The Great Depression, the Global Financial Crisis and Old Versus New Keynesian Thinking: What Have We Learned and What Remains To Be Learned?

Abstract

Following a brief overview of major developments in macroeconomic thought since the Keynesian revolution in the introduction the paper features three main sections plus a conclusion. The first section presents a detailed comparison of background institutions, policy responses and economic performance during the great depression (GD) and the Global Financial Crisis (GFC). The second section discusses the role of lessons from the GD in shaping fiscal and monetary policy responses to the GFC as well as newer problems that emerged during the second crisis. Among the newer issues are runs between financial institutions, the role of financial derivatives, the opaqueness of securitization, the too big to fail problem, the incompleteness of micro-based risk assessments by financial institutions and a modern reinterpretation of the liquidity trap. The next section contains a systematic comparison of the methodological similarities and differences between old Keynesian economics and its recent New Keynesian Economics reincarnation. The concluding section points out missing elements in both old and new Keynesian methodologies and speculates about the likely path of future macroeconomic research in the aftermath of the GFC.

Presented at the symposium on “Perspectives on Keynesian Economics”, Ben Gurion University, 14–15 July 2009.

Appendices

The Great Depression, the Current Crisis and Old Versus New Keynesian Thinking. What Have We Learned and What Remains To Be Learned?: Discussion

Avia Spivak, Ben-Gurion Universeity and the Van Leer Institute

Where I Agree with the Paper

Cukierman correctly characterizes the current crisis (GFC) as less severe than the former crisis (GD). He lists a few reasons behind that phenomenon.

• (a) The greatly increased role of the government in the economy. The GFC institutional landscape included features that automatically stabilized the economy, such as the financial safety net to depositors. (Cukierman overlooks the contribution of the social safety net to the unemployed, poor, old and sick in limiting the severity of the crisis.) The increased power of central banks and treasuries in the economy allowed them to react swiftly to the crisis.¹⁵

• (b) Under GFC there was a much better international system as compared with GD.

• (c) On the nominal side, the inflation targeting together with flexible exchange rates were successful in keeping international capital markets functioning while allowing substantial exchange rate flexibility.¹⁶ On the real side, countries came to mutual agreement to avoid trade wars and managed to keep the international flow of goods and services unhindered.¹⁷

• (d) Lessons that were learned in GD were applied in GFC, especially the need for active role of the central bank. Luckily, the Fed’s chair, Bernanke had studied the failures and mistakes of the Fed in GD, and thus was ready to prevent repetitions of the same mistakes in the GFC.

An important insight of the paper is that FDIC insurance solves run on banks by depositors, but not by banks on other banks or financial institutions. Run on banks by other banks can also have systemic repercussions, as the fall of Lehman Brothers on September 15, 2008 – that sent shock waves through the entire global system – showed. Thus, the theory that big financial institutions are too big to fail was proved and immediately applied to the rescue of AIG. The theory that non-banks financial institution – “shadow banking” need not be regulated because the market will regulate them proved to be false.

Where I Disagree with the Paper

• (a) The paper is silent on the political and intellectual background that allowed the phenomenal growth of the shadow banking. Both were united in the person of the then legendary Chairman of the Federal Reserve, Alan Greenspan. In his autobiography (2007) he writes:

The resulting advance of global financial markets has markedly improved the efficiency with which the world’s savings are invested… As I saw it, from 1995 forward, the largely unregulated global markets, with some notable exceptions, appeared to be moving smoothly from one state of equilibrium to another. Adam Smith’s invisible hand was at work on a global scale. But what does that invisible hand do? … Given the trillions of dollars of daily cross-border transactions, few of which are publicly recorded, indeed how can anybody be sure that an unregulated global system will work? Yet it does, day in and day out. Systemic breakdown occur, of course, but they are surprisingly rare. Confidence that the global economy works the way it is supposed to work requires insight into the role of balancing forces. (Those forces regrettably seem more evident to economists than to the lawyers and politicians who do the regulating.)…

The inevitable mistakes and euphorias of participants in the global marketplace and the inefficiencies spawned by those missteps produce economic imbalances, large and small. Yet even in crisis, economies seem inevitably to right themselves….[crisis] creates opportunities to reap abnormally high profits in the buying or selling of some goods, services and assets. The scramble by market participants to seize those opportunities … eliminate both the abnormal profit margins and the inefficiencies that create them. (Greenspan 2007, pp. 367–368).

It is this world view that was behind the abolition of the Banking Act of 1933 (The Glass–Steagal Act) in 1999 which was a signal for the relaxation of regulation of the financial system.¹⁸

• (b) In the same vein, and not less important is the presentation of macro-economics as going through a process of seemingly harmonic evolution, centered around the NKM – New Keynesian Models school, These NKMs represent, according to the view presented – the best of the two worlds: Keynesian models that manage to be based on sound microeconomic foundations. Most economists, however, acknowledge the rift between the Chicago–Minnesota RBC school and the MIT–Harvard–Berkley school, nicknamed by freshwater economics vs. saltwater economics. This is how Nobel laureate Paul Krugman describes the RBC theory:

By the 1980s, however, even this severely limited acceptance of the idea that recessions are bad things had been rejected by many freshwater economists. Instead, the new leaders of the movement, especially Edward Prescott, who was then at the University of Minnesota (you can see where the freshwater moniker comes from), argued that price fluctuations and changes in demand actually had nothing to do with the business cycle. Rather, the business cycle reflects fluctuations in the rate of technological progress, which are amplified by the rational response of workers, who voluntarily work more when the environment is favorable and less when it’s unfavorable. Unemployment is a deliberate decision by workers to take time off.

Put baldly like that, this theory sounds foolish – was the Great Depression really the Great Vacation? And to be honest, I think it really is silly. But the basic premise of Prescott’s “real business cycle” theory was embedded in ingeniously constructed mathematical models, which were mapped onto real data using sophisticated statistical techniques, and the theory came to dominate the teaching of macroeconomics in many university departments. In 2004, reflecting the theory’s influence, Prescott shared a Nobel with Finn Kydland of Carnegie Mellon University.

Krugman goes on to criticize the NKM:

But the self-described New Keynesian economists weren’t immune to the charms of rational individuals and perfect markets. They tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse. The fact that such things continued to happen in the real world – there was a terrible financial and macroeconomic crisis in much of Asia in 1997–1998 and a depression-level slump in Argentina in 2002 – wasn’t reflected in the mainstream of New Keynesian thinking.¹⁹

The lack of explicit financial system in the NKM due to the rationality of its agents and the smooth functioning of most markets that hence can go wrong is at odds with the original Keynes approach who put much stress on the mal-functioning of the stock market (the famous beauty contest paradigm). Indeed, Cukierman concedes that this part is still missing in the NKM: “The GFC makes the development of such analysis essential” (p. 28).

• (c) The rift in academic macroeconomics has implications for policy making in the GFC, and not on a small issue, but on the effect of fiscal policy on economic activity. More technically, by how much will a one percent increase in government expenditures increase the GDP. This magnitude is known as the Keynesian multiplier and the two schools arrive at very different numbers because they use different methodology. Table 2 shows the results:

  Table 2 Impact of a permanent increase in government spending by 1% of GDP (federal funds rate set to zero throughout 2009 and 2010)

Romer and Bernstein (2009) use old Keynsian models: “we use multipliers that we feel represent a consensus of a broad range of economists and professional forecasters… They are broadly similar to those implied by the Federal Reserve’s FRB/US model and the models of leading private forecasters, such as Macroeconomic Advisers”. Smets and Wouters use a NKM model.

The striking difference between the results say it all: the NKM results show only a transitory effect on the output, declining to less than six-tenths after 2 years. If physists and engineers had such disagreement on such basic calculations they could never have landed a man on the moon. (Macroeconomics today looks more like the failed project of landing a probe on Mars, where some teams used the metric system and the other the Anglo-Saxon system of inches and pounds; Mankiw (2006) separates between the role of the Macroeconomist as a scientist that uses very strict methodology with his role as engineer, who can use his intuition and broad knoweldge of the data and the economy to suggest useful analysis of the economy).

Conclusion

Cukierman correctly attributes the success of preventing the GFC from becoming another GD to the practical lessons learned from the GD and the resulting change in the institutional framework.²⁰

The influence of the academic development in the macro area is less clear. The Keynesian Revolution was succeeded by a monetarist counter-revolution led at first by Milton Friedman and them by Robert Lucas. According to Lucas and his school, there is very little that the government can do to change the course of the economy, even in times of crisis. It is fortunate that the decision makers were more practical.