The congressional gridlock over U.S. government funding and the debt limit during the month of October has left the rest of the world both bewildered and alarmed, particularly in Europe where the Euro countries have yet to fully recover from the their own financial crisis triggered by the confluence of the lingering consequences of the U.S. financial collapse of 2007-2008, and the chickens of their own profligate deficit spending over past decades finally coming home to roost. Most alarming to these countries is not so much the gridlock itself—most assume that the deadlock will be resolved—but rather the spectacle of political brinksmanship in which congressional parties seek to gain political gain by threatening each other with financial Armageddon, not just in the U.S., but worldwide, if the other side doesn’t back down.
Thus, conservatives, after giving up proposals to defund Obamacare, have been blamed for demanding, as a price of passing a government funding bill, that individuals be given the same one year grace period under the Obamacare mandate that Big Business has already received, and demanding that members of Congress be required to live by the same Obamacare rules as those imposed on the rest of the country. Meanwhile, those on the left, particular those who control the U.S. Senate, have been blamed for denouncing all such proposals as “blackmail”, an attempt to hold the country “hostage”, and so outrageous as to prompt the President both to refuse to negotiate and to predict a stock market meltdown and economic catastrophe if the government is not fully funded and the debt not raised because of such demands.
While the stock market has mostly shrugged off the government shutdown—especially after the overhyped predictions of catastrophe under the “sequester”, which resulted in only a rather modest decline in the increase in government spending—the threat of default of U.S. government debt does carry significant economic risks. Indeed, the very threat of such a default has already caused the cost of insuring U.S. debt to rise dramatically. More alarmingly, the use of U.S. debt around the world as collateral for international obligations means that a default, especially if extended, could indeed threaten international economic collapse.
In order to take this risk out of the equation and deprive any party of using it as a threat in the game of economic brinksmanship, the U.S. House last passed the McClintock—Toomey bill, which would have guaranteed U.S. debt by requiring that U.S. debt be paid from incoming tax revenues even during a period of shutdown. This proposal, which would have greatly alleviated international concerns over the possibility of U.S. default, was subsequently denounced in the Senate Majority leader as the “Pay China First” bill, where it subsequently died. (This despite the fact that China hold only about 7% of U.S. debt, while Americans hold about two thirds).
So, how, might an ignorant but intelligent man from Mars might ask, did we ever get to this point?
The answer may be traced back in large measure to the Great American Housing Bubble and subsequent collapse in 2007-2008.* In 2008 alone, American consumers suffered a catastrophic loss of sixteen trillion dollars in purchasing power. Much of that loss came in the form of six trillion dollars in lost home equity when the housing bubble collapsed. In the name of expanding home ownership, the bubble had been created by a deliberate government policy of encouraging banks to lend money to unqualified buyers with low or no money down and low interest rates. Banks were only too eager to comply since they could unload most of their loans on taxpayers via Freddie and Fannie, or on hapless investors through the government promoted vehicle of “securitization”, by which loans are sliced and diced and sold to unsuspecting investors worldwide.
At the height of the bubble, consumers became accustomed to using the equity in their homes as personal piggy banks, creating an illusion of wealth that could be used to buy vacations, cars, second homes, and other consumer goods. Thus when that equity was destroyed, it had much the same effect as bank failures had in the depths of the Great Depression. The loss of such purchasing power reduced the demand for goods and services, resulting in unemployment, bankruptcies, stock market collapse, and extreme financial distress.
The first chapters of Econ 101 explain that there are two ways to replenish such catastrophic losses in purchasing power caused by either bank failures or the collapse of a housing or stock market bubble. The first is through monetary policy by the simple act of printing more money. The second is through fiscal policy, reducing taxes and thereby increasing the take home pay of consumers and leaving them with increased purchasing power to demand goods and services and thereby put people to work.
The latter policy is the much preferred method of replenishing purchasing power because its application can be spread more broadly across the entire economy, whereas monetary policy tends to have a disproportionate effect on more narrow sectors of the economy such as housing or the stock market in ways that risk the creation of yet another bubble cycle in those sectors. Indeed, the current extreme application of monetary policy by the Fed—reducing short term interest rates to absolute zero and printing money to buy long term securities—is already showing signs of creating yet another such bubble cycle in the housing and stock market.
Unfortunately, the reality of America’s political system is such that fiscal policy can rarely be employed as a method of replenishing lost purchasing power. Over the past several decades, politicians have won votes by relieving almost half of all Americans of the duty of paying any federal income taxes at all. This had resulted in an economy in 2013 in which the top 20% of Americans now pay 71.8% of all taxes, and the 1% pays almost one third of all U.S. federal income taxes. This in turn has created a voter population in which 47% of all Americans have no stake in their government other than that of receiving government benefits. Like the populace of ancient Rome, whose support could be won by the promise of bread and circuses without any concomitant duty to contribute, many U.S. voters today see no benefit to themselves if taxes are reduced, and thus have no reason to vote for politicians who propose to reduce taxes as a means of replenishing purchasing power in the economy as a whole.
Thus any proposal to reduce income taxes is likely to be denounced as “tax breaks for the rich”—the” rich” apparently being defined as anyone among the hapless 53% of Americans who are asked to bear the entire federal income tax burden.
But while politicians are reluctant to reduce the tax contributions imposed on those who pay taxes, they are often much more enthusiastic about employing the second prong of classic Keynesian fiscal policy—namely spending, which has the political advantage of catering to those who either pay no taxes or who receive more in government benefits than they pay in taxes. The politicians who endorse such spending, rather than tax-reduction policies, often claim that they are only employing tried and true “Keynesian” policies of replenishing purchasing power by financing vast government programs, thereby introducing money into the economy in the same way as if they had reduced taxes. They conveniently forget that Keynes recognized that purchasing power could be replenished by either increasing spending or reducing taxes.
The question therefore is which of the two prongs of fiscal policy—reducing taxes or increasing spending—is more likely to revive a moribund or unemployed economy.
Reducing taxes allows taxpayers to keep more of their earnings, and spend it on such consumer items as food, lodging, gas, and refrigerators. Those who provide such goods and services are soon employed. Increased spending, on the other hand, as if so often does when politicians get to spend other people’s money, is more likely to be spent on more speculative ventures that most people, when spending their own money, would never dream of spending it on—think Solyndra, Fisker, bailing out inefficient companies or cities being strangled and bankrupted by unrealistic defined contribution pension plans, unsustainable entitlement programs which blithely ignore the demographic changes of an aging population, or even fancy cars for millionaires.
Not surprisingly, such spending has had far less effect on reducing unemployment than its sponsors hoped for. Indeed, since the government launched its most extravagant spending programs in the aftermath of the housing collapse in 2007-2008, the labor participation rate has actually decreased from 64% to 55.8%, as millions give up hopes of ever finding a job—a disastrous result only exacerbated by government policies of drastically reducing the wages of poverty-stricken minorities and legal immigrants by–at the instigation of Big Business seeking higher profits– the import of cheap foreign labor encouraged by lax immigration law enforcement.
With the option of sound fiscal policy off the table, or used counter-productively, virtually the entire burden for replenishing purchasing power has fallen on the unelected Federal Reserve and reliance on its vast monetary powers. Taking a cue from Chapter One of Econ 101, the Fed has flooded the economy with newly printed money in a process known as “quantitative easing” (i.e. buying long term government bonds that no one else in their right mind would even consider buying) in hopes of reducing interest rates to such a low level that businesses will want to borrow money cheaply and use it to expand and hire more workers. Not surprisingly, the billions so created out of thin air have thus far had a depressingly modest effect on employment, though it has greatly benefitted the rich who own the biggest houses (and thus get the biggest tax deductions), and own the most stocks and bonds, not to mention inducing the government to go even deeper in debt since it need pay almost nothing on the money it borrows in the short term, and very little in the long term. (If one wonders who really believes that long term interest rates will not increase in the next thirty years and is thus willing to risk substantial principle by buying a 30 year bond, the answer is that virtually no rational investor is willing to do that except the government itself in the form of the Fed).
The reason for the lack of success of quantitative easing can be found in the later chapters of Econ 101 which describe Keynes’s “liquidity trap”, and also explains why low long term interest rates may not spur business expansion, and may even slow it and exacerbate unemployment: investors who buy a company’s long term bonds risk a catastrophic losses of principle when super-low long term interest rates inevitably rise. They are far more likely to wait until long term rates do rise before buying these long-term bonds, thus depriving those companies of capital when they are most needed—namely now, when the economy is struggling, and employment participation rates are at historic lows.
In the aftermath of the housing bubble collapse in 2007-2008, and the subsequent destruction of six trillion dollars in consumer purchasing power, the government had a once in a lifetime opportunity to replenish the money supply by reducing taxes without risking inflation, and putting new purchasing power into the hands of consumers to buy consumer goods and thus stimulate employment. Instead it has squandered that opportunity by instead printing money by the trillions, and reducing interest rates to the point where potential investors risk catastrophic loss of capital when they invest in business expansion. The tragedy is that the longer the present addictive low interest policies are pursued, the more investors will, out of desperation, risk that catastrophic loss and contribute to yet another cycle of stock market and housing bubble and burst.
We tolerate politicians whose time horizons do not extend beyond the next election, because we understand the realities of politics, elections, and demagoguery. It is also tempting to tolerate members of the Fed, upon whom has been cast virtually the entire burden of saving the economy in the absence of sound fiscal policy by the politicians. The pressures of that burden no doubt accounts for such catastrophic decisions as the one made by Fed Chairman Alan Greenspan to fuel the housing bubble with artificially low interest rates, and Chairman Bernanke’s later failure to discern the dangers of such a bubble as when he said, on May 17, 2007:” (W)e believe the effect of the troubles in the subprime market will be limited…Importantly, we see no serious broader spillover to bank or thrift institutions from the problems in the subprime markets”.)
But without resisting these temptations, the lesson of the final chapter of Econ 101 is that we have yet another cycle of bubble, burst and economic catastrophe to look forward to, including another round of international economic distress.
Robert Hardaway is Professor of Law at the University Of Denver College Of Law, and the author of twenty two published books on law and public policy, including “The Great American Housing Bubble” (ABC-CLIO Publishers, 2012)
* See Hardaway, The Great American Housing Bubble: The Road to Collapse (2012).