A Look Inside the Economy Jude Wanniski February 15, 2002

To: Students of Supply-Side University
From: Jude Wanniski
Re: A Look Inside the Economy

For our lesson today, I’m reaching back to the earliest days of Supply-Side University, December 20, 1996, when we went to two students from one. It was a cozy enough classroom back then for me to spend an entire lesson asking questions of two students. In reading over this lecture a few weeks ago, it struck me that it is perfect for this political season, when there will be a heated debate as Congress begins assembling the 2003 budget. Because both the Republicans, led by President George W. Bush, and the Democrats, led by Senator Tom Daschle and Congressman Richard Gephardt, are trying to address weaknesses in the economy in a “demand model,” neither can find a solution. This is because in “demand-side economics,” which focuses on the economy’s consumption or “demand” for goods and services, money either goes into the pockets of aggregate consumers and is “saved,” or is taken out of the pockets and “spent.” The fiscal problems that Congress will be mulling over this year and next are of course compounded dramatically by the problems that occur when the Baby Boomers begin to retire en masse. In the supply model, the resources to pay the old folks are found by concentrating on making the pie bigger, not by saving, but by producing more useful goods and services with less effort. This should really be the objective of all economics: How to produce more with less, by “economizing,” by not wasting effort -- the time, energy and talent of the people in the national economy. Eliminating the inefficiencies in our monetary system and tax code are the only way to "save" Social Security without benefit cuts or tax increases. Here is the lesson of December 20, 1996, with a Q&A appended from a subsequent lesson relating to this lecture. There were only two registered students at SSU back then.

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We have a new student in the class, Brian Carlson, who joins Kevin Isbister, our first student. Brian poses a most interesting question this week: "Is gambling a 'zero-sum' activity? Seems to me that though a few politically connected riverboat owners are getting rich at the expense of people who can ill afford to throw their money away (I mean, have you ever been in one of those things?), nothing is actually being created... no wealth, that is. In addition, the money and time spent are diverted from other areas of the economy where wealth can be created."

My response: Is wealth created when you go to a barber and have your hair cut? Of course it is. You pay the barber out of your after-tax income, which is your wealth, and he adds it to his after-tax income, which is his wealth. $10 has changed hands, and nothing seems to have been created in dollar terms, yet your hair is cut. That is the gain to society. If society is run so poorly that you cannot afford to have your hair cut, there is no work for the barber and his wealth is diminished. What does he do with the $10. He now has the wherewithal, the wealth if you will, to come to you and ask you to cut his grass this weekend. At the end of the weekend, the $10 has made a round-trip, no wealth seems to have been created in the sense you meant it, yet your hair is cut and his grass is cut. When the government is able to keep track of such transactions, it will demand some of the $10 you pay the barber and will then demand some of the $10 the barber pays you. Up to a point, it's worth it in a complex society to give the government its due, because it has provided the "money" instead of you having to barter a haircut for a grasscut. In a complex society, you really don't have time to walk around the community with a sign saying "Will cut grass for haircut."

Now, you can increase your wealth if you can learn to cut grass better or faster, which means you can either charge more than $10 or can get $10 for a half-hour of work instead of an hour. If you can rent a power mower instead of a manual mower, you are essentially investing after-tax income on the chance that it will increase your earning power. If you dream up a better way of building a power mower, and can get it patented, you can sell it or lease it to thousands or millions of grass cutters, and you will become enormously wealthy, with more money than you can possibly spend on haircuts or anything else in your lifetime.

But what about gambling? Gambling resorts provide services that are the equivalent of hair cuts. You take $100 to a casino and over an evening's time at the slot machines, you leave it there. The casino has the $100, and you have the equivalent of a hair cut -- except in this case you have acquired an evening's worth of entertainment as well as the opportunity to increase your wealth in the process, if you are lucky. The people who own the casinos are nothing more than bankers -- financial intermediaries is the usual expression -- who arrange a place where the fellow who cuts hair and the fellow who cuts grass bring their day's wages, say $100, for fun and possible profit. The amount the casino owner takes from each transaction is quite precise, although occasionally someone will figure out how to beat the odds -- say by counting cards at blackjack. If you shoot craps, over the course of an evening, the casino takes about 1.5% from each transaction, whether you are betting with the house or against the house. This 1.5% is the equivalent of a fee you are prepared to pay a bank to put you together with people who have more money than they need to spend, and wish to have it put to use -- say in the construction of a home -- which you will pay back over time, with interest. Part of the interest goes to the bank, part to the bank depositor.

If you are looking for an argument against gambling in the economic realm, you are more likely to find it in the tax codes. All growth is the result of risk taking. If you invest your after-tax income as a barber in a bigger shop, hiring more barbers, you need to feel the effort will produce greater wealth for you -- more after-tax income that is available to be spent on goods and services. If the after-tax return on a bigger shop is small or negative, you may decide to hell with it, and go to Vegas to attempt quickly to increase your wealth by a streak of good luck. In this model, you can see that lowering the tax rates on investments in barber shops, as well as lower tax rates on people who need haircuts, will cause the gambling that people do at casinos to drop off and the gambling they do on the productive efforts of each other to increase.

In this sense, you can do battle against Sodom and Gomorrah by cutting tax rates where they most discourage people from investing in each other. This is why supply-side leaders, like Jack Kemp, urge elimination of the capital-gains tax. There is nothing that would do more to reduce gambling as a prosperous industry than a cut or elimination of the capital-gains tax. If you wish to read more in detail about gambling economics, from one of the best economists in the world, I suggest you look into the works of Reuven Brenner of McGill University in Montreal. Reuven, a good friend, has written: History -- the Human Gamble (1983); Betting on Ideas (1985); Rivalry (1987); Gambling and Speculation (with Gabrielle Brenner, 1990); Educating Economists (with David Colander, 1992); and Labyrinths of Prosperity (1994).

Student Kevin Isbister has been brooding on Lesson No. 4, in which we discussed casino gambling and how it becomes more attractive to the masses when there is less risk-taking available in the economy at large. Says he: [Your] reasoning implies that something that I don't believe is a reasonable assumption; that the people who most frequent gambling establishments have the means to invest. Casinos around the country aren't patronized en masse by rich Texas oilmen, who possess the financial means and likely the accompanying smarts to recognize a bad investment when they see them. The bulk of a casino's income is generated by lower middle-class to outright poor people who are enticed by the chance, remote as it is, to pull themselves into a higher tax bracket by putting some quarters in a slot machine."

The assumption of mine which you infer is that I wish to have the very rich who are in the casinos bet instead on small business. I was trying to make the argument that casino gambling in some, but not all ways, is a symptom of the problems in the general political economy -- where it has become increasingly difficult for an ambitious poor man to lift himself up by hard work, risk-taking and enterprise. Perhaps it would help if I turned the problem around, and began with a perfectly functioning political economy, and you would see that casino gambling and state lotteries do lose much of their appeal when individuals can work hard and save a sufficient amount to either invest in others in order to climb into a higher economic class, or invest in themselves to that end.

First, we should make clear that most of the savings and investment in the United States is done by ordinary people in the lower- and middle-income classes. That's where most of the money is in a $6 trillion economy. We don't expect the 125 million people who are in the work force to "know a bad investment when they see one." That's why we have a market economy, in which tiny amounts of money are deposited in banks, S&Ls and credit unions or pension funds or mutual funds. People who are supposed to know good from bad investments work for these institutions. They gather the mites into bundles and package them for other people who show up in search of capital. The mechanics of the marketplace requires that the experts -- the broad class of financial intermediaries -- be able to assess the likelihood of the potential return on investment to these bundles of cash.

In a casino, except when big wins are involved, there is no tax collector involved in the proceedings. Almost everyone knows which casinos have better payoffs, "looser slots," and that returns on the table games are fixed by the laws of probability. When you increase your savings out of your after-tax earnings, the financial intermediary in assessing the risk of investment must take into account the tax take of the government on a successful investment. This becomes very complicated, especially when the inflation rate is figured into the equation.

Remember, on one side of the economy we have people who are able to save something out of their after-tax income and on the other side people who need immediate resources to accomplish what they wish to accomplish. The financial intermediary is between them, undertaking the job of matching the funds of one with the needs of the other. When the intermediary sees the after-tax returns decreasing because the government has raised tax rates on returns, or expected inflation will produce fictitious returns on capital that will be taxed as real returns on capital, the intermediary will reject the "bet," because the after-tax payoff is too uncertain or likely negative.

When the enterprise is rejected because of that burden of taxation, the number of people who would have been employed in that enterprise remain unemployed or underemployed. A small part of the economy that would have been, is not. A risk that would have been taken at X payoff, is no longer willing to bet at X - T payoff. As you add these experiences up week by week, month by month, year by year, your healthy, growing economy will go into reverse gear -- which is what the U.S. economy has been doing for the past 30 years. The measure of the economy's production has been showing an increase, but that is only because the decline in capital formation has been offset by the number of people working. That is, it takes more and more people working to produce the same amount of usable goods. The government also measures unusable goods as part of "economic growth," so we are stuck with having 615 out of every 100,000 citizens in jail -- the highest percentage of any nation on earth. The cost of tracking them down, bringing them to justice, and caring for them in a prison system, is all counted as Gross Domestic Product! We also have almost a million lawyers plus the several million who work for them and several million accountants who count as part of the GDP.

All of this economic waste is the product of a tax system and a monetary inflation that has smothered capital formation. In this corrupting atmosphere, the potential return on the investment of a dollar in Las Vegas becomes competitive with the investment of a dollar in your future through the market economy.

I hope you can see that when you have a market mechanism trying to link up savings over here with the demand for saving over there, there can be no deal if there is no positive return in the calculation. This is why the breakdown of capitalism because of poor tax and monetary policies will almost always lead to a socialist government. Because a people have to save and invest for the future to survive -- and must take risks to that end -- if the market mechanism will not let them do it, the people will turn to government to do it for them. As inefficient as the government is next to a free market, at least it doesn't pay taxes, so it can take risks which have positive returns, up to a point.

These should be simple concepts for those of you who have not been educated in a demand-side world, but they are almost impossible to grasp for an academically trained Ph.D. economist. The economics profession today says our problem is that our people do not save enough. The problem is that the tax and monetary system erected on the advice of these Ph.D. economists prevents the people from coming together in the marketplace to share their surplus time, energy and talent with others who have great ideas on how to succeed in business, but are short of time, energy and talent. From a supply-side perspective, we have too much savings in our economy -- an enormous fraction of our population which should be producing usable goods and services is instead "saving" itself from productive efforts. Practically the entire prison population is there because the society made it unattractive for them to take the normal risks that would result in self-realization, forcing them underground, where you only pay a confiscatory "tax" when you are caught. (You go to prison.)

Your question was an excellent one, Kevin. All growth is the result of risk-taking and the human impulse is to advance by taking risks that have commensurate rewards. If the "system" of government discourages risk-taking through normal means of work, saving and investment, people will take abnormal risks outside the system, through legal or illegal gambling and even crime.