A lost chance to overturn Keynes with the fiscal cliff

November 9, 2012

If free-market economists were serious about their ideas, they would surely be arguing vociferously right now for the economy to plunge over the fiscal cliff. But where are the laissez-faire economists lining up to urge John Boehner to lead his Tea Party tribe in the House to veto all compromise and put our money where their mouths are? They are strangely silent. Instead, the debate is about how Keynesian we should be.

A reminder for those who haven’t read John Maynard Keynes lately, or who have never read Keynes but oppose him anyway out of principle, he was a British math whiz who transformed economics forever with the publication of his “General Theory” in 1936. It suggested three ways to put wind in the sails of an economy in the doldrums. The problem, Keynes suggested, was that there was not enough demand for goods and services, and that governments should take a lead in stimulating spending to encourage business leaders to invest and create jobs.

Keynes’s first prescription was for central banks to make borrowing as cheap as possible with low interest rates. This deters saving and makes new investment in business activity more attractive. Businesses will employ workers who go out and spend their earnings. After studying the roots of the Great Depression, Milton Friedman and Anna Schwarz blamed the economic slump on money being too tight for too long. Such was the fear of returning to the deflationary devastation of the 1930s that successive Federal Reserve chairmen have taken this lesson to heart. Faced with a recession in 2001, even Alan Greenspan, a lover of the free market who flirted in his youth with the Lioness of Laissez-Faire, Ayn Rand, kept money rock-bottom cheap for the whole of the first decade of this century.

In light of the financial freeze of 2008-09, Friedman’s most distinguished disciple, Federal Reserve Chairman Ben Bernanke, an avowed Republican, set out to keep interest rates low to the horizon by buying government bonds in the process known as quantitative easing. Bernanke acted to the horror of fiscal conservatives, who fear the threat of inflation far more than high unemployment.

In the GOP primaries, during his “severe conservative” phase, Mitt Romney joined with every other Republican presidential hopeful in demanding Bernanke’s head. One outcome of President Barack Obama’s reelection is that Bernanke will stay at his post until at least January 2014, perhaps longer, and he will continue to keep money cheap.

The second measure Keynes suggested that would give a shot of adrenaline to a flagging economy ‑ what might be called the Lance Armstrong effect ‑ was to slash personal taxes. Many Republicans, even those who profess a passing acquaintance with economic theory, are under the illusion that cutting taxes was championed by conservative saints like the Austrian Friedrich Hayek. In fact, Hayek was opposed to cutting taxes unless a government was in the black. When asked about Ronald Reagan’s deep tax cuts, he said, “I’m all for reduction of government expenditures, but to anticipate it by reducing the rate of taxation before you have reduced expenditure is a very risky thing to do.”

Democrats and Republicans agree that extending the Bush tax cuts would bolster the economy. They differ only over whether individuals earning more than $200,000 and couples earning more than $250,000 should benefit. Keynes, who made two vast fortunes, wrote little about taxing the rich. He was never, like Hayek, a socialist. His motivation for cutting taxes for the middle class rather than the rich was practical. As the purpose of Keynesian tax cuts is to encourage spending, it is best to concentrate tax cuts on the middle class, who readily spend the cash. The rich save it.

The nonpartisan Congressional Budget Office has waded into this debate and put a price on the president’s pledge to oblige richer Americans to pay more because “those who have benefited most from our way of life could afford to give back a little more.” The CBO suggests that not extending tax cuts to the rich would restrain domestic growth by 0.25 percent, which would mean 200,000 fewer new jobs. This contradicts Romney’s claim during the Denver debate that failing to extend the tax cuts to the rich, whom he claimed to be predominantly job-creating small business owners, would mean 700,000 fewer jobs.

Keynes’s third idea for stimulating a flagging economy was to increase government spending. Just as the government is the borrower of last resort, so it should be the spender of last resort. Neither side in the tussle over the Budget Control Act – the fiscal cliff’s formal name ‑ is arguing for more public spending; both think it is time to start paying down the deficit. They appear to agree on the size of the spending cuts and where they should come from.

Keynes added a corollary to his three means of boosting growth: Do not pay down debt until the economy is booming again. To levy higher taxes when more people are working again would be less painful by spreading the burden. Keynes would likely argue that it is too early to cut public spending, because that would slow an already fragile economy. The CBO spells out what that means. While the fiscal cliff’s automatic cuts and the lapsing of the Bush tax cuts would together reduce the deficit between fiscal years 2012 and 2013 by $560 billion, they would also cause growth to shrink to just 0.5 percent next year. The CBO predicts that leaping off the fiscal cliff would lead to “a contraction in output in the first half of 2013 [that] would probably be judged to be a recession.” In short, the fiscal cliff would prompt a double-dip recession, just as similar policies have in Britain and the euro zone.

There is a lot of talk among conservatives and libertarians about “pushing the government out of the way so the free market can do its work.” Having lost the election, they cannot hamper Bernanke in his Friedmanite boosting of the money supply to head off stagnation. But they could follow Hayek’s example and insist that taxes be allowed to rise and public expenditures be cut starting on Jan. 1.

But where are those voices? Where is the clamor to abandon, as they would put it, Keynes’s “pernicious” influence over economic policy? The same free-market economists were also noticeably absent when Wall Street crashed in the fall of 2008, the financial markets froze, banks went bust and the world peered over an earlier cataclysmic cliff. Perhaps the truth is to be found in the candid remark of the 1995 Nobel Prize winner for economics, Robert Lucas, a leading light in the ultra-conservative Chicago School of Economics, who said in October 2008, “I guess everyone is a Keynesian in a foxhole.”

Nicholas Wapshott’s “Keynes Hayek: The Clash That Defined Modern Economics” is published in paperback by W. W. Norton. Read extracts here.


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My problem with Keynesianism is that the government has a long track record of being lousy spenders.

Posted by jambrytay | Report as abusive

…conservatives and libertarians about “pushing the government out of the way so the free market can do its work.”

Conservatives want to win control of the political machinery to advance agendas. Libertarians want to eliminate it. Big difference.

A free market cannot exist with monopoly. End the money monopoly and allow competing currencies. Currency competition would increase responsible behavior in its management.

Posted by LysanderTucker | Report as abusive

Conservatives and libertarians did not, in fact, “lose” the election. While they lost the battle for the presidency, they increased their majority in the House of Representatives, the branch from which all revenue-generating bills must originate. It is entirely possible that the House will sit back and allow the very scenario of which the author speaks, “following Hayek’s example,” to happen.

Posted by Randy549 | Report as abusive

I addressed this topic at length in a rather long open letter to President Obama several years ago:


Posted by mattfunk | Report as abusive


{Democrats and Republicans agree that extending the Bush tax cuts would bolster the economy.}

And this is where they a both wrong. The above statement can only hold true when an economy has just begun its descent into the inferno of a recession or, worse, a depression.

It does not work when psychology installs itself over a lengthy period of time reducing Consumer Demand because of real or imagined threats of job security. People, in such a circumstance save rather than spend, regardless of the tax-credits or -reductions.

Their “propensity to spend” is tired if not exhausted. What is required is a renewed faith in the economic climate that reduces any fear of being unemployed (with two kids to feed and a mortgage to pay). Then they will get back to a more typical “shop till you drop” consumption behaviour.

Economists, particularly those who have become too seduced by arcane statistical modeling, forget that behind the formula GDP = C + I + G is human psychology – which, last time I looked, cannot be modeled predictively. It can be understood nonetheless.

Let’s understand that above equation simply. The key component is Consumption, without which there is no reason to Invest. With both reduced, there is reduced production meaning Government revenues (from sales and income taxation) occurs. Which can provoke a need to reduce Government expenditure in some addled heads. Whilst exactly the opposite is the medicine needed to rekindle Consumption.

In fact, reducing Government expenditures is exactly the OPPOSITE of what nations should do.


And the notion that reducing taxes on the rich spurs investments is pure and simple inanity. The rich are evidently not fools – why invest in a weak economy? No, they will take any tax reduction and invest it in the money-market biding their time until the economies improve. And certainly not looking for rewarding investments to make.

Besides, the rich have more than enough of anything that they really want or need? How many Ferraris can you drive at one time? How many yachts anchoring in the harbor in St. Tropez (France)?


Reducing taxes on the poor and middle-class will prompt renewed propensity to spend, but let’s not have any great expectation. As presently shown, the uptake in consumption is positive but not sufficient to provoke Investment (meaning an increase in production that lowers unemployment).

So, full circle, Keynes was very right 80 years ago. Regardless, though his work (cited in this article above) was an earth-mover in both government and economic circles, it nonetheless took WW2 stimulus-spending to definitively end the Great Depression.

Now who in their right mind would want another war to stop this recession? (Don’t answer! ;^)

Posted by deLafayette | Report as abusive

{jam: My problem with Keynesianism is that the government has a long track record of being lousy spenders.}

“The” government? Which government? We’ve had quite a few since he wrote his treatise in 1933.

Eisenhower warned us about the M-I-C and who new better than complex than he? Did we listen? Nahhhh ….

And it went on to gobble up a major part of our economy, so much so, it too thought for a while that it was TBTF. And when the Romney Guy promised Americans that he would focus on Jobs, Jobs, Jobs, which group did he have his mind on? One guess.

Social Justice is an uncommon phrase in the US. But it is or should be at the heart of any economic policy. After all, such policy decision-making, exercised by a PotUS, should want to do the most good for most people.

Yes, the M-I-C employs a lot of people. But building schools would also employ the same number. So, why the kneejerk reaction that favors expenditure on the M-I-C. Habit, I suggest. We have a bad habit of spending money on more toys for our boys.

Europeans do not spend a tenth of their budgets on the M-I-C, so they can spend it on universal health care that is far less costly than ours.

Policy is always a matter of choice. And that choice (or choices) should be formulated by an electorate. Which is why it is a shame that most of ours is so indifferent.

Only 50% of American voters turned out to vote last week. Which indicates much about our collective sense of Civic Duty.

Posted by deLafayette | Report as abusive

Well they lost the presidency, so maybe the moderate Republicans have told the extremists in their party to shut up with the crazy talk already.. One can only hope.

Posted by Sue4 | Report as abusive

For credibility’s sake, I mention that I’m a lawyer, MBA and economist. Live in Seattle.

#1: People mention snippets about a philosophy without mentioning (or worse, not knowing) about it in entirety. Here, Hayek. Hayek would not recommend CUTTING expenses or LOWERING TAXES until the government had provided 100% HEALTH INSURANCE and 100% HOUSING for ALL CITIZENS. If you know this, you might think Hayek to be even more socialist or communist than Republican or Democrat and you’d be right.

#2: Based on our extremely high unemployment rate and especially the lack of upward mobility for the newly graduated and basically anyone who makes less than $250k a year, our American life is not only under attack, it’s almost DONE and GONE. I know very few individuals or couples who can afford the basics of a house, car and a decent nice life. Then add in children and trying to save for college for those children and it’s basically impossible. If you’re over 40 and trying to get a job, no one will hire you as you are considered too expensive and too old to fit in with the cheaper and inexperienced workers, especially the slave labor from India and China.

#3: There’s only one economist who makes sense in this given times: Paul Krugman. Basically, we need to do what he recommends.

#4: Many people know that our U.S. Declaration of Independence starts with the immediately below paragraph; however, the other paragraphs below that start with “That to secure…” shows that we do have a right to “throw off such governments” if they are not taking care of us and there is only one way to do this, not voting but by force, which temporarily will sacrifice public safety during this transition to a new government of the people.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.

That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed, That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness. Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn, that mankind are more disposed to suffer, while evils are sufferable, than to right themselves by abolishing the forms to which they are accustomed. But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.

Posted by joelrain | Report as abusive

@ joelrain —

I am a retired CPA/MBA.

I worked mostly in the high tech industry since it began around the mid-1980s, mainly as a Plant Controller and Finance Manager for several multinational corporations.

I too live in Seattle.

You may be a lawyer, but you are certainly no economist.

I don’t know which Hayek you are referring to, but it is certainly not the one familiar to most people.

(From Wikipedia solely for ease of access on this subject)

“US President Ronald Reagan at his time listed Hayek as among the two or three people who most influenced his philosophy, and welcomed Hayek to the White House as a special guest.[52] ”

“Hayek disapproved of the notion of ‘social justice’.

He compared the market to a game in which ‘there is no point in calling the outcome just or unjust\'[69] and argued that ‘social justice is an empty phrase with no determinable content\';[70] likewise “the results of the individual’s efforts are necessarily unpredictable, and the question as to whether the resulting distribution of incomes is just has no meaning.”[71]

He generally regarded government redistribution of income or capital as an unacceptable intrusion upon individual freedom: “the principle of distributive justice, once introduced, would not be fulfilled until the whole of society was organized in accordance with it.

This would produce a kind of society which in all essential respects would be the opposite of a free society.”[70]

With regard to a safety net, Hayek advocated “some provision for those threatened by the extremes of indigence or starvation, be it only in the interest of those who require protection against acts of desperation on the part of the needy.”[72]



We all know Reagan was a “bleeding heart liberal”, and he certainly thought highly of Hayek, who influenced him on his economic decisions.

That certainly doesn’t sound like the Hayek I know and despise.

Posted by Gordon2352 | Report as abusive

@ joelrain —

By the way, Paul Krugman, with his “pop-psychology” version of economics is an idiot.

Posted by Gordon2352 | Report as abusive

A writer who calls Hayek a conservative is a writer that is simply writing propaganda. I suggest that the author reads the famous “Why I am not a conservative” chapter of Hayek’s second most famous book.

Posted by Brilakis | Report as abusive

@ joelrain —

You state, “Many people know that our U.S. Declaration of Independence starts with the immediately below paragraph; however, the other paragraphs below that start with “That to secure…” shows that we do have a right to “throw off such governments” if they are not taking care of us and there is only one way to do this, not voting but by force, which temporarily will sacrifice public safety during this transition to a new government of the people.”

If by that comment you are advocating the forceful overthrow of the US government, you apparently have a rather feeble understanding of the history of revolutions and their results, which are typically highly unpredictable at best.

I have argued in many previous comments that it is in the best interests of the wealthy class to be reasonable or we all could lose everything, but this has fallen on deaf ears.

Clearly, the American people are not yet ready for an “American Spring”, but I think once the US economy heads down the same “slippery slope” as the eurozone has, this may become a reality by as soon as next year and their mood may shifts when they begin to lose their homes and life savings.

The idea that a forceful overthrow of the government could be so well managed that we could somehow magically “temporarily … sacrifice public safety during this transition to a new government of the people” is fanciful to say the least.

I think the wealthy do not understand the present makeup of American society, judging it be the same as it always has been — docile and compliant. They are apparently only just becoming aware of it now due to the results of the latest election, but I think they will not accept the “handwriting on the wall”.

The election proves the demographics have changed dramatically over the last few decades since WWII and I do not believe the American people will remain docile and compliant much longer.

Thus, any “American Spring” is likely to turn very violent very quickly, and such a smooth transition to a government of the people as you envision has literally a zero chance of occurring.

To state it plainly, I am NOT in favor of a forceful overthrow of the US government, but as this trend progresses, I think it will soon move beyond the present state of affairs to something much more as you describe.

I wish I was wrong, but I believe you are correct in what you state, just not how you state it. Basically, the only thing I disagree with you on is how smooth this transition would be.

One way or another, I do not believe this nation will survive unless radical changes are made.

Posted by Gordon2352 | Report as abusive

@ jambrytay —

You state, “My problem with Keynesianism is that the government has a long track record of being lousy spenders” but you real problem is you have no idea of what Keynesian economics was designed to do.

Don’t feel bad, neither do most of the so-called economists out there either.

Posted by Gordon2352 | Report as abusive

In the States, the FED trope being passed around now, with almost the same vociferocity as the AGW trope, is that ‘The United States prints its own currency, and as long as we have the Fed, we can always print our way out of debt!’

Of course, the Fed Charter is due to expire this 2013, a nuance that you didn’t hear in pre-elections debate.

So there’s that. Yes, so just spend, spend, spend, and increase the FED MANDATORY OFF THE TOP DEBT SERVICING.

We can always print more checks for you!!

Posted by Chip_H | Report as abusive

Last time I saw my check stub, I’m paying 15% of my paltry income with no pension for that Hayek ‘safety net’, which we here in the States refer to as our SS/MC TRUST FUND, and which those in the private Fed bank refer to as ‘Our unwitting junk buyer of last resort’.

So by the time we reach the ‘American Spring’ stage of citizen revolt, after having Wall Street steal our 401ks with their Dot.Con, their 2000 Coup steal our Federal surplus with their WMD.Con, after SCDO-gambling driven theft of American home equity with their Credit.Con and now Bernanke’s QEn tapping directly into our SSTF, my friend, THERE WON’T BE ANYTHING LEFT TO FIGHT OVER!

US Treasury will be as empty as Al Capone’s bank vault.

Posted by Chip_H | Report as abusive

Then, unable to pay the MOUNTAIN of debt servicing on the entirely synthetic Federal ‘deficit debts’ stolen by the international privateers, our American Spring revolt will be quickly quashed by the IMF-World Bank, our nation and currency declared illiquid and in default, then the private international vulture capitalists will swoop in, privatize all public energy and utilities infrastructure, hydroelectric dams, nuclear power facilities, everything our taxes went to pay for, and we will receive … nothing.

Nothing but the clothes of the kulak and a few turnips, then suffer the tithes, taxes, tariffs and tolls of the highway robbers.

“So it goes, first your money, then your clothes.”

Posted by Chip_H | Report as abusive

Giving money to banks does not mean they will loan. Their profit motive is to make as many loans they can good times and sell them off. In b ad time they cannot sell it off and people are credit worthy. A better idea wold be to issue non-transferable script to every one that is only good for limited time to buy from those places that agreed to hold last year’s prices (no inflation of profiteering. Since the money is no good later or to anyone else it has to be spent.

We have a long term problem as well; imports exceed exports. So does most of the other high wage nations for decades. Free trade does not work for them.

Posted by Samrch | Report as abusive

governments and free markets are peoples creation, thus, they both screw up once in a while. both Keynes and his critics (Hayek) are correct, it’s all cyclical…
right now China, jobs exodus and US political standoff are the biggest concern. Russia is potentially concern #2, it’s not a democracy, to say the least.

Posted by UauS | Report as abusive

For those of you out there who believe the US economy is in recovery and the best Rx is to begin cutting the deficit without raising taxes, here is an article from the Prudent Bear that may prove interesting.


Mr. Global Economy – The Economic & Psychological Prognosis

by Satyajit Das
October 11, 2012

As requested, I have undertaken an extensive examination of Mr. Global Economy, both physical and psychological.

Patient History

The patient’s history includes a seizure in 2007/2008 – financial losses, banking problems, a major recession, etc. Liberal injections of taxpayer cash avoided catastrophic multiple organ failure assisting a modest recovery.

Governments ran large budget deficits in the period after the crisis. Interest rates around the world were reduced to historic lows, zero in many developed countries.

With interest rates constrained at zero, central banks have adopted “innovative” treatments, referred to as quantitative easing; the fashionable appellation of a more old-fashioned procedure – printing money. Balance sheets of major central banks have increased from around $6 trillion to $18 trillion, an unprecedented 30% of global gross domestic product (GDP).

As evident from the anticipation of and reaction to decisions by the U.S. and European central bank to provide further support, the global economy is now addicted to monetary heroin. Increasing doses are necessary for the patient to function at all.

Lifestyle Changes

Mr. Economy has also not made the recommended changes necessary for a return to full health. He seems to have taken rock star Steven Tyler’s advice: “Fake it until you make it.”

Borrowing levels remain unsustainable. Debt levels for 11 major nations have increased from 381% of GDP in 2007 to 417% of GDP in 2012. Debt has increased in Canada, Germany, Greece, France, Ireland, Italy, Japan, Spain, Portugal, the UK and the U.S.

There has been a shift of debt from private borrowers to governments. There has also been a change in the identity of the lender – governments and central banks have heroically stepped in to take over debt from commercial lenders and investors.

Global imbalances – major current account surpluses and deficits – remain. Large exporters like China, Japan and Germany remain resistant to abandoning their export-based economic model.

Little progress has been made in bringing the banking system under control. Regulatory initiatives involve activity if little achievement. New regulations of stupefying complexity run to thousands of pages.

The process provides continuing employment to thousands of needy policy advisors, regulators, lawyers and lobbyists, who would otherwise struggle to gain productive employment. Without their heroic efforts and stoic acceptance of privations (first class travel, 5-star hotels, constant conferences and symposiums etc), the recovery would be even more tepid.

Major Organs – U.S.

Physical examination revealed that the U.S. is in marginally better condition than other organs – the “cleanest dirty shirt” is the expression. Despite a $1 trillion annual budget deficit (6% of GDP) and zero interest rates, growth is a tepid 2%.

The housing market’s rate of descent has been arrested but prices remain 30-60% below highs. New housing starts have stabilized, at around 50% below peak levels. Benefiting from a weaker dollar, manufacturing has improved. Lower oil and natural gas prices have benefited the economy.

Employment remains weak. If discouraged workers who have left the workforce and part-time workers seeking full-time employment are included, then unemployment is over 15%, well above the headline 8% rate. The total number of Americans now employed is around 140 million, well below the peak level above 146 million.

Consumer spending remains patchy. Job insecurity, lack of earnings and wealth losses are causing households to reducing spending and repay debt.

Record corporate profits have been achieved mainly through cost reductions and minimal revenue growth. Investment is weak due to the lack of demand.

Bank lending is sluggish due to lower demand for credit and problems of financial institutions.

Federal public finances remain unsustainable. Hardening of the political arteries means that there is little resolve to deal with deep-seated problems. There is risk of a “fiscal cliff” episode.

If there is no political resolution, then automatic tax increases (non-renewal of tax cuts) and spending cuts equivalent to about 5% of GDP, mandated under the 2011 increase in the national debt ceiling, will automatically occur. This would mean a contraction equivalent to more than $600 billion in the first year and $6.1 trillion over 10 years. This would improve the budget deficits and slow the growth in debt, but adversely affect growth.

State and municipal finances are also under stress, with an increasing number of borrowers filing for bankruptcy.

Other Developed Organs

Many European countries have high debt levels, budget and trade deficits, social spending inconsistent with tax revenues, poor industrial competitiveness (with some exceptions), a rigid monetary system and inflexible currency arrangements. This is compounded by weaknesses of the European banking system with large exposure to sovereign bonds issued by peripheral nations.

Intellectually and institutionally, Europe is unable to deal with its debt crisis. Europeans believe stabilization and recovery can be achieved through greater integration. Even if issues of national sovereignty can be overcome, integration will not work. Unsustainable levels of debt do not magically become sustainable by changing the lender or guarantor. The monetary arithmetic of European debt problems is that the EU and Germany, its main banker, does not have enough funds to rescue the beleaguered euro-zone members.

Austerity dooms Europe to a prolonged and severe recession as the debt burden is worked off. The alternative, a debt write-off, would result in significant loss of wealth for the mainly Northern European lenders triggering an economic contraction and prolonged period of economic stagnation.

Japan is in a state of advance atrophy, despite decades of therapy. The temporary rebound, mainly the result of the recovery from the tragic tsunami and government spending, is running out of steam. The political system is even more blocked than that of the U.S., allowing only a trickle of oxygen to circulate, impairing function.

Japan’s primary investment merit is that almost all possible manmade and natural disasters have happened and the worst is factored in.

Emerging Parts

Mr. Economy’s physicians originally hoped that the BRIC (Brazil, Russia, India, China) nations would offset weakness in more developed and weaker elements. Unfortunately, China’s growth is slowing rapidly. India and Brazil have also lost momentum, with growth weakening. Russia is dependent on high energy prices.

BRIC weakness is a function of lower demand from developed countries reducing exports and weaker commodity prices.

The withdrawal of European banks, historically major lenders to emerging markets, has decreased the flow of money to countries needing foreign investment. For example, in 2011 large European banks accounted for 36% of global trade finance, based on a World Bank study. Some 40% of trade credit to Latin America and Asia was provided by French and Spanish banks. As the European banks, besieged by financial problems at home, reduce their international activities, the supply of financing has decreased and its cost has increased.

Emerging markets also show increased susceptibility to the developed world credit virus. A rapid expansion of domestic credit in China, Brazil, Eastern Europe, Turkey and India will result in banking system problems. The combination of external and internal weaknesses threatens emerging economies, naturally prone to serial crises.

Psychological Assessment

As requested, Dr. Freud assessed the psychological condition of Mr. Global Economy.

He concluded that Mr. Economy is delusional, believing complete recovery is imminent. Presented with contrary evidence, he quoted philosopher Friedrich Nietzsche: “There are no facts, only interpretations.”

Like many terminally ill patients, Mr. Economy has embraced faith healing techniques. Keynesian and monetarist regimes, he believes, will boost demand and create sufficient inflation to bring his elevated debt levels under control.

Keynesian Kool-Aid

The Keynesian cure entails government spending financed by taxation or borrowing to restore Mr. Economy’s health. There is no evidence that it can arrest long-term declines in growth.

Government spending boosts activity temporarily, but may create excess capacity in the absence of underlying demand. Nostalgia about President Roosevelt’s infrastructure projects during the Great Depression is misplaced. Excess electricity generation capacity from dam projects was only absorbed by wartime demand for defense equipment.

As tax revenues have fallen due to slower economic activity, governments have already borrowed to finance large budget deficits.

Government ability to borrow to finance further spending is increasingly limited, without resort to the innovative monetary techniques. In recent years, the Federal Reserve has purchased around 60-70% of all U.S. government debt issued. The European Central Bank is now financing governments indirectly by lending to banks to purchase sovereign bonds.

The ability of the U.S. to finance its large budget deficit relies heavily on several unique factors. The Federal Reserve and the banking system flush with central bank funds have been a large purchaser of U.S. government bonds. The status of the dollar as the major trade and reserve currency has allowed the U.S. to find buyers of its securities, even at very low interest rates. The U.S. ability to finance is also underpinned by the balance of financial terror – overseas buyers, such as China, Japan, major oil producers are forced to continue purchasing U.S. government debt to avoid loss of value on existing large holdings.

The limits of government’s ability to borrow and spend are highlighted by the European debt crisis. Investors are increasingly concerned about public finances, becoming reluctant to finance nations with high levels of debt or demanding high interest rates.

Monetary Boosters

Having reduced interest rates to zero, central banks are giving Mr. Economy the modern Monetarist prescription, changing the quantity of money available. Under quantitative easing, they buy government bonds injecting money into the banking system to lower borrowing costs and increase the supply of money to stimulate demand and inflation. Central banks believe they can keep rates low and print money to finance government debt purchases indefinitely.

But greater government spending, lower rates and increased supply of money may not boost economic activity. Crippled by existing high levels of debt, low house prices, uncertain employment prospects and stagnant income, households are reducing, not increasing, borrowing. For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment.

Loose monetary policies may not also create the hoped-for inflation, needed to lower real debt levels. Banking problems and the lack of demand for credit means the essential transmission mechanism is broken. Banks are not using the reserves created and money provided to increase lending. The reduction in the velocity of money or the rate of circulation has offset the effect of increased money flows. The low velocity of money, the lack of demand and excess productive capacity in many industries means the inflation outlook in the near term remains subdued.

Side effects

The treatments being taken have serious side effects. Low rates entail a transfer of wealth from investors to borrowers, with the lower coupon payment acting as a disguised reduction of the principal amount of the loan. They provide an artificial subsidy to financial institutions, allowing them to borrow cheaply and then invest in higher yielding safe assets such as government bonds.

Low rates discourage savings, creating a disincentive for capital accumulation. They encourage mispricing of risk and feed asset bubbles, such as that for income (high-dividend-paying shares and high-yield low-grade debt) as well as speculative demand for commodities and alternative investments.

Low policy interest rates have created massive unfunded pension liabilities for governments and companies. S&P 1500 companies have aggregate pension deficits of $543 billion, an increase $59 billion in the first half of 2012.

In the long run, economies become dependent on low rates as high debt levels cannot be sustained at higher borrowing costs.

Internationally, low interest rates distort currency values and also encourage volatile and destabilizing short term capital flows as investors search for higher yields. Attempts by nations to increase their competitive position by weakening their currency also threaten tit-for-tat currency wars, trade restrictions and barriers to investment flows.

The faith healing cures provide symptomatic relief but do not address fundamental problems – the high debt levels, lack of demand, declining employment, lack of income growth or the problems of the banking system. It is not clear how if at all any of the cures being pursued can create real ongoing growth and wealth to restore Mr. Economy’s health.

Limits to Knowledge

The number of medical advisors involved and variety of drugs – stimulus, austerity, quantitative easing, leeches, cupping, witchcraft – is unhelpful. While doing nothing is politically and socially impossible, the treatments may be doing more harm than good. As French playwright Moliere noted: “More men die of their remedies than of their illnesses.”

Interestingly, these same faith healers until recently oversaw Mr. Economy, prescribing regimes that caused the present financial and economic calamity. Perhaps like writer Samuel Beckett they are keen to fail better next time.

There is no recognition of the limits to knowledge and policy tools. Economic relationships are poorly understood, complex and unstable. Cause and effect is uncertain – does money supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply of money? The ability of governments and central banks to influence economic activity is overstated. As economist Wynn Godley put it: “governments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet.”

To paraphrase Voltaire’s observation on doctors, Mr. Economy’s faith healers prescribe medicines of which they know little, to cure diseases of which they know less, in economic and financial systems of which they know nothing.

Prognosis for Mr. Economy

Mr. Economy now has a serious chronic condition with limited prospects of a full cure. He might continue to live but in an impaired state of no or low growth for a prolonged period. The threat of a sudden life threatening seizure cannot be discounted. Constant management will be needed.

Happily, Mr. Economy remains remarkably optimistic. Perhaps he recognizes the truth of Mark Twain’s observation: “Don’t part with your illusions. When they are gone you may still exist, but you have ceased to live.”

© 2012 Satyajit Das

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

Views are as of October 11, 2012, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.

Federated Equity Management Company of Pennsylvania

Posted by Gordon2352 | Report as abusive

Currency competition? Two currencies in the same economy?

Competition does exist, say between the Dollar and the Euro. However, the Euro should probably be axed by the third world countries in the Euro zone such as Greece and Spain, who should go back to their respective historic currencies. They’ll never get out of their severe depressions as long as they can’t devalue.

Meanwhile, the Fed has essentially devalued the Dollar with QE, QE2 and QE3, not to mention historically low interest rates for a prolonged period. And guess which economy is growing?

Posted by LoveJoyOne | Report as abusive

China’s economy is growing. It slowed down a bit since the Big Recession. But that centralized economy is growing. How do the Tea Partiers, Austrian Schoolers, Trickle-Downers, and Free-Marketiers reconcile that one? I suppose we just have to wait a bit and their economy will crumble before our eyes. I just wonder if their economy will crumble before ours.

Seriously, I think we have something to learn from China and it’s not how to build a coal fired power plant. I think it is that if something isn’t working, try something different. And it seems to me that history has not been kind to the theory that cutting tax rates has leads to sustained job growth. It has been kind to investment in education and transportation. And that is worth considering.

Posted by LEEDAP | Report as abusive


{jr: Based on our extremely high unemployment rate and especially the lack of upward mobility for the newly graduated and basically anyone who makes less than $250k a year, our American life is not only under attack, it’s almost DONE and GONE.}

Not by any stretch of my imagination (issuing from an economist’s mind) would I paint Hayek as even with a taint of socialism. But that is not the point.

Discussing personalities such as Hayek or Keynes is child’s play for students of EC101 classes. As if what these savants had to say was biblical scripture – which it aint.

And the above remark about “over and done” is wide of the mark. Ever hear of business cycles?

What is over and done is a period-of-time, call it post-WW2 (or call it what you will). It was a period of, for the most part, world-peace and sustained economic momentum that was purchased initially by the Marshal Plan and the reconstruction of Europe.

Followed by a period that we did not quite expect – that is, the American Plan for reconstructing economically China with a massive import of cheap-goods bought with T-Notes – that the Chinese were and still are happy to keep. (Talk about having Uncle Sam by the short ‘n curlies.)

The Chinese reconstruction started, unbeknownst to most of western leaders, in the early 1990s when China shucked its centrally planned economy and embarked upon free-enterprise. Overnight literally, the world’s supply of Labor was doubled. We should have known then that the tide was turning and American jobs (un- and semi-skilled) were imperiled and destined to be exported to the Far East.

But no, rather, we remained fat, dumb and happy with the status quo. To take our minds of a humdrum existence we invented a couple of wars and carried on with business as usual. Jobs were aplenty and profits were pretty darn good.

Business-as-usual, however, was a connivance between Main Street (realtors and banksters) and Wall Street Investment Banks. It washed fraudulent subprime debt and their derivatives, abracadbra!, with Triple-A detergent from cronies at the Credit Agencies and securitized it by sales to some pretty stupid investors.

Thus stoking the Credit Mechanism Seizure in 2008 and the Great Recession of 2009 from which millions of unemployed Americans have yet to see the light at the end of the unemployment tunnel.

Which brought us to our present context. This cycle will come to its end as all cycles do. Our impatience, however, is unacceptable. Who went binging on cheap-credit beyond their means of repayment should unemployment occur?

We, the sheeple, harking to the consumers siren-song of “I want it all and I want it NOW!”

Well, NOW is time to pay the piper. It’s not the end of life-as-we-know-it-on-earth. That is yet to come – but, rest assured, are consummate silliness about the earth’s ecology, will assure that it does happen.

Not quite yet though. But coming soon enough to an atmosphere near you!

Posted by deLafayette | Report as abusive


I was using Keynesianism in the commonly used and non-pedantic sense of the word, i.e. govt as the spender of last resort.

Posted by jambrytay | Report as abusive

Obama’s plan to tax the rich is a farce:

The centerpiece of President Obama’s plan is to raise taxes on the rich (households making $250.000 or more). The only problem with this “solution” is that it is dishonest. President Obama likes to give the impression that his plan to tax the rich can significantly reduce the deficit, a claim which is false and which Obama knows is false.

Everybody knows that the rich have a lot of money, so it may appear reasonable to non-economists that taking some this wealth can fill the hole in the budget. What the public doesn’t know, and what President Obama will not tell them, is that there are just too few rich people in America for this plan to work.

According to the CBO, over the next 10 years the Obama budget will produce a deficit of $10.900 billion, or 5.3% of GDP on average. (cbo(dot)gov/publication/22061)

According to the left’s own calculations, Obama’s plan to raise taxes on the rich will generate $700 billion in additional revenue over the next decade, or just a pathetic 0.3% of GDP. (cbpp(dot)org/files/1-31-07tax.pdf)

In other words, the plan to raise taxes on the rich will only cover one out of fifteen dollars of deficit spending. Where is President Obama going to get the other fourteen out of fifteen?

To the $10.9 trillion in deficits we need to add the unfunded liabilities of Medicare and Social Security. According to the Trustees of these programs, the unfounded liabilities are a staggering $52 trillion. (cga(dot)ct(dot)gov/2010/rpt/2010-R-0197 .htm)

Again, any honest economist who knows the facts can tell you that a measly $70 billion in revenue per year from the rich will not come close to cover America’s fiscal hole of at least $63000 billion dollars.

Posted by jaham | Report as abusive

@ jambrytay —

You state, “I was using Keynesianism in the commonly used and non-pedantic sense of the word, i.e. govt as the spender of last resort”.

That is the commonly misunderstood meaning, and invariably carries negative connotations, which is wrong no matter how you look at it.

Posted by Gordon2352 | Report as abusive

4 lines? that’s a bit skimpy for you.

Posted by jambrytay | Report as abusive

@ jambrytay —

After my “close encounter” with you, I have learned that the venue does not permit much more than a “bumper sticker” approach — no offense intended — which means I simply try to state the minimum to be effective and nothing more.

There is no point in expanding on a subject, when the majority don’t want to hear it anyhow.

That way I get my point across and it is up to the individual to pursue the thought if they so choose.

So, in a very big way you have made your point with me.

Posted by Gordon2352 | Report as abusive

Hey, all I ask is that people talk slowly and use small words.

Posted by jambrytay | Report as abusive

This article seems to be a total muddle. It supports 3 ideas from Keynes while failing to mention, as seemingly all Keynesians do, that in order to run deficits the government should NORMALLY run balanced budgets or surpluses. Only under that arrangement should deficit spending be attempted. Then he goes on to support the “first prescription” of low interest rates and then tries to stand that up as something we somehow aren’t doing or haven’t been doing. There are many economists that believe Greenspan’s prolonged cheap money approach was a primary cause of the problem we got ourselves into. At the very least, we were following this “prescription” for the decade leading up to 2008 and look where that got us. Then the author recommends slashing taxes, but raising them for those families making more than $250K/year as if that extra revenue will somehow dent Obama’s 4-billion-dollar-per-day borrowing binge. Finally, of course, the “third prescription” of government spending, as if the trillions we’ve spent under Bush/Obama in bailouts and stimulus wasn’t enough which begs the obvious question: if liberals/keynesians believe so firmly in government spending, slashed taxes and cheap money then why not have the fed government spend 4 trillion we don’t have, cut the tax rates in half for everyone so we can’t pay for the government further, and then have a negative interest rate (and pay the banks no interest on excess reserves)? We’ve had 12 years of excessive government borrowing/spending, cheap money, and low interest rates (the ultimate Keynesian “prescription”),and this is where we are because of it…here’s looking to another 4 years of it.

Posted by dwinfield10 | Report as abusive

How many remember the hoopla in the late 80’s and early 90’s about the deficit? And although I am too young to remember, it was there following WWII as well. In 1992, Ross Perot took these concerns as well as trade agreement backlash to a 19% share of the popular vote in the US Presidential race on a third-party ticket. The Concord Coalition was founded over deficit concerns also in 1992. A deficit counter was displayed in Times Square to try to scare the bejeezus out of us. What happened? Clinton implemented a tax increase that I personally didn’t even realize had happened until some years later and a pay-as-you-go policy and voila, we grew our way out and into a surplus. Similar minor tweaks got us out of the WWII deficit as well. Let’s keep our heads and focus on what will get us to widespread prosperity and the deficit will take care of itself.

Clearly, lower taxes for the rich do not trickle down. Can we at least get agreement on basic facts?

“My problem with Keynesianism is that the government has a long track record of being lousy spenders.” — examples please. How do they compare to Enron, Goldman Sachs, BP, Madoff, Country Wide, Global Crossings, Lehman Bros, NECC pharmacy, and on-and-on-and-on. Sure, there are examples of government waste, largely resulting from the defense department running up against the profit motive in the entities it contracts with, but the Social Security Administration and Medicare are two of the largest and best-run organizations the planet has ever seen. So please let’s dispense with that trope as well.

Chip_H : 15% sounds pretty reasonable. How long do you think you’ll be retired for? If you work 40 years, saving 15% of your income and assuming the savings can keep up with inflation, you might reasonably expect to fund ~7-1/2 years of retirement, perhaps 10 if you cut your expenses in retirement. But perhaps your concern is that the government, in a panic about deficits, will cut the benefits that you have been paying into? Join the club.

Posted by Sanity-Monger | Report as abusive