Learning to Live in a Not-So-Efficient World

|Peter Boettke|

Luigi Zingales has a very interesting paper entitled "Learning to Live With Not-So-Efficient Markets" that he published in Daedalus (Fall 2010).

Compare with my paper "What Happened to Efficient Markets."

Rajan and Zingales are consistently the economists who I find the most insightful throughout the recent policy debates over the Great Recession.  In Rajan's response to Krugman's critique of Fault Lines, he argues that what Krugman fails to realize is how the very policy responses we are choosing are not getting us out of the crisis, but sinking us deeper into it.  It was, Rajan argues, the policy response to the last crisis that created the conditions that caused this crisis.  Zingales's home page at Chicago has a complete collection of his various papers, op-eds, commentary, etc. on the crisis.  As he says in the preface to a collection of those, the past 2 years have been sad years for an economist who believes in the free enterprise system.

Make sure to read Zingales paper on "Capitalism After the Crisis", especially p. 33ff because he explains how free enterprise via very public choice type mechanisms became political capitalism, and that our current crisis is a consequence of political capitalism and the challenges that we economists have to face rhetorically and intellectually because of this.

Ultimately, what I think we are learning (if we care to learn it) from the crisis is the following:

(1) Keynesian responses (fiscal policy) to a perceived Keynesian crisis (aggregate demand failure) creates a Keynesian world of macroeconomic volatility;

(2) A monetarist response (monetary policy) to a perceived Keynesian crisis (aggregate demand failure) creates a Keynesian world of macroeconomic volatility;

(3) A neo-Keynesian synthesis response (fiscal and monetary policy activism) to a perceived Keynesian crisis (aggregate demand failure) creates a Keynesian world of macroeconomic volatility;

(4) 1-3 demonstrate the both the mythology of the Great Moderation as well as our response to the Great Recession has been the opposite of what we should be learning (see Selgin's recent EconTalk podcast for a discussion of the empirical record and the mythology of the Great Moderation).

(5) That the continued political efforts to prevent market corrections to a previous set of policy induced distortions turns those market corrections into an economy wide crisis, which in an interconnected world economy creates a Global Financial crisis.

Therefore, it is time to go back to pre-Keynesian economics and think seriously about the institutional framework (monetary and fiscal) that provides the pre-condition for individuals to realize the gains from trade, the gains from innovation, and create wealth and generalized prosperity.  What we find is that this is about secure private property rights, freedom of contract, free trade, sound money, and fiscal restraint.

Comments

[Jerry O'Driscoll]

I always enjoy Pete's Public Choice approach to issues. I endorse his conclusion that we must focus on the institutional framework.

I think many free-market economists who endorse an institutional approach are not consistent when it comes to money. The argument often is about policies (e.g., targetting nominal GDP) with only passing attention paid to monetary institutions. Existing institutions are assumed, not critically analyzed.

A classical liberal would never assent to the degree of discretion that the Fed possesses in other areas of policy. Some would argue that a "rule" would constrain the Fed. But the "rules" proposed are not Hayekian rules, but pieces of legislation.

Some argue for a constitutional monetary rule. But there is actually a provision in the US Constitution giving Congress control of monetary policy. Courts have so stretched its meaning, however, that it is interpreted as providing for the system of discretion and rule by men that currently describes monetary policy.

We need sound money and sound banking, and have neither. Their absence threatens the larger market economy.

[jsalvatier]

I don't think fiscal policy is a good idea, but I'm unclear on what recent evidence you think (1) or (2). Care to clarify?

[Pietro M.]

It is sometimes difficult to distinguish rules and discretion.

Let's assume a central bank, let's call it "European Central Bank" has one only target: medium-term inflation rate. A purely nominal target without any reference to the real economy.

Let's assume banks overstretch their possibilities and lend to unworthy borrowers by creating too much money supply (in the meanwhile, an increased demand for money because of the stock and real estate market rallies, higher investments, and higher raw material prices may arise).

After a while investments turn bad and are not returned. The banks are forced to reduce their lending and shrink the money supply.

The central bank sees this and cuts interest rates to zero to maximise the expansion of the money supply. This gives banks a free ride on money holders and bond holders.

It turns out, however, that this does not suffice. Then, to further increase the money supply, the central bank starts preventive monetization to enrich banks and improve their capacity of multiplying money, for instance by buying banks' assets such as "CMBS" and "sirtaki bonds".

Now, is the central bank following the rule? Yes.

Is it acting discretionary? Yes.

The problem is that there are hundreds of items to monetize, i.e., hundreds of degrees of freedom to give a free gift to banks, and only one target. The problem is ill-posed, because underdetermined.

A rhetoric of rule can mask a practise of discretion.

PS My point is not that inflation targeting is bad macroeconomic policy. My point is that a rule is not enough a constraint to avoid discretion. The Fed, without even having a rule, is in much worse shape.

[Silvano Fait]

Institutions matter. About fiscal issues there is a strong tendency to consider government as a technocratic and neutral agent or almost something similar. In debating about the Ricardian Equivalence theorem or about the effects of deficit spending, stimulus plan, etc. from a macroeconomic perspective there is a lack of considerations about the effects that could spring when the number and the volume of financial decisions made by elected official increase. Changes in spending decision are often assumed to be quasi linear or the effects on the future taxation are assumed to be easely predictable and unescapable. This even if everyone knows that some lobbies could gain more and other could lose, some group of people can reap political gains and other could try to ease the burden of the debts on less politically influent voters. And after, when cuts are needed, every beneficiary always found a rationale for his own receipts. "Government" can't be considered just like a simple variable that could be adjusted when datas change.
In short what I mean to say is that when we deal with the economic effetcs of political decision whe couldn't ignore the results and the way they are reached, on the dynamic efficence of the environment where they are taken.

[David Stinson]

"the continued political efforts to prevent market corrections to a previous set of policy induced distortions turns those market corrections into an economy wide crisis, which in an interconnected world economy creates a Global Financial crisis."

Very nicely put.

[Daniel Kuehn]

I'm with jsalvatier - I'm a little unclear on exactly where you're coming from on those first several points. It may be clearer to you than to others what you mean.

Your description of pre-Keynesianism is a little strange to me too - this sounds perfectly consistent with Keynesianism to me as a strategy for growth (which is how you present it). I would differentiate between Keynesian approaches to full employment (which are different from some - not all - pre-Keynesian ideas) and Keynesian approaches to growth, which aren't all that different.

[Doc Merlin]

"(1) Keynesian responses (fiscal policy) to a perceived Keynesian crisis (aggregate demand failure) creates a Keynesian world of macroeconomic volatility;

(2) A monetarist response (monetary policy) to a perceived Keynesian crisis (aggregate demand failure) creates a Keynesian world of macroeconomic volatility;

(3) A neo-Keynesian synthesis response (fiscal and monetary policy activism) to a perceived Keynesian crisis (aggregate demand failure) creates a Keynesian world of macroeconomic volatility;"

These points are worth their metaphorical weight in gold.

[Doc Merlin]

Wrt EMH, I think EMH is just a result of a zeroeth order approximation of the true efficiency condition, which is that markets are "efficiency seeking, or efficiency creating," not actually efficient.

[Barrie Real Estate]

The main problem in the recession of the economy is the division of labor. Some countries concentrated on capital intensive and some on labor. The income, demands and production are the forerunners that affect the growth of economy.

Barrie Real Estate