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

Tyler Durden's picture

Fooled by Stimulus, by Eric Sprott and David Franklin

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.

In a follow-on study, Harald Uhlig estimated that an approximate $3.40 of output is lost for every dollar spent on stimulus.3 Another study on the same subject by C’ordoba and Kehoe (2009) went so far as to say that, "massive public interventions in the economy to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead to a great depression."4

If the conclusions of these studies are even close to being correct, we are now in quite a predicament – not just in the US, but across the Western world. Remember that the 2007-08 meltdown was only two years ago, and as we highlighted in April 2009 in "The Elephant in the Room", the US government has spent more on stimulus and bailouts, in percentage of GDP terms, than it did in the Gulf War, Operation Iraqi Freedom, the Vietnam War, the Korean War and World War I combined.5 All that spending was justified by the understanding that it would generate sustainable underlying growth. If it turns out that that assumption was wrong, have the governments made a fatal mistake?

Another recently published Harvard study looked at stimulus at a micro-economic level and derived some surprising conclusions. Entitled "Do Powerful Politicians Cause Corporate Downsizing?", the authors compiled 232 occasions over the past 42 years when either a Senator or a Representative was voted into a controlling position over a big-budget congressional committee. Unsurprisingly, the ascendancy of the politicians resulted in extra spending in their respective districts – typically in the form of an extra US$200 million per year in federal funds. The researchers examined the economic effects of this increase in spending and found "strong and widespread evidence of corporate retrenchment in response to government spending shocks." The average firm cut back on capital investment by 15 percent and significantly reduced its R&D spending.

Companies collectively operating in the affected state reduced capital investment by $39 million a year and R&D by $34 million per year. Other consequences included increases in unemployment and declines in sales growth.6,7 Yikes!! That is not the response we’re supposed to get from government spending!

The Canadian government’s experience with Keynesian-style stimulus has been no better. The Fraser Institute reviewed the impact of the Government of Canada’s "Economic Action Plan" and found that "the contributions from government spending and government investment to the improvement in GDP growth are negligible."8 They state that, of the 1.1% increase in economic growth between the second and third quarter of 2009, government consumption and government investment contributed a mere 0.1%. Of the 1% improvement in economic growth between the third and fourth quarter of 2009, government investment and consumption contributed almost nothing. In the end, it was actually net exports that were the largest contributor to Canada’s growth. No Keynesian miracle in this country.

Our own findings compare favourably to the academic studies cited above. We looked at government spending and current dollar GDP increases in our ‘Markets at a Glance’ entitled, "A Busted Formula". Our findings, using decidedly un-econometric techniques, showed similar results, and are presented in Table A below. We looked at current dollar increases in GDP as published by the Bureau of Economic Analysis (BEA) and current dollar expenditures and receipts for the US government taken from the Treasury. One current deficit dollar resulted in an increase in current dollar GDP of a mere 10 cents. Again - no miracle Keynesian multiplier here.

If we use the Fed’s own numbers, the impact of debt on GDP is even more dismal. In Chart B below, we present the marginal impact of debt on marginal GDP since 1966 using data from the Federal Reserve. Deficit spending, which has generated smaller and smaller increases in GDP over time, is now generating a negative impact on GDP due to the costs of servicing the debt. The chart suggests we have already entered what PIMCO refers to as the "Keynesian endpoint", where the government can no longer afford to increase debt levels.10 No debt = no stimulus. No stimulus = ???

A more timely epitaph for our Keynesian funeral comes from a recent op-ed piece by Jean-Claude Trichet, President of the European Central Bank, that was published in the Financial Times and entitled "Stimulate No More". In it Trichet states that, "…the standard economic models used to project the impact of fiscal restraint or fiscal stimuli may no longer be reliable."11 He explains that while debt in the euro zone has increased by more than 20 percent in only four years and by 35 to 40 percent over the same time period in the US and Japan, we have very little, if anything, to show for it. We agree. New housing sales are at all time lows, consumer intentions for auto purchases are at multi year lows, the University of Michigan consumer confidence index has turned negative, new jobless claims have started to increase, and the ECRI - a composite of leading indicators - is now forecasting a recession (see Chart C).

Since Keynesian economics is no longer relevant, some are now arguing that tax cuts will save the day. Two of the academic studies we reviewed suggest that tax relief is a much stronger stimulus to the economy than government spending, and under normal circumstances this is probably true. But we are not in a normal economic environment. Even if the tax cuts implemented by George Bush in 2006 are extended by the next Congress, the US will still face the ‘Keynesian Endpoint’. A Government Accountability Office (GAO) report published in January 2010 states the following: "In our Alternative simulation, which assumes expiring tax provisions are extended through 2020 and revenue is held constant at the 40-year historical average; roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020."12 Extending tax cuts won’t solve anything.

In the end, Keynesian stimulus ultimately fooled us all. It roped in the politicians of the richest countries and set them on an unsustainable course of debt issuance. Recent Keynesian stimulus has even managed to fool the sophisticated economic models designed by central banks. The process of accounting for massive government spending ‘confuses’ the models into calculating a recovery trajectory when it doesn’t exist. The Bank of England confirmed this with its announced £3.5 million overhaul of its current model due to its inability to generate accurate inflation and recession forecasts.13

Keynesian stimulus can’t be blamed for all our problems, but it would have been nice if our politicians hadn’t relied on it so blindly. Debt is debt is debt, after all. It doesn’t matter if it’s owed by governments or individuals. It weighs on the institutions that issue too much of it, and the ensuing consequences of paying off the interest costs severely hinders governments’ ability to function properly. It suffices to say that we need a new economic plan – a plan that doesn’t invite governments to print their way out of economic turmoil. Keynesian theory enjoyed a tremendous run, but is now for all intents and purposes dead… and now it’s time to pay for it. Literally.


1 Ferguson, Niall (July 19th, 2010) "Today’s Keynesians have learnt nothing". Financial Times. Retrieved on August 10, 2010 from:
For those interested readers "The Ends of Four Big Inflations" by Thomas Sargent can be found at:
2 Mountford, Andrew and Uhlig, Harald (July 2005) "What are the Effects of Fiscal Policy Shocks" SFB 649 Discussion Paper Humboldt-Universität zu Berlin. Retrieved on August 10, 2010 from:, pg. 20
3 Boskin, Michael. (July 21, 2010) "Obama’s Economic Fish Stories" The Wall Street Journal. Retrieved on August 10, 2010 from:
4 Uhlig, Harald (May 15, 2009) "Some Fiscal Calculus" Unpublished. Pg 13. Retrieved on August 10, 2010 from:
5 Sprott Asset Management, Markets at a Glance April 2009. The Elephant in the Room.
6 Reynolds, Neil. (June 9, 2010) "The Hidden cost of Stimulus programs" The Globe and Mail. Retrieved on August 10, 2010 from:
7 Cohen, Lauren; Coval, Joshua; Malloy, Christopher. (March 16, 2010) "Do Powerful Politicians Cause Corporate Downsizing?" Unpublished. Retrieved on August 10, 2010 from:
8 Amela Karabegovic, Charles Lammam, Niels Veldhuis (March 23, 2010) "Did Government Stimulus Fuel Economic Growth in Canada? An analysis of Statistics Canada Data" Fraser Institute. Retrieved on August 10, 2010 from:
9 We used current-dollar GDP numbers provided by the BEA to determine the marginal impact of deficit spending on GDP. There is no separate data set generated by the BEA, however the number is published in their news releases. It is also worth noting the divergence between reported numbers from the BEA. While the current dollar measurement of GDP decreased by $185.1 billion or 1.3% on 2009, real GDP was widely reported as increasing by 0.1%. This divergence is due to seasonality adjustments in real GDP and the percentage change reported is a blended increase over the 4 quarters in 2009.
10 Goodman, Wes and Reynolds, Garfield (June 8, 2010) "Pimco’s Crescenzi Sees ‘Endpoint’ in Devaluations (Update2)" Bloomberg. Retrieved on August 10, 2010 from:
11 Trichet, Jean-Claude. (July 22, 2010) "Stimulate no more – it is now time for all to tighten" Financial Times. Retrieved on August 10, 2010 from:
12 United States Government Accountability Office. The Federal Government’s Long-Term Fiscal Outlook January 2010 Update (GAO-10-468SP). Retrieved on August 10, 2010 from:
13 Aldrick, Philip (August 10, 2010) "Bank of England overhauls forecast model after errors" Telegraph. Retrieved on August 11, 2010 from:


Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
delacroix's picture

drizzle, drazzle, druzzle drone

SimpleSimon's picture

Keynesian theory enjoyed a run only because politicians saw it as an easy way to enable them to spend more i.e. empower themselves more. 

NOTW777's picture

exactly. it has more to do with politics than economics.

Temporalist's picture

Was going to post the exact same idea.

Bailing out one industry snowballs to any industry that thinks it is TBTF.

Giving politicians free money is like giving an arsonist gasoline, explosives and blasting caps.


MSJChE's picture

+1 to everyone here.

The question is:  is there any way out?  No country has ever dug themselves out of a debt/entitlement hole.  I can't reasonably argue that the public has the neccessary understanding and fortitude to prevent a cataclysmic end to the Keynesian Era.

NotApplicable's picture

Sure there's a way out, repudiation/default.

cossack55's picture

Sure, the neocon mantra "Permanant war for permanant peace". Raytheons babys need new shoes.'s picture

I guess we will have to grow our way out, with wheat. Oil industry is under attack and coal is absolutely destroying the planet. Think, think, maybe buying PDA's or another TV or car will grow us some GDP.

Nope, employment issue there, hard landing coming.

robobbob's picture


2) Pecora commision. people-jail-now

3) ditch all of the progressive BS, NEA, gov unions, EPA, DOI, entitlements. bare essentials only

4) ditch the neocon crap. close the overseas bases, troops home now, only enough bombs to blow up world X1 1/2 times, no more USA world police

5) drill here drill now, mine here, mine now, nuke, nuke, nuke

6) complete revisualization of the US. Nawapa water projects. Turn the western US and northern Mexico into the breadbasket of the world. the future belongs to those with food and water. instead of every bunker for themselves, make it a team effort.

7) massive public transit system high speed rail

8) massive internet connectivity expansion

9) complete scraping of deweys craptastic PU-blic edumacation system.

ColonelCooper's picture

At this point I can go for, "robobob 2012". 

Geoff-UK's picture

Way out=default via inflation.  Banks will fight it once it appears getting out of hand, but it'll be too late.

Fred Hayek's picture

A friend got me onto a list of folks who receive an email newsletter from a guy named Rick Weissman.  The writing is pretty interesting.  His main thesis of late is that the Fed would love, love, love, to duplicate now what the Fed did back in the late 40's which was to buy up massive amounts of treasuries and, somehow, bully everyone into keeping the rates low even as there was pretty strong inflation.  Here's an excerpt from his August 12 newsletter:

. . . For one, let me say that the government has already embarked on an inflationary agenda, by virtue of the QE (money printing) strategy the Fed has embraced. The precedent for these actions is what the Fed has done in the 1940's. This concept is one which no one has managed to understand or consider. Nor is anyone in the popular media talking about this. To repeat what I have said before: the Fed managed to impose an interest rate cap during WW2, with long bonds capped at 2.5%, and the Fed successfully managed to hold the line on this level of interest rates in the late 1940s, and after the war, when we had 25 consecutive CPI readings above 8%, a high monthly reading above 19%, and a 2 year average of 12.5%. How was that possible? The Fed basically bullied market participants to accept the price floor or yield cap on government debt. If you are a bond trader, this is a great situation, since you can go out there and buy bonds anytime it gets near the price floor, knowing that you have the "Fed Put" to bail you out. In fact, knowing that the Fed is there for the markets will encourage investors to buy bonds at yields just below the Fed's cap.

So my question or comment is: how many trillions of dollars of bonds will the Fed need to buy to maintain a rate cap at, say 4% on the long bond, and 3% on the 10 year? With the size of the US publicly held debt at $8 to $9 trillion, and expected to grow by $1.3 to $1.5 trillion a year, it would probably take a few trillion dollars of Fed purchases, or at least the threat of purchases to successfully implement a rate cap. Furthermore, there is about $5 trillion of agency backed MBS and another $1+ trillion of agency debt which might need to be back-stopped as well. So long as there is no inflation, then it is likely that the Fed will print trillions of dollars, first in the name of preventing deflation. If the Fed ever starts targeting interest rates, it is game over for shorting bonds, because they can just print as much currency as possible to soak up the supply of bonds. This would eventually result in inflation, despite the horrific state of the US housing market, and its 40% contribution to CPI. And as our experience in the 1940s showed, it is possible to have double digit inflation with very low interest rates. . .


aerojet's picture

It's not so much the fortitude as the mental capacity to even understand what is going on.  Witness the line of black people in Atlanta looking for mortgage workouts.  Those people know nothing about any of this, they just want their handout.  When the handouts end, the chaos begins, then the strong man comes, and we fully realize fascism, with the regular folk cheering all the way because he will restore order.

RockyRacoon's picture

That was an amazing scene, and don't think it wasn't broadcast all over the world.  A friend of mine in Nicaragua emailed me and asked what the hell was going on and wondered if I was safe -- 1,200 miles away.  Just like the scenes in Greece, it is only the tip of a larger iceberg.  A  piece of paper seemed to quell the "mob", but soon it will take much more.  I see truckloads of food and water rolling up to calm them very soon in our future.  New Orleans will look like a minor skirmish.

Jendrzejczyk's picture

That situation was not for mortgage workouts, it was merely for section 8 voucher application forms----actually, to just get on the waiting list for section 8 vouchers.

Sadly enough, I don't think most of those people knew why they were there.

FEDbuster's picture

FREE is a very powerful word.  Chance at free housing attracts 30K in one suburb of Atlanta. 

Number of people on food stamps, 40.8 million. Imagine the "bread lines" on CNN, if the 41 million had to line up every Saturday to get their box of food.

StychoKiller's picture

As it's been said before:  You can't fix Stupid!  I too am amazed that this mob scene was just to get on some waiting list -- I was totally gobsmacked!

mynhair's picture

They thought it was an Obama Stash distribution point.

SRV - ES339's picture

"Witness the line of black people in Atlanta looking for mortgage workouts.  Those people know nothing about any of this, they just want their handout."

 These are poor people (what does black have to do with it?) without jobs, and desperate to refinance their mortgage (not walk away from under water mortgages with millions in the bank, like many of the wealthy are doing)... that's not a handout. But if it makes you feel better to vilify those who have been devastated by the greed of the elite, go for it.

And what if the strong man never comes? Perhaps you may want to temper your contempt for those less fortunate... for your own safety.


It's time to cull the herd.

Caviar Emptor's picture


Supply siders sold America a swindle that was packaged an economic rescue plan. Following the money trail we find that wealth has been transferred from the middle class to the wealthy who's taxes have been cut. The country is broke, in a depression and with an outsourced productive economy, consuming way more than we produce.

Ned Zeppelin's picture

"Keynesian thought . . . 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."

Someone forgot that the intended recipients of all of the forgeoing made out quite well, thank you very much. Ask Jamie or Lloyd how they made out.  Don't forget the footnote to all of this: that Keynesianism was espoused by those types for some very specific benefits that they did receive. They were not thinking about J6P when they asked for all of these programs, just themselves.  We just got the bill.

Turd Ferguson's picture

The end of The Great Keynesian Experiment is upon us.

Prepare accordingly.

Mr Lennon Hendrix's picture

No matter what comes, gold will stay as the best wealth investment; oldest story ever told.  I say the price could drop to $1040 if the Tau gets punished to $8000, but then the seperation would really occur when the dow drops to the low thousands and gold stays in a number that is still "expensive" 9by the standards of "rational consumers" that need new ipoduhs for different outfits.  People look like clowns walking around stuck in the medias cultural trance of mass consumption while the greatest depression continuess on.

nevadan's picture

Extending tax cuts won't solve anything, but a few bank failures might be a good start.

lieutenantjohnchard's picture

one bone to pick. at the end of the article sprott says that keynsianism fooled us all.

actually, not all of us.

the public (those dumb country folk in flyover country as opposed to the brilliant bright lights on the eastern seaboard) was onto the game from the outset. remember when the house vote on the stimulus bill went down in flames when the public roared no! the market sold off huge, and then the house rammed it through in the next few days to save the asses of the top few percent in the usa. then, the market rallied.

other than that - good piece.

chunkylover42's picture

agreed, and one other bone to pick.  Sprott refers to the CBO analyses of budget deficit and GDP projections, particularly when he's discussing the notion of extending the Bush tax cuts.  He fails to mention that those analyses are 'static' in their projections, meaning they don't account for any change in behavior due to a change in tax rates.  Clearly this is dumb, but the CBO does it anyway, which is why every projection they make is off by some factor of 10.

That's not to say that extending the Bush cuts are any panacea, just that the analysis of their impact is incomplete at best.

lieutenantjohnchard's picture

just like medicare / medicaid was off by a factor of 10 when passed many years ago. and how obama care (see massachusetts) likely will be off by an equal amount. oh well, the bright side is the taxpayer will never have to pay off these debts. they're too big. no combination of spending cuts, tax increases and growth can win the day. it's inflation or default.

tony bonn's picture

speak for yourself sprott - keynesian theory never fooled me and i have lambasted the fool crackpot theory before its first death in the 1980s...when the corpse rolls by me i am going to kick it...but the damned bitch will come back for more - it's a cat and politicans love to ride it since it provides intellectual cover for raping and pillaging....

lieutenantjohnchard's picture

exactly. and yet in b school we students had lecture after lecture in economics over the fool theory. sure, i sold out and regurgitated the crap on tests. but now i feel like one of those soviet era commisars whose education was based on a discredited theory.

akak's picture

Regarding Keynesian "theory":

... politicans love to ride it since it provides intellectual cover for raping and pillaging....

That is really all that needs to be said, and the ONLY reason that Keynesian economic thought (sic) dominated in the academic and political realms for the last 80 years.  Even thieves and murderers like to have some high-sounding theory to justify their rape and slaughter.

Rainman's picture

" Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency ".

                                               J.M. Keynes

                                               The Economic Consequences of the Peace

Cognitive Dissonance's picture

Rick Santelli just had a quiet toe to toe with Ron Insana around 3:05 PM EDT. As is typical with Insana, when he's challenged, his back goes up and his sensibilities are outraged that anyone would question the insufferable prick.

"What's that got to do with my point Rick" and "Yes, I would like to get back to the point of the discussion" and so on. And don't forget the eye rolling and the "Lord save me from these insufferable fools" look on his face. Someone needs to stick a point in his annulus.

I'm not going to try and recite what was said but it's clear Insana is a believer in all things Fed and has little problem pushing the propaganda. In fact, I believe he's the most dangerous type of propagandist out there. He might actually believe what he's saying is true.

NotApplicable's picture

Is there anything Ron Insane-a can't fail at?

Other than being the CNBS junk-yard dog, that is. I guess after this morning's rant, they had to bring him out to put Rick "back in his place" in the eyes of their comforted herd.

watchingdogma's picture

I saw Rick so I turned up the volume - it looked to me like Ron genuinely was stumped - like he didn't understand why Rick was worried about money that came out of nowhere - like he understood how to breath, but all of this talk about oxygen was completely over his head.  "Stop talking about oxygen Frank (er - I mean Rick!) - let me get back to my discussion on the need for air when breathing!"

RockyRacoon's picture

Ron is rabidly, insanely afraid of gold.  I saw him a couple of weeks ago get really apoplectic and get spittle all over his $200 tie.  Gold is the final bogeyman that will give ole Ron a fatal heart attack.

akak's picture

I still have daydreams of cramming a 400 oz. gold bar down the throat of Erin "What good is gold, you can't eat it?" Burnett, and crowing "See, you can eat it, BITCH!"

Oswald Spengler's picture

Keynesianism has given intellectual cover to the socialists who come ever closer to enslaving us.

TBT or not TBT's picture

I never thought it would come to this, but apparently America is into bondage.

centerline's picture

Got to give credit for Chart B to Nathan Martin over Economic Edge.

gaugamela's picture

This bit gave me a good laugh. Complete rubbish. Quote: "A two percent spending increase inevitably requires an increase in taxes." Really? Inevitable? Reads like an undergrad term paper.

Astute Investor's picture

It's confirmed - you really are an ignoramus.

Segestan's picture

You assume... usury is not the second oldest profession.