Revision of Economic Crisis, Cycles, and Measures to Fix It from 4 October, 2011 - 10:00

Asian and European markets fell overnight, priming Wall Street for a drop that will put it in bear market territory. Meanwhile, a double dip recession in the US is increasingly likely, China is finally showing signs of its own, potentially cataclysmic debt crisis, and both the Eurozone sovereign debt crisis and the American debt SNAFU are looming storm clouds. Morgan Stanley and Bank of America seem to be in deep trouble.

In other words, we're looking at the perfect storm. 

One of the factors exacerbating this crisis is the loss of traditional tools for dealing with the economy. Starting with the Great Depression, Keynesian economic policy gave governments a way of getting out of bad times and even of avoiding them entirely. The method was simple enough: use deficit spending in a down cycle to stimulate the economy by investing in the future, primarily by building infrastructure, then pay off that deficit by taxing more highly during boom times, thus slowing down the boom, prolonging the good times. The goal was to turn recessions into slowdowns. Only the lunatic fringe thinks that Keynesianism was socialist. Far from it: capitalists embraced it for producing a long postwar boom. In the US, the 1930s saw the construction of roads, dams, and bridges across the country. The dams of Tennessee Valley Authority and the Pacific Northwest made possible the refining of Uranium and production of aluminum, providing the raw materials that allowed the Allies to win the Second World War while the dams of the Southwest allowed Los Angeles and Las Vegas to grow. Detecting a recession in the mid-1950s, Eisenhower responded with the program to construct the Interstate highway network. It all seemed to work splendidly. In a December 1965 issue of Time Magazine, economist Milton Friedman stated that that "We are all Keynesians now," referring to the dominance of the model among economists (or at least such is the way the statement was read, see the Wikipedia link on the topic). The bottom fell out immediately thereafter—the consequence of a slowing economy and overcommitment to the costly Vietnam War and social welfare programs—and the US economy didn't recover for another twenty years.  

The problem with Keynesianism, ultimately, is that it relies on political will to operate: deficit spending and taxing during boom times are matters for politicians to approve, not just for economists to formulate. Given that taxes are never popular, conservatives typically preferred to cut rather than tax more during boom times. As the event horizon for investors became shorter and shorter, the idea of paying off one's debts seemed nostalgic. In the US, only during the boom years of the Clinton administration was a concerted effort made to pay off the national debt. Facing a recession and desparate to keep taxes low while waging two senseless wars, George W. Bush's admistration played Keynesian economics badly, creating an unprecedented national debt for the US and hamstringing the Obama administration when it came to power amidst the worst economic crisis of the postwar era. Now mind you, this may be a deliberate strategy, called "starve the beast." But surely even the most maniacal conservative politician wouldn't do that, would they?

Notwithstanding Bush's political use of Keynesianism wound up in disrepute after failing to get the US out of the economic turmoil it faced after 1966. By the 1980s, monetarist economic theory, led by the same Milton Friedman, took hold in the US. Avoiding the political hassles of Keynesianism, it suggested that the economic could be tuned by the Federal Reserve Bank which would adjust interest rates. Keep them low when the economy needs stimulus. Raise them to slow it down. To curb the stagflation of the late 1970s, Paul Volcker, a Democratic economists appointed by Jimmy Carter, raised the federal funds rate to 21%, thus bringing down inflation dramatically. Soon after, the Republican administration used Keynesian economic policy—albeit giving the economy a boost in the form of tax cuts instead of infrastructural investment—to successfully get the US economy going again. The Republicans took the credit for all of this, but perversely, it was a Democratic Fed chairman and a form of Keynesianism that worked.

With the death of Milton Friedman and the relative success of monetary policy since then, Larry Summers (Obama's chief economic advisor, among other things) would state in his 2006 eulogy for Milton Friedman, "we are now all Friedmanites." Although the full text was "any honest Democrat will admit that we are now all Friedmanites," it seems likely that Summers expected that all Republicans were by Friedmanites as well.

But with interest rates impossibly low and the national debt impossibly high, we seem to be facing a 1966-like moment. Economists have run out of options for solving this crisis in capitalism. Political will for either more manipulation for the Fed (and really, what can they do at this stage with the federal funds rate flatlining just above zero? see here) or for more Keynesianism has evaporated.

Game over, you've run out of quarters. Don't expect this crisis to be fixed for a long, long time.   

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