Crisis section

Crisis section
Gödel's Money : The future of freedom and civilization
- Macroeconomic Policy and Measures for the Financial System -

Senior Fellow, RIETI

Ninth installment

Is Economics Useful? (Part 2) - Lucas' Insight

Non-constructive dichotomy

The debate between Prof. Paul Krugman and Prof. John Cochrane of the University Chicago is showing signs of becoming a sort of non-constructive dichotomy. Prof. Krugman argues that, "Modern economics insists that the central bank would manage to moderate economic cycles with its monetary policies alone on the premise that the market hardly ever fails, which has now been proved to be incorrect. The financial markets have turned out so unstable and therefore unreliable that the government had to launch a fiscal stimulus package. In response to Prof. Krugman, Prof. Cochrane points out that, "Keynesian economics should not claim that it has ascertained the causes of the current financial crisis (only because modern economics failed to predict it) and the fiscal policies have not yet proved to be effective in solving the financial turmoil. Prof. Krugman argues with political intent to convince people into supporting the governments' fiscal actions by willfully trying to discredit other economists. It is not fair at all.

After all, neither Prof. Krugman nor Cochrane discuss the root causes responsible for the current financial crisis or solutions to it, instead they are just trapped in a stereotypical debate between Keynesian and neoclassical economists. Interesting as it might be, it has nothing to do with analyzing the current financial crisis.

What do mainstream modern macroeconomists consider to be the cause and nature of the current financial turmoil? Prof. Robert Lucas of the University of Chicago, who developed a paradigm in modern macroeconomics based on the general equilibrium theory, delivered a speech at Seoul National University on September 18, expressing his view on the financial crisis. Lucas was in fact the person who made Keynesian economics obsolete in 1970s, and therefore is on Prof. Krugman's blacklist to victimize in his writings. Incidentally, Prof. Krugman is a scholar, who has specialized in foreign trade theory and regional economics, for which he was awarded a Nobel prize, but his achievements as a macroeconomist are limited. Perhaps it is because Prof. Krugman, well known as being less familiar with macroeconomics, lacks an understanding of modern macroeconomics (as Prof. Cochrane claims) that he so fiercely attacked it.

Prof. Lucas' point of view is not dogmatic at all. Unlike the mainstream economists ridiculed by Prof. Krugman for believing that, "the market always works perfectly" or that, "failures by the White House and the Fed are to be blame for the financial crisis," Lucas never goes on with such abstract nonsense. Instead, he is realistic and well balanced giving us a sense of security with his modest assessment.

Lucas' assessment - the "evaporation of money" at the heart of the crisis

Prof. Lucas describes this financial crisis with just one phrase, "the evaporation of money." Money as medium of exchanging goods evaporated all too soon, which hindered the economy from functioning and allowed this recession to occur. This can be compared in nature to the Great Depression in the 1930s. Prof. Lucas pointed out in his speech that in those days, money deposited with banks (herein comparable to "money" in circulation in the markets) had dropped sharply. A chain of "bank runs" had caused this plunge of money in circulation. With no protection available for their deposits at the time of the Great Depression, people rushed in a "me-first" manner to their banks to withdraw their deposits because they feared the banks would fail. As a result, money (i.e. bank deposits) evaporated across the economy.

As Prof. Lucas continues, the federal deposit insurance system came into force in 1934 following the enactment of the Glass-Steagall Act of 1933, which also separated commercial banks from investment banking activities to prevent banks from taking too much risk, to create the banking regulation system. It served for decades to prevent a recurrence of such a depression (as a storm of bank runs sweeping all across the nation), however, deregulation in recent years removed the fire wall between commercial banking and investment banking, and with the development of financial engineering the market environment deteriorated so much that banks began to overextend themselves.

This current financial crisis has not seen people rushing to their banks to withdraw deposits thanks to the FDIC protection. However, banks' short-term liabilities not covered by the FDIC shrank so drastically that financial institutions faced difficulties in the rollover of short-term borrowings and were forced short of money. Banks' uncovered short-term liabilities, substantially similar to the depositary liabilities (at the time of the Depression), caused the credit crunch by "bank-running" participants in the short-term money market. The money transactions (as short-term liabilities) grown gradually outside the regulatory purview have become vital for normal economic activity. Money as such was withdrawn by creditors worrying about the insolvency of financial institutions as they faced deteriorating balance sheets due to the housing bubble collapse. Consequently, money evaporated across the economy all too soon. This is Prof. Lucas' assessment of the situation.

Prof. Lucas is very flexible to show a positive response to the measures taken against the current financial crisis by the U.S. administration and the Fed: (If he were something like the typical neoclassical economist that Prof. Krugman ridicules, he would dogmatically have refuted these governmental interventions.) Why not pump up money to revive economic activities once it has dried up in the market? The unprecedented rescue actions by the Federal Reserve, looking extreme though, was a relief policy based on a diagnosis that a central bank should supply ample liquidity for the economy in case the financial markets fail to maintain it, and, in fact, badly needed in the advent of this crisis. To the end of supplying liquidity, it does not matter whether the policy launched is a fiscal policy or a monetary policy. When supplied in an economy suffering from a shortage of it, money pumped in does work in itself, whether it is through governmental subsidies or public spending or loans from the central bank. Prof. Lucas is not a dogmatist who denies the effectiveness of fiscal policies, but rather agrees to admit they relieve the economy from the crunch with money evaporating in the financial crisis.

No matter how modestly Prof. Lucas confesses that he does not intend to claim he has made a new scientific discovery, he has an insight that, the current financial crisis, in essence, was caused by the evaporation of money, i.e., the medium of exchange, through a mechanism similar to a bank run. Prof. Lucas' view of the crisis overlaps with my own and it is this theme that I will pursue in this series of articles.

* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the October 12, 2009 issue of Kinzai Financial Weekly

January 21, 2009

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