Market Sees Through Budget “Solution”

While politician are congratulating themselves today (Senate Majority Leader Harry Reid: ”Our country was literally on the brink of disaster.”), the markets weren’t fooled by their hyperbole and the Dow declined 2.19% (265 points) and the S&P dropped 2.56%.

Republicans are celebrating that “business has changed in Washington” because of their efforts. The Tea Party Caucus was divided between those like Rand Paul who accurately noted that the bill does nothing to balance the budget or actually cut spending (vs. reducing future budget increases) and other who say they “shifted the debate” to one of cutting the budget rather than spending. There is truth in both of these views.

So, why the the market tank? They perceive that nothing really significant changed and that the cuts weren’t enough to avoid an eventual credit rating knock.  While the rating agencies (Moody’s and Fitch) have reaffirmed our AAA rating, it remains to be seen whether or not the spending cuts are sufficient for the U.S. to eventually avoid being downgraded. 

 Also investors are realizing that our economy is fundamentally weak, not just going through a “soft patch.” Perhaps they have been reading the Daily Capitalist. Among the data that came out today that helped encourage this negative view was the fact that consumer spending was -0.2:

But I have an additional reason why the markets tanked: Lord Keynes. Most folks on Wall Street believe that cutting government spending will harm the economy.

Here is a comment from Michael Feroli of JP Morgan, typical most economists:

Impending fiscal drag for 2012 remains intact. The deal does nothing to extend the various stimulus measure which will expire next year: we continue to believe federal fiscal policy will subtract around 1.5%-points from GDP growth in 2012. Its possible the fiscal commission could do something to extend some measure such as the one-year 2% payroll tax holiday, though we think unlikely, as it would need to be paid for, which would be tough. If anything, the debt deal may add modestly to the fiscal drag we have penciled in for next year.

I don’t mean to pick on Mr. Feroli, but he and everyone else believing this is wrong. The reduction in federal spending can only help the economy.

If government spending were the cure, why hasn’t the $3 trillion of fiscal and monetary stimulus already worked? In fact such stimulus has never worked and never will.1

The logic of Keynes is that since consumer spending is lacking we–anyone including the government–just needs to spend more and the economy will recover. I’ve written a lot about why consumers aren’t spending and that isn’t the problem with the economy. The overhang of malinvested real estate and its related debt is the problem.

But here’s how I see Keynes’s remedy:

Government creates nothing; it only spends.2 Once it is finished spending, the jobs go away because no lasting enterprise was created by the spending. Only private businesses create viable businesses and lasting jobs. If you suck money out of the private economy and waste it on government projects, then there is less capital available for business to expand and create jobs. Thus, once the money is spent by the government we are all poorer: the government jobs are temporary, we receive questionable value for our money, and money has been shifted from my pocket to the government’s thus depriving me of the ability to create something that might help the economy.

As Professor Don Boudreaux  said today, Keynes and his believers mistake symptoms for underlying problems and then propose to treat the symptoms. Here is Don’s analogy which is pretty clever:

It’s as if a person who is bleeding to death because of a gunshot wound in his stomach is brought to a physician.  The physician correctly realizes that the patient is losing massive amounts of blood and, also, correctly understands that such blood loss is dangerous to the patient’s health.

So the physician prescribes massive infusions of blood, period.  If the patient doesn’t recover, the physician orders that the volume of blood-infusions be increased.  If the patient dies, the physician will forever blame himself for not increasing the volume of blood-infusions even further.

If the patient does recover, the blood-infusions will be praised for saving the patient.

The big hole in the patient’s stomach is called a “micromedical” problem.  It might well be a significant problem, the physician concedes, but our physician is  trained to diagnose and cure one specific “macromedical” problem only, which is the problem of bleeding.  Micromedical problems are fundamentally distinct from the macromedical problem, which is insufficient blood coursing through the patient’s body.  (Blood, after all, is vital to a person’s vitality and vigor.)  When a patient who had until recently been quite healthy begins losing blood, the consensus of many physicians is that by far the most important treatment – certainly a necessary one, and, generally, a sufficient one – is to keep pumping more and more new blood into the patient until his health is restored.

Questions of precisely whywhere, and how the patient is losing blood aren’t as important as is the realization that the patient is losing blood.  “A bite by a spirited animal” is the famous phrase that is typically used to explain the mysterious bleeding.

It’s very simple, really.

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1. Paul Krugman says we are making a huge mistake:

We currently have a deeply depressed economy. We will almost certainly continue to have a depressed economy all through next year. And we will probably have a depressed economy through 2013 as well, if not beyond.

The worst thing you can do in these circumstances is slash government spending, since that will depress the economy even further. Pay no attention to those who invoke the confidence fairy, claiming that tough action on the budget will reassure businesses and consumers, leading them to spend more. It doesn’t work that way, a fact confirmed by many studies of the historical record.

The facts don’t support Professor Krugman. Yesterday Professor Russ Roberts pointed out that:

… in 1946, federal spending fell about 55% when the war ended. The Keynesians predicted a horrible depression. Yet despite the release of 10 million people into the labor market with demobilization private sector employment boomed and the economy thrived.

Also, Professor Roberts noted that no one else has been able to find those studies Krugman refers to.

2. Yes, I know the government builds roads and bridges, and provides defense and these things are good. But that’s not what the government is doing now with our money. The items spent per Recovery.gov are a total waste and I urge you to visit this site and actually drill down to the individual contracts and you will see where the money goes. A new roof on an outhouse in Yellowstone is not going to create jobs, if you mean by “jobs” something other than government transfer payments. Only private industry can create jobs through market based production which consumers vote for every day with their pocketbooks. Those jobs are the jobs that last.

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3 comments to Market Sees Through Budget “Solution”

  • George

    Excellent perspective and well written! So, what would your approach be to resolve the poor economic outlook given our current situation? Cut taxes and government spending which would increase our government debt further over the short term (i.e. is there a faster way out of our current low growth, inflationary economy)?

  • Anonymous

    Without the blood transfusion can the gunshot wound ever be healed? I’m no Doctor but in most cases the answer must surely be no.

  • Mike

    The blood transfusion analogy to money printing is quite good. Could have taken in another step pointing out there is only so much blood (as with real versus printed money) available for transfusions making the treatment non sustainable and therefore the patient will die.