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Japan Us Economics & Keynes

post Aug 21 2010, 12:36 PM
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I wrote this as a sort of resume for a job, editing financial articles for a company here in Japan. I doubt that I will get the job, but since I went to the trouble I'll post it. tongue.gif


John Manyard Keynes, whose ideas formed the basis of Keynesian economics, and Friedrich Hayek, a major contributor to the Austrian School of ecomonics are considered representatives of polar opposite schools of economic theory. Interestingly though, Hayek was reticent to criticize Keynes during the last decade Keynes was alive - for the surprising reason that Hayek thought that the policies Keynes advocated during the economic climate of World War II were, in Hayek's own words, "preferable to the alternative".

To understand the extent that Keynes and Hayek were in agreement, an analogy is appropriate. If an economy is a hot air balloon tethered to the ground, Hayek was in favor of keeping it that way. Keynes on the other hand thought that the tethers could be cut away, and that the balloon could be controlled by regulating the heat you applied to the air in it. What the two men agreed on in the 40's was how much heat (inflation) should be fed into the ballon - but not whether or not the ballon should ever have been set loose in the first place.

The "setting loose" of the balloon was of course what we would call loose monetary policy. England, like most other countries of the world, had abandoned the gold standard during the Great Depression and during the 40's was contemplating whether or not to return to sound money. Hayek would have liked to have seen a return to a gold standard, however not at the old parity of the 20's. Keynes couched his argument in terms of returning to the old parity or abandoning the gold standard all together, ignoring in effect Hayek's middle ground position, and he had his theories of macroeconomics with which to convince everyone of the viability of "Keynesianism" in the post-war period.

It's no surprise that Keynesianism won out in the end, large banks have always fought to institute looser and looser monetary policies, which Keynes' theories have traditionally been used to legitimize. As governments have become addicted to the easy lending which central banks aquired the power to grant, Keynesian economic principles have become universally accepted.

It was not always so of course, and the slide down the slippery slope from sound money principles to modern fractional reserve banking is an interesting story.

America's foray into fractional reserve banking began in 1863, when the National Banking Act permitted banks in the US to operate with 25% of deposits kept in their vaults as reserve. Two years prior, the Civil War had started. Lincoln was president, and he needed money. He went begging to New York bankers for a loan, who, in accordance with their London counterparts set the terms at over 30% (I have read as high as 36%) interest.

The bankers thought they had the president over a barrel, but Lincoln's Secretary of the Treasury pointed out to him that the government could simply print its own money instead - i.e. U.S. Treasury Notes. Lincoln took his Treasury Secretary's advice, and the notes he printed were called "greenbacks" because of the green ink used on the bill's reverse side.

The bankers were blindsided by Lincoln's move, but in the following year they struck back. Lincoln needed permission from Congress to print his "greenbacks", and the bankers enjoyed enough Congressional support to pass the aforementioned "National Banking Act", albeit barely. This National Banking Act which had been proposed, in addition to legalizing fractional reserve banking, also granted charters to the country's largest banks to issue "national currency" for the first time. If Lincoln wanted his greenbacks, he would have to give the bankers their National Banking Act in return. The banking act subsequently passed and Lincoln signed it. He had no choice, there was a war on and he needed money.

Lincoln might have thought that his greenbacks, being interest-free, could successfully compete with the new national currency issued by private banks. But that was not to be the case. Two years later Lincoln was assassinated in the Ford Theatre, the Treasury stopped printing his greenbacks and Fractional Reserve Banking was off and running. Private bankers pushed through currency legislation in the form of the Federal Reserve Act in 1913, and fractional reserve requirements were soon whittled down to 10%. The Great Depression largely pushed countries around the world off of the gold standard, and as a viable alternative the U.S. dollar replaced gold as a reserve currency when the Bretton Woods agreement was signed in 1944. Finally when the dollar was decoupled from gold by Nixon, the currencies of world essentially became free-floating, suspended optimally in mid-air by the tenets of John Manyard Keynes, or so the world hoped.

Keynesianism is not without its up-side, and Hayek was aware of this as is evidenced by the truce between himself and Keynes during the 40's. Possibly one of the best economic minds of today is doctor of law and author Ellen Brown, who is not a fervent supporter of Austrian economic principles. She points to the continued prosperity of the state of North Dakota, a state which despite being one of the most inhospitable (i.e. cold) places to live or work in the United States has been largely immune to the current economic crisis. The reason, she explains, is that North Dakota has their own State Bank, independent of the Federal Reserve and its national network of member banks. The State Bank of North Dakota does not operate on any sort of gold standard, nor did the pre-revolutionary colony of Pennsylvania, whose monetary system and prosperity Benjamin Franklin was always quick to celebrate. What North Dakota and the colony of Pennsylvania had in common, Dr. Brown points out, is that in both cases money volume was tailored to the amount of goods and services produced in the region. How this balance was achieved in each case is beyond the scope of this article, but a paper monetary system run responsibly by the State has been shown to be quite viable.

So why is the rest of the United States in such a mess? There are of course a multitude of possible answers to that question, but with regard to money creation, not to put too fine a point on it, the rub is that currency in the U.S. (as well as in most places around the world) is created with interest attached.

The State Bank of North Dakota charges interest of course when it makes loans, but the profits are public and stay in the state. The Federal Reserve by law returns its profits to the U.S. government, but the private stockholders of the FED member banks get a 6% dividend on their stocks come rain or come shine. FED loans to the government are ballooned close to a hundred fold as money is loaned throughout the system, and there is interest attached to all of this money creation, interest which needs to be paid with money which is not yet in the system. This is the achilles heel of fractional reserve banking, for to keep the machine churning without lots of people left with no chair to sit on everytime the music stops, economies have to continually expand. Despite Keynes' assurances to the contrary, we may have reached the practical limit of economic expansion in the developed countries of the world given the productivity and resourses available. This may well be the root cause of the chaos we are seeing.

Japan bought into the Keynesian model long ago, and at first glance America and Japan might seem to be in the same general boat. However, the two countries couldn't be more different. Both countries are deep in debt, but nearly all Japanese debt is held by Japanese citizens. Japan still enjoys a large trade surplus with respect to America and is the largest holder of US debt. America of late has begun to vere more toward a 'social democratic' model that has proved successful in Japan, but America's chances of duplicating Japan's success in this respect are slim to none. Japan is a homogenous nation where public servants still more or less serve the greater good and waste is kept within reason. America on the other hand is an "every man for himself" country by nature, and socialist government programs in the U.S. have a miserable track record. Government invention in health care and education have driven costs through the roof and Obama's new health care reform bill only promises more agony.

If recent economic data are any indication, Obama's efforts to jump-start the U.S. economy with government spending and socialistic programs isn't working. Some would even say that trying to reinflate the housing bubble while running a trilliion dollar-plus deficit is essentially like trying to put out a fire with gasoline. China senses the dangers ahead and is beginning to cut back on its US bond purchases. Chinese bond holdings have declined from 930 billion in September of 2009 to 840 billion this past July. That's over 10% in under a year. Who's picking up the slack? ...That would be Japan, and the FED.

Japan increased its holdings of U.S. Treasury Securities by 56 billion over the same time period (September 2009 - June 2010), and her purchases of U.S. debt have accellerated since then. The FED is monetizing the lion's share of the rest of the shortfall, which places downward pressure on the dollar. After the massive monetary creation which financed U.S. government debt under Bush and the more recent bailouts, it's no wonder the U.S. dollar is beginning to decline precipitously against the Yen.

Japan is in a predicament. She hardly has the option of cutting back on U.S. debt purchases, much less divesting herself of them. America, which Japan relies on for her national defense, is also her number one trading partner, and a falling dollar means hard times for Toyota and Nissan. Yet Japan may soon find herself the last significant purchaser of U.S. Treasury Securities in the world. Can Japan alone prop up the U.S. economy and subsidize Obama's big government agenda? Or is Japan tied to a sinking ship?

The answer to that question really depends on whether the principles of Keynesianism are fundamentally sound or not. If Keynes was right and if a country like America can indeed spend and borrow its way out of a serious recession, for that is exactly what the U.S. is trying to do, then we'll all be fine. But what if there is a limit to how much big government and deficit spending an economy can support, and the U.S. ship has already taken on too much water and is really sinking?

If there is indeed a practical limit to how far the Keynes model can be stretched, then Japan, with its boat tied to the sinking USS dollar, will have some difficult decisions to make in the not too distant future.
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