"We have magneto trouble. How, then, can we start up again?" mused John Maynard Keynes in December 1930, likening the stagnant economy of the Great Depression to a broken generator in an automobile. Fear not, he wrote, the car eventually would get rolling again, and "we need not assume that motoring is over."
As 2011 begins, many investors are acting as if Keynes' "magneto trouble" has been fixed. Stock markets are up as investors feel the return of "animal spirits," to use another of Keynes' graphic metaphors.
But is the economic engine really fixed? As Keynes would have noted, that's partly a matter of perception. If investors believe that good times are back and start investing on that expectation, then a virtuous cycle will take over: Growth will accelerate, manufacturers will add more workers and build new plants; unemployment will fall; consumers will spend more, and eventually we're back to full prosperity.
Fed Chairman Ben Bernanke is a good student of Keynesian psychology, which helps to clarify his controversial experiment with the monetary strategy known as "quantitative easing." His goal was to change investors' expectations, and thus alter the underlying reality.
By purchasing $600 billion in Treasury securities last fall (and thereby flooding the economy with freshly printed cash), Bernanke hoped to make money so cheap, and fixed-income yields so low, that investors would find it irresistible to buy stocks. As the equity markets rose, he hoped, we would see the virtuous cycle of investment and job creation.
So far, Bernanke deserves good marks for playing the confidence game. "Despite all the consternation over quantitative easing, it was a pretty shrewd move, assuming his later exit strategy works," says David Smick, a Fed watcher who wrote the prescient book "The World Is Curved."
From the Fed's perspective, here's what has happened since Bernanke announced the bond-purchase program last August: The S&P 500 index of major stocks is up about 20 percent; the Russell 2000 index is up more than 30 percent; stock-market volatility, as measured by the VIX index, is down roughly 30 percent.
Beyond these financial measures, there are signs of improvement in the real economy. The Institute for Supply Management reported Monday that its index of factory activity rose in December for the 17th straight month. Sales of automobiles and other consumer durables have been increasing. And the banking system finally seems to have steadied.
Here's one striking example of how the system is healing itself. According to the Bank for International Settlements, the volume of outstanding credit default swaps -- the risky instruments that helped exacerbate the crisis -- has declined by nearly half from its peak of $60 trillion in 2007.
What could go wrong with this happy picture? Given that it's composed of expectations about the future, almost everything: The economy is still fragile and vulnerable to another shock. That's why Bernanke has not ruled out purchasing even more Treasury bonds (that is, run the printing press a little longer), and why he thinks Congress should enact pro-growth fiscal measures to complement the Fed's monetary policy.
The best sign that the economic engine is really repaired would be a joint plan by the White House and congressional Republicans to trim the federal budget deficit over the next 10 years. The elements of such a long-term recovery program are clear: reform and simplification of the tax code; cuts in entitlements programs; reduction in military spending to reflect a changing strategic environment. There is bipartisan support, in principle, for such moves, but in practice?
Keynes put it well at the end of his 1930 essay. He explained that political leaders, "like-minded and acting together, could start the machine again within a reasonable time; if, that is to say, they were energized by a confident conviction as to what was wrong."