Why Obama's Economic Director Lawrence Summers Failed: Ideology Trumped Reality

Includes: DIA, SPY
by: Howard Richman

In 2009 and early 2010, Lawrence Summers, then Director of President Obama's National Economic Council, tried to engineer a Keynesian economic recovery that was to take place during the recovery summer of 2010. The Obama administration tried to boost the three primary components of aggregate demand at the same time: (1) Household Consumption, (2) Business Investment and (3) Government Purchases. They succeeded!

Unfortunately, Summers was a Keynesian who didn't understand Keynes. In the chapter about mercantilism in his magnum opus (The General Theory of Employment Interest and Money), Keynes explained what happens to trade deficit countries:

(A) favorable balance, provided it is not too large, will prove extremely stimulating; whilst an unfavorable balance may soon produce a state of persistent depression. (p. 338)

Indeed, the very trade deficits that Keynes warned about killed Summers' recovery. The stimulus that President Obama was pumping into the economic tire leaked out. Summers was the tire repairman who pumps up a tire without fixing the leak.

If not for growing trade deficits, Summers' Keynesian stimulus would have boosted the economy by 4.8% in the first quarter and 5.6% in the second quarter of 2010, as shown by the red line in the graph below. Such fast growth could have ignited business investment, which could have sustained future growth. But due to growing trade deficits subtracting from demand for American products, the economy only grew at a 3.9% growth rate in the first quarter and 3.7% in the third quarter as shown by the blue line in the graph below:

By the time the third quarter data came in, it was clear that the recovery summer had failed. Lawrence Summers was able to read the data. In November 2010, he resigned and returned to academia.

In August 2010, New York Times columnist Paul Krugman could see what was happening. In one of the rare postings (Killer Trade Deficits) in which he wrote about international economics, his own field, he called for sanctions against Chinese products, arguing that the U.S. failure to respond to China's "predatory trade policy" creates a "world in which mercantilism works."

But Krugman hasn't learned anything from recent economic history. He's now calling on Bernanke to inflate the dollar even more, driving up the inflation rate to about 4% in order to cause Americans to consume now because it is pointless to save. The new stimulus would fail again, just as Obama's recovery plan failed, just as Bernanke's QE2 failed. There is no point in stimulating an economy that has a huge trade deficit leak. The harder you pump, the faster your stimulus leaks out and all you are left with are national debt and dangerous inflation.

Summers and Krugman are examples of a terrible truth. When there is a conflict between ideology and reality, ideology usually wins. The economic profession believes so much in its free trade ideology, that it is unable to learn what Keynes explained in 1937.

Despite the evidence of recent economic history, even midst the dying gasps of the euro, the economic advisors of the western world continue to promote free trade even though balanced trade is much more important. When will they ever learn?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.