Evidence of sticky wages

Econ 101 teaches us that prices adjust to clear supply and demand. Accordingly, in the aftermath of an economic boom when wages have risen, as recessions strike and unemployment rates climb, businesses lower wages which in turn lowers production costs and boosts investment and further hiring. In other words, high unemployment rates do not persist since wages fall proportionately to clear any labour market over-supply.

This has been used as a justification to oppose any government intervention to clear markets suffering from recessions. If the markets clear by themselves, it is argued, then where is the need for any discretionary fiscal policy intervention by governments. Though markets may deviate from the equilibrium, it is only a matter of time before the aforementioned dynamics takes over and restores stability.

However, as we have seen with the Great Recession and persistent high unemployment rate in the US, labour markets are not so accommodative. It is obvious that labour market does not clear so easily. In fact, the New Keynesian schools have long talked about "frictions" and "stickiness" with wages and prices which come in the way of markets regaining their earlier equilibrium. Economists like George Akerlof have pointed to downward wage rigidities, especially in conditions of low inflation.

In this context, an excellent study by researchers from the San Francisco Fed highlights the magnitude of this problem. They used individual-level survey data from 1980-2011 from the Current Population Survey (CPS), the monthly survey conducted by the Bureau of Labor Statistics used to measure the unemployment rate, to demonstrate the salience of downward nominal wage rigidity. They write,

Despite a severe recession and modest recovery, real wage growth has stayed relatively solid. A key reason seems to be downward nominal wage rigidities, that is, the tendency of employers to avoid cutting the dollar value of wages. This phenomenon means that, in nominal terms, wages tend not to adjust downward when economic conditions are poor. With inflation relatively low in recent years, these rigidities have limited reductions in the real wages of a large fraction of U.S. workers. 

In the current American context, since inflation is low and therefore keeping wages constant cannot reduce real wages, the only way for employers to lower wages is to actually cut nominal wages. The graphic below is an excellent illustration. The dashed black line shows a symmetric normal distribution, while the blue bars plot the actual distribution of nominal wages in 2011. The blue bar that spikes at zero shows that a large number of workers report no change in wages over a year. The prominence of this psike shows that disproportionately large numbers of employers simply kept wages fixed over the year. This proposition is also supported by the fact that the gap in the normal distribution and the actual wage distribution is much higher on the left side. This gap suggests that the spike at zero is made up mostly of workers whose wages otherwise would have been cut.

Similarly, the researchers also compare the trends in such wage rigidity over the past 30 years. They compared the proportion of workers in the same job who report no year-over-year wage change and find that their share rises in recessions and persist well into the recovery. Further, this proportion has risen sharply in the Great Recession for all categories of workers. They find that from 2007 to the end of 2011, the fraction of workers experiencing no yearly wage change rose to 16% from 11.2%. This is five percentage points higher than the average size of the spike at zero from 1983 to 2007.

The same trend is observed among all categories of workers.

See also Paul Krugman (also here) and Mark Thoma. 

The "confidence fairy" trumps Keynes in UK!

Even as a fierce debate rages about the policies required to address the Great Recession across the developed economies, among the major economies Britain has made a decisive choice to embrace fiscal austerity to restore market confidence. The land of Keynes appears to have blinked on the face of massive fiscal strains and chosen to break with Keynesian policies and follow the path of balancing government finances to revive economic growth.

In recent days, France has decided to raise the minimum retirement age to 62 from 60 and the age for a full pension to 67 from 65. Earlier Greece, Spain, and Ireland had embraced deep spending cuts in an attempt to avoid sovereign bankruptcies.

The Conservative Government in Britain last week followed its other European partners by annoucing the country’s steepest public spending cuts in more than 60 years in an effort to eliminate government deficits by 2015. This comes as Britain faces one the worst public debt problems among all developed economies - 11.5% public deficit and 61% public debt. It is hoped that these steep cuts will repair government's fiscal balance, improve market confidence, stimulate the private sector and restart growth.

The proposed measures include a reduction of expenditures in government departments by an average of 19% (£83 billion or about $130 billion) by 2015, sharp cuts in welfare benefits, increase in the retirement age from 65 to 66 by 2020 (saving $ 8 bn a year), and elimination of 490,000 public sector jobs (out of a total of 6 million jobs or 8% of the total) over the next four years. Further, payments to the long-term unemployed who fail to seek jobs will be cut saving $11 billion a year, and a new 12-month limit will be imposed on long-term jobless benefits, and measures will be taken to curb benefit fraud.

This follows an earlier decision to stop paying its hitherto universal child benefit payments ($32 a week for a first child and $21 for each subsequent one) to people earning more than around $70,000 a year. There is also a proposal to accept the findings of the Browne Review on subsidies for university education, which suggests dramatic cuts on university education spending.

The Browne review advocates scrapping of the present system that caps a year's tuition fee at £3,290 ($5,275) in favor of a free-market approach paid for by the students themselves — but only after they graduate and are earning more than £21,000 a year. It is being suggested that the government could then cut about 80% of the current $6.2 billion it pays annually for university teaching, and about $1.6 billion from the $6.4 billion it provides for research. To make up for the shortfall, universities would have to raise tuition to an average of more than $11,000.

On the revenues front, the British Government has already announced plans to levy a one-time 50% marginal tax on bankers' bonuses of more than £25,000 ($40,700). This would be levied not only British banks but also the London subsidiaries of Wall Street giants. The move is more symbolic than substantial since it would raise only £550 million.

Such a hair-trigger alarmist repsonse from Britain is surprising, and far from engendering market confidence may end up rousing market anxiety and even panic. Unlike fellow Europeans like Greece and Ireland, despite its high 11.5% fiscal deficit, Britain is nowhere close to bankruptcy or reeling from any bond-vigilantes. There were no bond-market panics and inteerest rates have remained low. Public debt at 61%, while high, is not so large as to press the panic button. And all these macroeconomic indicators are similar to that in the US (fiscal deficit of 10.7%), which is debating the extent of accommodation - monetary and fiscal - required. Further, there will be serious questions about the need to eliminate government deficits at all, and that too within such a short-time and starting from an aggregate demand shrinkage driven recession.



These dramatic measures carries with it considerable risks and even goes against the grain of historical record of countries which faced similar situations. In simple terms, the spending cuts are made on the assumption that the private sector will be able to able to make up for the 19% and 8% cuts in government spending and employment respectively, over the next four years.

However, this private sector growth in output and job creation to cover up for the government's exit would have to be a top-up on the regular growth. And regular growth itself will have to be large enough to bridge the yawning output gaps that shows no signs of narrowing. In simple terms, Britain will have to grow at its highest rate in the post-war era, close to double digits, just to return to normalcy. What makes this even more formidable is the fact that this momentum will have to get generated immediately and there appears nothing in the horizon among the private sector that could trigger off such a dramatic spurt in growth.



And all this has to start immediately, since any delays would only end up pushing the can further down the road and widening the output and employment gaps, necessitating even more higher rates of growth and job creation. There are serious and well-grounded fears that such optimism may be misplaced.

It is also hoped that these measures will restore market confidence and encourage the private sector to come forward with their investment and spending plans. However, as the evidence so far from Ireland, which has been similarly savage with its spending cuts, shows, such assumptions may fall through. After its initial round of spending cuts failed to enthuse the markets and trigger any recovery and make any dent on its stupendous budget deficit of 32% of GDP, Ireland is set to announce another round of cuts, which would take the total cuts to 14% of its GDP.

As Joseph Stiglitz wrote in response to the British decision, the excessive faith in the confidence fairy and attendant spending cutbacks "will weaken Britain, and even worsen its long-term fiscal position relative to well-designed government spending". He wrote,

"There is a shortage of aggregate demand – the demand for goods and services that generates jobs. Cutbacks in government spending will mean lower output and higher unemployment, unless something else fills the gap. Monetary policy won't. Short-term interest rates can't go any lower, and quantitative easing is not likely to substantially reduce the long-term interest rates government pays – and is even less likely to lead to substantial increases either in consumption or investment. If only one country does it, it might hope to gain an advantage through the weakening of its currency; but if anything the US is more likely to succeed in weakening its currency against sterling through its aggressive quantitative easing, worsening Britain's trade position...

The few instances where small countries managed to grow in the face of austerity were those where their trading partners were experiencing a boom... Lower aggregate demand will mean lower tax revenues. But cutbacks in investments in education, technology and infrastructure will be even more costly in future. For they will spell lower growth – and lower revenues. Indeed, higher unemployment itself, especially if it is persistent, will result in a deterioration of skills, in effect the destruction of human capital, a phenomena which Europe experienced in the eighties and which is called hysteresis. Lower tax revenues now and in the future combined with lower growth imply a higher national debt, and an even higher debt-to-GDP ratio."

It is being argued in some circles that the apprently contrasting responses (atleast till now) on both sides of the Atlantic to addressing the Great Recession comes from their respective different historical experiences and the attendant institutional memories. The memories of the Great Depression and the human sufferings and long-term damage inflicted to the economy is thought to inform the relative acceptance of fiscal and monetary accomodation in the US. In contrast, Europeans are driven by even more recent experiences with government deficits that have resulted in sovereign defaults and episodes of run-away inflation. In particular, it is being claimed that the Conservative Government's decision now is grounded in memories of Britain’s economic collapse in the 1970s, when the International Monetary Fund had to come to the rescue just as it has done recently in Greece.

Joe Stiglitz should have the last word,

"Austerity converts downturns into recessions, recessions into depressions. The confidence fairy that the austerity advocates claim will appear never does... Consumers and investors, knowing this and seeing the deteriorating competitive position, the depreciation of human capital and infrastructure, the country's worsening balance sheet, increasing social tensions, and recognising the inevitability of future tax increases to make up for losses as the economy stagnates, may even cut back on their consumption and investment, worsening the downward spiral...

Britain is embarking on a highly risky experiment. More likely than not, it will add one more data point to the well- established result that austerity in the midst of a downturn lowers GDP and increases unemployment, and excessive austerity can have long-lasting effects... it is a gamble with almost no potential upside. Austerity is a gamble which Britain can ill afford."

Interpreting Keynes - restoring market confidence

The 'neo-classical synthesis' of Keynesianism and classical microeconomics holds that the economy is Keynesian in the short-run because wages and prices are "sticky" (as initially interepreted by John Hicks in England and Alvin Hansen in the US), while it is classical in the long-run when prices have found their right level. It implies that, to restore full employment, we simply need to realign nominal prices with nominal demand, either with monetary policy to stimulate private spending or with fiscal policy to replace private spending with public spending. Opponents of the Keynesian fiscal policy to stimulate aggregate demand, led by the likes of Robert Barro and Eugene Fama, invoke Ricardian equivalence to argue that government spending will crowd out private expenditure.

UCLA Professor Roger Farmer, in a series of recent working papers and articles, while conceding the usefulness of fiscal policy he argues that the fiscal stimulus induced government spending multiplier is smaller than claimed and presents an alternative approach to address such deep economic crisis. He argues that orthodox Keynesian interpretations of the General Theory misses the story and offers an alternative reconciliation of Keynes with microeconomics that does not rely on sticky prices.

About the problem with fiscal policy, he writes,

Keynes said three things in the General Theory. First: the labour market is not cleared by demand and supply and, as a consequence, very high unemployment can persist forever. Second: the beliefs of market participants independently influence the unemployment rate. Third: It is the responsibility of government to maintain full employment. He was right on all three counts. But he was wrong about something else.

Keynes thought that consumption depends on income... Consumption, and this is two thirds of the economy, depends not on income but on wealth... the theory of the (government spending) multiplier and the implication that fiscal policy can get us out of the current crisis rests on exactly this point... but if income depends on wealth then fiscal policy may be less effective than the Keynesians claim... fiscal policy cannot provide a permanent fix to the problem of high unemployment.

Prof Farmer raises doubts on the Ricardian equivalence claim since its logic "requires that rational forward looking households fully internalize the future tax burden of current fiscal profligacy", an unlikely fact since human "lives are short and not everyone cares for their descendents".

In the first paper, Prof Farmer claims that the equilibrium business cycle theory is flawed and presents an "alternative paradigm that retains the main message of Keynes’ General Theory and which reconciles that message with Walrasian economics". He argues that unemployment will remain trapped at a high level due to two labor market failures - arising from a lemons problem and an externality. The aforementioned two market failures makes it difficult and costly to match unemployed workers with vacant jobs, by not providing "the necessary price signals to ensure that a given number of jobs is filled in the right way". This results in economically and socially inefficient multiple "equilibria in which the unemployment rate is determined by the self-fulfilling beliefs of stock market participants". He writes,

"Firms decide how many workers to hire based on the demand for the goods that they produce. The demand for goods depends on wealth. Every different equilibrium unemployment rate is associated with a different set of prices for factories and machines and the value of these physical assets depends on what market participants think they will be worth in the future. The world economy is currently headed rapidly towards a high unemployment, low wealth equilibrium which was triggered by a loss of confidence in the value of assets, backed by mortgages in the US subprime mortgage market. The inability to value these assets has since led to an amplification of the crisis as panic hit the global financial markets. Even though the US stock market is appropriately valued based on historical price earnings ratios — investors are worried that the value of stocks could fall further... (any further) drop may prove to be self-fulfilling...".

In another working paper, he draws attention to a less costly and more effective alternative to fiscal policy. He feels that the "current financial crisis is an example of a shift to a high unemployment equilibrium, induced by the self-fulfilling beliefs of market participants about asset prices". His arguement is summed up as - "informational asymmetries cause missing markets, missing markets lead to the existence of multiple equilibria, and psychology, in the form of self-fulfilling prophecies, becomes an additional fundamental that selects an equilibrium".

Under such circumstances, a better "alternative might be for the Fed to intervene in the asset markets through purchases and sales of a broad index fund of stocks". He writes, "We need a new approach that directly attacks a lack of confidence in the asset markets by putting a floor and a ceiling on the value of the stock market through direct central bank intervention".

Fiscal policy debates

The economic crisis has initated an intense debate (Conservatives Vs Liberals, Monetarists Vs Keynesians) about whether monetary or fiscal policy are of greater significance during times of such turmoil. It has also re-kindled the old debate about the relative importance of the various fiscal policy options, especially the respective economic multipliers of tax cuts and government spending.

Mark Thoma and Robert Skidelsky weigh in on the importance of government spending led fiscal policy over tax cuts and monetary expansion. Paul Krugman writes that we have reached a world in which monetary policy, both in US and soon in Europe, has little or no traction, and therefore fiscal policy is the only option left. James Galbraith too appears to agree.

Greg Mankiw, invoking studies by Christina and David Romer, Bob Hall and Susan Woodward, and Valerie A Ramey, argues that the tax cuts offer a higher multiplier than government spending. He claims that unlike the later which works through increases in disposable income and consumption demand, the former also incentivizes more investment demand from businesses. However, Martin Feldstein, a doyen among conservative economists, broke ranks and declared that the $168 bn tax cut dominated US fiscal stimulus of February 2008 failed because people actually ended up saving and paying off debts instead of spending it on consumption.

Mark Thoma sums up the debate about the relative utilities of the various fiscal policy options, mainly between tax cuts and government spending. Catherine Rampell in the Economix blog of NYT has the recommendations of an exhaustive list of distinguished economists.

Update 1
Marginal Revolution draws attention to a recent NBER paper by Andrew Mountford and Harald Uhlig which finds that of the three fiscal policy options - deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion - deficit financed tax cuts have the highest multiplier on the GDP. Free Exchange is not impressed and takes up issue here.

Update 2
The always insightful Mark Thoma has an excellent parable explaining how fiscal policy works during economic downturns and depressions. The commonest criticism against fiscal policy that it crowds out private investment may not apply to downturns and depressions, since at such times there are idle resources that are involuntarily unemployed and private investors are in any case unwilling to make any additional investments. So Paul Krugman is spot on in claiming that normal rules do not apply when the world is in depression.

Update 3
The most definitive proof that monetary policy can save the economy in times of economic slowdown comes from the present crisis. Unlike the Great Depression, nobody can accuse the Central Banks across the world, individually and collectively, of not doing enough and quickly at that. We have seen the Fed and others summon all the monetary policy levers - lower rates aggressively to the zero bound; capitalize banks and financial institutions with the most liberal terms; inject liquidity through their discount windows by relaxing all lending standards; act as a market maker of last resort by purchasing troubled assets and commercial papers; and provide blanket guarantees to deposits. The amounts involved have been mind boggling - more than $1.3 trillion in the US alone, and counting!

Apart from a few hours (in a few cases, a couple of days) of market rally, the financial markets and the economy appears to have hardly acknowledged these interventions. If anything, Central Banks, and not the Governments, have been the primary players in the drama so far.

However, despite the overwhelming proof, apologists of Monetarism, will surely claim that had the Central Banks not intervened so aggressively, the situation could have been much worse!

Update 4
Gary Becker takes a historical perspective, of the past fifty years, and restrains any knee-jerk aggressive government regulatory interventions that may have adverse long term consequences.

Update 5
Paul Krugman draws attention to the work of Adam Posen who finds evidence that the Japanese fiscal stimulus in 1995 did actually work and increase economic growth rate. However, Tyler Cowen debates the reliability of the Japanese example, given other factors involved.

Update 6
Paul Krugman gets to the basics of Eco 101 in favour of stimulus in the form of infrastructure spending and providing public goods, as opposed to stimulus in the form of tax cuts. A marginal dollar spent on public goods is worth more than a marginal dollar spent on private consumption, because in any case these are goods that a functioning society and market requires and will be under-supplied by the private sector.

Update 7
Bloomberg has this excellent article tracing the roots of the Monetarist take-over of economic policy making since the seventies. And Barry Ritholtz writes the obituary for Chicago School.

Update 8
Paul Krugman uses numbers to prove that the multiplier is much higher for public spending, by way of the increase in taxes ploughed back to the economy. The net stimulus is therefore smaller, or there is more bang for the buck.

Update 9
Daniel Gross sums up the debate between fiscal and monetary policy and favours using both in such extraordinary times.

Update 10
Here is the famous NBER working paper of 1994, at the center of debate now, by David and Christina Romer that claims that in post-war recessions, monetary policy has been more effective in the early stage of recoveries. They write, "We find that the Federal Reserve typically responds to downturns with prompt and large reductions in interest rates. Discretionary fiscal policy, in contrast, rarely reacts before the trough in economic activity, and even then the responses are usually small. Simulations using multipliers from both simple regressions and a large macroeconomic model show that the interest rate falls account for nearly all of the above-average growth that occurs early in recoveries."

Update 11
Eugene Fama opposes fiscal stimulus on grounds that government debt only transfers burden from one generation to another.

Update 12
Brad Delong writes about the eclipse of the Chicago School.

Ineffectiveness of Monetary Policy

The last few decades have been the high water mark of Monetarism. It had become a hallowed axiom of Central Banking and macro-economic policy making that by targetting inflation and maintaining price stability, economic growth could be controlled. When the inflationary pressures rose, raise interest rates, and conversely when it fell, cut the rates. The unprecedented long period of economic growth, with only minor blips, appeared to lend credence to this view. The business cycle appeared to have been tamed.

The Monetarists had long claimed that contrary to the Keynesian contention that monetary policy was impotent during depression-type conditions, the Fed could have, by loosening the monetary base prevented the Great Depression. Newer versions of the monetary theories have even claimed that the Fed caused the Depression. Paul Krugman lays evidence to prove that both the assumptions are wrong.

The original claim is disputed by the evidence that the monetary base rose steeply during the Great Depression. The aggressive monetary loosening by the Fed and bailout of the financial sector by the Treasury during the ongoing sub-prime crisis and its failure to stem the cascade of bad news seriously undermines the claim that monetary expansion can prevent Recessions.

Update 1
The most definitive proof that monetary policy can save the economy in times of economic slowdown comes from the present crisis. Unlike the Great Depression, nobody can accuse the Central Banks across the world, individually and collectively, of not doing enough and quickly at that. We have seen the Fed and others summon all the monetary policy levers - lower rates aggressively to the zero bound; capitalize banks and financial institutions with the most liberal terms; inject liquidity through their discount windows by relaxing all lending standards; act as a market maker of last resort by purchasing troubled assets and commercial papers; and provide blanket guarantees to deposits. The amounts involved have been mind boggling - more than $1.3 trillion in the US alone, and counting!

Apart from a few hours (in a few cases, a couple of days) of market rally, the financial markets and the economy appears to have hardly acknowledged these interventions. If anything, Central Banks, and not the Governments, have been the primary players in the drama so far.

However, despite the overwhelming proof, apologists of Monetarism, will surely claim that had the Central Banks not intervened so aggressively, the situation could have been much worse!

Keynesian moment - time for Government to takeover?

Ben Stein and Paul Krugman, among others, feel that the US economy may be slipping into a Great Depression type high unemployment, long term Keynesian equilibrium. They feel that the tsunami of fear that first enveloped the financial markets, now threatens the economy. The result is that consumers and companies have cut back on spending, credit taps have gone dry and lending has come to a standstill, all of which raises the real possibility that economic activity will continue indefinitely at a level consistent with serious recession or even depression.

This fear psychosis and the possibility of getting trapped in its vortex, is being cited as a compelling enough reason for aggressive government intervention, both through large enough fiscal stimulus and bailouts of major firms and sectors. (Monetary policy has been driven to irrelevance as a stagflation beckons) Ben Stein writes that the costs of getting out of this turmoil are going to be high, "We cannot nickel-and-dime our way out of this".

How do we know we have reached the "Depression eve"? What are the ideal fiscal stimulus measures for the time and how large should they be? How should the fiscal measures be structured and scheduled? How do we select the firms and sectors to be bailed out? What should be the bailout help and how should it be structured? What should be the eligibility for bailout assistance?

These and other questions are going to be at the forefront of economic policy debates in the days and weeks ahead. None of these have clear answers, and decisions will be taken based on the individual and collective perceptions and judgements of the decision makers. One can only hope that decisions are taken as informed choices, untainted by ideological predilections and vested interests, perceptions of all stakeholders get appropriately aligned, and tons of luck follows.

Only time will tell whether these policies were good or bad. Such situations highlight the difficulty of economic policy making. There are no policy certainties in managing an economic situation.

Update 1
Greg Mankiw, of all economists, now sets the Keynesian context, which leaves only the Government with the leverage to boost aggregate demand, though he still finds greater role for the monetary policy. But as Paul Krugman points out, the Keynesian stimulus and the war spending laid the foundations for robust post-war economic growth, which combined with inflation, created an environment in which interest rates were high enough in the subsequent normal times that monetary policy was effective at fighting slumps. In other words, the post-war effectiveness of Monetarism was largely dependent on the success of Keynesian demand management policies earlier.

Update 2
Brad De Long finds virtue in old-fashioned Keynesianism, "the government must take a direct hand in boosting spending and deciding what goods and services will be in demand". He finds fault with the obsession of policy makers to prevent the princes of Wall Street from profiting from the crisis, which was reflected in the Fed-Treasury decision to let Lehman Brothers collapse in an uncontrolled bankruptcy without oversight, supervision, or guarantees. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

The second lapse was the obsession with keeping private sector private, which meant a reluctance to avoid partial or full nationalization of the components of the banking system deemed too big to fail.

Keynes and the crisis

I am inclined to agree with Robert Skidelsky that the present global economic crisis has decisively resurrected Keynesianism into the mainstream of economic thinking, displacing the neo-classical theories of Friedrich Hayek, Milton Friedman and the Chicago School.

While the economy was on a sustained boom, it was easy to forget the lessons of the Great Depression, and write the obituary for Government intervention. The ideological thrust of Thatcherism and Reaganism, institutionalized through the Washington Consensus and its instruments like the World Bank, IMF and WTO, clearly assumed markets as self correcting and saw limited role for governments. The pervading belief was that boom-bust cycles must be caused by outside 'shocks' - wars, revolutions, and above all political interference. The financial markets were considered efficient, accurately pricing all the risks in all the trades at each moment in time. As Skidelsky says, greed, ignorance, euphoria, panic, herd behavior, predation, financial skulduggery and politics, were all considered exogenous.

It was even argued that the spectacular technological progress of recent years had created a "goldilocks" (not-too-hot and not-too-cold) economy, that attenuated and smoothed the business cycle. The global "savings glut", China's emergence as the "cheap factory of the world", American consumers propensity to spend as there was no tomorrow, all of them fueled by the historically unique combination of low interest rates, inflation, and unemployment rates, more or less explained this extraordinary period of boom.

But the events of the past few months have shaken all these entrenched beliefs to the core, marginalized markets and brought governments back to the center of the debate on economic issues. As Skidelsky argues the present crisis has shown that market mechanism are not always rational and there may be no automatic barrier to the slide into depression, unless a government intervenes to offset extreme reluctance to lend by huge injections of cash into the economy. The importance of the Keynesian "automatic stabilizers" - the movement of the budget into deficit or surplus as the economy slowed or speeded up - assume importance for both Wall Street and Main Street.

Keynes had held that during times of economic turbulence, governments should vary taxes and spending to offset any tendency for inflation to rise or output to fall. Therefore, a depressed economy might remain trapped for a long time in a state of "underemployment equilibrium", from where it could be rescued only by a massive external shock. The surge in government spending to support the World War II effort, was the external shock that took the US economy out of the 1930s depression.

Skidelsky contends that Monetarism had failed to appreciate the important fact that price level is not a leading, but a lagging, indicator. Therefore asset bubbles can coexist with a stable price level, even while the rest of the economy is starting to slide into depression.

Skidelsky writes that Keynes had argued that during times of asset bubbles, "Money was being switched from production to speculation. The rich were getting very much richer, while the incomes of the rest were stagnating. "Profit inflation," fueled by collateralized debt, went together with an "income deflation." Share prices were being driven up to dizzying heights even as farmers were finding it harder to service agricultural mortgages. Every financial crash is different in detail - today's started in the banking system, not the stock market - but the anatomy of all is surprisingly similar: A speculative frenzy, triggered by some technical innovation such as mortgage-backed securities, that collapses when reality - in the form of more sober valuations - kicks in."

Chris Dillow, as always is more nuanced, and feels that Keynes may not be the ideal place to find explanation for the present crisis. The financial market, rather than real economy, origins of the crisis, and the impossibility of governments to predict and thereby prevent recessions, means Keynesian explanations may not work well. He writes, "please don’t think Keynes thought booms and slumps could be prevented merely by pulling fiscal and monetary policy levers."

But once recessions have arrived, as is the case now, the only option to smooth over or attenuate the impact of the downturn is by "pulling fiscal and monetary policy levers"!

Update 1
Edmund Phelps makes an interesting distinction between a drop in asset prices springing from monetary causes – an exogenous, or autonomous, increase in the demand for money – and one springing from causes having nothing to do with supply and demand for money – say, diminished expectations about future returns on business assets or houses. Keynes had argued that all such phenomenon could be solved by lossening monetary policy.

The former phenomenon could be solved by monetary means: the central bank could boost the money supply (by purchasing public debt, say), which would drive asset prices back up without driving up other prices and wages equally in a pointless spiral. But Phelps feels that events like the recent collapse of speculation on houses, are a non-monetary phenomenon - there has to be a drop of the money price of (a basket of) houses relative to the money price of (a basket of) consumer goods - and hence cannot be addressed by the traditional monetary loosening.

He also feels that the Keynesian contention that consumer demand would drive employment (an increase in demand encourages companies to raise production and hire more workers) may not hold in an open economy, where the fiscal stimulus may only go abroad. In the global economy, increased consumer demand would ultimately do little more than raise interest rates, thus setting off declines in real asset prices, investment and real wages.

Update 1
Keynes message to the President of US - spend, spend, spend!

Update 2
Martin Wolf argues that Keynes genius, especially in a world where the debate had crystallized into a battle between the left and right, state and market, command economy and free market, the need of the hour is to approach an economic system not as a morality play but as a technical challenge - preserve a market economy, without believing that laisser faire makes everything for the best in the best of all possible worlds.