Yesterday Charles Wheelan of the University of Chicago illustrated that even highly regarded economists may be misinformed when it comes to The Great Depression and our current financial crisis.

"Should we be fixing our huge budget deficits right now, so that we're not swamped by the mounting debt (e.g. Greece)?  Or is that exactly the wrong thing to do when the global economy is operating so far beneath its capacity -- a Herbert Hoover approach.  Hoover sought to balance the budget during the Great Depression, which by most conventional accounts made a desperately bad situation even worse."

The excerpted introduction for "Learn to Love Our Massive Deficit" is mostly fiction. 

Keynesian Full Capacity Bears No Resemblance to the Credit Bubble's Peak

Keynesian Stimulus, as articulated by its inventor, is beneficial when the economy is operating below productive capacity due to normal business cycle disruptions.  It is far from clear whether our economy is operating below Keynes' definition of full capacity.  Obviously high unemployment represents an underutilization of resources, but much of that human capital was misallocated during the decade-long housing distortion.

Throughout the Housing Bubble the U.S. economy operated above sustainable capacity, fueled by expanding debt, rising asset prices, housing equity-driven consumption, record low savings, and rapidly growing government expenditures.  Current production is below this historically demonstrated capacity.

Is the Economy Above or Below a Sustainable Level?

Keynes was not in favor of Government manipulations designed to elevate economic productivity above sustainable full capacity.  He would not support the federal obsession with homeownership or initiatives which elevated or seek to preserve housing prices above normal, market-determined levels.

Keynes might define the full homeownership rate as being approximately 64%, because this level was supported stably by the undistorted economy for 30 years predating the Housing Bubble.  Today homeownership is 67.1% versus the previous record high of 65.8%.

Maynard would likely argue that housing should be priced at valuations approximating pre-bubble levels adjusted for inflation.  That would entail at another 20%+ decline in house prices.

Keynes would be appalled both by current levels of home equity, made possible by Government subsidization of highly leveraged loans, and an evisceration of the national savings rate through 70 years of concerted efforts to promote the consumption of debt.

The reality is that evaporating housing equity, collapsing home prices, shrinking tax receipts, and restrained access to credit have not reduced the nation's production below capacity.  These events have washed away highly-leveraged economic activity that was in excess of full capacity.

A Portrait of "Excess Economic Capacity"

Las Vegas is not operating below capacity just because vacancy rates are high.  Casinos built $10 billion in new hotels/condos to accommodate real estate brokers, mortgage brokers, housing speculators and ancillary beneficiaries who were all supposed to be rich by 2010.  No amount of stimulus is going to resuscitate the subprime money-making machine.

Is Harley-Davidson operating below capacity because baby boomers may no longer use HELOC loans to monetize paper home equity gains and buy toys with their make-believe wealth?

Condos are empty because there are too many of them and they are overpriced.  Stimulus from the Government in the form of foreclosure moratoriums, default mitigation, subsidized mortgage rates and "Cash-for-Condos" tax credits do not change this reality.

Entire businesses were born, that should not otherwise have existed, and flourished in an environment defined by debt-financed, economic excess.  For a decade the economy geared itself to service credit, housing and consumer bubbles that no longer exist.  No amount of Government stimulus will reignite this unsustainable economic activity.

Hoover Was a Buffoon, but Fiscal Prudence Wasn't the Problem

Hoover directly contributed to The Great Depression by implementing disastrously repressive economic policies including the Smoot-Hawley and Davis-Bacon Acts.  But his efforts to balance the budget were largely irrelevant.

In 1929 Federal Spending accounted for 3.7% of GDP.  To argue that balanced budgets associated with less than 4% of the economy made the Depression materially worse is absurd.  In fact, Federal Spending actually increased each year that Hoover was President in gross terms and as a percentage of GDP.




Furthermore, in 1931 Hoover did expand government spending to no productive end.  He also raised taxes which was damaging to the economy.  FDR continued this tax and spend strategy, and the depression dragged on until WWII.  Barack Obama has also emulated "tax and spend" but is doing so on a different order of magnitude.  In addition to record deficit spending he intends to again raise taxes in 2010 by allowing previous reductions to lapse and implementing health care and carbon emission taxes.

Replacing Dom with Ripple

Wheelan later contends that:

"Cutting government spending, which is a substitute for private consumption and investment right now, would make the situation worse." 

See yesterday's post: Pork Barrel Projects Stifle Innovation, Perpetuate Poverty and Create Dependency

The Wrong Recommendation at a Bad Time

Wheelan's personal recommendation for solving the Depression:

"Let's send a signal now that we're resolved to tackling our fiscal challenges.  And have it kick in later.  It's the best of Franklin Roosevelt (fiscal stimulus) and Hoover (fiscal rectitude), all wrapped in one."

If we can only convince consumers, including the unemployed, to subscribe to Mr. Wheelan's strategy maybe we can reignite the Spending Bubble.  If the poor and jobless just go shopping, blow up their credit cards, and waste some money our problems will be solved as long as they promise to behave in a few years and pay it all off.

The author ignores that fiscal stimulus in response to a deflating asset/credit bubble is not beneficial.  In our current circumstance, wasting money and accumulating debilitating debt accomplish nothing but to extend the downturn by slowing the economy's much needed restructuring.  Additionally, the certainty of high taxes in the future has a negative impact on economic activity and would impede a recovery. 

Dismal Reality

A better plan would be to reestablish an environment in which profit seeking businesses and entrepreneurs have sufficient confidence in their ability to earn risk-adjusted return on capital that they invest in productive, job creating undertakings.  Reducing corporate taxes from the second highest rate among industrialized countries would be a good start.

Better yet, disembowel Federal Government spending which burdens the private sector, taxpayers, consumers, investors, and employers by confiscating productively disposed capital, misallocating it towards politically expedient projects, and borrowing money which must be serviced and repaid by the private sector.

If our policy makers do not understand economic history, or fail to grasp the dynamic aspects of this unique downturn, they are doomed to repeat the blunders which needlessly perpetuated The Great Depression and are imperiling our solvency.