Tuesday, April 14, 2009

Will the Liquidationists get their revenge?

US monetary authorities are following Keynesian remedies as never before. The FED has expanded dramatically its balance sheet and moved to radical 'quantitative easing' including purchases of US Treasuries. Administration economists like Christie Romer cite Keynes with almost religious devotion. Massive government subsidies and expanded entitlement programs are back in vogue. Will this stem the crisis and lead to a speedy and robust economic recovery? Alternatively, will this lead to unanticipated side effects, that result a prolonged period of stagnant growth leaving the US a poorer, weaker country?

The Liquidationists of the Great Depression era may soon take their revenge on today's concepts of financial engineering and risk-taking. Anti-Keynesian economists like Joseph Schumpeter believed in ‘creative destruction’ and argued that there was a “presumption against remedial measures which work through money and credit.… policies of this class are particularly apt to…produce additional trouble for the future.” The approach of the Liquidationists was to write off the losses where they occurred because they feared the negative side effects otherwise and wanted to make room for new players. They believed the role of government in the economy was to secure a level playing field. They advocated balanced budgets and low public debt. Today we live in a world where government plays an increasing role in socializing losses and regulating business by public policy. Debt inflation is key tool used by US authorities in the current financial crisis.

The Obama administration is continuing the policies of the previous Bush administration in subsidizing the US banking industry rather than having financial institutions holding so-called subprime 'toxic waste' write off the bad paper. The US government is effectively socializing the losses in the banking sector, shunning the conventional remedies of bankruptcy, bridge banks and reorganization and replacing this with elaborate subsidy schemes for recapitalization. The hope is that by massively increasing the money supply, prices will again begin to rise in the housing markets and the banks will be made whole again on their bad assets.

The new twist to the Obama administration is the return of big government to the broader US economy. What Obama proposes is a "post-material economy" de-emphasizing the production of ever-more private goods and services and harnessing the economy to achieve broad social goals. The logic of the "post-material economy" is to spend heavily and finance this by an expansion of public deficits and debt. Government policy would play a strong role in credit and capital allocation. The theory is that the deficits and public debt that would be eventually paid off by a robust economic recovery based on this new economic paradigm

The risks are that the resulting debt inflation in both government and households as well as increased tax load will crowd out demand for goods and services and lead to prolonged period of economic stagnation in the US. The US tax system favors debt rather than equity financing. By encouraging debt, it has prompted a tax shift onto the “real” economy’s labor and capital. The resulting interest charge and tax shift mean that US is not as efficient and low-cost producers as it used to be.

To get a lower-cost world, the US has to counter political pressure from real estate owners and their bankers to shift taxes off rent-yielding properties onto labor and capital. Income and sales taxes add to the price of doing business, and hence reduce their supply and competitiveness. By contrast, the FED is trying to reflate real estate asset prices to safeguard an over-sized financial industry

It is very difficult to have a productive economy that creates wealth and value as well as broadens the tax base without robust a goods and services sector that rewards capital and labor. This simply will not happen if people’s incomes are cannibalized by taxes and debt service from socialization of the financial sector losses and government-guided post-material economic policies. The room for discretionary spending will shrink. The debt inflation and high tax burden risks ever-higher breakeven levels for US businesses and households, making the US very uncompetitive internationally.

The present crisis was generated from the excesses in dealing with the aftermath of the Dot.com bubble. The excesses from the present financial engineering and new government economic policies are yet to be quantified. The Liquidationists feared the success of capitalism would lead to a form of corporatism and a fostering of values hostile to capitalism -especially among intellectuals - that would lead to capitalism's demise. Democratic majorities would vote for the creation of a welfare state and place restrictions upon entrepreneurship that destroy the capitalist structure.

They would probably turn over in their graves today because this thinking now reflects a good part of the existing political and economic landscape in the US. The real issue for the US economy is competitiveness and productivity that creates new wealth and value. It is very hard to see anything at present in the Obama administration that fosters the entrepreneurship needed to lead to this result.

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