The Evil Genius of John Maynard Keynes

The mainstream use the term stagflation so loosely, it’s becoming a buzzword. But few people actually know what it means or what causes it. Here’s the answer…

Seventy years or so ago, Keynes saw that if Muhammad would not go to the mountain for a lower paycheck, the mountain must come to Muhammad.

What Keynes realized was that if modern institutional arrangements and political short-termism were going to prevent wages from falling far enough in the bust in terms of the dollars and cents people were paid in (if wages were "sticky downwards" as economists have it) – unlike the price of beach hats during a rainy summer, which, as far as politicians are concerned, can fall all they like – he could achieve the same result by making the dollars and cents themselves worth less!

Monetary inflation can price people back into work so long as they are under the illusion that they are not suffering a real cut in their wages, concluded Keynes…and the message spread.

Sooner, rather than later, of course, that illusion was dispelled. Soon, the workers and their representatives, not to mention the pensioners and welfare recipients, began to watch the published price indexes very closely and at the first hint of an uptick, they would all demand to be compensated for the loss to their purchasing power that that increase comprised.

Indeed, before very long, they were making the process pretty much automatic, by building indexation clauses into working agreements and state benefit payments.

John Maynard Keynes: Guns and Butter

So as more and more money was pumped into the world economy in the 1960s – led by a U.S. trying then, as now, to have both guns and butter – and as this inflation pushed prices up ever more rapidly, workers became ever quicker to adapt to the change, making any lessening of their real cost to employers ever more transient and unreliable.

Inflation, then, was not reducing unemployment in anything like the manner the Keynesians had predicted, and this was solely because the plumbers had outsmarted the professors and the sausage makers had gotten a jump on the central bankers.

In due course, this helped hasten the monetary breakdown of the early ’70s. Nixon put America into another partial default (FDR having been the first to do so) by closing the gold window. The breakdown of the Bretton Woods system, which Keynes himself had helped to construct before his death, soon followed.

Then, as the dollar – for so long propped up only by the purchases made, largely unwillingly, by all the other central banks – plummeted, and war broke out in the Middle East, the oil producers decided they would not sell their resources artificially cheaply for depreciated paper, an aversion naturally heightened by the fact that some of these same resources were being used to fuel their enemies’ assault tanks and jet fighters.

Here another blunder was made by unthinking mainstream economists, under pressure from their political masters.

John Maynard Keynes: Core Consumer Prices

Instead of accepting that oil was henceforth going to cost more dollars than it had before, and instead of reining back on the creation of money, so that the inflation that brought this about might be slowed, energy costs were baldly dropped from the calculations. About this time, the concept of something called "core" consumer prices – a measure excluding first energy, but later also food prices – became the vogue.

Now, if you had spent $10 on gas and $5 on groceries yesterday, by rights, when gas went up to $12 overnight – and assuming you would rather be without your shallots than without your Chevy – you should have had only $3 left with which to buy food today – and the price of food should have fallen to reflect this new economic reality.

No extra money (no inflation) and no overall rise in price, only a relative change in these prices would have ensued.

But no! Most central banks, anxious not to see money diverted from domestic producers to the account of the foreign oil magnates, simply had another $2 printed up so that you now had $17 to spend in place of your original $15, so $12 for oil and $5 for food could be simultaneously accommodated, at least in accounting terms.

What they failed to notice, of course, was that this did not give full voice to the more urgent requirement for gas, nor did it truly reflect individuals’ lesser relative demand for green beans and that by "monetizing" the oil price rise, they were only making matters worse!

They also struggled to see that the sheiks still got more of the pie, both in monetary and in real terms, despite their efforts to confound this shift in free market valuations.

Remember, too, that while all this was going on, organized labor and the political parties that represented it were perhaps at the zenith of their powers, and so as prices rose, wages and benefits rose just as fast, if not actually faster.

This meant that, rather than becoming cheaper, workers were, in many cases, getting pricier, and goods, as we saw, that are more pricey do not tend to sell as readily as those that are not. Unemployment, therefore, rose.

Whereupon there was another reason to inflate again, for once the market adjusts to a given volume of money and a given matrix of prices, to prevent another relapse, the artificial stimulus must be reapplied, and in increasing dosage to boot.

This process – in another failure of economic vocabulary – became known as "cost-push" inflation, or as the "wage- price spiral." That way, the real culprits – the men whose hands were covered in printer’s ink – could conveniently lay the blame for the woes of the world onto militant union leaders at home or onto sinister Arab princes abroad.

John Maynard Keynes: Fiscal Drag

At the same time, "fiscal drag" – by which we mean the process wherein tax thresholds and depreciation allowances are not adjusted fully in line with rising prices – was bleeding businesses of internal funds, limiting their ability indirectly to employ others higher up the cone of production, by placing orders for capital equipment and plant via continued investment.

Moreover, with foreign exchange rates going wild, with interest rates more volatile than for many a long year and with commodity prices soaring alongside labor costs, few businessmen were able to make any meaningful plans for the future.

Indeed, the whole question of what constituted a profit became vexed when historic costs of inventory or equipment recorded on the books bore little relation to prices being charged on current markets.

Further, with all this "core" consumer price nonsense and amidst all these ex-food and ex-energy shenanigans, all manner of relative prices were being distorted, too, as our green beans and gas example illustrates. It cannot be over- emphasized that relative prices are the kinds that provide the most important market information of all to any entrepreneur.

This is because, in many ways, the entrepreneur is effectively someone who takes a recipe out to a shop, buys the ingredients listed there, and then bakes a cake to be sold later in his or her market stall. If he can’t accurately price the flour and the sugar, the fruit and the butter, and measure the total against his estimate of what someone is likely to pay for the finished pastry, how can he expect to make a profit by his efforts?

John Maynard Keynes: Less of Everything

So in addition to being unable to afford the higher wages arrived at under threat of strikes, or through subjection to government "arbitration" and the forced complicity with national pay deals, on top of having capital consumed by the interaction of flawed accounting systems and rapacious government revenue departments, company executives and business owners alike found themselves increasingly uncertain as to what it actually was they should be doing if they were to make a profit; even one, at root, that they couldn’t properly quantify if and when they were to make it.

Naturally, then – either voluntarily or by force of circumstances – they did less of everything. Production was cut back. Joblessness rose, and stock prices plunged – though sometimes the extent of their fall was disguised by the coincident steep fall in the value of people’s money.

For a while, as all this went on, the politicians and the central banks fell back on their two most readily utilized means of Depression-busting – a resort to the command economy means of maximum prices, mandatory wage caps and of restrictions on the mobility of capital and, of course, to more inflation to combat the spreading stagnation of output and work.

Ultimately, however, this was recognized as being inherently self-defeating and, clad in the political camouflage of an adherence to the "new" doctrines of monetarism, the Anglo-Saxon central bankers – a distinction we draw because their more conservative continental counterparts had, as ever, been a deal less susceptible to such follies – began to do what was long overdue: They cut back sharply on the pace of credit creation and let the inevitable bust work itself out at last. For such a belated recognition of economic reality was Paul Volcker apotheosized and allowed to ascend the monetary Mount Olympus from whence he appears occasionally to berate the poor mortals who succeeded him!

And that, ladies and gentlemen, was what stagflation was all about – and a fairly horrid experience it was, too.


Sean Corrigan
for The Daily Reckoning
August 24, 2004

"I don’t see what the problem is," said Forbes columnist Ken Fisher over dinner last night. "This economy is great. I don’t see any problems. Stocks are cheap – at least compared to junk bond yields.

"Look, at the beginning of the year, everybody was singing the blues about the twin deficits…because the dollar was going to collapse, interest rates were going to rise and the stock market was going to melt down. And guess what happened? Nothing. We’re still waiting. None of those bad things happened.

"And yet, everybody’s still so negative. I think what we’re going to see is a big surprise later this year…a melt-up in the stock market, when people get tired of worrying and start thinking about making money again."

Could prices "melt-up"?

Of course they could. But when we look around us, what we see are many more reasons why stocks are likely to get cheaper, rather than more expensive. Stocks hit a major high four years ago. They don’t usually go for another major high – without hitting a major low first. The whole cycle takes about 30-40 years, peak to peak. We have a long way to go down before another major bull market begins. Buying stocks before the next low is achieved is very risky business; you’ll be fighting nature all the way.

There is also the interest rate cycle, the rising oil price, the unresolved trade deficit, consumer debt, mortgage debt problems, the decline of the dollar, declining consumer incomes and a shortage of jobs. Any one of these alone could lead to an economic slump or falling stock prices. Together, they could conspire to create an extreme financial collapse. Not a melt-up but a meltdown…

Nothing much has happened so far this year. The Dow seems frozen in one spot, at about 10,000. Gold is stuck at $400. Each time we think one of them might be thawing out or breaking away, a cold blast comes down…and the move comes to a chilly halt.

Sooner or later, something’s bound to melt. By our guess…more likely down than up.

More news from Eric Fry…


Eric Fry, reporting from the Pacific Coast…

– Work is the new vacation…R&R is démodé. According to the glossiest of America’s glossy travel magazines, working vacations are all the rage. Trout fishing is out; counting butterfly larvae in the Amazon is in.

– For just a few thousand dollars, the vacationing "Type A" can enjoy a week in Tanzania monitoring mating cheetahs. Alternatively, for a modest fee, hardworking Americans can take a break from their labors by working for someone else. Pitched as an opportunity to check out a "dream job," they could spend three or four days learning to make cheese or learning to run a bed-and-breakfast or learning to tend bar.

– Your New York editor cannot relate…when it comes to vacationing, he is a traditionalist. Vacations are for rest and relaxation. He tries to do nothing at all…and usually succeeds. Occasionally, he yields to the restlessness of his co-vacationers and does a little something…like driving to a different beach for the day.

– Over the last few days, your New York editor has visited various Hawaiian and Californian beaches…and he has not missed a single sunset. Few natural wonders can compare with a sunset in the Pacific. And yet during one particularly spectacular sunset, your editor turned toward the five-star hotel behind him and noticed that every single one of the hotel’s balconies was empty. In other words, the hotel guests were either taking in the sunset in some other location or were holed up in their rooms watching The Apprentice. In other words, almost every one of the hotel’s $500-a-night guests had elected to do something other than watch the sunset from their $500-a- night hotel room.

– Who would spend thousands of dollars to fly to Hawaii and stay in an ocean-view room at a five-star hotel merely to miss the sunset? Almost everyone with the money to do so, it seems. Have Americans forgotten how to relax?

– "The indigenous Hawaiians never invented a wheel or anything else of value," grumbled a fellow tourist to your New York editor last night.

– "Why would they?" came the reply.

– "Well, don’t you think they should have invented something of value?"

– "Why would they?" came the reply again. "And you’re wrong, by the way."

– "Huh?"

– "Didn’t Hawaiians invent the surfboard? The Greeks and Romans lived next to water for thousands of years and never invented a surfboard."

– "Are you serious?"

– "Yes," your editor replied. "And let’s not forget that Hawaiians also invented the mai tai. Maybe you should reconsider your definition of ‘advanced culture.’"

– Hawaiians did not invent the sunset, of course. But the skies over the Hawaiian islands host some of the most beautiful sunsets in the world. Meanwhile, 6,000 miles from Maui, investors watched the Dow sink slowly below the horizon yesterday.

– The blue chip index drifted 37 points lower to 10,073. The Nasdaq Composite Index was virtually unchanged at 1,838. The price of crude oil also fell, as the benchmark October contract dipped 67 cents, to $46.05. That’s more than $3 below the record-high price of $49.40 a barrel reached last Friday.

– Hope, more than substance, seemed to push the price of crude oil lower. Investors hope that there will be some sort of resolution to the standoff in Najaf between militiamen loyal to rebel Shiite cleric Muqtada al-Sadr and U.S. armed forces. Investors also hope that the Russian government will cease and desist from threatening to push Yukos into bankruptcy. But as yet, neither hope boasts much in the way of substance.

– The resurgent gold price took a breather yesterday, pressured by strength in the dollar, after climbing nearly $9 over the prior two sessions. The precious metal slipped $2.40, to $411.

– Once again, the financial markets are becoming as fascinating as they are treacherous. Once again, investors must ask themselves, "Which market is ‘right?’" The gold market (seconded by the oil market)? Or the stock market? Is the gold market correctly anticipating a climate of rising geopolitical tensions and price pressures? Or is the stock market correctly anticipating a MOSTLY favorable climate for the U.S. economy?

– We don’t know the answer, but our temerity leads us to favor gold’s clairvoyance…and besides, we like the way gold glistens…kind of like a Maui sunset.


Bill Bonner, back in Paris…

"The airline industry as a whole has lost money, ever since it began," said British analyst Tim Price. "It has been a net destroyer of capital."

Airplanes are one of the most successful new technologies of all time. Invented only a century ago, now the skies are full of them. Yet had you bought the shares of all airlines as they came to market, you would have actually lost money over the entire period.

Employees made money. Passengers enjoyed the convenience of air travel. Airplane manufacturers and suppliers made money. A lot of money changed hands. But the capitalists who financed the airline industry made nothing.

Go figure.

On the other hand, we wonder if investors – overall – ever make any money…and whether Wall Street, itself, is not a net destroyer of capital.

"I saw one study," Tim continued, "that showed that during the last bull market of the ’80s and ’90s stocks rose at an annual rate of 17%…but investors really only made an average of about 5%. And this was during the greatest bull market of all time. Think what actually happened during bear markets."

How could it be, dear reader?

We have a hypothesis. Wall Street, we believe, is a giant flimflam outfit. The "flim" is investors’ natural inclinations to do the wrong thing at the wrong time for the wrong reasons. A stock goes up – investors buy it. They are throwing bad money after good – indirectly overcapitalizing a good business, inviting its managers to waste money on projects that are much less likely to pay off than those that got them going. Eventually, the shares go down and investors lose money.

The "flam" is the cost of doing business on Wall Street. Brokers, analysts, lawyers, shills, market makers, coffee makers, rainmakers, bookmakers – nothing comes cheap. The flam is the friction in the machine, which Warren Buffett estimates as high as 30% of all capital invested.

*** "Paris insulted. Paris bruised. Paris martyred. But Paris liberated. By herself. Liberated by her own people…"

Charles de Gaulle stood at the Arc de Triomphe and exaggerated. Sixty years ago today, Paris was liberated from the Germans. A French captain, accompanied by Spanish troops, drove up to the town hall and took charge. The day before, the German commander, von Choltitz, had been given a direct order by Hitler himself: Reduce Paris to ruins. But the Allies were only a few days away…the Germans were going to lose the war…and von Choltitz was no fool. Earlier, Paris Mayor Pierre Taittinger, had paid him a visit and spelled it out for him: One way or another, history would remember the German – either as the man who destroyed Paris or the man who saved it.

Capt. Dronne, Gen. de Gaulle, Gen. Le Clerc, Col. Rol- Tanguy, Gen. Eisenhower – a lot of men could claim to have liberated Paris. Ernest Hemingway claimed he had liberated the bar at the Ritz.

But von Choltitz was the real hero of Paris’ liberation. A career soldier, he knew he had to obey his commander in chief. But he had a talent as rare in a military man as good manners in a teenager: He was able to see his duty…and have the good sense not to do it.

The Daily Reckoning