Slashing Government Works

It Can Happen Here

Government really can be cut: case studies from Canada, New Zealand, and the United States

Arnold Kling, David Henderson & Maurice McTigue from the November 2010 issue of Reason

In an era of frightful budgets and frightened politicians, cutting government may seem like a flatly impossible task. But a look around the world—and at our own recent economic history—turns up a few inspirational examples of knife work that not only trimmed back budget deficits but created the conditions for unprecedented prosperity.

New Zealand, Canada, and the postwar United States all managed to slash the state on a grand scale. Governments shed responsibility for forests, railways, radio spectrum, and more while relaxing labor markets, slimming the welfare state, and ending price controls. Far from damaging economies or increasing unemployment, these reductions in the size and scope of government boosted GDP, improved services, and created jobs.

Government cutters faced opposition along the way, from skeptical Keynesians to Kiwi bureaucrats. But they also found unlikely allies, with left-wing parties playing major roles in the Canadian and New Zealand examples. The stories below should encourage would-be cutters and reassure skeptics: It can be done.

Turning Guns to Butter
How postwar America brought the boys home without bringing the economy down
Arnold Kling

When World War II ended in 1945, President Harry Truman faced a problem. Public opinion called for a rapid demobilization that would bring the boys home as soon as possible. But the Keynesians who were gaining prominence in the economics profession warned that a rapid decline in government spending and the size of the public work force would produce, in the late economist Paul Samuelson’s words, “the greatest period of unemployment and dislocation which any economy has ever faced.”

Thankfully, Truman ignored the Keynesians. Government spending plummeted by nearly two-thirds between 1945 and 1947, from $93 billion to $36.3 billion in nominal terms. If we used the “multiplier” of 1.5 for government spending that is favored by Obama administration economists, that $63.7 billion plunge should have caused GDP to fall by $95 billion, a 40 percent economic decline. In reality, GDP increased almost 10 percent during that period, from $223 billion in 1945 to $244.1 billion in 1947. This is a rare precedent of a large drop in government spending, so its economic consequences are important to understand.

The end of World War II thrust more than 10 million demobilized servicemen back into the labor market, but without the catastrophic consequences Keynesians feared. Close to 1 million took advantage of the GI bill to attend college. In addition, some of the increase in the male work force was offset by a decline in female labor force participation from World War II levels. But if Rosie the Riveter became a housewife, many of her friends continued to work outside the home. Over all, from 1945 to 1947 the civilian labor force increased by 7 million, or 12 percent. The vast majority found work, as civilian employment rose by 5 million, an increase of 9 percent.

In addition to the demobilized servicemen, the federal government let go of more than a third of its civilian employees—over 1 million workers. Many of these civilians had been engaged in government attempts to manage the economy. As the economist Gary M. Anderson has pointed out in The Freeman, more than 150,000 people were employed by various wartime economic regulatory agencies, such as the War Production Board, the War Labor Board, the Office of Civilian Supply, and the Office of Price Administration.

With responsibilities that extended well beyond wartime production to include restrictions and controls on the civilian nonmilitary economy, those agencies and boards disbanded with great reluctance. The 1946 election, which gave Republicans a majority in the House of Representatives for the first time since 1930, prompted a change of heart, with Price Administrator Chester Bowles removing virtually all remaining price controls five days after the vote.

The conversion to a peacetime economy was a remarkable undertaking by the private sector. It did not merely involve converting wartime manufacturing to peacetime uses. For example, of the 2.8 million workers let go by the “other transportation equipment” sector between 1943 and 1948, when military vehicles were no longer needed, just half a million were absorbed by the civilian automobileindustry. The big employment gains turned out not to be in manufacturing at all. The sectors that saw the most hiring were retail trade, services, contract construction, and wholesale trade, which together added nearly 4 million workers.

There are important differences between circumstances today and the circumstances in 1945, of course. Back then, federal spending was much larger as a share of GDP (40 percent, vs. less than 10 percent today), and government employment was a much larger share of the labor force than now (20 percent vs. 2 percent), so a more significant adjustment was required.

But there are other factors that make change more difficult today. During World War II, the personalsavings rate climbed to more than 20 percent, so after the war households were able to offset the decline in government spending by consuming a larger share of their incomes. Today, with a savings rate of about 5 percent, households have much less room to expand. In addition, the skill requirements of today’s industries make it more difficult to match workers with jobs than was the case in the much simpler economy of the 1940s.

Any way you look at it, though, America’s experience from 1945 to 1947 demonstrates that the private sector is capable of overcoming a tremendous drop in government spending. As a percentage of GDP, the decrease in government purchases then was larger than would result from the total elimination of government today. While no one can be sure what would happen if the government were to shrink that quickly, the ’40s boom offers a hopeful example.

Reason

Bank of Japan Throws in the Towel

Zero percent interest rates and huge governmental deficits have not helped in Japan. Why do we expect they will work in the United States?

Japan's fall also followed a huge property bubble. Real wages in Japan have been falling for twelve years. These trends hit the middle class the hardest. The middle class is the bedrock of any society. What is the lesson for the US?

Falling wages in the private sector and rising wages in the government is a toxic combination. Add to that the government and Wall Street sponsored breaking of US manufacturing and the resultant structural rise in unemployment and wages and you have a very nasty combination.

US federal deficit spending was aided and abetted by the pernicious additional affect of allowing and encouraging Japan and China to buy US sovereign debt. Stopping that practice is a necessary step in any serious effort at stopping the slide.

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Bank of Japan Cuts Rates to as Low as Zero Percent
By HIROKO TABUCHI
Published: October 5, 2010

NY Times

TOKYO — In a surprise move, Japan’s central bank lowered its benchmark interest rate to a range of 0 percent to 0.1 percent Tuesday, a tiny change from its previous target of 0.1 percent but a significant move back into an age of zero-interest rates.

The Bank of Japan also said it would set up a new ¥5 trillion, or $60 billion, fund to buy Japanese government bonds, commercial paper and other asset-backed securities amid concerns over weakening growth in the world’s third-largest economy. The bank also kept its credit facility for banks at ¥30 trillion.

With the interest rate cut, a bid to kick-start lending in Japan’s moribund economy, the central bank effectively reintroduces a zero interest rate policy for the first time since July 2006. The decision underscores concerns that a strong yen and persistent deflation threaten the country’s economic recovery.

In a statement, the bank confirmed that it would maintain its “virtually zero interest rate policy” until it achieved “medium- to long-term price stability”— or an end to deflation.

Hirokata Kusaba, senior economist at the Tokyo-based Mizuho Research Institute, said in a note to clients that the bank’s move went beyond market expectations. “The latest move gives off a much more powerful impression than past, incremental measures, which had sparked market disillusionment,” Mr. Kusaba said.

“Though there will be debate over the effects of the monetary loosening, I believe the Bank of Japan has done all it can at this time,” Mr. Kusaba said. But that also meant that the bank “had now depleted most of its policy options,” he said.

The dollar rose against the yen on the announcement, climbing 0.7 percent on the day to ¥83.90 from about ¥83.55 before the decision.

“The central outlook for the economy, and prices, have worsened more than had initially been predicted,” Bank of Japan Gov. Masaaki Shirakawa told reporters following the decision. Working out a package of policies, Mr. Shirakawa said, would allow the bank to draw out their maximum effects. He said he would consider expanding the 5 trillion yen asset-buying scheme, depending on its effectiveness.

The unanimous vote to lower the key interest rate came after a two-day meeting of the central bank’s nine-member policy board. The Bank of Japan had been under increasing pressure from the government to take more drastic steps to shore up the economy.

In particular, Prime Minister Naoto Kan has called on the bank to do more to help battle the powerful yen, which has surged to 15-year highs against the U.S. dollar in recent months, wreaking havoc with the country’s export-led economy.

A strong yen hurts Japanese exporters by making their goods more expensive overseas, and eroding the value of their earnings. Despite the weaknesses in Japan’s economy, the yen tends to strengthen against other currencies in times of global financial uncertainty, partly because the country still runs a current-account surplus, making a run on the yen unlikely.

The yen’s value is also related to the difference between Japan’s interest rates, and those elsewhere. The lower Japan’s interest rates, the bigger the difference between interest rates in Japan and higher rates overseas.

That gives investors more incentive to sell the yen to invest in higher-yielding currencies, weakening the yen. More purchases by the central bank of government bonds and other assets have a similar effect.

After weeks of talking down the yen in what economists called “verbal intervention,” the government finally intervened in currency markets on Sept. 15, the first such maneuver in six years, selling about ¥2.125 trillion to tame the yen’s persistent climb. But a lack of international support has undermined Japan’s efforts, and the yen is back to levels seen before the intervention. Meanwhile, some investors have warned that other Asian countries could also try to weaken their currencies as a means to boost exports, sparking a “currency war.”

With intervention yielding little effect, many within the Japanese government have stepped up demands that the Bank of Japan lower rates and buy more government bonds, both steps that would bring downward pressure on the currency. But Gov. Shirakawa had been reluctant for the central bank to play a role in financing Japan’s public debt, fast approaching twice the size of its gross domestic product.

Moreover, future moves by the U.S. Federal Reserve to further ease monetary would again reduce the effective interest rate spread between Japan and the United States, limiting the impact of the Bank of Japan’s actions.

The U.S. Federal Reserve has also kept short-term interest rates near zero since December 2008. In the past week, momentum has build toward resuming large-scale purchases of government debt to help the flagging economic recovery.

Japan’s central bank had also long come under fire for failing to end deflation, the general fall in prices that eats into profits and wages that has weighed heavily on Japan’s economy for the past 12 years.

Core consumer prices, which had shown signs of stabilizing in 2008, have fallen since early 2009. Consumer prices fell by 0.9 percent in the year to August, according to latest numbers from the Organization for Economic Cooperation and Development.

As the American economy also flirts with deflation, some economists have warned of a Japan-style deflationary trap that could delay recovery for years.

Indeed, Japan’s experience shows that deflation can creep up on an economy — and can be difficult to shake.

It took about four years for Japan’s economy to hit rock bottom following its spectacular asset bubble burst in 1990, and another four for deflation to take hold in 1998. The following year, the Bank of Japan responded by lowering its policy interest rate to zero; by that time, however, the country’s economy was so depressed that even zero interest rates could not bring about recovery.

Critically, it was not until another five years later, in 2003, that the central bank sharply increased its purchases of financial assets to expand the money supply, setting the stage for a gradual recovery. Despite stable economic growth of about 2.5 percent between 2004-2007, however, deflation did not disappear completely.

Still, emboldened by a nascent recovery, the Bank of Japan raised its lending rate in July 2006, bringing it to 0.5 percent the following March — a controversial step some economists, as well as politicians, called premature.

Before that debate had fully played out, however, the global economic crisis ravaged Japan’s export markets, plunging the country into its worst recession yet since World War II. In December 2008, the Bank of Japan slashed interest rates to 0.1 percent.

The Bank of Japan’s perceived ineffectiveness has sparked a debate over its independence from the government in decision-making, guaranteed by a 1998 law that protects the bank’s governor from dismissal by the government, and prohibits the government from supervising the bank’s operations.

The law was put in place after criticism that the bank, overly influenced by government euphoria in Japan’s booming eighties, did not raise interest rates quickly enough, letting the asset bubble grow to massive proportions before it burst in 1990.

Your Party, an opposition group, plans to soon submit a bill to Japan’s parliament that would give the government greater influence over the central bank. Officials within the government have made similar suggestions.