Here We Go Again

The Bear's Lair: Here We Go Again

By Martin Hutchinson | 6 September 2008

The echoes of the 1930s in the current situation are not confined to foreign policy. Economically also, the parallels between the 1929-32 downturn and the current difficulties are becoming alarmingly apparent. It must be remembered: the Great Depression became such, as distinct from a garden-variety downturn, though egregious policy errors by decision-makers in a number of countries. Repetition of those errors, all of which would have appeared unthinkable a decade ago, is becoming increasingly likely and in some respects is already happening. One area where the mistakes of the 1930s are being replayed, although so far piano rather than fortissimo, is in international trade. There is no repeat of Smoot-Hawley on the horizon— whatever the question marks over the belief system of Barack Obama, it is pretty clear that his flirtations with protectionism during the primaries were no more than populist stunts. Nevertheless, the Doha round of trade talks have been killed stone dead, the South Korean and Colombian trade treaties with the United States seem unlikely to make it through the Democrat-controlled Congress (though there may be some chance of progress after the November election) and further trade treaties have been stymied by the President's lack of a "fast-track" negotiating authority from Congress.

More ominously, world trade has in the past few months reversed its rapid growth since 2000. Indeed if the world economy goes into a prolonged downturn there must be a substantial likelihood of a protectionist backlash, both in the wealthy economies of the US, the European Union and Japan, but also in the more autarkic emerging markets such as China, India and particularly Russia.

Neither China nor India [[nor Russia: normxxx]] is instinctively committed to free trade; to the extent that they, and not an enfeebled United States and Britain, are steering the world economy, protectionism will surely increase and global trade and prosperity suffer accordingly. There is only a limited probability of a full 1930's trade death-spiral, but the 1990's optimism about globalization and the peace to which it leads seem equally distant.

A second huge error in the United States that made things much worse was the Herbert Hoover tax increase of 1932, which raised the top rate of income tax to 63% from 25%. Even the Republican attack machine cannot paint Barack Obama as committed to quite such a suicidal move, but there is no question that an Obama administration would see considerably higher tax rates on the well-off, if only through allowing most of the provisions of the 2001 and 2003 tax cuts to expire.

Here the main need is for care. While I am as convinced as anyone that the drop in top marginal tax rates from 70% to 28% played a major role in the growth of the 1980s, and that Hoover's increase from 25% to 63% made the Great Depression much worse and more prolonged, it is not clear to me that more modest moves in marginal rates have any great effect. [[Indeed not, as Bill Clinton demonstrated in 1993: normxxx]]

Probably the only George W Bush tax cut that had a significant economic effect was that reducing the double taxation of dividends, by cutting personal tax on dividend income to 15% from 35%. Like almost all Bush initiatives, this one too was botched. A more sensible approach would have been to allow dividends paid to be deductible from corporate income for tax purposes; this would have put the tax shelter industry out of business and leveled the playing field between debt and equity for capital planning purposes.

Nevertheless, reversal of the Bush tax cuts, a modest increase in social security contributions at high income levels and a reversion of the capital gains tax rate to 20% are unlikely to be too damaging. The key will be not to allow the combined rate of Federal and state tax on any income to rise above 50%, nor to allow dividend tax to be increased, as dividends are already taxed at close to 50% including corporate and personal tax. That suggests that the top marginal rate of tax and social security contributions combined should be no more than 44%, allowing a 10% state income tax (deductible against Federal tax) to bring the overall rate up to 50%. If Obama is cautious therefore, and it seems likely that he will be, the initial effect of the planned tax cuts should be only marginally economically depressing.

The difficulty will arise if the US economy sinks into substantial recession, bringing the almost inevitable US$1 trillion budget deficit. At that point, the strong temptation for a president Obama and a majority Democrat Congress would be to increase taxes further on high incomes. This would be highly dangerous for two reasons. First, the actual marginal rate of taxation would climb towards the 55%-60% level at which serious problems of evasion and disincentive occur. Second, the confidence effect of a 15%-plus rise in the top marginal tax rate over a short period of time would be considerable, similar to that caused by Hoover's misguided budget-balancing attempt. That could depress the long-term rate of US growth, suppressing productivity gains and driving capital out of the country.

In the event John McCain wins in November, there would be at most a modest additional tax rise, which would have little effect. The severe danger in this case would be the recession and its accompanying deficit, which would bring a chorus of calls to McCain to engage in punitive tax increases to balance the budget. Since he appears to have no ideological objection to such increases, and little economic understanding of why sharp, unexpected increases would be damaging, the resulting policy might be as depressing as that pursued by Obama.

The third major policy failure that contributed greatly to the Great Depression is the failure of the Fed to loosen monetary policy after the failure of the NY Bank of the United States in December 1930. Even though interest rates remained low, money supply declined as banks failed and the public lost its deposits. This time around, monetary policy has been extremely loose, so there would seem little danger of a repetition.

However, the principal cause of the Fed's failure in 1931 was the "pushing on a string" effect, also seen in Japan in the late 1990s, where in a period of very low interest rates money supply began to shrink unexpectedly and new money proved difficult to create. In both cases, autonomous money supply shrinkage was accompanied by economic decline.

We may be seeing the beginnings of a similar effect now: growth in the St Louis Fed's Money of Zero Maturity, which had been over 20% per annum in the six months to April, has slowed since then to only 5% per annum without any rise in interest rates above their current negative real level or any visible tightening in monetary policy. This may indicate a sharp deceleration in the US economy, making money demand inadequate to absorb money supply. The next few months will give us an answer on this, one we may not like.

Overall, however the most disturbing similarity between the present situation and the early 1930s is the revived faith in the ability of government to solve problems. This never entirely went away, of course— during the cheap "end of history" triumphalism of the 1990s one was aware that the search for a "Third Way" was mere marketing, and that the old faith in government as an all-powerful solver of problems was by no means dead.

This old-time socialist religion has manifested itself in a number of ways. One is the bailout of failing enterprises. In the United States, since the 1930s the only substantial company to be bailed out had been Chrysler in 1979. This year we have seen bailouts of Bear Stearns, Fannie Mae and Freddie Mac, and it now seems likely that government money in some form will be put into the automobile industry.

As anyone with experience of the British economy in the 1960s and 1970s could tell you, this won't work. British Leyland, the British automobile company, for example, was bailed out repeatedly by the taxpayer, only to lose more and more money until finally in the 1980s [prime minister, now] Lady Thatcher put most of it out of its misery.

Government bailouts prevent the Schumpeteran process of 'creative destruction' from working, diverting resources from productive taxpayers and bond market investors to the worst losers in the economy. In extreme cases, the economy ceases to work at all, as political pull becomes the only reliable approach to obtaining resources. Increased taxes, environmental controls and the attempt to move towards a state-directed healthcare system are all further symptoms of this trend.

It is here that one can most ferociously blame former and present Federal Reserve Board chairmen Messrs Alan Greenspan and Ben Bernanke and their decade of irresponsibly cheap money. By distorting price signals throughout the economy, and producing burst bubble after burst bubble without significant improvement in living standards except at the very top, they have enabled the left to claim that capitalism "doesn't work" [[except for the very rich: normxxx]] so we must bring back government and the unfortunate taxpayer to solve economic problems.

Last time around in the 1930s, economic recovery was almost prevented altogether by government meddling, from Hoover's Hoot-Smawley Act and the political-pull Reconstruction Finance Corporation, through Roosevelt's destruction of the private capital market by de-capitalizing investment banking, eg, by the Glass-Steagall Act, to the odious creation of the farm subsidy monster [[which threatened to swollow the whole economy at times: normxxx]], to the fascist-inspired National Recovery Act. The result was an economy in which private enterprise did not recover until the early 1950s, and some of the public sector excrescences are with us still. Only a few of the public sector innovations, notably bank deposit insurance, did more good than harm, even while distorting the market. [[And even the FDIC is no unmitigated good in that it tempts bankers to play a lot more loosely with their depositors' money.: normxxx]]

John Maynard Keynes believed that the free market economy had died in 1914, and that modern economies were best run by high-minded bureaucrats like himself. As public-choice theorists have subsequently definitively proved, this approach depends on a moral purity and economic perceptiveness in the public sector that simply does not exist. Hence it damages both the economy itself and civil liberties. Nevertheless in Britain and the United States it took 50 years to get rid of it. Alas, it has now returned[[— with a vengence: normxxx]], much to the joy of the free market's fair-weather friends in organs such as the Financial Times, which had a triumphalist ode to public-sector meddling this week.

The other parallel to the 1930s, of course, is the emergence of well-armed autarkic states seeking to expand at our expense. However that is only peripherally an economic problem.

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Normxxx    
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