Friday, May 29, 2009

Interpreting Keynes - restoring market confidence

The 'neo-classical synthesis' of Keynesianism and classical microeconomics holds that the economy is Keynesian in the short-run because wages and prices are "sticky" (as initially interepreted by John Hicks in England and Alvin Hansen in the US), while it is classical in the long-run when prices have found their right level. It implies that, to restore full employment, we simply need to realign nominal prices with nominal demand, either with monetary policy to stimulate private spending or with fiscal policy to replace private spending with public spending. Opponents of the Keynesian fiscal policy to stimulate aggregate demand, led by the likes of Robert Barro and Eugene Fama, invoke Ricardian equivalence to argue that government spending will crowd out private expenditure.

UCLA Professor Roger Farmer, in a series of recent working papers and articles, while conceding the usefulness of fiscal policy he argues that the fiscal stimulus induced government spending multiplier is smaller than claimed and presents an alternative approach to address such deep economic crisis. He argues that orthodox Keynesian interpretations of the General Theory misses the story and offers an alternative reconciliation of Keynes with microeconomics that does not rely on sticky prices.

About the problem with fiscal policy, he writes,

Keynes said three things in the General Theory. First: the labour market is not cleared by demand and supply and, as a consequence, very high unemployment can persist forever. Second: the beliefs of market participants independently influence the unemployment rate. Third: It is the responsibility of government to maintain full employment. He was right on all three counts. But he was wrong about something else.

Keynes thought that consumption depends on income... Consumption, and this is two thirds of the economy, depends not on income but on wealth... the theory of the (government spending) multiplier and the implication that fiscal policy can get us out of the current crisis rests on exactly this point... but if income depends on wealth then fiscal policy may be less effective than the Keynesians claim... fiscal policy cannot provide a permanent fix to the problem of high unemployment.

Prof Farmer raises doubts on the Ricardian equivalence claim since its logic "requires that rational forward looking households fully internalize the future tax burden of current fiscal profligacy", an unlikely fact since human "lives are short and not everyone cares for their descendents".

In the first paper, Prof Farmer claims that the equilibrium business cycle theory is flawed and presents an "alternative paradigm that retains the main message of Keynes’ General Theory and which reconciles that message with Walrasian economics". He argues that unemployment will remain trapped at a high level due to two labor market failures - arising from a lemons problem and an externality. The aforementioned two market failures makes it difficult and costly to match unemployed workers with vacant jobs, by not providing "the necessary price signals to ensure that a given number of jobs is filled in the right way". This results in economically and socially inefficient multiple "equilibria in which the unemployment rate is determined by the self-fulfilling beliefs of stock market participants". He writes,

"Firms decide how many workers to hire based on the demand for the goods that they produce. The demand for goods depends on wealth. Every different equilibrium unemployment rate is associated with a different set of prices for factories and machines and the value of these physical assets depends on what market participants think they will be worth in the future. The world economy is currently headed rapidly towards a high unemployment, low wealth equilibrium which was triggered by a loss of confidence in the value of assets, backed by mortgages in the US subprime mortgage market. The inability to value these assets has since led to an amplification of the crisis as panic hit the global financial markets. Even though the US stock market is appropriately valued based on historical price earnings ratios — investors are worried that the value of stocks could fall further... (any further) drop may prove to be self-fulfilling...".

In another working paper, he draws attention to a less costly and more effective alternative to fiscal policy. He feels that the "current financial crisis is an example of a shift to a high unemployment equilibrium, induced by the self-fulfilling beliefs of market participants about asset prices". His arguement is summed up as - "informational asymmetries cause missing markets, missing markets lead to the existence of multiple equilibria, and psychology, in the form of self-fulfilling prophecies, becomes an additional fundamental that selects an equilibrium".

Under such circumstances, a better "alternative might be for the Fed to intervene in the asset markets through purchases and sales of a broad index fund of stocks". He writes, "We need a new approach that directly attacks a lack of confidence in the asset markets by putting a floor and a ceiling on the value of the stock market through direct central bank intervention".

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