Tuesday, June 16, 2009

More boring economic theory

This article, by Andy Xie, former Morgan Stanley economist and current board member of Rosetta Stone Advisors (and found from this blog), is a pretty interesting analysis of what's going on right now with US economic policy, and what could potentially happen in the near future. I'm just going to include a small section I found interesting:
Stagflation in the 1970s spawned the development of rational expectation theory in economics. Monetary stimulus works by fooling people into believing in money's value while the central bank cheapens it. This perception gap stimulates the economy by fooling people into demanding more money than they should. Rational expectation theory clarified the underpinning for Keynesian liquidity theory. However, as they say, people can't be fooled three times. Central banks that tried to use stimuli to solve structural problems in the '70s saw their stimuli didn't work. People saw through what they tried again and again, and began behaving accordingly, which translated monetary stimulus straight into inflation without stimulating economic growth.

Rational expectation theory discredited Keynesian theory and laid the foundation for Paul Volker's tough love policy, which jagged up interest rates and triggered a recession. The recession convinced people that the central bank was serious about cooling inflation, so they adjusted their behavior accordingly. Inflation expectations fell sharply afterward. The credibility that Volker brought to the Fed was exploited by Alan Greenspan, who kept pumping money to solve economic problems. As I have argued before, special factors made Greenspan's approach effective at the same. Its byproduct was asset bubbles. As the environment has changed, rational expectation theory will again exert force on the impact of monetary policy.

It's an interesting analysis, if you're into that sort of thing. If not, just don't read it. :)

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