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JakilaTheHun (99.94)

Babbling About Keynes, Part I

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June 06, 2011 – Comments (14)

Keynesian spending policy is one of the most misunderstood areas of economics.   I do not consider myself a Keynesian and my own views are probably closer to the Monetarism and the Chicago School of Economics.  All the same, I do believe it’s important to understand the actual logic Keynes employed. 

Keynes provided more insight into economics, than virtually any other 20th Century economist.   However, I do not believe one has to agree with Keynes' prescriptions to understand the premise behind them.  

Keynesian Policy During a Bust Cycle

Let’s start off with the part that most people understand.  Keynes advocated increased government spending and deficits during an economic bust where deflationary pressures are present.  A banking crisis would be the prototypical example. 

In a banking crisis, there is an abnormally low supply of money flowing in the economy.  This is a result of credit contraction, as banks must shore up their balance sheets and cannot lend out to others.  This creates deflationary pressures in the economy, which then harm investment, and create high unemployment.

Keynes advocated using fiscal policy to solve this dilemma.  This could be in the form of increased government spending or could also come in the form of lower taxes.  Keynes might have even advocated both during a particularly brutal recession/depression.   Both measures would pump money back into the economy, stimulate private investment, and help drive down unemployment under Keynesian reasoning.

This differs from classical liberal thought which suggests that the market can fix the problem on its own over time.   There are of course drawbacks to Keynes approach; the most notable of which is that advocating heavy deficit spending could lead to sovereign debt issues down the line. 

Keynesian Policy During a Boom Cycle

While many people understand Keynesian policy during bust cycles, its Keynesian policy during boom cycles that is particularly misunderstood.   If money supply is too low during an economic bust and fiscal policy is needed to pump more money into the economy, then it stands to reason that the exact opposite would be necessary in a boom cycle.

Under Keynesian theory, a boom cycle would likely result from excess debt (i.e. money) in the economy, which artificially increases the price of assets, creating high inflationary pressures.    In order to cool off the boom, one thing Keynes might advocate would be cutting government spending, running a government surplus, and paying off sovereign debt.   This would tend to have the effect of decreasing money supply in the economy and cooling off a bubble, while also allowing for a national government to have a more sustainable budget.

This is why the idea that Keynes advocated nothing but unbridled government spending is flawed.   Keynes viewed things in very cyclical terms and government deficits were meant to combat a situation where there is too low investment and money being used in the economy.   A bubble would call for cutting back government spending and paying off debt.

In Practice

Unfortunately, in practice, Keynesian policies are normally ignored during boom cycles.  We only see them advocated by politicians during bust cycles.  Politicians tend to advocate neo-liberal policies during boom cycles.

There’s a reason for this.  The incentive of a politician is different from that of a market participant.  Politicians always want to increase spending (i.e. increase services to constituents) and decrease taxes.   Likewise, they never want to do the reverse, which is often political suicide.  People generally like “free stuff” and not paying taxes.  The public doesn’t always consider the long-term consequences of these short-sighted economic actions.

Then there’s also the corporate side of this.   Corporations like for the government to stay out of their way generally.  This changes in an economic bust, as many corporations (particularly banks) stand on the verge of insolvency.  It’s at this point that many corporations love the government interfering in the marketplace.  For the corporations, they'd like to privatize the profits and nationalize the losses.  In other words, they want all the results of their risk-taking activities, but they want the public to absorb all the negative results. 

For these reasons, Keynesian policies tend to only be enacted during bust times, in reality.  Or even worse, politicians find ways to spin normal economic environments or even boom cycles as “bust cycles”, and use this as an excuse to provide a “Keynesian stimulus.”   In this way, Keynesian policies are frequently abused in practice.   Moreover, one might argue that Keynes’ failure to consider the incentives of politicians is one of the major flaws in his economic prescriptions.

Was Keynes Right?

Personally, I’d suggest that there’s a considerable amount of evidence to back up Keynes’ basic reasoning here, but that his prescriptions are not always ideal and very difficult to implement in the real world.   Government policymakers do not set fiscal policy or tax policy based on economic cycles.   Governments also react slowly to developments (unlike private market participants) and deploy capital in very inefficient ways (since they look at political rather than economic considerations).  

Even if governments were to follow Keynesian theory correctly, there’s still no guarantee that this would achieve the most efficient result.  Since governments typically use fiscal policy to pick winners and losers in given sectors of the economy, what normally happens is that the government, by its nature, creates maldistributions of capital, which can potentially make an economic downturn even worse (and even create more deflationary pressures).  Of course, Keynes realized that governments were not efficient allocators of capital, but believed that the greater evil was for an economy to artificially be operating below its productive potential.

In my view, Keynesian Economics is absolutely vital to understand, because Keynes’ insight into boom and bust cycles, fiscal policy and its effects on the economy, currencies, and trade (not mentioned in this blog) are so important to a total understanding of the economy.   But I don’t think one has to agree with his prescriptions or ignore some of the flaws in those proposed solutions, in order to appreciate many of the important insights he had.  

Keynesian Policy in the Housing Boom

As I said from the onset, I am not a Keynesian, but find the general abuse of the term frustrating.   One common theme I hear is that the US has been following Keynesian policies for several decades.  I disagree with this.

We veered away from Keynesian policies in the ‘00s.  In 2002, we had a housing boom underway and high inflation. The Federal Reserve Bank, which does not look at housing prices in its inflation measures, dramatically underestimated CPI inflation.  So a narrative began that we were in a downturn, when in actuality, we were in a situation of rapidly increasing money supply and rising inflation.

In spite of this, the Bush Administration advocated lower taxes and more government spending.  This was particularly evident in the Administration’s push for war in Iraq, which dramatically increased military spending. In other words, Bush was advocating the ultimate anti-Keynesian solution. 

In a boom cycle, Keynesian theory advocates running a government surplus and using fiscal policy to reduce money supply.  Instead, we saw a total breakdown of this and politicians not only failed to balance the budget, but actually increased the government deficit, pumping even more money into a credit-fueled boom.

For this reason, I don’t think it’s fair to blame Keynes for the recession that followed.  This is not to say it’s not fair to blame several supposed Keynesian economists who might have advocated policies that further inflated the boom, however.  Merely that Keynesian economic theory itself does not advocate this.

 

 

 

I have more thoughts on the inefficiencies of government spending and the flaws in Keynesian economic thought, but we'll save that for Part II.  Generally, I'd like to see more informed discussion of Keynesian thoguht, because I don't think you can effectively criticize something unless you truly understand it.  And I think there are good reasons to criticize Keynesian economics, but it's more common to see misinformed criticisms. 

14 Comments – Post Your Own

#1) On June 06, 2011 at 5:32 PM, MegaEurope (< 20) wrote:

Even if governments were to follow Keynesian theory correctly, there’s still no guarantee that this would achieve the most efficient result.

In a system as complicated as the macro economy, trying to achieve the "most efficient result" can be dangerous.  Optimization isn't the correct goal - instead we should try to avoid catastrophe. 

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#2) On June 06, 2011 at 6:51 PM, chk999 (99.97) wrote:

Excellent blog Jakila!

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#3) On June 06, 2011 at 10:23 PM, Valyooo (99.40) wrote:

Great blog.  Sorry to hijack but you seem to be good at analyzing banks.  With all of the negativity, is it time to buy?  I bought some BAC today.  I am down about 10% on C and 3% on GS. I am wondering if I should cut my loss now

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#4) On June 06, 2011 at 11:12 PM, JakilaTheHun (99.94) wrote:

Valyooo,

I'm divided on that issue.  Of the big banks, I like GS and C the most. 

But betting on the banks is also a bet on the macro economy in many ways.  

I've dramatically reduced my exposure to banks over the past few months.  I went from having about 35% of my portfolio in banks down to maybe 15%. 

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#5) On June 06, 2011 at 11:44 PM, L0RDZ (81.28) wrote:

What do you call 100,000 economists   at the bottom of the sea ???

A good start to  fiscal healing...

 

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#6) On June 07, 2011 at 2:12 AM, jgknot (30.49) wrote:

nice read

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#7) On June 07, 2011 at 3:45 AM, rancidx3 (40.37) wrote:

Are you still in tncc?

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#8) On June 07, 2011 at 3:48 AM, Valyooo (99.40) wrote:

What do you like about GS so much?  I mostly like them because they are largely above the law, and good at making money, and historically trade between p/b 1 and 2...and this time are at 1.

Also, somehting to consider for C (you probably know but maybe not); they are the least dependant of all of the big banks on credit card swiping fees.  So the least to be hurt from that reform, should help them outperform the others coupled with emerging market stuff and the fact that Pandit actually said the shares are cheap

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#9) On June 07, 2011 at 7:06 AM, JakilaTheHun (99.94) wrote:

rancidx3,

I exited most of my shares of TNCC when they first announced FDIC troubles. I still own a very small (but mostly insignificant) number of shares. 

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#10) On June 07, 2011 at 7:10 AM, JakilaTheHun (99.94) wrote:

Valyooo,

I wouldn't say GS is "above the law" any more.  I think the previous perception of them being "above the law" has created a situation where the Feds now mindlessly go after them for silly things. But that's part of the reason why the stock is discounted so much.  

Earnings are still fantastic and I think they are better run than all the other banks.  As you said, it's selling for a P/B of 1, which is the lower end of its historical range.  Intrinsically, I don't see any reason why it shouldn't be worth at least $170 and probably more like $200.

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#11) On June 07, 2011 at 7:50 AM, whereaminow (< 20) wrote:

Really good blog.

The original Keynes-Hayek (or Hazlitt) debates focused mainly on the single issue:  can government spending offset a recession?

However, as you have indicated and I agree, post-Keynes the debate turned to what can government spending accomplish in all areas of economic life?  This is where Hicks, Robinson, and Samueslon (most notably) took the Keynesian revolution.  Today it is hard to rectify the ideas of DeLong, Krugman, and Galbraith with the old Keynes-Hayek debate.

That means we have two debates going simultaneously, and I can see why so many people would have trouble following.

One debate is about the effectiveness of government in curtailing recession.  (A tangent to that debate would be how the recession was caused in the first place.)

The second debate is about the effectiveness of government in promoting optimal outcomes in market behavior.  That debate should not be associated with JM Keynes, but because so many Keyenesian economists support these government interventions, it understandable to hear people blame it on Keynes.

David in Qatar

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#12) On June 07, 2011 at 12:07 PM, miteycasey (30.34) wrote:

pretty much common sense.

The economy a bit slow the governement should spend. The economy booming the government should cut back on spending.

The funny thing is the second one never happens.

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#13) On June 07, 2011 at 2:08 PM, Option1307 (29.95) wrote:

Excellent stuff here, looking forward to part deux.

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#14) On June 13, 2011 at 9:20 AM, DaveMarcus82 (30.80) wrote:

@ #11; Sorry, I can't read Keynes-Hayek debate this week without thinking of this video

 

 

 

 

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