John Maynard Keynes - Fausta's Blog

At the Wall Street Journal,
The Keynesian Dead End
Spending our way to prosperity is going out of style.

Like many bad ideas, the current Keynesian revival began under George W. Bush. Larry Summers, then a private economist, told Congress that a “timely, targeted and temporary” spending program of $150 billion was urgently needed to boost consumer “demand.” Democrats who had retaken Congress adopted the idea—they love an excuse to spend—and the politically tapped-out Mr. Bush went along with $168 billion in spending and one-time tax rebates.

The cash did produce a statistical blip in GDP growth in mid-2008, but it didn’t stop the financial panic and second phase of recession. So enter Stimulus II, with Mr. Summers again leading the intellectual charge, this time as President Obama’s adviser and this time suggesting upwards of $500 billion. When Congress was done two months later, in February 2009, the amount was $862 billion. A pair of White House economists famously promised that this spending would keep the unemployment rate below 8%.

Seventeen months later, and despite historically easy monetary policy for that entire period, the jobless rate is still 9.7%. Yesterday, the Bureau of Economic Analysis once again reduced the GDP estimate for first quarter growth, this time to 2.7%, while economic indicators in the second quarter have been mediocre. As the nearby table shows, this is a far cry from the snappy recovery that typically follows a steep recession, most recently in 1983-84 after the Reagan tax cuts.

The response at the White House and among Congressional leaders has been . . . Stimulus III. While talking about the need for “fiscal discipline” some time in the future, President Obama wants more spending today to again boost “demand.” Thirty months after Mr. Summers won his first victory, we are back at the same policy stand.

The difference this time is that the Keynesian political consensus is cracking up. In Europe, the bond vigilantes have pulled the credit cards of Greece, Portugal and Spain, with Britain and Italy in their sights. Policy makers are now making a 180-degree turn from their own stimulus blowouts to cut spending and raise taxes. The austerity budget offered this month by the new British government is typical of Europe’s new consensus.
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President Obama’s tragic mistake was to blow out the U.S. federal balance sheet on spending that has produced little bang for the buck. The fantastical Keynesian notion (the “multiplier”) that $1 of spending produces $1.50 in growth was long ago demolished by Harvard’s Robert Barro, among others. That $1 in spending has to come from somewhere, which means in taxes or borrowing from productive parts of the private economy. Given that so much of the U.S. stimulus went for transfer payments such as Medicaid and unemployment insurance, the “multiplier” has almost certainly been negative.

With the economy in recession in 2008 and 2009, we argued that some stimulus was justified and an increase in the deficit was understandable and inevitable. However, we also argued that permanent tax cuts aimed at marginal individual and corporate tax rates would have done far more to revive animal spirits, and in our view would have led to a far more robust recovery.
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What the world has now reached instead is a Keynesian dead end. We are told to let Congress continue to spend and borrow until the precise moment when Mr. Summers and Mark Zandi and the other architects of our current policy say it is time to raise taxes to reduce the huge deficits and debt that their spending has produced. Meanwhile, individuals and businesses are supposed to be unaffected by the prospect of future tax increases, higher interest rates, and more government control over nearly every area of the economy. Even the CEOs of the Business Roundtable now see the damage this is doing.

BizzyBlog adds,

The Journal left one name out of this passage who should be there: then-Ohio Congressman John Kasich. The Associated Press, in a too-rare example of historically accurate reporting in June of last year (original BizzyBlog post; saved AP article), noted that Ohio’s current GOP gubernatorial candidate “was the chairman of the U.S. House of Representatives’ Budget Committee in 1997 that balanced the nation’s budget for the first time in more than 30 years.” More than any other person, Kasich was responsible for the relative spending restraint in the 1998 and 1999 fiscal-year budgets that led to the actual and projected budget surpluses of the period. The restraint started its disappearing act after Kasich left Congress, and his claim that free-spenders on both sides of the political aisle quietly celebrated his departure is sadly true.

Unfortunately, I don’t agree that Obama’s and Congress’s decision to “blow out the U.S. federal balance sheet” was a “tragic mistake.” Given false intellectual cover by the likes of Larry Summers and Christine Romer, the administration and Congress gleefully did so. Perhaps Obama, Pelosi, and Reid are still deluded, as are Summers and Romer, about the awful historical record of doctrinaire Keynesianism. If they’re not, the only alternative is to assert that they have inflicted their damage deliberately.

Incredibly, no one except GOP candidate Rudy Giuliani was advocating further tax cuts. Democrats and their presidential candidates, most notably Obama, advocated vast tax increases; GOP candidates McCain and Romney were satisfied advocating making the current tax structure which had been in place since 2003 permanent. That wasn’t good enough, guys.

The FUDGE economy (Fear, Uncertainty, Doubt, and Government Excess) continues. The Business Roundtable’s tardy arrival to the corps of the concerned is no accident. The too-numerous band of crony capitalists in this group thought they would disproportionately benefit from a Washington-driven spending spree, and are late in recognizing that this administration’s hostility to the private sector was far more than election campaign posturing.

Q&O:

Most who understand at least rudimentary economics knows that some “stimulus” from government spending, coupled with other government actions, such as tax cuts for individuals and businesses, may have a beneficial effect in times of recession. The stimulus funds get money in circulation and the tax cuts encourage businesses to expand and hire.

What we’ve seen is nothing but “stimulus” – no tax cuts, no incentive for businesses to come off the side lines. Additionally we’ve seen attacks on the business community, calls for much more draconian regulation and new mandates imposed by legislation such as health care reform.

The result has been a seemingly perpetually unsettled business atmosphere that has provided absolutely no incentive for companies to expand or hire.

What we should have all taken from this is that government “stimulus” funded by massive public debt isn’t the answer we were led to believe it was and, when it is all that is done, is more of a problem than any sort of a solution. All the “stimulus” has managed to accomplish is the promise of large tax increases to pay down the debt it created.

The other service it hopefully has rendered is to prove defective the once cherished Keynesian belief that government can spend us out of recess.

And now for the bad news: Keynesian economics are not dead yet. Not by a long shot. For as long as there are politicians, there will be government spending as if there is no tomorrow.

21278

Oh lordy. That would be the worst of both worlds.

The Wall Street Journal has a must-read on the subject,
The Yuan Scapegoat
The U.S. establishment flirts with a currency and trade war with China.

The battle concerns China’s decision to peg its currency, the yuan, to a fixed rate of roughly 6.83 to one U.S. dollar. To hear the American political and business establishment tell it, this single price is the source of all global economic problems. The peg keeps the yuan “undervalued” in this telling, fueling China’s exports and harming the U.S., Europe and everyone else. If the Chinese would only let the yuan “float,” it would soar in value, China’s export advantage would fall, and the much-despised “imbalances” in global trade would end.

President Obama has picked up this theme, calling last week for Beijing to adopt “a more market-oriented exchange rate” that “would make an essential contribution to that global rebalancing effort.” Less diplomatically, 130 Members of Congress sent a letter to Treasury this week demanding that unless China lets the yuan rise in value, the U.S. should impose tariffs on Chinese goods. Just what the world needs: a trade war.

At the core of this argument is a basic misunderstanding of monetary policy. There is no free market in currencies, as there is in wheat or bananas. Currencies trade in global markets, but their supply is controlled by a cartel of central banks, which have a monopoly on money creation. The Federal Reserve controls the global supply of dollars and thus has far more influence over the greenback’s value than any other single actor.

A fixed exchange rate is also not some nefarious economic practice rare in human affairs. From the end of World War II through the early 1970s, most global currency rates were fixed under the Bretton-Woods monetary system created by Lord Keynes and Harry Dexter White. That system fell apart with the U.S.-inspired inflation of the 1970s, and much of the world moved to “floating rates.”

But numerous countries continue to peg their currencies to the dollar, and with the establishment of the euro most of Europe decided to move to a fixed-rate system. The reason isn’t to get some trade advantage against their neighbors but to gain the economic benefits of stable exchange rates—and in some cases a more stable monetary policy. A stable exchange rate eliminates a major source of uncertainty for investment decisions and trade and capital flows.

The catch is that under a fixed-rate system a country yields some or all of its monetary independence. In the case of euro-bloc countries this means yielding to the European Central Bank, and for dollar-bloc countries to the U.S. Federal Reserve.

This is what China has done with its yuan peg to the dollar. By maintaining a fixed yuan-dollar rate, China has subcontracted much of its monetary discretion to the Fed in return for the benefits of exchange-rate stability. For more than a decade, this has served the world economy well, leading to an explosion of trade, cheaper goods for Americans that have raised U.S. living standards, and new prosperity for tens of millions of Chinese.

Read the entire article, with special attention to how a market solution may be the answer to the problem,

China’s build-up in dollar reserves is contributing to the world’s anger at China, and it represents a huge misallocation of global resources. Instead of letting its dollar reserves find their best private investment use, China uses them to buy U.S. Treasury bills or Fannie Mae securities.

One solution would be to make the yuan convertible, and let capital and trade flows adjust through private markets rather than the Chinese central bank. This is how Germany recycles its trade surplus. A one-time small revaluation to, say, 6.5 yuan to the dollar accompanied by convertibility would help with global adjustment while avoiding the perils of Japan-like deflation.

The Chinese government resists open capital markets because it fears less political control. At least at first a convertible yuan might also lead to a surge in capital outflows from China as Chinese companies and individuals diversified their currency holdings and investments. But over time, and probably quickly, markets would adjust and reach a new equilibrium. Convertibility would also increase the domestic pressure for China to further liberalize its financial system.

This is where the U.S. should put its diplomatic pressure, rather than on the exchange rate. Even better would be a joint U.S. Treasury-Chinese declaration on behalf of such a policy shift, which would give credibility to the new monetary arrangement.

It would be interesting to see the effect of a surge in capital outflows from China on the economies of our hemisphere, since the Chinese have been investing heavily in producers of raw materials, mines, and commodities. The dangers of volatility and political risk are holding back a lot of investments, but would the increase in outflow make investors less risk-adverse?

Either way, the answer does not lie in Keynesian-type solutions.