Memo To: Website fans, browsers, clients
From: Jude Wanniski
Re: A Thanksgiving Special
Way back in 1988, at the end of the Reagan years, Tim Forbes, the younger brother of Steve and then the publisher of American Heritage monthly, interviewed me for the magazine. The headline was “Can History Save Us From a Depression?” I came across it the other day while rummaging through my files and decided it holds up pretty well over these last dozen years. It is rather long, but we are in for a long weekend, four days worth, and Supply-Side University is on Thanksgiving break. Take your time.
Can history save us from a depression? It depends on whose interpretation of both history and the current crisis you believe. For one of America's most prominent supply-side economists, the answer is yes.
An Interview with Jude Wanniski by Timothy C. Forbes
Jude Wanniski was among the early leaders in the revival of supply-side economic theory. A former associate editor of The Wall Street Journal, he founded and is president of the consulting firm Polyconomics, Inc., which is located in Morristown, New Jersey, and advises leading corporations and institutional investors on economics, politics, and communications. In 1978 Simon & Schuster published his pioneering book on economic theory and history, The Way the World Works. In it he draws heavily on historical precedent to argue that low tax rates are essential not merely to the wealth of a nation but to the welfare of its citizens and the progress of society. His ideas have significantly influenced the Reagan administration. Interestingly, he has no formal training in economics (he holds a B.A. in political science and an MS. in journalism from UCLA); but the late chairman of the Federal Reserve, Arthur Burns, once observed to him that this was precisely his advantage.
This conversation took place in Wanniski's office on Election Day, November 3, 1987.
In your book The Way the World Works, you pin the cause of the crash of October 1929 on the rising protectionist sentiment that ultimately yielded the Smoot-Hawley Tariff Act. That's not the consensus of economic historians. How did you come to this idea?
Until October 1987, at least, the crash of 1929 was the most cataclysmic economic event of the century. As a result of the crash of '29, supply-side economic theory, which had been dominant in the Western world for almost two centuries, was forced into retreat. In other words, those economists who built their ideas, their economic models around the assumption that the producer of goods was the dominant actor in the economy couldn't explain why the market crashed. Consequently, policy makers turned to alternative models. They turned to demand-side economists, the Keynesians and the monetarists, who came up with the idea that the Depression had occurred because of insufficient purchasing power. The masses of people had insufficient purchasing power, insufficient demand power. So the demand-management school of economics took over and bit by bit became dominant throughout Europe and especially in the United States. But by the 1970s the demand-side theories were no longer working. They could not explain the stagflation that began creeping into the system in the late sixties and became a way of life in the 1970s.
This was the state of things that led me to those economists who were reviving classical theory -- supply-side theory -- as a way of thinking about the world of the 1970s. But the requirement, I felt, was to find a rationale for the cause of the crash of '29 that would enable us to rehabilitate the classical model. I knew there had to be some event that caused such a cataclysmic interruption in dealings between producers and traders. And my answer was that it was the Smoot-Hawley Tariff Act of 1930.
How did you make this discovery?
I was at the American Enterprise Institute for Public Policy Research writing my book, and I had promised the publishers that I would explain the crash. But I was already into the fourth chapter, and I was no closer to finding the causes. Then one of the professors at the institute, Dr. Gottfried Haberler, and I had lunch. And I could see that there was nothing I could squeeze out of him that I hadn't gotten out of the literature. But when I got back to my office, a messenger came from his office with a monograph he had written on the Great Depression. It was only thirty pages long, and, maybe on page 12, Haberier had mentioned something about how the Smoot-Hawley Tariff Act of 1930 had contributed to the Great Depression. When I saw "1930," I got very excited, because I'd always thought Smoot-Hawley was 1931. But 1930 meant that the Congress that passed Smoot-Hawley was the same one that was sitting in 1929. Well, I couldn't wait to get into the library to get out The New York Times microfilm and crank it up to the last week in October.
There, at the top of the page, the market was crashing -- and on the bottom of the page, the Smoot-Hawley Tariff Act was being debated in the United States Congress. So that was the "Aha!" experience.
In John Kenneth Galbraith's book, The Great Crash of 1929, he proposes quite a different hypothesis, one that I think appeals to the moralist bent in Americans. He acknowledges that tax rates, monetary policy, and earnings expectations motivate stock prices early in a bull market. But as the prices rise for a period of time, a new element enters. He calls it the "dynamics of speculation"- greed, in short. This dynamic drives the price out of any relation to underlying values. In fact, a crash-the crash of '29, and I'm sure he'd think much the same about the crash of '87 - is inherent in this very dynamic. It's inevitable that the bubble is going to burst once this virus has infected the system. How credible an explanation of the rise and fall of bull markets do you believe this is?
In the largest sense I don't think it has very much substance. There's certainly truth to the idea that most people who are piling into a bull market don't really know what they're doing. They're being pulled in by the vacuum. What's really happening is an arbitrage between profit opportunities and the availability of capital. And it's almost a mathematical certainty that if profit opportunities are seen by people, and they are willing to commit enough of their resources, they draw others in.
But what you have with a sharp run-up in the value of shares in the 1920s and 1980s is a reaction to long periods before then of errors in economic policy that drove profit opportunities down to a very low level. And suddenly some smart people came in and changed the structure of government policy. Profit opportunities rose so quickly that markets adjusted rapidly. Then the collapse in prices occurred because a great, almost accidental error was made; in the case of Herbert Hoover it was his signing of protectionist trade legislation.
There's this idea that much of the run-up occurs because of the greater-fool thesis, that people are buying shares and passing them on, one to the other. But this ignores, especially in the United States, the tremendous hedge markets we have. We've got a lot of smart people out there who are selling short, betting the market will fall. And they're as motivated by greed in their short sales as others who are motivated by greed going long.
I've always felt that Galbraith, if he had looked at The New York Times the way I did, might have found the Smoot-Hawley answer. But I think what happened with Galbraith is that he was so far along in his career by the time he had come to write The Great Crash of 1929, he probably had a research assistant looking at the microfilm who didn't notice that there was something going on there. So he had to come up with a theory of why the market crashed, and it was a theory that the market crashed because it was too high.
In other words, it's a non-explanation. While the forces may be operating - greed is certainly part of life - it doesn't explain what actually triggered the crash?
Right. The crash of '29 was triggered by the recognition on the part of the world markets that the United States was more likely at the end of the last week of October 1929 than it was at the beginning of the week to impose protectionist trade barriers on world commerce. And so the Dow-Jones industrial average fell from its peak of 381 around Labor Day of 1929 to a low of 230 in the last week of October. Of course, this was only the first wave. Other countries retaliated against Smoot-Hawley with protectionist tariffs of their own. So you had an imploding of world trade that sent the world reeling backward, giving up perhaps thirty years' worth of progress. And we had to go through a depression and a world war in order to get to a higher state.
One of the things that's frightened me throughout the current period is that although supply-siders like me believed they knew what was going on, they were confronting a world of policy makers who didn't. We believed that unless we could act rapidly enough, we could wind up having the world break down into a global depression that would lead to a nuclear war. The global electorate has to keep its wits about it and move to avoid the same kind of cataclysm we had in the 1930s and 1940s.
A lot of people now are drawing the parallels between '29 and '87. We've had a boom, and a stock market crash, and now the question on everyone's mind is, Where do we go from here? Is a recession or even a depression unavoidable?
The adverse effects of the crash of '29 could have been avoided. The market expectations of October 1929 were that bad things were going to happen in the future. Now if Hoover hadn't signed the Smoot-Hawley Tariff Act, or if foreign retaliation had not followed and further diminished commerce, something very different might have occurred. And remember, this diminution of commerce brought government revenues down in the United States so much that Hoover said we had to raise taxes to make up for the lost revenues. One error built upon another error until we got to the low point of the Dow Jones Average, 41, that was hit in the summer of 1932. It was within days of Roosevelt's nomination in Chicago and his acceptance speech with its commitment to free trade.
Which was a flat repudiation of Hoover and the Republicans as the party of protectionism and isolationism.
Exactly. Our ruling elite didn't see, in 1929, how important it was that we be international in our approach, how important it was that in being a global leader, we not act as we had in the previous periods of our growing up, as narrow nationalists. In earlier days we could get away with pushing tariffs up and down and had done so. But we were in a far different position by the 1920s.
What had changed?
The United States in the 1920s was already the richest country in the world. We were booming on the supply-side ideas of Andrew Mellon, the Secretary of the Treasury, and Presidents Harding and Coolidge. We were growing at a great pace, and the rest of the world was kind of drawing water and hewing wood in support of our boom. But historically this kind of disequilibrium can't go on for very long. Either we were going to have to become poorer or they had to become richer.
The correct solution back in the late twenties, rather than the one we chose through the Smoot-Hawley Tariff Act - which made us poorer - was to share these growth ideas with the rest of the world. I'm not talking about sharing through the distribution of goods, by sending foreign aid out of the United States. I'm talking about sending ideas out. We are now getting a second run at this global leadership. Now, I hope, we're going to be able to meet the challenge.
You mention the Mellon tax cuts of the twenties, which are one of the inspirations, certainly, for the whole supply-side revival in economics. Those tax cuts, and the boom that followed, actually increased government revenues to the point where there were regular surpluses. In that period, the national debt declined by some 30 percent. Why didn't the Reagan tax cuts of our era achieve the same ends?
A couple of things. One is that there was no social safety-net system in the 1920s. So when the crash occurred, Andrew Mellow said, well, you liquidate capital; you liquidate labor; you just liquidate things until you get back to a new equilibrium. But that meant that the poorest people in the country were crushed in the process. You can't do that today - and shouldn't. The second thing is that in the 1920s we were on a gold standard. That meant that monetary policy was acting at an optimum rate.
Now we have a floating currency, where monetary errors can be made and have been. We had a monetary deflation that brought the price of gold down very sharply from when Reagan was elected - from $620 to less than $300 in the summer of 1982. So we wound up with a recession, and this process brought the big deficits. Supply-siders were warning in the early 1980s that unless the Federal Reserve System was prevented from tightening monetary policy in 1981 and 1982, as it did, we would wind up with colossal budget deficits.
Recession in the kind of welfare state we have arranged is enormously expensive. The safety net is a good thing, but it costs. So supply-siders have been arguing from the beginning of the Reagan administration that at all costs recession must be avoided.
So, in your view, the budget deficits are a consequence not of tax cuts but of a restrictive monetary policy that triggered a recession in 1982. In any event, for years now, we have been running the highest deficits in our history, and we have a two-trillion-dollar national debt. Many suggest that the crash of October 1987 was in response to this. Is that right? How serious are the budget deficits? How serious is the national debt?
Again, the greatest threat to our deficits and our national debt is recession. The two-trillion-dollar national debt is not something that supply-siders are frightened by, because we have seen the tremendous addition, over the last several years, to the asset side of the ledger. The value of past savings, the value of financial assets to the United States, has risen by a phenomenal amount. It should make it relatively easy to finance the deficit, as long as we get it under control at some point. Now getting it under control at some point means not having any more recessions for a while. Not engineering them, certainly.
Doesn't history offer some comfort in terms of the debt and the budget deficits? They've increased tremendously in nominal terms, but as a proportion of gross national product or - as you just pointed out - as a proportion of assets, they're roughly what they were twenty-five years ago.
And they are much lower than they were at the end of World War II. At that time the publicly held national debt in the United States was something on the order of 120 percent of GNP. In other words, the whole country would have to work for fifteen months in order to pay off the national debt completely. At the present moment the publicly held national debt is something less than 50 percent of GNP, which means we would have to work six months to pay off the creditors.
What about the trade deficit?
We've become the world's greatest debtor because of the enormous capital inflows that have come into the United States as a result of supply-side growth policies. When we were beginning to sell the idea of encouraging the wealth of nations by getting tax rates down to an optimum level, we pointed out that if we did this first in the United States, we would quickly have to get the rest of the world to replicate our policies. Otherwise, capital would flow to the United States. And capital can flow to the United States net only if we run a trade deficit. A trade deficit is the flip side of a capital inflow.
If Japanese investors see that profit opportunities are greater in the United States than they are in Japan, they will sell us more goods than they're buying from us so that the differential can be used to buy financial assets. In other words, they can't buy stocks or bonds or hotels on Central Park South unless they sell us more goods than they're buying from us. So the capital inflow is huge today because we're a magnet for capitalism worldwide.
Why did this happen?
Because the United States, under President Reagan, had to grope its way out of the world of the 1970s - the world of stagflation - by cutting taxes. With the tax reform of 1986, the United States will have a top tax rate of 28 percent. This makes us, as The Wall Street Journal put it, the biggest tax haven in the world. And it is the capital flowing in that produces these enormous trade deficits.
The only solution to this disequilibrium is a recession in the United States or tax reforms in the rest of the world. Governments should bring the tax rates down in Europe and Japan and even more in the Third World. The highest tax rates in the world now are in Central America, South America, and sub-Sahara Africa, where no economic activity can really take place, because as soon as any occurs that's visible to the tax collector, the government confiscates the profits.
The common wisdom today says that the trade deficits and the budget deficits are looming over the economy in America, that they are the fundamental problems this economy faces. And according to many, they're a function of irresponsible tax cuts.
Those who make that argument are essentially correct, except that they're talking from the standpoint of those who would correct the problems by having a depression. They're part of the wrong solution - the one we really don't want to choose. Even those who are saying, "We must have a recession to correct the disequilibrium," can be faintly heard every now and then saying, "Well, yes, Germany and Japan should expand." But it's a kind of weak call, because they don't really understand the supply-side position. They know that there's something to what we say, but they're far more convinced of their own solution. So they say, "Even though we may have to go through some pain, better do it now than later, before it gets worse."
But I think that as long as we have a sense that we can get past these current difficulties, we'll be okay - if President Reagan can hang on with his commitment to keeping us out of recession through the rest of his term. Which means, as he puts it, to not allow deleterious tax increases to slow the economy down, to not permit protectionist trade legislation to be enacted, and to not get caught up in some great monetary error.
So, what triggered the crash of '87?
The feeling, worldwide, that the President has lost his dominant position in being able to manage this great economy. And the perception that the Congress of the United States, controlled by the Democratic party - which at this point in history is a party of pessimists - believes we must have trade legislation, we must have tax increases, we must even have a recession. All these threats are the real ogres now hanging over the market as a result of the world market's loss of confidence in President Reagan's ability to manage things.
But how do we solve the problem of the trade deficits? Let the dollar fall into oblivion?
No. Letting the dollar fall is inflationary. We could get into a 1979-80 cycle, in which the markets would see the value of financial assets evaporate in a monetary inflation.
That would be a trade war by other means, wouldn't it?
Yes. There are three major threats to the economy: a monetary inflation; increased taxation that could bring about a recession by reducing domestic profit opportunities; and increasing tariff walls through protectionist trade legislation that could reduce and diminish the United States as a magnet for capital. These three things could bring about the kind of recession that would make us poor enough to correct the trade deficit.
See, once you're poor enough, you can't afford the goods of the rest of the world, so you don't buy them. You're even too poor to buy the goods that you've produced yourself. So you sell them at going-out-of-business prices to the rest of the world. You have a fire sale. All of a sudden you have huge trade surpluses. This is what happened in the 1930s in the United States. Every month, month after month, the Department of Commerce would announce, "Well, the unemployment rate has gone up, but the good news is that the trade surplus has gotten bigger." We ran a trade surplus throughout the Depression.
So a trade surplus is not necessarily a sign of economic well-being?
No, it's not. You have to be able to look at the conditions. The trade surplus after World War I and after World War II was a sign of great strength in the United States, because the rest of the world was buying goods from us in order to rebuild, giving us financial assets in exchange. But now the trade deficit that we're having is a sign of great vitality because the capital inflows are arising out of the fact that we now have enacted the lowest tax rates on individuals in the world and we have become a magnet for capital. There is a great potential now for producing enough wealth to pay off the investments of the rest of the world, down the line. The rest of the world is really buying income streams; they're buying annuities here.
I think the only real solution to the trade deficits and the budget deficits is to go back again, again and again, to persuade the rest of the Western industrial democracies to reduce their tax rates, to expand. Not to reflate but to grow.
When we talk to the Germans now, all they seem to hear us saying is that they should increase their budget deficits and inflate their money supplies. And they're afraid of doing that because they think it will lead to inflation. But supply-siders are not saying that. We're talking about having them bring down their marginal income tax rates. They have a 56 percent top rate in Germany. Now they've promised to bring it down, by 1990, to 53 percent. But that's not enough. And it's not only Germany and Japan. I met with Treasury Secretary Baker a few weeks ago, and I told him, "You've got to get Germany and Japan to lower their tax rates, not just because those two countries are the problem but because they would serve then as models for Europe and Asia." Once Germany cuts its tax rates, then the rest of the European community would have to, in order to compete with Germany.
What would happen if they did not follow the German lead?
The Germans would have tremendous capital inflows. They would then switch from a trade-surplus country to a trade-deficit country. There's another, human dimension here too. Unless they were followed quickly by the rest of Europe in getting tax rates down, the Germans would then have to import workers from Italy and Turkey-guest workers-to come in and perform the work, just as now we have pressures in the United States with these great capital inflows to import people from the rest of the world to do the work.
The political disequilibrium is horrendous. Imagine, in the ridiculous extreme, that the United States was the only country in the world applying a correct economic policy. Then the only solution for the rest of the world would be to move to the United States. Everyone would come to the United States eventually if you had open immigration and if tax rates were 100 percent around the rest of the world and they were at optimum here. But we shouldn't have to do that. We shouldn't have to import the rest of the world just because we're the only land of opportunity.
Our mission is to serve as a beacon to the rest of the world, so that we can export our ideas. People in Mexico shouldn't have to move to San Diego to fulfill themselves. They should be able to stay where they are, with their families, their friends, their roots, their background and their culture. That is the objective of the 1990s. This is the challenge for the next American President and the growth leaders in the United States and in the Western world: to export the ideas of growth so that we solve the problems by having the rest of the world grow, not by having the United States decline.
That's the challenge. But what do you think will really happen?
The crash we had in October 1987 was a good dose of ice water, even on those politicians and businessmen who have come to take it all for granted and who may have brushed aside the idea that we have to worry about the rest of the world, believing that we can be an island of prosperity in a world of either semi-prosperity or poverty. The world won't let that happen. The global electorate won't let that happen.
Even if 98 percent of the world is prosperous and 2 percent somewhere has still not been brought aboard - and I can imagine this happening centuries from now - that 2 percent will give the rest of the world great headaches until we resolve that. They have to be brought up to the next stage. That's the march of history, the way I see it.
So in the long run, and in the short run, I'm very optimistic. I think this time around, the United States is going to sidestep protectionist trade legislation. We're going to avoid a recession. And we're going, in 1988, to choose a political leader who will be able to deal with the "rest of the world" problem. But the margins for error have narrowed. It's a very sporty course out there.
Timothy C. Forbes is president of American Heritage magazine