economic growth

The Rahn Curve Revisited

The theory behind the Rahn Curve is simple — but not simplistic. A relatively small government with powers limited mainly to the protection of citizens and their property is worth more than its cost to taxpayers because it fosters productive economic activity (not to mention liberty). But additional government spending hinders productive activity in many ways, which are discussed in Daniel Mitchell’s paper, “The Impact of Government Spending on Economic Growth.” (I would add to Mitchell’s list the burden of regulatory activity, which accumulates with the size of government.)

What does the Rahn Curve look like? Daniel Mitchell estimates this relationship between government spending and economic growth:

Rahn curve (2)

The curve is dashed rather than solid at low values of government spending because it has been decades since the governments of developed nations have spent as little as 20 percent of GDP. But as Mitchell and others note, the combined spending of governments in the U.S. was 10 percent (and less) until the eve of the Great Depression. And it was in the low-spending, laissez-faire era from the end of the Civil War to the early 1900s that the U.S. enjoyed its highest sustained rate of economic growth.

In an earlier post, I ventured an estimate of the Rahn curve that spanned most of the history of the United States. I came up with this relationship:

Real rate of growth = -0.066(G/GDP) + 0.054

To be precise, it’s the annualized rate of growth over the most recent 10-year span, as a function of G/GDP (fraction of GDP spent by governments at all levels) in the preceding 10 years. I used a lagged relationship because it takes time for government spending (and related regulatory activities) to wreak their counterproductive effects on economic activity. Also, I include transfer payments (e.g., Social Security) in my measure of G because there’s no essential difference between transfer payments and many other kinds of government spending, which also take money from those who produce and give it to those who don’t (e.g., government employees engaged in paper-shuffling, unproductive social-engineering schemes, and counterproductive regulatory activities).

Because of the marked decline in the rate of growth since World War II, I’ve taken a closer look at the post-war numbers. With this result:

Real rate of growth = -0.372(G/GDP) + 0.067(BA/GDP) + 0.080

Again, it’s the annualized rate of growth over a 10-year span, as a function of G/GDP (fraction of GDP spent by governments at all levels) in the preceding 10 years. The new term, BA/GDP, represents the constant-dollar value of private nonresidential assets (i.e., business assets) as a fraction of GDP, averaged over the preceding 10 years. The idea is to capture the effect of capital accumulation on economic growth, which I didn’t do in the earlier analysis.

The equation has a good r-squared (0.66) and is highly significant (F-value = 2.84E-11). The p-values of the coefficients and intercept are also highly significant (1.812E-09, 1.059E-11, and 9.192E-06). The standard error of the estimate is 0.0055, that is, about one-half of 1 percentage point. I found no other intuitively appealing variables that add to the explanatory power of the equation.

What does it mean for the next 10 years? Based on G/GDP and BA/GDP for the most recent 10-year period (2004-2013), the real rate of growth will be about 1.9 percent. The earlier equation yields an estimate of 2.9 percent. The new equation wins the reality test:

Year-over-year changes in real GDP

Stagnation is upon us.

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Related reading:
Arnold Kling, “Business Births and Deaths,” askblog, January 2, 2014
Sean Davis, “No, Demographics Are Not the Reason for Labor Force Dropouts,” The Federalist, January 13, 2014
James Pethokoukis, “3 Disturbing Charts Showing the Alarming Decline of US Economic Dynamism,” AEI.org, May 5, 2014
Ryan McCarthy, “The Story of the American Recovery in 15 Charts,” Wonkblog (The Washington Post), May 8, 2014 (See especially chart 4.4.2, which is consistent with my estimate and suggests that slow growth will be the norm among “social democracies.”)
James Pethokoukis, “Declining Business Dynamism … ,” AEI.org, May 22, 2014
James Pethokoukis, “JP Morgan: Less ‘Creative Destruction’ Is Hurting the US Economy,” AEI.org, June 4, 2014
James Pethokoukis, “Where Are All the Startups? More on America’s Economic Calcification,” AEI.org, November 19, 2014

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Related posts:
The Laffer Curve, “Fiscal Responsibility,” and Economic Growth
The Causes of Economic Growth
In the Long Run We Are All Poorer
A Short Course in Economics
Addendum to a Short Course in Economics
As Goes Greece
Ricardian Equivalence Reconsidered
The Real Burden of Government
The Illusion of Prosperity and Stability
Taxing the Rich
More about Taxing the Rich
The Keynesian Fallacy and Regime Uncertainty
Why the “Stimulus” Failed to Stimulate
The “Jobs Speech” That Obama Should Have Given
Say’s Law, Government, and Unemployment
Regime Uncertainty and the Great Recession
Regulation as Wishful Thinking
The Commandeered Economy
We Owe It to Ourselves
In Defense of the 1%
Lay My (Regulatory) Burden Down
The Burden of Government
Economic Growth Since World War II
Government in Macroeconomic Perspective
Keynesianism: Upside-Down Economics in the Collectivist Cause
Economics: A Survey (also here)
Why Are Interest Rates So Low?
Vulgar Keynesianism and Capitalism
Estimating the Rahn Curve: Or, How Government Spending Inhibits Economic Growth
America’s Financial Crisis Is Now
The Keynesian Multiplier: Phony Math
The True Multiplier
Obamanomics: A Report Card
The Obama Effect: Disguised Unemployment
Income Inequality and Economic Growth

Signature

McCloskey on Piketty

The left loves Thomas Piketty‘s Capital in the Twenty-First Century because it lends pseudo-scientific backing to some of the left’s favorite economic postulates; to wit:

  • Income inequality is bad, even if real incomes are rising across the board. Why is it bad? It just is, if you’re an envious Marxist. But also…
  • Income inequality is bad because wealth usually derives from income. The rich get richer, as the old song goes. And the rich — the super-rich, in today’s parlance — acquire inordinate political power because of their great wealth. (Leftists conveniently overlook the fact that the penchant for statist schemes — redistributionism among them — is positively correlated with income. This is a morally confused stance, based on guilt-feelings and indoctrination at the hands of leftist “educators,” “journalists,” and “entertainers.”)
  • Further, inequality yields slower economic growth because persons with high incomes consume a smaller fraction of their incomes than do persons with low incomes. The result, according to the Keynesian consumption-based model, is a reduction in GDP, other things being the same. And other things being the same, slower growth means that it is harder for low-income persons to rise from poverty or near-poverty. (This is a logically and empirically backward view of reality, which is that economic growth requires more investment and less consumption. And investment spending is stifled when redistribution takes money from high earners and gives it to low earners, that is, persons with a high propensity to consume. Investment is also stifled by progressive taxation, which penalizes success, and burdensome regulation, which deters entrepreneurship and job creation.)

Deirdre McCloskey‘s forthcoming review of Piketty’s book praises it and damns it. First the praise:

Piketty gives a fine example of how to do it [economic history]. He does not get entangled as so many economists do in the sole empirical tool they are taught, namely, regression analysis on someone else’s “data”…. Therefore he does not commit one of the two sins of modern economics, the use of meaningless “tests” of statistical significance…. Piketty constructs or uses statistics of aggregate capital and of inequality and then plots them out for inspection, which is what physicists, for example, also do in dealing with their experiments and observations. Nor does he commit the other sin, which is to waste scientific time on existence theorems. Physicists, again, don’t. If we economists are going to persist in physics envy let’s at least learn what physicists actually do. Piketty stays close to the facts, and does not, say, wander into the pointless worlds of non-cooperative game theory, long demolished by experimental economics. He also does not have recourse to non-computable general equilibrium, which never was of use for quantitative economic science, being a branch of philosophy, and a futile one at that. On both points, bravissimo.

His book furthermore is clearly and unpretentiously, if dourly, written….

That comes early in McCloskey’s long review (50 double-spaced pages in the .pdf version). But she ends with blistering damnation:

On the next to last page of his book Piketty writes, “It is possible, and even indispensable, to have an approach that is at once economic and political, social and cultural, and concerned with wages and wealth.” One can only agree. But he has not achieved it. His gestures to cultural matters consist chiefly of a few naively used references to novels he has read superficially—for which on the left he has been embarrassingly praised. His social theme is a narrow ethic of envy. His politics assumes that governments can do anything they propose to do. And his economics is flawed from start to finish.

It is a brave book. But it is mistaken.

There is much in between to justify McCloskey’s conclusion. Here she puts Piketty’s work in context:

[T]he left in its worrying routinely forgets this most important secular event since the invention of agriculture—the Great Enrichment of the last two centuries—and goes on worrying and worrying, like the little dog worrying about his bone in the Traveler’s insurance company advertisement on TV, in a new version every half generation or so.

Here is a partial list of the worrying pessimisms, which each has had its day of fashion since the time, as the historian of economic thought Anthony Waterman put it, “Malthus’ first [1798] Essay made land scarcity central. And so began a century-long mutation of ‘political economy,’ the optimistic science of wealth, to ‘economics,’ the pessimistic science of scarcity.” Malthus worried that workers would proliferate and Ricardo worried that the owners of land would engorge the national product. Marx worried, or celebrated, depending on how one views historical materialism, that owners of capital would at least make a brave attempt to engorge it…. Mill worried, or celebrated, depending on how one views the sick hurry of modern life, that the stationary state was around the corner. Then the economists, many on the left but some on the right, in quick succession 1880 to the present—at the same time that trade-tested betterment was driving real wages up and up and up—commenced worrying about, to name a few of the grounds for pessimisms they discerned concerning ”capitalism”: greed, alienation, racial impurity, workers’ lack of bargaining strength, women working, workers’ bad taste in consumption, immigration of lesser breeds, monopoly, unemployment, business cycles, increasing returns, externalities, under-consumption, monopolistic competition, separation of ownership from control, lack of planning, post-War stagnation, investment spillovers, unbalanced growth, dual labor markets, capital insufficiency … , peasant irrationality, capital-market imperfections, public choice, missing markets, informational asymmetry, third-world exploitation, advertising, regulatory capture, free riding, low-level traps, middle-level traps, path dependency, lack of competitiveness, consumerism, consumption externalities, irrationality, hyperbolic discounting, too big to fail, environmental degradation, underpaying of care, overpayment of CEOs, slower growth, and more.

One can line up the later items in the list, and some of the earlier ones revived à la Piketty or Krugman…. I will not name here the men … , but can reveal their formula: first, discover or rediscover a necessary condition for perfect competition or a perfect world (in Piketty’s case, for example, a more perfect equality of income). Then assert without evidence (here Piketty does a great deal better than the usual practice) but with suitable mathematical ornamentation (thus Jean Tirole, Nobel 2014) that the condition might be imperfectly realized or the world might not develop in a perfect way. Then conclude with a flourish (here however Piketty falls in with the usual low scientific standard) that “capitalism” is doomed unless experts intervene with a sweet use of the monopoly of violence in government to implement anti-trust against malefactors of great wealth or subsidies to diminishing-returns industries or foreign aid to perfectly honest governments or money for obviously infant industries or the nudging of sadly childlike consumers or, Piketty says, a tax on inequality-causing capital worldwide. A feature of this odd history of fault-finding and the proposed statist corrections, is that seldom does the economic thinker feel it necessary to offer evidence that his … proposed state intervention will work as it is supposed to, and almost never does he feel it necessary to offer evidence that the imperfectly attained necessary condition for perfection before intervention is large enough to have reduced much the performance of the economy in aggregate.

I heartily agree with McCloskey’s diagnosis of the causes of leftist worrying:

One begins to suspect that the typical leftist … starts with a root conviction that capitalism is seriously defective. The conviction is acquired at age 16 years when the proto-leftist discovers poverty but has no intellectual tools to understand its source. I followed this pattern, and therefore became for a time a Joan-Baez socialist. Then the lifelong “good social democrat,” as he describes himself (and as I for a while described myself), when he has become a professional economist, in order to support the now deep-rooted conviction, looks around for any qualitative indication that in some imagined world the conviction would be true, without bothering to ascertain numbers drawn from our own world…. It is the utopianism of good-hearted leftward folk who say, “Surely this wretched society, in which some people are richer and more powerful than others, can be greatly improved. We can do much, much better!”

Piketty’s typically leftist blend of pessimism and utopianism is hitched to bad economic reasoning, ignorance of economic history, and a misreading of his own statistics:

Piketty’s (and Aristotle’s) theory is that the yield on capital usually exceeds the growth rate of the economy, and so the share of capital’s returns in national income will steadily increase, simply because interest income—what the presumably rich capitalists get and supposedly manage to cling to and supposedly reinvest—is growing faster than the income the whole society is getting.

Aristotle and his followers, such as Aquinas and Marx and Piketty, were much concerned with such “unlimited” gain. The argument is, you see, very old, and very simple. Piketty ornaments it a bit with some portentous accounting about capital-output ratios and the like, producing his central inequality about inequality: so long as r > g, where r is the return on capital and g is the growth rate of the economy, we are doomed to ever increasing rewards to rich capitalists while the rest of us poor suckers fall relatively behind. The merely verbal argument I just gave, however, is conclusive, so long as its factual assumptions are true: namely, only rich people have capital; human capital doesn’t exist; the rich reinvest their return; they never lose it to sloth or someone else’s creative destruction; inheritance is the main mechanism, not a creativity that raises g for the rest of us just when it results in an r shared by us all; and we care ethically only about the Gini coefficient, not the condition of the working class. Notice one aspect of that last: in Piketty’s tale the rest of us fall only relatively behind the ravenous capitalists. The focus on relative wealth or income or consumption is one serious problem in the book. Piketty’s vision of a “Ricardian Apocalypse,” as he calls it, leaves room for the rest of us to do very well indeed, most non-apocalyptically, as in fact since 1800 we have. What is worrying Piketty is that the rich might possibly get richer, even though the poor get richer, too. His worry, in other words, is purely about difference, about the Gini coefficient, about a vague feeling of envy raised to a theoretical and ethical proposition.

Another serious problem is that r will almost always exceed g, as anyone can tell you who knows about the rough level of interest rates on invested capital and about the rate at which most economies have grown (excepting only China recently, where contrary to Piketty’s prediction, inequality has increased). If his simple logic is true, then the Ricardian Apocalypse looms, always. Let us therefore bring in the sweet and blameless and omni-competent government—or, even less plausibly, a world government, or the Gallactic Empire—to implement “a progressive global tax on capital” (p. 27) to tax the rich. It is our only hope…. In other words, Piketty’s fears were not confirmed anywhere 1910 to 1980, nor anywhere in the long run at any time before 1800, nor anywhere in Continental Europe and Japan since World War II, and only recently, a little, in the United States, the United Kingdom, and Canada (Canada, by the way, is never brought into his tests).

That is a very great puzzle if money tends to reproduce itself, always, evermore, as a general law governed by the Ricardo-plus-Marx inequality at the rates of r and g actually observed in world history. Yet inequality in fact goes up and down in great waves, for which we have evidence from many centuries ago down to the present, which also doesn’t figure in such a tale (Piketty barely mentions the work of the economic historians Peter Lindert and Jeffrey Williamson documenting the inconvenient fact). According to his logic, once a Pikettywave starts—as it would at any time you care to mention if an economy satisfied the almostalways-satisfied condition of the interest rate exceeding the growth rate of income—it would never stop. Such an inexorable logic means we should have been overwhelmed by an inequality-tsunami in 1800 CE or in 1000 CE or for that matter in 2000 BCE. At one point Piketty says just that: “r > g will again become the norm in the twenty-first century, as it had been throughout history until the eve of World War I (… one wonders what he does with historically low interest rates right now, or the negative real interest rates in the inflation of the 1970s and 1980s). Why then did the share of the rich not rise anciently to 100 percent?

McCloskey gets it right:

With a bigger pie, someone has to get more. In the event what rose were wages on raw labor and especially a great accumulation of human capital, but capital owned by the laborers, not by the truly rich. The return to physical capital was higher than a riskless return on British or American government bonds, in order to compensate for the risk in holding capital (such as being made obsolete by betterment—think of your computer, obsolete in four years). But the return on physical capital, and on human capital, was anyway held down to its level of very roughly 5 to 10 percent by competition among the proliferating capitalists. Imagine our immiserization if the income of workers, because they did not accumulate human capital, and their societies had not adopted the accumulation of ingenuities since 1800, had experienced the history of stagnation since 1800 that the per-unit return to capital has. It is not hard to imagine, because such miserable income of workers exists even now in places like Somalia and North Korea. Instead, since 1800 in the average rich country the income of the workers per person increased by a factor of about 30 (2,900 percent, if you please) and in even in the world as a whole, including the still poor countries, by a factor of 10 (900 percent), while the rate of return to physical capital stagnated.

Piketty does not acknowledge that each wave of inventors, of entrepreneurs, and even of routine capitalists find their rewards taken from them by entry, which is an economic concept he does not appear to grasp. Look at the history of fortunes in department stores. The income from department stores in the late nineteenth century, in Le Bon Marché, Marshall Fields, and Selfridge’s, was entrepreneurial. The model was then copied all over the rich world, and was the basis for little fortunes in Cedar Rapids, Iowa and Benton Harbor, Michigan. Then in the late twentieth century the model was challenged by a wave of discounters, and they then in turn by the internet. The original accumulation slowly or quickly dissipates. In other words, the profit going to the profiteers is more or less quickly undermined by outward-shifting supply, if governmental monopolies and protectionisms of the sort Matt Ridley noted in recent British history do not intervene. The economist William Nordhaus has calculated that the inventors and entrepreneurs nowadays earn in profit only 2 percent of the social value of their inventions. If you are Sam Walton the 2 percent gives you personally a great deal of money from introducing bar codes into stocking of supermarket shelves. But 98 percent at the cost of 2 percent is nonetheless a pretty good deal for the rest of us. The gain from macadamized roads or vulcanized rubber, then modern universities, structural concrete, and the airplane, has enriched even the poorest among us.

But Piketty doesn’t see this because he’s a poor economist and a knee-jerk socialist:

Piketty, who does not believe in supply responses [as discussed below], focuses instead on the great evil of very rich people having seven Rolex watches by mere inheritance. Lillian Bettancourt, heiress to the L’Oréal fortune (p. 440), the third richest woman in the world, who “has never worked a day in her life, saw her fortune grow exactly as fast as that of [the admittedly bettering] Bill Gates.” Ugh, Piketty says, which is his ethical philosophy in full.

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[T]he effect of inherited wealth on children is commonly to remove their ambition, as one can witness daily on Rodeo Drive. Laziness—or for that matter regression to the mean of ability—is a powerful equalizer. “There always comes a time,” Piketty writes against his own argument, “when a prodigal child squanders the family fortune” (p. 451), which was the point of the centuries-long struggle in English law for and against entailed estates.

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Because Piketty is obsessed with inheritance, moreover, he wants to downplay entrepreneurial profit, the trade-tested betterment that has made the poor rich. It is again Aristotle’s claim that money is sterile and interest is therefore unnatural. Aristotle was on this matter mistaken. It is commonly the case, contrary to Piketty, and setting aside the cheapening of our goods produced by the investments of their wealth by the rich, that the people with more money got their more by being more ingeniously productive, for the benefit of us all—getting that Ph.D., for example, or being excellent makers of automobiles or excellent writers of horror novels or excellent throwers of touchdown passes or excellent providers of cell phones, such as Carlos Slim of Mexico, the richest man in the world (with a little boost, it may be, from corrupting the Mexican parliament). That Frank Sinatra became richer than most of his fans was not an ethical scandal. The “Wilt Chamberlain” example devised by the philosopher Robert Nozick (Piketty mentions John Rawls, but not Nozick, Rawls’ nemesis) says that if we pay voluntarily to get the benefit of clever CEOs or gifted athletes there is no further ethical issue. The unusually high rewards to the Frank Sinatras and Jamie Dimons and Wilt Chamberlains come from the much wider markets of the age of globalization and mechanical reproduction, not from theft. Wage inequality in the rich countries experiencing an enlarging gap of rich vs. poor, few though the countries are (Piketty’s finding, remember: Canada, U.S.A., U.K.)), is mainly, he reports, caused by “the emergence of extremely high remunerations at the summit of the wage hierarchy, particularly among top managers of large firms.” The emergence, note, has nothing to do with r > g.

How poor an economist? Consider:

Piketty’s definition of wealth does not include human capital, owned by the workers, which has grown in rich countries to be the main source of income, when it is combined with the immense accumulation since 1800 of capital in knowledge and social habits, owned by everyone with access to them. Therefore his laboriously assembled charts of the (merely physical and private) capital/output ratio are erroneous. They have excluded one of the main forms of capital in the modern world. More to the point, by insisting on defining capital as something owned nearly always by rich people, Piketty mistakes the source of income, which is chiefly embodied human ingenuity, not accumulated machines or appropriated land.

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The fundamental technical problem in the book, however, is that Piketty the economist does not understand supply responses….

Startling evidence of Piketty’s miseducation occurs as early as page 6. He begins by seeming to concede to his neoclassical opponents…. “To be sure, there exists in principle a quite simple economic mechanism that should restore equilibrium to the process [in this case the process of rising prices of oil or urban land leading to a Ricardian Apocalypse]: the mechanism of supply and demand. If the supply of any good is insufficient, and its price is too high, then demand for that good should decrease, which would lead to a decline in its price.” [This] clearly mix[es] up movement along a demand curve with movement of the entire curve, a first-term error at university. The correct analysis (we tell our first-year, first-term students at about week four) is that if the price is “too high” it is not the whole demand curve that “restores equilibrium” … , but an eventually outward-moving supply curve. The supply curve moves out because entry is induced by the smell of super-normal profits, in the medium and long run (which is the Marshallian definition of the terms). New oil deposits are discovered, new refineries are built, new suburbs are settled, new high-rises saving urban land are constructed, as has in fact happened massively since, say, 1973, unless government has restricted oil exploitation (usually on environmental grounds) or the building of high-rises (usually on corrupt grounds). Piketty goes on—remember: it does not occur to him that high prices cause after a while the supply curve to move out; he thinks the high price will cause the demand curve to move in, leading to “a decline in price” (of the scarce item, oil’s or urban land)—“such adjustments might be unpleasant or complicated.” To show his contempt for the ordinary working of the price system he imagines comically that “people should . . . take to traveling about by bicycle.” The substitutions along a given demand curve, or one mysteriously moving in, without any supply response “might also take decades, during which landlords and oil well owners might well accumulate claims on the rest of the population” (now he has the demand curve moving out, for some reason faster than the supply curve moves out) “so extensive that they could they could easily [on grounds not argued] come to own everything that can be owned, including” in one more use of the comical alternative, “bicycles, once and for all.” Having butchered the elementary analysis of entry and of substitute supplies, which after all is the economic history of the world, he speaks of “the emir of Qatar” as a future owner of those bicycles, once and for all. The phrase must have been written before the recent and gigantic expansion of oil and gas exploitation in Canada and the United States….

Piketty, it would seem, has not read with understanding the theory of supply and demand that he disparages, such as Smith (one sneering remark on p. 9), Say (ditto, mentioned in a footnote with Smith as optimistic), Bastiat (no mention), Walras (no mention), Menger (no mention), Marshall (no mention), Mises (no mention), Hayek (one footnote citation on another matter), Friedman (pp. 548-549, but only on monetarism, not the price system). He is in short not qualified to sneer at self-regulated markets (for example on p. 572), because he has no idea how they work. It would be like someone attacking the theory of evolution (which is identical to the theory the economists use of entry and exit in self-regulating markets—the supply response, an early version of which inspired Darwin) without understanding natural selection or the the Galton-Watson process or modern genetics.

McCloskey continues:

Beyond technical matters in economics, the fundamental ethical problem in the book is that Piketty has not reflected on why inequality by itself would be bad…. The motive of the true Liberal … should not be equality but [says Joshua Monk, a character in Anthony Trollope’s novel, Phineas] “the wish of every honest [that is, honorable] man . . . to assist in lifting up those below him.” Such an ethical goal was to be achieved, says Monk the libertarian liberal (as Richard Cobden and John Bright and John Stuart Mill were, and Bastiat in France at the time, and in our times Hayek and Friedman, or for that matter M’Cluskie), not by direct programs of redistribution, nor by regulation, nor by trade unions, but by free trade and tax-supported compulsory education and property rights for women—and in the event by the Great Enrichment, which finally in the late nineteenth century started sending real wages sharply up, Europe-wide, and then world-wide.

The absolute condition of the poor has been raised overwhelmingly more by the Great Enrichment than by redistribution. The economic historians Ian Gazeley and Andrew Newell noted in 2010 “the reduction, almost to elimination, of absolute poverty among working households in Britain between 1904 and 1937.” “The elimination of grinding poverty among working families,” they show, “was almost complete by the late thirties, well before the Welfare State.” Their Chart 2 exhibits income distributions in 1886 prices at 1886, 1906, 1938, and 1960, showing the disappearance of the classic line of misery for British workers, “round about a pound a week.”

And it didn’t stop there:

In 2013 the economists Donald Boudreaux and Mark Perry noted that “according to the Bureau of Economic Analysis, spending by households on many of modern life’s ‘basics’—food at home, automobiles, clothing and footwear, household furnishings and equipment, and housing and utilities—fell from 53 percent of disposable income in 1950 to 44 percent in 1970 to 32 percent today.” It is a point which the economic historian Robert Fogel had made in 1999 for a longer span. The economist Steven Horwitz summarizes the facts on labor hours required to buy a color TV or an automobile, and notes that “these data do not capture . . . the change in quality . . . . The 1973 TV was at most 25 inches, with poor resolution, probably no remote control, weak sound, and generally nothing like its 2013 descendant. . . . Getting 100,000 miles out of a car in the 1970s was cause for celebration. Not getting 100,000 miles out of a car today is cause to think you bought a lemon.”

Nor in the United States are the poor getting poorer. Horwitz observes that “looking at various data on consumption, from Census Bureau surveys of what the poor have in their homes to the labor time required to purchase a variety of consumer goods, makes clear that poor Americans are living better now than ever before. In fact, poor Americans today live better, by these measures, than did their middle class counterparts in the 1970s.” In the summer of 1976 an associate professor of economics at the University of Chicago had no air conditioning in his apartment. Nowadays many quite poor Chicagoans have it. The terrible heat wave in Chicago of July 1995 killed over 700 people, mainly low-income. Yet earlier heat waves in 1936 and 1948, before air-conditioning was at all common, had probably killed many more.

There is one point at which McCloskey almost veers off course, but she recovers nicely:

To be sure, it’s irritating that a super rich woman buys a $40,000 watch. The purchase is ethically objectionable. She really should be ashamed. She should be giving her income in excess of an ample level of comfort—two cars, say, not twenty, two houses, not seven, one yacht, not five—to effective charities…. But that many rich people act in a disgraceful fashion does not automatically imply that the government should intervene to stop it. People act disgracefully in all sorts of ways. If our rulers were assigned the task in a fallen world of keeping us all wholly ethical, the government would bring all our lives under its fatherly tutelage, a nightmare achieved approximately before 1989 in East Germany and now in North Korea.

And that is the key point, to my mind. Perfection always eludes the human race, even where its members have managed to rise from the primordial scramble for sustenance and above Hobbes’s “warre, as is of every man, against every man.” Economic progress without economic inequality is impossible, and efforts to reduce inequality by punishing economic success must inevitably hinder progress, which is built on the striving of entrepreneurs. Further, the methods used to punish economic success are anti-libertarian — whether they are the police-state methods of the Soviet Union or the “soft despotism” of the American regulatory-welfare state.

So what if an entrepreneur — an Edison, Rockefeller, Ford, Gates, or Jobs — produces something of great value to his fellow men, and thus becomes rich and adorns his spouse with a $40,000 watch, owns several homes, and so on? So what if that same entrepreneur is driven (in part, at least) by a desire to bestow great wealth upon his children? So what if that same entrepreneur chooses to live among and associate with other persons of great wealth? He has no obligation to “give back”; he has already given by providing his fellow men with something that they value enough to make him rich. (Similarly, the super-star athlete and actor.)

McCloskey gets the penultimate word:

Supposing our common purpose on the left and on the right, then, is to help the poor, … the advocacy by the learned cadres of the left for equalizing restrictions and redistributions and regulations can be viewed at best as thoughtless. Perhaps, considering what economic historians now know about the Great Enrichment, but which the left clerisy, and many of the right, stoutly refuse to learn, it can even be considered unethical. The left clerisy such as Tony Judt or Paul Krugman or Thomas Piketty, who are quite sure that they themselves are taking the ethical high road against the wicked selfishness of Tories or Republicans or La Union pour un Mouvement Populaire, might on such evidence be considered dubiously ethical. They are obsessed with first-[order] changes that cannot much help the poor, and often can be shown to damage them, and are obsessed with angry envy at the consumption of the uncharitable rich, of whom they personally are often examples (what will you do with your royalties, Professor Piketty?), and the ending of which would do very little to improve the position of the poor. They are very willing to stifle through taxing the rich the trade-tested betterments which in the long run have gigantically helped the poor, who were the ancestors of most of the rest of us.

I added the emphasis to underscore what seems to me to be the left’s greatest ethical offense in the matter of inequality, as it is in the matter of race relations: hypocrisy. Hypocritical leftists like Judt, Krugman, and Pikkety (to name only a few of their ilk) aren’t merely wrong in their views about how to help the (relatively) poor, they make money (and a lot of it) by espousing their erroneous views. They obviously see nothing wrong with making a lot of money. So why is it all right for them to make a lot of money — more than 99.9 percent of the world’s population, say — but not all right for other persons to make even more money? The dividing line between deservingness and greed seems always to lie somewhere above their munificent earnings.

*     *     *

Related reading:
David R. Henderson, “An Unintended Case for More Capitalism,” Regulation, Fall 2014
John Cochrane, “Why and How We Care about Inequality,” The Grumpy Economist, September 29, 2014
John Cochrane, “Envy and Excess,” The Grump Economist, October 1, 2014
Mark J. Perry, “New CBO Study Shows That ‘The Rich’ Don’t Just Pay Their ‘Fair Share,’ They Pay Almost Everybody’s Share,” Carpe Diem, November 15, 2014
Mark J. Perry, “IRS Data Show That the Vast Majority of Taxpayers in the ‘Fortunate 400′ Are Only There for One Year,” Carpe Diem, November 25, 2014
Robert Higgs, “income Inequality Is a Statistical Artifact,” The Beacon (Independent Institute), December 1, 2014
John Cochrane, “McCloskey on Piketty and Friends,” The Grumpy Economist, December 2, 2014
James Pethokoukis, “IMF Study, ‘No Evidence ‘High-End’ Income Inequality Hurts Economic Growth,” AEI.org, December 9, 2014

Related posts:
Taxing the Rich
More about Taxing the Rich
The Keynesian Fallacy and Regime Uncertainty
Creative Destruction, Reification, and Social Welfare
Why the “Stimulus” Failed to Stimulate
Regime Uncertainty and the Great Recession
Regulation as Wishful Thinking
In Defense of the 1%
Lay My (Regulatory) Burden Down
Economic Growth Since World War II
Government in Macroeconomic Perspective
Keynesianism: Upside-Down Economics in the Collectivist Cause
How High Should Taxes Be?
The 80-20 Rule, Illustrated
Economics: A Survey
Estimating the Rahn Curve: Or, How Government Spending Inhibits Economic Growth
The Keynesian Multiplier: Phony Math
The True Multiplier
Some Inconvenient Facts about Income Inequality
Mass (Economic) Hysteria: Income Inequality and Related Themes
Social Accounting: A Tool of Social Engineering
Income Inequality and Inherited Wealth: So What?
Income Inequality and Economic Growth
A Case for Redistribution, Not Made

Signature

Income Inequality and Economic Growth

Standard & Poor’s adds fuel the the already raging fire of economic illiteracy with its research report entitled, “How Increasing Income Inequality Is Dampening U.S. Economic Growth, and Possible Ways to Change the Tide.” The S&P paper mines the Marxian-Pikettian vein of “underconsumption,” which (in the Marxian-Pikettian view) leads to economic collapse. (That Marx was wrong has been amply demonstrated by the superior performance of quasi-free economies, which have lifted the poor as well as the rich. Many writers have found grave errors in Piketty‘s reasoning– and data — these among them.)

The remedy for economic collapse (in the Marxian-Pikettian view) is socialism (perhaps smuggled in as “democratic” redistributionism). It is, of course, the kind of imaginary, painless socialism favored by affluent professors and pundits — favored as long as it doesn’t affect their own affluence. It bears no resemblance to the actual kind of socialism experienced by the billions who have been oppressed by it and the tens of millions who have been killed for its sake.

I have read two thorough take-downs of S&P’s screed. One is by Scott Winship (“S&P’s Fundamentally Flawed Inequality Report,” Economic Policies for the 21st Century at the Manhattan Institute, August 6, 2014). A second is by John Cochrane (“S&P Economists and Inequality,” The Grumpy Economist, August 8, 2014). Cochrane summarizes (and demolishes) the central theme of the S&P report, which I will address here:

[I]nequality is bad [because] it is bad for growth, and if the reason it is bad for growth is that it leads to insufficient consumption and lack of demand….

That bit of hogwash serves the redistributionist agenda. As Cochrane puts it, “redistributive taxation is a perennial answer in search of a question.” Indeed.

There’s more:

Inequality – growth is supposed to be about long run trends, not boom and slow recovery.

Professor of Public Policy at U.S. Berkeley Robert Reich argues that increased inequality has reduced overall aggregate demand. He observes that high-income households have a lower marginal propensity to consume (MPC) out of income than other households.

Let us begin at the beginning, that is, with some self-evident postulates that even a redistributionist will grant — until he grasps their anti-redistributionist implications:

  • All economic output is of two distinct types: consumption and investment (i.e., the replacement of or increase in the stock of capital that is used to produce goods for consumption).
  • The output of consumption goods must decline, ceteris paribus, if the stock of capital declines.
  • The stock of capital is sustained (and increased) by forgoing consumption.
  • The stock of capital is therefore sustained (and increased) by saving.
  • Saving rises with income because persons in high-income brackets usually consume a smaller fraction of their incomes than do persons in middle- and low-income brackets.
  • The redistribution of income from high-income earners to middle- and low-income earners therefore leads to a reduction in saving.
  • A reduction in saving means less investment and, thus, a reduction in the effective stock of capital, as it wears out.
  • With less capital, workers become less productive.
  • Output therefore declines, to the detriment of workers as well as “capitalists.”

In sum, efforts to make incomes more equal through redistribution have the opposite effect of the one claimed for it by ignorant bloviators like Robert Reich.

So much for the claim that a higher rate of consumption is a good policy for the long run.

What about in the short run; that is, what about Keynesian “stimulus” to “prime the pump”? I won’t repeat what I say in “The Keynesian Multiplier: Phony Math.” Go there, and see for yourself.

For an estimate of the destructive, long-run effect of government see “The True Multiplier.”

Every Silver Lining Has a Cloud

Today’s big economic news is the decline in real GDP reported by the Department of Commerce’s Bureau of Economic Analysis (BEA): an annualized rate of minus 2.9 percent from the fourth quarter of 2013 to the first quarter of 2014. Except for times when the economy was in or near recession, that’s the largest decline recorded since the advent of quarterly GDP estimates:

Quarterly vs annual changes in real GDP - 1948-2014
Derived from the “Current dollar and real GDP series” issued by BEA. See this post for my definition of a recession.

What’s the silver lining? Quarter-to-quarter changes in real GDP are more volatile than year-over-year and long-run changes. Some will take solace in the fact that real GDP rose by (a measly) 1.5 percent between the first quarter or 2013 and the first quarter of 2014. (Though they will conveniently ignore the long-run trend, marked by the dashed line in the graph.)

What’s the cloud? Well, as I pointed out above, the quarter-to-quarter decline in the first quarter of 2014 is unprecedented in the post-World War II era. Unless the sharp drop in the first quarter of 2014 is a one-off phenomenon (as suggested by some cheerleaders for Obamanomics), it points two possibilities:

  • The economy is in recession, as will become evident when the BEA reports on GDP for the second quarter of 2014.
  • The economy isn’t in recession — strictly speaking — but the dismal performance in the first quarter presages an acceleration of the downward trend marked by the dashed line in the graph. (For those of you who care about such things, the chance that the trend line reflects random “noise” in GDP statistics is less than 1 in 1 million.)

Even if there’s a rebound in the second quarter of 2014, the big picture is clear: The economy is in long-term decline, for reasons that I’ve discussed in the following posts:

The Laffer Curve, “Fiscal Responsibility,” and Economic Growth
The Causes of Economic Growth
In the Long Run We Are All Poorer
A Short Course in Economics
Addendum to a Short Course in Economics
The Price of Government
The Price of Government Redux
The Mega-Depression
As Goes Greece
Ricardian Equivalence Reconsidered
The Real Burden of Government
The Illusion of Prosperity and Stability
Taxing the Rich
More about Taxing the Rich
A Keynesian Fantasy Land
The Keynesian Fallacy and Regime Uncertainty
Why the “Stimulus” Failed to Stimulate
The “Jobs Speech” That Obama Should Have Given
Say’s Law, Government, and Unemployment
Unemployment and Economic Growth
Regime Uncertainty and the Great Recession
Regulation as Wishful Thinking
The Real Multiplier
The Commandeered Economy
We Owe It to Ourselves
In Defense of the 1%
Lay My (Regulatory) Burden Down
The Burden of Government
Economic Growth Since World War II
The Economy Slogs Along
Government in Macroeconomic Perspective
Keynesianism: Upside-Down Economics in the Collectivist Cause
The Price of Government, Once More
Economic Horror Stories: The Great “Demancipation” and Economic Stagnation
Economics: A Survey (also here)
Why Are Interest Rates So Low?
Vulgar Keynesianism and Capitalism
Estimating the Rahn Curve: Or, How Government Spending Inhibits Economic Growth
America’s Financial Crisis Is Now
The Keynesian Multiplier: Phony Math
The True Multiplier
The Obama Effect: Disguised Unemployment
Obamanomics: A Report Card

See especially “Regime Uncertainty and the Great Recession,” “Estimating the Rahn Curve: Or, How Government Spending Inhibits Economic Growth,” and “The True Multiplier.”

Obamanomics: A Report Card (Updated)

Here.

The good news? There is none.

The bad news? Sluggish growth persists, despite the hype about an unexpected “jump” in third-quarter GDP. The U.S. remains in the midst of the worst post-World War II “post-recession recovery,” which is neither post-recession nor a recovery.

The liberals want the U.S. to be European? Their dreams have come true, politically as well as economically.

Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth

UPDATED 12/13/14 – This update consists of a comment about my estimate of the Rahn curve. I have just published a much better estimate of the curve for the post-World War II era.

UPDATED 12/28/11 — This update incorporates GDP and government spending statistics for 2010 and corrects a minor discrepancy in the estimation of government spending. Also, there are new, easier-to-read graphs. The bottom line is the same as before: Government spending and everything that goes with it (including regulation) is destructive of economic growth.

UPDATED 09/19/13 — This version incorporates two later posts “Estimating the Rahn Curve: A Sequel” (01/24/12) and “More Evidence for the Rahn Curve” (05/27/12).

*     *     *

The theory behind the Rahn Curve is simple — but not simplistic. A relatively small government with powers limited mainly to the protection of citizens and their property is worth more than its cost to taxpayers because it fosters productive economic activity (not to mention liberty). But additional government spending hinders productive activity in many ways, which are discussed in Daniel Mitchell’s paper, “The Impact of Government Spending on Economic Growth.” (I would add to Mitchell’s list the burden of regulatory activity, which accumulates with the size of government.)

What does the Rahn Curve look like? Daniel Mitchell estimates this relationship between government spending and economic growth:

Rahn curve (2)

The curve is dashed rather than solid at low values of government spending because it has been decades since the governments of developed nations have spent as little as 20 percent of GDP. But as Mitchell and others note, the combined spending of governments in the U.S. was 10 percent (and less) until the eve of the Great Depression. And it was in the low-spending, laissez-faire era from the end of the Civil War to the early 1900s that the U.S. enjoyed its highest sustained rate of economic growth.

Here is a graphic look at the historical relationship between government spending and GDP growth:

(Source notes for this graph and those that follow are at the bottom of this post.)

The regression lines are there simply to emphasize the long-term trends. The relationship between government spending as a percentage of GDP (G/GDP) and real GDP growth will emerge from the following graphs. There are chronological gaps because the Civil War, WWI, the Great Depression, and WWII distorted the relationship between G/GDP and economic growth. Large wars inflate government spending and GDP. The Great Depression saw a large rise in G/GDP, by pre-Depression standards, even as the economy shrank and then sputtered to a less-than-full recovery before the onset of WWII.

Est Rahn curve 1792 1861

Est Rahn curve 1866 1917

Est Rahn curve 1792 1917

Est Rahn curve 1946-2010

The graphs paint a consistent picture: Higher G/GDP means lower growth. There is one inconsistency, however, and that is the persistence of growth in the range of 2 to 4 percent during the post-WWII era, despite G/GDP in the range of 25-45 percent. That is not the kind of growth one would expect, given the relationships that obtain in the earlier eras. (The extrapolated trend line for 1946-2009 comes into use below.)

There are at least five plausible — and not mutually exclusive — explanations for the discrepancy. First, there is the difficulty of estimating GDP for years long past. Second, it is almost impossible to generate a consistent estimate of real GDP spanning two centuries; current economic output is vastly greater in volume and variety than it was in the early days of the Republic. Third, productivity gains (advances in technology, management techniques, and workers’ skills) may offset the growth-inhibiting effects of government spending, to some extent. Fourth, government regulations and active interventions (e.g., antitrust activity, the income tax) have a cumulative effect that operates independently of G/GDP. Regulations and interventions may have had an especially strong effect in the early 1900s (see the second graph in this post). The effects of regulations and interventions may diminish with time because of  adaptive behavior (e.g., “capture” of regulatory bodies).

Finally, and perhaps most importantly, there is the shifting composition of government spending. At relatively low levels of G/GDP, G consists largely of government programs that usurp and interfere with private-sector functions by diverting resources from productive uses to uses favored by politicians, bureaucrats, and their patrons. Higher levels of G/GDP — such as those we in the United States have known since the end of WWII — are reached by the expansion of the welfare state. Government spending (at all levels) on so-called social benefits accounted for only 7 percent of G and 0.8 percent of GDP in 1929; in 2009, it accounted for 36 percent of G and 15 percent of GDP. The provision of “social benefits” brings government into the business of redistributing income, which discourages work, saving, and capital formation to some extent, but doesn’t impinge directly on commerce. Therefore, I would expect G to be less damaging to GDP growth at higher levels of G/GDP — which is the message to be found in the contrast between the experience of 1946-2009 and the experience of earlier periods.

With those thoughts in mind, I present this empirical picture of the relationship between G/GDP and GDP growth in the United States:

Est Rahn curve 1792-2010

The intermediate points, unfortunately, are missing because of the chronological gaps mentioned above. But, as indicated by the five earlier graphs, it is entirely reasonable to infer from the preceding graph a strong relationship between GDP growth and changes in G/GDP throughout the history of the Republic.

It is possible to obtain a rough estimate of the downward sloping portion of the Rahn curve by focusing on two eras: the post-Civil War years 1866-1890 — before the onset of “progressivism,” with its immediate and strong negative effects — and the post-WWII years 1946-2009. Thus:

Est Rahn curve rough sketch

My rough estimate is appropriately “fuzzy” and somewhat more generous than Daniel Mitchell’s, which is indicated by the heavy black line. In light of my discussion of the shifting composition of G as G/GDP becomes relatively large, I  have followed the slope of the trend line for 1792-2010; that is, every 1 percentage-point increase in G/GDP yields a decrease in the growth rate of about 0.07 percent. That seemingly small effect becomes a huge one when G/GDP rises over a long period of time (as has been the case for more than a century, with no end in sight).

For the record, the best fit through the “fuzzy” area is:

Annual rate of growth = -0.066(G/GDP) + 0.054.

[A revised and more realistic estimate for the post-World War II era is

Real rate of growth = -0.372(G/GDP) + 0.067(BA/GDP) + 0.080 ,

where the real rate of growth is the annualized rate over a 10-year period, G/GDP is the fraction of GDP spent by government (including social transfers) over the preceding 10-year period, and BA/GDP represents business assets as a fraction of GDP for the preceding 10-year period.]

Again, it’s the annualized rate of growth over a 10-year span, as a function of G/GDP (fraction of GDP spent by governments at all levels) in the preceding 10 years. The new term, BA/GDP, represents the constant-dollar value of private nonresidential assets (i.e., business assets) as a fraction of GDP, averaged over the preceding 10 years. The idea is to capture the effect of capital accumulation on economic growth, which I didn’t do in the earlier analysis.

Maximum GDP growth seems to occur when G/GDP is 2-4  percent. That is somewhat less than the 7-percent share of GDP that was spent on national defense, public order, and safety in 2010. The excess represents additional “insurance” against predators, foreign and domestic. (The effectiveness of the additional “insurance” is a separate question, though I am inclined to err on the side of caution when it comes to defense and law enforcement. Those functions are not responsible for the economic woes facing America’s taxpayers.)

If G/GDP reaches 55 percent — which it will if present entitlement “commitments” are not curtailed — the “baseline” rate of growth will shrink further: probably to less than 2 percent. And thus America will remain mired in its Mega-Depression.

*     *     *

Source notes:

Estimates of real and nominal GDP, back to 1790, come from the feature “What Was the U.S GDP Then?” at MeasuringWorth.com.

Estimates of government spending (federal, State, and local) come from USgovernmentspending.com; Statistical Abstracts of the United States, Colonial Times to 1970: Part 2. Series Y 533-566. Federal, State, and Local Government Expenditures, by Function; and the Bureau of Economic Analysis (BEA), Table 3.1. Government Current Receipts and Expenditures (lines 34, 35).

I found the amount spent by governments (federal, State, and local) on national defense and public order and safety by consulting BEA Table 3.17. Selected Government Current and Capital Expenditures by Function.

The BEA tables cited above are available here.

*     *     *

ADDENDUM: THE RAHN CURVE: A SEQUEL

In the original post (above) I note that maximum GDP growth occurs when government spends two to four percent of GDP. The two-to-four percent range represents the share of GDP claimed by American governments (federal, State, and local) throughout most of the 19th century, when government spending exceeded five percent of GDP only during the Civil War.

Of course, until the early part of the 20th century, when Progressivism began to make itself felt in Americans’ tax bills, governments restricted themselves (in the main) to the functions of national defense, public order, and safety — the terms used in national-income accounting. It is those functions — hereinafter called defense and justice — that foster liberty and economic growth because they protect peaceful, voluntary activity. Effective protection probably would cost more than four percent of GDP in these parlous times. But an adequate figure, except in the rare event of a major war, is probably no more than seven percent of GDP — the value for 2010, which includes the cost of fighting in Iraq and Afghanistan.

In any event, government spending — even on defense and justice — is impossible without private economic activity. It is that activity which yields the wherewithal for the provision of defense and justice. Once those things have been provided, the further diversion of resources by government is economically destructive. Specifically, from “Estimating the Rahn Curve” (above):

It is possible to obtain a rough estimate of the downward sloping portion of the Rahn curve by focusing on two eras: the post-Civil War years 1866-1890 — before the onset of “progressivism,” with its immediate and strong negative effects — and the post-WWII years 1946-2009. Thus:

Est Rahn curve rough sketch

My rough estimate is appropriately “fuzzy” and somewhat more generous than Daniel Mitchell’s [in “The Impact of Government Spending on Economic Growth”], which is indicated by the heavy black line. In light of my discussion of the shifting composition of G as G/GDP becomes relatively large, I  have followed the slope of the trend line for 1792-2010; that is, every 1 percentage-point increase in G/GDP yields a decrease in the growth rate of about 0.06 percent. That seemingly small effect becomes a huge one when G/GDP rises over a long period of time (as has been the case for more than a century, with no end in sight).

The following graphs offer another view of the devastation wrought by the growth of government spending — and regulation. (Sources are given in “Estimating the Rahn Curve.”) I begin with the share of GDP which is not spent by government:

Est Rahn curve sequel_priv GDP as pct total GDP

A note about my measure of government spending is in order. National-income accounting purists would insist that transfer payments (mainly Social Security, Medicare, and Medicaid) should not count as spending, even though I count them as such. But what does it matter whether money is taken from taxpayers and given to retired persons (as Social Security) or to government employees (as salary and benefits) or contractors (as reimbursement for products and services delivered to government)? All government spending represents the transfer of claims on resources from persons who earned those claims to other persons, who either did something of questionable value for the money (government employees and contractors) or nothing (e.g., retirees).

In any event, it is obvious that Americans enjoyed minimal government until the early 1900s, and have since “enjoyed” a vast expansion of government. Here is a closer look at the trend from 1900 onward:

Est Rahn curve sequel_private GDP pct total GDP since 1900

This is a good point at which to note that the expansion of government is understated by the growth of government spending, which only imperfectly captures the effects of the rapidly growing regulatory burden on America’s economy. The combined effects of government spending and regulation can be seen in this “before” and “after” depiction of growth rates:

Est Rahn curve sequel_growth rate of private GDP

(I omitted the major wars and the Great Depression because their inclusion would give an exaggerated view of economic growth in the aftermath of abnormally suppressed private economic activity.)

The marked diminution of growth  after 1900 has led to what I call America’s Mega-Depression. Note the similarity between the downward path of private sector GDP (two graphs earlier) and the downward path of the Mega-Depression in the following graph:

Est Rahn curve sequel_mega-depression

What is the Mega-Depression? It is a measure of the degree to which real GDP has fallen below what it would have been had economic growth continued at its post-Civil War pace. As I explain here, the Mega-Depression began in the early 1900s, when the economy began to sag under the weight of Progressivism (e.g., trust-busting, regulation, the income tax, the Fed). Then came the New Deal, whose interventions provoked and prolonged the Great Depression (see, for example, this, and this). From the New Deal and the Great Society arose the massive anti-market/initiative-draining/dependency-promoting schemes known as Social Security, Medicare, and Medicaid. The extension and expansion of those and other intrusive government programs has continued unto the present day (e.g., Obamacare), with the result that our lives and livelihoods are hemmed in by mountains of regulatory restrictions.

Regulation aside, government spending — except for defense and justice — is counterproductive. Not only does it fail to stimulate the economy in the short run, but it also robs the economy of the investments that are needed for long-run growth.

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ADDENDUM: MORE EVIDENCE FOR THE RAHN CURVE

Here:

[W]e have some new research from the United Kingdom. The Centre for Policy Studies has released a new study, authored by Ryan Bourne and Thomas Oechsle, examining the relationship between economic growth and the size of the public sector.

The chart above compares growth rates for nations with big governments and small governments over the past two decades. The difference is significant, but that’s just the tip of the iceberg. The most important findings of the report are the estimates showing how more spending and more taxes are associated with weaker performance.

Here are some key passages from the study.

Using tax to GDP and spending to GDP ratios as a proxy for size of government, regression analysis can be used to estimate the effect of government size on GDP growth in a set of countries defined as advanced by the IMF between 1965 and 2010. …As supply-side economists would expect, the coefficients on the tax revenue to GDP and government spending to GDP ratios are negative and statistically significant. This suggests that, ceteris paribus, a larger tax burden results in a slower annual growth of real GDP per capita. Though it is unlikely that this effect would be linear (we might expect the effect to be larger for countries with huge tax burdens), the regressions suggest that an increase in the tax revenue to GDP ratio by 10 percentage points will, if the other variables do not change, lead to a decrease in the rate of economic growth per capita by 1.2 percentage points. The result is very similar for government outlays to GDP, where an increase by 10 percentage points is associated with a fall in the economic growth rate of 1.1 percentage points. This is in line with other findings in the academic literature. …The two small government economies with the lowest marginal tax rates, Singapore and Hong Kong, were also those which experienced the fastest average real GDP growth.

My own estimate (see above) for the United States, is that

every 1 percentage-point increase in G/GDP yields a decrease in the growth rate of about 0.07 percent. That seemingly small effect becomes a huge one when G/GDP rises over a long period of time (as has been the case for more than a century, with no end in sight).

In other words, every 10 percentage-point increase in the ratio of government spending to GDP causes a not-insignificant drop of 0.7 percentage points in the rate of growth. That is somewhat below the estimate quoted above (1.1 percentage points), but surely it is within the range of uncertainty that surrounds the estimate.

Why Are Interest Rates So Low?

A REISSUE (WITHOUT UPDATES) OF THE ORIGINAL POST DATED DECEMBER 7, 2011

Interest rates reflect the supply of and demand for funds. Money is tighter now than it was in the years immediately before the onset of the Great Recession. Tim Congdon explains:

In the three years to October 2008, the quantity of money soared from $10,032 billion to $14,186 billion, with a compound annual growth rate of just over 12 per cent. The money growth rate in this period was the highest since the early 1970s. Indeed, 1972 and 1973 had many similarities to 2006 and 2007, with bubbling asset markets, buoyant consumer spending and incipient inflationary pressures. On the other hand, in the three years from October 2008 the quantity of money was virtually unchanged. (It stood at $14,340 billion in October 2011.) In other words, in the three years of the Great Recession the quantity of money did not increase at all.

But if money is relatively tight, why are interest rates so low? For example, as of October 2011, year-over-year inflation stood at 3.53 percent (derived from CPI-U estimates, available here). In October, Aaa bond yields averaged 3.98 percent, for a real rate of about 0.4 percent; Baa bond yields averaged 5.37 percent, for a real rate of about 1.8 percent; and conventional mortgages averaged 4.07 percent, for a real rate of about 0.5 percent. By contrast, in 1990-2000, when the CPI-U rose at an annual rate of 3.4 percent, real Aaa, Baa, and conventional mortgage rates hovered in the 4-6 percent range. (Real rates are derived from interest rate statistics available here.)

The reason for these (and other) low rates is that borrowers have become less keen about borrowing; that is, they lack confidence about future prospects for income (in the case of households) and returns on investment (in the case of businesses). Why should that be?

If the post-World War II trend is any indication — and I believe that it is — the American economy is sinking into stagnation. Here is the long view:

  • 1790-1861 — annual growth of 4.1 percent — a booming young economy, probably at its freest
  • 1866-1907 — annual growth of 4.3 percent — a robust economy, fueled by (mostly) laissez-faire policies and the concomitant rise of technological innovation and entrepreneurship
  • 1970-2010 — annual growth of 2.8 percent – sagging under the cumulative weight of “progressivism,” New Deal legislation, LBJ’s “Great Society” (with its legacy of the ever-expanding and oppressive welfare/transfer-payment schemes: Medicare, Medicaid, a more generous package of Social Security benefits), and an ever-growing mountain of regulatory restrictions.

(From this post, as updated in this one.)

And here is the post-World War II view:

Annual change in real GDP 1948-2011

This trend cannot be reversed by infusions of “stimulus spending” or “quantitative easing.” It reflects an underlying problem that cannot be cured by those simplistic macroeconomic “fixes.”

The underlying problem is not “tight money,” it is that American businesses are rightly pessimistic about an economic future that is dominated by a mountain of debt (in the form of promised “entitlements”) and by an ever-growing regulatory burden. Thus business investment has been a decline fraction of private-sector GDP:

Non-household GPDI fraction GDP - G
Derived from Bureau of Economic Analysis, Table 1.1.5. Gross Domestic Product (available here). The numerator is gross private domestic investment (GPDI, line 7) less the residential portion (line 12). The denominator is GDP (line 1) less government consumption expenditures and gross investment (line 21).

As long as business remains (rightly) pessimistic about the twin burdens of debt and regulation, the economy will sink deeper into stagnation. The only way to overcome that pessimism is to scale back “entitlements” and regulations, and to do so promptly and drastically.

In sum, the present focus on — and debate about — conventional macroeconomic “fixes” (fiscal vs. monetary policy) is entirely misguided. Today’s economists and policy-makers should consult Hayek, not Keynes or Friedman or their intellectual descendants. If economists and policy-makers would would read and heed Hayek — the Hayek of 1944 onward, in particular — they would understand that our present and future economic morass is entirely political in origin: Failed government policies have led to more failed government policies, which have shackled both the economy and the people.

Economic and political freedoms are indivisible. It will take the repeal of the regulatory-welfare state to restore prosperity and liberty to the land.

The Price of Government, Once More

I was pleased to read a recent post by Mark Perry, “Federal regulations have lowered real GDP growth by 2% per year since 1949 and made America 72% poorer.” It wasn’t the message that pleased me; it was the corroboration of what I have been saying for several years.

Regulation is one of the many counterproductive activities that is financed by government spending. The main economic effect of government spending, aside from regulation, is the deadweight loss it imposes on the economy; that is, it moves resources from productive uses to less productive, unproductive, and counterproductive ones. And then there is taxation (progressive and otherwise), which penalizes success and deters growth-producing investment.

All in all, the price of government is extremely high. But most voters are unaware of the price, and so they continue to elect and support the very “free lunch” politicians who are, in fact, robbing them blind.

Consider, for example, these posts by James Pethokoukis:
Is the Era of Fast U.S. Economic Growth Coming to an End?AEIdeas, July 13, 2013
My Counter: Why U.S. Economic Growth Doesn’t Have to Come to an End,” AEIdeas, August 23, 2012

Pethokoukis’s thesis, with which I agree, is that government — not lack of opportunity — is the main obstacle to the resumption of a high rate of growth.

For much more, see:
The Price of Government
The Price of Government Redux
The Mega-Depression
Ricardian Equivalence Reconsidered
The Real Burden of Government
The Rahn Curve at Work
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
The Stagnation Thesis
America’s Financial Crisis Is Now
Estimating the Rahn Curve: A Sequel
Lay My (Regulatory) Burden Down
More Evidence for the Rahn Curve

 

Taxes Matter

A recent story in The Telegraph (UK) leads with this:

Almost two-thirds of the country’s million-pound earners disappeared from Britain after the introduction of the 50 [percent] top rate of tax, figures have disclosed.

Surprise, surprise!

It happens here, too. For example, the net flow of persons among States (i.e., pattern of inter-State migration) is strongly determined by the relative tax burdens of the States (including taxes imposed by local governments).

The table below gives a hint of the strong relationship between tax burdens and inter-State migration. “In/Out represents the number of residents who moved into a State from another State, divided by the number of residents who moved out of the State to another State. The tax burden represents total State and local taxes levied on residents of a State, divided by income earned by residents of the State. (Sources and methods are discussed in the footnote to this post.)

In-out ratios and tax burdens of States

Green shading indicates States in the top (best) one-third of each distribution; gray shading indicates States in the bottom (worst) one-third. Alaska and the District of Columbia are omitted for reasons discussed in the footnote.  As it turns out, statistical analysis yields two significant determinants of a State’s In/Out ratio:

  • whether it is situated in the “Blue,” heavily unionized, North Central region of the United States, with its relatively high unemployment rate; and
  • the State’s tax burden.

Take California (please). In 2010 alone, the Golden State’s heavy tax burden — 11.2 percent vs. the national average of 9.5 percent — cost it 54,000 residents. And California is not the most repulsive of States (“tax-wise”). That “honor” goes to New York, with a burden of 12.8 percent in 2010 — a burden that cost the Empire State 66,000 residents in that year. Then there is Wisconsin — with only 1/6 the population of California — which lost 33,000 current and prospective residents because it is in the North Central region and has a tax burden of 11.1 percent.

When low In/Out ratios persist for years — as they have in California, New York, and most of the North Central States — the result is a massive reduction in the number of taxpaying citizens and businesses. Persistently low In/Out ratios lead to fiscal death-spirals:

  • Current and prospective residents and businesses are driven away by high taxes and other unfavorable conditions (e.g. unionization).
  • Instead of paring government and taking other steps to make the State more attractive (e.g., playing tough with public-sector unions), taxes are raised on remaining residents and businesses.
  • More residents and business are driven away.
  • Some amount of paring may eventually occur, but taxes remain disproportionately high (and other unfavorable conditions usually persist), so more residents and businesses are driven away.
  • And so on.

Detroit — which lost more than 60 percent of its population between 1950 and 2010 — is a prime example of a jurisdiction in a death-spiral, but it is far from the only one.

But voting with one’s feet, which works on the municipal and State levels, does not work on the national level. And the proponents of Big Government understand that. It is a sad fact that, for most citizens, the cost of fleeing the country for a better place (if one can be found) would far outweigh the additional burden of higher marginal tax rates, higher rates on capital gains, the perpetuation and expansion of “entitlements,” and the ever-growing volume of regulations (which are taxes in a different guise).

What the proponents of Big Government do not understand — or do not care about — is that they are killing the goose that lays the golden eggs. When people cannot reap the hard-won rewards of their labors and their investments, they labor and invest less. The result is slower and slower economic growth, and the imminent Europeannirvana” so devoutly wished by proponents of Big Government.

Related posts:
The Laffer Curve, “Fiscal Responsibility,” and Economic Growth
The Causes of Economic Growth
In the Long Run We Are All Poorer
A Short Course in Economics
Addendum to a Short Course in Economics
The Price of Government
The Price of Government Redux
The Mega-Depression
As Goes Greece
Ricardian Equivalence Reconsidered
The Real Burden of Government
The Illusion of Prosperity and Stability
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
Taxing the Rich
More about Taxing the Rich
America’s Financial Crisis Is Now
A Keynesian Fantasy Land
The Keynesian Fallacy and Regime Uncertainty
Why the “Stimulus” Failed to Stimulate
The “Jobs Speech” That Obama Should Have Given
Say’s Law, Government, and Unemployment
Unemployment and Economic Growth
Regime Uncertainty and the Great Recession
Regulation as Wishful Thinking
The Real Multiplier
Vulgar Keynesianism and Capitalism
Why Are Interest Rates So Low?
The Commandeered Economy
Stocks for the Long Run?
We Owe It to Ourselves
Stocks for the Long Run? (Part II)
Estimating the Rahn Curve: A Sequel
In Defense of the 1%
Bonds for the Long Run?
The Real Multiplier (II)
Lay My (Regulatory) Burden Down
The Burden of Government
Economic Growth Since World War II
More Evidence for the Rahn Curve
The Economy Slogs Along
The Obama Effect: Disguised Unemployment
The Stock Market as a Leading Indicator of GDP
Government in Macroeconomic Perspective
Where We Are, Economically
Keynesianism: Upside-Down Economics in the Collectivist Cause
The Economic Outlook in Brief
Is Taxation Slavery? (yes)

__________
EXPLANATORY NOTE AND REFERENCES:

I began with Census Bureau estimates of State-to-State migrations in 2010. I derived estimates of in- and out-migration for each State and the District of Columbia. The “turnover” rates for Alaska and the District of Columbia proved to be much higher than the rates for the other 49 States. Preliminary analyses of the relationship between In/Out ratio and key variables (e.g., tax burden) confirmed that the inclusion of Alaska and D.C. in the analysis would bias the results, so I dropped those two entities from the analysis.

For the other 49 States, I considered the relationship between In/Out ratio and several variables:

  • population (from the same source as migration statistics);
  • regional effects, represented by dummy variables for Northeast & Mid-Atlantic (CT, DE, ME, MA, NH, NJ, NY, PA, RI, VT); North Central (IL, IN, MI, MN, OH, WI); South & Southeast (AL, AR, FL, GA, KY, LA, MD, MS, MO, NC, OK, SC, TN, TX, VA, WV); Plains & Mountain States (AZ, CO, IA, ID, KS, MT, NE, NV, NM, ND, SD, UT, WY); and West (CA, HI, OR, WA). (The statistical results are unaffected by reasonable variations in assignments — MD and VA to Northeast & Mid-Atlantic, TX to Plains & Mountain States, for example.)

Regressions on various combinations of explanatory variables yielded one statistically significant equation:

In/Out = 1.60 – 0.21NC – 5.58TB

where NC is 1 if a State is in the North Central region (otherwise it is 0), and TB is the State’s tax burden (expressed as a decimal fraction). Each State’s tax burden includes local taxes and taxes imposed on the State’s residents by other States. (A person who lives in New Jersey and works in New York knows that one price of living in New Jersey is the payment of New York’s income taxes.)

The equation and its constant and coefficients are significant at the 1-percent level, and better. The standard error of the estimate is 0.15, against a mean for In/Out of 1.048. The residuals are randomly distributed with respect to the estimated values.)

According to the equation, a North Central State with a tax burden of 10.2 percent (the average for North Central States) would have an In/Out ratio of 0.82; the average for North Central States is 0.83. A State in another region with a tax burden of 9.4 percent (the average for all other States) would have an In/Out ratio of 1.08; the  average for States not in the North Central region is 1.08.

Here is a plot of estimated vs. actual In/Out ratios:

In-out ratios_estimated vs actual

The outliers — States with residuals greater than 1 standard error — are indicated by the green shading (good) and gray shading (bad):

Residuals for estimate of In-out ratio vs Ncent and tax burden

The top 6 States have something extra going for them; the bottom 9 States have something extra going against them. The extras could be an especially hospitable or inhospitable business climate, climatic and/or geographical allure (or lack thereof), cost of living, unemployment well above or below the national average, the political climate (“Blue” to “Red” shifts prevail), or something else. Whatever the case, I am easily persuaded that New York (where I have lived and run a business), Michigan (my home State), California (a well-known basket case), Nevada (ditto), New Jersey (ditto), and West Virginia (with which I am all too familiar) have a lot going against them, even when it is not an excessive tax burden.

The Economic Outlook in Brief

I have elsewhere quantified the connection between government spending and economic growth (e.g., here and here).* I have also shown that stock prices indicate the direction of economic growth. It should not surprise you if I say that

  • the re-election of Obama portends further growth of government spending — specifically, the uncontrolled growth of entitlement spending, as accelerated by Obamacare;
  • the rate of economic growth will continue to decline for as long as entitlements grow as a percentage of GDP; and
  • in anticipation of slower economic growth, stock prices will continue to decline, in real terms.

You can follow the links in the first paragraph if you wish to learn more. Here is a bit of additional evidence for my gloomy outlook. The real value of the S&P Composite Index has fluctuated in trough-to peak-to trough cycles, four of which have been completed since the 1870s:


Derived from Robert Shiller’s data set at http://www.econ.yale.edu/~shiller/data/ie_data.xls.

We are now on the downside of the fifth cycle, which began in July 1982 and peaked in August 2000. If the present cycle follows the pattern of the other two long cycles, it may not bottom out until sometime after 2020  (though it may never end if economic growth continues to decline). And if it does bottom out then, the real value of the S&P composite will have risen only about two-fold from where its value at the start of the cycle in July 1982. In nominal terms, the S&P Composite will have dropped to about half its current level by 2020.

But, as I say, the stock market merely anticipates underlying economic conditions. Those conditions seem destined to worsen because the entitlements mess will not be dealt with for as long as there is gridlock in Washington.

__________
* See also the second graph in this post by James Pethokoukis of the American Enterprise Institute. The graph highlights the inverse relationship between entitlement spending and growth-producing innovation. Entitlement spending diminishes investments in innovation by (a) diverting resources from productive to unproductive uses and (b) penalizing (taxing) productive activities that fund innovation and its implementation.

Related posts:
The Laffer Curve, “Fiscal Responsibility,” and Economic Growth
The Causes of Economic Growth
In the Long Run We Are All Poorer
A Short Course in Economics
Addendum to a Short Course in Economics
The Price of Government
The Price of Government Redux
The Mega-Depression
As Goes Greece
Ricardian Equivalence Reconsidered
The Real Burden of Government
The Illusion of Prosperity and Stability
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
Taxing the Rich
More about Taxing the Rich
America’s Financial Crisis Is Now
A Keynesian Fantasy Land
The Keynesian Fallacy and Regime Uncertainty
Why the “Stimulus” Failed to Stimulate
The “Jobs Speech” That Obama Should Have Given
Say’s Law, Government, and Unemployment
Unemployment and Economic Growth
Regime Uncertainty and the Great Recession
Regulation as Wishful Thinking
The Real Multiplier
Vulgar Keynesianism and Capitalism
Why Are Interest Rates So Low?
The Commandeered Economy
Stocks for the Long Run?
We Owe It to Ourselves
Stocks for the Long Run? (Part II)
Estimating the Rahn Curve: A Sequel
In Defense of the 1%
Bonds for the Long Run?
The Real Multiplier (II)
Lay My (Regulatory) Burden Down
The Burden of Government
Economic Growth Since World War II
More Evidence for the Rahn Curve
The Economy Slogs Along
The Obama Effect: Disguised Unemployment
The Stock Market as a Leading Indicator of GDP
Government in Macroeconomic Perspective
Where We Are, Economically
Keynesianism: Upside-Down Economics in the Collectivist Cause

Where We Are, Economically

UPDATED (10/26/12)

The advance estimate of GDP for the third quarter of 2012 has been released. Real growth continues to slog along at about 2 percent. I have updated the graph, but the text needs no revision.

*  *   *

It occurred to me that the trend line in the second graph of “The Economy Slogs Along” is misleading. It is linear, when it should be curvilinear. Here is a better version:


Derived from the October 26, 2012 release of GDP estimates by the Bureau of Economic Analysis. (Contrary to the position of the National Bureau of Economic Research, there was no recession in 2000-2001. For my definition of a recession, see “Economic Growth Since World War II.”)

The more descriptive regression line underscores the moral of “Obama’s Economic Record in Perspective,” which is this:

The claims by Obama and his retinue about O’s supposed “rescue” of the economy from the abyss of depression are ludicrous. (See, for example, “A Keynesian Fantasy Land,” “The Keynesian Fallacy and Regime Uncertainty,” “Why the “Stimulus” Failed to Stimulate,” “Regime Uncertainty and the Great Recession,” The Real Multiplier,” “The Real Multiplier (II),”The Economy Slogs Along,” and “The Obama Effect: Disguised Unemployment.”) Nevertheless our flannel-mouthed president his sycophants insist that he has done great things for the country, though the only great thing that he could do is to leave it alone.

Obama is not to blame for the Great Recession, but the sluggish recovery is due to his anti-business rhetoric and policies (including Obamacare, among others). All that Obama can rightly take “credit” for is an acceleration of the downward trend of economic growth.

Related posts:
Are We Mortgaging Our Children’s Future?
In the Long Run We Are All Poorer
Mr. Greenspan Doth Protest Too Much
The Price of Government
Fascism and the Future of America
The Indivisibility of Economic and Social Liberty
Rationing and Health Care
The Fed and Business Cycles
The Commandeered Economy
The Perils of Nannyism: The Case of Obamacare
The Price of Government Redux
As Goes Greece
The State of the Union: 2010
The Shape of Things to Come
Ricardian Equivalence Reconsidered
The Real Burden of Government
Toward a Risk-Free Economy
The Rahn Curve at Work
The Illusion of Prosperity and Stability
More about the Perils of Obamacare
Health Care “Reform”: The Short of It
The Mega-Depression
I Want My Country Back
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
The Stagnation Thesis
America’s Financial Crisis Is Now
Understanding Hayek
Money, Credit, and Economic Fluctuations
A Keynesian Fantasy Land
The Keynesian Fallacy and Regime Uncertainty
Why the “Stimulus” Failed to Stimulate
The “Jobs Speech” That Obama Should Have Given
Say’s Law, Government, and Unemployment
Regime Uncertainty and the Great Recession
Regulation as Wishful Thinking
Vulgar Keynesianism and Capitalism
Why Are Interest Rates So Low?
Don’t Just Stand There, “Do Something”
The Commandeered Economy
Stocks for the Long Run?
We Owe It to Ourselves
Stocks for the Long Run? (Part II)
Bonds for the Long Run?
The Real Multiplier (II)
The Burden of Government
Economic Growth Since World War II
More Evidence for the Rahn Curve
The Economy Slogs Along
The Obama Effect: Disguised Unemployment
Obama’s Economic Record in Perspective

The Capitalist Paradox Meets the Interest-Group Paradox

An insightful post at Imlac’s Journal includes this quotation:

Schumpeter argued the economic systems that encourage entrepreneurship and development will eventually produce enough wealth to support large classes of individuals who have no involvement in the wealth-creation process. This generates apathy or even disgust for market institutions, which leads to the gradual takeover of business by bureaucracy, and eventually to full-blown socialism. [Matt McCaffrey, “Entrepreneurs and Investment: Past, Present, … Future?,” International Business Times, December 9, 2011]

This, of course, is the capitalist paradox, of which the author of Imlac’s Journal writes. He concludes with these observations:

[U]nder statist regimes, people’s choices are limited or predetermined. This may, in theory, obviate certain evils. But as McCaffrey points out, “the regime uncertainty” of onerous and ever changing regulations imposed on entrepreneurs is, ironically, much worse than the uncertainties of the normal market, to which individuals can respond more rapidly and flexibly when unhampered by unnecessary governmental intervention.

The capitalist paradox is made possible by the “comfort factor” invoked by Schumpeter. (See this, for example.) It is of a kind with the foolishness of extreme libertarians who decry defense spending and America’s “too high” rate of incarceration, when it is such things that keep them free to utter their foolishness.

The capitalist paradox also arises from the inability and unwillingness of politicians and voters to see beyond the superficial aspects of legislation and regulation. In Bastiat‘s words,

a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

The unseen effects — the theft of Americans’ liberty and prosperity — had been foreseen by some (e.g., Tocqueville and Hayek). But their wise words have been overwhelmed by ignorance and power-lust. The masses and their masters are willfully blind and deaf to the dire consequences of the capitalist paradox because of what I have called the interest-group paradox:

The interest-group paradox is a paradox of mass action….

Pork-barrel legislation exemplifies the interest-group paradox in action, though the paradox encompasses much more than pork-barrel legislation. There are myriad government programs that — like pork-barrel projects — are intended to favor particular classes of individuals. Here is a minute sample:

  • Social Security, Medicare, and Medicaid, for the benefit of the elderly (including the indigent elderly)
  • Tax credits and deductions, for the benefit of low-income families, charitable and other non-profit institutions, and home buyers (with mortgages)
  • Progressive income-tax rates, for the benefit of persons in the mid-to-low income brackets
  • Subsidies for various kinds of “essential” or “distressed” industries, such as agriculture and automobile manufacturing
  • Import quotas, tariffs, and other restrictions on trade, for the benefit of particular industries and/or labor unions
  • Pro-union laws (in many States), for the benefit of unions and unionized workers
  • Non-smoking ordinances, for the benefit of bar and restaurant employees and non-smoking patrons.

What do each of these examples have in common? Answer: Each comes with costs. There are direct costs (e.g., higher taxes for some persons, higher prices for imported goods), which the intended beneficiaries and their proponents hope to impose on non-beneficiaries. Just as importantly, there are indirect costs of various kinds (e.g., disincentives to work and save, disincentives to make investments that spur economic growth). (Exercise for the reader: Describe the indirect costs of each of the examples listed above.)

You may believe that a particular program is worth what it costs — given that you probably have little idea of its direct costs and no idea of its indirect costs. The problem is millions of your fellow Americans believe the same thing about each of their favorite programs. Because there are thousands of government programs (federal, State, and local), each intended to help a particular class of citizens at the expense of others, the net result is that almost no one in this fair land enjoys a “free lunch.” Even the relatively few persons who might seem to have obtained a “free lunch” — homeless persons taking advantage of a government-provided shelter — often are victims of the “free lunch” syndrome. Some homeless persons may be homeless because they have lost their jobs and can’t afford to own or rent housing. But they may have lost their jobs because of pro-union laws, minimum-wage laws, or progressive tax rates (which caused “the rich” to create fewer jobs through business start-ups and expansions).

The paradox that arises from the “free lunch” syndrome is…. like the paradox of panic, in that there is a  crowd of interest groups rushing toward a goal — a “pot of gold” — and (figuratively) crushing each other in the attempt to snatch the pot of gold before another group is able to grasp it. The gold that any group happens to snatch is a kind of fool’s gold: It passes from one fool to another in a game of beggar-thy-neighbor, and as it passes much of it falls into the maw of bureaucracy.

[The interest-group paradox] has dominated American politics since the advent of “progressivism” in the late 1800s. Today, most Americans are either “progressives” (whatever they may call themselves) or victims of “progressivism.” All too often they are both.

Related posts:
Democracy and Liberty
The Interest-Group Paradox
Is Statism Inevitable?
Inventing “Liberalism”
The Price of Government
Fascism and the Future of America
The Indivisibility of Economic and Social Liberty
Law and Liberty
The Devolution of American Politics from Wisdom to Opportunism
The Price of Government Redux
The Near-Victory of Communism
The Mega-Depression
Tocqueville’s Prescience
Accountants of the Soul
Ricardian Equivalence Reconsidered
The Real Burden of Government
Rawls Meets Bentham
Is Liberty Possible?
The Left
The Divine Right of the Majority
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
Our Enemy, the State
Understanding Hayek
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
The Stagnation Thesis
America’s Financial Crisis Is Now
Utilitarianism and Psychopathy
Estimating the Rahn Curve: A Sequel
Lay My (Regulatory) Burden Down
The Burden of Government
Economic Growth Since World War II
More Evidence for the Rahn Curve
Obamacare, Slopes, Ratchets, and the Death-Spiral of Liberty

Economic Growth Since World War II

As we await (probably in vain) the resumption of robust economic growth, let us see what we can learn from the record since World War II (from 1947, to be precise). The  Bureau of Economic Analysis (BEA) provides  in spreadsheet form (here) quarterly and annual estimates of current- and constant-dollar (year 2005) GDP from 1947 to the present. BEA’s numbers yield several insights about the course of economic growth in the U.S.

I begin with this graph:

The exponential trend line indicates a constant-dollar (real) growth rate for the entire period of 0.81 percent quarterly, or 3.3 percent annually. The actual beginning-to-end annual growth rate is 3.2 percent.

The red bands parallel to the trend line delineate the 99.7% (3-sigma) confidence interval around the trend. GDP has been running at the lower edge of the confidence interval since the first quarter of 2009, that is, since the ascendancy of Barack Obama.

The vertical gray bars represent recessions, which do not correspond precisely to the periods defined as such by the National Bureau of Economic Research (NBER). I define a recession as:

  • two or more consecutive quarters in which real GDP (annualized) is below real GDP (annualized) for an earlier quarter, during which
  • the annual (year-over-year) change in real GDP is negative, in at least one quarter.

For example:

Annualized real GDP in the second quarter of 1953 was $2,366.2 billion (i.e., about $2.4 trillion in year 2005 dollars). Annualized GDP for the next  five quarters: $2,358.1, $2,314.6, $2,303.5, $2,306.4, and $2,332.4 billion, respectively. The U.S. was still in recession (by my definition) even as GDP began to rise from $2,303.5 billion because GDP remained below $2,366.2 billion. The recession (i.e., drop in output) did not end until the fourth quarter of 1954, when annualized GDP reached $2,379.1 billion, thus surpassing the value for the second quarter of 1953. Moreover, the year-over-year change in GDP was negative in the first three quarters of the recession.

Unlike the NBER, I do not locate a recession in 2001. Real GDP, measured quarterly, dropped in the first and third quarters of 2001, but each decline lasted only a quarter. But, whereas the NBER places the Great Recession from December 2007 to June 2009, I date it from the first quarter of 2008 through the third quarter of 2011 (at least).

My method of identifying a recession is more objective and consistent than the NBER’s method, which one economist describes as “The NBER will know it when it sees it.” Moreover, unlike the NBER, I would not presume to pinpoint the first and last months of a recession, given the volatility of GDP estimates:

This graph suggests three things: (1) the uncertainty of quarterly estimates, (2) a declining rate of growth since 1947, and (3) some degree of periodicity in economic growth.

The periodicity, though irregular, can be seen more clearly in the following graph, where the vertical gray bars indicate quarters in which growth is below the declining trend line shown in the preceding graph.

The two preceding graphs lead to two observations:

The following statistics underscore the first point:

Inter-recessionary period Annual  growth rate
1947q4 – 1948q4 4.6%
1950q1 – 1953q2 7.5%
1954q4 – 1957q3 3.9%
1958q4 – 1960q1 3.7%
1961q2 – 1969q3 5.1%
1970q3 – 1973q4 4.4%
1975q4 – 1980q1 4.2%
1981q1 – 1981q3 3.3%
1983q2 – 1990q3 4.2%
1991q4 – 2007q4 3.1%

To put a point on it, here are the rates of growth during the three longest periods of above-trend growth since World War II:

  • 1963q1 – 1966q1 — 6.6%
  • 1983q1 – 1986q1 — 5.1%
  • 1995q3 – 1999q4 — 4.5%

It is hard to deny the almost-constant deceleration of growth in the post-war era — especially the sharper deceleration after 1970 — a deceleration that is embedded in the longer downward trend that began in the early 1900s.

In this connection, I note that the “Clinton boom“ — 3.4 percent real growth from 1993 to 2001 — was nothing to write home about, being mainly the product of Clinton’s self-promotion and the average citizen’s ahistorical (if not anti-historical) perspective. The boomlet of the 1990s, whatever its causes, was less impressive than several earlier post-war expansions. In fact, the overall rate of growth from the first quarter of 1947 to the first quarter of 1993 — recessions and all — was 3.4 percent.

What about the lingering Great Recession? It lingers mainly because it has been used — first by Bush, then by Obama — as an excuse for eve more disastrous expansions of the cost and reach of government.

Related posts:
Are We Mortgaging Our Children’s Future?
In the Long Run We Are All Poorer
Mr. Greenspan Doth Protest Too Much
The Price of Government
Fascism and the Future of America
The Indivisibility of Economic and Social Liberty
Rationing and Health Care
The Fed and Business Cycles
The Commandeered Economy
The Perils of Nannyism: The Case of Obamacare
The Price of Government Redux
As Goes Greece
The State of the Union: 2010
The Shape of Things to Come
Ricardian Equivalence Reconsidered
The Real Burden of Government
Toward a Risk-Free Economy
The Rahn Curve at Work
The Illusion of Prosperity and Stability
More about the Perils of Obamacare
Health Care “Reform”: The Short of It
The Mega-Depression
I Want My Country Back
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
The Stagnation Thesis
America’s Financial Crisis Is Now
Understanding Hayek
Money, Credit, and Economic Fluctuations
A Keynesian Fantasy Land
The Keynesian Fallacy and Regime Uncertainty
Why the “Stimulus” Failed to Stimulate
The “Jobs Speech” That Obama Should Have Given
Say’s Law, Government, and Unemployment
Regime Uncertainty and the Great Recession
Regulation as Wishful Thinking
Vulgar Keynesianism and Capitalism
Why Are Interest Rates So Low?
Don’t Just Stand There, “Do Something”
The Commandeered Economy
Stocks for the Long Run?
We Owe It to Ourselves
Stocks for the Long Run? (Part II)
Bonds for the Long Run?
The Real Multiplier (II)
The Burden of Government

Higher Taxes, Higher Government Spending, Slower Economic Growth

J.D. Foster and Curtis Dubay, writing at The Foundry (“Of Course Higher Taxes Slow Growth — A Response to Diamond and Saez“), make mincemeat of Peter Diamond and Emmanuel Saez’s arguments for higher taxes on “the rich.” Implicit in Foster and Dubay’s takedown of Diamond and Saez is the demonstrably strong (and negative relationship) between government spending and economic growth.

Spending is funded by taxes, after all. And even when spending is funded by borrowing it amounts to a tax on the productive sectors of the economy. How is that? When government sell bonds to the public it redirects money from productive uses in the private sector to unproductive and counter-productive uses in the so-called public sector (i.e., government). The thievery is no less destructive — but more apparent — when the Fed creates money out of thin air to finance government spending.

So, the focus should be on spending, for which taxation is a proxy. The effect of government spending on economic growth is nothing less than disastrous. I have treated the subject at length in “Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth.” Here is another version of the final graph in that post:

The bottom line is that for every 10 percentage points by which government spending rises, the rate of growth declines by 0.7 percentage points. If you think that 0.7 percent is negligible, try compounding it over a lifespan of 80 years. In that time, a sustained 10 percent rise in government spending will reduce the average person’s real income by more than 40 percent.

That, my friends, is soak-the-rich Obamanomics at work. Apologists for Obamanomics, like Diamond and Saez, should be ashamed of themselves for abetting economically destructive demagoguery.

Related posts:
The Causes of Economic Growth
A Short Course in Economics
Addendum to a Short Course in Economics
Enough of “Social Welfare”
The Case of the Purblind Economist
Economic Growth since WWII
The Price of Government
Does the Minimum Wage Increase Unemployment?
The Price of Government Redux
The Mega-Depression
The Real Burden of Government
Toward a Risk-Free Economy
The Rahn Curve at Work
The Illusion of Prosperity and Stability
Society and the State
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
Undermining the Free Society
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
Build It and They Will Pay
Government vs. Community
The Stagnation Thesis
Government Failure: An Example
Taxing the Rich
More about Taxing the Rich
Voluntary Taxation
Money, Credit, and Economic Fluctuations
A Keynesian Fantasy Land
“Tax Expenditures” Are Not Expenditures
The Keynesian Fallacy and Regime Uncertainty
Why the “Stimulus” Failed to Stimulate
The “Jobs Speech” That Obama Should Have Given
Regime Uncertainty and the Great Recession
The Real Multiplier
Vulgar Keynesianism and Capitalism
Why Are Interest Rates So Low?
Don’t Just Stand There, “Do Something”
Economic Growth Since World War II
The Commandeered Economy
We Owe It to Ourselves
In Defense of the 1%
The Real Multiplier (II)

Stocks for the Long Run? (Part II)

In “Stocks for the Long Run?” I say that

unless the course of the regulatory-welfare state is reversed, a prolonged downward shift in the real rate of GDP growth is in the works — probably to about 2 percent. At that rate, expect a continuation of the present trend [since 2000] — stock-price “growth” [adjusted for inflation] of about -4 percent a year.

Be sure to note the minus sign in front of the 4.

Stocks are not bound to rise predictably over time, despite graphs like the next one, which I constructed from the data set cited in “Stocks for the Long Run?”. “Price” (the blue line) traces the real growth in the value of S&P Composite Index; “price + dividends” (the orange line) traces real growth in the value of the S&P Composite Index plus dividends paid on the stocks comprised in the index; “dividends reinvested” (the green line) traces the real value of the S&P Composite Index if dividends had been reinvested in shares of the stocks comprised in the index (green line):

From 1871 through 2010, the average annual increase in the value of the S&P Composite, with dividends reinvested, was 6.7 percent. This kind of hypothetical long-term “return” is cited often as a reason for buying and holding stocks. But a real return of 6.7 percent is not graven in stone, as the following chart indicates.

After a period of decline in the early 1900s, the cumulative rate of return on the S&P Composite, with dividends reinvested, dropped to 5.3 percent in 1920, jumped to 8.3 percent in 1929, plummeted to 5.4 percent in 1932, returned to 7.6 percent in 1966, dipped to 6.2 percent in 1982, climbed back to 7.4 percent in 2000, and (as noted above) dropped to 6.7 percent by the end of 2010. In other words, long-run averages can be moved considerably by short run bouts of what I call “irrational exuberance and rational pessimism.”

Moreover, as a practical matter, the buy-hold-reinvest strategy would not work if there were a massive influx of stock-buyers intent on buying, holding, and reinvesting dividends. They would be chasing illusory returns because massive purchases of stocks would not be rewarded (quickly, at least) by proportionate increases in corporate earnings, which is the main driver of stock prices in the long run. The more likely result would be a bubble — like those of the late 1920s and late 1990s — which would burst, leading to lower stock prices and a greater reluctance to invest in stocks.

More realistic measures of expected returns from buying and holding stocks are depicted by the “price” and “price + dividends” lines. At the end of 2010, the average annual real return on the S&P Composite Index since 1871 was 2 percent. With dividends, the average annual real return was 2.3 percent. But almost no one — not even an institutional investor — is likely to hold stocks in the S&P Composite Index for 140 years.

It makes sense, therefore, to consider shorter holding periods: 10, 20, and 30 years.

If history is any guide, consistently positive real returns on stocks are available only to the relatively rare investor who adheres doggedly to the buy-hold-reinvest strategy for 20 years or longer.

But history is not a reliable guide because — unless the course of the regulatory-welfare state is reversed — the rate of GDP growth will continue to fall, and stock prices are likely to fall in sympathy.

Related posts:
The Price of Government
The Price of Government Redux
The Mega-Depression
As Goes Greece
The Real Burden of Government
The Illusion of Prosperity and Stability
The “Forthcoming Financial Collapse”
Estimating the Rahn Curve: Or, How Government Inhibits Economic Growth
The Deficit Commission’s Deficit of Understanding
The Bowles-Simpson Report
The Bowles-Simpson Band-Aid
The Stagnation Thesis
America’s Financial Crisis Is Now
Why Are Interest Rates So Low?
Economic Growth Since World War II
The Commandeered Economy
Stocks for the Long Run?