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Time to choose: Keynes or Krugman?

By Paul Murphy

It's a new year – and a new opportunity to take issue with the policy response now being adopted in Washington and the capitals of Europe: quantitative easing. It is now commonly assumed that, with the dollar printing presses rolling, America will lead a huge fiscal stimulus programme aimed at limiting the severity and length of the recession. Indeed, hardly a day goes by without some government somewhere announcing a multi-billion-dollar package of some description.

So, to coin an old cliché, "We're all Keynesians now."

Except we're not. Not by a long chalk.

Take Peter Schiff, an American strategist at Euro Pacific Capital who was one of the first to warn openly of the coming economic catastrophe. He calls himself a "pragmatic economist" when warning that rapid expansions of government debt (as required by the Keynesian approach) invariably led to inflation and higher interest rates.

In a rather lucid comment piece in the Wall Street Journal, Mr Schiff noted that just about all respected economists were now taking the theories of John Maynard Keynes as gospel. Moreover, there was an odd consensus whereby economics at a personal or corporate were somehow governed by laws different from those in effect at the national government level.

What he was referring to here was the simple notion that individuals or companies suffering from a heavy debt burden – and faced with shrinking income – instinctively know that they must reduce spending. They need to tighten their belts, pay down debt and live within their means. But, adds Mr Schiff, "it is axiomatic in Keynesianism that national governments can create and sustain economic activity by injecting printed money into the financial system".

The Euro Pacific man says there is a sense of smoke and mirrors here – that something can be magically created out of nothing by the chairman of the Federal Reserve.

As Mr Schiff says: "It would be irresponsible in the extreme for an individual to forestall a personal recession by taking out newer, bigger loans when the old loans can't be repaid. However, this is precisely what we are planning on a national level.

"I believe these ideas hold sway largely because they promise happy, pain-free solutions. They are the economic equivalent of miracle weight-loss programmes that require no dieting or exercise. The theories permit economists to claim mystic wisdom, governments to pretend that they have the power to dispel hardship with the whir of a printing press, and voters to believe that they can have recovery without sacrifice."

Mr Schiff's alternative solution is pretty simple – and unavoidably painful. He believes market forces apply equally to people and nations, and that belt-tightening is now required by all.

Governments cannot create things out of nothing – they can simply redirect resources. And directing resources away from the private

sector to state control will, essentially, lead to lowered economic efficiency. Along the way, if the government spends money it doesn't have then taxes must go up, while bailing out institutions with freshly printed dollar bills simply devalues each dollar already in circulation.

Inflation is low or non-existent now because of the house price implosion, the stock market crash and collapsing economic confidence across the world. But once asset prices stabilise and excess inventory has worked its way through the system, then all those newly-printed dollars will lead to a new era of sustained inflation.

Of course, there is a flip-side to this argument – vocalised, most notably, by the recent Nobel laureate Paul Krugman.

The underlying assumption here is that the American economy in particular is in a liquidity trap, where the real danger is the onset of depression. In such circumstances, the marginal cost of government intervention is actually very low, and so there is a strong case for big government spending so as to restore employment – and ultimately economic demand. To do otherwise would simply be criminally neglectful, in the Keynesian view.

The argument between these two camps promises to be the most strident intellectual debate of the coming year. What's shocking is the number of people it will ultimately effect.

So stay tuned!

- Paul Murphy is Associate Editor of the Financial Times