Keynes' Follies
or
Prediction: The Limits of Economic Control


L. Reichard White
June 17, 2008
So his [John Maynard Keynes] theory was that the government should actively intervene in the economy to manage the level of demand. These policies are often known as demand management policies, aptly named since the idea of them is to manage the level of aggregate demand. If you want to impress your teachers or lecturers even further and leave them totally stunned with your intimate knowledge of Keynesian economics (!), you could even call these policies counter-cyclical demand management policies. They are termed this because the government should be doing the exact opposite to the trade cycle. When economic activity is depressed (perhaps because it had been reading too much Classical economics) the government should spend more, and when the economy is booming the government should spend less. --John Maynard Keynes - Theories

SOUNDS good on paper! The problem Keynsians didn't recognize is that it's at least as difficult predicting the down phase of a "trade cycle" as it is a downward gambling fluctuation.

Heck, if you knew in advance you were going to have a losing streak, all you'd have to do is halve your bets. Heck, just stop playing till the fluctuation was over! If this worked, all the casinos would be out of business.

Likewise, if you knew when the trade cycle was turning down, goose the economy with a money injection -- done these days by decreasing interest rates and thereby hopefully increasing loans thus stimulating business activity. [1]

But the trade cycle's NOT predictable any more than a gambling fluctuation is - - -

The leading economists of that day [1930] saw no hints that the economy was about to take a deep dive. It would be easy to assume that this failure to forecast was due to a lack of knowledge that economists now have well in hand today. Not so. In fact, even contemporary mainstream economists, using current forecasting techniques, were unable to predict the 1931 downdraft retrospectively. This was reported in an atricle published in 1988 in The American Economic Review. As an exercise to find out why forecasts from the early thirties were so poor, three economic historians reformatted the data from that period in ways compatible with modern forecasting techniques. They even added reconstructed time series unavailable in the thirties.
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All the data were then examined for the statistical picture they painted of the economy, and forecasts were generated using the same techniques now employed by most business and government economists today. The results: they saw nothing indicative of deflation. They failed to forecast the initial downturn in 1929. And their forecasts based on 1930 data indicated "a speedy recovery." --James Dale Davidson & Lord William Rees-Mogg, The SOVEREIGN INDIVIDUAL, (New York, NY: SIMON & SCHUSTER 1997), p.17 & 18

Further, Davidson & Rees-Mogg note on pg. 375 that:

At the end of 1929, the New York Times looked back on the year to identify its biggest story. It was Admiral Byrd's trip to the South Pole. There is a hint in this that is worth noting. Like the dog that did not bark, the failure to recognize the evidence of impending depression tells you again that expectations are linear. The smartest reporters in the world could not see the importance of the stock market crash in 1929.
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... The immense, and false, assumption was that the authorities could counteract a depression if one began. This proved untrue in 1930. It is no more likely to be true in the 1990s. Even recognizing that a slump is underway is often beyond the vision of the authorities. Consider that the 1973--75 recession began in November 1973, but, reported the Wall Street Journal, "as late as August, 1974, Arthur F. Burns, the Federal Reserve chairman, was assuring Congress that the economy was still expanding."

In fact, you can get a feel for the lack of comprehension in some of the 1929 NEWS LETTERS FROM NAT'L CITY BANK.

But, you're thinking, that was 35 years ago -- and the study was done in 1988, 19 years ago. Surely they've got it nailed by now! Not exactly - - - -

History tells us that sharp reversals in confidence happen abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short time period.
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We can readily describe this process, but, to date, economists have been unable to anticipate sharp reversals in confidence. Collapsing confidence is generally described as a bursting bubble, an event incontrovertibly evident only in retrospect. --Federal Reserve Chairman Alan Greenspan, "New challenges for monetary policy," Jackson Hole, Wyoming August 27, 1999

OK, but that was Greenspan eight years ago. Surely they've got it now - - - -

'Dumb' economists still can't predict recession
FED Chair Bernanke, Mayflower Hotel, Jan. 10, 2008

So for the Federal Reserve to operate "counter-cyclical demand management policies," they have to anticipate when down-turns are going to happen --- like gamblers lowering their bets BEFORE they start a losing streak. But, just like OTHER gamblers, the FED doesn't know till AFTER the fact. If then.

Health, happiness, & long life,
Rick

P.S.

The problem for investors is they don't look beyond the third standard deviation:

Probability distributions that are estimated largely, or exclusively, over cycles excluding periods of panic will underestimate the probability of extreme price movements because they fail to capture a secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic. Furthermore, joint distributions estimated over periods without panics will misestimate the degree of correlation between asset returns during panics. ... Consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account. --Federal Reserve Chairman Alan Greenspan, "New challenges for monetary policy," Jackson Hole, Wyoming August 27, 1999
MBAs were all doing the same thing, all evaluating these vehicles the same way. Partly as a result, we have a 25 sigma event -- which should happen only once every 10,000 years -- and now they had one every day for three days in a row. --CNBC guest, 3:52 PM 10/23/2007

Notes:

[1] Credit expansion amounts to the same thing as money creation --

When Daniel Webster said that credit has done more a thousand times to enrich nations than all the mines of all the world, he meant the discovery that a debt is a saleable commodity, or chattel; and that it may be used like money; and produce all the effects of money." --John R. Commons, Legal Foundations of Capitalism, (New Brunswick, NJ: Transaction Publishers 1995), p.246 Originally published in 1924 by The Macmillan Company return