Keynes the key to today's paradigm

Alex Millmow
October 16, 2008 - 12:06PM

John Maynard Keynes, not dead after all

THESE are hair-raising times for university economists. Perhaps it was the sight of French market traders in quiet prayer on the trading floor that threw us. Or perhaps it was the po-faced head of Lehman Brothers defending his massive payout.

Many would be speechless at what happened in the past three weeks. It reads like and certainly looks like one of those Hollywood disaster movies. Wall Street merchant bankers and their counterparts elsewhere, living and working in the temple of free-market capitalism, have destroyed their religion more than any socialist ever could.

A market failure in US financial markets has spread to the global economy. Last week, Western economies came the closest to the Great Depression, with markets gripped by uncertainty, inertia and fear. In response, British and US banks have been nationalised.

For university boffins, it is hard to come to grips that theoretic concepts such as the efficient-market hypothesis, the Ricardian equivalence theorem and rational expectations have been thrown out the window.

Even worse, Keynesianism is back. The talk is of reflation, not inflation. Instead of talking about government failure, we are talking about a market failure in the heights of capitalist economy.

I cannot help but notice that a new US economics textbook I am using does not have the words "depression" or "subprime mortgages" in the glossary. Yet "depression" and "recession" have been bandied around with gay abandon in the past few weeks. We have gone from one economic paradigm to another in less than a month. The world has changed.

It was John Maynard Keynes who noted that the market could be irrational longer than one could be solvent. It was Keynes who came up with the phrase "animal spirits" to describe how investors go stir-crazy with all the fear and uncertainty gripping financial markets and sharemarkets.

Keynes suggested that in such climes we would much prefer to be liquid or cashed up. This would result in the so-called liquidity trap that renders monetary policy totally ineffective. Japan experienced this in the 1990s. Even if an interest rate cut can be triggered, there is no guarantee that it will deliver any stimulus. Keynes would have backed the bail-out and governments shoring up their banks. He would have added his blessing to Kevin Rudd's pre-emptive fiscal stimulus to keep the economy from falling into recession, though he might think that the Prime Minister acted a little prematurely.

Is it the case that our official economic forecasters know a little more than we do? Are our big banks as squeaky clean of toxic debt as they say they are? English economics commentator Will Hutton suggests that the Big Four would have been using the same business model as the afflicted Royal Bank of Scotland and HBOS.

It is better, Keynes figured, to be in a semi-boom than a semi-slump. The generous assistance to the first-home buyers' scheme is designed, along with last week's interest rate cut, to bolster the property market and housing construction that had begun to wilt.

The only Australian academic economist who has been airing his views on the crisis is Steven Keen of the University of Western Sydney. He has been pushing the debt overhang thesis based on the theories of Hyman Minsky. Keen has been going around saying that Australian property prices are way out of kilter with median incomes and that a major readjustment is on the cards. He has put his money where his mouth is by putting his Sydney house on the market and renting.

Whether the great game of borrowing money on rising property prices has come to an end is yet to be seen. It might be that Rudd's revamped housing assistance scheme will defer the inevitable adjustment. US property prices have plummeted and there has been a 12% fall in house prices in Britain.

If local property prices were to go the same way, Australia would be sucked into the recessionary vortex sweeping the world. Once we saw net equity slip, the days of consumption expenditure afforded by wealth effects, and financed by equity loans, would be over.

The winner of this year's Nobel Prize in economics, Paul Krugman, is probably the most Keynesian-orientated of the galaxy of US academic economists. The economic geographer, who is an Ivy League professor and an opinion writer at The New York Times, knows how to connect with a broader audience. He was warned by his colleagues that writing for the popular press would be detrimental to his academic gravitas! Krugman has praised the British solution of buying equity into troubled banks as the way to unblock credit markets.

A few years ago, Krugman wrote a book called The Return of Depression Economics. It will no doubt be rushed back into print.