Budget Office Warns of New Recession

Budget Office Warns of New Recession
"The economy could relapse into a recession if President Obama and Congress remain at an impasse and allow several big tax increases and spending cuts to take effect at the start of 2013, the Congressional Budget Office reported on Tuesday." ( New York Times)

Stuck on the misconception that spending cuts cause recessions.

What Spending and Deficits Do
Henry Hazlitt
February 1977 • Volume: 27 • Issue: 2 •

Henry Hazlitt, noted economist, author, editor, reviewer and columnist, is well known to readers of the New York Times, Newsweek, The Freeman, Barron's, Human Events and many others. Best known of his books are Economics in One Lesson, The Failure of the "New Economics," The Foundations of Morality, and What You should Know About Inflation.

The direct cause of inflation is the issuance of an excessive amount of paper money. The most frequent cause of the issuance of too much paper money is a government budget deficit.

The majority of economists have long recognized this, but the majority of politicians have studiously ignored it. One result, in this age of inflation, is that economists have tended to put too much emphasis on the evils of deficits as such and too little emphasis on the evils of excessive government spending, whether the budget is balanced or not.

So it is desirable to begin with the question, What is the effect of government spending on the economy -- even if it is wholly covered by tax revenues?

The economic effect of government spending depends on what the spending is for, compared with what the private spending it displaces would be for. To the extent that the government uses its tax-raised money to provide more urgent services for the community than the taxpayers themselves otherwise would or could have provided, the government spending is beneficial to the community. To the extent that the government provides policemen and judges to prevent or mitigate force, theft, and fraud, it protects and encourages production and welfare. The same applies, up to a certain point, to what the government pays out to provide armies and armament against foreign aggression. It applies also to the provision by city governments of sidewalks, streets, and sewers, and to the provision by States of roads, parkways, and bridges.

But government expenditure even on necessary types of service may easily become excessive. Sometimes it may be difficult to measure exactly where the point of excess begins. It is to be hoped, for example, that armies and armament may never need to be used, but it does not follow that providing them is mere waste. They are a form of insurance premium; and in this world of nuclear warfare and incendiary slogans it is not easy to say how big a premium is enough. The exigencies of politicians seeking re-election, of course, may very quickly lead to unneeded roads and other public works.


Welfare Spending

Waste in government spending in other directions can soon become flagrant. The money spent on various forms of relief, now called "social welfare," is more responsible for the spending explosion of the U.S. government than any other type of outlay. In the fiscal year 1927, when total expenditures of the federal government were $2.9 billion, a negligible percentage of that amount went for so-called welfare. In fiscal 1977, when prospective total expenditures have risen to $394.2 billion-136 times as much–welfare spending alone (education, social services, Medicaid, Medicare, Social Security, veterans benefits, etc.) comes to $205.3 billion, or more than half the total. The effect of this spending is on net balance to reduce production, because most of it taxes the productive to support the unproductive.

As to the effect of the taxes levied to pay for the spending, all taxation must discourage production to some extent, directly or indirectly. Either it puts a direct penalty on the earning of income, or it forces producers to raise their prices and so diminish their sales, or it discourages investment, or it reduces the savings available for investment; or it does all of these.

Some forms of taxation have more harmful effects on production than others. Perhaps the worst is heavy taxation of corporate earnings. This discourages business and output; it reduces the employment that the politicians profess to be their primary concern; and it prevents the capital formation that is so necessary to increase real productivity, real income, real wages, real welfare. Almost as harmful to incentives and to capital formation is progressive personal income taxation. And the higher the level of taxation the greater the damage it does.


Disruption of the Economy

Let us consider this in more detail. The greater the amount of government spending, the more it depresses the economy. In so far as it is a substitute for private spending, it does nothing to "stimulate" the economy. It merely directs labor and capital into the production of less necessary goods or services at the expense of more necessary goods or services. It leads to malproduction. It tends to direct funds out of profitable capital investment and into immediate consumption. And most "welfare" spending, to repeat, tends to support the unproductive at the expense of the productive.

But more importantly, the higher the level of government spending, the higher the level of taxation. And the higher the level of taxation, the more it discourages, distorts, and disrupts production. It does this much more than proportionately. A 1 per cent sales tax, personal income tax, or corporation tax would do very little to discourage production, but a 50 per cent rate can be seriously disruptive. Just as each additional fixed increment of income will tend to have a diminishing marginal value to the receiver, so each additional subtraction from his income will mean a more than proportional deprivation and disincentive. The adjective "progressive" usually carries an approbatory connotation, but an income tax can appropriately be called "progressive" only in the sense that a disease can be called progressive. So far as its effect on incentives and production are concerned, such a tax is increasingly retrogressive or repressive.


Total Spending the Key

Though, broadly speaking, only a budget deficit tends to lead to inflation, the recognition of this truth has led to a serious underestimation of the harmfulness of an exorbitant level of total government spending. While a budget balanced at a level of $100 billion for both spending and tax revenues may be acceptable (at, say, 1977 s level of national income and dollar purchasing power), a budget balanced at a level above $400 billion may in the long run prove ruinous. In the same way, a deficit of $50 billion at a $400 billion level of spending is far more ominous than a deficit of the same size at a spending level of $200 billion.

An exorbitant spending level, in sum, can be as great or a greater evil than a huge deficit. Everything depends on their relative size, and on their combined size compared with the national income.

Let us look first at the effect of a deficit as such. That effect will depend in large part on how the deficit is financed. Of course if, with a given level of spending, a deficit of, say, $50 billion is then financed by added taxation, it ceases by definition to be a deficit. But it does not follow that this is the best course to take. Whenever possible (except, say, in the midst of a major war) a deficit should be eliminated by reducing expenditures rather than by increasing taxes, because of the harm the still heavier taxes would probably do in discouraging and disorganizing production.

It is necessary to emphasize this point, because every so often some previous advocate of big spending suddenly turns "responsible," and solemnly tells conservatives that if they want to be equally responsible it is now their duty to "balance the budget" by raising taxes to cover the existing and planned expenditures. Such advice completely begs the question. It tacitly assumes that the existing or planned level of expenditures, and all its constituent items, are absolutely necessary, and must be fully covered by increased taxes no matter what the cost in economic disruption.

We have had 39 deficits in the 47 fiscal years since 1931. The annual spending total has gone up from $3.6 billion in 1931 to $394.2 billion -- 110 times as much -- in 1977. Yet the argument that we must keep on balancing this multiplied spending by equally multiplied taxation continues to be regularly put forward. The only real solution is to start slashing the spending before it destroys the economy.


Two Ways to Pay

Given a budget deficit, however, there are two ways in which it can be paid for. One is for the government to pay for its deficit outlays by printing and distributing more money. This may be done either directly, or by the government's asking the Federal Reserve or the private commercial banks to buy its securities and to pay for them either by creating deposit credits or with newly issued inconvertible Federal Reserve notes. This of course is simple, naked inflation.

Or the deficit may be paid for by the government's selling its bonds to the public, and having them paid for out of real savings. This is not directly inflationary, but it merely leads to an evil of a different kind. The government borrowing competes with and "crowds out" private capital investment, and so retards economic growth.

Let us examine this a little more closely. There is at any given time a total amount of actual or potential savings available for investment. Government statistics regularly give estimates of these. The gross national product in 1974, for example, is given as $1,499 billion. Gross private saving was $215.2 billion -- 14.4 per cent of this -- of which $74 billion consisted of personal saving and $141.6 billion of gross business saving. But the Federal budget deficit in that year was $11.7 billion, and in 1975 $73.4 billion, seriously cutting down the amount that could go into the capital investment necessary to increase productivity, real wages, and real long-run consumer welfare.


Sources and Uses of Capital

The government statistics estimate the amount of gross private domestic investment in 1974 at $215 billion and in 1975 at $183.7 billion. But it is probable that the greater part of this represented mere replacement of deteriorated, worn-out, or obsolete plant, equipment, and housing, and that new capital formation was much smaller.

Let us turn to the amount of new capital supplied through the security markets. In 1973, total new issues of securities in the United States came to $99 billion. Of these, $32 billion consisted of private corporate stocks and bonds, $22.7 billion of state and local bonds and notes, $1.4 billion of bonds of foreign governments, and $42.9 billion of obligations of the U.S. government or of its agencies. Thus of the combined total of $74.9 billion borrowed by the U.S. government and by private industry, the government got 57 per cent, and private industry only 43 per cent.

The crowding-out argument can be stated in a few elementary propositions.

1. Government borrowing competes with private borrowing.
2. Government borrowing finances government deficits.
3. What the government borrows is spent chiefly on consumption, but what private industry borrows chiefly finances capital investment.
4. It is the amount of new capital investment that is chiefly responsible for the improvement of economic conditions.

The possible total of borrowing is restricted by the amount of real savings available. Government borrowing crowds out private borrowing by driving up interest rates to levels at which private manufacturers who would otherwise have borrowed for capital investment are forced to drop out of the market.


Why the Deficits?

Yet government spending and deficits keep on increasing year by year. Why? Chiefly because they serve the immediate interests of politicians seeking votes, but also because the public still for the most part accepts a set of sophistical rationalizations.

The whole so-called Keynesian doctrine may be summed up as the contention that deficit spending, financed by borrowing, creates employment, and that enough of it can guarantee "full" employment. The American people have even had foisted upon them the myth of a "full-employment budget." This is the contention that projected Federal expenditures and revenues need not be, and ought not to be, those that would bring a real balance of the budget under actually existing conditions, but merely those that would balance the budget if there were "full employment."

To quote a more technical explanation (as it appears, for example, in the Economic Report of the President of January, 1976): "Full employment surpluses or deficits are the differences between what receipts and expenditures are estimated to be if the economy were operating at the potential output level consistent with a 4 per cent unemployment" (p. 54).

A table in that report shows what the differences would have been for the years 1969 to 1975, inclusive, between the actual budget and the so-called full employment budget. For the calendar year 1975, for example, actual receipts were $283.5 billion and expenditures $356.9 billion, leaving an actual budget deficit of $73.4 billion. But in conditions of full employment, receipts from the same tax rates might have risen to $340.8 billion, and expenditures might have fallen to $348.3 billion, leaving a deficit not of $73.4 billion but only of $7.5 billion. Nothing to worry about.


Priming the Pump

Nothing to worry about, perhaps, in a dream world. But let us return to the world of reality. The implication of the full-employment budget philosophy (though it is seldom stated explicitly) is not only that in a time of high unemployment it would make conditions even worse to aim at a real balance of the budget, but that a full-employment budget can be counted on to bring full employment.

The proposition is nonsense. The argument for it assumes that the amount of employment or unemployment depends on the amount of added dollar "purchasing power" that the government decides to squirt into the economy. Actually the amount of unemployment is chiefly determined by entirely different factors -- by the relations in various industries between selling prices and costs, between particular prices and particular wage-rates; by the wage-rates exacted by strong unions and strike threats; by the level and duration of unemployment insurance and relief payments (making idleness more tolerable or attractive); by the existence and height of legal minimum-wage rates, and so on. But all these factors are persistently ignored by the full-employment budgeteers and by all the other advocates of deficit spending as the great panacea for unemployment.


One-Way Formula

It may be worth while, before we leave this subject, to point to one or two of the practical consequences of a consistent adherence to a full employment-budget policy. In the twenty-eight years from 1948 to 1975 inclusive, there were only eight in which unemployment fell below the government target-level of 4 per cent. In all the other years the full-employment-budgeteers (perhaps we should call them the fulembudgers for short) would have prescribed an actual deficit. But they say nothing about achieving a surplus in the full-employment years, much less about its desirable size. Presumably they would consider any surplus at all, any repayment of the government debt, as extremely dangerous at any time. So a prescription for full-employment budgeting might not produce very different results in practice from a prescription for perpetual deficit.

Perhaps an even worse consequence is that as long as this prescription prevails, it can only act to divert attention from the real causes of unemployment and their real cure.

Perhaps a word needs to be said about the fear of a surplus that has developed in recent decades–ever since about 1930, in fact. This of course is only the reverse side of the myth that a deficit is needed to "stimulate" the economy by "creating purchasing power." The only way in which a surplus could do even temporary harm would be by bringing about a sudden substantial reduction in the money supply. It could do this only if the bonds paid off were those held by the banking system against which demand deposits had been created. But in 1976, out of a gross public debt of $620.4 billion, $92.3 billion were held by commercial banks and $94.4 billion by Federal Reserve banks. This left $433.7 billion, or about 70 per cent, in nonbanking hands. This could be retired, say over fifty years, without shrinking the money supply in the least. And if the public debt were retired at a rate of $5 billion or $10 billion a year, private holders would have that much more to invest in private industry.


The Phillips Curve

A myth even more pernicious than the full-employment budget, and akin to it in nature, is the Phillips Curve. This is the doctrine that there is a "trade-off" between employment and inflation, and that this can be plotted on a precise curve–that the less inflation, the more unemployment, and the more inflation the less unemployment. But this incredible doctrine is more directly related to currency issue than to government spending and deficits, and can best be examined elsewhere.

In conclusion: Chronic excessive government spending and chronic huge deficits are twin evils. The deficits lead more directly to inflation, and therefore in recent years they have tended to receive a disproportionate amount of criticism from economists and editorial writers. But the total spending is the greater evil, because it is the chief political cause of the deficits. If the spending were more moderate, the taxes to pay for it would not have to be so oppressive, so damaging to incentive, so destructive of employment and production. So the persistence and size of deficits, though serious, is a derivative problem; the primary evil is the exorbitant spending, the Leviathan "welfare" state. If the spending were brought within reasonable bounds, the taxes to pay for it would not have to be so burdensome and demoralizing, and politicians could be counted on to keep the budget balanced.

http://www.thefreemanonline.org/features/what-spending-and-deficits-do/