classic book Manias, Panics, and Crashes: A History of Financial Crises is based on Minsky’s model. This book is an encyclopedic account of financial crises through history. Similarly, Robert Shiller has gained prominence from a series of books that argues that financial bubbles are the cause of financial crises. One of his latest is The Subprime Solution, in which he states that the housing market bubble began in 1997 (well before the Fed cut interest rates), and that the actions taken by the private sector can be explained by the existence of rising housing prices. Why not make loans to anyone when the price of the house will always go up? Who cares if the borrowers are not qualified? But housing suppliers responded and the bubble burst – as it always does. The Financial Crisis Inquiry Commission (2011, p. xvi) stated:
But our mission was to ask and answer this central question: How did it come to pass that in 2008 our nation was forced to choose between two stark and painful alternatives – either risk the total collapse of our financial system and economy or inject trillions of taxpayer dollars into the financial system and an array of companies, as millions of Americans still lost their jobs, their savings, and their homes?