1 Wicksell,Hayek,Keynes,Friedman:WhomShouldWeFollow?

AxelLeijonhufvud UCLAandtheUniversityofTrento
2 Theshortanswertothequestioninthetitle thatyourPresidenthassetformeis:Noneof theAbove.Buttherearethingsofrelevancetobelearnedfromeachoneofthem,soIwillnot stopthere.Iwillfirstbrieflydiscusstheviewsofthesegiantsoftheprofessionandthenalsotry toexplainhowmyowndiagnosisofourtroublesdiffersfromtheirs.

Wicksell In1896,Wickselllivedinagoldstandardworldinwhichthebulkofthemeansof paymentconsistedofbanknotesissuedbyprivatebanks.Giventhestockofmeansofpayment, thequantitytheorydeterminedthepricelevel.Predictabilityofthepricelevelheconsidered essentialtothejustfunctioningoftheeconomyandthusalsotosocialstability. TheproblemthatconcernedWicksellwasthis.SincethedaysofRicardo,thenonbank publicsdemandformintedgoldhadgonebasicallytozero.Atthesametime,theBritish bankingsysteminparticularhadevolvedmethodstoeconomizeongoldreservesuntil,as describedbyWalterBagehotin LombardStreet,theentireenormousstructureofcreditwas balancedasaninvertedpyramidontheslendergoldreserveofthebankofEngland.Wicksell askedthequestion:Whatwouldhappenifboththegoldcointobanknoteratioandthebanks goldreserveratiowenttozerointhelimit?Theanswerwashispurecrediteconomymodel,in whichthesupplyofbanknoteswasindeterminate.Thismeantthattheeconomywouldnothavea marketdeterminedequilibriumforthepricelevel. Althoughthepriceleveldoesnothaveanequilibrium,Wicksellexplained,itwaspossible inprincipletokeepitconstantbycentralbankpolicy.Alevelfortheinterestrate,thenatural rate,shouldexistsuchthatifthecentralbanksetmarketrateatthatlevelthepricelevelwould notmove.Increasingpricescouldbecounteredbyraisingbankrate,fallingpricesbylowering therate. Inflationtargeting, inotherwords. WicksellsDayofJudgment,asIhavecalledit,waspostponedforroughlyacenturyby twocrucialchangesinmonetaryregulation.Noteissuewaseverywheremadeagovernment monopolyandreserverequirementswereimposedonbanks.Thesechangeseffectivelyprevented thedemandforbasemoneyfromvanishingandgavetheancientandhonorableQuantityTheory anewleaseonlifethatlasteduntilabitmorethanadecadeago,albeitwithvaryingfortunes.

Talk(giveninabsentia)atMontPelerinSocietyConferenceTheEndofGlobalizingCapitalism?ClassicalLiberal ResponsestotheGlobalFinancialCrisis,New York,March5 7,2009. 2 Iwilladdonenametotheonesweshouldconsider,namelyHymanMinsky,evenasIrecognizethatsodoingputs themenfittobechartermembersoftheSocietyintotheminority.

ThereisreasontorememberWicksellsmorethanacenturyoldbook.Wenowliveina worldwherereserverequirementsarebasicallyabolished,wherenewsubstitutesfortheuseof papercurrencyareconstantlybeinginvented,wheremoneymarketfundsoffersubstitutesfor bankdeposits,andwherethemonetarybasevariesendogenously.Welivevanishinglycloseto histheoreticalcaseofthepureinsidemoneyeconomy.Sofartheprivatesectorhasnotbeenable tocomeupwithaperfectsubstituteforfederalfunds.Thatisbasicallytheonlyremaining difference. Harkingbacktomytitle:ShouldwefollowWicksellthen? Notsofast.Learningthe rightlessonfromWicksellhasturnedoutnottobesimple.InflationtargetingfailedintheUnited 3 States. TheFederal Reservespolicyofkeepingthefederalfundsrateextremelylowhelpedthe economyrecoverfromthecrashofthedot.comboom.Intheyearsthatfollowed,theCPIstayed withintheFedsinflationtargetrange,whichseemedtoshowthatthecentralbankhadfoundthe rightlevelfortheinterestrate.ButtheabsenceofsignificantCPIinflationwasmisleading. Consumerpriceswerekeptincheckbyanumberofcountriesintentonkeepingtheircurrencies undervaluedinrelationtothedollarsoastomaintainlargepositivetradebalancesvisvisthe UnitedStates.Americanconsumerpriceswerekeptfromrisingfasterbycompetitionfromthese imports. TheFederalReservewasineffectmisledintokeepinginterestratesfartoolowforfartoo long.Thiswasnot theonlyfactorintheinflationofassetpricesanddeteriorationofcredit standardsthathavefollowed.Butithascertainlybeenamajorfactor.

HayekversusFriedman:DivergentPaths HayekandFriedmanbothprofessedthemselvesinfluencedbyWicksell.Butthetwoof themhardlyagreedonathingintheentirefieldofmonetaryeconomics.Thetwoare representativeoftwodivergenttheoreticaldevelopmentsstemmingfromWicksell.Somewhat paradoxically,whileHayekwasmorethoroughlysteepedinWicksellswork,Friedmanwas moretruetoWicksellinonefundamentalrespect Wicksellthoughtofhiscontributionasatheoryofthegeneralpricelevelandofhowto controlit.Monetaryeffectsonrelativepricesandonresourceallocationwouldbetransitory.The samemaybesaidofFriedman.Ontheotherhand,Wickselldisapprovedratherstronglyofthose who,likeMisesandHayek,adaptedhisbasicanalyticalideatobusinesscycletheory. InFriedmanstheory,therealrateofinterestisdeterminedbytherealfactorsof productivityandthrift.Thecentralbankcannothaveanybutthemosttransienteffectonit. Exceptforanevanescentliquidityeffect,anexpansionarymonetarypolicywillsimplyserveto raisenominalratesofinterestthroughitseffectsoninflationaryexpectations.Friedmanreasons throughoutasifhisrealratecanbeidentifiedwithWicksellsnaturalrate.Moreover,giventhe naturalrateofinterest,therewillbeanaturalrateofunemploymentcorrespondingtoit.Ifthe capitalmarketscanbedependedupontocoordinatetheintertemporalplansofhouseholdsand
3

Leijonhufvud,ThePerilsofInflationTargeting,VoxEUJune2007.

businessfirms,flexibilityofwageswillsufficetobringtheeconomytofullemployment. Monetarypolicymightmakeitdeviatefromthenaturalratebutonlytransitorily.So,inthis theory,asweallremember,thePhillipsCurveisvertical. ThereisnotmuchtobefoundaboutcreditmarketsinFriedman.Beforemonetarism,the mainresponsibilityofcentralbankshadbeentoensurethestabilityofcreditmarkets.Friedman madestabilityofthepricelevelthemainconcernalmostthesoleconcern

MacroeconomicsafterFriedman Overthelast40yearsmacroeconomicshasbyandlargedevelopedoutofthetheory outlinedbyFriedmanin1968.Hisassumptionsthatmarketforceswould(withsomelags)bring theeconomytothenaturalrateofinterestandthenaturalrateofunemploymentwereelaborated byRobertLucasandtheNewClassicalsintoamodelof stablegeneral equilibriumdetermined solelybytechnologyandtastefundamentals.

4 TherationalexpectationstheoryprettymuchemasculatedFriedmansmonetarism and evolvedinafewyearsintoRealBusinessCycletheoryinwhichneithermoneynorfinance playedaroleofanyconsequence.However,thetechnicalcapabilitiesofmacroeconomistsalso progressedrapidlyinthecourseofthisdevelopmentwiththeresultthatthedynamicstochastic generalequilibrium(DSGE)modelbecamethecommonworkhorseofmacroeconomic theoristsin recentyears. Modelsofthisclassassumethattheeconomycanbemodeledasa stableintertemporalstochasticgeneralequilibrium.NewKeynesianshaveadoptedthis technologywhileNewClassicaleconomistshavejoinedtheminintroducingavarietyof frictionsorimperfectionstoimprovetheempiricalverisimilitudeofthesemodels.This 5 convergenceofthetwotraditionsisnowknownastheNewNeoclassicalSynthesis.

Itisworthnotingthateconomistsofthismodernschoolhavealsotackledtheoldriddleof thedepthanddurationoftheGreatDepressionandhavecometotheconclusionthatthe frictionsandimperfectionsintroducedbytheRooseveltadministrationexplainwhythe economydidnotrecoverpriortotheoutbreakofthewar.6 Itistruethathisadministration experimentedwithallsortsofnewpolicies,notallofwhichlookwiseinretrospect.Ofcourse, theeconomistsofhistimecouldnotprovideRooseveltwithmuchguidance. ShouldwefollowFriedmanssuccessorsinordertodealwithourcurrentproblems? Not sofast. ItisdifficulttoseethatDSGEtheoryhasprovidedany policy guidancewhatsoever.Our policymakershaveconfrontedthethreatofdepressionwithanincrediblearrayofimprovised measures,mostofthemenactedindesperatehaste. LikeRoosevelt. Ifwehavelearnedonething

IdonotthinkthatMiltonFriedmaneverconcededtotheLucasiansthatonlyunanticipatedmonetaryimpulses couldhaverealeffects. 5 TheoriginalNeoclassicalSynthesisputwagerigiditiesintoasimpleGEmodeltoproduceKeynesianresults. Thosewho,likeme,regardtheNeoclassicalSynthesisasanintellectualfraudareboundtotakeajaundicedviewof theNewoneaswell. 6 ItisdifficulttoseehowbyusingtheDSGEmodeltheycouldpossiblyhavecometoadifferentconclusion.

7 sincethe1930s,itistheimportanceof actingquicklyanddecisively . Butthatisnotalesson drawnfromformaltheory.

Viennavs.Chicago HayekandFriedmanarepatronsaintsoftheSociety.However,bothcannotberightabout theeventsofrecentyears. Onthatcriterion,oldViennadoesbetterthanChicago. IntheAustriantheory,thebankingsystemcanbringtherealratetothewrongleveland maintainitthereforquitesometime.IfthebankssetamarketratebelowWicksellsnaturalrate, toomuchmoneywillbecreatedwithinflationasaresult.Atthesametime,ratherthan productivityandthriftdeterminingtheequilibriumrealrate ofinterest,thebankdetermined interestratedistortsproductivityandthriftincentives.Intheinflationaryupswing,toolittleis voluntarilysavedandtoomanyresourcesarebeinginvestedincapitalthatistoodurable.The FederalReservewasclearlyabletoreducetherealinterestrateforaperiodofseveralyearsand this,equallyclearly,wasamajorfactorinourrecenthousingoverinvestmentboomandthe associatedfinancialshenanigans. Hayekwasconvincedthat,althoughbankingpolicycouldkeeptheeconomyaboveits equilibriumcapitalaccumulationpathforyears,fundamentalmarketforcesmusteventually reassertthemselvesandbringtheoverinvestment(ormalinvestment)boom toan endandthatthe endmustcomewithafinancialcrash.Butwhathehadtosayaboutthefinancialsideofthecycle wasnotveryconvincingtohiscontemporariesandhaslittletoteachusaboutthefinancial st 8 systemofthe21 century. So,sincetheHayekianexplanationofourlateboommakessense,shouldwefollowhim indealingwiththeconsequencesofthecrash? Notsofast. TheAustriantheorypresumesthatthe marketsystemisstableeventhoughitmayrequireyearsforittocoordinatethetimestructuresof durablecapital,ontheonehand,andof householdconsumption,on theother. Theendofthe boomsignalsanoverduemarketdrivencorrectionofthemisallocationofresources. The governmentshouldstayoutofit,therefore. Itcanonlymakemattersworse. This,again,presumesthestabilityofthesystem.Theforcesunleashedinthecrisiswill bringtheeconomytoanewequilibriumbytheshortestroute.Alldestructionwillbecreative. Thepossibilitythatthesystemwillspinoutofcontrol andendupinastateofsucheconomic miseryastoendangersocialstabilityisnottakenseriously.

Evenso,Rooseveltwasalotquickerindealingwiththebankingsituationinhisday.

TheAustriantheoryisnotwithoutproblems.Itmakestootightalinkbetweeninflationandoverinvestment.Japan inthe1980shasanextremeoverinvestmentboomwithoutinflation liketheUnitedStatesinthisdecade.Andthe evidencefromhighinflationsisthattheyareassociatedwithextremely low levelsofcapitalformation.Cf.Daniel HeymannandAxelLeijonhufvud, HighInflation,Oxford:OxfordUniversityPress1995

Stability Thenaturalwaytothinkaboutstabilityissuesisinthecontroltheoretictermsof negative 9 andpositivefeedbackloops. Inmarkets,negativefeedbackreducesthediscrepancybetweensupplyanddemandor betweenmarketpriceandsupplyprice.Theydriveselflimitingadjustmentsthatare equilibrating.Excessdemandcausespricetorise,whichreducestheexcess.Amarketprice abovesupplypricecausesoutputtorise,andreducestheprofitmargin.Themarketparticipants neednotbequantsforthistowork.Simplesensiblerulesofbehaviorwillsufficetocoordinate activities,toregulatemarketpriceandoutputinanappropriatemanner. Apositivefeedbacklooptakesthevariablewhichitcontrolsfartherandfatherawayfrom someinitialvalue. Normally,therangeisboundeditdoesnotgofromzerotoinfinity.Butthe boundmaybeacompletebreakdownofthesystemofwhichthevariableispart. Ourfaithinunfetteredfreemarketsisbasedonthebeliefthattheyworkbypositive feedbackcontrol.Therestofthislecturewilldealwithsomedoubtsconcerningtheuniversal stabilityofoureconomicsystem.

Keynes Keynesdoesnothaveanythingdirectlytoteachusabouttheboom precedingourpresent crisis.Itdevelopedinamannerquitecontrarytothatpresupposedby theGeneralTheory.The backgroundtotheGreatDepressioninBritain,asKeynessawit,wasthedecliningtrendinthe returntoinvestmentsincetheendofWorldWarI(atwhichtimeithadbeenexceptionallyhigh). Britainhadreturnedtogoldatanovervaluedparityandtheimperativeofdefendingtheexchange ratehadcausedittomaintaintoohighalevelofinterestrates.Thecombinationofadeclining marginalefficiencyofcapitalandinterestratesthatdidnotdeclinepropelledthecountryintoa recessionthatwasdeepevenbeforetheUnitedStatesslippedintodepression. TheprocessleadinguptotodaysAmericanfinancialcrisishadthedollarexchangerate supportedbyforeigncentralbanksexportingcapitaltotheUnitedStates.TheFederalReserve Systemhasnothadtodefendthedollar(sofar).Onthecontrary,thiscapitalinflowwasnoteven tobediscouragedbyaFederalReservepolicyofextremelylowinterestrates.Sotherecentboom doesnotmakeaKeynesianstory.Itisratheran Austrian or,asweshallsee,aMinskystory. However,Keyneshasseveralthingstoteachusaboutthestabilitypropertiesofsystems ofmultipleinterconnectedmarkets.First,herealizedthatiffinancialmarketsfailedtocoordinate investmentwithsavingfromfullemploymentincome,flexiblewageswouldnotbringthe economytofullemployment.Inotherwords,FriedmansverticalPhillipsCurvepresumesthe

Theterminologyisoftenmisunderstood.TheFedhasrecentlybeguntorefertopositivefeedbacksasadverse. Thelaymanmightconfuseadversewithnegative.

priorachievementofintertemporalcoordination.Itdoesnotalwaysholdanditcertainlydoes notholdinourpresentsituation). Second,whenthepreconditionsforthestabilityofthenaturalrateofunemploymentare notfulfilled,ahighdegreeofwageflexibility willbedangerousratherthanbeneficial.Rapidly fallingwagesandpriceswillderangethefinancialmarkets,asKeynesputit.Usinglatterday terminology,rapidwagedeflationwouldtriggerpositivefeedbackprocessesinthefinancial 10 markets.Intheworstcase,itwouldsetinmotionaFisheriandebtdeflation . Third,Keynesunderstoodthat, inamoderneconomywheremoneyintermediates virtuallyallexchanges, thefeedbackofinformationonwhichmarketsdependfortheir functioningmaybeinterrupted.Anincreaseinpresentsavingdoesnotconstituteaneffective demandforfutureconsumptionandthusmaynotstimulateinvestment.Theofferoftoworkby theunemployeddoesnotinitselfconstituteaneffectivedemandforconsumptiongoodsoutput. Theseeffectivedemandfailureswillnotbeofmuchconsequenceinnormaltimes.Inthewake ofafinancialcrash,however,whenagreatmanyagentsareliquidityconstrained,theycan seriouslyimpairtheequilibratingcapabilitiesoftheeconomy. ThereisgoodreasontoremembertheseKeynesianlessonstoday,therefore. Minsky Minsky sawfinanceasthecauseoftheinstabilityofcapitalism.Hencehepaidmore attentionthananybodyelsetoworkingoutthefinancialsideofbusinesscycles.InKeynes financecanamplifyfluctuationsbut,inhistheoryasinthatofHayek,financialdevelopmentsare endogenoustothefluctuationsinrealactivitywhichareduetoothercauses.InMinskysview, thecapitalisteconomyhadan everpresent,inherenttendencytogenerate speculativebooms. AlthoughMinskyalwaysprofessedtodrawhisinspirationfromKeynes,thisupwardinstability hypothesisstandsinstarkcontrasttotheeconomystendency,inKeynesstheory,togravitateto astateofunemploymentequilibrium. Theconceptsofhedge,speculativeandPonzifinancingarecentraltoMinskystheoryof systemicfragility.Aunitishedgedifexpectedcashflowfromoperationssubstantiallyexceeds itsdebtservicingcommitments.Itisengagedinspeculativefinanceifithastodependon periodicallyrefinancingdebt.APonziunithastoconstantlyborrowmoreinordertomeetits debtservicingcommitments.Aprolongedperiodofstability,Minskyargued,wouldinducesome unitstomigratefromhedgetospeculativeandfromspeculativetoPonzifinance.Thismakesthe systemasawholeincreasingly fragile.Inahighlyfragileeconomy,noidentifiableexogenous shockisneededtounleashacrisis.Sometrivial,randomeventcanbethetrigger. InMinskysview,stabilitygerminatestheseedsofinstability.Therecentlyhighlytouted GreatModeration,whichhasnowcometoacrashingend,fitshistheoryperfectly.Andthe unmaskingofBernardMadoff,thebiggestPonzioperatorofalltime,hasmadetheMinskystory sadly almosttooperfect!
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IoughttohaveincludedIrvingFisheramongthegreateconomistswhoseworkisofvalueinunderstanding presentpredicaments.However,thisomissionwillhavetoberemediedonanotheroccasion.

Itcannotbedoubted,however,thatthelowinterestpolicyoftheFederalReserveSystem gavesignificantimpetustothespeculativeboom.SothereisadefiniteAustrianelementto the eventsofthelastfewyears.Austrianeconomistsmightpresstheircaseandarguethatitmakes theMinskyhypothesisoftheupwardinstabilityofcapitalismotiose.Butsquared,cubedand multisectoralCDOsfitmorenaturallyintotheMinskystory andso,ofcourse,doesBernard Madoffandalltheotherswindlersthatarenowcomingoutofthewoodworkalmostdaily. Both theoriescontributetoourunderstandingofhowweendedupinthepresentpredicament.How muchvalidity shouldbeaccordedtoeachIamnotpreparedtosay. SoshouldwefollowMinsky?Notsofast.Minskydidnotbelievethatregulationscould provideapermanentsolutiontothefinancialinstabilityofcapitalism.Themarketswouldalways findinnovativewaysaroundany systemofregulation.Hissolution:BigGovernment. IthinkI willleaveittothemembersoftheMontPelerinSocietytomakeuptheirmindsaboutthatone.

Leveragedynamics Theoveralllevelofleverageintheeconomyisnotstabilizedbymarketforcesunder presentarrangements.Itissubjecttopositivefeedbackprocessesthatrenderitunstable. Whenleverageisincreasinginthesystemasawhole,witheveryonebuyingoncredit, everyoneisalsobookingaprofit.Leveragemakesforhighprofitaslongasthegoingisgood. Butitisalsoriskyandmakesforlargelosseswhentheprocessgoesintoreverse. Ontheupswing,competitionforcesalsothosewhorealizethatriskisincreasingtofollow along.Thosewhodonotrunwiththeherdwillshowlowerratesofreturnthanothersandbe forcedoutofthegame.Meanwhile,securitizationandcreditdefaultswapsobscurethesystemic risksandhelpindividualdecisionmakersrationalizeriskypolicies.When competition compressesthemarginbetweentheratesonassetsandonliabilities,thebankscanrespondby increasingleveragefurtherorbymovingintoriskierassetclassespromisinghigherreturns.Thus therecentboomendedwithleverageratiosathistorichighsandriskpremiaathistoriclows. Athighleverageratiosalossofjustacoupleofpercentonassetsrendersaninstitution insolvent.Ifithasasubstantialportfolioofresidentialmortgagesormortgagebackedsecurities, alossofthismagnitudeiseasilyreachedgiventhatthepricesoftheultimatecollateralhas declinedbymorethan20% andhasnotreachedbottomyet.Oncetheprocessgoesinto reverse,therefore,thepressuretodeleveragebecomesextremebecausethesurvivalofthe institutionsisimmediatelyatstake. Thesituationofahighlyleveragedinstitutioncanbeimprovedbyobtainingfreshcapital, bysellingassetstopaydowndebtorbyusingcurrentnetrevenuestoreducedebt.Obtaining newprivatecapitalisnoteasywhenthereasonforitistoreplacelossesincurredbythecurrent management.Inpractice,governmentbailoutsbecomevirtuallytheonlyoptionfor recapitalizingthebanks.

Thereisgoodreasonwhysomanygovernmentsallovertheworldarepursuingavariety ofschemesforrecapitalizingfinancialinstitutionsdespitetheirunpopularitywithvoters.General 11 deleveragingisaprofoundlydestabilizing,dangerousprocess. Whenmanybanksaretryingto sellthesameclassofassetsinordertopaydowndebt,assetpriceswillfall.Ratingagenciesand regulatorswillthendemandthatthebanksincreasetheircapital.Moreover,assetpricesmight easilyfalltothepointwheretheirdebttoequityratiosactuallyincrease.Forthelast18months ormoretheauthoritieshavebeenscramblingtohelpthebigbanksavoidthisparticularvicious circle.Thishasenabledthefinancialinstitutionstoproclaimthatthemarketsarefrozenand thatthemarketvalueofmanyoftheirassetscannotbeobjectivelydetermined. Thethirdwaytoreduceleverageistospendlessthanyoutakein.Forbanksthismeans notrelendingthefundsflowingbackintheservicingofloansbuttousetheminsteadtocleanup theirbalancesheets.Whenthebanksarealloperatinginthismode,ordinarycommercialand consumercreditdriesup.Whenmostunitsinthenonfinancialsectortrytospendlessinorderto paydowndebt,thenetresultisthatrevenuesdecreaseallaround. Thedropinincomethen reducestheabilitytoservicedebt andthebankingsectorisweakenedevenfurther.

KeynesAgain Thedeclineinassetpricesresultingfromfinancialdeleveragingwillcometoaffectalso reproducibleassetsinthepresentsituationparticularly(butnotonly)houseprices.The production oftheseassetswillfall,therefore,andsowillemploymentinconstructionandcapital goodsproducingindustries.Americanhouseholdsarealsofairlyhighlyleveredatthistimeand virtuallytheonlywayforthemtoreducedebtistoincreasetheirsaving. Adeclineininvestmentcombinedwithanincreaseinattemptedhouseholdsaving: surely,thissoundsliketheEcon2textbookdiagnosisof aKeynesianrecession? Furthermore,we recognizethatpresentfinancialconditionsaresuchastorendertheautomaticadjustment tendenciesoffreemarketspeculiarlyineffectiveinproducingarecoveryfromarecessionofthis type. So,shouldwefollowKeynes? Notsofast. ThegreatweaknessofKeynesianincomeexpenditureanalysisisthatitfailstodeal 12 systematicallywiththestateofbalancesheets.Andthisisabalancesheetrecession. Our troublesstartwiththeconditionofprivatesectorbalancesheets,particularlyofourfinancial institutions,andthisistheproblemthatmustbesolvedifthetroublesaretoendanytimesoon.
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MiltonFriedmansfavoriteexampleofthefallacyofcompositionwasthatwhenpeopleingeneraltryto increasetheirmoneybalancesbuttheaggregatesupplyofmoneyisgiven,theresultmustbethateveryonesincome falls.JohnMaynardKeynessParadoxofThrift madethesamepoint:whenpeopleingeneraltrytoincreasetheir saving,giventherateofinvestment, theirincomeswillfallandtheamountactuallysavedmayfallaswell.The fallacyofcompositionlessonforourowntimesisthatwhenbanks,firmsandhouseholdsarealltryingtocuretheir balancesheets,theaggregateresultwillbetheoppositeofwhattheindividualagentsaretryingtoaccomplish.

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ThetermisduetoRichardC.Koo, BalanceSheetRecession:JapansStrugglewithUncharteredEconomics anditsGlobalImplicationsSingapore:Wiley2003.

Japansendlesstravailssincethecollapseofitstwinstockmarketandreal estatebubbles in1990providealessonnottobeignored.TheJapanesegovernmentdidnotacttorepairthe balancesheetsoftheprivatesectorfollowingthecrash.Instead,itchoseapolicyofkeepingbank ratenearzerosoastoreducedepositratesandletthebanksearntheirwaybackintosolvency. Thisprovedineffectual.Anumberoflongsufferingbanksfailedin19977yearsafterthe crash! promptinglimitedgovernmentrecapitalizationofthesystem.Finally,latein200212 yearsafterthecrash! thegovernmenttookdecisivestepstocleanupthebadloansproblemin thebankingsystem.Thistookanotherthreeyears. Duringthisentireperiod,theJapanesegovernmenttriedtosupport therealsectorby repeatedlargedosesofKeynesiandeficitspending,alltolittleapparentavail. Theydidhowever addtothenationaldebtuntilitexceededayearsGDPbyasizeablemargin. ThepolicyadoptedbySwedenfollowingits1992crisishasbeenfrequentlycitedin recentmonths.Swedenactedquicklyanddecisivelytocloseinsolventbanks,andtoquarantine theirbadassetsintoaspecialfund.Eventually,alltheassets,goodandbad,endedupinthe privatebankingsectoragain.Thestockholdersinthefailedbankslostalltheirequitywhilethe losstotaxpayersofthebadassetswasminimalintheend. Swedendidnotneedtosupplement thesecapitalaccounttransactionsbyalargestimuluspackagebecausethe2530%devaluation ofthekronaintowhichthecountryhadbeenforcedproducedalongperiodofstrongexportled growth. Thearithmeticoftheincomeaccountstellsusthat, iftheprivatesectorasawholeis tryingtorunapositivecashflow,incomecanonlybestabilizedbythegovernmentrunninga 13 deficit. Similararithmeticforthecapitalaccountstellsusthat,iftheprivatesectorasawhole 14 isundercapitalized,onlythegovernmentcanrecapitalizeit. ThelessonofJapaneseandSwedishexamples(andthereareothers)isthatdeficit spendingwillbeabsorbedintothefinancialsinkholesinprivatesectorbalancesheetsandwill 15 notbecomeeffectiveuntilthoseholeshavebeenfilled.

Conclusion Thepresentcontractionisnotanequilibratingadjustment.Itisanunstable,highly dangerousprocessdangerousnotonlyforeveryonespocketbookbutforsocialstabilityhere andabroad.Wecannotwaititoutandlookforfreemarketstothenpickusoffthefloor.

13 14

Unless,ofcourse,exportscanbereliedontodothejob. Unlessforeigncapitalcanbehadinsufficientamounts. 15 Duringtheyearsthatnationalincomefailstorespond,taxreceiptswillbelowersothatthefederaldebtislikelyto enduplargerthanifthebankingsectorslosseshadbeennationalizedattheoutset..

Postscript IamsorrythatIcannotbepresentattheconferencetoanswerthequestionsand objectionsthatmypapermayelicit.Someofthematleastwill havebeenansweredinmy writingsdealingwiththecrisis,whichyoumayfindontheCentreforEconomicPolicyResearch andVoxEUwebsites. Theperilsofinflationtargeting,VoxEU,25June2007 Bubble,bubble,toilandtrouble,VoxEU,26October2007 Centralbankingdoctrineinlightofthecrisis,VoxEU,13May2008 FixingtheCrisis:Twosystemicproblems,VoxEU,12January2009 Noordinaryrecession,VoxEU,13February,2009 MonetaryandFinancialStability,CEPRPolicyInsight,No.14,October2007. KeynesandtheCrisis,CEPRPolicyInsight,No.23, May2008. TwoSystemicProblems,CEPRPolicyInsight, No.29,January2009.

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