The danger of deficits lurks in Bizarro Keynesianism

By Jack Schwager Published: March 19 2009 02:00 Last updated: March 19 2009 02:00 "A billion here, a billion there, and pretty soon you're talking about real money." - Everett Dirksen. Welcome to the world of hyper-real money. The budget figures for 2009 are frightening: a $1,750bn deficit, equal to a staggering 12 per cent of gross domestic product, double the prior record post-second world war level. Even worse, giant deficits loom ahead for 2010 and beyond. The Republicans have assumed the mantle of fiscal responsibility, warning of the very real dangers associated with cumulative huge deficits. Forgive me, though, if I choke on the hypocrisy. This is the same party that had control of the presidency during the past eight years as well as both houses of Congress from 2003 to 2006. This is the same party that inherited a budget surplus and transformed it into a string of unbroken deficits, doubling the entire national debt in the process and leaving behind a $1,000bn deficit and an economy in shambles by the time Barack Obama was sworn in. Now when they have just lost power and the economy is in freefall, Republicans are championing fiscal responsibility. Taken as a whole, Republicans seem to be following a doctrine that could be termed "Bizarro Keynesianism" - deficit spending during bubble economies and deficit restraint in collapsing economies. (In the Bizarro World, a creation of the Superman comic book series, everything is the opposite of what it is in our world.) Still, aren't Republicans at least correct in expressing outrage at the 2009 spending bill, which in flagrant disregard of the financial crises was loaded up with earmarks and recently signed by Mr Obama? Of course they are, but their indignation would be more convincing if the average total earmark spending per Republican senator weren't higher than the corresponding average for Democrats. Hypocrisy, however, does not alter the validity of Republican concerns over the exploding deficit. We are in dangerous territory. The ballooning of the US debt burden in the years ahead could have many adverse consequences - a debasing of the currency, which could lead to inflation and rising interest rate costs. Higher interest rates would increase borrowing costs, placing further upside pressure on the deficit, while depressing economic activity. We could end up facing an economic dilemma even worse than the current one. Add to this list the long-term demographics and the associated implied expansion in entitlement expenditures and it is difficult to see how we can avoid an economic endgame that ends very badly, unless we change radically a spending process driven by political expediency rather than economic efficiency or cost/benefit considerations. If we are to avert disaster, we must act decisively. The most important thing we need to do is fix the banking system. The argument against so-called "nationalisation" of the banks is a sham in at least four ways: * No reasonable economists are recommending nationalisation in the socialistic sense of the word. No one wants government running banks permanently. What is being recommended is a Federal Deposit Insurance Corp restructuring of problem banks followed by re-privatisation. * The FDIC is already restructuring problem small banks. So if we are to use the loaded language of opponents of government intervention to take over and clean up banks, we already have "nationalisation" of banks. We are fixing small problem banks, while procrastinating in dealing fully with large problem banks. If battlefield medics used that logic, they would dispense lozenges to soldiers with sore throats while ignoring the wounded in the hope they would get better on their own. * What we are doing right now is far worse than nationalisation; essentially, we are privatising profits and socialising losses. There is only one word that can describe adequately opposition to a government-supervised restructuring of problem banks in the name of capitalism: chutzpah. * We are supposed to be worried about the poor job the government would do in cleaning up the banking system. Well, just how much worse could they possibly do than the managements that got us into this mess in the first place? Moreover, we are extremely fortunate that the agency that could spearhead a bank clean-up, the FDIC, is expert at the task. A plan that would restructure all problem banks, large and small, would address the heart of the problem, eliminate the uncertainty that is having such a lethal effect on the markets, minimise the waste of throwing good dollars after bad in a futile attempt to avoid the inevitable, and allow taxpayers to benefit from the sale of the cleaned-up banks to private hands. It is not only the best solution but also the one that would have the least detrimental impact on deficits. Jack Schwager is investment director at the Fortune Group, a London-based alternative asset management firm, and author of the Market Wizard and Schwager on Futures book series. This is an abridged version of a fuller article which can be read on ft.com