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Friday, April 29, 2011

An End To Keynesian Economics

Keynesian economics had not ever been tested in the US. The theory was formulated during the Great Depression. While Keynesian economics works during recessions, the real test of the theory was always:
What would happen if Keynesianism was tried at the outset of a depression?
Depressions used to be called "panics", because depressions always incorporated a factor of drastic credit term changes. They would be preceded by sharp growths in lending, and then the end to a business cycle (aka recession) would produce a small change in loan quality. The small change in loan quality would act on the massive body of outstanding loans to change an ordinary correction into a panic, which in modern-day terms would be a credit contraction. So a depression usually was caused by a small real-world change which occurred at the end of a cycle of massive credit growth. The reinforcing cycles of growth reduction from business activity/withdrawal of credit/growth reduction from no working money produced relatively similar cycles of a bad year followed by a tumultuous crash.

The two distinctive, and interlocking, features of the modern era that were supposed to prevent this from happening were banking regulation and Keynesian government programs. Banking regulation seemed to work before it was effectively abandoned in the mid-to-late 1990s. Keynesian economics just had never been tested, but was looking good because it clearly did act to shorten the length and severity of business downturns.

Banking regulation was supposed to prevent excessive loan growth (riskier and riskier lending) which would then have to be suddenly retracted if conditions worsened only a bit. Banking regulation also included bank deposit insurance, which kept people from yanking money out of banks and thus forcing a credit contraction. Of course such insurance would benefit institutions that took on more risk without supervision and external intervention to shut down such institutions. You cannot have a banking insurance program without strong banking regulation; you also cannot have banking insurance without a means of inflicting massive and highly painful losses on the primary decision makers at banks (or any institution which lends a lot and is government insurance in any way). We backed off both the regulation and the loss-inflicting aspect in the 1990s but kept and expanded the government insurance (implicit and explicit). What we got in the 2000s was the inevitable result.

Keynesian government programs are income supporting programs such as unemployment insurance, food stamps, etc. These programs work by supporting income levels within the population, which clips off some second and third order parts of an economic contraction. These are produced when businesses must slow activity, and then reduced incomes (and fears of reduced incomes) of workers cause a deeper reduction in worker spending, which then forces a new round of slowing in business activity. Economics is the classic ouroboros.

Anyway, as a result of throwing away all bank regulation (done, let me remind you all, on a completely bipartisan basis) in the 1990s, we got a chance to test Keynesian economics.

The results (from table 2.1 line 4):

Click on this and open it up in another tab or window. The graph shows percentage changes in private wages and salaries over series of intervals (1-6 quarters).

The green line is the six quarter result. This graph shows nominal seasonally adjusted payments to workers in the private sector. It does not include payments to government workers and it does not include benefits, such as medical insurance.

You can see that the six quarter rolling change spent quarters below -5%. If Keynesian economics really worked, this shouldn't have happened.

And yes, the shape and effect was preceded by the 2001 recession, which was much more serious than it appeared. The 2001 recession was precipitated by a bubble in the 1990s. I intend to write much more about this graph.

However, the Keynes-fans will claim that yes, we avoided a second panic, or depression, or whatever you want to call it. The duration was cut by years. This is a Truth, but clearly not the Whole Truth, because what we had to do to accomplish this was to end Keynesian economics itself:

This graph, courtesy Fed Fred, is of federal government debt held by the public against real personal incomes excluding current transfer receipts (benefits paid to the public)

Worse yet, this graph ends in 2010. At the end of the year debt held by the public was 9.39 trillion; as of 4/27/2011 it is 9.65 trillion. That is much worse than it sounds, because usually in April Debt Held By The Public drops substantially as income tax payments come in.

This year, Debt Held By The Public was 9.651 as of 3/31, and we will either be very close to that or over that as of 5/1. Personal income also includes all receipts from rents, dividends, businesses, and interest.

In order to cut the duration and severity of the downturn, we increased our federal debt from 5.1 trillion at the end of 2007 to 9.65 trillion as of 4/27/2011, and we haven't stopped the massive escalation yet. It cost us about 3.8 trillion extra (compared to the path we were on pre-recession). It has to be obvious that we are almost at our borrowing limits.

You note that REAL personal incomes ex government transfers haven't rebounded to the pre-recession levels. If we were trying to be Keynesian about it, we now need to increase taxes to build up the ability to insert money into the economy at the next cyclical downturn.

We must pay for all our government spending, including payments to individuals and interest on debt, from personal incomes.

I look at these graphs, and I think that our entire social consensus since the GD is gone - no longer possible - and that since we can't afford to be Keynesians any more, we had better at least try to reinstitute bank regulation. And then I look at Ron Paul and scream in terror.


When reading this post, all I could think was, "Arrggghhh!"

Seriously though: the question is when the bond market begins to get this. Plans "A" through "Z" to get out of this are, "experience robust growth in real incomes". What happens if we don't? That is why the pace of this recovery is critical. Growing RGDP by only 2% is the same thing as pointing the car towards the cliff and stepping on the accelerator lightly.
Anyway, as a result of throwing away all bank regulation (done, let me remind you all, on a completely bipartisan basis) in the 1990s, we got a chance to test Keynesian economics.

It tested fine until the Republicans got the White House. The GOP screwed up the test on purpose to make it look bad!

You think you can get partisanship/religion out of the discussion, but it will never die.
All we need to do is figure out a way to give everyone a 40% raise at the same time we raise their taxes by 48%.
I'm not sure it's reasonable to expect any theory of economic policy to grow personal income in a demographic-driven depression. Nothing can overcome that, neither Keynesian nor classical economics. They both worked fine until hit with huge waves of people entering their 60's, and classical economics got thrown out due to the Great Depression.
David - given our demographics, it was always unlikely that we would see robust growth in real incomes through 2020. As far as I can see, we did the banking thing to kick the ball down the road further. But as it turns out, the ball collided with reality, bounced back, and we had to turn back and chase the ball.

We are clearly further behind than we were in 2002.

But we haven't changed our plan yet, either. I expect it to happen suddenly if we push this all the way. The short durations of debt that we have out there and the large volumes we have to roll over indicate that if we do not correct, there will be a massive panic. No one knows the day, but it will come.
Neil - but the larger portion of the boomers in 2000 were still entering their peak earning years.

You're ten years off. We are entering the demographic zone now.

Another way to state the same thing is that the "trust funds" for Social Security and Medicare hold over 4 trillion dollars - but we just spent that.

So now we are faced with lower structural income trends, a necessity to raise taxes sharply, and then the necessity to put more money by to fund retirements.
Seems like a regulation conundrum to me.

As we piled more and more regulation onto individuals and industry, we let them "pay" for those regulations by relaxing financial regulations.

In other words, we wound up doing the exact wrong thing. The founders of the country basically agreed on one thing: few laws/ regulations on anything EXCEPT finance/banking which should be regulated to the hilt.

But at this point, if the only bank that existed was run by the US government, it would be run even worse than Chase/BoA/WF/etc. (See: Fannie & Freddie.)
M_O_M, I thought you were talking about the the 2008 crash? Or at least the loss of personal income following it?
The tax and trade policies have both brought
us an economic mess which we then tried to
paper over with easy credit. The tax code rewards
Speculation over labor and trade policy rewards
Offshoring to compete with the third world.
We reap what we have sown.

Neil - yes and no. If you look at the first graph and the green line (6 quarter % chg in private wages) you see we had already changed the function by 2000. The green line started an epic drop completely unlike the patterns of previous recessions. We just had not managed to blow so huge a bubble so we didn't get so low.

Aging really wasn't the problem in 2007-2009, but it absolutely is now and for the rest of this decade. That's what's so terrifying. To the overhang of 15 years bubblizing we now add the demographic public finance crunch, which goes on for decades.

Ay-yi, our future's so bright we gotta wear shades.
Neil - although I do think age and, er, profligacy had a lot to do with the form the bubble took. The reason why people believed they could keep the RE bubble credit going was because so many people needed it to go. But it wasn't aging-related incomes that caused the 2007 recession.
Spork - the green trend line certainly has a lot to do with trade balance.

I just wonder how everyone's going to survive the cure?

That kind of gets me to a future post, though.
Neil - you also might want to see this graph from John Mauldin.

You'll note that the actual inflection point occurred in the 1990s, not this decade. It's just that as we gradually blow out all the capacity, the excess ended up at the federal level.

I think we have run out of borrowing options!
John Mauldin.

Good stuff, not the regular pap. The guy has run a regular business.
When all the graphs are indexed to a floating currency, any conclusion can be supported.

I do not write that as an endorsement of a gold standard. If any of y'all want to reduce the distortion of money out of the equation, I would love to see a graph with hours of labor on one of the axes. That introduces its own fuzziness--I'm not a Marxian--but labor hours are how to poor and the middle quintiles experience an economy.

I still think the 2008 crash was enabled, if not driven, largely by demographics. Or at least demographics caused its depth to be so great. It's true that the financial crisis came one or two years ahead of the theoretical peak Boomer spending, but impending retirement is what drove the Boomer response to the crisis. Things like:

-All those 50-somethings on unemployment, unable to find a job that is better than unemployment.

-The sudden shift from spending to savings (or at least, to debt repayment) as home equity and IRA gains evaporated. Wouldn't have seen this in 1992.

In other words, Boomers who thought they were on a glide path to retirement started acting old slightly before their time when the glide path turned turbulent. We could also say that dependency on SS/Medicare made people's behavior more volatile as they perceived increased systemic risk. I guess it's a lesson not to get too cute when you're timing demographic crises.

I'll agree, though, that the period between 2000 and 2008 is an indictment of Keynesian economic policy.

The 2000 crash was probably an unfortunate confluence (not sure it was a coincidence, though) of a short-term peak in people aged 45-to-50, along with the crossover point of the information technology acceptance S-curve. That's the point at which the second derivative goes negative, the middle of the "S". Either one guarantees a crash, so we got it hard. During the build-out phase of a technology S-curve, everything depends on efficient use of capital, and that's something that our economic and monetary policy frowns on. So we haven't been getting the kind of gains in productivity you'd expect. After brilliantly innovating up to 2000, we've got little long-term gain to show for the build-out phase. We muffed the revolution. Pray we do better on the energy revolution.
MaxedOutMama, You make the very common mistake of thinking that Keynes advocated extra spending funded by extra borrowing. He actually advocated funding via extra borrowing OR newly created money, i.e. “printed money”.

E.g. see a letter from him to Roosevelt here (top of 2nd page):


Obviously if a country reaches the limit of the amount it can borrow, it can go for the “print” option.

Personally the borrow option strikes me as silly because the effect of borrowing is deflationary (in the “reduce aggregated demand” sense of the word). Indeed, this deflationary effect is widely recognised as is called crowding out.

Also there is evidence that Keynes only advocated the borrowing option because he regarded himself as being surrounded by economic illiterates who thought that a money supply increase necessarily leads to inflation.
Musgrave - oh, no, you have misunderstood the post.

Suppose I ran up to you and yelled "Call the cops, that man over there just shot that woman in the head!" Would you immediately start defending the dead woman's reputation? Isn't it the murderer who must be forced to defend himself in court?

IMO, Keynes never did stand a real chance in a credit-linked depression, because those are always so large that they distort economies, and the distorted economies are not capable of absorbing the monies you want to throw in. You can't correct the cycle as Keynesian approaches normally do.

But the significance to us is that we will not be able to do this again for at least thirty years, so we might as well buckle down and deal with our current circumstances.
"we had better at least try to reinstitute bank regulation"

The real problem is the rampant fraud and the current government's complicity, along with the socializing (after the fact in some cases) of the cost of risk. There should be no FDIC, no Fannie Mae or Freddie Mac or other GSEs, no TARP or other bail-outs, no government backstops or market ventures of any sort. There should also be a justice system that puts fraudsters (such as robosigners and their management chain, and Countrywide employees that lied about loan information) in jail and/or makes them pay triple damages. (As a side note -- the same thing that may prevent these issues from ever being fixed also even more assuredly prevents meaningful regulation from being created: Thanks to a clueless population, our government is the banksters' bitch.)

"And then I look at Ron Paul and scream in terror."

Why? Granted, getting rid of regulations (or even just continuing to fail to reinstate something like Glass-Steagall) *without* fixing the above mentioned issues is a recipe for disaster (as has been demonstrated). But I'm pretty sure Ron Paul understands that. He has written about these topics many times and demonstrates a knowledge of the issues completely lacking in most congress critters (the ones you would trust to provide regulation; well, the ones that sign into law the regulations they don't even read but which are so kindly provided to them by their bankster buddies). E.g., first google hit on "ron paul fdic": http://www.lewrockwell.com/paul/paul289.html (For comparison I also tried "barney frank fdic": http://www.thehotjoints.com/2008/10/02/video-oreilly-shreds-barney-frank-in-interview/ O'Reilly is an ass, but Frank is clearly a liar -- and not just on the stuff he was called on.)

The government needs to be small in scope (to limit the damage it can do and the corruption it attracts) and simple (so voters can understand it and get suitably angry/active when it goes wrong). (Realistically though there needs to be an education component as well -- right now the typical voter is too ignorant and lacking in reasoning skills to make good choices even on simple matters.) By trying to regulate proper risk management via government (especially via the monopoly that is the federal government), you ensure we get complicated monstrosities like the recent financial reform law that probably does little good and lots wrong and voters (and probably most in congress) don't have any clue what it actually does so there is no real chance of congress being held accountable or the contents being meaningful. And by having the federal government take on the responsibility for these decisions -- even if its members were mostly operating in good faith, and they are not -- you still introduce massive systemic risk (as is true of all schemes based on central planning). And by having the government make these mistakes (either by choosing inappropriate regulations, whether too strict or too lax or just plain wrong, or by failing to enforce them appropriately) you set up a situation where when things go wrong the government (i.e., taxpayer) is expected to step in and fix everything, and where a conflict of interest is created where those that are supposed to represent us lie to our face because they can't admit they were a part (or even the primary cause) of the problem.

You can get similar complexity issues with private entities (e.g., terms of service contracts that are rediculously long/convoluted). But at least with private entities you can (when the government isn't busy granting monopolies and destroying small businesses) have some choice (or just don't opt in) without having to flee the country and renounce your citizenship.

I would love to see a social movement towards simpler contracts. Unfortunately most people seem to have already "solved" the problem by just not reading what they sign. Sigh.

"I think we have run out of borrowing options!"

For what it is worth, I think we've run out of borrowing options that actually help (or appear to help) our situation.

Real Debt Growth Per Capita (Musical Tribute)

My word verification is "mutio". I'm thinking it must be Italian for what Bernanke would wish I would do if he read my blog, lol.

In other words, "Shut the @#$% up!" ;)
As a side note, the charts I just did imply that the inflection point could be the early 1980s.
I've been of the opinion, for some time, that we made a huge mistake by discontinuing civics classes in schools. We had them in the 50s and 60s. At the very least, you force kids to listen to what government is supposed to be about. Now, we seem to be hellbent on turning out functional illiterates.
As a side note, the charts I just did imply that the inflection point could be the early 1980s.

That is certainly the inflection point of the borrowing craze. But that was mostly a "solution" to the printing craze of the 70's (which went back to Nixon, not just Carter).

Essentially we've been following an "extend and pretend" policy for so long that the majority of the population has not lived under any other policy, to them "extend and pretend" is normalcy.

Hope & Change = a new way to say Extend & Pretend.
Banking regulation seemed to work before it was effectively abandoned in the mid-to-late 1990s.

This is the thing that Carl at NOfP refuses to see. That's why I don't read him anymore.
Hi, Mom!

I borrowed your first graph there, if that's all right. Thanks.

Thanks MOM,
I had a pleasant spike on my Blogger stats thanks to you.

Your response to mine comparing your trend of private wages to capacity utilization has emboldened me. I'd like to ask you to evaluate my new graph of the federal debt.

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