Many mistakes were made during the Great Depression of the 1930s, and we seem determined to repeat all of them. They include starting a trade war with Smoot-Hawley, raising marginal tax rates in the middle of the depression, tightening monetary policy through misinterpretation of the meaning of excess bank reserves, and, of interest here, the demonizing of bankers and businessmen for political advantage.

The proposed new tax can only be understood as pandering to uninformed or misinformed populism  after their pound of flesh from “the bankers.” Support of the banking system through the TARP program has been successful, and it is proving to be profitable from the Treasury/taxpayer point of view. The Treasury is earning about 18 percent on the preferred stock and warrants of the big commercial and investment banks that have repaid.

It appears evident to me that the TARP funds going to banks will show a net profit. This rush to impose a new tax to cover expected “losses” suggests they are trying to get it in before an overall profit becomes evident. They seem to be projecting losses to justify a new tax.

Loans to AIG and the car companies are frequently cited as likely losses, but that is far from certain. Remember, the government owns almost 80 percent of the stock of AIG, which still has many assets and, given time, may well return to profitability. Ed Whittaker, the acting CEO of General Motors, has vowed to repay TARP funds sooner rather than later. (Why would the administration project GM as a loss in the face of that commitment?) I don’t know about Chrysler, but, if they are able to do so, the pressure will be on them to follow GM’s lead.

The government’s obligation to back up Fannie and Freddie predates TARP, and, don’t forget, the government now owns them and will be in a position to sell them later. In any case, their losses were in large part created by following government (Congressional) mandates to support the expansion of home ownership beyond prudence.

Bank bashing in order to tap into the mob-rule psychology of the current populism undermines the ability of the administration’s tax policies to be taken seriously by serious people.

One area of absolute and comparative disadvantage for me is health-care economics. That’s okay because the National Center for Policy Analysis for whom I work has several experts on health care economics. John Goodman, the founder and president, for example, is considered by many to be the father of Health Savings Accounts. He and Jeanette Goodman recently conducted an online petition drive against a government takeover of health care that collected a record 1.3 million signatures. My only contribution to that was to sign the petition. 

I do know enough about the health-care debate in Washington to be strongly opposed to the proposed reforms, but, because of the comparative advantage of my colleagues in that area, I haven’t immersed myself in it. Instead two or three simple facts tell me all I need to know.

If the reformers were really serious about reducing the cost and increasing the availability of health care, they wouldn’t pass up the low hanging fruit. An obvious place to start–both in terms of impact and low cost–is medical lawsuit reform. Win-the-lottery lawsuits raise the cost of necessary malpractice insurance for doctors and cause doctors to practice defensive medicine that also raises cost dramatically. If the reformers won’t go there, it means they have higher priorities than better, cheaper health care. They are clearly placing the financial interests of plaintiff lawyers above the health-care goals they claim to pursue. No doubt they will be substantially rewarded in campaign dollars.

Another example passing up low-hanging fruit is the failure to do anything to increase the number of doctors or to remove obstacles such as the caps they have placed on the number of medical residencies for medical students. We are expected to believe that we can add tremendously to the demand for medical services while limiting the supply and have costs fall. They don’t have a high opinion of our intelligence, do they?

Here at the end of 2009 we are reading about dying patients and the families of patients on life support trying to hang on a few more days or hours to 2010 when the death tax declines to zero. They shouldn’t hang on too long, however, because in 2011 the death-tax rate goes back up and the exempt amount goes back down.

Let’s see now, Congress lowered the death-tax burden for a few years, eliminated it for one year, and are raising it back to its original high level the following year. With decisions like that, how can they expect us to take them seriously? At least they are sparing me the trouble of digging deeper into the details. Don’t forget that the death tax taxes wealth that came from income that was already taxed, probably more than once.

On a slightly different topic, on Christmas Day, all that kept an airliner with over 300 passengers from being blown up over Detroit was a malfunctioning bomb fuse or detonator.  It was pure dumb luck. Yet, the head of homeland security says our security procedures had worked. Then the TSA announces new security measures that have nothing to do with the nature of the new threat. They would be laughable if they weren’t so inconvenient.

My personal favorite is a new requirement to remain seated for an hour prior to landing on international flights. I don’t know about you, but nothing makes me want to go to the bathroom more than being told I can’t go. For some time after 9/11, they enforced a 30 minute sit-down rule on flights into Washington D.C. I found that that was about my limit, and I’m about eight years older now. I think most people are.

A depression does seem paradoxical. People can’t spend because they don’t have the income. They don’t have the income because they aren’t spending. Around and around it goes with the gears not engaging. Looking ahead, there is no supply because there is no demand and no demand because there is no supply.

Which is it? Does supply create its own demand? Or, does demand create its own supply? Apparently, we must choose the one, and only one, correct answer. Who was right: Say (supply creates its own demand) or Keynes (demand creates its own supply)? Are you a Methodist, or a Baptist? We are discussing religion, you know.

On the first day of my Money and Banking class, circa 1961 or 1962, Professor Waller asked us if we knew the way to Kennedy’s New Frontier? We didn’t. He said, well you go to Harvard and turn left. Harvard was left; Chicago was right. Harvard, you see, was under the influence of the Great Satan, John Maynard Keynes. (Jean Baptiste Say was an early Classical economist who was influenced by Adam Smith and who, in turn, was a great influence on Frederick Bastiat, among others.)

Although I never quite learned why, I did learn early on that Keynesianism was a corrupting influence to be avoided, or, better yet, refuted. That wasn’t all that easy since the national income accounts had adopted Keynes’s spending categories and the elementary economics textbooks–by the late Paul Samuelson and his imitators–had laid out “the Keynesian System” with simple graphs and formulas that were easy to remember and easy to teach. Who can forget that the multiplier is the reciprocal of the marginal propensity to save?

Relevant to today, much attention was paid to showing that Classical economics had a logical answer to the Keynesian “Liquidity Trap,” a condition whereby the demand to hold cash balances becomes perfectly elastic (horizontal) so that increases in the money supply no longer reduce interest rates. Such a condition seemed highly unlikely at the time, and the search for a non-Keynesian way out struck me as the proverbial search for the number of angels that could dance on a pin. The root-canal solution at the time was that deflation would raise the value of cash balances to the point that spending would resume. A kinder-gentler reaction would be not to wait for deflation to prime the spending pump, but to increase the money supply anyway (called quantitive easing nowadays) until the marginal value or utility of additional money units held fell below the marginal utility of what could be bought with extra money and spending resumed.

If more money is only hoarded and does not lead to more spending, the solution is still more money until spending finally resumes. The metaphor in the modern era became dropping money from helicopters, which Chairman Bernanke caught so much flack for using mostly from people who had no idea he was using a well-known (among economists) metaphor. The root-canal version, which waits for deflation to become self-correcting after a while was dubbed the Pigou effect or Pigou-Patinkin effect.

I wondered why there was such satisfaction at finding (or creating) this escape from the Keynesian liquidity trap when the Keynesian prescription of fiscal stimulus financed with newly created money was so much less painful and could actually be used in the real world. I suppose the answer was, and still is among some, that the Keynesian solution involved government action. Any solution that involves government action is to be avoided at all costs. Keynes. I agree with the “avoiding” part; just not the “at all costs” part.

To me it seemed obvious that while Keynes’ General Theory may not be a guide for all times, it was a practical blueprint for fighting recessions caused by a lack of sufficient “aggregate demand.” In normal times, the supply side is the constraint and deserves our attention; in depressed times, insufficient demand must be remedied first. The gears have to be engaged for the supply side to work.

I don’t get why we can’t be supply-siders in normal times and yet accept that Keynes is relevant for depressions and   deep recessions. Both supply and demand are important. Why must each side ridicule the other? Why must it be a religious issue?

I have much sympathy with the supply-siders who prefer private sector solutions to our problems. I are one, as they say. However, denying the relevance of demand–the relevance of Keynes during a deep recession–erodes our credibility unnecessarily. Why fear Keynes? He’s into his long run and can’t bite us. Why leave it to others to state the obvious?

I don’t know how many readers may have misunderstood what I meant by the whole load, but I know of one, which is one too many. It came from the following story, which I heard many years ago. I don’t know the origin of the story.  

 A young preacher arrived at a small country church to preach his very first sermon. Unfortunately, a heavy snow storm had limited his congregation to only one wise-looking old farmer.

The young preacher asked the farmer what he should do.  

The farmer said, “Well, I don’t know much about preaching, but I do know about farming. If I went out to the pasture with a load of hay to feed my cattle and only one cow showed up, I would certainly feed that cow.”

The young preacher said “Great. Sit down and I’ll preach you a sermon.”                        

The farmer sat down and the young preacher preached a fire and brimstone sermon that lasted 45 long minutes. When the preacher finally wound down, he asked the farmer what he thought about his first sermon.

The farmer thought for a moment and said, “Well, as I said, I don’t know about preaching, but I do know about farming. Like I told you, if I went out to the pasture with a load of hay to feed my cattle and only one cow showed up, I’d feed it. But I sure wouldn’t give it the whole load.”

Our national saving—made up of personal, business and government saving—is being supplemented by the foreign capital inflow that finances our current account deficit and helps support domestic investment. The floating dollar adjusts to help maintain the necessary relationships.

China has absorbed fewer dollars lately because our trade deficit has shrunk as reduced domestic demand has reduced our demand for imports more than reduced foreign demand has reduced the demand for our exports. China’s dollar holdings are influenced by everything that affects our trade deficit and capital inflow, including our budget deficit, along with personal and business saving.  Those holdings aren’t independent of these complex relationships.

If any category of our national saving increased, other things equal, our current account deficit would tend to shrink. An appreciating dollar would likely be part of that adjustment process. So, more personal saving, more business saving, or more government saving (a smaller deficit) would all tend to strengthen the dollar. Conversely, a reduction in those categories by our trading partners would have a similar effect.

One caution: if the government increases its deficit to increase transfer payments, which get saved by the recipients, there is no increase in national saving. The greater government dissaving offsets the greater personal saving.

Everyone would be happier campers if we saved more domestically and China and other trading partners would consume more and save less domestically. This would indirectly reduce the trade imbalances and the comparable capital flows and ease the downward pressure on the dollar.

Of course, government saving is tax revenue minus government expenditure; so more government saving could occur either through less spending or more tax revenue. Note that I said tax revenue, not tax rates.

Under those circumstances the dollar would be strengthened by the fundamentals. Attempts to support the dollar without the underlying support of the fundamentals would be like moving the dial on a thermometer without changing the temperature.

 Next day below that:  “Who are you to tell me what to do?” 

The Tobin Tax came up on financial TV the other day. It brought back memories.

I gave the keynote address at a conference in Dax, France  in 2001, celebrating the 200th anniversary of the birth of Frederic Bastiat, most easily described as the French Adam Smith. The conference was by Le Cercle Frederic Bastiat and was sponsored by the International Society for Individual Liberty and Libertarian International. I titled my remarks, Why Bastiat is My Hero.

(According to the notes I wrote on my text, I was asked to stay within 40 minutes or the moderator would “agitate a cow bell from the Perinese.”)

During the afternoons we took field trips to places associated with Bastiat, including the dedication of his bust in a local village square, a visit to his country home, and a visit to his birthplace.

At the bust dedication, we encountered hostile demonstrators who had covered the bust with a drape. They chanted slogans and helped themselves to the outdoor buffet that the locals had prepared for our group. Small groups formed and engaged in debate, and the violence that seemed inevitable was avoided.

The demonstrators showed up again the next day for another tense encounter. They had covered the plaque signifying Bastiat’s birthplace on a narrow street–more like an alley. Given the close confines, I was sure violence would break out, especially when a female member of our group climbed up to remove the cover from the plaque. It occurred to me that I had missed the sixties, so now was my time. Also, I wasn’t sure how I would find my wife during the melee as she was shopping in one of the little shops facing the alley, oblivious to the violent clash of ideologies about to occur.

What was this ideological clash all about? Well, we were individuals from several countries, but mainly Americans, many of whom considered ourselves libertarians, paying homage to a French lover of liberty born 200 years earlier. They appeared to be French socialists whose primary cause was some version of the Tobin Tax. They wanted to tax financial transactions (stock, bonds, foreign exchange?) and give the proceeds to the poor.

The alpha male in the group was dressed in all-black — pants, shirt, coat and hat — and appeared to be a professional actor. He led the chants with great volume and gusto. The main epithet he and his mob used on us was “gangsters.” They were calling us gangsters. We thought of ourselves lovers of liberty, but they were calling us gangsters. I couldn’t figure it out.

There are several versions of the “Tobin Tax,” named after James Tobin, Nobel-prize winning economics professor at Yale University. We never know who our fans will turn out to be.

I later learned that the protesting group called themselves ATTAC, and the tax they had in mind was a one percent tax on international currency transactions. They considered their “Tobin Tax” to be a tax on globalization as well as a source of tax revenue for the poor. I understand they had some subsequent success in French politics.

I just learned of the death of our beloved Rose Friedman.

This picture of me with Rose and Milton Friedman was taken at a Dallas Fed conference celebrating the twenty-fifth anniversary of their Free To Choose. Both of them graciously flew to Dallas and participated fully.

A few years earlier I had the honor of visiting the Friedman's in their San Francisco home. I had taken my two Dallas Fed board members who were the founders of the Fair Tax movement-then just called a national consumption tax-to discuss their proposal with the Friedman's, who were generally supportive.

Except for the spectacular view of the San Francisco Bay, their high rise home was predictably modest. Even the Nobel Prize hanging on the wall seemed unpretentious. Rose participated fully in the conversation, but also found time to serve milk and cookies.

Years later, at the Dallas Fed conference, I reminded Rose of that visit and asked her if the cookies were homemade. She said, "If I served them, I made them."

We will miss you too Rose.

I think we should look for an alternative explanation.

We've heard much chatter about Treasury Secretary, Tim Geithner, and Economic Advisor, Larry Summers, both making similar gaffes last week-end, cracking the door open for a "middle-class tax increase." I'd say the probability is low, let's say one in a hundred, that the Former Treasury Secretary and former Harvard President, would make such a gaffe in view of the boss's repeated statements to the contrary. I think the probability is equally low that the current Treasury Secretary and former President of the New York Fed would make such a gaffe. If so, the probability of both doing so is 1 in 10,000-1/100 x 1/100.

Come on folks. I'm supposed to be the naïve one around here. Alternative explanations are in order. What about those boys were testing the water for their boss?

Bob McTeer
Stating the Obvious

Tax policy is perhaps the most important issue in the coming Presidential election: whether to keep the Bush tax cuts, let them expire, or modify them.  If no action is taken, the tax rates on capital gains and dividends will rise automatically at the end of 2008 while the others will go up at the end of 2010.  Mr. McCain and most Republicans wish to keep the lower rates, and perhaps lower some others.  Mr. Obama and most Democrats apparently wish to allow the reduced rates to expire, especially those on higher income levels.

When the latest tax cuts were enacted in 2003, their sponsors never intended them to be temporary.  A sunset provision was needed to keep the scoring within certain legal limits, but everyone understood that the intention was to renew them.  To allow the cuts to expire is a tax increase, and its merits should be judged on that basis.

Although not often mentioned, the Laffer Curve, which shows the relationship between tax rates and tax revenue, is central to the tax debate.  Republican "supply siders" are the chief advocates of keeping the low rates where they are and possibly lowering other taxes as well.  Supply siders generally believe the Laffer Curve proposition that lower tax rates generate higher tax revenue; so to raise tax rates, or let them rise automatically, would not only hurt taxpayers, but would also, by depressing the economy, actually reduce the tax revenue raised by the government.  This would be especially true of the tax on capital gains and dividends where tax payers have some control over their realization.

The other side of the tax debate believes that the supply-side position is nonsense in general and that its intellectual core, the Laffer Curve, in particular, is a proven failure.  George Bush, the father, once famously labeled the supply side position, "Voodoo Economics."

There appears to be no middle ground in this debate because each side is engaged in "all or nothing thinking."  Laffer Curve predictions either work as advertised, or they don't.  Higher tax rates either lower tax revenue or raise tax revenue.  Each side thinks the other side just doesn't get it.

This great divide might not be so great if more people actually had a look at a Laffer curve such as the one below.  Although it's not clear how steep the slope of the curve should be, it is still rather obvious that whether tax collections rise or fall depends on where we are on the curve.  The higher the existing tax rate, the less revenue is likely to be generated by even higher rates.  At some point, the peak, higher rates will start producing lower revenue.

In a world of all or nothing thinking, it is unfortunate that the Laffer Curve was originally over-hyped.  It was advertised as allowing tax rate cuts to "pay for themselves."  That didn't happen completely, to a large extent because of higher government spending, especially on the military, so the budget deficit grew.  As a result, the critics declared the Laffer Curve a failure.

In a more rational world, the fact that it happened largely, if not completely, would be classified as a success, or, at least, a partial success.  All or nothing standards rarely produce successes of any sort.

Instead of arguing whether tax cuts work (pay for themselves) or not, the question should be to what degree they pay for themselves. How much disincentive is there in the present tax structure, and how can it be reduced?  Surely, even the tax increasers don't have maximum tax revenue as their goal.

All-or-nothing thinking is responsible for other needless irrationalities in the tax debate.  For example, one side says "the rich" are the main beneficiaries of the Bush tax cuts without acknowledging that those same rich still pay most of the taxes collected.  And they never acknowledge that many on the lower end of the income scale pay no income tax at all and that number was increased by the Bush tax cuts.  The Orwellian language used in these debates rose to a new level when the government giveaways in the recent stimulus were called "rebates."  Rebates of what?

Taxes are only one area where all or nothing thinking makes debate and rational policymaking more difficult:

In energy policy, it's said there is no policy because prices have risen, or because we are importing more oil, or because oil companies make too much profit or their executives are paid too much.  There is either the preferred outcome in all respects, or there is no policy.

All or nothing thinking bedevils monetary policy as well.  In the recent credit crunch, at first the Fed just didn't get it.  It should be reducing rates for heavens' sake.  Then, when rates were reduced, the Fed was pushing on a string, and ineffective.  When inflation rose, predictably, why did the Fed let that happen?  They pushed rates too low; now look what's happened to the dollar as a result.  Nowhere in the dialog can you find discussion of trade-offs, balancing objectives, or substantial successes.  Monetary policy either works, or it doesn't.  Apparently it doesn't.  Neither, in the view of the all-or-nothing crowd, does anything else.

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!