There may be a much less enthusiastic holding of Euros by both individuals and Central Banks.

Alejandro Ferro

Do you really believe that the Euro will be there in 2 to 3 years, or just trying to be nice?

It does not seem so obvious to me that the world governments, across the board, would take to large deficits as a result of the current financial crisis. Sure, market fundamentalism has been out of favor since the mid-90s or so. The exacerbation of crisis conditions in Latin America and East Asia caused by the IMF's strict advocation of balanced budgets, the failure of transforming the former Soviet Union and the East-bloc countries into market economies, and the rigid economic and foreign policies of the George W. Bush administration were major factors in puncturing the credibility of pursuing free market policies. As a result of this backlash against market fundamentalism, Keynesian policies have been gaining ground steadily during this decade. Consequently, it has become fashionable for the United States, the IMF and the World Bank to call for large deficit spending and drastic rate cuts, not only in the United States but uniformly throughout the world, to tide over the current economic crisis. However, as governments around the world take a serious look at their priorities, in view of the dire economic conditions prevailing currently, it is becoming increasingly obvious to many of them that Keynesian policies are not in their long-term interest.

What is the problem with Keynesian theory? To examine the relevance of Keynesian theory to the modern economy, we first recall the most important intellectual development in economics during the 19th century, namely, marginal utility theory. The 19th century economists -- notably Walras, Jevons and Menger -- succeeded in formulating a vastly general framework under which marginal utility theory would apply. In this framework, the whole national economy is modeled as a single entity, with the producers and the consumers in this economy, interacting under the terms of most freedom. Due to the myriad interactions of the consumers and producers at different levels, the individual markets are all subject to pulls and pressures from each other. At an initial point in time, supply and demand in these markets are supposed to be in equilibrium at those price levels that are determined by marginal utility theory. Moreover, this theory also determines (qualitatively) what happens when changes in the supply and demand in one market sets off changes in various other markets, resulting in a move away from general equilibrium. However, the way the problem was formulated was too complicated, and it was not clear whether such changes in supply and demand would result in the economy getting back to general equilibrium. A clear set of conditions for the existence of general equilibrium were not discovered until the Arrow-Debreu model appeared in the 1950s.

As is well-known, during the Great Depression in the 1930s, the industrial economies of the West were caught in a downward spiral of unemployment, deflation and contraction. The model of the economy as being under a general equilibrium was not useful in determining when, if at all, supply and demand in the various markets would finally settle down at an equilibrium price level. Employment kept falling until a quarter of the population was unemployed, GDP kept contracting until the annual output declined by a third. Even if the economy reached an equilibrium after these devastating events, it would clearly be meaningless. Moreover, the general equilibrium framework was not useful in showing how to avoid such catastrophic events in the future. It was in this situation that John Maynard Keynes became famous for his theory described in his book, 'The General Theory of Unemployment, Money and Interest'.

In Keynes' outlook, though the economy is described by general equilibrium theory as a maze of inter-connected markets for the exchange of different objects, in reality, it is a single market, namely the stock market, that plays a predominant role in determining the functioning of the economy. Moreover, the behavior of the consumers and producers in the economy could not be described as rational and free, as expounded by the liberal ideals of the Rennaissance Enlightenment. Instead, the market participants have expectations about the future performance of the economy. These expectations are driven in equal parts by rational observations, probabilistically informed guesses and animal spirits. From his experience with playing the stock market, Keynes also took into consideration, the effects of speculation and the drying up of liquidity. Note also that this formulation of an economy as centered on the stock market means that the news channels that serve as the mechanism for transmission of information between the broader economy and the stock market gain importance. These news channels amplify the role of psychological factors like fear, panic, confidence, greed and foolhardiness.

In keeping with the intellectual ethos of those times, Keynes built on the store of mathematical concepts, as introduced in Albert Marshall's book, that served as a new foundation for economic theory. Using these tools, Keynes pioneered the examination of how developments at the microeconomic level -- that is, in households and in firms -- aggregated to influence the macroeconomic situation. Focusing on the aggregates of savings, investments and money supply, enabled him to make a serious attack on Say's Law -- that wants are unending, and supply creates its own demand. He was able to demonstrate that managing aggregate demand was equally important as investments on the production process. In short, his prescription to recover from the Great Depression was for the government to spend as much money as is necessary to maintain the economy at full employment. This would prevent a downward spiral of unemployment and deflation, though not necessarily a contraction in GDP.

The first problem with Keynesian theory is that this theory is only appropriate for intellectuals occupying positions close to the seats of power in an empire that is inexorably on the path to decline. It might have been convenient for the British empire to ignore the vast amounts of information flowing in from its colonial outposts as just so much noise, and focus solely on that part of the news that is relevant to its stock market performance. In particular, with the empire so pre-occupied with maintaining its own economy at full employment, one could see why millions of farmers perished in the Bengal famine of the 1940s. The global situation at present is quite analogous, with the liberals advocating trillions of dollars in deficit spending, and further trillions of dollars in monetary expansion, while millions of people in the poor countries run the risk of starving. In earlier decades, poor countries that had adopted deficit spending for their social safety programs had found their currencies devalued when economic conditions deteriorated. Not infrequently, they have required the bailouts from the IMF and the World Bank under stringent conditions.

The second problem with Keynesian theory is that it does not provide a clear demarcation for the role of the government. Even though Keynes relied on a mathematical foundation, especially in his treatment of expectations, he had clearly taken on more mathematics than he could handle. Dwelling on highly elusive issues like animal spirits, fear, confidence and speculation made it difficult to give a clear treatment of his theory. As a result, there was no specific restriction on government spending. Government should spend to maintain full employment. Government should spend to avoid the liquidity trap. Government should spend to stimulate consumer demand. Government should spend to defeat bear-runs triggered by speculator frenzy. There was no end to government spending. For this reason, I have introduced a new formulation of Keynesian theory in which a purely mathematical argument is given as the basis for the role of the state. Considerations of behavioral psychology and expectations, be it rational or non-rational, could be proposed independent of this basic mathematical argument for the state's role. My argument is as follows:

Marginal utility theory implies that the free market should be relentlessly focused on the present. In the interest of fairness and efficiency, the free market should not entertain arbitrage opportunities for the market participants. This implies information about economic developments should be generated in an unbiased manner and should spread quickly among the market participants. But this already means that the free market should only follow random walks of price levels. However, these random movements do not accurately reflect the functioning of the broader economy. Sure enough, changes in economic activity can be sudden and random, but usually a nation's economy has some continuity to its functioning, and based on this assumption, economic decisions are often made looking into the future. Investments on raw materials, inventory management, extension of credit to consumers, time value of money, experimenting with new technology, R & D, hiring new employees are some examples where the trust in our ability to gauge the future is crucial. Thus the nature of the price movements in a free market are at odds with the price movements in the broader economy. Because of this fundamental discrepancy, the allocation of resources that the market mechanism makes could be efficient, at best, only in the short run. There is no guarantee that the allocation of resources would turn out to be optimal in the long run. Hence there is a role for an external agency, like the government or the central bank, to step in and take corrective measures whenever it is obvious that the functioning of the markets would not be optimal in the long run.

Please note that in the above argument there is no reference to animal spirits, investor confidence, speculative frenzy, nor even the social strife set off by drastic unemployment, to justify the role of the state. Moreover, the above argument suggests that the government and the central bank should first spend money directly on the broader economy instead of trying to stimulate confidence in the financial markets. Also, my argument proposes to put a limit to deficit spending -- spend only as much as is necessary to keep the broader economy from deterioration.