The Bubble Economy

Two rap videos eloquently explain the difference between Keynesian and Austrian School economics.  The first is called “Fear the Boom and Bust,” and can be seen in the link below.  Keynes raps before Hayek (and most of the people reading the Daily Libertarian are apt to prefer Hayek), so be patient.

The second is a sequel called “Fight of the Century,” and can be seen here:

These raps are brilliant, and they cover all of the basics of both schools of thought.

In a nutshell, Keynes believed that Aggregate Demand (AD) was everything, and that it was comprised of Consumption (C), Investment (I), Government Spending (G), and the balance of trade (Exports (X) minus Imports (M)).  The formula is: AD = C+I+G+(X-M).

Keynes makes no differentiation between the relative importance of consumption, investment, government spending, and the balance of trade (exports minus imports).  To Keynes, the only part of the equation that matters is aggregate demand – anything that boosts that number also boosts the economy.  Keynes, however, never actually studied economics.  He believed that whatever economists before him had come up with was worthless; he was going to re-write the entire profession from scratch, making all other economic thought obsolete.

Hayek, from the Austrian School of Economics, was one of the economists Keynes believed to be obsolete.  Hayek believed that economies always strive toward balance, and that it was impossible to know where that balance should be (he called this ‘the pretense of knowledge’), so the best way to find balance is to simply leave the economy alone.

Hayek believed that people were, for the most part, rational, and that we will, for the most part, rationally pursue our own individual (or family) interests.  Keynes believed that people were inherently emotional, and that emotionality rather than rationality was the primary motivating force behind economic activity.

Keynes believed that economies go into boom and bust cycles because of emotion.  When people’s collective emotion turns negative, for any reason, they hold onto their money, crashing the economy.  Keynes prescribed government spending to make up for any drop in consumption.  Government could, according to Keynes, also make both consumption and investment cheaper, by manipulating interest rates.  In this view, the economy is like an engine that ‘we the people’ tend to drive into the ground.  We require a large and active government to keep things running smoothly.

To Hayek, the economy is not like an engine at all.  Hayek said that the economy is nothing more than the organic activities of everyday people living their lives.  Government spending does not ‘balance’ the economy, but rather throws the economy out of balance, creating bubbles that will eventually burst.

These views are diametrically opposed.  Keynes focused on the bust part of the boom/bust cycle and tried to correct for it, whereas to Hayek, the boom was the problem.  When booms are bubbles, those bubbles burst, causing recessions.

The core difference was actually in how interest rates work.  Hayek, believing that people act rationally, expected interest rates to set themselves, or, as he put it, “the market coordinates time with interest.”  To Keynes, since people are emotional actors, interest rates move irrationally, requiring government to control them.  Interestingly, Milton Friedman (The Chicago School) largely agreed with Keynes on how interest rates work, though he agreed with Hayek on almost everything else.

The truth is somewhere in the middle.  Each industry in the economy has its own boom and bust cycle, and emotions tend to balance out, leaving rational thought as the predominant factor in both interest rates, and in supply and demand curves.  If an economy is overly reliant on a small number of industries, it is possible for the regular boom and bust cycle to cause a recession, but for a diverse economy, like what the United States has, different industries go into booms and busts all the time, and they cannot, by themselves, all go into a boom or a bust at the same time.  Only three things can cause the entire economy to go into a boom or a bust, all at once: natural disasters, rapid and unexpected changes in the value or supply of money, and government policies.

It is not hard to figure out how natural disasters can throw an economy into recession, but there is a correlation between the size of an economy and the size of the natural disaster necessary to cause a recession.  Hurricanes and tornados won’t do much to our economy, except locally, where those events occur.  We recover very quickly from these events as a result.  The Dust Bowl would have caused a recession in the 1930s had we not already been in a depression (which the dust bowl contributed to).  Our economy is much larger now, and less reliant on agriculture, so I don’t know that a dust bowl like that of the 1930s would cause a recession today (except locally), but nor would I want to find out.

When the value or supply of money changes unexpectedly and/or rapidly, it can cause the entire economy to go into a period of price discovery, all at once.  Most recessions are caused by this.  The severity of the recession will be directly related to the level of change in the value or supply of money, as well as how unexpected the change was.

It is important to note that the value of money and the supply of money, while related, are not the same thing.  When we were on the gold standard, the value of money was tied to the value of gold.  If gold supplies changed, and the value of gold fluctuated compared to other things, it could cause a recession.  Printing too much money, relative to gold holdings, could cause a run on the money supply, with people rushing to trade money for gold out of fear that the government would run out of gold.  If the government did run out of gold, it could cause a depression.

With a fiat currency, the value of money is relative to the amount of money in circulation (after being multiplied by bank lending – the M2 money supply), and the size of the economy.  When the M2 money supply grows faster than the economy, it creates inflationary pressures that work their way through the economy over time.  The value of gold tends to follow changes in M2 very quickly.  The cost of labor, and thus wages, moves last – sometimes decades later – and since labor is in everything else, once labor starts to move in price, everything else gets more expensive again too.  Once inflation hits wages, it moves in waves until a new balanced price point is found.

Government policies always have both intended and unintended, as well as both short and long term, consequences.  The intended consequence of Clinton’s ‘Everyone should be able to own their own home’ policies was that everyone, for a while, could own a home if they wanted to.  Banks were required to loan money to people independently of their ability to repay – looking at things like credit worthiness was deemed racist – and the Federal Reserve was employed to find a way to make that work.  The result was the creation of pools of ‘mortgage backed securities,’ and an explosion in the derivatives market around mortgage backed securities.  Housing prices began to rise more rapidly than usual, and Alan Greenspan told us this was a good thing, as rising house values made home owners more wealthy.  Greenspan called this the ‘wealth effect.’  Alan Greenspan, and then Ben Bernanke, seemed to think this could go on forever, and Keynes would say, ‘of course it can.’  Never mind that Alan Greenspan was not a Keynesian – he got bit by the bug.

Then the bubble burst, as bubbles always eventually do.

We have bubbles all the time in the economy, and we have several right now.  Healthcare costs are in a bubble.  College costs are in a bubble.  The stock market is in a bubble.  Housing is in a bubble again, and there are other bubbles out there as well.  All of these things will burst.  Whether or not one or more of them bursting will cause a recession will be determined by how big the bubble gets, and how quickly it bursts.  In the long run, lower healthcare and college costs would boost the economy, and both stock as well as housing prices should be set by markets, rather than being manipulated by fed policy.

By focusing solely on aggregate demand, Keynesian economics ‘solves’ recessions by causing them, each bubble pulling us out of a recession, only to eventually pop, plunging us right back into another recession.  The reason is simple: the ‘growth’ is artificial, based on government policy rather than organic demand.  Those who ‘study’ Keynesian economics, neo-Keynesian economics, Modern Monetary Theory, and other Keynesian offshoots, are studying the management of those bubbles – how to grow them larger than before, how to pop them more gently than before, how to sustain them, how to balance them so they don’t all pop at once, and things like that.  Keynesians are so caught up in their bubble-ology that they cannot see out of it.  Keynesians cannot even fathom an economy operating without government interference, based solely on organic demand, caused by the voluntary exchanges made between everyday people, where there are no bubbles.

You can sometimes tell how rational something is, based on how rational the people who believe in it are.  Rational people tend to follow rational things, and tend to be consistent in their principles.  Most of the people who follow Keynesian beliefs also believe that the United States is a paternalistic society, and that paternalism is evil.  Their solution is to create a far more paternalistic society, in which government, acting as daddy, controls every aspect of the human experience, and in which the best we can hope for is an economy based solely on bubbles blown by the government, raining down all around us: a bubble economy.  This is the best Keynes can offer.