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Duke Ai asked Yu Zo: "It has been a year of
famine and there are not enough revenues to run the state. What should I
do?"
Zo said: "Why can't you use a 10 percent
tax?"
The Duke answered: "I can't even get by on a 20
percent tax, how am I going to do it on 10 percent?
Zo said: "If the people have enough, what
prince can be in want? If the people are in want, how can the prince be
satisfied?"
Analects of Confucius (12:9)
The next president is going to have his hands full
with economic problems. It might even evolve into something like the Great
Depression -- although the characteristics of the present period are quite
different from that period. The defining characteristics of the Great
Depression were, first, an explosion of tariffs around the world, touched off
by the Smoot-Hawley Tariff in the United States, which put a 60% tariff on
just about everything. The second aspect was an explosion of domestic taxes,
such as Herbert Hoover's decision to raise the top income tax rate in the U.S. from 25%
to 63% in 1932. Roughly the same thing happened in Britain
and Germany
as well. The third aspect was currency devaluation, starting with Germany, Austria,
Britain
and Japan in the second half of 1931.
The defining characteristics of the present
situation are, of course, the housing bubble and the concurrent EZ-credit
bubble, both of which are bursting. This is taking place in an environment of
inflation, i.e. currency decline.
The Great Depression became what it was not because
of the starting conditions, but mostly because of bad decisions made along
the way. Japan didn't
mimic the U.S.
policies of higher taxes. The Japanese government kept tariffs low, didn't
raise taxes, and actually cut taxes in the mid-1930s. Although the Japanese
economy was affected by the events in the rest of the world, like everyone
else, statistics like industrial production actually show more growth during
the 1930s than during the 1920s, a time when the Japanese government was
raising taxes.
I said at the beginning that the primary problem
today is that of bank capitalization, and the natural response is government
recapitalization.
January 27, 2008: Crisis
Management
The government has been pressed down this path in
any case, and that will intensify as private sources of bank capital (the
sovereign wealth funds and the private equity guys) have apparently learned
their lesson. I am surprised they provided as much as they did. Government
recapitalization is a messy business, with many regrettable consequences. For
example, if the government nationalizes (or partially nationalizes) Bank of America or
Citigroup, but lets hundreds of smaller banks fail, that tends to exaggerate
the big banks' already substantial unfair advantage. It accelerates the trend
toward corporate giantism. It may provide spectacular opportunities for
"easy money" (basically taxpayer theft) for a handful of insiders.
But, on a broader basis, it's good to have a banking system, and a banking
system needs capital, and the only source of capital -- in the multi-hundred
billion size necessary -- is the government, so there it is. One could argue
that it would be worthwhile to let the "private market work it
out," but that is an experiment that would be potentially perilous to
undertake. One lesson from the Great Depression is don't let the banks fail,
and I tend to agree with this, at least as much as one can given the very
small experimental base.
OK, what else can you do? Recessions/Depressions are
the typical point at which there is a resurgence of "demand
economics." "Demand economics," or "demand-side
economics" is typically concerned with recession, where there is an
apparent "shortage of demand." I've already talked about how this
"demand" is really a reflection of productivity. It is not hard to
see how productivity (the ability of people to cooperate productively) was
impaired by tariffs and taxes during the Great Depression, with additional
monetary instability on top of that.
October 14, 2007: Say's Law
Thus, to avoid a Great Depression, the most
important thing is don't do anything stupid. In other words, if the
government can't do something that helps, it should at least avoid doing
something that makes the situation worse. The Great Depression became what it
was not because of the initial downturn in 1929-1930, but the government
policy reaction to that downturn. So, let's look at some of the things
potentially on the table. This is really a continuation of my discussion in
August:
August 5, 2008: Tax Cuts are the
Solution to Everything
The government typically affects the economy (and
life in general) by three avenues: spending, taxing, and regulating. Plus,
fooling with the currency. Let's look at the options:
Government spending up: There's nothing politicians like doing more than spending other
people's money, and a recession provides a great rationale for doing so. The
Japanese politicians never had much regret for the giant spending packages
they undertook in the 1990s. It was like politicians' Christmas every day.
Did it accomplish anything, besides radically indebting the Japanese state?
Government spending during a recession accomplishes roughly what government
spending does at all other times, which is generally not very much. However,
during recessions, there is a cry for welfare-type contributions from the
government. A government should probably provide something, to the degree it
is capable. This has already been institutionalized to some degree, as a
reaction to the Great Depression. Unemployment benefits, for example. Maybe
some sort of basic food provision. Even some public works projects, or a
public service corps, like a domestic Peace Corps. As a rule, however, governments
should avoid any spending which is undertaken primarily to tweak GDP
statistics. As is always the case, the government should aim for the most
benefit with the least cost. Beyond this welfare-type aspect, the government
isn't really capable of changing the overall economic situation all that much
via its spending plans. It is, however, capable of radically changing its own
financial situation, which can lead to all number of unpleasant outcomes.
Among worthy spending projects, I'd put a decent national
rail system on the top of the list, combined with major buildout of rail
systems in major cities. Whether for "peak oil" reasons, general
environmental reasons, or just general urban pleasantness reasons, trains are
by far the superior solution. We should have a train system at least as good
as that of France,
and why not a few steps better while we're at it.
Government spending down: Recessions are normally accompanied by a falloff in
tax revenue. This leads to big deficits, and typically a push to reduce
government spending as well. After all, households and corporations are
usually doing the same thing -- cutting out waste and focusing on their most
important goals. Typically, after a long boom, governments are rife with
waste, theft and parasitic hangers-on. The recession provides both the
rationale and the political will to clean out this sclerotic mess. Maybe that
means reducing government employee headcount. Maybe it means withdrawing from
expensive overseas wars.
Conclusion: Spending up and down together. In general, while I think welfare-type spending
should increase in a recession, and possibly that meaningful and worthwhile
projects such as public works, that would be undertaken anyway for their
specific merits, should be funded on an accelerated basis, it is also a grand
time to eliminate government waste. So, Good Spending Up, and Bad Spending
Down. All in all, I think this would lead to a reduction in spending on net.
The Good Spending projects should be temporary for the most part. No need to
create massive new permanent entitlements, when the government is going to
choke on its past entitlements anyway. I think there might be a place here
for the introduction of state-provided healthcare, if it is done in a
rational way -- in other words, in a way which reduces total healthcare
spending from its present super-bloated level (it is about 16% of GDP now,
which is an abomination, and is expected to rise to 20% of GDP in 2016), and
lowers it to about the level of other countries with a government healthcare
system (10.9% in Switzerland, 10.7% in Germany, 9.7% in Canada, and 9.5% in
France). In all seriousness, even 10% is probably way too high. About 6%
seems right.
Although I wasn't planning on talking about
medicine, let's think about it for a moment. What is Western Medicine good
for? It has accomplished two goals in spectacular fashion. The first is
infectious disease. Tuberculosis, syphilis, dysentery, cholera, polio,
influenza, typhus, malaria etc. used to be enormous problems. Today, they are
considered historical oddities. This has been due primarily to a more
sanitary living environment, with good water, good sewage, good trash collection,
regular bathing, etc. On top of that, there was a flurry of "miracle
drugs" in the middle 20th century, especially the antibiotics. Today,
you can resolve many of these diseases in about two weeks with $20 of generic
antibiotics. That's amazing.
The other great accomplishment has been in physical
trauma. Cuts, broken bones, and all the other results of unfortunate
accidents. Modern dentistry works great too, and doesn't seem to cost too
much.
If you think about it, these things could be
provided with very little cost today. Western Medicine has been so effective
against infectious disease that treating it is almost free. Physical trauma
is also rather rare, which also reflects a safer work environment and less
physically dangerous activity in general.
As for all the other maladies: diabetes, heart
disease, obesity and related conditions, cancer, depression, etc. etc.,
Western Medicine is almost totally impotent. But, they will provide some sort
of service and take all your money in payment, if you let them. Most can be
resolved with a better diet and exercise. Everybody knows this. Some, like
arteriosclerosis, can be resolved with cheap, non-invasive and well-known
techniques like EDTA chelation, which the heart-bypass surgeons are desperate
to keep under wraps. I think you could get 90% of the present advantage of
Western Medicine for about 10% of the cost. As far as infectious disease and
physical trauma go, even relatively poor countries like Cuba or Thailand have no great difficulty
providing adequate service for their populations. Think how stupid it is to
give 16% or 20% of GDP (of GDP!) to the medical industry and get virtually
nothing in return.
One of the reasons Roosevelt is remembered as being
successful today is not because he did much to address the difficulties at
the time (he raised taxes, devalued the currency, and spent some money on
welfare-type stuff), but because he instituted a number of programs that were
broadly desired before the Depression, and were beneficial afterwards. The 40
hour workweek. Social Security and unemployment insurance. Bank deposit
insurance. Regulation of banking and the securities market, and so forth.
Regulation up: Normally there is a flurry of regulation to prevent whatever is
perceived to be the problem from happening again. Often, this is a good
thing. Look at the stock market regulation that appeared in the 1930s for
example -- the requirement for independent accounting and public financial
statements for listed companies, or the limitations on mutual fund leverage.
For the most part, it has worked out fine. There will probably be some new
regulation regarding the banking system to come out of this episode, and that
probably wouldn't be a bad thing. It would be nice if the government didn't
take such a legalistic path, and that things were kept somewhat more
informal. For example, if the banking regulators, rather than having some set
of rules, were simply able to say to banks "OK guys, this is getting
silly. Time to back off these EZ-credit housing schemes." This is more
common in Asia. The Chinese government
simply says "not so many loans to commercial developers please,"
and it happens without having to gin up thousands of pages of legislation.
Not so much regulation as oversight, perhaps.
However, recessions can also result in all kinds of
unpleasant and even disastrous regulation as well. Historically, some of the
worst have been price-fixing programs. Rent control, for example, while
seeming to be a sort of welfare gift, can lead to incredible urban decay as
controlled rents no longer support investment or maintenance in residential
structures. Insta-slums. The combination of price-fixing and inflation can
result in a total collapse of the market economy, as it no longer becomes
worthwhile to provide a good or service at the regulated price.
Regulation down: Probably one could make a list of unproductive regulation. This could
be taken care of at any time, and there's no better time than during a
recession. If it's good for the economy in the long run, it's probably good
in the short run as well.
Conclusion: Regulation up and down together. Governments seem to be able to adjust their
regulatory environments reasonably well. That's why I rarely talk about it.
However, sometimes in a crisis, some very stupid things are done.
Price-fixing has been a big one historically, and all the other things which
tend to lead to a more centrally-planned environment. I don't think there is
the kind of support today for the nationalization of large sections of the
economy, such as Britain undertook in the 1930-1980 period.
With that said, I don't think that privatization of
traditionally government-provided services accomplishes much except the
possible enrichment of the buyer. Things like roadways, water utilities, a
postal service, etc. The government actually does a pretty good job here.
Taxes up: OK, here's one near to my heart. Don't raise taxes in a recession.
Even if you don't lower them, at least don't raise them. The expanding budget
deficits during recession, due to both falling tax revenues and the urge to
spend spend spend as a counter-recessionary tool, tends to lead governments
to raise taxes. This rarely generates any extra revenue, but it does cause
additional economic deterioration, with the result that the government is
asked to "do something" even more intensely. This "do
something" tends to translate into additional spending and currency
devaluation. The additional spending leads to more tax hikes. People forget
why Herbert Hoover thought it necessary to radically increase taxes in 1932.
It was at least in part because, in 1929-1931, he radically increased
spending as a counter-recessionary move, leading to huge deficits. Remember,
the secret is:
Low Taxes
Stable Money
We can see how recessions can lead politicians
toward higher taxes and currency devaluation, which is of
course totally contrary to the principle above, and the primary reason for
the Great Depression.
At present, there is a tendency toward higher taxes in
the U.S. Obama, likely to be the next president, is talking about much higher
capital gains tax rates, and higher payroll taxes. This would likely be
accompanied by a "phase out" of various Bush tax cuts, leading to
higher income taxes, higher dividend taxes, and higher inheritance taxes.
There is some talk about tax breaks for seniors, but I doubt it will make
much progress.
Taxes down: Cutting taxes in a recession takes vision -- vision which really
doesn't exist in the U.S. today. However, it has existed in the past.
President Kennedy did it. When he was elected, the U.S. was in a recession
with the unemployment rate reaching 7.1% in May 1961 and budget deficits
swelling. Kennedy planned a large tax cut, which was implemented after his
death, in 1964.
U.S. official unemployment rate, 1950-2008
Of course, Reagan's tax cut vision, from 1980, also
came in the midst of economic difficulties. I have many other successful
examples of governments that cut taxes in the midst of economic hardship in
my book. If the economic problem was caused, at least in part, by higher
taxes, then obviously lower taxes are the easy solution. However, even when
the problem may be caused by something else, like too much EZ-credit, a
significant tax cut is an effective way to deal with the problem. Indeed, I
might even say that it is the only effective, positive thing a
government can do. As you might have gathered from reading this far, neither
changes in spending nor changes in regulation tend to alter the course of
economic developments very much, unless there are really egregious problems
in those areas. George W. Bush, though much loathed (here too) for many other
things, nevertheless had the right idea when he cut taxes in 2003.
I hear that China's government is planning some tax
cuts in response to its recent slowdown.
Conclusion: Once in a while, a country gets a great leader, like Vladimir Putin in
Russia. In 2000, Putin explained a vision of 7%+ growth rates for many years,
which would put Russia back on its feet and return it to its traditional
place as a Great Power. At the time, this might have seemed ridiculous. The
Russian economy was a total disaster, and sustained 7%+ growth rates had been
unheard of for the previous 90 years. Putin had a strategy to go with this
vision however: lower taxes, specifically the 13% flat income tax but also
lower taxes for corporations and others, and a stable ruble. The strategy
worked, and nominal dollar growth rates did not only exceed 7%, they exceeded
20% for several years running. For a while there, the annual nominal increase
in average workers' salaries approached 30%! If leaders are not able to
muster this sort of vision, at the very least they should avoid doing anything
destructive, like raising taxes in a recession.
Currency devaluation: The government is asked to "do something!" about the
recession. Once the spending plans are in place, and if tax cuts are not
considered, then the next option is normally currency devaluation. This takes
many forms, with "lowering interest rates" the most common today.
The free market is perfectly capable of lowering interest rates on its own in
the face of recession. By the time Keynes started talking about "lowering
interest rates" in 1936, actual market interest rates were already at
rock-bottom levels, without Fed assistance. He was really talking, coyly,
about currency devaluation. Milton Friedman too, with all his blather about
the "money supply," was really talking about something like a
combination of bank recapitalization and currency devaluation. Keynes and
Friedman didn't exactly invent currency devaluation, however. It has been a
common tool of government since the eighth century BC, if not earlier.
Sometimes, economic problems are caused by currency
issues in the first instance. This was the case in the Asia Crisis of
1997-1998, and Japan's long period of monetary deflation in 1990-2004. For
these situations, the proper response is to fix the currency problem. If
currency issues are not the initial cause of the problems, as was the case in
the Great Depression, then it would be best not to cause new problems with
currency instability. Just keep the currency stable, and find other ways of
dealing with the problem.
Conclusion: What the Government can do. In a recession, the government usually makes things
worse by higher taxes and currency devaluation. If not
devaluation per se, at least some sort of monetary turmoil, such as the
super-high interest rate targets foisted on Asian governments by the IMF in
1997-1998. So, don't do those things. What's left? Some welfare-type spending
plans. Maybe some regulatory adjustments. And, tax cuts. You can't expect
instant results, but, if the government doesn't make things worse, typically
recessions will resolve themselves naturally over time. If there is a big tax
cut, then the following boom can be quite lovely.
The economist Alan Reynolds summed it up: Cut taxes
in a recession. Cut spending in a boom. This is consistent with Keynesian
"counter-recessionary" principles, and also the classical
principles I espouse here.
What is the U.S. doing now? I mentioned the trend
toward higher taxes in the U.S. This hasn't been too dramatic, but it is a
significant negative factor coming right when the existing factors -- housing
decline, financial issues, falloff in consumer spending, unemployment -- are
reaching their peak in 2009-2010. As for the monetary side, the Fed seems
committed to a Keynes-style "lower interest rates" strategy, which
has had the effect of causing a steady decline in currency value. I don't see
any reason why the government intervention over the last couple months, in
the forex and gold markets, should change that trend. We will probably get some
welfare-type spending from an Obama administration, which would be welcome.
This might be matched with a reduction in spending elsewhere, with the
military the most obvious candidate.The U.S. government has been somewhat
hesitant about recapitalizing the banking system. This is quite
understandable, but there is some risk of "systemic" issues if this
gets out of control.
There is concern about the overall level of debt
carried by the U.S. government, and whether the government will be able to
fund this debt, especially considering new burdens such as bank
recapitalization or the now-retiring Baby Boomers. If it turns out that there
is no alternative but to cut spending radically, then cut spending radically.
Don't raise taxes. When you raise taxes, you impair the ability of the
private market economy to function, which impairs the ability of the
private market economy to absorb the new available labor. The U.S.
military would probably do a better job with 50% of the present budget, since
the existence of the vastly oversized military today seems to prompt
unproductive foreign engagements. Something will have to be done about
Medicare entitlements, and this could be wrapped up into a broader health
care reform. The pork and corporate subsidy which forms much of the rest of
the Federal budget can be mostly eliminated. Indeed, to the extent that such
actions result in an intensification of recessionary conditions (a wave
unemployed former government workers and former defense contractor employees
for example), that is all the more reason to counteract such effects with a
tax cut.
Such is the ill-will generated by the recent
Republican administration, and all the various thievery and advantages gained
by the very-wealthy during this period, that a further Bush-style tax cut
does not seem very fashionable today. I would keep the existing Bush tax cuts
(keep capital gains, dividend, upper income tax and inheritance tax rates at
their present level), and add a big deduction for the lower incomes. Obama
has proposed making $50,000 of income tax-free for seniors. Why not extend
this to everyone? In time, this could morph into more like a Jack Kemp-style
flat tax, with a big basic deduction and a single flat rate of 20% or less.
In further time, the existing payroll taxes could be replaced with something
more like a 10% Federal sales tax, with the 20% flat income tax on higher
incomes, and some sort of basic public health care system. Pretty much
everyone would be better off with a system like this, and the U.S. economy would
thrive.
Nathan Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has
appeared on financial television in the United States, Japan, and the Middle
East. About the Book: Gold: The Once and Future Money (Wiley, 2007, ISBN:
978-0-470-04766-8, $27.95) is available at bookstores nationwide, from all
major online booksellers, and direct from the publisher at
www.wileyfinance.com or 800-225-5945. In Canada, call 800-567-4797.
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