Tag Archive for: JohnMaynardKeynes

The Boom-Bust Cycle is Not a Greed-Fear Cycle

Estimated Reading Time: 6 minutes

The CNN Index invites a simple question. “What emotion is driving the market now?”


If you ever find yourself on the business section of CNN’s website, you’ll notice a peculiar thing on the top of your screen. There you’ll find a small ticker labeled “Fear and Greed Index.”

The ticker invites a simple question. “What emotion is driving the market now?”

As an economist, I was very interested in the underlying theory and methodology CNN business was using to determine what was driving the market. Presumably, anyone who understands what drives the stock market better than anyone else is making a lot of money on it. So I looked into the details.

On the index explanation page, a detailed explanation is given.

“The Fear & Greed Index is a way to gauge stock market movements and whether stocks are fairly priced. The theory is based on the logic that excessive fear tends to drive down share prices, and too much greed tends to have the opposite effect.”

So we have the theory now. What about the application? Well, the site says, “the Fear & Greed Index is a compilation of seven different indicators” and “tracks how much these individual indicators deviate from their averages compared to how much they normally diverge.”

Unfortunately, armed with this information, it’s clear that the Fear and Greed Index isn’t any good for understanding markets at all. There are fundamental problems with both the underlying theory and the measurement of the index.

The theory behind the CNN Fear & Greed Index is not new. In fact, it’s just a new way to talk about one of the most discussed ideas in macroeconomics—animal spirits.

The idea of “animal spirits” working in investment was created by mathematician John Maynard Keynes. Keynes was convinced that irrational waves of optimism and pessimism seized control of investors and drove them to make poor investment decisions. He referred to these forces as “animal spirits.”

Have you heard of bear and bull markets? These are Keynes’ “animal spirits.”

Keynes’ thinking on this topic has so permeated culture, that most of my students come into my macro class as default Keynesians without even knowing who Keynes is. I like to start my first-day macro class with a quiz that asks students what they think causes recessions. Some variation of “fear” always tops the list.

In Keynes’ own words,

“There is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions … can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction”.

So what’s wrong with the animal spirits idea? Well, there are many issues. I’ll discuss four.

First, and most importantly, the explanation isn’t an explanation at all. It’s more of a label.

Consider that instead of saying waves of optimism and pessimism seize investors randomly, we could say that the universe generates good vibes and bad vibes that seize investors randomly. Or perhaps real spirits randomly control investors. How does this change the Keynesian animal spirits story?

It doesn’t. And that’s the problem with the idea. Keynes’ animal spirits explanation is essentially saying that something random (in the mathematical sense of the word) and beyond further explanation grabs hold of people and makes them do things. In other words, the explanation is something unexplainable. Fear and greed. Bear and bull. Unicorns and gargoyles.

Second, the animal spirits explanation displaces other explanations about what drives investment behavior. Before Keynes, the economics profession had a strong explanation for changing investment behaviors.

The idea is simple, and it follows the logic that undergirds all of microeconomics. As it becomes more expensive to borrow money over time, investors will borrow less money and take on more short-term projects. When it becomes less expensive, investors borrow more and take on more long-term projects.

The price of borrowing is called the interest rate, and interest rates are affected by savings. If people save more and increase the supply of funds available to borrow, that drives interest rates down making borrowing cheaper. Businesses make long-term expensive projects while consumers save for them.

Although Keynes was unclear about his belief about saving and investment (in some places he says savings equals investment and in other places he says it does not) the effect of animal spirits was to break the theoretical linkage between the two among economists. Basic economics was out and animal spirits were in. “Macroeconomics” was born.

Third, Keynes’ theory of random fear and greed leads to an underdeveloped view of how expectations are formed. In the quote above, Keynes argues investors won’t be “mathematical” about expectations. In other words, they aren’t acting in an internally consistent way given different probabilities and uncertainties.

This may sound reasonable at first. Economists who believe people do not consistently make the same mistake over and over (sometimes called rational expectations) are often derided because some think it implies people make their decisions by doing mathematical equations.

But this is a straw man. These economists do not believe people actually run sets of equations in their head. They believe that human behavior happens in a way that looks like they do.

For example, I don’t believe mountain goats calculate their jumps down to determine if the distance is fatal or not. But I do believe they act like they do that. Mountain goats who consistently misjudge jumps will literally die out. Similar channels operate in investment.

This under-developed expectations theory led to problems for Keynesian economists in the 1970s. These Keynesians wrongly believed they could consistently lower unemployment by printing money and tricking workers into taking jobs that seemed to be high paying. However, when inflation hit, workers’ expectations changed and unemployment soared. This was the first instance of “stagflation”—a situation involving high inflation and slow or negative economic growth—in US history.

So what is a good theory of expectations in place of Keynes? My position on this is with economist Ludwig von Mises who quotes Lincoln’s law (which may not have been said by Lincoln) in saying, “you can fool some of the people all of the time, and all of the people some of the time, but you can not fool all of the people all of the time.”

Fourth, Keynes applied his theory of animal spirits inconsistently. In investment markets, irrational pessimism and optimism reigned, but, as economist Murray Rothbard points out, Keynes excluded the possibility of animal spirits for the class of politicians and technocrats. As Rothbard highlights,

“this class, this deus ex machina external to the market, is of course the state apparatus, as headed by its natural ruling elite and guided by the modern, scientific version of Platonic philosopher kings. In short, government leaders, guided firmly and wisely by Keynesian economists and social scientists (naturally headed by the great man himself), would save the day.”

While this asymmetry in Keynes’ work does not undermine the explanation of animal spirits like the above three arguments do, it does undermine any application of the idea to policy-making unless a good reason for the asymmetry can be explained.

I’ve done my best to provide a list of fundamental issues with the theory of animal spirits. But, CNN’s Fear and Greed Index suffers from application too.

Even if Keynes was completely right about animal spirits, the index would still not be much good.

Remember the methodology. The index tracks today’s deviations in asset values and compares them to historical averages of past deviations. But there is a fundamental problem here. Historical averages have nothing to do with modern valuations, and historical deviations tell us nothing about what modern deviations should be.

Imagine you built your house in 1970 and put in shag carpets. Now you’re selling the house and buyers tell you the shag carpets is something that takes away from the value of the house. You reply, “but I spent $300 on this carpeting!”

Alas, it doesn’t matter what shag carpets were worth in the 70s. It matters what people value them today. The same hold for deviations of value. If hardwood floors are still popular in 2050, the shag carpet seller can’t argue that shag carpets shouldn’t deviate in value since hardwood floors didn’t. It simply does not follow.

There are plenty of good reasons why modern assets should deviate further below average than usual. For example, natural disasters and weather patterns could cause assets to fall below their average more than usual. Also, even if investors don’t systemically error, they can still error. Bad policies could drive investors to make bad investments which, when realized, cause the value of assets to fall further from average than usual.

In other words, an asset falling further in value than usual does not imply the market is responding to “fear.” These assets could be responding to real changes or discovered facts about the economy.

To use an extreme example, imagine an earthquake destroyed the headquarters of most major companies in the US and they all temporarily suspended operations. This would certainly take stocks to historic lows.

The CNN Fear and Greed Index would measure this drop and say that fear is driving the market. But it’s obvious that fear isn’t the cause of this drop—the earthquake is. The fact that people may feel afraid is irrelevant to the cause.

Perhaps not coincidentally, this measurement of “fear and greed” makes the same fundamental mistake of the animal spirits. The index observes when asset prices are further down than usual and simply names the phenomena “fear.”

But labeling a market change “fear” does not mean fear is driving the market. It means you named something.

The index simply assumes what has yet to be proved. A bust by any other name is just as sour. And calling the bust fear doesn’t make us any more informed about it.


This article was published by FEE, Foundation for Economic Education and is reproduced with permission.

Want to Understand the Inflation Problem? Look to Harvey Road, Not Pennsylvania Avenue

Estimated Reading Time: 4 minutes

As news headlines have reported, the US economy today suffers its worst inflation in two generations. Not coincidentally, US public debt is also at its all-time high. As if on cue, opposition pundits are blaming the Biden administration, whose apologists, in turn, blame Russia and corporate greed while touting the success of Washington’s $5 trillion in recent crisis spending. This partisan and ideological bickering misses the central point.

Some economists know better than to treat today’s economic woes as a partisan problem with roots in the 2020 election. Alan Blinder of Princeton University, for example, has for several years complained that politics gets in the way of smart ideas. Professor Blinder’s “lamppost problem” suggests that we would not be here had past policies not fallen victim to the politicization of ideal economics. Moving forward, mainstream economists join Professor Blinder in saying that we now must aggressively neutralize politics, unchain the ideas of intellectual elites, and finally—hallelujah!—let smart policies rule. Never mind that these same economists have admitted fault for getting it wrong, thus vindicating the steady analyses of AIER’s Sound Money Project directed by Will Luther.

Let’s be honest. Even gifted Ivy League economists must have trouble keeping a straight face while recommending that we take politics out of the equation. This is America, after all. Aren’t we the world’s shining exemplar of political inclusion? Sure we are. Yet puzzlingly, there is a long line of thinkers who say that we should replace politics with the judgment of elites. In today’s monetary and fiscal policy, this thought goes back to at least the days of John Maynard Keynes.

On the eve of the early 1980s high inflation rates, mainline economists James Buchanan and Richard Wagner drew attention to the rising debt and inflationary risks of the time. Their 1977 book carried the evocative title, Democracy in Deficit: The Political Legacy of Lord Keynes. Buchanan and Wagner’s prose minced few words, describing the Keynesian influence as the culprit behind “continuing and increasing budget deficits, a rapidly growing governmental sector, high unemployment, apparently permanent and perhaps increasing inflation, and accompanying disenchantment with the American sociopolitical order.”

Buchanan and Wagner argue that the post-Keynesian era suffers from the “presuppositions of Harvey Road.” Harvey Road is a reference to the Keynes family home in Cambridge. A biographer of Keynes, R. F. Harrod, coined this “presuppositions” expression, and Buchanan and Wagner use it to argue that Keynes’s economic theory operates in a political vacuum where the world of monetary and fiscal policy is carried out by wise men in authority. This intellectual aristocracy could ensure conditions of prosperity, freedom, and even peace. In 2011, after President Obama’s stimulus package, many remarked that “Keynes was back.” In reality, the Keynesian influence never died, and modern macroeconomists and policymakers still suffer from the presuppositions of Harvey Road.

Following Harrod’s description, today’s politicians, Federal Reserve officials, and mainstream macroeconomists still posture as enlightened, wise people, who therefore know from their expert analysis what is the best course of action. These elites are also trusted as benevolent people, therefore, they can be trusted to choose the course of action that is best for society. Finally, they are deemed reasonable people, therefore, they will seek to persuade one another and the general public that their chosen course is the best course. Is it just us, or does this 45-year-old description seem more apropos than ever in 2022?

While the proverbial lampposts might shine more brightly along Pennsylvania Avenue than along Harvey Road, let us not fall victim to casting central blame along the former. America’s fallible and often mistaken ruling elites have fanned the flames of today’s economic dumpster fire. It may be tempting to jump to the conclusion that we should replace the “intellectual aristocracy” with democracy. Again, this is America. But when you look closely at the history behind these problems, as we have done in our recent and ongoing work, it becomes clear that unchained democracy has been part of the problem, and crisis periods have justified all of us in treating the government as a fiscal commons.

Perhaps the central point for today’s inflation problem is that we cannot remove the political dimension, but we can better insulate our fiscal and monetary house from the foul sides of politics. One part of the course forward should be to replace trust in politics and elites with acceptance, followed by restraint. This requires recognition that politicians and ruling elites are neither angels nor wizards, and that voter demand for largesse deserves moral judgment alongside corporate greed. From the standpoint of a healthy economy, it is wrong for big business to rent-seek its way to corporate welfare. It is wrong for households to demand loose money to bubble up home values and retirement plans. It is wrong for politicians to take credit for loose budgets and every economic success while bickering over blame for their failures. And it is wrong for Fed officials to invent new instruments of control that transforms their jobs into old-fashioned central planning. Taking politics out means adopting ex-ante rules that retrain all of us from treating the government like a fiscal commons. Instead of replacing smart elites with unchained democracy, we should turn to “small c” constitutional constraint and republican governance. A bipartisan generation of loose money and loose budgets has created major negative spillover effects, and today’s inflation problem is what we all have to show for it.

Taking Buchanan and Wagner’s Democracy in Deficit seriously means putting the focus on political morality and institutional rules. These rules restrain discretion in monetary policy and limit both the scope and scale of fiscal policy. AIER’s Alex Salter and others are right that we need Milton Friedman back now more than ever. But even more so, we need Buchanan and Wagner to take front and center in the political and economic discussion.


This article was published at AIER, American Institute of Economic Research, and is reproduced with permission.

‘Inflation Tax’ Will Cost Families This Many Thousands This Year, Bloomberg Analysis Warns

Estimated Reading Time: 2 minutes

There goes $433 a month from your family’s budget…


Another day, another alarming inflation metric. We just got the numbers for the Personal Consumption Expenditures index (PCE), the Federal Reserve’s favored inflation metric, and they’re jaw-dropping. The PCE hit a 40-year high in February, with the measured prices rising 6.4% year-over-year.

What does this mean in real life?

A new Bloomberg analysis sheds some light on this key question. It finds that this year, inflation will cost the typical US household an additional $5,200 just to afford the same goods as last year. That’s $433 a month taken out of the average family’s budget.

Why is this happening?

Inflation is a Policy Choice

In the mainstream media and among progressive economists, price inflation is often portrayed as an abstract force beyond our control, like the weather. But in reality, it is directly caused by reckless government policies.

The Federal Reserve decided to “stimulate” the economy amid the pandemic by (digitally) printing trillions of new dollars out of thin air. But scarcity and trade-offs are the defining reality of economic life, so their actions had consequences. By putting trillions of new dollars out into the economy, they made the dollars Americans currently held less valuable—inflating away our savings and wealth.

Just consider the below graph, which shows the number of US dollars in circulation over the last 5 years:


What’s more, the federal government flooded the economy with “stimulus” money.

It ran up massive, multi-trillion-dollar budget deficits—at the very time, various levels of government were restricting economic life and constraining supply. Through trillions in debt, Congress signed us up for grave economic costs in the future in order to artificially inflate consumer demand in the short term, which doesn’t work as a “stimulus” to begin with.

Yet when you do this at the very same time you are constraining the economy and hindering the supply chain, it’s inevitable that price levels overall will surge as demand so far outpaces supply.

So, no, inflation isn’t an abstract phenomenon. But it is, essentially, an indirect tax on everyday Americans.

Inflation is a ‘Stealth Tax’

What is a tax, after all, other than a cost forcibly imposed on the citizenry to finance/enable government expenditures? And that also perfectly describes the inflation currently hitting Americans in the wallet.

The government wanted to engage in reckless money-printing and spending without bearing the political brunt of directly raising peoples’ taxes. As a result, our savings were inflated away.

That’s the textbook definition of a “stealth tax.”

Even John Maynard Keynes, hardly a free-market economist, famously acknowledged this reality.

“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens,” Keynes once said.

Keynes found agreement on this point from across the spectrum. Nobel-Prize-winning free-market economist Milton Friedman similarly quipped that “inflation is taxation without legislation.”

Ultimately, Americans shouldn’t fall for this financial sleight-of-hand.

“Inflation” isn’t really what will cost families $5,200 extra this year. The government is what’s truly imposing that burden upon us all. 


This article was published by FEE, The Foundation for Economic Education and is reproduced with permission.