Watching the failure of the “New Economics”

Oct 4, 2011 20:50 UTC

In his classic critique of John Maynard Keynes, “The Failure of the ‘New Economics’,” Henry Hazlitt notes in a passage entitled “Equilibrium of an Ice Cube”:

It is not too difficult to account for Keynes’s misuse of the term “equilibrium” and for the uncritical acceptance of this misuse by so many writers. The older economists thought of equilibrium as an actual state of affairs. They contrasted “stability” with “disturbance,” a “period of equilibrium” with a “period of transition.” But any living economy is always in “transition” – and fortunately so. An economy that had reached completely “stable equilibrium” would be an economy that had not only stopped growing but had stopped going.

The way Hazlitt derides the Keynesian concept of “equilibrium” reflects the view I have developed working with my colleague Dennis Santiago — namely that the human action we call “economics” is a lot closer to the physical concept of entropy than to metaphors such as bubbles.

Entropy is derived from the second law of thermodynamics and is a fancy way of describing the movement of energy in the physical world. We’re not talking the quantum world of atoms here, but rather things you can see and measure — the sensible, classical world as defined by Richard Feynman. A pendulum is an example of entropy, with roughly equal energy moving from one side to another.

Another example of entropy is an ice cube melting in a glass of water in a warm room. The disaggregation of the ice crystals into liquid or the energy spent in the change of state from ice to water and then ultimately into vapor, is entropy. The process is continuous and can repeat endlessly. When the room gets colder, the water vapor condenses and freezes. Think of the Fed trying to turn up the heat in the room when it comes to the US economy.

Entropy is applied to information theory as well as the physical world of people and markets, as when a piece of information is provided to a single agent. The progression of the data to other people mimics the way energy moves through the physical world – and data moves through financial markets. How that information moves from one person to another, driven by the relevance of that data, affects consumers and whole societies.

For classical liberals like Hazlitt, each person or company is free and independent regarding what it contributes to an economy. Call that contribution “energy” using the entropy metaphor. People were not the rational, consistent actors “assumed” by the Keynesian faith for the sake of selling their crackpot ideas, but independent agents.

But by the time Hazlitt stopped writing for The New York Times in 1946 and moved to Business Week, the evolution of US economic thinking toward a more “dynamic”, a.k.a. Keynesian model, was complete. Over the next half century, anything like a free market perspective in American economic thinking became more and more rare as generations of American economists adopted the Keynesian world view of government-managed economies and endless public debt.

Why did the Keynesian faith win out? Economist salesmen like Keynes focused on the future, a perfect formula for the political class to use to drive growth well into the 1990s. This Keynesian message of growth via inflation and debt was also perfectly aligned with the message produced on Wall Street of ever rising earnings growth and stock prices. With the Keynesian revolution, however, also came debt, inflation, and progressively larger and larger financial and economic busts.

In his new book, “Where Keynes Went Wrong and Why World Governments Keep Creating Inflation, Bubbles and Busts“, Hunter Lewis attacks Keynesian economic thinking when it comes to the role of the state in the economy and more. In an overt tribute to Hazlitt, Lewis wastes no time in calling out Keynes as an elitist who really had contempt for free individuals and markets.

Lewis divides his work into three opening sections, including a review of Keynes’ writings and statements, and then a discussion of how Keynes’ economic ideas went badly wrong. Lewis relates the abandonment of traditional American economic values to current events, and the shameful behavior of President George W. Bush following the 2007 financial crisis.

President Bush famously said to conservative critics: “I’ve abandoned free market principles to save the free market system.” He was talking about authorizing useless fiscal stimulus and bailouts for Wall Street banks. Lewis asks: “How exactly did Bush know that his actions were necessary or that they would prevent the worst? How could he be sure that his actions would not make matters worse, either immediately or over time?” How, indeed.

The answer, Lewis says, is because of Bush’s economic advisers — Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke. These men are adherents of the neo-Keynesian faith which, in bad times, says to increase spending and monetary policy, whether funded with tax dollars or debt. The predominance of the Keynesian world view is so complete, Lewis argues, that policy makers in Washington from Bush to Barack Obama see policy responses “through a Keynesian lens,” to quote economist Gregory Mankiw of Harvard.

For Americans and any other people who value personal freedom, the work of J.M. Keynes ought to be anathema, not a widely followed and respected economic rule for policy. Hunter Lewis provides an excellent overview and refutation of Keynes’s work that informs readers who are trying to understand the roots of the economic crisis affecting us and and provokes them to participate in the solution.

COMMENT

Where Keynes went wrong????

This is like reading about an eight hour long film of economic GOP policy picking its nose and Libertarian critics acclaiming it as a profound examination upon the contemporary economical condition. Deeply moving.

I would say that Mr Hazlit needs to Occupy something else (why not Wall Street) rather than babble the same ad nauseaum right wing rhetoric.

Posted by elsueco | Report as abusive

Can Barack Obama channel Teddy Roosevelt?

Sep 9, 2011 14:50 UTC

My copy of the new book “Feynman”, written by Jim Ottaviani and illustrated by Leland Myrick, arrived last week and does not disappoint. I discussed it earlier on Reuters.com, “Steady state or dream state?” On the second page of this comic narrative led by one of the most remarkable personalities of the 20th century, Feynman asks:

Different theories of physics are very similar. Maybe that’s just because of our limited imagination … We try fitting every new phenomenon in the framework we already have! … Maybe it’s because we physicists have only been able to think of the same damn thing over and over again. Of course another possibility is that it is the same damn thing over and over again.

I read the words of the great American physicist last night as President Barack Obama was proposing yet another fiscal stimulus plan to a joint session of Congress. Basically Obama gave the same speech as last time and, again, largely avoided discussion of housing or banks. Indeed, the Obama Administration has been fighting against change since the President took the baton from George W. Bush. Witness Dodd-Frank, TARP, HARP, HAMP and various other deliberately ineffective policy initiatives from Washington supposedly focused on the banking and housing sectors.

A decade after the 9/11 attacks and the subsequent boom and bust in the housing sector, Americans remain unwilling and unable to embrace economic change – or to respond affirmatively to this change. Perhaps the biggest change facing us is the ongoing deflation of the bubble economy, which is manifested in stark terms by the reduction in both demand for and the supply of credit. Until we break the cycle of deflation, employment and economic activity will not rebound.

Both Washington and Wall Street remain defiant in their refusal to accept that there are probably still as many losses to be taken on housing and related securities as have already been recognized to date. And there is no concession among America’s political oligarchy that existing banks must be restructured in order to fix housing, restart credit creation and avoid economic catastrophe.

Pollock’s first law, named after American Enterprise Institute resident scholar Alex Pollock, states that debts which cannot be paid must default. In an upcoming article in Mortgage Banking Magazine, he notes that the political class resists real change in existing structures and debt:

Because this iron law and its implications are highly unpleasant, financial actors and politicians strive mightily to escape them, in spite of the fact that they cannot, with scheme after scheme. All to no avail, of course. The massive losses must ultimately be taken. So the questions are not: Will the loans default? They will. Or: Will the losses be huge? They will be. The only real questions are: What form will the defaults take? Who will take the losses? And when will the losses be recognized by those who are going to take them?

Notice that there was barely any mention of broad mortgage refinancing in President Obama’s speech last night, merely a comment about more emphasis on helping profoundly under-water borrowers via the HARP program. But without relief for the millions of home owners that cannot refinance their homes, the economy will not recover and many of these borrowers are likely to turn into future defaults. More defaults mean more deflation, fewer jobs and social instability.

The real world impact of the studied inaction by President Obama can be seen in the increasingly desperate situation at Bank of America. The bank has been selling assets willy-nilly and now has threatened to start closing branches and laying off 42,000 people, Reuters reports. Yet as I discussed in a previous post on Reuters.com, “Housing, debt ceilings & zombie banks,” Bank of America’s parent company needs to be restructured. See my discussion with Aaron Task and Henry Blodget on The Daily Ticker about how a BAC restructuring ought to proceed.

If President Obama was really concerned about jobs, he would pick up the phone and order Treasury Secretary Tim Geithner to start discussions with BAC about a voluntary restructuring with government and industry support. With Geithner, Fed Chairman Ben Bernanke and FDIC Chairman Martin Gruenberg standing around, the President would tell the American people that the bank subsidiaries of BAC are sound, that there will be no layoffs, and that the White House and Congress are directing Fannie Mae and Freddie Mac to move aggressively to refinance every performing American borrower who wishes to do so.

But of course this would require Barack Obama to get some new advisers, grow a set of cojones and start channeling President Teddy Roosevelt — and that is probably not going to happen. Just remember, Mr. President, that inaction does have a cost.

 

 

 

 

COMMENT

I just read an article about Obama channeling Franklin Delano Roosevelt. If I am not mistaken, and I am only going by the information provided to me in school, both Franklin Roosevelt and Teddy Roosevelt are dead and channeling is described as : the practice of professedly entering a meditative or trancelike state in order to convey messages from a spiritual guide. This article confuses me more than enlightens me.

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