THE BEAR'S LAIR The non-existent contradiction
By Martin Hutchinson
The Keynesian US commentariat, which includes quite a high percentage of nominal Republicans, has been proclaiming a "contradiction" between the needs of economic policy. The need to cut government spending to reduce the deficit is supposedly balanced by ill-effects from declines in government employment- even the Wall Street Journal's economics blog claimed that the US unemployment rate would be 7.1% had governments (mostly state and local) not cut their workforce. In Britain, infinitesimal
spending cuts are blamed for continuing economic stagnation, while the sharp rise in the value-added tax (VAT) is ignored.
This is nonsense. There is no contradiction. Government employment cuts are good, not bad for the economy.
Britain's prolonged, possibly triple-dip recession can be easily explained. Taxes climbed by 1.3% of gross domestic product (GDP) between 2009 and 2011, according to Organization for Economic Cooperation and Development statistics, as pre-election tax cuts were ended and the value-added tax was increased by 2.5 percentage points in January 2011.
That's larger than any OECD member except Chile (which released funds from its Social and Economic Stabilization Fund in 2009, which the OECD perversely counts as negative taxation), France and Iceland.
Even if Keynes were right, and government spending cuts were as economically damaging as tax increases, government spending did not change by anything like as much- government consumption declined from 23.4% of GDP in 2009 to 22.9% of GDP in 2011, before rebounding to 23.5% of GDP in 2012.
In other words, the greatest swing in government consumption was less than half as large as that in taxation, and it has since been more than completely reversed. Add in government investment, and the decline in 2009-11 is 0.9% of GDP, declining to 0.6% of GDP in 2009-12 - still much smaller than the tax effect.
Add to that an economically suicidal monetary policy (of which more later) a coalition government determination to devote massive public subsidies to investments in wind farms and other greenery which, being hopelessly unprofitable are in the classic Austrian sense "malinvestment'', and a "ring-fencing" of other bloated and unproductive spending sectors such as the National Health Service and foreign aid, and it's not at all surprising the place has enjoyed almost no growth.
Prime Minister David Cameron's much vaunted "austerity" has come overwhelmingly at the expense of the taxpayer, and Britain's current fiscal and monetary policy mix is highly growth-destructive.
In the US, most of the cuts have come at the state and local level. Since the end of 2009, gross private product (GPP), the output of the private sector, has grown by 3.0% per annum, a 50% faster growth rate than GDP as a whole. It is thus not surprising that the private sector has added 6.3 million jobs in the same period whereas government at all levels has lost 637,000.
This does NOT mean, as Keynesians would have you believe, that if only government had added jobs instead of subtracting them, job creation would have been correspondingly more robust. For one simple reason: government is paid for by the private sector.
Whether by borrowing money (which sucks resources out of the bond market) by printing money (which impoverishes private sector savers by keeping interest rates artificially depressed) or by old-fashioned taxation, the government finances its spending by taking from the private sector.
Thus if 637,000 more employees had remained in the government, then even if those employees had been as productive as the private sector average, over time 637,000 more employees would have vanished from the private sector, as private sector growth would have been depressed as much as public sector growth increased.
The key output number to look at is GPP growth, which tells you how fast you are increasing productive resources, to pay for a larger government or to enrich the populace. On employment, we should look at private employment, to determine how many jobs are being created by activities that produce wealth rather than consuming it.
Thus from the first quarter of 2001 to the last quarter of 2009, GPP increased at only 1.3% annually, barely faster than the population increase of 1% annually. Government in that period, of the George W Bush administration and the early months of Barack Obama, was growing quite rapidly (at 2.4% per annum, plus additional growth in "transfer payments" such as food stamps that the statistics don't count) so that it sucked out almost all the resources that technological advances would normally have made available to the private sector.
By the standards of 2001-09, or even 2001-07, when GPP grew at only 2.6% in spite of a six-year speculative boom, the private sector recovery since 2009 doesn't look too bad. Of course, compare it to the 1990s, when in 1991-2000 GPP grew at 4.4% annually while government grew at only 1%, and you realize that even with the modest downsizing in government, US growth is still anemic.
The problem with Keynes' theory of "stimulus" from additional government spending is that it doesn't take account of interest rates. In a normally functioning economy, in which monetary policy is not set by Federal Reserve chairman such as Ben Bernanke, an additional "stimulus" of government spending, without a tax increase, raises interest rates since both public and private sectors finance themselves from the same capital pool.
The rise in interest rates in turn deflates private sector investment and therefore output, usually with a lag. When Bernanke's printing money, the "stimulus", does not directly raise interest rates (because it can't), it diverts wealth into sterile rises in commodity and asset prices while suppressing savings.
However only in the world of the FDR Keynesian Simon Kuznets, the inventor of GDP accounting, does an increase in public spending matched by a decline in private spending leave you in the same place, let alone push you forward.
In reality, much public spending is wasteful, producing output of lower value than the input, whereas private spending by definition only takes place if it produces a net gain in welfare for the spender or a profit for the investor. If a government hires an extra worker, that worker's wages are included in GDP, whereas a private sector hire of a worker has no effect on GDP until that worker produces something.
Thus even though the unproductive public sector worker produces a gain in reported GDP, he produces a loss in overall wealth because productive private activities are sacrificed through higher interest rates to pay for his unproductive public sector existence. As I said, there are lag effects, the new hire will produce a GDP gain in the short-term because of the government-friendly way the accounting is done, but in the longer term the GDP losses will outweigh the gains. "Stimulus" public spending over any but the shortest period produces a negative economic effect.
The economic trajectories of Britain and the United States are thus explained. In Britain, taxes were raised too much, while cuts in public spending were too limited, leaving too much untouched. The contractionary effect of the tax increases produced a decline in GDP, which counteracted the normal forces of recovery.
Add to that two special factors, the decline in North Sea oil output and the troubles of the City, which still employs a large number of well-paid people even though little of its unique value is now British, and it's not surprising productivity growth has been dire, economic growth has been dismal, but employment has held up reasonably well.
In the US, slightly worse policies have been followed than in Britain, with the US$1 trillion "stimulus" of 2009-10 prolonging the recession, with its "drag" on the private sector pulling down GDP and employment even after the artificial high of the extra spending had ended. The over-expansive monetary policy and the trillion-dollar deficits have starved the private sector of savings.
However, while Britain has suffered bad luck in the decline of North Sea oil, the US has enjoyed exceptional good fortune in the rise of fracking and shale hydrocarbon production, which has increased both productivity and GPP. Consequently, output has risen much more robustly than in Britain, though employment hasn't, producing a worrying surge in those "leaving the workforce" and becoming structurally unemployed.
The solution is similar in both countries. Britain needs more "austerity" not less, cutting spending in the unproductive sectors of the NHS, green energy and foreign aid. In addition to lowering the deficit, however, it should return some of the savings to the public through tax cuts, with a bias towards middle-income consumers, thereby renewing economic growth. At the same time, it should raise interest rates well above inflation, thereby reducing the subsidies to the banking system, restoring returns to Britain's beleaguered savers, and increasing the availability of small-business finance.
In the United States, tax cuts are less necessary; the priority should be deficit reduction through public spending cuts, especially in eliminating the appallingly wasteful subsidies to agriculture, green energy and, through the tax code, to housing and charities, as well as cutting the country's global defense commitments down to size.
Again, interest rates should be raised, increasing the excessively low savings rate, closing the balance of payments deficit and deflating the dangerous bubbles in stock, bonds and commodities. The result will be a surge in GPP and, more important, in private sector employment.
As I said, there is no contradiction. Once the central functions of government have been carried out on a minimal basis, increasing public spending contracts true output and reducing it increases it. The contrary is an ideological shibboleth of the Keynesians and a statistical illusion of distorted GDP accounting.
Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.
(Republished with permission from PrudentBear.com. Copyright 2005-13 David W Tice & Associates.)