By Neville Bennett Ben Bernanke told a town-hall-style meeting in Kansas this week that he was not going to "preside over the second Great Depression". Dr Bernanke appears to be fighting to save his job and reaching out to the people for understanding and support. He told the audience that he had not wanted to prop up the big finance companies: indeed, "nothing made me more frustrated, more angry, than having to intervene" when corporates were "taking wild bets that had forced these companies close to bankruptcy". Although "disgusted", Bernanke was minded that "when an elephant falls down, all the grass gets crushed". This episode is interesting because it reflects a notable former economics professor confronting the possibility of a depression. It comes at a time when world trade and economic production is tracking the Great Depression. It would have appeared an impossibility even four years ago and economists are reeling, especially people like Paul Krugman are saying a macroeconomics education is "a costly waste of time". He told an LSE audience that most macro was "spectacularly useless at best, and positively harmful at worst".
Few Crystal balls Economists did not see the crisis coming and are somewhat divided on how to treat it. When I studied economics at the LSE, it was widely assumed that crises were a thing of the past. Economic growth could be managed, and any small fluctuation in demand could be easily dealt with by adjustments in monetary and/or fiscal policy. We students thought it was not difficult to plan for growth. Paul Samuelson's "economics", our textbook dismissed crashes in a few lines. But there was a stable environment then. Banks were conservative institutions and very reluctant to extend credit. I recall an interview when I was a student, on a good scholarship, where I asked for a loan in order to buy a cheap Vespa scooter (these were much admired in the UK). I was given to understand that the risk was unacceptable. The manager implied that the mighty Midland Bank could come crashing down if I failed to meet my repayments, which I might do if I had an accident. I was in my mid-thirties when all that changed, and credit cards were showered upon me. The main source of economic instability in my earlier life was foreign exchange. But there were strong management systems. In the UK and NZ foreign transactions were controlled. Tourists had limits on the amount they could spend. A property bubble was inconceivable as mortgages were tightly controlled. Practices were solid, and the theory appeared robust. Keynes Classical economists assumed that full employment was usual because supply created its own demand. They thought that income was either spent or saved. Spending stimulated the economy and savings went into investment The theory did not explain the Great Depression. Keynes explained that uncertainty motivated entrepreneurs and savers alike to stay their hand. Both might develop a liquidity preference. Demand would fall. If private sector activity slowed, the public sector should be involved through low interest rates and public works if necessary. The theory was avidly adapted in the western world. Keynsian economics worked to get the world out of depression, manage the war effort in the UK and USA without massive inflation, and promote growth though to the 1980's. But economists were baffled by stag-inflation, and in the US split into two camps. Freshwater v. Saltwater Schools The University of Chicago blamed stagflation on central bankers who meddled too much in the economy in order to smooth oscillations. The lake-siders believed in the classical assumption that markets cleared, eventually goods were cleared leaving no inventory or unemployed workers. Their opponents were the coastal universities ( "salt-water school" ) who held true to theory that markets could malfunction, justifying state intervention. The Economist has recently reviewed this debate and said eventually the schools melded into brackish macroeconomics. One product was "inflation targeting', embraced first by New Zealand, and later by Canada, the UK, Sweden and some emerging countries. Ben Bernanke was a renowned member of brackish economics. From the mid-1980's until recently it seemed that macroeconomists knew what they were doing. Certainly there was price-stability and that was also the focus of central banks. Blind spot Economists and central bankers failed to appreciate the risk of financial instability. LSE professor William Buiter now argues that training in macro is a severe handicap. Student worried about the cost of goods and wage rates but did not think of the price of assets. Too much faith had been put in financial markets, and the financial system was under-studied. In many macroeconomic models, it is assumed that insolvencies cannot occur. It stretches the bounds to credulity to discover that the Bank of England's model is indifferent to whether business is funded by equity or credit. It does not even incorporate financial intermediaries such as banks. As Buiter observes, the model is useless for issues where financial intermediation is of importance. Pity this crisis is such an issue! The modelers eventually smooth away many issues because they are too complicated. They find it easier to assume a firm can always borrow as much as it needs at the going rate or sell as much as it desires. This spilled over into financial organisations who made the fatal mistake that they could always sell structured products - but as readers of this column will know, that first casualty of the crisis was the "over-the-counter" markets used for selling bundles of sub-prime or similar constructs. There was no exchange for these goods and sellers could not establish a market. Many firms disappeared in a liquidity spiral. It brought back Keynes's concept of liquidity preference. The Fed also had models which have not stood up well. In the summer of 2007 it predicted that even if the housing market turned down by 20%, GDP would fall only by 0.25% and there would be negligible unemployment. All the Fed had to do was reduce interest rates by 1%, and the damage would be contained! Fantasy in the Fed! ____________ * Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared. firstname.lastname@example.org www.bennetteconomics.com