A Chinese proverb known by Americans as the “Chinese curse” says: “may you live in interesting times”. Boy do we live in interesting times. This is a veritable golden age in economic evolution. New theories are being crafted as we speak and old theories that have stood the test of (our short) economic time are being torn down. No theory has come under fire in recent years like Keynesianism. After decades of success, Keynesianism doesn’t appear to be having the same magical effect. Economic theorists are confused. To their dismay (and with all apologies to Sir John Templeton, to whom I promised I would never utter these words) – it’s different this time. Literally.
We are fighting a very rare and wretched economic beast. As Bernanke’s great reflation experiment has ripped higher I have maintained that the hyperinflationists are wrong. Though we appear to have slipped through the hands of the balance sheet depression Grim Reaper, the balance sheet recession continues to nip at our heels. At his side always is his good friend Deflation.
A balance sheet recession is so rare that it has only occurred a handful of times in modern economic times. And thus far, he remains undefeated by all of the powerful economic minds who have stood in his path. In his path today is the great Sir John Maynard Keynes. The global economy has stood behind the theories of Lord Keynes as the economy has tumbled and Central Bankers have literally bet their printing presses on his theories. I fear they are not working and could be setting the table for an even greater catastrophe.
Over the course of the last 75 years governments around the globe have implemented policies of print and spend in times of economic downturns with great success. The truth is – Keynesianism works – in the right environment. It works well when debt is fairly low and organic economic growth is relatively strong, but exponential debt growth becomes an increasing concern every time you print your way out of an economic downturn. The larger the downturn, the larger the response. So on and so forth. If you happen to enter a period of severe irrationality and spending the problems multiply. If the recovery period is not used to pay down debts the problems become exponentially worse. The tipping point comes when the debt burden hinders future economic growth and destroys your ability to spend your way out of any future recessions. It effectively turns into one great pyramid scheme if it you let it get out of hand.
Marc Faber believes we are already there. He refers to the current period in U.S. history as “zero hour” – the point where we have indebted ourselves so deeply that we can’t be trusted to pay off our debts. Perhaps worse, however, is the inability to fend off future economic downturns. Not everyone agrees with this perspective, however.
Paul Krugman argues that the deficit worrying is entirely political. He’s correct to a certain extent, but as someone who loathes politics and understands that money has no political party I can say, without bias, that Krugman is also wrong to a large extent. Krugman argues that the economic downturn caused much of the current budget deficit – as if that somehow justifies it. But therein lies the problem. The prior Keynesian responses became multiplied and directly contributed to the current downturn. 20 years of easy money and accommodative print and spend monetary and fiscal policies have finally boiled over. In essence, we have tried to print and spend our way out of one too many recessions while failing to use the recovery periods to pay down our debts.
The problem is, as the United States economy has matured we have become increasingly confident of future growth and increasingly less fiscally prudent. The following chart shows the decade change in debt, GDP and debt/GDP. What was once a sustainable ratio in the 50’s, 60’s and 70’s has ballooned in the 80’s, 90’s and 00’s. The story in the private sector is largely the same as debt ratios have ballooned in the 90’s and 00’s.
Now, as the recovery remains weak and worries of a double dip increase, Krugman and the other Keynesians are saying we’re not spending enough:
“The point is that running big deficits in the face of the worst economic slump since the 1930s is actually the right thing to do. If anything, deficits should be bigger than they are because the government should be doing more than it is to create jobs.”
Talk about doubling down on a losing bet….The truth of the matter is the U.S. economy is on an unsustainable path and our Keynesian economic responses have been large contributors. As the U.S. economy has matured and growth has slowed our spending has actually picked up pace. As we became more wealthy as a society we began to price-in increasing wealth expansion and with it came more debt – and more risk. That’s all well and good until the revenues begin to fall off a bit and then the debts become a substantial constraint.
Reinhart and Rogoff recently published a paper titled “growth in a time of debt“. They found that debt at 90% of GDP begins to substantially impact future economic growth:
“The relationship between government debt and real gross domestic product (GDP) growth has been weak for debt/GDP ratios below a threshold of 90% of GDP. Above 90%, median growth rates fell by one percentage point and average growth fell considerably more. The threshold for public debt was similar in advanced and emerging economies.”
With the budget expected to reach 95% of GDP this year we are nearing the point of no return. Not only will the public debt severely hinder our ability to grow our way out of the debt crisis, but this continued growth in debt will severely hinder our response to future downturns. Remember, I am not an anti-Keynesian. I simply don’t believe it is applicable in times of a balance sheet recession.
Krugman argues that there is no need to panic about the debts now:
“But there’s no reason to panic about budget prospects for the next few years, or even for the next decade.”
The Rogoff and Reinhart study shows that Krugman is wrong. The time to worry about the deficit is right now. Unfortunately, the Keynesian policies which Krugman has promoted, not only contributed to the current downturn, but severely cripple the U.S. economy going forward. Doubling down or continuing such policies has the potential to create subsequent economic downturns – downturns which we won’t have the option to print a trillion dollars in response to.
My greatest issue with U.S. monetary & fiscal policy over the last decade is a continuing lack of risk management (something, ironically, which is all too prevalent in the money management business as well). We continue to run up massive debts based on false economic growth assumptions. Like the consumer who assumed the 90’s would continue forever, (or the banker who created mortgage backed securities assuming real estate could never decline) we continue to spend assuming future growth will be high and recessions will be rare occurrences. What our policymakers should be asking themselves is how we can best prepare for the worst should the economy grow at a lower than average rate and downturns become more common occurrences. Instead, they continue asking themselves how quickly we can return to the go-go 90’s.
There is little doubt that Keynesianism works in a time of low debt and stable GDP growth, but this balance sheet recession is different. And it requires a different solution. A solution that politicians with short terms in office do not have the stomach (or time) to deal with.
In sum, the idea that you can turn on the debt spigot every time your economy gets into trouble is deeply flawed. The major flaw in the Keynesian approach is that it ignores exponential growth in debts. As a government continually spends and prints to get themselves out of one recession the debt they incur slowly hinders their ability to overcome any impending economic woes. Should they continue to attempt to print and spend their way out of each subsequent recession it becomes a negative feedback loop. The debt hinders future economic growth, the potential for subsequent downturns actually increases and the ability to handle those downturns is severely reduced. If fiscal imprudence continues in times of recovery you end up right where we are today.
Richard Koo, who has helped the Japanese deal with their own devastating balance sheet recession, believes we can spend our way out of this debt crisis. I disagree. At this point, our only option appears to be regulatory overhaul and belt tightening – and for a bloated U.S. economy that could mean substantial short-term economic pain. On the bright side, a little short-term pain will help us in removing the excesses that hinder the economy and will help to lay the foundation for the next great bull market. Unfortunately, the great Keynesian minds of our day continue to push these failed policies and the politicians in charge are unlikely to bite the bullet given their short-term needs for re-election and instant gratification. That likely means we confront increasing chances of facing our own “zero hour” and the more we spend the worse we can expect that event to be.
We live in most interesting times, and unfortunately, they are “cursed” not by the times we live in, but by the people who are crafting the economic policies of the times. This is not the time for more spending. Disastrously , I fear that our flawed response of bailing out the banks has already hindered our ability to recover. It would take a great leader and great economic mind to deviate from the flawed paths we have chosen. Unfortunately, in these “cursed” times neither appears to be in existence.
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