Keynes Versus Friedman

Keynes Versus Friedman

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I recently got an email from a friend who complained about lack of liquidity mechanisms into the U.S. economy. To quote my friend: "The market today is dominated by liquidity providers but the liquidity provision mechanism is broken. Unfortunately there is a presumption that that functional capitalism requires these dysfunctional liquidity providers (hedge funds, frequency traders, etc.)."

What did he mean?

Although I am not an economist, my impression, from trying to stay abreast of policy debates, is that since the 1930s, economists think that government should make policies that smooth out bumps in business cycles. To stimulate the economy during periods of low growth, the policy would take the form of government spending and tax breaks. To curb inflation during periods of high growth, the intervention would take the form of cuts in government spending and tax hikes. For a recent review of the theory, implementation,and effectiveness of Keynes economic policies, see this book.

Milton Friedman advocated the monetary policy view. He specifically advocated for increasing the money supply after getting into a position of stability. The economy would be stable if the government increased the money supply at a 3% annual rate. Friedman also said that if the Federal Reserve tightened the money supply too much, the result would be deflation. He said the Great Depression was caused by the fact that the Federal Reserve shrank the money supply by a third. The effect was terrible; it caused all kinds of misery. People were and are worried about that happening again. In my opinion, Ben Bernanke deserves several Nobel Prizes in a row for peace, medicine, and lesser-than-anticipated economic disruption because he has kept the economy stable. When the economy is stable, fewer people die.

Canada has been fine all this time. Canada has too-big-to-fail banks. Paul Krugman wrote a blog about it two months ago. People in the money business are looking for ways to make more money, like any people in business. Car makers want to sell more cars, doctors want more patients.

Good policy provisions can cause you to increase the whole assemblage of goods and services such as cars, medical supplies, and education. Bad policy can cause you to cut back on those goods and services. In many countries, taxes have gone up to give people public, social goods or private goods, such as subsidies to buy houses. But if you want a growing assemblage of goods and services and changes in taste, then the money supply should be the servant of that policy. Traders of financial derivatives would argue that the availability of these complicated liquidity instruments helps to manage the stability of these goods and services. Others would say that interfering with the money supply interferes with the fullest creation of real goods and services.

Milton Friedman said that the money supply consisted of demand deposits, plus currency, then added timed deposits. People have conventions about what the money supply is but it has not been settled. I think that money is a good thing to have. It serves as a store of value. Let's think of money as a commodity that minimizes transaction costs. To put it simply, if we didn't have it and I wanted a haircut, and the person who cut my hair wanted a car, we couldn"t do a transaction.

Where do hedge funds come in? What did my friend mean by the presumption that capitalism required dysfunctional liquidity providers? Liquidity is not about money itself. It is about the ability people have to transact goods and services without having to mark up or down the price much. People can buy and sell stocks or houses without much price increases or decreases. Hedge funds and frequency traders provide a readiness to buy and sell stuff in response to a proposition from the other side. Frequency traders make it possible to sell a stock at three times as much as it"s worth at a given time.

In order to have liquidity, with substantial amounts being able to flow between buyer and seller, a number of things are required. You need a money supply but you also need a set of views on the part of the public that if I think my house is worth X, then I have to be able to sell my house in the next month or two. People live with that degree (a month or two) of illiquidity; perfect liquidity means you could sell it instantaneously. Hedge funds are additional buyers and sellers of stock. If I want to buy a house I want to be able to sell some stock to have the money to buy that house. I think we need much more sophisticated regulation of derivative securities, their creation and their trading because we got into deep trouble two years ago. We also had baloney going on with sub-prime mortgages. So yes, there has to be some careful monitoring of derivatives.

While I am on the subject, I was curious that this same friend then went on to propose a "return to the dividend payout model" as a method of valuing a company. Merton Miller and Franco Modigliani wrote about the dividend payout model. Essentially, the value of the stock depends on three things. It depends on the cost of equity capital for that enterprise, it depends on the growth rate of the company, and it depends on the return on capital that the company is able to earn. In this line of analysis, the company should keep money it has and invest in projects that return more than the cost of capital. If it doesn"t have enough money, then it should sell stocks to invest in projects that do provide a return on invested capital. The dividend policy growth and the valuation of shares has a fair amount of mathematics and algebra, with three factors essentially involved in valuing a company: the cost of capital, the return on capital, and the rate of growth. There"s no reason that dividends even have to be paid. If dividends are taxed more than capital gains, then wouldn't you prefer stock buyback plans?

Thank goodness for Paul Krugman. It gets very complicated very quickly.

About the Author:
Leslie Pratch, Ph.D. is a clinical psychologist with an M.B.A. in Strategy and Finance and a B.A. in Religion from Williams College. She works with boards of directors and private equity investors to select and develop executives. She can be reached at (312) 464-7919 or email her at leslie@pratchco.com.



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