The US government is on an unsustainable path. Deficits are soaring and the Obama administration is planning massive tax hikes.



Moreover, businesses have little reason to hire already because of massive overcapacity. Add increasing health care costs to the list of reasons for businesses not to hire.



Given that government spending crowds out private investment, these policies all but assures that unemployment is going to remain high for a long time as noted in Structurally High Unemployment For A Decade.



Killing The Goose



Last week in Thoughts on the Economy: Problems and Solutions I listed the problems and some of the solutions facing the economy. It was a discussion between John Mauldin and I about his weekly E-Letter Killing The Goose.



John and I agreed on many, but not all solutions. I would also like to add something I have proposed before, killing the Davis-Bacon prevailing wage act.



Muddle Through Where Art Thou?



Back in 2002, the usually optimistic Mauldin proposed the economy would somehow manage to "Muddle Through".



However, because of the unsustainable path we are on. John has changed his mind. Please consider these excerpts from Muddle Through, R.I.P?



I defined a Muddle Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we would return at some point to such an environment at the end of the recession I was predicting.



However, gentle reader, never in my wildest dreams did I think we could be

looking at government deficits of $1.5 trillion dollars and actually budgeting future

deficits of over $1 trillion as far as the eye can see. And there is real reason to think that under current plans, $1 trillion deficits are optimistic.







Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019. And that assumes nominal growth that is north of 3% and unemployment dropping back below 5% in reasonably short order.



Japanese Disease



Some readers wrote this week telling me I am far too worried about a rising government deficit. Right now we are at roughly 42% of debt to GDP. In 1989, at the

start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it is at 178%, and the world has not come to an end for them. In fact, they are running massive government deficits today and plan to do so for a long time. Why, I am asked, can’t we be like Japan?



In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP

ratio of 212%. Now it is at 110%. And the total of both government and private debt is roughly the same (within 5%) of where it was 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country?



Before I answer that, read these paragraphs from Hoisington Asset

Management’s latest letter (last week’s Outside the Box):



“The federal government’s promise to extricate the U.S. economy from this

recession involves more spending (increasing public debt) and more subsidies for

consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt.



“This means there is no long term income benefit from stimulus programs.

According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.”



For all intents and purposes, Japan has had no growth for almost two decades.

Their nominal GDP is where it was 17 years ago, and the number of employed people is at 20-years-ago levels. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President’s Council of Economic Advisors, and further explored by European economists. There is general agreement on these facts.)



Large government deficits choke off the very investment that we need to create

jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation.



The New Muddle Through Economy



This is not a prescription for a return to normal growth. We are headed for a New

Normal that is less than what the market currently believes. Unless the deficit comes

under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so. But it will not be fun. It will not be long-term 2% growth and employment going back to 6% any time soon. Can we reverse the course? With a different attitude and leadership in Congress, maybe we can. But it won’t happen next year, and it’s unlikely in 2011.



I am afraid we will have to put my old friend Muddle Through, as I previously

defined him, back in his box for a while.

Japan Rethinks A Dam

The clatter of construction machinery still fills this forested mountain gorge, where legions of men in hard hats busily pour concrete, clear hillsides and erect a huge, unfinished bridge whose concrete supports tower over the valley floor like crucifixes in an immense graveyard.



It seems an apt analogy. Japan’s new government has suspended the $5.2 billion Yamba Dam being built here and turned this valley four hours north of Tokyo into a symbolic final resting place for the nation’s postwar order, which relied on colossal public works spending.



The Democratic Party government of Prime Minister Yukio Hatoyama has chosen this dam as the first of 48 national government-financed dams that it wants to scrap, worth tens of billions of dollars.



Japan had around 60 large dams under construction in 2005, making it the world’s fourth largest dam-building nation, according to The International Journal on Hydropower and Dams, despite having a land area smaller than California’s.



Decades of pouring concrete have been widely blamed in Japan for cluttering rural areas with needless dams and roads to nowhere. They have also saddled the country with the developed world’s largest national debt — nearly twice its $5 trillion economy. Mr. Hatoyama’s party has vowed to replace Japan’s postwar “construction state” and the jobs it created with something closer to a European-style social welfare system.



Did Muddle Through Ever Work?