The Pseudo-Keynesians are Wrong

John Maynard Keynes is credited with the idea that if the government spends more money, it will put more money into the economy and create economic growth.  This would, in turn, help to maintain full employment.

Indeed, any economist could tell you that a greater supply of capital will lead to more investment in new enterprise, which in turn requires more workers.  This is the essence of both “supply-side” and “demand-side” economics.  More money, more resources, more jobs.

Politicians today, most of whom likely never read Keynes’ major work, The General Theory of Employment, Interest and Money, like to use this theory as the backup for the huge entitlement programs, welfare programs and bailouts we have seen for the last seventy years and continue to see today.  The recent “Stimulus Package” and “Bank Bailout” are almost caricature examples of the idea that government spending creates more jobs.

The problem that these pseudo-Keynesians have is that Keynes was talking about deficit spending, not debt spending.  There is a very important difference:

Deficit Spending is spending that is greater than current revenues, but is only temporary.  Either the growth of the economy or later cuts in spending result in a more balanced budget.

Debt Spending is spending that is greater than current revenues, and this expenditure is a permanent fixture, regardless of future government revenues; or it is so great an expenditure that the government must continue paying that debt until well into or even beyond the next economic retraction.

What we have in the stimulus bills today is debt spending, not deficit spending.  This is compounded by another problem:  Keynesian economics works when the government spends from its treasury.  Rather than injecting more money into our economy, the current stimulus is so large that the government must borrow or take money from our economy.  Indeed, the Treasury Department is desperately printing and issuing billions of dollars in treasury notes.  The President’s budget calls for tax hikes and the largest deficit (as a percent of GDP) since the end of World War II.  Hundreds of billions of dollars are being sucked out of the economy in a desperate attempt to pay for both the immediate and long-term costs of spending that has not yet even begun.

This money has to come from somewhere.  There are two places where the government of the United States borrows money: From the Federal Reserve Bank and from the Capital Markets.

The Federal Reserve can only issue so much cash without creating massive inflation (though this does not appear to be a concern to the current occupant of the White House, the Federal Reserve Chair, or the leaders in Congress).  This leaves the government with only one option:  To borrow from the Capital Markets.

When money leaves the capital markets, two outcomes are certain:  A loss of wealth for those in the capital markets (in plain English, the stock market falls), and slower economic growth.  The reasons for both are simple high school economics:  Supply and Demand.  Fewer dollars in the capital markets are chasing the same number of stocks, bonds and other securities causing the value of those securities to fall.  One amount of dollars buys more shares than before simply because there are fewer people with dollars buying.  Rather than dollars chasing shares, shares are chasing dollars, and share prices drop.  The secondary effect of such a situation is the loss of so much wealth results in the devaluation of most people’s retirement savings, as most 401(k) plans and IRAs (as well as many pension funds) are at least partly invested in the securities markets.

This shifting of money from the capital markets to government treasuries also affects the ability of companies to find the capital resources (that is, money) to expand their business.  Since the money is held in the treasury until spent, it has effectively been removed from the economy.  Unlike a bank, which will offer credit on both short and long term basis, government borrowed money is put in a lock box for weeks or months until the program it will fund needs it.  So businesses have less capital with which to buy equipment, employ workers and purchase raw materials for production.  Since the capital is not available, companies must use their savings or borrow money, further straining the credit markets.  All of this means a slowing economy, fewer jobs and lower tax revenues.

So in fact, one can see that greater spending, even when associated with tax cuts, will result in slower growth in our economy.  This is because the government must find its resources from elsewhere (borrowing), resulting in less capital for businesses, which in turn leads to fewer jobs, less demand and less saving and investment.

The surprising nature of the American economy is how incredibly resilient it is.  Despite invasive government regimes that siphon more and more money out of the economy, some of us just have to build new businesses; new empires of capitalism that create jobs and create more wealth.  So despite the poorly conceived actions of government, the erroneous perception that more spending creates more jobs, the counter-productive debt spending, we manage to rebound.

The only manner in which government can help is to increase the money supply.  This does not mean debt spending, or even deficit spending.  Cutting taxes while increasing spending is more productive than increasing taxes, but it still causes a drag on the money supply, since government must borrow to spend.  Rather, there are two really only effective methods for government to increase the money supply:  The first is to cut interest rates, while the second is to cut both spending and taxes.  Each results in more money in the money supply.

If the Obama Administration and the Congress were interested in helping our economy, they would not be borrowing so much money from the capital markets, increasing taxes, and printing more money.  This is a recipe for disaster, as what would have been a long but moderate recession will become a longer and very deep recession.  Rather than create jobs, Mr. Obama’s plan will actually destroy jobs, as dollars move elsewhere to avoid the heavy tax burden which will be placed upon them, further shrinking the supply of capital to build businesses.

Given time, the American economy and the economy of the world will recover.  How long that takes will be a function of how long it takes politicians to realize that government cannot spend its way out of recession.  Rather, government must cut its expenditures, increase the money supply, and accept the fact that some people will lose their jobs, poorly run businesses will close, and financial institutions will fail.  Accepting that as fact, the politicians can end this race down a path of economic self mutilation and put capital resources in the most capable and productive hands:  The entrepreneurs, small businessmen and investors to whom the capital rightfully belongs.