Skip to comments.Keynesian world thrown for curve as global economy grows
Posted on 08/19/2005 11:37:33 AM PDT by bayourod
IT is remarkable how Keynesian economic theories from the Great Depression are enjoying something of a vogue in a world that seems to bear little resemblance to the 1930s - at least outside Japan. It reflects an attempt to explain the behaviour of a global economy that has broken away from established economic verities, such as the link between current account deficits, interest rates and exchange rates.
For several years now there have been predictions of a crash of the US dollar, a leap in global interest rates, a collapse of asset prices and a possible global recession. Yet global growth is running on at good pace, despite weakness in Europe and Japan. World bond rates remain unexpectedly low.
The most recent manifestation of the resort to Keynesian theory is the two charts from this week's Economist, reproduced here. Generations of economics undergraduates have struggled with IS (investment/saving) and LM (liquidity/money) curves, although they have now fallen out of favour.
On the basis of some fairly limiting assumptions, the IS curve represents equilibrium in the goods market and the LM curve represents equilibrium in the money market. Where these two curves intersect is the unique combination of output and interest rates that represents balance in both the goods market and financial markets -- what the RBA's Ian Macfarlane might call Nirvana.
The chart on the left shows what happens if the private sector wants to save more than it wants to invest -- that is, there is an excess of savings. This is what Keynes called the paradox of thrift, another Keynesian theory that is getting a new lease of life. His paradox is that what may be good for individuals can be bad for the economy, because investment is the key to productivity and growth.
In a world of excess savings the IS curve moves down from IS1 to IS2 and interest rates and GDP fall (from R1 to R2 and from Y1 to Y2 on the chart). But what if the problem isn't excess savings but excess liquidity -- too much money? In that case, it is the LM curve that moves to the right, interest rates fall, but this time GDP rises. You don't really need to follow all this too closely to get The Economist's point.
Its left-hand chart represents what has become known as the "glut of savings" explanation of what is going on in the global economy and financial markets, a phrase coined by former US Federal Reserve governor Ben Bernanke in a recent speech.
China, Japan, some other Asian countries and the oil producers have been putting their excess savings into the US, which has obligingly accommodated them by going on a spending spree and running a large current account deficit, which the Asian savings have financed.
But The Economist argues that this view doesn't hold up, because contrary to what the first chart suggests should happen when there are excess savings, world growth has not fallen, but instead has been strong.
This fits better with the second chart, which also shows interest rates falling, but output picking up, in response to loose monetary policy. So far, easy money hasn't led to inflation, it argues, because of the emergence of China in world markets. To which could be added, the increased credibility of central banks as inflation fighters.
Which view is right -- excess savings or excess liquidity? The Economist thinks there could be a bit of both, but favours excess liquidity. The answer matters, because it implies different policy responses.
If it is excess savings, then America's response -- expansionary fiscal policy and, at least until recently, easy money -- is the right one for the world, provided the excess savings continue to be invested in the US.
I think there is more evidence to support the excess savings view than the alternative. While The Economist asserts there has been excess liquidity growth, it doesn't provide any figures and it is not that easy to demonstrate.
The boom in asset prices fits easily into the excess savings view, and unless there is evidence of rising global inflation, liquidity growth is by definition not excessive. Nor do bond rates point to inflationary fears in financial markets. On the contrary.
So, if the excess savings view is right, the key question for investors is: how long will the flow of savings from Asia go on funding the US current account, US consumption and investment and world growth?
Three economists who have been influential in the global savings debate -- Michael Dooley, David Folkerts-Landau and Peter Garber -- have just released a new paper. Their answer is: for the foreseeable future.
Answer: until they study economics and realize that they are giving away the store.
Keynesian economics is so popular because is requires massive government and armies of economists.
Keynes died in the '60 when Uncle Miltie killed him. Everything else is just catch-up.
Again, we agree. Keynesian economic theories are a steaming crock of .... (!)
The article refers to two charts they reproduced, but I couldn't locate them. Must have been in the hard copy version.
"We are all Keynesians now" --- RM Nixon
Thank you for that post. Keynes was undoubtedly brilliant, and would never have subscribed to the perversions that his theories have led to by irresponsible policymakers.
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