John Maynard Keynes Must Die

Includes: SPY
by: Eric Parnell, CFA


We have all lived in a Keynesian economics world since the Great Depression.

Unfortunately, it seems that the current application of theory first introduced by English economist John Maynard Keynes is doomed to failure.

The cumulative innate flaws of human behavior among those that have implemented these principles along the way has led to this dire conclusion.

We have all lived in a Keynesian economics world since the Great Depression. But despite having dominated the global economic scene for roughly eight decades, unfortunately it seems that the current application of theory first introduced by English economist John Maynard Keynes is doomed to failure. This dire conclusion is not necessarily due to the flawed policies first introduced by Keynes, but the cumulative innate flaws of human behavior among those that have implemented these principles along the way. In the end, John Maynard Keynes must die whether fair or not.

Economic Rock Star Of The Great Depression And Beyond

John Maynard Keynes burst on to the global economic scene during the Great Depression in the early 1930s. His early work highlighted the constraints placed on an economy that prioritized saving over investment, resulting in reduced corporate profitability and increased joblessness. Keynes was also a vocal critic of the bias toward austerity during the early years of the Great Depression, as he contended instead that budget deficits during periods of economic weakness were a necessary remedy to enable government spending to help offset the negative impact on the economy from the decline in consumption and investment. Otherwise, Keynes contended that the economy would be mired in a chronic state of low employment. Despite being widely opposed at first by the economic community, the theories put forth by Keynes eventually gained widespread acceptance and eventually became the foundation for the modern economics that we all have come to know today.

A Long Time Gone

John Maynard Keynes is widely credited for delivering the policy prescription that eventually brought the Great Depression to an end. And in the years since, Mr. Keynes has increasingly drawn criticism that his policies have helped result in the massive increase in federal debt levels for many countries across the globe. In fact, some would contend that the blame for the fact that the U.S. national debt has soared past $19 trillion and U.S. government debt-to-GDP ratio has moved in excess of 100% falls at the feet of Mr. Keynes.

But is this criticism fair? I would contend it is not. For just as the monster created by Victor Frankenstein in Mary Shelley's novel eventually came to be commonly known as Frankenstein, so to have the distorted economic policies that are being implemented today are referred to as Keynesian even though they no longer represent the policies first suggested by John Maynard Keynes eight decades ago.

What Happened To The Balance

Here's the thing. John Maynard Keynes did indeed advocate the use of budget deficits to support increased government spending to help offset the decline in gross domestic product resulting from a decline in consumption and investment activity. But this tells only half of the story. Mr. Keynes also emphasized that budget surpluses must also be run during times of economic prosperity in part to eliminate the debt accumulated during the prior period of economic weakness. Put simply, run up the Federal credit card during tough times, but pay off the bills once things get better. Fairly reasonable thinking, right?

Another aspect of Keynes's theory on budget deficits is that they should be run in order to offset major economic calamities, not periods of modest economic weakness. And as for the nature of these budget deficits, Keynes indicated that they should not be run to fund current expenditures but instead should be used to fund social investment in capital that was capable of generating a real return over time. Once again put simply, governments shouldn't run deficits to pay the bills but instead should use this borrowing to spend on worthwhile projects that have the potential to bring some of this money back to the government over time. These are also fairly sensible positions.

Much like the extraordinary monetary policy contortions that we have seen during the post financial crisis period, these economic principles are great in theory, but they are much more difficult in practice, particularly over the passage of time.

To highlight this point, the following is a chart of the real annual U.S. federal budget surplus or deficit from 1901 to the present.

One can see from the chart above the advent of deficit spending during the Great Depression, World War II and the years that followed. Initially, the U.S. government demonstrated at least some promise by periodically running budget surpluses during the 1950s and 1960s. But by the 1970s, the jig was effectively up, as surpluses effectively disappeared and budget deficits began to balloon. Over the next half a century, this deficit trend continued in earnest under both Democratic and Republican administrations. The only exception was the period during the late 1990s when a democratic White House and a Republican controlled Congress were able to create an environment that led to four consecutive years of budget surpluses from 1998 to 2001. Of course, this period of time also coincided with the final years of the longest economic expansion in U.S. history, so if there was ever a time when a surplus could have been run, it was then in the late 1990s.

So Much Easier To Say "Yes" Than "No"

The repeatedly massive U.S. Federal budget deficits year in and year out highlight the fundamental flaws of Keynesian policy in application, the primary cause of which lies in innate human behavior.

Put simply, deficit spending is easy for the politicians that hold the U.S. government purse strings. Constituents come into your office asking for things, and when the government is running a deficit it effectively provides a way for politicians to answer "yes" to these requests. And saying "yes" is an answer that gets you re-elected to your post in the Federal government every two, four or six years depending on your position.

Conversely, running budget surpluses is hard for these same policy makers. For in order to run a budget surplus, it means that politicians must find a way to say "no" to their constituent requests. Perhaps even more challenging, it requires politicians to go back to their supporters and take away something that was once given. Remember that thing that I said "yes" to when times were tough? I'm going to have to now say "no" and take that away from you now. For a politician seeking to maintain the support of their constituents, the act of saying "no" is a surefire way to make sure that someone else will be sitting in your seat in two, four or six years from now.

This priority imbalance explains the ballooning budget deficits over the passage of time resulting in a skyrocketing national debt and an increasing percentage of our national GDP being allocated to paying the interest on this debt. And the next time a major economic calamity rolls around, the government is all the more hamstrung in their ability to actually provide meaningful deficit spending because the U.S. government credit card is already up against its spending limit. It is a wonder that the incredulity in the political debate is not around whether the U.S. debt limit should be increased, rather than why we are repeatedly running up against this limit in the first place in what has effectively been a sluggishly positive economy over the last several years. Certainly not the calamitous conditions that Mr. Keynes would have suggested deficit spending would be necessary.

Adding Gasoline To The Fire

The budget deficit fire on the fiscal policy side has seen added gasoline poured upon it over the past half century by the transformation that has taken place on the monetary policy side. When Keynes first presented his theories on demand driving supply and the relevance of deficit spending to fill the economic gap, global monetary policy was still operating under a commodity currency system with paper money backed by gold. But since the early 1970s, the global economy has transformed into a fiat currency system where money is backed by nothing more than the full faith and credit of the issuing government. Thus, central bankers have been set free from any constraints and now have the flexibility to print money at will and as they see fit. With the total assets of major central banks having increased from just over $6 trillion in 2008 to over $16 trillion today, monetary policy makers have been printing currency so aggressively in recent years it would leave a counterfeiter blushing.

Once again, while it is easy for central bankers to say "yes" and take actions like lowering interest rates to zero (if not below zero) and buying assets hand over fist to pump money into the economy and boost asset prices including the U.S. stock market (NYSEARCA:SPY), it is much more difficult as the U.S. Federal Reserve can attest in 2016 to say "no" and actually seek to raise interest rates by as little as 25 basis points. Such imbalances in policy behavior has rendered global monetary policy makers effectively impotent for any future financial calamities that may arise in the future.

The Bottom Line

Keynesian economics is doomed to fail in the end. Perhaps not today, next year or even a decade from now. But eventually it will reach its demise and a new school of prevailing economic thought will eventually rise to gradually take its place as the widely accepted foundation of modern economic thought for future years.

The demise of Keynesian economics will not take place because the policy prescriptions as stated by Mr. Keynes are fundamentally flawed, for they are actually grounded in sound and balanced reasoning. Instead, it will reach its end because of the flawed and imbalanced fiscal and monetary policy makers that have wildly distorted Mr. Keynes's original theories in carrying out the applied decision making for the economy in the many decades since. In short, they've managed over the years to really screw up what were some fairly sound and reasonable policy solutions. Just as Victor Frankenstein met his end because of the monster he created, so too will John Maynard Keynes eventually reach his demise as the man behind modern economic theory thanks to the policy making monsters that have been unleashed to implement and distort his theories in the decades since.

In the process of not being able to say "no" for so long during periods of relative economic stability and prosperity, policy makers have left themselves today without any additional tools to combat any future crisis. This lack of firepower is likely to result in some extreme price fluctuations across many asset classes across the capital market spectrum at some point in the future before it is all said and done. It's truly a pity.

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