Tuesday, September 22, 2009

Art Laffer on the Economy During the Depression and Now

Arthur Laffer's op-ed in today's WSJ deserves serious analysis.

He begins this way:
The 1930s has become the sole object lesson for today's monetary policy. Over the past 12 months, the Federal Reserve has increased the monetary base (bank reserves plus currency in circulation) by well over 100%. While currency in circulation has grown slightly, there's been an impressive 17-fold increase in bank reserves. The federal-funds target rate now stands at an all-time low range of zero to 25 basis points, with the 91-day Treasury bill yield equally low. All this has been done to avoid a liquidity crisis and a repeat of the mistakes that led to the Great Depression.
True, but Laffer neglects to point out that the Federal Reserve now pays interest on its reserves, which has resulted in excess reserves skyrocketing, since banks are simply parking funds with the Fed and not loaning them out. Thus, money supply is not growing. Currency, as Laffer points out, and the money supply (which he doesn't point out) haven't grown by any significant amount since February. The phrasing in this paragraph is interesting, though, and it will allow Laffer to imply something that isn't occurring, namely, that we are in an easy money period.

This is not an easy money period. In fact, if Ron Paul were running the Fed, my guess is money supply growth would be exactly where it has been for the last six months, near zero. For all practical purposes, Bernanke is running a Ron Paul type monetary policy, right now.

But watch Laffer try to hint otherwise:
Even with this huge increase in the monetary base, Fed Chairman Ben Bernanke has reiterated his goal not to repeat the mistakes made back in the 1930s by tightening credit too soon, which he says would send the economy back into recession. The strong correlation between soaring unemployment and falling consumer prices in the early 1930s leads Mr. Bernanke to conclude that tight money caused both. To prevent a double dip, super easy monetary policy is the key.
His purpose for setting up this strawman is a real, well, laugher. He wants to blame the length of the Great Depression on tax and tariff hikes:
While Fed policy was undoubtedly important, it was not the primary cause of the Great Depression or the economy's relapse in 1937. The Smoot-Hawley tariff of June 1930 was the catalyst that got the whole process going. It was the largest single increase in taxes on trade during peacetime and precipitated massive retaliation by foreign governments on U.S. products. Huge federal and state tax increases in 1932 followed the initial decline in the economy thus doubling down on the impact of Smoot-Hawley. There were additional large tax increases in 1936 and 1937 that were the proximate cause of the economy's relapse in 1937.
There is no question that the tariffs and taxes seriously intensified the depression, but the seeds of the depression were planted long before the tax hikes and tariffs were even a glimmer in the eyes of government manipulators. It was the money expansion prior to 1929 which distorted the economy and led to the Great Depression, and which was then were amplified by increasing taxes, tariffs, public works programs and minimum wage laws.

And, while taxes didn't cause the Depression, Laffer is correct to chronicle the tax increases, which were a significant drag on the economy. Laffer continues:
But the tax hikes didn't stop there. In 1934, during the Roosevelt administration, the highest estate tax rate was raised to 60% from 45% and raised again to 70% in 1935. The highest gift tax rate was raised to 45% in 1934 from 33.5% in 1933 and raised again to 52.5% in 1935. The highest corporate tax rate was raised to 15% in 1936 with a surtax on undistributed profits up to 27%. In 1936 the highest personal income tax rate was raised yet again to 79% from 63%—a stifling 216% increase in four years. Finally, in 1937 a 1% employer and a 1% employee tax was placed on all wages up to $3,000.

Because of the number of states and their diversity I'm going to aggregate all state and local taxes and express them as a percentage of GDP. This measure of state tax policy truly understates the state and local tax contribution to the tragedy we call the Great Depression, but I'm sure the reader will get the picture. In 1929, state and local taxes were 7.2% of GDP and then rose to 8.5%, 9.7% and 12.3% for the years 1930, '31 and '32 respectively
And his warning about the damage of increasing taxes is one we should all take to heart:
The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I'd give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s. Net legislated state-tax increases as a percentage of previous year tax receipts are at 3.1%, their highest level since 1991; the Bush tax cuts are set to expire in 2011; and additional taxes to pay for health-care and the proposed cap-and-trade scheme are on the horizon.
Laffer then goes on:

...The 1933-34 devaluation of the dollar caused the money supply to grow by over 60% from April 1933 to March 1937, and over that same period the monetary base grew by over 35% and adjusted reserves grew by about 100%. Monetary policy was about as easy as it could get. The consumer index from early 1933 through mid-1937 rose by about 15% in spite of double-digit unemployment. And that's the story.

The lessons here are pretty straightforward. Inflation can and did occur during a depression, and that inflation was strictly a monetary phenomenon.
Here, Laffer is implying, but not really stating, that because money supply went up, and the unemployment rate was still high, that the money supply growth failed to take the economy out of the Great Depression. He wants to just focus on taxes. What a way to cherry pick your data. Unemployment was high because of government regulations which prevented wages from falling while other prices fell in the early parts of the 1930s. The later climb in CPI was not enough to adjust for the floor placed on wages. The ensuing high unemployment is why it is viewed by the general public as still a period of depression. And, indeed, in this sense it was. But it wasn't because money supply growth wasn't doing its tricks. The stock market tripled during that period. At the start of 1933 to the end of 1936, the Dow Jones Industrial Average climbed from 60.26 to 179.90. And the NBER does not view the period of 1933 through 1936 as a period of recession. This wasn't as Laffer is implying, a period when money supply growth proved inefficient in propping up the economy. The multi-year advance of the stock averages is proof enough of that.

It was the regulations which put a floor on wages above market rates.

Laffer concludes:
My hope is that the people who are running our economy do look to the Great Depression as an object lesson. My fear is that they will misinterpret the evidence and attribute high unemployment and the initial decline in prices to tight money, while increasing taxes to combat budget deficits.
In other words, he doesn't want the Fed to print money. The Fed not printing money is a good thing. If the Fed got out of the money manipulation business, there would be no business cycle. But, Laffer is not basing his call on the belief that the Fed should be out of the money printing business. He is making the call because he is saying that money printing does not prop up the economy, and he points to the unemployment numbers in the 1930s as his eveidence. But, money printing, albeit in a distorted fashion, does prop up the economy.

Bottom line, money supply is an important factor in causing inflation (as Laffer points out), and a major factor in distorting the economy (Which Laffer ignores). Laffer's focusing on the unemployment rate simply distorts what went on during the period 1933 to 1936. Yes, price inflation can be said to always be a monetary phenomena, but so can the business cycle. Taxes, tariffs, regulations all distort the economy, but the business cycle would still exist if these roadblocks were permanently removed and central bank money manipulation continued.

1 comment:

  1. How can anyone consider Laffer after Peter Schiff schooled him so badly on national TV? Right or wrong, he will never have any credibility regardless of what he says at this point.