Wednesday, January 23, 2013

Keynesian Truth or Dare

What is the real truth about Keynesianism, that government fiscal deficits help get out of recession?

So let's rehearse the definitions, from Tino Sanandaji in “Why Keynesianism Works Better in Theory Than in Practice” at The American:
The first definition of “Keynesianism” is a theoretical explanation for recessions, a diagnosis of the illness. The free market will periodically fail to utilize all the capacity in the economy due to an inability to generate sufficient aggregate demand. In 2008, we witnessed a particularly dramatic example of this as consumer demand and industrial production plummeted as a result of a crisis in the financial sector. Keynes was once again proven right.

The diagnosis may be correct, but the medicine most commonly associated with it has been shown to be surprisingly impotent.

The second definition of “Keynesianism” is a policy recipe for coping with recessions, a cure for the disease of recessions. The promise is that the public sector can bring the economy out of recessions through deficit spending.
Frankly, I think that both of these definitions are wrong.  In the first place, my theoretical explanation for recessions looks to the Austrian theory of the business cycle, that recessions are caused by the collapse of the malinvestments of the previous boom.  Yes, demand drops in a recession, but the cause is the failures of the malinvestments.  (In the Crash of 2008, think of the failures of homebuilders and homeowners).  Income anticipated by the malinvestors, as evidenced by their debts, fails to appear, and so they must either cut back sharply or fail spectacularly.

The argument for Keynesianism is that by artificially maintaining demand with government spending we can jump over the chasm caused by the collapse in demand.  I think that confuses the issue.  The problem in a contraction is that the financial market has questions about the soundness of many investors and institutions, and so people are hesitant to lend to anyone.  The solution is to identify the sound investors and the unsound ones and prevent the unsound investors from polluting the rest of the market.  In the Crash of 1907, for example, J.P. Morgan and his assistants performed triage on the financial markets.  They refused to loan money to enterprises that they judged would survive without their help, and they also refused to help enterprises that they felt were bound to fail.  They did help people in trouble, but loaned money only to enterprises that they felt would survive if helped with an injection of capital.

You can see that the Morgan approach is actually doing what the Keynesians think they are doing.  Both are assisting enterprises to jump over the fiscal chasm.  But the Morgan approach is discriminating in its assistance.  It is saying: look, some of these plungers are past help.  But some folks are in trouble only because they are caught in the undertow caused by the panic.  We should help them.

In the Crash of 2008 the government did do a bunch of Keynesian stimulus.  But most of the money just went out in transfer payments.  Then there was TARP.  Love it or hate it, TARP was designed to inject capital into banks to make sure that semi-sound banks survived the crisis.  But there was another part to the government's bailout that hasn't received much press. Take a look at  TARP's $700 billion was just the tip of the iceberg.  Here is the full story.

Gross US government bailout outlays$4.6 trillion
US Government bailout guarantees$16.9 trillion

You can see that the biggest item was the guarantees. What was that all about?  Well, for starters, there was $3 trillion in guarantees to money market mutual funds.

So there you have it: $20 trillion in bailouts, where the US government is using its position as the soundest investor in the market to keep everyone else afloat.  Makes the "stimulus" program look like chump change.

That is the real story about how to stop a contraction.  You flood the zone with bailouts and guarantees to make sure that only the insolvent enterprises run aground.  Your flood of liquidity and guarantees keeps the marginal enterprises afloat.  The sound enterprises out in deep water will ride things out anyway.

Keynesianism?  Well it sorta helps.  But its chief attraction is that it gives politicians an excuse to do what comes naturally: spend money on their supporters.

Notice, in retrospect, that the institutions that needed help, the banks and the auto companies, have been for decades the little darlings of the politicians.  The banks are part of the nationalization of credit under the Federal Reserve System, and the auto companies are part of the crony capitalism of the authoritarian welfare state.  The banks got into trouble because the politicians forced them to make unsound loans; the auto companies went under because they were forced, decades ago, to make promises to their unionized employees that could not be redeemed.

Then we have Fannie Mae and Freddie Mac.  There were not merely the little darlings of the political sector, but conceived, subsidized, staffed, and led by the political sector.  The miracle is they lasted as long as they did.

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