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Friday, 8 August 2008

A SICK ECONOMY

ON 28 and 29 Oct, 1929, the US stock market crashed. The economy followed.

In previous downturns, it had snapped back on its own. But in 1930, that wasn't happening.

Things got worse in 1931 and 1932. Most nations went into a downward spiral that turned into the world's first and only great depression.

British economist John Maynard Keynes came up with the idea that an economy could remain depressed forever. He not-so-modestly called it 'Keynesian economics'.

His solution was to give people more money to stimulate the economy. It can be done through tax cuts, grants and spending on public works.

Is it really a good idea for governments to borrow and spend when recession has reduced their tax revenues?

Yes, governments must take the lead when everyone else is feeling cautious.

POWERFUL MEDICINE

Keynes' good idea is routinely used to pull economies out of recessions.

This year, the US government saw that lower home prices plus higher food and fuel costs were making people poorer. Their reduced spending was dragging the economy down.

To offset this, it is now giving tax rebates to people with taxable income over $350 per month, which includes practically everyone.

Since I pay US taxes, our family of four got a cheque for $2,500 (thank you).

It isn't cheap. The US government is paying out $225 billion which it financed by borrowing. Future generations will have to repay the debt.

US Senator Barack Obama has said that when (if) he becomes President, he will propose additional stimulus payments of $68 billion.

Doc Money's analysis: Here's the problem, what's the solution?

IN the old days, life was simple. Economists used one tool to fix one problem.

The problem was a recession caused by lack of demand. The tool was to give people more money to spend. That increased incomes, spending, production, employment and GDP. It worked every time.

Today, higher prices are making people poorer. It drags down spending and the economy.

The US solution is to boost spending power by sending most US families a check for $2,500. Ordinarily, that would fix the problem.

This time, however, things are different. People are poorer because of higher prices, caused by new demand from rising incomes in China, India and other developing nations.

The $2,500 government cheque is appreciated by Americans. With it, they can maintain their standard of living.

But spending at previous levels makes the scarce resources even scarcer. It pushes prices still higher, reducing incomes, requiring another round of government subsidies and handouts. It goes on and on.

This cycle has already begun. International Monetary Fund data shows that for the 12 months ending 30 Jun, food prices rose 40 per cent. Oil went up 80 per cent. All commodities, including minerals, rose 65 per cent.

A BRAVE NEW WORLD

Behind the numbers are genuine shortages of raw material inputs. Fewer inputs mean less output.

Not as many buildings get built, fewer airplanes fly and a smaller number of projects get off the drawing board. GDP growth slows and eventually declines.

The solution is... well, there is no solution. At least not yet.

It isn't so much that the world's economists are stumped. They haven't even started thinking about the problem.

To a large extent, they have mis-identified it as insufficient demand. They advocate the same old Keynesian solution: Get more money into everyone's hands. That will stimulate spending.

As explained, this time around, it makes things worse since the real problem is supply shortages. These are aggravated by increased spending.

How to fix things? A future John Maynard Keynes will have to come up with the answer. Perhaps he or she is studying economics now.

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