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.


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

“Reckless Endangerment” and the unwritten history of Washington

Jul 14, 2011 15:45 UTC

Some disclosures: I review the new book, “Reckless Endangerment: How outsized ambition, greed, and corruption led to economic Armageddon”, by Gretchen Morgenson and Josh Rosner, not because both authors are my friends. They are.  Nor do I review this book because it concisely summarizes the confluence of public policy and private avarice we all know as the subprime mortgage crisis. It does, and more.

No, I review this book because it names names. Names and more names, one after another, in that prosecutorial serial fashion readers of Morgenson know very well. The kind of relentless recitation of the facts and names meant to allow readers to follow the logical chain of a criminal act to an indictment.

With Rosner as the ferret of public and not so public data and Morgenson as the journalistic filter and wordsmith par excellence, the book delivers a readable yet detailed account of the people behind the mortgage debacle. When the show trials begin, the judges will have a copy of “Reckless Endangerment” close at hand.

The tale of how Washington played a crucial enabling role in the mortgage mess is a topic I have discussed with Rosner over many years. Morgenson and her fellow scribes at the New York Times have chronicled the debacle on a national scale, though Morgenson does so with a tenacity and sense of public indignation that probably irks some of her more pro-Wall Street peers on the Times’ business page.

This book soundly repudiates the notion that Wall Street led the subprime parade. Instead, it confirms that government intervention going back to FDR and the New Deal set the stage for a public-private orgy decades later. The book describes how government sponsored entities such as Fannie Mae, banks such as PNC Financial, corporations such as Sears Mortgage and private mortgage insurers  such as MGIC, led the way in the fall of 1993 to redefine the government-backed mortgage market, a market that has been backed by the government since the 1930s.

Recall in the early 1990s, when Citibank started to experiment in private mortgage securities coming out of the S&L crisis. Citi, Chase Manhattan and other large banks nearly failed just years earlier. Thus the move by Fannie Mae and the other members of the affordable housing coalition in 1993 to eventually broaden the definition of “conforming loans” to include loans with inferior credit quality and loans with private mortgage insurance is a key political event in the subprime crisis timeline, and also a sop for the big banks. Think of today’s real estate crisis starting in the 1980s, but delayed and made larger by the affordable housing coalition and Alan Greenspan’s Fed. This book tells that story.

Reckless highlights the relationship between former Fannie Mae CEO James Johnson, a Washington player who was a top adviser to Vice President Walter Mondale and former Countrywide CEO Angelo Mozilo. That fateful pairing of Johnson and Mozilo helped take the changes made in Washington to the legal framework of the government mortgage market and catapult them to the stratosphere on Wall Street.

The authors nicely describe how Johnson was the architect of “the disastrous home ownership strategy promulgated by William Jefferson Clinton in 1994. Johnson, after becoming chief executive of Fannie Mae in 1991 and under the auspices of promoting home ownership, partnered with home builders, lenders, consumer groups, and friends in Congress to transform Fannie Mae into the largest and most influential financial institution in the world.” Today, Fannie Mae is under government control again, after decades of being highjacked by various private agendas set by the affordable housing mafia.

The larger banks on Wall Street were not just copying and perverting the government market for mortgages. They also took example from Countrywide, Bear Stearns and the smaller, more aggressive mortgage firms. Countrywide, a firm that was an insurgent real estate company a decade before, grew to the point where by the end of 2005 it was a $250 billion asset national bank that was turning over its balance sheet three times a year.

Countrywide was selling most of that vast flow of new loan origination to Fannie Mae and Freddie Mac, but also sold a large chunk to private investors. Now Bank of America, which acquired Countrywide in 2008 for just $4 billion, faces tens of billions of dollars in legal claims arising from the Countrywide mortgage securitization franchise. Even today, years after the financial crisis began, Bank of America still faces the possibility of a restructuring because of the legal claims against Countrywide.

This fast moving book follows Johnson and Washington contemporaries such as former Treasury Secretary Robert Rubin through the Clinton years and into the mortgage boom years of 2004 and beyond. By then Johnson was sitting on the board of Goldman Sachs, the authors note, and setting the salary for then-Goldman CEO and later Treasury Secretary Hank Paulson. “Reckless” illustrates that people like Johnson, Rubin and Paulson, even when they reach the limit of their incompetence and fail miserably in positions of public trust, still seem to rise in power and private wealth.

“It is indeed one of the most frustrating aspects of this story — the rise of subprime, the dereliction of duty by so many who participated in the mortgage mess,” the authors note in a harmony that reflects both voices. “The cast of characters that helped create the mess continues to hold high positions or are holding jobs of even greater power.”

Hopefully with books such as “Reckless”, the frustrating fact of the impunity of money and power, graphically illustrated in this book, will change, and public officials will again start to act in the public interest — instead of their own.



I have to disagree. Angelo Mozilo was born in 1938 so he would be unlikely to live long enough for your ideas to inflict suffering commensurate with his lifetime achievements.

He should receive a very speedy trial under RICO that results in the confiscation of all of his assets, even those he has carefully hidden away. Then, he should be incarcerated somewhere nice like the Federal Pen in Sandstone, MN where he can spend the remainder of his life cleaning the latrine.

Posted by breezinthru | Report as abusive