DRI-186 for week of 1-5-14: The Secular Stagnation of Macroeconomic Thought

An Access Advertising EconBrief:

The Secular Stagnation of Macroeconomic Thought

The topic du jour in economic-policy circles is “secular stagnation,” thanks to two recent speeches on that topic by high-powered macroeconomist Lawrence Summers. The term originated just after World War II when Keynesian economists, particularly Alvin Hansen, used it to justify their forecast of the high unemployment and low growth that ostensibly awaited the U.S. after the war.

Now, nearly 70 years later, it is back. In a recent Wall Street Journal op-ed, monetary economist John Taylor likened its re-emergence to a vampire arising from his crypt. There is indeed something ghoulish about the propensity of Keynesian economists to ransack outdated textbooks in search of conceptual support for their latest brainstorm.

The backstory behind secular stagnation is only half the story, though. The other half is the insight it offers into the mindset of its patrons.

The Birth of the Secular Stagnation Hypothesis

As World War II drew to a close, economists gradually turned their attention to a problem that had intermittently occupied them since the late 1930s. The Great Depression had soured the profession on the workings of free markets. The publication of John Maynard Keynes’ General Theory of Employment Interest and Money had suggested a new framework for economic analysis that placed emphasis on unemployment and its elimination. While war mobilization had made this issue moot, the return of servicemen and readjustment to a peacetime economy brought it back to prominence.

Many Keynesians foresaw a return to mass unemployment and Depression. The leading American exponent, Alvin Hansen, developed a specific hypothesis along those lines. Keynes had posited a simple theory of aggregate consumption: consumption was a stable, linear function of income. These properties implied that, over time, it might become progressively more difficult to maintain full employment.

A numerical example using the simple Keynesian macroeconomic model will clarify this point. Y = real income or output, which is the sum of C (Consumption), I (Investment) and G (net Government spending). Further, C is a linear function of Y; that is, C = a + bY, where the “a” term reflects the influence on Consumption of factors other than real income and “b” (the slope of the Consumption function depicted diagrammatically) is the marginal propensity to consume from additional income acquired. Assume, purely for expository purposes, that a = 50, b = .75, I = 100 and G = 100. If Y = 1000, then C = 50 + .75 (1000) = 800. The influence of technology, which improves from year to year, will cause productivity to increase and output to increase over time, all other things equal. Assume, again purely for illustrative purposes, that this increase is 5%. In that case, the full employment level of income will increase from 1000 to 1050. But C does not increase by 5% to 840; it increases only to 837.50. In order to preserve full employment (according to Keynesian logic), the sum of I and G will have to increase by 212.50, an increase of 6.25% over its previous value of 200 – which is more than 5%. Over time, this putative annual shortfall in Consumption would get larger and larger, requiring successively larger doses of I and G to keep us at full employment.

Already we can see the germ of logic behind Hansen’s secular stagnation hypothesis, which is that Consumption over time will fall farther and farther behind the level necessary to preserve full employment. (The word “secular” does not reflect its customary meaning of “non-religious or worldly” but rather its technical economic meaning of “a long time series of indefinite duration.”) Underconsumption is a theme dear to the hearts of Keynesian economists. In this case, it depends as a first approximation on the algebraic structure of the simple Keynesian model, in which Consumption is a simple linear function of income (Y).

There was much more to the analysis than this. In principle, Consumption might increase for reasons unrelated to income. But Hansen predicted just the opposite. He believed the primary source of autonomous increases in Consumption was population growth, and he foresaw a sharp in U.S. population growth after the war. He was equally pessimistic about increases in autonomous Investment because he thought the highest-returning investments had already been tapped. Thus, by default, government deficit spending was the only possible remedy for progressively worsening unemployment and stagnating economic growth – hence the term “secular stagnation.”

The Gruesome Death of the Secular Stagnation Hypothesis

Alvin Hansen was known as the “American Keynes.” Presumably this was because of the apostolic fervor with which he preached Keynesian gospel. In this case, he shared something else with Keynes: the thoroughness with which history repudiated his ideas.

Hansen predicted population decline. Instead, the U.S. experienced the biggest baby boom in history. Among other effects, this produced an explosion of household investment in consumer durables such as homes, automobiles and appliances. The shortages and government-imposed rationing of World War II had generated a pent-up demand that burst its boundaries in the postwar climate.

Rather than unemployment and depression, the U.S. enjoyed one of its biggest expansions ever in 1946. This eventually created problems when, during the Korean War, the Truman administration preferred to fund the war via money creation rather than employing the borrowing that had financed most defense expenditures during World War II. The result was inflation, which the Administration countered with wage and price controls.

The U.S. had borrowed to the max in its conquest over the Axis powers, with debt climbing to its highest level as a percentage of national output. In his recent book, David Stockman pointed out the important role played by the Eisenhower Administration in paying down this debt and returning a semblance of sanity to federal-government spending.

This combination of private-sector buoyancy and government fiscal retrenchment left no need or room for the Keynesian remedy proposed by Hansen. As the 1950s unfolded, economic theoreticians on all sides of the spectrum delivered the coup de grace to the secular stagnation hypothesis.

In 1957, Milton Friedman presented his “permanent income” hypothesis of consumption spending, which fleshed out the individual utility-maximizing theory of consumer behavior with the picture of a consumer whose spending is governed by an estimation of lifetime or “permanent” income. He or she will tend to dissave by borrowing when young and by drawing down accumulated assets when old, meanwhile accumulating assets via saving in prime earning years. It is not actual or realized income so much as this individualized conception of expected normal income that influences consumption spending.

Keynesian Franco Modigliani developed his own theory of “life cycle” consumption, rather broadly similar to Friedman’s, within the same time frame. Left-wing economist James Duesenberry developed a “relative income” hypothesis stating that consumption was influenced by the consumer’s income relative to that of others. While there were important theoretical and practical differences between the three theories, they all rejected the simple Keynesian linear dependence of consumption on income. And this drove a stake through the heart of the secularly widening gap between consumption and income. The slats had been kicked out from under the secular-stagnation platform.

The secular stagnation hypothesis had already been proved to be a resounding flop in practice. Now it was shown to be wrong in theory as well. Before Keynesian economics had even been adopted on a wholesale basis, it had suffered its first crushing defeat.

The Rise of the Undead: Secular Stagnation Rises from the Crypt

Broadway impresarios sometimes revive past productions, but they invariably choose to revive hit plays rather than flops. Based on its first run, secular stagnation would not seem to be a prime candidate for revival. Nevertheless, Lawrence Summers mounted a new version of the concept and took it out of town for a tryout in two recent speeches, supplemented by comments on subsequent blog posts.

In his first speech, made to the International Monetary Fund Research Council, Summers grappled with the theoretical issues involved in resurrecting Hansen’s ancient bogeyman. Paraphrasing Clemenceau on war and generals, Summers mused that “finance is too important to be left to financiers.” The U.S. quickly recovered from the financial panic of 2008-09, but the ensuing four years brought astonishingly little progress when measured in standard macroeconomic metrics like employment and output growth. Although the term “secular stagnation” has long been neglected by his profession, Summers now finds it “not…without relevance” in understanding our current situation.

If the U.S. suffered a mass power blackout, output would fall precipitously. It would be idiotic for economists to object that electricity constitutes “only 4%” of total output – obviously, its importance is not indicated by its fraction of total output. Similarly, finance should be viewed in the same light – as the intermediating, lubricating force that enables the bulk of our goods and services. If a power blackout did occur, we would naturally expect restoration of service to be followed by a catch-up period of increased output, rather than the sort of prolonged stagnation we have actually experienced after the financial crisis. So why hasn’t it happened?

Summers’ explanation to the IMF audience was technical – that the “natural rate of interest” is negative; e.g., below zero. “We may need to think about we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back, below their potential.” Summers means that the practical inability to charge negative rates of interest – e.g., subsidize loans rather than charge money for them – is what is chaining the U.S. economy down.

In his second speech and follow-up blog  comments, Summers elaborated on the policy implications of his musings. “Our economy is constrained by lack of demand rather than lack of supply. Increasing our capacity to produce will not translate into increased output unless there is more demand for goods and services.” Of course, this is the old-time Keynesian religion of underconsumption, set to the background music of Cole Porter’s “Everything Old is New Again.” Secular stagnation has been brought down from the attic, fumigated with a dusting of demographics (the declining U.S. birth rate) to remove the stench of disgrace left by Hansen.

We need to “end the disastrous trends toward less and less government spending and employment each year.” In other words, the problem is not that we overspent and created too much sovereign debt in 2008-09; the problem is that we spent too little – and then cut spending after that. We should replace coal-first power plants – that will necessitate a huge program of capital spending to keep the power on. Following Keynes, Summers stresses the importance of supporting domestic demand by improving the trade balance.

Just as this program begins to sound suspiciously like a hair of the dog that bit us – or maybe the entire hair coat – Summers removes all doubt. It is “a chimera to rely on regulation” to pop asset bubbles in the face of the monetary excess necessary to underpin his program.

At the close of his first speech, Summers provided the only saving grace with the caveat: “This may all be madness and I may not have this right at all.”

Krugman’s Endorsement of Summers: For This We Need Economists?

Summers’ revival of the secular stagnation hypothesis was the talk of policymaking circles. Half of the talk was probably devoted to wondering what Summers was saying; the other half to wondering why he was saying it. Perhaps trying to be helpful, Summers’ partner in Keynesian crime Paul Krugman weighed in with his own interpretation of Summers’ remarks.

Inevitably, Krugman’s own views crept in to his discussion. The result was a blog post that could scarcely be believed even when read. (Readers with broad minds and strong stomachs are referred to “Secular Stagnation, Coalmines, Bubbles, and Larry Summers,” 11/16/2013, on the Krugman archive.)

Krugman begins with an uncharacteristic (and unrepeated) touch of humility. Noting the similarity between his own previous published diagnosis of our economic ills and Summers’ current one, he admits that Summers’ is “much clearer…more forceful, and altogether better.”

According to Krugman, he and Summers both view the U.S. economy as stuck in a “liquidity trap.” This is another Keynesian illustration of market pathology. As Keynes originally described the concept, a liquidity trap existed during an economic depression so intense that monetary policy was rendered impotent. Governments use banks as their tool for creating money; securities sold to the public are snapped up by banks, which in turn use them as the basis for making loans to businesses. But banks cannot force businesses to take out loans. If businesses decide that conditions are so bad that investing is too risky no matter how low the borrowing rate of interest, then monetary policymakers are helpless. In contrast, fiscal policy labors under no such constraint, since the government can always spend money for stimulative purposes. In a liquidity trap, though, monetary policy is likened to “pushing on a string” – a fruitless effort.

Krugman carries this notion further by identifying it with Summers’ evocation of a negative equilibrium interest rate. Investment demand is so weak and the desire to save so strong that the two are equilibrated only when “the” interest rate is below zero. In this climate, Krugman maintains, “the normal rules of economic policy don’t apply…virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment thanks to the paradox of thrift.” Krugman hereby drags in Keynesian anachronism #3. The so-called “paradox of thrift” states that the attempt to save more results in less saving because ex ante increases in saving will reduce income and employment, thus preventing the saving that consumers are trying to do, while reducing consumption as well. The only problem with this is that we have actually realized increases in saving and income at the same time, which is diametrically opposite to the effects predicted by the concept.

But these are trifles compared to the powerhouse contentions Krugman has coming up. Summers outlined a general program of public spending to increase demand and frankly admitted the futility of suppressing bubbles caused by the money creation necessary to finance the spending. Is Krugman troubled by this? Not merely “no,” but “Hell, no.”

“While productive spending is best, unproductive spending is still better than nothing…this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future.” And how could that possibly happen? (See “Europe, Sovereign Debt of; Europe, Financial Crises of; Europe, Bailouts Multiply Across; Europe, Political Protests Blanket.”)

Krugman continues with an example of wasteful spending by U.S. corporations that produced virtually no payoff after three years. “Nevertheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would have otherwise been idle.[emphasis added] F.A. Hayek characterized Keynesian economics as the negation of the market, a description well befitting this rationalization. In Krugman’s world, the labor market and relative prices might as well not exist, for all the effect they have. Microeconomics either does not exist or operates on a different plane of existence than the macroeconomic plane on which the statistical construct of aggregate demand wields its decisive influence. For this we need economists?

Krugman now arrives at “the radical part of Larry’s presentation” – as if the foregoing weren’t radical enough! He straightforwardly, even proudly admits what Summers guardedly suggests – that asset bubbles are a good thing. In fact, according to Krugman, U.S. prosperity has been built on bubbles for quite a while. “We now know that the economy of 2003-2007 was built on a bubble.” Krugman is being coy here since he made a celebrated statement in 2002 calling for the Federal Reserve to create a bubble in the housing market. Oddly enough, this attracted almost no attention at the time and has brought him no adverse reaction since then. “You can say the same about the latter part of the 90s expansion; and… about the later years…of the Reagan expansion, which was driven …by runaway thrift institutions and a large bubble in commercial real estate.”

Krugman’s recall of history is curiously defective, especially considering that he was employed in the Reagan Administration at the time, albeit in a minor position. The 1986 tax reform law was, and still is, pinpointed for tax-law changes that helped pop a real-estate bubble largely built on tax-deductibility. The political Left is fond of criticizing Reagan for claiming to have lowered taxes in the early 80s while actually raising them later on. The Left is even fonder of excoriating Reagan and Paul Volcker for ending inflation on the backs of the poor by killing off inflation by stopping monetary expansion too abruptly. Now Krugman is criticizing Reagan for doing just the opposite!

Krugman’s piece de resistance is his riposte to future critics who will object to the runaway inflation that the Summers/Krugman project will promote. Krugman unblinkingly admits that inflation “expropriates the gains of savers,” but replies that “in a liquidity trap, saving may be a personal virtue but it’s a social vice.” And in an economy facing secular stagnation, the liquidity trap is “the norm. Assuring people they can get a positive rate of interest on safe assets means promising them something the market doesn’t want to deliver.”

Krugman implicitly and explicitly assumes that markets are as dysfunctional as life-support patients with no respirator. But when he needs a justification for deep-sixing the life savings of hundreds of millions of people, he suddenly pulls out “the market” and gives its ostensible verdict a personal blessing of moral authority. Yet in this very same blog post, he cavalierly dismisses his critics as “a lot of people [opponents of Krugman] want economics to be a morality play and they don’t care how many people suffer in the process” [!!] For the benefit of readers unfamiliar with the long-running debate between Krugman and his critics, those critics are free-market economists who want bubbles to end with unsustainable businesses being liquidated rather than bailed out, and the business cycle to be cut short rather than prolonged indefinitely with each iteration worse than the previous one.

Intellectual Stagnation, Not Economic

At this point, it is all too clear that secular stagnation has taken place. But the stagnation is intellectual, not economic. Keynesian economists are framing policy arguments using terms like “secular stagnation,” “liquidity trap” and “paradox of thrift.” These recondite terms went out of fashion over thirty years ago, along with the paleo-Keynesian economic theory that spawned them. They survive in the 20th-century textbooks and graduate-school memories of economists now approaching retirement.

The shocking character of the Summers/Krugman hypothesis doesn’t derive from its vintage, though. Its anti-economic character – relative prices are irrelevant, waste is a good thing, markets are worthless except when economic managers need a pretext for arbitrary action – is professionally repellent. Even more frightening is the hubris on display. Summers is a disgusting sight, standing up in front of an audience at the International Monetary Fund, pontificating with grandiose gravity about “managing an economy” – as if he were the CEO of a U.S. economy of some 315 million people and tens of thousands of businesses.

There are quite a few people who consider a large public corporation too unwieldy to manage effectively. The difficulty of one economist managing an entire economy must increase not merely linearly but exponentially, considering the interaction and feedback effects involved. At least Summers had the minimal presence of mind to recognize that he might be mistaken. Krugman, in contrast, displays the same mindset as his intellectual antecedent, John Maynard Keynes. Several biographers and friends – including F.A. Hayek, with whom his relations were cordial despite their opposing views – remarked that Keynes was obsessed with his own preeminence as a public intellectual rather than with mastery of economic theory as such. Hayek remarked that Keynes may have been the most brilliant man he ever encountered but was a bad economist. Summers and Krugman show no signs of possessing the intellectual diversity and flexibility of Keynes – only his arrogance and deep-seated need for personal attention.

There is another shocking aspect to this latest policy flap. Summers/Krugman are in the anomalous position of criticizing the results of their own policies. That is, even they cannot credibly maintain that we have lived under a regime of laissez-faire or tight fiscal or monetary discipline for the last five years. They can only insist that not enough was done. Of course, this is the standard big-government lament; when big-government fails, try bigger government. But in this case, they are telling us that the results they formerly called bad were really good and we should expect no more from them in the future. The friendliest left-winger would have to acknowledge that Summers/Krugman are confessing failure and telling us that this is the best we can do. Notice, for example, that neither man stressed the very short-term nature of their policy prescription or promised that once their strategy of fiscal inebriation reached its apogee, we could let the market take over. No, theirs was a counsel of despair reminiscent of late 1970s malaise.

You can’t get any more stagnant than that.

DRI-221 for week of 12-8-13: What’s (Still) Wrong with Economics?

An Access Advertising EconBrief:

What’s (Still) Wrong with Economics?

Taking stock is an end-of-year tradition. This space devotes the remainder of the year to explaining the value of economics, so it’s fitting and proper to don a hair shirt and break out the penance whips as 2013 fades into the distance. What’s wrong with economics? Why doesn’t its productivity justify its title of queen of the social sciences – and what could be done about that?

This omnibus indictment demands an orderly presentation, organized by subject area.

Teaching: Although the motto of the Econometric Society is “science is measurement,” a better operational definition is “science is knowing what the hell you’re talking about.” On that score, economics has a lot to answer for. A science is only as good as its practitioners, who regurgitate what they are taught. Teaching is the first place to lay blame for the shortcomings of economics as a science.

In the past, economics has seldom been taught at the secondary level. That is changing, but only slowly. The subject is so difficult to master and absorption is such an osmotic process that an early start would vastly improve results. It would also force an improvement in the standard mode of teaching.

At the college level, economics is taught by teaching the same formal theory that Ph. D. students are required to master. Granted, college freshmen begin at the most basic level using far simpler tools, but they learn the same techniques. As the successful business economist Leif Olsen (among others) has pointed out, the tacit premise of college economics instruction is that all students will go on to study for their doctorate in the subject.

That is absurd. It forces textbooks to concentrate on force-feeding students bits (or chunks) of technique, supposedly to insure that all students are exposed to the tools and reasoning used by working economists. The use of the word “exposed” in this context should call to mind a disreputable man clothed only in a raincoat, accosting impressionable females in a public park. That captures both the thoroughness and duration of the exposure to each technical refinement, as well as the depth of understanding and relative appeal to the emotions and intellect on the part of the students.

What is needed here is textbooks and teachers that cover much less ground but do it much more thoroughly. Only a tiny fraction of students seek, let alone obtain, the Ph. D. The rest need to grasp the basic logic behind supply and demand, opportunity cost and the role of markets in coordinating the dispersed knowledge of humanity. This requires intensive study of basics – something that would also benefit today’s eventual doctoral candidates, many of whom never learn those basics. The only textbook serving this need that comes quickly to mind is The Economic Way of Thinking, by the late Paul Heyne.

In addition to the benefits accruing to undergraduate education, other advantages would follow from this superior approach. As it now stands, graduate students in economics are hamstrung by the subject’s austere formalism. The mathematical approach is now so rigorous at the highest levels of economics that the subject bears a stronger resemblance to engineering or physics than to the political economy practiced by classical economists in the 18th and 19th centuries. If this so-called rigor added value in form of precision to the practice of economics, it would be worth its cost in pain and hardship.

Alas, it doesn’t. Even worse, graduate students have to spend so much time grappling with mathematics that they lack the time to absorb the basic elements underlying the mathematics. Often, the mathematical models must eliminate the basic elements in order make the mathematics tractable. We are then left with the anomaly of an economic theory that must truncate or amputate its economic content in order to satisfy certain abstract scientific criteria. This obsession with formalism has substituted bad science for good economics – the worst kind of tradeoff.

The reader might wonder who benefits from the status quo, since beneficiaries have not been evident in the telling thus far. The current system creates a narrow road to academic success for career economists. They must fight their way through the undergraduate curriculum, then labor as part-time teachers and research assistants while taking their own graduate courses. Writing the Ph. D. dissertation can take years, after which they have a short time (usually six years) in which to write publishable research and get it placed in the small number of peer-reviewed economics journals. If they succeed in all this, they may end up with tenure at an American university. This will entitle them to job security and opportunity for advancement and a sizable income. If they fail – well, there’s always the private sector, where a small number of economists attain comparable career success. It is the survivors of this process, the tenured faculty at major American colleges and universities, who benefit from the system as it exists.

Perhaps this privileged few are an extraordinarily productive lot? Well, there are a tiny handful of the professoriate who produce research output that might reasonably be classed as valuable. Most articles published in professional journals, though, are virtually worthless. Nobody would pay any significant money to sponsor them directly. That’s not all. In addition to the arid mathematics employed by the theoretical research, there is also the statistical technique used to generate empirical articles. For several decades, the primary desideratum in statistical economics has been to obtain “statistically significant” results between the variable(s) in the economic model and the variable we are trying to understand. If questioned about this, the average person would probably define this criterion as “a large enough effect or impact to be worth measuring, or large enough to make us think what we are measuring has an important influence on what we are studying.”

Wrong! “Statistical significance” is a term of art that means something else – something that is more qualitative than quantitative. Essentially, it means that there is a likelihood that the relationship between the model variable(s) and the variable of interest is not due to random chance but is, rather, systematic. Another way of putting it would be to say that statistical significance answers a binary, “yes-no” question instead of the question we are usually most interested in. The big question, the one we most want the answer to, is usually a “how much” question. How much influence does one variable have on another; how great is the importance of one variable on another? The question answered by statistical significance is interesting and useful, but it is not the one we care about the most. Yet it is almost the only one the social sciences have cared about for decades. And, believe it or not, it is apparent that many economists do not even realize the mistake in emphasis they have been making.

Yet it is not the small number of beneficiaries or even their ghastly mistakes that indicts the current system. Rather, it is economic theory itself, which insists that people benefit from consumption rather than production. It is consumers of economics – students and the general public – who should be reaping rewards. The benefits earned by tenured professors are not bad if they are earned by providing comparable benefits to consumers rather than merely reaping monopoly profits from an exclusionary process. But students are lowest on the totem pole on any major university campus. Tenured faculty members teach as little as possible, usually only two courses per semester. Teaching is little rewarded and often poorly done by tenured and non-tenured faculty alike. Academic lore is filled with stories of award-winning teachers who neglected research for teaching and were dumped by their university in spite of their teaching accomplishments.

The late Nobel laureate James Buchanan characterized the position of academic economists today to “a kind of dole;” that is, they are living off the taxpayer rather than earning their keep. Administrators are fellow beneficiaries of the system, although they are pilot fish riding the backs of all academicians, not merely economists.

The Public: Consumers of economics include not merely those who study the subject in school but also the general public. Economists advise businesses on various subjects, including the past, present and future level of economic activity overall and within specific sectors, industries and businesses. They provide expert witness services in forensics by estimating business valuation, damage and loss in litigation, by representing the various parties in regulatory proceedings and particularly in antitrust litigation. Economists are the second-most numerous profession in government employment, behind lawyers.

For some seventy years, economists have played an important role in the making of economic policy. One might expect that economists would play the most important role; who is qualified to decide economic policy if not economists? In fact, modern governments place politicians and bureaucrats ahead of everybody when it comes to policymaking regardless of expertise. This has created a situation in which we were better off with no economic policy at all than with an economic policy run by non-economists. Still, the recent efforts of professional economists do not paint the profession in a favorable light, either.

The problem with public perception of economics and economists is that they have come to regard economics as synonymous with “macroeconomics;” that is, with forecasting and policymaking aimed at economic statistical aggregates like employment, gross domestic product and interest rates in the plural. This is the unfortunate byproduct of the Keynesian Revolution that overtook economics in the 1930s and reigned supreme until the late 1970s. The overarching Keynesian premise was that only such an aggregative focus could cure the recurrent recessions and depressions that Keynesians ascribed to the inherent instability and even stagnation of a private economy left to its own devices.

It is ironic that every premise on which Keynes based his conclusions was subsequently rejected by the four decades of extensive and intensive research devoted to the subject. It is even more ironic that the conclusion reached by the profession was that attention needed to be focused on developing “microfoundations of macroeconomics,” since it was the very notion of microeconomics that Keynes rejected in the first place. And the crowning irony was that, while Keynes ideas filtered down into the textbook teaching of economics and even into media presentation of economic news and concepts to the general public, the rejection of Keynesian economics never reached the news media or the general public. Textbooks were revised (eventually), but without the fanfare that accompanied the “Keynesian Revolution.”

So it was that when the financial crisis of 2008 and ensuing Great Recession of 2009 reacquainted America with economic depression, Keynesian economists could reemerge from the subterranean depths of intellectual isolation like zombies from a George Romero movie without triggering screams of horror from the public. Only those with very long memories and a healthy quotient of temerity stood up to ask why discredited economic policies had suddenly acquired cachet.

When the Nobel Foundation began awarding quasi-Nobel prizes for economics in the late 1960s, a good deal of grumbling was heard in the ranks of the hard sciences. Economics wasn’t a real science, they maintained stubbornly. A real science is cumulative; it creates a body of knowledge that grows larger over time owing to its revealed truth and demonstrated value in application. Economics just recycles the same ideas, they scoffed, which go in and out of fashion like women’s hemlines rather than being proved or disproved.

From today’s vantage point, we can see more than just a grain of truth in their disparagement – more like a boulder, in fact. What macroeconomist Alan Blinder referred to in a journal article as “the death and life of Keynesian economics” is a perfect case in point. Keynesian economics did not arise because it was a superior theory – research proved its theoretical inferiority. Not only that, it took decades to settle the point, which doesn’t exactly constitute a testimonial to the value of the subject or the lucidity of its doctrines. Keynesian economics did not triumph in the arena of practical application; that is, countries did not eliminate recessions and depressions using Keynesian policies, thereby proving their worth. Just the opposite; after decades of pinning his hopes on Keynesian economics, the British Labor Party leader James Cavenaugh renounced it in a celebrated denunciation in the mid-1970s.

No, Keynesian economics made a comeback because it was politically useful to the Obama administration. It enabled them to spend vast amounts of money and direct the spending to political supporters on the pretext that they were “stimulating the economy.” If economics had to justify its existence by pointing to the results of “economic policy,” economists would be thrown out into the street and forbidden to practice their craft.

In the early 1960s, Time Magazine put John Maynard Keynes on its cover and proclaimed the death of the business cycle. This obituary proved to be premature. Like Icarus, economists tried to fly too high. Their wings melted by the solar heat, the profession is now in freefall, putting up a bold front and proclaiming “so far, so good” as they plummet to Earth. The only remedy for this hubris is to straightforwardly admit that economics is not a hard, quantitatively predictive science in the mold of the natural sciences. Its fundamental insights are not quantitative at all but they are absolutely vital to our well-being. When combined with such other social sciences as law and political science, economics can explain patterns of human behavior involving choice. It can unlock the key to human progress by making the knowledge sequestered in billions of individual brains accessible in useful form for the mutual benefit of all. Thanks to economics, billions of people can live who would die without its insights. These benefits are anything but trivial.

Economics can even ameliorate the hardships imposed by the business cycle, as long as we do not expect too much and can resign ourselves to occasional recessions of limited length and severity. In this regard, success can be likened to hitting home runs in baseball. Trying to hit home runs by swinging too hard usually doesn’t work; making solid contact is the key to hitting homers. Many great home-run hitters, including Hank Aaron and Ernie Banks, were not large, powerful men who swung for the fences. They were wiry, muscular hitters who hit solid line drives. The economic analogue of this philosophy is to allow free markets to work and relative prices to govern the allocation of resources rather than trying to use government spending, taxes and money creation as a bludgeon to hammer the efforts of markets into a politically acceptable shape.

Remedies: In thinking about ways to right its wrongs, economics should take its own advice and fall back on free markets. Rather than trying to administratively reshape the academic status quo and tenure-based faculty system, for example, economists should simply support privatization of education. This is simply taking current professional support of tuition vouchers and charter schools to the next logical level. Tenure is a protected academic monopoly, unlikely to survive in a free private market. If it does, this will mean that it has unsuspected virtues; so much the better, then.

Recent decades have seen the rise of applied popular economics books written to bring economics to the masses. The best-known and most popular of these, Freakonomics, is among the least useful – but it is better than nothing. Better works have been submitted by economists like Steven Landsburg (The Armchair Economist) and David Friedman. Their worthy efforts have helped to turn the tide by correcting misapprehensions and redirecting focus away from macroeconomics. This is another good example of reform from within the profession that does not require economists to sacrifice their own well-being.

Perhaps the one missing link in economics today is leadership. Revolutions in scientific theory and practice are typically effected by individuals at the head of scientific movements. In economics, these have included men like Adam Smith, David Ricardo, Karl Marx, the Austrian economists of the 19th century, Alfred Marshall, Keynes and Milton Friedman. Today there is a leadership vacuum in the profession; nobody with the intellectual stature of Friedman remains to take the lead in reforming economics.

Given the woes of economics and economic theory, a new candidate seems unlikely to come riding over the horizon. It may be that economists will have to prop up an intellectual giant of the past to ride like El Cid against the ancient foes of ignorance, apathy, prejudice and vested interest. There is one outstanding candidate, the man who saved the 20th century in life and whose wide-ranging thought and multi-disciplinary theory is alone capable of midwiving a new sustainable economics of the future. That would be F.A. Hayek. Recent stirrings within the profession suggest a growing acknowledgment that Hayek’s economics have been too long neglected and explain the crisis, recession and current stagnation far better than anything offered by Keynes or his followers. There is no better body of work to serve as a model for what is wrong with economics and how to correct it than his.

DRI-241 for week of 12-2-12: Look for the Fiscal Cliff in the Rear-View Mirror

An Access Advertising EconBrief:

Look for the Fiscal Cliff in the Rear-View Mirror

With the demise of responsible journalism has come the advent of the “hook,” an attention-grabbing theme or event that acts as a long-handled tool with which to snag the media consumer. These days, the hook du jour is the so-called “fiscal cliff,” an economic precipice off which our figurative fall is scheduled for January, 2013.

As popularly defined, the fiscal cliff is a media-bred and -fed red herring that serves to distract attention from our real impending calamities, which are much worse than those imagined by the press.

The “Fiscal Cliff” as Conventionally Viewed

The conventional explanation of the fiscal cliff goes as follows: Beginning in the New Year, various cuts in federal-government spending and increases in federal taxes are scheduled to occur. The cumulative impact of these actions will be sudden, large and adverse. Hence the metaphor of a cliff, whose “fiscal” dimension refers to the government-expenditure-and-taxation connotation of fiscal policy.

In order to swallow this conventional view, we must believe it to be correct. That involves more than its factual accuracy; it also refers to its inherent soundness.

The fiscal-cliff narrative implies that both decreases and government spending and increases in federal tax rates are “bad for the economy” in some clear-cut, obvious way. The usual presumption is that they are both contractionary, tending to induce recession. The problem is that there is no reason to believe this.

Why the Conventional Thinking About the Fiscal Cliff is Wrong

The planted axioms in fiscal-cliffery are deep-rooted in contemporary life. They are have been repeated so long by the news media that the citizenry accepts them as gospel. They are fundamental principles of Keynesian economics. In the simple Keynesian economic model, the multiplier principle assumes that autonomous expenditures by government create multiple increases in income and employment. (It should be, but seldom is, put it more carefully: Whenever the economy operates at less-than-full employment, this multiplier effect will hold true.) It is trundled out and paraded by local news outlets every time a convention hits town or a sport team wants a justification for public subsidies.

If this proposition were true, we need never fear the onset of recession. Simply crank up the government spending mechanism and restore prosperity and full employment. It should be plain to one and all that it is false. History refutes it. In line with Keynesian precepts, government spending steadily increased throughout the 20th century and into the 21st, both in absolute terms and relative to tax receipts and aggregate income. Contrary to received wisdom, recessions were not banished by this spending regimen.

There have been no recorded instances of recessions-in-progress halted and reversed by timely administrations of government deficit spending. There was a brief period in the early 1960s that was hailed as the dawn of a new Keynesian age, but it began years after the Eisenhower recession and was stopped in its tracks by a combination of recession and inflation in the late 1960s. The phenomenon of stagflation continued into the 1970s throughout the Western industrialized nations, confounding Keynesian theorists and leading politicians like Great Britain’s James Callaghan to publicly repudiate Keynesian orthodoxy.

Both the Thatcher administration in Great Britain and the Reagan administration in the U.S. accepted recession as the price for ending double-digit inflation. They were rewarded by the subsequent long climate of prosperity known as the Great Moderation, which lasted into the next millennium.

The empirical defeat of Keynesian economics was mirrored by its theoretical decline. This took place over a longer time frame but was equally decisive. It is doubtful if any theory in the physical or social sciences was ever subjected to scrutiny so long-lasting and thorough. Over some 45 years, the economics profession obsessively focused on little else. By the early 1980s, the verdict was in.

Keynes had made his case in favor of government deficit spending on three grounds. Non-professional students and a few economists had long nourished a grudge against free markets on account of their alleged underconsumption. Increases in productivity and investment, it was alleged, would lead people to spend too little of their income, causing unsold goods to pile up and recessionary layoffs to ensue. Although Keynes did not incorporate this notion into his theory, he expressed sympathy for it. A decade before Keynes published his General Theory in 1936, two American economists named Foster and Catchings anticipated him by calling for a program of government spending to take up the slack created by private oversaving and underconsumption. In his 1931 article, “The Paradox of Saving,” F.A. Hayek meticulously explained why Foster and Catchings were wrong.

Keynes identified various flaws in the operation of free markets that he hauled out to justify activist government policies. These flaws formed the basis for the neo-Keynesian theory developed by his disciples after Keynes’ death in 1946. One by one over a 45-year period of controversy and research, each one was refuted. Keynes developed a theory of consumption as a simple linear function of income, used to buttress his concept of the multiplier. This was overturned by research done by three later economists, two of them Keynesians. Keynes insisted that downward inflexibility of wages and prices would prevent restoration of full employment without government intervention. History and research have also overturned the empirical basis for this strand of Keynesian thought. Falling prices, or deflation, would cause real incomes to rise through the operation of the real-balances effect. In other words, there is no inherent tendency for a fall in aggregate demand to result in unemployment of indefinite duration.

In later sections of the General Theory, Keynes gave his anti-capitalist prejudices free rein and inveighed against what he called “the fetish of liquidity;” e.g., the desire to hold money as a hedge against uncertainty. Keynes claimed that central banks should increase the money supply sufficiently to drive interest rates to zero (!), so as to discourage the demand for liquidity and end the scarcity of capital. The Great Recession of the New Millennium has given policymakers the chance to put this notion into practice. The technique of quantitative expansion of the money supply has kept interest rates artificially low in Japan for most of two decades; in the U.S., for about three years.

Japan’s economy has become nearly dormant, while the U.S. has seen a torpid recovery gradually metamorphose into a double-dip recession. So much for “the fetish of liquidity”! Near-zero interest rates did not end the scarcity of capital – quite the contrary; they made it nearly impossible to judge the relative usefulness of different capital assets and ushered in a state of near-paralysis. These recent examples reinforce the earlier experience of the Soviet Union, where the absence of market interest rates made it impossible for Soviet planners to judge the relative efficiency of different investments.

Finally, those without a sense of history or a nose for theory can simply review the results of the huge stimulus bill passed in early 2009. Government action was supposed to be better than waiting interminably for private markets to restore full employment. Instead, we waited interminably for government to spend stimulus money and then…overall employment continued to fall. Most of the glacial reductions in the rate of unemployment were due to dramatic declines in the rate of labor-force participation. Nobody can credibly maintain that Keynesian economics lived up to its billing.

Fiscal Cliff – or Fiscal Standoff?

We should not recoil in horror from reductions in government spending. When the federal government declines to spend our money, this does not constitute a lost opportunity to conjure goods and services out of thin air. It simply means that resources that would otherwise have been used to produce goods at the direction of government are now free for alternative use. This is no tragedy. Since the private sector follows the guideposts of profit, consumer sovereignty and utility maximization, the resources will probably be put to better use there than in the public sector anyway.

Nothing has been said here about where the spending reductions would take place. In principle, that should matter. After all, there are a few valid examples of public goods – goods that cannot be privately produced because private producers could not exclude non-payers from consumption and which cannot be consumed by one without being available to all. But the fiscal-cliff melodrama now playing full-time in media outlets makes no distinctions of this kind. It treats all government spending reductions equally, implicitly following the dictum of the late Keynesian economist James Tobin, who proclaimed, “Spending is spending; it doesn’t matter what you spend the money on.”

If government spending cuts are a bogeyman, who is it lurking underneath the white sheet blurting, “Boo!” Perhaps the defense of simple ignorance can absolve the news media for misinforming its audience – or perhaps not – but why don’t the President, Congress and professional economists blow the whistle on this farce? Each benefits from lying to the public about government spending, both in general and in this particular instance.

President Obama gains because his entire professional existence is focused on maximizing the power, influence and activity of the federal government The Republicans made the strategic mistake of assuming that the ineffectiveness of President’s policies would doom his candidacy. As this space accurately predicted three years ago, the President’s policies were not intended to be effective in the traditional sense, although that outcome would have been a welcome byproduct had it occurred. The policies were intended to make as many people as possible either employed by, subsidized by or beholden to the federal government. Thus, policies that increased unemployment rather than reducing it were still successful if they increased participation in unemployment benefits, food stamps, administration of benefits or any other government-related activity.

Democrats gain in Congress because their strategy is focused on demonizing Republicans. Their constituency consists overwhelmingly of net beneficiaries from redistributing government spending – or people who consider themselves net beneficiaries. By painting government spending as ipso facto beneficial, Democrats can achieve what gamblers call a “middle” – they can win either way. If Republicans cave in and restore threatened spending, Democrat constituents and their patrons in Congress gain. If Republicans hold firm against negating the cuts, Democrats can paint Republicans as villains. What’s more, if the overall economy deteriorates markedly as seems increasingly likely, Republicans will bear the blame for forcing us off the fiscal cliff.

Difficult as it may be to believe, Republicans also perceive gains from perpetuating the myth of the fiscal cliff. For one thing, Republicans have their own roster of constituent beneficiaries from federal-government subsidies, so they are secretly content to see spending continue – at least spending that they approve of. For another, Republicans also harbor hopes of blaming Democrats for anything that goes wrong next year. Most tellingly, Republicans by now have acquired a pathological fear of being publicly blamed and stigmatized by Democrats for anything and everything. They visualize an outcome similar to past misadventures with the debt ceiling and other attempts at spending discipline. Like whipped dogs, they cower in fear of another beating and will crawl in submission rather than face one. Thus, they are afraid not to cut a deal avoiding the mythical fiscal cliff.

One other factor influences Republican fear; namely, the other face of the fiscal cliff – tax increases.

Tax Increases – Good or Bad?

Republicans, goaded by longtime anti-tax activist Grover Norquist, have built a solid reputation as the party of opposition to tax increases. It is just about their one remaining principle of any substance. It dates back to the days of supply-side economics and the presidency of Ronald Reagan, whom Republicans venerate as the Democrats traditionally do Franklin Roosevelt. Is this principle well-founded?

The answer is complicated. Economic activity is conducted at the margin, so increases in marginal tax rates are well worth opposing because they deter the activities being taxed. Since most taxes are on earned income or production of goods and services, this means that taxation has an adverse effect on economic activity. This idea is conveyed by economic specialists in public finance through the concept of the “excess burden” imposed by the tax. On the other hand, surtaxes and lump-sum taxes have comparatively little effect on economic activity one way or the other – not enough to drive an economy off a cliff.

Many Republicans would really prefer to separate the issues of spending reductions and tax increases by embracing the first and opposing the second. But their track record on making fine distinctions in public debate is so dismal that they are inclined to give up that project as a bad job. After all, they had a whole year to work with but couldn’t even convince a majority of the electorate that Barack Obama was a bad President. Teaching the public basic economics in less than one month seems like a lost cause.

If the distinction between spending decreases and tax increases seems arcane, the bottom line about tax increases will sound positively esoteric. The Keynesian view of taxes is the same as that of spending – taxes are taxes. They affect the economy only as the receipt or loss of income rather than through their effect on incentives and behavior. Thus, their impact is cyclical; tax changes increase or decrease the likelihood of recession or expansion. But in reality, the Keynesian view is wrong here, as elsewhere. Changes in marginal tax rates affect long-run growth. (Whether the effects are temporary or permanent is another complex question.) They have little or no effect on business cycles because the causes (and cures) for business cycles lie elsewhere than with changes in aggregate demand. This is still one more reason why the current debate over the fiscal cliff is phony.

There is true irony in the fact that we are confronted with this faux fiscal cliff that nobody is willing to expose. We are facing a very real fiscal cliff. Or rather, we faced it over a period of decades. But we drove off the cliff like Thelma and Louise. Now the cliff is fading into the distance above us, getting small in our rear-view mirror. And we are about to crash into the ground below.

The Real Fiscal Cliff

The real fiscal cliff is the debt and spending behavior of U.S. governments at every level. The federal government’s debt (public and inter-governmental) is now approximately the size (100%) of annual GDP, or roughly $16 trillion. But this does not begin to capture the true size of federal government obligations. Taking future Social Security and Medicare committments into account (on a discounted present value basis) would make that number over 4 times greater. The Federal Reserve is monetizing debt; e.g., indirectly paying for government expenditures by creating money used by banks to purchase government bonds. This is a traditional sign of a government in the throes of a debt crisis, about to succumb to hyperinflation.

The Fed has created vast sums of money, but so far this has contributed only modestly to measured inflation because most of it has sat idle in excess bank reserves. By changing the rules allowing it to pay interest on those reserves – and by tightening regulations on conventional business loans to draconian degree – the Fed has persuaded banks to forego traditional lending and fatten their income statements passively. Meanwhile, the Fed has desperately tried to pump up real-estate prices and mortgages by buying mortgage-backed securities, the toxic asset most prevalent on bank balance sheets. In other words, the Fed has put the real economy in a therapeutic coma – therapeutic for banks but not for everybody else.

The Fed is working against time because default dominoes are wobbling in Europe. Greece has already defaulted; Spain, Italy and Portugal are on the brink and France is starting to look shaky. Outside Europe, Japan’s debt makes the U.S. look conservative by comparison and its coma is now Rip Van Winkle-length. This worries the Fed because U.S. banks are owed money and/or financial assets by banks in these countries, where the banking systems are mostly in even worse shape than ours.

Just about the only virtue displayed by leaders of the European Union is that they see the handwriting on the wall, even if they show varying degrees of willingness to act on their knowledge. But as an editorialist at London’s Financial Times recently observed, the belated willingness of Europe’s leaders to address the crackup of socialism and the welfare state comes just as the general public in the U.S. is embracing socialism at the polls.

In the past, economists have allayed fears about federal-government budget deficits by contending that what matters is the unified budget of state, local and federal governments. For many years, state government budgets were constrained by statute and tradition to remain in balance or even in surplus, thus offsetting federal extravagance somewhat. But today, at least a dozen state governments are nearly as bad off as the federal government. These include some of our most populous states, such as California, Illinois, New York and New Jersey.

The rot extends down to the level of city government. Detroit, Michigan was once an American powerhouse, home to the Big Three automakers. Today it lays in ruins, a dysfunctional ghost town whose City Council is reduced to begging for bailouts from a federal government that cannot bail itself out. Stockton, California has declared bankruptcy; a few other cities are teetering on the edge. Some major cities, like New York City and Chicago, are out of control and in decline.

If the American public and policymakers were united in perception and purpose, heading off default would be difficult. It would require a reversal of economic policy to promote economic growth. First, though, markets would have to reset and housing prices in numerous markets throughout the country would have to be turned loose to find their own level. This would entail a recession of indeterminate length, unfortunate but just as unavoidable as was the short, sharp recession back in 1981-82. Then government spending would have to be massively reduced – not trimmed, but chopped with a meat ax. Whole Cabinet-level departments would have to be eliminated and their work forces terminated.

Instead, we are traveling in exactly the opposite direction. Vice-Presidential Ryan’s modest proposal for entitlement reform went down to defeat along with Presidential candidate Romney. The two parties are squabbling about trivial differences in a plan for avoiding a fiscal cliff that doesn’t exist.

Après Moi, Le Deluge

Legend has it that his ministers confronted France’s Louis XV about the profligacy of his spending – palaces at Vincennes and Tuileries, wars against European rivals, a stable of mistresses including Madame de Pompadour. What legacy would he leave his successor and the nation? The king shrugged. “Après moi, le deluge,” he replied. (“After me, the deluge.”) That is apparently the position taken by politicians in Washington, D.C. in the face of the greatest crisis the United States of America have ever faced.

DRI-397 for week of 9-16-12: “QE3: Flying Blind”

An Access Advertising EconBrief: 

“QE3: Flying Blind”

Recently, Federal Reserve Chairman Ben Bernanke announced that the Federal Reserve would embark on still another venture in stimulative monetary policy – QE3. Bernanke characterized this sequel as intended to “help Main Street” by fighting unemployment, which “has remained stubbornly high.”

“QE” stands for “quantitative easing.” The meaning of this phrase will seem obscure to all but insiders; it implies that the focus of monetary policy is entirely on the quantity of money rather than something else. Economic textbooks of a half-century ago defined monetary policy according to the tenets of Keynesian economics – the manipulation of interest rates (usually downward) through changes in the quantity of money.

When interest rates are at or near zero, there is little further scope for employing this tool – at least in the orthodox manner. The idea behind quantitative easing is that further increases in the quantity of money may still have stimulative impact when selectively employed. Meanwhile, the increases have the effect of maintaining the Fed’s zero-interest-rate policy (ZIRP).

The third edition of the QE series both conforms to and differs from the first two. The additional money will come from monthly purchases of mortgage-backed securities by the Fed, in the amount of $40 billion. This is both a similarity and a difference. The .Fed has been trying since 2009 to raise home prices by buying mortgage-backed securities – without much success. Prior to QE3, however, this program was segregated from monetary policy as such and marketed as a kind of disaster relief for the housing industry.

The other element of QE3 is a continuation of “Operation Twist,” the revival of a little-remembered 1960s policy aimed at changing the maturity structure of federal-government debt. By buying and retiring long-term government bonds and selling short-term government debt instruments, the Fed has significantly shortened the average maturity of federal debt. Since short-term interest rates are being held artificially low, this has allowed the government to reduce its interest payments on the debt.

The Political Reactions to the QE Series

Technically, the Federal Reserve is an independent institution, neither completely governmental nor strictly private. Its actions are ostensibly motivated by non-partisan considerations and as such should be above politics. In practice, the Fed has become a sizzling hot potato on the election-year grill.

Most defenders of the administration – not all of them Democrats, surprising as that may seem – insist that the Fed’s actions since 2007 have been emergency actions aimed at rescuing us from the abyss of worldwide great depression, a la the 1930s. Since reported U.S. unemployment has not risen to 25% and GDP has not fallen precipitously, the Fed’s actions must have been successful.

Criticism of the Fed has been purely political, its defenders maintain, since its actions have been taken right out of the textbook – or perhaps “script” would be a more precise analogy – of measures designed to combat financial crisis, market crash and incipient depression. Since quantitative easing has been used only in Japan over the last dozen years or so and has been mostly deemed a failure, it is not clear why the Fed has called this play or why armchair quarterbacks tout this playbook so confidently.

Fed critics are aghast at the Fed’s actions and its rationale for them. Massive injections of liquidity and a long-term “zero-interest-rate-policy” (ZIRP) are draconian, unprecedented actions. Their justification can only be an emergency of life-threatening dimensions – to import an analogy from medical crisis management. But unlike the Great Depression that began in 1929, this emergency was never realized, only putative. There were no massive bank failures, no bread lines, no riots, no widespread unemployment. There was the popping of the government-policy-created housing bubble and an ensuing recession – the thirty-third if you believe the long line of U.S. recessions began in 1854, as the National Bureau of Economic Research does. But another decade-long depression was not inevitably in the cards.

Even more telling have been the Fed’s incoherent explanations for its actions. Bernanke says that this QE is supposed to fight unemployment. But each previous QE had the same rationale. Yet results were anemic at best – unemployment fell from almost 10% down to its present 8.1% mostly because the size of the labor force shrunk to a shocking, seldom-seen extent. Actual employment is still less than in 2007, prior to the onset of the recession.

The political camps are miles apart, but even Bernanke’s supporters should acknowledge, as he himself does, that legitimate doubts plague public acceptance of the QE series. Two nagging questions lead the list. First, why should this QE succeed where the first two largely failed? Surely not because the technical details are different; purchases of mortgage-backed securities have scarcely budged home prices previously, so why should they lift the entire economy now? Without saying it in so many words, Bernanke is implying that his intentions are what determine the results of the policy. Previously, the policy now labeled as QE3 was not intended to be stimulative, so it should not be criticized for its lack of punch. But now, less than two months before the Presidential election that will determine whether he is reappointed as Fed Chairman, Bernanke has recognized that need to fight unemployment. So we should expect that the same policies that didn’t work before will work now.

Second, the phrasing of Bernanke’s remarks clearly suggests that previous QEs had a different purpose. What was it and why did Bernanke fail to disclose it then and now? After all, it’s not as if he can be excused for holding political cards close to his vest. The Fed is supposed to be independent of politics and government policy.

And while we’re posing questions, let’s not forget an even more obvious one: How do we know that the QE cure is not worse than the disease it is supposed to fight?

The Curious Rationale for the QE Series

This space has previously addressed what seems to be the true rationale for the QE series; namely, the desire to prop up the banking system by subsidizing banks. Because banks and Wall Street are in bad odor with the public, the subsidies have to be undercover. The QE series has involved purchases of securities by the Fed from commercial banks and payment in the form of deposits credited to bank reserves by the Fed. In order to induce the banks to hold this money as excess reserves instead of lending it out, the Fed began paying interest to banks on their excess reserves in 2010. By restraining bank lending rather than encouraging it, the Fed has itself prevented its policies from stimulating the economy. Indeed, for the last year or so the Fed has even “sterilized” the increases in bank reserves with asset sales so as to hold the supply of base money roughly constant.

We cannot know the reasons for this policy because Bernanke has not even acknowledged it, let alone explained it. Presumably, the Fed believes that too many U.S. commercial banks are at or near the point of insolvency. Normally, the Fed handles insolvent commercial banks by merging them with sound banks, but this is clearly infeasible when a sizable fraction of banks are unsound. Absent its standard form of treatment, the Fed may be putting the banking system in a therapeutic coma until conditions improve. In other words, the Fed may be allowing bank balance sheets to fatten on safe interest payments earned on excess reserves while buying time for housing prices to rise. Housing price increases would increase the value of the mortgage-backed securities that form the bulk of commercial-bank assets.

This is consistent with the form taken by QE3, in which Fed purchases of mortgage-backed securities are the backbone of stimulative policy. This unprecedented policy change reverses age-old Federal Reserve precedent of purchasing and selling only government securities, in order not to favor or harm particular industries or firms in the private economy.

There is an alternative explanation for the QE series and ZIRP. The state of the federal budget is so parlous that by 2020, interest on debt threatens to overwhelm it and comprise almost all the projected total. This would crowd out almost all social spending directly and indirectly crowd out private investment spending by forcing an increase in market interest rates in order to attract the bond investment necessary to finance the projected budget deficits. ZIRP can be viewed as a delaying action designed to hold down federal-government interest payments as long as possible and buy time for Congress and the President to deal with the nation’s fiscal problems.

We should note, first, that these two alternative explanations for the QE Series are not mutually exclusive. Indeed, there reinforce each other. But they are both thoroughly dishonest because, if either or both are true, they mean that Bernanke has been lying through his teeth for years. They also signal the end of Federal Reserve independence from politics. Both involve Fed implementation of fiscal policy as well as monetary policy, even though fiscal policy is supposedly the sole preserve of the Treasury and the political administration in power.

Why Is the Cure Worse Than the Disease?

Judging from the actions of the Federal Reserve since 2008, one might think that the only function served by interest rates is to serve as levers by which the Fed speeds up or slows down the pace of economic activity. This is miles away from the truth. The true function of interest is outlined in economic textbooks and reference books.

In The Fortune Encyclopedia of Economics, Paul Heyne informs us that “interest is the price people pay to have resources now rather than later.” At a consumer-loan rate of 11%, we can borrow $900 for one year and repay $1,000 in one year’s time. Obviously, since we have the wherewithal to repay the $1,000 loan in one year, we could have simply waited one year and enjoyed $1,000 worth of consumption goods. But we chose instead to consume $900 today, and the 11% ($100) premium we paid is the price for our anxiety to consume in the present. It reflects the degree of our time preference, a term suggesting that an inherent human tendency to prefer consumption sooner rather than later is what accounts for a positive interest rate. And it is the ability to utilize capital goods productively that allows us to finance them with borrowed money and use their product to repay both cost and interest on the loan.

This implies that interest is not purely a monetary phenomenon. “The fact that loans are usually made in money leads to the mistaken belief that interest is the ‘price paid for the use of money'” and can be lowered mechanically be by increasing the amount of money in circulation. “But interest would also exist in a pure barter economy where money was not used.”

This is not merely conjectural. In wartime prisoner-of-war camps, prisoners made loans to each other from their limited stocks of ration goods, demanding repayment of a larger quantity of the good. When cigarettes later became the medium of exchange in the camps, these constituted both principal and interest for the loans. The medieval church condemned the collection of interest as sinful, but it purchased annuities to the proceeds of land rents at less than their face value; e.g., it charged interest to sellers.

The fact that goods and money are valued differently at different points in time means that interest rates are key tools of human valuation. “The interest rate enters at least implicitly into all economic decisions, because economic decisions are made by comparing expected future benefits to costs.” The farther into the future a prospective benefit is deferred, the lower its current value. That current or present value is calculated numerically by discounting the benefit using a relevant interest rate.

Every sort of investment decision requires this kind of discounting calculation or its obverse, the future value calculation – both of which require the use of an interest rate. People who want to save for their retirement must do these calculations and supply relevant interest rates for their own use. Businesses pondering fixed investment will probably wish to calculate a “hurdle rate” or interest rate of return for comparison purposes. To do it they will need market rates of return to serve as benchmarks.

The Soviet Attempt to Control the Interest Rate

Soviet Russia virtually eliminated private property and capital markets from the Russian landscape beginning in 1917. In principle, this eliminated both the opportunity and the need for nominal interest rates. But economics predicts that the phenomenon of interest is necessary for people to behave rationally. Sure enough, Communist economic planners eventually tried to invent an interest rate to improve the effectiveness of their own planning. (They couldn’t call it an interest rate, for fear of being shot – they called it the “efficiency index.”)

The Soviet government had the advantage of being able to observe Western financial markets and interest rates in constructing their artificial interest rate. Even so, their attempt failed miserably. Although few realized it at the time, subsequent research and archival disclosures revealed that their economy declined more or less continuously

when its private features were suppressed. Ultimately it collapsed completely, beginning in 1989. One important cause of the collapse was the utter inability to tailor investment to meet consumer wants and needs.

The U.S. Economy Under ZIRP

How would we expect a free-market economy to react when the price signals that customary guide production and consumption decisions are disrupted, garbled and stopped entirely? We would expect confusion and indecision to result. We would expect the pace of economic activity to slow as people groped for substitute decision variables on which to base their actions. We would expect to find extreme reluctance in committing large amounts of resources and money to future endeavors, whether in hiring or investment. In short, we would expect to see an economy very much like the economy we observe all around us today.

The effects of ZIRP are even more pernicious than they might seem at first glance. Although the interest rates most directly (and indirectly) affected by ZIRP are short-term rates, long-term interest rates under ZIRP are also not unhampered free-market rates. Just as with the prices of goods and services, interest rates act through their relative relationship to each other rather than through their absolute magnitude alone. That is, the relationship of (say) six-month to one-year rates is just as important as either rate by itself. Even though the effect of ZIRP on interest rates becomes progressively smaller as the term structure of the rates lengthens, the relative relationship between long rates and shorter rates is still affected by distortions in the latter. These distortions cause changes in the supply of and demand for savings and investment that, in turn, affect long-term rates as well. This is not only acknowledged but welcomed by the Fed – Bernanke expressly claimed lower long-term rates as an intended effect of QE3.

The 1970s Inflation – Comparing Distortions

The last time that widespread distortions in relative interest rates occurred in the U.S. was the late 1970s. They were due to the high inflation that had accelerated thanks to Federal Reserve policies throughout that decade. Although all interest rates came to include an “inflation premium” intended to compensate asset holders for the loss of purchasing power of fixed-income interest payments, this market-imposed version of financial inflation indexing was an inexact science. In practice, the relative relationship of interest rates of differing terms was also distorted by inflation, if only because few if any asset holders had exactly the same consumption patterns. Consequently, inflation had a different effect on the real value of a given interest return for each investor.

An even greater degree of distortion was experienced in 1970s’ consumer goods markets, where rapidly rising prices did not all rise at the same rate. Consequently, relative prices changed dramatically compared to their pre-inflation levels. Consumers’ money incomes also did not rise pari passu with inflation, causing marked shifts in real income away from those on fixed incomes and dependent on fixed-income investments.

Today, the greater distortion is experienced in financial and investment markets. Interest rates are to the future what a plane’s instrument panel is to a pilot. When the instruments are broken or unreliable, the pilot’s navigational horizon is limited to what he can see. ZIRP gives us interest rates that are unreal, phony, untrustworthy. This limits our planning horizon severely, making us unwilling to look very far ahead, hire employees or commit substantial funds to the future. And it even distorts the choices we make in the present.

Flying Blind Under ZIRP

Lower interest rates cause producers to become more future-oriented, shifting production to good with longer production processes using more capital-intensive methods. Under normal circumstances, when lower interest rates are the result of an increase in saving by the public, this is appropriate. The public’s increase in saving is a signal that it wants more consumption in the future and less now. This insures an adequate volume of purchasing power to buy the volume of future goods produced, while changes in the prices of goods and services insure that the right amounts of particular goods and services are produced.

But when the low interest rates are contrived artificially by the Fed instead of organically by private saving, there is no assurance that the future volume of consumption spending that consumers have planned will be adequate to purchase the goods produced by producers. Producers of slower-gestating goods will suffer losses because their prices will have to fall to unremunerative levels to clear the market. This will lead to business failures, layoffs and unemployment. Ordinarily this cycle would be reversed by changes in interest rates – unless interest rates cannot rise to cut it short. Then producers are in a quandary. The market signals they have come to rely on are now telling them to do things that have just failed. On the other hand, government regulators are telling them they can’t do many of the things they want to do. So they do nothing, or as little as possible.

Free markets have evolved a delicate and complex system of price signals to guide producers and consumers. Prices of goods and services guide us in our purchases from day to day and over very short time horizons. Interest rates guide our planning decisions over significant lengths of time; they are the instrument panel that helps us to navigate a cloudy and uncertain future. But when this system of prices fails or is hamstrung by government, as happened in the Soviet Union and in 1970s America and now under ZIRP, we find ourselves flying blind.

QE3: The Substitution of Politics for Markets

Fed Chairman Bernanke’s justification for QE3 is impossible to take at face value and difficult to rationalize in any favorable way. Evaluated as economic policy, it further accelerates the trend first kicked into overdrive in 2008; namely, the substitution of bureaucratic and political criteria for those of markets. The verbal cosmetics applied to beautify these actions do not mask their flaws. And the emergency rationale invoked to justify them cannot overturn the verdict of history and logic.