Keynesians: Fight the collapse of the bubbles by creating bigger bubbles

In 2002, Paul Krugman made his infamous statement:

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

Krugman, of course, later defended his comments to claim that he did not think such a thing to be desired, but nonetheless the underlying Keynesian principle was there: in order to fight a slump in "aggregate demand," the government must think and act boldly, or, to be more accurate, recklessly.

Indeed, Krugman's fellow Keynesian, Lawrence Summers, has taken this Keynesian principle in the same direction, recently declaring:

The central irony of financial crisis is that while it is caused by too much confidence, too much borrowing and lending and too much spending, it can only be resolved with more confidence, more borrowing and lending, and more spending. (Emphasis mine)

While Summers is recommending yet another attempt to reflate the housing bubble (in the name of "fixing" the housing market), the larger principle is the same: inflate SOMETHING. However, as I see it, Keynesians such as Krugman and Summers have overlooked the obvious, and that is the sad fact that governments around the world -- and especially the U.S. Government -- have created the Mother of All Bubbles with government paper. Indeed, as I will point out, the government debt bubble that has been created since the housing bubble fell apart about four years ago dwarfs whatever Wall Street produced with its subprime paper, and the U.S. Government and the Federal Reserve System (with Keynesians on the sidelines acting as cheerleaders) are hellbent on "solving" the current bubble-created crisis by unleashing massive inflation.

Before going on, however, I believe I need to point out the obvious: economic "theories" that declare that economies can grow only by the financial system creating phantom assets should be scrutinized and called what they really are: fraudulent. We have to understand that Keynesians now are saying that the financial system and the economy-at-large are at the point where the value of money must be ground down to near-zero in order to maintain our present economic standard of living.

Surely, people should be able to step back and understand just how destructive such beliefs really are, but instead, they are the core of current government policies and they dominate academic economics to the point where dissenters really are being cast into the Outer Darkness Where There Is Weeping And Gnashing Of Teeth. Indeed, in academic economics, the loudest criticism of the Obama administration and the Federal Reserve System has been that it has not inflated enough, that is, make the bubble in government paper even bigger in hopes that all of this finally will give the economy what Krugman calls "traction" and it can move on its own.

Now, Krugman and the others give no explanation as to how this can occur; they simply take it as an article of faith: the economy moves because the economy moves. They respond to dissent with, "No soup for you!"

However, we need to understand that the blizzard of public spending and borrowing now does not reflect the actual performance of the economy (present or future), but rather is just another bubble, this time with government securities. Furthermore, as debt markets go, it is pretty darned unregulated, chock full of moral hazard, and utterly unpayable. As for responsible policy, let us just say that the government policies of the past four years make the Housing Bubble look like the epitome of financial responsibility.

If a bubble means the blowing up of the value of assets well beyond any values as set by their fundamentals, then the government paper bubble easily fits that definition. I say this for the following reasons:

• The amount of debt the government openly admits to having is staggering, almost $15 trillion, and with the government financing about 40 percent of all its present spending via borrowing, we are not dealing with a situation like that of post-World War II, when the national debt as a percentage of Gross Domestic Product was higher than it is now. In other words, while U.S. debt fell rapidly after the war, right now it is growing like mad.

• There is no way the U.S. economy can pay its way out of this debt trap, and all of the "experts" are calling for accompanying inflation to allow the government to slowly repudiate its debt or what Krugman has called "deleveraging." (Krugman holds that inflation is good because it is a form of debt repudiation.)

• The budget numbers do not account for all of the hidden but very real liabilities that government obligations to Freddie and Fannie, Social Security and Medicare, which up those numbers at least another $50 trillion. These are paper obligations, obviously, as the U.S. economy will not perform well enough in any of our lifetimes to be able to meet these numbers. In other words, after a crisis caused in large part by moral hazard, the government has increased the amount of moral hazard in the system. Summers lives!

So, why do I say that we are in a government-paper bubble? After all, financially speaking, U.S. government paper is every bit as toxic as the sub-prime paper that collapsed Lehman and would have collapsed a number of other banks and financial houses. Yet, as Krugman happily points out, the interest rate on government bonds is extremely low, which he then uses to claim that the "market" is bullish on the U.S. Government and specifically the Obama administration.

Now, I find it strange that someone like Krugman who believes that markets usually get things wrong and only can operate properly under rigid state control all of a sudden is claiming that the Fed-manipulated low interest rates on U.S. bonds actually reflects the market view of things. If anything, the high price of U.S. bonds tells us that the rest of the economy, not to mention the troubles of the euro and the European Union, are in the tank even more than the government will admit.

In other words, the market for U.S. Government paper is not popular because of any underlying strength, but because it is perceived as being less awful than the situation in Europe. Krugman, of course, sees things differently. U.S. bonds are strong, he argues, because the government can print its own money, something I covered in this post. He writes:

Think about countries like Britain, Japan and the United States, which have large debts and deficits yet remain able to borrow at low interest rates. What’s their secret? The answer, in large part, is that they retain their own currencies, and investors know that in a pinch they could finance their deficits by printing more of those currencies. If the European Central Bank were to similarly stand behind European debts, the crisis would ease dramatically.

One hopes that Krugman would believe that such a scenario could not go on forever, with the government using "clever lawyers" (in Krugman's words) to have the Fed directly purchase government bonds instead of buying them (as the law states) on the secondary market.

Keynesians seem to believe that this is an optimal solution, if Krugman is representative of that group. Ultimately, the "Krugman Solution" would result in massive inflation, which would be a default by other means.

What we do know is that the massive government debt, be it in the USA or in Europe, cannot be paid back, especially since governments now are borrowing in order to fund their own debt services. This is not sustainable, not at all. And given that the dollar value of the government debt overwhelms anything we saw in the housing market, the future is not pretty.

There was another path we could have taken. We could have let the banks and financial houses that were holding mortgage securities to take the necessary haircuts and even go out of business if they were hopelessly insolvent. Despite what the Keynesians claim, the entire economy would not have collapsed, but I am sure that some CEOs would have lost their Connecticut mansions.

Likewise, instead of trying to find ways to prop up the unsustainable housing market, the government instead should have told the banks and mortgage holders that there would be no Uncle Sugar bailouts, and they would have to negotiate with borrowers instead of expecting the government to stand behind them as they went wily-nily with foreclosures. Yes, I believe there would have been a short and severe recession, but the difference is that we would be in a real recovery now.

Instead, we are in a depression. The economy is stuck at an "official" rate of 9 percent unemployment and probably an unofficial rate that is much higher, and there is no hope of a real and sustainable recovery in the future. Instead of looking to market entrepreneurs and at least getting out of the way of the still-profitable and productive entities in our economy, the Obama administration has decided to fight this downturn with massive subsidies and a vast number of new regulations that is raising the cost of doing business.

In other words, Obama and Krugman actually believe we can have a recovery by directing resources from higher-valued to lower-valued uses. That is not a prescription for bringing the economy back; it is a prescription for dragging down this economy until it reaches Third World status.