In the search for a model that explains the present economic conditions best and is therefore best suited to use for macro investors, we've been discussing Austrian economics in two previous articles (here and here). These first two articles were about the Austrian (more in particular, Peter Schiff's) views about monetary policy, their dislike of QE and their preference for a return to the gold standard.
We've argued that whilst the jury is still very much out with respect to QE, the combination of doing nothing and the strong deflationary effects of a return to the gold standard would be a terrible idea right now (see also The Economist from 11/9). More especially, we argued that the effects of the implementation of these ideas can, grosso modo, be seen in the eurozone, as the euro works very much like the gold standard did in the 1930s, also a time of great economic distress.
Today we're going to discuss fiscal policy. Here the stylized Austrian recipe has the following elements:
- Do not try to stabilize the economy, the crisis cleanses the economy of unproductive over-investment and stimulus would only be counterproductive
- Slash public spending to contain deficits and debts
- Slash taxes to reinvigorate capitalism (a supply, not a demand measure)
Within the confines of a single article, we can only do so much. Weather the economy needs to be cleansed and stimulus is counterproductive or not is an issue we'll leave for another day, so we start with the proposition of slashing taxes.
Peter Schiff has argued that the US should abolish corporate and personal income taxes. Our general view is that this is an excellent idea in places like Italy or France, much less so in the US, especially if we're talking about corporate tax.
Why? While nominally, US corporate tax rate is the highest in the world, consider the following stylized facts:
- US corporate tax/GDP is just over 1% (down from 6% after WWII, see graph below)
- US companies are producing record profits
- US companies are sitting on large excess cash balances
Companies are also buying back record number of shares, so one could envision a situation in which part of tax cuts are spend on buying back shares, while good for shares, we don't think this gives much bang for the buck in terms of creating economic activity.
There is actually remarkably little evidence that previous tax cuts, in the 1980s, set off any investment and/or productivity boom. This mythical supply side revolution simply didn't happen. With lower corporate taxes today and companies sitting on record profits and cash, is there any reason to believe that this will happen this time around?
What is a much better idea is a simplification of the system, here we're actually in agreement with Austrians like Schiff. The fact that the US corporate tax rate is the highest in the world, but actually just deliver just over 1% of GDP (whilst companies produce record profits) indicates that:
- US rate is very high, but so are deductions
- Big companies are profiting disproportionally, they are more internationalized (with all the opportunities of tax evasion attached) and can afford specialist tax lawyers.
Many big companies pay surprisingly little in corporate taxes as a result. This isn't, in and by itself, a problem for the economy, but the result is that the tax burden falls excessively elsewhere, on small companies and individuals.
While we wouldn't necessarily agree with the actual proposals from Schiff (abolishing corporate and personal income taxes, introducing a flat tax and a sales tax), but there is certainly a lot of room for improvement here with a net beneficial effect on economic activity.
In a fundamental statement in the WSJ, Schiff argues that belt tightening is required by all, including government. In case you would think that this would lead to Keynes 'paradox of thrift' in which if everybody cuts back spending in order to save more, the economy would just shrink since your spending is my income and vice versa, you would meet Schiff's statement where he calls this simply a myth, without further ado.
Is it really so strange to think that when the private sector hardly responds to even zero interest rates because they want to pay down debt, rather than embark on new debt, resulting in monetary policy being largely impotent (as interest rates can't be cut any further) which leaves only fiscal policy to stop the rot? In another article he argues:
The economy is only growing because of, so debt continues to swell [Bloomberg]
We don't claim anything, we just look at the facts, and these aren't really friendly to Mr. Schiff. Here is De Grauwe again:
Figure 4 shows the relation between the austerity measures introduced in 2011 and the growth of GDP over 2011-12. We find a strong negative correlation. Countries that imposed the strongest austerity measures also experienced the strongest declines in their GDP. This result is in line with the IMF's recent analysis (IMF 2012).
Indeed, austerity hasn't even improved the debt situation, exactly the opposite what Schiff argues
It is striking to find a strong positive correlation. The more intense the austerity, the larger is the subsequent increase in the debt-to-GDP ratios
One doesn't have to read Krugman or Koo but perhaps Schiff is familiar with the writings of fellow conservative Evans-Pritchard, who rails weekly against austerity and it's denominator effect (that is, austerity leading to higher debt/GDP ratios because it shrinks nominal GDP, nicely summed up here). Or the recent IMF studies (and here) which show the fiscal multiplier to be much larger:
While economists expected that cutting a euro from the budget would cost around 50 cents in lost growth, the actual impact was more like 1.50 per euro.
Or the IMF's mea culpa on Greek austerity. Speaking of which, people like Schiff believe that markets always clear, which is why they argue that cutback in public spending will be filled by increases in private spending. Well, this kind of "expansionary austerity" is certainly possible, when an economy is running full capacity and interest rates (and or the exchange rate) have a lot of room to fall.
But these cases are rare, basically only Ireland in the late 1980s qualifies, and we couldn't be further from these kind of circumstances, with interest rates almost zero, having a fixed exchange rate and oodles of spare capacity in the economy. Here is what happened to Greece, for instance:
So when Greece (bottom left dot) cut government consumption by 17%, they expected private spending to increase by at least the same amount. But it did not happen, private spending also fell and GDP has fallen by almost 25% during that period. [Antonio Fatas]
All the available evidence doesn't seem to impact Schiff's views at all. In fact, while countries that issue their own currency can't really go bankrupt, Schiff argues that the US already is bankrupt, and actually ran for Senate to lead a filibuster, making sure the debt ceiling never gets raised.
Somebody should tell the Japanese. Their debt is nearly three times the US in relative terms, and they have embarked (15 years too late, in our view, but better late than never) on policies to grow and (mildly) inflate their way out of this, just as the US and UK have post WO-II, or Japan in the 1930s.
That the supposedly richest economy in the world, with nearly the lowest taxes and the smallest public sector and one of the more modestly sized welfare states of all developed economies, and the ability to issue its own currency would be bankrupt is curious. On these criteria, most other developed countries are bankrupt.
While we agree with Schiff and some other Austrians that the tax system in the US is too complex, and taxes are too high in a number of countries (France, Italy), the figures do not point to taxes as a major stumbling block for a US economic recovery. Some minor traction might be gotten from lowering taxes on small companies, but in general, corporate taxes are low in the US.
The fact that corporations enjoy record profits and sitting on record cash levels, engaging in large share buybacks, suggest that corporations have funds to invest, but are hesitant in putting these to work because of the economic outlook, not cost levels or profitability.
The main issue clouding the economic outlook is simply insufficient demand, as witnessed by the fact that actual output is running well below potential output (to such an extent that this has damaging effects already to the production capacity in the future). To slash public spending, as Schiff and the Austrians demand, is a bad idea under these circumstances. You slash spending when the economy is overheating, not when potential output exceeds real output by a wide margin.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.