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Mark's Market Blog

6-22-10: Economics: The Dismal Science

By Mark Lawrence

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Does deficit spending help in a recession?

Portions of this article published at BusinessInsider.com

There are three main schools of economics: Keynesians, Monetarists, and Austrians. We call them "schools of economics" because schools is such an erudite word; it sounds so very much better than "sects of economics" or "churches of economics," don't you agree?

Keynesians follow the ideas of Lord John Maynard Keynes, who during the Great Depression noted that if we paid people to dig holes then paid them to fill them in, that would be an improvement to having them unemployed and unfed. Keynesians believe the economy is determined by the level of government spending. There's a huge hole in Keynesian economics: during boom years, when everyone is already employed, government spending doesn't lead to more jobs, it leads to inflation. And history has shown that governments are completely unable to lay people off once hired, completely unable to terminate programs even centuries after their usefulness has ended. Please, someone, anyone, tell me what it is the Department of Energy does. Keynesians like to take credit for showing us how to spend our way out of the Great Depression, but many believe the Great Depression was only ended by WW II, not by any clever New Deal or Works Progress Administration programs. The most visible Keynesian today is Paul Krugman, shouting each week from the rooftop of the New York Times that governments must spend us out of this recession, that the austerity programs of Europe all but guarantee a new global Great Depression.

Monetarists have Milton Friedman as their most sacred idol. Monetarists believe that the economy is determined by the amount of money in circulation, so they believe that the interest rate and "quantitative easing" policies of the Federal Reserve control the level of economic activity. Federal Reserve interest rate manipulations means the Fed lowers interest rates, people borrow money at the lower attractive interest rates, and that money either gets spent or invested. Federal Reserve quantitative easing means that the Fed buys various government and private bonds, and they print money with which to buy them; the printed money goes into circulation and is used to buy more stuff, generating more business activity and eventually more jobs. There's a huge hole in monetarism, and we're in it right now: it's called the liquidity trap. When there's no one to whom the banks are willing to loan money, no one whom the banks regard as a worthy credit risk, then the Fed can lower interest rates all the way to zero (as they have in the US for over a year, and in Japan for two decades), and all that happens is the banks hold onto the Fed's money. The Fed can buy all the bonds that banks are currently holding, but the printed money will just sit in the banker's vaults. Monetarism cannot get you out of a severe recession or depression, when unemployment is high and most everyone is perceived as a potential credit risk. The most visible monetarist today is Ben Bernanke, who is calmly and quietly assuring everyone that he has things under control, that there will be no 2nd Lehman Brothers or Great Depression under his watch, that he can print money and quantitatively ease faster than events can take us down.

Keynesians and Monetarists have another problem: these theories were built before the emergence of the global economy. Although they allow for trade, they don't consider it a major factor in their equations, and they don't include the affects of powerful people in charge of other country's governments and their reserve banks who have their own agenda. The idea that a central bank or government is in complete control of their economy is rather laughable today.

Austrians, like Hindus, have no central authority, no authoritative religious book, no historic founding figure. Austrians believe that the economy is too diverse and rapidly changing to measure accurately; they believe economic models are either too simplistic to be useful or too complicated to be built; they believe that measures taken by governments such as Keynesian stimulus packages or Monetarist quantitative easing are doomed to failure and to, if anything, exacerbate the problem. There's a huge hole in Austrianism, and that's that in times like today, when politicians desperately need to be seen to be doing something and will most certainly do something, Austrians only guidance is "that's going to backfire." Not surprisingly, the Austrian school is quite popular on Wall Street but almost non-existent inside the Beltway. Like Hinduism, with its never-ending karmatic hamster wheel cycles of death and rebirth with no hope of ever stepping off, there's something deeply pessimistic and fatalistic about Austrianism. The problem with the Austrian school is that it's not so much a theory of economics as it is a criticism of the other theories. Austrianism is the Rush Limbaugh of economics - they've identified all the problems, but have none of the solutions.

Today a popular topic is an equation,

Gross Domestic Product (GDP) = Personal Consumption + Business Consumption + Investments + Government Spending + Exports - Imports.

Governments desperately want GDP to rise and bring new jobs with it. Personal consumption is on decline as people pay off their credit cards and consider a bleak outlook for retirement and employment. Business consumption is declining as businesses tighten their belts waiting for the return of consumers. We all agree that personal and business consumption is going nowhere. Investments are not doing so well these days, the stock market has been flat or down for a decade, and bonds are getting downright scary. We're all addicted to cheap imports from Asia, but this is subtracted from GDP: imports are a bad thing these days. Exports require buyers, and the world is very short of buyers. Europe is dropping the value of the Euro in hopes of attracting new buyers with their garage sale prices, but 1) there aren't many buyers out there, and 2) if it works, other countries will counter with lowering their currency or enacting trade barriers. That leaves government spending, and it leaves politicians with the sense that they get to put on their capes and fly to a very public and visible rescue. Today Keynesians are in ascendency in much of the world. Billionaire George Soros recently said, "We find ourselves in a situation eerily reminiscent of the 1930s. Keynes has taught us that budget deficits are essential for counter cyclical policies, yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip."

There's an assumption here, an assumption that any Chemist, Physicist, or Engineer knows never seems to work out. That assumption is that you can change one variable on the right, Government Spending, and everything else on the right will stay put, leaving the affect of the Government Spending to the variable on the left, GDP. You raise Government Spending and GDP goes up, jobs appear, people get hired, consumers return to the malls to buy trunk loads of stuff, businesses make money, tax receipts go up, the deficit disappears, politicians are big heroes and will get re-elected forever. Is it true? Did Cinderella really live happily ever after?

Take a glass of water, put a little bit of powdered lemonade mix into it. It dissolves easily. You decide there's an equation,

Lemonade = water + mix

Add more and more mix to the water. Pretty soon it stops dissolving - you've saturated the water. There's a pile of sugar at the bottom of the glass, and you find out a better equation would be,

Lemonade = water + mix - pile of sugar

Markets get saturated too. For ten years Greek debt sold at the same price as German debt, but then in 2009 that market saturated. For decades the auto industry and state governments paid their union employees whatever they wanted and passed the costs on to consumers. That market also saturated. The days of people making $85,000 per year to tighten lug nuts are behind us, and soon also will be the days of New York Metro conductors earning $239,148 per year or Illinois School Administrators accruing $11 million in retirement benefits.

Let's suppose the world's economy is at least as complicated as a glass of water. You raise Government spending, but you have no money, so you have to either print money or sell bonds. If you print the money, then you get jobs + inflation: some hiring takes place, some prices go up, balances in savings accounts shrink in value every day, businessmen are fearful of the future, and you eventually get the stagflation of the 70s or worse yet the runaway inflation of 1930s Germany. If you sell bonds, you need buyers. If those buyers are domestic, like Japan from 1990 to today, then some, perhaps nearly all their money goes into your bonds and consumers stay broke. Interest rates stay down due to quantitative easing, so your citizens aren't even making money on their bonds. Like Japan, perhaps you spend money wildly but only get a couple lost decades in return. Finally, let's suppose the bond buyers aren't domestic - suppose China is buying your bonds. China needs to have money to buy the bonds, you have to buy something from China so that they have the money to buy the bonds. So the government sells bonds, China buys the bonds, we buy Chinese crap at Walmart by the truckload, China moves more and more of their people from their poor farmlands into their cities to make more and more crap to ship to Walmart. The government spending, funded by Chinese buying bonds, results in jobs, lotsa jobs, but the jobs are all in China. Moreover, the investment in factories to hire those people is in China, so US unemployment changes from temporary to structural: when the economy does pick up, the shiny new factories that are ready to hire people are all in China, not in the US.

This is starting to look like a car stuck in Alabama mud: the more you press down on the accelerator, the faster your wheels spin and the more mud you sling around, but the car doesn't move. Deficit spending has four possible results: you buy more domestic jobs (the Cinderella case), you buy more domestic inflation (US 1970s), you soak up the savings of your citizens and buy a lost decade (Japan 1990-today), or you buy a bunch of jobs in China (US from 2000-2010). Of course the reality will be a mix of the four results, but governments are already so bloated that the mix will lean heavily towards the bad cases. Notice that I have good historic examples for the three bad cases, but I don't have an historic example for the good case, the Cinderella case, the Politicians as Super Heroes case.

We're left with a couple questions. (1) Is it true that government stimulus is a waste of time and money? That cutting the deficits in Europe will likely result primarily in fewer imports, that raising the deficits in the US will result in more jobs in China and more structural unemployment in the US? That Paul Krugman and Ben Bernanke are wrong, wrong, wrong, and all Krugman's proposed stimulus spending will wind up getting soaked up either by Bernanke's Quantitative Easing which turns it into stagflation, or by Chinese buying American Bonds and American Jobs?

The second question is, (2) If neither Keynesian spending programs nor Monetarist interest rate manipulations and quantitative easing will generate jobs, then what will pull us out of this world-wide recession, what will keep us from slipping into a full blown world-wide depression? Unfortunately, history does give us some guidance here.

During the Great Depression, every kind of economic policy you can imagine was tried. Just as Europe is cutting their deficits today, the US cut their deficits in the early 1930s. It didn't have much affect. Just as the US is deficit spending today, the US under Roosevelt deficit spent in the later 1930s, and that had little affect. What finally ended the Great Depression was World War II. In WW II, Roosevelt gathered up 1,000,000 unemployed men and shipped them off to Europe. Then he gathered up another 1,000,000 people and put them to work building tanks, ships, planes, ammunition. Finally, he put major rationing programs into place, making certain that the money he spent didn't go into consumption, rather it went into savings and then immediately into business investment. The Detroit auto industry, the Seattle and Los Angeles aircraft industries, the New England boat industries were built from this investment. After the war it was these industries that built a new world economy based on transportation - before WW II, cars, airplanes, cargo ships pretty much didn't exist, after WW II they quickly became ubiquitous. At the same time, during and immediately after WW II, a huge fraction of the world's population was killed in warfare, in the Japanese occupation of Asia, in the German occupation of Eastern Europe, in the pogroms of Stalin, Mao, Khmer Rouge. All told, something like 75 million people died during this period, roughly 4% of the world's population.

What will politicians do? Imagine for a bit that you're a politician. Who would you rather be, "Do nothing Hoover," who lost his bid for re-election, sent his republican party into the wilderness for 20 years, and went down in history as the president who caused the Great Depression; or Franklin Delano Roosevelt, who got us out of the Great Depression, Saved Capitalism, Destroyed Fascism, Made the World Safe for Democracy, and Created Social Security? For a politician, doing anything is better than doing nothing, a war is hugely preferable to being summarily thrown out of office. Besides, politicians are almost always reelected during a war - so much so that we had to change our constitution.

Where are we headed? There are many of us who fear that government spending programs will prove ineffective, just as Obama's $700 million stimulus package has failed to turn the economy around. We fear that the precipitous drop in the value of the Euro will either prove ineffective, or will move us towards trade barriers and trade warfare. We fear that a decade long depression will lead to social unrest (already started in Spain and Greece), a demand for law and order, and totalitarian governments, just as they did 80 years ago. We fear that some madman will find some way to throw a match into this growing world-wide tinderbox of unemployment, frustration, fear and anger. We fear that clueless politicians will decide to do something, anything, rather than admit they don't have any answers or solutions. Simply put, we fear World War III.

How will we pull the world out of Great Depression II? I don't know yet, but while I'm wondering, the madmen running Israel, Iran, Pakistan and North Korea are all jumping up and down waving their arms and shouting "Choose Me! Choose Me!"

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