Economics 101

Throughout this year’s campaign season, the Republican Party promised to reduce the nation’s rapidly growing debt by slashing federal spending for everything but the military. But permanent fiscal austerity of the kind embodied by the Ryan budget and the Romney/Ryan campaign platform would exacerbate the biggest economic problems facing the country—inequality and unemployment—while also depriving the federal government of the tools it needs to correct them. By denying the government’s responsibility for the overall health of the economy, the Republicans’ fiscal and monetary policies would expose Americans, rich and poor, to the dramatic swings of the business cycle. The U.S. economy used to be much more volatile. Before the New Deal and World War II, there were bigger crashes and longer recessions. The regulation of business (especially banks and financial markets), the creation of a safety net, and countercyclical fiscal and monetary policy have all dramatically improved economic outcomes, and have led to a long period of economic growth and shared prosperity. In the postwar period, a rising tide really did seem to lift all boats.

Starting with the Reagan Revolution of the 1980s, however, the Republican Party—too often with the support of some Democrats—began to dismantle the policies that had promoted greater equality and kept recessions short and shallow. As worker protections were removed, real wages stagnated. With the deregulation of banks and financial markets, the incomes of the top one percent began to skyrocket and financial markets became much more unstable. Unregulated financial innovations—which were said to reduce risk—turned Wall Street into a casino. Investment banks, whose primary function had been to direct capital to real businesses that could make productive use of it, grew fat on reckless speculation. Washington, meanwhile, looked the other way, persuaded that the only restraint the financial sector needed was provided by the market itself.

Just four years after the crisis on Wall Street, the GOP has succeeded in rehabilitating this dangerous illusion. The central argument of the Romney/Ryan campaign has been that the government is getting in the way of economic progress. Government spending, they say, is crowding out private investment. High taxes and regulation are discouraging entrepreneurs. On this view, the real cause of unemployment is unemployment compensation, which takes away the incentive to find work. Likewise, welfare programs don’t relieve poverty; they make it worse. And health-care costs are high mainly because of tax benefits for employer-provided health insurance. Whatever the problem, government intervention only compounds it, and the market is always the solution.

Paul Ryan has adopted an “originalist” interpretation of the U.S. Constitution as his guide for understanding the proper role of government in the economy. But our twenty-first-century economy has little in common with the economy our founding fathers knew. Back then, there wasn’t much the government could do to promote economic growth, besides enforcing property rights, providing law and order, ensuring a sufficient supply of (slave) labor for plantations, and taking land and natural resources from the Native Americans. Since then, the government has gradually taken a more active role in promoting the country’s economic development—from helping to develop Wall Street to subsidizing the railroads and the oil industry. With the New Deal, the federal government came to the assistance of workers, just as it had previously come to the assistance of rich industrialists. This eventually led to the middle-class majority that emerged after World War II.

Nearly every major technological development in the past seventy years can be traced back to government spending. It was research paid for by the government that led to computers and the internet, to the Green Revolution in agriculture, and to many other advances in science and technology that have greatly improved our standard of living. Of course, the government did not accomplish these things alone—businesses and universities were necessary partners—but few of the most important scientific discoveries and technological advances of the past century would have occurred without the government’s involvement.

One can obviously find examples of government interventions that were harmful to an economy, but no modern country has achieved economic success without a strong and active government leading the way. On page 42 of his most recent budget plan (.PDF), Ryan states that “no economic system in the history of mankind has done more to lift up the poor than America’s commitment to free enterprise.” In fact, most other developed countries have done a better job of lifting their citizens out of poverty. There is more upward mobility and less poverty in countries that make sure all their citizens have access to health care and higher education. So Ryan’s claims about the success of laissez-faire economic policy find no more support in other countries than they do in other periods of America’s own history. Whatever the intuitive appeal of his pet theory, it runs counter to the available evidence.

The central argument in Ryan’s budget is that we need to cut government “spending so the economy can grow.” Now, it is possible for government spending to crowd out private spending, but only when the economy is at or near full employment. In such cases—for example, during World War II—an increase in government spending will either come at the expense of the private sector or cause inflation. (During the war there were price controls and rationing to prevent inflation.) Today, however, when over 12 million Americans are still unemployed, there is no reason to think more government spending would inhibit private investment or lead to runaway inflation. And with so many people looking for work, it makes no sense to cut public-sector jobs hoping that will eventually lead to more private-sector jobs—as if only jobs that help an employer make a profit are acceptable. Jobs are jobs, public or private. A public-school teacher is no less employed—and no less well employed—than a banker or a sales clerk.

Ryan also claims that the poverty rate is increasing because of higher expenditures on programs like food stamps and that unemployment is high because so many people are receiving extended unemployment benefits. As with his argument that economic growth is low because of federal spending, Ryan is once again confusing effects with their causes. The high unemployment rate is due to insufficient aggregate demand, not to unemployment benefits spoiling potential workers. Making unemployed people more desperate for work by cutting their benefits will not create new job openings, and cutting benefits will only hurt the economy by further reducing demand. After all, the unemployed spend whatever money they get from the government, and spending is precisely what the economy needs more of right now. In fact, unemployment insurance is one of the most efficient forms of economic stimulus: according to the Congressional Budget Office, it has a 1.45 multiplier effect. By this measure, unemployment benefits are 3.65 times more effective at stimulating the economy than tax cuts for the wealthy and 7.25 times more effective than corporate-tax breaks. Just as important, most evidence shows that benefits to the poor are much too low to create a disincentive to work, and that tax rates on the rich are nowhere near high enough to discourage them from working more.

Ryan’s obsession, the deficit, is yet another area where he has confused cause and effect. The high deficits the government is now running are the effect of a weak economy and a lack of jobs, which together cause revenue to decline and expenditures to rise. The best way to reduce the deficit is to create jobs. Cutting spending now would cause the economy to shrink again, raising joblessness and thus increasing the deficit. The experience of European countries that have adopted austerity policies demonstrates what would happen here if the Ryan approach were followed. Of these countries, only Germany has seen any success—and this is because of growth in its export market. But not every country can improve its trade balance, for the simple reason that for every country running a trade surplus, there has to be a country with an equal trade deficit. Ironically, Greece’s economic problems have helped Germany’s exports by reducing the value of the euro. But as the economies of Brazil, Russia, India, and China slow down, Germany will run out of places to export its manufactured products. At that point it too will face rising unemployment rates, just like the rest of Europe.

While Ryan’s proposal to cut federal aid to the poor will cause an immediate increase in unemployment, his plan to transform the Supplemental Nutrition Assistance Program (SNAP) and Medicaid into block grants could end up being even more damaging. Ryan is worried that these programs are growing too fast; turning them into block-grant programs could limit this growth, but only by reducing eligibility or benefits. Such a move would also limit the government’s ability to stabilize a faltering economy. Entitlements are what economists call “automatic stabilizers”—changes in expenditure that kick in automatically to counter the boom and bust of the business cycle. While economists argue about the effectiveness of discretionary fiscal policy (when Congress votes to raise or reduce spending or taxes in order to slow the economy down or speed it up), few debate the effectiveness of automatic stabilizers. The problem with discretionary fiscal policy—for example, the stimulus package of 2009—is that it takes too long to work. It can take months to realize that you’re in a recession, months more to reach an agreement on what to do about it, and then another few months for the new spending to kick in. This is why there was so much emphasis in the 2009 stimulus package on “shovel-ready programs”: when the economy is in a steep decline, you want the spending increase to take effect as soon as possible. With automatic stabilizers, there are no lags. As soon as the unemployment rate starts to rise, spending on unemployment benefits increases without delay. Likwise, when the economy starts to grow again and the unemployment rate falls, spending on benefits falls off too. Most important, when the economy goes into recession the federal deficit goes up, providing stimulus to the economy and balancing the shaky portfolios of banks and corporations, as they move out of risky assets and into safe government bonds. And when the economy nears full employment, revenues increase, spending falls, and the supply of government bonds declines along with the demand for them.

This “portfolio effect” played a major role in stabilizing the financial system during the 2008 financial meltdown. Turning entitlement programs into block grants to the states would keep such programs from growing in response to greater need during a recession, or it would require special congressional action to increase the block grants. But even if Congress was willing to do this (which is far from certain these days), the economy would have to wait for months, if not years, for the adjustment to take effect. Thus, turning these federal entitlement programs into block grants would not only hurt the poor; it would make the entire economy significantly more unstable. Under the current system, the government is prepared for predictable downturns. Under the Romney/Ryan plan, the government would at best be playing catch-up.

The Republicans also claim that the tax system’s complexity is a major drag on the economy, and that simplifying it will lead to greater growth. History tells a different story. In the four years before Reagan simplified taxes (1983 to 1986), the economy grew at an average rate of 4.8 percent; in the four years following the simplification (1987 to 1990), the average growth rate fell by a third to 3.2 percent. While no one supports an unnecessarily complex tax code, there is no evidence that the current number of tax brackets is inhibiting economic growth. The charts in Ryan’s own budget show that high marginal tax rates on the wealthy are not a barrier to economic growth or job creation: the economy created more jobs in the 1970s, when top marginal rates were very high (between 70 and 90 percent) than it did in the 1980s, ’90s or 2000s, when rates were much lower. Over 20 million civilian jobs were added in the 1970s, compared with 18 million during the ’80s, 14 million during the ’90s, and just under 3 million from 2000 to 2009. Most economists who have studied the disincentive effects of marginal tax rates think they would have to be higher than 60 percent before they would become a disincentive to economic activity. (The top rate is now just 35 percent.) The fact is that when marginal rates go up, most people work more to keep their after-tax income from falling.

The Republicans’ use of the debt as an excuse for gutting entitlement programs they never liked in the first place is part of a long tradition of plutocrats taking advantage of the disastrous effects of their own policies to push through even more disastrous policies. As G. K. Chesterton noted long ago:

The key fact in the new development of plutocracy is that it will use its own blunder as an excuse for further crimes. Everywhere the very completeness of the impoverishment will be made a reason for the enslavement; though the men who impoverished were the same who enslaved. It is as if a highwayman not only took away a gentleman’s horse and all his money, but then handed him over to the police for tramping without visible means of subsistence.

Like the Great Depression, the Great Recession had many causes, but the most important cause of both was income inequality. When too much money goes to the very top, not enough money circulates in the real economy, where it would create jobs and raise people’s standard of living. Compensating for this problem requires higher levels of private investment and more debt, public or private. Not coincidentally, these were the things that fueled the last economic boom, which came to an abrupt halt in 2007. When reality finally caught up with the real estate market, only government borrowing was left to keep the economy from imploding. The only real path to lasting prosperity is more economic equality—making sure the average American has enough money to pay for the things the economy produces. Only by addressing inequality will we be able to lift up the poor, create jobs, and raise standards of living without the help of another bubble.