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Bernanke vs. Keynes                   

By Mike Whitney

November 23, 2010 "Information Clearing House" -- Investment drives the economy. It creates jobs, builds factories, develops technology, and stimulates growth.  When investment falls, spending slows, unemployment rises, and the economy languishes in persistent stagnation.  

Currently, businesses are sitting on nearly $2 trillion, a record amount of cash. The corporate coffers are full because business leaders cannot find profitable outlets for investment. That's because demand is weak. Consumers and households are unable to spend at precrisis levels because much of their personal wealth was wiped out when the housing bubble burst.  So, spending is down and borrowing is flat. There's little demand for the products sold by big business, which is why they are sitting on so much money.

At the same time, retail investors continue to exit the markets. Last week marked "the 27th consecutive week of domestic fund outflows." (zero hedge) Investors have been drawing-down their investments ever since the May  "Flash Crash" when the stock market plunged nearly 1,000 points in a matter of minutes. The credibility of the equities markets has been severely damaged by high-frequency traders who have been gaming the system with supercomputers that give them an edge over "mom and pop" investors.  Consider this:  "70% of the stocks that are traded are held for just 11 seconds". This is not a market; it is a casino, which is why retail investors are leaving.

So, corporations are sitting on a mountain of cash and private investors are fleeing the market. Both of these will stunt future growth. Even so, the  markets have continued to edge upwards due to liquidity injections from the Fed, historic low interest rates, and the lightening-fast exchange of paper assets between high-frequency players. Meanwhile, the real economy has reset at a lower level of activity--the "new normal".

The stock market is an important gauge of economic vitality. When stocks soar, the public becomes more optimistic and confidence grows. When confidence grows, consumers are more likely to spend which increases economic activity and boosts demand. It is a virtuous circle. Here's what British economist John Maynard Keynes had to say on the topic:

"The state of confidence, as they term it, is a matter to which practical men always pay the closest attention. But economists have not analyzed it carefully."

 Fed chairman Ben Bernanke's efforts to restore droopy confidence have fallen short because he has taken the approach of a technician rather than a psychologist. Quantitative easing (QE) does not address the fears that people have regarding investment. Rather, it's an attempt to push down long-term interest rates in the hope that it will lead to another credit expansion. But that assumes that the obstacle to investment is interest rates and not something more elusive, like fear or uncertainty. This is the basic flaw in Bernanke's approach, he doesn't see that investment requires confidence in one's long-term expectations and that those expectations change when markets are in turmoil and outcomes are affected more by policy than fundamentals. When that happens, uncertainty deepens and investors pull back. Here's an excerpt from Robert Skidelsy's "The Remedist" (in the NY Times) which sheds a bit of  light on the question of uncertainty:  

"Keynes created an economics whose starting point was that not all future events could be reduced to measurable risk. There was a residue of genuine uncertainty, and this made disaster an ever-present possibility, not a once-in-a-lifetime “shock.” Investment was more an act of faith than a scientific calculation of probabilities."

Central bankers ignore the psychological aspects of investing at their own peril. Confidence matters. It's Bernanke's job to restore confidence via regulation, price stability and job-generating monetary policy. But the Fed chairman has failed in this regard and there are metrics within the system for measuring the magnitude of his failure.  They're called bond yields and they show that investors are clinging to cash today as ferociously as they did on the day Lehman Brothers collapsed 2 years ago. Nothing has changed.  Bernanke has neither reduced widespread uncertainty or persuaded investors that it's safe enough to test the water.

Quantitative easing is just more of the same; more fiddling with the financial plumbing instead of striking at the heart of the problem. Bernanke plans to purchase nearly $900 billion in US Treasuries from the banks (Note--$300 billion will come from the proceeds of maturing mortgage-backed securities) to push down long-term interest rates and, perhaps, stimulate some additional spending. More than 90% of the Fed's purchases will be short-dated maturities. (6 month, 2-year, 5-year, 7-year, 10-year) Why? Because Bernanke wants to push investors out of "risk free" bonds into riskier assets, like stocks. It's the Fed's version of social engineering, like  zapping lab-rats onto the flywheel to earn their kernel of corn. This is not the role of the central bank. Bernanke's mandate is "price stability and full employment". It's not his job to reconfigure the economy to suit the objectives of his bank constituents.

Private investment is flagging because ordinary working people were fleeced for nearly $13 trillion in a gigantic mortgage laundering scam. They need time to recoup their losses and rebuild their balance sheets. Many of them are still afraid to invest because they don't think that Congress's new financial regulations have fixed the system which they think is still rigged. So, they continue to  stuff money into their mattresses instead of putting it in the market.  Keynes explored why people hang on to their money (even when they are getting nothing in return) and here's what he found:

  "The desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. . . . The possession of actual money lulls our disquietude; and the premium we require to make us part with money is a measure of the degree of our disquietude.” The same reliance on “conventional” thinking that leads investors to spend profligately at certain times leads them to be highly cautious at others. Even a relatively weak dollar may, at moments of high uncertainty, seem more “secure” than any other asset....

 It is this flight into cash that makes interest rate policy an uncertain agent of recovery. If managers of banks and companies hold pessimistic views about the future, they will raise the price they charge for “giving up liquidity,” even though the central bank might be flooding the economy with cash. That is why Keynes did not think cutting the central bank’s interest rate would necessarily — and certainly not quickly — lower the interest rates charged on different types of loans. This was his main argument for the use of government stimulus to fight a depression. There was only one sure way to get an increase in spending in the face of an extreme private-sector reluctance to spend, and that was for the government to spend the money itself." ("John Maynard Keynes", Robert Skidelsky, New York Times)

Repeat: "It is this flight into cash that makes interest rate policy an uncertain agent of recovery."

Keynes was familiar with quantitative easing (although it was called something else at the time) and supported it as part of a larger fiscal strategy. But QE won't work by itself nor will lower interest rates. The transmission mechanism (the banks) for implementing policy is broken, which means that stimulus must bypass the normal channels and go directly to the source---consumers, workers and households. There's no need to nibble at the edges of the problem with fancy asset shuffling operations (QE) that achieve nothing. Fiscal remedies have been used for over a half century and they work just fine. And, there's no need to reinvent the wheel either. What's needed is a second round of stimulus. That's all. Just drop the pretense, and get on with it. Time's a wasting.  
   
 

 

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