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Economics unhinged

Almost everyone wants the world's governments to do more to revive ailing economies. No one wants a "double dip" recession. The G-20 Summit in Toronto was determined to avoid one. But what more can governments do? It's unclear.

We may be reaching the limits of economics. As English economist John Maynard Keynes noted, political leaders are hostage to the ideas of economists -- living and dead -- and economists increasingly disagree about what to do. Granted, the initial response to the crisis (sharp cuts in interest rates, bank bailouts, stimulus spending) probably averted a depression. But the crisis has also battered the logic of all major economic theories: Keynesianism, monetarism and "rational expectations."

Consider the matter of budgets. Would bigger deficits stimulate the economy and create jobs, as standard Keynesianism suggests? Or do exploding government debts threaten another financial crisis?

The Keynesian logic seems airtight. If consumer and business spending is weak, government raises demand through tax cuts or spending increases. But in practice, governments' high debts impose financial and psychological limits. The ratio of government debt to the economy (gross domestic product) is 92 percent for France, 82 percent for Germany and 83 percent for Britain.

This means the benefits of higher deficits can be lost in many ways: through higher interest rates if greater debt frightens investors, declines in private spending if consumers and businesses lose confidence in governments' ability to control budgets or a banking crisis if bank capital -- which consists heavily of government bonds -- declines in value. There's a tug of war between the stimulus of bigger deficits and the fears inspired by bigger deficits.

Based on favorable assumptions, the Obama administration says its $787 billion "stimulus" program created or saved up to 2.8 million jobs. This might be. Lenders haven't yet lost confidence in U.S. Treasury bonds. But in Europe, financial limits have bitten. Greece's huge debt (debt-to-GDP ratio: 123 percent) resulted in a steep rise of interest rates. Germany and Britain are debating plans to cut their deficits to avoid that fate.

That's lunacy, writes Martin Wolf, chief economic commentator for the Financial Times. Concerted austerity may destroy the recovery. Exactly, echoes Nobel Prize-winning economist Paul Krugman, who argues that the U.S. economy needs more stimulus and bigger deficits. Not so, counters Harvard economist Ken Rogoff. Boosting spending now, with federal deficits exceeding $1 trillion, risks "a debt crisis down the road." Deficits should be gradually trimmed, he argues.

Like textbook Keynesianism, "monetarism" also has suffered in its explanatory power. This theory holds that big injections of money ("reserves") into the banking system by the Federal Reserve should lead to higher lending, higher spending and -- if large enough -- inflation. Well, since the summer of 2008, the Fed has provided about $1 trillion of reserves to banks, and none of these things has happened.

There's a great deal economists don't understand. Not surprisingly, the adherents of "rational expectations" -- a theory that people generally figure out how best to respond to economic events -- didn't anticipate financial panic and economic collapse. The disconnect between theory and reality seems ominous. The response to the initial crisis was to throw money -- to lower interest rates and expand budget deficits. But with interest rates now low and deficits high, what happens if there's another crisis?

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