The Bush Economy

President Bush is leaving office amid the worst recession in 25 years, and naturally his economic policies are getting the blame. But before we move on to the era of Obamanomics, it's important to understand what really happened during the Bush years -- not least so we don't repeat the same mistakes.

Mr. Bush has tried to explain events with one of his populist aphorisms: "Wall Street got drunk and we got a hangover." The remark is ruefully amusing and has an element of truth. But it also reveals how little the President comprehends about the source of his Administration's economic undoing. To extend his metaphor, Who does Mr. Bush think was serving the liquor?

Democrats like to claim the 1990s were a golden age while the Bush years have been disastrous. But as the nearby chart shows, Mr. Bush inherited a recession. The dot-com bubble had burst in 2000, and the economy was sinking even before the shock of 9/11, the corporate scandals and Sarbanes-Oxley. Mr. Bush's original tax-cut proposal was designed in part as insurance against such a downturn.

However, to win over Senate Democrats, Mr. Bush both phased in the tax rate reductions and settled for politically popular but economically feckless tax rebate checks. Those checks provided a short-term lift to consumer spending but no real boost to risk-taking or business investment, which was still recovering from the tech implosion. By late 2002, the economy was struggling again -- which is when Mr. Bush proposed his second round of tax cuts.

This time the tax rate reductions were immediate, and they included cuts in capital gains and dividends designed to spur business incentives. As the tax cuts became law in late May 2003, the recovery began in earnest. Growth averaged nearly 4% over the next three years, the jobless rate fell from 6.3% in June 2003 to 4.4% in October 2006, and real wages began to grow despite rising food and energy prices. The 2003 tax cut was the high point of Bush economic policy.

Mr. Bush's spending record is less admirable, especially during his first term. He indulged the majority Republicans on Capitol Hill, refusing to veto overspending and giving in to their demand that the Medicare prescription drug benefit include only modest market reforms. Even those reforms have helped to restrain drug costs, but now Democrats are set to repeal them and the main Bush legacy will be the new taxpayer liabilities.

Nonetheless, the budget deficit did fall mid-decade, as tax revenues soared with the expansion. In fiscal 2007, the deficit hit $161 billion, or an economically trivial 1.2% of GDP. That seems like a distant memory after the bailout blowout of the last few months, but the point is that the Bush tax cuts aren't responsible for the deficits. Before the recession hit, federal tax revenues had climbed above their postwar average of 18.3% of GDP.

Which brings us back to Mr. Bush's "hangover." While his Administration was handling the fiscal levers, the Federal Reserve was pushing the monetary accelerator to the floor. In reaction to the dot-com implosion and the collapse in business investment, Alan Greenspan rapidly cut interest rates to spur housing and consumer spending. In June 2003, even as the tax cuts were passing and the economy took off, he cut the fed funds rate to 1% and kept it there for a year.

His stimulus worked -- far too well. The money boom created a commodity price spike as well as a subsidy for credit across the economy. Economist John Taylor of Stanford has analyzed the magnitude of this monetary mistake in a new paper that assesses government's contribution to the financial panic. The second chart compares the actual fed funds rate this decade with what it would have been had the Fed stayed within the policy lanes of the previous 20 years.

"This extra easy policy was responsible for accelerating the housing boom and thereby ultimately leading to the housing bust," writes Mr. Taylor, who worked in the first-term Bush Treasury, though not on monetary affairs, and is known for the "Taylor rule" for determining how central banks should adjust interest rates.

By pushing all of this excess credit into the economy, the Fed created a housing and mortgage mania that Wall Street was only too happy to be part of. Yes, many on the Street abandoned their normal risk standards. But they were goaded by an enormous subsidy for debt. Wall Street did get "drunk" but Washington had set up the open bar.

For that matter, most everyone else was also drinking the free booze: from homebuyers who put nothing down for a loan, to a White House that bragged about record home ownership, to the Democrats who promoted and protected Fannie Mae and Freddie Mac. (Those two companies helped turbocharge the mania by using a taxpayer subsidy to attract trillions of dollars of foreign capital into U.S. housing.) No one wanted the party to end, though sooner or later it had to.

While the Fed is most to blame, the Administration encouraged the credit excesses. It populated the Fed Board of Governors with Mr. Greenspan's protégés, notably Ben Bernanke and Donald Kohn, who helped to create the mania and even now deny all responsibility. Meantime, Mr. Bush's three Treasury Secretaries knew little about the subject, and if anything were inclined to support easier money and a weaker dollar in the name of reducing the trade deficit. We know because numerous Bush officials sneered at the monetary warnings in these columns going back to 2003.

When the bust finally arrived with a vengeance in 2007, the political timing couldn't have been worse. Mr. Bush tried to rally with one more fiscal "stimulus," but he repeated his 2001 mistake and agreed to another round of tax rebates. They did little good. The Administration might have prevented the worst of the panic had it sought some sort of TARP-like financing for the banking system months or a year earlier than it did last autumn. But neither the Treasury nor the FDIC seemed to appreciate how big the banking system's problems were. Their financial triage was well meaning but came too late and in a frenzy that invited mistakes.

This history is crucial to understand, both for the Democrats who now assume the levers of power and for Republicans who will want to return to power some day. Mr. Bush and his team did many things right after inheriting one bubble. They were ruined by monetary excess that created a second, more dangerous credit mania. They forgot one of the main lessons of Reaganomics, which is the importance of stable money.

Herbert Hoover Brewer... or Herbert Hoover Napolitano?

Herbert Hoover

Some of Arizona’s government “stimulus” enthusiasts have been citing a recent Paul Krugman column, which was printed in the December 30th edition of the Arizona Daily Star, directly above an op-ed from AFP Arizona (http://www.azstarnet.com/business/273696).

Krugman’s column was titled “50 Herbert Hoovers: State cuts fuel economic crisis,” and rehashed the classical Keynesian line that governments should expand spending and increase deficits during recessions. In some local blog posts and columns, Krugman’s Arizona followers have used his column to argue against the kind of spending reductions we advocated in our op-ed. One column suggested that Gov. Jan Brewer may be "Herbert Hoover in high heels and a pantsuit." Those writers (and Krugman, for that matter) need to look again at the fiscal policies of President Herbert Hoover.

In reality, Herbert Hoover and the Congresses of 1930-32 did exactly what many on the left in Arizona would have the state government do in the current crisis: they went heavily into debt, raised taxes, and kept government spending at high levels as a portion of the economy. Indeed, Hoover's policies look suspiciously similar to those put forth this week by departing Gov. Janet Napolitano...

In 1930, the federal government had a surplus. But in one year, Hoover and Congress ran a deficit of $2.2 billion (yes, that’s a “b”), the largest peacetime deficit in US history up to that point. Hoover's Revenue Act of 1932 was the largest tax increase up to that point, and raised the top income tax rate from 25 percent to 63 percent. Of course, Hoover had also signed the Smoot-Hawley bill, which raised taxes on imports (tariffs).

While Hoover’s policies in 1932 were aimed at balancing the federal budget, he and Congress did not reduce government expenditures in any meaningful sense. According to the OMB, federal government outlays as a portion of US GDP rose from 3.4 percent in 1930, to 4.3 percent in 1931, to 6.9 percent in 1932. Spending by all governments in America rose from 13.2 percent in 1930, to 15.9 percent in 1931, to 21.2 percent in 1932.

The notion that Hoover governed as a do-nothing, laissez-faire conservative has no basis in fact, and is part of the wider New Deal mythology that is spoon-fed to American schoolchildren and repeated ad nauseum by Keynesian economists. In fact, Hoover is more properly understood as having been the first New Dealer. FDR took the hand-off from Hoover, and proceeded to tax and spend at even greater rates. The highest individual income tax rate went to 79 percent. FDR also continued--and greatly expanded--Hoover's efforts to goad producers into keeping factor prices high (exactly the opposite of what was allowed to happen in previous recessions).

Here are the total government outlays (including state and local) for 1930-1941 as a portion of GDP:

Year_____Total_____Federal

1930_____13.2%______3.4%
1931_____15.9%______4.3%
1932_____21.2%______6.9%
1933_____22.4%______8.0%
1934_____19.4%_____10.7%
1935_____20.2%______9.2%
1936_____20.0%_____10.5%
1937_____18.7%______8.6%
1938_____20.5%______7.7%
1939_____20.7%_____10.3%
1940_____20.1%______9.8%
1941_____19.2%_____12.0%

Keynesians try to explain FDR’s double-dip recession (even though output had not returned to 1929 levels, there was another downturn in 1937 and 1938) as the result of Roosevelt’s attempt to return to a balanced budget. But as you can see from looking at government spending as a portion of GDP, even if the federal government backed off from spending in 1937 and 1938, overall government expenditures in the country did not. In proportional terms, FDR taxed, spent, and went into debt like no other peacetime President before or since.

The cheerleaders for "fiscal stimulus" have routinely failed to explain why, if New Deal taxing, spending, and borrowing was so stimulative, the Great Depression lasted between nine and fifteen years--significantly longer than any previous recession in American history.* Even the apparent recovery in 1939 and 1940 was not much to shout about. Although the unemployment rate had fallen significantly from its apex of 25 percent in 1933, it never fell below 14 percent until after 1940.

(By comparison, unemployment was nearly as bad during the Depression of 1893-97, but the country benefited from Grover Cleveland’s laissez faire approach to economic policymaking, which resulted in a much quicker and heartier recovery. The same could be said of Warren Harding’s mostly hands-off response to the downturn of 1920-1922.)

Of course, the Keynesian explanation for the failure of “fiscal stimulus” to pull the country out of the Great Depression is that Hoover and FDR just didn’t spend enough or go deeply enough into debt—even though they spent far more and went farther into debt than any peacetime Presidents had ever done. For some folks, there's just never enough government spending.

Tom Jenney
Arizona Director
Americans for Prosperity
www.aztaxpayers.org

*Those who have read the “Economics focus” column in the January 3rd issue of The Economist may have gotten the impression that the recession of in the mid-1870s was the longest recession in US history. It's hard to argue with the NBER, but I've gone back and reviewed the recovery times for real GDP per capita in the Johnston-Williamson data (see below). I have also included the percentage drops in real GDP for the major US recessions.

Recovery Times & Percentage Drop for Real GDP/Capita
(Source: http://www.measuringworth.org/usgdp/)

Presidents on Duty**__________Years_______________Drop

Hoover/FDR______________1930-1938___(9)_________29%
Taft/Wilson_______________1908-1915___(8)_________13%
Van Buren/Tyler___________1837-1842___(6)__________4%
Cleveland________________1893-1897___(5)_________14%
Arthur/Cleveland__________1883-1886___(4)__________6%
Harding_________________1920-1922___(3)__________6%
Grant___________________1874-1876___(3)__________3%
Polk/Taylor_______________1848-1850___(3)__________2%

There were also three long recoveries following wars,
but wartime GDP stats may have been skewed upward:

Truman/Eisenhower_______1945-1954__(10)_________14%
Johnson/Grant___________1864-1871___(8)__________8%
Madison/Monroe__________1815-1823___(8)__________6%

(And in any case, researchers all readily admit that
national income information from the 19th century is
pretty murky.)

**This is just for historical reference, and not meant to imply
that the Presidents on duty were responsible for the length or
severity of their recessions. In most cases, the Presidents on
duty had little or nothing to do with the monetary conditions
that created their recessions. (However, as I outlined above,
there is strong evidence that the hyperactive “stimulus” policies
of Hoover and FDR made the recession of the 1930s much
longer and much more severe than it had to be.)

James Watt: Monopolist

by Michele Boldrin and David K. Levine

In late 1764, while repairing a small Newcomen steam engine, the idea of allowing steam to expand and condense in separate containers sprang into the mind of James Watt. He spent the next few months in unceasing labor building a model of the new engine. In 1768, after a series of improvements and substantial borrowing, he applied for a patent on the idea, requiring him to travel to London in August. He spent the next six months working hard to obtain his patent. It was finally awarded in January of the following year. Nothing much happened by way of production until 1775. Then, with a major effort supported by his business partner, the rich industrialist Matthew Boulton, Watt secured an act of Parliament extending his patent until the year 1800. The great statesman Edmund Burke spoke eloquently in Parliament in the name of economic freedom and against the creation of unnecessary monopoly — but to no avail.[1] The connections of Watt's partner Boulton were too solid to be defeated by simple principle.

Once Watt's patents were secured and production started, a substantial portion of his energy was devoted to fending off rival inventors. In 1782, Watt secured an additional patent, made "necessary in consequence of ... having been so unfairly anticipated, by [Matthew] Wasborough in the crank motion" [2]. More dramatically, in the 1790s, when the superior Hornblower engine was put into production, Boulton and Watt went after him with the full force of the legal system.[3]

During the period of Watt's patents the United Kingdom added about 750 horsepower of steam engines per year. In the thirty years following Watt's patents, additional horsepower was added at a rate of more than 4,000 per year. Moreover, the fuel efficiency of steam engines changed little during the period of Watt's patent; while between 1810 and 1835 it is estimated to have increased by a factor of five.[4]

After the expiration of Watt's patents, not only was there an explosion in the production and efficiency of engines, but steam power came into its own as the driving force of the Industrial Revolution. Over a thirty year period steam engines were modified and improved as crucial innovations such as the steam train, the steamboat and the steam jenny came into wide usage. The key innovation was the high-pressure steam engine — development of which had been blocked by Watt's strategic use of his patent. Many new improvements to the steam engine, such as those of William Bull, Richard Trevithick, and Arthur Woolf, became available by 1804: although developed earlier these innovations were kept idle until the Boulton and Watt patent expired. None of these innovators wished to incur the same fate as Jonathan Hornblower.[5]

Ironically, not only did Watt use the patent system as a legal cudgel with which to smash competition, but his own efforts at developing a superior steam engine were hindered by the very same patent system he used to keep competitors at bay. An important limitation of the original Newcomen engine was its inability to deliver a steady rotary motion. The most convenient solution, involving the combined use of the crank and a flywheel, relied on a method patented by James Pickard, which prevented Watt from using it. Watt also made various attempts at efficiently transforming reciprocating into rotary motion, reaching, apparently, the same solution as Pickard. But the existence of a patent forced him to contrive an alternative less-efficient mechanical device, the "sun and planet" gear. It was only in 1794, after the expiration of Pickard's patent that Boulton and Watt adopted the economically and technically superior crank.[6]

The impact of the expiration of his patents on Watt's empire may come as a surprise. As might be expected, when the patents expired "many establishments for making steam-engines of Mr. Watt's principle were then commenced." However, Watt's competitors "principally aimed at...cheapness rather than excellence." As a result, we find that far from being driven out of business "Boulton and Watt for many years afterwards kept up their price and had increased orders" [7].

In fact, it is only after their patents expired that Boulton and Watt really started to manufacture steam engines. Before then their activity consisted primarily of extracting hefty monopolistic royalties through licensing. Independent contractors produced most of the parts, and Boulton and Watt merely oversaw the assembly of the components by the purchasers.

In most histories, James Watt is a heroic inventor, responsible for the beginning of the Industrial Revolution. The facts suggest an alternative interpretation. Watt is one of many clever inventors working to improve steam power in the second half of the eighteenth century. After getting one step ahead of the pack, he remained ahead not by superior innovation, but by superior exploitation of the legal system. The fact that his business partner was a wealthy man with strong connections in Parliament, was not a minor help.

Was Watt's patent a crucial incentive needed to trigger his inventive genius, as the traditional history suggests? Or did his use of the legal system to inhibit competition set back the industrial revolution by a decade or two? More broadly, are the two essential components of our current system of intellectual property — patents and copyrights — with all of their many faults, a necessary evil we must put up with to enjoy the fruits of invention and creativity? Or are they just unnecessary evils, the relics of an earlier time when governments routinely granted monopolies to favored courtiers? That is the question we seek to answer.

In the specific case of Watt, the granting of the 1769 and especially of the 1775 patents likely delayed the mass adoption of the steam engine: innovation was stifled until his patents expired; and few steam engines were built during the period of Watt's legal monopoly. From the number of innovations that occurred immediately after the expiration of the patent, it appears that Watt's competitors simply waited until then before releasing their own innovations. This should not surprise us: new steam engines, no matter how much better than Watt's, had to use the idea of a separate condenser. Because the 1775 patent provided Boulton and Watt with a monopoly over that idea, plentiful other improvements of great social and economic value could not be implemented. By the same token, until 1794 Boulton and Watt's engines were less efficient they could have been because the Pickard's patent prevented anyone else from using, and improving, the idea of combining a crank with a flywheel.

Also, we see that Watt's inventive skills were badly allocated: we find him spending more time engaged in legal action to establish and preserve his monopoly than he did in the actual improvement and production of his engine. From a strictly economic point of view Watt did not need such a long-lasting patent — it is estimated that by 1783 — seventeen years before his patent expired — his enterprise had already broken even. Indeed, even after their patent expired, Boulton and Watt were able to maintain a substantial premium over the market by virtue of having been first, despite the fact that their competitors had had thirty years to learn how to make steam engines.

The wasteful effort to suppress competition and obtain special privileges is referred to by economists as rent-seeking behavior. History and common sense show it to be a poisoned fruit of legal monopoly. Watt's attempt to extend the duration of his 1769 patent is an especially egregious example of rent seeking: the patent extension was clearly unnecessary to provide incentive for the original invention, which had already taken place. On top of this, we see Watt using patents as a tool to suppress innovation by his competitors, such as Hornblower, Wasborough and others. Hornblower's engine is a perfect case in point: it was a substantial improvement over Watt's as it introduced the new concept of the "compound engine" with more than one cylinder. This, and not the Boulton and Watt design, was the basis for further steam-engine development after their patents expired. However, because Hornblower built on the earlier work of Watt, making use of his "separate condenser" Boulton and Watt were able to block him in court and effectively put an end to steam-engine development. The monopoly over the "separate condenser," a useful innovation, blocked the development of another equally useful innovation, the "compound engine," thereby retarding economic growth. This retardation of innovation is a classical case of what we shall refer to as intellectual-property inefficiency, or IP inefficiency for short.

Finally, there is the slow rate at which the steam engine was adopted before the expiration of Watt's patent. By keeping prices high and preventing others from producing cheaper or better steam engines, Boulton and Watt hampered capital accumulation and slowed economic growth.

The story of James Watt is a damaging case for the benefits of a patent system, but we shall see that it is not an unusual story. A new idea accrues almost by chance to the innovator while he is carrying out a routine activity aimed at a completely different end. The patent comes many years after that and it is due more to a mixture of legal acumen and abundant resources available to "oil the gears of fortune" than anything else. Finally, after the patent protection is obtained, it is primarily used as a tool to prevent economic progress and hurt competitors.

While this view of Watt's role in the Industrial Revolution may appear iconoclastic, it is neither new nor particularly original. Frederic Scherer, a prestigious academic supporter of the patent system, after going through the details of the Boulton and Watt story, concluded his 1986 examination of their story with the following illuminating words:

Had there been no patent protection at all,…Boulton and Watt certainly would have been forced to follow a business policy quite different from that which they actually followed. Most of the firm's profits were derived from royalties on the use of engines rather than from the sale of manufactured engine components, and without patent protection the firm plainly could not have collected royalties. The alternative would have been to emphasize manufacturing and service activities as the principal source of profits, which in fact was the policy adopted when the expiration date of the patent for the separate condenser drew near in the late 1790s…. It is possible to conclude more definitely that the patent litigation activities of Boulton & Watt during the 1790s did not directly incite further technological progress…. Boulton and Watt's refusal to issue licenses allowing other engine makers to employ the separate-condenser principle clearly retarded the development and introduction of improvements.[8]