Monday, June 8, 2015

Arguing Over the Zombie Corpse of Keynes

As I understand it, the core of Keynesianism is that, in an economic slump, it is a good idea for governments to borrow and spend, particularly on infrastructure. Because stimulus.

The idea is that when the government spends money on a useful thing like a bridge or a highway, there will be a "multiplier" effect, and the monies spent on infrastructure will "multiply" through the rest of the economy. Hence stimulus.

We non Keynesians have always been a bit suspicious about the "multiplier" effect and recent research has indicated that the multiplier might be less than one, meaning that the Keynesian stimulus has an anti-stimulus effect. In real recessions it seems that government spends a lot of the stimulus on e.g., grants to state and local governments to avoid laying off teachers.

Anyway, almost everything the government does is payoff to a special interest. What is the chance that any government spending "stimulates" the economy? I'd say pretty slim, Solyndra.

So it's natural for a non-Keynesian like historian Niall Ferguson to needle Keynes biographer Robert Skidelsky, who predicted disaster for the "austerity" policy of the Cameron government in Britain in 2010. Instead Britain has outpaced the rest of the EU in economic growth.

So did the Brit economy do better than forecast because of its austerity policy or in spite of it? Good question.

In my view the Keynesians are missing the point.

The point is that in an economic contraction a lot of people can't pay interest on their debt, and, what is worse, cannot repay their debt because their collateral can no longer liquidate the debt. Banks, of course, are the worst of all. this creates a financial crisis.

That's why we have central banks as the "lenders of last resort." The idea is to fold the debt of defaulters into bigger, healthier institutions, including the nation state itself. A lone borrower may be broke and unable to make payments, but the whole nation is not; the bigger, healthier institution can still make its debt payments and keep the credit system afloat.

In the Crash of 1907 the United States did not have a central bank and this was considered to be a Bad Thing. But in the crisis point, J.P. Morgan was told that a certain brokerage house was set to fail on the following Monday. So he got permission from President Roosevelt to do a debt-equity swap and saved the brokerage. End of crisis. Then Morgan grabbed the richest men in America into his library and they did triage on the economy. They lent money only to troubled corporations that they thought would survive if they lent them money.

But the establishment decided that this was not enough and so they legislated the Federal Reserve System. Unfortunately when the Federal Reserve was tested in 1929 it failed in its core mission by allowing a bunch of banks to fail. This reduced the money supply and created a cascade of failure. The result was the Great Depression and it didn't matter what stimulus and what-have-you the government got into. The basic credit system collapsed because the Federal Reserve did not do its job and act as lender of last resort.

The same thing almost happened in the Crash of 2008. The Federal Reserve, Ben Bernanke, proprietor, let investment bank Lehman Brothers collapse, saying that he didn't have the authority to rescue it. That was in September 2008 and the financial markets went into free fall. In the end, with TARP and other programs amounting to about $20 trillion in outlays and guarantees (see my, the federal government executed on a gigantic lender-of-last-resort program (meaning, roughly, that the feds took all the dodgy debt onto their own balance sheet) and the economy recovered.

Now my view is that Keynesian stimulus is counterproductive. In my view the problem at a financial crash is that, as the Austrian economists say, too many capital investments have turned out to be malinvestments. Those malinvestments of the previous boom must be liquidated and the resources released into more productive channels. A recession is the period of adjustment for the liquidation of the malinvestments of the previous boom.  But governments are in the business of bailing out politically favored corporations like General Motors, not in liquidating failed businesses so that the resources they consume can be reallocated to better businesses.

There is indeed an argument for temporary relief to workers thrown out of work during the period of adjustment. My argument is that this has a little to do with compassion and a lot to do with keeping disappointed people off the streets until the economy recovers and businesses are hiring again. What people call "austerity" is really the government's attempt to reduce the flood of government benefits so that people will start looking for work instead of reposing on their benefits.

I'm inclined to categorize Keynesianism in the category of what Charles G. Battig calls "bespoke science." It's science that is made to order for politicians by tame scientists. Politicians naturally respond to any economic crisis by spending and borrowing. Keynesianism gives them a fig-leaf to hide their economic embarrassment.

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