The Downfall of Keynesian Economics and the U.S. (Part 2 of 3)

For the second part of this series (see Part I here), we are going to start by looking back at the three farmer scenarios.

In today’s society, the three farmers have, for a while, experienced a period where the monetary base is growing enough to keep up with the debt that needs to be repaid. The problem is that available credit has dried up.

Let’s switch out that farmer with a home buyer today, but keep the farmer scenario present in thought as we move forward. This home owner receives a loan from a bank, which is now a liability for the home owner.

Let’s not forget the savings glut of the Vietnam era. Banks were able to make loans to those who qualified due to large savings. Now banks don’t have that kind of balance sheet so they are forced to package these loans up into mortgage backed securities and sell them to investors.

One large investor of those mortgage backed securities is China. It is sitting on plenty of these MBS in its forex reserves.

So we have many home owners who owe money on their homes. Unlike the farmer scenario where the capital stayed in the economy, the money now sits in the forex holdings of the Chinese because of our massive trade deficit.

In very recent history, this has been fine because China has been taking its excess U.S. dollars and buying MBS, U.S. debt, and other dollar denominated assets. This brings these dollars back into the U.S. economy which is absolutely essential for a Keynesian economy to survive. We are seeing that trend drastically change.

So looking at the three farmers reference, even though the dollars needed to repay the loans leave for a period of time, they had eventually reentered the country. All that’s needed now to keep the Keynesian economy going is for the monetary base to increase through either the printing press or an increase in the aggregate amount of loans.

Another example of a contraction in liquidity resulting in a scare for Neo-Keynesians was the “dot.com” bubble. The monetary base was contracting as a result of the collapse of the dot.com bubble.

To keep the Keynesian economy moving forward, the money supply and loan base needed to grow faster than the liquidity was being destroyed. So a contraction in the money supply was out of the question. Remember what needs to keep this economy going. It needs an increase in the money supply or an increase of loans. Not only were neither of these two things happening, but in fact, the money supply was going the wrong way…according to Keynesian theory.

The members of the Federal Reserve are not idiots, and they definitely understand that for this economy to move forward, something needed to be done, and they took serious action.

They immediately began printing money at a very rapid pace and started slashing interest rates in order for home loans to become more appealing. To add to that, we had the creation of exotic lending instruments in order to get more loans to the already strapped consumer. Also, I’m sure that you are well aware of Greenspan’s speech encouraging consumers to take out ARMs. Easy Al Greenspan was the worst Keynesian of them all.

Hence, we had the beginning of sub prime mortgages. What a great way to keep this Keynesian based economy running a little bit longer…but how much longer?

The Bigger Picture

I have used Keynesian economics to make some points starting with three farmers, then with the housing market, but let’s look at the whole economy now.

Obviously the MBSs in China’s forex reserves are not even close to making up the huge current account surplus that they run. It is based largely upon cheaply produced exports, and what some may call a manipulated currency.

There is also a huge amount of dollars sitting in the reserves of oil exporting nations as well. So what does this have to do with Keynesian economics? It has everything to do with Keynesian economics.

The importance of the notion of the dollars that were initially going into foreign reserves, but eventually returned to the U.S. economy in the form of purchased U.S. treasuries is grossly understated. Let me tell you why.

Once again I would like to refer back to the notion of the three farmers. There was the initial loan of $100 to each farmer. Now imagine that after the loans were distributed, $100 of the $300 leaves the economy. This is the equivalent of dollars flowing to China.

Now the first farmer pays off the $110 and there is only $90 to pay back the $220 that the second and the third farmers owe. Ouch.

Here’s how this is happening. TIC data, which displays net capital flows in and out of treasuries, started showing up negative in recent the last 18 months. This simply means that foreigners were net sellers of U.S. debt. Japan and China led the way selling $23 billion and $14.2 billion respectively. This comes even though these countries are still amassing U.S. dollars. So the dollars are leaving the country, but no longer reentering.

Instead of buying treasuries with those dollars and putting them back into the U.S. economy, they are purchasing tangible assets. This is very apparent with China setting up its sovereign wealth fund.

As the dollar continues to decline, foreigners will continue to be more averse to reinvesting their forex reserves into U.S. treasuries. The problem is that as our current account deficit continues to run in the red, dollars will continue to flow out of the country.

With an economy whose greatest importance is an ever increasing money supply, it is easy to see why the outflow of dollars is so important. So what’s the critical point of our Keynesian economy? This and more in the final issue of this three part series.

Disclosure: None.

Comments

[Steven Hansen:]

Nicholas, what did Keynes ever do to you to cause this diatribe? In part 3 suggest you link Keynesian economics to global warming.

2008 Nov 19 04:30 AM

[Moon Kil Woong:]

Keynes would get sick over what is happening. He beived in stimulus when the market was at a bottom and could not muster the drive to move back into activity. He also believed in saving and paying back debt when the market was not in a depression or recession.

Slowing a market deleveraging by dumping as much money as you can is a Helecopter Bernake idea that is silly and childish and shows he and Paulson need to go back to school more than anything else. For ever $1 the government dumps into the economy $10 dissapears. All you get is zombie companies, bigger deficits, and loss of faith in government intervention. Banks and financials instead of running a company as they should are running it based on what they think the government will give them rather than what will be the best for the bank. Sadly, what's best is to not lend to overleveraged debtors. That will be the inevitable outcome if not now... later.

2008 Nov 19 06:50 AM

[sunnsea:]

So this is the world created by Richard Nixon and Goldman Sachs. The way out of this is for China to buy more US manufactured products not assests. This of course it has an aversion to do. So we continue to sell ourselves off over the past 30 years. How stupid is that?

2008 Nov 19 09:57 AM

[carey_jim:]

You need to read a very good book called The General Theory of Employment, Interest and Money.

Unfortunately I forget who wrote it. But you can find it under that title in any good library.

2008 Nov 19 11:26 AM

[derryl:]

The hand,
LOL. Didn't Al Gore already link Keynes to global warming? I think Gore rephrased Keynes, "In the long run, we're all toast."

2008 Nov 19 12:54 PM

[derryl:]

carey_jim,
I don't know if you're being sarcastic but that's the title of Keynes' magnum opus.

2008 Nov 19 01:06 PM

[TinyTim:]

"foreigners were net sellers of U.S. debt. So the dollars are leaving the country, but no longer reentering. Instead of buying treasuries with those dollars and putting them back into the U.S. economy, they are purchasing tangible assets."

This doesn't compute.

2008 Nov 19 04:55 PM

[TinyTim:]

JC

LOL
General Theory of Employment, Interest and Money

2008 Nov 19 04:56 PM

[Vox Rationalis:]

Again, there's nothing here to indict Keynesian economic theory.

2008 Nov 21 08:37 AM

[CJJ:]

I also disagree with the author in that it is the unknown what will occur. Why doesn't anyone just agree that Economics is a voodoo discipline and now theories written by men before globalization are trying to be supported or discredited without taking into account the world is a much different place right now. Obviously this is a crisis in Globalization. If you're going to have it, there are going to be bumps along the road and I think this is the first major test. There will be things learned and new approaches tried.

China is in good shape because it is an emerging country which is now building and buying goods which was not the case in the past. Great, what do they do in 30-50 years? Their population numbers is going to breed trouble on a grand scale. Hopefully they still have the US paying them interest on debt.

Also why in the world would China(who all of these economists think are "smarter" about economics than the US, which I think they have just seen the errs of the past and been able to sidestep those for their benefit), cut off the United States. China would never and I repeat never ask for the US to pay its debt off or dump all US dollars. It would be the dumbest move ever. Its like if you have a bar patron who comes into your bar all the time. He has a running tab with you but only pays you 10% every month of the total. Just because the total tab keeps getting bigger you are still getting more money and a steady stream from the guy paying you the interest. This guys 10% payment is still more than the people who pay you 115% coming in once a month. It would only make sense to call the debt if you were about to go bankrupt, which China is not.

If China did call the debt of the US it would lead to(which I think will occur anyway) a really tough period in the US, but it will quicken the pace of the period as the US would become very isolated and US manufactoring returning to the US. China would lose out on its cash cow. It would probably lead to war, again not something I think China particularly wants or needs, and in the long run make the US stronger and more united against China. Also the debt would not be repaid.

Hyperinflation is another assumption. It very well could occur, it is not a certainty. Wiping out all but the rich in the country via hyperinflation would created a top heavy lower class of people on the order of 80-85% in the US, while anyone with wealth would be moving out of the country. All for what cause? To draw down debt?

Deflation of prices, which gets a bad rap as it is equated to deflation, should be embraced. If credit debt at all levels was guaranteed prior to creation, ie. individuals who don't pay of their credit cards would have their paychecks auto garnished, lenders would be on the hook for half the amount, etc. this problem would be minature to what it is now. The rules of the game are either not out there, being bent to the point of being worthless, etc.

Applying all of this to an economic model is simplistic and open to enough interpretation I could drive a truck through it, but thanks for the 3 part thesis.

I have a thesis, people will start to stockpile and breed cockroaches. They'll always be around(like gold), except you can each cockroaches(unlike gold).

2008 Nov 21 09:38 AM

[xsuddensam:]

The author states:

"So we have many home owners who owe money on their homes. Unlike the farmer scenario where the capital stayed in the economy, the money now sits in the forex holdings of the Chinese because of our massive trade deficit."

Wait a minute, I'm missing something here. Doesn't the money borrowed to purchase the home go to the builder or the seller of the home? Unless the builder or seller are Chinese, that money stays here.

The author further states:

"In very recent history, this has been fine because China has been taking its excess U.S. dollars and buying MBS, U.S. debt, and other dollar denominated assets. This brings these dollars back into the U.S. economy which is absolutely essential for a Keynesian economy to survive"

This Keynesian economy is quite the scam as "paper" assets are treated the same as hard assets. The toxic sub-slime mortgage securities and other dollar denominated "paper" assets, in all reality, are real economic liabilities when they become underlying securities for new debt. It's beyond me that reasonable thinking people, or the Chinese for that matter, can believe that a "promise to pay" is an asset.

Looks like and smells like a rat to me.

2008 Nov 22 05:29 AM