THE
BEAR'S LAIR The trillion dollar
deficit By Martin
Hutchinson
It was revealed last Thursday
that the George W Bush administration intends to
present a budget showing deficits of US$400
billion for each of the fiscal years to October
2008 and October 2009, at a time when we are close
to an economic peak. Given a normal recession,
that means the next "trough" deficit will probably
be over $1 trillion. The final report card can now
be written on the fiscal management of the Bush
administration, the primarily Republican
Congresses since 2001 and the Federal Reserve
chairmen of the period. One's only regret in
writing it is that no grade lower than F has been
discovered.
Budgetary management in a
democracy is damn difficult, to be fair. The
voting public gets only the most vague and generalized
benefit from spending cuts,
while the affected lobbies and interest groups are
energized to their maximum squawking intensity by
the idea that their precious budget handouts or
tax reliefs might be removed. On the other side,
tax cuts are inevitably skewed towards the
wealthier taxpayers, since they pay most of the
tax in the first place, but no amount of electoral
juggling can lead the wealthy to form an electoral
majority.
If taxation and government
spending had no economic effect, as people
believed between the 1950s and the 1980s, and
elections determined the share of output retained
by the state, the equilibrium political state
would be something like Sweden, in which the state
takes around 60% of gross domestic product and
doles it out in an egalitarian manner in health,
education, pensions, disability payments and other
benefits. The private sector would be limited to
food and consumer goods in which there was no
plausible rationale for state management (even
alcohol is a state monopoly in Sweden, for
example, and is inordinately expensive).
However, in practice, increasing the size
of government damages economic output, in three
ways. First, resources are diverted from the
economically optimized (by the price mechanism)
private sector to an area where decisions are made
on a political basis, so are generally nowhere
near economically optimal. Second, increasing
marginal tax rates is subject to a severe law of
diminishing marginal returns on the supply side.
At low rates a small increase will produce only
modestly less than would be expected by a linear
analysis, but a high marginal rate, above 40% or
so, or a sharp increase has repeatedly been shown
to be counterproductive in terms of revenue
raised, often producing a reduction in revenue
where an increase had been expected. Third,
institutions that are subject not to the
disciplines of the market but to the imperfect
controls of a large government bureaucracy become
corrupt, and that corruption, which is
proportionate to the resources controlled,
represents pure loss of output to the economy as a
whole.
Thus even in honest pious
Scandinavia the big government nirvana has been
proved sub-optimal, and in a country with a US or
Mediterranean level of graft it would quickly
descend into chaos.
The problem is then
that the adverse economic effect of a large public
sector is inchoate and diffuse, whereas the forces
tending to enlarge it are ever-present and
powerful. The Founding Fathers, almost all of them
wealthy men, were very aware of this problem and
attempted to limit the expansion of the federal
government, partly by making the income tax
unconstitutional; 19th century economists helped
by establishing a consensus that budget deficits
were bad, thus limiting the ability of government
to grow without inflicting immediate pain upon the
taxpayers.
However, in the early 20th
century, the progressives, economically more or
less illiterate but appalled by the sight of
nouveau riche businessmen consuming conspicuously,
removed these barriers. First they passed the
Sixteenth Amendment, allowing an income tax. Then
they discovered the joys of Keynesian economics,
which delinked revenues and expenditures, allowing
budget deficits and spending to be justified as
economic "stimulus" whenever the economy was
performing at less than 105% of capacity. Control
of the Federal Reserve system enabled them to
remove the short-run monetary constraints that had
previously prevented over-expansion, and the road
to larger government was cleared.
The
Great Depression and intermittent wars fueled the
increase; expansions of government that would have
been impossible in peacetime were justified as
emergency measures, and then embedded in the
system, so as to persist after the emergency
ended.
By the late 1970s, the economic
costs of ever-increasing government had become
obvious both in Britain and the United States, and
the political consensus in favor of it was
defeated by two determined leaders, Margaret
Thatcher and Ronald Reagan. That defeat was only
temporary however, as demonstrated by the failure
of their successors, John Major and the Bush
family, and the rise to prominence of supposed
"Third Way" leaders in Tony Blair, Bill Clinton
and, as it turned out, George W Bush.
Disguise discovered Blair and
Clinton discovered simultaneously that much of the
cost of increasing government could be disguised
for many years if it was done gradually and
combined with an excessively loose monetary
policy. They were assisted providentially by the
Internet communications revolution, which allowed
an increasing proportion of the world's consumer
goods to be produced in low-wage economies at
declining costs - this prevented the surge in
consumer price inflation that would otherwise have
been inevitable. Bush came to office promising
a reduction in the size of government and in
particular a tax cut, both traditional Republican
policies strengthened by Reagan's success in the
1980s. Instead, Bush, recently described by his
former chief speechwriter Michael Gerson as a
"large-hearted man" - at least with other people's
money - indulged in an orgy of feel-good social
policy.
Notably there was the "No Child
Left Behind Act" of 2001, which vastly increased
the federal government's intrusion into education
without noticeable positive results, and the
Medicare Part D of 2003, which was also hugely
expensive since it lacked effective cost controls.
The largeness of Bush's heart even extended to his
Congressional colleagues, whom he allowed to carry
on veto-free in an orgy of pork-barrel spending
and outright corruption without precedent in the
history of the Republic.
Even Bush's tax
changes had little or no supply side effect. His
2001 bill lowered top rates of tax only modestly,
while including so many sops to populism that its
effect was at best that of an equivalent-sized
Keynesian stimulus. In 2003, he passed a genuinely
supply side measure, reducing the top rate of
personal tax on dividends to 15% and thus their
total taxation to around 50% from the exorbitant
corporate plus personal rate of 61% they had
previously borne.
Even then, he did it
wrong; he should have made dividends fully tax
deductible at the corporate level, which would
have leveled the playing field between different
types of investors and removed almost all the
incentives to business tax evasion. If he had done
that, paying for it by capping the deductibility
of home mortgage interest at around $10,000 per
annum, and perhaps closing a few other corporate
tax loopholes, he would have truly have increased
the value and productivity of US business, while
quelling the speculative boom in housing that is
proving so unbearable to unwind.
Now Bush
is running into the next downturn proposing a
mindless Keynesian fiscal stimulus, with an
unrealistic economic forecast of almost 3%
economic growth in 2008 and 2009 and deficits in
those years at close to record levels. Since the
swing in the budget deficit from 2000 to 2004 was
over $600 billion, and the US economy is bigger
now, it seems inevitable that the bottom of the
recession will see a federal budget deficit of
over $1 trillion, with all the financing
difficulties and economic distortions that will
cause. In short, whatever the size of Bush's
heart, it is clearly bigger than his brain.
Glimpse of the future As the
primary season has proceeded, we are beginning to
see into the future. The picture is not entirely
negative. On the Republican side, the likely
winner is John McCain, a man with innumerable
drawbacks and unpleasantnesses but one pretty
solid virtue: he appears to be more fiscally
responsible than the incumbent, harking back
beyond the supply-side showboating of the 1980s
(which was always to some extent smoke and mirrors
as far as fiscal balance was concerned) to the
successful budget-trimming presidency of Gerald
Ford.
McCain's solution to soaring medical
costs is to reduce them through increased
competition; his solution to expanding the
military is to reduce the gold-plating and
log-rolling in the Pentagon. Faced with a trillion
dollar deficit, his likely solution would be to
cut back spending sharply and impose a swingeing
tax increase; faced with inflation rocketing into
double digits his likely solution would be to fire
Ben Bernanke. One can live with such an approach,
uncomfortable though it would be.
On the
Democrat side, the picture is less clear. Hillary
Clinton, the front-runner, appears to have her
husband's vice of sharp practice without his
virtue of fiscal prudence. While she might save
some money in Iraq she would spend all of it and
more on social programs. Faced with a trillion
dollar deficit, her twin solutions would doubtless
be to impose a tax increase that was as
redistributive as possible, albeit with loopholes
for her campaign donors, and to hire Wall Street
to push the envelope of deficit financing
techniques through securitizing the Washington
Monument. Double digit inflation would be pushed
into the future and blamed on others, as it was
from 1973-79.
Then there's Barack Obama.
On the surface, his policies are almost as
expensive as Clinton's, though he might be more
determined in reining back overseas military
adventurism, thus achieving a larger saving there.
On the other hand, his principal economic advisor,
Austan Goolsbee, is a senior business professor at
the University of Chicago so presumably has a good
economic grasp. Interestingly, Obama has now been
endorsed by Paul Volcker, in 1979-87 the only
really useful Fed chairman ever, who killed (but
alas not permanently, thanks to his feckless
successors) the double digit inflation of the
1970s.
Assuming Obama listens to his
advisors and the most eminent of his supporters
one can thus have some confidence that his
solutions to a trillion dollar deficit and double
digit inflation would be intelligent.
Looks like a two-out-of-three chance for a
decent solution, or thereabouts. But even
minimally competent and forward-thinking economic
management, in both the administration and the
Fed, would have avoided the problems in the first
place.
Martin Hutchinson is the
author of Great Conservatives (Academica
Press, 2005) - details can be found at
www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice &
Associates.)
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