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Current Economic Crisis: Causes and Cures

February 12, 2009 by  


By Dr. A. S. Nakadar, Publisher & CEO of TMO

keynes
John Maynard Keynes, 1883 – 1946.
Time Magazine cover, 1966

On June 8, 2006; I wrote an article entitled:  “The Crumbling American Might”. I said, “The world fears American might while America fears its own crumbling might, the dollar. And the American dollar is the US Achilles Heel”. About 15 months later the American dollar tumbled.

The cumulative effect of many years of fickle fiscal policies, especially of the last 7 years, is responsible for the present economic crisis. Many fear that we are on the brink of depression should the current severe recession continue.

Since the Second World War, the US has adopted two economic policies. One is Keynesian economic theory, proposed by the British economist John Maynard Keynes in 1930, and later in 1970’s the US adopted the supply side theory proffered by Milton Friedman and others.

According to Keynesian economics, the state should stimulate economic growth and improve stability in the private sector through, for example, adjusting interest rates, taxation and funding public projects.

The basic premise of the Keynesian economic policies is: for economic wellbeing, the state should stimulate economic growth through the private sector.  And, by adjusting the interest rates, the Fed maintains the stability of the private sector (i.e. you and me).

The Fed fine-tuned the money supply as and when it caused inflation or deflation. If inflation raised its head, it restricted the money supply by increasing the interest rates. And it would loosen the credit supply by lowering the interest rates, as an when economic activity slowed down or deflated. 

The stagflation of the 1970’s, (the awful combination of high inflation and slow growth) and the oil crisis of 1973 bedeviled policy makers in 1970’s. It sowed the seeds for the end of the dominance of Keynesian policies, as it had failed to stabilize the demand management. 

This bought the Austrian school of thought, supply-side economics, to the fore. The intellectual roots of supply-side economics have also been traced back to various early economic thinkers such as Ibn Khaldun and many others, especially Nobel laureates Robert Mundell, Milton Friedman, and James Buchanan. 

Supply-side economy basically propagates tight money to stop inflation, cut in marginal taxes to stimulate growth, and lower capital gains tax to encourage entrepreneurs.

The supply side economist typically argues to achieve the proper level of marginal tax rates, (tax cuts). According to them, maximum benefits are achieved by optimizing the marginal tax rates of those with high incomes. And hence it is termed as “trickle down economics.” Reduction in capital gains will most likely increase supply and thus spur growth. Thus it came to be known as “supply side economics.”

The Keynesian economist, by contrast, contends that tax cuts should be used to increase demand, not supply, and thus should be targeted at cash-strapped, lower-income earners, who are more likely to spend additional income.

What it means in simple terms is this: supply side economists target higher income brackets, while Keynesians target lower income brackets.

In both these theories, the critical word “personal savings” is missing, and both theories advocate spending either through borrowing directly from bank, via credit cards or money saved from lowered taxes.

The industrial prosperity of a country is measured by its Gross National Product (GNP) and not by Gross National Consumption (GNC). Although GNC may help increase GDP, but by default.

It is a historical fact that for more stable economies, individual savings plays a strengthening role. Thus, encouragement of personal savings is paramount in creating more stable economies.

Depending upon his savings, an individual buys goods after careful consideration of each purchase’s pros and cons–even if it is a leveraged buy or on installments. Essentially what it means is when an individual uses his savings or in combination with the borrowing he will be more prudent in his purchases or investments.

In the next few articles, I will discuss: the causes of the present economic crisis, that has little to do with Keynesian or supply side economics; whether the present proposed stimulus is enough or not and will it work or not; its long term impact and as an individual what you should do to protect your assets.

I hope you are reading Bob Wood’s weekly articles–many readers appreciate his articles and have benefited from his advice.

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