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November 21, 2009

Economist's View - 3 new articles

Stabilities and Instabilities in the Macroeconomy

More on what's wrong with modern macro, this time from Axel Leijonhufvud:

Stabilities and instabilities in the macroeconomy, by Axel Leijonhufvud, Vox EU: 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 stabilize 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 stabilizing 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 modeling 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 stabilization 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 destabilizing, 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 destabilizing 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 characterized 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 stabilized 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",, 25 June 2007

Leijonhufvud, Axel (2009), "Fixing the crisis: Two systemic problems",, 12 January.

Leijonhufvud, Axel (2009), "Curbing instability: policy and regulation",, 11 July.

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

This article may be reproduced with appropriate attribution.

Fed Watch: The Fed in a Corner

Tim Duy:

The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly countless number of undergraduates that Fed's hold on monetary independence was tenuous at best. Independence is not guaranteed by the Constitution. Congress made the Fed, and Congress can unmake the Fed. The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth. Deviating from such paths would have consequences.
The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed's independence.
Some find the loss of support for the Fed puzzling. Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:
First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.
The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure. Fair enough; I have few quibbles with policy since last fall. But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV's? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.
To be sure, there were plenty of other regulatory failures along the way, but the Fed - an independent Fed - should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies. The Fed's independence should have allowed it to be a leader, not a follower. Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard. Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.
The resulting crisis left the Fed struggling to keep the ship afloat - and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time. But that mission creep was simply incompatible with the Fed's desire for secrecy. This was all to predictable: Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback. The last I checked, this was still a democracy.
Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street. Of course, Fed officials see this a bit differently - they see supporting Wall Street as their mechanism for supporting Main Street. Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows. The purpose of Wall Street is supposed to be to channel investment funds into Main Street. But most Americans no longer view Wall Street as ultimately working in their best interests - maybe correctly. This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation. When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many? And when did policymakers embrace this view? As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance. Yet this is a world tht failed us to completely.
Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?
Now the Fed's relationship with the public is a mess. And I suspect it is going to get much worse. Free Exchange succinctly identifies the new challenge:
An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.
The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist. Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment. They equate credibility with maintaining a 1.7-2% inflation target. Couldn't credibility be consistent with a 4% inflation target? And wouldn't such a target be more appropriate in a zero interest rate world? But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively.
What if the only way to get the Fed to do the right thing is to strip them of their independence? It is a real possibility, although disastrous in the long-run. Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:
It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy "extremely accommodative."
But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.
Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES! Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain. Is the Fed headed to the same place? Maybe.
I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start. Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.

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