The beginning of the Keynesian Era can be dated, perhaps, to September 1931 - the year when Britain intentionally devalued the pound, throwing the world into turmoil and currency conflict. Today, we are again in an extended period of economic crisis. However, I suspect that this will turn out to be the end of the Keynesian Era - the time when it is, in fact, Keynesianism itself which destroys us.

"Keynesianism" is really just this century's version of Mercantilism, which dates from the beginning of the 17th century. There's nothing particularly new or original about it. Behind the billows of academic obfuscation, it amounts to two policies: exaggerated government spending in the face of recession, and some sort of "easy money" policy. Although the term "Keynesian" has become unfashionable, virtually all academics and government economic advisers are Keynesians today.

The primary attraction of Keynesianism, I would say, is not its wonderful overall results, but rather, that it provides a good excuse for politicians do to what they wanted to do anyway. Any politician knows that a certain way to increase one's popularity is to hand out government money. In a recession, politicians are likely worried about their declining popularity, and thus their first instinct is to hand out more money. The Keynesian economists often boast that the money can be spent on total waste, such as "digging holes and filling them back up".

The other Keynesian trick is some form of "easy money" policy, which usually results in a decline in currency value. Currency devaluation can, in some cases, result in what appears to be a short-term improvement in economic conditions. However, it is said that "you can't devalue yourself to prosperity", and it is true. The countries that have the greatest success in the long term, also have the most stable, highest-quality currencies.

A basic effect of currency devaluation is to reduce real wages, since wages are paid in a devalued currency. This can increase "competitiveness", but it is easy to see that a strategy that reduces real wages cannot create long-term prosperity.

'Easy money' policy

The Keynesian strategy - government spending, typically on waste, and an "easy money" policy that amounts to currency devaluation - is basically a kick-the-can strategy. Both policies are inherently destructive, but can create what appears to be a short-term benefit, particularly from the standpoint of a politician. Pursuing policies that are inherently destructive, over a long period of time, will result in economic decline.

When the Keynesian remedy was tried during the Great Depression, it did not work. The Depression went on for year after year. In 1939, President Roosevelt's Treasury Secretary Henry Morgenthau concluded:

"[W]e have tried spending money. We are spending more than we have ever spent before and it does not work… I say after eight years of this Administration we have just as much unemployment as when we started."

Japan has tried a similar approach for over 20 years now, and it is not working there either.

Today, governments have not really followed the hole-digging-and-filling routine of mid-century Keynesianism. However, the idea that the government will attempt to fix private-sector problems with the expenditure of vast quantities of public money remains. So far, this has taken the form primarily of filling the financial holes in bank balance sheets, so that private investors will not take a loss on their earlier poor decisions.

To do so, governments have dug huge holes in the public balance sheets. Several countries - Greece, Spain, Italy, Portugal and Ireland - have already reached the point where they would have defaulted if left to the private markets. Several other countries, including Japan and Belgium, are not far from default, and even the US and German governments are strong only in comparison to the alternatives. The notion of spending your way to prosperity has run into the brick wall of default.

This has made the Keynesians even more reliant upon their second trick, which is some form of "easy money" policy. Today, this has reached a degree that is unprecedented in the last century. The United States, the United Kingdom and Japan have adopted "zero interest rate" policies, and on top of that, they have undertaken aggressive "quantitative easing" policies. The ECB is not far behind: although their target rate is 1.0 per cent, the one-year German government bond trades at 0.03 per cent. Expectations are rising for the ECB to adopt some form of "quantitative easing", or perhaps, even dropping this euphemism and buying government bonds simply to facilitate government funding.

Currency decline

The result of this hyper-aggressive Keynesianism is that the values of currencies around the world have steadily declined over the past 10 years. The best measure of this decline is their exchange rates with gold. It now takes around five times as many dollars to buy an ounce of gold as it did in the 1990s. This is not, I assert, because gold has become more valuable, but rather because the US dollar has become less valuable, as a result of these Keynesian money manipulation policies.

Not surprisingly, it also takes about five times as many dollars to buy a barrel of oil, about $100 today compared to $20 in the 1990s.

If you consider the overall effects of this for a moment, it becomes clear that the real value of wages, pensions, bonds, stocks and other assets are declining as a result of this currency decline. You still can't devalue yourself to prosperity.

However, the negative effects have not yet been fully felt. With dramatically negative "real interest rates", and expectations for even more aggressive monetary easing worldwide, the trend towards currency decline will likely continue and in fact accelerate.

When Europe's various acronymic efforts to borrow themselves out of debt floundered recently, a near-universal chorus rang out: just have the ECB buy the debt. The quantities were in the hundreds of billions, and eventually trillions of euros. Even an economic simpleton can see this is a recipe for total currency annihilation. Yet, the supposed financial sophisticates were nearly unanimous.

I expect we will have our Keynesian crisis, in which several more governments, including the United States, either default, or print money to avoid a default. Currency values will probably continue to decline, perhaps not so gradually as has been the case thus far. Gold, which you could call the one currency that cannot be devalued by a government, would seem to soar to great heights, when measured in these plummeting bits of fiat paper. In fact, it would be essentially unchanged.

Eventually, governments will be incapable of either borrowing or devaluing their way out of their problems. Then what?

Address the problems

If Keynesianism amounts to can-kicking, a better approach would be to address the fundamental problems that are causing the crisis in the first place, and to improve economic conditions in a broad sense.

Contrary to popular imagination, a government default does not have to be a big crisis. We are in fact quite accustomed to government default, having much experience with it over the past few decades, mostly with governments of emerging market countries. What happens is: the borrowers and the lenders get together in a room, and decide on a restructuring of the debt. Typically, principal is reduced by about 50 per cent or so, which is what happened in the case of the Russian default of 1998.

That's it. By itself, it is relatively minor. Just as declaring bankruptcy can be a great relief for an individual, who is finally free of his obligations, it can also be a relief for governments, whose debt commitments are dramatically lightened.

A lot of the fears surrounding sovereign default are actually related to the various stupid and economically destructive things that governments often do in such a crisis. These might include such things as: huge tax increases, capital controls, outright confiscation of assets and currency turmoil. Countries can indeed be ruined for decades as a consequence of these sorts of actions.

However, it doesn't have to be that way. What did Russia do immediately following its default and currency collapse in 1998? In 1999, the government lowered the VAT rate from 23 per cent to 20 per cent. That was a warmup for the biggie: in 2000, the government passed a 13 per cent flat tax plan, implemented at the beginning of 2001. In 2002, the corporate tax rate was reduced from 35 per cent to 24 per cent. In 2004, the VAT was reduced again, to 18 per cent. Payroll taxes were reduced from a total of 35 per cent to 24 per cent. In 2005, inheritance and gift taxes were eliminated. In 2008, the tax rate on dividend income was reduced to 9 per cent from 15 per cent. In 2009, the corporate tax rate was again reduced to 20 per cent.

Russia did not suffer a decade of misery after its default in 1998. At the lows of that year, the RTSI stock market index hit a nadir of 38. By 2008, it had risen to 2487, an increase of 64 times! The Russian government's reaction to its default - implementing a barrage of growth-friendly policies - produced probably the most economically productive decade of the last two centuries of Russian history.

Russia's GDP, measured in US dollars, was four times larger in 2008 than it was in pre-crisis 1997. This strategy is completely opposite to the "austerity" approach of Greece and others today.

Declaring bankruptcy

Insolvency of banks is a major part of our crisis today, and oddly, nobody seems to know what to do about this. The solution is a form of bankruptcy, in which the institution continues to function, but the liabilities are restructured. In the U.S., this is known as "Chapter 11" of the bankruptcy code. American Airlines has entered bankruptcy, but its airplanes continue to carry travellers. General Motors entered and exited bankruptcy, but continued to produce cars.

No public money is necessary for this. The idea that fixing the bank problem requires a "bank bailout" and immense quantities of taxpayer funds is wholly incorrect. Banks can regain their solvency simply by swapping some portion of their debt liabilities for equity.

However, the government might have a role in organising this process. In 1933, the US undertook a "bank holiday" of about two weeks, in which insolvent institutions were reorganised.

"A currency, to be perfect, should be absolutely stable in value," wrote the economist David Ricardo in 1817. Even a brief glance at the economic history of our own era shows that the most prosperous countries are those with the most stable, reliable currencies, such as the US, Germany, China and Hong Kong. Currency turmoil is associated with economic stagnation and decline.

Before the Keynesian crisis is over, the US dollar, the euro, the yen, the British pound and other once-reliable currencies will probably be revealed as just so much-fiat junk.

For 182 years - 1789 to 1971 - the US had a stable currency policy in the form of a gold standard system. This worked beautifully. The country became the wealthiest and most productive in the world. The last two decades of that period, the 1950s and 1960s, were some of the most prosperous in US history.

However, the Keynesians have always hated the gold standard, because it prevents them from engaging in one of their favourite pastimes, currency jiggering. The floating currency system that emerged in 1971 is a reflection of these Keynesian ideas.

By the end of our crisis, we will probably see a worldwide rejection of Keynesian funny money ideology. People will want to return to the stable money principles of the gold standard era.

Today, government default, bank insolvency, and depreciating currencies plague our economic environment. Humans seem to learn slowly, and only with great pain and struggle. Eventually, I expect the crisis to get so bad that all attempts to maintain the status quo will disintegrate.

However, this would be the first step toward a much brighter future. With Russia-like tax reforms, banks that have been restructured to solvency without public funds, and a world gold standard system, the post-Keynesian era should be a time of great prosperity.

Source: Al Jazeera