In a CNBC debate last week, former Labor Secretary Robert Reich
presented a set of contradictory beliefs that unfortunately reflect the
conventional wisdom of modern economists. In a discussion with Wall
Street Journal columnist Stephen Moore, Reich correctly and comprehensively
listed the reasons why American consumers could spend so lavishly before the
crash of 2008 and why they can no longer keep up the pace. But instead of
making the logical conclusion that former levels of spending were
unsustainable and that spending should now reflect current conditions, he
advocated that government take on additional debt so that tapped out
consumers can spend like they used to.
To achieve this, Reich called for lowering taxes on working Americans
and raising taxes on the rich. He argued that middle-income Americans are
more likely to spend additional dollars while the rich are more likely to
save and invest. As a “demand-side” economist, Reich made clear
that spending is superior to savings and investing as a catalyst for growth.
To put it simply: Reich believes that the cart pushes the
horse. In his worldview, businesses produce goods and services simply
because consumers spend. Therefore, anything that increases spending
fuels growth. Unfortunately, he fails to see what should be strikingly
obvious: capital formation must precede production, which then allows for
consumption.
In a complex society like ours, those relationships are hard to see.
However, if we break it down to a simpler level, it becomes more obvious (as
I try to accomplish in my new book: How an Economy Grows and Why it Crashes).
For example, let’s take a look at a simple barter-based economy
consisting of only three people: a butcher, a baker, and a candlestick maker.
If the candlestick maker wants cake, he can’t simply demand that
the baker hand it over. The cake needs to be produced, and the baker has to
expend labor and material to produce it. Unless the candlestick maker offers
the baker something of value in exchange, the cakes won’t get baked.
The ability of the candlestick maker to demand cake from the baker is a
function of his ability to supply candles to trade. Without production,
consumption can’t occur.
What if the candlestick maker gets sick and produces no
candles? As the baker would be unwilling to give his cakes away, he
would likely stop baking cakes for the candlestick maker. Economic activity
would naturally contract until the candlestick maker recovers.
But according to Reich, if the candlestick maker doesn’t have
anything to trade, the government should step in and give him candles. But
where will the government get them? It could take them from the
candlestick maker; but if he is not making candles, how will he pay the
tax? Even if there were a few candles left to tax, any that the
government took would simply transfer demand from the candlestick maker to
the government. No new demand is created.
Alternatively,if the butcher is still healthy, the government could tax
him, and give his steaks to the candlestick maker to buy cakes. However,
this doesn’t create new demand either. It simply transfers demand from
the butcher to the candlestick maker.
Some may feel that a barter-based metaphor doesn’t hold water
because the ability to expand the money supply and create credit gives an
economy far more flexibility. This is a deceptive argument. Although money is
more efficient than barter, it doesn’t change the dynamic between
production and consumption.
But Reich suggests that printed money can stimulate demand just as
effectively as real candlesticks. But what good will the paper offer the
baker if there are no candlesticks to buy? All the baker can do is bid up the
prices of those goods, like steaks, that continue to be produced. Similarly,
if the government simply prints money and gives it to people to spend, no new
production occurs. Prices merely rise to reflect the increase in the
supply of money relative to the supply of consumer goods.
In a more complex economy, the relationship between production (supply)
and spending (demand) still holds. Every consumer either lives off his
own productivity or the productivity of someone else. When individuals work,
the wages earned result from the productivity of labor. The ability to
consume is directly related to the production of goods or services that
result from one’s efforts. However, if people waste their labor in
unproductive jobs, little real demand is created.
In the Soviet Union, everyone had a job, yet workers had to stand in
line for hours for basic necessities. Although everyone worked (for the
government), production was too low. This lack of production meant wages
delivered relativity little in the way of purchasing power.
Since production cannot be created by government stimulus, neither can
demand. To the extent that there are savings, demand can be brought forward
by stimulus – but only at the cost of future demand, plus interest. If
stimulus could produce demand, then no nation would be
poor. Taken to its logical end, Reich’s argument suggests that
African poverty would be wiped out if African governments simply printed
money more freely. In reality, Africans are not poor because they lack
currency to spend; they are poor because their corrupt and inept
governments inhibit production by soliciting bribes, denying property rights,
abrogating contracts, preventing the accumulation of capital, and
nationalizing profits.
Reich is correct about one thing: Americans are indeed
broke. But rather than encouraging the country to spend itself deeper
into debt, he should call for greater savings so that we have the means to
invest in new businesses and new industries. That is the true road back
to solvency, but it will only work if we have less government spending, fewer
regulations, lower taxes (particularly on those with the highest propensity
to save and invest), and higher interest rates.
Unfortunately, Reich and his allies are calling the shots in
Washington. The country cannot recover until the only thing politicians
stimulate is demand for new economic leadership.
Peter D. Schiff
President/Chief Global Strategist
Euro Pacific Capital, Inc.
20271 Acacia Street, #200 Newport Beach, CA 92660
Toll-free: 888-377-3722 / Direct: 203-972-9300 Fax: 949-863-7100
www.europac.net
pschiff@europac.net
For a more in depth analysis of the
tenuous position of the American economy, the housing and mortgage markets,
and U.S. dollar denominated investments, read my new book : The Little Book of Bull Moves in Bear Markets" (Wiley,
2008).
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