By Edmund Phelps

What theory can we use to get us out of the impending slump quickly and reliably? To use the “new classical” theory of fluctuations begun at Chicago in the 1970s – the theory in which the “risk management” models are embedded – is unthinkable, since it is precisely the theory falsified by the asset price collapse. The thoughts of some have turned to John Maynard Keynes. His insights into uncertainty and speculation were deep. Yet his employment theory was problematic and the “Keynesian” policy solutions are questionable at best.

Banks spoke of the downturn in house prices as an effect of some sort of shock. In their models, random shocks are forever knocking asset prices from forecast values. In fact, no quake or drought or other exogenous force caused prices to drop. The prime cause was forecasting with badly mistaken models. Speculators and home buyers, thinking that rentals or building costs would go up, bet on higher house prices in future, which also raised the price of existing houses. But over the years neither rentals nor costs (in real terms) budged. If they did not rise, (real) prices would sooner or later have to go back down.

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November 5, 2008 12:45am in Credit squeeze, Economists, Keynesianism | Comment