Northern Country

How globalization changes capitalism, the economy and politics

The myth that keeps Keynesians going

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– it is never quite the cigarette butt.

US economist and noble price winner, Paul Krugman, writes in his newest Times’ column about the "origins of the current disaster". In short lack of financial regulation that started during the Reagan administration turned us in and caused the current financial and economic crisis. The Reagan mantra and later neoconservative mantra ‘government is the problem’ becomes the focus point of criticism in the pre/post- prevention discussion.

For the more one looks into the origins of the current disaster, the clearer it becomes that the key wrong turn — the turn that made crisis inevitable — took place in the early 1980s, during the Reagan years.

The world class economist is in trouble. Krugman is a declared disciple of Keynes and his hand is leading the cavalry of government interference against "the worst economic crisis since the Great Depression". This is Keynesianism in its purest, something German Finance Minister Steinbrück and declared Krugman villain called “crass Keynesianism”. Why is the professor in trouble, well not really in trouble but lets say academically challenged?

The followers of Keynes like Milton Friedman, Alan Greenspan, Ben Bernanke, Paul Krugmann etc. believe in the almighty power of money that flows through the pipes of the economy. It is according to their believes, that manipulation of total amount of money available in an economy determines its direction. It is mainly in this context that the Federal Reserve finds the appropriate level of interest rates. A Keynesian will always believe in the dogma of inflating one’s way out of every macroeconomic problem by lowering interest rates and devaluing the nations currency.

Why not? It worked at least till now. Though the current crisis clearly shows the limitations and flaws of this philosophy. If Keynes was right how can he explain the current economic disaster? He can’t. In the words of past time guru, Alan Greenspan, ”shocked disbelieve” takes hold among Keynesians these days.

Since Keynesians cannot understand they try even harder to explain it. Krugman’s column in the NYT goes to the point. He writes about regulation and the lack thereof, taking hold during the Reagan administration. He even identifies the Garn-St. Germain Depository Institutions Act, that Ronald Reagan introduced into law in 1982, as the bill that "did it".

When Krugman blames the Reagan administration for scrapping "precautionary rules" he is absolutely right. It is just not the complete picture. To pinpoint our current problems to mortgage deregulation is part of the truth but not all of it. It is like pinpointing a bush fire to a single carelessly dropped cigarette butt when the real cause is climate change. Finding it and neglecting climate change will not prevent another fire down the road.

The idea that mere lack of regulation causes an economy and its financial infrastructure to overheat is not seeing the big picture because no matter what regulation always comes second to macroeconomic events. To Krugman’s second point, higher interest rates would have helped to improve the low savings rate of the private sector. How could regulation have helped to do the job?

At the height of the real estate bubble the whole mortgage market in the US was about 11 trillion dollar and subprime, the unregulated part Krugman writes about, was only 1.3 trillion dollar. At a delinquency rate of 40 percent and a recovery rate of 50 percent the cumulative losses should be about 200 to 300 billion dollar.

The US economy produces services and goods worth about 14 trillion dollar every year. The budget for military and defense in the US is about 500 billion dollar and that does not include the spending on the wars in Iraq and Afghanistan. The ensuing economic disruption caused by ‘mere’ lack of regulation is hard to grasp even after taking into account leverage and the Ponzi scheme of the securtitsation market in the financial industry.

In conclusion the Federal Reserve and its rate setting policies, that were guided to no small part by the ideas of Keynes, contributed substantially to the current crisis. It seems though that Krugman and his Keynesian friends are not ready to acknowledge it. How can we learn and get better, and at this point this is the best we can hope for, if our brightest do not strive to identify the root cause of the problem?

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