Are All Deficits Created Equal?

One of the ongoing debates in Washington and throughout the Land is whether we need a second dosage of stimulus. By all accounts the first one has been a colossal bust, Joe Biden and Robert Gibbs notwithstanding. Over $800 billion was budgeted: on top of the TARP, GM and Chrysler bailouts, and the never-ending Fannie Mae and Freddie Mac trips to the Treasury’s ATM to address the dramatic economic slowdown. This recession is the worst since the early 1980s. The responses to each are instructive.

In the 1981-82 recession, President Reagan made two critical choices. First, he supported Fed Chairman Paul Volker’s efforts to bring inflation down from its, by US standards, outrageous rate of 13%. This courageous act extended the recession but helped lay the groundwork for a quarter century of prosperity. Secondly, he cut tax rates. More precisely, he slashed the tax rates. Individuals and businesses now kept a larger share of what they produced. The tax rates didn’t kick in until 1983 so people deferred activity from 1982 until then, thus making 1982’s performance worse than it could have been. Tax revenues rebounded over time even though the deficit rose initially. (To be sure, Congress couldn’t restrain the impulse to spend the gusher of revenues.) Over the 1982-1988 period, the American economy grew by one-third(!) – the equivalent of annexing West Germany. The key was that the government didn’t suppose it knew best as to what activities and actions would be the most productive. It left those decisions to the individual firms and citizens. Clearly, it worked well.

Fast forward to today. The President and the Congress have earmarked most of the funds to prop up profligate state and local governments and school districts. These funds were used to prevent layoffs. There were going to be layoffs because the public sector unions REFUSED to forego pay increases, even while 55% of all Americans had either lost their jobs or had their pay reduced in the past two years. Anecdotes are rife about the callousness of the union leadership when it came to adapting to the new reality or throwing some members overboard. The real issue is whether these subsidies to other government units will result in the economy growing. To date, they haven’t. Joe Biden is reduced to touting the fact that two hundred thousand homes have been weatherized. Wow! There are over one hundred million homes in the US. You do the math on when this will be complete. I don’t need to remind you that these weatherizing programs have been notorious for their shoddy workmanship and flagrant theft over the years.

The premise underlying the Keynesian models that are being used by the administration and the pundits supporting them, personified by Paul Krugman, is that it doesn’t matter where one puts another dollar into the economy as long as another dollar is put in. I doubt if Keynes himself believed this. Resources need to be put to their highest valued uses if an economy is to prosper. The Harvard economist, Robert Barro, has shown that the government multiplier effect is, at best, about 1 and often below 1. For those who remember their introductory economics, a multiplier greater than one is the holy grail of government spending: take a dollar from individual A and give it to individual B and, voila, there is now more than a dollar of output. This is alchemy at its best.

Current macroeconomic research shows that the problem with most advanced economies such as ours is not the lack of sufficient demand but the relative dearth of investment, productive investment. Building more homes barely qualifies as productive investment, especially when at the margin those who were induced to buy one can’t afford them. This is the 21th century version of digging a hole and filling it back in. Government policies: the tax subsidy to home ownership; the community reinvestment act (CRA); HUD policies in the late 1990s; low interest rates from the Fed; and congressional meddling (read: Barney Frank); all contributed to the massive over-investment in housing. This mal-investment, if you will, now needs to be wrung out of the system. Since houses are long-lived assets this will take awhile.

Another key component of current macroeconomic thinking is that expectations of what the future will bring matter. Markets do not like uncertainty, either. The expected return of higher income tax rates in 2011 has influenced decisions. Projects that look marginally profitable today will be under water with the higher taxes, so these projects get shelved. The quagmire known as the health care reform act continues to causes firms to cringe as more of its details become known. While many of its mandates aren’t direct taxes; that is, they won’t show up in the government’s financials; they act like taxes, thereby reducing economic activity.

Recoveries tend to mirror the decline: if the latter was sharp, the former also tends to be since there is significant slack that can be easily absorbed without creating bottlenecks. That is another reason this recovery is so troublesome. The economy hasn’t bounced back and has slowed precipitously so far this year, in spite of the massive injections of money that have ballooned the deficit. Increasing the deficit with no prospect for growth to generate the revenue to pay for it is a recipe for disaster.

Germany took the tack opposite that of the US. It lowered tax rates and reduced regulations and it did not spend itself silly. Its recent growth, as that of many other European economies, has dwarfed that of the US. It is said that Albert Einstein defined insanity as doing the same repeatedly and expecting different results. The Administration has obstinately clung to its approach, despite its abject failure. The failure is clear from the current results. A comparison to the 1981-82 recession, and the results coming in from elsewhere around the world indicate that the approach the US has taken is seriously flawed. We can have deficits either with increased government spending on projects that pass the political test but not necessarily the economic test, or we can have deficits resulting from reduced tax revenues due to lower marginal tax rates. The latter is the preferred approach if the goal is to return the economy to its long-run growth path.

Posted by Jim


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