Economic Foolishness:
Listening to a business news show the other day, I heard a rather shocking comment by a guest whose byline was “Senior Economist” for the channel. This guest stated, and appeared to genuinely believe, that when the government hires a worker the income tax from that worker will increase net revenues to the government!
I was stunned and incredulous to hear such a ludicrous statement, which seems to me simply ignorant of economic reality and market operation, especially coming as it did from a supposed “Senior Economist.” How is it possible that such foolishness can pass for economic wisdom?
Aggregate Demand – The Keynesian “Knob”
The trouble with many so-called economic experts today is that they have drunk the “Kool-Aid” of Keynesian theory; a principle tenet of which is that measurement and manipulation of “aggregate demand” is the key to understanding and manipulating the economy. This seems inevitably to create a myopic focus on “spending” with too little regard for the source of the funds, or understanding of the target of the spending. Their logic is roughly equivalent to the foolish consumer who tries to feel better by running up their VISA credit card balance in a frenzied “buying spree,” and when the VISA bill comes, pretends to pay off the VISA by charging it to their MasterCard.
The Market is not the Keynesian’s Personal Toy!
The other major myopia from the Keynesians is to see markets as inanimate objects that they can mold freely without unintended consequences. They look at a sector of the market with $X flowing through it and think if they impose a tax of Y% they will receive $XY in new revenue. But markets are the aggregate of rational decisions by living breathing people who react to the changing economic climate around them. With a Y% negative impact on that activity they will generally look for other alternatives, perhaps not immediately, but ultimately.
The net effect, at some level of taxation, is a crippling of the economy in three ways; first they remove some of the profits which would otherwise find their way back into the economy at nearly a 100% rate of deployment, second, they cause a reduction in the activity which they taxed with its capital diverted to a use which is not as efficient as the initial use, and third, they create an environment of uncertainty which causes all businesses and investors to hesitate to put any capital to work which they can hoard or shelter for the rainy day which seems likely in light of ever larger government budget deficits.
Money vs Capital
Not all capital is “created equal.” When the government spends money, that spending can never represent increased wealth in the economy because it must come from the economy first and then the government usually burns up 50% to 70% of it in bureaucratic waste. The “government credit card” only has three sources of money, it either takes the funds out of the economy in taxes, or by inflationary devaluation of everyone’s dollars through expansion of the printed money supply, or by soaking up bond capital which otherwise would be available to invest in the private sector. There is no government “capital” tree; they can print dollars, but not wealth. The U.S. economy is worth precisely its net productive output just like the net profits of a company. The dollar’s value is just like the value of a share of stock in a company, if you print more stock, each share of stock is worth less.
Fiat Currency
The U.S. Dollar today is not backed by gold or any other “hard currency,” it represents literally the “full faith and credit of the United States.” The value of the dollar floats in relation to the value of the total U.S. economy. As our GDP increases, a given quantity of dollars in circulation become worth a larger share of that GDP. Conversely when the GDP shrinks, with the quantity of dollars in circulation held constant, each dollar becomes worth less. Of course, the government can print these pieces of paper at any rate they choose; ink and paper are relatively cheap. Since this simple relationship exists between the value of money and the GDP, increasing the supply of money has no effect on total wealth, but only the value of each dollar. If the government prints enough dollars to insure that the supply in circulation keeps pace with the growth of the national GDP, each dollar will “hold its value.” If they print too many dollars, each dollar will decline in value.
There is a “parlor trick” here that the government can use to its benefit. When the government first spends newly printed dollars which grow the money supply, these dollars are worth what they were before the new money supply expansion. It is only after the expanded circulation reaches a new value-equilibrium that the reduction in value is felt by others in the economy. Other things may also cause a delay in the inflationary effect of an expanded money supply; if widespread uncertainty causes people to hoard dollars, or turn them into illiquid assets like gold or other hard currency, taking money out of circulation, the existing dollar value equilibrium may not immediately exhibit any effect. As the uncertainty fades, and the hoarded savings is flushed back into circulation, it will create a sudden spike of inflationary devaluation.
The potential benefit of hard currency like gold is its relative stability. The supply of gold generally grows somewhat slowly, so those participating in the market know with a degree of confidence what their currency is worth. A responsible government can achieve the same effect with fiat money (printed dollars) by maintaining the circulating supply of dollars in relative balance with the growth of the nation’s GDP, but the temptation for government is to use their printing press as a personal money tree for government bureaucrats to enhance their political power.
The “Spender of Last Resort”?
With the Keynesian single-minded focus on “aggregate demand” as the economic control of choice, when the economy is in decline, they will often say that the government must become “the spender of last resort;” with a focus on “spending” as the key to growth and recovery in an ailing economy. The director of the Fed recently said, with regard to small business hiring and growth:
"Too slow a response on the small business side is one of the reasons that job creation is not as quick as we would like it to be, and I think it is important to try to remove the barriers and impediments for small business to expand. [With regard to tax policy], I agree that we want to make tax policy as small business friendly as possible to provide the right incentives to give them the opportunities to invest and hire; beyond that though, I think for them to do that, first they need demand, they need sales so we need to keep the economy growing, and the Federal Reserve is doing its part by maintaining supportive monetary policy, and we also need to be sure they get credit.” [bold emphasis added]Keynesian theory places a myopic focus on “aggregate demand” as both the surest indicator of economic conditions, and the panacea “knob to turn” to fix all that ails the economy. An economy is a closed system of countless interactions between supply and demand. You can always reach into this closed system and measure how things are going at any point in the cycle, and meddling with the system at various points will indeed produce effects on the system. In a closed system, any element may be viewed as both a cause and an effect; aggregate demand is just one of these cause/effect twins in the system. But there is a fundamental problem with the classic Keynesian exclusive focus on aggregate demand.
Ben Bernanke – June 9, 2010
Creative Innovation: The Engine of Wealth Creation
The great strength of a capitalist economy is the creative invention that it fosters. Command economies have always failed utterly to compete with free-market capitalism, because they are failures at creative innovation. A focus on government spending to create “aggregate demand” can only focus on demand for yesterday’s “supply.” You cannot create an iPod by stimulating aggregate demand, nor a Ford Model T, a personal computer, or a cell phone. All innovations in the market are the result of creative deployment of excess capital to create a new kind of supply that has never before existed. Innovation leads to new supply for which there was no measureable demand before that innovation hits the market. The best possible antidote to a severely depressed market would be a flood of new products and market innovations which in turn creates its own expanded aggregate demand. Expanded aggregate demand is the effect of creative innovation-driven growth in the economy, not its cause.
Attempts to “steer” the market by direct artificial injections of aggregate demand cannot stimulate innovation, but can only create temporary, artificial, ultimately unsupportable demand for existing production. This stimulation of what would otherwise be excess demand sends the market off in a direction it would not go on its own, so when this artificial stimulus is removed, the market inevitably flounders again. We have seen this quite clearly recently in both the housing and automotive markets. Any attempt to steer the economy into recovery through government spending is akin to steering a car while looking in the rear view mirror; if you focus on where you’ve been you will surely end up off in the weeds somewhere. Free market economies thrive on creative destruction; old markets are constantly being replaced by new innovations. Command economies fail because they stifle the creative innovation that can only be discovered through market freedom.
Economic Capital, or Political Capital?
With due respect to Chairman Bernanke and the Keynesians, they could not be more wrong about what the economy needs to grow. The creative innovation for a startup business cannot begin with demand and sales, it must first begin with readily available excess capital to invest. But what Chairman Bernanke calls “supportive monetary policy” soaks up vast amounts of this excess capital, and then some. The first round of “stimulus spending” is never enough, because it cannot lead to real organic growth of the economy. It always leads to call for additional rounds of even more “stimulus spending” by the government. One might think that even dullard government bureaucrats might begin to question the wisdom of their policy, except that direct government spending is a political drug which produces the heady intoxication of increased political power. The very thing the Keynesians do to stimulate the economy, direct government spending to expand aggregate demand, starves the creative innovation in an economy by soaking up excess capital, but it can be very effective at buying votes.
To Stimulate the Economy, Stimulate Creative Innovation
What is needed when the market is depressed, are injections of excess capital in the hands of private investors across the entire economy to allow new innovations to come to the market. Government simply cannot create these through direct investment, because no one knows where the next iPod or Model T will come from, until the free market discovers it. In all the recorded history of economic activity, an examination of all the innovation which came from direct government design (?) is dwarfed in comparison to the creative innovations of individual entrepreneurs who created products and services for which there was no pre-existing aggregate demand.
There are really only two ways the government can stimulate the economy today. The best approach overwhelmingly is to dramatically cut the size, scope, and cost of government. Every conservative politician in the modern era needs to be aggressively running on this platform. It is consistent with the founding principles of constitutionally limited government which made America great, and the only responsible course going forward. The second best way to stimulate the economy is large reductions in taxes across the board. This still raises deficits, like excessive spending, but unlike spending, it actually reduces bureaucratic waste and it allows the market to pick winners and losers. If accompanied by wholesale re-vamping of our entire tax structure toward a dramatically flatter, fairer, and simpler tax system, it will reduce uncertainty in the market. Ideally, all of these things should be pursued together. The reason these work is that they can place vast new capital resources in the hands of entrepreneurs in the private sector to pursue creative innovation.
Startup businesses in particular cannot rely on bank loans. A true startup business cannot qualify for small business loans, they depend on the broader private capital market for investments of personal capital and friends-and-family investments. This private capital and the small startup businesses that depend on it, look at the brutish, clumsy government spending which has taken center stage, and rightly stand in the wings until this “oafish bully of big government” will get out of the way and give the market “stage” back to the “artists of free market creative innovation.”
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