Should Government Try To Extend Booms Indefinitely?

by William L. Anderson

Recently by William L. Anderson: Does the Drug War Make Prosecutors Vulnerable?

In 1981, David A. Stockman, a former Michigan congressman turned budget director for President Ronald Reagan, gave a series of interviews to socialist William Greider who subsequently published an article in The Atlantic entitled, "The Education of David Stockman." The article portrayed someone who had come into the administration hopeful that the free-spending ways of the 1960s and 70s would be ended and that the U.S. Government would embrace fiscal sanity, but had become disillusioned by the whole process.

Because the U.S. economy at the time was mired in a deep recession, and because Stockman was not singing the same happy tune that everyone in the Reagan administration was supposed to be voicing, the article effectively destroyed Stockman's career in the Republican Party. Democrats seized on comments such as Stockman's description of the Kemp-Roth tax cuts as "trickle-down" to push their own agenda of high marginal tax rates and more government spending, while Republicans accused Stockman of being disloyal to his boss.

Democrats and many Republicans, aghast at the double-digit unemployment rates and the rise of interest rates into double-digits as well (home mortgages were at about 15 percent – if one could qualify for one at all), called for the Federal Reserve System under Chairman Paul Volcker to reflate the money supply, and Democrats called for a return of the 70 percent top rates. To his credit, Volcker withstood the pressure, although Reagan repaid him by appointing the "flexible" Alan Greenspan in his place in 1987. Two major financial bubbles later, Greenspan has his legacy.

In the interview, Stockman did not lament lower tax rates and certainly was not repudiating free markets, as Democrats and Republican critics were claiming, but rather was noting the fact that after Republicans managed to cut the top tax rate from 70 percent to 50 percent, the party no longer was interested in cutting the federal budget. Part of the reason, one should add, was that even small cuts first proposed by Stockman when the administration trotted out its first budget in 1981, were savaged in the media and by just about everyone else in the political establishment and most Republicans ran for cover rather than spending political capital to stop funding Big Bird.

Ultimately, Stockman left the administration and went to Wall Street, where he would gain yet another education in the annals of crony capitalism. He disappeared politically, but has reappeared in the form of a new book, The Great Deformation: The Corruption of Capitalism in America. The release of his book came simultaneously with his lengthy New York Times op-ed in which he laid out the failures of America's failed experiment in fascism, or "crony capitalism."

Not surprisingly, the book has faced a savage response from those who either support the political status quo or who believe that state-supported enterprise somehow is going to defy all the odds and lead the U.S. economy into glorious prosperity, and no one has been more vociferous in his denunciation of Stockman than Paul Krugman. Because Stockman essentially has cast his lot with the Austrians School of Economics, Krugman's anger has turned white-hot, the equivalent of Nebuchadnezzar's order to heat the furnace seven times hotter than usual.

Because Stockman's book covers a wide range of subjects, I would like to zero in on his view – one that Krugman hotly disputes – that when an economic boom crashes, the proper response of government and the monetary authorities is to restore sound money and not try to prop up enterprises that failed in the crash. Krugman's recent article, "The Urge to Purge," does what Krugman usually does: create an Austrian straw man and then supposedly "demolish" the false argument with Keynesian wisdom.

The Austrian argument about how to respond to a bust that follows a failed boom is laid out well by Murray N. Rothbard:

If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more grueling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure. If, in fact, we list logically the various ways that government could hamper market adjustment, we will find that we have precisely listed the favorite “anti-depression” arsenal of government policy. Thus, here are the ways the adjustment process can be hobbled:

  1. Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.
  2. Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government “easy money” policy prevents the market’s return to the necessary higher interest rates.
  3. Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.
  4. Keep prices up. Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.
  5. Stimulate consumption and discourage saving. We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further. Government can encourage consumption by “food stamp plans” and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds would have been saved and invested; all of the government funds are consumed. Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.
  6. Subsidize unemployment. Any subsidization of unemployment (via unemployment “insurance,” relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.

Keynesians like Krugman endorse every one of those six "remedies" in hopes that the reflating of the boom ultimately will allow the economy to gain what Krugman calls "traction" in order to put the economy back on track. Krugman writes:

When the Great Depression struck, many influential people argued that the government shouldn't even try to limit the damage. According to Herbert Hoover, Andrew Mellon, his Treasury secretary, urged him to "Liquidate labor, liquidate stocks, liquidate the farmers. … It will purge the rottenness out of the system." Don't try to hasten recovery, warned the famous economist Joseph Schumpeter, because "artificial stimulus leaves part of the work of depressions undone."

Like many economists, I used to quote these past luminaries with a certain smugness. After all, modern macroeconomics had shown how wrong they were, and we wouldn't repeat the mistakes of the 1930s, would we?

How naïve we were. It turns out that the urge to purge u2014 the urge to see depression as a necessary and somehow even desirable punishment for past sins, while inveighing against any attempt to mitigate suffering u2014 is as strong as ever. Indeed, Mellonism is everywhere these days. Turn on CNBC or read an op-ed page, and the odds are that you won't see someone arguing that the federal government and the Federal Reserve are doing too little to fight mass unemployment. Instead, you're much more likely to encounter an alleged expert ranting about the evils of budget deficits and money creation, and denouncing Keynesian economics as the root of all evil.

Krugman then turns his rant toward Stockman:

But the Mellonites just keep coming. The latest example is David Stockman, Ronald Reagan's first budget director, who has just published a mammoth screed titled "The Great Deformation."

His book doesn't have much new to say. Although Mr. Stockman's willingness to criticize some Republicans and praise some Democrats has garnered him a reputation as an iconoclast, his analysis is pretty much standard liquidationism, with a strong goldbug streak. We've been doomed to disaster, he asserts, ever since F.D.R. took us off the gold standard and introduced deposit insurance. Everything since has been a series of "sprees" (his favorite word): spending sprees, consumption sprees, debt sprees, and above all money-printing sprees. If disaster was somehow avoided for 70-plus years, it was thanks to a series of lucky accidents.

The problem with the U.S. economy, Krugman argues, is that the government is not borrowing and spending enough and that the Federal Reserve System is too timid when it comes to new money creation:

…like so many in his camp, Mr. Stockman misunderstands the meaning of rising debt. Yes, total debt in the U.S. economy, public and private combined, has risen dramatically relative to G.D.P. No, this doesn't mean that we as a nation have been living far beyond our means, and must drastically tighten our belts. While we have run up a significant foreign debt (although not as big as many imagine), the rise in debt overwhelmingly represents Americans borrowing from other Americans, which doesn't make the nation as a whole any poorer, and doesn't require that we collectively spend less. In fact, the biggest problem created by all this debt is that it's keeping the economy depressed by causing us collectively to spend too little, with debtors forced to cut back while creditors see no reason to spend more.

To solve the problems, Krugman argues, the government should re-create what essentially was a regulated banking cartel that existed before Jimmy Carter and a Democratic Congress essentially deregulated much of the banking system. Contrary to Krugman's assertion that this was part of the "Reagan Revolution," it was a response to the development of alternative financial entities like money market funds which were causing depositors to take their money from the banking cartel. It also was a response to alternative methods of financing new high-technology ventures that the banking cartel would not touch, with Michael Milken leading the way. (The cartel got its revenge a decade later by destroying Milken's career and having him wrongfully imprisoned.)

Contra Krugman, ideology had almost nothing to do with so-called banking deregulation, and it was politics-laden from the beginning, as one might expect and as Stockman found out when he became a point man for the Reaganites. Krugman's "solutions" to the current crisis continue:

So what should we be doing? By all means, let's restore the kind of effective financial regulation that, in the years before the Reagan revolution, helped deter excessive leverage. But that's about preventing the next crisis. To deal with the crisis that's already here, we need monetary and fiscal stimulus, to induce those who aren't too deeply indebted to spend more while the debtors are cutting back.

But that prescription is, of course, anathema to Mellonites, who wrongly see it as more of the same policies that got us into this trap. And that, in turn, tells you why liquidationism is such a destructive doctrine: by turning our problems into a morality play of sin and retribution, it helps condemn us to a deeper and longer slump.

The bad news is that sin sells. Although the Mellonites have, as I said, been wrong about everything, the notion of macroeconomics as morality play has a visceral appeal that's hard to fight. Disguise it with a bit of political cross-dressing, and even liberals can fall for it.

But they shouldn't. Mellon was dead wrong in the 1930s, and his avatars are dead wrong today. Unemployment, not excessive money printing, is what ails us now u2014 and policy should be doing more, not less.

In other words, Stockman and the Austrians are not following any kind of sound economic theory, but rather are engaging in metaphysical views about boom and bust. The excesses of the boom essentially are seen as the sins of Mardi gras, while the bust is akin to an economic Lent. The revelers should be punished for drinking too much, according to Krugman's view of the Austrians.

However, the Austrians argue – if one uses the hangover analogy – that Krugman is demanding a "solution" akin to "hair of the dog." The bust, say the Austrians, has not occurred because of a lack of "aggregate demand," but happens because the resources and capital that were malinvested during the boom no longer can be sustained, and that to pour new resources into propping them up robs entrepreneurs of the opportunities to find ways to take resources from lower-valued to higher-valued uses. Far from urging punishment upon individuals hurt by the recession, Austrians argue that government should not block the recovery because so doing unnecessarily prolongs the economic misery.

Krugman and the Keynesians retort with what they see as their trump card: interest rates are at record lows, so the problem is not that an economic "hair of the dog" policy is "crowding out" economic entrepreneurs, but rather that the economy is mired in a "liquidity trap" or a giant Nash Equilibrium from which no one can move unless the government acts with more spending. The problem is not that entrepreneurs are starved for resources and capital – there is plenty of money available to borrow – but that "aggregate demand" is so suppressed that entrepreneurs are not willing to take the necessary risks because the chance of failure is so great, and because reams of borrowed money really create no debt problems – "We owe it to ourselves" – the consumption party can go on indefinitely if only government would borrow even more.

Current space does not permit a full reply in this article to the Keynesian point regarding interest rates (Rothbard has his own rebuttal of "liquidity trap" doctrines), but I believe one needs to zero in on the heart of that argument: during a recession, the Law of Scarcity essentially is repealed. The presence of idle resources and unborrowed money trumps scarcity; abundance, not scarcity, is the problem.

Further examination of the Keynesian argument demonstrates that Krugman and others believe that demand for goods flows from money itself, and the more money that is made available to people, the more demand will follow. If you demand it, they will build. In the meantime, printing money allows governments to pretend to be prosperous when, in fact, scarcity has not been repealed and massive new government spending, be it financed through taxation, borrowing, or money printing, is not stimulating entrepreneurial investment, but rather suppressing it.

The current state of interest rates is not a market phenomenon, as the Keynesians want us to believe, but rather a combination of the Fed creating huge new monetary reserves and government policies suppressing entrepreneurial acquisition of resources. Moreover, as Austrians have noted, government is not promoting true entrepreneurial investment; it is promoting consumption.

On the fiscal side, both federal and state government have enacted so many restrictions on entrepreneurs that many of them find it useless to try to create new products in this country. Why bother? Success will be "rewarded" by government harassment, criminal investigations, and more denunciations of "the rich" by politicians and the media. Instead, we see taxpayers forced to give up their own wealth in order to finance crony capitalist adventures like "green energy" and production of corn-based ethanol, little of which would consumers actually purchase if given a free choice.

In short, the Law of Scarcity always stands. Investments that rode the boom and crash during the bust have done so because they actually were malinvestments and to try to recreate them after the bust is utter foolishness. Yet, that is what Krugman and the Keynesians are insisting that the government do, and anyone who disagrees does so, according to them, because that person loves watching other people suffer for supposed economic "sins."

Thus, Keynesians in the end are reduced to name-calling and wild denunciations of character. David Stockman cannot possibly be right, they argue. He is a nut case, a "wacko," a "kook." Why? Because he and the Austrians believe that government cannot circumvent the Law of Scarcity through fiat and when government insists on trying to do just that, economic conditions deteriorate. Keynesians and Krugman refuse to listen, and they always will refuse, but that does not mean the Austrians are wrong.

Keynesians always will appeal to the media and political classes. They preach what essentially is an economics with no risk and no need to give up short-term desires for long-term gain. It is an "eat, drink, and be merry" economics, except that the acts of eating, drinking, and making merriment really are what create prosperity in the first place.