Michael B. Duff

Republicans are celebrating (prematurely) now that Obama seems to be on board with preserving the Bush tax cuts.

I believe that tax cuts are always good, but doing something good for the economy is not the same as fixing the economy.

A friend of mine said recently that Keynesianism is a religion. Paul Krugman is using an unfalsifiable argument when he defends money printing and government stimulus. Sure, our predictions were wrong and unemployment is getting worse instead of better, but imagine how bad it would have been if we had done nothing.

Now Republicans are in exactly the same boat with tax cuts. Obama has called their bluff. They got what they wanted and preserved tax cuts for the “rich,” but what if the economy doesn’t improve?

What will the Republicans say? “Well sure, our predictions were wrong and unemployment is getting worse, but imagine how bad it would have been if we had let those tax cuts expire.”

Same unfalsifiable argument, same blind faith.

Tax cuts are really just another kind of stimulus. You can argue that private stimulus is more effective than government stimulus but even if we grant that, it misses the point.

The economy is not struggling because we lack “liquidity.” Demand for credit is going down, not up. There’s no monetary “shortage” out there. The problem is malinvestment. The succession of bubbles we’ve had in tech stocks, real estate, and bond markets have shifted the focus of the economy to things that cannot produce sustainable profits.

We have too many construction workers, too many bureaucrats and far, far too many real estate and finance professionals performing jobs that do not generate real wealth.

We have to regroup, refocus and retrain. Trillions in bad debt needs to be recognized, restructured and discharged. Hundreds of banks need to fail, thousands of mortgages need to be discharged and hundreds of executives on Wall Street need to go to jail.

Tax cuts are great, but tax cuts can not fix the fundamental problems with this economy.

Picture the economy as a big bucket with a small hole in the bottom. You’ve got a water hose that represents cash — money, liquidity, stimulus, tax cuts, whatever. Good investment stays in the bucket and raises the water level, bad investment leaks out of the hole.

You notice the water level in your bucket going down and you panic. You grab the hose and sure enough, the water level rises again, as long as you keep pouring water/cash into the bucket. But this action does nothing to patch the hole. You’re still leaking money out the bottom. In fact, when you add money into the system, velocity increases and the leak gets worse.

Congress comes along and has to make a choice. Are we going to let these tax cuts expire and reduce the flow of water into the bucket, or are we going to let things continue as they are?

Expiring the tax cuts would hurt the economy, i.e. reduce the total amount of water in the bucket, but they would also reduce the amount of bad investment leaking out the bottom. Allowing the tax cuts to continue will preserve the current rate of flow into the economy, but will do nothing to fix the fundamental problem.

Somebody needs to stand up and shout, “Hey! You’ve got a hole in that bucket!” and find a way to patch it. (In real life, this person is Ron Paul.)

But instead of listening to these people, politicians are arguing amongst themselves. Republicans say, “We need to cut taxes and pour hot water into the economy!” Democrats say, “The government needs to spend more and pour cold water into the economy!”

The only time they agree is when they get together on TV to shout, “Shut up, you idiots! The bucket’s fine! We’re just not getting enough water from the hose!”

This is the basic premise of the Austrian Business Cycle. Our efforts to patch the bucket may disrupt things and lower the total water level for a time, but the whole system will be healthier when we’re done. The repairs will be messy, but the repaired bucket will hold more water in the long run.

So no, I’m not expecting tax cuts to fix the economy. Honestly, I was hoping the Democrats would repeal them. This would serve two purposes. First, it would cause a surge in unemployment and provide evidence that tax cuts for the rich finance jobs for the poor. And second, they would force a lot of marginal companies to go bankrupt and help deflate the stock bubble on Wall Street.

We’re at the point where we must abandon our current tasks so we can focus our attention on better ones. Cutting interest rates and preserving the tax cuts encourages people to stick with the (failed) course they’re currently on.

A tax increase could provide a much-needed reality check to people who are currently addicted to easy money, reducing the “water level” so much, ordinary voters might even notice the hole in the bucket.

It’s a uniquely perverse way of looking at tax policy, but this is the world we live in.

So what should we do? Increase interest rates and stop the crazy flow of money that is making this problem worse. Free money from the Fed is encouraging all kinds of distortions in the market, to the point of rewarding blatant corruption. It must be stopped before things can get better.

The question is, will we stop it voluntarily, or will we have sanity imposed upon us, by a bond market that doesn’t believe our promises anymore?