Posted by: Dirk | May 30, 2008

Leijonhufvud and the Crisis

Axel Leijonhufvud asks some very important in his recent article, namely:

(1) How are we to understand what is happening right now? (2) What can be done about it? What is the best policy to follow? (3) Do recent events force us to modify what is today widely accepted economic theory? If so, what is wrong and how might we go about arriving at a more satisfying theory?

In the following, central bank independence and inflation targeting are attacked. Inflation-targeting does not work if import competition hold prices down, like in the US. What results is a far too easy monetary policy, creating an asset price bubble (the last one being the housing bubble). If then the central bank has to choose the level of inflation in a non-automatic way (discrete, not guided by a rule) way, its choice would have redistributive consequences. Debtors and creditors stand on opposite sides. The decision about the level of inflation should then be decided in a democratic way, Leijonhufvud says. This would mean that independence of central banks is no longer feasible.

This seems to me a plausible critique, since Ben Bernanke has already changed the rules of the game, showing that there was something wrong with the rules we had and the theory that supported them. However, as Axel Leijonhufvud concludes, there are no clear alternatives at this moment.

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