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).

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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.