|Janet Yellen - she's a pussycat|
To recap John Maynard Keynes Keynes's published his magnum opus, The General Theory of Employment, Interest and Money in 1936, the work served underpinned economic management in the fifties and sixties but went out of fashion during the era of stagflation in the late 70s and 80s. But like the yoyo the General Theory bounced back into fashion after the credit crisis of 2008 and has been used as a justification for the interventionist policies during this recession.
Keynes’ great break through was the concept of price stickiness – the recognition that in reality workers often refuse to lower their wage demands even in cases where a classical economist might argue it is rational for them to do so. This price stickiness in the labour market, helped establish that a shortage of "aggregate demand" may also lead to a shortfall in "aggregate supply", the combination of which may lead to mass unemployment – and in those cases, it is the state, and not the market, that we must depend on to boost supply (public spending). This price stickiness reached its zenith in the 70s when trade unionist preferred to see factories and pits close rather than see wages fall; and when business owners preferred to close plants down rather than invest for the future. But strangely this was accompanied with very high inflation, which contradicted the General Theory.
Keynes believed that without government intervention to increase expenditure, an economy can remain trapped in a liquidity trap where there is a perilous shortage of aggregate demand. Unfortunately for Keynes both Thatcher and Regan proved him wrong by dealing with the unexplained inflation and reinvigorating their respective economies with a mixture of monetary policy and deregulation. To this day Keynes still divides opinion with policy makers and central bankers. The key issue is whether the economic cycle and our response to demand shocks should be predicated on increasing demand through government intervention – more public spending (and borrowing) or whether we should rely on monetary instruments – interest rates and printing money.
To be fair to Ms Yellen she has spent much of her career modifying the Keynesian model to deal with the uncomfortable truths that emerged in the 70s and 80s, and she has allowed some of the monetarist thinking to enter her, not inconsiderable, intellect. Despite this mellowing her concern about the wastage associated with high unemployment has been the preoccupation of her working life. The compromise between Keynesian and Classical is best illustrated with this quote from Janet Yellen.
Stabilisation policy can significantly reduce average levels of unemployment by providing stimulus to demand in circumstances where unemployment is high but underutilization of labor and capital does little to lower inflation. A monetary policy that vigorously fights high unemployment should, however, also be complemented by a policy that equally vigorously fights inflation when it rises above a modest target level.
The new problem that Keynesian economist or Neo-Keynesians have to grapple with is the globisation of markets and capital. The huge flows of capital that wash around the world’s highly liquid markets are a new factor in the economic cycle, as emerging markets have found to their delight and more recently to their cost. The problem for followers of Keynes is that a response to high levels of unemployment that forces down interest rates and raises debts may be the wrong signal to international investors. These flows of capital have certain advantages over public spending, as the capital is normally invested in programmes that mature relatively quickly and the flows don’t increase public debts and they help underpin the value of currencies.
The current debt crisis in the US is a very modern accident in the making – old fashioned policies of monetary easing and very high government spending has led to an incipient recovery; as the politics further undermines the US as the premium destination for the world capital we can expect US recovery to be slowed further. All this is going to make Janet Yellen’s job so much harder.
Apart from the tribal politics that Ms Yellen will have to contend with (if adopted) the main question I have is whether central bankers should tasked to implement policies to reduce unemployment or whether they should be concerned only with the level of interest rates and the supply of money into the economy. If you are an economist or a politician you should be interested in reducing unemployment but my guess is that we will be entering dangerous territory if politicians abdicate responsibility for levels of employment to their central bankers. Where does this leave the opportunity for politicians take ownership for the economy and to make the kind of bold moves that Thatcher made in the early eighties? The answer is that our politicians are increasingly becoming irrelevant to economic policy and that, whatever you think of their class, is a terrible mistake. If I was appointing a central banker I would make the remit quite simple:
• Make sure we attract our fair share of inward investments
• Keep inflation low whilst raising the necessary funds in the debt markets
• Keep the banks safe
• Leave everything else to the politicians