Old Keynesian Dogs, Old Fiscal Tricks

by Gary North
by Gary North

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As a dog returneth to his vomit, so a fool returneth to his folly (Proverbs 26:11).

We are about to be thrown back into the tender mercies of Keynesian economists. In the current setting, this will push the economy lower rather than higher.

The main Keynesian solutions to a faltering economy are federal budget deficits and monetary inflation. This two-part program assumes unemployment at 25% and annual deflation at 10%: the Great Depression in America.

Problem: it's not 1936 any more.

Two recent articles reminded me that the intelligentsia of the United States is like Louis XVIII, the king of France in the post-Napoleonic restoration: he had forgotten nothing and had learned nothing.

What the intelligentsia learned from the popularizers of Keynesian economics after 1936 they have not forgotten. They have learned nothing new.

KEYNESIAN ECONOMICS

The heart of John Maynard Keynes' analysis in 1936 was the idea of a permanent free market equilibrium with high unemployment. For some reason, which he never explained coherently, sellers refuse to lower their prices when faced with buyers who refuse to buy at yesterday's pre-Depression prices. This is especially true of workers who refuse to cut their wage demands.

Keynesianism is based on two fundamental ideas: (1) sellers do not learn that something is better than nothing, and therefore will not lower their selling prices; (2) economists do not learn that government spending that is financed by debt is accomplished in one of only two ways: (a) money lent by savers, which could have been lent to businesses or consumers; (b) money lent by a central bank, which lowers the purchasing power of the currency unit. This is a philosophy of something for nothing.

We are told by economists that there are no free lunches. But, except for Austrian economists, all economists really do believe in something for nothing. They debate with each other about which "something" can be obtained for nothing – "nothing" always being a piece of legislation.

Non-Austrian economists believe that a gun, when held by a salaried government official and pointed at a citizen to extract his wealth, can sometimes produce economic growth, whereas a gun held by a thief and pointed at a citizen to extract his wealth always produces economic loss. The first produces something for nothing, whereas the second produces nothing for something. What is the difference? This: the person holding the gun.

KEYNES AND THE NEW DEAL

Early in Franklin Roosevelt's first term, Keynes met with Roosevelt. We know the date: May 28, 1934. Roosevelt's Secretary of Labor, Frances Perkins, noted in her published recollections that Keynes came out of the meeting and commented on the President's lack of economic literacy. Later, when speaking with Roosevelt, she noted that he said he thought Keynes must be a mathematician, rather than a political economist.

Both men had the other pegged exactly. Roosevelt knew no economics, and Keynes had earned a bachelor's degree in math. He had no degree in economics. He got his job at Cambridge University in 1909 because his father, a Cambridge economist, put up half the money to hire his son.

Because the meeting was in 1934, and because Keynes had not yet come up with Keynesianism – he was still working on it – I do not think the meeting was important for the future of the American economy. Keynes justified in theory in 1936 what every Western government had been doing for several years: printing money, raising taxes, running deficits, and regulating the economy.

The New Deal did not end the Great Depression in the United States. World War II did. The war allowed governments to increase deficit spending, inflate tremendously, impose price controls, draft young men and put them to work killing each other (which reduced the labor pool), and hire women to work in munitions factories at below-market wages, using patriotism to persuade them to enter the labor force. Patriotism was used as a way to persuade men and women to work at what would have been below-market wages in 1938. Then inflation and rationing reduced real wages even more.

Economics teaches this: "When the price falls, more is demanded." This is true of the price of labor. Keynes knew this in 1936, and wrote specifically that the reduced real wage rates produced by monetary inflation would fool workers into going back to work. But it took worldwide deception – wartime wages – to achieve this on a scale sufficient to end unemployment.

None of this is taught in any textbook – not in economics, not in history. To teach it would alert students to the economics of war, which centralizes the power of the State. This is the thesis of economist Robert Higgs in Crisis and Leviathan. This book's thesis and data never get into college textbooks.

With this as background, let me summarize the first of two documents.

TIME MARCHES ON!

In the May 15 issue of Time Magazine, there is an article by Justin Fox. I had never heard of Mr. Fox. His biography on Time's site says he has a B.A. in international relations. He therefore writes for the business section. He has recently published a book, The Myth of the Rational Market. You get the general idea.

Time was started in 1923 by Henry Luce (Skull & Bones, Council on Foreign Relations). It has long been a popular outlet for the American Establishment. In fact, Time is the news magazine written by the American Establishment in order to shape the thinking of the voters on the Big Picture.

Mr. Fox's enemy is what he perceives as Reaganism.

Economic eras don't last forever, though, and there are signs that the current slowdown is a harbinger of something bigger: an end to America's 25-year love affair with tax cuts and deregulation. A lot of the cracks that have emerged during that time, because of global economic shifts or our own neglect, have become impossible to ignore – stagnant incomes, a federal budget gone way out of balance, soaring energy prices, a once-in-a-lifetime housing crash and growing financial risks in retirement and from health care.

The evidence for a significant increase in American inequality since 1980 is based on tax evidence. But this evidence does not consider money in tax-deferred retirement funds. So, it is questionable.

In any case, the critics offer no evidence that their reforms will eliminate inequality. It does no good to provide a cure until a problem is diagnosed. Why is income more unequal today – if it is – than it was in 1980? Second, was 1980 significantly different from 1940 or 1900? Where is the evidence? Next, where is the explanation? Only after we have both should we – meaning policy-makers – begin suggesting solutions.

So what should be done about income disparity? In an April Gallup poll, 68% of respondents said wealth "should be more evenly distributed" in the U.S. – the highest percentage saying so since Gallup started asking the question in 1984. A smaller majority, 51%, agreed that "heavy taxes on the rich" were needed.

The politics of envy is the politics of this commandment: "Thou shalt not steal, except by majority vote." It is the politics of two wolves and a sheep voting on what to have for dinner. It is alive and well all over the world.

The author then launches an unsubstantiated attack on Reagan's cuts of the top brackets: from 70% to 28%. No mention is made of Kennedy's cuts from 91% to 70%. The economy boomed in both cases.

Then there is the energy crisis. What is needed? Not more production. We need more taxes and more subsidies by federal government.

What makes doing the right thing on energy difficult is that it would almost inevitably involve raising costs now, with higher taxes on oil, increased subsidies for other energy sources or higher energy-efficiency standards for vehicles and homes – or all three. Economists tend to prefer the first of these approaches because taxes on gas, oil or fossil fuels in general tamp demand and allow the market – rather than members of Congress – to sift out the best alternatives.

Interesting, though, to fight global warming, Clinton, McCain and Obama are all in favor of a carbon-cap-and-trade regimen, which would raise the price of fossil fuels just as surely as a direct tax would. Almost in spite of ourselves, we may end up with a semi-rational long-term energy policy. It won't make gas cheaper anytime soon – or perhaps ever – but in the long run, it could strengthen the country's economic prospects.

Several countries have dropped the mortgage-interest deduction in recent years, with no noticeably adverse effects, but there's no indication that any of our presidential candidates are contemplating such a move.

But there's real hope on this front. It is possible to conceive of a system that brings the 47 million uninsured into the fold, improves medical outcomes and costs less than what we've got now. It's possible to conceive of because many other wealthy countries already have such systems. Figuring out exactly how to make universal health care work in the U.S. is a matter better left to its own lengthy magazine article. But if you're looking for big economic change from the next Administration, this is the form it's most likely to take.

This article appeared in the premier Establishment outlet for the American intelligentsia.

My conclusion: get ready for a big dose of the politics of envy.

KUCINICH'S ECONOMIST SPEAKS OUT

There are not many American politicians further to the Left economically than Dennis Kucinich. In a recent interview, his economic advisor, Michael Hudson, provided a detailed and accurate assessment of the problems facing the Federal Reserve System. Then he offered solutions.

You will not like the solutions.

The interviewer knew what questions to ask. The questions centered around the solvency of America's largest banks. The FED is letting them swap bad debt for Treasury debt. Half of the FED's reserves have been swapped for this supposedly AAA-rated paper since last December. This cannot go on much longer.

Problem: this program merely buys time. How will the banks unload this bad paper on suckers? The supply of suckers has dried up.

The Fed's idea was merely to buy enough time for the banks to sell their junk mortgages to the proverbial "greater fool." But foreign investors no longer are playing this role, nor are domestic U.S. pension funds. So the most likely result will be for the Fed simply to roll over its loans – as if the problem can be cured by yet more time.

The financial sector has been living in the short run for quite a while now, and I suspect that a lot of money managers are planning to get out or be fired now that the game is over. And it really is over. The Treasury's attempt to reflate the real estate market has not worked, and it can't work. Mortgage arrears, defaults and foreclosures are rising, and much property has become unsaleable except at distress prices that leave homeowners with negative equity.

The dollar is likely to fall. The problem begins with the international trade system.

When Europe and Asia receive excess dollars, these are turned over to their central banks, which have little alternative but to recycle these back to the United States by buying U.S. Treasury bonds. Foreign governments – and their taxpayers – are thus financing the domestic U.S. federal budget deficit, which itself stems largely from the war in Iraq that most foreign voters oppose.

For over 30 years they have been pressured to recycle their oil earnings into the U.S. stock market and loans to U.S. financial institutions. They have taken large losses on these investments (such as last year's money to bail out Citibank), and are trying to recoup them via the oil market.

But the fact is, a refusal by central banks to buy T-bills is exactly such a structural break in the world monetary system. He thinks this is now happening. So do I. So, I see no way to remain optimistic about the future value of the dollar.

Regional banks will go under, he says. The FED and the government will oversee mergers.

False reporting also will help financial institutions avoid the appearance of insolvency. They will seek more and more government guarantees, ostensibly to help middle-class depositors but actually favoring the big speculators who are their major clients.

Then what should Obama do? Tax and spend.

As president, he will have to do what FDR did, and challenge the financial oligarchy with new government regulatory agencies staffed with real regulators, not deregulators as under the Bush-Clinton-Bush regime. . . .

Most of all, he will have to make the tax system back progressive again if the domestic market is to recover. He should remove the tax-deductibility of interest payments, and do what the original 1913 income tax did: tax capital gains at normal income rates rather than subsidizing speculation. . . .

What about Social Security and Medicare? Simple: exempt every family that makes under $60,000 a year and tax all income for everyone else – no cut-off at $105,000.

There is no deduction from gross income for donations under Social Security. This is just what the centralizers need! This will be Europe's tax system.

He says this will take power away from the American oligarchy. "Unless he does this, what used to be a democracy will be turned into an oligarchy."

Yet Time ran a cover story on just this sort of tax reform. And Time has been the popular news magazine for the oligarchy since its creation in 1923.

CONCLUSION

We are heading into a great reversal. We are going to see rising taxes and a falling stock market. Housing is unlikely to rebound next year.

The economic goal today is to keep what you have in the face of a revived welfare state. The days of wine and roses are going to be rolled back next year and beyond.

June 25, 2008

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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