To: Students of Supply-Side University
From: Jude Wanniski
Re: The Interaction of Money and Taxes II
We began this discussion of the interaction between monetary policy and tax policy last week in in Lesson #10. If you only read that lesson once, you might go back and at least skim through it, as this is one of the most difficult of all areas of modern supply-side economics. Prior to the late 1970s, there never had been a time in the history of the world when economists of the first rank had to grapple with the combination of inflation and progressive tax rates. Professor Robert Mundell was the first, as far as I can tell, who saw the damage the combination would do to the national economy. Tax rates would rise not because of the serious deliberations of government in weighing higher tax rates or borrowings to meet spending demands, but through the automatic increases caused by the interaction of inflation and progressivity.
It now seems obvious to almost anyone in public life, including professional economists, that when workers or investors are pushed into higher marginal tax brackets by inflation there are real effects on production. There is still disagreement on the point at which higher rates cause production to suffer to where tax revenues decline. President Clinton’s 1993 tax increase, which no Republican supported, raised the highest marginal income-tax rate to almost 39% and there appeared to be no adverse effects on the economy. I’m sure it has never been explained to him that the consequences of that increase were transmitted in different ways to the national and global economies. This is because the rise in marginal tax rates caused a decline in the demand for dollar liquidity, as there would be less need for liquidity with less production at the margin.
Put another way, when tax rates rise higher than they need be, there is less production and less exchange of goods and services produced. There is then less need for "money." We use the term "liquidity" to mean all forms of government "debt" that pay no interest, the cash in our pockets and purses and the bank reserves that sit in the bank computers or ledgers and can be converted into cash. Government debt that pays interest, bills and bonds, are "illiquid," in the sense they first have to be converted to liquid money to exchange for goods or services or for other financial assets. The objective indicator is the price of gold, which had been fluctuating around $350 since 1985. When the Fed did not withdraw the surplus liquidity in the banking system by selling bonds from its portfolio, the gold price rose 10% to roughly $385.
The Clinton tax increase, in other words, was the cause of an inflation that eventually would have driven the general price level up by 10%, as it already had put upward pressure on the world oil price and other commodities. Before all other prices could “catch up” with gold, however, gold began its long decline to $255 last summer (2001), then climbing to its current $305 level. Polyconomics associated the gold DECLINE with the 1997 Tax Act, which reduced the capital gains tax to 20% from 28% and made important supply-side changes to pensions and estate taxes. That is, the positive changes in the tax law made the economy want to expand to higher levels of production and exchange. It needed more liquidity, and when the Fed did not supply it, the economy had to make do with the existing money stock, which meant each dollar became scarce to some degree relative to real things, with gold the best proxy for all real things. It took fewer of these scarce dollars to buy gold, so the dollar-gold price fell. Deflation!!
This is no criticism of President Clinton, who thought he was doing what was best for the country. It was a fault of intellectual theory that has not yet been corrected. Clinton and his Treasury Secretary Bob Rubin still may believe the 1993 tax increase is responsible for the economic expansion of recent years, but the national electorate did not reward the Democrats in 1994 for his unnecessary tax increase in 1993. For the first time in almost a half century, in fact, it took the Congress out of Democratic hands and gave it to Republicans.
The GOP wasted the 104th Congress, trying to cut back spending instead of cutting tax rates, but the 105th did cut rates, as mentioned above, in 1997. With the lower rates, there would be a higher level of economic activity and a demand for more liquidity. When the Fed did not supply the liquidity, the price of gold declined, a sign to me that a monetary deflation was about to begin, which would pull down the price of oil and then other commodities. In notes and client letters to U.S. Fed Chairman Alan Greenspan and conversations with him, I made this case in early 1997, and made it also to then-Deputy Treasury Secretary Lawrence Summers. They rejected my deflation argument, as did many fellow supply-siders who were not persuaded the dollar-gold price still was as relevant.
I had learned gradually from Mundell since our first meeting in May 1974 that a dollar rise in the price of gold was a sign of surplus “dollars,” which only could be corrected by making dollars “scarce,” as he put it, via the sale of U.S. government bonds from the Federal Reserve’s holdings. He made me understand that the market only has a limited appetite for “dollars,” which are non-interest-bearing debt of the government. Once the banks had all the dollar reserves they needed to accommodate a demand for them, they would of course prefer to hold all other dollar assets in dollar bonds, which would pay them interest. This monetary concept is as old as the hills, but modern demand-side economists largely have ignored it, because it does lead back to the need for an objective indicator by the central bank on when there is too much liquidity and when there is not enough.
When Ronald Reagan was elected in 1980, the financial markets were in a chaotic condition because the demand-side economists at the time were unable to explain why the gold price had raced up to $850 in February 1980 from only $270 when President Carter appointed Paul Volcker as Fed chairman in late spring 1979. The news accounts more or less blamed the onset of the Iran-Iraq war for the turbulence, but it only could mean to me that the Fed was rapidly adding reserves to the banking system at the time the banks were seeing a declining demand for them. The real run-up in gold occurred when, in September 1979, the Fed announced a change in its operating procedure. The Fed had been adding or subtracting liquidity to maintain the overnight interest rate, the “fed funds” rate banks use to borrow from each other to maintain required dollar reserves. Its new “target” was the “money supply” numbers favored by Professor Milton Friedman and the monetarists.
The problem was that “monetarism” required a constant “velocity” of existing money -- the number of transactions each dollar could support. Under a gold standard, the velocity of money seemed to be constant over short and long periods of time, but when the dollar/gold link was broken, velocity went haywire. I like to use a “hot potato” as a metaphor in this case. When the dollar is losing its value relative to gold, because there are more dollars than are being demanded, holders of dollars try to get rid of them faster, as if passing a hot potato from hand to hand. When the dollar is gaining value relative to gold, as in a deflation where dollars are scarce, the potato is cool and is passed from hand to hand much more slowly.
With Reagan’s election, a Treasury Secretary and fiscal team were brought in that were committed to lowering the income-tax rates which had been swollen by past inflation. He also brought in Friedman “monetarists” who would manage that policy lever. The tax cuts, though, were causing a surge in the demand for money, as evidenced by a decline in the gold price, and the monetarists were observing their money-supply numbers that seemed to be higher than their optimum formulas -- which, remember, assumed a constant velocity. It was a tug of war, and in the early going of 1981-82, the monetarists dominated, criticizing Volcker at every step for not hitting their targets.
As an observer from his office at Columbia University, Mundell watched the gold price decline from over $600 when Reagan was elected to $425 in early September 1981. He opined that the gold price had fallen enough to take most of the incipient inflation out of the system and that $425 would be a good place to stop. As it fell further, it would cause the bankruptcies of dollar debtors who had believed they would be able to pay back their loans with inflated dollars. It would be better to have dollar debtors and creditors share an equal burden to prevent serious economic damage. I wrote several articles and papers to that effect and also wrote to President Reagan, warning him of the dire economic effects of allowing gold to decline further. The President wrote back that he had circulated my letter, but that he was getting the exact opposite advice from Milton Friedman. I of course still have his letter.
This is how the Reagan administration opened in 1981 with tax cuts phased-in over three years and one of the worst recessions in U.S. history. It did not end until the gold price went below $300, pulling down the dollar-oil price to a point where oil producers could not pay their debts. I discussed the phenomenon with Volcker in early 1982 and advised he had to find a way to get the gold price up, specifically urging him to buy bonds and add to the liquidity of the banking system. The monetarists warned that if he did so, he would reignite a major inflation. In June 1982, Mexico advised its U.S. banks that it could not pay its dollar debts because the oil price had collapsed -- and it depended on oil sales for hard currency. This would have meant bankruptcies of some of our major banks and a likely Depression rivaling the 1930s. Volcker went to Treasury Secretary Donald Regan and told him he would have to buy Mexican bonds with fresh dollar liquidity, so that Mexico could pay the U.S. banks. He also told Regan he could no longer aim at the monetarist targets. I not only assured Volcker (and Polyconomics clients) that easing would cause the bond market to strengthen, not weaken as the monetarists predicted, I also bought government bonds and made enough money in a few short weeks to build a wing on my home in Convent Station, N.J., which I named “The Volcker Wing.” The recession ended and the Reagan boom began.
Having demonstrated the Mundellian process by which tax cuts and a stable dollar-gold price at an optimum level was a far superior policy framework than the monetarist formula, I believed it would be only a matter of a year or two before we would re-establish a dollar link to gold. The monetarists were indeed no longer a powerful force in policy circles, but the neo-Keynesians stepped up to argue against a price rule, on the grounds that they could do even better in the management of the economy with the flexibility of a managed currency. The closest we got to a dollar-gold link was in September 1987, when then-Treasury Secretary James Baker III proposed an international monetary reform that would link the major currencies together, with central banks using “a commodity basket, including gold” as a “reference point,” a term I gave Baker at the time.
The idea was scarcely out of his mouth -- in a speech to the annual meeting of the International Monetary Fund -- when the Crash of 1987 occurred over precisely these issues. In his book, Maestro, Bob Woodward gives total credit to Greenspan for saving the country from recession during the stock-market crash of October 1987, but does not realize that Greenspan played a major role in causing the crash. A distinguished political reporter who knows how to interview dozens of people and reconstruct a political event, Woodward seems not to realize that you cannot interview dozens of people who don’t know why the market crashed and reconstruct a solution that has Greenspan at its center. Woodward also seems totally oblivious to the interaction of fiscal and monetary policy and would gain by reading these lessons. This is a lesson of unusual importance in that the monetary deflation that began in December 1996 continued as a major depressant on the stock market until it ended in the spring of this year.