Another nail in Keynes' coffin...

The great thing about math is that numbers don’t lie. Even if assumptions are overly optimistic or pessimistic, the resulting equation will remain mathematically true. This is the case when analyzing deficit spending and the validity of Keynesian economics, which we’ve discussed previously is on its death bed. Simply put, the math doesn't add up.

There is an interesting analysis that was just released which debunks the claim that "in a recession, government spending (read: deficit spending) is necessary to stave off a deep recession."

Let's start with the conclusion:

The federal government cannot create prosperity by spending funds that it does not have. It can, however, spend us into poverty by taking dollar balances from highly productive individuals and their business entities, through borrowing or taxing. This process of transferring these assets from income and wealth generators to other government applications has profound economic consequences.

The proponents of Keyneisan economics (and deficit spending) must hold these two important factors to be true: 1) the expenditure multiplier (which we discuss here) is greater than 1.00; and 2) increased government spending will not crowd out private business (and growth). If either point #1 or #2 are untrue, the rationale for deficit spending, at least within the confines of a capitalist system, would be intellectually dishonest and merely partisan (see our commentary on Romer later).

Point #1 begins with the notion that massive deficit spending increases the overall economic pie. That is, for every $1 of deficit spending, GDP increases by more than $1. In the last 10 years the deficit as a percentage of GDP has increased from 18.4% to 24.7%. Howevr, during that same time period,

"[t]he percent of the population working today is 58.6% while prior to the large budget deficit spending of the last ten years it was 64.6%. Our GDP was growing at 4.8% ten years ago, and today we are staggering out of recession."

The same holds true for Japan.

"Its government debt soared from 52% of GDP in 1989 to 184% today...GDP in that country is no higher than it was 18 years ago; its employment is no higher than it was 19 years ago, and there is no inflation since consumer prices are at 1993 levels."

How is this possible? It's quite simple really. Government expenditures must come from taxing or borrowing. Period. In both cases, as the analysis points out, resources are shifted from one sector of the economy to another which doesn't expand the economic pie, but merely its composition. There are historical examples where the government expenditure multiplier was 0 (that is, for every $1 of government spending, private spending decreases by a $1) and there are also examples of the multiplier being greater than 0 but less than 1. As the report illustrates,

"during the extraordinary conditions of World War II and the Korean War the multiplier has been calculated as 0.6, meaning that a $1 rise in government spending would lift the economy as a whole by 60 cents while reducing private spending by 40 cents." 

In an additional study, the conclusion was the multiplier was 1.1. Eliminating the 0 reading, the average is 0.85. Remember that number.

Point #2 simplistically holds that access to capital (in the fungible and economic sense) and the incentive to acquire / spend such capital remains unchanged in the face of increased deficit spending. However, as mentioned above, governments must tax or borrow in order to spend (which, in the event of massive borrowing will require additional taxes). The key is this:

Beginning January 1, 2011 the sizeable tax reductions enacted in 2001 and 2002 will expire. The administration projects that household taxes will rise by a cumulative $1.1 trillion over the ensuing ten year period, while business taxes will rise by $400 billion. This calculation was prior to any taxes enacted in the healthcare bill, and does not account for other taxes such as the recently mentioned value added tax suggested by administration policy advisors.

Like government spending, there is a tax multiplier, which seeks to answer the same question as the government multiplier, but in reverse. That is "an increase (decrease) in taxes will reduce (increase) GDP by how much?"

Dr. Barro estimates that the tax multiplier is minus 1.1, meaning that a $1 increase in taxes will reduce GDP by $1.10. However, Christina Romer, Chair of the Council of Economic Advisors and her husband David in an exhaustive study published in March 2007 found the tax multiplier to be –3.

If the tax multiplier is applied to the estimated increase in taxes, the drag on economic activity will be "between $1.65 trillion and $4.5 trillion."

So, if the government multiplier (the "revenue" portion of our equation) is 0.85 and the tax multiplier is roughly -2.1 (which is the "expense" portion of our equation) "then mathematically this country cannot spend its way to prosperity." That's because in an extremely overleveraged economy,

"monetary policy doesn’t work. Potential borrowers do not have the balance sheet capacity to take on more debt...Currently, borrowers are loaded with excess houses, office buildings, retail space, and plant capacity. No need exists to get even deeper in debt. Moreover, due to rising foreclosures and delinquencies, bank capital has been badly eroded and banks are not in a position to put more risk onto their balance sheets by lending to already over committed borrowers."

Book Review: In Our Hands

Today is the first of a multi-part series dedicated to the review / analysis of Charles Murray's book In Our Hands, which examines government redistribution plans and offers a new approach to social policy. In many ways, entitlement reform is the most important public policy issue facing Americans today and informed, non-partisan, and objective analysis is required. All options should be on the table.

According to the Dallas Federal Reserve, structural deficits inclusive of unfunded liabilities from Social Security and Medicare equates to roughly 700% of GDP (~$104 trilion compared to ~$14 trillion). It is estimated that “for financing future benefits without future tax increases, the United States and major European countries would be required to generate an annual present value surplus in the order of 8–10% of 2005 GDP over the period to 2050.” If those staggering numbers don't have you convinced, considering the following: if the United States freezes relative age-related spending as a % of GDP at projected 2011 levels, in the year 2040 it is estimated that debt/GDP would still be a staggering 200% (blue line). If it does nothing, debt/GDP will be in excess of 400% (red line), and if it reduces funding by 1% for five years starting in 2012 debt/GDP will be 300% (green line). France, Ireland and the UK are the only other countries where freezing age-related benefits will not reduce debt/GDP under any of the three scenarios...

Source: BIS

  

Estimates vary and depending on assumptions can produce fairly different results. However, what is undebatable is the severeity of the crisis and the implications of doing nothing. Murray's book tries to tackle some of these very questions, and unlike most analyses, he presents an alternative.

There are two tenets upon which the social welfare state was founded: (1) resources are scarce; and (2) the government can allocate scarce resources efficiently. As Murray appropriately acknowledges, the first tenet was largely true for the first half of the 20th century, or at least up until the end of World War Two.

The indigent elderly depend on charity, so let the government provide everyone with a guaranteed pension. The unemployed husband and father cannot find a job, so let the government give him some useful work to do and pay him for it. Some people who are sick cannot afford to go to a private physician, so let the government pay for health care. It turned out not to be simple after all. The act of giving pensions increased the probability that people reached old age needing them. Governments had a hard time finding useful work for unemployed people and were ineffectual employers even when they did. The demand for medical care outstripped the supply. But, despite the complications, these were the easy tasks. Scandinavia and the Netherlands—small, ethnically homogeneous societies, with traditions of work, thrift, neighborliness, and social consensus—did them best.

The second tenet, while the outcomes are charitable in theory, has proven to be too rigid to adjust to modernity.

Traditions decay when the reality facing the new generation changes. The habit of thrift decays if there is no penalty for not saving. The work ethic decays if there is no penalty for not working. Neighborliness decays when neighbors are no longer needed. Social consensus decays with immigration. Even the easy tasks became hard as time went on.

The moral hazard carte-blanche entitlement programs have created over multiple decades has only exacerbated the fragile foundations of America’s entitlement society, and by the 1980s it was clear that government failed, resulting in a twisted irony of sorts. As throughout history, the welfare state, particularly in an open society as complex and vast as the United States, results in a multi-front war of negative feedback loops, eventually leading to the destruction of the policy, and potentially the State. The first thing to go is “the traditions of work, thrift, and neighborliness… [which] spawns social and economic problems it is powerless to solve leading to inevitable insolvency.”


In order to combat insolvency, which is already the case even if the political class doesn’t want to acknowledge it, Murray proposes the elimination of entitlement program payments to individuals which are to be replaced by a $10,000 per year cash payment to anyone over the age of 21. The concept draws on Milton Friedman’s “negative income tax” as proposed in the early 1960s to eradicate poverty which essentially gave a cash payment to those under the poverty line equal to the difference between their income and the aforementioned poverty level. The logic followed that the opportunity cost of a direct cash payment would be less over the long-run when compared to administrating a “complicated welfare system”. Simplistically, Murray’s Plan (as we’ll call it) adheres to the same logic.

The Plan has six major components.

1. Each citizen will be given a Passport (the same as used today when traveling) and will ensure program eligibility.


2. The $10,000 payment will be deposited electronically into a previously established bank account, as set-up by the individual.


3. Earned income up to $25,000 will not be taxed, with a 20% surtax levied on earned income between $25,000 - $50,000 (eg, [$30,000 - $25,000] * 20% = $1,000 tax) up to a maximum of $5,000.


4. There is no Marriage Penalty.


5. Payment should be indexed to either median personal income or inflation.


6. The elimination of most “transfer” payment programs (ie, Social Security, Medicare, etc).

This is merely an introduction and an overview of Murray’s first chapter. There are many questions that arise, particularly at first glance. It will be interesting to see how Murray handles the legal and political aspects of such a drastic overhaul. That said, it’s important to appreciate that Murray, rightly or wrongly, is approaching this debate from two perspectives: 1) government’s role is limited and should be focused on equality of opportunity, not equality of outcomes; and 2) “here’s the money. Use it as you see fit. Your life is in your hands”.

Link to PDF of entire book (or you can buy it for $20): http://www.aei.org/book/846