According to chinese Premier Zhu Rongji (朱鎔基), a decline in China's exports by 4 percent next year could cause economic growth to drop to 5 percent. Given Beijing's fixation with its 7 percent target, a variety of methods are likely to be implemented to stimulate the economy to recoup the two-percentage-point shortfall. As it is, the principal aim of economic growth stimulus policies will be to boost overall demand.
Unfortunately, history shows little evidence of success when increased government spending or artificial cuts in interest rates are used to boost economic growth. Nowhere is this more evident than in China where deficit spending over the past decade has done little more than raise public-sector debt to dangerous levels.
Even when fiscal stimulus gives the appearance of "working," the impacts are temporary and the benefits illusory. This illusion is supported by confusing the creation of tangible output or services with changes in real measures in income or wealth.
Applying fiscal stimulus measures in response to the current economic slowdown draws support from a defunct body of Keynesian economic theory. Herein, government spending is misconstrued to be a form of investment and consumer spending is mistakenly seen as a key to economic recovery and growth. Following this same logic, artificial cuts in interest rates are seen as another way to raise economic activity through increasing aggregate demand.
However, sustainable economic growth does not occur from spending, per se. There must be the right sort of spending. As it turns out, a rise in living standards requires increased genuine savings to be used productively. As additional capital enhances the existing stock of capital, there can be an increase in productivity leading to higher real wages.
So, even if fiscal pump priming contributes to the production of new goods and services, economic growth is not stimulated in a real sense. To make matters worse, increased fiscal spending tends to mask fundamental economic weaknesses that need to be resolved. Using additional labor for the production of more consumer goods will not by itself raise real wage rates and living standards. For it is not the demand for commodities that serves as the basis of the demand for labor; it is the demand for capital goods that requires additional labor to support it. Only when funds are directed towards employing more labor for creating additional capital goods that raise productivity can there be a continual rise in real wages and employment.
While little real good comes from expansionary policies, the amount of real harm depends upon the course of action. If issuing new public-sector debt is used to finance additional spending, there will be a future tax obligation that represents a zero-sum game for taxpayers whereby gains are neutralized by losses. At the same time, more government borrowing will tend to push up long-term interest rates and crowd out private sector spending, another zero-sum game.
If new money is printed or credit expanded excessively, there will eventually be higher interest rates while workers will find prices inevitably rise more rapidly than do their wages or salaries. The immediate effect of attempts to force down interest rates is that after adjusting for price increases, income taxes, social security, and retirement contributions, the real earnings on savings may become negative. This hurts retirees who rely on their past savings for present and future consumption. As interest rates are artificially forced down, there is a reduced incentive for current saving so that fewer funds are available for long-term investments.
Although mild business cycles can occur without government fiddling, it is not market instability that causes extreme cases of economic turmoil. All modern instances of wide swings seen as economic booms and busts can be traced to some combination of promiscuity of fiscal and monetary policy. If it is the meddling of governments and their agencies that causes sharp swings in economic activity; they are unlikely to provide the best cure for these problems.
Unfortunately, the alternative is for there to be painful adjustments that involve the squeezing out of excess capacity. Downsizing is a necessary activity that allows labor and capital to be released to more productive uses elsewhere in the economy.
There may be complaints that some individuals will unjustly bear the brunt of the suffering. It should offer some solace that most others in the economy will benefit from the process to protect the few. Protecting visible jobs today will destroy jobs of the future that are presently invisible. Youthful new entrants into the job market should not be forced to shoulder the burden of delayed adjustments that would reduce future growth rates and job opportunities for them. This is not merely a battle over economic illiteracy. The choices are between one course of action with simple but misguided logic and another approach that is counter-intuitive but more likely to be effective. The first step is to abandon the faulty logic that portrays increased spending as the engine of economic growth, something that has unfortunately become an article of faith for so many. History shows that temporary tax cuts along with forced reductions in interest rate and higher government spending only create an illusion of increased economic activity.
In reality, higher consumption can only occur if there is a sustainable increase in production. A better approach to insure sustained economic recovery is to introduce large and permanent cuts in income taxes combined with expanded tax write-offs for depreciation to promote investment. Although the public-sector budget may initially fall into deficit, this imbalance will be erased by future gains in production and growth.
China has suffered more than enough misery from failed communist ideology. It would be a pity for Beijing to engage in a flirtation with the bankrupt body of Keynesian economic theory that will create more harm than good.
Similarly, Taipei should resist the siren's call of misplaced macroeconomic theory. Openness to trade and allowing entrepreneurs to keep most of the rewards of their risk-taking behavior was the secret of economic success in the past and should be so for the future.
Christopher Lingle is Global Strategist for eConoLytics.com.
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