How Capitalism Will Save Us

by Steve Forbes

  Again, the wiser, less destructive course for the United States and Britain would have been to link the dollar and the pound to gold based on the existing postwar price levels. As the economist Ludwig von Mises pointed out, you don’t undo the bad of an inflation by a subsequent deflation. Just accept that there is a new price level because of a crisis.

  The United States could successfully return to a gold standard as long as we don’t repeat those earlier mistakes. At this writing, the price of gold is around nine hundred dollars an ounce. The dollar-to-gold ratio when we last employed a gold standard in 1971 was thirtyfive dollars an ounce. Pricing gold at that level today would produce a tsunamisized depression and a massive deflation, with prices dive-bombing to 1971 levels. Even pricing gold at what it was in the early 1990s and in 2003—when it was around three hundred and fifty dollars an ounce—would produce a disruptive economic contraction.

  However, if we went to a gold standard at a realistic dollar price—and not what it was years or decades ago—we could avoid such an economic upheaval. Bottom line: we should go to gold but do it wisely.

  REAL WORLD LESSON

  Even the best medicines won’t work if used in the wrong doses. But if properly administered, a gold standard is the best cure for much of what ails the economy.

  Q DOESN’T GOVERNMENT SPENDING BOOST THE ECONOMY? AFTER ALL, THE GOVERNMENT BUYS PRODUCTS AND SERVICES.

  A GOVERNMENT SPENDING ONLY SHIFTS RESOURCES. THE TAXATION OR BORROWING REQUIRED TO SUPPORT THIS SPENDING DESTROYS FAR MORE ECONOMIC ACTIVITY THAN IT CREATES.

  One reason Obama administration supporters give to justify their out-of-this-world stimulus spending is that a dollar spent by government isn’t just a dollar. Uncle Sam’s money, they believe, has a “multiplier effect.” The enormous flood of dollars into the economy not only helps recipients, it gets everyone moving.

  In the Real World there’s a word for this: hogwash. In the case of the administration’s massive $787 billion stimulus spending, Obama’s economic advisers believe that the “multiplier” is 1.5; in other words, each dollar spent will generate a $1.50 increase in the gross domestic product.

  Really? Economist Robert Barro is among those who believe spending has anything but a multiplier effect—just the opposite. His own research on the U.S. economy during World War II revealed that government spending resulted in less output and a lower gross domestic product. Every dollar spent by Uncle Sam resulted in only 80 cents being generated in GDP.

  He concludes: “The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases and net exports—personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses—there was a dampener, rather than a multiplier.”20

  Barro takes on the whole idea that government spending is a net plus for the economy:

  The theory (a simply Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshalling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out.21

  Some people may ask at this point: What about all the activity that’s taking place as a result of all those government dollars flooding into the economy—going not only to the recipients of its largesse but to vendors, employees, and others who in turn spend and invest. Isn’t that helping people and having a positive effect? It may be helping some people, yes. But it does not ultimately boost the economy.

  In chapter 2, we discussed how the “broken-window effect” described by the nineteenth-century French economist Frédéric Bastiat shows that fixing a broken window doesn’t create wealth. It may make jobs for the people who have to fix the tailor’s window. But the tailor is out the money that he used to fix the window, as well as the business he would have had if his shop had not been damaged. In other words, fixing the window does generate some activity, but for the tailor and the community as a whole, there’s a net loss.

  Government spending fails to stimulate the economy because of the same broken-window effect. Spending may create jobs and economic activity. But at the same time, it drains capital from individuals and businesses, reducing the jobs and wealth that would have been created.

  Dan Mitchell of the Cato Institute reminds us that “the federal government cannot spend money without first taking that money from someone.”22 That means siphoning off capital from the economy through either direct taxation or, perhaps later, the taxation needed to pay for government borrowing. There’s less money in the economy for private-sector investment. There’s less money available to put into new innovations, businesses, and jobs.

  Every dollar that the government spends means one less dollar in the productive sector of the economy. This dampens growth since economic forces guide the allocation of resources in the private sector.23

  Not only that, there are additional costs. That’s because government spends money less efficiently than the private sector. The dollars are not allocated based on people’s needs in the Real World.

  Government all too often ends up spending the money for political and not economic objectives. Like a $150 million airport built in a remote city that has only three flights a day. That almost no one uses except the powerful congressman who flies back and forth on its tiny commuter airline to his job in Washington. This is not a hypothetical example. Powerful Pennsylvania congressman John Murtha (aka “the King of Pork”) did this very thing. The John Murtha Johnstown–Cambria County airport may have generated construction jobs; it doesn’t help create future wealth. It’s a dead asset that sits virtually empty. Nonetheless, in 2009 it was slated to receive some $800,000 in “stimulus” funds.

  Along with benefiting relatively few people, government spending on growing its own bureaucracy can drag down an economy by creating ever more costly market distortions. We’ve already seen the painful and costly consequences of domination of the healthcare market by Medicaid and Medicare. Mitchell also gives the example of welfare programs that discourage work. He calls such outcomes a “behavioral penalty cost.”24 If there is a multiplier effect associated with government spending, he suggests, it’s this long-term negative impact on the economy.

  Keynesians always justify spending with the rationale that spending mobilizes idle resources. It’s necessary during a downturn, they say, because consumers aren’t buying; businesses aren’t investing. However, government spending isn’t going to cure this. The only way to do so is to address the reasons behind the decline in activity.

  That’s why stop-gap spending on initiatives like tax rebates always flops. Rebates typically produce a spike in consumer spending when the checks are issued—but little else. In 2008, as the economic crises deepened, the Bush administration sent out rebate checks—onetime payments of $600 for single filers, $300 per child, et cetera. The Obama administration sent out $250 checks to seniors, veterans, and supplemental security income recipients. In each case what resulted was very little.

  According to Brian Riedl, “no new income is created because no one is required to work, save, or invest more to receive a rebate.”25 Riedl recalls that to boost the recessed economy in 2001, Washington borrowed billions of dollars from the capital markets. What happened? People bought more, but private domestic investment dropped more than 22 percent and the economy remained stagnant into the following year.

  The economy’s growth does take off, says Riedl, when the government spends less and not more.

  In the 1980s and 1990s—when the federal government shrank by one-fifth as a percentage of gross domestic product (GDP)—the U.S. economy enjoyed its greatest expansion to date. Cross-national comparisons yield the same result. The U.S. government spends significantly less than the 15 pre-2004 European Union nations, and yet enjoys 40 percent larger per capita GDP, 50 percent faster economic gr
owth rates, and a substantially lower unemployment rate.26

  Keynesian notions about government spending gain credence during challenging economic times for the very human reason that people are comforted by the idea of government taking swift action and coming to the rescue. In fact, the money doesn’t really get spent that quickly. By the time it leaks into the economy, a recovery is usually already occurring. By May 2009, for example, the Obama administration had spent only $31 billion of that “emergency” $787 billion stimulus package that was rushed through Congress soon after he took office.

  REAL WORLD LESSON

  Government spending can’t boost the economy because it drains businesses and people of capital for new business and job creation.

  Q WILL ALL THIS SPENDING LEAD TO INFLATION—OR DEFLATION?

  A DEPENDING ON HOW IT IS FINANCED, IT MAY LEAD TO BOTH.

  Experts such as Martin Feldstein and Forbes columnists and economists Brian Wesbury and Robert Stein worry that the Obama administration’s spending binge will lead to a severe inflation. They fear that with central banks around the world pumping the equivalent of hundreds of billions of dollars into their nations’ economies, we may experience a hyperinflation similar to what unfolded in Argentina between 1975 and 1991. Overexpansion of the money supply to pay for spending by a succession of Argentine administrations caused prices eventually to soar at a rate of about 3,000 percent a year. Amid the chaos, Argentina’s currency lost just about all its value. People shifted to barter, trading homemade wares, new and used clothes, and jewelry. Inflation was finally halted in 1992. Argentina pegged its currency to the U.S. dollar. But in 2001 the dollar-peso link was severed and another round of chaos followed.

  Feldstein’s concerns have particular resonance because he used to head the National Bureau of Economic Research, the nonprofit organization whose data marking the beginnings and ends of business cycles is considered definitive. The highly regarded economist believes that inflation is likely to hit “once we start to recover.”27 With credit tight, money sits in the banks. But Feldstein has voiced the fears of many that once lending resumes and money flows again, prices will skyrocket.

  However, economist and New York Times columnist Paul Krugman fears the opposite scenario—deflation: “Falling wages are a symptom of a sick economy. And they’re a symptom that can make the economy even sicker.”28 University of Munich economics professor Hans-Werner Sinn believes this deflationary death spiral could mean a future less like that of Argentina and more like that of Japan, whose economy has been crippled since the early 1990s. He explains,

  Japanese governments have tried to overcome the slump with … one Keynesian program of deficit spending after the other and pushing the debt-to-GDP ratio from 64% in 1991 to 171% in 2008. But all of that helped only a little. Japan is still stagnating. Not inflation, but a Japanese-type period of deflationary pressure with ever increasing public debt is the real risk that the world will be facing for years to come.29

  So which is it—inflation or delation? That depends on how the government finances spending, as well as on what the Fed does. We won’t get inflation if the government borrows the money on the open market; the money supply will remain constant. But if the Federal Reserve creates money out of thin air to cover the government’s deficit, the money supply will expand. With more dollars in circulation, prices will eventually go up. Interest rates will go up immediately.

  However, if the Fed doesn’t create enough money for the economy—which is what happened between December of 2008 and the spring of 2009—deflation will result. The shortage of money will mean tighter lending; consumers and businesses will sell assets to generate cash. This wave of distress sales will put downward pressure on prices. The problem will be compounded by Uncle Sam’s profligate spending, at levels never seen before in peacetime, and the time bomb of entitlements. These could suppress investors’ appetite for U.S. government bonds. (After all, would you lend money to a guy who’s not only broke but hopelessly overextended?)

  What next? Real interest rates will soar. The higher cost of money will further cripple the private sector. The higher taxes needed to finance the interest payments and spending will only increase the pain—raising the cost of productive activity, draining people and companies of capital and savings. There will be less money in the economy to buy and invest. The result: falling asset values and prices.

  It’s very possible that we might actually experience both inflation and deflation—inflation in prices and deflation in wages. We’ve already seen a wage deflation during the 2008–2009 recession. Commodity prices went down. Credit was unavailable. People and businesses scrambled to get cash. Millions lost their jobs and millions of others had to take wage cuts. If, to finance spending, the administration lets the capital gains taxes go up by 33 percent and personal dividend taxes to more than double, as they are scheduled to do at the end of next year, housing prices and stocks will be adversely affected. Moreover, the administration is toying with substantially increasing taxes on personal incomes by removing the cap on wages eligible for the 12.4 percent Social Security tax. Not only that, it wants to add a 5.4 percent surcharge to high-income partners to help pay for healthcare “reform.” The highest effective federal tax rate could jump from the current 35 percent to well over 50 percent. The joblessness and hardship this would produce could be as disastrous as Argentina’s currency chaos.

  REAL WORLD LESSON

  Heavy government spending and the excessive printing of money produce inflation—but they can also produce equally disastrous deflation if the government taxes heavily to finance spending.

  Q DOESN’T A DEMOCRATIC CAPITALIST SOCIETY NEED GOVERNMENT SAFETY NETS?

  A SURE, BUT THERE ARE RIGHT WAYS AND DESTRUCTIVE WAYS TO PROVIDE THEM.

  Yes, Virginia, even believers in free markets see the need for safety nets. The disagreement, however, centers on the size and scope of such government programs to help those who cannot help themselves.

  Even the Founding Fathers, with their basic belief in limited government, felt government should assist the needy. But they thought the primary purpose of such aid should be to provide a lifeline at a time of crisis—to get people back on their feet.

  Austrian school freemarket economist Friedrich von Hayek considered meeting “the extreme needs of old age, unemployment, sickness” a “duty” in a democratic capitalist society.30 Milton Friedman supported certain programs, such as the Earned Income Tax Credit (EITC), which basically transfers income to society’s lowest earners. In his book Against the Dead Hand: The Uncertain Struggle for Global Capitalism, Brink Lindsey of the Cato Institute has written:

  There is no inherent conflict between the principles of economic liberalism [i.e., freemarket economics] and a decent provision for the needy and unfortunate…. It is perfectly consistent with liberal precepts for government to supplement the charitable efforts of civil society with a more comprehensive and systematic safety net. Whether provided privately or by the government, social assistance lies outside the market, in the realm of public goods. That realm is not in conflict with the market; it is in addition to the market.31

  However, helping the poor and sick at their time of need is different from what we have today; giant antipoverty bureaucracies that provide ongoing subsidies, and not just to the poor. In the case of Medicare, everyone has to accept assistance, needed or not. The program is mandatory.

  Isn’t it ridiculous that billionaires like Bill Gates or Ross Perot are forced to take Medicare or Medicare Part D, rather than government and taxpayer resources being focused on the 20 percent of the population that truly needs this insurance?

  We have repeatedly noted that experts of all political stripes agree that Medicare and Social Security “entitlements” are not sustainable. Faced with unprecedented demands by the retiring baby boomer generation, today’s government healthcare system, even if it is not expanded, as well as Social Security, is in danger of collapse.

  Social Securi
ty and Medicare were sold to the public not as welfare, but rather as government-run insurance programs. The idea was that you would put in money as you would into a 401(k) or annuity during your working lifetime. Then you’d draw the benefits when you retired. The problem is that the cost of these programs continues to go up. Despite several extensions of Medicare coverage, millions of elderly Americans still need to buy more supplemental insurance.

  Social Security and Medicare were supposed to be self-financing, just like your private health insurance and pension plan. But the government is not an insurance company. It didn’t finance Social Security, for example, the way a private company would. There are no reserves. More and more taxes will be needed to finance these programs unless, as we have suggested, they are systemically reformed.

  Medicare and Medicaid don’t fully reimburse doctors and hospitals. So their costs are shifted to the private sector, which ends up subsidizing them in excess of $90 billion a year. And then there are those Fannie-and Freddie-sized distortions and the bureaucratic rigidities they create in the markets for health insurance and medical care. They also breed corruption, including fake claims and billing estimated to be in the billions of dollars.

  These programs—and others—have become so big because government spending all too often lacks the market discipline, accountability, and transparency you’d normally have in the private sector. Funding is propelled by politics—i.e., who screams the loudest—and not by actual need.

  This is true not only of the big entitlement programs. Writing in the magazine City Journal, Steve Malanga presented a compelling account of the little-scrutinized world of government-funded nonprofits. In New York City, they are a major part of the economy.