Posted on 05/17/2003 10:14:00 PM PDT by TomAdkinsCC
CUTTING RATES TO THE BONE
Why Interest Rate Cuts Don't Always Work
by Tom Adkins CommonConservative.com 05/16/03
Once again, Alan Greenspan raised interest rates to combat a nonexistent 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 minuscule 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.
Woven 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%. That takes money out of the productive cycle of the economy, and serves to slow growth 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.
*Tom Adkins is the publisher of CommonConservative.com
Of course, the difference between long-term and short-term rates means such behavior is not always effective. If there's a perception that short-term rates will drop, that drop will likely factor into long-term rates. Likewise if there's a perception that they'll rise. I don't think this is fully factored in by the market, though, since mortgage rates have tended downward even though they only place short-term rates can really go is up.
BTW, two points about taxes:
Waiting for a little while, to see how things shake out... When the real-estate prices really tank out, that's when I'll make my move... Get as many pieces of property as I can leverage into, and then rent/lease as needs be...
All I have to do is wait.... ;)
The government has just been playing with the first two. They have completely ignored the third.
When they get serious about spending cuts - hundreds of billions of dollars of them - then this economy could start a meaningful recovery. Until then, it's balancing on a three legged stool having only two uneven legs.
Actually it's (4). Move the mall overseas.
It doesn't matter how low the rent is when no one in town has the means or the customers to pay the rent.
Sadly, "This country IS somewhat like a shopping mall". Everyone is shopping, no one is producing. That can only last so long, which is why the (fictitious) mall is on the verge of closing.
Well, I was trying to suggest that the mall was analagous to the U.S. government; tenants represent tax-paying businesses, and the rent of course represents taxes.
Your #4 would be rather interesting given that analogy--the government itself moving overseas?
I understand from a simple metaphorical approach, but I suspect there are other factors this time.
Chinese are producing.
Glad I wasn't the only one. I believe that one day, students of history will look back on this time and wonder "just what the Hell were they thinking?!"
The 800 pound gorilla that the policy makers will not (or cannot) acknowledge is the amount of consumer debt still being carried. One more round of Fed-induced refinancing and that will just about eat up the remaining equity, even based on inflated house valuation. The ones who jumped into variable rate mortgages will be the first to fall when Greenspan has to try to put the inflation monster he is feeding back on a leash.
All I have to do is wait.... ;)
Be ready to wait for a while. I have a very nagging feeling in my gut that says that the popping of the real estate bubble will likely manifest itself with a relatively quick 10-20% drop, and then, after some buying interest surfaces, well be treated to home values dropping sort of like a lot of peoples' 401k's...every month people see it dropping and eventually stop watching because it's too depressing. THAT is when you pick up the ex-wife's assets for pennies on the dollar!
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