The Lesson We Never Seem to Learn

A good part of our current economic doldrums stems from the lesson that we seem never able to learn, until it is too late. And then, having ruefully learned the lesson at great cost, each generation fails to pass it on to the next, which is then doomed to have to learn it at great cost all over again.

This lesson is not arcane, or abstruse, or difficult to grasp in any way. In fact, I can state it in just nine words:

The more government grows, the worse the economy becomes.

The latest discovery of this truth is announced in a wide-ranging study of 108 countries over the years 1970-2008 conducted by the very geniuses who brought to you the most humongous central government bureaucracy the world has seen to date: the Europeans ( in particular, the staff of the European Central Bank, in Frankfurt, Germany). To save you the trouble of plowing through all their mathematical jargon, here is a choice excerpt from the report's conclusion:

This paper adds to the literature in providing evidence on the issue of whether “too much” government is good or bad for economic progress and macroeconomic performance, particularly when associated with differentiated levels of (underlying) institutional quality and alternative political regimes. . . .

Our results allow us to draw several conclusions regarding the effects on economic growth of the size of the government: i) there is a significant negative effect of the size of government on growth . . . iii) government consumption is consistently detrimental to output growth irrespective of the country sample considered (OECD, emerging and developing countries) . . . .

One does not need all the fancy technical jargon and applied mathematics to understand why the Eurocrats found what they found. Common sense tells us that because government produces no economic goods on its own, but instead derives its ability to function entirely by pulling money from the rest of the country's economy, there has to be a limit on its size for that economy still to be able to grow while supporting the government.

Too little government, of course, results in anarchy and the law of "might makes right" -- not a conducive atmosphere for economic investment and growth. Just as certainly, however, too much government diverts too many resources from the productive economy, and so stifles growth. This relationship between the level of government and the corresponding level of economic activity is expressed in what is called the Rahn curve.

As I say, this is not a difficult lesson to grasp. So why do we have to keep on learning it again and again, over and over, with each new generation? Our grandparents learned it under the Presidents from Harding to Franklin D. Roosevelt; our parents learned it under the Presidents from Eisenhower to Nixon, and now we are learning it under the Presidents from Reagan to Obama.

The cycle starts when a President takes office who reduces government spending and/or cuts taxes from what has gone before. The economy springs to life, and the country enjoys prosperity. But government also thrives on prosperity, and politicians cannot keep from using the increased revenues to institute new social and economic programs, which soon burgeon into more and more government. This continues until the sheer size of government begins to take its toll on the economy, which fades into a recession, and eventually, if the destructive growth of government is not halted, a depression.

In a depression, the government allocates most of the resources, because there is no investment due to the uncertain future, and no savings, since there are few jobs and everyone needs cash. By stepping in to provide handouts and public (non-productive) jobs, government actually hinders the functioning of the markets, and distorts economic reality. It also destroys individual incentive, since who needs to find work when one can simply cash an unemployment check instead?

The modern American welfare state came into full flower with the so-called "New Deal." But it is a myth to think that the welfare state originated with Franklin D. Roosevelt -- it actually started in Europe, in Bismarck's Germany, before it came to America via President Woodrow Wilson and his energetic young social engineer, by the name of Herbert Hoover. The latter learned how to organize massive deliveries of food and essentials, first to war victims, then to Belgians, Central Europeans, and Bolsheviks. At first the relief was private and humanitarian, but Wilson appointed Hoover the head of the U. S. Food Administration, and the bureaucratization of welfare soon followed.

Later, during his own term as President, Hoover tried to employ the same massive means to alleviate the sufferings of the jobless, at the outset of the Great Depression. FDR simply took up Hoover's policies where the latter left off. Take a few minutes to watch the following video, which lays out the actual statistics -- and please pay special attention to the numbers during the administration of President Harding (1921-1923), who succeeded President Wilson, toward the end:

In the video, there is a quote from FDR's Secretary of the Treasury, Henry Morgenthau, which could just as easily today have come from Secretary Geithner, or earlier from Secretary Paulsen:

We have tried spending money. We are spending more than we have ever spent before and it does not work. . . . We have never made good on our promises [on employment]. . . I say after eight years of this Administration we have just as much unemployment as when we started . . . and an enormous debt to boot!

The difficulty is that as the cycle repeats itself in each new generation, the welfare state becomes larger with each iteration, and becomes harder and harder to eliminate, even in times of prosperity. This phenomenon is partly tied to our ever-increasing population with each new generation; there are more and more people who become welfare state beneficiaries (or, in less charitable language, who "go on the dole").

FDR's Social Security is still with us, and in the seventy-odd years since its inauguration has mutated from a system in which there was one beneficiary for every 160 workers (a ratio of 159.4 to 1, in 1940) to one in which the ratio has now, for the first time ever, gone to less than three to one in 2010. The decreasing ratio, of course, is unsustainable -- because the percentage of pay withheld from each current worker is inadequate, even at a three-to-one ratio, to provide benefits for just one retiree. As the current Baby Boomer generation reaches retirement age, the ratio will drop even more. The system will eventually face bankruptcy unless people are required to work longer before receiving benefits, or workers pay still more in payroll taxes, or have their retirement benefits reduced, or some combination of all three is put into place.

Even if the system can be "fixed" before it goes bankrupt, however, one has to ask: what is the point of a scheme which forces current workers to support retired ones, in the expectation that when they retire, the people working then will support them? What does such a scheme do to individual incentives to save for retirement? A welfare state simply gets people hooked on more and more welfare, as is graphically illustrated by these two drawings (click each to enlarge):

As economist Robert J. Samuelson points out, the welfare state as a phenomenon of the late nineteenth and the full twentieth century is now facing its inevitable end, due to the impossibility of a government's supporting many more people than those who pay the taxes that support the government. He writes:

To flourish, the welfare state requires favorable economics and demographics: rapid economic growth to pay for social benefits; and young populations to support the old. Both economics and demographics have moved adversely. . . .

The modern welfare state has reached a historic reckoning. As a political institution, it hasn't adapted to change. Politics and economics are at loggerheads. Vast populations in Europe and America expect promised benefits and, understandably, resent any hint that they will be cut. Elected politicians respond accordingly.

But the resulting inertia poses an economic threat, one already realized in Europe. As deficits or taxes rise, the risk is that economic instability will increase, growth will fall, or both. Paying promised benefits becomes harder. Or austerity becomes unavoidable.

The paradox is that the welfare state, designed to improve security and dampen social conflict, now looms as an engine for insecurity, conflict and disappointment.

As I said at the outset, this is not rocket science, but common sense. It is also something that was once ingrained in our national character, when citizens instinctively saw something wrong with government taking on the role of rescuer of last resort. Indeed, as long ago as the 1880's, President Grover Cleveland summed up the national resistance to government-provided aid by pointing out that it was a slippery slope, and difficult to place limits upon once the practice became routine. Vetoing a Congressional bill to provide financial relief to drought-stricken Texas farmers, he asked the simple rhetorical question: "If the Government supports the people, who will support the Government?"

Lately, it has become common to point out the sins of conservative presidents, such as Ronald Reagan and George W. Bush, whose administrations saw huge increases in government debt and spending even as they lowered tax rates to generate more economic activity in the private sector. This was the welfare state continuing its incessant encroachment on individual incentives, with the public sector expanding steadily along with the economy. The recipe worked for a time, during prosperity; but in a recession or depression, the choke of the welfare state becomes a veritable death grip. And under President Obama, look how rapidly the numbers have deteriorated.

The cure for this cancer is not a mystery. After the Wilson administration ended in paralysis and failure, as noted in the video above (with the Gross National Product plunging 24%, from $91.5 billion in 1920 to $69.6 billion in 1921), a President with a solid middle-class upbringing, and small-town values (but unfortunately all too trusting of his friends and allies), turned the economy around by the simple tack of reducing government's slice of the economy. Warren Harding cut federal spending from $6.3 billion in 1920 to $3.2 billion by 1922. Taxes were reduced, and the number of unemployed was cut by more than half.

But that was just the beginning. On Harding's sudden death from a heart attack in 1923, Calvin Coolidge succeeded him, and his policies led to the "roaring Twenties." His budget going out of office was smaller than Harding's, even though the country had grown considerably in the meantime. He cut tax rates five times, and his eye on spending was just as sharp with his own White House budget as it was with the country's. The economy boomed, the stock market soared -- and then came Black Tuesday in October 1929.

The stock market crash, however, was not Coolidge's fault. If any fault is to be assigned to the government, it would have to be placed upon the newly created Federal Reserve Bank, which failed to curb leveraged speculation as the market boomed, and then withheld any cash infusion to the banking system after the crash itself. Eventually this led to widespread failures, and an ensuing panic as people tried to pull all their money out of banks at once. By then FDR was in charge, and he unfortunately did not have Coolidge's sense of thrift and limited government.

The rest is history. We are once more at a great crossroads. Whether this nation can wean itself from the welfare spigot of Franklin Roosevelt, and revert to the sensible values of Warren Harding and Calvin Coolidge, is the fundamental question of the day. The future of our own grandchildren will depend on the choice we make in 2012.