Is Keynes Back?

President-elect Barack Obama has no choice but to return to Keynesian economics. It is not because President Bush has mobilized the whole government and spent lots of cash to rescue difficult financial and insurance sectors, but because only the government can solve current economic problems.

If Obama must spend $1 trillion to revive the American economy, in addition to over $1 trillion already spent by the Bush Administration, then the U.S. government must pay more than $2 trillion to quiet down this financial tsunami. We are almost certain that this will take two years to complete.

$2 trillion is definitely not a small amount, and whether it will be effective or not is not yet known. But the market will one day find that the Federal Reserve is running out of ammunition, because the U.S. government can not afford to issue endless financial support. These problems cannot be solved unless many corporations and financial institutions that are no longer competitive are allowed to fail, giving the market opportunities to correct itself. The popular thought among political figures and Fed officials, however, is that no special political remedy for the credit disaster and the growing financial panic exists, and the only thing to be done is adopt a more active monetary policy.

The global economic nightmare started in September. To deal with the credit shrinking, the Fed, led by Ben Bernanke, quickly increased its assets, while commercial banks amassed frenziedly their reserve funds.

The total assets of the Fed jumped to $2.19 trillion on Nov. 19 from $1.28 trillion in early September. Reserve funds for saving institutions increased 13 times in two months, from $47 billion in early September to $653 billion on Nov. 19.

The excess growth of reserve funds, which reflects the worries of the financial institutions and the banks’ choices for avoiding or diminishing their loans, is an offsetting act to past over-loaning and speculative investment that broke the assets bubble. Credit standings of corporations and individuals are suspected at large, which makes money borrowing not as easy as before, so consumers’ loaning demands are actually decreasing and the credit market keeps freezing up.

With an approximate $4 trillion loss in house values and a $9 trillion loss in the stock market, American assets have taken a nose dive. But America is not the only nation suffering from this problem. These changes force people to alter their ways of consumption. The U.S. core Consumer Price Index dropped 0.1 percent in October, the first drop in CPI since December 1982. Deflation is thought to be out soon, while inflation is still high in many countries.

Roosevelt accepted Keynes theory to save economy by increasing governmental spending

In 2008, the financial derivatives created by investment banks in Wall Street gave rise to the biggest financial disaster since 1930. This proves the Keynesian allegation that the “market can not self correct.” Also, in this serious economic slide, “monetary-policy-is-of-no-use” rears its head and only fiscal policy can come into play.

Keynes participated in the negotiation for the Treaty of Versailles in 1919 and experienced two world wars. The great panic he had experienced cast many doubts on “the invisible hand” embraced by classical economics. Therefore, the government intervened.

Franklin Delano Roosevelt, after becoming president in 1933, accepted the Keynesian idea of saving the economy with more governmental spending. Today’s governmental solutions all over the world are causing growth in the number of Keynes believers. However, in the U.S., the Fed can only control the money supply rather than how the money will flow.

When will Bernanke, and others who believe in monetary policy, find out that the monetary policy is not that effective as they have expected? The problems Obama must deal with, however, are more complicated than those in Roosevelt’s age. And even though the spending on public engineering provided jobs, Roosevelt’s New Deal was unable to end the Great Depression.

The breakdown of the investment banks in Wall Street turned big financial institutions and car makers toward the government for funding or investment. Saving corporations with government’s power, the U.S. will taste a bitter fruit like Japan in 1990s when it implemented its monetary policy. The Fed is facing a situation similar to that of Japan, in which the economy might run into a deflationary spiral with great destructive power, say, a widespread price fall.

Zero interest rate foreshadows next bubble

It is believed that the Fed will remain its policy of interest cuts if the U.S. economy is still in dark and the inflation pressure keeps weakening. The Fed, as expected, took a final decision to drop the benchmark interest to 0-0.25 percent in Tuesday. This interest cut shows the Fed has run out of its traditional policy tools.

Zero interest definitely harms depositors, but it means a loan free of charge, which might cause a high wave of speculative investments and the risk of an investment bubble. Historically, the U.S. has never dropped the interest rate to zero. The prior lowest interest rate of 0.68 percent happened on July 1, 1958.

The Fed has stated that it will invoke the help of all emergency tools, including nontraditional ones, to recover the economy if there is no room for further interest cuts. These nontraditional tools might involve a so-called quantitative easing monetary policy.

Early this month, Bernanke hinted at nontraditional steps he might take. Direct intervention in markets to lower the costs of a loan, and a large purchase of public debts and corporate debts that investors are shunning, might be the next steps to reverse the recession.

Bernanke and his colleagues promised to use “all tools available” to deal with the gravest economic stagnancy since World War Two. It is thought that Bernanke decided to do so is because he wanted to ensure that the U.S. will not relive Japan’s “lost 10 years” after he leaves his post.

As Japan adopted a policy that many think is wrong, the interest rate of the yen stayed irrationally low for a long time. This policy failed to solve the deflation.

As early as 2002, Bernanke, then a Fed trustee, quoted economist Milton Friedman that if the economy gets into deflation, he will drop cash from a helicopter. Since then, the nickname “Helicopter Ben” follows him like a shadow.

The whole world has the same fashion when rescuing the economy. It does not mean that the Keynes school has won, because some theories from Friedman-led Chicago school are also adopted. The solutions by the Keynes school of economic thought are suspicious somehow. Keynes is back, but we have to look at history. After all, no economic theory can quickly and effectively rescue us from a pit of recession we have fallen into.

After the great panic in 1930, the function of bank is not just for borrowing money but moving assets and reselling them after portfolio packaging. The last few years have seen the most violent reform in financial markets, with a complexity unable to be elucidated by past economic theories.

Unquestionably, in 50 to 60 years after the war, the theories of Keynes and Friedman have changed a generation’s mindsets. Now we might need a new generation of economists, a new set of thinking methods to develop a coherent and comprehensive theory to analyze and define a direction for the post-globalization economic world.