Do we need a cold shower and a rest, or a hair of the dog that bit us?

Randall Forsyth at Barrons has a new article up that might as well have been a summary of Russ Roberts and I’s “Fear the Boom and Bust” which bits the government belt-tightening F. A. Hayek against his big spending rival, John Maynard Keynes.

The story begins in broad strokes:

In one corner are the advocates of fiscal austerity, many of whom are adherents of the Austrian School of economics. Hence, the contraction into “Austerian.” Their motto is to rip off the band-aid and get the pain over with.

Cute. “Austerians”. Riping off the band-aid  would have been great. It’s terrible to lose your job. But it’s a disaster to remain unemployed for 2 years, where your skills degrade, your mentality changes and your prospects for a future hire become a compounding problem. Trading “depth” for “duration” (if that is in fact the tradeoff that was made, who knows) seems to me to favor short and deep. Long malaise warps our culture and destroys our most precious resource: human “capital”.

I also have a big problem with using the term “austerity” to describe single-digit budget restraint in a world where our  government employees make significantly more than their private sector counterparts, our military spends billions to hang out in places like Germany and Japan and hundreds of billions in corporate subsidies fly out the door every year.

Is it really “austere” to ask New Jersey teachers to contribute 1% to their taxpayer-provided health plan or freeze their salaries (not lower them, mind you) in a year with 10% unemployment and near-zero inflation? I mean, give me a break. Talk about torturing the English language. “Austerity” suggests strict, harsh self-denial. Freezing government spending growth ain’t it.

We aren’t being faced with “austerity” in America. We’re being faced with just a tiny sliver of SANITY and JUSTICE.

Anyway, back to Barrons:

Opposing them are the Keynesians, who contend it’s counterproductive to tighten belts when people are hungry. Over the years, their prescription has evolved to Bloody Marys after every binge and bust instead of sweating out the previous excesses. So, each binge and hangover gets worse, requiring more relief the next day, which only encourages another bender.

What a great summary. They’ve even got the “hair of the dog” solution metaphor working against the Keynesians. But this is just faux “balance” on the part of the writer. It’s one jab at the Keynesian prescription for having gone too far, which he spends the rest of the article essentially supporting.

“This is the last thing a debt-laden economy needs, especially a debt-laden economy that is teetering on the brink of deflation anyway. But that doesn’t mean that policy makers won’t try to tighten. Indeed, one of the world’s worst economists and a paragon of orthodox belief, Alan Greenspan, opined in a recent Wall Street Journal OpEd that ‘an urgency to rein in budget deficits’ is ‘none too soon.’ Did you need more evidence that this was a really bad idea?!^

Such bad ideas do take hold. In 1937, both fiscal and monetary policies were tightened, setting the second stage of the Great Depression. Japan, meanwhile, tightened fiscal policy in 1997, prolonging its lost decade.

So after running their government debt up past 100% of their GDP, it was fiscal tightening that prolonged the so-called “long decade”? I think we may have a cause-and-effect reversal going on here. And it sure sounds like a call for another hair of the dog. If I run up my credit card to the point where my income can just about pay the interest, the fact that my spending moving forward will be lower is not because… um… my spending is lower. Debt is a burden. Literally. The writers seems to acknowledge that at the top of the paragraph yet not really understand what happens next.

CONTRACTION, DEFLATION AND CONFLATION

As for 1937, Forsyth points out that fiscal AND MONETARY policy were tightened. Government spending, taxes, deficits and monetary policy changes are not interchangeable in their effects on economic activity. Conflating them into simply “tightening” is a dangerous muddle that masks any hope of understanding. That said, separating the impacts of multiple changes in policy on an infinitely complex economy is also more or less impossible. For this reason, Austrian economists have tended to focus on principles that are established largely in general “micro” economics: Supply and demand, Prices as information, Incentives matter. “Macroeconomics” as constructed by Keynes with it’s pseudo-scientific emphasis on comparing aggregate data (total spending, GDP, etc) lacks any of the “microfoundations” that lie at the heart of economics. I’m not convinced “macro” as practiced is even economics at all.

All that said, let’s at least look at what actually happened in the late 1930s, since it’s become the reference point for today’s discussion about a “double dip”. Data collected from US Government Spending:

In 1936, Federal spending was $9.2 billion or  10.9% the nation’s $83.8b in GDP.

In 1937, Federal spending was $8.8 billion (down 4.5% from 1936) or 10.4% of the nation’s $91.9b in GDP (up 9.7%)

In 1938, Federal spending was $8.4 billion (down 4.7% from 1937) or 10.25% of the nation’s $86.1b in GDP (down 6.7%)

In 1939 Federal spending was $9.3 billion (up 10.7% from 1938) or 9.9% of the nation’s $92.2b in GDP (up 7%)

Is this really enough information to gain any knowledge of cause and effect? These are all after-the-fact numbers. Government spending rose with GDP in 1936. It fell in 1937 even as GDP grew that year. Then both fell in 1938. Then both rose in 1939. Not many data points to draw a conclusion in that.

Now let’s look at the federal deficit:

1936: $4 billion (4.7% of GDP)

1937: $2.6 billion (2.8% of GDP)

1938: $1.2 billion (1.4% of GDP)

1939: $2.1 billion (2.3% of GDP)

Talk about pushing on a string. Look at how small the Federal government’s outlays are compared with the economy in the 1930s (and compared with Federal spending today). The Feds were a bit player in the US economy.

More importantly, though is to understand what government spending does and does NOT do. Government spending may create demand for what it spends money on, but it doesn’t impact the incentives for all productive activity. Taxes, however, do. Keynesians look at tax cuts and spending increases as simply two sides of the same coin, but they aren’t. Tax rates impact EVERYONE. Spending impacts a tiny portion of us.

SPENDING ON SOME, TAXES FROM EVERYONE

So what happened with taxes during the late 1930s? In 1936, FDR signed the “Revenue Act of 1936” which increased taxes dramatically and included a shocking “undistributed profits tax” at a rate of 73%. Think about that. If your company earned a profit but saved the money, FDR took 73% of it. Remember, savings generally go in BANKS. Banks LEND the money to someone else. This tax created a MASSIVE disincentive to save and invest.

So while FDR went off sailing with his cronies, the entire private economy got socked with a massive increase on productivity, savings and investment.

Again, taxes impact EVERYONE. Government spending, especially in the 1930s, only impacted 10% of the economy. Keynesians claim that government spending magically “multiplies” so a dollar spent creates more than a dollar in economic activity and GDP. But when that dollar is being ripped out of the bank accounts of the private economy with absurd taxes, every dollar of government spending comes at the expense of a dollar of private spending plus the cost of the bureaucracy.

Again, lumping these vastly different effects on economic incentives simply into the level of federal deficits is absurd. It is lazy, sloppy and tragically mistaken. Keynesians may see tax cuts and spending hikes or tax hikes and spending cuts as indistinguishable but nothing could be farther from the truth.

MONEY: THE RIVER THAT RUNS THROUGH THE ECONOMY

Tax rates impact the entire economy. But even they aren’t as pervasive as money itself. Money is one side of EVERY transaction in a modern economy. Changes in the supply and demand for money and credit have economy-wide effects, which is why Mises and Hayek made these changes the focus of the theories on the boom and bust cycle of the entire economy.

Much like today, the Federal Reserve played a central role in causing the Great Depression in the first place. And yet, as is tradition in Washington, no bad deed goes unrewarded. Thus, a series of laws dramatically expanded this failed organization’s power over the US economy.  A vital one for studying this “depression within the depression” is the Banking Act of 1935. The Federal Reserve, making yet more mistaken use of it new powers, sharply increased reserve requirements on the banking system, arbitrarily reducing the amount of lending which banks could perform given their reserves. This caused the overall money supply to contract, as this graph from The Independent demonstrates:

Again, monetary changes impact the ENTIRE economy, unlike government spending.

When the money supply is falling, it reduces credit availability as well as money demand for goods. Once the impact of the contraction affects prices AND wages (a deflation), real purchasing power is preserved. You make less money but goods cost less, so your “real” wage is unchanged. Getting from here to there, however, involves a period of confusion known as the “money illusion”. People and businesses don’t know that the money supply is falling. All they see is falling demand. Planning for the future is more difficult during an inflation AND a deflation because prices become a less reliable signal for real demand. So while business will eventually cut prices, they may cut production and may do that first. Why keep producing more goods when you already have excess inventory? This has a downward spiral effect that Hayek referred to as a “secondary deflation”.

For that reason, Hayek’s theory DID NOT call for the kind of “monetary tightening” the Fed induced on the economy and wouldn’t today. For evidence, consider this quote from an op-ed Hayek co-wrote in 1932:

It is agreed that hoarding money, whether in cash or in idle balances, is deflationary in its effects. No one thinks that deflation in itself is desirable.

Hayek’s Austrian perspective of fiscal austerity is about DEBT, not deflation. Again conflating the two destroys the discussion. When you’re in a hole of debt, stop digging. But if there is an increased demand for money, Hayek’s theory as well as that of Milton Friedman’s is to increase the supply to meet the demand.

Faced with so many changing variables, it is not intellectually honest to make claim with certainty about how much each of these various fiscal and monetary policy changes impacted the economy in the late 1930s and how much today’s policy  may be impacting the current economy. But we CAN know the scope of policy. Who it directly affects and who is not under it’s direct influence. Considered through that lens, there is no question that taxes and monetary policy have a dramatically larger scope on the economy than the 10% of GDP in federal spending in the 1930s or even the 25% (a historic high mind you) today.

DEBT TODAY, AUSTERITY TOMORROW?

Forsyth offers what he believes is a “third way” between the “austerians” and the Keynesian spend-a-holics.

There is a third way, a via media as it were, which could be called Augustinianomics. To paraphrase St. Augustine, “Please make us fiscally sound, but not just yet.”

This is an often-repeated “middle ground” by those who grasp for the illusive “center”. We heard the calls during late 2008, early 2009 when the bizarre Keynesian “paradox of thrift” was being routinely invoked as a means to shame people for saving more and spending less. “We need to save more as a nation, just not right now” was the call then. And so it is today.

But this is more like a muddle ground, than a middle ground because it utterly ignores the role of expectations and plans for the future.

If you are told ‘here’s some money for you to spend, I’ll be back for it next week’, are you going to spend the money? If you see a boost in demand for your products, but are being told explicitly that future taxes WILL be going up, are you going to invest more and expand your business, or might you stockpile your earnings in order to weather the certain storm that’s coming?

I can imagine an economist technocrat responding to this problem with something like ‘what if we don’t actually tell people about the future austerity? That may get them spending today’. Leaving aside the fact that this idea essential advocates government fraud, it’s still unlikely that people are going to be fooled. The bill comes due. Today’s debt is tomorrow’s interest payment. There’s no hiding that, save for Enron-style accounting, and Greece has already demonstrated how long that game lasts.

Expectations matter. If people are worried about debt and deficits today, those problems need to be addressed today. Talking about future fixes will pull forward the private cutbacks without enacting the needed public ones.

UNUSUAL UNCERTAINTY

Forsyth ultimately concludes, I think correctly, that increased uncertainty is our main enemy for economic recovery right now:

The more likely scenario is more of the same, for now. The “unusually uncertain” outlook cited by Bernanke and the FOMC suggests as much for monetary policy.

New fiscal initiatives are unlikely before the November elections. But without Congressional action, the biggest tax increase in history takes effect with the sunset of the Bush tax cuts. The Obama administration favors only hiking taxes on the top brackets, that is, for couples making over $250,000. But that would require Congress to act, so who knows if it will happen, even in a post-election lame-duck session.

Thus, “unusually uncertain” could apply equally to fiscal policy as the standoff between Austerians and Keynesians drags on.

Government spending money on its various political interest groups can’t compare to the systematic impacts on behavior and incentives that come with changes to the value of our money and tax rates on our productivity. When these important factors are unknown, it makes matters that much worse.

Businesses need to have a reasonable sense of their costs in order to plan for the future and hire. One part of the 1937 story that rarely gets mentioned is the impact of The National Labor Relation Act of 1935 (or “Wagner Act”). This bill dramatically empowered labor unions and put them on an offensive attack on businesses and employers. This added substantially to business uncertainty and costs. Lest you think I’m a union-basher, consider this quote from Paul Krugman from his 2009 Macroeconomics textbook:

The actions of labor unions can have effects similar to those of minimum wages, leading to structural unemployment.

Why isn’t the Wagner Act being discussed today in the media’s review of the 1937 double-dip? I think it’s a combination of ideological, pro-union bias and ignorance of history. But history can and does repeat itself. A modern equivalent, the “Employee Free Choice Act” also know as “Card Check” is on the Congressional docket with powerful senators aiming to ram it through during the lame duck session. Surely this is having an impact on employers and their plans to hire new workers.

How many 1930s mistakes does this government intend to repeat?!?

Card Check and potential increase in taxes that loom are important factors, but they are not the only ones. Our government has already in the past year embarked on a legislative whirlwind, producing over 4000 pages of alleged ‘reform’ for most of economy: Healthcare and Finance. These are massive bills which our congressional overlords literally LAUGH at the thought of actually reading. (Yes, that should make you ready to take to the streets of DC with pitchforks).

But more important than congressional ignorance is the fact that these bills largely haven’t even created the new rules of the game. The healthcare bill is LOADED with taxes and mandates but most of the particulars have been left to the unelected bureaucrats in the executive branch to decide.

Even more vital and uncertainty-inducing is that lack of clarity in the financial regulations bill. This new 2000 page monster not only hands off to “regulators” all of the vital questions that can have 1937-like impacts on our economy (like how reserve requirements may or may not change and to what levels), but it even passes the buck on WHO THE BILL REGULATES.

NPR’s Planet Money has a great story covering “What the Finance Bill Doesn’t Tell Us”. In that story, Barney Frank one of the bill’s key authors is asked why he didn’t make any important decisions in the bill and left everything that matters up to the “regulators”. His answer defines in a nutshell the difference between progressives and libertarians:

“In democracies, there are no guarantees” – Barney Frank

In other words: leave it up to us, and if we suck, vote us out. But “democracy” has severe limits which is why our founders sought to limit its scope of influence with the Bill of Rights, as I highlighted in my post on July 4th, “about freedom, democracy and independence day”. I don’t recall ever having an election for the chairperson of the FDIC, SEC, CTFC or Federal Reserve. I don’t recall any election-season advertisement ever mentioning these mighty organizations as an election-year issue. What we need are clear rules of the game. A ‘rule’ that simply leaves the rules of up some regulator’s discretion is hardly a rule at all.

Welcome to the world of Regime Uncertainty and the sham anti-democracy of the “regulatory” state. It is the main force preventing real economic progress today…

…but what the hell do I know?