Obama Blazes The Path To Economic Suicide
Courtesy of John Carney at Clusterstock
The Obama administration’s embrace of a spending freeze at a time when it is proposing tax hikes is frighteningly reminiscent of the disastrous policies that exacerbated the Great Depression. He is doing nothing less than setting us on the path to economic suicide.
The Great Depression was actually two economic downturns. According to the National Bureau of Economic Research, the first recession ran from August 1929 to March 1933 and the second from May 1937 to June 1938. Unemployment remained high until the Second World War.
Neo-Keynesian Fears Of Contraction
The neo-Keynesians such as Paul Krugman and Christina Romer argue that what sparked the second downturn was an unfortunate inadvertent switch to contractionary fiscal and monetary policy. This is precisely what the Obama administration seems to be doing now: freezing spending and raising taxes even as the Federal Reserve retracts quantitative easing and considers rate hikes. All told this will take some $250 billion of spending out of the economy, according to the Obama administration. Doing this while job losses continue to mount threatens a new contraction, according to the neo-Keynesians.
But you don’t have to be a neo-Keynesian to be distressed at this combination of a spending freeze combined with a tax hike and monetary tightening. From a Hayekian perspective, the Obama policy mix also appears to be toxic for the economy. It threatens further contraction of the economy than necessary to correct the malinvestment from the boom years.
From the Hayekian perspective, the second downturn was the inevitable product of the first stages of the New Deal. The early New Deal stymied an economic recovery by creating a false dawn recovery. Employment returned and the economy grew but this was just another bubble. The misallocation of resources that occurred during the boom of the 1920s was just locked in or deepened.
The Hayekian Insight: Misallocation of Capital
A key insight of the Hayekians is that economic resources are malinvested during booms. Low interest rates encourage the allocation of capital toward investments that turn out not to be as profitable was expected in a higher interest rate environment. Hidden inflation in the form of asset bubbles creates the impression that there is more wealth than is actually available, again creating false expectations of profits. Capital—financial and human capital—is misdirected to the extent that it doesn’t match the actual availability of investments or consumption preferences. Basically, at the height of a bubble we invest too much in stuff people don’t really want or need.
When resources allocation becomes too far out of whack with reality, the economy begins to contract. This can come suddenly due to a change in tax or fiscal policies, a financial market crash that causes a panic, or a sudden shift in monetary policy. It can also come about without any such shifts, simply because capitalists begin to realize the mistake they’ve made and refuse to continue to making such mistakes.
At this stage, the economy contracts, businesses close, and jobs are lost. What is really happening is really happening is that investors stop investing in unproductive businesses, starving them of capital. Because factories have been built, business models developed and workers trained to work for those unproductive businesses, this can feel disastrous. Many of the resources we once had—well-trained workers who are highly productive, business relationships and efficiencies, and those factories—becomes suddenly worth far less. Much of what looked like the signals of wealth turn out to be pure waste. The malinvestments must be liquidated so that what resources can be recovered can be used in genuinely profitable ways.
To the neo-Keynesians, this liquidation looks like needless waste. If the economy was capable of growing at a certain rate or producing a certain amount of goods and services, a liquidation that requires a reduction of the rate of growth and the amount of production strikes them as an unnecessary “output gap.” They would have the government step in to increase spending in order to keep the demand for those old goods and services in place.
Allowing The Economy To Recover
The Hayekian critique of this is not so much directed against the stimulus here—government keeping up aggregate demand—but at the interference with the corrective action of liquidation. The problem with the government seeking to increase aggregate demand to spur an economic recovery is that it tends to increase demand in the very things and activities produced by the earlier misallocation of capital. That is, it keeps up demand for the junk we don’t need or want. (The best example of this that comes readily to mind is the multifaceted attempt by the government to keep resources from continuing to exit housing.) As a result of this, a healthy recovery is not just delayed—it is made more painful as more time, money, and human working hours have been malinvested during the government directed stimulus.
Hayekians would prefer to allow a downturn to run its course. It’s not just that old misallocations must be corrected. New ideas and products must be invented, the factories must be retooled, worker retrained. As they are, the economy recovers and begins to grow again.
The Danger We Now Face
This process, however, can be thwarted not only by bad government policies that stimulate the wrong things. The government can also stand athwart recovery by actively reducing the amount of capital available for private investment through tax hikes, over-aggressive constraints on bank lending, and tighter monetary policy.
When the economy sputters a second time, there is a strong danger of an over-reaction. Because investors and entrepreneurs perceive the failure of the second recovery, the economy may slip into a psychological contraction—one that goes far beyond the level necessary for the liquidation of malinvestment. This is the true “panic” stage of the economic cycle.
Welcome Back To The 1930s
What we’ve had is a replay of the 1930s, whether it is seen from the neo-Keynesian or Hayekianperspective. For the Keynesians, we’re risking a premature exit from monetary and fiscal stimulus. For the Hayekians, this looks like the government stomping on the breaks following a contraction-compounding attempt by the government to ameliorate the recession through stimulus plans and bailouts. The combination of the early recession fighting, higher taxes, new innovation constraining regulations, monetary tightening, and lower government spending will likely produce the psychological recession that will be far worse and longer lasting than what we originally faced.
No matter what you think about economics, this is a disaster. Which makes us wonder if the Obama administration policy makers behind the spending freeze have thought about economics at all.
