Questions from the class Jude Wanniski January 28, 2000

Enough interesting questions have come in from the class that I will extend the fall semester one more week to address them.

Q. I was reading a thread at the Motley Fool where there was a swipe at supply-side theory. The point was made that the "Wealth Effect" was a "good thing" according to supply siders of the 1980s but that ironically it is now invoked by Alan Greenspan as a "dangerous thing" that must be constrained by Fed policy lest the economy go out of control. Here was the relevant comment in the post: "The dangers of the wealth effect? Remember when the supply-siders thought the wealth effect and trickle down would cure all of ailments and genital herpes too? The truth is, none of the economists know what's going on."

JW. The concept of the "wealth effect" is a "demand-side concept," not "supply-side" at all. The "effect" refers to the idea that when an individual sees the value of his investment portfolio increase, he feels wealthy enough to buy something he would otherwise not buy. He would reach into his pocket and DEMAND a new car or a new washing machine, etc. Remember, the demand model focuses on consumption -- the consumer's pocket. It is a single variable model in that the consumer either puts money in his pocket or he takes it out. This is the central assumption of almost all economics taught in the United States -- Keynesian and monetarist. When the economy was booming under Reagan in the 1980s, it was the demand-siders who argued that it was the "wealth effect," and that this was a bad thing back then because only rich people owned stocks and the Reagan tax cuts were causing rich people to get richer and pull more money out of their pockets to buy expensive things. In the 1986 tax act, a big tax was put on luxury cars and yachts, that is how dopey the idea became. The tax on yachts had to be peeled back when it destroyed the domestic yacht-building industry.

Greenspan and other Federal Reserve governors have recently been citing the "wealth effect" as another excuse to raise interest rates. The idea first surfaced early in January in a speech by Alfred Broaddus, president of the Atlanta Fed, a man who has spent most of his life as an economist in the Fed bureaucracy in Atlanta. Even though there is no sign of inflation anywhere, Broaddus came up with the idea that the stock market was causing people to become so wealthy on paper, that they might spend more of their income on goods that were in short supply, thus causing "inflation." Because the stock market is supposed to forecast an increased output, in a demand mode as well as a supply model, Broaddus had to juggle these concepts to make his thesis fit together. Yes, there will be goods in the future, but the wealth effect takes place in the present. So interest rates must go up in order to cause buyers of goods (yachts?) to put their money back in their pockets and walk out of the yacht showroom. I am not kidding, students. This is the kind of nonsense that Nobel Prizewinners like Paul Samuelson and Robert Solow at MIT and James Tobin at Yale teach their students in the process of awarding them Ph.D. degrees.

In the supply model, the stock market may rise simply because the monetary authority has caused an inflation, which means that part of corporate assets which are hard -- plant, equipment and inventory -- rise in price although not in value. When this happens, simultaneously individuals are unloading dollars they have accumulated because they are losing purchasing power, buying goods (or gold and other commodities) in order to preserve their "savings." The economy is getting poorer, but people are "spending" faster. When this occurred in the Nixon-Ford-Carter years, demand-siders cooked up the "wealth effect" idea. When the monetary system is anchored by gold, the stock market rises only when there is a rise in the relative value of the factors of production, because they now can be more efficiently employed. The economy becomes wealthier, but only because it now is easier for people to exchange goods with each other in the broad exchange-economy. Jones makes bread and Smith makes wine, but the tax rate makes it impossible for the market to finance their exchange. When the tax rate is cut, the exchange now can take place, so the value of Bakery Inc. and Vineyard Inc. rise in value. Notice there are no consumer "pockets" in this explanation.

Q. I reread lesson #6 of this semester again where you explain the fallacies of Milton Friedman's monetary answers to the great depression. I am in agreement that you have effectively refuted his analysis of post-1929 solutions of the depression. My memory of Friedman theory says that pre-crash, the Fed mistake was that it was experiencing an influx of gold to the treasuries and not increasing money supply as required by international convention at the time. Did this refusal to increase money supply cause a deflation which could have aggravated a market correction into a market crash?. The theory being (monetarist, I admit) that a small increase of money supply before the crash would work where a large increase after the crash is too late.

JW. I don't remember Friedman making the argument that the Fed was too stingy with the monetization of debt prior to the Crash. The late Murray Rothbard, an Austrian of sorts, actually argued that the Fed increased the money supply too fast and that a bubble formed, which resulted in the Crash. Friedman shies from making arguments about too little money prior to the Crash because it would make his analytical model look even less reliable than it has been. The Fed's assignment in the 1920s was to provide liquidity when the market was demanding it at a gold/dollar unit-of-account rate of $20.67 per ounce. The Treasury did accumulate a bit of gold in the 1920s, but it does not matter how much gold Treasury buys or sells at the fixed rate of $20.67. The importance of the gold standard is to keep the price constant so the exchange economy has a fixed unit-of-account. There is a tiny volume of gold in the world, not more than 125,000 metric tons in all. It does not matter whether Jones has it locked in his vault or Smith has it locked in his or Uncle Sam in Fort Knox. No matter how many times you read a textbook blaming the stock market boom on the Fed or blaming the stock market crash on the Fed, do not forget that the Fed was powerless to inflate or deflate. It thus could not make any errors. Because it is now de-linked from gold, it can make errors every day, and it does.

Q. In the past seven years, we've seen the largest tax increase in the history of the world along with increases in the minimum wage, both items that supply-side economics show to damage the economy. It is argued that our fears against these things were unrealized since the economy still continues to experience growth. Another minimum wage increase will be debated in the coming session of Congress. I believe that the economy would have grown much more had those things not passed, but wanted to know what type of argument you would use concerning this issue.

JW. The 1993 tax increase may have been "the largest tax increase in history" in nominal terms, when accountants are asked to tote up nominal dollars. But at the time it passed, Polyconomics noted that it would not do much damage to the economy because it was raising tax rates on incomes where people were already avoiding payment by sheltering incomes in retirement plans. The Treasury estimated that the 1993 tax bill would bring in enormous amounts in these higher brackets, but that was not the experience that followed. The fact that the government left the capital-gains tax alone, at 28%, was enough to satisfy me that the economy could continue to do well with Greenspan persuading the market that there would be no accompanying inflation. In 1997, of course, there was a beautiful tax cut, bringing capgains down to 20% and giving us the front-loaded Roth IRA and a $1 million exemption on the estate tax, from $600,000. These were the ingredients of the Clinton expansion, which would have been healthier if the dollar had not deflated against gold. Yet even there, the deflation mostly hurt commodity producers, not our economy which is top-heavy in intellectual production.

Q. In the Sunday (January 23) Washington Post, there was an article concerning a G-7 meeting that focused on strengthening the Japanese economy. According to the article, Western officials signaled that they were unwilling to "help" by devaluing the yen. As you know and have talked about, organizations like the IMF and World Bank have consistently pushed currency devaluation as a prescription for ailing economies, much to the detriment of those nations. At the same time, Treasury Secretary Summers encouraged the Japanese not to cut public spending, indicating a Keynesian belief that government spending helps the economy to grow. What would you advise that Japan do to grow over their current 1 percent growth rate?

JW. The IMF only advises a country to devalue its currency when it will damage the country's economy. I sound like a wise guy, but it almost always happens that way. There are times when a "devaluation" will actually help a country -- if it has in the recent past "revalued," or "appreciated" its currency against gold. Japan is now such a country.... where the yen price of gold is down around ¥30,000 per ounce when its average over the last decade is closer to ¥40,000. Debtors are being crushed by this deflation and creditors suffer because debtors can't pay. If the yen devalued to any price closer to ¥40,000, it would benefit the Japanese economy. On fiscal policy, I have for years urged that it eliminate the capital-gains tax on real property, which is now so high that it prevents this form of wealth from being liquefied.

Q. Tax cuts, especially cuts in tax rates and capital-gains taxes, are criticized as benefiting the rich and taking away from saving Social Security. Even Republicans seem to buy into this argument when crafting tax cut plans. What is the best strategy for pro-growth candidates to show that rate cuts and capital-gains tax cuts actually benefit the poor and that such tax cuts will actually provide more revenue to reform Social Security? In other words, how does a Republican prevent the charge of "tax cuts for the rich" from hurting him at the ballot box?

JW. Twenty years ago, Margaret Thatcher made the comment that when a conservative allows a liberal to intimidate him with the "tax cuts help the rich" argument, he loses. When she led the Tories to a smashing victory in 1979, she openly made the argument for the Laffer Curve, and brushed aside all the criticisms hurled at her from the left. Ronald Reagan, like Thatcher, refused to allow the Carter-backers to ruffle him with their blasts about "trickle-down economics," just as he refused to allow the jibes from George Bush about "voodoo economics" to bother him. When Bush in 1988 pledged "read-my-lips, no-new-taxes," he won the election, because the voters thought they could believe him. It is a rare candidate who can stand up to criticism about lowering tax rates that the voters know are hurting them and the country. When he or she appears, the voters almost always reward them. In 1962, by the way, when John Kennedy proposed an income-tax cut to 65% at the top from 90%, the Republicans screamed that he was acting irresponsibly. This year, it almost certainly seems the case that if there is a serious argument made for cutting the capital-gains tax it will have to be Pat Buchanan.

Q. Is Buchanan's economic plan viewed by actual economists as good or bad? Do you think the IRS should be dismantled and replaced by a well-thought-out consumer tax?

JW. Buchanan has yet to present a specific economic plan. He has left the general impression that he will favor a protectionist tariff and block China's entry into the World Trade Organization. If he hopes to win the presidency on the Reform Party ticket, he has to spend the next few months building a coalition that will accept his core economic positions. I doubt we will see a Buchanan "platform" until the major party candidates have decided on their nominees and Buchanan has a clear picture of the program he can present that optimizes his candidacy. He already has indicated to me, as he has suggested in his Great Betrayal book, that he will not run on a "protective tariff," but one that is consistent with the Laffer Curve and the law of diminishing returns. A protective tariff, remember, is one so high that it prevents most goods from coming into the market, and therefore does not collect revenues.

Q. I'm confused on how the so-called "yield curve" inverts. Why would the 10-year government bond pay a higher interest rate than a 30-year bond? Whereas longer maturity debts are more volatile with respect to changes in interest rates than short maturity debts, why would they ever be more expensive? In a world of complete certainty, I'm pretty sure that all maturities of debt would have the same interest rate. If I'm wrong, please let me know. Maybe bond inversion represents a market discoordination, the long market has perceived a future fall in interest rates before the short market (shorts should fall too in anticipation of people taking advantage of the relatively high interest rate in the short market). At any rate, we can be almost positive that in the long run, the bond inversion will right itself, so why not just buy shorts and sell longs until the volatility-adjusted interest rates on shorts and longs equalize? Isn't this an almost assured pure arbitrage?

JW. The yield curve inverts when the market senses that the Federal Reserve is not going to be as "tight" in the future as it seemed the day before. The market always is having to assess the intentions of the central bank... which is why the yield curve never inverted when the Fed had to maintain the gold price. The reason for the inversion is due to the fact that there are two components to a "bond." One is its interest-rate component, the other its capital-gains component. Let us say the interest rate on the long bond is high, say 6.75%, because the Fed is fighting "inflation" with a high overnight interest rate, say 5.5%. Let us also say the rate structure in the futures market suggests the Fed will raise the overnight rate by 75 basis points to 6.25%. If the overnight rate is going to be 6.25% and the 30-year-bond 6.75%, the yield curve is as flat as a pancake. Then let us say the market begins to get information not readily available to most of us, but to a few, that the Fed may only rise the overnight rate by 50 basis points in the future. This tells the market that the 6.75% rate will have to come down, and the 10 year-rate will come down as well.

This is where capital gains comes in. If you observe a 30-year bond with a 6.75% yield and know (or bet) that yield will soon be coming down, you can lock it in. FOR 30 YEARS!!! If you observe the 10-year bond and know it will be coming down, you can also lock it in, BUT ONLY FOR 10 YEARS. Your capital gain is limited by the bond's DURATION. The 30-year bond becomes more attractive than the 10-year bond.

This is what happened this past week, with exactly the numbers I present here. Not only did the 30-year bond offer more capgains than the 10-year government bond. The yield curve inverted with the 5-year bond!!! The market is telling us that it most sincerely believes Greenspan will not be pushing up the funds rate as hard as conventional wisdom has been thinking. As for the argument that this unusual happenstance is a perfect arbitrage candidate -- buying the 5-year and shorting the 30-year, on the well-founded assumption that they will converge, we run into the problem of opportunity costs and transaction costs. If you know there is a spread between apples at $1 in New York and 99 cents in Newark, you can short New York and go long Newark apples, but you'd more easily make the part of the penny by plopping your money into a money-market account and forgetting about it.

The yield-curve issue is one that very few people understand. Certainly very few in the financial press, who have this week almost been discussing it in mystical terms. A number of commentators have suggested that the yield curve always inverts prior to a recession, for example. That is because when there have been inversions of the yield curve in the last 30 years of floating dollars, it always has happened when the Fed has raised interest rates in order to beat an inflation by inducing a recession. When the recession looks like it finally has appeared, the Fed then must switch to lower interest rates to combat the recession!!! Silly, eh? But that is demand-side economics, folks. When the market senses there is going to be enough economic weakness to cause the Fed to lower interest rates, it then bids up the long bond and the yield curve inverts. In the current circumstance, there would be no recession ahead, because the Fed has been fighting a non-existent inflation. Rates are higher than they need to be, but the economy is as strong as it is because of other factors, relative to tax policies and private-sector growth in new technologies.

To repeat, the yield curve inverts when the market can lock in a long-term capital gain on the bond, as opposed to merely its income. 

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Thanks for the good questions. Next week, spring semester and fiscal policy.