The True Costs Of Keynes
Martin Hutchinson

(Editor's Note: Bernanke received a PhD from MIT in the field of Keynesian Economics. A faux science for faux economists. Can you imagine anyone giving credence to such a bozo (either Bernanke or Keynes)? - JSB)

Adolf Hitler, Joseph Stalin and Mao Zedong each killed tens of millions of people, and John Maynard Keynes was a pacifist who never fired a shot in anger. However economically, when the billions come to be totted up, it may well be the case that Keynes was the most destructive of the four. He cannot entirely be blamed for mistakes in monetary policy, which he never understood, and even his "stimulus" ideas owed much to those who came before him - for example Arthur Pigou - and after him - for example Joan Robinson. Yet the other value destroyers had their henchmen too, in Heinrich Himmler, Lavrenti Beria and Jiang Qing. Overall, when henchmen are added in, Keynes runs the other value destroyers close, and may in the future surpass them as his value-destructions continue. Truly, persuasive but misguided economic theories can be much more damaging than they appear.

This is not to claim that big government per se is value-destructive (it is, but that's a separate issue.) The right size of government is a matter for legitimate debate and successful societies such as Sweden and Singapore can be built with very different sizes of government. Personally I would rather live in Singapore than Sweden, and I would expect Singapore to exhibit markedly faster long-term economic growth than Sweden, but both societies run their finances in a responsible manner and are models of governmental integrity.

Since both Sweden and Singapore currently have modest budget surpluses and have kept control of their currencies and avoided excessive monetary stimulus, they are in the modern debased sense of the term non-Keynesian, even if the managers of Sweden's economy might well describe themselves as Keynesians for the sake of harmony at international gatherings.

The Keynesian fallacy is in essence one of getting something for nothing. By Keynesian fiscal stimulus, normally involving spending more money though occasionally through tax cuts, providing they avoid the annoyingly savings-prone rich, we are supposed to produce additional economic output whenever there is an "output gap" from full employment, i.e., in all conditions save those of a raging boom, when resources are scarce. Keynes himself recommended such stimulus only at the bottom of deep recessions, and suggested that it should be balanced by running budget surpluses in times of boom. Needless to say his disciples have neglected the disciplines he recommended.

Similarly, the analogous monetary policy (which Keynes personally did not advocate, since he believed that interest rates had no effect on output) pushes down interest rates and indulges in ever more lavish bouts of monetary "stimulus" in the belief that by doing so the economy can be persuaded to expand more rapidly. It's fair to claim that monetary stimulus does not derive directly from Keynes (though it is not new - it was a policy advocated by Keynesians in the 1960s Johnson administration, for example.) However fiscal stimulus is a direct product of Keynes' 1936 "General Theory" and both forms of stimulus derive from Keynes' overall approach of flouting economic orthodoxy and using ingenious paradox to propound unorthodox policies. Keynes was the origin of the "stimulus" approach; its central idea that by manipulating monetary or fiscal policy we can get a bigger government than we pay for is his. It is thus fair to blame the costs of that approach on him.

Those costs are considerable. In the 1930s Herbert Hoover's reckless expansion of government spending, including loans to cronies through the Reconstruction Finance Corporation, caused further slowdown in the economy, which was exacerbated by his dreadful early 1932 increase in the top marginal rate of tax from 25% to 63%. Then, as I discussed a few weeks ago, Franklin Roosevelt's New Deal deficit spending, combined with his reckless "set the gold price in my pajamas" monetary policy prolonged the Great Depression far longer than would naturally have occurred, delaying full recovery from 1934-35 to 1939-40.

In the recent unpleasantness, fiscal stimulus worldwide initially appeared merely ineffective. By diverting resources from the productive private sector to unproductive public sector boondoggles it reduced long-term output. In the U.S. case, the Obama stimulus converted a vigorous recovery into an anemic one; only in the third quarter of 2011, after the effects of stimulus had begun to wear off, did output begin to accelerate and unemployment trend down (in this case we should celebrate public sector job losses and declines in public sector output, since they free up resources for healthy private sector growth!).

However with the euro crisis it has become clear that fiscal stimulus, if excessive, has an exponentially adverse effect. By increasing deficits to unsustainable levels, it precipitates bond market fears about the state's credit risk. Naturally, that strangles credit availability to almost all entities domiciled in the country concerned. Thus while a mild fiscal stimulus in a country that before recession was running a surplus might be mildly beneficial (because the differential between private sector savings rates and the 100% stimulus spending rate outweighed the inefficiency effect of diverting resources to the public sector) a large fiscal stimulus, or one incurred in a country like Greece or the 2009 U.S. that was already dangerously in deficit, will cause economic damage rising to many times the value of the stimulus itself, persisting for years or even decades to come.

Monetary stimulus is similarly damaging. As Walter Bagehot remarked over a century ago, the correct response to financial crisis is to lend on top quality security at very high interest rates. This was notably not done in 2008; instead the injection of liquidity to favored companies was accompanied by pushing interest rates far below inflation. Repeating the monetary stimulus in 2010 and again in 2011, when in the United States at least the financial crisis was over, was inexcusable.

Monetary stimulus causes structural damage to the economy in the following ways:

  • Normally, as was the case in 1965-79 it causes accelerating inflation. Since 1995, this has not been the case, because the West has benefited from an enormous deflationary force from the Internet and modern telecommunications, which has enabled massive outsourcing of goods and services to locations with much cheaper wage rates. That effect is now ending, while in some countries, notably Britain, the monetary stimulus has been increased to Weimar Republic-like proportions of 40% of public spending. We can expect the inflationary effect to strike with massively multiplied force compared with the gentle zephyr of 1965-79 when it finally arrives.
  • As discussed in this column a few months back, by making capital artificially cheap, monetary stimulus encourages employers to substitute capital for labor to an artificial extent, thus raising the equilibrium level of unemployment. In current circumstances, this substitution takes the form of outsourcing production to emerging markets, thus depressing U.S. and European labor markets further.
  • By allowing banks to make artificial profits from "gapping" -- borrowing short-term and investing in fixed rate long term bonds and mortgages -- it suppresses lending to small business, thus further increasing unemployment. It must be noted that the true level of U.S. unemployment is far higher than the officially admitted 8.6%, as many workers have become discouraged and left the workforce.
  • Ultra-low interest rates suppress savings (which receive negative real returns on their money), thereby de-capitalizing the economy.
  • Finally if, as happened in 2008, monetary stimulus is directed only at favored banks and finance houses, it destroys the integrity of the market. Beneficiary banks have been shown by the recent Fed audit to have benefited to the tune of $13 billion by profits made on emergency Fed loans. Had that money been lent at appropriate penalty rates, this profit would have been captured for taxpayers. It was in essence a gigantic subsidy to Wall Street bonus recipients by the corrupt Federal Reserve. Needless to say, damaging cronyism has thereby been encouraged.

As recent events have overwhelmingly demonstrated, both fiscal and monetary stimulus are highly addictive, since they appear to provide something for nothing and the cost of reversing them appears unpleasant to the Keynesians who control the levers of policy. As to their cost, the current Congressional Budget Office projections suggest that there is currently a 5% output gap below full employment, and that the output gap will disappear only in 2016. The cost of current Keynesian policies over 2009-16 can thus be conservatively estimated at about 15% of GDP, or $2.2 trillion in today's dollars. To that we can add very roughly 50% of one year's 1929 GDP, for the output lost through Keynesian policies in 1932-40, or another $500 billion, for a very conservative total of $2.7 trillion all-told in the United States alone.

That may not sound sufficient to counterbalance the tyrants' depredations, but consider: 1930s Germany, 1940s Russia and 1950s China were all much poorer countries than the modern United States. Very roughly, Germany's 1936 GDP and the Soviet Union's 1940 GDP were both about $500 billion modern dollars, while China's 1955 GDP was about $1,500 billion. Thus Hitler and Stalin could have destroyed their entire output for more than 5 years, and Mao for almost two years, before doing as much economic damage as Maynard Keynes has wreaked in one country.

It's a rough calculation, but illuminating - and while Hitler, Stalin and Mao are long gone, Keynes' depredations continue.

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put out by Wall Street houses remains far below that of "buy" recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) - details can be found on the Web site www.greatconservatives.com-and co-author with Professor Kevin Dowd of "Alchemists of Loss" (Wiley - 2010). Both now available on Amazon.com, "Great Conservatives" only in a Kindle edition, "Alchemists of Loss" in both Kindle and print editions.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Views are as of December 5, 2011, 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 or sector.

www.greatconservatives.com


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