Sunday, June 26, 2011

Why Have We Discarded Keynes?

I am not an economic historian and have not read the great economic theorists in the original. But after the September 2008 crisis hit, I found myself asking: Where were the economists? Why didn't they call it? Were they rewriting their theories? Any mea culpa's? Any apologies for leading the ship of state onto the rocks?

It is almost three years later. I have heard one apology, from Alan Greenspan, which was later softened or retracted. The Chicago School has not budged from its "efficient market", no such thing as an asset bubble approach. The Keynesians complain from the sidelines that no one understands that stimulus is good and necessary, when the consumer retrenches. The Republicans refused to join the majority on the Financial Crisis Inquiry Commission (which sited weak regulation, poor lending standards, perverse Wall Street incentives as principle causes of the crisis), and opted instead for blaming the entire mess on Fannie and Freddie, and their distortion of the housing market. In effect, in the Republican version, the GSEs' forced banks to reduce underwriting standards and make bad loans in order to increase minority home ownership. Neoclassicism reigns supreme: deficits are bad; government debt above certain levels will paralyze the country; government spending cannot create net new jobs; government borrowing will crowd out private borrowers, forcing interest rates up; and deadly inflation is just around the corner. But wasn't this the reigning economic ideology before the Crash? Why hasn't it been sent to the dustbin of history?

Didn't Herbert Hoover and his Treasury Secretary, Andrew Mellon, ascribe to this philosophy?  Don't most people feel they got it wrong, and that only the Keynesian deficit spending of FDR pulled us out of the Depression? And wasn't it only the huge deficit spending of WWII that pulled us out of the Depression for good?

Why is neoclassicism still the "economic law of the land"?Why are the Keynesians, like Paul Krugman, having to play defense? Is Economics simply one of those soft sciences where you can make equally plausible cases for both sides of an argument? Or does ideology determine what we see out there in the world?

I am sad to say that ideology appears to trump. What we believe to be true is what we will always discover confirming evidence to support. Look at the climate debate. Over 98% of peer reviewed academic papers confirm that global warming is occurring and it has a human cause, at least in major part. Yet almost half the US population believes global warming is a hoax. How can this be? Look at evolution: the science has been set for over 100 years. Yet over 40% of the US believes the Genesis Creation Story is what actually happened.

Science has lost much of it's dominance and luster. Part of this started out as progress, as postmodernism (beginning in the late 1960s') showed us that even Science is speaking from an observational viewpoint, and that perspectives/context matter. But this new frame of "context aware" scientific inquiry has lead to "truth chaos", not more self-aware perspective-taking. We don't know what is true anymore, so there is no effective check to our belief systems moving in to resolve our uncertainties. This is a step backward, if we are not aware that is what we are doing. Eventually, this becomes a major move forward, as our leading edge of thinkers reaches integral awareness, where AND is the ruling word, where we let go of binary, choice-forcing ways of thinking, and we see the world as extraordinarily complex, rich, creative, and chaotic but that there are underlying principles and patterns that govern the "power and flow of things".

We can not predict when this awareness will begin to take firm hold. We are now in that confusing, in-between time when loud voices and firm convictions/faith rule the day, and "objective truth" seems illusory. But it will not always be this way. Martin Luther King said that "the arc of history is long, but it bends toward justice." I believe we can discern another and parallel arc of history that moves us from ideology to "truth-seeing and telling", where we distinguish our personal perspective, and know we are "researching the world" from this viewpoint, and with this "integral awareness" we can discern the pattern and flow of things, and this viewpoint will be broadly accepted.

For now, confusion reigns. The neoclassical, pre-Keynes, pre-New Deal viewpoint has emerged from the dustbin of history and reigns supreme - here in the US, in Cameron's Conservative UK, in Trichet's EU/ECB, in the IMF. Only in Asia (China, Japan especially) and the rapidly growing BRIC countries do we see happy and successful Keynesians presiding over economic policy. Will we, in the West, take a page from their books? Probably not, for we are developed; they are not; and what we are doing - austerity - is right for developed countries, and when they get to our level, they will follow us. When people say, "But I thought Japan was fully developed," the neoclassical Westerners, respond: "Japan is in the tank. Their growth is anemic. Debt/GDP just passed 200%. They will soon default. They need to be practicing austerity like we are."

To begin to penetrate the confusion, I will make a clarifying distinction: Neoclassical economics is clearly and powerfully associated with conservative politics. Conservatives are ascendant in the US, the UK, and the EU/ECB/IMF. The Prime Directive for conservatives is small/reduced government in the interest of free markets and individual freedom. GET THE GOVERNMENT OUT OF THE MIX. This has been the organizing principle, the rallying cry, the vital energy that organizes complex pieces and policies into coherent movement with visible direction. Tax policy comes out of this: reduce taxes, particularly on those most likely to invest and build the economy. Cut spending: what the government spends is not available to the private sector to spend, plus spending is what gives the government power to intervene in the economy, in our lives. Reorganize/cut entitlements: with people dependent on the government, the government will retain and increase it's power, and the people will become inefficient, and lose their entrepreneurial energy. Low taxes. Low spending. Small government.

If this is your passion, your economists too will support small government. They will argue that government spending will not work to boost employment and grow the economy; that high government debt levels will bankrupt the country; that deficits and debt will spur widespread, deadly inflation; that free markets work best and any government action interferes and potentially disables this efficient marketplace; that efficient markets always "clear", at the "right" price (no asset bubbles) and demand is always sufficient ( unemployment is not a labor demand problem, it is a supply of labor problem: interference in the market by government with labor regulations and workers choosing not to work; low GDP growth/recessions are caused by supply problems, where business, concerned about government interference and tax/regulatory uncertainty, withdraws production from the marketplace, causing economic growth to fall); and more generally, demand is never a problem in the economy - there will always be sufficient demand to absorb the supply offered (Say's Law), and where demand appears inadequate, government spending will simply cause the private sector to withhold an equivalent amount of spending (Ricardian Equivalence) due to a felt need to put away reserves to cover the taxes coming down the road to fund this new spending.

For the conservative, a complete package of supportive economic theory. The anti-inflation, hard money policies mostly originated with Milton Friedman, who appeared like a giant on the scene from the University of Chicago in the 1970s' with his Monetarist Policy that went a long way toward dethroning Keynes. The efficient market/never a demand problem/ supply side focus came from Friedman descendants at the University of Chicago, called the Chicago School, led by Eugene Fama and Robert Lucas.

Is the conservative package of economic ideas right, partly right or just plain wrong?

Mostly just plain wrong.

 Friedman's Monetary Theory of Prices has elements of validity, especially, when the economy is operating at or near capacity and financial markets are heating up. Where he has been most wrong is precisely where he had the greatest impact: the idea that high government debt levels, deficit spending and increasing the money supply through debt issuance ("monetizing the debt") would cause serious inflation. Japan has run big deficits for most of the last 20 years with no inflation problems. On Friday, the US Treasury 10 year notes hit a 2011 low yield of about 2.93%, contrary to all predictions of what would happen when the Fed poured money into the economy in 2008/2009, providing liquidity for the financial system.

The Chicago School's efficient market hypothesis has been battered by the Crisis, but is tenaciously hanging on in conservative circles, because it suits the political agenda of bankers and Republicans. Similarly the "demand is never a problem" meme has been badly beaten, and should, in my opinion, be long gone, but it hangs on strongly in the political conversation, supporting the argument for attacking government deficit spending as unnecessary, inefficient and destructive. If demand will always be sufficient to clear the markets; if government spending/interference is always a problem; if deficits will always cause inflation - then Keynes is wrong and fiscal policy supported by the Democrats is poison for the economy. It is only a short step from here to attacking the debt ceiling increase and pushing for a balanced budget amendment.

So what should the President do? Obama, like most Democrats, is essentially Keynesian, at a time when neoclassicism is ascendant. Republicans and many Democrats are convinced we need austerity in order to move forward. Half the country accepts the "contractionary expansion" argument of the Republicans. The debt ceiling August 2 deadline is fast approaching. Critics on the Left argue the President must stop "leading from the rear." Republicans are saying the President must step out front and lay down the agenda he will support. Draw a line in the sand, Republicans say, so everyone knows where everyone stands. So what to do?

Recognizing that a Keynesian stimulus program is politically impossible right now, Obama's move, I believe, will be to minimize the damage to the economy from the budget cuts and hold out for essential fairness in sharing the coming sacrifice. Not a great Hope and Growth strategy, but appropriate to the context and the fierce conservative opposition. I think of the President as having to play the Russian General's game (Prince Kutuzov), retreating continuously before Napoleon's advance. Force the opposition to fully commit themselves. Let their positions become crystal clear. Then wait. At some point they will make a mistake and their own momentum will carry them into harm's way.

Obama has part way accomplished this, by not putting forward a "real budget", dilly-dallying in fact, until Rep. Ryan put his forward, and it quickly became Party orthodoxy, clarifying the Republican's real intentions for the first time since November 2008: Dismantle the large entitlement programs by turning them from defined benefit programs (as a Senior, my healthcare needs are met by Government program) to defined contribution programs (where the Government puts up a certain amount per year (over time, well below expected healthcare costs) and thus caps the Government's exposure). This alone might be a game changer: seniors and the white working/middle class will eventually rebel against a party that will take away its primary benefits, at the same time it supports added benefits for the wealthy in the form of tax cuts.

The debt ceiling is the next step. Obama would cut a deal with Republicans that would require significant budget cuts (including entitlements) if Republicans would put revenues on the table. Since it appears they won't, Obama must appear endlessly reasonable and always confident that good people can come together and find a fair solution. No lines in the sand, until it is absolutely necessary to do so. Some day, shortly before the end date of August 2, he should draw that line - announcing to the public that he will not agree to any arrangement that does not include revenue increases. Republicans are convinced the President will cave on the revenue question. When he does not, they will be very surprised. Then they will have a small amount of time to decide if they add some revenues in to make a deal, or if they follow the Tea Party off the economic cliff. My guess is that Wall Street Republicans, realizing default is imminent, will make Boehner relent. Result: No default. Major blow for Republicans, after endless statements of "no revenue increases" in the budget deal. Grover Norquist will be beside himself, etc. If this plays out, Republicans will be a long way toward disaster in November 2012, when Democrats can retake the House, and command a more growth oriented, Keynesian agenda.

If Obama blinks sooner, I think he will have a harder time being reelected.

If Republicans do not blink, and we go into default, and a true economic mess ensues, suspect initially it will be a "pox on both your houses", but that effective management of the economy after the second crisis, could put Obama, and Keynes, back on top.

In any case, we will probably not have a single, shared economic perspective any time soon. It is in the interest of Republicans to be anti-Keynesians, and they will continue to follow that path. Keynes will most likely only be reinstated if Obama and Democrats have a decisive win in November 2012.

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