Deficits Never Drove the US Economy

By: Gerard_Jackson

The myth that President Bush's deficits rescued the American economy from recession has taken root among some conservative economic commentators. (Of course, if you are a hardcore Democrat then Republican economic policies are always awful). This is a typical Keynesian response by people who should damn well know better.

A deficit is incurred when spending exceeds revenue. For the household this usually means getting into debt. Governments, however, are privileged: they can, and do, use central banks to create the additional money. So when someone argues that the deficit is driving the American economy they are really saying that monetary expansion is stimulating output. These same people do not seem to realise that a simple increase in output, i.e., a reduction in idle capacity, is not the same as an increase in economic growth.

From January to December 2000 M1 (currency, deposits and travellers cheques) fell by 1 per cent. For the years 2001, 2002, 2003 and 2004 M1 grew at 9.6 per cent, 4.7 per cent, 8 per cent and 8 per cent respectively. This was accomplished by the Fed driving interest rates below their market clearing rates thereby expanding the credit component of M1. (This is precisely what Bernanke is trying to do right now).

However, this monetary expansion was accompanied by tax cuts, particularly to capital gains. I think it is indisputable that the cuts promoted investment*. Any economist will tell you that if you decrease the cost of manufacturing any product you will increase the supply. (Computers are a graphic example of this self-evident truth). What tax cuts did was to reduce the cost of investing which, surprise, surprise, then increased the amount of investment.

Credit expansion is no substitute for savings, even when it involves the phenomenon of forced savings (See Friedrich von Hayek, Prices and Production , Pub. Augustus M. Kelley 1967). An expanding money supply works its magic by raising the value of the product relative to the costs of production. To suggest this process can bring about a sustainable expansion in the production structure is laughable.

We can now see that deficits can only expand 'demand' by increasing the money supply. (I am not talking about the confusion between expanding the capital structure and using inflation to release “withheld capacity”. On this topic see William Harold Hutt, The Keynesian Episode: A Reassessment , LibertyPress , 1979).

On the other hand, tax cuts expand real demand by raising investment. Nevertheless, Irwin M. Stelzer argued that "the economy … is hardly in need of further fiscal stimulus" ( The Daily Standard , Do Deficits Matter? , 15 February 2005). The sort of "fiscal stimulus" that Mr Stelzer and other economic commentators were talking about amounts to nothing but monetary expansion. In other words: inflation.

So-called "fiscal policy" is a dangerous Keynesian fraud that generates inflation, causes balance-of-payments problems, distorts the pattern of production and triggers the boom-bust cycle. A genuine fiscal policy would be one that cut taxes and regulations to bring about balanced economic growth. By balanced I mean growth that is not distorted by clusters of inflation-created malinvestments.

*Democrats now argue that tax cuts damage an economy but tax increases stimulate it. We now have the nauseating spectacle of the uber-rich Buffet making the malicious asserton that smacking capital gains with a massive tax increase would not have a detrimental effect on capital accumulation by savaging investment.

Note: Austrian school of economics definition of the money supply .

Currency outside U.S. Treasury, Federal Reserve Banks and the vaults of depository institutions.

Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.

NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations.

NOW balances at thrifts, credit union share draft balances, and demand deposits at thrifts.

AMS definition therefore equals cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.

M1 is clearly close to the Austrian definition even though it includes travellers cheques.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2008 Gerard Jackson

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