Wednesday, October 15, 2008

Dead Economics Rearing it's Ugly Head

Robert Skidelsky supposes in the Washington Post yesterday that economist John Maynard Keynes' economic theories would aptly have predicted the current financial crisis, and ostensibly prevented it. Skidelsky couldn't be more wrong nor more misguided. It's not a mystery that as a Keynes biographer Skidelsky would take this opportunity to hawk the Keynesian ideology but he does so with an obvious lack of understanding of both the effects of Keynesian economics nor the theories he claims to debunk.

He writes:

"...what is in even shorter supply than credit is an economic theory to explain why this financial tsunami occurred, and what its consequences might be. Over the past 30 years, economists have devoted their intellectual energy to proving that such disasters cannot happen. The market system accurately prices all trades at each moment in time. Greed, ignorance, euphoria, panic, herd behavior, predation, financial skulduggery and politics -- the forces that drive boom-bust cycles -- only exist off the balance sheet of their models."

The forces to which he is referring can be summed up in one phrase, the title of one of Ludwig Von Mises' seminal works Human Action, and to suggest that Keynes discovered some magical theory for predicting human action is more than misleading. Keynes as we can recall has been shown the architect and follower of a school of economics long since discredited as the type of policy that made the Great Depression last as long as it did. Keynes in fact advocated the kind of price manipulation that led us to the situation we are in today.

Skidelsky further writes:

"It held that governments should vary taxes and spending to offset any tendency for inflation to rise or productivity to fall. And for roughly 25 years -- from 1950 to 1975 -- they did. The developed world grew at an average annual rate of 3.2 percent without a business cycle, with very moderate inflation, and without the benefit of the huge rewards now deemed necessary to keep executives properly incentivized."

Bold times to reference until you considering the fact that such growth is modest at best when compared to a skyrocketing workforce and massive post war productivity. While inflation was stable during that time period it is important to understand that most of the inflation our economy was creating was exported along with the goods and services we sold to other nations whose infrastructures were recovering from the physical effects of a war we did not see on our soil.

"Plagued by inflation, governments around the world took up Friedman's monetarism, which maintained that inflation was due to governments' printing too much money. Central banks were made independent (the Fed already was) and were given the single task of keeping prices stable. Moreover, financial innovation in increasingly deregulated markets was said to make investment less and less risky"

While Friedman did advocate the policies that the FED has used to manage deflation. It's important though to understand that Friedman's monetarism was an answer to the failings of the Keynesian model, not simply an opposing viewpoint but an attempt to fix the failings within his framework. And further that it was not the absence of market manipulation simply manipulation through monetary policy and not fiscal policy. Suggesting that returning to Keynes from Friedman is like returning to the horse and buggy to improve vehicle fuel economy. Keynes didn't oppose market manipulation in fact he loved it, he simply believed in manipulation through the other end of the IS-LM framework. Keynes wanted to manipulate the market through the government's fiscal policy (government taxes and expenditures). That's an important distinction to make when you examine Congress' roll in creating lending policy and in it's encouragement and backing of Fannie May and Freddie Mac. We are in this situation in large part because of the kind of management that Keynes advocated.

"The price level is not a leading, but a lagging, indicator. Asset bubbles can coexist with a stable price level, even while the rest of the economy is starting to slide into depression."

Price is in fact a much more tuned indicator than Skidelsky suggests and while correct that it is not a leading indicator it is the first indicator in a market where it is properly allowed to do it's important job. Price, for instance would and did predict the current crises. The price of homes and mortgages took a drastic and unrealistic upturn while becoming inexplicably dissected from it's usual bedfellow; the rental price indexes. When home prices became separated drastically from rental prices it was an all too obvious indicator of things to come and free market economists have been screaming about it for years now.

He quotes Keynes
"Money, he argued, was being switched from production to speculation. The rich were getting very much richer, while the incomes of the rest were stagnating. "Profit inflation," fueled by collateralized debt, coexisted with an "income deflation.""

And here while he isn't entirely wrong about the events that occurred it is beyond obscene to suggest that the economy of the 1920's with years of prolonged negative growth, resembles the positive growth we have seen even this year in times of turmoil. What's more is that it's clearly not the same kind of "speculation" dissected from production when our economy is booming with production in a great many sectors. While it's true that wages have stagnated recently it's not in the neighborhood of the kind of stagnation that Keynes saw and responded to.

Skidelsky is correct that the most modern economic models do not predict with great accuracy things like what we have seen this year in our economy. That is as we expect because math has a very tough time predicting the very important elements of a person's full (not just financial) self interest, nor the choices that people will make when given the opportunity. Skidelsky is wrong however to suggest that Keynesian models would have predicted this; unless taken as such a vague suggestion that in 'this kind of market instability exists'. What's more important is to note that under Keynesian market management growth, prosperity, and market innovation are greatly stifled by fiscal policy constantly, and with only the vague hope of preventing the short moments of market instability that naturally occur. Regulatory market manipulation, the likes of which Keynes advocated contributed untold force to the current economic situation in this country and only the market and it's vast ability to re-connect prices with their intended properties of communication and incentive, will restore order.

The answer is not simply a return to one form of market manipulation over another. The answer is to implement policies that allow markets to experience the natural adjustments that occur when prices are out of equilibrium with real value. The Austrian model suggests just that. In the theories of F.A. Hayek and Ludwig Von Mises we would see not only the prediction Skidelsky wishes for but also the acceptance that in the long run the market will ebb and flow, prices will inflate and deflate, naturally in order to maintain proper and efficient relationships between producers, consumers, workers, employers and investors.

The problem Mr. Skidelski isn't the wrong manipulation, it is that manipulation is wrong.

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