The Keynesian Malaise

Can we really borrow our way to recovery...?

ACCORDING to Keynesian Theory, a recession is caused when there is not enough demand "aggregate demand" to soak up all the goods and services in the economy, writes Toby Baxendale of the Cobden Centre.

The way around this, apparently, is to force more consumption.

"Consumption – to (state) the obvious – is the sole...object of all economic activity...The more virtuous we are, the more determinedly thrifty...the more obstinately orthodox...the more our incomes will have to fall...Obstinacy can bring only penalty and no reward. For the result is inevitable."

So wrote John Maynard Keynes in his General Theory of 1936. And this increase in consumption can be done by the government extracting your money and spending it for you by way of a fiscal stimulus. Governments dedicated to the principles of laissez-faire would be better off to "fill old bottles with bank notes, bury them at suitable depths in disused coal mines which are then filled...with town rubbish, and leave it to private enterprise... to (invest in) dig(ing) the notes up again."

"Can American Spend Its Way to Recovery?" was the title to an article written by Keynes in 1934 for a magazine called Redbook.

"Why, obviously!" came his answer. "A man poor can make a nation wealthy."

Once the poor man is penniless, he should borrow so as to continue spending. And if some projects are uneconomical at current interest rates, the rates must be lowered so that businesses pursue them, thus driving up aggregate demand.

The ultimate target rate should be zero.

"I should guess that a properly run community...ought to be able to bring down the....(general rate of business profit and interest) approximately to zero within a whole generation. You should also create money out of thin air and place it in the banks so it can act just as savings would do, then require the banks to lend it out."

In the crazy Keynesian world, there is no appreciation that if you want to purchase something more costly than your monthly income, you should save. Where immediate means are insufficient, debt is always the answer.

The first gigantic bailout, fiscal stimulus, and massive printing money session (aka Quantitative Easing) has all come to pass and the effects are wearing off. The liquid share indexes such as FTSE are falling, as we predicted many months ago. Long ago on the Cobden Centre's site we explained why QE would not work.

Yet the mantra of Keynes and his modern-day followers is that one man's spending is another man's income. Therefore, if we all consume, there will be no recession. The problem with Keynes is he did not have a theory of capital.

To the mathematician Keynes, capital is summed up as the blob called K, a homogeneous blob that can mysteriously change form one thing to another to suit the needs and requirements of the people automatically. He did not consider that during the 1920s, as money was made artificially cheap, borrowers invested in longer methods of production – more capital-intensive methods – to produce goods for which there was no real demand for once the printing presses had stopped producing cheap money. This led to excess build up of capital producing goods no one really wanted. The bust was inevitable

In the current recession, we have postponed the inevitable correction. Our policy makers can take what I call the "Ireland route" or the "Keynesian Malaise route". In case you did not read Liam Halligan's article is this week's Sunday Telegraph, I will quote directly from his wise words:

"Last week, it emerged that the Irish economy has climbed out of recession. New data showed GDP grew by a buoyant 2.7% during the first three months of 2010, reversing a contraction of the same size during the previous quarter. This is highly significant – and not only if you're Irish.

"A year and a half ago, Ireland endured nothing less than an economic implosion. After a decade of rampant borrowing and spending, the Celtic Tiger was shot between the eyes. The country's runaway housing market and related construction boom turned to bust...

"Ireland's recovery is troublesome for a hard-core of neo-Keynesian economists, those still banging the drum for yet more government borrowing and spending. Such loose thinking is legion – hard-wired into the minds of many. The UK's tough new fiscal measures have been greeted with howls of protests by numerous economists who should know better. Less government spending will make things worse, they say, not better. Yet Ireland shows that if you knuckle down, take the medicine and reassure your creditors, then recovery can be relatively swift."

Earlier in the article, Liam mentions the Bank of International Settlements report, which gives a truer picture of our debt. Even if we accept the UK government's figures of a £900 billion national debt at the end of this year, with GDP projected at around £1.4 trillion and the state accounting for one half of it, this implies a private sector GDP of around £750bn. With interest service alone at £45bn this year, this implies that 6% of all private sector activity is paying our national debt interest service.

In addition to the redemption and ongoing tax extractions, it is mad to go down the Keynesian Malaise path of more fiscal spending and money printing. I vote we go down the Irish route as quickly as possible. But the great snake oil salesman himself said:

"The duty of ordering the current volume of investment cannot safely be left in private hands."

This is from Keynes' General Theory of Employment, Interest & Money. Now, with over half of the banking sector in the ownership of the state, and lending targets set and politicians in government embarking upon initiatives to "get lending going again", it is no big step to see that soon the state will become the allocator of capital in the economy.

So watch out for this next step in the tragic mess we are in.

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