Spengler: Ignore That Keynes Behind The Arras

The latest from Spengler at Asia Times:

This was supposed to have been the final triumph of John Maynard Keynes, the crisis in which governments actually did what he urged them to do during the Great Depression, the proof that an elite of puppeteers in control of monetary and fiscal policy could make the innumerable actors in economic life march wide-eyed toward recovery.

Keynes' idea is simple; in fact, it is simple by construction, for it focuses on the very short term within a closed economy. If consumers won't spend, the government will spend for them; if businesses won't invest, the government will invest for them; and if investors won't take risks, the central bank will reduce the yield on low-risk investments to almost nothing.

No forecaster of note a month ago expected the Greek debt problem to threaten the world financial system, yet it has. Nemesis always comes in through the unwatched door. The risk is that lending among international banks may freeze up as it did during the late autumn and winter of 2008-2009, with catastrophic consequences for governments that depend on the banks to fund enormous deficits.

The cost of insurance against European bank defaults is now even higher than after the Lehman Brothers bankruptcy of 2008. This is not a drill. It is a real crisis. Perhaps the European Community will calm things down for the moment. No matter: if they succeed, the crisis will find another outlet soon enough.

The Barack Obama administration, like most of the world's governments, decided on a massive dose of Keynesian medicine, taking the budget deficit to an unheard-of peacetime level of 13% and keeping short-term interest rates at near zero. It was advised by macroeconomic royalty: Obama's chief economic advisor Lawrence Summers is the nephew of two Nobel-Prize winning economists, Kenneth Arrow and Paul Samuelson, of whom the latter literally wrote the textbook that trained three generations of economists in Keynes' wisdom.

And it all seemed to be working. Even some of the bitterest critics of the Obama administration and Keynesian economics in general hailed the coming "V-shaped recovery". American consumers, right after suffering a US$6 trillion loss in wealth in the form of household equity, and right before the greatest retirement in American history, decided that they did not have to save after all. The savings rate fell and consumer spending rose. American corporations in the S&P 500 index stripped down to skeleton staffs and stopped investing, and declared a 60% rise in profits between the second quarters of 2009 and 2010. And the latest employment data show real improvement in the labor market.

It was Keynes' "money illusion" writ large. Inflate the currency, and the workingman will still see the same number of shillings in his pay packet, Keynes wrote at the beginning of his 1936 General Theory. Inflation thus will stimulate economic activity. This crude example illustrates a broader principle that might be called "wealth illusion": reduce the yield on low-risk investments to almost nothing, and investors will have to shift portfolios to riskier assets, stimulating investment and hiring.

As a closed-economy, short-run model, Keynes' approach has had two quarters of real success, and it behooves the Keynesians to declare victory and go home, as a Vermont senator proposed during the worst of the Vietnam War.

After the sovereign debt crisis erupted in Greece and spread globally - to the surprise of this writer as well as every forecaster he knows - the Keynesians must feel a bit like the hero of Pushkin's story The Queen of Spades, who plays cards on the advice of a ghost, only to win the first two rounds and lose everything on the third. One can imagine Lawrence Summers going as mad as Pushkin's gambler: "He is in the Obuhovsky hospital, room Number Seventeen; he does not answer any questions, but keeps muttering with astonishing rapidity: 'Three, seven, ace! three, seven, queen!'"

The trouble is that the world is not composed of closed economies, and investors do not think in terms of the short run - not always, in any event, and not when long-run considerations manifest themselves...
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