An interesting read from economist Richard Duncan (2012). For the first time, someone offers an explanation, that I can handle, for why Keynesian solutions may be a necessary evil in today’s environment. Duncan is able to flesh out how the global economy has changed, making fiat money the only way to avoid catastrophe. After walking through his theory and exposition, I’ll then point to a couple of issues that I have.
His basic premise is that we no longer live in a capitalist economy, but instead a government-driven one where credit expansion is the key variable to sustain growth. The statistic worth noting is that total U.S. credit hit $1 trillion in 1964 and has grown more than 50 times since then. Not surprisingly, that exponential move coincides with the breakdown of Bretton Woods and the end of the gold standard. Thereafter, the Federal Reserve constantly lowered reserve requirements, which allowed commercial banks to extend more and more credit, with the idea that the Fed could always provide funding to any bank that needed it. (So, in certain respects, this explanation marries the Post-Keynesian theory of endogenous money with the standard understanding of how the Fed’s control of interest rates and creation of new money impacts the velocity of credit.) But, over time, Duncan finds that the return on credit has gotten smaller – that is, the gap between the annual growth rate in credit and that of GDP has widened, where you need more credit issued to generate a dollar of GDP growth.
In more recent times, the other big phenomenon has been the U.S. trade deficit. Back when money was backed by gold, but the U.S. was a big manufacturer and exporter, there was a natural constraint on how much credit could be extended and how much of a budget deficit could be run. If the U.S. borrowed too much, inflation would hit, gold would leave, credit and spending would dial down, a recession would come, and things would be forced to reset. But, with globalization, trade liberalization, and loss of the gold standard, that natural constraint disappeared. Americans could import more without the bottlenecks in labor and industrial production that normally occurred and led to inflation. Americans could buy goods from countries where the cost of labor was far lower, and they could do it all on credit. Simultaneously, these other countries needed to buy dollar-denominated assets with their dollar reserves in order to keep the value of their own currencies lower and export-friendly, and so would fund a large portion of the U.S. budget deficits and drive up the price of U.S. assets generally. The wealth effect that followed from all that liquidity flowing back engendered higher consumption by Americans without the need to save anything first. And as the economy moved away from savings and investment to borrowing and consumption, credit expansion became the singular focus of government, leading to greater distortions and misallocations.
The key point in all of it is that the U.S., as well as the rest of world, has not functioned on laissez-faire principles for a great long time. Much of it can be traced back to military Keynesianism. First to fund WW1, which set the stage for the Roaring 20's and a period of credit expansion that eventually was unsustainable. Then there was the Great Depression, which many believe did not end until the fiscal stimulus of WW2 was introduced. Later, you had the stagflation of the 70's, so it was the Cold War and Reaganomics as solution. In each instance, massive amounts of debt were created to try and right the ship, and the previous distortions and mistakes were papered over – it is no longer capitalism, but “creditism”, driven in large part by the government. Confronted with that, with the scale of debt that now exists, a market-based solution of letting the economy reset would simply be too painful, probably taking democracy and society down with it. To quote: “There is no doubt that the abandonment of commodity money (gold) created distortions that interfered with the self-regulating market economy. The point to grasp, however, is that our global civilization has been built on and around those distortions and that it could very possibly collapse into ruin if those distortions are not perpetuated through further credit expansion…The question is not whether we are going to abandon capitalism and replace it with a different kind of economic system. We did that long ago. The question is: Are we going to allow the economic system now in place to collapse?” (pg. 147) The risk is a horrendous debt deflation spiral, right out of the mind of Irving Fisher.
Thus, Duncan believes that government spending is the only solution out there (since the private sector is not in a position to get the credit wheels going again), recognizing that they need to invest more intelligently, rather than just encouraging the wasteful consumption of the past. His preferred focus is on solar energy – as a way to gain energy independence, to deal with issues of global warming, and to create jobs and get the economy back on a sustainable path. I know far too little to opine on whether that solution is feasible.
With his basic story out of the way, let me start by mentioning that I find his treatment pretty reasonable. Nevertheless, I still have some criticisms. First, he uses Japan as an example of how greater government spending would not necessarily lead to a sovereign debt crisis in the U.S. any time soon. But, he ignores how Japan has (at least, historically) been able to fund huge levels of debt through its citizenry (versus foreign creditors). I think that’s an important distinction. Next, Duncan does not mention how the U.S. Dollar is the reserve currency. He offers no insights into how his understanding would be altered if that status were lost. Again, I think it matters, and would have a negative impact on the ability of the U.S. to borrow more. Lastly, Duncan’s reliance on government spending as solution is contingent on investment that generates an actual return for the U.S. – needless to say, I’m skeptical.
In conclusion, I think the book is well worth picking up. You stand to learn a little and to have some of your priors questioned as well.
