THE BEAR'S LAIR
Government digs a deeper hole
By Martin Hutchinson
The US$787 billion stimulus bill has been signed by President Barack Obama and
the $275 billion help for homeowners has been announced and generally well
received, but still the stock markets keep dropping.
Worldwide, daily new plans for stimulus and rescue are met with daily declines
in stock prices and gloomy economic figures. There's a reason for this: the
markets have figured out that the deepest economic hole out of which the global
economy will need to climb is the one that the world's governments have dug.
The relationship between public sector stimulus packages and
output is fairly simple, but it is non-linear and John Maynard Keynes was no
mathematician. It basically appears to depend on four factors: 1. the share of
public spending in gross domestic product (GDP); 2. the public sector deficit
as a percentage of GDP; 3. the composition of the stimulus package itself - its
split between tax cuts, unproductive spending of the "digging holes and filling
them in" variety, and productive spending along the lines of the Tennessee
Valley Authority (TVA) and interstate highways; and 4. the level of slack in
the economy.
US deficit spending during the Great Depression was thus fairly productive. The
share of public spending in GDP was low, so increasing it did not greatly
impact the private sector. The public sector deficit was low, so the spending
was easily financed, without too much "crowding out" of private sector needs.
At least some of the spending, the TVA, was productive. And the level of slack
in the economy in 1933-40 was enormous. Thus if Keynesian stimulus was ever
going to work, it should have worked then.
In reality, it didn't work all that well; unemployment remained above 10% until
the US entered World War II in 1941. Part of that failure was due to foolish
non-Keynesian policies that dragged the economy down - the Glass-Steagall Act
(which de-capitalized investment banks, thus almost closing the capital markets
to new issues) and the National Recovery Administration and unionization
policies which raised prices and wages above market levels. President Herbert
Hoover's 1932 tax increase, the Smoot-Hawley Tariff Act of 1930 and the
introduction of Social Security (heavily cash-flow-negative to taxpayers in its
early years) also weakened the economy, as did unduly restrictive monetary
policy in 1930-33. Conversely, the introduction of bank deposit insurance
strengthened it.
Still, even in the Great Depression, the Keynesian case is a difficult one to
make, judging by results alone. After all Britain, managed economically by the
anti-Keynesian Neville Chamberlain, cut back public spending and emerged from
the depression much more quickly and successfully than the United States.
Much though Obama may not wish to admit it, his stimulus plans are not
original. In 2001-02, a combination of a tax cut of 2% of GDP and spending
increases of another 4% of GDP (partly the "war on terror", partly the No Child
Left Behind Act and partly cyclical) provided fiscal stimulus of about 6% of
GDP between the fiscal years (ending in September) 2001 and 2002. Monetary
policy was also exceptionally stimulative, with short-term interest rates
declining to 1% from 6% within a two-year period while inflation remained
positive.
Judging by results, the George W Bush stimulus worked rather better than the
New Deal. It was begun from a position of fiscal surplus, lessening the strain
placed on the debt markets by its borrowing, while inflation during the period
was suppressed by the deflationary effects of globalization and the Internet.
However, it distorted the economy, leading to an undue concentration in the
unproductive sectors of housing and speculative finance, while manufacturing
and much of the high-skill service sector was outsourced to Asia. Notoriously,
the subsequent expansion led to very meager gains in living standards, except
for the very rich, while inflation crept up and the federal budget deficit
remained in substantial deficit, even at the top of the 2002-07 expansion.
This time around, the conditions for stimulus were much less propitious than in
either the Great Depression or 2001-02. Public spending, including state and
local spending, was far higher as a percentage of GDP than in the 1930s. In
Europe, particularly Scandinavia, and in Japan since 1990, we have seen the
adverse effect on growth exerted by high public spending. The increase in
global public spending through stimulus plans is thus likely to be
substantially growth-destroying in its own right.
Second, an exceptionally large stimulus (including bank and mortgage bailouts)
has been combined with a public sector deficit that was already excessive to
produce a likely federal budget deficit in fiscal 2009 and 2010 of more than
10% of GDP in each year. The difficulties of financing these deficits will
unquestionably be very serious, and the adverse effect on the US Treasury's
ability to borrow resulting from their probable persistence will be equally
severe. Outside the US, Britain and Japan are notable among other countries
that were already in a difficult fiscal position before the downturn hit, and
will be in impossible positions as a result of their misguided stimuli.
Third, the Obama stimulus package, having been largely dictated by Senate
majority leader Harry Reid (D-Nev) and House speaker Nancy Pelosi (D-Calif)
consists largely of short-term state budget palliatives or handouts to favored
constituencies, with very little TVA-type long-term beneficial spending.
Even in areas where true economic benefits might be expected, such as the $8
billion subsidy to high-speed rail, the package has not been designed to favor
rail projects in the country's main centers of population and economic
activity, which could hugely benefit from their rail systems being brought up
to current international norms. Instead, it favors the utterly frivolous
project to run a maglev (magnetic elevation) train, the most expensive and
least-tested technology available, to the isolated casino resort of Las Vegas.
Politically, that project may be very attractive to Reid, but it is
economically almost worthless because of Las Vegas's geographic isolation. It
would also be socially highly damaging, forcing the destructive forces of
gambling even more deeply into the fabric of American society.
Finally, at the time stimulus began with the bank bailouts last October, there
was very little slack in the US economy, with unemployment only around 6%, the
Dow Jones Industrial Average at bubble levels over 10,000, house prices still
sharply overvalued and the US savings rate still disgracefully moored at around
zero.
To re-stabilize the economy after its years of imbalance, the savings rate
needed to be brought back to its historical level of around 8%, or rather more
to make up for the years of nil saving, while the US balance of payments
deficit also needed to decline by 5% to 6% of GDP. In such circumstances,
injecting yet more wasteful spending into the economy was a wholly perverse
approach to the problem.
Going forward, we are now presented with an annual fiscal deficit of 10% of GDP
that will be very difficult to finance or to eradicate (and that's without
taking account of further costs of any more bank bailouts that the erratic US
Treasury or the Federal Reserve may consider necessary.) Obama's fiscal
responsibility summit on February 23 would find significant cuts in public
spending impossible, given the political orientation of the decision-makers and
the expectations of their followers. The only approach that would appear
feasible is thus one of massive tax increases, delayed sufficiently as to allow
recovery from the recession before they take effect.
[This column was written before the summit, at which Obama pledged to cut the
federal budget budget deficit in half in four years. The president was
scheduled to make a televised address to a joint session of the House and
Senate on Tuesday, February 24, and an overview of his budget proposal for the
2010 fiscal year, which begins on October 1, will be released on February 26.]
Substantial tax increases are already scheduled, with the December 2010 repeal
of the Bush tax cuts. At less than $200 billion per annum, however, this repeal
will go nowhere near far enough. To correct the budget imbalance, it will be
necessary to schedule tax increases of at least 4% to 5% of GDP ($600 billion
to $800 billion) unless public spending can be cut commensurately. Even those
draconian increases would only bring the budget deficit down within
historically precedented levels, rather than eliminating it altogether.
Not only will such tax increases have an appalling economic effect, they will
also be very difficult to fit into Obama's political timetable. Tax increases
that took effect in 2009 or 2010 would be disastrously counterproductive,
reproducing almost precisely Hoover's blunder of 1932. However, massive tax
increases that took effect in 2011 or 2012 would have an equally massive
adverse effect on Obama's re-election chances, particularly if they caused even
a minor relapse in the US economy.
Hence, all but modest tax increases are likely to be delayed until 2013 or
later, and the US budget deficit is likely to remain at least well above 5% of
GDP until then. That will increase US public debt to around 100% of GDP by the
2012 election. It will also cause a massive increase in interest rates, which
will doubtless be resisted to the utmost by the Federal Reserve of chairman Ben
Bernanke. That, in turn, will cause a resurgence in inflation, probably at a
speed and to a level that will make the late 1970s seem like child's play.
Already, the Producer and Consumer Price Indexes have continued increasing in
January, demonstrating that the specter of deflation is no more than a Bernanke
fantasy. Once inflation reappears in earnest, accompanied by higher interest
rates caused by the excessive budget deficits, Bernanke will not rein in money
supply immediately, as he currently claims he would; the unexpected (to him)
resurgence in inflation will cause hysterical denial and delay in necessary
tightening for at least a six- to 12-month period.
The Bernanke problem can only be solved by replacing him when his four-year
term is up next January, but it is not clear whether Obama has either the
understanding or the bottle to bring in a Paul Volcker clone to the Fed to do
what is necessary.
Internationally, the stimulus expenditures of Japan and Britain are likely to
prove equally damaging to those countries' recovery possibilities. Japan will
have an election this year, from which an anti-stimulus opposition government
may emerge; if so, it will face an uphill fiscal battle more strenuous than
that facing Junichiro Koizumi in 2001. In Britain, the election need not be
held until June 2010, and even after it the feeble David Cameron and George
Osborne team seems unlikely to provide much policy improvement.
It's already certain that 2009 will be a thoroughly unpleasant year, and many
commentators are coming to realize that 2010 will not be much better. Thanks to
stimulus, it now seems likely that 2011 and 2012 will also be years one would
rather not experience, and only in 2013 and after may some kind of feeble
economic recovery emerge.
Gee, thanks Maynard!
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 2005-09 David W Tice & Associates.)
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