Duke Ai asked Yu Zo: "It has been a year of famine and there are not enough revenues to run the state. What should I do?"
Zo said: "Why can't you use a 10 percent tax?"
The Duke answered: "I can't even get by on a 20 percent tax, how am I going to do it on 10 percent?
Zo said: "If the people have enough, what prince can be in want? If the people are in want, how can the prince be satisfied?"
Analects of Confucius (12:9)
The next president is going to have his hands full with economic problems. It might even evolve into something like the Great Depression – although the characteristics of the present period are quite different from that period. The defining characteristics of the Great Depression were, first, an explosion of tariffs around the world, touched off by the Smoot-Hawley Tariff in the United States, which put a 60% tariff on just about everything. The second aspect was an explosion of domestic taxes, such as Herbert Hoover's decision to raise the top income tax rate in the U.S. from 25% to 63% in 1932. Roughly the same thing happened in Britain and Germany as well. The third aspect was currency devaluation, starting with Germany, Austria, Britain, and Japan in the second half of 1931.
The defining characteristics of the present situation are, of course, the housing bubble and the concurrent EZ-credit bubble, both of which are bursting. This is taking place in an environment of inflation – i.e., currency decline.
The Great Depression became what it was not because of the starting conditions, but mostly because of bad decisions made along the way. Japan didn't mimic the U.S. policies of higher taxes. The Japanese government kept tariffs low, didn't raise taxes, and actually cut taxes in the mid-1930s. Although the Japanese economy was affected by the events in the rest of the world, like everyone else, statistics like industrial production actually show more growth during the 1930s than during the 1920s, a time when the Japanese government was raising taxes.
I said at the beginning that the primary problem today is that of bank capitalization, and the natural response is government recapitalization.
The government has been pressed down this path in any case, and that will intensify as private sources of bank capital (the sovereign wealth funds and the private equity guys) have apparently learned their lesson. I am surprised they provided as much as they did. Government recapitalization is a messy business, with many regrettable consequences. For example, if the government nationalizes (or partially nationalizes) Bank of America (NYSE: BAC, Stock Forum) or Citigroup (NYSE: C, Stock Forum), but lets hundreds of smaller banks fail, that tends to exaggerate the big banks' already substantial unfair advantage. It accelerates the trend toward corporate giantism. It may provide spectacular opportunities for "easy money" (basically taxpayer theft) for a handful of insiders. But, on a broader basis, it's good to have a banking system, and a banking system needs capital, and the only source of capital – in the multi-hundred-billion size necessary – is the government, so there it is. One could argue that it would be worthwhile to let the "private market work it out," but that is an experiment that would be potentially perilous to undertake. One lesson from the Great Depression is don't let the banks fail, and I tend to agree with this, at least as much as one can given the very small experimental base.
OK, what else can you do? Recessions/depressions are the typical point at which there is a resurgence of "demand economics." "Demand economics," or "demand-side economics," is typically concerned with recession, where there is an apparent "shortage of demand." I've already talked about how this "demand" is really a reflection of productivity. It is not hard to see how productivity (the ability of people to cooperate productively) was impaired by tariffs and taxes during the Great Depression, with additional monetary instability on top of that.
Thus, to avoid a Great Depression, the most important thing is don't do anything stupid. In other words, if the government can't do something that helps, it should at least avoid doing something that makes the situation worse. The Great Depression became what it was, not because of the initial downturn in 1929-1930, but because of the government policy reaction to that downturn. So, let's look at some of the things potentially on the table. This is really a continuation of my discussion in August: Tax cuts are the solution to everything.
The government typically affects the economy (and life in general) by three avenues: spending, taxing, and regulating. Plus, fooling with the currency. Let's look at the options:
Government spending up: There's nothing politicians like doing more than spend other people's money, and a recession provides a great rationale for doing so. The Japanese politicians never had much regret for the giant spending packages they undertook in the 1990s. It was like politicians' Christmas every day. Did it accomplish anything, besides radically indebting the Japanese state? Government spending during a recession accomplishes roughly what government spending does at all other times, which is generally not very much. However, during recessions, there is a cry for welfare-type contributions from the government. A government should probably provide something, to the degree it is capable. This has already been institutionalized to some degree, as a reaction to the Great Depression. Unemployment benefits, for example. Maybe some sort of basic food provision. Even some public works projects, or a public service corps, like a domestic Peace Corps. As a rule, however, governments should avoid any spending that is undertaken primarily to tweak GDP statistics. As is always the case, the government should aim for the most benefit with the least cost. Beyond this welfare-type aspect, the government isn't really capable of changing the overall economic situation all that much via its spending plans. It is, however, capable of radically changing its own financial situation, which can lead to all number of unpleasant outcomes.
Among worthy spending projects, I'd put a decent national rail system on the top of the list, combined with major buildout of rail systems in major cities. Whether for "peak oil" reasons, general environmental reasons, or just general urban pleasantness reasons, trains are by far the superior solution. We should have a train system at least as good as that of France, and why not a few steps better while we're at it.
Government spending down: Recessions are normally accompanied by a falloff in tax revenue. This leads to big deficits, and typically a push to reduce government spending as well. After all, households and corporations are usually doing the same thing – cutting out waste and focusing on their most important goals. Typically, after a long boom, governments are rife with waste, theft, and parasitic hangers-on. The recession provides both the rationale and the political will to clean out this sclerotic mess. Maybe that means reducing government employee headcount. Maybe it means withdrawing from expensive overseas wars.
Conclusion: Spending up and down together. In general, while I think welfare-type spending should increase in a recession, and possibly that meaningful and worthwhile projects such as public works, that would be undertaken anyway for their specific merits, should be funded on an accelerated basis, it is also a grand time to eliminate government waste. So, Good Spending Up and Bad Spending Down. All in all, I think this would lead to a reduction in spending on net. The Good Spending projects should be temporary for the most part. No need to create massive new permanent entitlements, when the government is going to choke on its past entitlements anyway. I think there might be a place here for the introduction of state-provided healthcare, if it is done in a rational way – in other words, in a way which reduces total healthcare spending from its present super-bloated level (it is about 16% of GDP now, which is an abomination, and is expected to rise to 20% of GDP in 2016), and lowers it to about the level of other countries with a government healthcare system (10.9% in Switzerland, 10.7% in Germany, 9.7% in Canada, and 9.5% in France). In all seriousness, even 10% is probably way too high. About 6% seems right.
Although I wasn't planning on talking about medicine, let's think about it for a moment. What is Western medicine good for? It has accomplished two goals in spectacular fashion. The first is infectious disease. Tuberculosis, syphilis, dysentery, cholera, polio, influenza, typhus, malaria, etc. used to be enormous problems. Today, they are considered historical oddities. This has been due primarily to a more sanitary living environment, with good water, good sewage, good trash collection, regular bathing, etc. On top of that, there was a flurry of "miracle drugs" in the middle 20th century, especially the antibiotics. Today, you can resolve many of these diseases in about two weeks with $20 of generic antibiotics. That's amazing.
The other great accomplishment has been in physical trauma. Cuts, broken bones, and all the other results of unfortunate accidents. Modern dentistry works great too, and doesn't seem to cost too much.
If you think about it, these things could be provided with very little cost today. Western medicine has been so effective against infectious disease that treating it is almost free. Physical trauma is also rather rare, which also reflects a safer work environment and less physically dangerous activity in general.
As for all the other maladies: diabetes, heart disease, obesity and related conditions, cancer, depression, etc., etc., Western medicine is almost totally impotent. But, they will provide some sort of service and take all your money in payment, if you let them. Most can be resolved with a better diet and exercise. Everybody knows this. Some, like arteriosclerosis, can be resolved with cheap, non-invasive, and well-known techniques like EDTA chelation, which the heart-bypass surgeons are desperate to keep under wraps. I think you could get 90% of the present advantage of Western medicine for about 10% of the cost. As far as infectious disease and physical trauma go, even relatively poor countries like Cuba or Thailand have no great difficulty providing adequate service for their populations. Think how stupid it is to give 16% or 20% of GDP (of GDP!) to the medical industry and get virtually nothing in return.
One of the reasons Roosevelt is remembered as being successful today is not because he did much to address the difficulties at the time (he raised taxes, devalued the currency, and spent some money on welfare-type stuff), but because he instituted a number of programs that were broadly desired before the Depression and were beneficial afterwards. The 40-hour workweek. Social Security and unemployment insurance. Bank deposit insurance. Regulation of banking and the securities market, and so forth.
Regulation up: Normally there is a flurry of regulation to prevent whatever is perceived to be the problem from happening again. Often, this is a good thing. Look at the stock market regulation that appeared in the 1930s for example – the requirement for independent accounting and public financial statements for listed companies, or the limitations on mutual fund leverage. For the most part, it has worked out fine. There will probably be some new regulation regarding the banking system to come out of this episode, and that probably wouldn't be a bad thing. It would be nice if the government didn't take such a legalistic path, and that things were kept somewhat more informal. For example, if the banking regulators, rather than having some set of rules, were simply able to say to banks, "OK guys, this is getting silly. Time to back off these EZ-credit housing schemes." This is more common in Asia. The Chinese government simply says, "Not so many loans to commercial developers please," and it happens without having to gin up thousands of pages of legislation. Not so much regulation as oversight, perhaps.
However, recessions can also result in all kinds of unpleasant and even disastrous regulation as well. Historically, some of the worst have been price-fixing programs. Rent control, for example, while seeming to be a sort of welfare gift, can lead to incredible urban decay as controlled rents no longer support investment or maintenance in residential structures. Insta-slums. The combination of price-fixing and inflation can result in a total collapse of the market economy, as it no longer becomes worthwhile to provide a good or service at the regulated price.
Regulation down: Probably one could make a list of unproductive regulation. This could be taken care of at any time, and there's no better time than during a recession. If it's good for the economy in the long run, it's probably good in the short run as well.
Conclusion: Regulation up and down together. Governments seem to be able to adjust their regulatory environments reasonably well. That's why I rarely talk about it. However, sometimes in a crisis, some very stupid things are done. Price-fixing has been a big one historically, and all the other things which tend to lead to a more centrally planned environment. I don't think there is the kind of support today for the nationalization of large sections of the economy, such as Britain undertook in the 1930-1980 period.
With that said, I don't think that privatization of traditionally government-provided services accomplishes much except the possible enrichment of the buyer. Things like roadways, water utilities, a postal service, etc. The government actually does a pretty good job here.
Taxes up: OK, here's one near to my heart. Don't raise taxes in a recession. Even if you don't lower them, at least don't raise them. The expanding budget deficits during recession, due to both falling tax revenues and the urge to spend spend spend as a counter-recessionary tool, tends to lead governments to raise taxes. This rarely generates any extra revenue, but it does cause additional economic deterioration, with the result that the government is asked to "do something" even more intensely. This "do something" tends to translate into additional spending and currency devaluation. The additional spending leads to more tax hikes. People forget why Herbert Hoover thought it necessary to radically increase taxes in 1932. It was at least in part because, in 1929-1931, he radically increased spending as a counter-recessionary move, leading to huge deficits. Remember, the secret is:
Low taxes
Stable money
We can see how recessions can lead politicians toward higher taxes and currency devaluation, which is of course totally contrary to the principle above, and the primary reason for the Great Depression.
At present, there is a tendency toward higher taxes in the United States. Obama, likely to be the next president, is talking about much higher capital gains tax rates and higher payroll taxes. This would likely be accompanied by a "phase out" of various Bush tax cuts, leading to higher income taxes, higher dividend taxes, and higher inheritance taxes. There is some talk about tax breaks for seniors, but I doubt it will make much progress.
Taxes down: Cutting taxes in a recession takes vision – vision which really doesn't exist in the U.S. today. However, it has existed in the past. President Kennedy did it. When he was elected, the U.S. was in a recession with the unemployment rate reaching 7.1% in May 1961 and budget deficits swelling. Kennedy planned a large tax cut, which was implemented after his death, in 1964.
U.S. official unemployment rate, 1950-2008.
Of course, Reagan's tax cut vision, from 1980, also came in the midst of economic difficulties. I have many other successful examples of governments that cut taxes in the midst of economic hardship in my book. If the economic problem was caused, at least in part, by higher taxes, then obviously lower taxes are the easy solution. However, even when the problem may be caused by something else, like too much EZ-credit, a significant tax cut is an effective way to deal with the problem. Indeed, I might even say that it is the only effective, positive thing a government can do. As you might have gathered from reading this far, neither changes in spending nor changes in regulation tend to alter the course of economic developments very much, unless there are really egregious problems in those areas. George W. Bush, though much loathed (here too) for many other things, nevertheless had the right idea when he cut taxes in 2003.
I hear that China's government is planning some tax cuts in response to its recent slowdown.
Conclusion: Once in a while, a country gets a great leader, like Vladimir Putin in Russia. In 2000, Putin explained a vision of 7%+ growth rates for many years, which would put Russia back on its feet and return it to its traditional place as a Great Power. At the time, this might have seemed ridiculous. The Russian economy was a total disaster, and sustained 7%+ growth rates had been unheard of for the previous 90 years. Putin had a strategy to go with this vision, however: lower taxes, specifically the 13% flat income tax but also lower taxes for corporations and others, and a stable ruble. The strategy worked, and nominal dollar growth rates not only exceeded 7%, they exceeded 20% for several years running. For a while there, the annual nominal increase in average workers' salaries approached 30%! If leaders are not able to muster this sort of vision, at the very least they should avoid doing anything destructive, like raising taxes in a recession.
Currency devaluation: The government is asked to "do something!" about the recession. Once the spending plans are in place, and if tax cuts are not considered, then the next option is normally currency devaluation. This takes many forms, with "lowering interest rates" the most common today. The free market is perfectly capable of lowering interest rates on its own in the face of recession. By the time Keynes started talking about "lowering interest rates" in 1936, actual market interest rates were already at rock-bottom levels, without Fed assistance. He was really talking, coyly, about currency devaluation. Milton Friedman too, with all his blather about the "money supply," was really talking about something like a combination of bank recapitalization and currency devaluation. Keynes and Friedman didn't exactly invent currency devaluation, however. It has been a common tool of government since the eighth century BC, if not earlier.
Sometimes, economic problems are caused by currency issues in the first instance. This was the case in the Asia Crisis of 1997-1998, and Japan's long period of monetary deflation in 1990-2004. For these situations, the proper response is to fix the currency problem. If currency issues are not the initial cause of the problems, as was the case in the Great Depression, then it would be best not to cause new problems with currency instability. Just keep the currency stable, and find other ways of dealing with the problem.
Conclusion: What the government can do. In a recession, the government usually makes things worse by higher taxes and currency devaluation. If not devaluation per se, at least some sort of monetary turmoil, such as the super-high interest rate targets foisted on Asian governments by the IMF in 1997-1998. So, don't do those things. What's left? Some welfare-type spending plans. Maybe some regulatory adjustments. And, tax cuts. You can't expect instant results, but, if the government doesn't make things worse, typically recessions will resolve themselves naturally over time. If there is a big tax cut, then the following boom can be quite lovely.
The economist Alan Reynolds summed it up: Cut taxes in a recession. Cut spending in a boom. This is consistent with Keynesian "counter-recessionary" principles, and also the classical principles I espouse here.
What is the U.S. doing now? I mentioned the trend toward higher taxes in the United States. This hasn't been too dramatic, but it is a significant negative factor coming right when the existing factors – housing decline, financial issues, falloff in consumer spending, unemployment – are reaching their peak in 2009-2010. As for the monetary side, the Fed seems committed to a Keynes-style "lower interest rates" strategy, which has had the effect of causing a steady decline in currency value. I don't see any reason why the government intervention over the last couple months, in the forex and gold markets, should change that trend. We will probably get some welfare-type spending from an Obama administration, which would be welcome. This might be matched with a reduction in spending elsewhere, with the military the most obvious candidate. The U.S. government has been somewhat hesitant about recapitalizing the banking system. This is quite understandable, but there is some risk of "systemic" issues if this gets out of control.
There is concern about the overall level of debt carried by the U.S. government, and whether the government will be able to fund this debt, especially considering new burdens such as bank recapitalization or the now-retiring baby boomers. If it turns out that there is no alternative but to cut spending radically, then cut spending radically. Don't raise taxes. When you raise taxes, you impair the ability of the private market economy to function, which impairs the ability of the private market economy to absorb the new available labor. The U.S. military would probably do a better job with 50% of the present budget, since the existence of the vastly oversized military today seems to prompt unproductive foreign engagements. Something will have to be done about Medicare entitlements, and this could be wrapped up into a broader healthcare reform. The pork and corporate subsidy which forms much of the rest of the federal budget can be mostly eliminated. Indeed, to the extent that such actions result in an intensification of recessionary conditions (a wave of unemployed former government workers and former defense contractor employees for example), that is all the more reason to counteract such effects with a tax cut.
Such is the ill-will generated by the recent Republican administration, and all the various thievery and advantages gained by the very wealthy during this period, that a further Bush-style tax cut does not seem very fashionable today. I would keep the existing Bush tax cuts (keep capital gains, dividend, upper income tax, and inheritance tax rates at their present level) and add a big deduction for the lower incomes. Obama has proposed making $50,000 of income tax-free for seniors. Why not extend this to everyone? In time, this could morph into more like a Jack Kemp-style flat tax, with a big basic deduction and a single flat rate of 20% or less. In further time, the existing payroll taxes could be replaced with something more like a 10% federal sales tax, with the 20% flat income tax on higher incomes, and some sort of basic public healthcare system. Pretty much everyone would be better off with a system like this, and the U.S. economy would thrive.