This speech was presented at the Jonathan Club in Los Angeles in December of last year.
As all of you know, the title of my speech is "Government Barriers to Economic Growth." Importantly, it's government barriers that keep the U.S. and global economy from growing right now, and if there's one thing I hope you'll take from my speech, it's this: never in the history of man has the profit motive, or capitalism caused a lengthy downturn or "recession" the likes of which we experienced in the 1930s, or the one since 2008.
What economists call "economic recessions" is in the above sense a certain misnomer. Capitalism can't cause recessions because at its core, capitalism is the happy process whereby the individuals who serve their customers and clients well receive capital necessary to grow in abundance, and those who are failing their customers and clients are properly starved of it.
In short, capitalism in equal parts describes success, and very importantly failure, and if left alone, failed ideas die a quick death so that profitable concepts can grow on the way to removing unease from our lives.
For background on this, I'll quote a March of 2000 Wall Street Journal op-ed by the great economist Charles Kadlec. In it, Kadlec made the essential point that underlies what I'm about to talk about, that "Booms and bull markets never die of old age. They always succumb to policy failure" instead. Our economy today doesn't suffer a lack of ideas or a lack of desire, rather it suffers policy failure that is making it difficult for the producers, or the vital few in our economy, to be productive.
History shows Kadlec's words to be very true.
To see why, let's look at the two major stock-market crashes of the 20th century. To this day, history books suggest that the 12.5% stock-market correction in 1929 was solely a function of stock market having gotten ahead of itself.
More realistically, markets never price in the present, rather they price in the future economic outlook, and on that day news accounts revealed that President Hoover would sign the Smoot-Hawley tariff in 1930. Investors properly understood that a legislative error in the U.S. that would restrict the ability of individuals to trade freely on a global basis would essentially put a tax on work, and worse, it would foster inefficiency globally given the barriers to economic specialization that tariffs on trade always engender.
In short, the stock-market crash of 1929 was then, and is now, easy to understand. Rather than a continuation of open global markets on the way to individuals seeking their own comparative advantage, Smoot-Hawley would put up barriers to the global harmony that free trade invariably brings, and worse, as U.S. statesman Cordell Hull once observed, when goods can't cross borders freely, armies inevitably do. Basically Smoot-Hawley foretold the death and destruction of World War II; war always an economy killer despite the views of some modern economists that wars help economies to expand. More on that horrifying lie later on.
Moving to 1987, stocks didn't correct 22.5% because their prices had risen too much; rather some very negative economic signals emanating from Washington in the week leading to the crash made it inevitable.
For one, Rep. Richard Gephardt was pushing through Congress a tariff bill on Japanese goods. Tariffs always scare investors because they ensure economic inefficiency through the subsidization of the weak at the expense of the strong. Secondly, the Senate Finance Committee was considering a bill meant to heavily tax the very leveraged buyouts that had made businesses around the U.S. far more lean and efficient.
Most problematic of all, U.S. Treasury secretary James Baker went on the Sunday talk shows the day before the crash and quite explicitly talked down the dollar. Contrary to modern opinion, the Treasury is the dollar's mouthpiece as opposed to the Federal Reserve, and for the head of Treasury to talk down the dollar is for that same person to talk down the very savings and investment that drive all economic activity.
To put it very simply, markets are the great voting booth through which investors cast ballots on the economy's future. To grow, economies - which once again are nothing but a collection of individuals - need but four things from the government: light taxation, little to no regulation, the ability to trade freely without regard to country borders, and a stable unit of account; in our case a dollar that is stable in value.
Anytime governments move away from these four basics, economies suffer, and markets must price in these negative inputs.
At present, economists, and most notably economist Paul Krugman, are arguing that there's not enough demand in the economy, and as such Washington must spend dollars taken from the private sector in order to get the economy moving again. The thinking here is false on its face.
Indeed, governments have no resources, so for them to spend is for them to tax or borrow funds from the private sector which, if left there, would more readily reach enterprising individuals eager to produce. As economist Joseph Schumpeter long ago noted, entrepreneurs can't be entrepreneurs without capital, so when governments vacuum up limited capital, the productive, job-creating private sector suffers.
Second about demand, it is our nature to always demand things. As such governments should never concern themselves with a lack of it. As humans our wants are unlimited, but as we all know in this room as individuals, we can only demand something insofar as we supply something first.
In the real economy, we trade products for products, so if demand is what the government seeks to stimulate, it must by definition to remove barriers to production which are once again taxes, trade barriers, regulations and unstable money values.
In my speech today, I'm going to talk about three things: first I'll cover the Great Depression, and how government intervention turned what should have been a minor downturn into a decade of economic hardship. Second, I'll somewhat briefly go over what I think caused the financial crisis given my very contrarian views on its causes. And three, I'll talk about the economy at present, and how intervention by Washington is yet again turning a recession that should have been brief and shallow into something much worse.
The Great Depression
First off, to have a reasonable understanding of the Great Depression, it's essential for you to know what happened in the early ‘20s, when the U.S. economy contracted in a far more severe way than it did beginning in 1930.
Importantly, and essentially as it goes to understanding what happened in the 1930s, the government response in the early ‘20s was the mirror opposite of what occurred in the 1930s. Essentially, Washington did nothing when the economy collapsed in 1920-21. That Washington pretty much let an economy of individuals fix itself explains very elegantly why most have never heard of the early ‘20s recession.
Indeed, as economist Benjamin Anderson pointed out in his classic book Economics and the Public Welfare, the federal government actually reduced spending from $6.4 billion in fiscal year 1920 to roughly $3.3 billion in 1923. "Austerity" of the spending cut variety has a bad name today, and very few economists would have the courage to call for massive reductions in the burden of government amid a recession, but less hamstrung by fallacy nearly 100 years ago, the size of government was slashed. According to classical economic theory, the government's non-intervention was the proper response. Government spending is a tax, and the pullback by the federal government left more capital in the private sector to fund real economic growth over government consumption.
And then with the dollar, contrary to the horrifyingly dim "truth" today that monetary authorities must devalue in the face of economic decline, authorities back in the early 1920s made sure to protect the dollar. As Anderson noted, the "gold standard was unshaken" despite the economic crisis. The savers and investors whose thrift authors our economic advancement were not told - as they have been under Bush and Obama - that their parsimony would be eviscerated by monetary mismanagement.
So while the 1921 downturn was surely severe, Anderson recounted that by 1923 we had a labor shortage. In the early ‘20s, barriers to production were removed, and the Roaring ‘20s that we all know about soon followed. Basically government spending fell, taxes declined to a 20th century low of 25% on top earners, regulation was light, and the dollar's integrity was largely maintained. The political class followed closely the four basics of economic growth, and in practicing textbook Classical economics, the economy soared.
The early 1920s economic decline shows that economies can naturally heal after a recession. Importantly, and this is another thing that I hope stays with you after my talk, and that's that recessions of the market variety are actually a healthy occurrence.
Indeed, recessions though painful for rising unemployment and business failure, are in fact a sign of an economy on the mend as bad ideas and improper employment are cleansed from the commercial sector so that limited capital can reach better, more productive uses. That's why recessions are usually short.
During recessions bad ideas are starved of capital, and good ones once again receive it abundance. In that sense, it's no surprise that the Great Depression that I'm about to cover lasted so long. Unlike previous downturns that reoriented capital to productive uses, during the Great Depression Washington sought to soften the pain, but in doing so it turned what should have been a short downturn into something very lengthy.
First up is government spending. Much as taxes rob us of the fruits of our labor, so does government spending once again turn the savings so essential for economic growth into cconsumed funds meant to support government waste. President Hoover doubled government spending on the assumption that demand from Washington would enhance the economy.
Hoover's rush to Keynesianism failed miserably on the way to him losing his 1932 re-election bid, and then in early January of 1934 President Franklin Roosevelt announced that to get the economy moving, the 1934 federal deficit would be increased to $7 billion. Having chosen to ignore the mistakes of his predecessor, FDR doubled down on Keynesianism. Not surprisingly, his contradictory "cure" made things worse.
The failure of 1930s Keynesian spending should in no way surprise us. To presume that productivity would multiply thanks to government largess is the equivalent of assuming that a thief could aid a convenience store by first stealing $20 from it, then returning later in the day to spend it. Logic tells us that no stimulation results from money simply changing hands.
Considering taxes, Hoover raised the top tax rate from 25 to 62 percent, and then FDR eventually one-upped him by raising the top tax rate to 79 percent in concert with a reduction in rate thresholds so that more Americans could be ensnared by higher tax rates. This is important because in any economy we're ultimately reliant on what economist Reuven Brenner terms the "vital few"; the creative and ambitious individuals who start new businesses based on innovative ideas that will make economies more efficient, and create jobs in the process.
Essentially the vital few were told that if they acted in productive ways in the ‘30s, the fruits of their efforts would be taken from them. Taxes are nothing more than a price, and if the price of productive work effort is a high, those who would necessarily be most productive sidelined themselves.
Looking at trade, J.P. Morgan head Thomas Lamont remarked that "I almost went down on my knees to beg Herbert Hoover to veto the asinine Smoot-Hawley tariff." GM's European head, Graeme K. Howard, sent a telegram to Washington which said passage of Smoot-Hawley would lead to the "MOST SEVERE DEPRESSION EVER EXPERIENCED." In one fell swoop, Washington shrank the very division of labor that enhances productivity, while the tariffs themselves greatly reduced the size of markets for U.S. firms to sell to.
The Smoot-Hawley tariff was an economy killer, and its impact can't be stressed enough. To see why, think of yourselves. All of you pursue an economic specialty, and presumably do so because it's what you're best at. But imagine if the government suddenly told you that you were no longer free to exchange the fruits of your labor for those of others; that essentially you'd be taxed if you bought televisions, cars, houses and clothes from others.
The inevitable result would be that all of you would lead lives of unrelenting drudgery. Given your need to provide on your own for shelter, clothes, transportation and entertainment, you'd spend enormous amounts of time doing what you're not good at, and the time spent would detract from your pursuit of what you're best at. Smoot-Hawley didn't exactly require what I've just described, but when tariffs to trade go up, economic efficiency by definition plummets for the reasons described.
On the wage front, FDR was able to pass the National Industrial Recovery Act of 1933 which, according to economist Richard Vedder, "raised wages in factory employment about 20 percent," thus stalling recovery. This legislation was thankfully killed by 1935, but the Wagner Act followed, and as Vedder recounts, the "resulting wave of unionism led to another double digit rise in money wages, reversing the previous unemployment decline." As a result, unemployment ticked back up to 20 percent by 1938.
It's also the case that heavy spending funded all manner of make-work projects in the United States. In that sense we should not be surprised that unemployment - at least reported joblessness - remained high. Think of it like you might a convenience store: When inventory is rising, meaning demand for goods is low, the logical response is to lower product prices to a market-clearing level that will attract buyers.
The Roosevelt administration did the opposite, whereby through government make-work projects and wage regulations, it made the cost of hiring workers back into the private sector greater than the market would bear. Far from compassionate, these artificially high wages raised the cost of hiring, thus explaining why the headline rate of unemployment was roughly the same at the end of the 1930s as it was at the beginning. Wages were not allowed to adjust to new, 1930s realities, thus explaining nosebleed worker inventory.
Of course in order for businesses to be able to attract the investment that funds expansion and job creation, the value of money must be stable. But rather than maintain the dollar's value as 1/20th of an ounce of gold, Roosevelt essentially robbed the nation's savers so crucial to economic growth with his devaluation of the dollar to 1/35th of an ounce of gold in 1933. Savers and investors were basically told that the dollar's value was a moving target, thus making investing in future expansion a dangerous concept.
Perhaps most economically crippling was the passage of the Undistributed Profits Tax of 1936. For corporations with profits of less than $10,000/yr. the tax ran from 10 to 42.14 percent, while companies earning more than $10,000 faced taxes on undistributed profits of 40 to 74 percent. The plan there was to force the distribution of profits through dividends that could be taxed as income, but what it meant in practice was that savings put aside by corporations for future growth or for a rainy day would have to be handed over to the federal government. Is it any wonder that the U.S. economy foundered in the 1930s? I think not.
The economy collapsed because the Roosevelt and Hoover administrations violated the four necessary inputs to economic growth: taxes went up alongside crippling regulations, trade was made less free, and the dollar was devalued. The Great Depression did not have to be.
World War II. Mentioned earlier was the conventional account suggesting World War II ended the Great Depression. The basic argument is that government spending employed a lot of people, and the economy grew. But logic tells us that this assumption puts the cart before the proverbial horse. Once again, governments can only spend if they can tax and borrow against productive work that's already occurred. Instead, it would be more accurate to say that a resumption of work combined with a less economically interventionist Washington did the job.
Amity Shlaes observed in The Forgotten Man that FDR knew a "war on business and a war against Europe could not happen at the same time," and as has been shown, New Deal legislation so harmful to employment and capital formation was effectively halted by 1938. In 1942, FDR ordered the liquidation of the Work Projects Administration. The WPA employed 2.4 million Americans in 1939, but by June of 1943 the number was down to 42,000. World War II didn't end the Great Depression so much as its seeming inevitably - right or wrong - to Roosevelt meant that the New Deal's myriad interventions in the economy would cease.
To assume war is stimulative is to argue for governments that regularly wage wars or massive employment programs. Looked at locally, and if you believe that war is stimulative, it would then be a good idea for Los Angeles politicians to regularly destroy all of the buildings in downtown, only to reconstruct them. Destroy wealth to stimulate an economy? I think not.
How death and destruction could help any economy has never been explained, and with good reason. War is as a rule a destruction of wealth that halts the international division of labor, and it involves the killing of potential customers. War can only delay the economic specialization which is at the core of economic growth, and as such was only stimulative insofar as it once again ended the New Deal.
Furthermore, if it in fact had been stimulative, then it would have to have been the case that once the war ended, that the decline in military employment in concert with greatly reduced spending would have led to another economic collapse. Instead, the opposite occurred as the U.S. economy boomed post-war thanks to Americans returning to productive pursuits over the killing, wealth destruction and autarky that defines war.
Better yet, the passage of the Bretton Woods agreement in 1944 which put the world on a dollar standard, and the dollar on the gold standard, was a signal that countries were chastened by the tariffs that made World War II more likely, and that instead the world return to a trade compact that would once again resume the global exchange of goods.
In short, barriers to growth gave us the war, but happily the war's aftermath ensured a return to freer trade, less in the way of government regulations, a stable dollar, and with government spending a tax on productivity like any other, an end to government spending made necessary by the war itself.
The Financial Crisis
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