Q&A Period Jude Wanniski March 20, 1998

Supply-Side University Economics Lesson #10

Memo To: Supply-Side Students
From: Jude Wanniski
Re:Q& A Period

• Political Character
• Exporting Entrepreneurial Capitalism
• Five Client Memos on Deflation
• Clinton in the Political Model

Political Character

Q-1 In our discussion of political character, several students asked questions about how we could force politicians to tell the truth, keep campaign promises, etc.

A. We have to expect that our political leaders will have to depart from campaign promises from time to time, as long as they present us with a good reason for doing so. Campaign promises mean more when they are made by a person who is known to believe in the validity of the promise. When George Bush said "Read my lips, no new taxes," he said it with such emphasis that it overcame the doubts of those who remember he had characterized the Reagan tax cuts as "Voodoo economics." Still, he broke his promise after waiting for one year. Because he gave the electorate no good reason for breaking his promise, it seemed clear to me that the voters would not re-elect him. Even at the height of his popularity in the Gulf War, I argued that his candidacy for re-election was doomed — but with one possibility to avert defeat being his replacement of Nicholas Brady as his Treasury Secretary with a gilt-edged supply-sider. Bush did "apologize" during the campaign, but as long as he gave every sign that he would retain his close friend at Treasury — the man who had begged him to break his campaign promise and raise taxes — the apology would not be accepted.

It is not in the electorate's interest to bind their representatives in government to a course of action on so broad an issue as taxation. The electorate wants the government to be pointed in the right general direction, but will understand if the leader at the helm of the ship of state has to make adjustments to avoid unexpected storms on the horizon. The electorate will not hold a politician to a pledge of "no new taxes" if the government simply raises a tax on A while cutting a tax on B. Shareholders of General Motors will not vote against management if it decides to raise the price of a Buick and cut the price of a Chevrolet. There must be room for such adjustments. What Bush did was damaging to the country, because there was no need to raise taxes except to make the beancounters happy. In the current environment, with taxes having been raised at the federal level again and again during the past 85 years, either through legislation or through inflation, it will be several election cycles before a political party will be rewarded at the polls for promising to raise taxes.

When a candidate for the legislature makes a series of promises, he or she is mainly defining their general philosophy, which becomes part of the electorate's decision in choosing between candidates. Some candidates win because they promise to serve the routine work of the constituency, making sure grievances with the bureaucracy are resolved, finding missing Social Security checks, for example. Promises on policy aren't taken into much consideration unless they are so out of whack with the voters. A candidate who pledges to only serve two or three terms and then quit will be forgiven if he has otherwise done a good job. Rep. George Nethercutt [R-WA] promised to quit after two terms and has now told his district's voters that he realizes you can't learn your job in only two terms, and he plans to run again. I'll bet he wins re-election in November. Every year also produces negative tv commercials of a candidate who is shown to be "flip-flopping" on issues before the public, as if they were untrustworthy for having changed their minds. It is important that if a candidate pays for such negative ads that the electorate agrees with the original position and not the flip side. Otherwise, you are simply advising the voters that your opponent has flip-flopped in the right direction. In sum, voters don't mind political representatives who change their opinions — as long as it is clearly in the right direction and part of a learning process. If they move in the wrong direction, and are seen to be under the financial sway of special interests in having done so, they will be punished.

Exporting Entrepreneurial Capitalism

Q-2. In response to Jack Kemp's speech on the world economy, a student responded: "One wonderful thing we could do for all the billions of people on the planet is to cut our taxes drastically. (This is basically equivalent to undoing the damage caused by the wartime economy.) If they see that we can go back to low tax levels like 30 years ago, they can press their governments to do the same."

A. The idea of instructing by example seems reasonable enough and I'd hope it would happen that way. The example set by Reagan in cutting income-tax rates to 28% at the highest threshold did inspire many countries around the world to do the same. In the developing world, tax rates at the top were routinely at 60% or 75% at the top, and are now closer to 35%. The benefits have not been as great as they might, because the thresholds remain oppressive. There really should be no income tax at all in poor countries. The revenues should come entirely from duties and excises. In many countries it costs more to collect the income tax than it yields in revenue. A great barrier to the kinds of tax reforms that would enable Africa, for example, to develop in healthy fashion is the International Monetary Fund and the other international financial institutions. These agencies operate on assumptions that keep Third World countries automatically depressed, always in debt. To have control over people, you can't do it any easier than keeping them in your debt.

I may have mentioned this before, but I like to point out that at the very time John F. Kennedy was asking the Congress to cut tax rates in order to expand the economy, his foreign policy team was telling President Diem of South Vietnam that unless he sharply raised taxes, we would withdraw military support. In order to help the rest of the world climb down from the top of the Laffer Curve, it will take something like Kemp winning the presidency in 2000 and making sure his people occupy the key posts where decisions like this are made. In other words, it is nice to think about setting an example, but the forces of darkness are forever at work, trying to obstruct peace and prosperity for all.

Five Client Memos on Deflation

Q-3. [From Don Luskin] Jude, thanks for posting the five client memos on deflation for the SSU students. Very interesting. One can't help but note the tone of the memos becoming gradually more sanguine over the weeks from first memo to last... indeed this tracks the market's reaction to the "Asian flu," the most publicized result of the dollar deflation. Finally we end up at the fifth memo in which the theme is, in essence, "where's the beef?" Indeed commodity prices have been smashed: classic deflation symptom. But why the stock market ebullience? If deflation is so sinister a threat, then why are the averages making new highs every day?

A. I was hardly wringing my hands in the first letter, December 4, but the letters did become more sanguine as the weeks rolled by and we could observe the situation being brought under control. Even at the early date, I noted the dollar deflation would have positive effects because of the progressivity of the income-tax. Inflation causes tax rates to rise automatically. Deflation causes tax rates to fall automatically. On the minus side, deflation rewards creditors at the expense of debtors, and this is having its effects as predicted. The dollar value of oil and gas assets have been in particular decline — with "black gold always first to follow yellow gold." Debtors who rely on commodities as collateral are discovering their nominal wealth is in decline. They have to produce more in order to meet their obligations. We are benefitting from the deflation because more people outside the U.S. use commodities as collateral It distresses me that a few billion people are hurting more because of the dollar deflation, but I hurt less because my portfolio of stocks on Wall Street is rising. In the last year, please note that wheat is down 24%, corn 14%, cotton 11%, and soybeans 8%. Personal and business bankruptcies are at record highs.

Remember my arguments that the dollar deflation occurred because of the tax cuts in last year's budget agreement. If you can't parse pluses and minuses in your own analytical framework, it helps to know that the broad market drove the gold price down by demanding dollar liquidity AS A RESULT OF THE TAX CUTS. We do have a quarter of a billion people in our country, and while some of the oil and mineral people have headaches, households generally are happy with the rise in the real value of household assets. If we are correct and gold belongs at $350, the decline to $290 can easily be offset by the pluses on the tax side of the ledger — the lower capgains tax, the Roth ERA, and the increase to $1 million in estate tax exemption.

The deflation of 1981-83, when gold fell by half in a brief period -from $620 to $290! — overwhelmed the positive income-tax effects. In addition, there have been some deflation adjustments built into the system, with such things as variable-rate mortgages. When you ask why the stock market is so ebullient, when deflation is supposed to be so sinister a threat, you suggest we were advising clients to become bearish in our letters. Our January 2 letter, though, weighed the pros and cons and predicted the Dow Jones Industrial Average would rise to 9000 this year and the 30-year bond yield would fall to 5.5%. It could be I was low on the 9000, which we are fast approaching, having failed to appreciate the power of the Roth IRA to create capital. There remain threats to the financial market, but unless the Fed permits gold to decline by some significant amount, the dollar deflation has been absorbed by the stock market.

[The five letters on deflation mentioned by Don are a series of reports Polyconomics sent to its clients between December 4 and March 3. Please see the FYI section.]

Clinton in the Political Model

Q-4. Herb Saunders directly challenges my political model in a long, thoughtful commentary, which I run as a question. He wrote in a March 8 TalkShop entry:

Jude and Falana are talking about different perspectives of the same issue. I think the common basis for both arguments is wrong. Both parties seem to think that the political market is somehow far more perfect than I think it is. Falana is, I believe, of the opinion that all people in America are equally equipped to make reasoned determinations of policy. This also infers a desire and interest on the part of the People in the debates of the day. This assumption fails on two facts: the low voter turnout of the past several years (not necessarily a bad thing by itself) and the failure of the citizenry to grasp (denial of) several clear facts about future results of present policy about social security and the effects of the current debt structure on the ability of the government to do anything in the event of any of a number of easily predictable conditions. Jude is of the opinion that the populace runs some sort of calculus of desired outcomes against the choices of available candidates.

This also presumes a level of information and analysis that the people have not heretofore exhibited. An obvious case is the vulnerability to extortion that Mr Clinton's probable behavior provides. Monica could easily have been an agent of any sort with recording devices. Had he suborned perjury, what leverage would that give to ... whom? The People don't seem to think that what happened is serious. This is a gross, obvious failure of analysis. I think the populace makes these determinations on the basis of discerned costs. Usually these costs are economic. As a side effect of the revolution in productivity caused by computers, the economic costs are very low or negligible. Lately the costs of Clinton are not readily discernable to the populace, since he is a magical politician, able to distract the people's attention with sugar plums and birdies. Costs will eventually accrue and become obvious. I think the area of foreign policy is the most likely immediate source of these costs. Other costs will be of longer term.

I disagree with Jude because the issue of character is central to any leader in a democracy. In a democracy there must exist a level of trust between the people and their leaders. The leader is a figurehead of the government. If leaders of poor character are elected, the confidence of the people in the whole of the government will erode. Considering that one of the basic functions of the government is the maintenance of order in the marketplace, one would think that he who studies markets would want the policeman to be thought incorruptible (This is why the idea that 'They all do it' is so pernicious.) At root I think that only 20 % of the populace pay enough attention to the issues of the day to rationally analyze them, assuming they have the equipage to do so. A cynic is an optimist with experience. 

A. When you say the think the political market is not as perfect as I think it is, I think you may believe I think the political system cannot be improved upon. I believe the electorate should be viewed as a perfect amalgam of individuals, perfectly capable to choosing  between A & B if given the best available information about A & E. The electorate cannot choose between C & D if that choice is not presented to it. If the electorate is perfectly capable of choosing between A & B, are those who choose B wrong because the majority has selected A? No, they gave their best guess, and if they later turn out to have been right, they will be able to persuade the majority to come over to B. When the decision is binary — voting a bond issue up or down — it is clearest that if Yea is chosen over Nay, the electorate's calculation is final and correct, given the available information. If the national government later screws up and the economy falters, perhaps the bond decision looks bad in retrospect. But the electorate cannot see the future with perfect vision. It can only guess at it.

In the economic marketplace, every day smart people are going bankrupt and uninformed people are getting rich. People fill their grocery baskets with stuff you would never buy. People buy clothes you would never wear and drive ugly cars you would never own. They are, though, part of the commercial electorate, and make wise decisions in the aggregate. In my own analysis of the economy, I overlooked the benefits of the new Roth IRA over the old form. I only discovered the benefits to the masses in the locker room at my health club, when I noted several young men chatting about the Roth IRA. The same kind of wisdom is disseminated in beer halls and bowling alleys, as people of ordinary means try to make the most of what they have and are constantly on the lookout for a better deal.

They do the same with politicians. Yes, character counts, but it is not all that counts in a politician. We know the mechanism of the government, what we can expect of it and what we cannot. So we know we are to a degree protected against unscrupulous characters who find a way of getting political power. In the same way, the masses communicate about the management of one department store over another, and decide that even though A is more trustworthy than B, the prices at A are low enough to cover the risk of being treated unfairly if the item turns out to be defective. The opponents of Richard Nixon long ago asked "Would you buy a used car from this man?" The metaphor carries over from the commercial to the political marketplace. Yet notice it is a used car that is specified. You can buy a new car from people of low character because you know the warranty will be honored at another dealer.

The electorate is behaving extremely well in regard to Clinton, and the longer the story goes on, the more I begin to appreciate the President's side of the story. That is, I don't doubt that there have been sexcapades, but I now think it was of the kind the electorate prefers to overlook, on the grounds that it was consensual. The Kathleen Willey story seemed most likely to cause him problems, but her appearance on "60 Minutes" persuaded me to doubt that she may  have been groped.

Put the question a different way: Does the President have character? How much? Enough to serve us well as President? In my political model, I assume every member of the electorate will decide these questions for himself/herself. From experience, I know that well-to-do country club ladies who vote Republican will say he should be impeached and then boiled in oil. And people at the bottom of the pile, who finally have some hope of climbing out of the gutter, the answers to the questions will be quite the opposite. In "My Fair Lady," Eliza Doolittle's father could not afford "Middle-class morality" and he made no bones about it. When I was a boy, in the early 1950s, I understood that the electorate would give bad marks to a candidate for President who had been divorced. If you cannot keep your own family together, how can you hold the national family together? When 1980 came along, and the choice was between the incumbent President who had never divorced, and Ronald Reagan who had, the circumstances of the national economy pointed toward Reagan as being a better provider than Jimmy Carter had been.

So far, President Clinton has weathered these storms, and I hope he continues to do so. The cost to the nation of one of its most important mechanisms — the presidency — would be extremely high if he were forced to resign. If we have to pay that cost, we will know it when the day arrives. I personally thought it would soon arrive when I first read of Monica Lewinsky and the tapes. Now, I'm not so sure. Had he bombed Iraq, I think he would be in more danger now than he is after being rescued by Kofi Annan. The electorate has to weigh the prospects of a President Gore, and I think it senses there would be a definite cost in going that route. At the moment, my personal answer to the question I posed is that, Yes, the President has enough character to serve us well. Will my answer be the same next month? That, I can't say. But if I change my mind, I'll be sure to tell you why.

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Surprise, surprise! Next week, we will have another guest lecture by Reuven Brenner on the efficiency of the financial markets. How lucky we are. I have just finished reading his lecture and it is wonderful. Professor Brenner produced it when I e-mailed him a question posed by one of the students about the topic. I asked if he would give a one-paragraph response, and he came back with a full-length presentation. Many of his insights are applicable to the political markets as well.