Macroeconomics: The Enemy Within Jude Wanniski May 21, 1999

Today's lesson draws on my personal archives, an op-ed I wrote for The Wall Street Journal almost eight years ago, "Macroeconomics: The Enemy Within," June 27, 1991. I'd forgotten about the piece, but an SSU student e-mailed recently that he had read it at the time, cut it out and saved it. The most instructive part of this lesson will not be in the substance of the op-ed, which adds nothing new to the material presented this semester and last. It is to demonstrate how little has changed in the eight years. The same institutions make the same mistakes:

MACROECONOMICS: The Enemy Within

Here we are in the last decade of the 20th century, the cold war behind us, Communism a failed experiment, and yet around the world we see almost nothing but economic distress.

Why is the U.S. in recession? Why are Canada, England, Australia and Sweden in recession? Most of Europe is suddenly struggling to stay on a growth track. Japan's stock market is in steady retreat and its dizzy economic growth has slowed. And how is it that so much poverty, unemployment, inflation and debt plague the Third World countries of Asia, Africa and Latin America?

Economists' Advice

These questions lead to a larger one: With so many Nobel laureates in economic science handed out in Stockholm in the past generation, why does the economics profession have so little to show for its skills? Reading these lines, these distinguished gentlemen will huff, "These misfortunes occurred because my counsel was not heeded." Regrettably, the opposite is true: All this misery befell the nations of the world precisely because they acted according to the advice of the economics profession.

Conventional macroeconomics is the most discredited branch of the profession. Harvard's N. Gregory Mankiw apologized for the macro model in a recent essay in "The Journal of Economic Literature" by comparison to astronomy: "At the time it was proposed and for many years thereafter, the Copernican system did not work as well as the Ptolemaic system [showing the sun orbiting the Earth]. For predicting the positions of the planets, the Ptolemaic system was superior.... If you had been an applied astronomer, you would have continued to use the Ptolemaic system."

Yet the influence of macroeconomics dominates the policymaking of a majority of the world's governments. American economic policy is now fettered to the macro model, as surely as Marx's theory guided the Soviet Gosplan. As a result of the budget agreement between the Bush administration and the Democratic Congress, the macro computers actually control policy. A tax rate can't be reduced unless the computers predict positive revenue effects. The most damaging error results from the computer assessment of the president's proposal to cut the capital-gains tax.

The same model is responsible for most of the economic misery in the Third World, thanks to the International Monetary Fund. Faced with galloping inflation and collapsed tax revenues, the IMF's macro model recommends devaluations and tax hikes to reduce demand. In every case, these measures have increased inflation and lowered tax revenues, as individuals defy government attempts to steal their savings and confiscate their income.

Macroeconomics founders upon a grotesquely elitist premise, namely that manipulation of aggregate demand or money supply or some other "macro" variable can homogenize the behavior of millions of individuals. The economics profession, liberal and conservative, peddles this elitism under the guise of "science." If we assume that individual human beings behave as uniformly as hydrogen molecules, we can write mathematical equations describing an economy. The academic economics curriculum has become as mathematical as the physics department. The further away economics strays from reality, the better it can be sold as "scientifically precise." We have been beguiled by the mirage of scientific surety, giving up in exchange the free exercise of economic policy.

Throughout the past few centuries, up until the late 1940s, economics was thought to be, at best, a behavioral science, no more precise than psychology or political science. Indeed, men and women who practiced it thought of themselves as "political economists," the two disciplines inextricably linked. They only could guess at how human beings would react under different economic circumstances triggered by various political events.

By liberating themselves from political science, economists were free to convert economic behavior to mathematical notation. In the 1940s, John Maynard Keynes's Marxist students at Cambridge University attempted to deal with the mathematician John von Neumann's proof that no mathematical model could cope with innovation. Changing technology, von Neumann proved, would collapse any possible system of equations. Common sense tells us the same thing: How does a mathematical model of vacuum-tube production predict the future output of micro-chips?

The economics profession, though, turned von Neumann's argument inside out, and excluded consideration of innovation in order to promote their mathematical model. In the early 1950s, a young American still in his Marxist phase, Lawrence Klein, refined this work into the first econometric model of the U.S. economy, for which he won the 1980 Nobel Prize. Mr. Klein's work provided the foundation for Wharton's econometric model, and altered the outlook of the economics profession ever after.

By treating individuals like identical hydrogen molecules, macro models crank out policies that manipulate demand, while destroying individual incentives to produce. Relying on their equations, economists in the early 1970s confidently asserted that the dollar could be devalued with predictable, beneficial results. If the dollar could buy fewer Japanese yen, the U.S. would import less. If the yen could buy more dollars, Japan would import more from the U.S. Almost without exception, liberal and conservative Ph.D. economists agreed on the general outcome. In 1971, President Nixon was persuaded to end the dollar's gold guarantee in order to permit devaluation.

People, through, are not hydrogen molecules. They did not sit still in accordance with the economic assumptions built into the computers, passively accepting the government's manipulation of the currency. As they saw their hard-earned dollars and dollar assets losing purchasing power against gold and foreign exchange, they shed dollars for gold and foreign exchange. The "velocity" of dollars, which monetarists assumed would remain constant, increased dramatically as citizens tried to get rid of them in favor or more reliable assets. None of the gains promised by the gains promised by the economists was realized in the inflation that followed. The world's central banks are now groping their way back to monetary stability.

Another massive failure of the econometric models is at the heart of the current U.S. recession. This is because the econometricians, unable to convert "risk taking" and "innovation" to mathematical notation, banish them from their equations. Economic growth, thought, results from individual initiative and innovation. The U.S. now subjects policies designed to foster innovation to computer models that explicitly exclude innovation from consideration. While the capital gains tax is not the only example, it is surely a clear one.

A lower capital-gains tax increases the after-tax reward for risk-taking and innovation. The federal tax burden has increased enormously during the past 20 years of inflation and in a micro-economic (or supply-side) analysis, has been smothering economic growth and will continue to do so. Cutting the rate to 15% and eliminating it entirely after a three-year holding period would have dramatic effects on economic growth and increase state and local revenues as well as federal revenues. It also would revive American competitiveness with Japan, where capital gains have been taxed little or not at all.

Ignore Innovation

Yet when the computers are asked what happens to economic growth with a lower capital-gains tax, they answer: "Not much." They have been programmed to ignore the effects of risk-taking and innovation.

Perhaps some day a brilliant macro-economist will find a way to capture the divine, infinite variability of human behavior in mathematical notation. We might then consider turning policy- making in the world economy over to the computers. Until that day, they are a menace to us all. They are the enemy within.

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P.S.

George Bush had campaigned in 1988 on a pledge to not only refuse to raise taxes, but also to cut the capital gains tax to 15%. In winning easily over Massachusetts Gov. Michael Dukakis, the Democratic nominee who opposed a cut in the capital gains rate, Bush easily could have put forward the tax cut as HR 1, claiming it as his electoral mandate, and it would have sailed through Congress. Instead, his advisors, who had little interest in lower rates, but were determined to balance the budget, decided to lump the capital gains proposal with major spending cuts. It would be the Deal of the Century, as envisioned by Budget Director Richard Darman. The strategy worked as Darman planned, right up to its defeat in the Senate on October 13, 1989. The budget deal had passed the House earlier that month and Darman thought it easily would make it through the Senate, where 20 Democrats privately indicated they would support the tax cut. At noon on the 13th, the White House told the U.S. Chamber of Commerce that it would not agree to a budget reconciliation bill unless the majority Senate Democrats agreed to permit a vote that would append the tax cut to the bill. It would hang tough against Senate Majority Leader George Mitchell, who opposed a vote, knowing it would pass by at least 70-to-30. Soon after noon the stock market began sliding and at 2 p.m. the wires carried the announcement that the White House changed its mind, after hearing from Senate Minority Leader Bob Dole that his troops had no stomach for a fight with Mitchell. The Dow Jones Industrial Average lost 190 points that afternoon, which would be the equivalent today of an 800-point loss.

Did the news media make the connection? Of course not. On the wires that afternoon was a report that a snag had developed in the financing of a takeover deal involving United Airlines. The nation's capital stock had lost 7% of its value in a few hours, and EVERY business/financial news outlet attributed the loss to the insignificant UAL deal. Richard Rahn, chief economist of the U.S. Chamber was quoted in a few papers as saying the loss was due to the Bush White House, but his view either was ignored or gently ridiculed.

The capgains rate was not cut in 1989 or in any subsequent year of the Bush administration. By the time I wrote "Macroeconomics: The Enemy Within," the President had already broken his "Read my lips, no new taxes" promise to the electorate in 1990. He was on his way to an agreement to raise the effective capital gains tax in a band of income classes, to 31% from 28%. The net economic effect of his actions was a recession and decline in U.S. living standards, reversing at least part of the advances of the Reagan years. The political cost to Bush and the GOP was the loss of the 1992 elections to Arkansas Governor Bill Clinton -- who promised a middle-class tax cut if elected, and immediately pushed through his Democratic Congress another income-tax increase. The conventional wisdom among Democratic political analysts at the time was that a presidential candidate could promise a tax cut to win election, but had to raise taxes during his first year in office. The reasoning was that there would be a recession sometime in his four years in office, so he might as well get the voters to take it early, so it would be over and the economy expanding when it was re-election time.

Why is the world economy in worse shape now than it was in 1991? Especially considering that we have another eight Nobel Prizewinners in "economic science. "As you read this, the only industrial economy in the world that is growing is the United States, with the possible exception of the U.K. There are Asian countries that are "recovering" from the Asian crisis brought about by the monetary deflation in the United States. And China, which we do not yet consider an industrial country, is still growing slowly as its unemployment rate rises. Unemployment is rampant throughout Europe, Africa remains in a pitiful state, and Latin America is hanging by its fingernails.

The single most important reason is that the Political Establishment remains in control of policy in the United States and the international financial institutions. The "establishment" by its very nature favors the status quo, fearful of being displaced by those not in the establishment. Demand-side economics, which treats human beings like identical hydrogen atoms, is the preferred model. Supply-side economics, which treats human beings as being unique, able to respond to incentives by taking risks that the community itself would not take, is the model which the establishment wishes to avoid. There is now not one major college or university in the United States that teaches classical economics in the core curriculum. Public and private universities have all been captured by the establishment, which is why you can only learn what they will not teach here at Supply-Side University.

Politicians who adopt supply-side models in their campaigns and cling to them after they are elected -- such as Ronald Reagan -- upset the established order. The population loved Reagan for what he achieved, with benefits that still flow from his policies. It is in the interests of the established order to prevent another Reagan at home. It is in the interests of the established order to maintain control over the International Monetary Fund, the World Bank and the World Trade Organization, to prevent other nations and other economies from challenging our political, economic or military leadership. This is the new imperialism, where the mother country keeps taxes high in the colonies to prevent them from competing in manufacturing. The colonies successfully rebelled against this established order that became the template for the British Empire. Now that the United States rules the world, our Political Establishment automatically and naturally conducts itself in a way that will keep the rest of the world under control, under our heel. The only possible antidote is our democracy.