Frank Shostak on the Fiscal Cliff

I recently wrote about the so-called “fiscal cliff” that is supposed to be coming.  I pointed out that tax hikes and spending cuts are completely different, and that spending cuts would actually be beneficial to the overall economy, at least in the long run.

Frank Shostak recently wrote a piece for the Mises Institute.  He also discussed the “fiscal cliff”.  I would recommend that you read his article, if you haven’t done so already.

I do have one point where I have somewhat of a disagreement with Shostak.  I will first get that out of the way.  Shostak wrote, “What about the fact that we will also have an increase in taxes as a result of the expiration of the Bush tax cuts?  To the extent that government outlays are going to be curtailed the increase in taxes should be regarded as a monetary withdrawal from the economy.  In this sense it is like a tight monetary policy.  A tighter monetary stance in this respect should be seen as positive for wealth generators since it weakens various bubble activities that sprang up on the back of past loose monetary policies.”

I think I understand Shostak’s point there.  He is saying that a smaller budget deficit is the equivalent of a tighter monetary stance.  If there is a smaller deficit, the Fed would not have to buy as much government debt to keep rates low.

My area of disagreement is in regards to the Laffer Curve.  Higher tax rates can lead to less economic activity, including labor and investment.  So regardless of government spending, higher tax rates can reduce productivity due to incentive.  If you accepted static scoring and human behavior did not change, then I would agree with his assessment.

Aside from my one point of contention, Shostak’s main point in his article is that government spending is what matters the most and a cut in government spending is good news for the economy.

I think this point is lost on most everyone, including many libertarians.  Conservatives especially do not understand it, or at least do not stand by it.  Conservatives seem to care so much about the so-called Bush tax cuts, yet any benefit from the tax cuts is extremely small compared to the vast damage of the massive spending done during the Bush years.

It is important to understand Shostak’s article.  All government spending hurts wealth generation, except, arguably, if the government spending is protecting life and property from aggression.  Government spending misallocates resources and hurts productivity that will most benefit consumers.

It doesn’t matter if there is a balanced budget or huge deficits.  If government spending is huge, then it is going to have a huge detrimental effect on productivity and wealth generation.  It doesn’t matter if it is funded through taxation or debt or inflation.  Government is spending resources when it spends money.

Think of a group living on an island where they have a finite number of coconuts, bananas, and fishing poles.  If the government there pays someone one coconut, one banana, and one fishing pole in order to  build surfboards, then this would be a misallocation of resources, unless everyone agreed that they wanted surfboards (in which case government action wouldn’t be necessary).  Perhaps, if left to the market, people would have chosen to pay the person to build stronger shelters, instead of surfboards, because that was more important to them.

Again, it shows that government misallocates resources.  And you can see in this example, the government had to seize one coconut, one banana, and one fishing pole from someone else in order to pay for its surfboard program.  It doesn’t matter if the government uses taxation, or inflation, or promises to pay back the food and fishing pole at a later date.  It is spending resources at that time and it is misallocating them.

In conclusion, the main point of Shostak’s article should be understood by anyone who is studying free market economics.  Do not get distracted from the big picture.  Total government spending is perhaps the most important figure, as it alone shows the resources being consumed and/ or misallocated.  The less government spending there is, the more wealth generation we will see.