Keynesianism, Monetarism and Complexity

January 7, 2010

by James G. Rickards

The debate between Keynesianism and Monetarism is over; they both won. Obama’s approach to the crisis is breathtakingly simple – print money and spend it fast. For Keynesians, stimulus substitutes for private demand until the latter is jump started and stimulus can be reversed.  For Monetarists, the logic is equally simple – increase the monetary base to expand GDP.  Don’t worry about inflation until you see the whites of its eyes. Then withdraw the money after the job is done.  Easy.

But what if Keynesianism and Monetarism are both fatally flawed? The evidence for a Keynesian multiplier is that there isn’t one.  At best it’s fractional, maybe 60 cents for each dollar spent.  Intuitively its hard to see how taking a dollar from the private sector and washing it through government creates any growth at all; experience says that part of the dollar is wasted; evidence bears that out.  For Monetarists, the relationships among money, prices and GDP break down once velocity is considered.  Targeting money against potential 3% real GDP growth is child’s play if velocity is constant.  When velocity drops in hard to measure ways, central banks are driving blind.

Apart from these flaws, Keynesians and Monetarists are wedded to the linearity of stocks and flows.  The idea is that some stock, such as money or deficit spending, can be dialed-up to create some flow, such as GDP growth in predictable ways.  But markets are complex nonlinear systems; inputs and outputs bear no predictable relationship except in sub-critical states.  The key question for policy is whether the financial system is in the critical state, i.e. dynamically unstable.  This is impossible to answer because the computational complexity defies analysis.  But it is possible to say with certainty that we are closer to the critical state than ever because of globalization, derivatives and leverage.  As scale increases parametrically, complexity and risk increase exponentially.  Critical thresholds at which diverse actors reject dollars in a cascading collapse are too near for comfort.  Pushing the system by money printing and deficit spending are not reversible probes but lethal catalysts which may ruin the U.S. dollar and federal finance.

What is needed is what has always worked: sound money, low taxes and light regulation.  This means raising interest rates and all that implies for valuations and bank collapses.  Lower taxes means higher deficits but there is a world of difference between deficits caused by spending and those caused by lower taxes; the former crushes creativity while the latter frees animal spirits.  Light regulation does not mean no regulation.  Reinstating Glass-Steagall and separating deposit taking from gambling would be a good start.  If this medicine causes hardship, use spending to mitigate that with unemployment benefits, food stamps, rental assistance and education, rather than profligate spending on inefficient technology and state jobs.

Keynesian and Monetarist approaches are not merely based on flawed assumptions about multipliers and velocity.  They are dangerous in a complex nonlinear world.  Classic sound policy and a dose of humility are needed now.

James G. Rickards is a writer, lawyer and economist.


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One could add that by crowding out rational economic actors (profit motivated corporations), moneterrorism and keynesian stimulus actually has a negative multiplier as it destroys the real returns of the still existing entities in the economy.

Stimulus that accelerates existing planned infrastructure capex is an exception to this as infrastructure typically has positive externalities, such as roads for examples.

Stimulus should only be applied to economically viable projects that the public sector can only supply. The Hoover Dam was a case in point of good stimulus.

Posted by nick gogerty | Report as abusive

” Pushing the system by money printing and deficit spending are not reversible probes but lethal catalysts which may ruin the U.S. dollar and federal finance. ”

Exactly. Bernanke and Geithner are not NASA operations personel calculating rocket burn times to reach a desired trajectory. Rather they are two guys making complex decisions without the benefit of Newton or Einstein to guide them.

I’d feel more secure with a guy with a background in Pay Day loans running the Federal Reserve these days. Have any of them asked for a ‘bailout’?

Posted by sangellone | Report as abusive

But what if Keynesianism and Monetarism are both fatally flawed? Yes they are…Get out of the way and let the free market work…

“The present crisis is not the result of market failure. Rather, it is the result of governments intervening in or seeking to supersede the market, both internally via loans, subsidies, or taxes and other handicaps, and externally via the IMF, the World Bank and other international agencies. We do not need more powerful government agencies spending still more of the taxpayers’ money, with limited or nonexistent accountability. That would simply be throwing good money after bad. We need government, both within the nations and internationally, to get out of the way and let the market work. The more that people spend or lend their own money, and the less they spend or lend taxpayer money, the better.”

–from “Markets to the Rescue,” Oct. 13, 1998 Milton Friedman

Posted by The Cynical Economist | Report as abusive

neither theory has any predictive power at all with regard to any economic metric. But economics is kind of like Hindu’s arguing with Buddast’s, or Christians with Muslins. Lots and lots of conjecture, lots of discussion, and at the end everybody still believes what they were taught when they were 5.

Posted by fresno dan | Report as abusive

Mr. Rickards should be commended for his application of systems-based thinking to finance. Far too few professionals it seems understand how important it is to look at money, finance, and the economy for what they are – complex systems.

People often fail to realize that ‘complexity’ is not just a term people use to refer to things beyond their level of comprehension. To the contrary, complexity is, if not a formal science, at least capable of formal study. So when someone like Rickards talks about things like “stocks” or “flows” he’s referring to them in a formal sense. One must understand the structure & dynamics of a system in order to have a snowball’s chance in hell of predicting how it might behave or evolve. I think this is what Rickards does very well, and why people could learn a thing or two by paying attention to him.

The thing about complex systems that so few people seem to realize is that they almost all go through perpetual cycles of growth, consolidation, decline, and reorganization. There are many different systems which are continuously going through these different phases which may or may not be synchronized with each other in time and space. The business cycle is different from the credit cycle for example (one is inventory based and typically shorter, the other is money based and typically longer). But the business cycle or credit cycle are just a small subset of the many other systems present on planet Earth. There are systems such as climate systems, sociopolitical systems, energy & material systems, and probably many more that I can’t think of right now.

The important thing that I think most people are missing is the synchronization that currently exists among the most important systems on planet Earth. Look at a chart of population, energy production or consumption, money supply, global industrial output, pollution, species extinction, or any other important variable from say the year 1750 until 2010 and every single one is an exponential curve. If all of these systems are growing exponentially, then the risks posed by the connectivity and interaction of these systems necessarily multiplies exponentially as well.

In biology, Leibig’s Law of the Minimum states that the growth of a system is constrained by it’s scarcest resource. If all systems require energy (defined as the ability to do work), then all systems, be they biological, or human-constructed, are subject to similar tools of investigation.

The question I really wish bright minds like Rickards would ask but don’t seem willing to, is – if the global economy is a system, AND in all systems growth is constrained by it’s scarcest resource, AND Peak Oil occurred in 2008 (which more & more credible analysts believe), THEN, does this mean that the growth phase of this complex system that we call the global economy is over or at least close to being over?

I realize this is a controversial question, given that it explicitly challenges what Rickards and many take to be the primary objective. Probably over 98% of all the discussion about the problems that plague us today, assume the same solution – namely, growth. Only the means by which that solution is achieved is what is debated.

But what if we recognized that in all complex systems, growth is but one phase within a bigger cycle? What then?

Posted by catagenesis | Report as abusive

I think people should understand the concept of demand and supply and then relate these concept with the Monetarism..

Posted by Nick Carter | Report as abusive