Beware the Incredible Shrinking Deficit!


As reported by the Congressional Budget Office, the federal budget deficit is shrinking – and fast. From a high of $1.4 trillion (10% of GDP) in fiscal 2009, it has shrunk to an expected $642 billion (4% of GDP) for fiscal 2013. In other words, the deficit has fallen by about 60% in only four years. Moreover, the CBO sees the deficit declining to about 2% of GDP by 2015. Good news, right? Well, let’s look a bit more deeply.

The brightened fiscal picture is the result of a recovering economy. In February the CBO estimated the deficit would be about $200 billion higher than it now projects. Better than expected revenues caused the CBO to revise its forecast in May. About $100 billion is accounted for by increased individual and corporate tax receipts. The other half comes from payments to the Treasury by Fannie Mae and Freddie Mac, the result of an improving housing market. A continued slow to moderate expansion of the US economy, together with the tax increases and spending cuts enacted earlier this year, will, the CBO says, get us to a deficit that’s only 2% of GDP by 2015.

Obviously, an annual budget deficit equal to 2% of GDP is preferable to one that equals 10% of GDP. But we will still be borrowing hundreds of billions of dollars every year, even during a time that is expected to be relatively peaceful and prosperous. The CBO has trimmed some $600 billion dollars from its ten-year (2014–2023) deficit projection. Under this rosy scenario we will still be borrowing a total of over 6 trillion dollars to keep the federal government running. That’s on top of the 16 trillion or so of government debt (federal, state, and local) that we have already accumulated. All of it is money that our children and grandchildren will have to pay back.

Already voices can be heard crying out that fiscal restraint has gone too far; that there is in fact no deficit or debt crisis; that changes in entitlements are not required; that more public spending, not less, is needed.

Worse, the CBO sees the deficit growing in the latter part of the next decade, reaching 3.5% of GDP by 2023. Rising entitlements and higher interest rates (which make it more expensive for the government to borrow) will cause deficits to expand in the future. Indeed, the current low cost of borrowing is responsible for both the economic recovery (tepid though it is) and the government’s ability to continue living beyond its means. Even a modest increase in rates would likely snuff out the recovery and cause deficits to soar once again.

We are, so to speak, temporarily becalmed, with a fiscal tempest on the horizon. Yet already voices can be heard crying out that fiscal restraint has gone too far; that there is in fact no deficit or debt crisis; that changes in entitlements are not required; that more public spending, not less, is needed if America is to sail into a brighter future. These voices are coming from the port side of the ship, with the irrepressible scribbler Paul Krugman shouting loudest.

The Krugmanite argument is not merely a call for steady as she goes, but an appeal to stoke the fires and sail full speed ahead into that tempest on the horizon. Steady as she goes is probably a justifiable short-term policy, given the iffy nature of the recovery. But stoking the deficit fires is a course pointed at eventual shipwreck. The Krugmanites see government, and specifically government spending, as the solution to our economic and fiscal problems. More spending, not less, is their mantra. But in reality we need to free up the American economy to promote growth and innovation. And that can only be done by shrinking government.

I’m no anarchist. I believe there are certain functions that government must perform in a civilized society. Moreover, I’m not opposed to any and all government spending to stimulate economic activity. For example, I would favor major spending on infrastructure, a crucial and long-neglected component of our economy. But such spending should be offset by major reductions and restructuring elsewhere. Entire government departments (Energy, Commerce, and Education, for example), should be radically modified or abolished. Entitlements must be means-tested. The tax code requires thoroughgoing reform, with rates lowered for both individuals and corporations, deductions capped, and loopholes and accounting gimmicks abolished completely, or almost so.

Finally, while we should not simply retire within our own borders, we must shrink the warfare state. We currently have bases in over 100 countries, and account for three-quarters of the NATO alliance’s military spending. A minimum 25–30% reduction in the US Defense budget, implemented over a five to seven year period, with concomitant changes in outlook and mission, would be most desirable. We have managed to ignore the crisis in the Congo, where some 7 million people have died in a civil war that began in 1997. If we can ignore those millions, why should we be exercised about the Syrians or the Afghans? No, the time has come (indeed, is well past) to admit that we cannot right every wrong in the world, that interventionism is too expensive and only rarely successful.

To continue as we have will almost certainly lead to fiscal and economic ruin in the 2020s or 2030s. The short-term shrinking of the deficit is an unexpected gift that we must not squander. We are being given a brief span — a few years only — to correct the errors of the past half-century. If we listen to the Krugmanites we may not become Greece writ large, but we will doom our descendants to less prosperity and a burden of debt that they had no part in creating, and that may, eventually, crush them.

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Cash Poor


In spite of Liberty contributing editor Mark Skousen’s observation that “income isn’t distributed, it’s earned,” much handwringing has followed recent reports that income distribution in the US is becoming increasingly unequal.

To a libertarian, how much one earns or owns — so long as it’s acquired honestly and honorably — is nobody’s business. But at the other extreme are the still-influential Rawlsian redistributionists. They believe that since each person’s station in life is due to little more than a roll of the existential dice, income distribution ought to cluster tightly. If it doesn’t, it’s an indication of an unjust society, and something must be done about it. That’s the ideology.

Nevertheless, there’s a pea under that ideological mattress: the fear of revolution if the rich get richer, the poor get poorer, and the middle class disappears. Though probably a reductio ad absurdum, it is nonetheless a theoretical possibility under a laissez-faire economic system.Friederich Hayek understood this, which is why — to the consternation of many libertarians — he advocated a minimal welfare state as a worst-case scenario safety net.

Whatever the chances might be that a just economic system — laissez-faire capitalism — could lead to the penury of a majority, income distribution is a concern to the inner Hobbesian in all of us. So when income inequality rears its ugly head, it bears critical investigation.

In 1912 Italian statistician and sociologist Corrado Gini devised the eponymous Gini Coefficient, a statistical formula based on the Lorenz curve, to measure variability and mutability among data in any discipline. The index is now widely accepted as a measure of income inequality in economics. Values range from 0, total equality, to 1, maximal inequality.

As of 2009, Sweden scored .23, the lowest Gini Coefficient, indicating the highest income equality; while Namibia rated a .74, indicating a large income inequality. Most first-world nations have Gini coefficients in the high point-twenties to the mid-thirties, with a .31 for the EU average. Back in 1980, the US rated a .40 Gini; today we rate around .47, a figure comparable to Russia or Turkey and a trend that is alarming to many.

The fear of revolution, though probably a reductio ad absurdum, is nonetheless a theoretical possibility under a laissez-faire economic system.

Paul Krugman, who could be considered the Linus Pauling of economics — for his previous Nobel-recognized genius, followed by descent into crankhood for his advocacy of snake-oil remedies: vitamin C in the latter case, dirigisme in the former — refers to the period after 1979 as the “Great Divergence,” because of the rapid increase in inequality that had occurred. According to a 2011 Congressional Budget Office report, “Real income (adjusted for inflation) in the US grew by 62% for all households between 1979 and 2007. However, after-tax income of households in the top 1% of earners grew by 275%, while income growth for the bottom fifth of earners was 18%.”

If, instead of income distribution, we look at wealth, the disparity is even greater. While the bottom 60% of the US population lost about 6% of its wealth, the net worth of the top 5% increased by 40% between 1983 and 2009.

Why the increasing inequality in a political and economic system deemed among the freest by classical economists?

* * *

Before addressing that question we must deal with a concept clamoring for immediate attention: fuzzy numbers.

Nearly all the figures quoted in this article come from Wikipedia compilations replete with references, from various other internet sites, The Economist,Scientific American, Money,Chris Martenson’s The Crash Course, and PuruSaxena’s Money Matters. Although these sources are ostensibly reliable, please take them with a pinch of salt. Some figures purporting to measure exactly the same thing vary wildly.

For instance, that 275% of after-tax household income growth for the top 1% earners, derived from 2011 Congressional Budget Office figures of 1979 to 2007, becomes a 176% increase — from 1979 to 2005, nearly the same time range — in a 2006 New York Times article.

Exactly what is being measured, how it is defined, over what period of time it is measured (a variable often manipulated for calculating equity returns down to the day), and what statistical tools are employed can have considerable impact on the figures. Just the difference between ‘”household” and “individual” income measurements can affect income inequality figures substantially.

Dodgy numbers can also lead to convertibility problems and out-of-this-world results — literally out of this world. Composite numbers (such as indices, among others), which are built up from subsidiary numbers, can become statistical black holes, swallowing endless data but illuminating little. As The Economist reports, “In theory, countries’ current-account balances should all sum to zero because one country’s export is another’s import. However, if you add up all countries’ current-account transactions, the world exported $331 billion more than it imported in 2010, according to the IMF. Are aliens buying Louis Vuitton handbags?”

And of course, ideology plays a big part. As the old saw goes, “He who frames the question determines the shape of the answer.”

On top of this are myriad unexamined assumptions. Statistician Joseph Locascio has identified what he calls “publication bias,” which means that academic journals “often give greater weight toward publishing articles that report statistically significant findings over those that don’t.” With this kind of review process, if out of 20 studies one shows a slight significance (perhaps because of chance), while the other 19 show none, that one will be published and the others ignored.

Not all people are driven to make the most money they can, all the time. Many earn and live below their possibilities, and spend the rest of their time pursuing their passions.

Hoover Institute economist Thomas Sowell suggests that many discussions of income equality are based on fallacious reasoning. For example, “an absolute majority of the people who were in the bottom 20% [of income] in 1975 have also been in the top 20% at some time since then. Most Americans don’t stay put in any income bracket. At different times, they are both ‘rich’ and ‘poor’ — as these terms are recklessly thrown around in the media.”

Finally, somewhere between the last two observations, lies individual choice. Not all people are driven to make the most money they can, all the time. Many earn and live below their possibilities, earning what they consider a sufficient amount, and spending the rest of their time pursuing their passions: music, rock climbing, walking around the world preaching the gospel . . . whatever.

So, to that pinch of salt, add a squeeze of lime and, what the hell, a shot of tequila.

* * *

But back to the ostensible causes of inequality, which remain unknown to many, even to theNew York Times, as proclaimed in an article onJune 5, 2005. Let’s consider these causes.

1. The rich work more than the poor. As of 2005, 42% of all US households had two or more income earners. However, in the top quintile of households, nearly twice as many (76%), had dual-earners. Among the lower class, the most common source of income is not occupation but government welfare (according to the leftish Winner-Take-All Politics by Hacker and Pierson, 2010).

2. The rich are more educated than the poor. In the top quintile, 62% of householders are college graduates; while many at the bottom half of earners hold at most a high school diploma. Educational and occupational achievement and the possession of scarce skills correlate with higher income.

3. People of modest means keep giving their money to the rich. George Mason University economist Walter E. Williams recently recognized that “the millions of people who watch LeBron James play are the direct cause of LeBron’s earning $43 million and are thereby responsible for — in Paul Krugman’s terms — ‘undermining the foundations of our democracy.’” The same can be said of the millions of Walmart and Microsoft shoppers who keep enriching the Walton and Gates families.

4. Government policies. Among the usual partisan suspects — such as decreased expenditure on social services and labor’s diminishing political clout, suffering from declining union membership — are Republican tax policies, specifically the “low” progressivity of US tax rates. Reversing these factors through government diktat is a crude cure that doesn’t address the underlying ecology (Thomas Sowell’s term) of the marketplace. The enforcement of legislation such as higher redistributive taxes and the imposition of closed shops would require force, a road down which classical liberals would prefer not to travel. Might there be another cause of the increasing income inequality that hasn’t yet been identified? One whose correction does not require coercion?

I believe there is, and that culprit is inflation — in spite of the fact that nearly all of the above statistics are adjusted for inflation. And, as Milton Friedman recognized, since “inflation is always and everywhere a monetary phenomenon,” it is a direct result of government policy. Inflation is a word often misunderstood. It is the decreased purchasing power of currency, caused by the expansion of the money supply, and not to be confused with price increases caused by scarcity.

Krugman’s “Great Divergence” begins soon after America’s divorce from the gold standard and the subsequent collapse of the Bretton Woods currency exchange system in the early 1970s. After that, the Federal Reserve instituted a Keynesian monetary expansionist policy. In 1972, the price of a new house averaged $27,600; in 2010 (despite 2008’s deflation of the housing bubble), the average price was $272,900. A 1972 Coke cost a dime; today it’s a buck. By 1973, gold hit a high of $126 per ounce; in 2009 it topped $1,212. In 1972 the Dow Jones Industrial Average hit 1,000; by 2010 it had reached 11,000 — a ten-fold increase in only four decades. A $10 Hamilton from 1972 is today’s $100 Franklin. How does this stark change affect the disparity between rich and poor?

* * *

But first, more fuzzy numbers.

Without an objective anchor such as gold, the value of money is subject to fluctuation according to the active “monetarist” policy set by the central bank. That policy is based on many variables — prominently including the consumer price index (CPI), with a nod to gross domestic product (GDP), processed through complex formulae and topped with a generous dollop of intuition. The objective is a stable currency — a very difficult goal with such a capricious policy, and one whose results always lag policy implementation.

For a variety of reasons, the central bank considers deflation a greater evil than inflation. So, wishing to avoid deflation at any cost, the Federal Reserve sets an inflation goal of 1–2%. It often misses this goal. The October 2011 rate was 3.53%, according to the Bureau of Labor Statistics (BLS), as measured by the CPI.

How reliable is this number? Not very — as it is neither accurate nor even precise. Like an aging diva afflicted with weight gain, wrinkles, fatigue, loss of figure and overexposure, the CPI has been massaged, injected with Botox, subjected to fad crash diets, over-cosmetized, face-lifted, repackaged, and rebranded. Richard Nixon, for example, bequeathed us the so-called “core inflation” measure, which strips out food and fuel — a bit like weighing yourself without your belly. In 1996 Bill Clinton implemented three oddities in the measure of inflation: substitution, weighting, and hedonics.

Krugman’s “Great Divergence” begins soon after America’s divorce from the gold standard and the Federal Reserve’s institution of a Keynesian monetary expansionist policy.

With substitution, it is now assumed (for example) that if the price of salmon goes up too much, people will switch to something cheaper, such as hot dogs. So as the price of an individual item within a representative basket of thirty goods rises, that item is removed and substituted with something cheaper, chosen by a trained bureaucrat. According to the BLS, food costs rose 4.1% from 2007 to 2008. But according to the Farm Bureau, which tracks exactly the same shopping basket of 30 goods from one year to the next without substitution, food prices rose 11.3% for the same year.

Weighting is an even sharper tool for cutting the measure of inflation. Anything that rises too quickly in price is undercounted in the CPI, under the assumption that people will use less of those things. For example, although healthcare is about 17% of the economy, it is weighted as only 6% of the CPI basket.

But the most creative way to fiddle with inflation is hedonics. This adjustment is supposed to reflect quality improvements. Here’s how it works, based on a presentation by a commodity specialist at the BLS and explained by Chris Martensen:

In 2004, the commodity specialist at the BLS noted that a 27-inch television selling for $329.99 was selling for the same price in 2007, but was later equipped with a better screen. After taking this subjective improvement into account, he adjusted the price of the TV downwards by $135, concluding that the screen improvement was the same as if the price of the TV had fallen by 29%. The price reflected in the CPI was not the actual retail store cost of $329.99, which is what it would cost you to buy, but $195. Bingo! At the BLS, TVs cost less and inflation is heading down. But at the store, they’re still selling for $329.99.

Hedonics rests on the improbable assumption that new features are always beneficial and are synonymous with falling prices (never mind that most old rotary phones still work, while modern cell phones seldom seem to last three years). Hedonics is now used to adjust as much as 46% of the total CPI.

What would the inflation rate have been for, say 2008, before all the fuzzy statistical manipulation gussied it up? John Williams of, using early 1980’s formulas, computed the figure at 13%: the BLS reported a 5% inflation rate for the same year — a stunning 8% difference.

But that’s not all. During Alan Greenspan’s tenure at the Federal Reserve — particularly while the real estate bubble was growing gangbusters — some economists bemoaned that, without asset prices such as real estate and equities being included in the CPI, true inflation rates would be misleading, thereby skewing monetary policy.

While inflation has been massaged down, GDP has been steroided up, by similar sleight-of-hand manipulations — further inflating the money supply.

So, at this point, brace yourself with another shot — this time of hedonic Cuervo Añejo.

* * *

Inflation affects the poor and the rich in completely different ways, though both lose wealth. No one benefits — except for government and banks, which, having access to newly created money before it hits the streets and raises prices, can buy goods and services at the old, cheaper rate. By the time the surplus money has permeated the economy and reached the masses, prices have usually risen significantly.

Broadly speaking, the poor — for the purposes of this essay, people in the lower 40% of income distribution — have fewer assets, lack financial sophistication, and tend to hold, at most, a high school diploma. They deal in cash and its derivatives and equivalents — CD’s, bonds, and interest-bearing accounts. In an inflationary regime, these lose value. In an underreported inflationary regime, the effect is not only obviously greater but, because wages only grudgingly and loosely track the “official” inflation rate of the CPI (if at all), “much of the developed world’s workforce has been squeezed on two sides, by stagnant wages and rising costs,” as The Economist opined in its November 19, 2011 issue.

There is one factor leading to wealth disparity that Rawlsians and Marxists most seem to ignore, but classical economists believe is fundamental — productive innovation.

As if this situation were not bad enough, many of the poor were lured into buying homes by dodgy loans and government social engineering policies (such as the Community Redevelopment Act, Fannie Mae and Freddie Mac practices, and lower than historic interest rates) in the middle of a bubble. When the bubble burst, these folks lost whatever equity they had managed to cobble together, as well as ending up with ruined credit. And they couldn’t even rely on their savings (what little they might have saved between stagnant wages and rising costs), as these too had dwindled along with the higher interest rates that made savings more attractive.

So, without a doubt, the poor are getting poorer. What about the rich?

While cash loses its value, real goods such as commodities, equities, and real estate track the changing value of money and, long term — with the dips and highs of the business cycle evened out — generally keep pace. The rich, with more education, more financial sophistication, and more discretionary income, invest. The poor, on the other hand, save (if they can afford to). All other things being equal, inflation makes investments tread water, but savings lose. Without inflation, income inequality might not have become so pronounced over the last 40 years.

Though the above analysis might go a long way toward explaining the increasing income inequality in the United States, it still isn’t the full picture.

There will always be income inequality, if for no other reason than the fact that people’s work habits, education, and ambition vary tremendously. But the one factor leading to wealth disparity that Rawlsians and Marxists most seem to ignore, but classical economists believe is fundamental — productive innovation — also plays a big part.

A study done by University of Texas economists James K. Galbraith and Travis Hale found that

During the technology boom of the late 1990s, most of the gains enjoyed by the top 1% came from a small number of counties, rather than a national trend. Almost all of the richest 1%’s gains occurred in the economic hotbeds of Silicon Valley, and also New York City. If the top four counties in those regions are removed, there is almost no trend towards income inequality during the years studied (1994–2000). On this basis, the researchers ascribe the growth in income inequality in the late 1990s to the growth of information technology.

Earned income.


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Welcome the Space Aliens!


Last month, Nobel Laureate economist and New York Times columnist Paul Krugman seriously suggested that what we need to stimulate the economy is an outside threat. Referring to the jobs created during World War II, he wrote, "If we discovered that, you know, space aliens were planning to attack and we needed a massive buildup to counter the space alien threat and really inflation and budget deficits took secondary place to that, this slump would be over in 18 months. And then if we discovered, oops, we made a mistake, there aren't any aliens, we'd be better [off]."

Well Mr. Krugman, a space alien did attack. Her name was Irene, and she is still causing havoc in the northeastern states. Billions of dollars were spent preparing for her arrival, and billions more are still being spent cleaning up her mess. Billions more were lost in opportunity costs as people stayed home that weekend, reducing the incomes of restaurant owners, taxi drivers, and other establishments owned by hardworking business people.

As it turned out, Irene didn't attack where she was expected, and many of the billions spent on sandbagging shorelines, boarding up windows, and evacuating neighborhoods were wasted. But according to Krugman, that's a good thing. We enjoyed all that economic stimulus, without enduring any of the damage. Win-win, right?

How is the alien attack working out for you, Mr. Krugman? Have you seen a big turnaround in the economy? Will you be cheering again this winter, when municipal leaders have no money left in their budgets for snow removal and pothole repair? But you don't have to wait until winter to see the results of such faulty thinking. Ask the family who spent $1,000 on gas, hotels, plywood, and batteries when they evacuated for the weekend. Because of that expenditure, they won't be able to spend that $1,000 on school clothes, a new computer, a real vacation, or even debt reduction.

I doubt that Keynesian Krugman is backing down any time soon. In fact, if an alien attack can produce so much economic stimulation, just think what a pandemic disease could accomplish! According to some cheerful historians, the bubonic plague was the best thing that happened in the Middle Ages. When the plague killed off an estimated half of the workers in Europe, supply and demand forced wages up, creating an economic turnaround that funded the continued growth of the second half of the last millennium. Wow! We ought to build a monument to those heroic fleas.

In fact, forget Obama's mantra, "Pass the Jobs Bill." Let's just pass the germs.

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