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Oh Keynesian, Where Art Thou?

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Tags Financial MarketsMonetary TheoryOther Schools of Thought

04/08/2008Mateusz Machaj

Almost everyone has something to say about the current crisis and the serious trouble our little greenback friend is in. We are about to be reminded that empires do not fall because of barbarians at the gates, wars of civilizations, or free trade. It's the inflation that kills them.

What is stunning about the current situation is the sudden disappearance from the stage of the not-so-long-ago fashionable Keynesian and monetarist doctrines. Even more surprising, most Keynesians and monetarists speak now in the language of fundamentals about micro problems and malinvestments.

Keynesian Is as Keynesian Does

Let us start with the Keynesian doctrine, whichever you want, orthodox-, new-, or post-. We can even create a new one under the label paleo-, but it would not change the substance of the dogma. The essence of Keynes's analysis of the price system is that it needs a specific kind of stimulus in order to keep the level of aggregate spending that drives the economy to its full employment level. What matters from the Keynesian perspective is that, for some reason, the free-market mechanism fails to achieve this goal. It might be a sudden collapse in the marginal efficiency of capital; it might be the fault of real and nominal rigidities, a decrease in consumption, or maybe, well, animal spirits are to blame for all the mess.

Depending on the particular story, we reach various versions of the Keynesian ideology, which apparently has a universal cure for the economy: government policies. Again, it may be fiscal policy, or monetary policy. Pick a version of your Keynesian story, and you'll know which solution to pursue. But the conclusion is rather obvious: the state, through its compulsory means, has to boost the level of aggregate demand in some way to stop the economy from falling into recession.

But if the usual Keynesian explanation is that one needs aggressive monetary and fiscal policy to boost the national income to survive recession, then how are we supposed to view the current crisis? Obviously current policies in the United States can be called many different things, but not conservative or even moderate. For a sustained amount of time the US government did everything it could to aggressively engage in monetary and fiscal pumping. Budget deficits soared and the interest rates were lowered to absurd levels. This helped the supply of dollars to go through the roof and prepare the green paper money for a remarkable collapse.

Of course, Keynesians can in no way explain the bust by referring to any of their official stories. Moreover, any serious economist saying now that the economy needs even more loose monetary policy would be considered a monetary crank, singing in the rain of falling dollars. At the same time a cry for an increase in government borrowings and issuance of more bonds to the credit markets would also be considered highly irresponsible.

Although Keynesians do not use their usual tales to analyze the real estate meltdown, nonetheless, in their theoretical analysis, on the academic level, they keep talking about the need to boost spending. Once again, neatly formulated theory detached from reality prevails.

The First Rule of Monetarist Reasoning Is that You Do Not Talk about Monetarist Reasoning

Just as a neoconservative lives in symbiosis with a social democrat, a Keynesian has a younger brother: a monetarist. The monetarist is definitely narrower in his investigations than the Keynesian, and his name fits him perfectly, for to him, all of economics is about money. What matters for economic activity is the money supply and the consumer price index (CPI) determined by it. The most famous monetarist, Milton Friedman, was primarily obsessed with money supply and keeping the CPI stable. If the CPI is unwavering, then the economy has to be in good condition. Problems might arise only when the official rate of inflation gets out of control. But if it is kept at low levels, then the economy is under control, and the monetary policy is sound.

In an interview from 2003 (conducted by Henri Lepage), Friedman stated that the conditions of prosperity are secured. The inflation monster has been tamed, unemployment is low, there is no financial crisis and no deflation, productivity is growing, and banks are in good shape. For many years Friedman praised Alan Greenspan's monetary policy. And although he did differ in some way from others (as most Keynesians differ one from another) and did not accept the discretionary tools that the Fed used, he still believed that policies of monetary pumping were a good idea and brought enormous prosperity.

So for a monetarist, the main macroeconomic aspect is the CPI, driven by Fed actions. If the CPI increases, the Fed should tighten, and in the case of decreasing CPI, the Fed should step in and loosen, to stimulate the economy. Serious recessions take place, according to this view, because the Fed does not pump enough money; this was supposedly what happened in 1929.

It is easy to see why the monetarist story is in as deep trouble as is its Keynesian relative's story. The overgrowing boom, which started many years ago, has been accomplished with a stable Consumer Price Index. During those days, monetary policy could be called anything but too restrictive. Under current conditions, with the banks in the kind of trouble that Austrians have foreseen for many years, the Fed's policy has never been so relaxed.

Both Keynesians and Monetarists are Quiet

Now, as we see, the current problems can be explained neither by the monetarist way of thinking nor by the Keynesian. Both macroeconomic approaches are flawed and cannot be applied to the recent crisis. The remarkable silence from those two doctrines proves the point. I do not mean that they do not discuss the crisis. Mainstream economists do talk about it, but they are not using the Keynesian and monetarist doctrine. Nobody talks about CPI as the only sign of economic stability, and nobody seriously states that the crisis is a result of decrease in aggregate demand and lack of loosened policies.

Instead, what most of us hear about are fundamentals and the crucial investment mistakes that were stimulated by lowered interest rates and a growing debt bubble. It appears that, for the purpose of explaining the current meltdown, macro gibberish about CPI and GDP seems unimportant. CPI does not reflect micro changes in the relative price structure, and GDP can impressively grow through malinvestments that eventually have to be liquidated.

Price relations, resource scarcity, the structure of liabilities and expected revenues between the firms in the market are the key issues. Welcome to the world of Austrian economics.

Due to banking bailouts, we could echo Paul Krugman, who says the same thing as William Poole of the Federal Reserve — that there is a difference between liquidity and insolvency. The central bank might pump the money in case of sudden leakage of the money from the system. But the case of insolvency is much more troubling, for it means that even if the central bank helps the commercial bank in the short run, the bank is still in trouble, since it started the expansion process that cannot be sustained over the long run through temporary offset of liquidity shortages.

Although the story of liquidity and solvency is a little overstated, one thing should be recognized. This difference cannot be made in the Keynesian macro framework. Nor can it in the monetarist. It can only be made at all by referring to the micro sphere, which has always been the subject of Austrian analysis.

Middle-of-the-Road Banking System Leads to Financial Socialism

Current monetary and fiscal policies, whether you prefer the Keynesian or the monetarist version, ended up in complete failure. So what is left for the mainstream economists after their favorite tools failed? Abolish the Fed and move toward a free-market monetary system? Of course not: if Fed policies failed, then it's not really the policies that are bad, but the free market itself! There had to be something inherently wrong with the market system that it did not comply with marvelous government policies and the theories behind them.

In this manner, for example, Irving Fisher — the Gandalf the Grey of paper money (Friedman being Gandalf the White) — before the Great Depression, argued that the gold market should have been manipulated in order to provide a sound monetary policy. Since the Great Crash brutally verified this idea, Fisher did not blame the inflationary policies of the roaring '20s and the manipulation of the gold market, but proposed more interventionist measures, i.e., a partial nationalization of the banking industry by subjecting the banks to a 100% fiat-money system.

One should not forget about Mises's great insight that middle-of-the-road-policy leads to socialism, which applies well beyond price controls. His contribution was that the price control imposed upon the market would not lead to expected results, but instead would create chaos. The endgame is to either abolish all controls, or go along the way of extreme interventionism and end up with full socialism, in which the government runs the economy.

How similar is the current situation in the case of the American banking system? After a tremendous bubble, not only in real estate, but the whole financial system, the day to pay the bills came at last. The necessary steps would be to liquidate bad investments and allow the recovery process to take place. Instead, we see more cries from the banking sector for more government intervention.

The Fed tries desperately to bail out any falling giants. It began to destroy the very last instances of the market mechanism in the banking sector. Now the wasted assets of the banks, mortgage based securities, are being exchanged (via innovative "TAF" and "TSLF" operations) by the Fed for government bonds in order to improve their balance sheets. At the same time, interest rates are being lowered to provide even more liquidity and to socialize risk, increasing moral hazard.

What we are witnessing is a great demonstration of one of the most important Austrian contributions to monetary economics: that a central bank has socialistic potential. Think about it. In socialism, the central planner increases the amount of goods he possesses by means of expropriation. If he needs anything, a decree is the way to acquire it. In the central banking system, the decree is replaced by something else: printing money. If something is needed, direct expropriation and an official decree are not required; fiat money is enough. Print the money and you can buy anything you want.

The ultimate boundaries differ of course. Under old-fashioned socialism, there is always the possibility of creating enslavement through direct use of force. In contrast, in the financial socialism that is being created right now, the last stop is hyperinflation, which will ultimately destroy central bankers' only way of redistributing property — fiat money.

Mainstream economists will not advise the abolition of this tool. Instead they will search for the cause in the liberalization of the banking system, poor accounting standards, and rating agencies that absurdly gave collateralized debt obligations high grades. Once we find the guilty parties, we will be ready to increase intervention on the market. The solution will probably include the issuing of new, extended Sarbanes-Oxley Acts, regulating even more rating agencies (despite the fact that it is the Security Exchange Commission that created the cartel of the Nationally Recognized Statistical Rating Organization), or maybe tighten the rules of BASEL regulations for the banks. All this is necessarily like extinguishing a fire with gasoline. It can only end up producing more turmoil and trouble in the future and at the same time move us further away from the free market system.

The only way to get out of the current mess it to go to its roots, and return to the personal responsibility that is inherent in the private-property order. Otherwise, any change in modern regulations will only open new doors for doing shaky business. It is time to reject the nominalistic and positivistic view that words coming from the mouths of lawmakers can change the nature of reality.


To answer the title question, our Keynesian friend has put his usual monetary and fiscal policies back into his pocket, at least for now. Unfortunately, he still wants the government to run the economy — and this time move us even closer to financial socialism.


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