How Simpleminded Economists Really Can Be

It's the Ultimate Fighting Event - Worldwide Economic Mud Wrestling! See it now!

First, the Honey Hun...German Chancellor Angela Merkel... took on a whole pack of central bankers and economists, charging that they were going to make the situation worse - by spending money they didn't have...and causing inflation.

Then, historian Niall Ferguson - Professor Punchy - took a jab at the meddlers in the pages of the Financial Times. His point was simple enough; that the feds were spending trillions of dollars without really knowing what they were doing. If they borrow money to stimulate the economy they are just taking money out of the private economy and diverting it to public spending. There's no gain in that, he said.

Watch out Niall...! The Nobel Knucklehead - economist Paul Krugman - hit back.

We'll return to this grapplefest. But first, let's take a look at what is happening outside the arena...

Nothing!

Yesterday, for the third day in a row...not much happened in the markets. The Dow fell 24 points - hardly worth mentioning. Gold held steady at $955. Oil rose a dollar - to $71. And the dollar itself remained about where it was - at $1.39 per euro.

It is as if everyone were waiting to see what happens next. Let's see...

We've seen the biggest stock crash in history...

..the biggest property crash in history...

..the biggest deficits in history (four times the previous record!)...

..the biggest bailouts in history (we can't even count that high)...

..the biggest bankruptcies in history...

..the auto industry and the finance industry have been largely nationalized...

..the president of the United States of America is now making financial decisions for formerly private industries...

What's left to see?

Oh yes...the depression...and hyperinflation.

And...now's the time to protect your investments from these dreadful consequences...

"Get ready for inflation and higher interest rates," warns Art Laffer in the Wall Street Journal. Remember him? Creator of the 'Laffer Curve.'

But don't worry about inflation, adds Harvard professor Gregory Mankiw, also in the Wall Street Journal: Inflation is just what we need. "In the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative..." to force people to get rid of their money as fast as possible.

Over in the bond market, investors are finding out what a little bit of inflation - or even hints of inflation - can do. People bought US Treasuries during the panic of '08 for safety purposes. Now, they're getting what we predicted. Alas, yes, they are getting what they deserve, not what they expected. Our friend Chuck Butler points out that prices of 10-year Treasuries have come down from $110 as recently as 5 months ago to just $94 this week. How's that for safety - a 15% loss!

What they were fleeing from was the uncertainty and risk of the big wide world of investing. When Lehman Brothers went broke foreign investors took the first available plane out of India, for example. But now, our friend Ajit Dayal reports that they're coming back. We're working with him now to develop an international report on investments in the BRIC countries, with ace editors on the ground in each. As soon as the report is ready we'll give you first crack at reading it here. Because right now things are looking up on the sub-continent:

"What a month!

"The 36% surge in client portfolios after the election results in India have brought the value of the client holdings back to where they were before the Lehman bankruptcy in September 2008.

"We see this as a base for a possible assault on a new peak by June 2010.

"That is the good news.

"The bad news is that many of the lessons learned in the implosion of capital markets in the year 2008 may be forgotten. Memories are short - in fact they may not exist."

Memories? Here at The Daily Reckoning we've got all the memories you could want. We may not be able to remember what we did with our car keys, but we remember that fateful day - August 15, 1971 - when Richard Nixon 'closed the gold window.' It's been downhill ever since...

In his blog, Krugman accused Ferguson of "living in a dark age of macro-economics, in which hard-won knowledge has simply been forgotten."

The "hard-won knowledge" he referred to was Keynes' "proof" that extra government spending was indeed a plus to the economy - as long as there was not full employment. Once full employment was achieved, things changed, he said. Then, government borrowing just "crowded out" private borrowing.

We don't expect Daily Reckoning readers to be deeply interested in these squabbles; you've got better things to do.

We just bring it up to make a point. The world's governments - led by the United States of America - are spending trillions to head off what they believe could be a terrible depression. Yet the theory on which they hang their reasoning is such a thin string, some of the world's leading thinkers can't seem to hold onto it. Merkel thinks the theory is wrong; Ferguson thinks it's wrong. Heck, we even think it's wrong.

Not that that proves anything. We could be wrong. But we're not spending trillions of dollars based on an idea that is the subject of hot dispute. It's a dangerous plan...

"Keynsian revolution was not a triumph of good science, but of good judgment," says the FT's headline from yesterday. Ha ha...that's a good one. They're right, of course. There was no science in Keynes' oeuvre. It was all guesswork. But good judgment? Not much of that either.

As for Keynes' "proof," it is defective. He argues only that when the feds borrow and spend in a recession they can't "crowd out" private borrowing without also increasing economic activity - which he takes as a gain.

Which reminds us how simpleminded economists can be. Imagine a town where people borrowed and spent too much. Faced with unemployment and a slump, the mayor borrows money to build a new town hall - thus putting "idle" resources back to work.

He doesn't "crowd out" private activity, because private citizens are hunkered down, trying to pay off their debts. They save. They lend to the mayor. Private borrowers have no better use for the money.

That is the theory of it. On the surface, it appears that the mayor's stimulus plan is a big success. Pretty soon, people are working again. Money is changing hands. The new city hall is going up.

But what has really happened? The citizens will have a new town hall. But it's a building they hadn't particularly wanted when the good times were still rolling. And now they have their share of the debt the mayor incurred to build it.

Yes, it may look as though the town is more prosperous - with people employed on the new town hall, collecting paychecks and spending money. But the prosperity is phony. Citizens got not just one thing they didn't want, but two - a new town hall and more debt. And somehow, sometime in the future...other spending plans will have to be shelved so that the town hall can be paid for!

That's what Angela Merkel was saying in her attack on the central banks. When all is said and done, 10 years from now we'll be back to where we are now.

This morning, we got a call from a reporter. "How long do you think this rally will continue," she asked. "Why do you think it won't last?"

"As to the first question, we have only an intuition...based on very few historical precedents. When you get a crash as big as we had until March...you can expect a rebound for 3-6 months after. The current rebound is now almost exactly 3 months old. By our guess it could run 3 months more...which takes it to September. But it's very dangerous. If you're playing this rally, be sure to use tight trailing stops...the next leg down could be worse than the first. Remember, after the Crash of October '29 the market rallied until the following May. Then, it went down. And it didn't bottom until 1932.

"As to the second question...why can't the rally become a real boom?...the answer is very simple. Debt is either expanding. Or it is contracting. When it gets to an extraordinary high...it tends to go down. Because it can't go up any more. That's where we are now. Since consumer debt can't increase - and since consumer incomes are definitely not increasing...especially not in Britain and America - there is no way that a consumer economy can expand. Since it can't expand, it must contract. You can't have a boom in a consumer economy when consumer credit, consumer incomes, and consumer spending are all going down. Forget it."

Bill Bonner
for The Daily Reckoning Australia

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