Why Keynesianism Fails

The Economist is a relatively excellent periodical. They claim to promote “a sever contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress.” There are times where this is not displayed in full measure. Such is the case in a recent article exposing the errors of banks and what can be done about it.

There are two solutions they propose: increase regulation and capital. The last is an absolute must because the events over the last year and half have exposed banks as extremely undercapitalized. The inappropriate marks of assets and liabilities led to the miscalculation of risk. Mathematical models underpriced risk and an undue qualitative judgment of the market environment compounded the problem. Concerning regulation, however, this solution is misaligned. Lack of regulation was the least of the causes that led to the bubble implosion. Subprime mortgage originations, for instance, increased in the earlier part of this decade like never before due to Fannie Mae and Freddie Mac’s interference in the market. These institutions would encourage banks to extend loans to less credit-worthy individuals by subsidizing some of the costs involved in the transaction.

But the most troubling part of enacting additional regulatory burdens as a means of preventing future crisis is the inherent assumption in this action. It requires an omniscient government. Make no mistake, regulation is an absolute must for any market to work efficiently. Nevertheless, more importantly there must be a sense of respect of the law. Regulators are responsible for ensuring market participants are adhering to them, and those that aren’t must be subjected to the appropriate punishments. This is critical and indispensable. Beyond a certain amount of regulatory measures, however, this process becomes burdensome and ineffective. Like any type of business, banking is best practiced under free-market competition. The “too big to fail” de facto policy must disappear. This simply distorts market incentives. Moreover, politicians are ripe to consider “campaign donations” from financial firms in order for the passage of favorable legislation. In other words, the corporate/state nexus would strengthen. As the article points out,

“Smarter regulators and better rules would help. But sadly, as the crisis has brutally shown, regulators are fallible. In time, financiers tend to gain the advantage over their overseers. They are better paid, better qualified and more influential than the regulators. Legislators are easily seduced by booms and lobbies. Voters are ignorant of and bored by regulation. The more a financial system depends on the wisdom of regulators, the more likely it is to fail catastrophically.”

The article was written by a Keynesian supporter, which often without realizing it endorse contradictory statements. Whenever someone supports two views that counter one another, that individual suffers from schizophrenia; or said differently, he/she is confused. This is the core of Keynesianism and why it ultimately fails.

A new global system is coming into existence

The following is an interesting article that was published in The Economist magazine. I present a critique of its argument in this post. Note that the italized sections of this missive represent The Economist's words, while the bold sections represent my refutations.

********************************************************

ALL monetary and economic systems are a struggle between borrowers, who favour inflation, and creditors, who are determined to maintain the purchasing power of the currency. In a democracy, this is a very fluid battle. The creditors have the money and therefore the ear of the political elite; the borrowers tend to have the votes.

[If an economic system is based on respect for the law in the form of property rights, sound money, and voluntary exchange there is no “struggle” to speak of. The “struggle” arises when perverse incentives get in the way by intervening in the market by government or a government-sponsored agency. ]

Creditors have periodically imposed monetary anchors in an attempt to defeat the borrowers’ lobby. These anchors are devised in prosperous times but run into difficulty during recessions. The gold standard failed to outlast the Depression. For nations with a shortage of gold, the “right” thing to do was to raise interest rates in an attempt to lure gold back; the austerity this imposed on the rest of the economy was politically unacceptable.

[One can write volumes expanding what the author has just claimed. Let’s speak in non-politically correct language. Creditors want sound money, borrowers do not. Creditors hate inflation, borrowers love inflation. The gold standard fomented sound money; as a consequence there was significant price stability. Given man’s unlimited wants, he will borrow if allowed without much hindrance. Too much borrowing always occurs. Borrowers can quickly gather to seek political favors: “I’ll give you my vote if you inflate.” The politician’s answer: “We need to get rid of the gold standard because it doesn’t permit me to inflate.” The borrower than says: “I’ll give you my vote if you inflate.” The politician then answers: “I will serve my constituents,”—which is another way of saying, “I want power.”]

The Bretton Woods era replaced a gold standard with a dollar standard (albeit with the American currency theoretically linked to bullion). The system worked well for more than two decades, helped by the post-war economic boom, particularly in Germany and Japan which began the period with undervalued exchange rates. It broke down because America refused to pay the domestic price for bearing the system’s weight.

[True. All empires extract some form of tribute from its territories. The American one did it in a peculiar manner. While previous empires levied tax money to flow from its conquered regions, the U.S. uses the inflation tax to get the same results. The U.S. dollar was inflated (i.e. print more than gold reserves allowed). The fact that the U.S. dollar is the world reserve currency gives the country special privileges (or as economist like to say, a free ride). The U.S. dollar free ride will continue until foreigners say “no mas.”]

When Bretton Woods failed, it was not immediately obvious what would replace it. European nations, in particular, maintained a hankering for fixed exchange rates. But floating rates eventually prevailed, particularly for the major currencies of the dollar, yen and D-mark.

The problem for creditors was that the floating-rate system was based on fiat (paper) money. What would keep the inflationary instincts of governments in check? The answer took a couple of decades (and recessions) to hammer out.

[Actually, what kept the inflationary instincts of governments in check was faith, or in economist-speak, managed expectations.]

Once it was accepted that the markets could set exchange rates, there was no real need for capital controls. And once capital could flow freely, ill-disciplined governments could be punished by higher bond yields. Politicians accordingly tried to reassure the markets by giving greater power to central banks, some of which set explicit inflation targets.

[During this time, the perception was given that central banks were “independent.” Of course, it was silly that market participants in fact believed this. There was never such a thing as central bank independence. Consider the Federal Reserve in its current standing: it does the dirty work of the Executive Office.]

The post-Bretton Woods system worked well, engendering the long period of low inflation and steady growth known as the Great Moderation. But one of the reasons for its apparent success—the growth of India and China—may have sparked its demise. The addition of these two great nations to the international financial system was a supply shock that put downward pressure on inflation rates.

[I would add the inclusion of formerly communist countries into the global financial system as a further supply shock. Moreover, financial innovation and technological improvement helped in this process too.]

As Stephen King, an economist at HSBC, has pointed out, the result might have been a benign deflation that boosted Western living standards. But central banks struggled to avoid a deflationary outcome; the result was a loose monetary policy that encouraged asset bubbles. Those bubbles lasted longer than expected because the flood of savings from developing markets held down the risk-free rate.

[It is absolutely true that central banks engaged in loose monetary policy, however some of the “savings from developing markets” was actually money printed out of thin air. The fact that the risk-free rate was below the one that would exist in the absence of manipulation caused all forms of capital misallocation. The present crisis is the result of central banking.]

Now it seems to be recognised that inflation targeting is not enough. Given the explicit government guarantee behind the banking system, central banks need to monitor both financial stability and asset prices. At the same time, some central banks have adopted (via quantitative easing) a policy of creating money to boost markets that also has the convenient side-effect of funding budget deficits. That is just what opponents of fiat money feared would happen in the long run.

[As I said previously, the idea that there was ever such a thing as central bank independence was silly.]

The same old dilemma will eventually occur. Having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (like Britain and America) that have trade as well as budget deficits, those higher taxes will be needed to meet the claims of foreign creditors. Given the political implications of such austerity, the temptation will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to this danger; ten-year Treasury bond yields are around a percentage point higher than they were at the start of the year.

[Translation: Defaults via mass inflation. In other words, this type of default on debt will occur by way of printing money (which already has been) out of thin air to pay back what is owed. There will be a heavy tax, but it will be in the form of high inflation.]

Creditor nations tend to set the rules and the new global monetary system will be unable to operate without the approval of China, a creditor country that has capital controls and a managed currency. It has been assumed that China will have to move towards the Western model. But why not the other way round? Western countries adopted free capital markets, as the British adopted free trade in the 19th century, because it suited them. Will China now be able to call the shots? Uncomfortable as it might be for the West, the next monetary order is more likely to be made in Beijing than in New Hampshire.

[China will loose a lot of wealth in the coming mass inflation. They will gladly incur the cost if it leads them to call the shots in shaping the new economic and financial world order which will emerge after the crisis.]

A View of Modern Society

Amidst the claptrap of government bailouts of Wall Street, Democrats vs. Republicans, liberal vs. conservative, globalization vs. protectionism, etc. there is an underlying theme that seemingly connects disparate groups. Few give it adequate attention. And those who do have their voice silenced or obliterated into oblivion. There is a profound battle occurring in our society today which does not have to do with weapons of mass destruction, guns, grenades, tanks, or any other typical army armament. For armed insurrections and rebellions, once successful in their attempts, lay the foundation to further insurrections and rebellions. The battle I am referring to is nothing of the sort. I am talking about the struggle to salvage the last remaining philosophical tenets that allowed our society to function and flourish. One just simply needs to scan daily newspaper headlines and have a genuine desire to seek the truth amidst the sheer amount of toxic information to “see” what I am speaking about. Failed states, failed policies, failing institutions. In other words, a society that seems to be falling apart at the seams. If I were to take a point in time, say ten years ago, the amount of change that has transpired is tremendous. The same can be said going back fifteen years. Yet, if I had taken inventory of this change on a yearly basis, it would have been so miniscule that the sheer exercise of it might have been futile. But this just merely exhibits the effects of compounding interest: that is, for example, a 2% change after one year is 2%, after two years the value is 4.04%, after three years it is 6.12%…after 10 years it is 21.89%. The point is that change adds up exponentially, sometimes for better or for worse. In our society today, it is the latter.

If you think my proposition is an exaggeration, let me give you four names: Harold Berman, Jacques Berzun, Robert Nisbet, and Martin Van Creveld. You probably have not heard of them. Let me give you a hint: They are not New York Times (or any newspaper) reporters, or journalists who work in some office of CNBC or Fox News (or any other TV personality)—many who pass on opinions as facts. They are academic luminaries who never forsook their profession’s seriousness into the inquiries of their disciplines and of society. By now I hope you have considered their qualifications and background to know they are far from obscure “gentlemen and scholars”. On the contrary, they have a remarkable authority to speak about their subject matter. All of them separately conclude of the tectonic shifts that have occurred during the last generation or two, which consequently has led to the abandonment of the pillars that sustain our modern society.

In his book, "Law and Revolution", Harold Berman makes the following observation:

“The two generations since the outbreak of the Russian Revolution have witnessed-- not only in the Soviet Union and the West—a substantial break with the individualism of traditional law, a break with its emphasis on private property and freedom of contract, its limitation on liability for harm caused by entrepreneurial activity, its strong moral attitude towards crime, and many of its other basic postulates. Conversely, they have turned to collectivism in the law, towards emphasis on state and social property, regulation of contractual freedom in the interest of society, expansion of liability for harm caused by entrepreneurial activity, a utilitarian rather than a moral attitude toward crime, and many other new basic postulates.” (pg. 36-37).

That is, administrative law as a means of market efficiency has been on a constant rise for almost a century. The belief that increased legislative measures alone will alleviate hardships is at least foolish to accept at face value and a half-truth at best. Indeed, laws and its concomitant respect are a prerequisite for any society to prosper. However, the underlying motives and reasons for enacting such laws is what Berman is considering. Laws are the agglomeration of what society considers relevant. The “bailout” mentality, for example, is not a new phenomenon, but one that has been bred for quite a while. Consider recently when Congress forced the Financial Accounting Standard Board (FASB) to change its accounting methodology at the risk of backlash if the former did not comply. These days financial institutions do not have to fend for themselves, given that politicians admonished the FASB that they would use administrative law to get its cooperation. FASB ultimately caved in to political pressure. This is clearly evidence of disrespect for private property rights. They were eschewed on some nebulous premise of market stability.

In Jacques Berzun’s From Dawn to Decadence, we learn that

“the 20th century has gone the 16th century one better in making the absurd a sign of righteousness, of surefire appeal. Any doctrine or program that claims the merit of going against the common sense has presumption in its favor—a major discovery is at hand. Where earlier the proponent was declared a charlatan, now he is the bearer of the desirable new and enlightened” (pg. 757-758).

Having just recently finishing my graduate degree from Columbia University, I can first-hand acknowledge the veracity of Berzun when it comes to assessing the current environment in academia—particularly in Economics. For example, the ideas of J.M. Keynes, which were discredited in the 1970s, have been re-packaged and dispensed in a new format to the entire student body. How about society in general, as Berzun points out,

“Western nations spend billions on public schooling for all, urged along by public cries for Excellence. At the same time society pounces on any show of superiority as elitism. The same nations deplore violence and sexual promiscuity among the young, but pornography and violence in films and books, shops and clubs, on television and the Internet, and in the lyrics of pop music cannot be suppressed, in the interest of ‘free market of idea’” (pg. 758).

One can go on and on to expose the rampant contradictions many live by. Few give it any passing thought about this absurdity. Perhaps this obvious cognitive dissonance—to borrow a phrase from social psychologists—is the effect of a structural cause of a society. Perhaps it has something to do with our idea of what progress constitutes, as Robert Nisbet claims. In “History of the Idea of Progress”, he states that

“everything now suggests, however, that Western faith in the dogma of progress is waning rapidly at all levels and spheres in this final part of the twentieth century. The reasons…have much less to do with the unprecedented world wars, the totalitarianism, the economic depression, and other major political, military, and economic afflictions which are peculiar to the twentieth century than they do with the fateful if less dramatic erosion of all the fundamental intellectual and spiritual premises upon which the idea of progress has rested throughout its long history” (pg. 9).

This encapsulates the very core of our identity as a society. Nisbet seems to say that we have entered a dark-age period.

In “The State: Its Rise and Decline”, Martin Van Creveld goes a step further and makes the assertion that the modern state is in its period of decline, which began somewhere between 1945-1975. The “global character of the changes indicates that they were produced by anonymous forces over which scarcely anybody could exercise any control. And in relation to which, indeed, the entire question of morality becomes almost irrelevant.” The decline is characterized by nuclear weapons proliferation, breakdown of the welfare state, and globalization. The product has been strife and continued disintegration in social structures.

Harold Berman, Jacques Berzun, Robert Nisbet, and Martin Van Creveld, albeit coming from different perspectives, all agree that something radically different is evident in our society. If what they claim is true (which, given my own research, I happen to believe they are right), unless a radical shift occurs, I cannot be absolutely sanguine about the future.

Stock Market Fraud?

According to Daniel Shaffer, CEO of Shaffer Asset Management, the recent upswing in the stock market has been the result of market manipulation. This is the transcript of his statement made on Fox Business Channel on May 14, 2009.

"“Something strange happened during the last 7 or 8 weeks. Doreen you probably can concur on this -- there was a power underneath the market that kept holding it up and trading the futures. I watch the futures every day and every tick, and a tremendous amount of volume came in a several points during the last few weeks, when the market was just about ready to break, and it shot right up again. Usually toward the end of the day – it happened a week ago Friday, at 7 minutes to 4 o’clock, almost 100,000 S&P futures contracts were traded, and then in the last 5 minutes, up to 4 o’clock, another 100,000 contracts were traded, and lifted the Dow from being down 18 to up over 44 or 50 points in 7 minutes. That is 10 to 20 billion dollars to be able to move the market in such a way. Who has that kind of money to move this market?
On top of that, the market has rallied up during the stress test uncertainty and moved the bank stocks up, and the bank stocks issued secondaries – they issues stock – they raised capital into this rally. It was perfect text book setup of controlling the markets – now that the stock has been issued…” (Transcripts courtesy of myprops.org)

This is the video where Mr. Shaffer made his statement. Pay particular attention on the 2 minutes and 30 second mark...

The Deflation Myth

Expanding on my last post, the decline in the CPI has sparked once again the fear of a deflationary spiral. The debate between “inflation” and “deflation” still continues to get media coverage, but adequate explanations are far from satisfactory. In this missive I will clarify why deflation is merely smoke and mirrors concealing the true menace: price inflation.

What is “deflation” and why it is bad?

When you hear economists mention the word deflation, they generally mean a fall in consumer prices. More specifically, it is the sustained fall in consumer prices. On the surface, declining prices are not pernicious in and of itself because buyers can purchase more goods with their money. In other words, their wealth increases. However, for society at large this outcome may not be optimal because the wealth-gain for some could be offset by wealth-loss for others. This is particularly the case in a debt-laden society. Economists refer to this as the theory of debt deflation: lower prices increases the true cost of debt, causing spending to decline, which leads to shrinking demand and consequently higher unemployment. High unemployment means higher risk of defaults. Thus we have the beginning of a spiral taking place.

Deflationists—which include the likes of Ben Bernanke—point to the period between 1929 and 1933 when prices (as defined by the CPI) declined approximately 27% as proof of their heightened concern. As a result, the current crisis has been treated by an extraordinary surge in liquidity by the Federal Reserve. In particular, the Fed’s balance sheet has more than double since September 2008.

Yet, in context their fear is misplaced. During the early years of the Great Depression, prices declined primarily for three reasons: 1) The money supply decreased between 1929-1931, which caused a sharp contraction in economic activity.

The subsequent increase in the monetary base had no effect since production was declining and 2) there were approximately 9,000 bank failures between 1929-1933. This caused the money multiplication effect, which is the byproduct of a fractional reserve banking system, to be nullified. The FDIC was nonexistent in those days; so when a bank would fail, depositors lost their money. In this instance, the supply of money simply “disappeared” from the economy. But most importantly, 3) the U.S. operated under a domestic gold-standard as its monetary system. In addition and in contrast to today, gold coin freely circulated as money in those days.

This last point is crucial to reiterate because deflation cannot occur outside of a commodity-linked currency. Said differently, it is impossible to have price deflation (i.e. a sustained decrease in prices) under a fiat monetary system, except only when productivity outpaces money supply. Critics will point to Japan as an example of the consequences of deflation. However, Japan’s economic malice is the result of government intervention (see here and here for a detail analysis on this country).

As demonstrated by the following chart, prices declined in the U.S. from 1928-1933 and subsequently increased thereafter. (Insert Chart).

It is of utmost importance to highlight that on April 5, 1933, President FDR criminalized the private holding of gold and forbade the usage of gold coins as money to settle transactions. There is no coincidence that prices began to increase post-1933.

Why prices decline under commodity-linked money and not under a fiat?

Inflation and deflation is always a monetary phenomenon. When the safety and soundness of banks during the Great Depression was suspect, the population’s demand for gold coins increased. People subsequently withdrew their bank deposits and converted them to physical gold. This resulted in a run on banks, their failures, and an overall decrease of the money supply—all which aggravated the economic conditions of the country. Under a domestic gold standard, monetary policy is very limited. And while the FED did inflate the money supply beginning in late 1931, it had no effect on the general tendencies of prices until FDR’s intervention.

Under a fiat monetary system, however, monetary policy is amplified and thus has more power. Price might decline from time to time, but a sustained fall is impossible because money (unlike the one backed by gold) has no anchor which to hold on to. Deflation proponents under a fiat monetary regime must answer the following facts: 1) most of the currency is held in the banking system, which is part of the monetary base, 2) this currency is part of bank deposits, which get multiplied in the fractional reserve banking system, 3) the FDIC main objective is to prevent banks to disappear, thus maintaining the money multiplier effect operative, 4) despite the high debt load by the U.S., there will always be somebody willing to borrow (e.g. the Federal government needs about $4 trillion this year alone to cover its expenses), and 5) monetary policy is without limitations, in contrast to the gold-standard era.

As can be noted, there are significant differences between the Great Depression period of deflation and our own time. Ignoring these facts has led policymakers and the population in general to “reason correctly from an erroneous premise”. If there is something else to salvage from my analysis is that once governments change the rules of the game, intertemporal comparisons become an evaluation between apples and oranges. Inflation continues to be the primary risk today.

Explaining the Fall in CPI

The most recent Bureau of Labor Statistics’ report demonstrates that the urban consumer price index (CPI) decline 0.7% from April ‘08 to April ‘09—the biggest fall since 1995. Excluding food and energy, or commonly known as core prices, have increased 1.9%. Policymakers use core prices as a proxy to manage inflation because they perceive they do not have “control” of the excluded items. This policy approach is a distortion because food and energy prices are legitimate costs bear by all consumers. I will explain why prices have decline momentarily.

But there is a deeper issue concerning the CPI that warrants further explanation—that is, the nature of indexation. Indices in many instances, the CPI included, are inadequate indicators to value a desired activity. First, the CPI is made up of a basket of goods and services set in a particular base year—this mean that the basket does not change from year to year. The problem is that consumer preferences change over time and hence their consumption habits. Indeed, the basket of goods and services can be altered at some point; however, the CPI is far from being a real-time indicator of preferences. What matters are relative price changes, not changes in the CPI. Second, “nonmarket goods” (e.g. recycling, clean environment) are not counted as part of the CPI basket of goods. Third, each individual imputes value to goods, which in many instances will deviate from their price. As such, the CPI’s basket of goods and services is far from static in terms of individual consumption: some people will consume more or less of what this basket constitutes. Fourth, outliers easily distort averages; that is, one large data point can skew the distribution. Therefore, it is more reasonable to use the median CPI as a rough proxy.

Having said that, the primary reason the fall in the CPI has to do with a massive fall in private inventories, which declined at an annual rate of 2.79% in 1Q’09 (see table 1.1.2). In comparison, for the years of 2007 and 2008 inventories declined .40% and .26% respectively. Except for 3Q’08, private inventories have fallen each quarter of 2008 and 2009. On a greater scope, they have fallen steeply since 2006. Private inventories consist of the following:

“purchases of fixed assets (equipment, software, and structures) by private businesses that contribute to production and have a useful life of more than one year, of purchases of homes by households, and of private business investment in inventories. Inventory investment, which is shown as “change in private inventories,” includes the value of goods produced during a period but not sold, less sales of goods from inventories that were produced in previous periods” [see page 8 here].

These figures (and the St. Louis Fed chart) tell us that firms are producing less (hence the fall in capacity utilization) and are selling-off their excess inventory in greater measure. The steep fall reveal that firms built an extraordinary amount of inventories during the bubble years. The recent fall in prices merely represent the law of demand and supply at work.

The trend of the annualized median CPI over the last several months, however, demonstrates a small decline in prices, but not as extreme as reported by the urban CPI. In November 2008, the 12-month percent change was 3%, 0.4% higher than the figure reported as of April 2009.

In conclusion, prices are declining because of excess quantities supplied and inventoried over the last expansionary economic cycle. The median CPI, an imperfect yet rough proxy of consumer spending habits, continues to demonstrate price inflation.

Decision-making Under Uncertainty: A Word of Caution

“What chiefly distinguishes the empirical research on decision making and problem solving from the prescriptive approaches derived from SEU [subjected expected utility] theory is the attention that the former gives to the limits on human rationality. These limits are imposed by the complexity of the world in which we live, the incompleteness and inadequacy of human knowledge, the inconsistencies of individual preference and belief, the conflicts of value among people and groups of people, and the inadequacy of the computations we can carry out, even with the aid of the most powerful computers. The real world of human decisions is not a world of ideal gases, frictionless planes, or vacuums. To bring it within the scope of human thinking powers, we must simplify our problem formulations drastically, even leaving out much or most of what is potentially relevant.”

Herbert Simon expressed these words in a 1986 briefing panel concerning decision-making and problem-solving. His statement admonishes us of the non-linearity of life in such process. We never possess complete information or perfect foresight. Yet, this does not hinder us from making decisions and expressing our beliefs. However, it is imperative we recognize our limitations.

One reason why, relatively-speaking, only a handful of people ever saw the financial crisis occurring relates to the mischaracterization of reality. In my view, I don’t believe there was ever a full understanding of what actually constitute risk and how that’s different from uncertainty. Risk is uncertainty that can be quantified. One measure of it might be “standard deviation”. Uncertainty, on the other hand, cannot be quantified. I think of this like a “black swan” or “fat tail” events. In many instances of business activity, it is the “unquantifiable” that poses the major risk. How can one quantify gov’t policy or geopolitical factors that are inherently non-numeric? Very difficult. Even if one could estimate it, chances are the prognosis may not be entirely accurate.

Business and financial models use parameters, which in many instances, “leave out much or most of what is potentially relevant.” This continues to be true today. This applies to me too. That is why I add that my predictions could be worse than I propose. The alternative—a better than expected scenario—is highly unlikely because I have already accounted what I believe is potentially relevant.