Monday, September 24, 2012

Keynes, Hayek, and Fisher

Most people who follow economic events have some familiarity with John Maynard Keynes and Frederick Hayek.  Both economists were contemporaries at the London School of Economics in the 1930’s and have huge followings in economics and public policy to this day.  People associate the public policies of expanding government during recessions financed through public debt and a weak dollar with Keynes.  They also associate austere government programs and a strong dollar policy with Hayek.  While Barack Obama would be characterized as a follower of Keynes, Ron Paul would be characterized as a follower of Hayek or what is currently referred to as the Austrian school, which was Hayek’s home country where he grew up and first taught economics.   While these two people represent the extremes of contemporary economic thought, there is a third economist that should be mentioned when attempting to understand the major economic event of the last five years.

That person is Irving Fisher who was an economist in the United States in the 1930’s during the Great Depression.  He had a number of followers who elaborated on his work.  Among them was Charles Kindleberger.  These two economists described the mechanisms associated with great financial economic depressions that apply to today’s economics. 

A financial collapse, such as the ones that were experienced in 1929 and 2007, usually begin with an asset that can grow over time faster than the average asset.  Speculators begin to recognize the growth potential and borrow money to buy more of the asset, which in turn, causes the value of the asset to grow at a more accelerated rate.  Financiers begin to see the potential of financing the asset as a growth market and put more funds into the area.  Soon, credit requirements are lowered.  More speculators are enticed by the financing possibilities and more credit is put into the market.  This cycle continues until there are no more speculators that can be enticed into the market to bid up the value of the asset in question.  In other words, there is no more credit that can be drawn into the market to finance the asset.  Either way, the value of the asset will fall leaving vast sums of unsecured credit exposure.  There is a financial collapse and neither Keynes nor Hayek adequately addresses it.

Fundamentally, what do we have here?  Assume that the national economy can be represented by a set of financial statements that a company, whether big or small, would maintain.  There is a balance sheet, which is a snapshot statement of assets, liabilities and equities, and an income statement, which is a summary of revenues and experiences.  Note that the Fisher process focuses on assets and liabilities, or balance sheet items.  It does not focus on employment, jobs, and growth, which are income statement items.

The policy responses of a Keynesian would be to expand government to take up the slack in the GPD.  In short, borrow funds to keep people working, which is an income statement strategy.   It assumes that the income statement would correct the balance sheet, which is rarely the case.   The policy responses of an Austrian would be to assume that the capital markets heal themselves.  In short, the impairment to the capital markets will result in creative destruction.  The economy will heal itself faster though a great many more people being hurt in the process when compared to a Keynesian approach that will not grow the economy much while not hurting as many people.  Both sides of this continuum sound silly, don’t they?

The policy response of the Fisher approach is to repair the balance sheet.  Unfortunately, we cannot do that without betraying a lot of bedrock American principles.  We do not take over banks and forgive the debt of the American public.  We recognize “moral hazards”, and avoid forgiving rational people for rational decisions that ended up badly.   So, how do we get out of this mess?

One thing that should not have been done is to adopt the stimulus program that was executed.  It turned out to be a “make work” program to keep as many people working for as long as it could.  If the President recast it into acquiring assets that could be leveraged for growth, then we would have been better off.  He talked about improving the electrical grid, which would have lowered energy prices and help businesses and consumers operate with lower margins.   He also talked about solar farms and similar things that would have improved our competitiveness globally.  This did not happen and we are left with the debt and not much productive improvement to our base that can be used to pay it down.  The result is more burdens on all of us.  It turned out to be a bad investment.  It still does not answer the question of what we do now.

One thing that should not be done is to increase the taxes on capital, which would be the impact of the current tax plan advocated by the Democrats and President Obama.  Assets need to be leveraged for productive use, and taxing capital will reduce this country’s ability to acquiring productive assets that create jobs.  Tax fairness is a legitimate issue, but cutting off one’s nose despite the face is not the way to go.

The public wants an administration that will increase employment and lower the unemployment rate.   Government has proven itself incapable of achieving this goal.  The business sector is all that is left and that raises the question of how do we make business work without raising our risks of capital destruction in a Fisher asset bubble?  Not totally sure, but the two approaches we have in our major political parties are not producing answers to our problems.   What I am looking for is a pro-growth economic philosophy that includes not just protecting our capital assets but also leveraging them for growth.  So far, I have not seen anyone on the current stage that talks this stuff, though Romney comes closest.

My apologies.  I led you, the reader, through a number of economic alternatives that probably raised the hope of you reading a bunch of easy to remember policy prescriptions only to find out that I don’t have any  -- yet.  I only have a bunch of questions with some clues as to what those prescriptions should be, and the realization that the current crop of answers is inadequate.

Public policy is not easy.  Those who say it is are not being honest.