By John L. Chapman, Ph.D.                                                                                                                                                  Washington, D.C.

The world economy has now entered its fourth year of deep troubles, with the Eurozone at zero growth and a few of its countries near default; China threatened with collapse of its bubble economy; Japan still lost after 20 years and now burdened by a crushing public debt and low growth; near-recession in much of Latin America; perpetual war in the perpetually-unstable Middle East; and of course a sclerotic U.S. economy, with its anemic 1.3% growth rate, and a record 27 million people who would like full time work now unable to find it.  Not since the 1930s has so much pessimism about the future been so pervasive, on a global scale.  A few obvious questions arise: why can’t policymakers address this?  What are we doing wrong?  Doesn’t the economics profession have answers for how to cure recessions?

The answer is simple, yet subtle; it comes in two parts, but it’s important to understand.  First, most policy-makers and elected officials are trained lawyers, with little to no real-world experience in business.  Specifically, few law-makers, not only in the U.S. but around the globe, have ever had profit-and-loss responsibility, had to make a payroll, or make decisions in the face of uncertainty which, if proven wrong, would mean loss of wealth (in the current Presidential race in the U.S., for example, only Herman Cain and Gary Johnson have had P&L operating experience running sizable enterprises).  Barack Obama is a canonical example of this: Mr. Obama just passed his 50th birthday but spent less than a year in the business sector (during 1983-84), leaving that 27 years ago to move to Chicago and become a “community organizer”.  As such, elected officials often pass legislation that seemingly has good intentions, but often comes with unintended consequences that lead to more harm than aid, over all.

This was classically demonstrated in a June 1, 1992 editorial-page essay in the Wall Street Journal by former Senator and 1972 Presidential nominee George McGovern, who had purchased the Stratford Inn in Stratford, CT in 1988.  Mr. McGovern had never before been a business owner, or spent any time in the private sector at all at any time in his prior life before this venture.  It was an expensive education for him at age 66, as he bought, renovated, and began to operate the 150-room inn, with the goal of providing a hotel, restaurant and public conference facility.  But he ran into trouble; the hotel entered bankruptcy in 1990, and closed in 1991.  As Mr. McGovern recounts, he previously had had no idea of the burdensome costs and regulations that federal, state, and local authorities place on business owners, and he openly lamented his prior lack of business acumen: too late in life, he came to understand the harm that elected officials can cause, even with the best of intentions.  He is worth quoting at length on this:

In retrospect, I wish I had known more about the hazards and difficulties of such a business……  I also wish that during the years I was in public office, I had had this firsthand experience about the difficulties business people face every day. That knowledge would have made me a better U.S. senator and a more understanding presidential contender. [emphasis ours].

Today we are much closer to a general acknowledgment that government must encourage business to expand and grow. Bill Clinton, Paul Tsongas, Bob Kerrey and others have, I believe, changed the debate of our party. We intuitively know that to create job opportunities we need entrepreneurs who will risk their capital against an expected payoff. Too often, however, public policy does not consider whether we are choking off those opportunities.

My own business perspective has been limited to that small hotel and restaurant in Stratford, Conn., with an especially difficult lease and a severe recession. But my business associates and I also lived with federal, state and local rules that were all passed with the objective of helping employees, protecting the environment, raising tax dollars for schools, protecting our customers from fire hazards, etc. While I never doubted the worthiness of any of these goals, the concept that most often eludes legislators is: `Can we make consumers pay the higher prices for the increased operating costs that accompany public regulation and government reporting requirements with reams of red tape.’ It is a simple concern that is nonetheless often ignored by legislators.

For example, the papers today are filled with stories about businesses dropping health coverage for employees. We provided a substantial package for our staff at the Stratford Inn. However, were we operating today, those costs would exceed $150,000 a year for health care on top of salaries and other benefits. There would have been no reasonably way for us to absorb or pass on these costs.

Some of the escalation in the cost of health care is attributed to patients suing doctors. While one cannot assess the merit of all these claims, I’ve also witnessed firsthand the explosion in blame-shifting and scapegoating for every negative experience in life.

Today, despite bankruptcy, we are still dealing with litigation from individuals who fell in or near our restaurant. Despite these injuries, not every misstep is the fault of someone else. Not every such incident should be viewed as a lawsuit instead of an unfortunate accident. And while the business owner may prevail in the end, the endless exposure to frivolous claims and high legal fees is frightening.

Coming from one of the most “far Left” Senators of the 20th century, this was a stunning admission of prior ignorance.  What Mr. McGovern does not state directly, but certainly alludes to in the above, is that his entire political career was spent in pursuit of policies which, seen from his new vantage point of greater wisdom, were wholly retrogressive — anti-job creation, anti-economic growth, and anti-progress.  Indeed, one of the ironies of his newfound wisdom is that while in the Senate, he was one of the biggest beneficiaries and defenders of the trial lawyers’ lobby: yet as a business owner, he was victimized by frivolous lawsuits that helped drive him into bankruptcy and misery.  (“Payback is hell”, as per a famous American idiomatic expression).

Sadly, McGovern’s statement above about the appreciation then extant among Democrats for the importance of ensuring a pro-business and pro-entrepreneurship foundation for legislation is no longer operative: Barack Obama has returned the Democrat Party to its (old) McGovernite stance of progressive taxation, heavy regulation, and big spending.  And the problem of legislators being wholly ignorant of the harmful effects of their legislation, freely admitted to by Mr. McGovern after learning about it first-hand as a small business owner, has returned in full force, if indeed it was ever temporarily solved. This is one primary reason why the political class in Washington has been so inept in combating the recent recession.

The Policy Blindness and Failing of the Economics Profession Itself 

An even deeper core problem exists, however, and is ultimately more important to correct.  For the fact is, bureaucrats and elected officials rely on professional economists for advice in forming legislative agendas dealing with the economy.  And therefore if, as is sadly true, the economics profession itself is confused about the basic questions of macro-economic policy — growth, recession, inflation, unemployment, trade, and regulation – then the time-honored axiom from the computer industry, “garbage in, garbage out”, will apply.  That is to say, the professional advice that economists have rendered to policymakers in recent years has been wholly incorrect, because it is based on a false theoretical construct of how the world works.

This is true partly for the same reason as the pervasive ignorance of legislators: most economists who are “loudest” in dispensing policy advice — Paul Krugman, Nouriel Roubini, Brad DeLong, Lawrence Summers, and Jeffrey Sachs come to mind — have, like Barack Obama, never worked in the real world of business. They are, as it were, ”cradle to grave” occupants of the ivory tower of academia.  And in turn, this inexperience feeds the larger problem with the modern economics profession: in their “world”, the business sector plays  out on a whiteboard or chalkboard, in the form of variables in equations.  And these variables move according to assumptions that the economist arbitrarily makes in setting up the model.  That is to say, the variables behave the way the economist, who is standing “outside” the model, and “above” it, wants them to behave.

So it is very easy to say, for example, “raise taxes on millionaires, and we will get this much more revenue.”  Or, “raise this minimum wage, and we will only see this much unemployment as a result”, since we “assume” we “know” the elasticity of demand for labor. Or, “set interest rates to here, and such and such will happen”, in terms of lending and investment.

In other words, these professionally-trained economists who have spent their entire lives in the world of high theory have an indomitable confidence that they can “fine-tune” the economy with discretionary policy moves that work perfectly well in theoretical models.  The progenitor of the modern economics profession’s love affair with activist policy intervention is, of course, none other then John Maynard Keynes.  Keynes was an indisputably brilliant man, but this was matched by his intense arrogance and self-flattery: he was convinced that his “revolutionary” theory allowed for timely policy moves that could over-ride or correct any problems in competitive markets — and that he and his disciples were smart enough to know exactly what to do and when to do it.

Unfortunately for the world, the Keynesian model for analyzing the macro-economy quickly came to dominate the profession, and has ever since; supported, of course, by a political class that benefits handsomely from Keynesian policy prescriptions for government spending.  We say “unfortunate”, because the Keynesian paradigm contains serious errors when applied to the real world, that in turn lead to incorrect and often harmful policy — errors that in this case have extended a long recession and now made things worse.  It will be the subject of another essay to fully outline the many ways in which Keynesian thinking leads to incorrect policy, but the most basic one of all is the very basis for Keynesian aggregative (macro) analysis, the core foundation of Keynesian theory:  Keynes defined the total output of an economy as a simple addition of total final spending, which he categorized into four areas, those being consumption, business investment, government spending, and the difference between exports and imports.  The sum of these four “buckets” of final spending equal, for Keynesians, total “aggregate demand” in an economy.

Viewed in this way, Mr. Obama’s (and before him, George Bush 43′s, Clinton’s, et al.) advisors focus on aggregate demand as the primary metric for signalling the health of the economy: recessions are, in this view, caused by a drop in aggregate demand.  As such, they emphasize total spending as tantamount to the primary cause of  economic growth itself: if total spending in an economy goes up, total aggregate demand rises pari passu, and jobs are created as a result.  And so none other than former Secretary of the Treasury and Harvard President Lawrence Summers talked, at the outset of the Obama Presidency, about the needed “plug” in government spending, to counter the drop in consumption and investment, with an increase in government outlays.  This was the primary justification for Mr. Obama’s first big legislative success, a $787 billion spending package that, after add-ons, amounted to a trillion dollars; but, we were assured by Obama-Biden advisors Christina Romer and Jared Bernstein that this would prevent unemployment from ever rising above 8%.

There are several errors in this formulation, but the fundamental one is that government spending is treated as wholly exogenous to the rest of economic activity, and that it can act as a “plug” to fill in any “gap” in what arrogant policymakers deign to be the “correct” desired level of private sector spending and investment.  But in fact, this classic example of an ivory-tower policy conclusion is absurd, seen from the vantage point of the real world:  by definition, any spending done by the government commandeers resources — that is to say, real wealth — from the private sector.  The government cannot create real wealth out of thin air: it spends only what it takes from private agents (individual human beings and corporate tax-payers), through taxation of their income, profits, and wealth; or, by debasing the currency through monetary manipulation (which is, effectively, a stealth tax on the private sector).  Therefore, any and all government spending must per force lead to a concomitant decline in consumption or investment spending, and/or net exports.  This will either happen immediately or in the immediate future, as government borrows funds that must be repaid out of future wealth and income.

Thus, and this is crucial to understand, the famous Keynesian spending “multiplier”, where one dollar of government spending leads to successive rounds of private spending (e.g., the government “buys” a bridge that is built by contractors, wo in turn receive wages for their labor in building the bridge; they in turn buy [say] food with their bridge-building wages; the grocer buys new clothes; the tailor buys a new bicycle, and so on) and all this in turn increases aggregate demand and wealth, is fundamentally wrong.  Because every dollar spent by the government is one dollar taxed from the private sector, so there is corresponding deceleration and less in spending rounds in the private sector.  The bridge-builder’s gain is the tax-payer’s loss.  Best case, assuming there were zero levels of waste and fraud in government spending, there would be no net gain or loss in wealth for the whole of society, but indeed, there is strong evidence that government spending is on net wasteful, and harms economic growth and prosperity.  It should also be noted here that this spectacular error in economic theory leads to a policy bias in favor of spending that consumes (or destroys) capital, and against saving, which leads to an accumulation of capital that in turn drives investment.

The other big error in policy-making driven by this Keynesian mindset, per the above, is that spending is seen to be a cause of economic growth and prosperity.  The Obama Administration wants to continue massive government spending (and a terribly easy Fed monetary policy) because in their view that adds to current “aggregate demand”.  Hence we observe the emperor-has-no-clothes-on contradictory absurdity of Messrs. Obama and Bernanke declaiming on the need for current high levels of government spending, but that this should then be followed by future austerity and deep cuts in the budget deficit (which the political class takes to mean as higher future taxes on the public).

But spending is not a cause of economic growth and prosperity, as Keynes held; it is an effect of it.  Prior production provides income and wealth that allow for greater spending, or, as Jean-Baptiste Say once pointed out: we produce in order to consume; production is the source of demand.  When viewed correctly in this real-world light, the correct policy prescription flows from a correct diagnosis of the fundamental problem: the U.S. economy suffers from a lack of capital, not a lack of spending.  A loss of over $12 trillion in net household wealth during the recession has only been partially recovered, and thus only a continuing recapitalization of our economy will best lead to strong and sustainable growth.  Government spending is, for the most part and excepting true long-term infrastructure investment, actually tantamount to a destruction of capital wealth, because most government transfer payments are effective immediate consumption.  That is to say, the Obama Administration, like Bush 43 before it, has pursued policies leading to a decumulation of capital.  As far as policy goes, as they say, “garbage in, garbage out.”  This more than anything explains the failure of “stimulus” spending in recent years.

It is not too strong a statement to say that ivory-tower Keynesian theory has been wholly destructive over time.  Ludwig von Mises scoffed at all the ivory tower academics, and predicted our modern torpor more than 60 years ago, as Keynesianism was at its zenith.  He pointed out that economics was a deductive science of logic, and that reality could be apprehended from building a series of axioms that are grounded in truth.  So, if  one will simply remember that any government stimulus has an opportunity cost associated with it via resources that are now taken away from the private sector, catastrophic policy errors that lead to the destruction of trillions of dollars of real capital wealth can be avoided.

The Tragic Example of Paul Samuelson

We cannot leave this subject of how errant economic theory leads to terrible economic policy without mentioning one of the most famous intellectual errors of all time: Paul Samuelson’s continual prediction for several decades that the U.S.S.R. would likely overtake the U.S. economy in size and scale.  Mr. Samuelson was a Nobel Laureate in Economics and the foremost American proponent of Keynesian theory, and he asserted with confident certainty that the future success of the Soviet model for economic growth was assured.  For several editions of Samuelson’s best-selling textbook on basic economics, in fact, over a thirty year period, he predicted that the Soviet economy could very well overtake the U.S. as the world’s largest.

This was depicted in text graphics such as the following, in which Samuelson posited that the superior growth rate in the U.S.S.R., thanks to government-directed investment, would lead to a higher level of output than the U.S. economy.  As shown in 1961, Samuelson felt that output parity could occur as early as 1984, or as late as 1996, if the Soviet economy grew at its maximal capacity:

 Table I. Chart from Samuelson (1961) Showing Superior Growth of Soviet Economy

                                               

To be sure, the lower line of the Soviet growth possibilities funnel depicted above leaves open the chance that the Soviet economy does not become bigger than the U.S. in terms of output, but Mr. Samuelson did not see that as likely; he was an enthusiastic believer in the ability of central planners to dictate investment that would drive strong growth.

As the years went on, and the Soviet economy continued to lag that of the U.S. (and indeed, the reality was even worse than the official government-reported statistics indicated, as shown in Mr. Samuelson’s writings here; viz., he held that the ratio of U.S. to U.S.S.R. output was about 2:1 throughout this period, but it was in reality 5:1 or 6:1), Samuelson never wavered in his belief that the gap would one day close dramatically.  Per the table below, Levy and Peart show that successive editions of Samuelson’s textbook continued to make the same fundamental error:

Table II.  Successive Editions of Samuelson’s Textbook Showing Lag Time Until USSR Overtakes US Economy in Size and Scale (courtesy Levy & Peart, 2009).

                                              

As late as 1989, Mr. Samuelson still waxed enthusiastic about the Soviet model!

Summary

Paul Samuelson was of course a giant in 20th century economics: his 1947 Foundations of Economic Analysis is the basis of both modern general equilibrium theorizing and the “neoclassical synthesis”, which married modern marginal analysis with the Keynesian paradigm.  But however brilliant an ivory-tower theorist, Samuelson was utterly blind to the reality before him.  Steeped in the intense study of economics all his life, he nonetheless failed to apprehend the importance of property rights, sound money, and entrepreneurship, three pillars of the modern economy that in turn drive the investment that yields gains in productivity and creation of wealth that improve living standards.  To make the same point more formally, he was blind to the process of capital formation, from which human progress springs.  As such, his disciples at M.I.T., which include Paul Krugman and Lawrence Summers, and those fellow-travellers who ply their trade in Washington, D.C. advising the political class, are utterly clueless in the current moment of economic torpor.  Rather than solve our current problems, their recommendations often make matters worse, as they surely have in recent years — a price we will be paying for many years to come.  This is solely due to their “intellectual blinders”, of seeing the world through the lens of a false theoretical construct.

The answer to our present troubles consists of a policy mix that induces strong growth based on saving and the accumulation of capital, and its subsequent investment in enterprise.  In practical terms this is best accomplished by lowered levels of government spending now (Mr. Obama wants higher); a strong dollar (Messrs. Obama and Bernanke endorse a weaker dollar); deep cuts in tax rates on capital and income (the Obama plan calls for higher taxes, on the “rich” at first, and eventually on all); unrestricted trade everywhere (Mr. Obama just last week finally moved trade agreements signed years ago with Colombia, Panama, and South Korea); and lower levels of onerous regulation (Mr. Obama has pushed for more regulation in many industries).    In other words, Mr. Obama’s preferred policy mix, derived from Keynesian ivory tower theorists, is harmful to economic recovery and growth in every area.

There may thus be many reasons to re-elect Mr. Obama next year, but growth in output, employment and higher living standards are not among them.  Meanwhile, a better future can be had with a better understanding of economics, such as that prescribed in a rising number of institutions in the policy world where Keynesian policies are deconstructed and, appropriately, rejected (e.g., see www.fee.org, www.mises.org, www.cato.org).

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@alhambrapartners.com. 

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