Our Current Keynesian Nightmare
Interest-Rates / US DebtOct 14, 2016 - 10:46 AM GMT
By: Frank_Hollenbeck
It is not an understatement to say that the economic policy of the United States since 2008 has been purely Keynesian. Interest rates are near zero and the national debt stands at nearly $20 trillion. This is a direct result of applying the policy prescription recommended in Keynes’ General Theory. One day, his book will likely sit next to Karl Marx’s Communist Manifesto as works that generated dangerously false notions of reality with disastrous consequences.
Keynes obtains most of his conclusions against capitalism by gutting its essential characteristic, i.e. adjusting prices to allocate resources where society deems most urgent. His theory assumes price inflexibility (wages being a price).
Suppose someone claimed that gravity doesn’t hold us to the planet like Newton told us, and that people would float off into space unless we build large nets to save humanity. Such a person would normally be hauled off to the asylum–if it were not for Keynes. By assuming price inflexibility, Keynes concludes that unemployment can be a permanent fixture of a capitalist economy and that legal counterfeiting (monetary policy) and robbing Peter to pay Paul (fiscal policy) are sound economic policies. Instead of being discarded as a crackpot economist, monetary crank, or ignorant zealot, Keynes was given the status of economic genius.
Why was such an incredibly poorly written book as Keynes’ General Theory so widely acclaimed? It had innumerable errors in logic and ever shifting definitions (e.g. savings, marginal efficiency of capital, and interest rates). The answer is simple: Politicians put Keynes on a pedestal because he gave them the theoretical foundation to justify policies that had been previously ridiculed by classical economists. Even today, it serves as the foundation of economic policy.
Take the concept of the fiscal multiplier: it does not exist! Rather, it only exists in the illogical minds of Keynesian and other economic professors and writers of economic textbooks. Since this concept is incorporated in every undergraduate and graduate textbook, a simple recapitulation will do: The idea is that if the government spends $1, someone will receive $1, who will spend a portion, say 80 cents, which will be received by someone else who will also spend only a fraction, and so on. Keynesians give a nice little formula that says in this instance the multiplier is 5 and $1 spent by the government will create $5 in national income.
Now the natural question of the inquisitive student would be to ask: How did the initial $1 of spending get financed? Here, the Keynesian have a neat little answer: the balance budget multiplier. If the government spends $1 and taxes $1, spending still initially goes up by 20 cents since the person who was taxed would have only spent 80 cents of it. The multiplier in this case is $1. At this point, most professors go on to another topic, unnoticed by the unwary student is the insidious assumption underlying this theoretical conclusion.
The multiplier concept makes the heroic assumption that the entire 20 cents was hoarded, or held in cash–the equivalent of stuffing money in your mattress. If, instead, the amount taxed had reduced savings1, in the place of hoarding, $1 of government spending will displace $1 of consumption and (savings) investment spending; the multiplier is zero, and government spending and, fiscal policy, have no direct aggregate demand influence on output. Of course, if we consider the supply side, the multiplier is negative. As Murray Rothbard eloquently said, this is a transfer of “resources from the productive [private sector] to the parasitic, counterproductive public sector.” The current $20 trillion debt reflects government spending or real resources that would have been put to better use had it been left in private hands.
Keynes also advocated the “euthanasia of the renter” by driving interest rates to zero. His faithful followers in the Eccles building in Washington have been busy following his advice. Yet, as Mises stated, this view of interest rates (here and here) is of unsurpassable naiveté2.
A microeconomics professor will explain to his students how price controls create a divergence between what society wants and what it produces–the unintended consequence are wine lakes, butter mountains and unemployment. Yet, this schizophrenic economist will then cross the hall and teach a macroeconomic class and explain how fiddling with capitalism’s most important price, interest rates, will solve society’s economic problems.
The reality is that the economy is not like a car and interest rates are not like the gas pedal. Interest rates play a key role in aligning demand with output across time. The longer you interfere with interest rates, the greater will be the misalignment and the greater will be the unavoidable adjustment necessary to realign output with demand.
We are currently in a deep hole. Our currently ill-conceived policies will lead to the crackup boom that Mises predicted and will be much worse than 2008. Yet we do not have the intellectual consensus to dig our way out. What is worse is that the next crisis will undoubtedly call for more of the same.Our current crop of economists is brainwashed into believing that the only solution is more government spending and printing: the one trick pony! The end game will then be hyperinflation, ultimately leading to dictatorships. Yet, there is a better alternative, and it starts with 1. Reestablishing sound money (here) , 2. Ending fractional reserve banking (here and here) and 3. Putting an end to central banks.
Notes
1 The correct narrow definition of monetary savings is a transfer of claims from one group to another. This is the definition found in the classical loanable funds theory of interest rates. The saver is giving up his claims to be able to consume more goods and services in the future. He makes this transfer to investors who use these claims to purchase plants and equipment to produce goods and services in the future. Keynes created immense confusion when he used the single word “savings” to reflect two acts: the transfer of claims (classical definition of savings) and the holding of claims, or hoarding (here).
2 “It regards interest as a compensation of the temporary relinquishing of money in the broader sense –a view, indeed, of unsurpassable naiveté. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest holds an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy.”
Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.
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© 2016 Copyright Frank Hollenbeck - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
Why Keynesian Economists Don’t Understand Inflation
By: Frank_Hollenbeck
The “monetary cranks” and “ignorant zealots” of old are back preaching salvation if only we had more inflation.[1] Keneth Roggoff and Fed President Charles Evans did not mince words, while others have been more circumspect. Christine Lagarde warns us of the “ogre of deflation” and the “risks” of low inflation, while others have been urging easier monetary policy to reduce the value of the yen or the euro. Of course, it’s much easier to let this inflation tiger out of its cage than to get it back in.
We have ample evidence that once inflation picks up, it’s extremely difficult to control. Inflation in the US was 1 percent in 1915, almost 8 percent in 1916, and over 17 percent in 1917. It was about 2 percent in 1945 and jumped to over 14 percent by 1947. During the 1970s, inflation was mild in 1972, and climbed to 11 percent by 1974 and stayed at very high rates until Volker raised interest rates to 19 percent to tame the beast.
Even if you agree a 2 percent inflation target is an appropriate policy, inflation should, at least, be measured correctly. Proper measurements are unlikely since mainstream economists today, unfortunately, use a simplified version of the original quantity theory of money. In this version, money is linked exclusively to nominal income, and the CPI or GDP deflator are used as a proxy for prices of the goods and services in nominal income. This version is obtained from Keynes’s theory of liquidity preferences.
Yet, the original, non-Keynesian quantity theory of money clearly shows that the demand for money is to conduct all possible transactions, and not just those that make up nominal income. Money is linked to prices of anything that money can buy, consumer goods, stocks, bonds, stamps, land, etc. From this, an average price cannot be measured since appropriate weights are not obtainable. The use of the simplified, Keynesian version in economic textbooks and by the professional economist has caused immense damage. When your theory is wrong, your policy prescriptions will likely also be wrong.
Unnoticed by many mainstream economists is the fact that we are actually having the inflation everyone was so worried about back in 2009. It is simply showing up in asset prices instead of consumer prices. For some reason we consider higher food prices as bad and something to be avoided, while higher home prices are viewed as a good thing and something to be cheered. But they are both a reduction of your purchasing power. Today, home prices outpace wage growth significantly in many markets, and remain at high bubble-like levels, pricing homes out of reach of many young couples. Their incomes have less purchasing power: the money can buy less of a house, just like it can buy less of a hamburger.
By setting an inflation target, the FED did not let deflation run its course after the crash of 2008, and that was a big mistake. During the 2001-2007 boom years, housing prices shot up. This speculative bubble led to massive overbuilding of both private homes and commercial properties.
Deflation would have allowed a realignment of relative prices closer to what society really wants to be produced, but by inflating the money supply, the FED interfered with this essential clearing process. Housing prices should have dropped, much, much more than they did relative to other prices. Housing should then have remained in a slump possibly for a decade or more, until this overhang of construction had been cleared off. The new ratio of relative prices would have allowed resources to move into the production of goods and services more in line with what society would demand in a functioning market. The carpenter might have moved on and worked on an oil rig, possibly at an even higher salary. But that did not happen.
Today, housing is back, with price increases at bubble-era levels and construction activity picking up. Yet, the overhang has not disappeared. It has just been left in limbo, because of the “extend and pretend” strategy of banks made possible by the central bank’s massive printing over the last five years. Of course, when the music, or money printing, stops, the adjustment in housing will be even more disastrous.
The Fed should draw several lessons from history about inflation. The first is that an ounce of prevention is worth a pound of cure. You treat inflation like sunburn, by protecting yourself before your skin turns red. Second, the FED should not be concerned with consumer price inflation, but the increase in all prices which we are incapable of measuring (the weights being impossible to calculate). The recent increase in asset prices, such as stocks or agricultural land prices should be a strong warning signal.
The real solution is to end fractional reserve banking. The central bank would then be superfluous. It would not be missed. Its record at counterbalancing the negative effects of fractional reserve banking has been disastrous, and if anything, it has made things much worse.
If banks were forced to hold 100 percent reserve, neither the banks nor the public could have a significant influence on the money supply. Banks would then be forced to extend credit at the same pace as slow moving savings. Credit would finally reflect the real resources freed up to produce capital goods. The money supply could then be what it should always have been, a means of measuring exchange value, like a ruler measuring length, and as a store of value.
Notes
[1] From Mises, “Planning for freedom” 1952, talking about the post Malthus-Say debates of the early 1800's. “Those authors and politicians who made the alleged scarcity of money responsible for all ills and advocated inflation as the panacea were no longer considered economist but “monetary cranks”. The struggle between the champions of sound money and the inflationist went on for many decades. But it was no longer considered a controversy between various schools of economist. It was viewed as a conflict between economist and anti-economist, between reasonable men and ignorant zealots.”
Frank Hollenbeck, PhD, teaches at the International University of Geneva. See Frank Hollenbeck's article archives.
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