John Maynard, Lord Keynes, (1883 - 1946) was a British economist whose ideas define modern fiscal policies, as they clearly elucidate the effects of government actions on the broader economy. Very generally, Keynesian economics advocates interventionist government policies to mitigate the adverse effects of economic recessions, depressions and booms. Spend (even unto deficits) to ameliorate the impact of recessions; repay deficits and retract discretionary spending during booms. The idea is to get us closer to the political economists’ holy grail of defeating the business cycle – nothing but good times. Lord Keynes’s body of work is the foundation of macroeconomics, a national economy taken as a single organism (microeconomics being the treatment of subsystems within the macroeconomy).

The most powerful tools a government has to influence the behavior of the broader economy are taxation and subsidization – if you want more of something, the adage goes, subsidize it; if you want less of something, tax it. Most famously, the Omnibus Budget Reconciliation Act of 1990 included – in the name of fairness, of course – a stern tax on “luxury items” (read: automobiles, aircraft, jewelry and furs over certain prices, and yachts costing more than $100,000). In 1990, the Joint Committee on Taxation projected that the 1991 revenue yield from luxury taxes would be $31 million. The actual effect was the loss of 330 jobs in jewelry manufacturing, 1,470 in the aircraft industry and 7,600 in boating, almost single-handedly dismantling the American boat-building industry. Thus, it became known as the “Yacht Tax”. The job losses cost the government a total of $24.2 million in unemployment benefits and lost income tax revenues. So the net effect of the taxes was a loss of $7.6 million in FY1991, which means the government projection was off by $38.6 million (or more than 124% in a single year!). This is such a shining example of governmental action having totally different results from those expected, that it serves as the poster child for unintended consequences.

What happened? Instead of people continuing their behavior of buying the same luxury items at the same rate, fewer people bought the taxed products. Demand went down when prices went up. In particular, people bought their yachts overseas. Government’s attempt to shift some of the revenue burden up the tax-brackets in fact hurt the highly-skilled, middle-class workers whose jobs were destroyed[1]. More than almost any other field of endeavor, applied economics is a living example of Frank Lloyd Wright’s admonition to his students – “A thing will do what its design permits it to do, regardless of what the designer had in mind.”

The MOAB (Mother Of All Blunders) of fiscal dysfunction, of course, was the utter collapse of capital markets that culminated in the stock market crash of 1929[2]. The situation was allowed to foment via incrementalism and a lack of regulatory vigilance. After the close of hostilities in the Great War, there was a general concern that a post-war pause would take some of the air out of our industrial base. As incentive to keep the money flowing, some brokerage houses allowed their best customers to buy stock on a 20% margin – giving them full discretionary rights (buy-sell-vote) on stock purchases by paying only 80% of the face value, the balance due upon sale or if the brokerage issued a “margin call” (calling in the balance). Over the next five years or so, nearly all houses were playing, margins had crept to 50% and eligibility had relaxed to include ordinary customers who had a favorable history with the brokerage.

It was somewhere around this point that the exchange and/or government should have warned about the moral hazard of letting more and more people buy things of greater and greater value contingent upon riskier and riskier credit. But no one did. Over the next five or so years, “conventional wisdom” had it that the NYSE would only go up, cab drivers were giving their customers stock tips, and anyone could buy stock on 90% margins. Catastrophe was inevitable.

Capitalism hadn’t failed, various players were allowed to distort price separately from the forces of supply and demand, and the market reacted accordingly. That’s the technical definition of a bubble, and government could have intervened if the affected sector didn’t. Neither did. An unobtrusive fix could have been executed, as noted, as margins approached 50% and eligibility was drifting away from those who could afford it toward those who couldn’t. The threat of banning the practice, or of draconian regulations could have reigned-in the practice and allowed the market to heal itself. Instead, risk was ignored until it dominated the market and a tipping-point was reached. The market disintegrated.

It happened again, in a lesser version, in 1999 - 2000, when the dot-com bubble burst, taking about of fourth of the NYSE with it, but the tech-heavy NASDAQ lost three-fourth of its value. Once again, [stock] price had become divorced from supply-and-demand [profitability] as “conventional wisdom” assumed that internet start-ups could only go up. Catastrophe was inevitable.

In both cases, laws – other than those of common sense – weren’t broken. Both are examples of abysmally bad fiscal policy – in the everyday world, not from government. But the lessons are the same – intentions are transparent to outcomes. If you operate a system counter to how that system functions, you will break it.

[1] This is a lesson politicians apparently must relearn every twenty years or so.

[2] It was in reaction to the Great Depression that Lord Keynes issued his classic works.