Robert Higgs has a wonderful essay that explains the fallacies of Keynesianism in terms anyone can understand. Some excerpts (click here to read the whole thing)
Capital and its Structure
Instead, the theory pioneered by Ludwig von Mises and F. A. Hayek in the first half of the twentieth century—a theory that fell into near oblivion after the Keynesian revolution in macroeconomics—is a theory of malinvestment, which is to say a theory of how an artificially reduced rate of interest leads business firms to invest in the wrong kinds of capital, in particular the longest-lived capital goods, such as residential and industrial buildings, as opposed to inventories, equipment, and software with a relatively short life. Thus, in the Austrian view, Fed-induced low rates of interest, like those between 2002 and 2005, led firms to overvalue longer-term capital projects and to shift their investment spending in that direction—producing booms in building construction, among other things. This shift would make economic sense if the interest rate had fallen in a free market, thereby signaling that people wish to defer more consumption by saving more of their current income. But if people have not changed their preferences in this way and continue to prefer present consumption relatively as much as they did previously, then businesses will make mistakes by choosing these kinds of investment projects, which are, in effect, attempts to anticipate future demands that will never eventuate. When the projects ultimately begin to fail, the boom that the artificially lowered interest rates set in motion will collapse into a bust, with attendant bankruptcies and unemployed labor, as unsustainable projects are liquidated and resources shifted, painfully in many cases, to more viable uses.
Because the vulgar Keynesian is blind to these microdistortions and to the need for their correction in the wake of an artificially induced boom, he fails to see any need for the bankruptcies and unemployment that necessarily attend a substantial economic restructuring. He supposes: if only the government stepped in and used its own deficit spending to make up for the reduced private investment and consumption spending, then business would be restored to profitability and workers reemployed without any economic restructuring.
It comes as no surprise, then, that people who think along such lines are currently working to continue a policy that contributed greatly to producing the unsustainable boom of 2002–2006, namely, subsidized lending to would-be homeowners who cannot meet normal commercial qualifications for receiving such loans. It does not occur to the vulgar Keynesians that too many resources have been directed into house and condo construction and that lending to homeowners who cannot afford to purchase homes unless they are subsidized to do so signals an uneconomic use of resources at the expense of the taxpayers who directly or indirectly finance these subsidies.
Vulgar Keynesians do not spend much time worrying about potential inflation; on the contrary, they are obsessed with an irrational fear of even the slightest hint of deflation. If inflation should become an undeniable problem, we may count on them to support price controls, which, on the basis of sketchy knowledge of such controls during World War II, they are convinced can be made to work well.
Malinvestments and Money Pumping
With their great, simple faith in the efficacy of government spending as a macroeconomic balance wheel, vulgar Keynesians disregard malinvestment, past and future, and support government spending in excess of the government’s revenues, the difference being covered by borrowing. Of course, they favor central-bank actions to make such borrowing cheaper for the government. In fact, they chronically prefer “easy money” to more restrictive central-bank policies. As noted previously, they prefer easy money not only because it lowers the visible cost of financing the government’s deficit spending, but also because it induces individuals to borrow more money and spend it for consumption goods—such increased consumption spending’s being viewed as always a good thing, notwithstanding the near-zero rate of saving by individuals in the United States in recent years. Reflecting on the vulgar Keynesian attitude toward Fed policy, I keep recalling an old country song whose refrain was “older whiskey, faster horses, younger women, more money.”
He ends with a section in regime uncertainty which I think was a major impediment to recovery in the last year.
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Michael Pinto-Fernandes
April 21, 2010 at 10:44 pmMr.Calhoun,
Austrian economics is very narrow minded in and of itself. It is absolutely right that booms and busts are inevitable and that a market has to correct itself in due course. However, it fails to take into account that people are people, not robots. That means we feel the pain of busts. So, we move to mitigate them. As you pointed it, we subsidize interest rates.
I find a major problem with the argument that interest rates itself caused an overvaluation of long-term capital projects, like houses and buildings. The problem is that it does not take into account the type of lending practices we have here in the United States, how commercial banks and investment banks are structured, the relationship between commercial banks and investment banks, and most importantly, leverage ratios.
If you already haven’t, check out The Leverage Cycle by John Geanakoplos. It’s definitely worth reading.
There is no such thing as interest rates that are too high or too low. Other nations with interest rates 5 or 8% percentage points higher than ours experience bubbles just as we do.
Think about it from a purely economics 101 point of view. What is the purpose of charging an interest rate? It’s to compensate the creditor for the risk of default by the borrower. Interest rates can be changed, either by the mechanism of the markets or by the Federal Reserve, but the riskiness of the borrower stays the same.
Btw, cool blog. It keeps me occupied for at least a while on my subway rides to school everyday.
Joseph Y. Calhoun, III
April 22, 2010 at 9:02 amIt looks like my previous response was a victim of my overzealous spam clean up efforts, so let me try this again.
Thanks for the kind words about my humble blog and for responding. I often wonder who is actually reading my scribblings.
I agree with a lot of what you have to say. Yes, there are vulgar Austrians too. Interest rates were only part of the problem but I do think monetary policy is the source of a lot of our current difficulties. Don’t confuse interest rates with monetary policy. Interest rates are a response to monetary policy not a means of implementing it. For Austrians, interest rates reflect time preference and so any distortion of rates results in malinvestment. While that is surely true, it isn’t the only thing that affects investment or the economy.
I have argued here many times for higher capital requirements for banks. They occupy a special place in our economy and warrant extraordinary limits on their ability to leverage.
Of course we want to mitigate the pain from recession. The problem with Keynesians is that they would have us believe that we can mitigate the pain at no cost. That isn’t true. We can reduce the amplitude of the economic cycle but only by increasing the wavelength. The price of a shallower recession is a longer one (and malinvestment if the Austrians are to be believed). There is no such thing as a free lunch.
Joe
Michael Pinto-Fernandes
April 22, 2010 at 1:12 pmWell, I guess we have to agree to disagree on a distortion of interest rates (through monetary policy) being an ignition factor for malinvestment. The only reason I say this is because I blame good old irrational exuberance. You know, the inevitable “madness of crowds,” and the stories of “Tulipomania” and “The South Sea Bubble.”
To me, there is an virtually endless well of investment opportunities can be overvalued by the market. All of them are prone to be overvalued if too much is invested in any one opportunity, thus turning into a malinvestment. A distortion of interest rates through monetary policy just brings speculators closer to acting on their impulse of actually pursuing those malinvestments. A potential malinvestment always exists regardless of rates. I mean we had our first panic in 1817 and there was no expansionary monetary policy the started it.
I agree that higher capital requirement are necessary, but only when commercial banks have been separated from investment banks. Sorry, I’m a fan of Glass-Steagall. Totally, leverage ratios are VERY VERY VERY important. In fact, there should probably be an objective and standard for leverage ratios that should be very difficult to change. Why the heck do a bunch of ex-lawyer Congressman have power over changing leverage ratios anyways?
I agree that the Keynesian theory of massive government spending to boost aggregate demand will solve all our problems. It’s not hard to see that we over $300 billion in debt interest as part of our non-discretionary budget spending. Our blank check is very unique to the United States, and we’re exploiting to the max, I wonder for how long.
Michael Pinto-Fernandes
April 22, 2010 at 1:49 pmWoops, I had a typo in the last paragraph. I meant, “I agree that the Keynesian theory of massive government spending to boost aggregate demand will NOT solve all our problems.”
Joseph Y. Calhoun, III
April 22, 2010 at 1:51 pmI’m not sure we actually disagree about all that much. I think you’ve mistaken me for a pure Austrian and that isn’t accurate. I certainly think von Mises, Hayek, Rothbard, et. al. have a better explanation for the workings of the economy than Keynes ever did (and I quote them a lot), but I don’t think anyone has the whole picture. We are talking about a social science here and as you pointed out earlier we are studying human behavior which is unpredictable at best.
On the other hand, I do see faulty monetary policy at the root of most of the crises we’ve had in the history of this country and in most others throughout history. You mention the Panic of 1817 (I actually think you mean the Panic of 1819 but close enough) and state that there was “no expansionary monetary policy that started it.” Au contraire. The First Bank of the United States had been dissolved during the War of 1812 and with the constraint of redeeming in specie lifted, there was a big monetary expansion to fund the war. It continued under the Second Bank of the US, but was finally curtailed in 1819 which precipitated the crisis. It is always the end of monetary expansions (or outright contractions) that cause the crisis. The amazing thing about all the panics we’ve had in our history is not that they are different but that they are so much the same.
Here’s a link to Rothbard’s book on the Panic of 1819:
http://mises.org/rothbard/panic1819.pdf
The South Sea bubble (and its concurrent twin the Mississippi Bubble) were both also monetary phenomona. Irrational exuberance, madness of crowds, etc. is a lot more difficult to achieve if there isn’t money with which to get exuberant. Yes, government can certainly distort investment patterns in ways other than monetary policy (for instance by charging a lower capital gains tax on the sale of a primary residence or by making mortgage interest tax deductible), but every bubble I’ve studied has a monetary component.
Seperation of commercial banking from investment banking is absolutely necessary if we are to maintain deposit insurance. And yes, capital requirements should be stringent, hard to avoid and hard to change.
I assume you meant that Keynesian government spending will not solve all our problems in that last paragraph?
Joseph Y. Calhoun, III
April 22, 2010 at 1:56 pmHere’s a link to an article I wrote in February 2009 titled, Nothing New Here…Move Along:
http://alhambrainvestments.com/nothing-new-heremove-along/
An excerpt:
In the panic of 1819, caused primarily by reckless lending and real estate speculation, Thomas Law advocated increasing the supply of money (from Murray Rothbard’s The Panic of 1819: Reactions and Policies which is available on line at the Mises Institute):
To advance his plan, Law attributed the depression mainly to a deficiency of currency, which caused shopkeepers to lose their markets and mechanics to lose their employment….To Law, domestic manufactures were distressed from “the want of money, for the home manufactures cannot afford to sell on long credits. They must have quick returns to pay workmen. I know of manufactures which have stopped, not because they were undersold by foreign goods, but solely because they could not get money. Money is the means to pay workmen, to set up machinery….”.
Maybe Milton Friedman, who believed that the cause of the Great Depression was a lack of monetary expansion, wasn’t the original thinker we give him credit for. There were plenty who argued for exactly that monetary expansion during the 1819 crisis and while some states tried various inflation schemes, they were largely ineffective. Law also expounds an early, cruder version of Keynes theory:
Elaborating on the benefits from increased money, Law point to the great amount of internal improvements that could be effected with the new money. He decried the slow process of accumulating money for investments out of profits. After all, the benefit was derived simply from the money, so what difference would the origin of the money make? And it would be easy for the government to provide money, because the government “gives internal exchange value to anything it prefers”. All it needs to do , concluded Law, was spend five millions of newly issued currency per year on public works, and, in a pump priming effect, “the money thrown into circulating would, in the course of a year, enable individuals to make a number of improvements also.”
Maybe Mr. Keynes wasn’t the original thinker everyone makes him out to be. The debate also centered on whether relief should be provided to debtors:
The immediate and pressing problem for debtors was the legal judgments accumulating against them for payment of their debts. Consequently, they turned to state legislatures, which had jurisdiction over such contracts, to try and modify the provisions of payment. The proposed laws either postponed legal executions of property or prohibited the sales of debtors’ property below a certain minimum price. The moratoria were known as “stay laws” or “replevin laws”, which postponed execution of property when the debtor signed a pledge to make the payment at a certain date in the future. Minimum appraisal laws provided that no property could be sold for execution below a certain minimum price, the appraised value being generally set by a board of the debtors’ neighbors. Such laws had been an intermittent feature of American government since early colonial Virginia.
Those on the other side of the debate employed arguments quite similar to the ones we see today:
A report strongly in the negative was delivered by Representative Joseph Hopkinson, and this served to send the bill down to a two and a half to one defeat in the House. The arguments of the Hopkinson report were a well considered statement, typical of the opposition to debtors’ relief legislation, as well as to proposals to increase the money supply. The report began with assurances that the committee was deeply sensitive to the prevailing financial embarrassments, and that they had given due weight to the numerous petitions for relief legislation. While the proposed legislation , however, would perhaps alleviate the condition of the debtors temporarily, it would, in the long run, make their distress worse. The contention that relief legislation would eventually intensify the depression was a central argument for the opposition in all the states. The Hopkinson Committee used a familiar medical analogy noting that “palliatives which may suspend the pain for a season, but do not remove the disease, are not restoratives of health; it is worse than useless to lessen the present pressure by means which will finally plunge us deeper in distress.” They added that it was their duty to be truthful with the people and not delude them with promises that could not be kept – even at the expense of their “immediate displeasure”…The report remarked that suffering men were disposed to complain about their lot and look for rapid remedies rather than admit that the only cure was slow and gradual.
This sounds remarkably similar to the debate which rages today. Then, as today, one side argued for monetary expansion, debt relief and public spending. The other side argued for sound money (gold standard),thrift and industry as well as limited government intervention:
“Time and the laws of trade will restore things to an equilibrium, if legislators do not rashly interfere to the natural course of events.” The New York Evening Post
There is nothing new in the world…..
Joe
Joseph Y. Calhoun, III
April 22, 2010 at 2:00 pmOne last thing: I send out a commentary every Sunday which you can subscribe to on this page:
http://alhambrainvestments.com/market-research/newsletter-blog/
Michael Pinto-Fernandes
April 22, 2010 at 4:54 pmWow, OK. You defused my entire point. Sorry, I did mean Panic of 1819.
Thank you for directing me to the material. There is really only one reason I feel that an expansionary monetary policy is essentially ineffective in boosting investment and expenditures. I’m not sure if my reasoning is correct or not. But here it is: Money always flows from bottom to the top, from the working classes, to the middle classes, and then wealthiest classes. That means the velocity of money is significantly faster among the wealthiest, which is also the fewest portion of the population. What I’m getting at is, even if there was an expansionary monetary policy, would the new money even make it to the working and middle classes? How much of it actually makes it to them, if any significant portion? I’m guessing in the long run the money finally touches their hands and thus causes long term inflation.
Btw, Milton Friedman thought the cause of the Great Depression was a lack of monetary expansion? (That’s a question, not sarcasm). I thought one of the major factors of the Depression was because there was a major monetary expansion? Sorry I haven’t read Milton’s, “A History of Monetary Policy in the United States…”
Joseph Y. Calhoun, III
April 22, 2010 at 5:10 pmOkay, let’s think about what happens when the Fed creates new money. Who gets that money first? New money is essentially created by creating bank reserves so the banks get it first. Who are banks more likely to lend to? Corporations and the wealthy since they are most likely to pay it back. So money creation starts with the wealthy and works its way down to the middle and lower classes. That’s why inflation (the creation of money in excess of demand resulting in a loss of purchasing power) also exacerbates inequality. When the wealthy receive the new money, prices haven’t risen yet. By the time the new money reaches the middle class it’s purchasing power has been reduced and they gain nothing in real terms.
Money velocity is higher among middle and lower classes because they have to spend their money as soon as they acquire it. The wealthy have the luxury of investing it and deferring consumption. Don’t think of inflation as rising prices though; that’s where many people make their mistake. Inflation is the expansion of the money supply; rising prices are the result. And the rising prices don’t have to be consumer prices – the price rise could be in….assets such as houses and/or stocks.
Friedman thought the worst of the depression was caused by deflation which he saw as a direct consequence of the Fed not expanding the money supply enough in response to bank failures. I think that is only part of the story but I’ll save that for another post for another day.