Keynesian Recession Coming

It looks like we are in for a real Keynesian recession. The liquidity crisis seems to have led to a stop to bank lending, so we are approaching a liquidity trap. Demand is now falling, witness the drop in retail sales announced today which shook the markets, and this is a sign that the recession is already underway. If monetary policy is ineffective due to bank's unwillingness to lend, we are in the almost classic "Keynesian type" recession of old textbooks.

The relevance of Keynes to our current experience was highlighted by Robert Skidelsky in this column. He is perhaps correct when he writes that

To understand how markets can generate their own hurricanes we need to return to John Maynard Keynes.

But I think he overstates his case considerably when he argues that " mainstream theory has no explanation of why things have gone so horribly wrong." In particular, he expresses the view that is prevalent now that economists focus on efficient markets blinded them to

Greed, ignorance, euphoria, panic, herd behavior, predation, financial skulduggery and politics -- the forces that drive boom-bust cycles -- only exist off the balance sheet of their models.

This is factually incorrect. We have models of bubbles and herd behavior. But more important it ignores the point that much of the problems we have now are the result of ignoring market efficiency. When investors believed they could earn extra return for no extra risk they were not basing their behavior on efficiency. The carry trade is an example of profiting from the absence of efficiency. The problems we now face are that markets caught up. The excess returns they were earning were just a compensation for the losses that are now incurred. If savers and investors had assumed that they could not earn extra return for no extra risk they would have been in index funds not CDO's. They would not have been fooled by ratings from ratings agencies.

Protection Racket

Many people wonder why Putin is willing to engage in activities that seem inimical to Russia's economic interests. These comments tend to miss the point of what Putin cares about. Cliff Gaddy sends in this comment that has it exactly right:

People ask, Why would Putin allow this to happen? It is not in Russia’s or his own interest. Foreign investors will be discouraged, oil production will suffer, and so on. It doesn’t make sense.

Thinking in these terms confuses efficiency as seen from the economic point of view and what might be termed political efficiency. Putin does indeed desire economic efficiency, that is, continued production of resource rents. But his first priority is control of the use of those rents – political efficiency. And here, informal taxes have two big advantages for Putin. First, informal taxes can be collected and redistributed much more flexibly than formal taxes. He and his inner circle need to be able to channel resources to precisely the people and purposes they choose, when they choose. One might object that they can do that anyway with the budgetary flows (the formal taxes) at their disposal. But those flows are not nearly as flexible. Putin is very concerned about his ability to react flexibly to changing circumstances. He needs to call on key actors to channel resources quickly.

The second advantage of informal taxes is even more important. Informal taxation is a key component of the property rights protection racket – Putin’s mechanism for manipulating the behavior of the resource owners. The world of informal taxes is a world of quasi-legality at best. Keeping companies in that world gives Putin leverage. It is absolutely a good thing for Putin that companies engage to a controlled extent in various forms of illegal payments such as bribes, kickbacks, padded contracts, and the like. Precisely because the actions are illegal, they make the companies vulnerable to the tax authorities and the police. Paying informal taxes forces companies to violate laws. And that is the point. The evidence of their financial crimes is collected at the same time that their money or favors are collected. The individual chiefly responsible for this branch of “Russia, Inc.” is Putin’s no. 2, Viktor Zubkov. Since his days as founder of Putin’s Financial Monitoring Agency (a “financial intelligence service”, as Putin once described it), Zubkov has been the personal repository of information that can destroy any major company and any wealthy individual in Russia. He can see to it that real – not fake – charges are brought against anyone, at any time. This is the way the Protection Racket works. Informal taxation is at its heart.

In a ruling handed down by the United States Supreme Court in 1819 (“McCulloch v. Maryland”), Chief Justice John Marshall wrote the famous words that apply to any society: “The power to tax involves the power to destroy.” In today’s Russia, the discretionary power to informally tax is an equally potent instrument of destruction and, more important, of control.