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The Downfall of Keynesian Economics and the U.S. Alike (Part 1 of 3)
This three part series will look into detail at how
decades of Keynesian based economics have lead us to the current
economic crisis. I will also be identifying what the future
consequences of Keynesian economics will look like, and what that means
for the U.S.A.
There are many similarities between the U.S.
economy today and the U.S. economy of the early 1970’s. I don’t need to
over elaborate on the details of the likeness of the two eras, because
it’s actually the one distinct difference that is going to matter going
forward.
First I would like to take a brief look into some
of the similarities. In 1959 the U.S. entered the Vietnam War. The
U.S. was not well versed in jungle war fare. The war dragged on with no
end in sight while support from the home land was waning. The price
tag, along with casualties, continued to pile up at a very uncomfortable
pace. Quite similar to the war in Iraq today…
Being that taxes are a very unfavorable way to pay
for war, monetary inflation began to run rampant until the U.S. was
forced to sever any formal tie between the dollar and gold. There
wasn’t anything fancy to this situation. It was simply a case where the
monetary base had grown so dramatically, that there was absolutely no
way to back the currency by gold anymore.
The greatest gold bull market in history ensued.
We saw gold soar from $50 /oz to $850 /oz before a man by the name of
Paul Volcker stepped onto the scene as chairman of the Federal Reserve.
More on Mr. Volcker in a second.
Let’s discuss the main difference between then and
now. It is very simple: personal consumer savings. I’m sure you are
very familiar with the analogy of guns and butter. Essentially there is
a maximum amount of economic output that can occur at any time, and the
allocations of the land and resources has to be determined between
industrial out put, and agricultural output. Now it’s obviously not
quite that simple, but you get the idea.
During the Vietnam War, the U.S. was producing
large quantities of tanks, ammunitions, air planes, and all of the other
goods that are essential in fighting a war. They then shipped these
goods to the front, and this contributed, in part, to a trade surplus
and domestic
savings.
There was also a significant amount of private
savings. In the 1970s, the notion of a negative consumer savings rate
would have been laughed at, but times change. Also at this time,
Americans didn’t use their homes as credit cards to buy that new car or
boat.
Banks were flush with the consumers’ savings, and
because of this, they didn’t much have to worry about capital ratios
like they do in today’s economy. They were able to make loans for
investment spending, residential housing, and just about everything in
between. When the war ended, the GIs came home and began doing just
that; taking out loans and spending some of their savings.
At this time, monetary inflation as a result of the
war and the large amount of savings sloshing around in these banks
started creeping into the prices of tangible goods such as metals, food,
and energy. Social Security benefits were rising at an annual pace of
near 10%. The system, much like today, was flush with liquidity. The
difference today is the price at which the money was loaned.
In 1979, Paul Volcker stepped in as chairman of the
Federal Reserve. He realized one important thing, and that was that we
needed to keep faith in the U.S. dollar or the Federal Reserve, along
with the fractional banking system of the United States, would
collapse. Volcker was not necessarily a champion of free markets. His
goal was never to purge the system of excess liquidity, but raising
rates to 20% brings that about as an unintended consequence.
This was a painful choice, but it was much less
painful than the alternative. Mass bankruptcies ensued, and we truly
saw the ultimate weakness of Keynesian economics. That weakness is the
inability to tighten credit standards once the flood gates of easy
liquidity have been opened. A contraction of money and credit in a
Keynesian economy is painful proportionally to the extent of the initial
growth in the monetary base and credit.
It’s the Keynesian school that has, more or less,
driven monetary and fiscal policy since the Great Depression
Keynesian Economics Today
Now one might think that the essential failure of
the Keynesian school of economics as a reason to do something
else…anything else. It sure makes sense to me, and I’m sure it makes
sense to you dear reader, but by now, you are well aware of our ability
as a nation to commit the same dumb mistakes again and again.
At this point I would like to bring these ideas
into present context, but I am going to break down Keynesian economics
into it’s most basic form, and than we can relate it to our current
economic situation.
The example I’m going to use is not my own. I do
not know it’s original author, but it is an example I read in an
economic journal. I apologize that I do not have the original source,
but it is an awesome way to describe Keynesian economics.
In economics, it is often very useful to breakdown
a theory and apply it to an elementary situation. It is very important
to understand this notion, as I will relate back to it throughout the
rest of this essay.
Imagine that there is an economy of just 3 farmers
and a lending unit. Each farmer borrows $100 to sew its land. So at
this point, we essentially have a monetary base of $300.
As with any loan, the farmers must pay interest.
Let’s say the interest is 10% on each loan. All three farmers have a
fine year and produce a significant enough crop to pay back each loan.
The first farmer pays the $110 that he owes. The second farmer pays the
$110 he owes. The problem is that there is now only $80 left in the
monetary base, and there is no possible way for the last farmer to pay
off his loan.
Well, not necessarily. There are two options.
Option one is that the authority can increase the monetary base. Option
two is actually a spin off of option one and essentially carries the
same end result.
Let’s say a forth farmer enters the scene and
borrows a $100 dollars for his crop. Now there is significant funds in
the monetary base for the third farmer to pay off the last loan, but the
forth farmer is left holding the short straw.
You see, the only way to keep a Keynesian economy
growing is to increase the monetary base and/or aggregate credit
outstanding, otherwise there will simply not be enough money to pay back
the due credit.
This scenario regarding the three farmers is a
grossly simplified version of the U.S.’ economy since the great
depression. Please note that when short term lending dried up, our
economy ceased to function properly. Our inability to exist without
lending is a result of decades of Keynesian economics. As always, please
feel free to send in your email questions, but don’t think that through
complex investment derivatives and globalization that this scenario is
suddenly sustainable. I understand that there are many other issues
that factor into this equation, but what you will actually see is that
these investment vehicles and globalization have only postponed the
inevitable and exasperated the system.
The next part of this series will take a deep look
into what roll our trade deficit has played in the growth of our
Keynesian based economy, and how foreign reinvestment of U.S. dollars
into our domestic economy has been our lifeline.
Nicholas Jones
Analyst,
Oxbury Research
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