Two British Gentlemen and the American Economy

Posted January 17, 2009

While watching one of the many news and news talk shows, from Morning Joe to American Morning, to News Hour with Jim Lehrer, even to HBO's Real Time with Bill Maher, one sees debate between American know it alls on the ailing economy. Economist like Paul Krugman provide credible but inconclusive analysis and political jacks of all trades like George Will and Patrick Buchanan provide easily refutable analysis of economic principles taken from the sweat off the brow of their researchers. The talk does little to clarify and often raises more questions than answers, and inevitably false premises creep in to the national debate and needed clarifications remain unresolved. Overseeing all of this is the fact that our economic woes may be the culminiation of a debate between two British Gentlement, separated by birth by more than a century, who held very different views of national economies and national government. I refer to Adam Smith and John Maynard Keynes. Since both are dead, the debate between them goes on with current day pundits of both the politican and economic kind speaking on their behalf (but not admitting so), and unfortunately, muddling the theories in their explanation.





While the purpose of this post is not to advocate for one gentleman's theory over the other, I do believe it is time to look at what Smith and Keynes offered for our times. Economic theories are complex fare and require far more analysis than offered here, but for that matter far more analysis than has been offered in some of the leading media outlets, including the financial and economic press. So I will do no better and hopefully no worse than the media when I reduce Adam Smith's theories to a mantra--his invisible hand mantra. By that it is assumed that economies, made up of markets, are self-healing guided by an invisble hand. Players in markets act rationally, which is toward self interests. A field of competition made up of rationally acting self interested players produces a Darwinian set of winners and losers, and the market adjusts to each little micro competition which when counted by the millions produces macroeconomic results--presumably all for the better. All of this activity is done in the private sector.

Such a market does not, in theory, need a lot of regulation since it operates off of a rather organic thesis. Darwinian winning and losing is natural and there is something about that need to succeed and the competition that protects winners and discards losers that keeps all or most outcomes within manageable parameters.

John Maynard Keynes might not be a foil for Smith, but by proposing the injection of government in the regulatory life of the economy as well as ensuring that economy's liquidity through government spending Smith's invisible hand gets a little visible guidance. Keynes' theories were the basis of the New Deal, and in a bit more extreme form, the socialization of Great Britain during the post war years preceding the government of Margaret Thatcher. Britain's socialization was extreme and bizarre and lead to the impoverishment of that world power during that period. Nonetheless the American version fueled the Great Society of Lyndon Johnson, and became pretty much the way government economic management was handled until the ideologically based changes wrought by the Reagan Administration.

Since deregulation and tax cuts this country has had its most dangerous periods of deficit spending, forcing economist to rethink some basic notions of how economies run when government is broke--spending more than one has means broke. I took graduate economics courses during the 80s and was told about the crowding out effect. That was supposed to be about how deficit spending forced government to go to the credit markets for money, raising the price of money via the supply and demand function, and making credit unavailable or more expensive for private sector players (and usually growth slows as well) . In minicosm, that is how exactly what happens and its called recession and the evidence of such can be found in the failures of developing country after country especially during the sovereign debt crisis of the 80's (the crisis is still going on, by the way).

For purposes of the developed states--ie the industrialized countries, recessions came and went, but a permanent state of recession has not occurred. Much of this has to do with complexities in financial markets, and, among other things, the creativity of the major players in these markets. Back to Adam Smith, assuming that everyone is a rational actor seeking maximum gain, the markets which provide liquidity to the system produced that liquidity through innovation. But if the private sector is crowded out because of the gorilla known as the US budget in the room getting its share of cash, where does the liquidity for private sector growth come from? It comes from new markets and new financial products.

The new markets are, of course, the newly industrialized countries, including China, and the new products are the product of creative packaging of the same small pie. New kinds of lending, new kinds of ways of profiting off that lending, and new kinds of ways of marketing these new products. A ponzi scheme except that the last one holding the bag was everyone in the market.

This was not supposed to happen. Our 18th century British gentleman Mr. Smith counted on rational behavior. His thesis lives or dies on whether economic historians define our period as one of rational behavior or irrational greed. Keynes would not seem to be a catch all solution because government is notoriously bad at running things and eventually government spending when out of control, as it usually is, produces the same deficits and crowding out that business oriented tax cuts do. Neither approach alone solves this mess.

But who ever said that we had to rely only one or the other?