Where Keynes Went Wrong



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Hardcover
384 pages
ISBN 9781604190175 Published Sept. 2009
Axios Press
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Where Keynes Went Wrong
And Why World Governments Keep Creating Inflation, Bubbles, and Busts
By Hunter Lewis 

Related Blog Posts
In the Books - Off to the Printers XIII
Posted Jan. 13, 2011 7:57 a.m. by dylan
In - 800 CEO Read Blog

The article below was printed in last year's In the Books—our annual review of the best in the business genre. It my (possibly ill-advised) attempt to look at how some of the books published in 2009 tackled the macroeconomic issues, with a (possibly ill-advised) splash of Candide thrown in awkwardly, for emphasis. If you don't feel like reading the entire essay on the topic, you can skip to the end of the post and see F.A. Hayek and John Maynard Keynes argue the points much more eloquently in a battle rap.

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Garden Economy BY DYLAN SCHLEICHER

Voltaire’s Candide was released in 1759, largely as a rebuttal to Gottfried Leibniz’s “best of all possible worlds” version of determinism, or Leibnizian optimism (since God is good and omnipotent, and since He chose this world out of all possibilities, this world must be good—in fact, this world is the best of all possible worlds). Candide’s tutor, Pangloss, schools him in this optimism, but after he is forced out of his “magnificent and most agreeable of all possible castles,” he is painfully disillusioned by the great hardships he endures and bears witness to in the real world.

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“This is the worst economic crisis we’ve faced since the great depression.”How many times have we heard that phrase, or a variation thereof, uttered in the past year and a half? And it rings all too true in our lives. Unlike past economic downturns, we’ve all felt the effects this time around—rich and poor alike, and everyone in between (or what’s left of the in between). We all have friends who have lost their jobs, and the scourge that began and spread this crisis—the real-estate bubble and so-called securities that surrounded it—has turned many of our neighbors out of their very homes.

There were many outstanding books this year that chronicled the collapse, from those focused on the bigger actors like Andrew Ross Sorkin’s Too Big to Fail to those that focus on individual companies (Lawrence G. McDonald’s A Colossal Failure of Common Sense:

The Inside Story of the Collapse of Lehman Brothers and Kate Kelly’s Street Fighters: The Last 72 Hours of Bear Stearns … are among the best of that category). This essay is not about those books. It would take more space than I have to get into those details, and there is a larger discussion happening that I think deserves attention here.

I will look at what this year’s business books have to say on how, exactly, we came to this point in economic history, and what some of the authors in the genre offer as a way out. The issues dealt with in these books are many, but I will distill them into three of the bigger themes: whether markets are inherently rational and should be treated as such; what that may have to do with the crisis we find ourselves in and; what the government’s role should be in the matter.

THE BACKGROUND

To start that story, we have to go back to just before the Great Depression. It was then (in 1906 to be exact) that Yale Professor Irving Fisher published The Nature of Capital and Income, an academic tome that was one of the first

works to claim that there was a fundamental rationality—even scientific order—to markets. He attempted to create mathematical models that would reveal that order and predict it’s movements (primarily, of course, to play in the market). It wasn’t a bestseller by any means, but Fisher’s work had a great deal of influence on economics in academia over the years and is part of the foundation of the complex financial instruments we see on Wall Street today. In The Myth of the Rational Market, the editor-at-large of Time magazine, Justin Fox, tells the story further:

“He is perhaps not the father, but certainly a father of modern Wall Street. Hardly anyone calls him that though. Economists honor Fisher for his theoretical breakthroughs, but outside the discipline his chief claim to lasting fame is the horrendous stock market advice he proffered in the late 1920s. Read almost any history of the years leading up to the great crash of October 1929, and the famous Professor Fisher serves as a sort of idiot Greek chorus, popping up every few pages to assert that stock prices had reached a ‘permanently high plateau’” (5).

Though Fisher was thus debunked in the real-world environs of Depression-era Wall Street, Fisher’s theories had garnered enough serious academic attention to gain a following amongst those interested in economic theory around the world. Fox follows this thread of influence through academia to its ideological apex—the campus of the University of Chicago in the 1960s. This “Chicago School” of economists, most notable among them Milton Friedman, believed not only that the market was fundamentally sound and rational, but that government involvement was a negative interference best left out of the equation. As Fox puts it:

“ … most economists of the day saw government as the solution to economic problems, while the Chicagoans were convinced that government was the problem” (90).

This was a pretty drastic departure from the Keynesian orthodoxy that had ruled in Washington since the depression.

John Maynard Keynes believed in government involvement in markets—indeed, thought it essential. Robert Skidelsky explain it simply in Keynes: The Return of the Master:

“Keynes gave governments two tasks: to pump up the economy with air when it starts to deflate, and to minimize the chances of serious shocks happening in the first place.” (xiv).

As Fox notes in The Myth of the Rational Market, the root of the Chicago School’s disbelief in government involvement stemmed partly from their real world experience of having worked in New Deal Washington, “where they became disillusioned with government attempts to manage the economy.” It also stemmed from a more academic experience, as they themselves stated, from reading Friedrich Hayek’s 1944 book, The Road to Serfdom. Again, from Fox:

“Having experienced the socialist ‘Red Vienna’ of the 1920s and watched the Nazi takeover of his homeland from afar, Hayek was appalled by the equanimity, even enthusiasm, with which Keynes and other English liberal intellectuals greeted the growth of government” (90).

As to whether or not the government should step into the markets during recessions, there seems to be agreement there. Even Milton Friedman, who believed government is the problem and not the solution to problems, believed it should step in when panic strikes. David Wessel explains in In Fed We Trust—his book on Ben Bernanke and The Federal Reserve’s response to the current crisis:

“The lasting lesson [of the Great Depression]—taught by economists with views as different as John Maynard Keynes and Milton Friedman, the leading economic minds of the twentieth century—is embraced almost universally by politicians and economic policy makers: government can and should act to prevent such a dangerous downward financial and economic spiral” (46).

In fact, Bernanke cited Friedman often in his arguments for government intervention:

“The government might, [Bernanke] suggested, cut taxes, increase the federal deficit, and issue bonds that the Fed would buy by printing money. This, he said, was ‘essentially equivalent to Milton Friedman’s famous “helicopter drop” of money.’ (Friedman used the line in 1969 to argue that depression and deflation were avoidable. If nothing else worked, the Fed could send a helicopter to drop dollar bills to get people spending.)” (78).

THE SCIENCE?

So, though he felt the government, in the form of the Fed, should step in when panic struck the country, he believed the market was normally rather rational and should be unfettered by government. Heinrich Hayek, however—the man Friedman partly credited for his general lack of trust of government meddling in the market—wasn’t himself a proponent of the Chicagoan’s bedrock philosophy that the market is inherently rational, that economics itself was a “science.” Joshua Cooper Ramo, in The Age of the Unthinkable, relates Hayek’s response to winning The Nobel Prize in 1974:

“‘The Nobel Prize,’ he began, ‘marks a significant step in the process by which, in the opinion of the general public, economics has been conceded some of the dignity and prestige of the physical sciences.’ But Hayek said, he wondered just how much of that prestige was really justified. ‘Economics are at this moment,’ he continued, ‘called upon to say how to extricate the free world from the serious threat of accelerating inflation, which, it must be admitted, has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things’” (38, 39).

As Hunter Lewis writes in Where Keynes Went Wrong:

“The question of whether economics is a science is briefly discussed in this author’s Are the Rich Necessary? The conclusion reached there is that economics is and never shall be a science. Why? In the first place, when we observe an apple fall from a tree, or deduce the force of gravity, it will not affect what an apple does. But human action, the subject of economics, is entirely different. It is very changeable; it is even changed by what economists tell us about ourselves. If economists tell us that stocks are the most reliable long-term investment, we all buy stocks and the prices will soar. Eventually there will be no more sellers, the price will collapse, and we will discover we have made a very bad investment. We saw that well enough in the 1920s and 1990s. So, on a whole, it is much better to accept that economics is trying to sort out possibilities, not truths, and is closely aligned with moral philosophy, also known as values” (44).

THE SOLUTION?

As we’ve seen, the financial instruments that have been put to use on Wall Street recently have not made money—they have engineered it. They have not made profits, but engineered them, sometimes with Keynesian motives for greater well-being, but with disregard to Keynesian principles.

In Free the Market!, Gary L. Reback looks to strike a balance, writing:

“Most markets neither require nor profit from extensive government regulation” (2).

But he goes on to argue that the proponents of systematic deregulation—specifically calling out the Chicago School and the weakening of anti-trust laws—has made markets less free:

“In our modern economy, Chicago School policies only serve to damage free market capitalism (and consumers specifically) by entrenching incumbents, retarding innovation, and making life miserable for entrepreneurs. Yet the Chicago School has been difficult to dislodge, notwithstanding its questionable record of protecting consumer welfare, because it is much more than just an enforcement policy. It is what one conservative economist called ‘a system of belief’” (4).

Both Keynes and Friedman, the two giants of economics in the 20th century, had something that will be invaluable to us in the 21st—intellectual flexibility. Friedman, who was staunchly opposed to government meddling in markets, knew there was a time for it. Keynes is often viewed as more of a philosopher than an economist. And Hayek, a strong proponent of deregulation (and, remember, the man The Chicago School of Economists credited for forming their stance against government involvement in the market) counseled a “nurturing” flexibility. Returning to The Age of the Unthinkable and his Nobel speech:

“Hayek warned, ‘If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible.’ Politicians and thinkers would be wise not to try to bend history as ‘the craftsman shapes his handiwork, but rather to cultivate growth by providing the appropriate environment, in the manner a gardener does for his plants’” (40).

But, if the markets can’t be trusted to be rational, and the government can’t be trusted at all, how exactly is the economic garden to be tended? Who, exactly, are the “gardeners” of our federal economy? Does the responsibility go to the economists at the Federal Reserve—who Stephen H. Axilrod defines as “independent within the government”—and, if so, how exactly will they tend the economic garden? Will they allow it to flourish wildly in it’s natural environment, sticking to the strictures of a rational market that can tend itself, or will they weed out what they see as undesirable elements with regulatory measures, creating a rational response to and oversight of the market? Axilrod describes the actors within the Fed in his insider’s account of the institution, Inside the Fed:

“I have often thought to divide the members of my often all too dour profession of economics between those whose approach might be very loosely considered poetic (not too many of them) and those who are basically scientific (large in numbers). The former are more intuitive, more prone to the sin of ‘casual empircism,’ and often more involved in the practical aspects of economics, such as (in my case) interactions between, on the one hand, monetary policy and, on the other, the behavior of often skittish and unpredictable market participants and the public more generally” (18).

He sees the “poets” as artists who can take the public stage and articulate the need for the Fed’s actions to control inflation and restore confidence in the market (and in the population itself) when it wanes.

As Reback stated in Free the Market:

“The benefits of the free market don’t come free. Competition must be nurtured and protected by the government, as Americans first discovered more than a century ago, in a turbulent time driven by technological change, an era not unlike our own” (2).

THINKING OUTSIDE THE BANKS

I’d feel remiss not mentioning at least two authors that counsel throwing our current system completely out the window. On the libertarian front, there is Ron Paul. Though most current observers see the government and Fed as indispensable, Ron Paul sees it as corrupt, counterproductive and even unconstitutional. Contrary to what the Fed itself sees as it’s primary role—controlling inflation—Paul believes it only adds to the problem by printing more money. In End the Fed, he writes:

“Ending the Fed is the one sure way to restore sanity to economic and political life in this country. It doesn’t mean that our political disagreements and fights in Congress will go away. Ending the Fed is not a magic pill to usher in Utopia. But it does mean that our disagreements and discussions will occur within the context of reality, not in the illusory world created by the unlimited printing of money” (8).

On the liberation front, there is Douglass Rushkoff who suggests that not only would we be better off having let banks fail, but that we need to break the hold the corporate model has on our very lives. He takes the narrative back all the way to the Middle Ages, when monarchies began replacing local currency with state currencies and setting up monopolies.

“The Renaissance was never about extending … prosperity but about monopolizing it. … the chartered corporation was at its core a scheme to lock in the recent success of … rising merchants” (167).

THE CONCLUSION

In some circles over the last three decades, to question the fundamental soundness of free markets was akin to questioning America itself—and “free market” was narrowly defined as unregulated, unfettered markets. The view seemed to be “This market is the very best of all possible markets.” And to meddle in it was to interfere with the “invisible hand” guiding it, which was economic blasphemy.

The pendulum seems to be swinging heavily the other way. It’s hard for many to see what has happened since the markets have been largely deregulated as anything nearing “rational.” The idea of a free market itself is being redefined. Just as traffic laws allow one to drive down the street safely—free from reckless road conditions—the government now seems intent on reestablishing order on Wall Street so that the general public feels safe there again. To many, it looks like the only rational thing to do.

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Like us, Candide once lived in great splendor, with an abiding faith that he inhabited the best of all possible worlds. When he was forced from his home and assaulted by the ugly realities of an often unjust world, he lost some of that faith, and stresses the work it takes to maintain vitality. Near the end of the book, his old mentor Pangloss tries to put a Leibnizian spin on the ordeals of Candide’s life:

“There is a concatenation of all events in the best of all possible worlds; for, in short, had you not been kicked out of a fine castle … ; had you not been put into the Inquisition; had you not traveled to America on foot; had you not run the Baron through the body; and had you not lost all your sheep … you would not have been here to eat preserved citrons and pistachio nuts.”

“Excellently observed,” replied Candide; “but we must cultivate our garden.”

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PREVIOUS POSTS FROM IN THE BOOKS



TIME's Person of the Year - In Fed We Trust
Posted Dec. 17, 2009 11:10 a.m. by dylan
In - 800 CEO Read Blog

Time magazine has picked its person of the year, beginning their description of him thus:

A bald man with a gray beard and tired eyes is sitting in his oversize Washington office, talking about the economy.

Hooked yet? Try this:

He's shy ... he prefers to eat at home with his wife, who still makes him do the dishes and take out the trash. Then they do crosswords or read. Because Ben Bernanke is a nerd.

Ben Bernanke was eerily suited to be the Fed Chief during a time of crisis. His life before public service was that of a scholar, and his scholarship was in the Great Depression. That serendipity might just be what has saved us—if indeed we are saved—from another full-blown depression.

Bernanke has caught a lot of political flack for his decisions—from both sides of the aisle. It wasn't a particularly populist move to pump hundreds of billions of dollars into a financial system that had just failed the country on so many levels. However, as Time's Managing Editor Rick Stengel stated last night on Charlie Rose, "The financial system and the economy are two different things, but if the financial system goes down, it takes the economy with it." Being a scholar of the Great Depression, Bernanke knew this and did what he thought necessary to prop up the financial system to stave off the worst-case scenario for the entirety of the American (and therefor world) economy.

There seems to be a growing number of folks distrustful of government intervention in the markets, in any scenario, that are worried about Bernanke's moves. Ron Paul's call to literally End the Fed is a bestseller, for example. But even Milton Friedman, the "OG" of distrust in government intervention, thought it necessary for the state to pump money into the economy in times of crisis. As David Wessel asserts in his great book In Fed We Trust: Ben Bernanke's War on the Great Panic, published by Crown Business in August:

"Today, the notion that the government should or would stand by as the stock market crashed, credit markets stalled, and the economy tumbled over the abyss seems implausibly bizarre. The public, politicians, professors, and the press have been shaped by searing memories or photographs from the Great Depression, the years in which the unemployment rate rose to 25 percent and the county's output of goods and services declined by 29 percent over four years. The lasting lesson—taught by economists with views as different as John Maynard Keynes and Milton Friedman, the leading economic minds of the twentieth century—is embraced almost universally by politicians and economic policy makers: government can and should act to prevent such a dangerous downward financial and economic spiral" (page 46).

Bernanke went so far as to use Friedman's ideas to rationalize his intervention:

"The government might, he suggested, cut taxes, increase the federal deficit, and issue bonds that the Fed would buy by printing money. This, he said, was ‘essentially equivalent to Milton Friedman’s famous “helicopter drop” of money.’ (Friedman used the line in 1969 to argue that depression and deflation were avoidable. If nothing else worked, the Fed could send a helicopter to drop dollar bills to get people spending.)" (In Fed We Trust page 78).

This sounds like it could have come straight out of the Keynesian playbook, but Bernanke is no reincarnation of the great John Maynard Keynes,* who, in the words of author Robert Skidelsky, "gave governments two

tasks: to pump up the economy with air when it starts to deflate, and to minimize the chances of serious shocks

happening in the first place.” (Keynes page xiv). Rather, Bernanke has acted an apolitical steward that has worked for two separate, almost ideologically opposite presidents, that has managed to avert an almost certain disaster. I think he's a fine choice for person of the year, and as Michael Grunwald wrote for TIME:

"He's earned the benefit of the doubt. It's now up to our dysfunctional political system to let him do his job—and to fix the financial system so that he never has to save the world again."

*There were a number of great books published on Keynes and his economic philosophy this year, including:

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