Media Briefings

Kick-Starting The Economy: The Answer Is Not Fiscal Stimulus But A Government Programme Of Buying Shares

  • Published Date: March 2012

The government should make large-scale purchases of equities to restore confidence and get the economy back on track. So says Professor Roger Farmer of the University of California, Los Angeles, drawing on his research published in the March 2012 issue of the Economic Journal.

He argues that the government should intervene to prevent wild swings in asset markets on both the upside and the downside. Right now, that means buying assets since restoring wealth is the key to restoring spending and reducing unemployment.

The study introduces a new view of the central themes in John Maynard Keynes’ famous book, The General Theory of Employment Interest and Money. Professor Farmer argues that Keynes was right to argue that government must act to restore full employment. But he was wrong to advocate large-scale fiscal expansion. Central bank intervention in the asset markets is a better alternative to discretionary fiscal stimulus.

The author points to two important ideas in Keynes’ work, which his work aims to bring back into the mainstream. The first idea is that market economies are not self-correcting. Left to itself, a market economy can end up with any unemployment rate. An unemployment rate of 5% or an unemployment rate of 25% could persist as a permanent equilibrium outcome. The second idea is that the ‘animal spirits’ of investors select which unemployment rate will prevail.

Professor Farmer notes:

‘Both of these ideas were forgotten or ignored by the Keynesian economists who interpreted Keynes’ ideas and gave us the current policy consensus. Keynes was not a Keynesian.’

By combining the best ideas from Keynes with a modern theory of search unemployment, the new study shows how high unemployment can persist in a market economy. Stock market wealth accounts for roughly three-fifths of all tangible wealth in the United States; the other two-fifths are in houses. In the fall of 2008, people lost confidence in the value of both those assets at the same time. They stopped spending, firms laid off workers and the drop in wealth was self-fulfilling.

In a well-functioning market economy, jobs are filled when workers and firms respond to price signals. But in search markets, these signals are missing. The result can be a catastrophic failure where demand is too low because unemployment is too high; and unemployment is too high because demand is too low. Persistently high unemployment stems from a lack of confidence and is a self-fulfilling prophecy.

This sounds a lot like the argument made by proponents of fiscal spending to kick-start the economy. But Professor Farmer disagrees with this approach. Instead, he says, government should intervene to prevent wild swings in asset markets on both the upside and the downside.

Keynesian policies of more government spending are based on the Keynesian hypothesis that consumption spending depends primarily on income. But research by Milton Friedman, Franco Modigliani and Albert Ando in the 1950s and 1960s showed that consumption depends not on income but on wealth. It follows that restoring wealth is the key to restoring spending and reducing unemployment.

In 2009, Peter Coy, writing in Businessweek, identified three economists with ‘big ideas’ on how to avoid the next global financial crisis. Roger Farmer was one of those economists. The big idea – that the government should make large-scale purchases of equities to restore confidence and get the economy back on track – was based on the academic research in this paper.

ENDS


Notes for editors: ‘Confidence, Crashes and Animal Spirits’ by Roger Farmer is published in the March 2012 issue of the Economic Journal.

Roger Farmer is at the University of California, Los Angeles (http://rogerfarmer.com).

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com); or Roger Farmer via email: rfarmer@econ.ucla.edu