New York Times – “Times Topics”

John Maynard Keynes

John Maynard Keynes (1883-1946), the British economist who developed the theory that increasing government deficits stimulate a sluggish economy, was long the guiding light of liberal economists. He is considered one of the major economists of the 20th century. And these days, he is enjoying a comeback.

In his times, he quarreled with laissez-faire economic policies, and with the beliefs that all uncertainty could be reduced to measurable risk, that asset prices always reflected fundamentals and that unregulated markets would in general be very stable.

Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities. And in this fact lay the possibility of huge systemic mistakes.

His basic question was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past (witness all the financial models that assumed housing prices wouldn’t fall) and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic.

Keynes’s prescriptions were guided by his conception of money, which plays a disturbing role in his economics. Most economists have seen money simply as a means of payment, an improvement on barter. Keynes emphasized its role as a “store of value.” Why, he asked, should anyone outside a lunatic asylum wish to “hold” money? The answer he gave was that “holding” money was a way of postponing transactions. The “desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” The same reliance on “conventional” thinking that leads investors to spend profligately at certain times leads them to be highly cautious at others. Even a relatively weak dollar may, at moments of high uncertainty, seem more “secure” than any other asset.

It is this flight into cash that makes interest-rate policy an uncertain agent of recovery. If managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on different types of loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending in the face of an extreme private-sector reluctance to spend, and that was for the government to spend the money itself.

This, in a nutshell, was Keynes’s economics. His purpose, as he saw it, was not to destroy capitalism but to save it from itself. — From “The Remedist,” by Robert Skidelsky, The Times, December 2008

Bloomberg.com

Bernanke May Owe Milton and Anna Another Apology

By Caroline Baum Oct 3, 2012 4:30 PM MT

 “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

-- Ben Bernanke, Nov. 8, 2002

That was how Federal Reserve Chairman Ben S. Bernanke concluded his remarks at a University of Chicago conference honoring Milton Friedman on his 90th birthday. Anna is Anna Schwartz, Friedman’s less famous yet no less significant collaborator who died in June.

In his speech, Bernanke refers to Friedman and Schwartz’s “A Monetary History of the United States: 1867-1960,” published in 1963, as “the leading and most persuasive explanation of the worst economic disaster in American history, the onset of the Great Depression.” Their research, which countered decades of Keynesian orthodoxy on the 1930s, placed the blame for what they dubbed the Great Contraction of 1929- 1933 squarely at the feet of the Fed.

Bernanke read “Monetary History” as a graduate student and became a self-described Great Depression buff. Not convinced the 1929-1933 contraction of the money supply was sufficient to account for the fall in output, he offered an additional explanation in a 1983 paper, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” Bernanke posited that the failure of financial institutions and increased cost of credit intermediation were partly to blame for the protracted decline in output and prices.

Theory Tested

Little did he know that, 25 years later, he would get an opportunity to test his academic theory.

How did he fare? Bernanke may have inadvertently repeated some of the same mistakes of the 1930s, in the view of some monetarists.

The parallels between the two periods are striking, according to Robert Hetzel, author of “The Great Recession: Market Failure or Policy Failure?” In both instances, the Fed attributed the recession to the bursting of an asset bubble and resulting insolvencies of financial institutions. In both instances, policy was focused on facilitating the flow of credit.

“In neither instance did policy makers make any association between a central bank and money creation,” writes Hetzel, a senior economist and research adviser at the Richmond Fed.

The similarities don’t end there. During both the Great Depression and the 2007-2009 recession, policy makers viewed low interest rates as a sign of easy policy. The same goes for the high level of excess reserves, the deposits banks hold at the central bank over and above what is required. The Fed unwittingly aborted the mid-1930s economic recovery when it raised reserve requirements in 1936-1937 to absorb the excess reserves banks were holding as a precaution against bank runs, according to Friedman and Schwartz.

What did the banks do in response? They cut lending so they could rebuild their excess reserves to desired levels.

Lesson learned? Apparently not. Fast forward seven decades, and the Fed started paying interest on excess reserves, “increasing the incentive for banks to hold more excess reserves, just as it did in 1936-1937,” says David Beckworth, an assistant professor at Western Kentucky University in Bowling Green, Kentucky.

He said that in a blog post in October 2008. Beckworth is part of a group of market monetarists who advocate a nominal gross domestic product target for the Fed. Nominal GDP plummeted in 2008-2009. And in the last four years it has grown at the slowest pace since the Great Depression.

New Assessment

It has taken your humble correspondent a few more years than Beckworth to come around to the view that the Fed isn’t running a recklessly easy policy. As I said in an Aug. 1 column, I have started to rethink monetary policy, partly in response to the results it has produced (lousy) and partly in response to recent research (provocative). Because the economy is stuck at sub-2 percent growth, and because the only bang from fiscal policy comes from monetary policy -- unless the Fed monetizes the spending, it’s just a transfer of resources -- the Fed must bear primary responsibility.

The Fed was slow to start easing before the recession even though there were warning signs that policy was tight. The Fed had been raising its benchmark rate in small steps from June 2004 to June 2006, when it reached 5.25 percent. Long-term rates peaked at about that time and headed lower, inverting the yield curve, a reliable harbinger of recession.

Yet the Fed waited until September 2007 to start cutting rates. Shortly thereafter, in December, the Fed announced the creation of the first of many credit facilities to funnel loans to specific sectors and borrowers.

Bernanke was putting his nonmonetary solutions into practice. He was also ignoring Friedman and Schwartz, at least initially, by neutralizing the increase in the monetary base with offsetting sales of Treasuries. The Fed didn’t begin to expand its balance sheet aggressively until after the collapse of Lehman Brothers Holdings Inc. on Sept. 15, 2008. And much of the increase in the money supply merely satisfied the elevated money demand on the part of the public and the banks, which Hetzel documents in his book.

Last month the Fed made an open-ended commitment to buy $40 billion of mortgage-backed securities a month until the labor market improves. Listening to Bernanke explain how this third round of quantitative easing works, it seems he’s still focused on credit policy.

Yes, buying mortgage securities -- actually buying anything -- expands the money stock. But Bernanke sees that as a byproduct, not the focus, of monetary policy.

The Fed needs to get out of the business of ministering to existing or potential homeowners; that’s fiscal policy. Nor should the Fed be selling its entire portfolio of short-term Treasuries in exchange for long-term notes and bonds under the guise of stimulus.

It’s time for the Fed to put the “money” back in monetary policy. Maybe a re-reading of Friedman and Schwartz is in order.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)