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Tax Rebates: Old Wine in Old Skins

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Tags Booms and BustsTaxes and SpendingMonetary Theory

01/25/2008Wolfgang Grassl

Here they go again. According to the news, the federal government intends to sprinkle $145 billion piecemeal among taxpayers in order to "fight recession." The details of tax rebates are still to be worked out, particularly who exactly should benefit from the public largesse. But regardless, it is the principle that is rotten, and for reasons of economic logic.

The main culprit of the recession — whether already officially declared or not — is the policy of monetary expansion that has been practiced for the better part of the past two decades. Low interest rates set by the Federal Reserve translated into monetary injections into the banking system, which in turn pressed them onto consumers in the form of cheap credit. For many years, American households and businesses have been inundated with credit offers that neither reflected the true cost of money on international markets nor individual creditworthiness or the expected profitability of projects. It has all led to a severe distortion of economic calculation by consumers and businesses alike.

If credit no longer reflects the true scarcity price of loanable funds, consumers will shuffle balances from one credit card to the next, and ultimately take out equity-backed lines of credit, until all equity they may once have held is consumed, and businesses will use supplier credit and ever more sophisticated financial instruments until they must face the unavoidable and declare bankruptcy.

At the level of the economy at large, this activates the cycles of booms and busts that Austrian economists have analyzed so perceptively. The consumer price index rose 4.1 percent in 2007, compared with a 2.5 percent increase in 2006. The Bureau of Labor Statistics reported (1/16/2008) that, discounted for rising prices, the wages of American workers fell 0.9 percent between December 2006 and December 2007. And stock market indexes have been sagging for weeks, not even to mention depressed values of real estate.

Just as the effects of credit expansion were predictable, it can be said with almost equal certainty that the proposed cure will be ineffective at best and pernicious at worst. Fighting easy money with even more of it? This has been done before in many countries, and always with the same effects. It was last practiced in the United States in 2001. Based on all historical evidence (and supported by simple economic logic) one may expect that opening the Keynesian toolbox will lead to even greater disaster, and for the following reasons:

First, about 70 percent of economic growth over the past years was a result of consumption. Now that consumption is slowing down — with lower retail expenditure during the Christmas season and dropping charges to credit cards — a tax rebate will again fan consumption. It will not do a thing to increase savings, from which future investments can be made. We all know by now that the way out of a recession is through the building of capital goods, not through the temporary fattening up of American retailers and Chinese manufacturers.

Second, government can finance its largesse only by either raising taxes — if for political reasons not now, then in future years — or by borrowing even more. Already today, total public debt amounts to over $9 trillion, or two thirds of annual GDP. About 44 percent of it is owed to foreign entities. It will have to be paid back — whether through years of lower consumption, or domestic inflation, or a reduction in the external value of the dollar.

Third, spending oneself out of a recession never works. Consider only the case of Japan, where the central bank engaged in no fewer than ten stimulus programs over the 1990s that totaled over 100 trillion yen — with economic growth being as paltry as it was before.

All this would counsel government not to sprinkle $145 billion piecemeal among taxpayers, even if rebates are added for businesses. It reinforces the exact mentality of a happy-go-lucky spending behavior that is the proximate if not final cause of artificial booms.

Now the economy must work itself out — through the reduced expenditure paths of millions of households, the sale of assets to reduce debt, the resizing or closing of firms, and the reduction of government programs, until such time as savings can again be built, new waves of investment can start, and product innovation leads to export revenue.

Making consumers and businesses appreciate the real value of assets is the way out. There are no shortcuts, only placebos. But realizing this seems to require more than can today be expected of any government — with a "conservative" label or any other.

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