Cutting Rates To The Bone
By Tom Adkins (05/18/03)
Once again, Alan Greenspan raised interest rates to combat a non-existent inflation boogieman. And once again, he's cutting those rates to fix the economy he devastated. And once again, it's not working. But why? Aren't rate cuts supposed to spur the economy into the stratosphere? Isn't Alan Greenspan and his Federal Reserve capable of breathing life into any dead economy?
No. There are two words that prove this theory wrong: wealth creation.
Let's regress a bit. During the first Bush administration, Greenspan jacked up rates because he saw growth. And like any old school Keynesian economist, he associates growth with inflation. Wrong. In fact, inflation has never coincided with a strong, supply side growth economy. And rate cuts alone won't boost an economy.
Here's why. Theoretically, if rates drop, people will have extra money to spend. Companies can refinance debt. And so can people. There are two things this doesn't consider. First, confidence means a lot. And Greenspan's 2000 interest rate attack on inflation was scattershot, taking out whole segments of the economy, including the stock market, along with the miniscule inflation threat. When the average family saw the 401k disappearing, they became less likely to buy that big screen TV. And second, if a family doesn't have any money, rates don't matter. When a peek at the wallet says there's fifteen bucks, it doesn't matter whether rates are 9% or 2%. They won't buy a new land-yacht for the driveway berth without cash in pocket. And this goes for businesses as well. Nobody spends money if there's no money to spend.
The Japanese found this out the hard way. Their bizarre economy is a combination of free markets within quasi-feudal statism, complete with quotas and protectionism. Once their vaunted efficiency revolution was fully exploited, their economy landed with a thud, with nowhere else to squeeze wealth production.
That's why tax cuts work. From hot dog vendors to ship builders to the average family on Maple street, when they look at the bank account and see an extra couple thousand dollars, confidence roars back. In fact, every strong economy has been preceded by significant tax cuts.
Let's take an edited look at the characteristics of the six major tax changes since 1960: Kennedy cut taxes, growth doubled, treasury revenue shot up and we had low inflation. Carter's new taxes and regulation maze slowed the economy, and revenues were relatively flat. The economy screamed when Reagan's tax cuts kicked in, doubling revenue with almost no inflation. Dad Bush's tax increase stalled the economy in its tracks. In the midst of recovery, Clinton's retroactive tax hikes created the worse two years since Carter, with almost no growth, and after a brief confiscatory bump, no revenue growth. When Clinton signed on to the GOP capital gains "tax cut for the rich", the result was an amazing expansion of growth and revenue. And in every case, the tax cuts resulted in the rich paying more. Today, the richest 10% pay 50% of the taxes, and the lower 50% pay 3% of all taxes.
Weaved throughout this picture is Greenspan's Fed movements. In the middle of GHW Bush's term, Greenspan raised rates, compounding the tax hike effect. Clinton benefited from mild rates, and thus the tax hikes worked wonders.
Of course, economies are complex, and all sorts of other issues throw weight into the discussion. Carter's inept foreign policies led to severe oil price hikes, creating "stagflation", an inflationary economy with no growth. Reagan's expert diplomacy led to less military spending, while GHW Bush's go-along attitude led to a Democrat congress squandering money on wasteful domestic spending. Clinton's survival instincts leg him to sign the tax cuts and welfare reform, which kick-started the economy he almost ruined.
That leads us to today. George W Bush inherited an economy that had taken two major hits. First, Greenspan's rate hikes crushed business growth and slowed spending. Second, Wall street discovered the Clinton administration had been "cooking the books," lying about revenue and growth. As businesses scrambled to ratchet down plans for market expansion, this created the first stock market stall. Once in office, the economy took a third and fourth hit. The corporate scandals erupted, as a few major companies shared the Clinton accounting recipe as the Clintons. Then came 9-11. And the economy was in a free fall.
Yet most economists will agree that the first round of Bush tax cuts cushioned the economic blow by generating a respectable 3% growth. And most politicians agree that tax cuts will help grow an economy. They are divided only on one issue: what will the tax cuts cost? Any politician that asks this question is either wholly ignorant of any economic issues or too partisan to represent America. (either way, unqualified for office) Tax cuts don't cost revenue. They produce revenue. The indisputable Laffer curve, which shows you can get the same revenue from two different tax rates, explains the inverse relationship between lower taxes and higher revenue. Otherwise, North Korea and Cuba would have the strongest economies in the world, and the Soviet Union would have certainly buried us long ago. Instead, Russia has a solid 6-8% growth with their new flat tax system. And people eat bark for dinner in North Korea.
What Alan Greenspan and most Keynesian economists (yes, Greenspan is Keynesian) fail to understand is the difference between productivity and inflation. When strong productivity kicks into high gear, you can have amazing growth with no inflation. In fact, you often get deflation. That's why televisions and computers keep getting better and cheaper. But you can also have deflation from a poor economy, as companies start cutting everything to the bone, including quality and service. It's like eating your leg to avoid starvation. That is what we are starting to see now. The old supply/demand/inflation/deflation paradigm doesn't apply. Yet Greenspan keeps applying.
Above all, the government keeps spending money when it doesn't need to. The budget is over 2 trillion dollars, and there isn't anyone alive who can make the case that waste is below 30%. Thattakes money out of the productive cycle of the economy, and serves to slow growt dramatically. It also serves to make it harder for tax cuts to get passed.
That brings us back to the original issue of tax cuts, rate cuts and spending cuts. Cut one, and you are likely to see modest movement. Cut any two, and you'll see a decent improvement. Cut all three, and the American economy might shed the shackles that keep us spinning our wheels without going anywhere. All we need is a congress and a Fed chairman who can actually grasp capitalism and the new economy. With Washington relying on emotional answers to solve emerging economic change, that won't happen soon.
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