The Downfall of Keynesian Economics and the U.S. (Part 1 of 3) 32 comments
Nicholas Jones
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This three part series will look into detail at how decades of Keynesian based economics have led us to the current economic crisis. I will also be identifying what the future consequences of Keynesian economics will look like, and what that means for the U.S.A.
There are many similarities between the U.S. economy today and the U.S. economy of the early 1970s. I don’t need to over-elaborate on the details of the likeness of the two eras, because it’s actually the one distinct difference that is going to matter going forward.
First I would like to take a brief look into some of the similarities. In 1959 the U.S. entered the Vietnam War. The U.S. was not well versed in jungle war fare. The war dragged on with no end in sight while support from the home land was waning. The price tag, along with casualties, continued to pile up at a very uncomfortable pace. Quite similar to the war in Iraq today…
Being that taxes are a very unfavorable way to pay for war, monetary inflation began to run rampant until the U.S. was forced to sever any formal tie between the dollar and gold. There wasn’t anything fancy to this situation. It was simply a case where the monetary base had grown so dramatically that there was absolutely no way to back the currency by gold anymore.
The greatest gold bull market in history ensued. We saw gold soar from $50 /oz to $850 /oz before a man by the name of Paul Volcker stepped onto the scene as chairman of the Federal Reserve. More on Mr. Volcker in a second.
Let’s discuss the main difference between then and now. It is very simple: personal consumer savings. I’m sure you are very familiar with the analogy of guns and butter. Essentially there is a maximum amount of economic output that can occur at any time, and the allocations of the land and resources has to be determined between industrial out put, and agricultural output. Now it’s obviously not quite that simple, but you get the idea.
During the Vietnam War, the U.S. was producing large quantities of tanks, ammunitions, air planes, and all of the other goods that are essential in fighting a war. They then shipped these goods to the front, and this contributed, in part, to a trade surplus and domestic savings.
There was also a significant amount of private savings. In the 1970s, the notion of a negative consumer savings rate would have been laughed at, but times change. Also at this time, Americans didn’t use their homes as credit cards to buy that new car or boat.
Banks were flush with the consumers’ savings, and because of this, they didn’t much have to worry about capital ratios like they do in today’s economy. They were able to make loans for investment spending, residential housing, and just about everything in between. When the war ended, the GIs came home and began doing just that; taking out loans and spending some of their savings.
At this time, monetary inflation as a result of the war and the large amount of savings sloshing around in these banks started creeping into the prices of tangible goods such as metals, food, and energy. Social Security benefits were rising at an annual pace of near 10%. The system, much like today, was flush with liquidity. The difference today is the price at which the money was loaned.
In 1979, Paul Volcker stepped in as chairman of the Federal Reserve. He realized one important thing, and that was that we needed to keep faith in the U.S. dollar or the Federal Reserve, along with the fractional banking system of the United States, would collapse. Volcker was not necessarily a champion of free markets. His goal was never to purge the system of excess liquidity, but raising rates to 20% brings that about as an unintended consequence.
This was a painful choice, but it was much less painful than the alternative. Mass bankruptcies ensued, and we truly saw the ultimate weakness of Keynesian economics. That weakness is the inability to tighten credit standards once the flood gates of easy liquidity have been opened. A contraction of money and credit in a Keynesian economy is painful proportionally to the extent of the initial growth in the monetary base and credit.
It’s the Keynesian school that has, more or less, driven monetary and fiscal policy since the Great Depression
Keynesian Economics Today
Now one might think that the essential failure of the Keynesian school of economics is a reason to do something else…anything else. It sure makes sense to me, and I’m sure it makes sense to you dear reader, but by now, you are well aware of our ability as a nation to commit the same dumb mistakes again and again.
At this point I would like to bring these ideas into present context, but I am going to break down Keynesian economics into its most basic form, and then we can relate it to our current economic situation.
The example I’m going to use is not my own. I do not know its original author, but it is an example I read in an economic journal. I apologize that I do not have the original source, but it is an awesome way to describe Keynesian economics.
In economics, it is often very useful to breakdown a theory and apply it to an elementary situation. It is very important to understand this notion, as I will relate back to it throughout the rest of this essay.
Imagine that there is an economy of just 3 farmers and a lending unit. Each farmer borrows $100 to sow his land. So at this point, we essentially have a monetary base of $300.
As with any loan, the farmers must pay interest. Let’s say the interest is 10% on each loan. All three farmers have a fine year and produce a significant enough crop to pay back each loan. The first farmer pays the $110 that he owes. The second farmer pays the $110 he owes. The problem is that there is now only $80 left in the monetary base, and there is no possible way for the last farmer to pay off his loan.
Well, not necessarily. There are two options. Option one is that the authority can increase the monetary base. Option two is actually a spin off of option one and essentially carries the same end result.
Let’s say a fourth farmer enters the scene and borrows a $100 dollars for his crop. Now there is significant funds in the monetary base for the third farmer to pay off the last loan, but the forth farmer is left holding the short straw.
You see, the only way to keep a Keynesian economy growing is to increase the monetary base and/or aggregate credit outstanding, otherwise there will simply not be enough money to pay back the due credit.
This scenario regarding the three farmers is a grossly simplified version of the U.S. economy since the great depression. Please note that when short term lending dried up, our economy ceased to function properly. Our inability to exist without lending is a result of decades of Keynesian economics. As always, please feel free to send in your email questions, but don’t think that through complex investment derivatives and globalization, this scenario is suddenly sustainable. I understand that there are many other issues that factor into this equation, but what you will actually see is that these investment vehicles and globalization have only postponed the inevitable and exasperated the system.
The next part of this series will take a deep look into what role our trade deficit has played in the growth of our Keynesian based economy, and how foreign reinvestment of U.S. dollars into our domestic economy has been our lifeline.
Disclosure: No positions.
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This article has 32 comments:
I am a university I.T. student in Australia, however I have studied economics for two years and learned that it's a big call to blame Keynes for what is occurring now.
I have issues with the model you explained. And you said it will be the basis for your essay. You said an economy of three farmers and a lending unit. To go further, lets give them names....Joe the Farmer, James the Farmer, Jane the Farmer and Ben the Banker.
What I learned in the very first lesson lesson of Macro 1001 was that the economy is a circular flow, in that if Joe, James and Jane want to make any money (i.e. the $10 interest) they must make it from Joe, James, Jane and most importantly Ben. Therefore if Joe and James make their $20 ($10 each) and return $220 to Ben (the lending unit) then surely Jane can make $110 from Ben (the consumer....bankers have time to eat too, even in heady times like today). And your model breaks down pretty easily (no complex derivatives are required).
Secondly, good regulation states that lending units should have a capital adequacy ratio (an amount of deposits that shouldn't be lent, to allow for customer withdrawals). If this is say 5%, then in fact the most that can be lent is $95 each to each farmer...and this further stretches the need to keep expanding credit to satisfy Jane. Therefore, if aggregate credit has to be expanded by $20 to cover Jane (under your model) and not $13.50 (under the model of capital adequacy ratio of 5%) then the ballooning credit problem is an issue of poor regulation...rather than Keynesian economics....and poor regulation appears to be one of the already pinpointed culprits.
I apologize in advance if my economics doesn't hold up, it has been a few years since I took those classes. And I apologize for my attitude (that is youth). But the headline of your story really attracted me and I was that disappointed that I have spent more time writing this than I spent reading it. I'm sure Keynes would give you a much better lashing than I could.
Regards,
Axel
Axel - What if Joe and James don't make their $20 ($10 each) and Jane had sold them each a horse for $10? Ben the banker used all their deposited money to make a bet at the race track and lost half of it. The money is a promise only and there is not gold in the bank to back up it's value. Ben the Banker goes to Henry in the Government, who raises taxes on Joe, James, and Jane to give to Ben to cover his bad bet on CDS at the race track (whose went lame halfway through the race from being pumped with steroids by an unethical trainer).
Now...don't you think Joe, James, and Jane will at some point sharpen up their pitchforks and tell Ben and Henry where to stick it?
I'm looking forward to parts 2 and 3; I think that is where more of the meat you were wanting resides.
Cheers,
Eric
All of these crash and burn scenarios leave out things like economic growth, technological advance, and the fact that there is a GDP (i.e. the farmers sell their crops (you forgot about the money they received in your money example).
I have actually read the General Theory (although it was many years ago), and I remember thinking that it was actually far less controversial than many people claimed.
As I remember it, he basically said that world trade is critical, we should not be wedded to a gold standard because it is nonsense and often causes deflation, and he said that when there is deflation, you've destroyed the ability of monetary policy to do anything since cash is worth more than any other asset so people sit on cash.
He suggested that when monetary policy is destroyed by having stupidly following a gold/deflation policy, you need some exogenous spending since no company will make an investment when what they sell is going to be worth less than the price today. He pointed to government spending as a possible alternative.
HOWEVER, what we see today is a true perversion of Keynes which came about in the 1980s with the advent of "supply side" economics supported by Freidman's "deficits don't matter.
Keynes NEVER suggested that a country run chronic deficits like Reagan did and Bush have done. He would have laughed at the idea of "supply side" economics (even Laffer disowns it now, even though that is the mantra of Republican politicians).
What we have now is very simple. Deficits DO matter, and we are going through a crisis similar to the crisis Reagan caused in the early 1990s.
Just like Reagan, Bush borrowed trillions of dollars ( NOT EVEN will to pay for the war -- what a patriot), and threw a huge party that caused wild speculation.
The party ended and now we get to pay the loans back (de-leveraging) -- or not (foreclosure).
By the way, as I remember it, Freidman had nothing but praise for the General Theory, especially its treatment of the monetary policies. He did not think much of the government stimulus, but more on the grounds that it wasn't very effective rather than having some ideological problem with it.
You essentially make Mr. Jones' point for him. Yes, financial flows are circular but the trouble with your idea, that Ben the banker will recirculate the money that is necessary for the farmers to pay their interest, is in misunderstanding the mechanics of "lending" by banks. It's not literally "lending" as banks don't lend from some stock of money they hold.
When a bank makes a loan it creates the money out of nothing. If you studied some financial economics you can look this up in your textbook. This is a simple fact, not a controversial opinion. When the loan principal is repaid the money ceases to exist.
I'll quote from my financial economics textbook:
"Through the creation of a deposit by making a loan or acquiring a security, a depository institution increases the money supply by the amount of the created deposit." ..."the liabilities of banks and other depository institutions have the peculiar characteristic that they are money."
A bank's balance sheet loks like this:
A = K + L
Assets (loans, which are the "debts" of borrowers) = Capital (bank stocks, common and preferred shares and long term debentures held by banks) + Liabilities (customers' deposit balances at the bank: these liabilities "are money").
Every loan creates an asset on one side of the balance sheet and a liability on the other side. When the loan principal is repaid both the asset and liability are written down to zero. The "money" which began its existence as a deposit in your account, ends its existence when your account is debited in the amount of the loan principal.
The loan added that amount of money to the money supply; your repayment deleted that amount of money from the money supply. The money came into existence as your loan and it ceased to exist with your repayment.
My text gives an example:
"The depository institution makes a loan for $1000 to a business, crediting the business's demand deposit with that sum of money. ...the business now holds money which previously did not exist. ...The money supply expands by $1000. When the loan is repaid a corresponding contraction of the money supply will occur, unless the institution replaces the loan with another of equal value."
This is Mr. Jones' point: the ONLY source of new money is new loans, and all loans are "debt" to the borrower, which has to be paid back. In Mr. Jones' example a total of $300 of new money is created and when that loan principal is repaid there will be no money left in the system.
Paying off your bank debts eliminates money. There is no extra money for the banker to recirculate into the system. If all 3 farmers manage to repay their loan principal there will be zero money left in the system so none of them will be able to pay their interest.
When farmers A and B repay their principal and interest the money supply is reduced by $200, leaving a total of $100 of money in the economy. The banker owns $20 of that money which he earned as his interest. If farmer C manages to collect ALL the money that remains in the economy, including the banker's $20, he will be able to repay his principal $100 and that $100 will cease to exist. Unless some other person takes out a new loan and adds new money and debt to the system, there is no money left for farmer C to pay interest to the banker.
The problem with your "circulation" theory of money is that the amount of money in the system diminishes as loans are repaid and ultimately somebody is left owing money that does not exist.
The simplest way to understand this is to see the system as a whole. All loans collectively create an amount of money P, the loan principal. At the same time as the money P is created, an amount of monetary debt is created P + I, the interest. As P is repaid it ceases to exist in the system, and if all P is repaid your are still left with I, the interest everyone owes the banking system.
Over time as many new loans are created and repaid the system ends up with a massive deficit of money available for everyone to pay their interest. That deficit equals I, the total amount of interest money that is owed but was never created.
Historically this monetary deficit is periodically corrected by recessions and depressions with massive defaults on loans. Banks write off defaulters' debts without collecting and eliminating the money that is owed, so "free" money is left in the hands of whoever sold stuff to the borrowers. This makes it possible for the non-bankrupt to continue paying off their bank debts.
That's the simple arithmetic of our banking system. "Fractional reserve" is kind of a red herring, as all this means is that banks must hold an amount of cash sufficient to meet the cash withdrawal needs of their customers, typically about 4% of total deposits.
Banks make no interest on their cash holdings and they owe the cash to their central bank--the issuer of cash as "Federal Reserve Notes"--so cash shows up on the liability side of the balance sheet.
But cash only changes the "form" of the money depositors' hold. If you withdraw $100 cash from the bank your credit balance is written down by $100 so there is no change to the money supply. Cash does not change banking arithmetic at all, though it perhaps confuses the issue with additional complications.
Second, only parts of Keynesian economics were tried in the United States during the 1930's depression but after World War II, neo-classical economics regained its dominant place in America and only a few economics professors wrote books about it (and still do.)
In the early 1970's, Richard Nixon said, "we are all Keynesians now" but what he meant was that it was generally accepted that governments (the Fed) would have a role in stimulating the economy by regulating interest rates. So the word "Keynesian" has come to mean, for some people, any government involvement in economics.
You need to do a little more homework. Here is a good reference: cepa.newschool.edu/~het/thought.htm#alte...
"cepa.newschool.edu/~het/thought.htm#alte...
cepa.newschool.edu/~het/thought.htm#alte...
I think a root of the difficulty in understanding our fiat money banking system is that classical economics, inasmuch as it deals with money at all, asumes money has some physical reality such as gold bullion. In this case the money is simply transferred around the economy as people buy and sell, and the money never goes out of existence. Gold is "hard money".
Google "Warren Mosler" and read his "Soft Money Economics". Mosler describes the kinds of mechanisms that are available to us in a modern fiat money system. We don't have to have cycles of recession/bankruptcy to correct monetary deficits. We just need to use the tools that our fiat money system makes available to us.
The model is overly simplistic to make any point regarding money supply and creation of fiat money. You are pre-supposing that the only payment taken for anything is money. Yet somehow the farmers bought their farms and the banker built his bank. If the economy were truly this simple then economic actors would barter or trade directly.
You might as well say one farmer borrowed all the money in the world and kept it, then the bank went under, and everyone else starved.
Fiat money is simply a replacement for tangible money arising from market forces and mutual agreement via trade. Throughout history man has used many different items as money, seashells, salt, spices, wampum, gold, etc.
The true downside to fiat money (as well as some of the other examples I give) is that the circulating supply can be easily increased to the benefit of certain parties and the detriment of others.
If seashells were money, would it benefit society more to spend your time walking along the beach looking for shells or to instead spend it weaving cloth? You might get very 'rich' by walking along the beach, but expect a lot of shivering during the winter while you walk around naked because nobody made enough cloth to cover your lazy butt.
CaptainJJack - You have made an excellent case for the selective mis-application of principles defined by both Keynes and Friedman being underlying much of the severity of our current situation. This has been especially true since 1980. The economic mistakes before 1980 Johnson and Nixon were corrected by the Paul Folker monetary medicine of the late 70's and early 80's. Since 1980, picking selected ideas from Friedman has resulted in the use primarily of monetary policy in addressing the economy. Friedman believed employing fiscal policy was less effective than using monetary policy. I don't believe he ever stated that fiscal policy should be ignored. Sound fiscal policy has been effectively ignored for the past 28 years.
derryl - As always, you have made very perceptive comments. A collolary to your propositions that a certain amount of inflation is necessary for growth in an economy based on exchange of fiat currency for goods and services. In a barter system, growth can occur as items of goods and services are directly exchanged for each other and wealth is accumulated by those who create goods or services that are more productive than previous goods and services. The previous goods and services will decrease in relative value as they are replaced, but the greater productivity of the new goods and services is a net gain overall, and growth occurs without what we call inflation.
Smarty_Pants - You said:
"If seashells were money, would it benefit society more to spend your time walking along the beach looking for shells or to instead spend it weaving cloth? You might get very 'rich' by walking along the beach, but expect a lot of shivering during the winter while you walk around naked because nobody made enough cloth to cover your lazy butt."
I love the analogy to the current crisis. Brilliant simile.
I haven't singled out any other commenters, but many others are quite good. And thanks again to Nicholas Jones for starting this discussion.
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should be:
A COROLARY to your propositions IS that a certain amount of inflation is necessary for growth in an economy based on exchange of fiat currency for goods and services.
CAPS are the corrections. Sorry, derryl.
Hmmmm.
We all know this is fake-o-nomics, scam-o-nomics, etc. at heart. How do we know this? Because without doing and PRODUCTIVE work, some members of society (the elitist bankers and moneymen) get to siphon hundreds of billions of dollars worth of money from those who are actually working and pulling their weight.
Any details past this are simply noise that obfuscate the point. This is why elite like to create lots of rules and debate them endlessly. They know that working people have no time or energy for such unproductive activities.
The fix is sooooo simple. Abolish the federal reserve. Return to hard money, honest money. Abolish fractional [fictional] reserve banking. If you take away the system that enables the scammers, the scammers will all perish and be absorbed back into productive society. Yes, any of the working people who bought too heavily into the scam will get hurt for a short time as well. But, being the productive people that they are, 3-4 years later they will be back on track enjoying the fruits of their production, minus the parasitic effects of the scammers.
At the end of the day there really is only so much economic output per unit time. You can allow the scammers to create schemes which bubble it up to have more today but that means there will be less tomorrow, and there is a high overhead to pay for the parasite bankers in this scam which comes right out of the daily labor of the productive citizen.
Anything other than paygo with hard money defies common sense and is just another type of overunity, "something for nothing" scan.
The farmer example cited in the essay has been used in many forums as an illustration of fractional reserve banking (see Chris Martenson Crash course) and the reason it forces / causes monetary growth. This particular example does not even consider the effects of successive relending on money supply, which turns $100 into several hundred at a 15% reserve rate (money multiplier). And with the exception of the first 15%, it's all debt. That's how money is created under a central bank system using fractional reserve. Obviously, a fractional reserve system also forces a fiat money system since it leverages the central bank holdings. A full reserve system forces monetary discipline, but complicates growth issues as the farmer example illustrates.
I am appalled at the confusion and mis-statements regarding Keynesian policy, including by the author. "It’s the Keynesian school that has, more or less, driven monetary and fiscal policy since the Great Depression" In an essay basically on monetary economics, it's surprising Keynes even comes up as relevant, much less in the title. A basic review of the history of the science of economics seems to be in order, lest we forget.
I didn't take "Money and Banking" (the course at my institution) prior to transferring to I.T. Your comments were not patronizing and informative.
However, I would still stay the examples of Eric W. (Ben the Banker betting heaps on a dud horse) is a more accurate description of why we are in this crisis, rather than a theory created for the needs of the Great Depression.
Also, from general knowledge (not any specific classes) aren't Greenspan and co. and modern governments and co. more from the Friedman school than the Keynsian school?
Willing to be corrected again,
Axel
Your comments were informative and not patronizing (if you couldn't tell already).
"However, I would still stay the examples of Eric W. (Ben the Banker betting heaps on a dud horse) is a more accurate description of why we are in this crisis"
I stress the word CRISIS....and not a "simple"/softer tightening of credit and money supply. Anyone losing their home (sub-prime or not) is tough for them, but it's a crisis when these complex derivative products have burrowed so deep into the financial system that banks have a hard time lending to each other, let alone any home-buyers.
Cheers,
Axel
Keynes always made sense to me. Like the farmer, we sow during the spring, reap in the fall, so the government can offset cycles by taxing and gathering surplus during flush times and spending the surplus during spare times. But Keynes makes no political sense. Governments spend, spend, spend, borrow, borrow, borrow. Kings may have the werewithal to prudently employ Keynesian countercyclicality (how do you like that word?), buy I suspect even Kings will tax/spend, tax/spend, so the problem with Keynesianism is that it can never work in practice.
Supply side: It will make a comeback.
On Nov 14 09:22 PM Axel Tracy wrote:
> Thanks Derryl,
>
> I didn't take "Money and Banking" (the course at my institution)
> prior to transferring to I.T. Your comments were not patronizing
> and informative.
>
> However, I would still stay the examples of Eric W. (Ben the Banker
> betting heaps on a dud horse) is a more accurate description of why
> we are in this crisis, rather than a theory created for the needs
> of the Great Depression.
>
> Also, from general knowledge (not any specific classes) aren't Greenspan
> and co. and modern governments and co. more from the Friedman school
> than the Keynsian school?
>
> Willing to be corrected again,
> Axel
I simply see that the monopoly game is over and we must close up the board put the money away and then reopen the board and provide money so that folks can began to buy board walk, the railroads, hotels, houses. I think that will drive manufacturing and economic security until someone ends up with all the money and we then will redistribute and start the game over.
It is possible that the inflation of the 1970s is a result of monetary effects from both the Vietnam war and previous Keynesian spending, and this may be why Reagan's policies were so effective for a while, but none of this suggests that government shouldn't be providing stimuli in difficult times. One of the main problems we face now is that government did not pay back its debt during the recent good times.
As for the 3 farmers, remember that we have a fractional reserve banking system, so it should not be possible to lend out 100% of the money supply. If you could lend 100% of the money supply, your example would work. But even lenders keep some money around to pay for next week's groceries (at least for their own consumption).
Sorry. You lost me right there. There is no comparison between the two, casualty-wise. And frankly, in many other ways.
It seems that under this theory, there should be no stigma attached to not paying off one's loans since default is preordained to some degree; and since we are now in a recession, maybe those who have large and unmanageable unsecured debt should go ahead and default. Losing one's credit is much more palatable than continuing to be a slave to indebtedness. Actually, it may be profitable and it certainly would be financially healthy to have no credit.
Hmmmmmmm....maybe I should just run up my zero balance credit cards and.... ;-)
> it's Freidmanian economics that has caused the current downturn. (...) >The current administration, a proponent of Milton Friedman style economics,
Milton Friedman advocated a full reserve banking system. In the last years, the reserve requirements have been DECREASED not increased. The current administration did quote whomever they could if it helped them helping their buddies.
What is true is that the current problems originated in the banking sector. To make Friedman who suggested a different banking system responsible for our problems seems far fetched.