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 January 2009 We're all Keynesians Now ... Again World War II Economic Policy Has a New Following in 2009
As 2009 gets underway, Barak Obama finds himself facing the same problems that confronted Franklin Delano Roosevelt and Jimmy Carter. The immediate causes of the economic strains may differ, but the conditions are strikingly similar. It also appears the attempted solutions will be quite similar as well. Popular history has it that Herbert Hoover fiddled while the stock market blew up and the economy burned. His "laissez-faire" policies let the economy sink into the Great Depression and it was only FDR's spending through the New Deal that got it rolling again. To be sure, the war effort helped step up production, but that, too, was a form of government spending. Flash forward forty years or so and you arrive at the malaise of the 1970s. Fueled by government spending for the Vietnam war effort, inflation was in the high double-digits. Richard Nixon tried imposing wage and price controls and Gerald Ford introduced the country to Whip Inflation Now (WIN) buttons. Jimmy Carter and the democrat controlled Congress certainly didn't stand in the way of additional spending and eventually the economy worked its way back to prosperity. Now Barack Obama faces an ever-slumping housing market, cash-strapped banks, and a frozen credit market. Businesses are suffering from the resultant economic slowdown and unemployment is on the rise. The government has been called upon to shore up teetering banks to help fend off the runs and collapses that marred the Depression era. Once again there's a pervasive belief that the government must step in to get the economy rolling. Once again republican rule has led to laissez-faire policies that simply can't keep the economy afloat. What's needed now is what was needed in the prior two crises, a strong dose of Keynesian economics.
Who Cares? True enough, government played a role in creating the problem, and like it or not, it's got to assume a role in the solution. But what that role should be is also important. As an investor, you stand to get hit from two different directions; both in the market as well as on your 1040. The critical thing to keep in mind is that neither governments nor businesses spend money or pay taxes, only individuals do. Any solution that involves either -- or most likely both -- is in some way coming out of your pocket, not anyone else's. That's why the approach our leaders take now is so important, especially since it looks like it's going to be a Keynesian one. Whatever actions we take now to stem the economic slowdown will spawn long-term effects that will be with us for quite some time. That's exactly what happened in the 1930s and the 1970s, and there's little reason to believe it will be different this time. The fact the same Keynesian policies were used then can help us get an idea of what's to come now -- and that's what's disturbing for both investors and taxpayers. In other words, you.
The Theory In his most influential work, the General Theory of Employment, Interest and Money, Keynes argued that aggregate demand rather than capital or production drove economic growth. "Aggregate demand" in this case is simply the combined demand of the entire country. Economic downturns occurred when aggregate demand fell too low and production dried up as a result. Booms were the result of high levels of aggregate demand pulling the economy forward. Periods of slow-growth and high unemployment could be combated by increased government spending to stimulate demand. On the flip side, an overheating economy could (and possibly should) be reined in by increasing taxes to retard demand. In either case, government plays an active role in both fiscal and monetary policy. This stands in stark contrast to the classical theory which relies on individual and corporate activity in a free market. Classical economists tend to fear the long-term effects of government intervention, a concern Keynes blithely blew off saying, "The long run is a misleading guide to current affairs. In the long run we are all dead." (A Tract on Monetary Reform, (1923), Chapter 3). Maybe we should all take up smoking because long-term concerns are certainly taking the back seat now. It all started with President Bush's' $115 billion stimulus package that sent checks to low and middle-class taxpayers last summer under the belief that these payments would quickly make their way back into the economy. Obviously that wasn't enough as just a few months later Fannie Mae, Freddie Mac, Lehman Brothers, and AIG were in desperate straights. The government spent billions preserving three of the four (Lehman got the short straw and ended up in bankruptcy). That wasn't enough, either, so in October Congress passed a $700 billion-plus package to create a toxic dumping ground for banks' tainted loans. After spending about half of that, Treasury Secretary Henry Paulson abruptly changed course saying the remainder would be used to help bail out struggling firms regardless of if they were in the financial industry. While smaller banks continued to fail, GM, Ford, and Citigroup lined up for assistance. Now, focusing on the short-term, incoming President Obama has called for another stimulus package, possibly totaling as much as $1 trillion. It would be directed at the same segment of the population as last year's effort. He obviously believes -- as do many others -- that future deficits don't matter when compared to the need to jump-start the economy and thwart deflation. This, of course, is very Keynesian. The Facts vs. the Myth
First, we can benefit from looking a little closer at government intervention in both periods. Contrary to popular legend, FDR didn't end the recession by invoking Keynesian strategies; Herbert Hoover had been trying them for years. That's right, the man who is traditionally painted as a laissez-faire republican was actually a Keynesian. In fact, earlier in his career, Hoover won praise from Keynes himself. Between 1929 and 1932, among other public works projects, Hoover's administration funded the San Francisco Bay Bridge, the Los Angeles Aqueduct, as well as his namesake dam. During that time, federal spending increased over 50%, a very Keynesian approach. But here's the important thing: Despite all the increased government spending the depression persisted and deepened. The short-term fix didn't work in the short-term. That's why FDR's additional federal programs and spending are to this day credited with getting the economy back on track -- and that didn't happen until the late 1930s. Just looking at this attempt to use government spending to stimulate aggregate demand, one should actually view this as a Keynesian failure. It didn't work in the 1960s and 1970s, either. In fact, it was excessive government spending that led to the runaway inflation that lasted into the 1980s. It took the Monetarists in the Reagan administration to show that in the short term increased federal spending only leads to higher prices but not increased production and growth. Of course in fighting deflation, today's politicians might welcome higher prices. If increased government spending could lead to that -- especially in the housing market -- the credit crisis could ease. Unfortunately, previous attempts at that haven't been successful -- even in the short-term. Look no further than last year's original economic stimulus package. The Economic Stimulus Act of 2008 was expected to put cash in the hands of strapped Americans; cash they were expected to quickly spend. But as the nearby chart clearly illustrates, that just didn't happen. Although disposable income spiked in the summer, personal consumption didn't. Evidently taxpayers used the proceeds to pay off existing debt and maybe even saved it. Normally the latter would fuel additional lending and growth, but against the backdrop of the ongoing credit crisis, banks are happy to hold onto any capital regardless of the source. That's a leakage in the money supply and counteracts Keynesian intentions. The Real Solution The best thing the federal government can do now is to act as a backstop for the remaining distressed loans still found on lenders' books. That was actually the highest and best use of last fall's $700 billion bail out, not the creation of a public loan cesspool or direct investment in banks. The government shouldn't buy troubled loans, it should back them. This would require much less taxpayer dollars and would have the potential to quickly unfreeze the credit market. Here's how it could work: Underlying the original idea of buying ailing loans from banks was the belief that somehow the Treasury could value the loans. The fact that no one has been able to do so to this point doesn't seem to matter. If -- and it's a big if -- the feds can somehow value these loans, they should do so and then guarantee them at that level. Rather than buy them, they would instead assure the holder that their price would never drop below that level. Certainly some would default and decline further, but taxpayer dollars would only be committed to those, not the ones that remain healthy. Your dollars could then go a lot further in backing troubled assets, and those that remain would be free to trade on the open market. That's would thaw the frozen credit market while holding taxpayer expense to a minimum. But that's not Keynesian. In fact, it would support the free market, something that now has a dirty name. So don't look for any solution like this from the new administration. Instead, expect more government spending without regard to the longer-term effects (read: 1970s'-style inflation) or regard to the free market. We are, after all, all Keynesians now. Search this site! Just enter you key word or words:
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NEW PRESIDENT FACING a moribund economy, rising unemployment, and a declining stock market. The problems aren't new, in fact they're fairly well entrenched. Previous fiscal and monetary efforts have so far failed to stem the economic decline. What is this? January 1933, January 1977, or January 2009? How about all of the above?
