New Keynesian Economics Supporting the Fed's Views
In this installment, I will look at how standard macroeconomic models (business cycle models) evaluate an asset bubble.
In a standard business cycle analysis, be it New Keynesian analysis or neoclassical analysis, the financial system is likened to pipes connecting households (consumers and workers) and businesses through the flow of funds. It is considered a passive entity. The financial system itself is not assumed as a potential cause for significant economic change. Money, which is handled by the financial system, is given only a role as an accounting unit indicating nominal prices in standard models.
I could say that standard models have not been set up to handle the emergence and collapse of a bubble, which caused the current global financial crisis. However, new ideas have been introduced to standard models so that they can deal with asset price bubbles and financial constraints (e.g. a constraint on borrowings by businesses in accordance with land collateral).
For example, assumptions have been introduced that corporate capital expenditure is constrained by borrowings with collateral and that changes in the values of real estate and capital stock as collateral affect capital expenditure. Federal Reserve Chairman Ben Bernanke was one of those people who, during his days as a university professor, contributed to the refinement and fine-tuning of a standard model in financial terms. The prevailing view among the U.S. monetary authorities prior to the failure of Lehman Brothers tended to be negative toward the prevention of asset bubbles and to respect the freedom of markets. These views might thus be called the Fed's views. I could say that a model developed by Professor Bernanke and others gave a theoretical basis to the Fed's views. (Of course there have been contributions by different economists, including Nobuhiro Kiyotaki and John Moore and a model developed by Carlstrom and Fuerst, before the Bernanke model was established. Besides the model generated by Bernanke and others, Christiano, Eichenbaum, and Evans developed a standard model for monetary policy analysis, however, space constraints prevent me from going into detail here.)
Bernanke and Mark Gertler published an article in 1999. Their research used a computer simulation to determine how economies change as the prices of pledged assets move in a bubble, in a situation where corporate capital expenditure is constrained by borrowings with collateral. They created models with U.S. and Japanese economic characteristics and then ran simulations to compare how monetary policy responds in the presence or absence of a bubble situation. The simulation revealed the following: (1) Monetary policy does not change an economic situation whether it responds to an asset price bubble or not; and (2) If monetary policy is excessive in response to an asset bubble, changes in production and employment situations are exacerbated, and the costs added to the entire economy become larger (than if monetary policy does not respond to the bubble). Research into the New Keynesian model by other economists has shown similar results. Based on the findings, present standard models are interpreted as supporting the views that a monetary policy responding to a bubble (a monetary policy that raises interest rates when asset prices rise, even if general prices do not rise) should not be adopted.
If you do not prevent bubbles in advance, you have to address them after they emerge. The Fed view suggests that if an easy-money policy is implemented quickly and on a large scale after a bubble bursts, large economic costs can be avoided. They believed that the adverse effect of the bursting of a bubble is not a major problem unless the policy response fails (as it did in Japan). This belief was strengthened after Former Federal Reserve Chairman Alan Greenspan navigated through the bursting of the IT bubble and the market disruption after the 9/11 terrorist attacks with a bold and easy monetary policy.
Enormous influence of an asset bubble on operating funds
New Keynesian models, including the Bernanke-Gertler model, suggest that the bursting of a bubble does not have a very large adverse influence on the economy and that the cost of a bubble is small even without a policy response. (Hence the prescription that monetary policy should not respond to a bubble.) However, the bursting of a bubble actually incurs a tremendous economic cost, as the world experienced in 2008 and Japan in the 1990s.
My views are that New Keynesian models underestimate the adverse effects of bubbles because the models do not sufficiently factor in the role of money as a medium of exchange. There is another reason relating to this: the assumption of a model where capital expenditure is constrained by borrowings with collateral. In the Bernanke-Gertler model, bank loans that businesses take out for capital expenditure are constrained by collateral, and a bubble in pledged assets eases constraints on collateral and triggers increases in corporate capital expenditure. The standard model showed that the investment-inducing effect of a bubble is smaller than expected, so the effect of the bubble on the economy in the model is also small.
However, as I discussed in the fifth installment of the series (August 31 issue), if the operating funds (or the working capital) of businesses rather than capital expenditure are constrained by borrowings with collateral, it becomes a different story. Constraints on operating funds reduce investments in labor and intermediate goods and have a significant impact on productivity. In a computer simulation that our group carried out, we discovered that an asset bubble has a much bigger impact on the economy than in New Keynesian models if operating funds are constrained by borrowings with collateral. I believe the stereotypical view of standard models―namely the idea that constraints on funds to businesses should be constraints on capital expenditure―has lead to this bubble being underestimated.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the September 14, 2009 issue of Kinzai Financial Weekly
