by Steve Forbes
American fear of Japanese economic muscle has faded considerably since the 1980s. Japan’s nonstop and wasteful government “investments,” building unneeded projects and squandering vital taxpayer capital, produced few gains for the Japanese economy or its taxpayers.
REAL WORLD LESSON
Most government “investments” produce few long-term economic gains because the taxes needed to fund them are wealth destroyers, not wealth builders.
Q IF GOVERNMENT SPENDING DESTROYS WEALTH, THEN WHAT DOES TODAY’S MASSIVE SPENDING MEAN FOR THE ECONOMY?
A IT MEANS THAT HIGHER TAXES AND GOVERNMENT BORROWING WILL DRAIN PEOPLE AND BUSINESSES OF CAPITAL, HOBBLING THE NATION’S ECONOMIC RECOVERY AND LEADING TO LONG-TERM ECONOMIC STAGNATION.
Even before the mind-boggling binge spending of the Obama administration, rising government outlays have been a concern. Experts have long warned of the unsustainable tax burden to be created when the Medicare and Social Security programs begin to buckle under the immense cost burden of caring for retiring baby boomers. Within the next decade, some seventy-seven million of them will be drawing on both of these entitlements. Social Security will soon be sending out more in benefits than it takes in from payroll taxes.
The national debt currently stands at more than $10 trillion. Yet the unfunded liabilities of Social Security, Medicare, and Medicaid are more than $70 trillion. And that’s before the spending needed to fund the current administration’s new and expanded programs.
The spending of the Obama administration is in addition to this entitlement time bomb. When the economic crisis is over, the Congressional Budget Office calculates that federal spending, as a proportion of the economy, will be about 25 percent higher than in 2007. America has never seen anything like it in peacetime.
That’s only federal spending. There’s also state spending. State politicians are almost as profligate as those in Washington. Before the Obama administration, total government spending—states included—was equal to more than one-third of our gross domestic product. Now it will approach 40 percent.
Additional funding needed by those already-existing entitlements will ratchet our total government spending to breathtaking levels approaching those in economically laggard Western Europe—as high as 50 percent.
And then there’s the huge tax burden that will come if some variation of the Obama administration’s healthcare ideas is enacted.
To place all of this in historical perspective, in 1929, when the United States was the largest and most complex economy in the world, the federal government spent only 3 percent of gross domestic product.
What this means for the economy, of course, is that individuals and businesses are likely to face a battery of new and higher taxes. Not only will the 2003 tax cuts be allowed to expire at the end of 2010, but FICA payroll taxes, which cover Medicare and Social Security, will substantially rise, making hiring people more expensive for employers.
Former Treasury Department economist Bruce Bartlett calculates that, based on current government budget projections, “federal income taxes for every taxpayer would have to rise by roughly 81 percent to pay all of the benefits promised by these programs under current law over and above the payroll tax.”15
That’s right. You read it correctly. He said “81 percent.”
What does this mean? Higher income-tax rates will increase the cost of risk taking, productive work, and success. People talk about this spending having an impact “on future generations.” However, experts like distinguished Harvard University economist Martin Feldstein believe that the future is now. Feldstein had been an economic adviser to President Reagan as well as to the Obama administration. He is the former head of the National Bureau of Economic Research—the nonprofit research organization that determines when recessions begin and end. He predicted that the expected rise in taxation under the current administration would “kill any chance of an early and sustained recovery.”16
Because hiring people will become more expensive, fewer people will be hired. Higher taxes will soak up capital that would have been invested in new and existing businesses that create new jobs and innovate. The economy will slow. Feldstein writes that the very expectation of this happening will depress the economy:
Households will recognize the permanent reduction in their future incomes and will reduce current spending accordingly. Higher future tax rates on capital gains and dividends will depress share prices immediately and the resulting fall in wealth will cut consumer spending further. Lower share prices will also raise the cost of equity capital, depressing business investment in plant and equipment.17
The seemingly dry numbers augur profound changes—not only in today’s economy but also in America as a society—that would make the nation a radically different place than it has been in the previous 230 years. Imagine the future this holds for young people—instead of saving to buy a house, you have to pay off the pension and medical bills of Grandma and Grandpa because your payroll taxes are 30 percent instead of 15 percent.
What does it really mean when an economy stagnates? New jobs and opportunities aren’t created. Businesses can’t grow or come into existence.
We pointed out earlier in this book that the United States, from the early 1970s until the recession, has been a far better job creator than Western Europe and Japan. With high taxes draining capital away from job creation, we’ll get what we already see in Western Europe—high unemployment among the young. Even before the current crisis, unemployment among young people in France and Germany was over 20 percent. With higher unemployment and more people needing government assistance, we will evolve into a European-style culture of dependence.
With less capital available for risk taking, entrepreneurship, and initiative, innovation will decline. Existing services—such as in health care—won’t be able to be developed or even maintained and will start to deteriorate.
Another consequence: society will become even more politicized, as interest groups of various stripes fight over government benefits. We’ll see the kind of generational conflict that is starting to occur in parts of Europe, where the elderly are increasingly looked upon as burdens. Several years ago, Holland was hit with scandals when it was discovered that hospitals short of beds were, not so coincidentally, euthanizing older, critically ill patients. Yes, this nightmare scenario actually occurred. Meanwhile, in Sweden, as we mentioned earlier, pressure has been exerted on the old to retire to “create jobs” for younger people.
Such episodes are extreme instances of what is essentially rationing. And rationing results when resources are limited and there isn’t enough of something to go around—whether that may be health care, energy, or jobs.
Most of the time, of course, bureaucrats end up deciding who gets what and how much.
The Real World bottom line in a government-dominated economy is indeed the Golden Rule: he who has the gold makes the rules. In a staterun market or economy, that means the needs and wants of people—and often, their rights—take a backseat to the agendas of politicians. The government, for example, tells auto companies what kind of cars they’re allowed to make, even if people don’t want to buy them. We’ve seen with Fannie and Freddie and with TARPed banks and life-insurance companies that it can mean that lending will be directed to politically desirable projects and not to those that make economic sense.
Recall the cases of Chrysler and General Motors, where senior secured creditors were browbeaten into accepting a reorganization that harmed their interests in favor of the politically powerful United Auto Workers union. And we’ve experienced the economic disaster that can be caused when politics, and not the market, drives economic decisions—namely, the misdirection of hundreds of billions of dollars into subprime mortgages.
If government direction were the way to go economically, the Soviet Union, and not the United States, would have won the cold war.
REAL-WORLD LESSON
Massive government spending and growing domination threaten not
only the economic welfare of future generations, but also the recovery of the economy in the here and now.
Q ISN’T THE FEDERAL RESERVE BANK NEEDED TO LESSEN THE IMPACT OF BOOM-AND-BUST CYCLES AND KEEP THE ECONOMY FROM OVERHEATING?
A BY PRINTING MONEY, THE FED CAN DELIVER A SHORT-TERM BOOST TO THE ECONOMY. BUT IN TRYING TO PREVENT NATURAL BUSINESS CYCLES, IT CREATES DAMAGING—EVEN CALAMITOUS—MARKET BUBBLES.
Growth in a democratic capitalist economy comes from production and innovation. It comes from finding better ways of doing things—new technologies, new processes, and new ventures that increase productivity and allow jobs and capital to be created. A wealth-producing innovation can be a wireless device that helps diagnose disease, a retail store that sells merchandise in a new way, or, as we’ve noted before, a single-size lid for coffee cups.
The Federal Reserve, the nation’s central bank, is charged with managing monetary policy and overseeing part of the banking system. It is not a wealth creator. However, throughout history, politicians and others have mistakenly believed that the Fed can soften the effects of business cycles. The notion has persisted that the Fed can cook up an economic expansion by simply printing more money, generating economic activity and more wealth for all.
Thus, the conventional wisdom has been that, during a downturn, all the Fed needs to do is “fine-tune” the economy by manipulating interest rates and the supply of money. But artificially changing the cost of money won’t in the long term create more wealth. As we learned from Hayek, as well as from the events in the last few years, it will only distort economic activity and can potentially be dangerous.
Hayek could have written the lesson provided by recent events. By keeping the cost of money artificially low, the Fed stimulated a massive boom in housing. Millions of people who really couldn’t afford a house ended up buying. Today we know that this proved to be disastrous for them, as well as for home builders, who became overextended, and a financial system that offered credit on the basis of inflated asset values. The boom in the housing and credit markets created by so much available money eventually collapsed, dragging the nation’s and the world’s economy down with it.
A similar scenario played out in the early 1970s. John Tamny, editor of Forbes’s RealClearMarkets.com, writes that Richard Nixon sought to achieve the Keynesian goal of “full employment” by increasing the money supply by 8 percent. This worked for a time.
The money illusion gave the appearance of economic growth, and Nixon won re-election in a landslide in 1972. As late as January of 1973 unemployment was near [the] target at 4.6%, while GNP in the first quarter of ’73 was rising at an annualized rate of 8.8%.18
But Tamny recounts that the balloon deflated.
Reality caught up with the illusion. GNP only rose at a 1.4% rate for the rest of the year, not to mention that all manner of commodities were rising in concert with the collapsing dollar.19
The following year both the economy and the stock market tanked. Remember our point in chapter 6 about attempting to manipulate the balance of trade with a weak dollar—the gains it produces are always temporary. Sooner or later, the market corrects. Same goes for the domestic economy. The market eventually seeks to correct artificially inflated prices of goods and services. And the results are traumatic.
The inflation that ensued in Nixon’s second term inflamed nerves already frayed by the debate over the Vietnam War. In an angry atmosphere exacerbated by the Watergate scandal, Nixon was forced to resign. The economy suffered through a decade of “stagflation.”
The Federal Reserve can’t “manage” an economy for the same reason that the rest of government can’t: there’s no way that a handful of people—even smart people—in Washington can effectively guide the economic actions of three hundred million Americans or, for that matter, 6.5 billion people around the world.
The Fed suffers from the shortcomings of any government bureaucracy. While supposedly independent, it’s vulnerable to political agendas. Nixon’s Federal Reserve chairman, Arthur Burns, was accused of pumping up the money supply, not only to boost the economy but also to increase the president’s chances of winning the 1972 presidential election. The Fed has made countless mistakes in regulating money. It was seen as undermining the value of the dollar in the fall of 1987, which helped precipitate the stock market crash that October. In the late 1990s, the Fed’s tight money policy caused the collapse of agricultural commodities. This in turn created political pressure to substantially increase wasteful farm subsidies under President Bush in 2001.
The Fed’s record regulating banks has been dreadful. Despite this, people have responded to the current financial crisis—a disaster that, as we’ve said, the Fed helped to cause—by wanting to endow the central bank with still more regulatory power. That would be a truly perverse mistake.
The Fed cannot prevent normal business cycles because they result from events that have nothing to do with the money supply—the economy’s natural process of creation and destruction. Some people, like Representative Ron Paul, who made a credible run for president in 2008, question whether we need a central bank in the first place. The Fed was established in 1913 to prevent crises like the banking panic of 1907 from happening again. Ironically, that upheaval was solved by the private sector without the help of government. Financier J. P. Morgan brought together his fellow bankers to shore up beleaguered banks and shutter those beyond saving.
The Federal Reserve’s prime function should be keeping the value of the dollar stable. A sound dollar would go a long way toward achieving the president’s goal of minimizing the kind of violent economic gyrations that we recently experienced.
REAL WORLD LESSON
The Federal Reserve cannot create prosperity or prevent normal cycles because wealth creation is about innovation, not the supply of money.
Q WOULDN’T IT BE TRAUMATIC TO RETURN TO A GOLD STANDARD AS IT WAS IN BRITAIN IN THE 1920S AND IN THE UNITED STATES AFTER THE CIVIL WAR?
A RETURNING TO A GOLD STANDARD WOULD BOOST THE ECONOMY BY REDUCING THE UNCERTAINTIES OF A FLUCTUATING CURRENCY. BUT IT MUST BE IMPLEMENTED CORRECTLY.
When governments allow the value of their currencies to fluctuate, it creates uncertainty and inhibits economic activity. Think about it: how easy would it be for a carpenter to build a two-thousand-square-foot house if the number of inches in a foot shifted frequently—from twelve inches one day to six the next, to eight the day after, et cetera.
It’s as though an economist said: If we change the size of a foot from twelve to fifteen inches, everyone will have a bigger house. Really? In the Real World, you’ll likely end up with a lot of confusion and fewer homes being built. Similarly, with a fluctuating dollar, you get less long-term investment, more speculation, and misdirected capital.
Prices are supposed to signal to producers and consumers what is plentiful (cheap) and what is rare (expensive). If prices are constantly changing because of government actions, then markets can’t gauge—or respond to—the desires of consumers.
Economists and politicians complain that fixing the dollar to gold would mean that the Federal Reserve couldn’t play a role in guiding the economy. We agree. However, that’s a good thing. It should not be the Fed’s role to guide the economy. Aside from the upheavals caused by natural disasters, pandemics, or major wars, the most severe economic disruptions—on the level we’ve experienced recently—are invariably the result of government errors. In a healthy democratic capitalist economy, the market is guided not by government fiat but by people—their wants, needs, and innovations.
Thanks to the misdiagnoses of economists like John Maynard Keynes, gold has gotten a bad rap, largely based on the mistaken notion that it helped trigger the Great Depression. And it was blamed for unemployment and price deflation after Britain reestablished a gold standard in 1925. The precious metal was also said to have caused a series of downturns in the United States after the Civil War.
We’ve discussed at length, however, that the trig
ger for the Depression was the calamitous outcome of global trade wars ignited by the Smoot-Hawley Tariff. With economic conditions deteriorating, people and financial institutions around the world became fearful. They began to turn in paper currencies for gold just as they do during wartime, putting pressure on government supplies. Some countries, attempting to maintain the link to gold, raised interest rates to induce people to keep their cash in the bank and not redeem their currency. But this only worsened the economic crisis. The British government, fearing it would run out of the precious metal, went off the gold standard in August 1931. Other countries followed. Gold was a victim of the Depression, not the cause. In the same way that a gold standard is suspended in a major war, it became impossible to maintain in the devastating global trade war that the United States unleashed in 1929–30.
What about the deflation that occurred after Britain returned to gold in the 1920s—and the misery that ensued after the United States went back to gold after the Civil War? Friedrich Hayek and his mentor, Ludwig von Mises, both pointed out that in each case, the mistake was incorrectly valuing currency in relation to gold.
In the case of the United States, we pegged the dollar to gold based on pre–Civil War price levels. But in the interim, the government had expanded the money supply to help pay for the war. When the value of the dollar was set according to preinflation prices, the result was a traumatic deflation.
Hayek wrote that Britain made a similar error in setting the pound-to-gold ratio after World War I. Prices by then had more than doubled. The British government should have reestablished the link at the new price level. Instead, the pound was relinked to gold at the pre–World War I level—the equivalent of $4.86 to the pound, instead of, say, $2.80. The drop in the money supply produced a severe recession, leading to a general nationwide strike. Millions of workers walked off their jobs. For over a week, economic activity came to a halt. The strikes were ultimately broken, but the anger and bitterness lingered.