A Structural Slump?
Edmund Phelps has written an interesting recent article on the current financial crisis. Like many other economists he argues that we need to recapitalize the banks. But what makes his article interesting is that he links current events to his structural theory of the business cycle. ‘The end of the speculative fever and the credit crunch each have structural effects on the real prices of business assets, real wages, employment and unemployment. As I see it, the former has pushed up the normal, or “natural,” volume of structural unemployment. The latter (and the excess houses) is pushing the economy into a temporary slump.’This argument is distinct from the main focus of the article which is on the need to price the toxic asserts that remain on the balance sheets of the banks. This is obviously true. The financial system and thus credit will not recover until they are dealt with. But I was structure by Phelps’s broader point which I feel only a few commentators have picked up upon. The claim made by policymakers is that we need only ‘unblock’ the channels of credit in order to get the economy back in order again. This is not true is the slump is structural as Phelps claims. According to this line of argument restoring liquidity and confidence to the financial system may be a necessary condition for a recovery but it cannot be a sufficient one.
The structural view of the slump bears thus some similarity with F.A. Hayek’s analysis of mal-investment during the 1920s. It implies that in addition to liquidity problem, there is a problem of real adjustment that needs to be worked through.
What form does this structural adjustment need to take? Ken Rogoff has been arguing here and elsewhere that one structural change that needs to take place before a recovery can begin is that the financial sector needs to shrink. Phelps similarly argues that’these steps toward making the system operational again will leave it dysfunctional. We don’t want to restore the system as it was’This readjustment could have serious consequences. To consider only the most obvious: if finance is bloated then this implies a reallocation of resources away from financial centres like London to other parts of the economy and possibly to other parts of Europe.
