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The rise and fall of Keynesian Economics

Prior to the Great Depression our government subscribed to the Business Cycle Economic Theory.  In 1929, at the onset of the depression, appropriate Business Cycle Theory monetary policies were enacted.  However, the economic contraction was greater than anticipated and amidst great societal suffering, the government was slow to help its citizens.  Business Cycle Theory was discredited and voters demanded social programs to mitigate their personal suffering.   New political leadership who embraced Keynesian economic theory was elected. 

This paper argues that embracing Keynesian Economic theory and avoiding Business Cycle Economic theory explains the economic situation we find ourselves in today.  This is not simply a rhetorical argument because it goes to the heart of whether Keynesian stimulation prevents recessions or whether Keynesian stimulation actually creates successively deeper recessions ultimately ending in economic failure.

Business Cycle Theory contends that down cycles are essential to a healthy economy; that down cycles should be accepted for their healing properties rather than avoided for their economic discomfort.  Keynesian theory, on the other hand, contends that economic down cycles are economically unnecessary, can and should be avoided by appropriate government stimulation.  John Maynard Keynes famously promised that “we will not have any more crashes in our time.”

The benefits of down cycles are; excess debt is paid down, and risky business models modified or abandoned.  Without down cycles, debt accumulates and excessively leveraged business models prevail.  Since the Depression, stimulative Keynesian economic policy to avoid the economic discomfort of down cycles has caused borrowers to become addicted to cheap credit and dependent upon highly leveraged business models.  Borrowers, at every level, individuals, corporations and governments have come to regard debt as wealth, a classic and tragic error of economic understanding and an unsustainable economic model. 

During this 80 year Keynesian experiment, the Federal Reserve has provided economic monetary expansion by lowering interest rates and Congress has enacted expansive fiscal policy multiple times to avoid the economic discomfort associated with normal down cycles. By avoiding down cycles, the economy was deprived of their healing benefits and each successive down cycle required ever lower interest rates for longer periods and ever larger sums of borrowed money to achieve the desired effect.  We have now reached a critical state where the economy cannot grow without continuous FED monetary support and the velocity of money borrowed to stimulate the economy is less than 1.  (The Treasury borrowed 10% of GDP to stimulate the economy, and GDP subsequently grew only 3.2%.)

How did we get to this state?  Excessive risk has been so richly rewarded by cheap money that the business model of essentially every large financial institution in the western world is now dependent on extreme leverage of “financially engineered products” with little 'main street' economic value.   Consequently, debt has reached historic levels:  The western world is burdened with over $100 trillion of seriously impaired debt.  

The economic hurdle we now have to overcome is that while the values of the underlying assets are impaired, the entire debt remains.   Essentially, we are over-indebted and absent structural changes, do not have the means to pay it back. 

With forced deleveraging occurring at private, corporate and local government levels, we have reached the perverse point where the Federal Reserve’s Zero Interest Rate Policy can no longer get money into the main street economy through normal financial intermediaries:  Instead, financial intermediaries use the 0% borrowed funds to purchase US Treasuries yielding 3-4% to bolster their own balance sheets rather than make new loans. 

In this scenario, FED policy contributes nothing to the ‘Main Street’ economic recovery leaving Fiscal Policy as the only engine for economic growth.  Congress borrows money provided by the FED and other foreign sovereign banks to fund government projects intended to stimulate employment.  Unfortunately, much of the borrowed stimulus money has gone to maintain current government employment (Federal, state and local) on the theory that a saved job is as good as a created job.  Essentially, no new private sector hiring occurs, instead state and local governments retain a larger labor force than their economy can structurally support.  And thus, fiscal policy has also become ineffective.   We are now at risk that foreign lenders will stop buying treasuries, leaving the Federal Reserve as the sole provider of funds to support US government borrowing.  A situation not unlike Zimbabwe!

After 80 years of applying successively stronger doses of Keynesian Economic Theory; Zero Interest Rate monetary policy no longer provides capital for the main street economy to grow and stimulative fiscal policy no longer adds jobs to the main street economy.  I believe the evidence shows that there is no way to improve the main street economy other than, to once again, embrace the Business Cycle Theory and accept the economic pain of healing down cycles. The unfortunate reality is that the longer that healing is (has been) delayed, the greater the economic discomfort of the healing process. 

Disclosure: No stocks mentioned

Disclosure: no stocks mentioned

Disclosure: no stocks mentioned

Disclosure: No stocks mentioned