The Pantland Rebuttals, part 1A

I promised a while ago to take on Walton Pantland on two statements, one of which was:

Keynesism (sic) is interventionism that largely pulled the US out of the free market created depression.

The “New Economy” of Keynes was indeed one of interventionism. However, both the stated cause of the depression, and the claimed Keynesian remedy, are wrong, in my view.

(Let me say first that I’m no economist. I apprehend economics in layman’s terms, and explain it in the same way. Still, even top economists continue disputing these particular issues. I hope that my attempt at explaining how I understand it won’t offend too many thinkers more qualified than I am on the subject.)

The Great Depression has a number of important features that argue against blaming it on free markets. In particular, markets had not been by any means free.

Before the depression, there were the Roaring Twenties. Growing out of the economic depths of the First World War, which had its perigee around 1921, the twenties featured rapid innovation and rising production levels. Times were good, but it should be remembered that this was not a boom as much as it was an economic recovery.

Now one might have expected prices to decline as production grew, and for interest rates to rise as demand for investment capital increased. However, interest rates, being set by central bank fiat, did not rise as rapidly as one might have expected. In an attempt to stablise prices, the government encouraged low interest rates, which artificially reduced the cost of capital, and artificially fuelled the expansion. Credit was extended hand over fist, while the going – read: central bank interest rates – was good.

This overinvestment, of course, was not sustainable. As we have seen more recently with the dot com boom, overinvestment tends to be followed by a painful return to equilibrium. Under normal circumstances, in which there is a free market in capital – i.e. interest rates are set by the market – the disequilibrium will be spotted early and equilibrium can therefore be achieved fairly rapidly. The pain, in the form of wage deflation, layoffs and bankruptcies, will be limited. However, combine an economic recovery with intervention that is designed to (or has the effect of) artificially extending or encouraging the expansion, it follows that the correction, when it comes, will be all the more harsh. Hence, the Great Depression.

That’s not unlike the situation in the 1990s. Alan Greenspan famously warned of “irrational exuberance” in the investment market. He said so with a straight face, when the very Federal Reserve of which he was chairman was setting the interest rates which drove credit extension. That’s like pouring fuel on a fire, and remarking that it’s getting very hot. (The more recent US housing boom is no different: again, interest rates are being kept low to artificially extend, rather than consolidate, the rising property market.)

In these cases, a free market in capital – in which the price was set by supply and demand, rather than by government policy implemented by a central bank – would have cause interest rate to rise more rapidly during the expansion. In both cases, that would have encouraged more rapid liquidation of misinvested capital, so that it could be more productively invested. Instead, capitalists continuing to fund their misallocated capital with artificially low interest rates, in the hope that one day it would pay off. This only made the pain worse.

There’s a clear historic correlation between central bank interest rate policy and asset values. Assets that do not depend on the price of credit, such as commodities, rise in value as interest rates go up. Assets that do, such as stocks (equity) and bonds (debt) decline.

This makes it clear – to me, at least – that the misallocation of capital and overexpansion, such as we saw in the 1920 and 1990s, are largely caused by how investors react to government policy, rather than how market participants would act on their own volition.

Now, as for John Maynard Keynes and Franklin D Roosevelt, were they really responsible for recovery from the Great Depression? It is clear that without government intervention in the first place, a giant recovery effort would not have been needed. The economy recovers naturally from every bust, as investors liquidate misinvested capital and prioritise where to allocate it to maximum economic advantage.

I am of the view that it would have recovered without any aid from Keynes or the New Deal. Interventionism artificially expanded and prolonged the prior boom, at the cost of better allocation of capital which would have entrenched the gains. In the same way, post-depression interventionism artificially impacted on the recovery, again resulting in misallocation of capital.

But I’m getting ahead of myself here. (I lie. I’m running out of time.) I’d welcome comments, corrections and amplifications on this summary from people who did study the subject in more detail than I did. Bonus points for identifying the economic theorists I’m cribbing from here…

In the next exciting installment, we’ll look at the real impact of Keynes.