The Coming Keynesian Catastrophe


June 9, 2010

(This originally appeared in the Huffington Post on June 9, 2010)

http://www.huffingtonpost.com/nathan-lewis/the-coming-keynesian-cata_b_605661.html


"Keynesianism" is a line of economic thinking that is actually quite ancient but was most recently revived by John Maynard Keynes in the 1930s. The gist of it is that economic problems can be solved by government deficit spending and some sort of "easy money" policy.

Sometimes, government spending actually serves an important purpose. For example, if you have raw sewage pouring into a river, that can be a problem. The government steps in and builds a sewage treatment plant. This costs money, but it can be money well spent.

However, the Keynesians are quite unconcerned whether government spending serves any useful purpose. Keynes himself boasted that when unemployment is a problem, the government should pay people to dig holes, and for other people to fill them up. In other words, total waste. Politicians usually think this is a wonderful idea. They probably have some friends who own hole-digging companies who, if offered an especially remunerative government contract, would be happy to reciprocate with a generous campaign donation. "Stimulus" is a great cover story for old-fashioned patronage and graft.

The effects of this "stimulus" spending are normally rather disappointing, and cease immediately after the money stops flowing. It is also extremely expensive, and often the next step is to raise taxes. These tax increases just depress the economy further, prolonging the recession and prompting the next round of "stimulus" spending. Governments can go around this spending/tax hike merry-go-round for years, even decades, as Japan has done.

Eventually, the government may hit the wall. Already, several countries in southern Europe have reached the point where, due to their uncontrollably large deficits and existing debt loads, their creditworthiness is no longer credible. Quite a lot of disastrous things can happen at this point, but at the very least, the government may insist on a major round of tax increases. This often pushes the economy from stagnation to deterioration to crisis, on top of the government's own fiscal crisis.

In the midst of all this, the central bank pursues some form of "easy money" policy. This can take the form of "lowering interest rates," "quantitative easing," some sort of Monetarist arrangement, or possibly an intentionally weaker foreign exchange rate. The short-term effects of this can be counter-recessionary, but the eventual result is that the currency loses value.

If a currency loses value and wages do not rise in proportion, then obviously workers are being paid less. In other words, they are poorer.

Especially when governments' ability to run big deficits are impaired, the Keynesians tend to lean even more heavily upon their "easy money" lever. In the extreme case, a government may even arrange for the central bank to finance deficits with the printing press.

Politicians also love "easy money" because it doesn't seem to cost anything, and doesn't require a difficult legislative process.

Does this sound familiar? It should. Practically every developed country government on Earth is traipsing down this path.

Let's take a little broader look at what's going on here. Some countries are wealthy and successful, and some are not. Did the wealthy countries become that way by spending enormous amounts on pure waste, and jiggering the currency? It should be obvious that you can't create wealth and prosperity by squandering your wealth on deficit spending, and then jiggering the unit of account. Indeed, if pursued long enough, this would seem a perfect recipe for economic decline.

The Keynesian formula will eventually end in catastrophe. Governments default on their debt, and taxes soar, crushing the private economy. In the midst of this, the currency's value falls, making everyone poorer. In extreme cases, the country may slide into debilitating inflation and even hyperinflation.

Sometimes the dollar gains against the euro and sometimes the euro gains against the dollar. However, for the last decade it has taken more and more dollars and euros to buy an ounce of gold. Both the dollar and euro are falling in value as a result of Keynesian "easy money" policies.

Eventually, the Keynesians are discredited. The same talking heads keep giving the same disastrous advice, but nobody listens to them anymore.

Then what?

A different economic viewpoint is then needed. One based on common sense, or to put it more bluntly, reality. (Economists call this the "classical" viewpoint).

First: Important government services, including welfare programs, should be maintained if possible. However, all forms of government waste, including bloated benefits for public employees, pork contracts handed out to cronies and "bailouts" of the oligarchs, must be curtailed.

Second: The tax code must be reformed so that it presents a tolerable burden for the private sector. For example, let's look at the tax code of Greece. The top income tax rate is 40%, which is about the same as the U.S. However, the 37% rate is effective at an income of only 30,000 euros. In the U.S., the 35% rate applies to income in excess of $372,951. The 27% tax bracket applies at only 12,000 euros! In the U.S., the 28% tax bracket applies at $137,000 for a married couple.

Imagine you are a worker in Greece. You have to pay 27% of all your income above a mere 12,000 euros. Then, with the money left over, you have to pay a 21% VAT.

But it gets worse: Greece also has a 16% payroll tax, paid by the employee, and an additional 28% paid by the employer! When you add it all up, I calculate that the effective aggregate tax rate is about 65% for income over a paltry 12,000 euros. This does not include any additional local taxes. Of course tax evasion is rampant in Greece. Nobody could live there without breaking the law. They would simply perish.

Greece is an extreme case, but other countries may end up in a similar situation after a few more cycles on the spending/tax hike merry-go-round. For Greece and these other countries, a major tax reform will be necessary.

Today, Greece's government is trying to push tax rates even higher. Another 3-4 percentage point increase in the VAT is expected. The likely effect is that tax evasion also rises to compensate, the economy goes from bad to worse, and the government ends up with the same or less tax revenue.

Third: "You can't devalue yourself to prosperity," goes the old saying. Prosperity is based on a stable currency. In the past, this meant a gold standard. During the 1980s and 1990s, currencies floated but remained roughly stable vs. gold. The dollar wavered around $350/oz. through those two prosperous decades. Eventually, Keynesian "easy money" policies will be discarded for some sort of "stable money" strategy.

There you go: moderate spending, moderate taxes, and a stable currency. This is the solution to the eventual Keynesian catastrophe. You have to laugh at the obviousness of it. Please remember it, because it will be important some years down the road.