Throughout history, governments have gotten themselves into trouble by spending more than they have, observes Peter D. Schiff in ‘How an Economy Grows and Why it Crashes’ (www.wiley.com). When the gap caused by overspending becomes too big, difficult choices arise, he adds.
“One option is for the government to increase revenue by raising taxes. This path is never popular with citizens, and in a democracy is hard to push through. Even in authoritarian states (where there are no pesky elections), tax increases are problematic.”
Higher tax rates always discourage productivity and deflate economic vitality, the author explains. There is a limit to how high taxes can go, he notes. “Raise them enough, and people stop working. Raise them higher, and they may even start rioting.”
Is there a better option? Yes, the government can cut spending. But this option is more difficult than raising taxes, because those whose benefits are cut are particularly apt to express their hostility both at the polls and on the street, Schiff cautions. This is especially true, he says, when the recipients feel entitled to the benefits. “Politicians make lots of promises to secure their elections and voters rarely consider the ability of taxpayers to actually foot the bills.”
Default or inflate
One other alternative before the government is to default, by telling the creditors that it cannot pay the full amount of its debt obligations; but this is an embarrassing option because it amounts to an official acknowledgement of insolvency, the author outlines.
If this sounds eerie, a disguise is available: Printing money to pay the debts, effectively repudiating the obligations by inflating them away. Since inflation is usually the easiest choice to make, it is often the most likely, he rues. “But while it may seem easy at first, it ultimately exacts the harshest toll.”
Inflation, as Schiff instructs, is simply a means to transfer wealth from anyone who has savings in a particular currency to anyone who has debt in the same currency. With hyperinflation, the value of savings gets completely wiped out and the burden of debt is removed, he continues. “Those who own hard assets do okay, because, unlike savings in currency, assets will rise in nominal value when inflation flares up.”
Illusion of improvement
A ‘reality check’ box in the book reminds one that an economy can’t grow because people spend; people spend because an economy grows. However, an ‘illusion of improvement’ can be created by the newly printed notes!
On the claim of some economists that the recession period in the US is over, the author is sceptical. Any recovery has been stopped by stimulus programmes, and so the work of rebalancing the economy remains unfinished, he feels. “The creation of ever greater quantities of debt has given us a reprieve from the process of returning to living standards commensurate with our productivity. But at some point in the foreseeable future, perhaps in the next few years, we will have a very ugly encounter with our debt.”
With more than half of US government debt currently sold to foreign governments, what will happen when the buyers change their mind? With very little domestic savings to tap into, Americans alone won’t be able to pick up the slack, avers Schiff. When that day comes, the two options before the US will be to default or to cause inflation. Both options, he foresees, will violently force American living standards downward through lost purchasing power and higher interest rates.
Allegory of island communities
The dismal tale of economy on a tailspin comes alive through catchy illustrations by Brendan Leach set in island communities, Sinopia and Usonia. Sample this: “Despite the bailouts and incentives made by Bass and Plankton, the Usonian economy continued to deteriorate during the Great Hut Rut. Strangely, no one showed much interest in buying new huts. Instead of spending their stimulus fish, some islanders elected to save them. With spending stagnant, the cart companies teetered on the edge of extinction. Hut Depot was devastated. Unemployment got worse. Public dissatisfaction intensified…”
Barry Ocuda, the new victor in the elections, decides to turn the economy around, with programmes such as ‘Carp for Carts,’ offering incentives to get people to turn in their grass guzzlers for more fuel-efficient carts. While it was easy to see how these ideas boosted sales and put people to work, what were not too evident were the jobs destroyed ‘as a result of diverting scarce labour and capital to the activities that the Senate deemed to be important enough to fund.’
Discredited free market
Through trial and error, market forces would have determined the best use for remaining investment capital, the author reasons. “Enterprises that misread the market would lose money and investors would back away. Those that got it right would profit, attract more capital, and expand.” Perhaps efforts would have been better spent building nets, farming equipment, or canoes, he suggests.
“The most successful ventures would have been those that most efficiently gave the people what they wanted, when they wanted it. But with the free market now apparently discredited, everyone put their faith in a small group of people to make decisions normally left to the island as a whole…”
There is no evidence, avers the author, that government planners have a better idea of what is good for society than savers themselves. He laments that history is littered with grandiose schemes hatched in government think tanks that have simply not delivered on their promise.
Virtues of lending discipline
More fundamentally, argues Schiff, the imposition of a government layer in between savers and borrowers separates the cause and effect of lending, and leads to an inefficient allocation of savings. “Private lenders tend to be influenced only by the financial results of a loan, rather than the political symbolism of the underlying activity. Businesses that adhere to successful models and are run by owners with strong records of achievement tend to repay loans at higher rates.”
As a result, these types of business plans tend to attract willing lenders, and much like Darwin’s idea that natural selection produces hardier species, lending discipline produces healthier companies and a stronger economy, reads an analogy.
A case in contrast is the situation where financial performance is secondary, and loans are made to individuals or enterprises that do not succeed in creating a needed innovation or expanding productive capacity. The result, as Schiff bemoans, is a weakened economy that has wasted its supply of savings.
Just as the principles of mathematics don’t change with the size of the problem, basic economic principles do not change with the size of the economy, the author writes. They are just harder to see because of the many layers that exist between savers and borrowers, he frets. “But the direct relationship among self-sacrifice, savings, credit, investment, economic incentive, and social and economic progress are always the same.”
Educative read that unravels why the economy smells the way it does.
**
