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Where Keynes Was Right

When the facts change, it's time to change your mind.

By Will Offensicht  |  December 27, 2011

The perpetual liberal push for increased government spending to combat the Obama Depression is based on the theories of celebrity economist John Maynard Keynes.

He is most famous for an argument that is plausible on its face: When the economy slows down, nobody has any money to buy anything, so the economy freezes up and can't restart on its own.  To get the economy moving again, government has to spend to create demand - it doesn't really matter on what, so long as the government spending flows to normal private citizens who spend it in their turn.  This artificially increased demand is supposed to "kick-start" the economy, in effect creating something out of nothing.

This appeals to politicians in two ways - it sounds so reasonable that it makes them seem smart, and it gives them an excuse to spend money on their friends which is what they like to do anyway.  For example, ABC reports:

On the road leading to Dulles Airport outside Washington, DC there's a 10' x 11' road sign touting a runway improvement project funded by the federal stimulus. The project cost nearly $15 million and has created 17 jobs, according to

$15 million to create 17 jobs is not a terribly efficient use of funds, though as we've seen previously, it's less than half the cost of new automobile-factory jobs in the United States.  Of course, those jobs are (in theory) permanent, whereas the roadwork jobs will disappear once the road is finished.

The article goes on to say that the sign announcing that the project was paid for by the taxpayers cost $10,000 which was taken out of the project budget.  This sort of outcome shows that Mr. Keynes' idea, plausible as it sounds, doesn't actually work in real life - government spending is too inefficient and too politically-directed to have much positive effect on the economy.  In the biggest idea that bears his name, the notion that Keynesian stimulus by government spending could fix an ailing economy, Mr. Keynes was simply wrong.

The True Keynesian Point

Mr. Keynes was spot on in another area, however.  Unlike many of our ruling elites, he realized that he could be wrong.  On one occasion, he was accused by a critic of flip-flipping.  His response is telling, and one that perhaps some of our current batch of politician should cite: "When the facts change, I change my mind. What do you do, sir?"

And in keeping with the trenchant observation of this brilliant, though imperfect, man, we here at Scragged will follow in his footsteps. We have just been proven wrong, so we're changing our mind.

In the debate about how to restart the American economy, we've long argued that government regulation is a massive job killer, as even the Cuban government has finally figured out.

Andy Stern, former President of the Service Employees International Union, further reminded us that the Chinese government created the largest economic boom in world history simply by getting out of the way.  On this basis, we've regarded most regulations as potent job killers for a long time.

However, note that key word "most."  Libertarians to the contrary, some government regulation is clearly needed; otherwise there'd be chaos on the roads as each driver drove down whichever side struck their fancy.  The trick is to get the right balance between helping the economy via sensible regulations versus holding it down with too many rules and restrictions.  This is extraordinarily difficult because bureaucrats will, over time, seek to extend their reach and power into every possible corner of the economy.

The Glass-Steagall act was passed in 1933 as part of the same law that established the Federal Deposit Insurance Corporation (FDIC).  In our view, the FDIC was a reasonable attempt to prevent depositors panicking and demanding all their money at once.  Banks instantly failed whenever such a "run on the bank" occurred, regardless of their underlying health.

The book The Great Depression: A Diary is a collection of notes made by Benjamin Roth, a lawyer who practiced in Youngstown, Ohio, during the depression.  He noted that when the banking system froze up, the entire economy froze up with it:

Oct. 16, 1931

Business is being operated in crazy-quilt fashion.  No one will accept checks and nobody has cash.  The wholesalers, most of whom have their offices in other cities, refuse to deliver merchandise to the stores except C.O.D. cash. P 31   [emphasis added]

Oct 17, 1931

The financial situation would be ridiculous if it were not tragic.  Everybody demands cash – no checks are accepted.  The Truscon Steel Co. paid its employees with checks drawn on a large New York bank and the local banks refused to cash them.  The check may be good today and bad tomorrow.   Even certified checks are regarded suspiciously.  P 32

The problems Mr. Roth observed weren't caused by all the banks failing.  Most banks were still perfectly healthy and checks drawn on them would in fact be honored - in the end, only about 20% of the banks failed.  The problem was that nobody knew which banks were good and which weren't, so everybody demanded cash.  The hope was that depositors wouldn't panic if they were told that the government would stand behind their deposits.  This would keep problems in the banking industry from spreading.

Eighty years later, the FDIC stands as a shining example of government regulation at its best.  The government stepped in to do something that no private enterprise possibly could - only a government that has the power to print its own money can credible guarantee that all ordinary depositors will be repaid no matter what.  It has executed this obligation flawlessly - so far as we are aware, though there have been many bank failures from that day to this, every last depositor has been repaid in full in strict accordance with the promises made.  As a result, the classic bank run has become an artifact of old movies; modern Americans simply don't worry about such things anymore.

This same law also separated investment banking and deposit banking; previously, the same banking firm had been allowed to participate in both activities at the same time.  Deposit banking is what most people think of as "normal" banking - paying customers a small amount of interest on their savings accounts and lending the money to small businesses and home buyers who'll pay it back over time.  Investment banking is what people think of as "Wall Street" - gambling in the stock market, the financial futures market, or in any other area where the bank wants to risk its own capital.

When A Necessary Regulation Goes Away

President Clinton (D) signed the repeal of the Glass-Steagall act in 1999, and also allowed the government to buy shoddier mortgages than before by relaxing lending standards.  We applauded killing Glass-Steagall at the time because we hoped that letting banks make more money would help them grow into global institutions that could serve overseas markets; we also, like most laymen, didn't too much worry about shoddier mortgages.  After all, if the borrowers stop paying, the bank can always foreclose and resell the house, can't it?

We were wrong on both points.  As it turned out, both of these actions, taken by a Democratic administration and wholeheartedly supported in a bipartisan way including by ourselves, allowed financial institutions to take on vastly more risk than was safe.  We all know the results of the mortgage crash and futures problems: longsuffering taxpayers were forced to make up for their losses for fear that the entire financial system would collapse.

Sen. Dodd and Rep. Frank, who had done so much to bring the financial crisis in the first place, availed themselves of the calamity to pass the Dodd-Frank bill.  This was a 1,200 page monster which rewarded the regulatory agencies, which had failed to stop the previous crash, with lots more money and power.  The bureaucrats busily started writing new rules to limit risk.

Dodd-Frank didn't bring back the Glass-Steagall restrictions on the same company investing customers' money and gambling with their own money.  The new law allowed regulators to write more rules to restrict risk instead.

With lightning speed, Dodd-Frank failed its first test when MF Global went bankrupt.  MF Global was being run by Jon Corzine, a former New Jersey senator and governor.  He got his start at Goldman Sachs and made a fortune as a trader.

When New Jersey voters rejected him, he went to work for MF Global.  He bought $6.3 billion worth of distressed European government bonds, borrowing about 80% of the money.

He knew that these bonds would pay off because he knew the Obama administration was going to prop up Europe with our money.  There was, in fact, hardly any risk at all - but he couldn't actually say so because that would have shown that he was trading on inside information.

Unfortunately, his perfectly well-laid moneymaking scheme was bulldozed by the regulator that his Senatorial buddies helped create.  MF Global went bankrupt when regulators said he had to put up more capital to support his bets, and he couldn't lay his hands on the cash demanded.  About a billion dollars worth of MF Global customer money seems to have gone missing; this is precisely what Dodd-Frank was supposed to prevent.  In this case, because Corzine's bets did in fact pay off - merely too late to meet the margin call demanded by the regulators but not by his lenders - all MF Global's investors would have been just fine had the regulators only left well enough alone.

The Guardian quoted a Reuters article explaining why regulators will never be able to keep this sort of thing from happening:

The off-balance-sheet accounting methods that Enron and Lehman Brothers made famous in their epic failures years ago have a modern-day poster child: MF Global.

After Enron, we were promised that Sarbanes-Oxley, which then-Senator John Corzine helped write, would keep this sort of thing from ever happening again.  When Lehman Brothers went down, Sen Dodd and Rep Frank claimed that Dodd-Frank would keep it from ever happening again.  Why can't the regulators get it right?  Because they aren't as smart as the traders:

The fact that MF Global was able to use the technique highlights how off-balance-sheet moves are evolving as quickly as new regulations intended to stop them. Earlier this year, the Federal Accounting Standards Board changed its rules to bar an off-balance-sheet loophole that had helped Lehman Brothers get into trouble in 2008.

Trading pays a lot more than regulating, so anyone smart enough to be a trader leaves the government and invents a new loophole.

Hubris Applies to Us Too

We rejoiced when Glass-Steagall was repealed - we thought that it was an unnecessary government restriction on free enterprise and private profit.  We now stand corrected.  Nobody can regulate a toxic mix of speculators making supposedly safe bets with their customers' money and also taking extreme risks with their own - not government inspectors, nor the Masters of the Universe themselves who are, on average, wrong as often as they are right.  The temptations to put up customers' money to avoid disaster are just too great.  Regulators look the other way for well-connected traders, and traders don't believe they can ever go wrong - obviously; if they thought they could be wrong they'd find another line of work.

"In this type of environment, when it's tough to generate high returns on anything, institutions may try to get a little cute in the way they take positions," said Montanus Group managing partner Nathan Powell. "That's the lesson I take from MF Global."

"A little cute" is an understatement - Jon Corzine got a billion bucks worth of cute, and it would have worked had another set of regulators not meddled, regulators who by definition did not have what it takes to be successful on Wall Street.

No set of rules will keep these guys from figuring out new ways to bet their customers' money.  The only solution is a rigid separation of customer's money and gambling money - by forcing each bank to choose which sort of bank it wants to be, one or the other, and stick to it, exactly as Glass-Steagall prescribed.

We were wrong, and like Mr. Keynes, we've changed our minds.  Bring back Glass-Steagall!