Below is an extract from a commentary originally posted at www.speculative-investor.com on 20th November, 2008.

It's not insanity; it's political pragmatism

Is it just us, or do others think it absurd that a) "New Deal" style policies are being advocated when the original "New Deal" prolonged the 1930s downturn, and b) similar policies to those tried in Japan during the 1990s are now being implemented/promoted by people who proclaim that the mistakes made by Japan must be avoided? It seems particularly absurd that even the Japanese government is advocating the same 'solution', namely, attempting to stimulate the economy by ramping up government spending, that failed so miserably in their own country during the 1990s. We wonder how many times Keynesian economic theory will have to fail in practice before the average economist concludes that there is something terribly wrong with the theory.

A definition of insanity is repeating the same behaviour and expecting a different result, so in this respect the proponents of traditional economic stimulus packages (economy-boosting schemes based on increased government spending) could be defined as insane. However, politicians would only be insane, by the aforementioned definition, if they advocated such guaranteed-to-fail policies whilst having the country's long-term well being at heart. Alternatively, for a politician whose all-encompassing objective is winning the next election it would probably make sense to endorse such policies because it has been proven, time and time again in election after election, that promising to help special interest groups by directing government funds their way is a very effective political strategy.

By way of further explanation, consider the hypothetical case of a US Presidential election that occurs in the aftermath of a burst credit bubble and is contested by Mrs. Smith and Mr. Jones. Mrs. Smith, who is both brutally honest and well-versed in economic theory, explains to the voters that widespread mal-investment during the preceding credit-fueled boom has taken the country to the point where a painful period of economic re-adjustment will be necessary to bring production back into line with sustainable consumption, and that ramping up the government's spending will only prolong the agony. In fact, according to Mrs. Smith, the right thing for the government to do is REDUCE its expenditure, an action that could exacerbate the short-term pain but will lead to a much stronger economy over the long-term. Mr. Jones, on the other hand, opts for a more traditional approach and tells the voters that the government can quickly get the economy 'humming' again by implementing a stimulus package. Mr. Jones explains that the government will temporarily take up the economic slack, thus getting people back to work and generally easing the average family's financial burden. He also promises to target government largesse at specific groups, such as pensioners, the "middle class", children from poor families, and the unemployed, paying close attention to how these promises will influence voting in "swing states". Who do you think would win this election?

In almost all elections, including the recent US presidential election, voters are given the choice between two or more versions of Mr. Jones. There won't be a real choice as long as most voters demonstrate a preference for candidates who offer-up solutions involving more government intervention in the economy and more government spending.

Evaporating wealth versus evaporating money

In response to numerous email comments we've received and some articles we've read on the internet, we want to reiterate that wealth destruction and credit contraction do not eliminate money. For example, no money is removed from the economy when the price of a house falls by 50%; the price decline simply means that 50% less money will now be needed to purchase the house.

By trying to counteract today's falling prices by increasing the supply of money, central banks are setting the stage for a major inflation problem in the future. Think of it like this: by the time the de-leveraging process has run its course a lot less money will be needed, but if central banks and governments get their way there will actually be a lot more money.

We acknowledge that wealth destruction could lead to less money being borrowed into existence in the future, and, consequently, to deflation. After all, tens of trillions of dollars have been knocked off the market values of equities, houses and high-yield bonds, thus reducing the collective ability of the owners of these investments to borrow money. However, as long as the total supply of money continues to grow we can confidently conclude that the deflationary forces that stem from wealth destruction and credit contraction are being more than offset by the inflationary actions of the central bank and the government.

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