The Bear’s Lair: Time for austerity all round

Governments all over the world have in the last four months indulged in a blowout of spending, financed by central banks’ monetary stimulus and zero or negative interest rates. They are currently planning further orgies of spending, even though their economies are mostly re-opening. This will lead them down a path of budget deficits and debts that can lead in only one direction: international bankruptcy. In the United States and indeed Germany, propping up an existing system of bad investments has been tried before; in 1930-32. It led to the Great Depression; let’s not do that again.

The great President Calvin Coolidge said succinctly as always: “Economy is idealism in its most practical form.” He was discussing government economy at the time, but the aphorism applies to both the public and the private sector. Needless to say, Coolidge’s wise words have recently been about as out of fashion as it’s possible to be, and the U.S. and world economies have suffered as a result.

Economy, in both the public and private sector, is one of the areas in which the quality of conventional economic thinking has deteriorated hugely in the last two centuries. Two hundred years ago, the already highly economical government of Lord Liverpool was denounced by both the official opposition Whigs and the Radicals as being wasteful with public money. The Whigs of that period remembered the Stuarts, and believed that government spending was inherently corrupt, while the Radicals shared that belief, and thought that taxes were only so high because of government waste. (They were wrong, at least in the short-term; taxes were high because of interest costs on the National Debt of over 200% of GDP, which had been incurred in the Napoleonic and previous wars.)

In Britain during the remainder of the 19th Century, government economy stayed in fashion – William Gladstone, as Chancellor of the Exchequer and Prime Minister was a keen exponent of it. In the United States, the Civil War inevitably involved enormous expenditures and budget deficits. However the first sign of a real change in thinking came in the first half of Benjamin Harrison’s Presidential term, when the Republicans wanted to raise tariffs from already prohibitive levels, and faced the problem of what to do with all the excess revenue. Their solution was to indulge in an orgy of spending through Civil War veterans’ pensions and benefits; when accused of running a “Billion-dollar Congress” their response was to claim “Well, this is a billion-dollar country.”

The Republican example of 1888-90 shows that the urge for governments to overspend other people’s money well predates Maynard Keynes (who was in his infancy at the time.) Indeed, even in the Parliaments of Liverpool’s time proto-Keynesian spendthrifts could already be seen, even though at that period the gigantic British public debt made overspending very fiscally dangerous indeed. Interestingly the “billion-dollar Congress” also produced a hangover – in the near bankruptcy of the United States in early 1895, when President Grover Cleveland was forced to go to J. Pierpont Morgan for a bailout.

The recession of 1893-96 was beaten by sharp cuts in public spending by the Cleveland administration; that of 1920-21 was beaten by sharp cuts in public spending by Andrew Mellon, Treasury Secretary in the Harding and Coolidge administrations. Then in 1929-30, a recession occurred that resulted not from government overspending but from private sector over-investment, caused by loose Fed money policies and a stock market bubble. This time around, despite Mellon’s pleas for liquidations, President Herbert Hoover provided bailout loans to politically connected large corporations through the Reconstruction Finance Corporation and sharply raised income taxes in 1932 – the top rate from 25% to 63%. Then President Franklin Roosevelt further increased the regulatory and spending burdens on the U.S. economy. As a result, the depression did not go away quickly but instead in the United States lasted almost a decade, ending only with the mid-term elections of 1938, which deprived the meddling New Dealers of Congressional backing for their schemes.

Ever since then, with Keynes’ General Theory having been published in 1936, recessions have been met, not with liquidation and austerity, but with government spending sprees and loose money. The result is that they have lasted much longer than necessary and have done far more long-term damage to the economy. The recession after the 2008 crash was unexpectedly long-lasting, with the true rate of unemployment above 10% throughout President Obama’s terms of office; only President Trump’s de-regulatory zeal restored a modicum of economic health, before Covid-19 hit.

Some of the items of Covid-19 spending have been more damaging than others. To the extent that forgivable loans went to endangered small businesses, and not to the Fortune 500 or charity-related scams, they probably did some good. The $1,200 “stimulus” payments, going to actual real people, were economically harmless and have valuably stimulated saving. The $600 per week extra unemployment payments were a reasonable palliative while lockdown was total but should be ended now because they provide an extra incentive to mooch off taxpayers.

Of the various suggested boondoggles, infrastructure spending happens far too slowly, given that even the target of the excellent new Trump Administration regulations is to get projects approved within two years – far too late to provide “shovel-ready jobs” to get us out of this recession. On the other hand, a temporary holiday from Social Security tax seems a good idea, as the incentives align correctly, provided the financial cost is made up by extra borrowing and doesn’t just pull Social Security bankruptcy a couple of years closer.

With the exception of some limited short-term incentive of that kind, however, the time has come for some budgetary and monetary discipline. The private sector has leveraged itself excessively over the last decade; hence interest rates must be raised to ensure that de-leverage takes place as quickly as possible and the weakest go properly to the wall. Big city real estate is now in for a major downturn, because the whole economic thesis for living in big cities has been destroyed by Covid-19 and the increased ability to work remotely. House prices in London and New York will probably halve; those in San Francisco will drop more than that. The quicker and more thoroughly this happens the better. Air travel will become much more expensive, whether we like it or not, and business travel will reduce substantially in volume. Hence Boeing and the airlines are toast, as is a great deal of low-end vacation real estate. Again, higher interest rates will speed their demise.

Certainly, these sectors should not be propped up, either by direct bailout from the government, or by the Fed buying decrepit corporate bonds. Propping up zombie companies and assets risks sending the economy into a stasis like that of Japan in the late 1990s, in which no new investment takes place because resources are so terribly wasted propping up the price of old investment. The bailout of Virgin Atlantic, for example, rescues a failing company with unpleasant management in an industry that needs to shrink – it has no redeeming virtues. Just as Japan has not been an especially happy economy for the last 30 years, and now has an insoluble government debt problem, so stagnation and declining living standards will result in the United States, Britain and Europe if dead assets are not quickly liquidated.

As for the public sector, the greatest need is to avoid waste, which has grown exponentially since the last attempt to balance the U.S. budget around 2000. It is not possible to balance the budget solely by increasing taxes, and it would be hugely damaging on the economy if you tried. Equally, there are some notorious tax loopholes that must go. Corporate tax must be levied on worldwide profits, with no exemptions for parking overseas operations and “intellectual property” in tax havens. In a period of fiscal austerity, the public has the right to demand that the largest corporations pay their share.

Even more important, the tax loopholes for the rich must be closed too. “Carried interest” for hedge funds and private equity funds must be taxed as the income it truly is, not as a fictitious capital gain. The Trump administration did well here in limiting the tax deductibility of state and local taxes, but there is an even more egregious and damaging tax loophole that must be closed: that for charitable tax deductions, a pure subsidy to the odious lifestyles of the very rich. The most sensible approach is probably to cap the global tax deduction at $100,000, when home mortgage interest, state and local taxes and charitable deductions are added together; that would create a level playing field.

However, studies have shown that balancing the budget through tax increases alone does not work, even when those increases take the form of eliminating damaging tax deductions. Hence the most important need of all, anathema to all the last three administrations (let alone a possible Biden administration) is a program of rigid austerity in the public sector, knocking 8-10% of GDP off public spending, reducing it to around 15% of GDP. Only when that is done will fiscal balance finally be achieved.

The next few years must be ones of liquidation in the private sector and rigid austerity in the public sector – completely different from our approach for the last quarter-century. I can’t wait to get started!

(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.)