Obama, Keynes, and the Perpetual Motion Machine

Obama is calling for government deficits over the next couple of years to avoid a “deep recession.” I’m not sure if he said it explicitly, but conversations with Democratic friends has shown me that it appears to be a widely held belief that the money can all be made up from tax revenue off of the booming economy that should result after a couple of years or deficit spending. It harks back to what I’ve heard many a Keynesian say; the government needs to run deficits in the down years and surpluses in the up years. “It would only work,” they say, “except that politicians can never bring themselves to reign in their spending.”

Just as markets work towards the betterment of all involved if they perform rationally and with good information, governments would be the perfect guardians of our welfare if only they were somehow free of corruption and not run by power-hungry politicians. Except that we don’t live in an ideal world, so we must make do with the best that we have. However, even if perfection were somehow available, Keynesianism would still be nothing but an intellectual fraud because it’s basically promising the economic equivalent of the perpetual motion machine.

For those of you who don’t know, the perpetual motion machine was a mythical device that, once set in motion, would continue to run forever without requiring any additional energy inputs. There were many attempts in the Middle Ages to create such a device, but they all failed. You can’t get something for nothing, you see. If a machine is to be in motion, then it will require energy. One can not derive more energy from the machine’s motion than it requires to set it in motion and run it. This was not understood at the time, because no one had yet devised the First Law of Thermodynamics which stated that “Energy can neither be created nor destroyed.” 

Similarly, Keynes promises similar benefits to the perpetual motion machine by theorizing that economic downturns are caused by a lack of demand and that the government can step in to become the prime demander, and thereby set in motion a chain of events by which the economy will start booming again. Keynes figured that money put into the system to get the demand humming again could later be taken back out. There’s a reason why Keynes’s system has never worked, and it doesn’t just have to do with greedy politicians. Just as in thermodynamics, you can not prime the pump of commerce and magically create a fountain of wealth from which you can withdraw far more than you put in. As my momma used to tell me growing up, “There ain’t no free lunch.”

Even if the government did exactly as Keynes said, it still wouldn’t work, because Keynes was wrong. Pure and simple. Economic downturns are not caused by “insufficient demand.” Indeed, insufficient demand is impossible, as Jean Baptist Say had started over a century earlier (and I’m paraphrasing), “There is not a supply, which is not also a demand.” That is to say that in order to make a product such as as car, I will demand inputs from labor as well as raw materials of all kinds. If the demand where not there for the car, then the demand would also not be there for the labor for the car or the raw materials. Keynes looked at this situation and said that we needed to stimulate demand for the car in order to employ the autoworkers, but what he didn’t seem to understand was that it is impossible, as a whole, for society to have inadequate demand for anything. Keynes attacked Says law as not being able to explain economic downturns, but Say himself actually clearly states that economic downturns are possible but will be hastened towards ending if the government and people are quickly willing to allow the market to find market clearing prices. (For a clearer understanding of Say’s Law, and the failures of Keynesianism, I’d refer readers to Rehabilitation of Say’s Law.

Try to picture it for a minute. How is inadequate demand possible? If people stopped demanding cars, it must be because they were demanding something else other than cars with the money they were spending the buy the cars. Thus demand lost in one arena is picked up in another. “But what if the consumer simply stopped demanding altogether?” you might ask. In that case, they will be looking for an excellent vehicle with which to park their savings gained by not consuming. As savings accumulates across society, interest rates are lowered because of all the money available to lend. Cheap money, as Keynes could tell you, leads to economic boom times as entrepreneurs can now go out and borrow the savings of the others and demand both labor and raw materials for their new venture. 

What, you still don’t believe me? What if no one ever, ever consumed enough to justify investing? Outside of being nonsense, let’s take a look at that scenario for a minute. Let’s simply it down so we can understand it easily, and let’s look at the economy of Robinson Crusoe who, incidentally, has been the target of so many economics texts that I’ve been tempted to pick up the book. One man alone one a desert island demand food and water, and so he must use his labor to create his the objects he demands. To do otherwise, is to starve and die. Now Crusoe demands other things as well as food and water: shelter, clothing, a boat namely. But to acquire those things, he must also build them himself. So in our economy of one, time spent is the only medium of exchange. Crusoe is free to do what he will with the time he has, but he will starve unless he uses at least some of the time to fish and gather water just as he will be without shelter if he does not spend the necessary time to make a house for himself. Even in our economy of one, Crusoe’s demands are far more than his ability to actually consume given the time he has, and so it is with all of humanity. Our wants are limitless. The idea of insufficient demand, is just a Keynesian fairy tale. 

Keynes wanted to explain the business cycle by saying that consumers weren’t demanding enough, but people always have wants for more than their ability to satisfy. As long as people have money, they will want to spend it and it is only interest rates offering us even more goods in the future if we would but forgo present consumption that incentives us to save at all. An across the board reduction in the demand for all goods is only possible when there has been an expansion of the money supply because then people go from having access to lots of credit in order to buy things to suddenly having less access to credit as they have taken on more and more debt. And so it is not the lack of demand that causes economic downturns, but rather the natural after effect of a previous credit expansion. Where the previous credit expansion to never have happened, then there would have been a far more even flow of demand across time instead of people demanding more than they could afford at one time and demand less in the future when the bill came due from past excesses. 

The reason I go into this is so that we could now understand just how ridiculous Keynesianism is. Credit expansions cause a surge in demand that must later be “corrected” when that source of credit is exhausted. Keynes proposed that the government could expand credit to gain great multiples of extra demand and revenue in the future, but that’s clearly impossible. The demand will naturally fall back to its natural level after the credit runs out, and if the government were to ever withdraw some of the credit in the future in order to try to follow Keynes’s advice to run surpluses in boom times, then the system would crash even harder. And so the source of continual budget deficits is not due to the greed or incompetence of politicians, but rather because credit expansions, once started, must continually be supplied with additional credit lest they collapse in on themselves. 

Some economists understood this. In his book, Human Action: A Treatise on Economics Ludwig von Mises wrote that, “The wavelike movement effecting the economic system, the recurrence of periods of boom which are followed by periods of depression is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion.” Yet here we are, decades after Keynesianism failed to bring us out of the Great Depression or Japan out of it’s “lost decade”, still seeing the same ideas spouted by politicians. Neurosis is the tendency to do the same thing over and over again and expect different results. It would seem we are a very neurotic people.

Everything I Need to Know I Learned from a Shock Jock

For those of you who don’t know, I listen to some pretty salty radio. Specifically, I listen to both Howard Stern and Bubba the Love Sponge on Sirius Satellite radio and, while I can’t specifically recommend shock radio for everyone, I can say that both shows have, in addition to a lot of material many would find objectionable, a healthy amount of intelligent dialogue. Both shock jocks have gotten increasingly more political over the last handful of years as both were targeted by George Bush’s FCC chairman Michael Powell with the largest fines in radio history. Having both found their home on sensor free satellite radio, they now both routinely comment on the absurdity of the “War on Terror” as well as favoring Barrack Obama in the Presidential race.

Having been so financially touched by the latest administration, politics has become personal issue for them. I find the politics of the Bubba show particularly interesting as he is not a traditional Democrat but rather someone like myself who has developed a Democratic sympathy out of utter dislike for the policies of the Republican party. Yesterday on the Bubba show, the topic of the housing crisis came up. Specifically they were discussing John McCain’s recent proposal that the government simply buy up all of the troubled mortgage’s and have the government renegotiate better terms with the home owners so as to keep everyone in their homes. Brent, the producer, pointed out that he had reread Ron Paul’s A Foreign Policy of Freedom and that the book had predicted both the housing crisis as well as the government’s bailout of it. Bubba then went on to say words to the effect that:

If they want to stabilize housing prices here’s what they need to do. Stop all this bailout <stuff> and just lower the price. Eventually, the price will get lower to those of us that have some spare change will go out and buy the house as an investment property and fix it up. Crisis solved.

This reinforced in my mind the utter simplicity of classical economic theory because Bubba, who did not even go to college, was doing a wonderful job as describing the effects of Say’s Law. Jean-Baptist Say (1767-1832) was a French economist who attacked the Mercantilist notion that recessions were caused by a shortage of money. Instead, Say argues that money is merely a medium of exchange and one can not actually buy anything without first supplying something else (i.e. a worker must first supply his labor in order to get its money’s worth to then buy goods) that it is not money that is in short supply but other goods. According to Say, a generalized over-production was simply not possible, while a specific overproduction of one given good certainly was. Thus Say’s solution was to allow the markets of goods and services to find their own clearing price and that that would quickly bring an economy back to stability and further help orient the markets production of goods and services towards what the society actually valued. 

Say’s law was attacked by Keynes who theorized that a generalized over-production was not only possible, but that it would tend to be persistent unless the government took action. It is Keynesian theory that lies behind John McCain’s plan, but Keynesians will quickly admit that if Say’s law is correct, that all of Keynes’s theories will fall apart. William Hutt’s A Rehabilitation of Say’s Law points out the how Keynes seemingly intentionally misstated Say’s Law in order that he might then attack it and how Keynes’s misstatement still seems to be accepted by most modern economists as the law itself when it, in fact, is not. 

Say’s law is obvious. So much so that it was unintentionally state by Bubba when describing the John McCain’s housing plan. To allow the economy to quickly realign itself with the actual wants and needs of society, we need to allow the value of housing, bank stocks, and collateralized debt obligations (CDOs) to find their own price rather than have the government move in to buy these products. Do not believe the argument that the “credit markets are frozen” and that no one will buy CDOs at any price. That is simple nonsense. I guarantee that if CDOs are allowed to fall enough in price, eventually they will find a market clearly price and the market will unfreeze itself. The problem is that this market clearing price is probably far below where the banks have it marked on their balance sheets. So you see, the problem is a political one, not a defect of the market itself. 

All in all, I think we would do well to follow the simple logic of Bubba and his crew. Allow the market to find it’s own market clearing price, and let the chips fall where they may.