Can state spending ever be cut?

Mar 16, 2017·Alasdair Macleod

President Trump was elected on several promises, including one that he would fund tax cuts by cutting public spending. Cynics might note that his first action was to increase spending on the military by $54bn, the equivalent of six Polish armies.

This is not a good start. Trump is hailed, in some quarters, as a latter-day Reagan, a Republican president who understood the impotence of the state, and how it is a burden on free enterprise. This is not a good precedent either.

Taxes and deficits increased under Reagan. As Murray Rothbard put it in a 1988 retrospective on Reagan’s years in the White House:

“In the first place, the famous tax cut of 1981 did not cut taxes at all. It’s true that tax rates for higher income tax brackets were cut; but for the average person, taxes rose, rather than declined. The reason was that, on the whole, the cut in income tax rates was more than offset by two forms of tax increase. One was ‘bracket creep,’ a term for inflation quietly but effectively raising one into higher tax brackets, so that you pay more and proportionately higher taxes even though the tax rate schedule has officially remained the same. The second source of higher taxes was Social Security taxation, which kept increasing, and which helped taxes go up overall.”

And in all the Reagan years that followed, taxes collected increased. Furthermore, the IRS raised fees, plugged loopholes and chased those suspected of dodging taxes. These increases did not even close the budget deficit, which averaged over the eight years of his tenure 4.2% of GDP annually. So much for Reagan’s promise to reduce the statei.

The reality all incoming presidents face is that the state is a parasitical entity separate from the electoral host upon which it feeds. And don’t the senior permanent staff know it. They are immensely skilled at protecting their budgets, and can easily arrange for adverse consequences for any president who dares to cut them. On defence, the US already outspends the next largest ten nations combined, including China and Russia, and six of America’s allies. There is a far more sensible case to be made for cutting spending on defence as Trump originally proposed, not raising it by $54bn. Until, that is, you talk to the permanent staff in the military.

The Rothbard quote above is also apt for the UK today, in the context of last week’s budget. Philip Hammond, the Chancellor, announced a minor rise in social security taxes on self-employed tradesmen, on the grounds of “fairness”. He was clearly breaking the Conservative’s election manifesto, that tax rates, including social security, would not be increased. Here is a case where an elected politician is more motivated by the arguments of his permanent staff, than of his commitments to the electorate, to which clear promises were made. Only a full-scale back-bench rebellion by Tory MPs forced Hammond to back down.

Part of all governments’ problem is that inflation, which Rothbard described as bracket-creep, is not making up tax numbers. High-spending establishments are resorting to all means of increasing taxes, despite their political masters’ clear electoral promises not to raise taxes. Never, ever, is government spending cut in aggregate to balance the national books.

Therefore, government spending, particularly in the welfare states, is always on the increase. Even in the Thatcher years, it grew from £85.2bn to £201bn, despite large swathes of loss-making nationalised industries being privatised. And Margaret Thatcher was an avowed admirer of Hayek. Conservatives, who laud her memory, have today abandoned all pretence that public spending should be reduced, and even pillory taxpayers who use legitimate tax planning to lessen the state’s tax depredations.

The Keynesian concept behind state intervention in the economy, that at this stage of the cycle government finances should be in surplus, no longer happens. The imperative has drifted from attempting to manage the economic cycle into the need to raise ever-larger funds from the tax-paying public, by any means overt and covert. And if extra taxes are resisted, governments either borrow, diverting capital from the productive private sector, or cause money to be printed in the form of bank credit, thereby debasing everyone’s cash and bank deposits. It is lose-lose for private sector actors.

Just imagine how high the deficit will be when the credit cycle turns again, which it will as surely as night follows day. Note how in the wake of the Lehman crisis, public spending accelerated in all welfare-driven states, while these states did the one thing they know best: spend the private sector’s money, at a time when the private sector needs it most.

It is not surprising this parasitic behaviour leaves private sector actors still struggling to create genuine wealth, other than through speculation, fully eight years after the last financial crisis. In the past, there was a well-defined credit-driven cycle of boom and bust. Far from devising monetary policies to discourage this repetition, centrals banks encouraged the commercial banks to create extra credit to fuel it even more. By preventing the creative destruction that is part and parcel of a bust (Schumpeter’s apt description), mass unemployment is deferred. Instead, uncompetitive businesses are nursed into a zombie-survival mode, becoming a brake on everyone’s economic progress. But at least the state has saved its own spending on unemployment benefits, and it continues to gather taxes from those it has ensured remain employed.

The cyclical accumulation of private sector debt never washes out of the system, and instead its progressive build-up leads to a credit super-cycle, where an accumulation of malinvestments spans several credit cycles. The two super-cycles we can identify since the Fed was established peaked in 1929 and in the late 1970s, admittedly with very different characteristics. Subsequent credit-cycle crises become progressively greater threats to the systemic survival of the financial system. Who can forget the heart-stopping moments after Lehman went bust, and prices collapsed, before the largest blank cheque ever written, estimated to be up to $13 trillion, paid for through monetary debasement, was offered by the Fed to the banks? And how bad will it be this time round, with all the extra unproductive debt incurred since 2008?

When the next credit collapse happens, we can be certain it will be on an even greater scale. Private sector debt in America and elsewhere has become so large and dangerous that sparking the credit collapse might not need a rise in interest rates. The credit cycle is showing signs of having become so monstrous that it could happen with just the passage of time alone.

Very few people understand the dynamics of a credit cycle, because they are conditioned to believe it is a business cycle that can be corrected by the judicious application of credit. Keynes, who is the economic god for all state-employed economists, got this horribly wrong. So did the monetarists, who trustingly believed the central banks only had to modify their monetary policies. You do not address a credit cycle by interest rate management and the application of yet more credit, no more than you give an arsonist another box of matches.

It is a situation of great frustration for the silent majority, the deplorables in Hillary Clinton’s words, those who remain silent until election time. But for the deplorables to get what they voted for is proving impossible, because it is a direct challenge to the state itself. We see this is the daily struggles between the US state and the newly-elected president. We see the myth, that the president commands the state, being disproved. The deep state, the intelligence agencies whose advice presidents have accepted without question, is winning key battles against President Trump. Putin is successfully demonised again, a new force is dispatched against ISIS (originally created by America’s allies with its tacit approval), and now an extra $54bn is going to be spent on the armed forces.

The most important battle between the state and the president unfolds from this week. The US Treasury has run out of money. Does the President attempt to curtail the state, as he promised his deplorables, or does he ditch his supporters in favour of higher debt limits, higher taxation, or both? The battle lines are set; the president’s position is being challenged not only by the deep state, but now by his Treasury department as well.

The consequences for financial markets are potentially alarming. Market valuations are justified on the assumption that Trump knows what he is doing and has a good chance of succeeding. If Trump fails to deliver on taxes and public spending, overvalued equity markets will be vulnerable to money being sucked out of Wall Street. Not only will companies continue to need to finance their malinvestments with escalating levels of debt, but a persistent and growing government deficit, in the absence of higher taxes, will require an increase in Treasury bond issuance. Add to these capital flows draining financial markets the need for the Fed to raise interest rates as price inflation accelerates, and all the ingredients for a sharp reversal in bond markets are in place.

And that is the likely outcome. The question posed in the title of this article, can state spending ever be cut, is answered with an emphatic no, not this side of a state bankruptcy. The deplorables are nowhere near understanding these dynamics, nor for that matter it appears is their appointee, President Trump. Nor, equally worryingly, does the Fed, which persists in the erroneous belief it is managing a business cycle. So what could possibly go right?

i See Why American History is not what they say: An Introduction to Revisionism by Jeff Riggenbach pp167.


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