The Terrorist Tax
Jude Wanniski
September 25, 2001


Memo To: Dr. Glenn Hubbard, chairman, President’s Council of Economic Advisors
From: Jude Wanniski
Re: A Psychological Barrier to Commerce

Since we last spoke in July about the weakness of the economy, Dr. Hubbard, the problems you face in advising the President on how to deal with the added blow of what I call “the terrorist tax” are worse than any in the history of your office -- which I think only goes back to the Truman administration. You have been well trained in macro-economics and I could call you one of the best of the administration’s economic minds, but your job is now complicated enormously with a macro problem that economic policy cannot deal with, at least directly. As long as there is even a slight chance of escalation of the terrorism, the psychological barriers to commerce are the equivalent of high tax and tariff walls between producers at home and abroad that will smother economic growth. Wall Street’s healthy advance Monday was the clear result of the market’s assessment that Secretary of State Colin Powell was in the driver’s seat, reducing the “terrorist tax” with skillful diplomacy, for the time being trumping the Pentagon and its eagerness to increase the tax with indiscriminate bombing of “targets.”

If you read The New York Times “Week in Review” section this past Sunday, you probably read the piece by Timesman Richard W. Stevenson, “The Prospect of a War Without a Wartime Boom.” As I told him in an e-mail I wrote as soon as I read it, his analysis is excellent. It cuts against those who have been arguing since September 11 that the bipartisan decision to put aside “the lock box” and to spend feverishly on infrastructure will actually lift the economy out of the decline occurring before September11. You may not be old enough to remember the explanations we were getting from Keynesian Ph.D.s in the 1960s on why Japan and Germany had become so wealthy. They said it was because their countries had been so demolished by the bombs of WWII that they had to rebuild, and that process led to rapid economic growth. Remember the Keynesian nostrum that in a recession, the government could alleviate it even if all it did were to hire the unemployed to dig holes and fill them up?

Note, though, that in his piece, Stevenson makes the mistake of thinking WWII helped end the Great Depression and kept growth at a high level during the Vietnam war. That’s also part of Keynesian lore. You may remember the Keynesians warned on V-J Day in 1945 that the government had to replace wartime spending with domestic public works or the economy would sink back into Depression. Nothing of the sort happened. Spending dropped sharply and the economy expanded sharply. The ex-post explanation was that the end of the war released “pent-up consumer demand.” More baloney. The theories never explained why Great Britain remained in a postwar slump even though it had been bombed out and its consumers had more pent-up demand than ours.

The economic problems we face now can be managed effectively, but not with most of the ideas I read about in the papers every day. The monetary deflation I have been warning about is still with us. By fixing that problem, which can be done with an executive order, the government can sharply reduce the risk of doing business, not only in the U.S., but around the world. I suggest you read my weekend memo, “Inflation and Terrorism,” which explains how President Richard Nixon’s decision to break the dollar/gold link in 1971 produced the global turbulence in finance and commodities that led, step by step, to the attacks of September 11. You might also get a copy of the American Spectator’s Sept./Oct. issue, where my lengthy essay goes over the political history of the last 70 years from a monetary perspective. I tried to put it all in one place so readers could get their arms around the issue. There are pieces of that history I think will surprise you. Here, though, is my brief memo to Dick Stevenson:

Sunday, September 23:

Excellent "Week in Review" report, as you identify what I'm calling "the terrorist tax," which is psychological, not real. Efforts to expand the economy will not succeed if the administration makes the kinds of errors in attacking terrorism that increase the risk of more terrorism. The weakness of the economy going into September 11 was the result of the monetary deflation I have been writing about for years. That deflation can be ended with a stabilization of the dollar/gold price at $325, more or less. I would err a bit higher, $350. This would reduce risks of commerce all over the world. If you read my memo today, "Inflation and Terrorism," you will get a clearer picture about how Nixon going off gold led to the events of September 11. It may sound odd to you, but it will make more sense when you read it. There has been nobody else in the world who studied the economic origins of the Iran/Iraq war more than I have. If more people had, we would have adjusted policy years ago in ways that would have nipped this kind of terrorism in the bud. And I'm not saying "poverty" caused terrorism.

The Depression began its end when Congress rolled back an earlier increase in the capital-gains tax in 1938. FDR threatened to veto the rollback, but he finally let it become law. The war also broke down the Smoot-Hawley Tariff Act, which had caused the Crash of 1929, and accelerated the reciprocal trade agreements that allowed bilateral skirting of the tariff with lower rates. Finally, the government borrowed and spent heavily, taking the risks that private enterprise had been reluctant to take given the high tax and tariff rates imposed by Hoover and FDR. It was essentially a command economy, in large part a necessary interlude with socialism.

The economy was not assisted by Vietnam, which was characterized by higher taxes and higher spending. The peak of the DJIA was in 1966, reflecting the Kennedy tax cuts passed in 1964. The market turned down as the government prepared to add a war tax, which was a surtax on the income-tax rates. Spending on the war did rise after 1966, but the stock market and the economy got weaker as the deficit increased.