They Done Us Wrong: Spending Our Way Into Greater Depression

by Michael S. Rozeff |

If you like economic depression, Obama is your man. The stock market is shouting this message loudly and clearly. The S & P 500 (measured by the security SPY) made a little high at 100.41 on November 4, 2008. The election was the next day. It has been downhill ever since. The close on March 2, 2009 was 70.60. This 30 percent decline qualifies as what used to be an ordinary bear market!

Congress and the President could not construct better measures, proposed and enacted, to deepen this depression if they tried. Congressional Democrats intend to ensconce Democrats as the majority party for the next 25 years or so. Their chosen method is wasteful pork sold as rational investment. But by gilding the nests of their chosen constituencies and supporters with huge taxpayer-funded giveaways, they will deepen and lengthen the depression.

The stock market tells us this, but it is easy for stimulus supporters to explain away the stock market’s drop in other ways. Obama supporters are likely to extol the good things that his program is doing to revive spending in the economy, and to regard the stock market as an aberrant den of gamblers and thieves who deserve their Bush-induced fate.

Very few men on the street, including my doctor, understand that spending, whether private or government, does not get rid of economic depression; and the lack of spending does not cause it. They do not fathom that government spending, borrowing, and taxing will further gash the sinking economy below the water line and send it to its watery grave. They are more inclined to believe, along with prominent economists, that government spending should be increased by trillions more. There cannot be too much of a good thing.

People automatically think that if everyone does not spend, then how can businesses keep going and hire people? How can the economy work? Then they think, if people only have money, then they can spend. If the government spending will only put that money into their hands, this will cause people to spend. It will jump start the economy, restore business confidence, and all will be well.

This story has a firm hold on the public imagination, but things don’t work that way. People in the aggregate can only earn money to spend by working productively. Money still doesn’t grow on trees.

The government doesn’t have a money tree either. Without resorting to inflation, it can only shift money around. America’s federal government is a group of Americans who are empowered to tax the rest of us and borrow from anyone in the world. This money is collected from you, me, and others. We then have less to spend. Shifting money from the left pocket to the right pocket doesn’t enhance the total amount.

Americans are not unwise enough to accept government money that is rolled off a printing press with absolutely nothing to back it up. Our government does not do things so crudely. Its money is printed up for it only after it issues government bonds that promise to pay interest. For all practical purposes, these bonds are perpetuities on which the promise is made to pay interest forever. There is no government money tree in this process because the government taxes Americans to pay the interest. If the government borrows from us and spends more now, we have less to spend now. The money goes from one pocket to another with no aggregate gain.

The government has another way to borrow. The central bank (the FED) can take the bonds and credit the government’s bank account. This exchanges one credit for another credit. The taxpayer must still pay interest. The credit created for the government has not directly diminished the taxpayer’s wealth on his personal account. There has been no money transferred from taxpayer to government. The taxpayers have a new liability, nonetheless. They will be made to pay the present value of the interest payments, which is the value of the bonds. This may or may not crimp their spending. It probably will not. They are unlikely at first to realize that they owe this money. As time goes on and they have to pay higher taxes, they might realize it. When the government relieves many people of direct taxes, it hides this burden of the debt for as long as it can.

So what do we have? The government can get money from the FED and spend it. It will seem to many people like money that grows on trees because they do not see the eventual taxes or the current hidden taxes. The government can spend this money. It will stimulate people into working at various government-selected projects. There is, however, no such thing as a free lunch. If people do not value these projects (which is usually the case) or the projects lose money (which they usually do), the welfare of people does not go up. It goes down, for they are paying for useless work. Furthermore, the government spending raises costs and prices by bidding labor and materials away from others. And this prevents those prices from adjusting to levels that make it profitable for businesses to employ people in making stuff that people really want.

There are those who contest the notion that government spending is largely waste. They imagine brand new bridges, newly-paved roads, and intercity rail transport. Even if these projects paid off, they are a tiny fraction of all government spending. And most of these do not pay off. Government spending only creates wealth if it spends money on things whose return exceeds the cost of the capital used. The government’s own operating costs are so high that, viewed as a business, it gets a return on its investments that falls far short of its capital costs. In other words, the government is like a gigantic money-losing business. One reason for this is that interest groups get the money. The image of public-minded officials dispersing the money efficiently is unreal.

Everyone who has spent any time at all looking into the matter of government spending, all regular readers of LRC, all readers of Ideas in Liberty, all readers of the publications of the Independent Institute, etc., and all those who have not looked into it, but have merely had experience with government, take it for granted that every $1 spent by government costs the taxpayer $1.25 or more. Governments routinely destroy wealth. The case is so overwhelming that anyone who believes otherwise can only be willfully ignorant or blinding himself. One scholar (Martin J. Bailey), who was far from a radical anti-government person, but who spent many years studying government and trying to write an improved Constitution to mitigate problems with representative government, wrote as follows:

“The leader, if truly well-informed, will know about several barriers to sound government. We may summarize these as follows. In existing nations the clash of interests often has powerfully wasteful and detrimental effects, among other reasons because elected professional politicians with almost unlimited authority to enact and administer laws are subject to enormous rent-seeking pressures. Indeed, they seek out groups that have been unable to solve their own organizational free rider problems and solve them through legislation – e.g., for labor in the 1930s through the National Labor Relations Act and more recently for the poor and the ‘homeless.’ Political discourse in all venues is routinely filled with fraudulent claims, slander and other misrepresentations. Even if they might wish to enact perfectly constructive, statesmanlike legislation, politicians have no reliable conduit with which to collect valid information about the preferences and values of their constituents. A fundamental reason for these symptoms is that citizens have no incentive to seek out the truth on public issues, but instead choose rational ignorance and, often, rational non-participation. See Downs (1957: 238–274). From this core problem emanate others that permeate government. Finding a corrective mechanism for this core problem is a necessary condition for overall improvement.”

It helps the cause of liberty when polite and well-mannered experts, people who have studied the matter for years and speak in restrained tones, inform us that politicians cater to interest groups and not the public welfare, that they routinely lie, that they organize interest groups and shake them down, that even if they wanted to, they could not serve the public interest, and that our representative government is wildly dysfunctional.

The image of government restoring confidence by raising and spending money could not be more mistaken. This is the fantasy of Keynes. It is the rhetoric of FDR (“the only thing we have to fear is fear itself”). If business confidence depended on government spending, there would not have occurred any of the last 5 recessions in the U.S., for government spending rose both before and during these recessions. And there would have been a recession during the Clinton years when government spending moderated. The confidence of a businessman depends on the anticipated demand for his goods and services. He does not invest in plant and hire labor on the basis that the government is spending money on its favorite interest groups.

There are unemployed resources in a depression. Doesn’t the government improve matters by putting these to work? There is a large vacant building for lease in a nearby commercial strip. It used to be a shoe store. At the same time, there are unemployed men and women in the area. So far, no business has seen fit to rent the building. Does the government have a viable business in view? This is highly doubtful. It is not how the government operates. If it directly hires the building, the chances are that it will hire people to do make-work. The operation will run a loss, paid for by taxpayers. Why should they be taxed to pay the unemployed and lose money in the process? Nothing is accomplished but a transfer of wealth from taxpayers to the unemployed and an additional loss. Meanwhile, when business recovers and seeks to satisfy needs of consumers, it finds that its costs are higher because the government has rented the building and hired labor. The government’s actions inhibit recovery. Why should wealth be taken from taxpayers? If they would have spent the money on goods, they no longer can. If they would have invested it, that too is no longer possible.

Meanwhile, there is another effect of government borrowing from the FED. When the FED credits the government, it creates bank reserves. This typically sets off a multiple credit expansion among banks. This stimulates business, but it is a process of credit inflation that leads to a recession or worse. Ordinarily, business demand for labor and materials is constrained and rationed by the supply of savings. The FED’s credit creation, however, causes a lowering of the interest rate. That relaxes the constraint. The stimulation causes economic distortions and imbalances and eventual recession.

Imagine that IBM is induced to borrow and to produce a new supercomputer because it thinks that its cost of capital is lower. It hires people, builds a new production line, and starts churning out new supercomputers. Other businesses do the same. But their planned selling prices and costs are predicated on spending, saving, and hiring patterns that no longer exist – the credit inflation changes all of that. The business activity that comes into the economy affects particular people first and not others, and their spending and saving behavior is not what would have occurred had they not been employed and paid in this new activity. Furthermore, people change their economic behavior when they observe the activities of others and experience price changes.

The result is that somewhere along the way, some businesses find that their costs are rising beyond what they planned and expected. Some businesses also find that people are not buying the newly-produced items in the anticipated volume. The costs are rising because IBM is competing with Apple and many others to hire factors of production. Some products are not selling because the stimulus is uneven or not neutral in its effects. To sell their products, some firms have to lower their prices. Since they still have to pay their debts, they find themselves caught in a squeeze. This leads to cutbacks. This affects other firms. A recession or depression starts.

Government credit inflation is not a free lunch. The Obamaniacs are not overtly promising more depression via increased government spending, but that is inherent in their program. If they borrow from the public, it has no net stimulating effect. If they borrow from the FED, it produces temporary stimulation and inflation and then further depression. Credit creation through the central bank ultimately sends the economy on a downward course.

The stimulus story is that if people only can get money, they can spend and the economy will rise. People only can earn money by working. They earn money by providing something of value to others, like their labor or a good or service. The money they get entitles them to cash in on the value of their service by choosing to buy the goods or assets that others make available.

The image of money making the wheels of commerce turn is misleading. The money is a counter, a ticket that allows one to buy an array of goods. Money is a chit or a voucher. Money is a credit that can be cashed in against society’s goods and services; it is a credit that you can use up as you choose. When you make money, that money measures something else that is more basic, which is that you have supplied a valuable service or good. The money is an option to get goods in return at a later time and place of your choosing.

Money is not the problem. We do not have a depression for lack of money. The official M1 money supply at this time is almost $1.6 trillion. It was $1.4 trillion when the depression began. The problem is much more subtle. It has to do with prices and the price system. It has to do with overcoming problems caused by bad credits that arose when the price system was distorted by inflation. We have a depression because of the distortions and imbalances in the economy that arose over many years when too many people were induced by the FED to borrow too many credits and use them to buy and produce goods and services.

The image of government spending putting money into people’s hands is misleading. When the federal government spends money on windmills, it has to get that money from taxes or borrowing. When it borrows from the public, it has to raise taxes to pay the costs of the debt. So we may as well say that all the federal spending is paid for with taxes. This takes money out of the hands of those who might otherwise spend it or invest it. The government isn’t jump-starting anything.

If people want to trade goods and do not have enough money to carry out their exchanges, they can always create more. Money itself is not the problem, as the spending and stimulus story suggests. What you spend is what you produce. You can only spend what you produce. (If you borrow and spend, you must eventually pay that back with your production.) If Iowa corn farmers want to buy Chinese pots and pans, they have to produce corn. If the Chinese want to buy Iowa corn, they have to produce pots and pans. They don’t want our dollars to eat anymore than we want their yuan to cook with; these currencies are only media of exchange. We can always arrange means of paying each other. The real problem is that the production of goods has been dis-arranged and that many firms have to restructure. Many will go bankrupt and liquidate. Many will lay off workers. The adjustments take time. This is not now a problem of money and credit, although it was brought about by central banking’s excessive money and credit. It is now a problem of real production being interrupted because it is not geared to producing what people want to and can buy at current prices. When a lot of us do not have the means to spend, it is because we are not producing enough product that others want at prices they are willing to pay. That happens because inflation has distorted the price system and production.

In this situation, government spending does not restore the production system to one that caters to people’s wants and demands. Government spending does the opposite. It induces men and materials into work that is not in demand. This lengthens the period of adjustment back to normal production. It causes even more distortion by bidding labor and materials away from businesses and into lines of work promoted by government. It creates a new inflation and price distortions that must cause more depression. Furthermore, as we know, the government spending itself is on wasteful activities.

The government spending under Bush and Obama is piling up immense new liabilities and debts. Americans are trying to save more. The data on their private account show this clearly. The personal savings rate in January of this year is 5 percent. From 2005 to April of 2008, it averaged just under 0.5 percent. Meanwhile their government is frustrating their actions by incurring immense new debts.

Sadly, spending is not the end of the story of the Obama administration. Its tax and regulatory policies are equally destructive. It is certain that higher capital gains taxes, estate taxes, income taxes, and carbon taxes will provide new depressing effects on the American economy. The federal government’s projects now include a growing array of wealth-destroying investments that include AIG, Citigroup, Fannie Mae, Freddie Mac, the auto industry, and other major banks.

Since the Democrat victory in November, the stock market has been discounting these negatives. It will continue to do so as long as these negatives continue and worsen. At present, the Obama administration is still serving up a daily diet of negative shocks to the economy and the stock market. It is frustrating the recuperative powers of Americans, just as it is frustrating their attempts to save and put the American house in order. If this is not an example of the evils of our federal government and of our form of representative constitutional government, I don’t know what is.

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