Niall Ferguson contrasts the Keynesians and their opponents. FT:

When Franklin Roosevelt became president in 1933, the deficit was already running at 4.7 per cent of GDP. It rose to a peak of 5.6 per cent in 1934. The federal debt burden rose only slightly – from 40 to 45 per cent of GDP -– prior to the outbreak of the second world war. It was the war that saw the US (and all the other combatants) embark on fiscal expansions of the sort we have seen since 2007. So what we are witnessing today has less to do with the 1930s than with the 1940s: it is world war finance without the war.

But the differences are immense. First, the US financed its huge wartime deficits from domestic savings, via the sale of war bonds. Second, wartime economies were essentially closed, so there was no leakage of fiscal stimulus. Third, war economies worked at maximum capacity; all kinds of controls had to be imposed on the private sector to prevent inflation.

Today’s war-like deficits are being run at a time when the US is heavily reliant on foreign lenders, not least its rising strategic rival China (which holds 11 per cent of US Treasuries in public hands); at a time when economies are open, so American stimulus can end up benefiting Chinese exporters; and at a time when there is much under-utilised capacity, so that deflation is a bigger threat than inflation.

Are there precedents for such a combination? Certainly. Long before Keynes was even born, weak governments in countries from Argentina to Venezuela used to experiment with large peace-time deficits to see if there were ways of avoiding hard choices. The experiments invariably ended in one of two ways. Either the foreign lenders got fleeced through default, or the domestic lenders got fleeced through inflation. When economies were growing sluggishly, that could be slow in coming. But there invariably came a point when money creation by the central bank triggered an upsurge in inflationary expectations.

Ferguson’s point about China in the italicized paragraph is important. As we have previously said, there are structural issues in today’s world that make Keynesian stimulus — whatever its past merits — far less likely to be effective today. No doubt China would play along for a while as “stimulus” spending in the US (a) stoked China’s exports and (b) expanded China’s holdings of the Treasury bonds issued to finance the spending. But the US can ill afford to put itself in such a vulnerable position vis-a-vis the world’s largest and fastest growing country.

This entry was posted on Wednesday, July 21st, 2010 at 10:46 am and is filed under business, China, Democrats, General, Republicans. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.