A Short History

As we are all too well aware, the economy is now in the deepest recession since the Great Depression. Much has been written about irresponsible bankers, irresponsible borrowers, speculators, investors, regulation, deregulation, and ineffective government. But that is not the focus of today’s article. Today, we find ourselves in the midst of the greatest binge in government borrowing and spending in the history of civilization. One may or may not agree with our government’s actions, but it is fitting to examine the stated economic rationale behind the policies.

Prior to the mid 1930s, most economists believed that free markets were self balancing and would emerge from recessions if left to their own devices. They knew that capitalist economies were a balance between savings and investment. If there was a large expansion in savings, then there would be a large supply of money available. The law of supply and demand mandates that any commodity in great supply (in this case money) will become less expensive. In the case of capital, this is manifested by lower interest rates. As interest rates fall, it becomes less expensive for both consumers and businesses to borrow and invest. Consumers buy CDs, stocks and bonds (because we are talking about savings, not consumption, for the moment ignore purchases of consumable goods such as cars, TVs, and the like). Businesses find it cheaper to borrow money to expand manufacturing capability, invest in research and new product development, expand marketing, or move into other product lines and geographies. As investment ramps up, capital (savings) are absorbed and put to productive use, resulting in economic growth. In the shorter term, as capital is sopped up, there is a reduction in the money supply. Interest rates once again begin to climb, bringing the entire system back into balance.

At least that was the classical theory. But during the Great Depression, economists were stumped. It is generally agreed that the Federal Reserve contributed to the onset of the crisis by raising interest rates in the late 1920s in an effort to stem stock speculation, but that is a side issue. The great stock market crash occurred in 1929 and the economy was in a downward spiral.

Keynes provides an explanation

The depression went on for years. Why didn’t automatic mechanisms in the free market bring the economy back into balance? In 1936, John Maynard Keynes believed that he knew the answer, published in his masterpiece “The General Theory of Interest, Employment, and Money“. In it, Keynes argued that the basic problem of the Depression (or any deep, lasting recession) was that there was a lack of investment on the part of business in spite of low interest rates. If there is a general malaise, businesses surely are not going to risk taking on debt to expand into a future where there is uncertain demand for their products. Such a course is far too risky. And here we come to the crux of Keynesianism; Keynes’ solution was that the only recourse remaining was for government to step into the breach and spur investment by borrowing and spending. Government spending would guarantee (some) businesses economic activity, which would provide a market for other industries that serve those businesses, and so on. This would halt the downward slide and reverse the course of the economy. As business recovered, the government could withdraw and allow private enterprise to return to normal.

It should be noted that “The General Theory” was published in 1936, 3 years into Franklin Roosevelt’s first term. Under Roosevelt, government spending had already increased 50% by 1936 as compared to 1929 ($15B vs. $10B). Although private investment did increase somewhat, the unemployment rate fell to only 17% from 25%. In spite of government expenditures, it would rise once again (to 19% by 1939). This was hardly a vindication of Keynesianism. In his 1953 work, “The Worldy Philosophers“, Robert Heilbroner provides the most cogent explanation of this ineffectiveness, one which is eerily prescient of the current policy debate:

“Nei­ther Keynes nor the government spenders had taken into account that the beneficiaries of the new medicine might con­sider it worse than the disease. Government spending was meant as a helping hand for business. It was interpreted by business as a threatening gesture.
Nor is this surprising. The New Deal had swept in on a wave of anti-business sentiment; values and standards that had become virtually sacrosanct were suddenly held up to skeptical scrutiny and criticism. The whole conception of “business rights,” “property rights,” and “the role of govern­ment” was rudely shaken; within a few years business was asked to forget its traditions of unquestioned preeminence and to adopt a new philosophy of cooperation with labor unions, acceptance of new rules and regulations, reform of many of its practices. Little wonder that it regarded the gov­ernment in Washington as inimical, biased, and downright radical. And no wonder, in such an atmosphere, that its ea­gerness to undertake large-scale investment was dampened by the uneasiness it felt in this unfamiliar climate.

Hence every effort of the government to undertake a program of sufficient magnitude to mop up all the unem­ployed–probably a program at least twice as large as it did in fact undertake–was assailed as further evidence of Socialist design. And at the same time, the halfway measures the gov­ernment did employ were just enough to frighten business away from undertaking a full-scale effort by itself. It was a sit­uation not unlike that found in medicine; the medicine cured the patient of one illness, only to weaken him with its side effects. Government spending never truly cured the econ­omy–not because it was economically unsound, but because it was ideologically upsetting.”

Note that during World War II the federal budget peaked at $103B, fully 10 times the 1929 amount. This did result in full employment, but at the cost of rampant inflation, as would be expected when the government indulges in the wholesale expansion of the monetary base.

Keynes misunderstood

Many modern politicians invoke Keynes in the name of government expansion, but the fact was that Keynes was a great admirer of Edmund Burke. He believed that government activity in the economy should be targeted and temporary, should focus on stimulus and investment, and should be withdrawn as soon as the free market was once again healthy.

In a letter to the New York Times in 1934, Keynes wrote “I see the problem of recovery in the following light; How soon will normal business enterprise come to the rescue? On what scale, by which expedients, and for how long is abnormal government expenditure advisable in the meantime?“. [emphasis added]

Are current policies “Keynesian?”

Governments around the world, from China, to the European Union, to the United States, are passing “stimulus” bills. The idea is to spark economic activity in an effort to get business to once again invest. Given what we have learned, an effective stimulus should have the following attributes:

• It should be large enough to have an effect. The 2007 Gross Domestic Product of the US economy was $14T. An $800B stimulus package is 5.7% of GDP. The 2007 federal budget was $2.8T. As explained above, in World War II, the U.S. government spent 10x the 1929 budget.
• It should be immediate. If the government is going to borrow huge amounts of money to stimulate the economy, it needs to get that money into the system as quickly as possible. One way to do so is to fund projects that are already in the pipeline. The money should not be spent on programs that do not spur investment or spark economic activity in the private sector.
• It should encourage private investment. No matter how much the government spends, if the private sector is not confident about the future, they will not invest. Therefore, the program should endeavor to make private investment as attractive as possible. Lower capital gains taxes encourage companies and individuals to take on more risk. Lower individual tax rates immediately provide an infusion of capital into the system, as well as incentivizing individuals to take more risk. If federal income tax, social security, medicare, state income tax, and property taxes add up to a tax rate of 65%, one can hardly expect an individual to risk their savings or livelihood in an effort to better their economic situation. They will be more reluctant to work harder for a bonus, more reluctant to join a start-up, more reluctant to relocate. In short, if you lower the rewards, then you have depressed the risk-taking activities that are the beating heart of a free market economy. Counter-productive in the best of times, policies that depress the investment climate are potentially catastrophic in the midst of a recession.

A word about the monetarists

Typically, one hears that the economic debate is between Keynesians and monetarists. Policy makers, rightly or wrongly, tend to invoke Keynes when arguing for more government involvement in the economy. Other policy makers invoke monetarists, principally Milton Friedman, to argue for a more laissez-faire approach to the free market.

What is monetarism? At it’s core, it is the belief that government can best tune the economy and prevent economic bubbles and recessions by controlling the supply of money and balancing the budget. By what mechanism? Primarily a central bank’s (for example the Federal Reserve) control of interest rates, as well as its sale (or withdrawal) of government bonds. As espoused by Milton Friedman, government should concentrate primarily on keeping prices stable. If there is too much money in the system, the result is inflation. Too little and there could be a lack of investment, causing a recession, and in severe cases a deflationary spiral. (Some ask why falling prices are a problem. Ask yourself what the result would be if businesses were incapable of making a profit).

Ben Bernanke, the current Chairman of the Federal Reserve, is generally thought to be non-ideological in his views of Keynesianism and monetarism. In his writings and actions, he seems to be a pragmatist, willing to use whatever tools are at the disposal of government to forestall a crisis or alleviate one.

Who is right?

In my (admittedly) uneducated opinion, neither school of economic thought is fully correct or incorrect. From a non-ideological viewpoint, we don’t live in world with a pure free market economy, free from all regulation and government interference. Nor do we live in a world with economies fully controlled in minute detail by government (unless you are one of the unfortunates residing in countries like Cuba or North Korea).

Was it a lack of regulation that caused the housing bust, as some claim? Were banks running wild? Did Alan Greenspan lower interest rates too much in the wake of the Internet bust and 9/11 (monetarism) in an effort to forestall a severe recession, thus contributing to the housing bubble?

What of government interfering in the housing market via the Community Reinvestment Act and the quasi-governmental entities, Fannie Mae and Freddie Mac? Most of us remember a time when a 20% down payment and a high credit rating were required to qualify for a mortgage. Was it deregulation of the banks that loosened lending standards, or was it that the CRA mandated that 50% of bank lending “meet the needs of the entire community”? (Note that this threshold was raised from 42% in 1999 by the Clinton administration). At the same time, Fannie Mae and Freddie Mac were mandated to meet housing goals set by the Department of Housing and Urban Development . As such, they bought and securitized trillions of dollars in sub-prime mortgages. One can hardly declare the failure of a “free market” that requires lenders to loan money to those that would otherwise be denied as poor credit risks, backstopped by GSEs (Government Sponsored Enterprises) holding trillions in risky mortgages; $6 trillion total, fully half of all mortgages written in the United States.

Modern economic systems are complex. Government regulation and intrusion only make them more so. Pure monetarism or Keynesianism is nearly impossible in such an environment. The best that we, as citizens, can do is to be watchful that government actors are invoking neither Milton Friedman nor John Maynard Keynes as a smokescreen in the pursuit of non-economic goals.

• Does a “Keynesian” policy meet the test as summarized above? Will it be timely, targeted, temporary, and large enough to have an impact?
• Keep an eye on incentives, as they are what drive a market economy. Will a proposed regulation throw sand in the gears of commerce at a time when we need as much economic activity as possible? Will a tax policy or law encourage investment by both business and individuals, or suppress it? Will it encourage risk taking and innovation or reduce the rewards of success to the point that investors aren’t willing to fund a venture and individuals are unwilling to go out on an economic limb?
• How much of a policy is economic and how much is social engineering? Is a policy designed to get the economy growing, or to change our society?

One last note; whether one agrees or disagrees with a particular social policy, it is extremely dangerous to add more uncertainty to a market economy that is already rife with fear. That is simply bad policy, whether it originates on the left or the right.