Killing Economic Prosperity

Debt And Deficits 

by Lance Robert

What is really causing the economic malaise that the U.S. faces today?  Most economists believe that it is the lack of aggregate demand that is causing the problem which can be rectified by continued deficit spending.  The current Administration believes that it is simply the lack of the "rich"  not paying their "fair share" and that a redistribution of wealth will solve the issue.  Romney believes that his 5-point plan will create 12 million jobs in the near future.  All are wrong.   

Raising Taxes Ain't Gonna Do It

First of all, as we have discussed in the past, raising taxes and redistributing wealth will impede economic growth.  Louis Woodhill put it best:  

"To 'tax' is to take away something from someone and give it to the government. 'The rich' are rich because they own a lot of assets. So, what it means to 'tax the rich' is to take assets away from rich people and transfer them to the government.

So, what are the assets that the rich own? The rich don't have money bins full of cash, like Scrooge McDuck. Rather, they own things like factories, office buildings, and oil wells, either directly or indirectly via stocks and bonds. In other words, the rich own most of the 'nonresidential fixed assets' of the nation. These assets certainly count as 'wealth', but what they are physically are the tools that workers use to produce America's GDP.”

This is critically important to understand.  By increasing taxes, to generate additional revenue for the government, you decrease the available capital that could be used for productive investments.  Since the government doesn’t want factories, office buildings, or oil wells, but rather cash, this forces the liquidation of productive investments thereby reducing capacity for economic growth.

As Mr. Woodhill goes on to state: 

“The relationship between nonresidential fixed assets and GDP has been essentially constant for the past 60 years. One dollar of nonresidential fixed assets yields about $0.50 of GDP. Real GDP per worker has risen over the years as real nonresidential fixed assets per worker have increased. In 2009, according to BEA data, the average job was underpinned by about $200,000 in nonresidential fixed assets.

So, if you tax away $200,000 from 'the rich', GDP goes down by about $100,000 per year, federal revenues go down by about $18,000 per year, and total employment goes down by one job. This is how 'spreading the wealth' actually works. This may account for why 'taxing the rich' is, inexplicably for Progressives, not popular with voters.

Now, $200,000 is more than $18,000, so doesn't 'taxing the rich' at least leave the federal government better off? No, it does not. This is because to get the $200,000, the federal government has to give up $18,000 per year in tax revenue from then on. The present value of $18,000 per year is about $620,000. So, when the federal government taxes $200,000 away from 'the rich', it makes itself worse off by $420,000, the country as a whole becomes poorer by $3.4 million, and Joe Lunchbox loses his job."

Now stop and think about all this for a moment.  Small businesses are in no mood to hire because of the economic outlook and the fact that final demand from consumers is still not present, which is why "poor sales" ranks so high on their list of concerns.

This is why the current Administration is failing once again to recognize that the problems that exist with this country, at this moment, does not lie with the "rich".  Instead, the problem is a lack of ability to consumers to maintain a standard of living that is well beyond their earnings capability.  While the two most recent Administrations have been heavily criticized for running burgeoning deficits - the reality is that the average American has been doing the same for the past thirty years.

Therefore, it is not surprising that raising taxes suppresses economic growth.   As shown in the chart if you want to increase revenue you need to produce economic growth. It will surprise most people that over the last 50+ years regardless of the level of tax rates - tax receipts as a percentage of GDP has remain mired between 16 and 21%. During recessions tax collections are at the lower end of the range.  Not surprisingly, during periods of economic growth, tax collections are at their peak.

So, while the current administration continues to believe that the solution to the nation’s economic problems is a function of “people paying their fair share” – they keep ignoring the 800-lb economic killing gorilla in the room which is the deficit. 

It’s The Deficit Stupid

Taxes are imposed on profits and earnings.  Once taxes are paid on profits and earnings the net savings are left alone.  This allows those dollars to be invested into productive investments which in turn generate more profits and earnings which will be taxed.  As stated above, as the “rich” invest in productive investments it leads to higher employment, strong consumer demand and economic growth.  In turn this leads to higher tax revenue.

However, deficits, and deficit spending, are HIGHLY destructive to economic growth as it directly impacts gross receipts and saved capital equally. Like a cancer – running deficits, along with continued deficit spending, continues to destroy saved capital and damages capital formation. 

We discussed recently the economic impact of spiraling debt levels that have eroded economic growth.  Debt is, by its very nature, a cancer on economic growth. As debt levels rise it consumes more capital by diverting it from productive investments into debt service. As debt levels spread through the system it consumes greater amounts of capital until it eventually kills the host. The chart below shows the rise of federal debt and its impact on economic growth.

We stated:  

“From the 1950’s through the late 1970’s interest rates were in a generally rising trend with the Federal Funds rate at 0.8% in 1954 and rising to its peak of 19.1% in 1981. Of course, during this time the U.S. was the manufacturing and production powerhouse of the entire global economy post the wide spread devastation of Europe, Germany and Japan during WWII. The rebuilding of Europe and Japan, combined with the years of pent up demand for goods domestically, led to a strongly growing economy and increased personal savings.

However, beginning in 1980 the world changed. The development of communications shrank the global marketplace while the rise of technology allowed the U.S. to embark upon a massive shift to export manufacturing to the lowest cost provider in order to import cheaper goods. The deregulation of the financial industry led to new innovations in financial engineering, easy money and wealth creation through the use of leverage which led to a financial boom unlike any seen in history. The 80-90's was a period of unrivaled prosperity and the envy of every nation on earth.

Unfortunately - it was the greatest economic illusion ever witnessed.

The reality is that the majority of the aggregate growth in the economy was financed by deficit spending, credit creation and a reduction in savings. In turn this reduced productive investment in the economy and the output of the economy slowed. As the economy slowed, and wages fell, the consumer was forced to take on more leverage to maintain their standard of living which in turn decreased savings.

As a result of the increased leverage more of their income was needed to service the debt - and with that the "debt cancer" engulfed the system.

The Austrian business cycle theory attempts to explain business cycles through a set of ideas. The theory views business cycles “as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.”

However, it wasn’t just the consumer leveraging themselves up to the hilt to offset their decline in economic prosperity.  Likewise the government, in order to offset ballooning spending with lower rates of revenue of growth, indulged heavily into deficit spending.  

As stated above, deficit spending, like debt, is very prohibitive to capital formation and impedes future economic growth.  The chart below shows GDP year over year growth rates versus the deficit. 

As you can clearly see the economy was able to grow rather strongly as long as the government wasn’t significantly living beyond their means.   However, beginning in 1980, as the use of deficit spending became an accepted government practice, economic prosperity began to erode.   Not surprisingly, the bigger the deficit has become the lower the rate of economic growth.

4% Economic Growth – A Distant Memory

This is the problem with all of the deficit reduction, and tax plans, that have been proposed by various parties – they all assume much higher rates of economic growth.  This is also the problem that is currently faced by the Federal Reserve. 

In “The Fed And Goldilocks Economic Forecasting” we wrote:  

“When it comes to the economy the Fed has consistently overstated economic strength.  In January of 2011 the Fed was predicting GDP growth for 2011 at 3.7%. Actual real GDP (inflation adjusted) was 1.6% or a negative 56% difference. The estimate at that time for 2012 was almost 4% versus 2.0% currently.

We have been stating repeatedly over the last 2 years that we are in for a low growth economy due to the debt deleveraging, deficits and continued fiscal and monetary policies that are retardants for economic prosperity. The simple fact is that when an economy requires nearly $5 of debt to provide $1 of economic growth the engine of prosperity is broken.

The chart below shows current real GDP as reported by the Bureau of Economic analysis versus that from the Congressional Budget Office which is used by the Administration for budgetary planning. 

As you will see, while the CBO expects there to be a strong economic recovery in 2013, which is VERY unlikely to occur given the current recession in Europe and slowdown in China, growth then tapers back off to 2% through 2018.  In other words, even the CBO is saying that the economy cannot achieve escape velocity as the drag from debt and deficits continue to retard growth.

The problem that is yet not recognized by the current Administration and mainstream economists is that the excessive deficits and exponential credit creation can no longer be sustained.  The process of a “credit contraction” which will continue to occur in fits and starts over a long period of time as consumers, and the government, are ultimately forced to deal with the leverage and deficits.

The good news is that process of "clearing" the market will eventually allow resources to be reallocated back towards more efficient uses and the economy will begin to grow again at more sustainable and organic rates.

Today, however, expectations of a return to economic growth rates of the past are most likely just a fairy tale. The past 3 years of stock market returns have been fueled by trillions of dollars of support and direct injections into the financial system - that support is not sustainable in the long run. While the injections have kept the economy from falling into a depression in the short term - the unwinding of that support will suppress economic growth for many years to come.

There is no way to achieve the necessary goals "pain-free."  The time to implement austerity measures is when the economy is running a budget surplus and is close to full employment.  That time was two Administrations ago when the economy would have slowed but could have absorbed and adjusted to the restrictive measures.  However, when things are good, no one wants to "fix what isn't broken".   The problem today is that with a high dependency on government support, high unemployment and near record budget deficits implementing austerity measures will only deter future economic growth, which is dependent on the very things that need to be "fixed".

Furthermore, the impact on the psyche of the consumer will continue to be impaired much to the same degree as those that survived the depression era. The mantras for frugality and conservatism are very hard to reverse and have economic consequences. With the economy mired at lower growth rates likewise the stock market, which is ultimately a reflection of the economy and not vice versa, will remain mired at lower rates of growth.

The processes that fueled the economic growth over the last 30 years are now beginning to run in reverse, and when combined with the demographic shifts in the U.S., the impact could be far more immediate and prolonged than the media, economists and analysts are currently expecting.  Sacrifices will have to be made, the economic will drag an subpar rates of growth, individuals will be working far into their retirement years and the next generation of Americans will lead a far different life that what the currently retiring generation enjoyed.   It is simply a function of the math.