The Keynesian Cult Has Failed: “Emergency” Stimulus Is Now Permanent

The Keynesian Cult Has Failed: “Emergency” Stimulus Is Now Permanent, by Charles Hugh-Smith. This explains an awful lot about the current state of our economies.

The dominant economic theory for the past 80 years is Keynesianism, i.e. the notion that the state and central bank must aggressively manage private-sector consumption (demand) and lending via centrally planned and funded fiscal and monetary stimulus during downturns (recessions/depressions). …

The Keynesian world-view is doggedly simplistic. The economy is based on aggregate demand for more goods and services. People want more stuff and services, and as long as they have the means to buy more stuff and services, they will avidly do so …

The greatest single invention of all time in the Keynesian universe is credit, because credit enables people to borrow from their future earnings to consume more in the present. Credit thus expands aggregate demand for more goods and services, which is the whole purpose of existence in this world-view: buy more stuff.

But credit, aggregate demand for more stuff and animal spirits make for a volatile cocktail. The euphoria of those making scads of profit lending money to those euphorically buying more stuff with credit leads to standards of financial prudence being loosened. In effect, lenders and borrowers start seeing opportunities for profit and more consumption through the distorted lens of vodka goggles.

Artificially low interest rates also fool businesses into making too many capital-intensive investments, because the price of capital (i.e. interest) is low. The economy ends up with mal-investments — non-optimal investments, made only because of the distorted interest rates.

Lenders reckon that even marginal borrowers will earn more in the future and therefore are good credit risks, and borrowers reckon they’ll make more in the future (i.e. the house they just bought to flip will greatly increase their wealth), and so borrowing enormous sums is really an excellent idea — why not make more money/enjoy life more now?

But the real world isn’t actually changed by vodka goggles, and so marginal borrowers default on the loans they should never have been issued, and lenders start losing scads of money as the value of the collateral supporting the defaulted loans (used cars, swampland, McMansions, etc.) falls.

Oh dear! The hangover of credit expansion is brutal, as lenders go bankrupt, wiping out their owners, and borrowers go bankrupt as they are unable to make their payments or sell the collateral to pay off the loan.

Just as credit expansion feeds on itself — everybody’s making a fortune buying and flipping houses, let’s go buy a house or two on credit — the hangover is also self-reinforcing: the value of collateral falling pushes more marginal borrowers into insolvency, and the lenders who made the loans are pushed into insolvency as defaults increase and collateral melts like ice in Death Valley.

Banks and government rule:

In the Keynesian universe, this self-reinforcing contraction of imprudent credit and widespread losses of speculative wealth are Bad Things. Very Bad Things.  Important, Powerful People tend to own issuers of credit (banks), and losses are not something they signed up for.

If all the Little People stop borrowing more money, the Powerful Owners of the credit-issuing machines (banks) can no longer reap enormous profits from issuing more credit, and that is a Very Bad Thing.

As a nasty side-effect of the credit hangover, businesses that depended on people borrowing more money to buy more stuff also shrink, and this contraction is also self-reinforcing: as sales decline, businesses must cut costs to stay solvent, which means laying off employees, abandoning under-utilized offices, closing factories, etc.

The euphoria of credit expansion turns to painful contraction.  Nobody’s happy in the hangover phase, and people naturally cry out, Somebody do something to stop the pain!

This phase started in the GFC of 2008:

The Keynesian answer is simple: the government should borrow and spend lots of money to replace all the money that the private sector is no longer borrowing and spending, and the central bank should lower interest rates and create a lot of new money that private banks can borrow cheaply to loan out to private-sector businesses and consumers.

In the simplistic Keynesian Universe, the credit contraction is like a temporary drought: all the government and central bank have to do to fix the drought is release a flood of new money onto the parched landscape of the credit-starved private sector, and aggregate demand and new loans will blossom like spring flowers.

Horray for central states and banks! Given the power to borrow (or create out of thin air) as much money as they need to flood the private sector with fresh money and credit, the drought ends, animal spirits are revived, people get to buy more stuff by promising to give their future earnings to banks and Powerful Owners of banks are once again earning great gobs of cash from lending to the Little People (i.e. borrowers in danger of becoming debt-serfs, whose earnings go largely to service their debts). …

The problem is always a temporary drought of aggregate demand caused by a temporary drought of private-sector credit, and the solution is always a state-central-bank issued flood of money and credit: the government borrows and spends more money to replace declining private spending, and central banks make it cheaper and easier for private banks to issue new loans to enterprises and Little People.

Banks and government have no incentive to face up to reality.

That this coloring-book ideology no longer describes the problem or solution is incomprehensible to the Keynesians.  That neither “the market” nor “the government” can solve the current set of problems is equally incomprehensible — not just to Keynesians, but to everyone who unthinkingly accepted that the market and/or the state can always fix whatever problems arise. …

But this time around, the drought never ended, no matter how much money was poured into the economy, and the earnings of borrowers stagnated or declined. (Recall that debt is borrowed from future earnings; if earnings decline, it becomes much more difficult to service existing debt, much less borrow more.)

Meanwhile, wages are stagnant or declining for nearly everyone:

If Keynesian stimulus is good for the economy, why not do it all the time? If printing money is good for the economy, shouldn’t counterfeiting be encouraged?

A standard reminder: The world now has the biggest credit bubble ever, both compared to GDPs, and because it is global in reach. Here are the US figures, similar to all the western economies:

David Evans, money supply

The world will eventually return to normal credit or debt levels, around 150% of GDP. Growth and dynamism will return when that happens. But to get there requires a huge credit contraction, which is likely to come either as a very nasty depression or prolonged moderate to high inflation. Central banks will choose the path and the timing, but for the last eight years they have mainly just been staving off collapse while they ponder and learn, and the economy stagnates.