Our economy is in dangerous territory. Obama inherited a mess; a bubble that was a culmination and a combination of reckless leverage, poor regulation, misguided fiscal policy, major shifts in the global economy,  and mistaken monetary policy.  A lot of mistakes from a lot of parties led us to a precipice where a rescue was necessary.

The result is an excess inventory of commercial and residential real estate, record unemployment, and record deficits.  Citizens are paying down debt, credit is being squeezed, costs are being cut.  This devaluation of assets and credit reduction can only reduce consumption and slow the economy.

Given the asset bubble and the debt liquidation the economy would have been rough regardless of who was in office.  Equity needed to be restored, property prices needed to fall, and the pain that follows bubbles needed to be tolerated.  It would have taken a special leader to convey this message.

If there was a mandate it would have been to restore and implement prudent regulations of the financial system; it was not to “exploit the crisis” and inflict further harm on the economy in the name of ideology.

The Democrats think that spending money to stimulate the economy is the answer. When this Keynesian prescription has failed in the past, it was always because they did not spend enough. When the economy finally did recover far later than it would have without the stimulus, then they took the credit.

It’s like the doctor who says that if I take the medicine I will get over my cold in seven days; otherwise it may take a week.

The Republicans on the other hand think that tax cuts solve every problem.  It is true that our corporate tax is among the highest in the industrialized world, and it is true that the Laffer Curve has properly demonstrated that previous  cuts in tax rates have in fact increased tax revenues. And as big a fan as I am of tax cuts to stimulate economic growth it is not without some understanding of the limits.

Even theoretically the Laffer Curve reaches a point where increased tax cuts will result in less revenue; if we tax 100% of income we will kill all incentive and get nothing; but we also get nothing if we take the other extreme and tax at 0%.  At some point in the curve between those extremes, lower rates will yield less revenues. I do not contend that we are yet at that point.

But lower tax rates cannot be considered in isolation from other factors effecting the business climate.  Mandates, uncertainty and anti-business antagonism from the bully pulpit will also chill incentives to economic growth.  Any gambler will avoid a blackjack table that they even suspect of being rigged.  And the special treatment given to unions and preferred sectors of the economy smacks of a rigged game.

When the president floats an idea to nationalize student loans for college and then allowing loan forgiveness if those student work in the public sector; he is clearly showing disdain for the ‘profit’ motivated private sector that ultimately must fund his endless government programs.  Addresses by Michelle Obama have belittled private sector work for the altruism of public service.

Giving such a large benefit to college grads to enter public work only raises the costs of hiring them into private employment.

While tax cuts may not be the answer, tax increases certainly will do substantial harm.  But it is the uncertainty, the discouragement  of being forced to play a rigged game, and the repetitive disdain for profit seeking enterprise that discourages economic growth.  The business man, small or otherwise, sees record deficits, strong pro-union regulation and sentiment, higher health care costs, and other attempts at adding layers of regulation and they know they are the targets of retribution.

The president may target his ire at ‘big business’, but like all populist platitudes he does not want to clarify at what size  a business is no longer small; Is it 50 employees, 500, 5,000? Or is it $250,000 in profits or  $2,000,000? Like other promises to tax the rich, when you are staring at the kinds of deficits we now face you will be surprised at how low the bar will become to be considered rich.

He fails to realize that big businesses come from small businesses. How can you stimulate economic growth when you demonize small business for becoming big businesses?

The reality is that you can tax 100% of the super wealthy and you would not cover the deficits for a week. Populists prefer demons to solutions.

Tax cuts will not encourage economic growth as they have in the past, when there are so many other disincentives to growth. The leadership that erected these barriers will not likely destroy them.

Until we have clear and fair rules, a responsible budget, prudent financial regulations, and an end to the contempt for profit seeking behavior,  private business will not take the risks required to grow and create jobs. Targeted tax credits and promises of tax relief alone will not overcome these greater obstacles.

It is probable that we habitually overestimate the extent to which inequality of incomes is mainly caused by income derived from property, and therefore the extent to which the major inequalities would be abolished by abolishing income from property. What little information we have about the distribution of incomes in Soviet Russia does not suggest  that the inequalities are substantially smaller there than in a capitalistic society. Max Eastman in The End of Socialism in Russia …. gives some information from official Russian sources  which suggests that the difference between the highest and lowest salaries  paid in Russia is of the same order (about 50 to 1) as in the United States; and Leon Trotsky…. estimated as late as 1939 that the “upper 11 or 12 per cent of the Soviet population now receives approximately 50 per cent of the national income. This differentiation is sharper than in the United States, where the upper 10 per cent of the population receives approximately 35% of the national income.”

HKO comment:

This footnote in Hayek’s The Road to Serfdom, published in 1944, reminds us that socialism is just the substitution of political self interest for economic self interest and does nothing to truly address inequalities of wealth. Higher wealth today is more likely to come from better education, intellectual capital, working longer hours, and taking more risk. This is even more true today when fortunes are made on ideas such as Apple, Facebook, and Microsoft than on real property such as real estate and natural resources.  In fact the real estate collapse has even widened that gap. The bigger threat is that the motive to equalize wealth will squelch the risk capital that has funded our huge successes.

The statesman who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted to no council and senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit the exercise it.

From Adam Smith’s An inquiry into the Nature and Causes of the Wealth of Nations, published first in the momentous year of 1776.

HKO Comment:

We think we need unique and new solutions to what we perceive to be a unique and new set of problems, but our problems are not new. They are in fact classical throughout  our history. The solutions and outcomes are also not new, though still painful.  We suffer for our lack of a sense of history.

The most misunderstood aspect of the success of the Reagan led supply side revolution was the monetary aspect. The idea adapted from Robert Mundell’s theory was that the Fed should focus ONLY on monetary matters and that fiscal policy should focus on policies such as employment and economic stimulus. The effectiveness of the supply side revolution was the restoration in the value of the dollar by monetary means COMBINED with the stimulative effect of lower taxes and less regulation, which is just another form of taxation.

Simply making the dollar worth a dollar is a daunting task in an age of fiat current and rapidly changing global competition.  The Fed was not formed to stimulate the economy and it was often blamed, sometimes justifiably, for contributing to periodic weakness and making cyclical recessions worse.  Milton Friedman and Bernanke both believe that improper Fed action made the recession much worse. But one cannot ignore the contribution of an even greater lack of understanding on the impact of fiscal policies like trade protectionism, higher taxes and a massive expansion of the government mandate.

In the Wall Street Journal Opinion Journal Online this point is given its necessary importance in The Fed’s Bipolar Mandate – Time to repeal the Humphrey-Hawkins Act of 1978.

An excerpt:

But with Humphrey-Hawkins, Congress ordered the central bank to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” The political context in that age of Jimmy Carter will sound familiar. U.S. unemployment was stubbornly high and the fiscal policies (tax rebates) of a Democratic Congress had failed to stimulate. So the politicians decided to conscript the Fed in its job creation mission by ordering the ostensibly independent central bank to target employment as well as prices.

The larger problem with the dual mandate is that it inevitably makes the Fed a political actor. Fed governors are forced to pretend they can be economic saviors, able to rescue workers and business from the consequences of failed fiscal and regulatory policies. This is precisely what the Fed is being asked to do today, using QE2 to save the Obama Administration from a 9.6% jobless rate despite trillions spent on economic stimulus, foreclosure mitigation and cash for clunkers. Mr. Bernanke has too often made the Fed appear to be an agent of the Treasury, as he did again yesterday in Frankfurt by blaming China’s pegged currency for U.S. economic ills.

Michael Barone writes in Townhall.com Obama’s Economists Missed What Voters Plainly Saw.

Barone makes an astute observation that there is a difference between the business cycle recessions more commonly seen in the past and a recession caused by a financial crisis.

In recessions caused by oscillations in the business cycle from the 1940s to 1970s, voters were confident that the private-sector economy could support the burden of countercyclical spending on things like unemployment insurance and public works projects.

That spending would stimulate consumer demand, the thinking went, and once inventories were drawn down, manufacturers would call workers back to the assembly line. The recession would be over.

But a systemic financial crisis is more rare and more severe. The damage is deeper and takes longer to recover.

The very able economists in the incoming Obama administration seem to have ignored the difference between these two kinds of recessions. Council of Economic Advisers head Christina Romer was surely sincere when she promised that passage of the stimulus package would hold unemployment under 8 percent.

Similarly, administration economists evidently thought the private-sector economy could bear the burden of a national debt that doubled over a decade. It would bounce back like it usually does in a business cycle recession.

Tea partiers took a different view — and before long, so did most voters. They seem to believe that permanent increases in government’s share of GDP will inflict permanent damage on the private-sector economy — and won’t do much, if anything, to move us out of this prolonged financial crisis recession. The evidence so far seems to support them.

Economists seem to always be fighting the last recessions like generals fight the last war.  Just as a general knows a guerilla insurgency requires different tactics than uniformed combat, economists must realize the difference in the conditions behind the recession.

Washington, especially under this administration, has been oblivious to the reality of this economy that so many of my small business colleagues see with blinding clarity.

They are applying a treatment to a patient with the wrong diagnosis and cannot understand why the patient’s recovery is taking so long. The common voters, considered so ignorant by the elitist pundits, understand this economy better than the PhDs.