Facing Fiscal Reality: You Can’t Tax Your Way Out of a Spending Problem

By on

'Ahh the French', as Orson Welles once declared in an infamous champagne commercial. The Hollywood legend made the point that French champagne has always been celebrated for its excellence. Today, the French are being punished for their excess. At least, that's how we see it.

Moody's Investor Service downgraded France's sovereign credit rating one notch earlier today. The ratings agency says France has some structural problems, including 'the gradual and sustained loss of competitiveness and the longstanding rigidities of its labour, goods and services markets.' It also said that, 'France's fiscal outlook is uncertain because of its deteriorating economic prospect.'

But we reckon the French economy has the same problem as most of the countries in the industrialised Western World: unrealistic expectations and a perverted understanding of wealth. On the one hand you have citizens who want more from their government without paying for it. On the other hand you have governments grasping at revenues and higher taxes to remain popular and stay in power.

Squeezed like a grape between both hands is the productive middle class. We'll get back to these poor suckers in a moment. But first, you'd never know we're in the middle of a historical drama, based on the stock market. The Dow Jones Industrials had a great day in New York. It was up 1.7%.

The S&P 500 did even better. It climbed nearly 2% to 1386.89. That little pop put it back over its 200-day moving average at 1382. That's a kind of line in the sand below which...well below which it might go a lot lower. You can see the index breached the 200-day MA in June as well, and then went on to rally. Will it happen again?

Click to enlarge Source: StockCharts

The catalyst for the US rally was a report that US politicians may reach a compromise and avoid going over the 'fiscal cliff'. By the way, the term 'fiscal cliff' has rapidly become the most over-used and least useful piece of jargon in recent financial memory. Not only is an annoying term, its wrong!

A cliff is something you want to avoid going over, unless you are a base jumper or a cliff diver, in which case you love cliffs. But the situation the US faces isn't akin to going over a cliff. The situation is as follows - unless some other deal is made, US law will mandate lower government spending and some increased taxes as of December 31st.

That's not a cliff. That's dealing with reality. The reality is that lower government spending and higher taxes (which leads to lower consumer spending) would probably wipe off about 5% from US GDP. But that shows you what a useless number GDP is.

The US economy needs to get back to living within its means and leave GDP figures to the statistical manipulators. Achieving growth for its own sake - especially if it's government spending and/or consumer spending financed by borrowing - is a long-term economic ill. Going over the 'cliff' would be a long-term boon for the US. It would force the government to spend less (by law) because politicians can't or won't (by choice, avarice, or stupidity).

In any event, the market action is almost certain to be misleading today. We'll see what Murray has to say tomorrow. Our own view is that everyone is basically front running QE right now. If more easy money isn't promised soon, the stock market is going lower.

The stock market isn't really a market anymore. It's been corrupted by the Federal Reserve. Ben Bernanke is now portfolio manager to the world. His prize for keeping the system afloat is that the public retains tepid confidence in the US dollar as the world's reserve currency.

But the public is fickle. Same as it ever was in a democracy. Just ask Francois Hollande. The well-groomed and charming socialist bureaucrat strolled into office with soaring popularity and the promise that he'd raise income taxes on the rich to 75%. By 'rich' he meant anyone earning an income over $1.27 million.

Now, Hollande finds his popularity plummeting. The 'temporary' hike in the highest marginal tax rate hasn't plugged France's big budget holes. The people are realising that you can't tax your way out of a spending problem. Wealth isn't automatically created so that the government may legally steal it.

This is the whole flaw with the idea of progressive taxation. Nothing about it is progressive. It is not forward-thinking, enlightened, or modern to increase the government's role in economic life. It only transfers power from the people to the elites, and money from your pocket to the public purse, where it is wasted or otherwise lines the pockets of the connected and the lazy.

Mind you, things could always be worse. In the past they HAVE been worse. The King or the Church could take what's yours and leave you with a patch of dirt, if you were lucky. The improvement in the modern feudal system largely comes down to cable TV and Wi Fi internet on a handheld mobile device. Bad food is also much cheaper. Calories have become just as debased as money.

Nobel Prize-winning economist Paul Krugman knows how to make things better. Pining for the 'economic justice' of the 1950s, Krugman reckons we should go back to a 91% marginal income tax rate. The more you make, the more the government takes. That is the surest way to make sure no one is more equal than anyone else.

But America in 1951 was a much different place, in economic terms. Unemployment was low. American manufacturing powered the world, partly thanks to the destruction of the rest of the world's industrial base in World War II. Employers were willing to invest with such a huge competitive advantage in place, and they had to pay competitive wages. The world's manufacturing workforce hadn't been globalised.

America was a lot more productive a place back then, too. Krugman wants to tax his way back to prosperity by way of what he calls a more equal, more progressive distribution of the country's wealth. But in the current context, he's really just talking about how to divide up the remaining Twinkies in the national cupboard. Meanwhile, no one's making any more Twinkies.


Dan Denning for The Daily Reckoning Australia

Join the Discussion