05/06/2010: Mr. Keynes and the 21st century

“I am now a Keynesian in economics”

– Richard Nixon, 1971

“I have argued today that improved monetary policy has likely made an important contribution not only to the reduced volatility of inflation (which is not particularly controversial) but to the reduced volatility of output as well. […] This conclusion on my part makes me optimistic for the future, because I am confident that monetary policymakers will not forget the lessons of the 1970s.”

– Ben Bernanke, 2004

Those two quotes make the same implicit statement: “we know how to correctly handle the economic cycle.” Both quotes came after long periods of very low growth fluctuations in the US. Both quotes were to some extent proven wrong.

In the early 1970s everyone, even Richard Nixon, was “Keynesian”, i.e. embracing the mainstream interpretation of John Maynard Keynes’ (1883-1946) General Theory. This interpretation stated that the government could smooth business cycle fluctuations by using both fiscal and monetary tools. Whether this is what Keynes really meant, remains an open debate between the different schools that emerged after the Keynesian revolution in the 1930s. Nevertheless, what seemed to work in the 1950s and 1960s was blatantly contradicted in the 1970s with the emergence of the stagflation, i.e. a period of stagnation/recession and a high inflation rate, something not anticipated by the mainstream economic theory.

In the early 1980s, after the great US inflation ended, a new economic policy consensus emerged: “keeping inflation and budget deficits under control” and creating the right “low tax, low government, highly deregulated” environment to boost both entrepreneurship and growth. Interestingly enough, this environment was looking more and more like the one of the Roaring Twenties before the Great Depression. It now seems to have ended abruptly in the 2007-2008 financial crisis.

Keynes came back in fashion through the Minsky moment

Some economists warned that the environment we enjoyed over the last 25 years and called the Great Moderation could lead us to a similar juncture as the Great Depression, trough a “Minsky moment.” Hyman Minsky, one of the most original Keynes’ followers and interpreters, demonstrated that the existence of economic stability itself encourages excessive credit creation, leading to, first, financial instability and speculative euphoria, then credit restraint and contraction, and finally, economic contraction and volatility, i.e. the chain of events that we are currently experiencing.

Which led straight into a liquidity trap

The credit restraint went so far as completely clogging the credit channels. We are now in a situation defined as a liquidity trap. Central banks may cut interest rates close to zero (something that is currently happening around the globe), but it has no impact at all on the economy because financial intermediaries are reluctant to give credit. A more severe form of the liquidity trap would be that even if financial intermediaries were willing to lend at those interest rates, companies and/or households would be reluctant to borrow. This reluctance can have several reasons, like uncertainty and risk aversion about future prospects, already high indebtedness, and worst of all: deflationary expectations.

If you are expecting prices to come down in the future, then interest rates might be quite high even at zero because what matters in an investment/consumption decision is not the nominal, but the real interest rate, i.e., the interest rate minus the expected inflation rate (or plus the expected deflation rate). According to the traditional Keynesian theory, environments characterized by low interest rates and liquidity traps are especially favorable for the other government tool beside monetary policy: fiscal policy through deficit spending.

Does fiscal policy work?

Japan at the beginning of the 1990s was in a similar situation as the US and parts of Europe are today. The bursting of both the housing market and the equity bubbles led to a deleveraging of the Japanese banking sector, which induced a severe credit crunch and pushed the Japanese economy into a recession. Reluctant at first, the Bank of Japan slashed interest rates to zero, but Japan was caught into a liquidity trap, where this no longer had any impact at all. Fiscal policy had to take the lead. The fiscal impulses were quite impressive: between 1991, the year Japan went into recession, and 2000, the year it finally emerged, government debt increased from 70% to 140% of GDP. But in the same period, real GDP just stagnated. It was by 2000 only 10% higher than ten years before. In hindsight, this period was called the lost decade.

For many economists, this is a sign that fiscal policy is not a blank check for success. In his new book, “The Return of the Depression Economics and the Crisis of 2008,” the 2008 Economics Nobel Price winner Paul Krugman explains what happened in Japan: the fiscal impulses “didn’t get enough bang for the yen” and the policy was not a consistent one. Years with high deficits were followed by years where fiscal responsibility prevailed leaving the impression of a “stop and go” type of policy.

However, Nomura’s Chief Economist Richard C. Koo argues in his 2008 book, “The Holy Grail of Macroeconomics – Lessons from Japan’s Great Recession,” that the tremendous fiscal impulse avoided a much deeper recession for Japan, which “successfully avoided economic apocalypse for 15 years. But from the perspective of the media [...] the government spent 140 trillion yen, and nothing happened.” The debate remains open.

While fiscal policy might be a good idea in an environment, which is obviously characterized by a liquidity trap, there are several shortcomings to keep in mind and which we have learned in the experiences of the 1950s-1960s.

How to spend it

What type of expenditures should be used, i.e., where would we find the most growth bang for the government buck? Tax rebates like the ones, that were already implemented in the first half of 2008 might be the fastest way to boost the economy. However, as was experienced this year, the effects were far less conclusive than expected. Moreover, one of the main problems, which led us into the current crisis, was the over-consumption, under-saving and large indebtedness of private households in the US.

Boosting their consumption will therefore just delay an over due correction of imbalances. Infrastructure expenditures seem the next obvious choice. They have the moral advantage that while financed by debt creation, i.e., something future generations will have to pay, they will also profit future generations. However, more often, large government-sponsored infrastructure projects have lead to earmarking and bridges to nowhere.

Another lesson learned in the 1950s and 1960s was that deficits meant to be cyclical became almost always structural in the end. Once a recession was over, government expenditures didn’t come back and deficits didn’t switch into surplus. According to the US Congressional Budget Office, only five years out of 45 between 1962 and 2007 showed a fiscal surplus. The period 1998-2001 remains a striking exception in US history.

With roughly a 3.5% yield on 10-year US Treasury paper, financing its budget deficit is especially cheap for the US government. But at some stage in the future investors might suddenly become nervous about the towering deficit and the debt-to-GDP ratio accumulating in the US, and elsewhere. And this realization might lead them to exit the government bond market as fast as they entered it as a safe haven during the financial crisis. This would turn today’s favorable picture on its head and lead to sharply higher interest rates and lower bond prices. Higher interest rates in turn would be dismal for a fragile economic environment.

John Maynard Keynes is back. But let us just hope he is not back in the malfunctioning interpretation of his work in the 1950s and 1960s. Because to quote him: “The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.”