Wrecking an economic recovery

Amity Shlaes over at the Washington Post outlines five ways to wreck an economic recovery, based upon research into the Great Depression. They are:

1. Giving in to protectionism (ie putting up trade barriers to protect local industry)
   
2. Blaming the messenger (ie restrictions on share market activity that was erroneously seen as the cause of the problem)
3. Increasing taxes in a downturn
4. Assuming bigger government will bring back growth (ie New Deal public works programs)
5. Ignoring the cost of inconsistency (ie picking and choosing to rescue certain financial firms or backing the US dollar)
   

Some of these points are interesting and worthwhile. Some, however, I would disagree with.

The first is the assumption that markets function better than government at virtually every level when it comes to economic performance. In relation to the Great Depression, Shlaes exonerates the market almost completely in her article and places the blame squarely upon "perverse monetary policy" as the real cause of this economic downturn. In other words, the market was fine, but the government (as the Federal Reserve) was the real cause. While there is no doubt that monetary policy during the great depression was pretty awful, to assume that policy makers at the time had a credible option in lowering rates is to be anachronistic. The fact that the tight monetary policy at the time exacerbated the depression so intensely is now widely understood. What Shlaes forgets to mention is that an unsustainable explosion in business and personal debt in the years leading up to the 1929 stock market crash - a terrible failure in market behaviour - was a major cause as well. It seems reasonable to assume that, in the current case, the popping of the subprime bubble is a similar example of serious market failure.

The second assumption Shlaes makes is the implied belief that government fiscal policy should not interfere with the market's ability to "right itself". While I agree that the marketplace that is a national economy can and does have the ability to stabilise itself, arguing that the government should neither raise taxes nor increase spending is to argue that the government has no real role to play in the way an economy functions or how an economic recovery can be managed. The government is thus relegated to being some sort of strange entity that needs to be silenced so that money can talk. Of course, such an attitude can be quite typical of "small government" types but is less prevalent amongst mainstream economists and modern society.

John Maynard Keynes, one of the 20th century's most important economic thinkers, deduced that governments should counter market trends when it came to fiscal policy. In practice, this meant that whenever an economy contracted, government should increase its operations to the point where it was borrowing money to fund a deficit; conversely, whenever an economy expanded, government should decrease its operations and aim to run fiscal surpluses. Throughout the course of the business cycle (whereby the economy expanded and contracted) government fiscal policy should be essentially neutral so that deficit spending is balanced out by surpluses. Keynes, of course, came up with this policy as a result of his study into the great depression. So when Shlaes says that governments shouldn't expand their operations during a downturn, she is essentially at odds with Keynes.

When it comes to raising taxes, however, Shlaes is only partially correct. All things being equal, governments should not seek to increase tax rates during an economic downturn - a lesson that all industrial governments painfully learned from their great depression experience. Unfortunately, in the current case, all things are not equal. If it is true that governments should not raise taxes during recessions, then it stands to reason that governments should not lower taxes during economic expansions - yet that is precisely what George W. Bush and the congresses under him have managed to do. The result of this structural budget deficit is a dangerously growing level of public debt. The only way to rebalance this situation is for the government to run fiscal surpluses, which means that tax revenue must exceed expenditure. Raising taxes is one of doing this. Another way is to cut government spending (a process that would probably have the same economic effect as a tax rise - an economy contracting faster as a result of less government spending). Another way is a combination of the two. A fourth way - printing money and be damned - cannot be seriously considered.

The problem with this current economic downturn is that it has occurred during a period in which America's Federal government has been fiscally irresponsible. Thus any room that can be made for fiscal "pump priming" (Keynsian spending increases or tax cuts) is just not there. Interest paid on US public debt is already larger by far than NASA, the Department of Energy, the Department of Eduction, the Department of Agriculture and the Department of Veterans Affairs combined. Moreover, interest repayments are already rivalling defense expenditure. This massive fiscal black hole cannot be made bigger through tax cuts and spending increases without serious medium-long term consequences. National bankruptcy can never be declared - but the effects of a fiscally irresponsible government will be felt in increasing levels of private and personal bankruptcies and decreasing levels of economic growth.

Counter to Shlaes' warnings, I would argue that a repeal of many of Bush's tax cuts (especially upon the rich) along with a severe cut in defense spending (say a cut of between 10-20%) is absolutely essential if public finances are to be rebuilt over the medium-long term. Without a sudden turnaround in the US Economy (a process which would lead to higher levels of tax revenue), government debt will continue to increase.

Of course, raising taxes and cutting defense spending will have a negative effect upon the economy. Nevertheless I believe that to not address America's fiscal shortcomings will have an even worse effect upon the economy and be far more damaging.

Sadly, however, I can't see much evidence that Bush, Congress or even Obama and McCain are concerned about this situation. While the Republicans are pretty much the party that got America into this fiscal nightmare (most of the current deficit resulted from decisions made between 2000 and 2006 when congress was more or less controlled by the GOP) I am not confident that Democrats have the testicular fortitude to solve the problem and make the changes necessary to return public finances to a more sustainable position (especially considering the post-2006 congress which is more or less run by Democrats who could have actually done something about it).

Then again, are we surprised that politicians make wrong decisions? No. But why can't it be different?