Fiscal Abyss And Keynes: The Other Story

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by: Carlos X. Alexandre

Fiscal cliff this, fiscal cliff that, and so goes the song, although the refrain is anything but appealing: Higher taxes across the board regardless of how you look at it. And that's the fiscal abyss. Yes, we're looking at higher government "revenue" and spending cuts, only because that is the only mathematically possible avenue to resolve the situation. Certainly everyone has heard how Greece keeps receiving bailout money while implementing austerity and enduring higher unemployment and lower GDP, while with every passing day the forecasts are adjusted to reflect the failure of European monetary and fiscal policies. But the U.S.A. is not Greece, and where money has been pumped into the Hellenic Republic only to keep the European banking system afloat, most of the money in America has been used to prop the economy.

Politics aside, government deficits have been the thorn on the economic side for quite a while now, and although the housing crisis delivered a profound disruption to our economy, the current deficits and ballooning debt also state that the "recovery" will continue to be elusive. As we embark on yet another $1 trillion deficit for 2013, we must point out that over the last five years, government debt grew by about $7 trillion, and that is where the Keynesian stimulus received its test. In addition, the problem here is that the $7 trillion was added to $9 trillion and the existence of the previous debt was hardly justifiable.

President Obama is now seeking $1.6 trillion in new taxes over 10 years for those earning $250,000 or more, and when the meager $160 billion per year is superimposed on the chart above, we can quickly see how the problem is far from being solved. We may as well seek double or triple the taxes the president wants, and still fall short. In essence, we've been in a permanent state of Keynesian stimulus because government has virtually pumped money into the economy that it didn't have.

Certainly not all of the debt was caused by a direct stimulus, but the fact that government spending hasn't abated to match revenue is a Keynesian workout in itself. For example, the extension of jobless benefits, although a necessity, is an indirect economic stimulus that is far more powerful than any bridge or road that could be built. And while we're on the infrastructure topic, let's bring up Roosevelt's "New Deal" and how its effectiveness is still questioned almost 80 years later, while my belief is that World War II was the true economic remedy. Unlike Europe and Japan, the U.S. didn't have to rebuild damaged infrastructure at home.

Except for a downturn in 1938 (historians still debate its origin), the economy and unemployment did improve after the onset of the New Deal. The country's real gross domestic product fell from $865 billion in 1929 to $635 billion in 1933 but rebounded to $1 trillion by 1940. The only hiccup was a decline from $911 billion in 1937 to $879 billion in 1938. But the percentage of jobless Americans remained in the double digits until the onset of World War II.

By the end of the war, the U.S. debt to GDP ratio was over 100%, and one can point to that fact as proof that it's not the end of the world. But consumer debt was nowhere to be found, and it only started to come into play after the credit card became mainstream in the late 1950s, adding another layer of borrowing demand -- and that's the missing economic link and its impact over the last 50 years is still misunderstood, yet predictable.

In 1959, the option of maintaining a revolving balance was introduced, according to MasterCard. This meant cardholders no longer had to pay off their full bills at the end of each cycle. While this carried the risk of accumulating finance charges, it gave customers greater flexibility in managing their money.

But contrasting a Keynesian type stimulus with private investment further highlights the deficiency of the former. Let's assume that John Doe decides to invest $1 million and he uses his savings and/or bank loans. If the investment fails, his savings are lost and the loans are either paid with collateral or become a loss for the bank. John Doe is bankrupt and it's the end of the story. Under Keynesian theory, the government borrows $1 million from John Doe and then proceeds with the investment. If the project fails, the government will tax John Doe and his friends to pay John Doe, and the government never has any skin in the game, allowing the process to repeat itself. Furthermore, private investment's driving force is profit, and jobs are always secondary and only a side effect of success. One does not open a business and hire people today for what one thinks revenue will be in three years. But isn't government building infrastructure? Probably, but there's yet another side to the story.

A Keynesian stimulus is best viewed as a non-organic economic growth model, because there's a difference between building a road to serve commerce and eventually paying for it through taxes generated from economic activity, and building a road just for the sake of building it. Just ask the Chinese how their empty roads and buildings are working out. I can comprehend the underlying logic, and it does make sense on the surface how the jobs created will feed into the economy, but even those building the road know that the future doesn't look bright and take the opportunity of earning a salary to save, not spend, and we're back to the widely misunderstood consumer behavior that flies in the face of mechanically driven economic theory that hinges on pulling a lever and getting everything fixed. Thus we get these jolts of economic expansion that never hold up.

Keynesian theory would probably work -- and "probably" is a big word here -- if government had a rainy-day fund stashed away, and then used the money to stimulate the economy during hard times. And when economic growth returned, the rainy-day fund would be replenished. But we'll never know, will we?

Considering that the U.S. and Europe are the consumer markets that matter, as illustrated in "The New World Order That Never Was," what exactly are we left with as far as global economic growth is concerned? Not much, if anything, and growth is the only other solution besides taxes and austerity. In addition, the usual buyers of U.S. government debt -- China, Japan, Europe -- are facing economic issues of their own, and even if they choose to hold their current portfolio of U.S. Treasuries, they're not in a position to keep feeding the beast in a meaningful manner. Certainly the current fiscal situation is solvable, but not without sacrifice across the social spectrum to take place over several years, and anyone that thinks otherwise must believe that the Earth is flat.

From an investment perspective, that's the background that we must understand, and while markets will always fluctuate between euphoria and despair as they are driven by snippets of daily and monthly economic data, as well as official sound bytes to mask the symptoms and dispel the disease, the key is finding the moments that are profitable -- and using Apple (NASDAQ:AAPL) as an example, all logic will be defied along the way.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.