A tale of two Crises: Keynesianism, monetarism and the mistakes of modern macroeconomics

The British proverb “horses for courses!” is a reminder, we are told, that you need to choose the correct people for any particular task; there is no “best team” only the right team for the circumstances.

So too—or especially so—with macroeconomics. Unlike the physical sciences, where outcomes are invariant to the political or social greenscreen, macroeconomics is all about context. It is all about choosing right framework for the situation at hand, or “choosing the right metaphor.”

And as the contours of the post-pandemic macroeconomic landscape begin to take shape, a failure to pick the right metaphor is emerging with echoes of the post-GFC narrative—revealing the possibility of a policy mistake every bit as consequential as that committed during the recovery from GFC.

Post-GFC: A failure of fiscal policy

The contrast runs roughly as follows. Post-GFC was all about rediscovering Keynesianism and the importance of fiscal policy—in a roundabout and belated way. 

It started with the (correct) fiscal expansion early after the financial crisis. But it ended with fears about debt sustainability (remember Greece?) and austerity. This then led to a period of miserable, sluggish growth—and ended with populism in key Western democracies of the kind that Keynesianism was invented to avoid. 

In other words, post-GFC austerity was a failure of macroeconomics and the eventual rediscovery of Keynesianism.

Post-pandemic: A rediscovery of Monetarism?

Our current landscape is very different, of course. The post-pandemic vista is one where household balance sheets, unlike post-GFC, are stronger than ever (setting aside distributional issues.) It is a world where fiscal policy is more supportive of the recovery (though not all countries.) Knee-jerk fiscal sustainability concerns have been set aside—for now at least. The government balance sheet is playing the role of shock absorber.

Still, that post-GFC failure to recall the lessons of Keynesianism could just as easily give way to the post-pandemic failure to understand the lessons of monetarism.

Let’s step back a moment. The pandemic required an unprecedented fiscal response—meaning saving by households in sheltered industries has been “intermediated” to those working in unsheltered sectors. Alongside this fiscal response, monetary policy through “quantitative easing” de facto required private sector saving to occur through monetary vehicles—that is, household saving has found expression through monetary financial claims to an extent not seen since wartime.

This step increase in monetary claims implies improved net worth of households—whereas post-GFC was about impaired household balance sheets, post-pandemic is about balance sheet strength. And so, whereas post-GFC required a rediscovery of Keynesianism, post-pandemic might bring a revived appreciation of monetarism. But will mistakes emerge on the way?


What happens when there is a discrete jump in the money supply—an improvement in net worth of households, of “outside assets” of the community as a whole? Well, as Tobin explained half a century ago: “If the economy and the supply of money are out of adjustment, it is the economy that has to do the adjusting.”

In other words, since this is outside money, the economy will have to adjust to stronger household balance sheets. Typically, we might think of adjustment of the deflator for money supply being the price of consumer goods—which is already underway—to leave the real money holdings eventually unchanged. But we might also imagine asset prices—house prices, used cars, crypto, other assets—also jumping to deflate the increased nominal stock of money. After all, what is the correct deflator for money holding? Why only consumption goods?

So far so good.

But what happens next? It’s useful to first dispel the myth that the pandemic saving will be “spent.” This might be true for the individual or household, but for the community overall this saving (unless, e.g., used to repay outstanding bank credit in the aggregate) will remain in circulation—only passed from one individual to another. 

That is: when some central banks talk of saving being “spent” once the pandemic ends (ECB and BOE for example) what they really mean is: the act of saving from the pandemic will be passed between actors within the private sector. To a first approximation, the money stock increase will not reverse because of spending. But that stock will support a greater volume and variety of underlying flows.

And as this spending is unleashed the price of currently produced goods and services, as well as asset prices, will adjust higher to reflect this new money stock. It’s already happening. As I sit here in England, house prices are giddy, a pint of beer and side of sausage roll will come to nearly 10 pounds, and milk by the pint is only available at a price that would make your mother red-in-the-face. 

But two things should be clear. First, the additional price pressure from the pandemic saving—which is, in any case, concentrated disproportionality with the wealthy—will only find partial expression in consumption goods. More likely, it will be capital goods that make money balances “balance”—as Tarquin’s school fees are sorted for the next 12 months and Sophie gets that conservatory she always wanted. 

Second, the economy adjusting to a one-off increase in the stock of money is necessary but not permanent. Indeed, such price pressure is not the same thing as a permanent increase in the rate of growth of monetary liabilities (due to credit growth) which would imply a permanently higher rate of CPI growth.

The post-pandemic policy mistake

With this, the stage is set for a post-pandemic monetary policy mistake, much as post-GFC brought revealed fiscal policy failings. And as then, the two main idiots in the story are Summers and Blanchard.

The mistake this time is failure to recognise the adjustment to a higher money stock as being different to a permanent change in the rate of growth of that stock. The latter would require a fundamental change in the disposition of monetary and non-monetary financial intermediaries in the provision to credit for current spending—and corresponding demand for credit for spending by the private sector. While this might happen, there is no evidence of it happening yet and there is no presumption it will happen under existing institutional arrangements.

Still, the necessary adjustment of prices to pandemic saving is enough for the “big names” to weigh in. Sometimes, less is more. 

But what is most annoying about the whole affair is that if modern macroeconomics has contributed anything useful in the past 40 years, it is the importance of dynamic or intertemporal “thinking.” This reveals the possibility of dynamic inconsistency in everyday decision- and policy-making. It requires careful consideration of the impact today (through expectations) of possible future actions. 

In the days of heady inflation, this meant giving control of monetary policy to someone who would not try and exploit any short-term trade-offs between inflation and unemployment—that which would instead only result in inflation with no real gain.

But it might just be the greatest irony of all, the macroeconomic Gods looking down in glee, that at the very moment macroeconomics as a profession discovered the problem of the “inflation bias,” the policy challenge subtly shifted to the need instead to overcome the “deflation bias.” In fact, inflation was on a secular downward path likely for reasons beyond the control of policymakers. Rather than committing to being “conservative” the community needed central bankers who would instead be reckless—willing to overcome the secular forces of deflation and depression.

And so, modern central bankers found themselves unable to create the very inflation over which they claimed to have command. There was indeed a slip between lip and cup, or something like that. 

The very best modern central bankers, such as Draghi, have been those prepared to abandon their perceived conservatism to experiment. Yet it was discovered that base money expansion was no meaningful substitute for broad money growth—that not all money is alike when it comes to impacting the real economy.

And yet, now we at last have some broad money ebullience and the possibility of escaping from the liquidity trap, those same advocates of the rational expectations, inter-temporal optimisation approach choose to fret about the temporary and necessary adjustment of prices to the higher money stock. This is exactly the possibility we ought to embrace to escape our recent malaise!

With this lack-of-imagination, our challenge of overcoming the structural disinflation bias remains.

This makes it incumbent on those of us who believe in macroeconomics as a force for seeing off extremism and fascism to keep pressing for sensible use of the opportunities provided by the pandemic for steering the macroeconomy. But it’s not made any easier by those who would rather engage in mindless self-promotion than serious macroeconomics.


Thomas Weiser’s recollections on the Greek Crisis

The Grecology substack last week highlighted how a stealth fight has emerged over the matter of sustainability of Greece once more. As noted there, an ESM blog pushed out by Rolf Strauch last week, making the case for sustainability, followed a short while after former IMF mission chief and European Department Director Poul Thomsen’s disparaging remarks at an online Economist conference. On that occasion, Thomsen downplayed the prospects for Greece within the euroarea still, lamented the inability of the Greeks to reform and the flaws in the European’s DSA. Indeed, Thomsen claimed the DSA being produced by the ESM is “not only wrong but also irrelevant” and that creditors only hold Greek assets because they believe they will be bailed out.

As previously pointed out here, Thomsen is a sociopath who systematically lies, has shown no sign of introspection as to his own legion failings in Greece (a program which did not add up, making it more of an Enron-style accounting fraud than a reflection of the fecklessness of the Greeks.) We can dispose of Thomsen later, as I will in my book.

But it is perhaps more refreshing to dwell on his online interlocutor on the occasion hosted by The Economist, Thomas Weiser, the former Eurogroup working group President—i.e., the chief technical staff member underpinning euroarea finance minister deliberations. And Weiser gave a much more thoughtful retrospective on the Greek Crisis and lessons to take from the experience. So, I want to elevate these remarks to a wider audience; for posterity, something worth studying.

On Greek sustainability from here, I indeed have a strong view. But that is not for now. But I would remark that there was little clarity on precisely what the challenge facing Greece is still—and the ESM blog was pretty poor also. So, not much has changed since 2010 despite Weiser’s wisdom.

Anyway, here is a faithful transcript of Weiser’s remarks, with minor edits:

I still distinctly remember the day when George Papakonstantinou [Minister of Finance for Greece] entered the Eurogroup meeting room and essentially said: “Brussels, we’ve got a problem.” And the conclusions that other finance ministers drew were that the main problem, or the only problem, was fiscal. And, of course, the more that we delved into the underlying issues the clearer it became to me and quite a number of others that the fiscal side was merely a surface phenomenon of totally different and very severe underlying imbalances and problems.

But, as I said, the situation led very many other actors to believe that the only problem was fiscal. And this had consequences for the programs and also for policy developments at the European level. And even though many of us realised it at the time, I think by now very many are cognizant of the fact that we in Europe more or less collectively stumbled into the situation lacking understanding and instruments and the political ability to solve the situation. That also was reflected in the design of the First [Greek] program; and these instruments and understandings evolved over time not very rapidly.

And that, in a way, also led to the fact that the IMF was involved and how the IMF was involved. And there was quite a discussion at the time amongst European politicians on whether the Fund should be in or the Fund should be out. And interestingly enough, I remember on one occasion [Wolfgang] Schäuble is saying to Jens Weidmann, who at the time was policy advisor to Angela Merkel: “if you honestly remember how the discussion went at the time he [Weidmann] will recall how very much against the involvement of the IMF and how much I was insisting that we in Europe need to deal with this issue all by ourselves, but you successfully persuaded the Chancellor that the Fund should be involved.”

At the same time over there in Washington, the then-Managing Director and quite a number of staff were all gung-ho to be involved because it came after an era when the Fund was laying off people en masse as many outside commentators and member states were reflecting that in the Goldilocks economy of the time, the Fund, as such, in this structure, was not necessary any longer.

So, as we know, there was hardly anybody in Europe who knew how to put together such an adjustment program. And we’ve seen a couple of reasons why the issue of debt sustainability was not solved in a more decisive manner and more upfront. And if I think: what was the largest mistake we made in 2009 and 2018? It is the debt sustainability issue. As others have said before me, the time for haircut in 2010 were absolutely not appropriate, but one could have dealt with it in a different manner.

But what we need to remember is, the whole setting up of the euro area was built on the totally mistaken understanding that there could be no current account crisis. Now, hardly any meaningful imbalances between member states because money was fungible, we had one central bank, and as such, entering EMU, the euro area, the European Union had done away with the so-called balance of payments mechanism which was and is a fund for such adjustment programs. Given the enormity of the Greek problem, it would have been pitifully too weak.

But again, I want to emphasise, there was a complete lack of understanding of what the issues were—and not only amongst prime ministers and finance ministers, but well down into many Chancellories and finance ministries and even central banks. Given this lack of understanding, there was also a total lack of instruments. And if you don’t understand what the issue is then you don’t start building an instrument to solve the problem that you don’t understand.

We, collectively—Europe collectively learned hard way. And we do now have the European Stability Mechanism, we have since people painfully were made aware of the doom loops between sovereigns and banks and banks and sovereigns; we partially solved the problem by setting up the single supervisory mechanism and a couple of other issues.

But were we able to solve the huge structural underlying issues that not only the Greek economy with Greek society was facing? I’m not as pessimistic as Poul [Thomsen]. We have to keep our respective attitudes there. There were significant attempts in the program to solve these distribution issues.

As soon as one does a post mortem on a program, I remembered the post-mortems on IMF programs in Asia that say: “Oh my God, we’ve made this huge mistake, we were much too invasive we were much too granular; we should have trying to define what the outcome should be and not prescribe minutely the liberalisation of taxi services and pharmaceutical issues and shipping industry between Athens and Crete and Athens and Samos and… hundreds and hundreds of pages actions,” but as soon as you’re confronted with the reality on the ground, bingo! there you go you start to liberalise pharmacies, taxis, this that and the other, not by saying to the Greek government you will get an adjustment loan if you liberalise your economy and get rid of clientelism. For some reason it never works that way.

Again and again I was approached by Greek friends who said the programme is not intrusive enough, you have to change our educational system, you’ve got to change our justice system, you’ve got to make sure that the police can enter universities again, you have to make sure that this doesn’t happen this happens and this doesn’t happen. I say: “guys, we’re already under fire because we’re much too invasive and intrusive into the Greek economy and Greek society. This is an issue that ultimately, in the interests of sovereign self-respect and in the interests of the representativeness of Democratic institutions and elections, the Greek society has to want and implement. And if you don’t, you don’t. But don’t want us, the institutions and the other member states, to be so invasive that the last vestiges of government disappear. It can’t work.”

So, this in a way encapsulates for me the huge dilemma that on faces all programmes and with programmes within the euro area very specifically.

Maybe a couple of conclusions there. One, the role of the European institutions. A bunch of geniuses in 1944 set up the Bretton Woods institutions and created the IMF as an institution which had one mission in life. It was financed, with one or two exceptions, with central bank money which is not under the purview of national parliaments. It is the nasty bogeyman sitting in Washington you can be totally pissed off with the IMF and get on with your other business.

The European Commission, on the other hand, is an institution which is the central European institution in dealing with Member States. And out of the 189 issues that the Commission has on its plate in dealing with member states, for 188 it needs of amicable, not antagonistic way of collaboration. Then you expect the Commission to behave as the IMF does as being intrusive and ordering a member state to do something? It doesn’t work. So, asking the Commission to do anything similar to the IMF was a failure right from the beginning. And I’m not quite sure if the ESM, as it is set up under finance ministries and financed by government, is yet fully fit to take over this role.

Secondly, within a monetary union you give up a huge amount of sovereignty and it is well known to prime ministers, finance ministers and others that you give up monetary autonomy. But few people realise or want to realise how much fiscal sovereignty and other sovereignty you give up. That is a dilemma. How do we run fiscal policy which, on the one hand, is under the purview of national sovereign parliaments, but on the other hand is geared in such a manner that it does not create imbalances or instability for other members of the euroarea.

And lots of people writing about it just stop dreaming about a fiscal union, common fiscal policy in our lifetime. No matter how young we are … you will not live to see a fully functional fiscal union. So, as Mario Draghi used to say, either you’ve got institutions, ECB, or you’ve got rules. But how do you structure the rules in a way that they are intelligent, are kept to, and… that respect, by a large, both the issue of sovereignty but [also] solidarity and treating policies as a matter of common concern within a monetary union. It is very difficult, and I think we’re still quite a way away from there.

…In the middle of 2014 I was pretty confident that Greece could be, in a way, on track to having debt relief and exiting the second programme in a fairly recent manner. For those who think that it was only from 2015 onwards that problems emerged, no, the second part of 2014 made one already extremely pessimistic and these were Greek problems not confined to only one government. But in 2015, of course, we came extremely close to the euroarea all of a sudden being made up only of 18 and not only 19 member states. And much of that much of the trouble and grief that Greece went through over the past five six years can be attributed to happenings in the first half of 2015.

Thomas Weiser, The Economist SE Europe Event on 200 Years of Greek Economy

Is this the greatest IMF memo ever written?

When I discovered in 2008/09 that the IMF was engaged in systematic fraud in her work with Europe (subsequently with Argentina and others) I tried very had to get senior staff to see the flaws in the work that the Fund produces. After repeated efforts, and after being deliberately blocked by the head of my Department, SPR, from having this dealt with, I was resigned to write a memo. (The head of my Department was himself breaking staff rules at this very time, of course. Such are the ethics of the institution.)

Imagine working at NASA as a senior manager and being told your spaceship will not reach orbit, at massive human cost, because the maths do not add up–and doing nothing about it.

How can this be explained to the lay person?

Saving-investment balances and the Great Reflation

Once again, simple Keynesian thought-experiments that hinge on saving-investment balances prove to be the best way to think through what is going on at the moment. Macroeconomics is less about supply and demand, more about saving-investment decisions.

Anyway, in thinking about this series for Exante, the following short macro accounting framework was useful.

The OBR on prospects for the UK economy: A look back to November

*This was written in November, published today only with a change in tense to reflect these are comments on the OBR’s previous forecast and not what will be revealed later this week. In short, be cautious about the headlines that surround the OBR’s medium-term forecasts.*

With Sunak’s Spring Budget later this week, and associated Office for Budget Responsibility’s (OBR) forecast update, it’s worth recalling some key judgments from Autumn.

Continue reading “The OBR on prospects for the UK economy: A look back to November”

The compass and the anchor: the ECB’s communication muddle

Last week’s press conference was the second time less than 12 months that the European Central Bank’s (ECB’s) communication of a key policy initiative fell short. The first occasion, of course, was on 12 March last year, during the announcement of the EUR120 billion asset purchase program (APP) expansion, when President Lagarde insisted “we are not here to close spreads”—a comment that has the rare distinction of being footnoted and clarified in the transcript. Just 6 days later the Pandemic Emergency Purchase Program (PEPP) was rushed through, a program certainly designed to closed spreads.

Continue reading “The compass and the anchor: the ECB’s communication muddle”