The Global Failure of Keynesianism

The world’s central banks are playing leapfrog, each trying to ease faster than the other. Since 2008, the world’s central banks have expanded their balance sheets by a staggering $4.7 trillion. The Federal Reserve’s quantitative easing forced the hand of the Bank of Japan, which earlier this week announced that it would double its rate of securities buying, pushing the 10-year Japanese government bond yield down to an all-time low of 0.43%. The Fed’s easing reduced the U.S. dollar’s exchange rate and boosted U.S. exports, largely at the expense of Japan and Europe. With some of Japan’s top export names at risk of bankruptcy, Japan responded with aggressive easing to reduce the value of the yen. Europe is the big loser, and the European Central Bank this week indicated that it might follow suit.

The central banks have been working straight from the playbook that John Maynard Keynes devised in the 1930s, and it has been a dismal failure. They are competing for a stagnant volume of world trade. Quantitative easing has shifted the pain around the world, but it hasn’t restored growth. Once again, the world has to learn the hard way that Keynesian economics fails. It’s disheartening that no major political party anywhere in the world has articulated a clear alternative.

Many conservatives bought into the market consensus, namely that Fed easing would boost asset prices, asset prices would boost consumption, and higher consumption would drive the overall economy. There was an element of self-consolation in this credulity: if the U.S. economy was indeed recovering, it “explains” the Obama victory last November and takes the Republican leadership off the hook for a devastating defeat. The alternative view — that Obama crushed Romney despite a very weak economy — puts the blame on Republican leaders. The fact is that Obama wasn’t lucky. We did a bad job.

Today’s reports from the Labor Department showed the smallest increase in employment in 10 months at just 88,000 and, more importantly, the lowest labor force participation rate since 1979 at just 63.9%. Americans are dropping out of the labor force because they can’t find work. The Shadow Government Statistics website puts the true unemployment rate (the proportion of Americans who could be working but aren’t) at 23%.

Conservatives (along with the market consensus) gave too much credibility to the supposed recuperative powers of the U.S. economy, and put too much faith in the Federal Reserve’s Keynesian machinations. The Fed has bought nearly $3 trillion of Treasury and mortgage-backed securities since the 2008 crisis, accelerating its purchases in recent months, in order to suppress long-term yields and (especially) the yield on risky securities.

Graph of Reserve Bank Credit - Securities Held Outright

That’s boosted the stock market, but–as we have seen from a week of disappointing economic data–not economic growth. As I wrote in Barron’s March 13, the Fed’s largesse has encouraged investors to lever up existing assets with cheap credit, but not to invest in new plant and equipment:

Optimism about U.S. consumers drove employment gains in February. Evidently the wealth effect from rising equity and home prices has spilled over into employment. About two-thirds of the employment growth came in construction and consumer-related services. This is good for stocks. But you don’t need a growth story to explain the improvement in equities. Leverage is driving stocks. The Fed is persuading businesses to re-lever balance sheets but not to break ground on new plants. Cheap leverage favors existing assets. The recovery remains lopsided with investment lagging badly.

Usually the stock market anticipates economic growth, but under the extraordinary regime of quantitative easing, equity prices reflect the cheapness of leverage more than expected earnings growth. That’s why low-volatility sectors with bond-like cash flows (consumer durables, consumer discretionary, utilities) have led the market while capital-goods producers like Cisco and Caterpillar have lagged.

Even the very modest growth the U.S. has managed to sustain during the past two years depends to a great extent on export growth. That might be the biggest contribution the Fed has made to growth; quantitative easing has helped keep the dollar cheap and that has been helpful to exports. The Fed did not target the dollar — Ben Bernanke simply does not think that way. The Fed, rather, targeted the risk composition of investor portfolios (negative short-term rates and long rates depressed by Fed purchases of longer Treasuries are supposed to force investors to invest in brick and mortar). It didn’t work out that way, to be sure; investors are buying existing brick and mortar with cheap leverage rather than investing in new plant and equipment.


FRED Graph

Japan, meanwhile, has gotten the other end of the stick. As the yen rose, Japan’s exports collapsed. Top Japanese names like Sony and Panasonic saw their stock price crater and their cost of credit soar. This forced the Bank of Japan to act aggressively and force down the yen exchange rate.

FRED Graph


Should we fear a catastrophic outcome, as former OMB director David Stockman claims? That is extremely unlikely. There is one great source of strength in the U.S. economy, namely the energy sector. With the United States poised to overtake Saudi Arabia as the world’s largest oil producer by 2020, the U.S. current account deficit is likely to settle in the 2% range, down from the 6% range during the mid-2000s. That will enhance America’s capacity to borrow overseas by reducing the risk of future dollar depreciation. The prospective improvement in America’s current account gives the Federal Reserve and the Obama administration a great deal more slack.

But it is fanciful to expect that energy alone will drive a U.S. economic boom. It’s great for North Dakota and a few other states, and it’s good for the current account balance and the U.S. dollar. We’ve already had a massive decline in natural gas prices and a massive increase in the proportion of our energy coming from natural gas, and the effect on overall economic output is small.

No magic bullet — not the Fed, not the energy boom, not the modest improvement in home prices- — is going to get the U.S. economy out of what Nobel Prize laureate Edmund Phelps calls a “structural slump.” This isn’t a new depression. It’s not even a double-dip recession. It’s just a permanent headache.

Graph of S&P Case-Shiller 20-City Home Price Index

The economy is stagnating, not recovering, and Americans are hurting. Republican leaders are playing small ball against the administration over budgetary issues. Getting out of the structural slump will require radical changes. It will probably take a drastic reduction on taxes on capital income, including corporate profits, capital gains, interest, and dividends to get investment going again. Slashing the defense budget, which has been the great driver of technological advances since the Second World War, is devastatingly wrong-headed by economic as well as national security criteria. Obamacare is killing small business. The National Federation of Independent Business’ Optimism Index remains at recession lows. The biggest negatives cited by small business owners are taxes and government regulation.

Small business optimism report for March 2013


The Republican Party needs to articulate the kind of broad vision for prosperity founded on free markets and American strength that we had under Reagan. Waiting for the pendulum to swing back in our direction just isn’t good enough.

More: Behind the Dismal Jobs Numbers: The ‘New’ Economy Takes Shape

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