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?

Consider this Part 2 of the screed that began with Republicans are sabotaging the economy!

Clearly, our two national parties have irreconcilable differences. I am so tired of this oscillating Nanny State/Daddy State bullshit, I’m tempted to see a judge and have myself declared an Emancipated Voter, just so I can get out of the house.

The parties are so devoted to their bunker mentality, they honesty can’t imagine the existence of a larger world. And they certainly aren’t smart enough to learn from Europe.

No one can see further than the next election. That’s why my mantra for the next decade is, “When it finally comes time to cut spending, it won’t matter who the President is.”

You think Ireland wanted to cut spending? You think Greece wanted to implement austerity?

Now that I’ve seen the exceptions, I’m ready to declare a rule: No democratic government can voluntarily cut spending. With the corollary, No democratic government can voluntarily raise taxes.

There are minor exceptions, so I have to add the unspoken clause “enough to matter” at the end of these.

The Republicans have a tentative mandate to cut spending as they take back the House in 2011, but they have already declared that Medicare and Social Security are off-limits. So where are they going to cut, defense?

The problem facing us is so huge, you could cut billions from discretionary programs without making a dent. And the bunker mentality assures us that the Democrats will fight every cut as if it were a bullet fired at grandma.

Expect to see huge fireworks over health care and the Bush tax cuts but these issues are sideshows to the main event. The eventual compromises will be so small, the final products will be so neutered, their effect on the deficit won’t even be a bump on the graph.

And no, they won’t do much for jobs, either.

America isn’t ready to cut spending yet. I would argue that is electorally impossible for either party to cut spending or raise taxes enough to matter. Any reform big enough to solve the problem would make the offending party unelectable in the next cycle.

The changes must come from outside. There must be a third party that both sides can blame. We must blame Europe or China or the bond market. My personal choice would be to blame the banks and host a bipartisan mortgage-burning on the White House lawn.

But that reform looks impossible, too, as long as both sides remain terrified of bank runs and civil unrest.

Keep one thing in mind, as you read the headlines this year. If Ireland and Greece could print money, they would still be spending. Hell, they still are spending, and will continue to do so, as long as Germany and France are willing to incur debt on their behalf.

There are only two ways this can end. Spend until debt is so expensive you can’t borrow anymore, or print money until you reach a hyperinflation tipping point.

The PIIGS can’t print, so they’ll stop when Europe stops subsidizing their debt. America CAN print, and the value of the dollar is being offset by the weakness of the Euro and the deflationary impact of the mortgage crisis, so we’ve probably got another decade before austerity is imposed upon us.

Everything that happens in the meantime is posturing and theater. Republicans and Democrats are fighting to see who will be Captain of Titanic when the music stops. When the reckoning comes, it won’t matter who the President is.

Personally, I hope it’s a Democrat, so Blue Team can spend 80 years of debt-financed “credibility” repealing the programs they created.

I really shouldn’t read Balloon Juice first thing in the morning. Fine to have it in the regular rotation but I should probably warm up with stuff I agree with first.

I was struck by this post, Listen all y’all, it’s sabotage which repeats Steve Bensen’s allegation that the Republicans are trying to deliberately sabotage the economy so they can blame Obama for it in 2012.

I already knew that Republicans lived in a self-referential world of conspiracy theories and circular logic. Nice to see the Left is keeping up.

You see how brilliant this is psychologically? If you’re convinced that spending cuts are bad for the economy, Republican attempts to fix the problem will be indistinguishable from sabotage.

If you’re convinced that tax cuts hurt the economy and reward the rich, any attempt to cut taxes will be indistinguishable from sabotage.

It’s not enough to admit that Republicans and Democrats subscribe to two diametrically-opposed economic theories. Democrats are so steeped in Keynesian orthodoxy they assume that even Republicans believe it, and are deliberately sabotaging the economy with spending and tax cuts.

You have to assume that your position is so perfect, so self-evidently correct, that no sane person could deny it.

I’ve heard this argument before. From Ayn Rand. Objectivists (at least the ones I argued with) believe that there can be no principled objection to capitalism. The benefits of capitalism are so overwhelming and so obvious, anyone who opposes it is, by definition, evil.

No rational personal can deny the benefits of capitalism, so anyone who denies them is doing so because they hate life itself. They “hate the good for being good” and should be judged accordingly. So ultimately, the only question worth debating with a Progressive is, “Why do you hate life?”

How amusing to see this same logic employed by the Left. They can’t just sit down with the Republicans and assume they’re serious. There can be no honest objection to Keynesianism, so this has to be some kind of PLOT to frame Obama and seize the White House!

Good job, guys. Ayn Rand would be proud.

I’m appalled by how narrow and petty this world view is. I knew this Red/Blue thing was out of control, but I hadn’t come face to face with the psychology of it before. Republicans and Democrats are so trapped in this paradigm, so steeped in their eternal turf war that they can’t imagine a bigger world — a world where tax increases drive capital to emerging countries and government borrowing increases the interest payment on the debt we already have.

Their myopia is staggering. Like a pair of boxers so intent on their opponents that they can’t see the stadium burning down around them.

Look around, guys. The world is bigger than your boxing match, and if you don’t come to your senses and start playing like grownups, the ref is gonna break it up.

After a brutal 18-month battle, House Republicans have finally passed their historic Fiscal Responsibility Act — a bill that promises to reduce the rate of increase in government spending by .05 percent by 2016.

Democrats have universally condemned the bill, insisting that these cuts occur at the expense of the poor and elderly. A Senate version, expected to reduce spending by .01 percent in 2018, is expected to be out of committee by October.

President Obama has promised to veto the bill, saying that he will not balance the budget on the backs of the poor, calling this, “the most egregious act of fiscal brutality” since Ronald Reagan cut spending by 1 percent in 1989.

These bills are not expected to affect the second round of European bailout talks, scheduled for August.

Boehner and the House Republicans have announced a 38-state “We Listened!” tour that will begin next week.

Okay Republicans, here’s your mandate:

1. Clean up this health care mess, but don’t touch my Medicare!

2. Cut government spending, but don’t touch my Social Security!

3. You can kill Cap and Trade but I need you to pretend to believe in Global Warming, at least while the cameras are on.

4. You can extend the Bush tax cuts, but pretend they’re not for rich people.

5. Keep us safe from terrorists, by frisking grandmothers and restricting the flow of toothpaste across state lines.

6. Punish those fat cats on Wall Street, without jeopardizing your “relationship” with their lobbyists.

7. Remember, only crazy people worry about the Federal Reserve. They’re over there doing lots of smart economics stuff and they don’t need you asking questions or messing things up. Ben Bernanke taught at PRINCETON for God’s sake. He doesn’t need you screwing up the market by going on TV and trying to pronounce big economic words.

8. War? What war?

9. Unleash the populist might of the Tea Party, but don’t let them say anything weird on TV.

10. Create lots of new jobs without cutting anything, spending anything or repealing anything.

11. And while you’re doing all that, please raise millions of dollars for the next election. 2012 is right around the corner.

Got it? Okay. Ready. Set. Govern!

The current crisis was caused by monetary policy. That is, by how much it costs banks and businesses to borrow money. In the old days the supply of money was connected to a physical commodity. Money was backed by gold, so when banks started to run low on gold, they had to stop lending money. The economic growth charts looked like a mountain range, spiking up as banks lent money and diving back down when they stopped.

This was actually a healthy process. When money got tight, businesses that weren’t making a profit failed and went bankrupt. They sold off their land and equipment to other businesses and their workers got jobs at places that actually were making a profit.

And since the supply of money was finite, banks had to be careful about who they loaned it to. Only people with good reputations, with a proven track record of borrowing money and paying it back had access to credit.

Malinvestment

Then some economists came along and said we didn’t have to live with all these contractions in the market. We could sever the connection between money and gold and have a permanent credit boom. Those scary peaks and valleys on the growth chart could be replaced by one smooth line, forever sloping up. Banks would have lots of money to loan out and everybody would have access to cheap credit.

But this creates a problem. Not every loan is a good loan. Not all business ventures will make a profit. And when money is easy to come by, business owners can afford to take risks that they wouldn’t take in a time when credit is hard to get.

It would be better for everybody if failing businesses were allowed to go bankrupt, so their labor and equipment can be redirected to smarter things. But when money is cheap, businesses can delay the consequences of bad decisions and keep rolling debt over in hopes that things will magically turn around.

That’s where we are now. Decades of cheap credit have created bubbles of fake prosperity, brought about, not by real sustainable profits, but by shaky promises backed up by cheap money. “Innovators” on Wall Street have invented new ways to bet on the outcome of these loans, and many of them have committed outright fraud, lying about the quality of the mortgages people were betting on — pretending they were all good loans made to reliable people, when most of them were just crap.

Economic calculation at the Fed

In the days before we had a central bank, interest rates were determined naturally, going down when banks had excess gold in their vaults and spiking up when they started to run low. The money supply was finite, so banks knew exactly how much they had to lend and could predict approximately how much they could expect to get back. The finite nature of the money supply provided reliable information to everybody lending money and helped them set the price of credit accordingly.

Now interest rates are decided by central planners at the Federal Reserve. This same kind of central planning failed in the Soviet Union because without organic feedback from the market, there’s no way to calculate an appropriate price for goods and services. The bureaucrats have to guess. When the planners produce too much you get waste and surplus. When they don’t produce enough, you get shortages.

The same dynamic applies to interest rates. Without feedback from the market, there’s no way for economists at the Fed to know what the “right” interest rate is. They have to guess. It’s a fool’s game even when everybody’s honest, but the process of setting interest rates is also vulnerable to political influence and outright corruption. Politicians love low interest rates. When rates are low, it’s easier for governments to borrow money, and since borrowing is easier than raising taxes, politicians have a strong incentive to keep rates low.

Consumer spending and the Real Estate Boom

Low rates make it cheap for people to borrow money, but they also make it hard for people to save money. When savings accounts and CDs barely pay enough to keep up with inflation, investors have to put their money in riskier types of investments in order to get a decent rate of return.

For the past ten years that investment capital has been put into real estate. Republicans and Democrats got together and agreed on the idea of an “ownership society.” They set up programs that would encourage people to buy houses. The price of houses shot up and all these investors, driven out of safer things by low interest rates, decided that real estate would be a great place to put their money.

Housing prices exploded. The housing market became so lucrative, ordinary people started buying big houses and borrowing against the expected future value of their homes. They cashed out the value of equity they hadn’t actually paid in yet and used it to buy boats, cars and flat screen TVs.

Banks lowered their lending standards because, hey, what’s the worst that could happen? Worst case, the bank forecloses on the house and ends up with an asset that is skyrocketing in value. The risk to the bank was negligible, as long as those housing prices kept going up.

This created a giant short-term boom in the economy and made everybody think they were rich for a while. Governments, business owners and private individuals scrambled to keep up, hiring new people and changing their production schedules to build all this new stuff people were asking for. But this wasn’t true sustainable growth. This was a bubble caused by the availability of easy money and the response to low interest rates.

The appliance stores who hired new staff, the boat-builders who bought extra materials and the car dealers who started stuffing their inventories with high-end SUVs were all preparing for a future that never happened. Now the money from all those home equity loans has been spent, the mortgage payments are piling up and people are scared of losing their jobs.

The car dealers are stuck with lots full of cars that won’t sell, the boat-builders are stuck with warehouses full of materials they don’t need and the appliance stores are laying off employees that don’t have enough to do.

This buildup of inventory, labor and capital goods based on artificial market conditions is malinvestment — the inevitable consequence of a bubble.

Moral hazard

There’s plenty of evil and corruption at work here, but the root of the problem is moral hazard. That is, creating conditions that encourage stupid risks and reward people for doing stupid things. The auto and bank bailouts are prime examples of this.

If the free market was allowed to work, all these bankers who made bad loans would fail and go bankrupt, and the next generation of bankers would learn from their mistakes. But government won’t let them fail. Government is rewarding them for doing all these dumb things because the credit bubble has grown so big, a lot of people are going to lose their jobs when it pops.

The politicians don’t want to get blamed for the collapse of this giant monetary bubble, so they’re trying to delay it — desperately pumping money, credit and government stimulus into the economy to try and push back the collapse.

But all spending is not equally good for the economy. You have to invest in smart things that will produce profit in the long term. If your investments are not sustainable, the money is going to be wasted and the bubble will start to collapse again, as soon as the flow of new credit stops.

Playing musical chairs with government debt

Remember, all this stimulus money has to be borrowed from somewhere. When governments borrow too much, people start to doubt the government’s ability to pay that money back. When that happens the government can’t find people to buy its bonds anymore. It has to offer a higher rate of return and promise to pay the money back faster. That means the government has to use bigger and bigger percentages of its current income to pay interest on debt, restricting the amount it has to spend here and now. In extreme cases governments default, admitting that they can’t afford to pay back what they owe — filing the nation-state equivalent of bankruptcy.

That’s happening in Greece, Spain, Portugal, Ireland and Italy right now. These countries have borrowed way more than they can pay back and the rest of Europe is buying bonds to prop them up, even though they know those bonds will never pay off.

But Germany and France have big debt loads, too, and if they spend too much bailing out other countries, lenders will lose faith in them too. It’s like a huge game of musical chairs right now, with big countries bailing out smaller countries, federal governments bailing out state governments and state governments bailing out city governments, until finally someone says enough and admits that they can’t do it anymore.

Great Britain is starting to cut back on spending but it probably won’t be enough. Most of the other countries are still borrowing and spending like they always have, desperately trying to prop up this bubble and pretend that everything will be okay.

But this bubble has been growing for decades. Trillions of dollars have been invested in things that will never pay off. We have to get back to basics and redirect our resources into things that are going to make money in the long term.

That means a lot of people are going to have to change jobs. A lot of equipment will have to be sold off. And a lot of buildings are going to come down. The economy must be allowed to contract and regroup, so we can shift our focus to things that actually produce value for people, instead of just shuffling cheap credit around.

There are a lot of libertarian pessimists out there today. It looks like debt-based government expansion has reached its inevitable end, but nobody can say when we’ll have our Berlin Wall moment.

It may still be 10 years away. But everything is so connected now. Financial markets change literally within milliseconds. So when that Berlin Wall moment happens, the reaction will be that much more dramatic.

It’s the drama that scares me — the possibility of social unrest and civil disorder. Germany and Great Britain are making noises about austerity, but they’re basically just pledging to spend 36% more than they take in instead of the usual 40%.

The unfunded liabilities, in terms of pensions, health care and welfare programs are so huge we can’t even comprehend them. And instead of dealing with the problem honestly, our politicians have abdicated their responsibility.

The California legislature can’t even pass a budget right now. The U.S. congress is about to do the same. There are no easy places to cut these budgets. There’s lots of easy pork, but even if you cut every dime of it, it wouldn’t be enough to make a dent.

The only expenditures big enough to matter are left in “untouchable” programs. Every cut will require a big courageous policy decision. If you want to cut enough defense spending to matter, you’ve got to take a stand on Afghanistan and the Iraq war. You’ve got to stand up in front of the American people and say, “We can’t afford this anymore.” Or you have to pretend it’s for foreign policy reasons and reverse 10 years of Neocon rhetoric.

This debt crisis is happening on every level. Every state government, every city government and every part of our Federal government is in the red. Illinois is even worse than California and even less willing to deal with it.

We’ve got some very hard choices coming; choices that will require decisive action from politicians who are willing to take risks. But the job of governing has been so easy for so long, our current crop of politicians does not have what it takes to make those choices.

For decades all they’ve had to do is get elected and spend from an infinite supply of government credit. The money was so easy, Republicans abdicated their symbolic pose as guardians of government spending and started competing with Democrats to see who could run up the biggest deficit.

Spending money for votes is relatively easy. For decades the primary job of a U.S. congressman has been to quietly collect bribes from special interests and convince voters they were still on their side.

The choices facing our political class now are an order of magnitude harder than what they’re used to dealing with. I could almost feel sorry for Obama, if he hadn’t ridden into town promising to solve every problem with government money.

We’re dealing with decades of malinvestment here. Cheap money and government bailouts have led people to take risks that they never would have taken in a “normal” economic climate.

Now all those bad investments are collapsing, all at once. All the projects that started in a climate of easy money, based on the assumption of cheap credit forever are starting to collapse.

The banks are hiding trillions in bad loans that we haven’t even talked about yet. We desperately need a recession. All these companies that made bad decisions need to fail and go bankrupt, so the labor and capital they have can be redirected to enterprises that will actually be sustainable in the long run.

But every politician in Washington, every pundit on the national news, and every crooked banker on Wall Street wants to keep the easy money coming, so they can line their own pockets and shift their losses to some other sucker before that Berlin Wall of Debt comes down.

This isn’t just a matter of greed and corruption. Economists, politicians and power brokers all over the world have built their reputations on the idea that governments can spend forever, that all spending is “good” and that we can borrow forever without paying it back.

Paul Krugman won’t be the only Nobel Prize winner caught with his pants down when this bubble pops.

So yeah, I’m a pessimist. But there’s a bigger picture than the one I usually look at, and there are actually a few libertarian optimists out there, smart enough to give me hope.

Here a couple choice quotes from libertarian optimist Greg Swann.

First, a warning, and an eloquent statement of the problem:

Governments destroy wealth best with wars, but they destroy wealth with almost everything they do. Anything that a government does that makes it harder for an honest trader to either produce, purchase or sell a marketable good or service is a net destruction of wealth. Money is not wealth, but money is the seed stock of new wealth, so, by despoiling the currency, by taxing productivity, and by rewarding stupidity, waste and sloth at the expense of wisdom, thrift and enterprise, governments systemically destroy wealth. This is all painfully obvious — by which I mean, the less obvious is it to you, the greater your pain.

Now the good news:

The productive capacity of the world has not changed. If anything, it continues to go up, even if perhaps at a temporarily slower pace. Wealth is not money. Wealth is goods and the intellect and husbandry and manufacturing capacity to produce more goods. Every bit of the real wealth we had yesterday, we have today. A lot of people have lost a lot of money, but our store of produced goods and our fixed capital base for producing more goods is undiminished.

Do you understand? If there had been a war, and if some significant fraction of the world’s capacity for producing goods and services had been destroyed, that would be a very bad thing. That would be a cause, going forward, for concerns about systemic poverty.

This hasn’t happened. We are richer today than we have ever been, expressed in terms of our ability to produce goods and services, and — because of the spread of data-processing, because of the enterprise of the Chinese, and because of the intellectual renaissance in India — we will be quite a bit richer — by those same standards — as soon as tomorrow. I mean that literally: Tomorrow.

I don’t necessarily share Greg’s optimism about the economic value of data processing or the educational value of people reading random stuff on the Internet. I don’t think the average person has been studying manufacturing techniques and engineering blueprints.

But once reality sets in and changes the reward structure, information technology will make it much easier for us to adapt. I think we’re going to see a lot of people grabbing cheap online degrees in the next few years, struggling to start 2nd, 3rd, or 4th careers when their pensions are cut off.

I particularly like what Greg said about the nature of real wealth. There hasn’t been a war (yet). Our population is smart, literate and healthy, more or less. Technology has given us a much more efficient baseline to start from and the buildings are still standing.

America has been on the wrong track for a long time, but once we have our moment of clarity, the turnaround should be very fast.

But when will that moment come, when every government, every bank, every school, and every media voice is working to delay it?

I’m confident that we can bounce back, but the longer we wait, the harder the fall will be. And if we fall too hard, we could trigger a breakdown of civil order and destroy the framework we need to rebuild.

Hopefully the Wall will fall in Europe first, and give us time to wake up.