Waiting for the Death of the Chicago School, and the Keynesian School also, Redux

So Paul Krugman gets a lot of ink, and everyone goes gaga for it.  I don’t buy his arguments for two reasons:

  • He misdiagnoses the cause of the current crisis.  He thinks it is too much of the “free markets.”  Rather, it was predominantly profligate monetary policy.  Secondarily, it was poor banking regulation.  Monetary policy necessarily involves banking regulation in a fiat money system, because credit is what drives the economy.  A failure to limit the ability of regulated institutions to issue credit is just another form of loose monetary policy, whether it results in measured price inflation or not.
  • Keynesian economics and Neoclassical economics do not consider the debt structure of the economy to be relevant for policy purposes.  I’ve written about this already in this blog post: Waiting for the Death of the Chicago School, and the Keynesian School also. Debt structure is more relevant than any other factor at present.  Economies with high levels of indebtedness are inherently fragile, because booms and busts are amplified by the financial leverage.

Let me take this a different way.  If monetary policy had been conducted properly through the Greenspan era, what should he have done?  Let’s start with the crash in 1987.  Greenspan should have done nothing — no announcement at all.  Maybe a few small clearing firms would have failed, and maybe some minor investment banks, but so what?  The economy would remain sound.  There would be little danger of an increase in unemployment.

Instead, he announces support for the markets, and debt levels increase as a result.  Bad debts are not liquidated, and new debts are incurred, because policy is favorable toward debtors.

Next came the commercial real estate crisis of the late ’80s to early ’90s.  What did the Fed do?  It cut rates from 9.75% to 3%.  What should it have done?  I have a basic rule that says that the Fed funds rate should never be more than 1% below the yield on the 10-year Treasury.  That means the Fed should have leveled out the Fed funds rate at 6-7%, and waited, and taken political heat for doing so.  If they had done this, there not would have been a residential mortgage convexity crisis in 1994, which ended up sinking Mexico as well.

Why not less than 1% below the 10-year Treasury rate?  Anything more leads to easy profits for the banks, with a large increase in the indebtedness of the economy.  Let the banks remain on a diet, and let savers get their due reward.  We don’t have to flood the economy with liquidity to get it to turn around.  Enough liquidity and willingness to wait will do it.  A policy approach like that will lead to a more stable and yet growing economy.

So what was the next crisis?  LTCM in 1998.  The Fed should have done nothing, and if any or all investment banks failed, it would have had little impact on the economy as a whole, because derivative exposures were small.  But no; they coerced the investment banks into a settlement, and loosened the Fed funds rate 0.75% when it should have kept policy tight, and not loosened at all, staying at 5.5%.

Perhaps the tech bubble would have been less virulent if liquidity had not been so plentiful.  Between the loosenings during LTCM and the extra build-up in liquidity for Y2k, the Fed put in the top of the equity market.  Then the Fed tightened significantly, bursting their new bubble.  After that, they went nuts, loosening Fed funds from 6.5% to 1.75% by the end of 2001.  It probably should have stopped at 3-4% and waited.  But no, not only did they go down to 1.75%, they went all the way down to 1% in June 2003, when it was obvious that a strong recovery was underway, and the FOMC left the rate there for a full year, while asset inflation springing from additional indebtedness coming from cheap financing ruled.

Instead of moving from 1% to 4% rapidly, the Fed chose a slow pace, a robotic pace for the next 17 meetings, increasing 0.25% each meeting.  Language dominated over policy as the market anticipated their actions.  They dared not surprise the market, but they overshot the 4% area that would have been closer to equilibrium.

If the Fed is unwilling to deliver surprises, it is unwilling to govern.  Give us what we need, not what we want.  At present, Fed funds should be in the 3% region, allowing a slightly positively sloped yield curve, which would allow most banks to do well in a normal environment.

What’s that you say?  It’s not a normal environment now, so why should the curve be flatter?  It is not a normal environment now precisely because the Fed was so loose for so long, allowing a huge buildup of debt that we are now fitfully trying to liquidate.  When that debt gets down to 1.5x GDP, we will have robust growth once again.  In the 3.0x+ position that we are now in, there is little hope for significant growth rates.  Our government should be aiding in liquidating zombie institutions, rather than keeping them undead with cheap financing.

Consider the position of David Walker.  He knows how bad the total debt crisis of the US is.  I’ve written about this many times before; this is the latest example.  Keynesianism does not address sovereign indebtedness, which is a huge flaw.  What if a country can’t make good on all of its promises?  Were the US  not the global reserve currency, that would be a big problem for us now.  Deficits are not helping the UK or Japan now.  But what happens when we go into perma-deficit in the next few years, where there is little to no hope to paying off debt, because excess revenues on social programs evaporate, and the elimination of deficits relies on the willingness of the US to raise personal income taxes across the board.  Soaking the rich will never be enough, and they always find ways of sheltering income.  Who will be willing to pick up the knife, and proudly say to constituents, “I did what was right for you and raised your taxes?” or, “I did what was right for you and cut social security payments by 30%, and created a 30% copay on Medicare.” or, “I helped create a new chapter in the bankruptcy code for states, with a modification to ERISA that allows for lowering of pension and healthcare benefits paid to former state employees for states under financial stress.”  No one will say any of that, obviously.

Perhaps there are simple solutions to all of this.  The only one I can think of is a large rise in taxes, which would be bitterly opposed, and might not result in that much additional taxes.  Any other bright ideas out there?

One final comment on the failure of macroeconomics — consider who did peg the crisis in advance.  Most were practical, business-oriented economists who saw the growth in leverage, and said, “This will not end well.”  The trouble is that timing and estimation of severity of the then-future crisis were problematic.  The moment that you say “This end badly,” in the midst of the bull phase, you can get labeled a perma-bear.  I hated that title, so I would tweak my language to avoid sounding too harsh.  Today that’s a pity, because the scenarios we privately talked about at my last employer are what are playing out now.

Why did macroeconomics fail us?  Bad theory in the two main schools of Neoclassical economics — Chicago and Keynesian.  There was an inability to appreciate the effects of overindebtedness on an economy.  Time to send both schools to the junkyard.

PS — I saw this in Barron’s.  If Henry Kaufman’s book is as good as it sounds, perhaps it will provide more insight into this situation.


  • The days of fiat currency are likely running out of time. The appearance of wealth by borrowing and inflation always leads to problems. The Austrian economist had it right all along. Let prices reset via deflationary forces (their rise was just an illusion), drastically cut government expenditures – the big one being our overseas empire, and reinstitute the gold standard (or something similar). Problem solved! LOL

  • David C says:

    Great post. Free markets didn’t fail us but cronyism on the part of the Fed and our government did.

  • q says:

    if the equity premium is almost zero, why wouldn’t rational investors choose debt over equity, and why wouldn’t this demand lead to more supply?

  • Lord says:

    Circularity in action. We get the economy the government provides and the government Wall Street desires. Did the government do it to please Wall Street or did Wall Street do it to please itself? Who acts for whom? Who controls whom?

  • Mike C says:

    Agree with David C. Great post.

    Most were practical, business-oriented economists who saw the growth in leverage, and said, “This will not end well.” The trouble is that timing and estimation of severity of the then-future crisis were problematic. The moment that you say “This end badly,” in the midst of the bull phase, you can get labeled a perma-bear. I hated that title, so I would tweak my language to avoid sounding too harsh.

    I noticed that you would tweak your language. :)

    But yes, I recall this distinctly. You had the Hussmans, Granthams, Roubinis all sounding the warning bells and ironically some of the sharpest criticism came from other professionals, both in the investment community and academic professor types who allowed sophisticated economic theory and econometric models to override the common sense of a massive build-up in debt.

    Interestingly, I could point you to numerous sources who still don’t get the magnitude of the debt issue and think it is just an issue of getting back to “normal” as if what existed the last 10 years was normal and sustainable. Even now, I’ve read numerous posts that those who did correctly identify the problem were essentially just “lucky” and if Lehman hadn’t happened we’d be humming along just fine right now.

    Bill Gross has an interesting piece this month:


    “The investment implications of this New Normal evolution cannot easily be modeled econometrically, quantitatively, or statistically. The applicable word in New Normal is, of course, “new.” The successful investor during this transition will be one with common sense and importantly the powers of intuition, observation, and the willingness to accept uncertain outcomes.

    One thing I’ve realized though is that common sense and simple observation is not so common amongst many academics and investment professionals.

  • James Dailey says:

    Hello David,

    I think you touch upon a critical issue of credibility, which indirectly touches upon an even more critical issue, in my opinion. There were quite a few people who “saw this coming”, however there were very few who had the courage to do something about it due to career risk and/or political pressures in their jobs. In addition, many more were in the “weak dollar” camp for this cyclical period and bought decoupling hook line and sinker.

    There were very few, such as Paulson, who not only saw this coming but also devised a way to benefit. Even someone like Grantham did something different with his personal money (I’m confident he made out very well) versus what GMO did for clients – we must all stay in business. Hussman, as brilliant as he is, hasn’t made his shareholders money in 5 years when inflation is accounted for. As much respect as I have for you, I recall having a couple of exchanges about how durable you believed the peak profit margins could endure due to the global growth story, which turned out to be wrong. Roubini is on record stating that he didn’t really change his personal portfolio in response to his macro forecast!

    So while there were actually a decent number of people who got the macro economic forecast reasonably correct, those who were able to translate that into investment performance were/are few and far between.

  • A good post. I’d point out that, in addition to Hussman, you also had non-academics such as the self-made billionaire banker Andy Beal sounding the warning bells about the debt bubble. The country would be better off if the administration asked men such as Hussman and Beal to advise it on policy. They don’t seem to be politically connected enough for that though.

  • pj says:

    Great post indeed. There never was a free market in the first place. Crony capitalism indeed.

  • Praxis22 says:

    Wouldn’t argue with you, beyond the pragmatic Keynesian stimulus seen thus far, both Chicago/Monetarism & Keynes are dead. The interesting thing is going to be seeing what takes it’s place.

  • Fed Logic says:

    In this post lies the great secret to American wealth. Just watch the Fed blow another bubble. With their flawed thinking and their flawed decision-making this is bound to happen quite often. Ride the Fed-induced bubble and leave at the first hint of trouble. Its okay to sell early. Enjoy your profits while you wait. When it all bursts, buy high quality assets for pennies on the dollar. Repeat. Historically a system like this has mostly benefited insiders and the crony capitalists but now with the internet and with it the difficulty of hoarding information, this very American road to prosperity is open to all.

  • RN says:

    You are right that indebtedness and loose monetary policy were problems. But they pale in comparison to the effects of the “free markets solve all problems” delusion. And the lack of regulation is merely a result in deluded faith in such.

  • But What do I Know? says:

    **Fed funds rate should be in the 3% region** Amen, amen.

    Regarding the importance of debt in macroeconomic concerns, I assume have you seen the work of Steve Keen, takes a similar tack. What do you think of him?

    BTW, I’m glad to see more comments here–this is one of the most intelligent and sober blogs out there. I can only hope that Rolfe Winkler links to you more often. . .

  • MJ says:

    Thanks for this post and blog. I really appreciate your thoughts on both investing and Fed and public policy.

    I find your call for a 3% fed funds rate NOW pretty gutsy, and refreshing. Since I have no debt and don’t plan to take on any, it would be fine with me. I think.

    I’d love a post from you laying out your preferred Fed and fiscal policies for – say – the next 3 years, including how said policies would affect various stakeholders and markets. For example, if the Fed were to raise the Fed funds rate to 3% now, how would it affect the banks? The housing market? How much pain would there be, and for whom, and when would the real recovery begin? Now that we have apparently avoided implosion and meltdown of the entire financial system, I mean.

  • David,

    Your a genius, I do enjoy your posts. I think you hit it on the head with Greenspan always running out to save eveyone who doesn’t need saving. I say bankrupcy is the only way to clear the system of bad debt of bad investments of bad businesses, it sucks but is the only way we have to keep capitalism alive.

    Now alot of people have said that, but politians never see it that way.

    One point, we may be at the last cycle but it hasn’t finished itself yet. The crash is followed by lower interest rates then the market finds its next thing.

    We already see the stock market rising and pundits saying, its excess liquidity. So maybe we have one last huge asset boom. How can we not will the U.S. Fed basically spending trillions to get humpy dumpy back again. The comes the next crash.


  • Sean says:

    The answer will wind up being a combination of the old robbing the young via tax hikes and the young robbing the old via high rates of inflation