Keynesianism's Last Stand

Two events took place over the weekend that indicate a revival of confidence in Keynesian economics. The first was the meeting of the G-7 nations in Washington, which was paralleled by a meeting of 15 nations in Paris. The second was the announcement of the Nobel Committee that this year’s prize went to Paul Krugman.

The two meetings concluded that national governments will extend protection against failure to large banks. The British government took over the Royal Bank of Scotland and HBOS. It bailed out one other large bank: Lloyd’s. This will take $64 billion.

The German government announced loan guarantees that may total $540 billion. The payoff: massive changes in equities law.

This is only the beginning. The British government and central bank have pledged a staggering $865 billion in total guarantees, constituting 30% of the county’s GDP. Germany’s total is $681 billion, approximately 20% of the nation’s GDP.

But wait! There’s more!

[German Chancellor Angela] Merkel said crisis-relief measures adopted by governments won’t suffice to calm financial markets over the long term. She renewed her calls for consolidated international action to strengthen the International Monetary Fund’s role in bank supervision, improve the work of credit-rating agencies and increase transparency of financial products.

“It’s high time for the international community to draw the right conclusions from all of this,” Merkel said. “We have already wasted a lot of time” resisting international changes.

What will the total bailout package be for Europe? Preliminary estimates put it at $2 trillion worth of euros. But no one really knows.

The chief economist of Morgan Stanley estimates that the U.S. government’s debt could be $2 trillion in fiscal 2009.

Beginning on Sunday, September 7, when Secretary of the Treasury Henry Paulson unilaterally nationalized Fannie Mae and Freddie Mac, thereby nationalizing America’s mortgage market, until the weekend of October 11, we have witnessed the reversal of the Reagan-Thatcher attempt to reverse the regulatory hand of central governments — rhetoric that was never matched by fiscal measures to back them up.

Keynesianism is back in the saddle again.

This will cripple the horse.


The heart of original Keynesianism was its commitment to government deficits as a way to stimulate consumer demand. Keynes also recommended central bank monetary expansion, but the heart of his economic theory was fiscal imbalance. Somehow, money lent to the central government by private investors would get the economy growing again, whereas this same money, if lent to the private sector, would produce extended depression.

The new Keynesianism is Keynesianism for bankers. The logic of the new version is this:

Banks lend to businesses.Banks lend to other banks.Loss of confidence by bankers regarding bankers has shut down the international credit markets.Governments must run deficits to bail out banks.Central banks should expand the monetary base to liquify frozen banking assets.Banks will then lend to businesses.Businesses will employ workers (consumers).Any government money to consumers will be minimal.

This is the Keynesian version of what used to be ridiculed by liberals as trickle-down economics. It is hailed today as the solution to the credit crisis. The $700 billion bailout of the banks in the United States and the weekend bailout of European banks by European governments constitute the largest Keynesian stimulus package in history. But it was a stimulus of a unique kind: to bail out banks.

The media cheered. Wall Street cheered. Bankers who were managing solvent banks cheered.

The public did not cheer in the United States and did not have time to register any opinion in Europe. The public will pay for all of this, either through taxes to pay off buyers of government bonds or through the inflation tax. In the second scenario, those who hold onto their government bonds will pay the inflation tax imposed on long-term bonds.

In justifying this immense transfer of taxpayer wealth to the commercial banks, politicians have promised a new era of regulation. They have all blamed American regulators for not regulating the securities market. No one is pointing to the main culprit: expansionist Federal Reserve monetary policy under Greenspan, which was matched by central bank policy around the world. Central bankers inflated their national currencies to support the domestic export markets. They did not want the dollar to fall, thereby reducing imports from foreign nations.

It was the mercantilism of central bank policy that produced the asset bubbles, especially the largest one: residential real estate. This is the ultimate carry trade: borrowed short (months or weeks) and lent long (30 years). When it popped, it removed consumer demand around the world.

The International Monetary Fund has predicted worldwide slowdown in 2009, with some nations moving into a recession. This increases the risk of lending to businesses. So, the expenditure of taxpayer money on bank bailouts may wind up supporting government debt. Treasury debt is seen as safe.

The coordinated big bank bailout programs do not solve the carry trade problem. They are designed to get banks lending to businesses. But in a worldwide recession, why would banks want to lend money to businesses? They would prefer to lend money to governments. Politicians like this. They can spend more money this way.

This transfers capital from the private sector to the public sector. It subsidizes government bureaucracies at the expense of productivity. But it is a rational response to recession when the government offers guarantees against bankruptcy. The guarantees are a major source of asset allocation from the private sector to the public sector.


The International Monetary Fund was created under the guidance of John Maynard Keynes at the 1944 Bretton Woods Conference in New Hampshire. There is no more Keynesian organization on earth.

Its 300-page report, World Economic Outlook (WEO): Financial Stress, Downturns, and Recoveries (October 2008) is the most gloomy that I recall. It was accompanied by a 200-page document, Global Financial Security Report. Combined, they constitute 550 pages of bad news.

On all fronts, the authors of the World Economic Outlook report that the world economy is headed for a slump in 2009. “The world economy is decelerating rapidly” it reports. Many advanced nations are moving into recession. The effects of the financial crisis have been limited so far. The tax rebate in the United States helped, and so have the relatively high profits of corporations. “But neither of these factors can be expected to last for very long” (p. xii).

The good news is that recovery will begin in late 2009, the report says. This assumes that U.S. housing will stabilize late in the year. It also assumes that the financial crisis will be solved (p. xii).

We now come to a passage that I did not expect to read in any IMF publication. The IMF guards its language, as most bureaucracies do. This is not guarded language.

It is now all too clear that we are seeing the deepest shock to the global financial system since the Great Depression, at least for the United States. Are we then doomed to a slump in output as occurred in the 1930s? As Chapter 4 shows, the historical record is mixed. Periods of financial stress have not always been followed by recessions or even by economic slowdowns. However, the analysis also shows that when the financial stress does major damage to the banking system — as in the current episode — the likelihood increases of a severe and protracted downturn in activity (p. xiii).

Even more amazing is its assessment of fiscal policy: government spending and debt. How effective is fiscal policy? “The findings are not very encouraging for proponents of fiscal activism. . . .” (p. xiii).

In the “Executive Summary,” there is a section: “Recovery Not Yet in Sight and Likely to Be Gradual When It Comes.” It says that recovery will come in late 2009. It will be “exceptionally gradual by most standards.” This forecast may be overly optimistic, the report admits.

There are substantial downside risks to this baseline forecast. The principal risk revolves around two related financial concerns: that financial stress could remain very high and that credit constraints from deleveraging could be deeper and more protracted than envisaged in the baseline. In addition, the U.S. housing market deterioration could be deeper and more prolonged than forecast, while European housing markets could weaken more broadly (p. xvi).

The report says that public funds will be required to help the banks. The month is not yet half over, and we have seen the biggest banking bailouts in history. The authors add the required calming statement for authorities. They must always be “mindful of taxpayer interests and moral hazard consideration.” As comedian George Goebel used to say half a century ago, “suuuuure they will.” The European bureaucrats announced a $2 trillion banking bailout over the weekend, and stock markets rose on Monday. Moral hazard? It is on a scale never before seen. The transfer of risk to the state was massive. There was no protest.

The policy-makers at the IMF admit that ever since August 2007, the world’s banking system has been unraveling.

Most dramatically, intensifying solvency concerns have triggered a cascading series of bankruptcies, forced mergers, and public interventions in the United States and western Europe, which has resulted in a drastic reshaping of the financial landscape (p. 1).

That landscape was reshaped over the weekend. The governments of Europe followed the lead suggested by Henry Paulson, the former CEO of Goldman Sachs. They nationalized large banks and put the rest on notice that a new era of regulation has arrived. Now the politicians will go to work.

What happened after the collapse of Lehman Brothers in mid-September was a “firestorm” (p. 8). This is not common language in IMF documents.

The annual joint meeting of the World Bank and the IMF was held on October 13. Odd; that was the day after the various joint declarations of the bailout were scheduled on Friday, October 10. What a lucky coincidence! (Or maybe not so coincidental.)

In his speech to the assembled bureaucrats, IMF Chairman Dominique Strauss-Kahn waxed eloquent about the powers of governments and central banks to overcome depressions.

We have tools to manage markets and economies now that we did not have then. We have the will to use them. I am confident that we can emerge from this crisis with our economies and our societies intact.

He said that the managers of the world economy need to do only three things:

We must act quickly.We must act comprehensively and imaginatively.We must act cooperatively.

The great thing, as it turned out, was that the crisis produced the outcome that the IMF had called for.

Second, national plans need to be comprehensive: they must contain guarantees to depositors and assurances to creditors that are sufficient to ensure that markets function; they must deal with distressed assets and provide liquidity; and most importantly they must include bank recapitalization. The Fund has been advocating this for several months. It seems that now we are all of the same opinion.

What is needed is a new era of international government control over capital.

The crisis in financial markets is the result of three failures: a regulatory and supervisory failure in advanced economies; a failure in risk management in the private financial institutions; and a failure in market discipline mechanisms. Preventing a recurrence of these failures will require an international effort, because borders do not confine financial institutions or keep out financial turmoil.

There was no mention of central bank policy as the cause of the crisis. There never is.

Who was in attendance at this meeting? Why, all of those folks who flew over to Washington to attend the G-7 meeting.

We can emerge from this crisis so long as we act quickly, comprehensively, and cooperatively. The Fund will do its part. But much will depend on you: finance ministers and central bank governors, representatives of your countries, to take the actions needed to restore confidence and stability.

We have been set up. The execution of a new world order in finance is now in force.

The best thing I can say for it is that it will not work. It will not last.


Ludwig von Mises in 1912 described what has happened around the world since 2000. Central banks inflate. This stimulates the economy. Then it slows the rate of inflation. This ends the boom in a wave of bankruptcies.

Greenspan inflated, 2000 to 2003. Then he reduced the rate of inflation. Bernanke reduced it further, beginning in February of 2006. That led to the credit crisis of 2007 and today’s credit crisis.

The focus of all parties is on the banking system. Injections of fiat money and government money are justified in the name of saving the banks. The consumers are being ignored. This is not traditional politics. The politicians are not challenging the finance ministers, who are agents of the central banks and the commercial banks. Their job is to protect their special-interest group: the financial sector. They are doing the best they can.

Mises said that the key to understanding the business cycle is to understand what it does to the real economy, what the media refer to as Main Street. The boom lures entrepreneurs into investments that should not be made. Home construction has been the main one over the last half-decade. Then the contraction phase comes. The beneficiaries of the boom become the losers during the bust. I mean on Main Street, not Wall Street. The big banks are the winners in the boom, and in the bust they are bailed out. This is politics in action. Bankers have more clout than voters.


Consumers in the United States still are not facing reality. They need to save. They are still spending and borrowing. But they do not have the confidence that they had a year ago. Their homes are worth less. They have seen the stock market fall. Fear is spreading.

Consumers will change their spending habits over the next year. This will produce losses for industries that had not planned for the crisis to hit. The losses will affect earnings. The P/E ratio need not change for the stock market to fall. If the ratio also declines, as people see dividends rather than capital gains, this will further depress prices.

The symbols of American financial capitalism have gone. Merrill Lynch, whose symbol is the bull, is gone. There are no more major investment banks. It took a bailout from Japan to save Morgan Stanley. Add to this demise of the number-four bank, Wachovia.

The public’s confidence is shaken. I think this will work its way upward to the investors in retirement funds: trickle-up skepticism.

I think we have entered a new phase of stock market investing. People who once told themselves that they would buy more shares if the price ever fell are thinking, “If it ever goes back up, I will sell.” This is a major shift in public perception. It makes major increases in share prices unlikely.

The recession will hit. People will be looking for assets to sell. When they sell, this will produce downward pressure on the price of the assets. This is why recessions are bad for capital assets.

All of this is compounded by the growing threat of war in Iran.


If the weekend joint program by European finance ministers and politicians does not reverse the recession, the financial system will be threatened again. The governments have given it their best shot, massively increasing their national debts.

What will they do for an encore? How will the investing public be reassured if this plan fails to reverse the slide of the stock market as it discounts the accelerating recession?

Keynesianism is getting another test. The world has returned to Keynesianism as its solution. The governments have bet the farm on this weekend move. If it fails to allay fear, as I expect it will, their next move will be more of the same, but with less effect. They have only two policies: more government debt and more fiat money.

October 15, 2008

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

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