Why Government Taxing and Spending Does NOT Work

There is an interesting article written by Van Hoisington and Dr. Lacy Hunt of Holsington Investment Management Company (which does bias their work somewhat I am sure, but you'll notice in the below excerpt it is written as a research report and quotes many other reports including Christina Romer's study done before she got her current job).

While this is a bit of a long read, and may be a little technical in areas, you definitely should read it and pass it on to your representatives as something to think about before they think that more Government stimulus is necessary.

"Interestingly, the term "federal stimulus spending" is an oxymoron. Many assume that the act of sending checks from the federal government sector to the private sector helps the economy through so-called spending multipliers. Multipliers take into consideration the second, third, fourth, etc. round effects from an initial change. Thus, multipliers capture the unintended consequences of policy actions. Although the initial spending objectives may be well intended, the ultimate outcome becomes convoluted. Over the past several years, multipliers have been intensively examined by leading economic scholars. Robert Barro of Harvard University calculates in Macroeconomics a Modern Approach (Thomson/Southwestern, 2008, p. 307) that the government expenditure multiplier from 1955 to 2006 was negative .01, not statistically different from 0. The highly respected Italian econometrician Roberto Perotti of Universita' Bocconi and the Centre for Capital Economic Policy Research has also done extensive work on this subject while visiting the fiscal policy division of the ECB. In October 2004, in his Estimating the Effects of Fiscal Policy in OECD Countries, Perotti calculates that the U.S. expenditure multiplier is also close to 0. Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth. There may be intermittent periods when government spending will lift the economy, but offsetting episodes will follow. The best available empirical research suggests that the current federal policy of expanding spending will retard, not improve, the performance of business conditions. In addition to spending multipliers, however, there are also tax multipliers."

"The most extensive research on tax multipliers is found in a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president's Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3."

"Presently, the federal government is increasing spending that in the end may actually retard economic activity, and is also proposing tax increases that will further restrain private sector growth. This policy mix is the same approach that failed in the U.S. from 1929 to 1941 and also failed in Japan over the past two decades, a subject we addressed in our April letter. In other words, fiscal policy is executing a program that is 180 degrees opposite from what it should be to stimulate the economy. How is it possible to get an inflationary cocktail out of deflationary ingredients?"

When is our government going to actually pay attention to economists who obviously have nothing to do with getting a paycheck from the government (they could even listen to what their paid economists said before they started getting the checks)?

Destructive Deficit Spending

You know that when analysts and economists who have always tried to stay away from expressing their political viewpoints start commenting about how change needs to take place or the long-term economy will not be good.

Here is the commentary of one of my favorite CFAs regarding the deficits:

"In our analysis of the current market environment, we believe that the massive budget deficit has place the Fed in a "no win" situation, in which every path it takes leads to higher interest rates and associated with economic problems. Importantly we have only explored the consequences of the Fed simply stopping the printing presses; the Fed will encounter even more unpleasant choices when the time comes to reverse course, sell assets and drain the excess liquidity from the U.S. financial system. If we have not made progress on putting our fiscal house in order before than point, then the upward pressure on interest rates could become overwhelming.

"This does not mean that the U.S. is doomed to experience persistently high interest rate environment of the 1970s and early 1980s. The ultimate long-term solution to these problems, in our view, is for the 2010 mid-term elections to revolve around an intelligent, credible debate about the future course of government spending, taxation and debt levels. The American people could provide the next Congress with a clear mandate to restructure government priorities so as to be less dependent upon deficit financing. A credible deficit reduction plan would take tremendous pressure off the Fed and give it much more flexibility in crafting a monetary policy that boosts current economic growth while keeping long-term inflationary expecations low.

"Cynics who do not believe that Cogressional elections can affect such dramatic changes should remember the 1994 election, when Congress was granted a clear mandate to shift budget priorities and reduce the deficit. The fiscal changes negotiated between Congress and President Clinton after that election ultimately resulted in budget surpluses within a few years. Unfortunately for bond market bulls, this mandate for change was in part spurred by the painfully high mortgage rates experienced by American voter during 1994. The bond market vigilantes may have to return before budgetary change comes to Washington." - Rod Smyth of Riverfront Investment Group.

Yet another reason why I feel we should all push hard to get new people into Congress. No more of the current entrenched representatives.

Follow-up to Wealth Distribution

I read an article today by Martin Feldstein, brilliant Harvard Economist, who wrote regarding the Governments plans to remove the tax deductions for charitable donations given by the wealthy. I think the government is thinking that they are just closing up a tax loophole for the wealthy, but in fact they are going to hurt charitable giving. He explains why it is yet another not very thought out government idea.

I can't help but point out that I wrote my post before Mr. Feldstein did, but he most certainly wrote his more intelligently and with greater data to back up the argument.

Click here for the article.

Wealth Distribution

I know that many out there are thinking, why shouldn't the wealthy be forced to pay higher taxes so that the government can give the poor money?

The reason why that doesn't work is because for every dollar pulled in by the government through taxes, very, very little goes to middle to lower class families (When is the government going to realize that it just isn't at all efficient? And when are we going to stop putting up with that?). However, when the wealthy are given the chance and encouragement to share their wealth then for every dollar spent a dollar goes to the middle and lower class families. The interesting thing is that the wealthy like giving money and are willing to give on their own terms, but they will go to great lengths and hire attorneys and accountants to keep as much money as possible from the government.

Here is a great story that would be good for everyone to read. The company it talks about is now opening up in the U.S. to give loans and they already have people in other countries who are excited to now make these loans to people in the U.S. (How cool is that?). Also, just in case the article isn't clear enough, the company is struggling finding people to loan to because it is getting too much money to loan:

SAN FRANCISCO (Fortune) -- When the economic downturn took hold last autumn, the management team at non-profit Kiva.org made a calculated bet to curb investment, anticipating that donors would slow the volume of small loans they make to entrepreneurs in the developing world. That slowdown never came. Now, the non-profit site is racing to keep up with user demand even while planning to bring its unique form of charity to the U.S.

Nearly 500,000 users have lent almost $65 million, interest-free, to developing-world entrepreneurs through Kiva.org. The nearly four-year-old site received a major boost during its early days from a wave of media publicity (including FORTUNE's The only non profit that matters) and the very public endorsement by former President Bill Clinton.

Media attention has waned in the last year or so, but growth has only accelerated due both to friend referrals and loyal users who repeatedly re-loan money rather than withdrawing it. The site distributed $3.5 million last month. "The good news is that we're doing more loans than ever," says Premal Shah, president of the San Francisco-based organization. "The flip side is that we under-estimated demand. [Our growth] rate exceeds the rate at which we can scale."

Kiva takes no cut of the loans allocated for entrepreneurs. Instead, it solicits an optional 10% fee of every loan to help pay salaries and keep the lights on. The organization uses microfinance institution partners to vet entrepreneurs before allowing them to solicit funding. By asking a series of questions to assess roots in the community and the legitimacy of a business, Kiva is able to establish a risk profile for each entrepreneur. Before offering money to, say, the proprietor of a Dominican fruit stand, any lender can read the entrepreneur¹s profile, history of defaults, and a bit about the business.

Default rates are low --­ 2% total ­-- and users can lend a minimum of $25 to any single person. Spreading loans across a series of entrepreneurs further lessens a lender's exposure to risk, and gives more people an opportunity to put money into the system. Lately, however, lenders are putting up more money than Kiva can distribute. Several times in the last month, the site has displayed a message saying there were no entrepreneurs to lend money to.

"This is pretty much a fault of management," says Shah. "We assumed things were really going to fall off. We didn¹t sign up enough microfinance institutions. That turned out to not be the right assumption. There are plenty of poor people out there."

Great Economist's View of Current Issues

1992 Nobel winner Gary Becker recently sat down for an interview with the Wall Street Journal. As one of the few economists who uses the words "I don't know" when in fact he doesn't, and who also doesn't seem to be overly terrified of saying "I was wrong", I think he has some very refreshing views. He also happens to be one of the smartest economists out there.

Please click here to see the full interview.

Here is my favorite part of it:

Mr. Becker is underwhelmed by the stimulus package: "Much of it doesn't have any short-term stimulus. If you raise research and development, I don't see how it's going to short-run stimulate the economy. You don't have excess unemployed labor in the scientific community, in the research community, or in the wind power creation community, or in the health sector. So I don't see that this will stimulate the economy, but it will raise the debt and lead to inefficient spending and a lot of problems."

There is also the more fundamental question of whether one dollar of government spending can produce one and a half dollars of economic output, as the administration claims. Mr. Becker is more than skeptical. "Keynesianism was out of fashion for so long that we stopped investigating variables the Keynesians would look at such as the multiplier, and there is almost no evidence on what the multiplier would be." He thinks that the paper by Christina Romer, chairman of the Council of Economic Advisors, "saying that the multiplier is about one and a half [is] based on very weak, even nonexistent evidence." His guess? "I think it is a lot less than one. It gets higher in recessions and depressions so it's above zero now but significantly below one. I don't have a number, I haven't estimated it, but I think it would be well below one, let me put it that way."

As the interview winds down, I'm thinking more about how people can make pretty crazy decisions with the right incentives from government. Does this explain what seems to be a decreasing amount of personal responsibility in our culture? "When you get a larger government, when you have the government taking over Social Security, government taking over health care and with further proposals now for the government to take over more activities, more entitlements, the rational response is to have less responsibility. You don't have to worry about things and plan on your own as much."

That suggests that there is a risk to the U.S. system with more people relying on entitlements. "Well, they become an interest group," Mr. Becker says. "The more you have dependence on the government, the stronger the interest group of people who want to maintain it. That's one reason why it is so hard to get any major reform in reducing government spending in Scandinavia and it is increasingly so in the United States. The government is spending -- at the federal, state and local level -- a third of GDP, and that share will go up now. The higher it is the more people who are directly or indirectly dependent on the government. I am worried about that. The basic theory of interest-group politics says that they will have more influence and their influence will be to try to maintain this, and it will be hard to go back."