Monday, September 28, 2009

It is wrong to push the old into a quicksand

Francesco Giavazzi – the distinguished economist from Bocconi University, Milan, a frequent visitor to MIT – made two gaffes around September last year: about Lehman Brothers, and about derivatives markets. Then he lay low for about a year, to re-emerge now with two more gaffes: one on targeting the aged in order to cover the cost of fiscal stimulus, and one on a wishful drive towards global recovery. This just goes to show that the judgment of engineers who turn to economics should be seen as that of engineers.

Lehman Brothers

On 16 September 2008, the day after Lehman Brothers went bankrupt, Francesco Giavazzi expressed great enthusiasm for the US authorities’ decision not to bail it out. “Yesterday has been a good day for capitalism” (sic!), he wrote on, adding that “Now the liquidity cushion needed by AIG will also be provided by the market”. First he had to add a postscript to his piece, acknowledging that the US government had bailout AIG only a couple of hours later. Then he had to recognize – in a joint book with Alberto Alesina on the global economic crisis – that “ex-post, the failure to save Lehman Brothers probably was a mistake” (La crisi. Può la politica salvare il mondo? 2008, p. 49), rather than the “victory of the market” he had hailed earlier. Compare with Chris Giles, in the FT of 13 September 2009: “The collapse of Lehman Brothers transformed an expected global slowdown into the worst recession since the second world war. Though the direct losses from the Lehman bankruptcy caused little trouble, the ensuing panic that engulfed financial markets, banks and companies hit the global economy harder than the Opec oil crises of the mid-1970s, the loss of control over inflation in the late 1970s or the dotcom crash at the turn of the millennium”.

Derivatives markets

Expressed enthusiasm for the inordinate growth of the derivatives market, on the ground that derivative products allow Indian farmers to reduce the risks surrounding their crops, and enable the homeless to buy their homes, was another economic error. According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and at their peak earlier in 2009, when their total began to decline slowly, they had reached 1.14 quadrillion dollars (more precisely: $548 trillion in Exchange Traded Derivatives plus $596 trillion in notional Over-The-Counter derivatives). By comparison, the Gross Domestic Product of all the countries in the world is only 60 trillion dollars. What was supposed to be an instrument to distribute risk turned into a multiplication of risk. Or else those Indian farmers and US homeless have been exercising a lot of leverage.

But clearly the statute of limitations leaves errors unpunished in economics. Giavazzi has now reappeared to fire two more shots, though his aim has not improved over last year.

Targeting the aged

In a post on asking “What’s the proper exit strategy from the crisis?”, Giavazzi argues that the exit will take a long time, probably a matter of years, and the real co-ordination necessary is not across countries, but between monetary and fiscal policy. What should be rescinded first, exceptional monetary accommodation or the fiscal deficit?

Jean Pisani-Ferry argued recently that first should come structural reforms, then the gradual withdrawal of fiscal stimulus, then monetary policy could be reined in. He feared that Central Banks would not accept a secondary role, and was right: on 11 September, at a Bank of Italy Conference in Rome, ECB Board member Lorenzo Bini Smaghi said: “The more delayed the fiscal exit, ceteris paribus, the more the monetary policy exit might have to be brought forward. Indeed, given the level of the debt accumulated in most advanced economies, any delay in the fiscal exit is likely to have an effect on inflation expectations, and may even disanchor them.
This is a risk that monetary policy cannot take, as it would undermine its overall strategy.” (Bini Smaghi 2009 “An ocean apart? Comparing transatlantic responses to the financial crisis”; I was there and could not believe my failing ears).

Now, this does not sound like co-ordination, more like blackmail. Giavazzi likens the strategies of Central Banks and fiscal authorities to a game of chicken, whereby two car drivers on a collision course may both refuse to give way and crash – a patently inferior solution to a cooperative one. Giavazzi instead recommends that Euro-zone governments should commit themselves irrevocably to future spending cuts, in order to stabilize expectations and allow central banks to wait longer before they remove monetary accommodation. This would avoid the demand contraction that earlier fiscal cuts would cause.

True, but Giavazzi singles out for future cuts the ageing-related spending over the next 15 years. According to The 2009 Ageing Report issued by the European Commission (2008), ageing related spending amounts to 7% of GDP per year in Holland, 5% in Spain, 3.5% in Germany, and 3.3% in the EU27. Thus the budgetary effects of ageing are several orders of magnitude larger than the fiscal cost of the crisis. In terms of present value of total age-related expenditure (note: over 15 years), the present value of fiscal stimulus (temporary, over only 2 years) naturally is much lower, comparatively negligible (see Giavazzi’s Fig. 1, from IMF data).

Figure 1. The fiscal costs of the crisis compared to age-related spending

Source: IMF

The trouble is that all these figures are utterly misleading. The incidence of pension expenditure, on GDP or on total government expenditure, is not comparable across countries because of different statistical conventions (for instance in the treatment of golden handshakes and of payments to invalids), and even less comparable across countries with different incidence of so called distributive, Pay As You Go (PAYG) systems, versus capitalized, fully funded pension systems. Necessarily countries with a dominant PAYG system look as if they were more generous towards the aged than they actually are, because pension contributions should, but usually are not, counted as government revenue against pension expenditure. Conversely, an entirely funded system will appear as making no claim on government expenditure at all, because pension contributions are credited to the pension funds financing pension expenditure: but there is no reason why PAYG pension expenditure and revenue should be accounted for any differently. Only for uniform statistical conventions and for a comparable incidence of redistributive/funded pension systems will government expenditure on pension indicate – as the IMF figure produced by Giavazzi suggests – governments’ relative generosity towards old-age pensioners. Reflect on the fact that in 2006 the Italian pension system actually showed a surplus of 0.8% of GDP which therefore made a positive, significant contribution to the funding of public deficit (See R.F. Pizzuti, Rapporto sullo Stato Sociale, 2008, p.21), rather than wrecking social accounts from now to Kindom Come. See also three earlier posts on this Blog, of 13 June, 23 June, and 30 June, as well as the theoretical backing of Nick Barr and Peter Diamond, Reforming Pensions: Principles and Policy Choices, Oxford UP, 2008, and Pension Reform: A short Guide, Oxford UP (2009).

The same considerations apply to the additional expenditure due to population ageing, although its funding is not spelled out in the data quoted by Giavazzi. It is simply wicked to compare two item of expenditure in terms of their present value – two years in one case, 15 years in another. Besides, you cannot single out ageing as a specific source of expenditure, that can be cut at will regardless of the means provided by the recipients to finance the pension system as a whole. You might as well resort to the method – probably apocryphal but telling – that Federico Caffè used to quote when he discussed pensions: in some primitive society apparently the young brandish long pointed poles to decisively push into quicksand the aged no longer able to look after themselves. At the time of the Italian pension reform of 1995 the satirical magazine Cuore published a poster saying: “Your Government Needs YOU: Kill an Old-Age Pensioner”. Is this the Giavazzi solution? After all, it appears to be seriously considered by the IMF (2009).

The drive towards global recovery

In the September issue of the latest IMF publication, Development and Finance, there is a piece on “Growth after the Crisis”. If the world economy is to recover, a replacement must be found for the newly frugal U.S. consumer. Giavazzi calculates a consumption shortfall of about 3% of US GDP (i.e. a 4% increase in the saving rate from zero, of over 70% GDP being disposable income, = 2.8%), that cannot be compensated by the growth of China India and Brasil. China in particular will need to improve the provision of finance to the private sector, introduce a public safety net and risk-sharing financial products (this time we are talking about health and life insurance, and pensions, not derivatives…) before the Chinese saving rate is reduced. Europe – and particularly an export-led Germany, cannot or is not willing to do much (especially after the German elections).

So, Giavazzi argues, “the only way to maintain full employment is through higher investment.” This cannot be higher public investment, given the limited opportunities especially in the United States (where it is about 3% of GDP) and the “high probability that some of it will be wasted rather than contributing to raising the productive level of the capital stock”. Private investment (which is close to 20% in the USA) then must be the answer. But what would induce firms to raise investment spending in the middle of a sharp recession, and without any prospect of a likely technological breakthrough?

Elementary: “the realization that the crisis will change the composition of world demand for the long term. To address such a change, the structure of world output would have to adjust, which requires industrial restructuring and, as a consequence, new investment.” Because the crisis has brought about “a change in the composition of world consumption”, which “cannot happen without substantial restructuring, and, therefore, substantial investment.” What would prompt firms to invest is “the anticipation of a change in both the geographic allocation and the composition of consumption—relatively more consumption in China, relatively less in the United States; higher demand for such things as basic appliances and relatively lower demand for high-end automobiles.”

At this point the production of a long list of instruments of industrial policy, powerful enough to promote this kind of investment in restructuring, might be expected. But no, Giavazzi candidly relies on the incentive that “Those countries that do the restructuring—and get it right, including the portion that happens through public investment—will come out of the crisis richer.” Thus Giavazzi's pronouncements on the crisis range from applauding the Lehman disaster to misunderstanding the size role and danger of derivative markets; from the targeting of social welfare provisions for the old to the rosiest, starriest-eyed version of economic planning, not via public investment because of its presumed inefficiency, but presumably through the resurrection of French-type indicative planning that never worked and never will. Since when, in this century, do western governments take national investment decisions as they appear to do in Giavazzi’s world? Are private enterprises really enlightened and optimistic to the extent of selflessly investing in the hope of collectively implementing a balanced plan, starting from a large scale, tangible imbalance?

Giavazzi’s article appears in a prestigious official IMF publication; are his views shared by Dominique Strauss-Khan and/or Olivier Blanchard? The mind boggles.

Wednesday, September 23, 2009

Singular Priorities

In a procession, in the line of succession to the throne, in the sequence of steps that form the critical path to complete efficiently and rapidly a course of action, a person/pretender/step necessarily takes precedence over all others in a pre-assigned ranking. In this one and only sense one can discuss the set of their priorities, for there is no trade-off between the inclusion of one person/pretender/step and the inclusion of others. Fine. And you can say, with the Mahatma Ghandi, that “Action expresses priorities”, because the ranking does not precede but follows the actual decision and there is no longer a trade-off. Or, with Steven R. Covey, "Priority is a function of context": this is precisely the point.

The trouble is that people in general, and in particular politicians and bureaucrats – and especially New Labour politicians and Brussels eurocrats – talk incessantly and over-abundantly about “priorities” in the sense of ranked policy-objectives, in situations in which there is a trade-off between them, both in the terms in which their relative achievement is feasible, and in the terms in which they may be regarded as substitutes by the decision-makers. This habit is sloppy, meaningless and misleading; it should be forbidden, penalized and eradicated.

Yet examples abound. A Google search gives about 34,100,000 entries for priorities, 10,100,000 for top priority, 21,100,000 for Obama’s top priorities for 2009. “Brown promises 'new Government, new priorities'” (27 June 2007). Tony Blair: “It is not an arrogant government that chooses priorities, it's an irresponsible government that fails to choose." Peter Mandelson: “Europe has to address people's needs directly and reflect their priorities, not our own preoccupations.” “This page [on President Barroso’s website] gives direct access to all information regarding the Commission's current priorities”. Angela Merkel: “You should know what our priorities are.” And again Merkel: “I think it is a right idea to stage a special summit, which would deal with the question of priorities of European politics;” and again: “It must be clear what the priorities on the agenda are.” Kofi Annan: “From this vision of the role of the United Nations in the next century flow three key priorities for the future: eradicating poverty, preventing conflict and promoting democracy.” John Berger: “It is not, as poverty was before, the result of natural scarcity, but of a set of priorities imposed upon the rest of the world by the rich”. US ex-Vice President Dan Quayle: "For NASA, space is still a high priority". Peter MacKay: "What Canada has to do is to have a government connected to the priorities of the people of which it is elected to serve. Those priorities include ensuring medicare is sustainable, support for the military, and tax and justice systems that work". Bill Clinton: “It's the American people who sent us here; it's our obligation to meet their priorities. So let's roll up our sleeves, get back to work and finish the work we were sent here to do".

“Di mamma ce n’è una sola” is an old Italian saying: you only have one mother. In the Roman Law sense of “mater semper certa” this has been falsified by progress with artificial insemination and wombs for rental. But strictly speaking, and in the sense of a unique emotional link with one special person, the saying remains true. My old friend Gemma, fed up with her little daughter’s apparent lack of respect, used to remind her adding: “Tutte le altre sono matrigne” (All the others are stepmothers). This is why I teach my students that priority is like your mamma: you can only have one. All the others are objectives, or targets - either independent of each other and therefore simultaneously pursuable without their having to be ranked, or impossible to rank without reference to 1) their actual trade-off with one another, in comparison with 2) the trade-off preferred by the decision maker, individual or government. Thus by definition you cannot have priorities, let alone top priorities; as you can have only one, that one can only be top, so the top is redundant.

A philosopher friend tells me that I am too literally minded: “Priorities” - she says - simply mean a set of objectives that are singled out as generally desirable, as opposed to all the other possible objectives which are regarded as less desirable, or indifferent, or undesirable outright. But I am adamant and unrepentant. If we have a list of undesirable things, their reduction or cessation or elimination must be regarded as desirable. Therefore ultimately something is either indifferent, or desirable in some form (including its opposite when it comes to undesirables). And the desirability of desirables cannot be stated in abstract, but is exclusively subject to its rate of substitution with other desirables, in the decision-maker’s system of preferences, being greater than the rate at which the desirable in question can be obtained at the cost of another desirable. Cost can also be measured in terms of a common desirable such as money, or the time and/or effort it takes to explore the desirability and substitutability of a desirable objective for another. There is no point in stating that something is desirable, without specifying up to what point it is desirable, either in terms of its direst cost in terms of money, time and effort, or in terms of the lower degree of achievement of other desirable objectives.

Anyone listing as alleged priorities a number of conflicting objectives, whether ranked or unranked, has said absolutely nothing about their relative desirability and the extent to which each one can/should be sacrified to the higher realization of another. This is what most of microeconomics is about: the comparison of the rate of transformation of one good into another in production and in the system of preference of a decision-maker, ideally both equalized to relative prices in the market. In the most general meaning of the word, prices are “the terms on which alternatives are offered” (Wickstead). Thus the wrong-headed concept of “priorities” - a contradiction in terms, the ultimate one-word oxymoron – may be forgiven to non-economists in common speech but is unforgivable when voiced by economists or people in charge of the economy talking about economics.

When there is more than one declared priority, nothing has priority. The Soviet economy was organized - to a different extent at different times in its history - mostly according to a system of multiple priorities, instead of a system of prices: the result was necessarily disorganization and chaos, ultimately leading to economic collapse. Multiple priorities were at their peak during War Communism (1918-21), when towards the end they multiplied beyond belief, to the point that even pen nibs were added to the senseless and useless priority list.

The multiple objectives meaninglessly classed as priorities can be qualitative as well as quantitative, as long as there is a possible conflict and therefore a trade-off between the fulfilment of one qualitative target and another. Indeed what prompted this post is a recent document of the Bruegel Think Tank, on Europe’s economic priorities 2010-2015 – Memos to the new Commission, Edited by André Sapir, Brussels, 2009.

Tuesday, September 15, 2009

A Big-Bang Euroisation? Not Now

Unlike the UK and Denmark, that negotiated an opt-out clause within the Maastricht Treaty, the EU New Member States of the 2004 and 2007 enlargements that have not already done so will have to adopt the euro sooner or later: it is part of their obligations of membership, the so-called acquis communautaire. In this respect their position is formally identical to that of Sweden, although Swedish euro-procrastination was backed by a national referendum. Slovenia and Slovakia have already adopted the euro. Except for occasional contrary remarks by Vaclav Klaus – when he was Minister of Finance, though, not as Czech President – none of the other New Members States has ever indicated unwillingness to join the euro-zone (or Economic and Monetary Union). They have all experienced directly, or indirectly, the high costs of monetary dis-integration – of COMECON (the Council of Mutual Economic Assistance), the Soviet Union, the Czechoslovak Federation, the Yugoslav Federation. Therefore they do not need persuading of the significant, symmetric advantages of monetary unification: lower transaction costs, greater stability in trade relations within the euro-zone, the ability to borrow in their own currency thus avoiding exchange rate risks, the greater attraction for Foreign Direct Investment and portfolio investment, low (though for some of them, like the Czech Republic, not necessarily lower) inflation and interest rates.

The Maastricht Treaty has set for euro-zone candidates a veritable obstacle course, with strict criteria for fiscal convergence, more strictly enforced than for old EMU members and for non-EMU-candidates, who are only subject to the looser constraints of the so-called Growth and Stability Pact. Candidates also have to satisfy criteria for monetary convergence, plus exchange rate stability vis-à-vis the euro for two years. [1] The main reason why the New Member States are not rushing to meet the criteria and join the euro is the pain involved in satisfying fiscal convergence.

The question arises whether early membership of the euro-zone might assist recovery from the deep crisis of 2009, which on average has involved a GDP contraction of 5% in the 28 transition economies that are EBRD clients, ranging from zero growth in Poland to -18% in Lithuania.
There is a presumption that small open economies would probably gain from being part of a large currency area in times of crisis, although Slovakia (where the euro only became legal tender on 1 January 2009) and the Czech Republic who is not a member have done rather well outside of it.

The IMF has been in favour of euro-zone enlargement for some time (see Susan Schadler, Ed., IMF, 2005). Barysch (2009) alleges that “On April 6th [2009] it emerged that the IMF would advise Central and Eastern European countries to adopt the euro, unilaterally and without meeting the EU’s strict criteria for the single currency, if necessary.” This recommendation - which was neither denied nor confirmed - is said to have been made “in a leaked report written in March”; it clashes with the long-standing EC decision that rules out the unilateral replacement of the national currency with euro by EU members and candidates; Kosovo and Montenegro have done it but were neither at the time. The EU allows a hyper-fixed link to the euro through a Currency Board, certainly before EU membership, as in the Baltics, Bulgaria, Bosnia & Herzegovina; presumably also after joining the EU but before applying for EMU membership, though this is not absolutely certain, as there are no precedents.

Currency Boards reduce the probability of a crisis at the cost of making the crisis catastrophic if and when it happens (as in Argentina in 2001), and European Currency Boards are not yet out of the danger zone, especially in Latvia where the Central Bank acts as a Currency Board and the lat has been on the brink of devaluation for the first three quarters of 2009.

The European Central Bank’s role as Lender of Last Resort is remarkably undetermined and left to informal arrangements with the Central Banks of euro-zone member states. Non-members with hyper-fixed links to the euro (whether unilateral euroisation or Currency Boards), or with an ordinary fixed exchange rate, might very well be left high and dry in times of crisis. Sweden and Denmark have been offered swaps by the ECB, unlike other non-members. Loans to Latvia have been primarily in the interest of European banks whose loans would have not been serviced otherwise (Bezemer, Hudson and Sommers 2009). Darvas (2009) points out that “The ECB accepts non-euro denominated securities eligible for refinancing in three currencies (US dollars, British pound, and Japanese yen, provided the security was issued in the euro area), but it should accept high-quality securities issued anywhere in the EU in all EU currencies. The ECB should also give access to ECB refinancing facilities for non-euro-area commercial banks, which could substitute the malfunctioning euro-area money market for these banks.”

The EU could well have admitted at least a few other New Member States to the euro-zone by loosening the Maastricht convergence criteria. In theory the criteria for fiscal convergence are looser than those of the so-called Growth and Stability Pact (GSP, which involves not only a 3% ceiling to government deficit but a stricter zero per cent over the cycle) and apply to all EU members regardless of euro-zone membership. In practice the GSP strictures and the associated penalties were considerably relaxed in March 2005 and further loosened de facto during the current crisis, whereas Maastricht criteria for joining the euro have been very strictly enforced. This glaring asymmetry is unreasonable and injust.

It is also unreasonable to subject countries that grow much faster than the euro-zone members and have relatively low ratios between public debt and GNP to the same fiscal stringency as stagnant and highly indebted euro-zone members (like Italy). It is more unreasonable to apply to prospective members fiscal constraints more stringent and inflexible than those applied to existing EMU members and to non-members who are not candidates. It is even more unreasonable to apply to prospective EMU members an inflation constraint linked to the “three best-performing member states of the EU in terms of price stability”, regardless of whether or not they are EMU members and arbitrarily interpreted as the three least inflationary EU members (with a non-negative inflation rate; see Darvas 2009). The very fact of EU enlargement from 12 to 27 members has implied – Darvas argues – a toughening of the inflation condition by virtue of this interpretation.

Lithuania, for instance, in 2006 was left out of the euro-zone only because its inflation exceeded the average inflation of the three least inflationary EU members by 1.6% instead of the 1.5% prescribed by the Maastricht Treaty – not exactly enlightened or rational behaviour, especially considering that two of those three least inflationary countries (Sweden and Poland) were not euro-zone members. Slovakia, on the contrary, was admitted in 2009 in spite of a 25% nominal revaluation of its crown in the two years before joining, which was a significantly greater departure from the basic parity than the stipulated maximum band of variation of +/-15%. “The EU can certainly be criticised for clinging to criteria ill-suited to catching-up countries and the case for reforming them is strong” (Darvas and Pisani-Ferry, 2009, op.cit.; see also Nuti, 2006).

Piatkowski and Rybinski (“Let us roll out the euro to the whole Union”, FT 11 June 2009) now propose “a ‘big bang’ euro area expansion to introduce the euro in all 27 member states by 2012.” “Such a bold decision - they claim - would give a credibility boost to the enlarged euro-zone, accelerate replacement of the dollar by the euro as the global reserve currency and breathe new life into a united Europe.” This might have been a good idea when the euro was first introduced in 1999 - certainly not now with some of the countries in a financial turmoil, for membership of a single currency area is a preventive remedy, not a cure. The authors point out that “the combined GDP of all euro-zone candidate countries in central and eastern Europe amounts to less than 10 per cent” and therefore costs would be contained, but this “little-me-ism” by itself does not amount to a case.

The idea that Latvia should first devalue substantially with respect to the euro and then join the euro-zone in a hurry (Roubini 2009) does not make sense. Lat devaluation is probably unavoidable. Of course it would aggravate the prospective Latvian insolvency on euro-denominated debt and force a restructuring, but a crisis of the type and scale of Argentina 2001 seems impossible to procrastinate much further. However, euro-zone membership would not reduce the blow of that devaluation, only the risk of future devaluations; immediately after a devaluation there would be no hurry to join - other than to better milk resources from EMU taxpayers. And since the hyper-fixed exchange rate with the euro was Latvia’s problem, currency conversion even at a lower rate cannot be the solution. Yet the OECD (2009) is now advocating a similar solution for Iceland: join the EU, devalue and join the euro-zone as soon as possible. Here as well there is no case other than an unwarranted and expensive benefaction on the part of the rest of Europe. Reade and Voltz (2009) argue that Sweden should join the eurozone: no problem there, if only they asked.

Darvas (2009) recommends new rules which - he claims - are based on greater logic and common sense: 1) “All criteria should be related to the euro-area average”; 2) “The inflation, interest rate, and budget balance criteria should allow some deviation from the euro-area average”; 3) “The requirement for the ratio of government debt to GDP could simply demand that this ratio should not exceed the euro-area average, unless the ratio is diminishing sufficiently and approaching the euro-area average at a satisfactory pace.” “The suggested change in euro-entry criteria would still require substantial effort from the applicants, but it would ease their pain. It would also boost confidence, helping kick-start the private capital inflows – not western taxpayers’ money – that these countries desperately need.” (Darvas 2009).

However, focusing on average EU parameters would be disastrous, for it wouls trigger off a game of self-fulfilling expectations. In a crisis each member expects every other member to raise its deficit and debt, and possibly inflation afterwards; each therefore raises its own target parameters accordingly. Collectively, they cause a rise in average parameters, thus making it easier for them to satisfy average constraints individually: any macroeconomic discipline goes by the board. Imagine a party of diners, each of them on an expense account, and each having to pay out of pocket only the excess cost of their lunch over the average cost for all diners. Insofar as their choices of dishes are affected by cost considerations, each diner will have a more expensive lunch than otherwise. Average limits would tend to be high and to escalate fast,

It would be wiser, in order to encourage euro-zone membership, 1) to exclude any non-EMU member from the determination of monetary convergence parameters, and 2) to end the asymmetry that penalises candidates, thus modifying Maastricht fiscal parameters in line with the changes introduced in March 2005 to the so-called Growth and Stability Pact, softening them for countries characterised by fast growth, low debt, and high public-investment.
[1] The well-known Maastricht conditions are: an inflation rate no more than 1.5% above the average rate of the three least inflationary members of the EU; long term interest rate no more than 2% higher than the average rate of the same three least inflationary EU members; government deficit no higher than 3% of GDP and public debt no higher than 60% of GDP, or within reach of those constraints and falling; and the additional condition of two-year membership of the Exchange Rate Mechanism II, holding a course within a +/-15% band around the euro parity agreed with the EMU monetary authorities before joining the ERM II.

Wednesday, September 9, 2009

Fiscal stimulus: larger, more balanced, co-ordinated

A United Nations source (World Economic and Social Prospects-Update as of Mid-2009) estimates that, since September 2008, Governments worldwide have made available massive public funding (amounting to $18 trillion, or almost 30 per cent of WGP [World Gross Product]) to recapitalize banks, to acquire ownership stakes in ailing financial institutions, and to provide ample guarantees on bank deposits and other financial assets. Further, recognizing the inadequacy of these monetary and financial measures to stave off a recession, many countries have also adopted fiscal stimulus plans, totalling about $2.6 trillion (about 4 per cent of WGP), to be spent over 2009-2011. ”While significant, this may still fall somewhat short of the stimulus of 2 to 3 per cent of WGP per year that would be required to make up for the estimated decline in global aggregate demand. “ (Ibidem).

In the same document the UN makes a number of recommendations of preconditions affecting fiscal stimulus effectiveness: the adequate recapitalisation of banks; the “fundamental reforms of the international financial system… to overcome the systemic flaws which caused this crisis” (a “macro-prudential regulatory system”, “counter-cyclical capital provisioning”, supervision of all financial market segments in which systemic risk is concentrated, including hedge funds and cross-border flows); “a new framework for global economic governance”, attributing to the IMF the role taken until now by the “Group of 7, the Group of 8, the Group of 20 or other ad hoc forums, lacking the participation or representation of important parts of the international community, especially from developing countries.”

These preconditions would produce spillovers such as the reduction of tax evasion (enhancing development resources), of corruption, of drug trafficking and the financing of terrorism. The UN document stresses the need for mechanisms of debt restructuring, and for “a new global reserve system which no longer relies on national or regional currencies, as the major reserve currency must be created.”

But the most important policy recommendation of this UN document is that of a co-ordinated stimulus, “with global sustainable development objectives”. In truth this is understood to involve more than just co-ordination, and to include an increase and redistribution of the stimulus, 80% of which is coming at present from developed, deficit countries. Greater efforts are expected of surplus countries in order to reduce global imbalances and to contribute “about $500 billion extra over 2009-2012, compared with the uncoordinated scenario” to middle and low-income developing countries, strengthening their social protection systems and making long-term investments in sustainable development. “The additional resource transfers needed would include about $50 billion for the least developed countries.”

Global coordination should also eliminate unfair trading practices associated with many stimulus packages that provide subsidies to domestic firms, in order to benefit through trade those countries that cannot afford domestic subsidies and fiscal stimulus. There would be “concerted efforts to provide countries with greater access to developed country markets as envisaged in a truly developmental Doha round of multilateral trade negotiations.”

The WESP-Update reports that the UN Department of Economic and Social Affairs has made simulations with their global policy model, which suggests that the proposed larger, more balanced and coordinated global macroeconomic stimulus would yield significant gains in terms of global growth, compared with the existing scenario of uncoordinated fiscal stimulus being individually undertaken by national Governments. The simulations are summarised in the figures below. (Click to enlarge).

The figures illustrate economic recovery under coordinated and uncoordinated global stimulus, 2009-2015. Source: United Nations/Department of Economic and Social Affairs, based on policy simulation within the UN Global Policy Model. From: UN WESP-World Economic Situation and Prospects, Update as of Mid-2009, New York.

In such a coordinated, development-oriented policy scenario, the world economy would recover at an annual growth rate of around 4 to 5 per cent in 2010-2015, led by robust growth of about 7 per cent per year in developing countries. In the uncoordinated scenario, developing countries - including transition economies - would recover at only 3 to 4 per cent per year.

Developed countries would also gain from the proposed policy broadening and coordination, with their GDP growth accelerating to about 4 per cent per year, up from 2 to 3 per cent in the uncoordinated scenario. “Furthermore, the simulation results for the coordinated policy scenario predict a benign unwinding of global imbalances, keeping external asset and liability positions of major economies in check, which would, in turn, support greater exchange-rate stability.” Coordination would require monitoring mechanisms. There would be net gains all round.

All this might be considered as “pie in the sky”, but - especially at a time of generalised discussions of premature “exit strategies” it is a timely reminder of the generalised, large-scale additional gains, and the possible improvement in global imbalances, that are within the grasp of a slightly larger, more balanced, co-ordinated stimulus package.

Thursday, September 3, 2009

Akerlof & Shiller, Animal Spirits: A Misnomer for Their Sound Economics

Animal Spirits - How Human Psychology Drives The Economy, and Why It Matters for Global Capitalism, by George A. Akerlof and Robert J. Shiller, was published earlier this year by Princeton University Press, Princeton and Oxford, 2009. It is a timely book, as it addresses the questions of why most economists failed to foresee the current global crisis, to provide explanations for its occurrence and to suggest effective remedies to counteract it. But above all it is a refreshingly original, formidable set of economic propositions, corrosive and at the same time constructive, with pointed and valuable policy implications.

Bob Solow’s book-cover endorsement - “… a sorely needed corrective” - is an understatement. The book should be highly recommended in the reading lists of all social sciences students in every year of their curriculum, and made compulsory reading for government officials, businessmen and anybody operating in credit and financial markets. If I could afford it I would do for the book what a US millionaire is reputed to have done for Joseph Heller’s Catch 22, advertising in the press to give away free copies to the general public.

Akerlof and Shiller claim that “Keynes appreciated that most economic activity results from rational economic motivations - but also that much economic activity is governed by animal spirits” (p. ix). They understand these as “individual feelings, impressions and passions” (p. 1), “a basic mental energy and life force” (p. 3) and “describe five different aspects of animal spirits … confidence, fairness, corruption and antisocial behaviour, money illusion, and stories” (p.5). Confidence changes interact with the state of the economy and amplify disturbances. Concerns about fairness affect the setting of prices and wages. Temptations of corrupt and antisocial behaviour have a significant role in the economy. The public is confused by inflation and deflation and suffers from money illusion. “Finally, our sense of reality, of who we are and what we are doing, is intertwined with the story of our lives and the lives of others. The aggregate of such stories is a national or international story, which itself plays an important role in the economy” (p.6). The book first describes how these five animal spirits affect economic decisions, then argues that they play a crucial role in answering eight crucial questions:

“1. Why do economies fall into depression? 2. Why do central bankers have power over the economy, insofar as they do? 3. Why are there people who can’t find a job? 4. Why is there a trade-off between inflation and unemployment in the long run? 5. Why is saving for the future so arbitrary? 6. Why are financial prices and corporate investments so volatile? 7. Why do real estate markets go through cycles? 8. Why does poverty persist for generations among disadvantaged minorities?”. Moreover, a post-script to Chapter 7 includes their analysis of the current crisis and policy recommendations.

Akerlof and Shiller criticise and de-bunk many conventional economic theories, the foundations of the hyper-liberal tradition associated with the Thatcher and Reagan governments: from rational expectations to the efficient market hypothesis, from the natural rate of unemployment - and the associated denial of a trade-off between unemployment and inflation - to the very notion of voluntary unemployment, from the alleged benefits of de-regulation to the significance of Tobin’s q (the ratio between the current stock exchange valuation of a company’s shares and bonds and the replacement cost of its productive assets: a high q is supposed to promote investment but not always does). We are presented, instead, with waves of optimism and pessimism, manias, euphoria, panics, dishonesty, booms and busts, and the problems of how to put back together again the broken pieces of the financial Humpty-Dumpty.

The conclusion is that “… capitalism can give us the best of all possible worlds, but it does so only on a playing field where the government sets the rules and acts as a referee. Yet we are not really in a crisis for capitalism. We must merely recognise that capitalism must live within certain rules”. “And … in our view capitalism does not just sell people what they really want; it also sells them what they think they want. Especially in financial markets, this leads to excesses…”(p.173).

All very convincing, but for reasons largely different from the ones they offer. Keynes mentioned “animal spirits” as a shorthand for the driving force of entrepreneurship in general and particularly investment. Akerlof and Shiller turn it into a generalised motive that pervades and dominates the whole economy; they dissect the genus into the five species listed above, quite arbitrary and each of them still something of a black box. They identify animal spirits with 1) irrational behaviour and 2) non-economic motives, which is neither necessary nor useful. A powerful critique, but we are left clutching only a few straws. In the end animal spirits become a trite and somewhat irritating cliché, like the fuzzy drawings by Edward Koren supposed to capture them, and of little value added for our understanding of the modern economy.

Irrationality and non-economic motives

The inclusion of irrational behaviour and non-economic motives in macroeconomics is crucial for Akerlof and Shiller: “Picture a square divided into four boxes, denoting motives that are economic or noneconomic or responses that are rational or irrational. The current model fills only the upper left hand box; it answer the question: How does the economy behave if people only have economic motives, and if they respond to them rationally? But that leads immediately to three more questions, corresponding to the three blank boxes: How does the economy behave whith noneconomic motives and rational responses? With economic motives and irrational responses? With noneconomic motives and irrational responses?”.

“We believe that the answers to the most important questions regarding how the macroeconomy behaves and what we ought to do when it misbehaves lie largely (though not exclusively) within those three blank boxes. The goal of this book has been to fill them in” (p. 168).

The question of whether Keynes meant animal spirits to imply irrationality has been the object of a debate, completely ignored by Akerlof and Shiller. R. C. O. Matthews (1984) [“Animal spirits”, Proceedings of the British Academy, 70, 209-229, pay per view] backs the irrationality implication. He argues that Keynes first heard about the term in a lecture in Modern Philosophy on Descartes and other philosophers: in his lecture notes, Keynes commented on animal spirits: "unconscious mental action" (p. 212). Also for Roger Koppl (1991) [“Retrospectives: Animal Spirits”, Journal of Economic Perspectives, 5 , no. 3, 203-210, pay per view] Keynes believed that "the actions induced by animal spirits are irrational." (p. 205). Koppl also conjectures a connection with Descartes for whom, he says, blood that was heated in the heart and transported to the brain could be "animated" and as such make the person "act contrary to their best judgment."

Sheila and Alexander Dow, (1985) [“Rationality and Animal Spirits” in Tony Lawson and Hashem Pesaran, Eds, Keynes' Economics: Methodological Issues] on the contrary claim that explanations based on animal spirits do not imply irrationality: "If evidence is scant for the propositions put to business decision-makers, then they may legitimately weigh them lightly as offering little in their way of prescience. This behaviour is wholly rational, as is the use of direct knowledge (such as business intuition) in such circumstances." Hans O. Melberg [“A Note on Keynes' Animal Spirits, Critical notes on the use of Keynes' suggestion that animal spirits can "explain" economic instability". (Observation, 14 February 1999)], also strongly criticises the inference of irrationality. Akerlof and Shiller conveniently ignore all these arguments and plunge for non-economic motives and irrational responses without making a case for either of them. In their book even trust and confidence are irrational, rather then born out of experience or a plausible game strategy: “The very meaning of trust is that we go beyond the rational” (p. 12)

What Keynes actually said is: "our knowledge of the factors which govern the yield of an investment some years hence is usually very slight and often negligible." (General Theory, p.149). "If we speak frankly we have to admit that our basis for knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of patent medicine, an Atlantic liner, a building in the City of London amounts to very little and sometimes nothing ...)" (p. 149-150)

"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." (161-162) "... human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist ... it is our innate urge to activity that makes the wheel go around ..." (p. 162).

Now, there is nothing irrational, or uneconomic, in pessimism and optimism. The same applies to the “spontaneous urge to action rather than inaction”, seeing that the particular course of action we select on that basis remains unspecified; until we know such a course we cannot rule on its rational and economic character or otherwise. If “a weighted average of quantitative benefits multiplied by quantitative probabilities” is not available, spontaneous impulses rooted in moods (pessimism/optimism) are perfectly rational and economic. What Akerlof and Shiller themselves define as “a basic mental energy and life force” does not lend itself to characterisation as either irrational or uneconomic. Rightly or wrongly one feels that Shiller - the successful author of Irrational Exuberance (Alan Greenspan’s famous expression) - may have led Akerlof farther in this direction than he would have gone on his own.

Moreover what Keynes actually said or meant is immaterial, what counts is the validity of whatever today he is understood or claimed to have meant. All that remains of Keynes’ proposition about animal spirits today is the volatility of investment decisions, their dependence on “the state of the news” as well as the interest rate relatively to the perceived marginal efficiency of capital, or the internal rate of return of investment projects. (Keynes was wrong, here, to consider the expected internal rate of return of investments, instead of the expected present value per unit of investment as a suitable criterion; but not seriously wrong in so far as internal rates of return and present value criteria normally lead to the same screening of investment projects into profitable and unprofitable, though with a different ranking).

And what is irrationality in this context, anyway? According to the New Oxford Dictionary of English, irrational means: ”Not logical or reasonable. Not endowed with the power of reason.” As opposed to rational: “(of a person) able to think clearly, sensibly and logically. Endowed with the capacity to reason. … from Latin ratio, reckoning, reason; ... based on or in accordance with logic or reason”. In economic terms irrational can only mean: “knowingly and deliberately acting against one’s perceived interest” (my definition, for Akerlof and Shiller do not provide one; compare with Koppl’s “a person act[ing] contrary to [his or her] best judgment”).

True, economic agents can be and often are misguided: superstitious, gullible, incompetent; they may believe in dreams, ghosts, miracles, magics, Unidentified Flying Objects, kidnapping by alien visitors, metempsychosis, after-life punishments and rewards, luck and unluck; horoscopes; the ability to predict lotto or roulette numbers from their recorded infrequency, and to predict stock exchange trends by drawing charts; casting the evil eye and getting rid of it, love potions; proteins-only diets, homeopathy, aromatherapy and acupuncture. Economic agents may be addicted to drugs; suffer from mental illnesses; be psychopaths. These phenomena and their intensity and distribution are all aspects of society’s history and culture, but do not necessarily imply irrationality in the sense of “knowingly and deliberately acting against one’s perceived interest”. They are data like the state of technology or the distribution of primary resources; they only matter when they change rapidly, radically and systematically. There is method in human action, no matter how mad humans are: even the actions of masochists are ultimately directed towards the pursuit of their happiness. I for one am completely indifferent to whether or not the three empty boxes that worry Akerlof and Shiller are ever filled or remain empty.

Expectations are most certainly never “rational” in Lucas’s terms. This does not make them “irrational”, though: there is a long-standing tradition in the theory of expectations - rigid (tomorrow’s values like today’s, as in the cobweb or pigs’ cycle), regressive (tending to return to a normal value when falsified, as interest rates in Keynes’s liquidity preference), extrapolative (projecting past rate of change into the future, perhaps the most common model), adaptive (adjusting expected change to the degree of success of the last prediction), with any number of lags and distributed lags. And of course often expectations are self-fulfilling. None of these expectations models can be said to be “irrational” or “uneconomic”. The question is whether one or another expectations model is right or wrong, or at any rate performs satisfactorily or does not, in a particular market at a particular time and place.

An alternative to Akerlof’s and Shiller’s five animal spirits

Is the concept of animal spirits the only unifying approach, or let’s call it umbrella, for the five phenomena which Akerlof and Shiller characterise (exhaustively, one presumes) as animal spirits? Namely, “confidence, fairness, corruption and antisocial behaviour, money illusion, and stories”? Suppose instead that we choose as a unifying approach a fairly conventional “intertemporal allocation”, and split this into “expectations, aspirations, enforcement of contracts and laws”. Do we miss out anything of all the things that Akerlof and Shiller include under the allegedly innovative five categories of animal spirits?

We do not. Confidence issues arise primarily in an inter-temporal framework, that must be backed by means of inter-temporal contract enforcement, if only to reinforce confidence; while simultaneous bilateral transactions only require a minimum of law and order. Fairness is a question of aspirations, which may be inconsistent in the judgement of several agents, something that is otherwise missed when we talk of fairness tout court. Corruption - which Akerlof and Shiller use not so much in the sense attributed to it by Transparency International but as associated with antisocial behaviour - is covered squarely by our notion of law enforcement; it is true that antisocial behaviour is a broader concept, for it would include also moral hazard, i.e. opportunistic behaviour, but this is a first and most conspicuous omission from the analysis offered by Akerlof and Shiller, so they would not miss it. Money illusion, especially in the way it is used by A&S in the inflation-unemployment trade-off, is precisely a matter of expectations and aspirations, and would be well covered by our alternative framework. [Incidentally, here there is second inexplicable omission from A&S, namely the principle of Central Bank Independence that is strictly derived from the lack of an inflation-unemployment trade-off, a lack that they rightly so strongly criticise]. As for “stories”, they are simply the experience (or presumed experience, that sometimes may have been wrongly distilled from available facts, or glorified into false myths) which is at the basis of expectations, nothing else.

Under the heading “Inter-temporal allocation”, and its three subheadings “expectations, aspirations, enforcement of contracts and laws”, one could still address the eight questions whose analysis is regarded as the pay-off of the theory of animal spirits developed by Akerlof and Shiller.

Eight Issues: 1. Depression

“Why do economies fall into depression?” Because markets do not guarantee inter-temporal efficiency, or rather because they guarantee inter-temporal inefficiency. Because savings depend on the level of income and investment on its rate of growth, so that their equilibrium is not necessarily automatic and anyway takes time. Because of the interaction between the multiplier and the accelerator (Paul Samuelson once wrote that economics is the science of optimisation under constraint - except for the interaction between multiplier and accelerator - one of the most eloquent statements of the inadequacy of neoclassical economics). Because economic growth along the long term trend of population and productivity has a full employment ceiling, and a floor due to the fact that net investment and feasible subsistence consumption cannot fall below zero. As the ceiling or the floor are approached, without necessarily being hit, the growth slowdown turns into decline and the decline slowdown turns back into growth. Because booms cause wage growth thus carrying the seeds of their own bursting, while recessions depress wages and restore profit margins allowing the financing and the encouragement of new investment. Because on top of all this there is also the political cycle first investigated by Michal Kalecki. I am very happy with the Harrod-Domar knife-edge growth paths, Dick Goodwin' growth cycle and Hyman Minsky's financial cycles.

2. Central Banks powers

“Why do central bankers have power over the economy, insofar as they do?” Because on the basis of a faulty theory (of rational expectations and the associated denial of a trade-off between inflation and unemployment) since the late ‘eighties they have been given Independence from the government and discretionary powers over inflation targeting, while they are allowed to ignore the wreckage they often inflict on output and employment (the Fed is not so bad, because it is less independent and its remit includes also interest rates, employment and the exchange rate).

3. Unemployment

“Why are there people who can’t find a job?” Because in a closed economy (and the global economy is closed to the outside by definition) unemployment cannot necessarily be solved by lower wages, for these lead immediately to lower consumption, which may or may not be compensated for by higher investment - not least because lower wages will tend to lower also the investment intensity of new capacity. In the open traditional non-global economy these considerations apply to a lesser extent, but they are still operational if import and export weighted elasticities with respect to prices add up to less than unity.

Some unemployment is “classical”, i.e. caused by the lack of equipment in a quantity sufficient to employ everybody even at subsistence wages, or rather at the efficiency wages that minimise labour costs per unit of output. Some unemployment is “neo-classical”, i.e. due to the money value of the marginal product of labour measured at its competitive price being lower than money wage. Some unemployment is Keynesian, i.e. due to the lack of effective demand and to imperfect competition.

The most important cause of unemployment of all is probably imperfect competition - which does not gets a single mention in the entire ambitious theoretical construction by Akerlof and Shiller. For under imperfect competition producers will value the marginal product of labour not at its price but at its marginal revenue, which may become zero or negative well before full employment of labour is reached, therefore preventing full employment even if wages were flexible downwards right down to zero. Apart from the fact that even if the full employment marginal product of labour reckoned at its marginal revenue was positive, and the wage rate fell down to its level, entrepreneurs might regard as unrealistic - on the basis of experience - the continuation of such a low wage into the future, necessary to make investment pay, and still refrain from additional investment thus maintaining unemployment.

By comparison with this set of explanations, the one provided by Akerlof and Shiller is not at all satisfactory. People - they say - are perfectly willing to work for the wage rate per unit of time that would correspond to full employment, but then employers will take into account the positive feedback of higher wages on productivity (through higher morale of employees and the like), and will go and pay wage rates per unit of time higher than the full employment rate in an effort to reduce, indeed minimize, the wage cost per unit of effort, or for unit of product. At this higher wage rate, lots of willing workers remain unemployed. But this is just another form of a naïve theory of voluntary unemployment, because the implication is that the unemployed would be willing to work for a lower wage but would then supply a more than proportionally lower amount of effort or product. If this is the problem, there is a simple remedy: linking wages to productivity, but A&S do not take it into consideration. And their neglect of imperfect competition is a damaging omission in any serious discussion of unemployment.

4. The Phillips Curve

“Why is there a trade-off between inflation and unemployment in the long run?“ Because there is at least some money illusion, A&S say. This is one way of looking at it; more rigid inflationary expectations will also do the trick. Except that the question of whether or not there is a trade off is ultimately an empirical question, and empirical verifications of the Phillips curve linking inflation and unemployment are not particularly satisfactory.

5. Saving

“Why is saving for the future so arbitrary?” Because the inter-temporal trade-off between dated consumption of an individual or of households depends on too many, too uncertain factors, and on different responses. For instance people might save more at a higher (real? nominal?) interest rate, but a target saver will save less to obtain a given consumption transfer into the future. And there is absolutely nothing in saving behaviour to support the necessity for a positive real interest rate, as usually presumed by the Bretton Woods institutions. Here again, as for the Phillips Curve, it is not enough to note or even explain the erratic nature of saving behaviour, but it is necessary to positively identify and verify empirically the impact of the many factors that might be at play.

6. Volatile assets prices

“Why are financial prices and corporate investments so volatile?” This one is easy. The market valuation of the shares of a company, if market work, will correspond to the current dividend d per share, cumulated at its expected nominal growth rate g per year, and discounted at the appropriate nominal discount rate r. Thus the slightest change in the rates g and r expected to prevail in the future will generate disproportionate, massive changes in the share price. If both the expected growth rate g and the discount rate r were constant, and r>g, the price of the share will be equal to d/(r-g). If g>r the share price would tend to infinity with the time horizon tending to infinity. Conversely, the generalised downwards revision of g relatively to r (as in the bursting of the bubble) will precipitate a stock exchange crisis [With apologies to readers for an earlier ambiguous formulation of this problem]. This is the beginning of an answer. Add securitisation, originating assets not to hold but to sell, leveraged betting on derivatives (never mentioned by A&S as such) and a credit crunch, and Bob’s your uncle.

7. Real estate cycles

“Why do real estate markets go through cycles?” Because there is a cycle in building activity, just as there is in pig production or in general investment: high rentals lead to high capital values of existing buildings and to new construction; as new houses and commercial buildings are built their rental and therefore market value fall, and so on for the time it takes to reduce the buildings stock to an equilibrium level, which will then tend to overshoot. And for the same reasons of optimistic expectations, non sustainable asset price increases, the slowdown in capital gains leading to a decline in asset prices, etcetera etcetera in reverse.

8. Poverty Traps

“Why does poverty persist for generations among disadvantaged minorities?” From the impact of so-called stories of minority discrimination, - say Akerlof and Shiller - to be remedied by stories of positive role models and “affirmative action”, that “can play a a significant role in breaking down the barrier between the two Americas” (p. 164). But look at it another way, as Branko Milanovic does in a recent paper [“Global inequality of opportunity. How much of our income is determined at birth?”, mimeo, World Bank, February 2009]. “Suppose that all people in the world are allocated only two characteristics over which they have no control: country of citizenship and income class, within that country, of their parents. Assume further that there is no migration.” Under this premise, Milanovic shows that “at least 80 percent of variability in income of almost 6 billion people in the world is explained solely by these two characteristics. Thus, globally-speaking, the role of effort or luck in improving one’s income position, cannot be large. On average, “drawing” one-notch higher parental income class (on a twenty-class scale) is equivalent to living in an eleven-percent richer country” (Milanovic, op.cit.). This makes A&S’s concern for disadvantaged minorities pale into insignificance. And let there be no doubt that Milanovic’s kind of explanation and analysis rests on no notion of animal spirits.

The current crisis and its remedies

A post-script to Chapter 7 of Akerlof and Shillers includes their analysis of the current crisis and policy recommendations. This is one of the best parts of the book, but their kind of analysis is by now more and more widely accepted. It does not sound very different from, say, the analysis by one of the most conventional, shrewd economists around: the ECB President Jean-Claude Trichet, [“The ECB Enhanced Credit Support”, a keynote address given on 13 July 2009 at the University of Munich].

The only original new remedy proposed by Akerlof and Shiller is a credit target, in addition to the traditional interest rate and fiscal stimulus. “The aggregate demand target will indicate, on the one hand, the fiscal stimulus and interest rate policy needed for full employment. The credit target will show what judicious application of methods 1, 2, and 3 [respectively: expansionary discount window, direct investment in banks, and use of government sponsored enterprises] must achieve: together they must create the financial flows - the issuance of commercial paper, bonds and other instruments - that are also associated with full employment” (p.96). And “of course the two target approach and Humpty Dumpty [meaning coping with the irrevocable fall of financial markets, see also earlier reference] do not apply only to the United States but internationally as well” (Ibidem).

The alleged originality of the animal spirits theory that Akerlof and Shiller have been developing in their book is exposed as another way of speaking of what is well understood in standard analysis.