Thoughts on the Public Debt Jude Wanniski April 25, 1997

Supply-Side Economics Lesson No. 20

[Since I met Minister Louis Farrakhan last year, he has been deeply interested in understanding supply-side economics and has been following our lessons. I was in Chicago last week to address the Chicago Financial Analysts Society and the Commonwealth Club. At a dinner with Min. Farrakhan at the Nation of Islam's National House, he asked me to explain how he should think about public debt and I told him I would respond in writing.]

Memo To: Louis Farrakhan
From: Jude Wanniski
Re: Thoughts on the Public Debt

Think of the budget deficit as the equivalent of a rider on a horse, the horse being the economy. The rider is now $100,000,000,000 [100 billion] and the horse is $6,000,000,000,000 [6,000 billion]. The rider is l/60th of the size of the horse. Does it make any sense to starve the horse in order to reduce the size of the deficit? If we would increase tax rates calculated to raise $100 billion, we could say the deficit would be reduced to zero. But what would this do to the horse? The horse would continue running but at a much weakened pace. Translate this to the economy and the slow pace would show up in a higher unemployment rate. Revenues would decline and the costs of supporting the needy would rise. The deficit would be back, but now on the back of a smaller horse.

One of the real confusions perpetrated by the Establishment, which trains almost 100% of our Ph.D. economists and furnishes almost as high a percentage of our financial writers, is that our national debt was caused by Ronald Reagan increasing spending and cutting tax rates simultaneously. The actual original cause of the deficit was in the decision to leave the gold standard, a decision begun in the Lyndon Johnson administration and completed in the Nixon administration. The devaluation of the dollar relative to gold caused a monetary inflation, all prices rising, including wages — the price of labor. By driving wages and capital into the higher tax brackets and by leaving both unprotected against inflation, the only beneficiaries of the inflation were debtors. The biggest debtor, of course, was and is the federal government. If Reagan had not arrived to reduce the tax rates that had been swollen by this great inflation, the tax rates would have crushed out all economic activity. The biggest cost of going off gold and the resulting inflation was that the entire debt of the United States had to be refinanced at ever higher interest rates. The cost of debt service today is now almost three times the size of the entire U.S. budget in 1967, when LBJ closed the London gold pool and started us on the skids. That was the last time we were prepared to exchange gold from our monetary reserves for the surplus dollars the Fed was printing. When Nixon doubled the capital gains tax in 1969, he magnified and compounded the error on the advice of his Keynesian economic advisors. The economy weakened, and when Nixon tried to strengthen it by getting the Federal Reserve to print more money, the resulting financial turmoil led him in August 1971 to officially close the Treasury's "gold window." The dollar price of gold quickly doubled and the inflation of the 1970s was underway. The government debt today, in terms of the amount of gold owed by each citizen, is considerably lower than it was in 1945, at the end of WWIL Our government essentially cheated its creditors — its own people and foreign governments that held our bonds, by paying off its debts with dollars worth one-tenth as much in gold today as in 1971. The "horse" is smaller than it was in 1971, but so is the rider. The idea that our economy is now better than ever is a fiction built upon statistical inflation.

I'm still hoping you will find time to read The Way the World Works. I watched the tape of your St. Louis speech last September and found that you were making fun of the idea that cutting tax rates can balance the budget. Remember you asking me about "dynamic analysis"? I explained with ice cream cones. If you 10 sell cones @ $1 and have revenues of $10, static analysis says if you raise the price to $1000 per cone, you will have $10,000 in revenues. That is another way of describing the law of diminishing returns. Ice-cream vendors sell for $1 because they find that at $1.05 per cone they lose money, as they also do at 95 cents. As tax rates rise on productive people in order to finance the costs of giving people goods and services they should be buying for themselves, production declines and the use of publicly-financed free goods expands. The government can reduce the deficit by cutting out free goods, forcing people to fend for themselves. It does this best by putting pressure on Congress to trim out the lowest priority public goods. This does not work as well as it might, if the stronger have more power than the weaker. Or the government can identify those tax rates which are beyond the point of diminishing returns, which means the increase in after-tax production will cause more capital to form and more goods to be produced. This doesn't work as well as it might when the Big Guys control the government, as they will tend to choose to reduce tax rates that benefit them the most and have the least beneficial effects on the masses who would like to work, but cannot afford to work at such low after-tax incomes.

When you hear about the "Laffer Curve," you need only think of the law of diminishing returns. I named the Curve after Art Laffer in the  course of writing my book. I'd watched him draw the curve on a paper cocktail napkin at the Two Continents lounge in the Hotel Washington, across from the Treasury building. This was in early December 1974. Laffer was trying to get Dick Cheney to understand the concept, that there are always two tax rates that will produce the same revenues. If you tax zero percent of income, you get zero revenue, and if you tax 100% of income, you get no revenue, as people will not work for nothing. In between those two extremes, zero and 100%, there is always a rate that will produce optimum revenues. In order to determine the rate, Congress would have to engage in "dynamic analysis." But our government has adopted a requirement that forces it to do only "static analysis." (By the way, I coined the terms "dynamic" and "static" analysis to fit the needs of the Laffer Curve.) Congress continues to engage in this pathetic practice, as if it were under the spell of an evil witch.

That evil witch is the Economic Establishment that dominates thinking in both political parties. The Establishment exists to resist change, to avoid risk. In the several years leading up to Republican control of the House in 1994, House Republicans especially were furious with Democrats for insisting that when a tax rate is cut in half, revenues are cut in half. As soon as the Republicans got control, they themselves forswore dynamic analysis and insisted on spending cuts to balance the budget. Newt Gingrich, the revolutionary and champion of dynamic analysis while on the way up, threw aside dynamic analysis when he got to the top. Precisely the same thing had happened when Reagan was elected, when David Stockman teamed up with Dick Darman and outside Establishmentarians, including Alan Greenspan, to postpone the tax cuts in order to balance the budget. But that's another story.