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.
shargash's picture

Not all deficit spending is Keynesianism. Since the failure of Keynesianism in the 1970s, you haven't been able to find a Keynesian in any position of power pretty much anywhere. The Chicago school of monetarists dominated economics until they blew up the world in 2008.

Keynes never said you should run permanent structural deficits. Keynes never counted bailing out failed banks as stimulus. What's been going on in the past 40 years resembles Keynesianism about as much as the current US economy resembles capitalism.

Now look, I don't like Keynesianism either. But language matters. All this recent bashing of Keynes is just to set us up for austerity -- i.e. now that they took our shit, we're supposed to suffer quietly.

But the fact is that neither austerity nor stimulus is going to do jack, until the economy is reformed, the banks are reined in, and the bezzle is removed from the system.

gaugamela's picture

"But the fact is that neither austerity nor stimulus is going to do jack, until the economy is reformed, the banks are reined in, and the bezzle is removed from the system."

This is the problem with the debate: there is no way to test both methods. Keynesiast say that w/o stimulus the slowdown would be worse and that the modest growth we've experienced is b/c the stimulus was not large enough. I tend to side w/ this argument. Nobody else but the Fed would have bought MBS securities in early 2009.

However, you can't argue that austerity would work better b/c you can't run two scenarios in a live economy and see how people's expectations play out.

VWbug's picture

it's a moot point, as it is simply immoral to take money forcefully from some and give it to others.

It's doubly immoral to take it from the poorest and give to the richest,  or from the most competent to the least.

gaugamela's picture

Yes, indeed, both "austerity vs stimulous" and "kenysianism vs. monetarists" debates are moot. It's also a good that you are not the arbiter of what is moral.

Geoff-UK's picture

Are you really claiming that VWBUG's statement above is arguable?!  That it was, in fact, moral to take $ from the middle class to bail out AIG/GS/et al?

knukles's picture

Here, here. 

Used to be Right vs. Wrong,
Then degenerated to Legal vs. Illegal,
Now resting upon "What can I get away with without being caught."

Historically, societal justification of the latter condition has pre-staged revolutions.

faustian bargain's picture

We're each the arbiters of what is moral.

What we aren't, are the arbiters of what is legal.

Caviar Emptor's picture

The "Monetarists" were more Keynesian than Keynes. Many believe that pure monetarism ended in 1981. Deficit spending and supporting the trade deficit then became the major source of economic stimulus. 

perchprism's picture

 Nobody else but the Fed would have bought MBS securities in early 2009.

At par.

At the actual market value, if one had been allowed to be established, there'd have been plenty of buyers.  That's how it's supposed to work.

lieutenantjohnchard's picture

excellent thoughts. but how does the bottom 90% of law abiding, peaceful citizens remove the bezzle from the system captured by a corrupt 10% oligarchy with the force of law and arms behind it?

maybe november is a start. or a crash.

Walt Whitman's picture

I wish the oligarchy was 10%; if it was, there might be some trickle down. As it exists, the oligarchy is around .0001%. At that percentage, it's royalty, not oligarchy. Just ask them, they'll tell you. They just employ a rather large buffer between them and the law abiding, peaceful citizens.

lieutenantjohnchard's picture

you're closer to being right than me. i use the 90/10 only inasmuch as it represents stock ownership across the usa.

Geoff-UK's picture

I don't think November is going to fix it.

In fact, I wouldn't be surprised if there's nothing we could to do fix it, short of guillotines.

Ruling class is getting theirs, and they have enough financial power at this point to buy as many politicians as they need to maintain their funding stream (i.e. "us in the middle class").

As John Derbyshire says, We Are Doomed.

Mark Noonan's picture

I'm sorry, but that is a bit like saying that Marx never envisioned Stalin - but the fact remains that Stalin was implicit in Marxist theory from the start, just as Pelosi's $36 billion payoff to the government unions was implicit in Keynesian economics from the start.

Things are never half true or half false - they are true or false.  It was always false to say that government could provide a net gain to economic activity.  The simple fact that government has no money is stark, inescapable and is entirely missed by Keynes.  Government only has what is can extract from the people - it can only move resources around (invariably wtih a bit of carrying charges) so that even if there is a "gain" by government action, it comes at the expense of some other activity now unfunded because government took the money. 

Keynes theory is this beautiful calculation which, unfortunately, starts off with 1+1=3.  It doesn't matter what else is said beyond that first error, it will all be wrong.  It will all be false.  That grafting politicians and businessmen would latch on to it and add even more nonsense doesn't excuse Keynes from his first, incredibly stupid error.

George Costanza's picture

Keynse empowered politicians.  It gave them a  theory (excuse) to increase their power and influence.    It will be difficult for them to adopt another theory, which would require them to reduce their own influence and power.

That may require a true Depression.

michael.suede's picture

Not one mention of the Austrian School.

This is an outrage.

ATG's picture

Austrian proponent of free markets for creative destruction...

eddybaby's picture

What we have here is a failure of elected officials to show the courage to make real tough choices, because their own personal career success of failure does not depend on an assessment of long term performance, but on short term popularity.

This collective self interest and moral cowardice has led us to into a very dangerous world, and yet, still its politics as usual.

If you stand back far enough you see one of histories great tragedies playing out in front of you.

LeBalance's picture

the politicians do not and have never been working for you.

they do not make choices that you understand because they do not work for an agenda that you are aware of.

they understand a larger portion of the matrix that we live in.

traderjoe's picture

They do not understand a larger portion of the matrix. I agree with your first two points. They merely use the system to their own benefit and the voters favor short-term gain over long-term sustainability. 

tip e. canoe's picture

"they understand a larger portion of the matrix that we live in."

that's what they like to think.  then again, kings used to think of themselves as one step closer to God.   the question is:  are they?  do they?  and if so, why do they?  couldn't be all that secret information they've been hiding from the plebes for thousands of years could it?

Dr. Sandi's picture

This is too true.

Unfortunately, none of has to stand back too far to enjoy this tragedy. Coming soon to a household near you.

Geoff-UK's picture

Elected officials DID make a courageous choice--that Joe Sixpack would not notice the elected official got campaign donations and free golf trips from AIG/GS/BoA/et al.

Middle class doesn't have the cash to compete=we're screwed.  Feudalism's back.

centerline's picture

Keynesian stimulus fooled no one over here.  Need to revise the "all"  statement at the end.  Debt-backed money was doomed to fail from the moment it was conceived (1913 for the USD).  The game is much, much older than the USD though.  That is really the sad part.

Tao Jonesing's picture

What dominates the cliff-diving in Chart B is not Keynesian economics but the monetarism of Milton Friedman as managed by his devotee, Helicopter Ben.

The overwhelming majority of new debt incurred by the U.S. government was not used for Keynesian stimulus but to prop up the TBTF banks as reserves on their balance sheets (and it continues to stay there).  Keynes did not believe that propping up the supply side of money would do all that much, that a proper stimulus required giving money directly to the demand side, who would spend it instead of hoard it.

So, what Sprott is really eulogizing is the death of the Chicago School of economics, or Ponzinomics, as I like to call it. 


centerline's picture

Nicely put.  There have been several other debates over this illustrating that even Keynes would be pissed off at what is going on.  This is way beyond Keynesian economics.

Fred Hayek's picture

Are you suggesting that Milton Friedman would have advocated propping up the TBTF banks?

Council of Economic Terrorists's picture

One name to save us Friedrich Hayek, a rational economic thinker opposite keynes and against  reagan tax cutting + deficit spending. 

LeBalance's picture

that is certainly one, but there are hosts of others, Mises, Rothbard, de Soto, Baum, every Sci-fi writer writing incisive pieces under cover: Orwell for instance, Brunner, Malzberg, many others.  The list is very long, but they are out there.'s picture

every Sci-fi writer writing incisive pieces under cover:

Vonnegut's Harrison Bergeron is too good to miss.

Ripped Chunk's picture

Viking funeral appropriate here. 

LeBalance's picture

I think the USSA is going to do the "rockets red glare" and thermobaric and air-fuel mixture "bombs bursting in air" deal, with a healthy dose of DU for long term killing power.

Shameful's picture

Glad to know I'm not the only one waiting for Hillary to play the Nuclear Blackmail card.

Ripped Chunk's picture

Well she did have the wedding 2 weeks ago. Now she will get back to the bidding of the dark overlords.

TBT or not TBT's picture

If our state dept isn't playing the nuclear blackmail card, it no longer represents the american people.   Nukes are very cheap as big sticks go.  Been working their magic for 65 years.

Temporalist's picture

Yea but now too many players have the same toys so everyone gets to blackmail...look at North Korea, Pakistan, Isreal, India, China...

TBT or not TBT's picture

U-238 and jacketed lead bullets have scarcely different radioactivity levels, for practical purposes of health effects on humans.   For what it is worth, I'm for both, each in its role.

flacon's picture

Why Governements try to control prices, by Keynes

"A sentiment of trust in the legal money of the State is so deeply implanted in the citizens of all countries that they cannot but believe that some day this money must recover a part at least of its former value. To their minds it appears that value is inherent in money as such, and they do not apprehend that the real wealth, which this money might have stood for, has been dissipated once and for all.

This sentiment is supported by the various legal regulations with which the Governments endeavor to control internal prices, and so to preserve some purchasing power for their legal tender. Thus the force of law preserves a measure of immediate purchasing power over some commodities and the force of sentiment and custom maintains, especially amongst peasants, a willingness to hoard paper which is really worthless...

If, however, a government refrains from regulations and allows matters to take their course, essential commodities soon attain a level of price out of the reach of all but the rich, the worthlessness of the money becomes apparent, and the fraud upon the public can be concealed no longer."

~John Maynard Keynes, Economic Consequences of the Peace, NY, 1920, p. 239-40

ATG's picture

Or Gold and Economic Freedom by Alan Greenspan in Ayn Rand's 1966 Capitalism, the Unknown Ideal...

Temporalist's picture

Right so those that defend Keynes also are advocating his condoning a lie upon all people.

THE DORK OF CORK's picture

I think we can all be good Austrians on the Internet and feel a warm glow inside but speaking from a country that took a 16% drop in GDP and more importantly a 25% drop in GNP, its hard.

Also the safety valve of young people leaving our shores and exports to more stimulated economies has protected us from a full scale implosion.

But this is not a solution to the world economy - listening to Santeli on the other thread he is dead right about the stupidity of dead money going into dead housing to keep the money supply going.

What is missing from Anglo economies for some time as been large scale core applied science endeavours - we have tinkered with i pads and technologies that give marginal efficiencies with existing technology for too long now.

If we are prepared to spend trillions to pour into black holes which by definition is inflationary as the money printed does not add any value why can we not have one shot at reaching for the stars, splitting the atom and other such noble endeavors.

The spirit of adventure and maybe conquest is what has defined the wests culture and identity for so long now we cannot turn our backs on it in this moment of crisis - it is our final chance is it not.

If we are to fall down lets not collapse making houses in some zoo city or hudde around some Austrian cavefire.

Lets light this fucking candle.

Shameful's picture

At least you guys took the hit even if your political class is also in bed with the banks.  We here in the states are trying to push off the day of reckoning.  So when that day comes it will wash over us and leave nothing intact after it's passing.

THE DORK OF CORK's picture


Its over in Ireland - we have been a tax haven for American corporations and a monetary  sink for corrupt banks for decades although in the last 10 years this has gone exponential.

Our monetary external debts are over 10 times our fiscal debt which was at zero before the crisis when you count our pension surplus which was thrown on the banking fire.

We are therefore not a good example as our level of globalisation or more accurately control by our banking masters is extreme.