Reversing the Bush tax cuts

Paul Krugman, columnist for The New York Times, has written an op-ed piece (click here) arguing that the various Tax cuts that George Bush instigated will eventually come back and bite America, hard. I agree with him.

The US Republican party is heavily influenced by a number of economics and political philosophies that has guided them into making certain decisions - including the Bush tax cuts. Libertarianism, along with Economic Neoliberalism, sees the role of the government in the free market as a necessary evil, but one which must be continually reined back to prevent it from exercising too much influence within the marketplace. The tax cutting that Bush and Reagan have achieved is now seen as a long term way of achieving such a goal. Taxes are cut, and the resulting deficits are handled by spending cuts. This sort of activity is known as "Starve the Beast". Political opponents to such actions are easily dealt with by accusing them of wanting to raise taxes, and to spend lots of government money on inefficient and bloated services that cannot produce any meaningful outcomes because they are not part of the natural marketplace.

The problem is that such an activity, while politically astute, is economically stupid. A government cannot keep running huge deficits without affecting the marketplace significantly. The larger a government's debt is in relation to GDP, the harder it will be for creditors to justify lending it any money.

Imagine a person who spends far more than they earn. Eventually they no longer have the means to sustain such a lifestyle, so they have a choice - either cut their spending or borrow the money. Let's say that our spendthrift decides to borrow the money from his friends and family. When the time comes for him to pay back this money, he simply borrows more to pay off that debt. Now let's imagine that his friends and family - his creditors - choose not to stop their lending. Who is going to suffer? Certainly not our spendthrift. The ones who suffer are his creditors, for they will have less and less money to invest and spend on other things. In other words, their decisions are "crowded out" by their desire to lend to our spendthrift.

Now let's apply this to the macro. Our spendthrift is the government, who spends beyond what it receives in taxation. The creditors are the marketplace, the various banks and investment companies who make decisions about where to invest money. So long as the US government deficit continues to grow (the deficit being the amount of money borrowed to fill the gap between spending and income), the more it "crowds out" the investment choices of the marketplace. In other words, although the aim is to "Starve the beast" and to reduce the size of government, tax cuts and big deficits will always have a major influence upon market behaviour.

The most obvious effect is in market interest rates. The more the government wants to borrow, the more expensive borrowing becomes - and the higher the interest rates for all borrowers. The government is fine - it can borrow as much as it likes because of its size - but the rest of the marketplace suffers from higher interest rates.

"Ah ha", you might say "Aren't these deficits reduced by spending cuts?". Theoretically the answer is yes - spending cuts that match tax cuts will put things back into balance. In practice, however, this has never occurred. George W. Bush, especially, has not made any attempt to rein in government spending because he needs all the money he can to pay for the war on Iraq, as well as trying to stimulate economic activity.

Eventually, deficits will come back to bite nations. If we consider the reign of Bill Clinton, we can see that controlling government deficits can, over the long term, bring many economic benefits. From 1992-2000, Clinton, a Democrat, along with many Republicans in congress and the senate, worked together to erase the Reagan deficits. The result was an unprecedented period of economic growth.

But, of course, don't assume that I think that Clinton did it all. He didn't. I think he just happened to be the lucky guy in the White House at the time. And of course the economic growth that occurred alongside this deficit reducing period was shown to have feet of clay, as the 2001 recession showed. Nevertheless, it did have a positive impact upon the marketplace.

At this present moment in time, the US economy is heading for a huge fall. There is a growing Housing bubble in the US, and the value of the US dollar is only kept where it is by the kind activities of the Japanese and Chinese central banks. Moreover, there is a huge current account deficit that is over 5% of GDP. If the market corrects itself, the housing market will pop, the dollar will drop and you will find lots of people out of work. This situation will be made worse if the US government continues to run a budget deficit.

And through gritted teeth I admit that, for all the foibles and political butchery that typifies the Howard and Costello government in Australia, at least the budget is under control. Our housing market and current account are bad too, but at least we have built up some slack in the reduction of government debt.

From the Osostrian School Department.

© 2005 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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1 comment:

Mark said...