Is Keynes to Blame?

When evaluating the theory of John Maynard Keynes in the context of current monetary and fiscal policies in the United States, Austrians are quick to bash Keynes and blame his theory for most of the mess we are in today. I find myself engaging in this kind of general accusation all too frequently. But, while I think some of these accusations are well deserved by Keynes himself, a lot of the blame lies elsewhere. Let me explain.

There are undoubtedly massive problems with Keynesianism. Fundamental issues such as the broken window fallacy, the assumption of the irrational behavior of consumers (animal spirits), and the homogeneous structure of capital create giant holes in his theory. Unfortunately, many of these crucial snags are overlooked by the mainstream economics establishment in academia, and therefore by our policy makers as well. For decades now, organizations such as the Mises Institute, the Foundation for Economic Education, the Institute for Humane Studies, The Koch Foundation, and many others have worked to expose these fallacies not only in academia, but also to undergraduates, high school students, and the population as a whole. Progress is definitely being made, especially through efforts in new media via Facebook and YouTube targeting our small-attention-span culture.

But, Keynes still reigns supreme—or that’s what one would assume. In reality, that is not true. One huge omission is made to Keynes’ theory when he is cited consciously and subconsciously by congressional leaders, presidents, and central bankers: the importance of balancing deficit and surplus spending over the business cycle, and establishing a monetary policy that coincides with that goal.

Keynes made it very clear that while deficit spending could be used to combat a recession and help bring the economy back to natural output, government surpluses were necessary during economic booms to fund that deficit spending. This would ultimately lead to a fluctuation between deficits and surpluses from year to year, but over the entire business cycle would lead to a balanced budget and prevent the accumulation of massive sovereign debt. This of course is assuming the budget is balanced in respect to tax revenue, social programs, and defense spending in the absence of the need for economic stimulus. Since fiscal and monetary policies go hand in hand, the central bank must follow suit by cutting interest rates in times of recession and raising them again in times of expansion to smooth out the harmful effects of the business cycle.

What we see in reality is a complete deviation from this theory.

Looking back in history, we have seen the federal government consistently run larger and larger deficits while maintaining a fairly predictable easy credit monetary policy. This completely disregards Keynes’ call for monetary retraction and budget surpluses during expansionary periods. Honestly, I don’t find it surprising that this distortion has occurred. When you give the government the power and justification (legitimized by academia) to spend other people’s money with the guise of ensuring economic stability, they will do so without restraint. There always seems to be some need for fiscal and monetary stimulus, both in relatively prosperous economic times and in economic crises. For example, after the Dot-com bubble burst at the turn of the century, the Federal Reserve lowered interest rates to 1%. President Bush passed tax cuts that were supposed to act as fiscal stimulus as well. As the years went on, the stock market started to boom, and housing prices shot up, creating the mortgage-backed-security market as well as prevalent house flipping. At this point, Keynes would have called for the brakes to be applied; to take advantage of the new expansion and balance the budget deficit created by the tax cuts, and increase interest rates to pull money out of the system and prevent against inflation. Unfortunately, the brakes were not applied. The bubble finally burst, and recessionary conditions returned. As output fell dramatically and enormous amounts of wealth were erased overnight, the federal government and Federal Reserve acted quickly and took bold action to hopefully ease the effects of the oncoming recession by spending trillions of dollars in the name of stimulus and cutting interest rates even further to practically zero percent.

And the same cycle will continue. National debt just hit $15 trillion. The Fed is now meddling with the long-term bond market to bring long-term yields down because short-term yields can’t go any lower. The constant disrespect for a critical part of Keynes’ theory is fueling this behavior.

So when we cite Keynes as being the source of our absurd economic policies, we need to keep in mind that politicians and central bankers aren’t even adhering to the basic tenants of Keynesianism! I think he is rolling in his grave watching the world completely misinterpret what he was trying to say. I find myself always referring to politicians and central bankers as Keynesians, but in reality, they can’t even get his theory remotely correct.

Operation Twist: More Bad Medicine

At the FOMC meeting earlier this afternoon, Federal Reserve chairman Ben Bernanke announced the unveiling of “Operation Twist” in order to once again stimulate economic growth. Instead of resorting to the ominous and expected “QE3″, the Fed decided it needed to lower long-term interest rates by swapping out $400 billion short-term bonds for an equal amount of long-term bonds to incentivize even more borrowing and spending.

With 30 year yields hovering around 3.02%, 10 year yields at 1.88%, and short-term yields (< 12 months) at virtually zero, interest rates can’t really get much lower. Despite this, people and firms still aren’t borrowing money. Firms like Apple are sitting on billions of dollars in cash — not investing, not taking risks, and not helping the economy.

Once again, the Fed is prescribing the wrong medicine because they STILL don’t understand the problem. Firms are not investing or taking risks — we can all agree on that; but it isn’t because the cost of borrowing money is too high, it is because firms don’t know what is profitable to invest in. As more and more intrusive regulatory legislation is passed under the Obama administration’s direction, regime uncertainty forces firms into hiding. No one wants to hire because hiring someone is one of the riskiest and costliest decisions a firm can make, therefore unemployment numbers are stagnant around 9%. In particular, companies are most scared of the ramifications of Obamacare. Dr. Steve Horwitz argues this point in a blog post back in July.

Peter Schiff testified before Congress last week concerning Obama’s new job bill which of course is also aimed at “stimulating” the economy and creating jobs. He consistently hits the nail on the head by reaffirming that government cannot create jobs, especially since the jobs it “creates” do not actually create value, they only drain resources from the productive and valuable private sector. You can view the entire testimony here.

Both of these strategies in the monetary and fiscal realms have continuously been tried and tried again, yet we still remain in the same rut. Albert Einstein said the definition of insanity is doing the same thing over and over again while expecting a different result.

We are now bordering on insanity.

 

More Insanity in the Housing Market

If you look at the news on any particular day, reports are constantly highlighting the woes of the housing market. Prices continue to fall with no end in sight. The media portrays a “doom and gloom” scenario when it comes to this situation, claiming that we must *do something* to stop the free fall in housing prices and save the helpless homeowners that now have underwater mortgages.

But any competent economist would say, “No! Let prices fall.” Even as heartless as that statement sounds to the millions of families struggling with the effects of the housing crash, it is what needs to happen in order for recovery to begin. Here is a very interesting chart showing different indices of housing prices over the past 36 years.

The drastic rise in prices between 1998 and 2007 was caused by 2 things:

1) The expansionary monetary policy of the Fed.

Between 2002 and 2005, the Fed slashed interest rates to an average of about 1.5%. This made borrowing money a lot cheaper and gave entrepreneurs and businesses the incentive to borrow money for capital projects. As we found out fairly quickly in the early 2000′s, most of this cheap money went into housing construction.

2) Legislation pushed by Clinton and Bush to boost home ownership nationwide, especially amongst minorities and low-income individuals that would not be able to afford a mortgage without government intervention.

As private entities expanded housing construction nationwide, the government pledged to make owning a home more affordable and more accessible especially to low-income individuals. By subsidizing these loans through government-controlled mortgage giants FannieMae and FreddieMac, mortgages were being dished out left and right to people who knew they couldn’t afford them in the long-run.

As the government subsidized more mortgages and interest rates stayed at historical lows, both the supply and demand for houses started to spiral up. The housing market became so lucrative that “house flipping” became a common practice. An individual could purchase a home they could not afford and then sell it a year later for 20% profit because housing prices continued to skyrocket.

Unfortunately, scarce resources caught up to us.

The artificially-induced boom in the housing market had to peak somewhere, and it did in 2007. As prices started to fall, house flippers were immediately in big trouble. They had been banking on a 20%+ growth housing in prices every year, and now they were stuck with mortgages they could never dream of affording. Toxic assets like these started showing up all over the place, and as housing prices tanked, more and more people defaulted on their loans, and sketchy credit-default swaps (which are convoluted investment vehicles that investment banks were using to fund and insure these toxic mortgages) started to fail. “Wealth” that was accumulated over the past 10 years vanished in a matter of weeks.

In reality, it wasn’t real wealth. It was an artificially inflated market induced by the actions of the Federal Reserve and legislative policies of the government.

So here we are in 2011. Housing prices continue to fall. Unemployment nationwide stands at about 9.2% which doesn’t include people who have given up the job search. In the midst of all this, I was watching TV briefly the other day and saw this commercial that was run by the National Association of Realtors:

My reaction: “YOU HAVE GOT TO BE KIDDING ME.” The number of economic fallacies contained in this ad is frightening. Let’s take a few of them step-by-step:

1) “America needs jobs.. and housing creates them. For every two homes sold, one job is created.”

It is true that Americans need jobs. It is not true that housing creates them or should create them. Housing prices are still falling for a reason, namely that there is an excess supply of houses. That means we need less houses, not more. Building more houses, or investing in the housing market would be the stupidest decision for an entrepreneur to make right now, because the market still hasn’t cleared yet. As for the claim about how two houses equaling one job, what does that even mean? This reminds me of the unfortunate Keynesian assumption of homogenous capital, that growth is just blobs of GDP and we just need to build more houses or make new “stuff” to create these mystical “jobs.” If I was a wealthy business-owner, I could easily hire 1000 people (and create 1000 jobs) to manufacture pipe cleaners. According to the assumptions made by most mainstream economists, this would be considered economic growth. When I see that I have produced 200 million pipe cleaners that now sit in a warehouse, I will come to the realization that I engaged in a malinvestment, and that the pipe cleaners truly have no value, because no one will buy them.

2) “Each home purchased pumps nearly $60k into the economy…”

3) “Home ownerships accounts for nearly $2 trillion of our GDP.”

More empty jargon. The use of the word “pumping” assumes that our entire economy revolves around spending and consumption. This is exactly what has caused our current recession: overspending and not enough national saving. We borrowed beyond our means and now we are paying the price. As for the “home ownership” quote, is it suggesting that more people need to own homes? Is it reminding us how vital home ownership is to the economy? The last time I checked, this attitude was the main driver behind the credit expansion and legislative action that propelled the housing boom, which has now turned to a bust.

This post has been a bit scatter-brained because there are so many issues here I could delve into. The housing market will not be fixed by stupid commercials trying to convince Americans to go out and buy a home. “Consumer confidence” will not return until house prices finally bottom out and the recovery begins. The market is in a correction period in which housing prices are reevaluated and adjusted to their true equilibrium points. Less “stimulus”, less government intervention, and true market price adjustments will eventually lead us on a path to recovery. In the mean time, the NAR should stop wasting its time and resources on stupid TV ads that make no logical sense.

Update from Atlanta

Today marks the final day of this year’s first week-long summer seminar run by the Foundation for Economic Education (FEE). College students from across the world descended upon Atlanta this week for “Freedom University: Basic Economics” to listen to inspiring speakers, participate in engaging activities, and network with fellow students interested in economics and liberty. Having only worked at FEE for the past two weeks, I am just realizing how awesome this organization is and I am proud to be involved in FEE’s mission, namely to study and advance the philosophy of freedom.

My role as an intern here at FEE is to do all the photography for the seminars as well as help run operations. But when I’m not behind the camera, I have the unique opportunity to speak with and get to know the faculty members that FEE chooses to speak at the seminars. This kind of interaction and experience is what I will cherish the most from my summer with FEE.

Next week, another group of students will arrive in Atlanta for a slightly more advanced seminar on Austrian economics, and I am looking forward to being inundated with Austrian Business Cycle Theory throughout the week.

See more photos and FEE’s facebook page here!!

The 20th of April

A multitude of fairly cliche and suggestive Facebook statuses started popping up even before the clock struck midnight to signal that it was finally time to celebrate a day of defiance and civil disobedience. Brownies were baked, college dorm hallways reeked of Febreeze, and the timeless music of Bob Marley found its way into the ears of those who walked by.

Yes, it was 4/20.

Madison Liberty sprung into action as we always do on the 20th of April to raise awareness about an issue of personal freedom that is often overlooked and kicked to the curb by individuals on both sides of the aisle. I don’t think the prohibition of marijuana is one of our most pressing issues in an era of massive government spending, huge deficits, and runaway entitlement programs that will bankrupt America in the not-to-distant future, but the prohibition of marijuana continues to rape our nation in a multitude of ways:

Prohibition perpetuates poverty. Inner-city kids are incentivized to join the illegal drug trade because of the lucrative opportunities that come with a black market. Prohibition fills our jails and prisons with people who need to be rehabilitated, not incarcerated. Prohibition costs taxpayers billions of dollars every year to support these prisoners as well as the police officers and resources necessary to apprehend and incarcerate drug users. Prohibition promotes the formation of gangs, gang violence, and murder. Prohibition encroaches on personal choice and liberty. Prohibition has created a “War on Drugs” (who knew you could win a war against an inanimate object?) that has turned into a multi-billion dollar industry with no limits on its expansion.

Now, let’s take a step back. All of this? In the name of what? Keeping harmful drugs out of the hands of our kids? For all the precious prices we pay for this “war”, our society gets NOTHING good in return. There are still more drug users than ever, and marijuana is even easier for high school students to acquire than alcohol.

Even though all this evidence of prohibition’s absurdity exists, there are still challenges and barriers that continue to block change in our society. Conservatives cite morality in their defense of prohibition. Somehow, inhaling the smoke of a burning plant is immoral. They use this argument all the time to legislate their personal preferences and choices onto the entire nation. I say If you don’t like it, then don’t partake in it.

The knee-jerk response I get from most people when I voice my opinion about drug prohibition is, “well, you just want to get high, you dumb pothead!” I savor these moments, because at this point, I can look them straight in the eyes and honestly say that I do not use marijuana or any other illegal drugs. This usually leaves them speechless. I have nothing against those who choose to smoke because it is up to them what they put in their bodies. I just choose not to smoke out of personal preference.

On this particular 20th of April, Madison Liberty distributed t-shirts on campus along with literature explaining the ill-effects of the drug war. Thanks to a Students for Liberty protest grant, we were able to do so at little cost to our club, and therefore we gave out the shirts for FREE. They were a hit (no pun intended) and were gone within 45 minutes!

College students seem to be very open to the idea of legalized marijuana, and not just for the obvious reasons either. I think young people are all libertarians deep down inside. That true longing for independence after being raised in a system that emphasizes rules, barriers, grades, and conformity starts to shine once we reach college. Why should some stuffy old white guy up in Washington D.C. tell you what you can and cannot do with your own body?

Yet, after these short 24 hours pass, the issue seems to fade into the background and the novelty of the situation no longer motivates people into action. People continue to accept the status quo because most people never see the direct negative effects of prohibition with their own eyes. What will it take to finally realize the end to prohibition? I don’t have all the answers, but we can start with continual education and the restoration of common sense. The latter seems to be quite scarce in our nation today.

So, however you decided to celebrate (or not celebrate) the 20th of April this year, I think we all need to take a conscious step back and evaluate the United States’ current drug policy. Portugal decided to end drug prohibition and they have seen decreases in violence and drug use across the board. Wake up America!

2011 International Students for Liberty Conference: A Review

A few weekends ago I took the opportunity to travel to George Washington University with 7 fellow JMU students to attend the 2011 International Students for Liberty Conference (ISFLC). Students for Liberty (SFL), an organization founded just a few years ago to help organize and supply pro-liberty students across the world with books, resources, and internship opportunities, holds multiple conferences annually. I attended the Mid-Atlantic Regional Conference at Drexel University in Philadelphia last fall, and that convinced me to attend the largest gathering of pro-liberty students in the history of the movement this year at ISFLC. Over 500 students from all over the country (and the world) descended on Washington D.C. to network, hear from successful and talented speakers, and be a part of the John Stossel Show. This is my official review of the conference.

My first thoughts: Wow. The energy and enthusiasm at this gathering was off the charts! With all the apathy I see here at JMU, I was surprised to see there were so many other people out their that actually care about individual freedom and actively want to preserve it. The general aura of the students was impressive: they were all well-read, well-dressed, and ready to change the world. As I said earlier, everyone was just excited to be there. Here’s a shot of everyone right before they started taping the John Stossel Show. I’m over on the right with my fist raised in the air (I was pretty pumped).

The conference was organized into main events and then 6 “breakout sessions” where you could decide which lecture to attend. Friday evening consisted of a few main events worth mentioning. First, we watched a sneak preview of the new movie based on Ayn Rand’s “Atlas Shrugged”. Atlas Shrugged: Part 1 will be released on April 15th (strategically placed on Tax Day) and it actually looks pretty awesome. It is being independently made with quite a small budget, but that isn’t stopping the producers from making a high quality film.

After the screening, SFL presented its annual awards for event of the year, student of the year, and group of the year. Congratulations to all the winners! They definitely deserved recognition. A lot of winners came from the west coast where the liberty movement seems to be exploding. That’s great news for a part of the country that is currently suffering from the effects of big government, high taxes, and massive deficits.

Here’s the 8 members of Madison Liberty that attended the conference at the social on Friday night:

SATURDAY

Yes, it had finally arrived: the day we had all been waiting for. The events on Saturday went from 10am to 7:15pm, so we had quite a lot in front of us. Once everyone had a few cups of coffee, we were all excited to get on with the day. My favorite speaker was Dr. Chris Coyne. He is an economics professor at George Mason University and is a strong advocate for Austrian economics. I went to 2 of his lectures, speaking about Austrian business cycle theory as well as the faults of protectionism. He is very down-to-earth and knows exactly what he is talking about. I am continually impressed with Mason’s economics department.

Later in the evening, Gary Johnson spoke about his experiences as the former governor of New Mexico and how he ran the state like a business. Every decision was based on a cost-benefit analysis, and that caused Johnson to veto over 750+ appropriations bills while he was the chief executive of New Mexico. His presidential platform takes on many issues that many candidates as well as current leaders refuse to touch. Johnson wants to balance the budget by cutting the federal government by 46% and immediately start working on phasing out social security, medicare, and other welfare programs that are sucking our resources away. He is also a strong advocate of ending drug prohibition along with the multi-trillion dollar industry that is the “war on drugs.” I’m not sure if he will be electable as a president, but one can only hope.

After Gary Johnson spoke, David Boaz (VP of the Cato Institute) joined John Stossel on stage to film a new episode of The Stossel Show. The atmosphere was totally electric when the cameras started rolling, and students were invited to ask Stossel and Boaz questions during the show. The episode will air on Fox Business on March 31 at 8pm, so be sure to tune in then! I don’t get Fox Business on my current cable plan, so I will most likely be watching it online the day after.

I had the pleasure of meeting David Boaz later that evening at one of the socials in D.C.

The final keynote for the conference was Megan McArdle, D.C.-based blogger and writer for The Atlantic. SFL did a great job of selecting Megan to speak last because she was probably the most inspirational of all the speakers. As someone who constantly has to defend her viewpoints, McArdle pleaded with the audience to always practice intellectual honesty, because the only way Libertarians can eventually be effective in the pubic sphere is to be more intellectually honest than the other sides. The left and right have become almost exclusively driven by emotion in their responses, arguments, and reasons for their beliefs. She also said that everything really revolves around value judgments. People inherently have different value structures, and a lot of times, people with different ideologies and beliefs will never be able to completely reconcile with each other because of their diverse value structures.

Even though there are so many different value systems, I do believe there are “right” ways to go about things based on human action and the sciences. Economics is a science. It has natural laws that cannot be violated, because the basis of economics is human nature and human action. Science describes what is, not what we want it to be. Science does not deal with morality or what is “right” or how things “should be.” Unfortunately, we have politicians who violate the laws of economics and still expect their policies to work because that’s the way they believe things “should be.” These failed policies include: education for all, a “living” wage, free healthcare, etc. There are limited resources, and no legislation that violates the laws of economics will ever be successful.

Ludwig von Mises elaborates on that point in much more detail in Planned Chaos which I hope to write a few posts about in the near future. That was a little bit of a tangent, but McArdle’s point about value judgments reminded me of it. This conference provided me with an enormous amount of resources to continue to educate myself beyond the cookie-cutter structure of bullshit general education classes and single-minded, model-intensive Keynesian economics that my university will continue to shove down my throat. College no longer provides true education by itself. It provides individuals with the resources and the ability to educate themselves, but it is up to the individual to take the reigns and actually convert that ability into action.

Students for Liberty has created something amazing. The community of students, educators, and writers at the conference was astounding, and I plan on being more involved in SFL and pro-liberty organizations in the future (hopefully this summer if everything goes as planned!)

The Opposite Effects of Current Interventionist Policies of the Fed

This is a really quick blog post, and I will probably return back to this topic as market conditions change and new information is available.

I’ve been doing some research about why there is still a liquidity trap in the loans market. It’s still impossible for people to get loans.

In normal economic conditions, banks hold around .02% of excess reserves. They hold on to the required 10% by the Fed, but loan out anything that is left. Because of the money multiplier, this is actually the main way money is created (only holding 10% in currency, and lending out the other 90% and treating it as real “funds”). According to the latest Fed report, as of January 2011, banks are holding an unprecedented 51% of excess reserves! Remember Obama’s empty rhetoric about injecting money into the economy through bailouts so that banks could start lending out money again and the credit freeze would be solved? Those billions of dollars have ended up in the excess reserves of the banks.

I have found 2 reasons why this money isn’t being lent out.. I found them in reports published by the New York Fed in 2009, which is fairly ironic because their own actions to “stimulate” the economy have provided incentives for banks to not “stimulate” the economy!

1. The opportunity cost of lending is too high. With short-term interest rates driven down to almost 0% through open market purchases, banks can’t make any money off their investments, even if there is minimal risk involved. This means anyone trying to get a loan for any kind of entrepreneurial project is definitely out of luck. People who have steady income, excellent credit, and want a basic car/house loan can’t even get it. The central banks are paying interest on those excess reserves that banks hold, and it looks like those rates are higher than the rates the banks can get loaning out the money to entrepreneurs.

2. Remember how I mentioned open market purchases and bailouts? The reason why we haven’t seen any inflation from billions of dollars in money creation through those activities is because the banks are keeping them in excess reserves. The Fed report I mentioned earlier warns of the possible danger of massive inflation if banks lend out these 51% of excess reserves. So it looks like the Fed is in a sticky situation. Their 2 goals are inherently conflicting. They can’t keep price levels stable (control inflation) and also promote conditions for maximum GDP output. They want to thaw the credit freeze by injecting money, but don’t want inflation. It makes no sense.

Basically, the Fed has completely messed with economic incentives. Banks are now in a corner as well. It will be interesting to see what happens with these billions of dollars in excess reserves.

The Ricardian Equivalence Proposition

Ever since Reagan’s trickle-down economics was established as a legitimate fiscal policy in the ’80s, there has been a constant debate about the effectiveness of tax cuts. The simplest and most common argument for more tax cuts is that they will put more money in the hands of consumers, raise total consumption, and ultimately raise aggregate demand. Unfortunately, it isn’t that simple. If it was, George Bush would be a hero.

Yeah.

Anyway, a 19th century economist by the name of David Ricardo (1772-1823) developed a theory that addresses this very issue. His theory (later dubbed “The Ricardian Equivalence Proposition”) says that tax cuts don’t directly affect consumption because consumers internalize the government’s budget constraint and therefore plan for future tax increases. From the government’s viewpoint, when it comes to financing government spending, they have to choose to “tax now or tax later.” Financing the spending through bond sales would require a “tax later” policy to eventually pay back the debt (assuming the government doesn’t continue to raise the debt ceiling and just borrow itself into oblivion).

What I find interesting with this theory is that it assumes the complete rationality of consumers. It also assumes consumers have keen financial foresight and will act accordingly. We all know both of these are not true for the majority of Americans. How can we assume that people internalize the government budget constraint when most people don’t event know what the government is doing?

I think the relationship between tax cuts and consumption that the Ricardian Equivalence Proposition presents is flawed because of the lofty assumptions attached to it. David Ricardo eventually went back and criticized his own theory, and he probably didn’t support it anymore by the time he died.

The marginal propensity to consume (MPC) most likely determines the effectiveness of tax cuts. If the MPC is 0.9, consumers will immediately spend $0.90 for every $1.00 they receive in tax cuts. Other factors that affect MPC and the effectiveness of tax cuts is whether the tax cut is a fixed payment or a continuous tax cut.

But that isn’t the main point I am trying to get at.. (yeah it’s 1 A.M. right now, so this may sound a bit A.D.D. so far..)

When investigating this theory, it made me think of a peculiar trait of human nature in regards to money and economics: once there is a tax cut, people won’t put up with a tax increase in the future. Basically once you give them a tax cut in the name of “temporary stimulus”, people are not willing to give that up with a future tax increase. If the government tries to increase taxes, people will instinctively oppose them or just move away from the area that is being taxed. That is exactly what is happening in historically liberal states such as California, New York, and Michigan. Years of reckless spending through wasteful government programs left them with massive deficits that had to be funded by new taxes. The 2010 census revealed that people just decided to move instead of enduring a tax increase in these economically collapsing areas.

I think this all ties back to the fundamental economic law of incentives. Incentives are what drive consumer choice.

Another place where this applies is in the realm of government agencies/organizations. They are allotted x dollars every year to carry out their activities. When was the last time you heard of a government agency telling Congress that the money appropriated for their agency was TOO MUCH? Never! Because if they ever revealed that to Congress, they would receive less money in the next year’s appropriation. This is the major cause of government waste. There is no incentive to be efficient and cut costs.

Once people are given tax cuts, they refuse to give them up. Once agencies are appropriated funds, they refuse to accept anything less in the future. This is why I don’t think the Ricardian Equivalence Proposition is valid. It neglects to consider the most important economic assumptions of all: the fact that incentives drive consumer choice, and that people are instinctively going to make decisions that provide themselves with the most resources—because economics is all about how we allocate resources, and humans will always choose themselves over others when deciding who gets them.

The Bastardization of Capitalism

I have been meaning to write something about this for awhile now, but seeing this video of Obama speaking to the Chamber of Commerce made me stop studying for my macro test on Wednesday and quickly respond to his comments.

The first words that come out of his mouth are full of arrogance and show a lack of understanding of a market system (most likely because of his hatred of the market system). “But we have to recognize that some common sense regulations often will make sense for your businesses, as well as your families…”

He is basically telling business executives/investors that the government knows better than those who are actually taking the entrepreneurial risk, and then making strategic decisions (through “common sense regulation”) for those executives/investors. In a true market economy, consumers will consume products from the firms that produce the highest quality products for the lowest price. Firms that fail to do so will fall by the wayside and will no longer be able to compete (in the absence of bailouts, of course). Therefore it is in a company’s best interest to fulfill the demand of the consumer. When miles of red tape are wrapped around their legs due to government regulation, companies instantly become more inefficient and cannot serve their customers as well as they could have otherwise. In the end, companies that are not dictated by the government will make better decisions. These decisions will be a true definition of “common sense”, because they will make or break the success of the company, which is dependent on the happiness of consumers.

Consider this:

With the recent move towards environmentalism, conserving resources and protecting our fragile ecosystems, firms are faced with a new challenge: produce for cheaper while potentially harming the environment, or incur higher overhead and variable costs to ensure the minimization of their environmental impact. This shift in consumer attitude has forced companies (at least the smart ones) to cater to consumer demand, which is to stop destroying the environment. The power of true incentives and consumer demand is much stronger than any government rule or regulation could ever be.

Obama goes on to say, “…the benefits can’t just translate into greater profits and bonuses for those at the top. They have to be shared by American workers…”

Investors and leaders of these firms have two possible outcomes of their actions: profit and loss. When capitalism is bashed for producing exorbitant executive bonuses, billions of dollars in profit, and multi-million dollar mansions for business leaders, the other side of the coin (loss) is disregarded. These people took risks that could have just as easily wiped out their personal assets or got them fired by their organizations. While American workers are vital to the production process, they do not incur as much risk as those at the top (by not spending thousands on college, first and foremost), and therefore are not entitled to as much reward/loss. This system spurs innovation, increased efficiency, and the possibility of achieving what we call “the American Dream”.

A true capitalist structure provides an environment where good ideas and innovation are rewarded with success, and inefficiency, laziness, and satisfaction with the status quo are rewarded with failure. Mr. President, please stop bastardizing capitalism, and let firms take responsibility for their own actions and deal with the consequences of those actions.

The Government Budget Constraint: Something politicians don’t want you to think about.

We all see the political rhetoric especially around election season, and we all grow sick of it very quickly. The attack ads, smear campaigns, and “analytical” talking heads fill our media outlets, and our brains whether we want them to or not. Buzz words like tax cuts, financial assistance/relief for group x, and stimulus, are thrown around more often than Brett Farve returns to football from retirement. Most uninformed voters soak up this rhetoric and vote accordingly.

The politicians fail to recognize (or at least intentionally do not mention) the other side of the story: how will we pay for it? With over $14.3 trillion in national debt, this practice has gone on far too long.

One of the most fundamental principles of macroeconomics and therefore public policy is the Government Budget Constraint (GBC). As an interesting and somewhat frightening side note, I was not formally introduced to this principle in class until last week in my intermediate macro course (ECON 332 here at JMU). Even more frightening, my professor notified the class that he had only seen one macro textbook ever mention GBC. How could college graduates with a degree in economics never learn about one of the most fundamental principles of economics? Want the simple answer? Because the bias of most college professors doesn’t want them to. This law of economics demotes the government from its prior status of being the “all-powerful, able to do everything for everyone who wants/needs it and not having to worry about spending” body to an entity just like all of us. We all have to balance our finances, pay our debts, and earn money first in order to spend it.

So after all that, you probably want to know what GBC actually says.

The government budget constraint says that government expenditures must be identically equal to government revenues. (Simple enough right? That’s what I thought too. But why is it not taught in most macro books? Fishy, if you ask me.) Here’s the equation:

G + TR = T + BS + MC

G = government spending

TR = transfer payments (unemployment benefits, social security, etc.)

T = revenue from taxes

BS = revenue from bond sales

MC = revenue from money creation

All changes on the left side of the identity must be financed by a change on the right side. This law CANNOT be violated. It is impossible. So let’s look at a few applications of this law.

You want to build a new highway interchange in a metropolitan area with gridlock problems. This project is contracted at a cost of $200 billion. That means government spending is going to increase by $200 billion. According to GBC, we must finance an increase in G. We have 3 options: 1) Reduce TR 2) Increase T 3) Increase BS 4) Increase MC.

No one will want a reduction in unemployment benefits or social security, so that excludes Option 1. Tax hikes aren’t popular either, so there goes Option 2. This leaves Options 3 and 4 as the “only” alternatives. And this is what the government is doing (and doesn’t want you to think about it). Option 3 issues new government debt at fairly high interest to mostly foreign nations (China holds around 20% of our debt). Option 4 is basically printing money. That leads to inflation, and possibly hyperinflation if Option 4 is used often.

It is the constant use of Option 3 to pay for government spending since FDR that has left us with $14.3 trillion in debt. And the people to blame aren’t just Democrats or Republicans, it is all of us. We rely too much on the government to solve our problems and then don’t think about things like GBC that say that we will all have to pay for it one day.

Think about this the next time politicians campaign for more government projects or tax cuts. There is no such thing as a free lunch. Someone will eventually have to pay. And it looks like it’s going to be my generation.

Cheers.