Saturday, November 28, 2009

Keynesianism & Asset Price Bubbles

I hinted in the last post that if the budget deficit had been larger in America, then the housing bubble wouldn't have been as big. I now see that the "Stumbling & Mumbling" blog has made a similar argument.

To state the argument in more explicit terms: The housing bubble was the result of too low interest rates, something which encouraged lending to the housing sector which fueled the housing bubble. While some observers have tried to blame Bush's deficit spending policies for the bubble, it may in fact have limited it. The reason for that is that budget deficits, all other things being equal, drives up interest rates, and also bids away resources to the receivers of deficit spending. Both of these mechanisms helped bid away resources from the housing sector and thus limited the bubble.

Now, budget deficits are bad too, so acknowledging this certainly doesn't mean that deficits are always net beneficial even during asset price bubbles. But it does mean that a deficit during a boom create a causal relationship which is countercyclical and limits asset price bubbles, which in turn means that the Keynesian aggregate demand analysis is not correct.

This is quite similar to the problem facing monetary policy. Standard Keynesian analysis says that the currency appreciation caused by higher interest rates will help policy makers contain booms. However which in turn will enable more imports while reducing exports, and so reduce savings and increase borrowing. That in turn will aggravate the imbalances associated with an inflationary boom. This will to a large extent counteract the stabilizing effect of higher interest rates and for really small countries like Iceland this effect could even be bigger. For bigger countries like the U.S. or the U.K., the interest rate effect will by contrast be larger, but even here the exchange rate effect will counteract part of the interest rate effect.

The common theme here is that the Keynesian analysis by focusing on the direct effect on aggregate demand misses the way in which government budget balances and exchange rates affect savings and investments, and that standard Keynesian policies for that reason are less effective or even counter-productive when it comes to stabilizing the business cycle.