312 California's Bleak State Budget. But it could escape by creating its own bank

California's Bleak State Budget. But it could escape by creating its own bank.

(1) California Governor Lays Out Bleak State Budget
(2) California could use Rainy-Day funds to start its own bank, escape Wall St debt trap - Ellen Brown
(3) Bank of England Act to transfer money-creation from commercial banks to the Bank of England
(4) Keynes Solution implemented by Schacht - Robert Skidelsky

(1) California Governor Lays Out Bleak State Budget

From: IHR News <news@ihr.org> Date: 21.05.2010 09:50 AM

The Associated Press

http://www.breitbart.com/article.php?id=D9FMT0201

Schwarzenegger lays out bleak California budget

May 14 06:34 PM US/Eastern
By JUDY LIN
Associated Press Writer

SACRAMENTO, Calif. (AP) - Gov. Arnold Schwarzenegger on Friday called for eliminating California's welfare-to-work program, one of the deep cuts he proposed to close a $19 billion budget deficit in the coming fiscal year.

Slashing the welfare program would affect 1.4 million people, two-thirds of them children.

In releasing his revised budget plan, the Republican governor laid out the most severe cuts to health and welfare programs since the state tumbled into recession nearly three years ago. He said cuts to government services over the past few years have done away with the "low-hanging fruit."

"We now have to use the ax to eliminate some of those programs," he said.

The Republican governor announced his revised budget plan for the fiscal year that begins in July, as the state's 12.6 percent unemployment rate ranks among the highest in the nation and tax revenue remains low. In April, personal income tax was $3 billion less than projected, which wiped away earlier revenue gains.

The state's general fund spending will be $83.4 billion for the new fiscal year, the lowest level in six years. The deficit accounts for more than 20 percent of all projected spending.

Among the options Schwarzenegger presented is eliminating CalWORKS, the state's welfare-to-work program. The program provides a maximum $694 monthly cash assistance for families and helps single mothers with child care and job training.

Gina Jackson, a single mother who lives in Fremont in the San Francisco Bay area, said she would not be able finish her college degree in political and social science without the state's assistance. She currently receives about $1,000 a month to cover after-school care for two of her four children.

"I certainly can't take my kids to school with me every single day," said Jackson, 45, who was laid off from her job as an administrative assistant two years ago.

The governor and Republican lawmakers have vowed not to raise taxes, as the Legislature did last year, ensuring that spending cuts will be the main solution. That could leave single mothers, foster youth, children from low-income families, the disabled and seniors who rely on state services feeling most of the pain from the recession's continued effects on California government.

Schwarzenegger acknowledged the cuts will be painful, but said he has no other options because the state's tax revenue has plummeted.

"We are left with nothing but tough choices, as you can see," said Schwarzenegger, who appeared somber and at times frustrated in presenting his updated budget plan.

Schwarzenegger and lawmakers have made cuts, borrowing and adjustments of about $60 billion over the past two years as tax revenue fell far behind annual spending obligations. Among the examples: Dental and vision care benefits were eliminated for those insured under Medi-Cal, the state's version of the federal Medicaid program.

The administration said Friday it would restore vision coverage as required under new federal law but the governor proposed limiting prescription drug benefits and doctor's visits.

Schwarzenegger also made good on his threat from earlier this year to eliminate the state's welfare-to-work program unless the federal government gave California an additional $6.9 billion, which Schwarzenegger maintains is its fair share. So far, the state has received about $3 billion.

He did not follow through on a similar threat to eliminate Healthy Families, which provides health care to nearly 700,000 children from low-income families, because of requirements under the new federal health care law.

Instead, Schwarzenegger proposed cutting $15 million from the program and shifting more of the costs to recipients, including raising the co-payment for emergency room visits from $15 to $50.

Democratic leaders responded forcefully to his latest budget proposal, saying they will not allow programs for the needy to be gutted.

They pledged to find a way to maintain core health and social programs, such as in-home care for seniors and welfare assistance for single mothers. It's not clear how those programs will be sustained at current levels without a tax increase, which Schwarzenegger opposes, or even more money from the federal government.

Democrats want to close tax credits and loopholes, noting that the state allows $50 billion worth of tax deductions.

"We will not pass a budget that eliminates CalWORKS. We will not be party to devastating families," said Senate President Pro Tem Darrell Steinberg, D-Sacramento. "What kind of civilized society maintains business tax breaks and eliminates child care? That's not the California I take pride in living in."

Assemblyman Jim Nielson, R-Yuba City, vice chairman of the Assembly Budget Committee, said he hoped CalWORKS would not be cut entirely, but conceded it could come to that.

"If we are going to fund it at any level, then we have to balance the budget around and shift dollars from other sources," Nielsen said.

In recent years, Schwarzenegger and Republicans won a series of corporate tax credits and giveaways, costing the state treasury an estimated $2 billion a year. They say such tax cuts prompt businesses to create jobs, but Democrats said there is no evidence they have done so.

While Democrats control both houses of the Legislature, Republican support is needed because of the two-thirds vote threshold required to pass a budget and tax increases. Schwarzenegger and the Legislature approved one of the largest tax increases in state history a year ago, raising the personal income and sales taxes, as well as the vehicle license fee.

Republican lawmakers say such a move is off the table this year.

"Until we get serious about job creation in the private sector, California's fiscal problems will continue," Republican Sen. Bob Dutton of Rancho Cucamonga, vice chairman of the Senate Budget Committee, said in a statement. "We won't restore California's economy by trying to tax our way out of our budget problems."

Even last year's temporary tax increases were not enough to put California on firm fiscal footing. The national recession continued to batter the economy of the nation's most populous state, which has been wracked by high home foreclosures and job losses across almost all sectors of the economy.

All the tax increases passed last year are set to expire in June 2011.

Associated Press Writers Cathy Bussewitz, Don Thompson and Juliet Williams contributed to this report.

(2) California could use Rainy-Day funds to start its own bank, escape Wall St debt trap - Ellen Brown

From: Ellen Brown <ellenhbrown@gmail.com> Date: 22.05.2010 04:51 PM

The Mysterious CAFRs: How Stagnant Pools of Government Money Could Help Save the Economy

May 21, 2010

http://www.huffingtonpost.com/ellen-brown/the-mysterious-cafrs-how_b_585011.html

For over a decade, accountant Walter Burien has been trying to rouse the public over what he contends is a massive conspiracy and cover-up, involving trillions of dollars squirreled away in funds maintained at every level of government. His numbers may be disputed, but these funds definitely exist, as evidenced by the Comprehensive Annual Financial Reports (CAFRs) required of every government agency. If they don't represent a concerted government conspiracy, what are they for? And how can they be harnessed more efficiently to help allay the financial crises of state and local governments?

The Elusive CAFR Money

Burien is a former commodity trading adviser who has spent many years peering into government books. He notes that the government is composed of 54,000 different state, county, and local government entities, including school districts, public authorities, and the like; and that these entities all keep their financial assets in liquid investment funds, bond financing accounts and corporate stock portfolios. The only income that must be reported in government budgets is that from taxes, fines and fees; but the investments of government entities can be found in official annual reports (CAFRs), which must be filed with the federal government by local, county and state governments. These annual reports show that virtually every U.S. city, county, and state has vast amounts of money stashed away in surplus funds. Burien maintains that these slush funds have been kept concealed from taxpayers, even as taxes are being raised and citizens are being told to expect fewer government services.

Burien was originally alerted to this information by Lt. Col. Gerald Klatt, who evidently died in 2004 under mysterious circumstances, adding fuel to claims of conspiracy and cover-up. Klatt was a an Air Force auditor and federal accountant, and it's not impossible that he may have gotten too close to some military stash being used for nefarious ends. But it is hard to envision how all the municipal governments hording their excess money in separate funds could be complicit in a massive government conspiracy. Still, if that is not what is going on, why such an inefficient use of public monies?

A Simpler Explanation

I got a chance to ask that question in April, when I was invited to speak at a conference of Government Finance Officers in Missouri. The friendly public servants at the conference explained that maintaining large "rainy day" funds is simply how local governments must operate. Unlike private businesses, which have bank credit lines they can draw on if they miscalculate their expenses, local governments are required by law to balance their budgets; and if they come up short, public services and government payrolls may be frozen until the voters get around to approving a new bond issue. This has actually happened, bringing local government to a standstill. In emergencies, government officials can try to borrow short-term through "certificates of participation" or tax participation loans, but the interest rates are prohibitively high; and in today's tight credit market, finding willing lenders is difficult.

To avoid those unpredictable contingencies, municipal governments will keep a cushion of from 20% to 75% more than their budgets actually require. This money is invested, but not necessarily lucratively. One finance officer, for example, said that her city had just bid out $2 million as a 30-day certificate of deposit (CD) to two large banks at a meager annual interest of 0.11%. It was a nice spread for the banks, which could leverage the money into loans at 6% or so; but it was a pretty sparse deal for the city.

Meanwhile, Back in California

That was in Missouri, but the figures I was particularly interested were for my own state of California, which was struggling with a budget deficit of $26.3 billion as of April 2010. Yet the State Treasurer's website says that he manages a Pooled Money Investment Account (PMIA) tallying in at nearly $71 billion as of the same date, including a Local Agency Investment Fund (LAIF) of $24 billion. Why isn't this money being used toward the state's deficit? The Treasurer's answer to this question, which he evidently gets frequently, is that legislation forbids it. His website states:

Can the State borrow LAIF dollars to resolve the budget deficit? No. California Government Code 16429.3 states that monies placed with the Treasurer for deposit in the LAIF by cities, counties, special districts, nonprofit corporations, or qualified quasi-governmental agencies shall not be subject to either of the following: (a) Transfer or loan pursuant to Sections 16310, 16312, or 16313. (b) Impoundment or seizure by any state official or state agency.

The non-LAIF money in the pool can't be spent either. It can be borrowed, but it has to be paid back. When Governor Schwarzenegger tried to raid the Public Transportation Account for the state budget, the California Transit Association took him to court and won. The Third District Court of Appeals ruled in June 2009 that diversions from the Public Transportation Account to fill non-transit holes in the General Fund violated a series of statutory and constitutional amendments enacted by voters via four statewide initiatives dating back to 1990.

In short, the use of these funds for the state budget has been blocked by the voters themselves. Bond issues are approved for particular purposes. When excess funds are collected, they are not handed over to the State toward next year's budget. They just sit idly in an earmarked fund, drawing a modest interest.

What's Wrong with This Picture?

California's budget problems have caused its credit rating to be downgraded to just above that of Greece, driving the state's interest tab skyward. In November 2009, the state sold 30-year taxable securities carrying an interest rate of 7.26%. Yet California has never defaulted on its bonds. Meanwhile, the too-big-to-fail banks, which would have defaulted on hundreds of billions of dollars of debt if they had not been bailed out by the states and their citizens, are able to borrow from each other at the extremely low federal funds rate, currently set at 0 to .25% (one quarter of one percent). The banks are also paying the states quite minimal rates for the use of their public monies, and turning around and relending this money, leveraged many times over, to the states and their citizens at much higher rates. That is assuming they lend at all, something they are increasingly reluctant to do, since speculating with the money is more lucrative, and investing it in federal securities is more secure.

Private banks clearly have the upper hand in this game. Local governments have been forced to horde funds in very inefficient ways, building excessive reserves while slashing services, because they do not have the extensive credit lines available to the private banking system. States cannot easily incur new debt without voter approval, a process that is cumbersome, time-consuming and uncertain. Banks, on the other hand, need to keep only the slimmest of reserves, because they are backstopped by a central bank with the power to create all the reserves necessary for its member banks, as well as by Congress and the taxpayers themselves, who have been arm-twisted into repeated bailouts of the Wall Street behemoths.

How the CAFR Money Could Be Used Without Spending It

California, then, is in the anomalous position of being $26 billion in the red and plunging toward bankruptcy, while it has over $70 billion stashed away in an investment pool that it cannot touch. Those are just the funds managed by the Treasurer. According to California's latest CAFR, the California Public Employees' Retirement Fund (CalPERS) has total investments of $360 billion, including nearly $144 billion in "equity securities" and $37 billion in "private equity." See the State of California Comprehensive Annual Financial Report for the Fiscal Year Ended June 30, 2009, pages 83-84.

This money cannot be spent, but it can be invested -- and it can be invested not just in conservative federal securities but in equity, or stocks. Rather than turning this hidden gold mine over to Wall Street banks to earn a very meager interest, California could leverage its excess funds itself, turning the money into much-needed low-interest credit for its own use. How? It could do this by owning its own bank.

Only one state currently does this -- North Dakota. North Dakota is also the only state projected to have a budget surplus by 2011. It has not fallen into the Wall Street debt trap afflicting other states, because it has been able to generate its own credit through its own state-owned Bank of North Dakota (BND).

An investment in the State Bank of California would not be at risk unless the bank became insolvent, a highly unlikely result since the state has the power to tax. In North Dakota, the BND is a dba of the state itself: it is set up as "the State of North Dakota doing business as the Bank of North Dakota." That means the bank cannot go bankrupt unless the state goes bankrupt.

The capital requirement for bank loans is a complicated matter, but it generally works out to be about 7%. (According to Standard & Poor's, the worldwide average risk-adjusted capital ratio stood at 6.7 per cent as of June 30, 2009; but for some major U.S. banks it was much lower: Citigroup's was 2.1 per cent; Bank of America's was 5.8 per cent.) At 7%, $7 of capital can back $100 in loans. Thus if $7 billion in CAFR funds were invested as capital in a California state development bank, the bank could generate $100 billion in loans.

This $100 billion credit line would allow California to finance its $26 billion deficit at very minimal interest rates, with $74 billion left over for infrastructure and other sorely needed projects. Studies have shown that eliminating the interest burden can cut the cost of public projects in half. The loans could be repaid from the profits generated by the projects themselves. Public transportation, low-cost housing, alternative energy sources and the like all generate fees. Meanwhile, the jobs created by these projects would produce additional taxes and stimulate the economy. Commercial loans could also be made, generating interest income that would return to state coffers.

Building a Deposit Base

To start a bank requires not just capital but deposits. Banks can create all the loans they can find creditworthy borrowers for, up to the limit of their capital base; but when the loans leave the bank as checks, the bank needs to replace the deposits taken from its reserve pool in order for the checks to clear. Where would a state-owned bank get the deposits necessary for this purpose?

In North Dakota, all the state's revenues are deposited in the BND by law. Compare California, which has expected revenues for 2010-11 of $89 billion. The Treasurer's website reports that as of June 30, 2009, the state held over $18 billion on deposit as demand accounts and demand NOW accounts (basically demand accounts carrying a very small interest). These deposits were held in seven commercial banks, most of them Wall Street banks: Bank of America, Union Bank, Bank of the West, U.S. Bank, Wells Fargo Bank, Westamerica Bank, and Citibank. Besides these deposits, the $64 billion or so left in the Treasurer's investment pool could be invested in State Bank of California CDs. Again, most of the bank CDs in which these funds are now invested are Wall Street or foreign banks. Many private depositors would no doubt choose to bank at the State Bank of California as well, keeping California's money in California. There is already a movement afoot to transfer funds out of Wall Street banks into local banks.

While the new state-owned bank is waiting to accumulate sufficient deposits to clear its outgoing checks, it can do what other startup banks do - borrow deposits from the interbank lending market at the very modest federal funds rate (0 to .25%).

To avoid hurting California's local banks, any state monies held on deposit with local banks could remain there, since the State Bank of California should have plenty of potential deposits without these funds. In North Dakota, local banks are not only not threatened by the BND but are actually served by it, since the BND partners with them, engaging in "participation loans" that help local banks with their capital requirements.

Taking Back the Money Power

We have too long delegated the power to create our money and our credit to private profiteers, who have plundered and exploited the privilege in ways that are increasingly being exposed in the media. Wall Street may own Congress, but it does not yet own the states. We can take the money power back at the state level, by setting up our own publicly-owned banks. We can "spend" our money while conserving it, by leveraging it into the credit urgently needed to get the wheels of local production turning once again.

(3) Bank of England Act to transfer money-creation from commercial banks to the Bank of England

From: ERA <hermann@picknowl.com.au> Date: 22.05.2010 09:25 AM
Subject: [ERAInf] James Robertson newsletter extract
Economic Reform Australia
Information Network

Date: Saturday, 22 May, 2010
Relayed by: Nadia Mclaren <nadia.mclaren@gmail.com>

James Robertson's Newsletter No. 30 - May 2010

A GOOD QUESTION,

As We Face The Hardship Years Ahead

by James Robertson

http://www.jamesrobertson.com/news-may10.htm

Why, in modern democracies, should we continue to allow commercial banks to enjoy the privilege of creating the national currency and money supply, instead of transferring responsibility for creating it in the national interest to a public agency?

A draft "Proposed Bank of England Act 2010" to implement this banking and monetary reform is now on the internet at http://www.bankofenglandact.co.uk. It has been prepared for "a group of economists, lawyers, engineers, former civil servants, university academics and business people who have realised that the root of the instability in the world economy, and huge burden of debt in every country, is due to the fundamental design of the banking system".

This monetary and banking reform will directly help our new government to deal with two of our most urgent economic problems. It will help to ease the burden of paying off our massive public debt - see http://www.bankofenglandact.co.uk/benefits-of-reform. It will also prevent future banking failures from causing credit booms and busts that result in damaging financial crises.

The reform will transfer the function of creating the money supply to the Bank of England from the commercial banks. The Bank will create the amount of money it decides is necessary to meet the published objectives of monetary policy laid down by the elected government and Parliament. The Bank will give the money it creates to the government, and the government will spend it into circulation on public purposes under normal democratic budgeting procedures. This will be a permanent, more democratic development of the Bank's recent creation of money by "quantitative easing" to support the banks.

The proposed reform will remove the present subsidy to the banks in the form of special profits made by them from being allowed to create the money supply. So, as well as requiring the government to carry out more efficiently its responsibility for a public money system that serves the public interest, the reform will motivate the banks to meet the borrowing and lending needs of the economy more efficiently and less expensively in a more competitive market economy.

More people are now becoming aware that we depend unnecessarily on the commercial banks to provide us with more than 95% of the national money supply; that the banks now create it as bank-account money ('credit') out of nothing, in the form of interest-bearing loans to their customers (profit-making debt); and that less than 5% is now created as banknotes and coins by the Bank of England and the Royal Mint as agencies of the state. Hitherto, very few people have realised that our money supply is created that way. As the numbers grow who realise it, how will they respond to that knowledge in the hardship years ahead?

The "Banking Reform" section of the new government's coalition agreement between the Conservatives and Liberal Democrats - http://news.bbc.co.uk/1/hi/uk_politics/election_2010/8677933.stm – does not mention this more basic commonsense reform. It would, in fact, be a simpler way of dealing with almost all the points covered in the agreement.

Opponents are already complaining that the new government's "Banking Reform" proposals will put UK banks at a competitive disadvantage in favour of other countries' banks, and say that this will reduce the amount of tax the UK banks contribute to the Exchequer and the contribution they make to our economy. The same claim will be made against the simpler and more basic banking and monetary reform discussed in this note.

Those claimed reductions in benefits will almost certainly be greatly offset by the reduction in the present cost of money which every activity in the economy now has to bear - whether in booms or busts or normal times - as a result of the present way of creating it. Unbiased cost/benefit calculations covering the longer-term and shorter-term plusses and minuses (costs and benefits) would no doubt confirm that conclusion. The new government should be encouraged to commission them urgently.

James Robertson     17 May 2010

The Old Bakehouse, Cholsey
Oxon OX10 9NU, UK
Tel: +44 (0)1491 652346
e-mail: james@jamesrobertson.com
www.jamesrobertson.com

PS. Please feel free to distribute this to anyone who might be interested.

(4) Keynes Solution implemented by Schacht - Robert Skidelsky

Deficit Disorder: the Keynes Solution

Robert Skidelsky

New Statesman 17 May 2010

http://www.skidelskyr.com/site/article/deficit-disorder-the-keynes-solution1/

The new chancellor will find himself in the worst starting position of anyone new in that job since the Second World War. According to the Treasury, we are just starting to limp out of the "most severe and synchronised downturn since the Great Depression in the 1930s". Recovery is not secure. With the Greek crisis as the trigger, the world monetary system is starting to disintegrate. The historically minded will recall that the international financial crisis of 1931, two years after the start of the Depression, aborted an incipient recovery and forced Britain off the gold standard. A double-dip recession is a distinct possibility today.

Once a new government is in place, the chancellor will have to face the situation as it is, not as his party claimed it would have been had it been in power. The government's finances are dire. The £163.4bn that the Labour government borrowed in the fiscal year 2009-2010, representing 11.6 per cent of GDP, is the biggest deficit in the postwar period. Public-sector net debt at the end of March was at £890bn, or 62 per cent of GDP - an increase of almost 10 percentage points over last year.

The worsening of the public finances is mainly the result of the deterioration in the economy. This has two aspects. The British economy is 5.4 per cent smaller than it was two years ago. But in addition, the fiscal forecasts at that time assumed that the economy would continue to grow to trend, reckoned to be 2.5 per cent a year - a growth that failed to occur. As a result, the British economy is 8.2 per cent smaller than it would have been had it continued to grow at that trend over the past two years. This, and not the actual shrinkage of the economy, measures the true deterioration in economic performance and the resulting deterioration in the public finances. Perhaps the forecasts were over-optimistic. But hindsight is the easiest form of virtue.

Such poor private-sector performance has inevitably had severe effects on the public finances. Tax revenues dwindle and social expenditure goes up. Of the total deficit of 11.6 per cent of GDP, 70 per cent is "structural", representing a continuation of pre-recession spending. The £14.4bn tab for the fiscal stimulus in 2009-2010, plus the "automatic stabilisers" representing increased spending on the unemployed, amount to almost 5 per cent. This spending will shrink automatically as the economy recovers: the government saves £1bn a year until 2012 for every 200,000 people who leave claimant count unemployment. The most recent projections for this year's deficit are already £13bn, lower than projections for the same period made 18 months ago.

However, even if the economy now resumes "growing to trend" - the 2010 Budget projects steady GDP growth in the next few years reaching between 3.25 per cent and 3.75 per cent in 2012, while inflation is expected to converge on the target rate of 2 per cent - there will remain a "structural" deficit of between 7 per cent and 8 per cent of GDP, which will have to be filled by increases in taxes and cuts in expenditure. The Labour government promised to launch a programme next April aimed at cutting the deficit to £74bn or 4 per cent of GDP by fiscal year 2014-2015. The Tories promised to start cutting sooner and more, but how much sooner and how much more would depend on George Osborne's promised emergency Budget.

If the recovery falters, even this drastic fiscal consolidation plan will seem inadequate. Although the stock market has recovered, the "real" economy is still struggling. In the first quarter of this year, GDP increased by only 0.2 per cent (half the figure in the last quarter of 2009), hardly the catch-up recovery some were hoping for. In February, unemployment figures rose by 43,000 to 2.5 million in total - or 8 per cent of the workforce. The US has started to grow more strongly, but Europe is flat. And, as already remarked, there is a not negligible risk of a double-dip recession.

Stimulating facts

In the pre-election period, there was a "war of economists", in which I myself took part. To the outsider, the engagement might have seemed to be on too narrow a front to be interesting. It was about how soon fiscal consolidation should start. However, behind this technical issue lay two contrasting theories, or models, of the economy. The first, which we may call "classical", is highly sceptical about fiscal stimulus under any conditions. The argument is that when the government issues bonds or debt to pay for its spending, this is bound to be at the expense of private lending and borrowing. The stimulatory effect of a government deficit is therefore bound to be zero, or very small.

The second, or Keynesian, view is that this is not true when there is a lot of slack in the economy. The reason for the slack is that the private sector is not spending enough to employ all those seeking work - whether because investment prospects are too uncertain, or because it is paying off debt. In these circumstances government spending is not at the expense of private spending: it compensates for its absence. If the government were to economise on its own spending at the same time as the private sector was spending less, the result would be a slide into even greater recession. Keynes called this the "paradox of thrift".

Those in the first camp do not deny the need for some stimulus when the economy is depressed, but they think this should not be at the expense of existing private spending. The only type of stimulus that meets this requirement is printing extra money. "Monetarists" put their faith in so-called quantitative easing (QE); Keynesians are happy with printing money, but deny that it is enough. The extra money has to be spent, and only the government can ensure that it is. (There is another way: the government can give all households time-limited spending vouchers - that is, special pounds, perhaps printed red, valid only for three months, and to be spent on buying British goods - and could issue successive tranches of these until the economy revives. This move would bypass the frozen banking system, but no political party has advocated it, and we can be sure that the incoming chancellor will put the horrendous thought to one side.)

The monetarists believe that the level of aggregate income is directly proportional to the amount of money in the economy. If the money supply goes up by 10 per cent, money income will go up by the same amount, and aggregate spending by the same amount. As the British monetarist Tim Congdon explains (using a more carefully defined notion of money): "large-scale creation of new bank deposits by the state can stop any recession".

Printing money has an additional advantage. As the Chicago economist Robert Lucas remarked, monetary expansion "entails no new government enterprises ... and no government role in the allocation of capital ... These seem to me important virtues." Except for one thing: it doesn't do the job.

Keynesians argue that the demand for real cash balances (the amount of "ready command" or liquidity that people want) varies with the state of confidence. In the old days people would start hoarding gold when confidence fell. Now they add to their cash reserves or buy liquid securities. Building up cash or liquidity buffers, however, means that the new QE money is not spent, and therefore does not contribute to increasing output. While the Keynesians accept that an increase in the money supply is a necessary condition for an increase in national income, they deny that it is a sufficient condition. With increased preference for liquidity, the injection of cash into the banking system by the Bank of England may not lower the rate of interest sufficiently to restore a full-employment level of aggregate spending. As Keynes put it, if money is the drink that stimulates the system to activity, "there may be several slips between the cup and the lip".

The numbers bear this out. From early 2009, the Bank of England started printing money with which to buy back government debt (as well as some high-grade corporate bonds) from the public. Over the year, roughly £200bn - or 15 per cent of GDP - worth of gilts and bonds was exchanged for cash. The monetarists expected a cash injection of that size would allow Britain to leave the recession with a bang.

Yet, as the 0.2 per cent GDP growth in the first quarter of this year is telling us, there was very little bang for quite a lot of buck. So what happened? Already at the first evaluation of the QE policy in August, six months into the programme, the Treasury and the Bank had noticed that something was not working. By then £144bn had been injected, yet UK bank lending had not picked up. Money from bond sales remained stuck in the banking system. The commercial banks held on to the cash, either in the form of reserves at the Bank of England or by buying new gilts or corporate bonds for the cash. Overall, in the 11 months between the launch of quantitative easing and its suspension, broad money supply (which includes bank deposits) actually fell by almost 10 per cent. And if we consider what John Slater calls "effective money" - a measure that, by including credit in the shadow banking system, is broader still - this fall is likely to have been even steeper.

The injection of money may have caused a stock-market boom in the financial economy, but on the real economy - the target of the policy - it had little effect. In short, damaged expectations may cause the credit crunch to outlast the circumstances that gave rise to it. In such circumstances government spending needs to be the main agent of recovery - and that means fiscal policy, however it is financed. We learn from experience nonetheless. If flooding the banking system with money doesn't do the trick, there is a big problem with fiscal policy as well. The nature of this first emerged in an enthralling exchange between Keynes and the Treasury official Richard Hopkins before the Macmillan committee on finance and industry in 1930. Keynes was arguing for a big expansion of the public works programme; Hopkins countered that the effects of any government programme would depend on its effects on business confidence.

Fear of Labour

Hopkins did not disagree that government work programmes could, in principle, cure unemployment, but went on, "if you had to get [the loan] taken up at a very high rate of interest and accompanied by an adverse public sentiment you would very quickly lose what you gained by that from the number of people who would think it better to invest the next lot of money they had in America". In other words, "psychological crowding-out" would cause the government to have to pay more for its debt. Extra government spending would cure unemployment only if it did not spook the markets.

Keynes himself was fully alert to the importance of confidence. He acknowledged that "economic prosperity is excessively dependent on a political and social atmosphere which is congenial to the average businessman. If the fear of a Labour government or a New Deal depresses enterprise, this need not be the result either of a reasonable calculation or of a plot with political intent; it is the mere consequence of upsetting the delicate balance of spontaneous optimism." He would even accept a "conservative Budget ... if this would be helpful as a transitional measure".

Keynes wrote his General Theory of Employment, Interest and Money (1936) not just to change the minds of economists, but to persuade the business world that government intervention to rescue failing economies would be in its interest. But he tended to the view that the root of "lack of confidence" was lack of demand for goods and services and that confidence would automatically revive with the revival of spending, however engineered. In all this, he underestimated the visceral business hatred of big government. By 1939, however, even he had come to doubt whether a "democracy would ever have the courage to make the grand experiment necessary to prove my case outside the conditions of war".

In fact, that grand experiment has never been made outside war or other than under a totalitarian state, in the sense of Keynesian policy being used to rescue an economy from a slump. Franklin D Roosevelt's "New Deal" gave Americans hope and important reforms, but achieved only a modest recovery from the Depression - largely, Keynes thought, because the scale of government spending was insufficient. Full employment in democracies was restored only in the Second World War, when the government started spending 70 per cent of the national income, with the national debt rising above 200 per cent.

The one experiment that did prove Keynes's case was undertaken in Hitler's Germany, under the aegis of the Führer's economics minister Hjalmar Schacht, though not in conditions that encouraged democratic emulation. The Schachtian system consisted of three main elements: a) controls on capital exports, b) bilateral payments agreements, whereby Germany's trading partners were only allowed to sell as much to Germany as they brought from Germany, and c) huge state credits to German industry ("printing money"), which over four years reduced unemployment from six million to near zero, with inflationary pressure being repressed by wage and price controls.

Gilt trip

Given the potentially conflicting requirements of "confidence" that he will face, what should the incoming chancellor do? He should choose the path dictated by economic reason, refuse to be spooked by what Samuel Brittan calls the "teenage scribblers", and continue to pump money into the economy, counting on this advantage: that the markets do not expect the UK government to go bankrupt.

While Greece is paying close to 11 per cent for its ten-year bonds, the UK Treasury is still paying less than 4 per cent, and the UK coupon is not even 100 basis points higher than the German. In fact, the bid yield on the ten-year gilt is roughly 50 basis points lower now than at the start of September 2008. Unless and until confidence runs out, running a Budget deficit is far less costly than a return to recession. If we fear market reactions to sluggish growth and large deficits, imagine market reactions to no growth and much larger deficits.

To ensure that the policy of continued macroeconomic stimulus does not lead to the capital strike that Richard Hopkins feared and his modern successors predict, the chancellor should make a few simple promises. He should promise (and prepare) sharp fiscal cuts the day the government's credit rating comes into serious doubt; he should promise to withdraw support for QE in the quarter that annualised inflation exceeds, say, 3 per cent; and he should promise to reconsider any type of stimulus measure once annualised GDP growth exceeds, say, 2.5 per cent for two quarters in a row. These promises could be part of a new fiscal constitution, adherence to which would be independently monitored. Spelling out precise conditions for the continuation of the fiscal stimulus would reassure the markets and shorten the period necessary to have one.

Beyond this, we cannot continue to run an economic system in which there is such a large gap between the beliefs of ordinary people and the beliefs of the business and financial worlds about the properties of the economy and the requirements of a decent economic life. Keynes rightly thought that ordinary people are instinctively more reasonable economists than economists and financiers. It is to them that the chancellor is ultimately responsible.