Christopher Whalen

In the most recent issue of Housing Wire Magazine, economist Paul Krugman suggests more government spending as the means of dealing with the economic slump and the housing crisis.

“We will be seeing low interest rates for a very long time,” the Nobel laureate said. “The thing about housing … housing prices were stable for a long period of time, then they soared and came back down.”  So now we know that what goes up must come down.  Thank you Dr. Krugman.

Incredibly, neither Krugman nor his soul mates among the neo-Keynesian elite, a distinct group which exercises hegemony over American economic policy, seem to accept that government spending and more debt, enabled by double digit inflation, is not a solution.

“Government policies promoting consumer indebtedness with low interest rates and low down payments were partly responsible for the housing bubble,” notes Anthony Sanders of George Mason University in Housing Wire.  “It should be called the Keynesian bubble.”

Despite all of the academic fussing about the triumph of neo-liberal economic thinking in the 1980s and 1990s, the real underlying model of American political economy is entirely socialist in political terms and inflationist as to the core monetary model.  When the advocates of free market economic tenants have shown the temerity to challenge the control of the temple by the neo-Keynesian Sanhedrin, the result has been more government and ever mounting piles of public debt.

The roots of neo-Keynesian socialism of the Krugman variety go back to before WWI, to the creation of the Federal Reserve System in 1913.  I spent a good bit of time talking about the statist and ultimately socialist roots of the Fed in my book Inflated: How Money and Debt Built the American Dream, including a number of sources that deserve more attention. One of these is “The Role of Keynesians in Wartime Policy and Postwar Planning,” by Byrd L. Jones of the University of Massachusetts, who described how Harry Hopkins and the socialist brain trust around FDR plotted a course to “full employment” using deficit spending funded with debt.  Historians of this era lionize these socialists for “saving what even conservatives call capitalism,” to quote James Galbraith on Alvin Hansen, another of the authors of the Keynesian illusion of pretend economic growth via deficits and debt.

Hansen was one of the key architects of the idea of “full employment,” a concept he developed during a series of lectures at Harvard University, one of the great birthing grounds of American socialism.  James Tobin wrote of Hansen in 1976 that as the principal intellectual leader of the Keynesian conquest, Hansen deserves major credit for the “fiscal revolution in America.”

That revolution, sadly, put the US on the road to fiscal recklessness and a steady rate of debt accumulation and inflation that has robbed Americans of most of the value of a dollar of a century ago. FDR operatives such as Leon Henderson, Richard Gilbert and Lauchlin Currie based the recovery of the US economy in the 1930s on defense spending, arms exports and domestic subsidies — a tendency for an expanded government learned in WWI, expanded in WWII and continued happily ever since.

Currie, a Canadian socialist who like Hansen worked at the Fed and later at the White House for FDR, also focused on war as a means of economic stimulus — a policy still followed under President Barrack Obama.  Jones writes that in Currie’s analysis, defense spending and arms exports were means to be “temporary” aids to the economy, but that a long run solution not dependent upon “chronic fiscal deficits” required “a liberal program of progressive taxes, increases in social security benefits, more public works projects and encouragement of investment (especially in home building).”

If you think that the last sentence sounds an awful lot like what we hear coming from the mouth of Paul Krugman and other advocates of more public spending today, then you’re correct.  The basic program of the neo-Keynesian socialists has not changed in decades, namely to expand the role of the state in the US economy and use inflation to create the illusion of economic prosperity — what liberals call “full employment.”

During the years following WWII, America donned the clothing of free market capitalism, at least in a rhetorical sense, but the underlying model of political economy has remained true to the socialist roots of FDR.  Conservatives from Hayek and Henry Hazlitt on forward have warned that the end result of the neo-Keynesian path is an authoritarian state and we have one today.

Yet even with a government monopoly on the housing sector, professor Krugman still wants to spend and borrow more.  In a post on Zero Hedge yesterday, “Counter-Cyclical Follies,” my friend Dick Alford argues that economists are finally realizing that “counter-cyclical fiscal and monetary policies do not address the cause of the under-performance of the US economy and hence are not solutions.”

Maybe.  But it has taken educationally deprived Americans a century to figure out this key economic insight.  So long as people take their policy guidance from committed neo-Keynesian advocates like Paul Krugman, who continue to follow the same socialist line set down a century ago by the likes of Hansen and Currie, we shall make no progress on truly fixing the US economy.

“[F]or many philosophers, conflict is inevitable in politics because a government should seek both to make its people equal in wealth and opportunity and also to safeguard their liberty, but it cannot do both because people can be made equal only through serious constraints on their freedom. This is not simply a statement of the obvious fact that different people and different communities hold different values. The argument claims that even a single sensitive person cannot express, either in how he lives or how he votes, all the ideals he knows he should recognize.”

Justice for Hedgehogs
Ronald Dworkin

In an article in the April 28, 2011, New York Review of Books, “For a National Investment Bank”, Robert Skidelsky and Felix Martin argue that the Obama Administration ought to create yet another state sponsored financial institution in the US to explicitly stimulate the economy by issuing debt. This is a truly bad idea whose time has come and gone.

The authors rightly describe the lack of aggregate demand in the US, something we have also discussed at some length in this space. “Few dispute that the US is not enjoying a normal recovery by recent standards,” they write. So true. But their suggestion of creating a new government sponsored enterprise (GSE) to address slack growth and employment lacks imagination and practicality. Skidelsky and Martin specifically want to use the NIB to finance public infrastructure projects, but without the new debt required showing up on the federal budget. How clever.

Nowhere do Skidelsky and Martin, nor most neo-Keynesian economists, admit that much of the nominal economic growth of the past several decades in the US was increasingly supported by debt and inflation. The national investment bank they propose would take its place alongside dozens of existing New Deal and Great Society agencies such as Fannie Mae and the Federal Housing Administration, as well as the Bretton Woods GSEs including the IMF and World Bank. Martin, an economist at Thames River Capital LLP, worked at the World Bank for two stretches between 1998 and 2008 and must be familiar with this history. The NIB is more of the same stuff in policy terms.

The NIB proposal shows just how bankrupt the American political discourse has become when it comes to economics, but especially on the left.  It also reveals the indifference of liberal economists to the political consequences of economic policy choices. This is not to suggest that Republicans are exactly fonts of economic innovation at present. Most Republicans are indistinguishable from big government Democrats in terms of their willingness to prune back the corporate state. Fiscal conservatives have been fighting this battle for decades now.

The first observation about the NIB proposal is that we are talking, once again, about using debt to create the illusion of economic prosperity. Skidelsky, Emeritus Professor of Political Economy at the University of Warwick and the author of Keynes: The Return of the Master (2009), is an unabashed advocate of the aggressive state in action. Yet what he and Martin propose promises few benefits in economic terms. Indeed, you cannot make an argument for more GSEs on utilitarian grounds.

The most offensive thing about the NIB proposal is that it pretends to rely upon Keynes. Skidelsky and Martin say that they intend some sort of pump-priming, jump starting catalyst for private sector growth. Keynes was no apologist for using debt to simulate real economic growth but he also believed in individual economic liberty, which he greatly benefited from. Living through the privation in the UK during and after WWII, Keynes understood the desperate situation facing Britain. Modern economists spend too little time considering politics when assessing the motivations of the day.

My friend Sol Sanders and William Alpert talked about Keynes in The Institutional Analyst last month (Keynes, Keynesianism — and Keynesianitis): “‘The day is not far off’, he wrote, ‘when the economic problem will take the back seat where it belongs, and the arena of the heart and the head will be occupied or reoccupied, by our real problems/the problems of life and of human relations, of creation and behavior and religion.’  In 2010 we are still waiting.”

The same lack of demand and unemployment that faced Keynes and the leaders of the Western economies after WWI and WWII, and to which Skidelsky and Martin rightly raise in alarm, has driven liberals today to embrace ever more inflation and debt. An aggressive combination of reflation by the Fed and restructuring of the housing and banking sectors is the way to restore US economic growth, but you won’t hear about restructuring large banks from adherents of the neo-Keynsian faith.

Skidelsky and Martin assess the political situation facing the Obama administration, saying “that it has become politically impossible to increase the deficit.” Quite right. But the solution offered by these two honorable gentlemen is to create yet another GSE to issue more debt off the books? Such expedients are entirely transparent to the marketplace, but Skidelsky and Martin do not seem to appreciate that more incremental debt buys less and less bang for the buck in terms of nominal economic growth.

Skidelsky and Martin, and their American contemporaries led by the likes of Paul Krugman, call for “fiscal stimulus,” but what they are really arguing for is permanent inflation. The Fed has been pursuing the reflation path via quantitative easing, but with less than astounding results, owing to the lack of benefit for US households.

The only way to fix the twin problems of deflation and unemployment is to keep money easy and restructure the insolvent parts of the banking system and economy. In both the US and EU, the policy has been implemented but the lack of financial restructuring of the insolvent banks of the US and EU is the chief obstacle to economic renewal. To restructure and renew is the alternative to the proposal from Skidelsky and Martin.

Instead, Skidelsky and Martin want to layer more state-guaranteed debt on top of an already wobbly foundation. This is not only bad economic policy, but it has truly hideous political implications. John Stuart Mill acknowledged that utilitarianism had to admit the moral superiority of classical liberalism and that, to save it, certain preferences (those the classical liberals generally would favor) simply had to be acknowledged as preferable.

Why is it that so few economists ever assess the social and political implications of their policies? Skidelsky and Martin are following the road to hell trodden by Franklin Roosevelt in the 1930s. Not only do we have the New Deal zombies like Fannie Mae and the Federal Housing Administration as examples of failure, but dozens of parastatal banks and development entities in the EU that are effectively insolvent today. The embrace of the fascist economic model proposed by Skidelsky and Martin has not saved the EU from economic malaise.

As Ronald Dworkin notes in his new book, Justice for Hedgehogs, the differences between different ethical and political systems do matter very much. Keynes believed in using temporary government action to help restore private economic activity, but I doubt he would have supported the type of debt accumulation much less the creation of permanent GSEs that Skidelsky and Martin propose.

Instead of embracing a permanent state of inflation, as has been the case in the US since the 1970s, we need to deflate the bubble and start again. It is not too late for President Obama and Congress to restructure the US financial system, fix the housing market and create the conditions for true economic growth. All we need to succeed is leadership and the knowledge that the bastard children of Lord Keynes cannot help us in the difficult task ahead.