Since President Obama was elected, there has been a good deal of interest in Keynesian economics. John Maynard Keynes was a Depression-era economist who’s (arguably) most famous contribution to Economics was the idea that when an economy is in trouble, the government must step in and stimulate job growth by increasing spending. He did not believe that markets were efficient and took things like recessions and depressions as evidence of that.
Recently in the LA Times, Michael Hiltzik writes an editorial entitled “The world still can learn from Keynesian economics“. His basic contention is that free markets led the economic meltdown and that Keynes, having predicted this sort of thing, should be our source of guidance for how to get out.
Needless to say, I don’t agree with Mr. Hiltzik (or Mr. Keynes, for that matter). I’ll take you through his argument and talk about where and why I disagree with him.
Myth 1: The Financial Markets in the US Are Free Markets
The tagline for his article is “Reagan-like faith in efficient markets set the stage for the financial meltdown”. Unfortunately, he mistakes the American financial and housing markets for free markets. They are not. The financial and housing markets are replete with government regulation and intervention. Not only that, the Government-sponsored Entities (or GSEs), Freddie Mac and Fannie Mae, are estimated to be responsible for over 75-90% of the losses to taxpayers from the crisis. These institutions are backed by the Federal Government and underwrite the loans written by commercial mortgage lenders. In other words, they have to approve every loan they underwrite. Here’s an example of the damage these highly regulated firms caused:
“By 2001, it was offering mortgages with no down payment at all. By 2007, Fannie and Freddie were required to show that 55 percent of their mortgage purchases were LMI loans [Loan Mortgage Insurance loans. This means less than 20% down, in most cases] and, within that goal, 38 percent of all purchases were to come from underserved areas (usually inner cities) and 25 percent were to be loans to low-income and very-low-income borrowers. Meeting these goals almost certainly required Fannie and Freddie to purchase loans with low down payments and other deficiencies that would mark them as sub-prime or Alt-A.”
As you can see, they were forced by regulation to set goals that targeted home ownership by those that, most likely, wouldn’t be able to afford it. My point here isn’t to lay blame, but instead to show that regulation does not bring about efficiency. It sets artificial targets with unintended consequences. This is because regulations are created by a few people who, even though they may have honorable intentions, are human.
Additionally, as third-parties, regulators necessarily have different incentives and goals than those who participate in these markets. In this case, the regulators goals were to extend home ownership to low-income people, regardless of ability to pay for the loan. The market participants, banks and borrowers had other goals. Banks goals were to make a profit by loaning as much money as possible, to those who could pay them back. Borrowers goals were to get as low a payment as they could afford and still own a home. Please note, it was in nobody’s best interests to lend or borrow more money than the borrower could pay back, except the regulators, whose goals were around quantity (the number of low-income families that owned a home), not quality (those who could pay for it).
Note how a free market solves both problems. First, it harnesses the intelligence, knowledge, courage, drive and ingenuity of all participants (which can number from 2 to billions). Also, I should define a free market here. A free market, in my opinion, is one where any transaction can take place, participants are not coerced into, nor discouraged from, participation, and where all relevant information is available to all participants. I believe the key here is the availability of information. When that is present, no regulator can hope to match the collective brainpower of a free market.
Second, a free market solves the incentive/goal alignment problem because it allows each participant to achieve their disparate goals. Think of it this way: anytime you sell a stock, you and the person you sell to necessarily disagree on the future returns of that stock. Yet both participants can be happy because their goals are different. Assume the stock is a high risk/high return security. The seller may be somebody close to retirement whose goal is to keep their nest egg safe. The buyer may be a young 20-something looking to maximize returns and who can weather a few losses because he’s got plenty of time. Note they have wildly different goals but can come together in a free market to achieve those goals. If people were regulated like these GSEs, we may have been told we had to invest a certain high percentage of our portfolio in high-risk stocks. That works for some people but probably not all.
The main difference here is that a free market can bring about efficient outcomes (in other words, the best possible outcome) for all participants while a regulated market necessarily creates winners and losers. In software terms, that’s not a bug with regulation. It’s a feature.
You’ll notice that Hiltzik’s article directly contradicts this:
“the financial disaster of recent times was born in the hubris that the financial markets are nearly flawless machines for assessing risk and that government regulation would make them inefficient.”
Unfortunately, we know this isn’t true. It was born in the setting of an artificial agenda by regulators and legislators, as far back as 1978 with the Community Reinvestment Act (or CRA).
Myth 2: Regulation and Government Can Manage Away Business Cycles
His next contention is that a business cycle (the periods of GDP growth and decline) are evidence that markets don’t work:
“‘If you have a self-regulating market,’ Skidelsky explains, ‘you don’t have crashes like this. You don’t have great contractions.’”
(A self-regulating market is a free market)
I won’t pretend to understand the underlying logic of this statement. I do understand that, at the heart of it, the contention here is that a regulated market brings about more efficient outcomes by smoothing the cycle out. When things are going poorly, regulators step in and make them better. When things are going very well, regulators step in and make sure they don’t overheat. Basically, the idea is that regulators do a much better job of managing growth than markets do.
I hope you can see the fundamental danger of that statement. The thought is that people should be insulated from their mistakes and the mistakes of others. No regulator can hope to do away with all mistakes in all transactions. Therefore, their only hope is insulate us from the effects of those mistakes. Any reasonable parent understands the moral hazard inherent in this philosophy. If you raise a child without teaching him the oven is hot when he’s at home, you are likely to see him get severely burned when you’re not around anymore, requiring much more suffering on his part, not to mention potentially more resources.
Similarly, regulators who insulate market participants from the effects of their mistakes only guarantee more mistakes. On the other hand, free markets ensure that participants feel the full weight of their decisions. Those who fail to plan ahead and think carefully about what they do, suffer the consequences quickly and brutally. If they participate again, they do so in a much more thoughtful and careful manner. Unless the consequences of their actions are born by others, which is the heart of regulation.
I found this quote particularly interesting:
“Banks were allowed to enter the securities businesses because surely they know how to manage risk.”
He spends the first half of the article telling us how banks were unregulated and participants in a free market. Then he tells us they were “allowed to enter the securities business”. Not a free market.
Myth 3: Wealth Is A Zero-Sum Game
“Another Keynesian notion suppressed by the free-market lobby was the danger, not to say immorality, of increased income inequality. Skidelsky acknowledges that later Keynesians have made more of this than the master himself, but Keynes did feel that excessive inequality promoted speculation by those at the top of the income scale and reduced consumption by everyone else — a formula for economic stagnation, or worse.”
The inherent thought here is based on zero-sum thinking. The idea is that the amount of wealth in the economy is fixed. So, if I consume 1 more unit, you necessarily consume 1 fewer unit. 1 + (-1) = 0 (thus, the name). This is a fallacy of the highest order. Wealth, unlike matter, can be created and destroyed. For example, say you have an idea for a business. You start it up and convince people to buy your product. Why do they buy your product? Because they either take funds they weren’t using (savings) and use it to buy your product, or they take funds they were using for something else and switch those funds to your product. Either way, they decided they got more value from your product than from saving or consuming something else. In other words, your new product returned more value to them than any other option they had available to them before. Both you and your consumer are better off than when you started. Value (and similarly, wealth) was created. Please note, that value creation and wealth creation are not the same thing nor is wealth creation a guaranteed result of value creation. But the process by which wealth is created is similar to that of value creation.
This zero-sum notion is at the heart of regulation. Regulators believe that if somebody, somewhere is making money, somebody else is losing it and it’s their job to right this wrong. Unfortunately, the task of assigning wealth to others is very difficult to do well and regulators haven’t proven to be very successful at it. Welfare programs incent people to stay in welfare programs, not improve their situation. Willingness to regulate in favor of the underdog leads groups to position themselves as underdogs, whether it be true or not, in order enhance their favor with the regulators, quashing innovation and competitiveness and destroying value.
Free markets are the only truly unbiased entity (if a market can be called an entity). They don’t care about religion, race, sexual orientation or anything else. They favor those with the best information and the willingness to use it. Truly, free markets are blind.
It is my belief that, for the reasons above, Keynes’ ideas lengthened the Depression and caused it to be much worse than it would have been. I also believe the Obama administration is leading us in a similar direction, away from free markets, toward inefficient, regulated markets. As you consider who to vote for in the coming years, I hope you will vote for the candidate of whichever party you believe will most allow the markets to operate freely. To quote my brother-in-law’s blog title, “Free Market, Free People“. Let freedom ring.