Quarterly Review and Outlook, Fourth Quarter 2017

By Lacy Hunt, PhD, and Van Hoisington, Hoisington Investment Management

Optimism is pervasive regarding U.S. economic growth in 2018. Based on the solid 3%+ growth rate during the last three quarters of 2017, this optimism is well-founded. The acknowledgement of this economic health by the Federal Reserve (Fed) is evident: they have outlined a continued pattern of increasing the federal funds rate over the coming year. Further, the solid 2017 performance of the European Union and of Japan is forecast to continue in 2018. Finally, the recent enactment of a tax cut is expected to boost U.S. economic growth in the new year. Well-regarded economic research suggests a 2.5% - 3.5% real growth rate in 2018 with continuing stable inflation. In addition, most surveys suggest a modest interest rate increase across the entire maturity spectrum of the yield curve.

Our view of the economic environment is somewhat divergent from the consensus opinion. Our analysis of concurrent and leading economic variables, including consumers, taxes, monetary policy and the yield curve, suggest that disappointing growth, lower inflation and ultimately lower long-term interest rates will hallmark the new year.

Consumer spending, the economic heavy lifter of U.S. economic growth, has expanded by 2.7% over the past year (as measured by real personal consumption expenditures, or PCE, as of November 2017). This is similar to the past eight years of the expansion, with real PCE averaging 2.5%. What is interesting about the increase in spending is that incomes have failed to keep pace. Real disposable personal income rose by only 1.9% over the past year. It was only the ability to borrow that supported the spending increase. In economic terms, borrowing is a form of dissaving. The saving rate for consumers dropped from 3.7% a year ago to 2.9% in November, a 10-year low.

It is remarkable that as recently as October 2015 the consumer saving rate was 5.9%. Had that rate been sustained through November 2017, the cumulative spending increase over the past 25 months would have registered only a 3.2% advance (1.5% annual rate) or $496 billion. However, actual spending was $939 billion, a 7.5% cumulative gain (2.8% annual rate). An increase in consumer credit of $253 billion and an actual reduction in savings of $190 billion account for this difference. It is possible that the saving rate will continue to fall. A drop of the same magnitude in the next 25 months would mean the saving rate would be -0.1%, a possible yet unlikely scenario. The higher probability is that the saving rate begins to move up towards its historic average of 8.5%.

History suggests that the economy will register a slower rate of expansion following a low saving rate (Chart 1). This positive correlation between current saving and future consumption means a low saving rate should be followed by a lower level of consumption and vice versa. Therefore, considering that the only period in which the saving rate was lower than it is today was 1929–1931, it is more likely that spending in the future will be in line with, or lower than, real income growth, which is currently weak.

Furthermore, the modest increase in real disposable income of 1.9% over the past twelve months will be under downward pressure in 2018 as employment growth continues to slow. Employment growth actually peaked in early 2015, expanding year-over-year by 2.3%. However, by December 2017 the growth rate had diminished to 1.4% (Chart 2). This slowing trend will persist in 2018, placing downward pressure on income gains and therefore on spending as well.

Conventional wisdom suggests that rising consumer confidence significantly boosts spending. However, plotting the quarterly percent changes in real per capita PCE against percent changes in consumer confidence from 1967 through the third quarter 2017, it appears that consumer confidence is unreliably related to real PCE (Chart 3). Over this very robust sample of 202 observations, a 1% gain in confidence only boosts real per capita PCE by a minuscule 0.006%. While the correlation is positive, the relationship is not statistically significant with a coefficient of determination (R2) of only 0.02.

Finally, borrowing should slow in 2018. The 125 basis point increase in the federal funds rate since December 2015, and its magnified effect on short-term financing rates, coupled with deteriorating loan quality, should continue to reinforce the slow-down in borrowing at the consumer level. Therefore, both the supply and demand for credit is waning.
Slower borrowing and modest income expansion, along with a potential reversal in the near historic low saving rate, means consumer spending will likely be one area of economic disappointment in 2018.

In 1820, the great economist David Ricardo (1772-1823) was asked whether it made any difference to the overall British economy if the Napoleonic Wars were financed by an increase in debt or by an increase in taxes. He theorized that the two were equivalent (the Ricardian Equivalence). However, Ricardo candidly cautioned that his theory might not be valid. Indeed, continuous streams of data and statistical computing techniques that are available today were not available in the early 1800s to test his theory.

The economics profession followed Ricardo’s theory until 1936 when John Maynard Keynes (1883-1946) introduced the government multiplier concept. It posited that $1.00 of debt nancing would expand GDP by some multiple of that amount. Keynes, like Ricardo, did not offer empirical proof for his proposition. And like Ricardo, it is doubtful he could have produced such analysis given the lack of advanced statistical computing techniques at that time.

To further analyze these theories, using data from 1950 through 2016, we developed a scatter diagram plotting the year-over-year percent change in real per capita GDP against real per capita gross federal debt, with lags in the debt of one and two years, equally weighting each year (Chart 4). We added the prior two years in order to capture any lags in the response of the economy to the debt changes. The results of this diagram add to the evidence that Ricardo’s theory was correct. The most important conclusion of this extensive data set, which excludes recessions, is that the slope of the line is negative but not statistically significant. A 1% increase in debt per capita over three years results in a slight decline in real per capita GDP of 0.06%, and the coefficient of determination (R2) is just 0.02. If the scatter diagram is calculated without lags, the slope is a virtually identical -0.04, with an even lesser R2 of 0.01. In short, these results align with Ricardo’s theory; although individual winners and losers may arise, a debt-financed tax cut will provide no net aggregate benefit to the macro-economy.

If the tax cuts were instead to be financed by a reduction in expenditures (revenue-neutral), then the economic growth rate would benefit to a minor degree. Since productivity is higher in the private sector than in the government sector, tax cuts should have a more favorable multiplier. In this type of revenue-neutral package, the economy would thus receive a slight boost. The tax cuts should increase incentives and efficiencies, and possibly lower the cost of capital and moderate the increase in the steady and substantial rise in federal debt.

Federal debt, however, still remains a problem since gross government debt recently exceeded 106% of GDP. A debt level above 90% has been shown to diminish an economy’s trend rate of growth by one-third or more. When President Reagan cut taxes in 1981 growth ensued, but the government debt was only 31% of GDP, an economic millennium from our present 106%. Looking forward, the Joint Committee on Taxation expects a $451 billion revenue gain from improved growth over the next ten years, yet it still expects the recent tax bill to add $1.1 trillion to the deficit. The Congressional Budget Office expects a $1.5 trillion increase in the deficit over the same period. According to some private forecasters, due to the front-loading of some provisions, for the next two years the federal deficit will be rising – moving from roughly 3.6% of GDP in scal 2017 to 3.7% of GDP in fiscal 2018 to 5% of GDP in 2019. Thus, the continuing debt buildup will have the unintended consequence of slowing economic growth in 2018 and beyond, despite the favorable multiplier contribution that individual tax cuts impart.
Monetary Policy

Although the economy may slow due to a poor consumer spending outlook and increases in debt, the real roadblock for economic acceleration in 2018 is past, present and possibly future monetary policy actions. The Fed first began raising the federal funds rate in December 2015. A year later the Fed implemented another 25 basis point increase. Three more rate hikes occurred in 2017. To raise interest rates the Fed takes actions that reduce the liquidity of the banking system (Chart 5). This action has historically caused a reduction in the supply of credit through tighter bank lending standards. The demand for credit is also diminished as some borrowers are priced out of the market or can no longer meet the higher quality standards.

The impact of this tightened Fed policy on money, credit and eventually economic growth is slow but inexorable. The brunt of these past and current policy moves will be felt in 2018. Irving Fisher provided the arithmetic formula that money times its turnover equals price times transactions, or nominal GDP (MV=PT). This simple equation provides a roadmap of ebbing growth next year. Velocity (V) is currently low. At 1.43, velocity is standing at its lowest level since 1949, well below the 1.74 average since 1900 (Chart 6).

Money (as defined by M2) expanded by 7% in 2016. Owing to Fed actions, money growth slowed to a 5% year-over-year growth rate at the end of the third quarter 2017, a 2.5% reduction from the previous year. In the fourth quarter of 2017 the Fed planned to reduce its balance sheet by $30 billion, an action we term “quantitative tightening” (QT). This action has and will continue to put additional downward pressure on money growth; a $60 billion reduction is expected in the first quarter of 2018, a $90 billion reduction is expected in the second quarter of 2018, and an additional $270 billion in reductions are expected following the second quarter of 2018. It is important to note that historical comparisons and analysis are unavailable as the magnitude of this balance sheet reduction is unprecedented; however, the three- month growth rate of money has already slowed further to 3.9% at the end of 2017.

In the 1960s, economists Karl Brunner (1916-1989) and Allan Meltzer (1928-2017) both proved M2 equals the monetary base (MB) times the money multiplier (m) (M2=MB*m).

They also algebraically identified the determinants of m. Application of their model, which has been verified by numerous others, suggests the monetary slowdown will intensify, thereby increasing the drag on economic growth, as 2018 unfolds. If the Fed continues QT for one year as outlined, we calculate the overall change in M2 could turn negative by the end of the year. If money (M2) continues to decelerate, and V stabilizes (although it has declined at a 2.4% rate over the past eight years), then nominal GDP will record a lower growth rate in 2018 than the estimated 2017 pace of 4.0%.
Yield Curve

The determinants of short-term interest rates are far different than those of long-term interest rates, thus causing the shape of the Treasury yield curve to significantly change shape over the course of the business cycle.

Changes in long-term Treasury bond yields are determined by the Fisher equation, one of the pillars of macroeconomics. In this equation, the nominal risk-free bond yield equals the real yield plus expected inflation (i=r+πe). Expected inflation may be slow to adjust to reality, but the historical record indicates that the adjustment inevitably occurs. Although very volatile over the short-run, the real rate can be stable over longer time spans; inflationary expectations ultimately dominate the longer run movements in the Treasury bond yield. The Fisher equation can be rearranged algebraically so that the real yield is equal to the nominal yield minus expected inflation (r=i–πe).

Short-term interest rates are determined by the intersection of the demand and supply of credit that the Fed largely controls through shifting the monetary base and interest rates. The higher funds rate can be reached by a slower but still positive growth rate in the monetary base or by an outright decline in the base. When the base money becomes less available, the upward sloping credit supply curve shifts inward, thus hitting the downward sloping credit demand curve at a higher interest rate level.

Restrictive monetary policy impacts the economy through several observable phases, all of which take time to work. Initially, the monetary shift causes the federal funds rate to rise. As mentioned earlier, as the federal funds rate moves higher, the growth rates of the monetary and credit aggregates slow. A sign that this restrictive process is beginning to more meaningfully impact monetary conditions is that the yield curve begins to flatten, with short-term rates rising relative to long-term rates. Historically, as the yield curve flattens, the profitability of the banks and all similarly structured entities is diminished from this influence. Thus, initially the change in the curve is a symptom of monetary tightness, but the flatter curve reinforces the earlier monetary restraint.

The full spectrum of monetary policy is aligned against stronger growth in 2018. A higher federal funds rate, the continuation of QT, low velocity and abruptly slowing money growth all put downward pressure on growth. The flatter yield curve will further tighten monetary conditions. This monetary environment coupled with a heavily indebted economy, a low-saving consumer and well-known existing conditions of poor demographics suggest 2018 will bring economic disappointments. Inflation will subside along with growth, causing lower long-term Treasury yields.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Getting Technical

Are You Ready for the Next Market Meltdown?

By Michael Kahn

Are You Ready for the Next Market Meltdown?
Photo: Getty Images/iStockphoto

Stocks may be in the melt-up phase in this nine-year-old bull market, but whatever we call it, investors must always prepare for the worst.

And at the same time, they must also be ready for the best.

There is plenty for bulls to like right now. Market breadth is strong; there is no traditional chart resistance overhead; money continues to flow into stocks and exchange-traded funds; and markets around the world are strong, if not in all-time high territory.

Fundamentally, things look good, too. On Thursday, the initial jobless claims number dropped to a 45-year low. Auto makers have committed to big investments in the U.S., and businesses seem to be responding well to recent tax and regulation reform.

Of course, the bulls seem to be downright giddy about it. The level of bullishness is in extreme high territory, according to surveys from Investors Intelligence and the American Association of Individual Investors. That usually does not end well—when “everyone” is bullish, theoretically there is nobody left to buy. Demand dries up and one spark can send the herd stampeding toward the exit doors.

One look at the Standard & Poor’s 500 index shows the rally accelerating yet again (see Chart 1). Some call it a parabola, and we can see it as each trendline steepens.

Chart 1

Parabolas are dangerous, but not just for bulls. They can last far longer than people expect, and when they finally do turn, it happens quickly. Timing must be perfect because being off by just one day—long or short—can result in big losses. Just ask cryptocurrency traders.

So what’s an investor to do? It seems odd that a market timer such as me would say that timing the market right now is too difficult. But that does not mean you cannot take steps to cushion the blow when the correction eventually happens, without selling everything now and fortifying your bunker.

First, look at the long-term trend that defines what kind of market it is. Right now, secular and cyclical trends are rising (see Chart 2). We can argue whether the current bull market began at the 2009 low or when the S&P 500 broke out from its 1997-2013 trading range. Regardless, the index now trades above its 200-day moving average, and for many investors that is all we need to know about the major trend.

Chart 2

True, the market is as far above that average as it has been in years, but touching it would amount to only a 5% dip. I imagine almost every analyst would welcome such an event and call it healthy. If you can handle that size correction, then you can be comfortable that the bull market is still intact. Overbought, yes, but intact.

Next, not all stocks are created equal. Some of them lead while others lag. We can exploit the characteristics of these two broad areas because weaker stocks tend to fall harder when the market declines. The current rally may have just swept them along for the ride, but they do not have the capacity to weather any storm that will eventually appear.

It wouldn’t hurt to look at a portfolio and prune the weakest members. You can determine what those stocks are any way you like. Relative performance on charts is a great method, but weak balance sheets, lack of sales growth, or even a low score from a ratings agency can be your filter.

It also would not hurt to take some money off the table even as the market roars higher, Thursday’s action notwithstanding. Selling portions of a position along the way allows you to take out your original investment and lets your profits ride. How much and when is a personal decision, but why not turn a little of your paper profits into real cash in the bank? I bet bitcoin investors wished they did some of that when that market topped $19,000.

Finally, know your “uncle” point, because all the analysis in the world cannot stop a market that has changed from bullish to bearish. It could be a stop loss at 10%. It could be the break of a technical feature, such as a trendline or major chart support.

For the S&P 500, a 10% drop would take it down to the trendline drawn from the start of the current leg of the bull market in February 2016. Below that, we would have to concede that the bears have, in fact, taken over.

The point is to have a plan and know what you will do if and when something happens.

On a Personal Note

This is my last column for Barrons.com after nearly 17 years. It’s been quite a ride, and I’ve enjoyed being affiliated with a top-notch financial outlet and a host of excellent writers and editors.

Over the years, the markets have changed, and technical analysis has had to adapt. Yet people still do similar things when faced with similar circumstances—and charting remains an excellent way to figure out the markets and what you should do about it.

But with so many ways to express bullish and bearish opinions (stocks, options, ETFs, funds) and the ability to find, research, and execute trades in minutes, many of the tried and true indicators and techniques don’t work quite the same way they did when they appeared on the scene decades ago.

Volume analysis was a big victim of the explosion of alternatives to stocks. So were many intraday analyses, such as money flow and tick, and that was made even worse when trading moved from eighths to pennies.

But we move on, using indicators with a grain of salt and always remembering that price action alone is king. Everything else plays a supporting role.

And with that, farewell, dear readers. I hope I was able to enlighten.

Michael Kahn, a longtime columnist for Barrons.com, comments on technical analysis at www.twitter.com/mnkahn. A former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, Kahn has written three books about technical analysis.

Competition in the digital age

How to tame the tech titans

The dominance of Google, Facebook and Amazon is bad for consumers and competition

NOT long ago, being the boss of a big Western tech firm was a dream job. As the billions rolled in, so did the plaudits: Google, Facebook, Amazon and others were making the world a better place. Today these companies are accused of being BAADD—big, anti-competitive, addictive and destructive to democracy. Regulators fine them, politicians grill them and one-time backers warn of their power to cause harm.

Much of this techlash is misguided. The presumption that big businesses must necessarily be wicked is plain wrong. Apple is to be admired as the world’s most valuable listed company for the simple reason that it makes things people want to buy, even while facing fierce competition. Many online services would be worse if their providers were smaller. Evidence for the link between smartphones and unhappiness is weak. Fake news is not only an online phenomenon.

But big tech platforms, particularly Facebook, Google and Amazon, do indeed raise a worry about fair competition. That is partly because they often benefit from legal exemptions. Unlike publishers, Facebook and Google are rarely held responsible for what users do on them; and for years most American buyers on Amazon did not pay sales tax. Nor do the titans simply compete in a market. Increasingly, they are the market itself, providing the infrastructure (or “platforms”) for much of the digital economy. Many of their services appear to be free, but users “pay” for them by giving away their data. Powerful though they already are, their huge stockmarket valuations suggest that investors are counting on them to double or even triple in size in the next decade.

There is thus a justified fear that the tech titans will use their power to protect and extend their dominance, to the detriment of consumers. The tricky task for policymakers is to restrain them without unduly stifling innovation.

The less severe contest

The platforms have become so dominant because they benefit from “network effects”. Size begets size: the more sellers Amazon, say, can attract, the more buyers will shop there, which attracts more sellers, and so on. By some estimates, Amazon captures over 40% of online shopping in America. With more than 2bn monthly users, Facebook holds sway over the media industry. Firms cannot do without Google, which in some countries processes more than 90% of web searches. Facebook and Google control two-thirds of America’s online ad revenues.

America’s trustbusters have given tech giants the benefit of the doubt. They look for consumer harm, which is hard to establish when prices are falling and services are “free”. The firms themselves stress that a giant-killing startup is just a click away and that they could be toppled by a new technology, such as the blockchain. Before Google and Facebook, Alta Vista and MySpace were the bee’s knees. Who remembers them?

However, the barriers to entry are rising. Facebook not only owns the world’s largest pool of personal data, but also its biggest “social graph”—the list of its members and how they are connected. Amazon has more pricing information than any other firm. Voice assistants, such as Amazon’s Alexa and Google’s Assistant, will give them even more control over how people experience the internet. China’s tech firms have the heft to compete, but are not about to get unfettered access to Western consumers.

If this trend runs its course, consumers will suffer as the tech industry becomes less vibrant.

Less money will go into startups, most good ideas will be bought up by the titans and, one way or another, the profits will be captured by the giants.

The early signs are already visible. The European Commission has accused Google of using control of Android, its mobile operating system, to give its own apps a leg up. Facebook keeps buying firms which could one day lure users away: first Instagram, then WhatsApp and most recently tbh, an app that lets teenagers send each other compliments anonymously. Although Amazon is still increasing competition in aggregate, as industries from groceries to television can attest, it can also spot rivals and squeeze them from the market.

The rivalry remedy

What to do? In the past, societies have tackled monopolies either by breaking them up, as with Standard Oil in 1911, or by regulating them as a public utility, as with AT&T in 1913. Today both those approaches have big drawbacks. The traditional tools of utilities regulation, such as price controls and profit caps, are hard to apply, since most products are free and would come at a high price in forgone investment and innovation. Likewise, a full-scale break-up would cripple the platforms’ economies of scale, worsening the service they offer consumers. And even then, in all likelihood one of the Googlettes or Facebabies would eventually sweep all before it as the inexorable logic of network effects reasserted itself.

The lack of a simple solution deprives politicians of easy slogans, but does not leave trustbusters impotent. Two broad changes of thinking would go a long way towards sensibly taming the titans. The first is to make better use of existing competition law. Trustbusters should scrutinise mergers to gauge whether a deal is likely to neutralise a potential long-term threat, even if the target is small at the time. Such scrutiny might have prevented Facebook’s acquisition of Instagram and Google’s of Waze, which makes navigation software. To ensure that the platforms do not favour their own products, oversight groups could be set up to deliberate on complaints from rivals—a bit like the independent “technical committee” created by the antitrust case against Microsoft in 2001. Immunity to content liability must go, too.

Second, trustbusters need to think afresh about how tech markets work. A central insight, one increasingly discussed among economists and regulators, is that personal data are the currency in which customers actually buy services. Through that prism, the tech titans receive valuable information—on their users’ behaviour, friends and purchasing habits—in return for their products. Just as America drew up sophisticated rules about intellectual property in the 19th century, so it needs a new set of laws to govern the ownership and exchange of data, with the aim of giving solid rights to individuals.

In essence this means giving people more control over their information. If a user so desires, key data should be made available in real time to other firms—as banks in Europe are now required to do with customers’ account information. Regulators could oblige platform firms to make anonymised bulk data available to competitors, in return for a fee, a bit like the compulsory licensing of a patent. Such data-sharing requirements could be calibrated to firms’ size: the bigger platforms are, the more they have to share. These mechanisms would turn data from something titans hoard, to suppress competition, into something users share, to foster innovation.

None of this will be simple, but it would tame the titans without wrecking the gains they have brought. Users would find it easier to switch between services. Upstart competitors would have access to some of the data that larger firms hold and thus be better equipped to grow to maturity without being gobbled up. And shareholders could no longer assume monopoly profits for decades to come.

How Economics Survived the Economic Crisis

Robert Skidelsky

Chicago Board Options Exchange

LONDON – The tenth anniversary of the start of the Great Recession was the occasion for an elegant essay by the Nobel laureate economist Paul Krugman, who noted how little the debate about the causes and consequences of the crisis have changed over the last decade. Whereas the Great Depression of the 1930s produced Keynesian economics, and the stagflation of the 1970s produced Milton Friedman’s monetarism, the Great Recession has produced no similar intellectual shift.

This is deeply depressing to young students of economics, who hoped for a suitably challenging response from the profession. Why has there been none?

Krugman’s answer is typically ingenious: the old macroeconomics was, as the saying goes, “good enough for government work.” It prevented another Great Depression. So students should lock up their dreams and learn their lessons.

A decade ago, two schools of macroeconomists contended for primacy: the New Classical – or the “freshwater” – School, descended from Milton Friedman and Robert Lucas and headquartered at the University of Chicago, and the New Keynesian, or “saltwater,” School, descended from John Maynard Keynes, and based at MIT and Harvard.

Freshwater-types believed that budgets deficits were always bad, whereas the saltwater camp believed that deficits were beneficial in a slump. Krugman is a New Keynesian, and his essay was intended to show that the Great Recession vindicated standard New Keynesian models.

But there are serious problems with Krugman’s narrative. For starters, there is his answer to Queen Elizabeth II’s now-famous question: “Why did no one see it coming?” Krugman’s cheerful response is that the New Keynesians were looking the other way. Theirs was a failure not of theory, but of “data collection.” They had “overlooked” crucial institutional changes in the financial system. While this was regrettable, it raised no “deep conceptual issue” – that is, it didn’t demand that they reconsider their theory.

Faced with the crisis itself, the New Keynesians had risen to the challenge. They dusted off their old sticky-price models from the 1950s and 1960s, which told them three things. First, very large budget deficits would not drive up near-zero interest rates. Second, even large increases in the monetary base would not lead to high inflation, or even to corresponding increases in broader monetary aggregates. And, third, there would be a positive national income multiplier, almost surely greater than one, from changes in government spending and taxation.

These propositions made the case for budget deficits in the aftermath of the collapse of 2008. Policies based on them were implemented and worked “remarkably well.” The success of New Keynesian policy had the ironic effect of allowing “the more inflexible members of our profession [the New Classicals from Chicago] to ignore events in a way they couldn’t in past episodes.” So neither school – sect might be the better word – was challenged to re-think first principles.

This clever history of pre- and post-crash economics leaves key questions unanswered. First, if New Keynesian economics was “good enough,” why didn’t New Keynesian economists urge precautions against the collapse of 2007-2008? After all, they did not rule out the possibility of such a collapse a priori.

Krugman admits to a gap in “evidence collection.” But the choice of evidence is theory-driven. In my view, New Keynesian economists turned a blind eye to instabilities building up in the banking system, because their models told them that financial institutions could accurately price risk. So there was a “deep conceptual issue” involved in New Keynesian analysis: its failure to explain how banks might come to “underprice risk worldwide,” as Alan Greenspan put it.

Second, Krugman fails to explain why the Keynesian policies vindicated in 2008-2009 were so rapidly reversed and replaced by fiscal austerity. Why didn’t policymakers stick to their stodgy fixed-price models until they had done their work? Why abandon them in 2009, when Western economies were still 4-5% below their pre-crash levels?

The answer I would give is that when Keynes was briefly exhumed for six months in 2008-2009, it was for political, not intellectual, reasons. Because the New Keynesian models did not offer a sufficient basis for maintaining Keynesian policies once the economic emergency had been overcome, they were quickly abandoned.

Krugman comes close to acknowledging this: New Keynesians, he writes, “start with rational behavior and market equilibrium as a baseline, and try to get economic dysfunction by tweaking that baseline at the edges.” Such tweaks enable New Keynesian models to generate temporary real effects from nominal shocks, and thus justify quite radical intervention in times of emergency. But no tweaks can create a strong enough case to justify sustained interventionist policy.

The problem for New Keynesian macroeconomists is that they fail to acknowledge radical uncertainty in their models, leaving them without any theory of what to do in good times in order to avoid the bad times. Their focus on nominal wage and price rigidities implies that if these factors were absent, equilibrium would readily be achieved. They regard the financial sector as neutral, not as fundamental (capitalism’s “ephor,” as Joseph Schumpeter put it).

Without acknowledgement of uncertainty, saltwater economics is bound to collapse into its freshwater counterpart. New Keynesian “tweaking” will create limited political space for intervention, but not nearly enough to do a proper job. So Krugman’s argument, while provocative, is certainly not conclusive. Macroeconomics still needs to come up with a big new idea.

Robert Skidelsky, Professor Emeritus of Political Economy at Warwick University and a fellow of the British Academy in history and economics, is a member of the British House of Lords. The author of a three-volume biography of John Maynard Keynes, he began his political career in the Labour party, became the Conservative Party’s spokesman for Treasury affairs in the House of Lords, and was eventually forced out of the Conservative Party for his opposition to NATO’s intervention in Kosovo in 1999.

The Age of Cryptocurrencies: Is This the End of Money?

bitcoin new

Wharton Dean Geoffrey Garrett sees a big split in how blockchain-based digital cryptocurrencies like bitcoin are viewed on Wall Street versus in Silicon Valley. On the East Coast, the idea of a cryptocurrency replacing a fiat currency is still met with skepticism. But in the Valley, they seem “all in.” In this opinion piece he offers his views on this corner of fintech.

I spent the first week of the New Year with a great group of Wharton undergraduates visiting many of our tremendous alumni in the San Francisco Bay Area. To say it felt very different from the East Coast is an understatement. And I am not talking about missing the “bomb cyclone,” which we did.

I am talking about blockchain/bitcoin/cryptocurrencies, which are much more than a speculative Chinese-cum-millennial obsession.

Whereas most people on Wall Street remain skeptical, playing a wait-and-see game, Silicon Valley is all in. Literally every meeting I participated in, from the biggest tech companies to the smallest startups, was rich with enthusiastic and creative crypto conversations. I used to think “fintech” meant the end of physical cash — replaced by mobile payments platforms owned by big multinational firms and currently led by China, in established currencies regulated by national governments and international agreements.

I now wonder whether the ultimate fusion of technology and finance will mean “the end of money,” at least as we have known it for the last millennium. It’s no longer sci-fi to imagine the replacement of dollars and other “fiat money” with open sourced, radically decentralized, deeply encrypted and self-regulating transactions in digital units of exchange that are “mined” rather than issued by central Banks.

I have to admit I went west very much in the Jamie Dimon mindset. The JPMorgan Chase CEO and voice of Wall Street since the financial crisis famously dismissed bitcoin’s virtual rise in 2017: “I could care less about bitcoin.” Strip out his typically gruff rhetorical flourishes, and Dimon was making two fundamental points. Dimon’s first point was that “blockchain” — a globally distributed ledger of financial transactions made secure by advanced cryptography and competition among “miners” (computers competing to execute and record transactions, and being compensated for doing so) — has massive upside. But to become central to mainstream commerce, blockchain will have to lose its unregulated open source roots, be managed by a big multinational conglomerate (think some combination of Visa/Mastercard transactions and SWIFT international transfers), and fall under the clear jurisdictions of national governments and international agreements.

His second point was that the transactions that blockchain records will ultimately be in “cryptodollars,” or cryptoeuros, cryptoyuan, etc. — not bitcoin, ethereum, or any other “non-fiat,” purely “digital” currency that is not issued by central banks. This is because there is literally no underlying value to a bitcoin (“worse than tulips,” to use the oft-cited example of the Dutch “tulip bubble” in the 17th century). In contrast, there is underlying value to a dollar — guaranteed by the U.S. Federal Reserve and tied to the strength of the American economy.

The more I talked with people in the Valley, the less convinced I became of these two points. This is very disconcerting to people like me, steeped in more than 200 years of macroeconomic thought. All the giants (Adam Smith, David Ricardo, John Maynard Keynes, Milton Friedman, Paul Samuelson, and others) not only assumed the centrality of currencies as we have known them. They also valorized money as literally the foundation of a well-functioning economy — both a unit of exchange and a store of value.

In Silicon Valley, there is a healthy disregard for all things Washington, government and regulation — and of course for the status quo. It’s no surprise there seem to be many more bitcoin believers on the West Coast.