Monty Pelerin * EconomicNoise.com

Keynesian economics holds as central premises that economies should, need and can be managed. Each of these premises is plain wrong. It was wrong when Keynes introduced his theory in 1936 and it is even more wrong today and politicians and acolytes have extended its use beyond which even John Maynard Keynes would likely accept.

Economics is not an adjunct of engineering where one can focus on a handful of aggregate variables and alter outcomes. It is complex and involves millions, no billions, of individual decision-makers with their own goals and ideas how to achieve them. No one man or central authority can possibly comprehend this complexity. Friedrich Hayek expressed the problem of central direction and management in this fashion:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

Unfortunately generations of students have been indoctrinated with the claptrap of macroeconomics as taught from the Keynesian-Statist view. Government is supposed to “manage” the economy. Politicians were taught this brand of economics. Few even know there are contradictory schools or beliefs in economics. Even fewer want to know because Keynesian economics is the source of much of their control and power.

After decades of politicians proclaiming false successes from governmental economic policies, voters believe the nonsense. Political expectations require government to “do something” every time there is a economic hiccup or displeasure . Expectations are such that even if politicians know their actions are harmful, it is political suicide not to take them. They are, after all, in charge. Not acting is considered a sin of omission.

Since the mid 1960s economic policy has been one series of “remedies” after another. Expressed by Didier Sornette (see below):

Each excess was felt to be “solved” by measures that in fact fueled following excesses; each crash was fought by an accommodative monetary policy, sowing the seeds for new bubbles and future crashes. Not only are crashes not any more mysterious, but the present crisis and stalling economy, also called the Great Recession, have clear origins, namely in the delusionary belief in the merits of policies based on a “perpetual money machine” type of thinking.

That is the petard that Keynes built and upon which Keynesianism and our meddling politicians will destroy the economy.

John Mauldin provided a wonderful discussion of economic complexity in his weekly newsletter (subscribe, it is free), and an example of how policy-makers are trapped in the Keynesian mindset. Pavlovian responses may solve short-term political problems but they do not solve long-run economics problems. They make them larger and more intractable. Here are Mr. Mauldin’s comments:

We Can’t Take the Chance

On Saturday night David scheduled a formal debate between bond maven Jim Bianco and former Bank of EnglandMonetary Policy Committee member David Blanchflower (everyone at the camp called him Danny). Jim Bianco needs little introduction to longtime readers, but for newbies, he is one of the top bond and interest-rate gurus in the world. His research is some of the best you can get – if you can get your hands on it.

Blanchflower needs a little setup. He is currently a professor at Dartmouth and has one of the more impressive resumés you will find. He is not afraid to be a contrarian and voted in the minority in 18 out of 36 meetings in which he participated as an external member of the Bank of England‘s interest rate-setting Monetary Policy Committee (MPC) from June 2006 to June 2009. (The MPC is the British equivalent of the US Federal Open Market Committee.) Blanchflower’s The Wage Curve, drawing on 8 years of data from 4 million people in 16 countries, argued that the wage curve, which plots wages against unemployment, is negatively sloping, reversing the conclusion from generations of macroeconomic theory. “The Phillips Curve is wrong, it’s as fundamental as that,” Blanchflower has stated. Blanchflower is also known as the “happiness guru” for his work on the economics of happiness. He quantified the relationship between age and happiness and between marriage, sex, and happiness. Who knew that people who have more sex are happier? Well, we all did, but now we have economic proof.

I got to spend a good deal of time with Danny on this trip and enjoyed hearing him talk about what it was like to be responsible for setting monetary policy in the midst of a crisis. We also argued late into the night on a variety of subjects. He is an altogether fun guy as well as a professional who takes his economics seriously. He is far more mainstream than your humble analyst, as were many of the denizens of Camp Kotok. On the other hand, I can’t think of a major stream of economic thought that wasn’t represented aggressively at one point or another. If you have thin skin or weak data, this outing is one you might not enjoy. You need to bring your A game with this crowd.

The format for the debate between Bianco and Blanchflower was simple. The question revolved around Federal Reserve policy and what the Fed should do today. To taper or not to taper? In fact, should they even entertain further quantitative easing? Bianco made the case that quantitative easing has become the problem rather than the solution. Blanchflower argued that quantitative easing is the correct policy. Fairly standard arguments from both sides but well-reasoned and well-presented.

It was during the question-and-answer period that my interest was piqued. Bianco had made a forceful argument that big banks should have been allowed to fail rather than being bailed out. The question from the floor to Danny was, in essence, “What if the Bianco is right? Wouldn’t it have been better to let banks fail and then restructure them in bankruptcy? Wouldn’t we have recovered faster, rather than suffering in the slow-growth, high-unemployment world where we find ourselves now?”

Blanchflower pointed his finger right at Jim and spoke forcefully. “It wasn’t the possibility that he was right that preoccupied us. We couldn’t take the chance that he was wrong. If he was wrong and we did nothing, the world would’ve ended and it would’ve been our fault. We had to act.”

That sentence has stayed with me for the past week: “We couldn’t take the chance that he was wrong.” Whether or not you like the implications of what he said, the simple fact is that he was expressing the reigning paradigm of economic thought in the world of central bankers.

Now, let’s hold that train of thought for a few minutes as we introduce an essay by French geophysicist and complex systems analyst Didier Sornette and his colleague Peter Cauwels. Sornette is Professor on the Chair of Entrepreneurial Risks at the Department of Management Technology and Economics of the Swiss Federal Institute of Technology Zurich. (This introduction comes from work I have been doing in collaboration with Jonathan Tepper, my co-author for Endgame.)

By far the biggest advances in understanding the dynamics of bubbles in recent years have come from Sornette. He has developed mathematical models to explain earthquake activity, Amazon book sales, herding behavior in social networks like Facebook, and even stock market bubbles and crashes. He wrote a book titled Why Stockmarkets Crash. He found that most theories do a very poor job of explaining bubbles.

Sornette found that log-periodic power laws do a good job of describing speculative bubbles, with very few exceptions. Classic bubbles tend to have a parabolic advances with shallow and increasingly frequent corrections. Eventually, you begin to see price spikes at one-day, one-hour, and even ten-minute intervals before crashes.

After a crash, journalists go looking for the cause. They’ll blame something like portfolio insurance for the crash of 1987 or the bankruptcy of Lehman Brothers for the Great Recession, rather than blaming a fundamentally unstable market. Sornette disagrees:

Most approaches to explain crashes search for possible mechanisms or effects that operate at very short time scales (hours, days or weeks at most). We propose here a radically different view: the underlying cause of the crash must be searched months and years before it, in the progressive increasing build-up of market cooperativity or effective interactions between investors, often translated into accelerating ascent of the market price (the bubble). According to this “critical” point of view, the specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability. Think of a ruler held up vertically on your finger: this very unstable position will lead eventually to its collapse, as a result of a small (or absence of adequate) motion of your hand…. The collapse is fundamentally due to the unstable position; the instantaneous cause of the collapse is secondary. In the same vein, the growth of the sensitivity and the growing instability of the market close to such a critical point might explain why attempts to unravel the local origin of the crash have been so diverse. Essentially, anything would work once the system is ripe.

Sornette’s conclusion is that a fundamentally unstable economic system plus human greed means that market bubbles and crashes won’t disappear anytime soon.”

A Few Impossible Things

I want to focus on the recent paper Sornette wrote with Cauwels, entitled “The Illusion of the Perpetual Money Machine.” I’m going to quote a few paragraphs from the introduction. They begin with that marvelous exchange from Alice in Wonderland:

There is no use trying,” said Alice. “One can’t believe impossible things.”

continue article at EconomicNoise.com:

http://www.economicnoise.com/2013/08/11/keynesianism-is-killing-us/