09.13.2011 0

The end of Keynes

By Robert Romano — So addicted to credit are Europe’s most troubled governments that without credit expansion, their economies can no longer grow.  This is seen in Greece, where no longer able to spend more than it takes in, in the second quarter, its economy contracted by 7.3 percent.

This addiction is problematic, because so large have the debts of Greece, Portugal, Ireland, and Italy become that credit expansion itself — via annual deficit-spending — has become unsustainable.  Yields on one-year Greek government bonds have moved north of 117 percent, and without the European Central Bank’s printing press, the country can no longer afford to pay its bills.  Default is likely the next step.

Call it Keynes’ growth contradiction: Beyond sustainable levels, public debt drains economic output.

Under John Maynard Keynes’ economic theories, in the midst of an economic downturn, the government is supposed to engage in monetary and fiscal expansion to offset the loss of “aggregate demand” in the economy.

This belief since the 1930’s has led to an explosion of government spending and borrowing all over the world.  In fact, the theory has proven so popular among policy makers in the U.S. that the national debt has increased every single year since 1958.

Eventually, it led to the creation of conditions that made the global credit expansion of the 1990’s and 2000’s possible — sowing the seeds for the inevitable crash that followed.

While Keynes’ theory accounts for economic output as it relates to levels of government spending and the size of the government-created money supply, it fails to consider what happens to those same economies when public debt reaches such exorbitant levels — as has happened today in Europe, the U.S., and Japan.

Europe’s ongoing debt crisis, Japan’s lost decade, and the anemic American recovery today all suggest there is a real upper limit on how large public debt can get before it becomes detrimental to growth.  It is the point when nations can no longer afford to borrow more money to spur growth, because the government’s borrowing needs have become larger than the market’s capacity to service them.

Reality therefore is dealing a crushing blow to Keynes’ central policy prescription — that credit expansion by government is necessary to foster economic growth.  So, what went wrong?

The trouble is the larger the debt becomes, the more of it that needs to be refinanced on a constant basis, and the larger the annual interest payments to creditors become — eating up an ever larger portion of the nation’s wealth on an annual basis.  This means more money needs to be borrowed every year just to keep creditors whole.

So, even at a time when borrowing is ever increasing, less and less of the credit expansion goes to actually spurring growth.  Instead, it is simply used to pay past debts and to prop up financial institutions that lent governments the money in the first place, eating up liquidity and capital that could have otherwise been invested in equities, creating jobs.  It is a cycle of diminishing returns.

This diversion of resources, first to government, and then to financial institutions, is at the heart of today’s economic malaise.  To merely survive, once public debt becomes a drag on economic output, these institutions require ever-larger shares of the nation’s wealth in the form of higher taxes and interest payments, until the moment of national default.

Therefore, a bankrupt government’s final act is to confiscate the remaining vestiges of its society’s wealth in a gambit to save itself from insolvency.  However, since after such confiscation it would still remain incapable of honoring its obligations, default is the only option to honestly deal with today’s crisis.

This is seen today particularly in Europe.  When the Greek debt crisis began in 2010, yields on one-year Greek bonds were just over 2 percent.  Now at 117 percent, borrowing costs have grown by an astronomical 5,700 percent in just a year and eight months.  Greece has raised taxes repeatedly to help with payments to creditors.

But why even bother raising taxes or ramp up on even more borrowing in Greece to attempt to service a €350 billion debt that in reality cannot possibly be paid? Default is inevitable.  The only question is whether stronger members of the European community, including Greece’s creditors in France and Germany, are prepared to deal with its fallout.

Robert Romano is the senior editor of Americans for Limited Government.

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