LESSONS LEARNED #79: “Tax cuts stimulate. Not tax hikes.” -Old Pithy

Posted by PITHOCRATES - August 18th, 2011

With Bubbles the Ride Down is never as Enjoyable as the Ride Up

Bill Clinton dealt George W. Bush a horrible hand.  Clinton enjoyed the irrational exuberance.  He rode the good side of the dot-com bubble.  Saw the treasury awash in cash.  Dot-com people cashing in their stock options and paying huge capital gains taxes.  There was so much money pouring in that projections showed a balanced budget for the first time in a long time.  As long as the people stayed irrationally exuberant.  And that damn Alan Greenspan didn’t raise interest rates.  To rain on his parade.

But he did.  The days of free money were over.  (For awhile, at least).  Because people where bidding up stock prices for companies that hadn’t produced a product or provided a service.  Money poured into these dot-coms as investors were ever hopeful that they had found the next Microsoft.  These companies hired programmers.  Colleges couldn’t graduate enough of them.  To program whatever these companies would eventually do.  But with the spigot of free money turned off these companies ran out of startup capital.  As most of these businesses had no revenue they went out of business.  By the droves.  Throwing these programmers out onto the street.

And then the great contraction.  Which follows a bubble after it is a bubble no more.  Prices fell as deflation replaced inflation.  And as prices fell, unemployment went up.  The phantom prosperity at the end of the Nineties was being corrected.  And the ride down is never as enjoyable as the ride up. 

Easy Monetary Policy and lack of Congressional Oversight of Fannie Mae and Fannie Mac

And then there was, of course, 9/11.  Which further weakened an already weakened economy.  So that’s the backstory to the economic activity of the 2000s.  A decade that began with the aftermath of one bubble bursting.  And ended with an even worse bubble bursting.  The subprime mortgage crisis.  It was a decade of government stimulus.  George W. Bush used both tax cuts (at the beginning of his presidency).  And then a more Keynesian approach (tax rebates and tax incentives) at the end of his presidency.  In other words, tax and spend.

But the subprime mortgage crisis was so devastating that the 2008 stimulus urged by Ben Bernanke (Chairman of the Federal Reserve) to ward off a possible recession failed.  The easy monetary policy and lack of Congressional oversight of Fannie Mae and Freddie Mac caused big trouble.  And put far too many people into houses who couldn’t afford them.  The housing bubble was huge.  And because Fannie and Freddie were buying these risky mortgages and repackaging them into ‘safe’ securities, the fallout went beyond the housing market.  Pension funds, IRAs and 401(k)s that bought these ‘safe’ securities lost huge swaths of wealth.  The economic fallout was vast.  And global.

And then came Barack Obama.  A Keynesian if there was ever one.  With the economy in a free fall towards a depression, he signed into law an $800 billion stimulus package.  Not surprisingly, it turned out that about 88% of that was pure pork and earmarks.  Making his ‘stimulus’ stimulate even less than the George W. Bush $152 billion stimulus package.  And worked about as well.

Home Ownership was the Key to Economic Prosperity in the U.S.

So let’s look at the numbers.  Below is a chart graphing GDP, the unemployment rate and the inflation rate for the 2000s.  GDP is in billions of 2005 dollars.

(Sources: GDP, unemployment, inflation.  *Average to date (GDP – 2 quarters, unemployment rate – 7 months and inflation – 7 months).)

You can see the fallout of the dot-com bust.  The decade opens with deflation and a rising unemployment rate.  GDP, though, was still tracking upward.  After the bush tax cuts in 2001 (Economic Growth and Tax Relief Reconciliation Act of 2001) and 2003 (Jobs and Growth Tax Relief Reconciliation Act of 2003) you can see improvement.  Unemployment peaks out and then falls.  Inflation replaces deflation.  And GDP grows at a greater rate. 

Things were looking good.  But lurking in the background was that easy credit.  And federal policies to qualify unqualified people for mortgages.  To put them into houses they couldn’t afford.  All because home ownership was the key to economic prosperity in the U.S.

Which makes the rising rate of inflation a concern.  Rising inflation (i.e., expansionary or ‘easy’ monetary policy) created the dot-com bubble.  A rising inflation rate can be bad.  But at least during this period the growth rate of GDP is greater than the growth in the inflation rate.  Which indicates real economic growth.  Accompanied by a falling unemployment rate.  All nice.  Until…

Bernanke and Company Crapped their Pants

Those people approved for mortgages they weren’t qualified for?  Guess what?  They couldn’t make their mortgage payments.  And because Fannie and Freddie bought so many of these risky mortgages, these defaults weren’t the banks’ problems.  They were the taxpayers’ problems.  And anyone who bought those ‘safe’ securities.

Long story short, Bernanke and company crapped their pants.  He urged the $152 billion Economic Stimulus Act of 2008 to ward off a possible recession.  This was a Keynesian stimulus.  Remember that summer when you got those $300 checks?  This was that stimulus.  But it didn’t stimulate anything.  People used that money to pay down debt.  Because they were crapping their pants, too.

The good times were over.  That huge housing bubble was bursting.  And nothing was going to stop it.  Certainly not more of the same (Keynesian stimulus).  GDP fell.  Unemployment rose.  Inflation became deflation.  And Bernanke stepped in and turned the printing presses on.  Desperate not to make the same mistake the Fed made during the Great Depression.  When bad Fed policy caused all of those bank runs.

An Inflation Rate Greater than the GDP Growth Rate may Return us to Stagflation

The Obama administration (all Keynesians) pushed for a massive stimulus to fix the economy.  The best and brightest in the administration, Ivy League educated economists, guaranteed that if passed they could hold the unemployment rate under 8%.  So they passed it.  And Bernanke kept printing money.  In other words, more of the same.  More of what gave us the dot-com bubble.  And more of what gave us the housing bubble.  Inflationary monetary policy.  And more government spending.

Didn’t work.  It took a year for the deflation to end.  As the market corrected prices.  And readjusted supply to match actual demand.  The unemployment rate maxed out around 10%.  And the Obama stimulus didn’t move it much from that high. 

GDP growth resumed.  However, the growth of inflation is now greater than the growth of GDP.  A very ominous sign.  Indicating that GDP growth is not real.  And will likely collapse once the ‘free money’ Fed policies end.  Or the growth of inflation coupled with high unemployment return us to the Jimmy Carter stagflation of the Seventies.

Keynesian Stimulus is the way to go if you want Deflation and Recession 

Further Keynesian stimulus may only make a bad situation worse.  And prolong this economic ‘recovery’.  These policies make bubbles.  Which are fine and dandy until they burst.  Giving us deflation and recession.  And the bigger the bubble, the greater deflation and recession that follows.

Tax cuts stimulate.  They ended the dot-com recession.  All Keynesian attempts during the 2000s have failed.  Proving again that tax and spend doesn’t work.  Easy monetary policy and government spending does not end well.  Unless you want deflation and recession.  Then the Keynesian way is the way to go.  But if you want to stimulate economic activity.  If you want real GDP growth.  Then you have to go with tax cuts.  As their track record of success shows.

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