By Jay B Gaskill

Also posted on the Policy Think Site –

The liberal economist/columnist Paul Krugman and the other public policy mavens of like minds cut their teeth during that halcyon era when American production seemed to prop up the whole world economy. These smart men and women may sincerely believe they have accommodated their views to all the wrenching economic changes of the last twenty-five years.  But their minds are still eddying in the past; their theories and approaches are still caught in the drag of old assumptions.

One thing they seem to have missed: Scale changes the rules.

Exhibit One. In the run-up to our most recent crisis, underwater mortgages were packaged in hugely complex credit instrument bundles that were floated as assets – as it later was revealed, vastly overpriced assets. These packages were so out of scale (in size & complexity) with more straightforward traditional credit instruments, that ordinarily intelligent players were misled by their old assumptions.

The collapse of a misplaced trust bubble followed, and it almost took the world’s economy down with it.

Dr. Krugman is a Neo-Keynesian economist, a term that requires some explanation.[i] In its most benign form, counter-cyclical Keynesian economists advocate money-supply boosting measures to smooth out the business cycle – deficit spending in a recession, and running surpluses to pay down the debt during a boom.

The first counter-cyclical Keynesians were the Egyptian pharaohs.  Idle, off-season agricultural workers were impressed into pyramid building work.  But no one messed with the harvest; the laborers impressed into pyramid work would not otherwise have been employed at much of anything.  Egypt was a net food exporter and the pyramid workers returned to the fields every season.

The last prudent counter-cyclical Keynesian leader (IMHO) was President John F Kennedy.  His economic team used Keynes-style deficit spending and monetary policy to boost the money supply during a recession, but reversed the process during prosperity to repay debt.

Both boost and payback were modest by today’s standards. And scale matters.

In fact, scale-sensitive regimes are a universal principle in nature.  In physics, for example, the effective operating rules change when the scale changes.  At the extremes, quantum tiny (Heisenberg/Feynman/Plank), and cosmological huge (Einstein/Hubble/Peacock), the straightforward mechanics of Isaac Newton no longer work in the same way.  In fact, if the rules did not work differently at these different scales, we would not have computers, lasers or flat screen displays.

In economics, things also behave differently at the very small and the very large scales. Somehow, this basic caution has caught the current generation of economists by surprise.  As a result, modern overconfident economists are feeling their way in the dark, seduced by their new tools: massive computers using under-tested algorithms.

I mentioned that Paul Krugman is a neo-Keynesian economist.  Dr. Krugman and his fellow travelers have kept the kernel of John Maynard Keynes’ assumptions and doctrines, with important tweaks.  After all, Keynes (1883-1946) did all his work before computers, and well before the emergence of the modern world economy.  The Neo-Keynesians have produced mathematical models more or less based on Keynes’ principles. By utilizing very complex algorithms, the potential policy utility of simple Keynesian principles was greatly amplified.  A Keynesian advisor can plausibly tell a policy maker, “If you spend X in stimulus money, then our computers say you can get Y in increased employment.”  When this does not happen as predicted, the same economists tend not to blame the algorithm.  Instead they tell the policy makers that the plan worked, but the gains in employment were masked by other factors.

Just as was the case with the overly complex bundled debt instruments, the magnitude and consequences of potential policy error is also ramped up by blind reliance on algorithms. Their uncritical use by macro-economists is the modern equivalent of shooting in the dark.

Here is most persistent kernel of Keyes’s thinking: Because sharp reductions in the money supply can bring the production-consumption & employment-spending engines of an economy to a standstill, it follows (so Keynes and his apostles thought) that sharp increases in the money supply will work the opposite magic: One adds money in circulation and abracadabra, the injection generates a restart of the stalled production-consumption & employment-spending engines.

We need to note that Keynes’ particular focus was employment. This was a famously myopic frame of reference because employment takes place in the context of an employer that is generating income through the production or transfer of goods and services or via necessary ancillary activities.

In a famous example, Keynes asked us to imagine an English village paralyzed by intractable joblessness. He asked us to imagine in this famous thought experiment, that a benefactor (like the government) buries a cache of money just outside the village and gives the city the treasure map.  Quickly, a full-employment industry develops, digging up and distributing the buried Pounds Sterling.  No matter that the primary economic activity thus stimulated was make-work: In Keynes’ doctrine, general consumption will be stimulated; ergo further production and prosperity will return to the village.

Several under-examined assumptions were buried in this example, not the least of which the hidden assumptions about the scale and local nature of the problem. The village economy was not the whole of England. The newly “wealthy” villagers were able to import goods and services from the rest of the country.  After all, they couldn’t eat, drink or otherwise use pounds sterling except as that currency retained credibility as a medium of exchange. Moreover, the rest of England was actually working (for the most part) producing the goods and services that the villagers purchased, using their buried money from the make-work digging.

Clever counterfeiters have done just as well, thank you, as long as they remain a small minority…and are not jailed.

We saw this myopic conceit repeated in arguments made by former Speaker Nancy Pelosi when she defended the purported employment/consumption multiplier effect of extended unemployment benefits.  Keynes’ example was little more than unemployment benefits coupled with illusory, non-productive make-work.

In economics, supply-demand is a conservative law, something that liberals and Marxists have repeatedly tried to repeal with embarrassingly conservative results[ii].  But its application to real world situations also varies depending on scale.

For example, in a small isolated village where there is a single inventory of widgets and a fixed money supply, supply/demand works exactly as advertised, without fuzzy math.   Introduce a whole lot of extra money and it still works, but now you have added a whimsical demand factor.  A lone wolf player with a boatload of money can sew up the beer supply in our hypothetical village for example, and drive up prices.  This will eventually create an incentive for somebody to import outside beer…and so it goes.

Parked fiat money can achieve excessive levels without immediately affecting prices.  Think of weird Uncle Fred keeping a huge fortune under his mattress where old Fred is a non-drinker.

In the world of 1950’s America, the USA was a very large village.  Moreover we were the unchallenged lead producer of goods and services in a world the manufacturing base of which had either been reduced to rubble by bombs or had not yet emerged at all. American households had accumulated modest savings and big pent up demand because rationing had been in effect during the war.

Flash forward to the early 21st century.

  • If most WWII households were goods-deprived, by contrast most modern American households are goods-saturated.
  • Almost everything that is “made in America” faces a strong competitive counterpart somewhere else in the world.
  • The relevant money supply (that aggregate of exchange media that supports transactions) is no longer just American currency.  It is a whole range of currencies, debt and asset instruments of which the traditional greenback (including its virtual electronic forms) is merely one component.  [Economists depend on a measure of the aggregate money supply, but their data lags far behind the realities of the international economy.]

The profound internationalization of the money supply, driven by currency exchange markets and wildly differing local regimes, is an economic wild card.  There are so many hidden mattresses, so many realized and neglected spending opportunities, so many quirky demands and shortages.

Supply and demand laws still operate but the playing field is vastly more complex and significantly more unstable. IF the system remains sufficiently free and IF the players remain sufficiently rational, THEN shortages can level out whenever supply can be increased – or alternative products and services and fill the demand/supply gap.  For the moment, the system is not particularly free even in the USA – I note that government policies are holding back supply in sensitive areas like energy production.

Therefore, the injection of a huge overload of fiat money (as in deficit spending or the less obvious measures of the US fed) invites what we can call the tornado inflation effect.  A tornado can be a chaotic, unpredictable event.

Living with a large overhang of fiat money is analogous to living with the energy in a potential tornado-generating storm system.  A spot supply-bottleneck in any one critical energy or foodstuff component can suddenly draw a lot of buying energy, generating a price increase cascade that spills over to a range of other consumer prices with serious effects.  This risk tends to be masked before, during and after, by the macro-numbers that the experts are monitoring.  This is why catastrophic inflation is almost always a “surprise”. While the actual risk is amplified greatly by the fiat money load, longer effects of the monetary actions by the fed are not all that predictable.  Put another way, the algorithms can lie.

All of the historical destabilizing hyperinflationary episodes, from pre-Nazi Weimar Germany (1921-23) through the banana republic episodes in South America (1980-94), came as a surprise. Ugly surprises are in the nature of chaotic systems

There are several critically important questions that modern economists cannot yet definitively answer.  Among them looms this big one – Q: Please quantify the aggregate money supply, including all funds and financial instruments that are capable of fueling inflationary demand surges in the USA’s economy.

The fed’s entire structure of control rests on the legalistic axiom that it controls the “legal tender” question for all key transactions that can affect the US economy. This belief was founded in the doctrine that only US dollars can be used to settle US debts.  In the context of the world economy, this is a fatal conceit.  Article I, Section 8 of the Constitution does grant the federal government exclusive power to coin money and “regulate the value thereof.” The Federal Reserve central banking system was created on 12-23-1913 in order to achieve the orderly lending of money and “to regulate the value thereof.”  As a result, the fed and its bankers have felt secure in the assumption that, whatever mischief the other countries of the world commit, at least the USA will control its own economic destiny. But American dollar are only one component in the US domestic economy.

Conventional thinking at the fed treats the aggregate USA money supply in different categories, based on its working assumptions about liquidity.  The most liquid category (M1) consists of checking deposits and cash.  M2 expands the aggregate money supply to include short term savings, some money market funds and other reasonable quick access deposits. A third category (M3) has not really been used much, as I understand it[iii], but it attempts to roll in institutional money market funds, Euros, certain time deposit and the like.[iv] Ironically, the reserves of banks that are linked to the fed are not counted (presumably because the fed believes that it can control this component by metering its bank-to-bank lending).  Moreover the fed’s aggregate money supply does not include the whole sector of day-today borrower discretion lines of credit.

For all these reasons, I submit that the fed is incapable of coming up with a realistic, reasonably accurate answer to the real aggregate money supply question.

Consider just the most recent debacle in which bundled credit instruments containing “toxic assets” (translation grossly inflated, hugely overleveraged mortgages) were operating as a de facto part of the money supply. They might as well have dropped into the US economy from outer space.  Now consider the pervasive extent of international monetary entanglement with every aspect is US domestic commerce.

Far too many external influences are at work for Keynesian management of the US economy to amount to more that guess work covered in a thin patina of economic jargon.

  • Can we be reassured that the obligations of American businesses can only be retired by paying dollars when the very US business entities have footprints in six other countries?

  • Can we be reassured that foreign-controlled purchase moneys will not drive up demand for scarce US resources?

  • Can we be reassured that the fed really has a handle on all of the credit deals, deposits, asset-swap arrangements and dollar-equivalent currencies and quasi-currencies capable of impacting the US economy?

Of course not…

If the fed is not capable of coming up with an adequate answer to the aggregate money supply question, then how can we describe the fed’s attempts to manipulate the money supply as anything but experimental?

And if Fed Chair Bernanke’s efforts are experimental, why isn’t this just shooting in the dark?

Fed Chair Ben Bernanke & his colleagues are not sleeping well at the moment.  I give them credit for their attempts at ongoing monitoring – within the constraints of the available data.  One hopes and prays that with close, proactive attention, the fed may be able to tamp down the risks of hyperinflation that recent increases in the money supply can easily trigger.  But strong inflationary pressures are already in play.  For the moment, Bernanke and co. are distracted by the supposed risks of deflation, based on the price-collapse of a single asset class (US real estate).  Wiser heads counsel to let the real estate market bottom out sooner rather than later, rather than add to the general inflationary pressures in a futile campaign to prop up the unproppable.

The overall financial system has an irreducible chaotic component; and there are always costs of inflation containment. Anti-inflationary measures will impose costs in the form of new bureaucratic controls, higher interest rates and other measures (no doubt heavily influenced by politics), all of which are likely to restrain or reverse economic recovery.

If you take away no other lesson from this discussion, please highlight the risks that attend political interference with market forces. The decades-long political interference with the American economy has brought us this dangerous precipice. More of the same will lead us ever deeper into a mess from which there will be no easy escape.

All this suggests a strong cautionary message to fed chair Bernanke: You may be wrong.  Your algorithms may be dangerously misleading.

The entire system is a trust pyramid.  Never lose sight of that bedrock fact.

Over time, the fed’s tinkering impulses (so far in the form of quantitative easing and below zero interest loans) and the partisan impatience to govern by decree will begin to fatally damage the fragile core trust relationships on which the whole business system depends.  The real economic engines that fund everything else are tasked to earn money by producing and selling goods and services for which there is a real demand…and to do so at a profit.  Business activities are founded in trust relationships – in government policies that promote and protect predictability, transactional stability, in the legal preservation of earnings, in a stable and level playing field, and a non-hostile business environment.

When the core trust relationships on which healthy commerce depends fail then no algorithm, no theory, and no doctrine can avert the crash.

Or so it seems to me out here in Lake Foebegone country, where America has no enemies and every adult liberal is above average.


[i] My own romance with Keynesian doctrine ended with the crash of 2008.  See my article at

[ii] The Chinese communists of fifty years ago repeatedly attempted to decree supply increases without allowing for demand incentives.  They failed. The operations of supply-demand markets were a mystery to them.

[iii] I suspect this is because the needed data is too difficult for the fed to collect.

[iv] This is a simplification, of course, but it conveys the idea of economists trying to keep up with rapidly evolving transactional strategies in which traditional “money” is just one element.

Copyright © 2012 by Jay B Gaskill

First published on The Policy Think Site (

and the Dot-2-Dot Blog (

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