Politicians lack the courage to privatize the huge, loss-making public sector because they are afraid to lose the vote of organized labor. They resist dismantling subsidies for power, fertilizers, and water because they fear the crucial farm vote. They won’t touch food subsidies because of the massive poor vote. They will not remove thousands of inspectors in the state governments, who continuously harass private businesses, because they don’t want to alienate government servants’ vote bank. Meanwhile, these giveaways play havoc with state finances and add to our disgraceful fiscal deficit. Unless the deficit comes under control, the nation will not be more competitive; nor will the growth rate rise further to 8 and 9 percent, which is what is needed to create jobs and improve the chances of the majority of our people to actualize their capabilities in a reasonably short time.{699}
While such problems may be particularly acute in India, they are by no means confined to India. In 2002, the Congress of the United States passed a farm subsidy bill—with bipartisan support—that has been estimated to cost the average American family more than $4,000 in inflated food prices over the following decade.{700} Huge financial problems have been created in Brazil by such generous pensions to government employees that they can retire in a better economic condition than when they were working.{701}
One of the pressures on governments in general, and elected governments in particular, is to “do something”—even when there is nothing they can do that is likely to make things better and much that they can do that will risk making things worse. Economic processes, like other processes, take time but politicians may be unwilling to allow these processes the time to run their course, especially when their political opponents are advocating quick fixes, such as wage and price controls during the Nixon administration or restrictions on international trade during the Great Depression of the 1930s.
In the twenty-first century, it is virtually impossible politically for any American government to allow a recession to run its course, as American governments once did for more than 150 years prior to the Great Depression, when both Republican President Herbert Hoover and then Democratic President Franklin D. Roosevelt intervened on an unprecedented scale. Today, it is widely assumed as axiomatic that the government must “do something” when the economy turns down. Very seldom does anyone compare what actually happens when the government does something with what has happened when the government did nothing.
The Great Depression
While the stock market crash of October 1929 and the ensuing Great Depression of the 1930s have often been seen as examples of the failure of market capitalism, it is by no means certain that the stock market crash made mass unemployment inevitable. Nor does history show better results when the government decides to “do something” compared to what happens when the government does nothing.
Although unemployment rose in the wake of the record-setting stock market crash of 1929, the unemployment rate peaked at 9 percent two months after the crash, and then began a trend generally downward, falling to 6.3 percent in June 1930. Unemployment never reached 10 percent for any of the 12 months following the stock market crash of 1929. But, after a series of major and unprecedented government interventions, the unemployment rate soared over 20 percent for 35 consecutive months.{702}
These interventions began under President Herbert Hoover, featuring the Smoot-Hawley tariffs of 1930—the highest tariffs in well over a century—designed to reduce imports, so that more American-made products would be sold, thereby providing more employment for American workers. It was a plausible belief, as so many things done by politicians seem plausible. But a public statement, signed by a thousand economists at leading universities around the country, warned against these tariffs, saying that the Smoot-Hawley bill would not only fail to reduce unemployment but would be counterproductive.
None of this, however, dissuaded Congress from passing this legislation or dissuaded President Hoover from signing it into law in June 1930. Within five months, the unemployment rate reversed its decline and rose to double digits for the first time in the 1930s{703}—and it never fell below that level for any month during the entire remainder of that decade, as one massive government intervention after another proved to be either futile or counterproductive.
What of the track record when the government refused to “do something” to counter a downturn in the economy? Since the massive federal intervention under President Hoover was unprecedented, the whole period between the nation’s founding in 1776 and the 1929 stock market crash was essentially a “do nothing” era, as far as federal intervention to counter a downturn.
No downturn during that long era was as catastrophic as the Great Depression of the 1930s became, after massive government intervention under both the Hoover administration and the Roosevelt administration that followed. Yet there was a downturn in the economy in 1921 that was initially more severe than the downturn in the twelve months immediately following the stock market crash of October 1929. Unemployment in the first year of President Warren G. Harding’s administration was 11.7 percent.{704} Yet Harding did nothing, except reduce government spending as tax revenues declined{705}—the very opposite of what would later be advocated by Keynesian economists. The following year unemployment fell to 6.7 percent, and the year after that to 2.4 percent.{706}
Even after it became a political axiom, following the Great Depression of the 1930s, that the government had to intervene when the economy turned down, that axiom was ignored by President Ronald Reagan when the stock market crashed in 1987, breaking the record for a one-day decline that had been set back in 1929. Despite outraged media reaction at his failure to act, President Reagan let the economy recover on its own. The net result was an economy that in fact recovered on its own, followed by what The Economist later called 20 years of “an enviable combination of steady growth and low inflation.”{707}
These were not controlled experiments, of course, so any conclusions must be suggestive rather than definitive. But, at the very least, the historical record calls into question whether a stock market crash must lead to a long and deep depression. It also calls into question the larger issue whether it was the market or the government that failed in the 1930s—and whether a “do something” policy must produce a better result than a “do nothing” policy.
Monetary Policy
Even a nominally independent agency like the Federal Reserve System in the United States operates under the implicit threat of new legislation that can both counter its existing policies and curtail its future independence. In 1979, the distinguished economist Arthur F. Burns, a former chairman of the Federal Reserve System, looked back on the efforts of the Federal Reserve under his chairmanship to try to cope with a growing inflation. As the Federal Reserve “kept testing and probing the limits of its freedom,” he said, “it repeatedly evoked violent criticism from both the Executive establishment and the Congress and therefore had to devote much of its energy to warding off legislation that could destroy any hope of ending inflation.”{708}
More fundamental than the problems that particular monetary policies may cause is the difficulty of crafting any policies with predictable outcomes in complex circumstances, when the responses of millions of other people to their perception of a policy can have consequences as serious as the policy itself. Economic problems that are easy to solve as theoretical exercises can be far more challenging in the real world. Merely estimating the changing dimensions of the problem is not easy. Federal Reserve forecasts of inflation during the 1960s and 1970s under-estimated how much inflation was developing, under the chairmanship of both William McChesney Martin and Arthur F. Burns. But during the subsequent chairmanships of Paul Volcker and Alan Greenspan, the Federal Reserve over-estimated what the rate of inflation would be.{709}
Even a successful monetary policy is enveloped in uncertainties. Inflation, for example, was reduced from a dangerous 13 percent per year in 1979 to a negligible 2 percent by 2003, but this was done through a series
of trial-and-error monetary actions, some of which proved to be effective, some ineffective—and all with painful repercussions on the viability of businesses and on unemployment among workers. As the Federal Reserve tightened money and credit in the early 1980s, in order to curb inflation, unemployment rose while bankruptcies and business failures rose to levels not seen in decades.
During this process, Federal Reserve System chairman Paul Volcker was demonized in the media and President Ronald Reagan’s popularity plummeted in the polls for supporting him. But at least Volcker had the advantage that Professor Burns had not had, of having support in the White House. However, not even those who had faith that the Federal Reserve’s monetary policy was the right one for dealing with rampant inflation had any way of knowing how long it would take—or whether Congress’ patience would run out before then, leading to legislation restricting the Fed’s independent authority. One of the governors of the Federal Reserve System during that time later reported his own reactions:
Did I get sweaty palms? Did I lie awake at night? The answer is that I did both. I was speaking before these groups all the time, home builders and auto dealers and others. It’s not so bad when some guy gets up and yells at you, “You SOB, you’re killing us.” What really got to me was when this fellow stood up and said in a very quiet way, “Governor, I’ve been an auto dealer for thirty years, worked hard to build up that business. Next week, I am closing my doors.” Then he sat down. That really gets to you.{710}
The tensions experienced by those who had the actual responsibility for dealing with the real world problem of inflation were in sharp contrast with the serene self-confidence of many economists in previous years, who believed that economics had reached the point where economists could not merely deal in a general way with recession or inflation problems but could even “fine tune” the economy in normal times. The recommendations and policies of such confident economists had much to do with creating the inflation that the Federal Reserve was now trying to cope with. As a later economist and columnist, Robert J. Samuelson, put it:
As we weigh our economic prospects, we need to recall the lessons of the Great Inflation. Its continuing significance is that it was a self-inflicted wound: something we did to ourselves with the best of intentions and on the most impeccable of advice. Its intellectual godfathers were without exception men of impressive intelligence. They were credentialed by some of the nation’s outstanding universities: Yale, MIT, Harvard, Princeton. But their high intellectual standing did not make their ideas any less impractical or destructive. Scholars can have tunnel vision, constricted by their own political or personal agendas. Like politicians, they can also yearn for the power and celebrity of the public arena. Even if their intentions are pure, their ideas may be mistaken. Academic pedigree alone is no guarantor of useful knowledge and wisdom.{711}
GOVERNMENT OBLIGATIONS
In addition to what the government currently spends, it has various legal obligations to make future expenditures. These obligations are specified and quantified in the case of government bonds that must be redeemed for various amounts of money at various future dates. Other obligations are open-ended, such as legal obligations to pay whoever qualifies for unemployment compensation or agricultural subsidies in the future. These obligations are not only open-ended but difficult to estimate, since they depend on things beyond the government’s control, such as the level of unemployment and the size of farmers’ crops.
Other open-ended obligations that are difficult to estimate are government “guarantees” of loans made by others to private borrowers or guarantees to those who lend to foreign governments. These guarantees appear to cost nothing, so long as the loans are repaid—and the fact that these guarantees cost the taxpayers nothing is likely to be trumpeted in the media by the advocates of such guarantees, who can point out how businesses and jobs were saved, without any expense to the government. But, at unpredictable times, the loans do not get paid and then huge amounts of the taxpayers’ money get spent to cover one of these supposedly costless guarantees.
When the U.S. government guaranteed the depositors in savings and loan associations that their deposits would be covered by government insurance, this appeared to cost nothing until these savings and loan associations ran up losses of more than $500 billion{712}—the kind of costs incurred in fighting a war for several years—and their depositors were reimbursed by the federal government after these enterprises collapsed.
Among the largest obligations of many governments are pensions that have been promised to future retirees. These are more predictable, given the size of the aging population and their mortality rates, but the problem here is that very often there is not enough money put aside to cover the promised pensions. This problem is not peculiar to any given country but is widespread among countries around the world, since elected officials everywhere benefit at the polls by promising pensions to people who vote, but stand to lose votes by raising tax rates high enough to pay what it would cost to redeem those promises. It is easier to leave it to future government officials to figure out how to deal with the later financial shortfall when the time comes to actually pay the promised pensions.
The difference between political incentives and economic incentives is shown by the difference between government-provided pensions and annuities provided by insurance companies. Government programs may be analogized to the activities of insurance companies by referring to these programs as “social insurance,” but without in fact having either the same incentives, the same legal obligations or the same results as private insurance companies selling annuities. The most fundamental difference between private annuities and government pensions is that the former create real wealth by investing premiums, while the latter create no real wealth but simply use current premiums from the working population to pay current pensions to the retired population.
What this means is that a private annuity invests the premiums that come in—creating factories, apartment buildings, or other tangible assets whose earnings will later enable the annuities to be paid to those whose money was used to create these assets. But government pension plans, such as Social Security in the United States, simply spend the premiums as they are received. Much of this money is used to pay pensions to current retirees, but the rest of the money can be used to finance other government activities, ranging from fighting wars to paying for Congressional junkets. There is no wealth created in this process to be used in the future to pay the pensions of those who are currently paying into the system. On the contrary, part of the wealth paid into these systems by current workers is siphoned off to finance whatever other government spending Congress may choose.
The illusion of investment is maintained by giving the Social Security trust fund government bonds in exchange for the money that is taken from it and spent on other government programs. But these bonds likewise represent no tangible assets. They are simply promises to pay money collected from future taxpayers. The country as a whole is not one dollar richer because these bonds were printed, so there is no analogy with private investments that create tangible wealth. If there were no such bonds, then future taxpayers would still have to make up the difference when future Social Security premiums are insufficient to pay pensions to future retirees. That is exactly the same as what will have to happen when there are bonds. Accounting procedures may make it seem that there is an investment when the Social Security system holds government bonds, but the economic reality is that neither the government nor anyone else can spend and save the same money.
What has enabled Social Security—and similar government pension plans in other countries—to postpone the day of reckoning is that a relatively small generation in the 1930s was followed by a much larger “baby boom” generation of the 1940s and 1950s. Because the baby boom generation earned much higher incomes, and therefore paid much larger premiums into the Social Security system, the pensions promised to the retirees from the previous generation could easily be paid. Not
only could the promises made to the 1930s generation be kept, additional benefits could be voted for them, with obvious political advantages to those awarding these additional benefits.
With the passage of time, however, a declining birthrate and an increasing life expectancy reduced the ratio of people paying into the system to people receiving money from the system. Unlike a private annuity, where premiums paid by each generation create the wealth that will later pay for its own pensions, government pensions pay the pensions of the retired generation from the premiums paid by the currently working generation. That is why private annuities are not jeopardized by the changing demographic makeup of the population, but government pension plans are.
Government pension plans enable current politicians to make promises which future governments will be expected to keep. These are virtually ideal political conditions for producing generous pension benefits—and future financial crises resulting from those generous benefits. Nor are such incentives and results confined to the United States. Countries of the European Union likewise face huge financial liabilities as the size of their retired populations continues to grow, not only absolutely but also relative to the size of the working populations whose taxes are paying their pensions. Moreover, the pensions in European Union countries tend to be more readily available than in the United States.
In Italy, for example, working men retire at an average age of 61 and those working in what are defined as “arduous” occupations—miners, bus drivers, and others—retire at age 57. The cost of this generosity consumes 15 percent of the country’s Gross Domestic Product, and Italy’s national debt in 2006 was 107 percent of the country’s GDP.{713} Belatedly, Italy raised the minimum retirement age to 59. As France, Germany and other European countries began to scale back the generosity of their government pension policies, political protests caused even modest reforms to be postponed or trimmed back.{714} But neither the financial nor the political costs of these government pensions were paid by the generation of politicians who created these policies, decades earlier.
Basic Economics Page 53