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The Upside-down World of John Maynard Keynes

Mises Daily: Thursday, April 23, 2009 by

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[An MP3 audio version of this article, read by the author, is available as a free download.]

The Upside-down World of John Maynard Keynes

John Maynard Keynes often employed flowery language like "animal spirits" and "liquidity trap" to describe things he did not understand. He was, after all, more of a bureaucrat than an economist. In fact, he would best be described as an anti-economist because he eschewed things like supply and demand and held the opinion that government could run the economy.

So, for example, he could not understand why people would invest resources in risky adventures that helped keep the economy growing at full employment. He therefore substituted "animal spirits" for the profit motive. These spirits allow entrepreneurs to proceed with a naïve confidence and to set aside concerns over losses. Similarly, the failure to invest was also a psychological problem that he dubbed the "liquidity trap." This trap occurs when investors seek liquidity in cash and when monetary policy — in terms of cutting interest rates — no longer produces an increase in investment.

The problem with Keynes is that he thought that if entrepreneurs lose their collective nerve, the government should socialize investment, prop up demand and employment, and provide assurances to drive the economy back to full employment. He did not understand how the economy works so he could not understand how the economy corrects itself once a contraction occurs.

The problem for us is that Bush, Obama, Geithner, and Summers are all following the Keynesian playbook, with Nobel laureate Paul Krugman serving as head cheerleader. If instead we just allowed the free-market process to work, the economy would likely have already bottomed; companies like AIG would be emerging from bankruptcy and the unemployment rate would be dropping instead of continuing to rise.

The market process was curtailed just a few months into this contraction and — over the last 15 months — has been almost wholly replaced with government intervention. Many of the interventions have been rightly described as "unprecedented" in that they are completely untried. This means that neither market participants nor policy makers have experience with them — and it shows.

This slew of interventions has been disorderly. Many interventions, like the takeover of AIG, were total surprises, causing volatility in stock markets. Moreover, these interventions have been extremely large and wide ranging in scope. Measured in dollar terms, the money "allocated" totals over $12 trillion by one account.

Ironically, by adopting the Keynesian position that we have lost our "animal spirits" and are suffering from a psychological problem of fear, the government has undertaken extreme policy changes that greatly undermine the profit motive. Entrepreneurs are no longer looking for new profit opportunities in the economy. Instead, they are more likely either trying to preserve their capital or lining up for a government bailout.

Preservation of capital requires that you place your wealth in low-risk assets like government bonds, cash, CDs, and gold. So people are saving more and paying down debt to protect themselves, but in Keynesian terminology, we have fallen into the very dangerous liquidity trap.

For Keynes, the liquidity trap occurred when frightened consumers attempted to save more and consume less. He reasoned that less consumption would hurt businesses and production and therefore put businesses and labor at risk. These lower incomes would mean, in turn, that the attempt to save more would actually result in a much worse economy.

The liquidity trap is really about hoarding and saving. While hoarding has a bad name among economists, it actually is a very good thing. Typically, people do not hoard resources irrationally or for no reason; they hoard as a way to protect themselves from dangerous situations. Depression, inflation, war, and other calamities are typically what cause people to hoard.

Not only does the increased saving help the economy, but hoarding is actually a good thing because it helps facilitate the process of deflation and deflation helps bring about recovery. If people reduce consumption (demand) then prices fall, particularly in the early stages of production. As all types of resources and goods are becoming cheaper, including labor, the purchasing power of every hoarded dollar increases. All the prices that were bid up during the boom — particularly land, capital, and various asset classes — are thus reset at lower levels. Debt is liquidated and savings are restored and the prospects for a return to prosperity emerge, first among producers and then by consumers. Therefore hoarding speeds up deflation and deflation speeds up the correction process.

But Keynesians are afraid of this process because they don't understand how it leads us back to full employment and economic growth. I have named this fear apoplithorismosphobia.Download PDF Joseph SalernoDownload PDF has shown that there is no theoretical basis for this fear and Greg KazaDownload PDF has shown that there is no empirical basis for this fear. Ironically, it is Keynesian policies, such as bailouts, stimulus packages, and inflation that should be feared, because they can threaten our animal spirits for profit and leave us stuck in the liquidity trap for many years.

Hoarding eventually fixes most balance sheets, but in a Keynesian-dominated economy, it takes an extremely long time. During the interval, people can become permanently jaded about the market and investing. They may become permanent hoarders. This is what happened to many Americans who lived through the Great Depression. Frugality and thrift, while admirable, became a kind of psychological scar they wore for the rest of their life.

Keynesian-style policies have resulted in disasters such as the Great Depression, the "stagflation" in the United States from 1970 to 1982, and the aftermath of the Japanese Bubble. Each lasted more than a decade. It would be far better to allow for an unobstructed free-market correction process. With no government safety net or bailouts, there would be more hoarding, faster deflation, more bankruptcy, and a speedy return to prosperity.

While bankruptcy sounds horrible, it is actually a wonderful and orderly process. First of all, it fixes balance sheets quickly. It also provides an opportunity to remove current owners and administrators who operated businesses in a risky fashion. No need to worry about bonus questions here! Some bankrupt firms will go completely out of business and their resources will be auctioned off to other entrepreneurs at very low prices. I would imagine that the dozens of startup firms working to bring electric cars to market would love the opportunity to buy an auto plant in Michigan for pennies on the dollar. Other firms will remain in business with most workers keeping their jobs, but bankruptcy reduces debt and cost and provides an opportunity to renegotiate contracts and wage rates.

The resulting environment after bankruptcy is one of new owners and operators with far less debt who have not had their "animal spirits" crushed. Firms would have less debt and therefore lower cost structures. Some consumers would be flush with hoarded cash and have an opportunity to buy at much lower prices. The economy enters recovery mode and can quickly attain full employment and economic growth. Most importantly, by not bailing out the losers, there is no moral hazard that entrepreneurs will believe they can rely on bailouts in the future.

Because they do not understand how the market works, Keynesians think this is a fantasy. But if you follow the Austrian recipe of allowing liquidation of bankrupt firms and debt, allowing prices to fall without monetary inflation, not propping up employment or subsidizing unemployment, and not discouraging hoarding, you will end up with the quickest possible recovery and minimize the magnitude of economic pain.