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Paul Krugman’s December 29th New York Times Op-Ed piece “Keynes Was Right” is a brilliant tour de force from one of America’s greatest economists and worldly philosophers. He accurately describes Keynes’ remedies for an economic malaise such as that of today's United States, and correctly notes that the Congress and White House have inadequately applied them to the American economy. It ought to be required reading for all congressmen, presidents, and economic pundits – despite the fact that its policy implications may be misleading and unrealistic.

Keynes' basic thesis is quite simple and well-known to every businessman – customers are important and if employers don’t have enough of them, they will have to lay off workers and cut back on production. That was the situation that existed in the UK in the 1930s, when Keynes wrote his epic “General Theory” – employers did not have enough customers. So millions of workers were laid off, profits and dividends disappeared, tax collections fell so that deficits arose, and the stock and bond markets collapsed.

Prior to Keynes it was assumed that market-oriented economies, such as Britain’s, would always automatically have enough customer spending to keep everyone employed, and that the economy’s interest rates would automatically adjust-- so that any income saved instead of being spent would be loaned out to businesses and others who wanted to spend more than their incomes. In other words, with interest rates free to rise and fall, total customer spending would not go down, and there would never be a recession or depression.

Then came the Great Depression, and Keynes asked himself how that could happen if interest rates had dropped to all time lows-- just as they have today in the United States. He looked at the various types of customers: consumers, businesses buying plant and equipment, foreigners buying the country’s exports, and governments buying roads, tanks, law and order, etc. One or more of them had to start buying more, enough more, and until that happened there would be no recovery. He also saw that interest rates during a depression, no matter how low they might go, were neither going to cause consumers who were afraid of losing their jobs to spend more, nor cause businesses with idle plants and equipment to buy even more of them.

The resulting situation in Britain in the Keynes-era was the same as that of United States today – massive unemployment due to a lack of customer spending despite interest rates being extremely low. Under such circumstances, said Keynes, government is the only answer: it must increase its spending. It could also encourage others to spend by reducing taxes.

Professor Krugman suggests such actions should be taken today in the United States and correctly notes that the so-called “stimulus” package passed by the Congress in 2009 was a mere drop in the bucket compared to the size of the customer shortfall. He also rightly views with disdain the notion that the government can somehow put people back to work and make businesses more profitable and the markets rise by cutting spending and raising taxes to reduce the deficits inherent in an economic decline. If anything, Keynes said, that would cut business even more and result in more unemployment and lower tax collections.

In essence, Professor Krugman's essay made the classic Keynesian case in favor of the federal government spending more, taxing less, and accepting the resulting bigger deficit. He ignores monetary policy, as Keynes ignored it, probably because interest rates are already so low.

In other words, Krugman advocated the classic Keynesian solution for the United States-- more federal spending and lower federal taxes. Unfortunately, for two reasons, his policy prescription is much more appropriate for the UK of Keynes than it is for today's United States.

First, fiscal policy can be implemented quickly in the UK. The Prime Minister can put a fiscal change before the Parliament and have it voted on and almost always have it passed immediately and fully intact because he/she also controls the majority of the votes. In other words, a Keynesian fiscal policy is a realistic and viable way to end a recession in the UK.

In contrast, Keynesian fiscal policy is neither viable nor realistic in the United States – because it can take years for the House, the Senate and the White House to work out compromises and get something passed. And what passes for fiscal policy in the United States, as Krugman correctly notes, may not be of a sufficient size-- and certainly wasn’t in 2009. In essence, 1) Krugman’s call for more fiscal action is equivalent of saying “let's leave the economy in the doldrums for years and then maybe do something” and, 2) Congress’s efforts to cut spending to cut the deficit will make things worse (and probably also make the deficit worse by further reducing taxable business profits and employee wages).

Second, monetary policy and the responsibility to maintain prosperity in the U.S. is very different from that of Keynes’ UK, where fiscal policy can be effective. Because of its inability to use fiscal policies to come to grips with macroeconomic problems in a timely manner, Congress long ago charged the US central bank, the Federal Reserve System, with the responsibility of maintaining prosperity and full employment. In the UK the parliament is responsible.

There are other differences: In the UK the general level of interest rates is set by the Bank of England. The Bank of England puts money into the UK economy by setting a rate at which commercial banks can borrow newly created money to loan to their customers. The Federal Reserve does not operate that way, despite breathless claims of media news desks such as “the Federal Reserve today lowered Interest rates.” In the real world of the United States, for all practical purposes, the only rate the Fed actually sets is the overnight rate banks charge each other to borrow reserves to meet their latest reserve requirements – and let me assure you what every banker knows: commercial banks in the United States do not borrow money they have to repay 24 hours later in order to make loans to consumers and businesses.

What the Federal Reserve does when the economy needs more customers is create new money and move it into the economy by buying assets in the open market, usually federal bonds. In essence, the Fed creates money and puts it as loanable funds into the banks, directly as it buys assets from the banks and indirectly as it buys assets from others who then inevitably deposit the money they receive into a commercial bank. The Fed’s goal is to provide the banks with enough loanable funds for their business and consumers, so that they spend enough to cause full employment and the profits and tax collections associated with it. Not too much money, so there is inflation from excessive spending, nor too little money so that there is unemployment due to a general lack of customer spending.

Normally, it works. Unless, of course, the Fed’s governors are political appointees who don’t create the right amount of money because they do not understand macroeconomics or how monetary policy and commercial banking operate in the real world; or are so naïve that they confuse providing a handful of large financial institutions with liquidity to cover their trading losses and handle their financial transactions with providing commercial banks with loanable funds for consumers and businesses; or are so naïve they think that changing the overnight rate between banks actually affects the availability of consumer and business financing.

But sometimes (today? 1930s?) things are really so bad that just putting more money into the commercial banks does not cause customer spending to rise, no matter how low the interest rates charged by the banks is. Keynes called this the “liquidity trap” in that the additional money created by the central banks gets to the commercial banks but is then “trapped” there by the lack of borrowers, instead of being loaned out to be spent.

So where are investors today if fiscal policy is not operational because of time lags and a dysfunctional congress, and monetary policy won’t work because money poured into the banks will not be loaned out as consumers and businesses won’t borrow it to increase their spending? This is the question and the problem Krugman did not address with his advocation of a classic Keynesian UK–oriented fiscal solution. And how can the Federal Reserve address the problem as it is charged to do?

The answer is probably that we will be stuck in our current economic malaise until the Federal Reserve creates liquidity and flows it directly to would-be customers (eg. social secuity recipients) with high propensities to consume instead of indirectly to the commercial banks where it will be “trapped.” When that happens, customer spending will rise, businesses will hire more workers and make more profits, tax collections will rise so deficits are reduced or eliminated, and the stock market will boom.

What are the chances this will occur? Slim to none, because today there are few, if any, macroeconomists with real world experience in business and banking among the Fed’s decision making governors and regional presidents. In other words, the U.S. economy and its financial markets will stagnate until qualified governors and regional presidents are appointed and take charge.

The governors are appointed by the President and confirmed by the Senate - so far the politicians have failed at getting competent governors, and the latest two nominees seem like more of the same. Investors should proceed as if the current economic stagnation will continue until at least 2013 and probably longer.

Source: Krugman, Keynes, And The Economy