The Dow soared past the 12,000 mark Wednesday on news that the Fed would ease Europe’s liquidity crisis. Here’s the Times account:

Wednesday’s rally was among the biggest yet, with the three main indexes on Wall Street rising 4 percent or more, and the Dow Jones industrial average rising 490.05 points, its largest gain since March 23, 2009. Still, some analysts warned that the central banks’ action addressed only some symptoms of the euro financial crisis, so this rally, too, could evaporate.

“It helps to prop up the banks for a while which is going to buy time for Europe to fix the problem,” Burt White, the chief investment officer for LPL Financial, said. “This is basically a Band-Aid.”

Burt White’s quote sums up my feelings: this is a temporary measure that boosted the market on Wednesday, but won’t do anything to alter the global financial crisis over the long-term. It’s simply a stop-gap measure.

Nothing has fundamentally changed. Financial elites are still acting as if they tinker around the edges and flood Europe with dollars (in this case), all will be well. Banks will lend, demand will pick up, and recovery will ensue.

I fear it won’t happen that way. The Euro crisis requires re-examination (and ultimately abolition) of the single currency system. That’s not going to happen overnight, and I doubt it will ever occur. After all, Europeans have aspired to a united Europe and a common currency (a United States of Europe) since 1945.

Rejecting this system won’t come naturally, but market forces might ultimately demand Europeans to do so. Quantative easing is not the long-term solution: At best, it will lead to a boom and bust economy; at worst, it will lead to hyper-inflation when the economy picks up.

To better understand my thoughts on the situation (and my policy recommendations for all developed economies), I encourage readers to watch the Youtube lecture on the Austrian business cycle theory.

We live in a politically correct society that eschews principled positions and straight talk. Americans celebrate diversity and have made accommodation a fundamental aspect of civic/social life.

I’m not judging this; I’m merely saying that political correctness has dominated the post-modern worldview.[1]

It’s also affected how American Christians react/respond to hell. Traditionally, Christians said that hell was where sinners went. If one didn’t confess sin and accept Jesus Christ as personal savior, one was condemned to an afterlife of hell.[2]

But this view is no longer accepted by a majority of self-identified believers. Accommodationism and diversity, which shape our civic life, has altered the public’s faith. Specifically, most American Christians now proclaim they’re universalists, meaning they believe all paths to God are equally valid, everyone will receive salvation and all will go to heaven.

Rod Dreher highlights Sherry Weddell of the Catherine of Siena Institute, an organization designed to make lay parishioners into apostles for Christ. Weddell estimates that 95% of the Roman Catholics she encounters are “functional universalists” unconcerned about personal salvation. This, she says, makes her fellow Roman Catholics modern-day Pelagians.

Pelagianism was a 4^th century heresy which proclaimed that man can be saved without God’s grace and without Christ’s sacrifice on the cross. They didn’t believe in original sin, or the fall of man. They also maintained that man had the ability to become righteous and gain salvation on his own merit.

But man can’t gain his own salvation. If he tries, he will end up in hell.[3] That was/is the orthodox view.

Now the question of who’s in hell is a tricky one. No one knows who’s exactly there. But orthodoxy teaches that there’s a hell and some of the dead will spend eternity there.

That’s a dogmatic position, for sure. Perhaps that’s why so many struggle to accept it wholeheartedly. We don’t want to contemplate our friends from non-Christian faiths spending the afterlife there. How can faithful observers from other traditions be punished because they don’t accept Jesus as Lord of all? These pious non-Christians followed their teachings and lived the good life, didn’t they?

Educators have contributed to believers’ doubt too. Public education has taught us to question dogma and absolutes. That makes publicly educated believers ask: Are non-Christians condemned to hell in perpetuity? Why can’t they just spend some time in purgatory and then ascend to heaven?

These thoughts have contributed to moral relativism and the diversity/accommodation ideal both in civic and religious life. All cultures/religions are unique. They each have something significant to contribute. Hierarchical values are inherently subjective.

That’s the message pounded into public school children from pre-K through graduate school.

No wonder adults now accept relativism as truth. These ideas have consequences.[4] Who’s to say which individual is/isn’t going to hell?

Such thinking has led to the acceptance of universalism. It’s become, in Dreher’s words, the emerging orthodoxy.

The Austrian Business Cycle Theory (ABCT) explains the boom and bust of the market economy. The Austrians highlight monetary policy-primarily the artificial expansion of credit- as the reason for the boom and bust; Murray Rothbard, one of the intellectual titans of Austrian economics, has said that such actions by central bankers lead to a cluster of errors in the business cycle, and ultimately put the economy into recession.

Recessions most often occur, according to the ABCT, because a distortion in the money supply creates a distortion in the relative prices of goods. Resources shift accordingly because it looks (to the naked eye) as if there is an underlying change in the economy.

Central bankers give artificially created money (ACM) to banks. In so doing, they inflate the currency; this leads to a decrease in short-term interest rates. As interest rates decline, investments that hitherto looked unprofitable begin to look worthwhile because the cost of investing (which is affected by the interest rate) has declined.

Since Mises and Hayek, Austrians have focused on how the price of time, i.e. how interest rates, affects the economy. Hayek theorized that money was an all important part of the business cycle because it affected the entire economic system.

In other words, it had system-wide implications. If the money supply increased, interest-rates system wide would decrease. This would lead to a system-wide distortion of investments and create a boom and bust cycle.

Austrians believe the coordination of resources is central to economic stability. But resources don’t coordinate automatically. Entrepreneurs and investors rely on nominal prices to understand where the market is and where it is going. Nominal prices, in other words,  shape economic coordination.

But what if those nominal prices get out of whack? That’s what Austrians fear. As George Mason University economist Don Boudreaux says: individuals “don’t look out in the world and see the real underlying economic phenomena. [The] Window of economic prices [i.e. nominal prices]…is a cloudy window.”

The injection of ACM makes things murkier for individuals trying to get a sense of the economy. The ACM will hide things and lead to mal-investment. That is, good money chases bad investments because the ACM has lowered interest rates.

Things seem fine during the boom period, but the boom is unsustainable because ACM will not last forever. Austrians emphasize the lag time that takes place from when ACM enters the system until inflation comes about. Printing money doesn’t devalue the currency overnight and neither consumers nor investors will see an increase in price in the near term.

The boom is fueled by consumer spending and excessive investment. Unfortunately, the capital needed to sustain investment projects runs out (if it was ever there to begin with) because individuals have the incentive to buy now rather than save for later. Individuals over-extend themselves during the boom; when the ACM stops entering the system, people realize that interest rates will rise and the cost of things will increase.

Austrians say this time is a self-correcting one in which mal-investement is liquidated because investment plans are unsustainable. This will take time and some sectors (notably the financial sector and economically productive sectors) will suffer economic losses. But this time-in which recession occurs-is necessary for individuals to move their resources back to the margins and look for more profitable investments. This is a time when supply will once again get in sync with demand.

This self-correcting time is called a recession. Economists have tried to understand what puts an economy into recession for centuries. Since the 18^th century, Austrians have argued that recessions are caused by mal-investment. Jean-Baptiste Say, an intellectual progenitor of the movement, argued that market disequilibrium took place when the proportions of supply/demand were out of sync. This reflected mal-investment in the economy and led to a slowdown in the business cycle.

The Austrians’ critics-the Malthusians in the 19^th century and the Keynesians in the 20^th century- claimed that recessions resulted from an absence of aggregate demand in the economy and that excessive supply (a glut of goods) was to blame for the economic slow down. To them, supply and demand were separate entities. Demand must be pumped back into the economy for growth to occur.

Austrians disagreed. They maintained that supply and demand were inter-related, a position articulated by Benjamin Anderson in his 1949 work Economics And The Public Welfare: “every commodity is either a supply of its own or a demand for other commodities.”

Laissez-faire was seen as the key to economic prosperity When the economy soured, Austrians insisted that government should stay out of the economy. They claimed that the mal-investment which had occurred would be liquidated, new capital formations would take place, and the economy would pick up again.

This view remained widely accepted until the Great Depression. Then, the interventionist ideas first promulgated by Thomas Malthus came back into fashion.

Why did that take place? The neo-Malthusian prescriptions provided a specific plan to get people back to work and promised to get the economy moving again. John Maynard Keynes articulated these ideas persuasively and his General Theory claimed the public sector could manage the business cycle and create full employment.

With massive unemployment around the globe, people were willing to take Keynes at his word. He had a plan and the articulate, erudite British economist charmed people around the world with his “revolutionary” General Theory.

The Austrians failed, according to Professor William L. Anderson, because they continued pushing laissez-faire when the global economy was in depression and millions were out of work. In other words, the Keynesians won the public relations battle over mal-investment liquidation.

Mal-investment liquidation plays a critical part in helping the economy recover; that point cannot be emphasized enough. Companies need this period to get rid of their bad investments and build up their capital formations in order to invest in new things and start growing again. This was a time to re-organize and get investment and production patterns in line with consumer demand.

Interventionists insisted that mal-investment liquidation led to under-consumption in the economy and created a demand-deficiency. They called for governments to pump money into the economy through fiscal policy (deficit spending) or have central banks print money and inject ACM into circulation.

These policy prescriptions horrified Austrians. They believed this would either exacerbate a recession or lead to an unsustainable recovery, marked by the boom-and-bust cycle.

Government policy, according to the Austrians, should encourage capital formation and should not interfere with the price adjustment which took place as businesses were liquidating their mal-investments. Nor should it re-inflate the money supply. Only real savings-not inflated ones-would shorten the length of the recession and lead to real, sustained economic growth.

So what should government do in the midst of recession? It should cut taxes on the rich. The wealthy would use their tax rebates to invest back into the economy, prompting the capital formation needed for investment and growth.

Unfortunately that’s not what governments do. They attempt to use fiscal and monetary policy to stimulate demand in an ailing economy. In other words, they follow the Keynesian play-book.

Keynesians like to brag about their triumphs. They point to deficit spending getting the United States out of the Great Depression. They highlight President Obama’s stimulus plan which took an economy that was falling off a cliff when Mr. Obama assumed office in January 2009 and was out of recession by the middle of that year. These interventions show that deficit spending has worked in the past and will work in the future.

Let’s accept this premise. Government stimulus “worked” and the economy came out of recession because of deficit spending. The ATBC would caution those enthusiastic about the “economic growth” that came after the recession ended and warned that this “growth” likely occurred because intervention had launched a boom-and-bust cycle.

This began with QE, an attempt to inject liquidity into the market by printing money.This will stimulate demand; Paul F. Cwik notes: “with the decline in short rates, the cost of financing short-term consumer purchases (with credit instruments such as credit cards) falls. Thus, an immediate result of the monetary injection is an increase in demand for consumer goods.”

Low short-term interest rates reward spending now. Products are cheaper if you buy today than they would be if you bought tomorrow. And sentient individuals-from consumers, to entrepreneurs, to businesses, and corporations- realize this and start spending their money rather than investing it for the future.

Millions of people do so. These individual decisions drive up the cost of things over time. During this period, individuals deplete their savings because they are using their capital to buy now.

This will get the economy going in the short-run, but fears of inflation will develop over time. The central bank will respond by hiking interest rates, putting the breaks on an economic recovery. This is called the Fischer effect, a move that crunches credit in an attempt to combat inflation. Increased interest rates will create tremendous demand for short-term treasuries.

More often than not, firms without investment grade bonds (often small businesses) will look for short-term credit options to finance their investments. When hundreds/thousands of individual consumers/entrepreneurs/small businesses do so, the demand for short-term loans (referred to as yield) will begin to steadily rise.

Over time, the yield curve will start inverting. An inverted yield curve signals that short-term rates are higher than long-term rates. For instance, the rate on a 6 month treasury would spike to 4% while the rate on a 10 year treasury would remain steady at 3%. The inverted yield curve usually means a recession is right around the corner.

Paul F. Cwik argues that inverted yield curves were a reflection of mal-investments. His doctoral dissertation (which studied this problem) concludes: “when short-term rates are low, yield curves are more likely to have an upward slope; when short-term rates are high, yield curves are more likely to slope downward and be inverted.”

An inverted yield slope is an anomaly. The longer the treasury note, the greater yield one would expect to earn. That is reflected in a normal yield curve, which is shown with an upward slope. Inverse shields, on the other hand, show a downward slope.

Cwik’s research suggests that an inverted yield curve means that a recession is coming in the next four or five quarters. His dissertation notes: “an inverted or humped yield curve has occurred no more than 5 quarters before every recession since the mid-1950s. Except for the Q3: 1990-Q:1 1991 recession, the yield curve has inverted in every recession since the 1960s.”

Austrians know how to fix an inverted yield curve: Let the mal-investment liquidation begin. Keep government out of the economic “recovery” and yield curves will begin to normalize. A recession is necessary because companies need this time to rid themselves of bad investments and build up their capital formations, so that they can begin growing again. It is a time to re-organize and get investment and production patterns in line with consumer demand.

Put more simply: laissez-faire. Let new capital formations develop.[1] Allow real savings to occur. Then watch the economy grow again.

Keynesianism has dominated economic thought and shaped public policy since the 1930s. John Maynard Keynes’ General Theory revolutionized economics and made the demand side of the equation paramount. Recessions, in his mind, were caused by insufficient demand. Fix the demand failure and you get the economy out of recession.

This theory refuted classical economics, specifically what had become known as Say’s Law. Professor Steven Kates tells us why : Keynes said insufficient demand led to recessions; classical economists, on the other hand, said there was no such thing as a demand deficiency. Keynes’ contribution, as Ludwig von Mises noted in 1950, was abandoning classical economics and offering a different way (the polar opposite way in fact) of fixing recessions.

Recessions could be fixed by government deficit spending according to Keynesians. This called for government to step in during recession and pump money (inject tax-pay dollars) into the economy. This will pick up the slack and will eventually put the business cycle back into equilibrium.

The General Theory relied upon the writings of Thomas Malthus, a late 18^th century/early 19^th century intellectual best known for his thoughts on overpopulation. In 1820, Malthus wrote a treatise on economics-Principles of Political Economy- that argued the recession in Britain following the Napoleonic Wars was a result of excessive savings/investment in the economy.

In other words, there was insufficient demand in the economy. This demand deficiency led to a breakdown in the business cycle and put the British economy into recession.

Malthus’ writings went against the classical consensus of his contemporaries, specifically the writings of David Ricardo and Jean-Baptiste Say. Classical economists said that demand played no role in understanding the business cycle.

Ricardo wrote to Malthus in 1821 shortly after the publication of Malthus’ Principles, saying: “men err in their productions…there is no deficiency in demand.” That point, along with several others, fused together and became known as Say’s Law. Say’s Law dominated economic thought throughout the 19th century, but was abandoned when it (and classical economics generally) looked impotent during the Great Depression.

There are several propositions in Say’s Law. Most importantly, there is no demand deficiency. Both Malthus and Keynes argued that excessive savings/investment would lead to an excess/glut of goods/services in the economy. Classical economists said this was nonsense. There is no such thing as excessive supply. Any unused supply was put into savings/investment which lead to capital formation. In other words, no hoarding of supply took place.

The second proposition is just as important as the first. Demand is constituted by supply. Read that again. Demand is made up of supply. It won’t grow unless there’s a growth in supply. Value added productivity must occur for demand to increase.

20^th century British economist Henry Clay put it this way:

An increase in the supply of cloth is an increase in the demand for other things; and vice versa, an increase in the supply of anything else may constitute a demand for cloth. What is divided among the members of society is the goods and services produced to satisfy its wants; and the same goods and services are both Supply and Demand.

Ludwig von Mises came to a similar conclusion. The Austrian said that commodities ultimately paid for other commodities. Money was just the means used during the transactions. In effect, our services rendered or our goods provided (our value added productivity) pay for new goods/services that we desire.

This is the third proposition of the classical economists: money is the conversion of one’s goods/services into currency which is used for new goods/services.

Here’s a thought experiment. Imagine you work eight hours a day on the assembly line of a profitable car factory. The company uses some of its profits to pay you X amount for the week. X is a reflection of services rendered. You take that X in the form of a paycheck and use that paycheck to buy other goods/services, e.g. groceries, mortgage payments, car notes, etc.

Those three propositions explain how an economy operates. But what explains why it slows down? What leads to recession?

Classical economists say that recessions occur because of high levels of involuntary unemployment. This is a result of structural problems in the economy. More often than not, this takes place when the structure of supply and the structure of demand are out of sync. When demand patterns no longer reflect the actual output of supply, the economy goes into recession.

19^th century British economist Robert Torrens said that market equilibrium was paramount. Keeping supply and demand properly proportioned was the goal of economics. If that market equilibrium was in place, Torrens asserted, increased value-added production would lead to an increase in demand.

Finally, Say’s Law highlights the importance of monetary policy. Many recessions occurred because of structural imbalances in the credit market-e.g. too many dollars chasing too few goods (excessive credit expansion) or too few dollars chasing too many goods (insufficient credit expansion). Monetary policy could also lengthen/prolong/exacerbate a recession if it was incorrectly implemented.

Nowhere do the classical economists say that recessions are a result of insufficient demand. This was/is a fallacy.

Keynesianism doesn’t work because it is based on an economic fallacy. Unfortunately, economists have embraced its policy prescription (deficit spending) as the solution for fighting recessions. But as David Ricardo could have told you, deficit spending will not fix an ailing economy. It will only hike the public debt and inflate the currency.

The key to economic expansion is market equilibrium and the growth of value added production. Let the invisible hand restore the natural order between supply and demand. That will, in turn, promote additional economic activity and lead to an increase in value added production. These two things-market equilibrium and increased value added production- will restore prosperity.

Occupy Wall Street has focused the nation’s attention on income inequality. Here’s their critique of “the system:” The rich are getting richer off the labor of the poor and middle class. The middle class, once the engine of America’s economy, is dying. Poverty is rising. Something must be done to change an unjust economic system.

Similar complaints are coming from the Right as well. Pundit Pat Buchanan frequently notes middle class wage stagnation that has taken place over the last forty years and claims free-trade policies (e.g. NAFTA) have destroyed America’s manufacturing base and eliminated millions of well paying, blue collar jobs. Presidential candidate Rick Santorum wants a 0% tax on manufacturers, hoping to lure back companies that have outsourced jobs in recent decades.

All this talk is centered on American decline. Has the American Century ended? When will China and India surpass it economically? What’s next?

There is wide discontent with President Obama’s performance on the economy. Mr. Obama seems content to manage America’s decline. His Keynesian stimulus got the country out of recession, but unemployment has only grown on his watch. Americans fear going into a double-dip recession, a concern exacerbated now that forecasters predict the European debt crisis will put the Continent into recession (and America shortly thereafter).

Government statistics only add fuel to the fire. 1 in 6 now live in poverty. Workers, desperate for employment, have accepted diminished wages and benefits to get back into the labor force. The misery index has soared.

But how bad is it, really? This is not a facetious question. Sure people are hurting out there. The economy is sputtering along. High growth seems unlikely. Political gridlock in Washington has faith in government at an all time low. People are angry. Kids are protesting in the streets.

But I would argue things are much better than they seem. Stay with me here. Look at the developments and life enhancers Americans have enjoyed over the last forty years.

Most people, undeniably, are better off in 2011 than they were in 1971. True income inequality does exist and should be addressed, but this does not negate the tremendous quality of life advances that have taken place during that period. These things immediately jump to mind.

            Cell phones and Ipods are now ubiquitous

            Ditto Satellite and cable television

            Ditto the internet

            Ditto the availability/accessibility of air travel

Americans are still an affluent people and are, ironically, the 1% that OWS complain about. We are a blessed people. But that’s not the impression one gets from reading the headlines or watching the nightly news. Doing so would give the impression that Americans are poorer than ever and starving in the streets.

In fact, America is concerned with an obesity epidemic. This is such a pressing “crisis” that First Lady Michelle Obama has made fitness and obesity prevention the cornerstone of her agenda. Only a prosperous society could have such a problem.

We are so fat and happy because the American economy boomed over the last several decades. GDP per capita doubled from 1970-2009 according to recent research conducted by University of Notre Dame and the University of Chicago. Conservative fiscal policies put into place under President Reagan and accepted by President Clinton and the New Democrats led to a quarter-century of economic prosperity. Median income and consumption both rose by 50% during this period.

But poverty rose 2% during those years as well. How is that possible? Washington spends about $500 billion annually in transfer payments for the poor. Programs like food stamps, heating and home assistance and Medicaid all address the less fortunate. Washington is still fighting President Johnson’s quixotic “War on Poverty”.

Conservatives have long argued these transfer payments won’t fix anything. When Republicans took over the House in January 1995, incoming House Ways and Means Chairman Bill Archer (TX) argued the war on poverty (a 30 year effort at that point) was a colossal failure and had cost taxpayers $5.3 trillion. Chairman Archer echoed President Reagan, who famously said: “we fought a war on poverty and poverty won.”

Clearly transfer payments aren’t the solution to ending poverty, as the research points out (page 5 of 77 page PDF file). This academic study is a critique of big government and federal efforts to combat poverty.

The lesson of the 1960s—it seems to me—is that the Kennedy tax cuts were good (fueling a decade of economic expansion) and the Johnson social democratic agenda was idealistic (liberalism at its best), but catastrophic in terms of public policy (leading to anarchy and political unrest).

Shifting back to the present day, I would argue that income inequality is a problem, but it shouldn’t be the country’s top concern. The anemic economy should be issue number one.

Only economic expansion will get the United States out of the doldrums. Private consumption and spending will pick up and demand will be pumped back into the economy when things turn around. Government coffers at the local, state and federal level will all fill up. The housing crisis will get resolved. Happy days will return.

We know what leads to economic expansion. Unfortunately, we’re not pursuing those policies- e.g. tax reform, entitlement reform, letting the housing market clear, rolling back regulations on business, etc. Until we change course, income inequality will persist and America’s malaise will continue.

On the front page of today’s New York Times , readers encounter this headline: Greece and Italy Seek A Solution From Technocrats. The article chronicles the political transitions taking place in these two debt ridden countries. A sample:

Greece named Lucas Papademos, a former vice president of the European Central Bank, interim prime minister of a unity government charged with preventing the country from default. In Italy, momentum was building behind Mario Monti, a former European commissioner, to replace the once-invincible Prime Minister Silvio Berlusconi as early as Monday.

Can technocrats manage the debt crisis? The Times asks. Politicians failed. Can bureaucrats succeed? And if they do, what does that portend?

The article goes on to chronicle the difficulties of the two countries. While they both have massive debt, they take a different approach to handling the situation. Italy has welcomed technocratic advice and solutions; Greece has resisted “outside interference.” Greece has a small economy (comparable to the size of the Dallas/Fort Worth Metroplex); Italy has the world’s 7^th largest. Roman politicians welcome a unity government; Athens has suffered political polarization for the last forty years.

This article confirms my earlier bias: Italy is a credible member of the EU; Greece is not. While I doubt the long-term efficicacy of “technocratic reforms,” I think they are the most plausible short term remedy for the Europeans. Certainly I don’t see European socialists abandoning Keynesian economics during this crisis. Thus, they may muddle through the current situation, but will not enjoy an economic boom that would come if they implemented laisse-faire, pro-growth policies.

Americans should pay attention to the European debt crisis, particularly the political impotence shown by its political class. Note this Times observation:

Mario Baldassarri, the chairman of the Senate Finance Committee, singled out the political class, saying, “Because in Italy there are 3,000 or 4,000 people who count on waste and theft of public spending and now they are more powerful than 60 million people.”

America has a similar political class invested in the status quo. Making real reforms (entitlement reform/tax reform/eliminating superfluous bureaucracies in the administrative state) limit their power. Politicians understand this. Reducing it is an existential threat to statist officials.

In addition, we see the tendency to tinker around the margins rather than making fundamental reforms to the welfare state — doing just enough to muddle through but not enough to rock the boat.

This is what conservatives fear from a Mitt Romney presidency. He is not a true-blue conservative. He is a technocrat. He won’t stake his presidency on entitlement reform and won’t fight tooth and nail to reduce the size and scope of government; instead, he’ll aim to slow its growth.

We know what President Obama and the Democratic Party want. Omnipotent government. State economic planning. Entitlements for all. A social-democratic state.This is unsustainable, as the European experiment has shown. Yet they want it anyway.

Of course neither side will get everything they want. Some kind of  political compromise is in the cards. Politicians must then implement policies to reform (by that I mean improve/modify it based on 21^st century demographic rates/economic conditions, etc) it.

Austerity alone won’t solve the problem. Pro-growth policies are needed. Fortunately Republicans have spent this primary season articulating these ideas: 9-9-9 and the flat tax immediately jump to mind. A growing economy will solve many of our current fiscal dilemmas.

Will America implement pro-growth policies? Certainly not until President Obama has left office. Or will voters re-elect Mr. Obama and put their stamp of approval on his European trek? Stay tuned.

The European debt crisis has sent uncertainty and fear throughout global markets during 2011. Last week the international community watched Greece; this week, all eyes are onItaly.

On Tuesday night (US time) yields on 10 year Italian treasury bonds crossed the 7% barrier, which is seen as the threshold in which a government must seek a bailout because it can no longer pay off its welfare spending and the interest on its debt payments.

Greece,Portugal and Ireland have all needed a bailout after crossing the 7% mark in recent years.

Amy Wilson of the Daily Telegraph explains how this will affect Italy:

The yield is the interest rate on the loan, or bond, ie. how much the government has to pay to the bank, institution or country which has bought its bond and loaned it money – in the same way individuals have to pay interest on a mortgage or bank loan…

In Italy’s case, paying a 7pc interest rate to borrow new money means it becomes extremely expensive for the country to pay for its public services and service its debts.

It has been calculated that if Italy had to pay 7pc interest on all its debt – which will not happen at once because the government’s existing borrowings are already fixed at earlier agreed rates – then the country would have to pay an extra €70bn (£60bn) a year just in interest payments.

The country could find itself in the position of borrowing more money just to make its interest payments – and, like using a credit card to pay off a mortgage, that does not make it an attractive proposition to potential lenders.

On Wednesday, yield on long-term Italian treasuries soared to 7.5%, the highest rate since the Euro’s inception. Fortunately (for Rome), the European Central Bank stepped in and bought plenty of short term bonds to help the country cover its near-term obligations.

Italy sold € 5 billion in short-term debt yesterday at an average yield of 6.087%, nearly double the short-term yield from October 11^th (3.57%), according to Wall Street Journal reporting 

The Italian fiscal house is tumbling down. This year the government must borrow 23% of its GDP in the bond market to pay its bills. Currently it has a €1.9 trillion in sovereign debt. That’s nearly a quarter of the continent’s total debt level.

For now, the European Central Bank has stepped in and offered vital aid to Italy. How long will that last? Is this just delaying an inevitable Italian default? The Italian government must step in and get its act together quickly, i.e. begin implementing austerity measures now, if it has any hope of attracting outside (non ECB) bond market investors.

With the economy anemically plodding along, political gridlock has hit Washington. President Obama insists that the key to job creation and economic growth is another round of stimulus. That’s a political non-starter for the House Republicans who believe that lowering taxes and reducing federal spending is necessary for the private sector to pick up again.

This political polarization is another round in the “fight of the century,” an economic dispute that’s gone on for the last eighty years between “conservatives” and “liberals.” It’s an ideological battle that has led to numerous vituperative debates through the years.

Hoover Institution fellow Russ Roberts (host of the indispensible Econtalk podcast) and Nicholas Wapshott, a British journalist, discussed these competing economic visions on the October 17^th edition of Econtalk. The interviewer, Roberts, is a noted Hayekian and progenitor of the sensational Youtube series on two of the 20^th century’s most prolific economists. Wapshott is author of the recently published Keynes Hayek: The Clash That Defined Modern Economics.

The conversation briefly gave biographical sketches of the life and thought of the two economists. Hayek was an Austrian classical economist who believed that government should steer clear of planning the economy. Unintended consequences would no doubt ensue if government sought to manage the economy. Let the business cycle correct itself, Hayek claimed.

These words rang hollow during the midst of the Great Depression. Seemingly, the classical economists had no solution to solve rampant unemployment. Unemployment remained astronomically high year after year. When would the misery end?

British economist John Maynard Keynes’ General Theory offered a panacea for the depressed economy. Keynesianism, as it came to be known, called for government intervention in economy during business cycle downturns. It had a moral responsibility to do so; when people hurt, government must act.

How would this work? Government should pump demand (spending) into the economy during recession because the private sector was incapable of doing so. This made fiscal policy (the use of government spending) key to turning the economy around.

Hayek warned that injecting demand into the economy would create inflation. He feared that once the pump was primed, it would be impossible to control. This was not out of the realm of possibility. After all, Hayek had seen the horrors of hyperinflation destroy Germany following the Great War. Inflation’s impact on the social fabric concerned the Austrian economist.

Keynes said inflation was a tolerable trade-off if it put people back to work. This ultimately was reflected in the Phillips Curve, a graph which dealt with the inverse relationship between inflation and unemployment. Full employment created inflation while rising unemployment would bring inflation down. Government planners would use the Phillips Curve to manage the macro-economy and handle the twin challenges of inflation and unemployment.

The perceived success of the New Deal made Keynesianism triumphant in America. Many felt that Roosevelt had saved the country by using Keynesian policies to get the country out of the Depression. Successive administrations followed the Keynesian playbook for decades. Even Republicans bought into the argument. The nominally conservative President Richard Nixon famously proclaimed “we’re all Keynesians now.”

This went on for forty years. The academic world considered Hayek’s warnings, and indeed his scholarship, out-of-date. Russ Roberts sardonically compared this period as Hayek’s time in the desert, referring to the forty years the Israelites spent wandering in search of the Promised Land.

This period of Keynesian hegemony ended abruptly in the 1970s when stagflation hit the Western world. Stagflation, or high unemployment and high inflation, threw Keynesian economists for a loop. Stagflation, in their mminds, simply could not happen. Yet its impact led to a decade of economic malaise.

Around this time, classical economics began a renaissance and Hayek’s work garnered praise and admiration around the globe He received international recognition when the Nobel Committee awarded him its economic prize in 1974.

The Austrian delivered a famous acceptance speech in Stockholm, which was titled “The Pretence of Knowledge.” This was his retort to Keynes and the “General Theory” (something he had famously eschewed after Keynes’ book came out). Hayek condemned what he perceived as “the pretense of knowledge” that government planners possessed. Tinkering with the economy was detrimental and ineffectual because experts in Washington lacked the knowledge to plan the macro-economy.

Economics was not a physical science, Hayek argued. Keynesianism rested on the micromanaging of the macro-economy and claimed its theory would solve fluctuations in the business cycle. That was a Sisyphean task because no one (or group of bureaucrats in Washington) had the requisite knowledge of every sector of the economy. It was too vast and too complex for even a super-computer to fully grasp.

Hayek’s solution was simple: let the price system work. The price system gave individuals the best way to make sense of the fluctuating market. This provided what Hayek called “spontaneous order,” something which benefitted the social order and was superior to any state design.

At the conclusion of his address, Hayek implored his contemporaries to show some humility and recognize the limits of human reason. Interventionists always thought their “plans” would work and would produce greater economic growth and prosperity for all. But instead, their “plans” led to less freedom and prosperity for the masses.

These unintended consequences should teach planners a lesson. State intervention could not work because man lacked the knowledge to plan the macro-economy. Pursuing such aims would ultimately destroy civilization.

Keynesians scoffed at this critique, then and now. But considering the malaise that’s afflicted theUnited States during the last four years -high unemployment, growing political unrest, loss of faith in government and institutions- Hayek’s warning now appears prescient.

When you’ve lost the Crimson, you’ve lost America. So said Wall Street Journal opinion editor Paul Gigot on the latest “Journal Editorial Report.”

Gigot’s colleague, Bill McGurn brought up the Harvard undergraduate walkout of an introductory economics course-Econ 10- on the hits and misses of the week segment. He cited this November 3^rd editorial as a sign that even the Crimson editorial staff was fed up with the antics of these left-wing students.

The students were protesting the bias Econ 10 and asserted this bias “contributed to and symbolizes the increasing economic inequality in America.” Econ 10, coincidentally, is taught former George W. Bush administration official, Greg Mankiw, a tenured professor at Harvard. Ironically, the boycotted lecture would have focused on inequality between top income earners and average workers.

The OWS movement, as the Crimson points out, remains unfocused and undisciplined. Increasingly their rhetoric is nihilistic: No set of policy proposals have come out of this leaderless movement. Instead, the movement has complained about “the rich” and high levels of college debt.

Protestors’ actions, meanwhile, have turned violent. Police have arrested hundreds of protesters around the country and anarchy has broken out inOakland. Municipalities have spent millions in police overtime, something no local government can afford to do in tough economic times.

These developments have irked Middle America. Its acolytes have appalled the Crimson.

The Left never miss an opportunity to miss an opportunity. OWS started out with great promise and many hoped they’d focus the nation’s attention on growing inequality and develop proposals to rectify the situation. Instead, they’ve shown themselves to be fundamentally unserious and incapable of reforming the system.

The Obama administration has spent its time pursuing a Keynesian solution to fix the ailing American economy. Day after day, the administration has lamented the absence of demand in the economy. Boosting demand will rapidly grow the economy, they insist.

As readers know, I reject this argument. Keynesianism has been tried again and again. It has come up short repeatedly. It never delivers. But politicians love it because it gives them a reason to use fiscal policy in hopes of assisting an ailing economy.

Ludwig von Mises once wrote that the genius of Lord Keynes was his justification for what politicians wanted to do anyway. Keynes thought during economic downturns, government should step in and pump money into the economy to boost demand. Insufficient demand, Keynesians believe, is what causes recessions, market failures and difficulties with the business cycle.

The Raison d’être for this is the (misguided) belief that there is an absence of money/spending (demand) in the economy. Who has the money to spend when the economy was in the toilet? Government does.

Classical economists warned such attempts would create a boom and bust environment. They feared government interference in the market would screw up the business cycle; pumping money into the economy would also inflate the money supply and create future problems down the road.

Mises condemned politicians’ tinkering inclinations, saying they would sacrifice the long-term health/stability of the national economy in order to win the next election. He was especially concerned about the unintended consequences that came from priming the pump by expanding credit. He called credit expansion/inflation the government’s “first principle of economic policy.”

What should government do, instead? Keynesians ask. Government can’t just stand by and let people suffer. This thinking stems from a fundamental rejection of classical economics, primarily the contributions from 18^th century Frenchman Jean Baptist-Say.

Say’s writings focused on the supply-side of the economy. He concluded that the production of goods opens up demand for other goods. In other words, the ability to demand goods comes from one’s own production. Say’s law, as it came to be called, has been popularly summarized as follows: “supply creates its own demand (a phrase first used by James Mill).”

While supply always will equal demand, demand will not always equal supply. Think about it: when you go shopping, you don’t spend all your money at once. You save some money for future needs.

Money, Say reminded us, is not what allows people to buy things. Money is simply a reflection of one’s productive assets. It’s a mechanism that reflects consumers’ purchasing power.

Wealth was derived from production, not consumption, classical economists maintained. Lord Keynes emerged in the 1930s and turned that notion upside down. The Keynesians said that consumption (demand) was what needed be boosted in order to create an affluent society.

If insufficient demand causes economic downturns, how does insufficient demand come about? They wondered. Insufficient demand is a result of excess supply, a result that is derived from classical economics. A glut (concentration) of goods is left unsold because consumers lack the demand to buy them.

Classical economists categorically reject this assertion. There is no absolute overproduction of goods. Mises claimed that there may be a relative overproduction of some good in the short term, but this would not take over/influence/derail all sectors of the economy.

In other words, Mises said there would not be a general overproduction of all goods.

He used an example of relative overproduction in a department store to illustrate his point. The store sold slacks and shirts and, at a particular moment, might have too many slacks and not enough shirts. How do you fix this? Simply raise the price of slacks, making the price of shirts more competitive

That didn’t mollify Keynesians, who still that excessive supply was the chief obstacle in the business cycle. Excessive supply also results from “the rich” hoarding supply. Therefore, Keynesians promote fiscal policies designed to “fix” the problem. Government must step in and redistribute wealth (through a progressive tax system) from the affluent to the poor and middle classes, ensuring that demand trickles down to the least among us.

No. No. No. Classical economists say. Money is not hoarded. The rich invest their excess supply in the market. They also put their money in banks, primarily in checking accounts. If that money is invested or in a bank, this excess supply will be used to lend others that “excess” supply.  This will straighten out the supply/demand equilibrium.

So if insufficient demand doesn’t cause a recession, what does? Classical economists say a recession is a result of monetary failure, i.e. there is too much/too little money in the economy.

Throughout the 20^th century, these ideas shaped what became known as the Monetarist tradition. Milton Friedman became the intellectual godfather of this movement. Friedman argued that the key to economic stability was controlling the money supply. Here are a few of his general policy prescriptions:

      The theoretical foundation is the Quantity Theory of Money.

      The economy is inherently stable. Markets work well when left to themselves. Government intervention can often times destabilize things more than they help. Laissez faire is often the best advice.

      The Fed should be bound to fixed rules in conducting monetary policy. They should not have discretion in conducting policy because they could make the economy worse off.

      Fiscal Policy is often bad policy. A small role for government is good.

2oth century Christian apologist G.K. Chesterton once famously remarked: “Christianity has not been tried and found wanting; it has been found difficult and not tried.” The same can be said for classical economics and the monetarist tradition.

Politicians, by their very nature, are averse to the political implications of the laissez-faire policies promoted by classical economists. The voters will kick us out if the economy is in the tank and they don’t see us doing anything, politicians think. This idea has facilitated the Keynesian revolution over the last eighty years. It has also kept the economy in the doldrums since the 2008 financial crash.