I'd originally planned a Q&A for this week, but decided instead on having you read an important "document" in the modern revival of supply-side economics. It is an interview I did with Professor Robert Mundell of Columbia University in September of 1974. It was Mundell, a Canadian, who was the primary source of what I began to call supply-side economics in 1976. It was much more than an interview, in that I had become a free-lance student of his in the spring of 1973. (Later I went on to write "The Mundell-Laffer Hypothesis, a New View of the World Economy," in the Spring 1975 issue of Public Interest.) The September interview came against the background of the 1974 congressional elections, with the Republican Party lined up behind President Gerald R. Ford, who was promising a tax increase to fight the inflation rampant at the time. In January of 1972, Mundell had predicted the inflation would follow President Nixon's closing of the gold window and devaluation of the dollar. He knew, and I believed, that the Ford tax increase would, if it materialized, cause a worse recession than the one which he knew was coming in January of 1975. Almost the entire economics profession was encouraging Ford's tax increase and William Kerby, president of Dow Jones and the publisher of my newspaper, The Wall Street Journal, had chosen the moment to write a special plea of support for a tax increase. I was lucky that Editorial Page Editor Robert Bartley let me write the "interview" with Mundell and run it under my by-line. It was written very carefully, with Mundell going over every word I'd written several times to hone it to perfection. It stands up today as the tightest exposition of the model I've ever written. As it happens, a young congressman from Buffalo named Jack Kemp read the article. It was his first step in eventually learning the model from me the way I had learned it from Mundell and Mundell's protégé, Art Laffer.
It's Time to Cut Taxes
The Wall Street Journal
DECEMBER 11, 1974
Robert A. Mundell, a Canadian economist now at Columbia University, does not believe the United States can Whip Inflation Now and climb out of the deepening recession by harking to either the classical economic advice of tight money and balanced budgets or to the neo-Keynesian nostrum of easier money, public-service employment and wage-and-price controls.
The correct prescription, says Professor Mundell, is a $30 billion tax cut and the temporary halting of open-market operations by the Federal Reserve to assure monetary restraint.
Furthermore, asserts the placid professor, whose voice in conversation rarely rises above a whisper, if this medicine is not taken soon, there will be by mid-1975 more than seven million or even eight million Americans unemployed, an inflation rate perhaps double the consensus prediction of 7% per annum, and a huge budget deficit arising from the recession-level tax revenues and widespread company and household bankruptcies.
Professor Mundell's prescription is obviously not part of mainstream thinking in the United States, but it bears consideration for no other reason than the 42-year-old Canadian's standing and reputation among international economists. "He's the most creative, innovative international economist I know of," says Harold B. VanCleveland, vice president and economist at First National City Bank. Sir Roy Harrod, J.M.Keynes' biographer, has toasted him as one of the "greatest economists in the world." And Lord Robbins, chairman of the court of governors of the London School of Economics, said of him at the Bologna conference on global inflation in 1971: "Bob -- and here I lay down a sociological law -- is seldom wrong. And even when you disagree with him, you must disagree with your hat in the hand."
The heart of the current problem, Mr. Mundell believes, lies in the international arena. Inflation is, and has been for several years, a global phenomenon. The collapse of discipline of the balance of payments has unleashed a wave of inflation on the world. He believes that the eventual solution must involve not only control of the dollar supply produced in the United States, but regulation of the Eurodollar market, the restabilization of gold and a return to the fixed system. With Professor Arthur B. Laffer of the University of Chicago, he has worked out an economic model to deal with this problem.
To deal with the immediate crisis of simultaneous inflation and recession, though, Professor Mundell departs from the traditional belief that monetary and fiscal policies should always be working in the same direction. He believes that inflation and unemployment are separable problems and that to combat them distinct policy instruments are required. He believes that tight money should be used to combat the inflation, while expansive fiscal policies -- preferably through lower taxes -- can be used to combat the recession in a way that also works against inflation.
A Cause of Inflation
He argues that monetary expansion no longer works as a means of stimulating production; it simply causes inflation. To some degree and for short periods it may have been a reasonably good anti-cyclical weapon during the best years of the Bretton Woods system. But now, in the regime of floating exchange rates, monetary stimulation by the Fed not only increases wage demands, but is immediately perceived by the foreign-exchange markets, causing depreciation of the dollar and an automatic increase in the price of imports. This raises costs and aggravates inflation directly. It also raises wages and thus quickly shows up in the Cost of Living Index.
To eliminate at least this cause of inflation, he says the Fed should temporarily halt open-market purchases of government securities, the traditional means through which it increases the basic money supply. The thrust of demand expansion must come from fiscal stimuli, and when the U.S. economy responds to that stimulus, growth in the real money supply can come about through a resumption in open-market purchases. At the same time, the reviving U.S. economy would draw money from Europe and the Middle East and thus protect the U.S. balance of payments. Something else would occur as the economy's growth responds to the fiscal stimulus while monetary growth is checked. The dollar would appreciate against foreign currencies, which means the U.S. would then be able to buy a greater share of the world's goods and services with the same number of dollars.
Real economic growth would be stimulated by the big tax cut on both personal and corporate incomes. He would adjust income tax brackets across the board and index them to correct for future inflation, as is now the practice in Canada, and he would get the corporate tax bite down closer to Canada's 40%.
"The level of U.S. taxes has become a drag on economic growth in the United States," he says. "The national economy is being choked by taxes -- asphyxiated. Taxes have increased even while output has fallen, because of the inflation. The unemployment has created vast segments of excess capacity greater than the size of the entire Belgian economy. If you could put that sub-economy to work, you would not only eliminate the social and economic costs of unemployment, you would increase aggregate supply sufficiently to reduce inflation. It is simply absurd to argue that increasing unemployment will stop inflation. To stop inflation you need more goods, not less."
As it is, he believes U.S. policymakers are unwittingly creating a larger sub-economy of the unemployed guaranteed to reduce aggregate supply, and thereby aggravate inflation. A $30 billion tax cut implies a large initial federal deficit. But if taxes are not cut now, the size of the unemployed sub-economy will expand. Tax revenues of state, local and federal governments will decline. At the same time their outlays for unemployment relief and welfare will expand. Combined government deficits might even exceed the amount implied by a tax cut. But what's worse, the nation would be no closer to turning the economy around. He disagrees with both the Keynesians and the classical economists on the economic effects of a tax cut. "The Keynesians only look at its effect on demand and have always considered it inflationary," he says. "They neglect the financing side, aggregate supply and inventory effects."
"The classical economists are only concerned about the ‘crowding-out' effect," by which he means the effect of deficit financing on the private capital market, i.e., government financing needs crowd out private borrowing that would otherwise go into capital expansion. "Both of these extreme views do not see that there is a middle position."
A tax cut not only increases demand, but increases the incentive to produce. "The government budget recycles tax dollars into the spending stream through expenditures, but in so doing it reduces the incentive to produce and lowers total production. After all, if total taxes and expenditures become confiscatory, all economic activity would cease and the government tax bite would be 100% of nothing." With lower taxes, it is more attractive to invest and more attractive to work; demand is increased but so is supply.
So too with the "crowding-out" effect, an argument against tax cuts that was popular in the 1920s. The government sale of bonds to finance a tax cut indeed crowds private borrowers out of the capital market. This is only one effect, he says. Four other things occur. Because capital and labor are the main recipients of the proceeds of the government bond sale that finances the tax cut, they are in effect receiving as a gift $30 billion they would otherwise have to borrow. In this sense, they are happily crowded out of the credit market.
Secondly, the finance required for the tax cut would be less than what would be needed if the recession is allowed to deepen. Third, Professor Mundell believes the size of the credit pool would automatically expand as the prospect of real economic growth engendered by the tax cut allows a recovery of real savings. That is, dollar holders will have a higher incentive to invest in capital goods the larger and more rapid is the recovery from the recession. The fourth effect is that the bond sale method of financing the tax cut will draw money from abroad.
Helping Capital Flows
The international effects of a tax cut are particularly important, he asserts. With announcement of a major tax cut, the capital market would instantly perceive that it is more profitable to do business in the United States than the rest of the world. Capital that is now flowing out would remain; foreign capital going elsewhere would come in. The increased real economic growth would mean the U.S. would run a sizable trade deficit as the U.S. would keep more of what it produces and buy more goods from abroad. Offsetting this in the short run would be an inventory effect caused by tighter monetary conditions; the expectation of slower inflation would cause a reduction in optimal inventory levels.
There would be a balance of payments equilibrium, he says, because the capital flows would cover any residual trade deficit until market opportunities were arbitraged world-wide. The U.S. tax cut would help to pull the whole industrial world out of its slump, he maintains.
In a real sense, he sees the $30 billion tax cut as a future public's investment in the current private, productive sector of the economy that is now unutilized. He argues that the unemployed sub-economy would respond not only by producing goods and services sufficient to repay the bonds, but would meanwhile sustain itself with output and would not have to be carried by the government dole. Six months from now, perhaps $30 billion of that potential output will have been irretrievably lost and the economy will be in much worse shape than it is right now.
As he sees it, there is not now any self-corrective economic force acting to pull the economy out of its inflationary nosedive. At present there is no control of international reserves and even the value of gold gets indexed with inflation. "Inflation itself breeds even more money which in turn breeds more inflation." There was self-correction to an economic slump during the days of the gold-exchange standard, when deflation raised the purchasing power of gold, and self-correction to inflation when inflation reduced gold's purchasing power. There is none of this today in a world of floating exchange rates, he says. The nation's economic problems feed on themselves.
"They feed on themselves through the effects of inflation on the progressive income-tax schedules and through the negative multiplier effects thus generated," says Professor Mundell. "They feed on themselves through the ever-increasing percentage increases in wages needed to maintain workers' purchasing power. And they feed on themselves through the international escalation of world money supplies that has taken place since the breakdown of the gold-exchange standard. The $30 billion tax cut is needed immediately to arrest the world slump, and if it is delayed by even one month, the figure required will be higher."
Mr. Wanniski s a member of the Journal's editorial page staff.
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The article does not mention the Laffer Curve, which was only drawn for the first time on a cocktail napkin a few days earlier, on December 4, 1974. Notice that Mundell did not specify what kind of $30 billion had to be cut, but instead framed his response in Keynesian terms. In other words, any reduction in tax rates that would produce a decline in revenue of $30 billion would save the economy from recession. In retrospect, this was a glaring error, because it led the Ford administration to propose a $50 tax REBATE for every taxpayer, with no change in the rate structure. As soon as I saw the idea coming across the Dow Jones news wire, into the editorial page where I worked, I called White House Chief of Staff Don Rumsfeld and told him a terrible mistake had been made. The rebate would have no positive supply-side effects, because the taxpayers would be getting money back for work and investments they had already completed!
Alas, there was nothing that could be done about it. The Treasury Department economists who had designed the tax cut were all Keynesians, interested in putting money into people's pockets as fast as possible, to increase aggregate demand. Rumsfeld and Treasury Secretary William Simon had some arguments over the blunder, but it went forward. The tax bill that was enacted did have one provision that had magnified supply-side effects, but it was more or less snuck into the bill and got no credit for stabilizing the economy. The provision increased the lower corporate tax preference for small businesses to profits of $50,000 per year from $25,000. The error in legislating a $50 tax credit instead of a rate cut may have cost Ford the presidency in 1976, when Democrat Jimmy Carter ran on the theme that the U.S. tax system was "a disgrace to the human race." What did Carter do when he was elected? He proposed another $50 tax credit. Not until Reagan showed up in 1981 did the rate cutting take place that led to the reinvigorated economy we have seen since.