New thinking in Economics: Getting out of the financial crisis

Written by Vernon Cheung

March 29, 2012

In 1929 we had the Great Depression which inculcated a whole generation with common sense and prudence. This was followed by an era of stability until the Great Inflation of the 1970s following the various oil shocks. Once inflation was brought to heel, we had the Great Moderation where many economies experienced low inflation and high economic growth.
So economists thought they had it all figured out. A well-known monetary economist, Frederic Mishkin wrote in 2007 that managing the economy has become as mundane as the work of a dentist. Then in 2007 we experienced the Great Financial Crisis.

Suddenly economists realised that conventional monetary policy cannot stabilise everything. Low inflation led to low interest rates, but this created incentives for banks and investors to take more risk by borrowing as much as possible. More risk-taking led to prices of financial assets rising to unsustainable levels. Monetary policy turned out to create the very financial instability it sought to avoid.

When the bubble finally burst, conventional monetary policy turned out to be virtually useless. Banks did not want to lend. Interest rates worldwide fell to almost zero, and could not fall much further. Increasing money supply (so-called quantitative easing) had little impact as this additional money was simply hoarded in the form of gold and cash holdings. Governments stepped in with increased government spending financed by increased borrowing, and many ended up (or are heading for) a debt crisis.

Did they really expect to get out of the crisis so easily? These solutions may have worked for the Great Depression, but conditions are quite different now. One does not solve a financial crisis, caused by debt, by creating more money and extending even more credit. This merely sets us up for an even bigger crisis in the future, as George Soros is already predicting.

What is needed is old-fashioned common sense. Build up reserves in good times and draw them down during the bad times. This is what the recent Basel III and macroprudential policy is about – improving the capital adequacy and liquidity of banks and introducing counter-cyclical measures to make the whole financial system more resilient. Obviously many commentators and banks don’t like this as they say it will constrain economic growth – but that is the whole point.

There are no more “get out of jail free” cards. Keynes gave us one with his idea of public works programmes after 1929, and Milton Friedman gave us another one with his idea of money supply rules in the 1970s. But what is left now is to take the pain of an extended recession, pay our debts and live within our means. Hardly something you need an economist to tell you, but certainly new thinking to anyone who cannot remember the Great Depression.

By Arnold Wentzel, Department of Economics and Econometrics, University of Johannesburg

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