Friday, May 16, 2008

Conversation with Steve Waldman; Act 3: Keyensian Logic and Bank Runs

From my running conversation on Steve Waldman's blog:

Steve,

Generally what I would say about that graph is that yes volatility in the U.S. economy plummeted just about right at the time of the adoption of (at least largely) Keynesian policies by strong central banks, and it stayed that way for over 50 years, right up to today, but was it causal or coincidental?

I would say it was almost surely highly causal, primarily due to information not in the graph – the very strong logic chains of Keynesian demand-crunch economics. And these are logic chains that rely only on extremely realistic and plausible assumptions. That's the strongest evidence. You saw a nice chunk of it in the Krugman baby-sitting co-op article, and to see a lot more and with great intuition I recommend again Krugman's books, "The Return of Depression Economics" and "Peddling Prosperity".

But other evidence for strong causation in the graph comes from timing, magnitude, and associated logic. The U.S. economy did become more large and diversified after the adoption of Keynesian policies in from about 1935 on, but it had been doing that to a large extent for the period from 1835-1935, and we saw no drop in volatility. The drop only came suddenly just about right at the time of strong use of Keynesian techniques by central banks. As far as political stability, stable periods like 1880-1910 had far greater volatility than during the Keynesian years.

One big thing, though, which did occur just about simultaneously with strong Keynesian central banking, was simply strong bank regulation, FDIC insurance, etc. This, you could argue, deserves the credit for the decreased volatility. A quote from the text, "Money, Banking, and Financial Markets", 3rd Edition, by Miller and VanHoose: "In the United States between the 1830s and 1930s, national banking panics seemed to occur in regular cycles of fifteen to twenty years." (pages 35-36). But nonetheless, again, the strongest evidence is the very strong logic chains of Keynesian demand-crunch economics.

I do think, like in any part of government, transparency is crucial (with, of course, a few exceptions, like some ongoing military operations), as are checks and balances. This can greatly increase performance. On that subject, another book I recommend is University of Texas Economist and Public Affairs Professor Robert Auerbach's new book, "Deception and Abuse at the Fed". I just got it and have only perused it, but it looks good. I think you'll really like it.