Geoff Gannon January 25, 2009

On Keynes, the Stimulus, and Old Ideas

John Maynard Keynes was a genius. We can all learn from his example. And the first thing we should learn is to end our foolish love affair with his ideas.

Keynes would not have spent his days warming up some dead man’s leftovers. Keynes would have understood the importance of all we have learned in once disparate fields and what this means for macro-economics.

Complex Problems, Simple Solutions

Economies are complex. But macro-economic solutions remain stubbornly simple.

What exactly is the case for government stimulus?

I don’t mean generally. I mean in this specific situation – right now, today, what is the case for government stimulus?

Forget ideology. Forget theories. Forget models. Think only of the situation we face and the actions we might take.

There will be plenty of time for theories later. But to start by imposing a framework, especially a framework that assumes a special case belongs to a general population, is dangerous.

Why do we assume that special cases belong to populations we know something about?

Because that is what experience teaches us. Our everyday experiences teach us to expect normal distributions. More than that, our everyday experiences encourage us to think that all differences are merely quantitative differences – simply matters of degree – rather than qualitative, systematic differences.

To the extent that the problems, populations, and systems we are dealing with are simple and unplanned I have little problem with making such leaps of faith – extrapolating from a few specific cases to create sweeping general theories.

But when we are dealing with complex, planned systems – systems with actors who learn and adapt, systems with actors who make new mistakes, actors who remember pain and pleasure as vividly as we humans do – when we are dealing with such systems, general theories are dangerous precisely because they are so elegant.

In a complex science, general theories are just special theories that win wide acceptance. If wide acceptance within an academic community was convincing evidence of utility, I would say stick with general theories.

A quick check of human history shows that, no, popularity is not a good indicator of utility. A few bad ideas always slip through – and worse yet, most good ideas – ideas like Keynes’ – outlive their usefulness.

The Burden of a Great Idea

Intellectual lifecycles can be painfully long. First, a great man like Keynes leads the way. Then a lot of not so great men follow. They don’t how to think up the new and useful principles the way the great man did; instead they keep applying old principles to new problems – problems the poor, dead man never saw.

Had he seen different problems, he would have found different solutions. But, he’s dead and his ideas aren’t. So the best a follower can do is warm up the dead man’s leftovers.

Ideas are limiting. The great ones are the most limiting of all.

Warren Buffett was limited by Benjamin Graham’s thinking. He had to learn to keep some principles – Mr. Market and Margin of Safety – and throw out most of the rest.

Warren doesn’t focus on balance sheets. He doesn’t diversify. He does analyze businesses. In each of these things, he is Graham’s polar opposite. And yet Graham was successful. And, for a time, Warren successfully aped him.

But had Warren clung to all of Graham’s ideas, you would never have heard his name. Buffett competed in a system that adapted fast. He kept some general principles. But he threw out a lot of ideas that turned out to be either special applications of general principles or ideas that only worked under special circumstances.

The Danger of General Theories

The danger of confusing what is special and what is general is captured in the title to Keynes’ The General Theory of Employment, Interest, And Money.

“I have called this book the General Theory of Employment, Interest and Money, placing emphasis on the prefix general. The object of such a title is to contrast the character of my arguments with those of the classical theory of the subject, upon which I was brought up and which dominates economic thought, both practical and theoretical…”

Did Keynes really think he had come up with a truly general theory? I doubt a man that smart could think something that dumb.

In my post In Defense of Extraordinary Claims I quoted Keynes’ review of Smith’s Common Stocks as Long Term Investments:

“It is dangerous…to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons why past experience was what it was.”

I argued then, as I am now, that people were seeing something special and calling it general. I said then, back in December of 2006, that future stock returns would not match historical returns, because historical returns were achieved under special circumstances – low prices relative to normalized earnings – that no longer existed.

I am sounding much the same alarm here. Everyone from the far-left to the far-right is talking stimulus. Everyone is thumping the bible of spend, spend, spend.

Or almost everyone.

Balance Sheets

In his most recent quarterly letter, Jeremy Grantham notes the importance of repairing the balance sheets of American consumers.

We talk about bank balance sheets. And we talk about consumer spending. But we don’t talk about consumer balance sheets.

Consumers put mortgages on the liability side to finance houses on the asset side. Many of those houses were financed at prices above intrinsic value.

When the market price of houses fell, consumers realized they did not have the ample equity they thought they did but somewhere between a sliver of equity and a deep, deep hole of negative net worth.

That hole has to be filled.

Banks can’t lend with Swiss cheese balance sheets. Nor can consumers spend.

We might do well to talk a little less about the Great Depression and a lot more about Japan.

At this point, the purpose of a stimulus is to bring consumption back in line with what it had been at a time when the illusory wealth of financing assets at prices higher than intrinsic value provided cash flows to consumers that would later be offset by massive asset losses.

You can’t pull that trick off twice. There’s nothing left to borrow against – and there’s nothing saved for consumers to spend.

And, if consumers spend everything they take in today, they keep their balance sheets weak. If they keep their balance sheets weak, they can’t borrow more to spend more today and they have to save more tomorrow.

We need to take the leverage off our balance sheets. Our banks, businesses, and households need to increase equity and decrease debt.

We can do it fast or we can do it slow. But we can’t spend ourselves into financial strength.

Special Problems

Our biggest problem is not underconsumption; it is balance sheet weakness.

The stimulus promoters suffer from man with a hammer syndrome. They have just one tool. It may be a powerful tool. I’m not arguing that point. I don’t have to. It’s the wrong tool for the job.

A stimulus may or may not be a good idea. But it can’t be our only idea.

It’s time to start thinking more like Keynes. The first step is to admit The General Theory is a special theory. Parts of it we can keep. Parts we need to chuck.

But whatever we do we need to adapt.

We have new problems. We need new ideas.