I have blogged before about who did, and who should have, foreseen the credit crunch. Brad Delong has a lengthy quote of Michael Musa, that is the best pre-crunch explanation of what went wrong that I have seen yet.
What is so good about this is that it is a relatively simple explanation, from 2004, that accurately describes what happened.
Remember when how low inflation was regarded as a great triumph of central bankers (especially Greenspan)? Musa points out that this leads to high asset prices (see NPV). If monetary policy is tightened too soon (i.e. raising interest rates) to keep asset prices down, the this can lead to an unnecessary recession.
If policy is tightened too late, then the asset price bubble becomes larger. The choice then is to either try and keep the bubble alive, or too deal with the collapse of the bubble. Keeping the bubble alive will just defer the problem. As for dealing with a collapse, that is what we are seeing at the moment.
Comments
Robin SooleHi Graeme,
That is a fascinating link to Mussa. Thanks. It is a shame that he also does not suggest the correct policies and measures that should be used to guide us to a sustainable recovery (instead of the immensely misleading measure of GDP that today’s governments like to use).
I have to ask, is a recovery that is based solely on the extraordinary profit of moving gigantic amounts of money around (apparently only benefiting those who least need it) really a sustainable economic recovery? I really, really struggle to see what has actually changed in the last two years which speaks of a new economic revival.
Please someone tell me?
Every time I see the words “Cash For Clunkers” I keep thinking that people are being paid to buy yesterdays clunkers to get them off the showroom floors. In two years time these cars will look distinctly old fashioned with all the new developments out there (230 miles to the gallon – pull the other one, GM).
Still I can’t really complain. If some consumers want to satisfy their ‘pent up demand’ for yesterday car models, which will go down in value by half within a year, then that leaves more real assets available for other people to buy. Hooray :-)
GraemeI think moving money around does move the economy - Keynsianism works recessions.
The questions are sustainability and long term consequences. A double dip recession is possible, the damage to public finances will take years to repair, and the moral hazard of banks that are too big to fail has been exacerbated.
Robin SooleWell, moving the economy is one thing, but you must also pay attention to the direction. Sometimes straight up, propelled by a big rocket pack and no steering, might not be the best way to get you back on track.
Right now, the world governments are desperately trying to move the global economy back to where it was at the middle of 2007 albeit on a smaller and more maintainable scale. Is this a good economic model?
This is a model where efficient use of finance (read ‘tax avoidance and other scams’) makes more profit than actually running a good business. How is this going to help us avoid the worlds rapidly approaching crisis’s is water, food, energy, demographics and climate change? Perhaps a government led initiative which made it genuinely more profitable to find practical green solutions would help inspire the new economic revolution that is needed.