The decision by Standard & Poor's to downgrade the U.S. credit rating to AA-plus caused a stock market slump and an extraordinary rally in U.S. Treasuries, the latter further proof if you needed one that markets are often irrational. In spite of Ben Bernanke's Flying Dutchman-like attempt Tuesday to nail interest rates to zero until 2013 it also marked a turning point: the final death-knell of the twin policies of excessive fiscal and monetary stimulus.
The Keynesian theory of fiscal stimulus, under which random government spending stimulates the economy, is bolstered by one enormous hidden advantage: Keynesians designed the principal measure of economic output, GDP. Unlike private sector output, which is measured by what markets are actually prepared to pay for something, government output is measured purely on a cost basis, with no accounting for that output's value. Thus if a dozy government wastes $1 billion on rubbish of no value, GDP is said to be increased by $1 billion. Naturally, with that kind of "cooking the books" stimulus can appear to stimulate.
It would be grossly unfair to say that no government output had any value. Indeed the most basic functions of government, national security and the preservation of order, often have a value far in excess of their cost, as sufferers from last week's British riots have discovered. Nevertheless, many government functions have far less value than their cost; indeed if this were not the case they would already be provided by the free market, without any government intervention at all. Naturally, those government functions carried out as a result of an unplanned "stimulus" to boost an economy out of recession will tend to be less valuable than average, since if a need for them had been seen earlier they would already have been included in the annual budget.
The other argument against the GDP metric is that government output under its measure reflects political rather than economic decisions, so that including such output obscures the behavior of market participants and can give an erroneous picture of the economy's health.
The solution is a simple one, even based on the statistics we are already provided with by the Bureau of Economic Analysis: subtract line 21 (government consumption expenditures and gross investment) from line 1 (GDP) and examine the behavior of the net figure, which we can conveniently call Gross Private Product (GPP).
Through most historical periods, GPP and GDP track each other closely, since even quite rapid expansion of government does not greatly alter the overall track of the economy. However in times when government is expanding or contracting rapidly or overall GDP growth is very weak, the two statistics diverge, with GPP providing a better indicator of the performance of the real economy. In the Great Depression, GPP performed even worse than GDP during Herbert Hoover's futile expansion of government. GPP then paralleled GDP through the New Deal, reaching its 1929 level a year later, in 1939 rather than 1938. Real GPP growth of over 10% in 1940, a year in which real government spending grew only 2.5%, showed that the U.S. economy was by that stage rapidly leaving the Great Depression behind it.
The two series then diverged during the war years, with real GPP halving between 1940 and 1944, showing that contrary to Keynesian opinion World War II did not reflate the private economy but squeezed it further – real GPP in 1944 was a quarter below its 1932 nadir. The true explosion of GPP growth came in 1945-47, with an astonishing doubling of real GPP in 1946, and GPP growth continuing through 1947 and 1948 before a "double-dip" recession in 1949-51 as the Korean War squeezed the private sector again.
Turning to more recent history, the divergence of GPP and GDP since 2007 is instructive. By far the largest expansion of government overall, at a 5.9% annual rate, came in 2009's second quarter when GDP declined marginally and GPP declined more substantially, at a 2.3% annual rate. Conversely, by far the two fastest growth quarters in GPP, at a 5.1% annual rate, came in the last quarter of 2009 and the first quarter of 2010, when government was actually shrinking at a 1.1% annual rate. Apart from 2009's second quarter, when federal spending grew at an astounding 14.4%, the biggest federal spending stimuli came in 2008's third quarter (11.8%), 2007's third quarter (9.6%) and 2008's fourth quarter (9.0%); the 2007 quarter was the only one of those three to show GPP growth, with the last two quarters of 2008 tipping the economy into sharp recession.
By the GPP measure, 2011's economy is not so bad, with steady growth in the first two quarters at 1.9%, compared to official GDP growth of 0.8%. Notably, government has been shrinking during this period, with both federal spending and total spending down at a 3.5% annual rate. That suggests that the current economic position is not in fact dire; it also suggests that continuing government shrinkage may encourage further growth.
There are two opposing positions on government spending stimulus: the Keynesian position that it stimulates economic growth generally and the Austrian position that by crowding out the private sector it substitutes less efficient for more efficient use of resources and hence retards growth. From the GPP data now available, while as always there is considerable "noise" in the statistics, the Austrian view is decisively the more plausible.
What, you may ask, has this to with Ben Bernanke? I once got an A in a Business History course in spite of writing the entire final exam on early 20th century monetary policy, when the paper had asked for fiscal policy. My only concession to reality was to scrawl hurriedly "Whoops, I always get those two muddled" on the front of the exam notebook. Apparently my analysis of the formation of the Federal Reserve was much liked, even though it was entirely irrelevant to the topic under discussion. Truly, in college as in life, dumb luck and chutzpah will beat you every time!
However, I have not repeated this mistake here. It is now clear that the massive expansion of federal debt would have been impossible without Ben Bernanke running negative real interest rates and buying more than $3 trillion of federal and agency debt over the last three years. With a Gold Standard or Paul Volcker at the Fed, the massive deficits required for "stimulus" would have caused indigestion in the government bond markets long ago, and forced the rating agencies into a realization that the U.S. credit was not all that it might be.
With a firm Fed and Platonic rating agencies, un-swayed by political considerations, the U.S. Treasury would have been downgraded in early 2007, when it became clear that the economically witless Bush administration was running a $400 billion deficit at the top of a credit cycle. By now, Standard & Poor's rating of the U.S. government would be about the same as that of Dagong, the Chinese rating agency, which currently rates the U.S. Single-A, having downgraded it twice in the last year. Bernanke has enabled the futile "stimulus" madness, and has exacerbated many of its effects by his own extremist monetary policies.
Recent market convulsions are surely making it clear even to Bernanke that the game is just about up. The fact that the S&P rating downgrade was followed by a DECLINE in the 10-year Treasury bond yield, with buyers scooping up a massive new issue enthusiastically, is a clear sign that the long-term Treasury bond market is now in an out-and-out bubble, no more rational than that for Dutch tulip bulbs in 1637. The bubble in tulip-bulb Treasuries is within months, possibly even weeks, of bursting, at which point no amount of swearing by Bernanke that he will keep rates low until 2100 or the end of the universe, whichever comes first, will prevent a bond market Armageddon.
At that point the efforts of the exquisitely constructed 12-man Congressional deficit commission to produce a modest mix of spending cuts and tax increases that will allow all its members to achieve triumphant re-election will prove futile. The market will no longer support deficits; lenders will stop providing the deadbeat Uncle Sam with any money. Making it impossible for the government to spend money it does not have will have an immensely beneficial effect on future policies, both monetary and fiscal. Whether Republicans, Democrats, Tea Party or Alinskyites will come to dominate U.S. government after that is currently shrouded in mist, but one thing is absolutely clear: the House of Bernanke will have fallen.
Originally appeared in .
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)—details can be found on the Web site –and co-author with Professor Kevin Dowd of "Alchemists of Loss" (Wiley – 2010). Both now available on Amazon.com, "Great Conservatives" only in a Kindle edition, "Alchemists of Loss" in both Kindle and print editions.