Holding down the tax chair at NCPA is somewhat different from what I'm used to.  During my 36 years at the Fed, and especially my 14 years as a policymaker on the FOMC, I thought of taxes primarily as half of fiscal policy, which has more to do with how tax receipts stack up against government spending than with the efficiency of the tax regime. During most of my tenure, government spending exceeded tax receipts and produced a deficit.  The perennial question was what the deficit would do to the economy. Would it spark inflation? Would it pull us out of recession?  Did it really matter?

My early training and subsequent reading led me to conclude that the economic impact of a federal budget deficit depends mostly on how it is financed–with existing money, new money, or new money plus new bank reserves, which means further monetary expansion. In other words, the impact of fiscal policy depends primarily on how it is financed, and on monetary policy. The other relevant factor is the state of the economy–how close we are to full employment of labor and other productive resources, or how much slack we have.  The financing and the condition of the economy determine the impact of a deficit, which really means that monetary policy is more important than fiscal policy.

In general, I shared the profession's preference for a balanced budget over time, with helpful deficits during economic weakness matched by helpful surpluses during more exuberant times.  This ideal almost never happened, of course, so a lower bar led us to measure the deficit as a percentage of total GDP and forgive those that didn't break through historical benchmarks.

When I came to the Dallas Fed in early 1991 and was briefed by its excellent economists, I asked our public finance specialist whether there was a good rule of thumb for good tax policy.  I don't remember her exact words, but the answer was that taxes should have broad coverage and low rates. They should distort economic activity as little as possible.  Balanced budgets over time and cycles were preferable to chronic deficits. The main evil of deficits was that they represented negative saving, which had to be offset elsewhere to finance adequate investment.

While I considered deficits to be important, I was persuaded by Milton Friedman's argument that the magnitude of government spending relative to the size of the economy was more important than how it was financed, whether by taxes or debt. In other words, the size of government was more important to economic performance, and especially to individual liberty, than the size or percentage of the deficit. I also accepted the Friedman proposition that deficits were not necessarily a bad thing if they caused the politicians to curb spending.  The problem with higher tax revenues to balance the budget was that, in practice, they would just be spent to make government bigger. They would just feed the alligator.

Some, but not much, attention was paid to whether the existing tax system was a good system and whether it should be scrapped in favor of something radically new and different.  The most common reform proposals, which sounded good to me, were versions of the flat income tax.  I recall Dick Armey coming to the bank to explain his flat tax proposal and emphasizing that taxes could be reported on a post card.  I remember thinking that it sounded like a good idea, but in the back of my mind I couldn't help thinking about the old line that, if something sounded too good to be true, it probably was.  I must now reevaluate that thought in view of the successful adoption of flat-tax systems by several eastern European governments. Who would have thunk it?

The most radical tax reform proposal during my time was conceived by two friends of mine-the national sales or national consumption tax, more recently called the Fair Tax.  In many respects, it made the most sense of all the reform proposals, but it was so radically different that I had a hard time imagining it as a practical alternative to the flat income tax. I participated in a discussion of the national sales tax with Milton Friedman, who pronounced it a good idea-the ideal solution, perhaps-but he too worried about its practicality.

That was several years ago, and I've been surprised by the growing national support for the Fair Tax.  It's still a long- shot reform, but not as long a shot as it once seemed.  In thinking about that, it occurred to me that Friedman's qualification was not very Friedman-like. He was a well-known advocate of economists limiting themselves to "positive" economics and leaving the normative aspects to practitioners, i.e., politicians. Economists should not concern themselves with practicality or the political appeal of sound economic proposals. They should give the politicians their best possible proposals and let them worry about implementation.

So, here's where I am now.  Both the flat tax and the fair tax are big improvements over the current mess. The fair tax is probably superior to the flat tax if it could be implemented. Fortunately, the world is not holding its breath waiting for me to decide.  But if you are interested in the topic, as you should be, I recommend that you learn more about the fair tax and decide for yourself.  Start with their excellent web site, http://www.fairtax.org/. I recommend it to you and ask that you not–as they use to say in my church–"harden your hearts" against it.  Please, give the fair tax a fair chance!

The main fallacy in monetary theory and policy is the confusion of money and wealth. Money is wealth from the individual perspective since individuals can usually exchange it for goods and services. Money — and financial assets easily converted to money — may not be wealth for society as a whole if the production of goods and services has not kept pace with claims on it. Early spenders may have some success, but inflation will dilute the buying power of others. The bottom line is that real wealth has to be produced; it can't be printed.

Don't call me a Keynesian, but Keynes's Paradox of Thrift is another example of the fallacy of composition — what's true for the individual may not be true for the group. Most U.S. families should be saving more. Indeed, the personal saving rate — the percentage of disposable income not spent on consumption — hovers around zero, with frequent dips into negative territory. This is made possible, for a while, by selling assets, accumulating debt, or spending capital gains in the housing and stock markets. Money obtained by realizing capital gains spends as well as money earned on the job. But not if too many of us try it at once.

The Paradox of Thrift says that attempts to save more in the aggregate reduce consumption spending, which, if not offset by increases in other spending, will reduce total spending and income. The paradox comes in when attempts to save more results in reduced saving out of lower incomes. The irony is that policy makers advise more saving but those who take the advice will benefit only if most of us ignore it, and policy makers are implicitly counting on that outcome.

A parallel is the farmer who hopes for a good crop year. But, if all or most farmers have a good crop year, the decline in prices may more than offset higher yields. What our farmer really needs is a good crop in a bad crop year. Then he could look for a popular restaurant that isn't crowded.

I realize this is not very sophisticated stuff, but it's on my mind because of the many talking heads I hear dismissing the adverse consequences of our low personal saving rate by saying it ignores capital gains as a source of spending. "Properly measured," they say, saving is not a problem.

Again, that may be true for the few, but not for the many. A penny saved may be a penny earned, but it matters whether it was earned by producing more or by a rise in the price of existing financial assets. A stock or housing market boom creates apparent wealth in the form of capital gains, but trying to convert it to real wealth en masse can make it disappear.

Economists say the main reason they worry about the budget deficit or the current account deficit is their impact on domestic saving. But my guess is that only other economists really get their meaning. Most people may be even further misled by the implication they hear that since the main harm of deficits is their impact on saving, they must not be too harmful after all. The old-fashioned notion that deficits are bad because they create debt that must be paid back with interest is probably a better prod to constructive behavior. Or that deficits impose a burden on our children or grandchildren.

Alan Greenspan has been one of the few economists to explain these matters correctly and — I can't believe I'm saying this — understandably, usually in the context of Social Security or other entitlement reforms. Whenever confronted by various financial fixes during congressional testimony, he frequently pointed out that any solution to the problem had to include real economic growth. With claims on output growing rapidly, output has to grow equally rapidly, or the claims are bogus. Any solution to our entitlement problems must include a bigger, more productive economy in the future. It's really as simple as not selling more tickets to the Super Bowl than there are — or will be — seats in the stadium. Of course, the political preoccupation with distribution rather than production puts unnecessary limits on the size of the economy on Super Bowl day.

The problem goes beyond government entitlement programs. Consider the baby boomers whose IRAs, 401(k)s and personal investments helped drive the stock market to record highs. What happens when cash-in time comes? There will be a mountain of paper claims on output, but will there be an equally tall mountain of output?

The great French economist, Frederic Bastiat, said that "The state is the great fictitious entity by which everyone seeks to live at the expense of everyone else." It's time to get real about producing real wealth, not just financial claims on wealth.

*Appeared in the Wall Street Journal on July 17^th.

The beat goes on in the job market (see the previous posting).  The June payroll report showed an increase of 132,000 jobs with upward revisions to April and May totaling 75,000.  The household survey, as usual, was better still, showing a June increase of 197,000 jobs, sufficient to keep the unemployment rate flat at a low 4.5 percent.  Earnings and the work week both increased, with earnings in June up 3.9 percent over the past year.

So, with the job market doing so well over an extended period of time, why all the worker angst and insecurity we keep hearing about?  Why the gloom?

Part of the answer is that the monthly employment numbers are small net numbers that mask gross job losses and job gains many times larger.  Job losses at shrinking or closing firms make the headlines even if job gains elsewhere in the economy are rising even faster. Most workers have friends or relatives that have lost jobs in this supposedly "good" economy.  Many jobs are always lost in a good economy, which causes anxiety even when more new jobs are being created.  Economists and pundits follow the net change in the numbers; the rest of us live in a gross world.  

In the 3^rd quarter of 2006-the latest numbers available-only 19,000 net new private jobs were created nationally.  But that small number was the net of 7, 364,000 jobs created and 7, 345,000 jobs lost. The previous quarter was better:  7,761,000 jobs were created and 7,295,000 were lost, for a net private job gain of 466,000. The quarter before that was better still:  job gains of 7,556, 000, losses of 6,772, 000, yielding 784,000 net new jobs.  In this best quarter of the three, almost ten jobs were lost (and gained) for each net job gained.  Nobody knows who the 784,000 are, but we all know some of the 6,772,000 job losers.  Nobody pays much attention to the 7,556,000 new job holders since they aren't complaining. Of course, over time these tend to be the same people, plus new entrants into the labor force.

My hunch is that this rapid job churn accounts for much of the job angst despite the fact that the constant turnover in jobs keeps our economy responsive to change and up to date. Joseph Schumpeter called this churning phenomenon, creative destruction.  Allowing creative destruction to take place-that is, allowing the old jobs to go away to free up workers for the new jobs-is better job protection in the long run than trying to keep the old jobs from going away.  This is reflected in the lower unemployment rate in the United States than in Old Europe, where nanny states try harder to "protect" their workers.  It turns out that a dynamic economy is better protection than legal and regulatory restrictions.  As I put it in a poem once,

          "Laws against firing
           Discourage hiring  
           And too high a safety net 
           Is sure to snare and abet 
           Those dead set 
           On avoiding sweat"  
                      (See www.bobmcteer.com/rhyme/growth.html)           

The employment dynamic numbers cited above contain other interesting information. (See www.bls.gov/bdm/home.htm.) For example, of the gross job gains of 7,364,000 in the third quarter of 2006, 1,537,000, or almost 21 percent, were goods-producing jobs while 5,827,000, or 89 percent, were service jobs. This is roughly the same proportion as in the job losses, although, over time, there have obviously been more job gains in services than goods.

Another interesting breakdown of the numbers is between gains and losses resulting from expanding and contracting firms and from new firms and disappearing firms.  81 percent of the gains come from expanding firms while 19 percent come from new establishments  The same round numbers apply to job losses-81 percent from shrinking firms and 19 percent from closing firms.

Pareto rides again.  

Three months after "Be Still My Heart," employment growth continues robust for an economy so close to full employment, especially considering the weakness in the housing sector. Payroll employment rose 132,000 in June and, as is usual lately, earlier monthly gains were revised upward.  April employment growth was revised up from 80,000 to 122,000, and May was revised up from 157,000 to 190,000, a combined upward revision of 75,000 jobs. 

As measured by the separate household survey, employment increased by an even larger 197,000 jobs in June, which was sufficient to keep the unemployment rate flat at a low 4.5 percent.  The unemployment rate has been at 4.5 percent for several months.

Earnings increased 0.3 percent in June and 3.9 percent for the year ending in June. The average workweek increased 0.1 hours to 33.9 hours.  All in all, an excellent jobs report.

So, how did financial markets react to the good news?  Initially, they responded negatively by pushing bond yields up and equity prices down. They continue to show a preference for good medicine (from the Fed) over good health.  Go figure.