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Keynes can't help us now

Governments cling to the delusion that a crisis of excess debt can be solved by creating more debt.

February 06, 2009|Niall Ferguson | Niall Ferguson is a professor at Harvard University and Harvard Business School, a Fellow of Jesus College, Oxford, and a senior fellow of the Hoover Institution. His latest book is "The Ascent of Money: A Financial History of the World."

It began as a subprime surprise, became a credit crunch and then a global financial crisis. At last week's World Economic Forum in Davos, Switzerland, Russia and China blamed America, everyone blamed the bankers, and the bankers blamed you and me. From where I sat, the majority of the attendees were stuck in the Great Repression: deeply anxious but fundamentally in denial about the nature and magnitude of the problem.

Some foretold the bottom of the recession by the middle of this year. Others claimed that India and China would be the engines of recovery. But mostly the wise and powerful had decided to trust that John Maynard Keynes would save us all.

I heard almost no criticism of the $819-billion stimulus package making its way through Congress. The general assumption seemed to be that practically any kind of government expenditure would be beneficial -- and the bigger the resulting deficit the better.

There is something desperate about the way economists are clinging to their dogeared copies of Keynes' "General Theory." Uneasily aware that their discipline almost entirely failed to anticipate the current crisis, they seem to be regressing to macroeconomic childhood, clutching the Keynesian "multiplier effect" -- which holds that a dollar spent by the government begets more than a dollar's worth of additional economic output -- like an old teddy bear.

They need to grow up and face the harsh reality: The Western world is suffering a crisis of excessive indebtedness. Governments, corporations and households are groaning under unprecedented debt burdens. Average household debt has reached 141% of disposable income in the United States and 177% in Britain. Worst of all are the banks. Some of the best-known names in American and European finance have liabilities 40, 60 or even 100 times the amount of their capital.

The delusion that a crisis of excess debt can be solved by creating more debt is at the heart of the Great Repression. Yet that is precisely what most governments propose to do.

The United States could end up running a deficit of more than 10% of GDP this year (adding the cost of the stimulus package to the Congressional Budget Office's optimistic 8.3% forecast). Nor is that all. Last year, the Bush administration committed $7.8 trillion to bailout schemes, in the form of loans, investments and guarantees.

Now the talk is of a new "bad bank" to buy the toxic assets that the Troubled Asset Relief Program couldn't cure. No one seems to have noticed that there already is a "bad bank." It is called the Federal Reserve System, and its balance sheet has grown from just over $900 billion to more than $2 trillion since this crisis began, partly as a result of purchases of undisclosed assets from banks.

Just how much more toxic waste is out there? New York University economist Nouriel Roubini puts U.S. banks' projected losses from bad loans and securities at $1.8 trillion. Even if that estimate is 40% too high, the banks' capital will still be wiped out. And all this is before any account is taken of the unfunded liabilities of the Medicare and Social Security systems. With the economy contracting at a fast clip, we are on the eve of a public-debt explosion. And similar measures are being taken around the world.

The born-again Keynesians seem to have forgotten that their prescription stood the best chance of working in a more or less closed economy. But this is a globalized world, where uncoordinated profligacy by national governments is more likely to generate bond-market and currency-market volatility than a return to growth.

There is a better way to go: in the opposite direction. The aim must be not to increase debt but to reduce it.

This used to happen in one of two ways. If, say, Argentina had an excessively large domestic debt, denominated in Argentine currency, it could be inflated away -- Argentina just printed more money. If it were an external debt, the government defaulted and forced the creditors to accept less.

Today, America is Argentina. Europe is Argentina. Former investment banks and ordinary households are Argentina. But it will not be so easy for us to inflate away our debts. The deflationary pressures unleashed by the financial crisis are too strong -- consumer prices in the U.S. have been falling for three consecutive months. Nor is default quite the same for banks and households as it is for governments. Understandably, monetary authorities are anxious to avoid mass bankruptcies of banks and households, not least because of the downward spiral caused by distress sales.

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