Sometimes the answer is hiding in plain sight, looming so large that you don’t see it.
That’s what happened to me yesterday when a web acquaintance posted an opinion piece by Michael Boskin claiming the Obama Administration was trying to raise income tax rates to 70%.
My first reaction was Michael Boskin? Can anyone take this guy seriously after the spectacular failure of the policies he championed as George Bush’s chief economist?
That’s when it hit me — for all my interest in the Kondratyev wave, I failed to see why the major competing economic policies of the past century failed, and especially when they failed.
I know this will take some time and further evidence to flesh it out and get the signposts, but it feels right, and I want to just put it out there and develop it over time.
Here’s the basic premise:
For decades, we’ve suffered under a false dichotomy between two competing theories of economic stimulation: Supply Side theories (the past thirty years) and before that, Keynesian stimulation. The fact is that each fails when used in the wrong circumstances, and each works when used appropriately.
How to tell which is needed? How to tell when we need to “put on the brakes” rather than “step on the gas?”
The answer might be as easy as the first day’s lecture in Econ 10 (Econ 101 for most people.)
Look at the supply/demand curve.
When the economy has so much excess capacity that producers are failing, the economy is shrinking, and prices and wages are falling, the answer is to stimulate (replace) demand with deficit spending (Keynes). When the economy has overheated inflation that is prompting people to “buy now” to avoid future price increases, yet adjusted wages are failing to keep up with inflation, the answer is supply side investment stimulation and policies that lower interest rates and other costs of doing business (Friedman/Greenspan).
Yes, it really is that simple. Increase demand when there isn’t enough to maintain the economy and grow. Increase supply when there isn’t enough production to maintain the economy and grow.
I’ve already scheduled a call with George Ure to see how we can put this into our joint writing effort. Like the physicists when they recognized the mathematics that explained the apparent contradiction between matrix and wave models for quantum mechanics, I have a sense that this can unify our longstanding debate on economic policy that has devolved into ugly partisan politics.
Let’s see whether we can develop the unified field theory of economics.
First let me digress and confess my own initial confusion during the last inflationary peak of the K-wave (late 70’s).
Specifically, it really bothered me that Volker was raising rates to stop inflation. After all, a key part of the cost for any business is the cost of operating capital, especially the short term cash that would be subject to Prime Rate loans from banks. The Prime Rate went up, literally the same day and the same amount, every time the Fed raised its target for Fed Funds. It seemed like drastic medicine that made inflation worse, not better.
By the time Prime was over 20%, the economy was going into recession and the demand-fueled inflation of the time was receding.
I think what I missed was importance of breaking the inflationary feedback loop at the time, even though it did take high unemployment and the dreaded “double dip” recession of the early 80’s.
The other thing that happened during that period was was the rise of “supply side” economics. That was anathema to Keynesians, and, incidentally, very hard on the working poor and lower middle class, because they were expected to provide the increase in productivity that fueled growth in profits, which was then followed by growth in capital investment.
Still, breaking the inflation of wages (and raw materials, and capital) is what the late-cycle K-wave inflation needed. Of course, we could look back to the early 70’s to see why wages and raw materials were on inflationary spiral in the first place (wage freeze under Nixon and rise of OPEC), but that doesn’t change the fact that the feedback loop was building on itself, which meant no amount of Keynesian stimulation could break a recession in those circumstances.
They even had to invent a new word for what was going on — stagflation. Since most families and workers (the basic operating unit of any economy) were unable to keep up with the inflation, they were experiencing a recession and a decline in standard of living.
So there it is – the blindingly simple realization – what actually changed the trajectory of the late-70’s and early-80’s malaise was lowering the cost of production, and that meant lowering the cost of capital, lowering the cost of labor, and lowering the cost of raw materials. Naturally, the politicians could only lower the cost of capital. It took the Volker/Reagan double-barreled recession to lower the cost of the other two.
But nothing in our complex modern economic system is ever that easy, or that unidirectional. The tax reform of 1986 actually went against supply side policy by substantially raising the cost of capital for commercial real estate investment. That triggered a commercial real estate washout, which was overbuilt with tax-incentive driven uneconomic buildings that a casual observer could “see through” because there were no tenants. The collateral damage (pun intended) took out hundreds of S&L’s, but we’ll have to leave the asymmetric de-regulation cause of that failure for another post.
The point, of course, is that stimulating additional supply when you already have too much supply is counterproductive (and very expensive), just as stimulating demand when you have too much demand can spiral out of control and cost a ton, too.
By the end of the Nixon/Ford era, we had already overused Keynesian demand stimulation. Once we stopped feeding the Viet Nam war machine and the limits imposed under the wage/price freeze were released, there was no hope that additional government-driven demand could create a healthy economy. Jimmy Carter came in with a tool bag that only held Keynesian hammers, but all the nails were already driven in.
It was time for the pendulum to swing the other way, and for policy to help it. Tax cuts for capital especially, and for higher income earners in general, that was the medicine that gave us the means of growing production and defeating the demand-pull inflation.
But we silly humans always fight the last war when faced with the new one, and we always try to keep doing whatever feels good. In the 80’s certain tax cuts felt good, because they stimulated new investment. Other tax measures actually cut demand by being increased, such as drastic increases in gasoline, tobacco, sales and school taxes. Ordinary consumer debt (credit cards and auto loans) lost their deductibility, which raised taxes for those who carried credit card balances, which slowed consumption. Payroll tax was nearly tripled in the 80s, but only on income beneath an arbitrary cutoff that was initially below $80,000 and gradually grew to around $100,000 today. Taken together, a huge number of taxes were raised during the 80’s, and almost all of them applied to middle class consumers. That slowed consumption and allowed supply to catch up (on a macro level) as investors and business owners got huge tax cuts.
By the 90’s, those capital and business owner tax cutting policies were already beginning to lose their “punch” but we kept the party going by making credit more widely available, and allowing lenders to “sell” the debt into securitizations while continuing to collect servicing fees. In the Clinton years, income tax rates increased but capital gains tax rates decreased. Corporate tax breaks proliferated as special tax treatments, and the prior decades’ shift of the tax burden from corporations to consumers and wage earners as a percentage of GDP continued and even accelerated its decline. In fact, from about 1990 onward, most companies found that their best “capital” investment was to pay lobbyists to get them special tax breaks, subsidies, or government contracts managing publicly built facilities. CEO’s started getting single-year paychecks that totaled nine figures, and some even became modern-day popular heroes.
Consumers “kept up” by borrowing, and financial firms went on a true binge of leverage, growing their debt twice as fast as any other sector (government, consumers and corporates). In fact, the Federal Government almost stopped borrowing by the end of the 90’s, though government borrowing as whole continued to grow by low single digits when state and local government debt was taken into account. By the end of the 90’s, the total debt in our economy was growing at the rate of about $3 for each $1 increase in GDP.
For comparison purposes, in the 1950’s through the 70’s, debt grew at about $1 for each $1 in growth of GDP, in spite of fears of too much debt offered to millions of new young families for everything from sofas to TVs to dishwashers to cars, and of course, mortgages which the FHA and VA guaranteed with only 3% or 5% down payments.
The total debt load grew even faster after the year 2000, as did the amount of stimulation given to the supply side of the supply-demand balance. By 2005, the rate of growth in all debt had reached $5 for every $1 in GDP growth. The system was rapidly approaching debt saturation, so aggregate demand could not keep growing no matter how much incentive for investment we put in place.
With tax deductible stock options, generous accelerated depreciation, lowered capital gains and dividend tax rates, massive research credits and tons of local tax abatements, getting new capital to invest became almost free. Not surprisingly, people and companies responded by trying to maximize their capital gains, dividends and borrowing, and tried to minimize the income and the wage component of their expenses. After all, wages got taxed at a minimum of 15.3%, and the cost went up from there for higher paid salaried employees, while capital gains and dividends maxed out at a 15% tax rate, and that was only paid at some time that might be pretty far into the future.
By 2005 to 2007, the party was effectively over, and no amount of supply-side stimulation could keep the pendulum from swinging deep into the deflation side of the balance. Individual middle class workers’ paychecks had already been deflating for a ten years or so by then, once you looked at what was left after paying taxes and the minimum co-payments for the rapidly rising cost of health insurance, not to mention the per-family cost of educating children (both school taxes while still at home, and then through student loans and/or massive tuition bills in college). Even families with two salaries were having trouble making ends meet.
Once their largest asset (houses) were deflating in price while their mortgage debt was staying, a broad swath of American families were trapped in the cycle of self-reinforcing debt deflation and liquidation.
Just to be clear, I’m not talking about the minority who stretched or even lied to get their houses with alt-A “liar loans” structured as Option ARMs, nor am I talking about the subprime borrowers with two year teaser rates around 7% rather than the 10% they’d be paying with full risk pricing (and which they would have to pay once the rate resets kicked in).
I’m talking about those families that did everything right — documented their income without cheating, paid 20% down payments from savings, and took out 30 year fixed rate mortgages they could afford. Those families – the ones who did everything “right.” They are trapped. Five or ten percent of them have to sell their houses every year. If they can’t pay off their mortgage, they have to default. When they default, they lose everything, and you and I as taxpayers keep the investors from losing a dime by covering the losses through Fannie Mae or Freddie Mac.
I have to look on in wonder when economists seriously suggest that the solution is to give even more incentives to investors. I nearly throw up when another “solution” is to cut demand directly by cutting off unemployment, cutting Social Security payments, or removing half the people now buying food with food stamps. How can those economists think the investors will do better (and hire people for jobs) when they are losing customers and already have too much capacity?
It’s just as ridiculous as Jimmy Carter proposing stimulus spending in the late 70’s. Right now, supply side stimulus is a waste, and maybe even counter-productive, especially if you’re talking about tax cuts for international corporations or capital gains tax cuts.
What we really need to do is understand the dynamics of various sub-markets for labor, materials, services and finished goods, and figure out where we have too much demand or too little supply, and where growth is needed. If any sectors have too little supply or too little demand, then apply the appropriate stimulus policy to that sector.
If, on the other hand, we are supplying any sector too fast (commercial real estate development in the 80’s, for example), we need to put on the “supply brakes”. In the 1986 Tax Act, we did that, by taking away the leveraged tax break passive equity partners enjoyed. For Dot Com insanity, the “brakes” would have been to require companies to state their earnings to investors using the same numbers they used to report their taxes. Instantly we would have seen as investors that the value of compensation (including stock options) was overwhelming the profits we thought we were buying when we bought the company stock. Bubble avoided (maybe).
We’ve known for a long time that we can tax consumption that we’d rather discourage. Cigarettes and alcohol come to mind. Europeans drive high performance diesel cars that get fifty miles to the gallon. Why, you might ask? Easy. Very high taxes discourage profligate use of fuel, and manufacturers respond by building high mileage vehicles that are fun to drive.
So, my national sales tax believing friends, especially those who think even more supply-side stimulation in the form of lower corporate taxes and zero capital gains is what we need, just be aware that you’re saying you want falling prices and shrinking consumption. How’s that business plan going to work out with falling sales as far as the eye can see? Are you really sure that’s what you want?
I’ll be working on an system design that turns taxation in various sectors and forms into the “brakes” and investment incentives or government spending into the “gas pedals” for a stable and growing economy. Key to the effort will be a first try at defining dynamic methods of applying them.
The good news is that I already know what the goal is:
To grow the economy just a bit faster than population growth and inflation, and to translate that growth into a long term, sustainable increase in our standard of living. Piece of cake. As a starting point, I already know two approaches that only work some of the time. We need to be realistic about when we apply them.
PS I’m not crazy enough to believe this could actually be implemented, given our politics. I just want to play “what if” in a way that might allow us to get the big things right, and stop the insanity of always using the same “solution” no matter what the problem might be.