Sunday, June 5, 2011

When people assume good ideas are bad

Once upon a time there was an economist called John Maynard Keynes. Keynes looked at the consequences of World War I, and the economic aftermath, and determined that things might possibly be bad. A decade and a half later, another crisis was engulfing the world, this time economic, and Keynes reasoned that the issue was that there was a lack of people buying things, and that this needed to be dealt with if the crisis was to be dealt with.

In the meantime, governments did what they always do, and prevaricated, going back and forth between constructive ideas and destructive ideas. The US government, for example, would spend money on public works in an attempt to revitalize the economy, and it would work. Then when unemployment started to fall, the government, concerned about the whole "People might think we're communists" crap, would cut back, and the economy would collapse again. This went on again and again, and was only broken after another war broke out, and the government was able - nay, required - to spend money like it was going out of fashion.

Keynes became a giant amongst economists after WW-II. He was proven right, again, and again, and again, about the links between unemployment, inflation, and fiscal policy, and governments began to seriously embrace Keynesian ideas concerning their own economies. But there was an asterisk to be put against the embracement. Keynes advocated massive government spending during bad times, and massive government saving during good times. But some governments used Keynes to justify spending at all times, and this caused an already skeptical group of economists to want to get away from Keynes, who was seen as encouraging too much government intervention in markets.

After much debate, most started to rally behind the ideas of Milton Friedman. Friedman adapted the Keynesian models, but addressed the underlying causes of poorly performing economies using what's arguably a similar but more generic set of concepts. Friedman argued that the cause of the great depression was a lack of money.

The amount of money in a modern economy is generally decided upon by a so-called central bank, a bank that acts as the manager of the country's currency. The bank has a number of tools available to it to allow it to expand the amount of money in the economy. It can, for example, adjust reserve rates, allowing banks to "lend" considerably more money than they "borrow" (from savers.) It can make loans of money cheaper, making it cheaper for banks to obtain more cash to put against their reserves.

When the Great Depression started a large number of banks collapsed because a lack of confidence in them caused numerous runs. The banks failed because they were unable to borrow enough to pay their savers. Friedman argued this was fundamentally the cause of the Great Depression, and that the Federal Reserve, the US's central bank, didn't do enough to increase the money supply to take care of the problem.

The arguments of Friedman and Keynes are often portrayed as polar opposites, but in reality they're similar, they just propose different groups of people as having the responsibilities involved. Both argue for an increase in the money supply, but Keynes proposes a "hard money" solution whereby the government borrows (or, preferably, spends savings) to inject more money into the economy via spending on commerce and business, while Friedman proposes a "soft money" solution where money is literally created to inject into the economy via banks.

Unmodified Keynesian economics was generally the default until the mid seventies. We have President Carter to thank for a switch over to Friedman's Monetarist economics in the US, and Margaret Thatcher for the switch to Monetarism in the UK. Both countries were suffering stagflation, which seemed to be caused by inflexible adherence to Keynesian economics. In particular, mainstream Keynesian opinion seemed to be that inflation and unemployment were negatively correlated. If measures were taken to deal with inflation (by tightening government spending), unemployment would likely rise, and if measures were taken to deal with unemployment, inflation may rise. Unfortunately, both countries were suffering both inflation and unemployment, and Keynesian economists were largely considered to be at a loss on how to deal with both happening at the same time.

OK, recap time.
  • From the 1950s to the 1970s, Keynesian economics had been dominant
  • The interventionist nature of Keynesian economics, and its use to justify heavily interventionist policies, made free market advocates eager to find alternatives, regardless of how effective Keynesian economics really were.
  • During this 20-30 year period, one possible crisis was identified that most generally consider both unsolvable by classic Keynesian models, and caused by them, notably stagflation.
So, what happened here? Well, monetarism was tried, and it didn't work out as well as people hoped it would. The economies of both the UK and US significantly worsened, with unemployment rocketing. Indeed, this was by design - monetarists argued that if inflation was controlled, the other problems with the economy would eventually sort themselves out.

Growth in the US and UK slowed down. Both countries have had rates of growth since the 1980s that was positive, but nothing like as strong as the post war period that preceded it. And just to make matters worse, the Japanese had their own economic crisis after having what's considered the most healthy economy in the world. Upon collapse, the Japanese chose to let their Central Bank deal with the crisis, and only made minimal use of fiscal policies to deal with the issues, just like the Monetarists said they should.

The Japanese banks were suddenly awash with money, which they invested in countries whose economies were healthy, finding it almost impossible to lend money at home. Oops. Monetarism suddenly had its equivalent of stagflation, in this case a situation where unemployment remained high, while the Central Bank was running out of ways to inject more currency into the economy without devaluing it significantly in the process.

OK, recap time (2):
  • Monetarism was tried, and appeared to have even worse problems than ordinary Keynesian economics. Keynesian economics at least took two or three decades to show any flaws, while Monetarism barely lasted half that time, and seemed to cause a lot of misery even when it was "working".
  • Monetarism was clearly less effective than Keynesian economics at keeping an economy growing.
Now, here's where it gets interesting.

Recall the basic Keynesian principle: spend when your economy is having problems to get out of those problems, save when it isn't. It's not exactly rocket science, if you've ever taken out a student loan, you probably understand the concept.

Well, here's the problem. During the nineties, several things happened.

First, in the US, nobody wanted to admit that Monetarist economics were, well, just awful. And if they didn't want to admit that, they certainly didn't want to admit that Keynesian economics, flawed though it might be, was better, that it generally worked, and that Keynesian economists might have found ways to deal with the whole stagflation part. Why? Well, because Monetarism was a "free market" solution, at least in the sense that it didn't involve the government directly. Nice, free market, banks got to choose where to spend the money.

The second part was that the guy who came after Carter, Reagan, was an utter imbecile who decided to win elections by using a new lowest common denominator tactic - simply claim it was OK to reduce taxes. And it became gradually impossible for anyone to get elected who thought raising taxes was a good idea.

And so we got to the a state where by the early part of this century, US governments basically started to do things because they weren't Keynesian. Bush Jr, for example, used the fact the country was running a surplus as a reason to cut taxes. Keynesians would argue (and did) that given the economy was healthy (at that precise point) and the fact we had a large deficit, we should be keeping taxes where they are, using the surplus to pay off the deficit.

Do you know now where I'm going with this?

Keynes was never "discredited", any more than Isaac Newton was when Einstein said those fateful words "Wait a moment, I think there's more to it than that*". Keynesian economics turned out to be astonishingly effective, and one flaw in the classic Keynesian system shouldn't be used as a reason to switch permanently to a system that's clearly inferior. We've seen some absolutely awful economic policies since the abandonment of Keynesian economics within the US.
  • The promotion of bubbles
  • A refusal to pay off deficits when we can afford to do so
  • A complete unwillingness to raise taxes when clearly they need to be raised.
  • A refusal to spend when we clearly need to.
The doors to this path opened when Carter and Thatcher decided to try monetarism, the situation was made considerably worse when Reagan essentially promoted having your cake and eating it policies, and a lack of integrity in economics, and when nobody in power on this side of the Atlantic proved willing to admit that any of this was wrong.

We now have a government and establishment that:
  • Probably knows that only government spending will fix the crisis
  • Knows that monetarist solutions like lowering interest rates and quantitive easing can only go so far.
  • But has decided the deficit is more important, like an idiot deciding they should put $5 towards their credit card debt rather than towards a bus ticket to a sure thing job interview.
  • Are treating the deficit as a problem caused by overspending, rather than undersaving.
  • Have so much invested in looking at the big deficit number, they've forgotten that the real problem with the economy is the lack of jobs. People with jobs can support themselves, and pay taxes towards paying things off.
Until our politicians accept the last thirty year's fiscal policies might have been utterly stupid, we can expect to have an economy that's just as bad as Japan's.

* OK, I don't think Einstein ever said that.

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