“Animal Spirits” react to monetary policy

Greenspan has an article in the Nov/Dec issue of Foreign Affairs entitled: “Never Saw It Coming-Why the Financial Crisis Took Economists By Surprise

He´s become a fan of “animal spirits”:

What went wrong? Why was virtually every economist and policymaker of note so blind to the coming calamity? How did so many experts, including me, fail to see it approaching? I have come to see that an important part of the answers to those questions is a very old idea: “animal spirits,” the term Keynes famously coined in 1936 to refer to “a spontaneous urge to action rather than inaction.” Keynes was talking about an impulse that compels economic activity, but economists now use the term “animal spirits” to also refer to fears that stifle action.

Later on:

What explains the failure of the large array of fail-safe buffers that were supposed to counter developing crises? Investors and economists believed that a sophisticated global system of financial risk management could contain market breakdowns. The risk-management paradigm that had its genesis in the work of such Nobel Prize–winning economists as Harry Markowitz, Robert Merton, and Myron Scholes was so thoroughly embraced by academia, central banks, and regulators that by 2006 it had become the core of the global bank regulatory standards known as Basel II. Global banks were authorized, within limits, to apply their own company-specific risk-based models to judge their capital requirements. Most of those models produced parameters based only on the last quarter century of observations. But even a sophisticated number-crunching model that covered the last five decades would not have anticipated the crisis that loomed.

And why not? The simple answer is that no one (or any model) would have imagined the Fed would make the sort of mistake it had last made in 1938 to wit, allow nominal spending (NGDP) to crash!

The illustrations help understand why “animal spirits” went wild. Imagine if monetary policy had not lost its bearings and had “righted itself” one year earlier (March 2008)?

Animal Spirits_1

Animal Spirits_2

Update: To calm “animal spirits” Scott Sumner suggests giving them a larger dose of “MOAR“!

5 thoughts on ““Animal Spirits” react to monetary policy

  1. It was all about, only about, inflation. Headline inflation. Nothing else appeared to matter. Over 4%, nearly 5%. Central bank credibility was on the line. They kept it intact, no matter what it cost.

      • It wasn’t an academic thing, the anti-inflation obsession, but a psychological fear to which most of us fell prey. It wasn’t just the central bankers, though perhaps they should have known better, given it was their job. In years to come, analysing the central bankers capture by popular fears will be the issue that gets most academic historians attention.

        I think it is a generational thing, too many oldies with too much in cash savings thinking too narrowly about their own pockets. It’s not an excuse, but it is an explanation. It’s an incredibly short term obsession, and if pursued to the end can result it in a Cypriot-style bank rescue-writedown of those savings.

  2. The Fed tightened exactly when many investors had heavily leveraged to buy real estate…both commercial and residential…exquisitely poor timing…and then let NGDP sink through the floor…

    On the positive side, they did beat inflation! Ain’t it grand?

  3. James, this post by Nick Rowe puts the point perfectly (where the fear has chnaged from inflation to financial imbalances):
    “The best way to raise interest rates is to say you will cut interest rates if the economy doesn’t recover quicker. The best way to lower interest rates is to say you are scared to cut interest rates. The Bank of Canada’s stated fear of cutting interest rates makes it more likely its fears will be realised.”

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