What we are now experiencing is unlike a normal recession. A normal recession is a contraction in GDP, usually brought on by tight monetary policy. What the world is going through now is economic contraction brought about by deleveraging and reinforced with fear. Businesses are cutting back on debt and investment funds have been forced to downsize, dragging down prices of almost all asset classes and exacerbating the implosion of credit markets.
Normal recessions are manageable via interest rates. Today, monetary policy no longer works because interest rates are close to zero and the credit markets are not functioning properly. The cost of new debt is higher than what businesses can earn in this stagnant economy, so it is not financially viable to lend.
That's why applying Keynesian solutions is wrong for our circumstances. Keynes developed his theory in the 1930's. It was a good fit for the world eighty years ago: little international commerce, no public debt and limited capital movements. Today's global economy is very different: huge global commerce, substantial capital mobility and public debt responsible for a major role in determining interest rates and ergo, growth. All these factors play no part in the naïve and obsolete Keynesian model.
One Keynesian dogma is the fervent effort to get to full employment. We can quickly and easily get to full employment by a variety of measures, such as embarking on massive infrastructure projects (those are certainly better than the alternative Keynesian methods of launching a war or discarding machines and hiring more people to replace them). But even reasonably efficient infrastructure projects take valuable resources and convert them into something less valuable. In other words, they do not produce wealth; they destroy wealth.
In fact Keynesian methods remind me of the story of the two men watching a giant earth mover working on a construction site. The first guy sighs: "there could have been jobs for 100 men with shovels right here!" The second man comments "better yet, there could have been jobs for 1,000 men with spoons..."
A second flawed Keynesian concept is public debt. From $946 billion in August 2008, the size of the Fed's balance sheet has more than doubled, rising to $2.1 trillion. With the Fed on track to purchase almost $2 trillion in Treasury and Agency debt by year end, as well as dramatically expand the Term Asset-Backed Securities Lending Facility, the size of the balance sheet could double yet again, to at least $4 trillion by the end of the year.
The administration's stimulus program will create jobs at the cost of an enormous increase in the government debt that has to be financed. And it does very little to increase productivity, which is the main engine of economic growth. We are engaged in a futile effort to stave off the impact of the decline in housing prices by rapid expansion in the Fed's balance sheet.
But housing prices have to fall because they have been inflated for years, nation wide. We have to let the real estate market reach an economic equilibrium. When that is accomplished, the financial system will recover and the economy will improve, which in turn will boost business investment, corporate profits and employment.
Keynes-style fiscal policy which amasses debt to obscure our fundamental problems will only make matters worse. This approach is saturated with factual errors and theoretical misunderstandings. Systemic worldwide failures should not be met with policy experimentation by our government. However innovative those policy experimentations are and however well intentioned, they will have broad and dire unintended consequences.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.