IT’S OFFICIAL: Keynes was Wrong—A Response to Henry Blodget

Yahoo Finance contributor Henry Blodget has, for now, taken the position that Paul Krugman and the Keynesians have it right, austerity doesn’t work.

Look at Greece; it’s austerity plan has kicked off an economic death spiral there.  Lower government spending reduces GDP, which reduces tax revenue, which requires further spending cut, and so on.  To right the problem requires government spending on projects designed to foster economic growth through investment, say the Keynesians. Sign-up for my 100% FREE Alerts

All sides of the economic debate agree on one thing, that is, avoiding the ‘liquidity trap’ in the first place, because, ultimately, someone has to pay during the Kondratiev Winter.  The question, then, becomes a political one, not an economic one.  Who pays?

“In the aftermath of a massive debt binge like the one we went on from 1980-2007, when the private sector collapses and then retreats to lick its wounds and deleverage,” stated Blodget, “the best way to help the economy work its way out of its hole is for the government to spend like crazy.

“Or, rather, if not the ‘best way,’ at least the least-worst way.”

Because the amount of debt from the private sector and government sector has reach levels which strangle economic growth, job creation and real incomes, adding more debt to a system that desperately wants to deleverage is natural behavior among its participants.  Therefore adding direct injections of money into a delevering economy will more likely cause consumer-price inflation and worsen the most important driver of aggregate demand, rising real income.

Economist Hyman Minsky stated in 1982:

Stable growth is inconsistent with the manner in which investment is determined in an economy in which debt-financed ownership of capital assets exists, and the extent to which such debt financing can be carried is market determined. It follows that the fundamental instability of a capitalist economy is upward. The tendency to transform doing well into a speculative investment boom is the basic instability in a capitalist economy.

In other words, participants during an asset boom period of the Kondratiev cycle were tricked into believing wealth could be created through ever-rising stock and real estate prices, driven by debt.  However, following nearly four years of the Winter period on the K-wave and declining asset prices, participants no long have the appetite for speculation (as they now see it for what it always was) and risk.  Those who took on too much got burned.  The mood has changed.

Naturally, the behavior of the consumer/investor has markedly changed, and all media propaganda leveled at consumers don’t square with their personal experience.  Confidence has been lost and the attempt to ‘trick’ the consumer to increase spending without gains in real income growth (further eroded by rising CPI) only serves to infuriate them, increasing the level of distrust for the system.

“Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system but in doing so have had to depart from the assumption of rational economic behaviour …,” Fed Chairman Ben Bernanke wrote in 2000.  “I do not deny the possible importance of irrationality in economic life; however it seems that the best research strategy is to push the rationality postulate as far as it will go.”

Getting back to Blodget.  Further debt won’t ‘solve’ the problem of the tremendous forces of the Kondratiev Winter, but adding debt can impede the process of righting debt levels to match GDP.  How the two reconcile at a more sustainable level is in the hands of the Fed and foreign creditors.  Will savers be punished by the process of debasing the currency, or will debt be cleansed from the system through default or debt jubilee?

In other words, will savers and pensioners be punished by low interest rates and high inflation (for all), or will the lenders accept the loss and reward savers for their prudence?  Real or nominal GDP must decline to match the destruction of debt cleansing from the system.

There is only one other alternative, however, to the undeniable process.  War.  Napoleon and Hitler attempted that route.  Could that be the out for the Fed?

And for Blodget to argue that WWII and the massive government spending to fund the war lifted the U.S. out of the Great Depression is a specious one.  Could we consider that following the conclusion of WWII, the United States was the only significant industrial power not to have had its infrastructure and manufacture capacity destroyed by bombs?

Additionally, in 1944, the U.S. dollar became the world’s reserve currency.  Trade conducted in a currency issued by the only surviving industrial economy open for business on Day 1 of a peacetime economy lifted the U.S out of the Great Depression—despite the debt. Sign-up for my 100% FREE Alerts