Is Keynesian the answer? If not, why?

[ButterflyBreath]

A friend of mine and I debate a lot on how to get this country out of this financial mess we’re in. Personally, I don’t like debt and feel we should cut spending, otherwise eventually our financial system will crash. Initially I also thought we should tax more as well, but make sure it goes to debt reduction, not expanding the government further. However I do see how that will allow less money for consumers to spend in the economy and could further the recession. So I still feel that we should change the tax system, maybe make large corporations more accountable for taxes and the rich. I wonder if I could say this if I myself were rich though. If it gets down to it, there are many people who could live on less. Anyway, that’s not my question.

My question is this. My friend believes the Keynesian economics thinks we should just borrow and borrow until we create enough jobs and that will return us to a healthy economy. I told him that either there are not enough economists who subscribe to this thinking, or they have thought about it and decided for whatever reason that it wouldn’t work in this case.

He said this is how we got out of the great depression and therefore it will work this time as well. I’m thinking that a lot of things have changed since then and it’s not that simple. We can’t say that because it worked then it will work now. For some reason we are not borrowing more and more. What is the reason? Why did we just now decide that we shouldn’t borrow more? Where do Keynesian economists decide that borrowing line is? If we have decided against it, what is the reasoning? I would think it’s the ability to pay the interest on our debt but he disputed this and I can’t remember what he said.

Any thoughts?

[creaker]

Investopedia explains Keynesian Economics
A supporter of Keynesian economics believes it is the government's job to smooth out the bumps in business cycles. Intervention would come in the form of government spending and tax breaks in order to stimulate the economy, and government spending cuts and tax hikes in good times, in order to curb inflation.

Read more: http://www.investopedia.com/terms/k/keynesianeconomics.asp#ixzz1VfWgK8gh


The problem is we've been practicing Keynesian economics during the bad times but not during the good times (socializing losses and privatizing profits). Basically charging up the credit cards when we are short but not paying them back down when we have extra. And it's not sustainable.

Edited to add: doesn't the fed manipulating interest rates throw this whole model out on it's ear? Why do spending cuts and tax hikes to curb inflation (which would hopefully generate surpluses to pay down debt and build up rainy day funds) if you've already curbed inflation by raising interest rates?

[Zigzagman]

I see the problem as being very different than anything we have previously experienced. On one hand the idea of a short-term boost of public spending to get the economy moving again followed by a cut of public spending would should like a good move but there are roadblocks this time.

If you look at the cause of the housing bubble it was because the Federal Government encouraged banks to make loans they normally wouldn't have done (sub-prime loans). The thinking was poor people could own homes. Sounds great right? As a result housing prices inflated to the point that people couldn't afford to pay their loans.

In a free market these banks wouldn't have made these decisions knowing it would be bad for them, and if there were any banks that did, it would have been nowhere near as catastrophic as it ended up being.

But lets say the banks still made these decisions so what should the Government have done? They should have let the free markets regulate them, if you make bad decisions you go out of business or someone else buys your business etc.. Instead of letting the free market clean out the trash we had a urgent and desperate call for TARP by Bush, Paulson, and all for the same greedy bankers that were on the verge of going bust. We were told that the world we knew would collapse when in fact probably what would have happened is these businesses would have gone bankrupt, the million dollar bonuses would have stopped. Maybe even a few frog-marched to prison (na, I doubt it). By the government intervening they're messing with the free market and rewarding bad behavior. Add on top of that we are engaged in at least two expensive wars and are cutting taxes at the same time? Insane.

So is Keynesian approach the right thing to do? I am not sure anyone knows. I think the only other choice we have now is to step back and suffer the pain of severe recession or even depression (depending on how it affect you as a individual). The wars are not over, taxes are not being raised and it seems everyone is all about cutting.

One major exception in the FED. I am not knowledgeable enough on economic policy to know if what they are doing is appropriate or not.

My question is are the politicians and most households willing to take the real pain for 3-5 years or is it easier to deal with a looong drawn out recession? I think the latter.

Peace

[iris lily]

...One major exception in the FED. I am not knowledgeable enough on economic policy to know if what they are doing is appropriate or not.


[/SIZE]
oh zig, I don't think that the FEDS are knowledgeable enough to know, either. It's all theory.

[freein05]

Well having worked in banking at the time housing was booming I will put forth my experience. I had attended the National School of Real Estates Finance at the University of Wisconsin about 15 years before the real estate boom. My position with the bank I worked for at the time of the real estate bust was Chief Compliance Officer. We were a Fed regulated bank. I would attend meetings at the Federal Reserve Bank in San Francisco. The local Fed people at the low levels were concerned about the crazy real estate financing that was going on. I was too. But our the Feds leader at the time Allen Greenspan was a free market person and believed the markets would correct themselves. They sure did. The leader of our bank and many banks like mine were MBA wizards but had no idea about how a bank should not take on high risks. I think one word can describe them is greedy! The board of directors of most banks also have no idea of risk.

When I left the bank two board members took me out to lunch and asked me how I thought the bank was doing. I told them the bank was growing too fast and depending too much on real estate financing for it's income. I guess my almost 40 years of banking experience meant nothing. Four years later the bank was closed by the Fed. The reasons given were rapid growth and too many bad real estate loans.

As for Zigs comment about banks being encouraged to make loans for housing to people that is true with one exception. The banks were always advised to make sound loans to people who could afford them. But greed set in again and bank management only took the encouragement to make loans and to make sound loans was left in the dust.

I do believe Keynesian economics but I am not sure if a government has the ability to spend enough money to pull a country out of a depression or a deep recession. The money spent during the Great Depression really did not get us out of the depression. It was WW11 and the massive spending on the war that got us out of the depression. I do believe that Keynesian Economics will work with small recessions but a one like we are in now I don't believe it will work it will help. We sure should not be cutting public service jobs that only makes it worse.

[Zigzagman]

Well having worked in banking at the time housing was booming I will put forth my experience. I had attended the National School of Real Estates Finance at the University of Wisconsin about 15 years before the real estate boom. My position with the bank I worked for at the time of the real estate bust was Chief Compliance Officer. We were a Fed regulated bank. I would attend meetings at the Federal Reserve Bank in San Francisco. The local Fed people at the low levels were concerned about the crazy real estate financing that was going on. I was too. But our the Feds leader at the time Allen Greenspan was a free market person and believed the markets would correct themselves. They sure did. The leader of our bank and many banks like mine were MBA wizards but had no idea about how a bank should not take on high risks. I think one word can describe them is greedy! The board of directors of most banks also have no idea of risk.

When I left the bank two board members took me out to lunch and asked me how I thought the bank was doing. I told them the bank was growing too fast and depending too much on real estate financing for it's income. I guess my almost 40 years of banking experience meant nothing. Four years later the bank was closed by the Fed. The reasons given were rapid growth and too many bad real estate loans.

As for Zigs comment about banks being encouraged to make loans for housing to people that is true with one exception. The banks were always advised to make sound loans to people who could afford them. But greed set in again and bank management only took the encouragement to make loans and to make sound loans was left in the dust.

I do believe Keynesian economics but I am not sure if a government has the ability to spend enough money to pull a country out of a depression or a deep recession. The money spent during the Great Depression really did not get us out of the depression. It was WW11 and the massive spending on the war that got us out of the depression. I do believe that Keynesian Economics will work with small recessions but a one like we are in now I don't believe it will work it will help. We sure should not be cutting public service jobs that only makes it worse.

Thanks for the insight, Free. Your comments remind be of a local situation we had in my neighborhood. A small horse farm (150 acres and house) was on the market for $650K near me. My neighbor who is a rancher and heavily in debt (that is the nature of ranching usually) was anxious to get the place or at least a portion of it that joined his place because it had excellent coastal bermuda hay fields and then maybe sell the rest himself. As I said he was heavily in debt with the bank already and equally in debt with private loans as well. He met with a local banker and the banker told him, "sure we will loan you the money, no big deal" and were actually encouraging him to buy with no money down. He was luckily outbid by someone else or he would have aquired the loan - of course with the drought, etc. he is is terrible financial shape now and would be bankrupt now had the purchase gone through.

Sorry to veer off-topic but I thought it was a good example of the banks really pushing these loans without any consideration if they could be repaid or not.

I also agree with your assessment of our present situation. With the mood of the country there is no way that we could spend enough to get us out of this mess and I fear it will go on for a very long time. Not good for workers, businesses, or retirees. I think we really screwed up this time!

Peace

[Rogar]

I have had a similar debate with a friend. One thing that seems to always come up is that QE1 and QE2 did not help the unemployment situation. I think as time has passed and the analysts have had time to digrest things, there is some agreement that it helped. I've read a few articles saying that unemployment might have risen to 16 or 18 percent without them. Reality is that we have no way of knowing. The test was the QEs, but there was no control group to say what really might have happened. But now that the money is mostly spent, seems like we're back into trouble (which may be realted, or not). This is probably where the Krugman camp says it wasn't enough. But I think the general indications are that the stimulus money did help.

I have to say that it seems to me that the money was mis-directed and could have been better spent. I think the theory was to shotgun the money into the economy and assume that the multiplier effect would eventually trickle down to the middle and lower classes. I think what heppened was that the money never trickled down. Corporate profits went up, but they were too afraid to hire. Bank cash reserves went up, but they were too afraid to lend. So the money stayed with those less likely to benefit. Some did help, like the extension of unempoyment benefits. The money would have been better spent with wise planning targeting the unemployed and underemployed. I haven't made a study of it, but I think of the WPA as an example of a program that was successful in the depression years.

The other issue right now is that the ratio of government debt to GDP is at a level that is historically record high. Many economist say that we are at a critical level where interest on government debt starts to drag down the whole economy. As best as I can figure, the big planners have to do much better with any more stimulus money or it isn't the right thing to do. Could be that we are just going to have to ride things out or hope some brilliant politicians can help us find a different way out.

[Dragline]

A Keynesian-type stimulus will not work right now, because the fundamental problems remain unresolved. We are awash in a sea of bad debt in a time of credit contraction. There are only two ways debt is resolved -- via payment or via default. Both need to occur.

When Sweden faced its crisis in the early 1990s, it nationalized the banks, split good debt from bad and allowed the bad to default. Sweden recovered and is in good shape today.

In contrast, when Japan faced its crisis, it tried to hide its debt in zombie institutions and enacted a series of stimulus plans. Japan has not recovered.

Our problem is worse than Japan's, because we do not run a trade surplus like they do, but a huge deficit, which has led to the current debacles.

We have had a lot of misallocated investments related to financial maneuvers by large institutions, particularly following the repeal of Glass-Steagal. As long as the large banks are running our show, we are going to have serious problems. We cannot avoid this problem with any short-term stimulus from Congress and the Fed. It is only putting a bandaid on an infectious wound. The infection will remain.

For a lot of excellent analysis on this read Professor Steve Keen's blog at www.debtdeflation.com. (He's in Australia and has no connection to conservative econs like Michael Boskin or liberal ones like Krugman.)

[Gregg]

I think a Keynesian type of stimulus (as in government spending) could be very effective right now, but ONLY if the money was spent on the right things. Helping shore up corporate profits is not necessarily the right thing. Rebuilding our infrastructure and, as discussed in another thread, massively increasing domestic energy production would accomplish everything necessary to turn the ship, IMO. It would generate enough jobs and domestic spending that the combination should be self-supporting in a relatively short period of time. The benefits would last for generations, not a quarter or two. In other words it would be a long term investment, not simply spending for the sake of spending and hoping it does some good. BTW, it still seems like we should reduce spending for things that do not provide tangible benefits. Fraud in government programs is rampant. Eliminate that. Eliminate the wars and the incredible spending on military weaponry development. Etc.

[Dharma Bum]

Intervention would come in the form of government spending and tax breaks in order to stimulate the economy, and government spending cuts and tax hikes in good times, in order to curb inflation.



But what happens when the bad times become the new baseline? Then you find out you borrowed to artificially prop up your standard of living for a few years and now there is the debt to pay as an additional drag on your new permanent lower income.

[creaker]

But what happens when the bad times become the new baseline? Then you find out you borrowed to artificially prop up your standard of living for a few years and now there is the debt to pay as an additional drag on your new permanent lower income.

I don't think the model applies in economic "climate" change - but just in terms of smoothing out the dips and bumps. I think we've maintained a level that is no longer sustainable in the US and Europe, and the amount of correction required to bring this into alignment keeps growing larger and more unacceptable, which has lead to postponing the inevitable.

I think Keynesian was misapplied by only doing it during the bad times and we're seeing the accumulating mess this has created.

[Dharma Bum]

I think we've maintained a level that is no longer sustainable in the US and Europe

That's my fear. If you are living on $100k a year, $90k that you've earned and $10k that you borrowed every year for the past few years and your company restructures and leaves you making only $80k, the answer is not to borrow even more, $20k, to keep your standard of living the same while you hope your income goes back up. Borrowing more is that much harder to pay back when you are making that much less. Maybe you just need to adjust to a lower income and standard of living.

[Mangano's Gold]

Politics aside, the real answer, if we want to keep our current system, is figuring out how our workforce can be competetive with the rest of the world.

Returning to politics, I think that our fiscal policy should be even more expansive, but that is politically off the table. So I support Ben Bernanke and QEI, II, III, XX. As long as they have a reasonable beleif that they can slow things down, if necessary, I'm okay with them hitting the gas even harder. The most likley scenario is that it does nothing (little harm, little good). The money they are (trying to) push out into the economy isn't going anywhere. It is "trapped".

If there were a magical way to enginner inflation, on balance, I think it would be a good thing. 6% good. 16% bad. But if you try for the former, you may get the latter.

[Zigzagman]

If there were a magical way to enginner inflation, on balance, I think it would be a good thing. 6% good. 16% bad. But if you try for the former, you may get the latter.

I think we are experiencing inflation these days at >6%. Not sure how the government calculates it but I know my dollar is not going near as far as it did 5 years ago. I know the housing has gone down but I haven't seen anything else.

Peace

[Gregg]

Well Zig, the Fed gets to live in that little ivory tower where food and energy prices don't matter. It's a little different for the rest of us.

[Gregg]

Politics aside, the real answer, if we want to keep our current system, is figuring out how our workforce can be competetive with the rest of the world.

In my mind the key is getting our workforce to produce things the rest of the world wants/needs. We can't compete with China producing widgets and wouldn't want to even if we could. Food (meaning something other than just corn) is another matter. Energy could be. When we can trade a bushel of wheat for a barrel of oil I'd say we are on the right track.

[jp1]

That's my fear. If you are living on $100k a year, $90k that you've earned and $10k that you borrowed every year for the past few years and your company restructures and leaves you making only $80k, the answer is not to borrow even more, $20k, to keep your standard of living the same while you hope your income goes back up. Borrowing more is that much harder to pay back when you are making that much less. Maybe you just need to adjust to a lower income and standard of living.

I don't necessarily agree with this, but I think the concept of keynesianism is more that you were living on $100k a year and of that $100k you were spending $20k on a college degree. Now your company restructures and only pays you $70k so you borrow the remaining $30k so that you can continue your lifestyle plus continue your education. Then, by the time your education is done you can now find a new job at $110/year and both continue your lifestyle and pay back the money you borrowed during the couple of years it took to finish your degree.

That said, I think a lot of the stimulus that was spent over the past few years was wasted. Tax cuts for the wealthy weren't the answer. No investment was made by them into anything that produced jobs. Judging from what I've read most of that money went into driving up the prices of precious metals and commodities like basic foodstuffs. Some of the other stimulus spending probably helped the economy, but more long-term useful stuff like energy efficiency/renewable energy, etc should have been done.

Back to my original analogy I think what we got was more of someone who is spending $5k on their education, takes a pay cut and borrows the money to keep up the lifestyle and maybe continues to spend the $5k on their education, but in the meantime continues to spend $20k of borrowed money on frivolous stuff and at the end of their education they will be lucky to get $10k additional income, but that won't even be enough to pay the interest on the student loan.

[Dharma Bum]

I don't necessarily agree with this, but I think the concept of keynesianism is more that you were living on $100k a year and of that $100k you were spending $20k on a college degree. Now your company restructures and only pays you $70k so you borrow the remaining $30k so that you can continue your lifestyle plus continue your education. Then, by the time your education is done you can now find a new job at $110/year and both continue your lifestyle and pay back the money you borrowed during the couple of years it took to finish your degree.


If only. We have been living on borrowed money just to pay the bills. We didn't make enough to cover our expenses even when times were good. Moreover it has never been shown that a dollar of spending equates to increased income. If that was true we'd be all the richer for the trillions of borrowing and spending. I'm sticking with what I said - we were living beyond our means, and our income went down. Borrowing more is just living even further beyond our means with the risk it will be that much harder to pay back.

[jp1]

If only. We have been living on borrowed money just to pay the bills. We didn't make enough to cover our expenses even when times were good. Moreover it has never been shown that a dollar of spending equates to increased income. If that was true we'd be all the richer for the trillions of borrowing and spending. I'm sticking with what I said - we were living beyond our means, and our income went down. Borrowing more is just living even further beyond our means with the risk it will be that much harder to pay back.

Actually I agree with you. Like I said, I don't think keynsianism is, or ever was the answer.

Keynesianism actually has 2 parts. Government borrowing and spending, and loose monetary policy in bad times, and government paying off debt and tighter money during good times. We've only ever done the first half. Ever since Nixon took us off the gold standard in 1971 we've been in a perpetual state of borrow more, spend more, borrow more, spend more. And this had actually started well before nixon took office. Johnson's guns and butter program was what forced nixon to end the gold standard in the first place, since other countries were watching things get out of whack and were redeeming dollars for an ever shrinking amount of US gov't gold.

I only see two ways out of our current situation. One, default on the debt and start over. Two, more quantitative easing or other money printing, thus causing inflation and a significant devaluation of the dollar until the debt is once again manageable. It's pretty obvious that Bernanke will opt for the latter. I have no idea how it's going to turn out but I'm guessing that there will be much unpleasantness along the way.

[Mangano's Gold]

If only. We have been living on borrowed money just to pay the bills. We didn't make enough to cover our expenses even when times were good. Moreover it has never been shown that a dollar of spending equates to increased income. If that was true we'd be all the richer for the trillions of borrowing and spending. I'm sticking with what I said - we were living beyond our means, and our income went down. Borrowing more is just living even further beyond our means with the risk it will be that much harder to pay back.
There is definitely risk, as you suggest. But if growth doesn't return to trend, or close to it, we are in a world of hurt whether or not we spend an extra few trillion trying to right the ship. It's really a matter of picking your risk in an uncertain environment.

[Mangano's Gold]

I only see two ways out of our current situation. One, default on the debt and start over. Two, more quantitative easing or other money printing, thus causing inflation and a significant devaluation of the dollar until the debt is once again manageable. It's pretty obvious that Bernanke will opt for the latter. I have no idea how it's going to turn out but I'm guessing that there will be much unpleasantness along the way.
I share your "I have no idea how it's going to turn out."!

I'd like to add a few things. The Fed has a dual mandate of low unemployment and low inflation. This is generally understood to be a tradeoff (The Phillip's Curve). Given what many many people think is a naturally (currently) deflationary environment and high unemployment, it makes sense for the Fed to push much harder to create employment.

Also, I don't have a link into Bernanke's head but I suspect he makes much less of a distinction between public and private debt than most people do. In other words, governemnt debt is just a subset of the total debt situation. One man's debt (liability) is another man's stash (asset). The problem is that so much of society is buried in debt that it is adversely affecting our economy. The view from 5,000 feet says that the fix is to relieve the overall debt burden, which means a big wealth transfer from lender to debtor. The path is of course inflation. It is just a bad situation, and a dangerous game.