America's Great Depression (3 page)

The confusion and intellectual despair we noted in the introduction to the third edition has now intensified. It is generally conceded that Keynesianism is intellectually bankrupt, and we are treated to the spectacle of veteran Keynesians calling for tax increases during a severe depression, a change of front that few people consider worth noting, much less trying to explain.

Part of the general bewilderment is due to the fact that the current, severe 1981–83 depression followed very swiftly after the recession of 1979–80, so that it begins to look that the fitful and short-lived recovery of 1980–81 may have been but an interlude in the midst of a chronic recession that has lasted since 1979. Production has been stagnating for years, the auto industry is in bad shape, thrift institutions are going bankrupt by the week, and unemployment has reached its highest point since the 1930s.

A notable feature of the 1981–83 depression is that, in contrast to 1973–75, the drift of economic thought and policy has not been toward collectivist planning but toward alleged free-market policies. The Reagan administration began with a fanfare of allegedly drastic budget and tax cuts, all of which lightly masked massive
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increases in taxes and spending, so that President Reagan is now presiding over the largest deficits and the highest budgets in American history. If the Keynesians and now the Reagan administration are calling for tax increases to narrow the deficit, we find the equally bizarre spectacle of veteran classical liberal economists in the early days of the same administration apologizing for government deficits as being unimportant. While it is theoretically true that deficits financed by sale of bonds to the public are not inflationary, it is also true that the huge deficits (a) exert enormous
political
pressure on the Fed to monetize the debt; and (b) cripple private investment by crowding out private savings and channeling them into unproductive and wasteful government boondoggles which will also impose higher taxes on future generations.

The twin hallmarks of “Reaganomics” so far have been huge deficits and remarkably high interest rates. While deficits are often inflationary and always pernicious, curing them by raising taxes is equivalent to curing an illness by shooting the patient. In the first place, politically higher taxes will simply give the government more money to spend, so that expenditures and therefore deficits are likely to rise still further. Cutting taxes, on the other hand, puts great political pressure on Congress and the administration to follow suit by cutting spending.

But more directly, it is absurd to claim that a tax is any better from the point of view of the consumer–taxpayer than a higher price. If the price of a product rises due to inflation, the consumer is worse off, but at least he still enjoys the services of the product.

But if the government raises taxes in order to stave off that price rise, the consumer is getting nothing in return. He simply loses his money, and obtains no service for it except possibly being ordered around by government authorities he has been forced to subsidize.

Other things being equal, a price rise is always preferable to a tax.

But finally, inflation, as we point out in this work, is not caused by deficits but by the Federal Reserve’s increase of the money supply. So that it is quite likely that a higher tax will have no effect on inflation whatsoever.

Deficits, then, should be eliminated, but only by cutting government spending. If taxes and government spending are both
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slashed, then the salutary result will be to lower the parasitic burden of government taxes and spending upon the productive activities of the private sector.

This brings us to a new economic viewpoint that has emerged since our last edition—“supply-side economics” and its extreme variant, the Laffer Curve. To the extent that supply-siders point out that tax reductions will stimulate work, thrift, and productivity, then they are simply underlining truths long known to classical and to Austrian economics. But one problem is that supply-siders, while calling for large income-tax cuts, advocate keeping up the current level of government expenditures, so that the burden of shifting resources from productive private to wasteful government spending will still continue.

The Laffer variant of the supply-side adds the notion that a decline in income tax
rates
will so increase government revenues from higher production and income that the budget will still be balanced.

There is little discussion by Lafferites, however, of how long this process is supposed to take, and there is no evidence that revenue will rise sufficiently to balance the budget, or even will rise at all. If, for example, the government should now raise income tax rates by 30

percent, does anyone really believe that total revenue would
fall
?

Another problem is that one wonders why the overriding goal of fiscal policy should be to maximize government revenue. A far sounder objective would be to
minimize
the revenue and the resources siphoned off to the public sector.

At any rate, the Laffer Curve has scarcely been tested by the Reagan administration, since the much-vaunted income tax cuts, in addition to being truncated and reduced from the original Reagan plan, were more than offset by a programmed rise in Social Security taxes and by “bracket creep.” Bracket creep exists when inflation wafts people into higher nominal (but not higher
real
) income brackets, where their tax rates automatically increase.

It is generally agreed that recovery from the current depression has not yet arrived because interest rates have remained high, despite the depression-borne drop in the rate of inflation. The Friedmanites had decreed that “real” interest rates (nominal rates
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minus the rate of inflation) are always hovering around 3 percent.

When inflation fell sharply, therefore, from about 12 percent to 5

percent or less, monetarists confidently predicted that interest rates would fall drastically, spurring a cyclical recovery. Yet, real interest rates have persisted at far higher than 3 percent. How could this be?

The answer is that expectations are purely subjective, and cannot be captured by the mechanistic use of charts and regressions.

After several decades of continuing and aggravated inflation, the American public has become inured to expect further chronic inflation. Temporary respites during deep depressions, propaganda and political hoopla, can no longer reverse those expectations. As long as inflationary expectations persist, the expected inflation incorporated into interest rates will remain high, and interest rates will not fall for any substantial length of time.

The Reagan administration knew, of course, that inflationary expectations had to be reversed, but where they miscalculated was relying on propaganda without substance. Indeed, the entire program of Reaganomics may be considered a razzle-dazzle of show-manship about taxes and spending, behind which the monetarists, in control of the Fed and the Treasury Department, were supposed to gradually reduce the rate of money growth. The razzle-dazzle was supposed to reverse inflationary expectations; the gradualism was to eliminate inflation without forcing the economy to suffer the pain of recession or depression. Friedmanites have never understood the Austrian insight on the necessity of a recession to liquidate the unsound investments of the inflationary boom. As a result, the attempt of Friedmanite gradualism to fine-tune the economy into disinflation-without-recession went the way of the similar Keynesian fine-tuning which the monetarists had criticized for decades. Friedmanite fine-tuning brought us temporary “disinflation” accompanied by another severe depression.

In this way, monetarism fell between two stools. The Fed’s cut-back in the rate of money growth was sharp enough to precipitate the inevitable recession, but much too weak and gradual to bring inflation to an end once and for all. Instead of a sharp but short recession to liquidate the malinvestments of the preceding boom,
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we now have a lingering chronic recession coupled with a grind-ing, continuing stagnation of productivity and economic growth. A pusillanimous gradualism has brought us the worst of both worlds: continuing inflation plus severe recession, high unemployment, and chronic stagnation.

One of the reasons for the chronic recession and stagnation is that the market
learns
. Inflationary expectations are a response learned after decades of inflation, and they place an inflationary premium on pure interest rates. As a result, the time-honored method of lowering interest rates—the Fed’s expanding the supply of money and credit—cannot work for long because that will simply raise inflationary expectations and raise interest rates instead of lowering them. We have gotten to the point where
everything
the government does is counterproductive; the conclusion, of course, is that the government should do nothing at all, that is, should retire quickly from the monetary and economic scene and allow freedom and free markets to work.

It is, furthermore, too late for gradualism. The only solution was set forth by F.A. Hayek, the dean of the Austrian School, in his critique of the similarly disastrous gradualism of the Thatcher regime in Great Britain. The only way out of the current mess is to “slam on the brakes,” to stop the monetary inflation in its tracks.

Then, the inevitable recession will be sharp but short and swift, and the free market, allowed its head, will return to a sound recovery in a remarkably brief time. Only a drastic and credible slamming of the brakes can truly reverse the inflationary expectations of the American public. But wisely the public no longer trusts the Fed or the federal government. For a slamming on of the brakes to be truly credible, there must be a radical surgery on American monetary institutions, a surgery similar in scope to the German creation of the
rentenmark
which finally ended the runaway inflation of 1923. One important move would be to denationalize the fiat dollar by returning it to be worth a unit of weight of gold. A corollary policy would prohibit the Federal Reserve from lowering reserve requirements or from purchasing any assets ever again;
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better yet, the Federal Reserve System should be abolished, and government at last totally separated from the supply of money.

In any event, there is no sign of any such policy on the horizon.

After a brief flirtation with gold, the Presidentially appointed U.S.

Gold Commission, packed with pro-fiat money Friedmanites abet-ted by Keynesians, predictably rejected gold by an overwhelming margin. Reaganomics—a blend of monetarism and fiscal Keynesianism swathed in classical liberal and supply-side rhetoric—is in no way going to solve the problem of inflationary depression or of the business cycle.

But if Reaganomics is doomed to be a fiasco, what is likely to happen? Will we suffer a replay, as many voices are increasingly predicting, of the Great Depression of the 1930s? Certainly there are many ominous signs and parallels. The fact that Reaganomics cannot bring down interest rates for long puts a permanent brake on the stock market, which has been in chronic trouble since the mid-1960s and is increasingly in shaky shape. The bond market is already on the way to collapse. The housing market has at last been stopped short by the high mortgage rates, and the same has happened to many collectibles. Unemployment is chronically higher each decade, and is now at the highest since the Great Depression, with no sign of improvement. The accelerating inflationary boom of the three decades since the end of World War II has loaded the economy with unsound investments and with an oppressive moun-tain of debt: consumer, homeowner, business, and international. In recent decades, business has in effect relied on inflation to liquidate the debt, but if “disinflation” (the lessening of inflation in 1981 and at least the first half of 1982) is to continue, what will happen to the debt? Increasingly, the answer will be bankruptcies, and deeper depression. The bankruptcy rate is already the highest since the Great Depression of the 1930s. Thrift institutions caught between high interest rates to their depositors and low rates earned on long-time mortgages, will increasingly become bankrupt or be forced into quasi-bankrupt mergers with other thrifts which will be dragged down by the new burdens. Even commercial banks,
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protected by the safety blanket of the FDIC for half a century, are now beginning to go down the drain, dragged down by their unsound loans of the past decade.

Matters are even worse on the international front. During the great credit boom, U.S. banks have recklessly loaned inflated dollars to unsound and highly risky governments and institutions abroad, especially in the Communist governments and the Third World. The Depository Control Act of 1980, which shows no signs of being repealed by the Reagan administration, allows the Federal Reserve to purchase unlimited amounts of foreign currency (or any other assets) or to lower bank reserve requirements to zero. In other words, it sets the stage for unlimited monetary and credit inflation by the Fed. The bailing out of the Polish government, and the refusal by the U.S. to declare it bankrupt so that the U.S. taxpayer (or holder of dollars) can pick up the tab indefinitely, is an omen for the future. For only massive inflation will eventually be able to bail out foreign debtors and U.S. creditor banks.

Since Friedmanite gradualism will not permit a sharp enough recession to clear out the debt, this means that the American economy will be increasingly faced with two alternatives:
either
a massive deflationary 1929-type depression to clear out the debt,
or
a massive inflationary bailout by the Federal Reserve. Hard money rhetoric or no rhetoric, the timidity and confusion of Reaganomics make very clear what its choice will be: massive inflation of money and credit, and hence the resumption of double-digit and perhaps higher inflation, which will drive interest rates even higher and prevent recovery. A Democratic administration may be expected to inflate with even more enthusiasm. We can look forward, therefore, not precisely to a 1929-type depression, but to an inflationary depression of massive proportions. Until then, the Austrian program of hard money, the gold standard, abolition of the Fed, and laissez-faire, will have been rejected by everyone: economists, politicians, and the public, as too harsh and Draconian. But Austrian policies are comfortable and moderate compared to the economic hell of permanent inflation, stagnation, high unemployment, and inflationary depression that Keynesians and Friedmanite neo-Keynesians have gotten us into. Perhaps, this present and
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