Keynes-Fisher Macroeconomics: the Failure of 'New' Economics

Thu, 28 Jul 2016 11:40:24 -0400

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KFM: Keynes-Fisher macroeconomics

It is almost embarrassingly easy to debunk 20th-century macroeconomics. Indeed, by failing to predict yet another vast cataclysm, one might think the field had met its end.

And indeed when we see mainstream articles with names like "How the Entire Economics Profession Failed", we might seduce ourselves into the pleasant, Candidean belief that the "entire economics profession" was ready to resign its sinecures, and seek new employment in the lawn-care industry. Ah, if only. Yves Smith has links to a couple more pieces in this vein. Alas, they are all equally clueless.

For example, it is remarkably easy for Professor Madrick (above) to escape from the titanic disaster he seems to describe. Not counting Marxists, there are three significant schools of economic thought today: one founded by Lord Keynes and revitalized by Paul Samuelson (also known as "economics"), one founded by Irving Fisher and revitalized by Milton Friedman (also known as the Chicago School), and one founded by Ludwig von Mises and revitalized by Murray Rothbard (also known as the Austrian School).

As a rough guess, there are ten Keynesian professors for every Fisherite, and twenty Fisherites for every Misesian. Only Keynesians and Fisherites have an influence on public policy today. And, if you read Professor Madrick's article, he is a Keynesian and not interested in quitting his job at all. Oh, no. What he turns out to mean is that monetarist (ie, Fisherite) economics has failed. What appears to be a mea culpa is simply a dishonest attack on the competition, rendered in the same sneering, Stalinist tone we have just seen in our AGW section, by a bureaucrat whose resume makes him sound exactly like the Joe Romm of economics. (If nothing else, dear reader, you now know what it sounds like when power is spoken to truth.)

You may ask: why is it that Misesian economics has no influence on government policy? There are many ways to divide the profession (and I'm sure some would quibble with the classification above), but there is one simple division: we can divide economics into orthodox economics and new economics. Keynes and Fisher are new economics. Mises is orthodox economics.

These terms may seem a little strange. Why is new economics, which dates to the '20s, mainstream, and orthodox economics - which also dates to the '20s - shunned? And from the tone that the Keynesians and monetarists use to describe Austrians - when they deign to describe them at all, which isn't often, you'd think orthodoxy was the other way around.

But in fact, I am using the term orthodox in much the same way as Keynes himself. As anyone who has read Hazlitt's essential Failure of the New Economics [book-length PDF] knows, the Baron was anything but a precise thinker, but he generally uses the term orthodox to describe 19th-century or at least pre-WWI economics. This certainly would include Mises, whose school is the only real 20th-century survival of anything like what Victorians called economics.

I have a very simple, precise definition of orthodox and new, which matches Keynes' usage and seems reasonably serviceable to me. Let's say an orthodox economist is an economist who believes that any supply of money is adequate, and the money supply should be either fixed or bound to a commodity whose supply is very difficult to expand, such as gold. A new economist is a believer in an "elastic currency": he believes that the amount of money in a country should expand as the country "grows." Typically this involves a belief in paper money.

By this definition, it is indeed the new economics (of Keynes and Fisher) which has failed. It has failed totally and completely, it is morally and intellectually bankrupt, it has inflicted vast suffering on humanity, and if there was any justice its acolytes would be packing their bags one jump ahead of the law. They're not, of course.

When we remember that the world did, in fact, exist before 1914, we find it quite easy to justify the term new economics. Returning to our favorite Charles Francis Adams essay, for instance, we find the following trenchant passage:

The currency debate presented three distinct phases: first, the proposition, broached in 1867, known as the greenback theory, under which the interest-bearing bonds of the United States, issued during the Rebellion, were to be paid at maturity in United States legal tender notes, bearing no interest at all. This somewhat amazing proposition was speedily disposed of; for, early in 1869, an act was passed declaring the bonds payable "in coin." But, as was sure to be the case, the so-called "Fiat Money" delusion had obtained a firm lodgment in the minds of a large part of the community, and to drive it out was the work of time. It assumed, too, all sorts of aspects. Dispelled in one form, it appeared in another. When, for instance, the act of 1860 settled the question as respects the redemption of the bonds, the financial crisis of 1873 re-opened it by creating an almost irresistible popular demand for a government paper currency as a permanent substitute for specie.
This passage was written in 1901. Note Adams' perception of the paper-money advocates: they are insane, demagogic monetary cranks. Curiously enough, this is exactly how the responsible mainstream intellectual of today regards a Misesian, or any other gold-standard advocate.

Isn't this an interesting reversal? Doesn't it remind you slightly of our last case? Remember how the AGW promoters, shepherding a pseudoscience which has become mainstream, are so eager to dismiss their critics as pseudoscientists. These reversals happen for a reason: if you are a quack, quackery is what you know, so the obvious way to dismiss your critics is to label them as quacks. The approach is especially attractive for the mainstream quack, who knows that faced with a pair of arguing experts, each of whom claims the other to be a quack, most spectators will pick the one who has wormed his way into the most prestigious position.

Thus we have our hypothesis already: the "Fiat Money delusion" somehow worked its way into the mainstream, displacing the old, orthodox "hard money" economics. Since it is clear that, 75 years or so later, some school of economics has failed, and since hard-money economics has been long displaced from the temples of power, the simple answer seems clear. Now, let's try to understand it.

First, both the Keynes and Fisher schools are what a Misesian would call inflationist. (Adams would probably use the same word, too.) That is: they believe that expanding or otherwise debasing the currency is on some or all occasions beneficial to the health of the State. Again, we note the accuracy of our terms: before the 20th century, in both European and Greco-Roman times, monetary debasement was considered the pathetic act of a sick, decaying polity.

We can separate the Keynes and Fisher schools based on their preferred vehicles for inflation. Keynesians think governments should inflate the money supply through deficit spending - the "stimulus" we have grown to love so dearly. Fisherites think the best way to inflate the money supply is by fixing interest rates, a policy sometimes known as "easy" or "cheap" money. I'm afraid that, with AmeriZIRP in full swing, the Keynesians have rather the best of it. Perhaps we can give Professor Madrick credit for being right about that.

So the "new economics" does, after all, live up to its name. It is a product of the 1920s and '30s, when Britain discovered that her World War I debts would not allow her to stay on the classical gold standard that she once had established - at least, not at the now-overvalued prewar parity. There was too much paper and not enough gold. The failure cascaded, the world switched to paper money, and a new economics was needed. Under which "going off gold" was not a failure at all, but in fact a step into a brighter new world.

Who was right? Was the end of the classical gold standard a disaster? Or were the old orthodox economists just a bunch of no-fun fuddy-duddies, who didn't get it at all? And if so, how did they metamorphose from fuddy-duddies into nutball cranks?

First, it's easy for us to dismiss the inflationists on logical grounds. Inflationism simply cannot be right. It violates logic. Nothing can violate logic.

Second, an orthodox economist need not be a goldbug. The difference between paper and gold, as monetary goods, is immaterial. People hold money to defer consumption into the future, not for the industrial qualities of the money itself. Gold makes a good monetary system not because gold is "intrinsically" valuable in some sense, but because the supply is strictly limited. Ideally, there would be no new gold mining at all. And we can duplicate this effect with paper money, by issuing a certain number of notes and double-promising not to issue any more. (The advantage of gold is that the promise is a lot more credible.)

Rather, the difference is between a hard or inelastic currency, and a soft or "elastic" one. The former cannot be inflated; the latter can. An ideal hard currency has no new supply.

The key fact about money is that what matters to you is not how much money you have, but what fraction of the total money supply you have. It is the latter than determines your power to exchange money for other goods, in competition with present moneyholders. Eg: if, following Hume's Archangel Gabriel, we turn every dollar into two dollars (being careful to adjust debts as well), we have changed nothing.

Even simple inflation - printing money and spending it, Keynesian style - can be emulated with an ideal hard currency. To "print" new money in this currency, simply confiscate it pro rata from all present holders of the currency. Eg, if you want to print 1/100th the present money supply, find every dollar in the world, pay its owner 99 cents, and use the leftover pennies to fund your plan.

The effect of this policy is precisely the same as that of inflating an elastic currency, although the elastic implementation is much more straightforward. Perhaps this is the advantage of elasticity. But it avoids the critical question, which is why we'd want to do this in the first place. Oddly enough, although we know they are semantically identical, the inflation option seems much more fair and reasonable. Oddly, too, even Adams seems to acknowledge that, although an elastic currency may be pernicious, it is desired by many.

Keynes and Fisher did not propose inflation as an all-purpose stimulant for general fun. They proposed it as a cure for economic recessions and depressions, which were certainly in no short supply at the time. We are entering a recession or depression now, so it seems wise to revisit the issue. Is cocaine a good remedy for depression? Why do so many people want to inflate?

Again, the answer is easy. What we see in a recession or depression is a drop in consumer spending. Since spending is the flip side of production, we can think of the GDP (the sum of the prices of all goods and services sold by businesses to consumers) for any country as the amount of money spent on that country's goods and services. If that number falls by, say, 5%, the average business in the country has produced 5% too many goods and services.

Obviously, this is quite painful. And it also gives rise to calls for inflation - or, to use a more precise term, monetary dilution. There is an easy way to correct the situation to our business's satisfaction: print 5% more money, and spend it on goods and services. Hence the "stimulus."

If we switch back to hard-currency mode and look at what we're doing, it is even weirder. In order to prop up consumer demand, we steal one nickel from every holder of a dollar, add it all up, and spend it on goods which we throw away. Is this healthy? Keynes thought it was.

Basically, the way to perceive the "new economics" is in exactly the same way that Adams perceived it: not a sane government policy, but a response to pressure groups. Fortunately or unfortunately, those pressures were a lot stronger after WWI than before it, and sound money went the way of the dodo. So, for example, our pressure group here is the business owner. Farmers in debt also tend to do quite well with inflation. But, again: any monetary debasement can be modeled as a monetary transfer.

As in the case of AGW, we ended up with "new economics" because that was what Washington wanted to hear. The case is the same today: Barack Obama's "stimulus" proposal involves doubling Federal discretionary spending, ie everyone's budget. Obviously, this makes quite a few people very happy. And it probably spreads the loot around a little better than if we were just to give it all, up front, to Tony Rezko.

Hence the death of orthodox economics. The orthodox economists of the 19th century, the believers in sound money, were not in general policymakers. They viewed their task as one of describing the economy, not controlling it. But in the '20s and '30s, when university men started to move into government, politically palatable solutions were needed. The Austrians and other orthodox historians had nothing of the sort. So they were left out of the pie when all the power got distributed, and today they have no government jobs and only a few marginal academic ones.

What at least the Austrians had, however, was an accurate understanding of the disease that the Keynesians and Fisherites were trying to treat - the pattern of repeated booms and busts. The "new economists" called it the "business cycle," a term implying some endogenous origin in the commercial community - which, coincidentally or not, tended to align with Harding and Coolidge rather than Hoover and FDR. Bankers and economists tend to be more left-wing.

"Business cycle" is an extremely misleading phrase. A better phrase would be banking cycle. As I discussed here, the cause of the recurrent panics and collapses is a bad accounting practice in the Anglo-American banking system, generally known as maturity mismatching.

A maturity-mismatched bank, which is any bank today, writes promises of money it doesn't have - yet. It "borrows short and lends long," balancing short-term liabilities (such as checking deposits, whose term is zero, as they can be withdrawn at any time) with long-term assets (such as mortgages paid over 30 years). Sometimes appearances can be deceiving. Sometimes something that sounds like a bad idea is actually just a bad idea.

Without going into too much detail, suffice it to say: while a maturity-mismatch structure is not quite the same thing as a Ponzi scheme, they both have a tendency to collapse catastrophically in a cloud of dust, leaving investors with a lot less money than they thought they had. Effectively, maturity mismatching lets banks teleport money from the future into the present. What's bad is that this is inflationary, and what's worse is that - when the scheme collapses - the inflation reverses. This creates your recessions, depressions, etc.

So we now have a perfect understanding of the origins of Fisher-Keynes inflationism. It exists not because it makes sense but because politicians desire it. Politicians desire it as a palliative for the deflationary conditions of a maturity crisis (or any other crash). In the 19th century, such crashes were often described as "shortages of money" (meaning shortages of present money). And printing will certainly solve that.

It's important to note that while maturity-mismatch inflation has a reverse gear, and so do the open-market operations used for Fisherite monetary policy (these can either create money or retire money), Keynesian spending does not. This is a pattern that leads to long-term monetary decay: first, maturity mismatching inflates the economy and creates a huge amount of debt; second, a maturity crisis triggers a panic, the debt goes bad, and the country enters depression; and third, massive doses of Keynesian heroin are injected into its aorta, waking it up. Sadly, it will need more heroin tomorrow - and so on.

What a sane and healthy government tries to avoid is inflation dependency. This addiction is a state in which a substantial percentage of consumer spending originates in newly printed or lent money. For example, before the real-estate crash, about 5% of US GDP was home-equity withdrawals - money teleported out of the future, and into thin air. Most banks have stopped providing this service, leaving a mortgage-equity-withdrawal-shaped hole in US GDP. But President Obama will fix it, of course, with his wonderful stimulus.

We start to see how appalling the Keynesian stimulus is. First, it replaces one addiction - the vanished "home ATM" - with a new one, Federal money. Second, budgets in Washington do not get cut, at least not routinely. The stimulus will be permanent, which means we've replaced one addiction with another.

And third, when we do this, we shift a substantial percentage of private economic activity into the hands of Washington's finest, who never turn down either money or power. It is probably a coincidence that the inauguration of The One coincides with the Congressional murder of America's handmade toy industry (thanks, Ralph Nader - no, really). But it is a bit symbolic. We are heading for Brezhnev faster than most of us think.

At a higher level, both monetary policy and Keynesian stimulus pretend to be cures for the banking cycle. Neither claims to understand it at all, but both have been promising to eliminate it for the last 75 years. This has not happened, of course. The remedies are palliatives for the destructive effects of the collapses, but this is like taking cocaine for your strep throat. What it really needs is a specific cure, ie, antibiotics.

To end the banking cycle permanently, our existing structures of long-term debt which back short-term liabilities need to be restructured. One way to do this is the classic Austrian approach: let everything collapse. If we were actually on the gold standard, this might well be our only option - but we're not. It is much easier to transition to a fixed-supply fiat currency, which is in fact harder than gold (because there is no new production at all).

Basically, the only painless, specific, and lasting way out of the banking cycle is to purchase all financial assets with freshly-issued dollars, then sell the assets and destroy the dollars paid for them, and start lending back up with new banks and maturity-matched accounting. This is a full reboot of the financial system. Accept no substitutes. Yes, it involves some inflation, but the inflation is (a) one-time, and (b) pointed at the actual problem.

Once again, this is not going to happen - despite the fact that it should be obvious. There is simply no power in the world, not even obviousness, that can displace our present economics faculty, or dislodge them from their lock on policy.

They have tenure, after all. They're scientists, which means that if you oppose them you're an ASS. And they will remain in power until someone drives a tank or two into Harvard Yard - which, come to think of it, doesn't sound like such a bad idea at all.

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