We need additional macroeocnomic theory to combat the crisis

Comments on Michael Lind's commentary "Domestic disturbance", 24-5/04/2009, on http://www.businessspectator.com.au/bs.nsf/Article/Neglecting-domestic-duties-pd20090424-RE4TC?OpenDocument&src=sph

Whether it is two presidents in price, two Obamas, or one Obama in two situations, it reflects the sharp contrast between the degree of difficulties in handling the American foreign policy and its domestic economy at this particular time and in this unique situation. The unique situation has been that America was facing two disasters - one domestic financial and economic crisis, the other foreign policy crisis. The latter had probably been unprecedented. The former, however, was not as bad as the Great Depression, though very close to it. These two crisisses were very serious and their combination at the same time was unique.

In this particular unique case, whether there had been precedencies, however, is not an indication of the degree of the difficulties in resolving them. The American foreign predicament, though unprecedented, was relatively easy to remedy, the president only needed to do normal things in that area as most presidents could have done, and that is just what he has done. The task itself does not need to be innovative and is relatively easy, so to speak.

To resolve its domestic financial and economic crisis, on the other hand, is very different and not so easy. It will require some innovation and new approaches to achieve. This is because that there are some seemingly unprecedented policy vacuum areas in this case, although there has been the Great Depression as a precedent and we had some well established macroeconomic policy tools like fiscal and monetary policy instruments that were not available during the Great Depression. These main macroeconomic policy tools have often been adopted by government to increase the aggregate demand when demand from the private sector fell short and their success has been a mix. When they were mostly successful, the causes of the problems were correctly diagnosed and the policy tools correctly applied to the situation. When they were unsuccessful, either one of them or both went wrong.

The current crisis originated from the realisation of problems of sub-prime mortgages, worsened by declining housing and equity markets. That was further exacerbated by high leverages of most financial institutions and also assisted by the close international connectedness of most large financial institutions. All those caused the collapse in confidence. The realisation of financial losses, especially under the mark to market accounting standard, the need to de-leverage and recapitalise and a move to risk aversion resulted in a severe credit crunch not only in the US but also internationally. The collapse of some large financial institutions further worsened the case.

The two main conventional macroeconomic policy tools, namely fiscal and monetary policies can be effective to boost the aggregate demand to a degree when addressing a shortfall in the private demand in what I would call is relatively conventional demand deficiencies. The current crisis, however, has some unconventional features in that many financial institutions simultaneously require very large amount of capital injection and some of them may have been insolvent.

This is where the degree of the difficulties in dealing with it rises. Fiscal policy can only reach a certain degree in boost demand due to inevitable constraints. Monetary policy can only be effective when the interest rate is positive and the authority can further reduce it to lower financial costs. Both were probably implemented to their maximum degree. After that point, the authorities began to apply some what they call non-conventional policy methods. This is innovation mostly on the Federal Reserve’s part under its chairman who is an expert in studying the Great Depression and has been willing to try new approaches, although other authority figures may be tied too much with either conventional approaches or failed practices. This should be commended. But so far it appears that they have been met with a mixed success at the best and there could be very high costs due to these policies and methods.

There is a need to apply more non-conventional and effective approaches. It also needs to be applied in a manner to minimise the costs to the point which are unavoidable. This requires an extension or expansion of the Keynesian theory and approaches. We are eagerly waiting for this to emerge, but it should not be too long to come. 26/04/2009, 0:35 am.