Pennsylvania borrowed more money to build infrastructure supporting canals than any other state to take advantage of the trade opportunities of the Erie Canal. Construction started on the South Fork Dam in 1838 with scheduled completion within a year, but by the time it was finished in 1852 the railroads had made it obsolete. The state wrote it off and it eventually provided a fishing lake for Pittsburgh’s elite. When it burst in 1889, causing the Johnstown flood, the total loss in life and property was probably 100 times the initial construction cost. Pennsylvania, having long since declared bankruptcy in 1841, blamed the rich.
Most every year the Congress metaphorically dances on top of the earthen South Fork Dam looming over Johnstown with the water lapping at their feet. Their solution is always the same: Let’s throw some more dirt on top this year. We’ll drain it when we drain the swamp, after we eliminate the air pollution in Johnstown, the price paid for the industrial revolution raising American living standards in the late 1800s.
The primary issue facing America during the post WW II era was whether its consumerist economy could continue to produce rising living standards for all, the cornerstone of political legitimacy. The leader of America’s competitor Nikita Khrushchev in the Soviet Union put the issue crudely six decades ago: “we will bury you” with a savings and investment rate several multiples of yours. America’s intelligence community and economic elite were shocked by the sudden collapse of the Soviet economy – like a dam bursting – less than three decades later.
Khrushchev, like most of America’s development economists, understood the role of saving and investment but not how important the private capital markets were to the allocation of capital to its highest and best use, politically directed credit being the main cause of their collapse. In Johnstown everyone knew that the valves to lower the water level in the lake had been removed during the last amateurish reconstruction, but fixing or removing it was opposed by rich land owners. The debt ceiling has similarly proven an ineffective mechanism to control America’s flood of debt, with the central bank standing ready to buy it all to the benefit of the wealthy. American politicians, feeling unbound by constitutional constraints, are addicted to issuing debt, the birthing person’s milk of politics. The Biden Build Back Better Plan promises to strengthen the dam, but like the amateurish repairs to the South Fork will weaken the dam’s foundation while causing water levels to rise, possibly to a critical level.
The Debt Level is Reaching a Crisis Stage
Keynes may be dead, but savings still equals investment and productive investment remains the only source of all real economic growth and rising living standards. America’s comparatively low national savings rate of the 1950s and 1960s has been declining further for the last half century, with net investment following in lockstep, dipping close to zero in the last recession.
The US is a “mixed” economy with federal credit allocation implemented through taxes, regulations and more recently Soviet style central-bank directed credit. Households compete in the capital markets for savings with business and government primarily to finance housing which improves living standards directly. Business investment historically improved real wages but they have been stagnant for the last half century, implying that worker productivity no longer rises in lockstep with business investment. Real income has kept pace with GDP growth due to transfers financed primarily by directly or indirectly taxing the returns on capital that undermine private investment incentives and government borrowing that crowds it out, leaving future generations to pay the principal and interest out of reduced real wages.
This has lead to accelerating federal debt, now at over $27 trillion, to finance welfare and entitlements, the primary cause of low national savings. Financing the additional unfunded liability for Social Security and Medicare is estimated to cost about one hundred trillion dollars. CBO’s current baseline forecast has the debt growing by only 50% by the end of this decade, so that water levels never reach the crest of the dam, but based on their historical optimism, the actual debt will likely grow by almost 250% of that amount. The only question at these debt levels is whether America goes out with a bang or a whimper, the dam bursting being the primary historical precedent.
Politicians and their research arm the CBO use the per capita growth rate of real GDP as the measure of return on investment and improved living standards. This works for the competitive private sector, but bureaucratic incentives at all levels of government in the US aren’t much different than in planned economies. Real increases in teachers salary and administrative expenses, for example, don’t generally result in improvements in primary education, resulting instead in political enforcement of a government monopoly. Parenthetically, some libertarians have suggested government expenditures be subtracted from GDP as counterproductive.
Starting from a recessionary low, per capita GDP growth remained negative for the first several years of the Obama Administration, which ended with a 1.5% average, the lowest in 70 years in spite of a trillion dollar infrastructure program. The Trump business tax reform provided a small temporary boost to business investment and hence GDP growth, but ignoring COVID gyrations business investment is only about 2.2% of nominal GDP and trending down. Obviously, these trends need to be reversed soon to prevent the dam from collapsing.
Biden’s Build Back Better – the Soviet Way
The first step to avoid this fate is to change the direction of savings by incenting savings over consumption for households, businesses and particularly government, and most importantly the federal government. The second step is to restore capital allocation of this limited pool of savings to its highest and best use. That’s been obvious for the past half century.
But the current Biden Plan proposes more of the same: roughly $1 trillion physical infrastructure and an additional $3.5 trillion (more likely $5 trillion) for human infrastructure to “grow” out of the debt problem. The environmental agenda, which I previously described as national suicide, is mostly held back for phase two. Taxes fund little of the physical infrastructure bill and the potential tax increases for human infrastructure are mostly imposed on capital, which reduces private investment as much as public debt, so the total package can be evaluated as substituting federal spending for state and local and mostly private investment. What are the expected returns?
The Physical Infrastructure
There is nothing unusual or urgent about the bipartisan infrastructure bill. Calculating returns for federal investment requires an unbiased assessment of indirect cash and non cash returns and the distribution of possible outcomes. Such investments will add to GDP growth if the appropriately measured returns, direct and indirect, exceed the average return on private fixed business (for simplicity as home ownership services aren’t included in GDP) investments they are replacing and subtract from GDP growth if they are below. Put differently, federal investments will be written up to reflect excess returns and down to reflect shortfalls, i.e., deficit financed expenditures. This is essentially the CBO approach, which based on past experience assumes that the return on federal investment is only half that of the private sector.
The first striking thing about the now bipartisan infrastructure proposal, e.g., $110 billion for roads and bridges, $200 billion utilities, $135 billion other transportation, $35 billion environmental, is that all of this could have been funded by the states: it is estimated that 99% of the Obama federal stimulus substituted for state expenditures. The second thing is that almost all of these expenses have at one time and or place been financed privately or by independent corporate utilities or instrumentalities. Much of what was historically considered public infrastructure, e.g., roads, reflected the inefficiency and expense of user fees, now obsolete with built in transponders and GPS. Even basic research mostly substitutes for private investment.
Because the plan eschews all control mechanisms of private or corporatized entities such as user fees, bypasses local control and gives federal politicians direct control over who gets funds, I assume the CBO discount of 50% for long lived assets. The CBO writes it down about half this much, mostly reflecting funds diverted from already budgeted sources that would not otherwise be spent.
The “Human” Infrastructure Spending
With the death of Fidel Castro, Budget Chairman Bernie Sanders at 80 years old may be the oldest living socialist leader. His “human infrastructure” budget is the most extreme progressive budget yet. I’ll comment on the two biggest parts, education and welfare, the difference being that the former has not obviously improved human productivity, while that latter has reduced it.
In the wake of the federal sub-prime lending debacle, the Obama Administration took over student lending in 2010 to “use” the $58 billion in projected taxpayer saving to finance and pass Obamacare. Instead, the final write-downs, write-offs and loan forgiveness could easily exceed a trillion dollars. Started in the early 1960s to accommodate the first of the baby boomers, e.g., President Biden, the public university expansion continued on for about a half century beyond the peak of the baby-boom bubble, crowding out all but the more elite private institutions. The purported rationale was that the investment in human capital would pay off in higher productivity and living standards as the “A & E” (agriculture and technical [engineering]) land-grant public institutions founded in the second half of the 19th Century had. Costs have continually skyrocketed with the federal demand stimulus, with much of the expense going to layer upon layer of administration and such amenities as luxury dorms.
College graduates have historically earned substantially more than high school students. But the marginal students induced into college that do not graduate with science, technology, engineering or math (STEM) degrees remain unemployed longer and many ultimately accept jobs not requiring a college degree, catching up to their high school peers only after years of on the job training. Low/no initial entry requirements and grade inflation have reduced the college graduate signaling effect, and almost half haven’t graduated after six years.
Until the early 1970s real wages in the US increased in lockstep with business productivity, implying that labor and capital were complementary, requiring on the job training. One can think of numerous industries where formal education has increased subsequent worker productivity, e.g., computer science. But it is hard to find the payoff for the population as a whole for either non-STEM higher education or the plethora of government training programs. Similarly, since the creation of the federal Department of Education in 1979, the total cost of primary and secondary education has steadily risen while the quality has steadily fallen.
Societies always find a way to help those who need it, but socialist economies enforced work requirements with a credible threat of the Gulag, leading to the Soviet worker’s quip, “We pretend to work and they pretend to pay us.” Parenthetically, the same incentives apply to the US public sector and quasi-public government-dependent institutions, many of whose workers now earn much more than their private sector counterparts. The Great Society’s subsidy programs had no work requirements, hence reducing labor force participation and precautionary savings. The effort to add work requirements during the Clinton Administration didn’t last. Whatever else may justify the Sanders/Biden expansion of the welfare state, this remains a substantial contributor to the national debt.
As $6 trillion is about the current annual rate of business investment, the loss, spread over 5 years, would further reduce the growth rate of GDP annually by about 20%. As then Vice President Biden said to President Obama (and the world) “it’s a big f—ing deal,” not because it alone filled the lake, but because it could be the last flood. Millionaires Bernie Sanders at 80 and President Biden at 78 – ten to fifty times wealthier and twice the age of the average American – are in a rush and don’t seem too worried about potential consequences. But unlike the South Fork, it won’t take the perfect storm. To paraphrase their contemporary, Bob Dylan, it doesn’t take the CBO to know which way the wind blows. and it’s a hard rain that’s gonna fall.
Kevin Villani, Chief Economist at Freddie Mac from 1982 to 1985, has held senior government positions, has been affiliated with ten universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath.