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An Analysis of Production and Consumption Based Economic Stimulants

Economics / Economic Stimulus Aug 19, 2009 - 09:10 AM GMT

By: Fred_Buzzeo

Economics

Diamond Rated - Best Financial Markets Analysis ArticleFred Buzzeo writes: A Double Shot of Espresso ?

When I begin to feel sluggish and low on energy, I stop by the local café and order a shot of a true, time-tested stimulant- a double espresso. Within minutes, I begin to feel energized and ready to move full speed ahead. So it seems that an economic stimulant might not be such a bad idea- especially for a sluggish economy or one on the verge of collapse.


But what type of stimulant do we employ to perk-up a lethargic economy?  Do we use a true, time-tested stimulant brewed by individuals pursuing their aspirations in the market place, or do we use a government-induced, synthetic stimulant that will result in the misallocation of resources and a further erosion of our economic and social well-being? The choice is obvious if we dismiss the political rhetoric and allow successful outcome to be our guide.

I should like to point out that stimulation would not be necessary if the market were left to operate unhampered. Such a market would be driven by individuals seeking their best interest and would produce a constant movement toward equilibrium. An adherence to free market principles would go a long way towards eliminating the drastic mode swings of an artificially induced expansion.

Unfortunately, politicians, acting in their own self-interest or through the looking glass of a flawed ideology, seldom allow the free market to operate. Instead they interfere through excessive regulation and through the manipulation of monetary and fiscal policy. As we are seeing today, a favorite fiscal policy tool of the political crowd is the stimulation of “aggregate demand.” The results of their actions are the drastic mode swings of the business cycle- usually ending in a recession requiring, according to the same politicians, a stimulus to “rescue” the economy

Production or Consumption

Throughout most of economic history, the path to growth has been viewed through an increase in the productive capacity of a nation. Jean- Baptiste Say has stated this case most succinctly. He writes:  

“In a community, city, province, or nation that produces abundantly, and adds every moment to the sum of its product, almost all of the branches of commerce, manufacture, and generally of industry, yield handsome profits, because the demand is great, and because there is always a large quantity of products in the market, ready to bid for new productive services. And , vice-versa, whenever, by reasons of the blunders of the nation or its government, production is stationary, or does not keep pace with consumption, the demand gradually declines, the value of the product is less than the charges of its production; no productive exertion is rewarded; profits and wages decrease; the employment of capital becomes less advantageous and more hazardous; it is consumed piecemeal, not through extravagance, but through necessity, and because the sources of capital have dried up.”

The essence of Say’s argument, referred to as Say’s Law, is that an increase in productive capacity will create employment and naturally increase the demand for products in general. An increase in production, therefore, is the key to a true economic stimulant that will result in job creation, greater consumer demand, and a higher standard of living.

Empirical evidence supports the course of action stated above. Each time that an increase in productive capacity was encouraged, the economy expanded and jobs were created. Such “supply side” stimulation has generally taken the form of tax cuts. The success of tax cuts rests on the simple notion of putting money back in the hands of individuals and businesses- those entities that can use the money in the most efficient ways. High tax rates discourage work effort, savings and investment, and promote tax evasion.

JFK and the Tax Cuts of 1964

In 1964, President Kennedy, speaking to the Economics Club of New York, made the case:

          “Corporate taxes must also be cut to increase incentives and the availability of investment capital… The final and best way for stimulating demand among consumers and business is to reduce the burden on private income and the deterrents to private initiative which are so hampered by our present tax system.”

It seems contradictory that the administration which installed the “new economics” into the US political system pushed through such targeted tax cuts. According to then assistant budget director, Charles Schultz, “the tax cuts went against the grain of everyone including, initially, the president.” There is no doubt that the author of the tax cuts, Walter Heller, claims to have viewed them from a Keynesian perspective.

 Some have even argued that the Kennedy tax cuts were an attempt to stimulate demand, not supply, by putting money in the hands of consumers. Such an argument, however, goes against the statements made by President Kennedy in his speeches, including the one to the Economic Club of NY quoted above. The words “to increase incentives and the availability of investment capital” clearly are uttered with the intention of expanding productive capacity. In addition, in 1962, the Kennedy administration had pushed through a restructuring of the depreciation allowance and an investment tax credit to encourage business investment. Such actions further support the notion that the administration understood the importance of a supply side stimulant.  Whatever the philosophical beliefs behind the Kennedy tax cut, it was an unquestionable attempt to spur production.    

More importantly, the tax cuts worked. Top marginal rates for individuals were reduced from an astonishing 91% to 70%.  Corporate tax rates were reduced from 52% to 48%. Unemployment fell from 5.2% to 3.8% in 1966- the lowest level since WWII. From 1962 to 1969, the growth rate in business investment averaged 6.1% yearly. There was an upsurge in investment and an increase in economic growth that lasted until the profligate spending of the Johnson administration brought the economy to a decade-long standstill.

 The Great Society of the 1960s

The 1960s was one of the most tumultuous times in US history and anything but great. It was, however, a time of tremendous government spending aimed at, among other things, stimulating the purchasing power of those on the bottom of the economic ladder- a noble but misguided effort. It was also a time of sustained budget deficits, a weakening dollar, and a general economic malaise that culminated in the late 1970s.

Christina Romer, Chairwomen of the Council of Economic Advisors, states:

“Rather, the revolution in the 1960s was a revolution in economic ideas. The model that policymakers used to understand the economy changed in dramatic ways. This led them to make radically different policy recommendations. The resulting policy outcomes had two effects on the economy. One was to generate inflation and short-term instability. The second was to end the historical norm of long run budget balance. The 1960s introduced Americans to the phenomenon of persistent peace time deficits.”

What she does not add, however, is that this economic “revolution” was the result of the hold that Keynesian economics had on US policymakers during this time- a hold that was most formidable during the Johnson administration and that lasted until the onset of Reaganomics in the 1980s. For the economic “brain trust” of the 1960s included such notable Keynesians as Walter Heller, James Tobin, Robert Solow, Gardner Ackley, and Kermit Gordon. And let’s not forget Lyndon Johnson himself, a man who politically came of age in the New Deal. In addition, budget deficits, social spending, and the confiscatory tax policies that follow, are the main tools of a Keynesian induced stimulation of “aggregate demand.”

Economics professor Brad De Long confirms the above analysis when he writes: 

“At a somewhat deeper level the United States had a burst of inflation in the 1970s, because the economic policy makers of the 1960s dealt their successors a very bad hand.  Lyndon Johnson, Arthur Okun, and William Mc Chesney Martin left Richard Nixon, Paul McCracken, and Arthur Burns a painful dilemma.”

The “Great Society” was extensive and reached into every aspect of American life. Its main component, the “War on Poverty,” consisted of over 40 different programs. These programs included legal services, the Jobs Corps, the Neighborhood Youth Corps, the Community Action Program, Model Cities, Medicare/Medicaid and many others. Between 1964-1968, over 400 pieces of legislation were enacted by Congress to set the “Great Society” in motion. According to the Congressional Research Service, the “Great Society” cost the American taxpayer $308 billion in inflation adjusted dollars in the first 5 years alone. This does not include the cost of lost economic growth and other dislocations during the next 18 years.

The economic dislocation caused by the runaway spending of the “Great Society” was severe. Inflation began escalating, jumping from 5% in 1968 to over 10% by the mid-1970s. In 1968, nominal hourly wages were increasing 6.5% per year and headed to a peak of 8% per year. Productivity, which had averaged 2.8% per year since 1947, plummeted to 1.3% per year in 1972. Mortgage rates eventually rose to an all time high of 18.45%. On August 15, 1971, President Nixon (a so called conservative Republican) imposed wage and price controls- a 90 day freeze unprecedented in peacetime US history. By 1982, the prime rate was at an astonishing 21.5%. A new term was coined to describe the hitherto unknown combination of a stagnant economy and high inflation- stagflation.

Some have argued that these economic dislocations were the result of supply shocks (most notably, energy) that hit the US during the 1970s.  But as De Long points out, the baseline inflation rate was 5% per year in the early 1970s before there were any supply shocks.  In addition, the wage spiral that so devastated the economy was set -in –motion as early as 1968. Therefore, though supply shocks certainly added to the economic distress, they were not the principal cause.

One thing is certain, however, the ‘Great Society” did not end poverty. According to economist Thomas Sowell, the poverty programs of the 1960s caused the disintegration of the black family- a unit that withstood 200 odd years of slavery. To use the words of Ronald Regan: “In the 1960s we fought a war on poverty and poverty won.”

Supply Side Tax Cuts to the Rescue

In 1980, Ronald Reagan was elected President with a clear mandate to get the economy and the nation moving upwards again. With a conservative political philosophy, he shunned the consumption-based theories of his predecessor and went full-speed ahead with a powerful production based stimulant: tax cuts.

At the behest of the President, the Economic Recovery Act of 1981 was pushed through Congress.  Its main component was the Kemp-Roth tax cuts providing for a 25% across the board reduction in marginal tax rates.  The top rate now fell from 70% to 51% while the bottom rate went from 14% to 11%.  Corporate tax rates were eventually reduced from 46% to 34% in 1986. It is interesting to note that the 1981 tax cuts were smaller than those pushed through by President Kennedy in 1964 (1.4% of income versus 1.8% of income respectively).

The results were decisive. By the end of the Reagan presidency, mortgage rates had fallen from a high of 18.45% on 1/10/81 to 9.74% on 1/12/89. The prime rate was brought down to 8.50%, and unemployment, which had been at 7.1%, had fallen to 5.3% by 1989. Inflation was finally subdued after a decade of failed attempts.

Twenty-million new jobs were created and the longest peacetime expansion in US history ensued. The Dow soared from 776 in 1980 to an astonishing 11,500 in the Clinton years, albeit with a few corrections along the way. Real family income grew by $4,000 in the Reagan years, but experienced a $1,500 decline after President Reagan left office. The general economic malaise was over and the US was once again perceived as the unquestionable leader of the free world.

The critics of the tax cuts make two claims: 1) tax cuts increase the burden on the poor and middle class and 2) tax cuts cause greater budget deficits. According to the Joint Economic Committee of the US Congress: “The Reagan tax cuts, like similar measures enacted in the 1960s, showed that reducing excessive tax rates stimulates tax growth, reduces tax avoidance and can increase the amount paid by the rich.” In fact, there was a 51% increase in the taxes paid by the top 1% of taxpayers and a reduction in taxes paid by the bottom half. The political arguments that supply side tax cuts have a negative effect on the poor and middle class are baseless.

The budget deficit is another matter. There is no doubt that the deficit increased under Reagan. The cause of this was not tax cuts, however, but a refusal to significantly cut domestic spending and an increasing commitment to a build-up in military defense. When Reagan took office, the US military was in shambles, and President Reagan was a committed anti-Soviet warrior. Defense spending soared, running as high as 6.2% of GDP.  However, the Soviet Union collapsed trying to play catch up with the US. This resulted in the ability of the Clinton administration to cut military spending to 2.7% of GDP. The reduction in military spending made possible by the collapse of the Soviet Union, along with a reduction in interest payments due to the decreasing debt, made possible the budget surplus of the Clinton years. Nevertheless, tax cuts must go hand-in-hand with a reduction in government spending in order to attain the full benefits of this powerful tool.

From a balanced perspective, the Reagan Tax cuts proved once again that production based stimulants in the hands of individuals work. The reason is simple: they encourage work effort and promote a high level of innovation and investment. Jobs are created, the economy expands, and income rises. The individual, through his actions in the marketplace, is the only natural economic stimulant.

The Current Economic Climate

With the election of Barak Obama and with the liberal sweep of Congress, we are seeing a quick movement away from production based economics and a return to the demand induced stimulation inherent in the Keynesian model. Attempts are being made to stimulate demand by channeling resources into areas that government planners consider socially beneficial. For example, a bonus is given to individuals who trade in their “clunkers” for sub-compact fuel efficient cars. In the end, such programs will prove futile and result in a misallocation of resources. Although, the program has increased car sales to date, it has detracted from the rest of retail sales, a perfect example of the broken window fallacy mentioned below. In addition, of the 10 most popular automobiles purchased by consumers, 6 of them are made by foreign companies. Planned economies do not work. If you want proof, just look at the planned economy of the ex-Soviet Union- an economy that Paul Samuelson told us would surpass the US economy in productive capacity.

The Bush and Obama administrations have spent more money on “rescuing” the economy than imaginable. However, little has improved. Credit is still tight, housing is still depressed, and unemployment is still at 9% and rising. All of this spending, of course, is reflected in the spiraling budget deficits.  As Gerald F. Seib of the Wall Street Journal points out: “The deficit this year will be $1.8 trillion, and next year will be $1.4 trillion under current estimates. The $290 billion deficit that prevailed when Mr. Perot went on his crusade seems a pittance by comparison.”

Without a corresponding increase in productive capacity, all of these dollars put in circulation will once again cause an unacceptable level of inflation. Economist Arthur Laffer writes:

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10…The currency in circulation component of the monetary base-which prior to the expansion had comprised 95% of the monetary base- has risen by a little less that 10% while bank reserves have increased 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less that 50% of the monetary base. Yikes!”

In the end, those on the bottom of the economic ladder will be most affected. For a loss of purchasing power will have a devastating effect on those living on a fixed income or living on subsistence wages. Once again, government attempts to “help” only hinder.

The Broken Window Fallacy

Henry Hazlitt has so effectively demonstrated how we must look beyond the immediate effects of an economic policy to gauge its true consequences. Money spent by the government is taken from individuals who now no longer have that money to spend. Instead, it is spent by politicians and bureaucrats who cannot gauge the real desire of consumers. As a result, society in general, is no better off. Such spending thus becomes a synthetic stimulant and results in the misallocation of resources- as in the “Great Society.”

So then, how do we get a declining economy moving again? The answer is clear: The government should return money to its rightful owner, the taxpayer; eliminate excessive spending and budget deficits; and encourage a stable monetary policy. The market will do the rest.

As a well brewed espresso stimulates the individual, so the unhampered actions of the individual will stimulate the economy. We need a return to the wisdom of old. To quote John Stewart Mills: “What a country needs to make it rich is never consumption, but production. Where there is the latter, we may be sure that there is no want of the former.”

Notes:

Jean Baptiste Say, in The Critics of Keynesian Economics, Henry Hazlitt ed, Of the Demand and Market for Goods, (Foundation for Economic Education, 1995) pgs.21-22.

John F. Kennedy, Address to the Economics Club of NY, Dec.14, 1962.

Kyle Crichton, Walter Heller: Presidential Persuader, New York Times, 6/21/87, Section 3, pg.1.

Source for the above statistics: Federal Reserve Bank, Board of Governors.

Christina D. Romer, Macroeconomic Policy in the 1960s: The Causes and Consequences of A Mistaken Revolution, presented at the Economic History Association annual meeting, 9/7/07.

J. Bradford De Long, America’s Only Peacetime Inflation: The 1970s, MBER working paper #H0084, May, 1996,

Federal Reserve Bank, Board of Governors.

Common campaign theme used by Ronald Reagan during his 1980 presidential run.

Federal Reserve Bank, Board of Governors.

Joint Economic Committee, Congress of the United States, The Reagan Tax Cuts: Lessons for Tax Reform, 4/96.

Sara Murray, Retail Sales Slide, Wall Street Journal, 8/14/09.pg. A2.

Gerald F. Seib, Deficit A Growing Concern For Public, Wall Street Journal, 8/7/09,pg.A2.

Arthur Laffer, Get Ready For Inflation and Higher Interest Rates, Wall Street Journal, 6/10/09, pg.A15.

See Henry Hazlitt, Economics in One Lesson, (New York: Harper and Brothers, 1946).

John Stewart Mills, in The Critics of Keynesian Economics, On The Influence of Consumption on Production, pg.26.

Fred Buzzeo is a real-estate developer and as a consultant to small property owners in the New York City area. He resides with his wife and two sons in the Town of Oyster Bay, (Long Island), NY. During the 1990s, he held executive positions in city municipal government. It is during this employment that he saw firsthand the pitfalls of government intervention and regulation. Send him mail. See his article archives. Comment on the blog.

© Copyright Fred Buzzeo 2009

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

Thomas Auletta
19 Aug 09, 20:05
You missed

I am not convinced. You missed. Economies work by demand not by supply. Increase taxes on the very wealthy. They have proved that their unproductive investments cause bubble economies. Increase wages to those who work per hour. They will spend more and this drives the economy. Successful growing economies do not work any other way. Tax cut for the wealthy and supply side economics always end in a crash.

Your interpretation of history is not correct. See Ravi Batra.


Coldtype
15 Nov 09, 13:05
Johnson's "Great Society"

I'm puzzled. In your comments regarding the cost of Johnson's "Great Society" programs you make no mention of the cost (read: waste) of the Vietnam War. Let's imagine the Great Society programs being funded minus the additional drag of attempting to crush peasants fighting for self-determination on the other side of the globe.


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