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Neo-Keynesian Trap

Cheap, abundant credit stimulates the wrong kind of growth.
Paul Krugman

The grand global debate in political economy boils down to Keynesian stimulus vs. austerity. Stripped of rhetoric, the debate is much the same in nominally communist China, socialist Europe, and notionally free-market America: should the central state continue borrowing and spending enormous sums of money to maintain or restart economic growth (Keynesianism), or should it live within its means (austerity)?

Polemics have distorted the debate on several levels, starting with what “Keynesianism” and “austerity” actually mean. As many observers have pointed out, John Maynard Keynes did not, in fact, advocate permanent government deficits, but rather a commonsense policy of paying down public debt in good times and borrowing in bad times to bolster demand for goods and services.

What Paul Krugman and his allies propose today is neo-Keynesianism, and what that prescribes should be spelled out without spin: governments should borrow and spend all the time, but a lot more during recessions.

The neo-Keynesians have succeeded in painting austerity as the grim policy of wresting bread crusts away from widows and orphans, but its unspun meaning is that governments must live within their means rather than fund basic programs with borrowed money.

The neo-Keynesian left claims that fiscal stimulus is responsible for America’s recovery—in contrast to Europe’s ongoing crisis under austerity—and that all we need do to escape the darkened woods of slow growth is borrow another couple of trillion dollars a year for a few years. The Tea Party right claims that fiscal stimulus is like fusion energy—its proponents have been saying it will work next year for 20 years—and the jobless U.S. recovery, dependent on unprecedented government borrowing, is not even real growth.

But fiscal stimulus, right or wrong, is only the surface of the problem. The core lies much deeper, in the systemic mispricing and misallocation of capital and risk.


We cannot grasp the dynamics of what both sides claim as their ultimate goal—broad-based economic growth—without first understanding the engines of growth: capitalism and credit. Capitalism has two key tenets: capital is put at risk, and the open market discovers the price of capital, labor, credit, and risk through supply and demand. Gain is not guaranteed: loss and failure provide the discipline and feedback the system needs to function. Moral hazard is the separation of risk from gain—those exposed to risk behave very differently from those not exposed to risk.

The key feature of credit is that its cost is reflected in the interest rate established by the market.

Contrast these basic tenets with central-state fiscal and monetary policy as practiced virtually everywhere, by center-right governments as well as left-wing ones. Interest rates are kept artificially low by central bank policies—for example, the Federal Reserve’s Zero Interest Rate Policy (ZIRP). As a result, borrowed money (capital) is both abundant and cheap. Supply and demand have been shown the door: regardless of the purpose for which money is borrowed, credit is plentiful and inexpensive both for governments and favored private borrowers.

This distortion of supply and demand is presented as a way to boost growth through low borrowing costs and easy access to credit. But since the discipline and feedback of the market have been banished, the system effectively incentivizes over-borrowing, excessive leverage, and misallocation of capital.

Cheap abundant credit is a form of moral hazard, as the risks of borrowing have been artificially reduced: if you can borrow money for near-zero, why not put that money to work in speculative “carry trades” that earn a few percentage points of profit? If credit were priced by supply and demand, the money might cost more than the gains earned in the carry trade, effectively limiting speculation. With credit at near-zero interest, there are no limits to speculative borrowing or leverage.

The assumption behind artificially extending cheap credit is that the money will be invested in the desired growth—i.e., productive enterprises. But since discipline and feedback have been eliminated, what actually happens is that credit fuels the growth of financial cancers. Why bother risking capital in legitimate enterprises when there are financial carry trades that are profitable thanks to ZIRP?

When credit is priced by the market, the purpose for which loans are to be used sets the cost of that money—the interest rate. Money bound for marginal, risky enterprises costs more, and so these enterprises must attract cash capital. If the venture can’t attract investors, it goes unfunded. This is how capital and credit are allocated in an open market that discovers the price of risk and credit.

Once credit is abundant and cheap, all sorts of marginal-return or high-risk ventures receive funding and the mispriced capital is misallocated.

The ultimate misallocator of capital is the centralized state: when there is little cost to borrowing, it’s a painless decision to fund bridges to nowhere, $300 million-a-piece fighter aircraft (the F-35), and other extravagances. If money were priced by the market, borrowing vast sums would require a tradeoff, as the interest paid would be recognized as being unavailable for other spending.

When governments can borrow virtually unlimited sums for near-zero interest (a 5-year Treasury bond yields .82 percent, and the 1-year yields .19 percent), there is no brake on borrowing or spending.

Risk—the foundation of capitalism—has been drowned by easy credit: if the government squanders the money it borrows, it can simply borrow more. Easy credit eliminates the tradeoff enforced by markets discovering the price of credit and risk: there is no need to debate what is productive or unproductive, as there is plenty of money for everything.

But risk cannot be eliminated; it can only be pushed beneath the surface. Borrowed capital has an opportunity cost: money borrowed and spent on one thing is no longer available for something more productive. Interest also bears an opportunity cost: revenue spent paying interest is no longer available for more productive purposes.

The neo-Keynesians’ basic premise is that cheap, abundant credit and massive government borrowing and spending generate growth by sparking “aggregate demand” for goods and services, which enterprises expand to provide. What Kurgman and company fail to consider is the systemic misallocation of scarce capital and revenue that their policies incentivize.

Having banished the discipline and pricing of the market, their policies have no mechanism to differentiate between consumption and productive investment: any and all borrowing and spending is considered good because it creates demand for something.

This intrinsic inability to distinguish between squandering borrowed money and investing it in productive enterprises is neo-Keynesianism’s fatal flaw.


The neo-Keynesian faith in borrowing and spending trillions of dollars as the surefire solution to recession or slow growth is rooted in an idealized “proof of concept”: World War II.

In their mythology, the central state ended the Great Depression by borrowing trillions of dollars into existence and spending it on the hugely wasteful enterprise of global conventional war. According to this myth, it didn’t matter if millions of people were paid to make things that ended up on the bottom of the sea: what mattered was that workers were getting paid and their savings and “animal spirits” were building up aggregate demand, which would be unleashed once the war ended.

While the narrative is accurate in broad-brush, it fails to note the unique conditions of America in 1941 that made the war effort and postwar expansion possible:

  1. America was the Saudi Arabia of the world at the time, with seemingly endless reserves of cheap oil to burn on global war.
  2. America’s federal government had little debt.
  3. The private sector also had little debt, as credit had contracted in the Depression.
  4. The idle labor force could be employed at modest rates of pay and overhead and could generally be trained for duties in factories or the military in a matter of months.
  5. Wartime restrictions on consumer goods were a form of forced savings as there weren’t enough goods available for workers to buy. These forced savings formed a massive pool of capital.
  6. These forced savings flowed into war bonds, so federal borrowing was largely funded by domestic capital.
  7. Foreign capital and manufactured goods played insignificant roles in “Fortress America.”

None of these conditions apply to 21st-century America. Instead, the public and private sectors alike are burdened with gargantuan debts, and the private sector’s primary household asset, the home, has had its value gutted by the popping of the credit-fueled housing bubble. Foreign capital is required to fund government borrowing, as domestic savings remain anemic in our over-indebted, highly leveraged economy.

What’s missing from the neo-Keynesian narrative is this: America in 1941 was wealthy enough in natural resources and borrowing power that it could waste enormous quantities of energy, material, and labor. The forced-savings capital accumulated in the war fueled the long postwar boom, and this precious pool of capital was by and large efficiently allocated by the market.

The situation is entirely different now, thus it is little wonder that the model of 1941 isn’t working as intended. Instead, the federal government’s open-throttle fiscal and monetary policies have unleashed unintended consequences such as commodities inflation: when abundant credit and scarce commodities meet, inflation results.

Since scarce commodities are priced in the global economy, the cost of these essentials responds to newly printed or borrowed-into-existence dollars by leaping higher. We received a taste of this when the flood of global stimulus unleashed in late 2011 by central banks resulted in higher gasoline and oil prices, at least for those of us holding U.S. dollars.

In a global economy competing for resources, Keynesian stimulus triggers inflation and speculation in commodities, not growth. Once again, the suppression of market discipline and pricing leads to distortions that cannot be fixed by additional stimulus. What is stimulated is toxic to real growth: over-indebtedness, speculation, and inflation.


Cheap credit, unlimited government guarantees on loans, and debt-financed spending provide no mechanisms for distinguishing between unproductive consumption and productive investment. Thus every $100,000 student loan is counted as an investment, even though there is a world of difference in the job market between a degree in software design and one in fashion, medieval literature, or even in business, as MBAs appear to be in massive oversupply.

When all borrowing and spending is equally “good” and market discipline and feedback have been eliminated, then unproductive spending is equated with productive investment. The consequences of this Keynesian myopia are catastrophic: students enter the job market with essentially worthless degrees and $100,000 in debt; roughly 40 percent of all Medicare expenses are fraudulent (though nobody really knows as only a tiny proportion of expenses are actually audited); Head Start teachers employed by government are paid roughly double what equivalent private-sector teachers earn; the new F-35 fighter aircraft costs six times more than the F-18 it replaces—the list of unproductive spending is nearly endless because there is always more free money to be borrowed and spent next year.

Though it may seem as if our ability to borrow and print dollars is unlimited, history suggests otherwise: capital and resources are scarce, and squandering them on unproductive consumption means they won’t be available for productive investments that fuel real growth in productivity and output.

What we desperately need is not a misleading debate between stimulus and austerity, but a return to an economy that is allowed to transparently price credit, risk, capital, and labor, so the discipline and feedback of reality can inform our choices about investments of scarce capital and resources.