23 February 2008

Time for Neo-Keynesian Economics

We're all Keynesians now."
- Richard Nixon

The Tipping Point for Crisis: When Actors in an Environment Become the Environment
When Long-Term Capital Management (LTCM) was formed, the founders were intent on making monster money. LTCM’s board included two Nobel Prize winning economists. For a few years, they had annual returns in excess of 40%, before losing more than $1 billion a month for about four months in 1998 and folding in 2000. It is not just LTCM that collapsed. UBS was founded in the mid-18th century; because of the money it lost betting on LTCM, it would have likely collapsed had it not “merged” with Swiss Bank. LTCM was so heavily leveraged that it hurt lots of firms when it imploded.

LTCM’s method depended on fairly complex algorithms and a simple idea: use historical data to determine fair spreads between, for instance, various kinds of bonds. Using this data, they bet on particular convergence trends. And they bet heavily. They had leveraged about $4 billion with about $120 billion in loans. (If you are confident that you can make 6% on money you borrow at 5%, the only thing that limits the amount of money you can make is the amount of money you can borrow.)

The problem was, they were successful. Not only did they grow, but others began to imitate them. Suddenly, LTCM had changed the environment they’d assumed to be stable. The historical trends and relationships had changed because LTCM and their imitators assumed that these relationships would not change. You might say that one ingredient for creating a crisis is for the actors in an environment to change that environment in ways that obsoletes the old assumptions. At a certain point, one is no longer weaving in and out of the slalom poles but is, instead, weaving in and out of other skiers who are also moving. To put it mildly, this changes things.

Managing a system depends on clearly distinguishing between the environment, the system, and the parts. In LTCM’s case, their system grew to encompass the environment and then collapsed. A similar thing might be happening with regards to economic policy; globalization has changed the line between the system (nations and their policies) and the environment (the global economy).

Time for Neo-Keynesian Economics
John Maynard Keynes defined modern economic policy. His ideas are still genius, but given that the system boundary has shifted from nation to globe, his ideas need to be updated.

Keynes made a small fortune trading stocks while having breakfast in bed. A recent college graduate, his response to missing questions on his civil service exam on economics was, "Hm. How odd. I must know more about economics than they do." And Keynes was the first to articulate a theory that explained how it was that the actions best for households or firms might not be best for the whole - the macro - economy.

Put simply, Keynes invented macroeconomics. Before him, there was only microeconomics, but no one knew it was micro. The pre-Keynesian view didn't really distinguish between what drove optimal behavior for firms or households and what drove optimal behavior for the economy as a whole.

His insight seems simple now. Indeed, like other brilliant ideas such as representative government and gravity, his insight now seems obvious. He pointed out that a slumping economy could make it rational for firms to spend less - saving money by spending less. However, when firms spend less, households have less income, so they, too, spend less. As households spend less, firms spend less. As firms spend less, households spend less. When everyone does what is good for the individual, the result is something that is bad for the economy. (Which is, of course, bad for individuals.) Keynes said that the government could reverse this by spending money, lowering interest rates, or injecting some cash into the system. As it should be, this has become accepted and is now common practice in most every country.

Keynes invention of macroeconomics arose from a distinction between the behavior of systems and their parts. He looked at the whole system and made conclusions that seemed counterintuitive at the level of parts.

Keynes, however, wanted limits to capital flows between countries. For him, the system of consequence was the nation-state; his definition of macroeconomics was a prescription for national economic policy. His system was the country.

And yet today’s economy is global. We live in a post-national economy. Many Americans are about to receive checks as part of a stimulus package that gained broad support among all parties in DC. This package will be financed by loans from China and will be used to buy goods from China. Keynesian economics might not work as planned.

Worse, all this teeters on top of global financial markets that no longer have proven mechanisms for stability – like the mechanisms created by Keynesians to stabilize national banking systems and financial markets during the last century. Given how tightly coupled markets now are – a crisis in Thailand can quickly create a crisis in Brazil’s stock market – any attempt to devise system-level controls and checks suggests the need for neo-Keynesian policies that directly deal with the global economy we’re in.

It’s time for a neo-Keynesian economics. This will probably be less a matter of formulating new philosophy than putting in place new mechanisms, agencies, and regulations that do for the global economy what Keynesian economics have done for national economies.


Gypsy at Heart said...

I can't believe I actually understood that. Guess this means I feel another Kung Fu - Grasshopper moment coming on. How well you've explained this Ron. I'm so impressed. You are the master at distilling information for the layman like me.

David said...

My recent reading indicates the US politically transitioned from Keyesian economics in the late 1970s (Kemp-Roth et al) and I'd call it neo-K but I see you don't? Greenspan doesn't call it that but validates the change from pure K economics. I like your ideas about new mechanisms and regulations and maybe even a few agencies if they're not US government-run.

Ron Davison said...

Thanks. And if I succeeded at explaining things to a layman like you, it is only because I, too, am a layman. I've realized that I dont' really have an expertise - certainly not in economics. But this is the beauty of blogging, no? No expertise needed.

Keynesian economics has evolved, but it still seems consistent with his original principles. And to be fair, there are international agencies working towards goals of financial stability across national markets, but it seems pretty ad hoc and crisis driven to me.

cce said...

Gasp...it must be Monday and I can't wrap my head around this one. But I'll just sit here sipping my tea and smile in a knowing way because that's all I can do when the talk turns to global economic markets. Glad to be back here even if I've got nothing much to offer today.

David Lee said...

The thing I find most disturbing about Keynes is his views on long term economics (or lack thereof). He is noted as saying one of the most famous economic quotes, "in the long run we are all dead."

Keynesian economics, in my interpretation, fails due to the disregard of the free market. The free markets in the past have been empirically proven to be more stable and successful than the restricted/regulated markets. See Hong Kong for example. John Stossel proved that it only takes about five minutes to start a business in Hong Kong, which is why Hong Kong has a thriving economy.

I do not believe economies should be "run" in the way that a Keynesian--or any branch would "run" it. As seen in the Simi Valley Republican debate, when asked "how you would manage the economy," Congressman Ron Paul answered, "the government is not supposed to run the economy, the people are supposed to run the economy."

It is this regulation and intervention that gets our economy into the slump in the first place. The current standard of policy nowadays is to add even more involvement, such as lowering the interest rates and giving rebate checks. This may provide short term benefits, which is great news for a Keynesian economist, though the long term consequences are often disregarded. In this case, the long term consequences include a significantly devalued dollar, an extended recession, and economic instability.

The discontinuation of M3 statistics by the Federal Reserve is seen by some as a cover-up for the actual empirical data that proves a greater devaluation rate than the Fed currently reports. I read a seemingly qualified report by a third-party company that estimated the current inflation rate on M3 to be upwards of 17% (based on six-month sampling).

It appears that after Greenspan left the Federal Reserve, the economy has become more unstable and the patterns of regression have started to decrease. Some blame this on the business cycle, which is true to a certain extent. The business cycle is partly to blame for this, though the depth of this has been increased through failing economic policies.

In closing, I would like to give my respek to Milton Friedman.

Ron Davison said...

glad to have you back.

David Lee!
Welcome to R World.
Keynesian economics is not the same as big government. In fact, Keynes would have shook his head at sustained deficit spending through an expansion. And I agree that too many regulations make it hard to expand business. But having said that, the thought of an economy without rules seems to me like a football or hockey game without officiating. We don't want the referees to play the game (the story of communism) but we don't want it played without referees (the story of robber baron capitalism).