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11 September 2017 Financial Analysts Journal Book Review

Modern Financial Macroeconomics: Panics, Crashes, and Crises (a review)

  1. Martin S. Fridson, CFA
The author and the school of New Institutional Economics finally give financial markets their due in the business cycle. This book is a welcome antidote to the view of business cycles that emphasizes the traditional channels of monetary transmission—interest rates, exchange rates, and the wealth effect.

Identifying the sources of cyclical downturns and ultimately learning how to mitigate them are key aspirations of economists. To individuals reared on popular perceptions of the Great Depression, stock market excesses figure prominently in the debate. Most major schools of economics, however, steadfastly refuse to consider the independent role of financial markets.

Classical and neoclassical models, for example, assume that by cutting interest rates, central bankers can always induce lenders to resume lending and thereby jump-start a recovery. In reality, recessions cause lenders to focus acutely on the risk of not getting repaid. They know that they are at an informational disadvantage vis-à-vis loan applicants regarding the applicants’ creditworthiness and that the riskiest borrowers are the ones most likely to seek loans. Consequently, opening the credit spigot often fails to provide the stimulus that policymakers expect.

Author Todd A. Knoop of Modern Financial Macroeconomics: Panics, Crashes, and Crises points out that the founder of another major school of economics, John Maynard Keynes, linked speculative excesses to swings in investment and, ultimately, the production of goods and services. Knoop, a Cornell College economist, notes, however, that the Keynesians did not follow Keynes in this respect. They emphasized consumption volatility over investment volatility. The Keynesians’ chief opponents of the 1950s and 1960s, the Monetarists, similarly minimized the role of imperfect financial intermediation in producing economic shocks. They blamed, instead, inept central bankers.

Knoop deftly details how the models that give short shrift to financial systems fail to explain economic fluctuations as a function of the traditional channels of monetary transmission—interest rates, exchange rates, and the wealth effect.For instance, the U.S. Federal Reserve Board controls only the overnight lending rate, yet long-term interest rates are what truly determine the financing costs of investment and consumption. Furthermore, numerous studies have found little correlation between interest rates and levels of investment—especially fixed business investment. Neither has empirical evidence emerged that monetary policy creates wealth effects large enough to influence real economic activity materially nor has research shown that exchange rates, given that international trade represents a small portion of GDP in the United States and other large economies, play more than a minor role. Despite this sorry record for traditional monetary mechanisms in influencing the economy, Knoop notes that they “are so widely accepted among economists, the public, and the media as to be almost accepted as law.”

In light of such pervasive misapprehensions, investors would do well to familiarize themselves with New Institutional Economics (as a part of New Institutional Theory), which is finally giving financial markets their due. These modes of economic thought focus on balance sheet channels of monetary transmission: Monetary policy affects borrowers’ and lenders’ financial conditions, which, in turn, influences default risk, thereby causing financial intermediaries to increase or decrease their activity—and that is what produces swings in aggregate output.

Knoop expertly applies New Institutional Economics analysis to such topics as the Basel Accord of 1988, the Asian Financial Crisis of 1997, the 2007 credit crunch, and the operations of the International Monetary Fund. He meticulously documents his arguments with recent research that challenges conventional wisdom across a broad front. (Too bad for ideologues for whom it is an article of faith that the Smoot–Hawley tariff triggered the Great Depression!)

Considering the book’s important insights, it is regrettable that the publisher did not take time to edit it more carefully. The author mischaracterizes the infamous Dutch “tulip mania” by stating that prices soared on the flowers themselves rather than on bulbs. The bulbs, in fact, had considerable value by virtue of their ability to propagate exotic varieties. Knoop also incorrectly credits economist Irving Fisher (1867–1947) with the invention of the rotary card file known by the trademark Rolodex. It was actually invented more than a decade after his death by Arnold Neustadter, although Fisher became wealthy by patenting a forerunner device in 1912.

Misspellings risk undercutting the text’s credibility (e.g., “Paul Volker” for “Paul Volcker,” the “Glass-Stegal Act,” and “Arthur Anderson” for “Arthur Andersen”). Other stylistic flaws include redundant phrasing (“help facilitate,” “new innovations”), together with numerous subject–verb disagreements (“legal systems that protects”) and antecedent–appositive conflicts (the plural pronoun “they” referring to singular nouns, such as “central bank” and “the public”).

One hopes that most readers will fight their way through such imperfections. We are not overstating the case to assert that Modern Financial Macroeconomics will revolutionize the thinking of readers conditioned to view business cycles through the lens provided by Wall Street economists, politicians, and the financial media. Knoop and the New Institutional economists make a compelling case that the TV talking heads who agonize over the Fed’s next move on interest rates are missing the point.


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