The Business Cycle and other Q&A Jude Wanniski March 26, 1999

Q: (Barry Schneiderwind) I have read TWTWW and most of the articles on this website and I have not found any discussion of the business cycle. Is it your view that there is no such thing as the business cycle? It seems that your view would be that we should talk about the "government screw-up cycle" instead of the business cycle. Is this correct?

JW: When economists talk about a business cycle, they have in mind a natural expansion and contraction of the national economy, not a "business." In that sense, I don't believe in the conventional "business cycle." But I do believe that individual industries expand and contract along cyclical paths. When we think of a business cycle, we normally imagine a sine curve, rising and falling. The national economy need not go through much of this if it is not being terribly mismanaged by government policy. Individual industries and the entities that comprise them cannot really avoid cyclicallity, even under optimum government conditions. This is because the prices of the goods they produce rise and fall as supply and demand for the goods rise and fall. When a price rises relative to other goods and services, it will draw more capital or more labor or both, in order to capture the profits or share of market. When these factors of production are able to churn out more goods, the price will fall, and because there almost always will be more than enough competitors trying to gain from the higher price, the new supply will overwhelm demand and prices will fall. The least efficient producer of that product or service will be driven out of business, or will have to use its cushion of reserves to ride out the cycle. At the low end of the cycle, of course, no new capital or labor or both will be drawn to the industry, and as a result, in time capital and labor wear out and demand will begin to outstrip supply -- again raising prices which invite fresh capital and labor.

In a national economy with myriad industries, such as the United States, these individual cycles can be represented on a graph that will appear as a biorhythm chart -- one sine wave on top of other sine waves, all at different rising and falling positions. If there are no outside disturbances to this system, no exogenous shocks, the price of bread will be at a peak while the price of wine will be at a trough, the price of apples headed toward a peak, the price of oranges headed toward a trough. This is a perfect condition in the system, because there is not simultaneous competition for the factors of production. Winemakers at the margin will shift into baking, orange growers will be tempted to grow apples. Suppliers of capital who know nothing about making bread or wine and are indifferent to which supplies the profit, can easily run up and down the curves, adding or subtracting fresh capital. In this condition, an overall index of prices will be zero, as some prices are rising and others falling.

In a small economy, which produces only one or two commodities that t    rade with the rest of the world, the population has to be on its toes to withstand downdrafts that appear from abroad, and to resist squandering the updrafts when they appear. The communist experiments in the Soviet Union and China were the result of frustration in dealing with exogenous shocks -- wars and depressions. The experiments aimed at national self-sufficiency, with the USSR and People's Republic of China attempting to produce everything needed within their borders, and to manage the internal peaks and troughs through five-year plans aimed at eliminating the cycle. In the world economy today, the United States is benefiting from the Federal Reserve's monetary deflation, which has crippled global commodity producers and forced them to sell at low prices. U.S. commodity producers also are punished by the deflation, but the overall economy averages out at a higher level of growth because of the decline in tax rates on capital formation here. The communist experiments broke down primarily because the central planners could not figure out how to allocate capital and labor in a world of floating currencies -- and were not clever enough to peg the ruble to gold, as Karl Marx would have advised had he been alive.

Q: (Barry) Is it your view that with tax rates kept at the right point on the Laffer curve, the dollar tied to gold and no other unnecessary government wedges put between producers and consumers, we would never again see a serious recession or contraction except as perhaps part of the readjustment process after a war or natural disaster? Would we also have to prevent screw-ups by other nation's governments to avoid what has been called the business cycle? If a form of the business cycle occurred despite these efforts, what measures would you recommend to bring us out of the slump?

JW: There is no point on the Laffer Curve that is optimum from one day to the next, except for a zero rate on capital gains. When new people come to work for Polyconomics, I advise them right off that there is no rigid ideology in our proprietary model. When you look in the mirror in the morning, to shave or put on your face, always remember that the day ahead is unlike any day that has ever occurred in the history of civilization. Theoretically, at some distant point of history, the world will be organized as perfectly as it can be to prevent sudden shocks that now occur because of political and economic errors -- singly or cumulatively. Fixing the dollar to gold at the optimum price -- or close enough so that the world would be able to easily adjust -- would be the one thing that could be done that most eliminates the terrible swings in the world economic cycles of today. Our market can more or less live with a floating gold price because we have the computers and financial instruments to manage the chaos, but think of how hard it is for little countries around the world to manage their allocations of capital and labor in this chaos.

And even then, there may come a point at which gold no longer can serve as the most monetary of commodities, and be the unit of account that permits national economies to defend against monetary errors by Alan Greenspan & Co. If suddenly a new use were found for gold, which would cause it to be more valuable than as a monetary commodity, its continued use as the numeraire or reference point for the people trading bread for wine would be deflationary. And if suddenly a process was discovered that permitted gold to be easily extracted from sea water, where we know most of the gold exists, a gold numeraire would be inflationary. Some other commodity would have to be used as a substitute, as it is hard to imagine a system of money management which holds up over time without being somehow anchored to the earth.

There is of course much more to be said about the cyclicality of national economies, domestic and international industries, and business cycles involving economic and even family units. Perhaps I will be encouraged by this excellent question to collect further thoughts for a future lesson, and questions posed in the SSU Talk Shop will spur me in that direction.

Q: (Tim Keeler) What is the best way to measure the demand for liquidity in the individual member states of the European Union? The Euro gold price would be the same across the board, obviously. And the supply of liquidity would be the same. But fiscal structures are vastly different across the board at the federal levels. Would it be gold flows? Any thoughts?

JW: I do not think, even at this late date, that the euro mechanisms have been designed. I asked Professor Mundell about this issue, and he said the problem surely was being addressed, but he did not know what the policy would be. If there were a consolidated debt throughout Europe, as there is in the United States, there would be no problem. There are eleven different national debts that together comprise the Eurodebt. In the United States, there are 12 different Federal Reserve districts, each with its own liquidity demands. Dollars circulate freely throughout the U.S., but they got their initial footing because of a demand for non-interest-bearing debt in one of the 12 districts. In the current euro system, Italy cannot issue lire unless there is a demand for lire, otherwise the surplus lire will be collected and sent back to Rome for interest-bearing bonds. It is futile to try to beat the system once you are locked into it. Mundell assumes the architects of the euro are figuring all this out, but he can not say for sure that they are. His expectation is that the Eurobank in Frankfurt will issue regular orders to the 11 separate central banks, informing them about the amount of liquidity they can create by exchanging currency and bank reserves for interest-bearing debt. But he is not sure, nor am I. It strikes me as a very complex exercise. It could become even more difficult when the transition to the euro is complete in a couple of years. At that point, all 11 national currencies will be replaced by the euro even as a transactions media, but each of the 11 will still have its own national debt.

If there are two countries, yours and mine, and yours has a $1 trillion debt, and mine has a $1 billion debt -- which is one-thousand times less than yours, how do we decide on a common currency that involves monetizing national debt? Mundell assumes there will be a process of pro-rating, and I imagine they are smart enough to be able to do this, and agree upon it politically. In the same way, there are seignorage gains for the euro market by its ability to issue euros, which pay no interest, and that the 11 members will watch like hawks to make sure they each get every last penny of the seignorage. Alas, nobody writes about these issues, because there are no politicians or journalists in Europe who understand the importance of "money" as a unit of account, and of gold as a numeraire. NOBODY? Well, remember there are probably not more than a dozen men and women in Europe who are making these mechanical policy decisions. They actually may launch the euro as a circulating medium without telling the world what their operating procedures will be. Hey, this information is too important for the public to know about. We must operate in total secrecy and be totally independent of all democratic forces.

Q: (Henry Meers) My question is: What are the flaws and virtues of a sales tax? Surely, a sales tax discourages consumption, and encourages us to adopt austere lifestyles...1977 Caprices, for example. Or maybe mules? On the other hand, a LOW marginal rate on income gives one money to be spent freely, at one's discretion. The key to me is having a low marginal rate. Basing taxes on income, to me, is not a bad idea. (The alternatives are taxing real estate, personal wealth, consumption...who knows?) The real questions are two: What tax system promotes growth? And, what tax system promotes freedom? The final question invites another: What claim does government have on our property?

JW: A sales tax discourages consumption only when it seems higher than the options available. A 6% sales tax seems reasonable, except in states where there is a zero sales tax. I don't think that fairly low sales taxes discourage consumption, as most people understand they are contributing to their own government's financial health by paying the tax. When a citizen can calculate a tax savings by crossing a state line to make a purchase, if the extra time involved does not wipe out the saving, the trip will be made by those for whom time is money. The carriage trade will rarely inquire about the sales tax, except when the purchase involves a yacht or a sable or a diamond bracelet. Then, a phone call across the border for a mail order will respond to a high sales tax. Basing taxes on income is not a bad idea, as Henry Meers suggests. As long as the government is attentive to the Laffer Curve and its law of diminishing returns, the income tax is an extremely efficient way of financing public expenses desired by the national electorate, left or right.

As to the last question Henry poses: What claim does government have on our property? In theory, the government can expropriate all of our property through taxation, if our representatives choose to raise taxes to confiscatory levels. Because we control our representatives through the democratic process of voting them in or out, they can not get away with confiscatory policies for very long.