Rivera and Steele: You're Missing the Point

In keeping with my rule to blog only when my thought isn't yesterday's news, memo to Geraldo Rivera and Michael Steele:  your argument on whether to raise taxes on the "rich" completely misses the point.  (Some would say you're accepting their premise, but that's not my point, either.)

This isn't about philosophy; it's about economics.  Philosophically, we can argue all day about whether the "rich" can "afford" to pay more, and where the line should be drawn.  Wrong argument.  Cutting taxes on the middle class increases demand, because they'll spend the money (or so the theory goes).  Ditto for cutting taxes on the poor. (Oops, they don't pay income taxes.  Withdrawn.)  Cutting taxes on the "rich" increases investment.  And, no, I don't mean, "Let's go buy some stock."  I mean capital investment, as in, "I think I'll open that new store this year.  I think I'll buy that new machine this year.  I think I'll invest in Bob's new idea.  I hope there's labor available, because we'll need five more workers."

It's an old saw, but I really never have seen a poor person create a job.  You need "extra" money for capital investment--you have to pay your rent, pay your employees, pay yourself, and pay your taxes.  Then, if you have some income left over, you can expand--and create jobs.

Republicans haven't made this argument yet, but they need to.  When the President says, "We can't afford to give this money to the rich!" they need to cut them off with economics, not ideology.  The ideological response is, "Mr. President, it's not your money.  It's theirs.  You're not giving them anything; you're choosing not to take it.  Let's cut spending, instead."  Good answer, but not the winning one.  The correct, winning response is, "We can't afford not to.  Your idea, sir, is that government spending will create jobs.  We've tried that.  It failed (again).  The only way to create jobs is for the private sector to do it--and they can't do it if you take away their capital."

The Fallacy of Stimulus

Like many people, last year’s collapse of the financial system led me to take another look at the economics I learned in college. In earlier posts, I’ve mused about the notion that we’re all missing something—that there’s some subtlety that it takes a Keynes or a Krugman to figure out.

I’ve changed my mind. This plan is ridiculous, and it takes nothing more than common sense and experience to see that.

Over the last six months, the Obama administration and Congress have poured trillions into the economy in an attempt to avert more serious recession. The idea was that Roosevelt didn’t ‘spend enough, fast enough,’ and that was a major contributor to the Great Depression. My gut and my study of history told me that was wrong—it's pretty obvious that Roosevelt's tax policies prolonged the Great Depression, and only World War II pulled us out. Moreover, I’ve worked in government, and with government, so I was immediately suspicious of the concept of “shovel ready” projects. No one—no one—plans, designs, and approves a project knowing they don’t have money for it. Oh, sure, you can find the one exception, but even money says that “exception” is actually a project that was funded that lost its funding.

The crux of the problem came home last week when Vice President Biden made a comment that the government would have to reinvigorate its efforts to get the stimulus money spent—that only some $40 billion or so of the $787 billion authorized had actually been spent. For me, that was the alarm bell that finally made me realize all those (mostly conservative) pundits were right—most of this “stimulus” won’t be spent until 2010, well after it could do any good. In fact, it will be spent just in time to help with the 2010 elections, and if the incumbents are lucky, just before too much money in the system sparks inflation. (Although the President has a plan to curb inflation—he will be raising taxes in 2010, by letting the Bush tax cuts expire.)

The simple truth is that governments cannot spend billions extra in a matter of weeks. The system just doesn’t work that way. Even after the money is authorized by Congress, it takes months just to get it obligated on a contract. It takes more months to get it expended—and until it’s expended, it isn’t stimulating anything. And, while “months” is really, really fast when you’re building something, it’s far too slow to have any relevance to the business cycle.

I don’t know if the Keynesians just don’t understand the reality of bureaucracies, or if their faith in theory has simply blinded them to it. I do know that common sense tells me there are two ways to get money into the economy rapidly: 1) cut taxes, 2) hand out cash.

It has become popular to argue that this collapse has “proven” supply-side economics doesn’t work. I have yet to see anyone actually make that case with anything other than partisan talking points, and I don’t think they can. Instead, they rely on the populist argument that cutting income tax only helps the rich—because half of Americans pay no income tax at all. Um, okay—I thought we were talking economic stimulus? When did we switch to social policy? We can certainly have that discussion, but conflating the two issues suggests the redistributors have a not-so-hidden agenda.

But, if you’re worried about getting money into everyone’s hands, it isn’t just income tax that can be cut. Slash the corporate income tax, and 1) companies can cut prices; which 2) makes goods more affordable; which 3) increases demand; which 4) increases the need for labor. It isn’t just shareholders who benefit—everyone does. But, of course, that’s not popular to say in these populist times. (And shareholders benefiting just creates stimulus, too--because they either spend or invest their profit, and if they invest it, that just gives it to someone else to spend. Stimulus all around.)

This leads us to consider option two: handing out cash. That will certainly get money into everyone’s pockets, but there’s an obvious problem—for the 50% of Americans who pay no income tax, you’ve simply taken capital out of the system, because you have to borrow that money to pay them off. (And, please, spare me the argument that these folks pay Social Security taxes—they will get that back fivefold when they retire, and again, we aren't talking social policy here.) So, you may get a very short term stimulus from the demand, but you’re choking the engine that will ultimately create more jobs.

Finally, that brings us to the ultimate Keynesian argument—that deficit spending is okay in a recession, because the capital you’re borrowing isn’t being used, anyway. While that might be the case in some recessions, it certainly is not the case now—the major argument the populists are making against the banks is that they aren’t lending. Of course, they aren’t lending because they’re scared to death about what's next and what's really on their balance sheets, so they are keeping higher reserves. How, exactly, does government stripping those reserves out of the system improve confidence? It doesn’t, of course.

Which is why I am, just now, starting to worry about stagflation.

Economics and the Factors of Production

Happy New Year.

I’ve been pondering, recently, what to believe about the economy. Sadly, there aren’t many reporters with enough grasp of economics to provide much of use, and most economists seem more interested in their pet positions to actually look at what’s really going on and what the real root causes are.

So, I’ve been rereading my economics books, checking out analytic pieces on both sides, and doing a lot of thinking. A lot of thinking. And here’s what I’ve come up with.

From “Economics Explained,” I recall that there are only a few things you can really do with money: you can spend it, you can save it, or you can invest it. (I had forgotten that saving and investing have a different effect on the GDP when you’re talking about consumer activity.)

If you spend it, your purchase contributes to the GDP: you bought a product or service, and in the process, used some of the factors of production—labor, capital, and land.

If you save it, your purchase does NOT contribute to the GDP: you chose not to buy a product or service, and in the process, you freed up labor and capital to be used elsewhere—especially by businesses, who will borrow your savings from your bank and use them to buy equipment, start a new business, etc. That’s a good thing if there’s a demand for labor and capital, because by making some available for businesses, you are helping to prevent inflation. (Otherwise, business demand has to compete with your demand by bidding up labor prices, interest rates, etc.) That’s a bad thing if there is little demand for labor and capital, such as occurs in a recession. All you’ve done is decrease consumer demand, which decreases GDP. In a recession, businesses don’t want to borrow your money.

If you invest your money, most of us are really just buying business ownership rights (or a claim on business debt) from someone else, unless you got in on an IPO. What effect that has on the economy depends on what the person who sold you the stock (or bond) does with your money.

So, it follows that government transfer payments don’t contribute to GDP, but government spending on stuff does contribute. Naturally, the recipients of transfer payments will probably spend them and contribute to GDP, but that money came from somewhere. That “somewhere” has less money to spend, so the economic question is which group would’ve made a better contribution. That’s key question #1 to ask.

The second key question is what happens when the government spends more than it takes in. Proponents of government spending to jump-start the economy argue there is unused labor, so putting it to work builds useful stuff (e.g. bridges) and puts money in the hands of folks who will spend it, thereby increasing demand for goods and thus helping GDP. In a recession, the capital necessary to put the labor to work is just sitting around unused, since businesses aren’t borrowing it. That makes sense as far as it goes, but I see a couple problems. First, the debt must be repaid, so the future interest payments will steal capital for decades, creating a drag on economic growth. Second, if the program creates an entitlement, then the need for funds will stretch to doomsday, and so will the economic drag. Third, if the capital is borrowed from other countries, they can’t put it to use in their own economies and employ their own labor. That seems like a problem, but I haven’t resolved it, yet. Finally, the implicit assumption of government spending as stimulus is that both labor and capital are unused. In the current financial crisis, a major problem seems to be that businesses can't get capital.

The third key question, in light of today’s never-ending government bailouts, is what that is doing to the economic need for creative destruction. The buggy whip industry had to die, and bailouts would’ve just delayed the inevitable. On the other hand, I recall an interview with Richard Branson in which he pointed out that the bank his airline uses nearly failed—and when he went to move his business’s money, he was advised to read the fine print; it wasn’t that kind of an account. He would have been in serious trouble through no fault of his own and despite the fact that his company was a solid going concern. That has me pondering…