Why Keynesianism is Failing in this Recession

The S&P500 unsurprisingly continued to bounce up, ending the week with a 2.4% gain.  Volume was very light, also not surprising in a rebound rally from a deeply oversold level several weeks ago.  The VIX (or fear) index also retreated, as one would expect in a price rally, but at 24 the VIX is still much higher than it was during the market price highs in mid-April.

The economy continues to sputter.  The Empire State Manufacturing survey, for example, was weaker than expected.  Housing starts absolutely tanked, coming in almost 10% lower than economists had predicted.  Producer prices and consumer prices were both showing little signs of inflation.  Initial jobless claims jumped up to 472,000, well above expectations and back to near the 500,000 level closely associated with bad recessions.  The leading indicators came in below expectations, and the Philly Fed survey absolutely collapsed.

Technically, the S&P has bounced back up as expected, to the 200 day moving average.  Next, it’s very possible that it will also move up to the 50 day moving average, somewhere near 1,130.  In both cases, the downturn that’s clearly evident on the weekly charts would not be violated.  For that to happen, the S&P would have to move well above 1,200. 

The US economy is now over 2.5 years away from the onset of the Great Recession, which began in the fall of 2007.  And many economic experts are now beginning to question why we’re not roaring back with a traditional V-shaped recovery. 

Why are jobs not being created?  Why is the official unemployment rate still near 10%?  Why are retail sales disappointing?  Why are housing prices stalling and beginning to fall again?  Why has the stock market taken such a turn for the worse?

Many experts, such as Paul Krugman, argue it’s because the US government did not spend enough on a fiscal stimulus to prime the pump of the economy so that it could resume growing on its own.

In fact, they argue that we should spend even more.  Today.  Even if we need to borrow all of the spending and expand our federal debt load even more.

But with over a trillion dollars in fiscal stimulus pumped into the economy already, why hasn’t the economy ignited and resumed vigorous growth on its own?

Does Keynesian economic policy prescription work? 

The answer is yes and no.

Yes, Keynesianism has been effective in almost all cyclical recessions after WWII.  Why?  Because the US government’s total debt load was so low–as a percentage of GDP–that it could take on additional debt (to pay for the additional spending) without creating risks in the credit markets and offsets in private spending.  And, the non-government debt load (also as a percentage of GDP) was low enough that the private sector did not have the need to massively contract this debt level and further destroy private demand.

In short, government dissaving and spending has nicely offset rising private saving and reduced spending to act as a shock absorber in the economy to allow for private sector growth to return in short order.

But today, Keynesianism does not seem to be working.  Why?  Because the US public debt load (as a % of GDP) was too high at the onset of the recession to be able to expand sufficiently to offset all the demand collapse in the private sector.  And the private sector’s debt load was also too high–in fact at levels never seen in the history of the nation.  That meant that the private sector had to (and still has to) massively contract its debt load; this has put (and will continue to put) a severe restraint on private demand. 

As a result, government dissaving and spending has not (and is not) nicely offsetting higher private saving and reduced spending.  The government’s shock absorbers were not able to prevent the economy from getting stuck in a pothole, to allow for the resumption of sustainable growth.

In fact, the economy is still stuck in this hole, this ditch.  And what’s worse, we really don’t know how to get out of it.

So Keynesian theory and policy prescriptions do work–usually.  But in this case, the economy was too larded up with debt–at the public and private levels–to permit these normally effective policies to push the economy back onto normal growth trajectories.


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