THE
BEAR'S LAIR Here we go
again By Martin Hutchinson
The echoes of the 1930s in the current
situation are not confined to foreign policy.
Economically also, the parallels between the
1929-32 downturn and the current difficulties are
becoming alarmingly apparent. It must be
remembered: the Great Depression became such, as
distinct from a garden-variety downturn, though
egregious policy errors by decision-makers in a
number of countries. Repetition of those errors,
all of which would have appeared unthinkable a
decade ago, is becoming increasingly likely and in
some respects is already happening.
One
area where the mistakes of the 1930s are being
replayed, although so far piano rather than
fortissimo, is in international
trade. There is no repeat
of Smoot-Hawley on the horizon - whatever the
question marks over the belief system of Barack
Obama, it is pretty clear that his flirtations
with protectionism during the primaries were no
more than populist stunts.
Nevertheless,
the Doha round of trade talks have been killed
stone dead, the South Korean and Colombian trade
treaties with the United States seem unlikely to
make it though the Democrat-controlled Congress
(though there may be some chance of progress after
the November election) and further trade treaties
have been stymied by the President's lack of a
"fast-track" negotiating authority from Congress.
More ominously, world trade has in the
past few months reversed its rapid growth since
2000. Indeed if the world economy goes into a
prolonged downturn there must be a substantial
likelihood of a protectionist backlash, both in
the wealthy economies of the US, the European
Union and Japan, but also in the more autarkic
emerging markets such as China, India and
particularly Russia.
Neither China nor
India is instinctively committed to free trade; to
the extent that they, and not an enfeebled United
States and Britain, are steering the world
economy, protectionism will surely increase and
global trade and prosperity suffer accordingly.
There is only a limited probability of a full
1930's trade death-spiral, but the 1990's optimism
about globalization and the peace to which it
leads seem equally distant.
A second huge
error in the United States that made things much
worse was the Herbert Hoover tax increase of 1932,
which raised the top rate of income tax to 63%
from 25%. Even the Republican attack machine
cannot paint Barack Obama as committed to quite
such a suicidal move, but there is no question
that an Obama administration would see
considerably higher tax rates on the well-off, if
only through allowing most of the provisions of
the 2001 and 2003 tax cuts to expire.
Here
the main need is for care. While I am as convinced
as anyone that the drop in top marginal tax rates
from 70% to 28% played a major role in the growth
of the 1980s, and that Hoover's increase from 25%
to 63% made the Great Depression much worse and
more prolonged, it is not clear to me that modest
moves in marginal rates have any great effect.
Probably the only George W Bush tax cut
that had a significant economic effect was that
reducing the double taxation of dividends, by
cutting personal tax on dividend income to 15%
from 35%. Like almost all Bush initiatives, this
one was botched. A more sensible approach would
have been to allow dividends paid to be deductible
from corporate income for tax purposes; this would
have put the tax shelter industry out of business
and leveled the playing field between debt and
equity for capital planning purposes.
Nevertheless, reversal of the Bush tax
cuts, a modest increase in social security
contributions at high income levels and a
reversion of the capital gains tax rate to 20% are
unlikely to be too damaging. The key will be not
to allow the combined rate of Federal and state
tax on any income to rise above 50%, nor to allow
dividend tax to be increased, as dividends are
already taxed at close to 50% including corporate
and personal tax. That suggests that the top
marginal rate of tax and social security
contributions combined should be no more than 44%,
allowing a 10% state income tax (deductible
against Federal tax) to bring the overall rate up
to 50%. If Obama is cautious therefore, and it
seems likely that he will be, the initial effect
of the planned tax cuts should be only marginally
economically depressing.
The difficulty
will arise if the US economy sinks into
substantial recession, bringing the almost
inevitable US$1 trillion budget deficit. At that
point, the strong temptation for a president Obama
and a majority Democrat Congress would be to
increase taxes further on high incomes. This would
be highly dangerous for two reasons. First, the
actual marginal rate of taxation would climb
towards the 55%-60% level at which serious
problems of evasion and disincentive occur.
Second, the confidence effect of a 15%-plus rise
in the top marginal tax rate over a short period
of time would be considerable, similar to that
caused by Hoover's misguided budget-balancing
attempt. That could depress the long-term rate of
US growth, suppressing productivity gains and
driving capital out of the country.
In the
event John McCain wins in November, there would be
at most a modest additional tax rise, which would
have little effect. The severe danger in this case
would be the recession and its accompanying
deficit, which would bring a chorus of calls to
McCain to engage in swingeing tax increases to
balance the budget. Since he appears to have no
ideological objection to such increases, and
little economic understanding of why sharp,
unexpected increases would be damaging, the
resulting policy might be as depressing as that
pursued by Obama.
The third major policy
failure that contributed greatly to the Great
Depression is the failure of the Fed to loosen
monetary policy after the failure of the Bank of
the United States in December 1930. Even though
interest rates remained low, money supply declined
as banks failed and the public lost its deposits.
This time around, monetary policy has been
extremely loose, so there would seem little danger
of a repetition.
However, the principal
cause of the Fed's failure in 1931 was the
"pushing on a string" effect, also seen in Japan
in the late 1990s, where in a period of very low
interest rates money supply began to shrink
unexpectedly and new money proved difficult to
create. In both cases, autonomous money supply
shrinkage was accompanied by economic decline.
We may be seeing the beginnings of a
similar effect now: growth in the St Louis Fed's
Money of Zero Maturity, which had been over 20%
per annum in the six months to April, has slowed
since then to only 5% per annum without any rise
in interest rates above their current negative
real level or any visible tightening in monetary
policy. This may indicate a sharp deceleration in
the US economy, making money demand inadequate to
absorb money supply. The next few months will give
us an answer on this, one we may not like.
Overall, however the most disturbing
similarity between the present situation and the
early 1930s is the revived faith in the ability of
government to solve problems. This never entirely
went away, of course - during the cheap "end of
history" triumphalism of the 1990s one was aware
that the search for a "Third Way" was mere
marketing, and that the old faith in government as
an all-powerful solver of problems was by no means
dead.
This old-time socialist religion has
manifested itself in a number of ways. One is the
bailout of failing enterprises. In the United
States, since the 1930s the only substantial
company to be bailed out had been Chrysler in
1979. This year we have seen bailouts of Bear
Stearns, Fannie Mae and Freddie Mac, and it now
seems likely that government money in some form
will be put into the automobile industry.
As anyone with experience of the British
economy in the 1960s and 1970s could tell you,
this won't work. British Leyland, the British
automobile company, for example, was bailed out
repeatedly by the taxpayer, only to lose more and
more money until finally in the 1980s [prime
minister, now] Lady Thatcher put most of it out of
its misery.
Government bailouts prevent
the Schumpeteran process of creative destruction
from working, diverting resources from productive
taxpayers and bond market investors to the worst
losers in the economy. In extreme cases, the
economy ceases to work at all, as political pull
becomes the only reliable approach to obtaining
resources. Increased taxes, environmental controls
and the attempt to move towards a state-directed
healthcare system are all further symptoms of this
trend.
It is here that one can most
ferociously blame former and present Federal
Reserve Board chairmen Messrs Alan Greenspan and
Ben Bernanke and their decade of irresponsibly
cheap money. By distorting price signals
throughout the economy, and producing burst bubble
after burst bubble without significant improvement
in living standards except at the very top, they
have enabled the left to claim that capitalism
"doesn't work" so we must bring in government and
the unfortunate taxpayer to solve economic
problems.
Last time around in the 1930s,
economic recovery was almost prevented altogether
by government meddling, from Hoover's
political-pull Reconstruction Finance Corporation,
through Roosevelt's destruction of the private
capital market by the Glass-Steagall Act,
de-capitalizing investment banking, to the odious
creation of the farm subsidy monster, to the
fascist-inspired National Recovery Act. The result
was an economy in which private enterprise did not
recover until the early 1950s, and some of the
public sector excrescences are with us still. Only
a few of the public sector innovations, notably
bank deposit insurance, did more good than harm,
even while distorting the market.
John
Maynard Keynes believed that the free market
economy had died in 1914, and that modern
economies were best run by high-minded bureaucrats
like himself. As public-choice theorists have
subsequently definitively proved, this approach
depends on a moral purity and economic
perceptiveness in the public sector that does not
exist. Hence it damages both the economy itself
and civil liberties. Nevertheless in Britain and
the United States it took 50 years to get rid of
it. Alas, it has now returned, much to the joy of
the free market's fair-weather friends in organs
such as the Financial Times, which had a
triumphalist ode to public-sector meddling this
week.
The other parallel to the 1930s, of
course, is the emergence of well-armed autarkic
states seeking to expand at our expense. However
that is only peripherally an economic problem.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found at
www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice &
Associates.)
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