Ken Szulczyk's Theory Why Monetary and Fiscal Policies Could Fail during Recessions

I present my theory on business cycles and explain why fiscal and monetary policies can fail during recessions and crises. I wrote, organized, and combined many known economic facts into a cogent, logical story, explaining the impact of economic expansions and recessions upon an economy. I show two characteristics – two and seven – as new deductions while everyone knows the other characteristics well.

As an economy traverses along the business cycle, people, businesses, and government experience good times. Companies are earning profits, and they hire and expand their workforce. Moreover, they invest in machines, equipment, and structures. Consumers are optimistic because they experience growing incomes, job prospects, and feel good about their futures. They spend a large portion of their after-tax income, called the marginal propensity to consume (MPC) and save the remaining portion, called the marginal propensity to save (MPS). Subsequently, banks freely lend to businesses and families. Businesses invest in machines, equipment, and structures while families buy houses, cars, and appliances. Finally, government collects more tax revenue as business activity keeps expanding. Then it usually spends the tax revenue to build roads, to improve infrastructure, to expand government, and so on.

Marginal propensities to save and to consume become the vital concepts. If we would give a person $1 more dollar of after-tax income, then that person saves the MPS part and spends the MPC portion. Moreover, economists believe these propensities remain constant while I believe they vary with the economy's state. For example, households and families raise their savings or MPS and reduce their spending or MPC during a recession or a crisis. Consequently, the changing propensities affect the Keynesian multipliers.

The Keynesian multiplier effect starts with consumers spending most of their incomes in the economy as consumers inject money into the economy. This increased spending causes companies to sell more goods and services, and they earn profits, and expand the labor force. Companies hire additional workers, who earn wages. These workers become consumers who spend a large portion of their salaries in the economy, contributing to economic growth.

The multiplier effect boosts the activity in the economy as the government boosts spending, or businesses raise investment in the economy. For example, a computer company builds a new factory in Small Town, U.S.A. The computer company directly affects the economy by investing $30 million in building the facility and hiring new employees. The construction workers and newly hired employees earn wages. With more income, the employees and construction workers spend more in the economy. They buy new houses, new cars, appliances, and electronic gadgets. Moreover, they dine more at restaurants, watch movies at the cinemas, and frequent coffee shops.

Then the multiplier effect kicks in. These companies serve more customers and make more profits and income. Thus, these businesses hire more workers and work their workers longer. These employees earn greater incomes and increase their spending and savings, and the process continues indefinitely. The $30 million investment in Small Town, USA could generate more than $30 million in incomes as the injection increases the business activity in the economy.

The multiplier effect could create other benefits. For instance, a computer company employs more white-collar workers, and people gain and acquire computer skills. The economy gains a more educated workforce. Furthermore, government collects more tax revenue as a community's income rises. Then government usually raises its spending and provides more services to the community.

The Keynesians, unfortunately, view the savings as leaking from the economy because they treat savings as if people hide their money under their mattresses, or inside the walls while businesses squirrel away their savings in massive, impregnable vaults. However, workers, consumers, and businesses in well-developed countries deposit their savings into banks. Thus, the banks become critical to economic development as they inject the savings into the economy via lending. Banks use the savings to grant loans to businesses, so companies can invest in machines, buildings, and equipment. In addition, the banks grant loans to consumers to buy houses, cars, and appliances. Thus, banks become the first Characteristic of the boom-bust cycle because the banks channel savings into investments in the economy.

Characteristic 1: : A strong banking and financial system lays the foundation of healthy economic growth.

Our economy continues growing and flourishing. Rising incomes fuels consumers' optimism. So consumers continue spending and saving. Businesses experience increasing sales and continually hire workers. Subsequently, the people and businesses continue depositing their savings into banks while the banks lend out the savings. Many economists believe the total savings must equal total investment. However, the banking system as a whole creates and expands the money supply.

For example, a person deposits $20,000 into his savings account and earns a tiny interest rate. The bank puts this money to work. It must retain a small portion of the funds and can lend out the remainder because a central bank imposes reserve requirements. A bank must hold onto a portion of the funds, ensuring this bank has money sitting in a vault or as a deposit at the central bank to meet depositors' withdrawal. In this case, we set the required reserve ratio to 10%. Thus, the bank grants $18,000 home improvement loan and retains $2,000 in the vault.

A homeowner takes the credit and buys $18,000 in materials at a construction store. The store deposits this money into its bank. The bank lends out $16,200 for a car loan to a taxi company and retains $1,800 in the vault. The taxi company uses the car loan to buy a new car at a car dealership. The dealership takes the funds and deposits it in its bank, and the deposit-loan cycle continues.

Similar to the multiplier effect, this deposit and loan cycle becomes an infinite process. Economists focus on the money supply, and the banking system as a whole creates extra money in the economy. However, we can define the home improvement loan and new car as investment. Of course, not all bank loans result in investment. Banks grant credit cards that allow people artificially to prop up their spending.

The banking system could amplify and enhance savings, so one dollar in savings can support more than a dollar in investment, which becomes Characteristic 2. It depends on whether businesses and households use the bank loans to invest in capital or artificially prop up spending. A country such as the United States where most people spend their incomes, the banking system can amplify the meager savings that let banks lend out as loans.

Characteristic 2: The banking system could multiply the investment through the deposit-loan process, causing investments to exceed savings during economic expansions.

The banking system creates a side effect as it amplifies savings. Many businesses and families use bank loans to buy real estate. As the economy continues growing, the banks continue granting loans. Businesses and families create a strong demand for real estate that pushes up property values, which leads to Characteristic 3. As people and businesses continually buy real estate, the bank loans inflate asset bubbles. As people and businesses witness the bubbles, they become exuberant and invest more into the appreciating assets. Even banks join the exuberance and could relax their lending standards. Even if the bank forecloses on a property, they know they can sell the property at a greater price, knowing the bank could come out ahead.

Characteristic 3: A growing economy with a strong banking system automatically creates asset bubbles.

Most companies do well during the expansion cycle while poorly performing companies can hide losses from the investors, banks, and stockholders. These companies can hold on and can convince banks to continue lending to them and convince investors to buy their stocks and bonds. Nevertheless, an event triggers an awareness that leads to shock, and eventually to extreme paranoia. The event could be a plunge in the stock market, currency devaluation, or a wave of massive businesses bankruptcies. Bankers and investors start scrutinizing every company's financial statements more closely. They discover the problems at the poorly performing companies and become horrified at the companies' losses. Then banks and investors stop lending, which becomes Characteristic 4.

Characteristic 4: Banks and investors become fearful to lend and invest during a crisis. Companies and people cannot borrow from the banks while investors stop investing in companies.

The badly performing companies begin contracting and laying off workers. The workers become fearful of the crisis, and they serve a dual role as consumers in the economy because they reduce their spending and boost their savings. Companies experience a decline in sales, and lay off more workers. Thus, we enter a vicious cycle where we have Keynes's Paradox of Thrift. Consumers continually reduce their spending and raise their savings while businesses witness drops in sales. Then businesses lower their production and stop investing into structures, machines, and equipment, which becomes Characteristic 5.

Characteristic 5: Investment falls during recessions and crises as companies become pessimistic of the future.

Consumers and families remain afraid and continue saving. Even if they deposit their savings into banks, the banks are afraid to lend. On the other side, firms and households may not want to borrow especially if they accumulated large amounts of debt during the economic expansion. Thus, savings no longer enter the economy and fuel investment. Furthermore, Keynes's Liquidity Trap strikes the economy. Even if the central bank reduces the interest rate to zero, banks refuse to lend. Then expansionary monetary policy stops working, which becomes Characteristic 6.

Characteristic 6 – Keynes's Liquidity Trap: As a central bank reduces interest rates, banks refuse to lend while businesses and households may not want to borrow. Thus, low interest rates have no effect on the economy, causing expansionary monetary policy to become ineffective.

Many economists believe the investment and government-spending multipliers are constant and equal about two. Thus, for every one dollar in additional investment or government spending boosts incomes in the economy by $2. However, the multipliers vary with people's and businesses' perceptions of the economy. For example, people see friends, relatives, and acquaintances being laid off, and they become nervous and start saving. Thus, people save more and consume less, causing the marginal propensity to save to increase while the marginal propensity to consume to decrease.

During a recession or crisis, people and businesses raise their savings, so the marginal propensity to save becomes high while the marginal propensity to consume becomes low. Economists calculate the simple multiplier by using 1/MPS. Thus, as the marginal propensity to save rises, then the multiplier becomes smaller, leading to Characteristic 7. Consequently, as the government injects more spending into the economy, people earn wages and siphon this spending out of the economy through saving. Even if people deposit their savings into banks, the banks are afraid to lend. Finally, if the government reduces income taxes to spur consuming spending, the taxpayers save this, so decreasing taxes during a recession also becomes ineffective.

Characteristic 7: The Keynes's investment, government spending, and tax multipliers change because they depend on people's and businesses' perceptions of the economy. Thus, the government-spending and investment multipliers vary with the state of the economy.

If the government tries to boost government spending or reduce taxes to expand the economy during a recession, the multiplier stops operating. Thus, government spending or taxes have little influence on the economy during recessions or crisis. Even if the government greatly expands spending and accumulates a massive debt, the economy would respond weakly.

We need three conditions for fiscal and monetary policies to work on the economy. First, people must start spending again to create sales for businesses. Second, companies must become optimistic as they experience increasing sales. Thus, they hire more workers and invest in machines, equipment, and structures. Finally, banks begin lending to families and businesses again that fuels investment into the economy. Thus, these three conditions become necessary to get the economy functioning again.

Most recessions last briefly because the three conditions return to normal quickly. Subsequently, government could restore confidence and faith in the economy by using fiscal policy. If people believe the government's policy to expand spending or reduce taxes, people begin spending again while businesses start investing again, and the banks begin lending.

However, we know fiscal policy had failed in Japan during the 1990s and in the United States after the 2007 Great Recession. I cannot answer for Japan, but the U.S. government created massive insecurity in the economy after the 2007 Great Recession. Many companies do not know how their costs will change with the new federal health care plan. Furthermore, the U.S. government passed the American Recovery and Reinvestment Act of 2009 to inject $831 billion into the economy. However, many experts and economists complained this amount was too small. Thus, the U.S. government has failed to restore the people's, businesses', and banks' confidence in the economy.

People continue to save and reduce consumption. Meanwhile, companies continue to shun investment and refuse to hire workers while the banks refuse to lend. Thus, we have the last characteristic - Characteristic 8.

Characteristic 8: Both monetary and fiscal policies can become ineffective during recessions and crises. Government must use its policies to restore people's, businesses, and bankers' optimism, faith, and confidence. Otherwise, the economy begins stagnating, and the country enters an extended recession.

For fiscal and monetary policies to be effective, they must restore faith and trust. Therefore, people will raise consumption and reduce savings raising the marginal propensity to consume and decreasing the marginal propensity to save. The faith restores the businesses wanting to invest in structures, machines, equipment, and technology, and to hire workers. The faith also restores bankers' confidence to start lending to lend to businesses and households. Then businesses begin borrowing from the banks and financial institutions while the financial markets start lending to businesses and households. As government uses the fiscal policy, the increase in government spending or fall in taxes has the appropriate effect on the economy because everyone in society has restored the Keynesian multipliers.

The Five Disastrous Mistakes I Made for Managing Disruptive Students

I taught economics at Suleyman Demirel University between 2008 and 2009, a private university located in Almaty, Kazakhstan. This country was once controlled by the Soviet Union before 1991. Kazakhstan inherited the Soviet education system with a strong foundation in mathematics and sciences. 

I recently started teaching and used the standard chalk and talk. I taught Production Economics to third year students, which can be a tough course. I used basic differential calculus and introduced students to game theory. The undergraduate students studied topics that professors would cover in graduate schools in the United States. I had five extremely bright students with two possibly being brilliant, and seven male students who were rotten to the core. 

The seven horrible students talked in class and usually arrived late. As a late student strolled into the classroom, he would disrupt the entire class by shaking everyone’s hand in his row and greet them before sitting down. 

I yelled and screamed at them. I would snap at the late student and would demand to know why he came late and why he must disrupt the whole class as he walked in. 

On one Saturday morning, the male students were excessively loud, as if they were throwing a party in the classroom during the lecture. Finally, I became furious as my face erupted into a bright rosy red, and I stormed out of the classroom half way during the lecture. 

At that time, I was young and impetuous. Even though I am a little older and a touch wiser, I can still be impetuous on occasion. Nevertheless, I never reflected why these seven male, misbehaving students acted the way they did. During that time, I emulated my U.S. professors who used the traditional teaching methods. We, students, must address the professor with his or her proper title. We were afraid to disrespect the professor or talk in class, unless to ask a question. We did not want to incur the professor’s wrath. Of course, I demanded my students act like the way I acted during my college days. Students must sit quietly at their seats, transcribing their notes, and only occasionally asking the professor questions politely. 

I let the frustration and angry simmer inside me. Some days, I wanted to toss my textbooks and white board markers into the trash and quit the teaching profession. However, I always awakened early in the morning, showered, and ate breakfast, dreading the long bus ride to the campus in the morning. Other times, I contemplated about wrapping my hands around one of the bad student’s neck, squeezing the life from him, and quieting his talking forever. Then rationality would invade my head as these questions flashed through my mind. Where would I hide the body? Could I handle the barrage of questions from the administration, and hysterics and tears from the parents? What is prison life like in Kazakhstan? However, I never reflected on why the students could not behave in the classroom. 

After reflecting on my classroom behavior, I made five serious mistakes. 

First Mistake: I assumed the students possessed a strong foundation of mathematics. Their previous instructors could have passed the bad students hoping never to see them again. I never assessed the mathematics skills of my students. Perhaps, the bad students could not sit quietly and listen to the lecturer speak in an alien language. They felt frustrated sitting in their chairs while the other students surrounding them nodded their heads in understanding. Then the bad students relieved their frustrations by lashing out at me. 

Second Mistake: I never nurtured a high-quality relationship with my students. I arrived at the classroom to deliver my lecture and waited in my office during consultation hours. I rarely interacted with my students outside the classroom. I never fostered an atmosphere filled with trust, mutual respect, and harmony (Kilmer 1998). According to Seidman (2005), instructors have fewer discipline problems if they nurture a high-quality relationship. 

Third Mistake: Students would prefer the instructor to talk to the disruptive, chatty student after class (Carter and Punyanunt-Carter 2009). Students do not want the instructor to yell at the talking student during class and demand whether the student needs to leave the classroom if he or she must continue their talking (Carter and Punyanunt-Carter 2009). 

Fourth Mistake: Instructors especially the inexperienced could be afraid to discipline or punish the student. As in my case, instructors never know whether the administration will back and support the instructor or take the student’s side (Seidman 2005). I should have sat down with the dean and discussed my options. Then if the dean would have agreed, we should have brought the disruptive students to the dean’s office and discussed their classroom behavior. 

Fifth Mistake: Students may not know how to behave in a classroom (Kilmer 1998). During Soviet times, the students would never disrespect their professors and authority figures, unless they wanted to work in the freezing labor camps scattered across Siberia. Once communism released its grip on society, the people became free while education transformed into a piece of paper that could be bought as a commodity. Political connections determine students’ future in Kazakhstan, and how far they would rise in a company or government agency. Thus, students have no incentive to do well in their courses. They will graduate and utilize their connections to jump-start their careers. 

Since disruptive students were becoming the norm at the university, the dean and faculty should have bonded together and designed a disciplinary plan. I became disturbed when an instructor described his second year students as “very naughty.” I would have taught these students next year if I had stayed at the university. Perhaps, the university should offer a course about classroom behavior, study skills, and study strategies. 

Unfortunately, the good students became the victims. They sat in the classroom and wanted to learn while they witnessed the instructor yell and scream at the misbehaving students. Alas, one or several bad students can taint and disrupt the class for everyone – one bad apple spoils the pie. Good students want the instructor to manage the classroom well (Seidman 2005). If good students experience a bad learning environment, they could withdraw from the university. Consequently, a university filled with instructors possessing poor classroom management skills can drop the university’s retention rate (Seidman 2005) as good students (and possibly good instructors) flee the university. 

References

1. Carter, Stacy L. and Narissra Maria Punyanunt-Carter. 2009. College students’ perceptions of treatment acceptability of how college professors deal with disruptive talking in the classroom. College Student Journal 43(1): 56-8.



2. Kilmer, Paulette D. 1998. When a few disruptive students challenge an instructor’s plan. Journalism & Mass Communication Educator 53(2): 81-84:



3. Seidman, Alan. 2005. The learning killer: Disruptive student behavior in the classroom. Reading Improvement 42(1): 40-6.

Paul Krugman and the New Keynesians

I just had read Paul Krugman’s book – End the Depression Now - for the second time. Everyone regardless of political philosophy should read this book. Even though Paul Krugman has become the top spokesman for Keynesian economics, he writes clearly, succinctly, and intelligently for an economist. Perhaps, Paul Krugman should rewrite Keynes’s book. Unfortunately, the world’s two most famous economists, Maynard Keynes and Karl Marx, are incredibly long-winded writers as every sentence overflows with superfluous words, and sentences stretch across pages.

Paul Krugman is correct in many ways but errs in other ways. The world continues to struggle from the Great Recession that struck the world in 2007. Something seriously happened to the U.S. economy, and many people do not get it. Paul and I get it, and I understand why most people do not get it. Everyone grew up during the prosperous times when the U.S. economy plowed ahead and created millions of jobs while the U.S. military and U.S. businesses dominated the world. If someone wanted to work, the person would simply fill out several job applications and wait for the phone call. Then this person had a job. Then this person could apply for other jobs while working, and gradually transition themselves into better positions.

Nevertheless, something had changed. After the 2007 Great Recession, the U.S. economy has become stuck like a truck spinning its tires in the mud. Jobs had become scarce while the unemployment rate gradually falls towards the 5% rate, which we consider normal. However, many smart people know something had broken in the U.S. economy.

Many politicians and leaders view the falling unemployment rate as a barometer on the economy’s health. However, a falling unemployment rate masks two problems. First, the U.S. government does not count discouraged workers as unemployed. Discouraged workers want to work, but they stopped searching for employment because they believe they can’t find a job in the economy. Second, some people found part-time jobs after being laid off during the 2007 Great Recession. However, some of these people want to work full time and not part time.

What had happened? Something struck the economy like the Ebola virus coursing through a healthy person’s body. Of course, I argue the transition from a manufacturing economy to a service-oriented one had replaced many good-paying, full-time jobs with low-paying, part-time jobs. Then we add an overbearing, all-controlling government that further damaged our economy. Now, we arrive at the first rule - just like the socialists and communists, Keynesians accurately describe the poor’s plight and misfortune.

Rule 1: The Keynesians, Socialists, and Communists can accurately describe the plight of the poor and misfortune in our society.

Paul Krugman correctly assessed Europe’s plight. European leaders have fallen into the austerity trap - governments must increase taxes and reduce government programs. If people picked up an elementary economics textbook, they would discover austerity would be a disastrous policy. During recessions, government should increase government spending and/or reduce taxes because the government injects money into the economy, raising consumers' incomes and spending. Similarly, the government could reduce taxes, allowing taxpayers to keep more income, so they can increase their spending and help expand the economy.

Paul Krugman, however, has missed the point. The European countries never used Keynesian economics correctly, which becomes Rule 2. Governments should use austerity during economic expansions that would slow the economy. Austerity helps create budget surpluses to reduce the government’s debt and strengthens a government’s finances. Then during a crisis or recession, government can boost its spending and lower taxes to expand the economy. Unfortunately, European governments reduced taxes and boosted government spending during the economic expansion, weakening their financial resources. As European governments tried to increase government spending during the 2008 Financial Crisis, investors became leery, pessimistic, and fearful. They stopped investing in Greek, Spanish, and Irish bonds. Investors believed these governments had issued too much debt, and the governments would experience troubles repaying the bonds with interest. We know this became true. Remember the Greek haircut? Euphemism for forcing the bondholders to take a 50% loss on their Greek bonds.

Rule 2: For pure Keynesian economics, government reduces spending or raises taxes during economic booms and boost spending or reduces taxes during recessions. Thus, government strengthens its finances to handle downturns in the economy.

Keynesians are biased towards government spending, which becomes Rule 3. Don’t get me wrong. I understand the concept well. Every economy has four broadly defined sectors: Consumers, businesses, governments, and exports-imports. During a recession, consumers and businesses become fearful and pessimistic about the future. Consumers reduce their spending, buy fewer imports, and boost their savings. As businesses sell fewer products or services, companies lay off some of their labor and reduce their investments. Meanwhile, if the recession had spread to a foreign country, then foreigners buy fewer exports from us. Consequently, our economy takes a huge hit from lack of spending. Consequently, government becomes the only entity that can defy the recession and can boost its spending to overcome society's lower spending.

Rule 3: Keynesians have a bias towards government spending. Nevertheless, government can reduce taxes to expand the economy and raise taxes to slow the economy down.

Many Keynesians discourage businesses, government, and consumers from saving, leading to Rule 4. They must spend all their incomes in the economy to buy goods and services, and keep the economic machine turning. Since everyone becomes fearful and saves more during recessions, people remove money from the economy. Thus, Keynesians are correct if people hide their savings under their mattresses while business and government store their money in vaults. On the other hand, if companies and people deposit their funds into banks, then banks can lend out their funds. Consumers borrow to buy houses, cars, and appliances while companies borrow to invest in buildings, machines, computers, and equipment. This explains why the Asian tigers - Hong Kong, Singapore, Taiwan, and South Korea - grew phenomenally. Asians are phenomenal savers who deposit their savings into banks. Then banks could grant loans to businesses that invest in their economies that fuel their extraordinary economic growth rates.

Rule 4: Keynesians are against businesses, government, and consumers from saving. They must continually spend to prop up the economy.

Here is where Paul and I begin to diverge. Keynesians pick certain periods to show Keynesian economics works, which becomes Rule 5. They always point to a particular time such as the U.S. government preparing the U.S. economy for World War II. The U.S. federal government ramped up spending to build ships, trucks, weapons, and supplies for soldiers. U.S. manufacturing went into overdrive and stomp on the economy’s accelerator. Many young men joined the armed forces while many factories hired women to work in the factories. No question, Keynesian economics had worked.

Rule 5: Keynesians choose their times well to show Keynesian economics works. Then they neglect other times when Keynesian economics had failed.

Everyone forgets Franklin Roosevelt, who started his presidency in 1932. The president boosted government spending during the 1930s by creating numerous alphabet soup agencies and sponsored massive public works projects. Did the U.S. economy recover? No - the U.S. economy had entered a recession in 1937. Of course, the U.S. government also raised taxes, which the government should never do during a recession, and the U.S. government encouraged companies to keep paying high wages to the workers. The high wages ensured the workers retained their purchasing power. Unfortunately, people increase their savings during uncertain times and reduce their spending.

Let’s say the Great Depression was an anomaly. I can find another significant failure of Keynesian economics. Japan entered its two-decade malaise starting in the early 1990s. Japan also used Keynesian economics since the 1990s as the Japanese government amassed a public debt to GDP ratio of 200%. Consequently, the Japanese economic engine continues sputtering and struggling along since the 1990s. What makes Japan unique is the Japanese government bonds are held within Japan, and thus, Japan has little risk of foreigners triggering a financial crisis, which I explain later in this blog.

Returning to our side of the world, the U.S. federal government has dumped trillions of dollars into the economy since the start of the 2008 Financial Crisis, and we have witnessed the weakest recovery ever. Of course, Paul Krugman said, if Keynesian economics does not work, then government must scale up its spending, which becomes Rule 6. Using Paul’s analogy from his book, the broken economy represents a car with a defective battery. The government must only replace the battery to get the car running again. Well, the government has spent $700 billion to bail out the financial institutions and another $831 billion for the American Recovery and Reinvestment Act of 2009. Then the Federal Reserve, our central bank, lent about $2 trillion to bail out the banks. Replacing the battery has become expensive while that damn car still won’t start. The U.S. economy measures about $16 trillion, so if government continues boosting its spending, it will dominate and control our society, similarly to the Soviet Union, where the bureaucrats controlled the entire economy.

Rule 6: Communists and Keynesians only differ in their scale of the government's planning.

I do agree with Paul Krugman – government should never decrease government spending or boost taxes during a recession. Nevertheless, I must add one caveat - government must have strong finances to weather the downturn. In his book, Krugman cites Minsky, an unknown economist. Minsky expounded a simple idea. A company with low debt can expand quickly by taking out bank loans, which we call leveraging. The company continues doing well and keeps expanding while banks keep granting the company more loans. Then a crisis happens, and banks start examining their loans. If banks believe the company has too many loans, the bank cuts the company off, which imposes hardship onto the company. The company begins deleveraging by cutting back on spending and repaying its loans. If a financial crisis strikes the company, then the company may nosedive while the bankers, stockholders, and bondholders panic. Subsequently, the company accelerates towards bankruptcy.

For example, Lehman Brothers bankrupted in October 2008. It began with a leverage ratio of 26 to 1 in 2003 that surged to 39 to 1 in 2006. Consequently, Lehman Brothers borrowed $39 for every $1 it had in equity. Equity measures a company’s financial strength by taking its assets and subtracting its liabilities. Investors want a low leverage ratio because they want to recoup their investments if the company bankrupts. Unfortunately, Lehman Brothers borrowed to buy expensive real estate at the height of the housing bubble.

Did you catch the irony? The U.S. federal government has a leverage ratio too. We know the U.S. government has accumulated $17 trillion dollar debt, but we do not know the government’s equity. Although the U.S. government spends about $3.5 trillion per year, this does not represent equity. We must add all the government’s assets, such as military bases, equipment, government buildings, and other assets and subtract its liabilities. I bet the government's current leverage ratio tilts towards the high side. If a government debt becomes too high, investors will stop buying the government bonds, triggering a financial crisis. Then government must deleverage by paying down its debt and selling off its assets. Unfortunately, the U.S. government holds many assets that it cannot sell, such as military bases, weapons, and so on.

Paul Krugman argues the U.S. government could ramp up its spending that would push the U.S. debt to new records. Although a high debt could trigger a financial crisis, a government does not have to deleverage if it experiences financial trouble. A government could force its central bank to buy government bonds. Thus, the central bank prints money to cover a government budget shortfall. However, printing money leads to inflation and weakens a currency. (The Greek, Irish, Italian, and Spanish governments have no control over the central bank. They only have the power to tax, spend, and borrow. Since investors do not want to buy these government bonds, these governments cannot expand government spending or reduce taxes during a recession.)

Here is where Paul Krugman stumbles in his book, which becomes Rule 7. The U.S. federal government cannot weaken the U.S. dollar by forcing the Federal Reserve to buy U.S. bonds because people around the world hold U.S. dollars to save their purchasing power. If the U.S. government weakens and depreciates the U.S. dollar, people will stop holding U.S. dollars. Then many countries will stop investing in U.S. government securities. For example, China holds roughly $1 trillion in U.S. securities. If the Chinese believes the U.S. government will depreciate the U.S. dollars, then those U.S. government bonds and U.S. dollars plummet in value. Thus, China will dump those dollars and bonds that would trigger a financial crisis. Then the world rushes to unload the U.S. dollars and U.S. government securities, and we Americans will truly experience hard times.

Rule 7: Government cannot debase its currency if the world uses the country’s currency as the world’s transaction currency. Thus, the Eurozone and United States cannot devalue their currencies to jump start exports.

I am not anti-Keynesian, and I do not object if a government builds and expands roads, hospitals, schools, and infrastructure during a recession to create jobs. Nevertheless, the government must possess good finances, which becomes the most important rule – Rule 8.

Rule 8: The politicians have butchered Keynesian economics. Most governments did not raises taxes or reduce government spending during good times, so they could reduce their debts and strengthen their finances. Then governments would have the resources to combat the downturns in the economy.