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"We Are Now Paying For The Funeral Of Keynesian Theory"



August 13, 2010 – Comments (5)

Zerohedge with the find:

Eric Sprott: "We Are Now Paying For The Funeral Of Keynesian Theory"


Despite our firm’s history of investing primarily in equities, we’ve spent much of this past year writing about the government debt market. We’ve chosen to focus on government debt because we fear its impact on the equity markets as a whole. Government debt is an intrinsically important part of the financial landscape. It is the bellwether by which we measure risk, and we believe we have entered a new era where traditional "risk-free" assets are undergoing a tremendous shift in quality.

In studying the government debt market, we have inadvertently been led to question the economic theory that most fervently justified recent government spending programs: that of Keynesian economics. The so called "beautiful theory" of Keynesian economics is arguably the most influential economic theory of the 20th Century, shaping the way Western democracies approached the balance between free market capitalism and government initiatives. Like many beautiful theories, however, Keynesianism has ultimately succumbed to the ugly facts. We firmly believe the Keynesian miracle is dead. The stimulus programs are simply not producing their desired results, and the future debt costs associated with funding these programs may cause far greater strife in the future than the problems the stimulus was originally designed to address.

Keynesian economics was born with the publishing of John Maynard Keynes’ "The General Theory of Employment, Interest and Money" in February 1936. Keynesian theory advocates a mixed economy, predominantly driven by the private sector, but with significant intervention by government and the public sector. Keynes argued that private sector decisions often lead to inefficient macroeconomic outcomes, and advocated active public sector policy responses to stabilize output according to the business cycle. Keynesian economics served as the primary economic model from its birth to 1973. Although it did lose some influence following the stagflation of the 1970s, the advent of the global financial crisis in 2007 ignited a resurgence in Keynesian thought that resulted in the American Recovery and Reinvestment Act, TARP, TALF, Cash for Clunkers, Quantitative Easing, etc., all of which have been proven ineffective, ill-advised and whose benefits were surprisingly short-lived.

The economic historian, Niall Ferguson, recently described a 1981 paper by economist Thomas Sargent as the "epitaph for the Keynesian era".1 It may have been the epitaph in academic circles, but the politicians clearly never read it. Almost thirty years later, we now get to experience the fallout from the latest Keynesian stimulus binge, and the results are looking pretty dismal to say the least.

There are a number of studies we have come across that suggest stimulus is the wrong approach. The first is a 2005 Harvard study by Andrew Mountford and Harald Uhlig that discusses the effects of fiscal policy shocks on the underlying economy. Mountford and Uhlig explain that from the mid-1950’s to year 2000, the maximum economic impact of a two percent increase in government spending was an ensuing GDP growth of approximately three percent. A two percent spending increase inevitably requires an increase in taxes. Due to the nature of interest costs, however, the government would have to raise taxes by MORE than two percent in order to pay back the initial borrowing. According to their data, this increase in taxes would generally lead to a seven percent drop in GDP. As they state in their study: "This shows that when government spending is financed contemporaneously that the contractionary effects of the tax increases outweigh the expansionary effects of the increased expenditure after a very short time."2 Stated simply, ‘borrowing to stimulate’ has never worked as planned because the cost of paying back the borrowed funds surpassed the immediate benefits of the stimulus.

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5 Comments – Post Your Own

#1) On August 13, 2010 at 11:35 PM, BMFPitt (79.30) wrote:

Keynesian Theory assumes that you're running a surplus in the good times in order to pay for borrowing in the bad times.  Calling the actions of the past 3 years Keynsian is as absurd as calling the actions of the preceeding 5 the free market.

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#2) On August 13, 2010 at 11:49 PM, ChrisGraley (30.25) wrote:

Keysian Theory also assumes that politicians will be fiscally responsible enough to pursue austerity in the good times.

Feel free to look back however freakin long that you want for an example.

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#3) On August 14, 2010 at 12:06 AM, samual135 (< 20) wrote:

Stimulus is really a wrong approach


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#4) On August 14, 2010 at 8:10 AM, FreeMarkets (97.61) wrote:

BMFPitt: A theory, like Keynesian Economics, that does NOT take into account the actions of people/politicians, is not a very good theory.

This is why the gold standard worked.  Not because gold has any instrinsic value, but simply due to its limited nature.  Politicians couldn't make it and we all know how alchemists tried.

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#5) On August 16, 2010 at 2:01 AM, guiron (< 20) wrote:

It's clear that, just as economists shouldn't talk of the stock market like they know what they're talking about, the reverse is also true.

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