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The Keynesian Illusion

Written on 30 June 2010 by Murray Dawes

The Keynesian Illusion

Obama’s letter to the G20 a few weeks ago imploring Western leaders not to embark on austerity measures to rein in their expanding budget deficits but instead to continue stimulating their economies has been the starting gun to an immense battle between the forces of rational economic management and Keynesian claptrap.

This is a battle full of misinformation and one needs to remain on their toes to see through the fog. Obama’s letter contained some glaring inconsistencies upon closer inspection.

He wanted nations to “reaffirm our unity of purpose to provide the policy support necessary to keep economic growth strong.” He also said that “it is essential that we have a self-sustaining recovery that creates the good jobs that our people need.”

Within those two sentences lies a conundrum for those with the desire to dig. Is economic growth really strong if it needs “policy support” to keep it going? Or is the growth that one sees really the mirage created by government stimulus spending?

Also how could he mention the need for a “self-sustaining” recovery when he has also said that the economy needs more government stimulus to keep it going? The government cannot create a self-sustaining recovery. They produce nothing. They just take money from Peter to give it to Paul. They also have the power to borrow and spend while the private sector is doing something that it has needed to do for years, which is deleverage.

The Keynesian crowd are quite prepared to keep throwing money into a bottomless pit in an effort to create the illusion of growth. They have what seems to be a strong argument because the illusion of growth that has been created thus far is said to be real growth.

When that growth falters due to the stimulus ending they will point to the slowing growth and say “see, you pulled the stimulus too early and now the economy is weakening again, therefore the reason for the weakness is not enough stimulus”, when in actual fact the initial growth was nothing but an illusion.

Japan is the perfect example of Keynesian theories gone mad. They sit on 200% debt to GDP with plenty of bridges built to nowhere and fantastic roads but stagnant growth and a stock and property market that is still 70-80% below where it was in 1989. When their interest rates turn up again they are going to be in a lot of trouble.

When the world’s economy double dips into recession as I believe it will, you are sure to hear people like Ross Gittins screaming that the world has gone mad and needs to throw trillions of dollars at the problem. Don’t listen to them. They are the last gasps for air of a dying philosophy.

European leaders thankfully ignored Obama’s letter and have signalled to the market their willingness to cut deficits going forward so that their debt spiral can perhaps get under control. This is not necessarily the end of the matter. By cutting deficits they will affect their growth going forward and will increase the chances of falling back into recession. This will in turn affect their debt to GDP ratios (via the lower GDP denominator) regardless of whether they are getting their deficits under control. They are not out of the woods yet.

An interesting table that I found on Mish’s Global economic trend analysis blog shows the total level of indebtedness of the major economies:

Japan stands out like a sore thumb as mentioned above, but it is very interesting to note that Britain is right up there too.

So how does this stack up in History? I mean, so what if the average debt to GDP is 300%. That might be chicken feed and we should push it to 1000%!

Well I think this chart says it all:


If we are to believe in the theory of mean reversion then we must be getting close to the mother of all inflection points in this chart. When it does turn there will be nothing with the power to stop it. Not even the Fed.

There is no doubt that the Fed will jump into action again and monetise the debt by creating mountains of money, but I don’t believe they will be able to create enough money to cover the immense deleveraging the system needs. The amount of money creation necessary will create immense problems for them down the track anyway.

Last night’s price action in the States with the S+P 500 falling 3% has left the markets teetering on the edge of some very important technical levels. With Economic leading indicators all turning south recently the stage is set for the market to crack and have another large leg down. The next level of support in the ASX 200 below the recent lows of 4175 is 3900. If the market can’t hold there then we could be heading towards the lows from last March of 3120.

ASX 200 daily chart


Click here to enlarge


The last 6 months range appears complete and a failure below the recent lows is very bearish and spells the end of the bull market (which I believe was just a bear market rally) from March last year. The secular bear market remains in place and the rally is being shown for what it is; A government lead inflation based on Keynesian principles which was doomed to fail from the outset.

As Bill Gross the Managing Director of Pimco, which manages the world’s largest bond fund, recently said in his June investment outlook, “Investors must respect this rather tortuous journey in the months and years ahead for what it is: A deleveraging process based upon too much debt and too little growth to service it.”

Murray Dawes
For Money Morning Australia


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18 Comments For This Post

  1. Nick Says:

    a conspiracy theory is only a conspiracy theory until it comes true.


  2. cb Says:

    Drew – fresh response to you under the Gold thread. Let me know if, and when, you have written. Ta.

  3. cb Says:

    Nick = Oh, yes, and our mf babyfaced little turd of a rudd has been at the forefront of trying to sell this country out. Let us see whether and how his treachery will be rewarded by the international Commissariat where he was so anxious to ingratiate himself and your cost and mine.
    Pheeeeeewwww … I spit in his face.

  4. Drew Says:

    Reply ready for you cb.

  5. puntpal Says:

    but for anti-keynesians you need to develop something better than ‘creative destruction’…the free market alternative of letting things collapse is not tolerable for politicians.

    I think there has to be a strengthened safety net…not concerned that is distorts the transision of the unemployed, because that subsidy allows honest people to live with dignity while they look for work and that money is better spent there than many other areas.

    I think Keynsianism stimulus spending that builds things with taaxpayers money and keeps consumers spending handouts – which is crap there to create a mirage of growth – needs to be seperated from the basic safety net.

  6. puntpal Says:

    p.s. this was an excellent piece!!!

  7. peter fraser Says:

    PuntPal I don’t understand, can you expand on that please.

    Actually Keynes didn’t encourage government deficits except when necessary to stimulate the economy.

    Constant government deficits was not something he advocated, therefore governments should have had a surplus prior to the current crisis. The fact that they did not, is not something we can lay at the feet of JM Keynes.

  8. KP Says:

    “”because that subsidy allows honest people to live with dignity while they look for work “”

    Worst thing possible, the crack in the door that lead to the floodgates we have now with Govts talking 70% tax.

    Those workers could have taken out private unemployment insurance, a semi-compulsory system like South Africa has, or relied on relations, friends and charities.

    For Govt to force some people to hand over their hard-earned wages just to pay themselves then hand it on to others who don’t contribute is theft and immoral.

    A bullet for Keynes would have been the best thing possible, considerng the misery he has caused millions of people since. A world run on Austrian lines would be so much further ahead it would be hard to see it.

  9. peter fraser Says:

    Yes KP – things are soooo much better in South Africa – no crime, no unemployment. We can learn a lot from them.

    Or maybe NOT


  10. Abby Says:

    KP made a valid point about having private unemployment insurance.
    Just because South Africa is a screwup (due to its socialist policies and softness on crime i might add) does not mean that every idea out of SA is a bad one. Far from it…

    For one, we in Australia could learn a great deal about how to build dams from the South Africans! (mind you that is a tribute to the ;apartheid’ South Africa where they actually had qualified engineers working for the government)

    Not to mention rugby…

  11. peter fraser Says:

    Abby you can get private income protection cover here. I suspect it is only a few who have the means to afford it in South Africa. Many people do take put cover when they buy a home.

    I believe we have qualified engineers here as well.

    Yes they play rugby and cricket very well.

    What is that semi compulsory scheme he mentioned?

  12. cb Says:

    Drew – I have been thinking of your suggestion of adopting one universal digital currency. I am no expert, but seeing the problems with the Euro, which you give as an example, I am not the only one with doubts whether it would work. My hunch is that the more you concentrate power and influence, the more vulnerable that centre of power becomes to it being hijacked and captured by special interests.

    And that is only for starters. When you factor in the diverse range of economic and labour conditions of the various parts of the world, if anything, a plurality of currencies is probably a must, and the more plurality you have, all the way down to the local and regional levels, the more flexible your system becomes, and the less vulnerable to a whole host of potential problems. Here is a brief interview of Gerald Celente on the very topic, who seems to be voicing some of those concerns.

    As it is, powerful money interests happen to be pushing for just your kind of solution through the SDR. They would love nothing more than having a universal currency like that, as they would then be able to control and dominate centrally the entire world economy. I, for one, distrust concentrations of power, as the more that happens, the more disempowered people become at the local and individual level. That is a definite pattern, and we should try to avoid it, I would say, like the plague.

    It is interesting, though, that the more you and I tend to think of all the issues on this subject, we tend to come to diametrically opposite conclusions. For what it’s worth, my view is that the current trend of globalisation is creating more and more problems, and that polarisation and localisation of issues and systems would serve us all much better. And, in terms of a universally acceptable and workable means of exchange, nothing is going to beat the naturally and universally accepted and trusted real money, which is gold, and silver, both of which represent payment in full and with no counterparty risk, as opposed to any system of IOU’s, be it paper or digital. When you have been paid in something of real, intrinsic value, you have been paid, and that’s that. What you are proposing is that people, businesses and countries be paid in promises. I agree with Celente that nothing of that sort is going to work.

    Human nature is not going to change, so any system of exchange and payment we devise will have to take it as a given. Any system would work with a community of angels, including yours. Alas, where the devil is part of the picture, you gotta be more picky.

    Gerald Celente: Go for the Gold

  13. Abby Says:

    CB, Drew
    I’ve added my two cents worth at the end of the gold article.

  14. cb Says:

    Sandra, Abby – I suspect that this will resonate:

  15. Abby Says:

    absolutely brilliant!! :

    Socialist Pigs
    By Joel Bowman

    Capitalism produces. Socialism distributes. The two systems do not coexist comfortably with one another. In fact, they are inimical.

    Some of the most celebrated champions of socialism have coined terms like “greedy capitalist” or “capitalist pig.” By implication, a socialist is neither greedy nor a pig. But economic history suggests that socialists are just as porcine as their capitalist counterparts…maybe even more so.

    One need only look to the recent goings on in Australia, your editor’s country of birth, for a glimpse into the real world outcomes of this ideological struggle. Kevin Rudd was last week ousted from Prime Ministership after a botched attempt to impose a “super profits” tax on the most productive sector of the Australian economy – the mighty mining sector. We provided a few details in Thursday’s issue:

    “The story is a classic ‘producer vs. parasite’ tale…Rudd, like any other socialist bully would do, attempted to sell the tax to the Australian public under the familiar ‘fair share’ slogan.

    “‘The infrastructure needs of this state are vast and on the existing tax base cannot be funded,’ Rudd told Australian reporters while on a recent visit to Western Australia, the nation’s largest mining state. ‘We say the sector of the economy most able to share a greater part of the burden for funding our infrastructure needs for the future is in fact our most profitable mining companies.’

    “If this sounds like thinly veiled Marxist rhetoric,” we remarked, “that’s because it is. As the founder of that ill fated, though persistently insidious ideology himself famously noted: ‘From each according to his ability, to each according to his need.’”

    One might be forgiven for thinking that, after Rudd’s spectacular political decapitation, replacement Prime Minister, Julia Gillard, would think twice before trying to kill the goose laying all of Australia’s golden eggs. Alas, it was out with one parasite, in with another.

    Ms. Gillard is certainly aware of the research released by the Western Australia Chamber of Commerce and Industry that suggests the “super profits” tax, as it stands, would have erased $4.4 billion and 17,000 jobs from the West Australian economy next year – before the tax was even scheduled to be implemented in 2012. The study further predicts the cost to the state’s economy would have risen each year to total $60 billion and 100,000 jobs lost by 2020.

    And yet…Gilliard revealed her parasitic DNA within hours of nabbing the Prime Minister’s post.

    “I want to make sure Australians get a fair share of our mineral wealth,” she declared, “But we want to genuinely negotiate…”

    Gillard is widely expected to push for a slightly diluted version of the “super profits” tax. “I am throwing open the door to the mining industry,” she said just last week, “and I ask that in return, the mining industry throws open its mind.”

    As warm and fuzzy as those sentiments may be, the fact remains that such featherweight idealisms invariably end up weighing a stone…and that is a burden the strongest, most able members of society are usually expected to shoulder. But theft is still theft…even if it is watered down a tad. Don’t expect the industrialists to take her play-nice politico-doublespeak lying down.

    Although he welcomed the new leadership’s change of tack, Atlas Iron chief executive, David Flanagan, was unequivocal in his assertion that tax must be axed.

    “We’ve been screaming blue murder to anyone who will listen about what the problems are with this tax,” he told The Australian this week.

    Australians have been getting a pretty “fair share” of the local mineral wealth for some time now anyway. Those who risked their capital and bought even a single share of BHP Billiton, Rio Tinto, Fortescue Metals, Atlas Iron et al., were richly rewarded over the past decade as the geologic and geographic blessings of the “Lucky Country” and, more importantly, the efforts and initiative of its mining companies, paid off handsomely. (Of course, China and India’s voracious appetite didn’t hurt, either.)

    In addition to capital appreciation and regular dividends for shareholders, ordinary, working Australians have also exacted what might be seen as a “fair share” of the local resource wealth. Through compulsory contributions to Australia’s Superannuation Fund – a scheme not entirely dissimilar to America’s Social Security, though decidedly healthier…at this point, anyway – working Australians have a large, indirect holding in the nation’s mining giants. Working Australians, therefore, saw the value of their retirement savings appreciate, more or less, alongside the rise and rise of the very companies the “super profits” tax sought to penalize. [Those same workers, not coincidentally, were among the first to see the value of their retirement nest egg shrink as the share prices of the nation's mining companies collapsed after the proposed tax was first run up the national flagpole.]

    Of course, all this is to say nothing of the tens of thousands of hard-working individuals who actually spend their days and nights thousands of feet below Australia’s rusty red surface actually digging the stuff up…and the carpenters, plumbers and electricians who build and service lodgings to house them…and the local businesses that profit from an influx of workers to the region…ect., etc., etc… (Not to mention the exorbitant taxes each and every link in this value chain already pay!)

    After all, a barrel of oil or a ton of coal is worth nothing until it is first brought to market. Invariably, that process takes an immense amount of capital, the expertise to extract said resources and the gumption to actually get one’s hands dirty doing the job.

    At the end of the day, those who deserved a “fair share” of the resource wealth got exactly what they deserved: a share commensurate to the effort they put in. By contrast, those who don’t work, don’t pay into Superannuation, don’t build or service mining towns in some way, don’t risk their capital by investing in those “conspicuously productive” companies; those who don’t actually contribute anything to the process of bringing the product to market at all, get exactly what they deserve: nothing.

    People seem to think that just because they have an emu and a big red kangaroo on their passport they are somehow entitled to a bounty of riches…riches someone else must earn for them, no less. They define a “fair share” as a Divine Right handed down to them the moment they were born – coincidentally – in a resource rich land.

    People of such a mind should consider asking how their poor brothers and sisters are faring in Venezuela, or Mexico, or Iran, or Nigeria or, for that matter, just about anywhere else on the African continent. These lands all enjoy an abundance of natural riches…and an abundance of government involvement in “distributing” the profits. And yet, curiously enough, the people living under these supposedly benevolent regimes are among the most repressed and impoverished on earth. Hmmm…

    Socialist maxims may score high marks for eloquence and pathos; but they score very low marks for economic wisdom. Capitalism produces. Socialism distributes. Without capitalism, socialism cannot function. In other words; socialism needs capitalism.

    Intriguingly, the inverse is not also true. Capitalism has no need of socialism whatsoever. Capitalism distributes wealth by creating opportunity, forged in the crucible of open competition. Capitalism amasses the capital that invests in the enterprises that enable others to advance their financial conditions. Capitalism does not confiscate wealth and redistribute it. Capitalism multiplies wealth…and in the process redistributes opportunity.

    Of course, productivity and wealth creation does not come from penalizing the most productive members of society. It comes from standing aside and allowing them to do what they do best, be that excavating minerals, building cars or growing bananas.

    Left alone, the free market operates as a kind of evolutionary arms race. Companies compete to offer the same product at a better price, or a better product at the same price. Those that cannot keep pace eventually whither and die. Through this “survival of the fittest” process, prices are over time driven down and the quality of goods and services forced higher. In this fashion, those at the lower end of the socio-economic spectrum benefit most from the toils of companies competing to capture their business. And, the best part is that nobody has to steal a penny to pay for it. The “capitalist pigs” will finance the whole operation themselves…if only the safety-net socialists would get out of the way and let them.


    Joel Bowman
    for The Daily Reckoning Australia

  16. cb Says:

    Thanks Abby. You hit the nail right on the head with your comments on gold.

  17. cb Says:

    Drew – I should correct myself. We are fundamentally at one about the absolute need for honest money, that the principle means of exchange should not be vulnerable to becoming a means of exploitation and enslavelment of others. What we are still debating is the best means of implementing a system of sound money that offers the best combination of freedom, convenience and protection against exploitation and fraud.

  18. cb Says:

    sorry, that should be principal means, not principle means.

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