The Downfall of Keynesian Economics and the U.s. (part 2 of 3)

In today’s society, the three farmers have, for a while, experienced a period where the monetary base is growing enough to keep up with the debt that needs to be repaid. The problem is that available credit has dried up.

Let’s switch out that farmer with a home buyer today, but keep the farmer scenario present in thought as we move forward. This home owner receives a loan from a bank, which is now a liability for the home owner.

Let’s not forget the savings glut of the Vietnam era. Banks were able to make loans to those who qualified due to large savings. Now banks don’t have that kind of balance sheet so they are forced to package these loans up into mortgage backed securities and sell them to investors.

One large investor of those mortgage backed securities is China. It is sitting on plenty of these MBS in its forex reserves.

So we have many home owners who owe money on their homes. Unlike the farmer scenario where the capital stayed in the economy, the money now sits in the forex holdings of the Chinese because of our massive trade deficit.

In very recent history, this has been fine because China has been taking its excess U.S. dollars and buying MBS, U.S. debt, and other dollar denominated assets. This brings these dollars back into the U.S. economy which is absolutely essential for a Keynesian economy to survive. We are seeing that trend drastically change.

So looking at the three farmers reference, even though the dollars needed to repay the loans leave for a period of time, they had eventually reentered the country. All that’s needed now to keep the Keynesian economy going is for the monetary base to increase through either the printing press or an increase in the aggregate amount of loans.

Another example of a contraction in liquidity resulting in a scare for Neo-Keynesians was the “dot.com” bubble. The monetary base was contracting as a result of the collapse of the dot.com bubble.

To keep the Keynesian economy moving forward, the money supply and loan base needed to grow faster than the liquidity was being destroyed. So a contraction in the money supply was out of the question. Remember what needs to keep this economy going. It needs an increase in the money supply or an increase of loans. Not only were neither of these two things happening, but in fact, the money supply was going the wrong way…according to Keynesian theory.

The members of the Federal Reserve are not idiots, and they definitely understand that for this economy to move forward, something needed to be done, and they took serious action.

They immediately began printing money at a very rapid pace and started slashing interest rates in order for home loans to become more appealing. To add to that, we had the creation of exotic lending instruments in order to get more loans to the already strapped consumer. Also, I’m sure that you are well aware of Greenspan’s speech encouraging consumers to take out ARMs. Easy Al Greenspan was the worst Keynesian of them all.

Hence, we had the beginning of sub prime mortgages. What a great way to keep this Keynesian based economy running a little bit longer…but how much longer?

The Bigger Picture

I have used Keynesian economics to make some points starting with three farmers, then with the housing market, but let’s look at the whole economy now.

Obviously the MBSs in China’s forex reserves are not even close to making up the huge current account surplus that they run. It is based largely upon cheaply produced exports, and what some may call a manipulated currency.

There is also a huge amount of dollars sitting in the reserves of oil exporting nations as well. So what does this have to do with Keynesian economics? It has everything to do with Keynesian economics.

The importance of the notion of the dollars that were initially going into foreign reserves, but eventually returned to the U.S. economy in the form of purchased U.S. treasuries is grossly understated. Let me tell you why.

Once again I would like to refer back to the notion of the three farmers. There was the initial loan of $100 to each farmer. Now imagine that after the loans were distributed, $100 of the $300 leaves the economy. This is the equivalent of dollars flowing to China.

Now the first farmer pays off the $110 and there is only $90 to pay back the $220 that the second and the third farmers owe. Ouch.

Here’s how this is happening. TIC data, which displays net capital flows in and out of treasuries, started showing up negative in recent the last 18 months. This simply means that foreigners were net sellers of U.S. debt. Japan and China led the way selling $23 billion and $14.2 billion respectively. This comes even though these countries are still amassing U.S. dollars. So the dollars are leaving the country, but no longer reentering.

Instead of buying treasuries with those dollars and putting them back into the U.S. economy, they are purchasing tangible assets. This is very apparent with China setting up its sovereign wealth fund.

As the dollar continues to decline, foreigners will continue to be more averse to reinvesting their forex reserves into U.S. treasuries. The problem is that as our current account deficit continues to run in the red, dollars will continue to flow out of the country.

With an economy whose greatest importance is an ever increasing money supply, it is easy to see why the outflow of dollars is so important. So what’s the critical point of our Keynesian economy? This and more in the final issue of this three part series.

Nicholas Jones
Analyst, Oxbury Research