Memo To: Students of Supply-Side University
From: Jude Wanniski
Re: The Interaction of Monetary & Fiscal Policy
One of the aspects of "demand-side economics," characterized as Milton`s Friedman`s "monetarism" or Keynesian "fiscalism," is that neither monetarists nor fiscalists spend much time thinking of how their policy manipulation of money or taxes is effected by the other. In Friedman`s "Monetary History of the United States," for example, there is scarcely a footnote in the 1000+ pages devoted to taxation, tariffs or government regulations that act as tariffs. As for Keynes, he wrote about money, prices, interest rates, in his formative years, but his primary work attributed the Great Depression to a surplus of savings by the wealthy who not spending fast enough. The government could correct that by taxing the wealth away from the wealthy (or borrowing it from them) and spending it for them on projects that would benefit all. I`ve always liked to think that Lord Keynes, who died in 1946, would have had a greater appreciation of the global inflation that began in 1971 when President Nixon took the dollar off the gold standard -- which ended the Bretton Woods experiment with a gold/dollar at the center of global money that Keynes helped create in 1944.
There was never a time in the economic history of the world quite like the past 34 years. It was Prof. Robert Mundell who pointed out to me soon after we met in 1974 that never before had there been a conjunction of international monetary inflation and progressive tax rates. This is because tax progressions were not introduced until 1902, when the British paved the way by placing higher tax rates on larger incomes. Tax progressions swept through Europe in order to finance WWI and a progressive income tax came to the United States in 1913 with the 16th Amendment to the Constitution. The rates became steeply progressive during the war and although they were sharply reduced under Presidents Harding and Coolidge in the 1920s, they steepened again under Presidents Hoover and Roosevelt during the Great Depression and WWII.
The tax progressions caused relatively minor problems for the first two-thirds of the century because they were fixed at very high incomes, and people with high incomes always were able to find ways around the high rates via “loopholes” or “tax preferences” in the tax laws. In the United States, at one point the highest marginal rate on income was 91% at $100,000, which meant the next dollar of taxable income would yield only 9 cents in after-tax income. (This was when gold was $35 oz, which means today the 91% would have taken hold at something above $1 million per year.) The “loopholes” back then enabled people with wealth -- by which we mean a sizeable amount of money that already had been taxed as income -- to invest some of that money in assets deemed worthy by the Congress and in so doing reduce their income-tax liabilities. They could “shelter” their incomes. Some of the worthy areas involved the exploration for oil and gas, the breeding of horses, and various preferences in agriculture.
In the countries of the British Empire, where marginal income-tax rates were left at absurdly high rates after WWI, economic growth was able to continue because in most of the British countries there was a zero rate of tax on capital gains. A farmer, for example, could take all profits from the sale of his crops and invest them in the farm itself, showing no income. When he sold the farm, it would be worth more than he had paid for it because of his investments -- in new barns, irrigation, equipment. He thus could reap a capital gain free from taxation. This is the only way ordinary income could be “turned into” a capital gain, but such a practice is fraught with danger, because the investment could turn sour. When the farmer or proprietor must sell, there may be no market for his assets, and he would have to sell at a loss. There are economists who continue to insist that there are ways to turn ordinary income into a capital gain -- but it is not possible to do so without putting such income at risk.
This was all possible because there was no monetary inflation, at least none of any significance. In the fall semester, when we concentrated on money and banking, we made clear the difference between a monetary inflation -- by which we mean a decline in the value of paper money relative to gold -- and a temporary rise in prices caused by a sudden demand for goods, as in wartime. If you would like to go over this with one of the great economists of the century, Ludwig von Mises, the Von Mises Institute put his masterpiece, Human Action, on line, and has provided an index to it. If you go to the index and scroll to “deflation,” you will find three links to the topic of deflation that are essential to understanding the world economy today and are not taught in any of the major universities. I assume the topic is taught where the Austrian school is represented, but I can’t say for sure that it is. Some Austrian economists -- the Rothbardians -- still rely on a single variable monetary model, with no interaction with taxation.
If there is a temporary surge in prices driven by the demand for goods, producers caught short-handed will react by increasing production, eventually bringing the price of goods back down. The best example is the surge in prices during WWI, when the dollar price of gold was constant at $20.67 per ounce throughout. Surprised first by the demand for goods from abroad and then by U.S. entry into the war, which drew capital and labor away from peacetime goods and into wartime goods, the price level for peacetime goods climbed. When the war ended, prices fell as government orders were suspended and in a few years were back where they had been. This was not a monetary inflation, so there was no serious conjunction of monetary inflation and progressivity until the 1970s, when President Nixon broke the dollar-gold link. Gold had been kept at $35 per ounce through a U.S. government guarantee to those foreign central banks that were members of the Bretton Woods international monetary system. When the link was suspended, gold quickly rose in 1971 to $70 from $35 from August to December. A true monetary inflation was underway.
This was only the fourth true monetary inflation in U.S. history. The first occurred early in U.S. history during the war of 1812, when the dollar-gold link was suspended, but was soon restored. The second occurred in the Civil War, when the Lincoln administration suspended the exchange of gold from its reserves for paper dollars issued by Treasury. The price of gold rose as high as $50 from $20.67 and the general price level more than doubled. There was no meaningful tax progressivity at the time so there could be no automatic increase in the rate of taxation because of a change in the dollar’s monetary value, i.e., no "bracket creep."
The third monetary inflation occurred in 1934 when President Roosevelt was persuaded to devalue the dollar relative to gold. Over a brief period, he changed the promise of gold worth $20.67 an ounce and made the new promise $35. The government’s creditors screamed because they would be paid with dollars that would buy less gold, dollars that would soon buy less of everything as a result of the monetary inflation. The dollar not only is used by the government to issue dollar bonds so it can use the dollars received from the public to buy things it wants. It also is more broadly used by the people of the United States as the unit of account with which they contract to produce and exchange goods and services.
The Roosevelt devaluation, which he hoped might end the Depression by driving up commodity prices, only made it worse. Neither the economists nor the politicians made the connection at the time, because the 59% dollar devaluation against gold was not followed instantly by a 59% rise in the general price level. There was a rise, but it took more than a dozen years for the general price level to rise by that amount. The government essentially cheated its own creditors by the devaluation, but suits against the government making that claim were thrown out in the Federal courts. Of course, private debtors got relief because of the dollar devaluation, and their creditors were stuck.
If you had a 30-year mortgage on your home or a 10-year lease on your place of business, the private banks or landlords that had financed these contracts had no choice but accept the cheaper dollars they had agreed upon prior to the devaluation. Then came World War II and price controls, which held back adjustments in leases and wage and price increases. When the war ended, the postwar inflation was explained by economists as reflecting a goods-driven “pent-up demand,” but it was in reality the final adjustment to the 59% dollar devaluation. I want to make it clear, students, that my explanation will not be found in any textbook, so if you were to write it on a test paper in a college economics course, you would flunk. But you would be right.
It is the fourth monetary inflation which occurred as a result of Nixon’s “closing of the gold window” on August 15, 1971 that brought an international inflation. The “gold window” is a picturesque way of describing the place where foreign central banks could appear and demand gold for the dollars they had taken in. Actually, by 1971, all this happened by telegraph. It is this event Mundell cites as being unique in the history of the world. While Switzerland briefly tried to maintain its gold link, Mundell explained it was too small an economy to be the only one tied to gold in a world of floating currencies. Suddenly every currency in the world was afloat, with no link to anything real and palpable. And there were very few places in the world that did not have a progressive income tax.
The Keynesians who dominated the International Monetary Fund and World Bank -- both of which were the products of the Bretton Woods agreement in 1944 -- sold almost every poor country on Earth on the idea that if it wanted to be modern, it had to have a progressive income tax!! A messianic British economist named Nicholas Kaldor traipsed the earth spreading this message, which sowed poverty everywhere he went. India was a prime victim and it has take half a century for New Delhi to find its way to the Laffer Curve, as I`ve written on my website earlier this week.
There was no precedent for this combination of economic forces, going back to Adam and Eve. Never before had a widespread monetary inflation caused tax rates to rise automatically as nominal wages and incomes rose to catch up with the rise in the gold price. The dollar/gold price preceded the rise of all other commodities, with oil being the first to ratchet up. As Mundell’s protégé Arthur Laffer told me in 1972, “You cannot change the terms of trade by changing the value of the unit of account.” That is, if one ounce of gold trades for 15 barrels of oil when the accounting unit is “1,” i.e., one dollar, they will continue to trade at one ounce for 15 barrels when the accounting unit is changed to ½. If one bottle of wine trades for one loaf of bread when the accounting unit is a dollar worth one-thirty-fifth of an ounce of gold, the same terms of trade will be found when the government changes the unit of account’s value to a dollar worth one-seventieth of an ounce of gold.
In 1971, when gold went from $35 to $70 an ounce, the Keynesian economists who advised President Nixon assured him the change would cause the dollar to become cheaper than the rate it had been set against the Japanese yen. They argued that Americans would find it more expensive to buy Japanese goods and the Japanese would find it cheaper to buy more American goods. Nixon believed the terms of trade could be easily altered in a way that would create more jobs in the United States. If Japanese cars, for example, became more expensive to import, domestic cars would be demanded at home, and Americans would be hired to make them. Detroit auto executives thought the idea swell and threw their support behind dollar devaluation.
Because holders of U.S. government bonds had been cheated by the devaluation, creditors lending to the government asked more in exchange for bonds -- and jacked up the interest rates to accommodate the risk of being cheated again. There are business reports this week that General Motors may soon be overtaken as the premiere automaker of the world by Toyota. Even though the dollar has cheapened again and again against the yen, the stories point out that interest rates are rising in dollars and costing GM a fortune! This is what happened in 1971: The cost of doing business in dollars rose and instead of more jobs being created as Nixon was promised, the cost of living rose instead. Workers found their labor was not buying as much in the markets as prices rose with the cost of capital. As their contracts expired, their wage demands jumped far beyond anything they had been asking for when there was no inflation -- and only productivity increases were being shared between capital and labor.
In January 1972, when Mundell predicted the rise in the gold price would soon be followed by an increase in the oil price, and then all other commodities, he had in mind the idea that the terms of trade between gold and oil would not change because of the change in the unit of account. The oil producing countries were selling their product to the oil-consuming nations for under $3 a barrel with gold at $35 an ounce. The U.S. had promised to restore the dollar-gold link at $43 once all those promised changes occurred in trade with Japan, but by the spring of 1973, instead of gold settling back to its official price of $43, it climbed to $140.
The Organization of Petroleum Exporting Countries (OPEC) finally lost its patience. It was getting paper dollars worth one-fourth as much in gold, and because other commodities had increased as well, oil was buying less and less of everything priced in dollars. In the summer of 1973, OPEC announced it was quadrupling the oil price and would adjust production in order to maintain oil at $12 a barrel. The demand-side economists who had assured Nixon that the devaluation would do all those wonderful things of course could not say, “Whoops, we were wrong. Sorry, Mr. President.” They simply fell in line behind the environmentalists who said the oil price had risen because the world was running out of oil. Too many autos, too many factories, too many labor-saving devices that consumed British Thermal Units (BTUs).
The world inflation was underway, and everywhere workers found the wage increases they demanded and got were forcing them into higher tax brackets. Income-tax rates that had been designed for the rich were being encountered by blue-collar workers, then by shop girls and apprentices. Prior to the 1950s, very few poor countries had income taxation, but British and American Keynesians like Professor Kaldor traveled the world explaining to their leaders that the road to prosperity lay in progressive income taxation! When that did not work, they counseled currency devaluations, which only meant poor people would be pushed into higher and higher income-tax brackets. Few paid income taxes because the combination of inflation and tax progressions prevented capital from forming. The problem exists today, as the International Monetary Fund continues to use this formula when dispensing "aid."
The word for the economic conditions that obtained was “stagflation,” the combination of stagnation and inflation, something that was never supposed to happen according to the Keynesian textbooks. It was something the Keynesian economists who ran all the top economic departments in the Ivy League had never anticipated. The late James Tobin of Yale, one of the leading practitioners of the devaluation idea, for years argued that the devaluations had not been big enough, but even he finally gave up trying to understand what had happened. In The Way the World Works, I devote a chapter to "Experiment in Puerto Rico," where I first encountered Tobin`s work, on a reporting trip to San Juan to find out why the unemployment rate had topped 20%. The government had paid $120,000 for a Tobin plan to energize the economy, a plan that included a 10% income-surtax levied atop a marginal rate of 80%!!! Ordinary people called it La Vamparita – the Little Vampire. Still, Tobin was given a Nobel Prize in economics and when he died in 2002, Paul Krugman of the NYTimes gave him credit for the Kennedy tax cuts of 1963-64. In fact, Tobin had nothing to do with the tax cuts, which Ludwig Erhard of Germany urged on President Kennedy in 1962, when JFK visited Berlin.
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We will devote a second lesson to the interaction of money and taxation next week. If there is sufficient interest, I`ll devote a Q&A session to the subject.
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