Memo To: Treasury Secretary John Snow
From: Jude Wanniski
Re: The Failure of the Last Cuts
Your Meet the Press arguments yesterday for the tax cuts being considered this week by the Senate were about as good as could be expected, considering the fact that you really could not say Bush tax cuts of 2001 flopped. And they were an expensive flop, for several reasons that we at Polyconomics warned about at the time. My assumption, Mr. Secretary, is that you were not aware that the U.S. economy was then struggling with a monetary deflation caused by the Federal Reserve’s supertight grip on dollar liquidity. If we had been on a gold standard, this error could not have been made, because the Fed would have been required to automatically supply liquidity to the banking system to prevent the dollar/gold price from declining – as it had from the $350 level in early 1997 to $265 per ounce when the Bush administration began in 2001. Neither tax cuts nor interest-rate cuts could arrest the deflation, which I explained to your predecessor, Paul O’Neill. I’m not being critical of O’Neill, because it would have been hard for him to buy my arguments when no other political economist shared them.
Because the tax cuts did not work as planned, you are now stuck with explaining how another round of tax cuts will expand the economy when the first round did not. All you can say is that things would have been worse without the first round, but that’s probably not true either. The best you can do, I suppose, is argue that the first round of tax cuts was specifically designed to spur consumption at a time the budget was still in surplus and the economy in recession. This round is designed to produce a bigger economy through rapid increases in production, by sharply cutting tax rates on the returns to capital. I’m happy to see you did tell Tim Russert yesterday that this program will cause tax revenues to increase at all state and local levels, which is sure to be the case. Democratic governors and mayors are plugging for increased federal spending on public works instead of tax cuts, but you are clearly right in saying the governors and mayors should make those decisions themselves when they do find increases in their revenues as a result of the bigger national economy. You have been saying the tax cuts will be good for the stock market. You should be saying that the expectations of the lower tax rates on capital have already been capitalized into equities to a significant degree, which is why all the major market indices have risen four weeks in a row.
I’d written a great many pieces for our clients on the monetary deflation in early 2001. This one I’ve selected, “Greenspan in Denial,” covers much of the ground I’ve discussed above, written only one month into the new administration.
February 28, 2001
Domestic Reports: GREENSPAN IN DENIAL
Federal Reserve Chairman Alan Greenspan's testimony this morning before the House Financial Services Committee indicates he is in complete denial of the Fed-induced weaknesses in the economy and the steps that must be taken to end the monetary deflation. He simply re-hashed the same generally-complacent testimony he gave before the Senate Banking Committee in January. Equities and bonds rose late Friday in response to the Bear Stearns press conference during which Wayne Angell, a former Fed governor who finally has recognized the deflation for what it is, noted that January's pair of 50-bps cuts in the funds rate did not budge the gold price. The enormous rally spawned by his prediction that Greenspan probably would cut another 50 bps from the funds rate this week no doubt was linked to the market’s assumption that the two men still exchange views. Today, when Angell heard Greenspan begin his testimony with happy talk about January sales figures, he withdrew his forecast and Wall Street headed lower.
The much-hoped-for rate cut before March 20th FOMC meeting now seems highly unlikely. Greenspan is sticking to his story that the current economic weakness is the result of an inventory overhang and capacity glut that will work itself out, although it "may last some time into the future." The most significant exchange during the Q & A period came when Rep. Barney Frank (D-MA) asked Greenspan why he was blaming the current economic weaknesses on an "irrational" public when it was the Greenspan-led FOMC that engendered the weakness by pursuing an extraordinarily tight monetary policy, based on the theory that unemployment had gotten too low. "Whatever happened to rational expectations theory?” Frank said. “Perhaps it's time to take back a few Nobel Prizes." In response, Greenspan defended the actions of the Fed, repeating that, beginning in late 1999, "an excess of investment demand over savings resulted in an upward surge on long-term interest rates. ... Had the Committee not followed with higher short term interest rates, the amount of liquidity required to hold short rates down would have fostered inflationary imbalances." This is more Greenspan-in-denial. The yield curve remained relative flat throughout late 1999 when the Fed began raising rates. The long bond actually inverted relative to the two-year in early 2000 as the Fed's rate-hiking cycle gathered force. Most importantly, the gold price, our most reliable proxy for dollar liquidity demand, traded in deflationary territory during the entire 1999-2000 "tightening cycle," where it remains today.
Despite the disappointing Greenspan presentation, the entire treasury yield curve is priced for at least another 100bps of Fed funds rate cuts by late summer and could pick up more gains across the term structure as more negative news on earnings, bankruptcies, and layoffs emerges. The combination of falling crude prices, a looser labor market, and an ebbing consumer confidence level is enough to give the Greenspan Fed a green light to continue whacking away at the 5.5% Fed funds rate. At the same time, the $10 jump in the gold price to $267 this week seems to be more connected to the lack of good news on the tax front than anything the Fed is doing. Its decline to $257 earlier in the month coincided with expectations that a capital gains cut would be merged into the tax bill, to accommodate the Senate and House Majority leaders. That would increase the demand for liquidity and be good news for the NASDAQ stocks. The Bush team not only scotched that idea, but also is running up against fierce Democratic criticism about the size of the tax cut -- criticism that cannot be answered in the static demand model that the Bushies have embraced.
President Bush’s budget address to a joint session of Congress last night did not help, except to show he is willing to spend liberally on new social programs in order to win the plaudits of Ted Kennedy. His whole growth program is based on getting the marginal income-tax rate down to 33% from 38.6%. While the path has been greased through the House, nobody knows what to expect in the Senate. Senate Minority Leader Tom Daschle made it clear in his response to the President’s address last night that the Democratic plan is to warn of the return of the Reagan budget deficits. Treasury Secretary Paul O’Neill was no help in his recent budget testimony, saying the Reagan tax cuts got us “in a ditch” when the spending cuts did not come through. We fed-exed O’Neill a copy of our recent deflation report warning of the monetary/fiscal Catch-22. But O'Neill clearly is not interested in monetary policy. (Yikes! Now we hear O'Neill is pushing the idea of a Manhattan Project to combat Global Warming and almost got it into the Bush address last night.) It is odd to watch this Catch-22 with monetary and fiscal policy pulling against each other, but that’s what we will have to live with until there are more epiphanies like Wayne Angell’s.
A week ago, on February 21, I express-mailed Fed Chairman Alan Greenspan a letter and copy of our recent report comparing the monetary deflations of 1982 and 1997-2001. Getting no response, I have decided to broadcast the letter:
Dear Alan: “For more than three years I have honored your request that I send you no more communiques on economic policymaking. I’m compelled, though, to send you this Polyconomics client essay, “The Monetary Deflation of 1980-82,” which reviews the monetary deflation that occurred in our country before you joined the Fed. As you will see, the paper is meant to draw parallels between that previous episode which followed a sharp decline in the dollar gold price, and with the very real dangers to our economy today if there is no change in the operating mechanisms of the Fed.
“I’m not broadcasting this letter at this time, Alan, but you will realize that my anxieties are such that I have been communicating them to the Bush White House and to the Treasury. The paper speaks for itself on the argument that no tax cut or no reduction in the fed funds rate can overcome the deflation juggernaut. Only a direct expansion of the Fed’s balance sheet with the aim of raising the dollar gold price can do that. It concludes that the problems we are only beginning to experience in painful ways can only end through a crisis in the financial system which forces the central bank to flood the system with liquidity, as Chairman Paul Volcker did in August 1982, or by the recognition on your part that such a crisis need not occur if you would avert it by policy change. If you wish to discuss these matters with me personally, by telephone or in person in your office, I would be only to happy to oblige. Sincerely and respectfully, Jude”
What we saw in the Federal Reserve Chairman's testimony this morning was Greenspan in complete denial. Denial of Fed-induced weaknesses in the economy and of the necessary steps to end the monetary deflation. He simply re-hashed the same generally-complacent testimony he gave before the Senate Banking Committee in January...