Saturday, September 27, 2008

ISLM and the crisis

Arnold Kling at EconLog wonders if there's a macro model that we can use to explain the crisis.

I've been explaining the crisis to my class as a drastic increase in Money Demand - in demand for extremely liquid assets and a rejection of bonds. Flight to quality, rise in spreads, etc.
Could the Fed have dealt with the crisis via monetary injection? No, for the reasons that Arnold mentions ("a capital trap"), ...but also because a) they were too close to a zero nominal interest rate for comfort and b) they were aware of the fact that monetary policy is too broad an instrument (may generate inflation) even if it had been effective.
Finally, as he well knows, the fact that it isn't in undergraduate textbooks doesn't mean that Bernanke's (1983) analysis of the non-monetary factors in the Great Depression is a "theory no one has ever studied."
Today's US crisis, I am sorry to say, is a sad repetition of every post-financial de-regulation crisis that scourged the emerging markets in the last 15 or so years. It's amazing to see what we haven't learned ... and yet, we have. The people at the Treasury and the Fed (and in Cambridge, MA) dealt with this kind of problem, made mistakes, and are applying quite a few of the lessons.
I hope that another lesson we don't forget is that which the work of Tornell and Westermann (2008) has demostrated: financial liberalization is more risky - no doubt about it - but also the path to greater growth. As Greg Mankiw points out, there are some who would have us forget.

1 comment:

Ignoramus said...

Thanks for this extremely informative blog!

It seems that the one word "regulation" can cover a whole host of governmental realities. No reasonable person would say that all government regulation of the economy is bad--for example, that the government should allow people to print their own money--and yet many reasonable persons seem to allow that such a thing as burdensome and counterproductive regulation does exist.

Is there any clear way to state what kind of regulation is bad and what kind is good? Examples are easy to come up with, but a general principle eludes me.