THE BEAR'S LAIR Resurrection of the charlatan
By Martin Hutchinson
The resignation of Japanese Prime Minister Yasuo Fukuda on the grounds that his
"fiscal stimulus" of US$18 billion was inadequate throws into sharp relief a
troubling reality - that most economically counterproductive of activities, the
Keynesian boost in government spending, is making a horrid comeback. Like some
eldritch creature from a 1950s Saturday morning horror serial, the old
charlatan John Maynard Keynes never stays dead.
Even before the Great Depression, Keynes had been seeking some way to make his
mark on economics that involved overturning some part or other of the classical
economic paradigm. Since the world was still primarily on a gold standard, he
couldn't usefully invent monetarism - in any case, he never seems to have got
the hang of interest rates. Denouncing Britain's
1925 return to the Gold Standard was enjoyable, giving rise to numerous witty
epigrams that went down very well with his Bloomsbury friends, but it was not
sufficiently original - too many other economists were doing the same thing.
Since the most enjoyable part of Keynes' career had been his period as a senior
civil servant, it was natural that he should see economic life as best directed
by a team of highly intelligent civil servants like himself. It's a well-known
conceit; sitting in a comfortable armchair one can always see how the world
should be better organized, the only difficulty being how to get oneself
appointed dictator with the power to organize it.
Keynes faced only two problems. First, the existing economic theories
postulated a government that was small in terms of the economy as a whole and
pursued balanced budget policies - so could have little effect on major
economic trends. Second, the political party he supported, the Liberal Party,
was undergoing a series of traumatic election defeats, and was well on its way
to utter irrelevance.
Keynes' work advising David Lloyd George in the run-up to the 1929 election was
seminal. He discovered that politicians, particularly activist ones with little
grasp of economic reality, like Liberal Party leader Lloyd George, were
delighted to be given a rationale for spending more of the taxpayers' money on
social programs, which could be used to bribe voters. While the immediate
result of Keynes' work in the May 1929 election was failure, it left the
Liberals and Keynes as their chief economic adviser in a position of balance of
power. For two years, he could use his powers of persuasion to advance his
theories, while disparaging efforts by the Conservatives and by the cautious
Labour chancellor of the exchequer Philip Snowden.
Keynes' dreams of power came to a sharp end in 1931, with the collapse of the
Labour government. New chancellor of the exchequer Neville Chamberlain
thoroughly distrusted Keynes and cut him off not only from the advisory top
table but from his sources of insider information, which had proved so
lucrative - causing Keynes' net worth to decline by two thirds between 1931 and
1936, even as the market was recovering.
Keynes despised the highly successful Chamberlain economic policies of public
sector pay cuts and a modest tariff, which produced almost immediate economic
recovery and made Britain's 1930s' experience far more benign than America's.
To get his revenge, he flirted with communism and wrote the General Theory of
Employment, Interest and Money - two out of the three of which he knew
very little about. The book was immediately influential among left-leaning
civil servants, and resulted in Keynes's readmission to the corridors of power
when war broke out in 1939.
From then until the 1970s, Keynes was never out of power, in the flesh until
1946 and then in spirit. Much of Britain's postwar poverty and lack of economic
growth were due to his pernicious influence, whether domestically, in ensuring
that government always overspent, or internationally, in setting up the statist
postwar financial system that destroyed the British Empire (by ending Imperial
Preference), gave Britain 30 years of economic stagnation punctuated by balance
of payments crises, and left us with the World Bank and International Monetary
Fund, still blighting the world economy today.
The inflation and slow growth of the 1970s at last caused policymakers to
question the Keynesian synthesis, and in particular its recommendation for
governments to indulge in bursts of public spending every time the economy
slowed. Far from there being a neat tradeoff between unemployment and
inflation, it had become clear that as Keynesian public spending was increased,
economies were very likely to get both, while growth rates became ever-more
sluggish.
To a classically trained economist this was not surprising. Government
spending, as Nobel prize winner James Buchanan was to point out at length
through public choice theory, involves bureaucrats disposing of resources in
ways that suit the bureaucrats, not the owners of the resources. Consequently,
it is much less efficient than private sector spending, automatically optimized
by the resources' owners. Hence diverting resources to the public sector has a
substantial cost in productivity and growth, worsening the tradeoff between
unemployment and inflation.
Using figures from the Organization for Economic Cooperation and Development
(OECD) for public sector size and economic growth you can run a regression for
the period since 1960. You will find that more than half the differences
between countries and eras in growth rates can be explained by two factors: the
size of the public sector and its rate of growth. Very large public sectors
lead to very sluggish economic growth rates, while the fastest growth rates
among OECD members are in countries such as South Korea and Japan before 1990
that have the smallest public sectors. Further, periods of rapid public sector
growth, as in Britain in 1964-79, West Germany in 1969-76 and France in
1974-82, produce sluggish or non-existent economic growth, even if the public
sector early in the period is relatively modest.
The revival of free-marketism in the 1980s and its successes, first in Britain
and the United States, and then with extraordinary results in East Asia, China
and India, appeared to have doomed Keynesianism to a well-deserved irrelevance.
To the extent that "stimulus" was thought necessary, it was carried out by tax
cuts rather than spending increases. These proved equally politically popular
and less damaging to long-term growth. Unless, as in the case of the Reagan tax
package of 1981 and the US dividend tax cut of 2003, the tax cuts had a
substantial supply-side effect; this "Republican Keynesianism" produced
ever-larger budget deficits, which could only be financed through ever-looser
monetary policy.
The "Washington Consensus" of the 1990s, supported even by the naturally
statist World Bank and IMF, notably did not include support for Keynesian
reflation. Indeed, it was largely deflationary, although in deference to its
origins it generally took the existing level of public spending as a given and
balanced budgets through tax increases, rather than the other way around, thus
producing a ratcheting up over time in the size of governments.
In the 1990s, the last bastion of Keynesian public spending was Japan, where
the collapse of the 1980s bubble produced a lengthy recession, worsened by the
refusal of the Japanese banks and their regulators to recognize that most of
their real-estate loans were of little or no value. Stimulus package after
stimulus package was introduced, largely taking the form of infrastructure
projects in rural areas (popular with backbench LDP parliamentarians.) The most
notorious of these, in 1998, was for no less than $400 billion, 10% of Japan's
gross domestic product.
Needless to say, these packages had no positive effect - the 1998 effort indeed
produced a renewed lurch into deeper recession, as free marketers would have
expected. They merely increased the size of Japan's public sector, depressing
the economy's efficiency and long-term growth and caused its public debt to
spiral to over 180% of GDP.
The futility of Keynesian public spending stimuli was demonstrated exhaustively
in Japan in 1990-2001; the success of the opposite policy, cutting back the
size of the public sector and allowing the private economy to expand into the
economic space opened up, was shown by the government of Junichiro Koizumi
after 2001. From the early months of 2003, when the new policies began to take
effect, Japan resumed healthy growth.
As of Koizumi's politically forced retirement in 2006, all that was needed was
an increase in short-term interest rates to prevent inflation and give adequate
returns to Japan's legion of savers, and continuing budgetary restraint, to
reduce the deficit, start paying down the monstrous public debt and return
Japan to the small-government position that had produced such remarkable
economic growth before 1990.
Regrettably Koizumi's retirement produced opportunities for backsliding. His
two successors, Shinzo Abe and Fukuda, tried to maintain his policies but were
less skilful than Koizumi in facing down the public spending barons. At the
central bank, Toshihiko Fukui, the sound-money governor chosen by Koizumi in
2003, stopped increasing interest rates in early 2007 because of an upper-house
election campaign, then wimped out at a crucial meeting in August 2007, as the
cheap-money faction was able to claim that the beginnings of the US subprime
crisis required Japan to maintain low interest rates.
When Fukui's term ended in March 2008, he was replaced by an inflationist, and
Japan's short-term rates are now substantially negative in real terms.
With Fukuda's resignation, and the likely succession of pro-spending Taro Aso,
the path is now clear for Japan to return to primitive Keynesian public
spending, combining it with negative real interest rates in a poisonous
combination reminiscent of 1970s Britain. This will produce one of two
outcomes.
If the Bank of Japan is more inflationary than the Ministry of Finance is
profligate, inflation will soar, reducing the real value of Japan's government
debt, but impoverishing the middle classes and producing long-term stagflation.
Alternatively, if Ministry of Finance profligacy wins out, inflation will not
destroy the value of Japan's public debt quickly enough, and its size will
spiral upwards until the country is forced into default. Not a happy future
either way.
Alarmingly, the return of Keynesian deficit spending is not confined to Japan.
In both Britain and the United States, governments of opposite political
persuasions have found it convenient to spend public money, while excessively
low interest rates have kept the apparent cost of financing their deficits
artificially low.
In both countries, the bursting of housing bubbles produced by
over-expansionary monetary policies have caused governments to invent various
housing bailout schemes, all of which increase public spending without
providing a means to finance it. The resulting recessions, possibly accompanied
in the US by the advent of a leftist government, will cause demands for
additional spending to spiral. The politicians will accommodate these demands,
since memories of the 1970s are now dim, while the more recent memories of the
(temporarily non-inflationary because of innovations in global communications)
something-for-nothing possibilities of 1995-2006 will prove only too alluring.
Eventually deep recession and spiraling inflation will cause even politicians
to realize they have got it wrong. By that stage, however, government will be
taking an even larger portion of the economy than it is currently and long-term
growth prospects will be correspondingly depressed.
"Madmen in authority, who hear voices in the air, are distilling their frenzy
from some academic scribbler of a few years back," said Keynes. One of the very
few times he got it right.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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