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By George P. Brockway, originally published December 2, 1991

1991-12-2  Taxing Our Credulity Title

EVERYONE seems to agree on two things. First, the economy is in a mess and something should be done about it. Second, neither the President nor congress did anything this year (beyond a belated extension of unemployment benefits), and nobody will want to do anything fundamental next year because of the election. If the second thing is correct, the first is moot: At least from now to 1993 we will have to test how we run on an automatic pilot that does not seem a whole lot more competent than the one in Airplane.

In the meantime, you and I can work off our frustrations by talking about them. We might as well start by talking about taxes, which can always generate heat on a wintry day. Several tax proposals are floating around Washington. All of them provide for reductions of one sort or another, most of them claim that they “target” the middle class, and some of them pretend to improve our productivity and beef up our international competitiveness.

The longest-running of the tax-cut schemes is Housing and Urban Development Secretary Jack F. Kemp‘s undismayed conviction that the way to balance the budget is to cut taxes à outrance. Kemp got us to go along with him on this scheme 10 years ago, when he was a New York Republican Congressman. He promised that savings and investment and tax collections would all increase, and we (present company excepted) believed him. None of his promises was fulfilled; instead we got an instant recession, followed by still burgeoning deficits. There is no reason to expect that what contributed to a recession yesterday will end a recession today.

The next longest-running notion is the President’s steadfast passion for a capital gains tax cut. The Education President told the children about it the other day when he visited a grade-school class. No one gave him an argument, but the best that can be said for the idea is that it might result in a modest one-time increase in tax collections as speculators rush to cash in old gains they’ve been sitting on.

Until 1987, when capital gains became taxed as ordinary income, executives with an eye to the main chance devoted endless time and ingenuity to schemes allowing them to take their compensation as capital gains. The use of stock options, a fairly routine dodge, could have gaudy results. One Donald A. Pels (whom you never heard of), CEO of LIN Broadcasting (which you never heard of), cashed his options in 1990 for $186,200,000 (which looks like a thousand times the speed of light). After paying taxes he had only $134,064,000 (plus a few millions in regular salary) left to show for 10 years’ work. If Bush had been able to get his tax cut through, Pels would have had $158,270,000 left, and his incentive wouldn’t have been so sapped.

Returning to a more mundane level, we find several Senators, Texas Democrats Lloyd Bentsen and Phil Gramm among them, eager to stir up lRAs again. You probably remember the commercials of a few years ago that had sports stars and movie actors earnestly urging us to join them in planning for a wealthy old age.

The beauty of it was that our self-serving endeavors would have the incidental effect of increasing the national saving rate and consequently the national investing rate. What happened, of course, is that those who participated merely switched their savings from one account to another. I can’t think why it would prove any different the second time around.

Finally, there are at least two proposals for reforming the income tax, both advanced by Democrats. A group led by Senator Albert Gore of Tennessee and Representative Thomas J. Downey of New York is pushing a plan they call (in pointed contrast to the President’s) the Working Family Tax Relief Act. This would reduce the taxes of 95 per cent of all families with children. Cuts would range from roughly $875 at the bottom of the income scale to $185 at the top; singles and families without children would continue to pay the present rates. The reductions would be paid for by increasing the taxes of the richest 1 per cent of taxpayers (whose average income is $676,000) by an average of $21,600, and of the next 4 per cent (whose average income is$132,000) by an average of $530. These increases are about 3.2 per cent and 0.4 per cent of the respective incomes. You will note that the Working Family Tax Relief Act is intended to be “revenue neutral” and so doesn’t upset last year’s budget agreement.

The simplest proposal has been made by Representative Dan Rostenkowski (D.-Ill.), Chairman of the Joint Committee on Taxation, who would allow a tax credit equal to one- fifth of Social Security and Medicare taxes. He would pay for it by boosting the tax on the richest 1 per cent; so he would be revenue neutral, too.

The effects of his plan on individuals look like this: The median family had an income in 1989 (the latest figure I can lay my hands on) of $35,975. Assuming that the entire income is from wages, the family pays $2,752.09 in Social Security taxes (which is an outrage, as Senator Moynihan says). One-fifth of that tax is $550.42, or $10.58 a week-not enough to make a difference in financing a new car or a new home or even a new video camcorder, but certainly welcome as a help in covering expected increases in bus and subway fares.

Chairman Rostenkowski’s average cut is about the, same as Senator Gore’s for a $75,OOO income. Since the Chairman’s plan is tied to Social Security taxes paid, the benefit for the lowest quintile of taxpayers is dramatically lower – $161, as opposed to the Senator’s $875. Also, of course, the cap on Social Security taxes puts a cap on Rostenkowski’s benefits – about $8S0, which would apparently be available to everyone right up to whoever succeeds Donald Pels as leader in the income sweepstakes.

Speaker Tom Foley of the state of Washington says he expects the House to pass Rostenkowski’s plan. Congressman Newt Gingrich of Georgia, the Republican whip, sneers that the plan would merely redistribute the wealth but would not make more money available for investment. For my part, I don’t think redistributing the wealth is such a bad idea. After all, those at the top of the income pyramid had wealth redistributed to them by the Kemp-Roth tax law 10years ago. As Jeff Faux of the Economic Policy Institute puts it, the bill should be sent to those who went to the party and are thirsting for another one.

If the purpose is to jump-start the economy, the trouble with all these plans is in the timing. Even if we could get Congress and the President to agree on one of them, could run it successfully past the House Ways and Means Committee and the Senate Finance Committee, and could manage veto-proof majorities in both houses (in case the President noticed at the last minute that the cost of an abortion would still be a deductible medical expense} – even then little good would come of it in our winter of discontent.

With luck we might put our 1040s in order by April 15 and begin getting our hands on the increased disposable income a week later, with spring already a month old. The economy would no doubt be startled, but the time for jump-starting would be past. This is not to suggest that the tax schedule should not be changed, and right quickly. As I’ve said before (see “The Evils of Economic Man,” NL, July 9-23, 1990), our economy and the society it supports are in for a long decline unless we correct our present course toward increased polarization.

So the correct answer to the multiple choice question asking which scheme will end the recession seems to be “None of the above.” None of the proposals on the table is likely to do much to get the economy out of the doldrums. Furthermore, they are not self-sufficient. Each silently assumes that a further step will be taken, yet that depends on whether their beneficiaries will be of a mind to take it. If they are not psychologically ready to spend their benefits with enthusiasm, the effects on the economy will be tentative and minimal.

WHAT IS needed is something positive to get money circulating – to get people working, to get consumers consuming, to get producers producing. I can think of two ways to achieve these results.

The first is the way we’ve done it for the past decade: Damn the deficit and go ahead with a military buildup. The effectiveness of defense spending has been demonstrated repeatedly over the centuries, from Periclean Athens to Reaganite America. Not the least of its virtues is its dramatic size. It is plainly visible. Its impact on localities and industries and job classifications can be calculated and counted upon, and so can the multiplier effects that spread throughout the economy. Plans can be made to get a piece of the action. Things start stirring very quickly.

Happily, there is another way. We are not doomed to waste our wealth and energy on devices we hope will never be used. Again we can learn from Periclean Athens, which is remembered now less for the power of the Delian League than for the wonders of the Acropolis, the most glorious public works project the world has yet seen.

American public works projects have hitherto been hampered by the lack of ready plans; consequently, they have been viewed as too slow-starting to be useful in ending a recession. But it happens that this is not true today of the states and municipalities.

Partly because of the niggardliness of the Reagan-Bush “New Federalism,” and partly because of the current recession, state and local governments have been in trouble for a couple of years and are in grave trouble now. Caught between constitutional requirements that they balance their budgets and the blind frenzy of taxpayers’ revolts, they have had to abandon capital improvements, emasculate services and fire thousands upon thousands of employees.

These draconian measures could be reversed in a moment. New York City alone has a list of several hundred bridges it needs to repair. Work on many of these could start tomorrow if money were available. In almost every city and suburb, library hours have been reduced and branches closed; what only a year ago was a marvelously helpful and rapid system of inter-library loans currently operates only sluggishly. The people who used to make that system function could be rehired overnight. The second cop who used to man patrol cars is also ready to return to duty in a flash. A year’s volume of this magazine could be filled with examples from every corner of the land.

If Federal grants to state and local governments were restored merely to the same proportion of Federal expenditures as in 1980, a sum of $63.1 billion would be available to fund such projects and break the back of the recession-peacefully. Could we do it? Well, we spent a lot more than that trying to drive Saddam Hussein from office. We could do it, all right, if we had the sense and the will.

 The New Leader

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By George P. Brockway, originally published October 7, 1991

1991-10-7  The Long and Short of Interest Rates Title

PEOPLE are beginning to growl that recovery from the recession is being delayed by the slow growth of the nation’s money supply, which seems in danger of falling through the bottom (or “lower parameter” if you want to be fancy) of the Federal Reserve Board’s target. The said target is to keep the annual rate of increase between 2.5 and 6.5 per cent.

Now, suppose that the Reserve agrees that the money supply is in danger of falling through its bottom. Resolved to their own selves to be true, they have to increase it. What do they do? The most obvious thing would be to coin some more coins and print some more paper money. But what would they do with it?

You may be sure that they wouldn’t send a packet of the stuff to each of us by Express Mail. Nor would they add to our savings accounts (although they firmly believe we ought to save more).

Instead, the Reserve would make it easier and more profitable for the banks to lend us money. We have some credit, represented by a plastic card that we show to a shoe clerk, who makes a copy of all the numbers, has us sign it, and hands us a pair of shoes. We have spent our credit like money, except we now are in debt to the bank that sent us the card.  Our credit has become money by becoming debt. Businesses create   money in the same way when they take down their line of credit extended by their friendly banker.

This pleasant arrangement expands the money supply, but it is limited in various ways – the chief one being the interest rate, the price banks charge us for the use of money. There are those whose doctrine requires them to pretend that the Federal Reserve Board has no control over interest rates, that they are made in the market, if not in heaven, by an invisible hand, and no mere mortal can do anything about them. More sophisticated observers recognize that the Reserve really and truly does determine short-term interest rates. When the Board sets the Federal Funds rate or the Discount rate, it is setting a rate at which banks can borrow (short term) from each other or from the System. When the Federal Open Market Committee buys or sells bonds, it raises or lowers the price of bonds and consequently is lowering or raising the interest rate. If the Board did not set at least short-term rates in these ways, it would be hard to ascribe any significance to its activities.

Indeed, the fact is that whenever the Reserve fears the money supply will fall through the lower parameter, it lowers the interest rate. It claims to control the money supply, yet all it can actually control is the interest rate.

If that is the case, why doesn’t the Board say so? I regret to have to tell you that it is possessed by doctrines that might have made sense in the days of mercantilism but have nothing to do with a modern capitalist economy.

In the days of mercantilism money was a commodity-gold, silver, sea shells, or some such. Trade was essentially barter. You swapped grain for silver, and then you swapped the silver for candles. At any given time (say, 1492) there was a certain amount of silver in circulation, and other commodities traded at more or less stable prices in terms of silver. Christopher Columbus (whether he discovered America or not) made a historical difference. The European supply of silver multiplied rapidly, while the supplies of other commodities, being agricultural products or custom made goods, expanded slowly, if at all. Some of the increasing supply of silver was swapped for the stagnant supplies of other commodities, whose prices rose.  Hence the notion that prices depend on the money supply.

Although the Federal Reserve Board seems not to have noticed, the modern economy is quite different from that of pre-Industrial Revolution days. As Karl Polyani rather sorrowfully pointed out, goods are now produced for the market, rather than on special order. While occasional shortages are far from impossible, industry is so organized that if a demand for an especially cute T-shirt suddenly develops, the supply can be replenished in a few hours or days. Since the supply of most commodities is now indefinite, if not infinite, the supply of money has no substantial effect on prices.

The way the interest rate is managed does, however, have an effect on prices. Here, again, is a historical change the Reserve has failed to notice. A frequently cited survey, published in the Harvard Business Review in 1939, reported that business people then paid little attention to the interest rate in making their plans. A few years later I was a business planner myself, and I assure you that’s the way it was. After all, the prime rate, held down by an “accord” between the Treasury and the Federal Reserve, was only 1.5 per cent. The accord was annulled in 1951, whereupon the Reserve embarked on its long and still-continuing hunt for the inflation snark, with the result hat today interest is one of the most prominent and most unpredictable costs of doing business.

Here, yet again, is a historical turning – one that has been missed by most mainstream economists but has been forcefully called to the attention of most businesspeople. If you have ever met a payroll, you know that your costs are an inescapable factor of the prices you charge. When your costs go up, so must your   prices, if you propose to stay in business. For 40 years now the Reserve has been idiotically trying to control inflation by inflating the cost of doing business.

In short, the price of money matters. Unhappily, it is widely believed – even by many who agree the Reserve can set short-term rates – that long-term rates are set by the “market” anticipating what the future will bring. Some say that the market anticipates the future rate of inflation; others that the market anticipates the short-term rates the Reserve will set in the future. In the former case, long-term lenders think of themselves as lending purchasing power and want to get their purchasing power back, with interest. In the latter case, long term borrowers guess that borrowing will be more expensive in the future than in the resent because the Reserve will, in its anti-inflation battle, allow (or force) short-term rates to rise.

It will be seen that the customary policies of the Federal Reserve Board work to reinforce both groups. Inflation, of course, is the Board’s panatrophy, and raising the interest rate is the Board’s panacea. What borrowers and lenders anticipate in, the long future is that the Board will continue to pursue the policies it is pursuing today. They may be wrong, just as prophets may be wrong about what the Board will do tomorrow morning. he point is that, regardless of the Federal Reserve Board’s intentions, its actions effectively control the long-term interest rate as well as the short-term rate.

THE SAME POINT may be reached from another direction. Keynes deplored the fact that most professional investors and speculators “are concerned, not with what an investment is really worth to a man who buys it ‘for keeps,’ but with what the market will value it at, under the influence of mass psychology, three months or a year hence.” In the 55 years that have passed since Keynes published this judgment, three months or a year has come to seem an unusually long time to hold an investment.

1991-10-7  The Long and Short of Interest Rates Nicholas Brady

The bond market is a place where people buy and sell bonds in which at least the seller did not intend to invest for keeps. Portfolio managers and professional traders treat long bonds and short bonds alike, and treat both as they treat stocks. They rank them according to their relative safety and relative liquidity and so on; and in that ranking it will happen that some long bonds are judged more liquid than any common stock. (After all, common stocks are “longer” than long bonds because they do not promise to return your money.) In all cases, long-term or short-term, the traders’ question is what the market will bear tomorrow, not what will happen over the next 30 years.

This being so, the long-term interest rate is not a separate problem. Even new bond issues are priced in relation to the current market, and that is priced in relation to short -term interest rates. Therefore, all interest rates respond to the activities of the Federal Reserve Board.

But may not international rates restrain those activities? In response to that question apologists for the present system will surely warn us about a flight from the dollar. We will be reminded that former Board Chairman Paul A. Volcker was tireless in arguing that interest rates had to rise to attract foreign money to finance our budget deficit. Rates had to stay high to keep the foreigners from pulling their money rugs  out from under us. Treasury Secretary Nicholas F. Brady has a similar fear of flying.

Who are the foreigners whose money is so important to us? Everyone knows that mainly they’re the Japanese. That knowledge should give us furiously to think. For the money that lands on our shores takes off from theirs. The flights to the dollar are flights from the yen. Yet their economy has been outperforming ours for the past many years. Have they outperformed us because they sent their money to us? Hardly. But their domestic saving and their currency’s flight had the same cause. Both were the result of their comparatively low interest rates and correspondingly high production (not productivity, but production). It was their expansion of employment and plant and output that made them prosperous.

Don’t let anyone tell you that Japan’s interest rate was so low because Japan’s savings rate was so high. In the first place, you have to produce a lot before you have a lot to save. You can’t save what does not exist. In the second place, Japan’s recent hike in its interest rate was not caused by a fall in savings but by the cold -blooded and wrong-headed decision of its central bank. The increased interest rate will reduce economic activity, and reduced savings will follow as a consequence, not as a cause.

The Federal Reserve Board’s money growth target is irrelevant. The Reserve should set the short-term interest rate at least as low as it did during the 1942-51 accord with the Treasury. The long-term rate conformed then, and it would do so today.

 The New Leader

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