Monday, February 2, 2009

Olivier Blanchard says that uncertainty feeds current global economic crisis

I remember Olivier Blanchard as the author of "Macroeconomics, 4th edition", a textbook in my Macroeconomics class at Carnegie Mellon Universty's Heinz College Australia in 2007. Blanchard who was then teaching Economics at MIT is now IMF's chief economist.

In a guest article in The Economist on January 29th 2009, he shows how subjective uncertainty, what is known in the field as the "unknown unknows"( in contrast to the "known unknowns"), is affecting negatively the behaviours of investors, consumers, and firms. Indeed, investors are now willing to hold only the safest financial assets such as U.S. T-bills in view of the complexity of current economic environment, and consumers and firms prefer to delay spending and investment decisions because it makes sense to wait and see "if you think that another Drepression might be on the corner".

As a result, the world is witnessing "enormous spreads on risky assets, a credit crunch in advanced economies, and major capital outflows from emerging countries" not forgetting to mention the drastic fall in demand for goods and services. All these factors have contributed to trigger global recession.

Blanchard recommends policies to reduce uncertainty by improving the health of private financial sector through recaptilisation, transfert of funds back to emerging countries. Stronger fiscal stimulus such as temporary subsidies to consumers, government spending on infrastructure should also be implemented to induce consumers to consume more and now and to encourage investment.

But the increase in spending as an effective way to handling the crisis seems to be a hot issue in the U.S. Alberto Alesina, a Professor of Political Economy at Harvard University says it is tricky to ask Americans to spend more now after having blamed them for saving too little.

The debate on Blanchard's article, animated by leading economists around the world, offers a more comprehensive view of the challenges facing policy makers right now. More importantly, it focuses on the psychological drivers of the current economic crisis. It is a must for anyone trying to understand why a quick recovery from a crisis like this is hard to achieve.

Commenting on an article in The Economist in December 2008, I put it this way:'' I guess economists have been clueless on how to handle the psychological problems of market actors in this financial crisis so far.The Fed's decisive move aims at stimulating the economy through consumer spending and investment.But there is no evidence that consumers and investors will respond positively in the face of gloomy job prospects and uncertainty across several industries.Let's combat now the opposite of irrational exuberance..."

Well, I learned by following the discussion on Blanchard's article that human psychology is an area of active research by economists. For example, Robert Shiller, Professor of Economics at Yale University, and his colleague,George Akerlof , have just published a book on the subjet entitled:"Animal Spirits: How Human Psychology Drives the Economy and Why It matters for Global Capitalism".

In African countries, the "fear of the fear itself" leads financial institutions and investors to hoard cash, consumers to consume less , and firms to invest inadequately. In short, uncertainty is hampering our economic growth.

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