The Bear’s Lair: The world must learn to love root-canals

Senator Marco Rubio wants to tee up yet another set of tax cuts, not oriented towards economic growth, that will further widen the U.S. budget deficit. Argentina is about to borrow $30 billion from the IMF, since it is unable to get close to balancing a budget, based on spending that is 60% higher as a percentage of GDP than it was at the time of Argentina’s last default in 2002. The two facts are intimately connected as are similar political moves in other countries. If we follow the policies of Rubio and his Argentine contemporaries, global government default and economic ruin will follow. It’s time for “root canal” economics worldwide.

Before 1929, governments everywhere attempted to balance their budgets, year after year. They did not always succeed, because depressions like that of the mid-1890s threw off calculations, but a balanced budget and debt that reduced in peacetime year after year was the aim.

You can see an extreme example of this in the policies of Lord Liverpool and his Chancellor of the Exchequer Nicholas Vansittart in the years after the Napoleonic Wars, when Britain faced a government debt of 260% of GDP, more than ever before or since. In the years 1814-1817, they reduced non-interest public spending by 69%, a level of austerity that would turn George Osborne’s hair white. That got the budget deficit down to about 0.5% of GDP in 1817. They then achieved a surplus in 1818, swung back into tiny deficit in 1819 as the return to gold produced a short-lived recession, then began a run of substantial and growing surpluses through the early 1820s.

Only after Vansittart’s feckless successor Frederick “Prosperity” Robinson began a succession of tax giveaways from 1823, estimating revenue three years in advance and giving away 4 years’ imaginary surpluses in 30 months, did a deficit reappear when recession returned in 1826-27. Each of Robinson’s first three budgets were greeted with a round of cheers in the House of Commons, a marked contrast to the grumpy silence that had greeted Vansittart’s. However, when deficits threatened Robinson, fearing that the cheers for his past budgets might turn into something rougher, attempted to resign, but was prevented from doing so by Liverpool, his boss. Sadly, Liverpool suffered a stroke shortly afterwards and was forced to retire – at which point Robinson got himself kicked upstairs to the House of Lords as Viscount Goderich, leaving the new Prime Minister, George Canning, to face the House of Commons himself with a deficit Budget delivered three months late.

Robinson’s modest profligacy may have made the 1830s and the “hungry forties” harder than they needed to be; the Liverpool/Vansittart policy of paying down debt through the Sinking Fund would over a couple of decades have greatly alleviated Britain’s debt burden, whereas merely balancing the budget and waiting for economic growth to shrink the debt to GDP ratio made the debt problem persist longer than necessary.

Robinson was a typical cowardly, popularity-seeking politician (Liverpool and Vansittart were altogether higher specimens of humanity). However, Robinsonian attempts to buy popularity with either tax handouts or public spending goodies were thwarted while the world remained on the Gold Standard. Fiscal profligacy in such circumstances led quickly to gold leaving the country, which necessitated a very painful credit crunch. Also, before 1929 no respectable economist recommended the government running budget deficits in peacetime.

That changed in the 1930s for two reasons. First, the world went off the Gold Standard and could now print money to fund budget deficits, running up their debts as they did so. Second, Maynard Keynes provided spurious academic justification for running budget deficits in recessions, which in practice has been used to justify deficits at almost any time. He was initially ignored in British policy circles, where Chancellor of the Exchequer Neville Chamberlain balanced the budget once the worst of the depression had passed, bringing Britain the fastest 5-year peacetime growth rate in its history over 1932-37. However, in the United States President Franklin Roosevelt and his advisors proved all too susceptible to Keynes’ siren song and began inexorably expanding the Federal budget.

In the post-war years, budget deficits became universal, but persistent inflation prevented debt growing too far, as the unfortunate investors were “rewarded” with negative real yields – 4% yields when inflation was 6%. Thereby British public debt was reduced from 250% of GDP to around 60% of GDP, and U.S. public debt came down from 120% of GDP to a mere 30% of GDP in 1980. Savers were devastated by this tactic, especially in Britain, but at least in the U.S. rapid growth in the economy and in living standards cushioned the damage and ensured that the populace did not get too restive.

Around 1980, two things changed. First, savers in both the U.S. and Britain woke up to the gigantic rip-off that had been perpetrated on them over the previous 35 years and started demanding positive real returns from their debt investments. This gave a prolonged upward bias to the debt to GDP ratio.

Second, even conservative statesmen abandoned budget balancing, deriding it as “root-canal economics” and began to promote “supply-side economics,” the idea that well -targeted tax cuts can pay for themselves. By removing the link between income and expenditure, politicians could give voters what they wanted, lower taxes, without having to engage in the difficult and voter-unfriendly work of cutting public spending. (Britain never embraced supply-side economics as such, delaying the necessary tax cuts for nine long years after 1979 because of budget worries, but insouciance about public spending came in with the Chancellorship of the undisciplined, principle-free Kenneth Clarke in 1993.) Naturally, once the right-of-center parties abandoned public spending austerity, the leftist parties took it as an invitation for a spending bonanza, come recession or boom.

Supply-side economics is not in itself wrong, merely limited. The reduction in the top rates of UK income tax from 98% to 60% in 1979 without question produced far more output than it cost, and that from 60% to 40% in 1988 was also efficacious, though the balance was closer. Such changes, by increasing entrepreneurship and risk taking in a very bureaucratic economy, raised Britain’s economic growth far above its previous performance. By doing so, they paid for themselves many times over.

In the United States, there is no doubt that the 1981 tax cuts, reducing the top marginal rate from 70% to 50%, paid for themselves. The 1986 tax cuts also, reducing the top marginal rate from 50% to 28% and eliminating many of the barnacles in the tax code, were likewise self-funding. However, for more recent tax cuts, the benefits are less clear. The 1997 capital gains tax cut from 20% to 15% came at a time when the stock market was already over-extended, so probably had little supply-side effect, and it was accompanied by flat rate tax handouts that did nothing for incentives.

The 2001 Bush tax cut was almost certainly self-defeating from a supply-side viewpoint, because a modest rate cut was accompanied by a mountain of expensive giveaways and an immediate relaxation in public spending controls. The 2003 Bush tax cut was better; it reduced the tax rate on dividends sharply, causing companies to shift at least partly to paying dividends and away from damaging share repurchases.

As for the recent tax cuts, those on corporations almost certainly did less for economic growth than they cost, because by making taxation territorial, they encouraged corporations to shift even more income out of the United States. Except for the modest cut in personal income tax rates and the provision limiting deductibility of state and local taxes (which encouraged better state tax systems), the other provisions were not supply-side oriented, so the overall package is likely to be revenue-negative. However, the Trump administration’s policies beyond the tax cuts should produce supply side benefits, except for the administration’s insouciance about public spending, which may well lead to disaster.

As I have remarked previously, the most supply-side tax provision that could now be passed would be to eliminate the tax breaks for charities, all of them, and bring that damaging sector of the economy properly within the market system. However, by taxing the very rich and the left, such a change is the essence of “root-canal” legislation.

The era of low and ultra-low interest rates from 1995 has made matters worse. It has reduced the apparent cost of public debt, thus inducing the average Robinsonian statesman to want more of it. At the same time, it has distorted the economy, making it less productive, which has had a heavily negative effect on tax collections. Grossly excessive regulation, from both the U.S. and the EU as well as several unelected global bodies, has not helped at all, either.

The correct policy now is the precise reverse of that Rubio and the average Argentine statesman would impose. Eliminate the tax benefits on charities, and limit further those on residential real estate. Tax corporations on all their global income, allowing deductions for all foreign taxes paid (that would remove all the tax haven games involving intellectual property). Cut public spending sharply, especially that on medical and educational benefits which have been allowed to grow uncontrollably. Finally, raise interest rates at least 4% above the level of inflation and keep them there. That will eliminate all the misguided investment, and encourage domestic saving, thereby reducing the leverage in the U.S. economic system.

All that would be extremely painful. But as the dentist says as he starts the root canal, it is essential for long-term health.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)