Q&A on Public Finance Jude Wanniski May 7, 1999

Q. Mike Darda. I was reading [Larry] Kudlow's new book, American Abundance, over the weekend and noticed multiple references to tax-rate cuts increasing the demand for money. At one point he defined it as tax cuts increasing the after-tax return on stocks and bonds, which increased the willingness of people to invest and hold those assets. My question is, does cutting tax rates on both personal income and capital gains result in an increase in the demand for real cash balances, or a spike in the demand for dollar-dominated assets...or some combination? Or is it simply a higher level of economic activity brought forth via the tax cuts that impacts the demand for real cash balances, allowing for more goods and services to chase a smaller level of liquidity in relative terms? Could you elucidate this one for me?

A. When a tax rate or tariff is higher than it needs to be in order to produce a desired level of revenue, it increases the cost of financial intermediation. If you offer bread and I offer wine, the modern economy arranges the exchange through an intermediary who finances the transaction. If the tax on the production of either the bread or the wine -- which could be income tax, sales tax, property tax, etc. -- is higher than it needs to be to finance the activities of government, it will discourage some part of the trade in those goods. There will be less need for currency or bank reserves -- by which we mean that part of the publicly-held national debt that does not pay interest. I prefer not to use the term "cash balances," which the monetarists use in their demand model to refer to some, but not all forms of federal debt that pays no interest. Kudlow seems to have one foot in that model when he talks about a willingness to hold more stocks and bonds when the tax rate is lower. Fed Chairman Alan Greenspan makes the same mistake in a different way, when he suggests "inflation" can occur if the unemployment rate falls.

When the cost of producing the bread or the wine, plus the cost of financial intermediation, is lowered, more production and exchange of goods will ensue. More "money" will be required. If the central bank does not supply it, its relative scarcity makes it more valuable. Relative to what? Relative to real goods, starting with the good that is the most monetary in its ingredients -- gold. The currency or reserves that become money have to "do more work," which brings forth a monetary deflation that adjusts all prices in the galaxy of prices to a new, lower level. If it takes more workers to produce the bread and the labor pool is so tight that more labor is not available, the price of labor will rise until it attracts labor from some other activity or permits the manager to buy a bigger bread-making machine. In any case, there can be no "inflation" as long as the central bank supplies only the amount of reserves being demanded by the various factors of production -- and no more. The question goes to the heart of the complexity in the marketplace, which is why it takes at least a semester of lectures to cover all its angles.

Q. Chris Youmans. I'm not altogether clear if the strength of the U.S. stock market is giving you reason to adjust your model. I understand that your model is dynamic and is always open to adjustment, but I'm not sure if the current conditions in the U.S. are stronger than you would have predicted given the deflation. It does seem likely that we would benefit from a deflation in the short run, as our economy enjoys average contract lengths well in excess of all other countries (an educated guess). But it also seems that at some point the market will begin to discount the likelihood that our own economy will be able to avoid the deflation. Do you think that the strength of the stock market is based on the assumption that the Fed will adjust monetary policy to avoid the negative effects of deflation in our economy? Is the market misreading the deflation or are the market valuations consistent with your model?

A. The question is one that our clients at Polyconomics ask us to grapple with, paying us for doing so. It thus is a bit out of the realm of questions we normally take at SSU. Let me say that I believe the broad market is perfectly efficient in determining values, all along the schedule of financial assets in the galaxy of prices. When you say the "strength of the market" you refer to the most popular indices, including the Dow Jones Industrial Average, the S&P 500 and the NASDAQ. These have advanced because of technological improvements that have made enterprises more productive. The advance also is because the tax and budget structure of the economy is more favorable to production and exchange, and the market believes it will be even better in the future. The Russell 2000 index, which represents smaller enterprises that are more vulnerable to economic mistakes or government policy surprises, has not been strong for almost the entire period of the monetary deflation. Even its recent modest gains are the result of some of the small Internet stocks that have increased dramatically in value in the past several months. We don't think the market has much confidence in the Fed, which is why bond yields are so high and climbing. Greenspan inspires less and less confidence in us as he finds more and more excuses for how the economy is not performing as he predicted and why he bears no blame for the global deflation. That is, he is intellectually further from a correct model of the economy than he was three years ago.

Q. Bill Moore. It seems to me that removal of barriers to trade, desirable in the fabled "long run," may wreak social havoc in the short run. And since we live in the latter it seems reasonable to extend the adjustment period if, thereby, the lives, jobs, moods, cohesion, etc. of millions of people (most a generation up from penury) are not suddenly imperiled. Might it all be a matter of "Timing"?

A. Of course, removing a specific barrier to trade will most benefit the consumers of imported goods that can now make it over the other hurdles that a foreign producer must traverse in order to make a profit in our market. If there are workers here engaged in production of similar goods, which now become uncompetitive at the lowered price of the imports, "social havoc" is wreaked on those families whose breadwinner gets laid off. This is why it is most useful to have trade and tariff barriers removed when capital is plentiful and labor is scarce. I told Pat Buchanan that I could support a slightly higher tariff to give his blue-collar voters a small measure of relief if the revenues collected went to displace the capital-gains tax. The increase in the size of our economy would remove the political pressures for protection against foreign goods.

Q. Name withheld. Former Fed Governor Alan Blinder, now back professing at Princeton, says he is puzzled by the current economic conditions -- strong domestic economic growth, tight labor markets, low wage growth and low inflation. Not quite a full embrace of New Era Economics. He says until about two years ago the Phillips Curve was providing a great view of the world. And until about 6 months ago he was of the opinion that luck, in the form of favorable supply shocks, enabled the economy to grow without inflation pressures building. As the last two calendar quarters have shown contained wage growth through the Employment Cost Index (ECI), Blinder's seeing the world a bit differently. He stated the economy and the stock market are feeding upon each other. Stocks soar, wealth increases and confident consumers spend money. What do you think about this?

A. Academic economists have been puzzled by the economy's condition and market's behavior for as long as I can remember. They make it up as they go along, which is why Ph.D. economists are almost worthless, except to politicians and government institutions which need Ph.D. economists who are willing to say almost anything for a handsome salary. I don't know what New Era Economics is about, except that it is an ad hoc attempt to explain why the Phillips Curve trade-off between inflation and unemployment is not working (it never did). Notice how Blinder, a truly dreadful economist, explains that lucky supply shocks that nobody foresaw explain how the economy can grow without inflation. He does not have the slightest clue that when you couple monetary deflation with lower tax rates on capital formation, you get lower commodity prices and faster growth in industries that are intellectually capital intensive. I began warning Greenspan in December of 1996 that the prospect of a capital-gains tax would pull down the gold price unless he added liquidity, and that all commodities would follow in train. There was no lucky "supply shock." Blinder also asserts that the economy and the stock market are feeding on each other. I picture a dog eating itself, starting with its tail. This would be pathetic analysis from a junior-grade analyst on Wall Street. Think of it coming from a tenured professor who served as Vice Chairman of the Fed. "Values" on the stock market only can rise when the market estimates increased chances of higher real returns on invested capital because of a stronger future economy. Blinder belongs in the corner of his class, with a tall pointy hat.

Q. Judith Grady. A Reuters article caught my eye today: "U.S. trade deficit jumps to $19.44 billion in Feb" WASHINGTON, April 20 (Reuters) - The U.S. trade deficit soared to a record $19.44 billion in February as imports of cars, consumer goods and other manufactured goods hit records while U.S. exports fell, the U.S. government said on Tuesday." The question that comes to my mind: how long can this imbalance in imports vs. exports continue? Indefinitely? Is there a limit?

A. First imagine an extreme example, the reductio ad absurdum, in which all the world's capital flows to the United States. This would be recorded as a perpetual trade deficit. If the United States is the only place in the world where invested capital can produce a positive return, all the world's population also would move to the United States. When everyone lives in the United States, the U.S. can no longer run a trade deficit with the rest of the world, which is now barren of all people and production. The United States has been sucking in capital from the rest of the world through positive-sum tax policies that reward returns on capital, plus a zero-sum monetary policy of deflation that benefits our technological economy at the expense of poorer countries that make their livings by producing commodities. Will this go on forever? No, it will turn as soon as a U.S. President is elected who understands supply-side economics. If we were to put the dollar on a gold standard and change the conditionality of IMF loans to poor countries, favoring growth over austerity, capital would flow to the rest of the world and we would run trade surpluses.

Q. Henry Meers. [Not so much a question as an observation.] There is never an infinite amount of money to be invested in a system, lender/investors have to have a way to choose where to put their money. Users of that capital compete for it. Someone is not going to be able to pay the price and will be left out. He may decide rates are too high or the market could refuse him on a credit-worthiness basis. October often has been a bad month for American stock markets, because a lot of credit demands hit the economy at that point in the year. Although they may seen unrelated, farmers have to pay for the harvest, Christmas inventory building begins and so on. Every one of these is a valid claim on the resources of the country. Think of April 15th the same way, and you will see that there could be a scramble for funds. Would a department store accumulate less inventory in a high-rate environment? In the fall of 1929, overnight money being loaned to stock market investors earned the highest rate people had ever seen, and that certainly made it more attractive than the traditional opportunities.

A. This is almost, but not quite the way markets work. There may not be an infinite amount of "money" that can be invested in a system. An infinite number is pretty big. But if you think of the potential of the entire population of the global economy, we have a long way to go before it is working at full potential. This is the limiting factor. Henry Meers describes a static snapshot of the supply and demand for capital and mixes up his example with "money." The two are not the same. Capital is the expression of the surplus of time, energy and talent available to those who have a deficit. It can take the form of debt (credit) or equity. "Money" is a transactions medium by which spot purchases and sales can be effected. There is no relationship between the equity market in October and the "credit demands" of farmers. Sorry, Henry. The stock market crash of 1929 was due to a collapse of Senate opposition to the tariff act it was considering. The sharp October 1987 decline was related to Fed Chairman Alan Greenspan and Treasury Secretary James Baker III almost simultaneously making statements that undermined the international agreement on monetary stability of the previous February. The October 1989 sell-off was linked almost to the minute by the decision to abandon the cut in the capital gains tax that had already passed the House. Markets at least are smart enough to be able to discount the normal needs for liquidity by farmers and Christmas inventory, as they occur as regularly as the seasons.

* * * * *

Thanks for the good questions, students. Don't be shy about asking for further elucidation if you don't understand some part of my answer or if you have a disagreement.