Leijonhufvud on the Current Crisis

21 August 2011 at 3:55 am 1 comment

| Nicolai Foss |

We have often blogged on the work of Axel Leijonhufvud on O&M (here). Here is a 2008 talk which was given in Denmark (and which, unfortunately, somehow missed my attention at that time) on “Keynes and the Crisis.” The talk contains many characteristic Leijonhufvudian themes (smashing of Ricardian equivalence, representative agent modeling, and the foundations of financial theory), little on Keynes (luckily!), and much critique of monetarism, in particular the choice of the CPI as the unique target of central bank policies and the notion of the independence of central banks from the political system. Here is Leijonhufvud’s overall diagnosis of the root causes of the current crisis:

The process leading up to today’s American financial crisis had the dollar exchange rate supported by foreign central banks exporting capital to the United States. This capital inflow was not even to be discouraged by a Federal Reserve policy of extremely low interest rates. The price elasticity of exports from the countries that prevented the appreciation of their own currencies in this way kept US consumer goods prices from rising. Operating an interest-targeting regime keying on the CPI, the Fed was lured into keeping rates far too low far too long. The result was inflation of asset prices combined with a general deterioration of credit quality (Leijonhufvud 2007a). This, of course, does not make a Keynesian story. It is rather a variation on the Austrian overinvestment theme.

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1 Comment Add your own

  • 1. Bill Woolsey  |  21 August 2011 at 8:42 am

    I agree that this is a possible problem with CPI targeting, but nominal GDP never deviated far from trend.

    So, yes, the U.S. builds a bunch of houses with resources that would have been used to produce other consumer goods which are provided by foreigners. The foreigners sell the consumer goods to get money to lend to people who want to buy the houses.

    In retrospect, many people only bought the houses to sell them to someone else at higher prices. Some people could only afford them if they could sell them at higher prices. It was a bad investment.

    But why is this a monetary policy mistake?

    If an excess supply of money was pushing up the demand for capital goods (including houses) and the prices of capital goods (including houses) weren’t included in the CPI, and so the CPI showed no inflation, then we would have a problem. But higher prices and/or quantities of houses and capital goods show up in nominal GDP.

    And so, the excess supply of money should show up in excess growth of nominal GDP. But it didn’t. (Or at least, not much.)

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