Tuesday, March 24, 2009

Keynesianism is tired

At 73 years of age (dating from the publication of Keynes' General Theory), the economic model that is Keynes' namesake is showing signs of weariness.

Keynesianism holds that fiscal and monetary policies can be fine-tuned to stimulate an economy in order to jump-start growth.

To push Demand, the Keynesian model relies on three policy levers:

1) Increase Government Spending ("G")
2) Increase Money Supply ("M")
3) Lower Taxes ("T")

Pull these levers in just the right way, and the economy responds accordingly.

Unfortunately, given today's conditions, these policy levers are unlikely to yield meaningful results:

1) "G" is unlikely to be effective

The 407-page, $800 Billion Stimulus Plan was intended as a Keynesian "jump-start" on a scale never before tested.

However, there are several problems:

a) The 'Stimulus' is not 'Stimulative'

Only a small fraction (the WSJ estimates $90 Billion, or 12%) of the "G" being deployed acqually qualifies as stimulus, as defined by an item which might concievably have a multiplier (such as fixing and building bridges and highways, developing broadband access, etc.).

For every bridge to somewhere in the plan, there are many bridges, and transfers, to nowhere (where is Sarah Palin when we actually need her?).

These include (to name but a few):

$50 billion for the National Endowment for the Arts
$1 billion for nutrition programs
$650 million for digital tv switching coupons
$400 million for global-warming research
$150 million to the Smithsonian Institution
$100 million for school-lunch programs
$250 million for domestic violence programs
$250 million for farm loans and grants
$225 million for assistance to Indian tribes

Any of these items may be worthwhile expenditures on their merits, however, none of them qualifies as "stimulus".

For the elegance of the manner by which they combine simplicity with profligacy, we especially admire the stimulus grants, with no other details specified, of:

$400 million for, simply, "Science" (quotation marks in the original bill - see page 17),
$150 million for "Aeronautics", and
$400 million for "Exploration"...

b) Someone must buy all the debt which is being issued to fund all this "G"! But whom?

The biggest buyers of US Government (and Agency) debt, for the past several years, have been China, Japan, and the Oil States.

However, the supply of loanable funds among these entities from which the US can borrow is drying up.

China's current-account surplus, the source of the funds for its Treasury purchases, has dropped precipitously as the global economy has contracted over the past several months.

Japan, another major buyer of Treasuries over recent years, is now posting trade deficits for the first time since the early 1970's. This current account deficit, combined with a significant fiscal shortfall and planned issuance of $33 Trillion Yen ($340 Billion USD) in government debt this year, means that Japan will be, in effect, competing with the US for funds, rather than lending to us.

And, the oil-exporters are in no shape to be buying anything right now, as oil prices have collapsed since last summers $147/barrel peak. Russia is busy selling foreign exchange to prop up its currency.

Brad Sester of the Council of Foreign Relations reports that foreign demand for long-term treasuries has faded, and notes, ominously, that "global reserves aren't growing". (Brad Sester's article, linked above, is highly recommended).

c) The FUNDAMENTAL difference between the original Keynesian plan in the 1930s and the Obama Keynesian version today is that back then, we had "idle loanable savings" in the US. Today, after 25 years of a declining savings rate, we have no savings--idle or otherwise, to deploy (although, the savings rate is increasing, finally).

Source: CalculatedRiskblog.com

Today the "G" must be funded by foreign capital inflow--there is no other way for the math to add up. This is a BIG difference in the funding of the fiscal deficit. And the implications thereof.

Fiscal deficits have traditionally been viewed to be 'sustainable' at a maximum level of 3% to 5% of GDP. (At this level, GDP growth is sufficient to maintain total debt at a servicable level). The European Union's Stability and Growth Pact actually requires member countries to maintain deficits of <= 3% of GDP. Will foreign creditors, who are already calling for the replacement of the US Dollar as the world's reserve currency, continue to fund US fiscal deficits as they race from 3% of GDP up to 13% (this year), 10% next year, and beyond...?

2) Pushing "M" in today's circumstances is ineffective

Despite the Federal Reserve's unprecedented increase in Money Supply over recent months, Aggregate Demand has not budged.

Fed Chairman Ben Bernanke is, famously, a student of the history of the Great Depression, and is determined not to repeat the Fed's mistakes of the 1930's.

However, the monetary problem at that time was one of illiquidity in otherwise-solvent institutions, resulting in bank runs which decimated the banking landscape and perpetuated the deflationary spiral.

Anna Schwartz, the economist who co-authored the seminal Monetary History of the United States with (Rutgers-educated!) Milton Friedman, wrote in the WSJ several months ago that today's bank problem is not illiquidity, but insolvency.

Let's review the definitions, in case Ben is reading:

The fundamental problem with today's banking system is that the major banks are insolvent, and are sitting on hundreds of billions (possibly trillions) of dollars of loans which are not worth anything near the value which the banks claim.

Recognition of this fact was the reasoning behind the TARP plan, whatever its merits, which was rolled out in its latest itiration this week (the Geithner plan), as a scheme to leverage taxpayer money to buy these bad assets. [Actually, the plan uses taxpayer money to (a) pay the banks more for the assets than they worth, (b) transfer any upside to private bankers and investors, and (c) transfer the losses to you, the taxpayer.]

Regardless, the problem cannot be solved by printing money. Nevertheless, the Federal Reserve last week announced plans to expand its balance sheet to more than $4 Trillion, with purchases of up to $300 Billion in long-term Treasuries (starting tomorrow), along with $850 Billion in mortgage-related bonds and securities...

The bigger picture is that the United States is at the beginning stage of a debt unwind of historic proportions. While the Fed's expansion of base Money appears astoundingly large when looked at in isolation...

... it nevertheless pales by comparison to the debt imbalances which must be worked off in the economy as a whole.

The charts below illustrate the scale of the issue facing Mr. Bernanke as he attempts to reflate. US private debt is more than 300% of GDP. This is twice the historical average. Reversion to the mean implies, ultimately, that there will be a debt unwind of some $25 Trillion in today's dollars.

As GDP is the denominator in the Debt/GDP equation, falling GDP, as we are experiencing now, exacerbates the problem.

If GDP falls by 5% during the current recession, this means that private debt must be retired (or monetized?) by $2 Trillion, just to hold the Debt/GDP ratio at 300%!

Here is long-term chart showing Money Supply and total private credit. The left-scale is in Billions ("$40,000" = $40 Trillion).

Base Money is represented by the red line at the bottom of the chart. Clearly, debt monetization of even $1 Trillion by the Fed barely even registers when compared to total private credit.

Unless Mr. Bernanke plans to expand, exponentially, the number of presses he is operating, he is tilting at windmills.

Finally, with regard to Policy Lever #3...

3) Taxes

While this lever has been deployed in the past with some effect, at this point in time, for better or worse, reducing taxes is not on anyone's radar. In fact, indications are that this lever will soon be pushed hard into reverse...

And so, there it is.

As policymakers desperately pull the Keynesian levers, we find that Keynes' beautiful model sadly offers little to help us at this juncture.

As Nobel-prize winning economist Gary Becker noted in a recent interview:

"Keynesianism was out of fashion for so long that we stopped investigating variables the Keynesians would look at such as the multiplier, and there is almost no evidence on what the multiplier would be." He thinks that the paper by Christina Romer, chairman of the Council of Economic Advisors, "saying that the multiplier is about one and a half [is] based on very weak, even nonexistent evidence." His guess? "I think it is a lot less than one. It gets higher in recessions and depressions so it's above zero now but significantly below one. I don't have a number, I haven't estimated it, but I think it would be well below one, let me put it that way.

Unfortunately, pulling the wrong policy levers is not only ineffective, but harmful. With each additional expansion of the Fed's balance sheet, each additional hundred billion in non-stimulative spending, and each new attempt to avoid the painful but necessary corrections in the economy, full recovery is further delayed.

It is time for Lord Keynes to take a breather, and rest up until conditions are more felicitous for the economic model which bears his name.

John Maynard Keynes... is tired.

Dr. Farrokh Langdana, Ph.D.
Rutgers University Business School

...is not tired!

For further information, see:

What Shape is Your Supply Curve? For a further exploration of the Keynesian model's application to today's conditions...

What's That Smell?, The Garbage Barge, and The Garbage Mega Ship, regarding the Fed's unprecedented balance-sheet expansion...

Don't Count on us to Bail You Out!, and Warnings from China regarding US fiscal and monetary policies, and...

Deflation Blues, for a discussion of Deflation and its implications.



  1. Thanks for the blogs. Very interesting reading for non-economists like me (who struggled with Samuelson) and great visuals.

    Just curious if these knobs are out of steam, what is general consensus in the economist world as to what the administration should do. At last night's press conference Obama seemed to give the impression that economists in general were in agreement with the budget.


  2. Keynes isn't tired, he's been dead a long time . Its just that the Democrats never got the obituary.

  3. - randy (Shanghai 06)April 29, 2009 at 3:10 PM

    Prof, can you put into perspective for me this paradigm shift to SDR as the newest preferred "safe haven" of foreign currency reserves for China and the likes.

  4. In regards to Japan, I'm guessing that unlike the American economy, the Japanese do in fact have idle loanable funds given their tendency to save more than spend (with the minor exception of their younger, single female population).

    Would Keynes be less tired in that economy?

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