Wednesday, December 31, 2008

UCLA Prof Wants Government to Prop Up Stock Indexes

Roger E. A. Farmer, vice chair for graduate studies in the department of economics at the University of California Los Angeles, has penned a column at FT that has me scratching my head. First he correctly writes:

Since world war two, economic policy in most western democracies has been based on Keynesian economics.

But although policy makers still rely on Keynes’ ideas, academics gave up on his theories 40 years ago and went back to classical economics: Keynesian theory could not explain how unemployment and inflation can coincide. The result has been 40 years of disconnect in which policy makers are tinkering with the engine without a manual.
But, then he goes on to state that the problem with the economy is the same one that Keynes promoted:
Classical economists argue that falling wages will restore equilibrium; but this is based on the belief that the labour market works like an auction in which employment is determined by demand and supply.

It ignores the very real frictions involved in searching for a job by both households and firms that can lead to many possible equilibrium employment levels just as Keynes argued in the General Theory.
So where does he really fall on all this? It turns out, he's a Keynesian on steroids. Here is his policy prescription:

So where do we go from here? The only actor large enough to restore confidence in the US market is the US government. The current policy of quantitative easing by the Fed is a move in the right direction but it does not, as yet, go nearly far enough.

It is time for a greatly increased role for monetary policy through direct intervention of central banks in world stock markets to prevent bubbles and crashes. Central banks control interest rates by buying and selling securities on the open market.

A logical extension of this idea is to pick an indexed basket of securities: one candidate in the US might be the S&P 500, and to control its price by buying and selling blocks of shares on the open market.

Even the credible announcement that a policy of this kind was being considered should be enough to boost the markets and restore consumer and investor confidence in the real economy.
Folks, honestly, the Fed is pumping so much money into the economy that Zimbabwe's President Robert Mugabe is getting jealous. The last thing we need is the Fed printing even more money to prop up the S&P 500 Index.

This plan is mad.

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