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The Tipping Point:

The reader of the first part of our “Fiscal Cliff” may have noticed our concern with total federal government expenditure exceeding the level of 19-20% of the U.S. economy (G/Y > 20%). Why is this number so important? It’s a simple exercise in economic logic. As we move along the spectrum from a government taking 0% to 100% of its citizen’s production, there will be some point at which a market economy begins to sour and its economic robustness and enthusiasm begins to decline. Experience indicates that this point in our economy has occurred at levels of sustained economic expenditure by the federal government in excess of 20% of GDP. It is here that private investment, new enterprise formation, economic growth, and private employment growth begin to disappoint. So-called “animal” spirits and the enthusiasm of free markets and capitalism begin to slacken. That is why our current level of federal expenditure of 25% of output is alarming (more like 40% if state and local governments are included).

The dynamic will be negative when we cross the tipping point. It is easy to imagine the road to a socialist state starting from a point of a government able to supply resources to its entitlements and dependents only by taking larger and larger shares of a shrinking and apparently underperforming private sector. The government would justify this behavior by “rescuing” more businesses and owning a bigger proportion of our economy and our lives. The eventual outcome for our country could be some sort of recreation on a larger scale of the drab and dismal examples of the decline of Europe under the paternal state socialisms of the sixties and seventies –recall Harold Wilson’s Britain, for example.

The Citizen’s Perspective :

When we see such a risk, many of us may wonder how individual Americans can tolerate or support such an outcome. What are individuals thinking who vote for or support such actions by the Federal Government? We see several possibilities:

(1) They might believe the expanding federal government budget is only a temporary, emergency level of spending that will be reversed as soon as the economy recovers. To see that this view is wrong we only need to observe that the current depression/recession endured by the U.S. economy is approaching record duration—even when compared to the Great Depression of the 1930s. Good luck! We hope you are right. Going over the fiscal cliff will prove it, if government expenditure is actually tamed. But remember, many a taking of citizen’s individual and economic freedoms and property has been justified by being referred to as a “temporary” measure.

(2) They may be unaware of these issues or their importance. Indefensible, but, alas, a more common position than we may care to admit. Ignorance, of course, endangers freedom.

(3) As bureaucrats or other receivers of the federal largesse, supporters of the growing government may rationally believe that, in their personal case, what is being expropriated away from them is less than what is being transferred back. What is missing from their calculation of course is the declining trajectory of output and economic growth over the future that will replenish the trough from which they dip.

(4) They have a large heart or a sensitive conscience. They believe it is important to take care of those in our society who are less fortunate, or more dependent. It is hard to impugn these admirable motives, perhaps shared by many or practically all of us. Yet we might ask ourselves if government programs and spending are the best way to achieve this goal. We would do well to read, for example, Milton Friedman’s Capitalism and Freedom. There we would be reminded of the dismally tiny fraction of each dollar of funding that actually trickles down through federal programs to support needy or dependent citizens after going through the hands of politicians, feather-bedding bureaucrats, entrenched lobbyists, and empire-builders. Friedman contrasts this to the robust private charity of churches and communities that existed during the nineteenth century in the U.S.—when there were no federal government safety nets. He suggests that period of private charity was superior and more moral in meeting dire human needs. If a person’s barn or house burned down, his neighbors or friends rebuilt it. That admirable motive for generous behavior still exists. However, now many believe that some government program would doubtless take care of a problem with our expensive tax dollars, and therefore would turn a deaf ear to pleas for help. The irony is that it is likely that the reassuringly-named government program would likely fail to actually provide the needed aid. We might ask ourselves which is more moral, a self-perpetuating state socialism that manages and controls the lives of its citizens while engorging itself, or free individuals wrestling with their own consciences in deciding what they should give to support the needy and unfortunate amongst them.

The immediate objection may be raised that privately provided aid is not universal and may be applied with a bias. If that is so, then, in the free-market of charity, new ones may be created which are not selective or do not serve such biases. In today’s America, who amongst us still believes that the individual programs within the staggering array of federal expenditure are not biased, selective, or politically motivated?

Taming Government Expenditure:

Going over the “fiscal cliff” is important if it actually results in the brakes being applied to government expenditure. Then it will re-affirm that the majority of our elected representatives actually still value and appreciate the strength of a private free-market economy. If tax rates are simply raised with no cuts in spending, the result will be dismal. Tax revenues actually collected at the higher tax rates will likely be lower rather than higher, deficits will continue to swell, economic performance will stagnate, and we will likely be past the tipping point.

An equally or even more important way to tame G/Y is, of course, the subject of our recent book, Capital as Money. Reform of our obsolete and de-stabilizing structure of fiat money and fractional-reserve banking is critical to the future performance and stability of our economy. We have the capability and technological tools at hand to create such a private money. A “capital-as-money” economy would remove a covert financing tool from the federal government that is perhaps more important and even more abused than taxes. If you haven’t already done so, you should read it. As we stated previously, most of us don’t like direct taxes and if the financing of government expenditure cannot be made covert, by inflationary printing of fiat money or borrowing for example, then the government expenditure, thus financed, is less likely to happen.

Ironically, not a great deal is required of the government, its political courage, or its behavior. Even a slowly but positively growing economy can forgive many sins. The federal government can get away with not cutting the absolute level of expenditure or even eliminating programs. It simply must follow the rule of limiting the growth of such programs to be less than the growth rate of the overall economy for a period of time. If that is done, if the greed of government can be reduced to just that level, then the government sector will gradually shrink relative to the private sector and G/Y can decline to a healthy level. Of course, this process will be sped up if government spending is actually cut or programs eliminated. Eventually we could get to a government sector spending only 7% (or some other number less than 20%) of GDP through government only growing itself more slowly than the average of the economy. However, this outcome would not be viewed with much enthusiasm by those politicians who are primarily interested in controlling larger and larger portions of their citizens’ economic and political lives.

Many of us, including some of our elected leaders see nothing exceptional or grand in our forefathers’ vision of individual liberty, economic freedom, and individual autonomy and responsibility. They may even view these ideals as unworkable, obsolete, or quaint, in the modern world. Unfortunately, until this perception is reversed in a majority of our citizens, darker days may lie ahead for America.

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The so-called “fiscal cliff” has created quite a stir. At issue is a set of automatic spending cuts and tax increases scheduled to go into effect on January 1, 2013. The news networks (particularly CNBC) have been hammering on this voguish topic for weeks, urging Congress and the President to DO SOMETHING! The impression is given that disaster is inevitable if an agreement isn’t reached, and fast.

For our own part, we hope we go over the cliff. It’s not that we’re big proponents of tax increases. But we do understand what the effective tax rate really is. When trying to decide whether taxes are high or low, it is not necessary to examine marginal tax rates applied to personal income or corporate income, or to do a careful analysis of gasoline taxes, or tariffs, or any other of the myriad of federal government taxes. We need not debate supply-side effects or the absence of them or whether one type of tax is to be preferred to another. One need only look at the ratio of government spending (G) to GDP (Y). When the ratio of G/Y is high, then the tax rate is high—if G/Y is low, then the tax rate is low (of course, “low” doesn’t happen much anymore).

Professor Steve Hanke of The John Hopkins University recently published an informative article examining the growth of federal government spending (see “An Age of Illusionists,” in GlobeAsia, December 2012). Professor Hanke calculated federal government spending as a percentage of GDP going back to 1952. Not surprisingly, today’s ratio of approximately 25 percent is higher than existed in any previous presidential administration during the period Professor Hanke considered. The low of 16.5 percent was recorded during the Eisenhower Administration. Interestingly, when the total federal take from the private sector exceeds the threshold of 19-20 percent, it has corresponded to periods of particularly tough sledding for the U.S. economy—that is inflation, stagflation, slow real growth and high unemployment. This has been noted as kind of a “spending limit” by a number of economic observers, including several members of previous administrations’ Council of Economic Advisors.

In case it is not obvious, perhaps we should clarify why the 25 percent figure is the real tax rate faced by the average person. GDP is the total amount of goods and services produced in an economy during a year. Clearly, the federal government can purchase 25 percent of the stuff that is produced only if private purchases are reduced by 25 percent. It is really that simple; if one party gets to eat 25 percent of the pie, then 75 percent is left for others to consume. Government finances its spending in one of three ways, which are direct taxation, new money creation, and borrowing. The various approaches to finance government spending differ in how goods and services are transferred from the private sector to the government, but in all cases the end result is that less private spending is required in order for there to be more government purchases.

Imagine a government that finances its spending entirely through the direct taxation of the income of its citizens. This would be an honest way for a government to finance itself and, of course, a government could purchase 25 percent of an economy’s GDP only if the tax rate was, on average, 25 percent. If the government wanted to increase its purchases to 30 percent of GDP, then a 30 percent tax rate would need to be applied.

Most people don’t like taxes (especially when they fall specifically on them), so the government often turns to a second approach for financing itself: it buys goods and services through expanding the money supply. Money financing occurs whenever the Federal Reserve creates new money in order to buy government bonds. From the government’s perspective, this approach to financing its purchases is appealing because it might fool some people into thinking the tax rate is less than it really is. But there is no magic associated with the printing of new money. As is the case with income taxes, government can consume 25 percent of the economy’s GDP only if it is taken from the private sector. In the case of printing money, the GDP is stolen from the private sector through the mechanism of higher prices. As prices rise, the typical person can purchase less—25 percent less to be precise. The inflation tax might fall on different people than a more honest income tax, but in the aggregate the end result is the same.

Finally, the third way government can finance itself is by borrowing from its citizens. Of course, the problem with this approach is that those citizens who are being borrowed from will necessarily have to pay themselves back through higher taxes in the future. Again when all the dust settles the outcome is the same—government consumes 25 percent of the economy’s total production only if the private sector consumes 25 percent less. The simple way to visualize bond financing is “ tax me later rather than tax me now.”

So, let’s get back to the fiscal cliff. Why do we hope a deal isn’t reached? Simply because of the automatic spending cuts that are scheduled to occur if there is no deal! We’d like to see government spending decline as a percentage of GDP. In fact for the long-term health of the U.S. economy we think a federal spending decline is imperative. Any other sort of deal that is struck between the President and Congress is likely to involve a few symbolic gestures such as a higher tax rate on “rich” people, while diverting attention away from the one real concern, which is the size of the overall bite the federal government is stealing from the GDP pie.

What would the original writers of the U.S. constitution think of a federal elected government that was stealing 25 percent of total output? They would no doubt be shocked and awestruck that the game “of rewarding those who voted for you by taxing those who voted against you” had come to this sorry point. They would probably hurry back to their draft and put in the missing part of our constitution. The missing part, which is desperately needed, would define the scope of government spending and functions and provide a reasonable limit on what can be stolen or spent. Twenty-five percent? We like a number such as 7 percent better. Surely a trillion dollars (2012) is enough to provide for the national defense and to protect citizens rights, freedoms and property.

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