The Financial Crisis and the 'Real' Crisis

Spoiler: This entire post is a lead-up to have you read this debate over on The Economist.

Economists usually abstract from money to study the 'real' economy - the production and consumption of goods and services. Money is a tool, a lubricant. In the long run, money (how much is printed, etc) shouldn't really matter as long as it's not so mis-managed as to take the economy down.

This is one of those times. The financial sector (money) has stopped provisioning credit to producers, gumming up the works.

Government's response to a crisis such as this one has to address two distinct problems. The first is the recovery of the financial sector to its regular role of intermediary, and the second is the revival of the 'real' economy.

The plan Geithner has just announced is meant to accomplish this, by encouraging financiers to buy high-risk assets. These 'toxic' assets are, it is hoped, vastly undervalued because of all the uncertainty attached to them. Getting them purchased and digested by new investors will presumably allow the financial sector to clean up and get credit flowing again. Krugman and DeLong disagree on how successful the proposed plan will work, as opposed to temporary nationalisation for example. Debate on this issue is technical, based on how undervalued assets are, how incentives will be aligned after government intervention.

The second question, about the real economy, pits pro-stimulus Neo-Keynesians against hands-off Monetarists. This debate is more meaty and inevitably falls to ideology. It's not immediately clear to me why a question such as this one that seems technical in nature is so deeply aligned along the ideological spectrum, but there you have it. On this issue DeLong and Krugman are in agreement.

For all of us still unsure of who to believe, and to what degree, a recent debate at The Economist is worth reading. Brad DeLong defends the (political) status-quo of government spending as stimulus, while Luigi Zingales (from the University of Chicago) pushes for a free market approach.

Start by reading the opening statements (navigating the conversation is a bit confusing).