Sunday, September 27, 2009

The Resurgence of Keynesian Economics and Interventionism

Guided by the theories of famous British economist John Maynard Keynes and American monetarist Milton Friedman, politicians and monetary leaders throughout the developed world have embraced interventionist policies in an attempt to engineer “soft landings” to economic recessions. Proponents assert that decisive monetary and fiscal policy response following the 1987 stock market crash, the 1990-91 recession, LTCM and the Russian debt crisis of 1998, and the implosion of the technology bubble in 2000 averted otherwise disastrous economic outcomes. Deutsche Bank strategist Jim Reid, however, likened such policy response to the evolution of strategies for fighting forest fires in his September 21, 2009 Early Morning Reid publication. Experts historically prescribed prompt and overwhelming action to minimize the burn area until it was learned that the accumulation of dead wood and foliage throughout the forest creates a tinderbox poised to explode. The misguided attempts to mitigate the damage caused by forest fires, it seems, ultimately lead to destructive blazes that were immune to the tactics and resources of highly trained fire fighters.

The policy tools of interventionists, such as government bailouts, artificially suppressed interest rates, and fiscal largess, lead to a host of undesirable consequences. Fundamental among them are distortions of risk premiums, reduced loss expectations, and the moral hazard inherent in the public assumption of private obligations. Never before has such a broad array of fiscal and monetary policy actions been implemented than the current economic crisis, resulting in serious consequences for future economic stability.

Justified by a desire to maintain employment during recessions, politicians embarked on bailout campaigns for “strategically important” industries. Whether through direct rescues of failed institutions (e.g. automakers, banks, etc) or surreptitious support through subsidies, tax breaks, and protectionism, governmental intervention in the real economy encourages excessive risk taking and prolongs the existence of “dead wood” companies. Failures of private institutions, often a result of inefficient operations or poor risk management, may be temporarily averted, but the societal costs of increased public debt and misallocation of scare capital far outweigh the immediate benefits of sustained employment and economic activity. Perhaps the most costly consequence of governmental bailouts, however, is the perpetuation of beliefs that certain companies and industries are exempt from the harsh realities of competition and creative destruction that define free market economies.

Fiscal Stimulus
A core principal of Keynesian economics is that demand, rather than supply, determines the equilibrium levels of output. The theory suggests that governments must intervene to support economic activity in the absence of consumer or investment demand. While Keynes generally envisioned public works spending to stimulate the economy, governments around the world have embraced spending packages that feature little direct investments in infrastructure but instead are comprised of welfare payments, subsidies for troubled industries, and tax breaks designed to encourage consumption. These programs often fail to reduce unemployment or generate measurable economic benefits. Instead, they exacerbate federal budget deficits, threatening future economic growth by increasing public indebtedness. Fiscal largess may inspire a temporary perception that the government is addressing the economic crisis, but the consequences of ineffective policies and skyrocketing public indebtedness are often misunderstood and drastically underestimated.

Monetary Policy
Monetarists add fuel to the fire by injecting massive sums of cash into the market in order to suppress interest rates and spur economic activity. By lowering the returns on holding cash, policy makers hope to induce consumption and encourage capital investment. Recent monetary easing programs have seen rates approach zero percent, but the impact on economic activity has been debatable. The extensive liquidity injections in the beginning of the decade led to massive asset speculation, both in housing and in mortgage backed securities. In an attempt to achieve higher returns, investors ignored default risk as they ploughed capital into mortgage and credit markets, engendering an easy credit environment that created the housing bubble. Today, monetary policy is even more accommodative resulting in similar signs of excessive risk-taking in credit and equity markets even without a sustained improvement in economic activity.

When The Well Runs Dry
The confluence of Keynesian and monetary interventionism, along with a host of new government programs to aid the housing markets and financial system, have seriously jeopardized future economic stability. Recent research suggests that individuals’ lifetime consumption smoothing preferences, already impaired by a decline in housing and investment wealth, have led to even greater declines in spending as they predict higher future taxes, interest rates, and expected inflation. No company can adequately plan for new investment because the regulatory and consumer demand landscape is constantly changing. For example, the U.S. “cash for clunkers” program rapidly depleted automakers’ inventories, but current results suggest that sales have fallen off a cliff as consumers merely pulled forward future purchases to avail themselves of government largess.

Many of the government programs and interventionist efforts have been designed to provide life support to inefficient companies and socialize private obligations to prevent failure of “systemically important” firms. The government has assumed or guaranteed trillions in private debt in an effort to prop up housing markets, preserve an automobile industry that failed to adapt, and rescue banks from the consequences of their own greed. With unemployment still hovering at or above 10% and economic stability that is tentative at best, the effectiveness of almost $800 billion in stimulus, zero percent interest rates, and a host of bailouts is highly questionable. Policy makers may have secured a temporary reprieve from what would certainly have been more corporate defaults and job losses, but they simply delayed realization of losses on poor investment decisions by inducing liquidity driven speculation in financial securities. The dead wood of underwater mortgages, inefficient companies, and distressed securities remains pervasive leaving the risk of an unassailable fire greater than ever before.