Once again, it is Adam Smith versus John Maynard Keynes and Hyman Minsky in the financial marketplace. Smith is winning so far, but his further prospects depend less on his theory of self-enlightened individual behavior in the private sector than on the efficacy of guardrails that governments and central banks put in place.
According to Smith, the collective good is best served by the atomized behavior of rational individuals driven by self-interest. In maximizing their own needs, individuals also maximize the collective objective - a process that has self-reinforcing dynamics.
This seems to be playing out in markets today. By being willing to underwrite ever greater investment risks and pursuing higher returns in virtually any market segment, investors are also improving the likelihood that we'll see a broad economic recovery and a smooth normalization in monetary policy. In turn, the much-hoped-for prospects of the latter encourage investors to take on even more risks at ever more elevated prices and lower yields.
What is happening today is starting to look eerily reminiscent of what transpired in the middle of the last decade. The "Great Moderation" that seemed to prevail at that time was so reassuring and captivating that many people thought of it as a "Goldilocks" scenario -- not too hot and not too cold. Of course, that was before important insights from Keynes and Minsky began playing out, first in financial markets and then the broader economy.
Keynes reminds us that excessive herd behavior often takes over markets, leading to unsustainable outcomes. In insights that have been confirmed since, he observed: "worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." Minsky went further in demonstrating how stability ends up breeding instability.
Contrary to Smith, Keynes and Minsky suggest that, in certain circumstances, what appears rational and beneficial for the individual may not be so for society as a whole. At some point, financial stability becomes too much of a good thing, because it encourages excessive and ultimately irresponsible risk taking by individuals and institutions. In the process, the economic system and, therefore, collective interest are threatened.
While we would all like to believe that enlightened self-interest will automatically stop the current Adam Smith phase from morphing into Hyman Minsky's, we would be foolish to do so. Misaligned financial incentives, classic principal-agent problems and hubris all tend to get into the way. So does the unwillingness, or inability, of investors to lower their return objectives in response to market valuations that may already be too high. Instead, investors increase their leverage and risk tolerance.
Rather than act in self-correcting fashion and risk being too early, many market participants are waiting for overwhelming evidence of a sustained turn in the market - even though by the time that happens it is unreasonable to expect they will all be able to exit in a timely or orderly fashion. So investors continue to circle around the punch bowl at the risk party and only their hosts, the public sector, can play the role of the sober adult. Yet most governments today have fewer tools at their disposal to perform that function effectively.
Unlike many past periods of market exuberance, the current one is not associated with a booming global economy. Instead, growth remains sluggish, even after many years of exceptional monetary stimulus. As a result, neither higher interest rates nor tighter fiscal policy can be used to reduce the risks of financial instability; and what would be gained on that front would probably be offset by the detrimental impact on an already-sluggish economic performance. Instead, governments and central banks must rely on two other tools: thorough regulatory and supervisory regimes, and the related ability to offset excessive risk-taking through the tactical use of macro-prudential measures.
The prospects for Adam Smith in this contest depend on the proper use of these two tools, rather than on timely course adjustments by the private sector. I doubt that his disciples -- who believe the invisible hand of the marketplace and self-interested behavior of individuals will always move the economy in a robust direction -- will find this reality reassuring. They certainly shouldn't.
This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
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Failure to solve the unemployment problem cost Democrats the 2010 election. Fifteen million Americans are out of work. Nine million more are involuntarily working part time. Many with jobs also feel threatened. Voters don't understand why jobs are scarce so they vote against those they believe are in power. Under similar circumstances they voted against the first George Bush in 1992, Clinton and the Democrats in 1994, and Republicans who had supported George W. Bush in 2008. They want jobs and they don't know what policies -- tax and spending reductions or spending to create jobs more directly -- will get them what they want so they keep changing horses.
So what do economists say would reduce unemployment? In truth economists paid little attention to unemployment as a distinct problem until the 1930s. Adam Smith, the wonderfully insightful father of free market economics was focused on how to expand the economic pie. He was a brilliant observer of how economies work, so much so that America's Founders were his disciples. His aim like theirs was to liberate the energies of entrepreneurial people to create wealth. The immediate problem though was monopolies not unemployment. Smith's political goal, therefore, was to get the British parliament to stand up to government-sponsored monopolies that in the 18th century kept competitors out of many areas and stifled growth. My copy of The Wealth of Nations is 900 pages long and has an additional 67 page index. There are no mentions of joblessness as a distinct problem in all those pages.
Smith's insights needed important tweaks by the 1930s because unemployment had emerged as a political issue and voters demanded action. John Maynard Keynes is the economist who suggested how unemployment could be attacked. A recent three volume biography of Keynes makes clear that he believed in markets as much as Smith did. He recommended, for example, that the British government use market prices not rationing to allocate scarce resources as World War II approached. During the Depression of the 1930s, however, the millions of jobless were a crucial political problem. Keynes argued that waiting for private investors to create jobs as conservatives said Smith would have done could lead to the overthrow of Great Britain's free institutions.
Conservatives were arguing in the 1930s, as they still do in 2010, that cutting taxes and reducing government outlays would create jobs in the "long run." Keynes famously responded that "in the long run we are all dead." He saw the Nazis in Germany and the Communists in Russia using government to create jobs, and he was afraid that these political systems that he abhorred would take hold in England if its government insisted on waiting for the "long run" solution to work.
The insights of Smith and Keynes are central to today's debate between the parties. Smith is still right that economic progress depends on liberating the energies of entrepreneurs so that they can create wealth. It is completely consistent to agree with Smith about the benefits of competitive markets and to support Keynes' tweak of it. The tweak says that tax and spending cuts will not create jobs quickly enough to satisfy voters. The argument that they will is an ancient folk remedy unsupported by the observation and knowledge of economic history that makes Smith so brilliant. Government has to pump money into competitive markets to get investment going again. That's what stimulus is. Tax and spending cuts are like bleeding George Washington to cure him of a cold. The folk remedy dressed up as medical expertise killed the great man while attempting to save him.