The Breaking Point & Death Of Keynes

Authored by Lance Roberts via,

You can almost hear the announcer for the movie trailer;

“In a world stricken by financial crisis, a country plagued by spiraling deficits and cities on the verge of collapse – a war is being waged; gauntlet’s thrown down and at the heart of it all; two dead white guys battling over the fate of the economy.”

While I am not so sure it would actually make a great movie to watch – it is the ongoing saga we will continue to witness unfold over the next decade. While the video below is entertaining, it does lay out the key differences between Keynesian and Austrian economic theories.

Just last week, the Federal Reserve released a report which forms the basis of the semi-annual testimony Ms. Yellen will give to Congress this week. There was much in this report which suggests the models the Federal Reserve continues to use are at best flawed and, at worst, broken.

For decades, ivory tower economists have heaped high praise on Keynesian policies as they have encouraged Governments to drive deeper into debt with the expectation of reviving economic growth.

The problem is – it hasn’t worked.

Here’s proof. Following the financial crisis, the Government and the Federal Reserve decided it was prudent to inject more than $33 Trillion in debt-laden injections into the economy believing such would stimulate an economic resurgence. Here is a listing of all the programs.

Unfortunately, the results have been disappointing at best, considering it took almost $17 Billion for every $1 of cumulative economic growth.

Keynes contended that a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  In other words, when there is a lack of demand from consumers due to high unemployment then the contraction in demand would, therefore, force producers to take defensive, or react, actions to reduce output.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Unfortunately, as shown below, monetary interventions and the Keynesian economic theory of deficit spending has failed to produce a rising trend of economic growth.

What changed?

The Breaking Point & The Death Of Keynes

Take a look at the chart above. Beginning in the 1950’s, and continuing through the late 1970’s, interest rates were in a generally rising trend along with economic growth. Consequently, despite recessions, budget deficits were non-existent allowing for the productive use of capital. When the economy went through its natural and inevitable slowdowns, or recessions, the Federal Reserve could lower interest rates which in turn would incentivize producers to borrow at cheaper rates, refinance activities, etc. which spurred production and ultimately hiring and consumption.

However, beginning in 1980 the trend changed with what I have called the “Breaking Point.” It’s hard to identify the exact culprit which ranged from the Reagan Administration’s launch into massive deficit spending, deregulation, exportation of manufacturing, a shift to a serviced based economy, or a myriad of other possibilities or even a combination of all of them. Whatever the specific reason; the policies that have been followed since the “breaking point” have continued to work at odds with the “American Dream,” and economic models.

As the banking system was deregulated, the financial system was unleashed upon the unsuspecting American public. As interest rates fell, the average American discovered the world of financial engineering, easy money, and the wealth creation ability through the use of leverage. However, what we didn’t realize then, and are slowly coming to grips with today, is that financial engineering has a very negative side effect – it deteriorated our economic prosperity.

Furthermore, this also explains why the dependency on social welfare programs is at the highest level in history.

As the use of leverage crept through the system, it slowly chipped away at savings and productive investment. Without savings, consumers can’t consume, producers can’t produce and the economy grinds to a halt.

Regardless of the specific cause, each interest rate reduction that was used from that point forward to stimulate economic growth did, in fact, lead to a recovery in the economy; just not at levels as strong as they were in the previous cycle. Therefore, each cycle led to lower interest rates and economic growth slowed and as a result of consumers and producers turning to credit and savings to finance the shortfall which in turn led to lower productive investment. It was like an undetectable cancer slowing building in the system.

The “Breaking Point” in 1980 was the beginning of the end of the Keynesian economic model.

Hayek Might Have It Right

The proponents of Austrian economics believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment. In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit. This expansion of credit then, in turn, creates an expansion of the supply of money.

Therefore, as one would ultimately expect, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities. Finally, the credit-sourced boom results in widespread malinvestments. When the exponential credit creation can no longer be sustained a “credit contraction” occurs which ultimately shrinks the money supply and the markets finally “clear” which then causes resources to be reallocated back towards more efficient uses.

Unfortunately, as is clearly shown in both charts above, this has hardly been the case.

Time To Wake Up

For the last 30 years, each Administration, along with the Federal Reserve, have continued to operate under Keynesian monetary and fiscal policies believing the model worked. The reality, however, has been most of the aggregate growth in the economy has been financed by deficit spending, credit expansion and a reduction in savings. In turn, this reduced productive investment in the economy and the output of the economy slowed. As the economy slowed and wages fell the consumer was forced to take on more leverage which also decreased savings. As a result of the increased leverage more of their income was needed to service the debt.

Secondly, most of the government spending programs redistribute income from workers to the unemployed. This, Keynesians argue, increases the welfare of many hurt by the recession. What their models ignore, however, is the reduced productivity that follows a shift of resources toward redistribution and away from productive investment.

All of these issues have weighed on the overall prosperity of the economy. What is most telling is the inability for the current economists, who maintain our monetary and fiscal policies, to realize the problem of trying to “cure a debt problem with more debt.”

This is why the policies that have been enacted previously have all failed, be it “cash for clunkers” to “Quantitative Easing”, because each intervention either dragged future consumption forward or stimulated asset markets. Dragging future consumption forward leaves a “void” in the future that has to be continually filled, and creating an artificial wealth effect decreases savings which could, and should have been, used for productive investment.

The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the end result, has been clearly wrong. It hasn’t happened in 30 years.

The Keynesian model died in 1980. It’s time for those driving both monetary and fiscal policy to wake up and smell the burning of the dollar. We are at war with ourselves and the games being played out by Washington to maintain the status quo is slowing creating the next crisis that won’t be fixed with another monetary bailout.


Erek Mon, 07/10/2017 - 09:16 Permalink

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The more awake I become, the less I want to fit in.

opport.knocks medium giraffe Mon, 07/10/2017 - 09:34 Permalink

Exactly, Keynes himself does not deserve the disdain that the majority Austrian school here on ZH pile on him. Governments are required to reduce debt when the economy is good for the policy to work, but they never do it. Unfortunately neither school adequately accounts for:1. The absolute corruption of humans and their political and financial institutions2. The stupidity and apathy of the general population3, Macro demographic changes.

In reply to by medium giraffe

Jim in MN opport.knocks Mon, 07/10/2017 - 10:37 Permalink

If one replaces 'aggregate demand for goods' with 'aggregate demand for debt' you then get the logic of the debt glut, along the same lines but at least as devastating because the one tool the government has is exactly the one thing no one wants--more debt.Thus, the Keynesian debt glut is the true poison.  Demo'd in Japan, now spread to much of the world.  Spurred on by the corruption and tyranny that is the core failure point for the 'West as we knew it'.Now we can only debate whether it's too late.......or just ALMOST too do anything about it. 

In reply to by opport.knocks

shovelhead Jim in MN Mon, 07/10/2017 - 12:48 Permalink

Not at all. There's productive debt that adds value and capacity/ effiency and there's non-productive debt that simply pulls future earnings forward with no productive increase or value adds. It's very important to make that distinction.The cost of that debt is also an important factor in determining whether pulling earnings forward is a justifiable risk or a malinvestment.

In reply to by Jim in MN

Jim in MN shovelhead Mon, 07/10/2017 - 14:32 Permalink

The word 'aggregate' as used here can't make that distinction.  In context, it's like calling some demand 'productive' and some 'non-productive'. It's not that the idea you mention isn't important.  It's just that in a major market crisis like we have, the productive baby goes down with the non-productive bathwater, no matter how many times you define the baby as worth saving.ZIRP (AKA debt glut) screws up all planning, savings and investment.  The good, the bad and the ugly.

In reply to by shovelhead

SDShack Jim in MN Mon, 07/10/2017 - 14:19 Permalink

Debt Glut is correct. The problem with the current system is that the Purveyors of Debt (banks) have a shrinking pool of actual credit worthy entities to fund. This is a function of both demographics and design. Foreign Outsourcing and corrupt Board of Directors that value Stock Valuation above all else, have produced a lack of organic credit growth that could result in accrued value in actual goods and services. This has elevated the growth of in-organic (or junk) credit that does nothing to foster any potential growth in either goods or services and is usually used to only service existing debt, which is just treading water at best.The end result is neither a functional economic or credit model, but actually a giant Ponzi scheme. Hence the need for banks to continue to expand the junk credit cycle to try to entice more and more "consumers" to buy in to prevent the entire Ponzi from collapsing. But with shrinking demographics, this requires immigration on a mssive scale any way possible to just keep the Ponzi going. Add to the fact that these same banks have unlimited credit to sell because they control the printing press, plus are now deemed TBTF and therefore rewarded with govt. funded bailouts if they do fail, and you have the perfect nexus of crony capitalism, govt dependency, and vote buying. A totally corrupt system that must eventually fail, probably by violent revolution, but not until the masses are literally starving in the streets.

In reply to by Jim in MN

Ghordius medium giraffe Mon, 07/10/2017 - 09:38 Permalink

+1 medium giraffe, for "These 'Keynesians' do much of what Keynes warned against and represent a great deal of what he despised "further... Austrian School? there is no such thing, in my experience, here on ZHeverytime I make an Austrian School argument, here, the Keynesians are out in force against it, with shrill cries of "Austerity kills!"coupled with "does not work" and "it stands to reason that... (neo-Keynesian argument)"nope. "doomers" isn't "Austrians"

In reply to by medium giraffe

TwoHoot Ghordius Mon, 07/10/2017 - 11:59 Permalink

Keynesians may emit shrill cries but I haven't noticed that there are a lot of them at ZH. Most of what I hear at ZH is, "Bring it on"!Austerity DOES kill and there will be an abundance of blood and rotting bodies when it occurs. It occurs when socialists run out of other people's money. I won't insult your intelligence with the many examples from around the world, recent and ancient.I think Keynes half-heartedly advocated controlled austerity in good times. Corruption makes sure that doesn't happen. The Austrians seemed to want to keep a clean balance sheet in both good and bad times. Neither has happened in practice. Maybe either would work, theoretically, maybe.But first we will probably face uncontrolled "austerity". Messy business.

In reply to by Ghordius

shovelhead TwoHoot Mon, 07/10/2017 - 13:22 Permalink

There's not much impetus to practice needed austerity when there's votes to buy with social programs and taxpayer funded largess to hand out to corporate sponsors and special interest groups.Seems a bit ironic to pay people to "represent" you when they re-write the laws to represent everyone BUT you, the guy who pays the bills.Cheap credit is fun until it stops being "cheap" anymore because there's so much of it, and you never have to worry about 'austerity' because it always has a way of making itself known.One way or another, incrementally or catastrophically.

In reply to by TwoHoot

Pollygotacracker Mon, 07/10/2017 - 09:35 Permalink

Basically, what we have is an financial/economic model that works against the real economy. You can only plunder and rob for so long. Why go to work and bust a hump every day when the system is designed to work against you? Our government is broken, as I suspect that everybody knows what is really going on but as long as the stock market is going up it is O.K. 

rejected Mon, 07/10/2017 - 09:39 Permalink

Anyone that has read Keynes knows what the Bank and government have been doing is not anywhere close to his economic theories. So it's all bunk. They only spread this  bull because they know Americans are the dumbshits of the galaxy and believe any corpgov utterance.Next up: Another week of praying to our god of fiat. What the Grand master says will be interpreted for us in hundreds of articles. Ahh-ooommmm, Ahh-ooommmm, Ahh-ooommmm, Ahh-ooommmm, Ahh-ooommmm, Ahh-ooommmm,

MEFOBILLS Mon, 07/10/2017 - 10:53 Permalink

. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment. Quantitative easing was not goverment injection.  It was corporate bank, called Federal Reserve, which swapped new keyboard dollars for TBills.  This was a reserve loop swap, and the net asset position of banks did not change. If government deficit spend does not go into the general economy, then it is not stimulative.  If deficit spend goes into finance, then that is the opposite of Keynesianism.  Buying and selling of debt or financial instruments is just heat and waste, it does not produce anything.  For example, buying and selling a house does not make a new house.  Buying and selling on the finance casino only pushes the prices of those finance instruments sold there.... this is not the general economy.  Purchasing power has to be put into the hands of consumers and producers to be Keynsian.Any sort of economic theory that ignores unearned income, rents, and usury methods is dishonest.  Austrian theory is silent on unearned income and rent seeking.  Yet, Austrian's clothe themselves in some sort of moral cloth as if they are paragons of virtue.The Classical economists DO account for unearned income, and rents.  They DO differentiate that which is non-productive and a cost to society.  New Currency Theory (NCT) is in oppositon to Austrianism. NCT does account for all of monetary history, and does not cherry pick to make the "data" fit, like Austrians.  There is overlap where both theories are against debt creation of money, but similarities end there. Banking is an ultraliberal counter-program to sovereign money. Sovereign money is in line with up-to-date > Currency Teaching. Free Banking, as the term suggests, propagates > Banking Teaching.Quite often, the idea of free banking is combined with wanting to return to a gold standard as is the case with the Neo-Austrian School. Neo-Austrians and New Currency Theory share a similar criticism of fractional reserve banking. Strangely enough, Neo-Austrians blame the problem on government and central banks rather than the banking industry. The Neo-Austrian idea of money and banking reform then is banking without legal-tender laws and central banks, on the basis of a return to a 100% gold reserve. This appears to be quixotic, but is a revelation to others.

falak pema Mon, 07/10/2017 - 12:38 Permalink

The breaking point of the Friedmanite floating rate debt based model occurred in 1980; it was that model that had replaced the Keynesian model when Nixon reneged on the gold exchange in 1971, under the gun of "exorbitant privilege" menace from France; aka I want my gold back!; and the debt spigot that Friedman had started thru eurodollar debt debasement and concomitant creation of the derivatives market in Chicago M exchange, was the rope that hung the middle class under Reaganomics unleashing the financialised economy.I am quoting Mr Reaganomics himself, aka David Stockman, who left the Reagan admin when it reneged on government spend reduction; all the while reducing the tax collection; leading to the spread of federal debt over 8 years. Stop flogging a dead horse by pointing to the wrong BOGEYMAN; "Carthago delenda est" is now old hat when the paleoconservatives-- who loved the Laffer Curve--reneged on government debt pile up all the while unleashing the "greed is good" era of Junk bonds et al via the WS beanstalk.Keynesian economics is Carthage to these liars and shills who debased capitalism just like the Roman Optimates who sang 'Carthago delenda est' as an eternal song, all the while they destroyed the Republic in CIVIL WAR after having burned Carthage and Corinth in the same year (146 BC).The GOP is now going down the same road to destroy new Rome. 

Jus7tme falak pema Mon, 07/10/2017 - 13:41 Permalink

RIGHT ON! It is not Keynesianism that is destroying the world, it is Friedmanism! As in Milton Friedman, the Monetarist who preached that any economic problem could be solved by selective manipulation of the money supply. Friedman omitted describing the part of the scheme where the manipulatiuon is done in such a way that the rich become richer and the poor become pooorer, and all assets are inflated.Friedmanism (monetarism) is the real enemy. Not this non-keynesianism that is being practised.

In reply to by falak pema

Horse Pizzle (not verified) Mon, 07/10/2017 - 12:13 Permalink

The chart breaks in 1972 not 1980. 1972 is the year oil prices spiked.  Wealth creation requires cheap energy as an economic input. 

venturen Mon, 07/10/2017 - 12:25 Permalink

stop giving the MONEY to the criminals causing the problems. Give it to the people...or better yet....just break up the wall street majors.... But stopping giving it to the gamblers!