John Maynard Keynes and Utopia

If you are like me, whenever I go past Milton Keynes on the M1, I unconsciously press the accelerator and go a little faster. The town sharing the famous monetarist's name is hardly Utopia.

New Crisis, New Theories

Since the twin crises of Credit Crunch and Recession loomed quickly on the Government so much so that they had to work hard on their usually well scripted tune on the economy to take us from prudent and stable economy to downright disaster but somehow blame it on a smalltown America, the economic theory behind the last 10 years has been rapidly ditched and the theory of John Maynard Keynes has been resurrected as the darling of Darling to 'Save the world' as daddy Gordon would put it.

Keynes, while writing in the depths of The Great Depression in the 1930's, said that the 'Paradox of Thrift' would cost us dearly. The idea that we should individually and collectively save during a recession was not common sense and that Government in particular should in fact not be prudent but effectively 'Party, Party, Party' like there was no tomorrow and spend far more lavishly than it ever planned. This would indeed fool us all to actually spend more and so stave off further recession.

There is a perverse logic to all this. If we we get gloomy and save then indeed demand further falls and so less investment goes into business, getting us into a vicious spiral of longer recession. Keynes said the way round this is to introduce vast new Government spending to stimulate the economy and we would all think more positively and not squirrel away our money.

Ah, But

There is, of course, a minor flaw in the plan and the economic theory of 'Rational Expectation' does kick in. This suggests we are not individually and collectively entirely stupid and that when a recession arrives, we tend to think slightly further ahead than the next mealtime. So factors like reality and our fear about our jobs, ability to pay bills like mortgages, future tax bills and feed the family tend to come to the fore.

There is also another important factor. This week, on top of the forecast for 600,000 job losses in 2009, we hear that house prices dropped to August 2004 levels. It doesn't take a genius to work out that most people who took out mortgages of 80% of value or more since 2004, are now likely to be in negative equity. With the job loss forecast, the possibility of defaults on mortgage payments are growing and it's forecast that 75,000 homes will be repossessed in 2009 despite the nice Government holidays on interest payments. Just as rapidly depreciating assets like cars are less attractive in hard times, buying a new asset like a house in a recession is not the wisest idea if it will be worth less than you paid for it within 12 months.

Keynes, as with most monetary theorists, was an idealist. The reality is that it makes much more sense to rein in personal spending in hard times than to spend more. Common sense, rather than fancy theories tell us this is sensible.

Borrowing Growth

Already Britons borrow some £1 trillion on credit cards and have leveraged their equity in their houses which has now collapsed, so it makes good sense for us individuals to think about saving rather than spending, if only as a buffer against potential job loss. While this is a self-perpetuating model in Keynes' eyes, it's hard-nosed reality to the person in the street.

Meanwhile, the Government, without accounting for the bank bail outs, will increase borrowing from above the 38% of GDP target today to around 57% of GDP by 2010. The bonds issued to fund this must be less attractive as our ability to pay has bigger doubts associated as tax revenues are due to sharply decline over the same period, not helped by the cut in VAT but the simple issue of higher unemployment benefits and less tax contributors will kick in. As the rich like Stelios and Sir Philip Green smile in their Monaco apartments as they can afford to avoid tax, the Government is suddenly getting hard on Welfare Claimers which means it will be tougher on the new wave of legitimate claimants as unemployment rises. The new claimants will pay the price of laissez-faire Government attitudes to long term claimants over the last 10 years.

The reality is that suddenly we have a Government about-turn on many fronts because it got sucked in by its own bull over the last 10 years and never ran the country properly. While we somehow think Gordon Brown et al are heroes for 'saving the world' and bailing out the economy using our money, we seem to have conveniently forgotten that it was the same crew who got us here.

It does not inspire confidence that if they did not get it right when the graphs pointed up over the last 10 years, that they have an earthly idea what they are doing when they point down.

The Difference and Why Keynes May Not Be the Way Out

The major differences between The Great Depression and Today that Keynes does not account for is that over the period since and particularly recently, home ownership in the affluent world has risen spectacularly and the value of those homes in the last 10 years has risen extraordinarily thanks to cheap and plentiful credit which relied on the values ever-increasing - it's own upward spiral. It meant that the affluent world had another source of capital gain outside of household income - the rise in equity of their homes. And boy did we use it.

Mortgage Equity Withdrawal has been the biggest stimulator to the economy in the last 10 years. And it was make-believe. What Keynes does not know is that the collapse in house values mean that the equity leveraged is worthless and all that is left is the debt. For many negative equity is now a reality and this was not a factor in The Great Depression.

Largely, Keynes wrote about an economy which relied on the confidence of a settled household disposable income. This new economy relied on Mortgage Equity Withdrawal and this has dried up. In the 10 year period to now, household disposable income has actually shrunk.

It's why economists are now talking of the economy shrinking by 2.9% in 2009, the biggest drop since 1940.

Reliance on an old theory about Recessionary forces is foolhardy and shows a complete lack of understanding of the actual situation. The last 10 years has seen unprecedented use of a new income source from home-equity. To get that back is going to take far more than tax cuts and bank bail outs. Just like the stupidity of paying vast bonuses to bank executives on profits that would subsequently be lost, the Government has gone down the path of trying to give a boom today when we are more interested in survival - but we will pay the price of this in the next generation of tax.

Personally, I believe the bank bail out has just shored up a status quo and we will not see modified behaviour from executives and shareholders, and we certainly have not seen banks acting in the interest of customers. We have just preserved a way of life and executive salaries. Meanwhile, around 1m more will join the dole queue as the likes of Peter Mandelson play God to save industries who scratch his back the most.

We must be idiots. Common sense says this is the wrong course of action. While we should not sit tight, we should allow the natural course of events on banks to play out. It's at the heart of the problems of the last 10 years and there is a price to pay. Avoiding it now will only make it worse in the future.