The “smoothing out the bumps” fallacy
Posted May 17, 2011
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 15th May 2011.
Governments and central banks have invoked the writings of J.M. Keynes to justify the massive increases in government spending and monetary inflation that have occurred over the past few years. However, some of Keynes's apologists have pointed out that the famous British economist would not have agreed with many of the policy responses for which his work has provided the intellectual justification. They point out, for example, that Keynes only advocated temporary increases in government spending as a means of absorbing shocks to the economy, and that he was dead against currency debasement and the creation of structural deficits. The problem, though, isn't that Keynes's theory has been applied to an unreasonable extreme; the problem is that the theory is completely wrong.
For starters, the laws of economics always apply, so if greater government deficit-spending really did act to strengthen the economy during recessions then it would also act to strengthen the economy during the good times. On the other hand, if greater government deficit-spending hurt the economy during the good times then it would also hurt the economy during recessions. The point is that there isn't one set of laws that applies during periods of growth and another set that applies during periods of contraction.
Secondly, the concept that the government can provide a sustainable boost to the economy by increasing its spending is based on the fallacy that increased consumer spending causes the economy to grow. It causes GDP to increase due to the way the GDP calculation is done, but for an increase in consumer spending to be sustainable it must be an EFFECT of real growth; that is, it must follow an increase in production. Consumer spending is at the end of the growth sequence, not the start.
Thirdly, most people realise that the government usually does things much less efficiently than the private sector. The fact is that government spending tends to involve a lot of wastage. This is not an issue for the true Keynesian because he views an increase in spending as an economic plus even if the spending is totally unproductive, but it should be an issue for a good economist.
Fourthly, the government doesn't generate any real wealth of its own that can be 'spent' in order to offset what's happening in the private sector. Instead, everything the government spends must first be borrowed or stolen from the private sector. So, how can the private sector possibly be helped by the government increasing the rate at which it steals and borrows from the private sector?
Fifthly, recessions occur because of the widespread mal-investment prompted by the earlier expansions of the supplies of money and unbacked credit brought about by the central bank and the commercial banks. As a result of this mal-investment, the economy's structure becomes distorted such that it is geared to produce too much of some things and not enough of others. Unfortunately, the Keynesians mislabel the distortion caused by inflation as an "output gap", which they then cite as justification for more inflation and more government spending. In effect, recessions are symptoms of the process via which an economy attempts to rid itself of the distortions caused by prior inflation and intervention, and yet, in its role as "economic shock absorber", the central-planning team comprising the government and the central bank tries to sustain the distortions. How can this possibly be beneficial?
If an economy is strong enough it should be able to recover DESPITE the application of Keynesian remedies designed to smooth-out the transition to the next expansion, but the economic structure will necessarily be weakened by each successive increase in government spending and each successive inflation-fueled boom until, eventually, the economy will be in such a weakened state that it will be unable to bounce back in the face of more Keynesian policies. At this point, continuing with the same policies will lead to hyperinflation and/or a totalitarian state as freedoms are rapidly removed in a desperate effort to maintain control.
Hyperinflation and/or a totalitarian state are the inevitable destinations if Keynes's theories are relentlessly applied over the long term. The reason is that each round of policy mistakes creates the justification for even greater mistakes, setting in motion a downward spiral that will be inescapable as long as the perceived solution entails more of the same. The only unknown is how long it will take to reach one or both of these destinations. If the theory continues to be applied as aggressively as it has been over the past few years then we could get there this decade.
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