The Keynesian Paradigm states that, under conditions of lagging demand for goods, the state can run a budget deficit and borrow to create artificial temporary demand aimed at accelerating economic activity. This makes sense only under the confusion of public debt, which conceals half of the equation of a loan agreement. In reality, government borrowing reduces private demand for goods in the aggregate by as much as the government increases its demand for goods. Deficit spending is nothing more than a wealth transfer from the productive sector of society, those who receive money in exchange for goods, to the parasitic sector of society, those who receive inflation.
Robinson Crusoe, alone on his island, does not benefit from a loan market. There is of course no use for money on a single-man island, but consumption can be shifted in time. Crusoe is limited in his choices of consumption in the present versus the future by his willingness to save to invest in capital goods, or as insurance against a fall in future productivity. He can, for example, accumulate a large supply of nuts to subsist on while building tools instead of foraging foods.
Once Friday arrives on the island, another option becomes available. Either men can exchange the present for the future. That is to say, Crusoe can give his stash of nuts to Friday in return for a promise by Friday to return more nuts later, and vice versa. The condition of this exchange is perfectly asymmetrical – the decrease in demand for nuts in the present of one is exactly the same as the increase in demand for nuts in the present of the other. Demand in the future is perfectly asymmetrical in the other direction – demand for future nuts increases for one and decreases by the same amount for the other. The aggregate demand for nuts at every point in time has not changed the least. It has only shifted from one participant to another.
Capitalist loan markets are of course based on the demand for money instead of the demand for nuts, but the same economic fact applies. In order for a loan to be arranged, the lender must give up demand for money in the present and the borrower must give up demand for money in the future. Aggregate demand for money is unchanged from this transaction, and so is aggregate demand for goods (if we account for differences in preference for goods between borrower and lender, then specific demand will shift in the present and future).
Things only get weird once a fractional reserve banking system is established. Under these terms, banks can arrange loans without having first earned enough savings (nuts) to lend to the borrower. The bank does not give up any demand in the present, it merely issues a note of credit that other market participants accept at face value. The bank promises to deliver nuts in its reserves in exchange for the note, and while the credit of the bank is unchallenged, the notes circulate as currency while the nuts remain in the reserve. Of course, as soon as any doubt arises over the quantity of nuts in the vault of the bank, the notes are redeemed and the bank collapses once the vault is empty of nuts and the marginal note cannot be redeemed.
What happens to demand in the present and the future under such a scheme? While the credit of the bank is good, there are more notes in circulation than the real money supply, the nuts or precious metal stashed in bank vaults. Hence, as the bank issues an ever greater number of fraudulent notes, demand for all goods increases while demand for money remains the same, resulting in a general increase in prices. This is the link between inflation and fractional reserve banking. When the bank’s credit collapses and the notes are no longer accepted at face value, the opposite phenomenon occurs – the real money supply is redistributed to those creditors who turn in their notes before the bank collapses, and the other creditors come to the realization that the supply of money they thought they owned is not real. Demand for money remains the same while the supply of money shrinks, causing a general liquidation of assets, crashes in stock prices and cutbacks in consumer spending. This is the deflationary correction of fractional reserve banking.
It appears that demand in the present increases and demand in the future decreases in this process, but that is deceptive. In fact, there emerges a triangular relationship. Because the bank has not saved the goods it lends out, it is the savers who are giving up demand against their will. Those savers deposited nuts or precious metal in the bank’s vault in return for the promise that the goods would be redeemed for the note. Little do they know that more promises than goods exist, and that their promise may not be redeemed. While they are out spending the notes they have received from the bank, the borrowers who received the same notes from the bank are purchasing the same goods as they are, with money that was “borrowed” from them. In the present there is then increased bidding for goods, and legitimate savers find themselves outbid for goods that they believed they could purchase, or have to bid more to purchase them. The result is the same as the relationship between Friday and Crusoe – the savers are reducing their demand in the present while the borrowers are increasing it. The banking institution is the fraudulent broker of this relationship, and pockets the interest as its own profit, while trying not to collapse.
Of course, fractional reserve banks do collapse, and many schemes were devised to prevent this and continue the expansion of the money supply (defined previously as the reduction in savers’ demand). The first such scheme was to nationalize the commodity behind currency, and through a central bank, the dilution of each individual claim (“devaluation”) to prevent runs to redeem notes. In this case savers are not randomly affected by the collapse of the system, but uniformly. However, both their present and future demand has been reduced, while the borrower’s present demand has increased, and the banker’s future demand also has. The consequence of this scheme was to make savers wary of saving, increasing time preference and sending interest rates for loans surging. This was when the floating fiat currency system replaced the commodity money system.
Under this scheme, the money supply is pure fiat controlled by the central bank, and the central bank sets the growth of the money supply by setting interest rate targets. These targets are met by purchasing assets, such as government bonds, until the supply of loans is so large that all fractional reserve banks compete the rate down to the central bank’s target. (Traditional lending is of course impossible in such a market.) Even more perversely, because the central bank declares its intention to purchase assets until its targets are met, there is an implied guarantee on loans given to bankers, and because the bankers lend money by credit instead of savings, these bankers can purchase the entire supply of, for example, Federal Treasury Bonds, at no cost to themselves. They can pocket interest as profit while the treasury enjoys increased present demand. It is once again the savers who do not experience this increased demand, and in fact their demand becomes outbid in the present by the state and the bankers.
The perversity of government budget deficits is thus exposed. There is no “moment of reckoning” when the country must learn to live within its means. There is neither a public “owing it to itself.” There is only a permanent exploitation of savers, in the present moment, for the benefit of those who receive money from the government treasury, and the bankers who earn interest on pure credit. Savers are impoverished in the present, reducing their demand for goods, while the state and the banking system is enriched in the present and demands more goods. The net impact on aggregate demand is the same, only the moral structure of society has shifted – saving is discouraged and politics is encouraged. The ultimate result of the process is national bankruptcy by means of fractional reserve banking’s destruction of the capitalist class.
In order to return to economic growth, the present demand of savers must be increased and the demand of government reduced to its absolute minimum. Because savers are by definition the productive sector of society (they earn money in exchange for goods), their savings result in more production, investment and economic growth. Government deficits shift aggregate demand towards the parasitic sector of society and must be remorselessly eliminated.
Combined with the elimination of taxes on production, most significantly income and sales taxes, this policy will turn around a depressed economy into a goldilocks economy.
Strangerous Thoughts 
Dave Narby
August 15, 2011
Always a pleasure to read you, Strangerous.
I may be in error on this, but as I understand it, Keynesianism has never actually been practiced – For it to be practiced properly, government must *save* during boom times, and then deploy the saved capital during lean times.
Naturally, given the power of the printing press (in this case unlimited credit via the Fed purchasing treasuries), governments spend too much during boom times and then even more during lean times, resulting in the classic Austrian Boom-Bust cycle.
So perhaps what we see practiced today should be more correctly called Neo-Keynesianism, not that drawing the distinction at this point would turn things around.