The essential economic problem we confront today is that our dominant Keynesian intellectuals have abandoned reality. They do not grasp what they have wrought with the mountainous loads of debt and malinvestment that are overwhelming us. Much of this burden must be liquidated before genuine demand and growth can be restored, which will require radical reform if we are to evoke a genuine cure.
To try and solve today's debt created crisis with more debt (as the Keynesians are presently doing) can only bring on a bigger bust the next time around, which will require still larger "debt injections" to stave off a still larger crisis. Eventually, the economic implosion will be so monstrous that it can no longer be rectified with "corrective debt injections." Consumers and businesses will have reached their limit. The Keynesian system will have met its Waterloo. Perhaps this denouement has already arrived.
This dilemma began because we altered the creation of money in a profoundly dangerous way with the inception of the Federal Reserve in 1913. Government expansion of the money supply today does not have to be redeemed in gold as the banks' fractional reserve loans were in the 19th century. What the Fed does now is pyramid excessive levels of credit upon totally irredeemable currency. It can print as much money as it wishes, and banks can loan out nine dollars in credit for every printed dollar. The Fed has been creating, over the past 100 years, far more excessive debt than the worst banking systems of the 19th century. This must end in an eventual collapse.
Keynesian rationale, however, maintains that the "total catastrophe" scenario can be averted by use of this credit pyramiding process. The Fed can continue injecting fiat money into the economy indefinitely and thus bring about an expansion of purchasing power for consumers and businesses. Why? Because somebody is always willing to sell bonds to the Fed, and that's all it takes. The Fed prints billions in new money to make the purchases. Liquidity is thus injected into the system, which will eventually recharge all producers and consumers to begin anew the boom cycle. Keynesianism has solved the "total catastrophe" dilemma.
But what Keynesians conveniently ignore is that the fiat money from those bond sales does not become credit until a banker offers it for a loan, and a borrower desires to borrow it. If consumers and businesses become overloaded with debt, and if bankers become worried about prospective borrowers' credit worthiness, then much of that fiat money remains just fiat money. It sits in the banks and does not find its way into the 9-1 fractional reserve lending process whereby $9 in credit is generated for every $1 of fiat money printed by the Fed for its periodic "liquidity / debt injections." In other words, the newly printed money does not so easily expand into mega-purchasing power via Fed credit pyramiding, which is what is needed to bring recovery from a recession.
Therefore, the Fed becomes basically ineffective in its efforts to restore real growth after a deflationary credit contraction that results from consumer and business debt saturation. This is because the Fed's only effective policy tool is the offering of more debt, which is the very poison that is destroying the system. Sure, the Fed can stop the deflation with massive "debt injections," but at what cost? The cost will be either runaway price inflation because of the size and repetition of the debt injections needed, or a pseudo-growth economy where relentless stagflation prevails and the stock market registers nominal gains rather than real gains.
The Wildest Credit Binge In History
Our economy today is so top-heavy with credit and debt that it is unlike all other economies in the past. Keynesians somehow believe that consumers and businesses will continue to borrow still more in face of this. Reason tells us they will not. There has to come a saturation point, and it appears we have reached it with the credit crisis and Dow collapse of September 2008. We have experienced, over the past 43 years, the wildest credit binge in our history. This time the inevitable hangover will be more than a regular hangover.
Because the Fed must fight the economic crisis with massive monetary inflation, the dollar must depreciate disastrously in the upcoming decades. Eventually, holders of U.S. dollars, stocks and Treasury bonds will sell their dollar related investments, which will bring severe deterioration to our economy and to the standard of living that Americans enjoy as either heavy price inflation or prolonged stagflation invade our lives.
In response to all this, our government leaders will continue to put forth an array of market manipulations, financial gimmickry and bailouts for Wall Street such as what we saw with Hank Paulson's Troubled Assets Relief Program (TARP) in 2008. Our leaders will grasp at straws. They will jawbone and delude themselves. They will stonewall and try to dump the more insurmountable problems into the next administration's lap. And, of course, they will continue to relentlessly inject massive debt into the system in hopes of not having to descend into the nastiness of a full-blown depression.
What has worked for the Keynesians for 78 years is now in its death throes. The policies of interest rate rigging and debt injections mixed with confiscatory taxes, which they have used since 1936 to manage their booms and busts, could conceivably have one more stimulatory credit bubble left, but it's doubtful.
Will Credit Reflation Work?
Hopefully the reader is now beginning to grasp that our present economic problems are far more serious than just another "recessionary cycle" in need of reflation. Because many of the debt injections being utilized by the Fed are being monetized (i.e., paid for by printing new money) this must bring price inflation down the road. But Fed and Treasury bureaucrats figure they can get away with such monetization. In fact, they think they can monetize any number of assets (U.S. bonds, mortgage securities, commercial paper, corporate bonds, etc.) and thus stem any deflationary spiral without incurring price inflation in the aftermath. Their reasoning is that afterwards they can then mop up all their injections of liquidity. They can sell the bonds and other assets later, which will withdraw liquidity from the economy. In this way, they can avoid serious price inflation problems in the future.
But three flaws in the Keynesians' reasoning exist. First, the government is buying and / or guaranteeing all kinds of loans and debt paper that no one in the marketplace wants. They are, in essence, buying trillions of dollars of "crappy paper" as the street defines it. But who will buy this crappy paper from the Fed and Treasury when they decide to re-sell it, which they will have to do if they intend to withdraw liquidity from the system later on? The re-sell argument sounds good coming from Keynesian spinners, but it will play out very badly when the time comes to implement it. Crappy paper that has no buyers in 2009 will have the same dearth of buyers in 2015. Time cannot turn dross into gold.
Second, the Keynesian spinners are ignorant of the fact that each succeeding decade in the evolution of a fiat paper money economy requires larger amounts of debt to be floated in order to maintain the same amount of economic growth. (See Keynesianism's Ugly Secret) This means that more and more massive amounts of liquidity will have to be injected in the effort to stave off depression and then withdrawn from the system in order to bring about a cessation of the inflationary pressures building up. These amounts will be far larger than the spinners are anticipating. It sounds plausible to say that all excess monetizations will be withdrawn later on. But it will be very difficult to mop up such massive amounts of liquidity in a smooth and practical manner. And what's more, it will be very difficult to pull the trigger on such withdrawals.
Will the Fed and Congress have the courage to withdraw liquidity from Wall Street in the midst of the most severe economic crisis since the 1930s? Are we to believe that Yellen and the FOMC are going to raise interest rates to American consumers and businesses who are already ignoring record low rates? Very doubtful. Moreover who will determine what constitutes "excess liquidity"? Junkies are the world's worst judges of whether or not they are engaging in excess, and this is who we have running Washington and Wall Street today – "liquidity junkies."
When all is said and done, such a massive injecting and then mopping up of liquidity will bring about a terribly volatile economy in which business calculation is unreliable, capital expenditures measly, real growth nil and countless decisions "politicized" by a growing herd of corporate-banking bureaucrats assuming the role of new economic Czars for the 21st century.
Third, there is the problem of "money velocity." As the massive amounts of liquidity for the bailouts begin to diffuse out into the economy and cause price escalation, consumers will begin to get nervous about the credibility of the dollar. They will perceive the currency debasement taking place and will act accordingly. In other words, they will spend their money faster (thus speeding up the velocity of money), which will create a chaotic inflationary price spiral rather than the productively growing economy anticipated by Keynesians.
The Sinister Inflation Game
This level of ignorance is embarrassing. Keynesians do not understand the sinister nature of the inflation game they are so desirous of playing. They think they can manage its explosive dangers with their sophisticated debt instruments, econometric models, and logarithmic forecasting programs. They overlook the mysterious vagaries of human nature. They are blind to the unpredictable reactions of human beings because they think only in terms of X's and O's on a graph. But society's real economy is comprised of real "human beings" and real "human actions." It is these human beings and their actions that always confound Keynesian central planners.
Here then is the major source of our problem: Keynesian statists in Washington can't grasp that a human economy, like an ecology in nature, runs on natural laws (supply and demand, profit and loss, diminishing returns, Say's Law, etc.). Its hundreds of billions of convoluted emotions, preferences, actions and reactions are self-correcting through these natural laws whenever excesses and miscalculations take place. When bureaucrats intervene into this complex ecology, they cause severe distortions, inflations, malinvestments, shortages, etc., which then require more government interventions, which then create more distortions until the entire ecology becomes stultified and collapses.
Unfortunately, Keynesian bureaucrats have been creating ever-increasing distortions in our economy for many decades, which has now brought us to stultification and collapse. How all this will play out over the long run cannot be known precisely. But a monstrous "government induced" crisis is now upon us, and the wisdom of history says it will not unfold benignly. The structure is too corrupted within. Our policies and perspectives are too warped, our excesses too huge. Too much damage has been done to monetary integrity and ethical propriety. Too many political humbugs and parasites, too many barnacles have accumulated on the ship's hull of our life's energy. The Rubicon was crossed in 1971. When Richard Nixon closed the gold window to the world, he opened the lid to Pandora's Box. He tore down the last prevailing bulwark of economic sanity.