During the week of August 7, 2011, the Dow Jones Industrial Average either dropped or soared by 400-plus points per day for four consecutive days. Stock markets worldwide seemed to be trying to discount the downgrade of the U.S. government's credit rating, the political dysfunction leading up to the U.S. government's usually routine hike of its debt ceiling, and the increasingly prickly European sovereign debt issues and the challenge they pose to the European Union. Markets seemed like a proxy for a referendum on economic policy solutions supported by two schools of economic thought: those of John Maynard Keynes versus Friedrich August Hayek's. Here's what my sources told me as one of the most volatile weeks ever was ending:

Tom Connelly, who readers of The Gluck Report know has proved prescient repeatedly over the years, says the extraordinary increase in volatility is to be expected in a period characterized by high debt and deleveraging.

"That's still the backdrop, and it will be for some time," says Connelly, owner of Versant Capital Management in Phoenix.
Connelly believes the steps taken by the Federal Reserve and U.S. Treasury in the darkest days of the financial crisis in September 2008 deserve to be praised. Expanding the money supply and guaranteeing the solvency of too-big-to-fail banks like Citicorp, Bank of America and other institutions, saved the nation and the world from a calamity far worse. If the Fed and Treasury Department had not acted swiftly, says Connelly, "the whole financial system would have collapsed."
While praising government intervention at the peak of the crisis, Connelly argues against increasing federal spending to stimulate the economy now.

"I don't think Keynes would say you should stimulate the economy at times of financial distress," says Connelly. "Trying to execute Keynesian economics after financing two wars when you are running a big deficit is a bad idea."

Connelly believes the nation's largest banking institutions wield too much power. "I'm on board with the libertarians on this, and I believe the big banks should be broken up," says Connelly. "The banks pretty much own the White House. The Obama administration is doing whatever the bankers want them to do."

"I'm a Volckerite," says Connelly, referring to the former Fed chairman's stance on too-big-to fail banks, adding, "As things stand now, if one of the large banks fails, they'll all fail." Connelly favors enacting a modern-day version of the Glass-Steagall Act "to separate the circulatory system of the economy from depository institutions."

Connelly says he was initially embarrassed by the bickering in Congress over the debt ceiling. However, he has come to view the political discord as an ugly consequence of the U.S. democratic process and, as such, a step in the right direction. That, along with the public debate sparked by the Standard & Poor's downgrade, "has made the drumbeat for real solutions louder."

"I'm cautiously optimistic," says Connelly, 56.

Acknowledging that cutting government spending is inarguably deflationary and will result in dampening economic growth, Connelly nonetheless concedes it's necessary. But he sees hope in the fact that these issues were put on display in the run-up to the debt ceiling agreement and the downgrade of America's credit.

"I thought it was hopeless 12 months ago, so it was actually extremely positive that they came to an agreement on the debt ceiling," says Connelly, "not because the Tea Party and Republicans got their way, but because our elected officials are finally saying, 'Enough is enough.' They seem to have started to say 'No' to spending our grandkids' money."