Friday, January 9, 2009

Recessions and macroeconomic policy making

In the previous post, I had tried to put in perspective the challenge facing the world economy today. This post seeks to scan the landscape of macro-economic theory and conventional wisdom and see what specific policies (if any) are relevant for such times.

The challenge is to break the gridlock formed from a triple coincidence of banks refusing to lend, consumers refraining from shopping, and businesses postponing investments, all of which in turn reinforcing each other's expectations. The problem is that nobody is sure about what to do under such circumstances, as there are no specific and universally accepted theoretical principles for macroeconomic policy making during such times. The Chicago School of economists have for some time now been advocated that monetary policy acts faster and is more effective in smoothing over economic contractions than demand management policies. But as the present crisis has evolved, the limitations of this approach has been badly exposed, leaving fiscal policy as the preferred macroeconomic policy option.

Even when there is unanimity on the application of fiscal policy, there is raging controversy on what specific fiscal policy strategies to adopt. The knowledge from previous brushes with economic recessions appears to be of limited relevance as the results have been mixed and each crisis has its own unique features requiring situation-specific prescriptions.

While academics have from hindsight, gleefully dissected past crises, prescribed their versions of policy suggestions and blamed policy makers for failing to implement them, there appears to be nothing settled or certain about their prescriptions now. The old adage about the one-handed economist is more relevant now than ever. The fact remains that standard economic theories, while providing some form of loose and broad guiding framework, are of only limited utility in specific policy making during crises.

When the going is good, macroeconomic policy making has a ring of inevitability about it and the economic success appears to lend credence to beautifully constructed theories. It is therefore no surprise that the post-War neo-classical monetarist theories that emerged, to displace pre-War Keynesianism, during the golden age of capitalism, assumed a sacrosanct status (atleast, for a brief period of time in the eighties and nineties). This was more a case of co-relation equals causation, owed to an accident of history than arising out of any noteworthy successes in the real world.

Even during the good times, monetarism offers limited guidance on issues like how and when to prick speculative bubbles! Experience from even the recent examples of Central Bank interventions (or lack of it) during times of asset price inflation leading to bubbles, give little conclusive knowledge about monetary policy during the good times. For every example of a Greenspan "put" that created the conditions for speculative asset bubbles - first in equity and then in real estate - to develop, there is a contrarian example of a Bank of Japan conciously pricking a rapidly growing property market bubble in the nineties. The results were same in both cases - the equity markets crashed and recession followed.

The fact there is atleast some unanimity about the need for demand management through a fiscal stimulus is the surest indicator that Keynesianism remains the closest we have yet to a "theory of economic crisis"! However, a more comprehensive and complete theory of policy making during an economic crisis is still a work in progress...

Update 1
NYT has this article which captures the debate about macroeconomic policymaking challenges facing the incoming Obama administration. Every body agrees that "the goal ... is to jump-start economic activity by getting as much money as possible as quickly as possible into the hands of consumers and businesses, trying to make up for the falling demand in the private sector that is leading to higher unemployment". But how this can be done, with the lowest cost or the highest bang for the buck, is the issue.

At the end, the only consensus that emerges is that whatever support is provided, it should be so massive as to wash away all the troubles, something similar to using a steroid to cure a common cold!

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