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By David Ignatius
Wednesday, January 5, 2011

"We have magneto trouble. How, then, can we start up again?" mused
John Maynard Keynes in December 1930, likening the stagnant economy of
the Great Depression to a broken generator in an automobile. Fear not,
he wrote, the car eventually would get rolling again, and "we need not
assume . . . that motoring is over."

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As 2011 begins, many investors are acting as if Keynes's "magneto
trouble" has been fixed. Stock markets are up as investors feel the
return of "animal spirits," to use another of Keynes's graphic
metaphors.

The comments from financial analysts are upbeat, eerily so if you
remember the recent past. "We see equity markets trading strongly
through 2011," saidBritain's RBS. "We are in a bull market for sure,"
enthused John Lekas, a senior portfolio manager for Leader Capital.

But is the economic engine really fixed? As Keynes would have noted,
that's partly a matter of perception. If investors believe that good
times are back and start investing on that expectation, a virtuous
cycle will take over: Growth will accelerate, manufacturers will add
workers and build plants, unemployment will fall, consumers will spend
more, and eventually we're back to full prosperity.

Here's how Keynes put it in his essay titled "The Great Slump of
1930." The economic decline, he said, was "probably a little overdone
for psychological reasons." The key to a "real recovery," he
explained, was the return of shared business confidence - "partly by
lenders becoming ready to lend on easier terms and over a wider
geographical field, partly by borrowers recovering their good spirits
and so becoming readier to borrow."


Fed Chairman Ben Bernanke is a good student of Keynesian psychology,
which helps to clarify his controversial experiment with the monetary
strategy known as "quantitative easing." His goal was to change
investors' expectations and thus alter the underlying reality.

By purchasing $600 billion in Treasury securities last fall (and
thereby flooding the economy with freshly printed cash), Bernanke
hoped to make money so cheap, and fixed-income yields so low, that
investors would find it irresistible to buy stocks. As the equity
markets rose, he hoped, we would see the virtuous cycle of investment
and job creation.

So far, Bernanke deserves good marks for playing the confidence game.
"Despite all the consternation over quantitative easing, it was a
pretty shrewd move, assuming his later exit strategy works," says
David Smick, a Fed watcher who wrote the prescient book "The World Is
Curved."

From the Fed's perspective, here's what has happened since Bernanke
announced the bond-purchase program last August: The S&P 500 index of
major stocks is up about 20 percent; the Russell 2000 index is up more
than 30 percent; stock-market volatility, as measured by the VIX
index, is down roughly 30 percent.

Beyond these financial measures, there are signs of improvement in the
real economy. The Institute for Supply Management reported Monday that
its index of factory activity rose in December for the 17th straight
month. Sales of automobiles and other consumer durables have been
increasing. And the banking system finally seems to have steadied.

Here's one striking example of how the system is healing itself.
According to the Bank for International Settlements, the volume of
outstanding credit default swaps - the risky instruments that helped
exacerbate the crisis - has declined by nearly half from its peak of
$60 trillion in 2007.

What could go wrong with this happy picture? Given that it's composed
of expectations about the future, almost everything: The economy is
still fragile and vulnerable to another shock. That's why Bernanke has
not ruled out purchasing even more Treasury bonds (that is, run the
printing press a little longer) and why he thinks Congress should pass
pro-growth fiscal measures to complement the Fed's monetary policy.

The best sign that the economic engine is really repaired would be a
joint plan by the White House and congressional Republicans to trim
the federal budget deficit over the next 10 years. The elements of
such a long-term recovery program are clear: reform and simplification
of the tax code; cuts in entitlements programs; reduction in military
spending to reflect a changing strategic environment. There is
bipartisan support, in principle, for such moves, but in practice?

Keynes put it well at the end of his 1930 essay. He explained that
political leaders, "like-minded and acting together, could start the
machine again within a reasonable time; if, that is to say, they were
energized by a confident conviction as to what was wrong."