Two events took place over the weekend that indicate a revival of confidence in Keynesian economics. The first was the meeting of the G-7 nations in Washington, which was paralleled by a meeting of 15 nations in Paris. The second was the announcement of the Nobel Committee that this year's prize went to Paul Krugman.

The two meetings concluded that national governments will extend protection against failure to large banks. The British government took over the Royal Bank of Scotland and HBOS. It bailed out one other large bank: Lloyd's. This will take $64 billion.

The German government announced loan guarantees that may total $540 billion. The payoff: massive changes in equities law.

This is only the beginning. The British government and central bank have pledged a staggering $865 billion in total guarantees, constituting 30% of the county's GDP. Germany's total is $681 billion, approximately 20% of the nation's GDP.

But wait! There's more!

What will the total bailout package be for Europe? Preliminary estimates put it at $2 trillion worth of euros. But no one really knows.

The chief economist of Morgan Stanley estimates that the U.S. government's debt could be $2 trillion in fiscal 2009.

Beginning on Sunday, September 7, when Secretary of the Treasury Henry Paulson unilaterally nationalized Fannie Mae and Freddie Mac, thereby nationalizing America's mortgage market, until the weekend of October 11, we have witnessed the reversal of the Reagan-Thatcher attempt to reverse the regulatory hand of central governments – rhetoric that was never matched by fiscal measures to back them up.

Keynesianism is back in the saddle again.

This will cripple the horse.

KEYNESIANISM, OLD AND NEW

The heart of original Keynesianism was its commitment to government deficits as a way to stimulate consumer demand. Keynes also recommended central bank monetary expansion, but the heart of his economic theory was fiscal imbalance. Somehow, money lent to the central government by private investors would get the economy growing again, whereas this same money, if lent to the private sector, would produce extended depression.

The new Keynesianism is Keynesianism for bankers. The logic of the new version is this:

This is the Keynesian version of what used to be ridiculed by liberals as trickle-down economics. It is hailed today as the solution to the credit crisis. The $700 billion bailout of the banks in the United States and the weekend bailout of European banks by European governments constitute the largest Keynesian stimulus package in history. But it was a stimulus of a unique kind: to bail out banks.

The media cheered. Wall Street cheered. Bankers who were managing solvent banks cheered.

The public did not cheer in the United States and did not have time to register any opinion in Europe. The public will pay for all of this, either through taxes to pay off buyers of government bonds or through the inflation tax. In the second scenario, those who hold onto their government bonds will pay the inflation tax imposed on long-term bonds.

In justifying this immense transfer of taxpayer wealth to the commercial banks, politicians have promised a new era of regulation. They have all blamed American regulators for not regulating the securities market. No one is pointing to the main culprit: expansionist Federal Reserve monetary policy under Greenspan, which was matched by central bank policy around the world. Central bankers inflated their national currencies to support the domestic export markets. They did not want the dollar to fall, thereby reducing imports from foreign nations.

It was the mercantilism of central bank policy that produced the asset bubbles, especially the largest one: residential real estate. This is the ultimate carry trade: borrowed short (months or weeks) and lent long (30 years). When it popped, it removed consumer demand around the world.

The International Monetary Fund has predicted worldwide slowdown in 2009, with some nations moving into a recession. This increases the risk of lending to businesses. So, the expenditure of taxpayer money on bank bailouts may wind up supporting government debt. Treasury debt is seen as safe.

The coordinated big bank bailout programs do not solve the carry trade problem. They are designed to get banks lending to businesses. But in a worldwide recession, why would banks want to lend money to businesses? They would prefer to lend money to governments. Politicians like this. They can spend more money this way.

This transfers capital from the private sector to the public sector. It subsidizes government bureaucracies at the expense of productivity. But it is a rational response to recession when the government offers guarantees against bankruptcy. The guarantees are a major source of asset allocation from the private sector to the public sector.

BAD NEWS FROM THE IMF

The International Monetary Fund was created under the guidance of John Maynard Keynes at the 1944 Bretton Woods Conference in New Hampshire. There is no more Keynesian organization on earth.

Its 300-page report, World Economic Outlook (WEO): Financial Stress, Downturns, and Recoveries (October 2008) is the most gloomy that I recall. It was accompanied by a 200-page document, Global Financial Security Report. Combined, they constitute 550 pages of bad news.

On all fronts, the authors of the World Economic Outlook report that the world economy is headed for a slump in 2009. "The world economy is decelerating rapidly" it reports. Many advanced nations are moving into recession. The effects of the financial crisis have been limited so far. The tax rebate in the United States helped, and so have the relatively high profits of corporations. "But neither of these factors can be expected to last for very long" (p. xii).

The good news is that recovery will begin in late 2009, the report says. This assumes that U.S. housing will stabilize late in the year. It also assumes that the financial crisis will be solved (p. xii).

We now come to a passage that I did not expect to read in any IMF publication. The IMF guards its language, as most bureaucracies do. This is not guarded language.

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