Wednesday, January 02, 2013

The Dangerous Blindspots of Clueless Keynesians

The Keynesian model is a Cargo Cult, mired in a distant, romanticized past where Central Planning, intervention and manipulation were solutions rather than the root of the economy's fatal disease.

If we want to trace today's policy failures back to the source, we find ourselves at Richard Nixon's famous statement that "We are all Keynesians now." The fundamental Keynesian project is that the Central State and Central Bank should manage market forces whenever the market turns down.

In other words, the market only "works" when everything is expanding: credit, profits, GDP and employment. Once any of those turn down, the State and Central Bank "should" intervene to force the market back into "growth."

The Keynesian has two basic tools: the State can borrow and spend money (fiscal stimulus) and the Central Bank can create money and "inject" it into the economy (monetary stimulus): quantitative easing, lowering interest rates, extending unlimited credit to broker/dealer investment banks and financial institutions, etc.

The sharper the downturn, the greater the State/Central Bank intervention. This accounts for the martial analogies of State/CB responses: "bazookas," "nuclear option," etc., as the market is overwhelmed with ever greater fiscal/monetary firepower.

After basically voiding the market's ability to price risk and assets, the Keynesians believe the market will naturally resume pricing risk and assets at "acceptable to Central Planning" levels once fiscal and monetary stimulus is dialed back.

The entire Keynesian Project has numerous blindspots. When reality inconveniently fails to meet Keynesian expectations, reality is ignored or massaged to suit the Keynesian Cargo Cult's belief system.

For example, the Grand Poo-Bah of the Keynesian Cargo Cult, Paul Krugman, loves to repeat that massive fiscal-stimulus deficits haven't raised interest rates, confounding doomsdayers, but he never mentions the Federal Reserve's role in this magic: what would interest rates be if the Fed wasn't buying hundreds of billions of dollars of Treasury bonds every year?

The honest position would for Keynesians to state that the Central Bank's role is to print money to enable unlimited, fiscally reckless spending by the Central State. But dishonesty is a modest Keynesian fault compared to the blindspots in their core policies.

Here is a partial list of Keynesian blindspots:

1. The Keynesian Model no longer works; it is counter-productive and destructive.
2. Markets that have been managed by the Central State/Central Banks are broken and no longer function in pricing risk and assets.
3. Keynesians are incapable of recognizing opportunity cost: the money they borrow and squander on sinkholes is no longer available for productive uses.
4. Keynesians are blind to the difference between an investment that yields a positive return and a sinkhole that sucks scarce capital away from productive uses.
5. Keynesians are incapable of recognizing institutionalized moral hazard is the inevitable consequence of flooding the financial sector with cheap, easy money.
6. Keynesians are blind to the fact that cheap, easy money at near-zero rates destroys the premium on real capital (saved cash), fatally distorting the economy and finance.
7. The Keynesians are blind to the eventual consequences of higher interest rates on rapidly rising sovereign debt. What's left of the private market for bonds eventually recognizes that Central Planning has pushed the risk of default or currency depreciation much higher. That will push interest rates higher, unless the central Bank buys essentially all newly issued Treasury debt.

Regardless of who buys the debt, increasing sums of national income are diverted to pay interest on debt taken on to fund marginal-return Bridges to Nowhere, starving the State and economy of income and investment capital. Default is the only possible endgame when debt rises faster than income and productivity.

8. Keynesians are blind to diminishing returns: ever-higher debt produces ever-smaller returns.

I have often identified Keynesian economists and the Federal Reserve as cargo cults.

After the U.S. won World War II in the Pacific Theater, its forces left huge stockpiles of goods behind on remote South Pacific islands because it wasn’t worth taking it all back to America.

After the Americans left, some islanders, nostalgic for the seemingly endless fleet of ships loaded with technological goodies, started Cargo Cults that believed magical rituals and incantations would bring the ships of “free” wealth back. Some mimicked technology by painting radio dials on rocks and using the phantom radio to “call back” the free-prosperity ships.

The Keynesians are like deluded members of a farcical Cargo Cult. They ignore the reality of debt, rising interest payments and the resulting debt-serfdom in their belief that money spent indiscriminately on friction, fraud, speculation and malinvestment will magically call back the fleet of rapid growth.

To the Keynesian, a Bridge to Nowhere is equally worthy of borrowed money as a high-tech factory. They are unable to distinguish between sterile sand and fertilizer, and unable to grasp that ever-rising debt leaves America a nation of wealthy banks and increasingly impoverished debt-serfs.

The Cargo Cult faithful do not understand diminishing returns: at some point, the interest on skyrocketing debt drains income and capital from potentially productive investments to pay for previous unproductive spending on fraud, friction and malinvestments, starving the economy of productive investment.

"Free money" creates moral hazard, which means that those who can borrow money for almost nothing and never have to pay it back act entirely differently from those paying market rates for money and backing their loan with real collateral that is at risk.

The Keynesian definition of Heaven is World War II, because that war "proved" that digging a gigantic hole (global war) and filling it with trillions of dollars of borrowed money is the perfect (and perhaps only) way to create enough "aggregate demand" to lift an economy out of depression.

What clueless Keynesians cannot see is that World War II was a one-off and cannot be duplicated. The Global War "solution" had a key characteristic that is almost universally ignored.
Depression-era calls to bulldoze homes to be rebuilt and destroy grain so it could be regrown were rightly dismissed as malinvestment on a vast scale. But war is more or less an equivalent malinvestment on a grand scale. Hundreds of ships were built and then sunk, thousands of aircraft were built and then shot down or lost, and monumental mountains of provisions and supplies were manufactured and then either consumed or lost to enemy submarines, bad weather, rot and a host of other causes.

At the end of the war, most of the leftover goods manufactured--ships, tanks, aircraft, munitions, etc.--were mothballed or scrapped.

Despite this staggering waste, the war spending launched a long boom. How did it work this magic? One, it constructed new plant; unlike the Keynesian calls to bulldoze houses so they could be rebuilt, the war investment created factories that could then be converted to produce goods.

More importantly, the war spending created a vast pool of private capital--what we call savings. As resources were diverted to the war effort, rationing limited both the manufacture and availability of consumer goods. Meanwhile, tens of millions of people were put to work, either in the Armed Forces or in the war manufacturing sector, and most had few opportunities to spend money. Industrialists also piled up war profits.

Though the 1930s Central Planning extend-and-pretend policies did not write off the overhang of debt that had depressed the economy and destroyed the market's ability to properly price risk and assets, this gargantuan pool of private capital simply overwhelmed the remaining debt overhang.

Third, trust in the system was restored: the Federal government had effectively "won the war" by printing money and drawing upon the nation's vast surplus of energy and labor, and the manufacturing and financial sectors had been brought to heel by the extraordinary demands of the war and by legislation that had responded to financial fraud and over-reach of the late 1920s.

Keynesians are blind to the fact that the root of "capitalism" is capital. Capitalism requires two fundamentals--capital to invest and open markets for goods and services that transparently price risk, assets, hedges and goods.

Note that debt, and fiscal and monetary intervention are not essential to capitalism. Indeed, if we explore the roots of modern capitalism in the 14th and 15th centuries, we find that commercial credit and hedges were the key ingredients of success, not debt. Lacking sufficient coinage to handle the rising volume of trade, merchants settled accounts at the great trading fairs in Europe.

Long, risky trade voyages were hedged with the equivalent of options and limited stock companies that distributed risk for a price. Leverage was limited by the transparency and appetite for risk.

Compare that with Bernanke's Keynesian policies, all of which severely punish savers (i.e. the accumulation of capital) and reward leverage and debt. By lowering interest rates to zero, Bernanke has imposed the opposite of the World War II experience of forced savings--he has made cash into trash and pushed everyone into risk assets.

By making credit dirt-cheap and backstopping financial-sector losses (i.e. institutionalizing moral hazard), Bernanke has destroyed the market's ability to discipline malinvestment and openly price risk and assets.

World War II launched a boom precisely because private capital accumulation/savings were enforced; when the war ended, there was a vast pool of capital available for investment and consumption.

Keynesian policy is to punish capital accumulation and reward leveraged debt expansion. Rather than enforce the market's discipline and transparent pricing of risk, debt and assets, Keynesians have explicitly set out to re-inflate destructive, massively unproductive credit bubbles.

This is why the Central Planning Keynesian policies has failed so completely, and why they will continue to fail. The Keynesians are not engaged in capitalism, they are engaged in the destruction of capital, productive investment and the open pricing of risk, debt and assets. The markets are not allowed to price risk, capital and assets, so the economy is crippled. The Keynesian model is a Cargo Cult, mired in a distant, romanticized past where Central Planning, intervention and manipulation were solutions rather than the root of the economy's fatal disease.

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