To Be Clear, the 'Helicopter' Is Not Stimulus

Story Stream
recent articles

Before there could be John Maynard Keynes there was John Neville Keynes, a tautology given that John Neville was John Maynard's father. While the son has attained worldwide recognition and whose reputation looms large seven decades after his death, a great deal of what he did was learned from the father. John Neville was himself renowned, and for good reason. As a philosopher, he helped try to resolve the art of political economics toward more scientific principles, as difficult a challenge as that was and remains.

In 1884, John Neville published Studies and Exercises in Formal Logic, a work almost unique for its everyday proposals and method of explanation, uncommonly eschewing the heavy mathematics that dominated even at that time. His most famous published effort was 1890's The Scope and Method of Political Economy. It was an attempt, and a decent one, to bridge the philosophical divide during Methodenstreit; the "battle of methods" was a serious split in German economic principles, with Carl Menger and the Austrian school on one side advocating deductive reasoning (pure theory) and the inductive approach of Gustav von Schmoller and other Germans on the other. Keynes, essentially, argued that inductive reason should inform, in an overly simplistic distillation, the general premises of deductive reasoning.

Thus, Keynes set out to describe positive economics, the economy that is, versus normative economics, the economy that "ought" to be. Modern economic theory has been placed by those that have advanced it into the camp of positive economics, not just through Keynes, father and son, but also the work of Milton Friedman.

In 1953, Friedman published perhaps his most scholarly book, Essays in Positive Economics. While including other authors, the lead essay was Friedman's The Methodology of Positive Economics which remains his most cited academic piece of inside baseball. The first sentence of the essay quotes John Neville Keynes' 1890 Scope and Method, recognizing the substantial "confusion" between positive science, normative science, and art that has been "the source of many mischievous errors."

As the title of Friedman's essay directly states, his discussion was aimed at further refining and defining positive economics under what he believed sound scientific and methodological reasoning.

"Positive economics is in principle independent of any particular ethical position or normative judgments. As[John Neville] Keynes says, it deals with "what is," not with "what ought to be." Its task is to provide a system of generalizations that can be used to make correct predictions about the consequences of any change in circumstances. Its performance is to be judged by the precision, scope, and conformity with experience of the predictions it yields. In short, positive economics is, or can be, an ‘objective' science, in precisely the same sense as any of the physical sciences."

It is the substantial, philosophical basis for econometrics. A statistical model is axiomatically incorrect; it is a representation, therefore it can never be a full description of reality. The emphasis, then, is upon predictive capacity of the model not in its description of why or how that might occur. In 1987, statistician George E. P. Box coined the phrase "all models are wrong, but some are useful" which has been described in econometrics as an approximate slogan for what Friedman was driving at in 1953.

In more specific terms, Friedman argued that economic theory containing false assumptions did not, indeed could not, on its own invalidate the theory.

"To put this point less paradoxically, the relevant question to ask about the ‘assumptions' of a theory is not whether they are descriptively ‘realistic,' for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions."

To get to this point, Friedman claims a hypothesis must be "important", by which he defines as, "if it ‘explains' much by little, that is, if it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained and permits valid predictions on the basis of them alone." In statistical usage, this is justification for ignoring the "error" terms so long as the few independent variables supply sufficient predictive capacity.

Positive economics, then, is a structured paradigm that must follow its own rules. Econometrics, at least as it was closer to its origins, was supposed to be tidy and disciplined, pliable only in the sense that when predictions failed they called for even dramatic reassessment. All science is that, and if economics was to be taken seriously under those terms it could not be wedded to unworkable theories always describing only what "ought to be." To continue to do so risks those mischievous errors that Keynes, John Neville, warned of more than a century and a quarter ago.

There is, however, an inherent flaw where economic theory is perhaps most important in practical usage. This is something that Milton Friedman himself very briefly mentioned in passing in A Monetary History; a small little nothing that may have seemed unimportant or innocuous in the context of 1963, but in 2016 it seems as if it was written as if it was describing Ben Bernanke's turbulent tenure, including QE at the Fed, ECB, or Bank of Japan.

"In years of prosperity, monetary policy is said to be a potent instrument, the skillful handling of which deserves credit for the favorable course of events; in years of adversity, monetary policy is said to have little leeway but is largely the consequence of other forces, and it was only the skillful handling of the exceedingly limited powers available that prevented conditions from being worse."

That passage was recalling primary source material of Fed reports, in-house memorandums, and meeting transcripts, appearing in footnote 13 of the chapter he and co-author Anna Schwartz titled The High Tide of The Reserve System describing, in his view, the decade of the 1920's. That is all, of course, basic human nature, a mechanism of self-defense whereby it is always easier to blame someone else or take credit where it may not be entirely deserved. In the context of positive science, however, this is a dangerous insulation from the necessary processes of correction.

This was not an unrecognized weakness that he limited to one small footnote in an otherwise lengthy, highly distinguished career. In one of his last interviews before he died in November 2006, he said:

"The difficulty of having people understand monetary theory is very simple-the central banks are good at press relations. The central banks hire people and the central banks employ a large fraction of all economists so there is a bias to tell the case-the story-in a way that is favorable to the central banks."

When you add in the media prejudice that presupposes unquestionable science of central banks, central bankers, and economists all based on credentials and nothing else, the peril of monetary mistakes is neither incidental nor coincidental. Monetary policy is thus conducted in a bubble, wholly separated from challenge that is necessary to produce robust, scientific results. What is left is a rump "science", a small part dedicated to describing the economy that "ought to be" but largely in the form of not allowing the smallest hint of honesty when it is most called for.

The primary reason for that was/is the role that Federal Reserve myth has played in its own development of modern models; the Fed assumes it is a powerful entity, the most powerful entity, and by circumstance of "markets" believing in that power it can never be wrong. Therefore, the Fed's world that "ought to be" is one where it remains the focal center no matter what.

It is from this false assumption that proceeds as only enlarging QE's and now NIRP and even Milton Friedman's own "helicopter money." And as much as the helicopter has been invoked recently, it is done so as if Friedman would approve of it without ever referencing The Methodology of Positive Economy. Monetary policy of positive economics is not at all so ad hoc, whereby central banks simply throw something out with their fingers crossed. There are supposed to be rules guiding rigorous assumptions leading to predictable conclusions. The entire age of the Great Recession and its aftermath has been one violation of positive economics after another with economists flat refusing observation and to own up to failed predictions, preferring instead to remain curled up in the fetal position blindly invoking the recovery that should be and how it is still just a little further over the horizon even though nine years have now passed.

Ben Bernanke's relationship to the helicopter is quite well established. It was his presence in Japan just a few weeks back that started the rumors, not the least of which in association with his (in)famous November 2002 speech. That was the one where he spoke directly about just how powerful the central bank was because it possessed the "printing press." He even went so far as to explicitly reference Friedman's helicopter in the form of "a money-financed tax cut." Everyone simply forgets that this was already tried in early 2008 because its results were just that forgettable, yet here they are demonstrating again Einstein's definition of insanity.

As usual, however, it is elsewhere in that speech that contains the more relevant and important indications. The occasion of it was the context of the then-ongoing dot-com bust and the inability of the recovery to take hold as anything more than just the absence of further recession. Because of the combination of persistent economic weakness, "unexpected" of course, and uncertainty due to the stock crash, there were very real discussions about deflation at that time.

None was more representative of the climate of growing doubt than the FOMC discussion that took place in June 2003, just six months after Bernanke's speech. At that time there were even grave doubts inside the FOMC voiced by participants that suggested an opening for the kind of self-examination that every good scientific endeavor requires. It was none other than Alan Greenspan who challenged the group intellectually if not practically to truly consider the core myth of central banking and monetary policy; that though they all believed they had the "printing press", maybe it wasn't so straight-forward as it seemed.

Paraphrasing Greenspan's doubt, he essentially bid that they make sure they can do what they say they can do before they actually have to do it. Of course, they never did because the recovery that "ought" to be finally showed up. Rejecting Keynes, John Neville, they never reconciled the timing as an element of predictability.

By not doing so, they left the world economy vulnerable to what Bernanke was disparaging as impossible in late 2002 relating to his model of an all-powerful central bank.

"The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress."

He nearly perfectly describes 2007-09 as what did occurr under in the midst of his somehow still-celebrated tenure. But it also applies, more importantly, to the seven years (and counting) that followed. To boost "aggregate demand", they employed first a zero interest rate policy and then quantitative easing. Nothing worked. Though the unemployment rate today indicates "full employment" in absolute terms, it only does so by leaving out of the denominator some 10 to 15 million potential workers. By a broad survey of economic accounts, including GDP, the initial recovery was stunted and then by 2012 just stopped. This pattern is alarmingly uniform across the entire world.

A key clue to this unique and troubling circumstance was delivered also in Bernanke's 2002 speech, immediately following the part I quoted above:

"However, a deflationary recession may differ in one respect from ‘normal' recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero."

What might it say, then, when the nominal interest rate does decline to zero and remain there for seven years, and "close to zero" for still longer yet? We need to first make sure we define our terms. Deflation means a general decline in consumer prices. This is distinguished from specific declines as might arise from productivity and technological innovation. A general decline is a monetary phenomenon, not an economic one. This chronic condition is so feared by economists that they have chosen to target a 2% per annum inflation rate (3% in China; 4.5% in Brazil) lest "expectations" of deflation ever become grounded or "anchored."

Thus, the decline of interest rates to zero corresponds with a monetary imbalance in favor of deflation, if at least an abundance of deflationary pressures. This is something that Milton Friedman also talked about, particularly in 1998 with regard to Japan. He called it the interest rate fallacy, meaning that low nominal interest rates signify "tight" money conditions, or what would be consistent with significant deflationary pressure. It is and remains a fallacy because economists like those at every central bank around the world have decided instead that low rates are only "stimulus."

To correct this view, Friedman pointed out the basic, non-trivial distinction between a liquidity effect and an income effect. Low rates can be stimulative in the short run (the liquidity effect), but over the long run their persistence means something far different. A yield curve is supposed to be upward sloping given the core time value of money and investing. That arises from opportunity cost, meaning the more plentiful the opportunities the greater the time value and the steeper the curve (the income effect). Yield and/or money curves (the eurodollar curve and even the history of the OIS curve) that collapse and remain that way unambiguously demonstrate that "stimulus" deserves only the quotation marks.

Policies that continue to be categorized in that fashion while the interest rate fallacy remains are devoted to the economy that "ought to be", not the economy that is. The danger comes as Keynes warned, in repeating mistakes rather than learning from them. The result is a trap of exactly what Bernanke described as never being able to happen here: recession, rising unemployment, and financial stress. In comparison to 2009, none of those things seem appropriate descriptions; in comparison to 2007 (or even 2000), however, which is what truly matters, they all apply and significantly so!.

"Economists will argue that the US has been experiencing a recovery, and even a rapid one of late. According to the BLS, total hours worked do seem to point in that direction in the narrow view of an assumed business cycle. Through Q4 2015, total hours have increased by 12.8% since the trough of the Great Recession. The level that positive trend attained by the end of last year, however, is only 2% more than what the BLS estimates for the US economy at the peak (Q2 2000) just before the dot-com recession. In other words, there is barely more labor activity now at the end of 2015 than at the start of this century...

"The enormity of that decay is almost incomprehensible, especially when factoring population. The BLS in its other estimates tells us that the civilian non-institutional population, the aggregate pool of all potential laborers, expanded by nearly 41 million in those fifteen years. That means the raw count of potential workers grew by 19% while total labor output added just 2%."

In just these labor statistics we find that Bernanke was already wrong by 2002, and that the deflationary pressures that would end up exploding into the panic and Great Recession were already rotting underneath. The basis for any economy is trade, not money. Money is a tool which can restrict trade if insufficiently supplied, and can be overly distortive if in the other direction. It used to be the basis for modern monetary theory, even if simplistic to our modern sensibilities (h/t Izabella Kaminska of FT):

"High up on the wall of the Court Room at the Bank of England is a dial, linked to a weather vane on the building's roof. Now a novelty for visitors to the Bank's grandest function room, knowing the direction of the wind was a deadly serious tool of monetary policy on its installation in 1805.

"If the wind was coming from the east, ships would soon be sailing up the Thames to unload goods in London. The Bank would need to supply lots of money, so traders could buy the wares landed at the docks. If a westerly was blowing, the Bank would mop up any excess money issued to stop too much money chasing too few goods, thereby avoiding inflation."

This basic concept was one that was incorporated into the heart of Milton Friedman's analysis unlike what has come after him but still in his name. Central banks actually believe they can create the income effect via the liquidity effect, i.e., "stimulus"; in other words, they think they can reverse engineer the Bank of England's weather vane - create enough money and the ships will come in regardless of the wind. It's a dubious prospect on its face, but even more so given the more than two decades of "anomalies" that have showed central banks don't, in fact, have a printing press. They mess with the yield curve, short rates, real rates, asset prices, and anything in between all in search of being the master that they have mythologized without any good reason other than hearsay and circular logic for the mythology.

They claim to be the noble descendants of econometrics but we find only wreckage in their wake. In 1953, the father of their discipline demanded that if they choose to use so little understanding they must then explain a great deal that is important by it. Instead, they hold dear only that little no matter if it explains nothing. The world of 2016 makes a lot of sense under these terms; they purposefully know nothing so they accomplish nothing.

Modern economics is no longer anything like positive economics let alone claiming the mantle of science; it can't even live up to its own principles that once only aspired to be scientific. If we are to suffer the helicopter as all the rest, we should be very clear about what it is and what it is not. It is not stimulus; it is not Friedman; it is not even anything more than unjustified faith in an objectively disproven regime. It is the last (hopefully, should the world wake up sufficiently) gasp of the economy and recovery that "ought to be", an entirely out of place, intrusive Victorian era conviction of economics from before its infancy. This disastrous devolution is explained very simply and easily by another contemporary realization: power corrupts.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

Show commentsHide Comments

Related Articles