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Where does it all end?

Steven Kates

Nov 24 2009

5 mins

Really, what is one to make of this: 

BEIJING, Nov 18 (Reuters) – President Barack Obama gave his sternest warning yet about the need to contain rising U.S. deficits, saying on Wednesday that if government debt were to pile up too much, it could lead to a double-dip recession.

With the U.S. unemployment rate at 10.2 percent, Obama told Fox News his administration faces a delicate balance of trying to boost the economy and spur job creation while putting the economy on a path toward long-term deficit reduction.

His administration was considering ways to accelerate economic growth, with tax measures among the options to give companies incentives to hire, Obama said in the interview with Fox conducted in Beijing during his nine-day trip to Asia.

“It is important though to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession,” he said.

Unemployment keeps rising while jobs disappear. The trillions of dollars that have been poured into various pseudo-infrastructure projects are providing no return on the vast sums of money spent. The increases in public spending, far from giving the economy the slightest momentum, have unmistakeably pulled the economy back. Indeed, the uselessness of the reflation package is becoming so obvious, even the American President, who signed all of this expenditure into law, is beginning to notice. 

The more interesting question, though, is when will the economics profession begin to notice? There are still Nobel Prize winners out there whose only concern with the level of public spending has been that it is not enough. As for the run of the mill economists, populating not the commanding heights of our major economic outposts but those in the trenches on the front line, if this Keynesian reflation turns out to be the economic disaster it is shaping up to be, in what direction will they turn towards next? 

Because, when all is said and done, it is not the debt that is the issue on its own but the palpable fact that the labour market has continued to deteriorate in spite of all of the money that has been spent. Mainstream macroeconomic theory is quite clear on this: economies are driven by demand. When in recession, an increase in public spending will raise the level of output and increase the number of jobs. 

What you see in the labour market in the United States is the clearest evidence one could ever hope to find that the theory does not fit the facts. 

The result is that not only has there been a massive increase in the level of debt – an increase so large it is no longer possible even to think through how it can ever be repaid – but there has also been a major deterioration in the performance of the economy. There is absolutely nothing to show for the vast amounts of money that have been spent. 

In September, Nobel Prize winning economist Paul Krugman was still so confident about the way things were going that he could write that Keynesian economics is now the only game in town. 

The reality is that Keynesian economics is in the process of being so thoroughly discredited that should things continue into the future as they have over the recent past, no one managing an economy will, for at least two generations, consider public spending and deficit finance as the way to deal with a downturn in activity. You can’t keep a bad idea down forever, but it will not be until well past mid-century that such policies would be again able to creep out from under the rocks where they will have gone to lick their wounds. 

Meantime mainstream macroeconomic theory will be in need of radical replacement. Models built around increases in public spending as a counterweight to a slowing economy will obviously have to disappear. What to replace them with will be the next major issue in the development of economic theory. 

We have had as close to a controlled experiment in economics as it is possible to have. If we do not find ourselves rejecting Keynesian economics now and into the distant future, we will have no one to blame but ourselves. 

Meanwhile, back here in Australia, we are moving forward on the strength of a resources boom driven by our exports to China. The Bloomberg report below, published on 24 November, describes the similarities between the Chinese reflation package and the approach used by the Japanese some two decades back: 

China implemented a stimulus package, cut interest rates five times since September 2008 and encouraged $1.3 trillion of lending to boost domestic spending as the global recession curbed demand for the country’s exports. The credit expansion helped the Shanghai Composite Index rally 83 percent this year and home prices in 70 major cities climb at the fastest pace in 14 months in October. [Which economy does this remind you of?] 

The Nikkei 225 Stock Average surged sixfold and commercial property prices in the Tokyo metropolitan area rose fourfold in the 1980s before the bubble burst in 1990, leading to what the Japanese call the ‘lost decade’ of little or no growth. The Nikkei still trades at a quarter of its December 1989 peak. 

Our success relative to others is built not on our own increases in public spending, which are now a debt weight cost to the economy, but on the stimulus package introduced in China. How solid a foundation this actually is only time will tell but the precedents are not good.

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