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Illusions of the Age of Keynes

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01/25/2010Doug French

A year ago George Melloan wrote in the Wall Street Journal, "We're all Keynesian's Again." You remember last January — change was on its way. We had a new rock-star president and he was going to get us out of the mess that Wall Street had got us into. "Now is the time to jump-start job creation, restart lending, and invest in areas like energy, health care, and education that will grow our economy, even as we make hard choices to bring our deficit down," President Obama told Congress. The new president has a worldview that is "all but in name Keynesian," Carl Horowitz wrote last spring.

Meanwhile the guy running the Federal Reserve is an expert on the Great Depression. Ben Bernanke wasn't going to make the same mistakes the policy makers made during the 1930s. After all, he pointed out back in 2002 when he was just a Fed governor,

the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

And the new guy at the Treasury, well he used to run the New York Fed; he worked for Kissinger Associates, the Council on Foreign Relations, and the International Monetary Fund — so Washington figured he knew how to fix the economy. The Treasury secretary is so in touch with the market that he and his wife tried to sell their $1.6 million home in 2009 for more than they paid for it in 2004. They have been unsuccessful and forced to rent the place out.

The president's other top economic advisors — Larry Summers and Christina Romer — have been described as neo-Keynesian and "have made clear by their actions that they view the private sector, left to its own devices, as incapable of sufficiently investing in education, health care, infrastructure, energy and other areas of national well-being," wrote Horowitz. "They warn that in absence of a greatly expanded public sector, the current business downturn will be even more prolonged and painful."

Washington continues to have faith in government expenditure correcting the downturns of private investment. And the financial press has bought into the scam, evidenced by Time voting the Fed chairman "Man of the Year." The economy would be much worse if not for the actions of Bernanke and the Federal Reserve is the thinking. "He didn't just reshape U.S. monetary policy," Time's Michael Grunwald gushes, "he led an effort to save the world economy."

"The Greatest Depression that could so easily have happened in 2009 but did not is the tribute that the world owes to economics," wrote Arvind Subramanian in The Financial Times.

Martin Wolfe wrote at the end of last year, "We could not, in such times, even take the survival of civilisation itself for granted. Never before had I felt more strongly the force of John Maynard Keynes's toast 'to the economists — who are the trustees, not of civilisation, but of the possibility of civilisation'."

So, "the main reason Ben Shalom Bernanke is TIME's Person of the Year for 2009 is that he is the most important player guiding the world's most important economy," Grunwald explains.

His creative leadership helped ensure that 2009 was a period of weak recovery rather than catastrophic depression, and he still wields unrivaled power over our money, our jobs, our savings and our national future. The decisions he has made, and those he has yet to make, will shape the path of our prosperity, the direction of our politics and our relationship to the world.

So what kind of Keynesian world are Bernanke and the other wise ones in Washington shaping for us?

Keynesians see a depression as a lack of aggregate demand — as opposed to Austrians who know a depression is the required cleansing of the malinvestments created by the preceding boom of the government's making. Policy makers, following the Keynesian playbook, enact policies to stimulate aggregate demand and offset the fall in private investment. On the fiscal-policy side, Keynesians advocate higher government spending. On the monetary side, they insist on lowering interest rates to zero if necessary.

The world has recent experience with attempts at resuscitating a bubble economy. The Bank of Japan cut interest rates six times between 1986 and early 1987 and all that new money caused the Japanese economy to bubble over. As Bill Bonner and Addison Wiggin write in Financial Reckoning Day Fallout,

the problem with all money is that it is as fickle and unreliable as a bad girlfriend. One minute she goes along with the flow. The next minute she turns silly and bubbly. And then, she gives you the cold shoulder.

The prolonged period of low interest rates created one of the largest domestic bubbles in the world. For a brief moment in 1990, the Japanese stock market was bigger than the US market. The Nikkei-225 reached a peak of 38,916 in December of 1989 with a price-earnings ratio of around 80 times. At the bubble's height, the capitalized value of the Tokyo Stock Exchange stood at 42 percent of the entire world's stock-market value and Japanese real estate accounted for half the value of all land on earth, while only representing less than 3 percent of the total area. In 1989 all of Japan's real estate was valued at US$24 trillion which was four times the value of all real estate in the United States, despite Japan having just half the population and 60 percent of US GDP.

"The Japanese asset bubbles were identical to other asset bubbles in the sense that they were essentially inflated by credit," writes Asian bank regulator Andrew Sheng in his book From Asian to Global Financial Crisis.

Banks lent to highly leveraged developers to buy real estate against inflated collateral values, which then fueled the bubble further. Asset prices bore no realistic relationship to their return on capital, particularly since cost of funding was exceptionally low. The minute the credit stopped, the bubble began to deflate, and the main victims were the banks themselves.

After the bubble popped in Japan, that government pursued a relentless Keynesian course of fiscal pump priming and loose fiscal policy with the result being a Japan that went from having the healthiest fiscal position of any OECD country in 1990 to annual deficits of 6 to 7 percent of GDP and a gross public debt that is now 227 percent of GDP. "The Japanese tried to cure an alcoholic with heroin," writes Bonner. "Now, they're addicted to it."

Japan's monetary policy was to aggressively lower rates to .5 percent between 1991 and 1995 and has operated a zero-interest policy virtually ever since.

Between 1992 and 1995, the Japanese government tried six stimulus plans totaling 65.5 trillion yen and they even cut tax rates in 1994. They tried cutting taxes again in 1998, but government spending was never cut. Also in 1998, another stimulus package of 16.7 trillion yen was rolled out nearly half of which was for public-works projects. Later in the same year, another stimulus package was announced, totaling 23.9 trillion yen. The very next year an ¥18 trillion stimulus was tried, and, in October of 2000, another stimulus for 11 trillion was announced. As economist Ben Powell points out, "Overall during the 1990s, Japan tried 10 fiscal stimulus packages totaling more than 100 trillion yen, and each failed to cure the recession," with Japan's nominal GDP growth rate below zero for most of the five years after 1997.

After five years in an economic wilderness, the Bank of Japan switched, during the spring of 2001, to a policy of quantitative easing — targeting the growth of the money supply instead of nominal interest rates — in order to engineer a rebound in demand growth.

The move by the Bank of Japan to quantitative easing and the large increase in liquidity that followed stopped the fall in land prices by 2003. The Bank of Japan held interest rates at zero until early 2007, when it boosted its discount rate back to 0.5 percent in two steps by midyear. But the BoJ quickly reverted back to its zero interest rate policy.

In August of 2008, the Japanese government unveiled an ¥11.5 trillion stimulus. The package, which included ¥1.8 trillion in new spending and nearly ¥10 trillion in government loans and credit guarantees, was in response to news that the Japanese economy in July suffered its biggest contraction in seven years and inflation had topped 2 percent for the first time in a decade.

Newswire reports said the new measures would include assistance to the agriculture sector, support for part-time workers to find better employment, and rebates on toll roads. Additional spending was also to flow to healthcare, housing, education, and environmental technology.

Just this past April, the Japanese government announced another ¥10 trillion stimulus program. This was after Japan's economy shrank by a record 15.2 percent annual rate in the first quarter of 2009. This drop was on the heels of a 14.4 percent drop in the fourth quarter of 2008.

Last month, Reuters reported that the Bank of Japan reinforced its commitment to maintaining very low interest rates and may provide even further easing. "The bank said that it would not tolerate zero inflation or falling prices." The bank left its policy rate at .1 percent and analysts see the rate staying low possibly until 2012.

According to Reuters, the Japanese government "is fretting over the risk of the economy flipping back into recession and is pushing the bank for action." Economy flipping back into recession? Are they kidding? Japan's GDP at the end of this year will be no higher than it was in 1992–17 lost years.

"After 17 years of bailouts and stimulus programs, the Japanese should be getting good at them," write Bonner and Wiggin. "But it's a little like a guy who's getting good at suicide — if he's so good at it, you'd think he'd be dead already."

But Keynesians are wont to grade on a curve. Nobel laureate and New York Times columnist Paul Krugman, for one, points to Japan's fiscal stimulus packages as having "probably prevented a weak economy from plunging into an actual depression."

But the Nobel laureate's crystal ball seems to be getting cloudy. He told the Guardian newspaper

What we do know is that recessions normally end everywhere because the monetary authority cuts interest rates a lot, and that gets things moving. And what we know in Japan was that eventually they cut their interest rates to zero and that wasn't enough. And, so far, although we made the cuts faster than they did and cut them all the way to zero, it isn't enough. We've hit that lower bound the same as they did. Now, everything after that is more or less speculation.

When pressed, Krugman said he believed that there were two economic stories taking place in the world: the Japan story, where central banks can't cut interest rates any more to promote economic growth, and the Argentina story, "where everything falls apart because of balance sheet problems."

Krugman said he sees

The "Nipponisation" of the world economy with a bunch of "Argentinafications" playing a role in the acute crisis. But even after those are over, we have the Nipponisation of the world economy. And that's really something.

Well that is really something. What Krugman the Keynesian is saying is that the entire world will suffer from a lack of aggregate demand, punctuated with the occasional financial crisis. But as Ben Powell points out, Japan's problem is not a lack of aggregate demand "but a structure of production that does not meet consumer's particular needs."

Government Keynesians want to stimulate the economy by pouring taxpayer and inflated money into their pet projects. What they would spend money for stimulus on is different than, say, what Tiger Woods would spend his stimulus money on. And you may have noticed that energy, healthcare, education, infrastructure, and environmental technology are where Keynesians want stimulus money spent on whether they are American Keynesians or the Japanese variety.

"Producing things that nobody wants and propping up malinvestments cannot possibly help any economy," writes Powell.

This policy is equivalent to the old Keynesian depression nostrum of paying people to dig holes and fill them. Neither policy will revive the economy because neither forces businesses to realign their structures of production to match consumer demands.

And why don't those low interest rates get things moving? "With distressed banks, reflation fails to induce another bank credit expansion," Professor Jeffrey Herbener wrote in the Asian Wall Street Journal. "Keynesians have mistaken the impotency of the Bank of Japan to restart credit expansion in the 1990s as a liquidity trap. But the problem is not that interest rates are so low everyone expects them to rise and therefore hoards cash. Banks refuse to lend because of the overhang of bad debt. Any cash infusion is held as reserve against it. Businesses refuse to borrow because of their debt burden, built up to expand capacity during the boom, and their over-capacity resulting from their malinvestments."

Murray Rothbard explained in America's Great Depression that in an economic downturn the positive thing that government can do is "drastically lower its relative role in the economy, slashing its own expenditures and taxes, particularly taxes that interfere with saving and investment." The reduction of the tax-and-spending level will automatically increase saving and investment, "thus greatly lowering the time required for returning to a prosperous economy."

Instead of the government expanding its size and reach, propping up failed businesses, lowering interest rates to zero, printing money, and attempting to dictate which sectors of the economy thrive and which fall by the wayside, "the proper governmental policy in a depression is strict laissez-faire, including stringent budget-slashing and coupled perhaps with a positive encouragement for credit contraction."

However, committed Keynesian Paul McCulley of bond-fund giant PIMCO says that "an 'all-in' reflationary policy is what is needed" in Japan. "Japan's problem is deflation, not inflation as far as an eye can see," according to PIMCO's brass. Meanwhile, the Telegraph's Ambrose Evans-Pritchard fears the Japanese authorities will take McCulley's advice and, with Japan's economy now on the verge of blowing up, "the beginnings of debt monetization by a terrified central bank will ultimately spin out of control, perhaps crossing into hyperinflation by the middle of the decade."

Just as Japan's malinvestments of the 1980s should have been liquidated, so should America's of the last two decades. As Herbener explains,

when the government attempts to prevent liquidation with bailouts, socialization, fiscal expenditures, reflation and like policies, as in Japan in the 1990s and America in the 1930s, then the depression will linger. If Japan [or now America] expects to restore prosperity for the long term, central-bank monetary inflation and credit expansion, whether justified on Monetarist or Keynesian grounds, must be repudiated.

"There is no means of avoiding the final collapse of a boom brought about by credit expansion," Ludwig von Mises wrote. "The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

Washington's Keynesians say, "yes we can" stimulate the economy. But prosperity can't be printed. Government edicts won't magically make us better off. Their fatal conceit will only lead us to disaster.


Doug French

Douglas French is President Emeritus of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply, and author of Walk Away: The Rise and Fall of the Home-Ownership Myth. He received his master's degree in economics from UNLV, studying under both Professor Murray Rothbard and Professor Hans-Hermann Hoppe.