The Downfall of Keynesian Economics and the U.s. (part 1 of 3)

There are many similarities between the U.S. economy today and the U.S. economy of the early 1970s. 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 is 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 its most basic form, and then we can relate it to our current economic situation.

The example I’m going to use is not my own. I do not know its 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 sow his 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 fourth 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, 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 role 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