Let's Hear It For Classical Economics

There are some poor economic debates being fought right now.  There is a lot of finger pointing, and a lot of chest thumping.  However, data and results generally are the best scoreboard.  America has been run by Keynesian economic theories since 1940.  In times of plenty, we shied away from Keynes.  In times of stress unfortunately embraced him.

Some economists pointed out the fallacy of federal stimulus before it was passed. The failure of stimulus shows that Keynes is dead. It’s time to embrace the Chicago School, that was given up for dead and severely chastised for causing the crisis.  Classical economics didn’t cause the crisis-and it’s back.

Economists like Paul Krugman are stating we didn’t pass a large enough stimulus. In theory, he is correct. If we would have spent double or triple the amount correctly-we would have stimulated the economy. The debt generated would have been eaten up by the growth in the overall economy with time. Of course, that never happens except on an academic’s black board. Data shows that this is a fallacious argument without merit.  John Cochrane wrote an excellent paper and I will try and distill it here.

Let’s understand what a stimulus is as defined by Krugman. I don’t take $1 from Peter and give it to Paul. I borrow a $1 from Peter, and give it to Paul. Then I assume that we all are $1.50 better off. Do you understand the difference?

What happens to actual behaviour? Peter knows the government borrowed from him and the way to get the money back is via taxes. “Tax the rich”. Peter adjusts his behaviour today to prepare for the coming tax increase-even though the tax is going to happen in the future.

Even worse, Peter doesn’t work as hard. He might even drop out of the workforce. Paul hires lobbyists to get more stimulus money directed to him. That’s why the multiplier effect of stimulus is zero-or probably negative. All effort goes into competing for government dollars instead of growing the economy.

But, Krugman and the boys say, “No one really notices future taxes.” That point is debatable.  Most Americans know and internalize taxes.   But let’s say that Peter was going to do something else with the money. Maybe he owns a business and was going to spend $1 on more production. Now he can’t because the government borrowed it and gave it to Paul. Paul decides to buy a car with the $1. Does anyone care?

They do because the spending is now focused on consumption. Society’s overall wealth is not increased because of the borrowing. But it could have been increased with business investment. No one is any wealthier. Paul has a new car. Some may argue that the workers at the factory are wealthier because they were paid to build the car, except what happens when we can’t borrow any more money from Peter?

Here is data to chew on: Since stimulus was passed, cash is piling up on corporate balance sheets. Businesses are not expanding. That shows businesses are not investing. Governments cannot invest, they can only spend; and they borrow money to spend which is even worse. Stimulus isn’t broadening a base or creating wealth. It only created competition for government dollars.

A couple of more points on stimulus as it relates to broader market theory.

The stimulus passed in February of 2009 didn’t go to shovel ready projects. Instead it propped up state and local governments that were broke. What didn’t go to governments was spent on projects without any regard for their return on investment. For example, green light bulb research might be a neat concept, but the short term return on investment is 0. You might even believe that green light bulb research will have positive economic effects in the future-but stimulus is designed to help us today so it’s still a stupid way to spend government dollars. Even if you think stimulus can work, it doesn’t because of politics. This phenomena occurs no matter which party is in charge.

Secondly, stimulus is an allocation of money by centralized agents. They decide and pick which projects will get money and which won’t. What makes anyone think that central planning works better than thousands of people interacting in a marketplace? Why does a government official from either party know more than a decentralized competitive marketplace? Answer, they don’t.

So what should we do?

We need to focus policy on increasing production, growth. There is one data driven, proven way of doing that. Lower marginal tax rates. Lower rates are agnostic about who gets the money and can’t be politicized. The market picks the winners and losers, not a bureaucrat or government official.

At the same time we lower marginal rates, we should eliminate deductions. Before you say that’s a Republican talking point, let’s look at data.

Two times in the last 50 years have we lowered marginal rates and eliminated deductions. JFK, a Democrat, did it in 1961. We had economic expansion. Ronald Reagan, a Republican, did it in 1982. We had economic expansion. In 1991, George Bush raised rates, we had a recession.

Bill Clinton, a Democrat, raised rates in 1993, and we had expansion. Why? There was this thing called the internet that increased our production significantly. It was a once in a generation change. We also revamped the welfare system in 1994, and people had an incentive to be productive.

Critics will say that is not the sole reason. Tax cuts can’t be done in a vacuum, and then be heralded as the salve for all economic wounds. I would agree with them. However, tax cuts/increases change behaviour. Cuts incentivise people to work harder and become more productive. The current tax code doesn’t do that, and neither does the rhetoric coming from many leaders in Washington DC.

The entire world is in economic distress. The countries that are the worst off are the ones that have pursued the high tax, high government spending tactics that Krugman and the Keynesians would like the US to aggressively enact. Only by changing the paradigm significantly can we shock the economic system out of its doldrums to re-energize it and put it on a track for growth.

Critics of the Chicago School will cite George Bush and his economic policies. Bush was no believer in the free market economics taught by the giants of the Chicago School, although he paid lip service to it. The triple crisis in 1999, 2008 and today are not the result of free markets or classical economic theory. They are the result of governments sticking in their finger and changing the economic incentives which caused markets to go out of whack.

The way forward is to truly embrace classical economics. Get the money out of the hands of bureaucrats and Congressman. Aggressive tax cuts, combined with reduced Keynesian spending will put us on that path.

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