No Courage Required

Signature:1aa0edd3f00ecb0adc8aa215f572f8061f81f2bd7ee14d34f53c48d50acdcb69Those who have the weakest connection to our economy and the least understanding of how a market economy actually works and grows seem to think of production, wealth and income as a zero sum game.  “You do not have enough because somebody else has too much” is a popular socialist/populist refrain.  For example, most politicians and governments appear to view taxes in this way.  If the resulting deficit from current government spending and entitlements is too large, simply reduce it by raising tax rates (capital gains, payroll taxes, and push up income tax rates on the “wealthy”).  Surely, if we do this, more tax revenue will be collected and the deficit will shrink without forcing hard spending decisions on subsidies and entitlements.  After all, incumbent politicians view subsidies and entitlements as necessary rewards and bribes to the constituencies that elected them.

The problem is that economies are dynamic, growing and behavioral.  Thus, when tax rates are selectively raised, there is no assurance that individuals will not simply alter their behavior in order to avoid those rate increases as far as possible—in exactly the same way that if a popular restaurant doubled its prices, it would be naïve to assume the same number of customers would choose to eat there.  Two major budgetary harms can befall a government that simply raises tax rates to deal with the problem of a rising current and future debt burden.  First, the rise in tax rates may simply result in a disappointingly small increase or even a reduction in tax revenue actually collected (the traditional “supply-side” argument, often ridiculed but not refuted).  Second, the growth path of the economy may be damaged by tax increases paid out of private funds that would otherwise have been productively invested.  Private funds invested in capital could have resulted in the future growth of output, prosperity and employment.  Since, this growth trajectory will never be observed after a tax increase, it is sadly impossible to know exactly what opportunity we will have lost.  What is true for taxes, of course, is also true for debt or inflation-financed government spending as well.   When discussing the government budget, we have pointed out previously that the ratio of government spending to output (G/Y) is the one to watch.

As of January 10, 2013, the stock of government interest-bearing debt had risen to just over 100 percent of GDP.  This was highest level of that ratio within most of our memories and it resulted from bailouts, entitlement spending growth and new government programs following the credit collapse of 2008.  However, going back in history to a previous real emergency, the peak stock of federal debt in U.S. history actually reached its high point of 120 percent of GDP (  The high water mark was the result of debt financing of the armed forces and war material required for the allied victory during WWII.

How did we extricate ourselves from such a mess at that point in time?  Did we courageously cut federal expenditures and programs to the bone in order to rapidly pay down the stock of government debt?  Largely, we did nothing.  Of course, the spending in the defense sector immediately declined following peace, though it was still large and growing during the “Cold War” period.  The budget and debt problem was solved much less dramatically because, on average, during the 25 years following 1945, the growth of the U.S. economy exceeded the growth rate of the stock of debt—of the cumulative government deficits.  Simple economic growth forgives many sins. 

Politicians would do well to remember that.  Cold courage is not required of them.  Outright expenditure cuts and program elimination is not necessary to get the government’s financial house in order (although we would love to see it).  A much wimpier solution is possible.  If our government could simply restrain its greed to allowing existing government programs and cumulative expenditure to simply grow only by 1% to 2% per year, while the economy is growing at 3%, then the debt problem will be cured within a generation.  Then the politicians can take unearned credit and pat themselves on the back for political courage and good, hard-nosed management.  Will this slower-relative-growth solution happen?  Well it happened before, but in today’s political climate we shouldn’t be too hopeful.  After all, sustained slower growth of the government sector makes politicians less relevant to a robust market economy—the spoils system would be devalued.

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  1. Eamonn said:

    Although public debt/GDP was 120% post WWII, private debt/GDP was at its lowest level in living memory, 43%. This private debt includes business, financial, and household debt. Viewed on a chart at
    alongside private debt the public debt does not appear to be a major problem. The private debt/GDP grew linearly from 1945-circa 1980 at ~110% and then went parabolic, peaking at 303% in 2009.

    During WWII mobilization almost the entire US economy was suspended for 4 years while consumption spending was restricted, Americans continued to de-lever and save capital, and American industrial capacity/technology grew tremendously. We can debate whether or not US involvement in WWII was justified, however that was the positive aspect of war spending.

    Contrast that with our current situation where private debt/GDP has declined ever-so-slightly off its peak. I would like to believe that we could extricate ourselves from this by growing the denominator of that ratio, but this will be challenging when so much of the current income goes to paying interest on public debt (taxes) and private debt, particularly when much of the private debt was used in a ponzi game of gambling on real-estate asset price rises that subsequently collapsed, car loans, unsecured loans on consumer goods (credit cards) and student loans for education of dubious value rather than productive assets. The bulk of private debt leading up to the depression was business debt, and businesses can more easily de-lever by laying off workers, selling equipment and, if all else fails, going bankrupt. Viewed in that light, we are in an even worse situation than the 1930s depression.

    The 25 years or so from 1982-2007 felt like good times, but we were living on borrowed money and borrowed time. I view this as a consequence of the Fed ‘fragilizing’ the economy by allowing and encouraging this steaming pile of debt to build up. Bernanke described this period as “The Great Moderation” in a speech in 2004. But to use an idea from author Nassim Taleb, turkeys believe that they are in a permanent period of prosperity with daily feedings from the farmer right up until a few days before Thanksgiving. Hopefully it will not take a world-wide military conflict and associated hyper-Keynesian spending to return us to prosperity. Thoughts?

  2. Eamonn said:

    I think the readers of this blog will appreciate this:

    By Brett Arends

    To be read in the voice of Paul Harvey.

    And on the eighth day God looked down on his planned paradise and said, “I need someone who can flip this for a quick buck.”

    So God made a banker.

    God said, “I need someone who doesn’t grow anything or make anything but who will borrow money from the public at 0% interest and then lend it back to the public at 2% or 5% or 10% and pay himself a bonus for doing so.”

    So God made a banker.

    God said, “I need someone who will take money from the people who work and save, and use that money to create a dotcom bubble and a housing bubble and a stock bubble and an oil bubble and a commodities bubble and a bond bubble and another stock bubble, and then sell it to people in Poughkeepsie and Spokane and Bakersfield, and pay himself another bonus.”

    So God made a banker.

    God said, “I need someone to build homes in the swamps and deserts using shoddy materials and other people’s money, and then use these homes as collateral for a Ponzi scheme he can sell to pensioners in California and Michigan and Sweden. I need someone who will then foreclose on those homes, kick out the occupants, and switch off the air conditioning and the plumbing, and watch the houses turn back into dirt. And then pay himself another bonus.”

    God said, “I need someone to lend money to people with bad credit at 30% interest in order to get his stock price up, and then, just before the loans turn bad, cash out his stock and walk away. And who, when asked later, will, with a tearful eye, say the government made him do it.”

    God said, “And I need somebody who will tell everyone else to stand on their own two feet, but who will then run to the government for a bailout as soon as he gets into trouble — and who will then use that bailout money to help elect a Congress that will look the other way. And then pay himself another bonus.”

    So God made a banker.

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