Welsh Investment: WHEN THE CURE IS WORSE THAN THE DISEASE
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WHEN THE CURE IS WORSE THAN THE DISEASE
As discussed in “Paradox of Thrift-Sovereign Style” in the May 2010 letter, every developed country representing more than 65% of world GDP is embarking on a tightening of fiscal policy, with the goal of narrowing the aggregate debt to GDP ratio from 10% to near 3%. This admirable exercise in fiscal frugality will be accomplished by primarily raising taxes, which will reduce consumer’s disposable income simultaneously worldwide. The net result will be slower economic growth, and less tax revenue than any of the bean counters expect. In the U.S., the Congressional Budget Office uses static accounting, which postulates that tax payers will never change their behavior whenever tax rates are either lowered or increased. Before taxes are cut, the tax revenue the CBO estimates the government will ‘lose’ is often overstated, since tax payers will generate more capital gains or receive more income, if the government’s take is less. Conversely, in the face of higher taxes, taxpayers take whatever steps necessary (mostly legal) to shelter income and gains from the bigger tax bite. Invariably, the government rarely receives the amount of tax revenue the CBO estimates it will when tax rates are raised. The combination of higher tax rates and slower economic growth in the U.S. and around the world, virtually guarantees whatever estimate the CBO makes in terms of increased tax revenue will prove widely optimistic. It also means the budget deficit will remain higher than the CBO’s forecast.
Voters should be concerned about the budget deficit, since total federal debt next year is expected to exceed $14 trillion, about $47,000 for every U.S. resident. President Obama has appointed an 18 member National Debt Commission to make recommendations on ways to avoid a debt catastrophe. As I noted in the April letter, “Roughly 88% of the budget is mandated by law, which is great for members of Congress. With spending on autopilot, they can spend most of their time campaigning for their next election. The crew sworn in after the election in November won’t have it as easy.” The Co-Chairmen of the National Debt Commission addressed the National Governors Association on July 11, with a rare display of straight talk. Republican Alan Simpson told the governors that the entirety of the nation’s current discretionary spending is consumed by the Medicare, Medicaid, and Social Security programs. “The rest of the federal government, including fighting two wars, homeland security, education, culture, you name it, veterans, the whole rest of the discretionary budget, is being financed by China and other countries.” Democrat Erskine Bowles was equally blunt. “This debt is like a cancer. It is truly going to destroy the country from within.”
The governors understand the problem better than the 535 members of Congress, since state budgets are even in worse shape, as tax revenues remain weak, and the ‘stimulus’ money coming from Washington runs down. Since 49 states must balance their budgets by law, they really don’t have a choice other than to make the necessary tough choices. States are being forced to balance their budgets by cutting services and spending, including laying off state workers by the thousands. State spending represents 12% of GDP, so the reduction in state spending will represent another significant drag on GDP growth during the next 12 to 24 months.
A recent WSJ/NBC poll shows that 63% of Americans say the President and Congress should worry more about the deficit than the economy. I’m sure members of Congress will be carrying a copy of this poll in their pockets, as they stump around the country, thumping on this theme at every whistle stop. Anti-deficit sentiment has grown so ardent that Congress has refused to extend employment benefits to the 2 million workers whose benefits have run out as of mid July.
The Great Depression of the 1930’s was assisted and deepened by a number of policy mistakes. The Federal Reserve allowed the money supply to shrink by more than 30%. In June 1930, the Smoot-Hawley Tariff Law was passed, igniting a wave of global protectionism that resulted in a 40% decline in world trade within 18 months of its passage. After the economy rebounded in 1936 and 1937, the Fed tightened by raising reserve requirements. Taxes were increased to pay for social security, and the federal government cut spending. In 1938, the economy tanked anew.
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