The End Game Of Keynesian Economics

By Lance Roberts / Streettalklive.com

You can almost hear the announcer for the movie trailer; “In a world stricken by financial crisis, a country plagued by spiraling deficits and cities on the verge of collapse - the war is being waged; gauntlet’s thrown down and at the heart of it all; two dead white guys battling over the fate of the economy.”   While I am not so sure it would actually make a great movie to watch – it will be an episode that we will witness unfold before us over the next decade as we now face the critical test of Keynesian economic theory as it relates to the survival of the U.S. economy; or have the Austrian’s been right all along.

According to Keynesian theory, some microeconomic-level actions—if taken collectively by a large proportion of individuals and firms—can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession). Keynes contended that “a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”   In other words, when there is a lack of demand from consumers due to high unemployment then the contraction in demand would therefore force producers to take defensive, or react, actions to reduce output.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

This seemed to work.   From the 1950’s through the late 1970’s interest rates were in a generally rising trend with the Federal Funds rate at 0.8% in 1954 and rising to its peak of 19.1% in 1981. When the economy went through its natural and inevitable slowdowns, or recessions, the Federal Reserve could lower interest rates which in turn would incentivize producers to borrow at cheaper rates, refinance activities, etc. which spurred production and ultimately hiring and consumption.  

As the economy recovered and began to grow again the Fed would need to raise interest rates.   This program seemed to work fairly well as interest rates went to a level higher than the last as the economy grew at an increasingly stronger level.   This provided the Federal Reserve with plenty of room to maneuver during the next evolution of the business cycle.

Something Happened On The Way To The Coliseum

However, beginning in 1980 that trend changed with what we call the “Breaking Point”.   We are not entirely sure what created this breaking point specifically whether it was deficit spending by the Reagan Administration to break the back of inflation, deregulation, exportation of manufacturing and a shift to a serviced based economy, or a myriad of other possibilities or even a combination of all of them. Whatever the specific reason; the policies that have been followed since the “breaking point” have continued to work at odds with the “American Dream” to the benefit of Wall Street.  

America was once a country built on the solid foundation of the hard work, satisfaction and pride in the building of stuff.   We aren't talking about "namby pamby" stuff - we are talking about real stuff.   We used to produce everything from automobiles to steel to blue jeans; right here in America.   We ran telephone lines, built roadways and bridges, drilled for oil and constructed buildings.    It was the sweat of the brow and the strain on the back that built America into its former shining self.  A country made up of opportunity and prosperity with a solid moral foundation and a strong military to back it up.

That was then.   Beginning in 1980 our world changed as we discovered the world of financial engineering, easy money and the wealth creation ability of successful use of leverage.   However, what we didn't realize then, and are slowly coming to grips with today, is that financial engineering had a very negative side effect - it deteriorated our economic prosperity. 

As the use of leverage crept through the system it slowly chipped away at the savings and productive investment. Without savings - consumers can't consume, producers can't produce and the economy grinds to a halt as the cycle of economic growth is thrown into a "balance sheet recession" strangle hold that is slowly pushing the economy towards unconsciousness. 

Regardless of the specific cause, each interest rate reduction that was used from that point forward to stimulate economic growth did, in fact, lead to a recovery in the economy; just not at levels as strong as they were in the previous cycle.   Therefore, each cycle led to lower interest rates and economic growth slowed and as a result of consumers and producers turning to credit and savings to finance the shortfall which in turn led to lower productive investment.   It was like an undetectable cancer slowing building in system. The “Breaking Point” was the beginning of the end of the Keynesian economic model.

Austrian’s Might Have It Right

The Austrian business cycle theory attempts to explain business cycles through a set of ideas. The theory views business cycles “as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.”

In other words, the proponents of Austrian economics believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment.   In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit.   This expansion of credit then, in turn, creates an expansion of the supply of money.

Therefore, as one would ultimately expect, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities. Finally, the credit-sourced boom results in widespread malinvestments. When the exponential credit creation can no longer be sustained a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear” which then causes resources to be reallocated back towards more efficient uses.

This brings into view the assumption of classical economists known as the “veil of money” theory which basically says that when the money supply changes, the real economy does not because when money supply changes by a certain amount; everything else does as well. If it doubles, then prices double, and wages double as well to compensate for rising prices, therefore nothing really changes. In other words, classical economics states that money supply is the force that changes the price level.

However, we now must call into question this assumption since in reality this has not been the case.   Money supply changes have not equated to rising wages or stronger economic growth since the “Breaking Point” occurred in 1981.   60 years of Keynesian economics has now led us to the point to where we need to question the theories that we operate under.  

Time To Wake Up

For the last 30 years each Administration has continue to foster the Keynesian monetary and fiscal policies believing the model worked – when it reality most of the aggregate growth in the economy has been financed by deficit spending, credit and a reduction in savings. In turn this reduced productive investment in the economy and the output of the economy slowed.   As the economy slowed and wages fell the consumer was forced to take on more leverage which also decreased savings.   As a result of the increased leverage more of their income was needed to service the debt.  

All of these issues have weighed on the overall prosperity of the economy and what has obviously gone clearly awry is the inability for the current economists, who maintain our monetary and fiscal policies, to realize what downturns encompass. Washington continues to follow the Keynesian logic, mistaking recessions as periods of falling aggregate demand, and they rush to try and stimulate demand hoping to increase the rate of consumption.

However, the reason why the policies that have been enacted by the current Administration have all but failed to this point, be it from “cash for clunkers” to “Quantitative Easing”, is because all they have done is either to drag future consumption forward or to stimulate asset markets which create an artificial wealth effect thereby decreasing savings which could, and should have been, used for productive investment. 

The Keynesian view that "more money in people's pockets" will drive up consumer spending, with a boost to GDP being the end result, is clearly wrong.   It hasn’t happened in 30 years.   What is missed is that things like temporary tax cuts or one time injections doesn’t create economic growth but merely reschedules it. The average American may fall for a near-term increase in their take home pay and any increased consumption in the present will be matched by a decrease later on when the tax cut is revoked.  

The problem is that during a “balance sheet” recession the consumer is forced to pay off debt which detracts from their ability to consume.   This is the one facet that Keynesian economics doesn’t factor in. More importantly it also impacts the production side of the equation as well since no act of saving ever detracts from demand. Consumption delayed is merely a shift of consumptive ability to other individuals, and even better, money saved is often capital supplied to entrepreneurs and businesses that will use it to expand, and hire new workers. 

So, while classical economics says that production comes first, the problem becomes that during a “balance sheet recession” the economy is put into a stranglehold for productive investment. The continued misuse of capital and continued erroneous monetary policies have instigated not only the recent downturn but actually 30 years of an insidious slow moving infection that has destroyed the American legacy.  

This is why we need real reform in government that leads to a smaller government, more clarity for businesses through pro-growth policies, real regulation of Wall Street which separates banks and brokerages, as well as programs and subsidies for bringing back to America those jobs that require a little hard work, a little bit of sweat and create a whole lot of pride and prosperity along the way. 

It’s time for Keynes to step down and admit defeat.   It’s time for our leaders to wake up and smell the burning of the dollar – we are at war with ourselves and the games being played out by Washington to maintain the status quo is slowing creating the next crisis that won’t be fixed with monetary bailout.

Lance Roberts