On Keynes, The Stimulus and Old Ideas

John Maynard Keynes was a genius. We can all learn from his example. And the first thing we should learn is to end our foolish love affair with his ideas.

Keynes would not have spent his days warming up some dead man’s leftovers. Keynes would have understood the importance of all we have learned in once disparate fields and what this means for macro-economics.

Complex Problems, Simple Solutions

Economies are complex. But macro-economic solutions remain stubbornly simple.

What exactly is the case for government stimulus?

I don’t mean generally. I mean in this specific situation – right now, today, what is the case for government stimulus?

Forget ideology. Forget theories. Forget models. Think only of the situation we face and the actions we might take.

There will be plenty of time for theories later. But to start by imposing a framework, especially a framework that assumes a special case belongs to a general population, is dangerous.

Why do we assume that special cases belong to populations we know something about?

Because that is what experience teaches us. Our everyday experiences teach us to expect normal distributions. More than that, our everyday experiences encourage us to think that all differences are merely quantitative differences – simply matters of degree – rather than qualitative, systematic differences.

To the extent that the problems, populations, and systems we are dealing with are simple and unplanned I have little problem with making such leaps of faith – extrapolating from a few specific cases to create sweeping general theories.

But when we are dealing with complex, planned systems – systems with actors who learn and adapt, systems with actors who make new mistakes, actors who remember pain and pleasure as vividly as we humans do – when we are dealing with such systems, general theories are dangerous precisely because they are so elegant.

In a complex science, general theories are just special theories that win wide acceptance. If wide acceptance within an academic community was convincing evidence of utility, I would say stick with general theories.

A quick check of human history shows that, no, popularity is not a good indicator of utility. A few bad ideas always slip through – and worse yet, most good ideas – ideas like Keynes’ – outlive their usefulness.

The Burden of a Great Idea

Intellectual life-cycles can be painfully long. First, a great man like Keynes leads the way. Then a lot of not so great men follow. They don’t know how to think up the new and useful principles the way the great man did; instead they keep applying old principles to new problems – problems the poor, dead man never saw.

Had he seen different problems, he would have found different solutions. But, he’s dead and his ideas aren’t. So the best a follower can do is warm up the dead man’s leftovers.

Ideas are limiting. The great ones are the most limiting of all.

Warren Buffett was limited by Benjamin Graham’s thinking. He had to learn to keep some principles – Mr. Market and Margin of Safety – and throw out most of the rest.

Warren doesn’t focus on balance sheets. He doesn’t diversify. He does analyze businesses. In each of these things, he is Graham’s polar opposite. And yet Graham was successful. And, for a time, Warren successfully aped him.

But had Warren clung to all of Graham’s ideas, you would never have heard his name. Buffett competed in a system that adapted fast. He kept some general principles. But he threw out a lot of ideas that turned out to be either special applications of general principles or ideas that only worked under special circumstances.

The Danger of General Theories

The danger of confusing what is special and what is general is captured in the title to Keynes' The General Theory of Employment, Interest, And Money.

“I have called this book the General Theory of Employment, Interest and Money, placing emphasis on the prefix general. The object of such a title is to contrast the character of my arguments with those of the classical theory of the subject, upon which I was brought up and which dominates economic thought, both practical and theoretical...”

Did Keynes really think he had come up with a truly general theory? I doubt a man that smart could think something that dumb.

In my post In Defense of Extraordinary Claims I quoted Keynes’ review of Smith’s Common Stocks as Long Term Investments:

“It is dangerous...to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.”

I argued then, as I am now, that people were seeing something special and calling it general. I said then, back in December of 2006, that future stock returns would not match historical returns, because historical returns were achieved under special circumstances – low prices relative to normalized earnings – that no longer existed.

I am sounding much the same alarm here. Everyone from the far-left to the far-right is talking stimulus. Everyone is thumping the bible of spend, spend, spend.

Or almost everyone.

Balance Sheets

In his most recent quarterly letter, Jeremy Grantham notes the importance of repairing the balance sheets of American consumers.

We talk about bank balance sheets. And we talk about consumer spending. But we don’t talk about consumer balance sheets.

Consumers put mortgages on the liability side to finance houses on the asset side. Many of those houses were financed at prices above intrinsic value.

When the market price of houses fell, consumers realized they did not have the ample equity they thought they did but somewhere between a sliver of equity and a deep, deep hole of negative net worth.

That hole has to be filled.

Banks can’t lend with Swiss cheese balance sheets. Nor can consumers spend.

We might do well to talk a little less about the Great Depression and a lot more about Japan.

At this point, the purpose of a stimulus is to bring consumption back in line with what it had been at a time when the illusory wealth of financing assets at prices higher than intrinsic value provided cash flows to consumers that would later be offset by massive asset losses.

You can’t pull that trick off twice. There’s nothing left to borrow against – and there’s nothing saved for consumers to spend.

And, if consumers spend everything they take in today, they keep their balance sheets weak. If they keep their balance sheets weak, they can’t borrow more to spend more today and they have to save more tomorrow.

We need to take the leverage off our balance sheets. Our banks, businesses, and households need to increase equity and decrease debt.

We can do it fast or we can do it slow. But we can’t spend ourselves into financial strength.

Special Problems

Our biggest problem is not underconsumption; it is balance sheet weakness.

The stimulus promoters suffer from man with a hammer syndrome. They have just one tool. It may be a powerful tool. I’m not arguing that point. I don’t have to. It’s the wrong tool for the job.

A stimulus may or may not be a good idea. But it can’t be our only idea.

It’s time to start thinking more like Keynes. The first step is to admit The General Theory is a special theory. Parts of it we can keep. Parts we need to chuck.

But whatever we do we need to adapt.

We have new problems. We need new ideas.

Comments

[morph366:]

Very well said.
Keynes has been much misunderstood and reading Hyman Minsky can help to reveal this.
How does the average Joe repair his balance sheet other than through some kind of en masse Chapter 11 event where his/her debts are to use the euphemism - "re-structured." This would really scare the policy makers and I suspect that legislation would soon be enacted to prevent this from happening.

Jan 26 12:19 PM

[Tradememe:]

If bankrupt companies or banks are going to receive bailouts, the average Joe has the right to expect some sort of bailout too.

Jan 26 12:52 PM

[sheople:]

What is beind done is insane. The free maket needs to make the corrections so we can begin to heal. Instead the sore festers.

Jan 26 01:32 PM

[Chris B:]

What a perplexing article. The author calls Keynes a genius, but then takes the position of pre-Keynsian classical economist in saying that the market will eventually acheive equilibrium on its own as debts are liquidated.

Yet the author is correct that we should theoretically link cause with cure. Otherwise, we have no hope of taking the correct actions (or inactions). If we misunderstand the causes of this crisis, our efforts will be about as effective as antibiotics are on viral infections. The causes of the current crisis are:

1) The effective repeal in 1999 of the Glass-Steagal Act of 1933, which had previously kept investment banking and commercial banking strictly separate - and led to 60 years of crisis-free banking. Within a few years of the new Citigroup and BAC, a 1930's-style banking crisis had again brought the entire economy down as investment losses destroyed commercial lending.

2) Tax policies that encouraged speculation and mortgage-backed securities by taxing those activities at lower rates than productive work, such as manufacturing for example. Results: less production, fewer jobs, and more mortgage-backed securities and hedge funds.

3) Corporate compensation schemes that rewarded short-term results at the expense of long-term viability. The people who made this mess walked away with millions. Would they do it again? You bet!

4) A neoconservative SEC and justice deptartment that refused to prosecute anything, because they felt that enforcing the law might interfere with the free market.

5) A government that pursued only short-term priorities (Iraq, tax cuts, Greenspan's too-low interest rates, etc.) rather than doing the long-term work that enables economic growth (education, infrastructure, health, debt reduction, etc.).

Jan 26 01:34 PM

[JohnL:]

"We have new problems. We need new ideas."

Using cheap credit (permitted by fractional-reserve banking) to thow one hell of a party and then suffering the inevitable hang-over is not a new problem. And there is no need for a new idea (solution).

As long as credit booms are facilitated by our banking system, we'll have recessions and depressions. Stop the former and you stop the latter.

Jan 26 06:59 PM

[Alex Filonov:]

On Jan 26 06:59 PM JohnL wrote:

> "We have new problems. We need new ideas."
>
> Using cheap credit (permitted by fractional-reserve banking) to thow
> one hell of a party and then suffering the inevitable hang-over is
> not a new problem. And there is no need for a new idea (solution).

>
>
> As long as credit booms are facilitated by our banking system, we'll
> have recessions and depressions. Stop the former and you stop the
> latter.

And if you don't live you won't die. Useless talk.

Jan 26 08:39 PM

[Dirk McCoy:]

What is the goal? If it is to increase economic activity- produce more goods and services and distribute them better (and with 3 billion people living on less than $2.50/day, why wouldn't it be) then more supply and demand need to be matched up. In this deflationary cycle, supply capacity is evaporating as debt/income soars. While it is possible to change this dynamic via mass restructurings, it is also possible to change it with a little good old inflation.

Thus, printing money is the answer. Lots of money- trillions, without sterilization. But I'm shocked how few people understand the difference between monetary stimulus and fiscal stimulus, and I'm shocked how many people believe that printing more money means it has to be put in the hands of the government. This is not the case at all.

The Fed has the ability to spend the newly printed dollars in many ways. Buy oil. Buy Treasuries. Buy currencies. There are a great many ways this cash can be used than by giving it to the pork producers in Washington. That this seems to be an esoteric concept is truly sad, because inflation is the only solution that can solve this problem in a relatively short timeframe (like, less than half a generation).

Of course, if you're one of those people who think we're running out of everything, and don't mind the prospect of millions returning to a sustenance farming economy, I suppose increasing economic activity is not your primary goal.

Jan 27 01:04 AM

[Emily Ng:]

Actually, Keynes was extremely interested in the ideas of past economists, and devoted a huge effort - including in "The General Theory" - to drawing on them. He drew on Malthus, and Hobson, and lots of others.

Markwell quotes Keynes as writing in 1924, "A study of the history of opinion is a necessary preliminary to the emancipation of the mind."

One of the places Keynes most prominently drew on past economists, and showed his passionate interest in the "history of opinion", was his "Essays in Biography".

So you are quite wrong to think, in your colourful language, that "Keynes would not have spent his days warming up some dead man’s leftovers." This is precisely what he actually did!

Jan 27 07:40 AM

[ArtfulDodger:]

Fellow Commentators:

All socialists are geniuses; anyone who is not is a troglodyte. That’s the intellectual story of the 20th Century, and more than anything else that view is at the root of the nation’s and the world’s troubles.

Statist collectivism, which includes Central Banks as well as activist governments that poke their paws into everything that moves and doesn’t move, quite simply brought about the death of nearly 150 million people in the 20th Century, brought about numerous depressions and recessions, tore down governments and dynasties, and until this day accepts only statist cures for the ills that particular philosophy has caused.

All the technical thinking and philosophizing notwithstanding, the cure is more than simple, at least after one takes an objective view of the historical catastrophe that statist collectivism has caused: freedom—which can only be brought about by dismantling every single monster we’ve created, from the current school system to the Warring Warthog in Washington to its smaller Hoglings ruling over every state (most all of which are in dire financial straits themselves, because of wild spending and borrowing during the boom of 2003-07; none that I know of put up a dime of reserves for the hard times that always come and have come).

But I don’t hear one human mentioning freedom from the monster institutions that rule over us (or how we can obtain it) as the cure.

So, no matter whether these collectivist institutions follow Keynes or Hayek strictly or innovate new concepts while keeping a few of theirs, every single act will cause an unexpected and unthought of result that will require a new cure.

Such is the knowledge we should have learned from studying the history of our love affair with stateism.

But it’s clear from the people we elect and their ideas that we have learned exactly zero.

Right now the financial, retail, auto, real estate, and the residential and much of the commercial construction sectors are deep in the tank, and the government is attempting to spend them out. (It’s my personal view, knowing and understanding the leftist mind that’s running our nation, that most of these funds will go toward wealth transfers, paying off constituents, and buying new ones.)

I don’t think the state will be able to correct any of these problems, but for what little good the state’s actions will do, from those results more negatives will pop up. The state's answer to those: more state action.

To my point, did we not just give/lend (I have no idea which) Chrysler $6b to lend to car buyers at no interest? The state’s answer to our debt problem is more debt. How do you cure anything when those who have absolute charge over your funds have that type of mentality?

The knee-jerk reaction to what I advocate—Dismantlism—i... to claim I’m an anarchist. But nothing could be further from the truth—look what we did before we were a statist nation.

We defeated the tyrannical English twice, whipped the Spanish and the Mexicans and ran the French back to Paris, beat back hundreds of warring Indian tribes, shut down the Barbary Pirates, barred through the Monroe Doctrine the Europeans from claiming land on the Continent, built a national railroad system compared to none, created huge amounts of wealth that allowed us to build universities and hospitals the nation over—and we did all of this without an income tax or an inheritance tax or a corporate tax. Neither did we have a Central bank, massive government regulations and interference into the private sector or a military draft.

Look what we’ve done since 1913 when we began enacting these things.

We’re at the point now, however, that attempting to keep the small federal government in which states had all the powers that Jefferson and Madison advocated is useless. The Warring Warthog must be dismantled and abolished forever. We should then create thousands of small local governments with strict and very limited powers.

People and corporations with debt-laden balance sheets, and I certainly agree that far too many businesses borrowed too much money during the boom years of 2003-07—that debt is now stuck on their books and they’re having a hard time meeting the payments—these would have to work their debt out on their own without receiving “bailout funds” from the state.

Anything else, in my view, is placing a tiny band-aid on a patient bleeding arterially. You may slow the bleeding, but the poor sick patient is still dying.

So, toss out Keynes and Hayek and innovations off their philosophies and dismantle the mess. Let free people decide for themselves how to run their lives and their businesses. It would take some time, but the world would be better off. And Americans would be free again!

Oh, I know. We defeated Hitler and Communism after we became a statist nation. Well, without stateism neither National Socialism or Bolshevik Communism would have existed.

A note to Chris: Your comments are usually on the money, but your point that we’ve not had a banking crash since Glass/Stegall is wrong. Between 1987 and 1994 over 2000 banks and S&L’s busted out, mainly because of government actions, such as raising the insurance on S&Ls from $40k to $100k and allowing them to lend money for anything rather than their original purpose of home lending. Also, 1987 Tax Reform and Papa Bush’s and Billy Boy Clinton’s huge tax increases exacerbated the problem.

Jan 27 11:43 AM

[blonde molly:]

AD's comment makes more sense than any i've seen in regard to the government's intervening and controlling the private sector.

yes i say, demolish the thing and start over small. it's sick, broken and dying. why try to save a terminal patient?

Jan 27 12:28 PM

[JohnL:]

Are you equating fractional-reserve lending with living? Wow - what deep insight! Here, all along, I thought investors only required actual savings in order to innovate and grow production. You're telling me that by loaning fictional capital created out of thin air by the bankers we can all live better? Cool! Thank you so much for clearing up my confusion.


On Jan 26 08:39 PM Alex Filonov wrote:

>

Jan 27 12:48 PM

[milkchaser:]

Chris B seems to have missed the role of Fannie and Freddie in this mess. Without them, the market for MBS containing subprime and Alt-A loans would not have existed. These two companies were protected -- not by the SEC, which was barred from regulating them, not by the Bush administration, which attempted 17 times to regulate them -- but by its patrons in Congress who were carefully, methodically seduced. They exempted FNM and FRE from Sarbanes-Oxley so that their internal accounting problems took a while to come to light. They discouraged and denigrated the only regulator allowed to oversee these companies.

It is wrong to blame this problem on the SEC. Moreover, the political leanings of the SEC regulators had nothing to do with their actions. Except for actual commissioners, these are civil servants laboring in the SEC. And the commission is structured to be non-partisan with no more than three of the five commissioners belonging to the same party.

Christopher Cox is a conservative. Why call him a neo-conservative? Does Chris B think that the prefix neo- strengthen the pejorative connotation? It simply does not apply. Neo-conservatives are reformed liberals who came to adopt conservative values -- usually as a reaction to what they perceive as failed liberal values in the area of national defense or law enforcement.

Both liberals and conservatives can adopt pro-business policies. Being a good liberal does not obligate one to adopt socialist or Keynesian or anti-business economic policies. There are liberal free-traders -- liberal laissez-faire adherents. Hayek famously declaimed conservatism ("Why I am not a Conservative") and one can't get any more laissez faire than Hayek.

1) I fail to see the connection between the repeal of Glass-Steagall and the collapse of many big banks. In fact, the banks that survived were those that had both commercial and brokerage arms. The brokerage only banks went under (or converted). That tends to justify the repeal, seems to me. Just because one followed the other does not mean one caused the other.

2) Does Chris B know of people who gave up manufacturing jobs, or moved investments from manufacturers in order to take advantage of lower capital gains tax rates? Ultimately, the pressure inside a bubble comes from those who voluntarily overvalue an asset. The overvaluation of these assets far exceeded the added value from tax favoritism. Many of the purchasers of these assets, the ones least able to make their payments, or in lower tax brackets in any case. Back of the envelope, it doesn't seem plausible, and I would have to see serious research on this to believe it.

In any case, tax policies such as low capital gains rates encourage people to invest in any capital asset, not just housing. They encourage people to do as they please. If that includes making a bad investment, such as overvaluing a housing purchase, that is still the fault of the lender and the borrower -- two private parties -- and should not be laid at the foot of tax policymakers.

> 5) A government that pursued only short-term priorities (Iraq, tax
> cuts, Greenspan's too-low interest rates, etc.) rather than doing
> the long-term work that enables economic growth (education, infrastructure,
> health, debt reduction, etc.).

This is a killer. We are to believe that the Bush administration did not invest in education? The Bush administration raised federal spending on education at an unheard of rate. I don't know how health relates to economic growth, nor why the federal gov't should be responsible for it.

I will agree that debt reduction would have been good, especially if it came via lessened gov't spending. However, to the extent that tax rate cuts increased GDP growth, which they undeniably did, they accomplished the very sort of long-term growth Chris B claims to seek.

And I will never understand how he links the war in Iraq to Greenspan's monetary policy. Greenspan acted independently -- did not answer to Bush -- and certainly was not consulted on war policy. Nor will I concede that the Iraq war was a short-term effort. Indeed, it's effect is far-reaching and persistent. In a world where oil is becoming scarce, does it make sense to have continued the boycott of Iraqi oil? to continue to let that oil-rich region be imperiled by the rogue Saddam? His ouster will have the long-term effect stabilization of the region, which we see already.

Jan 27 07:13 PM

[ArtfulDodger:]

Milkchaser:

Excellent comment.

Finally, someone called the Democrats on their claim that repealing the G-S Act of 1933 caused the current financial blowout. You're right: there's not a drop of evidence pointing to their claim.

Good account of Cox and the SEC, both of which have been blamed by Democrats for causing the current financial debacle. They don't mention how the Clinton Administration sued banks and lending instutitions across the country and forced them to create Subprime Loans.

How The Democrats Caused The Financial Crisis: Starring Bill Clinton's HUD Secretary Andrew Cuomo And Barack Obama; With Special Guest Appearances By Bill Clinton And Jimmy Carter
www.youtube.com/watch?...

Jan 27 10:17 PM