The Facts About GDP and a U.S. Recovery

I like reading Larry Kudlow's columns even though I do not always agree with him. In a recent column he wrote that "free-market economies are resilient and self-correcting" and the "Friedmanite monetary stimulus — which has been substantial — is gradually exerting a powerful impact on economic growth". (Hey Conservatives, We’re Recovering, National Review Online, 1 September 2009). Kudlow is making a serious error. Markets are only "self-correcting" when they are left alone. The tragedy of the 1930s provides more proof than one needs of the truth of this statement.

Kudlow said that "4 percent growth is a lot lower than the 7 to 8 percent growth one would expect after a deep recession". But this kind of increased output is not growth. We have hardcore Dems like Charles W. McMillion, a former contributing editor of the Harvard Business Review, pushing the same fallacy by arguing that Roosevelt's disastrous policies were actually a roaring success because GDP took off under his presidency. Naturally, this committed Keynesian is 100 per cent behind Obama's economic spend and tax policies.

What this Harvard man (the more Harvard graduates I encounter the less respect I have for that university) has failed to grasp is that economic growth is not a reduction in idle capacity: it is the accumulation of capital. Maurice Fitzgerald Scott points out "that all growth must result from investment". (A New View of Economic Growth, Clarendon Press, 1998, p. 15). This led him to the very Austrian conclusion that there is no residual or separate factor called "technical progress" because technical advances are embodied in capital. (Incidentally, Fitzgerald Scott is a Cambridge man, England, and is certainly no Austrian). It follows that a genuine economic recovery must also lead to increased capital accumulation. That does not seem to be the case at present.

Instead of promoting growth Roosevelt's policies encouraged capital consumption. (Hoover was every bit as bad). In other words, the production structure actually shrank even though GDP rose. Professor Higgs calculated that from 1930 to 1940 net private investment was minus $3.1 billion. (Robert Higgs, Depression, War, and Cold War, The Independent Institute, 2006, p. 7). W. Arthur Lewis calculated that from 1929 to 38 net capital formation plunged by minus 15.2 per cent (W. Arthur Lewis, Economic Survey 1919-1939, Unwin University Books, 1970, p. 205). Benjamin M. Anderson estimated that in 1939 there was more than 50 per cent slack in the economy. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States 1914-1946, LibertyPress, 1979, pp. 479-48). This is what some contemporaries had to say about Roosevelt's economic policies:

...the present Administration has shown but scant inclination to profit in any way from the errors of its predecessors. By consuming more than we have produced we have succeeded only in digging our way deeper into depression; we have tried to recover from depression by spending our way out of it rather than adopting the alternative procedure, — the one which has effected recovery from every past depression, — of saving our way out of it. By the policy of maintaining consumer purchasing power we have had to draw upon our store of past savings, and by so doing we have not only failed to keep up our accustomed rate of capital formation but have actually destroyed past accumulations by neglecting to provide for maintenance, depreciation, and obsolescence. C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, pp. 165-166).

This was not a simple matter of opinion but a factual statement. It should be obvious — particularly to an economist let alone a layman — that if a process of capital consumption is underway then we should expect to see a rise in the average age of plant and equipment. The following table reveals that this is exactly what happened during the 1930s.

It needs to be pointed out that from 1933 to 1940 M1 increased by nearly 100 per cent, bank deposits by about 116 per cent and the monetary base by more than 100 per cent. You cannot get more Friedmanite than that and yet the country remained mired in depression while capital was consumed.

Now monetary expansion works by releasing what the late Professor Hutt termed "withheld capacity". Now when — as happened during the 1930s — a government enforced wage rate policy prevents the employment of idle capital and labour then a loose monetary policy is supposed to work by raising the value of the worker's product relative to his wage rate.

In simple English, inflation is used to lower real wages rates and so price labour back into employment. The policy failed because Roosevelt and his advisors adhered to the purchasing power of wages fallacy. (This tells us much about the Roosevelt administration's economic incompetence and concradictions).

It's true that Obama is no Roosevelt — thank God — and that he has not been able to impose the sort of regulatory regime that locked the US economy into depression in the 1930s. Nevertheless he is still doing a great deal of harm. For example, his intention to double the capital gains tax will strike a severe body blow at capital accumulation and technical progress. (Few understand that capital gains taxes reduce the funding of new inventions and retard investment in research and development projects).

There is also an impending avalanche of new taxes that Obama and his supporters assure Americans will have no affect on growth and living standards. Moreover, his massive deficits and borrowing policies will further retard the process of capital accumulation. It is preposterous for anyone to assert that the combined effect of these policies will not damage the prospects for future economic growth. Such a denial defies both history and sound economics. (How could anyone ever forget the spectacle of Democratic Congressman Pete Stark seriously asserting that the more debt the government accumulates the wealthier Americans will become).

In fact, one needs to consider the possibility that the US might now be facing the spectre of capital consumption. It has happened to others and there is no fundamental reason why it cannot once again happen to the US.

There is nothing unique about the Obama's of this world. They come and they go. But you can guarantee one thing: their presence eventually turns into a misfortune for others. In the 1920s Austria's Social Democrats implemented their version of Obama's vision. Theirs was a world in which every worker got a square deal and his union stood ready to defend him against rapacious capitalists, a world in which capitalist inequalities were verboten and the social good prevailed over profit motive and greed.

And how did that turn out? It was calculated that from 1918 to 1930 Austria lost something like 79 per cent to 87 per cent of its capital. Fritz Machlup to caustically observed that

Austria was successful in pushing through policies which are popular all over the world. Austria has most impressive records in five lines: she increased public expenditures, she increased wages, she increased social benefits, she increased bank credits, she increased consumption. After all those achievements she was on the verge of ruin. (Fritz Machlup, The Consumption of Capital in Austria, Review of Economic Statistics, II, 1935, p. 19).

I have said more than once that history never repeats itself: what happens is that people keep forgetting it.

Comments

[NUCLEAR1929:]

the recovery doesnt happen in 1 year, to bring economy to growth, few decades must pass, otherwise you think 2008 crash was a joke

Sep 07 09:44 AM

[Nick36:]

Perhaps the problem with the US economy is that a lot of capital goes into the financial sector to pay for multi-million-dollar salaries, huge bonuses, and speculative losses in financial markets.

And when the capital is being used so unproductively by the private sector. Then taxing the crap out of such capital gains becomes the popular thing to do.

If the private sector was piling most of its capital into scientific research and development of new technologies that led to economic growth and many well-paying jobs. Then indeed taxing such capital gains would've been a stupid thing to do.

But the fact is that the private sector is screwing up and misdirecting its capital to unproductive and in some ways exploitative uses. And that's why taxing such capital seems to make sense to a lot of people.

Of course, the real problem is the misdirection of capital. And the only reasonable way to deal with such a problem is to let the financial speculators and userers fail as a consequence of their own misdeeds so utterly and completely that it no longer makes sense for anyone to go that route again. Which would free up people's capital and energy for more productive uses.

The financial sector is too big for the good of the economy. And that's why the government wants to tax it more. But a more sensible way would be to let the financial sector shrink (instead of subsidizing it) and let the people's capital flow to more productive uses in the economy.

Sep 07 10:59 AM

[basehitz:]

Thank you for the provocative thoughts.

Kudlow is a chronic cheerleader . . . except. . . when he should. As the market topped in 2007 and cascaded lower, he was cheerleading his viewers to a 50% loss. Here is just one example of his misleading commentary. This video is from May 2008, just 4 months BEFORE the market imploded. Barry Ritholtz warned of the dangers, but was dismissed by Kudlow, Luskin, and Jimmy P, who practically mocked Ritholtz . . . even denying there would be any recession. Just a few months later it imploded. SPX was 1,400 when this tape was made. His followers are not even close to breaking even.
www.ritholtz.com/blog/.../

However, in early March ‘09, Kudlow was fearful. Again, back-asswards. Kudlow’s ratings have dropped 46% y/y. Why anyone watches him is a mystery.
seekingalpha.com/artic...

I agree with your economic analysis of our predicament. We have transformed our society from the manufacturing center for the world, to a consumption society increasingly lived beyond it’s means via financial engineering tricks. The result is a debt bubble that has gone parabolic.
2.bp.blogspot.com/_vIR...

I suspect that is why the govt has decided to throw everything at this in an attempt to reflate the bubble, rather than embark on the self-discipline required to deleverage and concentrate on restoring our job base, which has been undermined by outsourcing. Kudlow and the other cheerleaders are apparently trying to convince consumers that a rising stock market means things are OK, and they should resume irresponsible overspending.

Savings and spending patterns show this time the consumers aren't buying the BS.

Sep 07 11:22 AM

[Alex_G:]

The 2 things the obama admin is not doing are spending stimulus dollars on:
1) infrastructure that will provide economic benefit and

2) energy initiatives that will REDUCE the out-flow of money to foreign energy companies (if you take out oil purchases, our trade deficit is nearly 0) and INCREASE payments to domestic energy companies. Jobs and revenue here instead of overseas.

Sep 07 07:36 PM

[derryl:]

I agree with Nick36. The US financial sector has been consuming America's capital for at least 2 decades. The enormous profits this sector has taken out of the economy were not reinvested as capital but were distributed as bonuses to finance workers, with a thin slice going to shareholders. When finance consumes 40% of total US corporate profits there is not enough left over for real economy companies to keep up a healthy, sustainable level of capital formation.

I also agree with basehitz. US multinationals took their capital offshore to exploit cheaper labor and other resources in foreign countries. Domestic US industry, in response to free trade competition from cheaper countries, has become highly automated and efficient. Worker productivity is very high but this is part of the other problem basehitz mentions.

American industry produces with much reduced need for labor so there aren't enough good jobs for Americans to earn good incomes to buy all the output. So to maintain their standard of living Americans lived by debt which, as basehitz correctly states, has gone parabolic.

So the point is that not all profits and capital gains are created equal. Exxon will devote most of its windfall profits to exploring for and producing increasingly difficult and expensive to access oil. Goldman Sachs will devote its profits to bonuses. If US greens succeed in preventing Exxon from exploring in the US then all the capital formation goes to foreign countries.

Reducing or eliminating capital gains taxes on small to medium domestic businesses will likely result in domestic capital formation as these people use their money to start up other businesses. Reducing capital gains on big businesses, where the money is on a scale that lets these people take a global outlook, is likely to result in more capital flight than domestic capital formation.

Sep 07 11:16 PM

[Mad Hedge F...:]

tryio. US stocks are now the most expensive they have been in seven years, and never really got cheap during the March low, just fairly valued. At least I have some good company in my views, which are also shared by David Rosenberg of Gluskin Sheff, the former economist at the late Merrill Lynch. The “faith based” rally is now discounting a GDP growth rate of 4.0%, which has a snowball’s chance in Hell of actually occurring. This is up dramatically from the 2.5% growth rate the S&P 500 was discounting when the index was at 667. The best stock market rally since 1933 added an unprecedented eight PE multiple points to stocks, and there is now more risk in the market than the 2007 peak. Underweight portfolio managers and momentum driven day traders are to blame. It’s what happened after the 1933 rally that scares me. Needless to say, stocks offer no value here. You can sign up for David’s well thought out research for free by going to his website at www.gluskinsheff.com/.

Sep 08 10:36 AM