I
Unless they have taken a course in economics most people probably have never heard the name John Maynard Keynes. To his contemporaries this English economist, statesman, and general all-around charismatic intellectual, was a household name. And to generations of economics students in the period after World War II he was a hero. He was the man who invented macroeconomics, the man who revealed to the world how to avoid another Great Depression, the man who made it respectable for governments to target unemployment, to worry about balancing the economy and not worry about balancing the budget. He taught us that it is unnecessary to worry about the long run, because "in the long run we are all dead." He taught us that government leadership was necessary to safeguard us from the possible and likely instabilities of the market system. Capitalism was ok, it was the best system we had to ensure economic growth, peacefully and democratically. But it needed to be bolstered by enlightened governmental intervention at crucial moments. Most of this came packaged in his book The General Theory of Employment Interest and Money, published in 1936. It became the basis of the new conventional wisdom. And it is still with us.
To be sure, Keynesian ideas were around before Keynes, but they were mostly associated with quacks and crackpots. Economists before Keynes dismissed the idea that governments could "create jobs" by simply putting people to work on "public works" using money created by the central bank (inflation). After all, if resources were employed in public works, they would be unavailable for anything else. Society would have to forgo the alternative product of these resources - that was their opportunity cost. Governments could not simply "create" jobs where none existed before. They could only redistribute jobs away from the private sector into the public sector. And there was no reason to presume that the latter jobs were more valuable to society than the former. An understanding of economic history and of the market process suggested the opposite, namely, that private market decisions in the pursuit of profit would tend to produce the most valuable jobs for the most people.
Keynes was able to secure acceptance for his ideas for a number of reasons having to do with who he was, when he was and what he was. He was a very powerful personality (to say the least) who came to prominence at the time of the worst economic depression the world had ever faced and was the head of the most prestigious university economics department (Cambridge) in the world. He was uniquely placed to take these, hitherto dismissed, ideas and make them not only respectable, but the new revealed truth. It is an episode in history that is testimony to the power of ideas.
Keynes packaged these ideas in convoluted intellectual garb and he asked some legitimate and penetrating questions about how the market works, questions that are not easy to answer. Keynes suggested that the "dark forces of time and ignorance" made it implausible to suppose that private mortal entrepreneurs could be relied on to correctly anticipate the future demand for goods and services in any detail. This being the case, how can we rely on the market system to correctly put to work the savings of millions of private individuals? Savings is the sacrifice of present consumption spending for the option to consume in the future. But what guarantee is there that increased saving today could and would be translated into increased consumption tomorrow? After all, increased saving today means less consumption today and this is likely to discourage entrepreneurs from producing for the future. This is why we need the government to undergird the economy and prevent it from falling into a downward spiral built of the pessimism that could arise from underconsumption (however caused). In a modern monetary economy, private savings do not automatically get translated into private investment. Thus private investment needs to be supplemented and nudged by government investment -and if necessary, it would seem, also by government consumption.
II
The Keynesian message is appealing and intuitive and it has sold very well. In the post war period, first the academic economists, then the other social scientists and then the public at large became converts. From the time of John Kennedy onwards American economic policy became self consciously Keynesian. But there were pockets of strenuous resistance to the new creed - most notably at the University of Chicago (the economists of the Chicago School) and also among many individual economists around the world - notably those trained in the so-called Austrian School of Economics. The most prominent Austrians of that period were Ludwig von Mises (then at New York University) and Friederich Hayek (at the London School of Economics and later at the University of Chicago). The most famous Chicago economist in this context was Milton Friedman - perhaps America's most well-known economist ever. It was Friedman's relentless work (together with his students and colleagues) that paved the way for a sober reconsideration of the new Keynesian orthodoxy and its subsequent overthrow.
My own personal odyssey is revealing. I arrived at the university of Chicago in September 1972 to pursue my Ph.D. in economics. I was an informed and enthusiastic Keynesian, in spite of being taught in South Africa by Ludwig Lachmann, an adherent to the Austrian School and in spite of a detailed knowledge of Milton Friedman's monetary theory (on which I had done an honors thesis). Between 1972 and 1976 I was immersed in a detailed and rigorous examination of market economics. During these years the American economy was being put to the test. Friedman had long been preaching against the Keynesian macroeconomic policies of tax and (inflate and) spend, and, in his presidential address to the American Economic Association (1968), had warned that such policies would ultimately lead to the experience of inflation and unemployment at the same time. By the mid to late 1970's this is exactly what happened - a new American word, stagflation, was coined to describe it. High levels of both inflation and unemployment emerged, seemingly impervious to the stimulatory actions of government economic policy. In fact, people now began to suspect what Friedman (and Mises and Hayek and countless others) had been saying for years - that government policy was responsible for the mess, that government policy far from being the solution was itself the problem. People began to suspect that the pre-Keynesian economists were right in thinking that the market was not inherently unstable (as Keynes has asserted) and that government intervention in pursuit of the goal of improving on market outcomes actually succeeded in destabilizing the market even further, much further. By the end of 1970's people were ready for a change. It was in this climate of opinion that Ronald Reagan was elected president (around the same time that Margaret Thatcher was elected prime minister in Britain). When I left Chicago in 1976 I was convinced that Keynesian economics was a fraud and I have never seen reason to change my mind. I naively thought that my own passage from illusion to enlightenment was characteristic of the public in general and that Keynesianism (at least in its naive form) had been put to bed forever. I had thought that we now understood that inflation and unemployment were not alternatives and that any temporary stimulus achieved by money inflation be short lived and would itself cause a boom-bust cycle. The Keynesians had scrambled to put together an even more convoluted version of the story, but I had thought their efforts were basically seen as unsuccessful – at very least by trained economists.
Clearly not. The current financial crises has fueled a frenzied recycling of discredited Keynesian ideas. We are hearing again of the need for "public works" of the necessity to "stimulate" the economy - even at a time when unemployment has not moved very high. The Federal Reserve is frantically inflating the supply of money. We are laying the groundwork for a disaster reminiscent of the 1970's - and one hopes not even worse.
III
To understand this we need to look at some of the details of the current crisis. The conventional wisdom has it that the current situation is the result of too much reliance on the free market, on “too much deregulation.” The truth is exactly the opposite. The current debacle is the result of overreaching multiple government regulations and interventions. At the very base of the problem is a Federal Reserve System that has attempted to finely tune the economy through ups and downs, always reluctant to be the party-pooper that brings any boom to an end. Thus the “natural” end of the “telecom boom” was postponed by a reluctance of the Fed to allow interest rates to rise – allowing the supply of money to expand to fuel the necessary credit for continued expansion into ever more risky and unsustainable business ventures. When the bust came it came with more pain that necessary. The housing bubble that followed was similar to and related to this. The Fed provided the necessary fuel for this bubble as well.
But, the matter is more complicated than simply too much credit. The housing crisis is the result of a systematic, hard-headed social policy to increase the number of home owners in America. Using the politically-charged notion that minorities were suffering from discrimination in the mortgage industry (a notion that has been discredited), some Democratic politicians made it their mission to systematically rewrite the standards for the approval of mortgages and to ensure that they became the standard operating procedures for the industry. In this they were assisted by, indeed used, the quasi-government mortgage packaging institutions like Fannie Mae, Freddie Mac and Ginnie Mae. The result was a massive expansion of the production of new houses, an increase in housing prices and an increase in the proportion of Americans owning their own homes. The rise in housing prices in turn encouraged creative speculation in financial securitization based on mortgages. It also encouraged speculation in home ownership whereby, with very little or no money down, people were able to buy multiple homes and profit from the run-up in prices. When housing prices finally started to fall many people found themselves owing more than the houses were worth and simply walked away from them. Others found themselves facing mortgage payments that they could not afford – because of the systematic devaluing of mortgage standards (click here and here to see an in-depth analysis). In short, we have had a distortion of the production structure of the economy toward the production of items whose value did not justify their production in the first place. This is a production structure that cannot be sustained. Resources are “misemployed” and need to be redeployed – a process that is necessarily painful. (The same story characterizes the ailing auto industry over a much longer period.) This the background to the current financial meltdown.
IV
Against this background one can see that attempts to solve the crisis by simply providing more liquidity or “stimulating” the economy won’t work – in fact they will make things worse by creating the illusion that the distorted production structure can be preserved. Pay now or pay more later. In the meantime we hear talk of a massive stimulus in the works - $800 billion in addition to the $700 billion already available to be provided to stimulate consumption. This presumably is in anticipation of a precipitous fall in consumption spending that is expected to result from the massive capital losses that have resulted from the financial and housing price meltdowns – reminiscent of the Great Depression of the 1930’s. As bad as things now are we are nowhere near the situation of the Great Depression and one hopes we never will be. This massive expansion of money is occurring at a time of great uncertainty and so is not circulating through the economy very rapidly (as people are reluctant to lend and even to borrow). The time will come in the not too distant future when this excess liquidity will inevitably result in general price inflation and all the negative side-effects that this always brings.
The stimulus package and the other varied and unpredictable government initiatives that we have witnessed recently – like the “bailout” of Citigroup and AIG – are unlikely to do any good at all, except for those who are directly subsidized by these actions –at the taxpayers’ expense. We know from the logic of basic economics and from history that such initiatives are unlikely to work. And we know that they, at very best, will postpone the necessary reallocation of resources that must take place before the economy can recover. At worst they will exacerbate the misallocation of resources and make the recovery ultimately more difficult.
What is most alarming to me personally is the enthusiastic recycling, indeed apparent wholesale resuscitation, of discredited Keynesian ideas. The false prophet of the public purse is back.
