Why bother reading economic theories of decades gone by?
“Those who fail to learn from history are doomed to repeat it.” – Keynes – The General Theory of Employment, Interest and Money (1936)
My light reading for this week has been to re-visit John Maynard Keynes’ 1936 work, The General Theory of Employment, Interest and Money.
Prior to this revolutionary text, neo-classical economic theories had simply suggested that supply creates its own demand and that all income must be spent on goods and services (known as Say’s Law) – this is clearly wrong, as Keynes identified – we can also save income.
Classical economics had also argued that interest rates were purely a function of supply and demand, which Keynes also believed to be false. Indeed, we do now know that central banks can and do affect interest rates by adjusting the money supply.
Whereas elsewhere others argued in great detail over what caused business cycles to occur, Keynes preferred to argue that a depression was not necessary suffering to pay for the excesses of the past, instead choosing to focus on the causes of unemployment and how the unemployment problem could be solved.
Keynes refuted the conventional viewpoint that wage cuts lead to full employment. Workers are not always prepared to accept lower wages. He argued instead that the Great Depression was a solvable problem:
Keynes believed that mass unemployment was a result of inadequate demand with a simple solution: expansionary fiscal policy.
Considering the context and time in which it was written, Keynes’ General Theory is a work of such consumate and breathtaking brilliance that it is clearly impossible to summarise it in 50 words. Regardless, here’s my stab:
• Economies can suffer from a lack of demand which leads to unemployment
• Free markets can be very slow to correct the imbalance
• Governments can and should speed up the correction process and reduce unemployment
• Government spending can be the answer (simply increasing the money supply may not be enough)
A glib summary of Keynes’ work might argue that it is simply an argument in favour of deficit spending and that it plays down the influence of monetary policy. But we do need to remember that in 1936, interest rates were already near zero, so there was limited potential to reduce interest rates by printing more money.
What did Keynes miss?
Keynes wrote at a time when interest rates were low and were so for an extended period. He expected this to continue for the long term. Sceptics say that he “mistook an episode for a trend”.
He felt that the failures of the Federal Reserve and the Bank of England to revive employment through increasing the money supply would persist well into the future.
Instead, war intervened and technological progress and employment returned.
In fact, Keynes had believed that due to the marginal efficiency of capital, profitable projects would become ever harder to find and investment and growth would stagnate.
Keynes also didn’t foresee the high inflation of the 1970s and 1980s, but then, nor did anyone else in the 1930s.
Ironically, it was Keynes-influenced governments and their expansionary policies (cf. Heath, Nixon) which caused the high inflation in the 1970s to ignite.
Keynes also believed that the rate of saving would increase with per capita income.
Now that was definitely wrong! Consumerism has instead reigned supreme.
Deflation in Japan – will it be repeated elsewhere?
We no longer need to hypothesise over what might happen if interest rates hit near-zero and printing money fails to ignite growth. Why? Because we have now seen it happen in Japan over an extended period from around 20 years ago.
Japan had falling population growth, then around the turn of the century a falling population, and the Japanese government was notably slow to act.
When Japan tried to print more money this led only to the hoarding of ever more cash, leading the government to its last resort of huge public spending projects.
Widespread deflation eventuated with catastrophic outcomes for the economy.
Where we are now (and what should we do?)
With central banks targeting lower inflation since the mid-1990s and the return of near-zero interest rates over the past 3 years in the USA and the UK, Keynes’ ideas seem to me to be worth another look.
In Australia we have remained relatively unscathed to date, and we still have a cash rate of 3.50%, though many would say it appears likely that interest rates have further to fall yet.
Will expansionary policy save the US and the UK? Might we be in for an extended period of low growth and unemployment?
I don’t have a crystal ball, but my own world-view is that following the desperate outcome of slow intervention in Japan, governments will do anything within their power to prevent deflation and re-ignite growth.
They will print money (witness the massive quantitative easing programmes taking place in the UK and US), they will spend very heavily, and if the situation demands it, governments will even give us cash to stimulate private spending (recall the Australian stimulus package of 2009).
You have to form your own view on this. Warren Buffett, for example, has formed a long-term inflation bias. As is evident from virtually all of my writing, so have I. Australia’s Reserve Bank is frequently criticised for its supposed ‘dovish’ attitude to inflation and I simply feel that governments and central banks will attempt to avert deflation at all costs.
For me, the best approach for individual investors over the long term is simply to continue to acquire inflation-busting assets – such as blue chip industrial stocks, well-diversified index funds and prime-location investment properties – and hold on to them for the long haul.
Quality assets should increase in value over time with inflation and should provide an acceptable rate of return in excess of the inflation rate.
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