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Bretton Woods Blogging: Old Economic Thinking Is New, or Is It that New Economic Thinking Is Old?

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Mark Thoma cracks:

Economist's View: Re-Kindleberger: I've learned that new economic thinking means reading old books.

Okay, that's not quite fair, but one of the themes of the Institute for New Economic Thinking conference I'm at has been to reintroduce economic history into the undergraduate and graduate programs. As I've noted here many times in the past, I think that's a good idea, and not just a course on the history of economic thought. There's also a lot to learn from studying the economic history of the US and other countries.

Actually, it's not not quite fair. It is fully fair. Take, say, yesterday morning's panel with Carmen Reinhart and Richard Koo--both were making arguments the logical structure and framework of which seemed to me to be straight out of Walter Bagehot's Lombard Street. And Lombard Street was published in 1873.

Richard argued that--just as in Japan in the 1990s--the collapse of asset values had created a world desperately short of financial assets, in this particular case savings vehicles of moderate and long duration. The impairment of balance sheets thus left households and businesses anxious to cut back on their spending in order to rebuild their balance sheets. Since the interest rate could not fall any further to clear the market for savings vehicles, recession followed. The recession would, he said, last until and unless the supply of financial assets to serve as savings vehicles rose to levels consistent with financial-market demand. And government could materially accelerate this process if it stood up while the private sector was standing down: if it spent, invested, and borrowed in order to boost the market supply of savings vehicles.

Carmen by contrast argued that the world was desperately short not of savings vehicles but rather, due to overleverage, of safe financial assets. We had an excess supply of risky and leveraged financial assets and an excess demand for safe financial assets. Hence households and businesses cut back on their spending to try, in vain, to build up their holdings of safe financial assets that just were not there. Hence recession.

What did Carmen say could be done? Nothing. The privates cannot accelerate the deleveraging process because nothing they do can transform risky into safe assets right now. And if the government tries to do so it will crack its status as a safe debtor and we will have a bigger sovereign debt crisis on our hands which will make the recession worse, Basically, we are all Austria and it is 1931.

Of course, financial markets do not think we are all Austria and it is 1931. They think that Iceland, Ireland, Greece, Portugal, and Spain are Austria in 1931--and they are right.

My view is that Richard Koo is right, and economic core governments should be frantically engaging in expansionary fiscal policy right now until the wake-up call from financial markets comes, and then they should stop.

The main takeaway point, however, is that this is all the macroeconomics of 1873.