Keynesian versus neo-classical policies - A never ending struggle?

I find it both entertaining and fruitful how prestigious economists have gotten into fierce fights about the right approach on how to handle the economy. If you have a lot of time, you can read through Krugman’s How did economists get it so wrong and if you are still interested afterwards read through Levin’s open letter response. What is the whole struggle all about? Mr. Krugman claims that markets do not function without heavy government intervention and current models based on rational behavior are basically worthless. This questions the merits of a whole generation of economists and fierce criticism will inevitably follow such statements.

So who is right and who is wrong? It seems that, all the progress in technical modeling aside, economics will always be divided into two opposing views. One, based on the insight of Keynes of the 1930s, will propose state intervention in order to mitigate the amplitude of business cycles. The other, often called “neo-classical” school, will advocate a minimal role of the government that interferes as little as possible with the economy. There are a plethora of approaches somewhere in between imaginable and for the most part economic policy will not opt for one of the extremes. Although scholars have coined the term “neoclassical synthesis”, which means combining both views into one single approach, such a synthesis in the Hegelian tradition is a far cry.

The changes of political sentiment towards one of the two options seems to be almost as cyclical as the economy itself. After the Keynesian revolution, many economists believed they had solved the riddle of business cycles and could control them from now on. Stagflation in the 1970s gave rise to the opposing view again, successfully put into practice by Ronald Reagan and Margaret Thatcher. This movement is closely connected with Milton Friedman and is often described as monetarism. Monetarism proposes that the role of the state should be reduced to providing a stable monetary policy in order to ensure price stability. Now the pendulum is about to swing into the other direction and politicians are again following the Keynesian stimulus promise. To make it clear, Keynes was never out of the picture. The Federal Reserve intervened heavily and tried to steer the economy by contracting and expanding money supply anti-cyclically.

What seems to have happened in the current crisis is that we have gotten into something economics students learn in their introductory macro courses: The liquidity trap. In short, this phenomenon describes a situation where monetary policy cannot stimulate the economy further because interest rates are already close to zero and there are no negative interest rates (well, Sweden actually thinks there are, their banks have to pay now to deposit money at the central bank). According to Keynesian theories we would need, as the only remaining option, anti-cyclical government spending or nowadays more often tossed as a “stimulus package”. This involves much more political troubles as the public takes much more notice of such actions (they feel it affects them more directly in forms of higher taxes later, although theoretically expansive monetary policy can have the same wealth effect through inflation). In addition, the central bank is politically independent and can make its policies without approval of any parliament, whereas stimulus money needs the consent of democratic representations.

Personally, I think the truth lies somewhere in the middle. Both approaches have helped economies in different periods. It is and will stay a constant struggle between the two. Thinking a bit into the future, over-regulation and heavy government intervention seem to be down the road. This already paves the way for deregulation once governments realize the growth potentials of the economy have substantially shrunken. And the pendulum swings back again….

Are there economies of scale in banking?

I had the pleasure to listen to a quite inspiring lecture by Amar Bhidé who argues for more personal relationships in finance and banking. The lack of the latter and their replacement by mechanical, engineering-like, one-fits-all approaches, might indeed have contributed a fair share to the immense credit losses of the recent past. Mortgages have not been given according to individual judgment in a case by case decision, but based on corporate guidelines. “Bankers” selling such credit were actually salespeople that encouraged (over)-stretching those rules as they were not responsible for credit quality, but profited from a high sales record. The proposal of bringing back personal relationships into banking and finance means we have to turn back time, say about thirty years.

Credit ratings based on volatility measures and standard criteria are to be replaced by personal judgment again. Taking this idea a step further might indicate that a change in the regulatory framework and an increase in capital requirements, as it is on the table right now, will not eliminate the systemic risk in finance. This would mean politics is aiming for the wrong trade-off. Higher capital requirements for financial institution will in one way or another decrease growth potentials in the real economy. This is seen as a trade-off against a more secure financial system. If the argument of a lack of personal relationship holds, higher capital requirements and stricter regulation come at a cost that is not offset by the desired gains. The trade-off should be to scale back or reverse the central decision making in banking. True, this would reduce the overall efficiency of banks, but so would the current plans of stricter regulation. All in all, it seems economies of scale are limited in banking and they have been overly exploited at significant long run costs, far outweighing the initial efficiency gains.

So back to the old days where you went to a bank and had to convince a person and not a form that you should get a loan. Doing this would probably help to keep the numbers of employed bankers from declining even further. The jobs, however, will not be the fly-high, get-rich immediately ones, they will be boring, average-pay banker jobs – as we remember them from some time ago.

A Chinese view on international credit flows

It is a well known phenomenon that the Chinese economy buys a significant amount of U.S. Dollar denominated debt every month, partly offsetting Chinese trade surpluses with the U.S. Thereby China supports the status quo of the exchange rate of its, as many argue, undervalued currency. This creates a situation of mutual independence as a necessary adjustment of the exchange rate would hurt both countries. A sharp depreciation of the U.S. Dollar would cause trouble for the U.S. economy in many forms such as increased costs for energy imports and higher finance costs as a result of waning trust in the dollar. For China the problem is simple: their huge dollar reserves (around 2 trillion U.S. Dollar) would decline in value. So far this dilemma is well-known.

However, there is another layer which presents itself taking a Chinese perspective. The bonds Chinese private households, the government, and firms put their money in, yield relatively low interest rates. This is mostly due to the still dominant position of the dollar and the U.S. economy. On the other hand, U.S. companies pour their dollars back into the Chinese economy in forms of investments. Those investments are by no means low-profit investments and generate significantly higher profits. To put it short and sweet, the Chinese lend money to the U.S. at a low interest rate and U.S. firms and investors come back and invest getting a high return on their investment.

Naturally, one might think: Why not leave the money in the country from the start? That is, of course, what Chinese economists try to suggest and shift the investment flows towards domestic investments rather than investing abroad. This will not happen overnight, but in general Chinese economists seem to be often better heard in their country than elsewhere. Some even suggest to try to make the Renminbi the dominant currency, that is to say most debt should be denominated in Chinese currency. That is a far cry from now, but considering the population ratios and the current troubles of the U.S. economy, not impossible in the very long run.