Keynes believed that artificially increasing the money supply would solve our dilemma. Simply put, the extra money would be created and then spent by the government for either purchases or to employ workers. He appeared convinced that the effects of this newfound purchasing media would make companies and ordinary people feel that the economy was improving. This would stimulate additional demand which would eventually filter through the economy. This would produce further demand and consumption which would improve the outlook for the business community who in turn would increase their capital spending in anticipation of still further sales.
This worked well as it indeed helped shorten the devastating depression. Sadly, his teachings continued to be followed and were to become utilized to abort all future economic declines. They seemed simple to execute and were certainly politically expedient. Further, after working for many decades, they were easy for the average American to understand, and were accepted as foolproof. Unfortunately, few recognized the consequences and future dangers that were inherent in carrying out the monetary policy as espoused by Lord Keynes.
When Keynes was selling his ideas, the world was on the gold standard. This initially made it virtually impossible to implement his doctrines. Under the gold standard new purchasing media could only be created by a country if it possessed an equal or greater amount of physical gold. This was used to back the currency and was held in the vaults of the various central banks. Also, gold was used to settle international balance of payments deficits. In those days a nation was forced to ultimately pay for their purchases with gold.
This gold problem was circumvented in 1944, with the signing of the Bretton Woods Agreement by the major world powers. With this document the U.S. dollar could be used interchangeably with gold to back a country's money supply and for satisfying balance of payments deficits. Further, in the case of the U.S., it sanctioned our country with the ability to overcome the restraint of the gold standard. It allowed our government to produce additional dollars beyond the amount of warehoused gold. In effect, the dollar could be substituted for gold by the major nations of the world. It seemed logical at the time. With the dollar fully backed by gold, it indeed was as good as gold. Unfortunately, it removed the restraining feature of gold upon American politicians, and allowed them to create as many dollars as they desired.
With the implementation of the Bretton Woods Agreement the U.S. could now increase its money supply above that represented by the amount of gold that they possessed. This allowed the utilization of the Keynesian Doctrine. The initial increase in our money supply did indeed foster a sufficient rise in our gross domestic product to help extricate the U.S. from the grips of the devastating depression. When the politicians of the day recognized that Keynes' principles appeared to work the word quickly spread that he helped save our nation. Thus, the use of his doctrine became the method of choice to attack all future periods of economic decline.
Politicians have always hated gold. Throughout history whenever a monetary unit was not linked to gold the leaders of that nation ultimately debased its currency. The Romans first "clipped" their coinage, and later added base metals thereby reducing their intrinsic value. I believe that the dollar is the longest existing currency as all earlier experiments with paper money have ultimately ended with their becoming worthless. This, after their various governing officials inflated them out of existence. Fortunately, during each instance when a currency was being debased, gold preserved the purchasing power of those possessing it. Gold has been the eternal barometer because a rising gold price has forever forewarned a nation's citizens that something was amiss with their money. They would eventually recognize that their politicians had acted irresponsibly in protecting the value of their currency, and would eventually object or even rebel.
As time passed, and the Keynesian Doctrine was used to reverse the various recessions, it required increasing larger infusions of dollar creation to end each decline. A little monetary stimulation became greater volumes of inflationary dollar creation which begat today's exploding money supply. It's like a drug addict! He gets hooked with a small amount of cocaine. Later, his body adjusts to a certain level and he needs ever increasing amounts to attain the same high. So it is with the following of Lord Keynes' theories. Today, the Federal Reserve has been forced to increase our money supply by an unprecedented amount in their effort to revive our economy. During July, M3 increased at the mind blowing annual rate of 20.8%, and it remains to be seen if even this astonishing sum will be sufficient.
What at first was seen as a method of creating an unending era of economic prosperity, the continual issuance of inflationary purchasing media instead produced a series of damaging events. First, it cheapened the value of the dollar by drastically reducing its purchasing power. This in turn engendered higher prices for imported goods, which further stimulated domestic inflation, thereby reducing the desirability of owning government and other dollar denominated debt instruments. This fostered lower bond prices and higher interest rates than would have otherwise occurred. Then, the elevated yields acted to dampen economic activity as it raised the cost of doing business for the corporate community. It also acted to stimulate increased purchases of goods and services from abroad which ballooned our balance of payments deficit. Fortunately for the U.S., other nations eagerly sought our dollars in exchange for their precious goods, and we gladly accommodated them.
Over the decades, if the U.S. economy had been allowed to normally correct the excesses produced by the various boom periods, we would not be faced with today's plight. Instead, we live in a "bubble economy" where, as Richard Russell of DowTheoryLetters.com has so eloquently stated, "the U.S. must inflate or die." At some point following the teachings of Lord Keynes will prove fruitless in reversing an economic decline. Our future now rests in the hands of Alan Greenspan who, I believe, is presented with an overwhelming task.
Another little noticed result of decades of excessive monetary creation is a subtle change in attitude that affects individuals and produces a level of fear in the psyche of our country's citizens. When the purchasing value of a currency is constant for long periods, as it was under the gold standard, individuals would comfortably make future decisions. They could anticipate their long-term purchases and their retirement with certainty because they knew what their savings would buy at some later date. This was replaced by the fear of the unknown! No longer could individuals plan their lives based upon their present dollar or bond holdings!
I believe that it is this fear that has severely damaged the moral fiber of our nation's citizens. Now, Americans no longer know how much their savings will buy in the future. This forces many to feel compelled to perform in a fashion that in the past they would have considered inconceivable. With the uncertainty of knowing what their present dollars will buy later in life they feel obligated to acquire as much money as possible, and in any fashion that they deem necessary. Without the security of knowing how much wealth one needs for their future they no longer know how much is enough!
I believe that this is the prime reason behind the craze which is typified by the stock market bubble, the proliferation of lotteries as well as by all forms of gambling. This includes the explosion in the use of derivatives. They are merely a means of increasing one's leverage to the item that they represent. Further, it has created a "dog eat dog" society where lying, cheating and stealing are taken in stride as being a quasi-acceptable means of acquiring money and wealth. Further, I believe that this may be responsible for moral decay in our nation. Many people now feel that they should "live for today" because they live in fear for their futures.
During his tenure as chairman of the Federal Reserve Board, Alan Greenspan has presided over the greatest magnitude of excessive monetary creation in our nation's history. Greenspan now has to perform a nearly impossible juggling act! This, in order to keep the series of economic balls in the air, many of which were created by his policies. He is faced with among other major problems the need to reverse a serious economic decline that has the potential to snowball greatly in extent. He has the task of shepherding a $150 + trillion derivative monster that, given the recent enormous financial volatility in various markets and risk that it carries, has the potential to impact our financial and banking systems with destructive violence. The unprecedented decline in our bond market has generated yet to be announced losses that may spread throughout the financial system, is one possible example. Given the enormous level of derivative exposure in the economy, Greenspan may not be as fortunate in averting a disaster as he was in 1998, with Long Term Capital Management.
Additionally, he must balance the decline in the dollar, which I believe that the government covertly desires, with a further fall of the bond market. This will entail maintaining foreign confidence in our currency. He must suppress anything other than a gradual advance in our interest rates. Our economy will surely shut down if he fails. Also, while continuing to foster the public's belief in an economic expansion he must leave hope for the perma-bulls. This will prevent a stock market decline which, given our other problems, can lead to a devastating collapse with the attending fallout to the derivative market and our economy. I wish him well and hope that he is up to the task. However, I would not like to be in his shoes as his failure to keep all of the balls in the air will lead to serious consequences for us all.
Dr Richard Appel
Financial Insights
August 28, 2003
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