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


Leave a Reply

16 Comments on "The Keynesian Illusion"

Notify of
Sort by:   newest | oldest | most voted

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


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


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.


Reply ready for you cb.

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… Read more »

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

peter fraser

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.

“”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,… Read more »
peter fraser

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

Or maybe NOT–shootings-started.html

peter fraser

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?