Focusing Knowledge

A few days ago I posted the first part of this blog article, which dealt with the government takeover of the banking and finance industry, the automobile industry, and its suffocating influence in our energy industries.  As a small business owner, it’s important to keep a wary eye on the government and economic trends.  We all know that it’s getting harder and harder to make a decent living now.  In this article, I’d like to examine in a practical way monetary policy, tax policy, and healthcare, and how changes in those government policies are likely to impact us into the future.

In response to the credit crisis last fall, the government embarked on an all out campaign to flood the market with lquidity (the fed bought debt instruments of the U.S. Government on a grand scale).  This had the effect of putting money in banks, enabling them to lend it to their cuetomers, like GMAC, or GE Credit, in an attempt to encourage consumer demand and stimulate the ecomony.  Here’s a table from the Fed released just a few days ago which shows the magnitude of the changes in the money supply over recent periods.  M1 refers to mainly currency in circulation, travelers checks, and the amount in checking accounts.  M2 is a more reliable series, which includes M1 plus savings accounts, CDs, and money market funds.  The late Milton Friedman, who pioneered the study of the money supply and its effects on the economy, wrote that a steady 2-3% growth in the money supply was the growth level to be targeted for optimum performance in the economy.  As you can see, recent growth rates are substantially above that level.

Percent change at seasonally adjusted annual rates    M1                    M2

3 Months from Jan. 2009 TO Apr. 2009                     4.1                   2.6
6 Months from Oct. 2008 TO Apr. 2009                   15.9                   9.2
12 Months from Apr. 2008 TO Apr. 2009                   15.9                   8.5

In the past, deviations from Friedman’s target level have resulted in demonstrable changes in the inflation rate, as well as in the level of economic activity.  Sharp contraction of the money supply during the ’30s resulted in the great depression.  On the other hand, large increases in M2 during the Ford and Carter years resulted in high interest rates, huge inflation, and tough times.

In our recent case, even though the Fed made credit available, the banks did not aggressively promote loans.  In fact, in the early part of the period, they hoarded the excess liquidity for several months.  There’s another factor in the equasion for changes in money supply and its effect on the economy – the velocity of money.  That’s the number of times per year a dollar is turned over – or how fast people spend their money.  In recent months that’s been pretty slow. A lot of folks are out of work, and those who aren’t are very cautious, and tight with the buck.

But the artificially low short term interest rates are creating other problems.  The dollar has fallen 10% against the euro since its low of a few months ago, and long term interest rates (on government bonds) are beginning to climb.  Those trends alone signal trouble.  The cost of imported goods will start to rise, as will mortgage rates and the cost of long term borrowing.  More importantly, as demand increases from it’s current low level, so will the velocity on money.  Many respected economists feel that this turn of events will set the stage for a return of double digit inflation.

Taxes are another problem.  The government is adamant about raising income tax rates for financially successful people.  Some of those taxes are going to subsidize those less successful.  This results in a disincentive for the successful people to invest and take risk (because their return is guaranteed to be less), and a disincentive for the less fortunate to acquire new skills (why work harder when the government is giving you more purchasing power?).  In addition to increasing marginal rates by nearly a seventh, there’s a plan afoot to eliminate some of the deductions traditionally allowed.  This raises the effective increase even more that it would appear to be at first glance.  But the frenetically ambitions desire from the new government to overhaul and expand social programs argues very forcefully that additional taxes will be required, probably from the very people who were promised before the election that they would be getting a tax break.  Now there are trial balloons about taxing soft drinks, and adding a VAT  (a value added tax, or national sales tax of 10% to the purchases of all goods and services).  So if I am in the 35% tax bracket now, my effecting tax rate will go to 44& with the income tax increases, and it I spend 50% of my income, the VAT will clip me for another 5%.  Now don’t forget the states.  They’re hurting too.  You can surely count on them to add a percent or two on their income tax rates and sales tax rates.  Before you know it, my combined income tax rates (not counting VAT and soft drinks) have gone from 42 to near 50%.  Don’t forget the proposal to tax health care insurance for those who get it from their employers!  That’ll add another $10K of expense.  All of this taxation removes money from the system.  People who are taxed more will spend less.  It’s that simple.

It’s the function of a market to ration the limited supplies of goods among the available buyers.  I can afford a certain number of material goods, in the long run, consistent with my income.  I can buy, for instance, a Ferrari and nothing else, or a Ford Taurus, kids’ education, toothpaste, TV, food, etc – you get the idea.  That’s the way goods are allocated in a market economy.  With a government run healthcare system, it is my fear that that allocation process will be abandoned.  Instead of my choosing to allocate money to health insurance, the government will tax me and they will become the providers of the care.  They will choose the doctors, the procedures, and arbitrate the diagnoses in some cases.  I a very direct way, they will be able to dictate the compensation of those doctors.  In the longer run, with doctors’ compensation regulated by the government’s health care plan, fewer talented people will become physicians, choseing, instead a more lucrative profession.  Currently, I can choose a high priced health care insurance provider that will provide me with the level of healthcare that I choose.  (Remember I can spend more, because I chose NOT to purchase that Ferrari!)  It is the cost of that healthcare plan that rations its purchase in the market.  And, because I have that plan, I can go to the finest doctors and get the best care.  There are not enough of the best doctors around, so they have to ration their time among those who can afford to pay.

In the new U.S healthcare plan we have heard so much about, it will be the government, not the market, who decides who gets treated and what level of treatment they will have.  England and Canada have a similar system, and by all accounts there is widespread dissatisfaction.   The government cannot possibly provide ALL of the healthcare that any of its citizens demand – it will bankrupt the country.  So it will have to decide who gets what.  Older folks will not get that heart transplant paid for by the government – it’ll be more cost efficient for the government to grant it to a younger guy.  Or, there will be a huge wait for the government insured service, during which time, the marginal patient will die.

Adam Smith was a Scottish Philosopher in the Age of Enlightenment.  In 1776, the same the year the Declaration of Independence was written, he published ‘An inquiry into the Nature and Causes of the Wealth of Nations‘.  It was an astounding book at the time, and laid the foundation for the school of economic thought called ‘enterprise economics’.  That body of thought contended that if market participants were free, their choices guided by their own self interest would produce the most efficient and optimal use of the country’s resources.  He contended that efforts by the state to promote social goals would be ineffective, and would result in a consistently suboptimal result.  This economic point of view is commonly referred to as ‘the invisible hand‘, from Smith’s contention that under his laissez-faire theory of economic allocation, goods, utilization, and consumer satisfaction would be optimized as if by an ‘invisible hand’.  In Das Kapital, published in 1867, Karl Marx formulated his theory that the greatest good could be had from state control of the means of production.  We spent the bulk of the 20th century observing which theory worked best.  I hope we do not forget those lessons.