The Deadly Cycle of “Stimulus” and “Austerity”

The Deadly Cycle of “Stimulus” and “Austerity”
June 21, 2010

It seems that I hardly comment on current economic events anymore. I have the impression that everything is following the well-worn paths with a certain astronomical predictability. First comes the “stimulus.” Then comes the “austerity.” Then comes the “stimulus” again. The eventual result is disaster.

September 14, 2008: Depression Economics
November 10, 2008: “Austerity”
November 2, 2008: “Stimulus”

January 18, 2009: “Austerity” and “Stimulus” 2.0

June 9, 2010: The Coming Keynesian Catastrophe

I don’t think governments will be able to get off this merry-go-round of decline and deterioration until they stop using these words “stimulus” and “austerity.” Just the use of those words shows a certain fixed mindset leading to certain predictable conclusions.

“Stimulus” is mostly a big waste of money. Goverments everywhere love this, because it gives them a rationale to do what they do best, which is channel taxpayer funds to their political base: politicians, bureaucrats, public employees, and corporate cronies. The typical politician is worried about their support in the midst of recession anyway, and there is no law of nature more ingrained in the politcians’ consciousness than that handing out money is the best way to make friends. This waste of money often takes the form of disorganized spending on “public works” or similar boondoggles. This time around, the government has had a lot of bailouts, mostly of bankers although also the automakers and state governments. This all tends to get swept into the “stimulus” category although it is not really what Keynes had in mind.

I want to point out that the government support for “stimulus” is often not really motivated by high-minded economic insight, but grubby money-grabbing. Some sort of meaningful, permanent tax cut would also be a reasonable approach to “stimulus,” but we find that this is almost never considered. There might be a check-in-the-mail handout called a “tax refund,” or there may be some sort of temporary tax break aimed at accomplishing about the same thing (as was the case this time around with Obama’s payroll tax breaks). It is the natural tendency of most mediocre governments to attempt to increase their power and influence over the populace. This naturally tends toward higher taxes and higher spending. The better governments may pursue a low-tax strategy, as China is today. The government reasons that they are on the top of the pyramid, and the best way to make the pyramid taller is to make the base broader. This is actually not so uncommon, and even a lowlife like George W. Bush undertook a significant tax cut in 2003 with an eye to boosting the economy. My point, however, is that this sort of tax-cutting, even if it is aimed at boosting the economy in a recession, is almost never called “stimulus.” I don’t recall that term being used in reference to the 2003 tax cut. This “stimulus” terminology is a sort of mental prison, driving governments down the same paths of decline and disaster.

“Stimulus” tends to have a tangible result — you can’t quite say it has no effect at all — but it is weak and disappointing. The effects of “stimulus” tend to dissipate immediately after the money stops flowing. However, we have now established a new precedent. The politicians, bureaucrats, public employees and corporate cronies have been able to milk the taxpayer for rather large sums of money, in broad daylight, with this “stimulus” justification. Although the experiment has been shown to be a flop economically, it was a big success politically. The calls go out for “more stimulus.”

Before too long, this abject government waste, which has a funny way of flowing right into political insiders’ pockets, becomes unpopular. Politicians notice this public unrest. Also, some conservative politcians may begin to complain about the long-term consequences of large deficits, which is ultimately a crushing debt burden and default.

The government may not be in immediate danger of exceeding its borrowing capacity. However, today, many governments are rather close to the point at which nobody in the private market will loan them any more money. The southern European governments have already crossed this line. The U.K. is close. The U.S. is not there yet, but is plainly on the path to that point within ten years if large deficits are not curtailed. Japan is a bit of a mystery, but is beyond the point of remediation.

Today, the risks of excessive debts and deficits are not just a long-off potentiality described by crabby conservative politcians. They are here and now.

This was also true in the 1930s. We have talked earlier about Herbert Hoover’s lunge toward “austerity” in 1932. This followed default by several European governments in 1931. Actually, the U.S. still had a lot of debt-carrying capacity in those days — although they didn’t know that at the time.

Then comes the next step: “austerity.” With the danger of government default looming, governments attempt to bring their finances under control. However, it is likely that the government is already weak and corrupt, so this deficit-shrinking effort once again is bent into a form that politicians like best. If “stimulus” is mostly higher spending, “austerity” is mostly higher taxes.

It does not take very long before all the political insiders — politicians, bureaucrats, public employees and corporate cronies — agree that they don’t really want to cut spending. They were having such a nice time with their “stimulus” fiesta. Don’t cut you, don’t cut me … let’s cut the guy behind the tree. This usually means some sort of welfare spending, or public services like libraries, parks and so forth. In short, all the government cashflow that doesn’t land in the pockets of politcians, bureaucrats, public employees and corporate cronies. This time around, we have seen governments almost incapable of reducing bloated salaries and benefits of public employees, with the axe falling mostly on welfare programs and government services. On the federal level, we have two very expensive wars going on, for reasons nobody can remember. (“Weapons of mass destruction”???) Thus, the first round of government spending cuts tends to land on exactly those things which are the most important — especially in a recession — and not the gross amounts of waste flowing to the pockets of political insiders. Of course, when you cut the most important things, pretty soon there is a chorus of complaints, so cutting even the guy behind the tree is not so easy as it first seems. In the end, not much of anything at all is cut. Look at California or Illinois today.

Look at Herbert Hoover’s “austerity” budget. In 1929, the U.S. federal government spent $3,127m. In 1930, it spent $3,320m. In 1931 it was $3,577m. Then came the “austerity.” In 1932, the U.S. federal government spent $4,659m. (It was an election year.) In 1933 (under Roosevelt) it was $4,598m, and in 1934 it was $6,541m.

Not a whole lot of “austerity” on the spending side, especially when you consider that nominal GDP fell about 40% over that period.

Thus, the political focus turns to tax increases, both in terms of new taxes and higher tax rates, and also in the form of extreme fees for all sorts of things. We remember that Hoover raised the top income tax rate in the U.S. to 63% from 25% in 1932, along with higher taxes for businesses and all sorts of other things. He also tried to implement a national sales tax, but this was defeated.

Click here for U.S. federal budget data for 1789-2006.

The federal government was not the only ones following this “higher taxes” strategy. Most state-level sales taxes in the United States date from the Great Depression, with eleven states introducing their first sales tax in 1933.

In 1921, West Virginia became the first US state to enact a sales tax. Georgia passed legislation enacting a sales tax in 1929. Eleven other states enacted sales taxes in 1933. By 1940, at least 30 states had a sales tax.[3] Currently, 45 of the 50 U.S. states levy a sales and use tax against purchases. Alaska, Delaware, Montana, New Hampshire, and Oregon are the exceptions.[4]

Wikipedia on U.S. state sales tax history

Roosevelt continued along the same lines. In 1940, the federal government spent $9,468m, and the top income tax rate was 79%.

“Austerity” has a bad name among the Keynesian economists. For some reason, this is supposedly because of the shocking results of a dramatic decline in spending. However, as we have seen, there hardly ever is a dramatic decline in spending. Even if there was, I bet it wouldn’t be all that important. The overall effects of increased spending (“stimulus”) are tepid and weak, and thus the overall negative effects of a decline in spending are also likely to be relatively minor.

However, you can see why the idea that reducing spending would be catastrophic is popular among politicians, bureaucrats, public employees and corporate cronies. Thus, the economists who are willing to push this line are usually in high demand, and heck why not give them a Nobel while we’re at it?

The problem with “austerity” of course is the tax hikes, not the spending cuts which didn’t really exist anyway (except for those government welfare programs and services which are often quite important in a recession). These tax hikes genuinely have a negative effect on the economy.

We’re even seeing these days some arguments that “stimulus” is self-financing, or that if the government stops its “stimulus” spending, the resulting economic contraction would be so great that tax revenues would decline and the defcit would be just as large as before. You just have to laugh at this silliness. It was the same baloney that was sold to Richard Nixon in 1971, as I write about in my book. It’s the same baloney that John Stuart Mill laughed about in 1830:

Among the mistakes which were most pernicious in their direct consequences, … was the immense importance attached to consumption. …  It is not necessary, in the present state of the science, to contest this doctrine in the most flagrantly absurd of its forms or of its applications. The utility of a large government expenditure, for the purpose of encouraging industry, is no longer maintained. Taxes are not now esteemed to be “like the dews of heaven, which return again in prolific showers.” It is no longer supposed that you benefit the producer by taking his money, provided you give it to him again in exchange for his goods. There is nothing which impresses a person of reflection with a stronger sense of the shallowness of the political reasonings of the last two centuries, than the general reception so long given to a doctrine which, if it proves anything, proves that the more you take from the pockets of the people to spend on your own pleasures, the richer they grow; that the man who steals money out of a shop, provided he expends it all again at the same shop, is a benefactor to the tradesman whom he robs, and that the same operation, repeated sufficiently often, would make the tradesman’s fortune.

Actually, this principle applies not to spending, but to taxes. The effect of raising taxes is often — I would say typically — that the economy contracts, and tax revenues are no greater after the tax hike than they were before.

January 17, 2010: The Futility of Raising Taxes

Indeed, we see this in the case of Hoover as well. Total Federal tax revenue was $3,8623m in 1929 — with a top income tax rate of 25%. In 1931, it was $3,116m. Then came the “austerity” and tax hikes. In 1932, it was $1,924m and in 1933 it was $1,997m. Adjusting for the devaluation of the dollar from $20.67/oz. to $35/oz. in 1933, tax revenues did not return to their 1929 levels until 1938, with much higher tax rates and a moribund economy.

“Austerity” usually hurts. Important government services are slashed mercilessly exactly when they are needed most (but not the income of the political insiders). Then come the big tax hikes, and the resulting economic decline. Between the spending which doesn’t actually decline much, and the tax revenue which doesn’t actually increase much, the deficit is not actually improved much. Lots of pain without much gain.

This doesn’t remain popular for long. Pretty soon, someone suggests that we should postpone “austerity” until some future date when the economy is in better shape. Thus, the cycle turns back toward “stimulus.” Whatever minor spending cuts were imposed under “austerity” are reversed. However, the tax hikes remain — of that you can be certain. The next step is of course another round of government waste, most of which ends up in the pockets of the politicians, bureaucrats, public employees and corporate cronies.

And so the cycle continues, back and forth between “stimulus” and “austerity,” more spending and higher taxes, until the government comes to the brink of default.

At this point there is panic. “Stimulus” can no longer be justified. The government absolutely must bring its deficit under control, either to prevent default, or possibly as a result of default (you can’t run a deficit if nobody loans you money). Normally, at this point there is a double helping of “austerity.” Spending must be cut … but … it is so politically unpopular. (Even basket cases like Greece and California don’t seem to be able to do this.) Thus, taxes soar to stupid levels. Businesses see the trend, and go into bunker mode. Tax evasion soars and the economy comes to a standstill. This is the point at which political regimes fail, and the state may disintegrate, particularly if hyperinflation follows.

Just as large, meaningful Reagan-type tax cuts are almost never called “stimulus,” the big reductions in government spending and headcount are almost never called “austerity.” Margaret Thatcher undertook perhaps the most dramatic and successful slimming down of government of any major developed country. But this was never called “austerity.”

The way out of the “stimulus” and “austerity” cycle of disaster is a Reagan/Thatcher type strategy. Both aimed for smaller government (less spending), combined with lower taxes. Thatcher had quite a bit of success with her smaller-government efforts, while Reagan didn’t really accomplish much in the face of a Democrat-controlled Congress. (Actually, there was a trend toward less spending as a percentage of GDP which began around 1982 and continued to about 2000.)

May 9, 2010: The Two Santa Claus Theory

Both of these can be quite wonderful on their own terms, but they also work together in important ways. That’s why I recommend a similar strategy for Greece today.

May 2, 2010: Thoughts on Greece
February 14, 2010: The Problem with Greece

One of the reasons why Margaret Thatcher was so successful with her government-shrinking efforts was the popularity that came from her tax cuts. Immediately after her election in 1979, she lowered top income tax rates from 83% to 60%. By 1986, the top income tax rate was 40%, and the basic rate had fallen to 25%. Capital gains tax rates were reduced from 75% to 30%, and indexed to inflation. The corporate tax rate was reduced from 52% to 35%.

If you go the typical “austerity” route, you piss off everyone: public employees, beneficiaries of government programs, and taxpayers. Margaret Thatcher made sure she played Santa Claus at the same time:

May 9, 2010: The Two Santa Claus Theory

Second, it is much easier to slim down the government if the private economy is healthy and expanding. Imagine you are a bureaucrat or government employee. Do you want to get kicked out into an economy where experienced workers can’t find a job? No, you do everything you can to hold on to your desk and monthly paycheck. However, if employment is expanding, you are less likely to resist. Heck, it might be fun to be in the private sector. Likewise, government programs are easier to slim down when unemployment is low.

In the 1983 election, only 39% of British union members voted for the opposing Labor Party. Thatcher was popular. Just as Reagan was popular.

For now, governments seem stuck in the “stimulus”/”austerity” rut. They are running out of time. Already, much of Europe is on the edge of crisis, and the U.S. and Japan are not far off. One more round of “stimulus” in reaction to a downturn this autumn could bring them to the brink of default. Then comes the “austerity” and probably a big dose of “quantitative easing”/printing press finance. The ECB is already buying european government bonds on a regular basis, although this is “sterilized” through the sale of ECB financing bonds. (I haven’t quite worked out the likely outcome of this strategy.) Note how the ECB has more or less landed on this strategy by default, not through some extensive series of discussions or economic theorizing. The Fed is also widely suspected of participating in Treasury auctions anonymously. Both the dollar and euro are sinking against gold, as more and more people connect the dots as to where this may all lead.

So, where does it lead?

You couldn’t have been any worse off than Russia in 2000. After a decade of collapse and hyperinflation, and the disintegration of the Soviet Union, culminating in the default in 1998 and another round of currency collapse, Russia was on its back in 2000. The solution, as always, is a government that is lean and mean, with adequate services — possibly even new services, such as a universal healthcare system in the U.S. — but a minimum of wasteful spending. Plus low taxes. Plus a stable currency, which traditionally means a gold standard system. The recovery afterwards can be surprisingly quick. Russia did it recently, just as Germany and Japan did in the 1950s.

May 30, 2010: The Flat Tax in Russia
December 10, 2006: The Magic Formula

* * *

Russia Scraps Capital Gains Tax Hoping to Attract Investment: The BBC reports:

Russia will scrap capital gains tax on long-term direct investment from 2011, President Dmitry Medvedev has said. Mr Medvedev said that in terms of improving Russia’s investment climate “we, I hope, are moving forward”.

He also said the number of “strategic” firms, in which foreign investment is restricted and which cannot be privatised, would fall from 280 to 41. Mr Medvedev has been promoting the idea of “modernisation”, including diversifying the Russian economy.

Also, many investors have been wary of coming to Russia because of corruption and the dominant role the state plays in Russia’s business life. Mr Medvedev told the St Petersburg International Economic Forum that long-term direct investment was “necessary for modernisation”.

On their way to greatness.