Keynes and the Banking System

What we are now experiencing is unlike a normal recession. A normal recession is a contraction in GDP, usually brought on by tight monetary policy. What the world is going through now is economic contraction brought about by deleveraging and reinforced with fear. Businesses are cutting back on debt and investment funds have been forced to downsize, dragging down prices of almost all asset classes and exacerbating the implosion of credit markets.

Normal recessions are manageable via interest rates. Today, monetary policy no longer works because interest rates are close to zero and the credit markets are not functioning properly. The cost of new debt is higher than what businesses can earn in this stagnant economy, so it is not financially viable to lend.

That's why applying Keynesian solutions is wrong for our circumstances. Keynes developed his theory in the 1930's. It was a good fit for the world eighty years ago: little international commerce, no public debt and limited capital movements. Today's global economy is very different: huge global commerce, substantial capital mobility and public debt responsible for a major role in determining interest rates and ergo, growth. All these factors play no part in the naïve and obsolete Keynesian model.

One Keynesian dogma is the fervent effort to get to full employment. We can quickly and easily get to full employment by a variety of measures, such as embarking on massive infrastructure projects (those are certainly better than the alternative Keynesian methods of launching a war or discarding machines and hiring more people to replace them). But even reasonably efficient infrastructure projects take valuable resources and convert them into something less valuable. In other words, they do not produce wealth; they destroy wealth.

In fact Keynesian methods remind me of the story of the two men watching a giant earth mover working on a construction site. The first guy sighs: "there could have been jobs for 100 men with shovels right here!" The second man comments "better yet, there could have been jobs for 1,000 men with spoons..."

A second flawed Keynesian concept is public debt. From $946 billion in August 2008, the size of the Fed's balance sheet has more than doubled, rising to $2.1 trillion. With the Fed on track to purchase almost $2 trillion in Treasury and Agency debt by year end, as well as dramatically expand the Term Asset-Backed Securities Lending Facility, the size of the balance sheet could double yet again, to at least $4 trillion by the end of the year.

The administration's stimulus program will create jobs at the cost of an enormous increase in the government debt that has to be financed. And it does very little to increase productivity, which is the main engine of economic growth. We are engaged in a futile effort to stave off the impact of the decline in housing prices by rapid expansion in the Fed's balance sheet.

But housing prices have to fall because they have been inflated for years, nation wide. We have to let the real estate market reach an economic equilibrium. When that is accomplished, the financial system will recover and the economy will improve, which in turn will boost business investment, corporate profits and employment.

Keynes-style fiscal policy which amasses debt to obscure our fundamental problems will only make matters worse. This approach is saturated with factual errors and theoretical misunderstandings. Systemic worldwide failures should not be met with policy experimentation by our government. However innovative those policy experimentations are and however well intentioned, they will have broad and dire unintended consequences.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at [e-mail].

Comments

[Kathryn Tang]

what about externalized costs of the "giant earth mover" in your little anecdote? pollution at the mine, pollution at the factory, pollution during transport, pollution at the worksite - and pollution's just the tip of the rapidly-melting iceberg. your contempt for worker's rights and sustenance would be upsetting if you presented a serious, up-todate argument rather than regurg of old dogma

[Kathryn Tang]

author, please stop recycling what you were fed in business school 20 yrs ago. it's over, get it?

[Social Construct]

Like Forrest Gump would say, "Stupid is as stupid does."
I hold no specialized experience or education in the realm of the soft science of economic theory but I do, however, have the strong gut feeling that if we just sit it out and let the real estate markets find "equilibrium", then we won't have to bring Keynes into the 21st century because we'll bring the 21st century to Keynes' time; smack dab inside the 1930's.

[TJCole]

How about J.S. Mill and the Banking system...h­ow about that..?

[cam]

You paint with very broad brushstrokes and choose your colors from a very limited palette. Certainly the conditions were different in the 1930s, but it could be argued that some of the differences amplify Keynes' position rather than undermine it: It is not enough to point out differences; you must also prove that those differences invalidate the theory.

We have boostrapped our economy on the premise that consumption constitutes a viable economic sector; we have become the consumers our "consumer economy" demands. Whether we know it or not, we are in the painful first throes of making the transition back to a productive economy, and we need capital to do it. Right now the Government is the only supplier, and for the next four years, while we turn our economy to manufacturing and infrastructure development, we are going to have to go very deep into deficit spending. If we fail we are in very real trouble, if we succeed we can count on a growing productive economy and tighter credit to rescue us from our debt.

[cam]

An addendum - http://www.huffingtonpost.com/james-boyce/introducing-plastic-a-ser_b_206933.html discusses how we learned to consume beyond our means and developed a tolerance for deficit spending outside of dire neccessity.

[grateful4thedead]

wow, i agree with you for a change.

did you go short equities or short long treasuries?

again, without giving your position disclosures, your commentaries are suspect.

like i've said before (and it never seems to get through the huffpo free speech police), even the clowns at cnbc give their disclosures.

[DiogenesOfAlaska]

In this argument I sense a certain redundancy. Why bother discussing Keynes, current policy and what these two have to do with each other, when your ultimate conviction is that

'However innovative those policy experimentations are and however well intentioned, they will have broad and dire unintended consequenc­es.'

?

Another problem is that you argue about difficulties with Keynes' classical view while you admit that current policy isn't that.

All in all, it looks like you are expressing your personal preferences more than making a case.

[bobwalters]

Obviously, this guy has an axe to grind, which is preservation of the ability to manipulate the casino-economy for his and his hedge fund's benefit, BUT at taxpayer expense. Of course he doesn't like Keyensian solutions to the problems created by him and his fellows, because those solutions essentially shut them out of the profit stream. Bet he's a participant in the bankster efforts to resist and/or water-down any efforts to regulate CDSs or other fictional-asset derivatives.

[Henry]

I think you know nothing at all about Keynes! The Keynesian analysis does adress fiscal relationships and does connect the relations betwixt and amongst constituent markets e.g. labor, capital, credit and places the governent action into the equation. He does not suggest anything to Bernanke other than that the government is a player. I believe Keynes would well agree with your market assertion that the real estate market must be let to hit bottom. Al, if you're such the genius, what do you think the "market" rate of interest should or would be in our current predicament? I am afraid you are dead in the water, eh? (market rates in this deleveraging would be astronomical and we'd all be dicks guest for dinner)

[1sanevoice]

what's worse is that the author does not even suggest another policy, just tries to throw a wet blanket on the only action that can be realistically undertaken

he author does not take into account the audience here, either. one would expect most (on huffpo)to disagree with his premise. he should have met this expectation with cogent new counterpoints, but there really are none to be had. a halfhearted attempt at best. meh.

[kanester]

Of course the author doesn't like Keynes ... he's a part of the problem, a member of the rapidly deteriorating "the markets will regulate themselves" camp.

[solarenergy]

Aright then! Let's do nothing. Great approach.

In talking around "systematic worldwide failures" which led to this recession/­depression­, this individual -- an investment manager -- never once mentions the real cause -- this happened because people like him have fostered the unsustainable notion that economies can generate growth rates in excess of real demand. Reagan told us government was the problem, get out of the way and let "the markets" be free.

Well, it seemed to work. For a while. The a series of schemes were rolled out, starting with the S&L scams in the 1980s, followed by many others, including the dot-com, Enron accounting, and finally the the real estate bubble, a scam deliberatedly planned by the Bush administration with the publicly stated goal of getting poor people with bad credit to "own" houses (take out loans), but it collapsed.

I wonder how many CDOs or other imaginary "assets" the author sold to other people?

Don't like debt? Look in the mirror.