The Coming Retrenchment

by Michael S. Rozeff
by Michael S. Rozeff

Downsizing is on its way. It’s going to happen, but we don’t know what forms it will take. Let wiser minds or prophets make those specific predictions. What we all can be certain of is that cutbacks and retrenchments lie not too far ahead for Americans. They will begin within a rather short time, say five to ten years.

There are ways to have the downsizing be highly beneficial in an overall sense, and there are ways for it to make us a lot worse off. It depends on what we choose to downsize.

No matter whether in the aggregate we make ourselves better off or shoot ourselves, somebody’s oxen will be gored. Whose oxen will be gored and how will the goring be done? No one knows. There are only so many possibilities. We may not be able to foresee which ones will happen, but we can map out the possibilities.

Why we’re in trouble

The reason for the downsizing is that the promises made by the Federal Government far exceed the money available to pay for those promises, based on current money flowing into the U.S. Treasury. The Feds are slated to pay out a lot more than they are now taking in, and the kind of growth we normally get in the economy won’t be great enough to increase the Federal Government’s usual share of the take to pay for all their promises.

Suppose you ran a business and promised every employee a bonus 5 years from now, a new house paid for by the company. Suppose a parent promised each child a bonus 5 years from now, a $500,000 fully paid for college education. But suppose that these are promises that couldn’t be kept under current circumstances because the business and the parent were not making enough money. There would have to be retrenchment at some point in some form falling upon someone.

Cash inflow has to equal cash outflow, or sources of money have to equal uses of money in a given period. If a family’s cash inflows are $50,000 in a year, that $50,000 will unavoidably flow into uses of the money. Maybe $5,000 is saved, $5,000 given away, and the remaining $40,000 spent. It will all be accounted for in one way or another.

If the family’s promised outflows next year suddenly become $100,000 and the inflows are still slated to be $50,000, something has to give. Either (1) the promises have to be cut back, or (2) the family has to earn more, or (3) the family has to steal from someone, or (4) the family has to borrow, or (5) the family has to sell off some of its existing assets. I ignore getting this much from charity.

This is not far from depicting the situation of the Federal Government. Its future promises far, far exceed its future income. These promises comprise every single item of federal spending, such as Social Security, Medicare, Medicaid, military spending, veterans’ pensions, debt and interest payments, etc. Its cash inflows come mainly from taxes, borrowing, and printing money with small amounts from other sources like fees and asset sales.

The Federal Government’s choices

Like the family, the government’s choices are few. It can cut back on its promises. Whose oxen might be gored, that is, who might find promises to them not being kept? Not creditors. The Feds will pay its legally obligated interest and debt payments. It has to if it doesn’t want to fail. The other promises depend on political clout. Social Security and Medicare benefits may, probably will, be cut back because that’s where big promises have been made. Military adventures overseas and the associated spending could and probably will be curtailed, especially as it becomes more and more evident that the money is being wasted. All depends on politics. But the odds are overwhelming that some promises made will be broken. The Federal Government is under no legal obligation to keep its non-debt promises. There are no entitlements it can’t alter. There will be heated debates. There will be acrimony. There will be wailing, kicking, and screaming. In the end, there will be cutbacks in promised payments.

The next two alternatives for a family were to earn more or to steal. The Federal Government doesn’t earn very much money. Forget that. Mostly it steals, that is, collects taxes. It’s good at stealing and the machinery is in place. It will be tempted to increase taxes while maintaining some of its promises, and it will probably succumb to this temptation. If it does, the downsizing that will occur will be in the income of taxpayers. They will feel pain, more pain than they currently feel. In addition, by raising taxes while maintaining its programs, there will be a bigger drag on the economy. Capital accumulation will decline and future income will decline because of that effect. So economic growth will also be downsized if taxes are raised to pay for government spending, other things equal.

Next, a family could borrow. If it did, it would have to pay it back with interest. That would cut into what it could spend later on. The retrenchment would be delayed or spread over the future. The same goes for the Feds. If they borrow in order to keep their promises, they’ll have to pay it back later. They can do that mainly through future taxes, which will have to be raised. That reduces the spendable income of Americans in the future. Borrowing is tantamount to raising taxes. Borrowing causes retrenchment in the income of Americans. Furthermore, whatever is spent on keeping the promises tends to be money not spent on things like capital accumulation. That’s another factor making for lower future income.

How much people can borrow depends on their ability to repay in the future. For the Feds, its ability depends on being able to collect taxes. That depends on the tax system, on the amount of income that can be taxed, and the politics of levying taxes. The U.S. government has relatively few problems mechanically collecting taxes. It’s already collecting taxes at high rates and raising them is likely to face political resistance. Yet the chances are that it can and will raise taxes. It can squeeze Americans more. Therefore, it will be able to borrow more. But it may face rising costs of borrowing as its capacity to tax runs up against limits, and it surely cannot borrow the huge amounts required to keep all its promises. Borrowing may rise, but it won’t get the Feds off the hook.

The government can do something a family cannot. It can counterfeit. It can print up green pieces of paper and spend them. It does this in a roundabout way by issuing debt. The lenders try to protect themselves against being paid back with depreciated pieces of paper by charging higher interest rates. Many others of us lack such protection. We suffer the effects of an unanticipated inflation. The complex inflation process acts like a tax, an inflation tax. Like any other tax and like government borrowing, it results in downsizing of the incomes of Americans. While this raises some money, it doesn’t raise all that much. This is a secondary source of funds. Inflation will continue, but it probably won’t be used as the main means to fund promises. That’s my guess, and others disagree. I believe that if too much inflation occurs, it defeats the Feds’ purposes because then interest rates on their debts rise steeply. This increases their cash outflows, which works opposite to what they want. This effect motivates them not to let inflation become too severe.

The next possible way to fund promises is by selling off assets. Few people talk about this, but this is where big money might be. The Federal Government has assets that it can sell. It owns a tremendous amount of land. But realistically it would have to sell off the land slowly over long periods of time and this would probably not solve its problem. Undeveloped land in remote locations doesn’t always bring in much money. Where there is really big money is in our assets, yours and mine. The Feds will work overtime trying to figure out ways to lay their hands on our asset holdings.

Immigration might be a way for the Federal Government to alleviate its cash flow discrepancy for a while. If enough new, young, and productive people settle in the U.S., they will generate taxes that could pay for some of the promises. However, if one does the math, this source of funds cannot pay for more than a small fraction of the promises. Later on, if the promises were maintained at current levels, this Ponzi scheme would collapse.

The Federal Government and the country will most likely muddle through with a combination of higher taxes, higher borrowing, cutbacks in promises, and greater inflation. If so, we will see income, promises, capital accumulation, and the value of the dollar all downsized.

There are better ways

There are better ways to downsize, ones that result in higher incomes for Americans. Higher incomes will result when rates of capital accumulation rise. This will happen when taxes and tax rates are lowered. But lowering taxes while keeping government spending and future promises at the same or rising levels is futile. That just means that borrowing has to be raised, which entails future taxes. The better path has to involve first and foremost lowering government spending and promises. These then enable tax cuts to occur without there being offsetting borrowing that nullifies the tax cuts.

To get rid of the ill effects of inflation, which are many and varied and also discourage capital accumulation and accumulation in appropriate forms, the monetary system of the U.S. needs to be completely and radically altered by eliminating the Federal Reserve System, fractional reserve banking, and the Federal Government’s role in money. The beneficial way to downsize is the downsizing of the government’s control over money, its money monopoly.

To unlock the potential for economic growth, the economy needs to be thoroughly and completely deregulated. The beneficial downsizing here is the elimination of the vast numbers of laws and regulations that affect almost every market under the sun, everything from trade restrictions to words printed on toys.

America will have to retrench in a few short years. Its only choice is how to retrench. If it downsizes government and government spending, including existing government promises, then incomes can rise. Every bit by which it downsizes government programs and promises contributes to income increases. They won’t have to be downsized if cutbacks in government occur. They will increase. In the limit, downsizing government to nothing, that is, removing its monopolies over a wide range of activities, can not only prevent the retrenchment in American incomes that lies directly ahead but lead to a revival of income growth at rates not seen in a hundred years.

If, on the other hand, America decides to keep its excessive promises, then it will be forced to fund them through higher taxes, higher borrowing and eventual taxes, and higher inflation. Incomes will stagnate and decline. Capital accumulation will suffer. Income growth will suffer. If America increases its excessive promises, such as by creating prescription drug benefits and by creating never-ending wars, then the retrenchments in incomes and income growth will be exacerbated even more.

Conclusion

Which path are we currently on? We are on the path of lower incomes and income growth. Congress and the Executive branches are irresponsible. Their irresponsibility reflects the greed and ignorance of American voters at large as well as a malfunctioning political system whose incentives are geared toward more and more spending and more and more promises.

The American State is on a path toward its demise. It should not be replaced by another such State. In my opinion, it shouldn’t be replaced by any State at all. And the worst thing that could happen would be for the country to turn to ever more centralization and dictatorship to solve the problems that lie ahead. It can happen here. It is far better to downsize the State than upsize it.

There now exists a growing and cogent body of thought about what went wrong with this State and why it went wrong. There exists a body of knowledge concerning the ideas of market anarchism and free markets. It suggests that it is impossible to create and keep a limited State and foolhardy to try. We have guidance on how to do better, which is end the State’s monopolies and thus end the State. Given the path we are on, we need to alter direction radically to get on a beneficial path. Continuing on as we are now, with business as usual, we will eventually have a chance to do better when the State collapses. It will take a great deal of many things such as luck, knowledge, initiative, will, and goodwill, to pull off a bloodless Second American Revolution that does not repeat the errors of the first. Let us pray that this can be done.

July 28, 2006

Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.

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