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Excellent exposition of Keynesian policy disasters that have ruined the USA

Monday, January 2, 2012 10:54

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(Before It's News)

Robert Genetski has analysed the financial crisis in two excellent articles (this) and (this), in October 2011. Both are worth reading. The conclusion of his second article reads: “As long as policymakers continue to use the Keynesian framework in developing economic policies, the potential for another financial crisis is uncomfortably high.” Now that I've started understanding the dynamics of the federal reserve a little better (particularly with Griffin's talk), I don't think the situation will readily change. What we can therefore expect is not just a financial crisis but a long-term economic crisis in USA, with lukewarm (or negative) real growth, allowing others (like India?) to catch up.

Here are a few colour-annotated extracts from Genetski's first article: How Keynesian Economic Theory Contributed to the Financial Crisis.

EXTRACTS

It has been three years since the worst financial collapse in modern history. Key policymakers dealt with the crisis through the application of the Keynesian economic theory.

Series of Policy Mistakes

The financial crisis resulted from a series of policy mistakes by each of these policymakers. As the financial situation deteriorated in response to each policy mistake, the key players appeared oblivious to why things kept getting worse.

On October 9, 2008, after successive policy moves failed to contain the damage, White House Chief of Staff Joshua Bolten raised an important question: “I just wonder, Hank, why after all the steps we’ve taken to stabilize the market, are the markets not responding?”

Paulson’s response: “Josh, I wonder exactly the same thing.” (Paulson, p. 346).

Ignorant of Alternative Perspective

The reason financial markets failed to respond as these policymakers expected is their decisions were based on a flawed economic theory. Each of the key U.S. players—Paulson, Bernanke, Geithner and President George W. Bush—views the economy from a Keynesian economic perspective. None of these key policymakers were aware of an alternative classical economic perspective, which provides a different interpretation of economic events and how to deal with them.

Keynesian theory assumes when government increases its spending or provides credit to various entities, it adds to the total amount of spending or credit. The alternative classical economic theory assumes government spending and loans come at the expense of private spending and credit. From the classical perspective, a government move to boost spending or credit to one area of the economy simultaneously weakens another area.

A second distinction between the two competing theories relates to monetary policy. The Keynesian view emphasizes the importance of interest rates as a guide to the amount of money or liquidity in the economy. The classical view downplays the importance of interest rates and focuses instead on the amount of money and liquidity in the banking system.

A final distinction between the two theories relates to the role of confidence. The Keynesian view assumes confidence plays a leading role in determining the economy’s performance. In contrast, classical economic theory views confidence as a consequence of economic conditions.

Policymakers consistently relied on a Keynesian perspective to formulate economic policies to deal with the financial crisis. In so doing, they contributed to the financial crisis.

Gathering Economic Storm

From 2001-2005 the Federal Reserve adopted a highly expansive monetary policy. One key measure of money is bank reserves. They are the one measure of money completely under the control of the Federal Reserve. When the Fed creates bank reserves, the banking system transmits the newly created reserves into more spending. From 2001-2005 the Fed increased bank reserves at a 5 percent yearly rate. During 2005 bank reserves were essentially unchanged.

Critical Policy Decisions

Paulson’s discussion of the deterioration in the US economy in 2007 and 2008 is instructive. Throughout he shows how policymakers never considered the slowdown in spending and developing lack of liquidity might be related to Fed policy.

Wrong Call on Confidence

By January 2008 it became readily apparent the economy was getting worse. Instead of looking for the reason liquidity was drying up, Paulson and Bernanke perceive the problem as a lack of confidence. In an attempt to boost consumer confidence, Paulson recommends a $150 billion “stimulus” program including one-time tax rebates and tax breaks to encourage business investment. The idea was to put money in the hands of people so they would spend it.

Keynesian economic theory assumes when government provides people with more money, it raises their confidence and has a multiple effect on boosting spending throughout the economy. Classical economic theory assumes there is no increase in demand from government spending. Instead, government borrowing to fund the spending reduces the amount of credit available to others. The reduction in available credit produces less spending in other areas. This offsets the increase in demand from government spending.

During the spring of 2008, as consumers received and spent their tax rebates, there was a brief increase in demand. Since the market tends to allocate credit to its most efficient uses, policymakers’ decisions to reallocate it to other areas will tend to weaken, not strengthen the economy.

The weakness in the economy throughout the spring and summer of 2008 is consistent with this classical view.

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